Returning to sound moneyNov 18, 2021·Alasdair Macleod
This article takes its cue from Ludwig von Mises’s 1952 analysis of what was required to return to a proper and enduring gold standard —metallic money, particularly gold, having been sound money for thousands of years, to which everyone has always returned when government fiat currency fails.
When Mises wrote his 1952 article the dollar was nowhere near the state it is in today. But Mises had had practical experience of what was involved, having advised the Austrian government during and after its hyperinflation of the early 1920s, making his analysis doubly relevant.
As a remedy for the developing collapse of the dollar, this article can do little more than address the major issues. But it shows how an economic and monetary collapse of the dollar can be turned to advantage — the opportunity it creates through the destruction of Keynesian and other inflationist fallacies to secure long-term economic and monetary stability under which economic progress can be maximised.
IntroductionThere are two charts which sum up why the dollar and fiat currencies tied to it will collapse if current monetary policies persist, shown in Figure 1.
The growth in the M1 quantity since February 2020 has been without precedent exploding from $4 trillion, already an historically high level, to nearly $20 trillion this September. That is an average annualised M1 inflation of 230%. It is simply currency debasement and has yet to impact on prices fully. Much of the increase has gone into the financial sector through quantitative easing, so its progress into the non-financial economy and the effects on consumer prices are delayed — but only delayed — as it will increasingly undermine the dollar’s purchasing power.
The more immediate impact on the High Street is also alarming, shown in the second chart. A combination of the covid lockdowns and Federal Government money ending up in consumers’ pockets has driven their liquidity relative to goods purchases to unprecedented and unaccustomed heights. This is the more worrying chart because it quantifies the immediate fuel for a potential crack-up boom. A crack-up boom is the condition whereby consumers finally discard the currency, spending it to just get rid of it. We are not there yet, but clearly, if consumers take the view en masse that prices will continue to rise, then they will attempt to reduce their cash balances all at once by bringing their future purchases forward, thereby driving prices up even further and more rapidly, and therefore the purchasing power of the currency down. But for the moment, it is mostly creating a scramble for real assets, such as housing, which for the moment can be bought with mortgage finance fixed at deeply suppressed interest rates.
Given supply constraints, rising commodity prices, and other production costs rising as well as unaccustomed levels of consumer liquidity, the rise in prices can only accelerate. Unless there is a fundamental change in monetary policy, which requires the expansion of currency to be stopped completely, there will come a point where consumers finally realise that it is not prices rising but the purchasing power of the currency falling. This is a difficult concept for most people to grasp because they are used to regarding currency as always possessing the objective value in their transactions. The history of monetary inflations confirms that ordinary folk have always been reluctant to understand that the currency is declining until too late. But today, a significant minority of the population has already been alerted to this development by their participation in or observation of cryptocurrencies such as bitcoin. And if the wider population learns the same lesson and acts accordingly all hope for the currency will be lost.
The reason that changes in the quantity of currency recorded by narrow measures such as M1 must be closely watched is that it is the underlying base upon which bank credit is expanded. When interest rates inevitably begin to rise, rates paid to bank depositors are likely to lag, improving lending margins for banks. Improved lending margins will encourage the banks to expand credit, for the benefit of government and agency bonds, and for speculators such as hedge fund managers looking to arbitrage the difference between borrowing rates and the dollar’s future purchasing power. The narrow currency quantity therefore has a multiplier effect with respect to bank credit when it begins to expand.
A dispassionate consideration of these established facts leads the independent observer to conclude that unless today’s fiat currency system is secured with a sound money regime a collapse of everyone’s circulating medium is inevitable. Putting to one side minor central banks, the most egregious debaser of currency is the Fed, as the charts above attest. But with the dollar as the world’s reserve currency, where the dollar goes, so will all the other western currencies. Fixing the dollar must be the priority.
