Image by Salvatore Vuono

“Europe fights back against austerity” was how The Daily Telegraph headlined its weekend election coverage. “Anti-austerity movements are gathering pace across Europe following political earthquakes in France and Greece. A total of 12 European governments have now been dismissed in three years.”

As the European welfare state is officially in its death-throes none of us should be surprised if political strife gets cranked up to eleven. I firmly expect that we will see much more of this in the future. While I can understand the anger of the electorate and sympathize with the sense of desperation and foreboding, I can, however, not consider the electoral choices of the weekend particularly enlightened, and I do not think that they reflect a coherent, let alone intelligent strategy as the Daily Telegraph headline seems to imply. If those who ‘won’ the election deliver on their promises, economic disintegration will only accelerate. What is being offered in terms of ‘solutions’ is a dangerous assortment of economic poisons, more suitable to describe the European disease than provide a recipe for stronger growth.

Recovery through early retirement and infrastructure spending? – C’mon. Nobody can take that seriously.

But it seems that just because this heap of economic stupidity can neatly be swept under the wide tent of ‘anti-austerity’, the commentariat seems somehow willing to believe in the wisdom of the crowds and look for some deeper insights here.

I guess the reason for this is that the economic ideologies that are now being strenuously interpreted into the election results rhyme with the economic prejudices of most commentators. They, too, believe that state bankruptcy is best to be ignored or not to be taken too seriously so that we can spend our way out of this mess. For a long time media pundits have treated us to the perceived wisdom that economic growth can only come from the actions of the government. Only devaluation through euro-exit, inflation through more money printing and more government deficit-spending, preferably by the still credit-worthy Germans and then fiscally-transferred to the maxed-out Greeks, can revive the economy because only this can lift aggregate demand, the magic cure-all of economic problems.

What is lost on these commentators is that the European mess is nothing but the inevitable result of government-stipulated aggregate demand.  Easy money funded the Spanish and Irish real estate booms and bankrupted their banks and by extension their governments. Easy money allowed Greece’s political class to go on a borrowing binge that has now bankrupted the country and lured large parts of the population into zero-productivity, soon-to-be-eliminated public sector jobs.

Do you still want the state to ‘stimulate’ the economy? – Be careful what you wish for.

The real culprit of high youth unemployment in Spain and Italy is not ‘austerity’, which hasn’t even started there, but a bizarrely overregulated and sclerotic labour market in which it is almost impossible for firms of a certain size to fire people. The incentives are thus stacked massively against hiring. Yet, in France one of Hollande’s election promises is not to deregulate the labour market. If I were unemployed in France I would not be counting my chances of getting a job over the next five years.

In France the state runs more than half the economy, yet Hollande promises not to privatize state-run industry. Where is the wisdom in that?

Yet, the statists and socialists are delighted. Paul Krugman, who never saw a debt crisis you could not borrow and spend your way out of, rejoices at such display of economic genius. We are all Keynesians now! Listening to Krugman you would think Greek and French voters were not using the ballot to cling desperately to some remnants of the welfare state but were in fact positively advertising the wisdom of government stimulus and the mystical ‘multiplier’.

Some of the commentators tried to argue that what happened over the weekend was also some kind of anti-establishment vote, a verdict against centralisation and the dominance of the deservedly despised bureaucratic elite in Brussels.

Nice try but I think that that is rubbish.

This was not an anti-establishment vote at all. It was not a vote for change but a desperate vote for the status quo. Of course, the old elite deserved the sack but they were largely booted out not because people got tired of the old policies but because the leadership now finally admitted that they could no longer deliver on the old promises.

The established parties lost because they could not continue upholding the false promise that had kept them in office for years or decades, the promise to make the “European model” work. They had to admit that the European welfare state was now bankrupt. Kicking the can down the road is increasingly not an option as the end of the road is now in sight.

 And the election winners were those who had the chutzpah to maintain that drastic belt-tightening and painful reform were not required but that the people just had to ‘stick it to the man’, who is Angela Merkel and sits in Berlin. The tactic is straightforward. Shoot the messenger!

In France that meant voting for a charisma-free Socialist bureaucrat who will revive France with higher taxes, early retirement and a Hoover dam funded by Eurobonds and the ECB. In Greece, the big winner was an ex-Communist firebrand who admires Hugo Chavez, and who has raged against austerity measures and structural reform.

I guess we now know what the electorate is against. “Say no to cuts!” But what is it for? Over in Ireland, the deputy leader of Sinn Fein, Mary Lou MacDonald, had the answer: “A No vote (to the ‘Austerity Treaty’) in Ireland will strengthen those arguing for jobs and growth.”

Well, who could not love a politician who promises jobs and growth? But the relationship between politics and jobs and growth is a tenuous one. Politicians are not savers who fund the creation of a capital stock through saving, and they are not entrepreneurs who put that capital to productive use. Politicians are people who spend other people’s money. In Ireland the budget deficit runs at 13 percent of GDP per annum, which according to Krugman’s logic must be a fantastic recipe for jobs and growth. Let’s just sit back and watch how that economic miracle is going to unfold.

My guess is that many people in Europe still know, or at least instinctively sense, that the promises of jobs and growth through state spending and money printing are hollow. They know that the state is bust and cannot keep spending money it doesn’t have. The policy options are much more limited than the campaign rhetoric indicates. On trend, fiscal consolidation and structural reform will continue, and Germany’s negotiating position will remain strong.

Yet, on the margin this was an indication that Europe, and in particular France, remain in many areas unreformable, and that the pressure on the ECB to sustain the unsustainable with sizable money injections will, if anything, intensify.

In the meantime, the debasement of paper money continues.

Under-f@%&ing-taxed author

The debate over taxing the rich has reached new depth in the United States with a true man of letters entering the fray. Depth, that is, as in low point. What the essay by acclaimed and popular novelist Stephen King lacked in profundity it made up for in profanity: Tax me, for f@%&’s sake, was Mr. King’s eloquent plea to the government he so admires.

One of the freedoms that Americans of any income bracket still enjoy is the freedom to give more to the government than the government already takes from them by force. If you think that the government can spend your money better than you can, you are free to write them an extra check each year and hand it over with your tax return. King grudgingly acknowledges that he, like everybody else, has that right but that is not enough for him. He wants to see the state take more from ‘rich’ people, himself included, by force, and thus put it to better uses than the rich people themselves ever could.

The essay is a bizarre document of economic illiteracy, political naivete, plain arrogance and bad language. Of course, Mr. King and his ‘liberal’ Hollywood friends, like Steven Spielberg, know how to put their wealth to good effect. They fund fire departments and run loss-making radio stations. But not all rich people are that enlightened. There are some who also “give their money away”, such as the hated Koch brothers who fund libertarian think tanks (Cato) or fund independent, coeducational schools, such as Deerfield Academy. For these deranged people we thankfully have a government that has the power to tax, take the wealth from these retards and puts it to all the good uses that only government (and the Stephens, King and Spielberg) can really appreciate. But even worse, there are those rich people who do not even “give their money away” but who – can you believe this? – invest  it. They expect to make a return on it. For themselves! Sometimes even by investing abroad. (How unpatriotic!) With proper taxation we could get a better society with fewer and smaller investment portfolios and more government spending. Who can’t see the beauty in that?

But here is a real highlight:

“At a rally in Florida (..), I pointed out that I was paying taxes of roughly 28 percent on my income. My question was, ‘How come I’m not paying 50?’”

To which the proper answer, in Stephen-King-lingo, would be: Why the f@%& just 50%, Stephen? Why not 75%? — Well, come to think of it, why not 80% or 90%?

Let’s look at one of those enlightened places where the rich have for some time been paying – what’s the phrase, again? – their “fair share” of 50 percent or thereabout: France. According to King’s logic this must be a workers’ paradise by now, complete with great state schools, social mobility for children of all backgrounds, all-round social harmony and a balanced budget. Maybe, Mr. King, you should leave Planet Hollywood for a minute, buy yourself a first-class ticket to France and look for yourself.

Meanwhile, the debate in France is all about how to tax the ‘rich’ more. In progressive France, Mr. King’s ideas are way behind the curve. They seem positively, well, reactionary.

“50% taxes for the rich? Stephen, mon ami, what are you? A Republicain?”

Soon-to-be President Francois Hollande suggested that upward of a million euro in income, the tax should be 75%, while his left-wing challenger, Jean-Luc Melenchon suggested that from a certain level the tax should be 100%, meaning that a maximum income is established, upwards of which everything will be taxed away and go to the state.

You see, Stephen, that is the problem with a ‘fair share’. Fairness is in the eye of the beholder.

What Stephen King and his rich ‘liberal’ friends don’t get is this: The government never has enough money. The state cannot handle money, period. It needs more and more. That is the nature of the state, in particular the nature of a modern social-democratic state that depends on the votes of the masses.

Every prosperous and peaceful society depends on social cooperation. Social cooperation has to be voluntary and contractual and therefore has to be based on the institution of private property. Our problem – in the U.S. and in France and elsewhere – is that we have too much government, which, by definition, is the negation of liberty, and which always replaces voluntary and free interaction with forced reallocation of resources and forced redirection of human action. The problem is not that the state has too little funds but that it has too much power.

But I doubt that Mr. King nor any of his friends have any understanding of what makes a prosperous and free society. As an example of the social mobility that was supposedly once possible in America thanks to government, Mr. King cites Barack Obama. I guess that is his idea of what America needs: lawyers, community organizers and politicians. And that is supposed to be the American dream?

Such opinions are indicative of the intellectual decline that drives our social and economic decline: According to our opinion moulders, politicians are better than businessmen, charity is better than business, taxation is better than investing.

“Whom the gods would destroy, they first make mad.”

In the meantime, the debasement of paper money continues.

Paul Krugman is the high priest of Keynesianism and modern interventionism, of economic improvement through inflation and budget deficits. As such he is bête noir among us libertarians and Austrian School economists. What makes him so annoying is his unquestioning, reflexive and almost childlike enthusiasm for state intervention, even in the face of its obvious failure, and his apparent unwillingness to probe any deeper into the real causes of our present economic problems or to show any willingness to investigate the effectiveness or ineffectiveness of his particular medicine. His Keynesian convictions are presented as articles of faith that no intelligent person can seriously question. A Krugmanesque argument is always built on a number of assumptions that are beyond doubt:

1)   Recessions, depressions and crises are the result of the unhampered market. We actually do not have to investigate if markets were really free when recessions occurred or what really were the specific causes of whatever threw the economy off track. When there is a recession, depression or crisis, there must have been too much of an uncontrolled market.

2)   The Great Depression was caused by uncontrolled markets.

3)   Recessions, depressions and crises are practically the result of one problem: a lack of aggregate demand. People, for whatever reason (and who cares about the reason; let’s not get hung up on those details) don’t spend enough. If everybody were to spend more, people would sell more. Problem solved. It is the role of government to get people spending again. This is done by printing money and causing inflation so that people spend the money rather than save it. Or by the government running up deficits and spending it on behalf of the stupid savers.

4)   The Great Depression was solved by the government spending lots of money and the central bank printing lots of money.

5)   This explains ALL economic problems.

6)   If there are recessions, depressions and crises, they can all be solved by printing money and by deficit spending.

7)   If after many rounds of money printing and deficit spending, there is still a recession, then only one conclusion is permissible: There was obviously not enough money printing and deficit spending. We need more of it.

8)   If after another round of money printing and deficit spending we still have a recession, then….well, do you not get it? We obviously have NOT PRINTED ENOUGH MONEY and we are NOT ACCUMULATING ENOUGH DEBT! And, by the way, remember 7) above.

Krugman is practicing Keynesianism as a religion. The 8 commandments above are not to be questioned. Whoever questions them is not worthy of debate. Consequently, Krugman has turned down requests to debate people like Peter Schiff or Bob Murphy. Interestingly, he agreed to debate Ron Paul on TV. The link is here.

I have to say that Ron Paul did not do as well as I had hoped he would. He did not sufficiently attack Krugman in my view, for the failure and ultimately disastrous consequences of his policy prescriptions. Krugman is the one who should be made to explain his policy recommendations and who has to answer the criticism that policies like the ones he is recommending got us into this mess in the first place and that his policy ideas have been implemented for years to no effect, at least no positive effect. Yet, Krugman succeeded in putting Paul on the defensive, something in which he was greatly helped by the following: While Krugman may be the most outstanding, unashamed and fundamentalist of the celebrity Keynesians, the attitudes of the general public, the other journalists and thus most of the TV viewers are predominantly shaped by Keynesianism as well, and this means that Krugman, more than Paul or any ‘Austrian’ debater, can rely on some sense of intellectual sympathy. Maybe the viewers don’t quite share the unquestioning dedication to the Faith, that Krugman epitomizes. Maybe they feel queasy about printing trillions of paper dollars and running trillion-dollar deficits. Of course, a true believer like Krugman will never allow himself such feelings. But in general, the public, too, believes that the free market (and greedy bankers) caused the financial crisis; that we need low interest rates and other government measures to stimulate the economy; and that inflation is really not our main concern. Krugman, I think, cleverly used these attitudes to present himself as the safe and rational choice, and Paul as the weirdo who wants to pour out the state-policy baby with the crisis bath water.

Ron Paul started strongly by pointing out that Krugman’s policy is based on the idea that a bureaucratic elite can set interest rates and decide how much money should be created, and that this involves an arrogant and dangerous pretence of knowledge. Very good point.

