Whither Gold? Part 3 | |||||||||||||||
By: | Antal E. Fekete | ||||||||||||||
Date: | 10/29/1996 | ||||||||||||||
The curse of unemployment The amount of R&D capital being accumulated by the partnership of the annuitant and the inventor is the most critical indicator of the future shape and health of the economy. In the final analysis, this is what makes the difference between a progressive and a retrogressive economic system. The presence of chronic unemployment in the economy indicates that inventors are being hampered by social or institutional arrangements in their efforts to form R&D capital. From this perspective, the government-run compulsory social security and unemployment insurance schemes appear highly retrogressive. Apart from the dubiousness of the procedure whereby the government spends the net premium income on current consumption while letting future taxpayers shoulder the burden of disbursing the retired population, and of the procedure whereby the government pays able-bodied people for not working, there is also the sinister problem of depriving the inventor from his traditional source of financing. The inventor is condemned to idleness; at any rate, his efficiency is greatly reduced, and his talents are wasted. The government-sponsored `safety nets' are retrogressive because they represent the dissipation of the annuitand's income and the annuitant's wealth, without any redeeming feature as to promoting capital accumulation, in particular, the accumulation of R&D capital. This completes the description of the square model of the capital market, where the four corners of the square represent the annuitand, the inventor, the annuitant, and the entrepreneur. The two kinds of partnership that arise in this model correspond to the formation of (1) entrepreneurial capital, embodied in the partnership of the annuitant and the entrepreneur, and (2) R&D capital, embodied by the partnership of the annuitand and the inventor. Often these partnerships are concealed under family bonds. The father is the annuitand (later, annuitant) and the sons the entrepreneur and the inventor. The family is the primitive social unit, providing the framework for the exchange of income and wealth among its members, as the need may arise. The square model of the capital market is a great conceptual improvement over the diagonal model; still, there is room for further improvement. A short course on capital formation Zero interest means direct conversion of income into wealth. As a total denial of incentives to exchange income and wealth, it forces the annuitand and the annuitant to revert to atavistic methods of conversion via hoarding and dishoarding the most hoardable commodity. At zero interest there will be no exchange, only conversion of income into wealth. The point is that the annuitand and the annuitant do have a choice. In the absence of incentives they will forgo exchange but will go ahead and make the conversion, as planned, through other means. The same choice, however, is not available to the entrepreneur and the inventor. Unlike the annuitand and the annuitant, they are fully dependent on the agency of exchange and credit if they want to make the conversion. The square model of the capital market reveals that the exchange of income and wealth is inherently asymmetric. While the annuitand and the annuitant can still satisfy their need to convert if the exchange fails, the inventor and the entrepreneur cannot. For them it is: no exchange -- no conversion. The impairment of bargaining power brought out by the square model of the capital market will be assuaged as we pass to the pentagonal and hexagonal models. These models describe the real world more faithfully. Yet it must be clear that the impairment can never be completely removed. The most important consequence of this asymmetry is that the rate of interest can be low, but will always remain positive. The inventor and the entrepreneur can, of course, improve their bargaining position to some extent if they form a partnership whereby the former provides the income needed by the latter. As a result, they will be net long on future wealth, and net short on present wealth. In order for the partnership to be viable, they must find a third partner who is willing to provide the needed credit in exchanging present for future wealth. This need has led to the rise of a new actor in the drama of human action. He is the capitalist, and his entry heralds the advent of the pentagonal model of the capital market. The rise of the capitalist is hereby explained not in terms of exploitation, but in terms of services which only a specialist can provide. These services are demanded by the partnership of the marginal inventor and the marginal entrepreneur. The marginal inventor (entrepreneur) is the one who has just missed his chance to form a partnership with the annuitand (annuitant). Without the services of the capitalist, marginal talent would be wasted. Thus capitalism is seen as a social system which allows individuals to specialize in the exchange of present wealth for future wealth, in order to enlarge the scope for entrepreneurial and inventive talent. Much of this talent was lost to society before the advent of capitalism. The triangular partnership of the entrepreneur, the inventor, and the capitalist is the most potent and dynamic force in the economy which society has heretofore produced. Ludwig von Mises considers the individuals in this partnership the "most progressive elements in society", benefiting the nonprogressive majority in every possible way. The particular combination of talent, brain and will-power represented by the threesome heralds a new epoch of progress, far beyond the capabilities of individual talents if employed in isolation. There has been many an inventor since paleolithic times whose genius has been wasted. The steam turbine was invented in the first century