In a revised 1952 edition of his The Theory of Money and Credit, Ludwig von Mises added a section on The Return to Sound Money. Mises, who had cut his teeth as an economist dealing with Austria’s 1920s inflation made proposals which are still relevant. Under the influence of Keynesianism, the monetary situation facing America today is rapidly deteriorating towards the circumstances faced by Austria in 1920-22, but with technical differences. This article attempts to update Mises’s section on the return to sound money for current conditions to provide a framework for the benefit of monetary stability and long-term prosperity.
The intractability of current inflationismCentral banks and their governments like to say that the reasons for an acceleration of monetary expansion are short-term and justified by being expedient. But these policies, often termed extraordinary measures to validate them, become normal as we have seen with quantitative easing. We can reasonably assume therefore that no meaningful attempt to rein in currency debasement will occur, more extraordinary measures will be invented, and that the explosion in the M1 quantity is far from over.
Changing the official mindset is proving an impossible task so long as currency expansion is available. The Federal Government relies on it as a growing source for its funding, which allows it to ignore budget deficits. The state employs bureaucrats who agree with this policy and is advised only by economists who are prepared to justify it. The whole establishment is in groupthink mode and brooks no criticism over its inflationism. Furthermore, the administration has been democratically elected on a platform of continuing to provide free and easy money.
This is not a sudden phenomenon, being progressively ingrained in the establishment’s mindset for a century. It commenced with the establishment of the Fed before the First World War, which then fuelled an artificial boom in the 1920s after the brief post-war recession. The American state gradually subsumed control over money, removing it from transacting individuals and finally replacing it with completely fiat dollars in 1971. The course that the state had set itself was bound to lead to where we are now; the expansion of dollar currency getting out of control.
Nowhere in the Fed’s regular FOMC statements is there any mention of monetary policy per se. It is as if the quantity of currency in circulation is irrelevant to its purchasing power. It is an important cover-up, because if the relationship between the quantity of money and its purchasing power was admitted, then the Fed would have to exercise control over it. And not only would an admission of the relationship be a public acknowledgement of currency mismanagement, not only would the US Treasury come down on the Fed like a ton of bricks for jeopardising its source of non-fiscal revenue, but inflation of the currency would no longer be freely available as a policy tool.
One likes to think that there are policy makers with an understanding that inflation is of the quantity of dollars in circulation and not its effect on prices. But for a long time, it has not been in anyone’s interest to think this way — anyone who did so has been re-educated, sacked, or left the building. This is the essence of groupthink. It is worth noting that elsewhere, Jens Weidmann who is a well-known inflation hawk is resigning from the Bundesbank. And Andy Haldane has resigned as Chief Economist from the Bank of England, with a parting shot on inflation. Both these gentlemen appear to have decided it is a fight they cannot win.
The only chance of reform is from circumstances leading to the final abandonment of the neo-Keynesian policies that have promoted statism over free markets. And that is unlikely to occur before economic and currency destruction has become too obvious for anyone in control of economic and monetary policy to ignore.
We cannot be certain that this realisation in official circles will occur before the public finally loses all confidence in the currency. But so long as any hope for its recovery lingers, it seems unlikely that monetary policy will be reformed. To statist economists, the argument for sound money and its adoption would not only be a negation of everything they have come to believe, but it will be seen as destroying all their so-called scientific progress, particularly since the adoption of Keynes’s General Theory as the economists’ vade mecum.
Additionally, the use of statistics to guide policy, particularly of GDP and CPI, will have been found to have badly misled policy makers and markets. Along with statist management of the dollar, they must be abandoned. They are primarily tools for imposing state control on economic activity. The objective of the reformed approach is to return to free markets and sound money, which means handing responsibility for their actions back to economic actors, those who divide their labour and use money as the bridge between their production and consumption.
These are a volte-face from current policies and are sure to be strongly resisted even in the face of contrary evidence. Monetary reform is bound to be delayed until the last possible moment. The state’s preference is always to retain and build on the control it already has. This is why there are plans to introduce central bank digital currencies, which, it must be noted, are designed to continue with inflationary stimulation by other means. But as revolutionary France discovered, the substitution of one fiat (the assignat) by another (mandat territoriaux) merely leads to the more rapid failure of the second. Once public trust in the state to not debauch the first currency is gone, it cannot be restored for a succeeding unbacked state currency.
