Whither Gold?

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Professor Fekete.com
From the Archives : Originally published February 10th, 1996
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Category : Gold University







The year 1971 was a milestone in the history of money and credit. Previously, in theworld's most developed countries, money (and hence credit) was tied to a positive value:the value of a well-defined quantity of a good of well-defined quality. In 1971 this tiewas cut. Ever since, money has been tied not to positive but to negative values – the value of debt instruments.


This innovation has had two immediate consequences, both of which are pointedlyignored in the technical and scholarly literature on the subject: (1) the power to reducethe world's total debt in the course of normal payments has been lost: total indebtednesscan now be reduced only through default or through currency depreciation; (2) countrieshave lost the option to balance their current accounts with the rest of the world: eachcountry has to cope with unending deficits


The exception is a couple of countries that have been coerced into holding the debt of theworld, upon which the burden of default and currency depreciation will eventually fall:Germany and Japan. As a result of these two features the world's monetary system, whichpreviously was patterned on the model of an anchor, is now patterned on the model of aweather vane. As the tide of unpaid and unpayable debt grows, so the value of moneyebbs


That we have lost the facility to reduce the world's total indebtedness without resorting todefault or monetary depreciation becomes clear at once if we consider the fact that a debtof x dollars can no longer be liquidated. If it is paid off by a check, the debt is merelytransferred to the bank on which the check is drawn. The situation is no better if it is paidoff by handing over x dollars in Federal Reserve notes, ostensibly the ultimate means ofpayment. In this case the debt is transferred to the U.S. Treasury, the ultimate guarantorof these liabilities. But substituting one debtor for another is not the same as liquidatingthe debt. The very notion of `debt maturity' has lost all reasonable meaning previouslyattached to it. At maturity the creditor is coerced into extending his original credit plusaccrued interest in the form of new credits, usually on inferior terms. It is true that theoption to consume his savings remains open to him -- but is it not a strange monetarysystem, to say the least, which forces the savers to consume their savings whenever theyare dissatisfied with the quality of available debt instruments, or with the terms on whichthey are offered?Mainstream economic orthodoxy teaches that a depreciating currency is a boon to thecountry, and a valid tool in the hands of the government to increase competitiveness andthus to reduce or to eliminate the current account deficit. A debased currency makes thecountry an attractive place for foreigners in which to buy and an unattractive place inwhich to sell. Exports are boosted, imports curtailed; thus the deficit is narrowed


This is one of the most pernicious doctrines ever concocted -- as demonstrated both bytheory and practice. Deliberate currency depreciation puts the country at a cleardisadvantage, causing its terms of trade to deteriorate. As all items for export haveimported components, no one can maintain for long low export prices in the face of everrising cost of imports. This theoretical remark is fully borne out by history as shown, forexample, by the experience of the United States during the past 25 years


As the American government has been crying down the (yen) value of the dollar, theterms of trade of the U.S. vis-a-vis Japan is greatly undermined, creating an unendingstream of trade deficits which the Japanese are obliged to finance. To be sure, theJapanese are also depreciating the value of their currency. But as long as they do it at alower rate, which is what the Americans demand that they do, Japanese trade surpluseswill continue unabated


The grievous faults of the prevailing monetary arrangements raise serious questions aboutthe regime's stability and durability. The governments are busily constructing anenormous Debt Tower of Babel, apparently without giving the slightest thought to thewisdom or safety of their construction. The year 1996 marks the twenty-fifth anniversaryof the Brave New World of reckless debt breeding. A quarter of a century is not a greatlength of time in the course of history. But it might be sufficiently long to warrant anexamination of this deliberate policy of heaping more debt upon unpaid and unpayabledebts


Has the policy of unbridled credit expansion, blindly embraced by the governments of theworld some 25 years ago, served the people well? Or do the negative results of thisexperiment call for a more careful examination of the principles involved than hithertoprovided? The question is not raised, and the anniversary is being ignored by the opinionmakers


A great deal of obfuscation surrounds the issue


Officially, the topic is off limits to scholarship and research. Anyone who dares toquestion the legitimacy of the world's present monetary arrangements, or challenges thedoctrine that the regime of irredeemable currency represents `progress' over `obsolete'metallic monetary regimes, is browbeaten; his reward is official ostracism. Professionalstanding is reserved for those who pay lip service to the dogma that `emancipation' froma metallic monetary standard was a progressive, even necessary, historical development


This essay attempts to defy the odds. It intends to show that the essence of the goldstandard is not to be found in its ability to stabilize prices (that is neither desirable norpossible). It is to be found in its ability to stabilize the interest-rate structure at the lowestlevel compatible with economic conditions, and thereby to keep debt within limits. In theabsence of a gold standard, efforts to keep the rate of interest under control are doomed


Rising and gyrating interest rates bring about a wholesale destruction of values, as canalready be seen in the bond and real estate markets (not to mention the Japanese stockmarket). Further delay in putting the cancer-fighting gold corpuscles back into themonetary bloodstream may bring about a credit collapse and chaotic conditions in theworld economy, eclipsing the memory of the Great Depression


1. A Brief History of MoneyIt was Carl Menger who in his epoch-making book Grundsätze der Volkswirtschaftlehre(first published in 1871) elucidated the origin of money in terms of an evolution fromdirect to indirect exchange. Menger introduced the Principle of Declining MarginalUtility asserting that anybody acquiring subsequent units of the same economic good willearmark the last unit for uses with lower priorities than those assigned to previouslyacquired units


This is paraphrased by saying that the marginal utility of an economic good is declining


It is possible to rank goods according to the rate of decline in marginal utility. Theeconomic good with a marginal utility declining more slowly than that of any other isdestined to become money


Constant marginal utilityIn fact, the decline in the marginal utility of money is so slow that it may be considerednegligible, so that the marginal utility of money is constant. In 355 BC a keen observer ofantiquity, Xenophon, in his work Ways and Means, a Pamphlet on the Revenues ofAthens, described what we herein call the constant marginal utility of money in thesewords:"Of the monetary metal, no one ever possessed so much that he was forced to cry"enough!" On the contrary, if ever anybody does become possessed of an immoderateamount, he finds as much pleasure in digging a hole in the ground and hoarding it as inthe actual employment of it. And, from a wider point of view, when the state isprosperous, there is nothing that people so much desire as money. Men want money toexpend on beautiful armor, fine horses, houses, and sumptuous paraphernalia of all sorts


Women betake themselves to expensive apparel and ornaments. Or, when the states aresick, either through barrenness of corn and other fruits or through war, the demand forcurrent coin is even more imperative (whilst the ground lies unproductive) to pay fornecessaries or for military aid. And if it be asserted that another metal is after all just asuseful as the monetary metal, without gainsaying the proposition I may note this fact, thatwith a sudden influx of the former, its value is depreciated, while causing at the sametime a rise in the value of the latter. "The practical significance of the constant marginal utility of money can best be seenthrough examples. The government may open the Mint for the free and unlimited coinageof a certain metal only if the marginal utility of that metal is constant. Equivalently, theCentral Bank may post fixed bid/asked prices for an economic good only if it hasconstant marginal utility. This quality alone will guarantee an orderly and controlled flowof the metal into circulation in the form of coined money, and will make the orderlyexchange of coined money for credit instruments possible. If the government violates thisprinciple, then the Mint and the Central Bank will be buried under an avalanche ofinferior metal


This in fact happened in the 1870's. People continued to overwhelm the mints and centralbanks of the Latin Monetary Union with silver, while draining away their gold. In the endthe governments threw in the towel, closed the mints to silver, and instructed their centralbanks to stop the deluge by lowering the price of silver in terms of gold. In doing so thegovernments were eating their words, as this effectively demonetized silver -- somethingthey had said they would never do. The demise of bimetallism is an interesting episode inmonetary history, yet it is not well understood by authors. Ludwig von Mises writes inHuman Action:In the second part of the nineteenth century more and more governments deliberatelyturned toward the demonetization of silver . . . The important thing to be remembered isthat with every sort of money, demonetization -- i.e., the abandonment of its use as amedium of exchange -- must result in a serious fall of its exchange value. What thispractically means has become manifest when in the last ninety years the use of silver ascommodity money has been progressively restricted (op.cit., PP 428-9)


This appears to confuse cause and effect. In reality, the demonetization of silver was notthe cause but the effect of the decline in the relative value of silver. Moreover, it was notthe governments but the markets that did the demonetizing. Elsewhere in the same bookMises confirms this:"The emergence of the gold standard was the manifestation of a crushing defeat of thegovernments and their cherished doctrines. In the seventeenth century the rates at whichthe English government tariffed the coins overvalued the [gold] guinea with regard tosilver and thus made the silver coins disappear. Only those silver coins which were muchworn by usage or in any other way defaced or reduced in weight remained in current use;it did not pay to export and to sell them on the bullion market


Thus England got the gold standard against the intention of its government. Only muchlater [did] the laws make the de facto gold standard a de jure standard. The governmentabandoned further fruitless attempts to pump silver into the market and minted silver onlyas subsidiary coins with a limited legal tender power . . . . . Later in the course of thenineteenth century the double standard resulted in a similar way in France and in theother countries of the Latin Monetary Union in the emergence of de facto goldmonometallism. When the drop in the price of silver in the later seventies wouldautomatically have effected the replacement of the de facto gold standard by the de factosilver standard, these governments suspended the [unlimited free] coinage of silver inorder to preserve the gold standard (op.cit.,pp 471-2). "It would be more accurate to allude to government efforts "to pump silver back into themarket" -- silver that people were dumping at the doorstep of the mints. It was, of course,not any affection for gold, nor lack of affection for silver, that caused governments toabandon the latter. Governments were silverite by instinct


Moreover, bimetallism had been a lucrative, if illegitimate, source of revenues to them


They fought a fierce rear-guard action. But at one point they realized that the battle tosave bimetallism had been lost as silver no longer had the necessary characteristic of amonetary metal: it no longer had constant marginal utility. Further resistance to marketforces would have meant unsustainable losses. The lesson from this historical episode isthat the hands of the governments can be forced by the people. It was the market thatbrought about the de facto demonetization of silver in the 19th century. The writing is onthe wall that it may bring about the demonetization of irredeemable currencies in the21st


The fixed bid/asked prices the Central Bank may post for the monetary metal, gold, arealso called the lower/upper gold points, respectively. These points are not determinedarbitrarily; they are, in fact, market prices. The upper gold point is closely related to thegold export point above which the standard gold dollar is worth more in melted than incoined form (making it profitable to export it); the lower gold point is closely related tothe gold import point below which gold is worth more in coined than in bullion form(making it profitable to deliver imported gold to the Mint -- which explains how thesepoints earn their names)


The most important consequence of constant marginal utility is the fact that the utility ofmoney is proportional to its quantity, and money is the only economic good with thisproperty. This fact was instrumental in the disappearance of barter. Because of decliningmarginal utility, barter involves losses. One can minimize these losses by bartering forgoods with more slowly declining marginal utility. Clearly, the best terms of trade arereserved for those who barter for (with) the good having constant marginal utility


It is a misunderstanding to suggest, as Ludwig von Mises does (op. cit., p 404) that theconcept of constant marginal utility is contradictory because it is synonymous withinfinite demand. Rather, it is the concept of demand that is contradictory, and should notbe used in deductive science except, perhaps, in a metaphorical sense. The appropriateinterpretation of constant marginal utility is this: people are willing to accept money indischarge of debt in unlimited quantities, not because they want to hold wealth in theform of unlimited quantities of money, but because they understand that the way tominimize the inevitable losses inherent in any exchange is to execute it through theagency of money


Under the gold standard all the gold above ground is deemed to be on offer for sale, as itis deemed to be in demand. The value of the unit weight of gold is independent of thenumber of available units. By contrast, consider the value of the unit weight of iron


Certainly not all the iron above ground is on offer for sale. The first unit weight of ironhas a much greater utility to its owner than the one acquired last. The value of iron isdetermined by its declining marginal utility, making it depend on the quantity available


The difference in the behavior of the two metals in exchange is obvious


Menger introduced the concept of marketability of goods (Absatzfähigkeit) in order toelucidate the emergence of indirect exchange. A commodity with a lower rate of declinein its marginal utility is more marketable than another with a higher rate. The monetarycommodity is the most marketable good, preferred by all market participants, even if theyhave already satisfied all their personal needs for it. `Most marketable' is synonymous to`having constant marginal utility'. There is no need to quibble about the use of the word`constant' in this context


