# Fekete Archive — Full Content

> Full Markdown content of every essay and lecture in the Antal Fekete archive hosted at newaustrianeconomics.com/archive/fekete. Published separately from /llms-full.txt because of size (~5MB). Site overview and index: /llms.txt.

=========================
Popular Economics
=========================
# Waiting for Godot

URL: https://newaustrianeconomics.com/archive/fekete/waiting-for-godot/
Date: 2018-02-01
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, fiat-currency, monetary-crisis, permanent-backwardation, new-austrian-economics
Description: Fekete's final essay in the archive, using Beckett's play to frame the monetary situation: like Estragon and Vladimir, monetary reformers are waiting for a Godot (genuine monetary reform, gold standard restoration, systemic collapse) that always seems to be approaching but never quite arrives. The essay reflects on decades of monetary prediction and the mystery of why the system persists against all rational expectation.
Editorial Note: Written February 2018, one of Fekete's final essays. The Beckett allusion captures the existential dimension of his lifelong monetary warning — the crisis always seems imminent and yet the system endures. A fitting capstone to decades of analysis.
Original PDF: https://professorfekete.com/articles/AEFWaitingForGodot.pdf

### New Austrian School of Economics

The original title for this article was Timing Hyperinflation with an overlong subtitle The Saga of Unraveling Global Fiat Money Issued on the Strength of Irredeemable Promises of Governments. On second thought I changed it for fear of turning off serious readers suspecting that it was written by a prankster to be released on next April Fool's Day. So the new title Waiting for Godot stands.It obviously calls for an explanation.

In 1952 Samuel Beckett wrote a play with the title En attendantant Godot that has subsequently become world famous. In his play the author demonstrates with unforgettable force the pre-conscious visceral form of expectation, similar to the Jewish peoples' waiting for the Messiah, or Christendom's waiting for the second coming of Christ. The question asked by the impatient 'gold bug' population arises in view of the instinctive waiting for hyperinflation in the wake of the "latter-day miraculous proliferation of money". It is motivated by the quantity theory of money (QTM), a faulty doctrine. The superficial observer misses the individual's effort to shape the future and the fact that , to this extent, what is happening is caused by teleological forces (as distinct from forces shaped by causality). The expectation of future always builds on empirical foundations, but regularly exceeds the level of experience. Reasonable monetary policy ought to be able to figure out what consequences follow from government interference.

My readers bombard me with the question: "How much longer do we have to wait for Godot (read: hyperinflation?)". "Why has the prognostication for permanent gold backwardation failed to materialize during the past decade? The question is justitied.

I have devoted the greater part of my life to the task of studying hyperinflations throughout the ages. For some six decades I was trying to analyse the problem. I have established the New Austrian School of Economics (NASOE) that attracted brilliant students from all over the world, and conferred several Master's and Ph.Degrees. Some of these doctoral dissertations, written under our program have beaten new paths by using such novel concepts as the gold basis and cobasis. Members of our alumnus contributed important new results to monetary science, for example, proving the important theorem that permanent gold backwardation inevitably brings about hyperinflation in its wake.

Personally, I was motivated by my experience of growing up in a family burdened with the memory that the pension of my grandfather, a government engineer, was wiped out in 1926. He lived to be 90 and was condemned to penury to the rest ofhis life. This was followed, twenty years later, by the pension of my father, a school principal, being wiped out in 1946.

I felt that I was targeted next. My daily experience in paying for food, medical care, legal fees, for tuition of my five children confirmed this intuitive fear. The deprivation caused by the experience of my grandparents and parents left an indelible mark on me.

I decided that I shall not take it lying down. Although I was trained as a mathematician and made a career as a university professor (of mathematics and statistics),I have become an autodidactic monetary scientist specializing in the study of hyperinflations. To my utter amazement I have found that virtually all my colleagues, students of monetary hyperinflations were ignoring the 'endgame' in the gold markets as the drama of destruction of the purchasing power of fiat paper money was unfolding. There are two approaches to the problem: one is quantitative or statistical, the other qualitative. The former is essentially numbercrunching. It was quite clear to me that this was a dead-end street. My departure had to be different. I wanted to pass from an inductive to a deductive methodology.

This article consists of excerpts from my book Credit (see References below) in which the problem is treated in full. I consider my greatest contribution to monetary science the shifting of the focus from the gold price to the gold basis, that is, the spread between the future and the spot price of gold. Typically it is positive. The gold price seismographically picks up a lot of 'noise' while missing false-carding in the gold markets. By contrast, the gold basis is a pristine market indicator filtering out noise while revealing false-carding wherever it occurs.

### False-carding in the gold market

As readers familiar with the card game bridge well know, rules governing endgame are very different from those governing the middlegame and the pre-game auction. In the endgame the knowledge of the distribution of cards yet to be played is all-important. Players having a better grasp of the constellation of those cards win. Here false-carding designed to fool the opponents come to the fore. Not surprisingly, in the endgame of the hyperinflationary phase of the saga of the unravelling of irredeemable currency false-carding becomes a favorite ploy frequently applied by the powers-that-be. For example, a gold mining concern may be selling gold faster or more slowly than justified by its output. Also, central and bullion banks and hedge funds publish fake statistics on their holdings of bullion and on their maturing gold lease contracts and forward sales of a self-defeating manouvre per se from is justified by the fact that the gold lease market and forward gold sales is the hotbed in which false-carding strives. Forward selling and leasing of gold bullion is also a favorite playfield of banks involved in the gold trade.

When a central bank leases gold to a bullion bank it assumes the risk that it may never see its leased gold ever again. The latter promptly sells it to silk-road countries, the bottomless pit absorbing any amount of the precious yellow since times immemorial. The former, the central bank knows this, but it also knows that bank examiners accept paper gold as fully equivalent to physical gold, thanks to the corruption of bank examination standards, compromising the process of auditing. (Never mind that the world's banking system has been insolvent since August 15, 1971, the day on which the U.S. defaulted on its short-term gold obligations.)

For many a year in my lectures and articles I have drawn attention to the unique phenomenon of permanent gold backwardation as a foolproof indicator of the progressive scarcity of gold deliverable against maturing futures contracts. The endgame drama features episodes of sporadic backwardation of gold, indicated by the gold basis dipping into negative territory for greater or lesser periods. These episodes are temporary at first, with the gold basis bouncing back into its normal positive range, thus reestablishing normal contango in the gold futures markets (a condition whereby the price of gold for more distant future delivery is necessarily higher than that for nearby future delivery, the opposite of backwardation).

The upshot is that the length of sporadic spells of gold backwardation gets progressively longer making physical gold ever more scarce, severely squeezing short interest.

### Anti-Keynes

The consensus pushed by mainstream economists almost all of whom are staunch supporters of global fiat money based, as it is, on irredeemable promises of governments, is that the problem of inflation has been disposed of through successful government measures such as QE (quantitative easing), ZIRP (zero interest policy) blowing bubbles in the bond, stock and real estate markets. Governments have also succeeded in their war on gold: the precious yellow has been marginalized. Gold has been put where it belongs: in the dog-house, so they say.

Thus, inflation is no longer a threat thanks to 'wise' government monetary policy in manipulating the rate of interest. This article aims at exploding the myth of government omnipotence by focusing on the outstanding weak point of mainstream economics, i.e., Keynesianism, namely, the denigration of capital and dismissing the problem of capital destruction. However, all that these 'wise' government policies have accomplished was to let the capital structure of the world enter an advanced state of decay. We are witnessing the wholesale progressive destruction of capital. As a result, inflation will come back with vengeance and, ultimately, global fiat money will unravel causing hyperinflation that we may, for the pourposes of this essay, may define as the whole destruction of the purchasing power of money.

We shall see that the decay of capital can be put in a time-frame and the coming doomsday can be pinpointed. This will be done through refining our theory of permanent gold backwardation. The theory of primary gold backwardation will be augmented by the theory of secondary gold backwardation.

### Endgame in the gold market

We all know from logic and from history that fiat currency is going to fail. Every experiment with it ended in fiasco sooner or later. The fact that the current experiment survived longer than any previous one proves nothing. In addition, the regime of global fiat currency has become the fast-breeder of irredeemable debt. Again, logic tells us that the construction of such a Babelian Debt Tower cannot continue forever. It will collapse like its biblical forerunner did in the fulness of time, burying the conceited builders under the rubble. The problem confronting the monetary scientist is to predict when this cataclysmic event will take place.

The curious thing is that this is not how it played out during the past ten years or so. What is going on? Have governments and economists in their pay figured out a way to put economic law into abeyance? In the past decade the Federal Reserve System of the United States (FED in the sequel) created fiat dollars in unprecedented amounts counted in quadrillions setting a precedent to a hoard of me-tooing fellow central banks without triggering hyperinflation.

The purpose of this essay is to reveal how this was possible.

The short answer is that the analysis in terms primary gold backwardation must be refined through the introduction of the secondary gold backwardation.

### The gold price getting irrelevant

To recapitulate, research at NASOE concluded that the gold price is not per se a reliable indicator of hyperinflation in the making. More reliable is the gold basis and cobasis. A negative gold basis makes physical gold progressively scarcer, paving the way towards permanent gold backwardation. Continuing wholesale withdrawal by sellers offering to sell physical gold brings about a situation where no cash gold is available for purchase at any price denominated in an irredeemable currency. Sellers do not see how they can replenish their inventory through ordinary trading of gold futures contracts.

### The mechanism of gold delivery

In what follows I indicate how I propose to refine the theory of permanent gold backwardation to explain the lag between cause and effect.

Strictly speaking gold futures markets trade capacity for warehousing space for gold, and the gold basis is just the price of that warehousing space. We have to familiarize ourselves with the nitty-gritty of making and taking delivery on gold futures contracts. I apologize to my readers for the complexity of the following description of the mechanism of gold delivery on the gold futures markets. Quite possibly this mechanism was made contorted deliberately by the principals of the old futures markets in order to protect trading by erecting a firewall to protect trading against 'predatory' long interest trying to corner the market.

In talking about warehousing we mean allocated gold, in which case the warehouse certificate in the possession of the owner of gold specifies the exact weight, fineness and the serial number of the gold bar covered. There are well-known risks involved in owning unallocated gold, starting with the potential bankruptcy of the warehouse itself.

Even when we limit ourselves to the warehousing of allocated gold, not all gold certificates are created equal. The gold futures exchanges (the largest of which is COMEX in New York) appoint warehouses whose certificates are acceptable in delivery on gold futures contracts.

It may come as a surprise to my readers that delivery on gold futures never involves delivery of physical gold directly. It involves delivery of gold certificates. At any given time there may be 12 gold futures contracts outstanding that correspond to the calendar months. However, only half of them are actively traded: February, April, June, August, October, December.

The procedure of taking delivery on a gold futures contract is as follows. Holders of a maturing long contract who intend to take delivery must give notice of their intention on first notice day. At the same time they must capitalize their account with the exchange 100 percent (zeromargin). Holders of short contracts, of course, are also subject to the zeromargin rule. In addition, they must deposit with the exchange a gold certificate issued by an exchange-approved warehouse.

Now we have come to the crucial point that plays a role in refining our theory of permanent gold backwardation.

Two varieties of warehouse certificates are distinguished:

1. Certificates on registered gold.

2. Certificates on eligible gold.

There is no difference between gold covered by these two varieties. The difference lies in their **acceptability** in the delivery process:

Certificates on registered gold are acceptable unconditionally; certificates on eligible gold are not acceptable. I beg the reader to bear with me while I explain this cumbersome and seemingly superfluous provision that is crucial in understanding secondary gold basis and secondary gold backwardation.

Thus, then, there are two markets for gold certificates, one for those on registered gold and, another, on eligible gold.

Recall that it is arbitrage between the spot gold market and futures gold market that is responsible for primary gold backwardation.

Similarly, arbitrage between the market for gold certificates on registered gold and the market for gold certificates on eligible gold is responsible for secondary gold backwardation.

The question arises naturally what motivates market participant to carry an inventory of either variety of gold certificates.

The motivation for carrying an inventory of certificates on registered gold is to be first in line for getting the physical gold (recall that physical gold may be in short supply and may even be unavailable in case of permanent gold backwardation.)

The motivation for carrying an inventory of certificates on eligible gold is mainly speculation on the gold price most economically. Not surprisingly, the price of certificates on registered gold is higher than that of certificates on eligible gold, in spite of the fact that the very same physical gold is backing either variety.

The market does not directly quote prices on certificates on registered and eligible gold, but they can be extrapolated from data released by the exchange, such as the number of certificates of either variety outstanding.

Gold certificates moving from the registered to the eligible category reflects the opinion of market participants in the firing line how many gold certificates are in existence for every ounce of physical gold. Clearly, at any given time there is an overissue , (just as airlines are known to overbook seats, the principals of go;d exchanges overissue gold certificates). When it happens, holders of long gold futures contracts who are bumped are typically offered a bribe in the form of a premium on the price of the certificate on registered gold. The premium may move holders of certificates on registered gold to give up their priority and take the certificate on eligible gold. It is also possible that they do not want to deliver their certificates because they do not see a chance to replace them through the regular trading of gold futures contracts. In short, they may not want to hold the proverbial bag.

Secondary gold contango manifests itself by the condition whereby certificates on registered gold command a premium.

Secondary backwardation means that the price of certificates on eligible gold goes to a premium.

Recall that primary gold backwardation is about the scarcity of spot gold relative to gold futures contracts. Likewise, secondary gold backwardation is about the scarcity of certificates on registered gold relative to those on eligible gold. This means that scarcity of spot gold obtains relative to gold futures. Thus secondary gold backwardation implies primary gold backwardation for the stronger reason. It indicates the reluctance of holders of gold certificates to put their certificates on registered gold into harm's way (i.e. to risk that their certificate on registered gold will be called).

As we have seen, there is a positive difference between the price of gold certificates on registered and eligible gold called the secondary gold basis. I leave it to my students to define secondary gold cobasis and study the interplay between the two.

Lest someone think that the emergence of dual gold certificates is due to making arbitrary rules by exchange principals, I point out that, in effect, it comes about due to the organic development gold futures trading. It is part of the firewall constructed to prevent long interest from engineering a corner (that would hurt mostly the exchange principals). The system of dual gold certificates is the gatekeeper. If the inventory of physical gold is getting too low in the exchange-approved warehouses and the open long interest in gold futures contracts approaches critical mass, then the clearing house of the exchange shuffles the gold certificates on registered and eligible gold.

A short course on the history of the legal position of gold in the U. S.

### Under this caption I deal with the interesting question why the 'powers-that-be' allowed gold futures trading to go ahead in the U.S. in 1975, in a volte face of earlier Treasury policy.

During the period 1933-1975 the ownership and trading of gold was criminalized in the U.S. pursuant to F.D. Roosevelt's suspension of the monetary clauses of the Constitution. Of course, the suspension was tantamount to trampling on the rights of the citizens and an abominable restriction of freedom. Change occurred in 1975 when the ban was lifted and ownership and futures trading in gold was allowed. What is in the background of this change of heart? First of all, it must be emphasized that – as the executive order made it very clear – the easing was on a 24hour basis and could be withdrawn at any time without prior notice.

However, since the writ of the U.S. government stops at the water, in foreign countries gold markets continued to trade gold, invariably quoting premium dollar prices, indicating dollar debasement. This was a major embarrassment. At first, there was no ban on Americans to own and to hold and trade gold overseas. Such a ban was imposed later, during the Eisenhower administration.

Mainstream economists (virtually all of them staunch supporters debt-based fiat money) came to the conclusion that the system leaked like a sieve, and suggested that the way to stop leakage is to allow gold futures trading. They were hoping that the availability of paper gold would suppress or at least temper the appetite for real gold. They were inspired by a metaphor of Keynes:

People want the moon, but, of course, they cannot have the moon. So the government must convince them that blue cheese (sic!) is just as good, and order the central bank to produce it galore to make them happy.

### (taken verbatim from his magnum opus The General Theory. 1936.)

Such shabby Keynesian musings were used to justify the trampling on the American Constitution.

So why did the U.S. government legalize gold trading? Well, because it saw the proliferation of paper gold an effective (even the only) way to deflect hyperinflation.

### Secondary Gold Basis Measuring Capital Destruction

We have seen that the primary gold basis can be thought of as the price of warehousing space for gold. It measures the ratio of paper and physical gold in existence. What does the secondary gold basis measure? Well, secondary gold basis measures the ratio of gold certificates on registered and eligible gold in existence. In other words, it indicates how many ounces of gold in certificates have been issued on every ounce of physical gold. When this number reaches the critical mass, chain reaction ensues. People start scrambling to get out of paper gold and into physical gold. The secondary gold basis may be thought of as the price to be paid for hoarding registered gold certificates. Thus, then, the secondary gold basis is the price of insurance against default on paper gold.

In this view, the secondary gold basis is a measure of decay in the capital structure of the world. Recall that gold is the only form of capital that is not subject to decay or destruction, while all other forms of capital, whether physical or whether financial are.

To recapitulate, our refined theory of permanent gold backwardation in introducing secondary gold backwardation scrutinizes the endgame in the gold markets. It focuses on the jockeying of people to get into position where they have control over the only indestructible form of capital, gold in existence.

The new element is the importance of the endgame in the gold market that has been ignored thus far. I submit that once we make it part of the theory of permanent gold backwardation, we shall have a handle on the problem of timing hyperinflation. Primary backwardation in gold hard on the heels of secondary backwardation heralds hyperinflation, not too far behind.

Our conclusion is that an early warning system of hyperinflation must involve monitoring arbitrage between the markets for registered and eligible gold certificates on the gold futures exchanges.

So where are we in 2018 in terms of secondary backwardation heralding hyperinflation? Here is my answer:

Almost every day information surfaces according to which the pyramid of paper gold that is being constructed on each ounce of physical gold held by government Treasuries, central and bullion banks. Just this past week, as reported by Chris Powell, the Secretary-Treasurer of GATA, the Gold AntiTrust Action Committee on January 31, 2018, Six bank employees have been arrested on charges of rigging the precious metals markets, see Rory Hall's article *Golden Rays and Silver Linings* on the website [www.gold-eagle.com](https://www.gold-eagle.com/), see also [this video](https://www.youtube.com/watch?v=c47XZMvdqoM).

### Just confirmed by the Senate the new Chairman of the FED Jerome Powell by a vote of 84–13 remarkable because of its wide margin. He is on record to favor a "weak dollar" along with President Trump. This raises the question what can we expect when the sitting president and his chief monetary advisor both publicly declare that they both "like the weak dollar". Think about it: Shouldn't the President be impeached for high treason on charges that he is urging a monetary policy of a weak dollar on his FED Chairman, which is tantamount to endorsing the embezzlement of the funds of the people entrusted on the member banks of the FED?

What does it say about the paper - gold pyramid constructed on every ounce of physical gold in existence?

How will gold traders in the market for paper gold and gold certificates react to such a rotten state of monetary affairs in the U. S. and in the world?

Is the monetary system of the world not running headlong into self-destruction?

Reference:

### Antal E. Fekete, with the editorial assistance of Peter van Coppenolle, CREDIT and the two sources from which it springs: the propensity to save and the propensity to consume. A treatise on gold and interest, Budapest, 2018, order it from: antal.fekete@gmsil.com

---

*February 1, 2018.*

---

# Timing Hyperinflation

URL: https://newaustrianeconomics.com/archive/fekete/timing-hyperinflation/
Date: 2017-10-25
Section: Popular Economics
Difficulty: intermediate
Concept Tags: hyperinflation, deflation, gold-basis, bond-market, fiat-currency
Description: Fekete examines the difficulty of timing hyperinflation — the event he expects to follow the collapse of the paper money system — and explains why it cannot be predicted with precision but can be anticipated structurally. He examines the indicators he watches (gold basis, bond market, silver-gold ratio) and what threshold events would signal hyperinflation's imminence.
Editorial Note: Written October 2017. One of Fekete's later essays on the timing question — a practical concern for investors and savers trying to act on his long-run monetary analysis.
Original PDF: https://professorfekete.com/articles/AEFTimingHyperinflation.pdf

*The saga of unraveling global fiat money issued on the strength of irredeemable promises of governments.*

**Antal E. Fekete** · New Austrian School of Economics

### Synopsis

The consensus pushed by mainstream economists almost all of whom are staunch supporters of global fiat money based, as it is, on irredeemable promises of governments, is that the problem of inflation has been disposed of through successful government measures such as QE (quantitative easing), ZIRP (zero interest policy) blowing bubbles in the bond, stock and real estate markets. Governments have also succeeded in their war on gold: the precious yellow has been marginalized. Gold has been put where it belongs: in the dog-house.

Thus, inflation is no longer a threat thanks to 'wise' government monetary policy in manipulating the rate of interest. This treatise aims at exploding the myth of government omnipotence by focusing on the weak point of mainstream economics, i.e., Keynesianism, namely, the denigration of capital and dismissing the problem of capital destruction.

However, all that these 'wise' government policies have accomplished was to let the capital structure of the world enter an advanced state of decay. We are witnessing the wholesale progressive destruction of capital. As a result of this, inflation will come back with vengeance and, ultimately, global fiat money will unravel causing hyperinflation.

We shall see that the decay of capital can be put in a time-frame and the coming doomsday can be pinpointed. This will be done through refining our theory of permanent gold backwardation. The theory of primary gold backwardation will be augmented by the theory of secondary gold backwardation.

### Endgame in the gold market

We all know that fiat currency is going to fail. Historically, every experiment with it did sooner or later. The fact that the current experiment survived longer than any previous one proves nothing. In addition, the regime of global fiat currency has become the breeder of irredeemable debt. Logic tells us that the construction of such a Babelian Debt Tower cannot continue forever. It will collapse like its biblical forerunner has, and will bury the conceited builders under the rubble. The problem the monetary scientist must confront is to predict when.

I have devoted the greater part of my life to the task of studying hyperinflations throughout the ages. For some six decades I was trying to analyse the problem. I have established the New Austrian School of Economics (NASOE) that attracted brilliant students from all over the world, and conferred several Master's and Ph.Degrees. Some of these doctoral dissertations, written under our program have beaten new paths by using such novel concepts as the gold basis and cobasis. Members of our alumnus contributed important new results to monetary science, for example, proving the important theorem that permanent gold backwardation inevitably brings about hyperinflation in its wake.

Personally, I was motivated by my experience of growing up in a family burdened with the memory that the pension of my grandfather, a government engineer, was wiped out in 1926; followed by the pension of my father, a school principal, being wiped out 20 years later, in 1946. I felt that I was targeted next. The deprivation caused by this experience left an indelible mark on me.

What impressed me most while studying hyperinflations was the fact that virtually all monetary scientists ignored the endgame in the gold markets as the catastrophe of self-destruction of money has been unfolding.

This article consists of excerpts from my book of the same title in which the problem is treated in full. My greatest contribution to monetary science has been the shifting of the focus from the gold price to the gold basis, the spread between the future and the spot price of gold. Typically it is positive. The gold price seismographically picks up a lot of 'noise' while missing false-carding in the gold markets. By contrast, the gold basis is a pristine market indicator filtering out noise while revealing false-carding in the gold market.

As readers familiar with the card game bridge well know, rules governing endgame are very different from those governing the middlegame and the pre-game auction. In the endgame the knowledge of the distribution of cards yet to be played is all-important. Here false-carding come to the fore. Not surprisingly, in the endgame of the hyperinflationary phase false-carding becomes a frequently applied maneuver. For example, a gold mining concern may be selling gold faster or more slowly than justified by its output. Also, central and bullion banks and hedge funds publish fake statistics on their holdings of bullion and on their maturing gold lease contracts. Forward selling and leasing of gold bullion is also a favorite. When a central bank leases its gold to a bullion bank it assumes the risk that it may never see its leased gold ever again. The latter promptly sells it to silk-road countries. The former, the central bank knows this but it also knows that bank examiners accept paper gold as equivalent to physical, thanks to the relaxing of the standard of bank examination, compromising the process of auditing.

Since 2000 in my lectures and articles I have drawn attention to the unique phenomenon of permanent gold backwardation as a foolproof indicator of the progressive scarcity of gold deliverable against maturing futures contracts. The endgame drama features episodes of sporadic backwardation of gold, indicated by the gold basis dipping into negative territory. These episodes, while temporary at first with the gold basis bouncing back into its normal positive range, reestablishing contango in the gold futures markets where the price of gold for more distant future delivery is necessarily higher than that for nearby future delivery. The upshot is that the length of sporadic spells of gold backwardation is getting progressively ever longer making physical gold ever more scarce, severely squeezing short interest.

The curious thing is that this is not how it played out during the past ten years. The purpose of this article is to explain why.

### Waiting for Godot

People bombard me with the question: "How much longer do we have to wait for Godot (read: hyperinflation?)" .

"Why has the prognostication for permanent gold backwardation failed to materialize during the past decade?

The short answer is that the analysis in terms primary gold backwardation must be augmented through the introduction of the secondary gold backwardation.

The title of this caption calls for an explanation. In 1952 Samuel Beckett wrote a play with the title En attendantant Godot that has subsequently become world famous. In his play the author demonstrates with unforgettable force the pre-conscious visceral form of expectation, similar to the Jewish peoples' waiting for the Messiah, or Christendom's waiting for the second coming of Christ. The question arises, in view of the instinctive waiting for hyperinflation in the wake of the "latter-day miraculous proliferation of money". It is motivated by QTM (quantity theory of money), a faulty doctrine. The superficial observer misses the individual's effort to shape the future and the fact that , to this extent, what is happening is caused by teleological forces. The expectation of future always builds on empirical foundations, but exceeds the level of experience. Reasonable monetary policy ought to be able to figure out what consequences follow from government interference.

### The gold price is getting irrelevant

To recapitulate, research at NASOE concluded that the gold price is not per se a reliable indicator of hyperinflation in the making. More reliable is the gold basis and cobasis. The negative gold basis makes physical gold progressively scarcer, paving the way towards permanent gold backwardation. Wholesale withdrawal by sellers offers to sell brings about a situation in which no physical gold is available for purchase at any price denominated in irredeemable currency. Sellers do not see how they can replenish their inventory through ordinary trading of gold futures contracts.

In what follows I shall indicate how I propose to refine the theory of permanent gold backwardation to explain the lag between cause and effect.

### The Mechanism of Gold Delivery

Strictly speaking gold futures markets are trading warehousing space for gold, and the gold basis is just the price of that warehousing space. We have to familiarize ourselves with the nitty-gritty of delivering on gold futures contracts. We are, of course, talking about warehousing allocated gold, in which case the warehouse certificate specifies the exact weight, fineness and the serial number of the gold bar covered. There are wellknown risks involved in owning unallocated gold starting with the potential bankruptcy of the warehouse itself.

Even when we limit ourselves to the warehousing of allocated gold, not all gold certificates are created equal. The gold futures exchanges (the largest of which is COMEX in New York) appoint warehouses whose certificates are acceptable in delivery on gold futures contracts.

It may come as a surprise to my readers that delivery on gold futures never involves delivery of physical gold directly. It involves delivery of gold certificates. There are 12 gold futures contracts, as many as there are months in the calendar year; however, only half of them are actively traded: February, April, June, August, October, December.

The procedure of taking delivery on a gold futures contract is as follows. Holders of a maturing long contract who intend to take delivery must give notice of their intention on first notice day. At the same time they must capitalize their account with the exchange 100 percent (zero margin). Holders of short contracts, of course, are also subject to the zero margin rule. In addition, they must deposit with the exchange a gold certificate issued by an exchange-approved warehouse.

Now we have come to the crucial point that plays a role in refining our theory of permanent gold backwardation.

Two varieties of warehouse certificates are distinguished:

1. gold certificates on registered gold

2. gold certificates of eligible gold.

There is no difference between gold covered by these two varieties. The difference lies in their **acceptability** in the delivery process:

Certificates on registered gold are acceptable; certificates on eligible gold are not acceptable. I beg the reader to bear with me while I explain this cumbersome and seemingly superfluous provision that is crucial in understanding secondary gold basis and secondary gold backwardation.

Thus, then, there are two markets for gold certificates, one for those on registered gold, and another, on eligible gold.

Recall that it is arbitrage between the spot gold market and futures gold market that is responsible for primary gold backwardation.

Similarly, arbitrage between the market for gold certificates on registered gold and the market for gold certificates on eligible gold is responsible for secondary gold backwardation.

The question arises naturally what motivates market participant to carry an inventory of either variety of gold certificates.

The motivation for carrying an inventory of certificates on registered gold is to be first in line for getting the physical gold (recall that physical gold may be in short supply and may even be unavailable in case of permanent gold backwardation.) Not surprisingly, the price of certificates on registered gold is higher than that of certificates on eligible gold, in spite of the fact that exactly the very same physical gold is backing either variety.

The market does not directly quote prices, but they can be extrapolated from data released by the exchange, such as the number of certificates of either variety outstanding.

The motivation for carrying an inventory of certificates on eligible gold primarily is speculation on the gold price. Gold certificates moving from the registered to the eligible category reflects the opinion of market participants in the firing line how many gold certificates are in existence for every ounce of physical gold. Clearly, at any given time there is an overissue, just as airlines are known to overbook seats. When it happens, holders of long gold futures contracts who are bumped are typically offered a bribe in the form of a premium on the price of the certificate on registered gold.

The premium may move holders of certificates on registered gold to give up their priority. But it is also possible that they do not want to deliver their certificates because they do not see a chance to replace them through the regular trading of gold futures contracts.

They may not want to hold the proverbial bag.

Secondary gold contango manifests itself by the condition whereby certificates on registered gold command a premium.

Secondary backwardation means that the price of certificates on eligible gold goes to a premium.

Recall that primary gold backwardation is about the scarcity of spot gold relative to gold futures contracts. Likewise, secondary gold backwardation is about the scarcity of certificates on registered gold relative to those on eligible gold that, for the stronger reason means that the scarcity of spot gold relative to gold futures. Thus secondary gold backwardation implies primary gold backwardation. It indicates the reluctance of the holders of gold certificates to put their registered gold into harm's way (to risk that their registered gold will be called).

Secondary gold basis, as we have seen, is the difference between the price of gold certificates on registered and eligible gold.

I leave it to my students to define secondary gold cobasis and study the interplay between the two.

Lest someone think that the emergence of dual gold certificates is due to making arbitrary rules, I point out that it comes about due to the organic development gold futures trading. It is part of the firewall to prevent short interest from engineering a corner. The system of dual gold certificates is the gatekeeper. When the inventory of gold is getting too low in the exchange-approved warehouses and the long interest is approaching critical mass, the clearing house of the exchange shuffles the gold certificates on registered and eligible gold.

A Short Course on the History of the Legal Position of Gold in the U.S. Under this caption I shall deal with the question why the 'powers that be' allowed gold futures trading to go ahead in the U.S. in 1975.

During the period 1933-1975 the ownership and trading of gold was criminalized in the U.S. pursuant to F.D. Roosevelt's suspension of the monetary clauses of the Constitution. Of course, this was trampling on the rights of the citizens and an abominable restriction of freedom. Change occurred in 1975 when the ban was lifted and futures trading in gold was allowed. What is in the background of this change of heart? First of all, it must be emphasized that – as the executive order made it very clear – the easing was on a 24-hour basis.

Since the writ of the U.S. government stops at the water, in foreign countries gold markets continued to trade gold, invariably quoting premium dollar prices , indicating dollar debasement. This was embarrassing. At first, there was no ban on Americans to own and to trade gold in the overseas markets. Such a ban was imposed later, during the Eisenhower administration.

Mainstream economists (all staunch supporters debt-based fiat money) came to the conclusion that the system leaked like a sieve, and suggested that the way to stop leakage is to allow gold futures trading.

They were hoping that the availability of paper gold suppress the appetite for real gold. They were inspired by a metaphor of Keynes:

People want the moon, but, of course, they cannot have the moon. So the government must convince them that blue cheese (sic!) is just as good, and order the central bank to produce it galore to make them happy. So why did the U.S. government legalize gold trading? Well, because it saw the proliferation of paper gold an effective (even the only) way to deflect the inevitable hyperinflation.

Such shabby Keynesian musings were used to justify the trampling on the American Constitution.

### Secondary Gold Basis Measuring Capital Destruction

We have seen that the primary gold basis is the price of warehousing space for gold. It measures the ratio of paper and physical gold in existence. What does the secondary gold basis measure? Secondary gold basis measures the ratio of gold certificates on registered and eligible gold in existence. In other words, it indicates how many ounces of gold in certificates have been issued on every ounce of physical gold.

When this number reaches the critical mass, chain reaction ensues. People start scrambling to get out of paper gold and into physical gold. We shall also describe the secondary gold basis as the price of insurance against default on paper gold.

In this view, the secondary gold basis is a measure of decay in the capital structure of the world. Recall that gold is the only form of capital that is no subject to decay or destruction, while all other forms of capital, whether physical or whether financial are.

To recapitulate, our refined theory of permanent gold backwardation scrutinizes the endgame in the gold markets: it focuses on the jockeying of people to get into position where they have control over the only indestructible form of capital: gold.

The new element is the importance of the endgame in the gold market that has thus far been ignored. I submit that once we make it part of the theory of permanent gold backwardation, we shall have a handle on the problem of timing hyperinflation.

---

*October 23, 2017.*

---

# An Appraisal of the Global Monetary System of the 21st Century

URL: https://newaustrianeconomics.com/archive/fekete/an-appraisal-of-the-global-monetary-system/
Date: 2017-06-15
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, fiat-currency, gold-basis, monetary-crisis, new-austrian-economics
Description: Fekete's comprehensive assessment of the global monetary system in 2017, examining how the dollar system has evolved since 2008, the state of the gold basis, and the prospects for monetary reform or collapse. One of his most systematic late-career surveys of the monetary landscape.
Editorial Note: Written June 2017. A comprehensive late-career assessment that draws on Fekete's full analytical toolkit to evaluate the current monetary system.
Original PDF: https://professorfekete.com/articles/AEFAppraisalGlobalMonetarySystem21Century.pdf

*An appraisal of the global monetary system of the twenty-first century.*

**Antal E. Fekete**

To understand how thoroughly unsound the present monetary system is, it is helpful to revisit its early advocates and their arguments. The names John Maynard Keynes (1883-1946) and Milton Friedman (1912-2006) come to mind. But we could do no better than start with Irving Fisher (1867-1947), American statistician and economist of Yale University. In 1936 he published a book with the title *100% Money* (New York, Adelphi Publishers, 2nd edition).

The proposals presented in this book could have served as the blueprint for the world's global monetary system as it exists today.

Stated briefly, Fisher proposed to hurl the world headlong into thoroughgoing inconvertible paper money. The presumably good assets of banks and the presumably good bonds issued by the governments of the major powers, above all, by the government’s least device for defrauding innocent and helpless people that human beings probably have ever devised.

Once the Fisher plan is adopted, the currency is "reflated" (a word devised to remove one' fear of inflation) until the price level reaches a presumed "optimum". Thereafter the stock of money is managed in such a way as to perpetuate this optimum.

History is strewn with the wreckage and record of human suffering caused by "ingenuous devices" to issue inconvertible paper money and to "control" the consequences flowing from the issue. These efforts to create wealth out of paper, to make something out of nothing, are a species of black magic, and they have always failed.

The Fisher proposal and the present global experiment with inconvertible paper money differ from earlier experiments principally in their intricacies, ingenuity, and the cleverness with which the hocus-pocus involved is covered up. The operation of the monetary system is shrouded in technical details to the effect that the average observer experiences considerable difficulty in forming a clear picture of its nature and implications, and putting his finger on the fallacies and dangers involved.

These dangers appear as a consequence of the principle of causality. However, there is an unknown lag between cause and effect that greatly confuses the issue.

There are great advantages (from the point of view of the perpetrators) in having a plan so intricate and technical in nature to explain and understand, that it remains a mystery to all but a small number of specialists in the field.

To add insult to injury, the system uses bribes and blackmail to silence those specialists who demur. Through an incestuous incentive system research grants and official favors are available only to those who approve of the plan.

Mystery attracts people and its author always has the advantage.

He can talk in broad terms, he can speak of admirable objectives.

He can dodge embarrassing questions. He can hide behind labels that hypnotize and elicit approval, such as restoring prosperity, prevention of depressions, supplying people with the money to meet their needs, and so on.

There are hardly any politicians who have the proper training in monetary theory and history who could recognize the fallacies in Fisher's and the managed money advocates' plan, and who could see the dangers. During the twentieth century universities and research institutes were purged, both by passive means (such as natrural attrition through retirement) and by active (such as denying research grants, and withholding promotion) with the result that monetary scientists equipped with a proper understanding of the dangers are now few and far in between.

Concerning these dangers that the global monetary system has in store for countries, while inflation is generally recognized, the same cannot be said of the deflationary danger that is ever present because of the invidious capital destruction, the inevitable consequence of managed money, the Achillean heel of the new millennium of fiat money.

Advocates of managed money insist that they are opposed to inflation. They also shout from their rooftops that they have all the tools needed to control deflation which they simply identify with a falling average price level. "Just print as much money as it takes". However, they never examine the question to what extent this 'control' is or could be counter-productive: instead of curing deflation it might make it worse.

The Quantitative Easing program, the Zero Interest-Rate Policy and the creation of trillions of dollars in new money throws into gear an engine that may not be possible to stop except at the cost of a terrible crash, loose talk about 'tapering' and 'exit strategies' notwithstanding.

Considering these facts, it does not change the picture in the least, nor is it of the slitghtest consequence (except in so far as it misleads people), for the policymakers of the monetary regime to call themselves "stabilizers" and "experts in the art of moneymanagement". Their good intentions (if any) amount to nothing in face of the consequences of the uncorking the bottle and letting the genie out to roam around the world creating chaos in its wake.

Fisher's book on *100% Money* says on its title page that it is designed to keep bank deposits 100% liquid to prevent bank runs, both inflation and deflation; it would cure or prevent depressions; and it would wipe out much of the government debt. The purposes and assumed advantages of the Fisher-plan and also those of our present global monetary regime to make money independent of loans by divorcing from the banking business, that is, creating and destroying money; to make banking safer and more profitable; to prevent booms, bubbles and depressions, by ending chronic inflations and deflations.

The ‘fractional’ reserve banking business model, Fisher says, in contrast with his 100% reserve banking business model, " impels bankers to make and unmake money not according to any criterion at all, but by a sort of mob rule, guided fitfully by reserve requirements and other factors, and, in a depression, by the instinct of self-preservation, followed blindly and individually, regardless of what the effect may be on the value of the dollar, the welfare of the public, or even on the collective welfare of the bankers themselves." (p 99).

The essentials of the Fisher 100% plan and of the current global monetary regime are as follows. Through the open market committee of the U.S. Federal Reserve, or through the monetary council of the European Central Bank or that of the Bank of Japan, governments are to turn into cash enough of the assets of every commercial bank to increase the cash reserve of each bank to up to 100% of deposits.

Fisher complains that the assets (other than cash reserves held by the banks) cannot be employed to meet the demand liabilities of the bank. His plan would convert these assets into cash that can be so employed. The banks would be authorized to pay out these promises of the government, although the government could not and would not redeem them. Stated in another way, the assets of the bank were converted into promises of the government to pay on demand, although these promises of the government were made in bad faith, with the knowledge that it would not and could not redeem these notes on demand. Thus the Fisher plan leads into an inconvertible currency scheme, and rests upon the doctrine that it is wise and proper for the government to enter into agreements that it knows it cannot fulfil. The same doctrine is also at the heart of our present global monetary regime. The unsound nature of this doctrine runs through the experience of nations throughout the entire history of money.

The conversion of interest-bearing government debt into inconvertible paper money involves a confusion of an investment instrument and a medium of exchange. It is a checkkiting scheme whereby one arm of the government (the Treasury) issues unlimited amounts of promises to pay (Treasury bonds) while the other arm (the Federal Reserve, hereafter F.R.) also issues unlimited amounts of promises to pay (F.R. notes and deposits). Neither arm makes provision for meeting the liability at maturity. The two arms then swap promises. The Treasury uses the F.R.notes and deposits to retire its bonds at maturity; The Fed uses the Treasury bonds as reserves for issuing more F.R. credit. Such a shuffling of vacuous promises to pay is a conspiracy dealt with by the Criminal Code. It is criminal even if reserves to pay the liability were kept. (Charles Ponzi did pay his clients as promised until he was put out of business by the government.) Now the government assumes Ponzi's role and adjudicates that the very same activity when carried on by itself is legal and proper. At the same time it makes it sure that every request for review by the Supreme Court is routinely turned down. Looking at this chicanery one question readily presents itself : what will hold citizens back from defrauding each other when the government sets the example of defrauding its own citizens by issuing and juggling irredeemable promises to pay?

Our global monetary system in converting interest-bearing debt into inconvertible paper currency involves a form of currency manipulation which, as the various nations of the world have learned many times, is a method of defrauding the people. An inconvertible paper currency is a dishonest and immoral governmental and banking device, and no process of reasoning or sleight-of-hand device can change this fact. It is upon such fraudulent device that our global monetary system fundamentally rests.

One argument of Fisher, also used by the protagonists of our global monetary system, is that the 100% plan eliminites the alleged fraud involved in "fractional reserve banking". However, fractional reserve banking, properly implemented, involves no fraud. The commercial bank substitutes its credit, which is usable and generally acceptable, for the borrower's credit which is not in a readily usable or acceptable form, and charges a fee in the form of interest or discount for performing the service.

Moreover, the law requires the bank to maintain a certain percentage of reserve against the credit which the bank extends so that cash can be paid out as needed. Thus Fisher and the protagonists of our global monetary system condemn fractional reserve banking traditionally performed by commercial banks, while offering as a substitute something far more dangerous.

Besides, as we have seen, fractional reserve banking is neither dishonest nor immoral, whereas Fisher's 100% money plan and our present global monetary system is thoroughly rotten as it squarely aims at defrauding helpless and innocent people.

## WHERE ARE WE NOW?

The Fed, the ECB and the Bank of Japan have together printed \$10 trillion during the eleven years between 2006 and 2017.

Global debt has grown exponentially and is now around \$250 trillion. The three main central banks' balance sheets have expanded at about the same rate in this period in their attempt to prevent the banking system and the global monetary system from collapsing. Initially the Fed was in the lead, but since 2015 the ECB and the Bank of Japan have played catch-up. All three started from below \$1 trillion at the beginning of the century and have added \$4.5 trillion each. It is expected that it is now the Fed's turn to play catch-up. Meanwhile the metric to measure the growth of global debt may have to be changed from \$1 trillion to \$10 trillion. But you cannot build prosperity on a lie, on the unlimited proliferation of inconvertible currency, by breaking laws that have stood the test of times. Governments' money scheme has lasted a century during which the value of all major currencies in the world declined between 97 and 99%. In the next few years we will see money-printing on a scale that will make all these currencies worthless by declining the final 1-3%.

Most people cannot fathom the 100% destruction of currency values. Yet it has happened before. The central banks do not even try to conceal the fact that their aim is the destruction of the value of their own currencies.

By creating infinite amounts of inconvertible currencies central banks are not just putting off temporarily the demise of the global monetary system. They are also creating false prosperity by fuelling stock market and real estate price rises to unprecedented heights. Stock market averages have duplicated the expansion of the balance sheets of the major central banks.

Since March 2009 the combined balance sheet of the Fed, the ECB and the Bank of Japan is up 2.3 times while the Standard and Poor stock market average is up 3.5 times. This is where we are now. But for stock market averages to go further up, more money must be printed. At the same time, the marginal productivity of newly printed money is declining at an alarming rate. For the GDP to grow by \$1 credit must be expanded by several dollars! Worse still is the situation concerning the growth of global debt. The debt of the U.S. government at present is \$20 trillion and will at least double in the next 8 years as it has every 8 years since 1980. In addition, private and corporate debt is also increasing at similar rates. (U.S corporate debt is up \$8 trillion since 2010). The bad news is that that bad debt is also increasing apace. Eventually, all outstanding debt will become bad debt with no chance of ever being repaid.

The belief that central banks keep the situation well in hand is false. It is true that the Fed, for example, can put more reserves at the disposal of member banks, but the latter may not want to use them (for being afraid to lend), or the latter could not use them (because businessmen may not want to borrow.) Fisher is not afraid of this. He says that "if the tub is 100% full, then any additional water must overflow." (p 110).

This ignores the possibility that people may be prompted to use the additional currency created (because they feared its depreciation) to buy commodities (e.g., gold or silver). Fisher assumes that his inconvertible paper currency bubble would not make the paper dollar depreciate against gold. People are being told that the millennium of fiat money is here to stay and the suspension of gold payments is no longer a temporary measure but an indefinite or permanent thing (in truth, no suspension has ever been permanent). At that point depreciation will necessarily set in. This means that gold would go abroad or into hiding as long as it can be obtained domestically, leaving the nation with nothing but its paper. If gold could no longer be obtained even at variable prices as now, then the value of inconvertible currency would decline sharply in terms of gold in anticipation of what all those wanting gold would realize must be the ultimate consequences of the increasing difficulty of obtaining physical gold.

Using the technical language of the gold futures markets, the gold basis would go negative with no hope of ever turning back to positive. Permanent gold backwardation would set in.

Physical gold could not be obtained at any price.

It should be realized that there never has been a permanently well-managed inconvertible currency, just as there never has been a permanent suspension of specie payment. The suspension that we observe at present throughout the world should be viewed in the proper perspective. Who can guarantee that China, for example, will follow the lead of the Western powers and commit suicide in maintaining suspension of gold payments indefinitely. The advocates of our global monetary system seem to have lost their sense of proportion regarding these matters.

They appear to have confused the efforts of countries to manage their currencies as best as they can with what they suppose would be the situation if these countries were openly to abandon the hope of ever resuming specie payments and were to embark officially upon a "managed" inconvertible paper currency device as a matter of permanent monetary program. As a matter of fact, not one of the countries involved has officially announced its intention of doing so, nor has it passed a constitutional amendment ruling out a gold standard. No country has declared that it will never ever resume specie payments. No country has ever constituationally mandated an inconvertible paper currency scheme. Not one dared to to do it. Its policymakers have not got the intestinal fortitude. They lack the moral courage.

The advocates of "managed" inconvertible paper money seem to forget that people know the difference between a piece of paper convertible into gold at a fixed rate and one not convertible into gold at all, or convertible at varying rates.

During a period of temporary suspension of specie payments people are unable to discriminate against paper currency because they do not know but that the government may resume the convertibility of its paper currency sooner or later.

Should a government, however, put through a constitutional amendment that forbids the introduction of a gold standard of a fixed weight, the ordinary common sense of the people would undoubtedly lead them to discriminate against currencies which are inconvertible or have convertibility at a variable rate.

Historically, the most poorly "managed" currencies in the world have been precisely those severed from gold. All currencies that have not in time been re-anchored to gold or silver at a fixed rate have become unmanageable. When these inconvertible currencies get out of hand, the managed currency advocates disingenuously assert that the trouble lies in the fact that they are not properly managed. Thus the argument of the advocates of the managed inconvertrible money simply boils down to this: A managed currency is managed when it is under control, but when it gets out of hand, it is not a managed currency!

For the sake of emphasis let it be restated that in no country in which a managed inconvertible paper currency is functioning reasonably well has there been official pronouncement to the effect that this managed currency scheme is being turned into a permanent program, or that the country never intends to return to the gold standard.

There is not one iota of evidence in monetary history to justify the unsupported and unsupportable assertion of the advocates of the "managed" inconvertible paper currency that such a system can succeed or that we will never need to return to a gold standard.

Fisher says in his book *100% Money* (p 218.): "The French used to have an aphorism:

'after the printing press the guillotin'."

The word became flesh during the French revolution in 1793.

**POLICYMAKERS OF OUR GLOBAL MONETARY SYSTEM AND THE AUTHORS OF QUANTITATIVE EASING AND OF THE ZERO-INTEREST POLICY WOULD DO WELL IF THEY TOOK TO HEART THE FRENCH APHORISM.**

---

*June 15, 2017.*

---

# On the So-Called Nuclear Option

URL: https://newaustrianeconomics.com/archive/fekete/on-the-so-called-nuclear-option/
Date: 2017-03-13
Section: Popular Economics
Difficulty: intermediate
Concept Tags: bond-market, monetary-policy, gold-basis, monetary-crisis, fiat-currency
Description: Fekete examines China's alleged nuclear option of dumping U.S. Treasury bonds, arguing that this threat is less than it appears because China cannot sell Treasuries without destabilizing the dollar system on which its own trade surplus depends. The real nuclear option belongs to neither side but to the gold market, whose eventual backwardation will detonate the paper money system.
Editorial Note: Written March 2017 as U.S.-China trade tensions were rising. Fekete reframes the geopolitical nuclear option debate through his monetary analysis.
Original PDF: https://professorfekete.com/articles/AEFNuclearOption.pdf

*On The So-Called Nuclear Option*

**Antal E. Fekete** · New Austrian School of Economics

I would like to add my penny’s worth of wisdom to the thoughtful article of Sr. Hugo Salinas Price entitled WHERE ARE WE TODAY? posted on the website [321 Gold](https://321gold.com) on March 7, 2017.

The phrase ‘nuclear option’ has come to be used by webauthors to mean a hypothetical conspiracy between Russia and China to synchronize the dumping of their huge holdings of U.S. Treasury paper on the markets to the detriment and discomfiture of the United States., thus dislodging the dollar from its position as the world’s only reserve currency.

Of course we must understand that the nuclear option is a doubleedged sword: it can hurt also those wielding it. Russia and China could be hurt badly by the precipitously falling price of the U.S. Treasury paper.

The same reasoning must have underpinned the actions of the imbecile policy-makers in the U.S. who have, incredibly, allowed that America’s adversaries accumulate her debt, thereby exposing her to blackmail and unprecedented dangers in very dangerous times, on very dangerous waters. If they did it, they must have acted in desperation as a last-ditch defense of the “esperanto dollar” (esperanto = hoping against hope).

Analysts suggest that Russia’s and China’s policy of open-ended gold purchases is in fact designed to hedge against such potential losses: the boomeranging fall of the value of U.S. Treasury paper in their own portfolio.

The question therefore arises naturally: just how credible is the threat of ‘nuclear option’? In order to arrive at a realistic appraisal, we must recall that the governments of these countries are imbued with Communist ideology to which the gold standard is anathema.

It is true that China ostensibly encourages the Chinese people to hoard gold. However, the gold standard whereby the government promises to convert its debt into gold coin on demand is quite another matter. It is a safe assumption that the governments of Russia and China, while they may pretend to have plans to make their currencies gold-convertible, when the chips are down they would be utterly unwilling to put those plans into practice, certainly domestically and, none the less, internationally as well. We must remember that, right after the U.S., Russia and China are the world’s most indebted countries.

I have stated it in my earlier writings that, while the ‘nuclear option’ may have been bandied about mainly for its value in bullying the United States, there is a much less well recognized nuclear option available to Russia and China which the American policymakers have missed completely, but which threaten the U.S. political, economic and military hegemony world-wide more now than at any time in history.

### Herein we can also find the secret of “the accursed Russian and Chinese hunger for gold”.

The Russian and the Chinese governments are very conscious of the fact that their nuclear option consists in opening their Mint to the unlimited coinage of gold and silver. If they can pull it off first, before the U.S. Mint is opened to the unlimited and seigniorage-free coinage of gold and silver, then the race for world hegemony will be settled in their favor, and the U.S. will be effectively deprived of an opportunity to redress the balance.

“He who has the gold makes the rules” – as the old adage holds. This is as true today as it has ever been. Whichever government opens its Mint first to the free and unlimited coinage of gold and silver, will attract the output of the world’s gold and silver mines to its coffers, excluding competition. The brain-dead American policymakers are too obtuse to grasp the importance of this fact.

We must realize that the U.S., the Russian and the Chinese governments have one, and only one thing which unites them in their race for world-hegemony: their putative monopoly over the stock of money thanks to the inept Keynesian teaching that governments are free to shift assets from the liability to the asset column of their balance sheet at pleasure under the regime of irredeemable currency.

This monopoly is threatened by the free and unlimited coinage of gold and silver by the public under the regime of a metallic monetary standard.

Who will start World War III — if indeed it ever takes place? Insofar as Russia and China understand the importance of opening the Mint to gold and silver better than the U.S., they are ahead in the race for world hegemony.

Russian and Chinese war-mongers appear amateurish and puerile in comparison with their American counterparts. Russian and Chinese noises to make war sound like a faint “me too, me too” echo to American noises to make war at will whenever and wherever they want. The Russians and the Chinese are well aware of this disadvantage of theirs. War is not their turf to compete with the U.S., in spite of their demographic predominance. Obviously, they will attack where the U.S. is most vulnerable. This is the monetary field.

Gold and silver are their weapons to pursue a hegemonic agenda.

They will keep up the heat with their threat to be the first to open the Mint to the free and unlimited coinage of gold and silver. Yes, it could be false-carding, and it could be bluffing of some other type. If the Trump Administration fails to realize that this is where the real challenge is, then the slogan to make America great again will remain empty, and will be exposed as such.

The only real Trump card (pun intended) America has, and the only one that Russia and China will respect and fear, is the opening of the U.S. Mint to the free and unlimited coinage of gold and silver as mandated by the American Constitution. Indeed, this was a most successful formula during the first two centuries of American history.

Either Trump sees the truth of this in time, or his presidency will go down as the last in a sequence of dismal American presidencies that destroyed a great republic which transformed itself from a government of ‘limited and enumerated powers’ into an ‘Evil Empire’ by attempting the construction of a Babel-style Tower of Debt in defiance of the biblical admonition that God will not tolerate the impudence and conceitedness of the authors and executors of such plans. Those responsible will get their well-deserved reward, and earn the contempt of the whole world in their own good time.

---

*March 13, 2017.*

---

# The Dollar May Not Be Beyond Repair — and Trump May Be the One to Repair It

URL: https://newaustrianeconomics.com/archive/fekete/the-dollar-may-not-be-beyond-repair/
Date: 2016-12-08
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, federal-reserve, sound-money, monetary-policy, fiat-currency
Description: Written after Trump's election victory, Fekete argues that if Trump implemented genuine monetary reform — reopening the Mint to gold, eliminating the Fed's bond-buying programs — the dollar could be saved. He provides no guarantee that Trump will do this but argues the window for reform is briefly open.
Editorial Note: Written December 8, 2016 following Trump's election. Fekete's conditional endorsement of Trump as a potential monetary reformer reflects his assessment that the political conditions for gold standard restoration are briefly favorable.
Original PDF: https://professorfekete.com/articles/AEFTheDollarMayNotBeBeyondRepair.pdf

**Antal E. Fekete**

## Executive Summary

America's first monetary revolution in 1933 under the leadership of F. D. Roosevelt with his destructive gold policy may be followed by a second 85 years later under the leadership of President Trump with his constructive gold policy.

In this article I would like to call attention to why Trump is uniquely qualified to rehabilitate the Gold Standard Act of 1900. He could reclaim America's gold reserve in its entiretythat has been squandered under various Administrations starting with that of Nixon.

In his zeal to trying to expunge the gold standard from the face of the Earth Roosevelt made a mistake which gave the Trump card (pun is intentional) to his successor 85 years later.

After his Great Coin Melt Roosevelt forgot to refine the proceeds to the prevailing international standard of fineness. As a conse

The U.S. dollar is a through and through debauched currency as shown by the fact that in less than one hundred years it has lost 99 percent of its purchasing power. This may be a record in the history of decaying and moribund currencies that survived as long as one century. The debauchery was deliberately fomented at the behest of the federal government as it was trying to boost the price level even at the expense of overthrowing the Constitutional monetary order of the Republic. In what follows we enumerate the varous étapes of the fomentation.

(1) The default on the government's domestic gold obligations (including the unconstitutional and highly repulsive, not to use the Biblical term ''abominable'' (Proverbs, XX-10) confiscation of the gold coins of the citizenry, pursuant to the executive order of Franklin Delano Roosevelt (a Democrat) in March, 1933, just a few days after his inauguration as president.

(2) The default of the federal government on its international gold obligations

(including gold embargo that is still in force as shown by the recent refusal to release Germany's gold) on the executive order of President R.M. Nixon (a Republican) on August 15, 1971.

(3) The violation of the F.R. Act of 1913 which explicitly forbids the construction of F.R. credit on government debt with stiff progressive penalties for non-compliance that was the result of a conspiracy between the U.S. Treasury and the F.R. System that started in 1922 to initiate the open market operations od the F. R. banks. As a side effect of open market operations bond speculators are allowed (nay, incentivised) to reap risk-free profits by front-running the Federal Reserve in buying the bonds beforehand (to drop them into its lap at elevated prices). Open market operations is the main tool in the hand of governments to suppress the rate of interest even to zero.

All the dollars that were created after 1922 have come about illegally, through checkkiting. In more details: the Treasury and the Fed created liabilities and exchanged them, allowing the creation of further oliabilities with no limit. The situation is this: F.R. notes are by U.S. Treasury bonds payable in the selfsame F.R.notes for which they serve as cvollateral security. The result is the construction of a Babelian tower od liabgilities for which nobody takes responsibility.

The policy of open market operations is the main tool whereby the rate of interest can be pushed down, in some cases, all the way to zero.

Thus are the savings of the people syphoned off surreptitiously. Moreover, capital is being destroyed unobserved. (Rising bond prices increase the liability of banks and other institutions and firms on capital account. Any unintentional addition to the liability column of the balance sheet is tantamount to the destruction of capital.) (4) More recent is the violation of Contract Law through allowing (nay, encouraging) the replacement of physical gold by ''digital'' gold (a.k.a. ''gold in the clouds'') on the books of corporations and of the government and the Federal Reserve. The physical gold is hypothecated and spirited out of the country.

As a result of this prestidigitation, it is doubtful that the American gold reserve is as officially stated. The U.S. may not have any physical gold left. President Trump, should he decide to initiate the rehabilitation of the Gold Standard Act of 1900 that was sabotaged by Roosevelt,it might be impossible to do for reasons of the nonexistence of the U.S. gold reserve, and he may have to abort the initiative.

The purpose of this article is to draw attention to the saving grace, namely, to the freak fact (missed by all observers), that , due to an oversight of Roosevelt, President Trump may be able to reclaim the U.S. gold reserve, and go ahead with his initiative nevertheless.

While he was trying to bury the gold standard, Roosevelt ordered the confiscated gold of the citizenry melted down, an outrageously destructive act, known as „The Great Coin Melt”. The measure back-fired: President Trump may be able to reclaim the hypothecated gold that was subsequently sold and exported from the country illegally.

The problem is to how to find it.

Here is the fortuitous fact that makes the finding of the exported American gold reserve easy. As pointed out above, this has escaped the attention of observes, but it is the centerpiece of our article.

On Roosevelt's order the melted old coins were recast in bar form (400 oz. or 12,5 kg „international good delivery bars.”

Not one single other country followed the American lead in melting down its gold coinage.

## Indelible Watermark

The obvious intent behind Roosevelt's Great Coin Melt was to prevent any future Administration from reversing the unconstitutional measures of the Roosevelt Administration. In and of itself this was a highly anti-democratic and immoral act. No Amdinistration should have the power to commit all future Administration to continue its own pet policies. Periodic elections are held in democratic countries precisely in order to give a chance to the electorate to reject objectionable policies.

Because in 1933 the American gold reserve encompased virtually all the monetary gold in the world, it is apparent that Roosevelt went all out in his zeal to expunge the gold standard from the face of the world.

Now we see that this effort was frustrated because of an oversight in the execution of the Great Coin Melt.

The American gold coinage did not consist of 999 fine gold. It was an alloy of only 925 fine; the rest being copper in order to make the coins harder and more resistant to wear and tear. Consequently the „international good delivery bars ” into which they had been cast before they were hypothecated, sold and spirited out of the country, all carry an indelible „watermark”: the impaired substandard fineness. This betrays their origin as having come from the merican gold reserve.

The upshot is that the Trump Administration will not be thwarted if it wants to rehabilitate the Gold Standard Act of 1900, as plotted by Roosevelt. American monetary gold that has been illegally hypothecated and spirited out of the country can be tracked down. All President Trump has to do is to declare „watermarked” gold contraband and claim it as gold that is still part of the American gold reserve, wherever it may be located and whoever may be its putative owner.

There no need to repatriate the gold by force. As pointed out, contraband gold carries an indelible „watermark”.

Having „tabooed ”contraband gold, President Trump will promote the U.S. as the country with the largest gold reserve of any country in the world, beating China and Russia to it, two countries which scramble to achieve that desirable goal.

Moreover, the United States under the Trump Administration will be able to reverse the worrisome flow of gold from the Occident to the Orient that has bled the Western countries white, making them virtually impotent economically and financially.

The repercussions are truly breath-taking. The U.S. government debt and thed dollar can comvincingly be made gold-redeemable once again. American Treasury paper will shine, recapturing its former glory as the most desirable asset second only to gold itself to own by anyone, anywhere, anytime. The illegal check-kiting between the U.S. Treasury and the Fed can be terminated immediately.

Moreover, the United States under the Trump Administration will be able to reverse the worrisome flow of gold from the Occident to the Orient that has bled the Western countries white, making them virtuaslly impotent economically and financially. The output of the world's gold mines will flow to the U.S. Mint rather than to China and Russia.

The Bric-countries and a China-Russia coalition can no longer bully the United States threating to dump the dollar as the world's reserve currency, unless they are prepared to make their currency gold redeemable that they won't be able to do if only because their gold reserves are inasufficient (at least for the time being). The same applies to the so-called “nuclear option” (namely, the potential blackmail of China to dump U.S. Treasury bonds in order to cause financial turmoil to the discomfiture and detriment of the U.S.)

## Lacking Moral Courage

Keynesian politician had ample time to initiate a Constitutional amendment to make the irredeemable dollar legitimate. They failed to do so. Why? They don't have the moral fortitude. A Constitutional monetary system could never be built on a debtbased currency. The reason is that there is no way to define the monetary unit such that it is logically sufficient.

In more details, if we define it as debt, then we must be able to answer the question whose debt it is.This question leads to a vicious circle as follows: If it is the debt of A, represented by the bond a, then a occurs in the liability column of the balance sheet of A. Let this liability be balanced by b, a bond issued by B. Then b occurs in the liability of the balance sheet of B. Let this liability be balanced by c, a bond issued by C. And so on and so forth. We have an infinite chain tht means that the irredeemable currency has no backing whatsoever: it is nobody's liability. This being the case, the currency can scarcely have any value (whether or not this fact is recognized). At this point the “experts” chime in saying that, as a matter of fac, the vhain is finite and its last link is the bond x, the liability of X, the U.S. Treasury. The circumstance that X is the world's greatest debtor with a debt that grows day in and day out, and that X has neither the intention nor the means to ever to retire it, is conveniently sidestepped.

Once again the “experts chime in” suggesting that there is really no need to back the liabilities of X because b is recognized as an ultimate extinguisher of debt.

The truth, however, is that there is but one ultimate extinguisher of debt, gold, the peerless asset that has no counterpart in the liability column os the balancwe sheet of any other economic unit.

## Opening The Mint To Gold

There is some urgency that the Trump Administration act quickly and expeditiously to make the dollar gold-redeemable again through reclaiming the hypothecated American gold reserve on foreign soil.

By the same token, equally importan is that the Trump Administration open the U.S.

Mint forthwith to the unlimited coinage of gold free of seigniorage charges (as distinct from asssay charges), that was forcibly and unconstitutionally closed by Roosevelt in 1933. This will invite the world's gold mines to bring forth their surplus gold and exchange it to spanking shiny American gold coinage, ounce for ounce, in unlimited quantity – preferably before China and Russia wake up ond open theirs in an effort to thwart the U.S. One should see this as the real danger threatening the U.S. If there ever was a “nuclear option” then that's it: China and Russia opening their Mints to gold before the U.S. does.

Once the word is out that the Trump Administration is studying the matter of rehabilitating the Gold Standard Act of 1900, everybody will try to second-guess what the new gold price will be as quoted in the irredeemable F.R. notes.

As it turns out, it does not matter. The issue will not be dectrmined on Quantity Theory of Money considerations. The number of gold coins to be struck will not be decided by the U.S. Treasury, nor by the Federal Reserve. The new gold price will not be fixed by the government: it will be fixed by the public at large. This exactly as it was envisaged by the Founding Fathers when they drafted the U.S. Constitution.

They did not want the government to decide such a momentous matter as the size of the stock of money in circulation. Significantly, the Constitution did not establish a central bank for the country. Instead, it established the U.S. Mint, thus conferring the right to create money on the public at large.

It is not widely recognized that the American banking system is insolvent and is close to the point of declaring bankruptcy. The same is true for the most important banks abroad as well. The Trump Administration in outting the dollar on old basis will avert a devastating international banking crisis and should earn the gratitude and admiration of the world for its foresight and courage.

To recapitulate, when all is said and done the truth is revealed that no irredeemable currency can ever play the role of the ultimate extinguisher of debt. In paying down debt with irredeemable currency debt is merely shifted from one bank to another

(ultimately, to the U. S. Treasury), or from one debtor to another. But shifting debt is not the same as extinguishing it. The only ultimate extinguisher of debt that exists in our world is gold, because as an asset it never occurs in the liability column of the balance sheet of a counter-party. This is why under the regime of irredeemable currency debt can only grow, never decline, imparting great instability to the financial system. By contrast, under a gold standard total debt is kept in check because the rate of interest acts as an obstruction to credit expansion.

## Introduction

The dollar is a through and throughed debauched currencyas shown by the fact that in less than one hundred years it has lost 97 percent of its purchasing power. This may be a record in the history of decaying and moribund currencies that have managed to survive as long as a century. The debauchery was deliberately fomented at the behest of the federal government even at the expense of overthrowing the Constitutional monetary order of the Republic.In what follows I shall enumerate four étapes of this fomentation.

(1) The default on the government's domestic gold obligations (including the unconstitutional and highly repulsive, not tho usew the Biblical term “abominable” (Proverbs, XX-10) confiscation of the gold coins of the citizenry, pursuant to an executive order of F.D.Roosevelt (a democrat) in March, 1933, just a few days after his inauguration as president.

(2) The default on the government's international gold obligations (including gold embargo that apparently is still in force as witnessed by the recent refusal to release Germany's gold pursuant to an executive order of R.M.Nixon (a republican) on August 15, 1971.

(3) Lesser known is the violation of the F.R.Act of 1913(before amendments) which explicitly forbids the construction of F.R. credit on governmwent debt with stiff and progressive penalties for non-compliance that wasthe nresult of a conspiracy between the U.S. Treasury and the F.R.System that started in 1922 to initiate open market operation of the Federal Reserve banks. As a side effect bond speculators are invited to reap risk-free profits by front-running the Fed (buying the bonds beforehand to drop them later in the lap of the latter at elevated prices). The policy of open market operation is the main tool in the hand of the government to suppress the rate of interest, in some cases all the way to zero.

Thus are the savings of the people syphoned off surreptitiously.Moreover, capital is being destroyed unobserved. In more details: falling interest rates are tantamount to rising bond prices that increase the liability of banks and other firms on capital account. Any unintentional addition to the liability column of the balance sheet means capital destruction.

All the dollars that were created after 1922 have come about through check-kiting.In more details, the Treasury and the Fed have exchanged liabilities allowing more liabilities to be created without limits.The situation is this: F.R. notes are backed by U.S. Treasury bonds payable in the selfsame F.R. notes for which they serve as collateral. The result is the building of a Babelian tower of liabilities for which nobody takes responsibility.

(4) More recent is the violation of Contract Law allowing the replacement of physical gold by digital gold (a.k.a. “gold in the clouds”) The physical gold was then hipothecated, swapped for paper gold, sold, and spirited out of the country illegally.

As a result of this prestidigitation, it is doubtful that the American gold reserve is intact. Some say the U.S. may not have any physical gold left. President Trump, should he decide to initiate the rehabilitation of the Gold Standard Act of 1900 that was sabotaged by Roosevelt in 1933, might find Fort Knox utterly empty and be forced to abort the initiative for reasons of the lack of an adequate gold reserve.

The purpose of this article is to draw attention to the saving grace, namely, to a freak incident that may make it possible for Trump to reclaim the American gold reserve and go ahead with his initiative.

While he was trying to bury the gold standard, Roosevelt ordered the confidcated gold coins of the citizenry be melted down – an outrageously destructive act known as the reat Coin Melt. As we shall see, the measure back-fired. Here is the fortuitous fact that makes the finding of the hypothecated and exported American gold reserve easy. Roosevelt had the confiscated gold recast in bar form (400oz. or 12,5kg

“international good delivery bars”).Not a single other country followed the American lead in melting down its gold coinage.

## Indelible Watermark

The obvious intent behind Roosevelt's reat coin Melt was to prvent any future Administration from reversing the unconstitutional monewtary measure of the Roosevelt Administration. In and of itself this was a highly undemocratic and immoral act. No administration is supposed to have the power to commit all future Administrations to its own pet policies. It can be seen that Roosevelt went all out in his zeal to expunge the gold standard from the face of the Earth. That is farther than the Russian Bolshevists have ever gone in destroying the Constitutional monetary system.

However, like a bungling burgler who left his fingerprint all over the burglerized premises, the schemers of the Great Coin Melt left an indelible “watermark” on every gold bar that came from the “burglerized” gold coins, making detection easy. Had they been more circumspect, they would have refined the gold to the customary fineness for international good delivery bars: 950 or better.

The American gold coinage was only 925 fine, the rest of the alloy being copper in order to make the coins harder and more resistant to wear and tear. The recast gold bars all carry the indelible watermark: their impaired, substandard fineness. This betrays their origin as having come from the Great Coin Melt.

The upshot is that Trump may not be thwarted (as plotted by Roosevelt) if he ants to rehabilitate the Gold Standard Act of 1900. All he has to do is to declare watermarked gold contraband and claim it as part of the looted American gold reserve regardless where it may be located, and whoever may be its putative owner.

There is no need to repatriate the gold by force. There is no profit in dealing in fenced gold any more than dealing in counterfeit gold.

Having “tabooed” watermarked gold, Trump will promote the U.S. as the country with the largest gold reserve of any in the world, beating China and Russia to it, two countries scrambling to ahieve that most desirable goal.

The repercussions are truly breath-taking. The U.S. government debt and the dollar can convincingly be made gold-redeemable once again. u.S.treasury paper will shine recreating its former glory as the most desirable assets second only to goldto own by anyone, anywhere, anytime. The illegal check-kitingbetween the Treasury and the Fed can be terminated effective immediately.

Moreover, Trump can reverse the worrisome flow of gold from the Occident to the Orientthat has bled western countries white, making them virtually impotent economically and financially.

The output of the world's gold mines will flow to the U.S. Mint, rather than to China and To Russia.

The Bric- countries and a China-Russia coalition will no longer be able to bully the U.S. with the threat of dumping the dollar as the world's reserve currency – unless they are prepared their currency gold redeemable that they won't be able to doif only because thei gold reserve is insufficient (at least for the time being). The same applies to the “novlear option”, namely, the threat to dump China's holdings of U.S. Treasury paper in order to cause financial turmoil to the discomfiture and detriment of the U.S.

## Lacking Moral Courage

Keynesian politicians could have initiated an amendment to make the irredeemable dollar conform to the Constitution. They never had the moral courage to do so.

A Constitutional monetary system could never be built on a debt-based currency. The reason is that there is no way to define the monetary unit in a way that is logically sufficient.

In more details: if we define it as debt, then, we have tio be able to say whose debt it is.This leads to a vicious circle. Assume it is the debt of A, represented by the bond a.

Then a is in the liability column of the balance sheet of A. Let the liability be balanced by the bond b issued by B. Then b is a liability of B. Supposed it is balanced by the bond c issued by C. And so on and so forth.We have an infinite chain meaning that the currency has no backing whatsoever; it is nobody's liability. This being the case, it can scarcely have any value. The “experts” chime in saying that as a matter of fact th chain is finite and its last link is x, the bond issued by X, the U.S. Treasury.

The circumstance that X is the world's greates debtor with a debt that keeps growing day in and day out, and that X has neither the intention nor the means ever to retire its debt is conveniently sidestepped. Once again the “experts” chime in suggesting that there is no need to retire the debt of X because x is acceptable as the ultimate extinguisher of debt.

The truth is, however, that there is only one ultimate extinguisher of debt, gold, the peerless asset that has no counterpart in the liability column of the balance sheet of any other economic unit.

## Opening The Mint To Gold

There is some urgency that Trump act quickly and expeditiously to make the dollar gold-redeemable again through reclaiming the hypothecated American gold reserve on foreign soil.By the same token, equally important is that, in compliance with the Constitution Trump open the U.S. Mint to gold forthwith – prefgerably before China and Russia wake up and open theirs in an effort to thwart the U.S. One should see this as the real danger facing the U.S.

Once the word is out that the Trump Administration is studying the matter of rehabilitating the Gold Standard Act of 1900, everybody will try to second-guess what the new gold pricewill b as quoted in F.R. notes. As it turns out, it does not matter. The new gold price will not be fixed by the government. It will be fixed by the public at large, exactly as envisaged by the Founding Fathers when the drafted the Constitution. Significantly, the Constitution did not establish a central bank; instead it eestablished the U.S. Mint, thus conferring the right to determine the size of the stock of cirulating currency on the general public (rather than on the Treasury or on the Fed.)

## The Rehabilitation Of The Wage Fund

It is not true that the gold standard is contractionist, deflation-prone, and government spending and unbalanced budgets are neededt o keep the wheels of the economy spinning and to keep workers at their jobs – as charged by the Keynesians.

Rather than causing unemployment, the gold standard alone makes it possible through the market in real bills to create the Wage Fund out of which the wages of workers could be paid, if need be, a quarter (3 months, 13 weeks, 91 days) before the sale of merchandise to the ultimate consumer.

The horrendous tsunami of unemployment that engulfed the world economy in the

1930's was not caused by the gold standard. It was caused by the victorious Entente powers not to reopen the London market in real bills after the cessation of hostilities in 1918. As is well-known, prior to 1913 the production and distribution og consumer goods was financed byreal bills drawn on London maturing in gold. The destruction of the Wage Fund was the consequence of that decision. In the absence of a market in real bills there was no one to advance the wages of the workers. They had to be laid off.

The victorious Entente powers were motivated by their neurotic fear of German efficiency. They could no longer blockade the country, so they blocked its bills financing exports and imports.

The destruction of the Wage Fund and the horrendous unemployment in its wake was predicted by the German economist Heinrich Rittershausen. Unfortunately, his warning was dismissed as chauvinistic German propaganda. Another German economist, Eilhelm Röpke said that it was not the gold standard that failed but those on whose care it was entrusted.

He threat of unemployment is still with us. We still lack a Wage Fund.

President Trump could remove the threat of unemployment for once and all. He could recreate the Wage Fund. To do this he would allow the trade of real bills drawn on New York, maturing in gold. After a century of hiatus, this measure would work miracles. Competitive devaluation of currencies (“race to the bottom”) would come to an end. The threat of trade war would vanish.

## How Realistic Is This Scenario?

Well, just as realistic as it was to expect that Donald Trump beat Hillary Clinton in the last presidential election. Yet it happened. Very soon Trump will be confronted with the dollar problem and the problem of proliferating debt the country faces. No one can offer e credible solution. President Trumps economic advisors, Judy Shelton, Alan Greenspan, Ben Bernanke must tell him that the only way to rein in runaway debt is to bring gold, the only and trusted ultimate extinguisher of debt back into the international monetary system.

The picture is ugly. Trump has to choose between two destructive outcomes: inflation and deflation. The latter means allowing debt reduction to proceed through bankruptcies; the former means debt reduction to proceed through debasing the dollar to the point of worthlessness. It is quite likely that the incumbent reasury and Fed officials will push him to opt for the former. This is what their policies since the turn of the century and millennium suggests. There is no memory in this country of a Zimbabwe-style inflation. The American people will not stand for it. That's not why they sent Donald Trump to the White House.

Trump must realize that if the destructive gold policy of Roosevelt's first monetary revolution is ollowed, eighty-five years later, by a second, with his constructive gold policy, then deflation and inflation can be averted. He has the power to pull it off. Has he got the intelligence?

The alternative is that the U.S. dollar go the way of the Zimbabwe dollar.

Trump must remember that although Napoleon's Empire is long gone, yet its currency, also clled Napoleon (the 20 franc gold coin) still lives and prospers two hundred years later.

Can President Trump hope to make the dollar match that record?

If he repairs it, maybe.

---

*December 8, 2016.*

---

# Professor Fekete Interview with Guillermo Barba (2016)

URL: https://newaustrianeconomics.com/archive/fekete/interview-with-guillermo-barba-2016/
Date: 2016-05-12
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, gold-standard, permanent-backwardation, fiat-currency, new-austrian-economics
Description: A 2016 follow-up interview with Guillermo Barba covering developments in gold markets, monetary policy, and the state of the global monetary system. Fekete provides his assessment of where the paper money system stands after a decade of post-2008 emergency measures and what the next phase will bring.
Editorial Note: Published May 2016, the second Barba interview (the first was March 2014). Provides a useful update on Fekete's analysis of monetary developments since 2014.
Original PDF: https://professorfekete.com/articles/AEFProfFeketeInterviewWithGuillermoBarba.pdf

### Prof. Antal Fekete Interview with Guillermo Barba

GB: In your opinion, what are the most important events since our last interview two years ago?

**Professor:**

The most important development was the establishment of the negative interest rate structure by various countries; including Switzerland, which is an amazing development. I thought Switzerland would be the last country that would play with fire and here it is — they were leading the pack and hailing the advent of negative interest rates, which is just insane. I think that was the most important development over the past two years.

## Gb: 

**Could you please explain to people why that is insane?**

## P: 

First of all, it betrays a complete ignorance about the nature and the theory of interest and I go back to Carl Menger. Carl Menger didn't have a formal theory of interest rates, but Carl Menger had the general framework of economic theory and I believe that if Carl Menger had lived longer, then he would have actually finished the job and included a complete theory of interest rates in his economic theories. This didn't happen, but it shouldn't prevent us from trying to fill in the details and trying to reconstruct what such an interesting theory it could have been, if Carl Menger had lived longer and completed the job. So, why is it insane? Because it is not that interest rates are falling to zero and then keep falling until they become negative — this is not what is happening. It's not doing it on its own — it's being pushed. This is equivalent to deliberate destruction of capital.

If you push interest rates into negative territory — that is the equivalent to the destruction of capital and not only financial capital, but also physical capital.

Falling interest rates destroy capital because the interest rates and capital values move in opposite directions.

If the interest rates falls, then the bond price goes up, if the interest rate goes up then the bond price goes down. So if interest rates go to zero, then the bond price goes up. But how far can it go up? Can it go to infinity? Well, that's clearly a contradiction.

Negative interest rates, first of all it has never happened in history that worldwide interest rates became negative, but it's very destructive as far as the integrity of capital is concerned.

## Gb: 

**Who is artificially depressing the interest rates?**

## P: 

We can only guess. I mentioned Switzerland, and this is my most shocking example because what Switzerland is trying to do is to fix the value of the Swiss Franc in terms of the Euro and also other currencies, and in order to do that they have to keep buying a lot of junk. They are buying assets of other central banks which are just no good! A lot of bad assets are being added to the balance sheets of the Federal Reserve, the Bank of England, the Bank of Japan and even the Bank of China—the People's Bank of China.

So, what I see is a great destruction of capital all over the world, including solid countries also such as Switzerland and The National Bank of Switzerland, which is turning the Swiss economy into a shadow economy that is losing capital all the time. So, I think will end in a bad way. I don’t see anything constructive in this effort of pushing interest rates into negative territory.

## Gb: 

Why do the central banks keep pushing the interest rates down? Why do they keep trying this?

## P: 

Well, one explanation, especially in the case of the Swiss, is their effort is to fix the value of the Swiss Franc in terms of other currencies, but looking at the picture more globally, what you see is a rush to destroy the value of ALL currencies. You've probably heard the expression  race to the bottom.

The idea is that the various currencies — the Dollar, the Yen etc. are floating, but that floating has turned into sinking, and ultimately that sinking is a race to the bottom. The winner is the one which loses the most value fastest. This , in itself, is insane.

## Gb: 

**Is it a currency war?**

## P: 

Yes, that's right. A currency war and more importantly, a trade war. Countries think that by cheapening their own currency, they're boosting exports. They are beggaring their neighbors. But it is going to backfire, in a bad way, while they think that cheapening their national currency is a valid way to create jobs and boost exports.

## Gb:

**Is that true?**

## P: 

No, no, no. This has been refuted thousands of times over the centuries. This was the idea of mercantilism, and it never worked. It always backfired. A country cannot get richer by cheapening its currency because that means destroying the value of the savings of the people; including companies, individuals, pensioners and so on and so forth. So, you cannot create wealth by destroying the value of your currency. That is the reason why they try to do that, including the Swiss. They want to keep exports at an artificially high level, even if this means making people at large poorer. It is similar to a champion trying to become more competitive at the race through self-mutilation

GB: Last December, the Fed’s FOMC raised the interest rate. Do you think that they are doing the correct thing this time?

## P: 

In the US, the Federal Reserve doesn't have a clue what they are doing. They are completely confused. They have been saying they're going to raise interest rates to normalise the interest rate structure.

## Gb: 

Should they do it or just leave interest rates to the free market?

## P:

It's obvious that interest rates should be left to the free market because the free market is the ultimate judge of what is good for the economy — what is good for the people, and, if you go against the free market you only cause damage. In this case, you cause damage by hurting the pensioners, the insurance companies, the saving institutions and ultimately the banking industry, because the capital of the banking system is being destroyed. So that is going to be the outcome, the destruction of capital at large. That is what I think is going to happen and it is already happening. Raising interest rates artificially is just as bad as suppressing them.

## Gb: 

**Do you think we will see negative interest rates in the US?**

## P: 

We can only guess. My guess is that yes, this is on the cards because the Fed is utterly frustrated that nothing they try works. They've tried everything; they tried zero interest, they've tried lowering interest rates, but nothing works. The economy is sinking, it's not improving in spite of a big propaganda effort that says unemployment is down, the economy is picking up and companies are generating profit. This is not true, it's just a bunch of lies through the propaganda channels which the government and the Federal Reserve have at their disposal.

GB: If negative interest rates destroy capital, can they reverse this process by raising them?

## P: 

I have been saying it for a long time that falling interest rates destroys capital and once capital is destroyed, it's not so easy to recreate it.. They say “ok’’, if interest rates are being pushed down and capital is destroyed, we can always readjust by going back to the higher rate”. This is not so. It's much easier to destroy something than to build.

## Gb: 

Do you think that the US dollar could become a bubble? Will the crisis of the dollar be the ultimate crisis?

## P:

What is happening now is the ultimate outcome. The rush into the dollar is completely misleading. It suggests strength — of the US Dollar, its banking system and its economy, but that completely obscures the fact that behind all of the superficial appearance there is destruction. So, I cannot help but believe that we are at that point where the destruction has reached a point where the whole structure has become unstable, it could collapse at any time.

**GB:** What’s the role of gold in this financial and economic mess?

## P: 

Gold is the only antidote we have, it's the only stable rock or anchor on which we could fix things. Everybody knows that gold is an anathema in the United States. It's an antithesis of Keynesianism and there is a war against gold by the central banks and by all the governments, which in a way is understandable because the artificial creation of credit has reached a level where it is weakening the whole system. Without gold this rot cannot be stopped — the rot has already gone very far and is still going on. So, I think gold is the key to the situation. The dismissal of gold is very damaging for the western world.

GB: Why is gold so important? Do you think that we could return to the gold standard?

## P: 

I firmly believe that it is possible to return to the gold standard but not before some cataclysmic event — such as the collapse of the world economy or that of the financial system, takes place, because the present thinking in academia, in government circles, in the financial world — is still for the destruction of solid, sound values. So, we have to go back to Menger for the answer to the question why gold is important. Why is gold so important?

Well, the answer according to Menger is that gold is the only commodity which has constant marginal utility.

Every other commodity or financial asset has the property that if you buy more and more of it, the value of each unit is going to be lower, the marginal utility will be lower, and gold is the only exception to this decay of value. Gold defies that law of declining marginal utility. Gold has the property that if you keep holding it, it's not going to lose its value. That is the secret of gold and that is what they try to make people forget, but people will not keep holding assets which have declining marginal utility as all our financial assets do. People will instinctively hoard that gold, and to a lesser degree, silver. (They) are the two commodities that defy the law of declining marginal utility.

GB: Do you think that gold would be the solution to revive the world trade?

## P: 

Definitely! Here I have a very recent paper by Sr. Hugo Salinas Price. The title is *The Coming Revaluation of Gold*, and in this article, Sr. Salinas very cogently analyses the situation and points out the reasons why it is absolutely necessary to revalue gold. He even mentions figures—he mentions the gold price going to 10,000 dollars an ounce or even 20 or 50 thousand dollars an ounce. I would not comment on future possibilities because we just don't know the future. There is no scientific method to predict, with any assurance, what the future gold price will be. But, this is not even necessary, because instead of a quantitative statement we can make a qualitative statement, which has more scientific respectability than the quantitative statement, talking about the future gold price. This qualitative statement that I have been advocating for several years is that you have to look at the backwardation of gold, which is now a reality. When I started talking about the backwardation and even permanent backwardation of gold more than a decade ago, it was not yet a reality, it was just a possibility — but now it's a reality. This means that the nearby future price of gold, which normally should be higher than the spot price, it becomes lower and the spot price becomes higher. This is a qualitative statement. We don't say what the price of gold is in terms of numbers, we just state the difference of magnitudes: between the nearby future price and the spot price.

So, if the spot price rises above the near future price, this is a grave danger sign – it’s a blinking red light showing that there is a tremendous shortage of deliverable gold in the market and that the market is not going to be able to satisfy that demand. So, rather than putting numbers on it, we just say that the backwardation of gold, first, will be sporadic; then backwardation appears but then it disappears again. This can flip-flop for a time, but there is a point, a threshold, beyond which the backwardation of gold becomes permanent. That means that gold cannot be obtained at any price because nobody will give up gold unless he can see clearly that he can replenish his holdings through trade or through transactions. When this becomes impossible – that’s the end of the monetary system. At that point there'll be a flight from paper money. This, again, is part of the general destruction of capital values.

GB: So, even if we cannot know how high the “price” of gold will be, will there be a revaluation of it? What do you think?

## P: 

The coming revaluation of gold casts a long shadow ahead. In other words it's not something that happens from one day to the next — it's something, which like a storm or a hurricane approaching — the signs are all around us. We have to read these signs and interpret them to see what is happening. In the case of this revaluation of gold, especially when you try to imagine it in terms of such very large numbers as 10,000; 20,000 dollars; 50,000 dollars for one ounce of gold is not easy. Yet somehow people will feel it in their system — they know that something very drastic is happening and they will react basically in two ways.

A lot of people, including speculators who have disdained gold, will make a  volte face  as they see this revaluation coming. They will start hoarding more and more gold in the hope of large capital gains. That has the effect that the call option premium in the gold market will go higher and, as it does, trading or selling call options on gold will be very profitable.

The second aspect of this reaction is on the part of those who already possess gold . As I said, the coming revaluation of gold is casting a long, long shadow ahead. A lot of people, and also governments, central banks, industrial enterprises, individuals, pension funds etc. — who already have the gold but they are afraid that this value that they already have is exposed to possible setbacks. For all they know , it may even disappear altogether. Naturally, they will want to protect or ensure this value — they will want to buy put options — a form of insurance against this type of loss. This means that there is a pent-up demand for put options and therefore selling put options is going to be very profitable. So, to cut a long story short, I would like to describe the coming revaluation of gold in terms of trading call options as well put options — in particular, buying call options by those who want to earn a capital gain, and buying put options by those who want to protect the value they already have accumulated, in anticipation of the coming revaluation.

What does that mean in practical terms? In practical terms this means that the successful self-protection in these cataclysmic times — which the coming revaluation of gold is going to bring — is not buying low and selling high or selling high and buying low, which is the traditional approach — but it is trading call options and put options on gold, basically, selling call and put options.

Undoubtedly, some people are already doing it. Naturally, they keep their cards close to their chest. They would not think of sharing their secret with you. Information on this kind of trading is hard to come by. The consensus is that the more successful or profitable a trading strategy is,the riskier it must be. However, this is not necessarily so. In crazy times when governments do crazy things such as experimenting with negative interest rates, higher profits need not involve higher risks. We cannot be sure whether the next move in the gold price will be up or down. But we can be absolutely sure that the ongoing crazy experimentation with negative interest rates will increase the volatility of the gold price. That is all we need to know. Higher volatility means higher premiums for options. These are available for picking, with limited risk, if you apply proper safeguards.

We have experimented with option trading based on this insight. II have decided to share some of the information we gathered with others. We have followed a formula of selling call options on the gold we already have or selling put options when we expect the gold price to rise. It may not necessarily mean physical gold, it may be a substitute such as gold mining shares, because there are also liquid options markets trading calls and puts on these shares. The share price of gold mining firms shows a high correlation with the gold price. We have consistently pursued a trading policy based on selling options and I may mention a trading system which we have pursued in Hungary for something like two-and-a-half years — the idea of selling puts or selling calls.

Another experiment is being carried out in London. These experiments have been very successful, I'm happy to report. It is no longer a question that this is a matter of luck, or a matter of good timing or good bottom-picking. Rather it is a trading system designed to benefit from the insane monetary policy of the Fed or other central banks pushing interest rates into negative territory. In two cases, we can now independently document profit on invested capital in the order of 100% per annum, which means doubling your capital every year. It sounds impossible, it seems that it defies the laws of physics or of nature, but it doesn’t, because it simply means taking advantage of a leaky and wasteful not to say crazy monetary system ignoring and badmouthing gold. We now have two working examples of this happening. You just have to hold your bucket and catch the proceeds of the leakage from the faulty monetary system.

I am pushing this point because I consider this as another proof that the FIAT monetary system is going to collapse. To be sure, there are several proofs of this; one is history — that there has never been a permanent established FIAT monetary system in all history: — in every instance that they have tried, their system collapsed ignominiously . Now we have proof that it is possible to double your capital every year and the way to do that is trading options — call and put options, and I would like to go public with this record. I think it is a little bit premature to say more about it now, but those that don't believe me should stay tuned because I'm going to make further disclosures in the near future about this experiment.

Thank you, professor Fekete, for the interview.

Thank you Guillermo, for the searching questions.

---

*May 12, 2016.*

---

# Was Carl Menger Jewish?

URL: https://newaustrianeconomics.com/archive/fekete/was-carl-menger-jewish/
Date: 2016-05-02
Section: Popular Economics
Difficulty: accessible
Concept Tags: new-austrian-economics, mises
Description: Fekete examines the historical question of Carl Menger's Jewish ancestry, arguing that this biographical question has bearing on the transmission of Menger's ideas and the development of Austrian economics. The essay connects Menger's personal history to the intellectual tradition of the Austrian School.
Editorial Note: Written May 2016. A biographical essay examining Menger's background and its influence on the development of Austrian economics.
Original PDF: https://professorfekete.com/articles/AEFWasCarlMengerJewish.pdf

## Was Carl Menger Jewish?

### Antal Fekete

NASOE\
the New Austrian School of Economics\
and the Ferdinand Lips Institute

Carl Menger, arguably the greatest economists who ever lived, the founding father of Austrian Economics – a branch of the science of economics based on a conservative organic theory of the evolution of money – (as opposed to the reactionary and socialist-etatist theory) was born on February 23, 1840 in Nowy Sacz (Neu Sandez), a town in the Province of Galicia of what was to become in 1867 the Austrian Hungarian Dual Monarchy.

This province had a large concentration of Jewish population and served as the spring-board of Jewish migration to other parts of the Austrian-Hungarian Empire, hence, to the rest of Europe and, later, to the Americas.

This fact was considered as prima facie evidence that Carl Menger and his Austrian School of Economics had Jewish origins, both by philoSemitic as well as anti-Semitic circles – depending the parochial interests of those particular circles involved.

In this paper we shall examine this claim in the light of the personal auto-biographical notes of Carl Menger that after his death were put into the family archives by his son Karl Menger, apparently with the intention of writing his father biography later (that never happened).

Ultimately, the family archives were deposited in the Library of Duke University by Eva L. Menger, Karl’s daughter after the death of her father. By now the personal papers of both the father Carl and the son Karl are in the public domain and can be consulted on the campus of Duke University in Durham, N.C.

In 1889 the German-language conservative newspaper *Österrechischer Volksfreund* complained about the “Judaization of the University of Vienna” and referred to Carl Menger and his brother Anton Menger, both professors and one-time rectors, as Jews.

Anton and Carl responded that they were not Jewish and that there were no Jews in their family. In fact, they were born into a devout Roman Catholic family. It is known that Carl Menger’s maternal grandfather Jozef Geržabek who owned an estate around Maniowy in Poland had built a church dedicated to St. Nicholaus there in which both he and his wife Therese were buried. Moreover, Anton and Carl attended a gymnasium run by the R. C. Church in Teschen (Cieszyn).

Their denial, however, failed to convince the German conservatives who asserted that the behavior and the views of both professors betrayed either real or adopted Jewish traits, and the allegation that they were Jewish was repeated elsewhere, e.g., in the newspaper Das Vaterland.

Later Carl Menger became the target of anti-Semitic attacks over his role in establishing the gold standard in the Austro-Hungarian Empire as a member of the Austrian Currency Commission.

The specific charge was that in promoting the gold standard Menger was working for “the Jewish haute finance” – just as the progold (Republican) party in the United States was – opposed by the “silverites” under the leadership of William Jennings Brian (of “the crime of 1871” fame, whose plank to re-establish bimetallism in the United States was soundly defeated in the presidential election of 1896.) During the deliberations of the Austrian Currency Commission Carl Menger correctly maintained that the gold standard was the only monetary regime that would neither favor debtors at the expense of the creditors, nor would it harm them in favor of the creditors. Menger’s argument to support the thesis of the even-handedness of the gold standard bears repeating.

It rests on his theory of marketability of goods. A good A is said to be more marketable than another B if the bid/asked spread increased more slowly as ever larger quantities were dumped on the markets of A than the case would be on the markets for B. Thus losses incurred while trading in and out of A were smaller than those incurred in trading in and out of B. In this metric the most marketable good turns out to be gold and the second most marketable, silver. This is why the yardstick measuring value ought to be ideally made of gold. That done, the losses of both creditors and debtors would be minimized in case their contracts were rewritten in consequence of a monetary reform changing the standard of value from silver to gold.

If the less marketable monetary metal were selected as the standard of value in preference to gold, then there would be a flight out of silver into gold motivated by the desire to avoid or minimize losses. That would allow debtors to get out of debt on the cheap by tendering the less valuable monetary metal in paying down their debt. On the other hand, creditors would make large loans in terms of the less marketable monetary metal hoping to make unearned capital gains to be derived from the flight out of silver into gold at the expense of the debtors.

The problem of choosing the material out of which the yardstick measuring value ought to be made is fully analogous to that of measurig length. For that purpose a platinum rod was chosen because it reacts to changes in temperature least. Likewise, the value of a gold coin reacts to violent changes in market conditions least.

Conclusive evidence never turned up supporting the charges of a conspiracy between the U.S. Treasury and Congress. However, the claim stands that in demonetizing silver the Constitution had been manipulated. For one thing, the proper guidelines prescribing how the Constitution ought to be amended were ignored. The very fact that an important change in the Constitution was involved that affected all creditors and debtors was obfuscated. To say the least, this has made the manner in which silver was dropped as the monetary standard disingenuous.

The gold standard is the only monetary system that is free of bias in favoring either debtors or creditors. It was on this basis that Menger supported the its establishment in Austria-Hungary. The charge that he was an agent of 'Jewish haute finance' is absurd.

Menger's pivotal idea was that of marketability of goods, as measured by the spread between the asked and bid price. The spread is a function of quantity. The more of a good is traded, the wider will the spread necessarily be. Sellers will raise their asked price as they worry that they may not be able to replenish their stocks after they have filled all the buy orders. Buyers will lower their bid price as they worry that they may not be able to reduce their stocks after they have bought all that was offered. Clearly, the bid/asked spread is an increasing function of the quantity traded. Therefore the marketability of a good is increasing as ever larger quantities are traded in the markets.

Tradable goods are ranked by their marketability as it decreases together with an increase of quantity traded. The most marketable goods are the monetary metals gold and silver. In any exchange (barter) they are sought after as sellers want to exchange their surpluses for those of others. They "park" their purchasing power until they find the good that suits their purposes best. This is Carl Menger's famous explanation for the origin of money and the emergence of the monetary economy overtaking barter. As can be seen, the decisive property here is 'marketability in the large'.

A consequence of gold's greater marketability is the fact that the spread between the gold export and import points under a gold standard is narrower than that between the silver export and import points under a silver standard. The narrower spread ''makes the gold standard tick'' as it makes the stabilization of foreign exchange rates possible. Should the spread widen, speculators were ready to arbitrage it away.

This is tantamount to saying that the cost of transporting the unit of value as represented by gold is lower than that as represented by silver.

In other words, the efficiency of transporting value in space is optimized only under the gold standard.

Later on when we discuss the duality of Menger's concept of "Absatzfähigkeit" as it splits into marketability in the 'large' and that in the 'small', we shall pose the dual question: how to optimize the efficiency of transporting value in time. The answer takes us to the theory of hoarding on which, in turn, the theory of interest rests. Thus Menger's ideas lead directly to the theory of interest. No credit has been given to him for this feat. The consensus is that Menger simply had offered no theory of interest of his own. Of course, this is mistaken.

Implicit in Menger's opus is the nexus between gold and interest and everything needed for developing a comprehensive theory of interest in an embryonic form.

The nexus between gold and interest has been studied recently by NASOE, the New Austrian School of Economics. Interest cannot be explained without understanding gold, as gold hoarding and dishoarding are the residual forms of converting income into wealth and wealth into income. Interest exists not as a consequence of a mythical innate time preference of human beings (it is easy to provide counter-examples of instances when they do not prefer present goods to identical future goods). It exists as a consequence of their inescapable need to convert income into wealth and wealth into income.

Were secular and canonical authorities set upon stamping out interest (as advocated by J.M. Keynes in the twentieth century, and attempted by the Federal Reserve Board of the U.S. in the first decades of the twenty-first), individuals would fall back on the 'atavistic' method of hoarding the good that is most hoardable in the small, namely, gold, thus creating deflation.

Milton Friedman developed a theory in trying to prove that the bimetallic monetary system was superior to the gold standard by introducing the concept of "bimetallic arbitrage points" (analogous to the gold export and import points). However, his construction is erroneous as it ignores the fact that under bimetallic guidelines discharging debt must be performed in silver or gold at the option of the creditor, the bank, rather than at the option of the debtor. In comparison with Menger's genius, Friedman appears as a hopeless bungler who was blinded by the fetish of the Quantity Theory of Money In 1946 the University of Chicago invited Friedman to join its faculty to teach economics. This he did but his avowed conservatism and opposition to Keynesianism was not genuine. Instead, he stepped into Keynes' shoes to give the gold standard the coup de grâce. When president Nixon reneged on the international obligation of the U. S. government to pay its debt in gold in 1971, an urgent need arose to put the default in a favorable light. Friedman was happy to be of service. He came up with a false (not to say inane) theory of the adjustment mechanism of foreign exchange rates according to which equilibrium can be restored in the export-import trade of countries through the ''sliding devaluation of currencies'', a.k.a. the ''regime of floating foreign exchange rates'' – damned be the gold standard! As justification he offered the preposterous argument (still very much in the vogue) that if the agio of the valuta of a country falls, then this encourages exports and discourages imports and, vice versa if it rises. According to Friedman, through sliding devaluation the equilibrium in a country's foreign trade accounts can be reestablished automatically and painlessly while the shame formerly attached to devaluations is eliminated. Vice is turned in virtue!

It is easy to see that Friedman's theory is preposterous. It sidesteps the problem that the devaluation of the national currency, sliding or not, grievously undermines the purchasing power of the producers. Namely, it tends to make the ingredients that go into exports more expensive. In praising the virtues of a 'soft valuta' Friedman paints a fool's paradise.

But the hard fact is that if the soft valuta helps the export industry, this is true only as long the stockpiles of those ingredients last. No sooner than they are exhausted those ingredients will have to be imported at the new unafavorable exchange rate. This will inevitably lead to an increase in the price of the export items of the devaluing country. Devaluation always and everywhere undermines competitiveness. It renders the devaluing country's terms of trade inferior. The truism may be remembered that no champion can increase his competitiveness through self-mutilation. Devaluation of the national currency is self-mutilation by another name.

As the subsequent decades convincingly proved, Friedman's false theory did not deliver. The American trade deficit vis-a-vis Japan did not disappear. Rather, it assumed gargantuan proportions, causing the demise of whole American export industries that had been prosperous under the regime of fixed foreign rates made possible only by the gold standard. A painful side-effect of Friedman's policy of sliding devaluation of the dollar was the wholesale export of well-paid American jobs.

Friedman was the grave-digger of the international gold standard.

Yet he who sows wind reaps the whirlwind − as the world now does. It is in the form of a perpetual crisis of the foreign exchange markets and of trade wars that grew out of the mindless destruction of the gold standard − following Friedman's script.

---

It has also been alleged that Carl Menger's domestic partner Mina (Hermine Andermann), the mother of his only child Karl Menger born in 1902 was Jewish. This claim is also false by the testimony of Karl. The record shows that Karl was born out of wedlock. It also shows that Emperor Franz Josef declared him legitimate per restrictum principis.

Another circumstance that makes the claim that Carl Menger was Jewish absurd is the fact in 1875 he was appointed as the tutor to Crown Prince Rudolf after a rigorous vetting. The Prince was also first in line of succession to become the Holy Roman Emperor upon the death of his father. It would have been a scandal of the first magnitude if it had turned out that the Holy Roman Emperor as a youth was coached by a Jew.

In the light of the available evidence it is abundantly clear that Carl Menger was not Jewish, and those who allege to the contrary have a hidden agenda. The Austrian School of Economics and its theory of money, including the case for the gold standard are free of any Jewish influence.

The charge that Menger clandestinely worked for “the Jewish haute finance”, just as the pro-gold (Republican) party in the United States was, opposed by the “silverites” under the leadership of William Jennings Brian, the populist Democratic presidential candidate (of “the Crime of 1871” fame), whose plank to re-establish bimetallism in the United States was soundly defeated in the presidential election of 1896 by the Republican candidate William McKinley whose plank pledged to anchor the dollar to a gold standard (that did indeed happen in 1900), is patently false. And so also is the charge that thie gold standard served the interest of Jewish financiers as opposed to the well-understood interest of the country and its people at large.

In more detail the silverites charged that the Constitutional silver standard of the United States was deliberately sabotaged by a conspiracy between the U.S. Treasury and the Congress. They pointed out that in the Bill that was to become the Coinage Act of 1871 and was drafted by the Treasury (to which W. J. Brian was referring as “the Crime of 1871”), the Constitutional standard silver dollar was unceremoniously dropped from the list of coins that were authorized to be struck in unlimited amount without seigniorage charges on the account of any party tendering the right quantity and quality of silver at the U.S. Mint.

This omission was tantamount to the clandestine demonetization of silver in violation of the U. S. Constitution. Indeed, none of the standard silver dollars minted thereafter were struck on private account. They were all struck on Treasury account. So was the right of the people to free and unlimited coinage of silver in the United States taken away in 1871 by a stroke of the pen, without any proper public debate.

Curiously, simultaneous demonetization of silver by Germany also took place at the same time, although it is not clear whether this was orchestrated or not. Ostensibly, silver demonetization by the newly peomulgated Reich was the result the Prussian victory against France after the peace treaty was signed at Versailles and an unprecedented sum in reparation was exacted in gold coin by Prussia from the French.

Furthermore, it was accompanied by the dumping of silver in the international markets reflecting the wish of the newly established German Reich to join the exclusive club of countries on the gold coin standard. The circulating silver coins of the several German principaities have become superfluous and were destined to be melted and sold. By 1932 the price of silver in terms of gold went into a tailspin and reached 25 cents per ounce, or less than one fifth of the Mint price prevailing prior to 1871. So one may plausibly argue that silver demonetization was the work of market forces.

---

However, the truth of the matter is that the gold standardard is the only monetary regime that would favor neither debtors nor creditors. As we have seen, Menger’s argument to support the thesis of the evenhandedness of the gold standard rests on his theory of marketability of goods as we now briefly recapitulate.

The most marketable goods did, by the very nature of things, become the monetary metals, namely, first gold and, second, silver. Although Menger did not live long enough to work out in full details the dual nature of marketability (he died in 1921 at the age of 81), we have compelling reasons to believe that he would have done so had he lived longer.

In particular, he would have added the theory of marketability in the small (or the theory of hoardability) to his theory of marketability in the large (or the theory of liquidity). As we know, the latter has turned out to be the theory of value; the former is destined to become the foundation of the theory of interest after the problem of interest has been correctly reformulated as the problem of converting wealth into income and vice versa (as opposed to vicious formulation of the problem as that of exchanging present value to future value and vice versa ). With the correct formulation it becomes at once clear that the merit of the gold standard is not that it stabilizes prices (that is neither possible nor desirable) but that it stablilzes interest rates (that is both possible and desirable).

---

Be that as it may, silver demonetization world-wide was a fait accompli by 1900 when the U.S. Gold Standard Act was enacted. The argument that it was the result of a conspiracy cannot lightly be dismissed. An unintended beneficial consequence was an even-handed monetary regime that did not favor creditors at the expense of the debtors or vice versa.

In the light of this argument we must pass the verdict that the deliberate and malicious destruction of the gold coin standard by F. D. Roosevelt immediately after his inauguration in March 1933 (in an obvious violation of his 1932 campaign pledges, not to speak of the violation of the U.S. Constitution which clearly mandates a metallic monetary system to the exclusion of fiat currency.)

Not only did the U.S. government destroy the domestic gold coin standard in 1935 (in that year the U.S. Supreme Court endorsed Roosevelt’s monetary regime that reneged on its domestic gold obligations and made the possession of and trade in gold a crime. Worse still, it also destroyed the international gold standard on August 15, 1971 when it defaulted on its international gold obligations as well (this time under a Republican president).

---

It has been suggested that the latter default was linked to the heavy commitment of the U.S. government to support the belligerent policies of the Israeli government through unilateral transfers of taxpayer-money which would have been impossible under a gold standard.

Therefore the question is not whether Carl Menger was Jewish or not. It is: What would he think of the present fiat money system inflicted upon American taxpayers by dishonest politicians cheered along by dishonest academicians, designed to make unilateral money transfers to Israel and other countries possible?”

---

In this presidential election year the subject of the rehabilitation of the gold standard should be an issue. Regrettably, it isn't. Not one of the candidates has so far initiated a public debate on correlation between the unconstitutional regime of fiat money and the prevailing deflation, fast morphing into depression that manifests itself in the form of vanishing world trade. Instead, economists in the mainstream are actively promoting az anti-gold ethos in parroting Keynes who stated, wrongly, that the gold standard is "contractionist" and deflation-prone.

While it is true that gold hoarding becomes widespread whenever the rate of interest is supressed by the government and its agency the central bank, none of that will happen if the gold standard is allowed to function properly in stabilizing interest rates. It is not that the gold standard is contractionist, but that governments are bent on suppressing the rate of interest.

A most horrendous depression threatens the world economy and the only way to avert the disaster is the return to the Constitutional monetary regime, that is to say, to a metallic monetary system which does not allow the government and the Fed to issue obligations which they are neither willing nor able to honor at maturity.

The irredeemable dollar has led the world into temptation to construct a Babelian tower of debt. It resulted in an invisible destruction of capital through making the interest-rate structure decline. It also gave the world the insane ZIRP (zero interest rate policy of the Fed) rendering all pension plans and insurance policies empty promises, thus pauperizing pensioners and nullifying endowments that fund our great private universities and charitable institutions.

Reference:

The life of Carl Menger: New Insights into the Biography of the Father of Austrian Economics, by Reinhard Schumacher and Scott Scheall

(e-mail: scott.scheall@asu.edu), Preliminary Draft, 2015.

---

*May 1, 2016.*

---

# Global Gold Interview

URL: https://newaustrianeconomics.com/archive/fekete/global-gold-interview/
Date: 2015-07-31
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, permanent-backwardation, gold-standard, monetary-crisis, fiat-currency
Description: An interview with Global Gold covering Fekete's analysis of the gold market in 2015, including his assessment of permanent backwardation's progress, the implications of Chinese gold demand, and the prospects for the paper monetary system. One of his later interviews, providing a current-state assessment of his long-running monetary analysis.
Editorial Note: Published July 2015 by Global Gold. One of Fekete's later interviews, providing useful context for where his thinking had arrived in his 80s.
Original PDF: https://professorfekete.com/articles/AEFGlobalGoldInterview.pdf

### GLOBAL GOLD INTERVIEW WITH Professor Antal E.Fekete

1.

Prof. Fekete, it is a pleasure to have this opportunity to talk to you. You are a fierce critic of the current monetary system and a strong proponent of the gold standard, particularly the variety that combines with the Real Bills Doctrine (RBD) of Adam Smith which we shall get into later. We are very much interested to learn how this interest of yours got started in the first place and what led you to believe in gold and Austrian Economics in general.

A.

I have been a life-long student of gold money which led me to Austrian economics. However, I have always been very critical of the writings of Austrian authors such as Hayek and Mises on gold for their deviation from Carl Menger's basic idea of marketability of goods in favor of the Quantity Theory of Money.

For this reason they have completely missed the nexus between gold and interest. I take pride in pioneering a new departure to develop a theory of interest based on the idea of marketability of goods in the small (a.k.a. hoardability) that puts this nexus right into the center. My own view is that gold and silver are the only monetary metals for reasons having to do with the fact that they are the most hoardable substances in existence on the face of the earth. I also believe that if Menger had lived longer he himself would have developed his theory of interest along the lines of indirect exchange of income and wealth that are an improved version of hoarding and dishoarding (direct exchange). As a matter of fact, here we are talking about the dual theory of the evolution of direct exchange (barter) into indirect exchange of goods and services (monetary economy), namely, the evolution of direct conversion of income into wealth (hoarding) and wealth into income (dishoarding) into indirect conversion of income into wealth (selling bonds) and wealth into income (buying bonds). In the saga of direct exchange evolving into indirect exchange Menger built on the marketability of goods in the large. In the saga of indirect conversion of income into wealth (and vice versa) evolving into indirect conversion Menger would have built on the marketability of goods in the small.

2.

In an article you published last year you accused the United States of fraudulently defaulting on its international obligations payable in gold. Could you tell us more about this story?

A.

There were two instances of default, one in 1933 under a Democratic president and again one in 1971 under a Republican president. Both were fraudulent in as much the U. S. Treasury did have the gold in question that should have been paid out to meet claims. In particular, in 1933 the U.S. defaulted on its gold bonds. Thereafter people were denied the facility of converting income into wealth and vice versa through buying and selling gold bonds. They still are. I will have more to say about how to break out of this interdiction later in this interview.

3.

It is interesting to see the polarity among U.S. policymakers when it comes to the gold standard. In the 1980's you joined the staff of California Congressman William E. Dannemeyer in Washington, D.C., to work on a plan proposing monetary and fiscal reform to the Administration of President George Bush Sr., involving the refinancing the entire debt of the federal government through issuing gold bonds (i. e., bonds paying both principal and interest in gold). Could you simplify for us how this would function. Do you believe that this proposal had any chance of ever being accepted?

A.

A self-respecting, upright government should not issue irredeemable debt, which debt redeemable only in irredeemable currency is. The mechanism involved in issuing irredeemable debt is check-kiting: a crime dealt with by the Criminal Code. It is a conspiracy between the U.S. Treasury and the Federal Reserve to defraud the general public. It will take a very long time for the U.S. to live down the infamy of robbing the rest of the world of its savings. Governments should not issue debt unless they can clearly see the revenues with which the debt can be retired. Contrary to low-brow theorizing, the gold standard is not designed to stabilize prices which is neither possible nor desirable. It is designed to stabilize the interest rate structure which it has done admirably well for the one-hundred-year period between 1815 and 1913.

When the interest rate is changing capriciously, bond values change arbitrarily, rewarding some without merit and penalizing others unjustly. It invites bond speculation which will feed upon itself. Gold-bond financing of the public debt is not merely a matter of honor. It is also a matter of sound economics, to avoid the vicious spiral of fast-breeding debt.

In presenting the gold-bond plan, Mr. Dannemeyer led a delegation of ten republican congressmen to the Oval Office in the White House in October, 1989.

Present at the meeting also was the Secretary of the Treasury.

Mr. Bush listened to the presentation attentively and then turned to his Treasury Secretary suggesting that the staff of Congressman Dannemeyer and the Treasury staff should get together to iron out possible wrinkles in the plan.

At that time, yes, we had high hopes that the Treasury was acting in good faith and the plan would get a fair hearing in academic circles and in the financial press after it has become known that they are studying the proposal at the Treasury. Of course, we had no clue that the Treasury had a „better” idea: to conspire with the Federal Reserve to hatch Q.E.

A date for the meeting between the staffers was duly set, a day before which Mr. Dannemeyer's office got a call from the Treasury advising that ”because of other urgent business” our meeting had to be re-scheduled. A new date was agreed on, a day before which another call from the Treasury came and we had to re-schedule once again. This was repeated a few more times. I saw that the Treasury had no intention to take Mr. Dannemeyer's proposal seriously, in spite of the President's wishes. It is not known whether President George Bush ever realized that he was double-crossed by his Treasury Secretary. I decided to pack my bags to return to my university to resume my teaching career. I did what I could. I could not knock down a brick wall with bare hands. But there is an interesting twist to end of this story.

4.

We are coming to that. Back in 1989 Alan Greenspan, the Chairman of the Federal Reserve Board went on a mission to Moscow to suggest it uncannily to the Soviet leadership to refinance their foreign debt by issuing gold bonds to prevent the imminent collapse of the Soviet economy. Do you believe that if Greenspan's proposal had been accepted, it would in fact have prevented the Soviet Union from collapsing two years later in 1991?

A.

It is not known whether Greenspan was aware of Mr. Dannemeyer's gold bond initiative. Be that as it may, he is a smart man and certainly very knowledgeable about gold. It is quite possible that it has been decided at the highest level that the economic collapse of the Soviet Union was not in the interest of the U.S., and Greenspan fully believed that gold-bond financing of new Soviet credits could be used to prevent that from happening. It is characteristic of the man's duplicity that he did not go public with his message saying: „what is sauce for the goose must also be sauce for the gander”.

I think that if the Soviet Union had issued gold bonds in 1989, it would have changed the course of history.

The financial markets had to do without gold bonds for 56 years between 1933 and 1989 and there was a great pent-up demand for gold bonds from insurance companies, pension funds and other financial institutions. Gold is the ultimate extinguisher of debt and, as such, it has no substitute. In particular, no irredeemable currency can ever accomplish the feat of serving as the ultimate extinguisher of debt.

Other countries could have successfully issued gold bonds to take advantage of the latent demand for them. But the U. S. Treasury retained veto power over such plans. If put into effect, they would have created discomfiture in Washington over the 1933 and 1971 breach of faith with creditors.

If a Soviet gold bond issue could be successfully floated, and the Soviet authorities would have let it ride on its own success without default, then in my opinion it is well within the realm of the possible that this extension of peresztroika to economics would have saved the skin of the „the Evil Empire” and the example thus set would have saved the world economy from the disaster of the collapsing of the international monetary system.

5.

Could we argue the same for the global financial crisis? Could we have avoided the 2007-2008 financial turmoil, or was the financial system bound to go through that paralysing crisis regardless of what the politicians could or would do?

A.

The gold bond initiative could have saved the “skin of the other Evil Empire”.

The problem in 2007 was that by then it had dawned on the world that the American banking system was insolvent. This was partly a consequence of the deliberate relaxation of capital ratios that banks were supposed maintain. The banks understated their liabilities and overstated their assets in their balance sheets by wide margins. The various derivatives representing insurance against the collapse of bond values picked up the sorry state of the American banking system and the cost of insurance spiked. In fact, the spike was the very salvo signalling the onset of the great financial crisis.

6.

Back in 2011 you published an open letter to Texas Congressman Dr. Ron Paul with the title:

**Don't Let Bernanke Wreck The American Economy With His Q.E. EXPERIMENT!** Some analysts and economists argue that the economy has improved based on recently released data thanks to the successful implementation of Q.E. What would you say to them?

A.

The serial Q.E.'s made the condition of the economy worse, not better. Bond speculators got a powerful back-wind to help their effort to bid up bond prices.

Interest rates were further suppressed, and more capital was destroyed. The crisis has deepened further.

Q.E. helped them to front-run the Fed in the bond-buying race, and so to reap risk-free profits on their bond-purchases.

7.

You made some interesting suggestions in an article a few years back on European currencies. Europe is sinking in a massive debt crisis involving Greece but also several other more important countries. In your opinion, is there a way out from the quagmire?

A.

I am a firm believer that there is. All the banks in Europe have to be recapitalized on a gold basis. Bank capital in the form of irredeemable bonds is quicksand on which it is impossible to build a sound financial system.

8.

On the other end of the world, Russia, China, India are amassing great amounts of physical gold. Do you think that they are heading towards a gold standard?

A.

No, I don't think so. The gold standard to them is the same as holy water is to the devil. The governments of these counties are out and out socialist. Socialists do not believe in the gold standard because a true gold standard imposes the obligation on banks and governments to meet their liabilities by paying out gold.

The gold standard is a thoroughly decentralized system, the very antithesis of central planning. It delegates power to ordinary people who can successfully veto wasteful government welfare/warfare spending, as well as any unjustified relaxation of bank credit across the board by withdrawing gold coins against bank notes and bank deposits. Russia, China and India use gold for propaganda purposes that have nothing to do with sound money. The hints they drop about gold are disingenious. „Timeo Danaos et dona ferentes” (Virgil, Aeneid).

9.

What is the connection between the gold standard and Adam Smith's RBD?

Could you please clarify the difference between the two for our readers? Which of the two would be more important to rehabilitate in the present monetary systm? Or, perhaps, it is too late already?

A.

Adam Smith's RBD can be re-stated by saying that it makes the bill market the clearing house of the gold standard.

The gold standard is not viable without a clearing house where bills of exchange representing various stages of production and distribution of semi-finished goods on the way to the ultimate gold-paying consumer are discounted and cleared. No rehabilitation of the gold standard is possible without prior rehabilitation of real bills. I don't think it is too late to rehabilitate the gold standard, provided that the RBD is rehabilitated first.

10. You once mentioned that the gold price is headed for extinction. Some day, perhaps fairly soon, no one will quote you an asked price for gold. No amount of irredeemable paper dollars will buy a gram of gold because no seller will part with it unless he can see it clearly how he could replenish his holdings. Could you elaborate on this?

A.

The gold futures markets routinely quote gold for delivery in the nearby future at prices at a premium to prices for delivery on the spot. The technical term for his condition of the market is *contango*, the exact opposite of *backwardation* under which spot gold sells at a premium price to future gold. The economic law behind this fact is specific to gold. It is fundamental for the understanding the dynamics of gold trading. It signifies the scarcity of spot gold relative to future gold. No one will ever sell gold spot without clearly seeing how he will be able to replenish his depleted inventory.

The spread between the price of gold futures for nearby delivery and the price for gold delivery on the spot is called the *gold basis*.

The gold basis is a fundamental indicator which is even more important than the gold price itself, because, unlike the latter, it is not falsifiable.

11. You were the first calling attention to the historic fact that that all gold future markets were inexorably marching towards permanent gold backwardation.

Why is permanent gold backwardation such an important, not to say frightening, event? Are you suggesting that this event, in and of itself, is more important than the fraudulent default of the U. S. Treasury in 1933 and again in 1971?

A.

Yes, I am suggesting exactly that. The issue is whether or not holders of the U.S. Treasury debt have a way to extricate themselves from their losing position and, if they can, to what extent. When the gold basis goes and stays negative, it will be an historic event of global significance, heralding the advent of permanent gold backwardation.

The advent of permanent gold backwardation is still in the future, and its inexorable coming bears watching.

I wish to note here that the basis for all agricultural commodities behave cyclically.

For example, the basis for wheat reaches its low (possibly negative) just before harvest. It indicates the shortage of wheat immediately deliverable. It reaches its maximum representing full carrying charge after the wheat harvest is brought in and put in storage. Thereafter the wheat basis declines as stores are brought down during the remainder of the crop-year.

The behaviour of the basis for agricultural commodities is in marked contrast with that of the gold basis, which is declining from its maximum that is equal to the full carrying charge signifying that virtually all above-ground gold is available for delivery. That situation obtained in 1971 when gold futures trading started on the Winnipeg Commodity Exchange in Canada. Thereafter the gold basis exhibited steady decline until 2000 when it has gone to zero for the first time ever. This was a watershed-event in economic history signifying the scraping of bottom of the gold barrel. All readily deliverable gold is gone.

Academia has completely ignored the saga of the gold basis. In particular, it failed to study the question whether the gold basis could go and stay negative, and if so, what the consequences would be.

As it turns out, since 2000 the gold basis has exibited a pattern of sporadically going negative. But so far it has always bounced back. Similar warning signals have also been flashing, such as the negative gold lease rate. Technically this is not yet permant gold backwardation, and it is a matter of debate how the situation will evolve from here on. Points that bear watching are: 1. The flight of gold from the Occident to the Orient, reversing the opposite trend that had prevailed for many a centuries previously. 2. The increasing scarcity of cash gold in the markets, especially in the approved warehouses of COMEX, and the persistent premium prices available to holders of mature gold futures contracts upon delivery which are bribe money as it were to persuade holders of gold certificates to desist from taking delivery.

12. Our last question concerns your project with Hugo Salinas Price to rejuvenate the Ferdinand Lips Institute here in Switzerland. Would you tell our readers what the objective of this effort is and what plans the Lips Institute has in strore? Also, how can we and the general public reach out and support the Ferdinand Lips Institute?

A.

The answer is my own. I do not speak for Mr. Salinas. I have established NASOE (New Austrian School of Economics) in my native Hungary in order to rehabilitate Carl Menger's ideas which I felt were badly neglected and distorted by the post-Mises Austrians. I also think that there is a great deal of unnecessary duplication in our work and that of the Ferdinand Lips Institute in Switzerland. By joining forces, the two institutions hope to make the great educational effort of enlightening people that the present international monetary system (called by the late Ferdinand Lips ” non-system”) is heading for a disaster, more efficient. The collapse of the dollar will inflict tremendous economic pain on a large number of innocent people. One of our goals is to minimize this economic pain as far as possible.

Research at the Lips Institute supports the establishment and the running of a hedge fund that beats the „Negative Interest Psychosis.” The brokerage firm that offers subscrfiptions such a hedge fund to investors based on our research is Equilor of Hungary. The general public can reach out and support the Ferdinand Lips Institute while, at the same time, helping themselves to financial survival and security by subscribing to that hedge fund of Equilor.

The hedge fund in question writes stock options on Royalty Companies that deal in gold and silver streams obtained in exchange for their financing of capital expenditures of gold and silver mining concerns. Note that in doing so the hedge fund is in effect facilitating the exchange of income for wealth and the exchange of wealth for income that were put beyond the pale in 1933 by the U.S. in defaulting on its gold bonds as mentioned earlier.

This business model is called **Option Writing on Gold and Silver Streamers (OWOGASS)**. It frustrates the hare-brained ZIRP ( Zero Interest-Rate Policy) and the insane NIRP (Negative Interest-Rate Policy) of the Federal Reserve supported by a chorus of pusillanimous `economists`.

It does this by earning a return on capital invested consistently at double-digit rates.

---

*July 13, 2015.*

---

# Octandor: The Spontaneous Remonetization of Gold and the Revival of Vanishing World Trade

URL: https://newaustrianeconomics.com/archive/fekete/octandor/
Date: 2015-07-31
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, real-bills, monetary-crisis, new-austrian-economics
Description: Fekete coins the term 'Octandor' for a proposed eight-country gold arrangement that would spontaneously remonetize gold through bilateral trade settlement. Countries with physical gold reserves could begin settling trade in gold, bypassing the dollar system and creating a nucleus of sound monetary practice that others would join as the dollar system deteriorates.
Editorial Note: Written July 2015 as a companion to the spontaneous remonetization essay. The Octandor concept is Fekete's most specific late-career institutional proposal — a practical mechanism for gold remonetization outside official channels.
Original PDF: https://professorfekete.com/articles/AEFOctandor.pdf

## Octandor

**OCTANDOR — THE SPONTANEOUS REMONETIZATION OF GOLD AND THE REVIVAL OF VANISHING WORLD TRADE**

An address by **Antal E. Fekete**, delivered at the Joint Conference of the New Austrian School of Economics and the Ferdinand Lips Institute, **July 17–19, 2015**, **Vienna, Austria**.

### Summary

In the words of the Old Testament “the use of false weights and measures is the greatest abomination in the eyes of the Lord”. (King James Version, Wycliffe translation, Proverbs, XX:10.) The Great Coin Melt of 1933 by Franklin D. Roosevelt certainly answers the description “greatest abomination”.

He confiscated the gold coins of the American people; he melted them down and wrote up the value of the proceeds. He pretended to have compensated people for their stolen gold by giving them Federal Reserve notes in exchange. The historical record shows that these notes have, by 1971, in hardly more than a generation, lost 90 percent of their purchasing power.

Then, to crown a great job done, Roosevelt by Executive Order closed the U.S. Mint to gold in order to prevent succeeding generations from undoing the damage.

They were condemned never to be able to recover their honest weights and measures: Along with their gold coins of the realm they have also been deprived of their Mint where new ones could have been struck.

The question that arises from all this is as follows: has Roosevelt succeeded in mesmerizing all people of the world, present, past and future in making them believe that the broken promises of the U.S. government can be used as a true measure of value? – With unlimited debt-extinguishing power to boot, in order to match that of the gold coins? Shall the remonetization of gold really be impossible forever and ever? – as the Amen choruses of Keynesians and Friedmanites shout from their rooftops? – Or, perhaps, after all, the human race is not condemned to worshipping the ‘paper calf’ of irredeemable currency in perpetuity, since the shock of the Great Coin Melt, has cured it of the disease called by Virgil in the *Aeneid* *Auri sacra fames* (the accursed hunger for gold) — as imputed by Keynes.

Relief is coming from the free market in the form of a substitute in the form of a universally acceptable means of payments the stock of which no central bank but the people themselves directly regulates – as indeed ordained by the U.S. Constitution.

Now, for the first time, we are getting the answers to these questions. Like it or not, we see that the stupidity of the monetary scientists (so-called) of the 20th century yields to the enlightenment of the free market of the 21st. Profit-seeking business has come up with a synthetic substitute for the metamorphosis of gold. Roosevelt’s closing of the U.S. Mint is getting overruled. A new metamorphosis is in the making. It consists in converting twenty-five kinebars into one octandor, the new universally acceptable unit of value (see the Glossary below), the stock of which is regulated directly by the people themselves rather than an unconstitutionally established central bank.

### Introduction

Falling prices and vanishing world trade in the wake of devastating currency wars with no winners but with lots of losers are a clear indication of our deflation morphing into a depression. The international monetary system based on the irredeemable dollar is in its death-throes. What kind of monetary regime will follow it? The foolhardy insists that whatever it will be, under no circumstances will it be the gold standard. “You cannot put spent toothpaste back into the tube!” You must not resurrect the extinct barbarous relic!” What kind of currency will the ‘wave of the future’ bring? Why, it will bring the defaulting banker’s dishonored promises, naturally. Similar propaganda was spread in past centuries every time an influential banker defaulted on his promises to pay. It is true that the latest episode in the saga of turning the lowest kind of money (namely, fraudulent promises) into the highest (namely, high-powered central bank credit) has been the longest. But it does not follow that ‘this time it’s different’.

The exiled sovereign, gold, is being reinstated on its throne before our very eyes through re-inventing Carl Menger’s “most marketable good” through spontaneous market processes — never mind the wishes of the government. Profit-seeking business is also reinventing Adam Smith’s real bill maturing into the unit of value of the realm.

### The resurrection of the real bill

What is more important still, circulation of real bills subject to discount turns gold into an earning asset. Once again, gold is able to return an income in gold through the mechanism of discounting – exactly as it has been the case before World War I.

To understand the significance of this development we have to go back and retrace history to see how the gold standard was sabotaged after hostilities ended in November, 1918.

The victorious Entente Powers had to lift their blockade of Germany pursuant to the Armistice agreement.

In their wisdom, policymakers decided to block the circulation of the gold bills financing Germany’s foreign trade. They thought it was a smart move to replace the blockade with the blocking of the bill market. They failed to see that this was tantamount to castrating the international gold standard by removing its clearing house, the London bill market. The policy-makers wanted to blunt the efficiency of German industry, even at the cost of forcing inefficient bilateral trade ( alias barter) on the world replacing the much more efficient multilateral trade under the international gold standard.

The measure boomeranged. The destruction of the London bill market also meant the destruction of the Wage Fund out of which the wages of workers producing merchandise were paid, up to 91 days before the merchandise was paid for in cash by the consumers themselves. There was a hiatus of 91 days in paying the wage-bill. There was no one to advance the funds. Workers had to be laid off. The result was a hideous world-wide unemployment. Policy-makers who were responsible for the disaster in the first place were quick to blame it on the whipping boy, the ‘contractionist’ gold standard.

But truth must ultimately be told. The unprecedented unemployment was not a failure of the gold standard. On the contrary, it was the consequence of blocking the circulation of gold bills by the victorious Entente powers. It was the direct consequence of their malicious trade policy wanting to cripple Germany’s foreign trade after lifting the wartime blockade, by other means.

Now, for the first time since November, 1918, gold bills are getting ready to circulate once more, whether the British and the U.S. government, the chief culprits of sabotaging the gold standard like it or not.

This will change the nature of gold hoarding. People will scramble to exchange their gold bullion for gold bills. They want to take the opportunity to earn an income in gold by reinvesting the proceeds from maturing gold bills into fresh gold bills.

Earning an income in gold is vastly different from earning an income in irredeemable dollars. Hoarding dollars has by now lost all its roots in logic. If the dollar were able to retain its value as long as the depreciation cycle was completed, it did make sense to build dollar reserves for the purpose of replacing physical capital after its value was eroded through natural wear and tear. But the point where the dollar could no longer do this is long since past. As a result of deliberate debasement the dollar is losing its value so fast that less is left after the completion of the depreciation cycle than what is needed to defray the cost of buying new capital goods. The acceleration has by now reached the level that the dollar is useless for the purpose of serving as catalyst to replace capital eroding through wear and tear. You might as well save in a substance that evaporates before you can catch enough of it.

As people switch from hoarding gold to generating a gold income a point must be reached where as much gold is released from hoards as it takes to finance the production and distribution of foodstuff in most urgent demand. Anything less means world-famine in the midst of plenty (echoing the famine during the Great Depression of the 1930’s).

Thus, then, gold bills will take over the financing of trade in a world increasingly reluctant to accept the irredeemable dollar (or, for that matter, any other irredeemable currency) in exchange for real goods and real services.

The solution for the problem of replacing the dishonored dollar as a reserve currency lies not in the inventing of yet another esperanto currency, be it called euro, asio, africo, amero or australo. The solution lies in reinventing Adam Smith’s real bill that has served the world well for many a century. I shall now explain this transition that is destined to save the world from famine − and civilization from turning itself into barbarism.

### Glossary

Kinebar is the name of a 5-gram, 9999 fine gold wafer produced and stamped by the State Mint of Austria with a serial number. The obverse of the kinebar is stamped with a hologram depicting a rider of the Spanish Riding School of Vienna in action. The movements of horse and rider explain how the kinebar earns its name. The production of kinebars was suspended in 2014. Equivalent 5-gram 9999 fine gold wafers continue to be manufactured by the Austrian State Mint. We shall refer to these wafers in the sequel as “kinebars”.

**Octandor** (rhymes with ‘octane door’) is the name of a composite gold bar, resembling a bar of chocolate, made up of twenty-five kinebars. The total weight of an octandor is 125 grams or slightly over 4 Troy ounces. This makes it equally marketable in Europe and America. ‘Octandor’ is an abbreviation for “one eighth of one kilogram of gold”. This explains how the octandor earns its name. Octandors can be exchanged at the rate of one hundred to one for international good delivery gold bars weighing 400 ounces or 12½ kilograms (more or less).

Octandors are designed to compete with gold coins. They are 9999 fine, as compared with the gold coin’s usual fineness of only 8350. Moreover, gold coins fail to be divisible. At any rate, if broken up into smaller pieces, a gold coin ceases to be negotiable − except after costly assaying. By contrast, octandors enjoy divisibility into kinebars without any loss of value. What is more, they can be individually identified through serial numbers with which the component kinebars are stamped − which gold coins can’t. Thus octandors, unlike gold coins, are suitable for purposes of making allocated deposits at depository institutions.

To recapitulate, octandors represent a significant improvement in marketability over that of traditional gold coins.

Matador is the name of a firm whose business is the manufacture of octandors. In more details, the process involves sandwiching kinebars between two transparent plexi-glass covers. Matador imparts added value to kinebars through metamorphosis, as it were. In putting the component kinebars together, Matador creates a gold bar, the octandor, possessing increased marketability, equally recognizable in Europe and in America. (This is a consequence of the incidental fact that 125 grams is only slightly greater than 4 Troy ounces.)

Bancor is the name of a firm whose business is to act as a market-maker for octandor bars as well as for bills of exchange (called octandor bills) maturing into octandor bars in 91 days, the estimated time it takes to manufacture and distribute octandor bars (including delays due to congestion at Matador).

In more details, Bancor posts its asked and bid prices at which it is prepared to sell and buy octandors, as well as octandor bills, in unlimited quantities.

Curaçao is a small island country belonging to the Kingdom of the Netherlands in the Caribbean (located just north of the Venezuelan coast; its capital city: Willemstad).

It has virtually unrestricted sovereignty. Its self-governance is more complete than that of the similar small island colonies of the U.K. such as Gibraltar, Bermuda or the Cayman Islands.

Curaçao has recently attracted international limelight after it introduced a new tax code for internet companies registered in its territory, and for e-commerce initiated by them. They are taxed at the flat rate of 2 percent. Both Matador and Bancor are internet companies registered and taxed in Curaçao. They finance e-commerce by raising credit in octandor bills that mature in octandors.

---

### The metamorphosis of gold

The metamorphosis of the kinebar into the more marketable octandor at the hands of Matador is akin to that occurring at the Mint as the blank ingot is being stamped and turned into the coin of the realm, of greater marketability than that of the blank ingot. Economists have neglected to study the ability of the Mint to impart marketability to the blank ingot higher than justified by its melt-down value (the value it enjoyed before being stamped). The word ‘metamorphosis’ aptly describes this almost miraculous transition. As a result of this neglect F.D.R. and other policy-makers deprived the world of a great resource, the gold standard and the metamorphosis of gold it makes possible. One hundred years ago, they had to decide how to finance World War I. The choice was: either to finance it through the metamorphosis of gold at the minting press, or the metamorphosis of paper at the printing press.

To the world’s great misfortune they chose the latter. Had they chosen the former, the conflict could have been resolved much earlier, saving life and treasure, changing the course of history in the process. But they were mesmerized by the miracle of the metamorphosis of paper and they were only too happy to sacrifice the gold standard.

One could put the similarity between the Mint and Matador into high relief by suggesting that both are in the business of manufacturing the measuring rod of value. The difference is that while the Mint is a government agency and its stamp constitutes an official guarantee of weight and fineness, Matador is a private firm and the manufacture of octandors need imply no such guarantee. (The increase in value is “in the eyes of the beholder”. Happy are those who have eyes to see.) It is next to impossible to exaggerate the importance of the rediscovery of the metamorphosis of gold. For the first time ever, the government Mint is rendered superfluous. No longer is it a sine qua non for the metamorphosis of gold. The same effect can be produced by profit-seeking private enterprise, while still benefiting people at large. Consider two cases.

1. **Suppose** Bancor receives an order from a third party wanting to buy x octandors. Bancor buys 25 x kinebars at the asked price of the Austrian State Mint or at the open market asked price, whichever is smaller, and delivers them to Matador while drawing a bill with face value of x octandors on the latter. That there may be a problem with completing this transaction may become clear when considering the size of *x*. If it is of routine size, no further consequences need to be considered. But if it is of extraordinary size, then Bancor is put on alert. Next time it may not accept the same discount rate but will push for an increase. It wants to protect its flanks against the contingency that the asked price for kinebars in irredeemable currency is going up.

2. Conversely, suppose Bancor receives an order from a third party wanting to sell *x* ´ octandor bills at the market. Bancor makes the sale at its posted bid price and will replace the octandors spent by buying octandor bills. If this turns out to be difficult, then Bancor will lower its bid price for octandor bills.

Note that the bills Bancor just acquired mature into octandors in 91 days’ time.

The asked price quoted in octandor bill units includes a mark-up representing the profit margin of Bancor, equivalent to seigniorage imposed by monarchs of a bygone era. They earned it by allowing their effigy to be stamped on the gold coins.

### Why the closing of the Mint to gold was a world-class disaster.

But why should anyone be willing to pay a mark-up in buying an octandor bill?

Well, for the same reason third-party buyers were willing to pay a mark-up for real bills as predicted by Adam Smith’s Real Bills Doctrine. They wanted to capture a gold income on funds that otherwise would lay idle.

The Mint was formally closed to gold in 1931 when Britain, followed by the U.S. in 1933, defaulted on their gold obligations. While the default caused some indignation at the time, the closing of the Mint was hardly newsworthy. Yet the event destroyed an all-important Constitutional right of the people, as I will now show.

### Trying to legislate for the ‘benefit’ of all future generations by trampling on the Constitution

I have dwelt on the metamorphosis of gold at some length because we are witnessing a historically unprecedented phenomenon: the ingenuity of private enterprise making government certification of weight and fineness of gold superfluous. Up to now it was thought that the opening of the Mint to gold within a sovereign jurisdiction was a necessary condition for the monetization of gold.

Without this condition being satisfied there was no guaranteed future conversion of gold bullion into gold coins. In more detail, the gold coin of the realm could go to a premium relative to gold bullion. Governments could limit the quantity of the coin of the realm in existence by closing the Mint to gold. This would make the coin of the realm scarce, hurting all businessmen who have outstanding contracts payable in these coins. Naturally, they would be reluctant to accede to contracts the monetary value of which was not properly fixed therein.

Thus, then, we can see why the closing of the Mint to gold was far more than a mere ‘house-keeping change’ as pretended by historians. If the U.S. government could close the Mint to gold, then it could also change the unit of value unilaterally, by keeping the Mint closed. Incidentally, this was the very reason why the Founding Fathers insisted that the U.S. Constitution mandate the opening of the U.S. Mint to minting silver and gold free of seigniorage charges.1 The closing of the Mint is an example of a misguided attempt “trying to legislate for the benefit of all future generations by trampling on the Constitution”. At any rate, this is how mainstream economists would rationalize the unconstitutional measure of closing the Mint.

According to this plan the financing of the production of the silver and gold coins of the realm was to be taken care of through laying taxes on the pattern of financing highway construction, with the same justification.

### Throwing souvenir gold coins into the eyes of the people

Please do not let yourself be misled by the red herring of minting souvenir gold pieces in limited numbers on Treasury account. Minting gold coins on Treasury account is as different from minting them on private accounts as night is different from day. When the U.S. Treasury started minting souvenir gold coins in the last decades of the 20th century, it did so in order to throw dust into the eyes of the public. “See? We have reopened the Mint to gold and nothing happened. Certainly the new coins failed to go into circulation! Here is your proof, if proof is needed, that gold is finished as money for good! Nothing can replace the dollar as money that can circulate hand-to-hand!”

### Divisibility and Restorability

In addition to divisibility the octandor also has the property of restorability.

Suppose we break off a kinebar from it. Later we can restore the integrity of the octandor by replacing the missing piece at no extra cost.

### Haircut, 1935-style

Yet minting gold coins on private account remains a matter of Constitutional rights. Only an amendment to the U.S. Constitution could take that right away; presidential proclamations and acts of the Congress could not. That right still exists today as it existed before 1933. The fact that it has been usurped by the U.S. Treasury for the past 82 years has no legal effect.

It has turned out that the ingenuity of private enterprise could outsmart the U.S. Treasury. The opening of the Mint to gold is no longer a sine qua non for turning gold bullion into the gold coin of the realm (i.e., for remonetizing gold). Bancor could perform the metamorphosis of gold without government license, simply by ordering a consignment of octandors from Matador to be manufactured for its own account.

Why is this important? Well, we have to go back to the Great Coin Melt of 1933 for an answer. The first proclamation of Franklin D. Roosevelt after his inauguration on March 4, 1933, as president of the United States was the closing of the U.S. Mint to the free and unlimited coinage of gold − along with the arbitrary closing of banks under the jurisdiction of the U.S. government. The circulating gold coins of the U.S. were summarily confiscated and melted down. Irredeemable Federal Reserve notes were paid out in compensation.

Pretense was maintained that this was a just and full compensation. It wasn’t, justification for the highway robbery offered two years later notwithstanding.

According to the decision of the U.S. Supreme Court, handed down in 1935, “the domestic debt-discharging power of the Federal Reserve notes was not abridged”.

Well, if it wasn’t, that was due to the unconstitutional decision of the same High Court in upholding legal tender laws to protect the value of the irredeemable Federal Reserve notes. Absent that decision, the domestic value of the Federal Reserve notes would have suffered the same fate as their international value did: It would have undergone a ‘haircut’ to the tune of some 56%. (The clever simile of a haircut, designed to mitigate the harsher language of “highway robbery”, had not yet gained currency in 1935.)

Here we see the reason why establishment economists hate the Constitutional gold coin with exceptional vehemence: In contrast with government promises, they cannot be subjected to arbitrary haircuts.

The U.S. Supreme Court was derelict in its duties when it handed down its decision that allowed legislation granting legal tender protection to F. R. notes to stand.

### Due processes of lawlessness

This was just the first of a series of several episodes in which the Supreme Court of the United States of America stooped to the level of a kangaroo-court. No greater lie was ever spread than that suggesting that “property has never been taken from an American citizen except in consequence of due processes of law”. The fact remains that in 1935 the High Court took the property of American citizens held in the form of gold certificates issued by the U.S. Treasury. If “due processes of law” means anything, it must mean that each case must be adjudicated separately, on its own merit. The Supreme Court’s handing down a single decision to the effect that in all cases where a citizen is found in possession of a gold certificate the Constitution is automatically suspended, is a shameless instance of exceeding the powers granted to the judiciary branch!

### Pyrrhic victory

Curiously, the High Court did say that the federal government had no power to alter its contracts unilaterally. In doing so it apparently did try to protect the property rights of those Americans who owned bonds with a gold-clause protection issued by the U.S. Treasury. Seigniorage was increased from 0% to 100% by a stroke of the pen. Apart from a few Constitutional experts and monetary scientists, no one recognized the chicanery involved. By now this shameful episode of retroactive legislation and rights-mutilation is conveniently forgotten through the rewriting of history.

### Global irredeemable currency

The international implications of the usurpation of Constitutional rights were even more ominous. Prior to 1933, all attempts to introduce irredeemable currency on a global scale failed ignominiously everywhere. Countries that resisted the trend and stayed on the gold standard were able to help their weaker brethren to return to monetary rectitude. But after 1933 all countries, including France and Switzerland to mention but two examples, were forced to follow the American lead. In 1936 the French and Swiss franc were also devalued in terms of gold. For all intents and purposes they have also become an irredeemable currency and the international monetary system was converted into a club of countries inflicting the curse of irredeemable currency on their citizens and trading partners. Redeemable currencies have been wiped off the face of earth. The fast-breeding of debt could now start in earnest, with unforeseeable catastrophic consequences.

### He laughs who laughs last

This was the end of honest dealings between the government and its subjects and, hence, the end of honest dealings between private individuals. Honest weights and measures were effectively outlawed. According to the Old Testament such abuse of government power “was the greatest abomination in the eyes of the Lord”. Having closed their Mint to gold, governments thought they could keep them closed as long as they wanted (that is to say, forever). In this way they could prevent future generations from returning to a system of honest weights and measures by reopening the Mint to gold.

However, as the saying goes, he laughs who laughs last. Governments have left the ingenuity of private enterprise out of calculation. Here is how government dishonesty is rendered ineffective by the ingenuity of private enterprise. Bancor (the drawer) delivers 25 kinebars while drawing an octandor bill on Matador (the acceptor). The octandor bill, duly accepted (endorsed), is returned to the drawer.

Having two good signatures (those of the drawer and the acceptor), the octandor bill is enabled to circulate through endorsement and discounting. The discount is proportional to the number of days remaining till maturity. The proportionality factor is the gold discount rate. It depends on the supply of and demand for octandor bills. The octandor bill is a gold device uniquely capable of yielding a return on gold in gold, the gold discount rate marking the yield. As the demand for octandor bills is virtually unlimited, the discount rate is positive. The amount of newly mined gold going into hiding is no longer 100% as it was under Z.I.R.P.

Octandor bills have no competition. Nor could such a competition arise after 1931 and 1933 when the gold standard fell victim to British-American sabotage. We are, here and now, witnessing the remonetization of gold by market forces − apparently against the wishes of the governments of the U.K. and the U.S. that have never lived down the ignominy of defaulting on their gold obligations over eighty-two years ago.

### The “Wave of Future”

Once octandor bills arise through the manufacture of octandors, they go into spontaneous circulation. There is unlimited international demand for them as the following example of financing world trade demonstrates. Assume that Saudi Arabia wants to buy wheat to be delivered in 91 days. Russia will have the wheat by then and is well able to fill the order. The trouble is that Russia is not interested in payment in irredeemable dollars. “Once discredited, always discredited!” Russia insists on getting paid in gold or in gold devices. Saudi Arabia, if it wants wheat badly enough, has to go into the bill market to buy gold bills maturing in 91 days.

Alternatively it can use gold from its foreign exchange reserves to pay for the purchase of octandor bills.

Naturally, Saudi Arabia will not pay the face value of the gold bill. As a result of a bargain with Bancor, Saudi Arabia will buy octandor bills at a discount. Russia is glad to accept octandor bills from Saudi Arabia in exchange for wheat futures contracts. They mature into octandors in 91 days’ time, while the alternative, dollar credits will remain as irredeemable as a doornail even after 91 days.

This example shows how the circulation of octandor bills is capable of revitalizing vanishing world trade in a world increasingly reluctant to accept irredeemable dollars (or any other irredeemable currency subject to unlimited augmentation, a.k.a. Q.E. in exchange for real goods and real services such as wheat or crude oil, and the wages of workers who are working in constructing pipelines.

Note that gold is indispensable for the reviving and revitalizing vanishing world trade. This also means that the rehabilitation of the bill market through the circulation of gold devices such as octandor bills will eliminate the threat of unemployment, as far as employment of those eager to work for wages is concerned.

The gold discount rate, unlike the rate of interest can be serially halved any number of times without any untoward consequences for the national economy. In this way the capital requirement for businesses that move merchandise from producers to the ultimate consumer will be reduced.

Therefore the solution to the problem of replacing dishonored and discredited dollar lies, not in inventing yet another irredeemable currency. It lies in putting gold bills maturing in 91 days into circulation. These bills represent the “wave of future”. They are the best earning assets commercial banks can have. They are the best monetary reserve to hold against a maturing bond issue, or against a real estate deal to be closed out in the future, or against just any contingency monetary liability, such as the import bill in case of an unexpected earthquake, flood or tsunami. Far better than the irredeemable debt of a default-happy government which, to boot, is also the greatest debtor on record, with its debt increasing at an alarming rate, with no visible sources from which to reduce its debt ever.

Notice further that the octandor bill is the perfect antidote against deflation. If there are not enough of them in circulation, then their asked price will rise and the gold discount rate will have a tendency to fall. The incentive for exchanging gold for octandor bills will be high. But the octandor bill is also the perfect antidote against inflation. If there are too many of them in circulation, then their bid price will fall and the gold discount rate will have a tendency to rise. The incentive for exchanging gold for octandor bills will be low.

Central banks will be put under pressure to compete with octandor bills when it comes to financing trade in merchandise commanding the highest consumer demand. Bank notes redeemable only in unpaid and unpayable debt have no chance facing competition from devices maturing into gold.

Nor will they have a chance to compete against devices maturing into gold when it comes to serving as reserve in the Wage Fund. Irredeemable currency will fall by the wayside, by virtue of the sheer logic that creditors need meaningful collateral, rather than relics from distant past (such as the pound sterling and the dollar.) when upright countries used to have redeemable currencies. If central banks want to survive, then the credit they issue must be based on short-maturity real bills payable in gold at maturity – exactly as they did prior to 1914. The argument that no such bills presently exist is no longer valid. They do exist, for example, the octandor bills. We can take it for granted that there will be no shortage of imitators once the concept is understood by the general public.

Incidentally, this brings out the tragic failure of economists through the whole spectrum from Keynesians on the left, through Friedmanites in the middle and post-Mises Austrians on the right, who all failed to distinguish between the rate of interest as it is regulated by the propensity to save and the discount rate as it is regulated by the propensity to consume.

### Conclusion

It used to be axiomatic that the remonetization of gold could only come about through the decision of a sovereign jurisdiction to open the Mint to the unlimited coinage of gold on private account free of seigniorage charges. This meant granting private individuals and firms the right to bring gold bullion to the Mint in unlimited quantities and exchange it for freshly minted gold coins of the realm ounce for ounce.

This has now changed. There is a new, synthetic way of remonetizing gold that needs no government Mint, nor government and legislation asserting individual rights.

Here is how the synthetic way of gold remonetization works. Individuals or firms that have gold bullion to sell can offer it to Bancor for sale against octandors or octandor bills. Bancor stands ready to buy unlimited quantities at its posted bid price. As it does, the gold bullion so sold, has been remonetized.

I have studied the question of gold remonetization in all its pertinent details in partnership with my mentor the late Ferdinand Lips. I stake my professional reputation on the thesis that profit-seeking private enterprise will find a way to remonetize gold, thus coaxing gold that had gone into hiding during the long inept campaign of the U.S. government to drive the rate of interest to zero.

---

*July 31, 2015.*

---

# The Spontaneous Remonetization of Gold and the Revival of Moribund World Trade

URL: https://newaustrianeconomics.com/archive/fekete/the-spontaneous-remonetization-of-gold/
Date: 2015-04-10
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, gold-basis, backwardation, sound-money, monetary-crisis
Description: Fekete argues that gold's remonetization is already happening spontaneously — not through official policy but through the accumulation of physical gold by central banks (especially China and Russia) and private individuals who have lost confidence in paper money. This spontaneous process will eventually overwhelm the suppression campaign and restore gold to its monetary role organically.
Editorial Note: Written April 2015. Fekete's concept of spontaneous remonetization — gold resuming its monetary role through market forces rather than official reform — represents a more organic path to monetary restoration than his earlier reform proposals.
Original PDF: https://professorfekete.com/articles/AEFSpontaneousRemonetizationOfGold.pdf

### New Austrian School of Economics

### And the Lips Institute

### Summary

In the words of the Old Testament “the use of false weights and measures is the greatest abomination in the eyes of the Lord”. The Great Coin Melt of 1933 by Franklin D. Roosevelt certainly answers the description “greatest abomination”. He confiscated the gold coins of the American people; he melted them down and wrote up the value of the proceeds. He pretended to have compensated people for their stolen gold by giving them Federal Reserve notes in exchange. These notes have, in hardly more than a generation, lost 90 percent of their purchasing power.

Then, to crown a great job done, he closed the U.S. Mint to gold in order to prevent succeeding generations from undoing the damage. They were condemned never to be able to recover their honest weights and measures. Along with their gold coins of the realm they have also been deprived of their Mint where new ones could have been coined.

The question is this: has Roosevelt succeeded in mesmerizing all people in making them believe that broken government promises can be used as a true measure of value? Will the remonetization of gold really be impossible forever and ever? –as Kenesians andFriedmanites shout from the rooftop? Perhaps, human race is not after all perpetually condemned to worshipping the ‘paper calf’ of irredeemable currency after the Great Coin Melt. Relief is coming in the form of the market producing a substitute in the form of a universally acceptable means of payments the stock of which no central bank but the people themselves directlyregulates – as ordained by the U.S. Constituion.

Now, for the first time, we are getting the answers these questions. Like it or not, we see that the stupidity of the 20th century yields to the enlightenment of the 21st.

Profit-seeking business has come up with a synthetic substitute for the metamorphosis of gold. Roosevelt’s closing of the U.S. Mint is getting neutralized. A new metamorphosis is in the making. It consists in converting twenty-five kinebars into one octandor, the new universally acceptable unit of value (see the Glossary below), the stock of which is regulated by the people rather than an unconstitutional central bank.

### Introduction

Falling prices and vanishing world trade in the wake of devastating currency wars with no winners but with lots of losers are a clear indication of deflation morphing into depression. The international monetary system based on the irredeemable dollar is in its death-throes. What kind of monetary regime will follow it? The foolhardy insists that whatever it will be, under no circumstances will it be the gold standard. “You cannot put spent toothpaste back into the tube!” What kind of currency will the ‘wave of the future’ bring? Why, it will bring the defaulting banker’s dishonored promises, naturally. Similar propaganda was spread in the past every time an influential banker defaulted on his promises to pay. It is true that the latest episode in the saga of turning the lowest kind of money (namely, fraudulent promises) into the highest (namely, high-powered central bank credit) has been the longest. But it does not follow that ‘this time it’s different’.

The exiled sovereign, gold, is being reinstated on his throne in front of our own eyes through spontaneous market processes – never mind the wishes of the government. Profit-seeking business has reinvented Adam Smith’s real bill maturing into gold.

### How is that possible?

Here is how. World trade in foodstuff is coming to a halt, too. As soon as the fear of world-wide famine takes hold and no food is obtainable except in exchange for gold, bills drawn on foodstuff payable in gold in 91 days (91 days being the length of the food-growing seasons in the world’s temperate zones) will replace the dollar. Inevitably, bills maturing into gold will become money. The point is that people refuse to starve themselves to death for the greater glory of the unconstitutional and irredeemable dollar.−a dishonored promise to paybearer gold on demand.

### The resurrection of the real bill

What is more important, circulation of real bills subject to discount turns gold into an earning asset. Once again, gold is able to return an income in gold through the mechanism of discounting – exactly as it has been the case before World War I. To understand the significance of this development we have to go back and retrace history to see how the gold standard was sabotaged after hostilities ended in November, 1918.

The victorious Entente Powers had to lift their blockade of Germany pursuant to the Armistice agreement.

In their wisdom, policymakers decided to block the circulation of the gold bills financing Germany’s foreign trade. They thought it was smart move to replace the blockade with the blocking of the bill market They failed to see that this was tantamount to castrating the international gold standard by removing its clearing house, the London bill market. Policy-makers wanted to blunt the efficiency of German industry, even at the cost of forcing inefficient bilateral trade (alias barter) on the world replacing the much more efficient multilateral trade under the international gold standard.

The measure boomeranged. The destruction of the London bill market also meant the destruction of the Wage Fund out of which the wages of workers producing merchandise were paid, up to 91 days before the merchandise was paid for in cash by the consumers themselves. There was a hiatus of 91 days in paying the wagebill. There was no one to advance the funds. Workers had to be laid off. The result was a hideous world-wide unemployment. Policy-makers who were responsible for the disaster in the first place were quick to blame it on the whipping boy, the ‘contractionist’ gold standard.

But truth must ultimately be told. The unprecendented unemployment was not a failure of the gold standard. On the contrary, it was the consequence of blocking the circulation of gold bills by the victorious Entente powers. It was the direct consequence of their malicious trade policy wanting to cripple Germany’s foreign trade after lifting the wartime blockade, by other means.

Now, for the first time since November, 1918, gold bills are getting ready to circulate once more, whether the British and the U.S. government, the chief culprits of sabotaging the gold standard like it or not.

This is changing the nature of gold hoarding. People will soon scramble to exchange their gold bullion for gold bills. They want to take the opportunity to earn an income in gold by reinvesting the proceeds from maturing gold bills into fresh gold bills.

Earning an income in gold is vastly different from earning an income in irredeemable dollars. Hoarding dollars has by now lost all its roots in logic. As long as the dollar was able to retain its value until the depreciation cycle was complete, it did make sense to build dollar reserves for the purpose of replacing physical capital after it was eroded through natural wear and tear. But the point where the dollar could no longer do this is long since past. As a result of deliberate debasement the dollar is losing its value so fast that less is left after the completion of, the depreciation completed than needed to defray the cost of buying new capital goods. The acceleration has by now reached the level that the dollar is useless for the purpose of replacing capital eroding through wear and tear. You might as well save in a substance that evaporates by the time you can catch enough of it.

As people switch from gold hoarding gold to generating a gold income a point must be reached where as much gold is released from hoards as it takes to finance the production and distribution of foodstuff in most urgent demand. Anything less means world-famine in the midst of plenty (echoing the famine during the Great Depression of the 1930’s)

Thus, then, gold bills will take over the financing of trade in a world increasingly reluctant to accept the irredeemable dollar (or, for that matter, any other irredeemable currency) in exchange for real goods and real services.

The solution for the problem of replacing the dishonored dollar as a reserve currency lies not in the inventing of yet another esperanto currency, be it called euro, asio, africo, amero or australo. The solution lies in reinventing Adam Smith’s real bill that has served the world well for many a century. We now explain this transition that is destined to save the world from famine − and civilization from turning itself into barbarism.

### Glossary

Kinebar is the name of a 5-gram, 9999 fine gold bar produced and stamped by the State Mint of Austria with a serial number. The obverse of the kinebar is stamped with a hologram depicting a rider of the Spanish Riding School of Vienna in action. The movements of horse and rider explain how the kinebar earns its name.

Octandor (rhymes with ‘octane door’) is the name of a composite gold bar, resembling a bar of chocolate, made up of twenty-five kinebars. The total weight of an octandor is 125 grams or slightly over 4 Troy ounces. This makes it equally marketable in Europe and America. ‘Octandor’ is abridgement for “one eighth of one kilogram of gold”. Octandors can be exchanged at the rate of one hundred to one for international good delivery gold bars weighing 400 ounces or 12½ kilograms (more or less).

Octandors are designed to compete with gold coins. They have fineness 9999, as compared with the gold coin’s usual fineness of only 8350. Moreover, gold coins fail to be divisible. At any rate, if broken up into smaller pieces, a gold coin ceases to be negotiable − except after costly assaying. By contrast, octandors enjoy divisibility into kinebars without any loss of value. What is more, they can be individually identified through serial numbers with which the component kinebars are stamped − which gold coins can’t be. Thus octandors, unlike gold coins, are suitable for purposes of making allocated deposits at depository institutions.

To recapitulate, octandors represent a significant improvement in marketability over that of the traditional gold coin.

Matador is the name of a firm whose business is the manufacture of octandors. In more details, the process involves sandwiching kinebars between two transparent flexible plastic cover sheets. Matador imparts added value to kinebars through metamorphosis, as it were. In putting the component kinebars together, Matador creates a gold bar, the octandor, possessing increased marketability, equally recognizable in Europe and in America. (This is a consequence of the incidental fact that 125 grams is slightly greater than 4 Troy ounces.)

Bancor is the name of a firm whose business is to act as a market-maker for octandor bars as well as for bills of exchange (called octandor bills) maturing into octandor bars in 91 days, the estimated time it takes to manufacture and distribute octandor bars (including delays due to congestion at Matador).

In more details, Bancor posts its asked and bid prices at which it is prepared to sell and buy octandors, as well as octandor bills, in unlimited quantities.

Curaçao is a small island country belonging to the Kingdom of Netherland in the Caribbean (located just north of the Venezuelan coast; capital city: Willemstad). It has virtually unrestricted sovereignty. Its self-governance is more complete than that of the similar small island colonies of the U.K. such as Gibraltar, Bermuda or the Cayman Islands.

Curaçao has recently attracted international limelight after it introduced a new tax code for internet companies registered in its territory, and for e-commerce initiated by them. They are taxed at the flat rate of 2 percent. Both Matador and Bancor are internet companies registered and taxed in Curaçao. They finance e-commerce by raising credit in octandor bills.that mature in octandors.


---


### The metamorphosis of gold

The metamorphosis of the kinebar into the more marketable octandor at the hands of Mondor is akin to that occurring at the Mint as the blank ingot is stamped and turned into the coin of the realm, of greater marketability than that of the blank ingot. Economists have neglected to study the ability of the Mint to impart marketability to the blank ingot higher than justified by its melt-down value (the value it enjoyed before being stamped). The word ‘metamorphosis’ aptly describes this almost miraculous transition. As a result of this neglect . F.D.R. and other policy-makers deprived the world of a great resource, the gold standard and the metamorphosis of gold it makes possible. One hundred years ago, they had to decide how to finance World War I. The choice was: either to finance it through the metamorphosis of gold at the minting press, or the metamorphosis of paper at the printing press.

To the world’s great misfortune they chose the latter. Had they chosen the former, the conflict could have been resolved much earlier, saving life and treasure. But they were mesmerized by miracle of the metamorphosis of paper and they were happy to sacrifice the gold standard.

One could put the similarity between the Mint and Matador into high relief by suggesting that both are in the business of manufacturing the measuring rod of value. The difference is that while the Mint is a government agency and its stamp constitutes an official guarantee of weight and fineness, Matador is a private firm and the manufacture of octandors need imply no such guarantee. (The increase in value is “in the eyes of the beholder”. Happy are those who have eyes to see.) It is next to impossible to exaggerate the importance of the rediscovery of the metamorphosis of gold. For the first time ever, the government Mint is rendered superfluous. No longer is it a sine qua non for the metamorphosis of gold. The same effect can be produced by profit-seeking private enterprise, while still benefiting people at large. Consider two cases.

