How to return to sound money

Jan 9, 2020·Alasdair Macleod

Given the current fiat money system is on a path towards its own destruction it is not surprising that there has been increasing talk of a monetary reset. Without a completely different approach and by retaining the same institutions and macroeconomic concepts, any such reset is bound to fail.

This article provides a template for an enduring sound money solution that will deliver economic progress while eliminating destructive credit cycles. It posits that a properly constructed gold and gold substitute monetary system, which also includes the removal of bank credit inflation as a means of providing investment capital, is the only way that lasting stability and prosperity can be achieved. As well as the establishment of an incorruptible monetary system, the state’s role in the economy must be curtailed, budgets always balanced, banking reformed, and the private sector allowed to accumulate the wealth necessary to provide the investment for producers to produce. 

Monetary reform involves a clear understanding of why free markets succeed and why socialism, together with neo-Keynesian macroeconomics, are responsible for the impending monetary and economic collapse. It will require a complete change of socio-political and economic cultures, but properly approached it can be done.


There has been very little commentary in recent years about the benefits of sound money, being limited almost entirely to followers of the Austrian school of economics. Even less has been written about how to back out of inflationism, end unsound money and return to a monetary arrangement which cannot be corrupted by governments and the banking system.

The most notable attempt was by Ludwig von Mises who appended a chapter on the subject in his updated 1952 version of The Theory of Money and Credit[i] The circumstances were very different from that of today. At that time, the US had corrupted its gold exchange standard to progressively exclude the ability of individuals to demand gold for paper dollars. And both Keynesianism and socialism, in the West at least, were in their earlier days. Today, we face more of an end game where considerable damage has been done since to the status of circulating money, and we face the prospect not of reform but of a collapse of the entire fiat money system.

It is a situation which, if nothing had been done in the 1950s, von Mises predicted in his writings would eventually happen. We are now witnessing not just the failure of state currencies, but also the economic damage wrought. That the root of the problem is a combination of progressive inflationism fuelling a credit crisis is gradually becoming obvious to a small but growing number of critics.

Recent events, which are germane to all our economic prospects in 2020 and beyond, are now unmasking a deterioration in demand for manufactured output and declining credit quality consistent with the ending of the expansionary phase of the credit cycle. The increase of American trade protectionism at this point in the credit cycle has worrying echoes of 1929, when the Smoot-Hawley Tariff Act was passed by Congress and signed into law by President Hoover in 1930.

The opening months of 2020 should see yet more statistical confirmation that the world’s production is declining, only concealed by renewed monetary inflation. Recession and its consequences are the central banks’ worse fear and they are already in accelerated printing mode in yet another attempt to forestall it.

The immediate future of fiat currencies is centred on the dollar’s prospects as the reserve currency. Dollar-centric markets remain in denial, believing the dollar will always be supported by a flight to safety if things cut up rough. In the short-term, it might be a self-fulfilling prophecy. But after an initial Pavlovian reflex, the dollar’s future measured in other state currencies depends on the relative needs of economic actors on a national basis and the actual ownership position.

Here, the dollar fares badly, with dollar assets and cash in foreign hands totalling about $24 trillion, and US ownership of non-dollar assets less than half that at $11.297 trillion (end-2018). US ownership of foreign short-term debt securities was $502bn at that date, of which only $92bn was in foreign currencies the rest being in dollars, according to TIC data from the US Treasury. Other than foreign listed securities, which are small in total compared with foreign ownership of US securities, that $92bn is all the foreign currency American residents have to sell in a financial meltdown.

Of their $24 trillion total, foreigners owned $19.4 trillion of dollar assets, of which more than $8 trillion is in equities, and includes short-term debt securities of $980bn. Additionally, dollar deposits held through correspondent banks totalled $3.6 trillion last October. Dollar liquidity in foreign hands is therefore nearly $13 trillion, before one considers foreign investment in US Treasuries, which is mostly held by foreign governments and official organisations. Clearly, when foreign balances adjust to a world of contracting trade, dollars will be sold heavily, destroying its value and disrupting US capital markets with very little in the way of flows the other way to offset it.

