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Introduction
According to official doctrine gold was
demonetized in 1971 by the "Group of Seven", governments of the
most important trading countries of the world. Demonetization was meted out
as a punishment for "bad behavior". In
the words of Paul A. Volcker gold has been tolerated as long as it was
content to act as a constitutional monarch. No sooner had gold asserted itself as an absolute monarch than it was dethroned.
Indeed, by a stroke of the pen the 5000 year old monetary reign of gold was
unceremoniously terminated over the entire globe, never again to return.
But was it really? This is the question that
Gary North is grappling with in his paper "The Remonetization
of Gold" (www.LewRockwell.com, August 14, 2003). North is happy to accept the
official doctrine that gold is no longer money. Moreover, he doubts that it
ever again will be - short of an economic cataclysm. Even though the world
needs gold as money, he contends, the transition costs would be astronomical.
"Everybody wants to go to heaven, but nobody wants to die." North
blames the consumer, not the government. He asserts that there has been a
huge, historically unprecedented collapse of demand for gold since 1914.
"Demand for gold today is for industrial and ornamental uses, not
monetary uses."
In this rejoinder I take issue with North and
show that no combination of governments or consumers has the power to
eliminate gold as money, any more than they can eliminate nature. The dictum
of Horace applies: "Naturam expellas furca, tamen usque recurret"
(Expel nature with a club, return how it will). I also reject North's simile
that the pill of gold circulation is a pill of suicide. In reality going to
heaven would take nothing more drastic than opening the Mint to the unlimited
and free coinage of gold, as mandated by Constitution of the United States of America.
What makes gold the monetary metal?
Gold is the monetary metal par excellence
because it has constant marginal utility. While the marginal utility of every
other commodity declines at a more or less rapid rate, gold has over the
millennia displayed a rate of decline lower than that of any other. This fact
has made gold leap-frog as the substance of preference when it comes to
hoarding. Existing gold hoards have a feed-back effect on the hoarding
decision of individuals and, as a result, gold's marginal utility by now
declines so slowly that it is practically constant. Gold hoards are so huge
that they constitute a high multiple of annual output at present rates of
production. We express this by saying that the stock-to-flow ratio is by far
the highest for gold. By contrast, existing hoards of other metals constitute
a fraction of annual output. Their stock-to-flow ratio is low. No sooner had
a good other than gold been produced than it did disappear in consumption. By
contrast, hardly any gold is consumed. When it is, as in jewelry,
the monetary form is never too far away and can be restored through
relatively inexpensive processes of recycling.
To put the unprecedented hoards of gold into
context we must point to the superb confidence that individuals and
institutions have placed in its value over the ages. While obviously this
fact is subjective, it has over a long period of time translated itself into
the objective fact of a high stock-to-flow ratio. In this sense the value of
gold is objective while that of other goods is subjective. If a government
really wanted to demonetize gold, then first it would have to dissipate
accumulated gold stocks through consumption. Lenin understood this better
than our Western leaders. He suggested a most ingenious way to demonetize
gold. Under communism, Lenin said, gold would be used to plate the inner
surfaces of public urinals - an application for which gold is superbly fitted
for reasons of its chemical inertness, surpassing that of any other substance
known to man. Note the condition "under communism". Under any other
system the gold plates would be picked. Lenin certainly knew how to prevent
the picking of public urinals. He had the Cheka.
How to make the value of gold fall
Unlike Lenin, superficial thinkers assumed
that demonetization could be effected merely by the issuance of a government
edict. Before such an edict was issued in 1971 a number of
economists, Ludwig von Mises among them, were
thinking aloud what would happen if the unthinkable did indeed happen. They
concluded that as monetary demand was cut off the value of gold would fall,
and fall it would precipitously since monetary demand constituted the lion's
share. Economists cited the example of demonetizing silver a hundred years
earlier. When Germany, victor of the Franco-Prussian War did it in 1871 and
the United States government, victor in the Civil War followed suit
("The Crime of 1873"), the rest of the governments reluctantly toed
the line (with the only exception of China which refused). The price of
silver went into a long and steep decline from $1.29 in 1871 to 25 cents in
1933, less than one fifth of the original value.
