“Bretton Woods III”

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I have written here earlier about the potential consequences of central banks freezing the foreign exchange reserves of the Russian central bank, an unprecedented event since the origin of the current international monetary system in the aftermath of World War II. More recently, I noted that volatility in Credit Default Swaps (CDS) indicated a growing perception of instability in the ability of sovereign debtors to meet their obligations.

On 2022-03-07, Zoltan Pozsar, a New York based investment strategist at Swiss bank Credit Suisse, issued a report, prominently labeled by the bank “THIS IS NOT RESEARCH”, titled “Bretton Woods III” [PDF], in which he contends:

We are witnessing the birth of Bretton Woods III – a new world (monetary) order centered around commodity-based currencies in the East that will likely weaken the Eurodollar system and also contribute to inflationary forces in the West.

A crisis is unfolding. A crisis of commodities. Commodities are collateral, and collateral is money, and this crisis is about the rising allure of outside money over inside money. Bretton Woods II was built on inside money, and its foundations crumbled a week ago when the G7 seized Russia’s FX reserves…

The beautiful paradox of linear rates (the stuff you trade and I write about) is that you need to think linear to find relative value most of the time, but you have to think non-linear to recognize and survive regime shifts. We are seeing a regime shift unfold in funding markets currently (which, as always, will pass), and a sea change in inflation dynamics and FX reserve management practices.

“Bretton Woods” refers to the international monetary system put in place after World War II by the victors at a conference held in that New Hampshire resort town, and described in Benn Steil’s 2013 book, The Battle of Bretton Woods (link is to my review). That system was based upon a hybrid reserve standard of gold and the U.S. dollar, and was destroyed in August 1971 when U.S. president Richard Nixon unilaterally renounced the link between the U.S. dollar and gold and defaulted on the U.S. obligation under Bretton Woods to exchange dollars held by other central banks for gold at a fixed exchange rate.

Pozsar calls the system of floating exchange rates among fiat currencies not backed by gold, which was largely in place by 1973, “Bretton Woods II” (although it was not the result of a formal agreement like the system it replaced). This system, with tweaks and occasional speed bumps, persisted for almost half a century until, in Pozsar’s view, it was blown up in March 2022 by the decision of the U.S. and other large central banks to freeze the foreign exchange reserves deposited with them by the Russian central bank.

This crisis is not like anything we have seen since President Nixon took the U.S. dollar off gold in 1971 – the end of the era of commodity-based money.

The “Bretton Woods II“ era was based upon “inside money”: fiat currency reserves held by and at central banks, and the belief that these assets were as good and as safe as physical gold held in central bank vaults under the original Bretton Woods regime. Overnight, with the freezing of Russia’s central bank reserves, this confidence has been destroyed, and, once lost, is not likely to be restored.

At the end of a lengthy and detailed analysis, considering in particular the risks and opportunities this situation presents to China, Pozsar concludes,

When this crisis (and war) is over, the U.S. dollar should be much weaker and,on the flipside, the renminbi much stronger, backed by a basket of commodities.

From the Bretton Woods era backed by gold bullion, to Bretton Woods II backed by inside money (Treasuries with un-hedgeable confiscation risks), to Bretton Woods III backed by outside money (gold bullion and other commodities).

After this war is over, “money” will never be the same again…and Bitcoin (if it still exists then) will probably benefit from all this.

This is detailed analysis by financial geeks for financial geeks, written in financial geek-speak, with enough jargon and acronyms to “land a man on the Moon and return him safely to the Earth”. Here is a brief glossary with links.

This is a complex and detailed analysis, but it is the first I’ve seen that takes seriously the consequences of what has happened in the last few days: the demolition of the foundation of the international financial system which has been in place for half a century. It is impossible to forecast all of the eventual consequences of this or to foresee what new order (or disorder) may replace it, but the risks and opportunities in such a period of instability are likely to be very large indeed.

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And it was done so casually – with almost no democratic input whatsoever in any country.

Back in 1967 when Jolly Olde England devalued the Pound Sterling, Prime Minister Harold Wilson assured the punters: “The Pound in your pocket has not been devalued”. And that was true in a certain sense. It was only when a Pound had to cross an international border to pay for something that it had been devalued.

That suggests one of the opportunities which may arise in this new world order (over time – the financial supertanker does not turn quickly) could be in organizing much more efficient terms for international countertrades – Central American countries send bananas to China in exchange for iPhones, with no money changing hands. That in turn will put a premium on importers having real goods & services to trade internationally for things they cannot provide for themselves. Continuing large trade imbalances (surpluses as well as deficits) will become a thing of the past. Exporters will have no desire to build up large financial surpluses in foreign banks which can be stolen from them.

The actions of the EU, Switzerland, and North America against Russia will probably push us down a road where “money” becomes primarily a means of exchange, not a store of value. I am skeptical that gold will benefit from this over the long term. A type of bitcoin tied somehow to real products might be interesting.