In these circumstances it will be impossible for the US Government to fund its budget deficits through capital inflows as it is wont to do. And given the absence of domestic savings accumulation, which would detract from final consumption and therefore undermine the GDP statistic anyway, trillion-plus deficits will have to be financed almost entirely by monetary and bank credit inflation.

Sooner or later this is bound to lead to a severe crisis for the dollar and therefore all the fiat currencies that regard it as King Rat. The crisis will be further fuelled by a mixture of escalating government debt, falling purchasing power for the dollar, and increasing interest rates, the last being driven by the market response to a declining currency in terms of its purchasing power. It is a debt trap which will be reflected at the very least in a substantial decline of the full faith and credit in the US Government.

Eventually, possibly in a matter of only a few years, the dollar could become worthless. The few commentators aware of this danger have for some time been arguing for a currency reset without much idea how it can be implemented. It is almost certain that central banks will convene to cook up a new monetary plan as the dangers to the current system increase. But given the statist culture behind the problem, the basis of any state-initiated plan will surely include an attempt to secure the state’s monetary role and to extend its powers over markets. With the same underlying characteristics, any new currency arrangement based on a modification of the state-issued currency system is guaranteed to fail. History tells us that when the fiat route is pursued a second time, the public is already aware of government trickery and the second failure is swift (cf. France 1789-97 – assignats followed by mandates territoriaux which hardly lasted six months).

From an economic standpoint, the introduction of sound money will yield immediate benefits for the population compared with a failing currency regime. The problems obstructing it are a lack of understanding of catallactic theory by professorial economists and the establishment’s relentless grip on bureaucratic and political power.

To illustrate the required scale of the whole socio-economic and monetary reform involved, a solution which works must be proposed. Such a proposal must have sound incorruptible money at its heart, because no other arrangement will survive over time. It requires the termination of the central banking model. That central banks will be required to make their policy roles redundant virtually guarantees that the destruction of the fiat currency system, and its immediate replacement on a reset, are bound to occur before a sound money system of money and credit can be contemplated.

We should proceed with this assumption. Our sound money will be a phoenix rising from the ashes of monetary and economic destructiont.

This article provides a template for how a new monetary system based on sound incorruptible money can be implemented. It addresses the following topics: the reintroduction of gold as circulating money handing all monetary power to its users, dealing with existing government debt, reforming the banking system, and resetting economic theory to where it was before Keynes worked up fallacious roles for the state. Properly addressed and planned, its implementation should be less difficult than it at first appears, and any nation following the courses of action in this article is likely to see substantial economic benefits in less than a year.

Sound money – it can only be physical gold

For the avoidance of doubt, a gold substitute is a currency in all its forms fully backed by and convertible into gold on demand by all of its users. A gold exchange standard permits the expansion of unbacked bank credit and does not prevent governments inflating total money supply.

Before critics jump to the conclusion that I am promoting a role for gold, it should be clear that my primary interest is sound money, which happens to be gold. So, yes, I am promoting gold but only as sound money; the order is sound money first, gold second. This is why I (and my colleagues at Goldmoney) insist the proper role of physical gold is as money, and it is not to be regarded as an investment, though related media, such as ETFs, derivatives and mining shares are properly classified as gold-related investments.

There should be no need to reiterate why gold emerged as the money of people’s choice, ever since the division of labour progressed beyond the exchange of goods through barter. But it is worth making the point that the difference between today’s money of the state and gold is that the state uses the debasement of its currency as a means of wealth transfer from the people to itself and those in its favour. It is an instrument of funding additional to taxation.

With sound money monetary debasement is strictly limited. The quantity of gold required as money in the global economy is only part of above-ground stocks and its quantity and distribution is decided by economic actors, not the state. The obvious source of global supply is mining, which runs at about 2% of above-ground stocks, in line with long-term population growth. The other source of deployment is scrap, recycling gold to and from other uses. This is why prices measured in gold are inherently stable.

As a common form of trusted money, gold also facilitates trade across borders, and when trade is settled in gold or gold substitutes which a government or bank cannot magically create out of thin air, there are no trade imbalances other than temporary shifts in the ratio of gold to goods that align price levels across jurisdictions.

Clearly, the reintroduction of sound money requires a radical change of socio-political and economic culture. Constrained by a sound money regime, the inability of a government to run continual deficits will remove considerable power from the state. Sound money also forces governments to abandon socialising legislation and makes ordinary people more responsible for their own actions.

