The Scandal of Money: Why Wall Street Recovers but the Economy Never Does - George Gilder (2016)
Chapter 10. Hypertrophy of Finance
With the fall of gold as a means of payment and as a unit of account (but not yet as a store of value) . . . , the world monetary system is not easy to understand. At least conceptually, the pre-1914 gold standard was simple: the domestic and international means of payment were the same.
—Ronald McKinnon (1979)1
What can an exchange rate really mean . . . when it changes by 30 percent or more in the space of 12 months only to reverse itself? What kind of signals does that send about where a businessman should intelligently invest? . . . The answer to me must be that such large swings are a symptom of a system in disarray.
—Paul Volcker (1992)
I think [currency speculation] is better than currency restrictions, but a unified currency would be even better.
—George Soros (1995)
The idea of trekking back through twentieth-century history to excavate the ruins of the gold standard seems arrantly retrograde, like returning to quill pens, horse-drawn carriages, slavery, or wampum. After all, didn’t John Maynard Keynes call gold a “barbarous relic”? To Paul Krugman, the gold standard is a “mystical” repetition of the “sin of Midas,” worshipping a shiny metal. This is not a partisan issue. Krugman often cites Milton Friedman, who as early as 1951 made the case for banishing gold in favor of a free competitive float of currencies and fatefully counseled Richard Nixon to remove gold backing from the dollar in 1971.
Warren Buffett summed up the conventional view with his usual pith: “Gold gets dug out of the ground . . . we melt it down, dig another hole, bury it again and pay people to stand around guarding it. . . . Anyone from Mars would be scratching their head.”2
The gold standard has moved beyond the pale of respectable thought. A bipartisan University of Chicago business school poll for a Wall Street Journal blog in 2012 found zero support for the gold standard. Forty-three percent of the surveyed economists “disagreed” with returning to gold, and an additional 57 percent “strongly disagreed.”3 That adds up to 100 percent, a “consensus” that might spark envy even in such hermetic circles of “settled science” as a UN séance on climate change.
With a limited total tonnage, which could be stored in a single small room, gold is seen to suffer from an acute deflationary bias. Since the basic money supply cannot expand significantly, it is believed that money prices, including wages and salaries, have to shrink.
Academics make the case that gold failed first under the stresses of World War I, when the combatant states defected, one after another, and most noncombatants followed. Then it failed again in the Depression of the 1930s, with recovery coming to countries in the exact order of their departure from gold. Finally it collapsed, seemingly for good, in the 1970s, when, with gold bleeding from the American trove of reserves and the French kibitzing sanctimoniously, Nixon tipped over the table and set up the dollar as the house money. His Texas swagman John Connally explained the sophisticated strategic calculation behind Nixon’s move: “Foreigners are out to screw us. It’s our job to screw them first.” A system that is relinquished at every turn of the screw, gold seems a master too harsh and exacting for frail human capabilities.
Ultimately fatal for the gold standard were studies focused on the 1930s by some of the world’s most respected economic statesmen and scholars. From Friedman and Krugman to former Fed chairman Ben Bernanke and former White House chief economic advisor Christina Romer (chosen by Obama for her mastery of depression economics), all ascribed the Great Depression chiefly to the monetary shackles of the gold standard. Friedman, who advised Richard Nixon on gold, did the most damage. In his magisterial Monetary History of the United States, 1867–1960, written with Anna Jacobson Schwartz,4 he tied the Depression directly to the Fed’s gold-based monetary policy that supposedly forced a 40 percent money supply collapse amid the carnage of failing banks between 1929 and 1931.
Crediting Friedman, Bernanke’s influential paper “The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison”5 focused on how the Depression ended. He showed that Japan bolted from the standard first in 1931, with Britain close behind, and that they led the world in recovery, followed by Germany (1932), the United States (1933), and recalcitrant, gold-grasping France (1936). After Roosevelt abandoned gold in 1933, as Romer points out, U.S. industrial output lurched up 57 percent between March and July, apparently exulting over escape from its gilded cage. It is clear that if you are in a global depression, with a third of the workforce unemployed and communists marching in the streets (and in the White House advising you on money), the best course may not be to sit around counting your ingots and reflecting on the gold backing of the Industrial Revolution.
A better, faster, truer replacement for the gold standard, we are to believe, is the high-technology “information standard.” If you have an information economy with wealth as knowledge and growth as learning, you want a monetary system that rapidly conveys crucial information on prices in time and space. There has never been an information system so global, so fast, so robust, as the foreign exchange trading system of convertible currencies.