A.D. by Hero of Alexandria; the aeroplane in the fifteenth by Leonardo da Vinci. The efforts of pre-capitalistic inventors, for the most part, came to naught, due to lack of capital and entrepreneurship. The most ingenious technological inventions remain useless if the capital required for their utilization has not been or cannot be accumulated. Capitalism must be seen as the liberator of inventive talent, the creator of wealth and prosperity for the benefit of all. Its creative formula is: the trinity of the entrepreneur, the inventor, and the capitalist. One cannot assess the merit of capitalism without explicitly recognizing the great and durable reduction in the rate of interest it has brought about. Indeed, the only valid way to bring down the rate of interest is to enhance the bargaining power of the inventor and entrepreneur vis-à-vis the annuitand and annuitant through encouraging the activities of the capitalist. If the capitalist is hampered in his activities, then the annuitand and the annuitant will enjoy unrestricted monopoly power and the rate of interest will be high. The capitalist is anxious to break this monopoly. As a result of his competition, the rate of interest has been reduced from the extremely high levels prevailing in pre-capitalistic times to a low level which puts all bona fide inventors and entrepreneurs into business. Even more remarkable is the fact that capitalism has accomplished the feat of reducing the rate of interest without harming the annuitand and the annuitant. Every member of society is a beneficiary of the lower rate of interest brought about by capitalism, through the great increase in the availability of consumer goods at affordable prices, not to mention the unprecedented increases in wage rates. Only with reference to capital accumulation can we explain the practically inexhaustible list of prodigious amenities, and previously unheard-of comfort and security, the high wage-structure, all benefiting the common man, which is due solely to the lowering of the rate of interest by rising capitalism. Many of these great achievements have been frittered away since 1971, the year governments of the industrialized world declared irredeemable currency to be `money'. This declaration is directly responsible for the steep rise and gyration of interest rates during the past twenty-five years, a phenomenon that was previously unknown. The capricious increase in the level of interest rates has rendered a vast amount of capital and labor submarginal, caused unemployment, made capital maintenance inadequate and, ultimately, led to capital decumulation and destruction. The Shylock-syndrome The foregoing analysis of the phenomenon of interest in terms of exchanging income and wealth is far superior to the conventional analysis in terms of exchanging present for future goods. No one has ever exchanged an apple available today for 1 and 1/20 of an apple available a year from now (still less for 2 apples available 50 years from now); so the problem of exchanging present for future wealth does not arise out of any readily identifiable human need (except in the context of the activities of the capitalist in facilitating the exchange of wealth and income, as discussed above). Other than this residual activity of the capitalist, the exchange of present and future wealth has no basis in reality. By contrast, the problem of exchanging income and wealth arises out of natural and universal human needs: the need for educating the young and the need of the elderly for an income. This exchange explains the phenomenon and the nature of interest in terms of the division of labor, that is, by reaching back to lasting fundamentals. Exploitation, or temptation to exploit one's economically weaker brethren is not involved. Nor is odium or envy. The needs and aspirations of market participants, from the annuitands to the capitalist, are harmonious and complementary. There is no need to detest the capitalist and to depict him as Scrooge, any more than there is need to detest the heart surgeon and depict him as a butcher. They are both specialists, and their role can be understood only in the context of the need for their specialized services. The capitalist's role only emerges at the margin, after all natural partnerships between the entrepreneur and inventor have already been formed. Further advance at this point would not be possible without the services of a specialist, specializing in arbitrage between present and future wealth. By contrast, if we look at the problem of exchanging present for future wealth in isolation, before long the image of Shylock and his pound of flesh is conjured up in the mind. Above all, it is this Shylock-syndrome that socialist movements have been able to exploit with such consummate skill, appealing to the authority of Aristotle. This view is nurtured by a dismally inadequate understanding of the division of labor. As it appears to the socialists, the contract between lender and borrower demands that the latter be a superman. Only in uniting in himself the talents of the entrepreneur and the inventor can he meet the terms of his contract in full. How otherwise could he be expected to return a greatly enhanced wealth to his creditor at the end of the loan period, without ruining himself? Surely, the terms of his contract demanding a pound of flesh from any part of his body was designed with the extinction of his life in mind. What the socialists' view disregards is that the capitalist is not dealing with one individual but with a partnership combining the talents and skills of two: the entrepreneur and the inventor. Had Aristotle understood the problem of converting income and wealth into one another, and its optimal solution via the agency of exchange, credit, and the division of labor, the wind would have been taken out of the sails of socialist agitation before it had a chance to cause so much