In the article, we argue that the collapse of the present banking orthodoxy is inevitable. So-called “quantitative easing”, plus the inflationary combination of central banking with fractional reserve deposit taking is unjust and we should insist that banks operate according to the same commercial principles as any other business.
Soft gold prices without hard-money rates? Not for long, says the world’s 40-year unbacked money so far…
JUST HOW MUCH ABUSE can soft money take?Two-thousand-and-eleven sees a big, but so far little-noted ruby anniversary. Expect to hear lots more about it as August 15th draws near.
Because that day will mark 40 years since the United States’ government finally stopped redeeming its dollars for gold. That ended over 250 years of formal “gold backing” for the West’s dominant currencies. It also took the entire world off precious-metal money for the first time in 5,000 years of civilization.
Gold wasn’t being used as money in Aug. ’71, of course. Long banished to central-bank vaults, the ageless metal was represented instead by paper notes – the medium of exchange – in purses, wallets and tills. Nor did gold bullion bars back more than $1 in every four in circulation, gradually slipping from the 40% cover-ratio set during the Great Depression. And unbacked money had also been tried many times in the past as well. Persian kings, Mongol emperors, Scottish chancers in the French court, desperate men at the Reichstag…they all thought they’d found “the secret of the alchemists”, as Marco Polo called China’s paper-note chao in his Travels of the late 13th century – and they all found it disastrous.
But irredeemable money had never been applied worldwide before, and never without some element of “hard money” (meaning gold or silver-backed notes) running alongside. Since US citizens were pretty much barred from owning physical gold, however, removing the metal from inter-government settlement looked a small, inconsequential step to most, especially next to the wage and price controls Richard Nixon also announced in his “Sunday special”. (Tricky was apparently worried about upsetting voters by delaying the latest episode of Bonanza on TV, but he was more anxious still to break the news before markets opened on Monday 16th August.)
Indeed, refusing to redeem foreign governments’ Dollars for US gold bars should have played well to the crowd. Because Nixon was defending the States’ ultimate hoard against those overseas partners who dared to doubt Uncle Sam’s promise to…ummm…redeem his paper dollars for gold. France alone had swapped $250 million for gold in “recent months”, the Financial Times reported on 5th August, helping draw the US gold reserve down to “just over $10,000m, the lowest point since the early 1930s,” as the paper said four days later.
“There has naturually been a revival of the traditional theory that when the gold stock hit $10,000m, the US would simply close the gold window,” the FT explained on 9th August, adding that “There is no evidence that the Nixon Administration plans such action,” even as the Dollar crisis continued to make its front page each day.
Slamming the window shut, just as the “theory” suggested, “We must protect the position of the US Dollar as a pillar of monetary stability around the world,” Nixon told the nation (and the world) on 15 August, 1971. But as his central-bank chairman, Arthur Burns of the Federal Reserve, had feared (“What a tragedy for mankind!” wrote Burns in his diary) the early results soon proved as awful as they were entirely predictable.
Freed from gold’s seemingly arbitrary limits, money bred so fast – everywhere – that wholesale and consumer-price inflation reached untold peace-time levels, crushing savers in both the equity and bond markets pretty much worldwide. Freed from its official peg, in contrast, gold prices rose 20-fold. The public grew so discouraged that, within a decade of Nixon’s decision, his Republican successor, Ronald Reagan, ordered a commission to consider reversing it.
But thanks to those falling bond prices, however – which came thanks to bond buyers everywhere demanding ever-higher interest rates if they were lend money for any period of time to government – Washington got to ignore the Gold Commission’s minority report, and extend the world’s experiment with unbacked money for another 31 years (and counting…).
Because by 1980, and thanks to those soaring bond yields, central bankers had already stumbled upon the solution to unbacked money’s first global crisis…
Hike interest rates so high that cash-on-deposit actually starts paying a positive real return, post-inflation. The effect on gold – and so on any thought of returning to gold-backed money – was signal, as you can see.
