US Debt and the Restraint of a Gold Standard

Although FDR ended the use of gold in domestic circulation as currency in 1933, the US dollar remained on the gold standard until 1971.   The international currency system was formalized by the Bretton Woods Conference in 1944.

When Nixon arbitrarily shut the 'gold window' in 1971 the world entered a reserve currency system of fiat dollars, restrained somewhat by the debt markets and floating exchange rates, often called Bretton Woods II.

The existing monetary system is still under development, even though we assume it is well established and settled because of the Pax Americana.

As these things go, its relatively short reign from 1971 does not guarantee its continuing longevity. The inherent instability introduced by having one nation essentially own the reserve currency, and subordinate to its own domestic policy requirements, has not been sufficiently resolved. Certainly not to the satisfaction to the rest of the world, even if it is a jealously guarded privilege.

Related:   The Continuing Endgame For Bretton Woods II and the Role of Gold
                 An Essay Considering the Current Monetary Order and Gold
                 Europe Finally Has an Excuse to Challenge the Dollar

An Open Letter To Paul Krugman On the 'Republican Lust for Gold'

"People of privilege will always risk their complete destruction rather than surrender any material part of their advantage."

John Kenneth Galbraith, Age of Uncertainty

This is a response to Mr. Krugman's recent column as it was featured at Economist's View titled, Republican Lust for Gold

I am not in favor of a return to a gold standard.

I am a reasonably well-educated, politically progressive professional, a likely supporter of Bernie Sanders as an economic reformer and an opponent of endless war, and certainly not the 'Wall Street Democrats.'   I believe that the current 'debate' over the place of gold in the economy is breaking along ideological lines to the point of a religious fervor and intellectual blindness, on both sides.

I think of gold as an alternative store of wealth, which without any sanctions from the state pro or con can serve a very useful purpose. It gives people a 'choice.' It can act as a barometer of sentiment. And it serves a purpose, especially in times of pervasive fraud in the financial asset markets, as an asset without mispriced or even hidden counterparty risk if held directly.

And if you think that the problem of pervasive fraud has been fixed you are sorely mistaken.

If a system cannot stand the criticism offered by something which it cannot and probably ought not to control, then perhaps the fault is in the system, and not in the critics.

And while we are on the topic, what by any stretch of the imagination do you subscribe the issue of 'gold' to the Republican establishment? Who shut the gold window in 1971? One of the few things that Chairman Greenspan said is that statists from both sides of the aisle despise and fear gold because it constrains them in their quest for discretionary power. And he was right.

The current 'stimulus' is a massive failure because it has been trying to save a broken and largely unreformed financial system, rather than provide stimulus and support to the vast majority of the participants. It is the consequence of placing the highest priority in means and methods, because they are 'ours.' Our method, our model. First and foremost. Because we fear for our credibility.

And so the participants who are complicit in the fraud and those who are invested politically in the models and methods both become ensnared in a 'credibility trap,' and what Mike Lofgren has called 'the anti-knowledge of the elite.'

Unfortunately, Gresham's law is still works. Gold, and to a lesser extent silver, are flowing 'en masse' to Asia in almost astonishing numbers of tonnes each month. The numbers are there, little publicized and noted in the prestige media, but almost shocking. It has not yet made its way fully into official reporting mechanisms, even so called 'industry organs.'

Mr. Krugman, nine out of ten Americans will notice that the vast peoples of Asia and the Mideast are not 'Republicans.'   The central banks of the world are hardly 'Republicans,' but they became net buyers of gold around 2007.

No, they are not the easily mocked Republicans.

But they are looking for a safe alternative to a monetary and financial system that is going off the rails, again.  The modern hypothesis that all money is purely arbitrary is only feasible if one has the ability to make their purely arbitrary valuations stick.   That is the Faustian bargain with the will to power, the endless war of the monetary relativists.

Would we make enemies of the whole world for the sake of a corrupt and unsustainable financial system? Alas, some would, and are doing so even now.

As I am sure you know, once a force like Gresham's Law goes into effect, which it already has, it can quickly turn into a torrent of consequences.  Will we continue to argue until that event is upon us, as we did with the prevalent fraud in the housing bubble that was created by the same perpetrators who have continued to rig markets even until today?

The dogmatic modelist and political hack sees China and India and other nations buying gold and says, 'We must stop this! Control it!' The thinker sees a sea change in the monetary markets and says, 'we must understand why this is happening, and what we may be doing to provoke it. And if we are doing something wrong, then correct it.'

No I do not support the gold standard, not at all. It would be entirely inappropriate for a patient still in the ICU to be prescribed a regime of hard exercise and strict diet. And the corruption in this system is capable of corrupting anything, even an external standard.

Given the proper regulation, transparency, and judgement, a paper currency can emulate the steadiness of a gold standard while allowing for more latitude in times of distress. Do you really believe that we have held to that prescription with our serial bubbles, frauds and crises?

But I do feel quite strongly that the current policy of constant market intervention in the West, which is obviously happening to anyone who is capable and experienced in watching trade patterns, is going to tear a hole in the facade that this sick series of policy errors is becoming.

If one takes even a cursory look at the trade flows of gold, one can see that the flows into Asia and the Mideast are relentless, and growing. And the decline of 'free float' in the UK and US in particular is striking. The numbers are difficult to discover, but some have taken on that task.

The leverage and shuffling of free bullion around to dull the interest in leverage is approaching 300 to 1 in NYC and 200 to 1 in the 'physical' LBMA market in London is the kind of obvious error that one looks back at from the wreckage and says, 'What were they thinking?'

We made a mistake. A big one.  We have tolerated a farcically ineffective program of 'reform' and a massive top down stimulus focused on the 'system' with an austerity for the public that is going to rip a tear in the social fabric which will take years, and a significant amount of pain, to mend.

It is going to happen, no matter what models or arguments you may wish to stick your head in. I am not trying to argue a point. I am trying to encourage people to at least look at what is happening, and to stop comforting themselves with obviously faulty numbers and metrics from a system that has stopped serving most participants in favor of a powerful few.

This is going to end badly. I was more demure when we had similar discussions here like this prior to the housing bubble collapse. 'And no one could have seen it coming.'  Because their eyes were closed and they comforted themselves with what they wanted to hear.

There is, at some point, going to be a dislocation in the international currency and bond markets.   And it will be noticeable, unless we change our ways and embrace honesty, transparency, broader equity, and reform.

It will not come from the political process, because that has also been broken by the power of big money.  That has become so painfully obvious that the only way to continue to justify it is to declare corporations to be 'people' and bribery to be 'free speech.'

People may think of themselves as 'Keynesians,'  and what the 'other side' thinks about Keynes is admittedly mostly an ideologically tainted caricature.  But first and foremost what made Keynes effective was his practical focus on the desired results and not to a preconceived model which crushes out the better part of reality in its understandable and unfortunate inadequacy that is common to all 'models.'  Keynes was an independent thinker who was confident enough to occasionally change his mind without worrying overmuch about his credibility, and not an acolyte of some constraining school of thought made dogma. 