mischief in the world. Instant reward, instant penalty Another merit of the pentagonal model is that it makes the process of capital accumulation transparent. If we disregard the primitive accumulation of capital by the artisan fashioning his own tools, a process that no longer plays an important role in the economy of the industrial world, then we shall find that capital can only be formed in one of three possible ways: through the formation of a partnership of (1) the annuitant and the entrepreneur, (2) the annuitand and the inventor, or (3) the entrepreneur, the inventor, and the capitalist. Debt creation does not create capital per se; it only shifts risks implicit in previously existing partnerships, without necessarily producing new wealth. By contrast, the formation of capital in any one of the three combinations described here does in fact create new wealth. Furthermore, the pentagonal model establishes precedence and control among the five actors in the drama of human action. Thanks to the existence of these controls capitalism has become an instant reward/penalty system ensuring unparalleled efficiency. (This, incidentally, may be another reason it is hated so by the indolent.) The priorities of capitalist society are not set by bureaucrats or by zealots with the power of disposal over the fruits of the savings of others, but by the savers themselves who stand to suffer losses if the project fails. Bureaucratic power under socialism means that mistakes can be heaped upon mistakes without corrections being made. Socialism lacks a feedback mechanism that alone can make timely corrections possible. The hierarchy of controls under capitalism runs along the following lines. The annuitant has veto power over the plans of the capitalist; the annuitant in concert with the capitalist has veto power over the plans of the entrepreneur; the annuitand and the capitalist in concert with the entrepreneur have veto power over the plans of the inventor. The inventor has no veto power at all, but since there are more annuitands than annuitants under the conditions of positive population growth, capitalist society can employ even more inventive than entrepreneurial talent. The field is wide open for the inventor. A dynamic society tends to put a premium on new ideas. It has natural built-in incentives for higher education and advanced studies, even in the absence of compulsory schooling and government-sponsored research. It is these dynamic forces, represented by net R&D capital formed by the annuitand and the inventor, which create educational facilities and equip laboratories. The government can hardly do more than formalize and standardize these. It certainly cannot guide their destinies -- that would be the prerogative of their progenitor, the pentagonal capital market. A government that pretends to do more, one that tries to dictate educational or research priorities, is far from being progressive. It is, in fact, retrogressive -- as the present analysis shows. The welfare state as we know it... The pentagonal model of the capital market explodes the myth of the welfare state. According to this myth the government can finance welfare projects by taxing away some of the profits of the capitalist. However, the activities of the capitalist are marginal, representing but the tip of the iceberg. The incomparably greater part of the capital that society needs in order to provide annuity income for the aged is furnished by less visible partnerships between the annuitant and entrepreneur, or the annuitand and the inventor. Social security eliminates, or at least severely curtails, voluntary exchange of income for wealth, and thereby hampers capital accumulation. The welfare state confuses charity with entitlement, and its huge commitments in putting social security benefits on the basis of universality have no actuarially sound basis in finance. The making of these commitments puts the very people out of business whose savings alone can provide the wherewithal for the projected benefits. We cannot help but view the capitalist economy as an integrated welfare-machine: individuals voluntarily exchange goods against goods, goods against services, and income against wealth, increasing welfare at every turn. In the process they form voluntary partnerships representing the creation of new wealth through the capitalization of income. The welfare state cannot invade one part of this machine, taking over its functions, and expect that the other parts will go on performing satisfactorily. This invasion means the forcible dissolution of partnerships, and the dissipation of their capital. The assets disappear, yet the corresponding liability in the consolidated balance sheet of the nation remains. It will have to be balanced by printing government bonds, payable in irredeemable currency. As long as the purveyors of goods and services continue accepting irredeemable currency in exchange for real goods and services, the game of musical chairs can go on. But as the capital structure of the nation is seriously eroded, the production of goods and services become more costly, and producers suffer losses. At one point they must raise prices or, if they can't, go out of business. Either way, the benefits promised by the welfare state are jeopardized by currency depreciation and destruction of capital. The welfare state must be seen against this background: it is an accomplice in the scheme of currency debasement and, more ominously, in the scheme to dissipate and destroy the nation's accumulated capital. During the past year or so the leaders of several industrial nations have solemnly announced the end of the era of big governments with big deficits, and started talking about the need to down-size the welfare state. In view of the foregoing analysis, this is certainly a positive development. However, these leaders have failed to make the necessary connection