As Sanctions War Heat Up, Will Putin Play His Gold Card?

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risk-free arbitrage of 10% between the rouble and gold. You can bet than a large number of international investors would quickly sell some gold, dollars, or other currencies, and acquire some roubles, pocketing the hefty interest rate differential. That would support the rouble, possibly leading to a large re-appreciation vis-à-vis the dollar and other currencies left unbacked by gold. Rouble interest rates could then decline, perhaps to quite low levels, where equilibrium would eventually be reached. It could have worked in 1989, or 1998. It is far more likely to work today.

Could a Golden Rouble Catalyze a Global Remonetization of Gold?

There is another aspect to consider, however, which is the possible impact this policy would have on the dollar and the international monetary system. Recall that, as the primary global reserve currency, the dollar circulates in vast quantities abroad, where it forms the bulk of the monetary reserves of central banks. This is in part what allows the U.S. government and economy generally to finance themselves at such low interest rates. But other factors equal, if the dollar suddenly faces competition from a credible, gold-backed currency, it is likely that, at a minimum, central banks are likely to diversify at least some of their dollar reserves into interest-bearing, gold-backed roubles. Countries importing oil from Russia would have an additional incentive to do so as they would be able to pay for Russian oil imports in roubles and avoid sanctions. Speculators (or investors) anticipating an eventual internationalization of the rouble would front-run these developments, pocketing a nice return over time.

The implied upward pressure on U.S. interest rates would be perhaps small initially, but even a small rise in U.S. interest rates would spell trouble for a U.S. economy that is so highly leveraged to low rates. Growth would slow. The Fed could try to offset this by engaging in renewed QE, but that could add fuel to the fire, resulting in aggressive selling of dollars in the foreign exchange markets. In an extreme but hardly impossible scenario, the dollar could lose reserve status entirely, something that would be devastating for the U.S. economy. While a sharply weaker dollar would help U.S. competitiveness and exports over time, it would crush the dollar’s effective international purchasing power (eg for oil and other resources) and result in soaring consumer price inflation. The combined negative impact of higher interest rates on growth and rising consumer prices on inflation would make the stagflationary 1970s look like a picnic.

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As I argue in my book, The Golden Revolution, a loss of reserve status for the dollar would have vast repercussions for the international monetary system.[9] While a gold-backed rouble could challenge the dollar to a certain extent, it is unrealistic to think that an economy the size of Russia’s could back the dominant global reserve currency. No, as the dollar’s share declines, most probably multiple alternative currencies begin to serve as reserves. This is where things get interesting, however. Other factors equal, as a currency is used as a reserve, it strengthens that currency. That might be unwelcome in some economies heavily geared toward exports.

Thus dethroning the dollar does not end the currency wars but rather could escalate them further instead as one country after another tried to offset dollar weakness by weakening their own currencies. This sort of ‘race to the bottom’ was seen in the 1920s and 1930s, culminating in U.S. President Roosevelt’s executive decision to devalue the dollar by some 60% in 1934. In that instance, however, the dollar remained backed by gold and by what was by far the largest global economy at that time.

Not so today. The global economy has become increasingly multipolar, with both the euro-area and China roughly as large as the U.S.. Moreover, the U.S. has a huge accumulated and external debt, implying a growing risk of debasement and devaluation in future. As it stands today, only 2.3% of the narrow U.S. money supply is backed by gold. Thus the U.S. is simply no longer in a position to be a ‘monetary hegemon’, providing the global reserve currency.

But as all large economies have their own debts or other financial issues with which to deal; no major currency is in a position to replace the dollar as the pre-eminent reserve. This implies that the global monetary system is highly unstable. The dollar is hardly the only currency at risk of debasement and devaluation. Game theory implies that a race to the bottom is distinct possibility and it is unclear whether the dollar would lead or follow in that race.

As I further argue in my book, these combinations of economic multipolarity and the instability of the current global monetary equilibrium are highly likely to result in at least a partial if not full remonetization of gold, with an associated, large rise in price. Gold is the ideal way for countries to settle their trade imbalances in a world in which trust in currency stability is lacking. Accumulating reserves that can be summarily devalued by trading partners in a currency war is not a rational policy. Yet something must function as a reserve asset if trade is to take place at all. Gold provides that ‘something’ as supply is stable and it cannot be arbitrarily devalued. Backing currencies by gold would thus greatly increase trust and, thereby, facilitate international trade.