Immediately, the apostle Krugman raised his head. “You cannot get the state out of money.” “The Fed has to set interest rates.” “You cannot go back 150 years.”

I think this is where Ron Paul should have dug in and put Krugman on the defensive:

“Why not? There was no Fed before 1913. That the Fed made things more stable is your assumption. But is it true? People like you and Bernanke tell us that the gold standard was to blame for the Depression. In the run-up to the Depression we had a gold standard but we also had a Fed. How can you say that the gold standard was to blame and the Fed was ultimately the solution?

“Dr. Krugman just said, history told us. That is nonsense. History doesn’t tell us anything. You need theory to interpret history, and your theory is wrong. You assign blame for the depression according to your Keynesian theory. If that theory is wrong – and I think it is completely wrong – your interpretation of history is hopelessly wrong.

“Dr. Krugman, we no longer live in the 1930s. Why is it that you are harking back to those days? Are we still solving the Great Depression?

“Fact is that the monetary and economic institutions of America were shaped by people with your beliefs, Dr. Krugman. We have your system today. We have conducted and are conducting your policies. And, Dr. Krugman, do you really want to tell the American public that these policies and these institutions, such as the Fed, are working?

 “We have no gold standard. Since 1971, the Fed is entirely free to print as much money as it likes. That is your system, isn’t it? That is what you recommend. – You say the Fed needs to keep interest rates low and print money to stimulate growth. That is what the Fed did in 1998 after LTCM and the Russia default, just as you recommended. That is what the Fed did again after the NASDAQ bubble burst and after 9/11 – surely, that was not an Austrian policy but a Keynesian one. It was straight out of your rule book, Dr. Krugman.  You say the uninhibited market is to blame for the financial crisis. I say your policy is to blame. The mortgage bubble was blown by the ‘stimulus’ policy of the Fed – low interest rates and plenty new bank reserves – between 2001 and 2005. That was your recommendation, right? And those of your Keynesian buddies, such as Paul McCulley at Pimco.

“Since 2007, the Fed is conducting your policy. So is the US government. You demanded monetary stimulus and you got it. The Fed created $2 trillion dollars out of thin air. Interest rates have been zero for years. The US government is conducting stimulus policy to the tune of $1trillion-plus every year. Are you telling me, these are not Keynesian policies? What is it, Austrian policy?!

“What you are recommending has in fact been the guiding principle of global economic policy for years.  What you are recommending is a systematic distortion of the market place. It is persistent price distortion. That is why we had an unsustainable housing boom. That is why we had a mortgage boom. That is why we had a financial industry boom. And whenever these artificial booms – that you create with your policy – falter, the American public has to pay the price. And what do you suggest then? More of the same. More cheap credit. More government debt. In the hope that you can generate another artificial boom for which a later generation will again have to pay the price.

“Dr. Krugman, you just answered the question of this journalist about how much more debt we should accumulate, by saying maybe another 30 percent but that nobody can say for sure. I agree that nobody can say how much debt the system can still take. But tell us, why do you think that the next 30 percent of state debt will magically stimulate the economy and that these 30 percent will thus achieve what the previous 30 percent obviously failed to do.

“Dr. Krugman, you have me worried here.  And I think our viewers, too. The only response you have to the abject failure of your policies is that we should do more of them. Whatever Keynesian stimulus is being implemented and whatever money the Fed prints, all you ever say is that it is not enough. We need more. Has it ever occurred to you that maybe the problem is the policy itself? Maybe your medicine is making things worse and not better.

“And something else worries me, Dr. Krugman. When do we ever stop printing money and borrowing? I think that you are stuck in a failed paradigm, a failed economic theory and a failed policy program. This has happened to scientists and politicians before. You cannot admit that failure. When you are confronted with the failure of modern central banking, of Keynesian stimulus and of moderate inflationism, your only answer is that nothing is wrong with any of it, it is just not implemented forcefully enough. Dr. Krugman, you remind me of a doctor, who misdiagnosed the disease and prescribed the wrong medicine and who is now unwilling to look at the situation objectively. All you want to do is increase the dosage.

“If the viewers really want to understand what is going on, they should not buy Krugman’s new book but go to the website of the Mises Institute and look for some excellent Austrian School literature, in particular anything written by Ludwig von Mises himself. But if you don’t have time to do this, maybe you start by reading Paper Money Collapse.”

Well, I guess this is how it could have unfolded.

In the meantime, the debasement of paper money continues.

Headquarters of the IMF

“So what do you think should be done?”

I often get this question after I presented my case against our fiat money system, and I sense there is a trace of frustration in it, a bit along the lines of, you are telling us that we are in quite a mess but you offer no policy prescriptions. That is a fair point, I guess. Most writers who lament the economic ills of our time usually have a bag of policy advice on offer. Indeed, whispering new policy ideas into the ears of those in power is what most of these writers aspire to. I reckon what separates them from me is that they believe in government and I don’t.

The mess we are in is the result of policy, of the very idea – the silly idea – that the field of money and finance would work better if it were supervised, managed, guided and controlled by the state; that if we had clever, powerful and astute policymakers, consulted by economist philosopher kings, we could enjoy a smoother, better functioning economy. And if ever things were not running so smoothly, we would change the policy. So what is your policy, Mr. Schlichter?

Could you not be a bit more –

constructive?

My conclusion is straightforward. There should be no policy. The existence of policy is already the problem. What we need is proper capitalism in money and finance. We do not have that now. What we have is limitless state fiat money, quantitative easing, systematic market manipulation, bailouts, regulations, the IMF, the World Bank, the FSA, FDIC, TARP and LTRO. We need proper markets, not more policy, not more manipulation, and not more bureaucracy. And not more fiat money. We need the state to exit the field of money and banking. Completely.

The main problem with monetary policy is that there is such a thing as monetary policy.

The state is the problem. It will not be part of the solution.

Before I tell you what I think should be done, let me give you another reason why I have been so reluctant to offer policy advice. The aim of my book Paper Money Collapse was to expose widespread fallacies and debunk erroneous common wisdom concerning money. It was not to provide a program for reform. The book is meant to be an eye-opener. Almost the entire discussion on money and banking today is based on deeply flawed theories. This is true of the financial markets industry where I worked for 19 years. It is equally true of most of the discussion in the media and, as far as I can see, academia.

My intention was to challenge the present consensus and the established orthodoxy. I think this is what needs to happen before we can even talk about the drastic changes that our system requires. Any policy debate of the type you read in The Economist or The Financial Times occurs within the boundaries of the established consensus. Questions of a more fundamental nature cannot be addressed in the context of policy debates.

But I am not going to evade the question about policy. So let me talk a bit about policy and reform.

The first piece of advice is this one, naturally:

Don’t start here.

The big mistake has already been made. The gold standard was abandoned, in a step-by-step process that began around the time of World War I and that culminated in Nixon’s closing of the gold window in August 1971. For more than 40 years, gold has played no official role in global monetary affairs. State paper money ruled. Everywhere.

This was the era of the central banker, the monetary bureaucrat, of artificially cheap credit, of stimulus, of big equity rallies, of bigger real estate bubbles, of constant debasement, of the quick buck and the big bonus, of growing banks and of ever more sovereign debt. The global financial system got unhinged. After four decades of persistent inflationism we have an overstretched finance industry gravely addicted to the constant drip-feed of cheap money and an out-of-control public sector constantly issuing debt that will never get repaid. Capital misallocations and asset mispricing are gargantuan. The establishment prescribes itself ever more easy money to keep the show on the road.

So the first conclusion is, there is no painless exit. The cleansing crisis is inevitable. Simply being honest about the mess we are in would not be a bad starting point for policymakers.

And to acknowledge that this can’t go on forever.

It certainly won’t go on forever.

Okay, but what next? If you could design policy, what would it be? What is the number one thing that we need to change to restore financial sanity?

Fiat-money-critics have floated a whole range of policy proposals. There is the return to some form of gold standard. Also, there is the rather fiercely contested debate about whether fractional-reserve banking should be banned or at least restricted. Recently, colleagues of mine at the Cobden Centre in London have introduced a bill to Parliament that would make board members of banks personally liable for bank losses, which is supposed to reduce or eliminate moral hazard. Thus we are already faced with a range of policy proposals. What is my position on them?

I think we can have it much easier. My proposal is more effective and more easily communicated: Let us separate state and money completely. That is, I believe, the one thing that needs to change. Capitalism is the only economic system that works in the real world. But what we have today is monetary socialism, albeit a socialism predominantly to the benefit of the rich and well-connected.

We need to get the state out of the economy completely. To achieve this we must get the state out of ALL monetary affairs. The monetary sphere of society should be a no-go area for politicians and bureaucrats. State involvement in finance is the problem. Let us get the state out. Period. That is the one goal we should have. That is the one policy I recommend.

My enthusiasm for any other policy proposal varies considerably and is dependent on how much state intervention the policy still allows or in some cases even requires.

As an opponent of fiat money I am naturally positively inclined to a return to a gold standard. I believe that Mises was right when he wrote:

“If in the coming years or decades our civilization is not to collapse completely the gold standard will be restored.”

But what type of gold standard should be implemented? Would there still be central banks that would ‘administer’ that gold standard? Under any form of gold standard, the central bank would most certainly be more confined in its monetary operations than central banks are today but there could still be considerable room for manipulation. The US Fed was founded in 1913 under what was officially still the Classical Gold Standard but that didn’t stop it from funding the US government’s military spending in World War I and from initiating credit bubbles and business cycles. By 1933, the dislocations introduced by cheap money were so big that their dissolution – mandatory and normally automatic under a gold standard and indeed inconceivable under a proper gold standard – had become politically unacceptable. The Fed’s mission was accomplished and the gold standard was abandoned. The rest is history as they say.

An official, government-directed return to a gold standard also raises a lot of questions about implementation that would invite lobbying and horse-trading by various pressure groups. How much of the existing money stock – obscenely inflated after decades of money printing and fiat money debasement – should be backed by gold, or to put the same question in a different way, what should the new exchange rate between the money in circulation and gold be? How much should the existing money stock be devalued? Should banks be allowed to create deposits that are not backed by gold? Should fractional-reserve banking be permitted?

Questions over questions, and the room for political maneuvering and for political abuse are massive. Do we really want politicians, central bankers, bureaucrats, and their economic advisors make all these decisions? I don’t think so.

I know somebody who is best equipped to make all these decisions.

Mr. Market.

We may not all agree on the merits or demerits of fractional-reserve banking but as capitalists we should agree on the benefits, indeed the necessity, of free competition.

So how do we get from A to B? How do we get from the present system of finance socialism, of interest rates fixed by the central bank and asset prices manipulated by the central bank, of nominally private banks operating with the protection of a lender-of-last resort, to a system that again deserves the label capitalist?

Step 1: Privatize the central bank.

Do not even introduce a gold standard. Just transfer ownership of the central bank officially to the banks that have an account with the central bank. This is the first step for the state to exit the sphere of money. The central bank is no longer a public institution run by bureaucrats and politicians but an entirely private undertaking. It is owned and operated by the banks.

The central bank administers bank reserves and provides certain clearing functions. The banks need this, for now at least. Shutting the central bank down is not that easy. But its most pernicious aspect is that it is a policy tool. This would end abruptly with its privatization.

Step 2: The state revokes with immediate effect ALL laws and policies that relate specifically to banking and money.

From this moment on, banks are capitalist enterprises just like any other normal business. There is no lender of last resort (at least not one run by the state), there is no inflation target or other official monetary policy for which the banks function as conduits, which under the present system puts them in the strange position of being profit-seeking enterprises and policy-transmission mechanisms simultaneously. But equally, there is no backstop for the banks from the state any longer. No guarantees, no deposit insurance or taxpayer bailouts. If a deposit insurance institution exists, it is handed over to the banks, similar to the central bank. Again, the state has exited the business of regulating, supervising, licensing, subsidizing and backstopping the banking industry.

Entry into the field of banking is now free. You do not need a license. You do not need an account with the now privately owned central bank (although without such an account clearing with other banks might be difficult). There are no legal tender laws anymore, so if anybody has any bright new ideas about money (Liberty Dollars, bitcoin) they are most welcome to try them. The consumer alone will decide over success and failure.

Monetary policy has ended. Bernanke testimonies on TV will be replaced with reruns of old Simpson episodes. Senators and congressmen will have to find new soapboxes from which to propound their personal economic theories.

Step 3: The state’s gold hoard is handed over to the banks.

What? A gift to the bankers? – I do not consider this a gift to the banks but more a return of property to the bank depositors. The bank depositors are the ones that should benefit from this transfer most.

The present monetary system could only have come about because it was once based on gold. Deposit banking spread at a time when banks still promised to repay deposits or banknotes in specie, and when all banks were thus required to hold (some) gold reserves – reserves that no political entity could create at will. Only slowly and gradually was the gold backing removed and replaced with various implicit or explicit state guarantees, all of which are now practically failing.

Of course, just like investment genius Warren Buffett, the bankers may not know what to do with a pile of gold and may thus be tempted to simply put it on a big heap. I suspect, however, that the bankers will have a very good use for the gold. Their customers – the holders of bank deposits – may be very unsettled by the exit of the state and thus the taxpayer from the business of underwriting the banking industry. Most people only consider their bank deposits safe because they believe the state would not allow Bank XYZ to default, not because they have any confidence that Bank XYZ is run prudently. Now that the state has exited the field of money and banking, the banks are likely to use the gold as additional backing for their balance sheets. They will use the gold as it has been used for thousands of years – to gain trust. And to avoid bank runs.