Since the abandonment of the Bretton Woods agreement, the degree of monetary inflation has been substantial. The rise in the price of gold from the pre-war peg of $35 has to an unknown degree corrected earlier monetary inflation when the dollar was first put on a gold exchange standard, following the Gold Standard Act of 1900. It has continued to reflect monetary inflation thereafter, particularly following the suspension of all convertibility in 1971. The adjustment to date has not compensated for all of the increase in the quantity of fiat dollars in existence, but that matters less than a conversion price which can be maintained for all time, because if it is to succeed the new dollar must be a proper gold substitute.

The setting of the conversion price is the most important decision to be exercised by the issuer of new dollars. But as we have seen, an arm of the government is always ill-equipped to take monetary decisions, so the sensible policy would be to announce the decision to return to gold as the primary form of money and allow the market a period of time to approximately settle the pricing of gold relative to that of the new state currency. At the same time, consolidation terms for exchanging old dollars for the new should be announced, which will stop the old currency sliding into worthlessness, if it hasn’t already, and ensure the new currency is widely distributed at the outset.

During the period between announcing the scheme and its implementation, the central bank or Treasury department (in the case of the US) should cause an independent metal audit of its gold stocks to be conducted, having established an oversight committee drawn from neutral observers to oversee the process.

It is vital to ensure markets trust the existence of gold reserves from the outset. In the case of the US Treasury, with a stated 8,134 tonnes in possession a proper metal audit may take too long. A metal audit has to confirm the existence, identity, weight and purity of every bar and coin held in or allocated to the reserve backing the currency. In any event, there may be more gold in the Treasury’s possession than needed to back the new currency at the outset.

As soon as sufficient progress in the metal audit has been made for the auditor to indicate the degree of discrepancies (if any) then the approximate rate will have been set by markets in the knowledge there is sufficient gold to allow the new currency to circulate as a substitute. The remaining gold stocks (if any) can be held in abeyance.

Once the ratio between the new currency and a weight of gold is fixed, decisions can then be taken over matters such as the form of coinage. A dollar/gold rate would have been defined. For example one gram of gold might be represented by 10 new dollars. A new dollar therefore would be ten centigrams of gold. And every new dollar issued electronically, in paper or coinage form would only exist if it is 100% backed by gold held at the central bank.

All restrictions on gold ownership must cease. In order to ensure the state does not surreptitiously elide from a currency substitute system towards a gold exchange standard, it is vital to have gold circulating alongside its substitutes. This is easily facilitated by issuing high-value gold coins, the basis of the British sovereign, which ties a face value to a weight of fine gold. Depositors withdrawing funds from a bank must have the facility to withdraw them either in gold coin or paper substitutes.

Coins for small amounts would circulate as token money, instead of gold itself. This would permit the monetary authorities to issue practical, hard-wearing alloy coins for circulation, being fully backed by gold. The issuance of these tokens will also replace small-denomination banknotes to downplay the role of bank notes generally, thereby enhancing the role of gold as the true circulating medium. With the elimination of unbacked bank credit (see below) cheques and electronic transfers will also be fully backed by gold and be recognised as gold substitutes.

Converting government bond debt

Accompanying a fiat currency collapse, there is bound to be a substantial quantity of government debt outstanding, which will have increased alongside the collapse of its fiat currency. The conversion rate for old debt denominated in failing fiat, alongside all other debt, would be fixed at the rate decided between the old fiat and the new currency operating as a gold substitute. Obviously, under a gold substitute regime, debt interest becomes payable either in new dollars or convertible into their gold equivalent on demand.

Under our new regime the issuance of new government debt can only be funded by an increase in personal savings. Having abolished the central bank and its role in setting interest rates any extra funding would have to incur a market rate for borrowing gold. While the interest rate experience of a credible gold exchange standard suggests that in time the rate would probably settle down at two or three per cent, adjusted for the tendency for prices of goods and services measured in gold to fall over time makes increased government borrowing expensive in real terms. There is therefore a strong incentive to avoid budget deficits and not increase debt.