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I think the key message of the Pozsar analysis is, if correct, that this event has delivered a great, and possibly irrecoverable, shock to the confidence that central banks had in the safety of their foreign exchange reserves held at other central banks. (And this applies to all other forms of paper money reserves. Even bearer bonds in a foreign currency need to be cleared through the central bank that issues the currency in order to be spent.)

This means that central banks will have an incentive to place their reserves in assets which cannot be or are unlikely to be frozen or confiscated if they step on imperial toes. Gold is one obvious asset, and vulnerable central banks have been accumulating it over the last several years, but any commodity-based asset (such as the concept of ships filled with Russian raw materials) is another, or paper representing such assets issued by a party not known for being prissy about its holders (I’m talking about the PBoC).

Bitcoin or other inherent scarcity assets which cannot, by any known mechanism, be frozen or confiscated, may also be attractive in such an environment. I would expect the uptake among private treasuries to be quicker than central banks.

But, at the moment, we’re in the “shotgun in the aviary” period. There’s this silence after the kaboom, then a tweet, a twitter, a few more tweets, and it takes a while for the chirping to resume. It’s way too early to predict how things will sort out after such a massive disruption in the assumptions upon which central bank policy has been based throughout the lives of almost all current central bankers.

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It seems likely that China and Russia have been thinking about this for some time. Whether they have a plan remains to be seen, but they both started accumulating gold at the same time after the last Russian sanctions.

It may be that Putin is now a madman or getting bad advice because he is surrounded by sycophants, but there are clues that he has been preparing for a long time and this preparation was in coordination with at least China. I hope for the West’s sake that they don’t have a solution.

It would be a very bad day when the West thinks wealth is holding US dollars and the producers say we don’t accept those.

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Luke Gromen proposed a thought experiment. What if Russia said they would sell oil for gold at 1000 barrels per ounce? I would modify the experiment. What if OPEC+ do this?

Modify the ratios as needed.

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In my lifetime I have seen dollars labeled “silver certificates”, “federal reserve notes”, and coming soon, to a “global community” near you … federal reserve e-debt!

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Given what Western central banks have done, gold is an asset for a non-Western central bank only if it is in its’ own vault. Having gold stored in a vault in London or New York will no longer cut it. Physically shipping gold backwards & forwards around the world to settle accounts is clearly highly inefficient and subject to problems of theft and loss. And gold, like anything else, has no intrinsic value – it is worth only what someone else will trade for it at the point in time when the holder of the gold wants to exchange it. That is why I am a little skeptical about the future of gold – but I have been wrong before.

Now, if there were some way to apply bitchain technology to ownership of real goods, real commodities, real productive capacity – that could potentially be revolutionary; because we don’t want money, we want what money can buy. But the issue of trust would remain. In this new world order, if it is not in your direct possession, do you really own it?

Absolutely! When the remaining birds settle back on the branches, the aviary is going to look very different. There is no way back after what Western politicians have done.

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The triangulated path is Federal Reserve merges with Bitcoin.

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Why is physically shipping gold “clearly highly inefficient”. A Boeing 777F freighter has a cargo capacity in excess of 100 tonnes. With the price of gold around US$ 2000 per troy ounce, a single 777F could deliver US$ 6 billion in gold between any two financial centres in less than a day. (Not that you’d want to put it all on one plane, but you could. In practice it would be sent as multiple shipments, just in case.) Insurance for such a shipment is a small fraction of its value, and companies such as Brinks and Loomis will be happy to arrange end-to-end delivery and take care of all the details of secure pick-up and delivery, intermodal transfers, protection, and insurance.

But, in practice, there’s no more need to physically ship large quantities of gold around any more than one ships pallets of hundred dollar banknotes (unless bribing the mullahs of Iran). Account settling would be done, as it was for more than a century before 1971, by updating book entries for a small fraction of reserve gold stored in a financial centre bank. Since, over time, international money flow balances, this involves modest sums which can, in normal times, be risked to sovereign seizure, while the main reserves are kept in individual countries’ central bank vaults.

If I had a nickel for every time I hear this, I’d have … a huge pile of nickels. My response is “so what?” As you note, nothing has intrinsic value, and the relative values of all goods and services fluctuate over time. Forty centuries of experience have shown that things which work well as money tend to be those which have large value per mass and volume, are not subject to degradation, can be subdivided into small quantities, and have a high and stable cost of production and a small rate of production compared to the existing supply. Few alternatives meet these criteria better than precious metals.

That is the whole point of blockchain technology. If you control the private keys, you really own it, and nobody else can confiscate it. Further, private keys and smart contracts (as supported by Ethereum) allow creating custodial structures such as n of m key systems which cannot be done with paper assets or precious metals.

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And perhaps others were manipulating Putin into this war.

This war marks the end of Russia as a rival to China. China now regards Russia’s conventional military forces as a non-threat. And the cutoff from the west mans Russia is necessarily committed to any alternative China-centric financial system.

Thus, Russia is now clearly the junior party in the relationship.

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