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Diplomacy in Action

Money, Markets & Sovereignty

FPC Briefing
Dr. Benn Steil
Senior Fellow and Director of International Economics at the Council on Foreign Relations
Foreign Press Center
New York, NY
April 14, 2009

Date: 04/14/2009 Location: New York, NY Description: Dr. Benn Steil, Senior Fellow and Director of International Economics, Council on Foreign Relations, Briefing at the NY Foreign Press Center on

3:00 p.m.


MODERATOR: Thank you all for coming on this rainy, cold Tuesday. Or is it – where are we, Tuesday – it is Tuesday. Dr. Benn Steil is a senior fellow and director of international economics at the Council on Foreign Relations. He is the founding editor of International Finance, a top scholarly economics journal, as well as the co-founder and managing member of Efficient Frontiers LLC, a markets consultancy.

From 2002 to 2006, he was a nonexecutive director for virt-x securities exchange in London, which is now part of Swiss Exchange. Prior to joining CFR in 1999, he was the director of the International Economics Program at the Royal Institute of International Affairs in London. He came to the Institute in 1992 from a Lloyd’s of London Tercentenary Research Fellowship at Nuffield College in Oxford, where he received a Master’s and Doctorate in Economics. He holds a Bachelor of Science in economics summa cum laude from the Wharton School at University of Pennsylvania.

Dr. Steil has written and spoken widely on international finance, securities trading, and market regulation. His research and market commentary are regularly covered in publications like The Wall Street Journal, Financial Times, New York Times, The Economist, Reuters and Bloomberg. And one of the reasons we have him here today is to talk about his newest book, Money, Markets and Sovereignty, which was published by Yale University Press in February 2009.

And with that, I will turn it over to Dr. Steil. Thank you.

DR. STEIL: Thank you, Elia, and thank you all for coming. For those of you interested in getting a copy of the book, the publisher will be happy to send you and your colleagues one. I think there’s contact information on the back. I hope some of you at least will be interested after hearing the presentation.

There’s a lot of history in the book, so I hope you’ll indulge me for a little while if I talk about some of that history, because I assure you it’s very relevant to what’s going on at present. The idea behind this particular book came to me when I was writing my previous book, which is a book on the role of financial markets in American foreign policy. And I became fascinated while I was writing that book with the bigger question of what seemed to me to be an eternal struggle between states and their citizens to determine what exactly was money and who would control it.

So I decided I really had to do some digging into that question, and it turned out to be a very fruitful area, because the more I dug, the more I discovered that things that we take for granted today as being things that states naturally do is just as part of being states, like producing money or even producing loss, where in antiquity, things that – just organic groupings of people came to do on their own. Because they came up, at least a few of them, with a clever idea that if they could exchange things they had that they didn’t really want so much with other people who they didn’t really know very well who had things that they wanted a lot, that this could really be to their benefit.

And two things in particular they needed in order to do this: One was some sort of common medium of exchange, something that everybody seemed to value no matter where they came from. And generally, over time, that came to be various forms of metal, in particular, gold and silver, for very good reasons. The stuff was very durable. It was rare, so it had some value because you couldn’t get it easily. And it could be made into lots of useful things that people wanted. It could be made into machinery if you wanted to make machinery. It could be made into jewelry if you wanted to make jewelry. So that’s how money developed.

And also, they needed some sort of basic principles of just conduct – fair dealing, as it were – because without that, people didn’t have trust to come back and deal with each other over time. And that wasn’t such a simple thing to create, because within a family or a tribal group, you don’t really have principles of just conduct. You have a hierarchy and the person at the top of the hierarchy basically establishes the rules and everybody else follows. But when you’re dealing with people that you don’t know, that you don’t have common values with, that you may not even have a common language with, you have to find something that is essentially universal. And that’s about the means rather than the ends; that is, what is fair conduct between people.

Now naturally, rulers or aspiring rulers over time came to realize that it was in their interest both to monopolize the production of this stuff called money, and to monopolize loss. Monopolizing money not only gave them power, but it was very profitable because when you controlled money, you could make a profit out of the spread between what you said it was worth and what it was actually worth to make. And you could do that by continuously debasing the currency by putting less and less precious metal into it. And rulers have done that repeatedly over millennia in order to profit from it.

And in terms of laws, interestingly enough, very few rulers ever came to power in antiquity by saying that they would create the law. They came to power by saying – by credibly guaranteeing that they would enforce the law, which was something that was inherited by the people. And the people never accepted – I give examples in the book, but they never accepted the notion that the ruler had the right to create law. That was something that came from God or the gods. It was something that was eternal and inherited by the people.

So why should we care about this? Let’s get a little closer to modern times and modern concerns. We make reference several times in the book to a very important observation that the Scottish philosopher David Hume made in the 18th century. It was very radical at the time. He was talking about relationships between states. And he said, well, where do principles of just conduct between states come from? He didn’t believe that they came from God or that they were somehow etched in the eternal fabric of the cosmos. He said, look, realistically, these principles of just conduct come from this establishment of a belief that there’s a mutual commercial interest in having relations with other people. And the deeper this interest is, the more benefit all of them have from deriving, and then enforcing, these principles of just conduct.

And he pointed out that over time, when commercial opportunities were eliminated or faded away, so did these feelings of there being principles of just conduct among nations. So Hume emphasized that to the degree that we wanted harmony in international relations, what we really needed was commerce because that’s where these feelings of common values actually came from.