The lowest rate of decline will result in a marginal utility that is constant for all practicalpurposes, as the marketability of the commodity with that property will `snowball' intime. The first gold coin received by an individual certainly has the same utility to him asthe last: he can exchange both coins on exactly the same terms


The evolution of the monetary standard as the economic good with constant marginalutility or highest marketability is the crowning event in the transition from direct toindirect exchange, replacing the barter system with the monetary economy. Thesubjective theory of value, which explains price formation as a convergence phenomenon(as opposed to the quantity theory of money that explains price formation as anequilibrium phenomenon) is a consequence of that evolution


Convergence is a process, while equilibrium is state. The market is narrowing the pricerange within which transactions take place, in response to the activities of arbitrageurs


This analysis of price formation shows how the market process ultimately translatesmarginal utilities into market prices


The rise of indirect exchange has also made it possible for the first time to distinguishbetween buyers and sellers. Under barter no such distinction could be made. Theemergence of money separates the buyers who give up and the sellers who expect toreceive the monetary commodity in the exchange. It is precisely his command over themonetary commodity that puts the buyer in charge -- making the sellers his servants. Hiscontrol over the monetary commodity gives the buyer a choice. He can buy, or he canrefrain from buying. Sellers don't have the luxury of choice. If they don't sell, then theyadmit to failure and have to drop out of the rank of sellers. It is interesting to note that theregime of irredeemable currency attempts to abolish this prerogative. It puts pressure onthe buyers to buy indiscriminately, before their buying power is further eroded bycurrency depreciation


The role of plunderThere is a certain confusion prevailing among authors in regard to the objective versussubjective nature of the value of money. It cannot be denied that all economicphenomena, including the value of money, find their ultimate explanation in thesubjective value-judgments of individuals


However, through a long chain of causation taking place over very long periods of time, acumulative economic process has lent an objective character to the value of the monetarycommodities. The value of a monetary commodity is the result of an evolution that tookmillennia to complete. Consumers, producers, and other actors in the economic dramatend to keep sizeable stores of the monetary commodity on hand (partly because constantmarginal utility makes money an ideal place where to park one's assets)


The cumulative effect of this causes the combined stocks of the dispersed monetary metalto reach a singularly high level, relative to the rate of annual production. As aconsequence, the stocks-to-flows ratio (total stocks divided by annual production)eventually becomes a high multiple, quite unheard-of for other commodities. In the caseof gold this ratio has been estimated to be 50. This means that the total world stock ofgold is about 50 years' production at present rates of output. The same ratio for a nonmonetarycommodity is usually a small fraction, at any rate, no higher than 1. The ratio 1may be reached in case of staple food items harvested once a year, at harvest-time. Thismeans that society is not willing to carry in store more than a few weeks' or months'supply of most economic goods. The only exceptions are the monetary commodities


As the stocks-to-flows ratio for the monetary metal is so high, the likelihood of an upstartcommodity displacing it is remote. In order to bring about such a change it would benecessary to accumulate stocks -- a process that might take hundreds of years. (Thedisplacement of silver by gold in the second half of the 19th century was, in effect, a caseof monometallism replacing bimetallism -- not a case of one monetary commodityreplacing another, as explained above.)Thus the hegemony of the monetary metal, once established, can hardly be challenged. Itis possible to argue that the value of gold, unlike that of other goods, is objective. It isrooted in the objective fact that the world's accumulated stock of gold is a high multipleof the annual flow of new metal from the mines -- a fact independent of subjective valuejudgments. As already stated, this is not to deny that ultimately value must be explainedby subjective considerations; but in assigning a subjective value to gold the human mindfirst must deal with the objective fact that large and well-dispersed stocks of gold exist,relative to which the flow of new gold from the mines is small


The suggestion that the value of the monetary metal has often fallen, constant marginalutility notwithstanding, reflects a confusion of ideas. Historical examples cited in supportof that suggestion are the dispersal of Persian gold after the sack of Persepolis byAlexander the Great in 331 B.C., and the dispersal of the Inca's silver and gold after thesack of Cuzco by Francisco Pizzaro and the conquistadores in 1533 A.D


Both events have been followed by periods of pronounced and prolonged price rises allover the trading world, making the impression that the monetary metals have lost value


The pat explanation offered for this phenomenon is the quantity theory of money. Thevalue of silver and gold is no different from the value of other commodities -- so theargument goes. They are determined by available quantity. Whenever they become moreabundant, as they did in 331 B.C. and again in 1533 A.D., these monetary metals suffer aloss of value


However, the suggestion that the value of gold may decline under a gold standard ispreposterous. The length of a measuring rod in terms of itself as unit is always 1. Thecorrect interpretation of these historical episodes has nothing to do with the quantitytheory of money, which is a pernicious doctrine. An across-the-board increase in prices isone thing, and loss of value of the monetary unit is another. The former may occur incase of general scarcity, quite independently of the latter. In analyzing these historicalepisodes we must carefully note the role of plunder in each case


Wherever large stores of certain goods fall prey to plunder, scarcity results. The prices ofthese goods rise, and will stay high as long as scarcity persists. An apparent exception tothe general rule is the plunder of stores of precious metals that is never followed by a rise,but is often followed by a fall in value. Can this paradox be reconciled with the Principleof Declining Marginal Utility? Well, I argue that the value of gold cannot fall, any morethan the value of other commodities can, as a result of plunder. The key to the paradox isthe fact that plunderers do not want gold for its own sake -- just as the bank robbers donot want bank notes for their own sake. What they ultimately want is a host of goods


Bank robbery is the quickest way to loot society's store of marketable goods


Likewise, when a large store of gold is plundered, it is economically equivalent to theplunder of stores of all kinds of marketable goods. Thus, then, price rises in the wake ofplundering gold are explained by the subsequent scarcity of marketable goods. Higherprices always and everywhere indicate greater scarcity of goods -- never a greaterabundance of gold


Plunder -- modern styleIn the same light I wish to examine the across-the-board price rises that occurred underthe gold standard in 1896-1921 and, again, in 1934-1968. These episodes are no moreexplained by a greater abundance of gold than are those of 331 B.C. and 1533 A.D. Thekey to the understanding of these, surprising as it may sound, is also plunder -- makingmarketable goods relatively scarcer. It is true that the plunder involved is of a subtler kindthan the brutal events of 331 B.C. and 1533 A.D. Subtle or not, plunder remains plunder


Here is what happened


As monometallism was gaining ground over bimetallism, there was a great increase ingold prospecting and production. However, a funny thing happened to gold on its wayfrom the mines to the mints. Central banks hijacked it, in order to build a credit-pyramid,up to twenty times as great, upon their increased gold reserve. Without this interferencefrom the banks there would have been no extra demand for marketable goods and, hence,no price increases -- regardless how fast output of new gold may have grown


The new gold would have entered circulation in coined form. The Haberler-Pigou effect,to be described in the next paragraph, would have prevented any across-the-board priceincrease. The real cause of price increases in the inflationary episodes of 1896-1921 and1934-1968 was not the pronounced increase in gold output. It was the unwarranted creditexpansion engineered by the central banks that hijacked the gold


The same is true of the California gold rush and other similar episodes. Prices of goodsand services rose in California in the wake of the 1848 discovery of gold because of thescarcity caused by the influx of newcomers. But why did prices also rise in New Yorkand elsewhere a little later? Well, they did because of the unwarranted credit expansionthat the banks in New York and elsewhere constructed upon the hijacked gold that wasnot allowed to flow into circulation. If anyone denies this proposition, then he assumesthe burden of proof that no credit expansion took place following the California gold rush-- clearly an impossible task


Consumers controlling the gold coin could effectively resist price rises either in delayingpurchases, or in buying alternative products and in shifting custom. An across-the-boardprice increase would represent a capital loss inflicted upon holders of the gold coin, whowould scramble to recoup their losses by restricting purchases. Voluntary restraint onconsumption is the ultimate factor blocking price increases. Note, however, that theHaberler-Pigou effect operates only on the gold component of the money supply, but noton the credit component


As far as the latter is concerned, restricting purchases is an empty gesture. It is true thatthe holders of bank notes also suffer capital losses represented by the price rise but,because they are creditors to the extent of their holdings of fiduciary media, anothergroup of people -- their debtors -- will have experienced an equivalent capital gain. Thestepped-up spending of the latter group will offset the spending restraint of the former,and the net result is an across-the-board increase in prices. (For more on the Haberler-Pigou effect see: R. Hinshaw, ed., Monetary Reform and the Price of Gold, Baltimore,1967.)Abolishing the gold standard because it could not prevent price rises due to plunder(followed by a collapse in prices) is akin to putting the bearer of bad news to death. Goldwas simply doing its job in reporting the extent of economic disruption caused byplunder, credit expansion, flood, earthquake, war, etc. In no way can gold be heldresponsible for the disruption itself


Rumors about the death of the gold standard are grossly exaggerated. In 1930 Keynescorrectly described the impact of the two great historic dispersals of gold on the futuremonetary role of the metal in his book A Treatise on Money. He made a convincing casethat dispersal of gold from fewer to more numerous hands has always been instrumentalin promoting the monetary qualities of the yellow metal. But Keynes went on to prophesythat the exact opposite would take place in the 20th century -- probably having a fataleffect on gold's future prospect to continue as the monetary metal par excellence


What he referred to was the weaning of the public from the gold coin, the concentrationof gold in central bank vaults, and the unprecedented increase of bank notes incirculation. We need not be surprised that Keynes avoided using the word `plunder' todescribe this process: he himself was the chief instigator of the trick of "taking gold awayfrom man's greedy palms"


However, Keynes' prophecy concerning gold's future fell short of the mark. Keynes failedto foresee the coming of the third (and so far the greatest) dispersal of gold a generationafter his death in 1947. It took the form of a great official gold dumping, ushered in bythe U.S. Treasury gold auctions in 1974, followed by further auctions of central bankgold under the aegis of the International Monetary Fund (IMF). Later the auctions weresuspended -- possibly because it was belatedly realized that the U.S. Treasury and theIMF had made themselves the laughing stock of the world


They were throwing away their most reliable asset in exchange for irredeemable promisesto pay -- at ludicrous prices to boot. Still, official holders such as Canada, Belgium, andthe Netherlands occasionally dump gold on the market. Moreover, in 1995 there wasmore talk about new IMF gold give-aways (ostensibly to raise funds for economic aid tosupport the less developed countries). Thus the third great dispersal of gold is stillcontinuing. It may be confidently predicted that the ultimate effect will be the same asthat of previous historic dispersals: a reconfirmation of gold's position as the paramountmonetary asset of the world


The irony is that the authors of these gold dumpings were the most ardent students ofKeynes, but they completely misunderstood the teachings of their prophet about theconsequences of gold dispersal. When all has been said and done, these authors willappear as foolish as King Canute ordering the ocean to recede


Whose standard?It is the task of the government and the legal system of the country, in order to preservecivil conduct in the market place, to define the standard of weights and measures, and todefine the standard of value by issuing coinage and, in case of non-performance oncontracts or in case of fraud, to compel the delinquent party to live up to his side of thebargain, through the use of the government apparatus of coercion. However, this ideal hasoften been corrupted by governments misusing their prerogative, in defining the standardof weights and measures capriciously, in order to favor a minority at the expense of themajority. This type of government intervention in the voluntary exchanges of marketparticipants is no longer practiced. Public opinion would not tolerate the arbitraryshortening of the standard unit of length through the device of crowning an infant king,and declaring the length of his foot the new standard


Just how much this improvement in government policy is due to enlightenment andproper sense of justice, and how much to the changing parameters of public ignorance,can be decided only after considering the fact that it is still not below the dignity ofgovernments to tamper with the standard of value capriciously, in order to favor aminority at the expense of the majority. Governments have found that the level of generalignorance concerning the nature of value is such that public opinion can suffer the affrontof manipulating the standard of value