No, rather than a 'gold standard' now I think gold should stand alone, and be allowed to speak whatever truths it may. As for any use of it by nations, let them make what use of it as they wish. It is a tool. But once they make it 'official' they cannot seem to keep from trying to cage it, and control it. But by then it is merely collateral damage of a growing corruption and fraud of finance, rarely without an accomplice in monetary economics.

At some point the thought leaders will have to rise above their own political enthusiasms and personal aspirations and begin to honestly and openly address what is going wrong. And then perhaps we may begin to push for the return of some of the basic principles hammered out in the 'New Deal' which we so foolishly allowed to be weakened and then overthrown in the 1990s, and even until now.

And, Mr. Krugman, that was a decidedly bipartisan effort. And the players and their enablers who brought us that misery are still active, unabashedly, in the highest circles of power.

China, World Reserve Currencies, the SDR, and an Emerging 'Gold Standard'

“Gold has worked down from Alexander's time. When something holds good for two thousand years I do not believe it can be so because of prejudice or mistaken theory.”

Bernard M. Baruch

I thought this was interesting, particularly given the source of the interview at Bloomberg News.

It is short and so a little bit of a light touch perhaps, but a nice overview nonetheless.

 

One little point of fact I would raise is that the comparison of China M2 and the US M2 is not the whole story.  Since China is not a particularly international currency their M2 is probably a significant subset of their overall issuance. 

 

But in the case of the US, M2 does not account for 'eurodollars', which the Fed intentionally stopped tracking some years ago 'to save money' and thereby stopped issuing M3 figures.  This is a significant factor for the world's reserve currency as you might imagine, and a glaring omission in the validityof the comparison.

A key factor would be their price peg mechanism vis a vis the dollar, and any redeemability features.

They must approach this carefully, because the Anglo-American Banks and Funds will be using every trick of the trade if the yuan becomes less restricted, whether it is tied to gold or not.  

 

If they price it too cheaply, and the gold is redeemable, I can see the great flow of gold from West to East reversing to fill the pockets of the naked shorts.

But if they price it too highly, they cold do some damage to the value of their currency for international trade. I am not saying that they can't do it. And I do see them taking many of the steps required to do this sort of things well.

 

The inclusion of China as a reserve currency for global trade and the SDR has been a bubbling issue for a while.

 

The kind of 'pure fiat regime' we have had in place since 1971 is an historical secular event compared to the great stretch of monetary history. Typically the valuation of an enduring, widely used currency is tied to something external that disciplines its creation. 

But that is history, and our new masters of the universe are beyond the limits of human nature, like gods unrestrained, at least in their own minds and theories.

I should add again that I am not so sure about the power and reach of a gold standard at this point, given the exceptionally fraudulent and distorted nature of the financial system and the devious natures of unreformed, felonious denizens. 

 

Moral hazard is the rule of the day and the intentional mispricing of risk almost a benchmark.  I am sure the global financiers are already planning on how exploit such a development in their paper markets.

 

Our economists and bankers may have their faults, but they are the Michael Jordans of financial fraud.

Gold Daily and Silver Weekly Charts - Statism is Relativism With Reference Only To Itself

"If relativism signifies contempt for fixed categories and those who claim to be the bearers of objective immortal truth, then there is nothing more relativistic than Fascist attitudes and activity.

From the fact that all ideologies are of equal value, we Fascists conclude that we have the right to create our own ideology and to enforce it with all the energy of which we are capable. ”

Benito Mussolini, Diuturna

That philosophy described by Benito is fiat with a capital 'F.'  

In a fascist or more properly statist regime, the state is above all else.  All values, including money, are whatever we say that they are, to the extent that the state can back them up with whatever amount of fraud and force that are required.  Everything that a tyrant or tyrant state does is legal, because they hold their power as the ultimate source of the law, without the appeal to reasonableness or recourse to equanimity.

This is directly opposed to the principle of a higher justice that is embodied in the rule of law.   There can be no real independent justice if there is no value transcending human power.  If there is no standard of truth, then all ideas are equally meaningless and without inherent value unless backed by power and the will to decree 'let it be done.'  

A trillion dollars may be represented by market tested legal debt, by a finite store of gold, a single platinum coin, or the stalk of a rotting turnip, if we say that it is so.  All of these ideas are equally true says the sophist, and all value is arbitrary, to be decided by the will of the state.

This is the very blueprint for abuse from the extremes of both the left and the right, the statists of the Socio-Political Continuum who see power as the greatest good, whether their perspective is from the left or the right.

The great American innovation was to claim that certain values are self-evident, true without contingency to a counterparty, because they have been endowed as a part of nature by a transcendent power.   They may have made sometimes strong distinctions between human religions and that transcendent power, but the acknowledgement of the subordination of the law to certain higher values is unmistakable.  And because those values did not come from the state, they are 'inalienable' even by the state.

Yes, we can argue about the implications, dimensions and definitions of rights and freedoms.  But we can never cynically dismiss them as did the statists of the 20th century, most of whom also by necessity adopted a state religion, from state atheism to a vague neo-pagan mythology of the blood or some other state sponsored belief that was a tool of their official will.

I know this should be obvious, but it is remarkable how easily people can forget the basis for the great American experiment and the principles that inspired it.  It is the philosophical notion of the legal restraint of power and accountability of government to its source in the people themselves endowed with values and privileged by a power above the state.

Now, one can certainly argue how those standards will be incorporated into the law, and what those standards ought to be in practice.  But it is undeniable that there must be non-arbitrary standards, and that the law is not in any way sufficient to itself.  This is no form of legalism or a religion of the law. 

 

The law itself is answerable to those standards of authority granted by the consent of the governed with the bounds of recognizing that which exists transcendently.

"If there's no God and no life beyond the grave, doesn't that mean that men will be allowed to do whatever they want?'  

'Didn't you know that already?' he said and laughed again. 'An intelligent man can do anything he likes as long as he's clever enough to get away with it."

Fyodor Dostoevsky, The Brothers Karamazov

And once again, I am not saying that there ought to be a gold standard per se. Not at all. There are many ways to set standards and maintain them, with gold having many of the key characteristics of a good external standard.  And so it can inform us by its historical example.

 

All things can be turned to evil, even inherently good things.  Our system is capable of corrupting almost anything including the word of God itself, and our own Constitution if we allow it.   Our hypocrisy knows few bounds, and our law has too often descended into a mere ritual of legality with little enough reference to justice.

But those things that are transcendent of human power and our pride at least remind us that we are doing evil, and that we are not sufficient unto ourselves as the arbiters of the universe. 

But I will go so far to say that virtually every would-be statist who wishes to set themselves up as an authority by fiat will almost certainly find gold to be troublesome, an impediment, and something to be feared and if possible, controlled.  

Like private conscience, and a belief in a power greater than the power of the state, gold whispers in the silence to us, that something is terribly wrong.

It was a quiet option expiration on the Comex today.  More on that tomorrow.

Have a pleasant evening.

Let's File This Email About Greenspan and Replicating the Gold Standard Under 'Irony'

I found this little gem, and added it to my collection of reminders that Greenspan said that fiat money 'worked' because central bankers had learned to 'replicate' the gold standard through their policy actions.  I had said 'emulate' but perhaps that was a quirk of memory.