Over the first-half of the 1980s, real interest rates – paid over and above inflation – averaged nearly 5% per year. Major-currency savers hadn’t seen anything like it since Great Britain fought to defend (and lost) its own Sterling Gold Standard half-a-century before. And together with those desperate Gold Standard-style interest rates, the Dollar recovered something like a Gold Standard poise.
Peaking at almost 15% in 1980, the pace of US inflation then fell by more than two-thirds in the following half-decade. The Dollar gold price did the same, sliding from its (then) record peak of $850 per ounce to less than $285 five years later.
Why? Mining supplies rose, and the peak prices of 1979 and 1980 unleashed a torrent of scrap-metal supply back to market, too. But negative real rates had forced a growing number of otherwise cautious savers to abandon money for gold throughout the 1970s, just as they have again since 2001. Whereas strongly positive rates, in contrast – and positive like nothing since the scramble for gold of five decades earlier…when global bullion flows determined (and were thus targeted to maintain) international currency values – worked the opposite way. Because no one needs an inflation hedge, a defense against devaluation, when cash-in-the-bank pays 5% more. And that victory was so hard-won, the stability it brought to unbacked money continued even as real rates eased back…pretty much until they neared zero a decade ago.
Here in early 2011, cash savers and central bankers alike stand so far removed from gold-backed currency, let alone from gold-as-money itself, the idea of returning to redeemable notes seems ridiculous. But those killer rates of 1980-85 remain the only sure lesson of how confidence in unbacked money can be won back once it’s begun to dissolve. This month’s gold-price jitters, therefore, are both understandable and absurd. Most sensitive of all assets to a switch in interest-rate sentiment –and so clearly buoyed by the Fed’s repeated promise of “exceptionally low levels…for an extended period” – gold has turned 6% lower on inflation data that points higher, even as Western central banks make plain they’ve no plan of responding, and China holds its real rates some 1.5% below zero for cash savers.
Soft gold prices without hard-money rates? Not for long, we’d guess…not after faith in unbacked money has begun to dissolve. But the feint of 1975-76, however, might say otherwise.
Check the chart above. Gold prices halved even as real US rates stayed sub-zero but pushed upwards. Gold then rose 8-fold as rates fell again, finally forcing those very same hard-money rates which confidence in unbacked money demanded.
Reading the responses to Tuesday’s news that the British economy shrunk by 0.5% in the fourth quarter of 2010 will have left many confused.
On the one hand the Keynesians made the preposterous claim that government spending cuts which haven’t happened yet are ‘taking money out of the economy’. ‘Free market’ economists rapidly responded to the contrary, blaming the weather and dodgy stats. There is, they assured us, no danger of double dip.
As well as demonstrating the truth in Harry Truman’s old joke about the one armed economist, the confusion of mainstream economics in the face of the recession demonstrates their failure to address the fundamental question: what, actually, is a recession?
Austrian theory holds that the recession is the inevitable contraction in credit which follows its previous unsustainable expansion. Interest rates are cut by central banks, perhaps as response to something like the dot com boom in 2000 in the US or simply because, as in the UK, the government has diddled the inflation figures. Whatever the reason, as interest rates fell ever more marginal investment projects began to look viable and entrepreneurs borrowed to finance them. Individuals too can get involved, as they did over the last cycle with property.
But eventually, even in a world with dodgy inflation figures and, thanks to the vast productive capacity of countries such as China, prices which should be falling, the inflation caused by this credit expansion starts to show even in the central bank’s figures. Interest rates are raised, and those marginal investments that looked viable a short while ago are now underwater.
This is the recession. Over the previous boom period, capital has been allocated to investments, more properly called malinvestments, which have no hope of ever producing a return above their borrowing costs unless interest rates are kept low and credit is kept flowing. The recession is the liquidation of these unviable credit positions and it will not be over until this process is complete.
The response of policymakers to the current downturn has generally, however, been to try and inflate an air mattress of new credit under the nose-diving economy. If borrowing costs can be kept cheap, they reason, the malinvestments of the boom can be sustained, sparing the undoubted human cost that would accompany their liquidation. But, as we’ve seen, continued credit expansion leads to the inflation we are also seeing now. Continued attempts by central bankers to prevent a short, sharp, corrective recession will simply lead to a prolonged depression as demonstrated in Japan most recently.
