In Part I
, we looked at the period prior to and during the time of what we now
call the Classical Gold Standard. It should be underscored that it
worked pretty darned well. Under this standard, the United States
produced more wealth at a faster pace than any other country before, or
since. There were problems; such as laws to fix prices, and regulations
to force banks to buy government bonds, but they were not an essential
property of the gold standard.
In Part II
, we went through the era of heavy-handed intrusion by governments all
over the world, central planning by central banks, and some of the
destructive consequences of their actions including the destabilized
interest rate, foreign exchange rates, the Triffin dilemma with an
irredeemable paper reserve currency, and the inevitable gold default by
the US government which occurred in 1971.
Part
III is longer and more technical, as we consider the key features of
the unadulterated gold standard. It could be briefly stated as a free
market in money, credit, interest, discount, and banking. Another way
of saying it is that there would be no confusion of money (i.e. gold)
and credit (i.e. paper). Both play their role, and neither is banished
from the monetary system.
There
would be no central bank with its “experts” to dictate the rate of
interest and no “lender of last resort”. There would be no Securities
Act, no deposit insurance, no armies of banking regulators, and
definitely no bailouts or “too big to fail banks”. The government would
have little role in the monetary system, save to catch criminals and
enforce contracts.
As
mentioned in Part I, people would enjoy the right to own gold coins, or
deposit them in a bank if they wish. We propose the radical idea that
the government should have no more involvement in specifying the
contents of the gold coin than it does specifying the contents of the
software that runs a web server. And this is for the same reason: the
market is far better at determining what people need and far better at
adapting to changing needs.
In
1792, metallurgy was primitive. To accommodate 18th century gold
refiners, the purity of the gold coin was set at around 90% pure gold
(interestingly the Half Eagle had a slightly different purity than the
Eagle though exactly half the pure gold content). Today, much higher
purities can easily be produced, along with much smaller coins (see http://keithweiner.posterous.com/pieces-of-50). We also have plastic sleeves today, to eliminate wear and tear on pure gold coins, which are quite soft.
If
the government had fixed a mandatory computer standard in the early
1980’s (some governments considered it at the time), we would still be
using floppy disks, we would not have folders, and most of us would not
be using any kind of computer at all, as they were not user friendly.
When something is fixed in law, it is no longer possible to innovate.
Instead, companies lobby the government for changes in the law to
benefit them at the expense of everyone else. No good ever comes of
this.
We
propose the radical idea that one should not need permission to walk
down the street, to open a bank, or to engage in any other activity.
Without banking permits, licenses, charters, and franchises, the door is
not open to the game played by many states in the 19th century.
“To
operate a bank in our state, you must use some of your depositors’
funds to buy the bonds sold by our state. In return, we will protect
you from competition by not allowing out-of-state banks to operate
here.”
Most
banks felt that was a good trade-off, at least until they collapsed due
to risk concentration and defaults on state government bonds.
State
and federal government bonds are an important issue. We will leave the
question of whether and when government borrowing is appropriate to a
discussion of fiscal policy. There is an important monetary policy that
must be addressed. Government bonds must not be treated as money.
They must not become the base of the monetary system (as they are
today). If a bank wants to buy a bond, including a government bond,
that is a decision that should be made by the bank’s management.
An
important and related principle is that bonds (private or government)
must not be “paid off” by the issuance of new bonds! Legitimate credit
is obtained to finance a productive project. The financing should match
the reasonable estimate of the useful life of the project, and the full
cost must be amortized over this life. If the project continues to
generate returns after it is amortized, there is little downside in such
a conservative estimate (though it obviously makes the investor case
less attractive).
On
the other hand, if the plant bought by the bond is all used up before
the bond is paid off, then the entrepreneur made a grave error: he did
not adequately deduct depreciation from his cash flows and now he is
stuck with a remaining debt but no cash flow with which to pay it off.
Issuing another bond to pay off the first just extends the time of
reckoning, and makes it worse. Fully paying debt before incurring more
debt enforces a kind of integrity that is almost impossible to imagine
today.
With
few very limited and special exceptions, a bank should never borrow
short and lend long. This is when a bank lends a demand deposit, or
similarly lends a time deposit for longer than its duration. A bank
should scrupulously match its assets to its liabilities. If a bank
wants to buy stocks, real estate, or tulips, it should not be forcibly
prevented, even though these are bad assets with which to back
deposits. The same applies to duration mismatch.