Out of sheer ignorance, people meekly accept the consequences of this policy ofvictimization. In fact, governments of the 20th century have carried the practice to itsultimate. They have accomplished what no government in the long history of civilizationhas been able to do, hard as they may have tried. Governments can now tamper with thestandard of value on a monthly, weekly, daily, or hourly basis with impunity, through theinstrument of irredeemable currency, and through open-market operations in the foreignexchange and bond markets. Governments not only get away with this dangerousprestidigitation: they are lionized for performing it. (Part of the explanation for theanomaly of our "ignorance amidst informational bounty" is the subtle controlgovernments have over education -- but that is another story.)Before the tampering with the standard of value was developed into the high art ofdeception it is to-day, governments wishing to alter the terms of trade in favor of aminority at the expense of the majority could only do so at their own peril. They alwayshad the prerogative to coin money. But in attending to this task governments did notcreate money, still less wealth. An economic good becomes money only by virtue of thepublic's preference in making its marginal utility constant. Governments don't select themonetary metal: that is the market's prerogative. The government stamp placed upon apiece of metal does not create value; all it does is to certify the weight and fineness of thecoin. The purpose of stamping is to obviate weighing and the application of the acid testto each gold piece at every exchange. It is to facilitate the circulation of coins by talerather than by weight


Whenever governments have resorted to debasing the standard of value by issuing coinsof a baser alloy, but with the same stamp, the same name, and the same outwardappearance of coins, they knew full well that they were engaging in a fraudulent attemptto cheat the public. To the extent that it took time to expose the fraud, governments havebeen making an illegitimate profit, and they have been enriching a favored minority (theexport merchants) at the expense of the unsuspecting majority (the domestic consumers)


But after the fraud is exposed, as sooner or later it must be, the debased coins go to adiscount representing the extent of debasement. Governments have insisted that it is notthe alloy but the stamp that has made the coins valuable. They have declared it illegal todiscriminate against light coins in favor of the heavy ones. They have declared maximumprices. Violation of the `law of maximum' has sometimes been made punishable by death


But as the government's writ stops at the border, and people on the other side are free toseparate the light from the heavy coins as they see fit, the coin debasers are forced toadmit that their policy is a failure. However, tampering with the standard of valuecontinues. Techniques do change -- the intent to benefit a favored minority at the expenseof the unsuspecting majority does not


Bimetallism -- stratagem to benefit a minority at the expense of the majorityAs two precious metals, silver and gold, were used side-by-side as money, governmentsdeclared a statutory bimetallic ratio at which the monetary metals were to be valued at theMint. We may bypass the question whether it was ignorance or deviousness whichmotivated governments to enforce a rigid bimetallic ratio, in pretending that value couldbe created or altered by legislation. Be that as it may, bimetallism was dear to the heart ofgovernments as it offered an opportunity to tamper with the standard of value on aregular basis. This is how it worked


The public would deliver the overvalued metal to the Mint, making this metal the de factomonetary standard, while using the undervalued metal for payments abroad where itcommanded a higher value. In this way one monetary metal always appeared to beabundant, while the other appeared to be scarce before disappearing altogether. It was theinconvenience to trade caused by the abundance-cum-scarcity of bimetallic coinage thatgave occasion to repeated tampering with the standard. To grant relief, governmentswould alter the bimetallic ratio in favor of the scarce metal. This would cause theabundant coins to become scarce and the scarce coins to become abundant. The wrongshoe was now on the other foot, and the game of changing the bimetallic ratio could startall over again


It should be clear that whenever a change in the standard unit of value is proposed, somepeople stand to gain (namely those net long in the metal to be overvalued, or net short inthe metal to be undervalued by the impending change), while others stand to lose (namelythose net long in the metal to be undervalued, or net short in the metal to be overvalued)


Since the general public is always long in the metal to be undervalued, it is always on thelosing side. A minority of insiders with advance knowledge of the timing and extent ofthe devaluation stands to gain from it at the expense of the general public. Yet the gameof dropping one shoe after the other, only to repeat the trick afterwards, was wearing oneshoe thin faster than the other. The alternating standard resulted in a progressivedepreciation of silver in terms of gold


In antiquity the gold/silver ratio was about 10. Five hundred years ago, at the time of thediscovery of America by Columbus, the ratio was still only 11. The decline in the valueof silver continued during the next three hundred years. On April 2, 1792, the U.S. dollarwas defined as 371.25 grains of fine silver or 24.75 grains of fine gold. This wasbimetallism at the ratio of 15 at a time the market ratio was closer to 15, thus overvaluingsilver and putting the dollar on a de facto silver standard. On June 28, 1834, the U.S


Congress increased the official bimetallic ratio from 15 to 16


This new ratio was higher than the market ratio, overvaluing gold and putting the dollaron a de facto gold standard. By 1870 the accelerating decline in the value of silverthreatened the U.S. Mints with a deluge of the silky metal. To meet this threat Congressin the Coinage Act of 1873 dropped the standard silver dollar from the list of coins thatcould be minted freely on private account. Thereafter, silver was to be coined at thepleasure of the government. This would have put the dollar on a de jure gold standard,had the U.S. Mints been open to gold. But they were not. In 1873 the U.S. governmentstill maintained a regime of irredeemable paper currency, the greenbacks -- a legacy ofthe Civil War. This fact explains why the 1873 demonetization of silver went unnoticedby the general public, including the powerful silver lobby


The fall in the value of silver continued to accelerate as the gold/silver ratio rose from 16to 19 by Resumption Day in January 1879, when the U.S. government reopened the Mintto gold, and resumed gold convertibility of the greenback. Thereafter the value of silverwas falling precipitously, the gold/silver ratio almost reaching 40 by the turn of thecentury. The silver lobby woke up and started crying `bloody murder', bitterlydenouncing `the crime of 1873'. During the 1896 Presidential election campaign theDemocratic candidate, William Jennings Bryan, in his famous `cross of gold' speech onthe stump, pledged to return the country to a bimetallic monetary standard. He failed tounderstand, as did most other observers, that demonetization was the effect rather thanthe cause of the collapse in silver's value


With the demise of bimetallism in the 1870's the ability of the government to benefit aminority at the expense of the majority was greatly curtailed -- albeit not for long


Hijacking gold on its way from the mines to the mints by the central banks opened upnew possibilities for credit manipulation, making it easy for governments to defraud theunsuspecting majority in favor of a minority


In our days the deception that governments can create value and wealth out of thin air,through a judicious monetization of their own credit, is an article of faith at virtually allchanceries and universities. The opposing view, represented by this essay, that creditmanipulation cannot create but can indeed destroy capital, and so it cannot lead toprosperity but can ultimately pauperize the entire society through credit collapse, as it didduring the Great Depression, appears to be but "a lonely cry in the wilderness" (Isaiah,xl: 3)


A short course on demonetizationQuantity theorists widely predicted that the demonetization of gold would seriouslyundermine gold's exchange value. (A representative of this view is the first quotationfrom Mises on p 3 above.) They argued that the removal of the lion's share of the demandcould not help but make gold cheaper. As a reinforcement of this argument, quantitytheorists were fond of recalling the episode of silver demonetization in the last century


They claimed that demonetization had caused the prolonged decline in the price of silverthat has been continuing ever since


It is not known whether these views had any influence on the thinking of the decisionmakerswho `demonetized' gold in 1971. Be that as it may, the idea that dishonoringpromises to pay gold would somehow cause the dishonored paper to go to a premium ingold is preposterous. It is true that insolvent bankers have in the past often tried topromote their discredited paper (sometimes using such extreme measures as the threat ofthe death penalty, as did John Law of Lauriston in France) -- to no avail. Logic andhistory prove that dishonored promises to pay always and everywhere go to a discount --never to a premium. Indeed, this is exactly what happened after gold was `demonetized'word-wide in 1971


In less than a decade the U.S. dollar went to a 90 per cent discount in terms of gold. Thediscount is fully commensurate with the 90 per cent loss in purchasing power that thedollar has suffered during the same period. Even though the discount on the dollarfluctuates, the hope that it would ever disappear is a forlorn one. The disarray in thenation's budgetary and trade accounts suggest that currency depreciation is likely tocontinue, if not to accelerate. The only way to stop the rot would be to adopt a credibleplan to resume gold redeemability of the dollar -- but no party has so far mustered thepolitical courage to propose it


The comparison between the demonetization of silver in 1873 and the so-calleddemonetization of gold a century later is disingenuous. In fact, the use of the word`demonetization' in connection with the latter is quite inappropriate: it is but a euphemismfor debt-abatement or partial debt-repudiation inflicted upon the foreign creditors of theUnited States of America. In 1971 these creditors were deprived of a valuable propertyright to a fixed amount of gold, or to the dollar equivalent thereof


This unilateral and capricious act has done nothing to benefit the citizens or thegovernment of the U.S. On the contrary, the debt abatement had one predictableconsequence: harsher terms on future borrowings, as measured by the higher andunpredictable rate of interest at which the government and the people of the U.S. canborrow at home and abroad


It is true that the burden of the debtors who had contracted debt prior to the abatementwas lightened. But insofar as they were the same people and the same government onwhom the burden of the harsher terms on further borrowings fell for the indefinite future,there were no beneficiaries -- only losers. In particular, the big loser was the Americantaxpayer. The international credit of the United States government, which had been theenvy of the world for over a century, was grievously damaged -- as manifested by theunprecedented interest rates the Treasury was forced to pay upon its obligations after thedebt abatement


The stubborn insistence the credit of the U.S. has not been damaged in thedemonetization exercise of 1971 is the centerpiece of mainstream economic orthodoxy


Yet this is a world of crime and punishment and no one, not even the government of themightiest nation on earth can exempt itself from the consequences, which are numerous


America's industry has lost its international competitiveness. Due to the high rates ofinterest a large segment of America's park of capital goods has become submarginal, asproducers were either unwilling or unable to maintain it or to replace it by more up-todateequipment


As capital became submarginal, so did the producers using it. They were forced to selltheir businesses at a loss, and to invest the remnants of their former wealth in high-yieldTreasury bonds. This is a textbook-case showing that a government can only harm itselfby harming its own taxpayers. Printing high coupon-rates on its bonds the U.S


government turned former producers of wealth into coupon-clippers. The world iswitnessing the progressive de-industrialization of America, as a large segment of theproducers find themselves unable to compete with those capricious coupon-rates thegovernment high-handedly prints on its bonds. At the same time, the main competitors ofAmerican industry in Japan and Germany are the beneficiaries of a low interest-ratestructure, made possible by those countries' more stable currencies


While the so-called demonetization of gold was a farce staged by the U.S. government inorder to cover up its own insolvency, the demonetization of silver a hundred years earlierwas a genuine market-phenomenon. Government action in demonetizing silver amountedto little more than a belated acknowledgement of a fait accompli


There was no dishonoring of promises to pay. There was no deterioration in the publiccredit, no destruction of private capital. On the contrary, by virtue of its cooperating withmarket forces, the government greatly enhanced its credit. The United States was well onits way to become the world's greatest creditor nation. One hundred years later thegovernment, in demonetizing gold, was moving against market forces, and the credit ofthe U.S. government suffered its greatest setback in the history of the nation


The deterioration of the credit of the United States still continues, with unforeseeableconsequences. This is not generally acknowledged by financial writers at home andabroad. But one palpable and indisputable consequence of the `demonetization' of goldwas that, in a few short years, the U.S. has turned itself from the world's greatest creditorinto the world's greatest debtor nation. The United States was forced to borrow enormoussums abroad at exorbitant rates of interest. The gross mismanagement of credit hascreated enormous problems for which there are no painless solutions


The dual nature of moneyThe evolution of a dual monetary standard involving both silver and gold was noaccident. In every treatise on money, in one form or another the proposition is advancedthat money (whatever else it may be) is a transmitter of value through space and time


Thus the concept of money is directly linked to these two absolute categories of humanthought. The space/time dichotomy explains the dualistic nature of money -- explicitlyobservable throughout the ages, right up to the demise of bimetallism


In its first capacity money must be able to transfer value through space, over greatdistances, with the smallest possible loss. In antiquity, cattle were especially suitable forthis purpose, and became money. In its second capacity money must be able to transfervalue through time with the smallest possible loss. Cattle-money was scarcely suitable forthis second task