Will the gold hoard be sufficient?

I don’t know.

Presently, the US government sits on 260 million ounces of gold. At the present gold price of $1,655 per ounce, we are talking $430 billion. The monetary base is presently $2,673 billion; M1 is $2,220 billion and M2 minus money market funds is $9,163 billion. The gold hoard is thus only 16%, 19%, and 5% of these money stocks, respectively. Hardly a proper gold standard but it could be a start. Through proper balance sheet deleveraging and through additional gold purchases the private banks are obviously free to improve these ratios. (Again it is not for bureaucrats or economists to decide what is appropriate. This is the role of the banking entrepreneur.)

But now that the private banks own the central bank, would they not put the printing press into overdrive and create inflation?

I don’t think so. Through quantitative easing the central bank accumulates assets from the banking sector and expands the money supply. The central bank leverages its own balance sheet in the process. The Fed is already levered more than 50 to one, which is more than Lehman and Bear Stearns were when they collapsed. But now the banks own the capital of the Fed. They foot the bill, not the taxpayer. The banks can no longer dump unwanted assets on the central bank. They own the central bank. They cannot transfer risk to it.

Additionally, the public will be very suspicious of an overtly expansionary central bank. They know it is operated by the private banks and entirely for their own benefit. Any inflation concerns will translate into higher interest rates and that is detrimental to the highly leveraged banking sector. I would expect the private banks, now operating without any safety net from the state but under the suspicious gaze of their own customers, to be very cautious about how much money they print.

Easy money is great for the banks for as long as they can lower reserve and capital ratios. That was much easier when they could rely on government backstops or when meeting official regulatory requirements already gave their balance sheet policy an official seal of approval. Now that they are on their own, monetary expansion and thus debt accumulation and leverage are a double-edged sword. It will pay again to run a bank prudently and even advertise your higher capital and reserve ratios.

Furthermore, the relatively sounder banks (if we assume for a moment that those indeed exist) have little interest in running the jointly owned central bank for the benefit of the weakest banks. To the contrary, it is in the interest of the stronger banks to see weaker banks fail and exit the market. At the same time, it is not in the interest of even the strongest banks to see widespread bank runs or a general distrust in banks as that could quickly come to haunt them, too. I think it is very reasonable to assume that under my plan of complete privatization the key challenge of allowing corporate failure in banking on the one hand but avoiding a complete collapse of the banking system on the other will be managed much better. The reason is that this task is now given to bankers as entrepreneurs who have a keen interest in getting that balance right. As long as banking is under the protection of the state, monetary and banking policy will be conducted for the benefit of the weakest banks, and the strongest banks will simply reap windfall profits.

Does the state get off too lightly?

The state no longer has any responsibility for the banks or money. No more setting of policy, no big hearings in Washington, no bailouts, no IMF, no World Bank. A lot of money will be saved and many explicit and implicit claims on the taxpayer will be eliminated. But also, the state can no longer tell the banks that government bonds are safe and encourage the banks through bank regulation and official capital requirements to invest in them. There is no longer any bank regulation from the state. Banks will be regulated by the market, which means ultimately by the consumer. The state also loses the central bank and can thus no longer create an artificial demand for its securities. Remember, last year 61% of new Treasuries were placed with the Fed. Why should the banks, which now own the central bank, continue to accept this?

Government bonds everywhere benefit from the idea that states can’t go bankrupt because they can always print the money. This idea is fundamentally wrong as I have argued repeatedly. Once the debt load reaches a certain level, it can no longer be inflated away. If this is still tried, currency disaster will ensue. Be that as it may, with the state officially separated from the field of money and banking, it would have to manage its finances like any other entity, like a private corporation or a household (or almost like any other entity as it still benefits from the privilege of taxation). We would certainly see higher state borrowing costs, lower levels of spending and smaller deficits. This would be an important step to what Doug Casey calls “starving the beast”.

Of course, in such an environment we would not have to worry at all about how the banks arrange their executive pay, how their bonus schemes work, or if bank shareholders hold their board members at all responsible for their mistakes and failures. These are internal affairs of entirely private and capitalist enterprises. If bank shareholders get this wrong and set the wrong incentives, only they will bear the consequences. The idea that banking is a public service for which a specific set of rules and regulations must be designed and administered by the state does no longer apply.

Come to think of it, this proposal looks much better in terms of consistency and clarity than any other, in my humble opinion. Those who argue for an official gold standard are asking the state to design and implement a new monetary order. Those who ask for a ban on fractional-reserve banking ask the state to define what constitutes legitimate banking business and then enforce it. Those who want to introduce new legislation in response to executive pay and bonus schemes, ask the state to interfere in the relationship between shareholder (principal) and manager (agent).

I ask the state to do just one thing: Get the hell out of money and banking! Now!

In the meantime, the debasement of paper money continues.

International, inelastic, apolitical, lasting. (photo by Swiss Banker)

I hate to give personal investment advice. So please do me a favour and do not treat the following as investment advice. I am expressing my personal opinion here. I do so with honesty and conviction, without a personal agenda – I am not trying to sell you anything – but with some good arguments, hopefully. However, it is still an opinion. Nobody knows what the future will bring. I don’t know what will happen to the gold price in the next week, the next month or for the rest of this year. I don’t even know what 2013 will bring but please remember, neither do all the ‘experts’ out there who are much less squeamish about giving investment advice than I am. When you invest your wealth you are alone. You have to make up your own mind. And accept the consequences of your decisions.

Having said this, I can assure you that, personally, I remain a big fan of gold. I consider it the number one asset out there. It remains head-to-shoulder above anything else.

Gold has not been trading that well recently. Measured in the world’s number one paper money the precious metal reached an all-time high of slightly more than $1,900 per ounce in September of last year but then retreated and has mainly been trading sideways in a wide range since. Considering the ongoing tensions in European debt and banking markets and considering that the global financial system seems forever dependent on super-low policy rates, one could have reasonably expected gold to do better. The reasons for the somewhat disappointing ‘price action’ of late are not quite clear but could be manifold. Maybe it is a bit of rally fatigue. Don’t forget, gold traded below $300 ten years ago and had just been through a decade-long, unprecedented bull run. In one of gold’s biggest markets – India – the government recently introduced new taxes and regulations to discourage investment in gold (surprise, surprise), and international central banks are not believed to match their healthy buying of recent years. But the optimists will say it is something else: things are getting better so there is less need for a crisis-asset.

This is how the Wall Street Journal put it:

“Gold is still benefiting from the view the global economy is fragile, but the idea has been shaken by signs that conditions are stabilizing in the U.S.”

Are things getting better? Well, as I argued here, it doesn’t really matter. Nevertheless, let’s have a look at gold as a self-defence asset.

Naturally, the financial and political establishment is rejoicing at the prospect of gold losing its luster. After all, the phenomenal ten-year bull market was the equivalent of a raised middle finger in the face of the international paper money bureaucracy. Ben Bernanke, the money-printer-in-chief, famously answered Ron Paul’s question if gold was money by saying he thought it wasn’t, and that

“I think the reason people hold gold is as a protection against what we call ‘tail risk’  - really, really bad outcomes…To the extent that the last few years have made people more worried about the potential of a major crisis, then they have gold as a protection.”

And this is precisely why the establishment hates gold so much. The modern policy elite, people like Bernanke and his fellow central bankers, are tasked with avoiding bad outcomes, and they have at their disposal a body of theories (in large part faulty) and an interventionist tool kit that did not exist through most of gold’s three-thousand year history as the entire world’s monetary asset of choice. This tool kit, not least of which is the printing press, is supposed to enable the policy establishment to run the economy smoothly and efficiently and save us from depression and crisis. For the public to turn back to the ‘barbaric relic’ of gold certainly means a major vote of no-confidence for the modern financial architecture and all its supposed safety-valves.

The brilliant Jim Grant calls our post-1971 unrestricted paper money system astutely the ‘PhD-Standard’: We are asked to no longer rely on the apolitical and disinterested firmness of a precious metal to anchor the monetary system and to thus prevent financial extravagance and excess, but to put our economic fate in the hands of a bunch of self-confident and proactive intellectuals and bureaucrats who learnt how the world works by shuffling academic papers in the MIT economics department. Understandably, many people have more trust in gold. (By the way, this explains why the Financial Times, which adores and celebrates the policy establishment like no other media outlet I know of, only writes about gold when it goes down, when the gold ‘bubble’ is once again ‘bursting’, providing the FT with another opportunity to remind you that gold does not pay a dividend.)

Funny how Bernanke puts it with his ‘really, really bad outcomes’ and ‘tail risk’. He makes it sound as if you have to be a pessimist of biblical proportions to buy gold. Things must get ‘really, really bad’ because for anything else we have the Federal Reserve. Relax!

Limited understanding meets unlimited power to print

But the problem runs deeper than Bernanke implies. Much deeper.

While Bernanke’s quote contains some truth it also reveals an embarrassing misunderstanding of the nature of the problem, a misunderstanding that he shares with the majority of his policy-buddies: He implies that these “really, really bad outcomes” are just random and uncontrollable events, unquantifiable statistical outliers, freak occurrences that simply happen, that capitalism in its mysterious unpredictability occasionally throws at us. This is nonsense but this distorted worldview also shone through clearly in Bernanke’s recent lecture series. Inflations, recessions, depressions, asset ‘bubbles’ – all these things come over us like acts of God, like droughts and hailstorms, and Bernanke & Co. are charged with dealing with them on our behalf – and the rising gold price is merely an indication that some folks fail to appreciate the establishment’s good work. Hell, can nobody get any respect any more?

No – the problem runs much deeper than Bernanke seems to grasp, and that is precisely why gold is such a great asset in this environment. His limited understanding coupled with his unlimited power to produce paper money is indeed the number one argument for owning gold.

The present crisis is not an accident of capitalism but the inevitable product of the fiat money system and the faulty theories and counterproductive policies of Bernanke & Co. The present crisis is not just another business cycle – and business cycles are, of course, also created by central banks – but the unavoidable consequence of the political decision to abandon a gold standard and to adopt – in 1971- a system of unrestricted fiat money creation. As I explain in detail in my book Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown such a system, while appearing stable for a long time, inevitably accumulates imbalances as it systematically distorts capital formation and asset pricing. The constant artificial cheapening of credit through ongoing money injection – falsely deemed to be harmless or even beneficial because moderate inflation is supposed to be good – must culminate in the present horror show of bloated banks, inflated asset prices and an unsustainable debt load.

The really, really bad outcome is entirely home-made and the fully guaranteed by-product of decades of mild to medium inflationism, i.e. the modus operandi of modern central banking. The crisis is built into the system; it is part of the game. Bernanke still believes that his ongoing money printing is saving the world when it is indeed the root cause of this entire disaster. While Mr. Bernanke poses confidently, and I believe honestly yet entirely erroneously as a fire-fighter; he is really an arsonist, and his ‘stimulus’ is adding ever more fuel to the fire.

We should not buy gold because Bernanke’s policy (and that of other central bankers) is ineffectual but because it is, in an unintended and ironic way, all too effective. This policy preserves the accumulated imbalances, it sabotages their dissolution and liquidation, and it constantly funds new imbalances. His policy is guaranteeing the never-ending crisis (almost never-ending I should say, as it will end in a currency catastrophe when the public begins to shun his fiat money and when paper money becomes a hot potato). We do not own gold because we fear that Bernanke may stop his policy of saving the government and Wall Street, and because that may then lead to a really, really bad outcome. We own gold because we think he won’t stop saving them thus making a really, really bad outcome guaranteed.

Contrary to what Bernanke’s statement implies and what he undoubtedly believes, it is not by his policy activism that he may restore lasting confidence and stability and thus end the bull market in gold. If he wanted to undermine gold he would have to become passive, not ever more active. Paul Volcker successfully ended a gold rally (or, more accurately, put it to rest for 20 years) not by using the printing press to bail out the world a la Bernanke & Co. but, au contraire, by stopping the printing press altogether and allowing high real interest rates to cleanse the system of the imbalances from previous money production. That is what ended the last gold bull market and it is still the major threat to today’s bull market. However, I consider it very unlikely at present. Bernanke is no Volcker, and stopping the printing presses today will create bigger challenges than in 1979.

Not the crisis is the reason people seek safety in gold. It is policy that they seek protection from.

If gold is, for the time being, retreating because the investing public sees less need for it with monetary and fiscal stimulus presently sustaining the impression – the illusion, really – of stability and sustainability, then this is a great opportunity to buy gold.

In defence of “hoarding”

Let’s look at the logic of investing in gold. When doing so we immediately are confronted with widespread antipathy towards it founded on ignorance and misunderstanding: We gold bugs are not only pessimists who want to make money when the world goes to hell in a hand-basket, we even remove our spending power from the markets for consumer and producer goods and invest our wealth in “barren” and “unproductive” monetary assets. Shame on us!

