With this essay I will try to reconcile two apparently conflicting perceptions of the key problems with our present monetary system. I will start by characterizing these two positions.
As readers of this website and my book know, it is my conviction that the central problem with the present system is the high degree of elasticity of the money supply. A system of constant fiat money expansion, of ongoing injections of new money into the economy via financial markets – sometimes slow, sometimes fast – must systematically distort interest rates and disarrange saving and investment. This will lead to capital misallocations and the mispricing of assets. As these distortions are systematic, the resulting dislocations are bound to accumulate over time and thus progressively destabilize the economy. Elastic money is suboptimal, unstable and unsustainable.
The point is not that a gold standard is perfect or ‘perfectly efficient’ or even free of any disturbances or disruptions. The point is simply that by fading out gold as a fairly inelastic basis of the monetary system and replacing it with essentially fully elastic and unlimited fiat money, as happened around the world in the period from 1914 to 1971, we have made the financial system and by extension our economies substantially more unstable. While the system can appear stable on the surface for extended periods, the economy is constantly accumulating imbalances that will finally unhinge it.
The present debacle – characterized by excessive debt, an overstretched and out-of-control financial system, overextended banks, a plethora of asset bubbles, again on a global scale – is the inevitable outcome of our decision, 40 years ago, to abandon a gold anchor completely and go for unrestricted fiat money. The system is presently being kept going by ever more aggressive money injections (in particular base money into the banking system) and other state interventions, but I firmly believe that it is in its endgame.
“Fully flexible” and “unlimited” sound like a crazy ‘free-for-all’ but, of course, that is not what it is. The full flexibility to create any amount of money and inject it into the economy is a unique privilege in our post-gold-standard system that rests with the state and is entrusted to the central bank bureaucracy.
Ben Bernanke, the present US Printmaster, famously boasted in 2002:
The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost…
In moving away from gold, we have replaced the discipline and apolitical rigorousness of hard money that is the very foundation of a private property economy and a free society with full monetary flexibility in the hands of the state bureaucracy. He who has the power to print money can set interest rates, manipulate the credit markets and influence all sorts of asset prices. In fact, he cannot not do it. It is clear that by moving from gold to fiat money, we have abandoned a key pillar of capitalism and have adopted a form of monetary central planning.
Looked at the problem from this angle, my assertion that the present system will lead to ever-larger misallocations of capital, to ever-larger economic distortions, and that it must ultimately collapse, does not seem far-fetched at all. It is the fate of all systems of central planning and systematic market distortions. Just as the communist Soviet Empire collapsed under the weight of its inherent economic contradictions so will the system of politicized fiat money.
Gold and freedom
Central planning is not only rejected on grounds of its economic inefficiency and unsustainability but also rightfully despised for its inherent conflict with human liberty. Critics of paper money and central banking have always stressed that a gold standard is not only an effective counter against excessive risk and thus a guarantor of stability but also a guarantor of freedom.
In his seminal article ‘Gold and Economic Freedom’ from 1966 Alan Greenspan wrote:
In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. …The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.
This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.
An equally impressive document is the 1948-article by Howard Buffett, Congressman from Nebraska, entitled “Human Freedom Rests on Gold Redeemable Money”:
..when you recall that one of the first moves by Lenin, Mussolini and Hitler was to outlaw individual ownership of gold, you begin to sense that there may be some connection between money, redeemable in gold, and the rare prize known as human liberty.
There is no more important challenge facing us than this issue – the restoration of your freedom to secure gold in exchange for the fruits of your labors.
(Howard Buffett was a man of the Old Right in the US, a friend of anarcho-libertarian Murray Rothbard, and the father of billionaire oligarch Warren Buffett, who is today an outspoken critic of gold, an advocate of government bailouts and the willing poster boy for America’s tax-the-rich-more campaign.)
While my criticism of fiat money is strictly economic and focuses on the fundamental unsuitability of elastic money for capitalism, it is essentially congruous with the political objection to fiat money based on considerations of human freedom. Both aspects are two sides of the same coin. Therefore this forms one consistent anti-fiat-money position: the present system is a system of persistent state interventionism in markets that, very similar to socialism, leads to grave distortions and ultimately economic chaos. It is incompatible with a free society and a market economy.