This explains the emergence of another kind of money, suitable for hoarding anddishoarding with the greatest ease, in order to facilitate the transfer of value over time


Originally this other kind of money was salt. Not only was it less perishable than othermarketable goods, but salt was also the most important agent of food preservation. As thethreat of periodic food shortages loomed large in antiquity, the agent of food preservationwas destined to have a monetary role


To people of the antique world it appeared natural that two vastly different commoditiesanswered their money-needs, and they took the coexistence of cattle-money and saltmoneyfor granted. Our linguistic heritage clearly reflects this fact. The English adjectivepecuniary and noun salary were derived from the Latin words pecus (cattle) and sal(salt). Even though gold and silver which later replaced cattle and salt were far moresimilar to one another, the dual nature of money persisted throughout the ages


Only towards the end of the 19th century did advances in metallurgy make it possible thatone monetary metal, gold, could answer both money-needs of man better than any othercommodity. This was the development that made it possible to produce or recover gold inmolar quantities economically. The practical outcome was the recognition that the bestmonetary system was gold monometallism


As Bruno Moll put it in his book La Moneda, "gold is that form of possession which is ofthe highest elevation above time and space". The dualism of monetary systems is thecentral theme of this essay, as we explore the two sources of man's need for money. Thefirst, man's need to transfer value over space, was used by Carl Menger to build histheory of value on it. The second, man's need to transfer value over time (or as we shallmore specifically describe it, man's need to convert income into wealth and wealth intoincome) is used here to build a new theory of interest on it


The Janus-face of marketabilityIn developing his theory of value, Menger described the origin of money in terms of theevolution marketability. But as the ancient Italian god Janus (in whose honor the firstmonth of the year is named) marketability has two faces. The first is marketability in thesmall -- or hoardability. The second is marketability in the large -- or salability. The latteris synonymous with Menger's term Absatzfähigkeit, the cornerstone of his theory ofvalue. Hoardability has not been independently analyzed before. In isolating this conceptI propose to lay a new cornerstone for the theory of interest


A commodity is more marketable in the large (or more salable) than another if thebid/asked spread increases more slowly for the former than for the latter, as each isbrought to the market in ever larger quantities. For example, perishable or seasonal goodsshow the lowest, durable goods or goods for all seasons show the highest degree ofsalability. It is easy to see how cattle became the most salable commodity in antiquity


People had superb confidence that there could never develop a situation in which therewas a disturbing surplus of cattle


Long before anything like that could happen, owners would drive their herds to regionswhere there was a shortage of cattle. The cost of transporting the unit of valuerepresented by cattle over great distances was lower than that of transporting the samevalue represented by anything else, due to the self-mobility of cattle. This fact, too, ispreserved in our linguistic heritage. A herd is also known as a drove of cattle, and aherdsman as a drover (both are derived from the verb to drive). Thus mobility or, betterstill, portability is an important aspect of salability. The more portable a commodity is,the more easily it can seek out havens where it is in greater demand


The term salability refers to the quality of a good which allows very large quantities of itto be sold during the shortest period of time with minimal losses -- which explains howthe term earns its name. Among the most salable goods we find the precious stones andmetals. A long historical process promoted gold to become the most salable of all goods


For gold, the spread between the asked and bid prices is virtually independent of thequantity for which it is quoted. It only depends on the cost of shipping gold to the nearestgold center. Under the gold standard the spread is constant, and is equal to the differencebetween the gold points. By contrast, for all other goods, different spreads are quoted fordifferent quantities, and the larger the quantity, the wider the spread


Thus the gold standard is seen as the product of a market process in search for the mostsalable commodity. Some authors deliberately confuse the issue insisting that theconstant spread of gold is due to institutional factors, i.e., the statutory requirement thatthe central bank should stand ready to buy at the lower, and to sell at the upper gold pointunlimited quantities of gold. Once again, this is a confusion of cause and effect. Inreality, institutional constraints would sooner or later break down, and the commoditywith less than perfect salability would be demonetized by the market, if the authoritiestried to promote it to be the monetary standard -- as indeed happened to silver in the 19thcentury, to copper in medieval times, and to iron in antiquity


It is common knowledge that, although they have a high degree of marketability in thelarge, precious stones have poor marketability in the small. The process of cutting up alarge stone into a number of smaller pieces often results in a permanent loss of value


(This is just another illustration of the paradox that the value of a parcel is not necessarilythe same as the sum total of the values forming part of that parcel.) Even for preciousmetals whose subdivision into smaller parts is fully reversible, marketability in the smallcannot be taken for granted. A penetrating example due to a 19th century traveller is citedby Menger in the Grundsätze:When a person goes to the market in Burma, he must take along a piece of silver, ahammer, a chisel, a balance, and the necessary weights. `How much are those pots?' heasks. `Show me your money', answers the merchant and after inspecting it, he quotes aprice at this or that weight. The buyer then asks the merchant for a small anvil andbelabors his piece of silver with his hammer until he thinks he has found the correctweight. Then he weighs it on his own balance, since that of the merchant is not to betrusted, and adds or takes away silver until the weight is right. Of course, a good deal ofsilver is lost in the process as chips fall to the ground. Therefore the buyer prefers not tobuy the exact quantity he desires, but one equivalent to the piece of silver he has justbroken off. (Principles of Economics, op. cit., p281.)A commodity is more marketable in the small (or more hoardable) than another if thebid/asked spread increases more slowly for the former than for the latter, as each isbrought to the market in ever smaller quantity. The term `hoardability' refers to thequality of goods which allows large stores to be built up piecemeal through hoarding, orto be drawn down through dishoarding, with minimal exchange losses. It is this propertythat matters most when individuals are trying to convert income into wealth, or wealthinto income. They succeed best if they employ the most hoardable commodity


It is easy to see how salt became the most hoardable commodity in antiquity. People wereconfident that exorbitant surpluses of hoardable foodstuff would never develop


Everybody who could afford it would hoard it. People would recall the Biblical teachingthat the seven fat years would always be followed by seven lean ones


For the stronger reason, people were supremely confident that their hoards of salt -- thisforemost agent of food preservation -- would not lose its value, whatever the fortune mayhold in store. In antiquity it was not possible to transfer value over time with smallerlosses than those involved in hoarding salt


Other examples of commodities that have been highly hoardable at one time or anotherthroughout history are: grains, tobacco, sugar, spirits. It is interesting to note that therehas been heavy government involvement in the production and trade of all these. Thus wesee that an historical process, similar to the one making gold most salable, has promotedsilver to become most hoardable. Gold was the money used for paying princely ransomsand for buying territories (such as Louisiana and Alaska), and silver was the money usedby people of small means for accumulating capital (Maundy money)


Why bimetallism failedAs long as the necessary technology was lacking, gold could not challenge silver'sposition as the most hoardable commodity. The cost of producing or recovering a smallfraction of the unit of value represented by gold could involve expensive molar processes


The recovery of the same small fraction of the unit of value represented by silver incurredno such extra cost as the amounts involved were not molar, thanks to the lower specificvalue of silver. However, by the second half of the 19th century, with the progress ofmetallurgy, the cost of molar processes was lowered and commercial dealings in gold onthe molar scale became economically feasible. Thereafter gold could effectivelychallenge and ultimately displace silver as the most hoardable commodity. Thedemonetization of silver by the market was a logical consequence


To see clearly why it was gold, and not silver, that was destined to win the race forhegemony we have to consider the specific values of the monetary metals, and theirrelation to the spreads between the export/import points. Gold has a high and silver a lowspecific value, implying that the unit of value as represented by gold is lighter than thesame as represented by silver (in fact, 15 times lighter if we assume that the gold/silverbimetallic ratio is 15)


We have seen that the gold export (import) point is the melted value of the standard coinabove (below) which it becomes profitable to export (import) gold. The meaning of thesilver export (import) point is analogous. Clearly, the spread between the goldexport/import points depends on the cost of shipping the unit of value as represented bygold to the nearest gold center abroad. The same is true, mutatis mutandis, for the spreadbetween the silver export/import points. But shipping costs depend on the weight of theshipment. As the weight of the unit of value as represented by gold is relatively small, thespread between the gold export/import points will be relatively small. (It wasapproximately 1 percent of value between New York and London in the heyday ofbimetallism, while the spread between the silver export/import points was 15 percent ofvalue.)For example, assume that the statutory gold price is $20 per Troy ounce, and the upperand lower gold points are at $20.20 and $19.80, respectively. Assuming further that theofficial bimetallic ratio is 15, the statutory silver price will be approximately $1.33 perTroy ounce (20 divided by 15). Let us calculate the gold and silver export/import spreads


The cost of shipping the unit of value, $1, as represented by gold is 1 cent (because thecost of shipping 1 ounce of gold is $20 -- $19.80 = twenty cents; this we have to divideby 20 as the standard gold dollar weighs 1/20 of one ounce)


The melted value of the standard gold dollar may therefore fluctuate between 99 centsand $1.01 before it will induce a corrective movement of gold. The gold export/importspread is 2 cents. But the same unit of value, $1, as represented by silver, is 15 timesheavier, so the cost of its shipping will be 15 cents, or 15 times the cost of shipping thestandard gold dollar. The melted value of the standard silver dollar may thereforefluctuate between 85 cents and $1.15 before it will induce a corrective movement ofsilver. It follows that the silver export/import spread is 30 cents, or 15 times wider thanthe gold spread. We see that under bimetallism the export/import spread for the monetarymetal of the higher specific value is narrower by a factor equal to the bimetallic ratio


It is certainly true that under a monometallic monetary regime most large transactionswill not involve shipment of the metal as long as the price of gold stays within the rangebetween the gold points. Clearing is effected through the exchange of warehouse receipts


However, the case under bimetallism is different. Here the arbitrageur profits by actuallyshipping the undervalued metal out of, and the overvalued metal into, the countrymaintaining a rigid bimetallic ratio


What this shows is that silver is inferior to gold as a standard of value. Those who parktheir wealth in silver stand to lose 15 times more than those who use gold for thatpurpose, due to variations in the market ratio between the silver and gold prices. Theupshot is that people will gradually move out of silver and into gold. In due course themarket will demonetize the metal with the lower specific value, in this case, silver. Goldmonometallism was no accident: it was brought about by inexorable market forces. Forthe first time ever in human history one commodity, gold, became the undisputedmonetary metal, combining the characteristics of the most salable and the most hoardableassets


Mene TekelBut the distinctive property of gold, that it is the only remaining monetary metal aroundin the closing decade of the 20th century, should not blot out entirely the dualistic natureof money. In fact, it is monetary dualism that provides the only rational explanation forthe occasional breakdown of the monetary system. During periods of great monetarydisturbance, such as a hyperinflation, the distinction between the two kinds ofmarketability is most dramatically revived by the market


For shorter or longer periods, the government may succeed in forcing the circulation ofirredeemable bank notes, which may retain the characteristics of the most salable asset


Yet, at the same time, the government is patently unable to make these credit instrumentsthe most hoardable asset. Although the fast-depreciating bank note is still usable intransmitting value through space, it suffers from a fatal paralysis when trying to transmitvalue through time. It is inevitable that, ultimately, gold should assert its position as themost hoardable asset. Nor is there anything governments can do to save theirirredeemable paper from monetary destruction. Even if they succeed in banning theownership of and trading in gold, a number of other commodities stand ready to step intothe golden slippers to assume the role of the most hoardable asset


The most conspicuous defect of the quantity theory of money is its utter failure inexplaining the hyperinflationary episodes of history. Over-issue of the fiat currencycertainly cannot be the cause of the malady. It has been convincingly demonstrated that(especially in the final phases) there was always a desperate shortage of the doomedcurrency. Hyperinflation has nothing to do with quantity it has everything to do withquality of money. The true cause of hyperinflation is the inexorable human need for amost hoardable asset. It is the relentless search for a reliable transmitter of value throughtime. Those who believe that the millennium of irredeemable currency has arrived mustbelieve that governments have found a way to change human nature by legislative fiat


Under the regime of irredeemable currency hyperinflation is inevitable -- unless gold isonce more allowed to play its historical role that has been taken away from it throughgovernment coercion: the role of the most hoardable asset. The full implications of theinevitability of a breakdown in the regime of irredeemable currency are not yet clear tomost people. Purveyors of goods and services are still willing to give up real value inexchange for irredeemable promises. This ignorance may, of course, help postpone themoment of truth. In the meantime, Lincoln's dictum should be remembered, according towhich it may be possible to fool some people all the time, even to fool all the peoplesome of the time; but it is not possible to fool all the people all of the time