between the welfare state the promises of which are impossible to fulfill, and the regime of irredeemable currency that can make every promise appear credible that vote-buying politicians may care to make. The truth is that a meaningful review of the premises of the welfare state must of necessity include a review of the premises of the regime of irredeemable currency. Are our politicians ready for such a review? The gold bond Further division of labor saw the rise of a sixth participant, the investment banker, and the emergence of what we may figuratively call the hexagonal model of the capital market. Just as the rise of the capitalist was explained above in terms of the special services he was to provide to the marginal entrepreneur and the marginal inventor, so the rise of the investment banker is explained here in terms of the special services he is to provide to the marginal annuitand and the marginal annuitant. The marginal annuitand (annuitant) is the one who has just missed his chance to form a partnership with the inventor (entrepreneur). Without the services of the investment banker much of the marginal resources of society would be wasted. No two annuities are alike, and trading them would be difficult or impossible in the absence of an instrument readily exchangeable for either. The success of the capital market depends on the availability of a versatile and standardized trading instrument which can be used as (1) the standard of capital values, and (2) the balancing item of liabilities on capital account. This instrument is the gold bond. It evidences debt payable at maturity in gold, and provides an interest income till maturity, also payable in gold. The income is represented by the coupons attached to the bond. The gold bond is traded in a broadly based secondary market, and a sinking fund is established to make sure that its market value does not erode with time. It is incumbent on the issuer of the bond to do everything in his power to keep the market value of the bond stable, if need be, by retiring some of the outstanding issue prematurely. It is the price of the gold bond that determines the rate of interest. As prices, the rate of interest is also an outcome of the market process. However, keep in mind that the bond market is the epitome of a far larger and far more pervasive capital market encompassing every conceivable exchange of wealth for income, most of which is not readily visible. The investment banker's function is clearing and brokering: he matches the various and varied demands thrown upon the capital market from its five corners. He enters into partnership with the annuitand, the annuitant, the entrepreneur, the inventor, and the capitalist, as the need may arise, through his specialized instruments of mortgage and annuity contracts. He balances the net liability or asset arising from this activity through his purchase or sale of the standardized instrument, the gold bond. In effect, the investment banker is doing arbitrage between the six corners of the capital market. The hexagonal model of the capital market opens up a great increase in scope for the most successful combination of production: the triangle of the entrepreneur, the inventor, and the capitalist. From now on they can form their partnership even if unbeknownst to one another. The inventor need not waste time in seeking out a congenial entrepreneur, nor the entrepreneur in finding a suitable inventor. If the invention is good, and the enterprise is sound, they could immediately start production on the most favorable terms through the good offices of the match-maker, the investment banker. Nor does the capitalist have to remain wedded to the same inventor and entrepreneur for the entire duration of the project. Through buying and selling gold bonds he can always go after the project that appears most promising to him. Thus the problem of forming optimal triangles is safely thrown onto the bond market. The sterility of gold Aristotle introduced the concept of natural law and concluded that taking and paying interest on borrowed money violated it. Gold and silver are, by nature, sterile. Any return to productive investment belongs to labor in full, no part of it ought to go to the lender of capital resources. The Church embraced the notion of natural law, and the usury doctrine became a Church doctrine. Roman Law was combined with the teachings of Aristotle to become Canon Law. The prohibition on interest was designed to protect the debtor but, to the increasing embarrassment of the canonists, it had the exact opposite effect. It increased both the cost and the risk of doing business. After the Code Napoleon, adopted all over western Europe, had allowed the paying and taking of interest, the Church, too, decided to abandon the old usury doctrine. It was quietly buried in 1830, when the Sacred Penitentiary issued instructions to confessors not to disturb penitents who had lent or borrowed money at the legal rate of interest. Recently, mainstream economic orthodoxy has revived the old doctrine of Aristotle about the sterility of gold. No textbook on economics that mentions gold at all fails to add that gold is a barren asset, incapable of producing a return. Holders of gold are portrayed as morons waiting for doomsday, unwilling or unable to do anything constructive for society. This opinion is echoing Keynes who was the first economist suggesting that there was something bordering on the neurotic involved in the desire to hold a sterile asset. However, the neurosis is not on the receiving side of the anti-gold propaganda. Rather, it is on the giving side. Governments have pangs of conscience with respect to their citizens and creditors, with whom they have broken faith on several counts. Instead of making a clean breast of it, they have made it incumbent upon the economic profession to develop new doctrines to cover up chicanery and duplicity, to