Redeemability and Reserves
November 23, 2008
Wow, Citigroup is banging on the doors of the Treasury saying “save my bankrupt ass!” Here’s how you do it with Citi:
By the way, this Citi debt/equity swap converts about $560 billion of debt into equity. After a mega-writedown, Citi has about $400 billion of equity. A nice, clean bank like Citi-post-restructuring should get maybe 1.5x book (less than 2x due to the overcapitalization, which would impair ROE, but give them some credit for the franchise). So, $400 billion of equity has a market value of perhaps $600 billion. This means that the debt holders swap $560 billion of debt for $600 billion of equity. Not a bad trade, considering the alternatives.
But, today’s subject is the idea of “redeemability,” regarding currencies. I’ve said before that having a “reserve” that is “backing” a currency is really an imaginary concept. Locking a bunch of metal in a vault does not make some paper printed with presidents’ faces worth any more than it would be worth otherwise. I liken it to the huge safe, with massive metal door, typically on prominent display at retail banking operations. This is to make people who don’t understand how banks work feel “safe” that their money is in the “safe,” even if they actually know that their money isn’t in there. What makes their money “safe” is not the huge steel door, but whether bankers are doing their job properly (by avoiding excessive leverage and credit risk).
Actually, the same thing applies to foreign exchange reserves as well. Having a bunch of foreign bonds locked in a vault doesn’t manage the value of paper currencies either. Why should worthless paper trade as if its has value, just because some bonds are locked in a vault somewhere?
I’ve said before that the key to managing any sort of currency — of making worthless paper useful as money as if it was a gold coin — is the adjustment of supply to meet changing demand. The economist David Ricardo summed this up quite nicely in 1817, in a quote which is in my book:
It is on this principle that paper money circulates: the whole charge for paper money may be considered as seignorage. Though it has no intrinsic value, yet, by limiting its quantity, its value in exchange is as great as an equal denomination of [gold] coin, or of bullion in that coin. . . .
It will be seen that it is not necessary that the paper money should be payable in specie to secure its value; it is only necessary that its quantity should be regulated according to the value of the metal which is decalred to be the standard.
Principles of Political Economy and Taxation, 1817
Now, the interesting thing about this quote is that the British pound was actually a floating currency at the time, and had been for nineteen years. Ricardo was explaining how to peg it to gold again. This was accomplished in 1821, and lasted until World War I. So, these ideas were put into practice, and worked.
There are many ways to keep a paper chit’s value pegged to gold, but they all involve this adjustment of supply. Within these many methods are a subcategory of systems that involve redeemability.
The heart of any system of redeemability is the adjustment of supply in response to the outflow of reserves, as people take advantage of the currency’s redeemability. It goes the other way as well — when demand for currency increases, a natural outcome of economic growth, then currency supply increases. However, the situations which tend to become crises are when demand falls and a currency’s value declines, causing requests for redemption.
Under a proper system of redeemability, when, for example, someone wants to sell rubles and get dollars in return, the central bank (the currency manager in this case) will take the rubles and deliver the dollars. At this point, the supply of rubles must contract in proportion to the amount of currency redeemed. Last week, I explained that the ruble monetary base should contract by the same amount as the foreign exchange reserves expended in supporting the currency’s value.
We see here that the redeemability element is really a trigger that sets into action the supply adjustment process which is what is really managing the value of the currency. When a central bank sells “reserves”, whether foreign exchange reserves in the case of Russia or gold in the case of the U.S. in the 1960s, but does not adjust the monetary base appropriately, then the effect is just as if you or I sold dollars or gold for less than the market price. We would soon be sold out. It might take a while for this to happen, if we have enough gold or foreign exchange, but the end result is the same. If base money is not adjusted, then nobody is managing the currency, and it is just floating around as the result of ignorance and negligence.
When you have a fully functional system of redeemability, in effect you have a currency board. A currency board typically holds dollars (foreign exchange reserves) on a 1:1 basis with existing base money. If you wanted to peg the Polish zloty to the euro, as would be appropriate since Poland is now part of the eurozone and makes great use of euro-denominated funding, here is what you would do. Let’s say that the Polish monetary base was $100 billion zlotys, and they had a 5:1 relationship with the euro. (5 zlotys to the euro exchange rate target.) Then, the currency board would own $20 billion euros in the form of foreign reserves. First, let’s look at how the currency board could expand the monetary base. A Polish bank finds that it is issuing lots of zlotys. Someone who has a zloty bank account makes a withdrawal of zlotys in cash. The bank then sells a euro bond out of its portfolio in Frankfurt, and takes the euros received in return to the currency board. The currency board takes the euros and delivers zlotys. Now, the currency board has a few more euros in its reserves, and has issued more zlotys, so that they both maintain a 1:1 relationship.
Now, for whatever reason, people are selling zlotys and taking euros in return. The currency board buys the zlotys at 5/euro, and delivers euros in return. The central bank would buy the last zloty in existence as it delivered the last euro. The zloty is, in effect, a warehouse receipt for a euro.