Apparently the only time the government of the
United States
listened to Mises was on August 15, 1971, when
Nixon decided to prevent the value of gold from going to outer space by
demonetizing it. Subservient governments hastily joined in issuing an edict
to the effect that they considered their combined gold reserves as
"adequate" and, from then on, they would refuse to buy gold from
any outside source, and would ostracize governments that did. Newly mined
gold, having lost its biggest customers: governments and central banks, would have to go begging. Those who had speculated
that the official gold price would be increased ought to burn their fingers
"right to the armpit" in the words of a U.S. Senator. The world
must be taught a lesson who is in charge.
Causality versus Teleology
The economists couldn't be more wrong on gold.
No sooner had governments embargoed it than the price of gold soared. The
economists never answered the question how they could ever make such a
colossal blunder. We must do it for them. Doctrinaire belief in the
supply/demand equilibrium theory of price has led them astray. Economists
reasoned that if the demand for gold is cut abruptly then the value of gold
is duty-bound to fall. However, the equilibrium theory of price is a linear
model having a limited range of applicability. The world is non-linear.
As long as causality prevails, monetary circulation can be approximated with
linear models. But when teleology becomes dominant, as it sometimes does, the
world no longer behaves linearly. As teleology replaces causality linear
models, including the equilibrium theory of price, fail to be applicable. It
is incumbent upon the scientist to examine the range of applicability of his
model before applying it. This the economists have
forgotten to do in studying the probable effects of gold-demonetization.
If we really wanted to understand the
gold-demonetization episode of 1971, then we would have to look for the
teleological context. We would find it in the fact that gold-demonetization
was just a hoax, designed to cover up the fact of default on gold obligations
and so to save the face of the United States. It has never ever
happened in history that the paper of a defaulting banker would go to a
premium. Yet that is exactly what the economists predicted. They forgot that
the dishonored paper would always, without
exception, go to a discount. This would happen even if further issues of the
paper were drastically curtailed. The circulation of the dishonored
paper is definitely not governed by the laws of causality, the quantity
theory of money, or the equilibrium theory of price. Rather, it is governed
by the laws of teleology. Frightened holders of the paper would try to get
rid of it at whatever price they could, as they expected the discount to
widen and, ultimately, to go to 100 percent. Time has nothing to do with it.
Depreciation can take days, but it can also take decades to run its full
course. It is not possible to forecast how long. The only thing certain is
that time will not cure whatever ails the dishonored
paper. Once in default, always in default. True, the banker may not be at the
end of his rope. He may still have tricks up in his sleeves. He could use
bribery, blackmail, and other forms of coercion to keep his dishonored promises in circulation. He may even be able
to expand circulation. By hook or crook he might slow the rate of
depreciation, or even stall it. Sometimes he might succeed in reversing the
trend temporarily through false signals to the market. No matter. The
ultimate outcome is inevitable. The value of the dishonored
paper will eventually approach the marginal cost of its production, which is
greater than zero only by a negligible amount.
It is important to realize that the quantity
theory of money has nothing to do with monetary depreciation. Like the
equilibrium theory of price, the quantity theory of money is just another
linear model that is valid only as a first approximation. But where causality
ends, teleology begins and first approximations become useless. More
sophisticated models such as the disequilibrium theory of price,
and the depreciation theory of dishonored promises
are called for. Value is not collapsing because paper money has been
"over-issued". It is collapsing in consequence of the original sin,
the act of default. Monetarists and quantity theorists of all stripes, please
pay attention. Regulating the rate of increase of the stock of high-powered
money (e.g., by entrusting it to a "clever horse" on the tread-mill
as once suggested by Milton Friedman) may postpone but will not avert the
ultimate humiliation of the dollar, which is to join the assignats,
mandats, Reichsmarks, and
other dishonored promises in the garbage heap of
history. From there, as from Hades, no currency has ever returned.
The concept of marketability
North says that gold is no longer money
because it is no longer the most marketable commodity. The irredeemable paper
dollar is. I challenge this. Back in 1960 I carried out a little experiment.