justify fraudulent bankruptcies, retroactive laws, devaluations and debt abatements. Politicians and servile economists are still badmouthing gold as if it was a narcotic. They have triumphantly declared that gold is `dead'. Yet the gold corpse still stirs, and it keeps haunting the house of cards built upon irredeemable promises. The phrase `sterility of gold' needs to be scrutinized. For Aristotle it meant that gold, unlike corn, cannot be sown in the soil in order to harvest more gold later. His condemnation of usury was dictated by what he conceived to be natural law. Mainstream economists mean something else by that phrase. They admit that even corn is sterile in the sense of Aristotle. To reap a harvest takes more than seed corn and soil. Capital in the form of fertilizers, tilling and harvesting tools must also be introduced, along with human labor, in order to make the seed corn productive. Seed corn is just one of the numerous factors of production, and only the full complement of all these factors can be considered productive. And, since all these factors can be purchased with money, it is well-understood that money can be productive in the hands of the entrepreneurs. This fact is reflected by the willingness of banks to pay interest to depositors on money they pass along to producers. In this sense it is admissible to say that money is productive: it can earn a return. Mainstream economists do not deny that gold was productive, in this generalized sense, under the gold standard. But they insist that, with the advent of the new millennium, gold has forever lost its former productive power to the irredeemable bill of credit. Gold has become sterile again. It can earn no return -- only irredeemable bills of credit can. It is important for us to realize that every word of the doctrine on the sterility of gold is an outright lie. Not only can the owner of gold earn a return in gold on his holdings even under the regime of irredeemable currency, but gold is the only form of tangible wealth that can be lent out at interest and that is in constant demand as such. There is a lively gold loan market in the world: gold is put out in loans and is borrowed at interest on a regular basis. It is used in financing great capital projects as well as trade -- in the same way (although not on the same scale) as it always did under the gold standard. Under these loan contracts both principal and interest are payable in gold. Nor is this something new: gold lending has continued uninterrupted in countries where the necessary legal protection of contracts involving gold loans has not been abrogated. `Demonetization' did not succeed in abolishing the lending and borrowing gold at interest, it only abolished the truth about it. Even students of economics are deliberately kept in the dark about the existence, functioning, and extent of these gold loan markets. The reasons for this obscurantism are not hard to find. The rate of interest on gold loans is low and stable. The much higher and more volatile rates of interest payable on loans made in irredeemable currency could not stand comparison with it. Dissemination of truth could raise awkward questions about the legitimacy of the present monetary regime. People might inquire why they cannot have a monetary system that would automatically guarantee the lowest possible rate of interest. 3. The Redistribution of Losses The gold bond is essential to the theory of interest presented in this essay. The formation of the rate of interest under a regime where interest is payable in irredeemable currency is an entirely different matter. The central bank's attempt to keep a lid on the rate of interest is doomed, as this effort incorporates the contradictory aims of monetary policy and interest-rate policy. Open market operations in bonds can indeed be used to lower the interest rates that are high due to currency depreciation. The central bank goes into the open market and buys government bonds. As a result bond prices go up or, what is the same, interest rates go down. But the flipside of this is that now there is even more irredeemable currency in circulation. This cannot help but make the pace of currency depreciation increase. Yet it was the fast depreciation of the currency that was responsible for the high interest-rate structure in the first place. In other words, while the central bank is fighting a side-effect of the disease, it only makes the root cause more entrenched. Furthermore, under the regime of irredeemable currency malevolent bond speculation overwhelms and strangles benign bond arbitrage. Recall that under the gold standard there was no bond speculation -- none whatever. There was only arbitrage between different maturities, keeping the yield curve in good shape. The price of bonds, and with it the rate of interest, was remarkably stable, precluding profitable speculation. But when governments left the path of monetary and fiscal rectitude and started passing retroactive laws, declaring fraudulent bankruptcy, devaluing the currency under false pretenses, reneging on gold clauses enshrined in their bond obligations, and embracing the policy of debt abatement -- they threw the value of their outstanding bonds to the winds. The arbitrageurs responsible for maintaining stability in the bond market are gradually forced to vacate the field. Their place is being taken over by speculators who thrive in volatile markets. The entire character of the bond market and bond trading has changed beyond recognition. The rational basis upon which bond values rest was overthrown when gold-redeemability of the currency was abolished. The fanatic denial of this fact is central to mainstream economic orthodoxy. Nevertheless, the disappearance of predictable arbitrage and the advent of unpredictable speculation make for violent and increasing fluctuations in the rate of interest, throwing the capital markets