The Greatest Lie Ever Told
September 29, 2010
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Investors are still the primary allocators of capital in the market economy and the question on nearly every investor's mind is how much of that capital should be allocated to precious metals. I can't answer this question. It's up to the individual investor. I can, however, help you, the investor, understand how we went from a world of gold to a world of monetary chaos. That's the purpose of this post.
The Classical Gold Standard
In 1896, prices were lower in American than they had been in 1834, when the United States went back on a 100% gold standard. The Civil War caused some price distortions through inflation (wars and inflation are inseparable.) But from 1879, when the U.S. returned to a full gold standard, until 1896, prices fell at 3% annually. Wages, on the other hand, remained flat and in certain cases, even roses. In fact, wages rose steadily throughout the 1800's. Imagine the impact this had on the standard of living of poor Americans. For 18 years, assuming their salaries remained constant, their standard of living rose by 3% annually. That means that in 1896, the average American worker's standard of living rose by roughly 70% over what he enjoyed in 1879.
Price-Specie Flow Mechanism
The problem with the gold standard was its inflexibility. This was a problem for governments, not for the people. For the people, the benefit of the gold standard was its inflexibility. Central banks around the world used a pyramid scheme in conjunction with gold. At the base was a certain amount of gold. At the top was the created paper money, each with a claim on gold. If the central banks or the governments wished to increase the amount of money in circulation (inflate), they were restricted by a phemenon known as the price-specie flow mechanism. I will explain how this works in the comment section if requested. The end result was gold flowing out of the country at a rapid rate. To stop this flow, interest rates had to be raised, gold started flowing back in, and inflation was checked. So the price-specie flow mechanism was a built-in check on inflation. Economic law tied government's hands.
World War I
Within two weeks of the outbreak of WWI, every belligerent nation went off the gold standard. Monetary chaos followed. Inflation ravaged Europe. The United States stayed true to the gold standard for the most part until they entered the war in 1917. Gold travelled to the U.S. in large quantities during this time, causing a sudden increase in American wealth. For now, I'll spare you a lecture on modern war and inflation.
After the war, European nations had great difficulty in returning to the classical gold standard. The problem wasn't the gold standard. The problem was that government officials and the central banks refused to face the realities of what they had done. In 1925, England, for example, tried to repeg the Pound at the old ratio of one pound = 1/4 oz. of gold. This folly was compounded by the fact that England was already suffering a massive economic recession by that time. The reality was higher prices and a weaker peg to gold. But even if England had set the peg to reflect reality, they were still in for economic pain. Wars aren't free.
Due to the price-specie flow mechanism, gold was flowing out of England at a rapid rate. Representatives of the Bank of England met with the Federal Reserve and devised a plan to "save" England from destruction. Obviously, what England was trying to save itself from was reality. There is no escaping reality. The Federal Reserve agreed to raise prices in the United States through inflation (creating money out of thin air,) hoping that this would check the flow of gold from England to America. What followed was the roaring twenties, a stock market bubble, and a crash back to reality.
Monetary Chaos Leads to Political Intervention
In America, reality was wished away by Herbert Hoover. Hoover's role in turning a crash into a Depression can be explained further in the comment section if requested. Hoover's interventionism included public-works projects, expanding government spending to record levels, and forcing businesses to keep wage rates at price levels prevelant during the inflationary boom, instead of allowing businesses to adjust to the new economic reality.
Every western nation gave up on the classical gold standard by 1936. They had refused to face economic reality, and if one were to be honest you could say that every politician was attempting to put off paying for the war follies for as long as possible. In the United States, FDR, after campaigning against Hoover's fiscal irresponsibility, confiscated American gold holdings in 1933. This effectively ended the gold standard in America, though I argue that the Federal Reserve ended it in 1926 with an act of treason. Americans were not allowed to own gold, except in their teeth and around their necks, from 1933 to 1976.
FDR followed up his gold confiscation by repegging the dollar to 1/35th of an ounce of gold, rather than 1/20th. The purpose of this plan was to make inflation (again, classical definition) easier to implement. One doesn't have to be an economic genius to realize that you can't cure a disease caused by inflation with more inflation, but that was FDR's plan.
World War II and Bretton Woods
Sadly, Western countries weren't done sending people to the slaughter. The Great Depression, caused by the monetary chaos of World War I, led desperate people to turn their anger towards someone, they just didn't know who to blame. Their governments provided a scapegoat. It was everybody else's fault but theirs.