Banks
must use their best judgment in making investment decisions. However,
the job of monetary scientists is to bellow from the rooftops that
borrowing short to lend long will inevitably collapse, like all pyramid
schemes (see the author’s paper: Duration Mismatch Will Always Fail)
There
should be no price-fixing laws. Just as the price of a bushel of wheat
or a laptop computer needs to be set in the market, so should the price
of silver and the price of credit. If the market chooses to employ
silver as money in addition to gold, then the price of silver must be
free to move with the needs of the markets. It was the attempt to fix
the price, starting in 1792 that caused many of the early problems.
While “de jure” the US was on a bimetallic standard, we noted in Part I
that “de facto” it was on a silver standard. Undervalued gold was
either hoarded or exported. After 1834, silver was undervalued and the
situation reversed. Worse yet, each time the price-fixing regime was
altered, there was an enormous transfer of wealth from one class of
people to another.
Similarly,
if the market chooses to adopt rough diamonds, copper, or “bitcoins”
then there should be no law and no regulation to prevent it (though we
do not expect any of these things to be monetized) and no law or
regulation to fix their prices either.
If
a bank takes deposits and issues paper notes, then those notes are
subject to the constant due diligence and validation of everyone in the
market to whom they are offered. If a spread opens up between Bank A’s
one-ounce silver note and the one-ounce silver coin (i.e. the note
trades at a discount to the coin) then the market is trying to say
something.
What
if an electrical circuit keeps blowing its fuse? It is dangerous to
replace the fuse with a copper penny. It masks the problem temporarily,
and encourages you to plug in more electrical appliances, until the
circuit overheats and set the house on fire. It is similar with a
government-set price of paper credit.
A
market price for notes and bills is the right idea. Free participants
in the markets can choose between keeping their gold coin at home
(hoarding) vs. lending their gold coin to a bank (saving). It is
important to realize that credit begins with the saver, and it must be
voluntary, like everything else in a free market. People have a need to
extend credit as explained below, but they will not do so if they do
not trust the creditworthiness of the bank.
Before
banking, the only way to plan for retirement was to directly convert 5%
or 10% of one’s weekly income into wealth by hoarding salt or silver.
Banking makes it much more efficient, because one can indirectly
exchange income for wealth while one is working. Later, one can
exchange the wealth for income. This way, the wealth works for the
saver his whole life, and there is no danger of “outliving one’s
wealth”, if one spends only the interest. In contrast, if one is
spending one’s capital by dishoarding, one could run out.
No
discussion on banking would be complete without addressing the issue of
fractional reserves. Many fundamental misunderstandings exist in this
area, including the belief that banks “create money”. Savers extend
credit to the banks who then extend credit to businesses. The banks can
no more be said to be creating money than an electrical wire can be
said to be creating energy.
Another
error is the idea that two or more people own the same gold coin at the
same time. When one puts gold on deposit, one gives up ownership of
the gold. The depositor does not own the gold any longer. He owns a
credit instrument, a piece of paper with a promise to pay in the
future. So long as the bank does not mismatch the duration of this
deposit with the duration of the asset it buys, there is no conflict.
If
people want to vault their gold only, perhaps with some payment
transfer mechanism, there would be such a warehousing service offered in
the market. But this is not banking. It’s just vaulting, and most
people prefer the convenience of fungibility. Who wants the problems of
a particular vault location and a delay to transfer it elsewhere? And
who wants a negative yield on money just sitting there?
A
related error is the claim, often repeated on the Internet, is that a
bank takes 1,000 ounces in deposit and then lends 10,000 out. Poof!
Money has been created—and to add insult to injury, the banks charge
interest! The error here is that of confusing the result of a market
process (of many actors) with a single bank action. If Joe deposits
1,000 ounces of gold, the bank will lend not 10,000 ounces but 900
ounces (assuming a 10% reserve ratio).
Mary
the borrower may spend the money to build a new factory. Jim the
contractor who builds it may deposit the 900 ounces in a bank. The bank
may then lend 810 ounces, and so on. This process works if and only if
each borrower spends 100% of the money and if the vendors who earned
their money deposit 100% of it, in a time deposit. Otherwise, the
credit (this is credit, not money) simply does not multiply as Rothbard
asserts.