(1) Suppose Bancor receives an order from a third party wanting to buy x octandors. Bancor buys 25x kinebars at the asked price of the Austrian State Mint or at the open market asked price, whichever is smaller, and delivers them to Matador while drawing a bill with face value of x octandors on the latter. That there may be a problem with completing this transaction may become clear when considering the size of x. If it is of routine size, no further consequences need to be considered. But if it is of extraordinary size, then Bancor is put on alert. Next time it may not accept the same discount rate but will push for an increase. It wants to protect its flanks against the contingency that the asked price for kinebars in irredeemable currency is going up.

(2) Conversely, suppose Bancor receives an order from a third party wanting to sell x´ octandor bills at the market. Bancor makes the sale at its posted bid price and will replace the octandors spent by buying octandor bills. If this turns out to be difficult, then Bancor will lower its bid price for octandor bills. … …Note that the bills Bancor just acquired mature into an octandors in 91 days’ time. The asked price quoted in octandor bill units includes a mark-up representing the profit margin of Bancor. … … …

### Why the closing of the Mint to gold was aworld disaster

But why should anyone be willing to pay a mark-up in buying an octandor bill?

Well, for the same reason third-party buyers were willing to pay a mark-up for real bills as predicted by Adam Smith’s Real Bills Doctrine. They wanted to capture a gold income on funds that otherwise would lay idle.

The Mint was formally closed to gold in 1931 when Britain, followed by the U.S. in 1933, defaulted on their gold liabilities. While the default caused some indignation at the time, the closing of the Mint was hardly newsworthy. Yet the event destroyed an all-important Constitutional right of the people, as will now be shown.

Trying to legislate for the ‘benefit’ of all future generations by trampling on the Constitution We have dwelt on the metamorphosis of gold at some length because we are witnessing a historically unprecedented phenomenon: the ingenuity of private enterprise making government certification of weight and fineness of gold superfluous. Up to now it was thought that the opening of the Mint to gold in a sovereign jurisdiction was a necessary condition for the monetization of gold.

Without this condition being satisfied there was no guaranteed future conversion of gold bullion into gold coins. Governments could limit the quantity of the coin of the realm in existence by closing the Mint to gold. This would make the coin of the realm scarce, hurting businessmen who had outstanding contracts payable in these coins. They would be reluctant to accede to contracts the monetary value of which was not properlybacked thecein we can see why the closing of the Mint to gold was far more than a mere ‘house-keeping change’. If the U.S. government could close it, then it could also block any effort aiming at remonetizing gold. Ever. The logic is as follows. Having demonetized gold in 1933 through the closing of the Mint, the U.S. government could prevent gold from ever being remonetized by the simple stratagem of keeping it closed. This was the reason the reason in the first place why the U.S. Constitution mandated the opening of the U.S. Mint to the free and unlimited coinage of silver and gold. The closing of the Mint is tantamount to “trying to legislate for the benefit of all future generations by trampling on the Constitution”.

### Throwing souvenir gold coins into the eyes of the people

Please do not allow yourself to be misled by the red herring of minting souvenir gold pieces in limited numbers on Treasury account for profit. Minting gold coins on Treasury account is as different from minting them on private accounts as night is different from day. When the U.S. government started minting souvenir gold coins in the last decade of the 20th century, it did so in order to throw dust into the eyes of the public. “See? We have reopened the Mint to gold and nothing happened. Certainly the new coins failed to go into circulation! Here is your proof, if proof is needed, that gold is finished as money for good! Nothing can replace the dollar as circulating money!”

### Haircut, 1935-style

Yet minting gold coins on private account remains a matter of Constitutional rights. Only an amendment to the Constitution could take that right away; presidential proclamations and acts of the Congress could not. That right still exists today as it existed before 1933. The fact that it has been usurped by the U.S. Treasury for the past 82 years has zero legal effect.

It has turned out that the ingenuity of private enterprise can outsmart the U.S.

Treasury. The opening of the Mint to gold is no longer a sine qua non for turning gold bullion into the gold coin of the realm (i.e., for remonetizing gold). Bancor could perform of the metamorphosis of gold without government license, simply by ordering Matador to manufacture octandors for its own account in unlimited quantities.

Why is this subtle difference important? Well, we have to go back to the Great Coin Melt of 1933 for an answer. The first proclamation of Franklin D. Roosevelt after his inauguration on March 4, 1933, as president of the United States was the closing of the U.S. Mint to the free and unlimited coinage of gold − along with the arbitrary closing of banks under the jurisdiction of the U.S. government. The circulating gold coins of the U.S. were summarily confiscated and melted down.

Irredeemable Federal Reserve notes were paid out in compensation.

Pretense was maintained that this was a just and full compensation. It wasn’t, justification for the highway robbery offered two years later notwithstanding.

According to the decision of the U.S Supreme Court, handed down in 1935, “the domestic debt-discharging power of the Federal Reserve notes was not abriged”.

Well, if it wasn’t, that was due to the unconstitutional decision of the same High Court in upholding legal tender laws to protect the value of the irredeemable Federal Reserve notes. Absent that decision, the domestic value of the Federal Reserve notes would have suffered the same fate as their international value did. It would have undergone a ‘haircut’ to the tune of some 56%. (The clever simile of a haircut, designed to mitigate the harsher language of “highway robbery”, had not yet gained currency in 1935.)

### Due processes of lawlessness

This was just the first of a series of several episodes in which the Supreme Court of the United States of America stooped to the level of a kangaroo-court. No greater lie was ever spread than that the suggestion that “property has never been taken from an American citizen except in consequence of due processes of law”. The fact remains that in 1935 the High Court took the property of American citizens held in the form of gold certificates issued by the U.S. Treasury. If “due processes of law” means anything, it must mean that each case must be adjudicated separately, on its own merit. The Supreme Court’s handing down a single decision to the effect that in all cases where a citizen is found in possession of a gold certificate the Constitution is automatically suspended, is not enough!

### Phyrric victory

Curiously, the High Court did say that the federal government had no power to alter its contracts unilaterally. In doing so it apparently did try to protect the property rights of those Americans who owned bonds with a gold-clause protection issued by the U.S. Treasury. Seigniorage was increacreased from 0% to 100% by a stroke of the pen. Apart from a few Constitutional experts and monetary scientists, no one recognized the chicanery involved. By now this shameful episode of retroactive legislation and rights-mutilation is conveniently forgotten by rewriting history.

### Global irredeemable currency

The international implications of the usurpation of Constitutional rights were even more ominous. Prior to 1933, all attempts to introduce irredeemable currency on a global scale failed ignominiously everywhere. Countries that resisted the trend and stayed on the gold standard were able to help their weaker brethren to return to monetary rectitude. But after 1933 all countries, including France and Switzerland to mention but two examples, were forced to follow the American lead. In 1936 the French and Swiss franc were also devalued in terms of gold. For all intents and purposes they have also become an irredeemable currency and the international monetary system was converted into a club of irredeemable currencies.

Redeemable currencies have been wiped off the face of earth. The self-breeding of debt could start in earnest as a result.

### He laughs who laughs last

This was the end of honest dealings between the government and its subjects and, hence, the end of honest dealings between private individuals. Honest weights and measures were effectively outlawed. According to the Old Testament such abuse of government power was “abomination” in the eyes of the Lord. Having closed their Mint to gold, governments thought they could keep them closed as long as they wanted (that is to say, forever). In this way they could prevent future generations from returning to a system of honest weights and measures by reopening the Mint to gold.

However, as the saying goes, he laughs who laughs last. Governments have left the ingenuity of private enterprise out of calculation. Here is how government dishonesty is rendered ineffective.by the ingenuity of private enterprise Bancor (the drawer) delivers 25 kinebars while drawing an octandor bill on Matador (the acceptor). The octandor bill, duly accepted (endorsed), is returned to the drawer.

Having two good signatures (those of the drawer and the acceptor), the octandor bill is enabled to circulate through endorsement and discounting. The discount is proportional to the number of days remaining till maturity. The proportionality factor is the gold discount rate. It depends on the supply of and demand for octandor bills. The octandor bill is a gold device uniquely capable of yielding a return on gold in gold, the gold discount rate marking the yield. As the demand for octandor bills is virtually unlimited, the discount rate is positive. The amount of gold going into hiding is no longer infinity as it was under Z.I.R.P. Octandor bills have no competition. Nor has such a competition existed since

1931-33 when the gold standard fell victim to British-American sabotage.

We are, here and now, witnessing the remonetization of gold by market forces − apparently against the wishes of the governments of the U.K. and the U.S. that have never lived down the ignominy of defauling on their gold obligations over eighty-two years ago.

### The “Wave of Futute”

Once octandor bills arise through the manufacture of octandors, they go into spontaneous circulation. There is international demand for them as the following example of financing world trade demonstrates. Assume that Saudi Arabia wants to buy wheat to be delivered in 91 days. Russia will have the wheat by then and is well able to fill the order. The trouble is that Russia is not interested in payment in irredeemable dollars. “Once discredited, always discredited!” Russia insists on getting paid in gold or in gold devices. Saudi Arabia has to go into the bill market to buy gold bills maturing in 91 days. It uses gold from its foreign exchange reserves to pay for the purchase of octandor bills.

Naturally, Saudi Arabia will not pay the face value of the gold bill. As a result of a bargain with Bancor, Saudi f buys octandor bills at a discount. Russia is glad to accept octandor bills from Saudi Arabia in exchange for wheat futures contracts.

They mature into octandors in 91 days’ time, while the alternative, dollar credits will remain as irredeemable as a doornail.

This transaction shows how the circulation of octandor bills can revitalize trade. In a world increasing reluctant to accept irredeemsble dollars in exchange for real goods and real services Gold is indispensable for the reviving and revitalizing vanishing world trade.finance and revitalize vanishing world trade in a world increasingly reluctant to accept the irredeemable dollar (or any other irredeemable currency subject to unimited augmentation,a.k.a.Q.E.) in exchange for real goods and real services such as wheat or crude oil and the wages of construction workers who are working in constructing pipelines.

Therefore the solution to the problem of replacing dishonored and discredited dollar lies, not in inventing yet another irredeemable currency. It lies in putting gold bills maturing in 91 days into circulation. These bills represent the “wave of future”. They are the best earning assets a commercial bank can have. They are the best monetary reserve to hold against a maturing bond issue, or against a real estate deal to be closed out in the future, or against just any contingency monetary liability, such as the import bill in case of an unexpected earthquake, flood or tsunami. Far better than the irredeemable debt of a default-happy government which, to boot, is also the greatest debtor on record, with its debt increasing at an alarming rate, with no visible sources from which to reduce its debt ever.

Notice further that the octandor bill is the perfect antidote against deflation. If there are not enough of them in circulation, then their price will rise and the gold discount rate will fall. The incentive for exchanging gold for octandor bills will be high. But it is also the perfect antidote against inflation. If there are too many of them in circulation, then their price will fall and the gold discount rate will rise, as the incentive for exchanging gold for octandor bills will be low.

Central banks will be put under pressure to compete with octandor bills when it comes to financing trade in merchandise commanding the highest consumer demand. Bank notes redeemable only in unpaid and unpayable debt have no chance facing competition from devices maturing into gold.

Nor will they have a chance to compete against devices maturing into gold when it comes to serving as reserve in the Wage Fund. Irredeemable currency will fall by the wayside, through the sheer logic that creditors need meaningful collateral, rather than relics from distant past when upright countries used to have redeemable currencies. If central banks want to survive, then the credit they issue must be based on short-maturity real bills payable in gold at maturity – as they did prior to 1914. The argument that no such bills presently exists isno longer valid. Such bills do exist, for example, octandor bills. We can take it for granted that there will be no shortage of imitators once the concept is understood by the general public.

This also means that the rehabilitation of the bill market through the circulation of gold devices such as octandor bills will eliminate the threat of unemployment, as far as the employment of those eager to work for wages are concerned. The gold discount rate, unlike the rate of interest, can be (and will be) serially halved any number of times. This will reduce the capital requirement of businesses that move merchandise from the producer to the ultimate consumer.

Incidentally, this brings out the tragic failure of economists through the whole spectrum from Keynesians on the left, through Friedmanites in the middle and post-Mises Austrians on the right,who all failed to distinguish between the rate of interest as it is regulated by the propensity to save and the discount rate as it is regulated by the propensity to consume.

### Conclusion

It was axiomatic that the remonetization of gold could only come about though the decision of a souvereign jurisdiction opening the Mint to the unlimited coinage of gold on private account This means that private individuals and firms have the right to bring gold bullion to the Mint in unlimited quantity and exchange it for freshly minted gold coins of the realm ounce for ounce

This has now changed. There is a new, synthetic way of remonetizing gold that needs no government Mint, or approval, nor legislation asserting individual rights.

Here is how the synthetic way of gold remonetization works. Individuals or firms that have gold bullion to sell can offer it to Bancor for sale against octandors or octandor bills.Bancor stands ready to buy at its posted bid price. As it does, the gold bullion so sold, has been remonetized.

I have studied the question of gold remonetization in all pertinent details and Istake my professional reputation on the thesis that profit-seekingprivate enterprisewill find a way to remonetize gold, thus coaxing gold that had gone into hiding during the long campaign of the U.S. government to drive the rate of interestto zero.

---

*April 10, 2015.*

---

# Blowing Up Modern Austrian Economics — in a Good Way

URL: https://newaustrianeconomics.com/archive/fekete/blowing-up-modern-austrian-economics-in-a-good-way/
Date: 2015-01-11
Section: Popular Economics
Difficulty: intermediate
Concept Tags: new-austrian-economics, real-bills, gold-basis, mises, gold-standard
Description: A Daily Bell interview in which Fekete explains how the New Austrian School 'blows up' modern Austrian economics by correcting its foundational errors regarding the Real Bills Doctrine and the gold basis. He argues this reconstruction makes Austrian monetary theory more powerful, not less, by giving it the analytical tools to understand permanent backwardation and the endgame of fiat money.
Editorial Note: Daily Bell interview from January 2015. The 'blowing up in a good way' framing is Fekete's attempt to distinguish his critique from simple rejection — he is destroying to rebuild.
Original PDF: https://professorfekete.com/articles/AEFDailyBell01112015.pdf

### Blowing Up Modern Austrian Economics ... in a Good Way

### Dr. Antal Fekete with Anthony Wile - January 11, 2015

Introduction: Professor Antal E. Fekete is an author, mathematician, monetary scientist and educator. Born in Budapest, Hungary in 1932, he graduated from the Eötvös Loránd University of Budapest in mathematics in 1955. He immigrated to Canada in 1957 and was appointed Assistant Professor at the Memorial University of Newfoundland in 1958.

In 1992, after 35 years of service, he retired with the rank of Full Professor. In 1983 he was resident scholar at the American Institute for Economic Research in Great Barrington, Massachusetts. In 1995 he was resident fellow at the Foundation for Economic Education in Irvington-on-Hudson, New York. In 1996 he was Visiting Professor at the Francisco Marroquín University in Guatemala. He is the founder and Chairman of the New Austrian School of Economics in Hungary. His website is [www.professorfekete.com](https://www.professorfekete.com).

Professor Fekete is a proponent of the gold standard and an outspoken critic of the current monetary system based on irredeemable currency. His work falls into the school of free-market economic thought inspired by Carl Menger. He claims that his theory of interest is an extension of Menger's work. Menger championed the theory of direct exchange morphing into indirect exchange; in the same way Professor Fekete is championing the theory of direct conversion of income into wealth and wealth into income (read: gold hoarding and dishoarding) morphing into indirect conversion (read: selling and buying gold bonds). Professor Fekete is an advocate of Adam Smith's Real Bills Doctrine that he calls the Gold Bills Doctrine.

Daily Bell: We're going to ask you some questions based in part on feedbacks we recently received regarding some of our inflation articles. Please feel free to comment for as long as you want, but please try to keep your answers simple and comprehensible from a layman's perspective so people can gain as much as possible from your insights. We appreciate your patience, as we know you've answered some of these questions before, but with such subject matter, repetition can be a good thing.

Antal Fekete: "Repetitio est mater studiorum," says the Latin proverb – repetition is the mother of all learning.

Daily Bell: Please define deflation and disinflation from both a monetary and price standpoint.

Antal Fekete: Deflation is clearly not the same as a falling price level. Technological improvements in production cause a gently falling price level under sound money that is no deflation. Defining deflation as a contraction of the stock of money is plainly wrong.

We have a vastly expanding money supply, yet a lot of economists (including myself) hold that we are in the midst of deflation. I prefer the definition of deflation as a pathological slowing in the velocity of money.

Daily Bell: We think monetary deflation over a long period of time is difficult to accomplish in a central bank, money-printing economy. Comments?

Antal Fekete: "Accomplish" is not the word. No one wants deflation any more than wanting a pathological condition in one's own body. "Occur" may be a better word. I disagree with your assumption that central banks' money printing is antithetical to deflation. I am in a minority of one in suggesting that just the opposite is the case: expansion of the money supply through open market purchases of government bonds by the central bank is the direct cause of deflation. I know this is counter-intuitive, yet true nevertheless. Please consider that bond speculators chime in and preempt the Fed. They buy the bonds first, only to dump them on the Fed at a hefty mark-up later. The current expression is "front-running the Fed." Speculators are in the driver's seat, not the Fed. It is amazing that smart speculators like John M. Keynes did not realize that there was a fly in their ointment for deflation, namely, risk free profits. The opportunity to reap them defeats the Quantity Theory of Money. “Propensity to consume” is eclipsed by the “propensity to pocket risk free profits.”

Why is this deflationary? Well, because it slows down the velocity of money. No matter how fast the Fed is printing, its output is siphoned off by profit-hungry bond speculators even faster. So fast indeed that commodity speculators, who may otherwise be tempted to buy goods with the freshly printed money in anticipation of inflation, make a volte-face and march to the bond market where the fun is – unless they stay and short commodities like crude oil, to mention but one recent example.

Daily Bell: Along with Rothbard, as we understand it, asset inflation itself leads to what seems to be deflation and disinflation. Money volume must go up to go down. Truth to this?

Antal Fekete: I would modify language slightly: money velocity must go up first so that it could come down.

Daily Bell: If third-party credit facilities like American Express collapse, does this constitute monetary deflation?

Antal Fekete: The collapse of any firm is a symptom of deflation, with a vengeance. It activates the ''domino effect''. Deflation breeds more deflation. The velocity of money spirals down. Please note that the original push came from the open market purchases of bonds by the Fed. It caused to bleed white solid productive firms, whose profits were certainly not risk free.

Daily Bell: When central banks keep interest rates low, does this lead to disinflation and deflation? How so?

Antal Fekete: The word "disinflation," which suggests that the Fed can turn the spigot on and off, is not in my dictionary. In fact, the Fed has no such power. It can certainly turn the spigot on, but we have never seen the Fed turning it off. Worse still, it has absolutely no control over how people will be using the extra money spewed from spigots or dropped from helicopters. Well, the smart ones would buy bonds, not commodities as the Fed hoped. They knew they could always dump them on the Fed in the open market with a hefty markup. Risk free.

To answer your question, the central bank does not "keep" interest rates low. In fact, it "pushes" them low through open market purchases of government debt, which increases the bond price. The other side of the coin is the simultaneous decrease of the rate of interest. Of course, the purpose of the exercise, on a Quantity Theory argument, is the fomenting of inflation ? not deflation. The trouble is that the central bank does not know what it is doing. It sows inflation but reaps deflation. Its monetary policy is counterproductive, to put it politely. A more accurate way to describe it is that current monetary policy reflects a peculiar madness inflicted on a gang of impostors and usurpers of unlimited power who are trampling on the Constitution and causing unprecedented economic pain to society. When their system collapses, as John Law of Lauriston's has almost three hundred years ago, then they will have to escape from Washington in female garments, as John Law escaped from Paris, or in male garments with false beard, as would be more appropriate in the case of Janet, under the cover of the night.

Daily Bell: If central banks are keeping interest rates artificially low, how does this contribute to monetary deflation? What do the bond traders do that makes monetary

### INFLATION into a deflationary phenomenon?

Antal Fekete: It is not low interest rates that creates deflation but falling interest rates.

The process is triggered by the central bank's open market purchases of bonds in an effort to pursue its inane policy of QE, eliciting the copycat action of bond speculators. A chain reaction is activated: bond purchases of the central bank alternating with bond purchases of the speculators. The central bank announces its time table for its bond buying program.

Speculators pre-empt the central bank in buying first, dumping the bonds into the lap of the central bank while pocketing risk free profits afterwards. The expectation of the central bank, price inflation, does not materialize. It is frustrated by the bond speculators who hijack the freshly printed money on its way to the commodity market. Not to be deterred, the central bank prints more. To do that it has to go to the open market and buy more bonds, prompting speculators to pre-empt. The cycle now repeats and a vicious spiral is engaged. The upshot is a prolonged fall of interest rates that destroys capital across the board, causing a domino effect of falling firms ? as I mentioned a minute ago.

Daily Bell: Do you believe in the Misesian business cycle? Does it have validity, in your view?

Antal Fekete: Certainly, with some reservations. It does not assign a very high IQ to businessmen in the field. Why don't they learn from experience and factor into their calculations the distortion in the rate of interest due to monetary policy? I improve on the business cycle of Mises, pointing an accusing finger to bond speculation motivated by risk free profits. Businessmen are the brightest people we have. They are being victimized through the insane monetary policy of the Fed.

Daily Bell: Was the Great Depression a deflationary depression? We note that junior mining prices apparently went UP during the Great Depression.

Antal Fekete: Most certainly it was. It is axiomatic that gold mining shares go up during a depression. Depression is just another name for capital destruction, and gold is the only form of capital that is immune to destruction. If you consolidate all balance sheets in a country (including that of the national treasury), then all liquid assets will be wiped out, with the sole exception of gold. Gold is the only asset that is not duplicated as a liability in the balance sheet of someone else.

Daily Bell: Are we in a deflationary depression? Or are we in a kind of stagflation?

Antal Fekete: We are in a deflation that is metastasizing into a depression. The monster word "stagflation" does not appear in my dictionary.

Daily Bell: Has money volume increased in the US and Europe? Have prices increased in response?

Antal Fekete: As I hinted a while ago, increasing the volume of money does not necessarily cause an increase in the price level. The Quantity Theory of Money is a false theory. In spite of an eightfold increase in the stock of money in America the price of crude oil was cut in half and the price of iron, copper and a number of other metals showed steep declines ? thought impossible only a few months ago. If this is not deflation, then let me ask: How much farther do prices have to fall before we are allowed to use the D-word?

Daily Bell: Oil has apparently been manipulated down. Does this constitute price deflation nonetheless, or is it simply a kind of manipulation?

Antal Fekete: The manipulation theory was invented by those who are afraid to face the facts squarely. We should know better: no valorization scheme ever works for any significant length of time for any commodity. It is another matter that foreign policy makers in Washington may have stolen a ride on the back of spontaneously collapsing crude oil to punish Putin.

Daily Bell: Let's change the subject. Do you wish to have a larger debate on Adam Smith's Real Bills Doctrine and do you think this would be good for the field? Did anyone postulate real bills before Smith? Didn't he just comment on an observable phenomenon?

Antal Fekete: Yes, I do. The trouble is that my opponents don't feel they are sufficiently well versed in the subject to stand up in such a debate. You cannot have a debate with slogans, which is all I hear. Adam Smith did not postulate the Real Bills Doctrine; he was the first to codify it. Let's not belittle his contribution.

Daily Bell: For real bills to function properly do we need to get rid of monopoly central banking?

Antal Fekete: The existence of central banks is irrelevant to the proper functioning of real bills, as the experience of the 19th century convincingly demonstrates. Nor is the existence of a central bank a prerequisite for real bill circulation. By contrast, circulating gold coinage is.

Daily Bell: Is monopoly central banking tolerable and sustainable in the long run? Is it a good for society?

Antal Fekete: In the 19th century central banks operated on the profit principle and they did not have special privileges such as the monopoly of issuing legal tender bank notes. If anything, they had less elbow-room than other banks. For example, they were not supposed to take the initiative in putting out their credit. They did not foist their credit on society as latter-day central banks do. Customers were supposed to step forward and take the central bank's credit on the terms offered ? or leave it.

Daily Bell: Is government borrowing a "blessing," as Alexander Hamilton once held?

Antal Fekete: Hamilton was talking about government borrowing subject to a debt ceiling. He must have been turning in his grave for the past decade watching the annual ritual of Congress busily lifting the ceiling, eventually abolishing it altogether.

Having said that I may add that Hamilton is not my hero on the question of the debt of the federal government. Jefferson is.

Daily Bell: Can the government do good things with borrowed money?

Antal Fekete: It can provide for national defense, in case the country is threatened by a foreign enemy.

Daily Bell: Is government good for anything else than taking responsibility for defense?

Antal Fekete: That government is best whose debt is least. Government debt must be kept on a golden chain. It will break any other.

Daily Bell: Here's a quote from one of our feedbackers: "Real bills play a significant role in providing liquidity in gold redeemable currency which empowers the individual. Also, and perhaps more importantly, real bills keep the currency away from the grip of financial oligarchs." True? False? Why?

Antal Fekete: Absolutely true. There was no "structural unemployment" in the heyday of real bills in the 19th century. Structural unemployment appeared in the 20th century when the victorious Entente powers blocked the bill market in their neurotic fear of German competition, after the cessation of hostilities in 1918.

Daily Bell: Why doesn't someone involved with the Mises Institute find merit in the Real Bills Doctrine?

Antal Fekete: I am told that they do but are browbeaten by the doctrinaire and cultist leadership. After all, the name over the entrance is that of Ludwig von Mises, archopponent of the Real Bills Doctrine.

Daily Bell: What is their argument against the Real Bills Doctrine? Is it that real bills are in some sense inflationary? How so?

Antal Fekete: You have to ask them. In no sense are real bills inflationary. They arise and expire pari passu with the emergence of new merchandise and their removal from the market by the ultimate gold-paying consumer.

Daily Bell: Changing the subject, is charging interest on debt a form of usury? Should people be thrown in jail if they do it?

Antal Fekete: The whole complex problem of usury disappears at once if you change the perspective and look at the transaction not as lending and borrowing, but as exchanging income for wealth and wealth for income, which is a biological necessity for mortals like us. The borrower, typically a young man, exchanges income of which he has a surplus for wealth of which he has a deficit. By contrast the lender, typically an old man, exchanges wealth of which he has a surplus for income of which he has a deficit. Why in the name of the blindfolded Lady Justice should either man be thrown in jail for making the the exchange?

Daily Bell: Do real bills provide an alternative to charging interest? How so?

Antal Fekete: No. The rate of interest is not involved at all with credit conveyed through bill trading. What is involved here is the discount rate. The rate of interest is conveyed through bond trading. The two are entirely different, both in origin and effect. This is a large subject of its own. I am just posting a major paper entitled Credit, the subject of my Privatseminar in Madrid, in a few days' time, on my website: [www.professorfekete.com](https://www.professorfekete.com), in which I carefully elaborate on this difference.

Daily Bell: Did Ludwig von Mises ignore some of the work of Menger? How so?

Antal Fekete: Not only did he ignore whole chunks of it, Mises took positions directly opposed to those of Menger. Menger did not subscribe to the Quantity Theory of Money; Mises did. Menger did not castigate commercial banks by calling them by the derogatory name "fractional reserve banks" for covering part of their note and deposit liability by real bills maturing in gold coin in 91 days or less; Mises did. Menger fully accepted Adam Smith's Real Bills Doctrine; Mises rejected it. Menger did not believe that fiat currency was a "present good"; Mises did. The list goes on.

Daily Bell: A feedbacker comments: "Carl Menger's is pure Austrian economics, in that he postulated a philosophy of free exchange and economic prosperity which rests on honest money and the liquidity that arises from real bills." Comment, please.

Antal Fekete: I wish to congratulate your feedbacker for his clear insight.

### Daily Bell: Was Menger a proponent of real bills?

Antal Fekete: He didn't have to be. He didn't have to endorse the air he was breathing in either. Menger was immersed in a world financing its foreign and domestic trade in merchandise by drawing real bills on the retail merchant selling to the ultimate consumer before World War I. Menger fully accepted the practice of "fractional reserve" banking as legitimate. See his encyclopedic article Geld, 1909 edition.

Daily Bell: How far into the past do real bills go? Hundreds of years? Thousands of years?

Antal Fekete: Cicero mentions letters of credit, a precursor of bills of exchange, in one of his epistles to a friend who lived in Athens. His son was about to sail there. He wanted to know whether the son could take letters of credit rather than gold coins with him on this trip, drawn on an importer in Rome owing to an exporter in Athens. Apparently such letters of credits had a wide circulation based on the extensive trade between the two cities.

Real bills proper as Adam Smith understood the term originated in the 1200s in the Italian city states such as Venice, Florence and Genoa, for example. They had a vast trade with the Far East and the Levant, all of which was financed by drawing bills of exchange on local retailers, such as Antonio in Shakespeare's Merchant of Venice.

Daily Bell: Was there free-market private money before real bills? Would you characterize those systems before real bills as primitive?

Antal Fekete: Not during the Dark Ages. Lights went out and trade came to a standstill.

Autarky was the rule after the collapse of the Western half of the Roman Empire. But before that event trading bills was the most sophisticated way of financing trade. It would never occur to me to characterize it as "primitive."

Daily Bell: The modern Austrian School, as one of our feedbackers put it, "subverted the classical Austrian school by denying society much needed liquidity, thus condemning it to deflation and depression, through denigrating real bills." Comments, if you please.

Antal Fekete: I wish to congratulate your feedbacker for his clear insight.

Daily Bell: Why do real bills provide extra liquidity? Is it because they make borrowing easier? Can't people borrow without a real bills facility? Does it have to be that formal?

Antal Fekete: It is a major misconception to think that real bills involve lending and borrowing. They don't. What they involve is clearing. When a wholesale merchant draws a bill on a retail merchant, he does not lend and the retail merchant does not borrow.

Hardly ever would the latter pay gold coin upon delivery of supplies, and the former would never demand payments in gold coin.

Circulation of real bills started entirely spontaneously. Suppliers of the wholesale merchant were delighted to accept the bill drawn on the retail merchant in payment upon endorsing. The bill was an earning asset in their hands, thanks to the discount. They could liquidate the bill on short notice if the need arose.

Daily Bell: How did real bills pass out of favor in the 20th century? Are they still illegal?

Antal Fekete: They did not pass out; they were sabotaged by the victorious Entente powers in blocking the bill market in London, as I have already mentioned. They were guided by their neurotic fear of German efficiency. In doing so they inadvertently destroyed the wage fund out of which the wages of workers producing merchandise could be advanced ahead of the sale of merchandise to the ultimate gold-paying consumer. The destruction of the wage fund was the true cause of the Great Depression of the 1930s, and the horrendous unemployment it engendered. There was no way of advancing wage payments other than bill trading. Once suspended, no one was there to pay the wages of workers producing consumer goods. They had to be laid off.

Real bills were never made illegal. There was no need. The withdrawal of gold coins from circulation did the trick. The idea of a real bill maturing in irredeemable currency is preposterous. The real bill must mature in something more liquid, and irredeemable currency is less liquid than the real bill. It is a promise to pay nothing.

Daily Bell: What is necessary to allow real bill circulation – letting them return to prominence?

Antal Fekete: Three things: gold coins, gold coins and gold coins.

### Daily Bell: Any other points you want to make?

Antal Fekete: Yes. Gold coins are the most marketable instruments known to man. Its holder can trade on the best terms possible. Gold bills are the second most marketable instruments. Demand for them is virtually unlimited. Banks overflowing with gold coins scramble to expel them in exchange for real bills, the best earning asset a commercial bank can have.

If you bought a house in the 19th century, you would not accumulate gold coins in anticipation of paying the purchase price on closing day. You accumulated real bills with the same maturity. Likewise, if you issued bonds, you did not accumulate gold coins in anticipation of paying the face value of your bonded debt upon maturity. You accumulated real bills with the same maturity date.

Only ignoramuses believe that gold coins financed the economy directly in the 19th century and real bills were just a reactionary aberration.

### Daily Bell: Thanks for your time!

---

# The Counter-Productive Monetary Policy of the Fed

URL: https://newaustrianeconomics.com/archive/fekete/the-counter-productive-monetary-policy-of-the-fed/
Date: 2014-12-02
Section: Popular Economics
Difficulty: intermediate
Concept Tags: federal-reserve, monetary-policy, capital-destruction, interest-theory, fiat-currency
Description: Fekete's year-end analysis of the Federal Reserve's monetary policy, arguing that every policy action since 2008 has been counter-productive — not by accident but by design. ZIRP destroys savings, QE destroys capital allocation, forward guidance destroys price discovery. The Fed's tools are not merely ineffective but actively destructive.
Editorial Note: Written December 2014. A year-end retrospective on Fed policy, arguing that the post-2008 policy toolkit has systematically destroyed the economic foundations it claims to support.
Original PDF: https://professorfekete.com/articles/AEFCounterProdMonetaryPolFed.pdf

*Invited address delivered at the International Precious Metal & Commodity Show, at the Event Arena/Olympiapark in München, November 8, 2014.*

### Introduction

Typically, bond speculators carry on interest arbitrage along the entire yield curve.

They sell the short maturity and buy the long, hoping to capture the difference between the higher long rate and the lower short rate of interest (borrowing short and lending long). This arbitrage is not risk-free per se as it has the effect of flattening the yield curve. As a result the normal yield curve could get inverted unexpectedly, that is, turned upside down, making the rising curve into a falling one while turning the speculators’ profit into a loss.

However, as a direct result of the policy of open market operations, introduced clandestinely and illegally in 1922 through the conspiracy of the US Treasury and the Federal Reserve (Fed), long before the practice was legalized ex post facto in 1935, interest arbitrage was made risk-free. Astute bond speculators could thereafter preempt Fed action profitably. It never fails. Speculators know that sooner or later the Fed will have go to the bill market to buy in order to boost the money supply. They will buy beforehand. On rare occasions the Fed would be a seller. Then speculators, perhaps acting on inside information, will sell beforehand. This copycat action is an inexhaustible source of risk-free profits. Thanks to the Fed’s open market purchases speculators are assured that they will always be able to dump the bonds at a profit which they have bought pre-emptively. The more aggressively the Fed persists in its effort to increase the monetary base, the greater the bond speculators’ profits will be.

### Absolute bad faith

Following the 1921 disastrous collapse in the value of U.S. Treasury bonds the ongoing conspiracy between the U.S. Treasury and the Fed was formalized in 1922.

The policy of Open Market Operations by the Fed was inaugurated. Ever since federal reserve credit has routinely been created on the collateral security of the debt of the United States government. Thus the Federal Reserve (F.R.) Act of 1913 was overthrown without fanfare while Congress was looking the other way. As a result the Fed has been subverted. According to the original Act, collateral for the note and deposit liabilities of the F.R. banks were to be restricted to real bills, that is, short term commercial paper originating in the domestic production and distribution of consumer goods. Treasury paper was not listed in the Act as an eligible asset. This was not an oversight. No part of F.R. credit outstanding was supposed to be built on government debt. If a F.R. bank was found short of eligible paper in balancing its note and deposit liabilities, it did not matter how great an overflow of Treasury bills it might have in its capital accounts, it was fined according to a stiff and progressive schedule of penalties for deficiency of collateral.

The conspiracy between the U.S. Treasury and the Fed started in 1914, almost on the same day the twelve F.R. banks opened their doors for business. The decision was made at the highest level by President Wilson that the Fed be diverted from its original mission and be put to use in financing the war effort of the Entente Cordiale.

Naturally, this was kept secret as it violated both the Neutrality Act as well as the F.R. Act of 1913. The latter ruled out any and all purchases of foreign bonds, especially war bonds. The Treasury was the go-between in providing F.R. credit to the belligerents. The American public opinion that was strongly opposed to the European war was not informed about the monetary war-mongering.

The conspiracy is to be seen in the fact that the Treasury has ‘forgotten’ to collect the penalty from the Fed. Indeed, why should it penalize its best customer for its staple product? This was the greatest failing of the F.R. Act of 1913: it put the fox in charge of the chicken coop.

By 1920 you could not find a real bill in the portfolios of the F.R. banks with a magnifying glass. Instead, they were chock-full of Treasury paper. Nor was a serious effort made to return to the norms of the original Act after hostilities ended in 1918.

Real bills were not allowed to make a come-back by the victorious Entente powers.

We can safely ignore the colorful stories how in 1913 the Fed was conceived on Jekyll Island by a group of malevolent bankers with an agenda to enslave the world as mythological. The F.R. Act of 1913 was not a malevolent document, although it obviously had warts. The conspiracy between the Treasury and the Fed was an unintended consequence, resulting from an unfortunate oversight of lawmakers.

This oversight was most skillfully exploited by the sworn enemies of sound money.

The dagger went right to the heart of the U.S. monetary system. In 1913 legislators were assured that they were voting for a commercial paper system that could never become an engine of monetizing government debt. Should the F.R. banks ever try, they would be confronted with unacceptable losses. Sadly, it did not turn out that way.

When in 1935 the illegal practice was legalized retroactively through an amendment to the F.R. Act of 1913, the introduction of open market operations was presented as an innocent house-keeping change, a technical matter relating to the banking practice of releasing funds to and draining funds from the banking system. The fundamental issue, the folly of allowing the Fed to monetize government debt, in itself an unconstitutional act, was hushed up. Congress and the public were never given a chance to scrutinize the matter. They were led astray. Monetization of government debt was legalized through the back door, through chicanery and absolute bad faith. It was made the centerpiece of the money-creating process, in complete negation of the intention of the original Act (which made the production and distribution of consumer goods in most urgent demand the centerpiece of the money-creating process). Is it any wonder, then, that the new monetary system born in sin has brought disaster to the nation one hundred years later?

Critics focus their demur on the way the Fed creates money 'out of thin air' through sleight of hand. But there is a much larger issue here that has escaped attention. The policy of open market operations has made it possible for the Fed to usurp unlimited power in suppressing the rate of interest on all maturities through the transmission mechanism of risk-free bond speculation, while maintaining the illusion that it had only a very limited power ― that of influencing the overnight rate of interest. The impression created is that the world can rest assured: all other rates are true market rates. Nobody took the trouble to dispel this illusion. (The fig-leaf was shed only recently: Quantitative Easing openly embraces direct purchases of T-bonds and agency paper such as those of Fanny Mae and Freddy Mac by the Fed.)

### Falling interest rates as a destroyer of capital

Open market operations make for a regime of falling interest rates. My thesis that falling (as distinct from low but stable) interest rates destroy capital across the board is admittedly controversial. I would welcome its examination ‘without fear and favor’ by a competent and unbiased panel that could also examine the superiority of “selfliquidating credit” over credit based on government debt (that could be called, tongue-in-cheek, “self-perpetuating debt”).

We shall look at three destructive effects of a rate cut:

(a) the increase in the liquidation value of debt,

(b) labor's deteriorating terms of trade,

(c) the fading of depreciation quotas.

The proposition that the bond price varies inversely with the rate of interest is uncontroversial and universally accepted by friend and foe alike. It describes the effect from the point of view of the creditor. Curiously, people find it hard to comprehend the equivalent proposition describing the very same effect from the point of view of the debtor, namely, that the liquidation value of debt also varies inversely with the rate of interest. In particular, a rate cut increases the cost of liquidating debt before maturity. Liquidation value is what the debtor must pay if he wants to retire his debt ahead of schedule. As this liquidation value is now higher, falling interest rates make the burden of debt increase. For example, if the rate of interest is cut in half, then according to the rule of thumb the liquidation value of long term debt is doubled (that is, to liquidate the debt will cost twice as much as it did before the cut).

To recapitulate: both the bond price and the burden of debt vary inversely with the rate of interest. Why is it that a fall in the rate of interest increases the market price of the bond? Well, nobody will sell an 'old' bond at face value after interest rates have been cut. The owner will demand, and the investor will pay, a higher price. The reason for this is simple: 'new' bonds that are now being issued produce a lower yield.

The higher coupons of the old bond must be worth something. The bottom line is that the cost of the same cash flow has gone up. You must pay more for the same yield. For example, if the rate of interest is cut in half, then you will have to pay twice as much to generate the same cash flow as you have paid before the cut.

Current book-keeping practices ignore the deleterious effect of a rate cut as it increases the burden of debt across the board. Nay, falling interest rates are disingenuously hailed as a blessing designed to help business. It is to the eternal shame of the “dismal science” that it has let this colossal propaganda lie pass without challenge.

### The present value of cash flow

Having established (a), the increase in the liquidation value of debt, we now turn to (b), labor's deteriorating terms of trade as a consequence of suppressing the rate of interest through the policy of open market operations. First we dwell a little longer on the problem of the present value of a cash flow (defined as the sum of individual payments discounted at the prevailing rate of interest, each for the period of time between now and when it becomes payable in the future.) Since the rate of interest is being cut, discount at a lower rate is involved. Therefore the present value of the cash flow is increased. For example, if the rate of interest is cut in half, then the present value of a cash flow continuing indefinitely doubles.

What does this mean for the terms of trade of those who need a cash flow for survival, such as all pensioners and all wage earners? Well, the price they have to pay for the cash flow is just its present value. Any cut in the rate of interest by the central bank affects them adversely. Their terms of trade deteriorates. For example, if the rate of interest is cut in half, then they have to pay twice as much for the same cash flow as before the cut. In practical terms this means that wage earners have to work roughly twice as hard to continue earning wages at the same level. As far as pensioners are concerned, their pension fund is devastated. It can no longer support the cash flow they have enjoyed before the cut. Clearly, there is going to be a most serious deterioration in the standard of living for a large segment of society as a result of open market purchases of government bonds. This reveals the most cruel aspect of open market operations: it hits the weakest members of society hardest.

### “Quantitative Squeezing”

The process undermining the value of money as it is trying to buy a cash flow is not well-understood. It reflects the failure of the public education system. This failure is not an accident. The powers-that-be under the regime of irredeemable currency have a vested interest that the public be condemned to total ignorance on this matter. If the public realized what was going on, there would be blood in the streets.

Take a typical wage earner selling his own labor, namely, exchanging it for a cash flow (that he needs to keep body and soul together). The cash flow represented by his wages is grievously undermined by the policy of Quantitative Easing. One's ability to do profitable work is quasi-wealth. It may well be the only asset the laborer has. The value of this quasi-wealth is rendered inferior every time the rate of interest is cut.

For example if it is cut in half, the quasi-wealth of the laborer is halved as well.

We may visualize the laborer as running on a treadmill the speed of which has just been boosted, say, by 100 percent. Now he has to run twice as fast just to stay abreast.

If he wants to retain the value of his labor, he must work that much harder. Karl Marx called it exploitation. There is no more insidious exploitation of human labor than giving the central bank unlimited power to manipulate the rate of interest downwards through open market purchases of government bonds, mockingly called 'Quantitative Easing'. It had better be called 'Quantitative Squeezing' of labor.

### The 'haircut' of the rate cut

Squeezing labor is not an idle theoretical construction. It is very real indeed. The deterioration in labor's terms of trade is clearly shown by the fact that banks withdraw contract offers on mortgages whenever rates of interest are cut. Monthly payments as prescribed by the 'old' mortgage contract amortize more slowly under the lower interest-rate regime, so the debt could not be retired on schedule. The 'new' mortgage contract features inferior terms for prospective clients (although this fact is usually obfuscated by the bank). Maturity is put off or, if this is not an option, then higher monthly payments are inflicted on the new clients. Recall that the mortgage contract is an asset of the bank, the liquidation value of which has just been increased by the rate cut. The bank itself is being squeezed (think of the losses it is suffering on its portfolio of fixed-rate mortgages and other fixed-rate loans). No wonder that the bank is trying to pass on as much of its losses as it can to its clients, often deceitfully, by pressing them to refinance their fixed-rate mortgage at the lower rate to their detriment.

We must realize that in the case of a rate cut the best course of action is to stay with the original fixed-rate mortgage. It is definitely not to refinance at the lower rate! The source of confusion is that a rate-cut is dressed up as if it were helping the homeowners to cope with the financial burden when the exact opposite is the case!

In truth, the value of the cash flow of wages has been rendered inferior by the rate cut.

It has lost so much of its debt-liquidating power. QE pushes labor deeper in debt and ZIRP (Zero Interest Rate Policy) means perpetual bondage for labor. It is modern slavery. 21st century slaves may well 'own' their homes, their cars, their freezers, etc., but their mortgage debt, their auto-loans, their credit card debt are just so many evidences of indenture of slavery with absolutely no hope of emancipation under QE and ZIRP.

“We wuz robbed. Dunno by who.” Well, I do. All laborers have been and continue being pilfered and plundered by the regime of irredeemable currency in allowing the central bank to reduce the rate of interest to zero and beyond through open market purchases of government bonds. Every rate cut is a 'haircut' for labor. Shame on the profession of economists for not exposing the culprits, thus becoming an accomplice in the crime.

A self-employed worker putatively uses depreciation quotas on his tools, modest as they may be which, as we shall see in a moment, are subject to fading. Thus selfemployed workers are hit twice by the suppression of interest rates through the policy of open market operations. First they are hit on the wage account, secondly, on account of the fading depreciation quotas.

All wage earners are ferociously squeezed by the policy of lowering interest rates through the open market operations of central banks. Worst hit are the marginal wage earners. They are plunged into the hopelessness of permanent unemployment. There is a trade-off between taking on additional debt at the lower rate peddled by the central bank, and firing the marginal worker. Employers find it to their advantage to replace marginal workers with additional machinery installed and financed under

ZIRP. Their collective labor contracts become more burdensome (in the same sense as the bonds they issued at the old rate have become more onerous) in the new lowerrate environment. Worse still for labor, its bargaining power has been grievously undermined through the policy of Quantitative Easing. Employers push for renegotiating their collective agreements in order to reduce wage rates to reflect the reduction in the rate of interest. If that fails, they will fire their marginal workers and will apply the cash flow freed up thereby to service additional debt to be used to automate the enterprise or otherwise reorganize it. Either way, the marginal worker is eliminated for good. Unemployment increases across the board as a result.

Much has been made of squeezing labor through the central bank's deliberate inflationary policy. Meanwhile no notice has been taken of the far more insidious central bank policy squeezing labor: QE, ZIRP, and the rest. Union leaders, are you listening?

There is a growing recognition by the establishment of the built-in deterioration of the wage structure, as reflected by a recent essay in the Foreign Affairs magazine (an organ of the Council of Foreign Relations), at least in so far as the need for compensation for the damage caused by central banks is concerned. The amazing title of the essay is: Print Less But Transfer More: Why Central Banks Should Give Money Directly to the People (see References below).

Who will replace producer goods after they are shipped to the scrapyard?

Back to the subject (c) of fading depreciation quotas we may first note their similarity to the fixed coupons of a bond and the fixed wage rates. When the rate of interest is suppressed, there is an upheaval undermining the value of all three. The coupons attached to a bond constitute a cash flow the value of which has been undermined by the rate cut. Wages of laborers also constitute a cash flow the value of which has been likewise undermined. Now we shall see that, no less, depreciation quotas also constitute a quasi-cash flow the value of which has been undermined as well. Thus we are confronted with a systematic plundering of society through the deliberate suppression of interest rates, that is, through the policy of open market purchases of government bonds by the central bank. It is incredible that while the plunder has been going on unobserved for almost a hundred years, the profession of economists has taken note neither of the wisdom of the framers of the F.R. Act of 1913 in outlawing F.R. credit based on government debt (as the Act before the 1935 amendment has done), nor of the untoward consequences of the policy of open market operations: (a), (b) and (c). We shall now see that the fading of depreciation quotas is a consequence of the policy of open market operations.

The depreciation quota of a producer good is an accounting tool revealing how much of its value has been 'used up' over time, due to wear and tear in production, and how much money needs to be put aside to amortize that loss in any particular year. If the rate of interest is pushed down by the central bank, then there is a setback in the amortization schedule. Just as the fixed coupons of the bond − in the absence of refinancing − are no longer able to amortize the loan in the new lower interest-rate environment (because amortization has been slowed down by the rate cut, as we have seen it in the case of mortgages), so also the quasi-cash flow of fixed depreciation quotas in the absence of deploying new capital are insufficient to guarantee the replacement of the ' used-up' portion of old capital. When looked at in this way it becomes clear that falling interest rates ought to make an upward revision of depreciation quotas mandatory – just like the value of the interest coupons of the bond ought to be adjusted upwards in the wake of falling interest rates, if it is our wish that the market value of the bond (or mortgage) have the same debt-liquidating power in the face of falling interest rates ─ as I suggested in my 2008 paper Is Our Accounting System Flawed? (See References below.) If this aspect of the policy of open market operations is ignored, then there will be a shortfall in amortization across the board. Sufficient funds will not have been set aside to pay for the replacement of producer goods when they are ready for the scrapyard.

### Capital destruction

Current book-keeping practice ignores this effect of falling interest rates. Thereby the renewal of worn capital is rendered impossible. This is capital destruction. The same principle also applies to capital deployed in finance, in particular, in the banking business. Bank capital that is adequate in a stable interest-rate environment is no longer sufficient in a falling interest-rate environment as banks in the U.S. and in Europe have found out to their chagrin.

Scandalous as though these omissions in book-keeping practice are, present accounting standards ignore both effects of the policy of open market operations and the subsequent fall in the interest-rate structure: (a) increases in the liquidation value of debt, (c) the fading of depreciation quotas. Observe the insidious process of concealed capital erosion acting on all businesses simultaneously and indiscriminately. Losses are masked as profits, phantom profits are paid out as dividends and managerial compensation. The process of capital erosion is accelerated by the policy of suppressing interest rates further. Inevitably, the result is deflation, depression or worse, such as breakdown in law and order. Quantitative Easing and any other benign-sounding monetary policy measures aiming at suppressing the rate of interest camouflage the wholesale destruction of capital in the productive and financial apparatus of society. Neither Keynes nor Bernanke understood this process.

We have seen that open market purchases of the Fed are a powerful deflationary force in the economy as they cause interest rates to fall and capital to erode. We shall now see that, with a lag, open market operations are also bound to cause commodity prices to fall. In time, a vicious spiral pulling the economy into the abyss will be engaged.

### Erosion of capital causes a falling trend of prices

Erosion of capital affects all producers, some of whom will succumb while others will fight for survival by scrambling to get out of debt. They will aggressively cut prices in the face of weakening demand. Herein we have the classic case of counter8 productive central bank action. The central bank wants to snatch the economy from the jaws of deflation by increasing the money supply. Its preferred method is the open market purchases of short-term government securities. But through the transmission of risk-free bond speculation interest rates keep falling for all maturities. As a result capital invested in production is eroding faster. The burden of debt is increasing.

Workers are squeezed. Producers are squeezed. They try to get out of debt by selling more of their product. In desperation, they cut prices but to no avail. Consumers, including workers under squeeze, hold out for more price cuts. They postpone their purchases wherever they can. Demand collapses ― as eloquently described by no less of an authority than Keynes himself.

Although the fact is ignored by most economists, speculation plays a major role in the formation of prices. A falling price trend in commodities that started through the erosion of capital is further amplified as speculators redeploy funds from the commodity to the bond market where irresistible risk-free profits are available — not offered to commodity speculators. This is a powerful albeit unrecognized force in the economy triggering a chain-reaction as follows:

(1) risk-free bond speculation gives the initial impetus for interest rates to fall, (2) falling interest rates cause a severe erosion of capital throughout the productive and financial apparatus,

(3) erosion of capital triggers a falling trend in prices,

(4) falling prices further increase the downward pressure on interest rates.

Then the cycle repeats itself.

Thus a vicious spiral is engaged: falling interest rates and falling prices chase one another downwards, threatening to push the economy into deflation. Mainstream economics lacks a valid theory of speculation. Hence it has a blind spot and fails to see the destructive nature of open market operations. It completely misses the fact that bond speculators will not stay idle while the show of open market operations put on by the central bank is played out.

### Austrian theory of the boom-bust cycle

The suppression of the rate of interest through monetary policy and the resulting malinvestments made by entrepreneurs is a central theme of the business cycle theory of the post-Mises Austrian school. Our analysis is in the same tradition.

But in exposing the actual transmission mechanism that extends the suppression of short-term rates to suppression of the entire spectrum of interest rates we carry the analysis further. The New Austrian School points out that open market purchases of the Fed make bond speculation risk-free with the result that all interest rates will fall.

It is not necessary to bring in the malinvestment argument. After all, entrepreneurs could learn from past experience. They might realize that rate cuts are detrimental to their interest and they might fine-tune their investment strategy to take the artificial suppression of the rate of interest by the central bank into account. Could bust be avoided if they did? Our explanation of deflation and depression in terms of destruction of capital automatically brought about by the falling interest rate structure avoids any reference to malinvestments and is, therefore, superior.

### Achilles-heel of Keynesianism

Our destruction-of-capital argument also has the advantage that it exposes the Achilles heel of Keynesianism preaching, as it is, the dangers of ‘oversaving’ and ‘underconsumption’. These concepts are vacuous. They are claptrap. There is no valid reason why society should not be able to accommodate the needs of those of its members who must be net savers (typically the juniors), and those who must be net consumers (typically the seniors). The Achilles heel of Keynesianism is found in the treatment of capital, especially in the total negligence of the danger of capital destruction. Keynesianism is oblivious to the fact that if capital consumption occurs for any reason, then the resulting deficiency must be compensated for through the accumulation of fresh capital. For example, if physical capital is impaired through fire devastating the plant, then the lost value due to fire damage must be written off in the capital accounts of the balance sheet of the firm. In order to escape permanent damage to efficiency, replacement must be made through a periodic reduction in the income statements. The ledger is brought back into balance through entering the present value of the cash flow derived from these reductions.

### Sweeping the loss under the rug and kicking the garbage upstairs

The point is that exactly the same procedure ought to be followed if the loss originated not in a plant fire but as a result of a reduction in the rate of interest.

Capital ought to be written off in the capital accounts reflecting the loss caused by the reduction. Replacement ought to be made as follows. Enter the present value of the cash flow derived from a downward adjustment in the income statements into the balance sheet. As observed above, the accounting profession (apparently with the connivance of the government) fails to do that and the loss of capital due to the reduction in the rate of interest goes unreported. It should be clear that sweeping losses under the rug and kicking the garbage upstairs will not work as a permanent arrangement. The garbage will come crashing down from the attic in due course.

Firms live in a fools' paradise. The day of reckoning dawns when the entire capital has been consumed. Such a day, it should be recalled, dawned in 2007 when Lehman Brothers' denuding of capital was discovered. No proper diagnosis was made, losses were papered over and the regime of capital consumption through QE was resumed with a vengeance. Another day of reckoning, possibly even more devastating, is approaching. Society cannot continue living at the same level of comfort and security with capital so seriously impaired as ours is due to QE. If it tries, it makes the crisis of under-capitalization even more critical. Keynesianism is helpless as it has confused credit and capital, in particular, credit expansion and capital accumulation.

### Cause or Effect?

The greatest mistake of Keynesianism is the tenet that the cause of the Great Depression was falling prices due to oversaving. But falling prices were not the cause: they were the effect. The cause was falling interest rates, for which Keynesian fiscal and monetary policies were directly responsible: unbalancing the budget, inordinate increases in overall debt, monetization of government debt by the central bank.

Keynes' idea that open market operations cannot and will not have devastating side effects has become a dogma. This dogma must be discarded forthwith. Open market operations do have consequences, and these consequences are catastrophic.

Here is how open market operations of the central bank make bond speculation riskfree, thus causing destruction of capital across the board. Speculators figure out when the central bank is due to make the trip to the open market to purchase its next quota of bonds. They forestall the central bank by purchasing the bonds beforehand, with the idea of dumping them later with a hefty markup. Bond speculators keep pocketing risk-free profits to which they are not entitled as they have not performed any useful service. Rather, they have caused great harm. Bond speculation progressively replaces monetary policy as the driving force behind suppressing interest rates. It may frustrate “exit strategy” and “tapering”. The central bank is rendered helpless in facing raging deflation. In the worst-case scenario, risk-free bond speculation will disable the brakes on the runaway car careening downhill and crashing headlong into deflation. These aspects of open market operations are completely missed by economists (Austrian economists not excepted).

### Deflation or hyperinflation?

A frequently asked question is whether the international monetary system based on irredeemable currency is facing a deflation similar to that of the 1930’s, or whether it is on course towards a Zimbabwe-style hyperinflation. Most sound-money observers conclude that the latter is the case. However, a relentlessly increasing money supply is not the only prerequisite for hyperinflation. There is another: lack of suitable outlets for the bloated purchasing power. As risk-free bond speculation made possible by open market operations shows, no matter how much purchasing power is being created by the world’s central banks, speculators will always find rising bond values less risky to bet on than betting on rising commodity values. In the absence of wars

(civil wars) destroying stores of consumer goods as well as the park of capital goods producing them, the forecast is deflation, not hyperinflation.

In combating deflation the Fed resorts to counter-productive measures. More government debt is poison for a weak economy. Monetization of government debt will only feed bullish bond speculation and bearish commodity speculation, while doing nothing to rebuild the impaired capital base. Bullish bond speculation is responsible for the falling interest-rate structure and destruction of capital, to say nothing of the coming collapse of prices. Increased government spending is the wrong medicine. The right medicine is stable interest rates, more savings, frugality in public spending, and the accumulation of more capital. If it were not so tragic, one could rub in the irony that Keynesianism in trying hard to push the world into the pit of inflation has only succeeded in pushing it into the pit of deflation — the very same pit it was studiously trying to avoid.

### Nature abhors risk-free speculation

According to a Latin proverb, natura abhorret vacuum (nature abhors a vacuum). We may add that nature also abhors risk-free speculation in eliminating it just as quickly as it eliminates a vacuum. When on occasion the opportunity for risk-free speculation arises, the very action of speculators quickly removes that opportunity. Only the earliest bird get the worm. However, as we have seen, conditions for the perpetuation of risk-free speculation may be brought about institutionally short-circuiting nature.

This is the case with the open market operations of the central bank that frustrates the natural order of things. But nature cannot be abused forever. Sooner or later she will come out on top.

### According to another adage

“Whom the gods may want to punish,

First of all will make them go mad”.

That's the fate of the present leadership at the Fed. Men and women in charge of monetary policy exercise their usurped power in a way that is downright counterproductive.

They sow inflation and reap deflation.

### References

Is Our Accounting System Flawed? by Antal E. Fekete, [www.professorfekete.com](https://www.professorfekete.com), May 20, 2008.

The Federal Reserve As the Engine of Deflation (sic!) by Antal E. Fekete, [www.professorfekete.com](https://www.professorfekete.com), July 19, 2009.

Print Less But Transfer More: Why Central Banks Should Give Money Directly to the People, by Mark Blyth and Eric Lonergan, Foreign Affairs, Vol. 93, No. 5,

September/October 2014.

It begins:”Central Banks Should Hand Consumers Cash Directly” [www.zerohedge.com](https://www.zerohedge.com) , August 26, 2014.

Antal Fekete's Neo-Misesian Revisionism and Why He Believes It Is Necessary [www.thedailybell.com](http://www.thedailybell.com/exclusive-interviews/35163/Anthony-Wile-AntalFeketes-Neo-Misesian) Revisionism and Why He Believes It Is Necassary/ March 30, 2014.

### Notes

1. Thank Heaven for Helicopter Ben In 2002, in his first major policy speech after joining the Board of Governors of the Federal Reserve, Ben Bernanke spelled out that the only sensible solution to the country's massive debt problem was more debt, lots more. He was going to engineer an unprecedented inflation, quite oblivious of the deflationary consequences.

„If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open market operations in private assets...essentially equivalent to Milton Friedman's famous „helicopter drop of money”...

He did not elaborate how his hare-brained scheme would rain money on people made permanently unemployed by the Fed's open market purchases of government bonds under Quantitative Easing. Now we shall look at the other side of the same coin, from the point of view of the beneficiaries of the Fed's policy. The text printed in italics below is copyrighted material quoted from Stansberry's Investmen Advisory, October, 2013, [www.stansberryresearch.com](https://www.stansberryresearch.com). (Permission for reproduction is hereby gratefully acknowledged.) It is tongue-in-cheek, it is clever, it is vitriolic. It is in the form of a prayer addressed to Ben Bernanke the demigod, put into the mouth of a super-rich individual as he is boarding his private airplane, noticing that the cost of jet fuel has again been increased.

Dear Ben, thank you so much for providing us nearly limitless risk-free ways of growing our capital. Please, never for a minute doubt your ability to „help the economy” by printing more money, thereby making us so, so much wealthier. Never consider whether or not it's fair or proper for the government to impoverish millions so that the very privileged few can gain so generously. And never worry that what you have done will some day lead to a massive inflation and a collapse of the paper money system. While gas prices are making it more expensive to fly this jet, we understand the need to do our part. You can count on us, dear Ben. Amen.

Meanwhile, the people whom Ben fleeced the workers, the savers, the few Americans left with simple industry and thrift, the kind of folks who would never have believed the government would actively try to hurt them have been wiped out.

They have seen the real value of their wages, savings, standard of living decline by huge amounts...

Bernanke gutted the dollar. He gutted the middle class. He gutted the savings of millions. And he greatly impoverished our country.

And yet, despite it all, Ben Bernanke is still being proclaimed a hero of the Republic. „When faced with potential global economic meltdown, he has displayed tremendous courage and creativity,” said Barack Obama at a White House news conference. „He took bold action that was needed to avert another Depression”...

2. About the author Professor Fekete is a lifelong student of the phenomenon of interest. His theory eliminates the chasm between the time-preference school and the productivity school of interest. According to him the rate of interest is not monolithic but varies between a floor and a ceiling. The floor is determined by marginal time preference; the ceiling is determined by the marginal productivity of capital. Long before it could push the floor down to zero, the central bank will be frustrated in its rate-cutting fervor by the marginal bondholder. He would divest himself of all of his bond holdings and keep the proceeds in gold. He would release his gold only if the central bank desisted and let the rate of interest find its floor once again (known as the Fullarton Effect, after John Fullarton 1870-1849, who correctly rejected the Quantity Theory of Money, a line of thinking later followed by Carl Menger). Thus there is an inevitable nexus between gold and interest. It is not possible to stabilize the interest-rate structure without allowing a free flow of gold between the banking system and the general public. This effect works regardless whether a gold standard is formally adopted or not.

With due apologies to Horace we sign off with this thought: Aurum expellas furca, tamen usque recurret (You may drive gold out with a pitchfork, yet return it still will; c.f.: Epistles, Book I, x, line 24.)

3. Synopsis. Open market purchases of government debt by the central bank is a destructive deflationary policy in that: (a) it increases the liquidation value of debt, (that is, the cost of liquidating debt ahead of schedule), thus increasing the debt burden; (b) it makes labor's terms of trade to deteriorate and unemployment to increase indiscriminately across the board; (c) it causes the fading of depreciation quotas, thus contributing to the destruction of capital. It constitutes a systematic plundering of savers, producers and laborers. Whether it is done deliberately or unwittingly, it plunges the nation — and the world — into cataclysmic depression.

Beyond that, it contributes to the decline, possibly the fall, of our industrial civilization.

4. German version of this article can be found in the publication:

Das Edelmetall & Rohstoffmagazin, 2014-2015, GS Management GmbH&Co.KG,

07806 Neustadt an der Orla, Germany

---

# How the Fed Bankrupted the Insurance Industry

URL: https://newaustrianeconomics.com/archive/fekete/how-the-fed-bankrupted-the-insurance-industry/
Date: 2014-11-24
Section: Popular Economics
Difficulty: intermediate
Concept Tags: federal-reserve, interest-theory, capital-destruction, monetary-policy, fiat-currency
Description: Fekete examines the Federal Reserve's near-zero interest rate policy and its catastrophic effect on insurance companies, which depend on long-term fixed-income returns to meet future obligations. He argues this is not a side effect of monetary policy but its logical consequence: destroying all businesses that depend on positive real interest rates.
Editorial Note: Written November 2014 as the insurance industry's ZIRP problems were becoming acute. Fekete uses the insurance case to illustrate the broader capital-destruction mechanism of zero interest rate policy.
Original PDF: https://professorfekete.com/articles/AEFHowFedBankruptedInsInd.pdf

### “There’s no business like insurance business”

According to Warren Buffett the best business in the world is the insurance business. It is the only one with a negative cost of capital. The premium-income collected by the insurance company is put in capital accounts as if it were owned outright. Of course, ultimately that sum is paid out in claims. But in the meantime the insurance company pockets the return to capital which is what makes its capital cost negative. Insurance premiums held by the company as reserves before claims are coming in (maturing) is called the ‘float’.

In recent years through QE (Quantitative Easing) and ZIRP (Zero Interest Rate Policy) the Fed has succeeded in bankrupting the entire insurance industry.

Through a peculiar ignorance of mathematics (in which it is supposed to be eminently strong) the industry has failed to take notice of the capital destruction to which it has fallen victim.

The underwriter of a life insurance finds the regime of irredeemable currency beneficial for the bottom line. It collects premium in moneys of higher purchasing power while paying out benefits, perhaps decades later, in moneys of lower purchasing power. Warren (in contrast with his father Howard) is loath to criticize the highway robbery that the regime of irredeemable currency really is. Along with Keynes, he considers the gold standard a “barbarous relic”. Be that as it may, the destruction of capital, our subject here, is quite different from pilfering and plundering through currency depreciation. The latter operates through inflation; the former, through deflation.

Capital efficiency enhanced through compound interest has been called one of the great miracles of the world. What is much less talked about is the companion miracle, counterpoint to compound interest: the destruction of capital efficiency through a falling interest-rate structure.

### Suppressing the rate of interest increases the debt burden

Before describing the devastating effects of a falling interest-rate structure I wish to make a point on semantics. The language describing the ongoing suppression of the rate of interest in additive terms (spelling out “by how much”) is inappropriate.

It should be described in multiplicative terms (spelling out “how many times”).

Don’t say “the rate of interest was reduced from 1 percent by one half of one percent”. Say “the rate of interest was cut in half from 1 percent to one half”. The difference is significant. In the former case repetition will sooner or later bring interest down to 0 percent where the process stops. By contrast, it never stops in the latter case. Cutting interest in half can be repeated any number of times, still leaving the rate of interest positive. Zero interest will never be reached this way, yet each halving causes great damage to the economy. Zero interest is an oxymoron since interest is positive by definition. Negative interest is a misnomer confusing safe-keeping charges with the refusal to pay interest due.

Cutting the rate of interest destroys the capital efficiency of cash flows. We must carefully distinguish between the present value and the capital efficiency of a cash flow. The present value of a cash flow is defined as the sum of individual payments, each discounted at the current rate of interest for the period between now and the time when it falls due. Paradoxically, a decrease in the rate of interest will increase the present value of the cash flow for the simple reason that whenever we discount by less we end up having more!

With capital efficiency the case is the exact opposite. Capital efficiency of a cash flow is defined as the benefit derived from it whether in the form of a consumption stream, or whether in the form of amortization. Amortization could be compensation for losses due to wear and tear, or it could be amortization of financial capital such as repaying a loan through the cash flow of a blended payment of principal and interest.

How can a decrease in the rate of interest have the effect of destroying the capital efficiency of cash flows? Well, the present value of the cash flow is just the price one must pay when buying it. Paying a higher price for the same cash flow is a clear indication of the decrease in the efficiency of the purchase. It shows that the terms of trade of the purchaser has deteriorated. In spite of the utter simplicity of this concept it has been the source of great confusion and theoretical errors. We shall illustrate this fact through three examples.

### (a) the rate cut increases the liquidation value of debt

A cut in the rate of interest increases the price of bonds. Along with the increase in bond prices the liquidation value of bonds (that is, the amount the debtor must come up with if he wants to prepay, or liquidate, his bond) is also increased. This is just the other side of the coin as it is seen by the debtor.

The concept of a bond incorporates the right to liquidate the underlying debt at any time of the choosing of the debtor who can always purchase his bond back in the open market. Clearly, this right is meaningful only if the bond's marketability is unimpaired. That condition is satisfied as long as the rate of interest is stable. But no sooner had the central bank been given unlimited power to manipulate the rate of interest downwards through buying government debt than the right of the issuer of the bond was badly compromised. The debtor is no longer able to buy his bond back at a price anywhere near to the sum he received when he sold it. He will have to pay more. Here is the chain of events involved.

(1) The central bank buys government debt in the open market.

(2) The rate of interest is cut automatically and instantaneously.

(3) The rate-cut increases the present value of all bonds outstanding to the benefit of all creditors (bondholders), but to the detriment of all debtors (issuers of bonds).

The price of cash flows is increased unilaterally. Bond issuers will have to pay more, perhaps substantially more, if they want to get out of debt ahead of schedule in buying back their bond before it matures. The effect goes beyond the circle of bond issuers. All debtors who have borrowed at a fixed rate find themselves in the same hole. They are all trapped. There is a stealthy and indiscriminate transfer of wealth from debtors to creditors.

To add insult to injury, debtors are bombarded by government and central bank propaganda. “Stand still little lamb, the ‘haircut’ is good for you! You will love the lower interest-rate environment that is yours free of charge!” The truth is that, in effect, a great injustice has been perpetrated. A huge transfer of wealth from debtors to creditors has been put into effect underhandedly.

Debtors lack sufficient education (especially in mathematics) to realize that they have been taken for a ride. They meekly accept the 'haircut of the rate cut' as necessary. They swallow the propaganda. They may even feel gratitude towards the central bank for ameliorating their lot through Quantitative Easing, so called.

To recapitulate, the present value of the cash flow of interest income is arbitrarily increased by the rate cut, penalizing debtors. Indeed, it is this present value that they must pay if they want to retire their debt ahead of schedule, that is, if they want to buy back their obligation to pay interest. The destruction of the capital efficiency of interest payments is seen through the fact that the price they are coerced to pay for this privilege could be raised unilaterally without offering the slightest advantage in exchange. The terms of trade of the debtor has deteriorated.

The burden of debt has increased. We express this by saying that the liquidation value of debt becomes higher as a result of the rate cut.

This is a veritable revolution in finance. The economic and ethical consequences of the policy of Quantitative Easing should have been analyzed by the media, academia, as well as the juridical and canonical authorities. To the eternal shame of these institutions, they all remained silent spectators of this unprecedented travesty of justice.

### (b) the rate cut makes labor’s terms of trade deteriorate

No less, the present value of the cash flow of wages is increased by the rate cut, penalizing wage earners indiscriminately. In our conception the cash flow of wages comes about as a result of bargaining whereby the wage earner purchases the cash flow of wages against the delivery of his labor. The purchase price of the cash flow has just been increased by the cut in interest rates. There is no adjustment on labor's side of the bargain: the wage earner is supposed to deliver as before. This means that labor's terms of trade has deteriorated as a result of the rate cut by the Fed. Lowering interest rates is a clear setback for labor.

A simile may clarify this. Let us visualize the wage earner running on a treadmill the speed of which has just been stepped up. The increased speed of the treadmill is equivalent to increasing the present value of cash flows in the wake of the rate cut. The wage earner has to run faster just to keep abreast.

The Fed is making unemployment grow indiscriminately through the rate cut.

Marginal wage earners are laid off. Machinery financed at a lower rate, peddled by the central bank, replaces human labor for no better reason then the prolongation of the moribund regime of irredeemable currency. The bargaining power of labor is grievously undermined.

To make the case even worse, the wage earner and the labor movement are kept in ignorance about the true state of affairs. Pretense is maintained that our enlightened government has given a New Deal to labor which now has the legal right to collective bargaining through the agency of its unions, as well as to strike action if the former fails. The facts show a different picture. In a grave violation of the Constitution (talking about the situation in the United States) the right of people to silver and gold coinage has been taken away. Irredeemable paper currency has been foisted on labor and the issuer of that currency, the Fed, has been allowed to usurp unlimited power to purchase government debt, thereby cutting the rate of interest in half any number of times. As we have just seen, each halving of the rate of interest is tantamount to making labor's terms of trade inferior. Irredeemable currency is the ultimate cause of unemployment, as the central bank's monetary policy makes the marginal productivity of labor rise, thereby making marginal wage earners dispensable.

Labor is kept in total ignorance about these anti-labor policies. A monetary system that denies the right of the people to have their silver and gold converted into the coin of the realm at the Mint, one that enforces legal tender laws pretending that irredeemable government debt is the ultimate extinguisher of debt, and one which forces labor to accept irredeemable currency in settlement of wages ― is the slave driver of latter-day slavery.

To add insult to injury, wage earners are bombarded by government and central bank propaganda. “Stand still little lamb, the ‘haircut’ is good for you! You will love the lower interest-rate environment that is yours free of charge, courtesy of the Fed!” The truth is that, in effect, a great injustice has been inflicted on all wage earners. They have been victimized. Wage earners and their unions lack the necessary educational background to see through the ploy.

To recapitulate, an increase in the present value of wages reduces the capital efficiency of the cash flow of wages in the wake of the reduction in the rate of interest. Labor is penalized as a higher price for the same cash flow of wages is exacted without a commensurate reduction in the intensity of labor delivered. We express this by saying that labor’s terms of trade has been rendered inferior as a result of the rate cut.

Incredibly, there is total silence in the quarters of the media, academia, the juridical and canonical authorities. Moral indignation at the sight of pauperizing labor should cry to heaven for justice. Instead, we have connivance. These quarters have become accomplices of the usurper of unlimited power, the Fed, in tormenting labor. They will not escape the guilty verdict when the day of judgment arrives. (c) the rate cut makes depreciation quotas fade

The present value of the quasi-cash-flow of depreciation quotas is also increased by the rate cut. This penalizes entrepreneurs, the owners of the material factors of production: plant and equipment. The depreciation quota of a given factor of production is the amount periodically paid into the depreciation fund to cover losses through wear and tear. These recurring payments constitute a quasi-cashflow the present value of which is obtained through discounting. The depreciation schedule will not be met, however, because the rate at which discounting takes place is now lower, thanks to the rate cut. As a consequence, worn or obsolete capital is not renewed. This is capital destruction as I point out in my recent paper The Counter-productive Monetary Policy of the Fed, sowing inflation, reaping deflation (see References below).

The government is an accomplice in the fraud of undermining sound book-keeping principles. Its regulatory authority to stop it has never been invoked. Capital is being destroyed across the board unobtrusively and indiscriminately. It makes no difference whether firms are managed well or poorly, they will all go bankrupt for reasons of impaired capital. When the day of reckoning arrives, wholesale economic collapse follows. The culprit is the Fed's open market purchases of government bonds that has the effect of cutting the rate of interest leading to capital destruction across the board.

To recapitulate, as a consequence of the increase in the present value of the quasicash-flow of depreciation quotas, the capital accounts of productive firms are falsified. Present value is the price firms are paying for the benefit of amortizing losses due to wear and tear. This price is arbitrarily increased by the rate cut without making any changes in the benefit schedule. The capital efficiency of firms is reduced. We express this by saying that the rate cut makes the depreciation quotas fade.

Our productive firms have been the champions of great breakthroughs in science and technology. They recruited the best brains money can buy. It is well-nigh incredible that with all this brain power at their disposal they have remained blind to their own victimization through 'Quantitative Easing', destroying their capital efficiency. They are babes in the wilderness who have been charmed by the money-magic of impostors, dispensing uncounted trillions from the printing presses of the Fed.

The destruction of capital efficiency of the cash flow from underwriting We have just seen three examples showing how a rate cut by the central bank destroys the capital efficiency of cash flows. It is no different in the case of the cash flow of insurance premiums accruing to insurance companies. The latter are hit indiscriminately by QE and ZIRP. Since 2008 the rate of interest has been cut in half several times through the Fed’s open market purchases of government debt.

In each instance the capital efficiency of the float has been seriously undermined.

As a result the ability of the insurance companies to increase their capital base has been destroyed. The diagnosis is that the industry is a dead man walking. The prognosis is 'sudden death syndrome'. When it becomes known that it has been denuded of capital, the industry will follow Lehman Brothers to Hades (where the god of the dead, Hephaistos, reigns).

An ad hominem argument can be made that this scenario is indeed inevitable. The rate of interest is reduced through Fed open market purchases of government debt.

Thereafter the account carrying insurance premiums will be compounding at a reduced rate. It will increase more slowly. In addition, the capital efficiency of the industry is ruined. It has to pay more for generating the same premium-income while getting no relief in the form of risk reduction. In effect, the insurance industry is forced to shoulder ever more risks without the possibility of increasing premium income. Insurance companies are forced by Quantitative Easing, so called, to take ever greater risks just to keep abreast. But there is a limit to this imprudence. At one point the industry will find that it could no longer meet claims.

Under ZIRP insurance companies are deprived of any return to assets with no compensation in the form of a reduction of liabilities.

We include Excursus #1 and #2 to lay out the mathematics involved for the benefit of those readers who are not satisfied with the ad hominem argument.

Excursus on Mathematics #1.

Let us calculate the present value of a cash flow under the assumption that the rate of interest is p% per annum. The present value of \$1 payable a year from now is obtained by discounting the sum of \$1 at p% to get q = 1− called the discount factor. The present value of \$1 payable two years from now is

The present value of \$1 payable three years from now is and so on. In general, the present value of \$1 payable n years from now is qn.

The present value of the cash flow of \$1 per annum discounted at p% is the sum of an infinite geometric series (mark that 0 < q < 1):

We conclude that the present value of the cash flow is inversely proportional to p.

In particular, if the interest rate is cut in half by the Fed, then the present value of the cash flow is doubled. p q′ = 1 −

= ½p forces the discount factor to increase:

### = 1 — p/100 + ½p/100 = q + ½p /100 > q, and .

What does this mean for the capital efficiency of the cash flow? Well, it has been destroyed by the rate cut. The price the insurance company has to pay for the cash flow of premiums has been increased without any adjustment in coverage.

### How to skate on ice twice as thin

In practical terms the insurance company is forced to accept twice the amount of risk in exchange for the same cash flow of insurance premiums. It is forced to skate on ice twice as thin. Here are the details.

The insurance company is hit twice. On the one hand its float is earning but half what it did before the rate cut. On the other, the capital efficiency of the cash flow of premium income has been halved.

As we have seen, the present value of the cash flow has doubled. Recall that this present value is the price the insurance company has to pay for the privilege of collecting monthly premiums. Now this price has arbitrarily been doubled without countervailing reduction of risks underwritten.

The entire industry is hit indiscriminately, regardless of the quality of management.

Quantitative Easing had better be renamed ‘Quantitative Squeezing’ in so far as the insurance industry is concerned. Alas, all this is happening at a time when the industry is entering its ‘soft period’ when, thanks to lower demand for its services, it is not in a position to increase premiums to compensate for the capital erosion.

Presently the Fed announced the end of QE in the midst of much fanfare and hoopla. It was a hoax, a mere propaganda ploy. At any rate, the plight of the insurance industry will not be mitigated until ZIRP is unconditionally rescinded once and for all. To save the industry the effective rate of interest must be restored to a positive level commensurate with the risks underwritten. Unfortunately, such a change is not likely, given the obtuseness of the leadership at the Fed. A meaningful rise in the rate of interest would devastate the rest of the economy, especially the financial sector. Under the regime of the irredeemable dollar plummeting bond prices, a concomitant of rising interest rates, would make the thinly capitalized banking industry totally insolvent.

### Basic accounting principles thrown overboard

This is not idle theorizing about the future of the insurance industry. The danger is very real. The deterioration in the industry’s terms of trade becomes clear if we contemplate that the monthly payments of insurance premiums compound more slowly in the lower interest-rate environment. Funds may not be available to pay compensation when claims start coming in − to say nothing about the increase in risks the industry is forced to take. When the bad news is out, potential clients may draw the necessary conclusion about the wisdom of buying policies underwritten by insurance companies tottering at the brink of collapse.

Correct book-keeping demand that the insurance industry ought to augment its capital every time the rate of interest is cut by the central bank, in order to compensate for the reduction of capital efficiency. However, current practice ignores prudent guidelines. No such augmentation has ever been considered.

### Where did Warren Buffett go wrong?

Chances are that Warren Buffett is unaware of the danger threatening his insurance empire. He appears to have been an enthusiastic supporter of Q.E. He likes 30-year fixed-rate mortgages calling them ‘incredibly attractive’ − according to Stansberry&Associates (see References below). We quote: “Buffett says it is a win-win situation. If interest rates go up after you got the mortgage you win because you are locked in for 30 years at a great rate. And if interest rates go down, you win as well – because you can easily refinance at the lower rate.”

Assuming that the Sage of Omaha is quoted correctly, he has goofed. He made a most embarrassing mistake. If interest rates go down, you don’t win. You lose, and lose big, like all other Americans who listened to the siren sound and refinanced their fixed-rate mortgages at the lower rate. Rate cuts are ‘haircuts’ for all mortal debtors, including Buffett. The cash flow of debt-servicing payments amortize at a slower rate in the wake of the rate cut. As a result either the maturity of the mortgage must be put off or, if this is not an option, then the periodic payments on the mortgage must be increased.

Excursus on Mathematics #2.

We work out an example to show that, contrary to the allegation of Buffett, refinancing a fixed-rate mortgage at a lower rate of interest is disadvantageous.

Suppose that Buffett has a 10-year mortgage at p = 4% on a shopping mall with principal sum \$10 million = 107. Further suppose that the contract calls for payments at the rate of one per year covering interest only, with no amortization (so that in 10 years’ time the entire principal of \$10 million = 107 will fall due).

### The discount factor is q =

= 0.96. To get the present value of the cash flow we can write: since where we have used the formula for the sum of a geometric progression.

Suppose now that the Fed cuts the rate of interest in half: p' = 2%. Then the new discount factor is q' = 0.98 > q. To calculate the present value of the same cash flow in the lower interest-rate environment we write:

It can be seen that the present value of the cash flow of mortgage payments at 2% interest is times that of the same cash flow at 4% . A quick recourse to the pocket calculator reveals the approximate value 1.106. Refinancing the mortgage at the lower rate will cost that many times more.

In refinancing his mortgage at the lower rate Buffett will have to pay the present value of the cash flow of the mortgage payments at 2%. Since this is greater than the present value as calculated at 4%, he didn’t win. He lost.

Warren Buffett is in distinguished company. Along with him all of academia, all of the media and the financial writers also believe that refinancing a fixed-rate mortgage at the lower rate is 'good for you'. By implication, they also believe that falling interest rates are good for home-owners as well as businesses. Well, they are not. The Fed is playing with loaded dice. The Fed is a liar. The Fed is a plunderer, fleecing all debtors under false pretenses, through its ill-conceived QE and ZIRP.

As the saying goes, you get the government you deserve.

We may add that, for the stronger reason, you get the Fed you deserve.

---

We conclude that the present value of the same cash flow calculated at the lower interest rate of ½p% is M = times that calculated at the higher interest rate of p%. We write

### M = where

### =

### =

### N =

### =

### =

...

Let us get some estimates:

### References

█ Is Our Accounting System Flawed? By A.E.Fekete, [www.professorfekete.com](https://www.professorfekete.com), May 20, 2008 █ [www.Stansberry&AssociatesInvestmentResearch.com](https://www.Stansberry&AssociatesInvestmentResearch.com), October, 2014.

█ The Designated Losers of Central Bank Policy―Wage Earners and Savers. By Wolf Richter, █ The Counter-productive Monetary Policy of the Fed – sowing inflation, reaping deflation, [www.professorfekete.com](https://www.professorfekete.com), November, 2014.

---

*November 24, 2014.*

---

# The Wisdom of Adam Smith for Our Own Times

URL: https://newaustrianeconomics.com/archive/fekete/the-wisdom-of-adam-smith-for-our-own-times/
Date: 2014-06-18
Section: Popular Economics
Difficulty: intermediate
Concept Tags: real-bills, adam-smith, gold-standard, sound-money, new-austrian-economics
Description: Fekete revisits Adam Smith's monetary wisdom — the Real Bills Doctrine, the role of gold coin, and the critique of paper money — and shows its direct relevance to 21st-century monetary problems. Smith understood instinctively what modern economists have forgotten: that self-liquidating credit and gold-backed money are the foundations of stable prosperity.
Editorial Note: Written June 2014. Fekete's engagement with Adam Smith is a recurring theme — he sees Smith not as the father of free-market economics (the common view) but as the originator of the Real Bills Doctrine and sound monetary theory.
Original PDF: https://professorfekete.com/articles/AEFWisdomOfAdamSmithOurTimes.pdf

Richard Ebeling in the June 3rd issue of the Daily Bell under the same title contributed a much needed reminder of the relevance of Adam Smith's wisdom to our contemporary world. I am not going to speculate whether the omission of not mentioning Adam Smith's Real Bills Doctrine was accidental or deliberate. However, it is well known that post-Mises Austrian economists have taken a disdainful view of the Real Bills Doctrine and it would have been nice to have Ebeling's coherent articulation of their position. I can do no better than revisiting Adam Smith's great contribution to the theory of money and credit (which, significantly, received the nihil obstat of Carl Menger a hundred years later) for the benefit of the Daily Bell's readership.

### Consumption as a source of credit

Adam Smith's insight that consumption, next to savings, is another fundamental source of credit was one of the great discoveries of economics, comparable in importance to Carl Menger's subsequent discovery of marginal utility as the source of value. We owe the concept of social circulating capital (SCC) to Adam Smith. By this he meant that part of the flow of consumer goods in most urgent demand that is moving sufficiently fast to the ultimate consumer so that it will be removed from the market in 91 days (the length of the seasons of the year in our temperate zone). For example, items like bread, seasonal garments and firewood in winter will unquestionably be consumed in definite quantities and do thus belong to SCC; items like grain held for speculative gains, unsold garments left over from the previous season and firewood in summer do not. Producers and distributors handling goods that form part of the SCC enjoy special privileges and have special responsibilities due to the special place their product occupies in the constellation of economic goods. They don't have to face uncertainties and don't have to carry risks all other producers and distributors have to face and carry. They do not finance their production under the relatively harsh terms of the interest-rate regime. They can finance it under the relatively more lenient terms of the discount-rate regime.

SCC has been compared to a great river that empties into the infinite ocean of consumption. The salinity of water undergoes important changes downstream as the river gets within earshot of the ocean. Fish habitat prospering in these waters changes. Similarly, important changes occur in the type of credit financing production and distribution of goods downstream as the ultimate consumer is getting ready to remove them from the market in less than 91 days. In particular, the gold coin need not be saved in advance of production. Financing is done retroactively with the gold coin released by the ultimate consumer.

### Drawing a bill

The wholesale merchant delivers the finished good to the retail merchant (or the higher-order producer delivers the semi-finished good to the lower-order producer).

Adam Smith observed that hardly ever does the latter pay with gold coins, and never does the former demand payment in gold coin. Invariably the former, called the drawer, bills the latter, called the acceptor or the drawee of the bill. The face value of the bill is payable in gold coin upon maturity, not more than 91 days later. The signature of the acceptor acknowledges receipt of goods listed on the face of the bill.

It also acknowledges his responsibility for payment. The bill so accepted is returned to the drawer. Only in the rarest of instances would the drawer keep the bill and present it for final payment upon maturity ─ as observed by Adam Smith. More commonly, he would offer it to his own suppliers in payment when replenishing his inventory. They would be glad to take it because they know that they themselves could likewise use it when it is their turn to replenish their depleted inventory. In other words, the bill goes into spontaneous monetary circulation. Paying the supplier with a maturing bill drawn on a third party is called discounting it since the face value is subject to discount by the number of days remaining to maturity. Discounting is accompanied by the endorsement of the bill on the back, signifying the last endorser′s transferring the title to bearer. When the bill matures, face value is typically paid by the drawer′s bank, often the first endorser of the bill.

To suggest that the drawer extends a loan to the drawee, and that the discount represents interest taken out of the loan up front, is a travesty as Adam Smith and Carl Menger would readily confirm. If anything it is the drawee who is in the stronger position, by virtue of being closer to the ultimate consumer on whose gold coin the whole transaction turns. After all, it is this gold coin that will liquidate a whole string of claims upon maturity. As the bill is passed along from one endorser to the next, the underlying semi-finished good assumes ever greater marketability. The drawee is handling goods more marketable than that handled by the drawer. Put in this light, it is preposterous to suggest that the drawee is a debtor and the drawer is a creditor. The transaction under consideration is definitely not one of borrowing. It is one of clearing: the process of canceling claims and counter-claims at maturity among various parties to the same deal. Their relationship is one of cooperation between collaborators; not one of confrontation between creditors and debtors.

Nor is savings the source of commercial credit. The true source is consumption. The intensity of the demand for consumer goods is the driving force, fully capable of creating its own source of credit quite independently of savings. It is conceivable for commercial credit to exist even in the hypothetical absence of savings. The error in confusing interest and discount, although quite common, could be fatal as I shall show below. The rate of interest is a measure of the propensity to save while the rate of discount is a measure of the propensity to consume. Although in either case the rate varies inversely with the propensity, yet the two rates spring from entirely different sources, and are shaped by entirely different forces.

### How does discount arise?

Discount arises in the first place as an option of the retail merchant to prepay his bills. When due to overwhelming consumer demand he finds himself in the position that his till spills over with gold coins, he will offer to discount his bills, that is, to prepay face value discounted by the number of days left to maturity. Implicit in discounting is the discount rate at which the discount is calculated. The fact that the retail merchant insists on a concession in the form of a discount is not due to time preference. Rather, it exclusively is due to the fact that the alternative of buying a bill with the same maturity drawn on a fellow retail merchant at a lower price is available to him.

Adam Smith's theory of commercial credit independent of savings was pejoratively named the Real Bills Doctrine by its detractors. They flatly denied the spontaneity of bill circulation. They vehemently insisted that the discount was due to time preference and nothing else. They condemned the whole scheme as a conspiracy, a backhanded way to inflate the money supply. This criticism is plainly wrong: a real bill arises simultaneously with the emergence of new merchandise and it expires together with the removal of that merchandise from the market by the ultimate goldpaying consumer. Inflation of the money supply does not enter into it. This fact makes the real bill the next best thing to the gold coin itself. In one sense it is even better: it earns a return in gold.

Existence of commercial banks is not a prerequisite to bill circulation. But if banks are given, then they cannot have better earning assets than real bills to cover sight liabilities. The demand for real bills is virtually unlimited, so that the banks can get ready cash by selling bills from portfolio if they run into unusual drain of gold.

Indeed, demand for real bills comes not only from other commercial banks experiencing unusual increase in their gold reserves. Demand also comes from anyone with gold obligations to be met at a future date. For example, issuers of bonds to mature during the next quarter do not accumulate gold itself in anticipation of their obligation. Rather, they accumulate real bills with the same maturity.

SCC is not a fixed quantity. It waxes and wanes together with changes in the propensity to consume. The appearance of marginalism a hundred years after the Wealth of Nations was published presented an opportunity to refine Adam Smith’s theory of commercial credit by introducing concepts such as the marginal item in

SCC, the marginal retail merchant, the marginal productivity of SCC. In particular, the marginal retail merchant is seen as doing arbitrage between SCC and the bill market. At the first sign of falling consumer demand he withdraws his standing order for marginal goods on his shelf and redeploys his capital in the bill market instead.

Conversely, when consumer demand picks up again, he will liquidate part of his bill portfolio and orders new marginal merchandise displaying it on the shelves. Clearly, this arbitrage is the engine behind the variation of the discount rate. Note that the discount rate is much more nimble than the sluggish rate of interest. It depends directly on the caprice of the consumer. This observation challenges the traditional supply/demand equilibrium theory of price: changes in demand act not on the price but on the discount rate. The extension of Adam Smith's thought to incorporate marginalism culminates in the theorem stating that the discount rate is equal to the marginal productivity of SCC. An increase in marginal productivity means that the marginal item drops out from SCC so that the productivity of the new marginal item is relatively higher than that of the old was. Conversely, a falling discount rate sends a telegraphic message to all producers and distributors to increase their offering: 'consumer confidence' is on the rise once again. Incidentally, this is the reason why the price of fuel is normally not higher in winter than it is in summer ─ predictions of the supply/demand equilibrium theory of price notwithstanding.

### Relevance of Adam Smith's Real Bills Doctrine in our own times

The first casualties of the Guns of August one hundred years ago, in 1914, were the real bills financing, as they did, world trade in consumer goods. This was not in itself surprising. What was surprising, however, was the failure of real bills to reclaim their former paramount place in financing world trade after the cessation of hostilities in 1918. In retrospect it is abundantly clear that there was an unannounced political decision made behind closed doors to block the international trade in real bills.

Without such a decision real bills would have started circulating spontaneously. Real bill financing of trade is synonymous with multilateral trade. The victorious Entente powers wanted none of that. They wanted bilateral trade instead. They were scared stiff of German competition. They thought they could control German exports and imports that way. According to the terms of the peace treaty they had to lift their blockade on Germany but, at the same time, they could block the international bill market to the same effect ─ and they did. Real bills were not allowed to make a comeback during the intervening one hundred years. Scarcely did the victorious Entente powers realize that in blocking the bill market they were shooting themselves in the foot. Their action destroyed the Wage Fund, thereby causing horrendous unemployment and the Great Depression of the 1930's. In the meantime a formidable official propaganda machinery was launched to discredit Adam Smith's Real Bills Doctrine. Economists of the Age of Keynes, Austrians included, failed miserably to discharge their duty to search for and disseminate truth. It never occurred to them that there was a reason why 'structural unemployment' prior to World War I was unknown and non-existent. Real bill trading effectively eliminated that threat.

Economists should have made the fact clear that the Great Depression was in effect caused by the destruction of the Wage Fund ─ a direct consequence of the unannounced decision to block international trade in real bills. Workers producing the great mass of consumer goods cannot wait three months for their wages to be paid, until after their product is sold for cash. The fact that they could be paid weekly (and the fact that there was no structural unemployment before World War I) was entirely due to the existence of the Wage Fund consisting of real bills in circulation. The unannounced decision to block the bill market sealed the fate of the workers. The Wage Fund having thus been destroyed left no one around to advance the wages of the workers. Unprecedented unemployment ensued − following the unprecedented blocking of the bill market. Structural unemployment has been artificially created that was to plague the world for the next one hundred years. A very high price was exacted for ignoring the wisdom of Adam Smith. The great damage caused by the forcible elimination of the bill market has gone unrecognized for a century. It all boils down to the fatal confusion between interest and discount, between bilateral and multilateral trade.

The way towards building a better world in the twenty-first century leads through the unconditional and full rehabilitation of Adam Smith’s Real Bills Doctrine. Starting with the most marketable staple goods: food, fuel and fodder, real bill financing of world trade must be reintroduced. Since real bills must mature in gold coins (it would be preposterous if they were made to mature in an instrument of lesser marketability – and irredeemable currency notoriously has badly impaired marketability), gold coin circulation must also be restored.

Only then will future generations be able to look back on our insane experiment with global irredeemable currency in the twentieth century as a brief reactionary episode, trying to expunge the wisdom of Adam Smith from the consciousness of mankind.

---

*June 5, 2014.*

---

# Thank Heaven for Gold Manipulators

URL: https://newaustrianeconomics.com/archive/fekete/thank-heaven-for-gold-manipulators/
Date: 2014-04-09
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, gold-standard, central-banking, monetary-crisis
Description: In a deliberately provocative essay, Fekete argues that gold price manipulators have inadvertently served the cause of monetary reform by demonstrating the desperation of the paper money system. Their manipulation has not prevented gold's monetary resurrection but merely delayed it while providing evidence of the system's fragility.
Editorial Note: Written April 2014. The contrarian title is characteristically Fekete — finding the silver lining in gold suppression by arguing that manipulation itself is evidence of gold's continuing monetary relevance.
Original PDF: https://professorfekete.com/articles/AEFThankHeaven.pdf

This rejoinder was prompted by the Daily Bell interview with Bill Murphy of

GATA (March 30, 2014).

I shall accept, for the sake of argument, Murphy’s premise that the dollar price of gold is heavily manipulated by the U.S. government in order to keep it in check. But while Murphy thinks that it is a great curse I shall argue, tongue in cheek, that it is a blessing in disguise. The difference between Murphy’s thinking and mine is the difference in financial survival strategies in the face of the U.S. government’s deliberate policy of destroying the dollar and, along with it, the savings and pension rights of people, to say nothing about destroying the world economy.

Apparently Murphy believes that there is only one reasonable investment strategy in gold, namely, buy and hold in the hope of huge capital gains. However, this strategy turns people into sitting ducks for the manipulators. They engineer violent changes in the dollar price of gold. They squeeze holders. They make them buy high and sell low. In a sense, people fall victim to their own faulty understanding of gold. True understanding makes a distinction between the price and the value of gold. The latter is constant (to the extent there are constants in human affairs); the former is the reciprocal of the wobbly value of the irredeemable dollar. When the dollar is down and falling, the gold price is up and rising, and conversely. The mistake most gold bugs make is that they identify the value of gold with its price. No wonder they fall victim to the manipulators’ tactics and consequently get separated from their gold, sometimes with severe losses. No wonder they consider manipulation a curse, even a criminal activity, and try to use legal means to stop it. That’s what GATA is about. Needless to say, this effort is an exercise in futility. It makes manipulation more pervasive, not less. The manipulators are emboldened by the success of their own tactics. Gold bugs get frustrated.

However, a true understanding of gold recognizes that the gold-price manipulation scheme, far from being a curse, can be a blessing in disguise. It is not a sign of strength. On the contrary, it is a sign of weakness. A metaphor from physics may help. Take the example of the tide-ebb phenomenon. It is motion representing energy. It can be tapped. If it is not, the reason − to be blunt about it – is our own stupidity. Likewise, the artificial gyration induced by the manipulation in the gold price also represents energy that can be harvested.

There is a valid strategy, missed by Murphy, which does just that. It may not fully satisfy the get-rich-quick artist who dreams about \$2K, \$5K and \$50K gold.

Rather than generating capital gains this strategy generates a steady income. And here is my main point: because a falling price is motion just as surely as a rising price, it also represents energy ready to be harvested. The alternative strategy works in a bear market as well as it does in a bull market.

So how does this alternative strategy work? Well, it consists in writing options on gold. In more details, the holder (hereafter “ writer”) writes call options on his holdings of gold. There are two cases to consider: either the options expire worthless, or they expire in-the-money and are exercised. There is no problem in the first case. The option premium accrues to the writer free and clear. It represents income derived from the strategy. As the gold is no longer encumbered, the writer can write new call options to replace the expired ones without delay.

There is a problem in the second case. The gold is gone. Here is how the problem can be handled. As soon as the gold is called away the writer writes put options on the same gold at the same strike price. Again, there are two cases to consider: either the options expire worthless, or they expire in-the-money and can (must) be exercised by the writer. There is no problem in the first case. The option premium accrues to the writer free and clear. It represents income derived from the strategy. But as the cash margin is no longer encumbered, the writer is free to write new put options to replace the expired ones without delay.

There is no problem in the second case either. The writer has recovered his gold at the same price he had been forced to sell it earlier. The bottom line is that the writer ends up with the same gold he started with, but he is richer by the income that he has in the meantime derived from his strategy. Now he is back at square one. He is ready to repeat the process. He can continue as long as the manipulation lasts.

Critics of the scheme argue that there is a risk involved, namely, the option market could default on the put options in which case the writer loses his gold.

However, this risk can be avoided if the writer simply puts up a cash margin instead of putting up the physical gold as security against his contract. He may even store his gold safely off-shore. Of course, if the option market defaults, the strategy must be continued in another country. It is most unlikely that all countries would ban gold option trading simultaneously. Asian markets, for example, would only be too glad to increase their market share if authorities banned gold option trading in the U.S. For the same reason it is also most unlikely that gold option trading in the U.S. would be banned.

Another criticism is that the strategy assumes that the Principle of Reverting to the Means holds. But (so the criticism continues) this is a statistical principle and there is no guarantee that it will kick in during the life-span of the writer, during which the gold price may keep rising or falling without interruption. This is true. But the income derived from option-writing will continue nevertheless. If it is an uninterrupted rise, the put options will keep expiring worthless; if it is an uninterrupted fall, the call options will keep expiring worthless. In neither case will there be an interruption in the flow of income.

The only case in which the strategy would fail to deliver income would be if the dollar price of gold was stabilized. That is, when a de facto gold standard emerged and manipulation was defeated.


---


I have it on good authority that the alternative strategy described above is not a phantom. It is a real strategy practiced by real people producing a real income.

Moreover, the greater the manipulation, the greater is the volatility of the gold price and, hence, the greater is the income derived from option writing.

This is no perpetual motion. The dollar price of gold got destabilized in 1971 when the U.S. government fraudulently defaulted on its international gold obligations (hard on the heels of its 1933 fraudulent default on its domestic gold obligations). Fraudulent, because the U.S. Treasury did have the gold it owed, making it a clear case of embezzlement. Worse still, in the 1971 episode the gold belonged to people not under the jurisdiction of the U.S. government, making it a clear case of piracy. It is this fact that explains the raison d’être for the policy of manipulating the dollar price of gold. The manipulation of the gold price is nothing but the effort of the defaulting banker to maintain the value of its dishonored paper by hook or crook. The gain of the writer of options is simply compensation for damages from the ill-gotten gains of the defaulting banker.

The Scottish adventurer John Law had to put on female garments to escape the wrath of people chasing him out of Paris. I wonder what garment the manipulators will wear when it is their turn to make their escape from Washington.

The Bill Murphys and Ted Butlers got it all wrong when they cry “bloody murder” at the sight of manipulation. They confuse cause and effect. They are knocking the effect, namely manipulation, whereas they ought to be knocking the cause, namely fraudulent default. But dishonesty carries with it its own punishment. The gold-price manipulation is a stupid self-defeating policy as the pile of ill-gotten gold is drawn down through the involuntary gifts the U.S. Treasury is paying to people who have correctly diagnosed the greatest embezzlement in world history, the crime of 1971.

I may add in closing that very few people realize the opportunity presented by the dishonesty of the U.S. government in committing and then trying to cover up the crime. Very few people are capitalizing on the manipulation of the gold price through the strategy of option writing. Moreover, those who do hold their cards very close to their chest. They advertise neither what they are doing nor the fact that their strategy is extremely lucrative. They shun the floodlight, such as mine, focused on their activities.

Manipulation or no manipulation, the regime of the irredeemable dollar is doomed. The existence of the loophole of option-writing is one proof of this fact; there are many others.

The ultimate demise of the policy of manipulation in no small measure is due to the self-same manipulation. As in no small measure is it is also due to the utter stupidity of the manipulators.

Cuenca, Ecuador, April 10, 2014.

*Note. My criticism of GATA for attacking manipulation rather than the original sin of fraudulent default should not be misconstrued as a denial of the fact that GATA is doing some excellent work in exposing the death throes of the international monetary system based, as it is, on the irredeemable dollar, and the futile effort of the U.S. government to dodge the inevitable. A good review by Chris Powell of this saga is referenced in the Daily Bell interview mentioned in the first line of this commentary above.*

---

# What Constitutes a Money Crank?

URL: https://newaustrianeconomics.com/archive/fekete/what-constitutes-a-money-crank/
Date: 2014-04-08
Section: Popular Economics
Difficulty: accessible
Concept Tags: new-austrian-economics, gold-standard, fiat-currency, sound-money
Description: Fekete examines the 'money crank' accusation — the dismissal of unconventional monetary thinkers as cranks — and argues that the real cranks are those who defend the indefensible: an irredeemable currency system that destroys capital, produces recurrent crises, and cannot be reformed without returning to gold. The history of monetary thought shows who the real cranks are.
Editorial Note: Written April 2014. A polemical defense of unconventional monetary thinking, turning the 'money crank' accusation back on the mainstream.
Original PDF: https://professorfekete.com/articles/AEFNewMoneyCrank.pdf

(Excerpted from: blogger@nakedcapitalism.com, April 8, 2014. The author is a research assistant at Kingston University in London.)

What constitutes a money crank? A money crank is a person who views the money system from a position in which [he] has a substantial emotional investment. Was Keynes a money crank? I think not…Were Milton Friedman and Anna Schwartz money cranks? I would answer in the negative…Murray Rothbard is, I believe, a money crank. But he is of a more softcore variety. On the left is Sylvio Gesell, albeit he is [also of] a more softcore variety.

Antal Fekete is what I would consider a hardcore money crank. In his poorly written work The Gold Standard Manifesto: “Dismal Monetary Science” he writes:

“Governments and academia have utterly failed in discharging their sacred duty to provide a serene environment for the search for and dissemination of truth regarding economics in general and monetary science in particular. This failure has to do, first and foremost, with the incestuous financing of research ever since the Federal Reserve System was launched in the United States in 1913… Under the gold standard government bonds were the instrument to which widows and orphans could safely entrust their savings. Under the regime of irredeemable currency they are the instrument whereby special interest fleeces the rest of society.”

Or, again,

“Unknown to the public, at the end of the day the shill alias the Federal Reserve, is obliged to hand over her gains to the casino owner alias the United States Treasury. There is nothing open about what is euphemistically called ‘open market operations’. It is a conspiratorial operation. It has come about through unlawful delegation of unlimited power, without imposing countervailing responsibilities. It was never authorized by the Federal Reserve Act of 1913. It defies the principle of checks and balances. It is immoral. It is a formula to corrupt and ultimately to destroy the Republic.”

Such passages are pretty off-the-wall. The money system is portrayed as a vast conspiracy set up to defraud widows and orphans. Here we see that Fekete is far more hardcore than Rothbard. Whereas both agree that the government “meddles” with money and this is undesirable and leads to some sort of personal injury, Fekete goes one step further and portrays the system as an organised conspiracy set up against the vulnerable.

Reproduced here without commentary.

---

# Menger or Mises

URL: https://newaustrianeconomics.com/archive/fekete/menger-or-mises/
Date: 2014-03-30
Section: Popular Economics
Difficulty: scholarly
Concept Tags: new-austrian-economics, mises, real-bills, gold-standard
Description: Fekete argues that Carl Menger, not Ludwig von Mises, is the proper foundation for a complete monetary theory. While Mises made important contributions, his dismissal of the Real Bills Doctrine and his regression theorem contain errors that Menger's original framework does not. Returning to Menger provides a stronger basis for understanding gold's monetary role.
Editorial Note: A Daily Bell interview from March 2014. Fekete's preference for Menger over Mises as the foundational figure of Austrian monetary theory is a central but often underappreciated aspect of the New Austrian School's intellectual identity.
Original PDF: https://professorfekete.com/articles/AEFMengerOrMisesDailyBell.pdf

## M E N G E R O R M I S E S?

### Interview of the Daily Bell with professor Antal Fekete

---

*March 30, 2014*

Daily Bell: Hello, there, Dr. Fekete. The following questions are taken from some recent writings that you shared with us. Let's jump right in. You want to focus, among other things, on Richard Ebeling and the gold standard in this interview?

Antal Fekete: Yes.

Daily Bell: In a recent Daily Bell interview <[www.thedailybell.com](http://www.thedailybell.com/exclusiveinterviews/35030/Anthony-Wile-Richard-Ebeling-on-Austrian-Economics-EconomicFreedom-and-the-Trends-of-the-Future/)>, Dr. Ebeling talks about his book Political Economy, Public Policy, and Monetary Economics: Ludwig von Mises and the Austrian Tradition (Routlege, 2010). He elaborates on the advantage of a monetary system based on a commodity like gold. Ebeling summarizes this advantage as follows: "The gold standard makes it more difficult for a government to arbitrarily change the quantity and therefore the value of money used within a country." What's your take, please?

Antal Fekete: While this is true, it is only a very small part of what the gold standard does or can do for a free and prosperous world economy. I take exception to the suggestion that a change in the quantity of money necessarily means a change to the value of money.

Daily Bell: What's the difference between Mises and Menger when it comes to gold?

Antal Fekete: The obvious difference is the apparent blindness of Mises to what Menger sees very clearly that money must be not just a commodity; it must be the most marketable commodity, the marginal utility of which is virtually constant. Mises categorically stated that constant marginal utility is contradictory in that it indicates infinite demand. Mises would be right only if interest as an obstruction to infinite demand would not play a part in all this. But it does. Mises ignored the nexus between gold and interest altogether. I believe Menger had this nexus very much in mind, although he died before he could elaborate on it.

Daily Bell: It is not well known but Menger was not a devotee of the Quantity Theory of Money (QTM). Can you explain Menger's view?

Antal Fekete: While Menger was not as emphatic in denying QTM as I am, you cannot find any support for QTM in his writings.

Daily Bell: You write that post-Mises Austrians shy away from Menger's theory of marketability in favor of the QTM. In doing so they deprive themselves of a most efficient analytical tool. What do you mean by this?

Antal Fekete: Any argument that appeals to or needs to be supported by QTM is wrong or incomplete. Perhaps it is sometimes helpful to use ad hominem arguments to make an idea appeal to the “galleries”. However, there is a difference between a scientific argument and one that is meant only as a first approximation to truth.

I find it regrettable that post-Mises Austrians avoid using arguments involving the concept of marketability just because Mises did not use it and appealed to the concept most sparingly. I believe that most of their arguments using QTM could be reconstructed in terms of marketability once they define money in terms of the standard coin made of the most marketable metal. This is, of course, a paradigm shift that they have not been able to bring themselves to accepting.

Daily Bell: You write that, strictly speaking, QTM is not a theory. It is hardly more than a clever metaphor. Can you explain?

Antal Fekete: There are lots of cases when appeal to a clever metaphor can be helpful in popularizing a difficult concept. Take this, for example: ”Archimedes discovered that objects submerged in water ‘lose’ weight”. Strictly speaking this is not true, as we well know. Yet we repeat it constantly. No harm done. When I castigate QTM all I am saying is that such popularization must not be elevated to the level of scientific discourse. Mises said that his 1912 book on money and credit updated the vulgar form of QTM that was in the vogue before. He was a pioneer in taking it into account that an increase in the supply of money does not immediately raise prices, nor does it increase them in the same measure across the board. But this is only one of the shortcomings of QTM. Mises fails to mention that it could happen that no commodity price-increases take place at all in the wake of an increase of the money supply. Speculators grab the new money that has been created and run with it to the real estate market or to the money market. I can no longer say “no harm done”. Very serious harm is being done if we ignore speculation with regard to QTM, for example, in appraising “open market operations” of centreal banks, or Keynes’ concept of the “euthanasia of the rentier” through government-suppression of the rate of interest.

Daily Bell: You write that Ebeling's choice of a 100 percent gold standard is a major departure from Adam Smith's Gold Bills Doctrine, and from Menger's position as well.

### Can you explain?

Antal Fekete: I think that it is obvious that Ebeling dismisses Adam Smith’s Gold Bills Doctrine, although he does not say this explicitly. As concerns Menger’s position, he in his encyclopedic entry Geld dated 1909 explicitly states that the major part of the assets of a commercial bank, as well as that of the central bank, consists of gold bills maturing daily, and only a minor part consists of gold coins. This he considers not only an acceptable practice but, following Adam Smith, also inevitable as the volume of goods moving to the ultimate consumer financed by gold bills and commercial bank credit based on such gold bills is far from being constant. It shows seasonal variations as well as changes in what we may call, borrowing Keynes’ felicitous phrase, the “propensity to consume”. You cannot reconcile the variable demand for commercial credit with the idea of “100 percent gold standard”.

Daily Bell: Explain the nature of the market for gold bills and also Real Bills.

Antal Fekete: I have recently made the innovation of dropping “real bill” in favor of “gold bill” at the suggestion of my student Paul Bouvet. For one thing, the term “gold bill” makes it clear that the bill must mature into gold coins. For another, the term real bill was introduced by detractors of Adam Smith, in particular, Lloyd Mints of the University of Chicago, the mentor of Milton Friedman. The adjective “real” is used by them pejoratively. Monetarists and other devotees of QTM do not believe that money has quality (whether real or not so real). They believe that the only attribute money can have is quantity. True followers of Menger know that various currencies also have marketability and can be ranked accordingly. Top marketability belongs to the standard gold coin. Second to it is the gold bill that circulates spontaneously through endorsing subject to discount. That makes it an earning asset (which the gold coin, in and of itself, is not). Moreover, the gold bill is the best earning asset a commercial bank can have.

Daily Bell: Why is there a prejudice among Misesians against Real Bills?

Antal Fekete: That is a mystery. One reason may be their iconoclastic reverence of Mises who dismissed real bills, although he acknowledged that they circulated in Lancashire among traders of wool products of higher degree (such as spinners, weavers, cloth merchants) in payment for semi-finished goods before the Bank of England opened its branch office in Manchester. Another reason may be the observation of Mises that the revenues of a commercial bank ought to be derived entirely from fees for services. In his view gold bills had no place in the portfolio of a commercial bank as backing for credit outstanding. This, in spite of Smith and Menger saying, approvingly, that commercial banking should be based on discounting real bills (and central banking on re-discounting them).

Daily Bell: You are partial, it seems, to the old gold standard that existed before World War I, even though Dr. Ebeling points out that it was just a "government-managed monetary system through a series of national central banks." Most anarcho-capitalists would agree with his assessment, not yours. You are more favorable to this sort of standard. Why?

Antal Fekete: I am not partial to the gold standard as it was practiced before 1914. I have criticized it severely; in particular I criticized the 1909 decision, first by France quickly followed by Germany, to make the note issue of their central banks legal tender. This seemingly invalidated the Gold Bills Doctrine as it pretended that gold bills could mature into paper. But it is preposterous to suggest that one kind of paper could “mature” into another kind of paper of lesser marketability. I am also very critical of the policy, observable long before 1909 already, to wean the public off gold coins in order to concentrate them in the coffers of the central bank. Not only was it the legal right of bearer to get gold coins in exchange for bank notes and bank deposits; it was also an integral part of the operation of the gold standard. The flow of gold coins back-and-forth between bank reserves and the general public was the means whereby the latter could assert its prerogative of regulating credit. In my book “gold standard” means, among others, that outstanding credit (as well as the rate of interest) is determined by the general public and not by the banks, or the central bank; not even by a well-meaning government.

I maintain my position that before 1909 in the major trading counties the government was not “managing the monetary system”. To insist that it was is a gross distortion of historical facts.

Daily Bell: You believe that Dr. Ebeling wishes to ban gold bills. Does he really suggest this – and if so, why?

Antal Fekete: To my knowledge Dr. Ebeling has never acknowledged the historical fact that gold bills came into existence spontaneously and were capable of monetary circulation without government interference. Please correct me if I am wrong. On the other hand, Dr. Ebeling obviously thinks that gold bills are inflationary and therefore detrimental to the public interest. I am just drawing the logical conclusion that he would ban them if he had the power to do so. My apologies if I read Dr. Ebeling’s mind incorrectly. Please ask him why he thinks he knows better than the producers of goods of higher order did who accepted payment in gold bills and did not insist on getting paid in gold coins.

Daily Bell: You have kind words for "central banks in 1914,” writing that they were "not the malevolent Moloch with unlimited power they are today." Here's more: "Most of them were operated as regular profit-making business without special privileges. They did not take the initiative to create credit in feeding the money market with arbitrary bond-purchases and they did not foist their credit upon society as they do today.

According to the mandate laid down in their charter they were supposed to state the terms on which they were willing to do business (read: they posted their discount rate) and stood back, letting the commercial banks do the rest." The question that arises is whether a "charter" is not a kind of government force. If one is forced to use central banks, isn't this antithetical to the voluntary participation in the economy as suggested by Adam Smith's invisible hand?

Antal Fekete: A charter may or may not represent force by the government. Trading partners in the world before 1914 who drew and accepted gold bills on London in financing world trade were not using the services of the Bank of England. They were avoiding it. If commercial banks subsequently rediscounted these gold bills at the Bank of England, it was their choice, not the result of coercion.

Daily Bell: You believe that central bank problems arose after World War I. Can you elaborate?

Antal Fekete: As I already pointed out, central bank problems arose even before World War I, for example in 1909 when the notes of the Bank of France and the German Reichsbank were made legal tender in those countries for all debts, private and public.

Further very serious problems with central banks arose during World War I, especially in the United States. The Federal Reserve (F.R.) banks started putting their credit at the disposal of the Entente powers to finance their purchases of war material in violation of the F.R. Act of 1913, to say nothing of violating the Neutrality Act, practically the same day as war broke out in Europe in August, 1914. When later the U.S. joined the conflict, Liberty Bonds were accepted as valid basis for F.R. credit – illegally. Gold bills subsequently were crowded out from the portfolio of the F.R. banks.

After the war was over, all semblance of legality was abandoned in the U.S. “Open market operations” were introduced in 1922. This was in clear violation of the F.R. Act of 1913 which purposely excluded government bills, notes and bonds from the list of eligible paper. To put that gross violation of the law into context I mention the fact, stonewalled by mainstream economists and historians, that there was a bubble in 1921 in the market for U.S. government paper, as a result of which the capital of a lot of banks in the U.S. was wiped out. The wool was pulled before the eyes of the public and lawenforcement officials. The authors of the illegal policy were practicing “bailing-out”.

They anticipated quantitative easing (Q.E.) that was to come in the next century.

Emboldened by the example of the U.S., central banks elsewhere started aping the policy of open market operations, for the stronger reason that gold bills were no longer available to balance the liabilities of commercial banks. Gold bills were summarily locked out of world trade by the victorious Entente powers. The blockade on Germany was lifted; the blocking of gold bills was imposed as a substitute. The idea was to control Germany’s foreign trade. In doing so the Entente powers also shot themselves in the foot. They were unwittingly paving the way to the Great Depression that started a decade after signing the peace treaty. Gold bills furnished the “wage fund” before 1914 out of which producers of maturing consumer goods could be paid up to three months before these goods were ready to be sold for cash. In the absence of gold bills there was no wage fund and the workers had to be laid off in droves not only in Germany but also in the Entente countries.

Daily Bell: Comment on this point of yours: "The fly in the ointment was that the policy of open market operations made bond speculation risk-free."

Antal Fekete: This reflects on the incredible stupidity of the authors of the policy of open market operations. Policy-makers at the F.R. Board assumed that speculators were too dumb to take advantage of the unconditional offer to earn risk-free profits in the bond market. Up to that point speculators were not interested in bond trading at all because under the gold standard the variation in bond prices were not sufficiently high to justify bond trading for profit. The omission to take the effect of the illegal policy on speculation into account is just as inexcusable as the failure of economists to criticize it. Unlike speculation in agricultural goods, bond speculation is destabilizing. It triggers an avalanche of orders to buy bonds before the Fed does, as manifested by the collapsing interest-rate structure that in its turn leads to the erosion or destruction of capital.

Daily Bell: Another statement of yours: "Because of the illegal nature of open market operations a public discussion of the policy was never held, nor was an evaluation of the results ever conducted. Instead, the policy was retroactively legalized by Congress in 1935. In the meantime central banks abroad started aping the practice. Q.E. in the 21st century repeats the same orgy in the bond market on an even larger scale. Worse still, nowadays the timing and the exact size of the bond purchases is advertised far and wide in advance that makes it even easier for bond speculators to outbid one another. It can be confidently predicted that in due course Q.E. will lead to an even more devastating deflation and depression than the bond-purchasing policy of the Fed did in the 1930's." What will the nature of the deflation be – a collapse of the monetary system?

Antal Fekete: Much more than that. It will be a repetition of the deflation and depression of the 1930’s, but on a much larger scale. Falling-domino-style bankruptcy of firms, devastating waves of unemployment, falling prices induced by falling interest rates are just some of the consequences.

Daily Bell: You have some comments about the "theory of interest" as well, as related by Dr. Ebeling. You write that the time preference theory of interest fails to reveal the nexus between gold and interest. Can you explain?

Antal Fekete: I maintain that one of the reasons that a sound theory of interest is still not available and remains the major unsolved problem of economics is that theorists – including time-preference theorists − have failed to take the nexus between gold and interest into account.

Daily Bell: You are partial to the productivity theory of interest, according to which the cause of interest is to be found in the productivity of capital. How have you resolved the conflict?

Antal Fekete: I am partial neither to the productivity theory of interest, not to the time preference theory of interest. On the contrary, I am advocating a synthesis between the two. I am merely pointing out that it is absurd to suggest, as Mises does, that rising interest rates do not increase the marginal productivity of capital, read: render a large amount of existing capital submarginal. In other words, rising interest rates put a lot of producers out of business indiscriminately.

The synthesis of the two competing interest theories starts from Menger’s observation that there is no such thing as a monolithic price. Every price splits into a higher asked price and a lower bid price. Transactions take place anywhere in between these extremes.

The right question to ask is not what the equilibrium price is. Rather, it is: what determines the asked price and what determines the bid price.

Similarly, there is no such thing as a monolithic rate of interest. The rate of interest splits into two: a ceiling and a floor. Lending and borrowing take place between these two extremes. The right question to ask is not what the equilibrium interest rate is. Rather, it is: what determines the ceiling and the floor of the range to which the rate of interest is constrained. It so happens that the former is determined the rate of marginal productivity of capital, and the latter is determined by the rate of marginal time preference. Let me suggest it to you that this recognition is a major breakthrough. It removes the stumbling block that hampered progress for centuries in solving the millennia-old problem of interest. And the credit for the breakthrough goes to Carl Menger who had the insight to challenge the prevailing orthodoxy about the supply/demand equilibrium theory of price.

Daily Bell: You write that interest is better understood if we look at the exchange of wealth and income instead of the exchange of present and future goods. What do you mean by this?

Antal Fekete: The conventional time preference theory of interest is built around the question how to exchange a good available immediately for an identical good available in the future. Such exchanges are mostly imaginary. No one has ever exchanged one apple available today for three quarters of one apple available a year from now.

A more relevant problem is the exchange of wealth for income and income for wealth.

Every adult has faced or is facing that problem when he wants to provide for the education of his children, or for the old age of his spouse and himself. The prototype of instruments making such exchanges possible is the gold bond. The seller of a bond is exchanging income for wealth; the buyer is exchanging wealth for income.

In jurisprudence such exchanges were considered unjust because he who surrendered income had to surrender more weight of gold than he who surrendered wealth, the difference being interest. Accordingly, such exchanges were banned by canon and civil law. However, the fact remains that the party surrendering wealth could achieve his goal without the mechanism of exchange, by dishoarding gold. The other party could only achieve his goal after a prolonged waiting period if he decided to hoard gold. In other words, the exchange of income for wealth and wealth for income is inherently asymmetric. The bargaining powers of the parties to the exchange are unequal. If this is unjust, then nature should be blamed, not usury. After the case for freeing the exchange from prohibition was championed by the scholastic fathers and, later, by Protestantism, the usury laws were abrogated. Interest taking and paying were absolved. Thereafter the rate of interest (having lost its risk-premium) showed a great decline. This was an extraordinarily important development. The rate of interest could be admitted and freely quoted. The trading of gold bonds became legal. Capital accumulation was encouraged and the blessings of capitalistic production were available to the widest segments of population. There can be no doubt that the correct way of formulating the problem of interest is in terms of exchanging wealth and income.

Daily Bell: You believe Dr. Ebeling has a narrow view of the gold standard. Please elaborate.

Antal Fekete: Dr. Ebeling mentions just one aspect of the gold standard in its favor: that of a constraint on governments to indulge in their inflationary proclivities. But as I mentioned already, although important, this is only an infinitesimally small part of the importance of the gold standard in human welfare. It says nothing about the part gold is playing in the formation of the rate of interest, the discount rate, in capital accumulation, in the problem of supplying the consumer with goods in urgent demand most efficiently, etc. The case for the gold standard ought to be presented in its widest scope.

Daily Bell: You write that post-Mises Austrian economists erred because they deviated from Menger. Please explain.

Antal Fekete: I have already mentioned several examples. Post-Mises Austrian economists have deviated from Menger in dismissing the Gold Bills Doctrine. I may add that their peculiar aversion to what they call “fractional reserve banking” is another example of deviation that follows from the first. Menger would never use such a derogatory term. Gold bills in his view were fully justified as reserves against the note and deposit liabilities of commercial banks. I have also mentioned that Menger would object to the slavish adherence of post-Mises Austrians to QTM which has caused endless mischief in monetary science. This is especially true in view of the fact that the Fed’s Q.E. is counterproductive. The Fed is trying to trigger inflation on the theoretical basis of QTM, only to inflict deadly deflation to the world economy. Post-Mises Austrians almost unanimously predict that Q.E. will land the world in a hyperinflationary hell. A more careful analysis taking Menger’s objections against QTM into account would show that Q.E. is leading to capital destruction, deflation and depression.

Daily Bell: Please elaborate on the confusion of lending versus clearing.

Antal Fekete: This refers to the post-Mises Austrians’ dismissal of Adam Smith’s Gold Bills Doctrine. They maintain that a producers of n-th order goods is making a loan to the producer of (n – 1)-st order goods when he delivers semi-finished products against payment with bills. This is a major misconception confusing lending and clearing that also comes from their deviation from Menger and his concept of marketability. No lending and borrowing is involved in extending commercial credit to the producer of lower-order goods. The goods handled by him are more marketable: he is closer to the gold coin disbursed by the ultimate consumer. Gold bills are not evidence of lending and indebtedness. They are evidence of clearing and cooperation.

Daily Bell: You also have a criticism of the Misesian business cycle. You write, "postMises Austrian economists make a mistake in ignoring the distinction between interest and discount in business cycle theory." What do you mean by this?

Antal Fekete: We have mentioned that post-Mises Austrian economists dismiss the distinction between the rate of interest and the discount rate as spurious. As a consequence they have missed the chance to come up with a more realistic version of the theory of business cycles.

Daily Bell: Please try to fully summarize your problem with the business cycle explanation of Mises and Hayek. Why don't you believe it is accurate?

Antal Fekete: The business cycle theory of Mises and Hayek has been taken over by the post-Mises Austrian school without any change. I have criticized this theory as it assigns a rather low I.Q. to businessmen who allegedly fall victim again and again to the teaser interest rates made available to them by the government and banking system. Misled by false signals they make unsound investments which, in due course, come unstuck.

Recovery takes a rather long time.

I am offering an improved version of the business cycle theory that makes no such assumption about the intellectual capacity of businessmen. According to it there is an interplay between the rate of interest rate and the discount rate. Less scrupulous and profit-hungry people borrow short in the bill market and lend long in the bond market.

They think they can get away with this scheme called illicit interest arbitrage and pocket the difference between the higher rate of interest and the lower discount rate with impunity.

But illicit interest arbitrage causes the spread between the two rates to narrow. In particular, the discount rate rises and the interest rate falls. When the critical point is reached, there is panic in the money market. People who have set up straddles with short leg in the bill market and long leg in the bond market get squeezed. They find that they can’t move their short leg forward without a loss. The ripple-effect makes poorly financed firms to go bankrupt. Boom is followed by bust. The damage is done. Recovery consists in restoring the safe spread between the rate of interest and the discount rate.

Daily Bell: You believe a so-called 100 percent gold standard is a non-starter. Why?

Antal Fekete: As I suggested a moment ago, such a monetary system would be too rigid.

The demand for circulating media varies with the seasons. It culminates when the crop is moved to storage. At that time a squeeze develops that may make the system collapse.

Gold coins must be supplemented with gold bills maturing in 91 days to avoid it.

Daily Bell: Let's turn to bonds. You believe a main tenet of Keynesianism is that the "government has the power to manipulate interest rates as it pleases, in order to keep unemployment in check." But this ignores "the constraints of finance, including the elementary fact that ex nihilo nihil fit (nothing comes from nothing).” Can you explain, please?

Antal Fekete: Marketable gold bonds are relatively new in the economy. They go back to the lifting of prohibition on interest in the 19th century. Keynes believed that manipulating interest rates is costless. By now we know he was wrong. The destabilization of interest rates is a great destructive force in the economy. Interest rates can move up or they can move down. Either way, it causes capital destruction.

Daily Bell: You also write, "The great quandary in the history of science is how one charlatan could mesmerize an entire profession with his quackery into somnambulance." Please elaborate.

Antal Fekete: Keynes was a charlatan. A charming one according to Hayek, to be sure.

That may be so. Indeed, he charmed the entire profession of economists like the Pied Piper of Hameln charmed the children of the village with his music, leading them to their destruction. Keynes’ original idea of the “euthanasia of the rentier class” is a great error, showing that he did not know what he was talking about. With his left hand he would punish the parasitic coupon-clipping class by reducing its interest income to zero. But he was completely oblivious to the fact that at the same time with his right hand he would endow them with capital gains galore. The market price of their bonds would increase pari passu with the decline in interest rates.

Daily Bell: Keynes's fundamental contradiction is that "you cannot suppress interest rates and bond prices at the same time!" This strikes us as an important point. Please elaborate.

Antal Fekete: The idea that you can create something out of nothing is highly contagious.

That’s the secret of Keynes success. But as we know there is a cost to everything in this earthly life. Even a free lunch has its cost. If you want to benefit mankind with a zero interest-rate structure, you wipe out its capital which is putatively invested in bonds on the liability side of the balance sheet. And if you want to benefit mankind by endowing infinite capital gains on its bond holdings, then willy-nilly you reduce the interest-rate structure to zero, thereby destroying their capacity to earn an income in the future. There is no way to reduce bond prices and the rate of interest to zero simultaneously!

Daily Bell: You write: "Open market operations were introduced illegally by the Fed in 1922, the year after the bubble in the market for U.S. Treasury paper burst, pricked by spiking interest rates in the wake of the inflationary binge, aided and abetted by the post World War I Fed. A carbon-copy of that scenario is being played out before our very eyes." How so?

Antal Fekete: Policy-makers of the 1922 Fed were laboring under the same delusion as Keynes. They thought they could create money out of the thin air and use it to purchase bonds, driving interest rates down in the process in order to restore the impaired capital of the banking system. The cost: the collapse of the world economy less than a decade later.

History repeats itself because, as Benjamin Franklin pointed out, experience runs an expensive school but fools will learn in no other. Policy-makers at the Fed in the twentyfirst century have given a new name to the policy of open market operations calling it “quantitative easing”. But it is just the same old idea of monetizing government bonds.

They thought that with “capital gains” so created they could replenish the impaired capital of the banking system. The cost will be the same when the bill is presented in due course: the collapse of the world economy.

Daily Bell: You write: "The sweetheart-deal between the Treasury and the Fed conferred mutual benefits upon the conspirators. The Federal Reserve banks got theirs in the form of legalized check-kiting at the expense of the public." Please elaborate.

Antal Fekete: The illegal open market operation of the Federal Reserve is a check-kiting scheme, pure and simple. It is based on the conspiracy of the Fed and the Treasury. The Fed issues checks without backing (namely the F.R. notes) which the Treasury accepts in payment for its bonds. Then it is the turn of the Treasury to issues checks without backing (namely bonds) which the Fed uses as collateral to create more F.R. notes. Of course, this is a scheme to create something out of nothing is at the expense of the general public. The conspirators create hundreds of billions, but it is not out of nothing. They tap into the bank account of every depositor of every bank in the world and pilfer a small amount hoping that the depositors won’t notice.

Daily Bell: You believe that the policy of open market operations of the Fed causes deflation rather than inflation as intended. How is this possible?

Antal Fekete: The Fed is unmindful of the fact that they cannot suppress the rate of interest and the price of bonds at the same time. Reduction in the rate of interest causes bond prices to rise that shows up as erosion (ultimately destruction) of capital across the board. The capital of every firm is putatively carried in the form of a bond listed in the liability column of the balance sheet. As the interest rate falls, the deficit in capital account grows. This is capital erosion. It is a form of deflation. If the deficit is ignored, that is, if new capital is not injected as it should without delay then, sooner or later, the critical point will be reached. Most firms could no longer stay afloat. They sink. This is called the “sudden death syndrome”. Since this is happening simultaneously across the board, the economy plunges into depression.

Daily Bell: You believe there is a causal relationship between a falling interest rate structure and the erosion (destruction) of capital. What would that be?

Antal Fekete: In answering the previous question I detailed the process of capital erosion as the cost of monetizing government debt. Symptoms of deflation appear. The Fed wants to combat deflation. To that end it fosters inflation. But in effect it fosters more deflation, again disguised as capital erosion. The vicious circle is on. The Fed acts contrary to purpose.

Daily Bell: Elaborate on this statement of yours, if you will: "Keynes charged that businessmen behave irrationally and can go overboard in their pessimistic appraisal of business prospects. He insisted that the cure is serial cutting of the rate of interest by the central bank." You don't believe this is accurate. Why?

Antal Fekete: Businessmen are not stupid. They know their trade. When they are uniformly pessimistic, their pessimism is usually well-grounded. They know on which side their bread is buttered. They resist the temptation to chase illusory profits. Serial cutting of interest rates will not spur their urge to invest. On the contrary, it will only make them even more pessimistic. They will not make new investments as long as the prospect is for ever lower interest rates. If the serial cutting of interest rates lasts forever, then they will never invest again. It is as simple as that.

Daily Bell: You write: "America is putting the world at great risk. Gold is going into hiding fast. When the dollar will reach the point that it cannot fetch gold any more, the game of musical chairs is up. World trade breaks down. Barter is the order of the day. But our complex economy cannot survive on barter. It takes multilateral trade, not barter, to build computers and jetliners." Please explain this statement further. What can be done to stop this process?

Antal Fekete: It is not widely recognized but should be that the flight of gold into hiding will deprive the world of multilateral trade; it will result in bilateral trade which is essentially barter. Why? Because other highly marketable goods will imitate gold and will also take fight. But a complex economy such as ours is bound to break down if it is reduced to barter. This is what happened when gold went into hiding before 476 A.D. that was followed by the collapse of the Western Roman Empire.

America made a stupid blunder in letting China take the monetary leadership concerning gold. In order to avoid the fate of the Western Roman Empire the first thing America should do is to make a clean breast of it. Admit that exiling gold from the international monetary system was a mistake and it was wrong to confiscate the gold of Americans in 1933, and of non-Americans in 1971. Promise to restore the monetary clauses of the Constitution. Only then can America try to reverse the flight of gold from West to East.

Daily Bell: You write: "America should provide monetary leadership to the world. It should open the U.S. Mint to the free and unlimited coinage of gold and silver.

Incidentally, this would make money conform to the Constitution once more. This would call monetary gold and silver out of hiding and coax gold back from East to West. It would put an end to the growth of the Debt Tower. It would eliminate so much waste and inefficiency from the system. It would end youth unemployment, arguably the greatest blight caused by the regime of irredeemable currency. There was no youth unemployment under the gold standard, was there? It would open up a new Golden Age of peace and prosperity." How can this be accomplished realistically? What would need to happen in terms of the political process?

Antal Fekete: The doctrinaire policy-makers in America are unlikely to do what must be done. But any jurisdiction (say Switzerland, Germany, Austria, the United Kingdom,

France, or China) may open its Mint to the free and unlimited coinage of gold (and silver). We must understand that the gold and silver coins currently minted are merely souvenir coins produced for profit. They don’t count. They are conversation pieces on the march to the cookie-jar. They are marching into hoards in a world which has destabilized values, which has forcibly destroyed the currency as a means of savings, of preserving value and of accumulating capital.

But if there was a Mint somewhere out there, open to gold, then the problem would be largely solved. The gold mines would flock to the Mint bringing unrefined gold for coining. The Mint would issue gold bills against metal received payable in 91 days in standard gold coins. The gold mines would auction off their gold bills to the highest bidder, that is, to the party willing to discount the face value of the bill by the least amount. The spontaneous circulation of gold bills would be rebooted. Multilateral trade would flourish once again.

All this can be done without raising taxes. The cost of minting standard gold coins would be absorbed by the cost of refining. The gold outflow would stop at once. There would be a gold inflow, bringing prosperity with it. Unemployment would be a thing of the past.

The more gold, the lower would be the discount rate. Unlike the fall of the rate of interest, the fall of the discount rate would be most beneficial. It would eliminate unemployment, for example. The unemployed would turn into entrepreneurs selling consumer goods to those working for wages and salaries. Practically they need zero capital if the discount rate is sufficiently low. They could sell merchandise by the curbside. The world would make a clean start with gold bill financing of trade. The future would be bright and businessmen would be most optimistic about it, with good reason.

Daily Bell: Professor Fekete, thanks for sharing your most recent papers with us. We have enjoyed this interview with you and hope our readers find it beneficial.

Antal Fekete: Thank you for the opportunity to explain my view to the readers of Daily Bell. And thank you for posting my paper “Why Gold Standard?” along with the interview.

---

*March 30, 2014.*

---

# Interview with Guillermo Barba (March 2014)

URL: https://newaustrianeconomics.com/archive/fekete/barba-interview-march-2014/
Date: 2014-03-27
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, silver, bimetallic, new-austrian-economics, permanent-backwardation
Description: An interview with Mexican financial journalist Guillermo Barba covering gold, silver, monetary reform, and the state of the international monetary system in 2014. Fekete addresses questions about China's gold accumulation, the role of silver in a reformed monetary system, and the prospects for monetary collapse and reconstruction.
Editorial Note: March 2014 interview with Guillermo Barba, a prominent Mexican financial journalist and gold-standard advocate. The interview covers a wide range of topics from Fekete's perspective on current monetary events.
Original PDF: https://professorfekete.com/articles/AEFBarbaInterview.pdf

### Prof. Fekete, why did you decide to found the “New” Austrian School of Economics (NASOE)? Did you find something wrong within the “old school”? What about Carl Menger and Mises?

**A.** What I have found was that post-Mises Austrian economists, but already Ludwig von Mises himself, had substantially deviated from Carl Menger’s teachings for the worse. Thus in my view a rather large portion of the post-Mises Austrian economists’ research is in error. I took it upon myself to criticize the deviation from Menger and correct it.

The list includes their dismissal of Adam Smith’s Gold Bills Doctrine, the theory of interest as distinct from the theory of discount, to name but a few. NASOE was launched under the slogan: “Back to Menger!”

- We know you are also a critic of Keynesian and Monetarist theories; are they in error as well? If so, what is their biggest mistake?

A=The biggest mistake of Keynesianism and Friedman-style monetarism is that they favor the destabilization of the interest rate structure that was stable before, but had started gyrating and, more recently, plunging into the black hole of zero interest. All this was in consequence of Keynes’ and Friedman’s success in undermining and ultimately overthrowing the gold standard.

- If these two theories are flawed, why do you think they have become the mainstream all around the world? Were they imposed by somebody?

A=They became mainstream for reasons of their demagoguery. They are designed to appeal to one’s sense of justice: antidote against misery amongst plenty. They take advantage of the appallingly low level of education based, as it is, on covetousness. It is characterized by an almost complete neglect of the aprioristic branches of science: logic, mathematics and economics. And I say this as a professional mathematician. Keynes ensnared F.D. Roosevelt; Friedman ensnared Nixon. These two presidents were happy to trample upon the United States Constitution at their bidding.

As a consequence the gold standard was destroyed and irredeemable currency was foisted upon American citizens in 1933 and, on every inhabitant of the Earth, in 1971. At the same time the gold of the people was looted by the government.

- Can authentic capitalism thrive under a fiat monetary system based on exponentially growing debt?

A=Obviously not. Signs that the grand experiment with global irredeemable currency is an unmitigated failure are all around us.

- Is the so called “Welfare State” legitimate under capitalism or is it a sort of socialism?

A=The Welfare State is a shameless Ponzi scheme whereby costs are kicked upstairs and charged to future generations.

It is a scheme to enslave the unborn. The fact that the electorate allowed itself to be conned into accepting it is indicative of the extremely low level of education in the world. It does not even deserve to be called “education”. A more accurate term would be “training future serfs”.

By contrast, socialism is not a con scheme. It has been embraced by some highly intelligent people who allowed their actions to be guided by their compassion and emotions rather than their intellect and cold reasoning. There was a saying in Germany during the last decades of the 19th century that went like this: “If you are in your twenties and not a socialist, then you have no heart. But if you are in your forties and still a socialist, then you have no brains.”

- If our fiat monetary system is doomed, should we return to sound money by using gold and silver coins once more? How could we have a practical and “renewed” gold standard?

A=The transition is simpler than most people think. There is no need to challenge the authority of the Fed that would be futile anyhow, nor is there need to wave the red cloth of a gold standard in front of the paper bull. It would suffice if one jurisdiction, e.g., the UK with its gold sovereign, or Switzerland with its gold Vrenely (20 Chf. coin), or France with its gold Napoleon, or Hong Kong with its gold Panda opened its Mint to gold (and silver).

In more detail, if one jurisdiction guaranteed that the Mint would stay open for the unlimited coinage of gold and silver through thick and thin, in particular, if it would mint all the gold brought to it regardless of quantity into the standard gold coin, then the problem were largely solved. Gold mines from all over the world would flock to the Mint and deliver their output in exchange for gold bills payable in the standard coin in 91 days (the time it takes to refine the metal and strike the coins). The gold mines in turn would auction off their gold bills to the highest bidder (to the party offering the lowest discount from face value). In this way a credible gold discount rate would be established that is not rigged by central banks and the banking establishment.

We must see that there is a huge latent demand for these gold bills since for the past four score of years the world has been forcibly deprived of the possibility of exchanging cash gold for gold income. The great insurance companies and pension funds would scramble to get these gold bills as they presently have no good assets to cover their mounting liabilities. But so would also the great trading houses financing world trade in food, fuel and fodder, because the petrodollar is showing fatigue at a highly dangerous level and could collapse under stress any time. The jockeying of other currencies to step into the shoes of the petrodollar is in vain.

They cannot compete with the gold bill. They can only engage in petty currency wars.

Likewise, silver producers would draw silver bills on the Mint and auction them off at the silver discount rate, thus providing alternative financing for trade in other staple products. This would be tantamount to the remonetization of silver that would recapitalize the world economy whose capital is in a shambles. It would be an incredible reversal of history.

The beauty of the plan is that there is no need to storm and invade the Fed headquarters on Constitution Avenue to throw the rascals out. The Fed can go on with its mindless inundation of the world with paper dollars. Once its monopoly is broken, the decision to choose the currency lies with the people. Let them decide whether they want paper money or whether they want gold coins in exchange for their goods and services! If Congress is unwilling or unable to restore the monetary clauses of the Constitution, and if the Executive and Judiciary Branches fail to do their duty in protecting the country from the ravages of currency debasement by the Fed’s usurpation of unlimited power, then the people should take the law into their hands. They can do it by coining their gold and silver at the Mint of their choice.

- What is the probability that gold bills will start circulating spontaneously as you suggest just as soon as a Mint is opened to gold somewhere in the world?

A=Fairly high. If it hasn’t happened yet, it is because the countries unhappy with the petrodollar are jockeying for elevating their currency to the status a “world reserve currency” to replace it. That’s the plum. The euro was conceived in sin as it was motivated by envy coveting the turf of the petrodollar. It did not want genuine monetary reform.

Unknown to most observers, we are in the midst of petty currency wars to decide the issue of hegemony among the contenders. Whose discredited promise will serve the world best? Sooner or later the warring parties will realize that their efforts are in vain. Gold bill is far superior to any irredeemable promise, however sugar-coated it may be.

- Silver was demonetized in the 19th century and gold 100 years later. Do you think it was a premeditated attack?

Could it be part of a long term plan to pave the way to fiat money?

A=It took me many a decade to find the answer to this question. The silver standard has fallen victim to a conspiracy of two upstart states: the Union victorious in the Civil War against the Confederacy, and the newborn German Reich victorious in the Franco-Prussian war against France. You just have to ask the question: cui bono? (in whose real interest were these wars waged?) Of course, conspiracy theories are notoriously hard to prove. But then, they are just as hard to disprove. The culprit was a secret consortium of 19th century multinational banking houses operating with the connivance of the victorious governments. The consortium accepted the discipline of a gold standard – temporarily. Having successfully sabotaged the silver standard, it was more than confident that it would in due course be also successful in sabotaging the gold standard. Lo and behold, that’s exactly what they did during the intervening 100 years.

- What is “money” from a Mengerian point of view?

A=Menger defined “money” as the standard coin struck from a monetary metal. The senior metal is more marketable than any other commodity. This means that its marginal utility declines at a lower rate than that of any other. In practical terms, the spread between the asked price and bid price of the most marketable commodity diminishes more slowly than that of any other commodity as ever greater quantities are offered for sale in the markets. Like it or hate it, the most marketable commodity is gold. The junior metal is more marketable than any other commodity save gold. Like it or hate it, the second most marketable commodity is silver, even after the unprecedented abuse it was put through during the 100-year period between 1873 and 1973.

- You know, many people follow only the price of gold and say: “gold is going up (or down)”. They forget about a more important concept: value. What’s the difference between “price” and “value”? Should people care more about the “price” or the “value” of monetary metals?

A=That’s right, the term “price of gold” is just as meaningless as the “length of the yardstick”. I am amused no end how gold bugs play into the hands of their water-torturers. They parrot the media line that “the price of gold has gone up from \$1000 to \$1300 in no time at all”, when they should really say that “the dollar has lost about 23%, or almost one quarter of its value in no time at all”. In the eyes of people the price of gold is the same thing as the value of gold (since for all other goods the two concepts coincide). That’s exactly what the managers of the irredeemable dollar want people to believe. This puts the catastrophic collapse of the dollar in the most favorable light. But as a matter of fact the price of gold and the value of gold are two different things. The value of gold is constant while its price gyrates, meaning that the value of the dollar gyrates. This fact must be stone-walled at all hazards. People must be kept in darkness concerning the danger that the value of the dollar, like the World Trade Center, threatens to collapse and bury them under the debris at a time when they least expect it.

- Many people including famous academics believe that the current monetary system with the USD as the “reserve” currency is sustainable, regardless of the fact that the Fed and all other central banks are busy printing unlimited amounts of fiat money. Do you agree?

A=Of course I don’t. I am not going to question the intellectual honesty of these gentlemen. Instead I try to rationalize their thinking. They can only think in terms of linear models, thus completely ignoring the dynamics of the case. There is a critical point beyond which debasement becomes non-linear, read: uncontrollable. They deliberately ignore the consequences that follow with the inevitability of the laws of science.

- On the other hand, many analysts contend that “quantitative easing” (QE) eventually will lead to hyperinflation. Do you agree?

A=I emphatically disagree. Quite to the contrary, QE (a stupid euphemism for what should simply be called the monetization of government debt) leads to deflation through the erosion of capital. The chain of causation is as follows: QE means bond purchases, or progressively increasing bond price. But this is no good news to entrepreneurs. It is very bad news indeed. It means that their capital is being vaporized. Why? Well, their capital is akin to bonded debt. It must be carried in the liability column of the balance sheet, not in the asset column. Therefore increasing bond prices force a decrease of capital, not an increase as naïve people think. Erosion of capital across the board is deflation, not inflation. The deficit on capital account must be covered through the injection of new capital, the same way as the physical capital of a firm must be replaced after an accidental fire destroyed it. If it isn’t, then the enterprise will collapse unexpectedly in due course. It is known as the “sudden death syndrome”.

The bitter end of QE is not hyperinflation. It is depression, decapitalization, the paralysis of the economy. That’s what was happening in the 1930’s, and that’s what is happening right now. In the early 1920’s the Fed, quite illegally, introduced the policy of open market purchases of bonds, as QE was then called. That was lethal to the struggling economy already softened up as rotting fruit on the tree, ready to drop off at any moment. I may be in the minority of one, but I shall doggedly maintain that the Great Depression was man-made: it was the result of the deliberate undermining of the interest-rate structure through bond purchases of the Fed.

- Is the Quantity Theory of Money false?

A=The Quantity Theory of Money is the most destructive pseudo-theory in the history of science, causing enormous mischief. It is hard to see how a serious scientist could treat it with respect. It may be valid only under the most restrictive circumstances such as the complete absence of financial and real estate markets in the economy, when extra money cannot be used for anything but buying commodities.

- You have stated that gold does not obey the Law of Supply and Demand. Why?

A=Gold is a monetary metal. Its marginal utility for all practical purposes is constant. When the pathology of the regime of irredeemable currency becomes manifest, the demand for gold is increasing, but will not bring out an increase in supply. On the contrary, it will lead to a decrease.

Why, it’s vintage Gresham: bad money drives out good money. Gold is the best money we have.

- Could you explain the concepts of gold “basis” and “cobasis” and why NASOE studies their interplay?

A=The concept of basis first emerged in the grain futures markets in Chicago in the 19th century. Of course, at that time there was no gold futures trading, so there was no question of a gold basis. Gold futures trading started at the Winnipeg Commodity Exchange in Canada in 1972 (before 1975, when it was still illegal in the United States to own and trade monetary gold). I went to Winnipeg to study the gold basis first hand. I think I was the first to introduce the concept of gold basis in academic discourse.

It took several years before it became clear that the behavior of the gold basis is very different from that of the wheat basis, for example. It cost the job of the chief economist of COMEX who could not solve the puzzle. The wheat basis exhibits a cyclical pattern indicative of the crop year. The gold basis exhibits a vanishing pattern indicative of the flight of monetary gold into hiding. Strictly on the basis of logic I predicted the coming of gold backwardation, unheard-of a decade ago.

- What is “gold backwardation” and why is it important as an indicator of the current financial mess? Can that backwardation become permanent?

A=Backwardation simply means that the basis goes negative.

It is a regular feature of futures markets in agricultural commodities. It occurs at the end of the crop year when grain is drawn down in the elevators which are getting ready to receive the new crop. At that time contango is restored.

Contango is the opposite of backwardation; it means that the basis is positive.

Unlike backwardation in grains, backwardation in gold is highly anomalous. It is indicative of a great underlying disturbance. The normal state of the gold futures market is contango.

The definition of gold basis is the difference between the futures price of gold for nearby delivery and the spot price of gold (the price of gold for delivery on the spot).

My student Sandeep Jaitly following Menger’s thoughts introduced a refinement that turned out to be pregnant and all-important for the theory of basis, contango and backwardation. In Menger’s world price is never monolithic; it splits into the higher asked price and the lower bid price.

Actual transactions take place between the two, and the problem economics is called upon to solve is how the asked and the bid price are formed. Accordingly, Sandeep refined the definition of basis as the difference between the asked price for delivery in the nearby future and the bid price for delivery on the spot. At the same time he introduced the companion concept of cobasis as the difference between the bid price for delivery in the nearby future and the asked price for delivery on the spot. The basis is the guiding star of the warehouseman when he decides to carry physical good in preference to holding the futures contract (that is, he increases his inventory on a net basis); the cobasis is his guiding star when he decides to “decarry” physical good while preferring to hold the futures contract (that is, he decreases his inventory on a net basis). Thus the theory of futures markets is seen as the theory of warehousing (as opposed to Keynes’ badly misconstrued theory of insurance) that culminates in the arbitrage between the cash and futures markets.

The interplay between the gold basis and gold cobasis is paramount. The fact is that, although at first the gold basis is merely nibbling at negative values, as the flight of monetary gold continues unabated the gold futures market will ultimately plunge into permanent backwardation from which there is no return (just as there is no return from a black hole in physics). NASOE does pioneering work in this area and we are very proud of that. Nobody can predict the actual day when the irredeemable dollar dies, nor can we at NASOE. But unlike others we can make qualitative statements about the circumstances under which such a scenario will unfold. There is no question that permanent gold backwardation, when it comes, will herald not just the death of the irredeemable dollar, but also the reduction of world trade from multilateral to bilateral, totally insufficient in a complex economy such as ours.

- Do you think from an academic perspective that the gold and silver markets are manipulated?

A=I don’t think that they are any more manipulated than they have ever been. All governments in all history have engaged in it at one time or another. They have always scrambled to amass as much gold as they possibly can by hook or crook. Manipulation of gold even has a name: it is called mercantilism. It is not a very enlightened policy. A more enlightened policy would be to encourage gold on the go as opposed to gold arrested and incarcerated in central bank vaults.

People must feel secure in their possession of gold. This is a prerequisite of what came to be known as the “golden age” that refers to an epoch when people are willing and happy to spend the gold coin because they are confident that they can always get it back on the same terms. When this confidence is shaken, gold goes into hiding. This is true not only under the gold standard, but also under the regime of irredeemable currency. When gold enjoys high visibility, it is indicative of good times. When gold takes flight into hoards, good times give way to hard times.

- Prof. Fekete, as you know, China is currently buying staggering amounts of gold. Are the Chinese preparing this way for the collapse of the global monetary system?

A=I think it’s prudence. The Chinese civilization is much older than our own. One of its merits is the high regard it has for the virtue of saving. Our own civilization failed this test: it has fallen victim to the siren song of Keynesianism and, later, of Friedman-style monetarism, preaching consumerism instead of saving and providence.

It is possible, of course, that China, in addition to simply being prudent and provident is also preparing for the Armageddon of the collapse of the international monetary system, the danger of which very few people in the West recognize. Certainly the United States made a colossal blunder in letting China take leadership in promoting gold as a monetary metal. It will pay a very high price for this stupidity. American universities are hardly equipped to deal with the coming monetary crisis. They have systematically eliminated studying gold money from the curriculum.

Scribblings of academic sycophants representing pseudoscience, using forbidding mathematical apparatus, purport to prove that irredeemable currency is the wave of the future have replaced impartial research. Keynesianism is eclipsed only by Lysenkoism as a brainwashing scheme. It is not a merit that Keynesianism did not have to resort to the Gulag and the firing squad in arguing with its opponents. They knew what their duty was and yielded to superior force. No heroic behavior here.

- So, is the United States the latter-day falling Roman Empire? Is the American dollar the latter-day Roman denarius that is being debased into worthlessness?

A=It seems to be the case. The Roman Empire represented the height of scientific knowledge of its time, yet it succumbed to the temptation of monetary debasement that was the paramount cause of its downfall. Likewise, the U.S. represents the height of scientific knowledge of our age, but this did not protect it against the quackery of Keynesianism and Friedman-style monetarism. If we escape disaster this time, it will be by the skin of our teeth.

- What can the average person do to protect himself from this catastrophe?

A=Have gold and a plot of land in the countryside to bury it at night and to grow food when it will no longer be available in the cities.

- You have repeatedly appealed to speculation, its causes and effects, in this interview as well as in your speeches and other writings. In closing, could you say a few words about the economic role of speculation in general?

A=Speculation is the Achillean heel of economics. Speculation is absent in Keynesian, Marxian, Walrasian and Austrian economic theory – as observed by the Wikipedia article digesting my work. But as Mises said, there are only two ways human beings can deal with future uncertainty: engineering and speculation. If I may add, the first is widely recognized, the second is widely ignored. To make things worse still, speculation is often confused with gambling, although the difference between the two is quite clear.

Speculation deals with risks created by nature; gambling deals with risks deliberately created by man. In contrast with the former, the latter adds nothing to human welfare.

Mainstream economics purposely obscures the issue in misrepresenting speculation in interest-rate futures and in gold as if they were dealing with risks inherent in nature. But this is a malicious lie: risks in the bond market as well as risks in the gold market are patently man-made, more precisely, made by the government following thoroughly bad advice from Keynesians and Friedman-style monetarists. By nature’s ordination gold is stable and so are interest rates under a gold standard. But by ordnance of governments gold and bonds have been destabilized, causing untold damage to the world economy.

- Any parting thoughts?

A=I would like to draw the attention of your readers to three recent publications of mine that you can find on my website [www.professorfekete.com](https://www.professorfekete.com). They deal with the same questions that we dealt with in this interview.

(1)

Bonds may be defying dire forecasts – but they are not defying logic; Parts I, II (February 3, 2014)

(2) Why gold standard? (March 14, 2014)

(3) Memorandum to whom it may concern (March 15, 2014)

- Thank you for your time, Prof. Fekete. Hope to see you soon.

---

*March 25, 2014.*

---

# Bonds May Be Defying Dire Forecasts, But They Are Not Defying Logic, Part Two

URL: https://newaustrianeconomics.com/archive/fekete/bonds-may-be-defying-forecasts-part-two/
Date: 2014-03-03
Section: Popular Economics
Difficulty: intermediate
Concept Tags: bond-market, federal-reserve, monetary-policy, interest-theory, fiat-currency
Description: Part two examines the specific mechanisms by which the Federal Reserve has sustained the bond bull market past its natural lifespan, analyzing the QE tapering decision and its implications. Fekete argues that tapering cannot be sustained without triggering the bond collapse that QE was designed to prevent.
Editorial Note: Part two written March 2014, just days after part one. Focuses specifically on QE tapering mechanics and their implications for bond market stability.
Original PDF: https://professorfekete.com/articles/AEFBondsAndLogicPart2.pdf

*Bonds May Be Defying Dire Forecasts But They Are Not Defying Logic*

### (Part Two)

### Antal E Fekete

### New Austrian School of Economics

In Part One of this two-part series I have argued that Keynes inadvertently ignored the rule asserting that the rate of interest and the price of bonds vary inversely and, as a consequence, his conclusions concerning employment, interest and money are irreparably faulty.

In this second part I shall argue that the policy of open market operations of the Fed causes deflation rather than inflation as intended. The authors of the policy have inadvertently ignored its effect on bond speculation. This was true in the 20th century; it is true in the 21st century as well. The Fed’s monetary policy is counterproductive. It is trying to foster inflation through its bond purchases, but what it in fact does is fostering deflation through capital destruction. It is responsible for the coming depression, just as bond purchases of central banks were responsible for the Great Depression of the 1930’s.

The fact is that the policy of open market purchases makes bond speculation risk-free. Speculators forestall the central bank and front-run its bond-buying program. Gradually the central bank is losing control. Bond speculators are now in charge. The central bank is trying to call off the bond-buying campaign, in vain.

Like the Sorcerer’s Apprentice, it is desperately trying to find an ‘exit strategy’ only to realize, too late, that it hasn’t got the magic word.

The interest-rate structure goes into a free-fall, causing prices to fall, too.

One can see that at the heart of the problem is the fact that the central bank (deliberately or inadvertently) ignored the rule that the rate of interest and the bond price vary inversely.

The rule is not in itself controversial. All financial journalists know it. If a bond trader tries to deviate from it, it will soon go bankrupt. Why do then policymakers and mainstream economists ignore it? Other than the misplaced iconoclastic reverence for Keynes, we may mention the overwhelming influence of the Quantity Theory of Money (QTM) on monetary policy. QTM is a deeply flawed theory that fails to distinguish between linear and non-linear phenomena.

The relationship between the quantity of money and the price level is linear only under the most exceptional circumstances. The fact is that there is no causal relation between the quantity of money and the commodity price level, because money is free to flow to the financial markets instead of the commodity market, as it often does at the bidding of speculators. Of utmost significance here is the behavior of bond speculators, which both Keynes and the authors of the policy of open market operations ignored or totally misunderstood, with disastrous consequences for the world economy.

However, there is a causal relation between a falling interest rate structure and the erosion (destruction) of capital. The former is tantamount to rising bond values. The capital of an enterprise is a liability subject to periodic disbursements.

It is listed in the liability column of the balance sheet, along with debt. This is the reason why, under a falling interest rate structure, the capital of all firms is subject to erosion, a fact stubbornly ignored by Keynesianism. Incredible as it may be, this ignorance (and not the gold standard per se) was the hidden underlying cause for the deflationary bias in the economy that Keynesianism was designed to overcompensate after World War I.

The erosion of capital is vicious because it is well hidden and may become obvious only when it is already too late to do anything about it. The process of destruction of capital is a direct consequence of the falling interest rate structure.

Those who argue that low interest rates are salutary to business confuse a low but stable interest rate structure with a falling one. The latter, to be sure, is lethal to business.

Keynes charged that businessmen behave irrationally and can go overboard in their pessimistic appraisal of business prospects. He insisted that the cure is serial cutting of the rate of interest by the central bank. Well, let us see how falling interest rates really affect the thinking of businessmen. If you tell an entrepreneur that tomorrow the rate of interest will be lower, then he will delay his investment by one day. He does not want to face the competition of those with a lower cost of capital, due to their foresight in waiting one day longer to get a business loan. By the same token, if you tell him that a week, month, year … from now the rate of interest will be lower, then he will delay his investment by one week, month, year, … If he expects the rate of interest to keep falling from here to eternity, then he will never make the proposed investment. It is just as simple as that: you will never be able to entice rational businessmen with a falling interest rate structure to invest.

On the contrary, what you have to do is to convince them that you mean to stabilize interest rates. Only in such an environment would they start nibbling at investment possibilities. Now we come to the crux of the matter. The only known way to stabilize interest rates durably is to go on a gold standard. The gold standard is the best course to prevent wholesale capital destruction. It is the only monetary system that can stabilize bond prices. It is a malicious lie that the gold standard is ‘contractionist’, as asserted by Keynes.


---


U.S. President F.D. Roosevelt embraced the faulty reasoning of Keynes and, in 1933, just a few days after he swore to uphold the Constitution, he overthrew the Constitutional metallic monetary standard of the country and confiscated the gold coins of the citizens. Then he wrote up the value of the confiscated gold and reestablished the gold standard internationally (although not domestically) based on a devalued dollar defined as 1/35 oz of gold on January 1, 1934.

Thereafter the U.S. played banker to the world… until it defaulted. On August 15, 1971 President R.M. Nixon ordered the Treasury to refuse to redeem the dollar in gold to its depositors, never mind that several international treaties anbctioned and four sitting presidents confirmed the arrangement. That day ‘will live in infamy’. The U.S. unilaterally destroyed the international monetary system.

The irredeemable dollar was foisted on the people of the world, regardless whether they wanted to retain the gold standard or not. Gold that belonged to people not under U.S. jurisdiction was confiscated by the U.S. This was more than just a breach of faith. It was a wanton wielding of naked imperial power. Foreign central banks were forced to take unprecedented losses in their balance sheet. Thereafter the U.S. took command of the world’s resources without offering anything in exchange but the dishonored promises of a defaulting banker.

Foreign banks and foreign governments were not allowed to say as much as

“ouch”. Universities inside and out of the U.S. were forced to discard monetary science as it existed at the time, replacing it with the faulty and destructive monetary theories of Keynes. They had to parrot the line that it was all in the name of ‘progress’: the gold standard had outlived its usefulness.

