Minerd: Return to Bretton Woods?
Bretton Woods is a resort in the mountains of New Hampshire that was made famous by a series of meetings of world leaders and economists in 1944.
Nine months before the last of Hitler’s V-2 rockets struck Britain, 730 delegates from the 44 Allied Nations congregated in Bretton Woods to create a new world order, including a monetary system that could resolve the festering economic consequences of the First World War and the Great Depression.
Under the Bretton Woods Agreement, which lasted from 1944-1971, the world’s currencies would be pegged to the U.S. dollar and central banks would be able to exchange their dollars for gold at a set price of $35 per ounce. It was this arrangement that firmly established the U.S. dollar as the global reserve currency. During the early years of Bretton Woods, member states achieved increasing economic cooperation. (Track Gold here)
The trouble with the system was that global central banks had pegged their currencies at low levels to support exports to the U.S. This led to the accumulation of massive dollar reserves in the hands of foreign central banks. These dollars were used to buy interest-bearing U.S. Treasuries. This structural imbalance created problems that would ultimately compromise the existence of Bretton Woods. Today, global central banks are once again managing the exchange values of their currencies relative to the dollar to ensure export competitiveness
At the outset of Bretton Woods, the value of the United States’ gold reserves relative to the monetary base, also known as the gold coverage ratio, was approximately 75%. Less than three decades later, the gold coverage ratio had been reduced to 18% because of the issuance of new dollars and dollar-for-gold redemptions. Despite this disturbing fact, central banks did not call theFederal Reserve’sbluff by exchanging their dollar reserves. This was because by doing so they would have appreciated their own currency values, causing economic growth to slow.
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Beginning in 1959, Yale economist Robert Triffin warned of the unsustainability of Bretton Woods. Triffin predicted that foreign central banks would become saturated with Treasury securities and would seek to redeem them for gold. His theory was vindicated over ten years later. In the 12 months leading up to the end of Bretton Woods, the Fed exported nearly 15% of its total gold reserves, leading then-President Richard Nixon to abruptly terminate the dollar’s gold convertibility by ‘closing the gold window’ in 1971.
Today, although not officially acknowledged, central banks are once again tacitly pegging their currencies to the dollar. As the U.S. is expanding its monetary base through quantitative easing (QE), other countries have few options but to join this race to the bottom to maintain export competitiveness. This will not carry on indefinitely.
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Once global growth begins to accelerate and capacity utilization increases, economic bottlenecks will cause the price of inputs, such as energy, to rise. There will then be another inflection point when countries will realize that by allowing their currencies to appreciate, they will reduce import prices and spur productivity and domestic growth. Though the timing of this event is difficult to forecast, its occurrence will cause Bretton Woods II to collapse.
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During the decade after the price of gold was depegged from its official rate of $35 per ounce in 1971, it rose by more than 2000%. Investors migrate to gold when they become concerned that currencies no longer function as a good store of value. Were the gold coverage ratio to return to its historical average of 40% today, the price of gold would have to rise to more than $4,000 dollars per ounce. To reach 100%, which happened following the end of Bretton Woods, gold would have to exceed $12,000. This makes gold a low-risk investment and leads me to believe that it will never again trade below $1,600 an ounce.
The global economy is still living in the long shadow of Bretton Woods. Today’s paradox in the world’s monetary system is as unsustainable as it was under the Bretton Woods Agreement. The exact timing of an inflection point for Bretton Woods II remains unclear, and although it is not imminent, its eventual demise is virtually certain. The collapse of Bretton Woods in 1971 caused a decade of economic malaise and negative real returns for financial assets. Can anyone afford to wait to find out whether this time will be different?
Scott Minerd is the Chief Investment Officer of Guggenheim Partners.