This Insight is the eighth in the serial publication of the new, Revisited edition of my book, The Golden Revolution (John Wiley and Sons, 2012). (The first instalment can be found here.) The book is being published by Goldmoney and will also appear as a special series of Goldmoney Insights over the coming months. This instalment comprises the Introduction to Section II.
Part II: Why the Days of the Fiat Dollar are Numbered
“[T]hree-hundred and seventy-one grains of four sixteenth parts of pure, or four hundred and sixteen grains of standard silver.”
ORIGINAL DEFINITION OF A US DOLLAR, 1792 US COINAGE ACT
“This note is legal tender for all debts, public or private.”
CURRENT DEFINITION OF A US DOLLAR, AS STATED ON EACH FEDERAL RESERVE NOTE.
When one thinks of a reserve currency, one doesn’t think of one that is exploding in supply, pays a zero rate of interest, is backed by a central bank that apparently will stop at nothing to prevent an overleveraged economy from saving, is issued by a government running soaring budget deficits used to finance prolonged wars and openended welfare policies, is the legal tender for an opaque and quite possibly insolvent or even fraudulent financial system (e.g., the relentless stream of banking litigation and settlements for wrongdoing), and has been steadily losing purchasing power for decades. No, a reserve currency is naturally expected to be not only a reasonably stable store of value but also, arguably, the most stable store of value for the world at large; the anchor for all other currencies, be they officially pegged or allowed to float; and the universal, benchmark unit of account for measuring wealth generally.
Of course, for most of the dollar’s existence as the world’s primary reserve currency, things looked rather different. In 1944, the United States was by far the largest, most dynamic economy in the world, with an industrial base bigger than the rest of the world put together. (Of course, much of the European and Japanese industrial base had been destroyed by 1944.) Victory in World War II was within sight, and the United States was emerging as the clear winner. Although Britain, France, and the Soviet Unions were on the winning side as allies, their countries had suffered far more in terms of casualties, both military and civilian, and in terms of destroyed or damaged infrastructure. All were essentially bankrupt and, without considerable US assistance, Britain and France were at risk of losing control over their long-held overseas empires (which they, in fact, did give up during the subsequent two decades).
The United States took advantage of this overwhelmingly dominant position and, in that year, negotiated the Bretton Woods arrangements (named after the New Hampshire town where the conference was held) between the victorious powers, with the notable exception of the Communist Soviet Union. Following a multidecade period of global monetary mayhem, the ultimate cause of which was the economically devastating World War I, the United States took it upon itself to try to restore some degree of global monetary stability, in a way suited to US interests, of course. It was generally accepted that a return to some form of gold standard was desirable, as it was believed responsible for the monetary stability that underpinned generally healthy global economic growth in the decades leading up to World War I, a period economic historians refer to as that of the classical gold standard. As such, the cornerstone of the Bretton Woods arrangements was that the dollar would become the global reserve currency, fixed to gold at $35 per troy ounce, and that other currencies would then be fixed to the dollar. It was a nice arrangement for the United States in that member countries’ central banks were effectively forced to hold dollar reserves. This had the effect of lowering US borrowing costs, a tremendous economic benefit not only for the US government but for US borrowers generally.1
There was, however, a hitch, which was that by pegging the dollar to gold, in the event that other countries ran persistent trade surpluses with the United States—exporting more than they imported—then they would accumulate ever-growing dollar reserves. At some point, they might desire to exchange some of these dollars for gold at the official rate of $35 per ounce. Indeed, already in the 1950s, there was concern in France and, to a lesser extent, Germany, that the rate of dollar reserve accumulation was undesirable and unsustainable. But with the French franc and German mark fixed to the dollar, their persistent trade surpluses required rising dollar reserve balances.
It was Charles de Gaulle, under the influence of legendary French economist Jacques Rueff, who eventually decided to begin exchanging some of the accumulated French dollar reserves for gold. At this time, the United States held a substantial portion of the world’s gold reserves, and making occasional gold transfers was not considered problematic. But as the years went by and the transfers grew, observers began to wonder whether the Bretton Woods arrangements were sustainable longer term. The United States held only so much gold. At some point, it might start to run out. What then?
A brief digression: why exactly was the US economy chronically losing gold to Europe? Well, by the 1960s, the United States was running chronic government deficits to finance a rapidly growing welfare state at home and wars, hot and cold, abroad. These deficits needed to be financed. Private domestic savings were insufficient to cover these public deficits, so the savings needed to come from elsewhere, namely, Europe and, later on, also Japan. With foreigners supplying an ever-growing portion of the savings to the United States, their dollar reserve balances rose and rose.
