Russia’s Monetary Solution

The hypothesis that follows, if carried through, is certain to have a significant effect on gold and the relationship between gold and all government-issued currencies.

The successful remonetisation of gold by a major power such as Russia would draw attention to the fault-lines between fiat currencies issued by governments unable or unwilling to do the same and those that can follow in due course. It would be a schism in the world's dollar-based monetary order.

Russia has made plain her overriding monetary objective: to do away with the US dollar for all her trade, an ambition she shares with China and their Asian partners. Furthermore, in the short-term the rouble's weakness is undermining the Russian economy by forcing the Central Bank of Russia (CBR) to impose high interest rates to defend the currency and by increasing the burden of foreign currency debt. There is little doubt that one objective of NATO's economic sanctions is to harm the Russian economy by undermining the currency, and this policy is working with the rouble having fallen 30% against the US dollar this year so far with the prospect of further falls to come.

Russia faces the reality that pricing the rouble in US dollars through the foreign exchanges leaves her a certain loser in a currency war against America and her NATO allies. There is a solution which was suggested in a recent paper by John Butler of Atom Capital, and that is for Russia to link the rouble to gold, or more correctly put it on a gold exchange standard*. The proposal at first sight is so left-field that it takes a lateral thinker such as Butler to think of it. Separately, Professor Steve Hanke of John Hopkins University has alternatively proposed that Russia sets up a currency board to stabilise the rouble. Professor Hanke points out that Northern Russia tied the rouble to the British pound with great success in 1918 after the Bolshevik revolution when Britain and other allied nations invaded and briefly controlled the region. What he didn't say is that sterling would most likely have been accepted as a gold substitute in the region at that time, so running a currency board was the equivalent of putting the rouble in Russia's occupied lands onto a gold exchange standard.

Professor Hanke has successfully advised several governments to introduce currency boards over the years, but we can probably rule it out as an option for Russia because of her desire to ditch US dollar relationships. However, on further examination Butler's idea of fixing the rouble to gold is certainly feasible. Russia's public sector external debt is the equivalent of only $378bn in a $2 trillion economy, her foreign exchange reserves total $429bn of which over $45bn is in physical gold, and the budget deficit this year is likely to be roughly $10bn, considerably less than 1% of GDP. These relationships suggest that a rouble to gold exchange standard could work so long as fiscal discipline is maintained and credit expansion moderated.

Once a rate is set, the Russians would not be restricted to just buying and selling gold to maintain the rate of gold exchange. The CBR has the power to manage rouble liquidity as well, and as John Butler points out, it can issue coupon-bearing bonds to the public which would be attractive compared with holding cash roubles. By issuing these bonds, the public is in effect offered a yield linked to gold, but higher than gold's interest rate indicated by the gold lease rates in the London market. Therefore, as the sound-money environment becomes established the public will adjust its financial affairs around a considerably lower interest rate than the current 9.5%-10% level, but in the context of sound money it must always be repaid. Obviously the CBR would have to monitor bank credit expansion to ensure that lower interest rates do not result in a dangerous increase in bank lending and jeopardise the arrangement.

In short, the central bank could easily counter any tendency for roubles to be cashed in for gold by withdrawing roubles from circulation and by restricting credit. Consideration would also have to be given to roubles in foreign ownership, but the current situation for foreign-owned roubles is favourable as well. Speculators in foreign exchange markets are likely to have sold the rouble against dollars and euros, because of the Ukrainian situation and as a play on lower oil prices. The announcement of a gold exchange standard can therefore be expected to lead to foreign demand for the rouble from foreign exchange markets because these positions would almost certainly be closed. Since there is currently a low appetite for physical gold in western capital markets, longer-term foreign holders of roubles are unlikely to swap them for gold, preferring to sell them for other fiat currencies. So now could be a good time to introduce a gold-exchange standard.

The greatest threat to a rouble-gold parity would probably arise from bullion banks in London and New York buying roubles to submit to the CBR in return for bullion to cover their short positions in the gold market. This would be eliminated by regulations restricting gold for rouble exchanges to legitimate import-export business, but also permitting the issue of roubles against bullion for non-trade related deals and not the other way round.

So we can see that the management of a gold-exchange standard is certainly possible. That being the case, the rate of exchange could be set at close to current prices, say 60,000 roubles per ounce. Instead of intervention in currency markets, the CBR should use its foreign currency reserves to build and maintain sufficient gold to comfortably manage the rouble-gold exchange rate.