And we emphasize repeatedly in the book that to the extent that the current financial crisis undermines this feeling among people that there really is tangible benefit to them interacting commercially, that we’re also going to have a much tougher time making progress on issues that are important to many of us politically that have nothing to do with commerce. Things like human rights, things like controlling international weapons proliferation. To the degree that we lose this feeling that we’re all in this together commercially because we all have a vested economic interest in cooperating, we’re probably also going to lose this feeling that there are universal principles of just conduct, for example, with regard to human rights; for example, with regard to things like war and peace. So we think this is actually a very important idea.

Let’s get a little more into the question of economic globalization. Another observation that we make in the book is that when you look back through history, if you look at the great periods of globalization – globalization of trade and commerce – they’ve always been associated with the creation of some sort of universal monetary standard, something that everybody valued no matter where they came from.

And we talk in particular quite a bit about the first great modern period of globalization from about 1870 to 1914 with the outbreak of the First World War. During that period, countries were on what’s called a gold standard, where effectively, national currencies were just vouchers, credible vouchers that were exchangeable for gold at a fixed price. But gold was not only the national currency around most of the world, but it was the international currency. Everybody spoke the same commercial language as it were, which is gold.

Contrast that to today. Today is very unusual historically. In periods where countries were very protectionist or mercantilist – for example, in the 18th century, you had what we call monetary nationalism. That is, rulers created tight controls on currency. They routinely debased them, which made it difficult to exchange across borders because foreigners didn’t want it. But today, we have the most liberal international trade regime we’ve ever had in the history of the world, side by side with the most extreme doctrine of monetary nationalism that the world has ever seen. That is, almost all the world’s countries with the exception of part of the European Union, produced their own national currencies, each of which is exchangeable into precisely nothing. They’re what we call fiat currencies. They’re not redeemable for anything of underlying value. These are simply produced as manifestations of sovereign power.

So this is a very unusual combination historically, and we argue that it’s very perilous, that it’s inevitable that every five, six, seven years, we are going to see a cycle of crisis relating to the fact that most of these currencies that are being produced around the world are not actually valued by people, particularly by foreigners, that they will not hold them as a store of value.

Compare today with financial crises back in the late 19th century under the era of the classical gold standard. There were financial crises. There were banking crises. But they tended to be very short and very shallow. We didn’t have the sort of international currency crises that we routinely see today, and that is because people believed that after the crisis was resolved, that the currency parity with gold would be reestablished because everybody was wedded to that. So investment would naturally flow back to whatever country was affected because people believed that there was this sort of natural equilibrium mechanism involved, because everybody was devoted to the gold standard.

And why were governments devoted to the gold standard? Because their own people believed that gold was money. They didn’t believe that the national currency was money. They believed that it was gold. So what’s the relevance today? Well, when this broke down after World War I, a lot of very famous economists were extremely concerned about it and they said, look, this is going to lead to a routine economic and political disaster.

Because now, every time you have a crisis, what’s going to happen is it’s going to be exacerbated rather than relieved by the international monetary system because people will just assume that the problem would get worse. That is, when a country saw its currency plummeting, they wouldn’t be dedicated to reestablishing any sort of international standard; they simply let the thing fall to zero and that would make people run away from it even quicker. It would fuel crises rather than help resolve them and would create political conflict. And in fact, that’s pretty much what we’ve seen today.

Now, a lot of people who talk about the current crisis in historical perspective like to compare it to the 1930s and try to draw lessons from the 1930s. We actually believe that there are much better parallels to what we’re seeing today with the 1920s. In fact, there are remarkable parallels right down to a huge boom in real estate in Florida, which we saw in the mid-1920s. People like to say today that we have one advantage that we didn’t have in the 1920s and the 1930s, and that is that we’re not wedded to gold, that there was this – there’s a sense today that the big mistake we made back then was that governments were wedded to a gold standard.

In fact, in the 1920s, we were not on any form of gold standard whatsoever. We were using a variation of the gold standard that was inherently prone to collapse. And we repeated the same situation in the 1960s. Basically, what happened was this: Under the classical gold standard, when the U.S. bought something from France, it would send a dollar to France. France would redeem the dollar for gold in the United States. The gold stock in the United States would fall. And the U.S. authorities would have to reduce the money supply to accommodate it, and that would stop any sort of credit spiral from advancing. It was a sort of international self-equilibrating mechanism.

But during the period of World War I, countries – most countries went off the gold standard, had a terrible period of inflation, and then when they tried to reestablish it after World War I, price levels were much higher. But they didn’t want to change the gold parity. So you had this very small layer of gold supporting the international monetary system, and countries didn’t want to part with their gold anymore. There was a big international conference in 1922 in Genoa where they decided, well, we can change the way the gold standard works; in order to economize on the limited use of gold, countries should use other countries’ currencies as reserves, in particular, the UK pound sterling and the U.S. dollar.

So now you had a very different situation. In the 1920s, what happened, the U.S. sent a dollar to France. France, instead of redeeming the dollar for gold, would redeposit the dollar in a New York bank. That New York bank would then recycle the dollar throughout the U.S. economy, because the gold was double-counted. The U.S. counted the gold as its gold. France counted the gold as its gold. And you had a big international credit boom, which was particularly virulent in the United States.

Now if you look at what the Federal Reserve was doing in the 1920s, it was precisely what the Federal Reserve was doing in the earlier part of this decade. Fed officials made very clear in testimony before Congress that they were not obeying any sort of gold standard. They were trying to stabilize the price level. And since there was enormous downward pressure on prices in the United States because of technological advance, by stopping prices from going down, they fueled an enormous credit boom, just like we had in the early part of this decade. It particularly went into real estate and stocks. Those were the main places it went. And of course, it spiraled out of control until we had the crash in 1929.