We can only assume that at some point in the dollar’s descent towards worthlessness the US Treasury will be prepared to mobilise its gold reserves to stop it becoming completely worthless. We shall now look at the measures that are required from that point to return to sound money, that is to back the dollar credibly with metallic money, only gold and silver coinage — anything less will not be a permanent solution.
Initial actions to stabilise the currencyAt the time when monetary stabilisation becomes a practical proposition, interest rates and bond yields will have already been driven to previously unimagined levels, reflecting the currency’s collapse thus far. Write-offs from non-performing loans and losses on bond valuations will have almost certainly wiped out all the equity of weaker banks, and the survivability of the stronger ones will have become questionable as well. The Federal deposit insurance limit of $250,000 will have become meaningless and a banking crisis will become integral to the currency collapse as depositors attempt to flee from bank deposits into goods and gold.
A collapse of the fiat banking system was not a material factor when Mises tackled the problem in 1952. He was absorbed with preventing the currency’s collapse in the future, a future which was some way off but is now almost upon us.
The first action must be for the Fed to cease expanding the quantity of money and to introduce regulations to stop the expansion of total bank credit. The former is a simple task. In practice, controlling bank credit is also not difficult. If one bank increases its balance sheet, the increase must be matched by a decrease in the balance sheets of the other banks. This means that new loans can only be extended with the permission of the central bank centralising the information on bank and other licenced credit providers’ balance sheets. And net drawdowns of existing credit facilities must similarly be matched by repayments of others.
This is intended as an interim measure pending further reform of the banking system. But the consequences for surviving banks will be significant and immediate. The stabilisation of the currency will lead to increased savings. The allocation of these increased savings to investment capital will be routed through bond markets instead of across the collective balance sheets of the banking system. It will be up to savers and their agents to decide individual borrowing terms. And all taxes on savings must be removed to enable them to recirculate into productive investment. However, these measures will be consistent with the plans for subsequent bank reform described below.
The US Treasury will be competing for savers’ savings and will no longer have unrestricted access to bank credit. A bank wishing to increase its exposure to Treasury stock be able to do so by disposing of other assets, Alternatively, if other banks reduce their balance sheets permission might be obtained from the Fed on the lines described above. Whether buying Treasuries is a sensible commercial decision must be left to the individual bank, and Basel-originated regulations designed to give preference to government bills and bonds over other classifications of assets must be repealed. The objective is to permit the government and its agencies to borrow but only on a non-inflationary basis, with the investment decision purely decided by investors, their agents, and bankers making their own risk assessments without regulatory bias.
It is doubtful at this stage of the hyperinflation that economic activity would suffer overall from the loss of state intervention. The economy will already be in the deepest slump in living memory, with interest rates at unimaginable heights and beyond the Fed’s control. Anyone going bust will have most probably done so already.
In these conditions there cannot be a better time to ensure the state withdraws from economic and monetary intervention and to introduce plans to stabilise the currency. But on their own measures to halt currency and credit expansion would be insufficient to stabilise the dollar and dollar interest rates beyond a temporary basis without further measures, which must be our next consideration.
The return to a gold standardTo stabilise the dollar the US Treasury must recognise that gold is money and the dollar an inferior currency. Accordingly, all taxes on physical gold and silver must be removed, and both metals be permitted to be freely exchanged by the public for dollars. Given that the circumstance of the reintroduction of a gold standard are likely to be those of a last resort, we can assume that the market will have already repriced the dollar in gold terms. That being the case, the exchange ratio between gold and the dollar can be fixed along with the arrangements permitting gold coin and the dollar to circulate together, with the dollar and dollar-credit being converted into reliable gold-backed substitutes.