Capitalist money

I use the term “monetary asset” as I do not want here to go into the debate about whether gold is presently money or not. I know that you cannot buy a bus ticket with a gold coin but that is not what we are discussing here. For the purpose of this investigation gold is (almost) equivalent to physical paper money, i.e. to cash under the mattress. The person who invests in bullion does so for the same reason that somebody may hold a large pile of banknotes in a safe, namely to not commit this part of his wealth to consumer goods that may fulfill his present consumption needs or to producer goods that promise an investment return (dividends and interest). He is holding money – that is, gold or physical cash- because he wants to conserve his purchasing power and retain the flexibility of spending that purchasing power on consumer and producer goods some time later but still at the drop of a hat. Money is the most fungible good, the one that can most easily be traded for goods and services. People hold money because they value that flexibility and the maintenance of their purchasing power higher than what they can get for their money at present prices, including what they can get for it in terms of investment goods at present prices.

There are, of course, important differences between gold and cash. The latter is presently slightly more fungible. Remember the bus ticket. On the other hand, there is no limit to how much paper money central banks can produce today. For the paper money holder debasement is not only a risk it is almost a certainty as it is the declared goal of those in charge of the money franchise. I come back to that later.

Keynes had a keen eye for widespread prejudices (against the rentier class, against saving and against money hoarding) and was not above providing pseudo-scientific justifications for these prejudices. Thus, his silly ‘liquidity preference theory’ in his General Theory (in particular chapter 15), according to which it is okay to hold money to be ready for immediate transactions but not okay to hold money because you simply want to sit on the sidelines and retain purchasing power.

This is, of course, complete nonsense. Money, like any other asset, is only an asset because it fulfils the needs of its owners. Consumer goods fulfil consumption needs, investment goods promise monetary return, and money provides flexibility and security (at least honest money does) in an uncertain world.

As Henry Hazlitt has pointed out so well in his critique of Keynesianism, the “hoarder” of money does not speculate in money, as Keynes alleges, but simply refuses to speculate in bonds and stocks and other assets at prevailing prices. He has absolutely nothing against investing in “productive assets”; he just does not want to buy them at the current inflated and artificial prices.

Ben Bernanke (Photo by U.S. Federal Reserve)

Concerns about the stability of the overall economy and the sustainability of high asset prices are most prevalent at the end of credit booms when cheap money has created a false sense of prosperity and economic vitality, and when the prices of bonds, stocks and real estate are elevated by years of easy credit. In a system of inelastic money, such as a gold standard, growing demand for money at that late stage of the cycle will cause money’s purchasing power to rise and the money-prices of goods and services to fall (deflation). At the new and lower prices demand shifts back from money to other, non-monetary assets. “Hoarding” ends naturally; it is self-correcting. When money’s purchasing power rises, the opportunity costs of holding wealth in the form of money rise, and so does the attraction of spending that money on consumer or producer goods.

That money is not an unproductive asset has been argued by W.H. Hutt in his seminal essay “The Yield from Money Held” from 1956. For an excellent exposition of this view see this speech by Hans-Hermann Hoppe on the same topic. Holding money – and in particular inelastic money proper – is a sensible, legitimate, rational and by no means destructive strategy.

As I argued repeatedly, we have had an on-and-off but mainly on fiat money boom for 40 years. Capital misallocations and asset price distortions are massive. How big they are and where precisely they are located, nobody can tell. We would have to stop printing money and let the market expose the dislocations and then liquidate them but that is the one thing that authorities do not want to let happen. Be that as it may, the public’s desire to step back from inflated and systematically manipulated asset markets is understandable and entirely justified and naturally translates into demand for money – put proper, apolitical and honest money. i.e. gold.

But Bernanke & Co., just likes Keynes in his time, do not want you to disengage from speculation in bonds and stocks and real estate. Moving to the sidelines is strictly verboten. You have to keep playing – with your own hard earned savings. The policy establishment believes that it can manipulate the economy by manipulating your desire for assets through the manipulation of interest rates via the printing of money. These manipulations have to be ever more blatant, direct and heavy-handed. Manipulation used to be conducted in a roundabout way by just administratively easing the refinancing conditions for banks and then waiting for the ‘stimulus’ to play out in the wider capital markets and the economy. Now that this policy has brought us the aforementioned imbalances, the central banks have to manipulate asset prices openly and ever more directly via ‘quantitative easing’.

Here is Bernanke defending the practice in 2010:

“This approach (quantitative easing) eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

If you believe that this brazen manipulation by the paper money bureaucracy is going to work and that it will restore and then guarantee stability and prosperity, you can do without gold. Jump right back in. Put your savings at the mercy of the Great Manipulator! Good luck!

I would only feel comfortable participating in these asset markets if I were confident they were not rigged. It is not a good idea to invest in assets whose prices are artificially inflated for political reasons. The biggest danger, in my view, presently exists in bond markets, in particular in government bonds. As to equity markets, where would they trade without zero interest rates, and where will they trade when inflation picks up?

Sitting on the sidelines makes a lot of sense to me. I want to hold money but it cannot be paper money or bank deposits, as both represent state fiat money that the policy establishment will continue to create like confetti. Additionally, a bank deposit may be your asset but it is equally the bank’s liability, and banks everywhere are on life-support. Therefore, you have to go back to the eternal and international form of money: gold, which is not anybody’s liability but just your asset.

What about other ‘real assets’, such as property or farmland? Well, I guess you have to have considerable wealth to invest meaningfully in farmland. Also, the yield on farmland in places like Europe is very low and often dependent on state subsidies. With governments everywhere going bankrupt you have to expect those subsidies to be cut at some point with potentially adverse consequences for the value of that land. Be that as it may, I think it is generally a bad idea to invest in a way that makes you dependent on government spending. Additionally – and this is something that applies to all forms of real estate – you have to expect the level of property taxes to rise. This is low-hanging fruit for the taxman as things are getting desperate for him, too.

All major central banks are in pretty much the same sticky position. None of them have an exit strategy. The Fed has not expanded the monetary base since June of last year. That is not because monetary prudence has set in but because the steroids from the last round of QE are still working. Banks are doing the money creation themselves again. M1 has expanded by 14 percent since last summer, non-annualized. No deleveraging here. Additionally, the myth of Treasurys as safe assets is still alive and kicking, against all evidence to the contrary and probably thanks to the present fixation with Europe. When banks and sovereigns come under pressure again the monetary floodgates will be opened. Just look at the ECB and their recent €1 trillion-plus money injection.

“We’re on crack,” as John Hathaway, the manager of the Tocqueville Gold Fund put is so astutely in the Wall Street Journal. The financial community is completely addicted to cheap money and ongoing stimulus. Just wait for the withdrawal symptoms to set in and you can rely on another round from Bernanke & Co. Unless I see a Volcker-like figure emerging, the avenger of the paper standard, I am happy to sit with eternal money.

In the meantime, the debasement of paper money continues.

Unlimited Euros!, photo by Florian K.

Surprise, surprise, the Euro Zone debt crisis is back. Or was it never gone?

As yields on Spanish and Italian government bonds are heading higher once again, I am reminded of the old saying, you can’t fool all of the people all of the time. Not even with a trillion euros.

I previously described the relationship between banks and states as that of two drowning sailors who desperately cling to one another, and I still think it is an apt description of the charade that is being orchestrated in Europe and that is already wearing thin. Here is the Wall Street Journal Europe from March 29:

“The European Central Bank’s massive injections of cash into the banking system haven’t yet reached companies and households but have benefited governments…

Bank-lending growth to the private sector slowed to 0.7% in February compared with the year-earlier period, after rising 1.1% in January, unadjusted ECB data showed.

Thanks to the ECB funds, banks’ lending to governments grew at a 6% rate in February, up from 4.9% in January, though lending to other parts of the economy remained weak. Purchases of euro-area government debt by banks rose sharply, ECB figures show. Portuguese banks bought €4.24 billion of government bonds in February, up from €543 million in January. Greek banks purchased government bonds valued at €4.12 billion, after selling €128 million in January.

Italian banks bought €23 billion in euro-area government debt last month, even more than the €22.6 billion they bought in January in the immediate aftermath of the first LTRO. Spanish banks reduced their net purchases to €15.7 billion from €22.9 billion. ”

So bankrupt banks bail out bankrupt governments, which then bail out the bankrupt banks. All funded by the printing press. Hey, who needs those pesky savers or who even needs capital markets? We make our own prices!

But it was never going to last, was it? I would have given it a few more months but even that appears to have been too optimistic. Maybe the number of the hopelessly gullible and wilfully delusional is smaller than I thought.

What now?

No prize for guessing what the establishment wants.  – You got it! More free money.

“Alfredo Sáenz, chief executive of Spain’s Banco Santander SA, the largest bank in the euro zone by market value, called for ECB purchases of government debt, something the central bank has been loath to do except in small quantities.

‘The ECB has helped monetary expansion with its recent measures, but in my opinion, it should be more aggressive in the purchase of government and bank debt—that is, stronger European quantitative easing,’ Mr. Sáenz said at a banking conference.”

But then, of course he would say that. Alfredo Saenz Abad is a member of Europe’s financial elite. In 2007, his total compensation as Santander CEO was €9,604,000.00. Well, you may say, that was in 2007 when Spain’s real estate boom was still in full flow and the country enjoyed a triple-A rating. That’s true, and indeed by 2010, Senior Saenz’ total compensation had dropped to €9,179,000.00. I guess his paycheck is doing precisely what Spanish banking is doing, that is, not deleveraging. And why should they? As long as the free money is gushing out of the ECB, let’s pretend and extend. Mr. Draghi, new chips please!

Unlimited and never-ending!

Poor ECB. On many measures, the Frankfurt-based central bank is already the most aggressive monetizer on the planet, its waistline expanding faster than that of anyone else. Yet, funding every dodgy bank in its jurisdiction and accepting even the old carpets with the beer stains from the last office party as collateral has not convinced its doubters that the ECB is doing its fair share in market manipulation. No matter how many euros are raining from the ECB helicopters, the Telegraph’s Ambrose Evans-Pritchard is perennially whinging about the ECB’s tightfistedness and suspects the sinister dealings of some nasty German Bundesbankers in the background. His latest column quotes Guy Mandy of Nomura who stresses that the ECB’s ‘long term refinance operation’

“is entirely different from the stimulus of the Anglo-Saxon central banks. ‘There has been no transfer of risk to the ECB’s own balance sheet, which is what we think is needed to take away the tail-risk of another EMU blow-up.’”

Ah, you see? The accumulated toxic waste on the balance sheets of nominally private banks – such as Mr. Saenz’ – not only should be funded at zero cost forever but should be socialized wholesale. All past errors must be forgiven, the cost to be borne by the masses of fiat-money-users, so that another round of lending can commence. Hooray, we are to borrow ourselves out of a debt crisis.

And here is David Owen of Jefferies Fixed Income in the same piece:

“‘The ECB says its action is ‘temporary and limited’, and that is precisely the problem,’ he said. ‘They are making things worse with piecemeal measures’”.

I get it. Printing ever more money is the solution. It just has to be never-ending and unlimited to really work!

Of course, this is complete economic lunacy. Economics is the science of how we use social institutions such as private property and voluntary exchange on free markets to make the best use of scarce resources. These alleged financial ‘experts’ want to do away with scarcity. For them the printing press allows scarcity to disappear. Money has to be ‘unlimited’ and ‘free’ for the economy to work but these are two words that have no place in economics.

We are in this mess because our financial system has artificially cheapened credit for too long. These ‘experts’ tell us the solution is to cheapen credit further and ever more aggressively. There is never too much old debt, only too little new money.

Be that as it may, Evans-Pritchard, Mandy, Owen and Saenz Abad will get their way. The money-printing will not end because it cannot end. Nobody wants to take the pain. This is why I do not believe the deflationary forces that undeniable exist and that many of my readers worry about, will be allowed to get the upper hand. We are on the road to complete monetary meltdown, and no, my friends, we do not have another 20 years.

The Paper Aristocracy

Coming back to Banco Santander’s Senior Saenz: I was somewhat reluctant to mention his compensation as it can easily and unfairly associate me with the many habitual banker-bashers out there, a group that is already heavily populated with the economically illiterate and the perennially envious and, what’s worse, the many statists who believe that the solution to all our ills is more government intervention, more regulation and more taxation. Nothing could be further from my position.

I have absolutely no problem with people earning a lot of money, even millions or billions. As I have explained elsewhere, I am an advocate of 100-percent capitalism, of what Hans-Hermann Hoppe calls a private law society, in which the same rules apply to everybody (no legal privileges and no state authority) and where everything is based on voluntary, private, contractual cooperation.

In a free market, there is only one way to make money and to keep your accumulated wealth, which is to produce and keep producing something that your fellow citizens voluntarily spend money on. Bill Gates, Steve Jobs and Mark Zuckerberg didn’t steal the billions that made them rich (at least not to the best of my knowledge), and they did not and could not rely on ‘government stimulus’ or the backstop of a lender-of-last-resort. Like thousands of other and less well-known entrepreneurs and capitalists out there, who keep our economy going and who create the real wealth that makes our high living standards possible, they earned money in the marketplace by serving the ever-fickle consumer with his constantly changing tastes and desires, and if they had gotten it wrong at some step on the way, they would have potentially lost everything – and that can indeed still happen. They did not take from us. We, the consumers, made them rich by buying their produce. And if you want to be rich yourself you may want to take a close look at their example and create something that many people want – and if you want to be really rich, that hundreds of millions of people want.

Of course, most of us do not have it in us to be entrepreneurs. We contribute by working for entrepreneurs or investing with them. And by doing so, we play our part in bringing about a striving, wealth-creating economy.