Those familiar with the 1870s will note that there are now strong parallels with that important decade. Following German unification and the U.S. recovery from the Civil War, both of these economies were catching up rapidly with Britain. Japan had begun to industrialize. Under these multipolar conditions arose spontaneously, absent formal diplomacy, the classical gold standard system that would underpin decades of arguably the fastest sustained global economic growth ever experienced in history.[10]

So, Will Putin Play the ‘Gold Card’?

Let’s now return to Russia and leave aside a biased western perspective for the moment. Putin has arguably accomplished more for Russia than has any other contemporary leader of a major country. Yes, he may be something of an autocrat, but please show me one major developed country that has never been ruled by an autocrat. (The U.S.A began its life under George III and borrowed the bulk of its legal code and political culture from the UK.) Under Putin’s leadership, Russia has maintained its territorial integrity, something that had been left in question following the collapse of the Soviet Union, and Russia retains a formidable military capable of defending its vast frontiers (although not capable of policing the world). The economy has grown rapidly and, while still resource-dependent, has begun to diversify in various ways. (Keep in mind the young U.S.A was regarded by Europeans as a largely resource-dependent economy.) Russia has built strong economic and political ties not only with the BRICS but also many smaller economies in Eurasia and elsewhere around the world. Russia has only a small accumulated national debt, implying that this will not be a drag on future growth, as is likely to be the case in the U.S., E.U. and Japan. Russia also has an advantageous tax system, with a top 13% rate of income tax. Yes, Russia remains an economically unequal society, but we know what has happened to inequality throughout the developed economies in recent decades, not just following the 2008 global financial crisis.

Given these achievements, Putin is not a leader to be taken lightly and we should pay attention when he says it it his desire to end the ‘dictatorship of the dollar’, as he did just this week. [11] Perhaps he will indeed play the gold card he has hidden up his sleeve and thus kill two birds with one stone: shore up the rouble and Russian economy on the one hand; dethrone the dollar on the other. A period of international monetary and associated economic chaos might ensue, but with Russia suffering already under unwelcome sanctions and thus with relatively less to lose, Putin might calculate that now is the time to make his move. He may have already achieved his place in the Russian history books but imagine how he will be regarded in world history books if he sets in motion that which culminates ultimately in the return to some form of global gold standard.

My Recent Call on Gold

In my most recent Amphora Report, from October, I wrote that:

On multiple occasions over the past year gold has fallen to and found support around $1,200/oz. This has now happened again. There is widespread evidence of strong physical demand around this level, which I believe is long-term and strategic in nature, associated with official institutions, such as emerging economy central banks, and wealthy investors seeking a hedge against a future financial crisis. That said, a new forward hedging program on the part of major gold mining firms could send the price lower. Once this was completed, however, I am confident prices would recover quickly to above $1,200 again. The flow of produced (or forward-hedged) gold is tiny relative to the strong underlying physical demand over a multi-month or longer horizon.[12]

I stand by those words. Gold is putting in a floor here. Amid the escalating global currency war and associated monetary instability, there is much potential for it to rise in price, in particular if (or when) it becomes remonetized. Anyone accumulating gold below $1,200 will consider themselves lucky in future, or perhaps just smart.

Chief Investment Officer at Amphora; Atom Capital
Primary Tel: +44.20.7659.9907
63 Curzon Street London W1J 8PD

http://www.amphora-alpha.com

References:

[1] These comments were originally reported here. They were also a topic of a previous Amphora Report, Begun, The Currency Wars Have, vol. 2 (October 2010). Link here.

[2] For geopolitical and historical reasons Poland has been more openly supportive of economic sanctions against Russia than has Germany. However, the Poles are increasingly distrustful of their NATO allies, including the U.S.. Recently, for example, one senior Polish official used a crude sexual metaphor to describe Poland’s subordinate relationship with the United States. The link is here.

[3] Details of this program can be found at this link here.

[4] For details please see here.

[5] This has been a topic of several Amphora Reports, including here.

[6] James Rickards, in his 2011 best-seller Currency Wars, has also suggested this possibility. It can be found on Amazon here.

[7] Mr Wanniski’s WSJ editorial can be found at this link here.

[8] For a discussion of Russia’s gold accumulation please see here.

[9] The Golden Revolution can be found on Amazon here.

[10] The classic historical work on how the gold standard system arose is that by Giulio Gallarotti, The Anatomy of an International Monetary Regime: The Classical Gold Standard 1880-1914. It can be found on Amazon here.

[11] Putin’s comments were translated and reported here.

[12] Commodity Signals Flashing Red, Amphora Report vol. 5 (October 2014). Link here.

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