The populist view: unchecked markets are at fault
Now let’s look at what I would describe as the conflicting, at least superficially conflicting view of what is wrong with our financial system. This view is widespread among the general public today, it heavily influences the discussion in the media and it goes something like this:
Is it really true that we have too-much state involvement in finance? Do we really have some form of monetary central planning? Does this view not completely underestimate the power of the big private banks? When one looks at the gigantic positions these private banks have on their balance sheets (and the even bigger positions they have ‘off balance sheet’), and when one looks at the outsized bonuses the bankers pay themselves, and when one furthermore considers that most money-creation is done by the private banks, then it appears as if ‘central planning’ or ‘the power of the bureaucracy’ appear inaccurate descriptions of the present system. J.P. Morgan just admitted to losing $2 billion and counting on complicated derivative positions. How can that be the fault of central bankers or imaginary monetary ‘central planners’? Isn’t this the opposite of central planning? Is this not capitalism running amok? Maybe we need more regulation and more control by the state authorities. Is the main threat to our economic wellbeing really a too-powerful central bank, or is it not actually a private banking system that is run for the benefit of the bankers rather than the ‘real’ economy and that may collapse as a result of uncontrolled speculation? Our system doesn’t look like grey and boring Soviet-style central planning at all but more like flamboyant capitalism spinning out of control. And by going back to a gold standard would we not restrict the power of the central bank to save us from the mistakes of the bankers? Bringing back gold and restricting the manoeuvring space of central bankers will make things worse.
The way I described the populist view here contains observations and conclusions. I believe the conclusions to be largely incorrect. They may appear intuitively sensible but they do not stand up to closer scrutiny. However, there is no denying that many of the observations that form the basis of this popular view are evidently correct. It is my goal with the following to show that there is no logical conflict between these observations and the critique of fiat money as a form of monetary central planning developed above. In fact, all the symptoms that the populist view concerns itself with and that form the basis of the widespread public anger – the apparent detachment of global finance from the real economy, the outsized and uncontrollable derivatives market, the bonus culture and the instant claims of the private banks on unlimited bank reserves and unlimited bailouts – all have their origin in the decision to abandon the gold standard and replace it with unlimited fiat money under state control. And my hope is that once this connection has become clear, more of the system’s critics will see that the cure is not more power to the bureaucracy and more regulation and controls but simply a return to hard money and thus a return of a system that is controlled, not by bureaucrats and bankers, but by the consumers of financial services.
The power of the consumer
In capitalism, in a truly free market, the consumer decides what is being produced, how resources are allocated, and who makes profits and who doesn’t. By buying from some and not buying from others the consumer ultimately directs production, economic activity and the use of scarce resources. Under capitalism the consumer decides how capital is deployed. Our problem is that today we have no capitalism in finance, and the reason for this is quite simply the abandonment of a gold standard and the establishment in its place of a system of unlimited fiat money and of central banking.
In order to build my argument I will solicit help from an unusual source: Paul Krugman.
Paul Krugman recently debated Congressman Ron Paul on TV. Ron Paul started by making the case I laid out above: that in our system interest rates are set by a state agency and the supply of money is determined by a state agency; that this is some form of price fixing and economic management by the state, which has never worked and is incompatible with a free market system.
Paul Krugman started very poorly. He simply claimed that “you cannot leave the government out of monetary policy”, and that the “Federal Reserve will always be in the business of setting interest rates”. Evidently, this is nonsense. We can discuss whether these arrangements should prevail or not but to claim that there is some inevitability about them is gibberish. Before 1913 there was no Fed and yet there were interest rates and lending and borrowing and growth and jobs and markets. To claim that in the field of money the state simply has to set prices is hogwash, and it exposed Krugman again as a closed-minded statist.