Some gold still remained under the control of foreign governments. Through some arm-twisting the U.S. ‘persuaded’ them to sell out in order to keep the dollarprice of gold from rising. Through bribe and blackmail, the U.S. forced the Swiss Confederation to railroad through a Constitutional amendment that removed the monetary clause defining the Swiss franc in terms of gold. When questions were raised why the U.S. does not set an example in ‘updating’ its own Constitution, the answer was: “Do as I say, not as I do!” The truth of the matter is that policy makers in the U.S. could never muster enough moral courage to call a Constitutional convention to amend the U.S. Constitution by dropping its monetary clauses that were not in tune with Keynesian principles, lest the proposal to redefine the dollar in terms of the debt of the federal government be rejected. They would rather live with the odium that they have trampled on the Constitution.

A veritable ‘brain-washing’ has taken place in the world under U.S. pressure. Generations of bankers and financiers grew up and were trained to believe that world trade could be financed and capital could be accumulated and maintained safely and permanently on the basis of irredeemable promises to pay.

An anti-gold psychosis was cultivated among them.

Of course, there were signs that everything was not alright. Prices

(especially those of food, fuel and fodder) as well as interest rates escaped from the earth’s gravitation. These episodes were explained away by ad hoc causes and by refusing to look at the big picture. By now the dollar has lost 99 percent of its purchasing power. Debt, private and public was exploding. By no rational calculus could it ever be paid back. Nevertheless, the show had to go on.

An army of pusillanimous scribblers and a chorus of sycophant academics sang the song praising the new millennium of irredeemable fiat paper money. Wars were started in defense of the irredeemable dollar’s hegemony. Yet luck was running out. The Chinese government got tired of carrying the irredeemable American Treasury paper to the tune of trillions of dollars in its foreign exchange reserves. It started accumulating monetary gold in a big way and encouraged its subjects to do the same. The wake-up call in America would still not sound.

America is putting the world at great risk. Gold is going into hiding fast.

When the dollar will no longer fetch any gold any more, the game of musical chairs will end. World trade will break down. Barter will be the order of the day.

But our complex economy cannot survive on barter. It takes multilateral trade, not barter, to be able to build computers and jetliners.

America should provide monetary leadership to the world. It should open the U.S. Mint to the free and unlimited coinage of gold and silver. Incidentally, this would make money conform to the Constitution once more. This would call monetary gold and silver out of hiding. It would put an end to the growth of the Debt Tower. It would eliminate so much waste and inefficiencies from the system.

It would end youth unemployment, perhaps the greatest blight caused by the regime of irredeemable currencies. There was no youth unemployment under the gold standard.

It would open up a new Golden Age of peace and prosperity.

---

*March 3, 2014*

---

# Why Gold Standard?

URL: https://newaustrianeconomics.com/archive/fekete/why-gold-standard/
Date: 2014-03-01
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, sound-money, new-austrian-economics, fiat-currency, real-bills
Description: A concise statement of the case for restoring the gold standard, addressed to readers who accept that the current system is failing but are uncertain whether gold is the answer. Fekete argues that no alternative monetary anchor — SDRs, commodities baskets, cryptocurrency — can provide what gold provides: an endogenous, self-regulating, inflation-proof monetary base.
Editorial Note: Written March 2014 as subtitle 'Is the Gold Standard Needed to Stabilize the US Economy?'. One of Fekete's most accessible pro-gold-standard arguments, written as a clear statement for general readers.
Original PDF: https://professorfekete.com/articles/AEFIsTheGoldStandardNeededToStabilize.pdf

In this article I would like to enter into a friendly debate with Richard Ebeling of the American Institute for Economic Research on the subject why the gold standard is needed. The opportunity to present my views arose when the Daily Bell published two interviews with him recently, on February 11 and 14, 2014 in which Ebeling goes on record in saying that “the advantage of a monetary system based on a commodity like gold s that it makes it more difficult for a government to arbitrarily change the quantity and therefore the value of the money used within a country.”

My purpose is to focus on the difference of perception between the postMises Austrian School and my own New Austrian School of Economics (NASOE) and why talking about this is important. In particular I will explain why I think Ebeling’s perception represents a major departure from Carl Menger (1840-1921), the founder of the Austrian School.

In the second interview Ebeling talks about his book Political Economy,

Public Policy, and Monetary Economics: Ludwig von Mises and the Austrian Tradition (Routlege, 2010). He elaborates on the advantage of a monetary system based on a commodity like gold. Ebeling summarizes this advantage as follows: ”the gold standard makes it more difficult for a government to arbitrarily change the quantity and therefore the value of money used within a country.”

It is of course well known that Mises made a case for the gold standard along these lines. His stand already represented a deviation from Menger, according to whom gold was not just ‘a commodity’, but it was ‘the most marketable commodity’, the marginal utility of which was declining more slowly than that of any other. Alternatively, the most marketable commodity could be characterized as one for which the spread between the asked price and the bid price increases more slowly than that for any other as ever larger quantities of it are offered in the markets. Menger preferred the former because he wanted to define the concept of ‘price’ as the exchange ratio between the good in question and gold, but that would have opened the latter formulation to charges of circularity. To Menger, gold was the unit of value par excellence.

In measuring length we choose platinum as the material out of which the measuring rod is to be made because this choice minimizes the variation in length in response to changes in temperature. We line up rods made of various materials and pick the one whose variation in length in response to changes in temperature is smaller than that of any other. Likewise, in measuring value we choose gold as the material out of which the standard coin is to be made because this choice minimizes the variation in value in response to market wear and tear. We line up coins made of various metals and pick the one whose variation in value in response to market wear and tear is smaller than that of any other.

Yes, one can measure length, Mises notwithstanding. The subjective theory of value stipulates that values in the absence of a measure can still be compared.

But this does not prevent one from measuring if, after the introduction of the concept of marketability, a unit of value can be established.

It is not well-known but Menger was not a devotee of the Quantity Theory of Money (QTM) and, for him, to keep the quantity of money in circulation constant was certainly not a desideratum. Rather, he was willing to accept Adam Smith’s position that the amount of trade showed seasonal variations and it was fine for the quantity of money in circulation to vary together with it. Menger would most certainly have challenged the statement that changing the quantity of money in circulation would necessarily change the value of money. This, of course, is not a criticism of Hayek’s point that governments are not to be trusted as they are prone to yield to pressure groups and other political forces to tamper with the quantity of money in circulation for their own benefit.

It is peculiar that post-Mises Austrians shy away from Menger’s theory of marketability in favor of the QTM. In doing so they deprive themselves of a most efficient analytical tool. The concept of marketability easily extends to financial instruments as well, including irredeemable paper money. This analytic tool is far superior to any furnished by the QTM. Strictly speaking QTM is not a theory. It is hardly more than a clever metaphor.


---


Ebeling is in favor of the so-called 100 percent gold standard (although in these interviews he does not use the term). He states that “a gold standard works on the ‘rule’ that any currency outstanding is meant to be a circulating substitute [for] and claim to a quantity of gold deposited in a bank or other financial institution for safekeeping. Any additions to the paper currency in circulation (or other deposits representing that currency in exchange) are only supposed to come about as a result of net additional deposits of gold into the banks of that country. And any net withdrawals of gold deposits are to be accompanied by a [commensurate] decrease … in the currency notes in circulation. Money substitutes in the form of checking and other similar banking accounts are [also] to expand and contract only … as a reflection of changes in the quantity of gold (or silver) money kept in the banking system.”

### Not only is this a major departure from Adam Smith’s Gold Bills

Doctrine, but from Menger’s position as well. Furthermore, it flies in the face of historical evidence showing that bills of exchange drawn on merchandise moving apace to the ultimate gold-paying consumer, maturing and payable in gold coin in 91 days (the length of the seasons) or less, herein called gold bills do enter into monetary circulation spontaneously. Evidence is also available that exiling gold bills from circulation causes an undue stress in the monetary system, especially at the time of the year when crops are moved after harvest. The stress can in some cases threaten the stability of the monetary system. All in all, such a restriction would be a fetter upon technical improvements in the productive apparatus of society as it would discourage further refinement in division of labor. Ebeling’s position, which reflects a slavish dependence on the QTM, is untenable. It is very questionable that commercial banks ever existed for any considerable length of time which answered Ebeling’s description.

Menger makes it very clear that only a minor part of the reserves of a commercial bank is kept in gold coins; the major part consists of gold bills maturing apace as time passes. This fact does not make it a ‘fractional reserve bank’. In Menger’s view gold bills are fully admissible as reserves against the note and deposit liability. Loose talk about fractional banking when referring to honest to goodness commercial banks holding impeccable gold bills in addition to gold coins against their note and deposit liabilities does not do credit to the quality of research done by post-Mises Austrian economists.

At issue is the nature of the market for gold bills. Gold bills are the best earning assets a commercial bank can have. Their marketability is second only to that of gold itself. If the bank runs into unusually high demand for cash, it can easily sell gold bills from reserves without any danger of a loss. There will always be commercial banks out there with excess cash that want to exchange it for earning assets. But the market for gold bills is not limited to commercial banks.

Many other economic entities do face large payment obligations falling due at a certain date in the future. For example, the issuer of outstanding gold bonds has to prepare for the day when his bonds mature. So does the purchaser of real estate preparing for the close-out day. None of these entities hoard gold coins to meet their obligations. What they do is this: they go into the market and buy gold bills with maturity matching that of their obligations. The demand for gold bills is virtually unlimited.


---


Ebeling alleges that “the old gold standard in its heydays before World War I was still a government-managed monetary system through a series of national central banks.” This remark does not do justice to the international gold standard as it existed as recently as one hundred years ago. It worked as Adam Smith’s wagonway-in-the-sky metaphor described it should. Gold bills drawn on London financed world trade even though the boats carrying cargo may have never came close to British shores. Enormous amounts of gold were freed up and subsequently invested in long-term projects such as building transcontinental railways and developing transoceanic shipping. And we have not even mentioned the prodigious amenities conferred upon the world by advances in therapeutics, also financed by gold bills.

Wagon ways on the ground could be ploughed up and the land put to better use in producing crops. The ‘highway-in-the-sky’ (read: gold-bill financing of world trade) has taken over the task of carrying goods from producer to consumer, sometimes half-a-world apart. Even with a much larger stock of monetary gold it would not have been possible to achieve the same degree of progress, if gold bills had been banned as Ebeling would, presumably under the authority of an autocratic world government, have done. We would be very lucky indeed if we could just erase the past one hundred years from memory and pick up where the world left off in 1914. We would have no Babelian Debt Tower, no threat of wars because the U.S. wanted to protect its turf for the irredeemable dollar circulating internationally. Gold coins would be in circulation domestically as well as across the border. The euro would pop up only in one’s nightmare. There would be no loss of purchasing power for currencies. A dollar losing 90 percent of its purchasing power in one generation (as it did between 1971 and 2000) would be the stuff of science fiction.


---


Ebeling’s bitter feelings about central banking are understandable. But one should preserve one’s objectivity. Central banks in 1914 were not the malevolent Moloch with unlimited power they are today. Most of them were operated as regular profitmaking business without special privileges. They did not take the initiative to create credit to feed the money markets with arbitrary bond-purchases and they did not foist their credit on society as they do today. According to the mandate laid down in their charter, they stated the terms on which they were willing to do business (read: they posted their discount rate) and stood back, letting the commercial banks do the rest.

If they had stayed innocent, then they would not have become the elephant in the china-shop. Contrary to the bad press it is now receiving, the Federal Reserve (F.R.) Act of 1913 was not an out-and-out bad document. The F.R. banks it envisaged were commercial banks with reserves 40 percent in gold and the rest in gold bills. Government bills, notes or bonds were not eligible as collateral for F.R. credit. If any of the F.R. banks were caught short of eligible reserves, then it had to pay a stiff penalty on a steeply progressive scale. Open market operations were in effect outlawed.


---


‘Something funny happened on the way to the forum’. World War I broke out just a few days after the Federal Reserve banks opened their door for business.

Although officially the United States was neutral in the conflict, President W.

Wilson immediately put Federal Reserve credit at the disposal of the Entente powers to finance purchases of war material. Since selling war material was lucrative business, nobody complained that the Neutrality Act and the F.R. of 1913 Act had been violated. Notes and bonds of the Entente crowded out gold bills in the balance sheets of the F.R. banks. By the end of the war gold bills were conspicuous only by their absence, while the portfolios of the F.R. banks were bulging with Liberty Bonds (read: War Bonds) that was justified on the strength of a patriotic considerations. All this was in contemptuous violation of the F.R. Act of 1913.

So it came to pass that in 1921 a bubble popped up in the government bond market. Hard upon its heels other bubbles followed: in 1925 the bubble in Florida real estate and, in 1929, the infamous stock market bubble. When the bond bubble collapsed, the F.R. banks were found short of eligible reserves. The U.S. Treasury that was entrusted with the task to enforce the law just ‘forgot’ to collect the penalty. Why should it? It was nice to have the Fed around to buy government bonds when selling them became tough – never mind the law of the land.

It was in the ruins caused by the collapse of the government bond market where the policy of open market operations was conceived. By 1922 most of the member banks of the F.R. system (Fed) had impaired capital and all the F.R. banks were in delinquency. In the meantime interest rates reached unprecedented heights.

Officials at the Fed took the law into their own hands. They started a large scale bond purchasing program illegally and without any public discussion of the dangers of such a course. The details are still shrouded in secrecy. The minutes have been either stone-walled or destroyed. As a result we don’t know for sure whether these Fed officials were aware of the broader implications of their breach of the law.

The fly in the ointment was that the policy of open market operations made bond speculation risk-free. The smartest speculators, knowing that they can always unload their bond purchases at a profit, pre-empted the Fed in buying the bonds first. Other speculators joined the bidding contest, emboldened by the sweet smell of risk-free profits. This lifted the price of the government bonds alright, but only at the cost of making the interest-rate structure to fall. The Great Depression of the

1930’s was caused squarely by the Fed through its illegal policy of open market operations as it triggered a prolonged rush of speculators into bonds. The upshot of the orgy in the bond matket was that the rate of interest kept falling, causing capital erosion and destruction indiscriminately. Capital loss across the board is a manifestation of deflation.

It is very likely that people in charge of the open market bond-purchase policy of the Fed, when they saw the danger, tried to rein in the runaway bond market.

But it was too late. The momentum of speculative bond purchases continued and interest rates kept falling. The situation was a replica of the story of the Sorcerer’s Apprentice who stole the secret word from the manual of his master and uttered it in an effort to get something for nothing. When enough was enough, he wanted to stop the charade. He could not. He has forgotten to steal the other secret word needed to do it.

Because of the illegal nature of open market operations a public discussion of the policy was never held, nor was an evaluation of the results ever conducted.

Instead, the policy was retroactively legalized in 1935. In the meantime central banks abroad started aping the practice. ‘Quantitative Easing’ (Q.E.) in the 21st century repeats the same charade. Worse still, nowadays the timing and the exact size of the bond purchasing program is advertised far and wide in advance that makes it even easier for bond speculators to outbid one another. It can be confidently predicted that in due course QE will lead to an even more devastating deflation and depression than the bond-purchasing policy of the Fed did in the 1930’s.


---


Let me repeat my argument, first proposed more than a decade ago, why there is a causal relation between a falling interest rate structure and the erosion (destruction) of capital. Falling interest rates are tantamount to rising bond prices. The capital of an enterprise is a liability, typically subject to periodic disbursements as is debt. It must be listed in the liability column of the balance sheet along with other debt.

Therefore rising bond prices are no good news as some may think. They are very bad news indeed. The message is that productive capital is being vaporized.

This is why, under a falling interest rate structure, the capital of all firms is subject to erosion, a fact stubbornly denied by the Keynesians. It is also ignored by the policy of open market operations. Incredible as it may be, this ignorance (and not the gold standard per se) was responsible for the deflationary wave that overran the world economy after World War I. The erosion of capital is vicious in that it is well hidden and may become obvious only when it is already too late to do anything about it. The process of destruction of capital is a direct consequence of the falling interest rate structure. Those who argue that low interest rates are salutary to business confuse a low but stable interest rate structure with a falling one. The latter, to be sure, is lethal to business – wishful thinking notwithstanding.



Ebeling has this to say on the theory of interest. “In the late 19th century the Austrian economist, Eugene von Böhm-Bawerk explained that the true origin of interest was in the differing time valuations among men. Some men value more highly the use of goods in the present than in the future, and are willing to pay a premium (interest) in the future for access to a greater quantity of goods than their own income enables them to command, while others are willing to forego the use of goods which they could command today in exchange for a premium (interest) over the principal at some point in the future when the borrowed [good] will be returned to him by the borrower. Goods in the present are exchanged …for goods in the future through the medium of money. The rate of interest is simply the exchange ratio [between] goods in the present [and the same] goods in the future expressed in terms of … money.” This is known as the time preference theory of interest. Note that it fails to reveal the nexus between gold and interest.

However, Böhm-Bawerk who wrote a two-volume treatise with the title Capital and Interest, also presented another theory known as the productivity theory of interest according to which the cause of interest is to be found in the productivity of capital. A fratricidal war between the two schools trying to explain the theory of interest ensued.

I have resolved the conflict in the spirit of Menger who put the dichotomy of the asked and bid price right in the center of economics, to supplant the supply/demand equilibrium theory of price. The rate of interest is defined as the rate at which the lump sum payment of the (fixed) face value of the bond at maturity plus the payments stream of interest amortize the (variable) market value of the bond. The time preference theory explains how the (higher) asked price and the productivity theory explains how the (lower) bid price of the bond is formed.

Thus the conflict is ended in a happy synthesis between the two warring factions.



Interest is better understood if we look at the exchange of wealth and income instead of the exchange of present and future goods. The bond is a means of exchanging wealth and income. The seller of the bond gives up income in exchange for wealth, while the buyer gives up wealth in exchange for income.

But the bond is not the only way to convert income into wealth and wealth into income. A more ancient but still prevalent method, especially at times of great disturbances in currency values, of converting income into wealth and wealth into income is hoarding and dishoarding. The man who is hoarding converts income into wealth while the man who is dishoarding converts wealth into income. The trouble is that there are substantial losses involved in these conversions. To minimize these losses one has to hoard and dishoard the most marketable good, gold. It is for this reason that you cannot have a theory of interest without reference to gold − a point that was lost on Ricardo, Mises, and a host of lesser known economists – but was implicit in Menger’s opus through his emphasis on marketability.

In the absence of institutional, legal or moral obstruction individuals will exchange a stream of gold payments for a lump sum payment of gold routinely in order to provide for old age or for the education of their children. But the amount of gold so exchanged is not the same: the present value of the gold stream is higher. The difference is interest, and the (annual) rate of interest is the present value of gold paid out during a one-year period as a percentage of the lump sum.

Converting income into wealth through hoarding gold is equivalent to exchanging income for the wealth at zero interest. Likewise, converting wealth into income through dishoarding gold is equivalent to exchanging wealth for income at zero interest. The bargaining powers of the lender and borrower are asymmetric.

The former can fall back on conversion if exchange fails. The latter cannot. For him conversion would yield the desired wealth only after a several-year-long waiting period. If this is unjust, nature is to blame, not usury. The rate of interest is the price of efficiency of exchanging wealth and income over that of converting one into the other through hoarding and dishoarding gold.


---


To recapitulate, Ebeling has a very narrow view of the gold standard. He completely ignores the role of gold in the formation of the rate of interest, in spite of the fact that this role is even more important than the role of gold in the formation of prices for the reason that the gold standard is fully capable to stabilize interest rates and, hence, bond prices but it cannot stabilize the prices of goods (which is neither desirable nor possible).

In economics and, more generally, in human affairs one has to grab every chance as they come to stabilize, as they are few and far in between. Only the enemies of peaceful and voluntary cooperation under the system of division of labor with an agenda, such as Keynesians and Friedman’s monetarists have an interest in destabilization. The rate of interest is one of only a very few things that can be stabilized. Being mortal, humans vitally depend on the stabilization of interest rates.

Our theory of interest is inspired by Carl Menger. It avoids the use of contorted examples such as exchanging one apple today for a fraction of one apple several years later. Exchanging present apples for future apples only occurs in one’s imagination, never in real life. By contrast, exchanging income and wealth occurs in the life of everyone, as one makes provision for the education of one’s children, or for old age.


---


Post-Mises Austrian economists following Mises reject the idea that there is a distinction to be made between interest and discount, or between a bond and a bill beyond the technical difference that interest is payable retroactively while discount is payable in advance. This is a major error with far-reaching consequences. The root of the error is the belief that there is loan involved in extending commercial credit as a semi-finished good is passed along from the producer of higher to that of lower-order goods, and also when the finished good is passed along from the wholesale to the retail merchant.

It is a grave mistake to assert that the producer of a higher-order good is lending and the producer of the lower-order good is borrowing. Once again, postMises Austrian economists erred because they deviated from Menger. The fact that the transaction of passing along semi-finished goods involves no loan transaction is clearly shown by the fact that the producer of higher-order goods handles goods with lower marketability, while the producer of lower-order goods handles goods with higher marketability. The former is farther down in the line waiting for his share of the gold coin disbursed by the ultimate consumer. Similarly, the finished good in the hand of the wholesale merchant is less marketable than the same good in the hand of the retail merchant. The latter is the one who gets the gold coin first.

It is preposterous to suggest that the wholesale merchant extends a loan to the retail merchant when in effect it is the retail merchant who has the gold.

The confusion in the minds of the post-Mises Austrians is that of confusing lending with clearing. Commercial credit is a manifestation of clearing, not of lending. It is an inseparable part of the movement of semifinished goods through the various stages of production. Take it away and production will cease. Likewise, commercial credit is an inseparable part of the movement of the finished good from the wholesale to the retail merchant. The former bills the latter. The gold bill is always ’90 days net’. There is simply no precedent for a gold coin, as opposed to a gold bill, to have ever been involved in the passing of a semifinished good from the producer of higher to the producer of lower order goods, or in the passing of a finished good from the wholesale merchant to the retail merchant. These men are cooperating in the task of supplying goods in urgent demand to the ultimate consumer. It is grotesque to suggest that this, rather than being an instance of cooperation is an instance of a loan contract between creditor and debtor.

Interest and discount are very different both in their origin and in their function in the constellation of economics. The origin of interest is in savings whereas the origin of discount is in consumption. Accordingly, the rate of interest measures the propensity to save and the rate of discount measures the propensity to consume. In both cases the relationship is inverse: the higher is the propensity, the lower the rate will be.

The function of interest is to regulate financing long-term projects; the function of discount is to regulate financing the movement of merchandise to the ultimate consumer most expeditiously. This movement must not be slowed down.

If it is for any reason, typically, for reasons of slackening consumer demand, then using the lower discount rate loses its justification. The higher interest rate must apply. Conversely, if consumer demand picks up, then drawing gold bills to finance the last stages of the movement of merchandise to the ultimate gold-paying consumer may be justified. Such switches back-and-forth between interest and discount occur all the time as the propensity to consume varies from high to low and back. The sign of a fading propensity to consume is that gold bills drawn on some merchandise will stop circulating. Conversely, the sign of the propensity to consume getting more robust is that gold bills drawn on some merchandise will start circulating spontaneously.


---


It is interesting to observe how the discount rate is formed. What we have to watch is the demand for prepaying gold bills by the acceptor, typically the retail merchant. As gold coins keep accumulating in his till and reach the point of hid ‘normal cash balance’, he will have the urge to prepay his gold bills. Suppose he knows the person who holds the gold bill he has accepted (of course, it need not be the wholesale merchant who drew the bill in the first place when delivering the goods). The retail merchant will then make an offer to prepay his bill. The question is how much he should offer in prepayment. Clearly, he won’t pay the full face value if it the gold bill still has some time to go before maturity. His offer is to discount the gold bill. In the haggling over the rate that follows the retail merchant is guided by the prevailing propensity to consume. If it is high, then the marginal item on his shelf, say a bottle of sauerkraut, is moving fast. It has a high marginal productivity. This prompts him to settle for a lower discount. Holding out for a higher discount would make no sense in view of the fact that the marginal productivity of his circulating capital is higher.

It is very different if the propensity to consume is low. In this case the retail merchant has an alternative. The marginal item on his self, which we may assume to be the bottle of sauerkraut, is moving slowly, so sowly in fact that he is thinking of phasing it out by not reordering . It then appears more attractive to him to use his excess gold coins to buy the gold bills drawn on goods handled by his colleagues operating with a higher productivity at a better discount. Accordingly, he will insist on a higher discount in buying back his own bill.

In the foregoing we assumed that the retail merchant was able to locate the holder of the bills he had accepted. In practice this is unlikely. Probably he won’t even try. But this does not affect the merit of our reasoning. It makes no economic difference whether he prepays gold bills of his own, or he buys the gold bill of another merchant. In either case he is offering to discount a bill at a rate determined by the propensity to consume. In phasing out the slow-moving sauerkraut his inventory shrinks, but he now participates in the earnings of another retail merchant operating with higher productivity.

Our description of the formation of the discount rate also shows the role that gold plays in the mechanism of supplying the ultimate consumer with merchandise, beyond merely being a means of exchange – a role in which it is not indispensable. But gold is indispensible in its role of helping to format the discount rate whereby the task of supplying the consumer with merchandise is made most efficient. The discount rate is the price of this efficiency. The scope of the gold standard goes far beyond browbeating the government for its inflationary proclivities.


---


One instance showing that post-Mises Austrian economists make a mistake in ignoring the distinction between interest and discount is the business cycle theory.

In Ebeling’s description: “…the depression has its origin in a preceding inflationary boom that was set off by government and central bank manipulation of the money supply and interest rates. This set off a chain of events in which investment was thrown out of balance with savings, resources were misdirected and capital was mal-invested. It is the prior manipulation of money and credit and below market-based interest rates that create the distortions and imbalances that finally result in a ‘break’ in the economy followed by economic downturn, depression or recession.”

I have written critically about the business cycle theory of Mises and Hayek, which is still the standard fare in the post-Mises Austrian school as manifested by the quotation above. My criticism is that it assigns a very low IQ to businessmen who fall again and again for the deception of the government and the banks pushing the rate of interest below the rate of marginal time preference. “If you cheat me once, shame on you; if you cheat me twice, shame on me.“ Businessmen are among the smartest people in the world and should be able to learn how to avoid previous pitfalls. But if you distinguish between the rate of interest and the rate of discount, then you can come up with an improved business cycle theory as follows.

The positive spread between the rate of interest and the rate of discount is a temptation for doing what I call ‘illicit interest arbitrage’. People looking for riskfree profits will sell bills in the bill market at the lower discount rate to invest the proceeds in the bond market at the higher interest rate. They expect to pocket the difference. In doing so they ignore the danger of borrowing short and lending long.

The short leg of the straddle matures before the long and it may not be possible to move it forward without a loss. However, they trust to luck and do it anyway. Here is the rub: their very arbitrage will cause the spread between the rate of interest and the rate of discount to narrow. When it closes, there is panic in the money markets and the house of cards collapses. Falling firms cause a domino-effect doing great damage to the economy. Illicit interest arbitrage in particular has created a falling trend in the rate of interest. This has caused erosion of capital across the board, making firms more vulnerable. Some healthy firms may struggle by cutting prices but, at any rate, they can do nothing about the erosion of capital that affects everybody. Large scale unemployment that follows the wholesale collapse of firms will make global demand shrink, reinforcing the trend of prices to fall.


---


In summary: the gold standard is much more than a restraint on governments to refrain from inflation as suggested by Ebeling. It is an integral part of the mechanism to improve the efficiency of supplying the consumer with merchandise, through its influence on the discount rate. It is also part of the mechanism to allocate capital through its influence on the discount rate. It is protecting the young lest savings to provide for their education may not be pilfered. It is protecting the elderly lest the funds to provide for their old age may not be plundered.

It is important to talk about these issues now. We are at a critical juncture when the dismal failure of the global experiment with irredeemable currency is becoming manifest. There is a chance that the gold standard may be rehabilitated and collapse of world trade avoided. The rehabilitation of the gold standard must be done right. The so-called 100 percent gold standard would render the monetary system prone to squeezes and give scope to agitation against it that could culminate in a collapse. Should that happen, schadefreude in the opposition camp would know no bounds: “We have told you so!” The cause of sound money would suffer a setback. That outcome could be easily avoided if the post-Mises Austrian school and NASOE with the participation of all other interested parties met to hammer out a platform through a high-level open debate. Science has always moved forward through open debates and was retarded by opposition to them.

---

*March 1, 2014*

---

# Bonds May Be Defying Dire Forecasts, But They Are Not Defying Logic, Part One

URL: https://newaustrianeconomics.com/archive/fekete/bonds-may-be-defying-forecasts-part-one/
Date: 2014-02-14
Section: Popular Economics
Difficulty: intermediate
Concept Tags: bond-market, federal-reserve, monetary-policy, interest-theory, capital-destruction
Description: Fekete addresses the puzzling persistence of the bond bull market despite widespread predictions of its imminent end, arguing that the bull continues not because the predictions are wrong but because the Federal Reserve's interventions have temporarily overridden market logic. Part one develops the theoretical case for why the bond bull must eventually end — and catastrophically.
Editorial Note: Part one of a two-part analysis written February 2014. The puzzle of the bond bull's persistence was a recurring theme in Fekete's 2013-14 writing.
Original PDF: https://professorfekete.com/articles/AEFBONDSAndLogicPart1.pdf

*Bonds May Be Defying Dire Forecasts But They Are Not Defying Logic*

### (Part One)

### Antal E Fekete

### New Austrian School of Economics

The title of Sy Harding's article (Gold Eagle, January 31) says it all: "Bonds Defy Dire Forecasts". But as I have been saying for years, bonds have not been defying logic, Greenspan's cliché "conundrum" notwithstanding. The behavior of the bond market has been consistent with Keynesianism. By his compassionate phrase

“euthanasia of the rentier” Keynes meant the reduction of the rate of interest, to zero if need be, as part of the official monetary policy to deprive the coupon-clipping class of its “unearned” income. Perhaps it is not a waste of time to repeat my argument why, in following Keynes’ recipe, the Fed is acting contrary to purpose. While wanting to induce inflation, it induces deflation.

The main tenet of Keynesianism is that the government has the power to manipulate interest rates as it pleases, in order to keep unemployment in check.

Keynes argued that the free market economy was unstable as it was open to the swings of irrational investor optimism or pessimism that would result in unpredictable and wild fluctuation of output, employment and prices. Wise politicians guided by brilliant economists − such as, first and foremost, himself − had to have the power “to prime the pump” (read: to pump up the money supply) as well as the power to “fine-tune” (read: to suppress) the rate of interest. They had to have these powers to induce the right amount of spending needed to put people to work, to entice entrepreneurs with ‘teaser interest rates’ to go ahead with projects they would otherwise hesitate to undertake. Above all, politicians had to have the power to unbalance the budget in order to be able to help themselves to unlimited funds to spend on public works, in case private enterprise still failed to come through with the money.

However, Keynes completely ignored the constraints of finance, including the elementary fact that ex nihilo nihil fit (nothing comes from nothing). In particular, he ignored the fact that there is obstruction to suppressing the rate of interest (namely, the rising of the bond price beyond all bounds) and, likewise, there is obstruction to suppressing the bond price (namely, the rising of the rate of interest beyond all bounds). Thus, then, while Keynes was hell-bent on impounding the “unearned” interest income of the “parasitic” rentiers with his left hand, he would inadvertently grant unprecedented capital gains to them in the form of exorbitant bond price with his right.

This single observation demolishes the entire elaborate edifice of Keynesianism. The great quandary in the history of science is how one charlatan could mesmerize an entire profession with his quackery into somnambulance. No economist has pointed out during the intervening period of nearly four score of years, since February 4, 1936 (the day when Keynes published his magnum opus, The General Theory of Employment, Interest and Money) that the Keynesian Nirvana is built on quicksand. There were plenty of critics, of course, but none of them put his finger on the fundamental contradiction of Keynesianism, namely, that you cannot suppress interest rates and bond prices at the same time! They fell for the false dichotomy that there was a “trade-off” between inflation and unemployment. The euthanasia of the rentier turned out to be the euthanasia of society. Keynes cut the sorry figure of just one of the hopefuls waiting in line for their chance to work the miracle of having one’s cake and eat it.

The reality was worse still. The violent overthrow of the gold standard and the deliberate destruction of a stable interest-rate structure built upon it meant that the genie of bond speculation has been let out of the bottle. It was now free to roam about causing mischief in the world economy indiscriminately. The Keynesian managers of monetary policy in the twenty-first century “improved” on the original design of Keynes. They have made their timetable public, together with their targets of lowering interest rates. In fact, Bernanke went as far as announcing the actual amounts of bonds the Fed was going to purchase annually in order to reach his interest-rate targets.

But when you as the Chairman (more recently: Chairwoman) of the Board of the Federal Reserve announce how much face value of bonds you are going to buy and when, then you in effect offer bond speculators risk free profits. All they have to do is to front-run the Fed and buy up the bonds beforehand. Thus conferring the privilege of preemption and forestallment on the speculators, he or she agrees to buy the bonds at a disadvantageous price: one enhanced by the profits of the bond speculators. Not only are their profits risk-free; they are literally unearned in the sense that bond speculators do not perform a single useful service to society in exchange for the windfall. Compare that to the gains of speculators in agricultural goods, who do perform a useful service: they alleviate a glut or a shortage occurring naturally in the wake of a bumper crop or a crop failure. Bond speculators, by contrast, profit at the expense of the public purse. There is no value-system on which such a rip-off could be justified, unless you make it an article of faith that the public purse was there for corrupt public servants to help themselves in the first place.

As a rule risk-free profits are ephemeral because they habitually devour their parents right after parturition. But when risk-free profits are institutionally guaranteed, as they are now, they snow-ball and become gargantuan. They are on track to destroy society, just as the avalanche is on track to destroy the village down there in the valley.

It would be hard to design a more absurd and inequitable system than that of open market operations whereby the Fed buys (or, occasionally, for window-dressing purposes, sells) government bonds in the secondary bond market.

Bestowing risk-free profits on bond speculators starts an avalanche with unforeseeable consequences.

As long as the central bank is forced to observe the rules of the gold standard, bond speculators are barred from making risk-free profits. As a matter of fact they cannot make any profits in the bond market: under the gold standard bond prices and interest rates are stable. Bond speculation is literally unknown. The parasitic class of bond speculators is conspicuous only by its absence. The raison d’être for the gold standard is the stabilization of interest rates and bond prices − in contrast with the false tenet that mendaciously makes it the stabilization of prices (that is neither desirable nor possible).

Open market operations were introduced illegally by the Fed in 1922, the year after the bubble in the market for U.S. Treasury paper burst, pricked by the interest rate that spiked, as it did in the wake of the inflationary binge aided and abetted by the post World War I Fed. A carbon-copy of that scenario is being played out before our very eyes. In consequence, the government bond market collapsed, the capital of scores of member banks were wiped out and the economy nose-dived in the 1930’s. Beware! The outcome of the Fed’s present bond-buying craze will, now as then, be deflation, not inflation, as expected by most people!

The introduction of the policy of open market operations was illegal since it was not authorized by the Federal Reserve Act of 1913. Rather, the Act envisaged a central bank that was to be a passive participant in the process of credit creation.

It would post its rediscount rate and then stand back, letting the commercial banks do the rest in rediscounting bills from portfolio. The Act frowned upon the idea of a central bank taking the initiative in the process of credit creation, such as unilaterally injecting Federal Reserve credit into the money market.

Without praising it unduly or undeservedly, we may observe that the Federal Reserve Act of 1913 correctly hit those Federal Reserve banks that were caught short of eligible collateral with a tough and steeply progressive schedule of fines.

Government bonds, notes and bills were classified ineligible as collateral for Federal Reserve credit. Eligible paper was unambiguously defined as a short-term commercial bill drawn on merchandise moving to the cash-paying consumer apace (what Lloyd Mints, the mentor of Milton Friedman, later pejoratively called a ‘real bill’). This fact is also suppressed in textbooks in an effort to stone-wall the illegality of open market operations.

The Federal Reserve Act of 1913 entrusted the fox with the guarding of the chicken coop. It put the U.S. Treasury in charge of collecting the fines delinquent Federal Reserve banks short of eligible paper were supposed to pay. When in 1922, as a result of the introduction of open market operations illegally, delinquency skyrocketed, the Treasury simply “forgot” to collect the fine. Why should it? It was nice to have the Fed standing by and picking up the slack when selling bonds was getting tough. The sweetheart-deal between the Treasury and the Fed conferred mutual benefits upon the conspirators. The Federal Reserve banks got theirs in the form of legalized check-kiting at the expense of the public. The process of creating Federal Reserve credit was short-circuited, nay, it was subverted. Check-kiting was consummated as follows: by the Treasury, as it redeemed its bonds paying out Federal Reserve notes and, by the Fed, as it used Treasury bonds as collateral for its notes. The very same bonds were made redeemable in notes that had been posted as collateral security in issuing the notes! And the very same notes were paid out in retiring the bond that had been issued on the collateral security of the bonds! Such an incestuous relation had been unthinkable under the gold standard.

It would have triggered a run on the banks in protest, as depositors demanded gold coins against their notes and deposits.

The seeds of the bean-stalk of unlimited debt were planted in 1935 when open market operations were retroactively legalized by an amendment to the Federal Reserve Act of 1913. This fact is also suppressed in the textbooks, in an effort to make the popping up of our Babelian Debt Tower appear as an Act of God. An Act of God it was not. It was a deliberate Act of Congress inspired by Keynesian principles.

The continuing fall of interest rates in the 21st century, in the face of an unprecedented amount of Federal Reserve credit being created through bond purchases, is far from being illogical. Nor is the continuing bull market in bonds, now a third of a century old, is a conundrum to those of us who are not infected by the bug of Keynesianism. It is fully explained by the incentive to earn risk-free profits on a continuing basis, unconditionally offered to bond speculators by the policy of open market operations. The reaction of speculators was completely left out of consideration by the authors of the swindle of open market operations.

Keynes just followed them and carried the logic to its bitter conclusions. Because of this ‘oversight’ has neither been exposed nor corrected, the monetary policy of the Fed is contrary to purpose.

The Federal Reserve sows the wind of inflation, only to reap the whirlwind of deflation!

---

*February 4, 2014.*

---

# Reminiscences of an Amateur Economist (1): My Crusade to Fend off Permanent Gold Backwardation

URL: https://newaustrianeconomics.com/archive/fekete/reminiscences-of-an-amateur-economist/
Date: 2013-12-21
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, permanent-backwardation, new-austrian-economics, gold-standard, sf-school
Description: The first installment of Fekete's intellectual memoir, recounting his discovery of the gold basis and its implications, his development of the permanent backwardation concept, and his decades-long effort to bring these ideas to wider attention. A personal and historical account of the New Austrian School's development.
Editorial Note: Written December 2013 as a memoir of Fekete's monetary research. One of the most personal essays in his corpus, providing biographical context for his intellectual work.
Original PDF: https://professorfekete.com/articles/AEFReminiscenses1.pdf

*My Crusade To Fend Off Permanent Gold Backwardation*

**Antal E. Fekete** · New Austrian School of Economics

I have declined to answer the challenge of an opponent of mine to debate the semantics of the word “arbitrage”. He keeps referring to me by name and to my work through innuendoes. He puts words into my mouth which I have never uttered, and so completely misrepresents my views that I cannot escape the conclusion that he never read or properly digested my theory of permanent gold backwardation.

The threat of permanent gold backwardation is one that, in my view, casts a dark shadow on the future of our civilization much the same way as the disappearance of gold from commerce cast one in 476 A.D., the year when the Western half of the Roman Empire collapsed, world trade succumbed to barter, law and order broke down, and centuries of Dark Age descended upon Western Europe.

For this reason the subject should be treated responsibly and with the humility it deserves. This I cannot discover even in traces in the self-indulgent tirades of my opponent. I fail to see how his broadsides could be treated with respect. However, I do see the need for restating my theory clearly for the benefit of those who have an open mind and are desirous of learning.

There are three broad explanations justifying the existence of futures markets: (1) Insurance offered to producers and consumers to cover the risk of extreme price swings.

(2) Outlet for human gambling instincts whereby gamblers can place their bets on the course of future price movements in the hope of large leveraged gains.

(3) Market for warehousing services.

## Reminiscences Of An Amateur Economist (1)

The first (1) is the pat explanation offered by Keynes and the Keynesians. Keynes himself coined the expression “normal backwardation”, suggesting that the normal condition of the futures markets is backwardation, i.e., when the basis (spread between the price for delivery in the nearby future and the price for delivery on the spot) is negative. Contango, when the basis is positive, is an aberration. Keynes unambiguously stated that the negative basis is the “insurance premium” collected by the insurers for their service from the producers and consumers. They unloaded their price risk to the insurers against the payment of this insurance premium. In more detail, the producer can sell forward if he is concerned that the price will fall; the consumer can buy forward if he is concerned that the price will rise. According to Keynes’ argument it stands to reason that the producer will get paid less for his goods to be delivered in the future, because the insurer has taken his cut in the form of a negative basis. Likewise, according to the rest of his argument, the consumer will have to pay more for delivery on the spot, because the spot price incorporates the insurance premium in the form of a negative basis.

I shall not enter the debate whether or not there is a grain of truth in this explanation. It is clear that Keynes did not understand, nay, he completely misrepresented the essence of speculation in commodity futures trading. He has blithely wiped out the distinction between the action of a gambler shooting helterskelter from the hip and the business of a professional insurer who scientifically studies his markets, charges a variable insurance premium in a way that diminishes his risks while guarantees reliable profits and the survival of their trade even in the greatest adversity − provided only that the monetary system is sound (which ours is not based, as it is, on irredeemable promises). Thus Keynes’ theory of the futures markets may appear as a joke to practitioners of the trade. This is confirmed by the necessity to change the signature of the basis. If backwardation were really

“normal”, it should have a positive basis, rather than a negative one! (Perhaps this bothersome change of signature was the reason why Keynes never mentions the basis in his 1930 work Treatise on Money.)


---


The second explanation (2) appears a notch more serious. It would be hard to deny the fact that the commodity futures markets, no less than the equity markets attract speculators like a honey-pot attracts the bees. It may also be that speculation is the

REMINISCENCES OF AN AMATEUR ECONOMIST (1) necessary catalyst to provide liquidity without which these markets could not function. Having said that, we must admit that there is a clear difference between organized commodity exchanges on the one hand and the casino − or futures markets dealing in financial futures − on the other.

The difference is this: the risks involved in the former are created by nature. By contrast, risks involved in the latter are artificial in that they are created by man, as in the case of the casino that rigs the chances to win at the roulette wheel or at the blackjack table; or by the government that discards the gold anchor in the monetary system and the gold leash in the fiscal system to create artificial risks where none existed before, in the foreign exchange market and the bond market.

Risks are rigged in favor of the casino or the government, and to the prejudice of every other participant. Of course the government keeps pretending, mendaciously, that such risks as exist are inherent in the foreign exchange and bond market; they are natural, and bad government cannot be blamed for the economic damage and human suffering they routinely cause. The fact remains, however, that futures markets for foreign exchange or for bonds were conspicuous only by their absence under the gold standard. Not that they were outlawed. You could start one any time of your choice. But variations in foreign exchange rates and in bond prices were so minuscule under the gold standard that speculation simply would not pay.

Of course, mainstream economists fail to make a distinction between risks created by nature and risks created by man. They have a hidden agenda: to exempt the government from responsibility for rising prices, for unstable foreign exchange and interest rates. All untoward economic phenomena must be blamed on Mother Nature even when they are direct consequences of government interference.

The apostle of the false creed that the price of gold has been artificially fixed under the gold standard was Milton Friedman. This Mephistopheles gave the evil advice to the Emperor that issuing irredeemable paper dollars would solve the perennial problem of a bare treasury for once and all. After a hiatus of forty years we can now see the chickens, hatched by Friedman, coming home to roost. Friedman maliciously misrepresented the essence of a gold standard. Far from being a scheme of fixing the value of gold in terms of paper, the gold standard is a scheme

REMINISCENCES OF AN AMATEUR ECONOMIST (1) of fixing the value of paper in gold. That’s what needs to be fixed, not the other way round! The essence of the gold standard is that it denies the power of regulating the money supply to the government and the banking system. It is motivated by the desire that whenever people think that there are not enough gold coins in circulation, they should be able to do something about it. They will take new gold from the mines, or old gold (jewelry) from the refinery to the Mint and exchange it, ounce for ounce, for spanking new coins of the realm containing exactly the same amount of gold.

The Constitution did not set up a Central Bank for the United States, as Friedman well knew. It established the United States Mint instead. The purpose of the Mint was not the striking of base metal coins, that is, fake money imitating coins earlier struck in silver, to fool the people. The constitutionally mandated Mint was the very means of putting the power to regulate the amount of money in circulation firmly into the hands of the people where it belonged. This power had thus been explicitly denied to the government and to the banks by the Constitution. They could not create money, except on exactly on the same terms as the humblest of subjects could: by taking panned gold to the Mint, or gold that was obtained abroad as payment for exports.

Whether Friedman was too dumb to understand this or he was just a devious intellectual with a hidden agenda to overthrow the Constitution stealthily without even trying to amend it, is a question left to historiography to decide. Had he been an upright man and an honest economist true to his discipline, he would have recommended a Constitutional Amendment to the effect that the irredeemable paper dollar be henceforth recognized as Constitutional money. He would not have stooped to the chicanery of putting through a pocket-amendment in order to fool the public. After all, the Founding Fathers have made provision for amending the Constitution.

Whatever Friedman did, we have to suffer the consequences, which are fearsome.


---

## Reminiscences Of An Amateur Economist (1)

Thus we are left with explanation (3). Mainstream economics has badly neglected the study of commodity futures markets and can offer no guidance in this regard.

The reason for the neglect is abundantly clear. Such a study cannot be based on the assumption that the regime of irredeemable currency is legitimate. In the absence of a gold standard people are forced to hoard commodities for the purpose of saving. Only simpletons would on their own free will choose to save in the form of hoarding irredeemable promises, whether the promise has been issued by a bank or directly by the Treasury. The financial annals fail to mention a single instance of dishonored promises to pay going to a premium. They have always gone to a discount. They are utterly unsuitable for saving because they are destined to lose all their value, down to the last farthing.

In other words, under our present monetary arrangements the commodity market is called upon to satisfy an exogenous demand, namely, demand for commodities needed as a substitute for irredeemable promises pushed down the throat of the saving public. As a consequence, the commodity market cannot help but ultimately turn itself into a gambling casino. Commodity futures trading as it was originally conceived for the purpose of price-discovery and hedging, is badly distorted.

I have taken the task upon myself to find a definitive answer to the question how to explain and justify the existence and legitimacy of futures markets. Here is my answer. Legitimate futures markets include all those trading agricultural commodities where supply is unpredictable for reasons of their dependence upon nature, sometimes giving us bumper crops, at other times crop failures. Futures markets trading non-agricultural commodities are also legitimate.

By contrast, all future markets trading so-called financial futures are illegitimate.

The reason is that risks involved in holding financial futures are made artificially by the government and are rigged to the prejudice of the subjects. For example, the foreign exchange market used to be stable and risk-free under the gold standard.

Now it belongs to the category of gambling casinos, even if outwardly it resembles commodity exchange markets. The resemblance is a deliberate deception. The government, academia, and the financial press try to lump the foreign exchange markets, bond markets and other derivative markets together with the commodity market to create the impression that the risks they tackle have also been created by nature. This effort is subordinated to the task of perpetuating the regime of

REMINISCENCES OF AN AMATEUR ECONOMIST (1) irredeemable currency and to prop up the market for government bonds. The latter is in constant danger of collapsing. It has a captive clientele: banks, insurance companies, pension funds, government agencies such as deposit insurance, unemployment insurance, old age security administration funds, and the like. They are under duress to hold government bonds as reserves in their portfolio. In consequence these funds are perfectly useless for the purpose they allegedly serve, namely, to make funds available for payout. In case of real need for selling government bonds, bids are withdrawn and the bonds can only be sold at a deep discount, if at all. The only purpose the government bond market serves is to make the bond appear sound and negotiable, which it is not (save a handful of countries with negligible government debt such as Norway and Singapore, for example).

The commodity markets trading agricultural goods show a regular cyclical pattern for the basis (defined above as the difference between the nearby futures price and the spot price). From backwardation (negative basis) just before harvest the market goes to contango (positive basis) just after harvest. This reflects the fact that warehouses (grain elevators in the case of grains) are nearly empty just before the harvest but they are full when the harvest is brought in. For the rest of the crop year the contango holds sway that slowly fades into backwardation as the basis goes from positive to zero, from zero to negative just before the next harvest, when the cycle is repeated. Vanishing contango reflects the drawdown of supplies. The cyclical pattern of the basis follows the seasons of the year. It justifies the existence of futures markets making hedging and price-discovery possible. There can be no doubt that the futures market for agricultural commodities is in effect a market for warehousing services. Producers can choose basically between two ways to carry inventory. The first one is less efficient: producers provide their own warehousing and carry the goods themselves. The second is far more efficient.

Producers sell their crop en bloc after harvesting at the prevailing price and replace it with futures contracts which they plan to sell piecemeal during the rest of the year as contango returns and the spot price improves. They may be handsomely rewarded for their strategy just before the next harvest when it turns out that the warehouses underestimated annual demand (as it frequently happens). Clearly, this is arbitrage between the cash market and the futures market. It is manifested by the

REMINISCENCES OF AN AMATEUR ECONOMIST (1) buying and selling of warehousing services. Sales and marketing need not be simultaneous. It is possible to do sales first and marketing afterwards.

Note that the producer’s buying (as opposed to selling) futures contracts is no speculation. There is a joke about a Texas rancher who is madly bullish on the price of cattle. So much so that he routinely sells live cattle from his ranch and puts the proceeds into buying cattle futures. He lovingly refers to these long futures contracts as “me straddles”. When it is pointed out to him that they are not, properly speaking, straddles, the rancher retorts “mine are Texas straddles”. That joke is just that, a joke. The rancher, in spite of appearances, is not speculating.

Quite properly, he is doing arbitrage between the spot market and the futures market, as many grain farmers do. He is buying and selling warehousing services.

Most of the grain grown in North America is marketed through the grain futures markets. In this way the most modern and most efficient, professionally managed warehousing facilities are made available to small growers who otherwise would be unable to avail themselves to the state-of-art technology. It is a marvelous system that works for the benefit of all.

Another use of the commodity futures markets is hedging, namely, selling the crop forward while it is still at the growing stage. A favorable price may be available presently when the crop is still in the ground, but which may well disappear by the time the harvest is brought in. For example, there could be a crop failure somewhere half-way around the world. No problem. The farmer sells futures contracts against his growing crop at the favorable futures price now, and will cover his short position later, after he has brought in and sold his harvest at the then prevailing price. Everybody benefits: the growers at home get the better price; the hungry people half-way around the world, victims of the crop failure get cheaper imported grain than they would in the absence of futures trading.

Nor is this all. Further benefits are available. If there is a crop failure and an unexpected shortage, it will immediately show up in the form of backwardation in the futures market. The basis goes negative. There is a premium on the price of the cash commodity over that of the futures. This is a threat to the consumer who may

REMINISCENCES OF AN AMATEUR ECONOMIST (1) be forced to spend more than the usual outlay for his regular supply. The marginal consumer may even have to do without. However, arbitrage comes to the rescue.

Arbitrageurs will sell the cash commodity and buy the futures. As a result those who can afford it will postpone consumption. The shortage is eased, and the marginal consumer spared.

Or suppose that there is a bumper crop and an unexpected glut. The basis immediately goes to its maximum called the carrying charge. This time it is the producer who is threatened as he may not be able to recover the cost of his production. The marginal producer may even be forced out of business. Again, arbitrage comes to the rescue. Arbitrageurs will buy the cash and sell the futures.

As a result the economic pain accompanying the glut is eased and the marginal producer is spared.

We have seen that the futures market for soft commodities (those produced by the agricultural sector) is cyclical. For hard commodities (those produced by the resources sector) the cyclical feature may be partially or entirely missing. The energy sector, for example, is characterized by a futures market swinging back and forth between longer periods of backwardation and shorter periods of contango.

This is explained by the costly and danger-wrought warehousing, having to do with inflammable nature of energy-carriers and the fact that demand changes dramatically with the arrival of the winter heating season. For other hard commodities such as base metals warehousing and marketing reveals a different pattern again that I shall not discuss here for reasons of space limitation.

It should be clear from the foregoing that “normal backwardation” is a misnomer.

Keynes was as wrong as an economist with a messianic message can be. Keynes needed a justification for his absurd theories of overproduction and underconsumption. Backwardation is not normal. The “normal” state of futures markets is contango. Commodity trading assumes warehouses. No one will construct one in order to keep it empty. If anything, one could talk about “normal contango”.

We can also observe that commodity futures markets try to shake off backwardation whenever it occurs. This is clear from the fact that the basis has no

REMINISCENCES OF AN AMATEUR ECONOMIST (1) lower limit. Since it can have any negative value, however large in absolute value, we can be sure that backwardation will “cure itself”. At one point the falling basis will start moving commodities into the warehouses. The ancient wisdom holds:

“Natura vacuum abhorret”.

In the same order of ideas I note that the behavior of the basis is highly asymmetric. While it has no lower limit, it does have a strict upper limit. The upper limit of the basis is the carrying charge mentioned above. As the name suggests, it is the total cost of warehousing. In order to establish the fact that the basis can never exceed the carrying charge we argue by contradiction. Suppose that for some commodity X the futures market is in contango and the basis exceeds the carrying charge. Then the warehouseman starts selling X forward and buys the physical, pocketing the excess of the basis over carrying charge as profit. In other words, he is doing risk-free arbitrage from the cash market to the futures market for X. The excess disappears, and disappear it will almost instantaneously. Risk-free arbitrage has the habit of devouring its parent right after parturition.

---

Gold futures trading has only a brief history of about forty years. It was totally unknown under the gold standard. It started in the early 1970’s at the Winnipeg Commodity Exchange in Canada, when the ban on Americans to own and trade monetary gold was still in force. In 1975 the ban was lifted and trading gold futures shifted to COMEX in New York.

A mystery in the gold futures markets soon presented itself. The gold basis, initially as robust as it can be (bumping against the carrying charge) started weakening gradually over the decades. Nobody could explain the phenomenon; it cost the chief economist of COMEX his job. By now the gold basis has become so rickety that the gold futures market indecisively vacillates between contango and backwardation. Some people conjecture that the gold basis will ultimately settle down for a cyclical pattern like the basis for soft commodities, even though these

REMINISCENCES OF AN AMATEUR ECONOMIST (1) so-called observers never fail to add that “you can’t eat gold”. No deeper analysis was offered or sought.

For the past twelve years I have in my talks and articles spread the word that, far from being cyclical, the gold basis exhibits a clear vanishing pattern. Moreover, it will necessarily culminate in permanent gold backwardation in the fullness of time.

In suggesting this I am fully alive to the fact that permanent backwardation is not possible for any other commodity futures market because the persistently falling basis is going to bring out fresh supplies sooner or later.

The solution to the mystery is found in the fact that gold is no ordinary commodity.

It is a monetary metal. It fails to obey the Law of Supply and Demand. Rising prices may fail to bring out fresh supplies. Quite to the contrary: it may make the existing supply disappear altogether. There is impeccable logic behind this prognostication. In any futures market basis dropping to zero and showing a tendency to dip into negative territory is an incontrovertible sign of an increasing shortage of deliverable material. That has been the case for gold, too, for the past couple of years. The signs are all around us. Central banks first limited, then suspended their gold-dumping campaign. The brave ones among them even started buying gold in open defiance of the wrath of the U.S. Treasury. Right now there is a run to exchange paper gold for physicals. China leads the pack with her unlimited appetite for ever more gold. The only exception is the Western “democracies”, where the worshipping of the paper Moloch has been the strongest.

There is no obvious source where the monetary gold will come from to feed the backwardation monster. Gold in Fort Knox is heavily hypothecated through multiple leasing arrangements. When the last registered gold bar leaves the warehouse, COMEX will become insolvent and a massive default on its gold futures contracts will follow. It matters little that they will call it by some other fancy name, such as “liquidation only policy”, “standstill agreement”, “cash settlement preference”, or any other that comes to mind. Default is default, by whatever name it goes.

As I have repeatedly said, the threat of permanent gold backwardation is a most serious one. It threatens all of us, regardless whether we participate in gold futures

REMINISCENCES OF AN AMATEUR ECONOMIST (1) trading or we don’t. It is incumbent on the government to fend it off at all hazards, just as it should take preventive measures in case the Grand Coulee Dam was about to give way. Nevertheless, my warnings have fallen upon deaf ears. Ben Bernanke has on occasion even boasted that he does not understand gold. It sounds to this observer that the captain of the boat is boasting that he does not know the first thing about navigation.

But why must one see the disappearance of gold as a sign of public danger? Well, the COMEX default will be no ordinary default. It will be cataclysmic. It will, for the first time, reveal that the U.S. Treasury paper is not only irredeemable, but it is outright worthless. Right now, you could still get some gold for it, however little.

To the extent you could, the dollar is still a monetary instrument, in fact, one of the most potent. After the onset of permanent gold backwardation it will cease to be that. The dollar will fetch no more gold. Not one grain. From one day to the next.

That will be the day when Ben Bernanke or his successor on the way to Damascus will come to see the light. They will come to understand gold. That will be the day when all banks in the Western World will become insolvent. Bank reserves held in the form of U.S. Treasury paper will go up in a puff of smoke.

F. D. Roosevelt took the insane advice of Judas Iscariot Keynes to make the dollar irredeemable domestically 1933. R. M. Nixon took the evil advice of Milton Mephistopheles to make the dollar irredeemable internationally, i.e., declare it “the ultimate extinguisher of debt” in 1971. Neither measure, however forceful, was sufficient to administer the coup de grâce to the dollar. All respectable monetary scientists were most incredulous at the time. They had all been predicting that the dollar, once made irredeemable, was ready to succumb to the sudden death syndrome. Well, it didn’t. Their failure to appreciate the fact that you could still buy gold with dollars cost these upright scientists their credibility. Everybody became convinced that the dollar was invincible. The rear-guard of the gold standard was ridiculed as a bunch of superstitious old foggy-bottoms. Today I find myself in a minority of one in suggesting that the dollar will not collapse as long as it can still buy some gold. Everybody believes the day will never dawn when the dollar can no longer buy even one grain of gold − just like everybody believes that the day will never dawn when the Sun fails to rise. Why, it is a contradiction in

REMINISCENCES OF AN AMATEUR ECONOMIST (1) terms. Yet such a day that the dollar won’t fetch one grain of golf is going to dawn.

And you won’t have to wait for it till doomsday. It is around the corner.

I leave the challenge to debate the semantics of the word “arbitrage” unanswered. I will continue my crusade trying to fend off permanent gold backwardation. The American government could do it overnight by opening the U.S. Mint to gold. It is not too late to do it. I continue to sound the alarm that the present insane gold policy of our political and economic leadership shall land us in the black-hole of permanent gold backwardation, with a ticket to the next Dark Age of Western civilization.

---

*December 21, 2013.*

---

# Destruction of Capital, Economic Resonance, Hyperdeflation

URL: https://newaustrianeconomics.com/archive/fekete/destruction-of-capital-economic-resonance-hyperdeflation/
Date: 2013-11-07
Section: Popular Economics
Difficulty: scholarly
Concept Tags: capital-destruction, deflation, permanent-backwardation, gold-basis, fiat-currency
Description: A third Daily Bell interview covering three advanced topics: the mechanism of capital destruction under falling interest rates, the resonance/feedback dynamics that can produce monetary collapse, and the concept of hyperdeflation — a collapse in capital values more catastrophic than historical hyperinflation. Fekete argues hyperdeflation is the most likely endgame of the current monetary system.
Editorial Note: Third Daily Bell interview (November 2013). The three topics — capital destruction, resonance, and hyperdeflation — represent Fekete's most advanced analytical contributions, and the interview format makes them more accessible than the technical papers.
Original PDF: https://professorfekete.com/articles/AEFThirdDailyBellInterviewRev11713.pdf

### Destruction of Capital, Economic Resonance, Hyperdeflation

The Daily Bell is pleased to present this exclusive interview with Antal Fekete.

Introduction: Professor Antal E. Fekete is an author, mathematician, monetary scientist and educator. Born in Budapest, Hungary in 1932, he graduated from the Eötvös Loránd University of Budapest in mathematics in 1955. He immigrated to Canada in 1957 and was appointed Assistant Professor at the Memorial University of Newfoundland in 1958. In 1993, after 35 years of service, he retired with the rank of Full Professor. In 1959 he was Instructor in Mathematics at Columbia University in New York. In 1963 he was Visiting Professor at Trinity College, Dublin, Ireland. In 1975 he was Fellow at Princeton University, Princeton, New Jersey. In 1983 he was resident scholar at the American Institute for Economic Research in Great Barrington, Massachusetts. While on a tour of duty in the Congressional Office of William E. Dannemeyer, Congressman from California, in Washington, D.C., professor Fekete was working on monetary and fiscal reform in the United States. The plan was taken to the Oval Office by a delegation of ten Republican Congressmen led by Mr. Dannemeyer and presented to President George Bush in October, 1989. In 1995 professor Fekete was resident fellow at the Foundation for Economic Education in Irvington-on-Hudson, New York. In 1996 he was Visiting Professor at the Francisco Marroquín University in Guatemala, teaching Austrian economics. He is the founder and Chairman of the New Austrian School of Economics in Hungary. His website is [www.professorfekete.com](https://www.professorfekete.com) and [www.antal.fekete.com](https://www.antal.fekete.com) . Professor Fekete is a proponent of the gold standard and an outspoken critic of the monetary system based on irredeemable currency. His work falls into the school of free-market economic thought inspired by Carl Menger. He claims that his theory of interest is an extension of Menger’s work, who championed the theory of direct exchange morphing into indirect exchange. In the same way Professor Fekete is championing the theory of direct conversion of income into wealth and wealth into income (read: gold hoarding and dishoarding) morphing into indirect conversion (read: selling and buying gold bonds). Professor Fekete is an advocate of Adam Smith's Real Bills Doctrine that he calls the Gold Bills Doctrine.

He was last interviewed on the Daily Bell on May 5, 2013.

Daily Bell Interview, October 27, 2013.

Daily Bell: Hello again. Let's jump right in. The price of gold is still declining. Bring us up to date on the price action since we last spoke, please.

Antal Fekete: I take strong exception to your using the language of ‘rising and falling gold price’. It puts things standing on their head. It paints a will-o’-the-wisp picture of reality. The rising of the gold price in reality is the irreversible long-term decline in the value of the dollar due to the U.S. defaulting on its gold obligation to foreign central banks and international financial institutions; the falling of the gold price in reality is a temporary strengthening of the dollar for whatever, mostly irrelevant, reasons. There is absolutely no symmetry between the two events. Moreover, this is as it ought to be, since the dollar is nothing but a dishonored promise to pay gold. When did you last see the dishonored promise of a banker permanently go to a premium? Whatever decline in the gold price you are talking about, it has not made a dent in the towering fact that the dollar has lost over 95 percent of its gold value as well as purchasing power since it was dishonored 42 years ago in 1971.

The language of ‘declining gold price’ serves the interest of those whose hidden agenda is to blindfold the public in order to leave people in blissful ignorance about the terminal agony of the moribund dollar. It is disingenuous to suggest that the gold price is declining. A better way of expressing that fact is to say that a stay of execution for the dollar is in force.

Daily Bell: We hear that the Fed is actually considering increasing the amount of money being printed, presumably to break out of a liquidity trap. What's your take?

Antal Fekete: Liquidity trap is claptrap invented by Keynes. If the Fed is trying to fend off deflation, then it is using counter-productive means to achieve its ends. ZIRP (zero interest rate policy) has the effect of destroying capital. As the rate of interest is halved, the price the longterm bond is doubled. It now takes twice as much money to get out of debt. This is a loss that has to be charged to capital. The burden of debt has increased and the increase is the measure of destruction of capital.

Printing money makes the problem worse, not better. You see, opening the tap fully will not necessarily increase the water-level in the tub. You also have to consider the status of the drain. If it is unplugged, as it is now, monetarily speaking, witness the ongoing destruction of capital, then the water-level in the tub may well be receding.

Daily Bell: You have been taken to task by your critics for suggesting that a falling interest-rate structure erodes, even destroys, capital. A bank carries its capital in the form of bonds. But bond values increase as interest rates decline. How do you explain this apparent contradiction?

### Has bank capital been destroyed, or has it been boosted?

Antal Fekete: Most certainly it has been destroyed by the falling interest-rate structure. To the extent the appreciating bonds are on the capital accounts of the bank, sound book-keeping principles demand that their market value be reported in the liability column, definitely not in the asset column, of the balance sheet. It should be crystal clear that the regime of falling interest rates erodes and ultimately destroys intangible capital. Conversely, the regime of rising interest rates erodes and ultimately destroys tangible capital such as plant and equipment of producing firms, as they are rendered submarginal. The thirty-three years old bull market in bonds has taken a terrible toll on bank capital.

Virtually all banks have been rendered insolvent, with the rest to follow.

Governments and central banks burn the midnight oil in trying to stonewall this fact, in vain. They pretend that insolvency is but a temporary liquidity problem. But this unprecedented banking crisis cannot be wished away so easily. Keynes is dead, and so is his idea that items can be shifted from the liability to the asset column of the balance sheet of the government at will. My critics are ignorant of double-entry book-keeping. But the real scandal is ignorance at the Fed, the Treasury and in academia. No one exposed ZIRP as a blueprint for the wholesale destruction of intangible, including bank capital.

Incidentally, the banking crisis in the U.S. 80 years ago was also caused by the destruction of capital due to declining interest rates, but you mustn’t say this in polite company.

Daily Bell: Do you still believe there's no way out of this cycle but "extinction" and then barter?

Antal Fekete: It is not a cycle, it is a disaster brought upon us by the incompetence and ineptitude of our Keynesian and Friedmanite money doctors. It leads to permanent gold backwardation (read: headlong rush of gold into hiding) that will in the fullness of time convert our incomparable multilateral trading system into miserable barter, and our highly productive world economy into a subsistence economy.

### Daily Bell: What would you do if you were head of the Fed?

Antal Fekete: When Mises was once asked what he would do if he were the President of the United States he said he would resign forthwith. I answer your question by saying that I would issue a strongly-worded statement that I don’t want my name to be associated with a wrongheaded, utterly corrupt and unconstitutional experiment with irredeemable currency, foisting it upon the rest of the world. It is dishonorable. It is immoral. It marks the darkest hour in the history of this nation. Then I would resign.

Daily Bell: What is Janet Yellen going to do when she becomes Fed head? Will there inevitably be another crash?

Antal Fekete: She is well-heeled to kick the can further down the road, as they say. This road leads to a series of crashes, the blowing and pricking of bubbles. We are already in a depression, masked by unlimited money creation which is pouring oil on the fire of deflation. If 50+ percent youth unemployment does not indicate depression, then I don’t know what depression is. Bond purchases by the Fed lead to halving interest rates and halving them again and again. This is tantamount to destruction of capital as we mentioned a moment ago.

Lower interest rates mean higher bond prices, which measure the increase of the burden of debt, the proverbial straw that breaks the back of the camel. Not only is the debt increasing exponentially in absolute terms; the burden of debt is increasing as well on the top of that.

Daily Bell: Are the central bankers managing to re-stimulate? We believe that they will cause another stock market boom and bust. Your thoughts?

Antal Fekete: Central bankers manage to stimulate prosperity and the economy into oblivion. Capital destroyed by the falling interest rate structure cannot be resurrected by an exercise in “exit strategies” or in “tapering”. Besides, easy money (quantitative or otherwise) is addictive.

Once being hooked on it, the economy cannot be weaned off the drug.

There is a threshold of abuse beyond which the economy is doomed.

Daily Bell: The current "recovery" will not be extensive no matter how high the market runs because a money-led expansion cannot affect the underlying distortions of the economy. Only a full-fledged purging can do that, letting bankrupt firms fold up, etc. Comment?

Antal Fekete: You have put it beautifully.

Daily Bell: Let's return to your previous interview with some follow-up questions. Why does gold's marginal utility decline at a rate lower than that of any other commodity, as you observed last time?

Antal Fekete: It is the result of a long ongoing historical process that has started even before writing was invented. As Menger described it in his Origin of Money, people came to be using the most marketable good for exchange purposes, in order to reduce losses to irreducible minimum.

Like it or hate it, the most marketable good was (and is) gold.

Marketability is measured by the spread between the asked and bid price as ever greater quantities are thrown on the market. For the most marketable good the spread declines more slowly than it does for any other. Now Menger had a problem. He was about to define what “price” was supposed to mean, and got tangled up in a circular argument that used price in the process of defining price. He resolved the problem brilliantly by introducing the concept of marginal utility. Thereby he could avoid using the word “price” in the definition of price. By this stratagem he could break out of the logical vicious circle. To say that the marginal utility of gold declines more slowly than that of any other good is just another way of saying that the most marketable good within the observation of man is gold. It has to do with the fact that the ratio of existing stocks to annual flows of new production is far greater for gold than for any other good (with the possible exception of silver).

Daily Bell: You pointed out that gold does not obey the Law of Supply and Demand. "For example, a higher price of gold need not call out a greater supply; often it causes the supply to shrink further." So when Rothbard stated that higher gold valuation was bound to pull metal into the market, he was wrong?

Antal Fekete: Not necessarily. Perhaps Rothbard was thinking of a crisis-situation such as the one that presented itself on August 15, 1971.

On that day President Nixon was facing the world-wide flight of gold into hiding on an unprecedented scale. He could have solved the problem by doubling the official gold price from \$35 to \$70 per oz. This would have stopped the hemorrhage and would have coaxed a lot of gold out of hiding. On that day Paul A. Samuelson, the paramount apostle spreading the Keynesian gospel in an amusing but long-forgotten incident jumped the gun. He published an op-ed article in the Washington Post in which he stated that President Nixon decided to devalue the dollar in terms of gold by 50 percent! This amazing faux pas left Samuelson red-faced when Nixon went on world-wide TV announcing that, on the contrary, he was ‘closing the gold window’ – a euphemism for defaulting on the international gold obligations of the United States. It became clear that Nixon spurned the Nobel-prize laureate Keynesian in failing to consult him, of all people, in making a decision of such historical import.

Daily Bell: You have also said that "people would dishoard gold if its scarcity pushed up interest rates. In the 19th century there was a saying that the Bank of England could pull in gold from the moon with a bank rate of 5 percent." These two statements seem slightly contradictory.

### Can you explain?

Antal Fekete: Yes. The second statement refers to the routine operation of the gold standard, in the absence of a confidence crisis. Once the rate of interest has risen, the marginal bondholder buys back his gold bond at a lower price. In doing so he relinquishes the gold coin he obtained when he had earlier sold his bond at a higher price. This is known as the Fullarton Effect, an anathema of Mises. By contrast, the first statement refers to a crisis of confidence. Gold takes flight into hiding and drastic measures are needed to stop the flight and to coax gold out of hiding.

Daily Bell: You also told us, "Today no university offers courses treating the gold basis, the gold cobasis and their interplay. They are silent on the apocalyptic threat of permanent gold backwardation." Can you expand on what you meant?

Antal Fekete: Here I am talking about the ominous and frightening parallel with the flight of gold into hiding in 476 A.D., the year when the Western Roman Empire collapsed − after centuries of monetary mismanagement, debasement diluting the gold and silver coins of the realm by adding base metals to the alloy. The result was a disastrous return to barter and the breakdown of law and order. Today the situation is analogous with the difference that we now have a concrete measure of the flight of gold: the gold basis. When permanent gold backwardation sets in (meaning that the basis has turned and stayed negative), it will mark the withdrawal of all offers to sell gold. Those who want it must get it through barter. This will kick off a contagion, spreading barter to all markets trading highly marketable commodities such as food, fodder and fuel. Not one university in the world is sounding the alarm that the collapse of civilization may be in the offing comparable to that experienced during the “Dark Ages.” The New Austrian School of Economics is the only place where one can learn about the negative gold basis, permanent backwardation of gold and the drowning of the world in hopeless barter.

Daily Bell: You told us that silver available for futures trading is dwindling and disappearing fast. "Permanent backwardation of silver is a matter of time, probably not a very long time." Where are we on the time curve?

Antal Fekete: That is hard to say. The interesting question to ask is whether gold or silver will be the first to go to permanent backwardation. Either event would trigger the other. You must watch both markets for early signs of budding permanent backwardation. I conjecture that probably silver will go first, but the evidence is circumstantial at best.

Daily Bell: You said: “The likely cause of the recent shake-out in the gold futures markets is not what you call ‘too high expectations’. Rather, it is Bernanke's belated recognition of the threat of permanent backwardation, and his attempt to 'scare the horses properly.' ”In simplest terms, what is the consequence of backwardization and why should Bernanke be worried about it?

Antal Fekete: The correct term is ‘permanent gold backwardation’. As I have indicated a moment ago, it would usher in barter economy that is grossly insufficient to serve the multifarious needs of our complex world trade. All kind of shortages would appear; famine, pestilence, unemployment would be rampant. Bernanke should be worried about it because it would mark the operation of a black hole with its irresistible pull, from which there is no escape. Bernanke should know, he has been there. He studied the black hole of the Great Depression sucking in the world economy in the 1930’s.

Daily Bell: You pointed out to us previously that the "Constitution left it to the market to determine the rate at which the gold eagle would be tariffed in terms of the standard silver dollar. The Coinage Act of 1792, championed by Alexander Hamilton, the Secretary of the Treasury, established an official bimetallic gold/silver ratio at 15 to 1. This was price-fixing and as such unconstitutional." Did Hamilton know what he was doing? Did he realize he was destabilizing the US currency?

Antal Fekete: Hamilton was not a friend of the ideal of limited government. He wanted to enlarge the power of the federal government at the expense of state governments. He may not have realized that he was destabilizing the dollar, but he certainly believed in the omnipotence of the federal government to make his bimetallic ratio stick. Well, it did not and, as they say, the rest is history.

Daily Bell: You told us, "Historically money is not the creature of the state. It is the creature of the market in promoting gold as the most marketable substance on Earth over the millennia." It is probably safe to say that you don't believe along with assorted Gesellians and Brownians asserting that money is the province of the state and it cannot exist absent government control. True?

Antal Fekete: Yes and no. Comparable in importance to the invention of the wheel was the invention of the gold coin in the fifth century B.C.

It made gold payments possible by tale. The expression ‘paying by tale’ means counting out gold coins rather than weighing them − a clumsy procedure by comparison. Paying by tale is made possible by the government’s guarantee to strike gold coins to exact standards, and its willingness to absorb losses due to wear and tear – much the same way as it absorbs the cost of keeping the highways in good repair. The original meaning of ‘legal tender’, before advocates of monetary duress distorted it beyond recognition, was that the weight of the gold coin must fall within the range of established tolerance standards. Legal tender gold coins were those the weight of which complied with the standard. Legal tender gold coins were accepted at face value when paid out by tale, even if they were slightly under-weight. Coins that fell outside of the tolerance standards were not legal tender. They were accepted, but only by weight, not by tale. It can be seen that the involvement of the government in minting and circulating gold coins was an essential one, and we haven’t even mentioned how the government was supposed to deal with counterfeiters. But at this point government involvement must stop. In particular, the decision as to how many new gold coins ought to be put into circulation was not up to the government to make. It was up to the people. If they thought that there were not enough gold coins, then they could do something about it. They would take new gold from the mines, or old gold from jewelry to the Mint and get the same gold back in coined form, ounce-for-ounce. The right to regulate the money supply was the prerogative of the people, not of the government or of the banks.

Daily Bell: You have pointed out a weakness of the theory of the business cycle according to Mises. Why do people allow themselves to be fooled by money magic over and over again? Why don’t they learn from experience that banks are tempting them with teaser loans, and would lead them to their downfall? They should invest in new projects only after extra careful study leaving a wide margin of safety, after due allowance was made to for the distortion of interest rates by the banks.

Your perspective is that "an improved theory of the business cycle must consider the causality relation between varying prices and varying interest rates." And you explained it thus: "It is reasonable to appeal to the phenomena of economic oscillation that has often been talked about, and economic resonance that has been talked about much less. Here are the details. Apart from leads and lags, rising (falling) prices make interest rates rise (fall) and, conversely, rising (falling) interest rates make prices rise (fall)." This induces oscillation for both prices and interest rates. A huge money-flow from the bond market to the commodity market is generated. When commodity prices reach absurd heights, the money flow abruptly changes direction. Now it flows from the commodity market to the bond market, until bond prices reach absurd heights, when the direction of the flow changes again. And so on and so forth. This is economic oscillation: prices and interest rates both oscillate. If the frequency of oscillating prices happens to coincide with that of oscillating interest rates, then resonance occurs. It could be dampened or the opposite, self-boosting (also called runaway) resonance. In the latter case there is trouble. The energy-level of the oscillating system increases and gets arbitrarily large. It leads to what is known as hyperinflation, provided that it occurs during the phase when money is flowing from the bond market to the commodity market. Could you elaborate on that?

Antal Fekete: Hyperinflation always means that the velocity of moneycirculation is getting ever higher, in fact higher than any given velocity, however large. This may or may not be accompanied by central-bank money printing. The fact is that the underlying flow of existing money from the bond market to the commodity market can do the trick, regardless whatever the central bank does or wishes.

Daily Bell: But then you added: "there is also a second variety of the malady for which there is no precedent because governments never before experimented with irredeemable currency on the global scale. Up to now in each episode some governments have preserved their sanity and refused to join the insane experiment. This is the first time in history that all governments have joined in the suicide-pact. The result is hyperdeflation. That is what we are apparently going to have." Please elaborate on that as well.

Antal Fekete: Hyperdeflation means that the velocity of moneycirculation is getting ever lower, in fact lower than any given velocity, however small. The important thing to note is that this is happening regardless what the central bank does. It is the direct consequence of the spontaneous money-flow from the commodity market to the bond market. No amount of money-printing will change that. Hyperdeflation takes place when resonance and breakdown occur during the phase when commodity prices and interest rates are falling.

Daily Bell: Mises definitely did not believe that deflation could occur during a money-printing episode such as the one we are experiencing right now. Could you revisit this topic and make the process clearer?

### How does "economic resonance" affect interest rates?

Antal Fekete: As money flows from the commodity market to the bond market, commodity prices fall along with interest rates (because bond prices rise). Under a gold standard this process would be stopped sooner or later as commodity prices cannot fall to zero. Under our global fiat money experiment, however, the central bank is compulsively halving interest rates again and again, unwittingly causing further price declines in the commodity market. There is a vicious downward spiral in operation: falling commodity prices chase interest rates lower, and falling interest rates chase commodity prices lower. It is crazy. It is unbelievably stupid, but there it is. The central bank in blind faith in the Quantity Theory of Money is destroying the economy. Everybody is expecting hyperinflation, but what we are getting is hyperdeflation.

Daily Bell: You seem to believe that the velocity of money is entirely a monetary phenomenon. Misesians tend to believe that falling monetary velocity has to do with lack of demand because economic vitality is distorted by central bank money printing. Which is it? Or is it both?

Antal Fekete: Arguing in terms of a lack of demand is a Keynesian trait. I dislike arguing in terms of the velocity also. Mises once said that the velocity of money is always zero, period. At any one moment in time money is in the cash-balance of someone, sitting there with zero velocity. I think the correct approach to the deflationary spiral is through arguing in terms of resonance between oscillating commodity prices and oscillating interest rates. Mainstream economists do not understand speculation. Post-Mises Austrian economists are no better at it. Risk-free speculation in the bond market explains everything without a hitch.

Daily Bell: Please explain.

Antal Fekete: Speculators know full well that the central bank is buying bonds hand over fist. They can also time the central bank’s purchases pretty accurately. In fact, central bankers shout from their rooftops about QE and other imbecile tricks. They even give the timetable for the scheduled purchases away. Speculators react by pre-empting central bank purchases. They simply buy the bonds beforehand. True, sometimes the central bank falsecards. But it cannot fool speculators who risk their own capital and face hired hands of the central bank in the poker whose losses are automatically charged to the public purse. The result is that speculators have a free ride. (Think of George Soros and his busting the Bank of England.) They profit without taking any real risk.

They win big, and the merry-go-round keeps running out of control.

Daily Bell: Please share with us your criticism of the idea that fractional reserve banking is a crime, as Murray Rothbard once held.

Antal Fekete: This is a major departure of Rothbard and, before him, of Mises, from Carl Menger’s monetary theory. Menger held that commercial banks, quite properly, make more loans than their net gold reserves would on the face of it justify. The excess is balanced by gold bills, that is, bills of exchange maturing daily in gold coins. You can look it up in Menger’s Geld, third edition (1909). Mises published his Theory of Money and Credit just three years later, in 1912 (we do know that he wrote the manuscript in 1911). He must have read Menger’s Geld before his book went to press. It is totally incomprehensible to me why Mises fails to refer to Menger’s analysis of the commercial banks’ practice of monetizing gold bills. Or why he did not criticize it if he disagreed. Be that as it may, “fractional banking” is a malicious misnomer. The commercial banks’ reserves are not “fractional”. They are full because their portfolio of maturing gold bills is as good as gold.

The same is true of central bank reserves.

Daily Bell: You're a proponent of real bills. Can you remind us of why Misesian Austrians like Rothbard dismissed real bills as inflationary?

Antal Fekete: They call the monetization of gold bills fraud for the silliest of reasons. They hold that bank notes are fake warehouse receipts. They do not understand that bank notes are not warehouse receipts at all: they circulate as proxies of gold bills that are also capable of monetary circulation themselves. Bank notes are more convenient, and have a higher name-recognition. Post-Mises Austrians hold that issuing bank notes is fraudulent. It is inflationary – they say – as it increases the money supply. What they fail to see is that gold bills rise and expire together with new consumer goods morphing from semifinished into a finished good, before they disappear in consumption. The gold coins surrendered by the consumer liquidate all claims that have arisen along the passage of semi-finished goods from the producers of higher order goods to those of lower-order goods. Rothbard would have the producer of lower order goods pay the producer of higher order goods in gold coins. But this is absurd! No producer has ever paid a single gold coin for a semi-finished good, never ever! Payments in gold coin are made exclusively for finished goods, and that by the consumer, not by the producer! Producers of higher order goods get paid for their semi-finished goods by drawing bills on the producer of lower-order good, and that’s that.

Daily Bell: Explain to us again how commercial banks arose in reaction to the inconvenience of real bills denominated in odd figures, as compared to the convenience of bank notes denominated in round figures.

Antal Fekete: That was the smaller inconvenience. By far the greater inconvenience was that the discount had to be calculated and paid every time the gold bill changed hands, which it did often. But calculating and paying the discount was eliminated when turnover increased and people held the gold bill for such short periods of time that the amount of discount became negligible, not worth bothering with. People were happy to forgo the discount due to them, in exchange for the great convenience of being able to use bank notes. A third inconvenience that was eliminated by the appearance of bank notes was the need for endorsing. Paying with a gold bill was not complete until the payer endorsed it on the back. A fourth inconvenience was that gold bills had an expiry date to watch. Bank notes have no expiry date, although the bank of issue had the obligation to withdraw as many of them from circulation as the sum total of the face values of expired gold bills demanded. If the bank of issue failed to do that, then it was guilty of fraud. This was a crime dealt with by the Criminal Code. The bank of issue could not pay out bank notes that had been withdrawn from circulation at the time their gold-bill backing expired, unless it rediscounted an equal amount of fresh gold bills, or it purchased an equal amount of gold.

Daily Bell: Explain as clearly as possible how real bills ceased to function. Why were they attacked? Last time you mentioned that the real bill market was a casualty of World War One. Please expand and explain as simply as possible.

Antal Fekete: Gold bills did not cease to function. I shall put it bluntly: gold bills were brutally murdered covertly, after the young men put in uniform had been murdered in the field overtly. The blame goes largely to the victorious Entente powers that in 1918 acted unilaterally, without consulting anybody, keeping their plan in secret, covering their trail.

What was their motivation? Well, they feared post-war German industrial competition that they were not prepared to meet head-on. They were of course obliged to lift the blockade of Germany in compliance with the terms of the peace treaty, but they thought they could finesse their way through. Blocking the trade of gold bills in the London clearing houses promised to be a clever, if dishonest, substitute for the blockade. However, the Entente powers were caught in the trap of their own making that was supposed to harm their antagonists. They shot themselves in the foot. The gold standard Britain re-established in 1925 failed because it missed an organic part: the clearing house, that is, the market for gold bills. No gold standard could ever succeed without a proper gold bill market. British politicians, among others Winston Churchill, the Secretary of the Exchequer in 1925, were not bright enough to see that.

Daily Bell: You also explained that withering of the real bill market caused the Great Depression. This is a decidedly minority view, even within the hard-money community. Please revisit this topic.

Antal Fekete: This is the view of a minority of one: me. I again object to your choice of words. It was sabotage, not withering. In deliberately destroying the bill market, the Entente powers have unwittingly also destroyed the wage fund out of which workers producing merchandise for consumption could be paid, a good three months before their products were sold for cash. What politicians and economists forgot in 1918 was that without the bill market there is no wage fund, and without the wage fund there is no employment. Instead, there is unemployment, lots of it. There is no way to finance the production of consumer good now, for which the consumer will pay only 91 days later, unless gold bill financing is available. In the euphoria after the Entente victory several bubbles were blown: the bubble in the U.S. government bond market in 1921, the bubble in Florida real estate in 1925 and, most notoriously, the stock market bubble in 1929. Nobody realized that the bubble-financed consumer goods market would be starved of funds once the last bubble was pricked. That happened in 1930 when it dawned on the world that the bloated inventory of consumer goods was unsalable.

Had the bill market been rehabilitated in 1918 as it should have, adjustment in inventory would have been made in time to avoid the glut, and financing for further production would have been available through discounting gold bills. The upshot was that workers producing consumer goods had to be laid off in six-digit contingents. Puerile pseudo-theories were concocted by Keynes and others, such as the theory of oversaving, the theory of underconsumption, the theory of disappearing demand in ‘mature’ capitalist economies, the theory of ‘contractionist’ nature of the gold standard, to mention but a few. No one was looking for an answer in the forcible destruction of the global gold bill market that alone makes multilateral trade possible, inspired by the chauvinistic jealousy of the victorious Entente powers that stemmed from their neurotic fear of German industrial competition. They thought, wrongly, that bilateral trade, through which they wanted to control German exports and imports, could be a working substitute for the system of multilateral trade as embodied by the international market for gold bills. Bilateral trade turned out to be a disaster.

Daily Bell: For readers who may be reading this for the first time, please explain how real bills work and why they are so important.

Antal Fekete: The market for gold bills is entirely spontaneous. It was invented by no one; it was promoted by no government. Like money itself, the gold bill was the result of an evolution. Here is how it works.

The wholesaler delivers supplies to the retailer and bills him. Once endorsed by the latter the bill goes through a metamorphosis and becomes money in the hand of the wholesaler (and his suppliers, and the suppliers’ suppliers, etc.) that can be used in replenishing inventory. The gold bill, the next best thing to the gold coin, becomes money, albeit an ephemeral one. It is destined to expire in no more than 91 days. Gold bills are the best earning asset a commercial bank can have. Demand for them is virtually unlimited. Not only will producers and distributors of semi-finished goods scramble for them. Everybody with a large payment coming up, such as bond issuers just before the maturity date of their issue, or purchasers of real estate just before the closing date will, too.

They would not accumulate bonds, for example, in preparation of paying their obligations at maturity. Bonds are far too illiquid for that.

Daily Bell: Please review again your criticisms of the Quantity Theory of Money. It certainly makes sense on a simplistic level. When you print too much money, you devalue the rest. Why isn't this an accurate statement?

Antal Fekete: You can print all the money you want, but once you put it into circulation, you no longer have control over it. Money flows where it will; the only thing certain is that it will not flow uphill. Instead, it will flow to the place where the fun is. Right now the guys at the Fed hope against hope that their freshly printed Federal Reserve notes will flow to the commodity market or the housing market. But that’s not where the fun is. The fun is in the speculative financial markets. That’s where the money flows, frustrating the Quantity Theory of Money and those who believe in it.

Daily Bell: You stated your theory implies a rehabilitation of Adam Smith's Real Bills Doctrine. But how is the Real Bills Doctrine linked to the denial of the Quantity Theory of Money?

Antal Fekete: The Gold Bills Doctrine is a living reminder that the Quantity Theory is false. It is thorn in the flesh. Certainly, drawing gold bills will add to the money supply, but it does it in such a way that will not make prices to rise.

Daily Bell: Why did Rothbard dislike Adam Smith? He criticized Smith based on the title of his book, Wealth of Nations, pointing out that nations didn't own wealth, people did. Is this a valid criticism? If it is, does it imply a basic misconception on Adam Smith's part?

Antal Fekete: No, it doesn’t. The title of a book must be concise (not that the full title of Adam Smith’s book is the paragon of conciseness!) Rothbard is right in saying that macroeconomic aggregates such as a nation do not act like individuals, nor do they create or dispense wealth.

That’s the trouble with macroeconomics. It is a silly anthropomorphism.

It assumes that macroeconomic aggregates have free will. You must treat the “wealth of nations” as figurate speech.

Daily Bell: You stated previously that “the fratricidal war between the Time Preference School and the Productivity School of Interest must end.” Can you explain the differences between these two theories?

Antal Fekete: The Time Preference School teaches that interest exists solely because of our innate preference for present goods as opposed to the same quantity and quality of future goods. The Productivity School teaches that interest exists only to the extent of greater productivity due to the application of better tools and methods in production. Interest theorists, in their conceitedness, have never considered that both theories may be right simultaneously. This omission resulted in a stagnation of the theory of interest that has remained the most backward chapter in economics to this day.

Daily Bell: You stated the following: "Using Menger's idea of the bid/asked spread, the two theories can be merged in a happy synthesis.

Just as the price of goods is not monolithic but splits into bid and asked prices, so the rate of interest is not monolithic either: it splits into a floor and a ceiling rate. These two must be studied separately. Their rise and effect are different. The ceiling rate can be understood in terms of marginal productivity; the floor rate in terms of marginal time preference." Isn't this a bit complex for most people and is it not the reason why the quantity theory of money is accepted by popular acclaim?

Antal Fekete: The special theory of relativity is also “a bit complex”, yet you have to master it if you want to understand high-velocity physics dealing with particles moving almost as fast as light travels. It is not popular acclaim that has made the special theory of relativity valid. The trouble is that the rate of interest was never properly defined. Here is the proper definition: the rate of interest is that rate at which the stream of interest payments plus the lump sum payment of the (fixed) face value at maturity amortize the (variable) market value of the bond. The reason why economists have never hit upon this definition is that the bond market was suppressed pursuant to secular and canon law for centuries.

The last ban was lifted as recently as the 19th century when the Vatican instructed confessors not to disturb penitents accusing themselves of taking or paying interest (read: buying or selling bonds). Once you accept this definition you will realize that there must be two interest rates, one having to do with the asked price and the other with the bid price of the bond.

Daily Bell: Update us on your New Austrian School of Economics. Also explain generally the main differences between your school and Mises.

You seem to admire Menger more than Mises.

### Antal Fekete: I admire Mises as long as he does not deviate from Menger. I feel I have to criticize Mises whenever he does. Post-Mises Austrians think that criticizing Mises is sacrilege. It is not. In science there is no Revelation. Instead, there is debate out of which truth springs in full armor in the fullness of time. Just this month, October, 2013, the New Austrian School of Economics held a Seminar at the British Museum in London where the New Austrian Economic Manifesto was formally adopted. It considers six points of disagreement between the two schools, all concerning the denial of either Menger or of Adam Smith by post-Mises Austrians. You may read it on my website for a fuller understanding of our differences.

Daily Bell: Will you bring out more material on your theory of economic oscillations and resonance? How about a history of real bills?

Antal Fekete: The history of gold bills is treated adequately in the literature. I am working on my treatise entitled The Rise and Fall of Credit, to be published in German next year, in which I give a full treatment of the theory of economic oscillations and resonance, and the destructiveness of the latter as it becomes self-boosting.

Daily Bell: Are you in the midst of a truce with the Misesians, or does the Cold War continue? You called the "altercation" a "tragic waste of talent" in the past. Status quo?

Antal Fekete: I do mean it literally. There should be a dialogue instead of altercation. Mediaeval theologians had endless dialogues on the question how many angels can simultaneously dance on the tip of a needle. Our dialogue ought not to be like that. It would be about something on which the future of all of us, and that of our children and grandchildren, indeed the survival of our civilization vitally depends.

Daily Bell: Thank you for the interview.

Antal Fekete: Thank you for the searching and penetrating questions.

Note: This is a revised version of the original interview with the Daily Bell on October 27. The date of revision is November 7, 2013.

---

# New Austrian Economics Manifesto (October 2013)

URL: https://newaustrianeconomics.com/archive/fekete/new-austrian-economics-manifesto-october-2013/
Date: 2013-10-25
Section: Popular Economics
Difficulty: intermediate
Concept Tags: new-austrian-economics, gold-standard, real-bills, gold-basis, permanent-backwardation, sf-school
Description: The October 2013 revision of the New Austrian Economics Manifesto, incorporating the Gold Bills Doctrine and updated basis analysis. This version represents Fekete's most mature statement of the New Austrian School's complete theoretical framework, incorporating all the developments of his post-2005 work.
Editorial Note: The October 2013 version of the Manifesto — the final and most comprehensive version. Note: the site already has an MDX file for this content; this version documents the fully developed framework.
Original PDF: https://professorfekete.com/articles/AEFNewAustrianEconomicsManifesto4.pdf

## New Austrian Economics Manifesto

---

*July 4, 2013*

Formally adopted at the Seminar held in the British Museum, London, on October 6, 2013

In a recent pamphlet Llewellyn H. Rockwell, President of the Mises Institute writes that we are all ceaselessly being bombarded by the media and college educators with propaganda to the effect

“that capitalism causes depressions and exploits the poor. That government is our salvation, and the bureaucrat a hero. That America owes its wealth to the Federal Reserve. That without massive regulation we’d be sunk…That cutting government even a smidgen and permitting free markets would be a disaster…

John Maynard Keynes died more than 60 years ago, but his ideas still rule us from the grave: give government more power, and print more money…”

It is a pleasure to acknowledge that Mises University, the Mises Institute’s week-long summer program for students has done an outstanding service to society in flouting the conventional wisdom about government, and explaining the logic behind free enterprise.

Why then does the New Austrian School of Economics (NASOE) take issue with the Mises Institute? As this Manifesto explains it does because post-Mises Austrian economics has ceased to be open to new ideas. It is trying to ossify Austrian economics at the level where Mises left it. It is inimical to the appearance of new knowledge as it flows directly from the founding principles of our school, unless stamped with its own nihil obstat. Discussion and criticism are discouraged. Many a topic is outright tabooed. There is a tendency to turn science into cult. As a result, post-Mises Austrian economics never came up with a really potent theory that could offer an alternative to the mainstream. Nor did it draw up a comprehensive blueprint for the new economic order that would follow the collapse of the current experiment with global irredeemable currency. It claims a monopoly of ideas how the gold standard of the future ought to look like. It must be ‘one hundred percent’ or nothing.

The last thing it would consider doing is to sponsor a conference that would entertain ideas other than its own.

The reason for these failings is that post-Mises Austrian economics has deviated from, if not completely abandoned the philosophy and methodology of the founder of the movement, Carl Menger (1840-1921). To substantiate this charge here is a list of six errors, the first three of which are errors of commission; the last three are errors of omission.

(1) Post-Mises Austrian economics dismissed Adam Smith’s Gold Bills Doctrine (GBD) on the argument that it is ‘inflationary’ and has led to ‘the source of all evil’, fractional reserve banking. This was an act of denying Menger who, in his encyclopaedic article Geld (3rd edition, 1909) devotes an argument to justifying the practice [2].

Indeed, commercial banks do create credit upon deposits in excess of cash

(gold) reserves. The asset backing this liability is “their usually extensive discounting of bills of exchange”. The central bank issues “document money” in fulfillment of its mission to rediscount bills of exchange offered to it by commercial banks in need of cash.

Thus Menger, “in order to develop a realistic theory of an economy’s cash requirements”, far from condemning what post-Mises Austrian economists disingenuously call ‘fractional reserve banking’, endorses it. Apparently he does that because he accepts Adam Smith’s GBD without reservations.

The term ‘fractional reserve banking’ used in the context of discounting real bills is a malicious misnomer. Reserves of commercial banks discounting real bills are not fractional. They are full in the sense that the non-gold part of it consists of real bills ‘maturing into gold’ in less than 13 weeks. They are the most marketable instruments second only to gold. Real bills can fly on their own wings and under their own power (read: they can circulate as money without duress, something the reserves for irredeemable currency certainly cannot do). They represent self-liquidating credit. Accordingly, gold bills are the best earning assets a commercial bank can have. Demand for them is exceedingly keen. Not only do commercial banks scramble to get them; financial institutions and other economic agents with large maturing liabilities do as well. Bonds won’t do for the purpose of accumulating cash in anticipation of payments falling due. They lack the necessary marketability. Loose talk about the inflationary effect of discounting only betrays ignorance about basic banking theory as it was developed by German experts in the 19th century, and as it was understood by Menger.

The payments system incorporating discount facilities for gold bills payable in gold coin any time during the gestation period (not exceeding 13 weeks) of the maturing consumer goods made possible a spectacular and unprecedented expansion of production, employment and world trade in the nineteenth century − all promoting prosperity. It would do so again in the twenty-first.

The victorious Entente powers in their wisdom did not allow the bill market and the practice of discounting gold bills to make a comeback at the end of World War I in 1918. To that extent they can justly be blamed for the ensuing Great Depression of the 1930’s. The bill market is the clearing house of the gold standard, as it were. It facilitates wages to be paid before the finished goods are sold to the ultimate consumer for cash. It was not the gold standard per se that caused the Great Contraction, rather, it was the castration of the gold standard in removing its most potent part, its clearing house, that is, the bill market.

Without discounting facilities for bills the wage fund of society is strangled.

Horrendous unemployment follows the destruction of the wage fund. Workers cannot be paid as no one can advance wage payments in the absence of the bill market.

The only way to replenish the wage fund is to resurrect the bill market and the trading of gold bills. It has never happened. ‘Structural unemployment’ of today is due to the suppression of the bill market without which wages cannot be paid in advance of the sale of merchandise. The government would rather pay workers for not working and farmers for not farming than restoring gold bills.

The dismissal of GBD by post-Mises Austrian economics led to the fatal confusion between the rate of interest and the discount rate. It also confused the two inevitable sources of credit: savings and consumption. Post-Mises Austrian economics is quite unable to see how propensity to consume can be a source of credit. Well, just as the rate of interest gages the propensity to save (namely, the greater the propensity to save the lower does the rate of interest go), so the rate of discount gages the propensity to consume (namely, the greater the propensity to consume the lower does the discount rate go). Unlike the rate of interest, the discount rate can go to zero (as it did when people expected doomsday to occur on January 1, 1000). The propensity to consume and the propensity to save are not complementary because of the presence of a third, the propensity to hoard, especially as it becomes prominent during the terminal stage of the regime of irredeemable currency. Hoarding must be distinguished from saving. Despite formal similarities, the rate of interest and the discount rate are fundamentally different both with regard to their sources and their effects.

(2) Post-Mises Austrian economics embraced the Equilibrium Theory of Price and the concept of evenly rotating economy in spite of Menger who was the first economist defying Aristotle in pointing out that the price-phenomenon rests on disequilibrium rather than equilibrium. Far from being static, it is dynamic. As a result, price is not monolithic. It varies between two extremes, the higher asked and the lower bid price. These two extremes never coincide in the very nature of the case. Two separate analyses are required to see how asked and bid prices are formed, each on its own. Supply-demand equilibrium is a spurious concept for a second reason, too. It leaves speculation out of consideration. The presence of speculative bid and offer (that are often made intuitively on the spur of the moment) renders supply and demand indefinable insofar as science is concerned.

(3) Post-Mises Austrian economics failed to develop a theory of interest in the spirit of Menger. In particular, it has nothing to say on the origin of interest, even though the origin of money, treated by Menger, could serve as a pattern.

Paraphrasing George A. Selgin and Lawrence H. White [3], we may describe the origin of interest as follows. It is a logical evolutionary account or ‘rational reconstruction’ of the development of interest as it arose out of the economic need of man to hoard. It explains how interest had emerged incrementally and spontaneously from individuals’ efforts to economize on their costs of hoarding and dishoarding.

Just as Menger’s rational reconstruction of the transition from direct to indirect exchange, one also has the rational reconstruction of the transition from direct conversion of income into wealth (through hoarding) or of wealth into income (through dishoarding) to indirect conversion, namely, the exchange of income for wealth and wealth for income (through buying and selling bonds in the bond market).

The rise of money is the result of the evolution of marketability. But since we have two separate transitions involved, we need to refine the evolution of marketability into two distinct processes: the evolution of marketability in the large (also known as saleability), and the evolution of marketability in the small (also known as hoardability). Each promotes a monetary metal, the former gold, the latter silver, as money to be used for large and small payments, respectively.

Silver, at least initially, was more suitable for hoarding purposes. Gold’s specific value is so much higher as to make it unsuitable for coinage in molar quantities. The important thing to observe is how the evolution of interest was facilitated by marketability in the small.

Historically, the latter evolution was completed much later, after the scholastic fathers and protestantism have made interest taking and paying morally acceptable (they had previously been proscribed by canonical and secular law, making the quotation of the rate of interest perilous if not impossible). For the first time, legal protection was extended to gold bonds under contract law.

Bond-trading was legalized. In consequence, the bond market was able to supersede hoarding and dishoarding monetary metals as a means of converting income into wealth and wealth into income. Following the indulgence of interest taking and paying, vast quantities of monetary metals were freed for other purposes such as capital formation and refinement of division of labor. It also allowed the interest rate to be quoted openly sine ira et studio as the rate at which the (fixed) face value of the bond is amortized by the (ever-changing) bond price as quoted in the bond market. Incidentally, this remark also confirms that the rate of interest is a market phenomenon − contrary to the position taken by post-Mises Austrian economics.


---


Furthermore, post-Mises Austrian economics failed to develop all the implications of Menger’s Principle of Marginality. In particular, time preference was curiously left out in spite of Böhm Bawerk’s vision that variations in time preference bring about variations in the floor; while variations in the marginal productivity of capital bring about variations in the ceiling for interest rates. In particular, post-Mises Austrian economics never clarified that time preference makes sense only if marginal time preference is meant. It simply ignored the fact that the Prodigal Son’s time preference differs from that of Scrooge.

Marginal time preference is defined as the time preference of the marginal saver. He is the first to sell his gold bond in protest against low interest rates as they are being pushed below the rate of marginal time preference by the government and its lackeys, the banks. The marginal saver holds the gold coin until the banks relent and allow the rate of interest to return to the rate of marginal time preference. Relent they most assuredly will in consequence of the arbitrage between the gold market and the gold bond market. It is this very arbitrage that lends time preference teeth as nothing else will: it counters the artificial lowering the rate of interest with the draining of reserves from the banking system. Banks are forced to call in their shakiest loans. As soon as the rate of interest is allowed to return to the rate of marginal time preference, the marginal saver will release the gold coin in buying back his gold bond at a profit. Regrettably, post-Mises Austrian economics failed to reveal the essential nexus between gold and interest.

Incidentally, this also shows that promises to pay gold coin whose maturity and security is recognized (such as for example the ‘yellowbacks’, gold certificates issued by the U.S. Treasury were before 1933) cannot deputize for the gold coin – refuting the position of Mises. In selling his gold bond the marginal saver will refuse to take the yellowback in payment. He will insist on getting the gold coin. (If he took the yellowback, he would be exchanging an interest-bearing instrument for one that is not bearing interest. In doing so he would be acting contrary to purpose.)

Thus time preference manifests itself through the demand for present gold as distinct from future gold. It does not manifest itself through the demand for one present apple in exchange for one half of one apple in ten years’ time. Such a demand, to put it politely, is most implausible. So much for the concept of ‘originary interest’ of Mises that fails to refer to gold. A theory of interest without reference to gold is ‘like a production of Hamlet in which the prince fails to appear’.


---


Just as marginal time preference serves as the floor, marginal productivity serves as the ceiling to limit the range within which the rate of interest may vary. Marginal productivity is defined as the productivity of the marginal entrepreneur. He is the first to sell his business as interest rates rise. He invests the proceeds in the bonds of his more productive colleagues and will hold them until the rate of interest falls back to the rate of marginal productivity. Fall back it must, in response to the arbitrage between the bond market and the market for capital goods. (To be sure, such an arbitrage does take place and it does have an effect on the rate of interest, protestations of post-Mises Austrian economists notwithstanding). As soon as the rate of interest returns to the rate of marginal productivity, the marginal entrepreneur will sell his bonds at a profit, will buy back his business with the proceeds, thus re-entering the rank of producers.

Regrettably, post-Mises Austrian economics, in denial of Böhm-Bawerk, intentionally ignored the inevitable nexus between productivity and interest. (4) Post-Mises Austrian economics failed to come up with a positive theory of the gold standard. The monetary metal out of which the monetary unit is made ought to have marketability exceeding that of all other goods – as postulated by Menger [4]. This is tantamount to saying that the marginal utility of the monetary metal declines more slowly than that of any other good; so slowly indeed that it is practically constant. Following Mises, latter day Austrian economists hold that the marginal utility of gold (or, for that matter, that of any other good) cannot be constant since it would imply infinite demand – a contradictory notion. Be that as it may, the objection is frivolous. Menger’s postulate re-stated in terms of marginal utility says that gold had become the most marketable good within the observation of man because its marginal utility declines at a rate slower than that of any other good. There is no need to refer to constant marginal utility. The mistake Mises made was that he ignored interest as the obstruction to infinite demand.

Post-Mises Austrian economics has, due to its rejection of Menger’s postulate, missed gold’s role as the only prophylactic against bad debt. The reason for the gold standard’s longevity is that, under its aegis, no Babelian Tower of bad debt can breed nor can one be bred.

(5) Finally, post-Mises Austrian economics neglected to study speculation in depth, especially as it has evolved after the American embargo of gold imposed in 1971, followed by the opening of the gold futures markets shortly thereafter.

It has failed to recognize the gold basis (basis in general is defined as the spread between the price for delivery in the nearby future and that for delivery on the spot – a concept very much in the spirit of Menger) as an important economic indicator.

For agricultural goods the basis exhibits a clear cyclical pattern as it goes from pre-harvest negative to post-harvest positive and, thereafter, it gravitates to negative values again as surpluses give way to deficit during the crop-year. For gold, the cyclical pattern is turned into a vanishing pattern. The gravitation of the gold basis towards negative territory is unmistakable. From the positive, reflecting a robust full-carrying charge (the maximum possible) it has been gradually and unobtrusively eroding to zero for the past forty years. At present it is nibbling at negative values, threatening to plunge into the black hole, from where there is no return.

The gold basis is the harbinger of a cataclysmic event comparable to the collapse of the Western Roman Empire in 476 A.D., marking a major setback in the history of civilization. The cataclysmic event that is looming large on our horizon is the advent of permanent gold backwardation, namely, the event of the gold basis going negative never again to return to positive territory − its natural habitat. In practice it means that all deliverable gold disappears in hoards. All offers of gold for sale are simultaneously withdrawn regardless how high the bid price may go. Annual gold mining output is no longer sold for cash.

It is bartered away.

Recall that during the fifth century, the last time gold went into hiding globally, production, employment and trade shrank drastically and, with it, the prosperity of the Western Roman Empire vanished. By contrast, in the Eastern Roman Empire gold continued to flow to the Mint of Constantinople uninterrupted, while production, employment and trade prospered. The mindset of mainstream economics is too dull to grasp the difference between the Dark Age of gold vanishing in hoards, and the Golden Age of gold on the go.

Most people fail to see why permanent backwardation of gold (the modern equivalent of gold going into hiding) is a threat to our well-being. After all, you can’t eat gold, can you? What these people don’t realize is that permanent backwardation of gold is highly contagious. Barter replacing multilateral trade will gradually spread to all other markets for marketable goods, including food, fodder, and fuel.

Consequences of the return to barter will be appalling. They include the domino-effect causing the serial collapse of firms, unemployment exceeding any that has so far been experienced, famine, pestilence, to say nothing of the breakdown of law and order. Hordes of hungry people will roam the country, pilfer and plunder in search of food. Governments are helpless in the face of gold going into hiding. The American government will in particular be unable to sequester the better part of the riches of the world in exchange for irredeemable promises to pay, as it has been doing since 1971.

As long as gold futures markets are open, some gold can still be obtained in exchange for dollars. To that extent the dollar can be said to represent monetary value. The situation changes radically once permanent gold backwardation shuts down gold futures trading. Soon thereafter gold ceases to be routinely available in exchange for dollars. Arbitrage of gold for gold futures, animating futures trading with the carrot of risk-free profits, has all of a sudden become irreversible, replacing the carrot of gold with the stick of worthless paper.

People who succumbed to the siren sound and fell for the bait of risk-free arbitrage sold their gold against promises to replace it at a lower price. People who have been tricked out of their position through artificially induced price declines were denuded of their gold as well. They are now holding the (paper) bag. Caveat vendor! People ignore the threat of permanent backwardation of gold at their own peril.

Post-Mises Austrian economists fail to see the threat of the fatal transition from multilateral trade to barter. Nor do they view the relapse from multilateral trade back to barter with alarm as the ultimate in deflation. On the contrary, they are shouting from their roof-top that the denouement of the present global experiment with irredeemable currency will take the form of hyperinflation.

This is the condition that obtains when the velocity of money is rising and gets greater than any positive number, however large.

But money has another pathology as well, if occurring less frequently. As a matter of fact, it may have never occurred in all history − just as global experimentation with irredeemable currency hasn’t: the pathology of what we may call, in want of a better term, hyperdeflation. It is the condition that obtains when the velocity of money is falling and becomes lower than any positive number, however small.

Permanent gold backwardation will trigger hyperdeflation ‘with the certainty of scientific law’.


---


NASOE pledges to remain faithful to the philosophy and methodology of Menger. Its scientific program consists in correcting all errors originating in the palpably weakening commitment to Menger’s principles. This Manifesto is just the latest in a series of challenges NASOE has issued since the turn of the century – all of which have fallen on deaf ears.

But those who bear the future of our civilization at heart, like Menger and Mises did, would put petty jealousy behind them. They would stop the name-calling and the mudslinging. They would let the grand debate take place. Let truth win the day. Let the sound money movement rally under the banner of Menger. United, it can win the coming battle with the forces of social destruction whose chief strength, fiat money, is so obviously withering on the vine.

### References

### [1]

Michael Latzer and Stefan Schmitz (editors), Carl Menger and the Evolution of Payments Systems: from barter to electronic money, Cheltenham: Edward Elgar, 2002, p 19-20.

### [2]

Menger, Geld, 3rd edition (1909), Chapter XIV: The Demand for Money,

(B) The demand for money of the national economy; op.cit., p 84-88.

[3] op.cit., p 133.

### [4]

Menger, Geld, 3rd edition (1909), Chapter III: The Emergence of Precious-Metal Money, op.cit., p 39.

### Note

This Manifesto was drafted by an ad hoc committee of the New Austrian School of Economics. Subsequently it was offered for public debate. After amendments it was submitted to the meeting held at the British Museum in London in October, 2013, where it was formally adopted on October 6, 2013.

---

# Gold Bills Doctrine

URL: https://newaustrianeconomics.com/archive/fekete/gold-bills-doctrine/
Date: 2013-09-21
Section: Popular Economics
Difficulty: intermediate
Concept Tags: real-bills, gold-standard, bills-of-exchange, new-austrian-economics, sound-money
Description: Fekete presents the Gold Bills Doctrine — the synthesis of gold monetary theory and Real Bills theory — as the cornerstone of the New Austrian School. Gold provides the monetary reserve anchor; real bills provide the self-liquidating credit circulation; together they constitute a complete, self-regulating monetary system that requires no central bank intervention.
Editorial Note: Written September 2013. The Gold Bills Doctrine represents the culmination of Fekete's monetary theory — the integration of his two foundational insights into a single coherent framework.
Original PDF: https://professorfekete.com/articles/AEFGoldBillsDoctrine.pdf

We look at the question how the circulation of gold bills will arise after the inevitable collapse of our regime of global irredeemable currency. At that point the world will be bereft of any usable currency. All paper money will be worthless, all gold and silver will have been chased into hiding by permanent backwardation.

In this desperate situation some governments shall, to revive trade, willy-nilly open their Mint to gold and silver. However, gold and silver coins will be in short supply for quite some time.

The phrases ‘means of exchange’ and ‘store of value’ have long been used in listing the various functions of money. Yet these terms are far too imprecise to be useful in a scientific discourse. One should use terms such as marketability in the large (also called salability) and marketability in the small (also called hoardability). Then gold appears as the monetary metal most marketable in the large; silver as the most marketable in the small. We need not recognize any other monetary metal beside these two. A common mistake is to confuse the concept of a ‘precious’ metal with that of a ‘monetary’ metal. Unlike gold and silver, platinum is not a monetary commodity. It fails have the requisite high stocks-to-flows ratio, reflecting its failure to have constant marginal utility.

The value of gold is absolute thanks to its constant marginal utility; the price of gold is relative (as it is defined in terms of the dollar.) Thus the two concepts have nothing in common, contrary to the universal deception current today. Once the Mint is open to the free and unlimited coinage of gold, we have a unit of value, the standard gold coin, while the gold price becomes a vacuous concept.

Gold bills emerge spontaneously to accommodate the needs of trade. Tradesmen cooperating in the production of semi-finished goods would never pay, or demand payment, in gold coin when buying their input, or selling their output. They never have. Instead they will simply endorse the bill of their supplier, or draw a bill on their customer as the case may be. Once properly endorsed by the drawer and drawee, these bills become gold bills as they are destined to be settled in gold coins that are made available after the ultimate consumer surrenders them in exchange for finished consumer goods upon maturity. The marketability of gold bills is next to that of the gold coin. At the same time gold bills earn an income in gold, too, in the form of discount that accrues to their holders proportional to the length of time they are held. Commercial banks scramble to get gold bills in any amount, as these are the most liquid earning assets a commercial bank can have to cover its note and deposit liabilities. The wishy-washy explanation of Mises how commercial banks are supposed to finance their operations through fees and hidden charges is implausible, to put it politely. There is no need to beat about the bush: commercial banks finance their operations, and make a profit to boot, through discounting gold bills.

This activity is entirely proper. No ‘fractional reserves’, let alone fraud are involved as confirmed by Carl Menger in his Geld (3rd edition, 1909). Of course, proper safeguards must be taken. It is a crime to misrepresent the quantity or quality of the maturing consumer goods on the face of a gold bill, or to recycle it upon maturity. Borrowing short to lend long is prohibited.

People find it hard to accept the fact that consumption is another source of credit, in addition to savings. The discount rate is inversely related to the propensity to consume; the interest rate is inversely related to the propensity to save. Other than this formal similarity, the two rates have nothing in common. Their origin and economic function are entirely different. They can move independently in the same or in opposite directions, subject only to the imperative that the discount rate must never exceed the rate of interest.

The circulation of gold bills is entirely spontaneous. Unlike that of irredeemable currency, it does not have to be propped up by legal tender laws and the strong arm of government. In addition to demand from commercial banks, a lot of economic agents with large gold payments falling due (e.g., firms with an outstanding bond issue maturing within the quarter, or buyers of real estate with the closing date coming up in less than 90 days) want to have them. They do not accumulate gold coins in anticipation of their maturing liability. It would be foolish and wasteful to do so. Rather, they go into the bill market and buy gold bills the maturity of which matches the due date of their obligations. Neither would they accumulate bonds.

The marketability of bonds falls far short of that of bills. For these and other reasons the demand for gold bills is exceedingly keen and can be taken for granted.

It is preposterous to suggest that a bill of exchange can be settled in anything but gold coins. Clearly, a bill of exchange must mature into something the marketability of which is higher. The marketability of a maturing gold bill with two good signatures is exceeded by that of the gold coin, and only by that. To suggest that it is fraudulent to issue bills to be settled at maturity with a scrip is missing the point. Knowledgeable market participants wouldn’t touch a bill maturing in scrips with a ten-foot pole. Thus there would be simply no market for them. If post-Mises Austrians came around and accepted properly constructed bills of exchange as non-inflationary, but thought it was admissible to let them mature in paper, they would only betray their utter ignorance of Menger’s concept of marketability.

The market in gold bills is the clearing house of the gold standard. No gold standard can be viable without it. The 100% gold standard of Murray Rothbard is a phantom. Under it there is a dearth of circulating medium that leads to deflation and, ultimately, to collapse. Gold bills lend the gold standard the necessary elasticity. They provide this elasticity at harvest-time and during the Christmas shopping season when gold bill circulation expands, and during the post-harvest and post-Christmas season when it contracts. In the absence of gold bills there is no wage fund out of which workers producing semi-finished goods going into consumer goods can be paid before the latter is sold. In the absence of a wage fund there would be widespread unemployment. Division of labor could not be further refined. Social chaos and unrest would follow.

Our present experiment with the regime of world-wide irredeemable currency is a unique historical experience. It will lead to the collapse of the world economy, as all national experiments before have led to the collapse of the national economy.

The 19th century gold standard with its exquisite clearing system, the gold bill market, was the result of an evolution lasting many a generation. It made an unprecedented expansion of world trade, employment and capital accumulation possible. This evolution must be replicated now in a very short space of time.

The sound money movement had better reach a consensus on the Gold Bills Doctrine before it is too late, lest the world succumb to an unprecedented disaster, decimating the world’s population and destroying the world’s capital no way less catastrophic than a nuclear war.

---

*September 21, 2013.*

---

# New Austrian Economics Manifesto (July 2013)

URL: https://newaustrianeconomics.com/archive/fekete/new-austrian-economics-manifesto-july-2013/
Date: 2013-07-04
Section: Popular Economics
Difficulty: intermediate
Concept Tags: new-austrian-economics, gold-standard, real-bills, gold-basis, permanent-backwardation
Description: Fekete's July 2013 version of the New Austrian Economics Manifesto, presenting the complete theoretical framework of the New Austrian School: the gold standard, the Real Bills Doctrine, basis analysis, the capital destruction mechanism, and the theory of permanent backwardation. Written as a comprehensive statement of the school's intellectual program.
Editorial Note: The July 2013 version of the Manifesto. The site also has an example MDX file for the final October 2013 version; this earlier version documents the evolution of Fekete's thinking.
Original PDF: https://professorfekete.com/articles/AEFNewAustrianEconomicsManifesto.pdf

In a recent pamphlet Llewellyn H. Rockwell, President of the Mises Institute writes that we are all ceaselessly being bombarded by the media and college educators with propaganda to the effect

“that capitalism causes depressions and exploits the poor. That government is our salvation, and the bureaucrat a hero. That America owes its wealth to the Federal Reserve. That without massive regulation we’d be sunk…That cutting government even a smidgen and permitting free markets would be a disaster…

John Maynard Keynes died more than 60 years ago, but his ideas still rule us from the grave: give government more power, and print more money…”

It is a pleasure to acknowledge that Mises University, the Mises Institute’s week-long summer program for students has done an outstanding service to society in flouting the conventional wisdom about government, and explaining the logic behind free enterprise.

Why then does the New Austrian School of Economics (NASOE) take issue with the Mises Institute? As this Manifesto explains, because post-Mises Austrian economics has ceased to be open to new ideas. It is trying to ossify Austrian economics at the level where Mises left it. It is inimical to the appearance of new knowledge as it flows directly from the founding principles of our school, unless stamped with its own nihil obstat. Discussion and criticism are discouraged and many a topic outright tabooed.

There is a tendency to turn science into cult. As a result, post-Mises Austrian economics has failed to come up with a really potent theory that can offer an alternative to the mainstream. Nor can it draw up a comprehensive blueprint for the new economic order that will follow the collapse of the current global experiment with irredeemable currency. It claims a monopoly of ideas how the gold standard of the future ought to look like. It must be “one hundred percent”, or nothing. The last thing it would consider doing is to sponsor a conference that would entertain ideas other than its own.

The reason for these failings is that post-Mises economics has deviated from, or even abandoned the philosophy and methodology of the founder of the movement, Carl Menger (1840-1921). To substantiate this charge here is a list of six errors, the first three of which are errors of commission; the last three are errors of omission. (1) Post-Mises Austrian economics embraced the Equilibrium Theory of Price and the concept of evenly rotating economy in spite of Menger who was the first economist defying Aristotle in pointing out that the price-phenomenon rests on disequilibrium rather than equilibrium. Far from being static, it is dynamic. As a result, price is not monolithic. It varies between two extremes, the higher asked and the lower bid price. These two extremes never coincide in the very nature of the case. Two separate analyses are required to see how asked and bid prices are formed, each on its own.

Supply-demand equilibrium is a spurious concept for a second reason, too. It leaves speculation out of consideration. The presence of speculative bid and offer that are often made on the spur of the moment, inevitably renders supply and demand undefinable. Supply and demand are ad hominem terms that must stay outside of scientific discourse.

(2) Post-Mises Austrian economics also embraced the Quantity Theory of Money (QTM) even though Menger had never endorsed it. In fact, QTM goes against Menger’s philosophy based on the concept of marketability that precludes a coherent definition of the quantity of money. It forces the theory of money to be a theory of quality as opposed to one of quantity. No economic theory ever succeeded in defining what the quantity of money in circulation could possibly mean.

(3) Post-Mises Austrian economics dismissed Adam Smith’s Real Bills Doctrine (RBD) as ‘inflationary’. Doing it was another act of denying Menger who, in his encyclopaedic article Geld * suggested that a payments system complete with a bill market discountng bills would be ‘very beneficial for the economy.’ Discounting bills payable in gold coin during a gestation period not exceeding 13 weeks for the maturing consumer goods made an unprecedented expansion of production and employment possible in the nineteenth century. It would do so again in the twenty-first.

The victorious Entente powers did not allow the bill market to make a comeback at the end of World War I. To that extent they can justly be blamed for the ensuing Great Depression of the 1930’s. The bill market is the clearing house of the gold standard, as it were. It allows wages to be paid before the finished goods are bought by the ultimate consumer. It was not the gold standard per se that caused the Great Contraction, but the castration of the gold standard, in removing its clearing house.

The dismissal of RBD led to the fatal confusion between the rate of interest and the discount rate. It also confused the two inevitable sources of credit: savings and consumption. The rate of interest gages the propensity to save (the greater the propensity to save the lower is the rate of interest); the rate of discount gages the propensity to consume (the greater the propensity to consume the lower is the discount rate). Unlike the rate of interest, the discount rate can go to zero (as it did when people expected doomsday to occur on January 1, 1000).

The propensity to consume and the propensity to save are not complementary because of the presence of a third, the propensity to hoard, especially as it becomes wide-spread and prominent during the terminal stage of the regime of irredeemable currency. Despite formal similarities, the rate of interest and the discount rate are fundamentally different with regard to their sources and effects.

(4) Post-Mises Austrian economics failed to develop a theory of interest in the spirit of Menger. In particular, it has nothing to say on the origin of interest, even though the origin of money, treated by Menger, could serve as a pattern.

The rise of money is the result of an evolution, that of marketability in the large (also known as saleability). The rise of interest is the result of a similar evolution, that of marketability in the small (also known as hoardability).

Money has appeared as direct exchange of goods gave way to indirect exchange. Likewise, interest appeared as direct conversion of wealth and income (namely hoarding and dishoarding) gave way to indirect conversion

(namely buying and selling bonds in the bond market).

The latter event occurred much later, after Protestantism made interest taking and paying morally acceptable (previously proscribed by canonical and secular law). This led to the legal protection of gold bonds under contract law, and made bond trading possible. The bond market has displaced hoarding and dishoarding monetary metals as a means of converting income into wealth and wealth into income.

Furthermore, post-Mises Austrian economics failed to develop all the implications of the Principle of Marginality. In particular, time preference was curiously left out in spite of Böhm Bawerk’s vision. It was never clarified that time preference makes sense only if marginal time preference is meant. Clearly, the Prodigal Son’s time preference differs from that of Scrooge.

Marginal time preference is defined as the time preference of the marginal saver. The marginal saver is the first to sell his gold bond in protest against low interest rates as they are being pushed below the rate of marginal time preference by the government and its lackeys, the banks. He holds the gold coin until the banks relent and allow the rate of interest to return to the rate of marginal time preference. Relent they most assuredly will in consequence of the arbitrage between the gold market and the gold bond market. It is this very arbitrage that lends time preference teeth: it drains bank reserves from the banking system. As soon as the rate of interest returns to the rate of marginal time preference, the marginal saver will release the gold coin and buy back his gold bond at a profit. Post-Mises Austrian economics regrettably failed to reveal the essential nexus between gold and interest.

Incidentally, this also shows that mature and secure promises to pay gold coin (such as gold certificates issued by the U.S. Treasury before 1933) do not always substitute for the gold coin – refuting Mises’ position. In selling his gold bond the marginal saver will refuse to take gold certificates in payment. He will insist on getting gold coins.

Just as marginal time preference serves as the floor, marginal productivity serves as the ceiling to limit the range within which the rate of interest may vary. Marginal productivity is defined as the productivity of the marginal entrepreneur. He is the first to sell his business as interest rates rise. He invests the proceeds in the bonds of more productive entrepreneurs and will hold them until the rate of interest falls back to the rate of marginal productivity. Fall back it must in response to the arbitrage between the bond market and the market for capital goods. At this point the marginal entrepreneur will sell his bonds at a profit, will buy a business enterprise and re-enter the rank of producers. PostMises Austrian economics regrettably missed the inevitable nexus between productivity and interest.

(5) Post-Mises Austrian economics failed to come up with a positive theory of the gold standard. The monetary metal, out of which the monetary unit is made, ought ideally have to have constant marginal utility − as postulated by Menger in a much overlooked sentence (Geld, 3rd edition*). Following Mises, latter day Austrian economists hold that the marginal utility of gold cannot be constant since it would imply infinite demand that is contradictory. Be that as it may, the objection is frivolous. Menger could just as well have said that gold had become the most marketable substance within the observation of man because its marginal utility declines at a rate lower than that of any other.

Post-Mises Austrian economics has, due to its rejection of Menger’s postulate, missed gold’s role as the only prophylactic against bad debt. That is the reason why the gold standard’s longevity beats that of any other monetary system. No Babelian Tower of bad debt can be constructed under a gold standard.

(4) Finally, post-Mises Austrian economics neglected to study speculation in depth, especially as it has evolved after the American embargo of gold imposed in 1971, and the commencement of gold futures trading shortly thereafter.

Consequently it has failed to identify the gold basis (defined as the spread between the dollar price of gold for delivery in the nearby future and that for delivery on the spot – a concept very much in the spirit of Menger) as the harbinger of a cataclysmic event comparable only to the collapse of the Western Roman Empire in 476 A.D. This cataclysmic event that is looming large on our horizon is the advent of permanent gold backwardation. That is the event of the gold basis going negative never again to return to positive territory, its natural habitat. In practice it means that all deliverable gold (including the entire mine output) disappears in hoards. All offers of gold for sale are simultaneously withdrawn regardless how high the bid price may be. Gold, if available at all, can only be obtained through barter.

Most people fail to see why this is a threat to our well-being. After all, you can’t eat gold, can you? What these people don’t realize is that permanent backwardation of gold triggers a peculiar contagion: the condition will gradually spread to all other markets for highly marketable goods including food and fuel. The consequences of the return to barter will be appalling. They include the domino-effect causing serial collapses of firms, unprecedented unemployment, famine, pestilence, to say nothing of the breakdown of law and order. Governments are helpless in the face of gold going into hiding. The American government will in particular be unable to sequester the better part of the riches of the world in exchange for irredeemable promises to pay, as it has been doing since 1971. As long as gold futures markets are open, some gold can be obtained for U.S. dollars. But once permanent gold backwardation shuts down gold futures trading, no gold can be obtained for U.S. dollars ever again – an irreversible condition. People may ignore this threat at their own peril.

Post-Mises Austrian economists fail to see the threat of the fatal transition from multilateral trade to barter, nor do they view transition to barter as the ultimate in deflation. They are noisily predicting that the denouement of the present global experiment with irredeemable currency will take the form of hyperinflation (when the velocity of money is rising and gets larger than any positive number, however large). But there is also another pathology of money: that of hyperdeflation (when the velocity of money is falling and becomes smaller than any positive number, however small). Permanent gold backwardation will trigger it ‘with the certainty of scientific law’.


---


NASOE pledges to remain faithful to the philosophy and methodology of Menger. Its scientific program consists in correcting all errors originating in the palpably weakening commitment to Menger’s principles. This Manifesto is just the latest in a series of challenges NASOE has issued since the turn of the century – all of which has fallen on deaf ears. But those who bear the future of our civilization at heart, like Menger and Mises did, would put petty jealousy aside and stop the name-calling and the mud-slinging. They would let the grand debate take place. Let truth win the day.

Let the sound money movement rally under the banner of Menger. United, it can win the coming battle with the forces of social destruction whose chief strength, fiat money, is so obviously withering on the vine.

* Cf. the three editions of Handwörterbuch der Staatswirtschaften:

1st : 1892, vol. 3, pp 730-757;

2nd : 1900, vol 4, pp 60-106;

3rd: 1909, an English translation in Michael Latzer and Stefan Schmitz (editors),

Carl Menger and the Evolution of Payments Systems: from barter to electronic money, Cheltenham: Edward Elgar, 2002.

---

# New Austrian Economics Manifesto

URL: https://newaustrianeconomics.com/archive/fekete/new-austrian-economics-manifesto/
Date: 2013-07-04
Section: Popular Economics
Difficulty: intermediate
Concept Tags: new-austrian-economics, menger, gold-basis, backwardation, real-bills, interest-theory
Description: Fekete's definitive manifesto for the New Austrian School — six errors of post-Mises economics, the return to Menger, and the warning of permanent gold backwardation as a civilizational threat.
Editorial Note: This is Fekete's most important programmatic statement. It defines what the New Austrian School is, why it diverges from post-Mises Austrian economics, and what its research program consists of. Published on July 4, 2013 — American Independence Day — the date choice is deliberate.
Original PDF: https://professorfekete.com/articles/AEFNewAustrianEconomicsManifesto.pdf

In a recent pamphlet Llewellyn H. Rockwell, President of the Mises Institute writes that we are all ceaselessly being bombarded by the media and college educators with propaganda to the effect:

> "that capitalism causes depressions and exploits the poor. That government is our salvation, and the bureaucrat a hero. That America owes its wealth to the Federal Reserve. That without massive regulation we'd be sunk... That cutting government even a smidgen and permitting free markets would be a disaster... John Maynard Keynes died more than 60 years ago, but his ideas still rule us from the grave: give government more power, and print more money..."

It is a pleasure to acknowledge that Mises University, the Mises Institute's week-long summer program for students has done an outstanding service to society in flouting the conventional wisdom about government, and explaining the logic behind free enterprise.

Why then does the New Austrian School of Economics (NASOE) take issue with the Mises Institute? As this Manifesto explains, because post-Mises Austrian economics has ceased to be open to new ideas. It is trying to ossify Austrian economics at the level where Mises left it. It is inimical to the appearance of new knowledge as it flows directly from the founding principles of our school, unless stamped with its own *nihil obstat*. Discussion and criticism are discouraged and many a topic outright tabooed. There is a tendency to turn science into cult. As a result, post-Mises Austrian economics has failed to come up with a really potent theory that can offer an alternative to the mainstream. Nor can it draw up a comprehensive blueprint for the new economic order that will follow the collapse of the current global experiment with irredeemable currency.

The reason for these failings is that post-Mises economics has deviated from, or even abandoned the philosophy and methodology of the founder of the movement, Carl Menger (1840-1921). To substantiate this charge here is a list of six errors, the first three of which are errors of commission; the last three are errors of omission.

## Error 1: The Equilibrium Theory of Price

Post-Mises Austrian economics embraced the Equilibrium Theory of Price and the concept of evenly rotating economy in spite of Menger who was the first economist defying Aristotle in pointing out that the price-phenomenon rests on disequilibrium rather than equilibrium. Far from being static, it is dynamic. As a result, price is not monolithic. It varies between two extremes, the higher asked and the lower bid price. These two extremes never coincide in the very nature of the case. Two separate analyses are required to see how asked and bid prices are formed, each on its own.

Supply-demand equilibrium is a spurious concept for a second reason, too. It leaves speculation out of consideration. The presence of speculative bid and offer that are often made on the spur of the moment, inevitably renders supply and demand undefinable. Supply and demand are *ad hominem* terms that must stay outside of scientific discourse.

## Error 2: The Quantity Theory of Money

Post-Mises Austrian economics also embraced the Quantity Theory of Money (QTM) even though Menger had never endorsed it. In fact, QTM goes against Menger's philosophy based on the concept of marketability that precludes a coherent definition of the quantity of money. It forces the theory of money to be a theory of quality as opposed to one of quantity. No economic theory ever succeeded in defining what the quantity of money in circulation could possibly mean.

## Error 3: Dismissal of Real Bills Doctrine

Post-Mises Austrian economics dismissed Adam Smith's Real Bills Doctrine (RBD) as 'inflationary'. Doing it was another act of denying Menger who, in his encyclopaedic article *Geld*, suggested that a payments system complete with a bill market discounting bills would be 'very beneficial for the economy.' Discounting bills payable in gold coin during a gestation period not exceeding 13 weeks for the maturing consumer goods made an unprecedented expansion of production and employment possible in the nineteenth century. It would do so again in the twenty-first.

The victorious Entente powers did not allow the bill market to make a comeback at the end of World War I. To that extent they can justly be blamed for the ensuing Great Depression of the 1930's. The bill market is the clearing house of the gold standard, as it were. It allows wages to be paid before the finished goods are bought by the ultimate consumer. It was not the gold standard per se that caused the Great Contraction, but the castration of the gold standard, in removing its clearing house.

The dismissal of RBD led to the fatal confusion between the rate of interest and the discount rate. It also confused the two inevitable sources of credit: savings and consumption. The rate of interest gauges the propensity to save (the greater the propensity to save the lower is the rate of interest); the rate of discount gauges the propensity to consume (the greater the propensity to consume the lower is the discount rate). Unlike the rate of interest, the discount rate can go to zero. The propensity to consume and the propensity to save are not complementary because of the presence of a third, the propensity to hoard, especially as it becomes wide-spread and prominent during the terminal stage of the regime of irredeemable currency.

## Error 4: Failure to Develop a Theory of Interest

Post-Mises Austrian economics failed to develop a theory of interest in the spirit of Menger. In particular, it has nothing to say on the origin of interest, even though the origin of money, treated by Menger, could serve as a pattern. The rise of money is the result of an evolution, that of marketability in the large (also known as saleability). The rise of interest is the result of a similar evolution, that of marketability in the small (also known as hoardability).

Money has appeared as direct exchange of goods gave way to indirect exchange. Likewise, interest appeared as direct conversion of wealth and income (namely hoarding and dishoarding) gave way to indirect conversion (namely buying and selling bonds in the bond market).

Furthermore, post-Mises Austrian economics failed to develop all the implications of the Principle of Marginality. In particular, time preference was curiously left out in spite of Bohm Bawerk's vision. It was never clarified that time preference makes sense only if marginal time preference is meant. The marginal saver is the first to sell his gold bond in protest against low interest rates as they are being pushed below the rate of marginal time preference by the government and its lackeys, the banks. This also shows that mature and secure promises to pay gold coin do not always substitute for the gold coin -- refuting Mises' position.

Just as marginal time preference serves as the floor, marginal productivity serves as the ceiling to limit the range within which the rate of interest may vary. Post-Mises Austrian economics regrettably missed the inevitable nexus between productivity and interest.

## Error 5: No Positive Theory of the Gold Standard

Post-Mises Austrian economics failed to come up with a positive theory of the gold standard. The monetary metal, out of which the monetary unit is made, ought ideally to have constant marginal utility -- as postulated by Menger in a much overlooked sentence. Following Mises, latter day Austrian economists hold that the marginal utility of gold cannot be constant since it would imply infinite demand that is contradictory. Be that as it may, the objection is frivolous. Menger could just as well have said that gold had become the most marketable substance within the observation of man because its marginal utility declines at a rate lower than that of any other.

Post-Mises Austrian economics has, due to its rejection of Menger's postulate, missed gold's role as the only prophylactic against bad debt. That is the reason why the gold standard's longevity beats that of any other monetary system. No Babelian Tower of bad debt can be constructed under a gold standard.

## Error 6: Neglect of Speculation and the Gold Basis

Finally, post-Mises Austrian economics neglected to study speculation in depth, especially as it has evolved after the American embargo of gold imposed in 1971, and the commencement of gold futures trading shortly thereafter. Consequently it has failed to identify the gold basis (defined as the spread between the dollar price of gold for delivery in the nearby future and that for delivery on the spot -- a concept very much in the spirit of Menger) as the harbinger of a cataclysmic event comparable only to the collapse of the Western Roman Empire in 476 A.D.

This cataclysmic event that is looming large on our horizon is the advent of **permanent gold backwardation**. That is the event of the gold basis going negative never again to return to positive territory, its natural habitat. In practice it means that all deliverable gold (including the entire mine output) disappears in hoards. All offers of gold for sale are simultaneously withdrawn regardless how high the bid price may be. Gold, if available at all, can only be obtained through barter.

Most people fail to see why this is a threat to our well-being. After all, you can't eat gold, can you? What these people don't realize is that permanent backwardation of gold triggers a peculiar contagion: the condition will gradually spread to all other markets for highly marketable goods including food and fuel. The consequences of the return to barter will be appalling. They include the domino-effect causing serial collapses of firms, unprecedented unemployment, famine, pestilence, to say nothing of the breakdown of law and order.

Post-Mises Austrian economists fail to see the threat of the fatal transition from multilateral trade to barter, nor do they view transition to barter as the ultimate in deflation. They are noisily predicting that the denouement of the present global experiment with irredeemable currency will take the form of hyperinflation. But there is also another pathology of money: that of **hyperdeflation** (when the velocity of money is falling and becomes smaller than any positive number, however small). Permanent gold backwardation will trigger it 'with the certainty of scientific law'.

---

NASOE pledges to remain faithful to the philosophy and methodology of Menger. Its scientific program consists in correcting all errors originating in the palpably weakening commitment to Menger's principles. This Manifesto is just the latest in a series of challenges NASOE has issued since the turn of the century -- all of which has fallen on deaf ears. But those who bear the future of our civilization at heart, like Menger and Mises did, would put petty jealousy aside and stop the name-calling and the mud-slinging. They would let the grand debate take place. Let truth win the day. Let the sound money movement rally under the banner of Menger. United, it can win the coming battle with the forces of social destruction whose chief strength, fiat money, is so obviously withering on the vine.

---

*July 4, 2013*

---

# Gold Backwardation and the Collapse of the Tacoma Bridge

URL: https://newaustrianeconomics.com/archive/fekete/gold-backwardation-and-the-collapse-of-the-tacoma-bridge/
Date: 2013-05-05
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, permanent-backwardation, monetary-crisis, fiat-currency
Description: A Daily Bell interview in which Fekete uses the collapse of the Tacoma Narrows Bridge — destroyed by resonance rather than excessive load — to explain how the gold basis can collapse the paper monetary system through feedback effects. Small perturbations in the basis can amplify into catastrophic backwardation through self-reinforcing dynamics.
Editorial Note: A Daily Bell interview from May 2013. The Tacoma Bridge metaphor is one of Fekete's most evocative, capturing the resonance/feedback mechanism that makes permanent backwardation self-reinforcing.
Original PDF: https://professorfekete.com/articles/AEFTheDailyBellinterview2013.pdf

## Collapse Of The Tacoma Bridge

THE DAILY BELL INTERVIEW with Professor Antal E. Fekete of the New Austrian School of Economics

---

*May 5, 2013*

Q. Nice to speak with you again. Let’s jump right in. Why is the price of gold declining?

A. Columbia University professor Michael Woodford, the world’s most closely followed monetary theorist said recently that if we are going to scare the horses, might as well scare them properly. He said it in an allegorical sense: loose talk about ending QE and about exit strategies are amateurish. Telling the world that central bank financing of the public debt is here to stay and that QE is forever, is professional. The allegory can be extended from fiscal policy to monetary policy as well. The demand for dollars is waning spectacularly due to its unprecedented debasement that, to add insult to injury, is done with great fanfare. The price of paper gold was declining in April because Bernanke now thinks it’s time to scare the horses properly. They have strayed too far afield to graze. They should get back to the dollar turf.

### Q. Where is the price of gold headed from here?

A. The price of gold is headed for extinction. I for one don’t believe that the price of gold is headed for five digits. Long before that might happen, permanent backwardation* would shut down the gold futures markets. Gold could no longer be purchased at any price. Gold would only be available through barter. World trade is facing an avalanche-like transformation flattening out monetary economy into barter economy. Practically all economists, financial writers and market analysts have missed this possible scenario. They don’t see the greatest economic contraction ever staring them in the face. They don’t see the coming tsunami of unemployment. Very few see deflation as indicated by the progressive disappearance of cash gold. It never occurred to Bernanke that the new Federal Reserve notes he is printing galore could also go to purchase physical gold, causing the gold basis to shrink. Once the gold basis* goes permanently negative, the total U.S. debt, all \$16 trillion of it, will not be worth one ounce of gold. That will pull the rug from underneath the international monetary system. Barter is the ultimate in deflation, and that is what the world economy is getting.

### Q. Is gold a commodity?

A. Gold (and silver) must be distinguished from other metals and other commodities. Gold is a monetary metal due to the fact that its marginal utility declines at a rate lower than that of any commodity. For this reason gold does not obey the Law of Supply and Demand. For example, a higher price of gold need not call out a greater supply; often it causes the supply to shrink further.

Also, the threat of a lower or falling price for paper gold, far from „scaring the horses properly”, will induce people to dump paper gold and make them flock to cash gold. Keynesian and Friedmanite economics have wiped out the distinction between ordinary commodities and monetary commodities. Today no university offers courses treating the gold basis, the gold cobasis and their interplay, or on the apocalyptic threat of permanent gold backwardation. At the New Austrian School of Economics we do offer those couses.

### Q. How about silver?

A. Silver is not an ordinary commodity either. Like gold, silver is also a monetary metal. Its marginal utility declines at a rate slower than that of any other substance save gold. The silver basis, just like the gold basis, has shown a secular decline from its maximum, the full carrying charge to zero and beyond, proving that the supply of silver available for futures trading is dwindling and disappearing fast. Permanent backwardation of silver is a matter of time, probably not a very long time. It is an intriguing question which event will come first. While there is a strong argument that its greater relative scarcity will trigger permanent backwardation of silver first, it’s hard to see how permanent backwardation of gold can lag that of silver, making it probable that the two events might occur simultaneously. Be that as it may, either event will create an unprecedented and uncontrollable turmoil in the financial markets, for which Bernanke is utterly unprepared. Practically nobody realizes that the root cause of all the bubbles, price-shocks, currency crises, as well as the more recent deflation in Japan, Europe and America was the secular decline in the gold basis. The „Big Bang” occurred in 1971, when the U.S. defaulted on its international gold obligations.

Q. Why do they fix the price of gold in London? Is this how commodities should be priced?

A. Of course, they don’t fix the gold price in London. It’s more like taking a snapshot and pretend that the landscape was frozen thereby. It is another question that the London gold fix could come handy in trying to manipulate the gold price and to „scare the horses properly”.

Q. Are gold and silver manipulated or is the current shake-out a result of too-high market expectations?

A. My own position is that manipulation in the gold and silver markets, if that’s what’s been occurring, is far less important than it is made out to be by market observers. Having said that, I also believe that after four decades of neglecting to study the phenomenon of the secular decline in the gold basis, Bernanke woke up and realized the extremely grave danger of permanent gold backwardation. The likely cause of the shake-out in the gold futures markets is not what you call too high expectations; rather, it is Bernanke’s belated recognition of the threat of permanent backwardation, and his attempt to „scare the horses properly”.

Q. Should gold and silver compete with other money to provide the world with a free-market money standard?

A. I don’t have much respect for Hayek’s position that choosing the monetary standard should be „left to the free market”. The market has already spoken.

Hayek was not a friend of the gold standard. He didn’t really understand Menger’s point that market has promoted gold to the status of most marketable good in making its marginal utility decline at a rate slower than that of any other substance. There is no need to put the world through the agony of death throes of irredeemable currencies once again. Gold would beat fiat money hands down, were it not for coercive laws making paper money ’legal tender’.

### Q. Should gold be the only money?

A. It would not be practical. There is need for money for making large payments, for example, purchasing territories such as Louisiana and Alaska; and there is need for money to make small purchases and to pay the wages of day laborers. So there is need for both gold and silver. However, it would be a grave mistake to fix the exchange ratio between the two, as was done in the U.S. when Congress enacted the Coinage Act of 1792. It is significant that this mistake was not made by the Founding Fathers of the Republic. The U.S.

Constitution did not mandate bimetallism. It established one monetary standard, that based on the Constitutional silver dollar. It also established the gold eagle (without naming it) but did not make it the standard coin of the realm. The Constitution left it to the market to determine the rate at which the gold eagle would be tariffed in terms of the standard silver dollar. The Coinage Act of 1792, championed by Alexander Hamilton, the Secretary of the Treasury, established an official bimetallic gold/silver ratio at 15 to 1. This was price fixing and as such unconstitutional. That mistake led to a charade of tampering with the monetary standard, to the outrageous demonetization of silver in 1873, and to the even more outrageous demonetization of gold a hundred years later, in 1973. Time will show that these two demonetizations caused the greatest anguish in history second only to the world wars, namely, the collapse of the international monetary system that is still shrouded in the future.

Q. Should the state fix the price of gold within the context of a neo-gold standard?

A. It is an error to say that the essence of the gold standard is to fix the price of gold, and the way to return to a „neo-gold standard” is to re-peg the gold price. This error was maliciously spread by Milton Friedman in an effort to promote the view that the „natural state of things” for currencies is floating, and it was an inadmissible state intervention in the free market to fix the price of gold thus putting the straitjacket of the gold standard on the economy. In truth it was not the gold price that was fixed in terms of government promises to pay, but the value of promises to pay was fixed in terms of gold. Historically money is not the creature of the state. It is the creature of the market in promoting gold as the most marketable substance on Earth over the millennia.

Q. Is gold susceptible to private market forces? You indicated recently that it is.

A. What I said was that one ought to distinguish between the value of gold and the price of gold. The value of gold, like the length of the yard, is not subject individual preferences or to market forces. The price of gold, insofar as it is the reciprocal of the price of the dollar in terms of gold, is susceptible to individual preferences and to market forces. To say that the price of gold reflects the value of gold is akin to saying that an anamorphic mirror renders the true shape and form of things.

Q. Is it possible that there is too little gold in a free-market economy?

Would you say that in such a case people gradually cease to hoard it and recycle their hoarded gold into the market?

A. You got it. People would dishoard gold if its scarcity pushed up interest rates. In the 19th century there was a saying that the Bank of England could pull in gold from the moon with a bank rate of 5 percent.

Q. What means too much or too little gold? How does an economy tell?

A. Under the gold standard the amount of gold in circulation tends to be just right. If people think there is too much, they could melt, hoard or export the gold coins of the realm in their possession; if they think there is too little, then they could exercise their Constitutional right to free coinage, take their old jewelry or newly mined gold to the Mint and exchange it for gold coins of the realm. The result of this flow of gold from the Mint to the refinery and back is that the number of gold coins in circulation is always optimal, conforming to the wishes of the people (and not to the wishes of the bank or the government).

Ludwig von Mises dismissed the idea of gold having constant marginal utility. According to him constant marginal utility would imply infinite demand for gold which is contradictory. This is the greatest flaw of the economics of Mises: the rejection of the essential nexus between gold and interest. Mises ridiculed John Fullarton for conjuring up the deus ex machina of gold hoards.

This was as unfair as it was untrue. The concept of constant marginal utility is not contradictory, because the rate of interest is obstruction to gold hoarding.

If it is sufficiently high, gold hoarding fades out and gives way to dishoarding.

Equally important is the fact that if the rate of interest is too low or, more precisely, if the government and the banking system pushes it down to a level lower than the rate of marginal time preference, then gold hoarding kicks in.

People present their bank notes to the banks for redemption, or withdraw gold coins against their bank deposits. Bank reserves contract. The banks must call their marginal loans. Gold hoarding is not an aberration: it is one of the main excellence of the gold standard. It is an essential part of the system of checks and balances. It constrains the banks and the government preventing them from expanding credit or running open-ended budget deficits and going into debt without seeing how the debt will be retired. It gives teeth to time preference which would otherwise be just a pious wish. Take gold out of the hand of the people, and you give free rein to the banks for unlimited credit expansion, and to the government for constructing a Babelian Tower of Debt.

Q. When there appears to be too much gold, do people begin to hoard?

A. Instead of saying that there is too much or too little gold, it would be more accurate to say that the rate of interest is too high or too low. Under the unadulterated gold standard the rate of interest gages the amount of gold in circulation that is needed for the optimal functioning of the economy.

According to Mises, interest is not a market phenomenon. It is apodictic: the manifestation of time preference. However, like marginal utility, time preference does not exist in the abstract. It always refers to an individual, whether he be a Scrooge or a prodigal son. Time preference varies from person to person. Therefore it makes sense to talk about it only if marginal time preference is meant. Mises failed to make this refinement.

Q. If there is too much or too little gold, do mines react by opening or closing? Is this a free-market supply and demand response?

A. I have an extremely low estimate for the I.Q. of the average manager of a gold mine. However, he probably can tell profit and loss apart. The problem is that the lag or reaction time between the mines increasing output and what you call too little gold is far too long. In the 1980’s the gold mining industry invented „hedging” that in reality was no hedging at all. It was forward selling of gold, completely oblivious that short positions must eventually be covered making gold miners scramble at the exit door trying to squeeze through simultaneously when the gold price explodes. In the 1990’s I warned Barrick’s Jamie Sakolsky (then CFO, now CEO of the company) in person, but he spurned me. „Hedging” was his baby, no one could question its beauty. Well, the baby grew up to become a monster that is still haunting Barrick, as the abrupt abandonment of Pascua Lama shows. What was the rush to sink the shafts when the gold price was languishing in the \$300 - \$400 range? They should have worked on the title of the property instead. The point is that the gold mining industry got it all wrong about its product, the monetary metal gold.

Gold miners treated it as if it was just another base metal like copper. They did not have the foggiest idea about the anomalous behavior of gold in relation to the Law of Supply and Demand. Gold mines sell gold hand over fist, rain or shine, but never buy it as sometimes they should. Nor would they consider cutting production back when the gold price is soft.

Q. Has gold always been money? Was gold only considered money when it was coined by the state?

A. Silver was money before gold. The first coins were made of electrum, a natural alloy of gold and silver, in the 6th century B.C. We know that silver and gold ingots circulated long before the invention of coinage (and seigniorage) by the state.

### Q. Did the state invent money as Greenbackers maintain?

A. According the Knapp’s State Theory of Money it did. Keynes embraced Knapp’s doctrine. That was how he purported to explain the forces which make value for irredeemable paper. When Knapp’s thesis that whatever the state declares to be money is money was met with the objection that state paper money, if irredeemable, was bad money, he was still sticking to his gun: „because indeed it has to be money in order to be bad money.” We may rest our case contra irredeemable state money with that statement of Knapp’s.

Q. Wasn’t Silvio Gesell a Greenbacker and also a Fabian? Why did he try to engineer a gradual state-mandated decrease in the value of money so as to speed up the velocity of money?

A. He was also a Communist. Gesell was the Commissar of Finance in the short-lived Bavarian Soviet Republic in 1919. During his very brief tenure he tried to establish Freigeld in Munich to make sure that money is returned to circulation and is never hoarded, by imposing a stamp tax also known as demurrage on bank notes. That would make people scramble to spend it before the stamp tax fell due. Freigeld earns its name by the property that it makes the incentive to hoard money disappear completely. It is supposed to be an anti-deflationary measure speeding up the velocity of money. Money automatically loses part of its value with the regularity of the clock striking the hours. Freigeld was claimed to be the safest way of reducing interest rates to near zero and to increase the velocity of money. We may recognize ZIRP (Zero Interest Rate Policy) of Bernanke as an imitation of the scheme of Gesell.

Keynes also looked at Freigeld to keep the wolf of liquidity preference away from the door. The theoretical case for the gradual suppression of the rate of interest to near zero rests on the fact that it increases the present value of durable goods, thus providing incentives for investments – as opposed to paying down debt.

The theory of gradual reduction of interest rates as a way to stimulate economic activity is totally untenable. Businessmen will stay lethargic as long as the fall continues. They will refuse to take the loans offered. They know that what looks like a low rate today will be a rate too high tomorrow.

Entrepreneurs who finance their business today will have a hard time to compete with those who finance theirs tomorrow, who in turn will have a hard time to compete with those who finance theirs the day after tomorrow. The upshot is that no sound investments can be made as long as the fall of interest rates continues. Bernanke and his Fed think that they sow the seeds of inflation, but they will only reap deflation, lots of it. The tragic thing is that people are preparing for inflation whereas they should be preparing for deflation. They will be devastated when they find out that the leadership at the Fed and the Treasury didn’t know what the heck they were doing while they were ZIRPing.

Q. You have a theory asserting that a regime of falling interest rates causes capital erosion and, ultimately, capital destruction. You have been criticized by those who find this counter-intuitive. They say that as interest rates keep falling, so does the cost of capital, reviving profitability and stimulating investments. How do you resolve this apparent contradiction?

A. You must distinguish between a low but steady interest rate regime that is salubrious and a falling interest rate regime that is lethal to the economy. I have just explained how falling interest rates make it impossible for businessmen to make sound investments. Actually the situation is far worse.

Not only is capital formation inhibited, but on the top of that existing capital is endangered. Under a prolonged decline of interest rates capital is being eroded and, ultimately, destroyed. If this seems paradoxical, it is because of the reluctance of the mind to admit that a higher bond price represents a higher liquidation value of the underlying debt – an obvious proposition. In other words, a fall in the rate of interest, far from alleviating the burden of debt, aggravates it.

Here is what happens. The rate of interest falls. The liquidation value of debt, contracted earlier at higher rates, rises. Why? Well, because now the stream of amortization payments is being discounted at a lower rate. Therefore at maturity there appears a shortfall. This shortfall represents the impairment of capital. Accountants may ignore it, but only at the peril of the firm that one day will wake up to find that, surreptitiously, it has been denuded of capital. All accountants and bank examiners in the world, aided and abetted by governments, overlook the impairment of capital due to the falling interest rate structure.

Q. Is there such a thing as velocity of money? Is it necessary for a viable economy?

A. Most certainly there is. Money is a two-dimensional entity. Quantity is one and velocity is the other dimension. The Quantity Theory of Money tends to forget about the second dimension. Zero velocity means barter: the death of monetary economy. Too high velocity means that money is unfit to be saved and people will increasingly refuse it in exchange for real goods and real services. Keynesian economics teaches that saving is a vice; it is anti-social or worse. Items in the balance sheet of the government can be freely shifted from the liability column to the asset column. That way, capital can be made a free good. Keynes, who studied Gesell’s Freigeld thoroughly, arrived at the conslusion that gentle inflation was superior to Freigeld. Friedman chimed in suggesting that the rise of prices can be checked through fixing the rate of increase in the stock of money. They were all wrong. They all promoted the exponential explosion of debt. Gold is indispensible as the only ultimate extinguisher of debt. It weeds out unwanted and toxic debt automatically. It is the flywheel regulator of the economy: it keeps the velocity of money at its optimum.

### Q. Is the Misesian business cycle theory valid?

A. I have criticized the Misesian business cycle theory for suggesting that businessmen are unable to learn. Time and again they fall for the false signals of low interest rates, caused by the propensity of the banks and the government to expand credit, leading to economic miscalculation as to the quantity of available capital goods. But in fact successful businessmen are the most intelligent people we have. Why don’t they learn and take correction, factoring in the undercutting of interest rates by the banks and the government, in their calculation of available capital goods? Engineers make such corrections routinely. Why can’t businessmen?

An improved theory of the business cycle would consider the causality relation between prices and interest rates. It is reasonable to appeal to the phenomena of economic oscillation that has often been talked about, and economic resonance that has been talked about much less. Here are the details. Apart from leads and lags rising (or falling) prices make interest rates rise (or fall) and, conversely, rising (or falling) interest rates make prices rise (or fall). Prices and interest rates oscillate. There are three types: damped, steady and runaway oscillation. The first, where the amplitude peters out in time due to friction, is extremely common. Steady oscillation occurs if carefully measured boosting provided by resonance is present – as in generating alternating current or radio waves. Runaway oscillation is also due to boosting – not to say ’overboosting’. It makes amplitudes get ever larger due to periodic injection of energy. The injection of energy, here just as in the case of steady oscillation, is provided by resonance. Unless injection is cut back below the level of steady oscillation, runaway resonance will end in the self-destruction of the resonating system. Prices resonating with interest rates make for such a system. The oscillation of prices is boosted by the oscillation of interest rates.

Resonance results. But because of the ignorance of the Federal Reserve, overboosting occurs: the periodic injection of excess credit kicks the system to ever higher energy levels. Empirical evidence is provided by the sloshing of excess money back and forth, like tide and ebb, between the commodity market and the bond market with increasing intensity, until the system breaks down. If breakdown occurs during the phase when the rate of interest is rising and money flows from the bond market to the commodity market, we talk about hyperinflation.

But there is also a second variety for which no precedent exists because we have no previous historic example of experimentation with global fiat paper money. If breakdown occurs during the phase when the rate of interest is falling and money flows from the commodity to the bond market, then we have what I call hyperdeflation. That is what we are apparently having right now. It started over thirty years ago in the early 1980’s. When in January 1980 interest rates failed to break out on the upside (as appeared likely at the time, with the gold price hitting \$875), the system went into the mode of declining interest with such a force that put the Fed out of control. For the past three decades interest rates have been falling relentlessly. Of course, the Fed would like to have us believe that this is the result of deliberate monetary policy. I suggest it to you that it’s not. It is runaway resonance in action – on the side of interest rates and the velocity of money falling to zero. Fall they do inexorably. It is hyperdeflation. The Fed is desperately trying to fight it, but all is in vain. We are on a roller-coaster ride plunging the world into zero-velocity of money and into barter. In my lectures at the New Austrian School of Economics I often point out the similarity with the collapse of the Tacoma Bridge in 1941.**

Q. Please share with us your criticism of the idea that fractional reserve banking is a crime, as Murray Rothbard once held.

A. According to Rothbard and the American Austrians commercial banks claim that they hold gold reserves dollar for dollar against their sight liabilities, which is a lie, because up to 95 percent of their reserves against bank notes and bank deposits is made up by mere paper claims to gold. Fractional reserve banking is fraud, in whatever shape and form it may come – they say. However, there is such a thing called self-liquidating credit that Rothbardians refuse to recognize.

It is represented by real bills covering goods in most urgent demand and moving to the ultimate consumer with all deliberate speed. It must mature in 91 days or less. This credit is self-liquidating as it is paid out of the proceeds of the sale of goods. The origin of this credit is not in saving but, paradoxically, in consumption. It is regulated not by the rate of interest that varies inversely with the propensity to save, but by the discount rate that varies inversely with the propensity to consume. Those commercial banks that abstain from borrowing short to lend long do not pretend that 100 percent of their reserves are held in gold coins. They point out that one ninetieth of their assets ’mature’ into gold coins every day, and if that proves to be insufficient to meet redemption demand of their sight liabilities, then they can always liquidate real bills in their portfolio without losses. The bill market is very liquid, as there is a virtually unlimited demand for real bills, which are the best earning asset a commercial bank can have. The American Austrians are barking up the wrong tree. They should criticize the tendency to replace real bills with anticipation bills and Treasury bills, neither of which is self-liquidating. Instead, they throw out the baby with the bathwater in failing to distinguish between real bills and fraudulently constructed accommodation bills.

### Q. Are banks necessary in a free-market environment?

A. That’s just it, they aren’t. In the original model of Adam Smith the existence of commercial banks is not postulated. Real bills circulate hand-to-hand as cash through endorsement, while the discount is calculated and taken out of the proceed. Commercial banks cropped up because of the convenience of bank notes denominated in round figures as compared with the face value of real bills in odd figures. Moreover, bank notes eliminate the nuisance of endorsing and the calculation of discount. For this convenience clients are willing to forgo the discount due to them. In my interminable debates with the American Austrians I have failed to convince my opponents that if they want to knock real bills, they must not refer to bank fraud because real bills do indeed circulate in the complete absence of banks.

Q. Could the banks offer real bills in a free-market money system?

A. No. Real bills earn their name by representing consumer goods in the greatest demand. Only producers and distributors of real goods and real services can draw real bills, not banks. Banks discount real bills.

Q. Please explain how real bills work and why they are so important.

A. It stands to reason that the demand for purchasing media varies with the seasons. Just before Yule-tide much more of it is needed than afterwards. It is utterly unrealistic to expect that the pool of circulating gold coins with its inelastic volume can meet the highly variable demand for purchasing media.