Following another round of needless carnage called World War II, several better-than-thou snakes and scoundrels met at a fancy resort in New Hampshire called Bretton Woods (on stolen taxpayer money, of course). There, Britian's JM Keynes and America's Harry Dexter White (a Soviet spy) proposed ideas for a stable government-issued currency. Neither plan was adopted in total. A compromise worked out by the delegation resulted in the famous Bretton Woods agreement.
The agreement called for each country to hold dollars, rather than gold, as backing for their currency. America, the largest gold hoarder at the time, would promise to pay gold to any country wishing to exchange dollars. The idea was that this would allow countries to pursue a course of moderate inflation in order to..... that's right, repay war debts. (I hope you are starting to see that the entire idea of monetary policy is a giant joke intended to allow countries to pursue reckless wars and pass the buck to anyone stupid enough to pay it.)
Bretton Woods was doomed from the start. People will trust their governments, even when it becomes obvious that the government is full of crap. Other governments however, knowing how full of crap they are, have no such delusions. The French, perhaps more aware of their own crap than anyone else, were beginning to balk at this arrangement by the mid 1950's. The Germans were wising up too. It turns out, it's easier to bribe a German than a Frenchman (who would've guessed?)
Here's what happened. At first, everything was going along smooth. All parties played the charade and no one cared much that America was slightly inflating their currency. But instead of gold flowing out of America, as the price-specie flow mechanism would indicate, dollars were flowing out of America.
When LBJ took over and decided America could afford a war on just about everything he didn't like (and if there was one thing LBJ couldn't stand, it was something he didn't like), America started inflating the currency at a rapid pace. But it was exporting its inflation to Europe. Europeans, with dollars backing their currency, were paying high prices because of LBJ's policy of "guns and butter." Europeans paid for the Vietnam War. I'm sure they're very happy about that. When the Germans protested the inflationary policies of DC, they were told in polite terms that it might be necessary to withdraw America's defense shield. The French, however, couldn't care less. They knew America was attempting to run a "deficit without tears." In other words, they were passing the buck for the war to anyone stupid enough to pay it.
The Breakdown of Bretton Woods
Meanwhile, gold was being traded in open markets in Zurich and London. Whenever gold rose about $35/oz., European governments had to sell gold on the market to drive the price back down. The US government alternated between bribing Europearns and threatening gold producing countries, particularly in Africa, to slow production. (Don't you dare make money at our expense!) But doom was around the corner. In 1971, with countries lining up behind the French to redeem their gold, Nixon closed the gold window, essentially declaring bankruptcy and telling Europe, sorry but you won't be paid back for our military follies you financed. Haha, suckers!
The Short Lived Reign of the Keynesians
Enter the witch doctors. The Keynesians took over, despite being unable to determine the root cause of the world's monetary problems. The Keynesians wanted a world currency, with some gold backing that would allow a range of manipulation as needed. But their reign was cut short when America suffered from nasty inflation and unemployment (a combination known as stagflation), during the 1970's. The Keynesians had said that stagflation was impossible. They went back to their hole.
Next!
The Short Lived Reign of the Monetarists
The Monetarists rose to prominence in the 1980s. They wanted a free floating exchange between government paper currencies, with absolutely no gold backing. They figured that if one country inflated, the drop in its exchange rate would force them to raise interest rates and bring inflation back in line. Unfortunately, they didn't say what would happen if every country inflated. This is when world-wide inflation really took off.
Next!
If Neither Theory Works, Let's Combine Them
The 1990's saw the rise of the hyphenated economist. Everyone was a neo-this or a post-neo-modern-that. Keynesians bought the line from the monetarists that the Great Depression was caused by deflation. Monetarists accepted that some government spending might be needed to help stimulate a depressed economy.
We ended up with the worst of two worlds. Now every modern nation is inflating their currency and spending borrowed money. Predictably, we've crashed again, and crashed hard. So the same old story goes. Governments around the world are scrambling to figure out who they can pass the buck to. There has to be someone out there, some total patsy, willing to eat the debts we've accrued.
The Greatest Lie Ever Told
So what's the greatest lie ever told? It's the lie that places the blame on the Great Depression and the monetary chaos that has followed on anyone or anything besides the governments that caused it. These are not market failures. The booms and busts, the economic distortions, the inflation, the increasing destruction of the middle class, the robbing of savings, the increasing poverty, the rise of big business and big government, the death of liberty. All of these things are the result of governemnts refusal to accept economic reality.
Keep that in mind, as well as the events that brought us here, as you ponder how much capital you want to allocate to precious metals. Governments around the world are looking for a patsy. They can't pass the buck to you if you've already turned it in for gold.
David in Qatar
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