A closer look at trust in the U.S. dollar and debt ceiling madness | Cumberland Comment

For the last few weeks, we have published commentaries on the monetary policy dilemmas facing the Fed and central banks, the particularly American debt ceiling madness, and bank failures. We’ve discussed the U.S. dollar and the banking system in America and elsewhere in the world. All those discussions are archived on our website at cumber.com.

Several readers have asked about the lessons of history and what observations we can make, based on them, as we look forward into the foggy future. So, here’s a bullet list of observations.

· Money has a long history. Once we left off living in caves, we needed some method to accommodate trade and exchanges. We eventually settled on using metals like gold, silver, bronze, or copper; and we also used pearls and rare gems like diamonds or rubies. The first characteristic of any acceptable form of money is that it has some form of scarcity. That is what gives it value. Pearls were rare; that’s why pearls were a form of currency. Coconuts, on the other hand, are rare in some parts of the world and plentiful in others. On the Nicobar Islands, where fresh water was often lacking, coconut milk provided essential hydration, and coconuts served as a form of soft (though tough to crack) currency. There was even a silver rupee/coconut exchange rate used between Indian traders and the Nicobarese. (See encyclopedia-of-money.blogspot.com/2010/01/coconut-standard-of-nicobars.html.) For obvious reasons, however, coconuts did not gain wide acceptance as a form of world reserve currency. When the form of scarcity has broader acceptance, the “store of value” function of money becomes critical. This is true throughout history, whether the money is a coin or bar like gold or printed paper like the U.S. dollar. Money works because it is broadly accepted. That acceptance requires achieving trust. · When trust is broken, it cannot easily be repaired. Trust is fragile. This is why the international debt ceiling debate damages have already occurred. Distrust is not symmetrical with trust; distrust is a much more powerful force if it becomes the norm. The Weimar Republic fell prey to hyperinflation and the citizens lost all trust in its money. Weimar didn’t start out with hyperinflation; it took a few years to develop. Much the same happened in Zimbabwe recently. Many fiat currencies have similar histories. Distrust of the money is the key; we may see it in Argentina or Venezuela today. In U.S. history, the original continental dollar was inflated, and monetary trust was lost. That is part of what led to a new U.S. Constitution and the beginnings of a national banking system for America. · Governments control money. That is how they find ways to pay for things. Governments sacrifice some of the store of value in return for an exchange. That exchange is spending today and deferring the future obligation to cover the cost until tomorrow. We do that with the use of debt, as America has done for over a century. Or we do that with inflation, as America has also done for more than a century. A functioning government balances these two approaches by keeping the inflation rate low enough to avoid disruption while slowly making the exchange of consumption today in return for the deferral of cost until tomorrow. In today’s world, most central banks have decided that 2% inflation is the target policy inflation rate at which that exchange occurs without much disruption. At 2%, inflation doubles the price level every 36 years. · History provides many lessons from which to achieve the appropriate takeaways. Those lessons apply today and can be used by practitioners who study history. Without the history lessons, folks are left to misinformation and opinion only. But with history as a guide, they can delve deeply into the cause-and-effect relationship between monetary and financial action today and the outcome tomorrow. This exchange is what an independent investment adviser tries to accomplish on behalf of clients.