However, then Krugman made a statement that was interesting, essentially correct and that I will use as the basis of my further argument. He said that money was more than just pieces of paper with pictures of dead presidents on them, that the distinction between money and non-money wasn’t clear but that there was a continuum, and that we didn’t even know what money was. I think these are important points, but if we think them through we come to conclusions that are not in support of Paul Krugman’s monetary statism but in fact support Representative Paul’s aversion to state paper money.
What is money?
Gold and silver have been used as money in the form of coins for 2,500 years. ‘Modern’ finance started with the rise of banking, roughly 300 years ago. Banks have never really confined themselves to just taking deposits and making loans but, pretty much from the start, have been in the business of creating money, a business that they invented. Of course, money proper was still gold or silver, and those could not be created by banks, but banks issued what I will call money derivatives. Think banknotes or bank deposits. As these were not gold or silver they were not money proper but they were usually claims on gold or silver, and they began to circulate in the economy and were used by the public as if they were money proper. Of course, if all money derivatives in circulation had been fully backed by gold or silver in the banks’ vaults (i.e. by gold and silver that is not presently in circulation) then the supply of what the public uses as money would not have expanded and the banks would not have become money producers. But as we all know, banks quickly managed to issue money derivatives that were not backed by gold or silver, or at least not fully backed by gold or silver. To the extent that the public accepted uncovered money derivatives as money, the banks had indeed a license to print money, and this allowed the banks to extend more loans and make more profits. But the operative words in the previous sentence are “to the extent that the public accepted”. The consumer of finance, in particular the depositor, decided to what extent bankers could become money producers. If depositors became uncomfortable with the practices of their banker, they no longer accepted his money derivatives but instead removed their deposits and placed it with somebody else, or simply held physical gold and silver again. The consumer had the power to pull the plug on the bankers.
In defence of bank runs
What was money and what was not money had, with the arrival of deposit banking and fractional-reserve banking, become a somewhat fluid concept, and it has remained such ever since. It has become subject to change. There is, in the words of Krugman, a continuum. But under a gold standard, what was accepted as money was ultimately decided by the public. The license to print money could be revoked by the depositors at any time. That put the banker in a perilous position. Being a money creator was lucrative but it placed the banker at the mercy of a fickle public. There was always the risk of a panic and a bank run.
Now, who would be in favour of bank runs and panics? Are they not a sign of a potentially irrational and panic-prone public that fails to make wise decisions in its own best interest? — That is today the generally accepted view, I guess. But the prospect of bank runs is also without question a drastic form of consumer power, of capitalism’s essential checks and balances. The risk of a bank run, of the public’s sudden loss of faith in the prudence, reliability and solvency of a banker, is a powerful check on the banker’s risk-taking and overall business strategy. Not surprisingly, prior to the arrival of lender-of-last resort central banks and unlimited fiat money, banking seemed to have attracted a very different type of individual than it does today. Bankers were (because they had to be) conservative and extremely concerned with a public appearance of restraint, prudence and the utmost reliability. No macho-talk about ‘global business opportunities’, of ‘market share’ and high ‘return on equity’ here.
Power shifts from the depositor to the bureaucrat
Enter the central banks. This is what Milton Friedman and Anna Schwartz had to say in their seminal bookA Monetary History of the United States about the founding of the Federal Reserve:
The Federal Reserve System was created by men whose outlook on the goals of central banking was shaped by their experience of money panics during the national banking era. The basic monetary problem seemed to them to be banking crises produced by or resulting in an attempted shift by the public from deposits to currency [DS: currency meant specie at the time]
This ‘attempted shift by the public’ was none other than the sovereign consumer deciding that there were now too many money derivatives around and that he now preferred to hold money proper again, i.e. gold. It was apparently deemed okay for the consumer to shift from currency (gold) to deposits, thereby widening the definition of what was accepted as money and thus allowing the banks to create more of it. But, so the founders of the Federal Reserve System decreed, it was not acceptable that the consumer would ever narrow the definition of money again and reduce the banks’ ability to place more money derivatives. The state thus entered the scene in order to protect the banks from changing preferences of the public, at least those changes in preferences that were bound to limit money creation and credit expansion.