Eventually, observers no longer needed to wonder where this was going. The market price of gold in London began to rise above $35 as global investors began to lose trust in the willingness of the United States to keep the dollar pegged there indefinitely. Gold was thus being hoarded into private savings as a way to protect wealth from the growing risk of a future dollar devaluation. There were coordinated attempts by central banks and governments in the late 1960s to hold the gold price down to $35 per ounce, under London “gold-pool” conventions, but they failed under the growing demand for wealth protection. Finally, in 1971, the situation became untenable, and President Nixon made an executive decision to renege “temporarily” on the Bretton Woods arrangements and allow the dollar to float, that is, to decline theoretically without limit versus the market price of gold and, by corollary, versus any currency that chose to remain fixed to gold at the previous fixed rate. The unbacked fiat dollar as we know it today was born.
As for the future of the fiat dollar, to properly understand where we are going it is necessary to place contemporary events in the context of the monetary cycle of history introduced in Section I. Under Bretton Woods and for the entirety of its history, the US dollar was explicitly linked to gold in some way. While there is no specific reference to such a link in the Constitution of the United States—other than the link implied by giving the Congress the power to “coin” rather than “print” money—it was wholly unnecessary, as the circulating money of the time was overwhelmingly silver or gold coin, in particular the Spanish-milled silver dollar.2
The Coinage Act of 1792 is the first instance of the US Congress exercising its Constitutional monetary power by specifying an exact definition of a dollar as a fixed weight of silver. The act also specified the value of the dollar as a fixed weight of gold by setting an official gold-to-silver ratio at 15 to 1, thus making bimetallism official federal policy. The act stipulated that the dollar would henceforth serve as the official unit of account for the federal government, as it does to this day.
Yet the definition of a dollar has changed radically since. In the 180 years following the Coinage Act, as a result of one crisis or another, the dollar’s explicit link to silver and gold was gradually weakened. President Lincoln temporarily went off the bimetallic standard, issuing greenbacks to finance the Civil War. President Franklin D. Roosevelt nationalized gold holdings in 1933 and then devalued the dollar versus gold from $26.12 to $35 per ounce in 1934 in an unsuccessful attempt to end the Great Depression. It would be left to President Nixon, however, to sever the link to gold entirely, which he did abruptly at first in August 1971, then more formally in 1973, inaugurating the era of the unbacked, floating fiat dollar, with no official link to gold, which exists to the present day.
This section explores the reasons behind Nixon’s decision to close the gold window and the subsequent history of the fiat dollar, which, as we shall see, has been one of a steady series of crises, each progressively larger than that which came before it, and which collectively leave the US and global economies on the weakest monetary foundation in history, with only a tiny portion of currencies meaningfully backed by official gold holdings.3 In any reasonable long-term economic comparison, such as reference to average growth rates, or per-capita real income growth, the fiat dollar has been an economic disaster that continues to unfold before our eyes. Fortunately, the days of the fiat dollar are numbered. As we discuss in this section, the monetary cycle of history has entered a transitional phase in which the dollar, which has become a “bad” money, is in process of being displaced and, in time, replaced by gold. Let us first begin with a little history and then introduce some game theory. As we shall see, only gold can provide the game-theoretical international monetary equilibrium for an increasingly multipolar world highly dependent on trade.
1 A study by consulting firm McKinsey in 2009 estimated that US borrowing costs were some 0.5 to 0.6 percent lower because of the dollar’s reserve currency status. See “An Exorbitant Privilege? Implications of Reserve Currencies for Competitiveness,” McKinsey Discussion Paper, December 2009.
2 The history of the dollar long predates that of the Congressional definition in the 1792 Coinage Act. Indeed, the dollar was originally known as the thaler or Joachimsthaler, which translates into English as “from the Joachim Valley,” which is in Bohemia, today part of the Czech Republic. Count Hieronymous Schlick, a Bohemian prince, minted the thalers in the sixteenth century. They were considered such a superior coinage that they became the standard by which other European coins were measured. The greatest coin minters in European history, the Spaniards, who brought back the bulk of the silver and gold bullion from the New World in the sixteenth to eighteenth centuries, named their benchmark coins dollars, after the fabled thaler. The term pieces of eight is also related to the thaler in that it refers to the fact that the Spanish dollar, when introduced, was worth eight Spanish reales, the previous standard Spanish coin.
3 Today, at current gold prices, less than 2% of the US money supply is backed by US gold reserves.
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