We did the same thing in the 1960s. When we reestablished a gold-based system, we did it on the basis of this gold exchange mechanism and it – the same cycle played itself out. The U.S. was the only country whose currency was linked to gold, but the U.S. didn’t have enough gold to meet its promises. And the country that precipitated the collapse of the gold exchange standard in the early 1930s, France, was the same country that precipitated the collapse of the Bretton Woods system in 1971, France, by demanding their gold back. And in 1971, President Nixon decided, well, we can’t play this game anymore because we don’t have enough gold, so he closed the gold window. And since then, we have all been on this system of fiat currencies.

And what happened in the early part of this decade? Well, it’s the same exact thing that we did in the 1960s and the 1920s. The U.S. sent a dollar to China. China, instead of redeeming this dollar for gold – of course, the U.S. doesn’t meet any such promises anymore – would immediately hand the dollar back to the United States in the form of an extremely low interest rate loan. That dollar would then be used to create more credit in the United States. Since there was downward pressure on crisis in the United States from globalization and technological advance by trying to maintain a stable price level in the United States, the Federal Reserve actually precipitated a massive credit boom, which eventually collapsed with the falling house prices in 2007. So it’s the same thing that we experienced before in the 1960s and the 1920s.

Well, what is the underlying problem? The best analysis I’ve seen of late of the underlying problem actually came from the governor of the Central Bank of China. Many of you may have read a few weeks ago the statement of Governor Zhou. It’s posted on the website of the Central Bank of China. It’s an absolutely remarkable statement. For those of us in the United States interested in foreign policy, we usually assume that when China is going to make a statement, that it’s going to be a reactive statement – China saying, we don’t like this; we could tolerate that. But rarely do you see a statement coming out of China saying, we believe the whole world would be better off if there were another system. And this was the statement of Governor Zhou.

And his analysis of the situation was historically and logically impeccable. He referred to a thing we referred to in the book repeatedly called the Triffin dilemma. This was a dilemma that was first articulated by an economist named Robert Triffin in 1960, when he tried to explain why the Bretton Woods monetary system would have to collapse. He said, you’ve got a situation where one country, the United States, is producing the currency that the whole world has to rely on, and that situation will have one of two problems always.

First, the United States has to run continuous balance of payments deficits – or in the current context, current account deficits – in order to supply the world with the dollars it wants. But eventually, it will produce so much of the stuff that people will no longer have confidence that it can be redeemed for gold, and then we’ll have a crisis. So we’ll always have one crisis or another. Either the U.S. will not produce enough dollars for the world economy, and there’ll be a shortage of this stuff and there’ll be a crisis, or the U.S. will produce too much of this stuff, foreigners will panic, and they will try to get rid of it. In those – 1960s, they wanted their gold back. Today, they can’t ask for their gold back, so they’re looking for alternatives. So he described the problem impeccably. That’s exactly the problem we’re living with today.

Now what about the solution that he recommended? Well, if you take the view that the problem today is that we have one country, the United States, producing a fiat currency that’s not redeemable into anything, which will always be managed according to its own selfish interest – if you believe that that’s the problem, then Governor Joe’s solution probably won’t be the solution you’d want. He believes that the world’s currency should be a form of the IMF’s so-called SDR, that is, an index of national fiat currencies produced by national governments, redeemable for nothing, each of which is produced according to their own national interests. So if you believe that the flaw he’s identified is correct, then his solution probably has weaknesses as well.

So where do we go from here? We don’t believe there’s a simple solution. We do describe in the book the sort of system that we think could endure if it were created from scratch, but getting from here to there is very difficult. We explain why, with modern computer and telecommunications technology, it would be very easy to have a system of private, what we call “digital gold.” There are already gold banks that exist in the world where you can buy shares in real gold that are held in a vault, and then you can make exchanges with other people around the world for valuable goods and services using digital representations of that gold in exchange.

And if you think about it, if enough of us did that, you could actually have a world monetary system that worked that way. I could, for example, go into a café in Sao Paulo and I could pay for my cappuccino with a smart card that would – I could just swipe and deduct a flake of gold from my account, which might be some place in Ohio. And since people around the world have always viewed gold as a reliable store value, one reason why the gold price has been rising over the course of this decade, you could imagine that sort of system attracting confidence from people around the world. But we certainly don’t believe that getting from here to there would be anything easy. In fact, we described why it would be extremely painful and would probably be resisted by governments, in particular, the U.S. Government.

So our conclusion is that monetary nationalism really is a legitimate threat to globalization. In the short term, the best that we can really possibly do is hope for a more responsible Federal Reserve that will understand that it is very necessary to operate monetary policy in the United States as if there were some sort of gold standard in operation. In other words, that unless there’s credit expansion across the entire U.S. economy, inflation of asset prices in the commodities markets, in the real estate markets, in the art market, the stock market, that that’s probably a signal that there’s too much money. That is, it’s not just about price stabilization as the Federal Reserve believed in the 1920s, but that would really require a revolution in terms of how economists currently think about monetary policy.

And I would – as an editor of an economics journal, one of the things I’m very confident in is that I’m going to get a different type of submission in the near future. No longer am I going to continue to get recycled pieces about inflation targeting, but hopefully, economists will start thinking more deeply about the nature of good monetary policy and how mistakes in monetary policy help trigger the current crisis.

I hope I’ve given you a little food for thought and discussion. I’m sure you have some concerns and questions related to the current turmoil, so I’m very happy to address those.