The alternative is to let the recession run its course. Metaphors about hangovers often obscure just how painful this would be for many people but the historic record of these ‘free market’ recessions, most notably in the United States after both world wars, shows that they can purge the economy of malinvestments and set the stage for sustainable growth quite quickly.
The full corrective gale has yet to blow through the British economy and the frenzied efforts of the Bank of England’s printing presses to avoid it have only delayed it. But with inflation starting to roar they appear unable to postpone this second dip for much longer. The British economy may well be heading for double dip, but don’t blame the government.
There is another excellent piece in today’s Sunday Telegraph, from Mr Liam Halligan, summarising the end game situation at the recent Davos power elite comedy hour. I shall limit myself to cherry-picking just three quotes, one for each Marx brother.
Here is Groucho, always running away from his obligations:
“Yet while the grand-standing and finger-pointing should stop, it is absolutely not time to “move on”. The structural banking reforms we so desperately require are still a very long way from being agreed. The chances now are, given the Davos mood music, that they never will be.”
Here is Chico, preferring a good tune to actually ever achieving anything:
“Yet the actual document [Basel III accord] is so full of fudges and escape hatches that it amounts to very little. The only concrete policy – requiring banks to hold more capital against potential losses – doesn’t kick-in until 2018. Other measures designed to prevent future crises – such as liquidity standards and a global resolution mechanism for failing firms – have been postponed, allowing banks to carry on pretty much as before.”
And here is Harpo, silent but deadly:
“The question of “too-big-to-fail” remains entirely unresolved. And it looks as if we’ve now passed the high watermark in terms of Western leaders’ appetite for genuine banking reform. The country that should worry most about this grim reality, it pains me to write, is Great Britain.”
An interesting lecture from Robert P. Murphy, on how time, communication, prices, human time preferences, capital structures, and interest rates, are intimately linked together (or at least, should be intimately linked together), in a free market:
Presented by Robert P. Murphy at “Austrian Economics and the Financial Markets,” the Mises Circle in Manhattan on 22 May 2010 in New York, New York. Includes an introduction by Mises Institute president Douglas E. French.
Look out for the Bernanke joke on the choosing of professions.
Cobden Centre readers may want to set their radio clock alarms for 8:30pm on Monday evening, on the 31st of January, when Jamie Whyte takes a look at F A Hayek and the Austrian School, on BBC Radio 4:
My ‘Inner Rothbardian’ quails at that radio station branding a little, but if nobody tells Professor Hoppe then I’ll be able to listen too.
Hayek shares a joke with Mises
Here’s the BBC’s programme description:
Was the economic crisis caused by fundamental problems with the system rather than a mere failure of policy?
Over two weeks, Analysis investigates two schools of economics with radical solutions.
This week, Jamie Whyte looks at the free market Austrian School of F A Hayek. The global recession has revived interest in this area of economics which many experts and politicians had believed dead and gone. “Austrian” economists focus not on the bust but on the boom that came before it. At the heart of their argument is that low interest rates sent out the wrong signals to investors, causing them to borrow to spend on “malinvestments”, such as overpriced housing. The solution is not for government to fill the gap which private money has now left. Markets work better, Austrians believe, if left alone. Analysis asks how these libertarian economists interpret the state we’re in and why they’re back in fashion. Is it time to reassess one of the defining periods of economic history? Consensus would have it that the Great Depression of the 1930s was brought to an end by Franklin D Roosevelt’s Keynesian policies. But is that right? Jamie Whyte asks whether we’d all have got better quicker with a strong dose of Austrian medicine and whether the same applies now?
I have just stumbled across this excellent article in the day before yesterday’s Wall Street Journal. It is not only a good read but, for me personally, a real delight.
You see the author, Valentin Petkantchin, is an associate researcher at the Institut economique Molinari (IEM) the Francophone free market think tank set up and directed by a TCC Senior Fellow, Dr. Cecile Philippe. When I lived in Brussels between 2002-2005, I worked hard to support Cecile get the IEM off the ground.
