Thinking Things Over

Musings on the Markets from Inside the Beltway


By John L. Chapman, Ph.D.                                             Vol. I, No.4  081411


In this note:

  •  Remembering Nixon’s worst error, forty years later – and its lessons for policy (and for investors) today


Next week:

  • How an economy grows – and how investors secure a happier future

I.  A Brief Foreword to Today’s Main Topic on Monetary Reform

In the week that just was, we witnessed wicked market volatility around the globe, down-up-down-up action on the Dow to the tune of 500-point swings, teetering French banks, gold hitting an all-time nominal high above $1800, and consumer sentiment, as expressed by the University of Michigan’s benchmark survey, hitting a 30-year low. Laurence Kotlikoff of Boston University has recalculated the present value of government’s fiscal gap and now finds it at $202 trillion through 2075, a figure he arrives at by increasing both non-interest spending and all federal tax revenues by 2% per year (Kotlikoff looks at debt obligations of the U.S. government most correctly: he includes all government expenditures, from entitlements to “unofficial” or off-budget spending, matched against all tax revenues).

Clearly this debt may never be paid off, as investor Jim Rogers says, leading to an economic and currency collapse when creditors finally say to the U.S. government, “No More!”  Or, it will be paid down, in which case [1] punishing tax increases (Kotlikoff estimates a doubling of all tax rates is needed in present value terms), [2] painful cuts to beneficiaries, or [3] an inflation hurting most all consumers, and especially the elderly, will obtain – or, some grim combination of all three.

What is the ultimate root of these trying days, and what can be done about this core problem?  Today we address this, and we ask our Alhambra family of investors to spend a few extra minutes reading our thoughts, in the same way as MSNBC is now exhorting its viewers to “lean forward”.  We want your critical attention on this topic, the monetary system, which we consider to be the heart of the matter in terms of the ills that plague us.  We don’t just think this; we know it to be true.  And why not have such confidence?  After all, the 20th century’s most famous economist, John Maynard Keynes, agreed with us as far back as 1920.  Here’s what he said then, in our favorite quote of his, in his Economic Consequences of the Peace:

Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency…. Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society….[t]he 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.


As we describe in this essay, this was the most correct thing Keynes ever said or wrote, because as we also describe below, sound money is both a necessary condition and indeed a driver of economic growth.  And it is important to note Keynes’ prescient observation that “not one man in a million” can discern the monetary malfeasance at the time it is occurring.  Indeed, this is the heart of the problem, and our great challenge with this issue: monetary distortions are silent or invisible killers, but it’s so critical they be corrected.  In a monetary exchange economy, by definition, one side of every trade involves the monetary medium; if somehow a “virus” has “infected” the monetary medium, then every single transaction and every single price, or interest rate, or bank account value, is also infected; that is to say, incorrect.   And multiplied trillions of times over, these incorrect signals lead to sand and mud being built up in the economy’s gears, reflected in bad investments, losses, unemployment, and retrenchment to recover.

The other thing to note here at the outset to our Alhambra readership is that we do not blame you for not knowing about the arcane details of monetary theory and policy; after all, you’ve got a real life to live.   But we are less forgiving in our assessment of the lack of knowledge of our political elites.  Martin Feldstein, for example, prominent Harvard economist, former Chair of Reagan’s Council of Economic Advisors, and Washington fixture, opined recently in the Wall Street Journal that a weak dollar would hasten economic recovery, due to increased exports – getting the issue essentially 180 degrees wrong, properly considered.  And in an Iowa debate this week, Presidential candidate Mitt Romney rattled off seven items in his opening statement that he claimed would drive economic growth – but monetary policy did not make the list of his top seven. Willful blindness!


II. The Tragedy of August 15, 1971 – and Why It Haunts Us Today


Monday is an unhappy anniversary in the history of civilization. Forty years ago, on August 15, 1971, President Richard M. Nixon took to the airwaves in a national address from the Oval Office to declare that the U.S. Treasury would no longer redeem foreign demand for gold in exchange for dollars. Because the United States was then the last country in the world with a currency defined by gold, it represented a complete and historic decoupling of the globe’s currencies – literally the money of the entire world – from the yellow metal.  For the first time in at least 2700 years, dating at least to the Lydian coinage of what is now modern-day Turkey, gold was nowhere in the world used as official money. And for the first time ever, the world’s monetary affairs were defined by a system of politically-managed fiat currencies – that is, paper money run by governments or their central banks.  The story behind Mr. Nixon’s catastrophic mistake, and the lessons it contains for today, suggest a framework for monetary policy and reforms that will induce strong and sustainable economic growth moving forward.