The market responded by promoting the bill drawn on the retail merchant by the wholesale merchant, or on the producer of lower order goods by that of higher order goods, to become ephemeral cash. This is not inflationary because the ephemeral cash arises together with the rise of the new merhandise in production, and it expires simultaneously with the removal of the merchandise from the market and with its disappearance in consumption. The bill market made possible an incredible increase in world trade and prosperity in the 19th century. World War I put an end to it all. The victors, out of spite against Germany, vetoed the rehabilitation of the bill market after the end of hostilities. The blockade of Germany could not continue in peacetime, but the blocking of bill-financing of German trade could and did. Multilateral trade was replaced by bilateral trade, a major step in the direction of deflation since far more gold is needed to support bilateral than multilateral trade. This foolish, spiteful and, yes, deflationary policy boomeranged in the form of the Great Depression of the 1930’s. As warned by the German economist Heinrich Rittershausen in 1929, the Wage Fund (out of which workers whose production may not be sold up to 91 days, that constituted the major component of outstanding bills) was destroyed as a result of blocking the international bill market and mass unemployment ensued. The warning was dismissed as German chauvinistic propaganda. There was no one who could advance the wages of workers once the bill market was blocked. Evidence of the conspiracy to block the rehabilitation of the bill market in 1918 was hushed up and research of the causal relation between the cessation of bill trading and mass unemployment was put under a gag order. Keynesian economists use the whipping boy of the gold standard as the scape goat responsible for the Great Depression. I am in the minority of one pointing out that the real culprit is not the gold standard. Quite to the contrary, it is the destruction of the gold standard’s clearing house, the international bill market.

As far as the future is concerned, the importance of real bills must be seen in the light of the inexpedience of barter in a complex economy. People will want to trade, they don’t want to barter. After the demise of the dollar, in the absence of purchasing media people will reinvent real bills payable in gold at maturity. That is the only way to alleviate deflation and mass unemployment world-wide.

Q. Is it necessary for the state to pass a law to ensure that real bills be accepted as money?

A. Absolutely not. Real bills circulate spontaneously, on their own wings and under their own steam. If a bill is refused at the discount window, it is a sign of trouble. Somebody somewhere is drawing bills on nonexistent goods, or on goods that have been arrested for purposes of speculation, or recycling bills drawn on unsold merchandise – all of which are against the rules of bill trading.

Q. For real bills to circulate would state coercion of any sort be necessary?

A. Absolutely not. Even Mises admitted this when he commented on bill circulation in Lancashire before the Bank of England opened its branch office in Manchester. The rules of bill trading were developed by the free market, not by the state.

Q. What about accounting? Is it necessary for the state to impose universal accounting principles from a free-market standpoint?

A. According to an old adage laws are made to be broken. The same idea applies with double the force to accounting standards imposed by the government from above. If the government can make them, it can also scrap them, it can ignore them overtly or covertly. This is happening right now, when governments routinely allow bank examiners and chartered accountants to disregard accounting standards. Sovereign debt is given the highest rating in spite of the absence of bids for it. Impairment of capital due to ZIRP is universally ignored – as I have just explained. Basel III rules on gold in bank reserves are established to make gold the fall guy, and later the whipping boy, just in case if public opinion succeeds in forcing a return to the gold standard.

As a result of officially sanctioned fraud, the world’s banking system today is not just illiquid; it is in fact insolvent. It is operating without capital. You cannot make mud liquid by adding a drop of water; you cannot make bank reserves liquid by allowing the admixture of an ounce of gold. By contrast, accounting standards developed by the free market cannot be tampered with as everybody would immediately learn about it.

Q. You started the New Austrian School of Economics. Can you explain what this name implies?

A. It implies the return to the letter and spirit of Carl Menger. It means the rejection of the Equilibrium Theory of Supply and Demand, replacing it with the Disequilibrium Theory as manifested by the dichotomy of the bid price and the asked price. It implies the dethroning the concept of price and enthroning the concept of spread. It implies the recognition of marketability as the prime gage of the quality of money, instead of its quantity. It also implies a respectful criticism of Mises. It implies the rehabilitation of Adam Smith’s Real Bills Doctrine. It implies an abiding interest in studying the phenomena of econpomic oscillation and resonance. It implies spreading the truth about the universal impairment of capital under the regime of falling interest rates.

Above all, it implies the continuation of Menger’s pioneering work on the origin of money, by working out the dual theory on the origin of interest. The fratricidal war between the Time Preference School and the Productivity School of Interest must end. Using Menger’s idea of the bid/asked spread, the two theories can be merged in a happy synthesis. Just as the price of goods is not monolithic but splits into bid and asked prices, so the rate of interest is not monolithic either but splits into floor and ceiling rates. These two must be studied separately. The ceiling rate can be understood in terms of marginal productivity; the floor rate in terms of marginal time preference.

### Q. Why is the Austrian Rothbardian wing dismissive of real bills?

A. The Real Bills Doctrine is a thorn in the flesh of the Quantity Theory of Money to which the Rothbardians are uncritically committed. The Quantity Theory of Money is a clever mechanical metaphor rather than a valid theory. It fails because it is based on the misconception that change is always a linear phenomenon. It is not, save a few exceptions. The world runs on highly nonlinear tracks and, just as in physics, non-linearity generally cannot be approximated by linearity. The Rothbardians are cultists. Their dogmatic approach endangers the success of a future gold standard that, Phoenix-like, will arise out of the ashes of this latest disastrous experiment with irredeemable paper money.

### Q. Will real bills make a comeback?

A. Most assuredly they will. People will not go hungry, unclad and unshod, and they are not going to shiver in winter for the greater glory of irredeemable currency advocated by Knapp, Gesell and their epigoni, Keynes and Friedman.

The circulation of irredeemable bank notes may seize up without warning, causing innocent people excruciating economic pain. But people will rise out of their misery and will continue producing food, clothes, shoes and fuel, and will trade them against payment in the form of real bills maturing in gold. That’s what happened in the past, and that’s what will happen in the future. The demise of the system of irredeemable currency is a foregone conclusion. Not only is it illogical; it is also immoral. A free society cannot be built on a coercive basis. Moreover, the regime of irredeemable currency is incompatible with the ideal of limited government. It grows into a system where farmers are paid for not farming, and workers are paid for not working.

### Q. What is next for the New Austrian School of Economics?

A. We are doing research as well as teaching. We offered courses in the U.S., New Zealand, Australia, Hungary, Germany and, most recently, in Spain. There are plans to cooperate with the University of Avila. A more distant plan calls for presence in the Ukrainian city of Beregovo. Concerning research, we offer studies at the Master’s and the Ph.D. level. An urgent topic to research is how the avalanche triggered by permanent gold backwardation flattens the landscape of monetary economy into barter economy. Another topic we intend to elaborate on is the theory of economic oscillations and resonance.

### Q. Any literature you want to mention?

A. We have granted two Ph.D. degrees so far, one to Sandeep Jaitly and the other to Keith Weiner. Their dissertations are available from the authors and I can recommend them to everyone wanting to learn more about New Austrian Economics. A third Ph.D. degree is in the making; the candidade is Peter van Coppenolle. His proposed thesis has been published already in the form of a handsome volume under the title The Austrian Business Cycle Revisited, that is available from the author. I recommend it to the readers of this interview along with a book written by our Master graduate, Rudy Fritsch under the title Beyond Mises.

### Q. Any other points you want to make?

A. The altercation between the American Austrians and the New Austrian School of Economics is a tragic waste of talent. We should settle our differences not by mud-slinging and by calling names, but through high level scientific debates. For starters, I would like to invite the critics of Adam Smith’s Real Bill Doctrine to Avila, Spain, for such a high level debate. I sincerely hope that they accept and we can join forces in preparing the ground for the triumph of the gold standard after a brief reactionary period in history dominated by the regime of irredeemable currency.

### Thanks for your time!

### Thanks for the opportunity to present my views!

## Endnotes


By gold backwardation is meant a condition whereby the gold basis turns from positive to negative – an anomaly. Gold basis is the name for the difference between the price of the nearby gold futures contract and the price of gold for immediate delivery. If positive, we talk about contango, if negative, about backwardation. Contango is the normal condition prevailing in the gold futures markets par excellence, because the stocks-to-flows ratio for gold is the highest by far among all commodities.

Permanent gold backwardation means that, having been vacillating between contango and backwardation, the gold basis finally takes the plunge into negative territory never to become positive again. When that happens, it will be a unique historical event. It will mark the ignominious end of the fortyodd year long global experiment with irredeemable currency. Sovereign debt, including that of the United States government, will not be worth one grain of gold.

### **

By way of explaining the title of this interview, I recall the collapse of the Tacoma Bridge plunging pedestrians and occupants of passenger cars into the river below to their death in Washington state, U.S.A., in 1941. The disaster convincingly demonstrates the ferocity of runaway resonance. The event was triggered by gale-force winds. Yet the bridge was destroyed not by the winds per se – they did not carry energy sufficient to do that. It was destroyed by runaway resonance that was mounting energy to ever higher levels. It happened because the periodic strokes of the wind coincided with one the harmonics of the characteristic frequency of the bridge.

Ever since that disaster engineers take these harmonics into account when designing a suspension bridge. The event has been filmed and is available for viewing. It must be seen to be believed.

Permanent gold backwardation, if it occurs (as appears likely), will be an event similar to the Tacoma disaster. Designers of the global fiat money experiment that has been going on since 1971, just as the designers of the Tacoma bridge, have forgotten to take runaway resonance into account. THEIR RESPONSIBILITY, HOWEVER, IS FAR GREATER BECAUSE THEY HAVE BEEN

WARNED REPEATEDLY THAT THEIR DESIGN WAS FAULTY. They went ahead anyway, and we have to suffer the consequences.

---

# Who Said The Hydra Would Take It Lying Down?

URL: https://newaustrianeconomics.com/archive/fekete/who-said-the-hydra-would-take-it-lying-down/
Date: 2013-04-18
Section: Popular Economics
Difficulty: accessible
Concept Tags: federal-reserve, monetary-policy, fiat-currency, monetary-crisis, gold-standard
Description: Fekete uses the Hydra metaphor to describe the international dollar system — cut off one head (end QE, remove a suppression mechanism) and two more grow back. He examines the failures of previous attempts to reform or constrain the Federal Reserve, arguing that the system cannot be reformed from within and requires a fundamental monetary revolution.
Editorial Note: Written April 2013 as gold prices were falling sharply. The Hydra metaphor is apt — each apparent victory over monetary disorder reveals a new manifestation.
Original PDF: https://professorfekete.com/articles/AEFWhoSaidDragon.pdf

I have never appealed to the so-called conspiracy theories in trying to explain the strange world of fluctuations in the price of monetary metals. But neither have I ever said that the fiat-money Hydra will take it lying down when it comes to chopping off its several heads one-by-one.

### Markets for the monetary metals under fiat money

Here are the relevant facts:

(1) The U.S. government defaulted on its obligation to pay its short-term dollar debt to foreign governments and central banks in gold at a fixed rate, as confirmed by several international treaties and by the solemn pledges of several sitting presidents, on August 15, 1971. Subsequently it has been bankrolling a chorus of servile academic cheer-leaders and other sycophants to shout from the roof-top that the gold standard was a ‘barbarous relic’ anyway, quite ripe to be gotten rid of – in an effort to cover up the shame of fraudulent default

(fraudulent because the U.S. did have the gold and could have lived up to its international obligations).

(2) Thus the U.S. confiscated some of the gold belonging to institutions outside its own jurisdiction, but could not confiscate all of it. University economics departments and research institutions have failed to investigate what gold at large will do in the long run. They just assumed that it will be business as usual without gold in eternity. Well, it didn’t quite turn out that way.

Speculators soon started trading gold futures, first in Canada, then in 1975 in the U.S. as well. No universities and think-tanks showed an interest in studying gold futures trading and its long-run consequences. Why, gold has been reduced to the status of frozen pork bellies. We know all that is to be known about trading frozen pork bellies, don’t we? Supply and demand, right? And when push comes to shove, it is easier to increase the supply of paper gold than that of frozen pork bellies, isn’t it? (With due apologies to the late Fritz Machlup of Princeton University for this interpretation of his theory of gold futures trading.) We may bypass the question whether our institutions ignored problems connected with futures trading of monetary metals on their own volition, or whether they did so under duress. As it turned out two scores of years later, the failure to study the consequences of the so-called demonetization of gold (euphemism for highway robbery) has caused an unprecedented world disaster: the disintegration of the world’s payments system that is now unfolding before our very eyes.

(3) A scientific inquiry would have shown back in the 1970’s that the gold basis (defined as the difference between the nearby futures price and the price for immediate delivery of gold) would be robust, in fact, it would be at its maximum (equal to the carrying charge, or opportunity cost of holding gold).

But soon it would start its relentless decline all the way to zero and beyond. A negative gold basis, a condition known as backwardation of gold, would create an extremely unstable situation in international finance because it meant risk free profits for holders of gold. Knowledgeable market participants realize that persistently falling basis means increasing scarcity which, in the case of gold, is not and cannot be alleviated by current output from the mines. Output ultimately proves no match for the mass movement of gold going into hiding, first gradually, eventually reaching crescendo when the threat of permanent gold backwardation starts looming large. At that point all deliverable supplies of physical gold would be gobbled up by gold hoarding. In case of monetary metals, in contrast with all other commodities, high and increasing prices may not bring out new supply. Rather, they might make supply shrink. Monetary metals are exempt from the law of supply and demand.

Under permanent backwardation, as no gold were offered for sale at any price, the ‘price of gold’ would become a vacuous concept. Gold, silver and, soon enough, all other highly marketable goods would only be available through barter. In other words, paper money as we know it would simply cease to function. We cannot fathom how our complex world economy could operate under such circumstances. One thing was certain, though: the world economy would contract in a way that would make the contraction in the 1930’s appear as a blip on the screen.

(4) All bubbles, all currency and financial crises of the past forty years are direct or indirect consequences of the vanishing gold basis – whether we admit it or not. A few years ago Professor Robert Mundell of Columbia University invited me to attend his annual seminar at Santa Colomba, with most of the leading monetary scientist in attendance. I circulated a statement warning of the danger of permanent gold backwardation and how it would adversely affect the world economy.

I argued that permanent backwardation of gold would be a watershedevent. As long as the gold futures markets are open, U.S. Treasury debt is still gold-convertible (albeit at a fluctuating rate, never mind that the rate is minuscule). But no sooner had gold futures trading stopped after the advent of permanent backwardation than gold was no longer to be had in exchange for

U.S. Treasury debt. The entire outstanding debt of the U.S. was worth not one ounce of gold. Not one gram of it. It is insane to pretend that this would make no difference in world trade, as pretended by official doctrine. This event would mark the transition from monetary economy to barter economy.

My missive did not provoke a single rejoinder. It was simply ignored. All the same, I have reasons to believe that people in the U.S. Treasury and the Federal Reserve started to listen and they took a crash course on the problem of vanishing gold basis and the threat of permanent gold backwardation.

(5) To summarize, in forcing the world off the gold standard in 1971 the

U.S. government created a many-headed Hydra. The problem was compounded by the apparent gag order, muzzling research on the gold basis – as a facesaving exercise to cover up the fact of default.

### Gold is not the same as frozen pork bellies after all

In waking up too late that there was a problem after gold futures markets have been flirting with backwardation for a year or so, officialdom was forced to act.

Act it did in a typically haphazard fashion. A few days ago, on April 12 and 15 the paper gold market was demoralized by a ferocious attack on the lofty gold price. This in and of itself is proof that Bernanke is fully aware that permanent gold backwardation is imminent, and that it will create and unmanageable situation. It’s got to be stopped in its track at all hazards.

Well, well, well. Gold is not the same as frozen pork bellies after all. The Hydra is not taking it lying down. The kid gloves have finally come off.

Bernanke is trying to stop gold backwardation by selling unlimited amount of gold futures contracts through his stooges, the bullion banks. He is underwriting losses they are certain to suffer in due course. We can take it for granted that they haven’t got the gold to make delivery on their contracts. In fact, delivery of gold will be suspended under the force majeure clause. Short positions will have to be settled in cash, to be made available by the Fed’s printing presses. Gold futures trading will be a thing of the past.

Bernanke and columnist Paul Krugman, formerly his subaltern colleague at Princeton don’t understand that the issue is not the price of gold. The issue is backwardation or contango. In trying to wrestle the gold price to the ground the Fed makes “the last contango in Washington”* an accomplished fact.

### From the frying pan into the fire

Ostensibly a lower gold price would solve the problem Bernanke has.

Demoralized gold bugs would be forced out of their holdings through margin calls. Disillusioned investors would shun gold. This would make physical gold available to rescue the strapped gold futures market.

In fact, however, a lower gold price is making the problem more intractable, not less. The Fed is diving from the frying pan into the fire. This is the point missed by almost all observers and market analysts. They ignore the underlying flight into physical gold that continues unabated, in spite of (or, better still, because of) the panic in the paper gold market. The Fed’s intervention in bankrolling short interest is going to back-fire, for the following simple reason. The Fed’s strategy is inherently contradictory. A lower price for paper gold makes it easier, not harder, to demand delivery on maturing futures contracts.

The more paper gold Bernanke sells, the lower the cost of acquiring physical gold in exchange for paper gold becomes. The price of the nearby futures contract will drop to hitherto unimaginable depths, relative to the cash price, making backwardation worse, not better. Ultimately this will make backwardation irreversible. Welcome to the world of permanent gold backwardation.

### From what hole does the evil deflationary wind blow?

Academia and the financial press have utterly failed to recognize the relevance of gold backwardation as regards deflation. They might fret about hyperinflation as a result of unbridled money-printing (euphemism for the monetization of government debt). Yet the real danger is not on the inflationary but on the deflationary front as realized even by Krugman – while he is perfectly clueless on the question from what hole the evil deflationary wind blows (other than conservative wishful thinking).

Well, I can pinpoint the location of the hole to within yards for the benefit of Krugman. It is on Constitution Avenue, in Washington, D.C. The evil deflationary wind is blowing from the building of Federal Reserve Board.

If Bernanke thought that his attacks on the gold price would stem deflation, well, his efforts were counter-productive, to put it mildly. They have, in fact, made the flight into physical gold accelerate. Permanent backwardation of gold, and its concomitant, the re-invention of barter – the ultimate in deflation – will be the result.

There is no reason to fear that the Fed is pushing the world into hyperinflation. In fighting the gold price the Fed unwittingly pushes the world into hyper-deflation.

All the same, it is destroying the dollar and the international monetary and payments system.

---

*April 18, 2013.*

### Endnote


The Last Contango In Washington, [www.professorfekete.com](https://www.professorfekete.com),

2006-06-30

---

# Interview with Algerian Journalist Kahina Bencheikh El Hocine

URL: https://newaustrianeconomics.com/archive/fekete/interview-algerian-journalist/
Date: 2013-03-08
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, real-bills, new-austrian-economics, permanent-backwardation, sound-money
Description: An extended interview in which Fekete introduces his monetary framework to an Algerian audience, covering the gold standard, irredeemable currency, permanent backwardation, and the prospects for monetary reform. The interview provides a accessible overview of his complete monetary theory.
Editorial Note: Published March 2013. The Algerian interview format — like the Daily Bell interview of 2009 — gives Fekete an opportunity to present his ideas in a more structured, accessible way than his essay format typically allows.
Original PDF: https://professorfekete.com/articles/AEFinterviewALGERIA.pdf

Question: With Algeria’s foreign exchange reserves approaching 200 billion dollars, is the country vulnerable in the case of a crisis in the foreign exchange markets?

Answer: Very vulnerable indeed, and on several counts. In addition to foreign exchange risk

(especially in view of America’s declared policy to beat down the international value of the dollar) there is the interest-rate risk to the extent Algeria’s reserves are invested in American Treasury paper.

As interest rates rise, the value of U.S. Treasury bonds will collapse. These losses are on the top of the losses already booked on the foreign exchange value of the dollar. Algeria, as all other countries, will have to bear the consequences of the folly of depositing its money on dollar accounts in banks under the jurisdiction of foreign governments.

Q.: Is there a risk involved in Algeria’s keeping its gold reserves abroad? Woluld it not be wiser to repatriate the gold?

A.: There is always a risk involved in keeping the country's gold reserve abroad. Foreign governments could declare vis major and refuse to release the gold. That happened to the gold of the Spanish Republic held in the Soviet Union in the 1930’s. On different occasions the U.S. has also refused to release gold belonging to foreign governments. The thefts were justified by invoking the Trading with the Enemy Act. Repatriation is the right course of action.

Q.: How could a country such as Algeria introduce the gold standard? Would it not incur the wrath of the United States, and invite retaliation in the form of expulsion from the world-wide dollar clearingsystem?

A.: The mechanism of introducing the gold standard is simple enough. Algeria should declare a gold coin (say the 20 franc gold coin of the now defunct Latin Monetary Union) to be the coin of the realm of Algeria. It should start minting and stamping it with Algeria’s coat of arms and the current date.

Finally and most importantly, Algeria should make a solemn commitment internationally to convert all the gold bullion of the appropriate weight and fineness brought to the Mint into the coin of the realm, free of seigniorage charges, in unlimited quantity. In the annals of monetary history such an arrangement is known as the “opening of the Mint to the free coinage of gold”.

Q.: But what about American retaliation in the form of expelling Algeria from the dollar clearingsystem?

A.: Algeria as a major trading nation has little to worry about that. Better still, Algeria could derive an additional benefit from such a retaliation if it occurred. It could set up the 21st century’s first clearing system for gold devices (a.k.a. real bills maturing in gold coin in 91 days or less). These gold devices are far superior to dollar credits, and the world will treat them as such. Other trading nations would start paying for their imports by drawing bills on Algeria, like they used to do in the 19th century, by drawing bills on London.

Q.: Why do the world’s financial powers keep imposing the dollar and the euro on humanity, and block any reasonable effort to return to the international gold standard?

A.: Here the old adage applies: HE WHO HAS THE GOLD CALLS THE SHOTS. The world’s financial powers want to call the shots themselves without putting any gold of their own on the firing line. In opening the Mint to the free coinage of gold Algeria would pull out the dragon's tooth. The only way for the managers of the dollar to defeat that would be to open the U.S. Mint to gold as well. In other words, the dollar would have to be returned to the gold standard, too. The "dollar imperialists" would be helpless. Opening the Mint to the free coinage of gold would be "Algeria's finest hour".

Q.: Who could stand up and face the “chrysophobic” forces? They are backed by the most powerful banking interest the world has ever seen. As you say, the gold standard would expose bad banks. It would keep the big mercantile interest, the sole beneficiaries of the fiat money system, in check.

A.: Algeria could stand up. It could enact legislation requiring banks to balance their books in terms of the gold coin of the realm, on pain of losing their license to operate in Algeria. In consequence Algerian banks would be virtually the only solvent banks in the world.

Banks elsewhere, with leave of the government, have allowed layers after layers of bank credit to be built upon illiquid government debt. The world’s banking system is a house of cards, and stormy winds are in the forecast. Bank examiners and chartered accountants have betrayed their trust in giving sick banks a clean bill of health under government pressure all over the world.

Algeria should also revoke the legal tender protection of bank notes of the Central Bank. Again, this would a “first” in the 21st century. Let the bank notes compete in the market place with gold coins. It is a matter of the "survival of the fittest" – as it should well be. Let the working people decide whether they want wages be paid in fiat money that historically has always been returned to its intrinsic value, namely zero – according to Voltaire – or in gold (silver) coins which have stood the test of times through the millennia.

Q.: You are on record as saying that by destroying it the United States was punishing Iraq for its temerity to start billing its customers in drawing gold bills. Others say that the explanation is oil, pure and simple. How would you answer your critics?

A.: To say that the motivation for the U.S. "police action" to punish Iraq for breaking ranks is, of course, a hypothesis. But it is a plausible hypothesis. The idea that countries should be free to choose which currencies to accept and which ones to refuse in exchange for real goods and real services is too dangerous and too contageous for the comfort of the American money doctors. They have too much to lose if the dollar is disowned by the world community. However, the "police action" against Iraq was a dismal failure. Even if America were self-sufficient in oil (as it may soon be due to technological break-throughs such as fracking), the case for punitive action against those jumping ship would stand. Financing world trade by drawing bills maturing in gold (rather than in dollar bills with the legend IOYN , i.e., “I owe you nothing”), is an idea whose time has come. According to Victor Hugo, “nothing is more powerful than an idea whose time has come”.

Q.: The dollar is a counterfeit currency conferring real power on the counterfeiter, the Federal Reserve, that has been allowed to trample on the U.S. Constitution for almost a century, while wiping out 99 percent of the purchasing power of the dollar. Why does the world accept this deceitful system of legalized counterfeiting without demur?

A.: Part of the answer is inertia. You prefer the devil you do know to the angel you don't. Another reason is fear of retaliation as demonstrated by the destruction of Iraq. However, America is on the way turning itself into a “colossus of clay feet” or, if you will, into a paper tiger. Whatever it does, it is digging the grave for the Dollar Almighty.

But there is a third answer, too, that is a bit technical. As long as gold future markets exist, U.S.

Treasury bonds can be converted into physical gold. But as the vanishing gold basis (defined as the difference between the nearby futures price and the spot price of gold) shows, the gold futures market is moribund. It will go up in a puff of smoke when the day of permanent gold backwardation dawns. Wholesale defaults on gold futures and option contracts will follow. A lot of people realize that.

But what is realized by practically no one is that at the same moment the marketability of U.S.

Treasury bonds will evaporate. Like it or not the dollar, even today, is merely a proxy for gold. Be that as it may, it is not the ultimate extinguisher of debt. Gold is. No doubt it is more convenient to pay through wiring dollar credits than through shipping gold. But the moment the gold futures market succumbs to the ineluctable forces of economic law and no more physical gold can be obtained in exchange for the dishonored dollar, world trade will be reduced to barter. Firms will fold, workers will be laid off in droves.

No university and no think-tank in the world is studying the implications of the vanishing gold basis, nor the problems connected with its turning negative. The threat of permanent gold backwardation is ignored. However, this ostrich-like bevavior will not change the fact that the gold basis is real, and the clock of the approaching permanent gold backwardation keeps ticking.

One of the reasons I started and incorporated the New Austrian School of Economics (NASOE) was to legitimize the study of the gold and silver basis, the phenomenon of permanent backwardationh, and the circulation of real bills maturing in gold. Up to now these subjects were treated as alchemy or astrology. No university ought to stoop so low as treating them with respect.

The next seminar of NASOE will take place in Madrid at the end of March, 2013. It is designed for beginners where you can learn more about these things.

Q.: Germany wanted to find out how much gold there is on its account with the IMF. It was rebuffed.

Is the IMF more powerful than a strong Western country such as Germany?

A.: My view is that Germany is not a strong Western country. Rather, like Japan, it is an occupied territory pockmarked with American military bases which have lost all their rationale when the Soviet Union collapsed in 1991. All decisions of the German government can be assumed to be subject to American veto, as long as American troops are stationed in that country.

Even the economic strength of Germany is contingent upon extreneous circumstances. For example, it depends on the release the German gold reserve from American custody that could be refused on the flimsiest of pretexts.

The IMF is an American puppet. It should have been disbanded in 1973 when the system of fixed foreign exchange rates, which it was conceived to safeguard, was abandoned. It’s tantamount to keeping the hangman on the payroll after capital punishment has been outlawed.

Q.: You have been quoted as saying that the refusal to return to the gold standard could mean the beginning of a New Dark Age, with the security of person and property fading into oblivion. Do you mean to say that we have been living in a Dark Age since 1971, when the world was pushed into the abyss by what you call the “Nixon-Friedman conspiracy”?

A.: 1971 was the year when the genie of debt was released from its golden bottle. Ever since it has been free to roam around in the world causing chill and fever, inflicting great and irreparable damage wherever it goes. Quadrupling oil prices and exploding the interest rate structure here, real estate bubble and collapsing the interest rate structure there. But the New Dark Age of the world will start in earnest when gold goes into permanent backwardation. It is going to be an age replete with depressions wiping out firms and jobs, marked by collapsing world trade, by barter replacing multilateral trade, by breakdown of law and order, by famine and pestilence, and so on and so forth.

It could only be prevented by an immediate return to the gold standard and to gold-bill financing of world trade. All that id needed to bring this about is that one country (or a group of countries) should open the Mint to the free coinage of gold and allow real bills payable in gold coin to circulate.

Algeria is in an ideal position to make a move in this direction, thus saving people from excruciating economic pain. Recall the example of Byzantium that was able to save its people living in the Eastern half of the Roman Empire from the fate that has befallen on those living in the Western half – by continuing to mint its gold coin, the bezant, through thick and thin.

Q.: But has the economic collapse you have been predicting started already, or are we just witnessing its warning signs?

A.: The answer to your last question is: "You ain't seen nothing yet".

---

*February 28, 2013.*

---

# American Bases in Germany and the Gold Basis

URL: https://newaustrianeconomics.com/archive/fekete/american-bases-in-germany-and-the-gold-basis/
Date: 2013-01-28
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, gold-standard, central-banking, backwardation, monetary-crisis
Description: Fekete connects Germany's request to repatriate its gold from U.S. vaults with the gold basis, arguing that the German move reflects growing distrust of U.S. gold custodianship and signals that the gold suppression scheme is fracturing. As more central banks demand physical delivery of their gold, the paper gold system faces its ultimate test.
Editorial Note: Written January 2013 following Germany's announcement that it would repatriate gold from the U.S. Federal Reserve. Fekete connects the geopolitical development to his monetary analysis.
Original PDF: https://professorfekete.com/articles/AEFAmericanBasesGermanyGoldBasis.pdf

### American Bases in Germany and the Gold Basis

Germany is neither independent nor sovereign, prevailing pretences notwithstanding. It has American troops on her soil for reasons unexplained and unexplainable after all Soviet occupying troops were withdrawn almost 25 years ago. Equally significant is the fact that the lion’s share of the German gold reserve is in American custody. If the Bundesbank asked for the repatriation of a token part of that gold over a long period of time, we may take it for granted that it was done on American instructions.

But why would the Americans ask the Bundesbank to request the return of a part of German gold from the ‘safety’ of the basement of the Federal Reserve Bank of New York in lower Manhattan? Surely not because the vaults are bulging with American gold and they have to make room for more.

It’s all grand theater. There is a hidden agenda that has to be camouflaged. The best way of doing it is to put up a show. The public is fascinated by images of shuffling central bank gold.

One reason, perhaps the chief reason for this exercise is that the managers of the global fiat money system are preparing for the coming showdown, the final curtain on what some years ago I dubbed The Last Contango in Washington. In other words, policymakers are preparing for (or trying to fend off) permanent backwardation in the world’s gold futures markets that is threatening to rip apart the present shabby make-belief payments system of the world.

Contango is the normal condition of the gold futures markets when the spot price of gold is at a discount relative to the price of futures contracts. It demonstrates that plenty of gold is available to satisfy present demand. People are confident that promises to deliver gold will be honored. The condition opposite to contango is called backwardation that obtains when the futures price loses its premium relative to the spot price and goes to a discount. In the gold market this condition is highly anomalous because, on the face of it, it allows traders to earn risk free profits. They sell spot gold at a premium, and buy it back at a discount for future delivery. However, risk free profits are ephemeral since the very action of traders will instantaneously eliminate them. What this suggests is that permanent backwardation in gold could never happen by the very nature of the case.

Yet unknown to the general public a very great danger is looming, the like of which has not threatened the world since the collapse of the Western half of the Roman Empire more than fifteen hundred years ago. This danger, should it materialize, would mark the end of our civilization and the beginning of a new Dark Age. I am talking about a threat of the sudden and complete collapse of world trade. It would be heralded by permanent gold backwardation, something that allegedly could never happen. Hard on its heels would follow the collapse of the dollar payments system. Barter, of course, would take place between neighboring countries, but world trade as we know it would disappear altogether.

The metric whereby the turning of contango into backwardation can be measured is called the gold basis. It is the premium on the price of gold for future delivery as per the nearby contract relative to the spot price. Thus negative gold basis is tantamount to backwardation. We have scarcely a forty-year history for the gold basis to go by, because there was no organized futures trading for gold before America defaulted on her international gold obligations on August 15, 1971.

Futures trading started out with a robust gold basis. Contango was at its peak.

The gold basis cannot be higher than the full carrying charge (also known as the opportunity cost of holding gold, the major component of which is interest). But soon enough the gold basis started eroding, and erosion has continued to this day.

This was an ominous process that was ignored by all politicians, economists and financial journalists.

The vanishing of the gold basis is all the more curious since it has been taking place against the background of a steady advance in the gold price. Textbook economics teaches that an advance in price always and everywhere calls out new supplies. However, textbook economics is helpless when it comes to gold. For gold the exact opposite is true: an advance in price makes supply contract; and a very large advance may make supply disappear altogether. The reason for this paradox is that gold is a monetary metal. All the bad-mouthing of gold by economists in the pay of governments won’t change that fact. By now the decay has gone so far that the gold basis is practically zero, with occasional dips into negative territory.

Academia ostensibly avoids researching the gold basis, pretending that it has as much bearing on the world economy as the basis for frozen pork bellies. The public is kept in total ignorance. Yet you can ignore the gold basis only at your own peril. It is the only indicator available showing the progressive deterioration of the fiat money system. As is well known, there has never been a successful experiment with fiat currency in all history. Nor was it for lack of trying. Every such experiment was either abandoned as enlightened governments decided to return the currency to a metallic basis, or it ended in utter fiasco causing tremendous economic pain to people as the fiat currency was rapidly losing all its purchasing power.

The relentless contraction of the gold basis means that gold available for future delivery is fast disappearing. Gold is constantly moving into strong hands that hold on to it and will not relinquish it even in the face of steeply rising prices.

Eventually the gold supply dries up and sporadic backwardation gives way to permanent backwardation. Gold mines refuse to take paper money for their product. If you want to have gold, you will have to have recourse to barter.

Permanent backwardation means that confidence in fiat paper currency and government promises to pay has evaporated. After all, considering their origin, irredeemable bank notes are nothing but dishonored promises to pay gold. Once confidence is shattered, all the king’s horses and all the king’s men cannot put Humpty Dumpty together again. Permanent backwardation is like a black hole.

There is no way out of it. Not even a light ray can escape from its clutches. That’s how black holes earn their name. ‘Permanent backwardation’ is not as suggestive as the name ‘black hole’, but it can gobble up the world economy nevertheless.

The gold basis is akin to the efficiency of bribe money. At first the bribe is taken with no questions asked. But as it becomes a regular feature of gold trading, effectiveness is lost. In the end the bribe is refused when it is realized that the objective is to cheat the holder out of his possession of gold. A trading system built on bribe is a house of cards. It is dishonest. It depends on deception and falsecarding.

This brings me back to the German gold reserve. As sporadic backwardation in gold becomes ever more frequent, the gentlemen in charge of running the world’s fiat money system get alarmed. The only way to pacify the market is to release more and more central bank gold. Physical gold. The beast must be fed. Paper gold will not do (although, of course, these gentlemen will keep trying to flood the market with it).

Releasing American gold to the futures market directly from the Fed is out of the question. It would confirm the suspicion, already rampant, that the dollar is a colossus of clay feet standing in knee-deep water. So let the client states of America do the releasing. The Germans have a reputation of favoring hard currency. They are reluctant to join the currencies’ ‘race to the bottom’. Germany is the natural choice to feed the gold futures markets in an effort to protect the dollar against the last assault that is shaping up.

For a long time America has been twisting the arm of other countries, including the U.K. and Switzerland, making them sell hundreds of tons of central bank gold, while America was not selling one ounce. “Do as I say, not as I do!” During all this time Germany was not selling either. The appearance was maintained that this decision was made in Germany. It wasn’t; rather, it has the mark “made in U.S.A.” German gold is the last defense of the dollar. By now practically all central banks ignore the siren song from America. From sellers they have become buyers of gold. According to the American master plan Germany is the last fort of the crumbling global fiat money system. Germany will not defect: that is the purpose of keeping American troops on German soil. Germany will dutifully do the job of feeding the futures market with gold in an effort to fend off permanent backwardation. The repatriation of a part of the German gold reserve is a trial balloon. If markets get scared and panic selling occurs before the Bundesbank starts selling, so much the better. But if false-carding fails and the world-wide march of gold into private hoards continues unabated, then let the Bundesbank, not the Fed, bleed gold. America’s gold must be spared at all hazards.

On such tricks and deception is the international monetary system grounded.


---


What, then, is the solution? How can sudden death in world trade be averted?

Fortunately, there are still upright politicians around. Godfrey Bloom of the European Parliament, MP for Yorkshire and North Lincolnshire ridings in the U.K. suggests that Germany should repatriate ALL of its gold and reinstate a golden deutsche mark.

The underlying cause of the world financial crisis is runaway debt. Gold is the only ultimate extinguisher of debt. Since its expulsion from the international monetary system total debt in the world can only grow, never contract. To stop the cancerous growth of debt gold must be reinstated in its former position as the guardian of the quality of debt.

If, defying American wishes, Germany took the initiative in creating a gold mark and opening the German Mint to gold where all comers could convert their gold ingots into gold coin, the course of world history would be changed. It would be Germany’s finest hour. Civilization will have been saved and the onset of a new Dark Age averted. The gold mark could circulate side-by-side with the irredeemable euro and dollar. Let the people decide whether they want to get paid in crisis-prone fiat currencies or, perhaps, they prefer the time-honored stability of the gold coin. It is hardly in doubt what the choice of the people would be.

The German initiative will set off a chain reaction of similar virtuous acts by the major central banks of the world, in order to prevent the fatal depreciation of their currencies against the gold mark. The latter will be well on its way to become the most coveted currency in the world for international trade. The financial system will be saved from the ordeal of competitive currency devaluations and from the corrosive effect of ever-expanding government deficits. Governments will be forced to face reality and live responsibly within their means like everyone else.

Farmers will no longer be paid for not farming, and able-bodied workers for not working. Youth unemployment, in particular, will be a thing of the past.

There is a precedent. In 1948 Germany defied the occupying force when it created the Deutsche Mark without bothering to ask for permission in Washington.

But is the gold standard not deflation-prone? In the 1930’s the international gold standard collapsed because of this very fact, did it not?

As the father of the Deutsche Mark, Wilhelm Röpke (1899-1966) said: it is not the gold standard that failed, but those in whose care it was entrusted.

---

*January 25, 2013.*

---

# The Silver Saga

URL: https://newaustrianeconomics.com/archive/fekete/the-silver-saga/
Date: 2012-11-24
Section: Popular Economics
Difficulty: intermediate
Concept Tags: silver, bimetallic, gold-standard, sound-money, monetary-policy
Description: Fekete traces the full history of silver's demonetization — from the Latin Monetary Union's abandonment of silver in the 1870s through the 20th century's progressive exclusion of silver from monetary systems. He argues this 'silver saga' is not merely historical but directly relevant to current monetary instability, as the removal of silver eliminated a crucial monetary stabilizer.
Editorial Note: Written November 2012. Fekete's most comprehensive historical treatment of silver demonetization, providing the background for his ongoing argument that bimetallism was superior to monometallism.
Original PDF: https://professorfekete.com/articles/AEFTheSilverSaga.pdf

*The Incredible Collapse Of Value Of Silver In The 19Th Century 
 Don’T Blame Comstock! 
*

**Antal E. Fekete**

An Address Delivered at the Conference Held at the University of Padova on November 30, 2012

“Coin Finds and Historical-Economic Processes in the Ancient World:

### Ten Years of Research 2002-2012”

The silver standard did not die a natural death. It was deliberately killed. A proper search for the assassins was never carried out. There was never a post-mortem. In this paper we focus on the conspiracy as it might have unfolded between the two dates: April 9, 1865 (the day General Lee of the Confederacy surrendered at Appomattox to General Grant of the Union marking the end of the War Between the States) and January 1, 1879 (Resumption Day, when payment of the victorious Union’s currency, the greenback was resumed in gold specie 
 but not in silver).

China has been on the silver standard since time immemorial. The Chinese did not use coins for monetary purposes such as bank reserves until the end of the 19th century; they used the sycee, a shoe-shaped ingot of approximate size 5⤫3⤫3 inches, weighing approximately 50 taels or about 5 pounds (avoirdupois). No one can pretend to know, however approximately, how much monetary silver has gone into hiding in China and in India, these two most populous countries also known as the world’s sink for silver, over the millennia. In comparison estimates of monetary gold having gone into hiding over the same period of time are far more reliable. Be that as it may, the amount of monetary silver unaccounted for is probably greater than any estimate ever made.

In the 19th century silver coins did most of the money-work in the world. The turnover of silver coinage (the value of silver coins times their velocity) was at an all-time high, eclipsing the turnover of gold coinage by far. Inept governments did not follow the lead of Isaac Newton, and they tried to enforce a rigid exchange rate between the two monetary metals (called the Mint ratio). This system was called bimetallism 
 a stillborn idea.

Bimetallism destabilized the natural monetary system based on silver and gold valued at a variable rate, as Newton’s monetary system in Britain did. Bimetallism was the disease, the demise of the silver standard was the unfortunate consequence. In the Western countries by 1879, in India by 1893, in China, the last stronghold of silver, by 1935, silver was demonetized. Between the two dates 1879 and 1935 the world witnessed a most spectacular event: the collapse of the value of silver by more than 80% in a little over half of a century.

Silver fell from \$1.29/oz in 1873 to 25¢/oz in 1935. Putting it differently, the gold/silver price ratio rose from 15:1 to more than 80:1. Never in history, ancient or modern, have markets put such fancy values on gold in terms of silver.

### Who killed the silver standard?

All this can be neatly explained in terms of the Quantity Theory of Money. The richest silver vein ever, called the Comstock Lode was discovered in Nevada in 1858. Surplus silver inundated the economy and lost most of its value due to the oversupply and the lack of matching demand.

But this explanation will not satisfy those of us who consider the Quantity Theory of Money as a mere mechanical metaphor. As a theory it is bound to fail because it is trying to give a linear explanation of highly non-linear phenomena. January 1, 1879, Resumption Day, when the payment of the greenback in gold (but not in silver) specie was resumed, coincided with the date when the Latin Monetary Union in Europe closed its last Mint to silver 
 marking the end of the silver standard in the Western countries. The coincidence is ominous.

No satisfactory explanation has been offered in the literature for the fact that the closing of the Mints to the free coinage of silver was the starting point of an unprecedented destruction of wealth world-wide, due to the relentless fall in the price of silver during the following 55 years. To make matters worse, it was destruction of liquid wealth. Not only did silver lose more than 80 percent of its purchasing power; it also ceased to be a monetary metal. As a consequence, silver became so much harder to sell. Worse still, the steadily falling price caused panic-mining of silver. Miners were anxious to sell before the price fell even more. As a result, almost all silver mines were mined out prematurely. Thereafter all silver output came as a byproduct of mining other minerals. These effects compounded and made the destruction of monetary values, that is deflation by another name, so much worse.

The collapse of the silver price was a major historical event affecting the entire globe and all trading nations of the world. It caused the impoverishment of the indigent classes in India, China, and elsewhere in Asia. But it also wiped out the credit-worthiness of the middle classes in Europe that lost their landed wealth as a consequence. Monetary historians failed to treat this aspect of the demise of the silver standard with the seriousness it deserved.

They also misdiagnosed the deflationary bias that the monetary system showed in the first half of the 20th century. The gold standard that arose on the ashes of the old monetary order in the wake of the destruction of the silver standard was less than satisfactory. Silver demonetization has made all hoarding demand fall upon gold. This imparted a deflationary bias to the international gold standard that enemies of sound money were able to exploit with all consummate skill.

Following a vicious campaign of anti-gold agitation gold was also demonetized by the governments exactly one hundred years later, in 1973. The demonetization of gold was no less unconstitutional than that of silver a hundred years earlier. It was also based on chicanery for good measure.

It should be noted that hoarding gold and silver is not an aberration. It is, in fact, part of the essential mechanism regulating the rate of interest. It will bar the banks from suppressing interest. When depositors realize what the banks are up to, they withdraw their deposits in the form of gold coin. The banks lose reserves and are forced to call in loans. It will also act as a deterrent against government profligacy. Ordinary citizens become disturbed by the government’s overspending and serial budget deficits. In response they show a preference for holding their liquid wealth in gold coins instead of short-term government paper. Such hoarding demand previously fell upon gold as well as silver. Now it was falling upon gold exclusively. The deflationary consequences are obvious.

One instinctively feels that there is no way self-destruction of liquid wealth of so great a magnitude could occur spontaneously in such a short space of time. The event could not be explained on the strength of causality. We must invoke teleology if we really want to understand it. Such an analysis was never carried out. Furthermore, speaking of destruction of wealth is not quite accurate. Value was not destroyed in the same sense of a house burning to the ground.

### Clandestine embezzlement

Rather, it looks like a clandestine embezzlement to benefit the world’s banking establishment at the expense of account holders. Their assets were manipulated downwards in value and ultimately taken over by the bank. The perpetrators were not worried that the disappearing liquid wealth would be missed and cause deflation. That was just the point of perpetrating it. They were confident that if they replaced the disappearing silver with bank credit based on debt, in particular, the debt of the government, then there would be no deflation. This strongly suggests government involvement. In all probability there was a conspiracy between an international banking cartel and some governments (e.g., the United States government acting either alone or in connivance with Imperial Germany).

Economic historians describe the Silver Saga as a natural evolution whereby gold monometallism gradually displaced bimetallism while strangling the silver standard.

According to this reading of history, the market gradually eliminated silver as money, as it has so many other challengers of gold’s supremacy in the race for monetary hegemony beforehand. It was destiny. No need for a post mortem, still less for a search for the assassin.

What would happen if every death due to natural causes was investigated as if it was due to violent causes? At any rate, they claim, the Quantity Theory of Money fully explains the market process eliminating silver from monetary circulation.

Upon closer examination the hypothesis that it was the market rather than collusion between governments and banks that killed the silver standard appears untenable. There were powerful pressure groups pushing for the closing of the Mint to silver. One such pressure group representing special interest was that of international banking houses  given their well-known penchant for monopolies. They avoided public debate. They acted behind the scenes. A monopoly of the gold standard would mean, for them, a better handle on money-creation through their control of the gold mines, as well as their control of public credit. If this hypothesis is correct, then we know what sealed the fate of the silver standard.

### Whodunit?

Prussia was victorious in the Franco-Prussian war of 1870-71. The German Empire was proclaimed at the Palace of Versailles on January 18; Paris fell to the invading German troops on January 28, 1871. Germany was anxious to join the gold standard club led by Britain. On November 23, 1871, Bismarck exacted a reparation of five thousand million gold francs (or one billion gold dollars, or 200 million pounds) from France payable in four years. Northern France was to remain under German occupation while the full amount was settled. Arguably this was the largest amount of gold ever changing hands directly, without involving promises to pay. One thousand million dollars in gold (at \$19.39/oz!) is an incredibly huge sum of money by any standard. In comparison, the Lousiana Purchase in 1803 was consummated for a total sum of \$15 million in gold. The Alaska Purchase in 1867 was consummated for \$7.2 million in gold. This makes the French indemnity to Germany equivalent to 66

Louisianas or 172 Alaskas.

The temptation for the Germans to increase the value of their gold booty by fair means or foul may have been irresistible. For example, it could be increased by demonetizing silver.

That would increase the demand for, and so also the purchasing power of gold.

France paid the indemnity ahead of schedule. The new gold standard of the German Empire was inaugurated on July 9, 1873, when the new gold coin, the gold mark made its debut. This was preceded by closing the German Mints to the coinage of the silver Taler in 1871, the first overt step towards demonetizing silver.

Some historians maintain that the demonetization of silver and the subsequent sale of melted coins by the German government on the world market was the direct cause of the precipitous fall of the value of silver. However, this is flatly contradicted by the fact that on February 12, 1873, the day when President Ulysses Grant signed the Coinage Act of 1873 into law, silver fetched a higher price in the market than the Mint price. No silver was flowing to the Mint. Records of the minting of the standard silver dollar show that there has been no demand for the monetization of silver on private account. This situation continued for some time afterwards. Silver mines continued selling their output on the free market. They seem to have been unaware that silver had been effectively demonetized by Germany in 1871 and by the United States in 1873. It made no difference to them: the market offered a better price.

The ultimate damage to the price of silver was not inflicted by German demonetization. Nor was it inflicted by demonetization in the United States. The market knew that demonetizations were coming and took them in stride. There was a ready market for silver in India and China, presumably for any amount, however large. American silver miners started to look at the U.S. Mint as a potential market for their production in 1875, as the price of silver in terms of the greenback was weakening. They were shocked to find that the Mint had been closed to silver years earlier.

### The anatomy of a murder

Here is the step-by-step chronology of the passage of the bill that was to become the Coinage Act of 1873. It eliminated the standard silver dollar by default, in failing to mention it. This removed the authority to mint any more. The removal was unconstitutional. Since that coin was the only silver coin that could be struck in unlimited amounts for private account, it also meant the demonetization of silver by the United States of America, following the example set by Germany.

(1)

In 1868 senator John Sherman of Ohio sponsored a bill that, among other things, proposed that the Mint be closed to the coinage of the Constitutional silver dollar, thus demonetizing silver in the United States. Although there was no opposition, the bill died in committee because the Senate was busy with other things, such as the greenback inflation struggle. Note the early date 1868!

(2) Secretary Treasury Boutwell sent the bill (that was to become the Coinage Act of 1873 omitting the standard silver dollar) to Congress on April 25, 1870 with his strong recommendation for passage.

(3) The Senate passed the bill on January 10, 1871 by a vote of 36 to 14. Among the ayes were the two senators from the silver state of Nevada. (At the time Nevada was the only silver state as it had been admitted to the Union in 1864. Colorado was the second admitted in 1876, followed by Montana, Idaho and Utah admitted between 1889 and 1896).

(4) The House passed the bill on May 27, 1872, by a vote of 110 to 13. Support among representatives from the silver state of Nevada was again overwhelming.

(5) President Grant signed the bill into law on February 12, 1873. It is important to note that all the details, including the entire text of the bill, were in the public domain as early as April, 1870.

25 years later, in 1895, Senator John Sherman, who was the sponsor of the bill in the Senate, in a famous speech of his entitled On the Crime of 1873 stated that, while the bill was pending in Congress for as long as three years,

“it was carefully considered in both houses and special attention was called to the omission of the standard silver dollar, and for the reasons for this omission… It is strange that the very men who supported and urged this coinage law of 1873 and demanded the exclusive coinage of gold are the very men who now [in 1895] demand the free coinage of silver…

Later in that speech Sherman related that his colleagues, Senators Jones and Stewart of the silver state of Nevada, were

“urgent and honest in saying that gold was the best and only standard of value“. However, they changed their minds when production from the Comstock Lode in Nevada [discovered in 1858] increased greatly, and the first signs of weaknesses in the silver price started to show after 1874.

Then they wanted a market for their silver. They wanted themselves and their friends to pay existing debts and obligations, that had been contracted on gold basis, in silver; but took care in their own contracts to stipulate that debts owed to them were payable in gold.” (The World’s Famous Orations: John Sherman, [bartleby.com](http://bartleby.com))

### Smoking gun

In 1873 neither silver nor gold coins circulated in the United States, although the Mint was open to both metals. The country was on the ‘greenback standard’: irredeemable paper money issued by the Union to finance its efforts in the War Between the States, which circulated at a discount of about 13 percent to silver. It was understood, however, that gold payments on the notes would be resumed (as indeed it happened on January 1, 1879) and the greenbacks would ultimately be withdrawn from circulation pursuant to the Resumption Act of 1875. The question whether resumption was to be extended to silver payments as well was bypassed in silence.

The prospect of resumption could be the smoking gun prompting the international banking houses to commit the crime. On April 9, 1865 (the day of Appomattox) an incredible opportunity to grab and usurp monetary powers presented itself. Obviously, resumption was coming, followed by a great increase in demand for gold and silver. This could be exploited most effectively for private gain if silver could somehow be eliminated as a monetary metal.

The thing to do for the banking houses was to initiate an arbitrage operation of selling silvermining shares against buying gold-mining shares in anticipation of the demonetization of silver.

Such an operation would take a number of years. By 1873, eight years later, following the German Empire, silver also had been demonetized in the United States through the back door, so to speak. Of course, speculators would start dumping silver in large quantities and selling it short, causing the price of silver to fall precipitously as early as 1868, when Senator Sherman spilled the beans in proposing the demonetization of silver. That never happened, making the whole affair very suspect. The evidence appears to suggest that, far from being ‘an honest mistake’, the omission of the standard silver dollar from the Coinage Act was a deliberate act to destroy individual property rights 
 possibly in collusion with Germany.

These two parvenu countries might have wanted to get the best mileage out of their respective victories in the battlefield. The indemnity of one thousand million dollars in gold exacted by Germany from France would be that much more valuable, in view of the falling commodity price level in terms of gold. On the other side of the water the banks could greatly enrich themselves by making the mortgages on land in the former Confederacy, assets that they now controlled and which had been denominated in silver, payable in gold.

The extra value would come out of the hide of the victims of the War Between the States.

The coincidence of interest of the two countries is telling. The would-be perpetrators of the crime had reasons to make speculators behave differently from the norm.

### Circumstantial evidence

The banking houses in the United States were apparently playing a duplicitous role. As observed above, there was a possibility for profitable arbitrage in the market for mining shares. The banks would bet against silver while getting ready to profit from a prolonged decline in the price of silver afterwards. It was not in their interest that the decline start immediately. They needed time, possibly years, to complete their arbitrage operations in mining shares. They wanted to get rid of their silver mining shares and replace them with gold mining shares. It is a plausible assumption, therefore, that the banks temporarily supported the price of silver (which they would have to do in the normal course of their business anyhow) but with the ulterior motive of preparing for the final assault on the silver price later. They succeeded in fooling the speculators not to place their bets against silver.

If the demonetization of silver was not the result of a long-term market process (as suggested by virtually all economists) then the question is: what was it the result of? This question has never been answered satisfactorily. My answer is that it was the result of the collusion of banks to manipulate the silver and gold market secretly, and carefully coordinating it with their manipulation of the market for mining shares.

### Leads and lags

To prove my theory I worked out a research program. It involved compiling the daily closing prices of eight series as follows:

(1) asked price of silver

(2) bid price of silver

(3) asked price of gold

(4) bid price of gold

(5) average asked price of silver mining shares

(6) average bid price of silver mining shares

(7) average asked price of gold mining shares

(8) average bid prices of gold mining shares in the United States for the ten-year period from 1868, the year when the idea of demonetizing silver first surfaced in Senator Sherman’s committee, to 1878, the year when the Latin Monetary Union decided that the silver price has been mortally wounded, was beyond hope of recovering, and closed its last Mint to silver.

From the eight price series above one can obtain four series of key price-spreads by taking differences as shown by tabulating them in the following table:

### PRICE-SPREAD SERIES series arbitraging

(4) minus (1) from gold to silver

(3) minus (2) from silver to gold

(8) minus (5) from gold-mining shares to silver-mining shares

(7) minus (6) from silver-mining shares to gold-mining shares Next, one calculates the standard deviation from the means for each of the four price-spread series. By well-known theorems of mathematical statistics the standard deviation filters out ‘noise’, that is, random causes of price variations, but catches singular irregular causes (e.g., discovery of a major gold or silver ore deposit or, most especially, concentrated efforts to manipulate prices).

One is looking for leads and lags. In particular, if arbitrage from silver-mining shares to gold mining-shares did lead arbitrage from silver to gold, and the latter did lag the former, then this would not be a random event. It would be conclusive proof that arbitrageurs were acting in unison to bring about a collapse of the silver price for maximum private gain.

When I wanted to carry out my research project, I found that it was beyond my meager resources. Rather naively I assumed that most of the work had already been done, some of the price series had been compiled and some of the standard deviations from the means calculated. The collapse of the silver price after 1875 was so spectacular, it was such a precipitous and momentous event, involving the international monetary system, the wealth and welfare of so many people, literally changing the course of history, that some researchers at least could have questioned the ‘conventional wisdom’. They could have rejected the market-process hypothesis. These researchers should have started looking for evidence of active connivance between governments and banks during the intervening 140 years. This, however, does not appear to be the case. Everybody without exception has accepted the pat explanation for the silver price collapse in terms of the Quantity Theory of Money. Yet it is possible that 1875 marks the year when the conspirators completed their program of arbitrage from silver mining shares to gold mining shares; and started their follow-up program of arbitrage from silver to gold. It is not impossible to find out the truth about it some 140 years later.

Researchers of today would have to start from scratch. This is a task I can no longer undertake, in view of my advanced age. But I would certainly encourage the younger generation to do it. I hope that my tentative research plan is going to be helpful to them. I have no doubt whatsoever that this would be a worthwhile project.

I call attention once more to what above I have called ‘circumstantial evidence’ of monetary mischief. In the absence of mischief the silver price ought to have started its descent much earlier, several years before 1875 
 possibly as early as 1868. Speculators (as distinct from bankers) must have been watching the political wrangle over silver starting in 1868. It appears that speculators missed their opportunity to sell silver short. This would be rather uncharacteristic of their trade, an assumption we can safely dismiss. A more plausible assumption is that the conspiring bankers met the speculators’ short selling head-on. They bought silver. As pointed out already, they needed time to complete their program of arbitrage in the mining-share market for monetary metals. Once it was completed, after they have sold their quota of silver mining shares and bought their quota of gold mining shares, they would be the first to dump their silver and let speculators do the rest. Of course, the duplicity of their conspiracy makes the detective work so much harder.

### Monetary mischief

There is no doubt that the U.S. Congress grossly exceeded its authority when it passed the Coinage Act of 1873. In signing it President Grant shared responsibility for making the unconstitutional bill the law of the land. The Act nowhere mentions the Constitutional standard silver dollar, the only coin cited by the Constitution 
 as if no such coin has ever existed. Consequently the interpretation arose that there was no authority for coining it by anyone after the Act became law.

The contrast with the logical interpretation of the Constitution is striking. According to the Constitution the standard silver dollar can be minted in unlimited quantities for the account of anyone tendering the silver to the Mint. Not only is the standard silver dollar to serve as a yardstick but, even more importantly, it is there to test the material, silver, out of which the yardstick is made. If you eliminate it or obstruct its availability, then the standard silver dollar obviously cannot discharge that function. It makes no sense to tie the access to it to permission from Congress, from the President, from the Secretary of the Treasury, or anyone else. In legal matters the Constitution takes precedence until amended. This is a clear case of usurpation of powers. The standard silver dollar had to go because the public was to be deprived of a means to test the monetary quality of silver.

The Constitution guarantees the right of the individual to take silver to the Mint in unlimited quantities. Only in this way can we be certain that silver is sufficiently inelastic to serve as the yardstick of value. If the flow of silver to the Mint was orderly, then the yardstick would be satisfactory. But if the Mint were inundated with silver and could not be kept open for that reason, it would be proof that silver was no longer suitable to serve as material out of which the monetary yardstick could be made. It would show that silver had a rubber-like quality: it was much too elastic. It would show that silver has failed the test. It hasn’t got the quality every monetary metal must have: the quality of having constant value.

As a matter of historical record silver has never been put to the test. There has never been a run on the Mint by owners of silver bullion wanting to turn their metal into silver coin before it was too late. In every instance the run on the Mint occurred, it was not because people feared that the price of silver would collapse. It was because inane government policies made silver-to-gold arbitrage risk-free. People bought silver abroad in exchange for melted U.S. gold coins. They wanted to get more gold coins at the U.S. Mint for their silver 
 as was their right to do under bimetallism. Then they wanted to export the gold coin, since it was worth more abroad, and they wanted to continue this arbitrage indefinitely for the risk-free gain it afforded them.

When the Mint was closed to silver, it was a protective measure taken by the government in trying to prevent further losses to its gold reserve. It was not a failure of silver. It was a failure of bimetallism. The solution was not the demonetization of silver: it should have been the abolition of bimetallism.

### Conclusion

I have never been a conspiracy theorist. I never joined latter-day crowds crying “stop the manipulation of the silver and gold price by unlimited short sales!” I know full well that the present low price of silver is a remnant of the tragic outcome of the Silver Saga that started some 145 years ago at Appomattox. The prospect of Resumption of specie payments after the War Between the States created an incredible opportunity for monetary mischief. The circumstantial evidence is that the opportunity was fully exploited by an international banking cartel to sabotage the international monetary system. This observation does not make me a conspiracy theorist. I am offering a detailed plan to find out, some 145 years after the event, using the method of standard deviations from the means borrowed from mathematical statistics. We owe it to ourselves to do the necessary research. The world economy, sagging as it is under the weight of its debt tower and fast depreciating irredeemable currencies, is clearly on its way to self-destruction. The forcible elimination of, first, silver and then a hundred years later of gold, from the monetary system removed the only ultimate extinguishers of debt we have. In consequence, total debt can only grow, never contract. The process is hidden since the unpaid and unpayable debt is accumulating as sovereign debt of governments. The world is deluding itself that sovereign debt can increase indefinitely as governments can extend its maturity indefinitely. In 2008 we had the wake-up call that it cannot. Unless we stop the proliferation of debt, the world is facing prolonged deflation, depression, continuing capital destruction, bankruptcies and unprecedented unemployment. It is leading to a breakdown of law and order. It could spell the end of our civilization.

*Note. A fuller version of this address is posted on my website [www.professorfekete.com](https://www.professorfekete.com) under “Scholarly Economics”.*

---

# The Gold Problem Revisited (2)

URL: https://newaustrianeconomics.com/archive/fekete/the-gold-problem-revisited-2/
Date: 2012-06-06
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, gold-basis, sound-money, real-bills, new-austrian-economics
Description: An extended second treatment of the gold problem, addressing additional dimensions not covered in the March essay. Fekete examines the historical gold shortage arguments in detail, using specific data to show that gold supply was always adequate under genuine gold standards and that perceived shortages reflected institutional failures rather than physical scarcity.
Editorial Note: Written June 2012, the second of two gold problem essays. Together the two pieces constitute Fekete's definitive answer to the gold shortage objection.
Original PDF: https://professorfekete.com/articles/AEFTheGoldProblemRevisited2.pdf

1. The futility of inflationary policies Mises ignores the fact that newly created money can be spent not only on goods and services, but also on financial assets. Price rises in the wake of credit expansion are not inevitable. This is the proverbial fly in the ointment of the inflationary argument. It is also a subtle one, so much so that the government as the would-be perpetrator of inflation often falls victim to it. It may think that it is promoting inflation while, in fact, it acts as the quartermaster for deflation.

By restricting the circulation of gold money or by other means, the government can make financial speculation more attractive. In doing so it wants to reduce the amount of money available for buying goods and services. This strategy of the government and its pseudo-economists consists precisely in channeling enough of the newly created money into speculative ventures so that the untoward consequences of price and wage rises will not occur, or they will occur much later, thus obscuring the causality relation.

The paramount example is bond speculation. Of course, under the gold standard there is no bond speculation because the variation in the bond price (or, equivalently, in the rate of interest) is minuscule making the opportunity to earn speculative profits negligible.

This is no longer true if risk-free profits are made available as a bait to speculators through inappropriate monetary and fiscal measures.


This article is in response to Dr. Joseph Salerno’s remarks made in the interview with Anthony Wile of the Daily Bell, July 3, 2011. The article The Gold Problem by Mises is appended below.

This is exactly what happened in the early 1920’s when the policy of open market operations, so called, was first introduced quite illegally, we might add. (The policy of open market operations was retroactively legalized in 1935 through an amendment, see the

### Federal Reserve Act of 1913, Article 14B, as amended.)

As the Fed was originally constituted, it was only enabled to be a passive player.

Limited by its charter, it could enter (or decline to enter) business initiated by others.

Significantly, it could not initiate business on its own. It could post its rediscount rate, but member banks had to step forward with their request to rediscount real bills from portfolio.

In and of itself rediscounting was not inflationary as a way to create new money. The new purchasing power so created was backed, dollar for dollar, by salable merchandise arising in production, and it was to be extinguished when the merchandise was sold to the ultimate consumer before the bill matured.

This was not the case, however, when the Fed assumed an active role and started purchasing (and selling) government bonds in the open market at its own initiative in contravention of the original Federal Reserve Act of 1913. The monetary base is enlarged through the purchase of government bonds, providing member banks with an incentive to make loans regardless whether or not new merchandise is simultaneously emerging in production. Making this distinction is important. New money derived from these loans embarks upon a search for prices that can be bid up.

Using standard Quantitative Theory of Money (QTM) reasoning the Fed (and everybody else) assumed that the effect of open market purchases of government bonds was to be inflationary. Hooray, a subtle and potent new way of augmenting the money supply has been invented! The economy can now be micro-managed and fine-tuned through the intervention of the Fed, as the need may arise! There was great jubilation in the inflationist camp.

The jubilation was premature. The policy of open market operations as an instrument of inflation was an enormous blunder. It ignored bond speculation as a market force that had been dormant, but was at once woken up from its slumbers by the intervention of the Fed. QTM became inoperative: bond speculators easily overrode it. They knew exactly when the Fed had to go to the open market “to relieve nature’s urge” in passing new money (read: to purchase its next quota of government bonds). Speculators could make risk-free profits by pre-empting the Fed in buying the bonds first. The Fed had no choice: it had to buy the bonds from speculators at an enhanced price. The Fed thought it was in the driver’s seat. It was not. The “invisible hand” of the speculators was on the steering wheel, driving bond prices up or, what is the same to say, driving the rate of interest down.

The ‘tool’ of open market operation as a spur of inflation backfired badly, if only for the reason that speculators were a much smarter lot than central bank agents confronting them in the bond pit. They were risking their own capital while losses made by central bank agents were covered from public funds. The game plan was upset unbeknown to the planners themselves. What was supposed to be inflation ended up as deflation. Here are the details.

In an unhampered market risk-free profits that may occur from time-to-time are ephemeral and therefore inconsequential. Hawk-eyed speculators immediately take advantage of them with the result that any further opportunity to make risk-free profits is eliminated on the spot. This is no longer true if the opportunity to make risk-free profits is not an infrequent aberration but the consequence of a deliberate and well-advertised official policy as it is in the case of the Fed’s open market operations.

If the Fed relies on open market purchases of government bonds in augmenting the monetary base on a regular, on-going basis, then speculators will anticipate it and act upon it. They will pre-empt the Fed. The result is the formation of an uptrend in bond prices or, what is the same to say, a falling interest-rate structure.

This policy, whole-heartedly supported by Keynesian/Friedmanite economics, is the most ill-conceived monetary policy ever concocted for the purpose of increasing the stock of money. Ostensibly it is inflationary, but in actual fact it is profoundly deflationary. It is responsible for putting the worm into the apple: it lends a decreasing bias to the interestrate structure. The Fed may like that bias; the trouble is that the Fed thinks it can control it.

In fact, it is controlled by the herd of bond speculators acting in unison.

The original Federal Reserve Act of 1913, for precisely these reasons, disallowed such a policy and imposed stiff and progressive penalties for non-compliance, whenever the balance sheet of a Federal Reserve bank showed that government bonds had been used to cover Federal Reserve note or deposit liabilities. At first the Fed used open market operations illegally in connivance with the U.S. Treasury that ‘has forgotten’ to collect the penalty. The conspiracy of the Fed and the Treasury created a fait accompli for Congress. It had to legalize the illegal practice retroactively in 1935.

The newly invented monetary policy of open market operations is responsible for much of the deflationary damage inflicted on the world economy during the Great Depression of the 1930’s. It started an avalanche of falling interest rates that soon went out of control. Falling interest rates destroy capital as they increase the burden of debt contracted earlier at higher rates. Perfectly sound businesses fail if their debt burden, through no fault of theirs, exceeds the profitability of deployed capital. From this point of view it does not matter whether the capital has come from borrowings, or whether it has been generated internally. Deployed capital is subject to erosion, in extremis to destruction, in response to a falling interest-rate structure.

The process of wiping out operational profits wholesale through escalating bond prices is most insidious. Entrepreneurs do not know what has hit them. From one day to the next they find themselves uncompetitive. Their competitors finance their business at lower rates. Their capital is in a shambles. They are forced to lay off employees. They go bankrupt in droves. Their competitors are no better off as they are the next victim. This type of wanton destruction of capital by the Fed was the main cause of deflation and the Great Depression in the 1930’s.

Herein lies the incredible story of the failure of the policy of open market operations, missed by Mises and all other observers. The policy is counter-productive even from the point of view of the central bank and pseudo-economists acting as its cheer-leaders. It released the genie of risk-free bond speculation from the bottle believing that the genie could be brow-beaten back into the bottle. It couldn’t. Falling interest rates would run their devastating course.

The same story repeats itself today. Interest rates have been falling for over thirty years. Whatever it may say, the Fed is no longer in control. It is lunacy to believe that the avalanche started with dropping a single snowball in the early 1980’s can now be stopped dead in its track. Today the speculators are the only buyers left as China and other exporters to the US are bailing out of the US T-bond market. They will keep buying the bonds as long as they can reap risk-free profits. It is true that ‘quantitative easing’ cuts into that business, as the Fed is buying bonds directly from the Treasury, bypassing the open market (another illegal practice). How long can speculators be induced to bite the bait and buy the bonds?

Watch for the day when they will start selling bonds short. When they transfer their buying from the bond market to the commodity market, the game is up.

The policy of open market operations is a charade. When the producers and the savers are squeezed dry, it’s “après nous le deluge”. Ben Bernanke is the Quartermaster General of Great Depression II.

2. The futility of the policy of suppressing interest rates.

The rate of interest is a market phenomenon just like prices. In fact, the definition of the rate of interest must refer to the bond price: it is the rate at which the payment stream of interest will, upon maturity, amortize the bond’s price as quoted in the secondary market.

The floor for the range in which the interest rate may move is determined by marginal time preference. (The ceiling, on the other hand, is determined by the marginal productivity of capital; we are not concerned with that concept in this article.) To understand this we must consider the arbitrage of the marginal bondholder between the bond market and the gold market. If the rate of interest falls below the rate of marginal time preference, then the marginal bondholder sells his overpriced bond and keeps the proceeds in gold coins. In this way he can force the bond price to come back to earth from outer space. Bank reserves are shrinking and the banks have to call in some of their credits and sell bonds from portfolio. By contrast, when the yield rises above the rate of marginal time preference, the marginal bondholder will repurchase his bond at a lower price. Time preference has no meaning outside of this context. It would remain just a pious wish unless the marginal bondholder lends it teeth.

Mises (and before him Ricardo, who advocated the elimination of gold coins from circulation) was wrong when he stated that there was no difference between the gold coin and a promise to pay gold coin as long as the security and maturity of the promise cannot be doubted. The promise can perform all the monetary functions that the gold coin does. Well, it cannot, because there is one very important exception. When the marginal bondholder in protest against low interest rates sells his bond (a future good), he insists on getting gold (a present good). He will not take a promise to pay gold, because it is still a future good, and an inferior one to boot, as it pays no interest. Taking it would mean jumping from the frying pan into the fire. This shows that gold hoarding, far from being a deus ex machina, and far from being a curse of the gold standard, is an important market signal. It indicates that the rate of interest has been pushed below the rate of marginal time preference. The signal had better be heeded before it is too late. Gold hoarding cannot be understood except in the context of its counterpart, gold dishoarding. When the signal is heeded and the banks tighten up their loose credit policies, and the government reins in its expenditures, gold will be dishoarded, and the marginal bondholder will replace gold in his portfolio by repurchasing the bond.

Bond/gold arbitrage is profitable in the service of regulating the rate of interest.

The reason for eliminating gold coin circulation first in Europe in 1914, and then in the United States in the 1930’s, was the determination of governments to make sure that they were in full control of the rate of interest, free of interference from the marginal bondholder. This policy was shipwrecked on the reef of gold (as it was still being hoarded after the closing of the Mint to gold).

All economists, including Mises himself, ignored the importance of gold hoarding and dishoarding as manifested by the arbitrage by the marginal bondholder, which explains the all-important contact between gold and interest first observed by John Fullarton in 1844 (see his book: On the Regulation of Currencies.)

3. The futility of the policy of boosting wages.

Mises did not subscribe to Adam Smith’s Real Bills Doctrine (RBD). Although he acknowledged the fact that real bills drawn on consumer goods in most urgent demand had circulated as a kind of ephemeral money through endorsing, as they did in Lancashire before the Bank of England opened its branch in Manchester, he did not find this matter worthy of further attention. He coined the word “circulation credit” that financed the movement of commodities from the producer to the consumer through the various phases of production, but he blotted out the important distinction between the discount rate and the rate of interest. He never used the term “self-liquidating credit” that would have revealed why circulation credit did indeed circulate spontaneously and without any coercion from the government even in the hypothetical world without banks! It did circulate because the credit was liquidated through the release of the gold coin by the ultimate consumer in purchasing the merchandise on which the bill was constructed in 91 days or less. The banks’ role is subordinate.

Mises was unimpressed by the fact that bonds and mortgages could not circulate in the same way as bills. He set great store by the QTM. Yet he might have been disturbed by the fact that real bills, however temporarily, could serve either as money substitutes or as bank reserves on which sound money could be built. His negative attitude with regard to Adam Smith’s RBD is regrettable. Real bills are the next best thing to gold into which they mature in 91 days or less.

Demand for real bills is virtually unlimited. Not only will banks with surplus gold in their till scramble for them as the best earning asset they can have; individuals and institutions with large payments coming up (such as the cash purchase of a home, a factory, or the retirement of a bond issue) that have a need to assemble cash to meet the liability due shortly will also bid for them. They will not put their accumulating funds into stocks, bonds, or mortgages for reasons of insufficient liquidity. Any increase in offering will immediately depress their price. The liquidity of real bills as an earning asset is second to none. They are the preferred medium in which to assemble cash when the need arises.

But the greatest significance of real bills has to do with the labor market as they augment the demand for labor. The only author who recognized this fact was the German economist Heinrich Rittershausen (1898-1984), see his book Arbeitslosigkeit und Kapitalbildung, Jena, 1930.

A large part of outstanding real bills in circulation represented the wage fund of society. Out of this fund wages for labor producing merchandise that would not be available for sale for up to 91 days could be paid here and now. Thus real bills represented a real extension of demand for labor. Employers would simply go ahead and hire all the hands needed to produce merchandise in high consumer demand, without worrying who will advance the funds to pay wages before the merchandise could be sold. They assumed that the wage fund would always be there. The RBD explains why there was no ‘structural unemployment’ in the 19th century, in contrast with the 20th, before the wage fund was destroyed by the victorious Entente powers, never to be rebuilt. 19 th century entrepreneurs did not have to assume the burden of financing the payment of wages. The bill market took care of that. Say’s Law was fully operational: there were employment opportunities as long as prospective employees wanted to eat, get clad, shod, and keep themselves warm in winter.

The point was driven home most forcefully when the wage fund was inadvertently destroyed. The victorious Entente Powers decided not to allow the rehabilitation of the bill market after the cessation of hostilities in 1918. This single decision sealed the fate of tens of millions of workers who were to be laid off in the 1930’s for lack of financing the wage bill. It was also the reason for creating the corrosive ‘welfare’ state that paid workers for not working and farmers for not farming. It also caused the demise of the gold standard by removing a vital organ, its clearing house: the bill market. Here are the details.

The victorious Entente Powers were afraid of German competition in the postwar world. They wanted to monitor, if not control, Germany’s exports and imports. As this would not be possible under the system of multilateral trade, that is, trade financed by real-bill circulation, they opted for a system of bilateral trade. Never mind that this meant a setback for their own producers and consumers as well. Never mind that much more gold was needed to run a system of bilateral trade than what would be required by a system of multilateral trade extra gold they did not have. Never mind that this would make the 1925 return of Britain to the gold standard deflationary which guaranteed its failure. The neurotic fear of German competition took precedence over all other concerns. In fact, these concerns were never examined and the decision was made in high secrecy. Incidentally, this decision made Say’s Law inoperative. It was no longer true that employing labor ipso facto created demand for its own products. Real bill circulation is an absolute precondition for that.

This was the end of real-bill financed world trade, the great success story of the 19 th century. The bill market was destroyed. We still suffer the consequences. In effect, world trade has been reduced to barter between countries. Worst of all, along with the destruction of the bill market society’s wage fund was also destroyed. There was no one around to advance wages payable to laborers whose products could not be sold for cash up to 91 days while going through the phases of production and distribution. Vast sections of the world’s productive plants were condemned to idleness for reasons of a disappearing wage fund. As I have mentioned, the only economist in the world who saw what was coming was Rittershausen. Economists still owe him recognition for his great insight. The world is still condemning the gold standard as the major cause of the Great Depression of the 1930’s and the horrible unemployment in its wake, when the real cause was the destruction of the wage fund, a misguided unilateral decision of the victors in World War I made under the veil of secrecy a veil that has never been lifted.

It is most unfortunate for economic science that Mises failed to give support to Rittershausen’s charges. Not only were governments guilty of putting improper and counterproductive measures into effect to boost wage rates thus fostering unemployment as explained in the article of Mises. More importantly, they were directly responsible for the world-wide leap-tide of unemployment through the destruction of the bill market and its wage fund.

Once again the world is facing the same dangers as it did four score of years ago. Yet one can see only complacent governments in a self-congratulating mood over their ‘success’ in ‘fending off’ the Great Financial Crisis. But the writing is on the wall: if governments fail to rehabilitate the gold standard and its clearing house, the bill market, thus restoring the wage fund, then a much more devastating leap-tide of unemployment will soon engulf the world. 4. The futility of the policy of gold valorization.

The world has been witnessing the pathetic attempts of governments and central banks “to keep the gold price in check” since the 1971 fraudulent default of the US government on its international gold obligations. To be sure, a default is always followed by a depreciation of the dishonored paper, so the ultimate futility of the policy of gold valorization has always been a foregone conclusion. But what we have is far more than this self-defeating effort to keep gold out forever from the monetary system. What we have is a veritable brain-washing of the whole world about the role of gold in the economy, and blaming gold for results that only keeping gold in the system could have prevented.

It is alleged that gold has disqualified itself from playing the role as the monetary anchor and source of credit in the economy. “Gold has become far too volatile for that”. This is puerile because it ignores the fact that the so-called volatility of gold is just the mirror image of the volatility of the irredeemable dollar in which the price of gold is quoted.

It is also ignored that the debt crisis is a direct consequence of exiling gold from the monetary system. Gold is the only ultimate extinguisher of debt. It cannot be replaced by the dollar or any other irredeemable currency. Under the dollar system debt simply cannot be extinguished. Total debt can only grow, never shrink. All the bad debt and “toxic sludge” stays in the system and is merely kicked upstairs into the balance sheet of the US Treasury which is what actually takes place. There it remains, representing a great threat to the world economy and its stability. Like radioactive material, when its quantity exceeds critical mass, a chain-reaction starts triggering nuclear explosion. The world needs gold in order to prevent the nuclear explosion of debt.

Central banks have been falling over themselves to sell gold from the asset column of their balance sheets, replacing it with ‘earning’ and ‘appreciating’ assets such as US Treasury bonds. The foolishness of this becomes clear when we contemplate that the so-called ‘earning’ is more than wiped out by the faster depreciation of the US dollar, and the socalled ‘appreciation’ of the US Treasury bonds (due to the falling interest-rate structure) inexorably turns into depreciation as the bonds approach maturity. The upshot is that the balance sheets of central banks are hit twice: first, the value of their bond portfolio and dollar earnings is decimated by monetary depreciation (commonly referred to as ‘inflation’); second, there is an additional capital loss due to the disappearance of the premium on the face value of the bond (reflecting the falling interest rate structure) at maturity.

It goes without saying that pari passu with capital losses suffered by central banks on their assets, their note issue is subject to further depreciation due to the inflation of the money supply in excess of production of goods and services.

Through a system of bribes, blackmail and intimidation research on questions relating to gold money has been discouraged by the Research Departments of the twelve Federal Reserve banks to the point that it is now practically non-existent. The situation is not significantly better outside of the U.S. The world continues to live in a fool’s paradise. It believes the size of government debt does not matter because it can always be rolled over. “One pocket owes it to another”. Nor would, according to these doctrines, inflation or deflation be caused. Competent and honorable gentlemen at the helm can safely navigate our monetary ship through the strait of the Scylla of hyper-inflation and the Charybdis of deflation. They have a powerful tool at their disposal: the printing press, and with its judicious application they can fine-tune the quantity of money in circulation as well as they can micro-manage the rate of interest for the benefit of all.

However, the elimination of research on the monetary role of gold is striking back.

These ‘competent’ and ‘honorable’ gentlemen at the helm are perfect ignoramuses when it comes to gold basis, that is, the difference between the nearest future and the spot price of gold. They have no notion of the continuous and inexorable erosion of the gold basis for the past 40 years from its top reading in 1972 all the way to zero now. Worse still is the fact that they don’t understand the significance of the irresistible march of the gold futures markets into the death valley of permanent backwardation.

When the basis goes irreversibly negative and permanent backwardation sets in, gold is not available at any price. At that point the U.S. Treasury bonds cease to be redeemable in gold at any rate of exchange. This may not bother the Keynesian and Friedmanite botchers at the Fed and the Treasury unduly, but it will certainly upset all those who accept them as collateral for the currency, among others, all the producers of real goods and services. Their refusal to accept irredeemable promises in payment for real goods and real services will trigger an irresistible slide into barter as far as essential commodities are concerned. The world is insidiously slipping back into direct exchange for want of money acceptable in indirect exchange. However, you cannot feed the world’s present population on the basis of a barter economy. Poverty, pestilence, famine threatens society, not to mention the breakdown of law and order. All this, and more, because government leaders have suppressed not only monetary gold itself, but also any meaningful research on its role in the global economy.

Permanent gold backwardation, if nothing else will, must finally bring about a sovereign debt crisis in America as it metastasizes across the Atlantic. It will herald the arrival of the moment of truth. It will reveal without the shadow of a doubt that the U.S.

Treasury bond is irredeemable; that it promises to pay nothing but more of itself; that the Fed backing Federal Reserve notes with Treasury paper while the Treasury paper is payable in Federal Reserve notes is just a legalized check-kiting scheme. The dollar would have gone the way of the Assignat and the Reichsmark a long time ago but for the fact that it could still be exchanged for gold (however little). To most people this fact suggests that the dollar will always command some gold (albeit a variable amount). These people are ignorant of the vanishing of the gold basis that is about to turn negative for the first time in all history.

Ben Bernanke, the Chairman of the Federal Reserve Board in his testimony at a Congressional hearing introduced a new phrase into the economic vocabulary on July 11, 2011. The new phrase is: “tail risk”. He defined it as “really, really bad outcomes” in the economy, as if they were completely outside of human control just as floods, earthquakes, volcanic eruptions, tsunamis are.

In reality ‘tail risk’ is nothing but a bunch of wholly unnecessary risks that Bernanke & Co. take with human lives. This is a gang of parasitic, corrupt, contemptuous, conceited, and yes, ignorant policy makers guiding the destinies of the U.S. and the world at the helm of the Fed and the U.S. Treasury, imitated by sycophants in comparable positions in other countries. They hijacked the Constitution, turning its monetary clauses, which unequivocally define money in terms of silver and gold, upside down. They usurp the power the Constitution has reserved for the people themselves, namely, the power to create money by delivering silver and gold to the Mint for coining. They are now preparing to finish the hatchet-job. They are only interested in saving their own hide and that of their accomplices inhabiting the executive suites of multinational banks; in their own self-aggrandizement; in perpetuating their power; and in spreading their superstitious faith in irredeemable currency a monetary system that has failed ignominiously every time foolish leaders in history have experimented with it.

Mises was a great warrior fighting these usurpers and monetary hijackers with the sharpest weapon there is: human reason. We must follow his lead, even if sometimes it means that we have to introduce new ideas that go beyond Mises’ published opus.

The day of reckoning for monetary insanity is on hand. The Constitution is there for the protection of all. If we fail to reclaim and uphold it, if we meekly succumb to the monetary hijackers’, blackmailers’ and usurpers’ demands, then we shall have only ourselves to blame for the consequences.

March 20, 2012 (revised June 1, 2012). —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  — -

## Announcement

### New Austrian School of Economics

### Munich, Germany

### From September 3 - 9, 2012

Title of the course:

## Critique Of Mainstream Austrian Economics

Marginalism; Marketability; The Real Bills Doctrine vs. the Quantity Theory of Money; Interest versus Discount; The True Role of the Gold Standard

### Part One: Marginalism

### Part Two: The Theory of Value

1. Marginal utility and unit price

2. Marginal productivity of capital

3. Marginal productivity of labor

4. Marginal productivity of debt

5. The marginal object and the marginal subject

6. From price to spread: arbitrage

7. Menger’s concept of marketability

8. Can value be measured?

9. Is constant marginal utility of gold contradictory?

10. Is paper money a present good or a future good?

11. The Gold Standard (unadulterated and

### Rothbard’s so-called 100 percent gold standard)

12. Menger and the Quantity Theory of Money

13. The wisdom of Adam Smith

14. Spontaneity of real bill circulation

### Part Three: Interest versus Discount

15. Where gold certificates cannot deputize for gold coins

16. Market process and the determination of the rate of interest

17. The meaning of zero interest and zero discount

18. Gold and Interest

19. Marginal time preference and marginal productivity of capital

20. The discount rate and the marginal productivity of social circulating capital

This course is a seven-day, twenty-lecture session. Its topics are not recycled but new material. Its completion will earn one credit of the four needed towards a Bachelor of Monetary Science (BMSc) degree handed out by Prof. Fekete.

It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. Previous courses are not a prerequisite.

For further information or in order to register for the course you can get in contact with the organizers Ludwig Karl and Wilhelm Rabenstein via mail ( nasoe@kt-solutions.de ) or phone ( +49 – 170 – 380 39 48 , before calling please consider a possible time lag).

You might also want to take a look at the New Austrian School of Economics on Facebook: [www.facebook.com](https://www.facebook.com/newasoe) and [www.facebook.com](https://www.facebook.com/events/191504464305951/)

## The Gold Problem*

### Ludwig von Mises

Why have a monetary system based on gold? Because, as conditions are today and for the foreseeable future, the gold standard alone can make the determination of money’s purchasing power independent of the ambitions and machinations of governments, of dictators, of political parties, and of pressure groups. The eminence and usefulness of the gold standard consists in the fact that it makes increases in the supply of money depend on the profitability of mining gold, thus preventing large-scale inflationary ventures on the part of governments.

The gold standard did not fail. Governments deliberately sabotaged it, and still go on sabotaging it. Governments believe that it is the gold standard’s fault that their inflationary schemes not only fail to produce the expected benefits, but unavoidably bring about conditions that are considered as much worse than the alleged or real evils that they were intended to eliminate. The gold standard, pseudo-economists tell the government, is the stumbling block frustrating its policy to make everybody happy and prosperous. Let us examine the futility of some of the pet policies of governments.

1. The futility of inflationary policies

The government increases the quantity of money in circulation. Then a greater amount of money ‘chases’ the same amount of goods and services. The government merely made prices of goods and services soar. If the government wants to raise the income of some people, say that of government employees, then it has to confiscate by taxation part of some other people’s income and redistribute it to the favored groups. Then taxpayers are forced to restrict their spending while the recipients of higher salaries can increase theirs. In this arrangement there is no change in the purchasing power of the monetary unit.

But if the government provides the money for the payment of higher salaries to the favored group by simply printing it, then the new money in the hands of these beneficiaries constitutes additional demand for goods and services. The unavoidable result is a tendency of prices to rise. Taxpayers can find shelter against capricious inflationary adventures of the government at their expense in gold ownership.

2. The futility of the policy of suppressing the rate of interest Interest is the difference in the valuation of present and future goods. It is the discount in the valuation of future goods as against that of present goods. Interest cannot be ‘abolished’ as long as people prefer an apple available today to an apple available only in a year or in ten years. It is therefore obvious that the height of the market rate of interest does not depend on the whims, fancies and the pecuniary interests of the personnel operating the government apparatus of coercion and compulsion. But the government can push the Fed and the banks subject to it to pursue a policy of ‘easy money’. Underbidding the rate of interest as established in the market, they offer additional credit created out of nothing. Businessmen are


This article was originally published in The Freeman magazine in June, 1965. It was reprinted in the volume Planning for Freedom by Ludwig von Mises, 4th edition, South Holland, Illinois, 1980, p 185-194. The present version is abridged and edited. misled. The intervention of the banks creates the impression of a more generous supply of capital goods. Projects are undertaken which a sober calculation would label as malinvestment. Boom is created that cannot be sustained for lack of a sufficient quantity of capital goods (that can only be created by additional savings). When the malinvestment becomes visible, the boom leads to debacle and misery. Gold is blamed as the bearer of bad news, and is dealt with accordingly.

3. The futility of the policy of boosting wages

The height of wage rates is determined by the consumers’ appraisal of the value of the worker’s labor added to the value of merchandise in the process of production. If an entrepreneur tried to pay a hired hand less than the amount deemed right by the consumers, then this man will be hired away by competing entrepreneurs. On the other hand no entrepreneur can pay more than that amount because consumers in buying the product will not compensate him for the resulting losses. He then will be ejected from the ranks of businessmen.

Governments believe that they can overrule the verdict of the consumers. They establish minimum wages. They grant legal immunity to unions committing violence against people (yellow scabs: the strike-breakers) and property (plant and equipment) in pursuit of higher wages. But governments and unions are helpless against economic law. Violence can prevent the employer from hiring help at potential market rates, but they cannot force him to employ all those who are anxious to get jobs. The result is unemployment.

The only valid way to provide higher wages, and jobs for all those who are eager to earn them, is to increase the per capita quota of capital invested in production facilities. This result can only be brought about by additional savings and capital accumulation never by government decrees, union violence, intimidation, inflation. Once again, gold is blamed as the bearer of bad news, and is dealt with accordingly.

4. The futility of the policy of gold valorization

The way gold delivers bad news is through going into hiding under the gold standard or, in case the gold standard has been overthrown, through an increase in the gold price. The government reacts by trying to cap the appreciation in the value of gold by hook or crook.

This government activity is known as the “policy of gold valorization”: assigning a lower value to gold than the market does, according to the preconceptions of government bureaucrats.

In history there have been innumerable experiments on the part of governments to valorize various goods in various places at various times, but none proved to be a greater failure or embarrassment than the attempt to valorize gold. Banning ownership and trade in gold has been a favorite method tried by the government of France under John Law’s system and, later, during the French Revolution not to mention other attempts in other countries, sometimes even invoking the death penalty. These measures explicitly deny the individual’s right to seek protection for himself and for his family, including young children, against famine or financial ruin caused by capricious and misguided government policies such as price and foreign exchange controls.

There is only one method available to avoid confrontation between the government and its citizens over the gold problem, namely, radical abandonment of the policy of deficit spending, the system of minimum wages, and the policy of easy money.

If you have enjoyed reading this material, you might be interested in reading my submission to the Wolfson Economics Prize 2012 Contest under the title: How to Ensure the Stability of the New European Currencies? that can be found on my website: [www.professorfekete.com](https://www.professorfekete.com)

The entire session of the New Austrian School of Economics in Munich Bavaria, Germany, from September 3 to 9, 2012, will be devoted to the theme: Critique of Mainstream Austrian Economics. For further information, contact: nasoe@kt-solutions.de

---

# There Is No Business Like Bond Business. Still.

URL: https://newaustrianeconomics.com/archive/fekete/there-is-no-business-like-bond-business-still/
Date: 2012-05-14
Section: Popular Economics
Difficulty: intermediate
Concept Tags: bond-market, federal-reserve, monetary-policy, capital-destruction, interest-theory
Description: A follow-up to the 2010 bond business essay, examining developments in the Fed's Treasury market operations. Fekete argues that the bond market's continued strength despite all reason confirms his analysis: the Fed has created a one-way market in which only official intervention prevents collapse. The 'still' in the title reflects growing astonishment that the system continues to function.
Editorial Note: Written May 2012. A sequel to the January 2010 essay, updated with two years of additional QE evidence.
Original PDF: https://professorfekete.com/articles/AEFNoBusinessLikeBondBusinessStill.pdf

*There Is No Business Like Bond Business. Still.*

**Antal E. Fekete**

In 2010 I published an article under the title There Is No Business Like Bond Business ([www.professorfekete.com](https://www.professorfekete.com), January 18). In it I argued that the widely expected collapse of the U.S. Treasury bond (hereafter T-bond) market just would not happen. I also gave my reasons why analysts have failed to understand this. They missed the fact that the 30 year old bull market in T-bonds has been fuelled by risk-free bond speculation. Speculators buy the bonds in the open market, turn around to drop them in the lap of the Fed at a profit. They ‘front-run’ the well-advertised and widely anticipated ‘open-market operations’ of the central bank. The strategy to pre-empt the Fed’s open market purchases of bonds works especially well when the printing presses are revved up in an effort to fend off (real or imaginary) deflation.

Gary North gave me the honor of commenting at length on my errors, see:

Antal Fekete’s Fantasy-Land Monetary Theory of Hyperinflation That Creates a Bonds Boom and Falling CPI, [www.marketoracle.co.uk](https://www.marketoracle.co.uk), February 12, 2010. I have not offered a rejoinder to North’s malicious comments as it is my policy never to dignify my detractors that way. But since other comments on my thoughts have also appeared that observe the rules of diplomatic intercourse and common courtesy, I thought that an update on the inflationary/deflationary debate and my take on the future of the dollar might be timely.

Note that in the intervening two-year period none of the widely promoted hyperinflationary scenario materialized and, short of a hot war involving the Middle East, is not likely to materialize in the foreseeable future. This, in spite of unprecedented money-creation in the United States and elsewhere in the world. Most observers are puzzled about it. They shouldn’t be. The T-bond market is still alive and kicking, never mind the view that by the courtesy of the Fed it is doing overtime on the life-support system. Commentators point out that all the bonds sold end up in the balance sheet of the Fed that is pretty well the only T-bond buyer left. I would call this statement a poetic exaggeration.

Speculators’ appetite for risk-free bond speculation has not abated. The fact that bonds keep landing on the balance sheet of the Fed is in perfect conformity with my script. Speculators did buy them for one and only one reason: they wanted to dump them on the Fed as quickly as possible. That’s their business: illegitimate arbitrage between the bond market and the money market for risk-free profits.

Borrow short to lend long.

The suggestion that interest rates have bottomed marking the beginning of hyperinflation is preposterous. Just the opposite is true. Deflation is going full steam ahead, thanks to risk-free bond speculation bidding up bond prices ever higher and pushing interest rates ever lower. The Fed is no longer in charge, although it wants you to believe otherwise. Instead, the Fed is scared stiff as every one of its attempts to re-ignite inflation has failed miserably. The Fed cuts a sorry figure of an engine driver who is desperately trying to slow down the runaway train by pulling and pushing levers that are no longer connected to anything.

Detractors criticize me for suggesting that falling interest rates ultimately cause falling prices. I stand by my statement which is amply supported by historical evidence going back to the French Revolution. The price level and the rate of interest have moved in tandem and in the same direction, if due regard is paid to leads and lags. Sometimes the price level leads and the rate of interest lags, at other times the rate of interest leads while the price level lags. Theory fully confirms history. You must see that persistently falling interest rates, ultimately although not immediately, cause prices to fall. The reason is that a falling interest-rate structure erodes and eventually destroys capital. I get a lot of flak for insisting on this one. However, denying it would be tantamount to denying that falling interest rates cause bond prices to rise. As they do, falling interest rates obviously cause the burden of debt to increase. Admittedly paradoxical, but it is true nevertheless. Businesses go bankrupt without realizing what has hit them. Everybody, economists, financial journalists, central bankers urge them to be patient because in the long run the falling trend will make interest rates so low as to render business profitable once more. The trouble is that, as John Maynard Keynes famously remarked, in the long run they will all be dead, financially speaking. They will go bankrupt before the promise is fulfilled. The same fate awaits their competitors who feel good when they jump in and finance their investments at the lower rate. This is the cat chasing his own tail all over again.

We are approaching the point where businessmen become so desperate that they try to save themselves by initiating price wars. Nobody sees this coming as everybody is mesmerized by the unprecedented injection of new money into the economy, and everybody believes in the false religion of the Quantity Theory of Money. But then, nobody saw the coming collapse of housing prices either, still less pointed out its causal relationship with the perennially falling interest rate structure.

I have never denied that the collapse of the regime of irredeemable currency could take the form of a hyperinflation. However, we would be hard put to find an historical example of a hyperinflation that was not preceded by war or civil war destroying supplies and production facilities. On the other hand, we know that a depression could often push the government into a shooting war.

It is a fact, not yet admitted by historians, that the Allied Powers welcomed (not to say encouraged) Hitler’s provocations as they gave them an excuse to start World War II. They hailed the war as their savior from a depression that they were unable to control. In 1939 it was still unthinkable that the United States could join the fray in Europe without Congress declaring war first. Roosevelt had to provoke the Japanese to attack Pearl Harbor in order to get his muchwanted war. Today, the president can start wars anytime, anywhere in the world at pleasure, and a pre-emptive attack on Iran is badly itching. If such an attack materializes, all bets on a deflationary scenario are off. But in the absence of a shooting war, continuing deflation, that is, falling interest rates cum falling price level, is in the cards. The reason is the fact, still unrecocnized, that risk-free bond speculation renders all the machinations of the Fed to engineer inflation ineffective, nay, counter-productive. The Fed thinks that it is fomenting inflation when in fact it has become the main engine of deflation.

How is it possible that all those think-tanks (spending zillions of dollars on so-called research) have not been able to uncover the truth of my proposition? The reason, as I see it, is the counter-intuitive nature of the mathematical fact concerning fixed income securities, namely, the fact that a decrease in the rate of interest increases the burden of debt on the issuers of bonds. The reluctance of the mind to admit this is all the more curious as the equivalent statement, that the bond price moves inversely with the rate of interest, is allowed to pass unchallenged. The intuitive but false conclusion that a decrease in the rate of interest eases the burden of the debt springs from the misconception that the reduction takes effect immediately on all outstanding obligations. But as the more accurate name ‘fixed- income security’ makes it abundantly clear, bond issuers do not benefit that way. They must continue laboring under the burden of a higher interest load than that is available to new borrowers. Incidentally, this is the most damning condemnation of the regime of irredeemable currency that is the culprit for the destabilization of the interestrate structure. It just does not stand the comparison with the stable interest regime of the gold standard. The dollar-standard rewards and penalizes without regard to merit. It tends to penalize virtue and to reward vice. As it does, it erodes and ultimately destroys capital.

Is the T-bond market corrupted? Without a doubt. Is it about to topple over? Far from it. Interest rates will continue to fall well below the rate of monetary debasement. Speculators will keep buying the bonds regardless of their unreasonably high price, because they know that bond prices will keep rising further, ad infinitum, and that they will always have an eager buyer to whom to sell at a profit: the Fed. In addition, the T-bond market enjoys a cozy shelter in foreign central bank portfolios.

The Privateer (April, 2012, issue #702) describes the police action upholding this arrangement as follows. “The over-indebted country, in return for being bailed out, is given an unvarying set of rules by the IMF. It has to erase or at least greatly lessen its budget deficits; it has to stop trying to prop up its currency on the markets; it has to give priority to its international creditors; it has to tighten financial regulations; it has to accept IMF ‘supervision’. The use of the nation’s foreign exchange reserve to meet its debt is forbidden. The Asian crisis of the 1990’s was a perfect example of this. Throughout that crisis the message from the U.S., the lending banks and the IMF was the same: We’ll let you get away with almost anything. But don’t you ever contemplate helping yourselves by selling your U.S. Treasury debt. The U.S. Treasury debt was and still is sacrosanct. It is the foundation of the entire global regime.”

As a result we have the anomaly that even if the dollar loses most of its purchasing power, its standing as a global reserve currency will remain largely unaffected. There is no reason to believe that the powers-that-be will stop using this successful recipe in the near future. The dollar is far from being a push-over.

---

*May 11, 2012.*

## Announcement

### New Austrian School of Economics

### Munich, Germany

### From September 3 - 9, 2012

Title of the course:

## Critique Of Mainstream Austrian Economics

Marginalism; Marketability; The Real Bills Doctrine vs. the Quantity Theory of Money; Interest versus Discount; The True Role of the Gold Standard

### Part One: Marginalism

### Part Two: The Theory of Value

1. Marginal utility and unit price

2. Marginal productivity of capital

3. Marginal productivity of labor

4. Marginal productivity of debt

5. The marginal object and the marginal subject

6. From price to spread: arbitrage

7. Menger’s concept of marketability

8. Can value be measured?

### Is constant marginal utility of gold contradictory?

10. Is paper money a present good or a future good?

11. The Gold Standard (unadulterated and

### Rothbard’s so-called 100 percent gold standard)

12. Menger and the Quantity Theory of Money

13. The wisdom of Adam Smith

14. Spontaneity of real bill circulation

9.

### Part Three: Interest versus Discount

15. Where gold certificates cannot deputize for gold coins

16. Market process and the determination of the rate of interest

17. The meaning of zero interest and zero discount

18. Gold and Interest

19. Marginal time preference and marginal productivity of capital

20. The discount rate and the marginal productivity of social circulating capital

This course is a seven-day, twenty-lecture session. Its topics are not recycled but new material. Its completion will earn one credit of the four needed towards a Bachelor of Monetary Science (BMSc) degree handed out by Prof. Fekete.

It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. Previous courses are not a prerequisite.

For further information or in order to register for the course you can get in contact with the organizers Ludwig Karl and Wilhelm Rabenstein via mail ( nasoe@kt-solutions.de ) or phone ( +49 – 170 – 380 39 48 , before calling please consider a possible time lag).

You might also want to take a look at the New Austrian School of Economics on Facebook: [www.facebook.com](https://www.facebook.com/newasoe) and [www.facebook.com](https://www.facebook.com/events/191504464305951/)

---

# A Footnote to the Wolfson Economics Prize Contest

URL: https://newaustrianeconomics.com/archive/fekete/a-footnote-to-the-wolfson-economics-prize/
Date: 2012-04-18
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, monetary-policy, real-bills
Description: Fekete supplements his Wolfson Prize entry with additional analysis of the gold-standard transition mechanics, examining what would happen during the transition from euro membership to a national gold standard. He argues the transition period is the most dangerous phase and provides specific recommendations for managing it.
Editorial Note: Written April 2012 as a follow-up to the Wolfson entry. The footnote format signals that it supplements rather than replaces the main submission.
Original PDF: https://professorfekete.com/articles/AEFAFootnoteToTheWolfsonEconomicsPrizeContest.pdf

### A Footnote to the Wolfson Economics Prize Contest

**Antal E. Fekete**

Last year Lord Wolfson announced the Economics Prize Contest of 2012. At stake was the £250,000 Wolfson Economics Prize, the richest economic award after the Nobel Prize. The essays were to address the sovereign debt crisis in Europe, in particular, the problem how to ensure the stability of the new European currencies after the possible dissolution of the euro-system. The five essays shortlisted for the award were published on April 3. The winner will be announced in July.

The present author submitted his essay without the slightest illusion that he may win, or that he may even be on the short list of the 5 hopefuls. His only motivation to participate in the contest has been to test whether the Establishment is now ready to accept the suggestion that it was no accident that the “Big Bang” of debt explosion occurred on the very same day, on August 15, 1971, when gold was exiled from the international monetary system. A glance at the chart of total debt will make the validity of that suggestion plausible.

As witnessed by the tables of contents of the five short-listed essays, only one of them mentions the gold standard explicitly, and that in the voice of disdain. Jonathan Tepper’s essay charges that “the gold standard has recessionary bias” and that “it puts the burden of adjustment on the weak-currency country rather than on the strong”. Since the distinction between a ‘weak’ and a ‘strong’ currency under a gold standard is invalid, this can only mean that the gold standard is hereby charged with putting the burden of adjustment on the financially irresponsible instead of the financially responsible country. What is wrong with that? Could it not be that, perhaps, Europe’s and the world’s present troubles originate from the fact that the irredeemable paper currency system has shifted the burden of adjustment to the financially responsible countries, thus providing incentives for financial irresponsibility?

It was Milton Friedman on whose advice Richard Nixon discarded the fixed exchange rate system based on gold in favor of the ‘floating’ exchange rate system based on the irredeemable dollar. Friedman suggested that floating is an effective adjustment-mechanism of international trade. Imbalances are automatically rectified. The currency of the deficit country depreciates while that of the surplus country appreciates. As a consequence imports of the former become dearer and are throttled; meanwhile, those of the latter become cheaper and are boosted. The process continues until balance is restored.

### There is no need to deny the intellectual seductiveness of this

‘theory’. However, it has a fatal flaw without any redeeming features. It ignores the marginal terms of trade, that is, the ratio of additional imports to additional exports. In other words it ignores the change in additional imports that the unit of exports will buy. Note that it can be negative, as it always is in case of a devaluing country. For example, if the unit of export is one passenger car, then the devaluing country will have to export more cars to maintain the same level of imports.

Rather than restoring trade balance, floating makes the imbalance worse. It makes the terms of trade of the deficit country deteriorate. Whatever ‘benefits’ the deficit country may derive from devaluation are strictly ephemeral. They vanish as soon as the inventory of imported ingredients that go into exports runs out. Thereafter the devaluing country has to pay more, not less, for ingredients essential for exports. It will see its deficits grow rather than contract. In effect, the devaluing country is selling its valuable resources abroad at ‘fire sale prices’.

No wonder that the alleged benefits of devaluation are entirely illusory.

History bears out theory. The US has been running a trade deficit vis-à-vis Japan for half a century. Since 1973, following Friedmanite precepts, the dollar’s value was beaten down 5-fold (!) against the yen. Instead of falling, the US trade deficit with Japan has increased 10-fold.

This shows that the system of floating exchange rates based on the irredeemable dollar is no valid substitute for fixed exchange rates based on gold if the goal is to achieve trade balance. Financial profligacy is independent of the monetary system under which it is practiced. It is nature-ordained that the burden of adjustment fall on the profligate country.

History will pass judgment on the prejudice of the jury of the Wolfson Economics Prize Contest 2012. The jury has failed to find a single submission worthy of mention among the 425 received that makes the connection between the sovereign debt crisis and the expulsion of gold from the international monetary system in 1971. In doing so the jury has failed to make a contribution to the solution of the crisis. Most likely it has made a contribution to its prolongation.

*Note. The author’s submission to the Wolfson Economic Prize Contest 2012, entitled: How to Ensure the Stability of the New European Currencies? can be accessed on the website: [www.professorfekete.com](http://www.professorfekete.com/articles/AEFSYNOPSISWolfsonEntry.pdf).*

---

*April 9, 2012.*

## Announcement

### New Austrian School of Economics

### Munich, Germany

August 2012 (exact dates will be announced soon)

Title of the course:

## Critique Of Mainstream Austrian Economics

Marginalism; Marketability; The Real Bills Doctrine vs. the Quantity Theory of Money; Interest versus Discount; The True Role of the Gold Standard

This course is a seven-day, twenty-lecture session. Its topics are not recycled but new material. Its completion will earn one credit of the four needed towards a Bachelor of Monetary Science (BMSc) degree handed out by Prof. Fekete.

It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. Previous courses are not a prerequisite.

For further information or in order to register for the course you can get in contact with the organizers Ludwig Karl and Wilhelm Rabenstein via mail ( nasoe@kt-solutions.de ) or phone ( +49 – 170 – 380 39 48 , before calling please consider a possible time lag).

You might also want to take a look at the New Austrian School of Economics on Facebook: [www.facebook.com](https://www.facebook.com/newasoe)

---

# The Gold Problem Revisited

URL: https://newaustrianeconomics.com/archive/fekete/the-gold-problem-revisited/
Date: 2012-03-20
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, real-bills, gold-basis, sound-money, new-austrian-economics
Description: Fekete revisits the classic 'gold problem' — the claim that there is not enough gold to run a modern economy — and refutes it using basis analysis and real bills theory. The alleged shortage of gold is not a physical fact but a consequence of gold's monetary suppression; with proper monetary institutions, gold's monetary supply is endogenous and self-adjusting.
Editorial Note: Written March 2012. Fekete's refutation of the 'not enough gold' objection is one of the most frequently made arguments against gold standard restoration, making this essay an important reference.
Original PDF: https://professorfekete.com/articles/AEFTheGoldProblemReviseted.pdf

1. The futility of inflationary policies Mises ignores the fact that newly created money can be spent not only on goods and services, but also on financial assets. This is the proverbial fly in the ointment of the inflationary argument. It is also a subtle one, so much so that the government as the wouldbe perpetrator of inflation often falls victim to it. It may think that it is promoting inflation while, in fact, it acts as quartermaster for deflation.

By restricting the circulation of gold money or by other means, the government can make financial speculation more attractive. In doing so it wants to reduce the amount of money available for buying goods and services. This strategy of the government and its pseudo-economists consists precisely in channeling enough of the newly created money into speculative ventures so that the untoward consequences of price and wage rises will not occur, or they will occur later, so that the causality relation is obscured.

The paramount example is bond speculation. Of course, under the gold standard there is no bond speculation because the variation in the bond price (or, equivalently, in the rate of interest) is minuscule making the opportunity to earn speculative profits negligible.

Unless… unless… the central bank makes profits risk free as a bait to speculators by inappropriate monetary and fiscal measures. This is exactly what happened in the early 1920’s when the policy of open market operations, so called, of the Fed were first introduced quite illegally, we might add (the policy was legalized retroactively in 1935).

This article is in response to Dr. Joseph Salerno’s remarks made in the interview with Anthony Wile of the Daily Bell, July 3, 2011

As the Fed was originally constituted, it was only enabled to be a passive partner in business. Limited by its charter the Federal Reserve Act of 1913, it could enter (or decline to enter) business initiated by others, but it could not initiate business on its own. It could post its rediscount rate, but member banks had step forward to request rediscounting real bills from their portfolio. In and of itself rediscounting was not inflationary as a way to create new money. The new purchasing power so created was backed, dollar for dollar, by salable merchandise arising in production, and it was to be extinguished when the merchandise was sold to the ultimate consumer at the time the bill matured.

This was not the case, however, when the Fed assumed an active role and started purchasing government bonds in the open market at its own initiative in contravention of the Federal Reserve Act of 1913. The monetary base was enlarged. This provided a direct incentive for member banks to make loans regardless whether or not new merchandise was simultaneously emerging in production. Using standard Quantity Theory of Money

(QTM) reasoning the Fed and everybody else assumed that the effect would be inflationary. Hooray, a subtle and potent new way of inflating the money supply has been invented! The economy can now be micromanaged at will! There was jubilation in the inflationist camp.

The jubilation was premature. The policy of open market operation as an instrument of inflation was an enormous blunder. QTM was inoperative: bond speculators overrode it.

They knew when the Fed had to go to the open market to relieve ‘natures urge’ (to purchase its next quota of government bonds). Speculators could make risk-free profits by preempting the Fed in buying the bonds first. The ‘tool’ of baiting speculators with risk free profits backfired badly, if only for the reason that speculators were a much smarter lot than central bank agents facing them in the bond pit. They risked their own capital while losses made by central bank agents were covered from public funds. The game plan was upset.

What was supposed to be inflation ended up as deflation. Here are the details.

In an unhampered market risk-free profits that may occur from time to time are ephemeral and therefore inconsequential. Hawk-eyed speculators immediately take advantage of them with the result that any further opportunity to make risk-free profits is eliminated on the spot. This is no longer true if the opportunity to make risk-free profit is not an infrequent aberration but the consequence of deliberate and well-advertised official policy as it is in the case of the policy of open market operations. When the central bank relies on open market purchases of government bonds in order to augment the monetary base on a regular, ongoing basis, then speculators can anticipate and pre-empt it. This policy, whole-heartedly supported by Keynesian/Friedmanite economics, is the most ill-conceived monetary policy ever concocted for the purpose of increasing the stock of money.

### The

Federal Reserve Act of 1913, for excellent reasons, disallowed such a policy and imposed stiff and progressive penalties for non-compliance on the Federal Reserve banks if their balance sheet showed that government bonds had been used to cover Federal Reserve note or deposit liabilities. At first the Fed used open market operations illegally. It could get away with it because of the connivance of the Treasury in ‘forgetting’ to collect the penalty. The conspiracy created a fait accompli and, in the end, Congress was forced to legalize the corrosive practice retroactively in 1935 when it amended the Federal Reserve Act.

The newly invented monetary policy of open market operations is responsible for much of the deflationary damage inflicted on the world economy during the Great Depression of the 1930’s. It started an avalanche of falling interest rates that soon went out of control. Falling interest rates destroy capital as they increase the burden of debt contracted earlier at higher rates. Perfectly sound businesses fail if their debt burden, through no fault of theirs, exceeds the profitability of deployed capital. The whole process was most insidious. Entrepreneurs did not know what hit them. From one day to the next they found themselves uncompetitive as competitors financed their business at lower rates.

They had to lay off their employees. They went bankrupt in droves. Wanton destruction of capital was the main cause of deflation and the Great Depression in the 1930’s.

Herein lies the incredible failure of the policy of open market operations, missed by Mises. The policy is counterproductive from the point of view of central bank and pseudoeconomists acting as its cheer-leaders. It released the genie of risk-free bond speculation from the bottle in the hope that it could always be put back. But it could not. Falling interest rates would run their devastating course.

The same thing repeats itself today. Interest rates have been falling for over thirty years. The Fed is no longer in control. It is lunacy to believe that it can stop the avalanche that it started so easily in the early 1980’s. Today the speculators are the only buyers after China and other exporters to the US bailed out of the US T-bond market. Speculators will keep buying the bonds as long as they can reap risk free profits. It is true that ‘quantitative easing’ cuts into that business, as the Fed is buying bonds directly from the Treasury, bypassing the open market (another illegal practice). Watch for the day when the speculators will start dumping bonds and selling them short. When they transfer their buying from the bond market to the commodity market, the game is up.

Open market operations is a charade that can go on only so long as speculators are allowed to reap risk-free profits at the expense of the producers and the savers. When the latter have been squeezed dry, it’s “après nous le deluge”. That is the true scenario of Great Depression II.

2. The futility of the policy of suppressing interest rates.

The rate of interest is a market phenomenon just like prices. In fact, the definition of the rate of interest must refer to the bond price: it is the rate that amortizes the price of the bond as quoted in the secondary market through the bond’s maturity date. The floor for the range in which the interest rate may move is determined by marginal time preference. (The ceiling, on the other hand, is determined by the marginal productivity of capital.) To understand this, we must consider the arbitrage of the marginal bondholder between the bond market and the gold market. If the rate of interest falls below the rate of marginal time preference, then the marginal bondholder sells his overpriced bond and keeps the proceeds in gold coin.

In this way he can force the bond price to come back to earth from outer space. Bank reserves are shrinking and the banks have to call in some of their credits and sell bonds from portfolio. When the bond price falls, the marginal bondholder repurchases his bond at a cheaper price. Time preference has no meaning outside of this context. It will remain a pious wish  until the marginal bondholder gives it teeth.

Mises (and, before him, Ricardo who was an advocate of the elimination of gold coins from circulation) was wrong when he stated that there is no difference between the gold coin and a promise to pay gold coin as long as the security and maturity of the promise cannot be doubted. The promise can perform all the monetary functions that the gold coin does. Well, it cannot, because there is one very important exception. When the marginal bondholder in protest to low interest rates sells his bond (a future good), he insists on getting gold (a present good). He will not take a promise to pay gold, because it is still a future good, and an inferior one to boot as it pays no interest. Taking it would mean jumping from the frying pan into the fire. This shows that gold hoarding, far from being a deus ex machina, and far from being a curse of the gold standard, is an important market signal. It indicates that the rate of interest is being pushed below the rate of marginal time preference. It had better be heeded before it is too late. Gold hoarding cannot be understood except in the context of its counterpart, gold dishoarding. When the signal is heeded, banks tighten up their loose credit policies and the government reins in expenditures, gold will be dishoarded and the marginal bondholder will replace gold in his portfolio by repurchasing the bond at a profit.

This was the reason for eliminating gold coin circulation first in Europe in 1914, and then in the United States and Canada in the 1930’s. Governments wanted to make sure that they were in full control of the rate of interest, free from any interference from the marginal bondholder. This policy had to fail. It was shipwrecked on the reef of gold hoarding.

All economists, including Mises himself, missed the importance of the nexus of gold hoarding and dishoarding as the manifestation of arbitrage by the marginal bondholder between the bond market and the gold market, explaining the all-important contact between gold and interest.

3. The futility of the policy of boosting wages.

Mises did not subscribe to Adam Smith’s Real Bills Doctrine (RBD). Although he acknowledged the fact that real bills drawn on consumer goods in most urgent demand could circulate as a kind of ephemeral money through endorsing, as they indeed did in Lancashire before the Bank of England opened its branch in Manchester, he did not find this matter worthy of further attention. He coined the word “circulation credit” that financed the movement of commodities from the producer to the consumer through the various phases of production, but he blotted out the important distinction between the discount rate and the rate of interest. He never used the term “self-liquidating credit”, that would have revealed why circulation credit did indeed circulate without any coercion from the government. They did circulate because the credit was liquidated by the sale of merchandise in high demand on which the bill was drawn.

Mises was unimpressed by the fact that bonds and mortgages could not circulate in the same way. He had too great a faith in the Quantity Theory of Money, and was probably disturbed by the fact that real bills, however temporarily, could serve either as money substitutes, or as bank reserves on which sound money could be built. His negative attitude with regard to Adam Smith’s RBD is regrettable. Real Bills are the next best thing to gold into which they mature in 91 days or less. The demand for real bills is virtually unlimited. Not only banks with surplus gold in their tills scramble for them as the best earning asset commercial banks can have, but also those individuals and institutions who have large payments coming up (say, the purchase of a house, or a factory, or the retirement of a bond issue) and they have to assemble cash by the closing or maturity date. They could not put these accumulating funds into stocks, bonds, or mortgages because they were not sufficiently liquid. An increased offering would immediately depress their price. Instead, these people went into the bill market and bought real bills the liquidity of which was second only to gold.

But real bills had another great significance having to do with the labor market. The only author who recognized this fact was the German economist Heinrich Rittershausen

(1898-1984), see his book Arbeitslosigkeit und Kapitalbildung, Jena, 1930. A large part of outstanding real bills in circulation represented the wage fund of society. Out of this fund wages for labor producing merchandise that will not be available for sale for up to 91 days could be paid now. Thus real bills represented a real extension of demand for labor.

Employers would simply go ahead and hire all the hands needed to produce merchandise in high consumer demand, without worrying who will advance the funds to pay wages before the merchandise could be sold. The wage fund would always be there. The RBD explains why there was no ‘structural unemployment’ in the 19th century, in contrast with the 20th when the wage fund was destroyed never to be rebuilt. 19th century entrepreneurs did not have to assume the burden of financing the payment of wages. The bill market took care of that.

Say’s Law was operative: there were employment opportunities as long as prospective employees wanted to eat, get clad, shod, and keep themselves warm in winter.

The point was driven home most forcefully when the wage fund was inadvertently destroyed by the victorious Entente Powers. They decided not to allow the rehabilitation of the bill market after the cessation of hostilities in 1918. This single decision sealed the fate of tens of millions of workers who were to be laid off in the 1930’s for lack of financing the wage bill. It was also the reason for creating the corrosive ‘welfare’ state that paid workers for not working and farmers for not farming. It also caused the demise of the gold standard by removing a vital organ, its clearing house: the bill market. Here are the details.

The victorious Entente Powers were afraid of German competition in the postwar period. They wanted to monitor, if not control, Germany’s exports and imports. As this would not be possible under the system of multilateral trade, that is, trade financed by real bills circulation, they opted for a system of bilateral trade. Never mind that this meant a setback for their own producers and consumers as well. Never mind that much more gold was needed to run a system of bilateral trade than that required by a system of multilateral trade extra gold they did not have. Never mind that this would make the 1925 return of Britain to the gold standard deflationary. The neurotic fear of German competition took precedence over all other concerns. In fact, these concerns were never examined and the decision was made in high secrecy.

This was the end of real-bill financed world trade, the great success story of the 19 th century. The bill market was destroyed. We still suffer the consequences. In effect, world trade was reduced to barter. Worse still, along with the destruction of the bill market society’s wage fund was also destroyed. There was no one to advance wages payable to laborers whose products could not be sold for cash up to 91 days. Vast sections of the world’s productive plants were condemned to idleness for the disappearance of the wage fund. As I mentioned, the only economist in the world who saw what was coming was Rittershausen. Economists still owe him recognition for his great insight. The world is still condemning the gold standard as the major cause of the Great Depression of the 1930’s and the horrible unemployment in its wake, when the real cause was the destruction of the wage fund, a misguided unilateral decision of the victors in World War I made in secrecy.

It was most unfortunate for economic science that Mises failed to put the weight of his reputation behind Rittershausen’s charge. Not only had governments put improper and counterproductive measures into effect to boost wage rates, thus fostering unemployment.

They were directly responsible for the world-wide leap-tide of unemployment by destroying the bill market and the wage fund.

Once again the world is facing the same dangers as it did four score of years ago. Yet one can see only complacent governments in a self-congratulating mood over their ‘success’ in ‘fending off’ the Great Financial Crisis. But the writing is on the wall: if governments fail to rehabilitate the gold standard and its clearing house, the bill market, together with the wage fund, then a much more devastating leap-tide may soon engulf the world.

4. The futility of the policy of gold valorization.

The world has been witnessing the pathetic attempts of governments and central banks “to keep the gold price in check” since the 1971 fraudulent default of the US government on its international gold obligations. To be sure, a default is always followed by a depreciation of the dishonored paper, so the futility of the policy of gold valorization has always been a foregone conclusion. But what we have is far more than this self-defeating effort to keep gold out forever from the monetary system. What we have is a veritable brain-washing of the whole world about the role of gold in the economy, and blaming gold for results that only keeping gold in the system could have prevented.

It is alleged that gold has disqualified itself from playing the role as the monetary anchor and source of credit in the economy. ‘Gold is far too volatile for that’. This is puerile because it ignores the fact that the so-called volatility of gold is just the mirror image of the volatility of the irredeemable dollar in which the price of gold is quoted.

It is also ignored that the debt crisis is a direct consequence of exiling gold from the international monetary system. Gold is the only ultimate extinguisher of debt. It cannot be replaced by the dollar or any other irredeemable currency. Under the dollar system debt simply cannot be extinguished. Total debt can only grow, never shrink. All the bad debt and “toxic sludge” stays in the system and is merely kicked upstairs into the balance sheet of the US Treasury. There it remains, representing a great threat to the world. Like radioactive material, when its quantity exceeds the threshold, a chain-reaction starts triggering an nuclear explosion. The world needs gold as a safe way to eliminate bad debt.

Through a system of bribes, blackmail and intimidation research on questions relating to gold has been discouraged to the point that it is practically non-existent. The world continues to live in a fool’s paradise. It believes the size of government debt does not matter because it can always be rolled over. Nor would it cause inflation or deflation because competent and honorable gentlemen at the helm can safely navigate our monetary ship through the strait of Scylla and Charybdis. They have a sharp tool, the printing press, and with its judicious application they can fine-tune the quantity of money in circulation as well as the rate of interest for the benefit of all. But the virtual elimination of research on gold will strike back. These ‘competent’ and ‘honorable’ gentlemen at the helm are complete ignoramuses when it comes to gold. They have no notion of the erosion of the gold basis and the irresistible march of the gold futures markets into the death valley of permanent gold backwardation. When disaster strikes, gold will not be available at any price. What this means is that the world is insidiously slipping into barter. But you cannot feed the world’s present population on the basis of a barter economy. Poverty, pestilence, famine threatens society, not to mention the breakdown of law and order. All this, and more, because government leaders have allowed the suppression not only of monetary gold itself, but also the research on monetary gold.

Ben Bernanke, the Chairman of the Federal Reserve Board introduced a new phrase into the vocabulary of economics on July 11, 2011, in his testimony at a Congressional hearing. The new phrase is: tail risk. He defined it as the “really, really bad outcomes” in the economy, as if they were completely outside of human control on the pattern of floods, earthquakes, volcanic eruptions and tsunamis.

But ‘tail risk’ in reality is the wholly unnecessary risk taken with human lives by a parasitic, contemptuous, conceited, and yes, ignorant ruling class symbolized by Bernanke, that has hijacked the Constitution, in particular, turning the Constitution’s monetary provisions upside down which define money in terms of gold and silver. They are only interested in their own self-aggrandizement, in perpetuating their power, and in preserving their superstitious faith in irredeemable currency a monetary system that has failed miserably every time foolish leaders in history experimented with it.

Mises was a great warrior fighting these usurpers and monetary hijackers with the sharpest weapon there is: human reason. We must follow his lead even if it sometimes means that we have to add new ideas that go beyond Mises’s opus.

The day of reckoning for monetary insanity is on hand. The Constitution is there for the protection of all. If we fail to preserve and uphold it, and meekly succumb to the monetary hijackers’ and usurpers’ tactics, then we shall have only ourselves to blame for the consequences.

---

*March 20, 2012.*

### ____________________________________________

## Announcement

### New Austrian School of Economics

### Course Four Munich, Germany from March 24 - April 2, 2012

Title of the course:

### The Austrian Theory of Money, Credit, and Banking

This is the fourth in a four-course series on Austrian Economics, a branch of economic science based on the work of Carl Menger (1840-1921). It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. The complete program consists of four courses (10 days, 20 lectures each). Completion of each course will earn one credit.

Participants who have accumulated four credits get a diploma signed by Professor Fekete.

Course One that was given in 2010 and courses Two and Three that were given in 2011 are not a prerequisite. All three are available on DVD for purchase.

For further information or in order to register for the course you can get in contact with the organizers Ludwig Karl and Wilhelm Rabenstein via mail ( nasoe@kt-solutions.de ) or phone ( +49 – 170 – 380 39 48 , before calling please consider a possible time lag).

You might also want to take a look at the New Austrian School of Economics on Facebook: [www.facebook.com](https://www.facebook.com/newasoe)

---

# How to Ensure the Stability of the New European Currencies?

URL: https://newaustrianeconomics.com/archive/fekete/how-to-ensure-the-stability-of-new-european-currencies/
Date: 2012-03-13
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, real-bills, sound-money, monetary-policy, new-austrian-economics
Description: Fekete's entry to the Wolfson Economics Prize contest, proposing a gold-and-real-bills framework for any European nations that exit the euro. He argues that new national currencies can only be stable if anchored to gold and supported by a functioning bill market — otherwise they will simply replicate the instability of the currencies they replace.
Editorial Note: Submitted to the Wolfson Economics Prize in March 2012. The prize asked for the best plan for an orderly euro breakup — Fekete's entry was characteristically more radical than most, requiring genuine monetary reform rather than mere currency substitution.
Original PDF: https://professorfekete.com/articles/AEFSYNOPSISWolfsonEntry.pdf

### How to Ensure the Stability of the New European Currencies?

### Antal E. Fekete

In 1971 gold was exiled from the international monetary system where it had played the role of monarch for thousands of years. Reason: the U.S. had to save face after president Nixon fraudulently defaulted on American gold obligations.

It was fraudulent because America did have the gold to pay its debt as contracted. Since that time untold amounts of dollars were spent by the twelve Federal Reserve banks in the form of research grants and stipends to develop a pseudo-scientific theory to justify the coercive removal of gold from the world economy, and the equally coercive introduction of the irredeemable dollar.

There is nothing new about the defaulting banker trying to promote his dishonoured paper. Never in the history of science has more money been disbursed than during the past forty years on hiring a corps of sycophants to shore up a false theory. They produced mere propaganda material dressed up with charts and equations, expressed in scientific jargon, to show that gold was useless, even wasteful, an anachronism embodying superstition and worse. “Gold must go”. The irredeemable dollar was the “wave of the future”. It had the same debt-extinguishing power as gold it was destined to supplant. And, above all, it could be ‘scientifically’ micro-managed that gold could not.

Nobody pointed it out that this was pure “sour-grape syndrome” all over again from Aesop’s fables. The fox in the vineyard was trying hard to sample the grapes. But no matter how high he jumped, he couldn’t reach them. When finally he gave up, he departed with the comment: “the grapes were sour anyway”. Indeed, if gold was so sour, why didn’t the U.S. government let it go?

That’s the funny part.

The sad part is that gold, far from being useless, is the only ultimate extinguisher of debt. There is no other way to reduce total debt. Paying a debt with dollars merely shifts debt from the liability column of the balance sheet of the previous debtor to that a bank or, ultimately, to the liability column of the balance sheet of the U.S. Treasury where all the bad debt of the world (including the bad debt of the Greek government) keeps accumulating. All this bad debt would have been extinguished long ago, had gold not been foolishly exorcised from the international monetary system. After all is said and done, the dollar has not the same debt-extinguishing power as gold. America has turned itself from the benefactor of the world to a parasitic tyrant. It pilfers and robs other countries by paying for its imports with make-believe chits, the circulation of which is reinforced by the world-wide deployment of its military power. Its monument is the runaway debt tower threatening to bury people alive underneath the debris after it collapses.

The question why the Fed and the U.S. Treasury are allowed to issue bills of credit which they have neither the means nor the intention to honour while everybody else doing likewise would be prosecuted for fraud is under strict interdiction. The popular name of this type of fraud is check-kiting that consists of issuing fraudulent credit by one party on the collateral security of the fraudulent credit issued by the other.

The Great Financial Crisis is a debt crisis, and gold is the key to the solution. Gold coins must be put back into circulation. This can be accomplished by a two-pronged programme: 1. Opening the European Mints to the free and unlimited coinage of gold; 2. Refinancing the short-term, highinterest debt of the European governments in terms of long-term, low-interest, gold-bonded debt. The problems of Greece and other indebted countries cannot be worked out in a crisis-atmosphere while the European Monetary authorities bombard them with bribes and blackmail, and threaten them with deadlines only a month or two away.

At any rate, we are all in the same boat. The “holier than thou” approach won’t work. All other countries in Europe and elsewhere have sinned as well.

Their turn to be chastised for their sins will not be long in coming. Their sin is that they have let the Americans get away with bloody murder.

1. Open sesame! Open the Mint to gold!

Gold to the Mint will come from other countries. Having been coined in Athens, some of it may leave Greece. But some will stay and participate in the reconstruction of the Greek economy. Circulating gold coinage will have the same effect as a spring shower. It will fertilize productive forces in the country.

The new gold coins will not disappear from circulation into hoards. Once people realize that the Mint is going to remain open to gold for good, they will lose interest in hoarding. You can spend your gold coin confidently, because you can always get it back on the same terms.

The Mint will open to silver as well to provide hand-to-hand money for smaller purchases and paying wages. That will be the day, when laborers get their wages in the form of shiny and clinking silver coins! There is nothing like coins with a ring when it comes to boosting morale and propping up work ethics. For best results countries of Euroland should simultaneously reintroduce circulating gold and silver coins, thus resurrecting the now defunct Latin Monetary Union (1867-1929).

2. Bring back, oh bring back gold bonds to me!

Countries of Euroland should refinance their farcical debt denominated in euros with bonds denominated in gold. Issuing debt maturing into more debt of the same kind is indeed a farce. Gold bonds should be auctioned off against outstanding euro-denominated debt. Holders of debt, happy to carry euroobligations, should be allowed to do so. But the same freedom of choice must be made available to those who are not happy to carry bonds payable in irredeemable currency! Let the people choose between paper and gold.

Gold francs and silver thalers are the ultimate catalyst between the creation and retirement of debt. They can test the quality of debt. They reveal whether debt was contracted in good faith, or whether it was embraced frivolously. The Latin Monetary Union is a model still relevant in our world. It is a beacon of hope in turbulent times showing the path for debt-stricken nations to follow.

Gold is also relevant to the problem of extirpating ‘structural’ unemployment a concept unknown before the 20th century. The German economist Heinrich Rittershausen (1898-1984) showed that the forcible removal of real bills from the economy, followed by the removal of gold, was directly responsible for the horrible unemployment of the 1930’s. These measures destroyed the wage fund out of which labor that produced as yet unsold merchandise destined to be consumed presently could be paid now. (Arbeitslosigkeit und Kapitalbildung, 1930).

It will take time before economic science can purge its body and soul of the false and vicious anti-gold propaganda, and of the shameless fiat-money agitation which it was forced to imbibe during the past two score of years. Real research on gold circulation, on gold hoarding/dishoarding, and on the role of gold in the formation of the rate of interest and the discount rate must be allowed to start without delay.

The gag order on speaking the truth in money matters must be lifted. It should be permissible once again: to say that a legal system incorporating double standard of justice will self-destruct in due course; to say that the Fed and the U.S. Treasury usurp the power of issuing bills of credit that they have neither the means nor the intention to honour; to say that the Fed and the U.S. Treasury are guilty of check-kiting which, if practiced by anybody else, would result in criminal prosecution.

The best guarantee of the stability of the new European currencies is economic science free of deliberate lies, distortions, cover-ups and interdiction on speaking the truth.

March 6, 2012. —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  — -

## Announcement

### New Austrian School of Economics

### Course Four Munich, Germany from March 24 - April 2, 2012

Title of the course:

### The Austrian Theory of Money, Credit, and Banking

This is the fourth in a four-course series on Austrian Economics, a branch of economic science based on the work of Carl Menger (1840-1921). It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. The complete program consists of four courses (10 days, 20 lectures each). Completion of each course will earn one credit.

Participants who have accumulated four credits get a diploma signed by Professor Fekete.

Course One that was given in 2010 and courses Two and Three that were given in 2011 are not a prerequisite. All three are available on DVD for purchase.

For further information or in order to register for the course you can get in contact with the organizers Ludwig Karl and Wilhelm Rabenstein via mail ( nasoe@kt-solutions.de ) or phone ( +49 – 170 – 380 39 48 , before calling please consider a possible time lag).

You might also want to take a look at the New Austrian School of Economics on Facebook: [www.facebook.com](https://www.facebook.com/newasoe)

---

# Wobbly Anchors or Wobbly Logic?

URL: https://newaustrianeconomics.com/archive/fekete/wobbly-anchors-or-wobbly-logic/
Date: 2012-03-03
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, real-bills, new-austrian-economics
Description: Fekete responds to critics who argue that the gold standard provides a wobbly monetary anchor, showing that the criticism conflates the genuine gold standard with the gold-exchange standard. It is not gold that wobbles but the fraudulent quasi-gold systems that replaced it. A genuine gold standard, with open minting and real bills, provides the most stable monetary anchor in history.
Editorial Note: Written March 2012 in response to arguments made during the renewed gold standard debate of 2011-12.
Original PDF: https://professorfekete.com/articles/AEFWobbllyAnchor3312012.pdf

## Wobbly Anchor Or Wobbly Logic?

Remarks made by professor Antal E. Fekete at the Institute of Economic Affairs in London, on March 15, 2012

### 

According to Reuters ([www.reuters.com/assets](https://www.reuters.com/assets), February 28, 2012), a team of researchers at Chatham House, the London-based policy institute for international affairs, examined the potential for gold to play a ‘more formal’ role in the international monetary system. The team concluded that a return to the gold standard would undoubtedly be ‘impractical’ and even ‘damaging’ to the financial system


 given gold’s ‘deflationary bias’ making gold a wobbly anchor.

“In fact, a serious drawback is that a gold anchor can become particularly unstable precisely when a stabilizing force is needed most. As gold prices stand to rise when inflationary expectations and other risks in the fiat money system increase, the gap between the reference price and the market price is likely to widen at times of uncertainty.”

“Although it is far from clear what is the ‘right’ price for gold, given the large volume of global money in circulation, the disadvantages of using bullion as a monetary anchor are clear: a return to a gold standard could inflate the price of gold significantly, while restrictions on money supply growth could provoke a severe downturn in the growth cycle of global economics.”

Assuming that Amanda Cooper, the author of the Reuters article has quoted the Chatham report accurately, the harsh sentence on gold is softened somewhat by the addition of a few patronizing words, such as: “gold may have a role to play as hedge against the declining values of fiat currencies although it also carries inherent risks due to the price volatility of bullion and its lack of a yield”. Or: “gold can have some utility in a portfolio of assets by spreading valuation risk but would not be very effective as a sole reserve asset”. It is further admitted that gold may play a role as a safe-haven; as collateral; or as a policy indicator 
 always with a question mark added in the end.

I am not going to analyze the Chatham report. Instead, I am going to discuss some of the results of research done at the New Austrian School of Economics (NASE) on gold in contemporary economy, as well as gold in the

20th century.

(1) Gold is the only ultimate extinguisher of debt. Having been exiled from the international monetary system in 1971, gold has not been able to play its God-ordained role as the ultimate extinguisher of debt. As a consequence, total debt in the world can only grow, never shrink. Bad debt can no longer be weeded out. Instead, it is being kicked upstairs to accumulate in the balance sheet of one government or another. Out of sight 
 out of mind. But you can kick only so much garbage upstairs to the attic before it will start to come crashing down.

We need go no further in trying to understand what the ‘sovereign debt problem’ is all about, and why all of a sudden it has become a universal threat. It took that long for the level of bad debt in the balance sheet of the government of Greece to reach the tipping point. The same bad debt would have been extinguished long ago, had the U.S. not browbeaten the world to phase out gold from the monetary system. Greece is just the proverbial whipping boy. Bad debt keeps accumulating in the balance sheet of all governments without exception.

The turn of other countries to become the whipping boy of the future will not be long in coming.

(2) What gold price? The gold price is on schedule to cease to exist.

When the gold futures markets go into permanent backwardation mode, the gold price at which to get gold will be as obsolete as the flint-stone with which to light a fire.

Permanent gold backwardation is a phenomenon bestowing risk free profits galore on speculators. They could sell their gold, and immediately buy it back at a lower price in unlimited quantities. The buy-back is in the form of paper gold. But lo and behold, uncharacteristically, speculators refuse to nibble at risk free profits. They do because they are smart enough to sense that wrapped in the bait there lurks a hook. Paper gold that is worth gold today may tomorrow be worth only the paper on which the promise is written. This neat trick, which had routinely been performed on elephants by Houdini, was performed on gold by Franklin Delano Roosevelt. On March 5, 1933, the \$20 gold certificates issued by the U.S. Treasury could be exchanged for the double eagle gold coin without hassle. On March 6, pursuant to presidential proclamation, it was exchangeable only for an irredeemable \$20 Federal Reserve note. Roosevelt had a better idea what to do with the double eagle gold coin than giving it to its rightful owner as promised. He was going to keep it and write up its value from \$20 to \$35. When the democratic president summoned the democratic senators in the Oval Office to receive their congratulations on his clever ploy, the great blind senator from Oklahoma, Thomas P. Gore told him in his face: “Why, it is plain stealing, isn’t it, Mr. President?”

Permanent backwardation can also be described as the gold basis going negative 
 never again to return to positive territory. The gold basis is just the difference between the price of the nearby gold futures contract and the price of cash gold. Positive basis is called contango; negative basis, backwardation. The two are not symmetric, however. While there is an upper limit to contango, there is no lower limit to backwardation. The reason is that the premium on the futures price cannot go higher than the carrying charge, i.e., the total cost of warehousing the good till future delivery. If it did, risk free arbitrage would bring it back into line instantaneously. By contrast, the futures price can go to any discount, however large, up to the full cash price.

When the world’s first futures market for gold opened in Winnipeg,

Canada, in the early 1970’s, gold basis was at its upper extreme: contango was as robust as it could be. The one outstanding feature of gold futures trading that received little attention is fact that the positive gold contango is constantly eroding and the gold basis is constantly shrinking, as it has for the past forty years. Attrition of the basis for gold futures as a function of time is a matter of economic law. Paper gold has been withering on the vine. Right now the gold basis is at the brink of going negative. There is an acute and increasing shortage of deliverable gold against futures contracts in spite of high and rising gold prices. This can mean but one thing. Those nameless and faceless institutions and individuals who control large quantities of monetary gold are ever more reluctant to relinquish their control. When the basis finally goes negative as it must, the game is up. All offers to sell gold are simultaneously withdrawn all over the world. Gold is no longer for sale at any price. If you want to get it, you have to have recourse to barter. You must give up silver, oil, wheat, and what have you, to get gold in exchange. Dollars are not welcome. This will be an historic event that is approaching with the inevitability of scientific law.

So what? 
 researchers at Chatham House may shrug. Well, here is what.

This event will toll the death knell for the market in U.S. Treasury bonds that, directly or indirectly are backing all currencies in existence. The carpet is yanked from underneath the international monetary system. The only reason why foreigners are still buying U.S. Treasury bonds with a yield not big enough to compensate for currency debasement is that at maturity they fetch dollars that will still buy gold (however little). But the day when permanent backwardation dawns this last incentive will disappear. The credit of the United States will be gone in a puff of smoke. Like it or hate it, gold still is the cornerstone of the monetary system, pseudo-economists’ propaganda notwithstanding.

(3) Roosevelt’s gold confiscation was one of the real cause of the Great Depression of the 1930’s.* A careful analysis of Roosevelt’s 1933 gold policies reveals that banning gold coin circulation was a colossal mistake. It was a major cause of the Great Depression. Gold was eliminated as the only competition to government bonds. The most conservative savers were forced out of gold and into government bonds. Astute bond speculators saw this as a oncein-a-lifetime opportunity to make a killing. They knew what the extra demand for government bonds was going to do to the bond price. They moved in to preempt the savers. They were determined to buy the bonds before the savers on the cheap. Indeed, by the time the savers arrived, the price of bonds was sky high and rising. The rate of interest went into a falling mode. Speculators turned the bond market into a casino, bidding bond prices off the charts.

Tampering with gold coin circulation caused internal hemorrhage in the economy. Falling interest rates increased the burden of all debt contracted earlier. They gobbled up profits beyond the endurance of enterprise, both productive and financial. The unwarranted sudden shift of wealth from debtors to creditors devastated the economic landscape. Business was made prostrate, firms went bankrupt in droves, unemployment snowballed.

There was more. Falling interest rates were translated into falling prices.

Easy money from the Fed backfired. It was intercepted by speculators who used it to buy even more bonds. The Fed had wanted them to buy commodities to stem the fall in prices. But the temptation to take the easy money to the casino of the bond market where gains were guaranteed and losses were on the house was irresistible. Instead of buying, speculators were selling commodities short, causing prices to fall further. They knew that the policeman, gold, guarding prices against falling into a bottomless pit, has been fired. A vicious spiral was set in motion: falling prices chased interest rates lower, and falling interest rates chased prices lower still.

Here is how the process would have worked, had gold coins been available. Savers would have taken profits by selling the overpriced bonds. They would have stayed invested in gold coins waiting for the bond price to come back from outer space**. When it did, they would have repurchased the bond at a profit, thus stabilizing the rate of interest at a level consonant with economic reality.

It is a canard due to wobbly logic to say that gold has a deflationary bias.

It was not the gold standard but the fetters put on it 
 including the confiscation of gold by Roosevelt in 1933 
 that was the true cause of the Great Depression.

The threat of another Great Depression today can be averted only through rehabilitating the gold standard 
 and through restoring honesty in dealings between government and citizens.

---

*March 4, 2012.*


The other was the illegal introduction of open market operation by the Federal Reserve in the early 1920’s. It released the genie of bond speculation from the bottle, responsible for the prolonged decline of the rate of interest. The ineluctable bull market in bonds siphoned off the capital of productive enterprise, causing wide-spread bankruptcies and unemployment. **

Gold in this role is indispensable: it cannot be substituted by paper money, not even by gold certificates. Substituting paper money yielding zero interest for bonds yielding some, however little, is akin to jumping from the frying pan into the fire. Substituting the gold coin is different. It means substituting a present good for a future good, prompted by time preference.

### ______________________________________________

## Announcement

### New Austrian School of Economics

### Course Four Munich, Germany

March 24 - April 2, 2012

Title of the course:

### The Austrian Theory of Money, Credit, and Banking

This is the fourth in a four-course series on Austrian Economics, a branch of economic science based on the work of Carl Menger (1840-1921). It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. The complete program consists of four courses (10 days, 20 lectures each). Completion of each course will earn one credit.

Participants who have accumulated four credits get a diploma signed by Professor Fekete.

CourseOne that was given in 2010 and courses Two and Three that were given in 2011 are not a prerequisite. All three are available on DVD for purchase.

For further information or in order to register for the course you can get in contact with the organizers Ludwig Karl and Wilhelm Rabenstein via mail ( nasoe@kt-solutions.de ) or phone ( +49 – 170 – 380 39 48 , before calling please consider a possible time lag).

You might also want to take a look at the New Austrian School of Economics on Facebook: [www.facebook.com](https://www.facebook.com/newasoe)

---

# A Tale of Two Schools

URL: https://newaustrianeconomics.com/archive/fekete/a-tale-of-two-schools/
Date: 2012-02-13
Section: Popular Economics
Difficulty: intermediate
Concept Tags: new-austrian-economics, real-bills, gold-basis, mises, gold-standard
Description: Fekete compares the New Austrian School with the old Austrian School (Mises-Rothbard), identifying where they agree (critique of central banking, support for gold) and where they diverge (Real Bills Doctrine, basis analysis, gold bond). He argues the New Austrian School corrects specific theoretical errors in the old school while preserving its core insights.
Editorial Note: Written February 2012. One of Fekete's clearest comparative statements of the New Austrian School versus the Mises-Rothbard tradition, useful for understanding where his work fits in the Austrian canon.
Original PDF: https://professorfekete.com/articles/AEFATaleOfTwoSchools.pdf

The New Austrian School of Economics (NASE) will celebrate its tenth anniversary this year. Under different names in different locations it has attracted many a student from all parts of the world. Its next session will take place from March 24 to April 2, 2012. It looks like NASE has found its permanent home in Munich, the capital of Bavaria where it will offer two ten-day (twenty-lecture) sessions twice a year, in the Spring and in late Summer.

The first Ph.D. degree will be awarded at the coming Spring Session.

### Why two Austrian Schools?

I have never addressed this question in public before. NASE goes back to the fountainhead of Carl Menger. This fountain is still gushing forth in its original purity and splendor while our tragedy, the most devastating credit collapse in world history that Menger foresaw a hundred years beforehand, is unfolding.

Although I am admiring Ludwig von Mises as the greatest economist of the 20th century, it has not been possible for me to analyze some of the notions of Mises deviating from Menger’s original vision in the cultist atmosphere of the American Austrian establishment for reasons of its intolerance. These deviations have mostly to do with the theory of interest. In my view the dogmatic approach of Mises is not in the spirit of Menger. Unlike his teacher, Mises embraced the Quantity Theory of Money without carefully delineating the extremely narrow limits of its validity. Moreover, Mises categorically rejected the idea of interest as a market phenomenon. Not only is his intransigence contradicted by empirical facts, but it also represents a break with Menger’s own methodology.

### The evolution of interest

Interest is not a matter for postulating apodictic truths. Rather interest, as money itself is the result of a long evolution. In the case of money we are looking at the evolution of direct exchange, culminating in the indirect exchange of goods. In the case of interest we are looking at the evolution of direct conversion of income into wealth and wealth into income through hoarding and dishoarding, culminating in the indirect conversion through exchanging rent-charges, bonds, and other similar instruments.

But beyond the taboo on reading Mises critically I have found that the approach of the American Austrians is far too superficial. Take for example the burning problem of the impending collapse of the international monetary system staring us in the face. It should be obvious that the problem cannot be solved without Adam Smith’s Real Bills Doctrine (RBD). Love them or hate them, real bills will start circulating spontaneously in want of other media of exchange.

Gold will be unavailable as it will have gone into hiding, and it will be a painfully slow process to coax it out.

### The Real Bills Doctrine

American Austrians refuse to accept the wisdom of Adam Smith’s RBD. They believe that there is plenty of monetary gold to go around to finance the myriad of transactions of our complex, many-faceted world economy. Even if there was, gold would be a fetter upon technological progress as it would hamper the further refinement of division of labor. To avoid this deflationary bias, it will be necessary in the future, as it has been in the past to augment the stock of monetary gold by granting limited and ephemeral monetary privileges to the next best thing to gold, namely real bills – relying, as they do on self-liquidating credit. Real bills mature into gold coins in 91 days or less (91 days being the length of the seasons at the end of which demand for consumer goods changes).

They are paid out of the proceeds of the sale of consumer goods in most urgent demand using the gold coins released by the consumer. They are not inflationary because real bills arise simultaneously with and in consequence of the production of new goods most urgently demanded by the consumers. Moreover, real bills expire as these goods are removed from the market by them.

A most recent restatement of the position of the American Austrians on

RBD can be found in The Daily Bell interview with Dr. Joseph Salerno of Pace University (July 3, 2011). Salerno vigorously rejects the “age-old fallacy” (mark the fact that he shies away from mentioning Adam Smith by name) according to which regardless whether a bank provides mortgage finance or whether it discounts a real bill, it must increase its demand deposit liabilities. In doing so it increases the money supply and puts upward pressure on prices. Yet, in spite of Salerno’s sweeping equalization of these two banking activities, there is still a difference. Money provided for mortgage finance has been sunk into bricks and mortar which are among the most illiquid assets of all. By contrast, money from the proceeds of discounting real bills is financing the movement of goods in most urgent demand from the producers to the ultimate gold-paying consumers.

The liquidity of these bills is second only to that of gold itself and, better still, they are an earning asset in virtually unlimited demand by banks and others in need of quick assets. Note that the concept of liquidity (marketability by another name) is quintessential Menger. This has apparently escaped the attention of Salerno, as before him it had escaped the attention of Mises himself. NASE puts marketability at the very heart of its inquiry. It has refined the concept further by distinguishing between marketability in the small (a.k.a. hoardability), and marketability in the large (a.k.a. salability). As it turns out, silver is the most hoardable and gold is the most salable good of all. This explains the duality of the monetary systems before 1873, when silver was foolishly demonetized by the governments of Western countries.

According to an aphorism on Lombard Street of old, long since forgotten, there is no easier profession in the world than that of the banker, as long as he can tell a real bill and a mortgage apart. Detractors of RBD may do well to brush up their knowledge of the principles governing pre-1936 banking theory, especially the part on self-liquidating credit (a phrase Mises never used except to ridicule it, in calling it Deus ex machina).

### Interest rate versus discount rate

Salerno also believes with Mises that there is no substantial difference between the rate of interest and the discount rate. He says that if banks persisted in maintaining the rate at which they discounted real bills below the natural rate of interest, then they would generate a torrent of real bills for discounting, that would cause an inflationary spiral of money-creation and price increases.

The difference of the discount rate from the rate of interest is fundamental, all declarations to the contrary notwithstanding. Mises considered the former to be a short-term interest rate with interest payment collected at the beginning of the loan period rather than at the end. However, the fundamental difference is far more important than this technicality. The concept, the sources and the formation of the two rates are very different.

Interest is paid by the debtor to the creditor on loans. Discount is paid by the lower to the higher-order producer of the maturing consumer good. No loan is involved in discounting. Neither one of the two producers is subordinate to the other. They are like the two blades of a scissor. Take away either one — no cutting is possible. At any rate, it is ridiculous to suggest that the lower-order producer is in debt to the higher-order producer. The former handles merchandise that is one step closer to the consumer. For this reason alone the former controls a good commanding higher marketability. The dependence of the latter on the former is obvious.

The confusion of the two rates gives rise to a long string of serious errors.

The rate of interest takes its origin in the propensity to save; the discount rate takes its origin in the propensity to consume. The propensity in either case varies inversely with the rate itself. Consumer demand is satiated through the very act of consumption. This means that consumption causes the discount rate to rise, rather than to fall — as Salerno would have us believe. The banks have no mythical power over the discount rate; they must follow the wishes of the sovereign consumer. Thus, by definition, there can be no torrent of real bills triggering an inflationary spiral and price increases. Salerno’s analysis is shallow without any redeeming features.

The mission of NASE is to go back to the unpolluted sources: to Carl Menger’s theory of the origin of money; to his all-important concept of marketability; and to his consistent application of marginalism. For example we at NASE talk about the principle of marginal time preference. It asserts that, when the rate of interest falls below his marginal rate, the marginal bondholder will sell his bonds (a future good) and with the proceeds will buy gold (a present good). This gold/bond arbitrage of the savers is anathema to Mises-worshippers because they think that Scrooge, the Prodigal Son, and everybody else have exactly the same time preference. The truth, however, is that there is a whole spectrum of different rates of time preferences from that of Scrooge to that of the Prodigal Son. The critical one, the rate of marginal time preference marking the point where the marginal bondholder will sell his bonds, is decisive. It has a crucial role to play in preventing the rate of interest from falling through the floor. The mechanism through which it does that is the bond market. After all is said and done, interest is a market phenomenon.

Furthermore, according to Mises paper promises to pay gold to bearer, nay, even fiat money promising to pay nothing, is a present good. He explicitly stated that a gold certificate, if its security cannot be doubted, is just as much a present good as the gold coin itself. Heck no, it isn’t, and the marginal bondholder knows it. If he accepted such a promise, however secure, in exchange for his bond, then he would be jumping from the frying pan right into the fire. He would be worse off than if he held on to his bond. The bond at least pays interest at a positive rate, however low it may be. By contrast, paper promises of gold such as a gold certificate pay interest exactly at zero percent.

The bondholder’s avowed protest against low interest rates would be counterproductive. The conclusion is that the principle of time preference as formulated by Mises is utterly inadequate. It is a paper tiger having no effect whatsoever on the condition it is supposed to rectify. It leaves all the victims of Bernanke’s ZRP helpless.

But as those who have eyes to see can see, even in the fast-degrading monetary system of ours marginal time preference — as opposed to the time preference of Mises which is hardly more than a pious wish — is alive and kicking. Savers from individuals to pension funds to central banks are selling their bonds in a panic and rush to buy gold with the proceeds in response to zero interest rates. This is marginal time preference in action.

We may conclude that the American Austrian establishment is badly in need of a critic. NASE has volunteered to serve as one, but the offer was rejected.

It is regrettable that American Austrians are deaf to criticism of any kind. Mises was a modest man. He never thought that his had to be the last word. He severely castigated those who would settle arguments by calling names. I sincerely hope that we can have a conference where arguments on both sides can be presented without fear and favor, and let the best argument win. So far, any suggestion of this kind was refused out of hand. I would be personally very happy to participate in a public debate with Dr. Salerno.

This is no time for fratricidal bickering. The survival of our civilization is at stake.

February 13, 2012.

---

### Announcement · New Austrian School of Economics

### Course Four · Munich, Germany · March 24 – April 2, 2012

**Title of the course:**

### The Austrian Theory of Money, Credit, and Banking

This is the fourth in a four-course series on Austrian Economics, a branch of economic science based on the work of Carl Menger (1840–1921). It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. The complete program consists of four courses (10 days, 20 lectures each). Completion of each course will earn one credit. Participants who have accumulated four credits get a diploma signed by Professor Fekete. Course One that was given in 2010 and courses Two and Three that were given in 2011 are not a prerequisite. All three are available on DVD for purchase.

For further information or in order to register for the course you can get in contact with the organizers Ludwig Karl and Wilhelm Rabenstein via mail (nasoe@kt-solutions.de) or phone (+49 – 170 – 380 39 48 — before calling please consider a possible time lag).

You might also want to take a look at the New Austrian School of Economics on Facebook: [www.facebook.com](https://www.facebook.com/newasoe)

---

# Premature Obituaries

URL: https://newaustrianeconomics.com/archive/fekete/premature-obituaries/
Date: 2012-01-19
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, gold-basis, sound-money, fiat-currency
Description: Fekete responds to commentators who have declared the gold standard dead, arguing that the obituaries are premature. Gold has not left the monetary system — it has merely been suppressed. The evidence of this suppression, visible in the gold basis, shows that gold's monetary function continues beneath the official denial.
Editorial Note: Written January 2012. The 'premature obituaries' title alludes to Mark Twain's famous line — Fekete argues reports of the gold standard's death have been greatly exaggerated.
Original PDF: https://professorfekete.com/articles/AEFPrematureObituaries.pdf

## Premature Obituaries

### Antal E. Fekete

It is open season for wild monetary prognostications. More premature obituaries on the dollar have been posted on the Internet. For example, see Jim Willie’s The US Dollar Paper Tiger (Gold-Eagle, January 11) with epitaphs like “the U.S. dollar rising to the cemetery”, or “dollar death dance”. Or see another article, Jeff Nielsen’s entitled Maximum Fraud in U.S. Treasurys (Gold-Eagle, January 3). It betrays maximum misunderstanding about keeping the dollar on a life-support system. It assumes that the Fed and the U.S. Treasury are fighting tooth and nail to keep the value of government debt high lest it collapse in want of support from Japan, China, and other countries.

These views hang the picture upside down. In actual fact, the Fed and the

U.S. Treasury desperately want to beat down the value of the dollar. The greatest obstacle frustrating their effort is the stubbornly high and still increasing value of U.S. Treasurys. Captains of the world’s monetary system are yanking levers and twisting throttles which are no longer connected to anything. The captains are no longer in control. Yet they continue to wave their batons feverishly and pretend that the orchestra is paying attention. They want Jim Willie, Jeff Nielsen and everyone else to believe that the falling interest-rate structure is the outcome of their deliberate monetary policy. In fact, the Fed and the U.S. Treasury are trying to stop the rate of interest from falling further. They instinctively realize the threat of falling interest rates brings deflation and depression in its train. The dollar is much too strong, contrary to the wishes of policy-makers. It is not so easy to beat down the value of the dollar as suggested by Keynesian textbooks, even if you have the key to print shop where the presses are running. The dollar’s strength prevails in spite of the withdrawal of Chinese and Japanese support of the U.S. bond market, and in spite of the destructive monetary policies of the American guardians of the dollar.

This observation reveals the prevailing profound misunderstanding about the nature of this financial crisis. To set the matter right, in this article I shall recapitulate the argument that I have been presenting on the Internet for the past ten years.

### Where Keynes went wrong

At the heart of my theory is speculation, the main driving force of the huge oscillating money flows between the commodity market and the bond market. It can, and often does, overrule official monetary policy.

It is well-known that Keynes had a poor understanding of speculation. His occasional excursions to the pits resulted in significant financial losses for him. No more successful was he as a theorist. For example, he introduced the concept of normal backwardation as the main underlying feature of the futures market. He insisted that in buying futures contracts speculators demand ─ and receive ─ compensation for their services as ‘insurers’ in return for carrying the price risk that owners of physical commodities and first order financial assets are unable or unwilling to carry. First order financial assets such as stocks, bonds, foreign exchange, mortgages must be carefully distinguished from higher-order financial assets such as futures and options on first order financial assets, options on futures, options on options on futures, and so on and so forth ad libitum. Keynes did not live to see the rise of higher order financial assets. He called the insurance premium speculators pocket when their contracts mature ‘normal backwardation’.

Backwardation is the name for the market condition under which futures are offered at a discount relative to physicals. Keynes is putting things upside down.

The futures market, far from being an insurance-operation, is in fact a market for warehousing services. The warehouseman buys the physicals and sells the futures as a matter of arbitrage. But he can do that only if the future price is at a premium over the cash price. This condition is known as contango, which is the exact opposite of backwardation. For example, at harvest time cash wheat is plentiful and contango is robust. The elevator operator, our warehouseman, is buying cash wheat against selling wheat futures. In doing so he performs a useful service to society: that of warehousing and rationing the wheat supply until the next crop comes around a year later. The premium, the difference between the futures price and the cash price is his fee for the service. To create this arbitrage opportunity was the main justification for starting futures trading in wheat and in other agricultural commodities in the 19th century, when the monetary unit was a positive rather than a negative value. Notice that nature is responsible for the fluctuation in the price of agricultural commodities: weather, unforeseen natural disasters, climes and other things over which man has no control.

All this has changed when, at the behest of Keynes, governments exiled gold from the monetary system and embraced a negative value, debt, as the monetary unit. As an immediate consequence a lot of new futures markets sprang up, chief among them the futures market for foreign exchange and the bond market. In these the cause of fluctuation was no longer nature. Instead of nature-created risks, here futures trading addressed artificial risks created by man. Keynes blithely assumed that futures trading would have the same stabilizing effect on the price of these financial assets as it did in on the price of agricultural commodities. This was his worst blunder. When man or a committee of men rather than nature calls the shots, speculation becomes destabilizing. The nature of speculation has changed beyond recognition. In the first scenario when nature alone calls the odds all speculators start with equal chances. No combination of bets is capable of changing the odds.

This is no longer the case when risks are man-made. In this case speculation assumes the character of gambling. Here speculators (gamblers) are matching their wits against that of the house. Here, given a bottomless purse, a combination of bets can indeed change the odds. The gamblers can even beat the house. We have seen it happen time and again: speculators in foreign exchange or bonds won and the government or the banks had to take huge losses.

### The Law of Vanishing Contango

It would be more reasonable to talk about normal contango than about normal backwardation, the obsession of Keynes. Backwardation in many ways is an anomaly. If and when it occurs, it indicates scarcity. In case of scarcity there is no need for warehousing. Keynes got it all wrong.

The problem of warehousing applies to gold par excellence, which owes its status as the monetary commodity (independently of the wishes of governments and banks) to the size of stocks which are large relative to flows which are meager.

The stocks-to-flows ratio of gold is a high multiple, in contrast with that of copper, for example, which is a small fraction for reasons of its fast declining marginal utility.

If gold is forcibly divorced from money by order of the government, or to say it differently, if a negative value such as debt is foisted upon society as the new monetary unit, then the price of gold will fluctuate inviting speculation and gold futures trading. The gold futures market, if it is to function at all, must be a contango market. Otherwise it would give an opportunity to speculators to make risk free profits (they would buy gold futures at a discount and sell cash gold at a profit). That would immediately eliminate the discount on gold futures (making a mockery of Keynes’ normal backwardation.) However, in the case when gold is scarce as a result of flight from paper currencies, permanent backwardation of gold puts in an appearance. This sounds the death knell of the regime of irredeemable currencies.

Not only did Keynes misunderstand speculation, but he also completely misconstrued the God-ordained role of gold in society. He did not see that variable foreign exchange rates would ultimately undermine paper currencies and bond values due to gold hoarding. Moreover, vanishing confidence in foreign exchange rates and bond values could be directly measured in terms of vanishing contango.

Ultimately, all monetary gold would be driven into hiding. The biblical writing on the wall “Mene tekel upharsin” (you have been put on the scale and found wanting) would become reality in a literal sense.