As the rate becomes established, it is likely that the gold price itself will stabilise against other currencies, and probably rise as it becomes remonetised. After all, Russia has some $380bn in foreign currency reserves, the bulk of which can be deployed by buying gold. This equates to almost 10,000 tonnes of gold at current prices, to which can be added future foreign exchange revenues from energy exports. And if other countries begin to follow Russia by setting up their own gold exchange standards they likewise will be sellers of dollars for gold.

The rate of increase in the cost of living for the Russian population should begin to drop as the rouble stabilises, particularly for life's essentials. This has powerfully positive political implications compared with the current pain of food price inflation of 11.5%. Over time domestic savings would grow, spurred on by low welfare provision by the state, long-term monetary stability and low taxes. This is the ideal environment for developing a strong manufacturing base, as Germany's post-war experience clearly demonstrated, but without her high welfare costs and associated taxation.

Western economists schooled in demand management will think it madness for the central bank to impose a gold exchange standard and to give up the facility to expand the quantity of fiat currency at will, but they are ignoring the empirical evidence of a highly successful Britain which similarly imposed a gold standard in 1844. They simply don't understand that monetary inflation creates uncertainty for capital investment, and destroys the genuine savings necessary to fund it. Instead they have bought into the fallacy that economic progress can be managed by debauching the currency and ignoring the destruction of savings.

They commonly assume that Russia needs to devalue her costs to make energy and mineral extraction profitable. Again, this is a fallacy exposed by the experience of the 1800s, when all British overseas interests, which supplied the Empire's raw materials, operated under a gold-based sterling regime. Instead, by not being burdened with unmanageable debt and welfare costs, by maintaining lightly-regulated and flexible labour markets, and by running a balanced budget, Russia can easily lay the foundation for a lasting Eurasian empire by embracing a gold exchange standard, because like Britain after the Napoleonic Wars Russia's future is about new opportunities and not preserving legacy industries and institutions.

That in a nutshell is the domestic case for Russia to consider such a step; but if Russia takes this window of opportunity to establish a gold exchange standard there will be ramifications for her economic relationships with the rest of the world, as well as geopolitical considerations to take into account.

An important advantage of adopting a gold exchange standard is that it will be difficult for western nations to accuse Russia of a desire to undermine the dollar-based global monetary system. After all, President Putin was more or less told at the Brisbane G20 meeting, from which he departed early, that Russia was not welcome as a participant in international affairs, and the official Fed line is that gold no longer plays a role in monetary policy.

However, by adopting a gold exchange standard Russia is almost certain to raise fundamental questions about the other G20 nations' approach to gold, and to set back western central banks' long-standing attempts to demonetise it. It could mark the beginning of the end of the dollar-based international monetary system by driving currencies into two camps: those that can follow Russia onto a gold standard and those that cannot or will not. The likely determinant would be the level of government spending and long-term welfare liabilities, because governments that leech too much wealth from their populations and face escalating welfare costs will be unable to meet the conditions required to anchor their currencies to gold. Into this category we can put nearly all the advanced nations, whose currencies are predominantly the dollar, yen, euro and pound. Other nations without these burdens and enjoying low tax rates have the flexibility to set their own gold exchange standards should they wish to insulate themselves from a future fiat currency crisis.

It is beyond the scope of this article to examine the case for other countries, but likely candidates would include China, which is working towards a similar objective. Of course, Russia might not be actively contemplating a gold standard, but Vladimir Putin is showing every sign of rapidly consolidating Russia's political and economic control over the Eurasian region, while turning away from America and Western Europe. The fast-track establishment of the Eurasian Economic Union, domination of Asia in partnership with China through the Shanghai Cooperation Organisation, and plans to set up an alternative to the SWIFT banking payments network are all testaments to this. It would therefore be negligent to rule out the one step that would put a stop to foreign attempts to undermine the rouble and the Russian economy: by moving the currency war away from the foreign exchanges and into the physical gold market were Russia and China hold all the aces.

*Technically a gold standard is a commodity money standard in which the commodity is gold, deposits and notes are fully backed by gold and gold coins circulate. A gold exchange standard permits other metals to be used in coins and for currency and credit to be issued without the full backing of gold, so long as they can be redeemed for gold from the central bank on demand.

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Alasdair Macleod | Head of Research

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