Certain monetary economists can see the writing on the wall mene tekel: your days arenumbered -- you have been weighed in the balance and found wanting (Daniel v:26-28)announcing the verdict on the regime of irredeemable currencies. They propose a solutionthat would `tie' the value of the currency to that of a basket of commodities. Some go asfar as suggesting that -- horrible dictu -- even gold may be put into the basket. There isnothing new in these proposals. F.A. Hayek suggested it in 1943 in a paper entitledCommodity Reserve Currency. It is extremely doubtful that Hayek's scheme would work


Let us disregard the utter naivete of the scheme in ignoring the cost of warehousingperishable goods, and ignoring the problem of quality-control. Let us consider the schemein its simplest form known as symmetalism (originally proposed by the British economistAlfred Marshall a hundred years ago, but never tried in practice) whose unit of value is abasket consisting of a fixed amount of gold and a fixed amount of silver. Unlikebimetallism, this arrangement would let the prices of the monetary metals vary


We now show that symmetalism, no less than bimetallism (which Milton Friedman calledpreferable to gold monometallism in his book Money Mischief) would be shipwrecked onthe rock of gold's constant marginal utility. The market would stamp out symmetalismeven faster than bimetallism, precisely because of the price flexibility the former affords


The gold/silver ratio would widen further for reasons already discussed. The profitopportunities offered by symmetalism would result in a relentless arbitrage out of silverand into gold. The arbitrageur would redeem his currency in gold and silver; then hewould sell the silver and keep the gold. When the anticipated rise in the price of goldmaterialized, he would buy back his silver for less, and unwind his arbitrage bysurrendering the same amount of gold and silver in exchange for symmetallic currency,showing a net profit in gold


Let us note in passing that the scheme concocted at Maastricht (introducing yet anotherirredeemable monetary unit, the Euro, defined as a basket of irredeemable currencies) isdoomed for the same reason. The currency that depreciates at the lowest rate, in this casethe German mark, far from imparting strength to other currencies in the basket, wouldmake them even weaker. Arbitrage would act as a centrifuge, separating the componentsof the basket, throwing away the soft and keeping only the hardest of hard currencies. (Ifmarks, liras, etc. were no longer available for trading, then the object of arbitrage wouldbe the central bank assets that had been used to balance liabilities in marks, liras, etc.)The authors of the Maastricht scheme turned the ancient wisdom -- that no chain can bestronger than its weakest link -- upside down. They have invented a chain that is as strongas its strongest link


2. Towards a New Theory of InterestThe nature of interest is one of the great problems of humankind, as old as money itself


It has engaged the greatest minds, from Aristotle through the church fathers to Menger


The lack of a satisfactory solution to the problem has rocked empires, contributing totheir destruction. This author hopes that his essay can make a modest contribution to theultimate disposal of this great and vexed problem


Part of the difficulty is in the way the question has traditionally been presented, namely:what happens when a man with a need to borrow meets another with money to lend? Ithas always been in this context that usury was condemned by both criminal and canonlaw. It has not occurred to the philosophers and moralists -- or, for that matter, to mosteconomists -- that the nature of interest could be better grasped if the question wasreformulated thus: what happens when a man with income to spare but who is in need ofwealth meets another with wealth to spare but who is in need of an income?The resulting exchanges provide a passage from direct to indirect conversion of wealthand income. Indirect conversion represents a great improvement in efficiency over directconversion, interest being the manifestation of the market value of this improvement


Thus the proper setting for the study of interest is the indirect conversion of income intowealth (just as the proper setting for the study of price is the indirect exchange of goods)


It now appears that condemnation of usury is akin to condemning a man for charging orpaying the going price for bread


Traditionally, interest is conceived as a steady income in perpetuity which is exchangedfor the unit of wealth. It can be measured as a percentage of the unit of wealth accruing asincome to its owner after the exchange. If the unit of wealth is one gold dollar, and it isexchanged for an income in perpetuity amounting to one gold cent per quarter, then therate of interest is four percent per annum. Of course, an income in perpetuity is anabstraction, but it has great theoretical importance as the standard measuring interest. Themathematician has shown us exact formulas expressing the rate of interest involved inexchanges of wealth for income for a set period of time, as well as formulas expressingthe rate of interest involved in exchanging present for future wealth, in terms of thisstandard -- making arbitrage between various credit markets possible


I shall not pause here to give an iron-clad definition between "wealth" and "income'


Suffice it to say that an inexorable need exists, second only to the need for food andshelter, urging man to convert income into wealth in order that later, when past his prime,he may convert his wealth back into income. As the comedy of King Midas and thetragedy of King Lear show, a most important difference exits between controlling wealthand controlling income, and the possibility of converting one into the other must not betaken for granted. Income is an ultimate end for man, insofar as without it he may haveno other ultimate ends on earth. (If denied an income he, as King Midas, is in danger ofstarving to death.) Since wealth is an indispensable means to that end in the twilight yearsof his life, man's need for a reliable conversion mechanism is beyond doubt. (Withoutsuch he may, as King Lear, end up losing both his wealth and income.)The theory of private property ought to take full account of the fact that conversion ofincome into wealth is the rational and characteristically human manifestation of the lawof the biosphere whereby all living things can only survive and prosper by hoarding theirsubstance. In the case of man this substance, as we have seen, is the most marketablecommodity, gold, which is always in demand, whether it is offered in the largest or in thesmallest practically realizable quantity -- since it can always be traded with the smallestpossible exchange losses


The chimaera of hoardingHere we come to a paradox which utilitarian philosophy has failed to solve. An apparentcontradiction exists between the needs of the individual and his society. There is a time inthe life of every man when he wishes to draw on his savings accumulated earlier. Yethoarding and dishoarding are widely considered as anti-social. They are unsettling as theformer affects demand and the latter affects supply unfavorably, possibly at a time that isinopportune from the point of view of society. The utilitarian philosophers could notclarify how the market provides for the conflicting demands of society and its ageingmembers. Utilitarian philosophy has failed to solve the problem of hoarding anddishoarding


In particular, it has failed to explode the arguments of Silvio Gesell, John MaynardKeynes and other inflationists, according to which the contractionist and deflationarypressures inherent in a metallic monetary system are the source of poverty and chroniceconomic distress, as they invite hoarding. At the same time these authors described thepromised land of the inflationist paradise in glowing terms. There, the miracle of "turningthe stone into bread" would be routinely performed by monetary technicians in theservice of the government for the benefit of the people. In what follows I refute theinflationist argument in the spirit of utilitarian philosophy, hoping to remove an obstaclewhich has blocked the advancement of monetary science for a hundred years


The invention of double-entry book-keeping in Italy of the Trecento was a momentouslandmark in economic history. Göthe called it "one of the finest inventions of the humanmind" (Wilhelm Meister's Apprenticeship). Double-entry book-keeping is of utmosteconomic importance, second only to the appearance of indirect exchange much earlierthat had made direct exchange of goods obsolete. The new invention made the indirectaccumulation of capital via the instrument of contract possible, thus making the directaccumulation of capital via hoarding obsolete. Previously, there was only one way forpeople to convert income into wealth or wealth into income outside of family bonds:hoarding and dishoarding. (For much of the Orient, which was slower in developing theinstitutional framework to protect contractual rights, it is still the only way.)This immobilized large amounts of gold, and made capital accumulation an arduous andprotracted process in which reward was far removed from effort, dampening incentive


The invention of double-entry book-keeping made possible a heretofore unprecedentedincrease in the efficiency of gold as the catalyst of capital accumulation. Gold's physicalpresence was no longer necessary in every conversion. From then on gold could act byproxy, as its role in the conversion has become residual


Thanks to this breakthrough, partnerships could now be formed representing an exchangeof income (of the junior partner) for wealth (of the senior partner). Later, with the gradualacceptance of `sleeping' partners in the firm, it became possible to buy and sell shares inthe enterprise as if they were fixed-income securities. Indeed, this they were in all butname, in order to avoid censure by canonical and secular authorities under the usury laws


It is clear that without double-entry book-keeping, balance sheets and income statements,trade in shares would not have been possible, nor could a departing partner have beenbought out. There would have been no precise and objective way of attaching value to theassets and liabilities of the firm short of liquidation


The new development released huge amounts of gold from private hoards as peoplebegan to accumulate and carry wealth in the form of securities disguised as partnershipequity. (By contrast, in the Orient, where the social and institutional arrangements werefar more inimical to the individual and his freedom to choose, the demand for gold andsilver for hoarding purposes continued unabated.) During the Quattrocento golddisgorged by the Occident flowed to the Orient to finance the trade in exotic goods


Myrrh, spices, silk and satin enjoyed exceptionally high marketability in the Occidentwhere all the great banking houses engaged in financing this lucrative trade. The worldwas treated to the curious spectacle that the Occident was thriving while losing gold tothe Orient, because it had learned how to get by with less. It had learned to exchangewealth and income


This shows that gold is merely the whipping boy at the hand of the inflationists. Gold isnot scarce (in fact, as measured by the stocks-to-flows ratio mentioned above, themonetary metal is more abundant than any other economic good) but it quickly goes intohiding at the moment inflationists gain the upper hand. There is no contradiction betweenthe interests of society and its ageing members. Very little if any gold is needed tocomplete all the exchanges of income and wealth in the course of normal business,provided that the free choice of individuals is allowed to prevail. Only when governmentinterference is feared or expected does the demand for gold become disturbing. Thecorrect policy is `hands off' -- let the market decide what is best for its participants


Squaring the diagonalThe next advance came with the Reformation, during which the canonical and secularstrictures on interest were eased, the definition of usury narrowed and, later, theprohibition against both repealed. Whereas the partnership contract had originally beendesigned with the concealment of interest in mind, then it became possible, for the firsttime in history, to openly engage in the exchange of income and wealth, with thepayment of interest freely admitted, and the rate of interest explicitly quoted. The bondmarket was born as a result of these historical changes. The right to income reserved bythe bondholder could now enjoy the same legal protection as the right to rent-chargesenjoyed during the prohibition era. Thus, it remained for the Reformation to crown thegreat economic advances of the Renaissance, to free the exchange of income and wealthfrom its former fetters. For the first time in history, the rate of interest could manifestitself as a market phenomenon


The analysis of the formation of interest rates is usually given in terms of a diagonalmodel featuring just two participants in the market: the supplier and the user of `loanablefunds'. This model is woefully inadequate, as it blots out the time element and the crucialprocess of capital formation, it ignores the principle of capitalizing income, and itconfuses saving and investment. The present analysis will replace the diagonal modelfirst with a square, then a pentagonal and, finally, with a hexagonal model, in order togain a more penetrating insight into the process of capital formation. First we take a lookat the square model which has the merit of identifying the supply of and demand forwealth and income


In considering the problem of converting income into wealth and wealth into income, wemay isolate two fundamental needs: (1) the annuitand's need to convert income intofuture wealth; and (2) the annuitant's need to convert wealth into income. Typically, theannuitand is a young man who is looking forward to getting married. He tries to providefor the future needs of his family: for the education of his children, and for his and hiswife's old age. By contrast, the annuitant is a man in his harvest years, looking forward tohis twilight years with equanimity


He has by now accumulated the wealth which he is ready to convert into a suitableincome. If the annuitand (or the annuitant) is restricted to direct conversion, due toinstitutional restraints on the exchange of income for wealth (or wealth for income) thenthe optimum conversion is provided by gold hoarding (dishoarding). By definition ofmarketability in the small, no further improvement in efficiency is possible. However, ifthe institutional constraints on exchange are removed, then a whole new game comes intoplay and, indeed, further improvements become possible, for the benefit of allparticipants


On the one hand, the annuitant's need is answered directly by the entrepreneur who isanxious to give up income in exchange for present wealth. The latter could profitablyinvest the former's wealth in his business which would then generate a greater incomethat he could afford to share. On the other hand, the annuitand's need is answered directlyby the inventor ready to give up future wealth in exchange for an income. The latter isworking on a new production process that may take several years to perfect before it canbe put into place. In the meantime he has to maintain himself and has to defray the cost ofhis research and development (R&D)