There is also the consideration of the redemption arrangements of existing government bonds. As the old currency loses purchasing power, funding would only have been achieved at continually increasing yields, leaving nearly all outstanding debt trading at a significant discount to redemption value. The conversion of this debt into new dollars at an interest rate related to borrowing in gold would significantly lower interest costs.

Existing debt management procedures suggest that even with a balanced budget, maturing debt would have to be continually rolled over. Besides providing business for bond brokers unnecessarily, the ease with which this could be done could encourage the political class to slip into its bad old ways.

A better way to deal with the redemption problem is for the government to offer conversion terms into new consolidated loans with no final redemption date and a coupon rate high enough to ensure the conversion. On maturity, outstanding debt would be rolled into the new undated bonds. At the same time, a sinking fund should be established to allow the government to buy back its debt in the market when it is propitious to do so. The signal to the political class from this arrangement is that debt should be reduced over time and not just refinanced.

The British experience during the Napoleonic wars was that the yield on their consolidated loans reflected wartime risk. War funding proceeded by issuing new tranches of consolidated loans at a discount, so that a 3% gold coupon at, say, 60% of the nominal bond value becomes a yield to an investor of 5% in perpetuity. By backing the government at a time of war, an investor was rewarded with a handsome gain for doing so, particularly when the gold standard was reintroduced.

While we are assuming the introduction of a new gold substitute will be in peacetime, it is likely that public trust in government finances will be initially low, improving in time as confidence in both government finances and economic conditions improve. Like the wartime backers of the British government before Waterloo, early supporters of the new system will be rewarded with gains on their government bonds as yields begin to stabilise closer to long-term gold rates. These benefits, and indeed all gains and income from savings, must not be taxed in order to allow and encourage savers to replace fiat-money inflation as the source of all monetary capital.

Banking reform

The current banking system permits banks to lend credit into existence by creating money as loans are drawn down. There are consequences that flow from this facility. It permits banks to lend considerably more than their capital, expanding credit in good times and making the economy appear better than it really is. In this manner, every monetary unit of lending margin can become ten times profit, or even more, relative to a bank’s own capital. But credit expansion tends to lead to escalating demand for loans that cannot be satisfied without a very dangerous level of balance sheet gearing. Relatively cautious bankers then stop expanding their loan book, loan rates then rise and businesses, whose cost of working capital has risen, find their business plans are no longer profitable. It is always the riskier borrowers who start to find themselves in difficulties, and lending caution then spreads like a bushfire through the banking community.

The credit cycle turns, and the business cycle with it. Without the interposition of bank credit none of this would happen. In the absence of the creation of bank credit, failure of businesses becomes a healthy random event. Far from engendering stability, the combination of central bank inflation and the ebb and flow of commercial bank credit are destabilising, increasingly so over successive cycles.

The problem has arisen because in our financial system bank deposits are not customer deposits at all, but loans from so-called depositors to the banks. The customer’s possession of a bank deposit in a reformed banking system must be clearly addressed by banks being reorganised into either acting as deposit banks, being monetary custodians and paying agents for their customers, or loan arrangers which broker loans and investments. The same bank would be prohibited from doing both functions.

Additionally, the removal of limited liability for the bank’s directors would be a strong disincentive to bank fraud, so the entire panoply of expensive and ineffective bank regulation becomes redundant.

Resetting economic theory and the state’s economic role

For the purposes of this article, we have assumed that the implementation of a sound money regime will occur after the fiat money system has failed, and there will therefore be sufficient mandate from the public for the architects of a sound money and new banking system to proceed. It will be plainly evident that the old system has failed, and that macroeconomic and mathematical economists with their theories bear considerable responsibility for it. Quickly grasped, the opportunity for change will be there, but it will not silence the inflationists entirely.

All radical reformers have faced similar difficulties. It requires someone single-minded enough to weather all criticism and to focus on a pure solution. In the teeth of embedded inflationist habits and beliefs at the heart of government, it is perhaps a greater challenge than that faced by Hjalmar Schacht who tamed Germany’s hyperinflation in 1923, but did not address the bank credit problem. Or by Ludwig Erhard who was the architect of a new currency and of Germany’s post-war recovery in the late 1940s.