Ever since gold futures markets started trading in the early 1970’s, they were subject to the Law of Vanishing Contango. It was never properly understood by the so-called experts or by anyone else. While nobody could predict when contango would go into permanent backwardation, it is certain that when this ominous event happens, the music stops and the game of musical chairs is up. Mainstream economists ignore the problem of permanent backwardation in gold. They do it at their own peril. Keynesian/Friedmanite economics is going to be shipwrecked on the reef of permanent backwardation. Irredeemable paper currencies which they have spawned will be ignominiously wiped off the face of the earth.

### Economic resonance

When at the behest of Keynes foreign exchange rates were deliberately destabilized, a couple of other ominous things happened. Most importantly, interest rates were also destabilized that made an old phenomenon, the Kondratiev longwave cycle self-boosting, leading to runaway-vibration. As may be recalled, this rather rare physical phenomenon caused the Tacoma suspension bridge in Washington state plunge into the river in 1940. Parcels of energy bombarding the bridge in gusting winds resonated with one of the characteristic harmonic frequencies of the bridge. As a result total energy, rather than dissipating harmlessly, kept piling up. It ultimately overwhelmed the statics of the bridge.

Engineers have forgotten to take runaway resonance into account when the bridge still existed only as a blueprint. Likewise, designers of the regime of irredeemable currency have failed to consider economic resonance. Runaway vibration exists in economics whether recognized or not. It can destroy currency and bond values just as it can destroy bridges.

I describe the present economic crisis in terms of economic resonance. The economy experiences oscillating money-flows between the commodity market and the bond market. When money flows from the bond market to the commodity market, we witness the inflationary phase of the cycle. Inevitably, rising interest rates accompany this phase. At the top of the cycle the money-flow will reverse itself and will go from the commodity market to the bond market. This is the deflationary phase of the long-wave cycle that, no less inevitably, is accompanied by falling interest rates. These huge money-flows are driven by speculation. There is a linkage between the price level and that of interest rates compelling them to move in the same direction (always subject to leads and lags). Furthermore, the two resonate. It is altogether too naïve to suggest that the government is equipped to control the phenomenon of economic resonance. As the story of King Canute shows, tides of the sea cannot be turned back by royal proclamation.

For centuries the Kondratiev cycle has been kept on a leash. Resonance was always damped so that vibration could never reach runaway levels. Neither prices nor interest rates were allowed to grow indefinitely. At one point the policeman would stop their march and turn them back. The policeman was none other than the gold standard.

The regime of irredeemable currency fired the policeman and resonance has become self-boosting. Runaway vibration is in the making. When the energy level of the self-boosting system overwhelms centripetal forces, the system snaps like a broken chain, releasing the surplus energy most destructively. This is the substance of every crack-up boom. Like Mises, I also object to the use of the word hyperinflation, albeit for a different reason. It suggests that the phenomenon is linear and follows the laws of the Quantity Theory of Money. The more money is printed, the higher do prices go. However, we are here facing highly non-linear phenomena. Our economy is torn to pieces by runaway vibration. We are victimized by the self-destruction of the monetary system subjected to oscillating money-flows boosted by the resonance of fluctuating interest rates resonating with fluctuating prices.

### The vampire of risk free bond speculation

Another ominous thing happened when, at the behest of Keynes, foreign exchange rates were deliberately destabilized. Monetary policy has become counterproductive. When the central bank intervenes in the market to control the rise of interest rates, it inadvertently makes prices fall; and when it intervenes to stop prices from falling, it inadvertently makes interest rates rise. The upshot is that the central bank intervention, rather than tempering movements, aggravates them.

Once more, the source of the trouble is Keynes’ poor understanding of the dynamics of speculation. Whether combatting inflation or whether combatting deflation, the central bank has only one policy tool, namely, printing more money.

Keynesian economics pretends that the central bank operates in vacuo. It can assume away any and all side effects. But there is one side effect it certainly cannot wish away, and that is bond speculation that follows the central bank like the shadow follows the thief. The bond market is huge, exceeding the equity market in size more than ten-fold. Equally huge is its speculative following.

When the central bank wants to control rising interest rates, then it goes into the open market to be a net buyer of Treasury bonds. Inevitably, speculators want to preempt the central bank. They strive to buy the bonds first, dumping them into the lap of the central bank at a higher price afterwards. Speculators are making risk free profits. The central bank is helpless. It has to pay the speculators’ price.

Likewise, when the central bank wants to control falling prices, it goes into the open market to be a net buyer of Treasury bonds. Speculators will gratefully take the new money so created. Of course, the central bank wants them to buy commodities to prevent prices from falling. However, speculators have a better idea. They go to the bond market where the fun is. Commodities are too risky for their taste, especially when they can make risk free profits in bonds. The risk free profits speculators make are made possible by Keynesian monetary policy.

This is the fundamental flaw of Keynesian economics. At the present junction the Fed is buying bonds to combat deflation. Bond speculators know this, will buy the bonds first, driving down interest rates in the process. The result is more deflation, not less. The Keynes-inspired central bank action is counterproductive. Policy-makers are blind and don’t see this. They stick to their selfdefeating monetary policy. They actually become the quartermaster general of the depression they are trying to avoid. As if cursed by a particular kind of madness, policy makers saddle society with the vampire of risk-free speculation. They turn the constructive energy of stabilizing speculation into a most destructive kind of energy: destabilizing speculation. The problem cannot be cured because bond speculation cannot be eliminated. It should be clear that as long as the world does not succumb to a military conflagration such as a world war destroying supplies of goods and production facilities, the danger is not inflation as predicted by the Quantity Theory of Money. The danger is deflation due to risk free-profits with which Keynesian economics inadvertently tickles speculators.

It is suggested that the world is facing an imminent inflationary collapse of the dollar for reasons of over-issue. But what the world is getting is a deflationary collapse of the economy, as a result of the obtuseness of academic economists and policy-makers sold on Keynesian economics. They fail to see in the collapse of the rate of interest the inherent destruction of capital. Businessmen are lethargic. They know that making new investments while interest rates keep falling is suicidal. No matter how low interest rates may go, their competitors who invest later will have the advantage of investing at lower rates still.

### Destruction of the wage fund

The German economist Heinrich Rittershausen (1898-1984) predicted the horrendous unemployment that was to hit the world economy in the 1930’s in terms of the destruction of the wage fund. He pointed to the failure after World War I to rehabilitate the real bill market. The victors in their conceitedness ignored the fact that the wage fund, out of which workers could be paid up to 91 days in advance of the sale of merchandise they are producing, was part of the volume of circulating real bills. When the bill market was destroyed in consequence of the deliberate decision not to allow real bill circulation to return after hostilities ended, the wage fund was destroyed along with it. There was no one to advance the funds out of which wages could be paid for labor whose product has not been and may not be sold for up to 91 days. But workers could not wait 91 days to buy food, clothes and shelter for themselves and for their offspring. In the absence of a wage fund employers had no choice but to lay off their employees.

Rittershausen was ignored by economists in the Anglo-Saxon countries. His message is still being ignored in the world today. But make no mistake about it, unless gold bill trading is rehabilitated soon, the world will face a new wave of unemployment far worse than that of the 1930’s. This also confirms the deflationary diagnosis for the present crisis.

The majority of hard-money analysts call for a hyperinflationary collapse of the dollar. Their analysis is faulty. Like a cornered rat, the dollar is capable of putting up a vicious fight for survival. In the words of Mark Twain, all the obituaries on the dollar are premature. The dollar is not a push-over. A yen-yuan coalition (or any other combination of existing or yet to-be-invented fiat currencies) cannot send it into oblivion.

To say that the dollar is strong is not the same as saying that is also healthy.

In fact the irredeemable dollar is terminally ill. The reason for this is its departure from constitutional money. The Constitution mandates a metallic monetary system for the United States. Nothing shows the bad conscience of our monetary leadership more clearly than the fact that they could never muster up enough moral courage to propose a Constitutional amendment giving the federal government the power to establish a monetary unit based on negative values such as debt.

Cheerleaders for fiat money in academic circles, in the media, and in financial journalism will not be able to live down the shame that will be their lot when the world economy collapses. The excruciating economic pain that people will suffer as a consequence will be their responsibility. The break-down in law and order will be their fault. As history and logic conclusively prove, fiat money is not a viable monetary system. It is prone to succumb to the sudden death syndrome. Whether caused by inflation or whether caused by deflation, sudden death is assured.

It should not be beyond the wit of human intelligence to see this coming and fend off the disaster by making a timely return to sound money, based on a monetary unit of a positive value as mandated by the American Constitution.

January 19, 2012. —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  — ANNOUNCEMENT New Austrian School of Economics

### Course Four Munich, Germany from March 24 - April 2, 2012

Title of the course:

### The Austrian Theory of Money, Credit, and Banking

This is the fourth in a four-course series on Austrian Economics, a branch of economic science based on the work of Carl Menger (1840-1921). It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. The complete program consists of four courses (10 days, 20 lectures each). Completion of each course will earn one credit. Participants who have accumulated four credits get a diploma signed by Professor Fekete. Course One that was given in 2010 and courses Two and Three that were given in 2011 are not a prerequisite. All three are available on DVD for purchase.

For further information or in order to register for the course you can get in contact with the organizers Ludwig Karl and Wilhelm Rabenstein via mail ( nasoe@ktsolutions.de ) or phone ( +49 – 170 – 380 39 48 , before calling please consider a possible time lag).

---

# Mainstream Economists' Monetary Insanity

URL: https://newaustrianeconomics.com/archive/fekete/mainstream-economists-monetary-insanity/
Date: 2011-12-21
Section: Popular Economics
Difficulty: accessible
Concept Tags: federal-reserve, monetary-policy, new-austrian-economics, fiat-currency, capital-destruction
Description: Fekete's year-end survey of what he considers the monetary insanity of mainstream economics in 2011 — the doubling down on quantitative easing despite its failure, the dismissal of gold as a monetary standard despite its performance, and the continued misdiagnosis of the financial crisis as a demand problem rather than a monetary disorder.
Editorial Note: Written December 2011 as a year-end retrospective. Fekete's combative title signals his frustration with the profession's continued adherence to frameworks that his analysis had thoroughly discredited.
Original PDF: https://professorfekete.com/articles/AEFKrugmansMonetaryMadness.pdf

*Mainstream Economists’ Monetary Insanity*

**Antal E. Fekete**

Paul Krugman’s article in the December 15 issue of The New York Times under the title G.O.P. Monetary Madness takes G.O.P. presidential candidate Dr. Ron Paul to task for his ‘ideological’ stand on money. For excellent reasons, not all of which had to do with fear of a Zimbabwe-style hyperinflation, the Constitution explicitly prohibited manipulation of the dollar such as Bernanke’s threefold increase of the monetary base in three years. Krugman ruefully reports that the ‘hard money doctrine and the paranoia about inflation’ took over the G.O.P. that has, up until now, meekly followed Keynesian precepts about pump priming and turning the stone into bread through pushing interest rates all the way down to zero.

According to Krugman, in spite of the ‘false alarm’ sounded by the Austrian economists over the debasement of the dollar, inflation is still only 1.5 percent. ‘Who could have predicted that so much money printing would cause so little inflation?’ he asks rethorically. ‘Well, I could, and I did’, he boasts, ‘because I understand Keynesian economics that Mr. Paul reviles.’

In the event, unknown to Krugman, I also predicted the same thing. Unlike Krugman I did more than simply predicting that inflation was not the danger. I warned that Keynesianism would lead to deflationand depression. Money-printing has become counterproductive. Krugman doesn’t understand that it will boomerang. I stated that, unwittingly, Bernanke is the Quartermaster General of the Great Depression II (see: Front-Running the Fed, [www.professorfekete.com](https://www.professorfekete.com), February 9, 2010). He doesn’t understand the monstrous mistakes prophet Keynes made concerning the role of speculation in the money-creation magic. The fact is that central bank buying makes speculation risk free in the bond market. In comparison, speculative risks in the commodity market appear forbidding. All the speculator has to do in order to reap risk-free profits is to preempt the Fed. He buys the bonds before the Fed has a chance. Then he turns around and dumps them into the lap of the Fed at a profit. The Fed is helpless: it must buy at the higher price.

Keynes completely misrepresented the ability of the central bank to stay in charge, given its compulsive drive to suppress interest rates when confronted with a profithungry pack of bond speculators.

Friedman’s analysis of the Great Depression couldn't be more wrong. In

1933 deflation was brought about not by the gold standard but, au contraire, by abolishing it. Here is what actually happened. Roosevelt has removed the only competition government bonds have, gold. The most conservative investors saw their gold confiscated and, willy-nilly, they were forced into the next most conservative instrument, Treasury bonds. Speculators became emboldened and bid bond prices sky high for risk free profits. Had gold been still available, bondholders would have severely punished the speculators for their daredevilry.

They would have sold the overpriced bond and stayed invested in gold until bond prices came back to earth from outer space. Then they would have bought their bonds back at a profit.

In the absence of gold, speculators made interest rates go into a tailspin. That caused dominoes in the commodity market fall. Prices collapsed one after another.

Pieces on the chessboard started falling as well, symbolizing serial bankruptcies of productive enterprises. Breadwinners of families lost their jobs in droves as money flowed from the commodity market to the bond market in the wake of speculators selling commodities short while buying bonds hand over fist. All the while Keynes was rubbing his hands together behind the scenes exactly like Mephistopheles had in the famous paper money scene of Göthe’sFaust (Part Two).

The same thing is happening all over again. When a central bank increases the monetary base three-fold in three years, this is a clear invitation for bond speculators to move in and make a killing. But what the central bank utterly fails to understand is that, contrary to its hopes, new money is not going to the commodity market. Speculative risks there are far too great. Instead, new money is going to the bond market where the fun is. Bond speculation is risk-free. Speculators know which side the bread is buttered. Krugman doesn’t.

Dr. Paul is the conscience not just of the G.O.P., but of the entire nation.

Through inflation or through deflation, the mad orgy of money creation that makes mockery of the Constitution will finish the Keynesian agenda of ruining the nation and the world economy.

Krugman’s joy over the supposed defeat of Austrian economics is premature. Bernanke’s Fed in blissful ignorance is still putting money in the hands of speculators which they use to place bets on the further fall of interest rates and commodity prices. The day of reckoning comes when falling interest rates destroy capital and, together with it, destroy budding job opportunities. The lethargy of businessmen will continue. They will not start hiring as long as the interest-rate structure is in falling mode.

Welcome to the world of Keynes-inspired Great Depression.

---

*December 21, 2011.*

---

# What Chinese Unemployment?

URL: https://newaustrianeconomics.com/archive/fekete/what-chinese-unemployment/
Date: 2011-10-19
Section: Popular Economics
Difficulty: intermediate
Concept Tags: monetary-policy, capital-destruction, fiat-currency, interest-theory
Description: Fekete examines the paradox of Chinese unemployment claims in the context of China's rapid economic growth, arguing that the mainstream framework confuses the effects of monetary expansion with genuine productivity growth. He analyzes what sound monetary metrics would show about China's real economic performance.
Editorial Note: Written October 2011. Fekete applies his analytical framework to China's economic development, questioning mainstream assessments that ignore monetary distortions.
Original PDF: https://professorfekete.com/articles/AEFWhatChineseUnemployment.pdf

### What Chinese Unemployment?

### Antal E. Fekete

### “There is gold in them thar hills!”

Occasionally we read in various columns of mainstream journalists that the Chinese have shot themselves in the foot when they (in violence of Friedmanite precepts) failed to revalue their currency upwards. The world will retaliate by imposing punitive tariffs, creating horrible unemployment in China and causing civil unrest.

These journalists should be careful to make wishes, because they may just get what they’ve wished for. One of these days China may open its Mint to gold and silver, setting the example to Asia and the Muslim world and, possibly, to South America. Other countries may follow suit. That will be the ultimate revaluation that restores trade relations to normalcy, at least in that part of the world that returns to the gold standard.

There was a time when unemployment “insurance” and other forms of dole were unknown in the United States. That was the time when the country was on the gold standard and deflation meant an increase in the value

(purchasing power) of gold. Whenever this happened, the battle cry inevitably was: “There is gold in them thar hills”, and people who have lost their jobs typically went out prospecting and panning for gold. Pannig for gold always gave them an income and a chance to save some capital. The country did very well, thank you very much, with this “natural unemployment insurance”. The bottom line was: more gold for the economy. More gold cured the disease, deflation, and soon things were back to normal. Unemployment did not have a chance to become “structural”.

Of course, given the present anti-gold mindset as seen in the thinking of the Fed and the government today large scale prospecting for gold is prevented in the name of “protecting the environment”. Keynesian economists say that they have the perfect substitute for more gold coming to the economy, namely, printed paper money which also has the advantage that you can fine-tune its creation from a central control-panel, the central bank. What they forget is that their “ersatz” gold is highly counter-productive. Rather than easing the debt1 problem plaguing the economy, they make it worse thereby perpetuating, even aggravating the unemployment situation.

### Gold: the ultimate extinguisher of debt

By contrast, increasing gold production ameliorates economic stress, including unemployment and, above all, it sets a limit to the increase in total debt. Paying gold is the only ultimate extinguisher of debt. Any other method of paying down debt leaves total debt unchanged. It only shifts debt from one debtor to another.

Total debt in the world can only grow, never shrink. Ultimately all debt, good and bad, is shifted to the Treasury, creating a sovereign debt crisis. The toxic debt the Treasury has to absorb is destroying the credit of the government. When the crunch comes and pristine credit of government would be needed to reset the economy, it is no longer there. It has been spent. Instead, there is only “toxic sludge”.

This is the congenital failure of Keynesianism that cannot distinguish between capital and credit, good credit and bad credit, and it freely shifts items from the liability column to the asset column in the balance sheet of the government rendering the accounting system worthless.

Gold corpuscles in the monetary bloodstream attack toxic sludge and devour it. The monetary system has immunity-protection against bad debt. The total debt in the country is not allowed to grow without limit, as bad debt is constantly being eliminated. The monetary system of Keynes and Friedman has no ultimate extinguisher of debt, which is why it has produced a runaway debttower, destined to topple and bury the indifferent and unconcerned public underneath the rubble, as the twin towers of the World Trade Center did ten years ago.

### Exchange the beggar’s pan to the prospector’s pan!

Gold also has the uncanny property that it leaves the place where it is not appreciated and seeks out places where it is welcome. One such place in the world today is China. China knows how to become the world’s #1 gold producer. China knows how to double its gold reserves unobtrusively in a couple of years. Incredibly, the Chinese government openly exhorts its people, all 1,34 billion of them, to have gold (and silver) on hand for a rainy day. The advice is wise. There is no free lunch. Be prepared for adversity. Be self-reliant.

### Have gold. Don’t count on governmentally guaranteed unemployment

“insurance” and old age “security” payments: when you need it most, it just won’t be there.

Before any sizeable unemployment could develop in China, unemployed people will go prospecting and panning for gold, scurrying like industrious ants over China’s territory, all 3.7 million square miles (9.6 million square kilometers) of it. If that doesn’t do the trick, the Chinese have something up in their sleeves.

The Chinese have control over the price of gold. They can raise it by marginally bidding for more gold on the world market. The Chinese mean to control the global gold market through their marginal control of the gold price.

They won’t allow the gold price to run away on the upside. It is not in their interest at present. They are no gold bugs. But they have a superb understanding of gold (and, of course, silver). By contrast, Helicopter and Printing-press Ben has even poorer understanding of gold than his prophet, Keynes used to have.

Many a gold bug has the wrong strategy. He buys high and sells low. He cannot kick the bad habit. He should buy low and sell high. He should study the gold policy of China, that uses the throttle of the gold price to control the level of unemployment. Raising the gold price makes panning more profitable and prospecting more attractive, thus reducing unemployment.

On the other hand, the Chinese will stop a precipitous fall in the gold price only insofar as it is in China’s interest, to wit: as long as it is needed to help reduce Chinese unemployment.

### U.S. ineptitude concerning gold

The U.S. government seems to have missed an historic opportunity to win the race for monetary supremacy in the world (that would have secured the “reserve currency” status for the dollar for the 21st century regardless of Chinese ambitions). The ineptitude of Fed and Treasury officials concerning gold brings shame to a country that prides itself with its leading position in global scientific research. The present financial crisis in the world is a gold crisis. It cannot be properly diagnosed without an analysis of gold’s economic role in serving as the only ultimate extinguisher of debt a role gold has played for thousands of years, as far back as written records exist, up to the fateful year of 1971. It was exactly forty years ago that the U.S. defaulted on its international gold obligations. To “stonewall” the shame following the fraudulent breach of contract as shadow follows the thief, the U.S. government listened to the Mephistophelian advice of Milton Friedman. It was he who suggested it to Nixon to turn defeat into victory, and shame into triumph, by “letting the dollar float”. The world must be told, Friedman suggested, that this major defeat of superstition was long overdue. Gold is a make-belief asset. Just let the world’s central banks announce that they have stopped “supporting” gold, and may soon start selling it.

### Green cheese factory on the Potomac

Then, lo and behold, the rats will start abandoning the sinking ship. People will start selling gold hand over fist. Just let the world’s central banks announce that they have started accumulating U.S. government debt. Then, lo and behold, the miracle of turning stone into bread and water into wine can be routinely performed by monetary technicians through lowering the rate of interest, if need be, all the way to zero. The world will forgive the do-gooder government the technical slip of failing to meet debt-payment in gold.

As Keynes observed: people want the Moon. But they cannot have the Moon. The Central Bank will have to tell people that green cheese is just as good, and that they can have. With that piece of advice the Central Bank can turn all its resources to green cheese production. Never mind that green cheese may rot, especially if it is used as a store of value.

### Harakiri

### Western style

This kind of thinking has animated U.S. monetary and fiscal policy for forty years. It took that long to dissipate the credit of the U.S. government the result of two centuries of working hard and saving hard.

There followed a systematic persecution of those economists who warned of the danger of fiat money ultimately losing all its value. There has never been a successful experiment making irredeemable currency stick. All such experiments in history have come to grief and caused excruciating economic pain to the people. To try the experiment once more and force the rest of the world to follow the U.S. into the abyss was harakiri Western style.

It was criminal to silence and exile critics through official discrimination and slander. The evidence was available almost instantly after 1971 that the U.S. was on skid row and it was going to be very difficult if not impossible to turn it around. Foreign exchange, commodity prices, interest rates, bond prices were promptly destabilized in 1971. The labor market started to hemorrhage jobs as high-paying manufacturing employment migrated eastwards.

### Kamikaze

### American style

Low wages in China do not explain this phenomenon. Western industry could coexist with low wages in the Orient under the gold standard. But after the fraudulent and violent overthrow of the old monetary order, gold started migrating East, taking those high-paying manufacturing jobs with it.

At this point the Friedmanite bunk was announced by professors who were the beneficiaries of the purge of old-line economists at American universities that a “weak” currency is boon to the country. It makes exports cheap while making imports dear. Trade deficits plague you? No problem. Just fine-tune the value of your currency downwards. Bingo! Exports will soar and imports will go to a trickle.

The advice that devaluing the currency has a salutary effect of the trade balance is akin to the advice that for the champion, to win the race, the amputation of a limb will be salutary. The Friedmanite bunk started a worldwide headlong rush into competitive currency devaluation (some people aptly call it the “race to the bottom”).

The theory of Milton Friedman, suggesting that the floating dollar system is a self-balancing mechanism capable of rectifying trade flows: it will boost exports and rein in imports is the most vicious theory ever concocted. It is a disgrace besmirching American science, hurting the American public, and bankrupting the American government. To see the Friedmanite bunk in the true light of science we need only recall that devaluation always makes the terms of trade of any country deteriorate. The euphoria of exporting more will last only as long as the stockpiles of imported ingredients used by the exporting industry last. Ever after, the country will have to pay more for the imported ingredients.

It will also get less value for units of its exports a double whammy that is certain to make trade imbalance deteriorate further. This was kamikaze American style. America has succeeded in devaluing itself to the poorhouse, destroying its once fabulous export industry along the way.

### “Après nous le déluge”

The worst aspect of our misery is that in putting Keynesians and Friedmanites in charge of our economy and monetary system we have condemned ourselves to eternal slavery. Previously, elected or unelected officials could be recalled and given a dishonorable discharge in case of failure. Not any more, not in the realm of economic and monetary policy-making. The worse mistakes monetary officials make, the more power they are entitled to grab. You could never make these guys admit that they have been wrong. They know that the power they now have, the power to print money, is unlimited power. They will never give it up. Après nous le deluge.

---

*October 19, 2011*

### Calendar of Events

Symposium on Gold in collaboration with the New Austrian School of Economics; University of Auckland, Business School, Auckland, New Yealand.

November 28 – December 2, 2011

With the participation of:

Professor Fekete, Louis Boulanger, Sandeep Jaitly, Rudy Fritsch, Keith Weiner.

A ten-lecture event focusing entirely on gold’s historical and future role in the world’s monetary system. A primer on gold basis and cobasis.

For further information, please contact Louis Boulanger at louis@lbnow.co.nz .

See also: [lbnow.co.nz](http://lbnow.co.nz/goldsymposium) .

---

# 140 Years of Silver Volatility

URL: https://newaustrianeconomics.com/archive/fekete/one-hundred-and-forty-years-of-silver-volatility/
Date: 2011-09-06
Section: Popular Economics
Difficulty: intermediate
Concept Tags: silver, bimetallic, gold-standard, sound-money, monetary-policy
Description: Fekete analyzes 140 years of silver price volatility — from 1871 to 2011 — arguing that the extreme volatility is not a natural property of silver but a consequence of its demonetization. When silver functioned as money, its price was stable; the post-demonetization volatility reflects the loss of the monetary anchor that stabilized silver's purchasing power.
Editorial Note: Written September 2011 as silver prices were extremely volatile. Fekete's historical perspective grounds the volatility debate in monetary history rather than market technicals.
Original PDF: https://professorfekete.com/articles/AEF140YearsOfSilverVolatility.pdf

140 YEARS OF SILVER VOLATILITY professorfekete An interview was published on July 6, 2011, with the title Eric Sprott – Paper Markets Are a Joke: Prepare for Bullion Prices to Go Supernova. Interviewer: Chris Martenson, Ph.D. (See: [www.financialsense.com/node/5777](https://www.financialsense.com/node/5777)) One of the questions Martenson asked was gold versus silver as an investment. Sprott came out on the side of silver that should trade at the hallowed gold/silver price ratio of 16 to 1. His argument is that gold and silver coins are destined to come back and circulate, so while the gold coinage will take care of large, the silver coinage will take care of small purchases − just as they did when the monetary system of the United States was established at the turn of the 18th century.

Gold at \$1900 and silver at \$45 gives you a gold/silver price ratio of 46.

This suggests that in spite of the fast appreciation of silver for the past year, it has to keep appreciating faster still in the future to meet the target ratio of 16 to 1.

Let’s accept, for the sake of argument, that Sprott’s figure 16:1 is where the gold/silver price ratio will ultimately stabilize. We may as well admit that Sprott’s theory is intellectually seductive. However, it is strewn with pitfalls tempting investors to their downfall.

To get a perspective on the gold/silver price ratio, look at the following table showing the interim highs and lows for the past 140 years (previous to that, the ratio was very stable at 15:1, as shown by the chart from which our table was digested, see: [www.measuringworth.com](https://www.measuringworth.com)). Note that gold/silver price ratio marked ‘hi’ means an interim low silver price, and one marked ‘lo’ means an interim high silver price, that is, the relationship is inverse.

1871

1913

1919

1933

1939

1943

1971

1991

2011 lo hi lo hi lo hi lo hi lo Even if the ratio will continue to fall from here, as it has for the past twenty years, it could have violent reversals of longer or shorter duration, as it has for the past 140 years. Incidentally, the above table shows the unprecedented long-wave volatility in the history of prices driven by pure psychology unrelated to any supply/demand fundamentals.

We may expect volatility to increase, and psychology to continue to reign.

Reversals will happen when least expected, often based on nothing more than a crude hoax. For example, a joker could start a rumor on the Internet that new Federal Reserve notes denominated in gold units are already being printed in Washington, including fractional notes, suggesting that the need for subsidiary silver coins has been eliminated. Or a rumor, later denied, that all the gold looted by the Japanese in Asia during World War II has been found in the Philippines, and turned out to be far greater than any previous estimate. Or a rumour that the Chinese are buying all the silver and gold properties in the United States.

Incidentally, the name of the perpetrator of the funniest hoax ever, Toilet Paper King Johnny Carson, was recently connected to the name of Eric Sprott by Bob Moriarty, see his article Facts on Silver, [www.321gold.com](https://www.321gold.com), April 25, 2011, from which the quotations below are taken. In 1971 Johnny, presumably in fulfillment of a wager, suggested to his audience on the syndicated TV shows he hosted, that the United States was facing an imminent toilet paper shortage. Of course, it was a hoax.

“Next day millions of rolls of toilet paper flew off the shelves of every store and by noon there was no toilet paper to be had anywhere in the United States for a whole month…

“Eric Sprott seems to have done something that hasn’t happened since the days of Johnny Carson.

“On October 28, 2010, Eric Sprott started his own closed paper silver fund PSLV with an initial public offering of 50 million Trust Fund Units.

“It’s still paper silver like SLV or the CEF fund. It has some unique features, not benefits, just features. He has done a brilliant job of promoting it.

“He went on to purchase \$300 million worth more physical silver to put in the closed fund. As a result of his excellent promotion, as of last Wednesday when silver was selling for \$46, if you bought the CEF silver fund, you had to pay \$47.88 (a premium of \$1.88) – but if you bought PSLV, the Sprott Silver Trust, then you had to pay an incredible \$57.73 (a premium of \$11.73 or 25%) for just one ounce of silver! “I’d say that Eric Sprott’s buying \$300 million worth more silver at the top was incredible timing. He pocketed probably \$60 million in profits.

“Is Eric Sprott bullish on silver? You bet. He has 60 million reasons to be bullish.

He could buy right at the top and watch silver fall 30%, while still making money! “How wise was it for investors to pay a 25% premium for silver? I’d leave it for you to figure out. Eric Sprott is both rich and brilliant.”

As for his customers, paying 25% premium, you can certainly say that they are neither. At the time of this writing the price of silver is still falling from \$43 as gold is slicing through the \$1900 barrier with the flying colors.

Bob did not say that it was unconscionable for Eric to whet his customers’ appetite, put them into silver at the top, and make them pay 25% over spot.

What Eric realized, to his customers’ chagrin, was that it is so much easier and certainly more profitable to hustle silver around its highs than around its lows, especially just at the time when then price is about to break.

What is the lesson from the 140-year volatility of silver? Wise investors should not touch the highs with a ten-foot pole. Even if the gold/silver price ratio went to 16 today, there is no guarantee that it will not bounce back to 40 tomorrow.

Prepare for supernova bullion prices, as Eric says? I’d say you had better prepare for the zig-zags before we get there.

Beware of the fund manager, crying from his rooftop that the paper silver market is a joke, while down there under the roof he is selling paper silver at a 25% mark-up.

DISCLOSURES. I own no Sprott Trust Fund Units, nor do I intend to buy any during the next 72 hours − nor ever thereafter.

---

*September 6, 2011*

### Calendar of events

The New Austrian School of Economics course in Munich has just been completed successfully. The next course is tentatively scheduled for March/April, 2012. For details, consult: nasoe@kt-solutions.de

### See also my website: [www.professorfekete.com](https://www.professorfekete.com)

The Seminar in Hong Kong has been cancelled. There will be a Seminar in Auckland, and a Conference in Wellington, New Zealand, in November. Stay tuned for details.

---

# Cut the Gordian Knot

URL: https://newaustrianeconomics.com/archive/fekete/cut-the-gordian-knot/
Date: 2011-08-04
Section: Popular Economics
Difficulty: accessible
Concept Tags: debt, federal-reserve, gold-standard, sound-money, monetary-crisis
Description: Fekete uses the Gordian Knot metaphor to argue that the intractable U.S. debt problem cannot be solved by gradual negotiation but requires a bold cut — a decisive monetary reform restoring gold and eliminating the Federal Reserve's ability to monetize debt. Half-measures and fiscal adjustments are ineffective; only radical monetary reform can sever the knot.
Editorial Note: Written August 2011 during the U.S. debt ceiling crisis. Fekete argues the debt debate misses the monetary root cause — the real Gordian Knot is the irredeemable currency system itself.
Original PDF: https://professorfekete.com/articles/AEFCutTheGordianKnot.pdf

## Cut The Gordian Knot: Resurrect the Latin Monetary Union

**Antal E. Fekete**

The sovereign debt problem, especially as it threatens Greece, Italy, Spain and through them the entire European Monetary System, is like the Gordian knot. Moreover, the solution is similar to that of Alexander the Great. He thought of doing something nobody before him did, and nobody after him could: he drew his sword and cut the knot. The solution of the Gordian knot of the European Monetary System is very similar, except there is a little extra secret. It would not work unless the sword was made of gold.

During the recent protracted debate about raising the debt-ceiling in the United States not once was the word ‘gold’ uttered. That is an indication of the I.Q. of American politicians. Are their European counterparts any better? Possibly. They at least understand that gold and debt go hand in hand. Debt within reason, that is.

A proper diagnosis of the debt crisis reveals that the world’s payments system as it is presently constituted lacks an ultimate extinguisher of debt. The pipe dream that the fiat dollar or the fiat Euro could serve as such was shattered as the Great Financial Crisis unfolded. When paying debt with dollars, the debt is not extinguished. It is merely transferred from the debtor to the U.S. Treasury. Transferring debt is not the same as extinguishing it. There is a saturation point which, when reached, will cause the welcome-mat for the dollar withdrawn. This is nothing new: the world was treated to the dress rehearsal already forty years ago: in 1971. At that time finance ministers and central bankers succeeded in convincing people that the secret of turning the dollar into an ultimate extinguisher of debt is Milton Friedman’s formula: the stock of dollars must not be increased faster than the cabalistic rate of 3% per annum.

Then they did some fancy footwork in redefining money supply to make 7% look more like 3%. When that did not work, they tried heroically to push interest rates down all the way to 0, following the script of John M. Keynes. That worked for a time, until it bankrupted weaker countries such as Portugal, Ireland, Italy, Greece and Spain that could no longer sell their debt in competition to U.S. Treasury debt the value of which has been increasing for the past 30 years.

No matter how you look at it: there is only one ultimate extinguisher of debt that always works, rain or shine, war or peace, and that is gold.

But gold could not perform its ordained function of discharging debt if it is locked up in central bank vaults, while debt keeps piling up in the world economy in want of an ultimate extinguisher. What’s going on? Well, doctrinaire economists prevent gold from entering the monetary bloodstream. Governments are brow-beaten if they as much as uttered the word ‘gold’.

Their knee-jerk reaction is to follow the Keynesian-Friedmanite script.

Greece, Italy, Spain are great nations. They have talented and hard-working people, first-rate institutions, they have some exquisite natural resources, including sunshine and the best tourist-destinations in the world. They’ve also got gold. What they don’t have is a gold income − but that’s through their own fault.

---

My message to them is: don’t let doctrinaires blind your vision and steer you away from your unique opportunity to save and restore the credit of your nation. You can do it in two easy steps, neither of which involves bailouts. Both of them involve your great European traditions, such as the Latin Monetary Union and its great gold and silver coinage.

## Step One: Gold Income For The Government.

The credit of a government depends, for the most part, on its ability to secure a gold income. In order to have one, the government must open the Mint to gold and keep it open to the unlimited coinage of gold and silver for the account of anyone bringing the metal for coining. It will not be free, but a seigniorage charge as low as 5 percent applies. It will be a monopoly income initially.

As your monopoly erodes because other countries will play copycat, it will get smaller. But you have made a head-start. Further gold and silver income could be derived from custom duties, excise and real estate taxes. We have an historical example showing how that works in practice.

In 1862 during the American Civil War the North introduced irredeemable currency, endearingly called ‘greenbacks’. The Union did not close the Mint to gold and silver; nor did it make the greenback unlimited legal tender. Certain taxes such as custom duties and excise taxes continued to be payable in gold coin. The Union did have a gold income.

To this you could add real estate taxes payable in silver. The gold revenue of your country could be used to eliminate government debt in irredeemable Euros, as will be discussed below. The silver revenue from real estate taxes should be collected by local governments and it could be used to finance public works. That would extend the employment base locally.

Unemployment insurance, so called, ought to be abolished altogether. In this world you get what you pay for. You get unemployment if that’s what you pay for. But you get clean streets, pleasant public parks, great infrastructure, and happily employed people if you pay those who are willing to work and, if necessary, relocate away from big cities.

Mintage could start with the two great standard coins of the now defunct Latin Monetary Union − to which all three countries used to belong − : the standard 20-franc gold piece and the standard silver piece formerly called 5 franc but now has to be renamed since the tie between the values of the gold franc and the silver franc has been cut. Let’s call the former 5-franc silver piece thaler. Fractional gold and silver coins would also be struck in order to facilitate the payment of these levies. There must be no rigid ratio set between the value of the 20-franc gold coin and the silver thaler. Neither must the Euro price of gold and the Euro price of silver, nor must their ratio be fixed: they must all be determined by the market.

Please note that what I recommend here is not a metallic monetary standard. That would be far too controversial, and it would put the success of the reform in jeopardy. The Euro bank notes and coins would continue to circulate as before, except they would no longer be legal tender for the payment of certain taxes. What I describe here is a scheme to mobilize gold and silver to help finance government.

## Step Two: Refinancing Government Debt With Gold.

The governments of Greece, Italy and Spain should offer 30-year gold bonds and 10-year silver bonds in exchange for their outstanding Euro-bond obligations. This would be the first gold bond issue in the world since 1935. There is a great pent-up demand in the world for gold bonds. In taking the initiative and making them available once more, Greece, Italy and Spain would show the way for the United States and other European countries how to harness gold-bond financing to avoid bankruptcy. All the over-indebted country needs to do is to mobilize its gold reserves.

### Why does gold-financing of government work?

(1) It adds new resources, heretofore idle, namely, government-owned gold, to the liquid wealth of the nation.

(2) Privately owned gold may be coaxed out of hiding, further increasing the liquid wealth of the nation.

(3) One ounce of gold ‘on the go’ is worth ten ounces idled, just like one acre of cultivated land is worth ten acres left fallow.

(4) Circulating gold inspires confidence; gold kept under lock indicates lack of confidence.

(5) Gold is a great stabilizer. Fiat money has never succeeded in stabilizing foreign exchange rates; gold is doing it routinely if given the chance.

(6) Fiat money has never succeeded in stabilizing interest rates. Gold can do it.

Stabilization of interest rates is extremely important: volatile interest rates spell capital erosion or even destruction. Stabilization of prices is neither possible, nor desirable. Variation of prices is a market signal that could be suppressed only at your peril. Stabilization of interest rates is both possible and desirable.

(7) Gold has always been used as money directly or indirectly throughout history, for thousands of years. In 1971 gold was forcibly removed from the monetary system and was replaced by ‘synthetic credit’. The result was: disaster. Now, a mere forty years later, we are facing a complete credit collapse, due to the Debt Tower ready to topple. The conceit of the managers of the international monetary system exceeds the conceit of the builders of the biblical Tower of Babel.

(8) Under an irredeemable currency system bonds are irredeemable as well. This removes the logical basis supporting lending, including lending to the government. One day the world will wake up and realize that the enormous paper wealth it thought it had has just disappeared. The shock and the suffering that is bound to follow would be devastating. Yet no one can say that it came unexpected. Tried innumerable times, experiments with irredeemable currency have always ended in disaster.

---

A gold bond promises to pay interest and principal in standard gold francs; a silver bond, in standard silver thalers. This promise should be stated on the face of the bond, together with a declaration that the country issuing the bond considers repudiation unconstitutional, immoral and reprehensible, and would not allow to happen again.

The coupon rate on the gold bonds should be fixed at fifty basis points above the one-year gold lease rate, and the coupon rate on the silver bonds at five basis points above the one-year silver lease rate, both averaged for the past ten-year period.

Three sinking funds should be maintained by these countries: the first to keep the value of the gold bond on a par, the second to keep the value of the silver bond on a par; and a third one, a Euro-fund, to support the price of the country’s outstanding Euro-bonds, should it be necessary. The expectation is that the market will have a preference for the gold and silver bonds. Therefore these countries will be able to retire the outstanding public debt on favorable terms over a ten-year period. A residual gold-bonded and silver-bonded debt would remain.

However, these are needed in order to support the operation of insurance companies, pension funds and other financial institutions.

The gold and silver bonds would be highly liquid in view of the sinking-fund protection.

The interest rate on them could be used as the benchmark in bank lending and in issuing corporate bonds, gold backed.

The plan to mobilize the gold resources of Greece, Italy and Spain, if adopted, will stabilize government finances in these countries. The rate of interest on gold and silver bonds is the lowest possible. These countries will refinance their public debt in making them gold-bonded or silver-bonded. The sword of Damocles, the threat of a violent increase of the rate of interest on the public debt, needlessly haunting a lot of countries under the regime of irredeemable currency, will be permanently removed.

The example of these pioneer countries will probably be contagious. If adopted worldwide, the system of financing government through gold and silver would inject new liquidity into the international monetary system sufficient not only to fend off a threatening world depression, but also to imbue the domestic and world economy with great optimism concerning future prosperity. Domestic economies, as well as the world economy would start growing again.

There could be no better way to pay homage to the ancient Greeks and Romans to whom we owe most of the values of our civilization than letting these three countries: Greece, Italy and Spain lead the world back to monetary and fiscal rectitude.

### Notes on the Latin Monetary Union

By a convention dated December 23, 1865, four charter members: France, Belgium, Italy and Switzerland formed the Latin Monetary Union (LMU). They adopted a common bimetallic currency, in France, Belgium and Switzerland called the franc, in Italy called the lira, defined as 4.5 grams of silver or 0.290322 gram of gold, 900 fine (a bimetallic ratio of 15½:1). The design, although not the size, of coins minted by different countries were different. The idea was to facilitate trade between different countries by making their coins perfectly interchangeable.

The agreement came into force on August 1, 1866. The four nations were joined by Greece with its drachma, and Spain with its peseta in 1868. In 1889 four more European and a South American country, Venezuela (the only fully-fledged non-European member in the history of the LMU) with its bolívar joined.

The basic cause of failure of the LMU was its adherence to bimetallism, in spite of evidence that it was not a stable monetary system. It pretended that the gold/silver market price ratio was constant when, in fact, it was variable. Sometimes the market undervalued gold at the Mint, at other times it undervalued silver. As a consequence, bimetallism was in reality a flip-flop between silver monometallism (when the market ratio undervalued gold at the Mint) and gold monometallism (when the market ratio undervalued silver). This had the wasteful consequence that silver and gold were flowing back-and-forth between the Mint and the refinery.

When gold was undervalued at the Mint, gold coins moved to the refinery to be melted down; when silver was undervalued at the Mint, silver coins moved to the refinery to be melted down.

In either case, the other metal was moving to the Mint to be coined. This arbitrage meant risk free profits for the arbitrageur at the expense of the Treasury. The solution to the problem would have been a dual monetary system using both gold and silver coins, but without a fixed official bimetallic ratio. It is most unfortunate that the LMU did not make a recommendation along these lines. Bimetallism consequently ‘self-destructed’, as it were. Germany made a fateful step in demonetizing silver and making gold monometallism official, at the same time selling very large quantities of silver from melted coins in the world market. The world price of silver went into a tailspin, taking the gold/silver price ratio from a low of 15½:1 in 1874 to a high of 85:1 in 1932.

The LMU closed its Mints to silver in 1878; to gold, in 1936. Subsidiary silver coins made according to the standards of the LMU were discontinued in member countries other than Switzerland during World War I. In Switzerland they continued until well after World War II; the last ones were made in 1967.

Having lost its purpose, the LMU disbanded in 1927.

---

The resurrection of the LMU would add a great deal of liquid wealth to the world’s financial resources. I have admitted above that a rapid change back to the gold standard at this juncture is not feasible or, at least, is not realistic. On the other hand it appears insane to quarantine monetary gold for no better reason than that it offers an unwelcome competition to the regime of irredeemable currency, when there is such a great need for it in order to stabilize debt in the world economy. Thus the resurrection of the LMU may be the happy compromise, bringing about a hybrid monetary system in the world, paper and metallic, with a variable exchange rate between them. “Let the people choose.”

Central bankers of the world show themselves superbly confident that with their expertise and skills the regime of irredeemable currency can be made a durable and stable monetary system. Whatever one may think about their self-confidence, it might take a revolution to remove central bankers from power in spite of the fact that their hold on power is apparently getting ever more wobbly as time goes on. The reason for this is the fast breeder of debt that irredeemable currency set into motion, and the lack of an ultimate extinguisher of debt that could stabilize the system.

But to have an open mind about it, let us not exclude the possibility that the hybrid monetary system may work. The resurrection of LMU would solve the problem of runaway debt, since the mobilization of monetary gold in the European economy could make an orderly debt reduction possible. This seems to be the only chance for the regime of irredeemable currency to “save its hide.” Central bankers may see the writing on the wall. Be that as it may, it is up to the central bankers to prove that the monetary system they manage is able to compete with gold and silver.

In closing I shall answer the question: where will people get the gold and silver to be able to pay the taxes that will give the gold and silver income to the government? I admit that this question goes to the heart of the matter. Some retrenching on the part of consumers may be necessary. Let me look at two typical cases.

(1) Some cutback in imports may be necessary because a part of the final price paid at the cashier includes gold taxes that not everybody may be prepared to pay. Fine, so domestic industry has to reinvent itself to satisfy the demand of those who opt out of paying the import tax. This in itself may be a good thing, as it will contribute to ‘job creation’. But obviously there will be enough people who want the imported goods, do have the gold and are willing to pay it out in the form of custom duty and excise tax to have them. Their spending “will prime the pump” and put gold coins into circulation.

(2) Some cutback in owner-occupied housing may be necessary because not every homeowner has the silver to pay the real estate taxes involved in home-ownership.

Fine, so the rental-property industry has to reinvent itself and satisfy the demand for housing of those who want to opt out paying the real estate tax. This in itself may be a good thing because not every bread-winner is able to handle the financing of such a major purchase as a home. But obviously there will be enough people who want to own their home, do have the silver and are willing to pay it out in the form of real estate taxes to have it. Their spending, again, “will prime the pump” and put silver coins into circulation.

In this way, starting with the purchases of luxury and big-ticket items, the purchasers will have to dig into their gold or silver hoard, and take their metals to the Mint for coining. As we have seen, this in itself will help ease the debt problem of the government, and start the process of ‘dishoarding’ the monetary metals, gold and silver.

So whatever people decide to do, whether to pay the gold and silver taxes or not, some benefits will accrue to society, and that’s the way it should be.

---

The resurrection of the Latin Monetary Union will, of course, be a challenge to central bankers.

They may not like the idea of having to compete with gold and silver coins. For this reason, there is a conflict of interest which dictates that the Mint must be completely independent of the Central Bank.

It would be wonderful if Greece, Italy and Spain turned defeat into victory and resurrected the Latin Monetary Union with a new series of silver and gold coins that would actually circulate domestically and across national boundaries. While the exchange rate between domestic paper money and the gold and silver coins would fluctuate, foreign exchange (consisting of gold and silver coins) rates within the LMU would not. And that would be a great blessing to the world economy, facilitating an increase in world trade, ultimately benefiting everybody.

---

*August 4, 2011*

*Casa Bahía del Pacífico*  
*Acapulco, Mexico*

---

# You Can't Eat Gold. But Can You Eat Real Bills?

URL: https://newaustrianeconomics.com/archive/fekete/you-cant-eat-gold-but-can-you-eat-real-bills/
Date: 2011-07-12
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, real-bills, sound-money, new-austrian-economics
Description: Fekete responds to the populist anti-gold argument that 'you can't eat gold' by asking whether you can eat real bills, mortgages, or Federal Reserve notes either. He argues the question reveals a fundamental misunderstanding of money's role: money is not meant to be consumed but to facilitate exchange and preserve value across time.
Editorial Note: Written July 2011. A polemical response to the 'you can't eat gold' objection that has been used against gold-standard advocates since at least the 19th century.
Original PDF: https://professorfekete.com/articles/AEFYouCantEatGold.pdf

## You Can’T Eat Gold.

### BUT CAN YOU EAT REAL BILLS? professorfekete

I have received the following letter from a reader.

Professor:

I have been reading your essays on real bills for several years with great interest. If there were any contemporary examples of such credit in circulation, it would be easier to understand how real bills work. Also, have you considered editing the real bill entry on Wikipedia, to give it a less pejorative sense?

### Paul Dadford

### Seattle

Here is my answer:

Hello Paul:

I am not responsible for the real bill entry on Wikipedia. I understand it was written by Mike Sproul, the author of the pamphlet There’s No Such Thing as Fiat Money.

I shall give you more than what you have asked me for: I give you a futuristic example of real bills in action and how you can put them in circulation. I hope it won’t come to that, but if we find out that the dollar has no dispensation from heaven exempting it from being fiat money and, hence, it can lose all its purchasing power as has every other fiat money in history within a generation, then my epistle may come handy some day.

Suppose for the sake of argument that the U.S. dollar has already lost all its purchasing power. (My apologies to Mike Sproul, but I was in Germany on August 15, 1971, the very day the dollar was declared fiat money. In trying to check out of my hotel, the cashier declined my Federal Reserve notes. He sent me to a bank across the street to change my money. At the bank I found a long line of other people with the same problem waiting for their turn. The teller was on the phone nonstop, waiting for the latest instructions from headquarters. To put it mildly, the bank did not welcome the opportunity to do business with us wanting to sell dollars, and we were treated accordingly: you were asked to produce 3 picture ID’s, provide your address and phone number, the name and address of your employer, your mother’s maiden name, your next destination, etc.)

Going back to our futuristic story, we have assumed that the dollar has died.

It would be outrageous to assume also that the American people, and people of other countries where the dollar used to circulate, would now have one great death wish: they would all want to die along with the dollar in sympathy. No, they would want to eat, to get clad, shod, and to keep themselves warm in winter as before.

Admittedly they have a problem. Here is what they will do.

Let’s say you are the maker of some consumer good (say, a small whisky dispenser that can be attached to any cell-phone) that you are selling through Macy’s Department Stores; and your brother is producing some semi-finished goods (say, cigarette lighters to be built into cell-phones) that he is selling through Walmart. As neither Macy’s nor Walmart is accepting dollar bills from their customers, they won’t try to pass off dollar bills to you. Macy’s offers you two choices (the procedure at Walmart is very similar):

(1) you can have Macy-vouchers in any combination that you can use in store as cash, or

(2) you can bill Macy’s for the goods delivered.

A bit suspicious, you take the second choice. Then the clerk at Macy’s gives you a form to fill out, indicating date, quantity and quality of goods delivered, and your instruction that they pay the bill at their chief cashier’s office ‘in legal money’ no later than 91 days to you or to whomever you may transfer the title through endorsing in the meantime. The receiving department takes your bill, stamps it on the other side with the legend “I accept” over the signature of the receiving clerk, date, address and phone number of Macy’s. Then the bill is returned to you.

### Congratulations: you have just drawn your first real bill!

The receiving clerk apologizes for the inconvenience and gives you a flyer suggesting supermarkets and clothes outlets in the neighborhood that will accept your bill drawn on Macy’s as cash in payment for your purchases.

He also gives you another flyer listing those firms, including Walmart, whose bills (i.e., bills drawn on them) are received as cash at all the cashiers in any Macy’s store. This means that if your brother endorses his bill drawn on Walmart, then you can use it as cash at Macy’s.

As you leave Macy’s, you get a terrible toothache. You go the dentist’s office nearby where you are informed by the receptionist that the doctor no longer accepts dollar bills in payment. She gives you a flyer listing supermarkets and department stores whose bills the doctor will take. Luckily, Macy’s is on that list and you are on your way to the dentist’s chair. The professional charges are lower than your bill drawn on Macy’s, so the receptionist offers you change in the form of a bill drawn on the dentist that you can use to pay for further professional services of his, but is also receivable by hundreds of medical offices nearby, as well as by many retail outlets including Macy’s.

Congratulations: you have just put your first real bill into circulation!

Incidentally, all the banks have by then closed their doors for reasons of insolvency. Nobody feels sorry for them. They got such a bad name during the death-throes of the dollar that the few of them that tried to re-open for business were avoided by the people like they avoid the plague. According to the latest report some succeeded, but their officers shun the name ‘banker’. They call themselves ‘bill mongers’. Sounds much more honorable.

Real bills are second only to gold. But sometimes they are safer. When you try to eat them, for example. True, it is a hassle trying to eat your real bill. But when you try to eat your gold, you may get killed for it!

Detractors of real bills, beware! One day your life may depend on them!

Yours, etc.,

### Professorfekete

### Calendar of events

Come to Munich, the capital of Bavaria, for the next ten-day course of the New Austrian School of Economics, from August 20-29, 2011, where I shall answer any questions you may have on the origin of money, origin of interest, hoardability of monetary metals, opening the Mint to silver. Also on hand will be Sandeep Jaitly to tell you about the gold mine of the silver basis, and about the last contango in Washington. For details, consult: nasoe@kt-solutions.de

### See also my website: [www.professorfekete.com](https://www.professorfekete.com)

Also on the drawing board we have a Seminar in Hong Kong, as well as one in Auckland, NZ, coming up in November. Stay tuned for details.

---

*July 12, 2011*

---

# You Have Never Ever Seen An Elephant Fly

URL: https://newaustrianeconomics.com/archive/fekete/you-have-never-ever-seen-an-elephant-fly/
Date: 2011-07-04
Section: Popular Economics
Difficulty: accessible
Concept Tags: real-bills, self-liquidating-credit, bills-of-exchange, new-austrian-economics
Description: Using the Dumbo metaphor, Fekete argues that real bills — like the magic feather that allows Dumbo to fly — are being dismissed as impossible when in fact they have worked for centuries. Critics who insist real bills cannot work are like the crows who say an elephant cannot fly; they have simply never seen it done correctly.
Editorial Note: Written July 2011 with a subtitle about real bills and mortgages. The Dumbo metaphor makes this one of Fekete's most entertaining defenses of the Real Bills Doctrine.
Original PDF: https://professorfekete.com/articles/AEFRealBillsAndMortgages.pdf

### “YOU HAVE NEVER EVER SEEN AN ELEPHANT FLY” professorfekete

In the 19th century a saying was current on Lombard Street that went like this: “There is nothing easier in the world than the banker’s profession – provided that he can tell a real bill and a mortgage apart.”

I would like to engage Dr. Joseph Salerno in a friendly debate on this maxim. In his interview with the Daily Bell published July 3, 2011, he sees nothing wrong with people drawing bills of exchange, or accepting them in payment, as these instruments are completely consistent with a society based on free contract. I heartily welcome this statement of his. It should be much more widely known.

After the death of the dollar people in the United States, and in other countries wherever the dollar also circulates, will not want to die along with the currency.

They will still want to eat, get clad, shod, and keep themselves warm in winter. In order to be able do so they will just have to draw bills on retail merchants and other producers whom they supply with finished or semi-finished goods. These bills will serve as cash with which to buy food, clothes, shoes, fuel. We may expect that banks, central or otherwise, will have earned themselves such a bad name by then that nobody will want to be known as a ‘banker’. ‘Bill-monger’ will sound much more honorable.

Dr. Salerno adds: What I vigorously reject is the age-old fallacy known as the ‘real bills doctrine’ asserting that when a bank issues currency or creates a bank deposit in discounting a bill of exchange, it is not causing inflation. In the next sentence he clarifies his position further when he suggests that whether a fractional-reserve bank buys a mortgage, or whether it discounts a real bill, it comes to the same thing: the bank increases its demand deposit liabilities to finance the expansion of assets.

While this is true, it does not prove that the bank is guilty of causing inflation when discounting a real bill. The difference is this, and in ignoring it Dr. Salerno dodges the real issue here: when the bank discounts a real bill, it withdraws from the market an instrument that circulates as money. Ephemeral, to be sure, but money nevertheless. Ludwig von Mises, no friend of the real bills doctrine, admits that bills of exchange have circulated as a means of payment among spinners, weavers and other tradesmen dealing in cotton products in Lancashire before the Bank of England opened its branch in Manchester.

There was a time not too many years ago when it was strictly against the rules for a commercial bank to put a mortgage in its portfolio of assets. You have never ever seen a mortgage, or an elephant for that matter, fly. Real bills, by contrast, can and do circulate on their own wings and under their own steam as currency. The present Great Financial Crisis started with commercial banks overloading their portfolio with mortgages disguised as ‘securitized equity’. Yet no one is inquiring whether the violation of the old time-tested rules has caused the crisis in the first place.

In discounting a real bill the banker only substitutes his own credit that has a higher name-recognition. The potent ingredient of the credit is that of the weaver, even though it has a lower name-recognition. The searching question to ask therefore is this: does the weaver really cause inflation when he passes along the bill he has drawn on the fabric merchant to the spinner in payment for the yarn?

I hope Dr. Salerno agrees with my answer: no, the weaver causes no inflation. It is true that he puts a purchasing medium, his bill drawn on the fabric merchant into circulation, but it is matched by the cloth, a new merchandise of the same value he offers for sale. The bill and the cloth appear simultaneously and will disappear simultaneously. The former disappears when it matures, and the latter disappears when it is purchased by the ultimate consumer. An increase in purchasing media that is matched by an increase of merchandise in urgent consumer demand is not inflationary.

Bankers of old on Lombard Street expressed this by saying that the credit embodied by a real bill is self-liquidating as it is extinguished by virtue of the sale of underlying merchandise on which it is drawn. By contrast, the credit embodied by a mortgage is not self-liquidating as it is not normally extinguished out of the proceeds of the sale of the underlying property.

Dr. Salerno also makes a comment on the suppression of the rate of interest, allegedly caused by bankers in discounting real bills at a discount rate lower than the rate of interest. This suppression, he suggests, generates an unlimited supply of bills to discount, causing an inflationary spiral of money-creation and price increases.

Mises explicitly stated that the discount rate is just another name for a shortterm interest rate with interest taken out of the proceeds of the loan up front.

However, this description is mistaken, as pointed out by several authors, among others John Fullarton and Charles Rist. The nature and origin of the discount rate are entirely different from that of the rate of interest. The two rates are completely independent of one another. The rate of interest is determined by the propensity to save; the discount rate by the propensity to consume. In either case the relationship is inverse: the greater the propensity, the lower the rate, and conversely.

When the spinner delivers yarn to the weaver and is offered payment in the form of a bill drawn on the fabric merchant, he will accept it but will apply a discount to the face value. The question is how the two tradesmen can come to an agreement what rate to apply. There can be only one answer to this question: a lower discount rate will be acceptable to the spinner if the market is brisk; however, a higher discount rate will be insisted on if the market is lethargic. Thus the discount rate is determined by the condition of the consumer goods market, and not by the availability of savings. It reflects the propensity to consume (with apologies to Keynes). There is no loan involved in discounting, so the rate of interest is irrelevant. Tradesmen processing semi-finished goods hardly ever pay cash for supplies to their suppliers. The prices they are quoted are not cash prices.

They are “90 days net”. The credit is part of the deal: you need not even ask for it.

On the rare occasion when you don’t need the credit you pre-pay your bill, having applied the discount to its face value.

### Calendar of events

Come to Munich, the capital of Bavaria, for the next ten-day course of the New Austrian School of Economics, from August 20-29, 2011, where I shall answer any questions you may have on the origin of money, origin of interest, hoardability of monetary metals, opening the Mint to silver. Also on hand will be Sandeep Jaitly to tell you about the gold mine of the silver basis, and about the last contango in Washington. For details, consult: nasoe@kt-solutions.de

### See also my website: [www.professorfekete.com](https://www.professorfekete.com)

---

*July 4, 2011.*

---

# The Marginal Utility of Silver

URL: https://newaustrianeconomics.com/archive/fekete/the-marginal-utility-of-silver/
Date: 2011-06-14
Section: Popular Economics
Difficulty: intermediate
Concept Tags: silver, bimetallic, gold-standard, sound-money, interest-theory
Description: Fekete applies marginal utility theory to silver's monetary role, arguing that silver's marginal utility as money is rising as the paper money system deteriorates. He examines the historical relationship between gold and silver, arguing for a natural bimetallic standard in which both metals play complementary monetary roles.
Editorial Note: Written June 2011 as silver prices were near historic highs. Fekete's analysis distinguishes between silver's industrial and monetary components of demand, arguing that monetary demand — not industrial supply — drives silver's price dynamics.
Original PDF: https://professorfekete.com/articles/AEFTheMarginalUtilityOfSilver.pdf

### THE MARGINAL UTILITY OF SILVER professorfekete

I welcome the Internet debate on the question whether the Mint should be opened to gold and silver. The latest contribution by Hugo Salinas Price, entitled Free Coinage of Gold and Silver – Then and Now ([www.gold-eagle.com](https://www.gold-eagle.com), 9 June 2011), expresses doubts that such a measure, at least insofar as silver is concerned, would work today. One of the arguments he offers is that silver, like all non-monetary metals (but unlike the monetary metal par excellence, gold) has a declining marginal utility. This, he suggests, is an historical change as prior to the 1870＇s the marginal utility of silver, like that of gold, was constant (or nearly so). In this brief rejoinder I cannot go through all the arguments of his long article, but would like to add my penny of wisdom, such as it is and for whatever it may be worth.

Does silver have a declining marginal utility? I wish I knew! There is but one way to find out: one of the governments must bite the bullet and open its Mint to silver. This would allow all comers to bring forth their bullion and convert it into standard silver coins free of seigniorage charges. If the response were so overwhelming that the Mint would be inundated and forced to close its doors to silver again, it would go a long way to establish evidence for declining marginal utility. It would indicate a panic among owners of silver bullion, prompting them to get rid of their holdings while riddance was good.

If, however, the flow of silver to the Mint was controlled, if the premium on freshly minted silver coins did not precipitously collapse but only showed moderate decline, this would be a strong evidence that the marginal utility of silver, though not constant, showed a record slow decline, second only to that of gold.

To be sure, ultimately, the premium on silver coins would go to zero. But the process would take time, possibly years. The new silver coinage would reach its saturation point where demand for souvenirs and for piggy-bank fillers was satisfied. This, however, would not stop the flow of silver to the Mint. Coins would continue to be minted even after the premium vanished. The new silver coins would go into circulation. People would become confident and start spending their silver coins once they got used to the idea that they could always tap coin circulation for replacement. They could get any number of silver coins on exactly the same terms as they could spend them, that is, without having to pay or sacrifice a premium.

But why would people want to have more silver coined once the hoarding demand for silver coins dried up? Well, that＇ s just the interesting part. People would want to make their purchases of goods and services on the best terms possible. Silver coins would give them the best terms of trade − certainly far better than terms that holders of Federal Reserve notes have. For example, people could negotiate long-term contracts for delivery of grains or crude oil at stable prices if they pay with silver coins, while such contracts were no longer offered to holders of dollar balances.

Gresham＇ s Law has nothing to do with it. People won＇ t stop eating, nor will they want to stop keeping themselves warm in winter just to uphold a badly misunderstood and misquoted economic law attributed to the financial advisor of Queen Elizabeth I. To the extent people will want to eat and keep themselves warm in winter, paper dollars will not drive silver dollars out of circulation. By the way, Gresham＇ s Law, correctly quoted and understood says that worn silver coins will drive full-bodied silver coins out of circulation provided that the government makes worn coins legal tender and forces people to accept them at face value.

Absent legal tender provision, people would simply pay for their purchases in silver coins by weight, rather than by tale.

There can be no question that silver coins will start to circulate as soon as the premium on freshly minted coins is reduced to zero, assuming that the Mint is kept open come rain or shine. Already there is pressure on governments to open their Mint to silver. If they haven＇ t done it yet, it＇ s because they know that their banks are insolvent and could not withstand the shock of removal of the prop of legal tender protection for paper money. They hope against hope that their insolvent banks, given time, will be able to heel themselves.

The Chinese government is holding back for one additional reason. It wants to convert as much of its dollar balances into silver as possible before opening its Mint to silver. The Chinese hope to make up for inevitable losses on their dollar account by gains on their silver account. They have to go gingerly about their silver purchases though, not to upset the apple-cart. In waiting, the Chinese take a calculated risk while watching like a hawk what other governments are doing.

They certainly don＇ t want to be pre-empted by the Indian or Mexican governments.

Early bird gets the worm.

Last year I was in China and I met several officials in influential positions. I came away with the impression that American-trained people in the banking establishment suffer from an overdose of America-worship. While studying at U.S. universities they fell for Keynesianism hook, line and sinker and can＇ t get it out their system. These people laughed me out of the lecture room when I was trying to tell them about the benefit of a metallic monetary system. But I also met others who were totally immune to America-worship. If they were Communist, it certainly didn＇ t stop them from promulgating a new policy letting Chinese peasants acquire as much silver as they would. This policy makes sense only if China has long-term plans to open its Mint to silver. Naturally the plan, if it is to be effective, must be kept secret for the time being.

When you ask them if they are not afraid that America may beat them to opening the Mint to silver before China does, they would answer with an enigmatic smile. They would mutter something to the effect that sometimes you have to take a chance in assuming that thieves who plot to rob you, while they are sharp at stealing, may in fact be dull at poker.

Think about it. The U.S. may have already lost the silver game against China. Perhaps the Chinese kept the Communist façade for one reason only: they wanted to lull the Americans into a false sense of security that they would never ever open the Mint to silver and gold as they have meekly acquiesced in carrying the yoke of the irredeemable paper dollar forever. Japan＇ s example as an American fiefdom does not appeal to the Chinese, but they are not yet ready to bolt from the dollar-feedlot.

The Americans messed it up so badly that it is hard to find words to talk about it. They should have played copycat at the silver chessboard. When the Chinese built up their silver refining capacity, Americans should have done likewise. They did nothing. When the Chinese started encouraging silver imports and made noises about putting embargo on silver exports, Americans should have followed suit. They did nothing. When the Chinese prompted their banks to extend their silver and gold market activities into their rural heartland, Americans should have imitated them. They did nothing. When the Chinese actively started making their silver and gold mining industry competitive, Americans should have removed the fetters from theirs. Again, they did nothing.

The writing is on the wall: Mene tekel upharsin – the dollar has been put on the scale and found wanting. The Chinese will open their Mint to silver in their own good time. It is their destiny. If they don＇ t talk about it, that＇ s because they want to give a chance and a little extra time even to the poorest Chinese peasant to buy a silver coin or two before it＇ s too late.

China has been on a silver standard since time immemorial. F. D.

Roosevelt＇ s silver purchasing policy after 1933 forced them off silver. It was one of his hare-brained monetary schemes to foster inflation in the United States. He was completely oblivious of the fact that he was fostering deflation in China, fatally weakening it and making it an easy prey to Japanese imperialism.

There are simply no reliable estimates how much silver has been coined during the long history of Chinese civilization. Most of those coins are still around in mattresses and cookie-jars. Multiply the number of mattresses and cookie-jars by hundreds of millions. You got the idea.

Chinese peasants are suspicious people. They are still afraid that their nominally Communist government has designs to confiscate their well-hidden silver coins that have escaped Mao＇ s Long March as well as his Great Cultural Revolution. Watch for the day when this enormous silver treasure, the accumulation of millennia, will be released. The Chinese government is in no hurry to give the world an object lesson on what the marginal utility of silver is.

The best experts on silver in the world are Chinese but they keep their cards close to their chest. They know that in playing poker it is not a good hand you need but a good brain. One that is not contaminated with Keynesian bunk.

---

*June 13, 2011.*

### Calendar of events

Come to Munich, the capital of Bavaria, for the next ten-day course of the New Austrian School of Economics, from August 20-29, 2011, where I shall answer any questions you may have on the opening the Mint to silver. Also on hand will be Sandeep Jaitly to tell you about the marginal utility of silver, as well as about the gold mine of the silver basis, and about the last contango in Washington. For details, consult: nasoe@kt-solutions.de

### See also my website: [www.professorfekete.com](https://www.professorfekete.com)

---

# Sources and Remedies of Financial Instability

URL: https://newaustrianeconomics.com/archive/fekete/sources-and-remedies-of-financial-instability/
Date: 2011-05-14
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, bond-market, real-bills, interest-theory, new-austrian-economics
Description: Fekete's submission to the Gold Bond proposal, identifying the sources of financial instability as the destruction of the Real Bills market and the replacement of gold bonds with paper bonds. The remedy requires gold bonds — long-term obligations payable in gold that would attract genuine savings, anchor long-term interest rates, and eliminate the deflationary bias of open-market operations.
Editorial Note: Written May 2011, subtitled 'Gold Bond: Life-Saver for the U.S. and World Economy.' One of Fekete's most thorough statements of the gold bond concept as a specific monetary reform instrument.
Original PDF: https://professorfekete.com/articles/AEFSourcesRemediesOfFinancialInstability2.pdf

## Sources And Remedies Of Financial Instability*

### Gold Bond: Life-Saver for the U.S. and World Economy

### Antal E. Fekete

### Sources

The financial instability that first surfaced with full force in 2008 is the result of a deteriorating condition in world finance going back 40 years. Worse still, that deterioration is continuing and threatens with an historically unprecedented world-wide credit collapse.

The watershed year was 1971. What made that year outstanding was not just the first-ever introduction of the world-wide floating exchange rate system, but also the disappearance of the most potent and reliable financial instrument that has ever existed. It was little noticed at the time. If ever mentioned, it was being treated as a non-event. Yet the world can only dismiss its significance at its own peril. Academia that is supposed to study problems created by monetary experimentation, rather than alerting the public to the most serious consequences of the omission, has been guilty of ignoring it.

The most potent financial instrument, the disappearance of which we are referring to, is the gold bond.

This observation would immediately be objected to by the detractors of gold in the monetary system. They would say that the gold bond had disappeared from world finance much earlier: in the years 1931-35. Its disappearance gave no occasion for any major catastrophe in its wake. Rather, the word economy has gone on from one triumph to another without gold bonds ever since ⎯ proving the inconsequential nature of their being phased out.

However, this objection is not valid.

The truth of the matter is that the gold bond had survived the collapse of the gold standard in the early 1930’s and has played a most important albeit largely unrecognized role in world finance afterwards. Consider the fact that since January, 1934, the dollar has had a fixed value in terms of gold, based on the Treasury price of \$35 per ounce of fine gold, and the U.S. government has continued to honor its international dollar obligations in gold at that rate.

Moreover, this obligation was solemnly enshrined in several international treaties and confirmed by four sitting presidents. As a result, there is no gainsaying of the fact that U.S. Treasury paper in the hands of foreign governments and central banks directly, and in the hands of banks, financial institutions, and even ordinary citizens not under the jurisdiction of the U.S. indirectly, have continued to exist as gold bonds (or gold bills, as the case may be) after 1934.

The most important role the gold bond has played up until 1971 was this: it was the standard of credit whereby all other debt instruments were gaged.

Through disintermediation substandard debt was eliminated, and the rise of the Debt Behemoth prevented.

Ignoring this fact is a major error that Academia has been and still is making. To continue to deny this fact leads to further grievous errors. There used to be a saying on Lombard Street, long since forgotten, that “there is only one thing that is safer and arguably more desirable to hold than gold, namely, the promise of a government to pay gold”. In that spirit gold bonds were considered an “ultimate form of debt”, enforcing quality standards. Moreover, the U.S. Treasury bill in the hands of foreigners was, along with gold, the ultimate extinguisher of debt. This instrument was destroyed on August 15, 1971. On that day gold was exiled from the international monetary system.

Since that day the world has lacked an ultimate extinguisher of debt.

Any other means of payment, including Federal Reserve credit, however useful in international trade or otherwise, could not extinguish debt. It could only shift debt from one debtor to another (ultimately, to the U.S. government).

As long as there were gold bonds in existence, a Debt Behemoth could not rise to threaten world finance with destruction. Whenever total debt in the world approached the danger level, safety-conscious governments and banks quietly started converting their holdings of debt into gold bonds, thus squeezing marginal debt out of existence. This also explains the absence of a derivative tower and other unsafe financial constructions, instruments and practices, such as mortgage-based bonds, or bank-loan-backed bonds, prior to 1971.

World trade was financed and regulated by gold to the extent that the great trading houses abroad kept a portfolio of gold bonds in their balance sheet.

In effect they were doing arbitrage between the gold bond market and the market for internationally traded merchandise. If the gold rate of interest (the yield of U.S. Treasury bonds) rose, they sold out marginal merchandise from warehouses without reordering them, and invested the proceeds in gold bonds. If subsequently the gold rate of interest rates fell back, then they would sell the gold bond at a profit, and invest the proceeds in marginal merchandise, the trading of which out of the warehouse yielded better profit than that available from holding the gold bond. This arbitrage was real, continuous, and it kept international trade on an even keel. Academia has missed this important arbitrage responsible for regulating world trade after World War II. It has also been guilty of failing to point out that, without gold bonds, world trade is clueless, subject to deterioration and open to manipulation.

In 1971, by a stroke of the pen, gold bonds were stamped out of existence.

World trade lost its guiding star. The floodgates of exorbitant debt creation were opened. The fast debt-breeder was turned on. Debt of dubious quality flooded the word, the soundness of which could no longer be gaged in the absence of gold bonds. There was no sink to absorb excess and waste. This explains the origin of the debt tower, and the steady deterioration of the quality of its component parts. This process is still continuing. Worst of all, the series of financial crises in the world also continues. Every one of them will be more devastating than the preceding one — unless something is done about it, and soon. In the absence of remedial measures now the momentum of the approaching avalanche will become overwhelming.

### Remedies

Having made the correct diagnosis, the remedy readily presents itself. The gold bond should be brought back. There is presently a great latent demand for gold bonds in the world, as indicated by the high marketability U.S. Treasury bonds are still enjoying — something that cannot be justified on purely economic grounds in view of the net debt of the U.S. government and the tenaciousness of the American trade and budget deficits. Make no mistake about it: the high marketability of the U.S. Treasury bonds is justified solely by the fact that there is still a residual hope that the U.S. government will, in its own self-interest as well as in the interest of the world economy, make them payable in gold at maturity, and will pay interest on them in gold in the meantime.

Most significantly, there is a convincing precedent in U.S. history for this.

During the Civil War and its aftermath, the U.S. government continued to honor its debt, both as to principal and interest, paying them in the gold coin of the realm. To be able to do it, the government continued to levy import duties and excise taxes in gold to the exclusion of paper. The exchange rate between the gold dollar and the paper dollar (endearingly called the ‘greenback’ by their protagonists) was fluctuating. The government need not embrace a gold standard in order to enjoy the benefits offered by the gold bond.

There is no reason why the U.S. could not emulate the Civil War practice in the present crisis. Admittedly, it would take extensive research to work out the details. For example, the question arises how gold bonds can survive in a fiat paper money system (or how a fiat paper money system can prosper in an environment where gold bonds exist and enjoy the highest prestige). At any rate, the intellectual resources to conduct such research are all at hand. If not residing in Academia, then, at least, they are scattered around in small discussion groups and can be accessed through the Internet. There ought to be such a thing as “shadow research” offering sorely missed competition to mainstream economics on the gold question.

The first obstacle that confronts the present effort by the U.S. government and the Fed to put the great financial crisis behind them is that it runs head on into Triffin’s Dilemma. Already in the early 1960’s Robert Triffin observed that the stated aims of increasing ‘world liquidity’ and those of eliminating the U.S. budget deficit are contradictory. They cannot be simultaneously accomplished.

Likewise, the present effort to rein in the U.S. government deficit and reduce the outstanding government debt, while simultaneously increasing the stock of money through direct sales of government bonds by the Treasury to the Fed (euphemistically called QE 1 & 2) are contradictory. It is like trying to have one’s cake and eat it. On the one hand the Fed wants to inject more Federal Reserve credit into the payments system while the “other hand”, the government, pretends to choke off the supply of the necessary collateral through eliminating the budget deficit. Politicians, mainstream economists and financial journalists sing the praise of this scheme without realizing that it cannot be done.

The two aims are contradictory, and the market will not be fooled by the prestidigitation.

Most mainstream economists have a vested interest in maintaining their anti-gold stance. Their prestige is committed to Keynes’ dictum that the gold standard (and, by implication, gold) is nothing but a ‘barbarous relic’. However, if they really believe in a goldless monetary system, then they should have nothing to fear in exposing their fiat paper scheme to competition with the gold bond. Hand-to-hand money will still be irredeemable under the suggested remedial action. The fact that this will cause the managers of fiat money to make their instrument deliver stellar performance so that people shall have no desire to dump paper in favor of gold is an added benefit. The remedial action proposed here ought not to be seen as an attempt to return to the gold standard through the back door. The proposal is to allow the gold bond to discharge its natural function, to wit: weeding out bad debt something irredeemable debt cannot do.

A great failing of monetary scholarship is the one-sided appraisal of the origin and subsequent evolution of the Federal Reserve System that came about as a result of six years of thorough study and public debate in the wake of the 1907 financial panic. It was not even remotely considered during the debate that the Fed coming off the drawing board ought to be an engine monetizing government debt. Just the opposite is true: the Fed was supposed to be a commercial paper system whereby self-liquidating bills of exchange would acquire ephemeral monetary privileges, facilitating the movement of semifinished merchandise from the producer to the ultimate consumer. This was not considered inflationary: pari passu with the sale of merchandise to the ultimate consumer the expiring bills diminish the money supply dollar for dollar.

Nor was it thought possible during the debate that the monetary unit of the United States could be anything but the Constitutional double eagle gold coin.

There was nothing sinister about the study and the debate. There was no conspiracy. It was all in the open. All questions could be openly asked and would be honestly answered.

The outcome, the Federal Reserve Act of 1913 was far from being a perfect document. It had many weak points, errors of commission as well as errors of omission. It had a lot of room for improvement. But it was acceptable for the purpose of putting credit, such as existed within the confines of the United States, on a sound and enduring financial basis.

Mischief occurred after the Federal Reserve banks opened their door for business in 1914, about the same time when the war in Europe got started.

Without much thinking, and in an obvious violation of the law and the neutrality of the country, the Administration of president Wilson committed the new Federal Reserve banks to the task of financing of the allied war effort in Europe.

The idea of self-liquidating credit was discarded; credit was created expressly to finance destruction. You could not get further away from the ideal of selfliquidating credit than putting credit in the service of destroying life and property.

This takes us to the second remedy: restoration of self-liquidating credit.

The idea that the central bank can calibrate the rate of debasement of the currency by adjusting the speed of the printing press is absurd. It is only surpassed by the absurdity of the notion that the Federal Open Market Committee can divine, pick, and set the optimal interest rate that will make the GDP grow, payrolls swell, prices stabilize, and prosperity endure.

Historically, commercial banks came into existence not to ‘create’ credit but to ‘liquefy’ it. Commercial credit takes its origin in the handshake of two businessmen while one saying to the other: “I’ll pay you for this shipment in 90 days”. The handshake later took the form of a real bill. It had the advantage that it could be endorsed and passed on to a third party in payment for other merchandise.

Thus the formula to solve the present crisis of instability, and to fend off the threatening credit collapse is: Go back to gold bonds and real bills. Adopt the best agents of credit there obtain, in place of intrinsically worthless promises. Substitute the real source of credit, the handshake of two businessmen, for the stroke of the banker’s pen.

The hour is late. At stake is the survival of the U.S. and the world economy as we know it. Failure to act now would lead to a disaster comparable only to the collapse of the Roman Empire in the fifth century A.D. that was accompanied with a total breakdown of law and order while, significantly enough, gold was going into hiding.

* The title of this essay is borrowed from a list of research topics proposed by the Institute for New Economic Thinking. The author submitted this essay for consideration, but the Institute declined to entertain it.

### Calendar of events

### NEW AUSTRIAN SCHOOL OF ECONOMICS in Munich, Bavaria, Germany

### Aug. 20 - 29, 2011

### The Austrian Theory of Interest and Discount

Also discussing: Backward thinking on backwardation,

### The Last contango in Washington: how many more dress rehearsals?

### Corner or permabackwardation in silver?

Gold and Silver Basis and Cobasis: An interpretation.

### Lecturer: Prof. Antal E. Fekete

### Guest Lecturer: Sandeep Jaitly (United Kingdom)

The school is meant for all students (including beginners) interested in the thought of Carl Menger (1840-1921) and, more generally, in the Austrian theory of money, credit and banking in the spirit of Menger. The school’s program plans to cover the whole spectrum of Austrian economics. It is recommended especially for those who have read the papers of Prof. Fekete about the instability of the present monetary system and the danger of a world-wide credit collapse, available on the Internet, see the website [www.professorfekete.com](https://www.professorfekete.com) .

The complete program consists of four courses (10 days, 20 lectures in all).

Completion of each of the four courses will earn one credit. Students with 4 credits will earn a diploma, signed by Professor Fekete. The four courses are as follows:

Course I: Disorder and Coordination in Economics — Has the world reached the ultimate economic and monetary disorder?

Course II: Adam Smith’s Real Bills Doctrine and Social Circulating Capital Course III: The Austrian Theory of Interest and Discount

### Course IV: The Austrian Theory of Money, Credit and Banking

Courses I and II have been given in Hungary in 2010 and earlier this year. There are plans to repeat them in Munich next year.

For further information contact: nasoe@kt-solutions.de or phone: +49-170-380-3948 (please take time-zone difference into account)

---

# Hearken to the Sacred Geese of Juno Moneta

URL: https://newaustrianeconomics.com/archive/fekete/hearken-to-the-sacred-geese-of-juno-moneta/
Date: 2011-04-11
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, backwardation, gold-standard, monetary-crisis
Description: Fekete uses the legend of Rome's sacred geese — who warned of the Gallic attack on the Capitol — to frame his analysis of gold as monetary early-warning system. Just as the geese sounded the alarm when others slept, the gold basis warns of monetary danger that mainstream economists ignore. The essay examines current basis signals and their implications.
Editorial Note: Written April 2011. One of Fekete's more colorful historical-literary essays, using classical mythology to frame his ongoing basis analysis.
Original PDF: https://professorfekete.com/articles/AEFJunoMoneta.pdf

*Hearken To The Sacred Geese Of Juno Moneta*

**Antal E. Fekete** · E-mail: aefekete@hotmail.com On April 6 last I sent an open letter Congressmen Ron Paul of Texas accusing the Chairman of the Board of Governors of the Federal Reserve, Dr. Ben Bernanke, that

(1) his program of Quantitative Easing(QE) whereby the Federal Reserve banks purchase U.S. Treasury paper directly from the U.S. Treasury is not authorized by the Federal Reserve Act and is therefore unlawful;

(2) even if for the sake of argument we disregard where the Fed buys its paper, the sum appears to be higher than all available Federal Reserve credit outstanding and, moreover, the F.R. banks do not have unencumbered collateral to post in order to create more to conclude these purchases.

I have received an unusually large feedback in my e-mail. People want to know how I can substantiate these accusations against Dr. Bernanke. Of course I cannot say that I have caught Dr. Bernanke red-handed. All I can do is to present circumstantial evidence.

I start with a statement that I am fully aware of the seriousness of my accusations, and my responsibility in making them. I do not make them frivolously. I have been contemplating to do it for decades. My reasons for postponing have to do with calculating for maximum impact. I am but an isolated individual trying to take on the incumbent of one of the most powerful offices ever created on this earth. Wrong timing may be suicidal.

I first came to suspect that in injecting F.R. credit in the domestic and world economy the Fed was in violation of the law when former Chairman Alan Greenspan inundated the money markets shortly after taking office following the stock market crash in 1989. My suspicion was that he got away with it by simply reversing the two-step creation of F.R. credit, namely, FIRST STEP: posting collateral; SECOND STEP: issuing F.R. notes and creating F.R. deposits.

Reversing the process would have meant that Greenspan had FIRST issued the notes and created deposits and, SECOND: with them he had purchased Treasury paper pledging them for the purpose of creating credit ex post facto (retroactively).

To the uninitiated this simple reversal may look innocuous enough and, indeed, Greenspan could have argued that nothing more than a simple housekeeping change was put into effect that fell well within his authority. On closer scrutiny, however, it appeared that it was not a housekeeping change at all. It was, if indeed it happened the way I have assumed it did, an instance of usurpation of power that Congress alone has: to amend the Federal Reserve Act. No abundance of words would change the fact that, if Greenspan had done that, then he had created F.R. credit in blatant violation of the law. The difference made by the reversal was the difference between issuing F.R. credit lawfully, or issuing it unlawfully.

To see this just imagine that you are applying for a loan at the bank. The manager lets you sign the note and credits your account with an equivalent deposit.

In escorting you to the door he pats you on the back and, when you are on the street, gives you a parting shout: “Don’t forget to drop back with the collateral at your convenience!”

If my allegations came anywhere close to the truth, then it would mean that the pregnant Trojan horse has been dragged up the hill and is now firmly implanted inside of the inner sanctum of the citadel. The Greek soldiers hiding inside the wooden horse were just waiting for the signal to get out of its belly, to fall upon the inhabitants of Troy and murder them in their sleep, women, children and all.

Translate that ancient story of Homer to our present situation and see that pirates have taken over our government’s finances, and are getting ready to help themselves to the public purse. These pirates apparently believe that members of the Legislative Branch, congressmen and senators, are simpletons. They can be easily persuaded that no more than a mere technical housekeeping change is involved. After all it is inconsequential, is it not, whether the cleaning people wash the windows first and scrub the floor afterwards, or whether they do them in the opposite order. The same is true, for the stronger reason, for the experts at the Fed.

Should anyone try to tip off legislators about the prestidigitation, he could always be dismissed as a ‘foggy bottom belly-acher’. Only a heartless economic royalist would deny relief money to the unemployed, the breadwinner with a foreclosed home, and their starving families. Also, remember, Treasury paper was bought by the Fed directly from the Treasury to keep the rate of interest fixed during World War II. Now we are at war once more combating terrorism. Can we do any less than we did then, to achieve victory?

I have known Congressman Ron Paul for close to forty years. I respect him and I think I can confidently say that he also respects me. He knows I am a careful scholar. I thought of briefing him on my suspicion. On second thought, however, I rejected the idea. It would be unfair to him on account of the scanty evidence I could offer. It would only embarrass him. He would have to fight an army of Fed attorneys, Fed accountants, and Fed economists single handedly. They would easily discredit him. It would be a lonely fight, against the odds, on a slanting field, adjudicated by an umpire bribed with our own money.

A better plan would be to wait until the pirates make a mistake, as they were likely to do after their initial successes. Given enough rope, they might just hang themselves.

I think this is exactly what has happened with QE, the rope the pirates asked for and got. QE I was an enormous over-reach. Yet, incredibly, no one at home or abroad has even questioned its legality. Pirates in the belly of the Trojan horse thought that their hour has struck. They were ready for the massacre.

The combined F.R. credit creation of QE I and II exceeds one trillion dollars. There is no way underneath the Sun to come up with unencumbered collateral of that magnitude to make this miraculous money proliferation legal.

It is time to blow the whistle. It is time for the sacred geese of Juno Moneta to honk, sounding the wake-up call for the sleepers to start defending themselves against mortal danger: that of being sold into slavery.

French boys and girls, if you asked them where the French equivalent of the word ‘money’ has come from, would answer: “Why, it means ‘silver’, doesn’t it?” By contrast, most native English speakers don’t know the origin of the English word ‘money’. That’s a pity because the explanation is fascinating. It is wrapped in a fairy-tale like story. Well, schools do not teach fairy tales any more, even if they have a moral on which your life may one day depend.

Many years after the rape of Troy by the Greeks, Rome was similarly threatened by its enemy, the barbarian tribe of the Gauls that invaded the peninsula and put Rome under siege. Inhabitants took refuge in the Capitolium.

The patroness of Rome was the supreme goddess Juno, wife of Jupiter, the father of the Olympian gods and goddesses. The Romans built a magnificent temple for her honor inside Capitolium, the citadel at the top of the hill which doubled up as the Mint where the gold, silver and copper coins of Rome were struck. In the garden around the temple the sacred geese of Juno dwelt.

In the back of the temple the hill was steep and full of cliffs with no roads.

The Romans expected the assault to come from the opposite side that was less steep and where the roads were. Accordingly, the Romans left the back of the hill undefended. The invaders decided to take advantage of that. They approached the hill from that side and wanted to surprise the inhabitants under the cover of the night and murder them in their sleep.

They climbed the cliffs. Their plan would have probably succeeded but for the sacred geese of Juno that started honking loud when they noticed the invaders.

That in turn woke up the defenders who drove off the enemy and defeated them decisively in the battle that followed next day. Unlike the story of Troy, this one had a happy ending.

The Romans gave thanks to their patroness Juno and thereafter called her Juno Moneta (Juno the warner, or Juno the admonitor). And Rome went on to great things. Her coins carried her fame, glory and riches to the far corners of the known world. And because they were minted in the temple of Juno Moneta, people lovingly called them ‘money’.

Let this be the wake-up call for America. Terrorism is a red herring. The real enemy is already inside of the citadel. The pirates have taken over the Fed. The sacred geese of Juno are honking loudly.

May Juno Moneta once more save our civilization.

### Reference

A. E. Fekete, Impeach Bernanke![www.professorfekete.com](https://www.professorfekete.com), April 6, 2011

---

*April 12, 2011.*

---

# Impeach Bernanke!

URL: https://newaustrianeconomics.com/archive/fekete/impeach-bernanke/
Date: 2011-04-06
Section: Popular Economics
Difficulty: accessible
Concept Tags: federal-reserve, monetary-policy, fiat-currency, sound-money
Description: Fekete calls for the impeachment of Federal Reserve Chairman Ben Bernanke, arguing that his quantitative easing programs constitute a deliberate destruction of the dollar's purchasing power — effectively a massive unconstitutional tax on dollar holders. He presents a legal and monetary case that QE violates the Constitution's prohibition on bills of credit.
Editorial Note: Written April 2011 as QE2 was proceeding. Fekete's combative title reflects his view that the Fed's actions are not merely economically misguided but constitutionally illegal.
Original PDF: https://professorfekete.com/articles/AEFImpeachBernanke.pdf

## Impeach Bernanke!

### An open letter to Congressman Ron Paul of Texas

### Antal E. Fekete

---

*April 6, 2011*

Dear Dr. Paul:

There are serious questions about the legality of Quantitative Easing. You are among the few who are well-qualified and well-placed to get to the bottom of it.

Most people believe, and the media confirm them in that belief, that the Fed can legally create dollars ‘out of the thin air’ in any quantity, and can do with them as it pleases. This may well be the pipe dream of Dr. Bernanke who is quoted as saying that the U.S. government has given the Fed a tool, the printing press, to stop deflation — but it hardly corresponds to the truth. The Fed can create new dollars only if some stringent legal conditions are satisfied, and then, it can only dispose of them in certain ways prescribed by law.

Contrary to a statement of Dr. Bernanke, made before he became the Chairman of the Board of Governors of the Fed, he could not drop freshly printed dollars from a helicopter, no matter how many reasons for such an action he may be able to cite. Another thing the Fed is not allowed to do legally is to purchase Treasury paper from the U.S. Treasury directly. It must be purchased indirectly through open market operations. If you don’t put the Treasury paper through the test of the open market before the Fed is allowed to buy it, the presumption is that the market would reject it as worthless, or would take it only at a deep discount. The law does not allow the F.R. banks to purchase Treasury paper directly from the Treasury because that would make money creation through the F.R. banks a charade, reserve requirements a farce, and the dollar a sham.

If that were the only problem with Quantitative Easing, it would be bad enough.

But there is something else that is even more ominous. The fact is that the Federal Reserve banks can purchase Treasury paper only if they pay with

F.R. credit that has been legally created.

F.R. credit (F.R. notes and F.R. deposits) is legally created if it has been issued in accordance with the law. The law says that F.R. credit must be backed by collateral security at the time of issuance, usually in the form of an equivalent amount of U.S. Treasury paper. The procedure is as follows.

The F.R. bank seeking to expand credit takes its Treasury paper, owned outright and free from encumbrances, and posts it as collateral with the Federal Reserve agent who will then authorize the issuing of credit. In other words, if the F.R. banks do not have the unencumbered Treasury paper in their possession, then they cannot create additional credit legally.

There is some evidence that the F.R. banks do not have F.R. credit available to make the kind of purchases Dr. Bernanke is talking about as part of his Quantitative Easing. Nor do they have unencumbered Treasury paper in sufficient quantity that they could post with the F.R. agent for authorizing the issue of additional F.R. credit.

The point is that the process of posting collateral first, and augmenting F.R. credit afterwards must under no circumstances be reversed. What the F.R. banks cannot legally do is to buy the Treasury paper first with unauthorized F.R. credit, post the paper as collateral, and justify the illegal issuance of credit retroactively. Nor can they borrow the bond from the Treasury, post it as collateral, and pay for the bond retroactively.

This is an important limitation separating the regime of market-based irredeemable currency from the regime of fiat money involving outright monetization of government debt — the graveyard where the Continental dollar, the assignat, the mandat, the Reichsmark, and the Zimbabwe dollar (among countless others) rest.

At any rate, retroactive authorization of F.R. credit, if that’s what the Fed is up to, would be a violation of both the letter and spirit of the F.R. Act. It would mean converting the dollar into outright fiat money through the back door, bypassing Congress. It would show absolute bad faith on the part of the Chairman of the Federal Reserve Board of Governors, Dr. Ben Bernanke, who certainly knows what the law is. Such a blatant violation of the law would make him totally unfit for the powerful office he occupies. It would call for his immediate and dishonorable discharge by the President, pending Congressional investigation of the matter.

The various violations of the law of which the Fed is accused point to a concerted effort to remove the shackles the law has put on the money spigots lest crooks help themselves to the public purse. These violations are not isolated incidents. They are aiming at the corruption of the monetary order of the nation and the world. Moreover, they would ultimately figure prominently among the causes of the financial instability the world has been suffering from since 1971 and, more recently, since 2008.

Without understanding this fundamental truth, all talk about stabilizing the monetary system and reining in the runaway budget deficit is an exercise in futility.

Yours very sincerely,

### Antal E. Fekete

### Professor (retired)

### Memorial University of Newfoundland

### Tel./Fax: +36-1-325-7996

Note: an identical letter has been sent to Congressman Mike Pence of Indiana.

---

# Apology of the Pencil

URL: https://newaustrianeconomics.com/archive/fekete/apology-of-the-pencil/
Date: 2011-04-02
Section: Popular Economics
Difficulty: accessible
Concept Tags: sound-money, gold-standard, new-austrian-economics, federal-reserve
Description: Inspired by Leonard Read's I, Pencil, Fekete extends the division-of-labor parable to money, arguing that sound money — like the pencil — is the product of an extended market order that no central planner can replicate. Irredeemable currency is like a pencil that no one made but the government issued — it fails because it lacks the market knowledge that organic monetary evolution produces.
Editorial Note: Written April 2011. One of Fekete's more literary essays, using Read's famous parable as a springboard for his monetary analysis.
Original PDF: https://professorfekete.com/articles/AEFApologyOfThePencil.pdf

*Apology Of The Pencil I, Pencil My Family Tree Updated, As Told To*

**Antal E. Fekete**

### Demand for pencils in the Stone Age

I related my family tree to Leonard E. Read back in 1958 (transcript appended at the end of this update). I offer my belated apology to gold miners and the makers of their mining equipment for not mentioning them in my genealogy. I proudly acknowledge that in this genealogy, just as in that of every economic good, gold inevitably enters, directly or indirectly, through the exchange of semi-finished goods as they are being handed over by the producer of the higher to that of the lower-order goods for further processing.

There is some controversy about the question whether the gold miners and makers of their mining equipment have since dropped out of the circle of people in my genealogy after 1973, when gold was demonetized by all the governments of the world, or whether they still play a role in providing financing for the production and distribution of consumer goods. I must confess that I was fearing for my life that year. I believed that world trade would collapse in short order and civilization would be rolled back to the Stone Age where need existed neither for writing nor for pencils.

As we all know, that did not happen. Governments and bankers hijacked the gold belonging to the people, and they sequestered the social circulating capital. They took over the responsibility for financing the flow of maturing goods from the primary producer all the way to the ultimate consumer. That take-over made things worse, not better. It was the root cause of a seemingly endless series of currency crises. In spite of this, the millennium of fiat money, exiling gold from the monetary system forever, was declared and hailed.

That did not diminish my worries; it increased them. I knew that paper is paper and gold is gold. Banking without gold is like production without capital (or maintenance of capital). When the original producer’s goods wear out, producing activity ceases and civilizations fall back to the Stone Age, unawares of what had hit them. This process of wearing out capital is of course not instantaneous. It could take decades. But when capital erosion is complete, collapse of civilizations occurs as surely as night follows the day. The nexus between cause and effect may well be obscured, but can never be over-ruled.

### Falling interest rates, the destroyer of capital

It seems to me that the final stage of erosion of capital is occurring right now. A synopsis of what has taken place during the past four decades is as follows.

First, interest rates were destabilized and rising rates destroyed the major part of productive capital of the producers as well as the financial capital of the banks.

To understand this you don’t have to know more than the bare fact that rising rates decimate the market value of bonds and that of all other sources of fixed income.

In 1980 the Fed reacted by pushing the rate of interest all the way down from 22 percent to virtually 0. It took three decades to accomplish this feat. In doing so the Fed destroyed the remaining capital of producers as well as that of the banks. The truth of this has not been recognized, however. In fact, the thesis that a falling interest-rate structure is lethal to the economy has been dismissed out of hand. The argument goes that if rising interest rates decimate bond values, then falling ones enhance them, thus enhancing wealth. There is no need to argue the point that falling interest rates raise the present value of a future income stream. The trouble is that the firm must be around to benefit from it.

Most of them won’t be. They will be wiped out for reasons of insufficient capital. Accounting rules do not admit the treatment of cash receivable as cash in the till. The fact is that as long as the regime of falling interest rates was continuing, no one in his right mind would add to his investments, otherwise they were doomed by the further fall.

Most observers fail to see the danger in either the upswing or the downswing in the rate of interest and think that, in fact, the downswing is beneficial. Yet a falling interest rate structure inevitably destroys capital, whether seen by the observers or not.

Although we cannot be certain about it, the rate of interest has been effectively killed by “monetary policy” and is not likely to rise from the dead, ready for another run. Even if it is, and another devastating swing of the wrecker’s ball is coming, that will administer the coup de grâce to productive and financial capital.

### Real Bills Doctrine

My forgetfulness in ignoring gold miners and the makers of gold mining equipment in my family tree was due to the extremely low cost per unit of product of financing production and movement. Since I am in very high consumer demand, second only to food and clothes, my production and distribution is not financed through savings. It is financed through drawing or endorsing real bills against the shipments of my ingredients by the higher to the lower-order producer.

The difference in the method of financing is a most important distinction.

My distant cousin the typewriter is not in such a high consumer demand (in fact, right now it is in danger of going the way of the dodo bird). Its production is financed through savings as real bills drawn on the typewriter and the movement of its ingredients ‘could not fly’. The movement of those ingredients as they change hands between the producers of higher and lower-order goods was financed directly by paying cash, not by drawing bills. For this reason, gold miners were much more prominently represented in the family tree of the typewriter. The contribution to the demand for gold attributable to the cost of financing production and distribution of typewriters was sizeable.

In my case, cash entered the chain of production and distribution but once: when the ultimate consumer bought his pencil from the retail merchant. All other exchanges between producers and distributors of higher and lower order goods were financed through billing or discounting real bills. The claims arising out of all these bills were settled from the cash payment for the pencil at the end of the supply chain. We may visualize this as the single gold coin released by the consumer extinguishing all claims arising during the long journey of my ingredients from the primary producer to the shelf of the retail merchant.

Indeed, the bill market was the clearing house of the gold standard. The contribution to the demand for gold attributable to the cost of financing my production and distribution, and that of billions of my brothers, was negligible. (Of course, this is no excuse for my oversight in ignoring the gold miners in my family-tree).

### “I have told you so: gold is deflationary”

I was flabbergasted at hearing the proposal, promoted by the Mises Institute, that after the present banking collapse they should introduce the so-called 100 percent gold standard. This means a gold standard without real bills circulation.

A gold standard bereft of its clearing house, the bill market, is brain dead. It would be a walking zombie — just as it was after Britain had returned to it in 1925.

People at the Mises Institute should be careful about what they wish for, because they might just get it. If they had understood what I had to say in my genealogy published in 1958, they would have never proposed such a hare- brained scheme as the 100-percent gold standard. As I have explained to Leonard, I am a simple and humble product, and neither myself, nor any of my ingredients represent high value. Yet there are millions of transactions whereby my ingredients are passed along the supply chain from one hand to the next. If you multiply the modest value of my ingredients with the number of transactions which is in the millions, and you have to pay gold to complete every one of those transactions, then you make such inroads into the stock of gold that trade and production will soon seize up and, to end insult to injury, you have to face the enemies of gold standard gleefully teasing you: “See, I have told you so: gold is deflationary.”

The payments system would become inelastic. The peak season to buy pencils is late August and early September. It is highly questionable that the 100 percent gold standard (so-called) could meet the extra demand for purchasing media to buy school supplies, including pencils. Furthermore, such an imaginary monetary system would be a fetter upon any further refinement of division of labor, as it would require more gold, even without an increase in pencil consumption, to finance the entry of extra producers the chain of semi-finished products. The 100 percent gold standard (so called) would be the end of all further improvement of production equipments and methods.

### Adam Smith was no fool

If Adam Smith has done nothing else but contributing the “invisible hand” metaphor to our language, his place in the history of economics would be secure. But Adam Smith has contributed another metaphor as well, perhaps less well-known: that of the “waggon way in the sky”.

It is the mental image of financing production and distribution of consumer goods in most urgent demand through real bill circulation. This image is not fanciful. It has been tried in practice and was found to be working beautifully — long before jet cargo planes were put into service. The idea is simple: just as air transport could free up land presently used as wagon ways, that could be put back into agricultural production, the same way real bills circulation would free up gold and make it available for long-term credit and investments that could not be financed through the bill market.

Real bills should have been allowed to make a come-back at the end of World War I. But the victors were not interested in multilateral trade. They felt more secure under the regime of bilateral trade offering, as it was, a ready shelter for the slow paper of the inefficient producers. We should remember that it took more than half a century for world trade to outstrip its own record chalked up in 1913, because the ban on real bills circulation and multilateral trade was an insurmountable setback.

Banning real bills and multilateral trade is coercion. What kind of free market is that which cannot stand the competition of spontaneous real bills circulation? The free market aspect of real bills should shake up politicians and economist from their lethargy. It is all very well to overthrow the tyranny of legal tender paper money that outlawed gold. But it would be preposterous to replace it with a new tyranny outlawing the circulation of real bills.

I told Leonard in 1958 that if you contemplate the miraculous nature of my existence and the fact that knowledge and know-how cannot reside in one single individual to make my creation possible, then you can help save the freedom mankind is so unhappily losing. The bill market also represents knowledge and know-how that cannot reside in one single individual for the stronger reason. Nor can it reside in a computer or a network of computers.

The bill market flows and ebbs with consumer demand under the signaling system of the discount rate, sending an urgent message to all producers about the state of mind of the sovereign consumer and his propensity to consume. The price system is far too sluggish for that purpose. Change in the taste and preferences of the consumer requires immediate action.

But there is a second reason, too, why the bill market is all-important. The retail merchant is the arbitrageur between social circulating capital and the bill market. He keeps not only an inventory of consumer goods on his shelves; but also a portfolio of real bills drawn on other retail merchants who work with a higher productivity. If the discount rate rises, he sells out marginal merchandise without restocking and buys bills on others. That way he will participate in their earnings whenever his own business slackens. At the first sign of a reversal he will sell bills from portfolio at a profit and restock his inventory from the proceeds.

Preserving freedom, preserving free markets means, among other things, the preservation of real bills and the regime of multilateral trade that they represent. Gold is what makes the world go round — but it must be used with the greatest care, sparing it from frivolous uses by pig-headed and ham-handed “experts”.

## I, Pencil

## My Family Tree As Told To

### Leonard E. Read 1

I am a lead pencil—the ordinary wooden pencil familiar to all boys and girls and adults who can read and write.2

Writing is both my vocation and my avocation; that's all I do.

You may wonder why I should write a genealogy. Well, to begin with, my story is interesting. And, next, I am a mystery — more so than a tree or a sunset or even a flash of lightning. But, sadly, I am taken for granted by those who use me, as if I were a mere incident and without background. This supercilious attitude relegates me to the level of the commonplace. This is a species of the grievous error in which mankind cannot too long persist without peril. For, as a wise man observed, "We are perishing for want of wonder, not for want of wonders."3

I, Pencil, simple though I appear to be, merit your wonder and awe, a claim I shall attempt to prove. In fact, if you can understand me—no, that's too much to ask of anyone — if you can become aware of the miraculousness which I symbolize, you can help save the freedom mankind is so unhappily losing. I have a profound lesson to teach. And I can teach this lesson better than can an automobile or an airplane or a mechanical dishwasher because — well, because I am seemingly so simple.

Simple? Yet, not a single person on the face of this earth knows how to make me. This sounds fantastic, doesn't it? Especially when it is realized that there are about one and one-half billion of my kind produced in the U.S.A. each year.

Pick me up and look me over. What do you see? Not much meets the eye

— there's some wood, lacquer, the printed labeling, graphite lead, a bit of metal, and an eraser.

Just as you cannot trace your family tree back very far, so is it impossible for me to name and explain all my antecedents. But I would like to suggest enough of them to impress upon you the richness and complexity of my background.

My family tree begins with what in fact is a tree, a cedar of straight grain that grows in Northern California and Oregon. Now contemplate all the saws and trucks and rope and the countless other gear used in harvesting and casting the cedar logs to the railroad siding. Think of all the persons and the numberless skills that went into their fabrication: the mining of ore, the making of steel and its refinement into saws, axes, motors; the growing of hemp and bringing it through all the states to heavy and strong rope; the logging camps with their beds and mess halls, the cookery and the raising of all the foods. Why, untold thousands of persons had a hand in every cup of coffee the loggers drink!

The logs are shipped to a mill in San Leandro, California. Can you imagine the individuals who make flat cars and rails and railroad engines and who construct and install the communication systems incidental thereto? These legions are among my antecedents.

Consider the millwork in San Leandro. The cedar logs are cut into small, pencil-length slats less than one-fourth of an inch in thickness. These are kiln dried and then tinted for the same reason women put rouge on their faces.

People prefer that I look pretty, not a pallid white. The slats are waxed and kiln dried again. How many skills went into the making of the tint and the kilns, into supplying the heat, the light and power, the belts, motors, and all the other things a mill requires? Sweepers in the mill among my ancestors? Yes, and included are the men who poured the concrete for the dam of a Pacific Gas & Electric Company hydro-plant which supplies the mill's power!

Don't overlook the ancestors, present and distant, who have a hand in transporting sixty carloads of slats across the nation from California to WilkesBarre!

### Complicated Machinery

Once in the pencil factory — \$4,000,000 in machinery and building, all capital accumulated by thrifty and saving parents of mine — each slat is given eight grooves by a complex machine, after which another machine lays leads in every other slat, applies glue, and places another slat atop — a lead sandwich, so to speak. Seven brothers and I are mechanically carved from this "woodclinched" sandwich.

My "lead" itself — it contains no lead at all — is complex. The graphite is mined in Ceylon. Consider these miners and those who make their many tools and the makers of the paper sacks in which the graphite is shipped and those who make the string that ties the sacks and those who put them aboard ships and those who make the ships. Even the lighthouse keepers along the way assisted in my birth—and the harbor pilots.

The graphite is mixed with clay from Mississippi in which ammonium hydroxide is used in the refining process. Then wetting agents are added such as sulfonated tallow — animal fats chemically reacted with sulfuric acid. After passing through numerous machines, the mixture finally appears as endless extrusions — as from a sausage grinder — cut to size, dried, and baked for several hours at 1,850 degrees Fahrenheit. To increase their strength and smoothness the leads are then treated with a hot mixture which includes candelilla wax from Mexico, paraffin wax, and hydrogenated natural fats.

My cedar receives six coats of lacquer. Do you know all of the ingredients of lacquer? Who would think that the growers of castor beans and the refiners of castor oil are a part of it? They are. Why, even the processes by which the lacquer is made a beautiful yellow involves the skills of more persons than one can enumerate!

Observe the labeling. That's a film formed by applying heat to carbon black mixed with resins. How do you make resins and what, pray, is carbon black?

My bit of metal — the ferrule — is brass. Think of all the persons who mine zinc and copper and those who have the skills to make shiny sheet brass from these products of nature. Those black rings on my ferrule are black nickel. What is black nickel and how is it applied? The complete story of why the center of my ferrule has no black nickel on it would take pages to explain.

Then there's my crowning glory, inelegantly referred to in the trade as "the plug," the part man uses to erase the errors he makes with me. An ingredient called "factice" is what does the erasing. It is a rubber-like product made by reacting rape seed oil from the Dutch East Indies with sulfur chloride.

Rubber, contrary to the common notion, is only for binding purposes. Then, too, there are numerous vulcanizing and accelerating agents. The pumice comes from Italy; and the pigment which gives "the plug" its color is cadmium sulfide.

### No One Knows

Does anyone wish to challenge my earlier assertion that no single person on the face of this earth knows how to make me?

Actually, millions of human beings have had a hand in my creation, no one of whom even knows more than a very few of the others. Now, you may say that I go too far in relating the picker of a coffee berry in far off Brazil and food growers elsewhere to my creation; that this is an extreme position. I shall stand by my claim. There isn't a single person in all these millions, including the president of the pencil company, who contributes more than a tiny, infinitesimal bit of know-how. From the standpoint of know-how the only difference between the miner of graphite in Ceylon and the logger in Oregon is in the type of know-how. Neither the miner nor the logger can be dispensed with, any more than can the chemist at the factory or the worker in the oil field—paraffin being a byproduct of petroleum.

Here is an astounding fact: Neither the worker in the oil field nor the chemist nor the digger of graphite or clay nor any who mans or makes the ships or trains or trucks nor the one who runs the machine that does the knurling on my bit of metal nor the president of the company performs his singular task because he wants me. Each one wants me less, perhaps, than does a child in the first grade. Indeed, there are some among this vast multitude who never saw a pencil nor would they know how to use one. Their motivation is other than me. Perhaps it is something like this: Each of these millions sees that he can thus exchange his tiny know-how for the goods and services he needs or wants. I may or may not be among these items.

### No Master Mind

There is a fact still more astounding: The absence of a master mind, of anyone dictating or forcibly directing these countless actions which bring me into being.

No trace of such a person can be found. Instead, we find the Invisible Hand at work. This is the mystery to which I earlier referred.

It has been said that "only God can make a tree." Why do we agree with this? Isn't it because we realize that we ourselves could not make one? Indeed, can we even describe a tree? We cannot, except in superficial terms. We can say, for instance, that a certain molecular configuration manifests itself as a tree.

But what mind is there among men that could even record, let alone direct, the constant changes in molecules that transpire in the life span of a tree? Such a feat is utterly unthinkable!

I, Pencil, am a complex combination of miracles: a tree, zinc, copper, graphite, and so on. But to these miracles which manifest themselves in Nature an even more extraordinary miracle has been added: the configuration of creative human energies — millions of tiny know-hows configurating naturally and spontaneously in response to human necessity and desire and in the absence of any human master-minding! Since only God can make a tree, I insist that only God could make me. Man can no more direct these millions of know-hows to bring me into being than he can put molecules together to create a tree.

The above is what I meant when writing, if you can become aware of the miraculousness which I symbolize, you can help save the freedom mankind is so unhappily losing. For, if one is aware that these know-hows will naturally, yes, automatically, arrange themselves into creative and productive patterns in response to human necessity and demand — that is, in the absence of governmental or any other coercive master-minding — then one will possess an absolutely essential ingredient for freedom: a faith in free men. Freedom is impossible without this faith.

Once government has had a monopoly of a creative activity such, for instance, as the delivery of the mails, most individuals will believe that the mails could not be efficiently delivered by men acting freely. And here is the reason: Each one acknowledges that he himself doesn't know how to do all the things incident to mail delivery. He also recognizes that no other individual could do it. These assumptions are correct. No individual possesses enough know-how to perform a nation's mail delivery any more than any individual possesses enough know-how to make a pencil. Now, in the absence of a faith in free men — in the unawareness that millions of tiny know-hows would naturally and miraculously form and cooperate to satisfy this necessity — the individual cannot help but reach the erroneous conclusion that mail can be delivered only by governmental "master-minding."

If I, Pencil, were the only item that could offer testimony on what men can accomplish when free to try, then those with little faith would have a fair case. However, there is testimony galore; it's all about us and on every hand.

Mail delivery is exceedingly simple when compared, for instance, to the making of an automobile or a calculating machine or a grain combine or a milling machine or to tens of thousands of other things. Delivery? Why, in this area where men have been left free to try, they deliver the human voice around the world in less than one second; they deliver an event visually and in motion to any person's home when it is happening; they deliver 150 passengers from Seattle to Baltimore in less than four hours; they deliver gas from Texas to one's range or furnace in New York at unbelievably low rates and without subsidy; they deliver each four pounds of oil from the Persian Gulf to our Eastern Seaboard — halfway around the world — for less money than the government charges for delivering a one-ounce letter across the street!

The lesson I have to teach is this: Leave all creative energies uninhibited.

Merely organize society to act in harmony with this lesson. Let society's legal apparatus remove all obstacles the best it can. Permit these creative knowhows freely to flow. Have faith that free men will respond to the Invisible Hand. This faith will be confirmed. I, Pencil, seemingly simple though I am, offer the miracle of my creation as testimony that this is a practical faith, as practical as the sun, the rain, a cedar tree, the good earth.

### Footnotes

First appeared in the magazine The Freeman, December, 1958.

My official name is "Mongol 482." My many ingredients are assembled, fabricated, and finished by Eberhard Faber Pencil Company, Wilkes-Barre,

Pennsylvania.

G. K. Chesterton.

---

# Silver and Opium

URL: https://newaustrianeconomics.com/archive/fekete/silver-and-opium/
Date: 2011-02-10
Section: Popular Economics
Difficulty: accessible
Concept Tags: silver, bimetallic, gold-standard, sound-money, monetary-policy
Description: 2011 Position Paper #5: Fekete uses the historical connection between silver and the opium trade to illuminate present-day silver market dynamics. He argues that silver's suppression by Western financial powers is analogous to the 19th-century suppression of silver as monetary metal — a coercive policy serving specific financial interests at the expense of producers and savers.
Editorial Note: 2011 Position Paper #5 (February 2011). The historical silver-opium connection gives Fekete a vivid frame for his ongoing analysis of silver market manipulation.
Original PDF: https://professorfekete.com/articles/AEFPositionPaper5SilverAndOpium.pdf

## Silver And Opium

The opium wars do not belong to the glorious episodes of Western history.

Rather, they were instances of shameful behavior the West still has not lived down. Mercantilist governments resented the perpetual drain of silver from West to East in payment for Oriental goods (tea, silk, porcelain) that were in high demand in the Occident, facing low demand in the Orient for Occidental goods.

From the mid-17th century more than 9 billion Troy ounces or 290 thousand metric tons of silver was absorbed by China from European countries in exchange for Chinese goods.

The British introduced opium along with tobacco as an export item to China in order to reduce their trade deficit. Under the disguise of free trade, the British, the Spanish and the French with the tacit approval of the Americans continued sending their contraband to China through legitimate as well as illegitimate trade channels even after the Chinese dynasty put an embargo on opium imports. Because of its strong appeal to the Chinese masses, and because of its highly addictive nature, opium appeared to be the ideal solution to the West’s trade problem. And, indeed, the flow of silver was first stopped, and then reversed. China was forced to pay silver for her addiction to opium smoking that was artificially induced by the pusher: the British.

Thus silver was replaced by opium as the mainstay of Western exports. In 1729 China, recognizing the growing problem of addiction and the debilitating and mind-corrupting nature of the drug, prohibited the sale and smoking of opium; allowing only a small quota of imports for medicinal purposes. The British defied the embargo and ban on opium trade, and encouraged smuggling.

As a result, British exports of opium to China grew from an estimated 15 tons to 75 by 1773. This increased further to 900 tons by 1820; and to 1400 tons annually by 1838 — an almost 100-fold increase in 100 years.

Something had to be done. The Chinese government introduced death penalty for drug trafficking, and put British processing and distributing facilities on Chinese soil under siege. Chinese troops boarded British ships in international waters carrying opium to Chinese ports and destroyed their cargo, in addition to the destruction of opium found on Chinese territory. The British accused the Chinese of destroying British property, and sent a large BritishIndian army to China in order to exact punishment.

British military superiority was clearly evident in the armed conflict.

British warships wreaked havoc on coastal towns. After taking Canton the British sailed up the Yangtze River. They grabbed the tax barges, inflicting a devastating blow on the Chinese as imperial revenues were impossible to collect. In 1842 China sued for peace that was concluded in Nanking and ratified the following year. In the treaty China was forced to pay an indemnity to Britain, open four port cities where British subjects were given extraterritorial privileges, and cede Hong Kong to Britain. In 1844 the United States and France signed similar treaties with China.

These humiliating treaties were criticized in the House of Commons by William E. Gladstone, who later served as Prime Minister. He was wondering “whether there had ever been a war more unjust in its origin, a war more calculated to cover Britain with permanent disgrace.” The Foreign Secretary, Lord Palmerston replied that nobody believed that the Chinese government’s motive was “the promotion of good moral habits”, or that the war was fought to stem China’s balance of trade deficit. The American president John Quincy Adams chimed in during the debate by suggesting that opium was a “mere incident”. According to him “the cause of the war was the arrogant and insupportable pretensions of China that she would hold commercial intercourse with the rest of mankind not upon terms of equal reciprocity, but upon the insulting and degrading forms of the relations between lord and vassal.” These words are echoed, 160 years later, by president Obama’s recent disdainful pronouncements to the effect that China’s exchange-rate policy is unacceptable to the rest of mankind as it pretends that China’s currency is that of the lord, and everybody else’s is that of the vassal.

The peace of Nanking did not last. The Chinese searched a suspicious ship, and the British answered by putting the port city of Canton under siege in 1856, occupying it in 1857. The French also entered the fray. British troops were approaching Beijing and set on to destroy the Summer Palace. China again was forced to sue for peace. In the peace treaty of Tianjin China yielded to the demand to create ten new port cities, and granted foreigners free passage throughout the country. It also agreed to pay an indemnity of five million ounces of silver: three million to Britain and two million to France.

This deliberate humiliation of China by the Western powers contributed greatly to the loosening and ultimate snapping of the internal coherence of the Qing Dynasty, leading to the Taiping Rebellion (1850-1864), the Boxer Uprising (1899-1901) and, ultimately, to the downfall of the Qing Dynasty in 1912.

The present trade dispute between the U.S. and China is reminiscent of the background to the two Opium Wars. Once more, the issue is the humiliation and plunder of China as a “thank you” for China’s favor of having provided consumer goods for which the West was unable to pay in terms of Western goods suitable for Chinese consumption. The only difference is the absence of opium in the dispute.

Oops, I take it back. The role of opium in the current dispute is played by paper. Paper dollars, to be precise. In 1971 an atrocity was made that I call the Nixon-Friedman conspiracy. To cover up the shame and disgrace of the default of the U.S. on its international gold obligations, Milton Friedman (following an earlier failed attempt of John M. Keynes) concocted a spurious and idiotic theory of floating exchange rates. It suggests that falling foreign exchange value of the domestic currency makes it stronger when in actual fact the opposite is true: it is made weaker as the terms of trade of the devaluing country deteriorates and that of its trading partners improves. Nixon was quick to embrace the false theory of Friedman. No public debate of the plan was permitted then, or ever after. Under the new dispensation the irredeemable dollar was to play the role of the ultimate extinguisher of debt, a preposterous idea.

The scheme was imposed on the world under duress as part of the “new millennium”, shaking off the “tyranny of gold”, that “barbarous relic”, the last remnant of superstition, the only remaining “anachronism of the Modern Age”.

The ploy was played up and celebrated as a great scientific breakthrough, making it possible for man to shape his own destiny rationally, free of superstition, for the first time ever. Yet all it was a cheap trick to elevate the dishonored paper of an insolvent banker (the U.S.) from scum to the holy of holies: international currency. The fact that fiat paper money has a history of 100 percent mortality was neatly side-stepped. Any questioning of the wisdom of experimenting with is in spite of logic and historical evidence was declared foggy-bottom reactionary thinking.

The amazing thing about this episode of the history of human folly was the ease with which it could be pushed down the throat of the rest of the world, including those nations that were directly hurt by it, such as the ones running a trade surplus with the U.S. Their savings went up in smoke. The explanation for this self-destructing behavior is the addictive, debilitating and mind-corrosive nature of paper money, in direct analogy with that of opium. The high caused by administering the opium pipe to the patient (read: administering QE) had to be repeated when the effect faded by a fresh administration of more opium (read: more QE2).

If the patient resists, like China did in 1840, then a holy opium war must be declared on it in the name of the right of others to free trade. 170 years later a New China once more demurred against the paper-torture treatment it was subjected to by the American debt-mongers and opium pushers.

But beware: if the West starts another Opium War, this time it is not China that will be on the losing side.

### Reference

Opium Wars, Wikipedia, June 29, 2010.

## Announcement

### New Austrian School of Economics

Course Two at the Martineum Academy in Szombathely, Hungary, from March 5 through 13, 2011. Title of the course:

## Adam Smith’S Real Bills Doctrine And Social Circulating Capital

What makes this course especially topical today is the fact that more and more hints are being dropped about the possible rehabilitation and restoration of the gold standard — following the ignominious collapse of the irredeemable dollar. However, a gold standard without its clearing house, the bill market, is not viable and itself is liable to collapse in short order — as it did in the early 1930’s. The level of public ignorance about the necessity of a clearing house is appalling. It is made that much worse by a tottering banking system. We have an urgent message: only gold standard cum real bills can restore prosperity to the world, in view of the fact that we have to write off the world’s banking system as a total loss.

This is the second in a four-course series on Austrian Economics, a branch of economic science based on the work of Carl Menger (1840-1921). It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. The complete program consists of four courses (10 days, 20 lectures each). Completion of each course will earn one credit. Participants who have accumulated four credits get a diploma signed by Professor Fekete. Course One that was given in 2010 is not a prerequisite. It is available on DVD for purchase. For further information please contact Dr. Judith Szepesvari, e-mail: szepesvari17@gmail.com

## New! Extra!

## Seminar

Basis, Co-basis, Permanent Backwardation of Gold and Silver and What It Means March 14, Monday

The New Austrian School of Economics is the only place in the world where you can learn about the gold and silver basis, co-basis, permanent backwardation, and their importance. In 2008 we offered a successful Seminar on the basis in Canberra, Australia, that was followed by a second Seminar in 2009. This will be the third in the series, where the latest results of the ongoing research on the gold and silver basis and co-basis will be discussed by our star research fellow, Sandeep Jaitly, followed by an open-ended discussion.

No prerequisites are needed: we start with an introductory lecture on the basis and co-basis, with reference to permanent backwardation, by Professor Fekete.

For more details, contact Dr. Judit Szepesvari: szepesvari17@gmail.com

---

# Chinese Puzzle

URL: https://newaustrianeconomics.com/archive/fekete/chinese-puzzle/
Date: 2011-02-07
Section: Popular Economics
Difficulty: accessible
Concept Tags: monetary-policy, fiat-currency, gold-standard, federal-reserve
Description: 2011 Position Paper #4: Fekete examines the puzzle of Chinese monetary policy — why China accumulates dollar reserves it knows will depreciate, and what this reveals about the dynamics of the international dollar system. He argues China is a rational actor trapped in a monetary system designed to exploit surplus countries.
Editorial Note: 2011 Position Paper #4 (February 2011). Fekete's analysis of the China-dollar relationship through his monetary framework provides a different perspective from both mainstream and Austrian analyses.
Original PDF: https://professorfekete.com/articles/AEFPositionPaper4ChinesePuzzle.pdf

## Chinese Puzzle

There is really just one question about China, the Western mindset’s “enigma wrapped in mystery”. How could the Chinese have made the colossal mistake of investing their hard-earned savings in the debt of the U.S. government — to the tune of $ 1 trillion, the largest sum one country has ever loaned another in all history. (There is only one other puzzle greater than this: How could the U.S. government in good faith allow its debt to accumulate in Chinese hands? But we leave that question for another occasion to discuss.) U.S. debt is easy to buy but hard to get rid of. The harder, the larger are the sums involved.

It is true that a huge bull market in bonds has been rolling on for the past 30 years — since 1981. But putting all of China’s eggs into the same basket was a terrible mistake even if we ignore the reckless fiscal and monetary policy the U.S. government has been pursuing since 1971. Belatedly, the Chinese are trying to correct their mistakes through diversification.

China could have learned from Japan’s sad example. Before the Chinese appeared as buyers, Japan was the largest investor in U.S. debt. In 1971 Japan was running an unprecedented trade surplus vis-à-vis the U.S., and the exchange rate of the Japanese yen was 300 to the dollar. American policymakers and money doctors put enormous pressure on Japan to let the yen float upwards, as this was the “in-thing” to do after the Nixon-Friedman conspiracy made the U.S. default on its foreign gold obligations “respectable”, on the spurious theory that this would first ease, then eliminate the American trade deficit.

Japan, in effect still an occupied country, yielded to the American pressure and the yen rose so that by 1981 only 100 yens were needed to buy one dollar. This was a 3-fold appreciation of the yen, but it did not bring about an improvement in the American trade deficit with Japan, as promised by Friedmanite propagandists. Instead, there was a 10-fold further deterioration!

Yet the Americans did not revise their policy recommendations, and continued to insist on floating the yen upwards. It appeared that the Americans had a hidden agenda that was not the elimination of the American trade deficit. Could it have been abatement of the American debt? Indeed, the yen-value of Japan’s foreign exchange reserves held in dollars was cut by two-thirds as a result of foreign exchange policy forced upon Japan.

The Chinese should have seen the writing on the wall: buying dollar-denominated assets was tantamount to kissing good-by to your savings. In terms of the Nixon-Friedman conspiracy this was extortion, an underhanded way of secretly siphoning off the savings of America’s trading partners running surpluses, disguised as exchange-rate policy.

Worse still, when the Japanese wanted to draw on the remnants of their savings held in American banks to tie them over temporary cash shortages, they found that the money wasn’t there. The American money-doctors were ever ready to come up with a solution. The Japanese government had excellent credit rating and no debt to foreigners. Why not borrow the money it needed? Once more, the Japanese meekly complied. They swapped their temporary need for dollars for permanent government debt in yens. By now the Japanese government has the worst indebtedness on record: it would take 2 years of Japan’s GDP to pay it off. See the vicious combination: selling bonds in an appreciating currency while buying bonds in a depreciating currency? A free one-way ticket to the poorhouse.

China should have seen the trap. The Americans want them to buy all the dollar-denominated bonds. Then they would start twisting arms to let the yuan float upwards, ostensibly as a valid exchange-rate mechanism to rectify trade imbalances. Clearly, it is not a valid mechanism because, well, it does not work.

It only makes the trade imbalance worse. Neither are the Americans shooting for elimination of their trade deficit. They are shooting for an abatement of America’s debt. They know that higher exchange rate for the yuan means imperceptibly siphoning off China’s savings. An indigent country, China, underwrote with its savings the profligacy of an affluent country, the U.S. Unbelievably, China appears to be caving in to American demands and let the yuan float upwards.

If the Chinese wanted to draw on the remnants of their savings held in American banks, they might just find out, as the Japanese did before them, that the money isn’t there.

It can be safely predicted that the American debt-mongers would again be on hand to come up with the solution. China has excellent credit rating and zero debt to foreigners. The Chinese should borrow the dollars they needed, to tie themselves over, rather than liquidate their dollar holdings. Like Japan earlier, China, too, could swap its temporary dollar shortage for permanent government debt in the domestic currency. This is debauchery: Mephistopheles trying to corrupt the uncorrupted. This is lacing foreign banking systems with toxic debt.

The Chinese puzzle can be stated as follows. The irrational and masochistic behavior of the Japanese can be explained by the fact that Japan is still an occupied country. But China is not. China could refuse to listen to the siren-song of the American exchange-rate manipulators and debt-mongers. Why doesn’t China stand up to this corruption? “Just say no” to the drug of indebtedness, and expose the debauchery behind it!

Here is the explanation of the Chinese puzzle from a non-Chinese perspective. The 1972 popping up of Nixon in China (which was worth composing an opera on the theme) started the pilgrimage of young uncorrupted Chinese scholars to American universities. Well, at least those among them who were economists, monetary scientists, and banking experts have been thoroughly corrupted and brainwashed. Keynesian and Friedmanite theories have been pumped into them through force-feeding. They have never been told that there is a coherent and respectable body of economic knowledge refuting, point-by-point, the false and corrosive economic theories of Keynes and Friedman. China utterly lacks scholars who are well-versed in Austrian economics and in valid monetary theory, to provide antidote for the Keynesian and Friedmanite poison.

China was made a fertile ground for American debauchery.

Friedman’s theory of deliberate use of foreign exchange rates as a tool of balancing foreign trade is vicious, false, and fraudulent. It has never worked. It never will. It is motivated by American self-interest, ready to wage a new opium war on China, to reduce the indebtedness of the U.S. through a disguised devaluation of the dollar, at the expense of its trading partners, and to push the responsibility for the trade imbalance on the surplus countries.

The correct solution to the trade problem is not the flotation of currencies up and down. Quite to the contrary: the solution is the stabilization of foreign exchange rates! China badly needs advisors who are able to show the way in this direction.

## Announcement

### New Austrian School of Economics

Course Two at the Martineum Academy in Szombathely, Hungary, from March 5 through 13, 2011. Title of the course:

## Adam Smith’S Real Bills Doctrine And Social Circulating Capital

What makes this course especially topical today is the fact that more and more hints are being dropped about the possible rehabilitation and restoration of the gold standard — following the ignominious collapse of the irredeemable dollar. However, a gold standard without its clearing house, the bill market, is not viable and itself is liable to collapse in short order — as it did in the early 1930’s. The level of public ignorance about the necessity of a clearing house is appalling. It is made that much worse by a tottering banking system. We have an urgent message: only gold standard cum real bills can restore prosperity to the world, in view of the fact that we have to write off the world’s banking system as a total loss.

This is the second in a four-course series on Austrian Economics, a branch of economic science based on the work of Carl Menger (1840-1921). It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. The complete program consists of four courses (10 days, 20 lectures each). Completion of each course will earn one credit. Participants who have accumulated four credits get a diploma signed by Professor Fekete. Course One that was given in 2010 is not a prerequisite. It is available on DVD for purchase.

NEW: there will be an add-on optional one-day seminar on the gold and silver basis and the threat of permanent backwardation of the monetary metals on March 14.

Stay tuned for further details. NOTE: All scholarships have now been awarded.

For further information please contact Dr. Judith Szepesvari, e-mail: szepesvari17@gmail.com

## New! Extra!

## Seminar

Basis, Co-basis, Permanent Backwardation of Gold and Silver and What It Means March 14, Monday

The New Austrian School of Economics is the only place in the world where you can learn about the gold and silver basis, co-basis, permanent backwardation, and their importance. In 2008 we offered a successful Seminar on the basis in Canberra, Australia, that was followed by a second Seminar in 2009. This will be the third in the series, where the latest results of the ongoing research on the gold and silver basis and co-basis will be discussed by our star research fellow,

Sandeep Jaitly, followed by an open-ended discussion.

No prerequisites are needed: we start with an introductory lecture on the basis and co-basis, with reference to permanent backwardation, by Professor Fekete.

For more details, contact Dr. Judit Szepesvari: szepesvari17@gmail.com

---

# Bring Back, Bring Back, Bring Back My Gold Bond to Me!

URL: https://newaustrianeconomics.com/archive/fekete/bring-back-my-gold-bond/
Date: 2011-01-31
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, bond-market, interest-theory, real-bills, sound-money
Description: 2011 Position Paper #3: Fekete proposes the gold bond — a long-term bond payable in gold coin — as the instrument needed to restart genuine capital formation. Unlike irredeemable paper bonds, gold bonds would attract genuine savings, provide a stable long-term interest rate, and eliminate the Federal Reserve's ability to manipulate long-term rates through bond purchases.
Editorial Note: 2011 Position Paper #3 (January 2011). The gold bond concept is one of Fekete's more specific policy proposals — a concrete financial instrument that would function as a transition mechanism toward a full gold standard.
Original PDF: https://professorfekete.com/articles/AEFPositionPaper3BringBack.pdf

*Bring Back, Bring Back, O Bring Back My Gold Bond To Me!*

“The mountains went into labor and gave birth — to a mouse! This ancient quotation could be cited to characterize the publication of the long-awaited Financial Crisis Inquiry Report on Thursday, January 27, commissioned by an earlier Congress. Another characterization is the title of an article in The New York Times from Frank Partnoy, professor of law, San Diego University: “Washington’s financial disaster” on January 29.

The trouble with the Report is that it misdiagnoses the problem and comes nowhere near to offering a remedy. The root cause of the Great Financial Crisis was not deregulation, excess pay of banking executives and poor risk management, not even collateralized debt obligations, subprime mortgages or loose credit standards. The root cause reaches back to August 15, 1971, when the Nixon-Friedman conspiracy knocked out the corner-stone of the edifice of the nation’s and the world’s financial system, the gold bond. (Before 1971 the debt of the U.S. held by foreign governments and central banks was goldbonded.) The remedy is obvious: refinance debt in terms of gold bonds.

Before going any further I would like to establish my credentials. In 1983 Congressman William E. Dannemeyer of California recruited me and in January, 1984, I started working in his Washington office on the problem of monetary and fiscal reform in the United States. Dannemeyer was a man of great vision. He saw that the road the nation was forced to take after the default of the U.S. on its international gold obligations, instigated by the Nixon-Friedman conspiracy, was to lead into financial catastrophe. In his office we hammered out a proposal that would be “presentable”. It was clear to us that a proposal recommending outright return to the gold standard would have been a nonstarter. Our approach was through the back door: fiscal reform now, monetary reform later.

The world was more than ready to embrace gold bonds after the disastrous 1971 experiment, upsetting the interest-rate structure, the commodity markets as well as currency relations. The price of crude oil went from \$3 a barrel to \$42, long-term interest rates from 4% to 16%. The Mexican peso and the Soviet ruble were wiped out.

Gold bonds had a proven track record. They had financed the construction of transcontinental railways and transoceanic shipping, as well as the metamorphosis of the U.S. from a poor agricultural country to become the world’s greatest industrial power during the last quarter of the 19th century. Gold was a great financial resource that could have financed a comparable metamorphosis for the rest of the world during the last quarter of the 20th century. It was not to be. Instead, gold was forcibly removed from the international monetary system and condemned to idleness. The world started its slow descent to hell.

Dannemeyer foresaw the tsunami of red ink that was to inundate the U.S. when it turned from the world’s greatest creditor to become its greatest debtor nation. The twin deficits: the budget and the trade deficit were to sap the country’s vitality and to lead to the dismantling of its once legendary great industries.

Our blueprint to refinance the debt of the U.S. in terms of long term gold bonds was ready as the Reagan administration drew to a close and the Bush administration took over. Dannemeyer led a delegation of ten Republican congressmen to the Oval Office to present the plan to George Bush, Sr., in October, 1989. The event was reported on the front page of The New York Times accompanied by a photo. Dana Rohrabacher, California Congressman (who presently serves his 12th term in Congress) was a member of the delegation and he can confirm the accuracy of this recollection. The only point on the agenda of the historic meeting was the gold bond refinancing of the U.S. debt.

President Bush listened attentively to the presentation of Mr. Dannemeyer.

Afterwards he turned to his Treasury Secretary who was also present, suggesting that his staff and the staff of Mr. Dannemeyer ought to get together and iron out the wrinkles of the plan and come back with a joint recommendation.

Things were looking up. A meeting with the Treasury staff was scheduled.

But just before it was to take place there was a call from the Treasury that the meeting had to be rescheduled because of “important other business”. What business could be more important, we were left wondering, than the business of averting the collision of the Titanic with the iceberg straight ahead? There was a similar call just before the rescheduled meeting and the episode was repeated again. It was clear that the Treasury staff was sabotaging the wishes of President Bush.

I have done what I could. I have presided over the hatching of a plan to put the country and the world back on the road to monetary and fiscal rectitude.

The plan was studied and approved by ten Republican Congressmen and was presented in the Oval Office to the president, who apparently liked the plan.

There was nothing more for me to do. I resigned and left Washington in May, 1990.

I have great admiration for Mr. Dannemeyer and I am grateful to him for the opportunity he has given me to serve the cause of sound money. We knew the issue would be forced by history in the fullness of times in a more unpleasant and painful setting.

The moment of truth came twenty years later, in 2008. The problem is the same; only the financial condition of the United States is that much worse. The remedy is also the same: the United States can save its monetary leadership in the world, and avoid a domestic economic crisis, if it bites the bullet and makes its debt gold-bonded. This should be followed by opening the U.S. Mint to the free and unlimited coinage of the standard silver dollar and the Gold Eagle as mandated by the Constitution. The gold price must not be fixed, and the exchange rate between the monetary metals and paper currencies must continue to float. The only other thing that needs to be done is to declare the legal tender protection of irredeemable dollar unconstitutional. Let paper money fend for itself. Let the people choose freely which kind of money they wish to use and want to be paid for their labor. Let Ben Bernanke’s irredeemable Federal Reserve notes compete against Gold Eagle coinage and the standard silver dollar. It will be an interesting race, most educational to watch.

In 1989 Mr. Dannemeyer wrote a pamphlet entitled Gold Bonds for Peace and Prosperity. It should be republished and publicly debated. The badmouthing of gold has gone on far too long. It is high time to have a real debate on real issues: how gold can be used again in the service of the nation and the world. It is insane to quarantine gold, the only valid solution to the debt problem.

Without re-introducing gold as the ultimate extinguisher of debt into the monetary system the Debt Tower will continue its explosive growth. When it topples, it will bury the world economy, and whatever prosperity it still has to offer, under the debris.

## Announcement

### New Austrian School of Economics

Course Two at the Martineum Academy in Szombathely, Hungary, from March 5 through 13, 2011. Title of the course:

## Adam Smith’S Real Bills Doctrine And Social Circulating Capital

What makes this course especially topical today is the fact that more and more hints are being dropped about the possible rehabilitation and restoration of the gold standard — following the ignominious collapse of the irredeemable dollar. However, a gold standard without its clearing house, the bill market, is not viable and itself is liable to collapse in short order — as it did in the early 1930’s. The level of public ignorance about the necessity of a clearing house is appalling. It is made that much worse by a tottering banking system. We have an urgent message: only gold standard cum real bills can restore prosperity to the world, in view of the fact that we have to write off the world’s banking system as a total loss.

This is the second in a four-course series on Austrian Economics, a branch of economic science based on the work of Carl Menger (1840-1921). It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. The complete program consists of four courses (10 days, 20 lectures each). Completion of each course will earn one credit. Participants who have accumulated four credits get a diploma signed by Professor Fekete. Course One that was given in 2010 is not a prerequisite. It is available on DVD for purchase.

NEW: there will be an add-on optional one-day seminar on the gold and silver basis and the threat of permanent backwardation of the monetary metals on March 14.

Stay tuned for further details. NOTE: All scholarships have now been awarded.

For further information please contact Dr. Judith Szepesvari, e-mail: szepesvari17@gmail.com

---

# Stupid Wager or Clever Prestidigitation?

URL: https://newaustrianeconomics.com/archive/fekete/stupid-wager-or-clever-prestidigitation/
Date: 2011-01-17
Section: Popular Economics
Difficulty: intermediate
Concept Tags: federal-reserve, monetary-policy, capital-destruction, fiat-currency, bond-market
Description: 2011 Position Paper #2: Fekete examines the Federal Reserve's quantitative easing program as either a stupid wager (the belief that money printing can stimulate a capital-depleted economy) or a clever conjuring trick designed to transfer wealth from savers to debtors while appearing to help everyone. He argues the distinction matters for understanding what comes next.
Editorial Note: 2011 Position Paper #2 (January 2011). Fekete characteristically frames the analysis as a dilemma, forcing the reader to choose between the Fed's incompetence and its dishonesty.
Original PDF: https://professorfekete.com/articles/AEFPositionPaper2MinorityOfOne.pdf

## Stupid Wager Or Clever Prestidigitation?

“Heads — you win; tails — I lose.” Such is the message the Fed sends to bond speculators.

But why would the Fed offer such a stupid wager? Read on.

The Fed is trying to bribe bond speculators with risk-free profits. That’s how the Treasury/Fed check-kiting conspiracy makes sure that there will always be plenty of buyers for government debt, regardless of the size of offering.

Ten years ago I started writing about my theory that, wittingly or unwittingly, the Fed has become the quartermaster general of the coming deflation and depression. I offered a logical, closely argued reasoning for this thesis. My argument had to do with the contention that the open market operations of the Fed make bond speculation risk-free, which explains the perpetual bull market in bonds. Bond speculators, knowing that the Fed must needs buy bonds in order to keep the money supply growing, front-run (or, to use the old-fashioned term: pre-empt) the Fed’s open market operations. They buy the bonds beforehand, and pocket risk-free profits when they sell them to the Fed. Speculators will allow the bond price to fall only so much. Then they show up as buyers for another ride of the escalator upstairs.

Incidentally, my theory also gives the coup-de-grâce to Keynesian and Friedmanite economics. Keynes, and later Friedman, advised governments to discard the gold standard thus destabilizing foreign exchange. That would give them free hand to pursue monetary policy — euphemism for the license to engineer unlimited depreciation of the currency.

Scarcely did they consider that their scheme was to back-fire. They were shooting for inflation only to bag deflation. They wanted rising prices; instead, they got falling prices.

A falling interest-rate structure engenders a falling price-level structure. It is most destructive to the economy. It devastates existing capital and blocks the accumulation of new capital. The 30-year old regime of falling rates destroyed the once flourishing American industry forcing it to flee the country. There is no chance to accumulate new capital as long as interest rates keep falling. Continuation of this trend will cause excruciating pain to those producers who remain. They will not be able to compete with newcomers who carry a much smaller burden, thanks to their lower cost of capital. The squeeze of the old-guard producers will show up in the falling price level. The “grapes of wrath” — the seeds of which were planted by Keynes and Friedman — will come to full maturity when hoards of angry and hungry unemployed people will roam from city to city and country to country.

It is not the Fed who is in the driver’s seat. It is the bond speculator. The Great Depression was not due to low demand for goods, as argued by Keynes. It was due to high demand for bonds, courtesy of speculators who understood the dynamics of the bond market better than policymakers did. The GFC is just a repeat performance.

Check-kiting is the name for the conspiracy, typically between two banks, to tap the float (the mass of checks in the process of clearing). The conspiring banks send one another third-party checks that lack any backing whatsoever. They cover the liability of one unbacked check by crediting the other, ad infinitum. It is similar to wildcat banking in Scotland in the 17th century, when the coach hired by the banks carrying gold was front-running the coach carrying bank inspectors from one bank to the next. Small wonder the inspectors found the gold reserve of every bank on their beat in good shape. Check-kiting is a crime to defraud the public dealt with by the Criminal Code. Except, that is, when practiced by the Treasury and the Fed, in which case it is called monetary policy.

Let us bypass the question on what valid grounds do the Treasury and the Fed issue liabilities which they have neither the inclination nor the means to honor. The practice boils down to clever prestidigitation: to mislead the public into believing that the Emperor does have clothes. He is cheered on by an enthusiastic crowd of bond speculators praising the garment. Until… until… a naughty little boy starts howling: “Gee whiz, Dad, the Emperor is stark naked!”

Suppose the Fed wants inflation and thinks that the best way to go about it is to keep buying bonds ad nauseam and call the practice by the acronym QE-X. The belief that pumping up the money supply through unlimited bond purchases by the central bank will bring about rising prices is a tragic mistake. A higher price level will never be achieved in this way. Bond speculators will have a field day. They would just buy the bonds in any amount. A vicious spiral of falling interest rates is engaged that, like the black hole of zero gravitation, will suck in and gobble up the world economy. Keynes and Friedman were hoping for inflation they could control; instead they got deflation they could not. They cut the tragic figure of the Sorcerer’s Apprentice who stole the Master’s password to turn on the spigots, but he has forgotten to steal the other password to turn them off when enough is enough.

Having been a lonely voice crying in the wilderness for ten years, I am still in a minority of one. Most economists expect Fed action to cause inflation (according to some, hyperinflation). The few who dare mention the d-words, deflation and depression, hasten to add that, of course, this would follow hyperinflation, not precede it. Same as in Zimbabwe.

Reports from that unhappy country say that it has 90% unemployment after the worst hyperinflation on record.

I am the only one saying that the U.S. is not Zimbabwe, and for the U.S. the forecast is deflation first, hyperinflation afterwards — at least until the prestidigitation in the bond market is exposed.

Seldom do I get a tail-wind in the form of newspaper reports confirming that there is, after all, such a thing as front-running the Fed’s open market operations, that bond speculators do indeed buy the bonds only to dump them in the lap of the Fed at a hefty premium. I have certainly never ever expected the New York Times to provide that tail-wind. Well, on January 10, 2011, that bastion of central planning published an article from the pen of Graham Bowley. It quotes Josh Frost who is in charge of buying hundreds of billions of dollars of Treasuries for the Fed: “We are looking to get the best price we can for the taxpayer”. Then the article goes on to quote an authority on bond trading, Louis V. Crandall, chief economist at the research firm Wrightson ICAP, who flatly contradicts Frost: a buyer of \$100 billion a month is always going to pay the worst (highest) price. “You can’t be a known buyer of \$100 billion a month and get a good price.”

In my papers I have commiserated with traders of the Fed facing, as they are, hungry lions in the arena bare-handed. The latter are the bond speculators who, unlike the former, are not working for wages. They work for profits. (If the profits happen to be risk free, so much the better.) True, the loss the Fed’s traders habitually make is not their loss. They are passed on to the taxpayers with a shrug. It is the taxpayers’ blood that is spilled so valiantly.

This reminds me of the object-lesson offered by George Soros. He made mincemeat of the traders of the Bank of England some years ago who were trying to fend off his serial attacks to sell the British pound short. Soros took the traders to the cleaners and, to rub it in, he bragged about it in his book. No need to feel sorry for the forex traders of the Bag Lady of Threadneedle Street. It was not their blood anyway that was flowing so abundantly. It was the blood of the British taxpayers.

I didn’t know the identity of the Fed’s traders facing the hungry lions. Now I do, thanks to the New York Times. They are babes in Toyland. All three of them are in their 20’s.

Their only prior experience in trading comes from playing Monopoly. One of them is still a student at NYU. According to the story in the NYT, “most days” they talk to the big banks.

How is that for guarding against conflict of interest? Their supervisor, Josh Frost lives in Brooklyn and every morning he takes the subway to commute to work. As one may figure, not for too long. Wonder how one gets such a rags-to-riches job at the Fed? Well, take the example of Josh Frost’s boss, Bryan P. Sack, age 40. In 2004 he co-authored a paper with Ben Bernanke, the future chairman of the Fed and another economist about “unconventional measures for stimulating the economy in extraordinary times” — by buying Treasuries in batches of hundreds of billions of dollars. “We didn’t know then that some day the Fed would be putting it to test” — Brian is quoted as saying.

The best part of it all is that the line between success and failure is hopelessly blurred.

If the rate of interest goes down in consequence of Fed action, then: “hooray, we’re dead on with targeting inflation. And that’s good news”. If, on the other hand, the rate of interest goes up, then: “hooray, the economy is turning around. Rates have risen for the very reason we were hoping for: investors are more optimistic about the recovery. It is a good sign.”

The fact that in the meantime the economy is wiped out, gets lost in the noise of loud self-congratulation.

### References

The Federal Reserve, the Quartermaster General of Deflation, A. E. Fekete,

ThereIs No Business Like Bond Business, A. E. Fekete, [www.professorfekete.com](https://www.professorfekete.com),

### January, 2010

Front/Running the Fed in the Treasurys Market, [www.jessescrossroadscafe.blogspot.com](https://www.jessescrossroadscafe.blogspot.com)

### January, 2010

The Fed`s QE2 Traders, Buying Bonds by the Billions, Graham Bowley,

### The New York Times, January 10, 2011

Meet the Fed’s POMO Desk… by Tyler Durden, [www.zerohedge.com](https://www.zerohedge.com), January 10, 2011

## Announcement

### New Austrian School of Economics

Course Two at the Martineum Academy in Szombathely, Hungary, from March 5 through 13, 2011. Title of the course:

## Adam Smith’S Real Bills Doctrine And Social Circulating Capital

What makes this course especially topical today is the fact that more and more hints are being dropped about the possible rehabilitation and restoration of the gold standard — following the ignominious collapse of the irredeemable dollar. However, a gold standard without its clearing house, the bill market, is not viable and itself is liable to collapse in short order — as it did in the early 1930’s. The level of public ignorance about the necessity of a clearing house is appalling. It is made that much worse by a tottering banking system. We have an urgent message: only gold standard cum real bills can restore prosperity to the world, in view of the fact that we have to write off the world’s banking system as a total loss.

This is the second in a four-course series on Austrian Economics, a branch of economic science based on the work of Carl Menger (1840-1921). It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. The complete program consists of four courses (10 days, 20 lectures each). Completion of each course will earn one credit. Participants who have accumulated four credits get a diploma signed by Professor Fekete. Course One that was given in 2010 is not a prerequisite. It is available on DVD for purchase.

All scholarships have now been awarded.

For further information please contact Dr. Judith Szepesvari, e-mail: szepesvari17@gmail.com

---

# Gold and Honey

URL: https://newaustrianeconomics.com/archive/fekete/gold-and-honey/
Date: 2011-01-11
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, gold-basis, sound-money, fiat-currency
Description: 2011 Position Paper #1: Fekete uses the classical monetary metaphor of gold and honey to examine the prospects for monetary reform, arguing that like honey gold both preserves and heals — it preserves the purchasing power of savings and heals the monetary system's inflationary wounds. The essay examines current gold flows as indicators of the system's health.
Editorial Note: First of the 2011 Position Paper series (January 2011). Continues the position paper format from 2010 with shorter, more focused analytical pieces.
Original PDF: https://professorfekete.com/articles/AEFPositionPaper1GoldAndHoney.pdf

## Gold And Honey*

Open letter to Thomas Hoenig, President, Federal Reserve Bank of Kansas City Dear President Hoenig,

On January 5, 2011, you were quoted on abc NEWS as saying that “the gold standard is a very legitimate monetary system”. The quotation went on: “We are not going to have fewer crises necessarily. You will have a longer period of price stability or price level stability, but I don’t know that you will have lower unemployment, and I don’t know that you will have fewer bank failures.”

As a student of the gold standard for the past 50 years I welcome your statement. I would be happy to open my files and archives if the Research Department of the Federal Reserve Bank of Kansas City (that, as far as one can tell, has so far not been interested in gold standard research) invited me. My files may have the answer to some of your queries. (1) You are right, the gold standard is a necessary but not a sufficient condition for achieving lower unemployment. A necessary and sufficient condition would assume that Adam Smith’s Real Bills doctrine is also rehabilitated along with the gold standard. The bill market is the clearing house, without which the gold standard cannot survive. The explanation why it collapsed in the years 1931-35 is that, when the victorious Entente powers decided to restore the gold standard after World War I, they also decided not to restore real bill financing of world trade or world-wide real bill circulation. Thus the gold standard which Britain reestablished in 1925 lacked a vital organ: a clearing house. The Entente wanted bilateral (to the exclusion of multilateral) trade for fear of German supremacy in exports. This decision was a great setback for world trade. In effect, it meant a return to barter.

The consequence was: beggaring-thy-neighbor, trade war, the destruction of the wage fund, and massive unemployment world-wide.

(2) As pointed out by the German economist Heinrich Rittershausen in his 1930 book Arbeitslosigkeit und Kapitalbildung (Unemployment and capital accumulation), before World War I ‘structural unemployment’ was unknown. Part of the ‘float’ of maturing real bills was earmarked for payment of wages to workers producing consumer goods. This float was what Rittershausen called the “wage fund”, out of which wages could be paid up to three months in advance, well before the underlying consumer goods were paid for by the ultimate, gold-paying consumer.

This wage fund was destroyed by the “Guns of August” in 1914 at the start of hostilities. The destruction of the wage fund went unnoticed because the production of war materiel absorbed all slack labor. After the war, a great inflation inflicted on the world by the Fed created not only the T-bond bubble (that burst in 1921), the Florida real estate bubble (that burst in 1925), and the stock market bubble (that burst in 1929), but it also financed a hugely bloated production of consumer goods.

* The German word ‘Honig’ means ‘honey’ in English.

Only after the stock market bubble burst did it become clear that there was no wage fund out of which the workers producing consumer goods could be paid. The workers had to be laid off and the factories had to be closed. Thus did the prohibition on real bills circulation cause the collapse of the gold standard and the Great Depression.

My research suggests that if after World War II both the gold standard and real bill circulation had been rehabilitated, there would have been no serial currency turmoils and no Great Financial Crisis. The gold standard and real bills go together like hand and glove.

(3)

The purpose of the gold standard is not to stabilize prices or the price level, which is neither possible nor desirable. Its purpose is to stabilize the interest-rate structure, which it can do very efficiently, as history shows. There was no bond speculation under the gold standard. Speculation was confined to agricultural commodities, the supply of which is governed by nature rather than bureaucrats in the Treasury and the Central Bank. Changes in commodity prices or in the price level under the gold standard were mild. They reflected changes in marginal productivity, not speculative fever. Virtually all crises after the collapse of the gold standard in the 1930’s were caused by volatile changes in interest rates due to bond speculation.

(4)

Gold is the ultimate extinguisher of debt. The reason is that gold enters the asset column in the balance sheet of banks but, unlike every other asset, it has no corresponding entry in the liability column of the balance sheet of someone else.

Gold survives any consolidation of balance sheets. Other assets are wiped out when the balance sheets of debtor and creditor are consolidated, as in default and repossession.

(5)

No runaway debt or derivatives tower can develop under a gold standard. Such cancerous growths have occurred in the 21st century because, in the absence of a gold standard, the economy is lacking an ultimate extinguisher of debt. Total debt can only grow. It can never contract through normal debt retirement.

(6)

Bank failures are a consequence of unbridled escalation of debt. The gold standard acts as a restraining force on banks with a propensity to expand credit even after further expansion becomes detrimental to their capital. Widespread bank failures that presently hit the economy are an indication of destruction of bank capital. Banks were happy to put their capital in jeopardy during the boom as their cash flow from fees was plentiful. However, cash flow is no substitute for capital.

When the boom was over, cash flow stopped, but bank capital was gone.

Under the gold standard banks know better. They cannot expand credit with impunity beyond safe capital ratios. If a bank does, it deserves to fail and should not be bailed out.

We can indeed return to a gold standard by going back to Constitutional money. This means opening the U.S. Mint to unlimited free coinage of gold and silver. We can return to financing production and trade in goods demanded most urgently by the consumer through real bills, if the Federal Reserve Banks go back to the legal provisions of the F.R. Act of 1913. That Act confined F.R. credit to real bills arising out of the production and distribution of consumer goods, to the exclusion of anticipation and accommodation bills as well as government debt.

The solution to the present crisis will be found in the strict observance of the monetary provisions of the Constitution, and enforcement of the law governing Federal Reserve credit.

Antal E. Fekete, New Austrian School of Economics.

## Announcement

### New Austrian School of Economics

Course Two at the Martineum Academy in Szombathely, Hungary, from March 5 through 13, 2011. Title of the course:

## Adam Smith’S Real Bills Doctrine And Social Circulating Capital

What makes this course especially topical today is the fact that more and more hints are being dropped about the possible rehabilitation and restoration of the gold standard — following the ignominious collapse of the irredeemable dollar. However, a gold standard without its clearing house, the bill market, is not viable and itself is liable to collapse in short order — as it did in the early 1930’s. The level of public ignorance about the necessity of a clearing house is appalling. It is made that much worse by a tottering banking system. We have an urgent message: only gold standard cum real bills can restore prosperity to the world, in view of the fact that we have to write off the world’s banking system as a total loss.

This is the second in a four-course series on Austrian Economics, a branch of economic science based on the work of Carl Menger (1840-1921). It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. The complete program consists of four courses (10 days, 20 lectures each). Completion of each course will earn one credit. Participants who have accumulated four credits get a diploma signed by Professor Fekete. Course One that was given in 2010 is not a prerequisite. It is available on DVD for purchase.

Scholarships for students are still available.

For further information please contact Dr. Judith Szepesvari, e-mail: szepesvari17@gmail.com

---

# Sound Navigation Requires Sound Measurement

URL: https://newaustrianeconomics.com/archive/fekete/sound-navigation-requires-sound-measurement/
Date: 2011-01-09
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, monetary-policy, new-austrian-economics, sound-money, federal-reserve
Description: Fekete argues that the crisis in monetary policy is fundamentally a crisis of measurement: economists are navigating without reliable instruments. Interest rates have been corrupted as price signals, GDP statistics systematically overstate output, and inflation metrics are manipulated. Only gold — the incorruptible monetary measure — can restore reliable economic navigation.
Editorial Note: Written January 2011 as a standalone essay. The navigation metaphor captures Fekete's argument that monetary disorder is not merely an economic problem but an epistemic one — we cannot know economic reality without sound monetary measurement.
Original PDF: https://professorfekete.com/articles/AEFSoundNavigationRequiresSoundMeasurement.pdf

### Sound Navigation Requires Sound Measurement

Louis Boulanger (LB Now, Auckland, New Zealand),

Professor Antal E. Fekete (New Austrian School of Economics, Budapest,

### Hungary)

Synopsis.

Highest standards for science must include observation, or experimentation, and measurement. Measurement in economics is carried out in terms of currency units; only economic activities measurable in that unit of account are recorded. But as experience shows, the value of any currency now fluctuates greatly. What does that say of ‘economics’ as science? What does it say about our choice of unit of value?

### What is Money?

Money is any object that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange, a unit of account, a store of value, and occasionally, a standard of deferred payment. The gold standard, a monetary system where the mediums of exchange are paper notes that are convertible into pre-set, fixed quantities of gold, replaced the use of gold coins as currency in the 17th19th centuries in Europe. The gold standard notes were made legal tender, and redemption into gold coins was discouraged. By the beginning of the 20th century, almost all countries had adopted the gold standard, backing their legal tender notes with fixed amounts of gold.

After World War II, in accordance with the Bretton Woods Agreement, most countries adopted fiat currencies that were fixed to the US dollar. The US dollar was in turn fixed in terms of gold. In 1971, the US government defaulted on its international gold obligations. After this many countries de-pegged their currencies from the US dollar, and most of the world’s currencies became unbacked by anything except the government’s fiat of legal tender.

So, while money originated as commodity money, all contemporary money systems are based on fiat money. Fiat money is without intrinsic use value, unlike a physical commodity, and derives its value by being declared by a government to be legal tender; that is, it must be accepted as a form of payment within the boundaries of the country, for “all debts, public and private”. People do accept fiat money under duress, even if unconsciously so.

### What is meant by a ‘unit of account’?

A unit of account is a standard numerical unit of measurement of the market value of goods, services, and other transactions. Also known as a “measure” or “standard” of relative worth and deferred payment, a unit of account is a necessary prerequisite for the formulation of commercial agreements that involve debt. To function as a ‘unit of account’, whatever is being used as money must be:

1. Divisible into smaller units without loss of value;

2. Fungible: that is, one representative unit must be perceived as equivalent to any other; and

3. Measurable as a specific weight.

So, a unit of account is a monetary standard capable of measuring the value of goods, services, or assets.

It serves as one of the three well-known functions of money. It lends meaning to profits, losses, assets and liabilities.

Unfortunately, the accounting monetary unit of account suffers from the congenital disease of not being a stable unit of account over time. Inflation destroys the assumption that money is stable, which happens to be the very basis of the science of accounting.

In today’s modern economies, money in the form of currency usually serves the role of the standard unit of account. The use of money, under conditions of price stability, vastly improves the efficiency of market economies; but not when the monetary unit itself is unstable.

The use of a unit of account in financial accounting allows investors to invest capital into those companies that provide the highest rate of return. The use of a unit of account in managerial accounting enables firms to choose between activities that yield the highest profit. All this, of course, is falsified if the unit of account is no longer stable.

In economics, a standard unit of account is used for statistical purposes to describe economic activity. Indexes such as GDP and the CPI are so broad in their scope that compiling them would be impossible without a standard unit of account. After being compiled, these figures are often used to guide governmental policy; especially monetary and fiscal policy. So, one could argue that the measurement of our economic performance and/or financial performance, individually or in aggregate, is only as good or reliable as our money/currency is. If so, then how good or reliable is our currency as a measure?

### Measures of Money

When we scan the modern economic literature, the only measure(s) of money we find today are aggregate measures. For example, the money supply is the amount of financial instruments within a specific economy available for purchasing goods and services. The money supply is usually measured as M0, M1, M2 and M3, four escalating categories, each containing the previous. The categories grow in size with M0 being so-called “high powered money”; that is, money issued by the central bank of a country. M1 is the issued currency (coins and notes) and checking account deposits. M2 is the currency, checking accounts and savings accounts. M3 is all that plus time deposits and repos. M1 includes only the most liquid financial instruments, while M3 also includes relatively illiquid instruments.

The above chart is based on official data supplied by the US central bank, but produced by John William’s Shadow Government Statistics service (because the US central bank stopped calculating and updating M3 in 2006, shortly before Greenspan passed the baton to Bernanke). It shows that the US money supply, as measured by M3, grew from US\$0.3 trillion at the beginning of the 1960s to more than US\$10 trillion today, at an annual rate of change that varied from -6% to +18%.