The Role of Money in an Economy

First of all, it is important to understand what many current central bankers seem to have forgotten: the seminal importance of sound money – that is to say, dependably-valued, honest money whose value is not intentionally manipulated – as an institution in a modern exchange economy.  Economies grow, and material wealth and welfare are advanced, via three interconnected phenomena, all of which are supported crucially by a well-functioning monetary unit: (1) efficient use of scarce resources via a system of prices and profit-and-loss, which encourages optimizing behavior from everyone; (2) saving and the accumulation of capital for investment, and (3) the division of labor, specialization, and trade and exchange.

Regarding the latter first, we would all be poor, and indeed most of us dead due to starvation, if we had to make and produce all our own food, housing, clothing, and other necessities and modern luxuries.  But as Adam Smith explained in his famous examination of operations inside a pin factory, dividing up the metal-straightening, wire-cutting, grinding, pin-head fashioning, and fastening and bundling operations into eighteen separate steps increased the productivity of labor by twenty-four fold (this of course dramatically increased productive output and raised real incomes).  And of course for society at large, this specialization was not confined to single factories, but spread across industries and agriculture: the baker, the butcher, the brewer, and the cobbler could all focus on their productive specialties, and produce for a market wherein they could exchange with other specialists for desired goods.

Via economies of scale and scope, then, specialized production and exchange help to create a material horn of plenty for all in such a society based on peaceful, harmonious, social cooperation.  And here’s the key: none of this would be possible without a dependable monetary unit utilized as a medium for this exchange.  Absent sound money, in fact, a division of labor, with all its specialized knowledge and skills, could hardly be exploited, because a resort to barter would mean that, say, a neurosurgeon would have to find a grocer who coincidentally needed brain surgery, every time the neurosurgeon wanted to obtain food.  A barter society is by definition a primitive and poor one.

Similarly, the explosion in human progress in the last three centuries was propelled by the accumulation of capital, the tools and machinery and other assets that increase per capita output that are responsible for dramatic increases in living standards.  And here again, a well-functioning monetary unit facilitates the saving that allows for capital accumulation: income need not be consumed immediately, but can be transferred to others to invest productively, in return for future payment streams.  Sound money, in short, greatly enhances wealth-creating exchange and transfer of resources between present and future, and in doing so often assists in development of higher output capacity in the future.

There is a third crucial way in which sound money serves to advance civilized human progress: by providing a common denominator for the expression of all exchange prices between goods, money greatly facilitates trade between all parties, thus extending the breadth of markets as far as money’s use itself, which in turn intensifies the division of labor that increases productive output and per capita incomes. Think about it: without a monetary unit of account, there would be an infinite array of prices for one good against all other goods, e.g., the bread-price-of-shoes, the book-price-of-apples, etc.  In turn, calculation of profit and loss, upon which effective use of scarce resources so critically depends, would be impossible.

In sum, the institutional development and use of money has been an immense human achievement, every bit as important as language, property rights, the rule of law, and entrepreneurship in the advancement of human civilization.  And it is important to note that while several commodities were tried as monetary exchange media over the centuries, from fish to cigarettes, the precious metals and especially gold were seen to be most effective, as they are intrinsically valuable, highly divisible, durable, uniform-in-composition, easily-assayable, transportable, and high value-to-bulk, along with being relatively stable in annual supply.  In short, in an ever-changing world of imperfection, gold has been found to be a near perfect, and certainly dependably-valued, monetary unit.


Sound and Unsound Money, International Trade, and Economic Growth


To understand much about our current economic challenges and what to do to ameliorate them, it is important to understand why gold, after several centuries of trial-and-error, came to be seen as sound money, versus paper, other commodities, and even silver. The term sound money is especially important to grasp: it is meant to describe a reliable, dependably-valued medium of exchange and account, not subject easily to manipulation, and thus which can well-perform the three functions of money described above, all of which lead to prosperity and an advancing economy.  This is critical for a civilized society whose economy is based on monetary exchange, because money in this case is literally one-half of every trade or purchase transaction.  So when the value of the monetary unit is volatile, that is to say, when money becomes more or less unsound, it changes the intended terms of trade between parties, including especially when that transaction involves exchange between present and future, as per capital investment.  This in turn can cause such exchanges to break down, or lead to distortions in trade that lead to malinvestment of assets and waste of scarce resources.

