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Another
essay, by my friend, Antal Fekete. Please take time to read the footnote at
the bottom of the essay. There is still a lot of resistance to Austrian
economic thinking in mainstream educational institutions (specializing in the
history of economics?) Shame!
May 5, 2011
SOURCES AND REMEDIES OF FINANCIAL INSTABILITY*
Gold Bond: Life-Saver for the U.S. and World Economy by Antal Fekete
Sources
The financial instability that first surfaced with full force in 2008 is
the result of a deteriorating condition in world finance going back 40 years.
Worse still, that deterioration is continuing and threatens with an
historically unprecedented world-wide credit collapse.
The watershed year was 1971. What made that year outstanding was not just the
introduction of the so-called floating exchange rate system; but also the
disappearance of the most potent and most reliable financial instrument of
world finance. It was little noticed at the time and, if it is ever
mentioned, it is being treated as a non-event. Yet the world can only dismiss
its significance at its own peril. Academia that is supposed to study
problems created by monetary experimentation, rather than alerting the public
to the serious possible consequences of the omission, has been guilty of
ignoring it.
The most potent financial instrument, the disappearance of which we are
referring to, is the gold bond.
This pronouncement is immediately objected to by detractors of gold in the
monetary system. Their objection is that the gold bond had disappeared from
world finance much earlier: in the years 1931-35, and was no occasion for any
major catastrophe in its wake. Rather, the word economy has gone on from one
triumph to another without gold bonds ever since ¾ proving the
inconsequential nature of their disappearance. However, this objection is not
valid.
The truth of the matter is that the gold bond has survived the collapse of
the gold standard and has played a most important albeit largely unrecognized
role in world finance. Consider the fact that since January, 1934, the dollar
has had a fixed value in terms of gold, based on the Treasury price of $35
per ounce of fine gold, and the U.S. government has continued to honor its
international obligations at that rate. Moreover, this obligation was
solemnly enshrined in several international treaties and confirmed by four
sitting presidents. As a result, there is no gainsaying of the fact that U.S.
Treasury paper in the hands of foreign governments and central banks
directly, and in the hands of banks, financial institutions, and even
ordinary citizens not under the jurisdiction of the U.S. indirectly, have
continued to exist as gold bonds (or gold bills, as the case may be) after
1934.
The most important role the gold bond has played up until 1971 was this: it
was the standard of credit whereby all other debt instruments were gaged.
Through disintermediation substandard debt was eliminated, and the rise of
the Debt Behemoth prevented.
Ignoring this fact is a major error that Academia has been and still is
making. To continue to deny this fact leads to further grievous errors. There
used to be a saying on Lombard Street, long since forgotten, that
“there is only one thing that is safer and arguably more desirable than
gold, namely, the promise of a government to pay gold”. In that spirit
gold bonds were considered an “ultimate form of debt”, enforcing
quality standards. Moreover, the gold bill was, along with gold, an ultimate
extinguisher of debt. This instrument was destroyed on August 15, 1971. On
that day gold was exiled from the international monetary system. Since that
day the world has lacked an ultimate extinguisher of debt.
Any other means of payment, including Federal Reserve credit, however useful
in international trade or otherwise, could not extinguish debt. It could only
shift debt from one debtor to another. As long as there were gold bonds in
existence, a Debt Behemoth could not rise and threaten world finance with
destruction. Whenever total debt in the world approached the danger level,
safety-conscious governments and banks quietly started converting their
holdings of debt into gold bonds, thus squeezing marginal debt out of
existence. This also explains the absence of a derivative tower and other
unsafe financial constructions, instruments and practices such as
mortgage-based bonds, prior to 1971.
We can say that world trade was financed and regulated by gold to the extent
that the great trading houses abroad held gold bonds in their portfolio. In
effect they were doing arbitrage between the gold bond market and the market
for internationally traded merchandise. If the gold rate of interest (that
is, the yield of U.S. Treasury bonds) rose, they sold out marginal
merchandise from warehouses without reordering them, and invested the
proceeds in gold bonds. If subsequently the gold rate of interest rates fell
back, then they would sell the gold bond at a profit, and invest the proceeds
in marginal merchandise, the trading of which out of their warehouses yielded
better profit than that available from holding gold bonds. This arbitrage was
real, continuous, and it kept international trade in good shape. Academia has
missed this important arbitrage responsible for regulating world trade after
World War II. It is also guilty of failing to point out that, without gold
bonds world trade is clueless and will quickly start deteriorating.
In 1971, by a stroke of the pen, gold bonds were stamped out of existence.
World trade lost its guiding star. The floodgates of exorbitant debt creation
were opened. Debt of dubious quality flooded the word, the soundness of which
could no longer be gaged in the absence of gold
bonds. This explains the origin of the debt tower, and the steady
deterioration of the quality of its component parts. This process is still
continuing. Worst of all, the series of financial crises in the world also
continues and every one of them will be more devastating than the preceding
one — unless something is done about it, and soon. In the absence of
remedial measures now, the denouement will be fast in coming, and the
momentum of the approaching avalanche will become overwhelming.
Remedies
Having made the correct diagnosis, the remedy readily presents itself.
The gold bond should be brought back. In fact, there is presently a great
latent demand for gold bonds in the world, as indicated by the high
marketability U.S. Treasury bonds are still enjoying — something that
cannot be justified on purely economic grounds in view of the net debt of the
U.S. government and the persistence of the American trade and budget
deficits. Make no mistake about it: the high marketability of the U.S.
Treasury bonds is justified solely by the fact that there is still a residual
hope that the U.S. government will, in its own self-interest as well as in
the interest of the world economy, make them payable in gold at maturity, and
will pay interest on them in gold before.