Let’s recount some history in summary essay form so we don’t have to recite 100 citations. Money became gold-based and stayed that way through the period up to the Persian battles with ancient Greece. Croesus was a gold-backed emperor. Athens had silver mines. The drachma ascended to premier status because the ancient Greeks never debased it. They maintained the value in silver weight even as the Peloponnesian War divided the various Greek city states, and even as the epidemics of the time killed a lot of the population. The leaders of Sparta didn’t debase the drachma even though they won. The leaders of Athens didn’t debase the “owl” even though they lost. In the century after the Peloponnesian War, the Greek temples became lenders, and the notion of a fractional reserve banking system was seeded. Even though there were defaults, the powers in charge didn’t debase the drachma. There is evidence that the Athenian owl was accepted throughout the Mediterranean for almost 600 years and long after Greece was diminished by Rome’s expansions and power. We could point to the Athenian owl as the world’s true first reserve currency with longevity because it wasn’t debased. Rome followed this example in the beginning, and the denarius was maintained in the same tradition as the drachma. But after the Golden Age of Rome, the emperors began to realize they could debase the metallic weight and get away with it. Their picture was on the coin of the realm. They decided what was acceptable legal tender. And they found they could institute a hidden tax by debasing the currency. The silver-content denarius was replaced with the debased Antonian. This slippery slope continued for the rest of the Roman Empire’s history, including its collapse, as wars and pandemics destroyed the population while the money became untrusted. The world plunged into the Dark Ages after the collapse of Rome, until the Renaissance period. Once that evolution opened things up, the need for trade and payments and a reserve currency tied to the trading and payment arrangements created the demand for a reserve currency. Nature abhors a vacuum; payments were needed in a trusted currency. The first of those currencies was Portuguese. It functioned as the world’s reserve currency of choice, and that status endured from 1450 to 1530. Hat tip to Midas Gold Group for details and references. Spain’s reserve currency followed Portugal’s, from 1530 to 1640. Then came the Netherlands, 1640–1720. France was next, 1720–1815. Great Britain lasted from 1815 to 1920. And then came the United States, which has enjoyed world reserve currency status since 1921. Think about this history. Think about almost seven centuries of wars, pandemics, economic exchanges, trade, banking system evolution, extensions of credit among and between merchants and nations. The mosaic comes together. Currencies were trusted because they were trusted, and nothing had happened to undermine that trust. Metal was accepted because it was accepted. The debate between silver and gold continues today. In the times of the ancient Greeks, the ratio of gold weight to silver weight was 14 of silver to 1 of gold. In American history, William Jennings Bryan’s famous “Cross of Gold” speech stands out as the historical political inflection point (historymatters.gmu.edu/d/5354/). Gold won. America’s gold standard was established and maintained until the Great Depression, when President Franklin Roosevelt devalued the dollar and removed gold from transactional exchange. Then the fiat currency standard became the world reserve currency standard, and the U.S. dollar was the only trusted game in town. That state of affairs lasted throughout the World War II period, until the Breton Woods fixed-exchange-rate regime failed in the 1970s and President Nixon closed the gold exchange window and revalued the gold from $35 an ounce to $42. The official rate on the gold certificates held by the Federal Reserve is still $42 per ounce. The gold is in Fort Knox. The certificates are on the balance sheet of the Federal Reserve. Note that the U.S. Congress could reset the price from $42 to something else by passage of a legal change that the president could accept. If they did, and if they moved the price to the present-day $2,000 per ounce, the Federal Reserve’s balance sheet would have a capital increase of fifty times by the stroke of a pen when it comes to the gold certificates. The problem with the Congress’s doing that seemingly easy task is that it would empower other nations that hold gold hoards by revaluing their holdings. Russia is an example. So, the official gold price for the American central bank balance sheet purposes remains $42 per ounce. We hope readers appreciated this elementary summary essay. There are plenty of references for those who wish to dig more deeply. We will offer this one for serious researchers. The Bank of England has a marvelous database of about 800 years of interest rate history and lending history focused on Europe. Here’s the link. “Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018,” bankofengland.co.uk/-/media/boe/files/working-paper/2020/eight-centuries-of-global-real-interest-rates-r-g-and-the-suprasecular-decline-1311-2018.pdf?la=en&hash=5197703E8834998B56DD8121C0B64BFB09FF4881. · Our final takeaway is straightforward. The U.S. dollar is hegemonic because it is accepted and trusted. The shenanigans of our politicians are dismissed as political theater by all those participating in world trade, finance, and exchanges. That is why the dollar remains the premier world reserve currency. History shows, however, that it is very easy to lose that trusted status when government indulges in miscreant behavior, as some in Congress seem inclined to do. History shows that it doesn’t take much to lose the premier status and that, once it is lost, it is extremely difficult to retrieve. Do I expect the United States to default? No. Can it happen? Yes. We elect people to make those decisions for us. We either like what we get, or we change the personalities who make the laws. That is our system. It is messy and ugly, and it is what we have. What would I do if I saw the Congress fail and the U.S. default, as it has not done since the war of 1812? I would run like a deer away from the dollar. Do I invest as if that is going to happen? No. Do I worry about it? Yes. Just look at the outrageous things spoken by some members of Congress and examine their behavior. Right now, I’m a dollar bull. I believe the USD world reserve currency status has more years ahead. That could change at any time and because of any number of events.

David Kotok is chairman of the board and chief investment officer of Cumberland Advisors in Sarasota.

This article originally appeared on Sarasota Herald-Tribune: DAVID R. KOTOK: A closer look at the world's reserve currency