This is from a publicly published note by Jude Wanniski titled Savings Glut.

From: Jude Wanniski < jwanniski@polyconomics.com
To: Ben.S.Bernanke@ * * * * *.GOV
Subject: Fwd: Re: Savings glut
5:44 pm, 7/21/2005

"Greenspan was plain awful in his testimony this week. But members of Congress don't know any better, so they slobber all over him. He again said we don't need a gold standard, because he has demonstrated since he came to the Fed in 1987 that the central bank could 'replicate' the gold standard.

Take a look at the dollar/gold price from 1987 until today and you will see how terrific he has been in replicating the gold standard. I can't wait for him to leave, Ben, because he now has so much invested in his Fed legacy as a Maestro that he could never admit he screwed up almost all along the way."

Wanniski sent this to Bernanke, who was at that time either on the Fed Board of Governors, or on the Council of Economic Advisors to W Bush.  I can't recall the exact date of the transition.

The note is almost a howler, given the excesses in trickle down helicopter monetization and banking subsidies that Bernanke has engaged in since becoming the Chairman of the Fed, and the manner in which he has haplessly ravaged the quality of the Fed's Balance Sheet, while accomplishing little except extending the unsustainable status quo.  The Fed's performance as a major banking regulator has been almost pathological.

And I also like this note because it helps to dispel the myth that the Fed does not watch and worry about the price of gold, which we have known about for quite some time. It is tied to their aspirations on interest rates, through the management of market perception. Larry Summers wrote about this relationship in Gibson's Paradox.

Well, nothing has changed, the irresponsibles are still in charge, and they are being defended by their economic partisans while they degrade the national currency to support the looting of the system by their cronies from Wall Street and the Banks. 

The idea that stuffing the one percent's already swollen pockets with even more hot money will stimulate the economy would be funny if it was not having such tragic consequences, with even worse to come.

My only regret is that I wasted so much time trying to raise these concerns on economic chat sites with establishment economists who clearly did not wish to hear or see anything but the party line.  This is about when Brad DeLong, in explaining why he had to censor my concerns about Greenspan's monetary policy and the growing credit bubble said, "Greenspan never made a policy decision with which I disagreed."  Well Brad, how did that work out in retrospect? 

And as bad as the neo-Keynesians may be, the Chicago-Columbia austerity crowd are even worse.  Economics is a generally disgraced profession with only a few bright lights.

The stock, bond, and commodity markets are a joke. The Banking System resembles a control fraud.

The manipulation of the metals, equity, and credit markets is approaching a financial war crime, it is so contemptible. Although I am sure it will have its bureaucratic defenders.

At long last, they have no shame.

Another crisis is coming.  They know it is coming, and are attempting to cover it up while they make themselves and their patrons comfortable.  They are trying to stifle all alarms and indicators to the contrary.

The market is whatever we say it is, indeed.  And this time it will be worse.

I am sorry to speak so bluntly.  I keep trying to maintain some optimism, but these jokers are barking at the moon.  This disconnect between reality and the official story is becoming almost unbelievable.

Greenspan: Role Of Central Bankers Is to Try to Replicate the Stability of the Gold Standard

Greenspan said on any number of occasions that his model was that a 'fiat currency' works when it emulates the rigor of the gold standard.

I am using this post as a placemarker to gather a few citations along these lines. Sometimes people doubt these things, and it is not always easy to go back and find the actual idea in print.

I will place other example here as I find them but it is not a high priority because Alan Greenspan has never deviated from this point of view. One of the most poignant examples I have was when Ron Paul asked him if he still believed in what he wrote in his famous essay on Gold and Economic Freedom.

And Greenspan answered that he would not change a word.

I think the squaring up of what Greenspan believed, and what he did as Fed Chairman, is one of the more interesting conundrums that I hope that time will explicate. 

The other of course is why the flaming liberal and 'socialist' Obama is really closer to Richard Nixon in his performance and outlook than most would care to admit, on either the right or the left. 

This is from a 2007 Interview by National Public Radio with Alan Greenspan on Turbulence and Exuberance

Greenspan: Well actually, we were not fundamentally regulators [at the Fed]. The vast portion of our efforts were not involved in bank regulation.

NPR: No, but you were regulating interest rates, which have a profound effect on world economies.

Greenspan: You're raising really a very interesting question. I have always argued that the gold standard of the 19th century was a very effective stabilizer. It kept inflation essentially at zero, and I felt it was critical for the tremendous growth that occurred for the American economy in the latter part of the 19th century. When we went off the gold standard essentially in 1933, we then had to have what we call "fiat money" which is essentially money that is - it's printed paper money. Which unless we restrict the volume of, can be highly inflationary.

The type of interest rate regulation that I and indeed most central banks in the last 20 years have been involved in...has been to try to replicate the laws and rules that were governing the gold standard.

And so it is an odd situation where all the central bankers -- while none of them are advocating a return to the gold standard -- nonetheless try to replicate the various types of interest rate policies that the gold standard would have created. And it is an interesting question whether you call that regulation, or basically functioning of a central bank in stabilizing the economy."

I remember all such statements of Greenspan's vividly because they were one of the few times in which I felt that he was telling the truth, at least as he sees it.

I think that a fiat currency can 'work' if it emulates the rigor of an external standard. And exceptions that can be made to this rigor during times of exogenous shocks could be a quite useful tool for monetary policy.

The problem is that it NEVER seems to work out that way in the real world. It does not take long for financiers and politicians to discover the heady power and easy money to be had in manipulating the markets and the fiat currencies to their own advantage, the public and the real economy be damned. And then a pigfest ensues, and a nation's savings and civic virtue are consumed.

"And, indeed, since the late '70s, central bankers generally have behaved as though we were on the gold standard. And, indeed, the extent of liquidity contraction that has occurred as a consequence of the various different efforts on the part of monetary authorities is a clear indication that we recognize that excessive creation of liquidity creates inflation, which, in turn, undermines economic growth.

So that the question is: Would there be any advantage, at this particular stage, in going back to the gold standard? And the answer is: I don't think so, because we're acting as though we were there. So I think central banking, I believe, has learned the dangers of fiat money, and I think, as a consequence of that, we've behaved as though there are, indeed, real reserves underneath the system."

Greenspan, A., Hearing on Monetary Policy Report, US House Committee on Financial Services, 20 July 2005, Washington D.C.

From: Jude Wanniski < jwanniski@polyconomics.com
To: Ben.S.Bernanke@ * * * * *.GOV
Subject: Fwd: Re: Savings glut
5:44 pm, 7/21/2005

I thought you should see this. Greenspan was plain awful in his testimony this week. But members of Congress don't know any better, so they slobber all over him. He again said we don't need a gold standard, because he has demonstrated since he came to the Fed in 1987 that the central bank could "replicate" the gold standard.

Take a look at the dollar/gold price from 1987 until today and you will see how terrific he has been in replicating the gold standard. I can't wait for him to leave, Ben, because he now has so much invested in his Fed legacy as a Maestro that he could never admit he screwed up almost all along the way.

