Fiat money: the root cause of our financial disaster

A view from America, previously published at on August 15th

Is it possible that the ghastly unemployment, stagnant growth (and possible double-dip recession), and financial market convulsions all can be traced back to one single decision?  Perhaps.

Monetary policy is the most recondite yet most pervasive and powerful of economic forces.  Keynes, in The Economic Consequences of the Peace, wrote, “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

The converse also is true.  Restoring real monetary integrity engages all the hidden forces of economic law on the side of prosperity.  And forces for monetary reform are very much in motion.

The dollar has fallen in value by more than 80% from the day when Richard Nixon took the world off the tattered remnants of the gold standard.  Aug. 15 marks the 40th anniversary of the avowedly “temporary” abandonment of the gold standard by President Richard Nixon.

“Closing the gold window” was part of a series of dramatic but shocking and destructive tactics by Washington, including wage-price controls, a tariff barrier, and other measures, all leading to economic and financial markets hell.  All such measures save one stand discredited.  The only piece of the Nixon Shock still in force was the piece most ostentatiously designated as temporary.  Nixon: “I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold….”

Suspending convertibility was no trivial matter.  Nixon speechwriter William Safire recalled: “On the helicopter headed for Camp David, I was seated between [Herb] Stein and a Treasury official.  When the Treasury man asked me what was up, I said it struck me as no big deal, that we would probably close the gold window.  He leaned forward, put his face in his hands, and whispered, ‘My God!’  Watching this reaction, it occurred to me that this could be a bigger deal than I thought….”

It proved to be a very big deal.  How ironic that the most staunch defenders of a pure paper standard, the sole remnant of Nixonomics, are a few influential “progressives” such as Paul Krugman, Joseph Stiglitz and Thomas Frank.  Call them “the Nixonians.”  The poor jobs growth and stagnation of today’s “world dollar standard” are not, unsurprisingly, dissimilar to the results of the Nixon Shock.

There is ample evidence that restoring gold convertibility would put the world back on the path of jobs, growth, and a balanced federal budget.  Politicians do not like messing around with monetary policy. But gold, recently rediscovered by the Tea Party, has an impressive technical, economic, and political pedigree.  Gold convertibility has a very well established track record of job-creation, properly applied, during many eras.

The silver lining to the whipsawing Dow is that it makes politicians open to new ideas, even new old ideas.  Monetary statesmen from Alexander Hamilton forward have faced circumstances far more dire than those of today and turned things around.  Modern example? The German economic miracle, the Wirtschaftswunder.

That miracle was founded in currency reform.  On the very day when Ludwig Erhard’s currency reform was put into place, the economic paralysis ended.  The “rightest” economist of the 20th century, Jacques Rueff, wrote (with André Piettre) about the turnaround beginning on the very day of the reform:

Shop windows were full of goods; factory chimneys were smoking and the streets swarmed with lorries.  Everywhere the noise of new buildings going up replaced the deathly silence of the ruins.  If the state of recovery was a surprise, its swiftness was even more so.  In all sectors of economic life it began as the clocks struck on the day of currency reform.  Only an eye-witness can give an account of the sudden effect which currency reform had on the size of stocks and the wealth of goods on display.  Shops filled with goods from one day to the next; the factories began to work.  On the eve of currency reform the Germans were aimlessly wandering about their towns in search of a few additional items of food.  A day later they thought of nothing but producing them.  One day apathy was mirrored in their faces while on the next a whole nation looked hopefully into the future.

Rueff took a similar approach, including a dramatic currency reform, to reviving the French economy.  As economist and Lehrman Institute senior advisor John Mueller summarizes:

Despite the unanimous opposition of his cabinet, de Gaulle adopted the entire Rueff plan, which required sweeping measures to balance the budget and make the franc convertible after 17.5% devaluation – though not without qualms. ‘All your recommendations are excellent,’ de Gaulle told Rueff. ‘But if I apply them all and nothing happens, have you considered how much real pain it will cause across this country?’ Rueff replied, “I give you my word, mon General, that the plan, if completely adopted, will re-establish equilibrium in our balance of payments within a few weeks. Of this I am absolutely sure; I accept that your opinion of me will depend entirely on the result.’ (It did: ten years later, de Gaulle awarded Rueff the medal of the Legion of Honor.)

Today, on this the 40th anniversary of the closing of the gold window, a group of Americans issued a statement reading, in its conclusion:

[W]e support a 21st century international gold standard.  America should lead by unilateral resumption of the gold standard.  The U.S. dollar should be defined by law as convertible into a weight unit of gold, and Americans should be free to use gold itself as money without restriction or taxation.  The U.S. should make an official proposal at an international monetary conference that major nations should use gold rather than the dollar or other national currencies to settle payments imbalances between one another.  A new international monetary system, based on gold, without official reserve currencies, should emerge from the deliberations of the conference.