It is important that there is a convincing precedent in U.S. history for
this. During the Civil War and its aftermath, the U.S. government continued
to honor its debt, both as to principal and interest, paying them in the gold
coin of the realm. To be able to do it, the government continued to levy
import duties and excise taxes in gold to the exclusion of paper. The exchange
rate between the gold dollar and the paper dollar (endearingly called the
‘greenback’ by their protagonists) was fluctuating. The lesson
from this is that the government need not embrace a gold standard in order to
enjoy the benefits offered by the gold bond.
There is no reason why the U.S. could not emulate the Civil War practice in
the present crisis. Admittedly, it would take extensive research to work out
the details. For example, the question arises how gold bonds can survive in a
fiat paper money system (or how the fiat paper money system can prosper in an
environment in which gold bonds exist and enjoy the highest prestige). At any
rate, the intellectual resources to conduct such research are all at hand. If
not residing in Academia, then, at least, they are scattered around in small
discussion groups and can be accessed through the Internet. There is such a
thing as “shadow research” offering sorely missed competition to
mainstream economics on the gold question.
The first obstacle that confronts the present effort by the U.S. government
and the Fed to put the great financial crisis behind them is that it runs
into Triffin’s Dilemma. Already in the early 1960’s Robert
Triffin observed that the stated aims of increasing “world liquidity”
and those of eliminating the U.S. budget deficit are contradictory. They
cannot be simultaneously accomplished.
Likewise, the present effort to rein in the U.S. government deficit and
reduce the outstanding government debt, while simultaneously increasing the
stock of money through direct sales of government bonds by the Treasury to
the Fed (euphemistically called QE 1 & 2) are contradictory. It is like
trying to have one’s cake and eat it. On the one hand the Fed wants to
inject more Federal Reserve credit into the payments system, while the
“other hand”, the government, pretends to choke off the supply of
the necessary collateral. Politicians, mainstream economists and financial
journalists sing the praise of this scheme without realizing that it cannot
be done. The two aims are contradictory, and the market will not be fooled by
the prestidigitation.
Most mainstream economists have a vested interest in
maintaining their anti-gold stance. Their prestige is committed to
Keynes’ dictum that the gold standard (and, by implication, gold) is
nothing but a ‘barbarous relic’.
However, if they really believe in a goldless monetary system, then they
should have nothing to fear in exposing their fiat paper scheme to
competition with the gold bond. Hand-to-hand money will still be irredeemable
under the suggested remedial action. The fact that this will cause the
managers of fiat money to make their instrument deliver stellar performance
so that people shall have no desire to dump paper in favor of gold is an
added benefit. The remedial action proposed herein should not be seen as an
attempt to return to the gold standard through the back door. The proposal is
to allow the gold bond to discharge its natural function, to wit: weeding out
bad debt, something irredeemable debt cannot do.
A great failing of monetary scholarship is the one-sided appraisal of the
origin and subsequent evolution of the Federal Reserve System that came about
as a result of six years of thorough study and public debate in the wake of
the 1907 panic. It was not even remotely considered during that debate that
the Fed coming off the drawing board ought to be an engine monetizing
government debt. Just the opposite: the Fed was supposed to be a commercial
paper system whereby self-liquidating bills of exchange would acquire
ephemeral monetary privileges, facilitating the movement of semi-finished
merchandise from the producer to the ultimate consumer. Nor was it thought
possible during that debate that the monetary unit of the United States could
be anything but the Constitutional double eagle gold coin. There was nothing
sinister about the study and the debate. There was no conspiracy. It was all
in the open.
The outcome, the Federal Reserve Act of 1913 was far from being a perfect
document. It had many weak points and lots of room for improvement. But it
was acceptable for the purpose of putting credit, such as existed within the
United States, on a sound and enduring basis.
Mischief occurred after the Federal Reserve banks opened their door for
business in 1914, about the same time when the war in Europe got started.
Without much thinking, and in an obvious violation of the law and the
neutrality of the country, the Administration of president Wilson committed
the new banks to finance the allied war effort in Europe. The idea of
self-liquidating credit was discarded; credit was created expressly to
finance destruction. You cannot get further away from the ideal of
self-liquidating credit than putting credit in the service of destroying life
and property.
This takes us to the second remedy: restoration of self-liquidating credit.
The idea that the central bank can calibrate the rate of debasement of the
currency by adjusting the speed of the printing press is absurd. The notion
that the Federal Open Market Committee can pick the optimal interest rate
that will make the GDP grow, payrolls swell, and prices stabilize is equally
absurd.
Commercial banks have historically existed not to ‘create’ credit
but to ‘liquefy’ it. Commercial credit takes its origin in the handshake
of two businessmen while one says to the other: “I’ll pay you for
this shipment in 90 days”. The handshake later took the form of a real
bill that had the advantage that it could be endorsed and passed on to a
third party in payment for other maturing merchandise.
Thus the formula to solve the present crisis of instability and to fend off
the threatening credit collapse is: Go back to gold bonds and real bills. Get
real: adopt the best agent of credit there is in place of intrinsically
worthless promises; substitute the real source of credit, the handshake of
two businessmen, for the stroke of the banker’s pen.
The hour is late. At stake is the survival of the U.S. and world economy as
we know it. Failure to act now would lead to a disaster comparable only to
the collapse of the Roman Empire in the fifth century A.D. that was
accompanied with a total breakdown of law and order, accompanied,
significantly, by gold going into hiding.
* The title of this essay is borrowed from a list of research topics proposed
by the Institute for New Economic Thinking. The author submitted his essay
for consideration, but the Institute declined to entertain it.
Kirsty Hogg
Gold Wars
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