The late eminent banker Walter Wriston decades ago likened “the international financial markets . . . to a vote on the soundness of each country’s fiscal and monetary policies . . . held in the trading rooms of the world every minute of every day. . . . This continuing direct plebiscite on the value of currencies and commodities proceeds by methods that are growing [ever] more sophisticated. . . .”6 The chief difference today is that the telephones and telex machines of the past have given way to half a trillion dollars’ worth of supercomputer gear linked by fiber optic lines at the speed of light. The system now collects its information sixty million times faster, with hugely greater granularity, not by the minute but by the microsecond.
What’s not to like? As Wriston noted in The Twilight of Sovereignty (1992), “Politicians . . . are right to complain. Not only are governments losing control over money, but this newly free money . . . is asserting its control over them. . . .”7 President Clinton’s advisor James Carville famously expressed his wish “to be reincarnated as the bond market. It can intimidate anyone.” Underlying the bond market is the currency market that determines bond values in every country. As Wriston asserted, “The old discipline of the gold standard has been replaced . . . by the new discipline of the Information Standard, more swift and draconian than the old.”
As the venerable banker sternly admonished, quoting journalist Michael O’Neill, “There are no U-turns on the road to the future.” This new information standard is irreversible, as fully established and demonstrably effective as any institution in the world economy. Implementing the new standard is the largest and most flexible, liquid, widely dispersed, and competitive—indeed, as economists claim, most “perfect”—market in the history of the planet.
Three-quarters of the business is in spot trades and simultaneous foreign exchange swaps in which one currency is traded for another, spot and forward simultaneously. By transacting both now and in the future at the same time, all exchange-rate risk is removed. Whether the rate changes or not, the bank is compensated for the exchanges. Designed to insulate currencies from market turbulence, these ploys also enable profitable arbitrage. In drastically smaller but still huge volumes—trillions a week—there are also outright forward currency buys and sells, derivative currency swaps, and forex options, as financiers employ ever more ingenious techniques to take advantage of volatile price changes.
This awesome multidimensional system, spanning the globe and extending into the future, enables any company anywhere at any moment, without risk, to exchange goods and services for money with customers in other countries. It enables world trade, globalization, integrated markets, and multinational corporations. It provides a cosmopolitan carpet for comity and commerce in the modern world. It garners profits and fees and margins for its providers and enables commerce for the companies that use the services.
This trading system for floating currencies is Milton Friedman’s dream. But it also reflects the concept of “spontaneous order,” a mainstay of the Austrian school of Friedrich Hayek and Ludwig von Mises. On the world’s most advanced computer networks, it links the thousands of foreign exchange desks of all the major banks and other financial institutions, thousands of hedge funds and specialized dealers, and scores of principal trading funds (PTFs, mostly automated high-frequency operators, the so-called “flash boys”). It brings in multinational corporations that command sufficient international business to support their own trading desks. They all work in parallel, with no central coordination, to arrive instantaneously at convertible currency prices around the world.
Looming over the entire world economy, this web of exchange is also a part of the fabric of wealth creation and distribution, justice and growth. Just as land-based human beings tend to ignore the much larger portion of the earth’s surface covered by the oceans, so individual consumers tend to focus on the energy, agricultural, manufacturing, and service businesses with which they interact in their day-to-day lives and ignore the oceanic trading that surrounds and sustains them. But the volume of currency exchange dwarfs by orders of magnitude all other economic measurements—GDP, global trade, Internet transactions, industrial production, Google searches, global stock market exchanges, global commodity values, and even derivatives.
Every three years, the Bank for International Settlements (BIS) in Basel, Switzerland, adds it all up on a “net-net” basis adjusted to nullify double counting from local and cross-border transfers between dealers. By this careful metric, BIS in April 2013 identified a flow of some $5.3 trillion a day, more than a third of all U.S. annual GDP every twenty-four hours. The 2013 total signified currency transactions throughout the year and around the globe at a rate of more than $600 million every second.8
So how is it going? Measured by the rise in volumes cited by BIS in 2013, it was a runaway success. Since the crash of 2001, currency trading was up nearly fivefold. Since 2004, it was up two and a half times. Since the crisis year of 2007, it had risen 160 percent. It is still apparently rising fast. BIS will give us the details in 2016. Are you ready for an average billion-dollar trading second?
Providing entrepreneurs with accurate measurements of the relative value of all the world’s hundreds of different moneys, the float makes fungible funds available on the spot without currency risk. In other words, with vastly greater speed and automated efficiency, the system performs the role previously played by the gold standard, while at the same time enabling every country to follow its own monetary policy. In light of this indispensable double service, combining two apparently incompatible goals, no one has complained about inadequate liquidity or performance.
Supremely banking intensive, the system channels all the world’s commerce through the portals of the great international banks (just ten in the United States and fifteen in the United Kingdom) and enables them to collect fees. With 16.11 percent of the total trading in May 2015, the largest player is Citibank. Deutsche Bank ranks second with 14.54 percent. Outside the ten top banks, a small portion of the trading in the United States is dispersed among twenty-four other entities. For all the software apps for amateur currency trading, peer-to-peer freelancing is a drop in the ocean.