The new tool or process the inventor is perfecting represents future wealth which he iswilling to share with his partner, the annuitand, who puts the necessary income at hisdisposal in the interim. Both the entrepreneur and the inventor are engaged in thebusiness of capital formation; the difference is seen in the method of amortization. Thecapital formed by the entrepreneur is scheduled to begin its amortization cycleimmediately. There is a more-or-less prolonged waiting period before the capital formedby the inventor can start its amortization cycle


The curse of unemploymentThe amount of R&D capital being accumulated by the partnership of the annuitant andthe inventor is the most critical indicator of the future shape and health of the economy


In the final analysis, this is what makes the difference between a progressive and aretrogressive economic system. The presence of chronic unemployment in the economyindicates that inventors are being hampered by social or institutional arrangements intheir efforts to form R&D capital


From this perspective, the government-run compulsory social security and unemploymentinsurance schemes appear highly retrogressive. Apart from the dubiousness of theprocedure whereby the government spends the net premium income on currentconsumption while letting future taxpayers shoulder the burden of disbursing the retiredpopulation, and of the procedure whereby the government pays able-bodied people fornot working, there is also the sinister problem of depriving the inventor from histraditional source of financing. The inventor is condemned to idleness; at any rate, hisefficiency is greatly reduced, and his talents are wasted. The government-sponsored`safety nets' are retrogressive because they represent the dissipation of the annuitand'sincome and the annuitant's wealth, without any redeeming feature as to promoting capitalaccumulation, in particular, the accumulation of R&D capital


This completes the description of the square model of the capital market, where the fourcorners of the square represent the annuitand, the inventor, the annuitant, and theentrepreneur. The two kinds of partnership that arise in this model correspond to theformation of (1) entrepreneurial capital, embodied in the partnership of the annuitant andthe entrepreneur, and (2) R&D capital, embodied by the partnership of the annuitand andthe inventor. Often these partnerships are concealed under family bonds


The father is the annuitand (later, annuitant) and the sons the entrepreneur and theinventor. The family is the primitive social unit, providing the framework for theexchange of income and wealth among its members, as the need may arise. The squaremodel of the capital market is a great conceptual improvement over the diagonal model;still, there is room for further improvement


A short course on capital formationZero interest means direct conversion of income into wealth. As a total denial ofincentives to exchange income and wealth, it forces the annuitand and the annuitant torevert to atavistic methods of conversion via hoarding and dishoarding the mosthoardable commodity. At zero interest there will be no exchange, only conversion ofincome into wealth. The point is that the annuitand and the annuitant do have a choice. Inthe absence of incentives they will forgo exchange but will go ahead and make theconversion, as planned, through other means. The same choice, however, is not availableto the entrepreneur and the inventor


Unlike the annuitand and the annuitant, they are fully dependent on the agency ofexchange and credit if they want to make the conversion. The square model of the capitalmarket reveals that the exchange of income and wealth is inherently asymmetric. Whilethe annuitand and the annuitant can still satisfy their need to convert if the exchange fails,the inventor and the entrepreneur cannot. For them it is: no exchange -- no conversion


The impairment of bargaining power brought out by the square model of the capitalmarket will be assuaged as we pass to the pentagonal and hexagonal models. Thesemodels describe the real world more faithfully. Yet it must be clear that the impairmentcan never be completely removed. The most important consequence of this asymmetry isthat the rate of interest can be low, but will always remain positive


The inventor and the entrepreneur can, of course, improve their bargaining position tosome extent if they form a partnership whereby the former provides the income neededby the latter. As a result, they will be net long on future wealth, and net short on presentwealth. In order for the partnership to be viable, they must find a third partner who iswilling to provide the needed credit in exchanging present for future wealth


This need has led to the rise of a new actor in the drama of human action. He is thecapitalist, and his entry heralds the advent of the pentagonal model of the capital market


The rise of the capitalist is hereby explained not in terms of exploitation, but in terms ofservices which only a specialist can provide. These services are demanded by thepartnership of the marginal inventor and the marginal entrepreneur. The marginalinventor (entrepreneur) is the one who has just missed his chance to form a partnershipwith the annuitand (annuitant). Without the services of the capitalist, marginal talentwould be wasted. Thus capitalism is seen as a social system which allows individuals tospecialize in the exchange of present wealth for future wealth, in order to enlarge thescope for entrepreneurial and inventive talent. Much of this talent was lost to societybefore the advent of capitalism


The triangular partnership of the entrepreneur, the inventor, and the capitalist is the mostpotent and dynamic force in the economy which society has heretofore produced. Ludwigvon Mises considers the individuals in this partnership the "most progressive elements insociety", benefiting the nonprogressive majority in every possible way. The particularcombination of talent, brain and will-power represented by the threesome heralds a newepoch of progress, far beyond the capabilities of individual talents if employed inisolation. There has been many an inventor since paleolithic times whose genius has beenwasted


The steam turbine was invented in the first century A.D. by Hero of Alexandria; theaeroplane in the fifteenth by Leonardo da Vinci. The efforts of pre-capitalistic inventors,for the most part, came to naught, due to lack of capital and entrepreneurship. The mostingenious technological inventions remain useless if the capital required for theirutilization has not been or cannot be accumulated. Capitalism must be seen as theliberator of inventive talent, the creator of wealth and prosperity for the benefit of all. Itscreative formula is: the trinity of the entrepreneur, the inventor, and the capitalist


One cannot assess the merit of capitalism without explicitly recognizing the great anddurable reduction in the rate of interest it has brought about. Indeed, the only valid way tobring down the rate of interest is to enhance the bargaining power of the inventor andentrepreneur vis-à-vis the annuitand and annuitant through encouraging the activities ofthe capitalist. If the capitalist is hampered in his activities, then the annuitand and theannuitant will enjoy unrestricted monopoly power and the rate of interest will be high


The capitalist is anxious to break this monopoly. As a result of his competition, the rateof interest has been reduced from the extremely high levels prevailing in pre-capitalistictimes to a low level which puts all bona fide inventors and entrepreneurs into business


Even more remarkable is the fact that capitalism has accomplished the feat of reducingthe rate of interest without harming the annuitand and the annuitant. Every member ofsociety is a beneficiary of the lower rate of interest brought about by capitalism, throughthe great increase in the availability of consumer goods at affordable prices, not tomention the unprecedented increases in wage rates. Only with reference to capitalaccumulation can we explain the practically inexhaustible list of prodigious amenities,and previously unheard-of comfort and security, the high wage-structure, all benefitingthe common man, which is due solely to the lowering of the rate of interest by risingcapitalism


Many of these great achievements have been frittered away since 1971, the yeargovernments of the industrialized world declared irredeemable currency to be `money'


This declaration is directly responsible for the steep rise and gyration of interest ratesduring the past twenty-five years, a phenomenon that was previously unknown. Thecapricious increase in the level of interest rates has rendered a vast amount of capital andlabor submarginal, caused unemployment, made capital maintenance inadequate and,ultimately, led to capital decumulation and destruction


The Shylock-syndromeThe foregoing analysis of the phenomenon of interest in terms of exchanging income andwealth is far superior to the conventional analysis in terms of exchanging present forfuture goods. No one has ever exchanged an apple available today for 1 and 1/20 of anapple available a year from now (still less for 2 apples available 50 years from now); sothe problem of exchanging present for future wealth does not arise out of any readilyidentifiable human need (except in the context of the activities of the capitalist infacilitating the exchange of wealth and income, as discussed above)


Other than this residual activity of the capitalist, the exchange of present and futurewealth has no basis in reality. By contrast, the problem of exchanging income and wealtharises out of natural and universal human needs: the need for educating the young and theneed of the elderly for an income. This exchange explains the phenomenon and the natureof interest in terms of the division of labor, that is, by reaching back to lastingfundamentals. Exploitation, or temptation to exploit one's economically weaker brethrenis not involved. Nor is odium or envy. The needs and aspirations of market participants,from the annuitands to the capitalist, are harmonious and complementary


There is no need to detest the capitalist and to depict him as Scrooge, any more than thereis need to detest the heart surgeon and depict him as a butcher. They are both specialists,and their role can be understood only in the context of the need for their specializedservices. The capitalist's role only emerges at the margin, after all natural partnershipsbetween the entrepreneur and inventor have already been formed


Further advance at this point would not be possible without the services of a specialist,specializing in arbitrage between present and future wealth. By contrast, if we look at theproblem of exchanging present for future wealth in isolation, before long the image ofShylock and his pound of flesh is conjured up in the mind. Above all, it is this Shylocksyndromethat socialist movements have been able to exploit with such consummate skill,appealing to the authority of Aristotle. This view is nurtured by a dismally inadequateunderstanding of the division of labor. As it appears to the socialists, the contract betweenlender and borrower demands that the latter be a superman


Only in uniting in himself the talents of the entrepreneur and the inventor can he meet theterms of his contract in full. How otherwise could he be expected to return a greatlyenhanced wealth to his creditor at the end of the loan period, without ruining himself?Surely, the terms of his contract demanding a pound of flesh from any part of his bodywas designed with the extinction of his life in mind


What the socialists' view disregards is that the capitalist is not dealing with one individualbut with a partnership combining the talents and skills of two: the entrepreneur and theinventor. Had Aristotle understood the problem of converting income and wealth into oneanother, and its optimal solution via the agency of exchange, credit, and the division oflabor, the wind would have been taken out of the sails of socialist agitation before it had achance to cause so much mischief in the world


Instant reward, instant penaltyAnother merit of the pentagonal model is that it makes the process of capitalaccumulation transparent. If we disregard the primitive accumulation of capital by theartisan fashioning his own tools, a process that no longer plays an important role in theeconomy of the industrial world, then we shall find that capital can only be formed in oneof three possible ways: through the formation of a partnership of (1) the annuitant and theentrepreneur, (2) the annuitand and the inventor, or (3) the entrepreneur, the inventor, andthe capitalist


Debt creation does not create capital per se; it only shifts risks implicit in previouslyexisting partnerships, without necessarily producing new wealth. By contrast, theformation of capital in any one of the three combinations described here does in factcreate new wealth. Furthermore, the pentagonal model establishes precedence and controlamong the five actors in the drama of human action. Thanks to the existence of thesecontrols capitalism has become an instant reward/penalty system ensuring unparalleledefficiency. (This, incidentally, may be another reason it is hated so by the indolent.)The priorities of capitalist society are not set by bureaucrats or by zealots with the powerof disposal over the fruits of the savings of others, but by the savers themselves whostand to suffer losses if the project fails. Bureaucratic power under socialism means thatmistakes can be heaped upon mistakes without corrections being made. Socialism lacks afeedback mechanism that alone can make timely corrections possible. The hierarchy ofcontrols under capitalism runs along the following lines. The annuitant has veto powerover the plans of the capitalist; the annuitant in concert with the capitalist has veto powerover the plans of the entrepreneur; the annuitand and the capitalist in concert with theentrepreneur have veto power over the plans of the inventor. The inventor has no vetopower at all, but since there are more annuitands than annuitants under the conditions ofpositive population growth, capitalist society can employ even more inventive thanentrepreneurial talent. The field is wide open for the inventor


A dynamic society tends to put a premium on new ideas. It has natural built-in incentivesfor higher education and advanced studies, even in the absence of compulsory schoolingand government-sponsored research. It is these dynamic forces, represented by net R&Dcapital formed by the annuitand and the inventor, which create educational facilities andequip laboratories. The government can hardly do more than formalize and standardizethese. It certainly cannot guide their destinies -- that would be the prerogative of theirprogenitor, the pentagonal capital market. A government that pretends to do more, onethat tries to dictate educational or research priorities, is far from being progressive. It is,in fact, retrogressive -- as the present analysis shows


The welfare state as we know it..