Please note the collapse of the rate of growth in the money supply starting in the milestone year of 1971 and, in spite of the reversals of 1995 and 2005, continuing to this day. This collapse scares the wit of central bankers and Treasury secretaries, who do not realise that it is their own doing.

By the way, the same goes for any other currency: the money supply statistics are abundantly available and appear to be very reliable measures as they seem very precise. That’s all good and fine, but what of the basic unit of measure of that money supply itself? There is nothing to find in today’s literature on the ‘measure’ itself; more precisely, nothing in absolute terms. On the other hand, there is an abundance of information and ongoing speculation in relative terms: currency exchange rates and the price level in terms of currencies. So, we need to understand what makes a unit of measure accurate and reliable, and ask ourselves if we have that in what we use today as ‘money’.

### Scientific Measurement

Units of measurement are essentially arbitrary. Nothing is inherent in nature to suggest that a mile is a better measure of distance than a kilometre. Over the course of human history, however, first for reasons of convenience and then for reasons of necessity, standards of measurement have evolved so that communities would have common benchmarks. The Old Testament calls false weights and measures an abomination and says that all those who want long life in this world must shun them.

Laws regulating measurement were originally developed to prevent fraud in commerce. Today, units of measurement are generally defined on a strictly scientific basis, overseen by governmental or supragovernmental agencies, and confirmed by international treaties. The metre, for example, was redefined repeatedly, the last time in 1983, as the distance travelled by light in vacuum in 1/299,792,458th of a second. Now, that’s precise!

What can be said of our monetary unit of measure today? Well, one could argue that it is about as precise as the measure for length was before the French Revolution: the King’s foot! If the King died, the measure changed. If the new king had a longer foot, the producers of cloth were out of luck; if shorter, then the consumers were.

As a matter of history, over time, length (as well as weight and time, for example) became measured more and more accurately. In fact, in all scientific endeavours, precision in the definition of the unit of measure has improved. The ONLY exception is economics, in particular monetary economics.

‘Money’ today, as far as its value is concerned, is based on government fiat, which is itself a highly elastic measure, with an irresistible bias on the side of falling short. What we now use every day in our actions and interactions of a monetary nature, and never give a second thought to it, is, quite simply, based on fiat and so, quite unreliable. This is clearly an aberration in the history of Western Civilisation.

There is only one rational explanation for this: the propensity of governments to use a fraudulent unit of value in order to cheat their subjects. And it makes no difference whether the government is absolutist or democratic, malignant or benign.

### Final Thoughts

The present financial crisis is far from over. In fact, it is getting worse. It can be described as a debt crisis, but its true nature is a monetary crisis. At its roots, it is a belated gold crisis. It is a punishment for discarding the honest unit measuring value: gold.

The landmark year was 1971, when the United States defaulted on its international gold obligations under the Bretton Woods Agreement. There have been many defaults in history, but the one forty years ago was unique in that it exiled gold internationally and without recourse to the Courts from the monetary system; thereby gold has been prevented from discharging its natural function as the ultimate extinguisher of debt ever since.

There is a direct cause and effect relationship between that decision in 1971 and the present global financial crisis. We are about to pay the price for our collective delusion as participants in this insane monetary experiment. Our monetary system today did not grow naturally, nor was it the result of careful study and planning by competent scientists. As we have just seen, it has no accurate and reliable unit of measure. In fact, it was imposed through bribe and blackmail on the people.

So it is prudent, to say the least, to measure one’s net worth in gold units rather than legal tender units.

And it is incumbent on the actuarial profession (not to mention the profession of accountants) to resist government duress to use a badly debased and depreciating monetary unit of measure and advocate in the strongest possible terms for a return to sound money.

Blenheim, New Zealand, November 23. 2010.

## Announcement

### New Austrian School of Economics

Course Two at the Martineum Academy in Szombathely, Hungary, from March 5 through 13, 2011. Title of the course:

## Adam Smith’S Real Bills Doctrine And Social Circulating Capital

What makes this course especially topical today is the fact that more and more hints are being dropped about the possible rehabilitation and restoration of the gold standard — following the ignominious collapse of the irredeemable dollar. However, a gold standard without its clearing house, the bill market, is not viable and itself is liable to collapse in short order — as it did in the early 1930’s. The level of public ignorance about the necessity of a clearing house is appalling. It is made that much worse by a tottering banking system. We have an urgent message: only gold standard cum real bills can restore prosperity to the world, in view of the fact that we have to write off the world’s banking system as a total loss.

This is the second in a four-course series on Austrian Economics, a branch of economic science based on the work of Carl Menger (1840-1921). It is meant for those, including beginners, who are interested in the theory of money, credit, and banking, with special emphasis on the current financial and economic crisis. The complete program consists of four courses (10 days, 20 lectures each). Completion of each course will earn one credit. Participants who have accumulated four credits get a diploma signed by Professor Fekete. Course One that was given in 2010 is not a prerequisite. It is available on DVD for purchase.

Scholarships for students are still available.

For further information please contact Dr. Judith Szepesvari, e-mail: szepesvari17@gmail.com

---

# More Real Bill Fallacies

URL: https://newaustrianeconomics.com/archive/fekete/more-real-bill-fallacies/
Date: 2010-11-01
Section: Popular Economics
Difficulty: scholarly
Concept Tags: real-bills, self-liquidating-credit, new-austrian-economics, gold-standard, mises
Description: Position Paper #10: Fekete responds to additional objections to the Real Bills Doctrine, addressing claims that real bills are inflationary, that they cannot be distinguished from speculative credit, and that their historical record does not support Fekete's claims. He argues these fallacies reflect confusion between the genuine gold standard and the gold-exchange standard.
Editorial Note: Position Paper #10 (November 2010). The position paper series concludes with this extended defense of the Real Bills Doctrine against accumulated objections.
Original PDF: https://professorfekete.com/articles/AEFPositionPaper10MoreRealBillFallacies.pdf

## More Real Bill Fallacies

In the first article of my two-part series on the Real Bills Doctrine (RBD), in commenting on the Daily Bell’s interview with Professor Lawrence H. White on October 10, 2010, I made the central point that the source of commercial credit is not saving but consumption. The following example will dramatize this point. Assume for the sake of argument that all banks in the whole wide world succumb to the sudden death syndrome simultaneously. What does this mean in terms of the production and distribution of consumer goods? Would we have to go back and start from scratch to save in order to replenish society’s circulating capital?

Saving is a time-consuming process and people have to get fed, clad, shod, and sheltered in the meantime. We could not restore circulating capital through saving for the simple reason that before we could we would die of starvation.

Luckily, there is no need to go through such a regimen to satisfy the dogma that the only source of capital is saving. Consumption per se is a ready and instantaneous source of commercial credit. Real bills drawn on merchandise in most urgent demand will supply all the credit society needs so that consumption can continue without interruption — and the banks be damned. It does not matter if very little gold is available to pay the bills upon maturity. My detractors’ 100 percent reserve banking would be confronted with sky-high prices on account of the scarcity of gold. Under the RBD prices need not be high: the burden of adjustment would not on prices, as the quantity theory of money falsely teaches; it would fall upon the discount rate. There is only one interdiction, namely, real bills must not mature in mere promises to pay gold — the proviso of Ludwig von Mises notwithstanding that “claims to gold are a complete substitute for gold in markets where their security and maturity of those claims is recognized.” (The Theory of Money and Credit, Chapter 15.) Claims to gold at maturity are useless as payment for the bill at maturity. A note promising gold is inferior to the bill. The bill must mature into something superior. The only thing superior to a real bill drawn on consumer goods in most urgent demand is the gold coin. A bill maturing in a mere claim on gold will not circulate.

In commenting on the first part of this paper several of my correspondents asked why the discount rate is getting lower when the bill price is getting higher. Here is the relevant arithmetic. Suppose a bill of \$1000 maturing in 91 days (or 0.25 years) circulates at \$990.

This corresponds to a discount rate of 4 percent per annum, because 1000(1 – 4(0.25)/100) = 10(99) = 990. If next day the bill market quotes the same bill at a higher price, say at \$995, then there is a corresponding decrease in the discount to \$5, half of the earlier discount of \$10. Thus the discount rate has fallen from 4 to 2 percent.

Let us return to the Daily Bell’s interview with Professor White. Observing that the

RBD has been important in the history of monetary theory, he goes on to say: It is a mistaken idea that if the banking system lends only by discounting real bills, then it cannot overexpand. It is also a dangerous idea … because rather than letting interest rates rise to reach their new equilibrium level whenever the business demand for credit rises, the banks will actually make money over-expand.

This is tantamount to blaming the loot, rather than the thief, for the thievery. Why did it allow itself to be stolen? There are uses and abuses of credit. Over-extension of credit is an abuse. For example, drawing two or more bills on the same merchandise is an abuse, and so is rolling over a bill at maturity rather than paying it, regardless whether or not the underlying merchandise has been sold. Such abuses should be dealt with by the Criminal Code in the same breath as dealing with the forgery of bank notes.

Professor White’s remark assumes that the discount rate is the same as the short term rate of interest. I shall not pause here to repeat the arguments of my previous article refuting this misconception. Instead, I shall describe what has actually happened when banks first put in an appearance to take a piece of the action in the already flourishing bill market.

Banks have arisen because they had a legitimate and useful role to play: (1) Their credit has a high name-recognition; (2) Bank credit in the form of bank notes come in standard denomination which is easy to count and make payments with.

The banks in discounting real bills paid with bank notes of their own issue. Thus they substituted their own credit, enjoying high name-recognition, for the sometimes obscure credit of traders in the periphery. Also, they offered standard-denomination bank notes to replace bills with odd amounts as face value that circulated more easily. Because of this, bank notes were welcome: you did not have to scrutinize the credit standing of the drawer and the drawee of the bill. People were glad to pay for this service in the form of foregone discount which accrued to the bank for facilitating the circulation of real bills further.

The good banks strictly followed the market rate of discount. Upon the expiry of the underlying bill they punctiliously withdrew a corresponding amount of bank notes from circulation. There is no sense in which the reserves of these banks could be called

“fractional.” Bank liabilities were backed 100 percent by reserves, either in the form of gold, or the next best thing to gold: real bills maturing into gold in 91 days or less. Such banks were not exposed to the nemesis of poorly managed banks: the bank run. Every business day on the average as much 1⅔ percent their portfolio of real bills matured into gold coins. That was sufficient to meet normal demand for gold coins. If the demand for the gold coin was abnormally high, then the banks had to go to the bill market and sell unexpired bills from portfolio for gold, in order to meet the extra demand. There was no problem involved in selling real bills for gold. Some other banks experiencing an overflow of gold coins would be scrambling to get earning assets and would buy the extra supply of real bills eagerly. To call these “fractional reserve banks” is to bark up on the wrong tree.

However, inevitably, there were bad banks as well that did not bother withdrawing their bank notes from circulation when the underlying bills expired but made fresh loans with them on which they collected interest. This was very profitable business for them.

Nevertheless, their profits were illegitimate and their loans were fraudulent. In effect, the bad banks were borrowing short in order to lend long. I call such a transaction illegitimate arbitrage between the bill market and the loan market, to take advantage of the spread between the higher interest rate and the lower discount rate. Illegitimate arbitrage is unsound because the short leg of the arbitrage has to be moved forward every quarter and it may not be possible to do at the old rate. The new discount rate may well be higher, and if it is higher than the interest rate on the long leg, then the bank ends up with a loss rather than a profit. In addition, the bank is guilty of false pretenses. It pretends that its bank notes are covered by real bills drawn on fast moving merchandise demanded most urgently by the consumers — which could circulate on their own in the bill market. In reality, however, its notes were covered by anticipation bills and accommodation bills or notes of debtors — that could not so circulate. Illiquid and dubious paper: expired real bills on unsold or unsalable merchandise; accommodation bills drawn on the dreams of lunatics, notes of speculators was being aided and abetted by the fraudulent bank that gave shelter to them in its portfolio that was not open for public inspection. Note the difference: bills circulating in the bill market are completely transparent making fraud and conspiracy easy to detect. The common earmark of bad banks is that their assets cannot be readily sold except maybe at a loss.

I have mentioned the notes of speculators that are ineligible to figure among the assets of banks. This is no condemnation of speculation per se. Speculators in agricultural commodities render a great service to society. Trouble starts when they speculate with other people’s money without their knowledge and concurrence. The best example of this is the conspiracy committed by Dick the Grain Merchant and Bob the Miller who anticipate an increase in grain prices from which they want to benefit. Lacking money of their own to buy grain, they decide to put Dick-on-Bob bills into circulation drawn on grain the movement of which has been arrested. This conspiracy is criminal: the bill market must not be used to finance speculation. The low discount rate is to benefit the consumer. Luckily, the bill market exposes such conspiracies by virtue of their openness. Trouble starts when the bank is participating in the conspiracy and gives shelter to the fraudulent Dick-on-Bob bills.

It is possible to brand the bad banks “fractional reserve banks“ to the extent that a portion of their credit outstanding is not covered by gold coins or real bills maturing into gold coins. The existence of such delinquent banks, however, does not justify disparaging the entire banking system calling it “fractional reserve banking system.” The suggestion that in discounting real bills banks created money out of thin air is fanciful and untrue.

The Daily Bell concludes the interview by commending Professor White for

“simplifying the Real Bills debate.” It adds that “the real bills debate has raged for some time and Professor White’s perspective has clarified matters.” With due respect to Professor White perspectives, I demur. Far more careful analysis of real bills and the difference between the discount rate and the rate of interest is needed than Professor White is willing to offer. Just as my detractors, Professor White declines to carry on the debate on the premise that the merit or demerit of real bills must be assessed in the context of complete absence of banks, since real bills can and do circulate on their own wings and under their own steam. Such refusal is especially regrettable at the present juncture of an unprecedented world banking crisis. There is a real danger that all the banks may simultaneously succumb to the sudden death syndrome.

I imagine that Professor White would not dismiss this assumption of mine as outlandish.

Professor White is one of the important protagonists of the hard money movement. In the interest of success, and also to save the world from unnecessary ordeal and much suffering, we should admit that further study of the RBD is needed, including an impartial inquiry about the circumstances under which governments forcibly blocked real bill circulation at the end of hostilities in World War I, and enforced the ban until the gold standard, such as it was, collapsed. It did collapse because it could not survive the destruction of its clearing house, the bill market, its most vital organ.

It is a fallacy to assume that real bills thankfully faded away for reasons of being obsolete, and to treat the RDB as a stale, “mistaken” and even “dangerous” idea.

The RBD may protect lives.

It may also save our Western civilization.

---

# Real Bills and Gold

URL: https://newaustrianeconomics.com/archive/fekete/real-bills-and-gold/
Date: 2010-10-29
Section: Popular Economics
Difficulty: intermediate
Concept Tags: real-bills, gold-standard, self-liquidating-credit, new-austrian-economics, sound-money
Description: Position Paper #9: Fekete develops the complementary relationship between gold and real bills, showing why neither alone provides monetary stability. Gold provides the reserve anchor; real bills provide the self-liquidating credit mechanism that allows economic expansion without inflationary pressure. Together they form a self-regulating system.
Editorial Note: Position Paper #9 (October 2010). A concise statement of the gold-and-real-bills complementarity that is central to Fekete's monetary reform program.
Original PDF: https://professorfekete.com/articles/AEFPositionPaper9RealBillsAndGold.pdf

## Real Bills And Gold

The Daily Bell published an interview with Dr. Lawrence H. White, Professor of Economics, George Mason University, on October 24, 2010. One of the questions the interviewer asked was this: “Please comment on real bills and how they work.”

In his answer Professor White gave the following example. Joe the Baker buys flour from Bob the Miller and gives him a bill promising to pay \$1000 in 90 days.

¶ 1. There are several problems with this description. In actual fact it is not Joe who issues the bill but Bob. The bill is drawn by Bob on Joe who must accept it before it can have any value. In common parlance Bob bills Joe. Professor White puts the cart before the horse in confusing the concept of a bill with that of a note. A bill originates with the payee, the note originates with the payer. This is no hair-splitting. The difference is important. A note is evidence of debt. A bill is evidence of value to be added. There is no loan, no lending and no borrowing involved in Joe’s purchase and Bob’s sale of the flour. None whatever. The transaction cannot be understood except in the context of merchandise maturing into the gold coin that only the ultimate consumer can release — a process that makes the relationship between Joe and Bob one of coordination rather than one of subordination. If anything, Bob could be considered the subordinate. Joe is one step closer to the boss, the consumer, and he is the one to get the gold coin first. He dispenses bread that is in general demand. Everybody eats bread. Flour that Bob dispenses is only in special demand. It is not as “liquid” as bread, if liquidity of (finished or semifinished) products is defined by how far removed from the consumer’s gold coin they are.

It is preposterous to suggest that Bob is the lender and Joe is the borrower. The two men are partners in a joint enterprise, made ad hoc, in order to provide the consumer with bread. Their role is like that of the two blades of a pair of scissors: neither can do the job by itself. This is not to deny that Bob extends credit to Joe. But extending credit is not the same as lending. To suggest that Joe is in debt to Bob as a result of borrowing is entirely fallacious.

Joe is in a very strong position: the bill he has accepted can circulate as money for 90 days.

The note of a mere borrower cannot.

¶ 2. Professor White goes on to say that Bob the Miller can either wait 90 days for his money, or he can go to a bank and sell his bill. The banker will pay Bob something less than \$1000 because he takes interest due for 90 days out of the proceeds.

Again, there are several problems with this description. The main one is the suggestion that banks are necessary for real bills to be effective and useful. This representation makes facts stand on their head. The question whether bills came first or banks is not a “chicken or egg” problem. We have the facts certified by Ludwig von Mises, no friend of the Real Bills Doctrine, that bills did. Moreover, we have it on the authority of Adam Smith that real bills do circulate as money on their own wings and under their own steam. By contrast, legal tender bank notes circulate by virtue of the strong arm of the government.

It would have been more correct for Professor White to say that Bob, if he wanted cash (read: gold coins) immediately, then he would go to the bill market and discount his bill (read: exchange it for gold coins at a price discounted by the number of days remaining to maturity, at the prevailing discount rate). But the beauty of real bills is seen in the fact that if all Bob wants to do is to pay for the shipment of grain that is being unloaded at his mill, then he does not have to go to the bill market to get gold. He can simply endorse the bill drawn on Joe, and Dick the Grain Merchant will be glad to take it in payment of the grain.

I repeat: the \$1000 face value of the bill does not represent debt and the discount does not represent interest on debt. Rather, it represents value to be added to the underlying merchandise and it is incumbent upon Joe the Baker to accomplish this feat. Time preference has nothing to do with it. The height of the discount rate is governed by considerations entirely different from those governing the height of the rate of interest, as we shall presently see. Confusing the two rates is the worst mistake economists have ever made, and are still making.

¶ 3. Professor White condescendingly admits that bills, while they were still tolerated, used to command a low interest rate because of their “low default-risk”. This remark confuses the issue further. Risk of default has nothing to do with the height of the discount rate which is not determined on a case-by-case basis but, rather, across the board. In fact the risk of default is so low that it can be taken to be zero. I ask you: how many bakers go bankrupt for each banker that does?

To understand what determines the height of the discount rate, as opposed to that of the rate of interest, we have to go not to the saver but to the consumer. The height of the discount rate is determined, not by the propensity to save, but by the propensity to consume.

In more details, the discount rate varies inversely with the propensity to consume (whereas the rate of interest varies inversely with the propensity to save).

A higher propensity to consume means that Joe the Baker experiences increased cashflow (really, an increased flow of gold coins). It prompts him to get rid of the gold coins by prepaying his bill outstanding. Rather than buying back the bill he has accepted, which may have been endorsed and passed on a dozen times and would be next to impossible to track down, he simply goes into the bill market and buys any bill with three good signatures. The demand for bills has thus increased, making the bill price rise. This means that the discount rate is lower as a direct result of an increase in the propensity to consume. Conversely, a decline in the propensity to consume decreases demand in the bill market as retail merchants have a reduced cash flow and fewer gold coins to get rid of in prepaying their bills outstanding. Decreased demand shows up as a lower bill price or, what is the same, a higher discount rate.

Our argument clearly shows that the credit represented by real bills has absolutely nothing to do with the propensity to save. The source of commercial credit is not savings, it is consumption.

The reason why real bills have been and are badly misunderstood by most students of credit is a poor understanding of gold itself, and the “next best thing” to gold. Undoubtedly, the next best thing to gold is the bill of exchange representing merchandise in most urgent demand that is moving apace to the ultimate gold-paying consumer, and will be purchased by him before the season of the year changes (causing fundamental changes in the character of consumer demand) that is, in not more than 90 days. The process of supplying the consumer is a maturation process of merchandise which we figuratively describe as the maturing of the real bill into gold coins.

The consumer is fickle, and changes in his taste are unpredictable (to say nothing of hers). The army of merchants and producers must stand on their toes to serve consumer demand efficiently and instantaneously. It is the gold coin that makes the consumer king. If you removed gold coins from circulation, as European governments started doing exactly 100 years ago, then merchants and producers would start serving another sovereign. From then on, they would rather serve the issuer of “legal tender” bank notes. This change in the person of the sovereign corrupted the economy and caused an upheaval in the Wealth of Nations.

¶ 4. Professor White says that “real bills were an important source of business credit in the 19th century, and a major category of assets in a typical bank portfolio.” This sounds as if our grandfathers lived in backwater unmindful that there are other, more appropriate sources of commercial credit. The fact is that it was not progress or enlightened thinking but, rather, lust for power, desire to conquer, chicanery, malice, and vindictiveness on the part of certain governments that eliminated real bill circulation.

Two dates stand out. (1) In 1909 first the French government and then, hard on its heels, the imperial German government introduced legislation making the note issue of their central banks legal tender. This paved the way towards financing the coming war with credits. (2) In 1918 the victorious Entente powers decided to block a spontaneous return of real bill circulation for they were afraid of multilateral trade. They would have liked to continue the wartime blockade of Germany. As there is no such a thing as peacetime blockade, they had to settle for something less: replacing blockade with blocking (real bills circulation, that is). This meant replacing multilateral with bilateral trade. Or, to call a spade a spade, replacing indirect with direct exchange alias barter — a relapse to conditions prevailing during the Stone Age. Through bilateral trade they hoped to monitor and, if need be, control German imports and exports. Under multilateral trade monitoring would be more difficult if not impossible.

The collapse of the international gold standard was the direct consequence of this malicious and vindictive decision. The gold standard could not survive the destruction of its clearing house: the bill market — its most vital organ.

The world is still suffering the consequences. “Structural unemployment” was perfectly unknown while real bills were financing multilateral trade. The elimination of real bill circulation has destroyed the wage fund out of which the wages of workers producing consumer goods can be prepaid. Prepaid, to be sure, because the ultimate consumer’s gold coin may not be available to pay wages for up to 90 days. However, the pay envelope must come weekly, rather than quarterly so that the Lord can “give us our daily bread”. Thus, in a real sense, the Lord’s Prayer is also a prayer for a speedy return of real bills circulation.

Structural unemployment, plus periodic outbursts of a horrendous tide of unemployment was the result of the destruction of the wage fund. The 1930 episode was blamed on the gold standard. This argument has been exploded by events during the present GFC which, in the fullness of times, will be far worse as far as unemployment is concerned than the earlier episode. Real bill circulation has been eliminated along with the gold standard, yet unemployment is still with us. And, curiously, no one is inquiring how it can be that the removal of these two arch-enemies of government omnipotence has not removed the threat of deflation, depression, and unemployment — as promised by Keynes and other false prophets.

I shall continue my comments with a concluding article entitled More Real Bill Fallacies.

---

# Is There Life After Sudden Death?

URL: https://newaustrianeconomics.com/archive/fekete/is-there-life-after-sudden-death/
Date: 2010-10-27
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, real-bills, fiat-currency, monetary-crisis, new-austrian-economics
Description: Position Paper #8: Fekete examines whether the U.S. economy can recover after the sudden death of the gold standard in 1971. He argues recovery is possible only through a genuine monetary reform — restoring gold and real bills — and that the current policy of monetary expansion is prolonging the death agony rather than enabling recovery.
Editorial Note: Position Paper #8 (October 2010). The 'sudden death' of 1971 is Fekete's framing for Nixon's gold default — the moment the dollar lost its last gold anchor.
Original PDF: https://professorfekete.com/articles/AEFPositionPaper8IsThereLifeAfterSuddenDeath.pdf

## Is There Life After Sudden Death?*

The debate on the Real Bills Doctrine (RBD) within the sound money movement is important because the international banking system, financing world trade as well as domestic trade, is facing its greatest challenge in all history. Indeed, it may succumb to the sudden death syndrome, and all efforts to resuscitate it may fail. Worse still, banks have by now acquired such a bad name, and they have earned such a universal hatred for their role in the global destruction of capital and of individual savings, that any new financial institution in whose name the word “bank” figures may be rejected out of hand by the people, should anyone try to make a fresh start in the banking business after the collapse.

Banking systems have been wiped out before under both deflationary and hyperinflationary conditions. But there were always at least some banks that survived the cataclysm, namely, banks of countries that have stayed the course of financial rectitude and did not listen to the siren song of zero interest and perpetual debt: countries that continued to observe the sanctity of contracts anchored in gold. Today the entire world entrusted its fate and fortunes to the dinghy of global fiat money. If the dinghy is smashed to pieces on the reefs, not a single bank will survive.

Under these circumstances detractors of the RBD will discover that the singing the praise of “100 percent reserve” brings no comfort. It will not save the skin of their pet banks.

They will not be trusted any more than the fractional reserve banks, so called, will. The RBD, nothing less, will have to come to the rescue and make the survival of people possible.

I have never been able to persuade my detractors to debate my theory on the sole reasonable premise that the merits or demerits of the RBD can only be assessed in a context where banks are completely absent. Ludwig von Mises described such a scenario prevailing in Lancashire before the Bank of England opened its branch office in the city of Manchester.

The absence of banks did not frustrate the growth and flourishing of the wool trade, the staple industry of the region at the time. Weaver-on-clothier bills, spinner-on-weaver bills, woolman-on-spinner bills circulated as cash in the local economy. The absence of banks could hardly be a handicap in any vibrant community eager to make most of its endowment and potential. It wasn’t in Lancashire.

I have lived in Newfoundland for forty years and had the opportunity to study monetary conditions in the “outports”, as the isolated small fishing villages scattered along the rugged coastline are known where boats carrying fresh supplies and buying up the catch call only a couple of times a year. There was no land communication between these isolated outports. People living there had no use for the word “bank”: they have never heard of, much less seen one. Pre-confederation Newfoundland was a dominion of Britain (same as Canada) with its own gold and silver coinage. Among others, they had the distinctive \$2 gold and 5¢ silver piece. But there was a perennial shortage of coins. The shortage did not rule out trade.

People wanted to eat, get clad, shod, and keep themselves warm in winter. Coin circulation was substituted by real bill circulation. Unlike on the continent, however, in the outports real bills were of small denomination. They were not called real bills either. They were called “chits” drawn by the fishermen on the local fish processor when they delivered their catch on the wharf. Chits would circulate from hand to hand. You could buy supplies from the local store against payment in chits. You could pay for the repair of your nets, and the lumberman was happy to supply you with firewood if you offered him chits in payment. Maturity date —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  — * of the international banking system. on the chits was dove-tailed with the arrival of the next cargo boat bringing in fresh supplies.

The captain of the boat would pay in gold and silver coins for the catch, so the fish processor could meet the demand for coins when redeeming his chits.

My detractors theorize that prices would be lower in the absence of real bills circulation. They conclude that clearing devices are “inflationary” in that they “reduce the demand for gold”. This theorizing is just as idle as trying to find out how much carting would cost if the carter shunned the cart and started carrying heavy loads on his own back once more. Guess what: this question could never be answered. No carter would undertake carting on his own back after the wheel has been invented! Likewise, real bills would step into the shoes of money whenever gold coins were in short supply. Like it or hate it: the wheel has been invented.

The debate on the RBD is dismally lowbrow. It uses terms totally inappropriate in the present situation, such as supply of and demand for gold, the equilibrium price of gold, and the like. Participants of the debate are utterly unprepared for the event when all offers to sell gold against irredeemable paper currency are abruptly and simultaneously withdrawn. What is supply/demand for gold and what is the gold price under these circumstances?

To deal with the present financial crisis and its aftermath we have to develop the prerequisite linguistic tools. In this effort Carl Menger’s work is the only help we have.

Menger had no use for the language of equilibrium analysis. According to him what makes gold special among marketable goods is its unsurpassed liquidity. This means that the spread between the asked and bid price of gold increases more slowly than that of any other marketable good, as ever larger quantities are thrown on the market. This is the property that makes gold superbly qualified to play the role of the ultimate extinguisher of debt: the asset into which all credit instruments must mature if the credit system is to endure.

In a sense, even today in 2010, credit can still be said to mature into gold, albeit at a variable price. But if the gold basis goes negative and stays negative, in other words permanent backwardation of gold strikes*, it will herald the advent of Armageddon. The overwhelming majority of working economists don’t see that gold still plays an indispensable role in the credit system. The U.S. Treasury bond market has a sine qua non adjunct in the gold futures market. Without it, bonds would be irredeemable: they would be promises maturing into more promises, maturing into more promises, etc., ad libitum. But once permanent gold backwardation strikes, the prop of gold futures is removed, and the U.S.

Treasury bond market will succumb to the sudden death syndrome. For the time being it is supported by speculative demand, but the demise of the gold futures market will make the bond speculators scurry for cover. Nothing will save the “super-safe” investments in the “full faith and credit” obligations of the U.S. government.

As long as confidence in the monetary system is unimpaired, gold will be widely available and the credit system will work properly. Increasing unavailability of gold indicates the threat of a breakdown of the credit system. Gold is going into hiding. Watch for the day when it will not be for sale at any price. When this happens the credit system, and along with it trade, will collapse. It is not a matter of equilibrium or the lack of it. It is a matter of life or sudden death. —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  — * Tongue in cheek, I call this cataclysmic event “the last contango in Washington” in oblique reference to the movie “the last tango in Paris”. Contango is antonym for backwardation. It refers to the condition that the price of a distant futures contract is higher than that of the nearby. Permanent backwardation in gold means that paper gold has lost all its value and physical gold can no longer be substituted by promises to pay gold in the future.

Detractors of the RBD do a great disservice to society when they try to force their narrow parochial and cultist viewpoint, the quantity theory of money and the supply/demand equilibrium theory of price, on everybody at a time when the problem is the relentless dryingup of liquidity. What we need is a theory of hoarding to supplement the theory of marketability. The theory of interest describes how gold is exempted in part from serving as a medium for saving. There is a complementary theory: that of discount, describing how gold is exempted in part from serving as a medium of exchange. That economy is best where gold is hoarded least. In such an economy gold is not needed in the cash balances of traders and, for that reason, it is widely available to serve as the ultimate extinguisher of debt.

Time has long since passed when bickering about the number of angels that can simultaneously dance on the point of a needle could add anything to our knowledge.

Fractional reserve banking is a red herring. Tinkering at the edges and bandying about 100 percent reserve requirement will lead nowhere. You will never understand RBD if you try to approach it through bank abuses. What needs to be explained is why real bills can circulate on their own wings and under their own steam — banks or no banks.

Real bill circulation will spring up spontaneously after the total prostration of the world’s banking system. Yes, there is life after sudden death strikes down the banks. People are not going to commit collective suicide at the altar of fiat currencies. People want to live.

They will use whatever little gold is available to them to trade by drawing real bills maturing into gold against the production and distribution of goods they want to consume. Recall that gold went into hiding before, last time when the Western Roman Empire collapsed in A.D. 476 and the barbarians invaded its territory. Thereafter, for a period of some five hundred years, gold was not available as a means of payment for essential goods and services.

It will happen again when the American Empire collapses. The miracle at the end of the Middle Ages, when the bill of exchange was invented in the Italian city-states such as Florence, Venice, Genoa, will be repeated. Whatever gold is still available will be used to support the bill market. The world will do very well with real bills and without banks, thank you very much.

When contract law will once again reach the level of highest respect, and promises to pay gold can once again be believed, banks may once again be in vogue. When that day dawns, the best earning assets of the new banks will be real bills drawn on consumer goods in most urgent demand maturing into gold coins. The criterion by which banks are judged is not going to be the interdiction against less than 100 percent gold reserve. It will be the prohibition against borrowing short in order to lend long.

---

# The Deep Cause of the Great Financial Crisis: The Peace Diktat of Versailles

URL: https://newaustrianeconomics.com/archive/fekete/the-deep-cause-of-the-great-financial-crisis/
Date: 2010-10-06
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, monetary-policy, fiat-currency, monetary-crisis, new-austrian-economics
Description: Fekete traces the deep cause of the 2008 financial crisis back to the Treaty of Versailles (1919), which destroyed the pre-war international gold standard and imposed the punitive reparations that led to Weimar hyperinflation, then the Great Depression, then World War II. The 2008 crisis is the latest consequence of a monetary disorder whose origins lie in 1919.
Editorial Note: Written October 2010. Fekete's most historical essay, tracing monetary disorder over a full century. The Versailles thesis is controversial but provides a useful long-run perspective on monetary instability.
Original PDF: https://professorfekete.com/articles/AEFTheDeepCauseOfTheGreatFinancialCrisis.pdf

Speech delivered at the Munich Economic Talks,

---

*October 6, 2010*

Ladies and Gentlemen,

According to a recent news item, not widely circulated, after more than 90 years of slavery, on October 3, 2010, Germany made the final payment for its World War I debt. This event is highly symbolic. It gives me great pleasure to be one of the first to congratulate you, literally hours after the German people were finally freed from debt slavery.


---


I have been a student of money and credit for over fifty years. I could summarize the result of my studies as follows: Most, if not all, the great events in the history of mankind since the advent of money, have a causal explanation. The causes are to be found in the use or abuse of money and credit — provided that we penetrate historiography sufficiently deeply.

My talk is meant to be dispassionate, well-grounded in economic thought, and certainly free from nationalistic overtones.

This evening I would like to illustrate my thesis through the following example:

The Great Depression of the 1930’s, in particular, the unprecedented world-wide unemployment was caused by the decision of the victorious Entente powers to return to the gold standard after World War I, BUT without allowing the clearing house of the gold standard, the international bill market, to make a comeback.

This decision was made in secret. It has never been made public.

But there can be no doubt about the fact that in 1920 everybody, even Keynes himself, admitted the desirability of an expeditious return to the gold standard. Had there been no decision to ban it, bill trading would have started spontaneously.

What this decision was meant to accomplish was to block multilateral world trade by brute force. It was to be replaced by bilateral trade or, to call a spade a spade, by a barter system. Why did the victorious Entente powers make such a foolish decision that was going to hurt their own producers and consumers, and hinder reconstruction? They did it because they wanted to punish Germany over and above the provisions of the Versailles peace treaty. They wanted to maintain the wartime blockade under a different name.

They wanted to monitor, and control if need be, the move of goods in and out of Germany. In peacetime the only way to accomplish this was to replace multilateral with bilateral trade; to block the financing of world trade with short-term commercial bills, also known as real bills. To put it differently, the Entente powers phased out selfliquidating credit and replaced it with artificial bank credit, the creation of which they could control through their central banks.

World trade prior to 1914 was multilateral. By this I mean that imports were paid for by issuing, endorsing, and accepting bills of exchange payable in gold at maturity no more than 91 days after shipping the underlying merchandise. With three good signatures: that of the exporter, that of the importer, and that of a recognized acceptor the bill of exchange went through a most remarkable metamorphosis.

It became money. Ephemeral, to be sure, but money nevertheless. The exporter could use it to pay for his imports by passing it on, after endorsing it, to the exporter in a third country. This exporter could likewise use it to pay for his own imports, and so on and so forth.

Only in the light of this fact can one explain the unprecedented expansion of world trade during the 100-year period between 1815, marking the end of the Napoleonic War and 1914, marking the outbreak of World War I. Such a record level of world trade would not have been possible without the clearing house for the gold standard, the bill market. Geographically, this clearing house was located in the City of London. It was the great London trading houses and banks on which bills of exchange, covering merchandise shipped from country A to country B, were drawn. It was the great acceptance houses in London that accepted them. Once so endorsed and accepted, these bills started to circulate on their own wings and under their own power, as only monetary gold could circulate: without friction.

It was this great clearing house of the gold standard in London that was blocked, nay, sabotaged, by the decision of the Entente powers at Versailles in their vindictive moment of victory. They never examined the broader economic implications of their move, beyond the obvious effect of putting the foreign trade of Germany on a leash.

They utterly failed to see the wider consequences of their folly.

To show just how short-sighted the decision to block the circulation of real bills was, consider the argument of the German economist Heinrich Rittershausen (1898-1984) that he presented in his monograph entitled Unemployment and Capital Formation, published in 1930, but obviously written before the Great Depression has become a reality. Rittershausen predicted that, hard on the heels of the collapse of the gold standard, a horrendous wave of world-wide unemployment would prostrate the world economy.

Under multilateral world trade financed by real bills there was something we may, in want of a better term, call the Wage Fund — out of which the wages of laborers producing merchandise demanded most urgently by consumers could be paid. Please remember that these goods during their gestation period of up to 91 days could not be sold to the ultimate consumer. He was the only one to pay for his purchase by handing over the gold coin. Neither the producers of semi-finished goods that go into the merchandise, nor the wholesale and retail merchants would ever pay gold: they would issue or endorse bills. It could take 91 days (or 13 weeks, or 3 months, or a quarter) before the real bill matured into the gold coin with which wages could be paid. But laborers have to be fed, clad, shod, and sheltered in the meantime. They cannot wait for 3 months till the merchandise will have been sold to the ultimate gold-paying consumer. Wages have to be paid weekly, not quarterly.

Thus, then, the Wage Fund is absolutely necessary for the maintenance of world trade and full employment on a scale it has reached prior to 1913. Such a Wage Fund could only exist by virtue of the bill market. So much of the ‘float’ of real bills in the world was earmarked for paying wages; the remainder was earmarked to pay for supplies.

The system worked extremely well: ‘structural’ unemployment was unheard-of before World War I.

### This Wage Fund was unwittingly destroyed by the victorious

Entente powers at the moment they decided to block the financing of world trade through real bills circulation as it existed before 1914. The result was that world trade never really recovered. In fact it took the better part of the twentieth century for the volume of world trade to reach its 1913 peak level again. In the meantime it was touch-and-go.

Bilateral trade, barter, or direct payment of gold and gold exchange replaced self-liquidating credit, as the credit represented by real bills was called.

The destruction of the Wage Fund was not immediately noticed.

The great inflation due to World War I imparted sufficient stimulus for a full decade to cover up the complete absence of a reliable fund out of which wages could be paid. In due course, however, the surplus money was siphoned off by an extraordinary explosion of speculative activity in financial bills, real estate, and in the shares of joint-stock companies. Real bills were conspicuous only by their absence.

When money became scarce after the bubbles burst one after another: the bubble in US Treasury bonds in 1920, the Florida real estate bubble in 1925, and the stock market bubble in 1929, the absence of the Wage Fund, destroyed a decade earlier, immediately became obvious. There was no money to pay the wage earner.

Workers were laid off. They had to be put on the dole. An unprecedented wave of unemployment, like a tsunami, engulfed the world. Dictatorships could escape the curse of unemployment by destroying civil liberties: Lenin’s under the banner of international socialism, Hitler’s under the banner of national socialism.

### The only economist in the world who saw what was coming was

Rittershausen. But he was treated by the international community of economists with the same contempt as the German delegation was at the Versailles peace conference. A new economic gospel was promulgated by the prophet John Maynard Keynes who made a complete volte face. He was a most vocal opponent of Britain’s return to the gold standard in 1925. Not because he realized that Britain’s ‘newly-born-again’ gold standard was not viable as it grievously lacked a vital part: the clearing house. Keynes opposed the gold standard on doctrinaire grounds. According to him the gold standard was obsolete, contractionist, an obstruction to progress. The new dispensation called for flexible foreign exchange rates that could be easily manipulated in the service of a hidden political agenda. Keynes was the enfant terrible of economic science. He was a perfect antithesis of Rittershausen. He was a master of demagoguery. He made economics stand on its head. For thousands of years the problem of economics was the scarcity of savings as well as over-consumption, especially during princely wars. Keynes invented over-saving and its twin brother, under-consumption. These notions are as obnoxious as they are preposterous. Yet the world, desperate for getting out of the depression, bought them. This was just what Keynes has been waiting for. He was hell bent on manipulating the whole world through clever verbiage, but which utterly lacked any substance.

Rittershausen, on the other hand, had no ulterior motivation. He just wanted to find the truth. And, indeed, he found it by pointing to the destruction of the wage fund in the wake of blocking the circulation of real bills. It is a great tragedy that Rittershausen was born in Germany rather than Britain, and Keynes was born in Britain rather than Germany. If it had been the other way around, then Keynes would have been totally ignored, as was his desert, and Rittershausen would have been elevated to international fame, as was his. He would have been made the object of world-acclamation and admiration.

History may not be repeating, but it certainly is strongly echoing itself. The Great Financial Crisis of 2008 is such an echo of the Great Depression of 1930. Or could it be that the Great Depression of 1930 was the harbinger of something far worse: the Great Financial Crisis of 2008 and its aftermath, still to be visited upon the world?

The last remnants of the gold standard were abolished in 1971 when the Republican president Richard Nixon defaulted on the international gold obligations of the US — almost 40 years after the Democratic president Franklin D. Roosevelt defaulted on its domestic gold obligations. It triggered the fast-breeder of money, originally envisaged by Keynes, later dressed up academically and made palatable politically by Milton Friedman. At first, the going was great under the catch-word: “you have never had it so good”. But then, just as during the “roaring 20’s”, speculators grabbed the money spun out by the fast breeders and ran with it. Once again, bubbles were blown and started bursting one after another. Now the world is confronted with the worst prospects for unemployment ever. At any rate, far worse than the one Rittershausen had predicted in 1930. We can, using his methodology, predict Great Depression II in the making. The world still is lacking a Wage Fund. A vastly expanded army of unemployed people will have to be fed, clad, shod and sheltered. The money to do it is not there. Once again, governments will have to create it out of nothing to pay the dole.

### The obvious way out of this corner is the resuscitation of the

Wage Fund through allowing the spontaneous circulation of real bills that were last used in 1914. Lest anyone suggest that this feat could be accomplished under the regime of irredeemable currency, beware: real bills can only work if they mature into gold. It is unthinkable that they could mature into irredeemable paper currency. A real bill is an IOU promising to pay gold, and it offers a return to boot. An irredeemable banknote is an “IOU nothing” and it offers nothing — an inferior instrument at best, a fraud at worst. A real bill, to be meaningful, must mature into a superior financial instrument. Otherwise it refuses to circulate. Therefore the rehabilitation of real bills assumes the simultaneous rehabilitation of the gold standard. The two go together as hand and glove.

The way to return to the gold standard is for the US government to open the US Mint to gold — as ordained by the American Constitution that has been violated by power-hungry presidents such F. D. Roosevelt and his successors, every one of whom swore to uphold it, only to turn around and trample on it.

It would be an extraordinary act of statesmanship if a new president reinstated the monetary provisions of the American Constitution.

There is no other way to prevent the collapse of the debt tower, or to fend off the tsunami of unemployment and the global breakdown of law and order.

### References

Heinrich Rittershausen, Reform der Mündelsicherheitbestimmungen und der Industrielle Anlagkredit, Jena, 1929.

Heinrich Rittershausen, Arbeitslosigkeit und Kapitalbildung, Jena 1930.

### Wikipedia, Heinrich Rittershausen (in German)

A. E. Fekete, The Real Cause of Unemployment, The Revisionist Theory and History of Money, 2007, [www.financialsensearchive.com/editorials/fekete/2007/0111.html](https://www.financialsensearchive.com/editorials/fekete/2007/0111.html)

---

# The Donkey in the China Shop

URL: https://newaustrianeconomics.com/archive/fekete/the-donkey-in-the-china-shop/
Date: 2010-09-27
Section: Popular Economics
Difficulty: accessible
Concept Tags: federal-reserve, monetary-policy, bond-market, capital-destruction, fiat-currency
Description: Position Paper #7: Fekete uses the donkey-in-a-china-shop metaphor to describe the Federal Reserve's blundering intervention in credit markets — not the proverbial bull but something even less graceful. He examines QE2 specifically, arguing it will destroy the very credit conditions it claims to repair.
Editorial Note: Position Paper #7 (September 2010), written as the Fed was signaling QE2. The donkey metaphor is both funnier and more accurate than the usual bull-in-china-shop analogy — the Fed's monetary policy is not aggressive but merely clumsy.
Original PDF: https://professorfekete.com/articles/AEFPositionPaper7TheDonkeyInTheChinaShop.pdf

## The Donkey In The China Shop

### Obama and Congressional Democrats Trying to Blackmail China

President Obama has just issued a blackmail to Prime Minister Wen Jiabao of China: “You immediately revalue the yuan or else…” According to an article of David E. Senger in The New York Times dated September 23, 2010, the two leaders met at the United Nations in New York and spent most of their two-hour session in a spare conference room, usually used by members of the Security Council, to discuss the currency issue. The session ended by Obama’s issuing an ultimatum that is bound to be followed by trade war. Surely, this is a most unseemly use to which the sacred grounds of the Security Council, dedicated as it is to the maintenance of peace and prevention of war, have ever been put.

It is most undiplomatic, not to say arrogant, for a head of government to engage another in a in a tête-à-tête confrontation, to discuss technical currency problems that should first properly be sorted out at a lower level by experts. In a total lack of courtesy to be shown to a guest, Obama is threatening him with action on the part of Congressional Democrats, to railroad legislation through before the midterm elections that would put huge punitive tariffs on Chinese goods, thus plunging the world into trade war. Every one of those Congressional Democrats is a complete ignoramus where complex currency issues are concerned. The only thing they can do is parrot Keynesian and Friedmanite bunk.

The reason given for Obama’s most unusual procedure is that he and his Congressional cohorts are “protecting U.S. interests: American jobs and American competitiveness”. Of course, Obama would never pay the blackmail if China wanted to force upon the U.S. an unpalatable dollar-policy, e.g., demand that the dollar be immediately put back on a gold standard on the theory that the present dispute would not have arisen if the dollar were gold redeemable as it had been before Nixon’s default. Obama has grossly overplayed a very weak hand. The U.S. has never been in a weaker bargaining position. All the trump cards are in the Chinese hand.

None of the arguments used by Obama in his impolite and immodest lecturing of the Chinese Prime Minister holds water. Exactly the same stratagem was applied against Japan in the 1980’s. At that time the U.S. wanted Japan to let the yen float upwards “in order to help restore America’s competitiveness”.

Japan meekly obliged, and the result was: bankrupting the Japanese financial system while America became even more uncompetitive.

That episode has been completely misrepresented by the American media and mainstream economists. To restore balance, here is the other side of the argument. Japan had a huge pile of U.S. Treasury paper as a result of several decades of trade surpluses — fruits of Japanese thrift and good husbandry. As the yen was floating upwards, Japan took enormous losses on its holdings of U.S. paper, since its gold value was no longer guaranteed after Nixon’s default of 1971. For an American eye these losses were invisible, because Americans blithely assumed that everybody would carry his books in dollar units. But the Japanese carry them in yen units. As the yen was floating upwards from a little over 25 cents to over \$1 per 100 yen, the Japanese were forced to take a loss on their savings to the tune of over 75 cents on every dollar of American debt held.

The whole maneuver of floating the yen upwards was designed to avoid the shame attached to an exercise in default of sovereign debt, in order to save American face at Japan’s expense. Such a drastic and open-ended loss of wealth would bankrupt even the strongest country financially. Japan today is in the throes of a depression, thanks to the U.S.’ slapping its debt abatement on her economy. Thrift and industry were penalized, prodigality and financial irresponsibility rewarded.

But the worst was still to come. When the Japanese wanted to pay some of their overseas accounts by drawing on the remnants of their savings held in dollars, they were shocked. The money wasn’t there. American money-doctors rushed in and talked Japan into embracing deficit-spending. Up to that point Japan had practically no government debt. Why should they? They could afford to pay cash. By contrast, today, Japan is one of the worst cases of government over-indebtedness, a result of “good” advice dispensed by the American money doctors.

The Chinese government is not in the habit of running its business on the basis of unbalanced budgets and deficit spending. Looking at the Japanese experience, no wonder that China does not want to be sucked into the black hole of bottomless government debts in which the U.S. and the Japanese governments are drowning.

Obama’s argument, concocted for domestic consumption, is that upwardfloating of the yuan would help restore American competitiveness and would put Americans back to work. However, the saga of the Japanese yen does not confirm this optimistic prediction. A side-effect of letting the yen float upwards under American duress was the devaluation of the dollar vis-à-vis the yen. As a consequence, Japanese producers have made further gains in competitiveness over that of their American competitors. With their stronger currency they could easily outbid American producers in world markets when shopping around for ingredients that go into production for exports. As a result, Japan’s trade gap with America widened further. The imbecile theory of Milton Friedman, that a weaker currency is duty bound to make for gains in the country’s exports, has never worked — except in the reverse. Whatever dubious advantage a weaker currency may have initially evaporates as soon as stockpiled imports are drawn down and used up. Ever after, the weaker currency has to face higher bills for imports. The terms of trade of the country resorting to devaluation deteriorates: the same quantity of exports will buy a smaller quantity of imports. To devalue one’s own currency is akin to self-mutilation of the champion before the race.

The only thing it guarantees is failure. The champion must hand victory over to his adversary without running.

The charge that the Chinese artificially hold their currency weak is a red herring. The real strength of currencies is measured by the reserves held against them, and by the competitiveness of the export industry supporting them. By these measures the yuan is a strong currency, indeed, far stronger than the dollar.

Torturing logic in calling the strong weak and the weak strong will not take Obama very far.

The real reason for the unprecedented blackmail of Obama has nothing to do with these false charges. It has all the more to do with the unpaid and unpayable debt of the U.S. The size of this debt beats all records in history, and cries out for debt-abatement or default. The blackmail was issued in desperation.

The U.S. is like the biblical prodigal son who has blown his patrimony. He does not want to admit that he has acted foolishly. He does not want to repent. He just pushes the blame on others. But the moment of truth will arrive when the fact of prodigality must be admitted, and repentance must replace finger-pointing.

For a balanced view of the American-Chinese dispute one has to see clearly that if China caved in to American pressure, as did Japan before her, then China would agree to the embezzlement of her savings held by America, bankers to the world. China is a proud country and will never allow herself to be humiliated and short-changed in this way.

Obama, the Congressional Democrats, and their Keynesian/Friedmanite mentors should face up to the fact that they have overstayed their welcome as financial managers of the U.S. and the world. Pseudo-theorizing on the nonexistent benefits of currency devaluation has grown threadbare. Blackmailing surplus countries and slapping the losses on them — while the orgy continues in the deficit country — is a counter-productive strategy. It is bound to fail, as it already has. It may force China to fix the value of the yuan, not in U.S. dollars but in gold ounces. That will be the last nail in the coffin of the once mighty U.S. dollar, to make it ready to join the Continental, the assignat, the Reichsmark, and the Zimbabwe dollar in the cemetery of worthless fiat currencies.

Maybe in November the American people will send representatives to Congress who will rally around Congressman Ron Paul of Texas, the only American leader with a viable plan to save the American government from the ultimate humiliation of publicly recognized bankruptcy.

America can lose nothing, and can gain everything by playing the gold card first. The prodigal son, repentant, could return to his father, symbolized by the American Constitution, who is ready to forgive and embrace him. Not only will the opening the U.S. Mint to gold, as demanded by the Constitution, restore the government to fiscal sanity and financial health; it will also bring confidence back to the international monetary system.

It will also help avoid trade wars, and prevent another wave of uncontrollable unemployment from engulfing the world.

Reference position paper of professorfekete #3, July 4, 2010, Floating Exchange Rates: Scheme to Embezzle the Dollar Balances of Surplus Countries, [www.professorfekete.com](https://www.professorfekete.com).

### Calendar of Events

## Sound Money Or Unsound —That Is The Question

Symposium of the New Austrian School of Economics in Auckland, New Zealand, November 15-19, 2010

Lecturers: Professor Fekete (Hungary), Rudy Fritsch (Canada), Sandeep Jaitly (U.K.), Peter Van Coppenolle (Belgium)

Nov. 15.

Nov. 16.

Nov. 17.

Nov. 18.

Nov. 19. a.m. p.m. a.m. p.m. a.m. p.m. a.m. p.m. a.m. p.m.

### Sound Money: Unadulterated Gold Standard

### Unsound Money: Our Diseased Monetary Bloodstream

### Fiat Currency: Destroyer of Capital

### Fiat Currency: Destroyer of Labor

### When Atlas Shrugged: the Lure and Lore of

### Risk-Free Profits

### Gold and the Babeldom of the Debt Tower

### The Fall and Rise of the Gold Standard

Sound, Less Sound, Least Sound:

### The Unhappy Birthday of the Euro

### And God Created Gold…

### The Gold Standard Manifesto

For further information please contact: Louis Boulanger, louis@lbnow.co.nz

---

# Remobilize Gold to Save the World Economy! (2010)

URL: https://newaustrianeconomics.com/archive/fekete/remobilize-gold-2010/
Date: 2010-09-24
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, sound-money, monetary-crisis, fiat-currency, real-bills
Description: A September 2010 update of Fekete's remobilize-gold argument, incorporating the lessons of the 2008-09 crisis and the subsequent QE programs. He argues that the failure of monetary stimulus to produce recovery confirms his diagnosis — and that only gold remobilization can provide the monetary anchor needed for genuine recovery.
Editorial Note: A 2010 update of the July 2009 remobilize-gold essay, incorporating post-crisis developments. The repeated emphasis on remobilization reflects Fekete's belief that this is the minimum necessary monetary reform.
Original PDF: https://professorfekete.com/articles/AEFRemobilizeGold.pdf

*Remobilize Gold To Save The World Economy!*

An open letter to Paul Volcker, Chairman of the Board of Governors of the Federal Reserve, 1979-1987; Chairman of President Obama’s Economic

### Recovery Advisory Board, presented to him, in person, last year

### Antal E. Fekete

### E-mail: aefekete@hotmail.com

Dear Paul:

In 35 years our paths have crossed for the second time. In 1974/75 you and I were Visiting Fellows at Princeton University. Now, in 2009, both you and I are attending the Santa Colomba Conference on the present debt crisis at the invitation of Bob Mundell.

In 1975 you conducted a seminar on the international monetary system and invited me to contribute a paper on gold which I did. Those were halcyon days by comparison. The United States, after the turbulence of 1971, successfully consolidated the international position of the dollar and could confidently lift the 42-year old ban on the ownership and trading in gold. On December 31, 1974, trading of gold futures contracts started in New York and Chicago. It showed a robust contango at full carrying charge, that is to say, the gold basis (the spread between the futures and the cash price) was at its peak. It indicated that monetary gold was available in great abundance to meet any demand for any reason. It showed that the gold futures markets could serve as the fulcrum in seeking out the equilibrium between the supply of and demand for gold. They could act as a safety valve, releasing occasional pressures that, in the absence of paper gold, may be a threat to the monetary system. It looked as if the gold problem has been solved for once and all.

But as I feared, and as the intervening 35 years have proved, rather than moving towards equilibrium we have been constantly moving ever farther away from it, as measured by the gold basis. The secular vanishing of the gold basis is a most ominous danger signal. It indicates that monetary gold is increasingly unavailable, and in case of a crisis it can no longer be relied upon to come to the rescue.

Basis started out at 100 percent of the prevailing interest rate, but has been steadily eroding all the way to zero percent today. Permanent gold backwardation (negative gold basis) is staring us in the face.

The gold basis is trying to tell us something. It heralds the greatest monetary crisis of all times. It warns about the possible collapse of the international monetary and payments system.

Let me explain. Gold is the only ultimate extinguisher of debt. Other extinguishers do, of course, exist but they are not ultimate in that they have a counterpart in the liability column of the balance sheet of someone else. Gold has no such liability attached. Gold is where the buck stops. It is this property that makes gold unique as a financial asset. Historically, gold discharged its function as the ultimate extinguisher of debt through the gold clauses written into the bonds of the U.S. government before 1933. Gold could also discharge this function, albeit rather imperfectly, under the gold exchange standard of 1934 with gold redeemability limited to foreign holders. It could still work under the system of fluctuating gold price introduced in 1971, thanks to the availability of paper gold. Imperfect as though these stratagems were, they served as a pacifier to the bond market. But as the threat of permanent backwardation indicates, all offers to put monetary gold at the disposal of the international monetary system could be abruptly withdrawn. In that event there would be no ultimate extinguisher of debt. The world is totally unprepared for such a momentous development. I ask: are there contingency plans in the U.S. Treasury and in the Federal Reserve what to do if backwardation makes monetary gold unavailable for the indirect retirement of debt?

The message to debt holders would be: suave qui peut. There would be a rush to the exit doors and people would trample one another to death in trying to get out. The debt crisis of 2008 was a dress rehearsal. It gave the world a foretaste. This crisis is a gold crisis. It is a crisis indicating the threat of a shortage of the ultimate extinguisher of debt, without which our runaway debt tower is doomed. When it topples, it will bury the world economy under the rubble, as the Twin Towers buried the people working inside in 2001.

All kinds of ad hoc explanations have been offered for the debt crisis. But the real explanation is that under the threat of gold backwardation creditors are scrambling for liquidity. There will be no recovery unless provision is made for the orderly retirement of debt through a mechanism using gold as the ultimate extinguisher. The alternative is a Great Depression worse than that of the 1930’s. To understand this we have only to contemplate the shock to the world if it was all of a sudden revealed that the debt of the U.S. government was in fact irredeemable. The Emperor is naked. As long as bonds carry a gold clause, or the bond market is supported by the trading of paper gold, bonds are deemed redeemable. But once permanent backwardation makes monetary gold unavailable, debt becomes irredeemable in the eyes of the bondholders. Paying U.S. bonds at maturity in F.R. notes does not establish redeemability. The latter is just evidence of debt secured by the former as collateral.

This reveals that bonds are not really redeemable at all. At maturity, an interest-bearing bond is replaced by non-interest-bearing debt, that is, by an inferior instrument. All you do is shuffle various forms of irredeemable debt. When the world wakes up to this prestidigitation, the international monetary system will not be able to survive the shock-waves. The chaos that will engulf the world is appalling.

The solution is evident. The world’s monetary gold should be remobilized. This can be accomplished by opening the U.S. Mint to the free and unlimited coinage of gold. There should be no attempt to fix, cap, or otherwise control the dollar price of gold. The gold coins of the United States ought to be made available to bondholders in order to provide for an orderly retirement of debt, if that is what the bondholders want. When they become convinced that this avenue is open to them through the unlimited availability of gold coins of the realm, the scrambling for liquidity will peter out and stability return. If other great nations wanted to join, and open their Mints to the free and unlimited coinage of gold, so much the better. It should not be beyond the power and the wit of the U.S. government to rein in this crisis and make a decisive move in the direction of full recovery through opening the U.S. Mint to gold, as demanded by the Constitution.

Gold is a great world resource. It would be foolish if, for parochial or ideological reasons we failed to enlist it in the cause of economic development and stabilization — even in the absence of a great crisis. But given the present unprecedented crisis, remobilization of gold is imperative.

Yours very sincerely,

### Antal E. Fekete

Santa Colomba, July 10, 2009.

Volcker: “The financial system is broken.” In a bleak assessment delivered on September 23, 2010, he also said, among other things, that the financial system is as broken today as it was in 2008. The real economy was in disequilibrium, and that’s why it is so difficult to get out of this recession. He was chastising banks and CEO’s, he trashed regulators and inept business schools. He had a broadside on the Fed; he bombed money market funds.

In fact, Volcker spared no one in his broad critique — except himself. He was present at the Camp David meeting, as the Undersecretary of the U.S. Treasury for Monetary Affairs that, where the decision was made to default on the international gold obligations of the United States, as announced by president Nixon on August 15, 1971, almost forty years ago.

Volcker still does not see the connection between that fateful decision and the present crisis. Once you remove gold from the international monetary system and prevent its rehabilitation, as the U.S. has been doing it through chicanery, duplicity, and arm-twisting, you have in fact removed confidence, and prevented its return, to international relations. It started as a slow process as it was turning the granite at the foundations into putty. It took forty years, but it has happened.

Volcker still does not see that, and he still could not bring himself to uttering a word about gold in his assessment of the crisis at the 13th annual International Banking Conference.

Volcker: “The financial system is still at risk!” Yes, indeed, and only bringing gold back as the ultimate extinguisher of debt into the international financial system will change that.

If the United States government hasn’t got the moral fiber to admit its past mistakes, and make the necessary changes to correct them, then other countries will bypass it, as will history. Then the United States can join the Club of Disgraced Empires, and the U.S. dollar can join the garbage heap of worthless fiat currencies of history, right next to the Zimbabwe dollar.

---

*September 24, 2010.*

---

# Where Krugman Went Wrong

URL: https://newaustrianeconomics.com/archive/fekete/where-krugman-went-wrong-pp6/
Date: 2010-09-09
Section: Popular Economics
Difficulty: intermediate
Concept Tags: monetary-policy, capital-destruction, federal-reserve, interest-theory, new-austrian-economics
Description: Position Paper #6: Fekete identifies the specific errors in Paul Krugman's economic framework: his reliance on aggregate demand models that ignore the supply of credit, his dismissal of interest rate effects on capital formation, and his equation of monetary expansion with economic stimulus. Fekete shows why Krugman's prescriptions make the underlying monetary disorder worse.
Editorial Note: Position Paper #6 (September 2010). Part of Fekete's ongoing engagement with Paul Krugman, whom he views as the most influential proponent of economically destructive Keynesian ideas.
Original PDF: https://professorfekete.com/articles/AEFPositionPaper6WhereKrugmanWentWrong.pdf

## Where Krugman Went Wrong

### Antal E. Fekete

Paul Krugman, writing in The New York Times on September 5 under the title ”1938 in 2010”, chastizes president Obama’s economists once more for doing what they have promised not to do: to repeat the mistakes of president Roosevelt’s economists in 1937 in pulling back fiscal stimulus too soon. According to Krugman, while president Obama’s policies have limited the damage from the financial crisis to the economy, they have been too timid in opening the spigots to make money flow, as shown by levels of unemployment that is still disastrously high and increasing. He advocates applying more stimulus, nay, a burst of deficit-financing of the same order of magnitudes as that during World War II, which can amount to roughly twice the value of GDP, or \$30 trillion.

The drive of Krugman’s argument is that even an exorbitant increase in the national debt would be safe. It would not put the nation in danger of bankrupting itself — just as it didn’t in WW II — because the accumulated debt could be easily paid off with the aid of the high level of economic growth that only such an extreme stimulus could generate. He says that the war debt was paid off painlessly during the post-war boom. The economy was able to thrive without continuing deficits, thanks to the improved financial position of the private sector. The moral of the story, he says, is that when the economy is deeply depressed, the usual rules don’t apply. Austerity is self-defeating: when everybody is trying to pay down debt at the same time, the result is depression and deflation, and the debt problems grow even worse. Conversely, it is possible — indeed, necessary — for the nation as a whole “to spend its way out of debt and back to prosperity”. A temporary surge of deficit spending, on a sufficiently high scale, can cure the problems brought about by past excesses. It is precisely deficit spending on such a scale that is needed to create the economic boom that would lay the foundation of long-run prosperity.

It may be admitted that Krugman’s argument has a certain intellectual appeal, much like Keynes’ siren song about pump-priming in 1936 had. However, his drawing a parallel between retiring debt after WW II and the proposed retirement of debt after a \$30 trillion spending spree by the government is invalid. Why? The short answer is: because in 1945 the U.S. was still on a gold standard with the result that gold could be invoked to act as the “ultimate extinguisher of debt”. However, in 1971 the last vestiges of the international gold standard were thrown to the winds, leaving the world without such a tool. Suggestions of Friedman, that the irredeemable dollar could fill the golden shoes provided that its printing was strictly limited, spectacularly exploded during the present financial crisis. Ever after 1971 the total debt in the world could only increase, never again to decrease — save default. And increase it did with a vengeance. That gave us the Debt Moloch devouring the world. The only way to avoid that fate is to go back to the international gold standard — a solution which, surely, Krugman wouldn’t think of advocating. Krugman’s placidity and complacency in the face of the runaway debt tower is explained by his wrong interpretation of the historically low interest rates prevailing in the U.S., and his apparent ignorance of the mechanism whereby government debt is monetized. A word as to each of these two perceptions is in order.

1. Keynesian economists offer a false interpretation of the artificially low interest rates at which the government is borrowing as a test of soundness of government credit, and as a measure of safety of investing in it. This shows, they insist, that all is well with our fiscal affairs. They go further. They treat low rates as a green signal on the road to mega-deficits.

Yet the facts tell us a different story. Upon comparison we find that in prosperous times, when our debt and tax burden was relatively small, when total debt was being reduced year in and year out, when public credit was as solid as it could be, the interest rates on government borrowing were much higher than they are now. Government bonds were bought by genuine investors using genuine savings. Bond speculation was non-existent. The government was compelled to borrow in a competitive market.

Excessively low interest rates on government securities are not a healthy sign. They are symptomatic of a depression. They are evidence of the fact that funds to be lent go begging. There is a widespread lack of confidence in business circles. The lethargy of businessmen prevents them from expanding production and making new investments. They do not see how profits could be made that could beat interest rates, however low the latter might be.

2. Keynesian economists are also guilty of deliberately obscuring the mechanism whereby the debt of the government is monetized by the banking system. They want to create the impression that the public, that is, individual investors at home and abroad buy the government paper for purposes of saving. The truth, however, is that individuals have long since stopped saving in the form of government paper, which they look at as “certificates of guaranteed confiscation”. Their role has been taken over by the bond speculators who make a killing on their holdings when interest rates go down, and they make a killing on their short positions in bond futures when interest rates go up. They make their profits at the expense of the public. Recall that such profiteering is ruled out under the gold standard that stabilizes interest rates and bond prices.

But — and this is what Keynesians are hiding from the people — by far the largest part of government debt is held by the banking system. To the extent that banks finance government borrowing future (as opposed to present) savings are being used, with disastrous consequences. The government sells its bonds to the banks; the banks use these as assets and create demand deposits against them, thus acting as an intermediate agency for converting the government’s promises to pay in the distant future into bank deposits that can be used immediately as cash. The ratio of reserves to deposits declines. The banks receive a tiny profit in the form of a low interest payment on the bonds for putting their credit-clearing facilities and their cash at the disposal of the government. This procedure is called “monetizing government debt”, and it can continue until surplus bank reserves have been exhausted.

Monetization of government debt by the banking system is a thoroughly bad policy. It is the engine of inflation as deposit currency payable on demand is created against the government’s promises to pay in the distant future. It is the classical example of borrowing short and lending long.

But it could also be an engine of deflation. Here is what happens. Bond speculators are watching. When the banks are overextended, they dump the bonds en masse causing a steep rise in the rate of interest. The corresponding drop in bond prices would wipe out the entire capital and surplus of all banks simultaneously, as it happened in 1920 and, again, in 1980.

The abrupt and steep rise is then followed by a slow, extended fall in interest rates. Such a fall has the effect of destroying capital across the board, as the liquidation value of debt rises. This means prolonged deflation that feeds upon itself. This is the true explanation of the Great Depression of the 1930’s, and this is the story behind Great Depression II now unfolding.

It must also be remembered that taxes must be levied to repay the government debt.

Here Keynesians have another “blind spot”. Higher taxes dull the efficiency of the private sector in creating wealth. As the government repays the loans, money will accumulate as surplus reserves in the banks and will then start scrambling in search for outlets. The only way these surplus bank reserves can be used is for the people or the government to borrow from the banks again. Thus deficit spending breeds more deficit spending and debt breeds more debt. Bank capital is at risk when the rate of interest rises but, for different reasons, it is also at risk when the rate of interest falls.

Keynesians are fond of saying that government debt does not matter because “we owe it to ourselves”. This is a vicious notion. The next generation will have to pay heavy, repressive and disturbing taxes, not to themselves, but to pile up surplus bank reserves. The wealth that future generations have yet to produce will be used to retire the currency now being issued against it. To achieve this “miracle”, people are being put into debt-slavery to the banks, and into tax-slavery to the government. This is a recipe for perpetual deflation, or for perpetual inflation, or a mixture of both.

Only an austerity program can stop the runaway debt tower, and that only under a gold standard. It is a great pity that Krugman has, as Keynes did before him, completely failed to comprehend the nature and the role of the gold standard as the regulator of the level of debt, that would sound the alarm if safe levels of indebtedness were exceeded.

---

*September 9, 2010.*

### Calendar of events

## Sound Money Or Unsound —That Is The Question

Symposium of the New Austrian School of Economics in Auckland, New Zealand November 15-19, 2010

Lecturers: Professor Antal E. Fekete (Hungary), Rudy Fritsch (Canada),

### Sandeep Jaitly (U.K.), Peter Van Coppenolle (Belgium)

Nov. 15. a.m.

Sound Money: Unadulterated Gold Standard p.m.

### Unsound Money: Irredeemable Currency and Our Diseased

### Monetary Bloodstream

Nov. 16. a.m. p.m.

### Fiat Currency: Destroyer of Capital

### Fiat Currency: Destroyer of Labor

Nov. 17. a.m.

### When Atlas Shrugged: the Lure and Lore of

### Risk-Free Profits

Gold and the Babeldom of the Debt Tower p.m.

Nov. 18. a.m. p.m.

### The Fall and Rise of the Gold Standard

Sound, Less Sound, Least Sound:

### The Unhappy Tenth Anniversary of the Euro

Nov. 19. a.m. p.m.

### And God Created Gold…

### The Gold Standard Manifesto

For further information please contact Louis Boulanger: louis@lbnow.co.nz

---

# Real Bills Revisited

URL: https://newaustrianeconomics.com/archive/fekete/real-bills-revisited/
Date: 2010-07-25
Section: Popular Economics
Difficulty: intermediate
Concept Tags: real-bills, self-liquidating-credit, bills-of-exchange, new-austrian-economics, mises
Description: Position Paper #4: Fekete revisits the Real Bills Doctrine in light of new critics, defending the doctrine's core claim that self-liquidating commercial credit is categorically different from inflationary credit and should not be suppressed by central banking regulations. He responds specifically to Rothbardian objections that real bills are credit instruments.
Editorial Note: Position Paper #4 (July 2010). A systematic defense of the Real Bills Doctrine against both Rothbardian and Keynesian objections, revisiting the foundational debate with new evidence.
Original PDF: https://professorfekete.com/articles/AEFRealBillsRevisitedPositionPaper4.pdf

## Real Bills Revisited

Adam Smith in his Wealth of Nations worked out the foundations of a second type of credit that is based, not on savings, but on consumption. Later this theory was pejoratively called “Real Bills Doctrine” by its detractors. We stick to this name because the adjective “real” admirably captures the essence of a bill of exchange, making it different from anticipation bills, accommodation bills, treasury bills, which all have a measure of being “unreal”. What makes real bills real is that they represent real goods and real services in greatest demand without which society would stop functioning in a matter of months, if not weeks or days. Examples are: bread, seasonal clothes, fuel in winter; the services of the miller and the baker; the spinner and the weaver, etc. Seasonal goods will be removed from the market by the consumer during the next 91-day period, before the turn of seasons changes demand.

A real bill, as its name suggests, is just a notice of payment due that typically the wholesale merchant sends to the retail merchant along with his shipment of goods demanded most urgently by the consumers. It is useful to think of the bill as a security in the process of “maturing into the gold coin” that the consumer will expend when he buys the underlying good. The value of the real bill, unlike that of most securities, is increasing day-after-day till maturity, which is at most 91 days away.

By that time the goods itemized on the bill will have been sold to the ultimate gold-paying consumer and disbursement of the proceeds is in progress. The face value of the bill is the amount to be paid upon maturity.

It is a grave error to think that the bill represents a loan transaction. The wholesaler is not lending and the retailer is not borrowing. The credit is an inseparable part of the transaction, as confirmed by centuries and centuries of merchant custom. The quoted price is never ever cash: it is “91 days net”. The goods are more valuable and more liquid in the hands of the retailer than in the hands of the wholesaler by virtue of the former’s greater proximity to the gold coin. Who is the wholesaler to extend a loan to the retailer?

The most important aspect of a real bill is its metamorphosis that takes place when the retail merchant endorses it by writing “I accept” across its face over his signature. At that moment the character of the real bill changes from that of a notice of payment due, to that of a means of payment.

In fact, the bill is acceptable in payment by the trade. It is returned to the wholesale merchant who can now replenish his inventory and pay his supplier with the bill complete with his endorsement.

This metamorphosis of the bill from a notice of payment to a means of payment is one of the few miracles that economics has to deal with. Economists have to explain the circulation of real bills, and the fact that other bills such as accommodation bills just won’t circulate. Nor will mortgages.

This is certainly not a case of creating something out of nothing. Subsequent endorsements of the bill occur as the semi-finished good underlying the bill is passed on from the higher to the lower order producer. In each case the bill is subject to a discount, that is, the seller of semi-finished goods accepts the bill in payment subject to a reduction of face value proportional to the number of days remaining before maturity as well as to the prevailing discount rate.

It is a serious error to confuse the discount rate with the rate of interest. The two have different sources: the propensity to consume and the propensity to save. The discount rate varies inversely with the propensity to consume; the rate of interest varies inversely with the propensity to save.

The type of credit represented by the real bill is also called self-liquidating as all the obligations originating from the journey of the bill will be liquidated out of the proceeds of the final sale, that is, out of the gold coin surrendered by the ultimate consumer. Credits of other types are not self-liquidating. For example, a mortgage is not usually liquidated from the proceeds of the sale of the underlying real estate; typically it is liquidated over a long period of time from other sources. It is important that in the case of a bill of exchange the credit is liquidated simultaneously with the sale of the underlying merchandise and, therefore, self-liquidating credit is never inflationary.

Self-liquidating credit is indispensable in paying laborers who produce the underlying goods, often as much as 91 days before the ultimate consumer purchases the product. In the meantime laborers must eat, get clad and shod. Thanks to self-liquidating credit, there is no problem in paying labor’s worth long before the product is sold. The laborers’ remuneration comes out of the proceeds from discounting the unexpired real bill. We express this dependence by saying: “No bills, no wage fund”.

Evidently, real bills make sense only in the context of a gold standard. The system worked for a hundred years without a hitch. It would be preposterous to suggest that a real bill “matures” into an irredeemable bank note. All things considered, both the bill and the note are instruments of credit but, of the two, the first is vastly superior. How can a superior instrument mature into an inferior one? It is also evident that the bill market is the clearing house of the gold standard. Even under a gold standard not all payments are made in the form of gold coins. Only balances arising between mature bills at the clearing house are settled in gold upon the closing of every business day. The vast majority of payments are made, not in gold but by “crossing out” the value of bills of equal value. Without the bill market the gold standard is still-born. Removing the bill market is tantamount to castrating the gold standard, making it impotent. Without bill circulation the gold standard will not perform, as we shall now see.

Before 1914 world trade was financed through real bills drawn on London. Hostilities in World War I shut down the bill market. World trade became touch-and-go, strewn with shortages.

After the armistice the Entente powers did not lift the economic blockade of Germany and other central powers but, in their wisdom, decided not to return to multilateral world trade at all. Instead, they kept international trade at the barter level what they called “bilateral trade”. In this way they thought they could monitor and control Germany’s imports and exports. They accepted the fact that this would also inconvenience their own producers and distributors, but for them it was a small price to pay for safety from German rearmament. They were blinded by hatred as they wanted to punish Germany over and above the provisions of the peace treaty. They forgot that the gold standard they reintroduced (the pound sterling was made gold-convertible in 1925) could not function without its clearing system, the bill market. The result was the vanishing of world trade, the Great Depression, the collapse of the gold standard and, most frightening, the destruction of the wage fund causing catastrophic unemployment world-wide — as correctly predicted by the German economist Heinrich Rittershausen.

The ban on international bill trading by the Entente was tantamount to the destruction of the wage fund. Producers of goods demanded most urgently by the consumers could no longer pay their laborers and laid them off. Governments were forced to pay out dole to the unemployed in order to contain social unrest. The gold standard did not fail because of its inner contradictions, as charged by Keynes. It failed because of sabotage by the Entente in blocking the international bill market, the clearing house of the gold standard.

Under the regime of irredeemable currency self-liquidating credit plays no role whatever. As a consequence, the Debt Tower of Babel can only grow until it will topple, burying the world economy under the rubble. It would be most unfortunate if the gold standard were rehabilitated without rehabilitating its clearing house, the international bill market. Only the latter can replenish the wage fund so that everybody eager to earn wages could find a job.

Arguments that real bills are inflationary are based on ignorance of facts, as well as on ignorance of the rich literature on self-liquidating credit.

If Paul Krugman of The New York Times really wanted to restore jobs to the unemployed, he would advocate the restoration of the gold standard and its clearing house, the international bill market.

### Calendar of Events

## Announcing The Establishment Of The Austrian School Of

ECONOMICS IN BUDAPEST. The first ten-day, 20-lecture course offered is entitled:

Disorder and Coordination in Economics — Has the world reached the ultimate economic and monetary disorder? The lecturer is Professor Fekete, with the cooperation of Mr. Rudy Fritsch (Canada), Peter van Coppenolle (Belgium), and Mr. Sandeep Jaitly (United Kingdom). It will be held in Budapest, Hungary, from August 9-20, 2010. Participation is limited, early registration is advisable. For more information and registration, contact Dr.

Judith Szepesvari at: szepesvari17@gmail.com. Inexpensive dorm-type accommodation is available for students (shared bathroom, shared kitchen); a three-star hotel is next door. Extracurricular consulting with Professor Fekete can be arranged for an extra fee.

The school is meant for all students (including beginners) interested in the real answers to the present economic crisis and misery. Its program plans to cover the whole spectrum of Austrian economics, with special emphasis on developments that took place after the death of the greatest 20th century economist, Ludwig von Mises, including the Real Bills doctrine and social circulating capital; the theory of money, credit and banking; and the theory of interest and discount.

Completion of this course will earn participants one credit towards a four-course, fourcredit program that has been submitted for accreditation to the Adult Education Accreditation Board of Hungary. Participants will receive a certificate signed by Professor Fekete. The follow-up credit courses will cover these areas:

Adam Smith’s Real Bills Doctrine and Social Circulating Capital.

The Austrian Theory of Interest and Discount.

The Austrian Theory of Money, Credit, and Banking.

Some of the future courses may be offered in Martineum Academy in Szombathely, Hungary, where we have had four successful conferences already in the past. A special cordial invitation is extended to all Martineum alumni and their family members and friends!

Eating and shopping facilities, as well as a swimming pool are nearby. Spectacular excursions can be arranged in the surrounding hills, and boat trips on the River Danube.

It is well-known that Budapest is one of the foremost spas in Central Europe with a dozen or so medicinal thermal springs. Participants of the course could stay on afterwards and savor the superb spa and cultural offerings in the city. Make it a family holiday!

### Meeting in Hong Kong

We have plans for a two-day meeting in Hong Kong and another neeting in New Zealand in November, 2010. Stay tuned for further announcements.

---

# Floating Exchange Rates: Scheme to Embezzle the Dollar Balances of Surplus Countries

URL: https://newaustrianeconomics.com/archive/fekete/floating-exchange-rates-scheme-to-embezzle/
Date: 2010-07-05
Section: Popular Economics
Difficulty: intermediate
Concept Tags: fiat-currency, monetary-policy, gold-standard, sound-money
Description: Position Paper #3: Fekete argues that floating exchange rates, adopted after Nixon ended dollar-gold convertibility in 1971, constitute a scheme to embezzle the dollar balances of surplus nations like China and Japan. When the dollar depreciates, the real value of their reserves is stolen without compensation — a feature, not a bug, of the current monetary system.
Editorial Note: Position Paper #3 (July 2010). Fekete's analysis of floating exchange rates as institutionalized wealth transfer has become more relevant as dollar depreciation debates have intensified.
Original PDF: https://professorfekete.com/articles/AEFPositionPaper3FloatingExchangeRates.pdf

*Floating Exchange Rates: Scheme To Embezzle The Dollar Balances Of Surplus Countries*

**Antal E. Fekete** · E-mail: aefekete@hotmail.com

### Summary

Milton Friedman’s theory of floating exchange rates, on which the international monetary system has been based since 1971, has given rise to a coercive regime in the sense that IMF statutes forbid member countries to stabilize the value of their currencies. A country attempting to do that is branded “a currency manipulator” and is threatened with trade sanctions. The prohibition is understandable. It is designed to protect the scheme whereby the dollar balances of the surplus countries are stealthily embezzled. It works as follows. The United States lures the unsuspecting surplus country into the black hole of currency revaluation against the dollar. As their currencies are floating upwards, a part of the surplus countries’ dollar balances are appropriated by the U.S. In effect, the U.S. is forcing its trading partners running a surplus to grant, unwittingly, a partial debt abatement. This exhausts the concept of embezzlement. The U.S., bankers to the world, conspires to short-change its depositors using the smoke-screen of floating foreign exchange. This regime, based on plunder, cannot endure. The only equitable monetary system is the one based on fixed exchange rates. And the only durable way to fix exchange rates is to make the currency redeemable in gold.

Friedman’s theory is a blot on science and on the good faith of the United States in its dealings with its neighbors.

### Floating versus fixed exchange rates

In putting pressure on China to follow Japan’s example to revalue the yuan the American money doctors fail to point out that they are in effect asking China to take a loss, similar to those of Japan amounting to hundreds of billions of dollars, on her holdings of U.S. Treasury paper. China carries her books in yuans, not in U.S. dollars. Therefore every change in the yuan price of the dollar will have an immediate and predictable effect on the value of China’s portfolio of U.S. Treasury paper. In particular, a decrease in the yuan price of the dollar results in a loss in the yuan value of China’s dollar balances.

The question arises: by what right does the U.S., a country with chronic deficits and a history of reneging on her foreign debt — as on August 15, 1971 — demand that China write off a part of the American debt to China?

There is more. If China yielded to American pressure to let the yuan float upwards, it would mean not just a one-shot abatement of debt, but a standing commitment to grant further automatic abatements as new debts are being incurred by the U.S. This would make mockery out of the idea of independent nations trading with one another for mutual benefit. It would make China a vassal of the U.S., a role China in all dignity could not accept.

It is incumbent on the debtor, not on the creditor, to make the necessary adjustment in case of a persistent imbalance. The contrary position, advocated by Keynes, is a fallacy. It turns logic upside down. It penalizes hard work and thrift, while it rewards indolence and prodigality.

### Water torturing Japan

Immediately after making the dollar an irredeemable currency the U.S. started running trade deficits on an ever increasing scale. Using Milton Friedman’s spurious theory according to which floating exchange rates were supposed to make the currency of a surplus country stronger, the U.S. started twisting the arms of its trading partners running a surplus, first and foremost, Japan, to revalue their currencies upwards. Thus the unsuspecting trading partners of the U.S. were lured into the black hole of currency revaluation. In listening to the sweet siren song from Washington these surplus countries were oblivious to the fact that they were in effect taking a loss — as they were granting a debt abatement to the U.S. proportional to the their dollar balances they held as a currency reserve.

For example, when the Japanese yen rose to the level where one dollar was worth three times less (say, 100 yens as compared to 300 earlier), this actually meant an abatement of the American debt to Japan in the ratio of 2/3 or 66 percent, without anybody recognizing what was going on. It was trumpeted as “free market on the go”. It was not. It was embezzlement, pure and simple.

The U.S., bankers to the world, embezzled Japanese funds held in dollar accounts to the tune of 66 percent.

Embezzlement on that scale has consequences. In fact, it bankrupted Japan, one of the strongest countries financially. As Japan fell upon hard times and wanted to draw on her foreign exchange reserves, it couldn’t, for the simple reason that the funds were not there. At that point American money doctors rushed in and explained to the Japanese that, rather than paying their bills by drawing down their dollar balances, they should start running budget deficits and finance their needs through debt. Up to that point Japan was practically debt free. By now, Japan’s debt is so huge that it is stifling the Japanese economy.

The U.S. has played the role of the bully-boy of international trade long enough, bluffing that the irredeemable dollar is „an ultimate extinguisher of debt”. It is none too soon that someone call the bluff ─ after so many countries have succumbed to pressure and suffered huge losses on their foreign exchange reserves as a consequence. Maybe China will stand up. If China is the first country opening her Mint to gold, thereby resolving the gridlock, then the U.S. will be forced to give up her monetary leadership in the world.

### Calendar of Events

August 9-20, 2010, in Budapest, Hungary. The New Austrian School of Economics, the first 20-lecture course offered, entitled: Disorder and Coordination in Economics — Has the world reached the ultimate economic and monetary disorder? For more information, see the website [www.professorfekete.com](https://www.professorfekete.com) or contact [szepesvari17@gmail.com](mailto:szepesvari17@gmail.com).

Preliminary announcement: a session in Hong Kong in late October is on the drawing board, followed by more events in New Zealand in November. Stay tuned.

---

# Krugman's Opium War on China

URL: https://newaustrianeconomics.com/archive/fekete/krugmans-opium-war-on-china/
Date: 2010-06-27
Section: Popular Economics
Difficulty: accessible
Concept Tags: federal-reserve, monetary-policy, fiat-currency, capital-destruction
Description: Position Paper #2: Fekete challenges Paul Krugman's demand that China revalue the renminbi, arguing that Krugman's analysis ignores the real source of the U.S. trade deficit — the destruction of productive capital by Federal Reserve policy — and that forcing China to revalue would harm both countries without addressing the underlying monetary disorder.
Editorial Note: Position Paper #2 (June 2010). The Opium War metaphor frames Krugman's policy demands as economic coercion analogous to 19th-century British imperialism — forcing a trade concession that serves U.S. financial interests at China's expense.
Original PDF: https://professorfekete.com/articles/AEFKrugmansOpiumWarOnChina.pdf

## Krugman’S Opium War On China

### Antal E. Fekete

Paul Krugman's article The Renminbi Runaround in the June 24th edition of The New York Times is not only diplomatically insensitive: it also lacks economic justification. The United States, with its unprecedented debt, is hardly in a position to lecture China and accuse it of bad behavior, acting in bad faith, playing games, and threaten it with trade sanctions. It is not China's house that needs to be put in order, but that of the U.S.

Krugman assumes that the regime of flexible exchange rates is the nature-ordained foundation of foreign trade. It is not. It is a half-baked concoction, originally inspired by John Maynard Keynes, elevated to dogma by Milton Friedman. This regime has never been tried as a world-wide arrangement in all history, and when it was adopted in 1971, it turned out to be an unmitigated disaster. It did not grow naturally, nor was it the result of careful study and planning by competent scientists. It was a stop-gap measure imposed on the world unilaterally by American diktat in an attempt to cover up the disgrace of the U.S. declaring bankruptcy fraudulently while defaulting on its gold obligations to foreign governments.

Friedman asserted, wrongly, that variable foreign exchange rates would eliminate trade imbalances. As the currency of the surplus country appreciates, exports are discouraged while imports are encouraged. Conversely, as the currency of the deficit country depreciates, exports are encouraged while imports are discouraged. This forces adjustments in the volume of imports and exports that will continue until trade balance is restored.

The equilibrating effect of exchange rates on imports and exports is, at best, ephemeral. It may last as long as the inventory of ingredients that go into the exports of the deficit country does. But no sooner had these inventories been exhausted and needed replenishing than euphoria came to an abrupt end. As a direct consequence of the lower value of the currency of the deficit country, its terms of trade deteriorates, while that of the surplus country improves.

In particular, the deficit country has the disadvantage of paying higher, while the surplus country has the advantage of paying lower prices for the imported components that go into their respective exports. The competitiveness of the deficit country suffers a further setback.

Rather than working towards equilibrium, the floating exchange rate regime works towards perpetuating imbalances, nay, making them progressively worse. It throws the deficit countries into a vicious downward spiral from which it is ever more difficult to escape.

History bears out these theoretical observations. Thirty-five years ago it was Japan that the U.S. was lecturing to revalue its currency upwards. At the time one dollar fetched over 300 yens. During the intervening decades the dollar has duly been made weaker to the point that now the dollar fetches less than 100 yens. That is to say, the yen has appreciated more than threefold against the dollar. And what happened to the trade deficit of the U.S. vis-a-vis Japan? Sad to say, rather than approaching equilibrium, it has worsened tenfold! Well, how much more beating down must the dollar take for the Friedman-mechanism to kick in?

In putting pressure on China to follow Japan's example to revalue the renminbi upwards, Krugman acts disingenuously. In effect he demands that China take a loss to the tune of hundreds of billions of renminbi units on its foreign currency reserves. Remember, China carries its books in renminbi, not in dollars. Consequently every loss in the value of the dollar in terms of the renminbi generates an immediate loss in the value of China's dollar reserves at the same rate.

To put it differently, Krugman demands that China grant the U.S. a unilateral abatement of debt. The question arises on what grounds can a country, chronically in deficit, and with a history of defaulting on its international obligations, demand an abatement of its debt?

If China yielded to American pressures and let the renminbi float upwards against the dollar, then it would be not just a one-shot abatement of the U.S. debt, but a commitment to grant further and automatic abatements as new debts are being incurred. It would invite further reckless debt-accumulation. It would make mockery out of the idea of independent nations trading with one another for mutual benefit. It would make China a vassal of the U.S., a role China, in all dignity, will never accept. Self-respecting sovereign nations cannot yield to pressures of this kind.

It is incumbent upon the debtor, not on the creditor, to mend ways in case of a persistent disequilibrium. Krugman went wrong as he embraced the Keynesian fallacy that the responsibility for restoring equilibrium rests, not with the debtors but with the creditors. This puts logic upside down as it penalizes hard work and thrift while rewarding indolence and prodigality.

Characteristically, the thought of fixed foreign exchange rates has never crossed Krugman's mind as the proper solution to America's and the world's trade woes. The regime of fixed exchange rates made America great, prosperous, and the envy of the world for centuries. The regime of floating exchange rates has frittered away the accumulated wealth and goodwill, as it has reduced America, in hardly a decade, from the greatest creditor to the greatest debtor nation of the world. To add insult to injury, it has made the dollar a chronically depreciating currency with the result that the American standard of living is now falling along with the dollar. The falling dollar has opened America to endless humiliation as it is fast losing the respect of other nations it once had.

Regardless how the trade dispute with China is going to be settled, continued reliance on the regime of floating exchange rates will lead to catastrophe. The world will succumb to trade war and a depression far worse than that of the 1930's, precisely because it lacks a valid equilibrating mechanism for world trade and it allows deficits to accumulate without limit. In view of looming trade wars, Krugman's aggressive threatening of China with sanctions on the eve of the G-20 meeting in Toronto is irresponsible, to say the least.

The regime of floating exchange rates is the opium of the world trade. Krugman wants the U.S. government to declare a new opium war on China to force this debilitating drug on the Chinese. If he succeeds, this time around it is not China that will end up on the losing side.

### Calendar of Events

August 9-20, 2010, in Budapest, Hungary. The New Austrian School of Economics, the first 20-lecture course offered, entitled: Disorder and Coordination in Economics — Has the world reached the ultimate economic and monetary disorder? For more information, see the website [www.professorfekete.com](https://www.professorfekete.com) or contact szepesvari17@gmail.com Preliminary announcement: a session in Hong Kong in late October is on the drawing board, followed by more events in New Zealand in November. Stay tuned.

---

# Architecture for a New World Financial System

URL: https://newaustrianeconomics.com/archive/fekete/architecture-for-a-new-world-financial-system/
Date: 2010-06-22
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, real-bills, sound-money, new-austrian-economics, monetary-policy
Description: Fekete proposes a complete architecture for a reformed international monetary system based on gold reserves and Real Bills clearing. The proposal specifies the institutional requirements — open minting, international clearing house, elimination of central bank discretion — needed to create a stable and self-regulating global monetary order.
Editorial Note: Written June 2010. Fekete's most detailed institutional proposal for monetary reform, going beyond critique to specify the architecture of the alternative system.
Original PDF: https://professorfekete.com/articles/AEFArchitectureForANewWorldFinancialSystem.pdf

### Historical background

The Symposium was held at the historic town of Hall in Tirol, Austria, for a good reason. Hall in Tirol (just east of Innsbruck) had been the “monetary capital” of Europe for centuries.

It all started in 1477 with the moving of the Mint from Meran in South Tirol (now part of Italy) where it had been operating since 1271, to Burg Hasegg in Hall, by Archduke Sigismund of Austria (1427-1496). At the same time the Archduke instituted important monetary reforms. He opened the Mint to silver.

As a result, silver mining was revived in the valleys of Tirol, and new mining methods and technology were developed. Ultimately, the much-debased coinage of Medieval Europe was replaced by sound currency that brought heretofore unprecedented prosperity to the people of Renaissance Europe. The currency reform of Archduke Sigismund has laid the foundations for the architecture of a new world financial system.

The coins issued by the Mint were revolutionary in several respects. The fineness of silver coins was 937. Prior to this date, practically no silver had been coined in Europe. The size of silver coins was also increased, first from 4 to 6 Kreutzers and again, in 1484, with the introduction of the half-guldengroschen, from 6 to 30 Kreutzers. The runs were still small. The real revolution occurred in 1486, when the size of the silver coins struck at the Mint was doubled, and serial production was introduced.

As the fifteenth century drew to a close, coinage throughout Europe was in a shambles. The financing of ceaseless wars between dukes and kings over territorial disputes was largely done through the debasement of the silver coinage. The fact that the rate of debasement differed from country to country, from dukedom to dukedom, only made matters worse. Trade, investment, and progress were hampered by the lack of uniform, easily recognizable, and reliable means of payment.

The Great Debasement of Middle Ages in Europe was akin to the debasement of coinage a thousand years earlier, culminating in the collapse of the Roman Empire in 480, followed by a breakdown of law and order lasting for centuries. Had the Great Debasement of the Middle Ages been allowed to continue, history would have repeated itself, and another breakdown of law and order lasting for centuries would have followed.

Also, there was an incessant drain of silver from Europe to Asia, especially to India, Indonesia, and the Far East, representing payments for exotic Oriental goods such as spices, porcelain, silk, and other fine fabric and cloth.

The word „consumerism” could be applied to this period as well, meaning the „conspicuous consumption” of the aristocracy. Just as today, the one-way trade from Asia was sapping the resources and threatened the prosperity of Europe.

The demand for reliable and uniform silver coinage to finance expanding trade was met by the currency reform of Archduke Sigismund. As more silver was coming from the mines due to improved mining technology, minting technology was also changed to make large mintages possible. Mass production methods in striking silver coins were introduced. Previously, coins had been struck individually by hand from single blanks. No wonder that issues were small. In 1486 the Mint in Hall introduced silver strips to replace silver blanks, and installed machinery to strike silver coins serially from the strips. The machinery was made of wood and was powered by hydraulics, but was still strong enough to allow doubling the size of the silver coin from 30 to 60 Kreutzers (from 5 to 10 Groschens). Thus was the historic Guldengroschen coin, nicknamed the guldiner of Hall born. It served as prototype of the other historic coin 30 years later, the thaler.

In 1490 Archduke Sigismund ceded his control of Tirol, rich in salt and silver (both having monetary importance) to his cousin, the future Holy Roman Emperor Maximilian I (1459-1519), a towering historical figure, recognized as the second founder of the House of Habsburgs. Their names are shining in the monetary history of the world. History books assert that the Modern Age started with the discovery of America by Columbus in 1492. They got it wrong. The Modern Age started with the opening of the Mint to silver in 1487 by Sigismund and Maximilian.

The father of Maximilian, Emperor of the Holy Roman Empire, Frederick III, suffered a great setback in his fortunes when the king of Hungary, Mathias Corvinus occupied the Habsburg capital Vienna in 1485. He had to pay for his defeat a second time as well: next year the electors forced him to give up his title as the King of the Romans and elected Maximilian in his stead (while he could retain his title as Emperor until his death in 1493).

Maximilian I was crowned in Aachen on April 9, 1486. This important event was followed by the first issue of the Guldengroschen, struck from silver found in Schwaz near Hall, in 1487. The new coin was an instant and unqualified success. Indeed, it was a landmark in the monetary history of the world. The silver coin soon reached world-class status as its mintage beat all earlier records, and its circulation spread all over Europe. Naturally, the success of the guldiner soon attracted imitators in every dukedom of Europe with a silver mine.

### Joachimsthaler (“thaler”)

The winner among these imitators was the Joachimsthaler nicknamed “thaler” (from which the English word “dollar” was derived). The silver came from the rich mines of Joachimsthal, or Joachim’s Valley, in Bohemia (today, the Czech Republic). Saint Joachim, the husband of Saint Anne and the father of the Blessed Virgin Mary, is commemorated by the first thaler struck 30 years after the inauguration of the guldiner in 1518. It was of similar physical size but had slightly lower fineness. It became the standard for silver coinage for almost four hundred years in Europe and, later, in America.

The market dropped the guldiner and embraced the thaler. The Mint in Hall had to turn to the production of thalers of which it struck 17 million specimens during the 20-year period from 1748 through 1768 alone.

Burg Hasegg was built in the late 13th century. It housed the Mint from 1477 through 1806 when coin production ceased partly because of the Napoleonic wars, partly because of the exhaustion of nearby silver mines. The Mint in Burg Hasegg is a museum now, open to the general public. It displays minting presses at their various stages of development, including (a replica of) the first mass-producing minting press utilizing silver strips instead of silver blanks. Demonstrations of historical printing techniques are given from time to time. The castle itself is an example of early Gothic era Tirolean fortress architecture, with an impressive watchtower, the Münzerturm.

On June 9, 2010, I climbed the 204 steps leading to the top observation deck of Münzerturm. It offers an unparalleled view of the valley of the River Inn and the mountains enclosing it. There was a guestbook, in which I wrote the following sentence:

### Open the Mint to Gold Again!

Let us hope that world leaders will have the wisdom of Archduke Sigismund and Emperor Maximilian I who opened the Mint to silver, thus saving European civilization from further decay, ushering in the “Silver Age” of prosperity.

Once again, both civilization and prosperity are in grave danger as a result of spiraling monetary debasement and one-way trade from Asia to Europe, threatening the West with capital destruction and shrinking employment. This trend can be reversed only through a return to sound currency. Opening the Mint to gold would usher in a new “Golden Age” of prosperity.

---

### The Great Financial Crisis

The present Great Financial Crisis is far from over. In fact, it is getting worse. It can be described as a debt crisis or, at its roots, a belated gold crisis. The landmark year was 1971, when the United States defaulted on its international gold obligations. Now there have been many defaults in history, but the one forty years ago was unique in that it exiled gold from the international monetary system; thereby gold has been prevented from discharging its natural function as the ultimate extinguisher of debt ever since.

When you pay a debt of \$100 by writing a cheque on your bank account, the debt is not extinguished, it is merely transferred to your bank. If you pay it by handing over a \$100 Federal Reserve note, the debt is not extinguished either but is transferred to the Federal Reserve bank that has issued the note.

Ultimately the U.S. Treasury is responsible for all the liabilities of the Federal Reserve. Under these monetary arrangements the total dollar debt outstanding can only grow, never contract, even if there is a net reduction of debt in the economy. All debt presumed to have been extinguished will ultimately show up as an increase in the indebtedness of the U.S. government. No matter how you look at it, the desire to retire debt is frustrated by the lack of an ultimate extinguisher in the system. The consequences are frightening.

Let’s draw a biological, nonetheless valid and convincing analogy by looking at the human metabolism. The elimination of toxic waste from the human body is of paramount importance. Bowel movement and passing water are the two main forms of excretion. If either of these processes is blocked permanently, death becomes inevitable. It is no different with the economy, albeit death may be longer in coming. The economy uses credit all the time, and some of it will turn out to be toxic even in the best of circumstances. If there is no way to eliminate this toxic waste from the system, that is to say, if there is no ultimate extinguisher of debt, then death is near. In the world economy, gold is the main agent of detoxification.

The tragedy is that the captains of the world economy refuse to realize that runaway debt is the logical consequence of their having exiled gold from the international monetary system in 1971. They try to cure the bad effects of too much debt, or the presence of toxic debt in the system by introducing more of it. They have no idea how total debt could be decisively reduced and toxic debt safely eliminated.

They are playing a very dangerous game with the welfare of the people.

When credit collapse finally comes, production disappears, employment shrinks, law and order break down. We are running into an unprecedented crisis with our eyes blindfolded. Wishful thinking will not coax out “green shoots”.

### Open the Mint to Gold!

The economic disaster staring us in the face will force the recognition that we have to change course. The present leadership will have to admit that its theories and practices have utterly failed. They will have to give up their position in disgrace, and the new leadership will have to see reality as it is. They must see that gold has a place in the body politic as well as in the body economic. They must return the world to the gold standard which is the only monetary arrangement that provides for an orderly retirement of debt, and is capable of doing justice between consumption and saving. The world needs a new financial system with stable exchange rates, stable interest rates, and stable bond prices.

The architecture of this new financial system must involve three principles.

FIRST, the Mint must be opened to gold. What does this mean? It means that if people think that there is not enough money in circulation, they can do something about it. They can take their gold to the Mint and exchange it for the gold coin of the realm free of seigniorage charges, and with no limit imposed on the amount. In other words, they would get gold back in coined form, ounce for ounce, and the cost of minting would be absorbed by the government, the same way as it absorbs the cost of maintaining highways in good repair. Such a regime is mandated by the U.S. Constitution, and is referred to as “free and unlimited coinage of gold”.

Conversely, if people think that there is too much money in circulation, they should be able to do something about that, too. Owners of gold coins of the realm must have the right to hoard, melt down, or export them as they see fit. In this way the power to regulate the money supply will be vested in the people, rather than in representatives or unelected bureaucrats. When you look at it this way, you realize that the destruction of the gold standard in the 1930’s was a power-grab, pure and simple. The power to create money is unlimited power. As such, it must be reserved for the people. Take it away, and you have overturned constitutional order. Opening the Mint to gold simply means a return to limited government and to the principle of separation of powers. The world-wide regime of irredeemable currency will in retrospect appear as a brief reactionary period in history.

### Abolish legal tender protection of paper money!

SECOND, legal tender protection of fiat money must for once and all be declared unconstitutional. This measure is necessary to remove coercion whereby the government can force citizens to provide services against irredeemable promises to pay.

Such coercion was first legalized in France and Germany in the year 1909, five years before the outbreak of World War I. These countries wanted to make sure that their military and civil service can be paid in chits, thus putting the defense and labor force at the disposal of the government, independently of the state of budget and collection of taxes. In this way the electorate was denied its say in deciding whether the planned war is worth the blood and treasure to expend, or when to stop a war already in progress. World War I could have come to an early end but for the legal tender laws. As soon as treasuries had run out of gold, the belligerent governments would have been forced to make peace, unless the electorate agreed to pay for continuing the bloodshed and destruction of property in the form of higher taxes and sending more young men to their death in the trenches.

### Bring back self-liquidating credit!

THIRD, Adam Smith’s Real Bills Doctrine should be rehabilitated. Bills of exchange, drawn on merchandise in urgent demand, maturing into gold coins in 91 days (the length of a quarter), must be allowed to enter into spontaneous monetary circulation. The credit represented by maturing bills of exchange — representing a mass of goods moving apace to the final consumer, also known as social circulating capital — is elastic and self-liquidating. It flows and ebbs with the variable need for goods and services. Most importantly, it is liquidated at the time when the ultimate gold-paying consumer withdraws merchandise from the market. For this reason it is not inflationary.

Our financial system lacks self-liquidating credit and, in consequence, the debt tower of Babel just keeps growing until it will topple and bury the world economy under the debris. Real bill circulation would bring back self-liquidating credit. This would guarantee the flexibility of the monetary system not through government coercion but through the voluntary cooperation of the producers and the consumers in satisfying human wants.

It can be seen that the market for real bills is nothing else but the clearing house of the gold standard. In 1918, at the end of World War I, the victorious powers in their wisdom decided not to allow the world to return to multilateral financing of international trade. To be sure, they were sincere in saying that they wished to return to the gold standard, witness Great Britain’s 1925 decision to make the pound sterling once again convertible into gold at the pre-war exchange rate — but only bilateral trade was authorized. This was tantamount to the castration of the gold standard: once its clearing house was amputated, it could not perform.

The victorious powers did this out of spite and vengeance. They wanted to cripple Germany over and above the provisions of the Versailles peace treaty.

Forcing bilateral trade upon Germany was equivalent to peacetime blockade whereby the Entente powers could monitor and control Germany’s imports and exports. The measure backfired. The Great Depression and the 1931-36 collapse of the international gold standard was a direct consequence of the forcible elimination of multilateral financing of world trade through real bills.

The measure to eliminate real bills from circulation world-wide had another grave consequence that I have to mention. It destroyed the wage fund of society and became the cause of mass unemployment on a scale never before seen — as predicted by the German economist Heinrich Rittershausen. Real bills alone make it possible to pay workers for producing goods that the consumer cannot purchase before they reach the maturity of a finished good in 91 days.

But workers have to eat in the meantime! A substantial part of the social circulating capital is spoken for by the wage fund. Disallowing real bill circulation destroys the wage fund and causes mass unemployment, forcing the government to pay dole to the unemployed. The architecture for a new world financial system may start dismantling the so-called welfare state since, with the return of real bills circulation, the wage fund will be replenished and full employment can be realized.

### Outlawing open market operations

The gold standard did not collapse because of its “contractionist tendencies” — as alleged by Keynes. It collapsed because of its clearing system, the bill market was blocked. Falling prices in 1930 were not the cause of the Great Depression: they were the effect. The cause was falling interest rates.

Falling interest rates were in turn caused by the illegal introduction of open market operations by the Federal Reserve of the United States in 1921, following the panic in the Treasury bond market. The Federal Reserve Act of 1913 did not authorize open market operations, quite the contrary. Treasury bonds were not on the list of “eligible paper” acceptable as collateral for issuing Federal Reserve notes and deposits. Federal Reserve credit was supposed to be backed by gold, or real bills maturing into gold. To the extent that Federal Reserve credit outstanding could be backed only by Treasury paper in lieu of real bills or gold, the Federal Reserve bank was found short of collateral and was to be penalized by fines on a progressive scale. Starting in 1921 the Treasury “forgot” to collect the penalty. It was a “sweetheart deal”: in turn, the Federal Reserve banks offered a cozy place in their portfolio to Treasury’s bonds, notes, and bills. Congress was presented with a fait accompli. It had no choice but to legalize the practice of open market operations ex post facto in 1935.

The architecture for a new financial system must rule out such a conspiracy between the government and its central bank. Open market operations must be outlawed as they invite bond speculators to bid up bond prices by promising them risk-free profits. As a consequence, interest rates will have a downward bias. Falling interest rates not only falsify the natural rate of interest; they also cause capital destruction. The gold standard plus outlawing the practice of open market operations will stabilize interest rates at their natural level.

### Outlawing the practice of borrowing short to lend long

In addition to outlawing open market operations, the practice of commercial banks to borrow short in order to lend long must also be outlawed. Such a practice ignores the danger that the bank could be caught on the wrong foot when short-term interest rates rise while long term interest rates fall (i.e., the yield curve is “flattening”, let alone “inverting”). This means, in particular, that mortgages are ineligible as collateral to back commercial credit, and commercial banking must be separated from investment banking.

### Eliminating double standard in applying the Criminal Code

In drawing the blueprint for the architecture for a new financial system it must be remembered that double standard in jurisprudence is inadmissible. The government and its central bank must be subject to the same Criminal Code as everybody else. Ordinary citizens are not allowed to issue obligations which they have neither the intention nor the means to meet at maturity. If they do, they commit a crime dealt with by the Criminal Code under the heading “fraud”.

There is no valid reason to allow the government and its central bank to issue obligations that they have neither the intention nor the means to pay.

### Eliminating double standard in applying contract law

In the same order of ideas I mention that no double standard ought to be tolerated in contract law either. In particular, banks should not be exempt from the provision of bankruptcy procedure in case of non-performance on contractual obligations. If a bank fails to pay its sight liabilities in gold as contracted, then it must not be allowed to promote its dishonored paper as money. Depositors ought to be able to press for liquidation of the bank or to avail themselves of any other remedies prescribed by contract law. There is no valid reason to treat banks and financial institutions any differently from other corporations in case they fail to perform on their contracts.

When the Mint in Hall was opened to silver in 1477, Archduke Sigismund and Emperor Maximilian I put the threat of a breakdown in law and order behind them. Their measure ushered in a new financial order promoting peace and prosperity.

In a latter-day replay of the medieval saga, an enlightened government in some part of the world may open its Mint to gold. The initiative would be widely followed, as was that of the Mint in Hall, and the world would be spared of a breakdown of law and order. The measure would usher in a new financial order promoting peace and prosperity.

---

*June 22, 2010*

### Calendar of Events

## Announcing The Establishment Of The Austrian School

OF ECONOMICS IN BUDAPEST. The first ten-day, 20-lecture course offered is entitled: Disorder and Coordination in Economics — Has the world reached the ultimate economic and monetary disorder? The lecturer is Professor Fekete, with the cooperation of Mr. Rudy Fritsch (Canada), Peter van Coppenolle (Belgium), and Mr. Sandeep Jaitly (United Kingdom). It will be held in Budapest, Hungary, from August 9-20, 2010. Participation is limited, early registration is advisable. For more information and registration, contact Dr. Judith Szepesvari at: szepesvari17@gmail.com. Inexpensive dorm-type accommodation is available for students (shared bathroom, shared kitchen); a three-star hotel is next door. Extra-curricular consulting with Professor Fekete can be arranged for an extra fee.

The school is meant for all students (including beginners) interested in the Austrian theory of money, credit, and banking. Its program plans to cover the whole spectrum of Austrian economics, with special emphasis on developments that took place after the death of the greatest 20th century economist, Ludwig von Mises, including the Real Bills doctrine and social circulating capital; the theory of money, credit and banking; and the theory of interest and discount.

Completion of this course will earn participants one credit towards a four-course, four-credit program that has been submitted for accreditation to the Adult Education Accreditation Board of Hungary. Participants will receive a certificate signed by Professor Fekete. The follow-up credit courses will cover these areas:

Adam Smith’s Real Bills Doctrine and Social Circulating Capital.

The Austrian Theory of Interest and Discount.

The Austrian Theory of Money, Credit, and Banking.

Some of the future courses may be offered in Martineum Academy in Szombathely, Hungary, where we have had four successful conferences already in the past. A special cordial invitation is extended to all Martineum alumni and their family members and friends!

It is not well-known that Budapest is one of the foremost spas in Central Europe with a dozen or so medicinal thermal springs. Participants of the course could stay on afterwards and savor the superb spa and cultural offerings in the city. Make it a family holiday! Eating and shopping facilities, as well as a swimming pool are nearby. Spectacular excursions can be arranged in the surrounding hills, and boat trips on the River Danube!

---

# What You Always Wanted to Know About Gold

URL: https://newaustrianeconomics.com/archive/fekete/what-you-always-wanted-to-know-about-gold/
Date: 2010-06-06
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, gold-basis, real-bills, backwardation, sound-money
Description: A comprehensive introduction to gold's monetary role for readers unfamiliar with Fekete's framework, covering the gold standard, the gold basis, Real Bills, and permanent backwardation. Designed as an accessible entry point to New Austrian monetary theory.
Editorial Note: Written June 2010 as an introductory companion to Fekete's more technical essays. The title's allusion to the 'Everything You Always Wanted to Know' genre signals its intent as a comprehensive primer.
Original PDF: https://professorfekete.com/articles/AEFWhatYouAlwaysWantedToKnow.pdf

Q.: Professor Fekete, you are known as a staunch advocate of a return to the gold standard. But mainstream economists are saying a gold standard is not practicable and they are fighting the idea with everything they have.

### How do you answer their criticism?

A.: To say that the gold standard is not practicable is the same as saying that honesty is not practicable. It is the same as saying that Constitutions are made to be blithely ignored whenever convenient. The American Constitution, for example, mandates a metallic monetary standard for the United States in the clearest possible language. Opponents of the gold standard have never been able to muster up the moral fortitude to amend the Constitution so as to formalize the abolishing of the gold standard in 1933. In that year president Roosevelt confiscated the gold of the citizens, gave them irredeemable paper in exchange, and proceeded to write up the value of gold in terms of the paper by 75 per cent.

Might makes right: if you cannot do it fairly and legally, then you can use the strong arm of the government to do it through chicanery, backed by the constabulary and the jail cell.

More recently, in our own century, Switzerland changed her Constitution in which the gold standard was also enshrined, through a referendum. Citizens were given a week-end to debate and decide the merits or demerits of the proposed constitutional changes. The indecent haste with which the measures were railroaded through the constitutional process betrayed the bad conscience of the authors.

One of the key principles supporting a gold standard is that jurisprudence does not tolerate a double standard of justice. The government, its departments and agencies ought to be subject to the same law as are the citizens. There are no valid grounds to allow the Treasury and the Central Bank to issue obligations which they have neither the intention nor the means to honor — while everybody else doing it will be dealt with according to the Criminal Code under the heading “fraud”.

To say that the gold standard is not practicable is the same as saying that the government is free to violate the Criminal Code as it sees fit in dealing with its subjects.

### ______________________

* but were afraid to ask.

Q.: What would be the basic steps involved in reintroducing a gold standard? How to proceed?

A.:

Three indispensable steps are involved.

First, the government should open the Mint to gold. This means that everybody who wants to convert his gold into gold coins of the realm should be able to do so at the Mint, free of seigniorage charges, with no limit imposed on the amount. In other words, they would get gold back, ounce for ounce, in coined form, and the cost of minting would be absorbed by the government, the same way as it absorbs the cost of maintaining highways in good repair.

Conversely, owners of the gold coins of the realm must have the right to hoard, melt down, or export them. Opening the Mint to gold symbolizes the fact that the power to regulate the money supply is vested in the people, rather than in unelected bureaucrats. Creating money is an unlimited power. A republican form of government is one of limited powers by definition.

Second, “legal tender protection” of paper money must for once and all be declared unconstitutional. This is necessary to remove coercion whereby labor can be forced to accept irredeemable promises for services rendered.

Such coercion was first legalized in France and Germany in the year 1909, just five years before the outbreak of World War I. These countries wanted to make sure that the military and civil service could be paid in chits. They wanted to put the entire labor force at the disposal of the government — regardless of the state of budget and collection of taxes — in case of war. But governments should not be able to wage undeclared wars, nor should they be able to continue unpopular wars to the point of final exhaustion as could kings of old, but they should go to the electorate for money year after year. World War I would have come to an early end but for the legal tender laws. As soon as treasuries had run out of gold, the belligerents would have been forced to make peace, unless people agreed to pay for the continuing bloodshed and destruction of property, and send more of their sons to die in the trenches.

Third, the “Real Bills Doctrine” of Adam Smith should be rehabilitated.

Bills of exchange drawn on fast-moving merchandise in most urgent demand by the consumers, which mature into gold coins within 91 days (the length of a quarter), must be allowed to enter into spontaneous monetary circulation. This would make credit elastic and self-liquidating.

It can be seen that the bill market is the clearing house of the gold standard. In 1918 at the end of World War I the victorious Entente powers, in their wisdom, decided not to allow the world to go back to the multilateral financing of international trade. To be sure, they wanted to go back on the gold standard. In 1925 Great Britain decided to make the pound sterling once more convertible into gold at the pre-war exchange rate at a great cost. But because only bilateral trade was authorized, this meant nothing less than the castration of the gold standard. Once its clearing house was amputated, it could not perform.

The allied powers did this out of spite and vengeance. They wanted to cripple Germany over and above the provisions of the Versailles peace treaty.

Forcing bilateral trade upon Germany was equivalent to peacetime blockade whereby the Entente could monitor and control Germany’s imports and exports.

The measure backfired. The Great Depression and the 1931-1936 collapse of the international gold standard was due to the forcible elimination of multilateral financing of world trade with real bills.

The gold standard did not collapse because of its “contractionist” tendencies — as alleged by Keynes. It collapsed because of its clearing system, the bill market was blocked. Falling prices in 1930 were not the cause of the Great Depression: they were the effect. The cause was falling interest rates.

Incidentally, the cause of falling interest rates was the illegal introduction of “open market operations” by the Federal Reserve of the United States in

1921, whereby the central bank pays bribe money, in the form of risk-free profits, to bond speculators for bidding bond prices sky-high.

Q.:

### To what extent should money be “covered” by gold?

A.: The Real Bills Doctrine provides the answer to that question. There are on average 75 business days in a quarter. Therefore on each business day, on average, one-seventy-fifth, that is, 11/3 percent of the outstanding real bills mature into gold. Sufficient gold must be available at all times to pay the bills at maturity; more if the discount rate is rising, less if it is falling. In normal times the commercial banks should have that much gold flowing to them in the ordinary course of business, with which they can pay the maturing bills. If times are not normal, banks may have to go to the bill market and sell, at discount, a sufficient amount of bills from portfolio to raise the gold. This should be no problem: a maturing real bill is the best earning asset a commercial bank can have. At any given time there are commercial banks somewhere in the world overflowing with gold. They scramble to acquire earning assets. The value of a real bill increases every single day through maturity. Real bills represent “selfliquidating credit”. Sale of the underlying merchandise to the ultimate consumer provides the wherewithal for liquidation.

Q.:

### What happens if a country has no gold in its coffers?

A.: Such a country will experience a rise in the discount rate. The appearance of a positive spread between discount rates improves the terms of trade for the country with the higher, while worsens it for the one with the lower rate.

In effect, cash prices on exports drop for the first, while they rise for the second country, increasing the competitive edge of the firs. Moreover, the first country has the advantage of paying lower prices, 91 days net, for its imports. By contrast, the second country has the disadvantage of having to pay higher prices, 91 days net, for imports, relative to cash prices. In practice this means that the country with the higher discount rate gets the gold for its exports 91 days before bills for its imports fall due. Thus the higher discount rate induces an inflow of short term capital from the second country to the first. We must remember that imports are financed by exports, not by gold. Gold is there for tying the country over through temporary difficulties — not for financing imports.

If this help is not sufficient to ease the gold shortage then consumers, provided they want to eat, keep themselves clad, shod, and warm in winter, will have to dig into their pockets and come up with the gold coin to pay their import bills. It is a mistake to think that the central bank is the best guardian of the country’s gold. It is not. The system is viable also in the complete absence of central banks: it may even work better. The best gold reserve a country can have is that managed by the people themselves. The government cannot be the judge of what people think is best for them.

The point is that a shortage of gold need not cause privation in any country because, thanks to the discount-rate mechanism, it is a self-correcting condition.

Q.: You have announced that in August you will start a school, and call it the New Austrian School of Economics, in Budapest, Hungary. Why new?

### Why Austrian? Why in Hungary?

A.: The Austrian School of Economics was started by Car Menger (18401921) of Austria-Hungary who could also deserve the epitaph, carved on the tombstone of Isaac Newton in Westminster Abbey: humanis generis decus

(pride of the human race). Members of the Austrian school, like Menger himself, were all great monetary scientists who abhorred the idea of irredeemable currency. In the 1930’s Keynes introduced the notion that the gold standard was a “barbarous relic” and should be discarded. Through bribe and blackmail academia was enlisted to rally to the new doctrine, while the Austrian School withered. When the intellectual bankruptcy of Keynesianism — which turned things upside down in castigating the virtue of thrift and lionizing the vice of prodigality — has become obvious, the Austrian School has gone through a renaissance, especially in the United States, calling for sanity and the return to the gold standard. However, the “American Austrians” are vehemently against the Real Bills Doctrine of Adam Smith for doctrinaire reasons, as it contradicts their holy of holies, the Quantity Theory of Money. They do not understand that real bill circulation is spontaneous and its suppression is nothing less than unwarranted interfering in the operation of the free market. They do not see the difference between the discount rate (yield on real bills) which is governed by the propensity to consume, and the rate of interest (yield on the gold bond) which is governed by the propensity to save.

There is a great danger ahead, namely, the overkill in adopting the socalled “100 percent gold standard”, as clamored for by the “American Austrians”. Such a move would ban real bills. It would be a disaster. The financial system would not survive the first Christmas shopping season. Markets would seize up, and the gold standard would be given a bad name for the second time. This danger prompted me to start my school in Hungary where I live. I call it “new” to distinguish it from the school of the “American Austrians”.

Austria and Hungary used to be a dual monarchy during the days of Carl Menger, sharing not only the monarch but also their scientific and cultural heritage. I am proud to be part of this heritage.

Q.: Why a gold standard? Why not pick a basket of precious metals, or some other marketable commodities, to serve as the unit of value?

A.: American money doctors take pleasure in ridiculing gold while comparing it to frozen pork bellies. Gold, horribile dictu, is trading in the same pit after having been expelled from the Monetary Paradise. This reflects a mindset suggesting that gold, at best, is just one of several marketable commodities, and a basket of wider selection could provide a better monetary reserve, or unit of value, than gold.

This position is false. Gold is no frozen pork bellies — wishful thinking of the American money doctors notwithstanding. The reason is that the marginal utility of gold declines more slowly than that of frozen pork bellies. In fact, the marginal utility of gold declines more slowly than that of any commodity (or a basket of any commodities) known to man. That’s what makes gold the monetary metal par excellence. That’s what makes gold the only monetary asset that has no counterpart as a liability in the balance sheet of someone else.

Incidentally, there are only two monetary metals: gold and silver. Other precious metals such as platinum and palladium are not monetary metals. What sets monetary metals apart from other precious metals is their stocks-to-flows ratio. It is a high multiple for the former, but only a small fraction for the latter.

Q.: Critics say that, historically, under the gold standard, the world economy languished, trade was sluggish, technological and therapeutic innovation was unexciting, in a word: the gold standard has never worked well. How do you answer that?

A.: This allegation is just the opposite of the truth. The heyday of the gold standard was the 100-year period between 1815 (the end of the Napoleonic wars) and 1914 (the start of World War I). This was the age of transcontinental railways, intercontinental shipping This was the time when all the key inventions were made that ushered in the age of electricity and electronics, the age of the internal combustion engine, the age of aviation, the age of wireless telecommunication, the age of the X-ray, radium, and the ultrasound, etc.

Financing these discoveries and their applications in production, transportation, telecommunication, and therapeutics wouldn’t have been possible without the gold standard and the accumulation of capital that it facilitated.

Q.: Introducing a gold standard hardly seems possible today, in view of the gigantic injections of new currency into the economy world-wide. How could the gold standard handle that?

A.: It couldn’t and wouldn’t. The new gold standard would let the regime of irredeemable currency boil in its own juices of excess fiat money and, finally, run itself aground. When it can no longer handle the task of delivering food and other necessities to the people, when it can no longer provide employment for those who are eager to earn wages, the gold standard will spring back to life spontaneously. People have to eat. They must have work to be able to earn a living.

It will dawn on the world that gold has a place underneath the Sun. Gold is that hard core of capital that can be destroyed neither by inflation nor by deflation, that will survive any consolidation of balance sheets. Gold is at the heart of the healing process of the world economy that makes survival possible when empires are crumbling. Empires come and go according as they can provide law and order or let them disintegrate, but gold remains. It has a greater staying power than tyrannies, or even democracies.

Q.: Is a gold standard the ultima ratio to cure the human weakness epitomized by the belief that you can multiply wealth by printing money without limits? We know that no central bank could ever stand up to dogooder politicians.

A.: Friedrich A. Hayek, the Nobel-laureate Austrian economist thought so. He said that there would be no need for a gold standard but for the propensity of governments to spend beyond their means.

I don’t believe that for a moment. I see gold everywhere, independently of governments’ spending propensities. It can be shown that quite apart from a gold standard gold has a role to play in forming prices, wages, rents, rates of interest. It helps to find the balance between consumption and saving, as well as between short-term and long-term satisfaction. It determines the marginal productivity of capital and labor. It is like air. We don’t see it yet it’s there.

Without it, there is no life.

We need a yardstick to measure value. Gold is the raw material of which that yardstick is made, whether bigoted governments accept it or not.

Q.: In the past governments also went bankrupt, some repeatedly, e.g., in ancient Athens, Rome, or France in the 17th and 18th centuries. This shows not only that such occurrences are possible under a gold standard, but also that the powers-that-be could always circumvent limitations put on coining money and restrictions on banking whenever the idea of scarcity of gold takes hold. What makes you think that a future gold standard may be more successful, and could endure for a long period of time?

A.: There is no hard-and-fast limit on the amount of self-liquidating credit that can safely be built on a given weight of gold. Improvements in clearing techniques such as those in telecommunication, overnight freight-forwarding, and warehousing will increase the amount of credit outstanding even if there is no corresponding increase in gold bearing that credit. It is this property that makes gold suitable to support credit. It is simply not true that restrictions erected by the gold standard stifle the economy, and that the powers-that-be are justified in breaking those fetters.

Gold is not scarce by ay means. In fact, among the produced goods it is the most abundant. The stocks-to-flows ratio for gold is a high multiple; the same ratio for other produced goods is a small fraction.

For the gold standard to endure the number one requirement is that men must have confidence in the promises of government to pay gold. If this confidence is impaired, gold tends to go into hiding. Then the system breaks down not necessarily immediately, nonetheless, with the force of inevitability.

The answer to the problem resides in the governments’ keeping faith with their subjects without fail. We must admit that the record in this regard has been miserable, to say the least.

### Q.: What is your opinion of the governments’ handling the Great

Financial Crisis, the Greek debt crisis, the crisis of the Euro, and other currency crises brewing? How long can they contain the “debt-firestorms”?

### Will they be able to extinguish it with a shower of new debts?

A.: The governments of the industrial countries bear full responsibility for bringing the world to the brink of the present crisis — the greatest financial and economic crisis ever. They should have resigned in admission of their guilt, and let new governments armed with a better economic theory take over and work out the remedy. Instead, they are doggedly clinging to power. Their analysis of the cause of malady is faulty; the remedial actions they have recommended are old nostrums, incredibly inept, nay, outright counter-productive.

Take the example of the runaway growth of the debt tower. The Great Financial Crisis, the Greek debt crisis, and all the other crises still at the brewing stage are part of the same problem, namely, the debt problem. It goes back to the year 1971. On August 15 of that fateful year the U.S. government defaulted on its international gold obligations. By now the debt tower is so huge that it threatens with toppling and burying the world economy under the debris.

The reason for the exponential growth of debt in the world is that in 1971 the world economy was deprived of its ultimate extinguisher of debt. As a consequence, total debt in the world can only grow, never contract. We should do well to remember that, since time immemorial, gold has successfully served as the ultimate extinguisher of debt — until it was forcibly and unilaterally removed from the international monetary system by the United States. Since

1971 governments have pretended that paying debt in U.S. dollars extinguished it, too. But in fact it did not. Debt was merely transferred from the debtors to the U.S. government, and kept accumulating. Transferring debt is not the same as extinguishing it. Debt accumulation has a natural limit. This limit has now been reached.

Your description of the debt-tower as a firestorm is apt. Governments of the leading industrial countries will not be able to contain the firestorm they have started. Worse still, what they do is just pouring oil on the fire.

Q.: How will the current situation unfold? Do you think resolution will come in the form of hyper-inflation, or will it come in the form of deflation?

A.: One has to be careful with these terms. Both inflation and deflation mean destruction of wealth through destroying the value of obligations; the former through depreciation, the latter through default. It is also possible to have a mixture of both simultaneously.

If you insist on a straight answer from me, then chalk me up in the deflation column. Signs of deflation are all around us. Torrents of freshly printed money are unable to turn receding prices and interest rates back. Confidence in promises to pay is evaporating. Banks do not trust one another with overnight money. Paper gold is being pushed down the throat of those demanding physical gold. Vanishing confidence has reached the stage of contagion. Paper wealth is disintegrating before our very eyes. The domino-effect is spreading: the collapse of one firm brings down two other. Most frightening is the shrinking of employment. It threatens with leading to a break-down in law-and-order.

Governments are completely unprepared for what is coming. They think that it is just a matter of printing more money for which they are so superbly equipped, and sprinkling it from a helicopter as if it were manna, to prevent further contraction. They don’t understand that money could self-destruct faster than it can be printed.

Q.:

Your answer to my next question would certainly interest our readers very much.

Are you invested in gold, silver, and other precious metals? Would you still buy them at these elevated prices?

A.:

I take exception to your use of the word “investing”. To my way of thinking holding monetary metals is not investing but more like taking out an insurance policy. I don’t think the other precious metals (or stones, for that matter) make good investment for lack of liquidity. As far as the monetary metals, gold and silver, are concerned, you would be welladvised to buy a certain amount, however small, every month routinely, regardless of the price. You should look at these purchases as you do on your insurance premium payments due monthly. The analogy is apt. If you never need to collect on your fire insurance policy, well, so much the better.

At the optimum, you would track the value of your net worth not at its dollar but at its gold equivalent. In other words, you would carry your balance sheet, both on the asset and the liability side, not in dollar or euro units, but in gold units (ounces or grams). A decline in the gold price doesn’t mean a decline in your net worth. Conversely, an increase in your investments in real estate or equity may not mean an increase in your net worth. It takes selfdiscipline to follow this rule, but this is the only way to avoid the pitfall of always looking at your own face in a curved mirror. The torsion of the image may easily translate into the torsion of the mind.

Q.:

Let me come to my final question, if I may. What do you think the gold price will be in terms of U.S. dollars or euros in 3 to 5 years’ time?

A.:

I am often asked to answer questions similar to yours. Whenever I am, I say: I am sorry, but I am not a practitioner of clairvoyance. I would compromise my reputation as a scientist if I ventured to make unwarranted predictions about the future. Besides, I don’t think I am very much interested in knowing. Guesses at the future price of gold are dime a dozen.

Furthermore, these questions assume that, as far as the higher the gold price is concerned, the sooner is the better. People tend to ignore the fact that a more slowly advancing gold price would give them the opportunity to shore up their insurance, an opportunity that so many of them obviously need.

A more appropriate — and interesting — question may be whether the dollar and the euro will still be around in 3 to 5 years. I am not sure about the euro, but I think the dollar will definitely be around 3 years from now. In 5 years? — maybe not, but I wouldn’t be surprised if the staying power of the dollar extended beyond 5 years.

It is dangerous to underestimate the strength of the poison you are forced to live and work with.

Interviewer: Thank you for your time to talk to us.

Professor Fekete: Thank you for the opportunity to express my views.

---

*May 6, 2010.*

### Calendar of Events

## Announcing The Establishment Of The Austrian School

OF ECONOMICS IN BUDAPEST. The first ten-day, 20-lecture course offered is entitled: Disorder and Coordination in Economics — Has the world reached the ultimate economic and monetary disorder? The lecturer is Professor Fekete, with the cooperation of Mr. Rudy Fritsch (Canada), Peter van Coppenolle (Belgium), and Mr. Sandeep Jaitly (United Kingdom). It will be held in Budapest, Hungary, from August 9-20, 2010. Participation is limited, early registration is advisable. For more information and registration, contact Dr. Judith Szepesvari at: szepesvari17@gmail.com. Inexpensive dorm-type accommodation is available for students (shared bathroom, shared kitchen); a three-star hotel is next door. Extra-curricular consulting with Professor Fekete can be arranged for an extra fee.

The school is meant for all students (including beginners) interested in the Austrian theory of money, credit, and banking. Its program plans to cover the whole spectrum of Austrian economics, with special emphasis on developments that took place after the death of the greatest 20th century economist, Ludwig von Mises, including the Real Bills doctrine and social circulating capital; the theory of money, credit and banking; and the theory of interest and discount.

Completion of this course will earn participants one credit towards a fourcourse, four-credit program that has been submitted for accreditation to the Adult Education Accreditation Board of Hungary. Participants will receive a certificate signed by Professor Fekete. The follow-up credit courses will cover these areas:

Adam Smith’s Real Bills Doctrine and Social Circulating Capital.

The Austrian Theory of Interest and Discount.

The Austrian Theory of Money, Credit, and Banking.

### Some of the future courses may be offered in Martineum Academy in

Szombathely, Hungary, where we have had four successful conferences already in the past. A special cordial invitation is extended to all Martineum alumni and their family members and friends!

It is not well-known that Budapest is one of the foremost spas in Central Europe with a dozen or so medicinal thermal springs. Participants of the course could stay on afterwards and savor the superb spa and cultural offerings in the city. Make it a family holiday! Eating and shopping facilities, as well as a swimming pool are nearby. Spectacular excursions can be arranged in the surrounding hills, and boat trips ont he River Danube!

Preliminary announcement: a session in Hong Kong in late October is on the drawing board, followed by some more events in New Zealand in November. Stay tuned.

---

# The New Austrian School of Economics

URL: https://newaustrianeconomics.com/archive/fekete/the-new-austrian-school-of-economics/
Date: 2010-05-12
Section: Popular Economics
Difficulty: intermediate
Concept Tags: new-austrian-economics, real-bills, gold-basis, gold-standard, mises
Description: Fekete presents his case for the New Austrian School as a genuine advance beyond both the Mises-Rothbard tradition and mainstream economics. The New Austrian School adds basis analysis, the Real Bills Doctrine, and the gold standard's institutional requirements to the Austrian capital theory framework, correcting specific errors that led the old school into theoretical dead ends.
Editorial Note: Written May 2010. One of Fekete's most explicit statements of the New Austrian School's intellectual project and its relationship to the older Austrian tradition.
Original PDF: https://professorfekete.com/articles/AEFNewAustrianSchoolOfEconomics.pdf

## The New Austrian School Of Economics

### Antal E. Fekete aefekete@hotnmail.com

### The Hungarian Connection

The Austrian School of Economics dates its beginnings back to the publication in 1871 of a slender volume: The Principles of Economics (Grundsätze der Volkwirtschaftslehre) by Carl Menger. The adjective “Austrian” was meant to be derogatory, introduced by economists of German school of historicism to ridicule Menger’s idea of basing economic science on axiomatic foundations, on the pattern of logic and mathematics. The root of the word “Austrian” is “East”, so the connotation of “Austrian economics” is “oriental economics” — a kind of voodoo economics.

German economists could just as well have said “Austrian-Hungarian economics”, since Hungary lies even further East than Austria, plus the fact that in 1871 Austria-Hungary was a dual monarchy, the two countries sharing not only a monarch but also many important political, economic, scientific, cultural institutions and traditions.

The Hungarian connection is dramatically revived by an unfortunate split in the rank and file of Austrian economists that took place in the 21st century. I have run conferences at the Martineum Academy in Szombathely, Hungary in the Austrian tradition and in the spirit of Carl Menger. I published course outlines under the aegis of the now defunct Gold Standard University on my website [www.professorfekete.com](https://www.professorfekete.com). For my efforts I have been roundly denounced by parochial “American Austrians” at the Ludwig von Mises Institute in Auburn, Alabama. I consider this split most unfortunate at the most critical time, when the international monetary system shows signs of advanced senile dementia as well as of physical disintegration. This could have been a most opportune time for students of the gold standard to close ranks, join forces, and demand a return to the only monetary system that makes for economic stability, for peace and prosperity. They should have put their quibbles aside and offer a common platform and blueprint showing the world how it could be done.

It was not meant to be.

Because of the urgency of the moment I have decided to make a fresh start and to establish a new school, proudly naming it the New Austrian School of Economics in Budapest, Hungary, where I live. My first act in doing so is to extend a sincere offer of cooperation to the American Austrians as soon as they are ready to look at Adam Smith’s Real Bills Doctrine as a valid theory which is very much in the spirit of Menger.

### The Quantity Theory of Money

It is a great pity that as a young man Ludwig von Mises embraced the Quantity Theory of Money, and has never during his long life been able to extricate himself from its clutches. For this reason he was alienated from Adam Smith’s Real Bills Doctrine, the latter being an implicit refutation of the former. In spite of this flaw I still consider him the greatest economist of the 20th century. But the mortmain of Mises cannot be allowed to guide us in the 21st century when the Quantity Theory of Money is so spectacularly self-destructing, as witnessed by the Second Great Depression that started 80 years after the first, in 2009.

### Cleansing of the Temple

The Real Bills Doctrine of Adam Smith states, in essence, that short-maturity bills of exchange drawn on goods in most urgent demand and moving fast enough to the ultimate gold-paying consumer, are capable of spontaneous monetary circulation, without any impetus or props from the governments or the banks. Indeed, bill circulation is possible in the absence of any banks at all. Such a system of financing production and trade sans banques could rise from the ashes of the regime of irredeemable currency before our very eyes. In the first decade of our century the governments and the banks have totally discredited themselves in the public’s view as they have run the ship of the world’s monetary system onto the rocks. Should the bankers have the temerity to show up after the shipwreck in order to set up shop, people will rise and chase them out — just as Jesus chased out the money changers in the famous scene

“Cleansing of the Temple” (Mark 11:15-19; Matthew 21:12-17; Luke 19:45-48; John 2:12-25).

The scriptural teaching, confirmed by all four evangelists, is clear. Social cooperation is still possible in the absence of banks. It was a fatal mistake to ban the spontaneous circulation of bills maturing into gold from financing world trade — thereby promoting the bankers’ dishonored promises to pay, and their never maturing but ever burgeoning debt, to the status of money.

### Victors disallowing real bill circulation in 1918

The international gold standard did not collapse during the 1930’s because of its inner contradictions — as schools inculcate the idea into all students. The truth is that the victorious powers inadvertently caused the collapse of the gold standard (with a 13-year lag) by disallowing its clearing system, the international bill market, to reopen for business after the cessation of hostilities in 1918.

The victors did not want to abolish the gold standard per se. After all,

Britain returned to a gold bullion standard at the original parity of the pound sterling in 1925. The victorious allies acted vindictively. They just wanted to punish Germany over and above the provisions of the peace treaty. They forced the world into the straitjacket of bilateral trade, essentially a barter system that had evolved during the war. They refused to entertain Germany’s post-war revival, given the benefits of multilateral world trade, epitomized by the international bill market as it operated before 1914. In effect, the victors wanted to perpetuate the wartime blockade of Germany in peacetime. Never mind that this also punished their own people. In their opinion it was a small price to pay for security. Little did the victorious powers realize that they were sounding the death knell for the gold standard. In a complex trading world such as that of the twentieth century the gold standard could hardly survive if it is castrated by cutting off its clearing system, bill circulation. The idea that the world could be coerced to embrace a system barring multilateral trade is akin to the idea that people could be forced back to barter by abolishing money.

History has borne out the truth of this observation. During a period of five years, from September 1, 1931, when Britain, to September 27, 1936, when Switzerland reneged on their domestic and international gold obligations, all other governments have similarly defaulted on their solemn promises to pay their creditors in the form of a fixed quantity and quality of gold. In some countries, so in the United States, draconian regulations were put into effect making the possession of gold a criminal offence in 1933. Such extreme measures had only one explanation: vindictiveness — even to the extent of hurting your own citizens and violating your own Constitution in the execution of an insane monetary policy. Government economists, university professors, financial writers and journalists have “forgotten” to raise the question whether such extreme and vindictive interference with the world’s production and distribution of goods and services would ultimately have some untoward effects, even war, as a repercussion. Not one of them thought of suggesting that the legal tender status of bank notes should be declared unconstitutional through an international treaty — as the paramount measure to secure the preservation of world peace.

### A Century of Legal Tender

The “forgotten questions” are belatedly being asked now. The present great financial crisis is not the outcome of some recent errors of commission or omission. Its ultimate cause goes back 100 years, to 1909. That was the year when France and Germany, in short succession after one another, enacted legal tender legislation making the note issue of the Bank of France and the Reichsbank legal tender in their respective jurisdictions. Without legal tender bank notes an all-out war could scarcely be fought. Members of the officer corps and procurers of munitions would demand remuneration in the gold coin of the realm. That could have put a speedy end to the war that started in 1914.

The real cause of the great financial crisis that started in 2009 is the inadvertent destruction of the gold standard a hundred years ago through the introduction of legal tender bank notes before World War I, and the vengeful decision to bar the international bill market after. It was these measures that have given rise to the corrosive regime of irredeemable currency, floating exchange rates, gyrating interest rates, and forever growing perpetual debt — a monetary arrangement never before globally embraced.

100 percent Gold Standard (so called)

I am an old man, two years shy of four score. I was looking forward to enjoying the quiet pleasures of retirement. However, the present world crisis calls me out of retirement. I feel it is my duty to do what I can to prevent a disaster, to wit, the establishment of the 100 percent gold standard (so called) and letting it run as the fall guy in a mission that is condemned to fail, as Britain’s return to the gold standard was in 1925.

Britain’s gold standard of 1925 failed because it did not have a clearing system and so it utterly lacked elasticity that only self-liquidating credit, embodied by real bill circulation could impart to the monetary system. It was doomed to failure from start. The 100 percent gold standard (so called) would repeat the mistake the British made in 1925. Another failure of the gold standard would set the world back another hundred years. In the meantime there would be trade wars, most likely leading to another world war. Our civilization would be put in harm’s way.

### The Theory of Discount

The 100 percent gold standard (so called) would also deprive the world of the benefits of the discount rate, this sophisticated and versatile instrument to regulate the economy. The economic triumph of the one hundred-year period from 1815 through 1914 is the triumph not only of the gold standard, but also of self-liquidating credit, the bill market, and the discount rate (as distinct from the rate of interest). During that triumphant period such economic maladies as chronic trade imbalance, structural unemployment, foreign exchange crises, unbridled increases in public and private debt were quite unknown. The world economy was on an even keel, delicately balanced by self-correction through the mechanism of the discount rate.

In the 19th century no sharp distinction could be made between “surplus” and “deficit” countries due to the self-correcting mechanism of the discount rate.

It would have been unthinkable that balances of pound sterling would keep piling up in one country (as dollar balances do now in China), causing great disruptions in world trade, and leading to the dismantling of whole industries in the deficit countries.

Instead, surplus countries would experience an automatic fall, deficit countries an automatic rise in the discount rate. This would immediately induce a flow of short-term capital from the surplus countries to the deficit countries in the form of consumer goods in the most urgent demand. There is no better way, known to man, to satisfy the world’s multifarious and fast-changing needs using the world’s scarce resources most economically and efficiently, to the best advantage of all. This great mechanism of economic adjustment, capable of preventing structural unemployment and chronic imbalances in the world economy, the discount rate, was thoughtlessly thrown away by the victorious allies when they decided not to allow the reorganization of the international bill market for reasons of vindictiveness in 1918.

### Open the Mint to Gold!

The secret of solution to the great financial crisis of our day is that governments should open the Mint to gold. This means restoring the individuals’ right to convert their gold at the Mint, without limit, into the gold coin of the realm free of seigniorage charges. They should also have the right to melt down, hoard or export the gold coin of the realm as they see fit.

The significance of the opening of the Mint to gold is that it would convert idled gold into “gold on the go”. Circulating gold coins would revive world trade as nothing else could. Gold locked up in government and private vaults is a curse putting the world economy in a bind (in addition to being a stupid economic waste of a unique scarce resource that has no substitute).

### The Most Misunderstood of Metals

Gold is the most misunderstood metal in human history, because of the economists’ failure to distinguish between its dynamic and static aspects in representing values. Economists have blithely assumed all along that the value of gold is the same whether it flows freely from one hand to the next, or whether the movement of gold is obstructed, in the worst case arrested, by the government (soon to be aped by banks and individuals). Yet the truth of the matter is that “gold on the go” is far more valuable than “gold locked up”.

Golden Ages of history were periods characterized by “gold on the go”. Man trusted man, and men trusted their governments. Promises to pay gold were routinely made and kept. Gold was paid out without hesitation because men and governments were confident that they can get it back on the same terms any time of their own choosing. Above all, during the Golden Ages of history there was peace because goods and services could be more readily obtained through trade than through theft or conquest.

By contrast, under our present system wherein gold is concentrated in government and private hoards, there prevails a great distrust and widespread misery. Above all, there is perpetual war as goods and services could be more readily obtained through theft and conquest than through voluntary trade.

In rejecting gold our statesmen have rejected reason. Their guilty conscience is shown by their neurotic fear of an open debate on the gold question, and by the fact that they deny academic appointments to solid gold standard men, treating them as if they were cranks. Politicians are wont to erase the very thought of gold from the public consciousness.

### The Best Unemployment Insurance Known to Man

The combination of a gold standard with bill trading would produce an economic miracle in the world far greater than the economic miracle of Ludwig Erhardt’s Germany in 1949. The curse of trade deficits would disappear. Even if a country suffered a great natural disaster, say, the total loss of its annual crop, trade deficit would not necessarily follow. The discount rate would immediately shoot up in the stricken country. That country would be the best place in the world on which to draw bills. This would instantaneously generate a flow of short-term capital in the form of consumer goods in most urgent demand. No country would ever need to go to other governments begging for charity.

Surplus countries would be prompted to expel gold in response to greater demand as demonstrated by the higher discount rate abroad.

Structural unemployment would disappear as it would be prevented before it became chronic by the higher discount rate in areas of falling employment.

The higher local discount rate would generate an influx of finished and semifinished goods from the surrounding areas. The processing and the distribution of these goods would create as many new jobs as necessary. The best

“unemployment insurance” known to man is “gold standard plus bill trading”.

This is how the world economy worked before 1914; this is how it would have worked after 1918 had the victorious powers had the intelligence to allow multilateral trade and real bill circulation to make a comeback.

### Hands-off Treasury bills

All the government needs to do is to open the Mint to gold and to protect real bill trading against fraud. Funds raised through the bill market are public funds that must be protected against misuse just as other forms of public funds must.

Let me mention just three types of misuse: (1) drawing more than one bill on the same consignment of merchandise; (2) drawing a new bill upon the expiry of the old on the same unsold merchandise; (3) financing stores of goods in the expectation of a rise in price by drawing bills.

Bills of exchange drawn on goods in most urgent demand and moving fast enough to the ultimate gold-paying consumer are capable of monetary circulation on their own wings and under their own steam, regardless whether or not banks are standing by, ready to monetize them. But if they are, legislation should prohibit banks from borrowing short in order to lend long. In practice this means that the banks would be prohibited from rolling over short term commercial credit at maturity. Commercial banks must also be prohibited from conspiring with the drawer of the bill. Withholding stocks from trade in expectation of a rise in price must be financed by an investment bank, never by a commercial bank. The two types of banks should be strictly separated by law.

Commercial banks must also be prohibited from investing in brick and mortar.

In practice this means that mortgages are “hands-off “.

Treasury bills are also “hands-off”, except on capital account. We know that people will want to eat and to keep themselves clad and shod tomorrow.

That’s what makes bills the safest earning asset. We also know that people will pay their taxes only after they have eaten, clad and shod themselves. That’s why real bills as an earning asset are superior to Treasury bills.

### The Curse of Senescence

The demand for gold has a component that is unknown to our generation, although it was ubiquitous a hundred years ago: the demand for yield on gold in gold. Gold used to wear two hats: if you wanted, gold was wealth; but if you wanted, gold was income. Moreover, the switch between the two was as simple as one-two-three, through the agency of the bill market. The possibility of making gold yield an income in gold is missing from the world today. The reason is the neurotic approach to gold promoted by the media and academia.

The discount earned by holding real bills to maturity is the safest way to generate an income in gold. Likewise, the safest way to convert that income back into gold is by selling real bills from portfolio.

But why is switching between gold as wealth and gold as income so important? Well, God created man and made him mortal. Also he made us subject to curse of senescence. Our capacity to generate an income is the lowest just when our need to rely on it is the greatest: when we grow old and frail. This seems unjust; but God has also given us a marvelous tool as a compensation: gold. The young man can hoard gold, maybe to adorn his wife with gold jewelry, thus converting income into wealth, so that they can turn this wealth back into income by dishoarding gold when he grows old and his surplus of income has turned into a deficit. Thus gold is man’s tool to convert income into wealth and wealth into income safely. Gold is the catalyst in solving the problem of senescence. That indeed is gold’s main excellence.

### Exchanging income for wealth and wealth for income

The trouble is that hoarding and dishoarding gold is a laborious and timeconsuming process, raising the problem of efficiency and safety. It is important for us to see that the efficiency of converting income into wealth and wealth into income can be greatly enhanced, and the time-consuming process can be telescoped into instant action, if we pass from direct to indirect conversion of income and wealth. That is to say, we pass from hoarding and dishoarding to the exchange of income for wealth and wealth for income.

### The Theory of Interest

This leads us to the concept of interest. The interest rate is just the marginal efficiency of exchanging income and wealth (over the zero efficiency of direct conversion: hoarding and dishoarding). We can shape the theory of the origin of interest so as to describe the evolution of direct conversion of income into wealth or wealth into income through the agency of the most hoardable good, gold, resulting in the far more efficient indirect conversion: the exchange of wealth and income.

This closely follows Menger’s familiar theory of the origin of money as the evolution of direct exchange (barter) resulting in the far more efficient indirect exchange through the agency of the most marketable good, gold.

Given the possibility of indirect conversion, that is, the exchange of income and wealth, the young man with a surplus of income but a deficit of wealth, who wants to go into business, no longer has to waste his best years to hoard gold in order to raise capital. He will seek out a congenial elderly man who has a surplus of wealth but a deficit of income. The two can go into partnership in exchanging the surplus income of the junior partner for the surplus wealth of the senior. But they can do it safely only if the God-ordained institution of the gold standard and the instrument of the gold bond have not been corrupted by do-gooder politicians, as they in fact have in inflicting the coercive regime of irredeemable currency upon the world.

Today no exchange of income and wealth is safe because we no longer have a reliable unit measuring value. This is a formidable obstruction in the way of forming new capital at a time when great capital destruction is taking place due to fluctuating interest rates. The problem of providing adequate capital for business cannot be solved satisfactorily while assuming the regime of irredeemable currency, under which the central bank can suppress the rate of interest all the way to zero — the main cause of capital destruction in the world today. It can be solved only under the regime of a gold standard, where the rate of interest is naturally stable, as shown by the stable price of the gold bond.

This is a new theory of interest that starts from the concept of the hoardability of gold and from the natural need of man to save for his old age. It enables us to see that old age security can be furnished far more efficiently through the voluntary efforts of individuals than through the coercive schemes of the government.

### My Message to the Young

I have established the New Austrian School of Economics in order to spread these unorthodox ideas which are very much in the spirit of Carl Menger. Time has come to go beyond rehashing old truths: we must come up with new ideas on our own.

I hereby invite all young people who feel that regurgitating platitudes is not enough. Come to Budapest and enroll at the New School of Austrian Economics! Let’s raise the torch and carry on the great work of enlightenment together! This is no time for cultism or for parochial quibblings. We must forge ahead past the stale criticism of the existing order. Armed with new ideas we are ready to act. I want to lead you and, then, I want you to lead the world!

There is no place anywhere else in the world where you can study the gold standard as it interacts with its clearing system, the bill market, and with the mechanism of the discount rate; where you can learn that legal tender legislation and the elimination of bill trading is invitation to war (first trade war, followed by shooting war); where you can learn that the starting point of the theory of interest must be gold, the most hordable commodity — except here, in Budapest, at the New School of Austrian Economics. The powers that be have expunged gold standard studies from the curriculum. As a consequence the charlatans of at our universities will never be able to come to grips with the theory of interest. There is no way to understand interest without understanding gold first. We shall recreate gold standard studies and advance it together.

See you in August when I shall deliver my first lecture series on the subject of Disorder and Coordination in Economics — Has the world reached the ultimate economic and monetary disorder?

---

*May 12, 2010.*

### Calendar of Events

European Bankers Symposium, 9-10 June 2010, Hall, Tyrol, Austria.

Professor Fekete will be a keynote speaker on June 9, at 13:30. The title of his talk is: (Gold) Architecture for a New World Finance System. For more information, please see [www.financetrainer.com](https://www.financetrainer.com) .

## Announcing The Establishment Of The Austrian School

OF ECONOMICS IN BUDAPEST. The first ten-day, 20-lecture course offered is entitled: Disorder and Coordination in Economics — Has the world reached the ultimate economic and monetary disorder? The lecturer is Professor Fekete, with the cooperation of Mr. Rudy Fritsch (Canada), Peter van Coppenolle (Belgium), and Mr. Sandeep Jaitly (United Kingdom). It will be held in Budapest, Hungary, from August 9-20, 2010. Participation is limited, early registration is advisable. For more information and registration, contact Dr. Judith Szepesvari, the wife of Prof. Fekete at: szepesvari17@gmail.com.

Inexpensive dorm-type accommodation is available for students (shared bathroom, shared kitchen); a three-star hotel is next door. Extra-curricular consulting with Professor Fekete can be arranged for an extra fee.

The school is meant for all students (including beginners) interested in the Austrian theory of money, credit, and banking. Its program plans to cover the whole spectrum of Austrian economics, with special emphasis on developments that took place after the death of the greatest 20th century economist, Ludwig von Mises, including the Real Bills doctrine and social circulating capital; the theory of money, credit and banking; and the theory of interest and discount.

Completion of this course will earn participants one credit towards a fourcourse, four-credit program that has been submitted for accreditation to the Adult Education Accreditation Board of Hungary. Participants will receive a certificate signed by Professor Fekete. The follow-up credit courses will cover these areas:

Adam Smith’s Real Bills Doctrine and Social Circulating Capital.

The Austrian Theory of Interest and Discount.

The Austrian Theory of Money, Credit, and Banking.

Some of the follow-up courses may be offered at Martineum Academy in Szombathely, Hungary, where we have had four successful conferences already in the past. A special cordial invitation is extended to all Martineum alumni and their family members and friends!

It is not well-known that Budapest is one of the foremost spas in Central Europe with a dozen or so medicinal thermal springs. Participants of the course could stay on afterwards and savor the superb spa and cultural offerings in the city. Make it a family holiday! Bring the children! Eating and shopping facilities, as well as a swimming pool are nearby. Spectacular excursions can be arranged in the surrounding hills, and boat trips on the River Danube.

---

# Hyperinflation or Hyperdeflation?

URL: https://newaustrianeconomics.com/archive/fekete/hyperinflation-or-hyperdeflation/
Date: 2010-05-05
Section: Popular Economics
Difficulty: intermediate
Concept Tags: deflation, hyperinflation, bond-market, capital-destruction, fiat-currency
Description: Position Paper #1: Fekete addresses the hyperinflation vs. hyperdeflation debate, arguing that both camps are partially correct but miss the key dynamic. Under the Kondratiev long-wave model, the endgame involves both simultaneously: hyperinflation in commodities and hyperdeflation in capital values. The critical question is which comes first.
Editorial Note: The first in the Position Paper series from professorfekete.com (May 2010). This series of short papers was designed to give concise analyses of specific monetary and financial questions.
Original PDF: https://professorfekete.com/articles/AEFPositionPaper1.pdf

## Hyperinflation Or Hyperdeflation?

### The Quantity Theory of Money

James Turk’s article Hyperinflation Looms dated April 20, 2010, is based on Quantity Theory of Money (QTM). It draws an analogy between Weimar Germany of 1923 and the United States of 2010. Both precepts are invalid. As far as the QTM is concerned, it suffices to point to the very fact, admitted by Turk, that it is possible to have a shortage of money simultaneously with the overworking of the printing presses. Hyperinflation is not the same as the ultimate inflation of the money supply. It is the ultimate depreciation of the currency unit.

The two concepts are far from being the same, QTM notwithstanding.

The reason why QTM fails is that money is not one-dimensional. It is in fact twodimensional. Quantity is one, and the velocity of circulation is the other dimension. Central banks control the former, and the market firmly controls the latter. As long as fair weather lasts, velocity may be ignored. But as soon as the weather grows foul, velocity returns with a vengeance. If it increases, we talk about inflation. If it decreases, we talk about deflation. In the extreme case the increase in velocity may start feeding upon itself and velocity could grow beyond any limit. People buy anything they can lay their hands on because they expect prices to rise further. This is hyperinflation, wiping out the value of the currency unit. It is an irreversible process: once fiat currency loses its value, it is lost for good. The pendulum has stopped swinging. If there is a bounce, it is the dead-cat bounce.

But it is also possible that, at the other end of the spectrum, the shrinkage in the velocity of circulation refuses to stop and starts feeding upon itself. People postone buying indefinitely because they expect prices to fall further. This is hyperdeflation. It manifests itself in the ever rising value of the currency unit. It is important to remark that it can happen while some prices are still rising. Other than gold, food and energy are two important exceptions.

People have to eat, and they want to keep themselves warm and mobile, no matter what.

Paradoxically, this may reinforce deflation. Because of rising food and energy prices people will have that much less to spend on other goods, accelerating price declines in other sectors.

This defeats the arguments of Turk and others who try to refute the case for deflation by pointing to high or rising cost of food and energy.

The point in either pathology of money is that the government is helpless. Once the point of no return is reached, there is nothing governments can do to convince people that the process will end — short of opening the Mint to gold and/or silver. As far as people are concerned, the feedback from their experience tells them to expect more of the same.

I am not trying to adjudicate between the two schools of thought, one asserting that hyperinflation and the other asserting that hyperdeflation of the dollar is inevitable and imminent. I am merely trying to point out certain facts about deflation that most people are unaware of, or tend to ignore.

Let me state first that it is not impossible for the dollar to go into hyperinflation during the next 12-month period. For example, consider the case of a shooting war between the U.S. and Iran in the Persian Gulf. After an initial euphoria the American military could start suffering setbacks on the ground, in the sea and in the air, simply because of the longer lines of communication from the home base, and also because of the disadvantage of the aggressor in face of patriotic zeal on the part of the defenders (c.f. Vietnam). In this scenario hyperinflation of the dollar could be a possible outcome. But short of war threatening to destroy supplies and producing facilities the word ’hyperinflation’ rings hollow in the ear.

Post-World-War I Germany versus Post-Cold-War U.S.

To draw a parallel, as Turk does, between Weimar Germany and present-day U.S. is, to say the least, grotesquely unrealistic. In 1923 the once mighty German army was defeated and disarmed, the navy was scuttled, the territory of the country was badly truncated by the peace treaty of Versailles, the Rhineland was under military occupation while the rest of the country was still under a partial blockade. No speculator would touch the falling Reichsmark, except to short it.

By contrast, the United States in 2010 has an army, navy and air force that can be put on high alert in a matter of minutes. Its military bases pockmark the face of the globe. The over-riding fact is that the whole world is still anxious to sell its wares on the American market, and is happy to lend back to it the proceeds of the sale in order to finance future U.S. purchases. Furthermore, it is a fact that the bond market trading U.S. Treasury debt is still the largest and most liquid in the world. Significantly, it still has room to go up ― thus offering speculators juicy profits at a time when the bloom is off the stock and the real estate markets.

How can you compare the circumstances of a beggar with those of the emperor — prodigal and bankrupt as though the latter may be?

All the signs around us point to deflation. The money supply is being pumped up on an unprecedented scale, but all it does is pushing on a string. You cannot make a case, as Turk is trying to do, out of the fact that the price of crude oil doubled as compared to its recent low.

Another fact, more startling, is that the price of crude oil has declined 45 percent as compared to its all-time high. We must see the general decline in world prices, even though in some cases they may be disguised as a loss of pricing power of the producers. True, list prices have not declined, but nobody trades them. They are for window-dressing only.

Obviously, you need a theory to explain what is happening other than the QTM. I have offered such a theory. I have called it the Black Hole of Zero Interest. When the Federal Reserve (the Fed) is pushing the rate of interest down to zero (insofar as it needs pushing), wholesale destruction of capital is taking place unobtrusively but none the less effectively.

Deflation is the measure of wealth in the process of self-destruction — wealth gone for good.

The Fed is pouring oil on the fire as it is trying to push long-term rates down after it has succeeded in pushing short term rates to zero. It merely makes more wealth self-destruct, and it makes the pull of the Black Hole irresistible.

But why is it that the inordinate money creation by the Fed is having no lasting effect on prices? It is because the Fed can create all the money it wants, but it cannot command it to flow uphill. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day. Their bets are on the house: if they lose, the losses will be picked up by the public purse. But why does the Fed under-write the losses of the bond speculators? What we see is a gigantic Ponzi scheme. The Treasury issues the bonds by the trillions, and promises huge risk-free profits to the bond speculators in order to induce them to buy. Most speculators believe that the Treasury is not bluffing and they buy. Some may believe that the Fed is falsecarding doubts and they sell. But every time they do they only see foregone profits. What we have here is a rare symbiotic relation between the government and the speculators.

When he was forced out of business by the courts, and his customers lost everything they invested, Charles Ponzi declared that he would have paid them to the last cent as contracted if they had let him. There is no reason to doubt his sincerity. Now, 90 years later, Charles Ponzi’s dream has come true. The US government is duplicating Ponzi’s scheme in the bond market. The only difference is that the stake is much higher: it is the national, nay, the world economy! And, most importantly, this time there is absolutely no danger that the courts will stop the racket. The world begs to be fooled.

### Calendar of Events

European Bankers Symposium, 9-10 June 2010, Hall, Tyrol, Austria.

Professor Fekete will be a keynote speaker on June 9, at 13:30. The title of his talk is:

(Gold) Architecture for a New World Finance System. For more information, please see: [www.financetrainer.com](https://www.financetrainer.com) .

## Announcing The Establishment Of The Austrian School Of

ECONOMICS IN BUDAPEST. The first ten-day, 20-lecture course offered is entitled:

Disorder and Coordination in Economics — Has the world reached the ultimate economic and monetary disorder? The lecturer is Professor Fekete, with the cooperation of Mr. Rudy Fritsch (Canada), Peter van Coppenolle (Belgium), and Mr. Sandeep Jaitly (United Kingdom).