Our financial system, however, has little to do with capitalism. This is what the banker-bashers don’t get: Our financial system is not bankrupt because we got bad bankers. We got bad bankers because of a corrupt financial system. The unholy alliance between states and banks that has brought this crisis about, and that will make it still worse, is the direct result of our fiat money system. Under a state-fiat-money franchise administered by lender-of-last-resort central banks that are tasked with cheapening credit through constant monetary debasement, banks cannot be capitalist enterprises subject to the controlling forces of the marketplace. In such a system, banks are essentially extensions of the central bank. They are conduits for monetary policy. Of course, the banks happily play this role as long as possible because their participation in the money-creation process is profitable to them, and it comes with an extra safety-net that all truly capitalist firms have to do without. But this monetary socialism only lasts until it chokes on its accumulated imbalances. That is when the overleveraged banks and debt-addicted governments finally stare into the abyss.

To call our fiat-money-based financial system ‘capitalist’ is not only incorrect it is a dangerous misrepresentation. It gives capitalism a bad name. We should not let those who benefit from the fiat money privilege adopt the label ‘capitalists’ for themselves. So what should we call them?

The late Howard S. Katz coined the phrase the ‘paper aristocracy’ in his book of the same name. He wrote it in 1976, five years after Nixon closed the gold window and ushered in the period of unlimited money creation. Katz proved prophetic:

“The mild evils we know today (1976) are all the effect of a specific cause. For the past generation that cause has been operating in a mild form. But in 1971 a fundamental change was made so that the cause is now operating in a most virulent form. Unless those decisions, made between late 1970 and late 1971, are reversed, we are going to see our society collapse about our heads.

What is happening in America today (1976) is that we are seeing the formation of an aristocratic class – a new power structure which will be to the America of the future (if indeed our descendants of the 21^st century live in a place called the United States of America) as the ancient king and feudal lords who ruled society at that time were to the Dark and Middle Ages.

An aristocracy is a small elite who, through control of the government, have obtained special privileges in law and are thus enabled to live as parasites on the labor of others; by means of this exploitation they amass large amounts of unearned wealth. By this definition there is already an aristocracy in existence in America. But it has not yet consolidated its power and does not yet dare to come out in the open.”

In the early 21^st century there still is a place called the United States of America but I doubt that anybody in the mid-1970s, maybe not even Howard S. Katz, would have guessed that millions of ‘free’ Americans would be lining up at airports to be searched and x-rayed by members of a giant, 216,000-employee strong Department of Homeland Security.

Americans are supposed to believe that all of this will protect them from Islamist terrorists and ensure their freedom. But I reckon that this organization could come in handy for other domestic emergencies once the fiscal house of cards comes crashing down and America does a Greece – and given the country’s by now well-established fiscal trajectory of $1-trillion-plus federal deficits per annum, mainly funded by the Fed, that is only a question of time. Pointedly, the Department of Homeland Security has recently ordered 450 million new rounds of ammo to protect a domestic population of 313 million.

Already Americans are subject to de-facto capital controls. If you are an American and you don’t believe me, try opening a Swiss bank account. And with FATCA coming up – the Foreign Account Tax Compliance Act, by which the US government arrogantly co-opts the entire global financial system into the service of the US Inland Revenue – it will get harder to open an account anywhere in the developed world. And by the way ‘they’ are already working on new laws that prohibit you from travelling abroad if you owe money to the IRS.

These trends are not confined to the US but can be detected everywhere in the developed world. As the state fiat money system approaches its endgame, the state and its lackeys in the media are doing everything to blame the mess on the wealthy in general and on too much freedom. More controls, more state power, more restrictions – the recipes are the same everywhere. It is just that we libertarians understand what America once stood for and we naively still hold it to a higher standard as indeed America did herself once.

In the meantime, the debasement of paper money continues.

Image: Graur Codrin

I was thinking of starting this blog with a cynical comment along the lines of, last week equity markets came off, I think we need another €1 trillion from the ECB! – Okay, maybe it wasn’t the greatest joke but you get the idea. But then the Wall Street Journal beat me to it, and they weren’t even trying to be funny. In an article on weaker data in the Euro Zone one could find this remark:

“The unexpected drop in the purchasing managers’ index survey suggests more stimulus from the European Central Bank through interest-rate cuts or additional bank lending may be required to protect the economy from a more severe downturn.”

Sure. And why not?

Over the past 12 months the ECB expanded its balance sheet by 54 percent. At around 30 percent of GDP that balance sheet is now the biggest among the major central banks. The ECB’s printing press is providing an ‘unlimited’ backstop for all those financial ‘assets’ that nobody in their right mind would buy with their own savings, and providing ‘unlimited’ funding for the European banks, which are now permanently in intensive care. And we have to admit the strategy is not without success: Your neighbourhood Greek bank is again a going concern and those Spanish governments bonds are once more highly sought-after investments, even at single-digit yields. So, why not print another €1 trillion to get the economy really going? Isn’t it time the ECB really put its back into this whole stimulus business?

What a great policy ‘stimulus’ was back in 2001 when the Fed also ‘protected the economy from a more severe downturn’ and kept rates at 1 percent and blew the biggest housing bubble ever and thus set the world up for an even bigger ‘downturn’ in 2007. If you think about it, all our present problems are the result of past ‘stimulus’ – of past efforts to keep interest rates low and to ‘stimulate’ borrowing and encourage leverage. Now the interventionists of every couleur tell us that we can only get out of this mess by depressing interest rates even further for even longer.

Einstein said that the definition of stupidity was to do the same thing over and over again and expect a different outcome. This makes me wonder if economic intelligence has already been a victim of this unfolding crisis.

Exit the exit strategy.

That may well be so. Last week I read somewhere that a hard-left candidate in France (not Hollande, someone even more to the left of him) demands that the ECB lends money directly to companies. I think that this idea is not that farfetched considering how quickly and easily today’s consensus has embraced extreme policy intervention. Only five years ago it would have been unthinkable that the world’s major central banks would become the biggest marginal buyers and single largest holders of their countries’ sovereign debt, or that they would offer unlimited free loans to their banks with multiple-year maturities against the dodgiest of collateral. These used to be the type of irresponsible things that responsible central bankers scoffed at. Today, this is standard practice in most of the highly industrialized world. What was crazy five years ago is now merely ‘unconventional’.

And this evolution should not come as a surprise. As I explained in Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown, what we are seeing is indeed the logic of the state fiat money system taken to its natural conclusion. The raison d’etre of the system was to not leave the setting of interest rates and the availability of credit to the free market. On a free market the level of interest rates and the availability of credit are naturally determined by the available pool of voluntary savings. The idea was always to massage interest rates to lower levels and to encourage additional money and credit creation. In a paper money system like ours, the banks’ ability to create deposit money and loans is largely the result of administrative decisions by the central bank – at least until the banks have OD’ed on cheap money and the central bank has to use its own balance sheet to keep credit growth going. This is where we are now.

As is true of all types of market intervention, once you fix one variable you have to fix others, and sooner or later you have to get involved in everything. As ever more sections of the economy become addicted to cheap money, the risk of higher yields and wider risk premiums becomes an ever more potent threat to the overbuilt house-of-cards. To avoid collapse, the central bank has to manipulate ever more asset prices directly.

The communist chap from France has simply anticipated the next step in the degradation of our paper money economy, the point where not only the government and the banks will be supported directly by the central bank but also the corporations and the consumer. What is good for the former certainly must be good for the latter. Why do Greek restaurants still face the risk of bankruptcy when Greek banks get limitless cash?

In any case, this development is much more probable than any kind of ‘exit strategy’ for the central banks. — You don’t hear about those exit strategies any more, do you? There is a reason for it. There are none. Every day that the present free-money-madness continues, the central banks are digging themselves a deeper hole. With ever more assets mispriced on cheap cash and with ever more balance sheets propped up by free loans, policy tightening is equivalent to pulling the rug from under the whole system. There is no way out.

On steroids.

But back to the title of this Schlichter file. What recovery am I talking about? In Europe there apparently is none. But data has been improving lately in the United States, if at a snail’s pace. The ‘interventionists’ assign a lot of importance to these developments. Being interventionists, they pay little attention to the reasons for why we were in a recession in the first place. There is never much focus on the root causes of the crisis or any debate about if those have been removed. Recessions just seem to happen, so do asset bubbles and excessive leverage. All that matters is that the government creates some growth, then, with a bit of luck, this growth may just lead to more growth, and sooner or later we may just grow ourselves out of this mess. Simples.

I think the chances of that happening are pretty close to zero. And I do not care much about what present data is supposed to tell us. It does not make much of a difference.

Take the drop in official US unemployment. Could it be attributed to a decline in labour market participation as many long-term unemployed – their numbers have been growing markedly in this recession – drop out of the official labour market altogether? Or, could it be the result of the mild weather recently? Or, as the optimists will say, is it the result of additional hiring? Frankly, I don’t know and I don’t think it matters much.

We know what the problems have been and still are: misallocated capital and misdirected economic activity on a gigantic scale as a result decades of artificially cheap money. The policies of the interventionists – first and foremost zero interest rates and quantitative easing – were aimed at sustaining these imbalances, sabotaging their liquidation, discouraging deleveraging and postponing the – admittedly painful – cleansing of the economy of the accumulated dislocations. This policy has to a large degree succeeded, maybe with the exception of parts of the US housing market, which has indeed been correcting from bubble-levels. Other than that, I believe policy has so far managed to sustain the unsustainable a bit longer and thus project a false image of stability. Congratulations.

Of course, we can never exclude that this policy may also generate some additional activity here and there. Super-cheap money may not only stop the much needed deleveraging and cleansing but it may even encourage additional borrowing and additional investment. Who is to say that the trillions of new currency units will not cause some more balance sheets to get extended a bit further?

Fact is that none of what we see right now can be taken at face value. Not the equity rally, not yield levels, not headline economic data. Everything has to be taken with a sizable pinch of salt given the distortions from an outright surreal monetary policy stance.

But we can be sure about one thing: None of this should be taken as an indication of improving health. The patient is still sick but made to run laps around the track with the help of steroids, amphetamines and massive amounts of caffeine. The economy will not get fundamentally better until the underlying imbalances have been addressed and that is only possible if money printing stops and the market is again allowed to set interest rates and other prices.

I am not sure if the mainstream economists do really take a lot of encouragement from the manufactured asset price rally and the occasional green shoots in an economy that remains freakishly unbalanced and fundamentally sick. I don’t know what the economic data will tell us over coming months or quarters. I am confident that we are far from closing the book on the present depression.

In the meantime, the debasement of paper money continues.

Image by Idea go

I thought I should address a couple of points that I consider to be misconceptions and that frequently come up in discussions with the audience or other speakers when I present my views on the fundamental problems with fiat money. I am not always in a position to correct these misconceptions right then. They are often woven into questions on other points and I have to leave them uncommented as not to disrupt the flow of the debate. My book is, I believe, quite clear on these points, so I could simply refer people to Paper Money Collapse. But, for whatever reason, it is still the case that many in my audience make inferences from similar arguments to my arguments, and I fear that some of the differences between these positions might get overlooked. These differences are not unimportant, and I think it is worthwhile to highlight and clarify them.

The first point is related to the question what gives money its value? The second point is, is fractional-reserve banking fraudulent and should it be banned on the basis of property rights?

Let’s first restate the central premise of Paper Money Collapse. The main message is that today’s mainstream views on money are flawed. The most important difference between commodity money, such as a proper gold standard, and ‘paper money’, such as our present fiat money system, is the elasticity of the money supply. In the former, money is essentially inelastic, in the latter it is perfectly elastic. The present consensus holds that elasticity is a big advantage. It makes fiat money, if managed properly, superior as it allows monetary authorities to stabilize the economy. This position provides the intellectual foundation for our present fiat money arrangements. My argument is that this is false, and that the opposite is true, and that this was already understood and explained some time ago by eminent economists: the elasticity of the money supply in a fiat money system, and the constant expansion of the money supply under present arrangements in particular, systematically distorts relative prices, disorients economic actors and destabilizes the economy over time. Imbalances accumulate, which obstruct further growth and which will be countered with accelerated money injections, destabilizing the economy further. Elastic money is unnecessary, suboptimal, unstable, and ultimately unsustainable.

It is clear that my analysis rehabilitates the gold standard. It was not only unnecessary to abandon the gold standard it was a major mistake. It is also immediately clear that I consider fractional-reserve banking an inherently destabilizing force in the economy. Even when money was essentially gold and the supply of money proper inelastic, fractional-reserve banks managed to circulate fiduciary media, that is, claims on gold that are supposed to be redeemable in gold but are not fully backed by gold. To the extent that the public used these fiduciary media the same way it used money proper (gold), the supply of what was used as money in the economy expanded and an element of elasticity was introduced into the overall money supply, even under a gold standard. Fractional-reserve banking makes money elastic, expands the money supply –within limits, so therefore only to a degree – and causes economic dislocations. Most mainstream economists today do not even consider these distortions as they work under the entirely untenable assumption that constant money injections are harmless as long as inflation stays within tolerable ranges.

Now let me address the misconceptions on these two points that often appear to enter the debate. Some critics of fiat money and advocates of the gold standard express the following sentiments, which I consider to be unfounded and which are very different from my position: “How could we even have come to accept pieces of paper that are not backed by anything of value as money? Money has always been backed by tangible assets and it should again be backed by something tangible. Gold and silver have intrinsic value but paper money has an intrinsic value of zero. The public gets fooled into accepting these pieces of paper as money. If it realized how money was created and that it was not backed by anything, the public would dump it. Only gold (or silver) can ever be money.”