QUESTION: So how practical is this Chinese idea? What do you think of it?

DR. STEIL: I don’t believe it’s practical. I believe it’s the kind of idea that many governments would like to support for several reasons. First of all, for a very good reason, countries would like to free themself from dependence on the United States – in particular, the U.S. Federal Reserve and now, frankly, the U.S. Administration and Congress. China – if you look at their comments in 2007, 2008, most of their concern, if not all of their concern was expressed about monetary policy. But now they’re also expressing concern about fiscal policy. In other words, they’re very concerned about the fact that budgetary discipline in the United States seems to have gone out the window.

Well, what are they proposing? They are still proposing a system that would be based on governments producing currencies that are not redeemable into anything that people actually want. So I ask, is that the sort of system that people on the ground around the world would to ever have confidence in? For example, would an Argentine who is constantly looking for ways to protect his savings in moving it to offshore banks , and so on – would an Argentine want to hold an SDR? And my answer is no.

And if you look back through history, it’s quite clear that at the end of the day, it’s people on the ground that determine what is money and what is not. That is, if the people won’t use it, if the people won’t hold it as a store of wealth, if they’ll only use it in limited circumstances, for example, to pay their taxes to cover transactions with the government, then it doesn’t work. So I believe that the Chinese proposal has some superficial attractions to governments around the world, but I don’t believe it would be possible actually to establish such a system, because I don’t think that you would ever be able to engender confidence of people in such a system, even Chinese people. I don’t think at the end of the day you’re going to be able to convince a Chinese farmer that what he really wants to hold as a store of wealth – there’s this thing called an SDR that’s produced by an organization in Washington called the IMF. (Laughter.) And unless you can do that, it won’t work. That’s my view.

QUESTION: And – I’m sorry. Just another follow-up. What about the supremacy of the dollar? Do you think it can be challenged more nowadays because of the crisis that (inaudible) --

DR. STEIL: I do think so.

QUESTION: Which money that would --

DR. STEIL: Well, there’s only one other existing currency in the world that could possibly fill the dollar’s shoes, and that is the euro, because the euro is the only other currency in the world right now that currently exists that has the breadth of use that could actually play the role as an international currency. There isn’t any other currency available that could do that. The problem is that moving from a dollar-based world to a euro-based world, or even one of parity, is probably too painful to contemplate.

Let me explain why. Let’s say that China and other major creditors of the United States decided that they held too many dollars and wanted more euros, so they start accumulating more euros in reserves. The more euros countries accumulate in reserves, the more incentive they have to trade with each other in euros, rather than dollars. The more people trade with each other in euros, rather than dollars, the more incentive people have to accumulate euros. So it’s a sort of symbiotic relationship.

So what happens to the euro in such a scenario? It appreciates massively, first of all. This puts enormous pressure on European exporters who’ve complained to their governments. European – eurozone countries will have to start running large current account deficits in order to supply the world with euros, just like the U.S. today has to run enormous current account deficits to supply the world with dollars.

I personally don’t believe the common notion that the reason the U.S. runs such enormous current account deficits is because Americans hate saving and they just love consuming and borrowing. It’s part of the national psyche. When money is free, you borrow it. And the Chinese give us money for free. It’s wonderful. We go to Wal-Mart, we buy cheap Chinese goods, we give them dollars, and they give it back to us at a ridiculously low interest rate.

One of my favorite economists who I cite repeatedly in the book, a French economist, Jacques Rueff, explained it like this in the 1960s when he predicted that the Bretton Woods system would collapse. He said: “If I had an arrangement with my tailor, whereby for every suit I buy from him, he immediately gives me back my money in the form of a loan, I would have no objection to buying more suits from him.” (Laughter.) And that’s the nature of the relationship between the U.S. and China today.

So if Europe were put in the same situation where they had to continually run current account deficits, and the euro was appreciating massively, there would be such enormous political pressure on the European Central Bank to stop it, that I don’t think the European Central Bank could possibly maintain its political independence. You might see pressure from countries in the eurozone to leave the eurozone. I believe it would be catastrophic for them to try to do that. For example, if Italy were to try to leave the eurozone, it would mean that overnight, all its debts which are denominated in euros were now denominated in lira. There would be an immediate collapse of the currency in the country almost overnight. They would become Argentina times ten. So I don’t think it’s logical, but that would be the nature of the political pressure. So I don’t think, given how politically tenuous the institution of the European Central Bank is, that the euro is a very good alternative to the dollar.

But after that, there’s nothing left in terms of the existing portfolio of currency. The renminbi, for example, is a tightly controlled currency inside of China. China does not have a market-based financial system right now. Bank deposit and lending rates in China are completely controlled by the government, so you don’t have a currency that plays the role of a signal in terms of prices. So the renminbi is not in a position to play that role. So the only thing that I can see logically beyond the dollar and the euro is some sort of private-based gold system. I don’t think governments would ever go back on any sort of gold standard, nor do I think it would even be desirable for us to try because it would, inevitably in my view, end in complete disaster.

But if people really lose faith in currencies, not just in the dollar, where do they go? They go to the place that they’ve always gone. For thousands of years, gold has played the role of money in very diverse civilizations and civilizations that otherwise have very little in common. And I think that’s one of the reasons why we have seen this big run-up in the price of gold over the course of this decade.