Since those earlier times, the intellectual drift away from free markets and sound money towards state intervention and inflationism has continued apace. Very few are the university professors who reject the state’s right to supremacy over free markets and show an understanding of the benefits of sound money. So ingrained are neo-Keynesian and socialist misconceptions that the implementation of monetary reform should be undertaken in a carefully planned order.

The initial action must be to introduce gold as money and the currency be reformed to act unquestionably as a gold substitute. This initial focus will almost certainly have full public support, with everyone desperate for monetary stability, having suffered impoverishment from the collapse of fiat currencies. It will give a reformer a free hand in not only monetary reform, but for the reform and replacement of the old institutions involved, particularly curtailing the activities of the central bank.

As an extension of monetary reform, banking in the commercial sector can then be addressed as a second step, consistent with the objective of replacing failed fiat currencies with a lasting sound money solution. And it also goes without saying that the crony capitalism which allows bankers to influence politicians by providing self-serving “advice” must be understood for what it is and ignored.

By implementing a sound money solution and with the evidence of economic progress that will rapidly become apparent in the wake of monetary reform, critics from the economic establishment can be temporarily silenced. There must be no pause in the momentum of reform in order to keep these critics constantly on the back foot. There will also be strong criticism from socialists, who are bound to view the monetary reform proposed herein as a primal threat to their cherished anti-market beliefs. Both camps deploy statistics to support their beliefs, and there is a necessity to wean the establishment off them. Beyond what is strictly necessary for accounting purposes, government statistical departments should be closed because they serve no genuine purpose anyway.

In a post-fiat world, the starting point for governments will be one of national bankruptcy, giving a reformer the opportunity to start with a clean slate. Lacking the flexibility of inflationary financing, governments will have to reduce and amend much of the socialising legislation that has dominated the creation of welfarism, particularly since the Second World War. It will take time but implemented skilfully and with appropriate political leadership it should be eminently possible. However, in our current inflationary environment, it is difficult to discern where this leadership will come from; but we must hope that, as has often been the case before, cometh the hour, cometh the man (or woman).

The person tasked with the reform necessary will have to find a balance between the remaining provisions of state welfare, which should be seen to be consistent with the state’s affordability and both sympathetic and civilised. There will always be the elderly, the sick and the impaired, unable to work and who will need a degree of support which their families (if they have them) are unable to adequately provide. Charitable work is far more effective at remedying these social problems and is to be encouraged.

Additionally, the source of financial capital, which has been increasingly provided by monetary inflation, must revert back to savers. As a matter of urgency, a savings culture must be reinstated. All taxes on savings should be rescinded and guaranteed to be so for evermore by also removing the requirements for financial service providers to report their customers’ affairs to the tax authorities.

The cultural shifts behind these changes are necessary to support a lasting legacy of sound money. It involves returning decisions regarding money, its quantity, time-preference and allocation entirely to members of the public as a collective body. Other governments following the same route will find that settling trade in a common form of money, that is to say gold or through credible gold substitutes, brings enormous benefits, and by allowing individuals and businesses to pursue a comparative advantage through trade, as producers they become more competitive and innovative themselves.

Instead of wealth being transferred from producers and consumers to their governments through monetary debasement, wealth in the private sector can rapidly accumulate with sound money. If progressively higher rates of income tax are replaced with a flat tax, the accumulation of wealth in the hands of the successful will quicken even more. And as personal wealth builds, the burden of the state on the economy can be further diminished while tax revenues become bouyant.

Currently, national resources are disproportionately tied up in financial speculation and the institutions that service it. This form of business will be substantially eliminated by a collapse of fiat currencies, and while there will always be a continuing function for using derivatives to hedge risk in commodity markets, there should be little or no demand for purely financial derivatives. The undoubted abilities of those employed in financial services can be redeployed from speculation to more useful activities, and the brightest students, currently attracted to financial, legal and accounting services could find that these are contracting with less opportunities compared with alternative prospects.

On paper, the move to a sound money economy is not difficult to envisage and the economic benefits to all are very clear. Furthermore, a government’s power and influence is rooted in the economic success of its citizens. This article provides an overview of the essential actions to be implemented. Let us hope that someone can rise to the challenge when the time comes.

[i] The Theory of Money and Credit Part Four, Chapter lll.

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