It is easy to see that this system is basically foolproof, if it is properly adhered to. The “lender of last resort” function, in this case, is performed by the ECB. Polish banks borrow euros on the euro money market to obtain zlotys, if they need them.
Now, what doesn’t work is if the central bank buys zlotys at 5/euro but does not reduce the supply of zlotys. Let’s say people want to dump 20 billion zlotys and get 4 billion euros. Maybe they have lots of euro-denominated debt coming due. Who knows. The central bank takes the zlotys and delivers the euros, but the zlotys are not removed from circulation. Typically, they are reissued via some sort of domestic open-market operation, known as “sterilization,” but there are a number of ways this could happen. In any case, the supply-adjustment process is not being properly performed. Afterwards, you still have 100 billion zlotys, but only 16 billion euros. A week later, people dump another 20 billion zlotys on the central bank. At the end of that week, there are still 100 billion zlotys, and now 12 billion euros. You can see where this leads.
So, it is easy to see that a 1:1 or “100%” reserve ratio, in combination with proper management of the redeemability function as a currency board would operate, is a very strong system. In terms of gold, the gold ETFs work basically in this manner. They hold a 100% gold/shares ratio. Actually, there is some doubt about this, both regarding whether the bullion is really there and also what the implications of shorting ETF shares is on the share/bullion ratio. But, that’s the basic idea. The ETF shares are pegged to gold, using the process of supply adjustment just like a currency board would operate.
Unfortunately, the problem with applying this sort of system to gold is that there just isn’t enough gold out there to use this sort of system with a major international currency like the dollar or euro.
At this point, there is always some hard case who insists that it would work IF the dollar was redeemable at a rate of something like $5,000/oz. They just take the amount of gold in reserves, the monetary base (or some money measure), and do the math. Well, they just said themselves that the dollar is worth only 1/5000th oz. of gold. Which is a mammoth devaluation. A gold standard is supposed to prevent currency devaluation, not cause it! A dollar that is worth only 1/5000th oz. of gold is not worth very much. So, you would have to hold more of it. A cup of coffee would cost $15. That means that you would have to have maybe $1000 in your wallet. In other words, you would need many many more dollars than people need today, because they would only be worth 10% of today’s value. You can think of money as a sort of manufactured product that is used for economic transactions. Just as a larger economy tends to use more electricity or steel, it also tends to use more money. The amount of money that an economy uses (or, you could say, “wishes to use”) is dependent on economic conditions. It doesn’t change just because there is X or Y amount of gold in a vault, or someone has some big ideas. If you made the dollar worth 1/20th oz. of gold instead of 1/5000th, the amount of “money” needed by the economy would be about the same. The dollars X dollar value = total value amount would be about the same. That’s why I say that these systems only work if everyone is very poor. There isn’t enough gold to serve as currency (in the form of coins, or a 100% reserve system, which is almost the same thing) with today’s economy. However, since the amount of gold in the world doesn’t change much, if you had an economy that was 90% smaller, then there would be enough gold. Actually, you would need money use that was 90% less, not necessarily a 90% smaller economy. But you get the idea.
However, with that said, you can also have a partial reserves system, which uses redeemability. For example, let’s say a currency was redeemable at $100/oz. of gold. The monetary base is $10 billion and there’s 10m oz. of gold in reserves. Note that 10m oz. X $100 = $1 billion. So, there’s a 10x larger monetary base than gold reserves, or a 10% reserves coverage. The currency manager (central bank) holds the other 90% in the form of government bonds denominated in domestic currency.
In a healthy economy, the monetary base will tend to grow over time, roughly in line with nominal GDP. So, let’s call that 4% per year just for kicks. As the central bank issues more currency, it adds to its gold reserves so that they maintain a 10% reserves ratio. Then, there is some crisis that results in a contraction in demand for money, so people want to redeem their currency for gold. We might ask here: what sort of crisis? If the currency is properly managed, then the crisis shouldn’t be a currency crisis. So, the most common reason for central banks to experience this problem is already taken care of, by not creating the problem in the first place. Historically, a common reason for this sort of rush to currency redemption was the outbreak of war. Widespread bank failure could be another.
Since the normal growth rate is about 4% per year, in some sense a 0% growth rate already represents a significant contraction. However, let’s go beyond that. More requests for redemption come in. The central bank could contract the base by 10% using its gold reserves, which is actually quite a large amount. That should really be enough for most conceivable problems except perhaps invasion by a very large army. One this 10% is gone, the central bank can still reduce base money using sales of debt, which is also effective, but obviously there is no more redeemability in bullion.
Another thing the central bank could do is to also sell bonds in a 9:1 ratio to gold redemptions. So, if there are requests to redeem $1 million into 10,000oz. of gold, then the central bank would also sell $9 million of bonds, and make the currency received in trade disappear. This would of course reduce the monetary base by $10 million in total. This would also maintain the 90%:10% reserves ratio “on the way down” so to speak, just as it was maintained “on the way up.” It would work fine. Just as with the 100% reserves currency board, the last ounce of gold would depart just as the last bit of currency came in.