Participating in international commerce, every company must pay a toll to elite international banking intermediaries. The bankers love it. Trading and hedging currencies has become the chief generator of transactions volume at the giant banks and an important but far smaller source of profits (just ten banks totaled $21 billion in currency trading profits in 2008, while the world economy tanked). Much of the speculation cancels out in the wash. But currency trading is also an outreach leader for banks, engaging their international operations with all the leading multinationals.
By various measures, 90 to 97 percent of all the transactions are judged to be “speculative,” devoted not to enabling trade in goods and services but to harvest profits and fees from arbitrage and leverage. Contrary to some claims, however, hedge funds are not the culprits. Only around one-tenth of the traffic in 2013 was ascribed by BIS to hedge funds and PTFs. Transacting some 77 percent of the business are ten leviathan banks in Western countries. These tolls and fees are burdens on global trade and economic growth paid by the production sector of the economy to the financial sector. But it is the sum of all these activities—hedging, speculation, and derivatives—that accounts for the oceanic span of liquid and available currency services.
As Friedman taught us, currency speculation can assure price stability. Speculation, in his view, could be destabilizing only if the speculators lost money. But money losers would eventually exit the market, leaving the profitable speculators (like those ten big U.S. banks full of computers and specialists) in charge, accurately arbitraging among the currencies and smoothing out the divergences. Thus, according to the experts, a massively speculative, oceanic market like currency trading, approaching the ideal of perfect competition, tends to an equilibrium of stable and accurate relative prices. To its exponents, this market’s rapid growth attests to its usefulness and robust results.
Nonetheless, as one might suspect in the wake of the global crash led by the same big banks, the system is less than impeccable. The boom in currency traffic since 2001, 2004, and 2007 might imply that international trade was also booming. Trade in goods and services has indeed risen a total of 36 percent since the low in 2007, but currency trading has risen more than four times faster—160 percent. After 2011, trade flattened out while currency trading continued to rise, up 32 percent since 2010. No unexpected swell of trade explains the expansion of currency exchanges.
Dominating the system utterly is the West. In the forefront of the foreign exchange operations are the United States and Europe, with London’s “City” alone accounting for 36 percent of all trading. Some 87 percent of transactions involve the dollar, in which 63 percent of all international trade is denominated and which accounts for more than half of all global reserves held by central banks to back their currencies. Since the economies of these leading traders in the West have failed to grow substantially, recovering from the slump but not moving on to significant new highs by 2016, currency trading and its effects constitute a substantial share of total growth.
That is what we mean by the “hypertrophy of finance,” which accounts for 35 to 40 percent of corporate profits. While trade in goods and services languishes, currency trading soars. Financial service finds its ultimate test in how it affects the rest of the economy. But currency trading has been rising at least twenty times faster than productivity growth.
Does the West benefit from all this churn? Trade has grown most robustly in Asia and the emerging nations, led by China and its satellites and India. Yet China, Hong Kong, Singapore, and Taiwan—the spearhead of global trade expansion in recent decades—have all largely opted out of the floating-currency system. Against agonized protests from the West, they fix their currencies on the dollar as much as possible, and some of them impose controls on capital movements. Outside of the Asian emerging sector, world trade has inched up only slowly. Likewise world GDP growth.
As Wriston was the first to point out, this system provides a global “information standard” for currencies. If it takes between 35 and 40 percent of the profits of the economy to supply the information and to build the knowledge behind our twenty-first-century wealth, perhaps that is the price of progress in the information age. But as many have noticed, problems persist. A likely effect is inequality. If a large and probably increasing portion of all the profits in Western economies is skewed to a tiny elite of governmentally favored financiers in ten big banks, less income, presumably, flows to enterprise.
Currency trading is a hypertrophic manifestation of the “financialization” of the U.S. economy. Finance over the last decade has become an entente between government and banks, focused on precisely the least successful U.S. sectors. As Eric Janszen has pointed out: “[T]he incursion of finance into every aspect of American business and economic life . . . changed the way consumers buy automobiles and U.S. automakers run their businesses, the way students pay for school and universities fund their operations, the way homes are financed and consumer goods acquired. In short, credit became the biggest American business of all. . . . The entire economic system has been glued together by one profound fantasy: Finance can substitute for production and credit for real savings. . . . [But] governments cannot print either wealth or purchasing power. These must be earned.”9
Wriston acknowledged that the result of this global plebiscite on moneys is an estimate of the relative values of the currencies in the float. In other words, in this microsecond engine of information, there is no anchor, no peg, no grid, no standard, no metric, no parity value. In mathematical theory, as Kurt Gödel proved, an information system must have axiomatic roots outside itself. As we have seen, self-referential and circular, a monetary system in all its global glory can roll off the edge of the world. In foreign exchange currency trading, values at times can become whatever the most powerful traders want them to be.