Famous 2005 Exchange Between Ron Paul and Alan Greenspan about the Gold Standard


Related: Why There Is Fear and Resentment of Gold's Ability to Reveal the True Value of Financial Assets

Gold Is At Imporant Intermediate Term Resistance - Long Term GATA Has It Right

After the spectacular rally of last Friday it is natural for gold to pause and consolidate here.

However, I wanted to make sure you could see the position of the gold price with regard to the intermediate trend.

This is the key resistance which I referred to last week, clearly visible in the chart below.

The hedge funds were leaning very hard on the short side as we had shown in some of the indicators, and as several others had shown in the market structure through the Commitments of Traders Reports. And the bears had 'gotten smoked' by the commercials who hit them with a stiff short squeeze last week. As Ted Butler remarked, 'manipulation goes both ways.' Yes it does, but not in this case, because Ted does not understand even yet it appears the basic underlying reality of the long term gold market, perhaps because he is so focused on silver.

I think that the downward pressure, or bearish manipulation if you will, was greatly exaggerated by the trading desks because of the key market dates including option expiration. The ferocity of the rally was due to that pressure being relieved and turned back. It perhaps then could be better described as 'the end to the manipulation' than an active manipulation itself.

The rounded bottom showed how resolutely the bears had pressed on support, and how equally resolute the market was in holding its ground. If you coil a spring long enough, eventually it may snap back.

Now we see how the physical delivery situation plays out in June and July and if gold can finally break the downtrend. As I said, I do not think that the next leg up may have such an easy time of it because the foundation of the market manipulation is to suppress the gold price for the sake of a macroeconomic policy being put forward by the central banks.

As several commentators have pointed out, Kosares, Coxe and even my lowly self among them, the great trend change in the central bank attitudes towards gold which had driven the twenty year bear market with their organized selling has changed.  Central banks are now net buyers of gold.  It was their change in selling that marked the first turn in the market in 2000.  And now that they are buying we may see the next turn, until the market clears, or until they try to reinstitute a gold standard and fix the price at whatever valuation they believe they can sustain without provoking a 'black market' assault on their authority.

Make no mistake, they are still fighting the rally in gold every step of the way, not so that they can stop it, but because they want to control it, make sure it is 'orderly.' This is the underlying fundamental message of the market, and you will not find it in the Commitments of Traders reports. But you will find it in the kind of analysis and information being promoted by GATA for example.  For the last fifteen years they are the only group, as far as I can see, who have 'gotten it right.'

And it is not clear to me at all that a number of gold commentators get this fundamental fact yet. At some point they will, they will all get it. But not until the price of gold is much higher. But they may benefit from this market fundamental without realizing why, when the reversion to the long term trend occurs, and perhaps with a vengeance. And so they can ride the coattails of those who do get it, and occasionally try to appear 'wise' and curry favor with the popular financial media with dismissive and even snide remarks.

There are great events at work in the global financial markets. Only those who truly understand them will have the ability to profit in the longer term, because they will not be buffeted by the slick campaigns and the jawboning of the Anglo-American financial establishment which has been using the creation and distribution of fiat dollars as their personal piggybank for far too long.

Should the Fed Buy Gold At $5,000 per Ounce? Should Mexico Go to a De Facto Silver Standard?

These are two different interviews on two related topics: the place of specie in the reconstitution of national currencies in facilitating the recovery from a financial crisis.

I have to confess that there were some historical observations made by Lee Quaintance that made me scratch my head, wondering if we were coexisting in the same or parallel universes. I have tried to note them as they occurred in the text. What was most puzzling is that they seemed to be inserted in a line of thinking with which I was in completely agreement. Perhaps I just need another cup of coffee.

But in sum I found both interviews innovative and thought provoking. The concept of using Gresham's Law to induce people to save is interesting. I think the valuation model which my friend Hugo puts forward for a silver coin needs some work and some further thought, most likely on my part.

The status quo of economists and financial engineers, with their attendants politicians, will just hate these ideas. So I would not expect them to gain much traction, until things get substantially worse than they are today.

Hugo Salinas-Price on the Silver Peso and Deflation: Should the Fed be Buying Gold?
Chris Whalen, Institutional Risk AnalystJuly 19, 2010

"The difficulty lies, not in the new ideas, but in escaping from the old ones."

John Maynard Keynes
(1883-1946)

In this issue of The Institutional Risk Analyst, we shift focus from the U.S. to Mexico and feature a comment by Hugo Salinas-Price on his proposal for a silver-peso coin. We saw such a big response to the conversation with Jim Rickards about a gold-backed euro ("Paper Gold vs the Dollar? Interview with James Rickards," July 7, 2010) that we wanted to come back to the subject by speaking with an old friend from one of our favorite countries.

Salinas is founder, former chief executive officer, and honorary president of Grupo Elektra, the Mexican retailing company. He is also founder of the Mexican Civic Association Pro Silver, which for 10 years has been advocating the introduction of a monetized silver coin in parallel circulation with fiat pesos in Mexico. Legislation to that effect now is under serious consideration before the Mexican Congress.

Salinas describes the Mexican peso as a "derivative" of the dollar, a troubling prospect since, as we discuss below, the dollar itself is a derivative of nothing, at best a mere representation of a unit of work. But before we go to our feature, we need to comment on the latest minutes from the FOMC and the growing indication that the U.S. economy is continuing to slow.

To us, there is no "double dip" in the economy. We never recovered from the first decline in aggregate demand. Forget the bogus inflation and GDP statistics coming from Washington. Talk to your neighbors and family, the people in the community who own businesses. Ask them how their revenues for 1H 2010 are doing YOY...

In response to mounting concerns about deflation, news reports are filled with speculation that the Federal Reserve System will "ease" monetary policy further, an interesting idea given that interest rates already are at zero. The concept of further quantitative easing, as we understand it, would be for the Fed to purchase more securities from the Wall Street banks and hope -- repeat hope -- that a few pennies trickle down to the real economy. But mindful of the quotation from Lord Keynes above, maybe there is a better idea.

Last week The IRA spoke to Lee Quaintance, co-founder of QB Asset Management. Lee had worked in high yield credit and government bonds for several decades for the likes of Goldman Sachs (GS), CSFB and DLJ. Lee and his partner Paul Brodsky write a fascinating monthly market comment.

The IRA: So Lee, we see deflation as far as the eye can see but also rising costs. What's your view of the inflation/deflation debate amongst the chattering classes?

Quaintance: Credit inflations create asset bubbles that destroy the organic equilibrium mix between the factors of production. The deflation process curtails production and shrinks overall wealth but, ironically enough, redistributes a vast portion of the wealth that's left to the privileged few, mostly banks and government.

The IRA: We have created quite a mess.

Quaintance: A mess, yes, but, a predictable one nonetheless. Inflation and deflation are two sides of the same coin. Fiat currency and unreserved lending privileges are the root causes of all these imbalances. Throw in a bit of greed and malice too no doubt. The Austrians modeled it and predicted it. The Keynesians make excuses for it.