The pentagonal model of the capital market explodes the myth of the welfare state


According to this myth the government can finance welfare projects by taxing away someof the profits of the capitalist. However, the activities of the capitalist are marginal,representing but the tip of the iceberg. The incomparably greater part of the capital thatsociety needs in order to provide annuity income for the aged is furnished by less visiblepartnerships between the annuitant and entrepreneur, or the annuitand and the inventor


Social security eliminates, or at least severely curtails, voluntary exchange of income forwealth, and thereby hampers capital accumulation. The welfare state confuses charitywith entitlement, and its huge commitments in putting social security benefits on thebasis of universality have no actuarially sound basis in finance. The making of thesecommitments puts the very people out of business whose savings alone can provide thewherewithal for the projected benefits. We cannot help but view the capitalist economyas an integrated welfare-machine: individuals voluntarily exchange goods against goods,goods against services, and income against wealth, increasing welfare at every turn


In the process they form voluntary partnerships representing the creation of new wealththrough the capitalization of income. The welfare state cannot invade one part of thismachine, taking over its functions, and expect that the other parts will go on performingsatisfactorily. This invasion means the forcible dissolution of partnerships, and thedissipation of their capital. The assets disappear, yet the corresponding liability in theconsolidated balance sheet of the nation remains


It will have to be balanced by printing government bonds, payable in irredeemablecurrency. As long as the purveyors of goods and services continue acceptingirredeemable currency in exchange for real goods and services, the game of musicalchairs can go on. But as the capital structure of the nation is seriously eroded, theproduction of goods and services become more costly, and producers suffer losses. Atone point they must raise prices or, if they can't, go out of business. Either way, thebenefits promised by the welfare state are jeopardized by currency depreciation anddestruction of capital. The welfare state must be seen against this background: it is anaccomplice in the scheme of currency debasement and, more ominously, in the scheme todissipate and destroy the nation's accumulated capital


During the past year or so the leaders of several industrial nations have solemnlyannounced the end of the era of big governments with big deficits, and started talkingabout the need to down-size the welfare state. In view of the foregoing analysis, this iscertainly a positive development


However, these leaders have failed to make the necessary connection between the welfarestate the promises of which are impossible to fulfill, and the regime of irredeemablecurrency that can make every promise appear credible that vote-buying politicians maycare to make. The truth is that a meaningful review of the premises of the welfare statemust of necessity include a review of the premises of the regime of irredeemablecurrency. Are our politicians ready for such a review?The gold bondFurther division of labor saw the rise of a sixth participant, the investment banker, and theemergence of what we may figuratively call the hexagonal model of the capital market


Just as the rise of the capitalist was explained above in terms of the special services hewas to provide to the marginal entrepreneur and the marginal inventor, so the rise of theinvestment banker is explained here in terms of the special services he is to provide to themarginal annuitand and the marginal annuitant


The marginal annuitand (annuitant) is the one who has just missed his chance to form apartnership with the inventor (entrepreneur). Without the services of the investmentbanker much of the marginal resources of society would be wasted. No two annuities arealike, and trading them would be difficult or impossible in the absence of an instrumentreadily exchangeable for either. The success of the capital market depends on theavailability of a versatile and standardized trading instrument which can be used as (1)the standard of capital values, and (2) the balancing item of liabilities on capital account


This instrument is the gold bond. It evidences debt payable at maturity in gold, andprovides an interest income till maturity, also payable in gold. The income is representedby the coupons attached to the bond. The gold bond is traded in a broadly basedsecondary market, and a sinking fund is established to make sure that its market valuedoes not erode with time. It is incumbent on the issuer of the bond to do everything in hispower to keep the market value of the bond stable, if need be, by retiring some of theoutstanding issue prematurely


It is the price of the gold bond that determines the rate of interest. As prices, the rate ofinterest is also an outcome of the market process. However, keep in mind that the bondmarket is the epitome of a far larger and far more pervasive capital market encompassingevery conceivable exchange of wealth for income, most of which is not readily visible


The investment banker's function is clearing and brokering: he matches the various andvaried demands thrown upon the capital market from its five corners


He enters into partnership with the annuitand, the annuitant, the entrepreneur, theinventor, and the capitalist, as the need may arise, through his specialized instruments ofmortgage and annuity contracts. He balances the net liability or asset arising from thisactivity through his purchase or sale of the standardized instrument, the gold bond. Ineffect, the investment banker is doing arbitrage between the six corners of the capitalmarket


The hexagonal model of the capital market opens up a great increase in scope for themost successful combination of production: the triangle of the entrepreneur, the inventor,and the capitalist. From now on they can form their partnership even if unbeknownst toone another. The inventor need not waste time in seeking out a congenial entrepreneur,nor the entrepreneur in finding a suitable inventor


If the invention is good, and the enterprise is sound, they could immediately startproduction on the most favorable terms through the good offices of the match-maker, theinvestment banker. Nor does the capitalist have to remain wedded to the same inventorand entrepreneur for the entire duration of the project. Through buying and selling goldbonds he can always go after the project that appears most promising to him. Thus theproblem of forming optimal triangles is safely thrown onto the bond market


The sterility of goldAristotle introduced the concept of natural law and concluded that taking and payinginterest on borrowed money violated it. Gold and silver are, by nature, sterile. Any returnto productive investment belongs to labor in full, no part of it ought to go to the lender ofcapital resources. The Church embraced the notion of natural law, and the usury doctrinebecame a Church doctrine. Roman Law was combined with the teachings of Aristotle tobecome Canon Law


The prohibition on interest was designed to protect the debtor but, to the increasingembarrassment of the canonists, it had the exact opposite effect. It increased both the costand the risk of doing business. After the Code Napoleon, adopted all over westernEurope, had allowed the paying and taking of interest, the Church, too, decided toabandon the old usury doctrine. It was quietly buried in 1830, when the SacredPenitentiary issued instructions to confessors not to disturb penitents who had lent orborrowed money at the legal rate of interest


Recently, mainstream economic orthodoxy has revived the old doctrine of Aristotle aboutthe sterility of gold. No textbook on economics that mentions gold at all fails to add thatgold is a barren asset, incapable of producing a return. Holders of gold are portrayed asmorons waiting for doomsday, unwilling or unable to do anything constructive forsociety. This opinion is echoing Keynes who was the first economist suggesting that therewas something bordering on the neurotic involved in the desire to hold a sterile asset


However, the neurosis is not on the receiving side of the anti-gold propaganda


Rather, it is on the giving side. Governments have pangs of conscience with respect totheir citizens and creditors, with whom they have broken faith on several counts. Insteadof making a clean breast of it, they have made it incumbent upon the economic professionto develop new doctrines to cover up chicanery and duplicity, to justify fraudulentbankruptcies, retroactive laws, devaluations and debt abatements. Politicians and servileeconomists are still badmouthing gold as if it was a narcotic. They have triumphantlydeclared that gold is `dead'. Yet the gold corpse still stirs, and it keeps haunting the houseof cards built upon irredeemable promises


The phrase `sterility of gold' needs to be scrutinized. For Aristotle it meant that gold,unlike corn, cannot be sown in the soil in order to harvest more gold later. Hiscondemnation of usury was dictated by what he conceived to be natural law. Mainstreameconomists mean something else by that phrase. They admit that even corn is sterile inthe sense of Aristotle. To reap a harvest takes more than seed corn and soil. Capital in theform of fertilizers, tilling and harvesting tools must also be introduced, along with humanlabor, in order to make the seed corn productive. Seed corn is just one of the numerousfactors of production, and only the full complement of all these factors can be consideredproductive


And, since all these factors can be purchased with money, it is well-understood thatmoney can be productive in the hands of the entrepreneurs. This fact is reflected by thewillingness of banks to pay interest to depositors on money they pass along to producers


In this sense it is admissible to say that money is productive: it can earn a return


Mainstream economists do not deny that gold was productive, in this generalized sense,under the gold standard. But they insist that, with the advent of the new millennium, goldhas forever lost its former productive power to the irredeemable bill of credit. Gold hasbecome sterile again. It can earn no return -- only irredeemable bills of credit can


It is important for us to realize that every word of the doctrine on the sterility of gold isan outright lie. Not only can the owner of gold earn a return in gold on his holdings evenunder the regime of irredeemable currency, but gold is the only form of tangible wealththat can be lent out at interest and that is in constant demand as such. There is a livelygold loan market in the world: gold is put out in loans and is borrowed at interest on aregular basis. It is used in financing great capital projects as well as trade -- in the sameway (although not on the same scale) as it always did under the gold standard


Under these loan contracts both principal and interest are payable in gold. Nor is thissomething new: gold lending has continued uninterrupted in countries where thenecessary legal protection of contracts involving gold loans has not been abrogated


`Demonetization' did not succeed in abolishing the lending and borrowing gold atinterest, it only abolished the truth about it. Even students of economics are deliberatelykept in the dark about the existence, functioning, and extent of these gold loan markets


The reasons for this obscurantism are not hard to find. The rate of interest on gold loansis low and stable. The much higher and more volatile rates of interest payable on loansmade in irredeemable currency could not stand comparison with it. Dissemination oftruth could raise awkward questions about the legitimacy of the present monetary regime


People might inquire why they cannot have a monetary system that would automaticallyguarantee the lowest possible rate of interest


3. The Redistribution of LossesThe gold bond is essential to the theory of interest presented in this essay. The formationof the rate of interest under a regime where interest is payable in irredeemable currency isan entirely different matter. The central bank's attempt to keep a lid on the rate of interestis doomed, as this effort incorporates the contradictory aims of monetary policy andinterest-rate policy. Open market operations in bonds can indeed be used to lower theinterest rates that are high due to currency depreciation


The central bank goes into the open market and buys government bonds. As a result bondprices go up or, what is the same, interest rates go down. But the flipside of this is thatnow there is even more irredeemable currency in circulation. This cannot help but makethe pace of currency depreciation increase. Yet it was the fast depreciation of thecurrency that was responsible for the high interest-rate structure in the first place. In otherwords, while the central bank is fighting a side-effect of the disease, it only makes theroot cause more entrenched


Furthermore, under the regime of irredeemable currency malevolent bond speculationoverwhelms and strangles benign bond arbitrage. Recall that under the gold standardthere was no bond speculation -- none whatever. There was only arbitrage betweendifferent maturities, keeping the yield curve in good shape


The price of bonds, and with it the rate of interest, was remarkably stable, precludingprofitable speculation. But when governments left the path of monetary and fiscalrectitude and started passing retroactive laws, declaring fraudulent bankruptcy, devaluingthe currency under false pretenses, reneging on gold clauses enshrined in their bondobligations, and embracing the policy of debt abatement -- they threw the value of theiroutstanding bonds to the winds. The arbitrageurs responsible for maintaining stability inthe bond market are gradually forced to vacate the field. Their place is being taken overby speculators who thrive in volatile markets. The entire character of the bond marketand bond trading has changed beyond recognition


The rational basis upon which bond values rest was overthrown when gold-redeemabilityof the currency was abolished. The fanatic denial of this fact is central to mainstreameconomic orthodoxy. Nevertheless, the disappearance of predictable arbitrage and theadvent of unpredictable speculation make for violent and increasing fluctuations in therate of interest, throwing the capital markets into a turmoil


No longer does the propensity to save regulate the availability of long-term credit throughthe mechanism of the interest-rate structure. The regime of irredeemable currency ischaracterized by a chronic paucity of savings -- regardless how high the rate of interestmay go. Savers are not blind to the fact that their savings, denominated as they must be ina depreciating currency, are continually and systematically plundered. Their protectoragainst plunder, the gold coin, has been ousted from the system


But the savers are not entirely defenseless, and they can fight back. They could consumetheir savings before further depreciation takes its toll. More ominously, they can extendtheir consumption beyond the limits set by existing savings, if they plunge into debt in aneffort to turn a bad situation, created by the depreciating currency, to advantage. It canhardly be doubted that a lot of this is occurring in the world today


Crossing the wires at the traffic lightThe regime of irredeemable currency creates a disharmony between individual andsociety, where harmony has reigned before. Through a false incentive system, this regimeinhibits capital accumulation and, ultimately, it promotes capital consumption. The needto convert income into wealth is overtaken by the need to protect oneself against plunder


The propensity to save is corrupted by the false view that savings can be substituted bydebt. While there are natural limits to debt-creation under a gold standard, all such limitshave been thrown to the winds under the regime of irredeemable currency. The volume oftotal debt increases exponentially as interest paid on the old debt is immediatelyconverted into new debt. The mechanism to liquidate debt has been dismantled. Debt canno longer be liquidated, and at maturity it is dumped into the lap of the government