Very much the product of the Austrian School of Economics and in particular the Ludwig von Mises Institute in the US, Cecile and her French speaking colleagues are now achieving great success. Crucially, they are committed to not only promoting sound scholarship far and wide, but they are busy reconnecting the French-speaking world to its own heritage. This is no easy task because for too long, Bastiat, Turgot, Constant, Molinari – to name but a few – have been ignored. And this has meant that French students have been taught that free markets are somehow an Anglo-Saxon conspiracy.
If you speak French and have the time then have a look around the IEM site. You will not be disappointed.
As Murray Rothbard said in Left and Right: The Prospects for Liberty, we must discover who are friends and allies are, as well as our enemies, even if it is just within some segments of their orientation rather than the whole package.
So although I am an Austrian and I am entirely opposed to the overall technocratic, collectivist, and statist aims of the New Economics Foundation — the producers of the entertaining video above — it is good to see that the intrinsically Austrian message about our broken corporatist financial system has spread so far beyond we few, we happy few, we usual band of suspects within the movement for true economics.
The ‘someone’ mentioned at the start of video, who established the analogy of the vampire squid, is Matt Taibbi of Rolling Stone, but it’s a catchy term. Sean Corrigan referred to the vampire squid in his piece from two years ago on banking contractual law, and James Tyler used it again in his recent article on the banking system.
Whoever provided the immediate inspiration, I must applaud the producers of the above video for their excellent audacity.
Under the EU’s Markets in Financial Instruments Directive, the EU allowed the external countries of Iceland, Liechtenstein, and Norway to enter the ‘levelled’ EU financial markets, which Iceland took advantage of, to within an inch of its financial life.
When the Icelandic banks collapsed, the EU tried to make the Icelandic government impose ‘austerity’ upon the Icelandic people to ensure that EU banks were kept whole on their Icelandic investments.
Being outside the EU and being one of the most freedom-loving peoples in the world, with a proud history of North Atlantic island independence and a record of cocking a snook at the powers of the world — including defeating the Royal Navy in 1976 — the Icelandic people refused to bow their collective knees to their feeble quisling government and their government’s would-be overlords at the EU; they defaulted instead on their banking system’s enormous debts, much to the anger of the technocrats in Belgium.
Since then, Iceland has recovered from a low recessionary point, with this growth accelerating.
Meanwhile, back within the hallowed holy borders of the EU, the overlords of the Holy Roman Empire of Brussels have insisted that the Irish people suck up austerity and stop complaining, because this will:
Help prevent a terminal crisis for the glorious Euro project
Help prevent German and French banks collapsing
Help their satrap quislings in Dublin and their divine overlords in Brussels keep living the high life
You’ll notice that there’s little in the above package for the actual Irish people themselves.
However, because they allowed themselves to get ruled over by some of the stupidest politicians and most Machiavellian bankers in global history (and let’s not even talk about corruption and greed), this means in the explicit EU view, that the Irish people deserve to take their imposed punishment of austerity.
But is this divinely-directed EU edict written in French on tablets of Lapis Lazuli and then copied out in triplicate in Danish, German, and Greek? Or is it in any way modifiable?
Unfortunately for the EU, the Irish people also have a proud history of North Atlantic island independence, not unlike that of Iceland, which is also a lot closer to Ireland than it is to Belgium. This relative success of the Icelandic default, compared to the upcoming agony of austerity for the tax serfs of Ireland, is something that is also quite clearly visible from the north-western shores of County Donegal.
So in this latest King World News interview, Jim Rickards asks the question: What if the Irish people refuse to suck it up? What if they do what Iceland did and tell the EU and its tottering banks to take a hike? What happens next?
Personally, as Daniel Hannan reported, I think this is an unlikely outcome, because most people in Ireland still perhaps accept their political system — for its legion faults — and all of the politicians in Ireland still want to suck up to the EU, for whatever reason. But what if the Irish do default and overcome the selfish personal interests of their politicians?
We certainly do live in interesting times and that is perhaps an interesting question.