Legislation would have to be enacted to enshrine gold convertibility as an inalienable property right, never to be taken away from the public in future. This must also remove future devaluations as a government option, and even in the event of a crisis, such as a war, full convertibility must be maintained. A new body must be established, or the role of the Exchange Stabilisation Fund amended to act only as the custodian for the relationship between dollars and gold, with the nation’s gold reserves transferred to its control. We shall call this fund the Exchange Stabilisation Fund (ESF) hereafter. Dealing in foreign currencies and SDRs by the ESF must cease, and no other government or central bank entity be permitted to deal in gold. After acquiring its initial reserve from the Treasury, the ESF cannot be permitted to initiate gold transactions. Only dealings initiated by the public, exchanging gold for dollars or dollars for gold are to be permitted. Thenceforth, the expansion of dollars in circulation must be backed 100% by gold to be held transparently in a special account for that purpose.
The basis of convertibility must be on coins freely demanded by holders of dollars without limitation. Legislation must be passed for gold coins to be struck in suitable currency denominations to ensure their practical circulation. Silver coins must also be reintroduced by law for smaller amounts, and the issuance of paper notes suited for smaller purchases must be rescinded to ensure that silver coins and the smaller gold coins circulate.
The purpose of coin circulation is to permit the public to continually vote on the government’s adherence to the new rules. The slightest indication that it is considering breaking them will, in accordance with Gresham’s Law, drive the good money out of circulation: in other words, gold coin will be hoarded, and its paper substitutes disposed through spending. The knowledge that this is so will discourage politicians from considering watering down the standard.
The gold/silver ratio should be struck to give silver coins a minor premium over their bullion value to ensure they remain in circulation and are not diverted for industrial use or arbitraged into gold. This will avoid the pitfalls that plagued bimetallic standards in the past.
The introduction of a working gold coin standard on these lines will lead to a rapid fall in borrowing rates from their hyperinflation highs. The sooner it is operating and the currency stabilised, the quicker the economy can return to normality, which will be an obvious benefit for those persuading the public the merits of sound money. Interest rates will then correlate with the general level of wholesale prices. The reason for this correlation is that sound money allows producers to calculate for their business plans with a high degree of certainty about final prices. [i] With that certainty in mind, they can then assess the rate of interest they are prepared to pay savers for an enterprise to be profitable.
The disciplines of a working gold coin standard will also require other changes to take place.
Government reformThe time during a currency collapse when it might be adapted into a proper gold standard is also the most dangerous politically. The population will be suffering real hardships and dangerously disaffected from the establishment that steered them onto the economic and monetary rocks. The middle and professional classes will have lost nearly everything. It is a political situation ripe for violent revolution. It drove the French revolution and following the First World War drove Germany into Nazism.
It is the setting described by Hayek in his The Road to Serfdom. The departure from proper economics and the move towards increasing state control over the people militates for yet more socialism and violence, with a total monetary collapse being the excuse for total oppression of the people by the state. If that happens, the outcome is a different course of events from the constructive one proposed here.
But we must assume that the great American nation, for all its recent faults and having lost its way with economics and socialist drift, pulls back from the brink of the abyss. Unlike Germany following its hyperinflation of the 1920s, America’s population is ethnically diverse, comprised in the main of the descendants of refugees from political and economic oppressions elsewhere. We should accept that when the outlook is darkest, a Hayekian-described dictator might not emerge, but a statesman instead, like an Erhardt, who emerged for Germany in the late 1940s. Paradoxically, public support for a reform of the American currency system probably offers a better chance of success than similar measures taken elsewhere.
We must proceed with that assumption. The popular mandate for the role of government in the economy to be radically revised will therefore become available. Without the cover of inflationary financing, an economy based on sound money is more obviously incompatible with a high-spending government, which must then reduce its burden on the productive economy to the minimum possible. At its most fundamental, its obligation to provide mandated welfare must be strictly curtailed. The ambition is to reduce the role of government to framing and upholding the law and maintaining national defence — not to be confused with funding military adventures abroad. Foreign policy must return to that of Britain in the days of Liverpool, Castlereagh, and Wellington following the Napoleonic Wars: never to interfere in another nation’s internal affairs. And regulations must be rescinded to permit free markets to regulate themselves.