Those views are not always expressed this bluntly but a trace of them is often apparent in discussions about the failure of paper money, and because they point in the same direction as my arguments – toward the abolishment of state fiat money and a return to hard money, most probably gold – they are still not my views. In fact, I consider them to be wrong. They include fundamental misconceptions about money.

Who or what bestows value on money?

Do the paper tickets in your wallet have value? Of course, they do. They are valuable.

Why are they valuable? For one reason and one reason only: Because others in society accept these paper tickets as a medium of exchange. They accept them in exchange for goods and services in the knowledge that they can trade them again for goods and services from others.

This social convention – and only this social convention – makes these paper tickets money and thus bestows value on them. That is why paper money is money and that is why you act quite rationally when you hold some of your wealth in the form of these paper tickets (how much of your wealth is a different question) and when you use them as a medium of exchange.

Most money today is not even paper money but immaterial money. It only exists as bits on a computer hard-drive. Do these bits have value? Of course, they do. As long as others in society accept them in exchange for goods and services, as long as others accept them as money, they are money. They have exchange value. They are immaterial and of no use whatsoever, other than as a medium of exchange for as long as people accept them as a medium of exchange, which – on a purely conceptual level – might be forever.

Who bestows value on these paper tickets or bits on the computer hard-drive? The trading public does. And who determines how valuable these forms of money are? The trading public does. And who can remove the value from these paper tickets or this virtual money? The trading public.

Now consider a proper gold standard. All money is gold. Who determines the exchange value of each gold coin? You got it: the trading public does. Gold also has value as an industrial commodity or as an item of jewellery (in contrast to paper tickets and binary digits) but this value – its non-monetary value – only really played a role when gold made the transition from industrial commodity to monetary commodity, when it was first used as money. At that point its previous use-value as a commodity became the reference point for its first ever use as money. Once gold had become widely used as a medium of exchange or as a monetary asset, however, it was the public’s demand for such a monetary asset – the public’s demand for money – that determined gold’s exchange value. From that moment on – and this moment occurred a few thousand years ago – it was demand for gold as a form of money that determined its price, not its residual use as an industrial commodity, which at this point only retained secondary importance.

We conclude that the only thing that makes any substance or non-substance money and that bestows an exchange value on this substance or non-substance is the use of it as a medium of exchange, a facilitator of trade, by the trading public. Once something has become money – and in order to be money it has to be widely accepted as money – its physical properties, or even the absence of any physical properties, are entirely unimportant. They are, for lack of a better word, ‘immaterial’. Money only has exchange-value and no direct use-value. For its use as money and for determining its exchange value as money (its purchasing power in trade) it does not matter one bit what other use-value, if any, the monetary asset may have. One paper dollar has the specific exchange value it has today not because of any other use-value it has – because it evidently has none other than being a medium of exchange – but simply by its exchange value in trade. The same is true of gold. An ounce of gold has the value it has today because of the specific demand for it as a monetary asset. It would retain its monetary value even if, by some act of magic, it lost overnight all its use-value as an industrial commodity or an item of jewellery. Would this affect gold’s price and lead to a one-off adjustment in the gold price? Probably. But it would not make gold worthless. I am even fairly confident, although nobody can be certain, that the drop in price would be relatively small.

Servants of the state (Photo by Pete Souza)

The whole doltishness of Warren Buffett’s tiresome refrain that people are stupid to buy and hold gold as it doesn’t produce anything and, by the way, if you put all gold on one big heap what could you do with it, hehehe, now becomes apparent. The man may be able to read balance sheets and income statements. He evidently does not understand monetary economics. — What good would it do us if we piled all paper money in one big heap? Maybe we could have a nice fire. And all those immaterial money units that the Fed and the banks create on their computers – you cannot even put them into any pile, Mr. Buffett. Yet, all these things have value and it is quite reasonable to hold some of your wealth in the form of these ‘things’.

Mr. Buffett, statist that he is, does not object to you holding any of your wealth in state-issued paper dollars or in immaterial deposit money at Bank of America, in which he – increasingly a supporter of big business, the establishment and the status quo – has a stake. Just you holding gold, that bothers him.

Why gold is coming back

The reason why more and more people begin to prefer holding physical gold rather than paper money or electronic ledger money at shaky banks is not – at least not first and foremost – because of the physical properties of gold versus those of these other monies. The reason is that more and more people expect, correctly in my view, that the trading public, which always is the entity that bestows exchange value on or removes exchange value from any form of money, will bestow ever less value on paper money and electronic money going forward. Why? Because these forms of money are being produced in ever larger quantities for political reasons. Not their physical properties, or lack thereof, are the central problem with paper money and present forms of electronic money but the complete elasticity of their supply in present monetary arrangements. More specifically, the central problem today is that the massive over-issuance of these types of money over recent decades has created substantial imbalances that now cause considerable headaches for the banks and the various governments and that will most certainly result in ever more paper and electronic money being produced to fend off the painful dissolution of these imbalances.

International, inelastic, apolitical, lasting. (photo by Swiss Banker)

If the central problem with fiat money were its physical characteristics than we would not have to know anything about economics or about the specific process of paper money creation and its impact on the economy in order to pass a negative judgement on this form of money. But I do not think that this is possible. That today’s money consists of otherwise worthless pieces of paper or of immaterial electronic book entries is not the problem. What matters is the process of money creation and the impact on the economy. Once we have understood this process it is clear that the elasticity of the money supply is at the core of the problem and that we have now reached a point at which the further and accelerated production of these forms of money is almost a certainty. And that is why investing in gold makes sense, as gold is the oldest, most widely established form of money – the one with the most universal and longstanding social convention backing it – and as its supply is both inelastic and by its nature fundamentally outside the politicized process of modern fiat money creation.

Sometimes people tell me that they hesitate to buy gold as its value rests merely on others considering it valuable. What if we woke up tomorrow and people no longer considered this metal a monetary asset and thus especially valuable? This is a fair point but it applies logically to any form of money. The value of the paper money in your wallet and the electronic money in your bank account equally rests on the public continuing to accept them as money. Any form of money is only money through the acceptance of the trading public. There is no other potential source that its value could be derived from.

It is important to stress that the government does not and cannot bestow value on its paper money. This seems to be a widespread myth, as evidenced by this quote from, Philip Coggan’s recent book Paper Promises (p. 37):

“If people think that the value of something is equal to the cost of creating it, which in the case of paper and electronic money is virtually zero, then why do we accept it at all? We know there is no longer enough gold or silver to support it. The answer must be that we have faith in the government that stands behind it. The government can raise the taxes necessary to give the currency value.”

This is evidently wrong. The government does not support or back its paper money with anything. It is irredeemable money. You can take your state paper money notes to the state central bank but all you will get in exchange for them is new, freshly printed paper notes with the same numbers printed on them. The paper money in circulation does not constitute a claim on any assets that the government may possess or any reserve that the central bank may hold or any taxes that the government may collect. It is not a claim on the state at all. It is, in fact, a claim on nobody. Therefore, it is not debt. Today’s banknotes are, just like gold, assets that are nobody’s liability (in contrast to the electronic deposit money that is a liability of the specific bank that issued it and that will in fact disappear when the bank disappears). But this means the government does not guarantee money’s purchasing power. If these pieces of paper money retain any purchasing power at all it is because the trading public continues to use them as money.

In the debates on the present Greek crisis one often gets the perception that paper money would collapse if the states went bankrupt. This is completely unfounded. Sovereign default is only a threat to paper money – and a serious threat at that – because states, even when they are defaulting, retain the monopoly of paper money creation and when they are about to go bankrupt they tend to issue ever more money to sustain their spending and to appear solvent. The threat to money’s purchasing power thus comes again from the risk of over-issuance, and is again linked to the elasticity of the money supply, and not the creditworthiness of the state. If the ECB stopped printing euros, many European states would soon run out of money and default, and so would many banks, but that would not diminish the euro’s value as money, as a medium of exchange among the eurozone’s trading public, at least not that of the paper euros in circulation or the electronic euros in surviving banks. If the trading public could be confident that the market would not be swamped with paper euros in order to bail out overstretched eurozone banks and governments, there would be no reason to stop using this currency. Note that in a proper gold standard, the state would merely be a money-user, just like any household or company, and would have to manage its own finances sensibly, and if it didn’t do so, it would default on its obligations, yet nobody would stop using gold as money in response.

So, yes, the public may suddenly, one morning, decide to no longer consider gold money but I would suggest that the risk of the public no longer considering state paper money money is considerably bigger. And again, the reason is not the different physical composition but the fact that paper money is issued by the state for a reason, namely to facilitate the availability of credit beyond the availability of true, voluntary savings, and as this has now led to economic distortions of surreal magnitude, the political owners of the paper money franchise will print ever more of it. Gold is being remonetised by the public – always the ultimate arbiter of what is money and what is money’s purchasing power – because gold not only has a longer history of being money than any of the present paper monies, a history that spans all civilizations and the entire globe, it is also apolitical money, not issued by any central authority and, this is the most important aspect, with its supply essentially inelastic.

You may not wake up tomorrow to a world in which paper money is worthless but you most certainly wake up to a world in which more state paper money circulates but probably not more gold.

Elasticity and materiality

But is the elasticity of the money supply not intimately linked to the physical characteristics of the monetary substance? To say money is paper or a binary digit, is that not the same as to say money’s supply is fully elastic? Not quite, for we can imagine an immaterial form of money with a fixed supply, at least we can imagine such a thing since Satoshi Nakamoto invented Bitcoin. Bitcoin is immaterial — it only exists as virtual money on the internet. But equally it is commodity money because it is based on a cryptographic algorithm, which requires time and considerable computing energy to create Bitcoins and which is designed so that the overall supply of Bitcoin is strictly limited. Bitcoin shares with today’s electronic money that represents items on bank balance sheets the feature of immateriality. But in every other aspect it is much closer to gold: Bitcoin’s supply is strictly limited and inelastic, just as is the case with gold. Bitcoin has no issuing authority that benefits from a money-creation monopoly. Neither has gold. Bitcoin is not linked to any sovereign state. Neither is gold. Bitcoin exists outside the state-sponsored fiat-money-addicted banking sector. So does gold.

Whether Bitcoin can ever compete with gold or potentially even replace it is a hotly debated topic. We do not have to discuss it here. The point was simply to show that the key problem with today’s monetary arrangements is their politically motivated elasticity and that this feature is fundamentally different from money’s materiality.

Fractional-reserve banking and fraud

We can now address the second point that frequently comes up when discussing the unsustainability of present fiat money arrangements and that is the question whether fractional-reserve banking (FRB) is fraudulent and whether it should be banned on grounds of private property violation.

Today pretty much all banks are fractional-reserve banks. They can create money – book-entry money or deposit money – on the basis of limited reserve-money (physical cash in their vaults and deposits held at the central bank). Thus, unlike fund managers, banks not only channel savings into investment, they are also in the business of money creation. Most of the registered money stock in modern economies is simply a book-entry on bank balance sheets.

To analyze the fundamentals of FRB it is best to go back to the early days of deposit-banking when money was still essentially gold because back then the distinction between ‘original’ money (gold) and the ‘derivative’ money created by the banks (banknotes for example) was more apparent. The story goes something like this: When somebody deposited gold with a bank he received a banknote in return and was promised that he could immediately reclaim his deposited gold upon presenting the banknote. Banknotes began to be used as payment in economic transactions and to circulate in the economy as money because it was obviously more convenient to use paper tickets to pay rather than heavy gold coins, and the recipient of the banknote could always reclaim the gold. As long as all banknotes were backed by physical gold the supply of money did not expand. This was still a 100 percent gold standard, and the banknotes were simply a new form of payment technology, a means to transfer ownership in money more conveniently.

This changed when the banks began to lend the deposited gold to third parties or, to make it easier, they kept the gold but issued more banknotes than they had gold in their vaults and lent these banknotes to third parties as part of their lending activities. Of course, they still promised to repay all notes in gold when presented to them. Banknotes that are not fully backed by gold are not money proper but fiduciary media, claims on money that are not fully backed by money. Now there was money proper and fiduciary media circulating in the economy side by side. The overall supply of what was used as a medium of exchange in the economy had expanded. The supply of money was extended through FRB.

Critics of FRB argue that this process involves a property rights violation. The original depositor retains ownership in the deposited gold but the bank issues multiple claims on the same amount of gold, and whoever presents the banknote first, probably even somebody who never deposited gold in the first place but who obtained the banknote as payment in a commercial transaction, has the gold delivered to him. This appears to be a logical and convincing argument but there is one problem with it: FRB has been conducted for about 300 years. Have depositors not realized by now that they are being defrauded? If this is indeed fraud, how can the practice survive for so long?

One response is that most people do not understand how FRB works and that the banks misrepresent it. I do not think this is a valid point. To my knowledge, no bank today pretends that deposited cash is simply locked up in the vault waiting to be collected by the depositor at a later stage. Everybody knows (or should know) that banks lend deposited money to third parties. How else would they obtain the income to pay interest on the deposited money? That banks pay interest on deposits (at least in ‘normal’ times) should already give the game away. Think about it: What would you say if you valet-parked your car and the young man taking the car keys from you would offer to pay you a fee for having control of the car for a few hours? Wouldn’t you be suspicious? Would you really think he would just park the car somewhere safe and he is paying you for the privilege of doing so? –If deposit banking were indeed just about safekeeping then the depositor should pay the bank for its safekeeping services, not the bank the depositor for getting control of the money.