If you want to get some feel for how much farther gold has to go, if people really lose confidence in the dollar, in 1980, the gold price in current dollars reached $2,300 an ounce. That was when people completely lost faith in the dollar and didn’t know what was coming next. The dollar did reestablish its reputation eventually under the Federal Reserve, which was led by Paul Volcker at the time. Some of you may remember that interest rates hit almost 20 percent in order for the U.S. to bring down inflation and inflation expectations, and we had a terrible, terrible recession in the early 1980s. We may have to go through something like that again if we want to reestablish the credibility of the dollar. But I don’t really see the euro as a long-term, viable alternative.

QUESTION: What about the future amount of money pumped by this Administration to the economy? Do you see it as a danger to the (inaudible) in the world?

DR. STEIL: I definitely do.

QUESTION: How it can affect the global economy?

DR. STEIL: Yeah. The Federal Reserve balance sheet is likely going to hit $3 trillion later this year. It’s ballooning very fast. And although I can criticize specific things that they have done, the thrust of what they’re doing is logical. If people are hoarding dollars, then what happens is the – happening is that the velocity of money has collapsed. If dollars don’t turn over in the economy, the Fed has to make up for it by giving people the liquidity they demand. And as long as they’re hoarding it, it’s not inflationary. It’s fine. So right now what the Fed is doing doesn’t have any consequences for the world in terms of inflation.

But the thing is once any sort of confidence begins to reemerge in the economy and the velocity of money starts rising, the Fed is going to have to soak up all these assets again very, very quickly. And think of the political pressure that they’ll be under. They’re going to have trillions of dollars of private assets. Are they going to dump them all on the market at the same time, leading to a collapse in the price of such assets? It’s going to be very difficult for them.

If they manage it well, we may all be fine. The U.S. can breathe a sigh of relief. China can breathe a sigh of relief. But personally, I’m very concerned that they won’t move quickly enough. And if they don’t move quickly enough three things will happen. First, there’ll be a collapse in U.S. Treasury prices; then there’ll be a collapse in the dollar, probably with euros and gold rising in consequence; in about six months to a year later you’ll start to see the emergence of some serious inflation.

So what the U.S. is doing now is risky. I think a lot of what the Federal Reserve is doing is necessary. I think a lot of the ideas behind so-called fiscal stimulus in the United States are misguided. I think the Europeans are right to be more cautious in that regard. But we’re in a very fortunate situation in the United States. We can issue debt essentially for free, even better than free.

In December of 2008, the end of last year, three-month Treasury prices went below zero percent yield. That means that you had to pay the government for the privilege of lending to it. That’s a remarkable situation to be in. And in that environment, it’s not surprising that the U.S. is borrowing as much as it can, as long as the world will lend to it for free or better. Then we have, unfortunately, an incentive to keep building up a debt. I think it’s misguided and I’m worried about it. And I think for that reason, we should take the statement of the governor of Bank China Zhou very, very seriously.


QUESTION: Dr. Steil, the idea of digital gold is very exciting. Theoretically, how do you compare digital gold with gold? Gold has intrinsic value and it’s produced by Mother Nature.


QUESTION: So you know, in this respect, how do you compare – or how does digital gold compare with gold?

DR. STEIL: The digital gold is, in effect, real gold; at least legally. If you opened an account at one of the existing gold banks now – there are a whole bunch of them, you can find them on the web. They’re still a small business but they’re growing quite a bit over the course of the decade. They hold real bars of gold in a vault. And you’re buying a share of that gold, so you’d pay them a small fee for buying a share in that gold. But it’s real gold. It’s held in a vault and it’s audited. Now of course, they can commit fraud like Bernie Madoff. There’s always that possibility.

But let’s be honest about it, historically, governments have always produced fraud when it came to money. In the 1920s, for example, governments continually held less and less gold to back their currency. So their currency was, in a sense, like digital gold. You held paper money, but in principle, you could always go to the government and say I want my gold. I say in principle, because of course when people tried to do that, like the French Government tried to do that in 1971, the U.S. said no, we’re not giving you your gold. So these gold banks do hold real gold. So when you hold digital gold, legally you have a contract such that you own a portion of that gold in the bank. But fraud is always a possibility, just like it is with governments.

QUESTION: Okay. So the money supply can be, again, (inaudible) or limited by the hoarding of gold?

DR. STEIL: That’s correct. One of the – a great attractions of gold as a money, historically, is that the supply does react to the demand. That is, when people demand more gold, more supply is produced, but it’s very slow. The supply of gold can only be increased given the current state of technology and gold mining around the world, roughly about 6 percent maximum. That is, if there were a massive increase in the demand for gold, the supply couldn’t really adjust very radically. And frankly, that’s what has always made gold attractive.

For example, why has silver always failed as a money, even though historically, particularly during Middle Ages and the Renaissance, many countries were on a silver-based system, and that’s because too much of the stuff was produced. So people ran away from it and always kept coming back to gold.

So gold has some – it’s not a perfect money, by any stretch of the imagination. But it has some unique properties that other commodities don’t have: it’s extremely durable. Gold mined 10,000 years ago is the exact same chemically as gold mined today. You can’t tell any difference between the two. Supply does react to demand, but not too much. And you – as I said earlier, you can make gold into many different things. You can make it into machinery, you can make it into jewelry, so the fact that it has value in many different uses makes it unique as a currency.

QUESTION: But you have no specific ideas for the world establishing a kind of monetary system, you know, towards digital gold standards or something like that?

DR. STEIL: Yeah, well, I should emphasize that this is not something that I would expect governments to cooperate in. In fact, I would expect governments to try to criminalize it. In fact, in one circumstance, the U.S. Government, in fact, did try to criminalize one of these institutions for trying to create some form of alternative money. So I don’t believe that this is an alternative to the gold standard in the sense that governments will cooperate in its establishment. This would be something that would be produced privately because firms have an interest in supplying it and people are interested in the product. So it would happen organically on its own from market forces.