From this you can probably see that, instead of using a 90%:10% ratio, you can just use a 100% bonds system, with no redeemability. The value of the currency would still be pegged to the gold target, but the government wouldn’t actually take currency and deliver bullion in return. In this case, anyone who wanted to trade currency for bullion would still be able to do so, on the private bullion market. If the private bullion market ratio of currency/gold threatened to diverge from the proper parity, the currency-board type system would sell bonds and reduce the amount of base money, exactly as if a 100% bullion reserve system was operating. Remember, it’s this supply-adjustment function that pegs paper to gold, not gold. The supply-adjustment process is something that people do, not gold or foreign bonds held in a vault.
You can also have a system of redeemability in which the government has no gold reserves. In this case, instead of the currency holder trading his currency for gold in the private market, he trades it for gold with the government, and the government buys it on the private market. The government just acts as an intermediary.
We can see through these examples that the amount of bullion in vaults really doesn’t matter. It can be 100% — even 200%! — and if the currency manager is not properly managing the supply of paper chits, then the value of paper chits will do unpleasant things. Russia started its recent crisis with foreign exchange reserves equal to about 350% of the monetary base. Didn’t work, did it? However, if the currency manager is properly adjusting the supply of paper chits, then the system works whether there is 200%, 100%, 10% or 0% reserve holding of gold in the vaults.
If you ponder this for a while, it will become obvious that today’s central bankers have no idea what they are doing. But, now you know how to do it! Isn’t that amazing?
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from: Jesse’s Cafe Americain
One of the reasons why so many people were bullish a couple weeks ago was that most bear markets burned themselves out around this point, at -45% or so down from the peak. I figured it was at least good enough for a rally. Consider that not only are we on our way further down, but we didn’t even have a decent rally! That speaks of extreme fundamental weakness, which is obvious to anyone who is reading the news. There is so much more to come. People are just getting laid off, stores are just starting to close, the wave of debt defaults is just starting to get going, and U.S. house prices are still too high, if you can believe that. Plus, there might be a tax and currency thing coming up, especially since the Fed is now semi-officially on a “quantitative easing” platform, which is a nice way of saying “printing money.” Or a sovereign default? I’m guessing 5,800 on the Dow, and then maybe we’ll get a decent rally (by that time the Europe/Japan/EM stuff will be absurdly cheap), and then the final fifth wave into oblivion, wherever that may lead. By that time, the stock market may no longer exist. Did you know the Romans had a stock market in the second-century B.C.? By 400 A.D., even money had ceased to exist.
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Some promising indicators: (from the King Report)
The WSJ: President-elect Barack Obama’s new chief of staff, Rahm Emanuel, spoke of the Era of Reform, offering few details but working to shape the narrative of the next administration. He said the current economic crisis offers opportunities for change that wouldn’t have otherwise been possible. “Never let a serious crisis go to waste,” he said.
Emanuel didn’t offer any details on the size of a potential stimulus package next year, but he did make clear that the top priority would be tax cuts. He also stressed the need for “green” infrastructure spending, using mass transit and the upgrade of transmission lines as examples. But he also expressed concerns about the deficit, saying “We need to put fiscal discipline back into economic tool kit.” He presented the five main priority areas for change in an Obama administration: health-care cost control and expansion of coverage; energy independence and alternative energy; improving tax fairness and simplicity; education reforms; and regulatory overhaul that boosts transparency accountability.
I don’t think Obama is going to be a serious tax-cutter. However, he has been making a few baby steps in the right direction, which suggests, at the very least, that he won’t be a big tax-hiker.
The part about “healthcare cost control and expansion of coverage” also sounds promising. There is talk of supposed multi-tens-of-trillions of entitlement obligations up ahead. I’m not that worried about it, because obviously it isn’t going to happen. Actually, as I noted last week, comprehensive national health coverage is already being paid for, in the U.S. In the future, it will continue to be paid for. It will be about 5%-8% of GDP, same as it is now, it will cover seniors and everyone else, just like every other developed country in the world, and that will be that.
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Andrew Sworkin of the NYT agrees with my GM fix:
Maybe the government can get a little BK practice on the automakers, to warm up for the BK restructuring the financial system is going to need.
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Chris Whalen of Institutional Risk Analytics (one of the best so far on systemic credit risk) agrees with me on my AIG fix: the mega-payouts are to make good on CDS liabilities. AIG isn’t being bailed out, it’s AIG’s counterpartys, and I would guess that JPM and GS are high on that list. Whalen says: go through bankruptcy and make the CDS liabilities disappear. I think pretty much all the institutions with big CDS liabilities should do this. Like Citi hmmmm?
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You gotta love this! Hill City, Lakota – November 24, 2008 – In a stunning development, the Free & Independent People of Lakota announced today the introduction of the world’s first non-reserve, non-fractional bank that accepts only silver and gold currencies for deposit.
The Dances With Wolves people? Maybe they can see better than anyone where this is going. Go Lakota!