Stability out of chaos: Benjamin Graham’s commodity reserve currency

As WWII was drawing to a close the Allies came together to establish a new international financial order that could help correct the extreme imbalances that can grow from international trade.

The parties also wanted to avoid the deflationary bias that occurred under the gold standard where gold reserves became scarce due to low levels of gold mining and hoarding by holders of gold. Extreme imbalances and inflexible, deflationary monetary systems contributed to the Great Depression of the late 1920’s. A repeat of this type of scenario had to be stopped if the Allies wished to avoid a repeat of the conditions that led to hyperinflation in Germany and the emergence of Nazi military ambitions in Europe.

Imbalances can quickly develop when countries trade between each other: some countries develop large trade surpluses (the value of what they export exceeds their imports), while others develop trade deficits (import value exceeds export value). The sum of all those surpluses and deficits must add up to zero.

However, problems arise when one or more countries develop large trade deficits. In order to finance that deficit countries typically borrow the funds (often from external creditors), but if debts rise to a level that they can’t service them anymore then the economy can quickly spiral into a tailspin of currency depreciation, higher inflation, interest rate hikes and economic stagnation and unemployment. Soon enough you might have a depression on your hands. The economists and policymakers gathered at the Bretton Woods conference were trying to find a means by which trade surpluses could automatically be recycled back to those countries with trade deficits.

The British economist John Maynard Keynes proposed an overarching “International Clearing Union”. The union would incentivise nations to keep their trade balanced. Run too far into deficit, and a country would be required to devalue to reduce imports. But run too far into surplus, and a country’s currency would be required to appreciate so as to increase imports.

International commodity buffer stocks were also proposed. Stocks would be added to if commodity prices fell more than 10% below the long run cost of the most efficient producer. Stocks would be sold if prices rose more than 10% above the long run cost. In this way Keynes suggested that stabilising the commodity cycle would promote trade and provide an effective demand side pump in the event of a global slump.

Keynes proposed a new reserve currency, the “bancor,” that could only be used for settling international accounts. Member nations would pay a membership quota in proportion to their total trade. Countries in surplus would receive bancor credit, while those in deficit would have a negative account. A bancor tax would also be levied at an increasing rate on anyone with a large trade imbalance.

Keynes ideas was ultimately rejected. The US proposal in which the dollar would be pegged to gold and other countries would use semi-fixed exchange rates to anchor against the dollar was ultimately taken forward. The challenge of dealing with countries with large trade deficits was left to the newly formed International Monetary Fund to solve. Nations with large surpluses had no such restraints on growing even larger. The Bretton Woods agreement broke down in 1971 when US President Nixon suspended the dollars convertibility into gold.

Far less well known is that there wasn’t just two proposals on the table. Other smart people were also at the meeting with ideas of their own, ideas that could correct global trade imbalances and potentially promote productivity growth.

Graham’s commodity reserve currency

Investor Benjamin Graham is commonly known as one of the founding fathers of value investing. His book, The Intelligent Investor: The Definitive Book on Value Investing was described by Warren Buffet as “By far the best book on investing ever written”. Graham is far less well known for the advice that he gave policymakers, both pre-WWII and after the war during the Bretton Woods negotiations.

Graham had seen the waste that came with the commodity cycle, “If surplus stocks do not operate as a national liability rather than an asset, the fault must lie in the functioning of the business machine and not in any inherent viciousness of the surplus itself…Some means must be found to restore the Goddess of Plenty to the role of benefactress-in-chief that was hers without question under a simpler economy.”

Graham outlines his idea in the book, World Commodities & World Currency. His proposal was to create a new international currency that would be fully backed by a basket of raw materials. This was a big step further from Keynes’ idea of using buffer stocks to help stabilise the economy. The commodity reserve currency would not only serve in international payment and settlement between central banks, but could be used privately and issued privately through the production of commodities. In short his proposal was “to accord a composite group of basic commodities exactly the same monetary status as was formerly give to gold.”

Graham’s proposal for a commodity reserve currency had high aims. He wanted to resolve global imbalances, provide an anchor to real exchange rates, tame cost-push inflation, promote free trade, allow autonomous employment and credit policies, and provide the resource security necessary for equitable robust growth. And in the aftermath of WWII, world peace.

The basket of commodities

The new currency would be based on an index constructed of at least 15 storable commodities, with the actual number requiring a balance between “the conflicting objectives of of administrative simplicity and adequate commodity coverage.” The price of individual commodities would still be determined by the normal supply and demand fundamentals and private sellers would continue to be paid in dollars as they were previously. Graham proposed that the commodity index could be rebalanced over time based on changes in global production and trade in commodities.

A buffer stock would enable the price of the basket of commodities to be kept stable – Graham proposed a narrow spread of 10%. Reserves from the buffer stock would be supplied counter cyclically as long as commodity prices were positively correlated with economic activity. If, during a downturn in economic activity commodity prices rose (perhaps due to the unplanned closure of a mine) then some adjustment up in the index could be made. Buffer stocks would be held in both net-suppliers of commodities and net-buyers in order to increase the security of supply with the cost paid for by those who chose to store.

Graham recognised that on the one hand stockpiles are “praised as necessary, advantageous and in universal use”, while on the other they are viewed with suspicion: “Whether a commodity reserve system will function as a national asset or as a national liability depends upon the mechanism under which it operates. It is entirely a question of technique. A stockpile is beneficial and non-embarassing if it is set up solely to meet future needs. When the objective is primarily that of early sale, then a stockpile is likely to prove unsettling to the markets and expensive to those who hold it.”