QUESTION: From market forces?

DR. STEIL: Yeah, from the – yeah, from market forces. I should emphasize that although I think there’s a lot of logic to the system, I think if we were actually to have to move in that direction, it would be disastrous for all of us, because it would represent a complete collapse in confidence in the current international monetary system. It would be a very, very painful transition from here to there.

So even given the flaws in the current system, I would rather stick with the current system. But that relies on the U.S. Government to really – significantly reestablish the credibility of U.S. monetary and fiscal policy. And I’m concerned about both of those things, very concerned.


QUESTION: You say the end of this current crisis –

DR. STEIL: The current crisis has already had several phases; at least two distinct ones, and I think it’s going to have several more. So in the first phase, if you remember from September 2007 to June 2008, the Federal Reserve was cutting interest rates dramatically, increasing the money supply dramatically. Inflation soared in the United States, hit almost six percent last summer. Commodities prices were soaring around the world. That was very much a result of U.S. monetary policy. And so everybody was concerned about inflation, commodities prices, the rise of certain commodity exporters who were not particularly friendly to the United States, in particular, Venezuela, Iran. And everybody’s focus was on that.

Then, particularly after September of 2008, concerns changed dramatically. We were in the midst of a very major financial crisis, one that we hadn’t seen since the Great Depression. Inflation plummeted, and everybody turned to dollars, because that was the most liquid investment in the world and the closest thing to default-free. And so overnight, you switched from one crisis to another crisis.

My feeling is that we’re beginning to see the first signs that it’s coming to an end, probably later this year. You see a lot of small signs in the market that people are reestablishing confidence, they’re moving into the equity and bond markets again. There are some hopeful signs. But my view is that once confidence reemerges in the financial markets, that the Federal Reserve will just sit back and say, this is nice. We like this. We’ll have a little inflation and let the banks make some profits. And before we know it, China will be selling Treasuries, the dollar will collapse, and inflation will soar, and then we’ll be talking about the next phase of the crisis.

Now, obviously, I hope I’m wrong. But I don’t believe that this is just a short-term thing. I believe that we’ve – because of what we’re doing now, we will have problems in 2010, 2011, and beyond that we’re still trying to contain.

QUESTION: Are those the signs that you’re talking about are the same that President Obama was talking about this morning?

DR. STEIL: I didn’t hear --

QUESTION: The signs of improvements?

DR. STEIL: Yeah, I think the signs of improvements that he’s talking about are real. I think they are genuinely real. My concern is that the stimulus – so-called stimulus package, for example, which is a huge collection of every congressman’s spending wishes from the last several decades, most of that spending has not started yet. It’s coming later this year and next year, and even into 2011, well after the financial markets have started to recover and the real economy has started to recover. So we’re going to have a world flooded with dollars. And what does that mean?

So you know, my feeling is that the policymakers are always a step behind in a crisis. And in this case, I think the U.S. will be a step behind, that a lot of the so-called stimulus spending is going to come too late, after it’s necessary. It’s going to be politically extremely difficult, if not impossible, for the U.S. to stop it. Most of these spending programs, which are now supposed to be temporary, will become permanent. I mean, once you build up a political constituency for this type of spending, how do you stop it?

QUESTION: And one clarification about why are you focusing about the role of China mainly?

DR. STEIL: Because China is America’s major creditor. China consumes roughly about 30 percent of U.S. Treasury issues. If China were to stop buying this stuff, who would buy it? And if nobody stepped into the breach, that means that Treasury prices soar and the dollar collapses. So the nature – I mean, U.S. and China have an extremely important symbiotic relationship. One can’t exist without the other right now. Other countries are clearly part of the equation. America has other big creditors – Japan, South Korea, Russia, of course a lot of the Middle Eastern oil exporting states. But China is by far the most important in this regard.

QUESTION: I’d like to ask you something about the transitional period from the current – currency system towards your golden standard new era. You know that gold has a physical link only as a (inaudible). Current economic activity is expanded very definitely. There seems to (inaudible) between 1971. Does that mean that there is very huge interest that physical (inaudible) of gold and real economic activity? If we introduce such a new gold standard, there would be a very strong differentiation pressure (inaudible), one question.

The other question is very simple: If we continue the (inaudible) real economy activities in today’s level, the gold price could rise very sky-rocket from this towards – I don’t know, 3,000 or 10,000, very, very high level. Could you show me such an image of the transition from this current system towards that new golden system?

DR. STEIL: Okay. In terms of economic growth, I really don’t think that’s a threat. Because during the great period of industrialization in the 19th century, the gold supplies were quite sufficient. There were deflationary pressures, but deflation was considered a normal part of the operation of the gold standard. If you look at prices over the course of the 19th century, for example, in the UK, they were roughly flat, meaning that in an inflation-targeting system, the government wants inflation to increase by, say, about 2 percent a year. On a gold system, if inflation goes up to 1 percent in one year, on average, you would expect it then to go negative 1 percent the next year to balance it out. Prices are quite stable over time, but deflation is part of the system.

There were some major, major shocks, having said that, in the late 19th century when a lot of countries around the world moved off silver and other standards onto gold. So suddenly, there was an enormous new demand for gold that was above and beyond the demand that came from higher economic growth. And in fact, you did have some major deflationary shocks in the late 19th century that came from this new demand for monetary gold.