You may say it was good of the Fed to reduce the risk of bank runs and make banking safe. That is the standard interpretation today. (By the way, the Fed has neither made the economy more stable nor banking safer, as George Selgin demonstrates nicely in this excellent presentation.) However, the good economist does not just look at the immediate and most obvious consequences of policy but also at the long run consequences. There is no escaping the fact that the establishment of a central bank as a backstop for the banks’ production of money derivatives was the starting point of a process of disenfranchisement of the depositor as ultimate controller and arbiter of what is money, of how much there should be of it, and of what makes good and prudent banks. The power of the depositor, the consumer of banking, was weakened, and the power of the central banker, the bureaucrat, as ultimate judge of what is money and what is good banking was strengthened. The bond between banker and depositor was starting to be replaced with the bond between banker and central banker.
It is clear that the interests of banker and bureaucrat were closely aligned and both pointed toward ever more money production. The banker wanted to conduct the lucrative business of creating and placing money derivatives with the public without the risk of sudden changes in consumer preferences. The state officials wanted to encourage monetary expansion as this was deemed to be good for business and because the state itself was of course an important borrower. It is hardly surprising that with the advent of central banking and later unlimited fiat money, state borrowing began to expand.
The score at this point: Bankers/bureaucrats 1 – Consumers 0
There is no such thing as a free lunch. While that is a famous and very fitting quote of Milton Friedman’s (1912-2006), it is Ludwig von Mises (1881-1972) who the bankers and central bankers of the 1920s and 1930s should have listened to. The money-induced credit boom of the 1920s ended in the crash of 1929, and although the public had accepted more money derivatives during the boom as these now came with a government backstop from the young Federal Reserve (and this had made the extended boom possible in the first place), when the bust started the consumer definitely wanted to hold money proper again, and that was still gold. Bank runs still ensued and now were much worse than they ever had been in the pre-Fed era, simply because the Fed had by now encouraged the issuance of vastly more money derivatives. Although the country was officially on a gold standard and the banks had promised their depositors repayment in gold as part of their strategy to place their money derivatives with the public, the state decreed that the banks would collectively default on this promise and that they could still continue as going concerns. The state also decreed that money derivatives were now the new money proper and in order to leave the public no choice whatsoever – and no say in what was money or not – the state confiscated all previous money proper (that is gold) via executive order of the president in 1933. (In the United States of America private ownership of gold remained severely restricted until 1974.)
History is always written by its victors, and the victorious money statists, central bankers and Keynesian economists claim – to this day – that this was all for the better. It ended monetary contraction (true) and ended the Great Depression (not quite true but it probably provided a break). But – oh those long run consequences!
The money consumer had been disenfranchised. What bankers could do and not do, how much money there was in the economy and what interest rates were – none of this was any longer a give and take between profit-seeking bankers and their banking consumers, and thus identical in its dynamics to the relationship between any entrepreneur and his customer, but it was now the outcome of policy. In 1953 the Chamber of Commerce of the United States published a pamphlet entitled The Mystery of Money that roundly stated: “Money is what the government says it is.”
The bankers, by and large, embraced this change. It was better to be in bed with the state than the fickle public. The state had unlimited resources (almost) and could make laws. And most important, the state was interested in constant monetary expansion – a magnificently lucrative proposition for the bankers as money derivative producers.
The score: Bankers/bureaucrats 2 – Consumers 0
Closing another loophole
Were all money consumers disenfranchised? – No, there were still those pesky foreigners who got hold of various forms of money derivatives through trade but who had no use for them in their own local economies. Under the post WWII arrangements (Bretton Woods, which was, unlike the gold standard, not a system that had evolved spontaneously but one that was designed by the bureaucratic elite, only to be then undermined by the same elite – sound familiar?) these foreigners could of course hold on to their paper dollars if they so wished, or they could send them back to the issuers and demand payment in gold. These foreigners were therefore still in a position similar to domestic depositors prior to 1933. They could still threaten a ‘run’ if they felt that the money producers were using their license to print money too liberally.