I believe the correct answer is that the depositor knows what is going on but that he does not care about the deposited gold as such. This follows directly from our analysis above. Remember the depositor deposits gold that he considers money. He does not care that this is a tangible asset, that it is shiny and has certain other physical properties. He does not consider this gold to be an industrial commodity or a piece of jewellery. It is money – a medium of exchange. When he deposits it with the bank he receives a banknote that is  — equally a medium of exchange. The depositor has not given up anything. As long as the fiduciary medium he now possesses has the same purchasing power as the deposited gold – and this is the precondition for FRB to work – he has not foregone any economic benefit. The gold was a medium of exchange that provided him with limitless spending flexibility. The banknote he now holds in return for the deposited gold is equally a medium of exchange that provides him with limitless spending flexibility. In fact, the assumption of the banker that most depositors may never ask for their gold back is not absurd at all. As long as not too many banknotes get circulated, thus having their purchasing power meaningfully diluted, or as long as the issuing bank does not run into trouble, the banknotes may circulate forever. These are, of course, risks that the depositor shoulders but in compensation he receives interest on his deposited gold – which in fact the early goldsmiths paid as early as the late seventeenth century! – and he has the additional benefit of the convenience of paper tickets. The bottom-line is that the willing and knowing participation of the depositor in the FRB scheme is no riddle at all but may be a fully rational subjective choice.

I believe that the analysis of the anti-FRB economists rests too much on the analogy with other safekeeping contracts. When valet-parking my car, I hand over a valuable consumption good in return for a useless and pretty much valueless piece of paper. The benefit I receive from owning a car and the benefit I receive from holding a little paper ticket (well, there is no real benefit at all in the latter) are hardly comparable. That I may never reclaim my car and be content with holding that piece of paper forever is hardly a realistic assumption. But in the case of FRB it is. Exchanging money proper for fiduciary media means exchanging one medium of exchange for another medium of exchange.

Bank run in Germany (Photo Bundesarchiv)

I am not arguing that FRB is fine. All I am saying is that it is entirely conceivable that depositors voluntarily and knowingly participate in it. The problem with FRB is not that the depositors get defrauded but that it introduces an element of elasticity into the money supply. Thereby FRB undermines itself. When the banking sector in aggregate manages to lower reserve ratios and expands the overall money supply via FRB, they inevitably start a credit boom, and we know that this boom will end in a bust. FRB leads to business cycles, as Austrian Business Cycle Theory has explained so well. And it is in the business cycle downturn that the FRB banks run into trouble and that the public begins to distinguish again between fiduciary media, which are bank liabilities, and money proper, which is nobody’s liability. Again, we are back at the point of elasticity, which is the real Achilles heel of our system.

This is already a pretty long blog — so I stop here. I will conclude by saying briefly what I think is the one thing that needs to be done: It is to get the state out of money and banking completely. No central bank, no lender of last resort, no inflation targets, no bank regulation, no deposit insurance, no government backstops. All these modern interventions are supposed to make banking safe but what they really do is make money more elastic as they greatly incentivize banks to lower their reserve ratios and extend the money supply. This makes the economy less stable and banks ultimately less safe. Much less safe. These state interventions are nothing but gigantic state subsidies for FRB. This is what needs to stop. The state should not (and in my view cannot) ban FRB. It should simply cease to subsidize it and to socialize its costs.

In the meantime, the debasement of paper money continues.

Image by scottchan

Years ago a friend of mine in New York told me about his massively overweight neighbour who took to wearing a black t-shirt with “I beat anorexia” printed on it.

I think that is how our central bankers look at the wonderful job they are doing. Since the last link to gold was severed in August 1971, the dollar has lost 82 percent of its purchasing power and the global economy is more geared than ever and now in the death throes of a four-decade leveraging bonanza but our central bankers proudly tell us, hey, at least we beat deflation!

Every day we are told that the world is in the grip of a deathly deflationary spiral. Or that it would be in a deathly deflationary spiral if it weren’t for the valiant efforts of our central bankers. Here is the Wall Street Journal reporting on those efforts:

“The growth in balance sheets (since 2007) has been startling: The combined assets of the four central banks will top $9 trillion by the end of March, compared with $3.5 trillion five years ago, Deutsche Bank says. The European Central Bank’s €3 trillion ($3.93 trillion) balance sheet is the biggest relative to the economy, at 32% of nominal euro-zone GDP,…”

Remember the ECB just gave another freshly printed €1 trillion to European banks at practically no cost for three years.

So, how are we doing on the deflation front?

Here is the outlook from the ECB at yesterday’s press conference:

“Euro-zone inflation will stay above 2% this year ‘with upside risks prevailing’ Mr. Draghi (the President of the European Central Bank) said.”

Upside risk? No kidding.

Is anybody surprised that an orgy of money printing has lead to, what’s the term Draghi used, ‘stubbornly high inflation’?

In 2011, inflation in the eurozone rose throughout the Greek debt crisis. Now inflation is above target and ‘stubbornly high’, yet the ECB expanded its balance sheet by a cool 55% (in words: fifty five) over the past 12 months – most of it towards the end of the period, meaning the full inflationary effects are still to be felt in the future. Upside risk indeed.

Is inflation caused by inflation?

No doubt, the ECB will take credit for avoiding deflation but will take no blame for inflation. This is entirely somebody else’s fault.

“The ECB raised its inflation forecasts in response to a mix of higher oil prices and tax increases. ECB staff expects inflation to average 2.4% this year, well above the ECB’s 2% target, before declining to 1.6% in 2013.”

Get it? Deflation can be avoided through money-printing, but money-printing doesn’t cause inflation. Inflation is rising prices, which can be explained by, er, rising prices, such as oil prices. Genius.

But the advocates of easy money, and they are numerous, tell us that we are splitting hairs here. Thank God we didn’t get that nasty deflation. Because economies grow when they have inflation and contract when they have deflation. Every child knows that.

So with that stubbornly high inflation we get some growth in Europe, right?

 Well- no, we do not.

“The ECB said its staff economists shaved their euro-zone gross domestic product forecast for 2012 from 0.3% growth to a slight contraction. Still, Mr. Draghi said he expects the economy to recover “gradually” over the course of the year,…”

So an explosion in euro-liquidity has raised prices but the economy is still contracting, if only mildly. No surprises here, I would say. Just what one should expect. The ECB’s policy – and that of any other central bank – is not designed to solve the crisis but to arrest the collapse, to cover up the problems, to sustain balance sheets and asset prices at artificial levels, and to postpone the day of reckoning – preferably to after the retirement date of the present policy elite.

Not on my watch.

But, of course, by extending the problem they are making it bigger.

No deleveraging please!

When I presented my book to various groups of investors and hedge fund managers at the end of last year, I was often told that we would be subject to considerable deflationary forces as a result of the deleveraging of the European banks. That deleveraging would, of course, be an important step towards unwinding the excesses from the credit boom but it would be deflationary.

Guess what. Deleveraging has been put on ice. With limitless money for free the European banks are not in the mood for scaling back. Here is the Wall Street Journal again:

“The long-awaited restructuring of Europe’s banking industry has creaked into motion, but the pace may remain sluggish thanks in part to the European Central Bank’s recent wave of cheap lending to the Continent’s banks. …

‘It isn’t as important now,’ said the chairman of a major European bank. His bank has temporarily shelved plans to sell certain portfolios of real-estate assets, figuring that the bank can afford to wait until prices bounce back from their current lows.

The ECB loan program ‘has bought time,’ said Richard Barnes, a credit analyst at Standard & Poor’s.”

Pricewaterhouse Coopers estimates that European banks plan to shed €2.5 trillion of non-core assets over the next, wait for this, ten years. That is right. Slowly, slowly catchy monkey.

Make a guess how much will be shed this year! – €50 billion.

Well, the ECB just pumped a nifty €1,000 billion into the banking sector in three months and the banks ‘delever’ by €50 billion in 12 months? – Dear hedge fund managers, please forgive me if I do not take the deleveraging argument seriously.

Where we are going.

 I am not saying that two-and-a-half percent inflation is a disaster in itself. But it won’t stay at 2 percent, and it certainly won’t go down to 1.6 percent as the eggheads at the ECB with their stupid output-gap models are telling us. All central banks tell us that inflation will go down next year. Always next year. That is what their models tell them.

I am not arguing for deflation per se. Deflation in itself has no benefit but deleveraging has. After a credit boom that is what is needed to get the economy back in shape. Economies are not growing because of deflation. That is nonsense. Economies are not growing because of the massive imbalances that have accumulated as a result of years and decades of cheap credit. A cleansing correction  – in balance sheets, state budgets and debt levels – is urgently needed. Present policy doesn’t allow it. So the economy won’t grow.

We should accept that deleveraging is ultimately unavoidable. If it comes with a period of deflation – so be it. But we will get neither. The system will be sustained at this stage of arrested collapse for as long as policymakers can get away with it. My outlook is that we will get even bigger central bank balance sheets (forget exit strategies! There is no exit!), we will get no sustained growth but inflation will creep higher.

The noisy advocates of easy money and of government stimulus always pretend to care for Europe’s unemployed youth. It is today’s youth that would have most to gain from a cleansing correction now, and it is those who already made their money and who sit on inflated assets and overstretched balance sheets that have most to gain from the central bank’s policy of extend and pretend. That is, until the whole thing goes pop anyway. Which won’t take too long.

In the meantime, the debasement of paper money continues.

Eternal money

Last week, Chatham House, formerly known as the Royal Institute of International Affairs and a non-profit, non-governmental institution in London whose “mission is to be a world-leading source of independent analysis, informed debate and influential ideas on how to build a prosperous and secure world for all”, published a report with the title, “Gold and the International Monetary System.”

This report summarizes the findings of the Chatham House Gold Taskforce. This taskforce, comprising 10 permanent members but involving additional participants in meetings in Washington, London and Beijing, was set up to investigate “whether there is a role for gold in the international monetary system.” The conclusions are predominantly negative. Chatham House sees no important role for gold beyond being one of a variety of central bank reserve assets and occasionally an interesting portfolio component (a hedge against inflation).

I regard these conclusions ill-considered and rash, and in my view Chatham House fails to make an intellectually convincing case for them. But the conclusions are certainly not surprising. Looking at the descriptions of the taskforce’s mission and the procedure of its investigation, any other outcome would have been surprising. Support for the status quo was, by and large, to be expected.

Committed to the status quo

Chatham House stresses the independence of its research, and I have no reason to doubt it. I do believe that the conclusions were arrived at without any interference from or any implicit consideration of vested interests, and that they reflect the honest views and best judgement of the taskforce members. Independence is not the issue here. Something entirely different is the issue. And this other aspect is what makes the report ultimately interesting and worth reading beyond its rather predictable and conventional conclusions.

The report emphasizes that the taskforce took a “fresh and open-minded approach” to the gold question. But that is precisely what it did not do and from the start set itself up not to do. The taskforce was evidently content from the beginning to remain within the established consensus of opinion on money, on crises, and on the role of governments and central banks. The taskforce’s entire analytical toolkit, i.e. the theoretical framework that forms the foundation of its investigation and discussion, although often not explicitly stated, reflects the mainstream assumptions of the standard Keynesian and Monetarist textbooks. The taskforce does not articulate them, defend them or justify them. It just tacitly adopts them as if they were beyond critique or proper investigation.

One of the key questions in the gold debate – maybe THE most important question – has to be this one: Was it a mistake to abandon the gold standard and adopt a system of unlimited and elastic fiat money? Is this fiat money system superior, is it stable and is it sustainable? From here, certain follow-up questions impose themselves: What are the fundamental differences between a gold-based system and a fiat money system? Which is more compatible with the free market system?

It is not that these questions are being answered by the taskforce in favour of fiat money. These questions are not even being asked. It is already assumed from the beginning that a monetary system based on state-issued and state-managed fiat money is necessary in today’s world, it is already assumed (although never convincingly argued) that the gold standard failed (more about this later), and that the only question that remains, and the one that asking the Chatham House attests itself a lot of ‘open-mindedness’ for, is whether there is scope for any reform of this fiat money system that also involves gold.

But in order to go beyond the established mainstream, to question accepted common wisdom and to answer any of the fundamental questions above, one has to go back to first principles and conduct a theoretical economic analysis. That is precisely what I did, or at least tried to do to the best of my ability, in Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown. But the Chatham House report eschews any theoretical investigation. Thus, it remains hostage to the established mainstream and cannot drill any deeper into these fundamental problems than an article in The Economist or the Financial Times might do. The Chatham House report happily bobs about on the surface of the established belief-system.