Many of the signatories are associated with the American Principles Project, chaired by Sean Fieler, and the Lehrman Institute (with both of which this writer is professionally associated), chaired by Lewis E. Lehrman.  Signatories also include such important thought leaders as Atlas Foundation’s Dr. Judy Shelton and Forbes Opinions editor John Tamny.

Politicians may have forgotten the power that real money, such as currency convertible into gold, has to reverse an economic crisis.  But the people have not.  Earlier this year, the government of Utah restored, to international attention, the recognition of gold and silver coins as legal money.  Now news emerges that the largest and most respected political party in Switzerland is supporting the work of the Goldfranc Association, led by citizen Thomas Jacob, to introduce a gold-convertible Swiss franc as a parallel currency.

Proponents are using the Swiss political process to put the creation of a gold franc in the Swiss Constitution.   Jacob finds himself in the very distinguished company of Rueff and Erhard.

While London burns Switzerland thrusts gold-based currency reform toward the center of the international debate on how to rescue the euro, end the debt crisis, and turbocharge economic growth and job creation with integrity, not Nixonian manipulation.

Will a world Wirtschaftswunder — an economic miraclefollow a restoration of gold convertibility?  History shows how practical such a miracle can be.

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19 replies on “Fiat money: the root cause of our financial disaster”
  1. says: joebhed

    No, fiat money(as you define it – incorrectly) is not the cause of our financial disaster.
    The cause is the debt-based system of money, operating as fractional-reserve banking

    German economist Dr. Bernd Senf:
    On the Deeper Roots of the World Financial Crisis

  2. says: Paul Marks

    One was remember why Nixon closed the gold window (which was only for the use of governments, not private citizens). The Amercian money supply had been going up for many years (long before Nixon was President) so the claim of President Roosevelt (when he took, by force, the physical gold of the citizens and voided the gold clauses in private contracts) that 35 Dollars were worth an ounce of gold, was becomming more and more absurd. Without a rejection of the new economic system (of “fiscal and monetary stimulus” again and again) the closing of the gold window was inevitable – or other governments would have (quite correctly) just taken every ounce of gold the American government had, in return for fiat Dollars.

    Franctional Reserve banking – as so often “it depends what you mean”. If by FRB is mean that a bank takes in the savings of people (these are called “deposities” which is wildly misleading – as the money is not “deposited”, it is lent out) and then lends out a fraction of the them (even 99% of them) there is no boom/bust economic problem. The indivdual bank may go under (if it has lent money out unwisely), but the economy as a whole will not crash.

    However, if by FRB what is meant that the banks (and other such) lend out (via complicated book keeping tricks) more money than was ever really saved, then there is a problem.

    And “joebhed” is quite right in implying that it can happen under a gold standard also.

    For example, the United States was formally under a gold standard till 1933 – yet the banks (and other such) in the late 1920s were able to build up a massive credit money bubble (which eventually burst – as they always do).

    Even before the creation of the Federal Reserve in 1913 – banks were able to do this. And they did do it.

    Basically if more money is lent out than was really saved (“fractional reserve banking” only if one thinks that somethng like “one thousand tenths” is a normal “fraction”) then what is happening is a credit money bubble is being created (by “creative accounting” – if we do not want to use the word “fraud”).

    The monetary base (whether it be gold – or fiat government notes) should not be smaller than so called “broad money” (monetary base plus loans – as in M2, M3, M whatever), as loans should be from real savings.

    It it is smaller then a creidit money bubble is being built up and (sooner or later) will crash.

    This can not be avoided for ever – and the bigger the bubble, the bigger the crash.

    In short there is a big difference between gold-as-money (or silver as money, or even government fiat notes as money) and a “gold standard” (the word “standard” is a warning – but it is not treated as such).

    Of course what we have now is a “fiat note standard” – in short even what our money is “based on” (the rest being bank credit that is NOT from real savings – indeed it is just very complicated book keeping tricks) is just fiat notes.

    So (as recent actions to increase the monetary base have shown) there is no limit at all (under this “fiat note standard”) to the amount of currency manipulation that can occur. The last major nation to have any limits on political manipulation of the currency (even partial limits) was Switzerland before 1999 – yes even Switzerland is no longer the safe place that people think it is.