The IRA: Years ago, we made our friend Bill Janeway angry at us for calling Keynesian economics a coward's road to socialism (See "New Hope for Financial Economics: Interview with Bill Janeway," November 17, 2008). Now that we are at that endpoint, our political leaders are completely clueless. We have yet to find a single American politician able to talk about the role of the dollar in the global economy.

Quaintance: Have you asked yourself why most people have come to believe that deflation is to be avoided at all costs? It's painfully obvious to us -- because it destroys the banks and handcuffs the politicians. For everyone else, it's seemingly a zero sum game. Why all the fuss? (A zero sum game? Perhaps it has something to do with mass unemployment, and the transfers of wealth from the many to the few, the banks and the government, which Quaintance noted previously, leading to the decimation of the middle class, and a nation of hobos and millionaires. If all deflation did was destroy banks and harm politicians I would think it would be the most popular thing since the pre-elected version of Obama - Jesse)

The IRA: Well, if the U.S. economy continues to decelerate and deflate, we are going to see a lot of politicians facing mandatory "retirement" a la Harrison Ford in the film Blade Runner. A large portion of the U.S. population thinks that we are entitled to full employment, price stability and early retirement even as the government expands the deficit and currency at a double digit rates. The Chartalists think that we should just print money and use it to monetize all existing debt. The neo-Chartelist framework comes from the same intellectual wellspring as Keynesian economics and has been extended by the likes of Nobel laureate Bob Mundell. The current policy of the Obama Administration to borrow trillions of dollars to fund future deficits is similar madness, in our view, but is Fed-induced inflation better? What do you propose?

Quaintance: We have some basic views on what should be done and it comes in two steps. First, there needs to be a coordinated global currency devaluation. We argue for the Fed to tender for private gold holdings at something like $5,000 per ounce and to maintain that bid/offer. This would be the true economic/regulatory function of a central bank and/or monetary authority.

The IRA: The U.S. central bank has not had any gold holdings since FDR's expropriation of the private banking industry's gold in the 1930s. All of the gold in the Fed's vaults belongs to somebody else. We have a reserve bank with no reserves. So you would have the Fed buy gold rather than purchase more crap assets from the large dealer banks via a second round of quantitative easing (QE II)?

Quaintance: Precisely. The second step would be a major policy-mandated contraction in unreserved bank lending. These two simple steps would not only rebalance the financial books globally but would prevent leverage from over-inflating asset prices going forward, in turn creating another non-sustainable bubble economy. This isn't just theory. Let's look back. Employment trends in developed economies are being strangled presently by prior asset price inflation. As an admittedly crude example, the cost of shops on Main Street are overvalued and require artificially high rents to service debts. The average would-be shop owner can choose to pay his inflated lease or choose to pay workers - but not both. So, asset price inflation due to excessive unreserved credit expansion is not wealth enhancing but, rather, productivity destroying. (As a counterpoint though, it was not asset price inflation that started the process of breaking labor through offshoring and anti-union activity, a trend with its roots in the Reagan presidency, but general greed and lower tax rates on the monied interests. Why pay wages when you can pay yourself bonuses and tax free dividends to yourself and your friends? Capitalism has a natural dynamic to self-destruction, despite the mythology spun by the efficient market hypothesis folks. Given free rein, it will destroy itself by destorying its customers - Jesse)

The IRA: That is a structural problem. How does the Fed buying gold help?

Quaintance: You want organic employment growth? Lower the relative price of other factors of production. Boosting asset prices unilaterally while wage rates remain relatively stagnant is a recipe for unemployment. This is just common sense and it's what we're seeing today. The system yearns for more money, not more credit.

The IRA: Yes, their operating costs are rising but selling prices are compressed, just like our favorite Italian food dispensary in New York. As we have long argued with our friend Bill Greider, consumers and small businesses who do not do business with JPMorgan and Goldman Sachs are the big losers in the fiat system. You must be smart enough to surf the waves of inflation, not just swim with the tide, and that makes us all speculators. (It is really the arbitrariness of the money that is a root cause, and the creation of a monopolization of credit under an incompetent/corrupt Federal Reserve - Jesse)

Quaintance: Agreed. In the end, credit inflation historically leads to asset inflation while base money inflation leads to wage and basic goods/consumables inflation. No matter how you slice it, the ratio of outstanding global debts to global base money is irreconcilable. This is a mathematical tautology. From this imbalance flow many of the imbalances you cite, in my mind. Chris, as I said, we think this is as simple a problem as too little "money" in existence attempting to service and ultimately reconcile too much debt.

The IRA: So where do we go from here?

Quaintance: When the ratio of productive asset prices exceeds a theoretical limit vis-à-vis the other factors of production, the productive process breaks down. In the case of the U.S., it headed to developing economies overseas where labor demographics, regulatory apparatuses and asset pricing environments were far more in balance. This trend should continue until there is a serious reconciliation of that debt-to-base money gap.

The IRA: The one-sided era of free trade, with the U.S. open to all other nations but without reciprocity, has been like Smoot-Hawley in reverse, draining resources from the U.S. economy instead of what happened once WW II began. America ended up with much of the gold reserves and industry in the world but now we have swung to the other extreme. But most people don't realize that technological changes such as the electrification of the U.S. and resulting overcapacity in the 1920s drove the deflation of the 1930s, (What! How about the huge waves of bank failures? There is nothing like vaporizing a class of person's life savings to provoke deflation. How can someone make such a sweeping statement and ignore the most prominent feature of the time from an economic perspective! - Jesse) not the marginal increase in tariffs. Tariffs were already high and had been for 50 years. So Lee what we hear you saying is that we need another global reflation a la FDR's purchases of gold?

Quaintance: Yes. I abhor as much as the next guy proactive public sector administration of anything that a free market can manage better. But given the massive unreserved credit inflation of the last 20-plus years, a major -- and I mean major -- expansion of the global stock of base money must be administered ASAP to avoid further nominal private credit deflation and subsequent real economic contraction. Simply replacing vaporizing private debts with public debts is a mug's game -- a poorly-veiled requirement to inflate tomorrow. Why dance around the obvious here?

The IRA: So in a nutshell...

Quaintance: It's all about excessive unreserved credit having created real economic distortions that can't be reconciled through further debt creation. For a true financial reconciliation to occur the debt-to-monetary base ratio has to narrow significantly, and to set a sustainable course the growth rate of global money should be capped in a credible fashion. The easiest way to do this is by reinstituting and maintaining a true gold standard, at least for base money. This is not a radical notion. Remember the reason the gold standard "failed" historically was not the basic mechanics of hard money being "too restrictive". The problem has always been unreserved leverage that accompanies "gold standards" creating non-sustainable economic imbalances. There is plenty of gold, at the right price, to reserve all money and credit.

The IRA: The new $5,000 per ounce price for gold in greenbacks suggests a huge degree of suppressed inflation in the dollar system.

Quaintance: We see no other way to re-ignite the real economy and put it on a sustainable path. Policy makers are holding a burning match. They have to act or the markets and global trade partners will act for them.

The IRA: Thanks Lee.