into a turmoil. No longer does the propensity to save regulate the availability of long-term credit through the mechanism of the interest-rate structure. The regime of irredeemable currency is characterized by a chronic paucity of savings -- regardless how high the rate of interest may go. Savers are not blind to the fact that their savings, denominated as they must be in a depreciating currency, are continually and systematically plundered. Their protector against plunder, the gold coin, has been ousted from the system. But the savers are not entirely defenseless, and they can fight back. They could consume their savings before further depreciation takes its toll. More ominously, they can extend their consumption beyond the limits set by existing savings, if they plunge into debt in an effort to turn a bad situation, created by the depreciating currency, to advantage. It can hardly be doubted that a lot of this is occurring in the world today. Crossing the wires at the traffic light The regime of irredeemable currency creates a disharmony between individual and society, where harmony has reigned before. Through a false incentive system, this regime inhibits capital accumulation and, ultimately, it promotes capital consumption. The need to convert income into wealth is overtaken by the need to protect oneself against plunder. The propensity to save is corrupted by the false view that savings can be substituted by debt. While there are natural limits to debt-creation under a gold standard, all such limits have been thrown to the winds under the regime of irredeemable currency. The volume of total debt increases exponentially as interest paid on the old debt is immediately converted into new debt. The mechanism to liquidate debt has been dismantled. Debt can no longer be liquidated, and at maturity it is dumped into the lap of the government. As for the government, there is simply no way to retire its debt. Redeeming a government bond in irredeemable currency merely replaces interest-bearing debt by non-interest-bearing debt (that is, by a less desirable form of debt, making the debt-pyramid even more unstable). In the meantime total debt is increasing exponentially, following the law of compound interest. The inordinate growth of the Debt Behemoth and the ongoing capital destruction inevitably lead to a credit collapse. The forcible removal of gold from the heart of the credit system in 1971 was ill-advised. It brought about a radical change in the character of the bond market. It drove out the arbitrageur, and invited in the bond speculator. The regime of irredeemable currency crosses the wires at the traffic light. It sends the red signal to producers when the green signal is intended. High interest rates beget even higher interest rates, as speculators keep betting on lower currency and bond values. Threatened by ever higher interest rates, producers are confronted with endless capital losses. This is a regime of hot money jumping around nervously from place to place, seeing no safety anywhere, but going from places that seem unsafe to places that, for the moment, seem less unsafe. This is a regime under which men are afraid to make long-term plans, or to grant long-term commitments. This is a regime that encourages farmers to eat the seed corn, the dairy-man to slaughter the milch-cow for the meat, and the orchard owner to cut down his fruit trees for firewood. This is a regime of junk bonds. The degeneration of the bond market into a casino where gamblers run riot pronounces a most devastating verdict on the regime of irredeemable currency. Previously all owners of capital, including the speculators, were subjected to the same discipline, and were constrained in their activities by a market process making them servants of the general public. If they correctly anticipated changes caused by the uncertain future, speculators would reap profits. But if they failed to do this, then they would suffer losses and, unless they mended their ways in time, they would lose their capital to others who were better at serving the public. Now, under a new dispensation granted by the regime of irredeemable currency, speculators can be self-serving without the obligation to promote the general welfare. They grow fat on the sweat and blood of the public. All they need to do in order to make a killing is to out-guess government bureaucrats whose job it is to manipulate currency and bond values. The dance of the derivatives In the economic literature it is customary to make a distinction between stabilizing and destabilizing speculation. The distinction is spurious. All legitimate speculation is stabilizing, if by `legitimate' we understand speculation addressing risks inherent in nature (e.g., weather, natural disasters, etc.) By abuse of language, the word `speculation' nowadays is applied to market activity that addresses risks presented not by nature but by arbitrary government action. However, a word already exists in the dictionary to describe this kind of activity, namely, gambling. Properly understood, under the regime of irredeemable currency participation in foreign exchange and bond markets (including derivative markets in futures and options) is not speculation but gambling. The risks involved have been artificially created by arbitrary measures. Just as increased participation at the roulette table cannot reduce the risks of betting (and can often increase them) increased `speculation' in the bond markets cannot reduce price fluctuations (but is more likely to increase them). Under a gold standard speculation in grains is economically justified by the existence of future uncertainties presented by nature. In the case of an unexpected crop failure or bumper crop the price disturbance is minimized by the presence of a speculative supply or demand. No such justification for bond speculation can be offered. All the risks are wholly