If the world were to move toward some sort of gold-based monetary system again, you are absolutely right; the gold price would soar, probably in current dollars to something on the order of six, seven, eight, maybe even ten thousand dollars an ounce. That’s very possible. And the initial effect would be painful, would be very deflationary. Of course, after we acquired essentially the amount of gold that we all want to play the role of money, then prices would level off. But the transition period would be enormously painful. It would be very deflationary, and since few of us, with the possible exception of Japan, are used to living in a deflationary environment, politically this would be enormously challenging. So I should emphasize that I am not, in any sense, saying that we should move to such a system. I’m only saying that if the U.S. doesn't figure out a way to maintain international confidence in the dollar, that it’s probably inevitable that we will move in that direction.

QUESTION: I agree with you that it’s such a very realistic observation. Since after such eroding such confidence of the U.S. dollar that golden standard will come. But however, before then, it shouldn’t be rather difficult for us to adapt to this system.

DR. STEIL: I think it will be worse than difficult. I think we would find popular revolution in parts of Europe, in particular where you have much less flexible economies even than in the United States. Even within the United States, I don’t think the public would tolerate the enormous deflationary effect of the transition to a gold-based system. And that would produce pressures on the federal government to do extraordinary things, probably things that would not be conducive to international cooperation. I mean, we’re already seeing this. I think it’s fair to say that President Obama’s outlook on the world is generally internationalist, and that, I think, is welcome in most of the world. But as all of you are probably painfully aware, he is not particularly dedicated to free trade. And why is that? I don’t think President Obama has any ideological predisposition against free trade, but the popular pressures right now in a difficult economic environment in the United States against free trade are such that he would not have been elected had he not taken those positions. It wasn’t just President Obama who moved to the left and adopted a hard-line position on trade. As all of you are probably aware, Hillary Clinton and other candidates took a very hard-line position on international trade. Hillary Clinton’s husband Bill Clinton was the great driving force behind NAFTA, the North American Free Trade Agreement. And his wife was campaigning against it, saying that it was a losing proposition for the United States and that she wanted to renegotiate it.

Now, I think that President Obama is a wise man, and that he understands that to force open these trade agreements now would be catastrophic politically, absolutely catastrophic. So he probably won’t do it in the coming years. But I think you can all rest assured that there won’t be any significant new trade agreements signed by the United States. If you ask me to guess, by the end of President Obama’s first term, we might have a new free trade agreement with Panama. That’s about it. (Laughter.) South Korea, out. Colombia, out. Doha, I – out of the question. Not even conceivable. And the thing is that to the extent that the world believes that the United States is no longer committed to free trade, there really is an incentive for everybody to put up protectionist trade barriers.

So if you look at the way trade is declining now – and I would associate a lot of that, by the way, to monetary nationalism. In Central and Eastern Europe, the countries on the periphery of the Euro zone, they’re suffering catastrophic capital outflows right now. This is going to produce reactionary popular backlash against these governments. It’s going to produce a backlash against their Western European neighbors and against the United States who are not coming to their aid. You know, I’ve spoken to Chinese officials in the past. Some of them will tell me stories about their mother in some rural village who is angry at the United States because her own savings have declined with the loss of confidence in the dollar.

So, you know, people around the world are very sensitive to what’s going on in the United States right now. So I’m very concerned about our own stance on trade, very concerned.

QUESTION: Given all this – do you think that globalization will continue through the crisis, or could this really be the end of the (inaudible) globalization?

DR. STEIL: It could be. The – if you look at the degree of contraction of international trade we’ve seen in the past few quarters, it’s extremely worrying. There were some statements made at the – part of the G-20 communiqué from London that I take some encouragement from. That is, the leaders pledged not raise new protectionist barriers, even if existing barriers were already within WTO limits. That’s encouraging, and they also asked the WTO to play the role of what I would call namer and shamer; that is, the WTO would examine what G-20 members do going forward and would publish their evaluation of it. I think that’s welcome, but I don’t think it’s enough. I am exceptionally concerned that you will see countries around the world reestablishing barriers to trade and investment that will be very hard to pull down later. And I go further than that. I go back to David Hume, that to the degree that we all lose a vested interest in this trading system, I also think we start losing popular sentiment for international collaboration on other things that we all consider to be important – human rights, weapons proliferation, climate change. When globalization is going well, it’s much easier to talk about cooperation on things like climate change where it may involve short-term pain for all of us. It’s almost impossible to make real progress in an area like that when people are suffering and don’t view it as being in their economic interest. So I’m genuinely concerned that it will be very difficult to reestablish a sort of global optimism about economic integration that we saw developing in the 1990’s.

Having said that, can I inject one note of optimism? Governor Zhou’s comments about the national monetary system, I think, should be very, very welcome. And that’s because China is now, in my view, taking an extremely constructive role in the way the international economic system works. China is not just reacting to what the United States and others are doing. They’re saying, we have a strong vested interest in making sure that this international system works. It’s not just that we’re critical of what the United States and others are doing; we acknowledge that we have a responsibility for putting forward new ideas. And to the extent that China has a vested interest in globalization, then I think we can all be optimistic about the future of cooperative relations among the U.S., Europe, and China, which I think is exceptionally, exceptionally important for world political stability, not just economic stability.

MODERATOR: We have time for one last question.

QUESTION: Except that China may (inaudible) what do you think that will be the major problems in 2010 or 2011? And also, what is your suggestion for China to diversify its currency reserve?

