A Banker for All Seasons Part II

Aug 7, 2013·John Butler

A BANKER FOR ALL SEASONS, PART II: John Exter's Views on Financial Crises, Money Demand and the 'Exter Pyramid'

This is the second in a series of essays discussing the life, times and monetary theories of the late John Exter (1910-2006). He was an economist, central banker, commercial banker, teacher and monetary expert. In this essay, we explore how John's experiences in academia and policy circles contributed to the development of his theory of financial crises and the 'Exter Pyramid'.

John studied Keynesian economics at university and then ended up teaching it at Harvard. But it was at Harvard, in about 1939, that he realized that Keynes's "new economics" had come to dominate economic thought and policy and that the road ahead was treacherous. By 1943 Exter had become totally disenchanted with Keynesianism. His main concern about Keynesianism was that it assumed a closed rather than international economy. Exter also believed that the Keynesians failed to understand money and debt.

After the war John Exter's career took him to the Federal Reserve and by 1962 he had been in the Federal Reserve system for a decade. Exter set up two foreign central banks, served as the governor of one, and ended up in charge of gold and silver operations at the Federal Reserve Bank of New York.

While with the Federal Reserve Exter became dismayed with how many dollars were being printed and how those dollars flowed out to foreign central banks who then turned around and bought US Treasury securities to hold as reserves. This in turn helped to keep US interest rates low, thereby supporting growth. What seemed a virtuous circle, however, could only last as long as foreign central banks preferred holding Treasuries instead of swapping their dollar reserves for gold instead. It was an international, high stakes, monetary confidence game. In 1965, France made the first big move out of Treasuries and into gold and other countries followed thereafter.

Exter believed the Fed was locking itself into an expansionism it dare not stop. He went on to say that the Fed was becoming a prisoner of its own expansionism and the risk was a credit expansion reaching total US debt levels far in excess of the country's GDP. He envisioned a major debt crisis ahead and believed the crisis would then turn the economy down, like nothing seen since the Great Depression. He warned the Fed would find itself pushing on a string and would be unable to prevent a deflationary depression.

Exter realized, by the late 50's and early 60's, what had evolved was a debt based, debt driven economy and monetary system and to illuminate it's structure he devised an upside down debt pyramid as his model. He presented the US debt pyramid and drew attention to the fact that all foreign economies also had debt pyramids. The structure, precariously perched at its apex, was by its very nature unstable which Exter believed was also true for the financial system generally. In his original inverted pyramid were junk bonds, all illiquid debtors, commercial paper, bankers acceptances, developing economies' debts, CD's, Federal government debt, corporate and municipal bond debt and paper currencies. The categories with the greatest risk occupied the broad part of the pyramid. Further down the pyramid were less risky debt categories and the risk declined until Treasury Bills and cash (Federal Reserve Notes) were reached at the very tip of the pyramid.

Exter's original, upside-down debt pyramid balanced on the world's existing known quantity of gold, which at that time was a block representing about 140,000 metric tons. He put gold outside the pyramid because it represented the only real money in the world; it had no liability against it and it was the only asset refuge that could not default or be arbitrarily devalued in a crisis. In the Exter scenario, at some point people would lose faith in the financial system and move down the money pyramid to cash and then outside the pyramid entirely and into gold. So he envisioned the price of gold would be rising against all currencies as the value of debt and other securities declined.

John Exter was always reminding people that US dollars are debt obligations of the Federal Reserve and when FDR made it illegal for Americans to own gold, in 1933, the convertibility aspect of the dollar into gold ended for Americans. Americans were paid $20.67 an ounce for gold turned in and in 1934, under the Gold Reserve Act, the treasury raised the price to $35 an ounce. For Americans the dollar had been a promise to pay in gold but when convertibility ended Exter deemed the dollar had turned into an IOU nothing. The dollar remained convertible for foreigners, until 1971, when Nixon closed the gold window. So, for 42 years the dollar has been a total IOU nothing.

When John Exter came up with his inverted debt pyramid model, some 50 years ago, he was concerned that expanding illiquidity and existing debt in the system had already reached critical mass and the Fed was fast approaching a time when to revive an economy, which had turned down, would become impossible. But with the end of international gold convertibility in 1971, the Fed gained the ability to keep inflating indefinitely. As long as there was the political will to keep it going, total debt relative to the size of GDP could reach astronomical levels. We now know that it took until 2008 for the system to become so supersaturated with debt that a collapse was finally triggered.

In retrospect, the Exter debt pyramid model developed 50 years ago was able to keep expanding as long as clever financial innovation after innovation was introduced, enabling ever more leverage. The mushrooming derivatives market with its credit default swaps, collateralized debt obligations, which are a major force in the derivatives market and items like mortgage backed securities have all taken up residence at the top of the inverted Exter debt pyramid. According to Exter's model, those derivatives with the weakest and longest links to base money are the first to be rejected when confidence evaporates and the liquidation process then cascades into the value of the underlying collateral, eventually reaching the least risky securities and, at the tip of the pyramid, cash itself. Cash can't default, but unlike gold, it can be printed and devalued at will, and as we know, throughout history and without exception, paper monies have become totally worthless.

Let's look at the block of gold the Exter pyramid teeters on: In 1974 gold became legal for Americans to again own. By 1975 the gold price began to rise, reacting to increased inflation, around the world. The metal then made a major move which took it to $850 an ounce (London PM fix) on January 21, 1980. John Exter saw it as people simply converting whatever currency they were holding and leaving his pyramid for gold. But, the move ended abruptly in 1980 and gold began to be liquidated with proceeds going back into the debt pyramid and a 20 year generally declining gold market began which ended in the gold price bottoming out at $255.60 an ounce level (London PM fix) on April 2, 2001. The 1975 to 1980 period however, turned out to be proof of what happens when enough people exchange paper money for gold money.

It's now been five years since the 2008. Notwithstanding record global monetary and fiscal stimulus, growth has generally been disappointing in the US, Europe, Japan and, as 2013 unfolds, in many emerging markets as well. Currency debasement has been rampant but confidence in the paper money system generally has been maintained. The price of gold, which briefly reached $1,900 in August 2011, has declined back to around $1,300. Data also indicate that some holders of gold , mainly via the gold ETF market (ie 'paper' gold market) have sold out and are back in the securities and derivatives thereof in the Exter debt pyramid.

If John Exter were still alive, he would undoubtedly argue that on two separate occasions within the past forty years it's been demonstrated that investors seeking to reduce financial risk have reached the cash category in his debt pyramid, but then have lost confidence in whatever paper monies they were holding, and have chosen to move out of the pyramid entirely and into physical gold money. He would then look at the failing health of the 2013 global financial system, riddled with debt and leverage even more excessive than five years earlier, when the 2008 debt crisis nearly brought down the US and global financial system. The only conclusion he could possibly reach is that future moves from paper money into gold money will be magnitudes greater than what has already occurred twice in the past forty years. Will one of these be sufficient to collapse the system entirely? Will investors someday demand a return to gold-backed money? No doubt these are questions he would ponder.

John Butler
Managing Partner and Chief Investment Officer