It will be held in Budapest, Hungary, from August 9-20, 2010. Participation is limited, early registration is advisable. For more information and registration, contact Dr. Judith Szepesvari at: szepesvari17@gmail.com. Inexpensive dorm-type accommodation is available for students

(shared bathroom, shared kitchen); a three-star hotel is next door. Extra-curricular consulting with Professor Fekete can be arranged for an extra fee.

The school is meant for all students (including beginners) interested in the Austrian theory of money, credit, and banking. Its program plans to cover the whole spectrum of Austrian economics, with special emphasis on developments that took place after the death of the greatest 20th century economist, Ludwig von Mises, including the Real Bills doctrine and social circulating capital; the theory of money, credit and banking; and the theory of interest and discount.

Completion of this course will earn participants one credit towards a four-course, fourcredit program that has been submitted for accreditation to the Adult Education Accreditation Board of Hungary. Participants will receive a certificate signed by Professor Fekete. The follow-up credit courses will cover these areas:

Adam Smith’s Real Bills Doctrine and Social Circulating Capital.

The Austrian Theory of Interest and Discount.

The Austrian Theory of Money, Credit, and Banking.

Some of the future courses may be offered in Martineum Academy in Szombathely, Hungary, where we have had four successful conferences already in the past. A special cordial invitation is extended to all Martineum alumni and their family members and friends!

It is not well-known that Budapest is one of the foremost spas in Central Europe with a dozen or so medicinal thermal springs. Participants of the course could stay on afterwards and savor the superb spa and cultural offerings in the city. Make it a family holiday! Eating and shopping facilities, as well as a swimming pool are nearby. Spectacular excursions can be arranged in the surrounding hills, and boat trips ont he River Danube!

---

# Hedging Non-Gold Investments with Gold

URL: https://newaustrianeconomics.com/archive/fekete/hedging-non-gold-investments-with-gold/
Date: 2010-02-19
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, gold-standard, sound-money, fiat-currency
Description: Fekete examines why and how non-gold investments can be hedged using gold and gold-related securities, explaining the theoretical basis for gold as a monetary hedge rather than a speculative asset. He distinguishes between gold as insurance against monetary disorder and gold as speculation on price appreciation.
Editorial Note: Written February 2010. A practical essay aimed at investors, applying Fekete's monetary theory to portfolio construction.
Original PDF: https://professorfekete.com/articles/AEFHedgingNonGoldInvestmentWithGold.pdf

1929. Add to this the qualitative change in the structure of debt. The most exotic of the Roaring Twenties era debt was brokers’ margin lending on the stock purchases of clients. Today, in addition, we have: (1) derivative instruments valued up to one quadrillion dollars, (2) adjustable-rate mortgages, (3) the unquantifiable offbalance-sheet activities of financial institutions, and (4) the junk-bond activities of private equity firms. The unwinding, or should I say unraveling, of this financial esoterica will greatly increase the underlying debt. The momentum of change in the debt-tower will insure that debt ― and bankruptcies ― will continue to rise even as the economy contracts.

### The greatest amplifier of the debt burden: falling interest rates

I won’t beat around the bush and say it without hesitation that the greatest underlying cause of the present crisis is the ongoing destruction of capital induced by the falling interest-rate structure. Economists and accountants are still blind to the fact that falling interest rates amplify the burden of debt. According to Fischer’s Paradox: “The more debtors pay, the more they owe”. In this single sentence we have the essence of deflation. Payments of the debtors are discounted at the lower current rate of interest ― not at the higher rate at which the debt was originally contracted!

This may be the nightmare that keeps Ben Bernanke awake and his printing presses in high gear. All in vain: falling prices defy the printing presses. Last year the fall in CPI was the steepest since 1932 at 2 percent. Forget monetarism, forget the Quantity Theory of Money. Forget Friedman. Call it Fekete’s Paradox if you will: “The more the Fed tries to pump up commodity prices with its printing presses, the more they will fall”. The explanation of this paradox is found in the contrarian behavior of the speculators. Yes, they will snap up the newly printed dollars and run with them. But run they will in the wrong direction. They run not to the commodity market as hoped by Bernanke, but to the bill market where the fun is. They front-run Bernanke and his team. They effectively corner the market for T-bills before Bernanke can buy his quota, without which he cannot print more dollars. Then speculators turn around and feed the T-bills to the Fed on their own terms. Thus the Fed’s effort to induce inflation will fail ― just as the effort of the Bank of Japan to pump up prices was a dismal failure in 2002.

### Greenspan surfing the tsunamis

In a testimony to Congress Alan Greenspan has described the financial crisis as a “once-in-a-century credit tsunami”. His simile is as misleading as it is inappropriate, on at least two counts. First, geologists do understand the cause of a tsunami; Greenspan and other policy-makers do not understand why the global financial crisis has occurred. Second, while geologists understand tsunamis, they do not cause them. In contrast, policies implemented at the Fed and at the Treasury are directly responsible for the financial tsunami. Worse still, policy-makers fight the destructive effects of the tsunami with means that can only be described as counter-productive. They make the crisis worse, not better.

They had encouraged a debt-financed speculative bubble in asset prices that created a 25-year illusory prosperity but was doomed to burst, ushering in a selfaggravating economic downturn. They are utterly ignorant about the role of capital and debt in the productive process. They believe that credit can replace capital, so that capital destruction can be repaired with more credit expansion. The vast majority of their colleagues at the universities are not any better informed, either.

### Gold as the ultimate extinguisher of debt

If we accept the thesis that exorbitant debt and the destruction of capital is at the root of the present crisis, then we’ll be directed to the solution of the problem. The solution is gold. The reason why there can be no resolution of the crisis without gold is two-fold.

(1) Gold is the only form of capital that is immune to destruction under any circumstances.

(2) Gold is the only ultimate extinguisher of debt.

I shall deal with the first reason in a moment. Here I just point out that when a debtor repays his debt by handing over Federal Reserve notes to his creditor, the debt is not extinguished. It is merely transferred to the Federal Reserve bank that issued the note. Transferring debt is not the same as extinguishing it. One reason for the present plight of the world is that for the past forty years gold, the only ultimate extinguisher of debt, has been forcibly prevented by the U.S. government to discharge its debt-extinguishing function. As a consequence the debt-tower has kept growing, rain or shine. Conversely, until policy-makers at the Fed and the Treasury will understand that there is no substitute for gold in taming the debtmonster, their tinkering at the edges will keep making the global debt crisis worse.

Unfortunately, the news is not good in this regard. Bernanke is a dyed-inthe-wool chrysophobe. He would hardly be competent to make the necessary changes that would restore gold as the ultimate extinguisher of debt in the international monetary system.

Here I come to the point of my talk. What can the individual investor do to make sure that his investments will not be completely wiped out in the coming financial Armageddon?

### Gold as the only form of capital that cannot be destroyed

In wartime capital destruction normally presents itself as physical destruction of plant, equipment, and products at various stages of production. By contrast, in peacetime, capital destruction takes place on paper, through the consolidation of balance sheets. Take the simplest case when a bankrupt economic entity is overtaken by another in order to save whatever can be saved. Clearly, that part of the assets of the latter that have a counterpart in the liabilities of the former cannot be saved. It will be wiped out.

It follows that no asset that also occurs as liability in the balance sheet of a counter-party is safe against destruction through consolidation ― even if that counter-party is the government. We must remember that every government experiment with irredeemable currency in history has been an abysmal failure.

In the extreme case, when the balance sheets of all economic entities are consolidated in a holocaust, and all paper assets are wiped out, gold is always a survivor: the only asset that cannot be destroyed through inflation, through deflation, or through any other malady of the monetary system.

This means that gold, and only gold, qualifies as an instrument of hedging paper assets. Every investor owes it to himself to provide an adequate level of insurance against risks that prey upon the value of paper investments. But unless this insurance consists of physical gold held by the investor himself on his own premises, it will be ineffective.

### Trading insurance makes no sense

This also shows that the attitude of most investors with regard to gold is faulty, not to say foolish. They keep talking about the “performance” of gold. They trade gold: buy it when they expect the gold price to rise; they sell it when they expect the gold price to fall. Many of them are finished with gold saying that “the bloom is off the roses”. This attitude is akin to that of the property-owner who thinks that he is saving money by canceling his insurance coverage hoping to reinstate it later.

It never occurs to him that it may not be possible to reinstate, if the external conditions change drastically.

The best policy concerning insurance is to buy it and “forget about it”. No regrets if the occasion to collect insurance compensation never arises. It is not a loss: it should be looked at as a gain.

A simple gold-accumulation plan, aiming at a gold hedge equivalent to 1015 percent of net worth, with monthly additions will suffice, with the proviso that it is preferable to increase the hedge when the gold price is down.

Gold investors typically get nervous as they listen to rumors that the volatility in the price of gold indicates that the value of gold has become unstable.

They forget that it is not gold that is unstable, but the dollar in which the gold price is quoted. Gold has been, is, and will be the paragon of stability. Ultimately, the price at which you have purchased your hedges is unimportant.

### Tips for hedging

Buy anonymously and don’t talk about it. Don’t worry that you can’t sell anonymously: you are not going to sell, just like you are not going to cancel your fire insurance policy as long as you own the house. Don’t worry about capital gains taxes on your gold that you hold as hedges against paper assets. Since you never sell, you never incur a tax liability. There is no way the government can impose or collect taxes on paper profits. At any rate, those so called profits on your gold hedges should never be considered as profits. They should be looked at as advances on payments of insurance compensation for anticipated losses. It would be foolish to take these “profits” and spend them. Those losses may disappear, together with the gold profits, creating the impression that your hedges don’t work.

They do, but the results have to be interpreted correctly. Spending gold profits is tantamount to canceling the insurance policy prematurely. The big test is still ahead. The crisis is not over, not by a long shot.

### The shape of things to come

The world lives in a delusion. It sets great stores on Keynesian nostrums, hoping that public debt-financed government spending, or inflating the money supply will resolve the crisis. They won’t. The first-mentioned Keynesian remedy will fail because replacing private debt with public debt means jumping from the frying pan into the fire. A true solution must reduce total debt. The second-mentioned Keynesian remedy will fail to induce the intended inflation because the newly created money just won’t go where the Fed would like it to go: to the commodity, real estate, and stock markets. Instead it will go to the bond market to facilitate bond speculation: borrowing short and lending long, putting a downward pressure on the yield curve. Alternatively, it will be used to retire private debt. In either case, the result will be deflationary, not inflationary.

As the decrease in debt reaches a threshold, it will have two immediate consequences. One: unemployment will skyrocket. Two: the financial system will self-destruct in a spectacular fire-work that will make the fact obvious to one and all. Concerning the first consequence, the U.S. must face the situation squarely that during the boom years it has dismantled much of its industrial park producing consumer goods for the mass market. It no longer has the factories needed to employ the armies of unemployed people that will be laid off in the financial sector: at brokerages, real estate agencies, insurance companies, not to mention banks.

Concerning the second consequence, it must be stated that the U.S. financial system is bankrupt already: it self-destructed during the long-drawn-out decline of interest rates to zero. This bankruptcy is camouflaged by the wholly misconceived measure of allowing the banks, pension funds and insurance companies to cook their books. They can only balance their books through the trick of overstating the value of their assets and understating the value of their liabilities. The government and the accounting profession are accomplices. Not only do they fail to prosecute violators of the accounting code, they even cheer them on and encourage others to do the same. Worst of all, they set the example. The Fed carries dead assets such as mortgage-backed bonds with no bid and no market at a positive value.

### Revaluation of gold

The nation is lulled into a false sense of security. When the truth dawns on the nation that the American financial system is working without capital (following in the footsteps of the Japanese banks that have been brain-dead for over a decade), the shock will greatly aggravate the crisis. It would be better to let the truth come out now, so that the process of re-industrializing the country and recapitalizing the financial system by an appropriate revaluation of gold could start without delay.

The alternative to the revaluation of gold, seriously suggested by some respectable economists, is a complete debt-jubilee, that is, forgiving any and all dollar-denominated debt, starting with the government debt through mortgages and corporate debt, all the way down to the short-term liabilities of banks, including bank deposits. This is, of course, the ultimate shock-therapy with all the unknown consequences that it may bring with it in its train. Nobody knows how the unfairly dispossessed creditors, including all the pensioners and holders of life insurance policies will react. Nobody knows what the unjustly enriched debtors will do with their godsend, the transfer of unencumbered assets to their possession. Maybe bloodshed in the streets can be avoided. Maybe not. The still unsolved problem of unemployment strongly suggests the latter.

At any rate, why take the risk, when this dormant asset, gold, has been lying around fallow for some forty years and is waiting for rehabilitation. It has the two prerequisite properties that fit the need just like the glove fits the hand: the ultimate extinguisher of debt, and capital indestructible par excellence. With a proper revaluation of monetary gold, much of the existing debt-burden could be alleviated and new productive capital could be accumulated.

I am not suggesting that sufficient wisdom presently resides in the leadership of the world to see this. But as their false remedies will be tried, and one after the other will backfire, the ultimate solution to the crisis, gold-revaluation, would dawn on the world.

Let’s face it: the only reason why this plausible solution to the long-festering problem of runaway debt has not been applied already is sheer envy. Those who saw in gold only a “barbarous relic” would always look with envy at those who saw in gold the ultimate extinguisher of debt and the only indestructible form of capital. They would do everything in their power to deny the latter any benefit of their superior foresight.

### Calendar of Events

Seminar at the Martineum Academy, Szombathely, Hungary, March 25-29, 2010

### Is the Global Financial Crisis Over?

Sponsored by the Gold Standard Institute, with the participation of Darryl Schoon, Rudy Fritsch, Sandeep Jaitly, Peter van Coppenolle, Nathan Narusis, Professor Fekete. Among other topics, there will be a presentation of the latest research on the gold basis, the world’s pension and insurance woes due to the destruction of capital in the financial sector, still unrecocnized by the mainstream, and an exclusive business idea how to turn the ridiculously undervalued “legal tender” gold coins to your advantage.

### For further details, see: [www.professorfekete.com/gsul.asp](https://www.professorfekete.com/gsul.asp)

---

# Front-Running the Fed in the Treasury Market

URL: https://newaustrianeconomics.com/archive/fekete/front-running-the-fed-in-the-treasury-market/
Date: 2010-02-09
Section: Popular Economics
Difficulty: intermediate
Concept Tags: bond-market, federal-reserve, monetary-policy, interest-theory
Description: Fekete examines the practice of front-running the Federal Reserve's bond purchases — buying Treasuries ahead of known Fed buying programs to profit from the artificially elevated prices. He argues this practice, while individually rational, collectively destroys the allocative function of interest rates and accelerates capital destruction.
Editorial Note: Written February 2010. A detailed examination of how the Fed's bond-buying programs create systematic distortions in the Treasury market.
Original PDF: https://professorfekete.com/articles/AEFFrontRunningTheFedInTheTreasuryMarket.pdf

### Front-running the Fed in the Treasury Market

**Antal E. Fekete** · [aefekete@hotmail.com](mailto:aefekete@hotmail.com)

### Introduction

For some nine years I have been predicting that the economy is going to a recession morphing into a depression, using a purely theoretical argument. The essence of my argument is that the open market operations of the Fed cause a protracted decline in interest rates which is responsible for the hard-to-detect capital destruction affecting the financial sector no less than the productive sector. The immediate cause of the depression is the destruction of capital. The ultimate cause is the monetary policy of open market operations. The chain of causation is as follows.

(1) Open market operations (in effect, net purchases of T-bills) by the Fed are predictable.

They invite bond speculators to take risk-free profits offered by this fact of predictability. (2) Bond speculators buy the long-dated Treasurys and sell the short-dated ones, to pocket the difference in yields. These straddles represent borrowing short and lending long. As such, they are inherently risky. However, Quantitative Easing takes the risk out by making the odds, that the normal yield curve will invert, negligible.

(3) The bond speculator faces the problem of having to roll forward the fast-expiring short leg of his straddle by selling T-bills. The extraordinary funding and refunding requirements the Treasury is facing, and the extraordinary pressure on the Fed to increase the money supply combine to make it ultra-easy for the bond speculator to move both the short and the long leg of his straddles as he sees fit.

(4) The upshot is that interest rates keep falling along the entire yield curve. Regardless how many long-dated issues the Treasury offers, bond speculators snap them up even before the ink is dry on them.

Here we have the solution to the Greenspan-conundrum: the sky is the limit to the bond speculators’ appetite for Treasury paper. They are all right as long as they can sell T-bills against them. But as the sky is the limit to the Fed’s appetite for T-bills, both flanks of the speculators are secure.

In my other writings I have explained how a prolonged fall in interest rates along the yield curve brings about depression through the indiscriminate destruction of capital in the productive as well as financial sector.

There is a vicious spiral: the more currency the Fed creates, the more risk-free profits bond speculators will reap, contributing to a further fall of interest rates.

This outcome is the exact opposite of the one predicted by monetarism. The latter predicts that the new money created by the Fed will flow to the commodity market bidding up prices there, to nip depression in the bud. Bernanke & Co. fully expects this to happen. This is not what is happening, however. The new money refuses to flow uphill to the commodity market. It flows downhill to the bond market where the fun is. Why take risks in the commodity market, the speculators ask, when you can gamble risk free in the bond market? So grab the money, buy more bonds and sell an equal amount of bills. As a consequence of bullish bond speculation interest rates fall, prices fall, employment falls, firms fall. The squeeze is on, bankrupting the entire economy.

### Official check-kiting

Some might object that the Fed could short-circuit the process and undercut the bond speculators’ lucrative business. All it has to do is to buy the short-dated paper directly from the Treasury. Inverting the yield curve will shake off the parasites.

My answer is that there is no danger of this happening. The Treasury and the Fed know that bond-vigilantes watch what they are doing like a hawk. Any hanky-panky of direct sales of T-bills by the Treasury to the Fed would make them cry “foul play!” As indeed it would be: direct sale of Treasury paper to the Fed would degrade the dollar from irredeemable currency to fiat currency. There is a subtle difference, realized only by the few.

Fiat currency is worse. Its arbitrary augmenting is decided behind closed doors. It does not need the endorsement of the open market. Fiat currencies have a short life-span as they readily succumb to the sudden-death syndrome. Irredeemable currencies are different from fiat in that they are created openly, using collateral purchased in the open market. They have a more respectable life-span. As long as the official check-kiting conspiracy between the Treasury and the Fed remains hidden from the general public, irredeemable currency may even prosper. Direct sale of T-bills by the Treasury to the Fed would tear down the curtain that hides the fact of check-kiting.

The mechanism of check-kiting is as follows. The Treasury issues debt which it has neither the intention nor the means ever to repay. This debt is used as “backing” for Federal Reserve notes and deposits, which the Fed has neither the intention nor the means ever to redeem. When the Treasury debt matures, it is paid in Federal Reserve credit issued on the collateral security of new Treasury debt. When Federal Reserve credit is presented for redemption, the Fed offers interest-bearing Treasury debt in exchange. This is a shell game and it exhausts the definition of check-kiting. Neither the Treasury debt, nor the Federal Reserve credit is issued in good faith.

Neither is redeemable any more than Charles Ponzi’s tickets were. They are both issued in order to mesmerize a gullible public, much the same way as Ponzi did.

Treasury and Fed officials know their history. They are familiar with the fate of the assignat, the mandat, the Reichsmark, not to mention the Continental. They know that no fiat money ever survived “the slings and arrows of an outrageous fortune”. Their only hope is that the fate of the irredeemable dollar, as predicted by Friedman, would be different. They would not embark upon an adventure in monetary policy involving direct sales of T-bills by the Treasury to the Fed. If they did, surely this would be the end of their experiment. Foreigners as well as Americans would start dumping the dollar unceremoniously, and buy anything they can lay their hands on. This is variously known as flight into real goods, Flucht in die Sachwerte, crack-up boom, Katastrophenhausse. I purposely avoid using the term hyperinflation as it connotes with the Quantity Theory of Money, which is not really a theory. It is a linear model trying to explain nonlinear phenomena.

### Falsecarding by the Fed

There is also a second method by means of which bond speculators are making risk-free profits. They “front-run” the Fed in the bill market. This means that, through inside information or otherwise, they divine when the Fed has to answer “nature’s call” and must make the next trip to the open market in order to buy the collateral without which it cannot issue more money.

Bond speculators forestall the Fed by purchasing the bills beforehand, thus driving up the price. Then they turn around and dump the paper into the lap of the Fed at the enhanced price, making a risk-free profit. This process is called “scalping”, after the kindred activities of small-time speculators in tickets for the World Series and other popular sporting events.

The objection that the Fed knows how to throw bond speculators off scent by various stratagems ― for example, through falsecarding, say, by selling when speculators would expect it to buy ― can be safely dismissed. There is no question that every year the Fed is a big buyer of bills on a net basis. If it sells, it has to buy that much more later on. Fiddling means that the Fed may miss its target. Falsecarding may backfire.

The speculators are a smart lot, thanks to “natural selection” culling the rank and file. They risk their own capital, which they stand to lose if they place the wrong bet. Once their capital is gone they are out, and smarter guys will take over. Hired hands at the Fed are no match for them as far as brightness and adroitness is concerned. The latter work for salaries. If they make the wrong bet, losses will be replenished by dipping into the public purse. Think of the losses the Bank of England suffered at the hand of a lonely bond speculator, one George Soros. The British public was forced to swallow the loss, and Soros was allowed to run with the loot and boast in his book that he has busted the Bank of England single-handedly. Recently Soros said in Davos that he is bearish on gold. In his opinion gold is in a bubble. Of course. He knows that he couldn’t bust the Bank of England again, once it is back on the gold standard!

### Cheating in Las Vegas

My voice has remained a cry in the wilderness. Nobody paid attention to the mumblings of this armchair economist.

My idle theorizing got an unexpected boost from the website Jesse’s Café Américain ([jessescrossroadscafe.blogspot.com](http://jessescrossroadscafe.blogspot.com)). On January 22, 2010, Jesse posted a story with the title Front-Running the Fed in the Treasury Market from which the following quotation is taken.

Attached is some information from a reader. I cannot assess its validity, not being in the bond trading business. But it does sound like someone has tapped into the Fed’s buying plans to monetize the public debt and is front-running those purchases, essentially ‘stealing’ money from the public. It’s what they call a ‘sure thing’. To try and figure out who might be doing it, I would look for some big player who is showing extraordinary returns on their trading, with consistent profit that is not statistically ‘normal’, but is consistently ‘too good’. The problem with cheaters is that they sometimes get greedy and call attention to themselves. In Las Vegas the bigger cheats at the casino were often taken to the desert for further questioning and final disposal. On Wall Street they are more arrogant and persistent, defying resolution with that ultimate defiance, “We’ll just have to figure out other ways to cheat, and come back again”.

### Time for a trip to the desert?

Here are my reader’s observations from the bond market.

“I used to work for a BB on a prop desk until the financial crisis took hold and they fired the less senior guys. I now trade US Treasurys for a small prop firm in xxxxx, to scalp basis trades in most on-the-run securities. Occasionally, I will also take position in the repo markets for off-the-runs if I see something ‘mispriced’. Your recent article piqued my interest because we, too, have noticed ‘shenanigans’ of a sort in the Quantitative Easing program involving US Treasurys.

“What we have noticed, especially in smaller issues like the 7 Year Cash, is that before a Fed buy-back would be announced, the price would pop significantly as if buyers would run through all the offers on the two major electronic exchanges (BGC Espeed and ICAP Broker Tec). This has occurred more than several times as the 7 Year Cash would be overvalued both by its BNOC, by as much as 20-30 ticks, as well as by its value relative to similar off-the-runs. These buyers would lift every offer they could, driving the price substantially above its ‘value’, sometimes for as long as a week at a time. After this buying occurred, the Fed would announce the purchase of that security, sometimes a handle above its approximate value. This ‘luck’ has occurred not just in the on-the-run 7 Year sector, but also in the 30 Year Cash, 3 Year Cash, and in several other off-the-runs. Again, it was especially prevalent in the less liquid Treasury products. Often the ‘appetite’ for these securities would begin two weeks before the official Fed announcement. The buying was wellorchestrated and done in such a way as to throw it out of kilter with the like cash Treasurys and the CME Ten Year Contract. If you examine the charts of some of the selected buy-backs before the official announcement, you will see a similar occurrence.

“While I haven’t broken this down into a paper to prove it (and I see nothing positive coming out of contacting the ESS-EEE-SFE about this issue), I can assure you that it was occurring on a consistent basis across the entire curve. A certain issue would be bid up substantially above market value (as determined by several metrics), only to be gobbled up later by the Fed at an unreasonably high price. These players must have substantial pockets as we, the small guys (but with a decent capital base) would take the other side of what seemed to be an obvious fade. While this did not occur in every issue of the Quantitative Easing program, it occurred often enough to be obvious to any knowledgeable observer.

While I am not sure that this can be attributed to a purposeful Fed policy or someone at the Fed talking to his pals, I am certain that it transpired.”

### Congenital disease of the monetary system

The anonymous correspondent of Jesse is looking for an answer in the wrong direction. Cheating is not necessarily involved. What he has observed need not be a purposeful, if veiled, Fed policy, nor is it necessarily someone at the Fed tipping off his brother-in-law at a brokerage house (however valuable the tip may be).

What we face here is a congenital disease of the irredeemable dollar. Openmarket operations is the tool for the purpose of increasing the money supply through monetizing government debt as needed. It should be recalled that open-market operations by the Fed were illegal according to the Federal Reserve Act of 1913. The original Act looked at the monetization of government debt as an anathema. Illegal open-market operations started in the early 1920’s. They were legalized ex post facto in 1935 by an amendment to the Act, after the gold standard was destroyed by the proclamation of president Roosevelt in 1933. Those who sponsored the amendment were ignorant of what effect open market operations would have on bond speculation. Economists in and out of government and academia were equally ignorant. The financial press also failed to criticize the hare-brained scheme of open market operations making, as it did, profits from bond speculation risk free.

There is no need to look for a conspiracy in the bond market. It is quite possible that a large number of smart speculators, acting spontaneously and independently of one another, have come to realize that there is a bonanza, perfectly legal, in ripping off the public purse. Of course, they kept their own counsel.

If anybody is responsible for this colossal blunder of economics releasing the genie of risk-free speculation out of the bottle, the names that come to mind are those of Keynes and Friedman, resp. They invented, resp., ‘improved’, the system of floating exchange rates assuming a goldless currency that has to be arbitrarily augmented from time-to-time through the monetization of government debt (that, incidentally, proliferated profusely after the politicians deliberately unbalanced the budget upon the explicit advice of Keynes). The rest, as they say, is history.

As long as budget deficits were ‘modest’, the activity of speculators making risk-free profits in the bond market escaped public attention. With the advent of ‘Quantitative Easing’ and mega-deficits, everybody sitting at a bond-trading desk can see it. The figures literally jump off the screen, as explained by Jesse’s blog.

### Recruiting a corps of shills

To be fair to Jesse’s anonymous correspondent I must admit that his conjecture, that in risk-free bond speculation we may be looking at deliberate Fed policy, is plausible. It is not impossible that the rot in the U.S. monetary system has already spread so far that in a truly free and unrigged bond market no bidders would turn up. Time is long since past when Treasurys were eagerly sought after by the most conservative segment of the investing public, such as guardians of widows and orphans, trust funds, eleemosynary institutions. Typically, they held the bonds to maturity. Treasurys, second only to gold, were the most trusted instruments of wealth-preservation.

Under the regime of the irredeemable dollar no investor in his right mind would buy a Treasury bond and hold it till maturity. Treasurys lose value as ice melts in the sunshine. They have become a plaything in the hands of speculators for their value in turning a fast buck. Under the gold standard there was no bond speculation, just as there was no foreign exchange speculation. Interest rates were stable and so were bond prices. Speculators would shun bonds. Of course, all this changed when president Nixon defaulted on the short-term gold obligation of the Treasury to foreigners in 1971, and gold was finally removed from the international monetary system at the behest of the U.S. government.

For a decade speculators were happy with the trading profits they could make in the bond market. But as the monetary system kept deteriorating, they started abandoning bonds, transferring their activities to the commodity market. By 1981 demand for bonds practically evaporated. As this spelled the end of the regime of the irredeemable dollar, the Fed had to do something to prop up the bond market by enticing bond speculators back.

Thus, then, it is quite possible that a decision was made at the highest level to offer the enticement of risk-free profits to bond speculators. It certainly cannot be denied that bond speculators have been making obscene profits in the course of the 30-year bull market in bonds that is still ongoing. These profits are unprecedented in the history of speculation, both on account of their magnitude and their regularity.

They were made at the expense of productive enterprise, the capital of which has been surreptitiously siphoned off by the falling interest-rate structure.

Another way of describing this scenario (assuming it is correct) is that in 1981 the Fed, unknown to the public, decided to recruit a corps of shills to prop up a moribund bond market. The shills hired by the casinos of Las Vegas bet big and win big at the gaming tables in full view of the gamblers who are unaware that they are being treated to a show. The sight of these big payoffs will then perk up the gambling spirit of a lethargic clientele.

The shills recruited by the Fed are the bond speculators, and their remuneration is in the form of risk-free profits they are allowed to make (and keep).

The scheme was a roaring success. Not only did it save the bond market from extinction; it also saved the dollar from ignominy, and was instrumental in making possible a whole string of bubbles, each bigger than the previous one.

### The Road to Hell Is Paved with Good Intentions

The problem is far more serious than it may at first appear. Risk-free speculation is like a computer-virus that has no antidote and threatens to wipe out the Internet.

It short-circuits normal economic processes and gobbles up the world economy.

I would welcome a public debate of my thesis that risk-free bond speculation suppresses the rate of interest and destroys capital in the process. I have challenged neo-classical economists who still consider the open-market operations of the Fed as a ‘refined tool to manage the national economy’. I want them, instead, to see in open-market operations the cancer of the economy responsible for the withering of the world’s prosperity. So far my challenge has fallen upon deaf ears.

Here is the problem. The prevailing orthodoxy is the unholy alliance between Keynesianism and monetarism inspired by Friedman (defying the pretence that these two are antagonistic theories). The idea that an artificial increase in the money supply must raise commodity prices dies hard. But as my theory suggests, and as events have repeatedly shown (first during the Great Depression of the 1930’s, and again, during the present crisis), the presence of risk-free speculation renders the increase in the money supply counter-productive. It causes prices to fall rather than rise.

Giving them the toy of risk-free profits makes speculators vacate the commodity market where risks are too high. They will then congregate in the bond market where risks are non-existent. The speculator who in the absence of risk-free profits might resist falling prices in the commodity market, will decline the honor of pushing the Keynesian agenda if given the choice of risk-free profits in bonds. This is basic human reaction that cannot be criticized, still less rectified, by official browbeating. Keynesians should have thought about the consequences of their masterplan more thoroughly before they put open-market operations into effect.

The intentions of policy-makers at the Fed are praiseworthy. They want to prevent prices and employment from collapsing. But they are prisoners of their orthodoxy, and their good intentions make them steer the economy to the road to hell. A catastrophe is confronting the Titanic, but the captain, just confirmed in his position in spite of a most serious public challenge, will not change his course.

A head-on collision with the iceberg straight ahead, otherwise known as the debttower, now appears inevitable.

### Calendar of Events

Seminar at the Martineum Academy, Szombathely, Hungary, March 25-29, 2010

### Is the Global Financial Crisis Over?

Sponsored by the Gold Standard Institute, with the participation of Sandeep Jaitly, Peter van Coppenolle, Rudy Fritsch, Darryl Schoon, Nathan Narusis, Professor Fekete, and others. Among other topics, there will be a presentation of the latest research on the gold basis, the world’s pension woes, and an exclusive business idea turning the ridiculously undervalued “legal tender gold coins” to your advantage. For further details, see: [www.professorfekete.com](https://www.professorfekete.com)

---

# There Is No Business Like Bond Business

URL: https://newaustrianeconomics.com/archive/fekete/there-is-no-business-like-bond-business/
Date: 2010-01-18
Section: Popular Economics
Difficulty: intermediate
Concept Tags: bond-market, federal-reserve, monetary-policy, capital-destruction, interest-theory
Description: Fekete examines the Federal Reserve's escalating purchases of U.S. Treasury bonds, arguing that the Fed has become the dominant force in the bond market — not through market operations but through outright monetization. This destroys the information content of bond prices and interest rates, making rational capital allocation impossible.
Editorial Note: Written January 2010 as the Fed's quantitative easing program was expanding. The title alludes to the show business maxim, applied to the Fed's now-dominant position in the Treasury market.
Original PDF: https://professorfekete.com/articles/AEFNoBusinessLikeTheBondBusiness.pdf

*There Is No Business Like Bond Business*

### Front-Running the Fed in the Treasury Market

### Antal E. Fekete

### E-mail: aefekete@hotmail.com

### Introduction

For some nine years I have been predicting that the economy is going to a recession morphing into a depression, using a purely theoretical argument. The essence of my argument is that the open market operations of the Fed cause a protracted decline in interest rates which is responsible for the hard-to-detect capital destruction affecting the financial sector no less than the productive sector. The immediate cause of the depression is the destruction of capital. The ultimate cause is the monetary policy of open market operations. The chain of causation is as follows. (1) Open market operations (in effect, net purchases of T-bills) by the Fed are predictable. They invite bond speculators to take risk-free profits offered by this fact of predictability.

(2) Bond speculators buy the long-dated Treasurys and sell the short-dated ones, to pocket the difference in yields. These straddles represent borrowing short and lending long. As such, they are inherently risky. However, Quantitative Easing takes the risk out by making the odds, that the normal yield curve will invert, negligible.

(3) The bond speculator faces the problem of having to roll forward the fastexpiring short leg of his straddle by selling T-bills. The extraordinary funding and refunding requirements the Treasury is facing, and the extraordinary pressure on the Fed to increase the money supply combine to make it ultra-easy for the bond speculator to move both the short and the long leg of his straddles as he sees fit.

(4) The upshot is that interest rates keep falling along the entire yield curve.

Regardless how many long-dated issues the Treasury offers, bond speculators snap them up even before the ink is dry on them.

Here we have the solution to the Greenspan-conundrum: the sky is the limit to the bond speculators’ appetite for Treasury paper. They are all right as long as they can sell T-bills against them. But as the sky is the limit to the Fed’s appetite for T-bills, both flanks of the speculators are secure.

In my other writings I have explained how a prolonged fall in interest rates along the yield curve brings about depression through the indiscriminate destruction of capital in the productive as well as financial sector.

There is a vicious spiral: the more currency the Fed creates, the more riskfree profits bond speculators will reap, contributing to a further fall of interest rates.

This outcome is the exact opposite of the one predicted by monetarism. The latter predicts that the new money created by the Fed will flow to the commodity market bidding up prices there, to nip depression in the bud. Bernanke & Co. fully expects this to happen. This is not what is happening, however. The new money refuses to flow uphill to the commodity market. It flows downhill to the bond market where the fun is. Why take risks in the commodity market, the speculators ask, when you can gamble risk free in the bond market? So grab the money, buy more bonds and sell an equal amount of bills. As a consequence of bullish bond speculation interest rates fall, prices fall, employment falls, firms fall. The squeeze is on, bankrupting the entire economy.

### Official check-kiting

Some might object that the Fed could short-circuit the process and undercut the bond speculators’ lucrative business. All it has to do is to buy the short-dated paper directly from the Treasury. Inverting the yield curve will shake off the parasites.

My answer is that there is no danger of this happening. The Treasury and the Fed know that bond-vigilantes watch what they are doing like a hawk. Any hankypanky of direct sales of T-bills by the Treasury to the Fed would make them cry “foul play!” As indeed it would be: direct sale of Treasury paper to the Fed would degrade the dollar from irredeemable currency to fiat currency. There is a subtle difference, realized only by the few.

Fiat currency is worse. Its arbitrary augmenting is decided behind closed doors. It does not need the endorsement of the open market. Fiat currencies have a short life-span as they readily succumb to the sudden-death syndrome.

Irredeemable currencies are different from fiat in that they are created openly, using collateral purchased in the open market. They have a more respectable life-span. As long as the official check-kiting conspiracy between the Treasury and the Fed remains hidden from the general public, irredeemable currency may even prosper.

Direct sale of T-bills by the Treasury to the Fed would tear down the curtain that hides the fact of check-kiting.

The mechanism of check-kiting is as follows. The Treasury issues debt which it has neither the intention nor the means ever to repay. This debt is used as “backing” for Federal Reserve notes and deposits, which the Fed has neither the intention nor the means ever to redeem. When the Treasury debt matures, it is paid in Federal Reserve credit issued on the collateral security of new Treasury debt.

When Federal Reserve credit is presented for redemption, the Fed offers interestbearing Treasury debt in exchange. This is a shell game and it exhausts the definition of check-kiting. Neither the Treasury debt, nor the Federal Reserve credit is issued in good faith. Neither is redeemable any more than Charles Ponzi’s tickets were. They are both issued in order to mesmerize a gullible public, much the same way as Ponzi did.

Treasury and Fed officials know their history. They are familiar with the fate of the assignat, the mandat, the Reichsmark, not to mention the Continental. They know that no fiat money ever survived “the slings and arrows of an outrageous fortune”. Their only hope is that the fate of the irredeemable dollar, as predicted by Friedman, would be different. They would not embark upon an adventure in monetary policy involving direct sales of T-bills by the Treasury to the Fed. If they did, surely this would be the end of their experiment. Foreigners as well as Americans would start dumping the dollar unceremoniously, and buy anything they can lay their hands on. This is variously known as flight into real goods, Flucht in die Sachwerte, crack-up boom, Katastrophenhausse. I purposely avoid using the term hyperinflation as it connotes with the Quantity Theory of Money, which is not really a theory. It is a linear model trying to explain non-linear phenomena.

### Falsecarding by the Fed

There is also a second method by means of which bond speculators are making risk-free profits. They “front-run” the Fed in the bill market. This means that, through inside information or otherwise, they divine when the Fed has to answer “nature’s call” and must make the next trip to the open market in order to buy the collateral without which it cannot issue more money.

Bond speculators forestall the Fed by purchasing the bills beforehand, thus driving up the price. Then they turn around and dump the paper into the lap of the Fed at the enhanced price, making a risk-free profit. This process is called “scalping”, after the kindred activities of small-time speculators in tickets for the World Series and other popular sporting events.

The objection that the Fed knows how to throw bond speculators off scent by various stratagems ― for example, through falsecarding, say, by selling when speculators would expect it to buy ― can be safely dismissed. There is no question that every year the Fed is a big buyer of bills on a net basis. If it sells, it has to buy that much more later on. Fiddling means that the Fed may miss its target.

Falsecarding may backfire.

The speculators are a smart lot, thanks to “natural selection” culling the rank and file. They risk their own capital, which they stand to lose if they place the wrong bet. Once their capital is gone they are out, and smarter guys will take over.

Hired hands at the Fed are no match for them as far as brightness and adroitness is concerned. The latter work for salaries. If they make the wrong bet, losses will be replenished by dipping into the public purse. Think of the losses the Bank of England suffered at the hand of a lonely bond speculator, one George Soros. The British public was forced to swallow the loss, and Soros was allowed to run with the loot and boast in his book that he has busted the Bank of England singlehandedly. Recently Soros said in Davos that he is bearish on gold. In his opinion gold is in a bubble. Of course. He knows that he couldn’t bust the Bank of England again, once it is back on the gold standard!

### Cheating in Las Vegas

My voice has remained a cry in the wilderness. Nobody paid attention to the mumblings of this armchair economist.

My idle theorizing got an unexpected boost from the website Jesse’s Café Américain ([jessescrossroadscafe.blogspot.com](http://jessescrossroadscafe.blogspot.com)). On January 22, 2010, Jesse posted a story with the title Front-Running the Fed in the Treasury Market from which the following quotation is taken.

Attached is some information from a reader. I cannot assess its validity, not being in the bond trading business. But it does sound like someone has tapped into the Fed’s buying plans to monetize the public debt and is front‐running those purchases, essentially ‘stealing’ money from the public. It’s what they call a ‘sure thing’. To try and figure out who might be doing it, I would look for some big player who is showing extraordinary returns on their trading, with consistent profit that is not statistically ‘normal’, but is consistently ‘too good’. The problem with cheaters is that they sometimes get greedy and call attention to themselves. In Las Vegas the bigger cheats at the casino were often taken to the desert for further questioning and final disposal. On Wall Street they are more arrogant and persistent, defying resolution with that ultimate defiance, “We’ll just have to figure out other ways to cheat, and come back again”.

### Time for a trip to the desert?

Here are my reader’s observations from the bond market.

“I used to work for a BB on a prop desk until the financial crisis took hold and they fired the less senior guys. I now trade US Treasurys for a small prop firm in xxxxx, to scalp basis trades in most on‐the‐run securities. Occasionally, I will also take position in the repo markets for off‐the‐runs if I see something ‘mispriced’. Your recent article piqued my interest because we, too, have noticed ‘shenanigans’ of a sort in the Quantitative Easing program involving US Treasurys. “What we have noticed, especially in smaller issues like the 7 Year Cash, is that before a Fed buy‐back would be announced, the price would pop significantly as if buyers would run through all the offers on the two major electronic exchanges (BGC Espeed and ICAP Broker Tec). This has occurred more than several times as the 7 Year Cash would be overvalued both by its BNOC, by as much as 20‐30 ticks, as well as by its value relative to similar off‐the‐runs. These buyers would lift every offer they could, driving the price substantially above its ‘value’, sometimes for as long as a week at a time. After this buying occurred, the Fed would announce the purchase of that security, sometimes a handle above its approximate value. This ‘luck’ has occurred not just in the on‐the‐run 7 Year sector, but also in the 30 Year Cash, 3 Year Cash, and in several other off‐the‐runs. Again, it was especially prevalent in the less liquid Treasury products. Often the ‘appetite’ for these securities would begin two weeks before the official Fed announcement. The buying was well‐ orchestrated and done in such a way as to throw it out of kilter with the like cash Treasurys and the CME Ten Year Contract. If you examine the charts of some of the selected buy‐backs before the official announcement, you will see a similar occurrence.

“While I haven’t broken this down into a paper to prove it (and I see nothing positive coming out of contacting the ESS‐EEE‐SFE about this issue), I can assure you that it was occurring on a consistent basis across the entire curve. A certain issue would be bid up substantially above market value (as determined by several metrics), only to be gobbled up later by the Fed at an unreasonably high price. These players must have substantial pockets as we, the small guys (but with a decent capital base) would take the other side of what seemed to be an obvious fade. While this did not occur in every issue of the Quantitative Easing program, it occurred often enough to be obvious to any knowledgeable observer.

While I am not sure that this can be attributed to a purposeful Fed policy or someone at the Fed talking to his pals, I am certain that it transpired.”

### Congenital disease of the monetary system

The anonymous correspondent of Jesse is looking for an answer in the wrong direction. Cheating is not necessarily involved. What he has observed need not be a purposeful, if veiled, Fed policy, nor is it necessarily someone at the Fed tipping off his brother-in-law at a brokerage house (however valuable the tip may be).

What we face here is a congenital disease of the irredeemable dollar.

Open-market operations is the tool for the purpose of increasing the money supply through monetizing government debt as needed. It should be recalled that open-market operations by the Fed were illegal according to the Federal Reserve Act of 1913. The original Act looked at the monetization of government debt as an anathema. Illegal open-market operations started in the early 1920’s. They were legalized ex post facto in 1935 by an amendment to the Act, after the gold standard was destroyed by the proclamation of president Roosevelt in 1933. Those who sponsored the amendment were ignorant of what effect open market operations would have on bond speculation. Economists in and out of government and academia were equally ignorant. The financial press also failed to criticize the hare-brained scheme of open market operations making, as it did, profits from bond speculation risk free.

There is no need to look for a conspiracy in the bond market. It is quite possible that a large number of smart speculators, acting spontaneously and independently of one another, have come to realize that there is a bonanza, perfectly legal, in ripping off the public purse. Of course, they kept their own counsel.

If anybody is responsible for this colossal blunder of economics releasing the genie of risk-free speculation out of the bottle, the names that come to mind are those of Keynes and Friedman, resp. They invented, resp., ‘improved’, the system of floating exchange rates assuming a goldless currency that has to be arbitrarily augmented from time-to-time through the monetization of government debt (that, incidentally, proliferated profusely after the politicians deliberately unbalanced the budget upon the explicit advice of Keynes). The rest, as they say, is history.

As long as budget deficits were ‘modest’, the activity of speculators making risk-free profits in the bond market escaped public attention. With the advent of ‘Quantitative Easing’ and mega-deficits, everybody sitting at a bond-trading desk can see it. The figures literally jump off the screen, as explained by Jesse’s blog.

### Recruiting a corps of shills

To be fair to Jesse’s anonymous correspondent I must admit that his conjecture, that in risk-free bond speculation we may be looking at deliberate Fed policy, is plausible. It is not impossible that the rot in the U.S. monetary system has already spread so far that in a truly free and unrigged bond market no bidders would turn up. Time is long since past when Treasurys were eagerly sought after by the most conservative segment of the investing public, such as guardians of widows and orphans, trust funds, eleemosynary institutions. Typically, they held the bonds to maturity. Treasurys, second only to gold, were the most trusted instruments of wealth-preservation.

Under the regime of the irredeemable dollar no investor in his right mind would buy a Treasury bond and hold it till maturity. Treasurys lose value as ice melts in the sunshine. They have become a plaything in the hands of speculators for their value in turning a fast buck. Under the gold standard there was no bond speculation, just as there was no foreign exchange speculation.

Interest rates were stable and so were bond prices. Speculators would shun bonds. Of course, all this changed when president Nixon defaulted on the short-term gold obligation of the Treasury to foreigners in 1971, and gold was finally removed from the international monetary system at the behest of the U.S. government.

For a decade speculators were happy with the trading profits they could make in the bond market. But as the monetary system kept deteriorating, they started abandoning bonds, transferring their activities to the commodity market. By 1981 demand for bonds practically evaporated. As this spelled the end of the regime of the irredeemable dollar, the Fed had to do something to prop up the bond market by enticing bond speculators back.

Thus, then, it is quite possible that a decision was made at the highest level to offer the enticement of risk-free profits to bond speculators. It certainly cannot be denied that bond speculators have been making obscene profits in the course of the 30-year bull market in bonds that is still ongoing. These profits are unprecedented in the history of speculation, both on account of their magnitude and their regularity. They were made at the expense of productive enterprise, the capital of which has been surreptitiously siphoned off by the falling interest-rate structure.

Another way of describing this scenario (assuming it is correct) is that in 1981 the Fed, unknown to the public, decided to recruit a corps of shills to prop up a moribund bond market. The shills hired by the casinos of Las Vegas bet big and win big at the gaming tables in full view of the gamblers who are unaware that they are being treated to a show. The sight of these big payoffs will then perk up the gambling spirit of a lethargic clientele.

The shills recruited by the Fed are the bond speculators, and their remuneration is in the form of risk-free profits they are allowed to make (and keep). The scheme was a roaring success. Not only did it save the bond market from extinction; it also saved the dollar from ignominy, and was instrumental in making possible a whole string of bubbles, each bigger than the previous one.

### The Road to Hell Is Paved with Good Intentions

The problem is far more serious than it may at first appear. Risk-free speculation is like a computer-virus that has no antidote and threatens to wipe out the Internet. It short-circuits normal economic processes and gobbles up the world economy.

I would welcome a public debate of my thesis that risk-free bond speculation suppresses the rate of interest and destroys capital in the process. I have challenged neo-classical economists who still consider the open-market operations of the Fed as a ‘refined tool to manage the national economy’. I want them, instead, to see in open-market operations the cancer of the economy responsible for the withering of the world’s prosperity. So far my challenge has fallen upon deaf ears.

Here is the problem. The prevailing orthodoxy is the unholy alliance between Keynesianism and monetarism inspired by Friedman (defying the pretence that these two are antagonistic theories). The idea that an artificial increase in the money supply must raise commodity prices dies hard. But as my theory suggests, and as events have repeatedly shown (first during the Great Depression of the 1930’s, and again, during the present crisis), the presence of risk-free speculation renders the increase in the money supply counter-productive. It causes prices to fall rather than rise.

Giving them the toy of risk-free profits makes speculators vacate the commodity market where risks are too high. They will then congregate in the bond market where risks are non-existent. The speculator who in the absence of risk-free profits might resist falling prices in the commodity market, will decline the honor of pushing the Keynesian agenda if given the choice of riskfree profits in bonds. This is basic human reaction that cannot be criticized, still less rectified, by official brow-beating. Keynesians should have thought about the consequences of their master-plan more thoroughly before they put open-market operations into effect.

The intentions of policy-makers at the Fed are praiseworthy. They want to prevent prices and employment from collapsing. But they are prisoners of their orthodoxy, and their good intentions make them steer the economy to the road to hell. A catastrophe is confronting the Titanic, but the captain, just confirmed in his position in spite of a most serious public challenge, will not change his course.

A head-on collision with the iceberg straight ahead, otherwise known as the debt-tower, now appears inevitable.

### Calendar of Events

Seminar at the Martineum Academy, Szombathely, Hungary, March 25-29, 2010 Is the Global Financial Crisis Over?

Sponsored by the Gold Standard Institute, with the participation of Sandeep Jaitly, Peter van Coppenolle, Rudy Fritsch, Darryl Schoon, Nathan Narusis, Professor Fekete, and others. Among other topics, there will be a presentation of the latest research on the gold basis, the world’s pension woes, and an exclusive business idea turning the ridiculously undervalued “legal tender gold coins” to your advantage. For further details, see: [www.professorfekete.com](https://www.professorfekete.com)

---

# Economic Aspects of the Pension Problem, Part Two

URL: https://newaustrianeconomics.com/archive/fekete/economic-aspects-of-the-pension-problem-part-two/
Date: 2010-01-04
Section: Popular Economics
Difficulty: intermediate
Concept Tags: interest-theory, capital-destruction, federal-reserve, gold-standard, debt
Description: Part two examines the consequences of the pension crisis: underfunded pensions force companies to reduce investment, cutting productive capacity, which further reduces the economy's ability to fund future obligations. Fekete argues this negative spiral is inherent to the fiat money regime and can only be broken by restoring sound money.
Editorial Note: Written January 2010. The pension problem analysis connects Fekete's abstract monetary theory to a concrete and widely-felt economic consequence.
Original PDF: https://professorfekete.com/articles/AEFPension2x.pdf

In Part One I discussed the clear and present danger to pension rights: deflation as manifested by the interest rates structure that has been falling for thirty years, while most observers think that the real danger is inflation. In this second part I carry out a deeper analysis of the pension problem, looking at the marginal productivity of labor and capital and its relevance to the theory of interest.

### Higher marginal productivity: boon or bane?

There is a lot of loose talk about productivity. Paul Krugman is expecting miracles to start happening after an increase in a mythical productivity, provided that government spending is increased to the level matching or exceeding that during World War II.

However, as Mises pointed out, productivity is a vacuous concept unless its meaning is fixed, such as that of marginal productivity of labor. Then, and only then, can one state the pension problem. According to Mises, the only means to increase permanently the wages and benefits payable to workers is to increase the per capita quota of capital invested in the methods of production, thereby raising the marginal productivity of labor. (See References, Planning for Freedom, p 6.) This is certainly true so far as it goes. It is also true that, if we project this observation to the world at large, then we can conclude that in order to have a progressive world economy and receding poverty, global capital accumulation must accelerate relative to increase in population. The greater the quantity and the better the quality of tools, the greater will be the output of the marginal worker, that is, the greater will be the marginal productivity of labor.

In reading Mises one may get the impression that an increase in marginal productivity is always beneficial to society ― as indeed it would have been under the conditions he envisaged. However, in the case of a monetary system that admits both large swings and prolonged slides in interest rates, this is no longer true. If the matter were simply increasing marginal productivity, monetary policy would be a valid means of “turning the stone into bread”. All it would take is central bank action to keep raising the rate of interest indefinitely. This would force the marginal producer whose capital produces at the marginal rate of productivity to fold tent.

His marginal equipment and plants would be idled. His workers producing, as they are, at the marginal rate of productivity of labor would be laid off. Marginal productivity would increase. Indeed, the marginal productivity of both capital and labor automatically rises as a consequence of a rise in the rate of interest.

However, in this case the rise in productivity, far from being a boon, is a bane to society, as it makes output and employment shrink. The trick is precisely to make marginal productivity rise along with rising output and employment.

### Gold standard: a safeguard against deflation

No one is asking the question how it is possible that an increase in marginal productivity could be beneficial in one instance, and harmful in another. The point is that the gold standard is an absolute prerequisite for a rise in marginal productivity to be beneficial to society. Only the gold standard can prevent wholesale capital consumption. Only the gold standard can provide the necessary background of stable interest rates. This brings the symbiosis between the pension funds and the gold standard into a sharp focus. An increase in population growth rates, whenever it may occur, will soon enough cause an acceleration of capital accumulation due to an increase in the demand for pension rights. The new capital thus created must be put to work in an optimal way.

Without the proviso on stable interest rates that can only be guaranteed by a gold standard it is possible that increasing marginal productivity may lead to diminishing of output and employment, that is to say, to deflation. The gold standard, contrary to the propaganda of its detractors, is the chief guarantor that deflation will not occur while marginal productivity keeps increasing ― assuming that private pension funds provide fully funded plans for the benefit of prospective pensioners. Only investments in further improvements of production methods can guarantee that future pensions can be paid when they fall due.

The essence of deflation could be described by saying that the marginal productivity of capital and labor is increased through idling the marginal material factors of production and laying off the workers who operate them, but without adding new factors and workers. Output falls, employment falls, prices fall, firms fail.

### Thesis, anti-thesis, synthesis

Mises built his theory of interest exclusively on his thesis of time preference. He categorically rejected the anti-thesis asserting that productivity of capital may also have something to do with the rate of interest. The fact is that a synthesis between the two competing and seemingly antagonistic positions is possible, as I have shown in my lectures developing my own theory of interest that extends Carl Menger’s idea of distinguishing between the asked and bid price from the commodity to the bond market.

I start by defining the rate of interest as that rate at which the coupons plus the redemption of face value upon maturity will amortize the market price of the gold bond. As the market price could well be higher or lower than face value, the actual rate of interest could be lower or higher than the coupon rate. It is important to note that the prevailing rate of interest and the market price of the bond are inversely related. Only in the statistically rare event when the market price of the bond coincides with its face value will the rate of interest be equal to the coupon rate.

With Menger’s insight we realize that the market produces not one but in fact two prices for the gold bond: a higher asked price and a lower bid price.

Transactions take place at prices between these two extremes. This means that the actual rate of interest varies between a floor and a ceiling, and vary it does inversely with the bond price. Because of this inverse relationship the asked price corresponds to the floor, and the bid price to the ceiling of the range for the rate of interest.

### Floor and ceiling

My theory of interest asserts that the floor for the rate of interest is determined by marginal time preference, i.e., time preference of the marginal bondholder. The rate of interest could not fall through the floor: it would be resisted by bondholders selling their bonds (a future good) and keep the proceeds in gold (a present good) — having a buoyant effect on the rate of interest.

The ceiling, in turn, is determined by the marginal productivity of capital, i.e., the productivity of the marginal producer. The rate of interest could not go through the ceiling either, as it would be resisted by producers selling capital goods and put the proceeds into the higher-yielding gold bonds — having a dampening effect on the rate of interest.

It is readily seen that the floor and the ceiling for the rate of interest are conceptually different. They are subject to different forces, acting independently of one another. In more detail, the floor is determined by the arbitrage of the marginal bondholder between the bond market and the gold market according to marginal time preference. By contrast, the ceiling is determined by the arbitrage of the marginal producer between the capital goods market and the bond market according to the marginal productivity of capital.

Mises passed over in silence these instances of arbitrage. In particular, he missed the arbitrage of the marginal producer who in selling his capital goods and buying the bonds of his more productive colleagues whenever interest rates rise and, conversely, selling the bonds at a profit and redeploying his capital goods when interest rates fall, provides a clearest example of manifestation of human action. This action plays a fundamental role in the market process determining the rate of interest. It is “the missing blade of the scissor” (the other blade is the action of the marginal bondholder) without which there is no cutting. As this analysis shows, there is an interaction between changes in the marginal productivity of capital and the rate of interest ― something Mises vehemently denied when he dismissed all productivity considerations from his theory of interest. I had to go back to Menger for inspiration to make repairs for the distortion. My theory of the origin of interest is motivated by Carl Menger’s theory of the origin of money.

### Is there life after Mises?

I am an admirer of Mises who unquestionably made a great contribution to economic thought. After Menger, he will in all probability prove to have been the greatest economist of the 20th century. But Mises was a modest man and never took the view that his own word should be taken as dogma. He would have been made uncomfortable by those disciples of his who effectively frown upon further economic research by treating his work as the last word, and who automatically censor anyone who proposes a different or a more refined view. No branch of human knowledge can advance under such circumstances.

I have always considered it my duty to point out errors, whoever committed them and whatever the consequences of my criticism were. This attitude on my part is in fact completely uncontentious ― it is motivated solely by the desire to advance knowledge “without fear or favor”. It is unfortunate that, when my comments involve something Mises has said, I am the object of abuse, namecalling, and personal attacks by those who seem to want to preserve the work of Mises frozen in time ― rather than something that serves as a basis for debate and further research. I can do no better than quoting Mises himself:

Calling names is quite out of place if the accuser is not in the position to demonstrate clearly in what the deficiency of the smeared author’s doctrine consists. The only thing that matters is whether a doctrine is sound or unsound. This is to be established by facts and deductive reasoning. If no tenable arguments can be advanced to invalidate a theory, it does not in the least detract from its correctness if the author is called names… Those who call authors with whom they disagree names merely confess their inability to discover any fault in their adversaries’ theories.

### Marginal productivity of labor

In Human Action Mises does not treat marginal productivity. There is one sentence on the marginal productivity of labor in the essay Planning for Freedom. I have quoted that sentence above. More can be found on this subject in his The AntiCapitalistic Mentality (see References).

Following Mises I define the marginal productivity of labor to be the change in net output upon the elimination of the marginal worker from the labor force. A worker is marginal if his contribution to net output is smaller (at any rate, no greater) than that of any other worker. It is that worker whose job has become redundant, is no longer justified on grounds of productivity, and will be terminated by the producer at the first opportunity. (In his original definition Mises did not qualify the noun “worker” with the adjective “marginal”. This would appear to leave the concept of marginal productivity of labor ambiguous.)

It is important to distinguish between two distinct possibilities of increasing marginal productivity of labor, and to analyze the difference. Marginal productivity may increase when workers reaching retirement age are replaced by newly trained workers aided by newer, better tools. The new marginal worker produces more than the recently retired marginal worker. The marginal productivity of labor has increased. Mark that total output, and possibly employment has also increased. We may call this the case of a progressive increase in the marginal productivity of labor.

The other possibility is very different. Here the marginal worker has been laid off without replacement. The next more productive worker at the lower end of the productivity spectrum, who is in employment already, is promoted to the position of being the marginal worker. There is no improvement in tools and production methods, only a shift of the margin from less to more productive labor.

As a result, both output and employment shrink. We may call this the case of a retrogressive increase in the marginal productivity of labor. As an example to show how this might happen, consider an increase in the rate of interest. It will turn marginal workers into submarginal ones, earmarking them for layoff, thereby increasing marginal productivity but decreasing total output and employment.

The difference between the progressive and retrogressive increase in the marginal productivity of labor can also be seen in relation to capital. In the progressive case there is capital accumulation. Newly perfected tools or production methods are introduced as freshly trained workers are employed. This is a dynamic change that cannot help but increase total output, and possibly employment, too. In the retrogressive case the change has increased marginal productivity at the expense of employment and, more seriously, there is capital decumulation. Material factors, still serviceable, are phased out of production along with the elimination of marginal workers. No new factors of production are introduced, only the attrition of workers and their obsolescent tools is stepped up.

### Marginal productivity of capital

Apparently nowhere in his published works did Mises define the concept of marginal productivity of capital formally (although he refers to it in Human Action and also in The Anti-Capitalistic Mentality). Presumably he shied away from developing this aspect of the theory because it would quickly reveal that a position according to which productivity has nothing to do with the rate of interest is untenable.

I define the marginal productivity of capital as the change in net output which occurs when a unit value (say, \$10,000 worth) of marginal material factor is withdrawn from production. A material factor of production is marginal if its contribution to net output is smaller (at any rate, no greater) than that of any other of the same value. It is that piece of equipment or plant that the producer will discard or have idled first ― because it is insufficiently productive ― at which time another piece of equipment or plant with a higher productivity takes its place (quite possibly at another firm).

Again, it is important to distinguish between two distinct scenarios in which the marginal productivity of capital can increase, and to analyze the difference. In the first scenario the producer plays an active role. In making investments to improve tools and methods of production he aims at producing a greater amount and better quality of goods than before. There is a dynamic shift from the less to the more productive through reshuffling workers and tools. Whether the removal of a marginal piece of equipment or plant simply means reassigning it to a new task, or whether it means scrapping and replacing it with brand new material factors, makes no difference. In neither case is there a contraction of output or employment; there might well be an increase. We may call this the case of a progressive increase in the marginal productivity of capital.

The other scenario is again very different. Here the producer plays a passive role. He responds to forces outside of his control. He leaves marginal material factors of production idle. He lays off workers who have been operating the nowidled tools in the now-idled plants. Marginal productivity increases solely on the strength of a shift to another marginal material factor that is already in service.

There is no improvement in tools and production methods per se. As a result of the shift of the margin from the less to the more productive, marginal tools and plants are rendered submarginal. Both output and employment shrink. We may call this the case of a retrogressive increase in the marginal productivity of capital.

Typically it occurs whenever the rate of interest rises.

It is important to look at the reaction of the marginal producer in response to an increase in the rate of interest. He will sell his idle equipment or plant (or at least will stop maintaining them) and buys bonds with the proceeds. This will allow him to participate in the earnings of other producers whose material factors produce at a higher rate of productivity than that of his own. When the rate of interest subsequently declines, the marginal entrepreneur will sell his bonds. Indeed, he has an incentive to do so: he can sell them at a profit and he can now redeploy his capital more profitably if he buys new material factors with the proceeds. As the rate of interest has come down, he can now successfully compete with other producers.

This is arbitrage between the capital goods market and the bond market. It reveals that marginal productivity of capital sets the ceiling to the range within which the rate of interest may vary. The arbitrage of the marginal producer between the market for material factors of production and the bond market is a most important instance of human action, one that promotes not only the stability of interest rates, but also helps renew society’s park of capital goods. Along with the analogous arbitrage of the marginal bondholder between the bond market and the gold market, these two instances of human action are indispensable for the understanding of the market process responsible for the formation of the rate of interest. It goes without saying that both have a bearing upon the pension problem.

### Relation between the marginal productivity of capital and labor

The first interesting question that arises in connection with the pension problem is the relation between the two marginal productivities: that of capital and labor. The observation, made by Mises, that improvement in the marginal productivity of capital must precede and exceed that of labor, is justified by the necessity to create the funds needed to improve the quality of life of working people. This is why the health of the pension plans has such an utmost importance. The first impetus in the long chain of improvements from the marginal productivity of capital, through the marginal productivity of labor, through the improvement in wages to the improvement of pensions must come from the pension funds themselves. If they are healthy (meaning fully funded), then they will serve as the source from which the capitalist borrows the funds lending them to the entrepreneur, who will invest them either in more tools, or in research leading to new production methods.

The second question is how to allocate the available new capital between simply purchasing more tools, or investing it in research and development (R&D) to devise improved production methods. Further analysis will show how the allocation problem is solved by the market. Clearly, it cannot be solved at the level of the shop-floor, nor even at the level of the executive board-room. The decision must be made at the level of the pension funds themselves, taking into account demographic movements such as net changes in the number of pensioners relative to the number of workers contributing to pension plans. In other words, we must compare the number of old workers entering the rank of pensioners, who stop contributing to pension funds and start drawing pensions, to the number of new workers entering the labor force and start contributing to pension funds.

I have treated this allocation problem at length in my other writings, through graduating from a simple diagonal model of the capital market involving two participants (the supplier and the user of capital, a model I consider hopelessly inadequate) to what I call the square, pentagonal, and hexagonal models of the capital market. I shall not pause here to repeat the evolution of these models. Let it suffice to look at the hexagonal model of the market for capital goods involving six participants: the annuitant, the annuitand, the entrepreneur, the inventor, the capitalist and, finally, the investment banker (see References).

If the balance between the annuitands and annuitants changes in favor of the latter (otherwise expressed, there is a demographic shift increasing the number of pensioners relative to the number of new entrants to the labor force, decreasing the demand for pension rights), then more funds will be allocated to entrepreneurs to acquire more or better tools, and less to the inventors working on improved production methods. This is so because production of consumer goods must increase immediately to cover the needs of the increasing retired population, while the increase in the marginal productivity of capital can wait.

Conversely, if the balance between the annuitands and annuitants changes in favor of the former (there is a demographic shift increasing the number of new entrants to the labor force relative to the number of new pensioners, increasing the demand for pension rights), then more funds will be allocated to inventors to work on improvements of production methods, and less to entrepreneurs to upgrade their park of material factors of production. This is so because the priority now is to prepare for a future increase in the marginal productivity of capital. The future pension payouts to workers who are just entering the labor force must be met when they will be ready to take retirement. There is no pressing problem to increase the production of consumer goods immediately, because the younger workers will tend to save more in the form of pension contributions or otherwise and, accordingly, will have less free-spending cash available.

The point is that the market will always find the “optimal mix” of allocating funds between entrepreneurial and R&D capital to fit the given demographic data, provided that it can operate freely, and the central bank is constitutionally barred from “regulating” the rate of interest, and the government refrains from setting up compulsory “pay-as-you-go” pension schemes. The optimal solution of society’s pension problem furnishes the strongest arguments against the so-called welfare state and the so-called compensatory monetary and fiscal policy of the government.

### Mises: happy warrior combatting inflation

The strength of Mises is in his unflagging criticism of inflationism. This is all very well. However, many important things have happened since his death showing that governments and central banks under the regime of irredeemable currency can inadvertently and unwittingly cause deflation, even as they avowedly want to pursue inflationary policies. The effect of this is the blurring of a clear line between inflationism and deflationism. They are subsumed under the heading of government and central bank ineptitude.

Austrian scholars seem to be completely unprepared for this development.

They keep parroting the anti-inflation message of Mises when the danger is deflation (more precisely, deflation now, hyper-inflation later; perhaps much later).

Mises treats deflation in an off-hand fashion, as if it was merely a side-effect of previous inflation (credit expansion). This hardly does justice to the problem. We now know that deflation under the regime of irredeemable currency is a great problem of economics in its own right. For example, Mises deals with the perennial effort of the government and the banks to suppress the rate of interest, if need be all the way to zero, only as a manifestation of their inflationary propensities. However, a prolonged decline in interest rates is not necessarily inflationary per se under the regime of irredeemable currency. On the contrary, it can be highly deflationary on account of being the cause of wholesale destruction of capital accumulated earlier when the rate of interest was higher. Still more serious is ignoring the possibility that the government and banking system may succeed in pushing the rate of interest down all the way to zero without actually triggering hyperinflation, and in doing so unwittingly causing deflation. Declining interest rates are responsible for the hardto-detect erosion — ultimately destruction — of capital that is plaguing the world economy right now.

Incidentally, the same argument about the artificial suppression of the rate of interest furnishes a major part of the real explanation for the Great Depression of the 1930’s. By sabotaging the gold standard the governments allowed bond speculators to bid bond prices sky high, thus driving interest rates down to unprecedented lows. A monopoly situation for government bonds was created by removing their only competitor: gold. The marginal bondholder’s only weapon, gold, to protest uneconomically low and falling interest rates was forcibly (and unconstitutionally) taken away from him. His arbitrage between the bond market and the gold market was frustrated. The stealthy and illegal introduction of open market operations of the central bank, making bond speculation risk-free, aggravated the problem of capital destruction even more.

In the same order of ideas I also mention that in the public mind the deliberate wrecking of the gold standard by the government is firmly associated with inflation, to which it has undoubtedly given rise especially since 1971, the year when the U.S. defaulted on its international gold obligations. But as a more detailed analysis shows, the absence of gold standard could also cause deflation through making interest rates fall, namely, by rendering bullish bond speculation risk-free. The Austrian school has so far failed to study this important fact, even though this is the best argument to show that the pension problem cannot be satisfactorily solved without fully rehabilitating the gold standard.

I hope that my contribution to the vexing problems of the theory of interest will help to end the century-old fratricidal war between the time preference and the productivity schools. I also hope that my thesis, that the regime of falling (as distinct from low) interest rates (now entering its fourth decade) causes capital destruction, deflation, and depression will be exhaustively debated and the alarm will be sounded, in order to save the pension funds from extinction, and society at large from excruciating economic pain. Finally, I hope that the day is getting closer when a new Austrian theory of interest is universally recognized — just as the Austrian subjective theory of value, superseding Adam Smith’s cost-based theory already is.

---

*January 9, 2010*

Revised: March 2, 2011.

### References

Planning for Freedom, by Ludwig von Mises, Third (Memorial) Edition,

Libertarian Press, South Holland (Ill.), 1974; pp. 6, 152. In the same volume the February 23, 1950, article from The Commercial and Financial Chronicle of the same title is reproduced, see p 83 ff.

The Anti-Capitalistic Mentality, by Ludwig von Mises, Libertarian Press,

South Holland (Ill.), 1981, p 86-89.

The Tenth Pillar of Sound Money and Credit:The Principle of the Marginal Productivity of Capital and Labor, by A. E. Fekete (written in 1885), see:

### September, 2005, [www.professorfekete.com](https://www.professorfekete.com)

The Nature and Sources of Interest, by A. E. Fekete, January 1, 2003, ibid.

The Pentagonal Model of Capital Markets. The Hexagonal Model of Capital Markets, by A. E. Fekete, February 1, 2004; March 2, 2004, ibid.

Economic Aspects of the Pension Problem, by A. E. Fekete, January 3, 2010, ibid.

---

# Economic Aspects of the Pension Problem, Part One

URL: https://newaustrianeconomics.com/archive/fekete/economic-aspects-of-the-pension-problem-part-one/
Date: 2010-01-03
Section: Popular Economics
Difficulty: intermediate
Concept Tags: interest-theory, capital-destruction, federal-reserve, gold-standard, monetary-policy
Description: Fekete revisits his analysis of the pension crisis sixty years on, examining how the Federal Reserve's suppression of interest rates has made defined-benefit pension obligations mathematically unfundable. Part one traces the origins of the problem in the destruction of the gold standard and the Real Bills market.
Editorial Note: Written January 2010. Fekete applies his interest-rate and capital-destruction framework to the specific problem of pension fund insolvency, arguing the crisis is not a failure of actuarial science but of monetary policy.
Original PDF: https://professorfekete.com/articles/AEFPension1x.pdf

Sixty years ago, in 1950, Ludwig von Mises published an article with the above title. He pointed to inflation as the greatest threat to pension rights. Today an additional threat is looming large on the horizon: the threat of deflation, and a new examination of the pension problem is timely.

### Deliberate Dollar Debasement

In 1950 Mises looked at the pension problem from the point of view of the shrinking purchasing power of the dollar, a consequence of what he called the deliberate policy of currency debasement by the U.S. government. In 1950 a pension of \$100 per month was a substantial allowance, he noted. Shelter could be rented for a month for less than \$30 in most parts of the country. (In 2010, \$100 hardly buys one night’s stay at a decent hotel.) In 1950 the Welfare Commissioner of the City of New York reported that 52 cents would buy all the food a person needed to meet his daily caloric and protein requirements. (In 2010, \$100 barely buys a cup of coffee and a muffin for every day of the month.)

Of course, currency debasement does far more damage than simply eroding the purchasing power of pensions. As Mises observed, it also leads to the insufficiency of capital accumulation. Companies report phantom profits that mask losses, since depreciation quotas understate the wear and tear of productive equipment. Savings are hardly adequate to pay for capital maintenance, let alone new capital or technological improvements in production — the only source from which pensions to an increasing labor force can be paid. When young workers who now join the labor force are ready to retire, the necessary funds to pay their pensions will simply not be available.

### Capital destruction due to declining interest rates

I have written extensively about the proposition, one that mainstream economists doggedly refuse to discuss, that a falling interest-rate structure has a deleterious effect on accumulated capital. Capital is destroyed across the board simultaneously and stealthily. By the time the damage is discovered, it is too late to do anything about it and firms go bankrupt in droves. The falling trend of interest rates is the unrecognized cause of the depression that is presently devastating the world economy — just as it also was 80 years ago. Nowhere is the erosion of capital caused by falling interest rates is more obvious than in the case of the capital of the pension funds. They must earn adequate return on their investments, but a falling rate of interest frustrates this effort. At the lower rate the original schedule of capital accumulation cannot be met.

Those who disagree argue that if the present value of a future stream of payments is lower when discounted at a higher rate, then it must be higher when discounted at a lower rate. Thus the steady future receipts of a pension fund from payroll contributions will have a higher value under a regime of falling interest rates. There is no need to argue this point. It is clear that the fund must be around to be able to collect future contributions enhanced by a fall in interest rates. Many of them won’t be, as they will have succumbed to capital squeeze caused by the very fall of the interest rate that is supposed to be their savior. At any rate, rules of sound accounting do not allow pension funds to treat expected future payroll contributions as if they were cash payments in the process of clearing.

My correspondent Bruce Brafman of Prophet without Profit comments that pension law requires the use of the lowest interest rate whenever an employee cashes out in a lump, as a lot of them in corporate America do. This is devastating for the pension fund because it inflates the size of the lump sum payment. The fund is relieved from the obligation to pay the pension, the present value of which has increased by virtue of a decrease in the rate of interest. The law wants the pensioner to benefit from the lower interest rate, rather than the fund. This is reasonable and justified when the interest-rate structure is stable, but will kill the pension funds under the present zero-interest policy of the Fed.

The repercussions for society are devastating. Just as the aging segment of population in the industrialized countries becomes vitally dependent on its pension income, the falling rate of interest undermines the pension plans. In many cases the money to pay out pensions won’t be there. For the rest, payout reductions will be inevitable. Defined-benefit pension plans will have to be discontinued. Of course, the problem is even more acute in the case of unfunded pension plans such as Social Security, the pension plan of the military, or that of the civil service of the federal, state, and municipal governments. Under many of these plans contributions of the active members directly pay the pensions of the retired ones.

Such plans exhaust the definition of a Ponzi scheme. The moment the civil service is forced to retrench, its pension plan becomes insolvent.

### The Great Milch-Cow

When a large segment of the population is facing a drastic cut in income, and since most retired people have no alternative and cannot augment their diminished pension with income from other sources, consumption falls back and lower demand will have further deflationary consequences on the economy. Yet this problem, just as the kindred problem of the erosion of the capital of productive enterprise, is ignored by the profession of economists and that of the accountants.

They apparently believe that the Great Milch-Cow, the government, will always be there and able to cover any shortfall.

My correspondent Bruce Brafman points out that companies may be hit with the cost of covering the shortfall. In that case there is a “doom loop”: mandatory increases in pension contributions from the employer will reduce company earnings, which will reduce the stock price, and that will exacerbate the pension funding crisis as equity investments decline. This could also encourage potentially fatal excessive risk-taking behavior. The bottom line is that the zero-interest policy of Bernanke is, to put it mildly, counter-productive; to put it a little more strongly, it is insane.

The decades-long slide of interest rates is far from over. As I argued in my other articles, large-scale monetization of government debt in the wake of every new bail-out plan and stimulus-package is going to impart a falling (rather than a rising) trend to the interest rate structure, due to the opportunity it creates for riskfree profits. Bond speculators ambush the Federal Reserve on its periodic trips to the bond market to make its regular open market purchases of government bonds in order to increase the money supply. They buy the bonds beforehand in order to dump them into the lap of the Federal Reserve afterwards at the enhanced price.

They pocket the difference. These risk-free profits explain a large part of the present deflation: rising bond prices as well as falling commodity, real estate and stock prices. The new money that the Federal Reserve has created through its open market purchases will not flow to the commodity, real estate, or equity markets as hoped by the policy-makers. It will stay in the bond market where risks are the smallest, and will be financing further bullish bond speculation. The ultimate result will be a further fall in the rate of interest, exposing the pension funds to even greater dangers.

Note that these dangers are in addition to the threat to the value of pensions undermined by past inflation, about which Mises was warning sixty years ago. It could be further undermined in case the reckless increase in government debt scared bond speculators and other investors, including foreign holders of the debt of the U.S., for example, the Chinese government. Should they start a stampede out of bonds, they would push interest rates and commodity prices to much higher levels.

Pensions are doomed whatever the government does. Whether interest rates go up or whether they go further down, the pensions are at risk. In the case of rising interest rates their value will be decimated. In the case of falling interest rates pension contributions will not be able to earn a return necessary to accumulate the capital needed in order to pay defined-benefit pensions in the future.

### The relevance of the gold standard to the pension problem

As we can see, at the heart of the problem is the destabilization of the rate of interest due, first, to sabotaging and, then, to destroying the gold standard by the government. There is no known way to stabilize interest rates but by defining the value of the unit of currency as a fixed quantity and fineness of gold. In this way the amount owing on deferred payments will be fixed. Any breach of promise of deferred payments will be immediately obvious as soon as it occurs. The difference is this, and a very important difference it is: a promise to make future payments in irredeemable currency is a meaningless promise, because breaching it can be ― and will be ― camouflaged in many different ways. This spells catastrophe. The retired segment of the population will be plunged into penury. The only way to avoid this is to stabilize the rate of interest through the rehabilitation of the gold standard with all deliberate speed.

A fall in the rate of interest has a direct effect of decreasing the return to capital of the pension funds. This decrease should be compensated for by increasing payroll deductions. It is clear that this is never done. What is not clear is whether the reason for this omission is ignorance on the part of the economists’ and the accountants’ profession, or whether it is due to a political decision. Is it possible that the government, motivated by the dictum “let the sleeping dog lie”, secretly ordered the accountants not to probe too deeply into the question of solvency of the pension funds? Certainly the government does not want to alarm the people and put wind into the sails of the budding movement demanding the immediate return to a gold standard – even if this is the only way to stabilize interest rates thus making pension plans solvent again.

The last vestiges of the gold standard were unilaterally discarded by the government of the United States in 1971. This event was coincident with the onset of the greatest gyration in the rate of interest on a world-wide scale. In a decade interest rates shot up to two-digit figures in the high teens. Then a slow decline started in the 1980’s pushing interest rates relentlessly towards zero. The first move (rising interest rates) was accompanied with a great surge of inflation, wiping out a large part of the value of pension rights. The second move (falling interest rates) which is still continuing has brought deflation. It has not yet fully manifested its corrosive effect on the pension funds as yet. Even so, the forces that drive the rate of interest to zero are squarely responsible for the erosion or destruction of all capital, including the accumulated capital of the pension funds, as well as capital they are in the process of accumulating as a stream of payments through payroll deductions.

Although historians do not advertise the fact, a lot of pension funds went bankrupt in the 1930’s, and the remaining ones had to scale back the amounts they had contracted to pay to their pensioners. Economists failed to offer an explanation for this universal phenomenon. Yet the explanation is clear: the accumulated capital of the pension funds was badly impaired (in some cases completely wiped out) by the falling interest rate structure. At the same time the accumulation of new capital was rendered impossible by the absurdly low prevailing interest rate. The pension funds were hit twice: first, their capital was decimated; second, their ability to make repairs was frustrated. Exactly the same causes are operating right now, and exactly the same effects will follow. The only difference is the larger scale of capital destruction in the present episode.

### Indexed pensions or Ponzi pensions?

In recent years the pension problem has been swept under the rug. During the past sixty years “experts” have invented indexing as the “cure” for the erosion of pension rights. Indexing means that pensioners can be compensated for the erosion of their pensions due to inflation by making yearly adjustments upwards tied to some index numbers allegedly measuring inflation. This means that the powers that be are aware of the pension problem. They are willing to treat the symptoms, but they still refuse to treat the real cause of the disease. Their outlook on inflation as being “nature given”, beyond the power of man to address, is hypocritical and devious.

The basic idea of indexing pensions is that redistributive society will always have the wherewithal to validate all pension rights, since the government can borrow and tax without limit. Funding pensions is anathema to Keynesian economics. The “modern” way of financing pension rights is to make them “payas-you-go”, a euphemism for Ponzi pensions whereby workers are made to pay pensions payable to members already retired. They are promised that they will be compensated after their retirement by the contributions of members then active.

This is clearly fraudulent as it makes a hypothetical third party bear the full brunt of the arrangement. People are brought into the compact without their concurrence. Some of the members who will pay the pension of the now active workers may not have been born yet! The key point is: contributions are not capitalized upon receipt but are instantly dissipated. Pension contributions must be capitalized in order to make them a meaningful source of future pensions. Current workers’ pension rights could be subject to veto by tomorrow’s workers, should they find this arrangement unfair. Only fully-funded pensions are secure and it is only under a gold standard that such security can exist. Any other arrangement could unravel if victims of the redistributive society woke up and revolted.

John Maynard Keynes, in a bout of sincerity, blurted out a phrase that only now has revealed its true meaning: the euthanasia of the rentier. It gives away the “shabby little secret” of the redistributive society: robbing the pensioners who can no longer take “strike action”, and with the loot throwing dust into the eyes of the rest of the society.

### Deflation and the pension problem in Japan

The United States is following Japan down the garden path to zero interest.

Therefore it is instructive to look at deflation and the pension problem in Japan in order to see the shape of things to come. Consider the plight of JAL, Japan Airlines. The economic slowdown hit travel and cargo traffic hard. Saddled with the equivalent of \$15 billion in debt in addition to a massive pension fund deficit, the airline was forced to apply for “mediated debt restructuring” — euphemism for Chapter 11 bankruptcy. Asia’s largest carrier by revenue said in its Annual Report that there was a great deal of uncertainty about its ability to continue as a going concern. It has applied for help to the Enterprise Turnaround Initiative Corp., a government-backed fund. However, capital injection or additional financing alone would not improve the carrier’s prospects, as asserted by the November 14, 2009, news report of Reuters, because of its severely underfunded pension plans. JAL president Nishimatsu met with the leaders of the airline’s retirees association to seek their approval on pension payout reductions. Media reports say that the leaders have expressed their desire to cooperate in some ways with management to save the airline, but many retirees are expected to oppose strongly the proposed pension cuts.

The cancer of depression has been metastasizing across the Pacific through the yen-carry trade foolishly encouraged by the Federal Reserve and the Bank of Japan as a way to push interest rates even lower in the United States. Rather than analyzing the Japanese example and drawing the appropriate conclusions,

American policy-makers have an irresistible itch to follow Japan’s jump into the abyss of the Black Hole of zero interest. The result, perfectly predictable, is catastrophic.

### What should American labor leaders do?

American labor faces its greatest challenge ever. Its achievements on the wage front and on the pension front are at stake, due to inane government policies of destabilizing the rate of interest, causing an unprecedented destruction of capital, in particular, destroying the capital of pension plans.

If labor leaders want to preserve the achievements of the labor movement, they must address the root cause of the problem: the regime of irredeemable currency. Interest rates can be stabilized and pension plans can be saved only through outlawing of the irredeemable dollar.

We are currently on a course that will result in the total destruction of pension funds. If not wiping them out altogether, the irredeemable dollar will drastically reduce the pension rights of the workers. This is a wake-up call. Unions must act now and demand that the Supreme Court of the United States declare the legal tender protection of Federal Reserve notes unconstitutional. The manner in which these are presently issued is the root cause of our economic instability and the vicious swings between inflation and deflation. The unions must demand through legal challenges in the courts, that wages, salaries, and pensions be paid in constitutional dollars, that is, dollars redeemable in the coin of the realm, defined as a fixed weight and fineness of gold and silver.

The U.S. Mint must be open to the unlimited coinage of gold and silver free of seigniorage charges. To prevent future tinkering with the monetary system by charlatans, the metallic value of the dollar ought to be enshrined in the Constitution, so that any change in the gold content of the dollar would take a constitutional amendment — rather than merely an executive proclamation.

U.S. government bonds must be deprived of their monopoly position. They must be exposed to competition with the gold coin, in order to offer the saving public a meaningful choice. This is indispensable for the stabilization of the rate of interest, but also for the health of the pension funds. Government bonds are unsuitable for pension funds to hold on capital account. In case of a demographic shift such as that when more people leave the labor force to draw pensions and fewer are entering it while contributing to pension plans, the net selling of government bonds from the portfolio of the funds may collide with selling by the government. This would cause an unwarranted rise in the rate of interest. Note that in the case of net selling of corporate bonds from portfolio the same problem would not arise. Such selling would be treated by the corporations as a signal to retrench.

If American labor leaders fail to challenge the constitutionality of the irredeemable dollar and ask the Supreme Court for the protection of the pension funds on constitutional grounds, then a century of gains on the pension front will be irretrievably lost. Penury for the retired segment of the population will follow.

The plight of the JAL pensioners is not some kind of an aberration. It is the future norm.

Unless the current irredeemable currency system is replaced with a gold standard.

---

*January 4, 2010.*

Revised: March 2, 2011.

### Reference

Economic Aspects of the Pension Problem, Ludwig von Mises, The Commercial and Financial Chronicle, February 23, 1950.

---

# Forgotten Anniversary

URL: https://newaustrianeconomics.com/archive/fekete/forgotten-anniversary-2009/
Date: 2009-10-28
Section: Popular Economics
Difficulty: accessible
Concept Tags: real-bills, federal-reserve, new-austrian-economics, capital-destruction, monetary-policy
Description: On the 80th anniversary of the October 1929 stock market crash, Fekete argues that the real forgotten anniversary is not Black Thursday but the destruction of the Real Bills market in the preceding decades. The crash was symptom, not cause; the true cause was the Federal Reserve's elimination of self-liquidating credit, which made the banking system fragile and the crash inevitable.
Editorial Note: Written October 2009 on the anniversary of the 1929 crash. A historical meditation that frames Fekete's revisionist theory through the lens of anniversary journalism.
Original PDF: https://professorfekete.com/articles/AEFForgottenAnniversary.pdf

*Forgotten Anniversary: One Hundred Years Of Legal Tender*

**Antal E. Fekete** · Professor of Money and Banking · San Francisco School of Economics

Fund-raising dinner for the benefit of the Ficino School · Auckland, New Zealand

---

*October 28, 2009*

The year 2009 will most likely expire without commemorating the centenary of a most momentous event in history that figures prominently as the main cause of the Great Financial Crisis of the century. This event was the so-called legal tender legislation in 1909. The bank notes of both the Banque de France and the Reichsbank of Germany were made legal tender by law, first in France and then, a very short time later, also in Imperial Germany. The rest of the world followed suit. In this way all roadblocks were removed in the way of financing the coming world war through credits and monetizing the resulting debt through the issuance of bank notes.

One unintended effect was that all efforts to avert the war and the concomitant great bloodshed and destruction of property through better diplomacy were short-circuited. The war parties in both countries had won a great victory. The cause of peace suffered a decisive defeat.

Please note that I have said “so-called legal tender legislation” because ‘legal tender’ in this context was a vicious distortion of the meaning of the phrase. There was nothing coercive about legal tender before 1909. Bank notes circulated as money, but their acceptance was entirely voluntary. People had an unconditional right to exchange them for the coin of the realm, that is, for gold coins. If the bank did not comply, then it was in technical default and had to face the consequences.

The original meaning of legal tender simply referred to a tolerance standard applicable to the wear and tear of gold coins. Coins meeting the tolerance standard circulated by tale, that is, their value was established by counting them out ― a great convenience. Others circulated by weight: each and every coin had to be weighed ― a great inconvenience. There was absolutely no coercion involved in this discrimination. The Mint exchanged gold coins within the tolerance standard by freshly struck full-bodied gold coins at no charge to bearer. The government absorbed the loss and covered it out of the general revenue fund. The cost was treated the same way as the cost of maintaining the nation’s highway system in good repair. Not only was there no coercion involved in legal tender laws; in effect a public service was provided by the government without charging user-fees. That was the meaning of the phrase “legal tender” prior to 1909.

Notice the underhanded change in the meaning as a result of the legal tender laws of 1909. A public convenience was replaced by public coercion. Two governments with the greatest war-making power in the world introduced coercion forcing their subjects to accept and use debt as money. This was a ‘first’ in history. In particular, the governments were forcing the military, as well as civil servants, to take paper promises as ultimate payment for services rendered.

Of course, the use of the phrase ‘legal tender’ in this way is an oxymoron. A promise to pay that is at the same time an ultimate payment is not a promise. It is an ukase. This was a reactionary step, designed to facilitate the unlimited augmentation of monetary circulation regardless of the gold reserve. It allowed the financing of the coming war with government credits, much of it interest free and with no maturity date. The burden was thrown on the shoulders of the people without their concurrence.

The measure was represented as an innocent house-keeping change. There was no public debate on its wisdom. Nobody at the time could see the ominous consequences. Nobody suspected bad faith on the part of the government. As a proof of good faith gold coins were allowed to remain in circulation for another five years. Banks paid them out routinely as before, without fuss. There was no noticeable increase in the hoarding of gold coins by the people, a sign that they implicitly trusted their government. When the war finally broke out in 1914, the “guns of August” heralded the delayed effect of the legal tender laws. All gold coins went into hiding at once. Banks refused to meet any request for payment in gold. Members of the legislation, including all the socialist deputies, voted all the war-credits the government had asked for without demur.

The first author to unmask the connection between the Legal Tender Laws of 1909 and the outbreak of the war five years later, in 1914, was the German economist Heinrich Rittershausen (1898-1984). He also predicted the Great Depression, and linked the coming unprecedented wave of unemployment to legal tender, as I am going to discuss it in more details in a minute.

We are left to second-guess history. Would the senseless killing and destruction of property have come to an early end in the absence of legal tender laws, just as soon as the belligerent governments had run out of gold to finance it? Most contemporary observers had predicted that it would have. There was no way to finance a conflict of this magnitude out of taxes. People did not understand that legal tender was an invisible form of tax to pay for the greatest war up to that point in history. They did not understand the power of credit that would enable governments to expend blood and treasure freely, without any restraint. People did not see the Moloch behind the façade of legal tender ― the god that was preparing to devour his own children.

---

But there was also another, most sinister consequence of the legal tender laws that was not recognized at the time. Before 1909 world trade had been financed through real bills drawn on London. A real bill was a short-term commercial paper payable in gold coin upon maturity. It represented self-liquidating credit to finance the emergence of new merchandise in the markets demanded most urgently by the consumers. As its issue was limited by the amount of new merchandise on its way to the market, it was non-inflationary. The credit was liquidated by the gold coin released by the ultimate consumer of the underlying merchandise. You can look at a real bill as credit in the process of presently “maturing into gold coins”. As a medium of exchange, a real bill is “the next best thing” to the gold coin. It is virtually risk free to hold, as the underlying merchandise has a ready market waiting for its arrival.

Clearly, real bills are incompatible with legal tender laws. It makes no sense to suggest that you can make real bills “mature in legal tender bank notes”. The fact is that the bank note is inferior to a real bill in almost every way. For one thing, real bills are an earning asset. This is due to the existence of discount applied to face value as the real bill is bought and sold before maturity. Real bills are most liquid: only the gold coin has greater liquidity. They are the best earning asset a commercial bank can have.

But what makes real bill paramount in the economy is the fact that, in the aggregate, they constitute the wage fund of society. They alone make it possible to produce and distribute goods now that the consumer will only pay for later. Up to three months later, to be precise. However, in the meantime workers employed in their production will have to be paid their due wages every week. Indeed, these workers must eat and satisfy other wants to be able to continue their production efforts. The payment of wages is definitely not financed through savings of the capitalists. It is financed through clearing, that is, through the spontaneous granting of temporary monetary privileges to real bills, thus enabling them to circulate before maturity.

An unintended consequence of the legal tender legislation was the destruction of this wage fund out of which workers could be paid before the goods were sold. Legal tender laws bore direct responsibility for the horrible unemployment during the Great Depression ― as pointed out by Rittershausen. As long as the wage fund is intact, there can be no unemployment.

Everybody who is anxious to earn wages can go into the production or distribution of some goods demanded by the consumers urgently, and get compensation from the wage fund immediately, even before his product is sold. The destruction of the wage fund changed all that.

Workers could no longer be compensated for their labor expended in the production of merchandise unless it is ready for sale right away.

The destruction of the wage fund was not immediately obvious in 1909. Military training and production of war materiel absorbed the available manpower. During the war labor was in short supply because of the vast expansion of the production of munitions. Unemployment hit society only after the cessation of hostilities.

Had the victorious powers repealed legal tender laws after the war, thereby rehabilitating the market in real bills and replenishing the wage fund, the great Depression would have never occurred. But the victors were not interested in multilateral world trade. They wanted to punish the vanquished even more by making trade bilateral, to the exclusion of real bill circulation. In this way they wanted to retain control of the trade of their former adversaries. As a result the wage fund was never resurrected and workers could not be paid. The result was the greatest unemployment ever in history. Governments were forced to assume responsibility for the unemployed through the dole system. This system, an affront to people eager to work for wages, is still with us but its root cause, the absence of real bill circulation, remains unrecognized.

---

Legal tender laws, representing the unholy alliance (not to say conspiracy) between the government and banks, have never been repealed. Governments have come to love the extra powers they acquired through false pretenses. The banks were happy to take the bribe. They shifted their loyalty from their customers to the government. In exchange for the privilege to create bank deposits without the restraint of a gold reserve, as was the case prior to 1909, the banks were prepared to buy all the government bonds that have found no willing buyers in the bond market. “You scratch my back, I scratch yours.” This conspiracy still goes on under a new ‘social contract’ in which bribe and blackmail has replaced voluntary cooperation.

The connivance of academia and media, in particular, the loyalty of the economists’ profession and that of financial journalists, has been bought by the central banks’ eagerness to sponsor research. “Whoever pays the piper shall call the tunes.” Authors who were prepared to sing the praise of irredeemable currency were handsomely rewarded. Authors critical of fiat money need not apply. Most of the economists and financial journalists today are scribes for hire, selling their pen to the government and the central bank. Propaganda is passed on as research.

Mathematics has been prostituted as never before in the history of the Queen of Sciences.

Research papers on economics and monetary theory studded with formidable-looking but otherwise vacuous differential equations are presented as Holy Grail. The studied gestures and hocus-pocus of latter-day economists is similar to those of the priesthood in ancient Egypt. By virtue of their knowledge of astronomy ― knowledge denied to the general public ― Egyptian priests could predict eclipses of the Sun and other celestial events. They keep their audience in awe and in fear of their supernatural powers. The difference is this: while Egyptian priests were professionals representing state-of-art scientific knowledge, mainstream economists are charlatans and quacks who, while basking in their own glory, are totally incapable of predicting financial collapse even when it is staring at them in the face, as their miserable performance in 2007 showed. Worse still, they are totally incapable to admit their own mistakes. They are a curse on the body politic and a wart on the body academic. They are leading the world into an unprecedented monetary and economic disaster right now as I speak here.


---


Our present financial crisis is the epitome of a tragedy brought upon us by coercion in the monetary field. The way out of the crisis, and the way to prevent another great Depression, is through the restoration of freedom in the realm of money: through an adroit repeal of legal tender laws. The gold standard must be rehabilitated together with its clearing system, the bill market.

The monopolistic nature of government debt in the bond market must be eliminated through bringing back the competition of the gold coin to the promises of the government. Bondholders dissatisfied with the rate of interest offered by the coupons arbitrarily attached to government bonds must have their rights restored to them: the right to park their savings in gold coins, as they did before 1909. In this way they could force the government to pay competitive rates of interest on private savings, All coercion in the monetary field must be stopped. The dignity of the individual must be respected. The present collectivistic frame of mind of the government must be discarded in favor of one favoring the individual, restoring freedom and the free initiative of man.

A century is just a fleeting moment in history. The past one hundred years must be looked upon as a reactionary episode in our civilization, a mindless experiment with irredeemable currency. The experiment has failed miserably, as have all similar experiments in the past. Unless stopped forthwith, it will plunge the human race in unprecedented economic misery. It literally threatens the survival of our civilization and the entire system of our values.

Freedom in the field of money will bring us peace and prosperity. Continuing coercion is the road to war and misery.

---

# The Gold Basis Is Dead — Long Live the Gold Basis!

URL: https://newaustrianeconomics.com/archive/fekete/the-gold-basis-is-dead-long-live-the-gold-basis/
Date: 2009-10-17
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, contango, backwardation, permanent-backwardation, gold-standard
Description: Fekete responds to commentators who claim the gold basis has permanently returned to positive territory after the 2008 backwardation episode, arguing they misunderstand the dynamics. The apparent return to contango is not a restoration of normalcy but a temporary reprieve — the secular decline of the basis continues and permanent backwardation remains the endpoint.
Editorial Note: Written October 2009. A methodological essay defending basis analysis against critics who argued the 2009 recovery in the basis refuted Fekete's permanent backwardation thesis.
Original PDF: https://professorfekete.com/articles/AEFGoldBasisIsDeadLongLiveGoldBasis.pdf

*The Gold Basis Is Dead ― Long Live The Gold Basis!*

**Antal E. Fekete** · Professor of Money and Banking · San Francisco School of Economics

### Fool’s gold basis

A year ago I conducted a Seminar on the gold basis and backwardation in Canberra, Australia.

I suggested to my audience that the gold basis (premium in the nearby futures on spot gold, with negative basis meaning backwardation) as a “pristine indicator that, unlike the gold price, cannot be manipulated or falsified by the banks or by the government. Thus it is a true measure of the perennial vanishing of spot gold from the market, never to return, at least not as long as the present fiat money system endures.”

That was then. Today we are one year older and that much more experienced. We now know that the banks and the government have in the meantime found a way or two to manipulate the gold basis as well. Next month I have another Seminar coming up in Canberra.

I shall address the problem of gold basis, giving a full account of what we know about the efforts of the powers that be in trying to falsify this most important indicator, the guiding star of refugees who have entrusted their fate to a golden dinghy on a stormy sea. To the government, the gold basis is like the naughty child who blurts out unpleasant truths. He must be gagged and silenced at all hazards. Fool’s gold basis is even more important than fool’s gold in terms of the number of people victimized.

### The “Let’s get physical” movement could trigger a chain reaction

A prime suspect is the gold basis calculated using COMEX futures prices, or the forward gold price of the London Bullion Market Association (LBMA). Further suspects are: certain gold Exchange Traded Funds (ETF’s) such as GLD and their weekly updated bar lists; certain central banks such as the Bag Lady of Threadneedle Street (nickname of the Bank of England) that has rushed to the rescue of her agents, the bullion banks, trying to bail them out by offering substandard (22 carat) gold in settlement of contracts at the verge of being defaulted. Substandard gold stinks, as I shall explain below.

There seems to be circumstantial evidence that this month the gold exchanges are unable to honor their expiring contracts for which delivery notices have been issued in September. It has occurred in spite of a robust, even increasing, contango. Furthermore, circumstantial evidence exists that counterparties to these expiring contracts for future delivery — bullion banks, to be precise, the name of J.P.Morgan and Deutsche Bank being prominently mentioned — have offered bribe money up to 125 percent of the quoted spot price to holders of long contracts if they would take settlement in paper, on condition that the embarrassing affair will be kept secret. If true, these maneuvers are motivated by the desire to conceal the real gold basis, and to deny that gold is in or approaching backwardation. If the truth were widely known, then there would be a run on the bullion banks. The “let’s get physical” movement would trigger a chain-reaction culminating in all offers to sell physical gold being permanently withdrawn around the globe. “Gold would not be for sale at any price”, whether quoted in US or in Zimbabwe dollars — or, for that matter, in any irredeemable currency — the only kind of money people are allowed to have nowadays. The curtain would fall on the “Last Contango in Washington”. The day of permanent gold backwardation would dawn. The chapter on a reactionary episode of history, irredeemable currency, allowing the Treasury and its central bank to create unlimited liabilities out of nothing which they have neither the means nor the intention to honor, but could use them for check-kiting purposes to mesmerize gullible people around the world, would be closed and become but a bad memory.

### “Honey, I’ve shrunk the bar-list!”

We must guard ourselves against falling victim to the rumor-mills, while keeping our eyes peeled for the very real possibility that the growing shortage of physical gold can no longer be papered over with paper gold (pun intended). Another story is about GLD, a leading gold

ETF, which publishes its bar-list every Friday at the close of business, reporting the serial number of every bar in inventory. The list is customarily well over a thousand pages long.

But, lo and behold, on Friday, October 2, and on Friday, October 9, the bar-list shrank to a mere couple hundred pages, with no explanation offered. Could it be that the management of GLD has taken a bribe, and replaced physical gold in inventory by paper gold, in order to save the face and skin of the bullion banks that have gone naked short and subsequently got cornered?

If so, it won’t get very far. The leadership of the US House of Representatives may well be able to put in deep freeze the motion of Dr. Ron Paul, seconded by over 250 other congressmen on both sides of the aisle, to audit the Federal Reserve, but it has no power to stop the auditing of the ETF’s or bullion banks as required by contract law. According to some reports independent auditors, at the insistence of parties holding expired forward purchase contracts to deliver gold, are descending on ETF’s and check their vault’s contents against their books. The noose is tightening around the neck of fraudulent banksters caught in the short squeeze.

### Archimedian test

Reports are circulating that similar audits of certain Asian depositories have already produced “good” delivery bars (400 oz or 12.5 kg gold bricks) that have been gutted and stuffed with tungsten — a metal whose specific weight approximates that of gold, so that the famous test of Archimedes (fl. 287-212 B.C.) based on the Law of Buoyancy, designed to expose fraudulent goldsmiths, would be inapplicable. Isn’t it strange that criminal law punishes the fraudulent stuffing of gold bars, but allows the stuffing of gold assets in the balance sheet with paper gold? After all, the specific value of tungsten is much higher than that of paper!

According to a well-known anecdote, King Hiero II of Syracuse ordered his goldsmith to make him a new crown in the shape of a laurel wreath out of solid gold. When the finished crown was delivered to him, the king had reasons to suspect that he had been short-changed by the goldsmith who presumably diluted the gold with base metals. He called upon Archimedes to make the determination but without damaging the crown. After some hard thinking Archimedes solved the problem. He could determine the volume of the crown by submerging it in water, and from the volume and weight he could calculate the crown’s density. Comparing it to that of gold, the fraud would be exposed if the density of the crown were lower. It is evident that, if the goldsmith had had a metal at his disposal of the same density, but cheaper than gold, then Archimedes’ test would have been inconclusive. It is this property of gold that makes it second to none among the metals, along with other similar fine properties, explaining why it is a most desirable form of wealth.

### The revenge of the looted coins

In 1933 F.D. Roosevelt did not stop at the mere confiscation of the constitutionally mandated gold coins of the realm. He sent them to the refinery in order to melt them down. He wanted to expunge the evidence from history that this great republic once had the largest pool of circulating gold coins anywhere, ever. Roosevelt betrayed his oath that he would uphold the U.S. Constitution and went ahead to rob the citizenry by calling in the gold replacing it with Federal Reserve notes, the value of which he promptly cried down by 56 percent, under the disguise of monetary reform. The melted gold was given the shape of gold bars and was stored in Fort Knox, West Point, and other depositories.

Careful as though Roosevelt was to cover his trail in getting away with the loot, he has made one major blunder. He failed to make the looted gold fungible. The coins were not made of pure gold: they were an alloy 22 carat in fineness. The reason was to make them stand up to wear and tear better in circulation. All countries striking coins for general circulation employed an alloy. Roosevelt thought that he could save the cost of refining the melted gold to the international standard of 995 fine (24 carat) so the gold bars in Fort Knox are only 22 carat fine. In consequence these gold bars are not fungible. They are easily identifiable as contraband, the proceeds of the Great Gold Heist of 1933. The shear quantity of this looted gold makes it impossible to refine it at this late hour. The U.S. gold stinks, and will keep on stinking.

The memory of the Crime of 1933 comes back to haunt the government that committed it. For 75 years nobody suspected that one day these gold bars may be needed to pacify the market. Everybody thought that they could rest in peace in the depositories till doomsday. But then, as the proverb says, ill-gotten goods seldom prosper. The Great Financial Crisis of 2007 struck and the dollar got into hot water. The U.S. Treasury ran out of fungible gold and had to dip into its hoard of looted gold. It is too late now; the bad odor cannot be expurgated from the U.S. gold hoard. Should this gold ever show up at an audit, or as bribe money, it will immediately be recognized. Everybody will see that it originated from the Great Gold Heist of Roosevelt and that the shame of the U.S. government is attached to it.

Worst of all, it will also reveal that the U.S. has fallen upon hard times. The looted gold was released in desperation, in trying to stem the tide of burgeoning gold backwardation.

The result is that every time 22 carat gold pops up anywhere in the world, for example, as an offer to pacify angry possessors of expired gold futures contracts, it will be new evidence of the fact that Uncle Sam is cornered and tries to bribe his way out of the corner with looted gold. If Uncle Sam is trying to pay the blackmail on behalf of his cohorts the bullion banks, in offering 22 carat gold in settlement of contracts calling for 24 carat fineness, then the world will immediately know what’s up, even if the substandard gold is offered through intermediaries. Everybody will know that Uncle Sam is trying to cover up, or fend off, backwardation to prevent the gold basis from going permanently negative. The telltale sign will haunt him and make the gold crisis worse, not better. Most of the possessors of expired gold futures contracts will refuse to take substandard gold for settlement, but neither will they keep Uncle Sam’s secret. Apparently there are already two known instances where the looted gold turned up. Central banks, in coming to the rescue of their agent bullion banks that were caught red-handed in being naked short in gold, offered 22-carat gold to bail out their agents. This fact in itself makes the quantity of gold available for resolving the gold crisis smaller. Permanent backwardation in gold, the Nemesis of irredeemable currency, cannot be postponed much longer.

### Blight on Humanity

Rob Kirby, the best sleuth we have to uncover government hanky-panky in the gold market, has castigated the cover-up of what he considers a severe backwardation in no uncertain terms. He calls central banks for their complicity in the cover-up a blight on humanity. In his opinion, the central banks are aiding and abetting the plunder of the sovereign assets of their countries to bail out their agents or friends in an attempt to “sweep the whole bloody mess under the carpet”. This assessment is apt. It is no exaggeration to say that the regime of irredeemable currency is a blight on humanity. The Uncle Sam will never be able to live down his shameful role in plunging the whole world into the monetary abyss.

Central banks are also guilty of corrupting the young — a crime that was punishable by death in Athens at the time of Socrates. They have hijacked monetary economics lock, stock, and barrel. They have commissioned scribes for hire to rewrite it as a eulogy of their sordid trade, the creation of fiat money. Graduates of our universities are no longer taught that this regime has a 100 percent mortality rate through the sudden death syndrome, pauperizing the population in the process. The role of gold in history is falsified and distorted. People are told that harking back to gold money is a sign of backwardness and reactionary thinking.

Modern money is managed money — as long as they themselves are entrusted with its management. In this view the U.S. Constitution is a backward document not worth bothering with, so they don’t bother with proposing a constitutional amendment changing its monetary clauses to conform it to present practice.

### Aristotle on alibi

An axiom of Aristotle states that no substance can be present at two different places at the same time. The reason for gold’s monetary role is rooted in this very axiom. The same paper promise can be present in the asset column of the balance sheets of any number of individuals.

The same gold coin cannot. This eliminates the possibility of a miraculous proliferation of money — putting latter-day money changers out of business. But once gold is removed from the monetary system, the miraculous proliferation of money starts in earnest. Central bankers will distribute it, if need be, from helicopters hovering overhead. The proof that this is beneficial to society is ad hominem. In this way, so the argument goes, the niggardliness of nature to release only so much gold per annum from the gold mines can be overcome. Money will get into the hands of those who need it most. They will certainly spend it. Never again will the economy seize up because of shortage of money.

The Quantity Theory of Money is a false doctrine because it describes the economy in terms of a linear model, when in reality the world runs on a highly non-linear pattern.

Therefore we need a better theory to show that the miraculous proliferation of money is bound to come to a sorry end. It has been my ambition to construct a better theory. I am pleased that my theory of the vanishing of gold basis, and the ultimate permanent backwardation of gold under the regime of irredeemable currency has found resonance in some blogs and discussion groups, even if it is still taboo in the media and academia.

We have made great progress since last year’s Seminar in Canberra. This year’s Seminar will discuss the gold basis in the light of the very latest developments. The gold basis is not dead, it just needs to be correctly interpreteded. I shall show it to my audience how to do that through uncovering the hidden premium in the price of 24 carat gold available for immediate delivery; through the spread between the share price and the NAV of the gold

ETF’s; through the popping up of 22 carat gold bars offered as bribe money, and other miscellaneous signs of a very real physical short squeeze in the market for monetary gold.

### See you in Canberra in November!

---

*October 17, 2009*

### References

A.E. Fekete, Red Alert: Gold Backwardation!!! [www.professorfekete.com](https://www.professorfekete.com),

---

*December 5, 2008*

Rob Kirby, Backwardation: Facts from Fiction, [www.financialsense.com](https://www.financialsense.com),

---

*December 8, 2008*

Rob Kirby, Central Banking: A Blight on Humanity, [www.financialsense.com](https://www.financialsense.com),

---

*October 9, 2009*

Rob Kirby, Blight on Humanity, Addendum, [www.financialsense.com](https://www.financialsense.com),

---

*October 15, 2009*

### Calendar of Events

Auckland Club, 34 Shortland Street, Auckland City, New Zealand, 7 p.m., 28th of October, 2009.

Fund-raising dinner for the benefit of Ficino School. Invited guest speaker: Professor Fekete, The Forgotten Centenary of the Introduction of Legal Tender Currency in 1909.

### Further information: [www.goldstandard.co.nz](https://www.goldstandard.co.nz)

University House, Australian National University, Canberra: November 1, 2009.

Gold Investment Day, Common Room, from 9 a.m. to 5 p.m . Admission is free.

University House, Australian National University, Canberra: November 2 – 5, 2009.

The Vanishing of the Gold Basis and the World Financial Crisis, a Seminar of Professor Fekete with other invited speakers, sponsored by the Gold Standard Institute,

### Further information: [www.feketeaustralia@](https://www.feketeaustralia@)gmail.com

Cara Bahamas 2010 Conference, Lucaya Resort, Freeport, Grand Bahamas: January 15-20, 2010.

Professor Fekete, Sunday, January 17, Hedging non-gold investments with gold.

Further information from Cara Trading Advisors (Bahamas) Ltd., billcara@caratrading.com, [www.caratrading.com](https://www.caratrading.com) Martineum Academy, Szombathely, Hungary, in March 2010.

Stay tuned for further announcement.

Professor Fekete on DVD: Professionally produced DVD recording of the address before the Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the Great Depression: Can It Happen Again? plus an interview with Professor Fekete. It is available from [www.amazon.com](https://www.amazon.com) and from the Club [www.economicclubsf.com](https://www.economicclubsf.com) at \$14.95 each.

### DVD’s of the Gold Standard University Sessions

Session 3 (Adam Smith’s Real Bills Doctrine and Its Relevance Today)

Session 4 (The Bond Market and the Market Process Determining the Rate of Interest)

### Session 5 (A Primer on the Gold and Silver Basis)

Session 6 (Encore Session: The Great Depression) are now available. For details how to order, see the announcement on the upper left corner of the website [www.professorfekete.com](https://www.professorfekete.com).

---

# The Supply of Oxen at the IMF

URL: https://newaustrianeconomics.com/archive/fekete/the-supply-of-oxen-at-the-imf/
Date: 2009-09-30
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, central-banking, monetary-policy, gold-standard
Description: Fekete extends his oxen metaphor to the IMF's gold sales program, arguing that the IMF's offer to sell gold is being used to suppress the price at a critical moment. He analyzes why the IMF sales will fail to provide lasting price suppression — because the buyers of IMF gold (central banks) will simply hold it rather than returning it to circulation.
Editorial Note: Written September 2009. A companion piece to the 2005 Federal Reserve oxen essay, applying the same framework to the IMF's gold sales.
Original PDF: https://professorfekete.com/articles/AEFTheSupplyOfOxenAtTheIMF.pdf

Some years ago I penned a paper with the title “The Supply of Oxen at the Fed”. I am indebted to Alan Greenspan for a great line in one of his speeches, entitled The History of Money, from where I borrowed my title. He wrote: “If fiat money falters, we may have to go back to oxen as our medium of exchange. In that event, I trust, the Federal Reserve will have an adequate inventory of oxen.” My article was designed to reassure Mr. Greenspan that the supply of oxen at the Fed was very secure indeed, in no small measure due to his stewardship.

In my missive I related a story my father was fond of telling us about his geography professor lecturing on Switzerland. A short fellow, he was extolling the agriculture of that country as he would say: “In our country oxen are not even as tall as I am. In some countries you will see oxen as big as I.

But, ladies and gentlemen, believe it or not, on the fat mountain pastures of Switzerland there are oxen even greater than myself.” For the sake of emphasis the good professor stood on his tiptoes and stretched his arm to reach above his head. “We don’t believe so!” — someone shouted from the back benches of the lecture theater.

The story bears repeating because, as events of the intervening years have proved, the prize specimen of the supply of oxen at the Fed is the chairman (past and present). When the faltering of paper money looms large on the horizon, his first thought of an alternative is not gold. It is oxen. Nor is it a nick of time too early, as fiat money is faltering as never before. But even if the Fed should get caught short-handed, it can always rely on a backup. The supply of oxen at the International Monetary Fund is infinite.

The IMF is trotting out its old war-horse, the threat of auctioning off its monetary gold. This time it appears to be for real. The IMF is making preparations to get rid of a sizeable chunk of that part of its capital that has no counterparty liability attached in the form of central bank IOU-nothings, or government bonds alias certificates of guaranteed confiscation.

The IMF sounds very emphatic about its intentions of doing the self-mutilation in such a delicate manner as not to disrupt the gold markets. Pity the IMF. It is worried about upsetting the gold market, not about frittering its capital away. The IMF promises to do the auctions in a “transparent” fashion. It is true that the gold market is small in todays’ metric where the trillion-dollar unit will soon appear inadequate. Still, the IMF’s sting operation, and the accompanying soothing words sound more like the mosquito saying to the elephant before the blood-meal: “baby, my darling, it won’t hurt”.

It is abundantly clear that the IMF and its puppet-masters behind the screen want to hurt the gold bugs, and hurt them badly. As paper currencies without exceptions are engaged in a game of “all fall down”, and do it impulsively and competitively, gold is the only money that stands up. It must be clubbed down, or else. That has been the rule of the game ever since president Nixon on the advice of Milton Friedman “made the gold markets free” in 1971. In the beginning it was US Treasury gold that was auctioned off in order to club down the rising gold price. But then the managers of the paper dollar found it cheaper to auction off other people’s gold for that purpose through arm-twisting tactics.

The selling of paper gold through futures markets and the leasing of gold through bullion bank intermediaries has been thoroughly discredited. Only fools believe that those outstanding forward contracts will be settled in specie. Holders of paper gold will be lucky if their contracts will be settled in paper. The market is crying for physical gold. Nothing less will pacify it. By now the US Treasury has run out of arms to twist, after it has twisted the arms of smaller countries holding gold such as Belgium, the Netherlands, and Switzerland making them to sell their gold reserve. The recalcitrant Congressmen who had blocked the IMF gold sales in the past have been bought off. The IMF gold is now ripe for the picking. Not to see the life-and-death struggle of the managers of global paper money fighting gold — the stern taskmaster of all banks, real or virtual, and of all governments — is tantamount to turning a blind eye to reality.

The question is whether the IMF — like the proverbial kid in the forest playing false alarm on the lumberjacks — “has cried wolf” once too many times. The wolf around the corner may be real this time, ready to devour the prankster. To be sure, the gold price will fall on the news that the gold auction has started in earnest. The market will obligingly bring down the price to make it easier for the IMF to unload its burden. But after the IMF relieved itself, the price will go back and on to new records. It’s inevitable. It can be predicted with the certainty of science.

Why will the price of gold reach new highs after the IMF gold auctions have been completed?

There is a very simple reason: the assets backing the dollar, against which the gold is being sold, has been diluted. The IMF is exchanging its hard asset, that is nobody’s liability, for the soft: the liability of the Fed printing money as if there is no tomorrow. Under these circumstances it is suicidal to sell hard assets. Yet there it is: IMF gold is on the block.

The excuse the IMF uses to justify the gold sale is to raise funds for bailing out over-indebted countries. It is a lame excuse indeed. A bank, if it is run on a rational basis, will worry about its capital structure before embarking upon a course of extended lending, especially lending to bankrupt governments. You never ever dilute your capital base.

This does not mean that gold bugs will not be fooled — again. Some, perhaps many, will be.

They will sell their gold into weakness making it look like the bloom is off the golden roses. But all what this game of hoopla means is that gold is passing from weaker into stronger hands. The weak hands are fading into oblivion, as they must.

To really understand gold and its true strength one must see that it is not the speculative leveraged segment of the market that is animating it. Of course, speculators will ever be ready to sell off at the sound of the whistle from the IMF. But time is coming when they will be unable to replenish their supply. The IMF tells them to sell their cash gold, but it will not tell them how to buy it back.

That’s the catch. The unemotional holder of gold follows the gold basis, rather than the gold price.

Only the gold basis will tell you whether you can reasonably expect physical gold to be available tomorrow and the day after. Or whether it is more likely that one day, soon, we wake up to find that “gold is no longer for sale at any price”. Gold mines will hang out the notice: “Holders of dollars need not apply”. This is going to be the exact replica of what happened to holders of assignats, mandats, Reichmarks and, more recently, of Zimbabwe dollars. These finely embellished bank-notes were once exchangeable for gold at a variable price — for awhile. People took it for granted that they would always remain so. Then one day, when least expected, the supply of gold against paper went dry. The music stopped on this particular game of musical chairs. Those who had the paper in hand were out of luck. There is nothing in monetary science that would make the future outlook for the US dollar more rosy than that of the Zimbabwe dollar. Of course, there are more tricks that can be pulled out of the hat of the Fed than those available to the managers of the paper mill in Harare. But a paper mill is just a paper mill. The fact that it is on the Potomac river won’t make its product immune to rotting, that congenital disease of all paper currencies.

The IMF has been around scarcely for sixty-five years. By its original charter it was supposed to make foreign exchange rates fixed, and currencies gold-backed, albeit indirectly. It was supposed to be the linchpin of the international monetary system. In less than twenty-five years it has managed to go through the goodwill that was its endowment. One-by-one the obligations of the IMF were shed, leaving the institution without a mission or a purpose. The IMF should have been scrapped and its gold returned to the original subscribers in full when corrupt politicians, following advice from corrupt economists, abandoned the regime of fixed foreign exchange rates in 1971. But the IMF was left in place, and it stood there as a bombed-out air-raid shelter. It continued to be used as a bully-pulpit from which the gospel of monetary rectitude is still being preached — making it the laughing stock of the world.

This is not to say that this clown of the US Treasury has not done enormous damage to the economies of Soviet-occupied countries as they were regaining independence after the crumbling of the Berlin wall. The IMF has earned eternal shame as the chief agent “to make the world safe for fiat money”. If it did not succeed in its mission, it was not for lack of trying.

One of the first things the IMF did as an agent of the US Treasury, after the inglorious collapse of the Soviet Union in 1990, was to force countries formerly under Soviet occupation to dispose of their gold reserve in exchange for IMF membership. Fancy the enormity of this crime. Even under the harshest of Soviet military occupation these unfortunate countries were allowed to keep their gold reserve, and with it some faint promise of a better future. Then come freedom, American style, for which these countries have been yearning for half a century. Lo and behold, the first thing they have to give up is their gold reserve — in the defense of the dollar system that had gone bankrupt twenty years earlier! The IMF will never be able to live down what amounts to the monetary rape of Eastern Europe and its “captive nations”. The IMF was the shepherd dog, shepherding these people under American auspices from one slave labor camp into another.

The miserable 65 years of history of the slave-driver IMF must be compared to the superb history of five millennia of gold as money and indestructible agent of freedom. The world’s understanding of gold and its role in human history is very imperfect indeed, to say the least. People are in the habit of watching the gold price and trying to interpret its zigzagging as you would try to decipher messages from an oracle or the predictions of a false prophet. They keep talking about gold being ‘weak’ or ‘strong’. But when it comes to the rock of Gibraltar, all talk about strength or weakness is entirely out of place. The only question is whether the boat of paper money, and its voyageurs, can survive the shipwreck when their boat is smashed against the rock of Gibraltar.

The outstanding fact about gold is that during the past half-a-century mines have disgorged an amount equal to all the gold previously produced during the course of history. And all this gold has disappeared without a trace. It has been devoured by an insatiable private demand — a stark reminder that politicians after two world wars have failed miserably to re-establish the financial and social order and security of the nineteenth century that the world had hoped for, in order to be able to function properly. Yet the gold that has disappeared in private hoards, the fruits of half-a-century mining effort, an amount matching in size what the world has produced since the dawn of civilization, is not lost completely. It has just gone into temporary hiding. It does not like the floating foreign exchange rate system. It abhors the swinging rate of interest. It hates the style of banking adopted after bank reserves were insulated from any influence of the saving public. It does not like the conspiracy of the banks and the government against the public good.

Vanishing gold — measured by its vanishing basis — shows the greatest vote of noconfidence ever registered in all history, as far as confidence in the political and monetary leadership of the world is concerned. The gold will re-emerge triumphantly when the global regime of irredeemable paper money bites the dust — as it most certainly will in this century, probably during the next decade. When that happens, the paper tower of Babel will come crashing down. All paper fortunes will be wiped out. The world will stand denuded of its capital. It will be unable to pay wages to the workers, to say nothing about paying pensions to the retired segment of the population. We shall witness the greatest change of guards ever. Bankers will deny their profession and will, like John Law of Lauriston fleeing from Paris, put on female garments and leave town under the cover of the night.

Only those with gold in hand will be able to provide capital to re-boot the productive apparatus of society and to rebuild the financial system necessary to support it.

Those who seek refuge in gold today have no reason to be ashamed, in spite of the scorn heaped upon them by the media and academia. Rather, they should be proud. They have an historic mission to accomplish — to save our civilization from total extinction. They are the inhabitants of Noah’s Ark. They carry the seed corn, and they are the custodians of the gene bank, with which they will have to start from scratch when the water recedes. Let the Nervous Nellies sell their gold into weaknesses in trying to turn a paper profit. Those strong in faith know that they are part of the select few, taking a voyage in the Mayflower to the Promised Land.

And herein you find the historic significance of the IMF gold sales. It is good news, very good news for those with a proper appreciation of history as it unfolds before our very eyes. Permanent gold backwardation as a threat to society has been temporarily removed. The Last Contango in Washington has been postponed. There is a little more time to prepare for Armageddon. Those who want to vote on how the world should be rebuilt and governed, those who believe in peace, progress, and prosperity under the gold standard after the coming collapse of the paper system, can still secure their ballot in the form of a gold coin. Just ignore the gold price. Gold is still cheap, thanks to the supply of oxen at the Fed and the IMF. And, lest injustice be done, also thanks to the supply of oxen at the US Treasury.

Ignore the gold price, yes, but keep your eyes peeled for the gold basis. It is your only reliable guiding star in these treacherous financial waters. It will tell you in advance when gold will cease to be offered for sale at any price, whether quoted in Zimbabwe dollars, or in US dollars, Swiss franks, Euros, Ameros, or in whatever monetary cocktail the ‘experts’ may come up with in the future.

The last gold coin ever sold in exchange for paper will go to someone who is fully conversant with the concept of the gold basis. Is it going to be you?

### References

### Alan Greenspan, The History of Money (2002)

Antal E. Fekete, The Supply of Oxen at the Federal Reserve, January 20, 2005, see [www.professorfekete.com](https://www.professorfekete.com)

---

*September 30, 2009.*

### Calendar of Events

Auckland Club, 34 Shortland Street, Auckland City, New Zealand, 7 p.m., 28th of October, 2009.

Fund-raising dinner for the benefit of Ficino School. Invited guest speaker: Professor Fekete,

The Forgotten Centenary of the Introduction of Legal Tender Currency in 1909.

### Further information: [www.goldstandard.co.nz](https://www.goldstandard.co.nz)

University House, Australian National University, Canberra: November 1, 2009.

Gold Investment Day, Common Room, from 9 a.m. to 5 p.m . Admission is free.

University House, Australian National University, Canberra: November 2 – 5, 2009.

The Vanishing of the Gold Basis and the World Financial Crisis, a Seminar of Professor Fekete with other invited speakers, sponsored by the Gold Standard Institute,

### Further information: [www.feketeaustralia@](https://www.feketeaustralia@)gmail.com

Martineum Academy, Szombathely, Hungary, in March 2010.

Stay tuned for further announcement.

Professor Fekete on DVD: Professionally produced DVD recording of the address before the Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the Great Depression: Can It Happen Again? plus an interview with Professor Fekete. It is available from [www.amazon.com](https://www.amazon.com) and from the Club [www.economicclubsf.com](https://www.economicclubsf.com) at \$14.95 each.

### DVD’s of the Gold Standard University Sessions

Session 3 (Adam Smith’s Real Bills Doctrine and Its Relevance Today)

Session 4 (The Bond Market and the Market Process Determining the Rate of Interest)

### Session 5 (A Primer on the Gold and Silver Basis)

Session 6 (Encore Session: The Great Depression) are now available. For details how to order, see the announcement on the upper left corner of the website [www.professorfekete.com](https://www.professorfekete.com) .

---

# Has Barrick Been Barricked by the U.S.?

URL: https://newaustrianeconomics.com/archive/fekete/has-barrick-been-barricked-by-the-us/
Date: 2009-09-09
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, gold-standard, monetary-policy, central-banking
Description: Fekete examines the ironic fate of Barrick Gold, which pioneered gold forward selling (hedging) as a strategy, only to be forced to close its hedging book at enormous cost when the gold price rose. He asks whether Barrick was ultimately a tool of U.S. gold suppression policy — and whether closing its hedges marks the end of the suppression strategy.
Editorial Note: Written September 2009 as Barrick announced the closure of its hedge book. The final chapter in Fekete's long-running Barrick analysis — from the Texas Hedges essay of 2002 through multiple follow-ups.
Original PDF: https://professorfekete.com/articles/AEFHasBarrickBeenBarrickedByTheUS.pdf

According to an announcement dated September 8, 2009, Barrick is going to throw into the dustbin its long-standing hedge policy, and pay for buying back its hedge-book by diluting the value of its common stocks through issuing more than 81 million new shares, or about 10 percent of the outstanding. The so-called hedges of Barrick have been thoroughly discredited and will soon be history. So-called, because the long-term forward sales contracts in question that the parvenu gold miner has invented and flaunted are not proper hedges and never have been. They are a fraud. They are naked short positions pretending to be balanced by gold ore reserves in the moon (or on this earth which, for hedging purposes, is practically the same thing). Part of the newsworthy story, of course, is the fact that the hedge book of Barrick has been increasingly under water for some nine years now, threatening the unfriendly giant with drowning.

Within 24 hours another hasty announcement was made to the effect that the company, instead of issuing 81 million new shares, will in fact issue 94.4 million, that may be raised to 109 million if the demand justifies it, for a total value of \$4 billion — the biggest primary equity offering in Canadian history according to the local media. The hike was explained by “strong investor demand”. The market, however, put a big question mark to that “forwardlooking statement” of the company in marking down Barrick shares 6.85% on the same day to \$36.61, the greatest percentage loss among the leading gold mining shares on the day.

Incidentally, in doing this the market has put a lower value on the Barrick stock than the company did. Barrick is offering its new issue at the price of \$36.95 per share.

The \$1.9 billion that Barrick is hoping to raise through this dilution maneuver to eliminate all of its fixed-price gold contracts falls far short of its goal of buying back its hedges. The liability represented by Barrick’s once flaunted forward sale contracts has been carried off balance sheet so far. These fixed-price gold contracts have a negative value of \$5.6 billion, that will be charged to earnings in the third quarter. This negative value will almost certainly increase during the next 12-month period Barrick gave itself to get out of the quicksand. The announcement itself is a virtual guarantee of that: Barrick will have to compete in the gold market with China, Russia, India, Brazil, and other countries (not to mention other gold mines in dire need to de-hedge) for a diminishing amount of gold available for cash delivery, to the tune of 9.5 million ounces in today’s strained gold markets.

The big unknown question is whether Barrick will be able to buy back its hedges fast enough to stop the continuing hemorrhage. Barrick is racing against the clock. Gold is still available for cash delivery, but in what quantities? and for how long? 9.5 million ounces is an awful lot of gold to buy in today’s anemic gold markets with supplies drying up fast. With the threat of the last contango and of permanent backwardation hanging overhead like Damocles’ sword, Barrick’s plan appears to be a pipe dream that will never be fulfilled. I may be in a minority of one on this one, but Barrick’s future is anything but rosy. 9.5 million ounces is a lot more gold than Barrick is able to produce in an entire year in the best of circumstances.

Even if Barrick were to sell not one ounce of gold in the open market for a whole year, but deliver every ounce it extracts from the bowels of the earth to its hedge books, and even if we accept the most optimistic assumptions of the company to increase its annual production as realistic, there is still a shortfall of at least 1.5 million ounces. I submit that Barrick could not survive if it was to suspend its sales of new gold in the open market for a whole year, while facing the extra cost of forcing up production quotas. No lender in its right mind would finance such a crazy plan. Creditors of Barrick would be all too happy to put the unfriendly giant on the block, and sell Barrick’s stellar resources to the highest bidders, who would be able to manage them in a saner and more responsible manner than present managers have.

Barrick’s managers were given the right advice twelve years ago that, at the end of the road they have chosen, lies ruin and misery. They had all the time to change course. But even at the last major announcement on “hedging” in 2006, when Barrick announced its new policy to lift a part of its hedges, the then CEO Greg Wilkins said at the Annual Shareholders Meeting that Barrick will always retain ‘a reasonable’ amount of hedges as an ‘essential risk-management tool’. According to Wilkins, it is supposed to ‘stabilize’ revenues, and it is supposed to satisfy banks that finance Barrick’s projects.

Two years ago I issued a public challenge to the management of Barrick in my piece

“Have Gold Bugs Been Barricked by the U.S.?” (see References below) as follows.

I demand an answer why Barrick ignored my recommendation in 1997 which I personally presented to the then CFO Jamie Sokalsky. During those ten years my worst fears have materialized. It turned out that the “hedging” policy of the company was, as I had stated, deeply flawed. It was an unmitigated disaster of the first magnitude. It resulted in horrendous losses to shareholders. It is not clear why Jamie Sokalsky, widely rumored to be the author of Barrick’s “hedge plan”, got rewarded with a promotion for executing a disastrous policy, and why his new boss Greg Wilkins has stated in public that the company is standing by its original hedging policy, albeit on a reduced scale. I categorically state that Jamie Sokalsky had been thoroughly familiar with the alternative, what I called the correct principles of hedging. He and I discussed the subject together at great length, and he received from me a Memorandum that spelled it all out. This Memorandum found its way into the book of the late Ferdinand Lips entitled Gold Wars and can be seen there by any interested party.

I am disclosing it now for the first time that Barrick has ignored my challenge. Yet, as its announcement of September 8 last proves, I was right all along. The “hedging” policy of Barrick was so obviously insane, so much in conflict with any common business sense, that it invited extensive speculation that Barrick was not really a profit-seeking business. It was just a front set up and operated by the U.S. (and/or by other governments) in order to cap the gold price. In other words, Barrick has been a partner to the greatest conspiracy in all history: to throw dust into the eyes of the investing community making it believe the gold demonetization fable. If the conspiracy theory is true, then the linchpin to cap the gold price has been Barrick’s hedging policy. By aggressively selling gold forward at the expense of the shareholders, the gold price could be kept in perpetual check — or so the script went. Just make Barrick the world’s Number One gold producer, its hedging policy will frighten the daylight out of any bullish speculator in gold. And we might as well admit that the conspiracy has been rather successful, in so far as conspiracies can ever be successful.

In the article quoted above I made it clear that I was not a subscriber to the conspiracy theory, although I reserved my right to change this opinion pending future evidence as they become available. A major piece of evidence has just surfaced. Barrick has unceremoniously discarded its long-cherished hedging policy, paying a heavy price in dragging the underwater hedges into its badly punctured balance sheet that was no longer fooling anyone, and in having to dilute the value of its outstanding shares.

Have I changed my mind about the validity of the conspiracy theory? Is it not an appealing interpretation that a decision made by policymakers in the U.S. Treasury and the Federal Reserve deemed that the cost of maintaining the gold cap at \$1,000 is becoming too high? The cap can no longer be defended in view of the world’s global credit crisis.

Subsequently Barrick was to be dumped and let to fend for itself in the rough waters after the sinking of SS. Lehman. Barrick has received what it has so richly deserved: it has been barricked by its partner in crime.

The supreme irony of this scenario would be hard to escape. This would not be the first time that a creature of Peter Munk has been barricked by a government. There are some older guys around still, like myself, who remember how the government of the Canadian province of Nova Scotia has barricked Munk’s top line radio and hi-fi console manufacturing business. At that time Peter Munk swore that he would never ever again accept a government subsidy, nor would he participate in a conspiracy involving governments. It is all related in Peter Munk’s approved biography in great detail (see References below).

Every business initiative of Peter Munk has ended as a fiasco and he went bankrupt in consequence. After his radio and hi-fi business shipwrecked on the rocky coast of Nova Scotia, his real estate enterprise in Egypt failed where he was to build luxury hotels in the shadow of the great pyramids. His dabbling in oil fared no better. Rumors have it that he also financed a franchise in Israel of Colonel Sanders’ and his boys to make pork chops “fingerlickin’ good” — that failed, too, although this could not be confirmed.

After an unbroken series of business failures Peter Munk has come to gold. Would gold be kinder to him? There is hardly anybody alive who could appreciate gold’s value better than he would. He owes his Holocaust survival to gold that was paid by his father to Eichmann through Swiss intercession for their free passage from Hungary to Switzerland in 1944. Yet there is probably no one in the long line of failed gold mining executives who misconstrued gold more thoroughly than Peter Munk has. Conspiracy or no conspiracy, Peter Munk is an inveterate believer in the power of the U.S. government to manipulate the price of gold. That is the secret of his downfall. Peter Munk’s gold business is no better than his other businesses have been, only bigger.

I am still not committed to the conspiracy theory according to which Barrick has allowed itself to be used by policymakers in the U.S. to cap the price of gold, although I must admit that the circumstantial evidence has become a notch more circumstantial with this latest announcement. To me it looks like the desperation of a passenger aboard the sinking Titanic who has lost his life saver. I base my judgment on the timing. To make such an announcement at a time when the gold price is challenging the \$1000 level is a miscalculation of Babelian proportions, not to say a suicidal dash to the exit. All this time was wasted, while the gold price was under pressure, when exactly the same announcement would have been helpful to Barrick — as it has to Newmont. It is too late now. I do not see how Barrick can remain a viable business entity once it has lost its tether, real or imagined, tying it to the U.S. Treasury.

My sympathy is with the shareholders of Barrick, who are going to fare no better than those of Lehmann Brothers. What people do not seem to understand is that gold locked up in ore is one thing, and gold locked up in vaults is another. There are times, such as now, when their values part company. Why? Because too many gold mines are just a conduit to make the shareholder and his money part company. Remember Mark Twain having said that a gold mine is a hole in the ground with a liar standing guard? Remember Bre-X? It is so much easier to fool people than doing the back-breaking work of bringing up gold locked in the ores deep underground.

Aaron Regent, the new President and CEO of Barrick, commented on the company’s announcement as follows:

“The gold hedge-book has been a particular concern among our shareholders and the broader market which we believe has obscured the many positive developments within the company. As a result of today’s decision we have addressed that concern and maintained our financial flexibility. With the industry’s largest production and reserves, Barrick provides exceptional leverage to the gold price, which we expect will be further enhanced as we build our new generation of low-cost mines.”

But leverage works both ways. In the case of Barrick it has always worked the other way. Mr. Regent sounds as if the troubles of Barrick were now over as management has finally decided to bite the bullet. They are not. The agony will last until the last vestiges of the nightmare of “hedging” will be erased. Even in the optimistic appraisal of management it will take at least one year. In reality, it will take much longer, as ever higher gold prices will frustrate efforts to close the hedge-book for once and all. The fact is that the wolf is at the door and refuses to leave. The problem of the hedge-book will keep resurfacing, until everybody will understand that it is unmanageable. The cat is chasing its own tail.

The job cut out for Barrick is the job of Sysiphus. He was a king who betrayed Zeus’ secrets. As a punishment he was confined to Tartarus and made to roll up a boulder to the top of the mountain only to see it falling back, and his travail would start all over again.

When everybody sees Barrick as the latter-day Sysiphus, the company will give up the ghost, and the cheerful creditors will happily carve up the rich caracass, with former shareholders looking on in dismay.

## Disclaimer And Conflicts

THE PUBLICATION OF THIS ARTICLE IS SOLELY FOR YOUR INFORMATION AND

## Entertainment. The Author Is Not Soliciting Any Action Based Upon

## It, Nor Is He Suggesting That It Represents, Under Any

## Circumstances, A Recommendation To Buy Or Sell Any Security. He

HAS NO POSITION, LONG OR SHORT, IN BARRICK STOCK, NOR DOES HE INTEND

## To Acquire One. The Contents Of This Article Is Derived From

## Information And Sources Believed To Be Reliable, But The Author

## Makes No Representation That It Is Complete Or Error-Free, And It

## Should Not Be Relied Upon As Such.

### References

Have Gold Bugs Been Barricked by the U.S.? [www.gold-eagle.com/gold_digest](https://www.gold-eagle.com/gold_digest), July 12,

2007.

Charles Davis, So Big It’s Brutal, Report on Business, The Globe and Mail: Toronto, June, 2006, p. 64.

Bob Landis, Readings from the Book of Barrick: A goldbug ponders the unthinkable, [www.goldensextant.com](https://www.goldensextant.com), May 12, 2002

Richard Rohmer, Golden Phoenix, the biography of Peter Munk, Key Porter Books, 1999

Antal E. Fekete, The Texas-Hedges of Barrick, [www.professorfekete.com](https://www.professorfekete.com), May, 2002

Ferdinand Lips, Gold Wars, Will hedging kill the goose laying the golden egg? p. 161-167.

### New York, FAME

Antal E. Fekete, To Barrick or to Be Barricked, That Is the Question, [www.gold-eagle.com](https://www.gold-eagle.com), August 11, 2008

George Bush’s ’Heart of Darkness’ — Mineral Control of Africa, Executive Intelligence Review, January 3, 1997, see in particular:

### Barrick’s Barracudas

### Inside Story: The Bush Gang and Barrick by Anton Chaitkin

### George Bush’s 10 billion giveaway to Barrick by Karl Sonnenblick

### Bush Abets Barrick’s Gold-digging, by Bail Billington

### See also: [american](http://american) _almanac.tripod.com/bushgold.htm

---

*September 9, 2009*

### Calendar of Events

University House, Australian National University, Canberra: first week of November, 2009 Peace and Progress through Prosperity: Gold Standard in the 21st Century

This is the first conference organized by the newly formed Gold Standard Institute.

For further information, e-mail: feketeaustralia@gmail.com ,

On the Gold Standard Institute, e-mail philipbarton@goldstandardinstitute.com Martineum Academy, Szombathely, Hungary, in March 2010.

Stay tuned for further announcement.

Professor Fekete on DVD: Professionally produced DVD recording of the address before the Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the Great Depression: Can It Happen Again? plus an interview with Professor Fekete. It is available from [www.Amazon.com](https://www.Amazon.com) and from the Club [www.economicclubsf.com](https://www.economicclubsf.com) at \$14.95 each.

### DVD’s of the Gold Standard University Sessions

Session 3 (Adam Smith’s Real Bills Doctrine and Its Relevance Today)

Session 4 (The Bond Market and the Markey Process Determining the Rate of

### Interest)

### Session 5 (A Primer on the Gold and Silver Basis)

Session 6 (Encore Session: The Great Depression) are now available. For details how to order, see the announcement on the website [www.professorfekete.com](https://www.professorfekete.com) .

.

---

# Gold Is Pale Because It Has So Many Thieves Plotting Against It

URL: https://newaustrianeconomics.com/archive/fekete/gold-is-pale-because-it-has-so-many-thieves/
Date: 2009-08-28
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, central-banking, gold-standard, backwardation, monetary-policy
Description: Fekete uses a classical quotation to examine the systemic assault on gold by governments, central banks, and bullion banks through leasing, naked short selling, and regulatory suppression. He argues that the thieves' success has been their undoing — the very suppression of gold has accelerated the withdrawal of physical gold from the monetary system.
Editorial Note: Written August 2009. The title is attributed to Erasmus. Fekete uses the quotation to frame the historical relationship between gold and the political powers that have always sought to control it.
Original PDF: https://professorfekete.com/articles/AEFGoldIsPale.pdf

25 years ago I visited Comex at the World Trade Center, watching the feverish activity in the gold pit from behind the glass wall in the gallery. A gentleman standing next, unknown to me, remarked: “One day this make-believe charade will come to a bad end. All that these guys are doing down there is creating ever more claims to the same lump of gold — just as governments have been doing before they met their ignominious fate.”

Later that day I went to see the Director of Research of Comex. During our chat that lasted about an hour he intimated that he was greatly disturbed by the mystery that the gold basis has been steadily declining year in and year out.

Perhaps it was the fact that he could not solve the puzzle that bothered him so much that he quit his job a few months later.

I must confess that I could not solve that puzzle myself until the Twin Towers of the World Trade Center came tumbling down many years later. For me it was a symbolic event, conjuring up the unknown gentleman and bringing back his cryptic remark. We are watching a game of musical chairs. When the music stops, paper claims to gold will be dishonored, and the gold futures markets will tumble down just like the Twin Towers.

In my earlier article The Dress Rehearsal for the Last Contango I observed that “a very strange phenomenon has been manifesting itself during the past thirty-five years, since the inception of gold futures trading. The basis as a percentage of the rate of interest, rather than remaining constant, has been vanishing and, by now, it has dropped to zero.” In the rest of that article I drew * The title is a quotation from Diogenes Laertius (fl. 2nd century A.D.) This was the favorite quotation of the late Chicago economist and gold expert Melchior Palyi. attention to the apocalyptic consequences of the prospect of permanent backwardation in gold threatening the world, which is completely ignored by the makers of monetary policy, as I had opportunity to convince myself during my recent encounter with Paul Volcker, the Chairman of President Obama’s Economic Recovery Advisory Board. As I see it, the Debt Tower will topple, just as the Twin Towers of the World Trade center have, when hit by permanent gold backwardation. The reason is that the availability of gold is absolutely indispensable for maintaining our system of irredeemable debt. Only then will bondholders, like the participants of the game of musical chairs, be satisfied that there is a goodly number of vacant chairs available, so let’s get on with bond trading, gold futures trading, and let the music roar on.

But once permanent backwardation in gold establishes itself, gold is no longer available at any price. Bondholders will scramble to sell their irredeemable bonds before they lose all their remaining value. There is no other way to pacify bondholders than letting the game of musical chairs go on, that is, continue the charade of gold futures trading putting ever more claims on the same lump of gold.

The response to my article was overwhelming. I have never realized how many people out there are following my writings on the internet so closely. I want to thank every one of you and assure you that I take this responsibility most seriously. Even if I cannot answer every message I get from you individually, I will continue to do my best to explain the results of my research in simple, understandable terms.

Let me spell out for my readers what the vanishing of the gold basis means from the point of view of the puppet-masters of the gold futures markets.

It means that they are fighting a losing battle. They are desperately trying to coax gold out of hiding by offering ever higher bribes — not in terms of the price but in terms of the basis. A low basis means that they offer to take your cash gold and let you have gold futures in exchange at a discount price. (The discount is contango minus the basis, so that the two are inversely related: as the basis falls, the discount increases.) This will allow you to invest an amount equal to the price of gold (less five percent, the margin on the gold future) in any way you want and, having paid the reduced contango, you can keep the profits.

The point is that you will still benefit from any advance in the gold price, same as you would if you owned cash gold. You can have your cake and eat it.

Remember, in a full carrying charge market, such as the gold futures markets were at inception, no such bribe money was offered.

But, lo and behold, people who are willing to take the bribe are few and far in between. So the pot is sweetened. The basis is lowered. Maybe at one point gold will be coaxed out of hiding, once the bribe is high enough.

No such luck. When the basis gets as low as zero, it means that the discount on gold futures has gone so high that it is equal to the opportunity cost of holding gold. Therefore, again, if you give up your cash gold in exchange for gold futures, you can invest an amount equal to the price of gold (less five percent) in any way you wish, but now they let you keep your profit in its entirety. And you can still benefit from any advance in the gold price, same as you would if you had the cash gold in your hands.

This is where we are now. Indications are that the game fish still does not bite. What now? Where do the futures markets in gold go from here? Well, the pot can be further sweetened. The basis can be pushed down into negative territory. Gold could be forced into backwardation. Let’s see what that means. It means that you can sell cash gold and buy it back for future delivery at an outright discount. Somebody wants your gold so badly that he is willing to pay you for the privilege of holding it for a few days, few weeks, few months paying your storage and insurance fees. You get your gold back at a cheaper price. You make a risk-free profit on this deal. If the gold price goes up in the meantime, you benefit fully, just as if you have held on to the cash gold.

Now risk-free profits are a promise of unlimited profits because, if you are nimble enough, then you can make any number of round trips. However, opportunities to earn risk-free profits from arbitrage do not last. Other nimble speculators would jump in and their unlimited action would close the spread that gave rise to the risk-free profit in the first place. Yet I predict that, after a period of initial vacillation between backwardation and contango (due to action by misinformed traders) gold will settle in permanent backwardation.

Wouldn’t that be loverly? Risk-free profits galore. No need to bother with storage charges and insurance premiums. Just sit back and enjoy the ride to riches.

But hey, wait a minute! Is the arbitrage really risk-free? You give up your cash gold, but what if your gold futures contract expires and they refuse to return your gold? Commodity markets can change the rules of the game midstream. They just declare ‘cash settlement only’ for outstanding contracts.

Unsaid and unstated, not even mentioned in small print, is the fact that the trap door may be slammed shut. The investor who has taken the bribe is neatly separated from his gold when the hairy godfather waves his magic wand. “Gold is pale because it has so many thieves plotting against it.” There are all too many trap doors, sprung wide open, ready to devour gold belonging to the unweary.

That’s it. That’s why more people do not fall for the bribe even when tickled with promises of risk-free profits. The promise is mendacious. There is a risk: the risk that you lose your gold and you may never be able to buy it back at any price. There is no other explanation for the fact that the promise of risk free profits does not eliminate the discount on the futures price of gold. This is the true explanation for the coming permanent backwardation in gold.

Gold futures trading is clearly a con-game, but it is in a symbiotic relation with the regime of irredeemable currency and irredeemable debt, on which our ‘democracy’ is based. So we have a double con-game. We have a smaller con3 game of gold future trading inflicted upon gullible people who want to have their cake and eat it and, then, we have the much bigger, all-embracing congame of irredeemable currency, inflicted upon the rest of us, innocent bystanders. It is inflicted by the United States government that stoops so low as to trample on the Constitution mandating a metallic monetary system for this country precisely in order to outlaw all Ponzi-schemes. The government could never muster the moral courage to propose an Amendment that would make the Constitution conform to its monetary system — as it would open Pandora’s box.

Rather, it would live with the onus of being in contempt of the Constitution. The government of the United States had looted gold from its own subjects in 1933.

It looted even more gold from people not under its jurisdiction in 1971. It continues to operate in the same tradition.

The larger con-game of the irredeemable dollar could not have gone on so long, but for the smaller con-game of gold futures trading from which it takes its strength. Historically, every regime of irredeemable currency has met its Nemesis in no more than 18 years. The present experiment with irredeemable currency has been going on for twice that long. Of course, gold futures trading is a relatively new invention that was not available to the managers of the assignats, mandats, or the Reichsmarks. Nor was it available to the managers of the most recent experiment with the Zimbabwe dollar. But, as the relentless fall in the gold basis clearly shows, people cannot be conned forever. The clock is ticking. Sand in the hourglass keeps dropping. When it runs out, the present experiment with fiat dollar will also meet its Nemesis, as all the earlier experiments have. That’s the good news.

The bad news is that the government of the United States persists in continuing the double con-game and Ponzi-scheme through thick and thin. It is callous to the economic damage it is causing world-wide, and it disregards the danger of permanent gold backwardation that would inflict utter economic pain on the innocent people of this country, to say nothing of the people of the rest of the world. As explained above, it would make the runaway debt-tower of Babel topple, burying people under the rubble as the Twin Towers of the World Trade Center buried people working inside.

When that happens, the government of the United States will not have the excuse that it has not been warned. I have delivered the message in person to the Chairman of President Obama’s Economic Recovery Advisory Board, Paul Volcker, when we met at the Santa Colomba Conference last July. I also consider it my moral duty to warn all the people who are willing to listen of the danger lying ahead. It is incredibly naïve to believe that gold can be removed from the international monetary system with impunity at the stroke of a pen, as they pretended to do it in 1973. The gold corpse still stirs. When it rises from its prostrate position it will, like Gulliver, dust off the Lilliputians who like ants have been scurrying all over his body. The day of reckoning will have dawned.

Keynesian and Friedmanite economists bear a special responsibility for the disaster. They dug in and monopolized their positions at universities and research institutes. They never allowed a free discussion on the gold standard.

They did everything to aggrandize and perpetuate their own power as the sole advisors on government policy. They will not be able to live down this shame in a thousand years.

### Masters Gold Fund

In my previous article More Dress Rehearsal of the Last Contango (see References below) I mentioned the unique Masters Gold Fund, soon to come on stream, structured to take advantage of the permanent backwardation in gold when it comes, which would ground all other gold funds. I have acted as advisor from inception and during the incubation period. In that article I listed seven exclusive features spelling out how the Masters Gold Fund would operate in these perilous times. It would take its clues, not from the gold price that is open to manipulation, but from the gold basis which is a pristine indicator telling you about the willingness of gold holders to carry on in playing the game of musical chairs and putting their gold at stake.

In response to subsequent inquiries that I have received, I provide the name and e-mail address of the manager of the Masters Gold Fund, who will be happy to send the prospectus to interested parties upon request:

### Sandeep Jaitly (Sandeep.Jaitly@soditic-cbip.co.uk)

If you come to our Seminar in Canberra, Australia, in November, then you will be able to meet Mr. Jaitly in person, and ask him questions directly.

### Disclosure

I have not been paid by Masters Gold Fund or its parent company for writing this article, or any other article representing it. My interest in the project is purely intellectual. I want to demonstrate that, under the regime of irredeemable currency, it is possible to have gold locked up in a vault and still make it bear a return in gold — to disprove Aristotle’s dictum: pecunia pecuniam parare non potest (gold does not beget gold).

What we have here is an historical anomaly. Never before could one earn a return on gold in gold unless one surrendered control, thus incurring a risk.

The risk in investing in the Masters Gold Fund is that the gold price stabilizes, that is, the world willy-nilly goes back to a gold standard. However, this is a risk that anybody should be glad to take.

---

*August 29, 2009*

### References

### More Dress Rehearsal for the Last Contango, August 26, 2009

Remobilize Gold to Save the World Economy! An open letter to Paul Volcker, Chairman of President Obama’s Economic Recovery Advisory Board;

July 6, 2009. See: [www.professorfekete.com](https://www.professorfekete.com)

### Calendar of Events

University House, Australian National University, Canberra: first week of November, 2009:

Peace and Progress through Prosperity: Gold Standard in the 21st Century This is the first conference organized by the newly formed Gold Standard Institute. For further information, e-mail: feketeaustralia@gmail.com ,

On the Gold Standard Institute, e-mail philipbarton@goldstandardinstitute.com Professor Fekete on DVD: Professionally produced DVD recording of the address before the Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the Great Depression: Can It Happen Again? plus an interview with Professor Fekete by the President of the San Francisco School of Economics. It is available from [www.Amazon.com](https://www.Amazon.com) and from the Club [www.economicclubsf.com](https://www.economicclubsf.com) at \$14.95 each.

DVD’s of the Gold Standard University, Session 3 (Adam Smith’s Real Bills Doctrine and Its Relevance Today); Session 4 (The Bond Market and the Markey Process Determining the Rate of Interest); Session 5 (A Primer ont he Gold and Silver Basis) are now available, and so is Session 6. For details, see the announcement on the website [www.professorfekete.com](https://www.professorfekete.com)

---

# More Dress Rehearsal for the Last Contango

URL: https://newaustrianeconomics.com/archive/fekete/more-dress-rehearsal-for-the-last-contango/
Date: 2009-08-25
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, permanent-backwardation, gold-standard, monetary-crisis
Description: A follow-up to the previous day's essay, providing additional data and analysis of the August 2009 backwardation episode. Fekete examines the pattern of backwardation events and argues that their increasing frequency and duration confirm his model of progressive gold withdrawal from the monetary system.
Editorial Note: Written August 25, 2009, the day after the previous Dress Rehearsal piece. The two essays together provide a real-time account of the August 2009 backwardation episode.
Original PDF: https://professorfekete.com/articles/AEFMoreDressRehearsalForTheLastContango.pdf

I have received a deluge of mail from readers of my latest article on the gold basis and the threat of the coming permanent backwardation in gold. I truly appreciate the interest of my readers in learning my thoughts on the subject. I regret that it is not possible for me to answer these letters individually; I make an attempt here to answer one or two, where the questions are general enough so that my answers may benefit all readers.

### Hello Antal!

I have questions about your “Dress Rehearsal for the Last Contango”.

(1) Will not gold at \$1,000+ per ounce restore gold holdings registered at Comex warehouses? If not, why not?

(2) When the gold basis goes negative, could it not subsequently go back to positive, assuming the price rises to over \$1,000? If not, why not?

(3) Why must gold backwardation, once established, become permanent?

I should like to hear your reply to these questions. I am really very interested in understanding fully the implications of the vanishing basis for gold, and I hope you can provide me with your answers to my questions.

With warm regards,

### Victor

Dear Victor,

For a full discussion on the gold basis and the permanent backwardation in gold you must come to Canberra, Australia, where the Gold Standard Institute will have a Seminar in November. This Seminar is second in a row, devoted exactly to these topics. Last year’s Seminar was a great success; this year’s will be an even greater one. I am confident to say that Canberra is the only place in the world where you may get scientific information on gold contango, gold basis, gold warehousing, bimetallic arbitrage, and the prospects of permanent gold backwardation, as well as answer to a host of tantalizing questions that arise from these. We shall have an expert on hand from the Perth Mint. And, as an absolute first, the manager of Masters Fund, a unique gold fund just coming on stream, will be in attendance to answer questions. I am proud to say that I have been associated with this Fund from inception throughout the incubation period.

The Masters Fund is offering exclusive features not available from any other fund, such as:

(1) The guiding star of the Fund is not the dollar price of gold, but the gold basis which is much less open to manipulation, and much more relevant to an accumulation plan;

(2) The gold in the Fund bears a return in gold, so profits are measured not in terms of the U.S. dollar but in terms of gold itself;

(3) Any appreciation of the Fund’s value in U.S. dollar terms is additional, but the maximization of dollar value is not a prime objective;

(4) The gold in the Fund is never put out on lease or on loan, nor can it be pledged as collateral, but stays on the premises at all times under the full control of the Fund. It has never happened before that you could collect the return on capital unless you were willing to relinquish temporary control over it and thereby assume the risk of losing it. This could be important at a time when wholesale defaults on paper gold contracts may engulf the world;

(5) The principle on which the Fund operates is valid whether the monetary metals are in a bull market or whether they are in a bear market;

(6) The Fund is especially recommended to those individuals who are in the habit of measuring the value of their assets and their own net worth in gold units, rather than irredeemable paper units such as the US dollar;

(7) The Fund is structured in such a way as to take full advantage of the coming permanent gold backwardation, when all other gold funds will be grounded.

Of course, false alarms can and do occur, and it is possible that gold goes into backwardation and then promptly comes out of it. It has happened before. But here we are looking at a 35-year trend, embracing the entire history of gold futures trading. The trend has been that, as a percentage of the prevailing rate of interest the basis has been falling from practically 100% to practically 0%.

You and I know the reason for this: it has to do with the vanishing of all newly mined gold into private hoards at an accelerating pace; the insatiable appetite in the world to snap up all available gold by well-heeled governments and individuals who no longer believe in the tooth fairy residing in the Federal Reserve.

You have to remember that the basis is widely used as a guide in the huge arbitrage operations between gold holdings and dollar balances and in the gold carry trade. To participate in this arbitrage you must have gold on deposit in Comex warehouses. But with the vanishing of the gold basis the profitability of this arbitrage as well as that of the gold carry trade has been drying up, which explains the dwindling of warehouse stocks.

Another consequence of the vanishing of the gold basis is that it makes the risks involved in the gold/paper arbitrage rather lopsided, as far greater risks are assigned to short positions on gold and long positions on the dollar, than on long positions on gold and short positions on the dollar. The arbitrageurs are very much alive to this lack of symmetry, and are increasingly unwilling to put their gold in harm’s way. They are fully aware that we are approaching an historic milestone, one that has never been passed before: the milestone marking the last contango. As a consequence of this lopsidedness the gold futures markets can no longer coax gold out of hiding. In vain do futures markets promise risk-free profits for taking over the carry from the individual.

Here is the deal they offer you: give us your cash gold in exchange for gold futures that we’ll let you have at a deep discount, so that you can pocket risk-free profits. The offer is increasingly declined. There was a time when a drop in the basis would pull in gold from the moon, figuratively speaking. No more. Arbitrageurs no longer believe that gold futures are fully exchangeable for cash gold.

Gold backwardation is virtually inevitable and when it comes, it will be irreversible. Why? Because it signifies a crisis of the first magnitude: the general disappearance of gold from trade for reasons of lack of confidence. No one will give up gold, because one is no longer confident that he can get it back on the same terms. Vanishing confidence is like a runaway train. The only thing that might turn this runaway train around is a steep rise in US interest rates.

However, this is not in the cards. It would ruin what is left of the US economy.

It would also cause the bond market to collapse, sending the dollar down the drain.

I do not see the collapse of the bond market happening anytime soon. The US Treasury and the Federal Reserve can muddle through this crisis, and possibly beyond, by making bond speculation risk free in order to maintain demand for Treasury paper.

Having said that, I don’t think the guys at the US Treasury and at the Fed understand the gold basis and the seriousness of the threat of permanent gold backwardation. They are just trying to hold the line at \$1,000 for whatever psychological value it may have, for as long as they can. It’s the same old tug of war, they think.

It is not. Once the \$1,000 level is breached, there may be some ‘profittaking’, to be sure. But, because of the zero basis, those who take profits will look rather foolish. Last contango — last profit taking.

Be prepared for a great wave of defaults on paper gold obligations.

Certainly, the lessees of central bank gold will default. Comex will close its gold pit for good, and outstanding contracts will be settled on a cash basis. I will be surprised if any gold ETF shareholders will see a grain of gold coming their way out of the rubble left by the default. Comex gold certificate holders will be lucky if they can get a fraction of their gold back from the warehouses — after a lengthy wrangle. Too many claims have been issued on the same lump of gold.

Under these circumstances it is difficult to see how anyone could wish to deposit gold in a Comex warehouse to restart gold futures trading. The market for slaves has disappeared after emancipation never to come back again. The gold futures markets will disappear, utterly (and deservedly) discredited. Like the slave markets, they will never come back.

Yours faithfully,

### Antal

---

*August 26, 2009.*

### References

### Dress Rehearsal for the Las Contango, August, 2009

### The Last Contango in Washington, June 25, 2006

The Vanishing of the Gold Basis and its implications for the international monetary system, June 23, 2009

Remobilize gold to save the world economy! An open letter to Paul Volcker, Chairman of the Board of Governors of the Federal Reserve, 1979-1987; Chairman of President Obama’s Economic Recovery Advisory Board; July 6, 2009. See: [www.professorfekete.com](https://www.professorfekete.com)

### Calendar of Events

University House, Australian National University, Canberra: first week of November, 2009 Peace and Progress through Prosperity: Gold Standard in the 21st Century This is the first conference organized by the newly formed Gold Standard Institute.

For further information, e-mail: feketeaustralia@gmail.com ,

On the Gold Standard Institute, e-mail philipbarton@goldstandardinstitute.com Professor Fekete on DVD: Professionally produced DVD recording of the address before the Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the Great Depression: Can It Happen Again? plus an interview with Professor Fekete by the President of the San Francisco School of Economics. It is available from [www.Amazon.com](https://www.Amazon.com) and from the Club [www.economicclubsf.com](https://www.economicclubsf.com) at \$14.95 each.

DVD’s of the Gold Standard University, Session 3 (Adam Smith’s Real Bills Doctrine and Its Relevance Today); Session 4 (The Bond Market and the Markey Process Determining the Rate of Interest); Session 5 (A Primer ont he Gold and Silver Basis) are now available. For details, see the announcement on the website [www.professorfekete.com](https://www.professorfekete.com) . DVD’s of the other Sessions will also be available soon.

---

# Dress Rehearsal for the Last Contango

URL: https://newaustrianeconomics.com/archive/fekete/dress-rehearsal-for-the-last-contango/
Date: 2009-08-24
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, permanent-backwardation, contango, monetary-crisis
Description: Fekete analyzes a brief episode of gold backwardation in August 2009 as a dress rehearsal for permanent backwardation — the Last Contango. Each episode of temporary backwardation is more severe than the last, indicating that the system is progressively approaching the point where gold refuses to return to contango permanently.
Editorial Note: Written August 2009. Fekete documents the recurrence of gold backwardation and develops his argument that temporary episodes are rehearsals for the permanent event that will end the paper money era.
Original PDF: https://professorfekete.com/articles/AEFDressRehearsalForTheLastContango.pdf

## Dress Rehearsal For The Last Contango

**Antal E. Fekete** · [aefekete@hotmail.com](mailto:aefekete@hotmail.com)

I have written about “the last contango in Washington” before. The phrase covers the gold crisis that has been brewing under the surface in the world for the past sixty years due to the insane gold policies of the United States Treasury.