    At least under the “gold standard” there was supposed to be some connection to a non political thing (in this case – gold). With a fiat note standard (with lots of credit money on top) there is nothing real (nothing that is not a toy of politics) in the entire financial system.

    This is not a good thing.

    1. says: Rob Thorpe

      Franctional Reserve banking – as so often “it depends what you mean”. If by FRB is mean that a bank takes in the savings of people (these are called “deposities” which is wildly misleading – as the money is not “deposited”, it is lent out) and then lends out a fraction of the them (even 99% of them) there is no boom/bust economic problem. The indivdual bank may go under (if it has lent money out unwisely), but the economy as a whole will not crash.

      However, if by FRB what is meant that the banks (and other such) lend out (via complicated book keeping tricks) more money than was ever really saved, then there is a problem.

      I don’t understand what you mean here. What do you think is legitimate fractional-reserve banking and what do you think is a “trick”?

      How do you think a commercial fractional-reserve bank can lend out more money than was saved?

      1. Morning Rob,

        If it lowers its reserves, can it not issue more loans on one side of the balance sheet and thus create more deposits on the other side? Is this not bog standard FR banking?

        1. says: Rob Thorpe

          A banks reserves are it’s plain savings. If it lends those out then the total saved doesn’t increase.

          The questions there are: can this increase the quantity of money? and can this increase the price level?

          1. Evening Rob, reserves go down, the money is recycled into new loans. These loans are deposited in the issuing bank. This appears there has been a movement from one side of the balance sheet to the other , net worth of the bank in question is still the same, how it is accounted for is slightly different. Now these new loans get used, they get spent (deposited) in a multiplicity of other banks which kicks off the whole process in each of these banks again, thus new money is created by this act. Also, this money looked at across the banking system as a whole is new (not saved by someone labouring / toiling / doing something etc_ and forgoing consumption etc), but as an isolated bank, no , it is not new.

            1. says: Rob Thorpe

              Remember we are talking about savings here, not money. I agree with you that when a bank reduces it’s reserves it raises the money supply. We could talk about the theory of reserves and whether this is likely to cause inflation. But, at present we’re talking about *saving* not money supply.

              I think we agree about the first step. The first bank decides to replace it’s “plain savings” of gold reserves by “capitalist savings” of loans. That bank doesn’t save out of income. After this a borrower has a quantity of base money that he puts in a current account. The next bank in the chain can then lend out a large proportion of the reserves it acquires from that person and it probably will. But, the next bank still has a debt to this customer. Although that bank acquires a quantity of reserves it’s getting them in exchange for it’s promise to pay when the customer withdraws from his account.

              The same sort of pattern of corresponding credit and debt occurs when a timed-savings bank makes a loan too. Let’s suppose person A decides he has 100 ounces of gold he can invest. He then loans his 100 ounces to person B. Person B in turn loans 100 ounces to Person C. Person C then loans 90 ounces to person D.

              In this case lenders match borrowers. Person A is owed 100 ounces. Person B owes 100 ounces and is owed 100 ounces. Person C owes 100 ounces and is owed 90 ounces, and holds 10 ounces. It could be that Person’s A and C are bankers, though in terms of savings it doesn’t matter if they are. The total net amount of assets hasn’t changed here, the new liabilities are balanced by new assets.

              1. Yes re the last one, a timed savings honest bank (or series of them), the new liabilities are exactly balanced by the same asset passing from one persons balance sheet to another. This is true saving made with honest labour, with consumption forgone and lent to another to use in return for it back at a later date. This is the good savings that align the needs of consumers with savers as best we can in a market based society.

                Contrast it with the first , we have one original act of labour to produce goods and services sold for profit that produces the net result of some savings. This lending with multiple claims then proceeds and if the reserves move up or down the money created out of no where moves up or down. This does not align savers and consumers interests and it is doubtful that consumers and savers want this to happen. This is why any system predicated on fractional reserves is unstable, in theory and in practise .

              2. says: Rob Thorpe

                You’re making a distinction without a difference. Bringing money into the issue obfusticates it, what we were talking about is saving.

                In terms of savings there is no difference between a timed-savings bank and a bank providing fractional-reserve current accounts.

                In the first step you proposed the bank took some of it’s reserves and invested them. Those reserves belong to the bank. The bank could have obtained them in several ways, firstly they could have been provided by retained profits or investments from share issues. If they came from share issues then it is the share buyers who have laboured to provide them, if they have come from retained profits then that is the return of the bank’s shareholders being reinvested. The bank could have obtained them from a debt contract such as a fractional-reserve current account. For any debt contract the bank obtains the reserves, by agreeing to pay a sum back later (and/or by agreeing to supply banking services). This is little different from any other sort of agent doing the same thing. If I borrow £100 from someone then am I to be criticised because my savings of £100 have come from nowhere? Of course not, because I also owe £100, I have not saved on net. The same is true of a bank that has borrowed £100 from someone too.