Without roots in outside reality, any system can be pushed off course by self-interested parties. If currencies are valued only in other currencies, there is no way to certify that the entire system is functioning in a beneficial way. The worldwide economic doldrums suggest that it isn’t. There is little reason to expect self-referential global currency markets to gravitate toward a correct valuation of anything.
Yet the purpose of currencies is to enable real and reliable outcomes that correspond to economic truth and justice: optimal economic results and distributions. If financial profits are not in return for services that enrich the entire system, they are unjust. Bankers in one country should not be able to extort rents from microchip manufacturers in another country or from workers in another industry unless the banks are contributing real knowledge and learning.
One test of the currency trading system is its volatility. Do currencies gyrate more or less than the businesses and products, commodities and economies, payments and investments that they supposedly measure? The answer is obvious. Currencies go up and down far more frequently and violently than the economies behind them. Since 1990, for example, the economies of Japan and the United States have slowly diverged, U.S. GDP continuing to grow and Japan’s remaining sluggish. Japanese monetary policy has in general been far looser than America’s, but inflation has been flat. Interest rates in both countries were low to zero. On the surface, this scene would not seem to present promising opportunities for arbitrage.
Yet the yen-dollar rate has been all over the lot—far more volatile than the divergences in growth of the Japanese and U.S. economies. While currency traders exchanged hundreds of trillions of yen a day, the currency bounced around like a jitterbug. In currency trading, the movements are inverse: when the dollar rises in yen, the yen is falling in value. In 1990 the yen sank from 140 to the dollar to 160 and then leapt up to 120. The next year it tumbled down to 140 again, then in a series of jumps and gyrations it soared to 80 in 1995. By 1998 it had declined to 150, but it lurched back near 100 during the early 2000s, with plenty of bumps along the way. By 2002 it popped down to 135, and in 2004, with many passing adventures, it was a little above 100. And so on, appreciating ultimately in 2012 back to 80 yen to the dollar. Three years later it was back to 100.
This feckless juggling of measuring sticks provided endless opportunities for trading in securities denominated in the two currencies. Financial publications were full of descriptions of a lucrative “carry trade” by which bankers profited from irrational currency shifts and their effect on relative interest rates and bond prices.
As we have seen, a measuring stick more variable than what it measures does not promote equilibrium or stability. It exacerbates imbalances in the distribution of income and wealth, between financial and commercial corporations, and between politically favored and disadvantaged groups.
The international currency trading system is the alternative to gold. The world knows of the alleged flaws of gold. The flaws of the float are fundamental. A measuring stick cannot be part of what it measures. Currency trading is deeply embroiled in the world economy and its price system. A metric cannot be more volatile than what it measures. Currencies are drastically more volatile than the economic activity that they gauge. Thus floating currencies defeat the very function of money as a metric.
Controlled by governments, the float pushes politicians toward centralized solutions. An express purpose of floating currencies is to enable politicians to pursue insular economic policies. All too often these policies come at the expense of their citizens and of world economic growth.
Currency trading is vastly more voluminous than the traffic in goods and services that it enables. Its microsecond transactions are froth on the world economy with little or no informational significance. But with leverage, they can yield huge profits with no real economic productivity.
Currency trading is a playpen for financial predators. Because the holdings controlled by particular financiers and banks are so much larger than the economies of even sizable countries, intruders can upset the finances of countries with “hot money,” make a fortune, and leave. George Soros, the patron of both Piketty and Turner, is the leading case in point, building his fortune with disruptive excursions into the currencies of Great Britain, Indonesia, and Thailand.
Currency trading concentrates income and wealth in the government-linked financial sectors of Western economies, bringing about maldistribution that arouses envy and resentment and demoralizes capitalism.
Currency prices cannot be shown to reflect any rational basis of valuation. Calculations of purchasing power parity (comparing buying power for particular goods in different countries) do not apply: the need for constant PPP computations shows the errancy of currency values. Different growth rates seem irrelevant: China has been growing fast for two decades with scarce impact on its currency. Interest rates seem deceptive: zero-rates are suspiciously associated with currency appreciation. Monetary policies seem feckless as countries around the world try, with majestic futility, to control their currencies.
The most reliable technique seems to be to target gold. That is what Paul Volcker did in 1984 in taming U.S. inflation. It is what Hjalmar Schacht did in 1924 to master the Weimarian inflation, releasing a new gold-based Rentenmark to replace the worthless Reichsmark. It is what the Brazilians did in 2002 finally to get newly real.
Perhaps the world economy should get real. It should contemplate a new tie to gold.