No better illustration of this can be seen than in the German hyperinflation of 1923.  German war reparations mandated by Versailles had so burdened the German economy that the German government took to literally printing the currency known as the Papiermark en masse.  This rapidly depreciated the value of the ever-weakening currency until in the fall of 1923 workers were paid in wheelbarrows of cash, twice daily.  The velocity of spending spiraled as well, as workers immediately rushed to trade the quickly-worthless paper money for anything of tangible value, thus making purchases of commodities they often did not need.  Saving and investment were stunted, inflation soared out of control, and civil society lurched toward a complete breakdown by the end of 1923, when $1, which bought 5.21 Marks in 1918, bought 4.2 trillion of them.

Seen another way, the German hyperinflation is an example of a “virus” infecting the economy, which distorts the prices in every transaction, every entrepreneurial investment decision, and the value of every bank account.  Every calculation of profit and loss is changed in real terms as well, thus causing resources to be sub-optimally used or traded.  While the harm caused by unsound money may be lesser in magnitude than Germany in 1923, it is no less real in a 1970s-style inflation, a 1930s-style deflation, or a 2000s-style housing bubble fueled by falsified interest rates thanks to Fed monetary over-creation.

Conversely, it was sound money, based on the international gold standard, which greatly impelled the fantastic rise in living standards across the 19thcentury across many parts of the globe, by facilitating dramatic increases in integrating trade and the international division of labor. With a dependably-valued international medium of exchange and account, long-term investment could be undertaken and ever-increasing volumes of mutually-profitable trading developed between nations, increasing jobs, output, and living standards dramatically.  The century up to 1914 was a “golden age” of prosperity and harmony between nations, and while not devoid of all war, recessions or panics, was comparatively more peaceful and productive than any other period in human history.


The Rise of Central Banking, Politically-Managed Money, and the End of Gold


While the Bank of England was created in 1694, it was not until 1913 that the U.S. had a central bank with the creation of the Federal Reserve System; by 1935 and the creation of the Bank of Canada, all modern nations had a central bank.  In theory, central banks, via a monopoly of banknote issue and effective control of a nation’s money supply, serve as a stabilizing influence in an economy by acting as a banker’s bank, a lender of last resort providing liquidity in panics, and a regulator of commercial banks and thus governor of their excesses (however, a recent exhaustive study of Federal Reserve performance vis-à-vis pre-Fed macroeconomic outcomes in the U.S. economy shows the opposite is true: economists George Selgin and William Lastrapes of the University of Georgia, and Lawrence White of George Mason University show that recessions were shorter and less severe, inflation and unemployment lower, and economic growth stronger and more durable in the century before 1913 than since the Fed’s creation.); at the least, the central bank’s mandate included and seemed to assure maintenance of the value of the currency.

Beginning with World War I, and continuing through the Great Depression and the Second World War, the links to gold were for the most part often effectively severed from most nations’ currencies, including the United States.  In an attempt to resurrect the beneficial aspects of the 19th century’s classical gold standard, economists led by John Maynard Keynes and Harry Dexter White met at Bretton Woods, New Hampshire in the summer of 1944 to design a post-war monetary system conducive to international trade. The resulting mechanism, known as the gold-exchange standard, lasted until President Nixon’s vitiation of it in August 1971.  In short, the Bretton Woods agreement charged the United States with defining the U.S. dollar in gold (at $35 per ounce), and maintaining convertibility at this rate with foreign governments and central banks only (and, pointedly, there was no similar obligation to U.S. banks or citizens; gold had disappeared from circulation in the U.S. after 1933).  In turn, all foreign nations were to peg their currency’s value to the U.S. dollar, thereby preserving a regime (however illusory) of fixed exchange rates, so as to promote certainty in international exchange, and encourage cross-border trade and investment.

By the 1960s this system was beginning to break down on all sides: foreign governments announced periodic devaluations against the gold-linked dollar to promote exports and allow for domestic government spending, and the U.S. ramped up “guns-and-butter” federal spending on both the Great Society and the Vietnam War.  Inflation slowly crept into the U.S. economy, and gold redemption requests spiked by the late 1960s at the gold window of the U.S. Treasury.

President Nixon thus took his fateful decision in the summer of 1971, freeing the U.S. from any redemption obligations.  This had two immediate effects: it amounted to an automatic, if stealthy, repudiation of U.S. debt in real terms, because it devalued all dollar-denominated assets and currency at once; and it allowed the U.S. government, acting in concert with a technically-independent Federal Reserve, to manage the U.S. money supply for its own political ends indefinitely.  For the first time in millenia, gold was nowhere in the world used as a monetary medium.