And now to our feature. We have long believed that the U.S. government should issue silver and gold coins that are valued by weight. Most people are sophisticated enough to go down to their bank branch, look in the newspaper or online to ascertain the current value of silver or gold. By allowing the metal coins to trade on their intrinsic value instead of the arbitrary, political value assigned by the state, it would provide a way for average Americans to save and protect themselves from inflation. Hugo Salinas Price talks about how just such a system soon may be implemented in Mexico.

The Monetization of the "LIBERTAD" Silver Ounce in Mexico
By Hugo Salinas-Price
www.plata.com.mx

The correct diagnosis of the world's economic sickness is: there has been too much spending based on too much debt and there is a starvation of real savings.

What would be the treatment for the illness? Flush out the excessive debt accumulated by excessive spending with a laxative which will cancel that debt, and provide the patient with some healthy real money which he will greedily gobble up.

This is the philosophy which has led me to propose the reintroduction of silver money into renewed use in Mexico. I leave the cancellation of debt to others; my contribution is real, healthy money for the Mexican nation.

How to reintroduce silver into permanent use as money in Mexico?

First, since I do not wish to kill the patient, I prescribe a gradual introduction of silver into circulation, in parallel with fake money, which is the only kind of money in the world today. We shall gradually increase the amount of silver money in circulation in Mexico, as it circulates along with fake, fiat money.

It is necessary to take into account that although at one time - about a hundred years ago, in the case of Mexico - people calculated value in terms of weight of silver, today they would not be able to do so. People have become accustomed to using numbers to designate value.

Thus, if we want silver to circulate in the hands of the Mexican people, we must devise a silver coin to which is attributed a number. If the silver coin has a number officially attributed to it, the Mexican people will snap up all the coins they can afford to purchase, because they know they will be able to use the coin in commercial transactions at any moment - though we know they will not do so: they will instinctively save these coins (Gresham's Law). And that is what we want the patient to do!

There were silver coins circulating in many parts of the world, just after World War II. They had all disappeared from circulation a few years later. What happened? There was inflation of paper money all over the world, due to credit expansion. This inflation caused the price of silver to rise. Since all the silver coinage in circulation had engraved numbers signifying monetary value, and the engravings could not be erased, the silver coinage became more valuable if it was melted down into silver bullion. That sealed the fate of the silver coinage: it was all melted down and never came back. In fact, silver coins with engraved value can never come back as long as there is paper money in circulation - they will all suffer the same fate, they will all be melted down eventually, no matter what value is engraved, because paper or digital money leads to constant inflation.

You have Silver Eagle one-ounce bullion coins in the US, but they are purposely demonetized by having an engraved value of $1 Dollar; this makes them useless as ready money.

So the silver coin which is to be introduced into permanent circulation must have no engraved value. Providentially, there is such a coin in existence in Mexico: the "Libertad" pure silver ounce. We don't have to invent a new coin.

All we have to do is to obtain Legislation which will attribute a monetary value to this coin by means of a quote from the monetary authority, the Bank of Mexico. The quote will simply take the place of the engraved value.

It so happens that a former President of Mexico, Jose Lopez Portillo (1976-1982), tried to do just this, in a moment of inspiration, back in 1979. However, his legislation was defective and the measure was a failure because that legislation decreed that the Bank of Mexico should issue a monetary quote for the silver ounce, to depend directly on the international price of silver. The intention was excellent, but the legislation deficient, because the silver ounce bounced about in monetary value from day to day and no one could use it as money under those conditions. The law was allowed to lapse in 1981, but never repealed.

It took me many months of thought to find the solution to the monetization of the silver ounce, with no engraved value, but one day it came to me, right out of the blue: the Bank of Mexico must issue a quote which will give the Libertad a monetary value, but once given a monetary value, that value must not be reduced, under any circumstances! The central bank must stand ready to make an infinite market at the minimum quoted value. (I can see some a large hedge funds having fun with this one, testing the resolve of the Bank of Mexico. It probably needs more thought, as it is an absolutely pivotal point, and one on which the idea foundered before. I thought Hugo's idea of gold / silver for regulating international trade was brilliant, but I need to think more of how this one might survive the inevitable attacks of an unreformed financial system, capable of perverting almost anything it touches. - Jesse)

People will gladly receive a silver coin for savings, if it has a monetary value ascribed to it by a quote. But the quote must be stable, it must not be reduced - no one can accept as money, a coin whose monetary value may be less tomorrow that it is today. If we compare with paper money, a paper bill is acceptable because it says $100 pesos, and will always say $100 pesos. Its purchasing power may decline, but the bill will always say $100 pesos.

The same principle applies to a silver one ounce coin with no engraved value: if the quote is $300 pesos, the public must have the certainty that the quote will not be reduced. A fluctuating quote is what caused the failure of our former President's legislation: the coin had different monetary values from day to day, some days worth more, some days worth less.

On the other hand, people will joyfully accept a silver coin whose quote may be increased due to the increasing value of silver. In fact, this is an extremely powerful incentive to savings, and that is what we are looking for: more savings! No interest payment is necessary to entice people into saving this coin - silver is an irresistible magnet for savings. (The US is using it on a much smaller scale through the issuance of common coins with a marketing appeal, like the states and presidents series - Jesse)

So our proposed legislation is this:

The Bank of Mexico shall publish a monetary quote for the silver ounce, based on this procedure:

a. To the international price of silver in pesos, Bank of Mexico shall add a 10% seigniorage (profit) for itself. ($231.41 pesos X 1.1 = $254.55 pesos. Today's values of silver and pesos, at kitco.com)

b. The Bank of Mexico shall add to this, the cost of minting the silver ounce. ($254.55 + $19.02 estimate = $273.57 pesos)

c. The Bank of Mexico shall round out the sum of the two foregoing, to the nearest multiple of 5, to make the monetary value easy to remember. ($273.57 rounded out = $275 pesos quoted monetary value of the "Libertad" silver ounce)

d. When the international price of silver in pesos falls, the Bank of Mexico shall do nothing.

e. When the international price of silver in pesos rises and impinges upon the seigniorage of the Bank of Mexico, it shall increase the quoted monetary value to restore its seigniorage.

f. The Bank of Mexico shall mint sufficient quantity of Libertad ounces to satisfy market demand and prevent the appearance of a premium over the quoted monetary value of the Libertad.

By this means, the people of Mexico will have an ideal vehicle for savings and even those who cannot read or write will accumulate these coins as a family patrimony. A recent Mexican Treasury study discovered that 85% of all Mexicans do not have bank accounts. These are the candidates for savings in silver!

Under this legislation, the silver Libertad will never be melted down into bullion, as its predecessors. The coin will always be worth more as money, than as bullion.

A fall in the value of silver will not affect this coin. No matter how severe a collapse in the price of silver, this coin will always be preferable to any paper bill or digital money, because the paper bill and digital money have absolutely nothing to back them up, whereas this coin will always have some value due to its being silver. I find such a collapse hard to conceive, but one must take into account this possibility.

I cannot help adding that I believe that this silver money is what the whole world is waiting for, "waiting for the sunrise" out of our present deathly darkness. I believe that if it becomes a reality, it will be an enormous success.