This remaining constraint on money creation was removed in August 1971 when Nixon closed the gold window. Another group of externals, of finance-consumers outside the state-bank alliance that had some power to pull the plug on the money monopoly, was silenced. Now nothing stood in the way of the growing financial-political complex to expand the issuance of money derivatives further. The government could run budget deficits continuously; the banks could expand their balance sheets and issue money derivatives, which now were the new money proper even globally, to their heart’s content without having to worry too much about a fickle public. Keynesian economists were on hand to explain to the public that this was all to its benefit. Under the new PhD-standard (Jim Grant), enlightened bureaucrats would guide the financial system to constant and smooth expansion, a prospect that contrasted favourably with the official history version of early banking when bankers had to constantly live in fear of their irrational depositors.
Bankers/bureaucrats 3 – Consumers 0
These institutional changes have persistently widened the definition of what is money, they have made the supply of money ever more elastic and they have led to a constant expansion of the money supply, naturally beyond what the public truly demands. The vast amounts of new money could only be placed with the public at an ever-lower purchasing power of every new monetary unit. If the public really demanded to hold that much money, the price of money, i.e. the exchange value of each unit of money, would not have had to decline so much. Since 1933 the dollar has lost 94% of its purchasing power according to official government statistics. Since 1971, 82%.
Of course, I am not claiming that the public was entirely powerless. The public can always reduce its money-balances and keep more wealth in gold. These shifts are particularly pronounced whenever the state-bank alliance uses its money-printing privilege particularly brazenly, such as during the 1970s or recently, 2001 to today, leading to drastic depreciations of paper money versus gold. Since the closing of the international gold window in 1971, the price of gold as measured in paper dollars has gone from $35 to $1585.
Fiat money = disenfranchisement of the public
However, the key point of this essay is not inflation or not even the ever-larger economic dislocations that must result from constant monetary expansion, which is the topic of Paper Money Collapse. The focus here is on who controls banking and finance. Who is the ultimate arbiter of banking practices and even the size and scope of the financial industry? Again, in a proper free market it is the public, the consumer, who decides what products are being produced and where resources go and who makes profits. But for this to happen in banking and finance the public needs to be in control of banking’s raw material. That is no longer the case in our complete fiat money system, in which the raw material is no material at all but unlimited funny money at the full discretion of the central banking bureaucracy.
Gold means consumer power and banking discipline. The official demonetization of gold has severed the link between depositor as banking consumer and ultimate regulator of banking activity and the bankers. The banker is no longer at the mercy of a risk-averse depositor who funds the banker’s business but can demand repayment in gold. The banker does not have to explain the soundness of his operations to the public. As long as he can convince his superiors at the central bank that what he does deserves the generous funding with fiat reserves, or if he astutely figures out which assets the central bank will gladly monetize with its printing press, or if he can simply make the case that if he goes out of business he will hurt a lot of innocent bystanders so he is deserving of more reserve money, he is in business. And the bankers know that the bureaucrats will always tend to support them, to always lean toward a further expansion of the banking industry as that means credit growth. And the state itself has become totally dependent on persistent credit expansion to fund the welfare state and to keep the voters happy. The state bureaucracy is a junkie who is asked to regulate the activities of his own drug dealer.
That is why the Occupy-movement gets it so wrong. The culprit is not capitalism because we largely removed banking and finance from the normal discipline of a capitalist system. In a remarkable article for zerohedge, entitled The Real Debate on Gold and Money, Jeff Snider, President and CIO of Atlantic Capital Management, provided a brilliant description of the bizarre shape that our financial system has adopted:
As long as a bank can pledge some kind of financial collateral with a central bank, that bank will remain in business, regardless of how its depositors (the public) feel about its recklessness. Indeed, most of the credit production accomplished during the past thirty years (encompassing the whole of the Great Moderation) was done by banks that have no depositors whatsoever. The Great Moderation would be more appropriately called the Great Financialization, where securities overtook the role of “reserves”, and central banks committed to unlimited funding of those reserves (to achieve a specified interest rate target, meaning a zero or near-zero interest rate target can lead to the possibility of unlimited reserve creation, but, again, the effective restraint being the supply of “quality” collateral, as defined by central banks themselves).