It will require economic understanding, statesmanship and perhaps a few years to fully achieve all these objectives. But given that the purchasing power of the dollar will have already depreciated substantially, the costs of welfare, such as state pensions and unemployment benefits, will have already degenerated in real terms. Furthermore, the population will be staring into an economic and monetary abyss, reducing their opposition to substantial cuts in state spending. Only in these circumstances will it be possible to take the necessary action, and the opportunity will be there. An initial target of reducing Federal government spending to under 20% of GDP and cutting taxes accordingly should be followed by a target of less than 15% of GDP in due course.
Banking reformFollowing extensive debate between the currency and banking schools, England’s Bank Charter Act of 1844 was the watershed that validated bank credit cycles. The destabilising effect of these cycles led to Walter Bagehot’s concept of the role of The Bank of England being the lender of last resort, the excuse for central banks in the future to increase their powers of intervention.
By the time of the 1844 Act, banking law and double entry bookkeeping had established the method of credit creation, which is different from that which is commonly understood. A bank commences the expansion of bank credit by making a loan to a customer, which appears on its balance sheet as an asset. At the same time, double entry bookkeeping demands a contra entry, which is achieved by the bank crediting the customer with a matching deposit, which continues to balance as the loan is drawn down. The bank’s balance sheet has expanded without its own capital being involved.
The expansion of credit is monetary inflation, which eventually feeds through to rising prices, leading to increasing interest rates. Economic calculations made earlier in the credit cycle begin to go awry, and bankers eventually become cautious, contracting their balance sheets mindful of the gearing ratio between their equity and total liabilities. Alternatively, carried away by the apparent improvement in trading conditions, banks speculate in areas where they lack expertise or became overexposed and lack an exit. These were the respective reasons that Overend Gurney in 1866 and Barings in 1890 failed. Whatever the cause of their contraction, these cycles of bank credit lasted about a decade on average.
A reformed gold coin standard must be complemented by the elimination of bank credit cycles. To eliminate it entirely would require banking to be segregated into two distinct functions, one to act as a custodian of deposits with ownership remaining with the depositor, and the other to act as an arranger of finance for fees or commission. This would eliminate bank credit entirely.
The evolution of modern finance has led to the development of shadow banking, some of which has led to the creation of credit off-balance sheet by the banks or by unregulated entities. Measures should be taken to identify and end these practices. But given that shadow banking is the product of the interaction between the growth of fiat money and purely financial activities, shadow banking is likely to decline, or possibly even disappear with the end of fiat and the introduction of a gold standard.
Furthermore, the speculative bubble in cryptocurrencies, whose rationale is purely to hedge against the relative expansion of fiat currencies, will lose the reason for their existence beyond the purely technical innovations, such as the blockchain, that they bring. The ending of these speculative activities generally will reduce even further the perceived need for bank credit expansion, particularly for those banks funding purely financial activities.
Once the public and foreigners are confident that the dollar’s gold standard is firmly established it is likely that gold will flow back into the Exchange Stabilisation Fund, giving it yet more cover for future dollar redemptions and therefore credibility for the standard.
The benefits and workings of a new gold standardWith the dollar on a credible gold standard, there can be little doubt that other fiat currencies will develop similar monetary policies. The whole world works with the dollar as the international currency, even Russia whose energy earnings are paid to her in dollars, and China whose raw materials from abroad are sourced nearly entirely in dollars.
The replacement of fiat dollars with dollar-denominated gold substitutes will change currency priorities for all other nations. They will confront the same issues that faced the European nations in the second half of the nineteenth century, when Britain with her empire dominated global trade. Not only was there a drift towards free trade (for example, the Cobden-Chevalier Trade Treaty between France and Britain in 1860) but the European nations adopted similar gold standards. If America establishes a credible gold standard, any nation not following suit is likely to see its currency collapse.