artificial and cannot be reduced by inviting speculative participation. On the contrary, price-swings are likely to increase along with increased participation. This is a case of pure gambling. The linguistic innovation of calling it `speculation' will not change its nature. Government economists suggest that the derivative markets in interest-rate futures have the same salutary effect on interest rates as future markets in grains have on grain prices. There is not the slightest evidence to support this claim. The effort to smooth out interest-rate fluctuations under the regime of irredeemable currency by creating more opportunities for bond speculation and for trading derivatives in interest-rate futures is doomed. Opening ever more derivative markets will backfire. More gambling creates more uncertainty, not less. The regime of irredeemable currency is characterized by insufficient capital accumulation or maintenance and, ultimately, by capital destruction. It cannot be rescued by legalizing gambling. The `Dance of the Derivatives' of 1994-95 gave a foretaste of what is to come. Banks, commission houses, pension funds, and even municipal governments are known to have gambled and to have suffered grievous losses, some irreparable. Observers blamed the debacle on inept or dishonest traders. A more adroit analysis would, however, show that disaster had to strike in any case. The same thing would have happened even if traders had been meticulously following the traditional methods of hedging and arbitrage. The truth is that the old rules no longer apply. Once the sheet anchor of gold has been removed, the character of the game has changed beyond recognition. Previously gold acted as the policeman keeping speculators in line. Because of the presence of gold in the system, the speculators could gang up in order to bid up commodity prices, or to drive down foreign exchange rates and bond values, only at their own peril. Their bidding would immediately be confronted with relentless arbitrage, exacting a heavy penalty for reckless bidding. Arbitrageurs could count on gold, the policeman of the system, in resisting recklessness in speculation. But with the policeman fired and no replacement commissioned, speculators can gang up with impunity, induce and ride price trends unilaterally, until they are ready to make a killing. Speculation has become malignant. Speculators ran up the price of sugar to 75 cents a pound and that of crude oil to $42 a barrel -- and made money all the way up. They drove down the price of a $1,000 Treasury bond to $500 and the yen-price of the U.S. dollar to 78 -- and made money all the way down. And they made a killing when they sold sugar at 75 cents, crude oil at $42; and when they bought Treasury bonds at $500, the U.S. dollars at 78 yens. During these episodes arbitrageurs have been conspicuous only by their absence. They are intimidated in the absence of the police, and are gradually withdrawing their services. When the last arbitrageur abandons the market, the speculators will have a field day. They will bid commodity prices up to the sky, and drive currencies and bonds to the ground. Without the guarantees of the gold standard, no arbitrageur will be able to oppose the speculators when the bull-run in commodities and the bear-run in securities start in earnest. Sweeping losses under the rug The term `redistributive society', as it is used by both its protagonists and antagonists, refers to the redistribution of wealth and income -- after they have been produced. More ominously, a movement to redistribute future losses is afoot. If successful, losses will be perpetuated and passed on to society. The scheme will allow the indolent, the inefficient, the inept, and the consistent loss-maker to continue in business indefinitely at the expense of the industrious, the efficient, and the profit-conscious. But if the distinction between profit and loss is obliterated, society's internal communication system may be falsified. Ultimately, production would be thrown into confusion. The leitmotif of our chrysophobic age can be described as a parade of the loss-makers. The profit-conscious must be cowed into submission. The gold standard is anathema to the lobby of the loss-makers, as gold puts profit and loss into the sharpest focus, separating the adept from the inept, the industrious from the indolent. The lobby wants a system under which distinction between profit and loss becomes fuzzy, inefficiency can be covered up, and ineptitude entrenched. What is true for firms is also true for governments. The post-war monetary system is a creature of the victors, in particular, of the U.S. and the British governments. Its thinly veiled purpose is to accommodate indolence and ineptitude in international trade. Its authors have openly advocated a monetary system that gladly tolerates deficits, and unhesitatingly penalizes surpluses on current account. In practice the vanquished, especially the German and the Japanese governments, were forced to make their central banks a dumping ground for an endless stream of unwanted paper issued by the victors. The `unlimited demand' thereby created for U.S. Treasury issues makes the illusion in the public mind that the millennium of irredeemable currency has indeed arrived at the long last. We should be well-advised not to fall victim to this hoax. We should not be misled by the docility of the German and Japanese governments in playing faultlessly their preassigned role in the farce. They have absorbed losses counted in trillions, without ever saying "ouch". The Japanese started accumulating irredeemable paper when it cost them 360 yens to buy one dollar -- as opposed to the 1995 low of 78 yens to the dollar. The corresponding figure for the Germans is 4 1/2 marks to the dollar initially -- as opposed to the 1995 low of 1 1/3 marks to the dollar. The Germans and the Japanese are still sitting on mountains of paper losses that nobody is reporting, still less willing to discuss. Yet it is the destiny of paper losses that sooner or later they must be realized. Could it be that the collapse of the stock market in Japan earlier in the decade, the present banking crisis there, and the recent weakening of the German financial structure, are signs of the beginning of the end? Losses are a stubborn thing. They refuse to go out of existence, no matter how docile the victims of the redistribution of losses may be. This is a dangerous game of deception that governments can continue playing only at their own peril. 