The New Gold Standard: How We Are Anchoring Monetary Value to Real Assets

In this post, we will temporarily depart from the student loan discussion in order to bring forward a financial concept that I believe is tremendously important in understanding today's consumer credit markets and, therefore, today's student loan market.  The main discussion of this post will be around how the global financial markets have adjusted to the abolition of the gold standard and the rise of the Chinese economy and structural trade deficit.  This may seem very far afield from the discussion of student loans, however we hope to show that there is an inextricable connection between the two.  We describe this connection as the phenomenon of anchoring monetary value to real assets.

In 1971, President Nixon officially "closed the gold window" and floated the US currency.  There are a number of opinions on what affect this decision has had on the global financial markets, but the one that we focus on here is quite simple: the value of the US dollar changed from being a universal means of exchange and into a representation of the creditworthiness of the US Treasury.  In other words, the US dollar changed from being exchangeable into a real good (gold) into being exchangeable into a monetary good (a US Treasury security).  This is an enormous shift: before 1971, anyone looking to buy a US dollar would simply buy gold instead; after 1971, anyone looking to buy a US dollar would simply buy a US Treasury security instead.

The fundamental demand for US dollars is driven by a the desire to interact with the US economy.  A very good approximation for this demand is the US economy's share of global GDP.  As the chart above illustrates, the US's share of global GDP stabilized between 25% and 30% of global GDP, which should have correspondingly stabilized the demand for US dollars.  As we previously discussed, because the demand for the US dollar is essentially equal to the demand for US Treasury securities, we would expect the demand for US debt to have stabilized and would expect US debt as a percentage of GDP to remain equally stable over this period.  As we know, that has not been the case: US debt to GDP was 35% in 1975 and is over 100% today.  This makes no fundamental economic sense: the US share of global GDP has not increased, but the demand for US debt has increased seemingly without limit.  We note that the European Union is an even bigger example of this curiosity: the EU's share of global GDP declined from 35% to 28% since 1970, and yet the sovereign debt to GDP within the EU has climbed to 90%.  How can it be possible that as the US/EU share of the global economy declines the demand for their currencies can increase so astronomically?  The simple answer is China.

During the recent election cycle, we heard a lot about how China is manipulating its currency and how politicians need to "get tough with China" about its currency policy.  What we did not hear is how China's decision to manipulate its currency has artificially inflated the demand for the US currency and, therefore, allowed the government to borrow nearly limitless amounts of money.  On a simplified scale, this is how the transaction plays out: the US runs a trade deficit with China (~$300 billion in 2012) in which US consumers buy real goods in exchange for paper dollars.  In order to rectify this trade imbalance, China then needs to reinvest those dollars in the global market.  However, the market demand for US dollars is constrained by the US economy's share of global GDP, which has not changed since 1970 even while the Chinese deficit has ballooned since 1990.  Thus, so long as the US economy maintains its steady share of the global GDP, then any attempt by the Chinese to increase the supply of dollars would produce a decline in the value of the dollar.  This presents a problem for China: if it sells its US dollars on the market, the dollar will decrease in value with respect to China's currency and therefore make Chinese exports less attractive to US consumers.  Thus, in order for China to maintain its artificially low currency exchange rate, China must purchase US dollars on the open market in equal value to its trade deficit.  China can do this by purchasing US Treasuries or by purchasing any security that is guaranteed by the US Treasury. 

This last point is critical: the Chinese currency policy is driving an enormous demand for US sovereign debt for no other economic purpose except to maintain an artificial exchange rate.  If the Chinese only purchased US Treasury securities, then this would be a pretty innocuous transaction: China would receive dollars from US consumers in exchange from real goods, which it would then use to buy US Treasuries whose real value would decline over time as inflation of the currency outpaced the interest on the bonds.  That is a bad outcome for the Chinese - they traded real goods for paper money - but otherwise it would be relatively harmless to the US consumer.  However, the US government has put in place programs through which it uses the US Treasury to guarantee forms of consumer debt: most notably the federal mortgage program and the federal student loan program.  

When the US Treasury lends to homeowners through guaranteed mortgages, it turns American houses into conduits for China to purchase US dollars in order to offset its trade surplus.  When the US Treasury lends to students through the student loan program, it turns American students into conduits for China to purchase US dollars in order to offset its trade surplus.  This is extremely dangerous: China does not believe that US houses are good investments, it just wants to buy guaranteed mortgages in order to satisfy its demand for US Treasuries; China does not believe that US higher education is a good investment, it just wants to buy guaranteed student loans. In both cases, we are "anchoring" the value of our paper currency to the value of real assets - houses and tuition.  In both cases, this simply produces massive price inflation of the underlying assets: historic increases in both housing prices and tuition.  As a way to illustrate this connection, we put forward  the chart below that maps the American trade deficit with China alongside the price of both housing and higher education in the US over the same period.