I obtained a $1000 bill (in those days equivalent purchasing power would be
more than $10,000 in today's money). This was in Canada, and the bill had a light
pink color as I recall. The vast majority of people
have never seen a bill of such denomination. My experiment consisted in
trying to pass on the bill. Retailers flatly refused to touch it. It wasn't
that they could not make change. The price of a Volkswagen Beetle was around
$1000 then, but the dealer would still not take my bill. He would be glad to
take a personal check, but not the $1000 bill issued by the Bank of Canada.
He suggested that I go to the bank around the corner and come back with ten
$100 bills. The bank would take the bill only on condition that I opened an
account. I would have to provide three ID's, one of which would have to be a
picture ID. So much for the marketability of paper money.
I followed up with another experiment. I
offered a kilobar (1000 grams of fine
gold, then worth about $1200) to a Swiss bank. Without a bat of the eyes the
teller paid me at the going rate. No questions asked. No need to call the
manager. No need to open a bank account. No need to produce three different
ID's. So much for the marketability of gold. I am aware that things have
changed since. Swiss banks, as a result of some arm-twisting from Washington, no longer
deal in gold over the counter. They don't want to be open to the charge that
they facilitate money-laundering. You have to go to a large city where some
banks have special departments for dealing in precious metals, and they
certainly won't buy from you unless they know you.
The scientific concept of marketability is due
to Carl Menger (Absatzfähigkeit).
He based it on the distinction between the bid and asked price. Menger pointed out that it is not possible to buy
something in a market, then turn around and sell it at the same price. You
always buy at the higher asked price and sell at the lower bid price. The
difference is the spread. Obviously, the spread is a function of the quantity
of merchandise under negotiation. It is the behavior
of the spread that determines marketability. According to the Principle of
Declining Marginal Utility the bid price is a decreasing function of
quantity. Further insight shows that, by contrast, the asked price is an increasing
function. Market-makers are reluctant to deplete their inventory too fast
before securing further supplies. If they must quote an asked price for an
unusually large quantity, they naturally add a risk premium. The upshot is
that the spread is an increasing function of quantity.
Commodity A is more marketable than
commodity B if the rate of increase in the spread for A is
lower than that for B as ever larger quantities are thrown on the
market. On that basis gold was, is, and will be, as far in the future as the
eye can see, the most marketable commodity available. So much so that the
market, when not rigged by the banks or the government, would make the spread
practically zero. Thus gold is the only commodity that could, in the absence
of official sabotage, be bought and sold back-to-back without losses in any
quantity, however large. It is this property that has made gold the monetary
metal. Irredeemable currency certainly does not have this property, as a
quick check with a foreign exchange dealer will reveal. Please do not be
confused by the volatility of gold price. It is not an indication of the
uncertain value of gold. Rather, it is an indication of the uncertain value
of the dollar in which the gold price is quoted.
Is Gold Money?
This is a semantic issue as the answer depends
on how we define money. If you, following North, define money as something
Wal-Mart will take in exchange for made-in-China junk then, for you, gold is
not money. But if you adopt Carl Menger's more
scientific definition according to which money is a commodity for which the
spread between the asked and bid price stays small as ever larger quantities
are traded, then gold is money. It is not the consumer or the retail market
that decides the issue. It is the wholesale market trading as it does
unlimited quantities, that is privileged to make that determination.
It also follows that people and institutions
are, even today, willing to carry unlimited amounts of gold in the balance
sheet without any promise of return to capital, in preference to any
other asset. There is obviously no contest between gold and the dollar in
this regard. Apart from the fact that the dollar is but a dishonored
promise to pay, at best it is an asset that also shows up as a liability in
the balance sheet of a third party. As the only asset in the balance sheet
that is not at the same time the liability of someone else, gold provides the
only effective portfolio insurance against default.
The final monetary showdown between gold and
the dollar may be close at hand. As dollar-holdings of individuals and
institutions not subject to the jurisdiction of the United States
grow by leaps and bounds in consequence of increasing American trade
deficits, the ultimate test of "moneyness"
is being applied to the dollar. Are foreigners really willing to hold
unlimited amounts of dollar balances indefinitely? Euro-balances as an
alternative are not relevant. After all, the euro is just another
irredeemable promise to pay. The contest is not between the dollar and the euro.