The Predictable Aftermath of 1971


In developing his theory of money and credit a century ago, the great economist Ludwig von Mises explained why a system of fiat currencies was bound to break down: the politicians’ irresistible urge to inflate the money supply in order to commandeer the resources of the real economy via expanded government spending would prove too great.  Further, because the U.S. dollar was the de facto reserve currency of the globe post-Nixon (replacing gold itself), any U.S. inflation would encourage other nations’ money supply expansion and competitive devaluations pari passu. And indeed, an era of predictable instability has been the result: a trenchant stagflation in the 1970s; banking and S&L crises in the 1980s; Russian, Asian, and Latin American banking crises in the 1980s-90s; overleveraged financial institutions and moral hazard-based bail-outs of too-big-to-fail institutions in the 1990s-2000s; and in the last decade or so two Fed-induced bubbles and subsequent crashes, the second one based in the housing sector that went viral across the world thanks to the huge nominal amounts plus leverage of U.S.-based mortgage debt.

This instability has starkly proven another tenet of Mises’ seminal work: fiat currencies managed by central banks which have a monopoly of note issue, rather than being a source of macro-stability, are themselves the causal agents of repeated cycles of boom-and-bust business cycles.  By increasing the money supply at zero effective cost, central banks not only encourage government spending, they also cause interest rates to fall below their natural rate, which induces private investment and a temporary boom. But this boom, usually in capital equipment sectors or durable assets such as housing, is not based on real savings of individuals and institutions: that is to say, an accumulation of capital “backed” concomitantly by the real resources of society hasnot happened in this case.  Said more prosaically, the expansion is as phony as it is erroneous; by definition, such a boom is inherently unsustainable and unstable, and must end in a bust and painful retrenchment.  The greater and longer the creation of fiat money by the central bank, the harder and longer will be the ensuing recession.


A Path to Reform


The best solution to the myriad problems caused by the post-Nixon fiat currency management of the U.S. central bank is to return to a system of sound money, generated by private markets, and intermediated by a system of freely competing banks who issue their own notes.  These notes would be backed by any commodity, but likely would involve a return to gold.   Banks would compete for customer deposits and loan business via the soundness of their balance sheets, and thus could not over-issue, or face redemption of their outstanding notes and a collapse based on a bank run.  Such a system is far more stable than a monopoly central bank facing no constraints and the inexorable pull of political designs (malfeasance!).

But there are many challenges to developing and implementing such a free banking system with commodity money at the present time.  A second best solution would be for the Federal Reserve to cease and desist with any further fiat money creation – in essence, freeze the monetary base where it is,permanently.  The Fed could then announce an intent to return to full gold convertibility, and any new notes issued by the Fed (and utilized by Fed-member banks) would be 100% backed by gold. Any maturing securities held as assets on the Fed’s balance sheet would be used to purchase gold, to build the Fed’s reserves.  The permanent price of gold would be set over a period of months after the announcement of the new regime, as gold itself and competing currencies traded at new (likely lower) levels based on the U.S. government’s new commitment to dollar stability.

The results of this reform program would be electric and dramatic.  Capital investment would soar in the U.S., as America became a haven for high-productivity investment once again.  The entire U.S. economy would in effect be recapitalized.  While an end to activist Fed monetary policy would raise the short end of the yield curve, real interest rates would return to historic low levels due to dollar stability.  Such a monetary reform implies pro-growth fiscal reforms as well; the U.S. government’s spending profligacy would per force have to end, because fiscal laxity would no longer be supported by an accommodating Fed.   A new sound dollar and passive Fed would also engender other pro-growth reforms in banking, such as a reduction or end in deposit insurance, and a lower burden of regulations that stunt growth.  The banking sector would at once be more competitive, better capitalized, less brittle, and on sounder footing itself.

To bring this about, monetary policy must again become a big political issue – the dominating political issue – in a way it has not been since the Presidential election of 1896, when the pro-inflation William Jennings Bryan railed against a “cross of gold”, but was defeated in the general election by the proponent of sound money, William McKinley.   Indeed, this can happen if people come to understand that the main culprit of U.S. boom-and-bust recessions since 1971, and indeed the primary progenitor of the global disaster of 2008 from which we have yet to recover, is the political management of money by the Federal Reserve. Sound money, that is to say, honest money, is the antidote to the tragically unnecessary torpor of our modern world.

Dr. Chapman, an economist with Hill & Cutler Co. in Washington, D.C., is an advisor to Alhambra Investment Partners’ family of actively managed portfolios as well as a contributor to Alhambra’s research services. He and Alhambra founder Joe Calhoun are writing a book on how to invest and preserve wealth in today’s complex and turbulent markets.

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