Ron Paul (photo: United States Congress)

There is also a strange and suspicious unwillingness to even acknowledge that an academic debate about the merits of fiat money exists, or could exist. The report mentions US congressman Ron Paul, who has “always distrusted central government” (page 3), as a critic of fiat money and an advocate of a gold standard, but fails to explain that Paul’s economic views are not the idiosyncratic ramblings of an eccentric politician but firmly based on the Austrian School of Economics, a strand of economic thinking that may not be mainstream in the sense that it dominates today’s standard academic education but that, with such prominent exponents as Mises and Hayek in the twentieth century, and Menger and Boehm-Bawerk in the nineteenth century, produced outstanding work in economic science. Furthermore, the ‘Austrian’ view that elastic forms of money, such as complete paper money systems, lead to economic instability (business cycles) had partially been anticipated by the British Classical economists (such as, among others, David Ricardo) in the early nineteenth century, and thus stands in a long and established tradition. We are not talking about the fringe of economic debate here. We are not talking about economic cranks or tiny scientific sects. Here are some powerful and influential theories. Two generations ago almost all established economists would have stressed the importance of basing a monetary system on gold and they would have shaken their heads in disbelief had they had a chance to inspect the present and rather novel system of unrestricted fiat money. None of these views even get mentioned. Can we be certain that they were wrong? How can we show this? After all, the present monetary system is only 40 years old, and it is not doing that well. Chatham House does not touch on any of this.

Ludwig von Mises; photo by mises.org

The Chatham House report mentions Keynes as an opponent of the gold standard, and while it also refuses to discuss his theories and while it certainly does not present him as the winner of the monetary debates of the 1930s, the taskforce tacitly adopts key elements of the Keynesian framework for its further discussion of monetary systems. In particular, the taskforce accepts that active stimulus policy is desirable and that the government needs control over monetary affairs in order to stabilize economic performance. Any serious discussion of the role of gold in a monetary system must rigorously test and investigate these assumptions rather than silently adopt them as benchmarks for the analysis of monetary systems.

It is not only the refusal to engage in theoretical and conceptual economic analysis – maybe this refusal is understandable given Chatham House’s overall focus on policy – but also its voluntary self-confinement to what it considers politically acceptable solutions that makes its approach anything but open-minded. On page 3 of the report we find statements such as: “A ‘Bretton Woods III’, however, still remains a distant goal … A ‘big bang’ approach to reform is clearly not on the cards ….In pursuing a more evolutionary approach….” All of this may reflect a solid understanding of realpolitik by the Chatham House researchers but it is clear that their wish to remain relevant to today’s policy establishment must confine their analysis to the boundaries of consensus views and prejudices. What we as readers are certainly not getting here is a ‘fresh and open-minded’ approach.

At this stage we may want to put the Chatham House report aside as just another articulation of the consensus view on gold. But I think the report is still quite interesting as the authors, while making an effort to stick to the established consensus, repeatedly trip over the alleged short-comings of gold and the proclaimed benefits of fiat money when laying out their case. The report is, for the careful reader, instructive as it shows the deep-rooted misconceptions about gold, deflation and economic crises that characterize today’s mainstream. On close inspection Chatham House’s analysis does not even support its own stated conclusions but in fact reveals – unwittingly – some of the essential fault-lines of the fiat money system. Let me explain.

That old deflation chestnut again!

Early on, in the executive summary, we find this paragraph:

“The lessons of both the Gold Standard era and the post-war Bretton Woods period suggest that reintroducing gold as an anchor would undoubtedly be impractical or even damaging, given bullion’s deflationary bias.” (page viii)

Here we have one of the standard arguments against a gold-based monetary system. As it is not to be expected that the supply of gold will keep pace with the growth in productive capacity of the global economy, a gold-based monetary system would have a tendency towards secular deflation, that is, a tendency for prices to fall and for the purchasing power of money to rise over time.

This is correct. But why is that a problem? Why is it better to have prices rise by 2 percent every year, which is the present goal of most paper money central banks, than to have prices decline by 2 percent every year? As we get more productive, things become more affordable. That is the normal capitalist process. Would it not be more ‘natural’ to have this constant rise in affordability, the constant drop in real prices, also reflected in nominal prices?

Of course, that deflation is bad in itself is a persistent theme in the mainstream media today but any thorough – and ‘open-minded’ – analysis of monetary systems needs to be more sceptical and inquisitive and should be willing to question these views.

Capitalist money

As I show in detail in my book, the constant secular deflation of a hard money system is not only not damaging, it has in fact many economic advantages. But most importantly, as I also explain in some detail, any attempt to compensate capitalism’s inherent tendency towards falling prices through extra money-injections – as is now the official policy goal of all fiat money central banks – must always destabilize the economy as these money injections constantly suppress interest rates on capital markets, and must thereby lead to persistent mismatches between saving and investment, and thus to considerable capital misallocations.

These are all theoretical considerations, and as we have seen, the Chatham House taskforce eschews theory. Instead the taskforce bases its view that gold’s mildly deflationary bias must be harmful on its interpretation of the historical record, namely “the lessons of both the Gold Standard era and the post-war Bretton Woods period.” The report does give a brief historical sketch in chapter 2 (pages 6 to 9) with the subtitle “Why did the gold standard fail?” Bizarrely, this chapter does not support the conclusion in the executive summary that it was gold’s deflationary properties that derailed the gold standard or Bretton Woods.

It is a fact of history that, throughout the Classical Gold Standard, deflation was not a problem. Here the Chatham House report:

“In the run-up to the First World War, the Gold Standard provided the foundation for the expansion of the global economy in the first age of globalization. … In a period of globalization driven by technological advances and international migration, the deflation prevalent up to the mid-1890s was not accompanied by dramatic falls in output.” (page 6).

The last sentence is evidently a Freudian lapse. This deflation was not only not accompanied by falls in output, it was in fact accompanied by strong economic growth, rises in income, prosperity and overall living standards. Yes, deflation was accompanied by strong growth, as anybody who understands how capitalism works, should easily grasp.

Allow me to quote from my own book on this point:

“After the United States joined Britain on what became the Classical Gold Standard in 1879, prices declined on trend for the next 19 years at an annual average rate of just over 1 percent. This compares with a still positive inflation rate of 0.3 percent in Japan over the 20 years after that country’s money-induced real-estate bubble burst in 1990. Japan is today regularly cited by mainstream economists as an example of the evils of persistent deflation. Yet, the United States, during its two decades of gold-standard deflation, experienced solid growth and rises in income and wealth. In fact, even prior to joining the gold standard, the United States had gone through 12 years of almost no money supply growth and had experienced an almost halving of the price level from the elevated levels that prices had reached during the Civil War inflation. But still, U.S. economic performance was vibrant during this time, causing even such prominent advocates of state-paper money and central banking as Milton Friedman and Anna Schwarz to conclude that this constellation ‘casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible’.” (Paper Money Collapse, page 136, 137)

But the authors of the Chatham House report do not want to give up their preconceived opinion that deflation must somehow be a problem. Almost comical is this footnote on page 6 that refers to the quote above about there being ‘no dramatic falls in output’:

“….the problem probably could have been resolved had the price of gold been increased (i.e. paper money devalued, the economic cure-all of today’s mainstream, DS) by a factor of three or four.”

But what problem? There was no problem with gold or deflation as the report itself just admitted in the body of the text.

The state versus gold

So why was the gold standard abandoned then? We find the answer in the next paragraph:

“To finance the war effort, however, the Gold Standard was suspended by combatant countries…” (page 6)

Gold standard a victim of World War 1 (photo Imperial War Museum)

This is the crucial point. The gold standard was never an impediment to the growth of the capitalist economy, to the rise in living standards and to the growth in mutually beneficial trade. Quite the opposite, it was and still is the best possible – the only possible, in fact – monetary system for capitalism. Neither private citizens nor capitalist enterprises asked for an abandonment of the gold standard and the introduction of paper money. It is entirely wrong to assert, as the Chatham House report implicitly does, that gold’s inherent tendency towards falling prices posed a problem for the free market economy. But the gold standard put constraints on the financial dealings of the state. It was the state that did no longer desire to operate under the strictures of a gold standard. The gold standard did not fail, as the Chatham House report claims, it was dissolved for political reasons.

On further inspection it becomes clear that, once you abandon gold and start printing money, you may enjoy a temporary economic boom but at the end of this expansion you will be left with substantial dislocations, among them an overextended credit edifice. This is the essence of the monetary theory of the business cycles as developed by the British Classical economists, perfected by Mises & Co in the twentieth century, and entirely ignored by the Chatham House taskforce. Going back to hard money then is likely to incur a correction in these imbalances, and this correction is also likely to be accompanied by deflationary forces. But this is a very different type of deflation than the secular deflation of a hard money system that we discussed earlier. This is the corrective deflation after an extended inflationary boom. To put the blame for this deflation on the gold standard is complete nonsense. The blame can only be put on the inflationary boom, which was the result of a politically motivated abandonment of the gold standard.

These aspects clearly shine through the short historical account of the Chatham House report but the authors fail to connect the obvious dots. Here some examples:

“…but monetary expansion during the conflict had pushed prices up so much that when calculated at pre-war parities the available supply of gold had declined relative to the money value of the income it was intended to support.” (page 6).

At this point, it may be worthwhile to mention that there is nothing in economic theory – and certainly nothing in Austrian School economics – that would require a return to the old parities of the previous gold standard, such as was attempted by Britain in 1925. For a return to a system of stable and hard money, all that is required is to stop printing money and adhere to the new parity. Obviously, stopping further money injections will likely necessitate an economic correction, including a drop in certain prices, as the economy gets cleansed of the accumulated imbalances from the artificial boom, and this deflationary correction may not be easy to accept for political reasons. That is why, once the gold standard was abandoned, it was politically so difficult to go back to it. The inevitable dislocations from constant money injections – explained in detail in my book – were then papered over by more and accelerated money injections. The system moved progressively away from hard and apolitical money towards fully elastic money with no constraints whatsoever.

This is precisely why, after the gold standard, we had the gold exchange standard of the interwar years, then the post-WWII Bretton Woods system, and now, since August 1971, the non-system of unrestricted fiat money expansion and floating paper currencies globally. It is not surprising that the global monetary system has moved progressively away from inelastic money on which capitalism works best, and towards ever more elastic money that suits the money-issuers, first and foremost the state. The decline of the gold standard coincides with the rise, in the twentieth century, of the all-powerful warfare/welfare state. It is also no surprise that the system is now culminating, globally, in the cul-de-sac of zero-interest rates everywhere and ever more bizarre and desperate policies of ‘quantitative easing’.

Here is another revealing quote from the Chatham House report:

“The final straw for the United Kingdom was its realization in mid-1931 that the low ratio between its gold holdings and the amount of short-term obligations that could potentially draw on these reserves (and that had been issued in the preceding politically motivated off-gold credit boom, DS) made it impossible to defend the fixed value of gold.” (page 7)

And when the report speaks about the collapse of Bretton Wood, it again has to admit that the reasons were political, in particular the growing appetite of the state for control over the domestic economy:

“As the United States began running up persistently large external deficits while supplying the global liquidity required for international transactions, the volume of dollars held as foreign-exchange reserves by both official and private holders came to exceed the amount of gold in the Federal Reserve by a significant amount.” (page 8).

Nixon wanted flexibility in 1971 Photo White House

It is clear that under a proper gold standard this would not have occurred and that the trade imbalances would be self-correcting as gold would flow out of the United States and thus tighten financial conditions there, which would lower domestic demand and correct the deficit. But at this stage we had no proper gold standard any longer. Also, any automatic correction to excessive domestic demand was certainly unwelcome in the United States. What the United States cared about was not the effective discipline of a capitalist monetary system but to maintain what the Chatham report repeatedly calls ‘monetary policy sovereignty’ – the ability to manipulate domestic economic conditions by running deficits, lowering interest rates and printing money. This is really what is at the heart of the gold debate. Nixon closed the gold window in 1971 and thus ended Bretton Woods not because of any deflationary tendencies of gold and not because the, at the time, already tenuous link to gold hindered trade or overall economic growth but simply because he wanted to conduct fiscal and monetary policy without having to fear the negative consequences of gold outflows. In perfect analogy to the abandonment of the Classical Gold Standard, gold had become a straight jacket for policy-activists, not for economic growth.

The Chatham House authors are not only unwilling to question and investigate key theoretical assumptions of the mainstream macro-paradigm, they also readily accept that active macro-policy through control of the domestic paper money supply and the manipulation of market prices (predominantly interest rates) is desirable and beneficial to the overall economy. Again, they do not provide proof for this. They treat it rather as self-evident truth or as a given feature of the present political belief system.

Following is a rather apt description of the late 19^th century gold standard economy that also casts some light onto why the Chatham House taskforce ultimately had to arrive at the conclusions it did:

“This was a time (the time of the Classical Gold Standard 1880-1914, DS) when governments had a limited responsibility for the economic welfare of their populations and intervened less in their national economies. Monetary policy sovereignty was not deemed to be as important as today, so the loss of sovereignty required for the Gold Standard was more easily foregone.” (page 6)

As I argue in Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown, our modern fiat money system, a system of fully elastic and essentially unlimited paper money, is entirely incompatible with capitalism. It is a system of constantly intensifying monetary interventionism that requires progressively more money injections to cover up its inherent instabilities and to postpone the dissolution of its imbalances. There is nothing in the Chatham House report that makes me question any of these conclusions. To the contrary, if you read the report carefully, it unintentionally provides at various points poignant support for my case.

The authors of the Chatham House report and the policy establishment which they so eagerly want to please, may continue to ignore the obvious fault-lines of this system but reality is quickly catching up. They may believe that a ‘big bang approach’ to reform is not on the cards. But the monetary system that they have helped create and that they now defend is getting ready for a big bang, and then some radical new thinking will be required, thinking that is more ‘fresh and open-minded’ and not so much hostage to the status-quo as what the Chatham House has presented here.

In the meantime, the debasement of paper money continues.