4. Whither Gold? Gold in the monetary system makes for stability and efficiency. One cannot disparage either of these virtues any more than one can disparage motherhood. A low and stable interest-rate structure, in particular, cannot be achieved without making credit gold-bonded. This elementary truth is now in the public domain, even though our universities have been somewhat tardy in accepting it. But the U.S. Congress would be well within its constitutional authority if it provided monetary leadership in the world. It is possible that a majority of members in that body will come to realize that, in order to be master in their own house, they must get hold of the wildcard in the pack. If they want to control the budget deficit, they must regain control over the cost of debt servicing -- the very wildcard they haven't got. In order to get hold of the wildcard, Congress must once more make the public debt gold-bonded. As debt payable in irredeemable promises is being phased out, and gold-bonded debt is being phased in, the interest-rate structure will be stabilized at the lowest level compatible with the state of the economy. Only then can a meaningful program of deficit and debt reduction be implemented. As long as the wildcard is out, a collapse in the bond market will remain a constant threat, as sky-rocketing interest rates can frustrate any plan for deficit reduction. The expertise in how to execute the transition exists within the Halls of Congress. In 1989 Representative William E. Dannemeyer of California (now in retirement) pioneered a scheme of deficit reduction based on the idea of turning short-term/high-cost debt by long-term/low-cost debt. The miracle of turning water into wine can be accomplished by making the debt gold-bonded. Presently Senator Bennett of Utah is championing a similar plan. With the aid of gold the Debt Behemoth could be reined in -- provided the political will and statesmanship is there. How to cork the genie in the bottle Why is gold relevant to-day? Clemenceau's saying that "war is too important to leave to the generals" may be paraphrased as "interest rates are too important to leave to the central bankers". The genie of interest rates has been let out of the bottle and nobody, not even Aladdin Greenspan, can tame it. There is too much destruction and uncertainty in the world caused by gyrating interest rates. It is time to put the genie back into the bottle, and cork it. This is where gold comes in. Only a golden cork will do. The genie has learned how to sneak through corks made of paper. We don't even have a coherent theory of interest without reference to gold. Under the regime of irredeemable currency interest is merely bribe-money, trying to persuade reluctant holders of irredeemable promises to hang on awhile longer. The maturity structure of the U.S. public debt is contracting. Clearly this process cannot continue indefinitely. The size of the bribe expected increases with the amount of the fast-maturing debt. Gold cannot be wished away from the credit system. It is there, like it or not. Gold is the only conceivable standard of borrowing. The lowest rate of interest is available for gold-bonded debt -- and for no other. Loans payable in irredeemable currency carry progressively higher rates of interest. How high they go depends on public fear of currency depreciation. Paradoxically, gold's importance is growing while its dispersal from official hoards and the mines continues apace. Dispersed gold represents latent power, far greater in scope than its nominal market value, as sound credit can be built only upon a gold base. When the dispersal of gold reaches a certain threshold (nobody knows where exactly this threshold is), a metamorphosis of money will take place. Gold will reclaim its throne as constitutional monarch in the monetary and credit system of the world. Unfortunately, the transition may not be trouble-free. Procrastination in overdue monetary reform brings with it the danger of a credit collapse -- similar to that experienced under the Great Depression of 1929-39, causing widespread economic pain in the world. Educating public opinion to look at gold as a gift of Prometheus, rather than Pandora's box, after 75 years of vicious chrysophobic agitation and propaganda, presents us with a formidable task. Yet we must do what we can to disseminate the truth about gold. The consequences of the alternative, a credit collapse engulfing the entire world, are too horrible to contemplate. References Carl Menger: Grundsätze der Volkswirtschaftlehre, first published in 1871; American edition: Principles of Economics, New York University Press, 1980 Ludwig von Mises: Human Action, Chicago, 1972 F. A. Hayek: Commodity Reserve Currency, Economic Journal, vol. LIII, no 210 (1943), reprinted in Individualism and Economic Order by F. A. Hayek John Maynard Keynes: A Treatise on Money, in two volumes, London, 1930 Robert Hinshaw, ed.: Monetary Reform and the Price of Gold, Baltimore, 1967 (Conference proceedings; see Robert Mundell's contribution) Milton Friedman: Money Mischief, New York, 1992. Richard M. Salsman: Gold and Liberty, Great Barrington (American Institute for Economic Research) 1995. October 29, 1996. | ||||||||||||||||
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