Why There is Fear and Resentment of Gold's Ability to Reveal the True Value of Financial Assets

There were a few questions raised about the note on the long term chart of the SP 500 deflated by gold which was posted last night, and which is reproduced here on the right, which read "This is why the financial engineers like Bernanke hate and fear gold; it defies their plans and powers."

The chart shows something that most investors have suspected. There has been no genuine recovery in the price of stocks since the decline that cannot be fully explained by the monetary inflation of the dollar, as can be discovered by the ultimate store of value, which is gold.

I thought that this was a fairly straightforward observation, but it apparently jarred a few people and their thinking. So perhaps we have some new readers who are not familiar with the long standing animosity towards gold that is uniformly expressed by all those who promote centralized command and control economies, from both the left and the right.

Can any astute observer doubt the Fed's desire to act in secret and privacy? Their obsession with this is almost unbelievable and beyond comprehension, unless one understands that they are in a 'confidence game,' and use persuasion and even illusion to shape perceptions, especially at the extremes of their financial and monetary engineering of the real economy.

This animosity and desire for secrecy was described by Alan Greenspan in his famous essay, Gold and Economic Freedom, first published in 1966. In a fairly amusing exchange between Congressman Ron Paul and the former Chairman a couple of years ago, Mr. Paul asked Sir Alan about this essay, and if he had any corrections or misgivings about it after so many years. Would he change anything?

"Not one word." replied Greenspan, in one of his few candidly honest and straightforward statements.

It helps to understand the dynamics of the money world, which appear so mysterious to those who do not specialize in it, even economists, although some may feign ignorance to promote their cause or avoid unpleasant disclosures.

Money is power. Ownership of the means of production may provide for the control of groups of disorganized labor.  But the power of the issuance of money allows for the control of whole peoples and governments, through the distribution and transference of wealth, by the most subtle of means. And this is why the US Constitution relegated this power to the Congress and by their explicit appropriation, and denied it to the States and private parties except in the form of specie, that is, gold and silver which have intrinsic value.

It might be useful to review a prior post in reaction to the self-named maverick economist Willem Buiter, who wrote a few attacks on gold, prior to his leaving academia and the Financial Times to take a senior position with Citibank. Willem Buiter Apparently Does Not Like Gold

It may seem a bit perverse, but I do not favor a return to a gold, or a bi-metallic gold and silver standard at this time.   Each nation can be free to devalue or deflate their own money supply as their needs require, with the consent and knowledge of the people and their representatives.

What I do promote is for gold and silver to trade freely without restraint or manipulation as a refuge from monetary manipulation, and a secure store of value for private wealth. When nations adopt the gold standard, they invariably seek to 'fix' and manipulate its price, and reserve the ownership to themselves, with the tendency to seize the wealth of their citizen under the rationale of such an ownership, or dominant privilege.

Let those who have a mind to it have the means of securing their labor and efforts, and let the state do as it will, with the open knowledge and consent of the world.

"Gold is not necessary. I have no interest in gold. We will build a solid state, without an ounce of gold behind it. Anyone who sells above the set prices, let him be marched off to a concentration camp. That's the bastion of money."

Adolf Hitler

A draconian approach no doubt. It is much more common for the ruling parties to debase the coinage secretively while advantaging their friends and supporters, thereby manipulating the value of gold and silver covertly.

 In modern times of non-specie currency one might choose to select a few cooperative banks and the central money authority to manipulate the price using paper and markets, and hope that this scheme will remain undiscovered. But it always comes out, the truth is always known in the end.

"With the exception only of the period of the gold standard, practically all governments of history have used their exclusive power to issue money to defraud and plunder the people."

F. A. Von Hayek

There are any number of amateur economists and investing pundits around these days who betray an almost irrational opposition to gold, becoming jubilant in every decline, and despondent at every rally. And some of them even take the label of 'Austrianism' in their thoughts which is quite odd given that it is one of their schools strongest bulwarks.

Most often this can simply explained as the envy of those who have not prepared for a crisis, and wish ill upon those who have, regretting and hoping for another chance to provide for their own security. And yet they will fail to take advantage of every opportunity to do so, as they are creatures betrayed alternatively by their own fear and greed.

One of the best indications of quack advice on the question of investing in precious metals is when one of the reasons against it includes the scurrilous non sequitur, 'You can't eat it,' as if nutritional content is a valid measure of the durability of wealth. It betrays a lowness of argument and intellectual integrity that should promptly urge one to run in the other direction.

And regrettably, there are always those who will say almost anything for money, and the profession of economist seems to be particularly infested with that sort, given the stochastic nature of the discipline, and its lack of scientific rigor, being based on principles which do not easily lend themselves to objectification with serious damage to the data being made by the assumptions in their equations and proofs.

But most of all, the financial engineers, politicians, and Wall Street Banks fear gold because it is the antidote to their frauds, and the informant to their confiscation of wealth.

Do not expect them to capitulate once and for all, but only slowly and grudgingly as it becomes more difficult for them to sustain their illusions and persuasion. Protecting wealth against official adventurism is never easy.

Here is Alan Greenspan's famous essay on Gold and Economic Freedom. I suggest your read it, because it will help you to understand much of what is said and done as the global reserve currency system changes and evolves.

Gold and Economic Freedom
by Alan Greenspan

Published in Ayn Rand's "Objectivist" newsletter in 1966, and reprinted in her book, Capitalism: The Unknown Ideal, in 1967.

An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense - perhaps more clearly and subtly than many consistent defenders of laissez-faire - that gold and economic freedom are inseparable, that the gold standard is an instrument of laissez-faire and that each implies and requires the other.

In order to understand the source of their antagonism, it is necessary first to understand the specific role of gold in a free society.

Money is the common denominator of all economic transactions. It is that commodity which serves as a medium of exchange, is universally acceptable to all participants in an exchange economy as payment for their goods or services, and can, therefore, be used as a standard of market value and as a store of value, i.e., as a means of saving.

The existence of such a commodity is a precondition of a division of labor economy. If men did not have some commodity of objective value which was generally acceptable as money, they would have to resort to primitive barter or be forced to live on self-sufficient farms and forgo the inestimable advantages of specialization. If men had no means to store value, i.e., to save, neither long-range planning nor exchange would be possible.

What medium of exchange will be acceptable to all participants in an economy is not determined arbitrarily. First, the medium of exchange should be durable. In a primitive society of meager wealth, wheat might be sufficiently durable to serve as a medium, since all exchanges would occur only during and immediately after the harvest, leaving no value-surplus to store. But where store-of-value considerations are important, as they are in richer, more civilized societies, the medium of exchange must be a durable commodity, usually a metal. A metal is generally chosen because it is homogeneous and divisible: every unit is the same as every other and it can be blended or formed in any quantity. Precious jewels, for example, are neither homogeneous nor divisible. More important, the commodity chosen as a medium must be a luxury. Human desires for luxuries are unlimited and, therefore, luxury goods are always in demand and will always be acceptable. Wheat is a luxury in underfed civilizations, but not in a prosperous society. Cigarettes ordinarily would not serve as money, but they did in post-World War II Europe where they were considered a luxury. The term "luxury good" implies scarcity and high unit value. Having a high unit value, such a good is easily portable; for instance, an ounce of gold is worth a half-ton of pig iron.