This
view of money multiplication does not consider time as a variable.
Gold payable on demand is not the same as gold payable in 30 years. It
will not trade the same in the markets. The 30-year time deposit or
bond will pay interest, have a wide bid-ask spread, and therefore not be
accepted in trade for goods or services.
This
process involving the decisions of innumerable actors in the free
market may have a result that is 10X credit expansion. But one cannot
make a shortcut, presume that it will happen, and then assert that the
banks are “swindling.”
If
one confuses credit (paper) with money (gold), and one believes that
inflation is an “increase in the money supply” (see here for this
author’s definition: Inflation – An Expansion in Counterfeit Credit)
then one is opposed to any credit expansion and hence any banking.
Without realizing it, one finds oneself advocating for the stagnation of
the medieval village, with a blacksmith, cobbler, cooper, and group of
subsistence farmers. Anything larger than a family workshop requires
credit.
Credit
and credit expansion is a process that has a natural brake in the gold
standard when people are free to deposit or withdraw their gold coin.
Each depositor must be satisfied with the return he is getting in
exchange for the risk and lack of liquidity for the duration. If the
depositor is unhappy with the bank’s (or bond market’s) offer, he can
withdraw his gold.
This
trade-off between hoarding the gold coin and depositing it in the bank
sets the floor under the rate of interest. Every depositor has his
threshold. If the rate falls (or credit risk rises) sufficiently, and
enough depositors at the margin withdraw their gold, then the banking
system is deprived of deposits, which drives down the price of the bond
which forces the rate of interest up. This is one half of the mechanism
that acts to keep the rate of interest stable.
The
ceiling above the interest rate is set by the marginal business. No
business can borrow at a rate higher than its rate of profit. If the
rate ticks above this, the marginal business is the first to buy back
its outstanding bonds and sell capital stock (or at least not sell a
bond to expand). Ultimately, the marginal businessman may liquidate and
put his money into the bonds of a more productive enterprise.
A
stable interest rate is vitally important. If the rate of interest
rises, it is like a wrecking ball swinging into defenseless buildings.
As noted above, each uptick forces marginal businesses to close their
operations. If the rise is protracted, it could really cause the
affected country’s industry to be hollowed out. On the other hand, if
the rate falls, the wrecking ball swings to the other side of the
street. The ruins on the first side are not rebuilt. But now, capital
is destroyed through a different and very pernicious process: the burden
of each dollar of (existing) debt rises at the same time that the lower
rate encourages more borrowing (see: A Falling Interest Rate Destroys Capital).
From 1947 to 1981, the US was afflicted with the rising interest rate
disorder. From 1981 until present, the second stage of the disease has
plagued us.
Today,
under the paper standard, the rate of interest is volatile. The need
to hedge interest rate risks (and foreign exchange rate risk, something
else that does not exist under the gold standard) is the main reason for
the massive derivatives market. In this market for derivatives, which
is estimated to be approaching 1 quadrillion dollars (one thousand
trillion or one million billion), market participants including
businesses and governments seek to buy financial instruments to protect
them against adverse changes. Those who sell such instruments need to
hedge as well. Derivatives are an endless circle of futures, options on
futures, options on options, “swaptions”, etc.
The
risk cannot be hedged, but it does lead to a small group of large and
highly co-dependant banks, who each sell one another exotic derivative
products. Each deems itself perfectly hedged, and yet the system
becomes ever more fragile and susceptible to “black swans”.
These
big banks are deemed “too big to fail.” And the label is accurate.
The monetary system would not survive the collapse of JP Morgan, for
example. A default by JPM on tens or perhaps a few hundred trillion of
dollars of liabilities would cause many other banks, insurers, pensions,
annuities, and employers to become insolvent. Consequently,
second-worst problem is that the government and the central bank will
always provide bailouts when necessary. This, of course, is called
“moral hazard” because it encourages JPM management to take ever more
risk in pursuit of profits. Gains belong to JPM, but losses go to the
public.
There
is something even worse. Central planners must increasingly plan
around the portfolios of these banks. Any policy that would cause them
big losses is non-viable because it would risk a cascade of failures
through the financial system, as one “domino” topples another. This is
one reason why the rate of interest keeps falling. The banks (and the
central bank) are “all in” buying long-duration bonds, and if the
interest rate started moving up they would all be insolvent. Also, they
are borrowing short to lend long so the central bank accommodates their
endless need to “roll” their liabilities when due and give them the
benefit of a lower interest payment.