As for the government, there is simply no way to retire its debt. Redeeming a governmentbond in irredeemable currency merely replaces interest-bearing debt by non-interestbearingdebt (that is, by a less desirable form of debt, making the debt-pyramid evenmore unstable). In the meantime total debt is increasing exponentially, following the lawof compound interest. The inordinate growth of the Debt Behemoth and the ongoingcapital destruction inevitably lead to a credit collapse


The forcible removal of gold from the heart of the credit system in 1971 was ill-advised


It brought about a radical change in the character of the bond market. It drove out thearbitrageur, and invited in the bond speculator. The regime of irredeemable currencycrosses the wires at the traffic light. It sends the red signal to producers when the greensignal is intended. High interest rates beget even higher interest rates, as speculators keepbetting on lower currency and bond values


Threatened by ever higher interest rates, producers are confronted with endless capitallosses. This is a regime of hot money jumping around nervously from place to place,seeing no safety anywhere, but going from places that seem unsafe to places that, for themoment, seem less unsafe. This is a regime under which men are afraid to make longtermplans, or to grant long-term commitments. This is a regime that encourages farmersto eat the seed corn, the dairy-man to slaughter the milch-cow for the meat, and theorchard owner to cut down his fruit trees for firewood. This is a regime of junk bonds


The degeneration of the bond market into a casino where gamblers run riot pronounces amost devastating verdict on the regime of irredeemable currency. Previously all ownersof capital, including the speculators, were subjected to the same discipline, and wereconstrained in their activities by a market process making them servants of the generalpublic


If they correctly anticipated changes caused by the uncertain future, speculators wouldreap profits. But if they failed to do this, then they would suffer losses and, unless theymended their ways in time, they would lose their capital to others who were better atserving the public. Now, under a new dispensation granted by the regime of irredeemablecurrency, speculators can be self-serving without the obligation to promote the generalwelfare. They grow fat on the sweat and blood of the public. All they need to do in orderto make a killing is to out-guess government bureaucrats whose job it is to manipulatecurrency and bond values


The dance of the derivativesIn the economic literature it is customary to make a distinction between stabilizing anddestabilizing speculation. The distinction is spurious. All legitimate speculation isstabilizing, if by `legitimate' we understand speculation addressing risks inherent innature (e.g., weather, natural disasters, etc.) By abuse of language, the word `speculation'nowadays is applied to market activity that addresses risks presented not by nature but byarbitrary government action. However, a word already exists in the dictionary to describethis kind of activity, namely, gambling


Properly understood, under the regime of irredeemable currency participation in foreignexchange and bond markets (including derivative markets in futures and options) is notspeculation but gambling. The risks involved have been artificially created by arbitrarymeasures. Just as increased participation at the roulette table cannot reduce the risks ofbetting (and can often increase them) increased `speculation' in the bond markets cannotreduce price fluctuations (but is more likely to increase them)


Under a gold standard speculation in grains is economically justified by the existence offuture uncertainties presented by nature. In the case of an unexpected crop failure orbumper crop the price disturbance is minimized by the presence of a speculative supplyor demand. No such justification for bond speculation can be offered. All the risks arewholly artificial and cannot be reduced by inviting speculative participation


On the contrary, price-swings are likely to increase along with increased participation


This is a case of pure gambling. The linguistic innovation of calling it `speculation' willnot change its nature. Government economists suggest that the derivative markets ininterest-rate futures have the same salutary effect on interest rates as future markets ingrains have on grain prices. There is not the slightest evidence to support this claim


The effort to smooth out interest-rate fluctuations under the regime of irredeemablecurrency by creating more opportunities for bond speculation and for trading derivativesin interest-rate futures is doomed. Opening ever more derivative markets will backfire


More gambling creates more uncertainty, not less. The regime of irredeemable currencyis characterized by insufficient capital accumulation or maintenance and, ultimately, bycapital destruction. It cannot be rescued by legalizing gambling


The `Dance of the Derivatives' of 1994-95 gave a foretaste of what is to come. Banks,commission houses, pension funds, and even municipal governments are known to havegambled and to have suffered grievous losses, some irreparable. Observers blamed thedebacle on inept or dishonest traders. A more adroit analysis would, however, show thatdisaster had to strike in any case. The same thing would have happened even if tradershad been meticulously following the traditional methods of hedging and arbitrage


The truth is that the old rules no longer apply. Once the sheet anchor of gold has beenremoved, the character of the game has changed beyond recognition. Previously goldacted as the policeman keeping speculators in line. Because of the presence of gold in thesystem, the speculators could gang up in order to bid up commodity prices, or to drivedown foreign exchange rates and bond values, only at their own peril. Their biddingwould immediately be confronted with relentless arbitrage, exacting a heavy penalty forreckless bidding. Arbitrageurs could count on gold, the policeman of the system, inresisting recklessness in speculation


But with the policeman fired and no replacement commissioned, speculators can gang upwith impunity, induce and ride price trends unilaterally, until they are ready to make akilling. Speculation has become malignant. Speculators ran up the price of sugar to 75cents a pound and that of crude oil to $42 a barrel -- and made money all the way up


They drove down the price of a $1,000 Treasury bond to $500 and the yen-price of theU.S. dollar to 78 -- and made money all the way down. And they made a killing whenthey sold sugar at 75 cents, crude oil at $42; and when they bought Treasury bonds at$500, the U.S. dollars at 78 yens


During these episodes arbitrageurs have been conspicuous only by their absence. Theyare intimidated in the absence of the police, and are gradually withdrawing their services


When the last arbitrageur abandons the market, the speculators will have a field day


They will bid commodity prices up to the sky, and drive currencies and bonds to theground. Without the guarantees of the gold standard, no arbitrageur will be able to opposethe speculators when the bull-run in commodities and the bear-run in securities start inearnest


Sweeping losses under the rugThe term `redistributive society', as it is used by both its protagonists and antagonists,refers to the redistribution of wealth and income -- after they have been produced. Moreominously, a movement to redistribute future losses is afoot. If successful, losses will beperpetuated and passed on to society. The scheme will allow the indolent, the inefficient,the inept, and the consistent loss-maker to continue in business indefinitely at the expenseof the industrious, the efficient, and the profit-conscious


But if the distinction between profit and loss is obliterated, society's internalcommunication system may be falsified. Ultimately, production would be thrown intoconfusion. The leitmotif of our chrysophobic age can be described as a parade of the lossmakers


The profit-conscious must be cowed into submission. The gold standard isanathema to the lobby of the loss-makers, as gold puts profit and loss into the sharpestfocus, separating the adept from the inept, the industrious from the indolent. The lobbywants a system under which distinction between profit and loss becomes fuzzy,inefficiency can be covered up, and ineptitude entrenched


What is true for firms is also true for governments. The post-war monetary system is acreature of the victors, in particular, of the U.S. and the British governments. Its thinlyveiled purpose is to accommodate indolence and ineptitude in international trade. Itsauthors have openly advocated a monetary system that gladly tolerates deficits, andunhesitatingly penalizes surpluses on current account. In practice the vanquished,especially the German and the Japanese governments, were forced to make their centralbanks a dumping ground for an endless stream of unwanted paper issued by the victors


The `unlimited demand' thereby created for U.S. Treasury issues makes the illusion in thepublic mind that the millennium of irredeemable currency has indeed arrived at the longlast


We should be well-advised not to fall victim to this hoax. We should not be misled by thedocility of the German and Japanese governments in playing faultlessly their preassignedrole in the farce. They have absorbed losses counted in trillions, without ever saying"ouch". The Japanese started accumulating irredeemable paper when it cost them 360yens to buy one dollar -- as opposed to the 1995 low of 78 yens to the dollar. Thecorresponding figure for the Germans is 4 1/2 marks to the dollar initially -- as opposed tothe 1995 low of 1 1/3 marks to the dollar


The Germans and the Japanese are still sitting on mountains of paper losses that nobodyis reporting, still less willing to discuss. Yet it is the destiny of paper losses that sooner orlater they must be realized. Could it be that the collapse of the stock market in Japanearlier in the decade, the present banking crisis there, and the recent weakening of theGerman financial structure, are signs of the beginning of the end? Losses are a stubbornthing. They refuse to go out of existence, no matter how docile the victims of theredistribution of losses may be. This is a dangerous game of deception that governmentscan continue playing only at their own peril


4. Whither Gold?Gold in the monetary system makes for stability and efficiency. One cannot disparageeither of these virtues any more than one can disparage motherhood. A low and stableinterest-rate structure, in particular, cannot be achieved without making credit goldbonded


This elementary truth is now in the public domain, even though our universitieshave been somewhat tardy in accepting it. But the U.S. Congress would be well within itsconstitutional authority if it provided monetary leadership in the world. It is possible thata majority of members in that body will come to realize that, in order to be master in theirown house, they must get hold of the wildcard in the pack. If they want to control thebudget deficit, they must regain control over the cost of debt servicing -- the verywildcard they haven't got. In order to get hold of the wildcard, Congress must once moremake the public debt gold-bonded


As debt payable in irredeemable promises is being phased out, and gold-bonded debt isbeing phased in, the interest-rate structure will be stabilized at the lowest levelcompatible with the state of the economy. Only then can a meaningful program of deficitand debt reduction be implemented. As long as the wildcard is out, a collapse in the bondmarket will remain a constant threat, as sky-rocketing interest rates can frustrate any planfor deficit reduction


The expertise in how to execute the transition exists within the Halls of Congress. In1989 Representative William E. Dannemeyer of California (now in retirement) pioneereda scheme of deficit reduction based on the idea of turning short-term/high-cost debt bylong-term/low-cost debt. The miracle of turning water into wine can be accomplished bymaking the debt gold-bonded. Presently Senator Bennett of Utah is championing asimilar plan. With the aid of gold the Debt Behemoth could be reined in -- provided thepolitical will and statesmanship is there


How to cork the genie in the bottleWhy is gold relevant to-day? Clemenceau's saying that "war is too important to leave tothe generals" may be paraphrased as "interest rates are too important to leave to thecentral bankers". The genie of interest rates has been let out of the bottle and nobody, noteven Aladdin Greenspan, can tame it. There is too much destruction and uncertainty inthe world caused by gyrating interest rates. It is time to put the genie back into the bottle,and cork it


This is where gold comes in. Only a golden cork will do. The genie has learned how tosneak through corks made of paper. We don't even have a coherent theory of interestwithout reference to gold. Under the regime of irredeemable currency interest is merelybribe-money, trying to persuade reluctant holders of irredeemable promises to hang onawhile longer. The maturity structure of the U.S. public debt is contracting. Clearly thisprocess cannot continue indefinitely. The size of the bribe expected increases with theamount of the fast-maturing debt


Gold cannot be wished away from the credit system. It is there, like it or not. Gold is theonly conceivable standard of borrowing. The lowest rate of interest is available for goldbondeddebt -- and for no other. Loans payable in irredeemable currency carryprogressively higher rates of interest. How high they go depends on public fear ofcurrency depreciation


Paradoxically, gold's importance is growing while its dispersal from official hoards andthe mines continues apace. Dispersed gold represents latent power, far greater in scopethan its nominal market value, as sound credit can be built only upon a gold base. Whenthe dispersal of gold reaches a certain threshold (nobody knows where exactly thisthreshold is), a metamorphosis of money will take place. Gold will reclaim its throne asconstitutional monarch in the monetary and credit system of the world


Unfortunately, the transition may not be trouble-free. Procrastination in overduemonetary reform brings with it the danger of a credit collapse -- similar to thatexperienced under the Great Depression of 1929-39, causing widespread economic painin the world. Educating public opinion to look at gold as a gift of Prometheus, rather thanPandora's box, after 75 years of vicious chrysophobic agitation and propaganda, presentsus with a formidable task. Yet we must do what we can to disseminate the truth aboutgold


The consequences of the alternative, a credit collapse engulfing the entire world, are toohorrible to contemplate


Antal E. Fekete

San Francisco School of Economics



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Professor Antal E. Fekete is a mathematician and monetary scientist., with many contributions in the fields fiscal and monetary Reform, gold standard, basis, discount versus interest and gold and interest.
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