In the early stages of a developing money economy, several media of exchange might be used, since a wide variety of commodities would fulfill the foregoing conditions. However, one of the commodities will gradually displace all others, by being more widely acceptable. Preferences on what to hold as a store of value will shift to the most widely acceptable commodity, which, in turn, will make it still more acceptable. The shift is progressive until that commodity becomes the sole medium of exchange. The use of a single medium is highly advantageous for the same reasons that a money economy is superior to a barter economy: it makes exchanges possible on an incalculably wider scale.

Whether the single medium is gold, silver, seashells, cattle, or tobacco is optional, depending on the context and development of a given economy. In fact, all have been employed, at various times, as media of exchange. Even in the present century, two major commodities, gold and silver, have been used as international media of exchange, with gold becoming the predominant one. Gold, having both artistic and functional uses and being relatively scarce, has significant advantages over all other media of exchange. Since the beginning of World War I, it has been virtually the sole international standard of exchange. If all goods and services were to be paid for in gold, large payments would be difficult to execute and this would tend to limit the extent of a society's divisions of labor and specialization. Thus a logical extension of the creation of a medium of exchange is the development of a banking system and credit instruments (bank notes and deposits) which act as a substitute for, but are convertible into, gold.

A free banking system based on gold is able to extend credit and thus to create bank notes (currency) and deposits, according to the production requirements of the economy. Individual owners of gold are induced, by payments of interest, to deposit their gold in a bank (against which they can draw checks). But since it is rarely the case that all depositors want to withdraw all their gold at the same time, the banker need keep only a fraction of his total deposits in gold as reserves. This enables the banker to loan out more than the amount of his gold deposits (which means that he holds claims to gold rather than gold as security of his deposits). But the amount of loans which he can afford to make is not arbitrary: he has to gauge it in relation to his reserves and to the status of his investments.

When banks loan money to finance productive and profitable endeavors, the loans are paid off rapidly and bank credit continues to be generally available. But when the business ventures financed by bank credit are less profitable and slow to pay off, bankers soon find that their loans outstanding are excessive relative to their gold reserves, and they begin to curtail new lending, usually by charging higher interest rates. This tends to restrict the financing of new ventures and requires the existing borrowers to improve their profitability before they can obtain credit for further expansion. Thus, under the gold standard, a free banking system stands as the protector of an economy's stability and balanced growth. When gold is accepted as the medium of exchange by most or all nations, an unhampered free international gold standard serves to foster a world-wide division of labor and the broadest international trade. Even though the units of exchange (the dollar, the pound, the franc, etc.) differ from country to country, when all are defined in terms of gold the economies of the different countries act as one — so long as there are no restraints on trade or on the movement of capital. Credit, interest rates, and prices tend to follow similar patterns in all countries. For example, if banks in one country extend credit too liberally, interest rates in that country will tend to fall, inducing depositors to shift their gold to higher-interest paying banks in other countries. This will immediately cause a shortage of bank reserves in the "easy money" country, inducing tighter credit standards and a return to competitively higher interest rates again.

A fully free banking system and fully consistent gold standard have not as yet been achieved. But prior to World War I, the banking system in the United States (and in most of the world) was based on gold and even though governments intervened occasionally, banking was more free than controlled. Periodically, as a result of overly rapid credit expansion, banks became loaned up to the limit of their gold reserves, interest rates rose sharply, new credit was cut off, and the economy went into a sharp, but short-lived recession. (Compared with the depressions of 1920 and 1932, the pre-World War I business declines were mild indeed.) It was limited gold reserves that stopped the unbalanced expansions of business activity, before they could develop into the post-World War I type of disaster. The readjustment periods were short and the economies quickly reestablished a sound basis to resume expansion.

But the process of cure was misdiagnosed as the disease: if shortage of bank reserves was causing a business decline — argued economic interventionists — why not find a way of supplying increased reserves to the banks so they never need be short! If banks can continue to loan money indefinitely — it was claimed — there need never be any slumps in business. And so the Federal Reserve System was organized in 1913. It consisted of twelve regional Federal Reserve banks nominally owned by private bankers, but in fact government sponsored, controlled, and supported. Credit extended by these banks is in practice (though not legally) backed by the taxing power of the federal government. Technically, we remained on the gold standard; individuals were still free to own gold, and gold continued to be used as bank reserves. But now, in addition to gold, credit extended by the Federal Reserve banks ("paper reserves") could serve as legal tender to pay depositors.

When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve's attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable). The reasoning of the authorities involved was as follows: if the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain's gold loss and avoid the political embarrassment of having to raise interest rates. The "Fed" succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world, in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market, triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the full consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures. The world economies plunged into the Great Depression of the 1930's.

With a logic reminiscent of a generation earlier, statists argued that the gold standard was largely to blame for the credit debacle which led to the Great Depression. If the gold standard had not existed, they argued, Britain's abandonment of gold payments in 1931 would not have caused the failure of banks all over the world. (The irony was that since 1913, we had been, not on a gold standard, but on what may be termed "a mixed gold standard"; yet it is gold that took the blame.) But the opposition to the gold standard in any form — from a growing number of welfare-state advocates — was prompted by a much subtler insight: the realization that the gold standard is incompatible with chronic deficit spending (the hallmark of the welfare state). Stripped of its academic jargon, the welfare state is nothing more than a mechanism by which governments confiscate the wealth of the productive members of a society to support a wide variety of welfare schemes. A substantial part of the confiscation is effected by taxation. But the welfare statists were quick to recognize that if they wished to retain political power, the amount of taxation had to be limited and they had to resort to programs of massive deficit spending, i.e., they had to borrow money, by issuing government bonds, to finance welfare expenditures on a large scale.

Under a gold standard, the amount of credit that an economy can support is determined by the economy's tangible assets, since every credit instrument is ultimately a claim on some tangible asset. But government bonds are not backed by tangible wealth, only by the government's promise to pay out of future tax revenues, and cannot easily be absorbed by the financial markets. A large volume of new government bonds can be sold to the public only at progressively higher interest rates. Thus, government deficit spending under a gold standard is severely limited. The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. They have created paper reserves in the form of government bonds which — through a complex series of steps — the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods. When the economy's books are finally balanced, one finds that this loss in value represents the goods purchased by the government for welfare or other purposes with the money proceeds of the government bonds financed by bank credit expansion.

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.

Given his Randian audience and the mood at the time, it is interesting that Greenspan defines the culprits in the scheme of fiat monetization as 'welfare statists.' How ironic, that over a period of time there is indeed a group of welfare statists behind the latest debasement of the currency, the US dollar, but the recipients of this welfare are the Banks and the financial elite, who through transfer payments, financial fraud, and federally sanctioned subsidies are systematically stripping the middle class of their wealth. Perhaps they decided that if you cannot beat them, beat them to the trough and take the best for themselves until the system collapses through their abuse.