Why the war in Ukraine does not jeopardise the dollar's reserve currency status

A reply to Zoltan Pozsar

By Florian M. Kern, director at Dezernat Zukunft - Institut für Makrofinanzen

Zoltan Pozsar is one of the world’s most respected money market specialists and predicted the repo crisis in September 2019. Here he is getting it wrong, as he misses key aspects about the gold market and monetary policy implementation in his analysis.

Zoltan separates money in “inside money” and “outside money”. “Inside money” is money that is someone’s liability (balances at the Fed or USTs [United States treasuries]). “Outside money” is held outside the financial system, so you can sell it without the need of financial infrastructure (like gold). As the current sanctions target inside money – Russias’s FX [foreign exchange] reserves in EUR and USD are frozen – Zoltan argues outside money has become more attractive. Why his argument seems plausible at first, it doesn’t hold when you consider market plumbing in gold vs USTs.

First, the gold market is simply not very liquid. Never in history did the aggregated sales of all (!) central banks (CBs) exceed 400t in a year (!). And when that happened, gold market participants were already accusing CBs of “market manipulation”. Russia has 2000t of gold. There is just absolutely no way Russia could sell more than 5-10% of its gold reserves within like a month. If Russia was starting to sell, prices would plummet, as there is simply very little market depth (important!) in the gold market.

Nobody wants to catch a falling knife and a central bank with major gold reserves selling would mean much more supply then there is demand, so brokers would stop quoting gold. Gold only has value, if “gold whales” (=central banks) aren’t selling it.

But can you still repo the gold? Well, that depends if you find someone who loans you money against your collateral, that is someone who is unaffected by sanctions and loans you against collateral you couldn’t sell in a liquid market and which sits in a vault in Moscow. Good look with finding that person. If someone believes Russia would in a put its gold reserves in a credit event on a ship and then deliver it you (where you still couldn’t sell them), they are more naïve than the Germans who thought NS2 had no political implications.

Does that mean gold is bad as a FX reserve? It depends on what you think the goal of having them is. Imho they are something you actually want to be able to use in a crisis to generate forex. By being able to this, you deter markets from enforcing a current account crisis. Gold won’t help you here. Some argue gold has something like a placebo effect. “Yes, you can’t sell it, but since people aren’t rational they actually trust a CB if it has gold, and since trust is of upmost importance to a CB, gold has a role on a CB balance sheet.” To me that is not convincing. If we all believe in enlightenment, we shouldn’t see a role for superstition on a CB balance sheet. Instead, we should explain people why we actually have gold reserves (for most CBs, they are a legacy of fixed rate regimes).

So let’s think of “inside money” in Zoltan’s terms, that is for example money on accounts at the NY Fed or USTs. Are they bad reserves if the US can freeze them? No, they are actually fantastic, as you can always (!) use them as long as you don’t invade a sovereign country. While the gold market has very little market depth, the UST market has basically infinite market depth, which was proven in March 2020. If the value of USTs falls below future cash flows discounted by (expected short-term rates + term premia + balance sheet costs), the Fed will step in. The Fed did so in the past and will do so in the future, as it considers the UST curve rightfully important for monetary policy implementation. That is well documented through the Feds actions and through speeches by Fed officials.

How would the Fed do so? By buying USTs with fiat money to preserve price stability – and keeping UST yields from jumping due to fire sales is important to preserve market functioning, which is needed to ensure price stability. In a world in which all central banks held gold as FX reserves, no CB would be able to produce additional gold in a liquidity crisis. As nobody would want to sell gold out of fear to run out of it, yields for gold repos would skyrocket and 1929 would repeat itself. On the other hand, as long as you don’t attack your neighbor, CBs can always repo their USTs at the NY Fed’s FIMA repo facility. Thus, USTs are great FX reserves, as you can actually use them to prevent a current account crisis – which is what they are there for.

So as long as you can refrain from attacking your neighbor, which isn’t terribly hard to refrain from, USTs (+ other safe assets in big economies that enjoy unlimited support by the CB that controls the currency the assets are denominated in) are preferable as FX reserves.

Comment from our editors:

Florian Kern is one the leading experts when it comes to the practical implementation of monetary policy on financial markets. His reply to Zoltan Pozsar's prognosis that Western sanctions against Russia are possibly the beginning of the end of the US dollar's status as the world's reserve currency delivers an excellent insight into the relevant criteria of a reserve currency: above all, liquidity, which neither gold nor, for that matter, cryptocurrencies provide. By doing so, Kern turns the whole seemingly intuitive concept of 'inside/outside' money employed by Pozsar on its head, demonstrating that outside of unleashing an unprovoked war of conquest kicking the attacker out of the global financial system, it is the inside money of US treasuries providing the best safe haven attainable.

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