DR. STEIL: I have often asked myself that question – what would I do if I were Governor Zhou? Obviously, China does not want to do anything that will precipitate a major fall in the value of its existing dollar stock of assets. And if China were to start selling dollar assets, it would encourage others to do that, and China would absorb huge capital losses on its existing stock of dollar assets. So China is in a very difficult position.

So if I were Governor Zhou, what would I do? Would I start – stop accumulating dollars and start accumulating euros? Well, that would create the problem that I’m describing.

There is one valuable asset that China could start accumulating that would have absolutely no effect on the relative currency value of China’s stock of dollar assets, and that’s to start accumulating gold. If people sell dollars for gold, it has no direct effect on the dollar-euro exchange rate. And since central banks in the 1990’s around the world sold off huge quantities of their gold reserves, believing that they were no longer necessary or useful, there’s a sufficient incentive for central banks to start reestablishing their gold reserves. They’re actually very low, historically, so I would not be at all surprised to see China building up its stock of gold reserves in the coming years as quietly as possible. But China is so large and it runs such huge surpluses year after year it will – be impossible for them to hide this from the world for very long.

MODERATOR: Thank you all for coming. Dr. Steil, do you have any further thoughts or words that you’d like to share?

DR. STEIL: Well, yeah, I know there are still some more questions, so I’m very happy to stay around and talk to any of you privately.

QUESTION: I have a follow-up question. What would you do if you were Barack Obama or Tim Geithner or Ben Bernanke at this very moment?

DR. STEIL: Well, they’re all very different roles, I should point out. My first criticism of Bernanke and the Fed – the level of securitization that we’ve seen in the United States over the course of this decade is artificially inflated by the tax regime and the capital adequacy regime; that is, if a bank issues a mortgage to a customer and holds the mortgage on it’s book, it has to hold equity or other forms of expensive capital to support it. The tax system in the United States makes equity capital very expensive, and it actually subsidizes debt capital.

So the banks, because of the tax system and capital adequacy system – capital adequacy rules had an incentive to securitize them and sell them off to other people who didn’t bear those charges. The Federal Reserve and a lot of their programs like TALF, for example, are trying to keep the securitization level at a plateau that I don’t think we can support or should be trying to support. In my view, we should be – actually be moving in the other direction and adjusting the taxation regime to stop giving banks this incentive to put these things into off-balance sheet entities and then try to sell them off.

With regard to President Obama and Congress, I think the whole idea of fiscal stimulus is misconstrued. There’s no doubt that a lot of people in the United States are suffering right now, and that for good reasons associated with humanitarianism, we should support them and we should be spending more for various forms of social services.

However, if the problem in the economy is that people don’t want to spend, they want to hoard liquidity, dollars and treasury bonds, the Federal Reserve can supply that. There’s not – no problem with that. If people want to hoard dollars, the Federal Reserve can print them up overnight. And as I said, it’s not inflationary as long as people are just holding them. So the wide – if that’s true, if it is true, then why do people support so-called fiscal stimulus? Because then the politicians control the spending. And obviously, politicians love to control spending, because that’s how they get reelected. And so I am very concerned about handing that much power over to Congress, because these programs are never temporary.

Once you establish a spending program, it becomes permanent. As challenging as it will be for the Federal Reserve to unwind the liquidity that it’s pumped into the economy, it would be far more challenging politically for Congress to reverse this spending. And if you need any evidence, what are the major sources of spending at the federal level in the United States during a normal year, a year without wars in Iraq and Afghanistan? Health care and retirement benefits. Well, health care – President Obama is rightly trying to change the U.S. system, but the transition costs are going to be enormous.

As for retirement benefits, President Obama isn’t even discussing reforms to social security, for example, like increasing the retirement age in an era where people are living much longer and have longer, productive working lives. So the fact that we’re not even discussing these issues is a matter of great concern to me.

QUESTION: Is it time now to buy – what? (Laughter.)

DR. STEIL: Well, I should emphasize that a few of my investments last year were profitable.

QUESTION: (Inaudible) dollars and euros (inaudible) and you’re saying that the dollar might decline, the euro (inaudible).

DR. STEIL: Yeah, I mean, if you’re –

QUESTION : (Inaudible.)

DR. STEIL: If you’re fundamentally pessimistic about –

QUESTION: I mean, what do you suggest for the ordinary people to do with their money?

DR. STEIL: Well, one thing that they’re doing now that I don’t want to see them do, but that they’re doing for sensible reasons is accumulating gold. In an environment of zero interest rates, there’s little incentive to acquire financial assets that appear to be enormously risky if the economy falls off a cliff. So gold becomes a lot more desirable in such an environment.

My personal view, and I’m not trying to be a financial advisor here – is that U.S. treasuries offer such a ridiculously low rate of return that given current yields, U.S. corporate bonds are not a bad investment, at least in the short term – short-term U.S. corporate bonds. I – as I told you, I’m concerned about the future, meaning two, three years out, when this phase of the crisis fades.

But I think at current rates of returns, private debt is a better bet than public debt, and I think that any prudent investor for the long term would probably have a certain amount of gold as part of his or her portfolio because of the fact that the monetary system we’re living under now is, historically, extremely unusual. There has been no point in history up to 1971 where money way just paper, redeemable into nothing. There have been short periods where that happened, where governments stopped honoring their claims to make it redeemable, but these were aberrations, they were periods of war. Now, this is considered to be normal. My personal view is that it may not be sustainable, in which case you’ll look for alternative stores of value, and gold is probably the best one.

But to the extent that your gold investments go up, you can be pretty sure that everything else is going down. (Laughter.) It’s not something to cheer for. (Laughter.)

MODERATOR: Thank you all.

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