The public has been so far removed from a controlling function in finance that during the crisis the bureaucracy went to extreme measures to keep it outside. Remember that the US government forced private banks to accept the TARP bailout funds, even if these banks felt they did not need government assistance and that accepting it might tarnish their reputation with their customers. Recently, when some European banks made it known that they had not taken any of the ECB’s emergency LTRO funds, they were rebuked sharply by ECB president Mario Draghi. When gold was money and the state was outside finance, the depositor was in charge and the banker went to great length to distinguish himself from his peers in terms of solidity and reliability. In the new Orwellian world of government-controlled finance, all pigs are equal.
Or so we are to believe. That the truth is different we all know. But I guess it is a case of “You want the truth? You can’t handle the truth!” The bureaucracy knows what is best for us.
The depositor has still one important weapon at his disposal. He can withdraw his funds and by using cash can remove his financial affairs from the banking system. Not surprisingly, this last remnant of consumer power in finance is already under heavy attack from the state. Not only has it become fairly inconvenient in today’s world to use cash, mainly because of high nominal prices as a result of decades of monetary debasement, but also because the state is erecting ever more legal and regulatory barriers to the public’s transacting with the state’s own paper money. In many countries, legal limits on cash transactions have been implemented or are being debated. The official reason is cracking down on tax evasion, drug dealing or terrorist funding. But once we move to a cashless society, not only will every transaction be recorded and the state be able to monitor every individual better, but the inability to transact outside the established and government-controlled banking system will make the bank run impossible. Total disenfranchisement of the finance consumer will have been achieved.
The delusions of bankers and bureaucrats
We, the public, no longer know which banks are sound or even if any sound banks are left. We do not know what interest rates would really reflect the public’s true propensity to save and thus the real availability of resources for long- term investing. We do not know what assets out there are still supported by voluntary saving. We no longer know what the proper prices of any assets are. All of these aspects of our economies are manipulated by the ever-growing banking-bureaucracy cartel. We know that this cartel works toward an ever-larger state-finance complex, and we are supposed to believe that this vast complex is still being controlled in our own best interest.
Calls for more regulation are missing the point. Regulation only shifts power from banks to state within the anti-market state-bank alliance but do not bring back the public and the finance consumer as ultimate power broker into the equation. Those who only see ‘greedy bankers’ and a decline in business morals behind our present financial malaise take a too superficial view of things. Human decency is important but the most powerful check on greed and the most effective enforcer of sound business practice is still the prospect of loss, which in a market economy is the result of not serving your customers adequately. When gold was the basis of the monetary system the depositor was the most powerful banking customer. Gold anchored the financial system in the real economy. It was an enforcer of discipline and of sound banking practices. In our system today, the fate of banks, the prices of financial assets and the structure of the finance industry are largely determined by monetary policy and the various interventions of the financial bureaucracy. Ironically, whenever cracks appear in this new system of monetary central planning, they lead to more intervention and thus to a further removal of the system from the regulating forces of the market.
Bureaucrats and bankers are equally deluded if they believe that they can continue managing this system to their advantage, or even that this system will be sustainable. The bankers believe they can extend the house of cards of ever-bigger balance sheets and ever-bigger derivative positions forever with the help of zero-cost central bank funding and limitless bailouts if things go wrong. They seem to think that they can continue to combine the state-guaranteed security of the post office with compensation-packages that would be suitable only for free-market entrepreneurs. The bureaucrats believe that they can control this overstretched edifice of debt with their various policy tools, and that by tweaking yield curves, by massaging some asset prices higher and some interest rates lower, they can continue manipulating the real economy forever. Both are wrong. A system that is based on central planning, on price fixing and persistent market manipulation must ultimately collapse. Signs that this system has already checkmated itself are accumulating everywhere around us.
In the meantime, the debasement of paper money continues.
This article was previously published at Paper Money Collapse.