                The issue of money creation and destruction is really a separate one.

              3. says: Rob Thorpe

                “Rob, you have a very different understanding of savings than I .”

                Maybe one day you could explain yours. Mine is completely conventional. I’m using the same definitions of saving and savings that Mises uses, which are the same as the definitions the mainstream uses.

  3. says: Richard Allan

    “Franctional Reserve banking – as so often “it depends what you mean”. If by FRB is mean that a bank takes in the savings of people (these are called “deposities” which is wildly misleading – as the money is not “deposited”, it is lent out) and then lends out a fraction of the them (even 99% of them) there is no boom/bust economic problem. The indivdual bank may go under (if it has lent money out unwisely), but the economy as a whole will not crash.

    However, if by FRB what is meant that the banks (and other such) lend out (via complicated book keeping tricks) more money than was ever really saved, then there is a problem.”

    Argh, why?! Why do people still believe this? These two things are exactly the same! There is no difference! Even the wikipedia article on fractional reserve banking can explain this correctly. Seriously, people, please stop saying this, you’re embarrassing yourselves. Of course you won’t listen to me but whatever.

  4. I was out on the streets of Durham yesterday with anti fractional reserve banners, handing out leaflets from Positive Money and the Money Reform Party, which are both anti fractional reserve. See here for pictures:

    Richard Allen above asks in his last paragraph why there is a problem with fractional reserve. One problem is thus. Where did the money come from to bid property prices up to silly levels prior to the credit crunch and ditto for share prices prior to 1929? The answer is commercial banks. They lent like there was no tomorrow. And the money was created via fractional reserve.

    In contrast, under full reserve, the money supply would be stable, or it could be expanded by a small annual amount. That would lead to better stability.

    Positive Money and the Money Reform Party claim that fractional reserve leads to excessive debt because under FR every additional £X of money requires an extra £X of debt.

    I’m suspicious of that argument. I think a better argument is that it costs a bank nothing to create £X and lend same (administration costs apart). No one has to engage in real saving to enable the latter to take place. Thus in principle it is profitable for a bank to lend at a near zero rate of interest – though in practice of course they lend at the going or market rate. Nevertheless, the fact that creating money to lend costs nothing in principle means that fractional reserve will depress interest rates to a below optimum level.

    1. says: mrg

      I realise you jest, but what you’re talking about is exchange: after the transaction, both the dollars and the gold exist as stores of value.

      The idea with conversion is that the paper has no value of its own; it’s simply an IOU for the gold. I’d expect dollars converted to gold to be taken out of circulation (perhaps to be reused when physical gold is redeposited).

      1. says: Steven Shaw

        mrg, yes I was jesting but I hadn’t even thought of the dollar needing to be extinguished when _converted_ to gold. So true! I wonder does that help is solving the crisis though… Previously the USD was convertible at US$35 per ounce. It was fixed. I was jesting about the current price in part because it’s floating/variable. AFAICS, the original article fails to mention whether the dollar should be convertible at a fixed or floating exchange rate.

        This article seems to miss the point that the current money supply can expand but also contract. Many would say that the contraction of the money supply is a very dangerous thing. Perhaps it is but nevertheless I think we need some. Suggesting that every dollar be convertible to gold seems to be an attempt to fix the money supply just when contraction would seem to be taking over to take it’s necessary effect. I’m for fast tracking deflation with debt forgiveness – some kind of fast-track, mostly painless bankruptcy.

        I’d would like to see gold and silver allowed as money along side the national currencies. Currencies could be convertible to gold on a floating exchange rate (not a fixed one). I don’t think this solve the recession without the debt forgiveness though.

  5. says: Craig Howard

    Suggesting that every dollar be convertible to gold seems to be an attempt to fix the money supply just when contraction would seem to be taking over to take it’s necessary effect.

    Converting to a gold standard at the current level of the money supply would be all that is needed. There would be no need for contraction — that would only cause more misery.

    It is further growth in the money supply that is the greater danger.

    1. says: Steven Shaw

      I understand they’d be some pain – perhaps quite a lot. However, surely this is a kind of necessary pain/adjustment caused by monetary expansion during the boom? If fixing the money supply any time deflation/contraction tried to get hold (by say converting credit money to base money) seems like a recipe for a reset followed by further destructive credit expansion.

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