That was the view of many so called stockpiles in the inter war years and in the aftermath of WWII. Attempts to mange the commodity cycle focused on scarcity (including destroying oversupplied crops as in the case of coffee in Brazil), rather than abundance. This destroyed any incentive to become more productive in the toiling of the fields, extraction of metals and minerals and the exploration for energy. By giving authority to manage a single commodity under the purview of a political body this also meant it’s operation was prone to the attention and influence of special interest groups. According to Graham it was vital that the existence of stockpiles be outside of the political control of special interests, and instead be an automatic stabiliser that could not be dumped on the market:

“By placing commodity units at the side of gold in the monetary system, we place them also at a wholesome distance from the commercial markets. Their effect upon the markets can only be in the direction of stability – to support prices where they are generally weak and to supply commodities when prices are moving upward. Hence there is no reason for the units to cause the unsettled and apprehensive feeling with which business regards the existence of large government stockpiles subject to administrative discretion.”

The buffer stocks proposed by Graham offered quantity insurance. In contrast, market proponents advocating futures markets and other risk management strategies only provided price insurance.

A more equitable share in the expansion of global trade

According to Graham the commodity reserve currency has significant advantages compared with gold and the system of debt proposed by others, “It embodies the new attitude of groceries first. To this end it can bring the world economy closer to its merchandise economy and prevent world finance from interfering with the true business of the world which is to produce, exchange, and consume useful goods and services.”

The economist also made the case that because the pursuit of the commodities backing the currency would be dispersed, rather than concentrated, then this would mean that wealth could be captured by anyone wishing to work hard enough for a better living, not necessarily those closest to the existing financial system:

“Two other fundamental consequences flow from the eligibility of commodity units to serve as backing for currency. The first is that the world policy concerning the size of its stockpiles need not be controlled by financial considerations but can be guided instead by the more fundamental emphasis on possible and desirable living standards. The second, of perhaps greater importance than the first, is that the very financial inadequacies which make it so difficult to consume the world’s production in peacetime will be remedied by the process of building up the commodity-unit stockpile. Each addition to the store means a corresponding increase in the monetary resources or raw-material producers, and this benefit will not be concentrated on a small segment of activity as in gold mining, but instead it will be widely distributed among millions of producers everywhere.”

An improved standard of value would mean that commodity producers could yield a higher and more reliable income from their output. This would help those nations purchase manufactured goods, rather having to rely on debt. According to Graham, “Commodity units afford every country the opportunity to transmute its own productivity into sound international monetary units free from demoralising fluctuations in exchange value.”

The issuance of a commodity reserve currency would mean the accumulation of reserves by surplus countries could then be converted into material inputs for manufactured goods whenever they want. Meanwhile, low income countries who want to import more manufactured goods have an alternative to debt and foreign aid. Meanwhile, in contrast to a gold standard in which reserves were held by relatively few countries, Graham’s new currency would be more equitable and stable since many more countries depend on the production and consumption of commodities.

Price and output stability

It would result in much greater stability between currencies, “A stable price level for commodities implies, by definition, a stable value for the currency in which prices are measured. To that extent commodity stability is synonymous with currency stability. Our proposed international commodity reserve currency will therefore result in a stable international money of account.” Plans outlined by Keynes and others dealt with fixing the value of currencies against each other, but this would have done nothing to moderate the price volatility in the underlying commodities.

Graham argued that a commodity reserve currency is superior to the gold standard or one based on silver, “First, it relates money to the sound value of many money necessary goods and not to a largely facetious value imparted to one favoured commodity. Second, it will increase the supply of money more generously than can be done by coining silver alone, and it will spread the coinage advantages over many nations and millions more individual producers. Third, it will contribute directly to stabilizing the price level of basic raw materials and to stimulating a balanced expansion in their output. Fourth, it will create truly useful reserve stocks of such materials, which can minister to the safety and prosperity of the world.”

The fear among economists and politicians around the time of the Bretton Woods negotiations was that a return to the gold standard would result in deflation being transmitted from the united States around the globe:

“A plan to stabilise the key raw materials is itself a potent weapon against deflation and depression. There could be nothing in such an arrangement that could possibly run counter to any one country for stability and balanced expansion.”

He went further and argued that the commodity reserve unit would help ensure high employment by reducing the vagaries of the business cycle, “it will contribute greatly towards that end [full employment] by expanding the output of primary commodities and by increasing the purchasing power of numerous small producers. Since it will eliminate wide fluctuations in prices it will narrow the swings of the business cycle, and thus reduce unemployment caused by cyclical depressions.” Graham felt that if commodity prices were less volatile then this would be a significant stabiliser for the price of finished goods and overall inflation, “an adequate degree of stability in primary goods is certain to be accompanied by sufficient stability in processed goods.”

Graham wasn’t the first to see the benefits of two-way convertibility between the monetary unit and a composite of fundamental commodities. Both Alfred Marshall and W. S. Jevons outlined the basic idea in the mid to late 19th Century, but without conceiving (as Graham did) of how it would actually work in practice. The latter outlining his thoughts on the stability it could bring, “Indeed as the articles into which it is convertible are those needed for continual consumption, the purchasing power of the note must remain steady, compared with that of gold and silver, which metals are employed for only a few specific purposes.”

An idea whose time has come?

Could Graham’s ideas see a fresh look after recent events in Ukraine and the freezing of Russia’s central banks FX reserves? Whether it looks like Graham’s vision or not, the role of commodities as money could be making a new beginning. According to Zoltan Pozsar, investment strategist at Credit Suisse commodities could become a central feature of currencies once this crisis is finished as an alluring form of outside money:

“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…”

Pozsar believes it is China who is most likely to adopt such a system:

“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. 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…”

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