Ultimately, it is between the dollar and gold. When all is said and done, it
turns out that at one point owners of dollar balances will cry
"enough!" By contrast, history and logic show that there is no such
point for gold. This qualifies gold, and disqualifies the dollar, as money.
Gold and Interest
Yet the strongest argument proving that gold
is still money, the best available, is its relation to interest. According to
Carl Menger, subsequent units of a commodity are
valued less by the economizing individual than units acquired by him earlier.
This is known as the Principle of Declining Marginal Utility. If we rank
commodities according to the rate of that decline, then we shall find that
the marginal utility of one of them declines more slowly than that of any
other. The commodity with this property is none other than gold. In fact, the
marginal utility of gold declines so slowly that it is practically constant.
It follows that gold hoarding must be limited by something other than
declining marginal utility so that demand for it may not become arbitrarily
large, and gold coins may stay in circulation. The fact is that demand for
gold is limited by the positive rate of interest channeling
gold into monetary circulation, away from hoarding. This makes gold the
corner-stone of both the theory money and the theory of interest.
Ludwig von Mises in Human
Action denies that the marginal utility of gold is constant (second
edition, p 404). His reasoning is that constant marginal utility would mean
infinite demand which is contradictory. Elsewhere in the book (op. cit.,
p 205) Mises also denies that it is possible to
construct a unit of value because two units of a homogeneous supply are
necessarily valued differently, according to the Principle of Declining
Marginal Utility. Yet gold has successfully furnished the unit of value for
thousands of years to many a flourishing civilization, including our own, and
when it was removed it had to be done by travesty, trickery, and police
force. Mises failed to grasp the connection between
gold and interest. Interest is obstruction to gold hoarding: but for the
presence of interest gold hoarding would be unlimited, since gold's marginal
utility is constant. It is interest that keeps gold hoarding within bounds.
Interest is the opportunity cost of gold hoarding. By contrast, hoarding of a
non-monetary commodity is kept within bounds by declining marginal utility.
In this sense interest is analogous to a parking meter on a busy street which
limits the demand for parking space that would be unlimited otherwise. Be
that as it may, interest is specific to gold and no demonetization hoax can
change that fact. The gold-rate of interest (disingenuously called
"lease rate") is still the benchmark to which the dollar-rate and all
other paper-rates of interest are related by the application of a
depreciation premium.
Monetary demand for gold
North makes the point that demand for gold
today is for industrial and ornamental uses only; there is practically no
monetary demand. Thus North, a self-declared gold bug, forgets that his very own demand for gold is nothing more or less than
a monetary demand. He refers to gold as an "inflation hedge". The
demand for gold as an inflation hedge, too, is a monetary demand. The investment-demand
for gold, too, is a monetary demand. If Alan Greenspan owns gold, which seems
more than likely, his demand for gold, too, is a monetary demand, like it or
not.
By monetary demand is meant demand for medium
to circulate as money with whatever velocity, including zero velocity.
Therefore hoarding demand for gold that originates in protest, whether
against low interest rates, or against the banks' loose credit policy, or
against the government's fiscal policy, or against the central bank's monetary
policy, is part of the monetary demand. Furthermore, hoarding demand that
originates in fear, whether fear of devaluations, monetary depreciation, or
any other form of embezzlement of private wealth through monetary
manipulation, is also part of the monetary demand. Protest- and fear-related
demand started burgeoning in 1947, the first year when United States
hemorrhaged gold. Some of that gold went to central
banks that would keep it in circulation; most of it went to satisfy private
demand that would keep it out of circulation. In retrospect, hoarding demand
was justified by competitive devaluations triggered by the British pound
barely one year later in 1949. It was also justified by unprecedented
peace-time budget deficits ran by the United States that forced the
debasement of the dollar. The monetary history of the intervening years can
be described as a tug-of-war between the two demands for gold: that of
central banks and that of private holders of cash balances. Don't be fooled
by the rhetoric that central banks no longer need gold and they are anxious
to get rid of this barren asset by exchanging it for "earning
assets". Central banks, like individuals, need gold for the stronger
reason. They need a default-proof asset to balance their monetary liabilities.