If you would like to listen to the interview, which also discusses the honestfinancial assessments of Mervyn King, plus the situation in the metals markets, then click through either of the links below.
The heroes of Europe are to be found in Slovakia. The Slovak government is the only Eurozone government that did not participate in the €110 bn. bailout of Greece. While all other governments of the Eurozone work toward further centralization, an economic government and Euro bonds, only the Slovaks resist this trend toward inter-european transfers via bailout funds.
While the Slovak parliament had rejected the specific Greek bailout, it gave in to the creation of the “rescue fund”. However, it was only after massive pressure and the threat of “political sanctions” that they assented to the foundation of the European Financial Stability Facility (EFSF) of €750bn.
Prime Minister Iveta Radicova explained in August the Slovak resistance to European bailouts:
We had a difficult time with fundamental reforms between 1998 and 2002.And no one helped us. We did not get a cent. Nothing. It was our citizens who had to carry the burden and it was not easy. But we got through this phase with very unpopular, painful reforms. How should I tell our citizens that we should now help those who are not prepared to do something themselves.
Radicova shows more common sense than can be expected from European politicians. Indeed, Slovakia did commit to necessary structural reforms and cut public spending, against resistance on part of the population. Note: the Slovaks did this without the need for the EU commission or Germany to “impose” reforms, as is now the case in Greece, Spain or Portugal.
Finally, Greece is also undertaking unpopular reforms. Why does Greece get a reward in the form of a bailout while Slovakia did not? Not only did Greece defer the necessary reforms, but the Greek government lived beyond its means by borrowing and indirectly monetizing its debts. Thereby, it made all users of the common currency pay for its extravagancies. This was facilitated by the perverse setup of the monetary union. The Eurosystem allows for the monetary redistribution in favor of government with the highest deficits. Several independent governments can use one (central) banking system to finance their deficit spending (I explain the mechanism in detail in my book The Tragedy of the Euro).
By living beyond its means, the Greek government subsidized an uncompetitive Greek economy. Wage rates could remain artificially high as the Greek government paid generously for a large public sector, public employees, pensioners, and unemployed. At the same time, the Slovak government forced through unpopular reforms, reducing the public sector and making its economy more competitive and productive.
It is understandable that Slovaks feel uneasy about paying for the artificially high living standard of the Greek population via direct transfers. As a Slovak one might well think: “How have we been so stupid to do these reforms? If we’d waited a little bit longer and lived beyond our means, we might well have gotten the reward of a bail out like the Greeks.” One must take into account, however, that Slovak reforms were before the entry into the monetary union. Once you have entered, the incentives for reforms drop dramatically, as a bailout can be expected.
An intriguing fact is that GDP per capita in Greece is almost 50% higher than in Slovakia ($29,400 vs. $21,200). Hard working poorer Slovaks are expected to bailout lazy Greek bureaucrats? Unelected EU commissioner Olli Rehn was not embarrassed to accuse Slovakia of a “lack of solidarity” and criticize the decision of the democratically elected Slovakian parliament.
Recently, Ivan Miklos, Slovak Finance Minister, stated that Greece should restructure its debt. Such an acknowledgment of reality is not found often among politicians. Politicians must know that a restructuring will be necessary sooner or later. But they do not dare to say so. Miklos also stated that the EFSF was a mistake.
It is honourable that Slovak politicians call the EFSF for what it is, and that Slovakia resists the redistribution and tendency toward centralization in the EU. Unfortunately, Slovakia is not big enough to really matter in the fight for the future of Europe. Its contribution to the Greek bailout would have been less than 1% of the total (€ 800 million). Thus, Greece was bailed out anyway.
Unfortunately, politicians of countries that would make a difference do not resist the advancement on the fast track toward a transfer union. German chancellor Angela Merkel, by just saying that Greece should restructure and that the EFSF was a mistake, could bring down several governments in peripheral countries by causing a surge in their bond yields and their eventual default. This could stop the process toward centralization of power in Europe and the prospects of a transfer union. Yet, Merkel fails to defend the interest of the common man in Germany and in Europe. She should look to Slovakia for inspiration.
This article originally appeared on stevebaker.info.