Critics may say that instead of operating their own gold standards, other nations will simply operate dollar currency boards, throwing the burden on America to provide a global monetary standard. This would not be a problem, so long as the rules of 100% backing are followed by America. A country adopting a dollar standard for its own currency will have to acquire dollars, which it can only do for gold submitted to the Exchange Stabilisation Fund. By providing a simple solution to other national currency problems the ESF would therefore see substantial gold inflows, further securing its domestic and international currency position. The key is for the ESF to administer the new monetary rules, enshrined in law, to the letter.
Once the new gold standard is fully established, demand for circulating dollars will be set by markets and can be met by the ESF issuing dollars only on a 100% gold backed basis. Imports must be paid for in gold-backed dollars, and because monetary discipline will force government deficits to become a thing of the past, trade deficits will tend to be as well.
Changes to gold’s domestic purchasing power might be expected through changes in the savings rate, being the allocation between consumption and deferred consumption. Variations in the savings rates may be expected to drive price differentials between nations, but this would be an error. This is because a rise in domestic savings will tend to reduce domestic prices and increase exports, leading to an importation of gold. But the extra gold or gold-backed dollars in circulation from an export surplus will have a contrary effect, supporting prices so that there would be little change.
By way of contrast, a fall in the savings rate would be expected to lead to a tendency for domestic prices to rise and therefore to an increase in imports, and a corresponding outflow of gold. But the outflow of gold will then tend to act to reduce domestic prices, thus stabilising the effects of increased domestic consumption. In terms of cross-border trade, the benefit of a gold standard and its associated rules is to eliminate trade imbalances and price differentials as a cause of economic disruption, depoliticising global trade and promoting overall price stability. The peoples of individual nations can therefore set their savings preferences without affecting the general price level. It permits producers to make business calculations with a high degree of certainty of output prices, not only for domestic markets, but international ones as well.
Gold supply factorsUnlike proposed distributed ledger cryptocurrencies acting as the future form of money, the merits of a working gold standard are found in its flexibility. The growth of the amount of above-ground gold has tended to match the increase in the world’s population over time. But not all gold is held for monetary use, with more than half of it being estimated to be in jewellery, and a smaller amount allocated to industrial use. But much of the gold jewellery is quasi-monetary, being regarded as a reserve store of monetary value particularly among the populous Asian nations. There is, therefore, a flexible stock of non-monetary gold available through market mechanisms to support a global monetary standard.
The difference between a gold or gold exchange standard and fiat currencies is that the allocation of gold between its uses is determined by people through markets, and not by governments and their monetary policies. This means that the course of prices both generally and for individual products are set only by supply and demand. Price stability is the outcome, with competition, improved production methods and technology tending to reduce prices over time and rising living standards for all. This is the background which encourages savers to put aside some of their earnings, knowing that their savings’ purchasing power will be maintained, and even likely to increase over time.
For these savers, financial asset values will no longer be driven by excessive quantities of fiat currency. With the infinite feed of fiat currency removed, outright speculation will become a thing of the past, replaced by genuine risk assessments of individual bond issuers and of equity participations. The expansion of fiat currency will no longer be available as the principal fuel driving financial asset values.
It will be a different monetary environment, where capital will be scarce and therefore valued. Capital will be less wasted on spurious projects. It will be the basis for recovering economic progress, so sadly lost at an increasing pace since the dollar became purely a fiat currency.
It is apt to end by quoting von Mises’ concluding paragraph to his 1952 addition on currency reform in his The Theory of Money and Credit, the inspiration for this article:
“Cynics dispose of the advocacy of a restitution of the gold standard by calling it utopian. Yet we have only the choice between two utopias: the utopia of the market economy, not paralysed by government sabotage on the one hand, and the utopia of totalitarian all-round planning on the other hand. The choice of the first alternative implies the decision in favour of the gold standard.”
[i] See the explanation for Gibson’s paradox, here: https://www.goldmoney.com/research/goldmoney-insights/the-futility-of-central-bank-policy
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