As gold keeps disappearing from the asset column of the balance sheet of a
central bank, so does public trust in the value of the bank's notes in
circulation.
Private monetary demand is gradually winning
the tug-of-war. It is enormous and it keeps growing: not only does it absorb
the entire world production of gold, it also picks
up all the gold dropped by central banks to keep the wolves away from the
door. True, the price of gold falls whenever the U.S. Treasury, the IMF, and
"me-too" Bank of England announce their gold auction rituals. This
fall certainly does not mean that gold is in over-supply. It means that the
market is willing to play chicken with the protagonists of the
demonetization-hoax. Above all it means that the market exacts a price for
foolish market-behavior. If the desire to exchange
a non-earning asset for an earning asset were
genuine, then gold would not be auctioned with the loudest fanfare and widest
publicity designed to suppress the price. Instead, it would be quietly fed
into the market in order to fetch the highest possible price. But there is a
hidden agenda: to discourage private demand by the threat of a falling price.
However, the ploy to manipulate expectations is a failure, as shown by the
fact that the gold price always returns to a higher level the day after the
official gold-shedding program is completed. This was true for the auctions
of the U.S. Treasury, those of the IMF and, most recently, those of the Bag
Lady of Threadneedle Street. The exercise of
dissipating official gold is a hoax. It misleads simpletons only. Gold
disgorged by central banks is quickly absorbed by private monetary demand. In
auctioning off monetary gold the managers of irredeemable currency are
trying, in vain, to buy time to save their tottering regime.
The First and Second Decline of the West
When the barbarians overran Rome,
the government of the Western half of the Roman Empire
ceased to function. We may side-step the question whether the policy of
deliberate currency debasement which Rome
had pursued for centuries was ultimately responsible for the collapse. Be
that as it may, after the barbarian invasion there was no authority to
re-introduce gold coinage that would circulate. Gold coins of old had long
since ceased to circulate in the wake of debasement. They were hoarded or
exported to the Eastern half of the Empire, where the supply of gold coins by
the Mint of Constantinople continued uninterrupted for another thousand
years. The fact remains that the First Decline of the West had been
foreshadowed by the disappearance of gold coins from circulation. Only later
was it followed by a cataclysmic shrinkage of trade.
The Second Decline of the West, in our days
and age, has also been foreshadowed by the disappearance of gold coins from circulation.
We may take the year 1914 to mark the beginning of that process. We are worse
off than were people during the First Decline, insofar as there is no Eastern
half where gold coins would still circulate. The threat is that the
disappearance of gold coins from circulation will again be followed by a
fatal collapse in world trade and the survivors of wars will be forced to
live from hand to mouth. Nobody can deny that competitive currency
devaluations and trade wars, not to mention shooting wars, are presently a
threat to our survival and welfare. No one knows how long producers will
continue to accept irredeemable promises to pay in exchange for real goods
and real services. No one knows how long savers will continue to accept a
depreciating monetary unit as numeraire for
their savings. The vanishing of gold coins from circulation have historically
been followed by a collapse of trade if not immediately, then certainly in a
century or so. If the Second Decline isn't turned around soon by the
re-introduction of circulating gold coinage, we may again experience a
cataclysmic shrinkage of world trade, similar to that during the First
Decline.
Defeatist North considers a return to gold
circulation most unlikely, even undesirable. But remember, the First Decline
was stopped in its track and reversed by two amazing developments: (1) the
opening of the Mint to unlimited coinage of gold by Venice
and Florence;
(2) the financing of the trade of Italian city-states with one another and
with their trading partners overseas through the invention of the
gold-redeemable bill of exchange. Corresponding developments could halt and
reverse the Second Decline and save our civilization from ruin. It is not
the cost of returning to gold circulation that is astronomical as North
suggests, but the cost of not returning.
September
5, 2003
Dr. Antal E. Fekete
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