The
problems of the irredeemable dollar system are intractable. Halfway
measures, such as proposed by Robert Zoelick of the Bank for
International Settlements that the central banks “watch” the gold price
will not do. Ill-considered notions such as turning the IMF into the
issuer of a new irredeemable currency won’t work. Well-meaning gestures
such as a gold “backed” currency (price fixing?) might have worked in
another era, but with the secular decline in trust, why shouldn’t people
just redeem their paper for gold? One cannot reverse cause and effect,
trust and credit. And that’s what a paper note is based on: trust.
The world needs the unadulterated gold standard, as outlined in this paper, Part III of a series.
In Part IV, we will look at one other key characteristic of the Unadulterated Gold Standard: The Real Bill…
Addendum, by Pater Tenebrarum –
The Question of Defining Money and Fractional Reserve Banking
As
we have mentioned on previous occasions, we agree with many, even most
of the things Keith writes about above. But there remains a fundamental
difference between us when it comes to the definition of money and the
question of fractional reserve banking.
It
was a major advance in monetary theory, clearing up the major flaw in
the old dispute between the Banking and Currency Schools when Ludwig von
Mises pointed out in “The Theory of Money and Credit” (1912) that the
Peel Act of 1844 had to necessarily fail in its aim to stop boom and
bust cycles because it was not recognized by the Currency School that deposit money is also part of the money supply in the broader sense.
When
banks engage in fractional reserve banking, they most definitely create
additional deposit money literally 'from thin air', even though the
process involves the granting of credit and is in theory reversible (if
credit is paid back net, the supply of uncovered money substitutes will
shrink; it never happens, but it might happen and it did indeed happen before central banks and fiat money were introduced).
And it is not the case, in our opinion, despite modern-day legal conventions (which are plainly contradicted by centuries of European legal tradition beginning from antiquity),
that a demand deposit is a 'loan to the bank' and that the depositor
relinquishes his claim to the deposited money. How can it be a 'demand'
deposit, available on demand at any moment from the second it was
deposited, when the claim to it has been relinquished?
Obviously there must be a clear difference between irregular demand deposits and time deposits (mutuum
contracts). It is also not the case that this warehousing function
(which does not only include warehousing, but also things like checking
and payment services) means that the depositor will get back the exact
same coins (or fiat bank notes today, which are modern day standard
money) he has deposited. Rather he has the right to demand payment of
the tantundem (i.e., coins or banknotes of perfect fungibility
and equal value to those deposited) of his irregular demand deposit at
any time. The fact of the matter is that even though deposit money is
created in the process of credit creation, there is afterward a clear difference between what is 'credit' and what is 'money' (see also the links further below).
We
would submit that the current near $9 trillion in money available on
demand in demand and savings deposits in the US banking system are
indeed 'money'. Only a small fraction of this deposit money consists of
'covered' money substitutes for which bank reserves actually exist. The
remainder is money that was created from thin air in the course of
fractional reserve banking (i.e., it consists of uncovered money
substitutes for which no bank reserves exist), but nonetheless confers on its holders everything money can confer – in particular, every cent of this deposit money can be used for the final payment for goods and services on the market – hence it is money.
Today
the proportion of covered versus uncovered money substitutes has
increased sharply, due to the additions to the money supply since the
financial crisis having been driven primarily by active inflation on the
part of the Federal Reserve rather than by credit creation on the part
of the commercial banks. Prior to the crisis, the banking system was
levered up at far more than just 10:1 relative to its demand deposit
liabilities.
Without
the central bank there would have been a deflationary collapse of the
money supply back to its standard money basis (in old times, this would
have been the actual specie basis). Obviously the higher proportion of
'backing' of deposits in the form of excess bank reserves that exists
today is not the result of higher reserve requirements (those remain for
all practical purposes near zero); rather it is a result of the fact
that when the Fed monetizes debt, it automatically creates bank
reserves, which then are found on the liabilities side of its balance
sheet. Although these reserves are not money as long as they remain
deposited with the Fed, they nonetheless represent the 'cash assets' of
commercial banks. The Fed is bound by law to exchange bank reserves into
standard money (this is to say, banknotes nowadays) on demand (after
which such reserves will become additions to the money supply).
Article Source: Acting man