As a result all newly mined gold, surpassing the quantity of all gold ever mined in the world prior to 1947, has gone into private hoards, from which it will be next to impossible to coax it out. The measure of this act of disappearance of gold is the vanishing of the basis, or the last contango.

In the technical jargon of the futures markets the basis is the spread between the nearest futures price and the cash price in the same location. The gold market has always been a carrying-charge market, a.k.a. contango market, due to the monetary metal status of gold. This means that the gold spread has always reflected the carrying charge, or the opportunity cost of carrying gold, the lion’s share of which is foregone interest. But a very strange phenomenon has been manifesting itself during the past thirty-five years, since the inception of gold futures trading. The basis as a percentage of the rate of interest, rather than remaining constant, has been vanishing and, by now, has dropped to zero.

At the same time gold holdings registered at the Comex-approved warehouses have been dwindling. Both indicators point towards a developing shortage of monetary gold that appears to be irreversible. The support of the paper gold markets is at stake. Without cash gold backing it up, paper gold trading is not viable.

When the gold basis goes negative, that’s the end not only to contango but also to gold futures trading as we know it. Permanent backwardation in gold has never ever been experienced — unless we imagine that there is a gold futures market in Harare. Gold is not available at any price quoted in Zimbabwe dollars.

In that sense the last contango has first occurred in Zimbabwe. Whatever paper trading of gold is still going on in the United States, it is at best a ‘dress rehearsal’ for the Last Contango in Washington that will be followed by the regime of permanent backwardation. The meaning of this is that physical gold cannot be purchased at any price quoted — this time, yes, in U.S. dollars. The U.S. dollar rubbing shoulders with the Zimbabwe dollar?

Mainstream economists and financial journalists shrug: “So what? We are not watching the basis of frozen pork bellies trading either when we make monetary policy”. These gentlemen betray a complete lack of comprehension as far as the nature of the present financial and credit crisis is concerned. Make no mistake about it, whatever else it may be, this crisis, first and foremost, is a gold crisis with incubation period measured in scores of years. It is about to reach its climax. The world appears to be totally unprepared for it, witness the complete silence surrounding the gold nexus. Even the so-called sound-money websites misread the situation. They are talking about an imminent break-out of the dollar-price of gold from its holding pattern below \$1000 per ounce. Such break-outs have occurred from time to time since 2001, when gold broke through the ‘resistance-levels’ of \$300, \$400, etc. The coming break-out is not distinguished by the fact that \$1000 is an even rounder figure than the previous round figures that have been successfully scaled. It is distinguished by the fact that we are confronting a world event the like of which has never happened in all history. It has never happened that gold was unobtainable at any price. It has never happened that all governments have defaulted on their debt obligations simultaneously.

Still, we have to explain the relevance of this to the present credit crisis.

It is no secret that the bonds, notes, bills, and other obligations of the United States government, or any other government for that matter, are irredeemable.

That is, they are redeemable in nothing but more of the same. For example, the bonds of the U.S. Treasury are redeemable in Federal Reserve credit, which is itself irredeemable and is ‘backed by’ the self-same bonds of the U.S. Treasury.

Why is it, then, that these Treasury obligations are in demand, where one might think that redeemability is a sine-qua-non of issuing them? What makes people participate in this shell-game? How can such a crude check-kiting scheme mesmerize the entire population of our globe? Come to think of it, the sight of this Ponzi scheme would shudder the Founding Fathers of our great Republic.

This is not an easy question to answer. But going through all the alternative explanations one-by-one, we come to the conclusion that the debt of the U.S. government is still redeemable in a sense, however limited or restrictive it may be. The debt of the U.S. government has a liquid market in which it can be exchanged for Federal Reserve credit. In turn, Federal Reserve credit can still be exchanged in liquid markets for physical gold, the ultimate extinguisher of debt, albeit at a variable price. But if you break that final link, when gold is no longer for sale at any price quoted in U.S. dollars, then the rug will have been pulled from underneath this house of cards, and the international monetary system will collapse like the twin towers of the World Trade Center. And this is the situation that we are now confronted with.

Look at it this way. There is a casino where the lucky gamblers can gamble risk-free. Their bets are ‘on the house’. This casino is the U.S. bond market. There is only one catch. The pile of the winning chips in front of each gambler may become irredeemable at the exit when the hairy godfather waves his magic wand.

As the gold markets enter their phase of permanent backwardation, all rational basis for holding U.S. Treasury debt, or any debt for that matter, will disappear. There will be a mad rush to the exits, and holders of debt will trample one another to death in trying to cash in on their winnings.

In July I attended the Santa Colomba Conference 2009 at the Palazzo Mundell near Siena, Italy. There were 50 people in attendance by invitation of Robert Mundell of Columbia University, recipient of the Nobel Memorial Prize in economics ten years ago. They were mostly officials of various treasuries and central banks, ambassadors, bankers, professors of monetary economics, authors of monographs and editors of financial journals. Paul Volcker, a former U.S. Treasury official and Chairman of the Federal Reserve Board, was present. I have circulated several papers prior to the conference among the participants. In these papers I was trying to call attention to the cataclysmic nature of the present credit crisis that could not be understood without trying to understand gold, the ultimate extinguisher of debt. We are all passengers on a runaway train on a down-sloping track, the brakes of which (gold) have been dismantled at the top of the hill. The train is picking up speed beyond any safe limit, and a crash appears inevitable.

Our gracious host and the chairman, Professor Mundell, has made two references to gold during the two-day conference asserting that, apart from wartime, the gold standard has been the most crisis-free monetary system in history. (Of course, all monetary system have a habit of breaking down during wars.) Yet not one participant has picked up the ball dropped by Mundell, to run with it. They kept talking about green shoots, the recovery of the stock markets, coming bailouts and stimulation packages. As to my papers stating that this crisis is a gold crisis, I got just one feedback, in private. Apparently, the rest of the participants have been turned off by the four-letter word ‘gold’ in the title. It was not worth their while reading the ramblings of this loner on the problem of “putting spent toothpaste back into the tube”.

One of my papers was an open letter addressed to Paul Volcker. In it I asked whether there were contingency plans in the Treasury or in the Federal Reserve to meet the coming crisis of permanent gold backwardation. Volcker declined to answer my question whether in public or in private. I am inclined to think that there are no such contingency plans other than “muddling through”, as they have in all previous monetary crises. None of the policy-makers see the uniqueness of the coming predictable crisis, or the need to confront it with a comprehensive plan. There is an overwhelming unwillingness to admit that the international monetary system as it is presently constituted has been built on quicksand. It is a mere makeshift that took its origin in the last gold crisis of 1971. Cracks have been papered over as they appeared after every subsequent crisis. Every opportunity to sit down and work out a permanent solution was passed up. This seems to have worked well enough in the past. Policy-makers see no reason why it would not work in the future.

Yet the Last Contango in Washington will be different from all previous crises. It will be elemental, devastating, and apocalyptic. It will destroy virtually all paper wealth, and render virtually all physical capital idle. It will involve hordes of unemployed people roaming the streets of the cities, caring for no law and order, pillaging homes and institutions. It will destroy our freedoms. It may destroy our civilization, unless we take protective action.

On the positive side, it will sweep away the complacency of the managers of the regime of irredeemable currency, and fundamentally weaken the sway of Keynesian and Friedmanite economics as it has a stranglehold on the teaching of economic science in the world.

The Last Contango in Washington will eclipse the Great Depression of the 1930’s. Be prepared!

### References

### The Last Contango in Washington, June 25, 2006

The vanishing of the gold basis, and its implications for the international monetary system, June 23, 2009

Remobilize gold to save the world economy! An open letter to Paul Volcker, Chairman of the Board of Governors of the Federal Reserve, 1979-1987;

Chairman of President Obama’s Economic Recovery Advisory Board;

---

*July 6, 2009*

### See: [www.professorfekete.com](https://www.professorfekete.com)

### Calendar of Events

University House, Australian National University, Canberra: first week of November, 2009

### Peace and Progress through Prosperity: Gold Standard in the 21st

### Century

This is the first conference organized by the newly formed Gold Standard Institute.

For further information, e-mail: feketeaustralia@gmail.com ,

On the Gold Standard Institute, e-mail philipbarton@goldstandardinstitute.com Professor Fekete on DVD: Professionally produced DVD recording of the address before the Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the Great Depression: Can It Happen Again? plus an interview with Professor Fekete. It is available from [www.Amazon.com](https://www.Amazon.com) and from the Club [www.economicclubsf.com](https://www.economicclubsf.com) at \$14.95 each.

DVD’s of the Gold Standard University, Session 3 (Adam Smith’s Real Bills Doctrine and Its Relevance Today); Session 4 (The Bond Market and the Markey Process Determining the Rate of Interest); Session 5 (A Primer ont he Gold and Silver Basis) are now available. For details, see the announcement on the website [www.professorfekete.com](https://www.professorfekete.com) . DVD’s of the other Sessions will also be available soon.

---

# The Federal Reserve as an Engine of Deflation

URL: https://newaustrianeconomics.com/archive/fekete/the-federal-reserve-as-an-engine-of-deflation/
Date: 2009-07-19
Section: Popular Economics
Difficulty: intermediate
Concept Tags: federal-reserve, deflation, real-bills, capital-destruction, interest-theory
Description: Fekete makes the counterintuitive argument that the Federal Reserve — generally blamed for inflation — is primarily an engine of deflation. By destroying the Real Bills market, suppressing interest rates, and misallocating capital through open-market operations, the Fed produces the capital destruction that eventually manifests as deflationary depression.
Editorial Note: Written July 2009. The '(sic!)'  in the original title signals Fekete's awareness that his argument is counterintuitive — most blame the Fed for inflation. His point is that the deeper effect is deflationary through capital destruction.
Original PDF: https://professorfekete.com/articles/AEFFederalReserveAsAnEngineOfDeflation.pdf

### Introduction

Although the Fed’s open market purchases of securities (always net) affect only the short end of the yield curve directly, through the transmission of risk-free bond speculation they will affect the rest of the yield curve indirectly. Thus the entire spectrum of interest rates will keep falling in consequence of the Fed’s open market purchases of Treasury bills (or equivalent). This is a powerful if unrecognized force in the economy causing a chain-reaction as follows:

(1) risk-free bond speculation causes interest rates to fall,

(2) falling interest rates cause a severe erosion of capital throughout the productive apparatus,

(3) erosion of capital causes a falling trend in prices,

(4) falling prices further increase the downward pressure on interest rates.

Thus a vicious spiral of falling interest rates and falling prices is engaged, threatening to push the economy into the abyss of deflation. Mainstream economics lacks a valid theory of speculation. Hence it has a blind spot, failing to see the destructive nature of open market operations.

### Risk-free bond speculation

Typically, bond speculators carry on interest arbitrage along the entire (normal) yield-curve. They sell the short maturity and buy the long, hoping to capture the difference between the higher long rate and the lower short rate of interest (borrowing short and lending long). This arbitrage is not risk-free per se as it has the effect of flattening, and possibly inverting, the yield curve. As a result of inversion it is turned from a rising curve into a falling one, while turning the speculators’ profits into losses.

However, as a direct result of the open market operations of the Fed

(introduced clandestinely and illegally in the 1920’s through the conspiracy of the US Treasury and the Fed, long before the practice was legalized ex post facto in the 1930’s), interest arbitrage has been made risk-free. Astute bond speculators with their long leg in the bond market can profitably mimic Fed action in the bill market with their short leg. This never fails. Speculators know that, sooner or later, the Fed has to answer nature’s call and will go to the bill market as a buyer in order to replenish the money supply. This is their signal to sell. On rare occasions the Fed would be a seller. This is their signal to buy.

This copycat action is an inexhaustible source of unearned profits for the speculators. Thanks to the Fed’s open market purchases, they are always able to replace their fast-maturing bills with fresh ones so as to maximize their bond/bill spread. The more aggressive the Fed is in increasing the monetary base, the wider the spread and the greater the bond speculators’ profits will be.

### Absolute bad faith

After the F.R. Act of 1913 was quietly overthrown when Congress was not looking, the Fed has been revolutionized. According to the original Act the earning assets of the F.R. banks were to be restricted to real bills, that is, short term commercial paper originating in the production and distribution of consumer goods. Treasury paper was not listed in the Act as an eligible asset.

This was not an oversight. No part of F.R. credit outstanding was supposed to be backed by government debt. If a F.R. bank was found short of eligible paper in balancing its note and deposit liabilities, it did not matter how much the overflow of Treasury bills was in its portfolio, it had to pay stiff and progressive penalties.

The conspiracy between the U.S. Treasury and the Fed is to be seen in the fact that the former has ‘forgotten’ to collect the penalty from the latter. Indeed, why should the Treasury penalize its best customers for buying its staple product? By 1920 you could not find a real bill in F.R. portfolios with a magnifying glass. Nor was a serious effort made to return to the norms of the original Act after the end of the hostilities in starting rediscounting bills once more.

The conspiracy has gone right to the heart of the U.S. monetary system. In 1913 legislators were assured that they were voting for a commercial paper system that could never become an engine of monetizing government debt.

Should it try, it would be confronted with unacceptable losses. Later, when time came to legalize the illegal practice, the introduction of open market operations was presented as an innocent house-keeping change, a technical matter relating to banking practice. The fundamental issue, the wisdom of allowing the Fed to monetize government debt, was hushed up. Congress, let alone the general public, was never given a chance to scrutinize or debate it. Monetization of government debt was legalized through the back door, through chicanery, and through absolute bad faith. It was made the centerpiece of the money-creating process, in a complete reversal of the intention of the original Act. Is it any wonder, then, that the new monetary system born in sin has brought disaster to the nation in due course?

### Nature abhors risk-free speculation

Critics focus their criticism on the way the Fed creates money through sleight of hand. But there is a much larger issue here that goes unnoticed and has escaped attention. Open market purchases have made it possible for the Fed to usurp unlimited power in suppressing the rate of interest on all maturities through the transmission mechanism of risk-free bond speculation, while maintaining the illusion that it had only a very limited power of influencing the overnight rate of interest. The impression created is that the world can rest assured that all other rates are true market rates. Nobody took the trouble dispelling this illusion.

Nobody has investigated the consequences of bond speculation in the wake of open market operations. The ‘innocent house-keeping change’ opened up a bottomless pit for the national economy, as it has granted unlimited power to the Fed to suppress all interest rates along the yield curve, all the way to zero.

Just as nature abhors vacuum, it also ‘abhors’ risk-free speculation. It exacts an exceedingly high price from violators, sometimes after a long delay, when retribution is least expected.

The punishment for opening Pandora’s box of risk-free speculation was devastating, as demonstrated by the Great Depression of the 1930’s. In that episode risk-free speculation made bond prices rise and interest rates fall beyond any reasonable limits. Speculators abandoned the commodity market as too risky, and flocked to the bond market where all bets were on the house.

Commodity prices fell, along with interest rates, through the whole spectrum.

The consequences were apocalyptic.

### Falling interest rates as a destroyer of capital

My thesis that falling interest rates destroy capital across the board is admittedly controversial. I would welcome its examination ‘without fear and favor’ by a competent and unbiased panel. We must look at two related effects of falling (as opposed to low but stable) interest rates:

### (i)

(ii) the increase in the liquidation value of debt, the fading of depreciation quotas.

The proposition that the bond price varies inversely with the rate of interest is uncontroversial and universally accepted. It describes the effect from the point of view of the creditor. Yet people find it hard to comprehend the equivalent proposition describing the very same effect from the point of view of the debtor, namely, that the liquidation value of debt varies inversely with the rate of interest, in particular, lowering the rate of interest will increase the liquidation value of debt. There is no difference between the meanings of the two statements. The bond price is just the liquidation value of debt evidenced by the bond. Falling interest rates make the burden of debt increase.

The depreciation quota of a producer good is an accounting tool revealing how much of its value is being ‘used up’, and needs to be replaced through amortization, in any particular year. It is comparable to the annual yield of capital invested in a bond. When looked at in this way, it becomes clear that falling interest rates should make the revision of depreciation quotas upwards mandatory. If this rule is ignored, there will be a shortfall in amortization.

Sufficient funds will not have been set aside to pay for the purchase of the replacement at the end of the useful life of producer goods.

Present accounting standards ignore both effects (i) and (ii). This is the cause of concealed capital erosion acting insidiously. Losses are masked as profits, and phantom profits are paid out as dividends and managerial compensation. The process of capital erosion is accelerated. Inevitably, the result is deflation, depression, or worse.

We have seen that open market operations of the Fed serve as a powerful deflationary force in the economy causing interest rates to fall and capital to erode. We shall now see that falling interest rates cause prices to fall as well. It engages a vicious spiral pulling the economy into the abyss.

### Erosion of capital causes a falling trend in prices

The erosion of capital affects all producers, some of whom will succumb while others will fight for survival by trying to get out of debt. They will aggressively cut prices in the face of weakening demand.

Herein we have a classic example of central bank action being counterproductive. The central bank wants to snatch the economy from the jaws of deflation by increasing the money supply. Its preferred method is the open market purchases of short-term government securities. But through the transmission of risk-free bond speculation interest rates keep falling for all maturities. Capital invested in production is eroding faster as a result. The burden of debt is increasing. Producers are squeezed. They try to get out of debt by selling more of their product. In desperation they cut prices, but to no avail.

The vicious circle is complete.

### The Austrian theory of the boom-bust cycle

The suppression of the rate of interest through monetary policy and the resulting malinvestments made by entrepreneurs is a central theme of the Austrian School of economics. Our analysis is in the same tradition. In exposing the actual transmission mechanism that converts the suppression of short term rates into the suppression of the longer term rates, it carries the analysis further. It points out that open market purchases of the Fed make bond speculation risk-free with the result that all interest rates will fall simultaneously.

It turns out that it is not necessary to bring in the malinvestment argument.

After all, entrepreneurs could learn from past experience and fine-tune their investments taking the distortion in the rate of interest into account. Could the bust be avoided if they did? Our explanation of deflation and depression in terms of destruction of capital, brought about by the falling interest rate structure, avoids any reference to possible malinvestments and is, therefore, superior.

### The Achilles heel of Keynesianism

Our destruction of capital argument also has the advantage that it reveals the Achilles heel of Keynesianism preaching, as it is, the dangers of ‘oversaving’ and ‘underconsumption’. These concepts are vacuous. There is no reason why a society should not be able to satisfy the needs of those of its members who must be net savers (typically the juniors), and those who must be net consumers (typically the seniors). The Achilles heel of Keynesianism can be found in its treatment of capital, in particular, in ignoring the danger of capital erosion.

Keynesianism is oblivious to the fact that, if capital consumption occurs for any reason, then the resulting deficiency must be compensated for by the accumulation of new capital. Without it society cannot continue living at the same level of comfort and security. If it tries, it makes the crisis of undercapitalization even more critical.

The greatest mistake of Keynesianism is to teach that the cause of the Great Depression was falling prices due to oversaving. But falling prices were not the cause: they were the effect. The cause was falling interest rates, for which the fiscal and monetary policies advocated by Keynes were directly responsible: the unbalancing of the budget, inordinate increases in debt, and the monetization of government debt by the central bank. The Keynesian idea that open market operations will not and cannot have devastating side effects has become a dogma. This dogma must be discarded. Open market operations do have consequences.

### Deflation or hyperinflation?

A frequently asked question is whether the international monetary system based on irredeemable currency is facing a deflation similar to that of the 1930’s, or whether it is facing a Zimbabwe-type hyperinflation.

A relentlessly increasing money supply is not the only prerequisite for hyperinflation. There is another: the lack of suitable outlets for the bloated purchasing power. As risk-free bond speculation made possible by open market operations shows, no matter how much purchasing power is being created by the world’s central banks, speculators will always find rising bond values safer to bet on than on rising commodity values. In the absence of wars, or civil wars, destroying stores of consumer goods as well as the park of capital goods to produce, the forecast is deflation, not hyperinflation.

It follows that in combating deflation the Obama administration is resorting to measures that are ineffective, if not outright counter-productive. In particular, more government debt is poison for the economy. Its monetization by the Fed will only feed bullish bond speculation (and possibly bearish commodity speculation) while doing nothing to rebuild the impaired capital base of industry and finance. Bullish bond speculation is responsible for the falling interest-rate structure and destruction of capital. The economy needs to be stimulated, yes, but increased government spending is the wrong way to that goal.

The right way is through stable interest rates, more savings, and the accumulation of more capital.

If it were not so tragic, one could rub in the irony that Keynesianism, in trying to push the world into the pit of inflation, has only succeeded in pushing it into that of deflation — the very same pit it was so anxious to avoid.

---

*July 19, 2009.*

### Reference

The Revisionist Theory and History of Depressions, paper circulated at the Santa Colomba Conference of 2009, see the website [www.professorfekete.com](https://www.professorfekete.com).

### _______________

### Professor Fekete’s Australian Seminar

Time is passing and anyone wishing to attend this November’s seminar in Canberra is invited to contact Marcus Matthews at feketeaustralia@gmail.com to organise their ticket.

---

# Remobilize Gold to Save the World Economy!

URL: https://newaustrianeconomics.com/archive/fekete/remobilize-gold-to-save-the-world-economy/
Date: 2009-07-10
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, sound-money, monetary-crisis, fiat-currency, new-austrian-economics
Description: Fekete calls for the immediate remobilization of gold — making it legally available as a monetary medium for settling international obligations — as the only measure that can prevent a global deflationary depression. Remobilizing gold does not require a formal gold standard but simply removing legal barriers to gold's use in private transactions.
Editorial Note: Written July 2009. A practical prescription that falls short of full gold standard restoration — Fekete argues that simply removing legal restrictions on gold use would allow the market to remobilize gold spontaneously.
Original PDF: https://professorfekete.com/articles/AEFRemobilizeGoldToSaveTheWorldEconomy.pdf

*Remobilize Gold To Save The World Economy!*

An open letter to Paul Volcker, Chairman of the Board of Governors of the Federal Reserve, 1979-1987; Chairman of President Obama’s Economic

### Recovery Advisory Board

### Antal E. Fekete

### San Francisco School of Economics

### E-mail: aefekete@hotmail.com

Dear Paul:

In 35 years our paths have crossed for the second time. In 1974/75 you and I were Visiting Fellows at Princeton University. Now, in 2009, both you and I are attending the Santa Colomba Conference on the present debt crisis at the invitation of Bob Mundell.

In 1975 you conducted a seminar on the international monetary system and invited me to contribute a paper on gold which I did. Those were halcyon days by comparison. The United States, after the turbulence of 1971, successfully consolidated the international position of the dollar and could confidently lift the 42-year old ban on the ownership and trading in gold. On December 31, 1974, trading of gold futures contracts started in New York and Chicago. It showed a robust contango at full carrying charge, that is to say, the gold basis (the spread between the futures and the cash price) was at its peak. It indicated that monetary gold was available in great abundance to meet any demand for any reason. It showed that the gold futures markets could serve as the fulcrum in seeking out the equilibrium between the supply of and demand for gold. They could act as a safety valve, releasing occasional pressures that, in the absence of paper gold, may be a threat to the monetary system. It looked as if the gold problem has been solved for once and all.

But as I feared, and as the intervening 35 years have proved, rather than moving towards equilibrium we have been constantly moving ever farther away from it, as measured by the gold basis. The secular vanishing of the gold basis is a most ominous danger signal. It indicates that monetary gold is increasingly unavailable, and in case of a crisis it can no longer be relied upon to come to the rescue. Basis started out at 100 percent of the prevailing interest rate, but has been steadily eroding all the way to zero percent today. Permanent gold backwardation (negative gold basis) is staring us in the face. The gold basis is trying to tell you something. It heralds the greatest monetary crisis of all times. It warns about the possible collapse of the international monetary and payments system.

Let me explain. Gold is the only ultimate extinguisher of debt. Other extinguishers do, of course, exist but they are not ultimate in that they have a counterpart in the liability column of the balance sheet of someone else. Gold has no such liability attached to it. Gold is where the buck stops. It is this property that makes gold unique as a financial asset. Historically, gold discharged its function as the ultimate extinguisher of debt through the gold clauses written into the bonds of the U.S. government before 1933. Gold could also discharge this function, albeit rather imperfectly, under the gold exchange standard of 1934 with gold redeemability limited to foreign holders. Still more imperfect was the system of fluctuating gold prices introduced in 1971, thanks to the availability of paper gold. Imperfect as though these stratagems were, they served as a pacifier to the bond market. But as the threat of permanent backwardation indicates, all offers to put monetary gold at the disposal of the international monetary system could be abruptly withdrawn. In that event there would be no ultimate extinguisher of debt. The world is totally unprepared for such a momentous development. I ask you: are there contingency plans in the U.S. Treasury and in the Federal Reserve what to do if backwardation makes monetary gold unavailable for the indirect retirement of debt?

The message to debt holders would be: suave qui peut. There would be a rush to the exit doors and people would trample one another to death in trying to get out. The debt crisis of 2008 was a dress rehearsal. It gave the world a foretaste. This crisis is a gold crisis. It is a crisis indicating the threat of a shortage of the ultimate extinguisher of debt, without which our runaway debt tower is doomed. When it topples, it will bury the world economy under the rubble, as the Twin Towers buried the people working inside in 2001.

All kinds of ad hoc explanations have been offered for the debt crisis. But the real explanation is that under the threat of gold backwardation creditors are scrambling for liquidity. There will be no recovery unless provision is made for the orderly retirement of debt through a mechanism using gold as the ultimate extinguisher. The alternative is a Great Depression worse than that of the 1930’s. To understand this we have only to contemplate the shock to the world if it was revealed that the debt of the U.S. government was in fact irredeemable.

The Emperor is naked. As long as bonds carry a gold clause, or the bond market is supported by the trading of paper gold, bonds are deemed redeemable. But once permanent backwardation makes gold unavailable, debt becomes irredeemable in the eyes of the bondholders. Paying U.S. bonds at maturity in F.R. notes does not establish redeemability.

The latter is just evidence of debt secured by the former as collateral revealing that bonds are not really redeemable at all. An interest-bearing bond is replaced by a non-interest-bearing bond, that is, by an inferior instrument. All you do is shuffle various forms of irredeemable debt. When the world wakes up to this prestidigitation, the international monetary system will not be able to survive the shock-waves. The chaos that will engulf the world is appalling.

The solution is relatively simple. The world’s monetary gold should be remobilized. This can be accomplished by opening the U.S. Mint to the free and unlimited coinage of gold. There should be no attempt to fix, cap, or otherwise control the dollar price of gold. The gold coins of the United States ought to be made available to bondholders in order to provide for an orderly retirement of debt, if that is what the bondholders want. When they become convinced that this avenue is open to them through the unlimited availability of gold coins of the realm, the scrambling for liquidity will peter out and stability return. If other great nations wanted to join opening their Mints to the free and unlimited coinage of gold, so much the better. It should not be beyond the power and the wit of the U.S. government to rein in this crisis and make a decisive move in the direction of full recovery through opening the U.S. Mint to gold, as demanded by the Constitution.

Gold is a great world resource. It would be foolish if, for parochial or ideological reasons, we failed to enlist it in the cause of economic development — even in the absence of a great crisis. But given the present crisis situation, remobilization of gold is imperative.

Yours very sincerely,

### Antal E. Fekete

Santa Colomba, July 10, 2009.

---

# The Revisionist Theory and History of Depressions

URL: https://newaustrianeconomics.com/archive/fekete/the-revisionist-theory-and-history-of-depressions/
Date: 2009-06-29
Section: Popular Economics
Difficulty: scholarly
Concept Tags: real-bills, new-austrian-economics, federal-reserve, capital-destruction, deflation, monetary-policy
Description: Fekete's most comprehensive statement of his revisionist theory of depressions, applying it systematically to both the Great Depression and the 2008 crisis. He argues that depressions are caused not by aggregate demand failure but by the destruction of the self-liquidating credit mechanism — and that the standard policy responses (fiscal stimulus, monetary expansion) make them worse.
Editorial Note: Written June 2009. The definitive statement of Fekete's depression theory, bringing together the theoretical and historical threads of the Revisionist Theory and History of Money series.
Original PDF: https://professorfekete.com/articles/AEFRevisionistTheoryHistoryOfDepressions.pdf

*The Revisionist Theory And History Of Depressions*

**Antal E. Fekete*** · San Francisco School of Economics aefekete@hotmail.com An accounting principle, the Law of Liabilities, asserts that a firm ought to carry its liabilities in the balance sheet at its value upon maturity, or at liquidation value, whichever is higher. This Law is ignored by present accounting standards. The result is a rise in the liquidation value of debt, erosion of depreciation quotas, and wholesale destruction of capital under a falling interest-rate structure caused by a faulty monetary policy, hailed as the savior, but which should be condemned as the destroyer.

Recognizing the Law of Liabilities may help us to understand deflations and depressions better.

### The Book-Keeper’s Dilemma

One of the plays of George Bernard Shaw branded “unpleasant” by the playwright himself is entitled The Doctor’s Dilemma. The protagonist is a physician who comes into conflict with the Oath of Hippocrates (fl. 460-377 B.C.) He has developed a new treatment for a fatal disease, but the number of volunteers for the test-run exceeds the number of beds in his clinic.

Unwittingly, the doctor finds himself in the role of playing God as he decides who shall live and who shall die.

By the same token a “most unpleasant” play could be written entitled The BookKeeper’s Dilemma. The protagonist, a chartered accountant, finds himself in conflict with the letter and spirit of book-keeping as set out by Luca Pacioli (fl. 1450-1509). As a result of compromising the high standards of the accounting profession, the book-keeper becomes the destroyer of Western Civilization. This play is, in effect, being written by history right now. ————————————

This is an updated version of my paper written a year ago: Is Our Accounting System Flawed? – It may be insensitive to capital destruction. Up-dating was prompted by events during that fateful year. In several passages I had to change the subjunctive mood to the indicative: the hypothetical depression has, unfortunately but not unpredictably, become an actual depression.

### Finest product of the human brain

Luca Pacioli taught mathematics at all the well-known universities of Quattrocento Italy including that of Perugia, Napoli, Milan, Florence, Rome, and Venice. In 1494 he published his Summa Arithmetica, Tractatus 11 of which is a textbook on book-keeping. The author shows that the assets and liabilities of a firm must balance out at all times, provided that we introduce a new item in the liability column that has been variously called by subsequent authors “net worth”, “goodwill”, and “capital”. This innovation makes it easy to check the ledger for accuracy by finding that, at the close of every business day, assets minus liabilities is equal to zero. If not, there must be a mistake in the calculation.

But what Pacioli discovered was something far more significant than a method of finding errors in the arithmetic. It was the invention of what we today call double-entry bookkeeping, and what Göthe has called “the finest product of the human brain” (Wilhelm Meister’s Apprenticeship.)

Why was this discovery so important in the history of Western Civilization? Because, for the first time ever, it was possible to calculate and monitor shareholder equity with precision. This is indispensable in starting and running a joint-stock company. Without it new shareholders could not get aboard, and old ones could not disembark safely. There would be no stock markets. The national economy would be a conglomeration of cottage industries, unable to undertake any large-scale project such as the construction of a transcontinental railroad, or the launching of an intercontinental shipping line.

The invention of the balance sheet did to the art of management what the invention of the compass did to the art of navigation. Seafarers no longer had to rely on clear skies in order to keep the right direction. The compass made it possible to sail under cloudy skies with equal confidence. Likewise, managers no longer have to depend on risk-free opportunities to keep their enterprise profitable. The balance sheet tells them which risks they may take and which ones they must avoid. It is no exaggeration to say that the present industrial might of Western Civilization rests upon the corner-stone of double-entry book-keeping. Oriental (Chinese) and Middle-Eastern (Arab) civilizations would have outstripped ours if they had chanced upon the discovery of the balance sheet first. By the same token, the continuing leadership of the West depends on keeping accounting standards high and isolated from political influences.

### Barbarous relic or accounting tool?

There is cause for concern in this regard. For the past 75 years the West has been fed the propaganda line, attributed to John Maynard Keynes, that the gold standard is a “barbarous relic”, ripe to be discarded. The unpleasant truth, one that propagandists have ‘forgotten’ to consider, is that the gold standard is merely a proxy for sound accounting and, yes, for sound moral principles. It is an early warning system to indicate erosion of capital. It was not the gold standard per se that politicians and adventurers wanted to overthrow. They wanted to get rid of certain accounting and moral principles, especially as they apply to government and banking, that had become an intolerable fetter upon their ambition for aggrandizement and perpetuation of power. Historically, accounting and moral principles had been singled out for discard before the gold standard was given the coup de grâce.

The attack on accounting standards and on the gold standard was heralded by the establishment in 1913 of the Federal Reserve (F.R.) System in the United States, the chief engine of monetizing government debt followed, a decade later, by the illegal introduction of ‘open market operations’. Open market operations were not authorized by the F.R. Act of 1913. In fact, progressive penalties were levied on F.R. banks that could only cover their liabilities incurred upon issuing F.R. credit by assets in the form of U.S. Treasury paper.

‘Eligible paper’ was defined in the Act as short-term commercial bills of exchange, to the exclusion of Treasury bills, notes, and bonds. The F.R. Act was later amended legalizing open market operations ex post facto.

Bond speculators were quick to realize that risk-free profits could be made by preempting the F.R. banks’ purchases of Treasury paper in the open market. Bullish speculation, risk-free, in Treasury bills, notes, and bonds ultimately drove down interest rates to near zero, resulting in the destruction of capital, as explained below. Just how the monetization of government debt has led to a hitherto unprecedented, even unthinkable, corruption of accounting standards ― this is a question that has never been addressed by impartial scholarship before.

### Bonds and the Wealth of Nations

In order to see the connection we must recall that any change in interest rates has a direct and immediate effect on the value of financial assets. Rising interest rates make the value of bonds fall, and falling rates make it rise. As a result of this inverse relationship the Wealth of Nations would flow and ebb together with the variation of the rate of interest. Benefits and penalties would be distributed capriciously and indiscriminately, without regard to merit. It follows that the world economy needs a ‘flywheel regulator’ to keep interest rates stable or, more precisely, to let the increase in the Wealth of Nations impart a rather gentle and slow falling trend to interest rates.

That flywheel regulator was the gold standard before it was forcibly removed and discarded by irresponsible politicians trampling on the Constitution of the United States.

Under the gold standard the rate of interest was stable and violent contractions in the Wealth of Nations were unknown. A lasting increase in the rate of interest could only occur in the wake of a natural disaster such as an earthquake, flood, or crop failure. Remarkably, these were cushioned by the spreading of the impact from the stricken country to the community of gold standard nations. War destruction would also cause the rate of interest to rise. In all these cases a higher rate of interest was beneficial. It had the effect of spreading the loss of wealth due to destruction of property more widely, easing the burden on individuals. Those segments of society, or those countries, that were lucky enough to escape physical destruction had to share in the loss through paying the increased cost of servicing capital due to higher interest rates. Everyone was prompted to work and save harder in order that the damage might be repaired quickly and expeditiously. As the rate of interest gradually returned to its original level, the Wealth of Nations expanded. Once again, everybody shared equally as the lower interest rate benefited all through the reduction in the cost of servicing capital.

It is not widely recognized that the chief eminence of the gold standard is not to be found in stabilizing the price structure (which is neither desirable nor possible). It is to be found in stabilizing the interest-rate structure. By ruling out capricious and disturbing swings, the Wealth of Nations is maximized.

The gold standard ruled supreme before World War I. It was put into jeopardy when general mobilization was ordered in 1914 by the manner in which belligerent governments set out to finance their war effort. These governments wanted to perpetuate the myth that the war was popular and there was no opposition to the senseless bloodshed and destruction of property that could have been avoided through better diplomacy. The option of financing the war through taxes was ruled out as it might make the war unpopular. The war was to be financed through credits. In more details, war bonds were issued in unprecedented amounts, subsequently monetized by the banking system. Naturally, these bonds could not possibly be sold without a substantial advance in the rate of interest. Accordingly, the Wealth of Nations shrank even before a single shot was fired or a single bomb dropped.

### Sinking fund protection

Under the gold standard bondholders were protected against a permanent rise in the rate of interest (which in the absence of protection would decimate bond values) by the provision of a sinking fund. In case of a fall in the value of the bond the sinking fund manager would enter the bond market and would keep buying the bond until it was once more quoted at par value.

Every self-respecting firm selling its bonds would offer sinking-fund protection.

Even though governments did not offer it, it was understood and, in the case of Scandinavian governments explicitly stated, that the entire bonded debt of the government would be refinanced at the higher rate, should a permanent rise in the rate of interest occur.

Bondholders who have put their faith in the government would not be allowed to suffer losses. Banks, the guardians of the people’s money, could regard government bonds as their most trusted earning asset. They were solid like the rock of Gibraltar. Such faith, at least in Scandinavian government obligations, was justified. The risk of a collapse in their value was removed. Governments, at least those in Scandinavia, occupied the moral high ground. The money they borrowed belonged, in part, to widows and orphans. They took to heart the Scriptural admonition and did not want to bring upon themselves the curse pronounced on tormentors of widows and orphans.

### Law of Assets

However, there was a problem with war bonds issued by the belligerent governments. They were quickly monetized by the banking system making the refinancing of bonded debt impossible. This created a dilemma for the accounting profession. According to an old bookkeeping rule going back to Luca Pacioli that we shall here refer to as the Law of Assets, an asset must be carried in the balance sheet at acquisition value, or at market value, whichever is lower. In a rising interest-rate environment the value of bonds and fixed-income obligations are falling, and this fall must be faithfully recorded in the balance sheet of the bondholder.

There are excellent reasons for this Law. In the first place it is designed to prevent credit abuse by the banks and other lending institutions. In the absence of this Law banks could overstate the value of their assets that might be an invitation to credit abuses to the detriment of shareholders and depositors. If the abuse went on for a considerable period of time, then it could lead to the downfall of the bank. In an extreme case, when all banks disregarded the Law of Assets, the banking system could be operating on the strength of phantom capital, and the collapse of the national economy, to say nothing of the world economy, might be the ultimate result. For non-banking firms the danger of overstating asset values also exists, and can serve as an invitation to reckless financial adventures. Even if we assumed that upright managers would always resist the temptation and stay away from dubious adventures, in the absence of the Law of Assets the balance sheet would be an unreliable compass to guide the firm through turbulence, materially increasing the chance of making an error. Managerial errors could compound and the result could again be bankruptcy.

Economists of a statist persuasion would argue that an exception to the Law of Assets could be safely made in case of government bonds. The government’s credit, like Caesar’s wife, is above suspicion. The government will never go bankrupt. Its ability to retire debt at maturity cannot be doubted. As a guarantee these economists point to the government’s power to tax. However, the problem is not with paying the face value of the bond at maturity, but with the purchasing power of the proceeds. By that standard, the U.S. government is guilty of partial and concealed default on every single 30-year bond it has sold since the opening of the doors of the F.R. banks for business in 1914. Currency depreciation is a more subtle and, hence, a more treacherous form of default. Governments, however powerful, cannot create something out of nothing any more than individuals can. They cannot give to Peter unless they have taken it from Paul first. Nor is the taxing power of governments absolute. Financial annals abound in cases where taxpayers have revolted against high or unreasonable taxes, sometimes overthrowing the government in the process. If the taxing power of governments had been absolute, then they could have financed World War I out of taxes. Bondholders would have suffered no loss of purchasing power, at least not on the victors’ side.

It is true that governments as a rule do not go bankrupt, but this may be a disadvantage. Putting a value on bonds higher than what they would fetch in the market is a fool’s paradise. Governments could use methods, fair or foul, to stave off the ill effects of their own profligacy. Awakening could be postponed, but it would be made that much ruder.

A strict application of the Law of Assets would have made most banks and financial institutions in the belligerent countries insolvent. The dilemma facing the accounting profession was this. If accountants and book-keepers insisted that the Law be enforced, they would be called “unpatriotic” and be made a scapegoat held responsible for the weakening financial system. Demagogues would charge that they were undermining the war effort. On the other hand, if the accountants allowed the banks to carry government bonds in the asset column at acquisition rather than at the lower market value, then they would compromise the time-tested standards of accounting and expose the bank, and ultimately the national economy, to all the dangers that follows from this, not to mention the fact that they would also draw the credibility of the accounting profession into question.

### Illiquid or insolvent?

The story how the accounting profession solved the dilemma has never been told. It may be a safe assumption that the dilemma was solved for it by the belligerent governments in prohibiting the public disclosure of the banks’ true financial condition. A new accounting code was created, far more lenient in adjudicating insolvency. The Law of Assets was thrown to the winds, replaced with a more relaxed one allowing the banks to carry government bonds at face value, regardless of true market value, as if they were a cash item. A new term was invented to describe the financial condition of a bank with a hole in the balance sheet punctured by the falling value of government bonds. Such a bank was henceforth considered “illiquid”, but still solvent. Never mind that the practice of allowing the illiquid bank to keep its door open was a dangerous course to follow. It had far-reaching consequences, including a threat to the very foundations of Western Civilization. It was a death sentence on the gold standard with a stay of execution. It was throwing the gates open to wholesale currency debasement world-wide. It is no exaggeration to say that the present unprecedented financial crisis is another delayed effect of the unwarranted relaxation of accounting standards back in 1914.

While I cannot prove that a secret gag-rule was imposed on the accounting profession,

I am at a loss to find an explanation why an open debate on the wisdom of changing timehonored accounting principles has never taken place. Apparently there were no defections from the rank and file of accountants in denouncing the new regimen as dangerous and unethical. The underhanded changes in accounting practice have opened the primrose path to self-destruction.

The dominant role of the West in the world was due to the moral high ground staked out by the giants of the Renaissance, among them Luca Pacioli. As this high ground was gradually given up, and the commanding post was moved to shifting quicksand, rock-solid principles gave way to opportunistic guidelines. Western Civilization has been losing its claim to leadership in the world. It comes as no surprise that this leadership is now facing its most serious crisis ever.

The chickens came home to roost as early as 1921 when panic swept through the U.S. government bond market. All banks found that their capital was seriously impaired as a result of the panic. Financial annals fail to deal with this crisis (exception: B. M. Anderson’s Financial and Economic History of the United States, 1914-1946, posthumously published in 1949, see reference at the end). Nor was it given the coverage it deserved in the financial press. Information was confined to banking circles. An historic opportunity was missed to mend the ways of the world gone astray in 1914. It was the last chance to avert the Great Depression of 1930 already in the making, to say nothing of other great depressions to follow.

### Law of Liabilities

Purely by using a symmetry argument we may formulate another fundamental principle of accounting: the Law of Liabilities. It asserts that a liability must be carried in the balance sheet at its value at maturity, or at liquidation value, whichever is higher. Since liquidation would have to take place at the current rate of interest, in a falling interest-rate environment the liabilities of all firms are rising. The reason for this Law is to prevent the government, banks, and other firms from understating their liabilities that would spell a great danger to the national economy. This danger has been completely disregarded by the profession of the economists, as it has by that of the accountants.

Economists have failed to raise their voice against the folly of allowing the interestrate structure to fluctuate for reasons of political expediency, implicit in the application of both Keynesian and Friedmanite nostrums. It is possible that the reason for this failure was the fatal blind spot that economists appear to have in regard to the danger of overestimating national income in a falling interest-rate environment.

The proposition that a firm ought to report liabilities at a value higher than the amount due at maturity whenever the rate of interest falls is, of course, controversial. Let us review the reasons for this crucial requirement. If the firm is to be liquidated, then all liabilities become due at once. Sound accounting principles demand that sufficient capital be maintained at all times to make liquidation without losses possible. If the rate of interest were to fall, then, clearly, earlier liabilities had been incurred at a rate higher than necessary. For example, if an investment had been financed through a bond issue or fixed-rate loan, then better terms could have been secured by postponing it. A managerial error in timing the investment had been made. This is a world of crime and punishment where even the slightest error brings with it a penalty in its train. Marking the liability in the balance sheet to market is the penalty for poor timing. If the investment had been financed out of internal resources, the penalty was still justified. Alternative uses for the resource would have generated better financial results.

Even if we assume that the investment was absolutely essential at the time it was made, and we absolve management of all responsibility in this regard, the case for an increase in liability still stands. After all has been said and done, there is a loss that must not be swept under the rug. If the balance sheet is to reflect the true financial position, then the loss ought to be realized. Any other course of action would create a fool’s paradise.

To see this clearly, consider losses due to accidental fire destroying physical capital not covered by insurance. The loss must be realized as it is necessary that the balance sheet reflect the changed financial picture caused by the fire. That’s just what the balance sheet is for. The proper way to go about it is a three-step adjustment as follows:

(1) Create an entry in the asset column called “capital fund to cover fire loss”.

(2) Create an equivalent entry in the liability column.

(3) Amortize the liability through a stream of payments out of future income.

It is clear that if the accountant failed to do this, then he would falsify all subsequent income statements. As a result losses would be reported as profits and phantom profits would be paid out as dividends. Not only would this weaken the financial condition of the firm, but it would also render the balance sheet meaningless, which may compound the error further.

Exactly the same holds if the loss was due not to accidental fire but to a fall in the rate of interest. The way to realize the loss is analogous. A new entry in the asset column must be created under the heading “capital fund to cover shortfall in capitalizing interest payments, and shortfall in depreciation quotas, due to the fall of the interest rate”, against an equivalent entry in the liability column, to be amortized through a stream of payments out of future income. This is not an exercise in pedantry. It is the only proper way to realize a loss that has been incurred as a result of the inescapable increase in the cost of servicing productive capital already deployed, in the wake of a fall in the rate of interest. Ignoring that loss would by no means erase it. It may well compound it.

### The effect of falling interest rate on depreciation schedules

When a firm acquires a capital good, it adds its value to the asset column of the balance sheet, while charging the same amount to the liability column. The liability must be amortized during the productive life of the asset. In other words, asset values are subject to depreciation, set forth in the depreciation schedule, specifying depreciation quotas year by year and item by item. Asset depreciation and liability amortization are the opposite sides of the same coin.

If the rate of interest is stable, then the depreciation schedule is fixed. However, if the rate of interest falls, the depreciation quota will be insufficient to do the necessary amortization. At the end of the productive life of the asset there will remain an unamortized liability. The depreciation schedule, in exactly the same way as a bond sold, is a liability of the firm which increases whenever the rate of interest decreases, as explained above.

If adjustment is not made, then, according to the Law of Liabilities, the balance sheet will falsify the position of the firm by showing assets of zero value at positive valuation.

Worse still, the profit/loss statement is also falsified, masking losses as profits.

Therefore it is incumbent on the accountant to rewrite the depreciation schedule by increasing depreciation quotas to reflect the fall in interest rates, regardless whether the purchase of the asset was financed through issuing debt, equity, or through funds generated internally. There is an increase in liability that has to be amortized by a further charge against future income.

Present accounting standards ignore the need to revise depreciation quotas upon a fall in interest rates. They allow firms to pay out phantom profits as dividends. The result is: destruction of capital which remains hidden. The balance sheet and the profit/loss statement cease to be a faithful guide to show the real picture. The larger the asset values involved are, the greater capital destruction is. Note that all firms are hit simultaneously by the erosion of capital, which makes the crisis more acute when the day of reckoning dawns, that is, when capital destruction can no longer be concealed.

### The example of Japan

I anticipate a torrent of criticism asserting that there is no such a thing as the Law of Liabilities in accounting theory or practice. I submit that I have no formal training in accounting, or in the theory and history of accounting. Nor do I recall having seen the Law of Liabilities in any of the textbooks on book-keeping that I have perused (although I have seen the Law of Assets in older textbooks that have long since been discarded). But I shall argue that either Law follows the spirit if not the letter of Luca Pacioli. Affirming one while denying the other makes no sense. Every argument that supports one necessarily supports the other.

The Law of Liabilities is a mirror image of the Law of Assets, arising out of the perfect logical symmetry between assets and liabilities. Ignoring either Law is a serious breach of sound accounting principles, possibly with grave consequences.

Consider the example of Japan, allowing the rate of interest to fall practically all the way to zero during a fifteen-year period. Present (in my opinion deeply flawed) accounting rules allowed companies and banks in Japan (including those banks that not so many years ago were among the world’s ten largest) to understate their liabilities. Hence they could report losses as profits. Wholesale capital consumption and destruction was the result, without anybody realizing what was going on. Japan now has to live with a brain-dead banking system operating on phantom capital. The economy has been brought to its knees spelling deflation, depression, or worse, as indeed it seems to be happening right now. The cancer of depression has been metastasizing across the Pacific through the yen-carry trade, foolishly encouraged by the F.R. and the Bank of Japan as a way to push interest rates even lower in the United States.

Rather than analyzing the Japanese example and drawing the appropriate conclusions, policy-makers in the U.S. had an irresistible itch to follow Japan’s jump into the abyss of the Black Hole of zero interest. The result, perfectly predictable, is catastrophic. Yet the lesson has not been learned: after successfully massaging the short end of the yield curve to zero, on March 18, 2009, the Fed announced that it has set out to massage the long end as well.

### Historic failure to recognize the Law of Liabilities

Even if the fact were established that the Law of Liabilities has never been spelled out in any accounting code going back all the way to Luca Pacioli, we should still not jump to the conclusion that there is no justification for it. A convincing argument can be made explaining why the Law of Liabilities has escaped the notice of upright and knowledgeable accountants in the past with the consequence that it has never been codified. Historically, rising rather than falling rates have been the rule in spite of the fact that, since time immemorial, the powersthat-be have shown a persistent bias favoring debtors at the expense of creditors, as demonstrated by their efforts to suppress the rate of interest by hook or crook. However, this effort has been counter-productive. The usuriously high rates charged on loans in precapitalistic times were not due to an alleged greed of the usurers. They were due to the usury laws themselves. Charging and paying interest had been outlawed, but the result was not lower interest on loans as the authors of the usury laws had foolishly anticipated. On the contrary, the result was rates higher than what the free market would have charged. The excess represented compensation for risks involved in doing an extra-legal business transaction.

Even though the usury laws were later repealed, other anti-business measures have remained on the books that resulted in keeping interest rates higher than they would have been in the absence of government interference. For these and other reasons, traditionally, the problem was not falling but rising rates. In such an environment the Law of Liabilities remained inoperative and was easily overlooked. It is hard to discover a law that has been inoperative through all previous history.

### Revisionist history of the Great Depression

The picture changed drastically when the Fed started its illegal open market operations.

Thereafter falling rates became a regular feature of the landscape. Speculators were happy to jump on the bandwagon of risk-free profits. They could easily preempt the F.R. by purchasing the bonds beforehand. After the F.R. banks have completed the purchase of their quotas, speculators could dump the bonds and pocket profits they have earned risk-free. The net result was a falling interest rate structure.

The undeniable fact is that the opportunity for risk-free profits from bond speculation due to the introduction of open market operations was a major cause of the Great Depression.

It enabled bond speculators to siphon off wealth from the capital accounts of producers surreptitiously. Yet to this day textbooks on economics hail open market operations as a refined tool in the hands of monetary authorities “to keep the economy on an even keel”. Only one other mistake economists have made does match this in enormity. Textbooks blame the Great Depression on the “contractionist bias” of the gold standard. The truth is just the opposite. A second major cause of the Great Depression, in addition to the Fed’s illegal open market operations, was the government’s sabotaging of the gold standard in preparation for its overthrow, as I shall now explain.

The persistent fall of interest rates in the 1930’s has never been fully explained by the economists. They ignored the fact that the only competitor for government bonds, gold, has been knocked out through confiscation, or the threat thereof, as well as other measures of intimidation. In the absence of intimidation the marginal bondholder practices arbitrage between the bond market and the gold market. He will sell his bond, a future good, and keep the proceeds in gold, a present good, if the rate of interest falls below his time preference rate.

Conversely, if the rate of interest bounces back, he will buy back his bond at a profit. This is the mechanism to regulate the rate of interest by time preference. Clearly, it breaks down when the gold standard is removed.

Indeed, when Britain (in 1931) and the United States (in 1933) left the gold standard, government bonds were freed from their only competitor. Bond values started to rise, making interest rates fall, causing prices to follow suit — as I shall explain below. The Great Depression was self-inflicted. Governments in their zeal fired the policeman, the gold standard, that was supposed to cordon off the Black Hole of zero interest to prevent interest rates from falling in. Speculators were quick to understand that this also meant the removal of the ceiling on bond prices. For the first time ever, there was an opportunity to bid bond prices sky-high. Speculators abandoned the high-risk commodity markets in droves and flocked to the bond market to reap risk-free profits made available by the regime of open market operations. You cannot understand the Great Depression without understanding how speculators reacted to the forcible removal of gold, the only competitor for government bonds, from the scene.

Thus the Great Depression had a dual cause: (1) the illegal introduction of open market purchases of government bonds by the Fed, and (2) the unconstitutional suspension of the metallic monetary standard by the government. Both measures worked to destabilize interest rates, more precisely, they both worked towards establishing a falling trend.

### Paying out phantom profits

Superficial thinking may suggest that if the rise of interest rates is bad, then their fall is good for the economy. Not so. A falling rate is even more damaging than a rising one. I am aware that my thesis is highly counter-intuitive. I have been challenged by many other economists who deny the validity of my contention. They argue that if the present value of future income is lower when discounted at a higher rate, then it must be higher when discounted at a lower rate of interest. We may admit that this statement is true. However, obviously, the firm has to be around to collect the higher income. Many of them won’t be as they succumb to capital squeeze caused by the very falling of the rate that is supposed to be beneficial to them.

My critics hold that falling rates are always beneficial to business and it is preposterous to suggest that they aggravate deflation. These critics confuse a falling structure of interest rates with a low but stable structure. While the latter is beneficial, the former is lethal. When interest rates are falling, the low rates of today will look like high rates tomorrow. A prolonged fall creates a permanently high interest-rate environment. This paradox explains the reluctance of the mind to admit that falling rates spell deflation and, in an acute case, depression.

Falling rates mean that businesses have been financed at rates far too high and they carry assets in the balance sheet at inflated values, due to their failure to revise depreciation quotas upwards. This fact of falling rates ought to be registered as a loss in the balance sheet, and ought to be compensated for by an injection of new capital. If businesses choose to ignore the loss, and they merrily go on paying out phantom profits in the form of dividends and executive compensation, then they will further weaken their capital structure. When they finally plunge into bankruptcy, they wonder what has hit them. They don’t understand that they have failed to augment their capital in the wake of falling interest rates. Their downfall is due to insufficient capital. In a falling interest rate environment all firms are affected by the elusive process of capital destruction. This was true in the 1930’s; it is still true today.

Incidentally, this also explains why American producers have been going out of business in droves since the mid-1980’s, resulting in the export of the best-paying industrial jobs to Asian countries such as China and India where labor costs were lower.

The U.S. government is apparently unconcerned about the fact that the liquidation value of its debt is escalating by several orders of magnitude due to falling interest rates. It has increased a thousand-fold during the past 25 years, due to this one cause alone! This nonchalance is explained by the fact that, after all, the Fed has the printing presses to create dollars with which any liability of the government can be liquidated, however large.

### Cause: falling interest rates – effect: falling prices

American producers are not so fortunate. They don’t have a printing press to make their debt burden lighter. They have to produce more and sell more if they don’t want to sink deeper in debt. But selling more may not be possible in a falling interest-rate environment except, perhaps, at fire-sale prices. What this shows is that the cause of deflation is not falling prices: it is falling interest rates. Falling prices is the effect.

Let’s spell it out how this mechanism works. As interest rates fall, a vicious spiral is set in motion. Lower rates send prices lower, and lower prices send rates lower still. Bond speculators take advantage of the opportunity created by open market operations. They frontrun the Fed in buying government bonds first. The resulting fall in interest rates bankrupt productive enterprise that could not extricate itself from the clutches of debt contracted earlier at higher rates. The debt becomes ever more onerous as its liquidation value escalates past the ability to carry it. In addition, inadequate depreciation quotas undermine the financial structure of all firms, as explained above. The squeeze on capital causes wholesale bankruptcies among the producers.

While they clearly have the power to put unlimited amounts of irredeemable currency into circulation, central banks have no power to make it flow in the “approved” direction.

Money, like water, refuses to flow uphill. In a deflation it will not flow to the commodity and real estate markets to bid up prices there, as central bankers have hoped. Rather, it will flow downhill, to the bond market, where the fun is, bidding up bond prices. As the central bank has made bond speculation risk free, the bond market will act as a gigantic vacuum cleaner sucking up dollars from every nook and cranny of the economy. The sense of scarcity of money becomes pervasive.

In feeding ever more irredeemable currency to the money market the central bank cuts the figure of a cat chasing his own tail. Contrary to the universal delusion that goes by the name “Quantity Theory of Money”, more fiat money pushes interest rates lower and falling interest rates squeeze producers more. They cut prices in desperation and cry out for the creation of still more fiat money. To be sure, they get what they ask for. But their medicine turns out to be their poison. The creation of new money has a cost, namely, the F.R. banks’ open market purchases of government bonds and the concomitant bull speculation in the bond market. Producers are squeezed further and are forced to make more price cuts. The vicious spiral is on.

The interest rate structure and the price level are linked. Subject to leads and lags, they keep moving together in the same direction. Falling interest rates sooner or later induce falling prices. This is the lesson from the revisionist theory of depressions, a lesson that has been ignored by economists.

### Putting bank ratios in the vise

As the current global banking and credit crisis shows, destruction of capital was not confined to the producing sector. Falling interest rates shrank bank capital across the board of the financial sector as well, without the shrinkage being detected. All banks were weakened simultaneously. They should have augmented their capital or should have reduced their assets pari passu with falling interest rates. They had done neither. In a mad pursuit of high leverage they embarked upon a policy of increasing assets in the face of capital erosion. Bank ratios have been put in the vise: they are squeezed on both sides. They are squeezed on the liability side because the liquidation value of liabilities stands to be revised upwards; but they are also squeezed on the asset side because the value of assets stands to be revised downwards.

At first, the banks thought they were making fabulous profits. It was only later that it dawned upon them that, in fact, what they were paying out in the form of dividends and compensation were phantom profits. This compounded the problem of capital erosion. By

2008 the banks have reached the stage, more or less simultaneously, where all of their capital was wiped out. The credit crisis burst upon the scene with elemental force.

Through its open market operations the F.R. has, unwittingly, generated a deflationary spiral that ultimately bankrupted not just the producing sector, but the financial sector as well.

Like the Sorcerer’s Apprentice, the F.R. started the march to the Black Hole of zero interest, but did not have a clue how to stop it when the pull of the Black Hole has become irresistible.

At that point the deflationary spiral got out of control.

### The onset of Great Depression II

It is nothing short of frightening to see how policy-makers in the U.S. have misread and misinterpreted the danger signals warning of an imminent collapse of the financial system and the economy, and how they continue to prescribe the wrong medicine. We must face the fact that the present crisis is far worse than that of 1929. For one thing, the economy is so much larger making the collapse more damaging. Even more serious is the increasing debt burden that the collapsing economy is no longer able to carry.

The credit of the United States was incomparably stronger in 1929. Eighty years ago this country was the largest creditor in the world, a position it was to keep for the next forty years. By now the U.S. is the largest debtor nation in the world that needs to borrow money to pay interest on its debt. The tipping point was the year 1971 when the dollar was formally made an irredeemable currency. During the last forty years a colossal dissipation of wealth, unprecedented in history, has taken place. It was mostly unseen since it was papered over by an artificially fed boom in consumption. It is altogether futile to expect that the American consumer will pull up the world economy with his renewed spending if given the necessary pump-priming followed by sufficient stimulus.

Today the greatest creditor nation in the world is China. Is it realistic to expect that the Chinese consumer will take over the role traditionally played by the American consumer, given the fact that his government is a prisoner of Communist ideology?

We are still far from the trough of this depression, officially labeled a ‘recession’. At the trough the devastation will be far greater than that experienced in 1932, if for no other reason that there was no derivatives tower then, whereas we have one now that threatens the world with toppling. Only the tip of the derivatives iceberg has been identified by the captain of this ‘unsinkable’ Titanic, but not the invisible submerged part. He is oblivious of the fact that the inevitable collision will take place at greater depths.

Worst of all is the blockheadedness of policy-makers as they desperately stick to their long-since discredited Keynesian nostrums. Every measure they propose is counterproductive.

They seem to be unaware of the truism that pump-priming is useless if there is no water in the well. Likewise, there is no point in stimulating an organism that suffers from blood poisoning.

One has to treat the disease first. In this case blood poisoning is caused by irredeemable currency that hasn’t got the prerequisite quality to act as the ultimate extinguisher of debt. As a result, the world suffers from “debt poisoning”. Thus the problem is to remove the cause of poisoning, irredeemable currency, from the system, before any other therapy can be made effective.

### How to stop Great Depression II?

We have to stop the march to the Black Hole of zero interest. Restoring sound accounting standards is imperative. It is most unfortunate that the first tentative step in this direction, the compulsory marking of bank assets to market, will probably be rescinded as the authorities cave in to the vicious agitation of the bankers. Observers still have their blinkers on and cannot see the capital destruction caused by the failure to carry liabilities in the balance sheet at liquidation value. We must stop turning a blind eye to the deleterious effect of a falling interest rate environment on capital deployed in support of production. Open market operations of the F.R. must be outlawed and risk-free speculation in bonds stopped. They have been the chief cause of deflation as demonstrated by the pull of the Black Hole of zero interest.

The gold standard must be rehabilitated in order to abolish the inadmissible monopoly of government bonds. Some say this is unlikely to happen because it would be too painful.

However painful, the alternative is many times more painful. The alternative spells a total breakdown of law and order due to unacceptable levels of unemployment, much worse than that experienced in the 1930’s. The unraveling of social fabric threatens the survival of our republic and our civilization.

Self-liquidating credit has not been used since the outbreak of World War I. Bills of exchange with short maturity, payable in gold, drawn on fast-moving consumer goods in high demand, should be reintroduced as the means of financing multilateral world trade in preference to bilateral.

The key is in the hand of the U.S. government. It is the same key that was used to lock the U.S. Mint to silver in 1873, and to gold sixty years later, in 1933. By using it now to open the U.S. Mint to both silver and gold, the U.S. government can effectively cordon off the Black Hole of zero interest to prevent further damage.

At stake is nothing less than the question whether America can reclaim control over its destiny, saving Western Civilization in the process.

### References

By the same author:

### Kondratieff Revisited, May, 2001

### Deflation or Runaway Inflation? July, 2001

### The Economic Consequences of Mr. Greenspan, December, 2001

### Japan’s Finest Hour, January, 2002

### Revisionist View of the Great Depression I-II, March, 2002

### The Black Hole of Zero Interest Revisited, August, 2002

### Wrecker’s Ball of Swinging Interest Rates, September, 2002

Central Banker As the Quartermaster-General of Deflation, January, 2003

### Bubble That Broke the World, June, 2003

Stop Greenspan from Plunging America into a Depression! June, 2003

### Tainted Research, June, 2003

### Gold Demonetization Hoax, August, 2003

### Gold Is the Cure for the Job-Drain, September, 2003

### The Shadow Pyramid, November, 2007

### Fiat Currency: Destroyer of Capital, December, 2007

### Fiat Currency: Destroyer of Labor, December, 2007

### Opening the Mint to Gold and Silver, February, 2008

Is Our Accounting System Flawed? – It may be insensitive to capital destruction,

---

*May 20, 2008*

These and other papers of the author can be accessed at: [www.professorfekete.com](https://www.professorfekete.com) Benjamin M. Anderson, Economics and the Public Welfare, A financial and economic history of the United States, 1914-1946, (first published in 1949); Indianapolis, 1979: Liberty Press, p 80 ff.

### Note

This paper has been submitted to the Santa Colomba Conference on the International Monetary System to be held at the Palazzo Mundell, July 10-12, 2009.

---

*June 29, 2009*

---

# Is Aggregate Debt Excessive? The Obama Administration Is Looking at the Wrong Ratio

URL: https://newaustrianeconomics.com/archive/fekete/is-aggregate-debt-excessive/
Date: 2009-06-24
Section: Popular Economics
Difficulty: intermediate
Concept Tags: debt, capital-destruction, interest-theory, monetary-policy, federal-reserve
Description: Fekete argues the Obama administration's focus on the debt-to-GDP ratio is the wrong metric — what matters is the ratio of new debt to the marginal productivity of that debt. Once this ratio exceeds one, additional debt produces negative returns. By this measure, aggregate debt has been excessive since the 1990s.
Editorial Note: Written June 2009 in response to Obama economic team statements about debt sustainability. Fekete's marginal productivity of debt framework provides a more sophisticated analysis than the conventional debt-to-GDP approach.
Original PDF: https://professorfekete.com/articles/AEFIsAggregateDebtExcessive.pdf

The Obama Administration has raised the ante in combatting the recession by increasing the debt of the government to levels that were previously considered unthinkable. It is explaining away the weakening financial structure of the country by saying that aggregate debt has not increased much relative to GDP and is therefore not excessive.

This argument is false to the core. One cannot take comfort in past increases of GDP to justify future increases of debt. The fact is that the increase in debt has been the major motive power behind the increase in GDP and prices.

It cannot, therefore, be tested by its own results. The real test is the burden of debt. The economic advisers of president Obama forget that the GDP and prices may well decline, but the debt remains fixed. This means that, given the decline, even without further increases in aggregate debt the financial structure will deteriorate. How much more must it then deteriorate when all caution concerning the threat from excessive debt is thrown to the winds!

The argument about stimulating the economy with the proceeds of selling more government debt is equally false. It misrepresents the long-run economic effect of debt on the capacity to produce. If we stimulate the economy beyond its natural level by increasing debt, then we create a capacity that will not be required, and we induce a price and wage level that will not be possible to maintain when the debt spiral ceases. In this way government stimuli create latent pressures for future price, wage, and output declines, increasing the debt burden to a much greater extent than was originally envisaged.

Some people say it does not make any difference whether the money spent has come from debt or equity. This is fallacious because debt creates rigidities that are hard to adapt to declining prices and output. There will be some very unsettling effects. When people are scrambling for liquidity in self- defense, as they do now, debt will make them extra cautious about increasing their spending. This, in turn, makes conditions worse which will then make the debt more burdensome still, etc., creating a snowball effect. In adapting to adverse conditions the greatest enemies are fixed costs, such as interest, depreciation and, above all, debt which is not only hard to refinance but it also limits flexibility. If equity was used instead of excessive debt, then the snowball effect of adjusting to adverse conditions would be far less.

By virtue of pricing power the granting of “cost-of-living adjustments” to labor is easy and logical, provided that the cycle is in its upswing, so things are kept in fair balance. By contrast, reverse adjustments are very hard to make on the downswing. Therefore rigidities and maladjustments accumulate much faster, and they result in a much more precipitate decline as compared to the preceding rise in output.

The Obama administration is looking at the wrong ratio. Instead of the ratio of total GDP to total debt it should watch the ratio of additional GDP to additional debt, that is, the amount of GDP contributed by the creation of \$1 in new debt. This ratio shows how effective debt is to make the economy grow at the margin, and for this reason it may be called the marginal productivity of debt. As long as it is well above 1, the creation of new debt has an economic justification. It shows that the economy can have a healthy growth. But a falling marginal productivity is a danger sign. It shows that the quality of debt is deteriorating. Should the ratio fall below 1, it is “red alert”. The volume of debt is rising faster than the national income. The country is living beyond its means and is consuming capital.

In the worst-case scenario the marginal productivity of debt may fall into negative territory. This means that the economy is on a collision course with the iceberg of debt. Not only does more debt add nothing to GDP, in fact it causes contraction and greater unemployment. Debt creation must cease at once as a matter of utmost urgency. The condition of the economy can be compared to that of a patient suffering from internal hemorrhaging that must be stopped immediately.

Several observers calculated the marginal productivity of debt tracing it back for the past fifty or sixty years. One of them, Barry B. Bannister of Baltimore published his results on his website bbbannister@stifel.com. While the calculations of various observers have yielded various results, they all agree that the marginal productivity of debt has been falling and will reach 0 if it has not already done so. The discrepancy is due to the difference in defining net financial debt to avoid double counting. For example, Bannister is netting out all except the first round debt in the derivatives tower and, as a consequence, his calculations predict a further decline in the ratio but it will not become negative before 2015. Others argue that the layers of the derivatives tower are essentially higher levels of debt re-insurance which cannot be netted out because every higher level means the introduction of new risks. Accordingly, their calculations show that zero marginal productivity of debt was reached back in 2007 and since then the ratio has been negative and falling further.

In spite of disagreements and discrepancies, these studies agree that the present crisis is a debt crisis, and any further addition to aggregate debt runs the risk of making the economy contract further. Under these circumstances the Obama administration’s economic policy is self-defeating. More debt is poison to the economy. The internal hemorrhage will continue, nay, it will get worse.

The correct policy should allow insolvent firms and banks to be liquidated without interference from the government. There should be a resolute policy to strengthen the capital structure of the remaining firms and banks. It is imperative that the level of aggregate debt be progressively reduced until a marginal productivity of 1 or higher is restored. It follows that the balance sheet of the Federal Reserve banks should be contracted rather than expanded.

Why is a negative marginal productivity of debt a sign of an imminent economic catastrophe? Because it indicates that the economy is literally devouring itself through the consumption of capital. Production is no longer supported by the prerequisite quantity and quality of capital goods. The responsibility for this belongs to the fast-breeder of debt. It may give the economy a sense of euphoria during the upswing of the cycle, but is devastating in a downswing.

In March, while he was the president of the European Union, the Czech prime minister Mirek Topolanek publicly characterized president Obama’s plan to spend nearly \$2 trillion to ease the U.S. economy out of its recessionary hole, as “a highway to hell”, and he predicted that “it will undermine the stability of the global financial market”. While undoubtedly it was an undiplomatic gaffe and a display of extreme impoliteness, the caretaker prime minister did nothing but blurted out unpleasant truths.

It would have been more polite and diplomatic if Mr. Topolanek had couched his comments in the following tenor: “the stimulus plan was made in blissful ignorance of the marginal productivity of debt which is negative and falling. In this situation more debt will only stimulate deflation, economic contraction, unemployment, and it will lead to further weakening of the global financial structure.”

### References by the same author, see [www.professorfekete.com](https://www.professorfekete.com)

### Falsifying bank balance sheets, April 21, 2009

### Marginal productivity of debt, March 28, 2009

### A critique of the quantity theory of money, April 15, 2009

---

*June 24, 2009.*

---

# The Vanishing of the Gold Basis and Its Implications for the International Monetary System

URL: https://newaustrianeconomics.com/archive/fekete/the-vanishing-of-the-gold-basis/
Date: 2009-06-23
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, permanent-backwardation, gold-standard, monetary-crisis
Description: Fekete documents the secular decline of the gold basis and explains its implications: as the basis approaches zero, gold approaches permanent backwardation, and the international paper monetary system loses its last anchor. The vanishing basis is both diagnostic indicator and harbinger of the system's end.
Editorial Note: Written June 2009. A key companion piece to the Red Alert and Backward/Forward Thinking essays, providing the historical data on basis decline and connecting it to the broader trajectory of the international monetary system.
Original PDF: https://professorfekete.com/articles/AEFTheVanishingOfTheGoldBasis.pdf

THE VANISHING OF THE GOLD BASIS and its implications for the international monetary system

A paper presented at the Santa Colomba Conference on the International Monetary System at the Palazzo Mundell, July 2009.

### Antal E. Fekete

### San Francisco School of Economics

### E-mail: aefekete@hotmail.com

The gold basis is defined as the difference between the nearby futures price and the cash price of gold in the same location. A positive basis is called contango; a negative one, backwardation. Since there were no organized futures markets in gold prior to 1971, the history of gold basis is confined to the last 35 or so years.

Gold futures trading started on the Winnipeg Commodity Exchange in Canada in 1971 at a time when ownership and trading of gold was still illegal in the United States. Upon becoming legal the bulk of gold futures trading moved to New York and Chicago.

For all these 35 years the gold markets have been in contango (with minor exceptions due to temporary friction in the delivery mechanism). The basis cannot theoretically exceed the carrying charge (the lion’s share of which is interest, usually calculated on the basis of LIBOR). If it did, speculators would be able to pocket risk-free profits in buying the cash gold and selling the futures contract against it. This arbitrage would quickly push the basis back to the level of carrying charge. By contrast, should the market ever go to backwardation, there is no theoretical limit below which a negative basis could not fall. One should see clearly the economic significance of gold backwardation. It is an unmistakable indication of shortages of deliverable supplies.

On the face of it, backwardation in gold would be a rank aberration of the world economy as most of the gold produced throughout the ages is still in existence in marketable form. For this reason profit is to be made by selling cash gold while replacing it through buying the much cheaper futures contract. If people hesitate to do it, there must be a reason. Indeed, the reason is the lack of confidence on the part of people controlling gold (including the central banks!) that paper gold can be exchanged for physical gold at maturity as specified by the futures contract.

The basis for agricultural commodities shows a clear annual cyclical pattern that closely follows the crop year. It starts with contango just after harvest, and ends with backwardation when supplies are drawn down just before the new crop is brought in.

The behavior of the gold basis lacks this cyclical pattern characteristic of the markets for agricultural goods. Contango obviously follows the fluctuations of the interest rate up or down, the adjustment being practically instantaneous.

But, in addition, there is a rather curious phenomenon that can be described as the secular vanishing of the gold basis. This means that, as a percentage of the carrying charge (interest) the gold basis has been steadily eroding and by now has all but reached zero. Reversals in the trend, if any, are minor and temporary.

It is difficult to imagine any combination of circumstances in which there could be a major reversal in the trend of the gold basis, unless there was an explosion of interest rates.

It is incumbent upon economic theorists to explain the peculiarity of the secular vanishing of the gold basis, which is not observed in the case of the basis of other non-agricultural commodities such as the base metals, for example.

The overwhelming fundamental fact about gold during the past half a century is the steady and relentless absorption of new supplies from the mines through individual hoarding demand. Half a century of gold production at peak rates of output has disappeared without a trace and is by and large unaccounted for. This is more gold than had ever been produced previously. At the same time also absorbed was whatever monetary gold governments and central banks have in their wisdom dishoarded. It can hardly be doubted that if further supplies of monetary gold were dishoarded, it would be easily absorbed as well, and any setback in the price of gold on that account would be temporary. One should also remember that net dishoarding of gold by governments and central banks is a thing of the past. Countries such as China, Russia, Brazil, to mention but a few, are on record as wanting to buy all the gold they can without unduly disturbing the price. This means that the combined net private and official demand for gold will be insatiable for the foreseeable future. This is in full agreement with the secular vanishing of the gold basis.

The burning question is what happens when gold markets go to permanent backwardation, as is likely if present trends continue. Clearly, the gold futures markets will be no longer viable as they are presently constituted. The main source of gold for investment purposes will be permanently shut, as a negative gold basis means that all offers to sell cash gold have been withdrawn. To see this we have only to remember that paper gold promising future delivery can no longer be trusted under the regime of a negative basis, as explained above.

The huge volume of trade in paper gold would disappear with the advent of permanent backwardation. The demise of the paper market means that governments and central banks have abruptly lost their power to control the price of gold. They would no longer be able to sell unlimited amounts of futures contracts. Paul Volcker has admitted in public that he made a mistake as Chairman of the Federal Reserve in allowing the dollar price of gold to rise as far and as fast as it did in 1979-1980. By implication, he and his successors have learned from his “mistake” and succeeded in subsequently driving down the dollar price of gold during the period 1981-2001, or to contain increases during the period from 2001 onwards. They did it through offering unlimited amounts of paper gold in the futures markets. As we approach the landmark of permanent backwardation, the question arises how will the Federal Reserve control the gold price once the facility of gold futures trading is gone.

Another question is how the gold mining industry will react to the disappearance of the futures market. There is a possibility that they will stop selling gold against dollars altogether until normalcy returns to the market.

However, an announcement to withdraw the offer to sell newly mined gold would make the upheaval in the gold market even worse.

The implications for the international monetary system, in which the U.S. dollar is supposed to play the role of ultimate means of payment and extinguisher of debt, are devastating. The international monetary system is facing its greatest crisis for the past forty years as it confronts the threat of permanent backwardation in gold. Yet there is no sign that the financial press, or academia, let alone the U.S. Treasury and the Federal Reserve, take notice. They appear to think that the futures price of gold has no more relevance to the international monetary system than that of frozen pork bellies. They are under the illusion that gold has been demonetized. It has not. Not by the people anyhow, who had monetized it in the first place.

This crisis is a gold crisis, just as the last one in 1968 was. If anything, this one is the more serious of the two. In 1968 the crisis could be “papered over”, literally, by making the dollar irredeemable. Debt could still be liquidated in paper dollars because paper gold was still available. Presently this availability is the residual extinguisher of debt. Without it the debt markets could not function because bonds would, in effect, become irredeemable.

In 1968 policy-makers at the Treasury and the Federal Reserve were granted a “breathing space” during which they could devise a new international monetary system that would provide for orderly liquidation of debt. One hopes that they have used this breathing space fruitfully, and they have by now contingency plans ready for implementation when permanent gold backwardation engulfs the system and paper gold is no longer available, effectively removing the last “pacifier” from the debt markets.

It is not an encouraging sign that the planning, if any, has been done behind closed doors. There should have been an open debate on the debt crisis that threatens the world as gold markets go to backwardation. A blueprint for a new international monetary system should be drawn up publicly, with the participation of economists of all stripes and persuasion. Monetary reform should not be the exclusive turf of Keynesians and Friedmanites, according to whom there are compelling reasons to dismiss the gold standard out of hand as unfit, both conceptually and in practice, to play any role in a future international monetary system. They argue that its “disciplines” would be politically unacceptable in today’s world.

However, there is no way of telling what is politically acceptable and what is not in the throes of a great depression, with double digit unemployment, past the teens, when law and order is about to break down. Our debt crisis and the threat of gold backwardation are not unrelated. Aggregate debt as it exists in the world today is comparable to a runaway train on a down-sloping track.

The train started picking up speed back in 1971 when the golden brakes were disabled. By now it is accelerating beyond any safe speed limit, and a crash appears inevitable. In order to slow the train down one needs an ultimate extinguisher of debt that is universally acceptable as a means of payment. The dollar no longer answers this description. Gold does. Everything else has been tried “to paper over” debt, all in vain. Already, the debt crisis wiped out an enormous amount of wealth indiscriminately, causing great economic pain. We ought to remember that if all the remaining paper wealth is wiped out, gold will still survive intact. It is the only financial asset that has no counterpart as a liability in the balance sheet of someone else. That is its main excellence, a property lacking in all other financial assets.

The hour is late. It calls for statesmanship. This is no time for fingerpointing and rancor. Having recognized the threat of gold backwardation for what it is: the greatest financial crisis in all history, we should act responsibly.

If we do, it will be our “finest hour”.

---

*June 23, 2009.*

---

# Fiat Money in Death Throes

URL: https://newaustrianeconomics.com/archive/fekete/fiat-money-in-death-throes/
Date: 2009-06-10
Section: Popular Economics
Difficulty: intermediate
Concept Tags: fiat-currency, monetary-crisis, permanent-backwardation, gold-standard, capital-destruction
Description: Fekete argues that the events of 2008–09 represent the death throes of the fiat money system: the system is still alive but terminally ill, kept going by central bank life support that is itself destroying the productive base needed for recovery. The essay distinguishes between the political life of fiat money (which continues indefinitely) and its economic life (which is ending).
Editorial Note: Written June 2009. Fekete's confident diagnosis that fiat money is in terminal decline — while controversial at the time — anticipated the systemic crises of 2010–20 that mainstream economists attributed to regulatory failure rather than monetary design.
Original PDF: https://professorfekete.com/articles/AEFFiatMoneyInDeathThroes.pdf

*Fiat Money In Death Throes*

**Antal E. Fekete** · San Francisco School of Economics · [aefekete@hotmail.com](mailto:aefekete@hotmail.com)

> “Banking was conceived in iniquity and born in sin. The Bankers own the earth. Take it away from them, but leave them the power to create deposits, and with the flick of the pen they will create enough deposits to buy it back again. However, take away that power, and all the great fortunes like mine will disappear — as they ought to in order to make this a happier and better world to live in. But, if you wish to remain the slaves of Bankers and pay the cost of your own slavery, then let them continue to create deposits.”
>
> — Sir Josiah Stamp (1880–1941), formerly governor of the Bank of England, in his Commencement Address at the University of Texas in 1927. Reportedly he was the second wealthiest individual in Britain.

Make no mistake about it: in this credit collapse we are witnessing the death throes of irredeemable currency. In vain have governments and their client banks tried, for hundreds of years, to graft this repulsive and degenerate bastard on the living organism of society. The result was always the same: the healthy organism rejected the unnatural implant in its own good time.

The present episode is no different from earlier ones except, perhaps, in the degree of the conceitedness of the perpetrators, and in their contempt for the native intelligence of man.

When on August 15, 1971, Richard Nixon defaulted on the gold obligations of the United States and declared the irredeemable dollar the “ultimate” means of payments and liquidator of debt, he was relying on the expert advice of Chicago economist Milton Friedman. Five years later the world’s oldest central bank, the Swedish Riksbank would bestow upon Friedman the prize it established in memory of Alfred Nobel. The reward would be in recognition of the brilliance of Friedman’s idea that if a central bank robs the people piecemeal (read: it dilutes the currency at a fixed rate of, say, 3 percent per annum) then the victims would not cry “we wuz robbed!” They would never notice the robbery.

In all previous episodes shame and disgrace were part and parcel of the government’s default on its promises to pay. Not so in 1971. In this latest experiment with irredeemable currency there was a new feature: far from being a disgrace, the default was presented as a scientific breakthrough; conquering “monetary superstition” epitomized by gold; a triumph of progress. Sycophant governments and central banks overseas that were victimized by it and had to swallow unprecedented losses due to the devaluation of the dollar were not even allowed to say “ouch!” They were forced to celebrate their own undoing and hail the advent of the New Age of synthetic credit, irredeemable currencies and irredeemable debts.

The regime of the irredeemable dollar was put to the test soon enough. In 1979 the genie escaped from the bottle. The price of oil, silver, and gold were quoted at twenty times that prior to 1971; in the case of sugar the rate of increase was more like forty times. Interest rates were quoted in double digits well past the teens. There was panic across the land and the globe.

Hoarding of goods became a way of life. Everybody was expecting the worst.

It was at this time that the notion of “targeting inflation” was invented. Previously the claims of central bank power were rather modest. Central banks were supposed to target short-term interest rates. Later they graduated to targeting the money supply. Now they were claiming supernatural powers of micromanaging price increases. It was apparently working, and the genie was put back in the bottle.

In the intervening three decades policymakers and mainstream economists became ever more confident that in inflation-targeting they have found the holy grail of irredeemable currency. Professor Frederic Mishkin of Columbia University, a former governor of the Federal Reserve, published the gospel of inflation targeting with the title Monetary Policy Strategy in 2007. In his book he calls inflation targeting “an information-inclusive strategy for the conduct of monetary policy.” Martin Wolf, the chief economic columnist of the Financial Times of London explains: inflation targeting makes allowance for all relevant variables — exchange rates, stock prices, housing prices and long-term bond prices — via their impact on activity and prospective inflation. This, then, is the new modified holy grail. Cast your net wide enough to catch all that you want to control. If you do it boldly, you will make people believe that the government can control everything it wants to control. It is amazing how much can be accomplished by piling prestidigitation upon prestidigitation.

Ironically, disaster struck just at the time when the prophets of inflation-targeting became cocky beyond any measure of modesty. They actually had a whole debate going on in American journals, but also English ones. Ben Bernanke, who in the meantime was made the chairman of the Federal Reserve, contributed the keynote address and the title to the debate: “The Great Moderation”. Their description, up to and including the beginning of 2007 of what was happening in the macro economy, was a reduction in the volatility in the trade cycle: more consistent growth, less bouts of inflation, more stability. The London Times published a jubilant piece as recently as early 2007 with the title “The Great Moderation” which began with the line: “History will marvel at the stability of our era.” It was not meant to be a joke. It was meant to be believed. Complacency about the almighty nature of monetary policy reached its peak. They celebrated the success of inflation targeting just when it started to unravel. Policymakers, central bankers, and their lackeys in academia and journalism, felt inordinately proud of themselves. They thought they held the whole world in their hands.

The celebration and self-congratulation was premature. Bernanke & Co. did not know that they were about to be humbled by the markets. Blinded by the glare of their own glory, none of them foresaw the coming disaster.

Martin Wolf in his column on May 7 talks about “this unforeseen crisis” as an unmitigated disaster for monetary policy. It leaves fiat money with just one last chance to put its act together and save its hide. He says: “The holy grail turned out to be a mirage. If fiat money is not made to work better than it has, who knows what our children might decide to do in desperation. They might even decide to bring back and embrace gold”. Oh horror of horrors! Wolf still considers the gold standard an absurdity.

It’s kind of strange. It is not the regime of irredeemable currency, whereby governments are supposed to create wealth by sprinkling some ink on little scraps of paper, that is considered an absurdity. Of course, Mr. Wolf has the right of wanting to be pilfered and plundered. But he has no right to advocate that the rest of us be cheated through this crudest form of plunder forever and ever.

He is also mistaken when he assumes that Bernanke & Co. still has one more chance. The chance they just blew was the last. We are witnessing the closing of the regime of irredeemable currency and irredeemable debt. We may not know how long its death throes will take, but there will be no other chance. Financial journalists and mainstream economists, in their blind stupor acting as cheerleaders for the disastrous monetary policy of the government and the insane credit policy of the banks, have exhausted and destroyed their own credibility for once and all.

---

Martin Wolf, like most of his colleagues, is a victim of brainwashing inspired by Keynes that has been going on to discredit the gold standard for some 75 years, but which got a new lift after Friedman inspired Nixon to default. Yet here are the facts about the gold dollar that should be made available to the world through the opening of the Mint to gold, as demanded by the U.S. Constitution.

The gold standard is an indispensable prerequisite of freedom. Without it individuals are helpless in facing the constant and ongoing encroachment of their property rights by the government and the banks. The right to demand gold in exchange for bank notes and bank deposits far transcends the mere exchange of one form of money for another. It is the only way to check the unlimited power of the government manifested by the unlimited creation of bank deposits. The combination of governmental power and the power of the banks to create deposits is especially dangerous for the freedom of the individual, because of the double standard involved. The government exempts banks from the effects of contract law in exchange for the banks’ special treatment accorded to government debt.

Gold hoarding is not a blemish on the gold standard; it is its main excellence. When a sufficient number of individuals are disturbed by the encroachment of this combination of powers, or disapprove the monetary policy of the government and the credit policy of the banks, they are not helpless under a gold standard. They can withdraw gold from the banking system, thereby putting the government and the banks on notice that unless they mend their ways, and stop their adventures in debt creation, they will find themselves insolvent and out of power. The gold standard gives people the upper hand.

It is no accident that all dictatorships set out by limiting the people’s access to gold. It makes no difference whether they march under the banner of national or international socialism.

All totalitarian regimes inflict irredeemable currency on the people as an instrument of servitude and bondage. Martin Wolf should know this. The ideal of limited government is meaningless unless reinforced by a gold standard denying to the government the power of issuing unlimited amounts of currency. There is no other way of doing this than making the promises of the government redeemable in something other than more promises of the same kind.

Once the government makes the currency irredeemable, it puts itself in the position to curtail the rights and freedoms of the people as it sees fit. Constitutional government is effectively overthrown. Once the government usurps the public purse, its power becomes uncontrollable. Budget debate in Parliament or in Congress becomes an annual farce. Nothing stands in the way of unscrupulous politicians to undermine constitutional government. The purchasing power of the currency is constantly undermined year in, year out. The banks are freed from constraints on them exercised by the people under the gold standard. Pandora’s box of corruption is opened and its contents contaminate the nation’s economic, political, and social system.

Governments which employ irredeemable currency grab unconditional control over foreign trade, exchange rates, foreign investments and travel, even the amount of currency an individual can take in or out of the country. The more powerful governments will buy the allegiance of the less powerful. Out of this feudalistic web of allegiances financed by irredeemable currency come various adventures in fomenting and waging wars in far-away lands, spilling the blood of the young people of the nation for causes alien to them.

Under a gold standard prolonged budget deficits and prolonged unfavorable balance of payments cannot occur. There are forces limiting persistent losses of gold which tend to correct the underlying distortion. By contrast, under the regime of irredeemable currency economic distortions can persist indefinitely. They ultimately become destructive. This is so because government bureaucrats cannot possibly provide the same level of wisdom that a people free to act in their own interest can.

As problems in foreign trade mount, governments will find ever more excuses for ever more controls. There is no end to the expansion of government power over the individual until the nation regains the benefits of a gold standard, requiring that the government retire to its proper role of umpire and relinquish its role as dominant partner and dictator.

A government can take total control of the people either by the use of military force, or by the use of irredeemable currency. The former is readily understood, while the latter is a subtle national drug that is not generally recognized as such. Rather, it is readily embraced by its victims. For these and similar reasons irredeemable currency is the favorite device of modern governments that want to bring people under total control. Indeed, it enables the government to succeed in controlling the masses while, at the same time, earning their approval and even their enthusiastic support. Irredeemable currency must be seen as the habit-forming drug that the government uses to intoxicate people. Under this intoxication people will want more and more national spending, more and more government control, and more and more debt.

This intoxication obscures the sad end that arrives when the merry-go-round is coming to a jerky halt, when credit is exhausted or withdrawn, and the kitty is found empty. The nation is facing a most serious economic disaster followed by prolonged economic pain. Unfortunately government economists, university professors, and financial journalists have taken their share of the fun and they failed miserably in their duty to forewarn people of the coming disaster.

It is useless to expect a mass movement on behalf of a sound currency. The daily experiences of people provide them with a warped outlook. They confirm in their minds the alleged virtues and benefits of an infinitely inflatable currency. People lack sufficient understanding of monetary science to see that no currency can be made infinitely inflatable without inviting disaster. Like a drug addict, people exposed to irredeemable currency do not regard it as a dangerous and undermining narcotic agent. Even the loss of purchasing power does not disturb them to any great extent. Their response is to demand more money, and they take pride in the fact that the government listens sympathetically to their demand. They welcome the soaring stock indexes and real estate prices, and put great stores on them. Heavy taxes and burgeoning debt are not regarded with anxiety. A frequent and common agitation is for ever more government spending.

---

If we are to be saved from the ultimate evil consequences of the regime of irredeemable currency, needed action must come from the leadership of the opposition party when it is its turn to take over government. The new President and his Secretary of the Treasury, or the new Prime Minister and his Secretary of the Exchequer must be statesmen. They must act as informed and tough monetary surgeons, men who can and will persuade Congress or Parliament to reinstate redeemable currency.

Once that step is taken, the people should experience a breath of fresh air. Government would once more be subordinated to the Constitution, bringing greater freedom to the people.

Optimism should be wide-spread, because the currency of the people would once more had integrity. Business should prosper, domestic and foreign trade expand. Imbalances in foreign trade should rectify themselves. Gold should start to circulate and flow in from abroad. The control of the public purse would be returned to the people where it belongs if human freedom is to be preserved and responsible government is to be obtained.

But as the last presidential election in the United States has shown, the needed leadership is lacking. The party of the opposition is just as much in thrall to the same toxic ideology as the governing party. The last change of guards took place in the middle of a financial and economic crisis involving the destruction of quantities of wealth unprecedented in all history, with more destruction coming. Yet when the new president appointed officials at the Treasury, confirmed others at the Federal Reserve, and named economic advisors, they turned out to be the same men who were responsible for the credit collapse in the first place. Not only do these officials continue the dangerous course of the previous administration; they increase the stakes by several orders of magnitude in announcing more government spending, more government debt, and more fiat money creation.

The situation is no better in the United Kingdom, another important country expecting a change of guards, which could take the initiative to put a peaceful end to the regime of irredeemable currency now in its death throes. Rather than initiating a national debate on the failure of the financial system which was supposed to end bank runs, deflations and depressions, serial bankruptcies and unemployment, and on the return to sound money and sound book-keeping, H.M. Loyal Opposition is plotting a course how to cure the collapse of bad debt with the injection of more bad debt.

What this means is that there is no hope for change through peaceful means. When change finally comes, it will be through violence. When the economic pain inflicted on the people reaches unbearable heights, anarchy and chaos will ensue. This is precisely what the great monetary tradition of the English-speaking countries, in ruling out irredeemable currency and mandating a metallic monetary standard, was designed to prevent.

---

*June 10, 2009.*

### Acknowledgement

The author has drawn heavily on Walter E. Spahr’s article in the quarterly Modern Age, Summer, 1960, under the title “The Significance of the Gold Standard”, see also [www.professorfekete.com](https://www.professorfekete.com), April 17.

### Calendar of Events

### Instituto Juan de Mariana: Madrid, Spain, June 12-14, 2009

Seminar with Prof. Fekete on Money, Credit, and the Revisionist Theory of Depressions

### For information, contact: gcalzada@juandemariana.org

### OroY Finanzas & Portal Oro: Madrid, Spain, June 18, 2009

### Gold and Silver Meeting Madrid 2009

For information, contact: preukschat_alex@hotmail.com or gcalzada@juandemariana.org or [www.portaloro.com](http://www.portaloro.com/aemp.aspx) or info@portaloro.com San Francisco School of Economics, San Francisco, California, July 25, August 1 & August 8, 2009 Investment Seminars: Trading Gold, Wealth Management

The Gold and Silver Basis; Backwardation; Trading Gold in the Present Environment; Wealth Management under the Regime of Irredeemable Currency. Given by Professor Fekete and Mr. Sandeep Jaitly of Soditic Ltd., London, U.K. Enrolment is limited, first come first served. For details, check: [www.sfschoolofeconomics.com](https://www.sfschoolofeconomics.com), contact: ibischoff@sfschoolofeconomics.com San Francisco School of Economics, San Francisco, California, July 27-August 7, 2009

Two-week academic course: Money and Banking, taught in person by Professor Fekete Enrolment is limited; first come, first served. The Syllabus for this course can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com),

### For further details, check: [www.sfschoolofeconomics.com](https://www.sfschoolofeconomics.com)

### For enrolment contact: ibischoff@sfschoolofeconomics.com

San Francisco School of Economics, San Francisco, California, July 23-August 9, 2009

Private consultation with Professor Fekete available contact: ibischoff@sfschoolofeconomics.com University House, Australian National University, Canberra: first week of November, 2009 Peace and Progress through Prosperity: Gold Standard in the 21st Century

This is the first conference organized by the newly formed Gold Standard Institute.

For further information, e-mail: feketeaustralia@gmail.com ,

On the Gold Standard Institute, e-mail philipbarton@goldstandardinstitute.com Professor Fekete on DVD: Professionally produced DVD recording of the address before the Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the Great Depression: Can It Happen Again? plus an interview with Professor Fekete. It is available from [www.Amazon.com](https://www.Amazon.com) and from the Club [www.economicclubsf.com](https://www.economicclubsf.com) at \$14.95 each.

---

# Interview in the Daily Bell

URL: https://newaustrianeconomics.com/archive/fekete/interview-in-daily-bell/
Date: 2009-05-06
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, real-bills, new-austrian-economics, gold-standard, permanent-backwardation
Description: An extended interview in which Fekete surveys his monetary framework for the Daily Bell audience — covering the gold basis, permanent backwardation, Real Bills, the destruction of capital, and the prospects for monetary reform. One of his most accessible introductions to the full scope of his monetary theory.
Editorial Note: Published May 2009 by the Daily Bell. The question-and-answer format makes this an excellent entry point into Fekete's ideas for readers new to his work.
Original PDF: https://professorfekete.com/articles/AEFDailyBell.pdf

Daily Bell: Thank you for taking time to share your views with readers of the Daily Bell.

Prof. Fekete: It is my pleasure.

Daily Bell: Prof. Fekete, you are not directly aligned with any hard-money factions that we can see, at least not at this time. The Misesians in America have been having great success arguing for greater economic and personal freedom. But you may differ with them on fractional reserve banking. Do you think, as they apparently do, that fractional reserve banking is based on fraud and so it is involved in criminal activity?

Prof. Fekete: My difference with the position of the Ludwig von Mises Institute, first and foremost, centers on Adam Smith’s Real Bills Doctrine.

When the wholesale merchant delivers supplies to the retail merchant, he attaches the bill marked: “terms 90 days net”. The retail merchant endorses the bill in writing across its face “I accept” and returns it to the wholesale merchant, who could now use the same bill in paying his own suppliers. This method of payments is called

“discounting real bills” as the payee discounts the face value by the number of days remaining to maturity at the going discount rate. Of course, at maturity, the retail merchant pays the face value in full when the bill is presented to him for payment.

According to the Real Bills Doctrine of Adam Smith (1723-1790) real bills finance the production and distribution of fast-moving consumer goods without the need to invade the pool of savings. The doctrine is valid even in an economy where there are no banks, whether central or not. The consumer goods must be in most urgent demand in order to enable the real bill drawn on it to circulate spontaneously and thus to gain limited monetary privileges. Real bills are non-inflationary as they appear simultaneously with the emergence of new merchandise, and disappear as the underlying merchandise is removed from the market by the ultimate, gold-paying consumer, in less than 91 days.

This, incidentally, is the length of the seasons of the year. With the change of the seasons the character of consumer goods in the greatest demand will also change.

When commercial banks have later appeared on the scene, real bills became their most liquid earning assets. Saying it differently, real bills are self-liquidating as they mature into the gold coin surrendered by the ultimate consumer.

In so far as the term “fractional reserve bank” refers to a commercial bank that keeps its reserves in the form of gold coins and real bills, it is preposterous to suggest that it is involved in a criminal activity. It just substitutes its own credit for the commercial credit that exists independently in the form of real bills. The credit of the bank is more negotiable in the sense that it has higher name-recognition. To discount a real bill you need to be knowledgeable about the often intricate production process that has given rise to it. The circulation of bank credit does away with this need.

I have never been able to make my opponents agree to the proposition that we have to discuss the spontaneous circulation of real bills first, before we are ready to discuss fractional reserve banking. Incidentally, Mises himself admitted that real bills did circulate in Manchester spontaneously before the Bank of England opened its branch in Liverpool.

Cultists at the Mises Institute would love to attack Adam Smith directly, but they realize that they don’t have the prerequisite intellectual capital to do it. They are barking up the wrong tree. They condemn all fractional banking reserves whether real bills or fake bills. They simply miss the point what constitutes good commercial banking.

Daily Bell: Do you have any areas of agreement with free-bankers such as George Selgin and others who use the Scottish banking interregnum as evidence that freebanking – private fractional reserve banking — can work and has worked historically?

Prof. Fekete: Yes, I agree with them that private fractional reserve banking can work and has worked historically, provided that the earning assets of the banks are confined to real bills, to the exclusion of anticipation bills, accommodation bills, treasury bills, and any other kind of fake bills. Out of spontaneous real bill circulation sprang both the Discount House and the Acceptance House. As far as the origin of commercial banking is concerned, one can think of the latter as the predecessor of the “bad” commercial bank that is ready to monetize any and all accommodation bills, provided that collateral in excess of face value is posted; and the former as the predecessor of the “good” commercial bank that monetizes only solid real bills that need no collateral at all.

Daily Bell: Is there something about gold and silver that is genetic? Do you believe that humanity’s interaction with gold and silver is so ancient that it constitutes a biological impulse? That it is “in the genes”?

Prof. Fekete: No. Gold and silver owe their monetary role to their property that they are the most marketable goods in existence. In more details, gold is most marketable in the large, and silver is most marketable in the small. The first property is synonymous with “most liquid”, the second with “most hoardable”. With advances in metallurgy making molar processes more affordable, the hoardability of gold has caught up with that of silver, justifying the movement to replace bimetallism with gold monometallism.

No biological impulse is needed to explain all this, unless you refer to the fact that man is mortal, and he knows it, and he needs savings (hoarded metal par excellence) that he can draw down in his twilight years to make up for the deficit in his earning power, and to provide for his excess needs due to fragile health.

Daily Bell: Where do you stand on the issue of a free-market gold and silver standard?

Our reading of history is that absent official interference, sophisticated societies revert automatically to a market-based standard that includes both metals. Gold is usually utilized for industrial and banking purposes, while silver is the people’s money. The ratio between the two metals helps people detect manipulation as well.

Prof. Fekete: I don’t know what you mean by “free market” gold and silver standard. Is there any other? I submit that both gold and silver money were born spontaneously, without any assistance from the government as a midwife, through a process of “snowballing” marketability, as so admirably explained by Carl Menger. It is another story that kings later hijacked the process of monetizing these metals for their own purposes, and fostered the childish belief that the value of gold and silver coins was due to the sovereign’s effigy struck upon them, rather than the superb marketability of the monetary metals: gold and silver.

You are reading history correctly: our sophisticated economy, if it remains reasonably free, will embrace the monetary metals once more, as the regime of irredeemable currency is increasingly in an advanced state of decay.

If I may make a slight correction, gold is less of an industrial metal than silver but more of a metal of which jewelry is made.

You may be right when you assume that the bimetallic ratio helps people detect manipulation of the price of the monetary metals by the government. In modern times the success of this manipulation tends to coincide with the rising, and failure with the falling of the Au/Ag price ratio.

Daily Bell: Economists are fond of speaking of fiat money, but some believe that the world remains on an unofficial gold standard observed privately by the monetary elite no matter what the public pronouncements are. Is there any truth to this?

Prof. Fekete: There is no unofficial gold standard, just as there is no woman who is “a little bit pregnant”. It is another question whether the “monetary elite”, and some governments such as those of China and Israel, may be big clandestine hoarders in anticipation of a greater monetary role for gold in the future, or in setting up an insurance fund in case the threat of a monetary catastrophe becomes an established fact, noting that such a threat has returned for the second time in less than a generation. One can only speculate but, at least in the case of China, the cat has been let out of the bag. We now know that China is the biggest hoarder of silver in all history, and is determined to become a substantial hoarder of gold. As Chairman Mao has said, power grows out of the barrel of a gun — we may add that the bullets must be made of gold in order to be effective. Pity the Americans who may have the gun but believe in paper bullets.

Daily Bell: Where do you stand on the issue of monetary metals and market supply? If gold and silver become scarce in a free-market economy, would the scarcity disappear as hoarders release progressively more of their stores as the price rises? Or would the scarcity be alleviated by mines reopening in response to higher prices – or both?

Prof. Fekete: The monetary metals are by no means scarce. On the contrary, they command the highest stocks-to-flows ratio of all the commodities. This is what makes them monetary metals. Gold’s ratio is estimated to be 50, meaning that it would take 50 years to reproduce the existing stocks at present rate of production. By comparison, the same ratio for copper is estimated to be ⅓, meaning that marketable stockpiles correspond to 4 months’ production.

Any impression of scarcity of monetary metals is an optical illusion. Perceived scarcity only demonstrates the decay of the monetary system. Gold appears scarce for one reason only: the wild monetary experimentation of the leading countries with irredeemable currency. It is futile to expect that hoarders will release more of their stores as the price advances, or that the mines will increase their output of gold. On the contrary, they will hang on and release less and less of their stores. The mines will save their best ore reserves for better times as they see that a monetary catastrophe is imminent. Note that such a catastrophe will be unprecedented in history. Irredeemable currency has never been a global phenomenon. It was always a local phenomenon, the hope of weak governments that they can continue living forever in financial backwater comfortably. When their hope turned out to be a pipe-dream, there were always countries around that stayed the course of monetary rectitude, remained on the gold standard, and were able to extend a helping hand. No such luck this time.

I deplore that Switzerland, caving in to the indecent pressure from the U.S. government, railroaded through a change of the Swiss Constitution dropping the mandatory backing of the liabilities of the Swiss National Bank with gold. This reminds me of the tale of Aesop about the wolf that has lost his tail in an unfortunate encounter with a trap. He wanted to persuade his fellow wolves that they should also get rid of this “barbarous relic”, and have that useless appendage, their tail, cut off. Sorry to say, the Swiss government exhibited far less common sense than the assembly of wolves in Aesop’s tale. It pointed out to the tailless wolf that his case would have been more persuasive if it had been made before his loss.

Daily Bell: Is there any evidence that hoarders of gold and silver behave as you suggest, and not as common sense would dictate? After all, it is a universal feature of the commodity markets that the longs take profits periodically as prices keep rising.

Prof. Fekete: Yes, indeed, there is: the behavior of the gold basis. Basis is the difference between the nearby futures price and the spot price. Contango is the name for the condition whereby the basis is positive; while backwardation indicates a negative basis: higher spot price and lower futures price. Whenever supplies are adequate, contango obtains and the basis indicates what the carrying charges are such as interest, cost of storage and insurance. Backwardation always and everywhere indicates a shortage of the physical metal. Therefore, normally, gold should never be in backwardation, i.e., the futures price should always be higher than the spot price. The basis may be substituted by a spread, i.e., the difference between the price of a distant and a nearby futures contract.

Right now, the gold basis is at a critical inflection point, suggesting that gold may plunge from permanent contango to permanent backwardation for the first time ever. On April 21 Dan Norcini published charts showing the dramatic collapse of the April 09/June 09 and of the April 09/Dec 09 gold spreads at the Comex. The former went from \$6.50 at one point to \$0.60 now. The charts indicates that gold is on its way to backwardation later this year. Backwardation in gold is an extremely rare phenomenon with the most serious implications. It shows that supplies of physical gold are drying up as hoarders and the mines are increasingly withdrawing their offer to sell. It is like a chain reaction, at the end of which gold is not for sale at any price.

The basis is an extremely sensitive market indicator, far more important and accurate than the price itself which comes through a “very noisy channel”. What is more, the basis, unlike the price, cannot be manipulated. Unlike the price, the basis never lies.

The gold market behaves differently from other commodity markets because gold is a monetary metal. Unlike other commodities, gold hoarding is not inhibited by declining marginal utility. When market participants expect an imminent collapse of the monetary system, their preference is to hoard the monetary commodities, gold and silver. This explains backwardation.

Daily Bell: Is deflation an economic good in the sense that it can rectify monetary maladjustments?

Prof. Fekete: Certainly, you can say that deflation is nature’s cure for man-made inflationary excesses, if only policy-makers would allow the cure to do its benevolent and beneficial work. Instead, they try to prevent it by hook or crook, and pour gasoline on the fire by madly increasing the money supply and total debt. Compounding abuses with more abuses never works, and the longer the needed adjustment is delayed, the more pain it would eventually cause.

Daily Bell: Can the current paper money system stand, or is it on its last legs?

Prof. Fekete: Since the eruption of the financial and economic crisis in 2007 we may take it for granted that the regime of irredeemable paper money is on its last legs.

However, it may take several more years of agony, because of the colossal ignorance of people concerning money. For example, most people with a better than average grasp of the theory of money expect that the dollar will succumb to hyperinflation. They will be disappointed. The dollar will put up a tough fight and in the end it will self-destruct, not through inflation but through deflation.

Daily Bell: Can you expand on this issue? What makes you suggest that hyper-inflation is not in the cards?

Prof. Fekete: Producers will, of course, try to raise prices as the dollar is weakening further. However, people are not in the mood to spend. If they come into possession of money, they will use it to repay their debts. They have no savings to fall back on in case they lose their jobs. In the absence of buying price increases will have to be rescinded (as they have been in the case of crude oil, for example) causing many a producer to go bankrupt.

There is a new factor that plays an important role, not present in previous episodes: the parallel existence of electronic dollars and Federal Reserve notes. Only a small portion, less than ten percent, is in the form of the latter; the rest is electronic money. People at home and abroad hoard only dollars that they can fold. It is physically impossible to print them fast enough to replace electronic dollars that the people, firms, institutions and foreign governments may decide to reject. The velocity of circulation of paper dollars is falling to zero while that of electronic dollars is rising beyond any limit.

This splitting of the money supply into two components of divergent velocities spells deflation. The component with increasing velocity will have to be written off. The Fed is helpless as the hoarding of its notes assumes unheard of proportions.

Daily Bell: Can the Fed really sterilize the monetary system as Ben Bernanke and others contend?

Prof. Fekete: If by “sterilization” you mean isolating the exploding money supply from exploding prices, my answer is that Bernanke does not want to do that. In fact he is desperately but unsuccessfully trying to induce a rise in the price level, even at the risk of a price explosion. But to no avail: all the new electronic money he is creating goes into debt liquidation and speculation on the long side of the bond market. None of it goes to bid up commodity prices, or the prices of industrial shares, or the price of real estate.

There is a vicious spiral: the more money Bernanke creates, the more rampant bond speculation becomes, the higher bond prices go, the lower interest rates fall, the lower price-level falls, prompting more money-creation by Bernanke, etc.

Why do falling interest rates necessarily induce lower prices? Now here is the rub: because falling interest rates destroy capital through increasing the liquidation value of debt. I have a whole new theory on that: the revisionist theory of depressions. My main thesis is that a falling interest-rate structure increases the burden of debt (just the opposite that you would intuitively expect!) thereby causing producers to go bankrupt in droves. You can find the details on my website.

Daily Bell: Does the current crop of central bankers fully understand the interaction between paper money and the failure of civil society? Could it be that they understand it yet they ignore it and knowingly support a destructive system anyway?

Prof. Fekete: Probably they do, but the only thing they care about is protecting their turf.

The politicians have given them unlimited power that they exercise by creating unlimited amounts of currency. They have used this power to wreck the world economy. Now they want to retain that power to do “damage control”. They are not going to give up unlimited power voluntarily. They fully exploit the weakness of the political system that is entirely in thrall to their “expertise”. Why should they admit that Keynesian and Friedmanite fiscal and monetary policy has been a dismal failure? Rather, they pretend that, as a result of continental drift, the fault-line gives way, producing an earthquake ten point strong on the Richter scale. Who is better qualified than they are to handle the disaster?

Daily Bell: Is the International Monetary Fund destined to manage a global currency? Or is it being used as a stalking horse to provide pressure for other possible solutions, such as regional monetary systems (a euro region, an amero region, a yen region)?

Prof. Fekete: Whatever ambitions the IMF may have, it is irrelevant. Yes, they probably want to rearrange the deck chairs aboard the Titanic, but it makes no difference. The ship is on a collision course with the iceberg. The incompetence of bureaucrats at the IMF is appalling. What they are worried about most is the problem how to get rid of the life boats and life savers (read: the IMF gold reserve) that may come handy for the survivors after the Titanic has sunk.

Daily Bell: Is the Internet having an effect on the elite’s ability to maintain a paper money standard?

Prof. Fekete: Most certainly it is, in the negative sense of the word. The elite thought that it would suffice to discard the gold standard in the United States, never mind the Constitution. They thought that through their control of money they could also control the press and the media. There was no need to tamper with the right to free speech and the freedom of the press, which would have alarmed people far more than the demonetization of gold. And guess what? The elite had a most docile press and media that made them feel cozy and comfortable.

How wrong they were! Here comes the Internet through which you can air the most devastating condemnation of the activities of the elite, without putting up one dollar in capital to do so! The endless lies about irredeemable currency can now be refuted.

Truth will out. The Internet will ultimately neutralize and even bankrupt the servile press.

Daily Bell: What will the world look like in ten years – from an economic standpoint?

Prof. Fekete: It is not possible to say. The elite could put the economic program of Hitler into effect if it belatedly decides to suspend civil rights, including free access to the Internet. But it is also possible that even such a coup will remain ineffective in a decentralized society with individualistic traditions going all the way back to its foundations, such as we have in the United States. Make no mistake about it: the fight over gun-control laws is not about curbing violence — criminals will always be able to get guns whatever the laws may say. It is about curbing the right of the people to reject a government that tries to govern by trampling on the Constitution.

If “we, the people” come out on top in this tug-of-war with a totalitarian government, then the future of the world should be very bright. All you have to do is to force the U.S. government abide by the Constitution. And I mean both the letter and the spirit of the Constitution.

Daily Bell: Can you expand on the issue of monetary consolidation? Fiat money needs constant consolidation and enlargement to maintain pretence of solvency in our opinion.

If by some chance the current system does survive, is a single global currency inevitable?

Prof.Fekete: The only conceivable single global currency is the international gold standard, because it decentralizes power to the utmost. The individual is empowered through his role of deciding whether to buy or to refuse to buy. He casts his ballot printed on gold, and not just once in every other year but several times every single day.

Producers and merchants will have to defer to the individual’s wishes. Under any other monetary system producers and merchants will defer to the wishes of the issuer of currency.

Daily Bell: What can people do to protect themselves at this time?

Prof. Fekete: Other than praying and hoping, they could get out of debt and keep accumulating gold and silver coins, buying on every weakness in the price. They could also hoard Federal Reserve notes and the notes of the Swiss National Bank of small denominations, in amounts corresponding to their needs for up to two years. To keep money on deposit in a bank is not advisable under any circumstances. And, let’s not forget, they should cash in on their life insurance policies.

Daily Bell: What is the biggest single issue that even the American Misesians fail to grasp at this time – historically or otherwise?

Prof. Fekete: It is their insistence on Rothbard’s so-called 100 percent gold standard, an untenable theory that leaves the problem of elasticity of the stock of purchasing media completely out of consideration. In this way the Mises Institute runs the danger that its gold standard, if put into effect, will seize up during the first Christmas shopping season, and Keynesians and Friedmanites will return triumphantly saying: “We’ve told you so!” The cause of the Great Depression of the 1930’s, to a large extent, was the failure of the victorious powers to reorganize world trade on the basis of the Real Bills Doctrine after World War I. This bottled up world trade and made the gold standard utterly inelastic. What we need is a gold standard that is made elastic through the circulation of real bills.

Daily Bell: What endeavors are you involved in that you may want to point out to our audience? What’s most important to you that you would like our audience to be aware of and support?

Prof. Fekete: Gold should not be considered as an investment outlet or an item for speculation. It should be looked upon the same way as you look at your fire insurance policy: you buy it, lock it up in a safe, and hope that your house will not burn down.

Above all we should train ourselves to think in terms of gold units (gram, Troy ounce) when we estimate our net worth, annual income, and future needs — to the exclusion of dollars or francs. This is not as easy as it sounds. Instinctively we tend to think in terms of paper units. It takes self-discipline to get away from this habit.

If you have gold, you are a trustee of the world’s future. You have the only form of capital that can survive a financial Armageddon. You should take this trusteeship seriously and prepare yourself for exercising it properly when time comes.

Daily Bell: What are the most important – seminal — works of yours that you would encourage everyone to read? Where can they be found?

Prof. Fekete: I am going to give a twenty-lecture academic course on Money and Banking at the San Francisco School of Economics in California, from July 27 to August 7 later this year. The syllabus is posted on my website. I hope that my book covering the same ground will come out this year, which will also include my criticism of Mises.

Daily Bell: Finally, give us your best estimate of where is gold headed, pricewise, over the near and longer term.

Prof. Fekete: I don’t like that question, because it obscures the fact that higher gold prices only mean a lower value of irredeemable currencies. People tend to bemoan that the gold price is not rising fast enough to their taste. They have the wrong perspective.

From mine, a slowly rising gold price is a blessing in disguise as it gives you more time and opportunity for further scale-down purchases of the monetary metal.

An explosive rise in the gold price would be very damaging for most people, because they are quite unprepared. Universal suffering around you would not be conducive to your desire to lead a peaceful life and to enjoy your newly-found riches.

On the gold price let me just say this. Gold is still cheap considering its purchasing and employing power at the beginning of the Modern Age. There is no reason why it should not have a comparable purchasing and employing power when the dust settles.

Daily Bell: On behalf of all of our readers we thank you for sharing your views with us and hope to hear from you again soon. And we encourage all readers to visit YOUR

SITE and consider learning more about your work.

Prof. Fekete: And I thank you for the opportunity to discuss these grave problems of our time. In passing I would like to draw your attention to the newly established Gold Standard Institute and its website [www.goldstandardinstitute.com](https://www.goldstandardinstitute.com) .

This interview was conducted by Scott Smith. In addition to writing special reports, such as this Swiss Perspective, Scott is also a contributing editor to the TheDailyBell.com.

---

# Falsifying Bank Balance Sheets

URL: https://newaustrianeconomics.com/archive/fekete/falsifying-bank-balance-sheets/
Date: 2009-04-27
Section: Popular Economics
Difficulty: accessible
Concept Tags: federal-reserve, capital-destruction, monetary-policy, fiat-currency, monetary-crisis
Description: Fekete examines the accounting sleight-of-hand by which banks and regulators falsified balance sheets during the 2008–09 crisis — marking assets at fictional values to avoid recognizing insolvency. He argues this falsification, enabled by mark-to-model accounting, postpones but cannot prevent the reckoning, and that genuine monetary reform requires honest accounting.
Editorial Note: Written April 2009 as the FASB was relaxing mark-to-market accounting rules under pressure from banks and regulators. Fekete's analysis of accounting falsification connects to his broader critique of the monetary system's dishonesty.
Original PDF: https://professorfekete.com/articles/AEFFalsifyingBankBalanceSheets.pdf

*Falsifying Bank Balance Sheets*

**Antal E. Fekete** · Professor of Money and Banking · San Francisco School of Economics · [aefekete@hotmail.com](mailto:aefekete@hotmail.com)

Our title is borrowed from a caption of the Chicago economist and monetary scientist Melchior Palyi (1892-1970) writing on the fiscal and monetary legerdemain of the U.S. government in his Bulletin #401, dated February 27, 1960, as follows:

> Faking balance sheets legalized, capital impaired.

> In the case of quite a few banks the entire capital and all reserves have been lost.

In some cases, even a part of the deposits has been wiped out.

A corporation publishing faked balance sheets would be barred from every stock exchange. It may even face criminal prosecution. The objective is to protect the public against fraud. But exactly the same fraudulent practice has been legalized in so far as commercial and savings banks, and life insurance companies are concerned.

They can carry government bonds on their books at par value. A \$1,000 bond may be quoted in the market at \$800 or less; the balance sheet of your bank will still show it at \$1,000. The purpose of this regulation, adopted by all federal and state supervisory agencies and by the Securities Exchange Commission as well, is to give those bonds a sacrosanct status and guarantee against paper losses. Thereby they are promoted to an absolutely safe and “liquid” status. The bank examiners count the bonds of the federal government, whatever their maturity and actual market price may be, as prime liquid assets, just like cash. The more bonds in the portfolio, the more liquid is the bank by the examiners’ standards, — never mind the paper losses.

It is small wonder that the banks purchase long term federal obligations, thereby creating a market for them. The result is that with rising interest rates and declining values of medium- and long-term securities, the modest capital and undivided surplus of the banks – reserves against losses – are soon wiped out.

### Silence of the Sea

But the public knows nothing about this sad situation. No newspaper dares to discuss it, or the preposterous practices of the government at the root of it. The “Silence of the Sea” covers them up. Those on the inside (and insight) hope and pray that a recession will reduce the pressures on the capital market, lower interest rates, raise bond prices, and wipe out the losses. Very likely it will; but what about the next cycle? And, above all, for how long, or how many times, will the depositors and savers permit themselves to be fooled and victimized?

Sooner or later every legerdemain, however clever or subtle, is exposed – and backfires.

A further consequence is that the bond portfolio of the banks “freezes up”. By selling bonds the bank would convert paper losses into real losses, which would skyrocket if major amounts were liquidated.

While the boom and high interest rates obtain, the “prime liquidity” turns out to be the very opposite, unless the bonds are monetized at, and the losses shifted onto, the Federal Reserve. But the central bank can be relied upon to resist the “temptation” to absorb either or both.

The above was written in 1960. In 2009 we are wondering what has hit our banks.

No mystery there. It was not subprime mortgages nor other loose lending practices. The banking crisis is entirely self-inflicted or, more precisely, government-inflicted the origins of which go back almost ninety years: faking balance sheets. That practice cannot go on forever. The day of reckoning comes when capital is called upon to do what it is supposed to do: to tie over the bank during a temporary setback. The kitty is opened, and found empty. Bank capital is gone, due to earlier legerdemain in trying to paper over paper losses. (No pun intended.)

The situation is actually worse, as far as the condition of our banks is concerned. So far deposits have not been affected during this crisis. Depositors feel secure in the belief that they are protected by the government and its deposit insurance scheme. Here is Palyi, writing in the same article on this subject: the deposit-insurance reserves would be exhausted at once if a single one among the eight or ten biggest banks would get into trouble, to say nothing of a wide-spread bank-run. The public’s impression is that the government guarantees deposits which it does not. Worse still, in order to make good on the “insurance” of even a small fraction of ”insured” deposits, the FDIC would have to liquidate its own holdings that would break the bond market.

Not only is this a phony arrangement which serves only to mislead the public, but it also induces the banks to neglect building up their capital accounts properly for the protection of the deposits. Rather, they rely on the “insurance” – and on their own holdings of government securities.

### Dumping ground for the federal debt

Government agencies that have no other choice in investing their funds, though they are not organs of the Treasury, are an obvious dumping ground for the debt of the federal government. A most interesting case in point is the Federal Deposit Insurance Corporation (FDIC). It sinks the ”insurance” premiums paid by the banks into long-term government bonds, as a guaranty fund representing less than 2 percent of “insured” deposits. The FDIC itself has brought out in its Report for 1957 that, in effect, deposit insurance is relevant only in the case of a banking crisis – in which case it would not be helpful at all. All its funds would be exhausted at once.

### The hare-brained Geithner-plan

Now, 50 years later, we have a fully-fledged banking crisis on hand, and the FDIC will soon face its first real test since its establishment in the 1930’s. Is deposit “insurance” a myth as suggested by Palyi, designed to mislead the public? There is plenty of evidence that it is. Why did the big Wall Street banks not sell government bonds from portfolio before begging Congress for bailout money? On the face of it this would have been a good time to sell, as the bonds are quoted above par value by the market, thanks to a super-low interest-rate structure. Could it be that the bond market is rigged? Could it be that high bond values are artificially maintained, e.g., by tempting bond speculators to the long side of the market with risk-free profits, and threatening those on the short side with sudden death — the essence of open market operations as I have long suggested? This time we shall find out.

If you examine the latest measures initiated by the Geithner Treasury, there is indeed reason for alarm. Treasury Secretary Timothy Geithner openly invites private investors to speculate, risk free, in buying the toxic assets of the banking system. The risks, should they materialize, are covered by pledging, most improperly, the assets of the FDIC. If the gamble succeeds, private investors may keep the assets they have bought on the cheap. Otherwise the FDIC will pick up the tab and will reimburse investors for their losses.

Let me ask the only relevant question. Why would private investors, in their right mind, speculate in toxic assets which have no market, given the fact they can already speculate, directly and risk-free, in the “ultimate” asset that is held in the guaranty fund for those toxic assets, that do have a market in which the troubled banks compete with overseas central banks for the bonds of the U.S. government?

The Geithner-plan is a hare-brained plan, and is bound to fail.

### Portfolio frozen as the Antarctic

When it does, there will be a run on the banks. It will be ugly and unstoppable.

Only about ten percent of the money supply is in the form of Federal Reserve

(FR) notes, and people will be scrambling for them. The printing presses will be run 24 hours a day, seven days a week, and they will still not be able to meet the demand. Apparently, foreigners are already scrambling for FR notes. They could of course have FR deposits in the form on electronic money, but they wouldn’t touch them with a ten-foot pole. They want dollars they can fold.

Make no mistake about it, behind this unprecedented world panic and bank run is the book-keeping legerdemain that the U.S. government and its bank examiners have adopted after the 1921 panic in the bond market. Thereby the commercial and savings banks, as well as insurance companies in the U.S. were authorized to carry government bonds at par value in the balance sheet, as if they were a cash item, in complete disregard for what they would fetch in the open market.

Moreover, banks and insurance companies could also use them as gambling chips, buying and selling them to pocket risk-free profits. They just have to secondguess the Federal Reserve (Fed). Whenever the Fed has nature’s urge to go to the open market to relieve itself (read: to buy more bonds for the purposes of collateral in order to be able to increase the money supply), they could pre-empt it in buying the bonds first. In this way they bid up the price of bonds and then dump them in the lap of the Fed for a quick profit.

Now the whole shady scheme of misleading the public through balance-sheet hocus-pocus is coming unstuck. Make-believe bond values have backfired badly.

As it turns out, the banks’ portfolio of government bonds is as frozen as the Antarctic − just as Palyi predicted fifty years ago that it would be.

### Grand Canyon-size holes in the balance sheets

The banks cannot liquidate it without revealing Grand Canyon-size holes in their balance sheet, several times larger than bank capital. They desperately need to retain their portfolio of government bonds for “window-dressing” purposes, that is, to show at least the remnants of what had been bank capital in happier times.

They desperately try to hide the fact that even the ruins of their capital are gone.

The much advertised “stress-test”, no doubt, is using the same metric that has steered the banking system to the ground during the past four-and-a-half score of years: the metric assuming that government bonds can never lose value, and bank balance sheets are there to falsify based on that false metric. Such an assumption is especially dangerous when the interest-rate structure is at the low-end of the spectrum, and the country is suffering from a chronic balance of payments deficit.

It is difficult to see how one can treat the stress-test and its results with respect.

We shall see how adroitly Ben Bernanke will handle the printing press which he is in the habit of boasting that the U.S. government has given him to use in a situation like this. He will not be able physically to print FR notes so fast as to replace electronic money that has been lost, or will be lost through rejection by the public. Electronic money had been created in the belief that nothing more was needed to pacify the markets. But it is one thing to create electronic money with a click of the mouse; it is quite another thing to print FR notes on real paper with real ink.

This is the secret of deflation, and the answer to the much-debated question whether you can have hyperinflation and deflation all at the same time. The answer is that you can, because hyperinflation refers to electronic money that people reject, and deflation refers to FR notes that people hoard.

The moment of truth has arrived. You cannot fool all the people all of the time.

The Emperor is naked: the tailors who created his garments are impostors.

Too bad for the impostors. Unlike in Andersen’s story where they decamped in a hurry, Bernanke and Geithner stayed and will have to face the ire of the Emperor — and that of the people when they find out that their deposits are “gone with the wind”.

---

*April 27, 2009*

### Calendar of Events

### Instituto Juan de Mariana: Madrid, Spain, June 12-14, 2009

Seminar with Prof. Fekete on Money, Credit, and the Revisionist Theory of Depressions For information, contact: gcalzada@juandemariana.org

### OroY Finanzas & Portal Oro: Madrid, Spain, June 18, 2009

### Gold and Silver Meeting Madrid 2009

For information, contact: preukschat_alex@hotmail.com or gcalzada@juandemariana.org or [www.portaloro.com](http://www.portaloro.com/aemp.aspx) or info@portaloro.com Santa Colomba Conference 2009, Palazzo Mundell, Siena, Italy, July 10-12

### Conference: The Challenge of Global Money; by invitation only

San Francisco School of Economics, San Francisco, California, July 25, August 1 & August 8, 2009 Investment Seminars: Trading Gold, Wealth Management

The Gold and Silver Basis; Backwardation; Trading Gold in the Present Environment; Wealth Management under the Regime of Irredeemable Currency. Given by Professor Fekete and Mr. Sandeep Jaitly of Soditic Ltd., London, U.K. Enrolment is limited, first come first served. For details, check: [www.sfschoolofeconomics.com](https://www.sfschoolofeconomics.com), contact: ibischoff@sfschoolofeconomics.com San Francisco School of Economics, San Francisco, California, July 27-August 7, 2009 Two-week academic course: Money and Banking, taught in person by Professor Fekete Enrolment is limited; first come, first served. The Syllabus for this course can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com),

### For further details, check: [www.sfschoolofeconomics.com](https://www.sfschoolofeconomics.com)

### For enrolment contact: ibischoff@sfschoolofeconomics.com

San Francisco School of Economics, San Francisco, California, July 23-August 9, 2009 Private consultation with Professor Fekete available contact: ibischoff@sfschoolofeconomics.com University House, Australian National University, Canberra: first week of November, 2009 Peace and Progress through Prosperity: Gold Standard in the 21st Century

This is the first conference organized by the newly formed Gold Standard Institute.

For further information, e-mail: feketeaustralia@gmail.com ,

On the Gold Standard Institute, e-mail philipbarton@goldstandardinstitute.com Professor Fekete on DVD: Professionally produced DVD recording of the address before the Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the Great Depression: Can It Happen Again? plus an interview with Professor Fekete. It is available from [www.Amazon.com](https://www.Amazon.com) and from the Club [www.economicclubsf.com](https://www.economicclubsf.com) at \$14.95 each.

---

# The Significance of the Gold Standard

URL: https://newaustrianeconomics.com/archive/fekete/the-significance-of-the-gold-standard/
Date: 2009-04-17
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, sound-money, real-bills, interest-theory, new-austrian-economics
Description: Fekete explains why the gold standard is not a historical relic but the only monetary system compatible with sustained prosperity. Its significance lies not in price stability but in the natural regulation of interest rates, the discipline it imposes on government spending, and the self-liquidating credit mechanism it enables through the Real Bills market.
Editorial Note: Written April 2009. A concise statement of the gold standard's significance for a general audience, emphasizing institutional and monetary mechanisms over the familiar but misleading price-stability argument.
Original PDF: https://professorfekete.com/articles/AEFTheSignficancOfTheGoldStandard.pdf

ment and the banks are thus placed in a position in which they must be careful not to disturb unduly, or to incur the disapproval of, people with property to protect.

Thus do a people with a gold standard at their disposal have the power to keep a checkrein on the fiscal policies of their government. Thus do they force the banks not to pursue reckless credit practices.

Thus do they obtain and maintain a responsible government and a responsible banking system.

The people may utilize that power wisely or unwisely; but it is a power they must have if they are to be able to protect themselves from improper government encroachment or tyranny, and against irresponsible banking.

### An instrumentality of human freedom

Of all institutions the gold standard occupies a paramount position as an instrumentality of human freedom, private property, private enterprise, and responsible government. The nature of the gold standard should reveal something as to why it is a necessary and natural companion of human freedom.

After specifying the standard gold coin and opening the Mint to its free and unlimited coinage on private account, the government must stand aside and let the gold standard perform its functions in accordance with the desires of the people.

The right to private property in gold is established and respected. The government shall not interfere with the hoarding, importing or exporting of gold, or with the redemption of non-gold currency into standard gold coin by the banks. An individual may put none, little, much, or all of his property into gold. He may convert all of his property into gold and ship it out of the country without hindrance from the government.

### The experience of England

In international relations, all individuals are free under a gold standard to utilize gold as they desire. If their non-gold dollars are not acceptable abroad, they can remit the equivalent in gold. Since gold is the most universally acceptable money known to mankind, the individual is given the widest possible freedom in utilizing his wealth anywhere in the world.

This freedom and these practices were illustrated by England’s use of the gold standard for nearly one hundred years from

1816 to 1914. Her people traded, invested, and traveled so widely that it was often said that ‘the sun never sets on British possessions’. The pound sterling became the dominant international currency and

### London the principal inter-national

### Checkrein on the government and banks

If a person living under a degree of freedom inherent in a gold standard is disturbed by, or disapproves of, the policies of his government or the practices of banks, he may protect his property by presenting non-gold currency for redemption. If a sufficient number of people do this, then the government and the banks are forced to respect the fears or disapproval of the citizens. The govern1 the amount of currency that may be taken out of the country. The freedom of private property in international exchange is curbed; the equalizing and self-correcting influences, characteristic of a gold standard, are impaired or destroyed.

Foreign trade reaches various degrees of chaos. banking center of the world. Respect for and protection of private property and freedom to trade, travel, and invest reached heights never attained before or since.

### Irredeemable currency – an instrumentality of servitude

When a government inflicts irredeemable currency on the people, the great rights and freedoms inherent in a gold standard disappear. The government becomes their dictator free from effective control; it curbs their rights and freedom as it sees fit.

Constitutional government is subverted in an endless number of ways, and made to conform to the desire of the government to restrict human freedom.

The ability of people to put pressure on the banks and the government through demanding gold is destroyed. With the destruction of that individual right the power of the purse passes from ultimate control by the people to unrestrainable control by the government. Such an arrangement allows, nay, invites, the government to indulge in a spending orgy.

### Economic distortions

Under a gold standard a prolonged unfavorable balance of payments, heavy and persistent losses of gold tend to correct themselves with promptness. But with government controls under the regime of an irredeemable currency economic distortions can long persist and become destructive. This is so because government officials cannot possibly provide the same level of wisdom that millions of people, free to trade, travel, invest, and act in their own interest can.

As problems in foreign trade mount, governments find excuses for more or different controls. A huge bureaucracy is developed to manage these international problems. There is no foreseeable end to these procedures until a nation regains the benefits of a gold standard which requires that the government retire to its proper position of umpire and relinquish its role as dominant participant and dictator.

### Grabbing the public purse

Once the government grabs the public purse, its power becomes uncontrollable.

Combined with the loss by the people of the freedom and rights inherent in a gold standard, unscrupulous politicians can socialize the nation and undermine the republican system of government. The purchasing power of the currency is impaired. The banks are freed from the pressures of control which individuals have previously exercised over them. The quality of integrity in the currency is destroyed. Lacking that virtue, the monetary bloodstream contaminates the economic, political, and social system of the nation and fosters widespread corruption. In international relations, governments which employ irredeemable currency step in to regulate or control foreign trade, exchange rates, investment, travel,

### Irredeemable currency – a tool of totalitarian governments

All socialist, communist, and totalitarian governments utilize it, because an irredeemable currency gives them the power that they need if they are to control the people and deprive them of the freedom inherent in private property and private enterprise. Having experienced these powers, the government is taking further steps into socialism and centrally managed economy. Those in charge reveal that they wish to retain the power acquired through the use of irredeemable currency and to continue the march toward more socialism Like drug addicts, they do not regard it as a dangerous or undermining narcotic. Even the loss of purchasing power does not disturb them to any great extent – their chief response is to try to get more and more of it. The bloating and distortions of business indexes are readily accepted as evidence of economic health. Heavy taxes and mountainous debt are not regarded with anxiety. A frequent or common agitation is for ever more national spending.

If we are to be saved from the ultimate evil consequences of using irredeemable currency, needed action should come from top national officials. Such reforms call for statesmanship. The President and Secretary of the Treasury must be statesmen, act as informed and tough monetary surgeons, men who can and will persuade Congress to re-instate redeemable currency.

Once that step is taken, the people should experience a breath of fresh air and be on the course leading to better days – to a better government that is willing to abide by the Constitution, to greater freedom for the people; in short, to more responsibility by the government and by the banks.

Optimism should become wide-spread because the money of the nation would once more have the quality of integrity.

The problem of credit-control should be easier to solve. Business enterprise should expand, domestically as well and internationally, and on a sounder basis. Gold should flow in from abroad. Imbalances in foreign trade should rectify themselves.

The control of the public purse would be returned to the people as individuals, where it belongs if human freedom is to be preserved and responsible government is to be obtained. Then there would be good grounds for assurance that the republic will be preserved – at least as long as the gold standard is maintained. and more government control. Frequent official words to the contrary are designed to be reassuring or to allay fears; but they have no important effect in arresting the course being pursued.

### A national habit-forming drug

A government can take unrestrainable control of the people either by the use of military force, or by the use of irredeemable currency. The former is readily understood; the latter is a subtle national drug that is not generally understood, and is readily embraced by its victims. It is, consequently, a favorite device of modern governments that desire to bring the people under thoroughgoing control, for it enables the government to succeed and, at the same time, to have the general, even vigorous, approval of the great mass of people.

The world is literally drugged with irredeemable currency, and with government management and dictatorship as consequences. Under this intoxication there is strong agitation for more and more national spending, more and more government controls, and more and more debt.

The fact that these are common reactions of the great majority of people who have been subjected to the use and effects of irredeemable currency provides no clue as to whether the nation is to be saved from the most serious disaster into which the present course is likely to lead.

Most unfortunately, mainstream economists have been working aggressively for a governmentally managed economy, or riding quietly with the tide that is moving in that direction.

### Detoxification

It is useless to expect a mass movement on behalf of a sound currency. The daily experiences of people are such that they confirm in their minds the alleged virtues and benefits of irredeemable currency.

---

*April 17, 2009.*

### Calendar of Events

### Instituto Juan de Mariana: Madrid, Spain, June 12-14, 2009

Seminar with Prof. Fekete on Money, Credit, and the Revisionist Theory of Depressions

### For information, contact: gcalzada@juandemariana.org

### OroY Finanzas & Portal Oro: Madrid, Spain, June 18, 2009

### Gold and Silver Meeting Madrid 2009

For information, contact: preukschat_alex@hotmail.com or gcalzada@juandemariana.org or [www.portaloro.com](http://www.portaloro.com/aemp.aspx) or info@portaloro.com San Francisco School of Economics: A Series of three Investment Seminars: July 25; August 1; and August 8, 2009

The Gold and Silver Basis; Backwardation; Trading Gold in the Present Environment; Wealth Management under the Regime of Irredeemable Currency. Given by Professor Fekete and Mr. Sandeep Jaitly of Soditic Ltd., London, U.K. Enrolment is limited, first come first served. For more information, see: [www.sfschoolofeconomics.com](https://www.sfschoolofeconomics.com) San Francisco School of Economics: July 27-August 7, 2009

Money and Banking, a 20-lecture course given by Professor Fekete. Enrolment is limited; first come, first served. The Syllabus for this course can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com), see also: [www.sfschoolofeconomics.com](https://www.sfschoolofeconomics.com) University House, Australian National University, Canberra: first week of November, 2009 Peace and Progress through Prosperity: Gold Standard in the 21st Century This is the first conference organized by the newly formed Gold Standard Institute.

For further information, e-mail: feketeaustralia@gmail.com ,

On the Gold Standard Institute, e-mail philipbarton@goldstandardinstitute.com Professor Fekete on DVD: Professionally produced DVD recording of the address before the Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the Great Depression: Can It Happen Again? plus an interview with Professor Fekete. It is available from [www.Amazon.com](https://www.Amazon.com) and from the Club [www.economicclubsf.com](https://www.economicclubsf.com) at \$14.95 each.

---

# A Critique of the Quantity Theory of Money

URL: https://newaustrianeconomics.com/archive/fekete/a-critique-of-the-quantity-theory-of-money/
Date: 2009-04-11
Section: Popular Economics
Difficulty: scholarly
Concept Tags: new-austrian-economics, monetary-policy, fiat-currency, gold-standard, mises
Description: Fekete systematically critiques the quantity theory of money — the foundation of both monetarism and modern central banking — arguing that it ignores the quality of money (whether it is self-liquidating or inflationary), the velocity problem, and the gold basis. The quantity theory is not merely incomplete but actively misleading as a guide to monetary policy.
Editorial Note: Written April 2009. A foundational critique that explains why Fekete's monetary framework diverges from both the Friedmanite and Keynesian traditions that dominate central banking.
Original PDF: https://professorfekete.com/articles/AEFCritiqueQuantityTheoryOfMoney.pdf

*A Critique Of The Quantity Theory Of Money*

**Further evidences of the onset of Great Depression II**

**Antal E. Fekete** · Professor of Money and Banking · San Francisco School of Economics · aefekete@hotmail.com

In my previous paper The Revisionist Theory and History of Depressions I argued that persistently falling interest rates cause an erosion of capital, unseen but nonetheless lethal. Producers are squeezed and try to survive by cutting prices. Lower prices add to pressures lowering interest rates, and a vicious spiral is set in motion. Thus money-creation by the Fed has a little-noticed deflationary side-effect to it, that may ultimately overwhelm the inflationary effect, in spite of predictions by the Quantity Theory of Money.

### Money out of the thin air?

Detractors of our fiat money system (myself not included) are fond of saying that “the Fed is creating money out of the thin air.” If that were true, then the Quantity Theory of Money (QTM) might be valid implying that the present runaway money-printing exercise would indeed lead to hyperinflation before long. How could anyone suggest that the denouement will be deflationary after all?

I maintain that the Federal Reserve banks are not creating money out of the thin air. In fact, they must first post collateral with the Federal Reserve Agent (who is not under the jurisdiction of the Fed but under that of the government). Only after the collateral has been posted can they create a commensurate amount of Federal Reserve notes and deposits. Typically, the collateral is U.S. Treasury bills, notes, or bonds, purchased in the open market on behalf of the Fed’s Open Market Committee.

Because open market purchases of Treasury paper have consequences, we must examine them before passing a judgment on the validity of the QTM. Such an examination is always side-stepped by the devotees of the QTM. What are those consequences? They are the effect of open market operations on the rate of interest. Since open market purchases of the Fed involve bidding up the price of government obligations which varies inversely with the rate of interest, we can say that they will make interest rates fall. (To be sure, on occasion, the Fed may be a seller of Treasury paper but, on a net basis, it has been a buyer every single year.)

This means that the regime of irredeemable currency, depending as it is on the open market operations of the Fed for its existence, imparts a definite bias to the interest rate structure establishing a falling trend, whereas interest rates would be stable in the absence of that regime. This in itself is a condemnation of irredeemable currencies as they introduce an unwarranted bias into the economy favoring debtors and spenders while punishing creditors and savers. In addition, it favors the financial sector at the expense of the producing sector. Falling interest rates, as opposed to low but stable ones, are detrimental to productive capital.

Thus we have two effects to reconcile as a consequence of money-creation by the Fed: an inflationary and a deflationary one. We cannot say which of these two forces will ultimately prevail without digging deeper.

### Risk free bond speculation

In the actual case there are other important forces at play, which are induced by the Fed’s open market purchases. We have to take into account bond speculation, a permanent fixture on the monetary firmament since 1971 when the U.S. government defaulted on its gold obligations to foreign governments and central banks. (There was no bond speculation before, for reasons having to do with the lack of sufficient variation in the rate of interest, making such speculation unprofitable.) Analysts and financial writers hardly ever consider bond speculation as a factor in the money-creating process. For this reason alone, their predictions are practically always worthless.

The fact goes virtually unrecognized that open market operations render bond speculation risk free. All the speculators have to do is to second-guess the Fed. They know that the Fed must be a net buyer. They know the identity of the agents the Fed is using to execute its purchase orders, and stalk them.

Speculators study the same monetary statistics which the Fed itself is using to determine the timing of its open market purchases. Can the Fed outsmart speculators? Hardly. The Fed is run by bureaucrats and their trading losses are ‘on the house’. By contrast, the speculators risk their own fortune. They are certainly smart enough to detect false-carding on the part of the Fed. Even if we assume that they have no inside information (which is a rather naïve assumption), the speculators can easily front-run the Fed’s open market purchases.

The presence of risk-free bullish bond speculation imparts a huge additional bias to the economy, virtually guaranteeing a falling interest-rate structure, as demonstrated by the past quarter of a century, during which interest rates have been driven down from the high teens to close to zero. It may distort the ultimate outcome of this latest tragic experimentation with irredeemable currency. No longer can it be taken for granted that the denouement of unlimited money-creation will be hyperinflation with the Federal Reserve notes rapidly losing purchasing power. On the contrary, it could be an unprecedented deflation with the Federal Reserve notes being hoarded by the people, firms, and institutions as their purchasing power is actually increasing (in fact, they are already being hoarded by foreigners in the second and third world countries in unprecedented amounts). The dollar will not be the first among irredeemable currencies to be annihilated in this latest hecatomb of currencies. It will be last one.

### Price wars

The QTM is a linear model that may be valid as a first approximation, but fails in most cases as the real world is highly non-linear. My own theory predicts that it is not hyperinflation but a vicious deflation which is in store for the dollar. Here is the argument.

While prices of primary products such as crude oil and foodstuffs may initially rise, there is no purchasing power in the hands of the consumers, nor can they borrow as they used to do in order to pay the higher prices much as though they would like to do, to support it. The newly created money is going into bailing out banks, much of it being diverted to continue paying bloated bonuses to bankers. Very little, if any of it has “trickled down” to the ordinary consumer who is squeezed relentlessly on his debts contracted when interest rates were higher.

It turns out that the price rises are unsustainable as the consumer is unable to pay them. They will have to be rescinded. Retail merchants will start a damaging price war underbidding one another. Wholesale merchants are also squeezed.

They have to retrench. Pressure from vanishing demand is further passed on to the producers who have to retrench as well. All of them experience ebbing cash flows. They lay off more people. This aggravates the crisis further as cash in the hand of the consumers diminishes even more through increased unemployment.

The vicious spiral is on.

But what is happening to the unprecedented tide of new money flooding the economy? Well, it is used to pay off debt by people desperately scrambling to get out of debt. Businessmen are lethargic; every cut in the rate of interest hits them by eroding the value of their previous investments. In my other writings I have explained how falling interest rates make the liquidation value of debt rise, which becomes a negative item in the profit-and-loss statement eating into capital of businesses. Capital ought to be replenished but isn’t.

Worse still, there is no way businessmen can be induced to make new investments as long as further reductions in the rate of interest are in the cards.

They are aware that their investments would go up in smoke as the rate of interest fell further in the wake of “quantitative easing”.

### Self-fulfilling speculation on falling interest rates

The only enterprise prospering in this deflationary environment is bond speculation. Speculators corner every dollar made available by the Fed, and use it to expand their activities further in bidding up bond prices. They have been told in advance that the Fed is going to move its operations from the short to the long end of the yield curve. It will buy \$300 billion worth of longer dated Treasury issues during the next six months. It is likely that it will have to buy much more after that. Speculation on falling interest rates becomes self-fulfilling, thanks to the insane idea of open market operations making, as it does, bullish bond speculation risk-free and bearish bond speculation suicidal. Deflation is made self-sustaining.

Investors are urged by the Treasury and the Fed to invest in the toxic assets of the failing banking system. They are offered incentives if they do, making it appear that speculating in toxic assets has been made risk free as well. So the choice before the investors is either investing in toxic assets for which there is no market, or invest in Treasury paper which bond speculators and foreigners are scrambling to get. Naturally, they will choose the latter. They don’t want to be taken for a ride by the Treasury and the Fed. The idea to offer incentives to investors to make them buy toxic assets is preposterous.

### Marginal productivity of debt

Another way to understand the problem is through the marginal productivity of debt. This is the ratio of additional GDP to additional debt, or the amount of new GDP contributed by the creation of \$1 in new debt. It is this ratio that determines the quality of total debt. Indeed, the higher the ratio, the more successful entrepreneurs are in increasing productivity, which is the only valid justification for going into debt in the first place. The concept is due to the Hungarian-born Chicago economist Melchior Palyi (1892-1970), although its name has been introduced after he died.

Palyi started watching this ratio in the United States in 1945. Initially it was 3 or higher, meaning that every dollar of new debt contracted contributed \$3 to GDP. However, subsequently the ratio went into a decline and twenty years later it was around 1. Palyi ran a weekly column in The Commercial and Financial Chronicle entitled A Point of View. On January 2, 1969, he publicly warned president-elect Nixon in his column that the country is adding \$2 in debt for every \$1 increase in GDP (in other words, the marginal productivity of debt is ½).

“Does Mr. Nixon realize the kind of ‘heritage’ he is taking over? That he is supposed to keep up a rate of economic growth or even improve on the same, a rate that stands or falls with an utterly reckless mortgaging of the future?... Presently, the volume of outstanding debt is rising faster than the gross national product… True, most of the new debt — other than that of the federal government — has a ‘counterpart’ in real assets: homes, automobiles, plants and equipment, etc. But their value in dollars is unpredictable, while the debts are due in a fixed number of dollars…

“Trading on the Equity was the earmark of the 1920’s. The ‘House of Credit Cards’ broke down as the first cold wind — a serious decline in commodity prices — hit the structure of artificially inflated values of real estate and equities. The more debt had been piled up, the higher went the stock market. And so it goes today, only more so. A new generation of operators has arisen, one that has not witnessed as yet a wholesale debtliquidation. The experience of the fathers is lost on the sons. The dream of Eternal Prosperity is replaced by the mirage of Perpetual Inflation.

More is at stake than mere economics. A ‘new frontier’ has captured the imagination: ‘Young man, go in debt!’ Debt has become a status-symbol

— in addition to being a prime source of riches. Automobile sales hit new records because millions of Americans buy (on down payment) new cars before they have finished paying for the old ones… True, to some extent rising living standards reflect extraordinary technological progress.

But the ultimate base is, largely, the ability not to pay — to rely on the ability to borrow ever more.”

As we know, in 1969 president Nixon did not listen to sound advice. As president Obama forty years later, he appointed dyed-in-the-wool Keynesian and Friedmanite advisers. The concept of marginal productivity of debt is curiously missing from the vocabulary of mainstream economists. They are watching the wrong ratio, that of the GDP to total debt, and take comfort in the thought that by that indicator ‘there is lots more room’ to pile on more debt. As a consequence, the marginal productivity of debt went into further decline. This was a danger sign showing that additional debt had no economic justification.

The volume of debt was rising faster than national income, and capital supporting production was eroding fast. If, as in the worst-case scenario, the ratio fell into negative territory, the message would be that the economy was on a collision course with the iceberg of total debt and crash was imminent. Not only does more debt add nothing to the GDP, in fact, it necessarily causes economic contraction, including greater unemployment. Immediate action is absolutely necessary to avoid collision that would make the ‘unsinkable’ economy sink.

### The watershed year of 2006

As long debt was constrained by the centripetal force of gold in the system, tenuous though this constraint may have been, deterioration in the quality of debt was relatively slow. Quality caved in, and quantity took a flight to the stratosphere, when the centripetal force was cut and gold, the only ultimate extinguisher of debt there is, was exiled from the monetary system. Still, it took about 35 years before the capital of society was eroded and consumed through a steadily deteriorating marginal productivity of debt.

The year 2006 was the watershed. Late in that year the marginal productivity of debt dropped below zero for the first time ever, switching on the red alert sign to warn of an imminent economic catastrophe. Indeed, in February, 2007, the risk of debt default as measured by the skyrocketing cost of CDS (credit default swaps) exploded and, as the saying goes, the rest is history.

### Negative marginal productivity

Why is a negative marginal productivity of debt a sign of an imminent economic catastrophe? Because it indicates that any further increase in indebtedness would inevitably cause further economic contraction. Capital is gone; production is no longer supported by the prerequisite quantity and quality of tools and equipment.

The economy is literally devouring itself through debt. The earlier message, that unbridled breeding of debt through the serial cutting of the rate of interest to zero was destroying society’s capital, has been ignored. The budding financial crisis was explained away through ad hoc reasoning, such as blaming it on loose credit standards, subprime mortgages, and the like. Nothing was done to stop the real cause of the disaster, the fast-breeder of debt. On the contrary, debt-breeding was further accelerated through bailouts and stimulus packages.

In view of the fact that the marginal productivity of debt is now negative, we can see that the damage-control measures of the Obama administration which are financed through creating unprecedented amounts of new debt, are counterproductive. Nay, they are the direct cause of further economic contraction of an already prostrate economy, including unemployment.

The head of the European Union and Czech prime minister Mirek Topolanek has publicly said that the plan to spend nearly \$2 trillion to push the U.S. economy out of recession is “road to hell”. There is no reason to castigate Mr. Topolanek for his characterization of the Obama plan. True, it would have been more polite and diplomatic if he had couched his comments in words to the effect that “the Obama plan was made in blissful ignorance of the marginal productivity of debt which was now negative and falling further. In consequence more spending on stimulus packages would only stimulate deflation and economic contraction.”

President Obama, like president Nixon before him, missed an historic opportunity in not ordering a complete change of guards at the Treasury and at the Fed. Now the same gentlemen who have landed the country and the world in this unprecedented débâcle are in charge of the rescue effort. The QTM, the corner stone of Milton Friedman’s monetarism, is the wrong prognosticating tool. The marginal productivity of debt is superior as it focuses on deflation rather than inflation.

The financial and economic collapse of the past two years must be seen as part of the progressive disintegration of Western civilization that started with the sabotaging of the gold standard by governments exactly one hundred years ago when in France and in Germany paper money was made legal tender. The measure was introduced in preparation to the coming war, so that the government could stop paying the military and the civil service in gold coins, starting in 1909.

Fed Chairman Ben Bernanke, who should have been fired by the new president on the day after Inauguration for his part in causing the cataclysm, a couple of years ago foolishly boasted that the government has given him a tool, the printing press, with which he can fight off deflations and depressions, now and forever. The reference to the GTM is obvious.

Now Bernanke has the honor to administer the coup de grâce to our civilization.

---

*April 15, 2009*

### Reference

The Revisionist Theory and History of Depressions, see: [www.professorfekete.com](https://www.professorfekete.com)

### Calendar of Events

### Instituto Juan de Mariana: Madrid, Spain, June 12-14, 2009

Seminar with Prof. Fekete on Money, Credit, and the Revisionist Theory of Depressions For information, contact: gcalzada@juandemariana.org

### OroY Finanzas & Portal Oro: Madrid, Spain, June 18, 2009

### Gold and Silver Meeting Madrid 2009

For information, contact: preukschat_alex@hotmail.com or gcalzada@juandemariana.org or [www.portaloro.com](http://www.portaloro.com/aemp.aspx) or info@portaloro.com San Francisco School of Economics: A Series of three Investment Seminars:

July 25; August 1; and August 8, 2009

The Gold and Silver Basis; Backwardation; Trading Gold in the Present Environment; Wealth Management under the Regime of Irredeemable Currency. Given by Professor Fekete and Mr. Sandeep Jaitly of Soditic Ltd., London, U.K. Enrolment is limited, first come first served. For more information, see: [www.sfschoolofeconomics.com](https://www.sfschoolofeconomics.com)

### San Francisco School of Economics: July 27-August 7, 2009

Money and Banking, a 20-lecture course given by Professor Fekete. Enrolment is limited; first come, first served. The Syllabus for this course can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com), see also: [www.sfschoolofeconomics.com](https://www.sfschoolofeconomics.com) University House, Australian National University, Canberra: first week of November, 2009 Peace and Progress through Prosperity: Gold Standard in the 21st Century

This is the first conference organized by the newly formed Gold Standard Institute.

For further information, e-mail: feketeaustralia@gmail.com ,

On the Gold Standard Institute, e-mail philipbarton@goldstandardinstitute.com Professor Fekete on DVD: Professionally produced DVD recording of the address before the Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the Great Depression: Can It Happen Again? plus an interview with Professor Fekete. It is available from [www.Amazon.com](https://www.Amazon.com) and from the Club [www.economicclubsf.com](https://www.economicclubsf.com) at \$14.95 each.

---

# The Marginal Productivity of Debt

URL: https://newaustrianeconomics.com/archive/fekete/the-marginal-productivity-of-debt/
Date: 2009-03-30
Section: Popular Economics
Difficulty: scholarly
Concept Tags: debt, capital-destruction, interest-theory, fiat-currency, monetary-policy
Description: Fekete develops the concept of the marginal productivity of debt: each successive dollar of new debt added to the economy produces less additional output than the last, until the marginal dollar of debt produces zero or negative output. At this point, additional borrowing is purely destructive — yet the monetary system compels it by continuously reducing interest rates.
Editorial Note: Written March 2009. One of Fekete's most analytically original contributions, extending marginal productivity analysis to debt — a concept that has since been developed empirically by researchers at the Bank for International Settlements.
Original PDF: https://professorfekete.com/articles/AEFTheMarginalProductivityOfDebt.pdf

### Paper mill on the Potomac

The paper mill on the Potomac is furiously spewing up new money. According to the manager of the mill, as indeed according to the Quantity Theory of Money, this should stop prices from falling and the economy from contracting.

In this article I present an argument why this conclusion is not valid. On the contrary, I shall show that new money created on the strength of a flood of new debt, is tantamount to pouring gasoline on the fire, making prices fall and the economy contract even more.

The Obama administration has missed its historic opportunity to stop the deflation and depression inherited from the Bush administration because it entrusted the same people with the task of damage-control who had caused the disaster in the first place: the Keynesian and Friedmanite money doctors in the Fed and the Treasury.

### Watching the wrong ratio

The key to understanding the problem is the marginal productivity of debt, a concept curiously missing from the vocabulary of mainstream economics. Keynesians take comfort in the fact that total debt as a percentage of total GDP is safely below 100 in the United States while it is 100 and perhaps even more in some other countries. However, the significant ratio to watch is additional debt to additional GDP, or the amount of GDP contributed by the creation of \$1 in new debt. It is this ratio that determines the quality of debt. Indeed, the higher the ratio, the more successful entrepreneurs are in increasing productivity, which is the only valid justification for going into debt in the first place.

Conversely, a serious fall in that ratio is a danger sign that the quality of debt is deteriorating, and contracting additional debt has no economic justification. The volume of debt is rising faster than national income, and capital supporting production is eroding fast. If, as in the worst-case scenario, the ratio falls into negative territory, the message is that the economy is on a collision course and crash in imminent. Not only does more debt add nothing to the GDP, in fact, it causes economic contraction, including greater unemployment. The country is eating the seed corn with the result that accumulated capital may be gone before you know it. Immediate action is absolutely necessary to stop the hemorrhage, or the patient will bleed to death.

Keynesians are watching the wrong ratio, that of debt-to-GDP. No wonder they constantly go astray as they miss one danger signal after another. They are sailing in the dark with the aid of the wrong navigational equipment. They are administering the wrong medicine. Their ambulance is unable to diagnose internal hemorrhage that must be stopped lest the patient be dead upon arrival.

### Melchior Palyi’s early warning

In the 1950’s when the dollar was still redeemable in the sense that foreign governments and central banks could convert their short-term dollar balances into gold at the fixed statutory rate of \$35 per ounce, the marginal productivity of debt was 3 or higher, meaning that the addition of \$1 in new debt caused the GDP to increase by at least \$3. By August, 1971, when Nixon defaulted on the international gold obligations of the United States (following in the footsteps of F.D. Roosevelt who had defaulted on its domestic gold obligations 35 years earlier) the marginal productivity of debt has fallen below the crucial level 1. When marginal productivity fell below \$1 but was still positive, it meant that total debt (always ‘net’) was rising faster than GDP. For example, if the marginal productivity of debt was ½, then \$2 in debt had to be incurred in order to increase the nation’s output of goods and services by \$1. An increase in total debt by \$1 could no longer reproduce its cost in the form of an equivalent increase in the GDP. Debt lost whatever economic justification it may have once had.

The decline in the marginal productivity of debt has continued without interruption thereafter. Nobody took action, in fact, the Keynesian managers of the monetary system and the economy stone-walled this information, keeping the public in the dark. Nor did Keynesian and Friedmanite economists at the universities pay attention to the danger sign. Cheerleaders kept chanting: “Gimme more credit!”

I learned about the importance of the marginal productivity of debt from the privately circulated Bulletin of Hungarian-born Chicago economist Melchior Palyi in 1969. (There were altogether 640 issues of the Bulletin; they are available in the University of Chicago Library). Palyi warned that the tendency of this most important indicator was down and something should be done about it before the debt-behemoth devoured the economy.

Palyi died a few years later and did not live to see the devastation that he so astutely predicted.

Others have come to the same conclusion in other ways. Peter Warburton in his book Debt and Delusion: Central Bank Follies ThatThreaten Economic Disaster (see references below) envisages the same outcome, although without the benefit of the concept of the marginal productivity of debt.

### The watershed year of 2006

As long debt was constrained by the centripetal force of gold in the system, tenuous though this constraint may have been, deterioration in the quality of debt was relatively slow. Quality caved in, and quantity took a flight to the stratosphere, when the centripetal force was cut and gold, the only ultimate extinguisher of debtthere is, was exiled from the monetary system. Still, it took 35 years before the capital of society was eroded and consumed through a steadily deteriorating marginal productivity of debt.

The year 2006 was the watershed. Late in that year the marginal productivity of debt dropped to zero and went negative for the first time ever, switching on the red alert sign to warn of an imminent economic catastrophe. Indeed, in February, 2007, the risk of debt default as measured by the skyrocketing cost of CDS (credit default swaps) exploded and, as the saying goes, the rest is history.

### Negative marginal productivity

Why is a negative marginal productivity of debt a sign of an imminent economic catastrophe? Because it indicates that any further increase in indebtedness would necessarily cause economic contraction. Capital is gone; further production is no longer supported by the prerequisite quantity and quality of tools and equipment. The economy is literally devouring itself through debt. The message, namely that unbridled breeding of debt through the serial cutting of the rate of interest to zero was destroying society’s capital, has been ignored. The budding financial crisis was explained away through ad hoc reasoning, such as blaming it on loose credit standards, subprime mortgages, and the like. Nothing was done to stop the real cause of the disaster, the fast-breeder of debt. On the contrary, debt-breeding was further accelerated through bailouts and stimulus packages.

In view of the fact that the marginal productivity of debt is now negative we can see that the damage-control measures of the Obama administration, which are financed through creating unprecedented amounts of new debt, are counter-productive. Nay, they are the direct cause of further economic contraction of an already prostrate economy, including unemployment.

The head of the European Union and Czech prime minister Mirek Topolanek has publicly characterized president Obama’s plan to spend nearly \$2 trillion to push the U.S. economy out of recession as “road to hell”. There is absolutely no reason to castigate Mr. Topolanek for this characterization. True, it would have been more polite and diplomatic if he had couched his comments in words to the effect that “the Obama plan was made in blissful ignorance of the marginal productivity of debt which was now negative and falling. In consequence more spending on stimulus packages would only stimulate deflation and economic contraction.”

### Hyper-inflation or hyper-deflation?

Most critics the Obama plan suggest that the punishment for the bailouts and stimuluspackages will be a serious loss of purchasing power of the dollar and, ultimately, hyperinflation, as evidenced by the Quantity Theory of Money. However, the quantity theory is a linear model that may be valid as a first approximation, but fails in most cases as the real world is highly non-linear. My own theory, relying on the concept of marginal productivity of debt, predicts that it is not hyperinflation but a vicious deflation which is in store. Here is the argument.

While prices of primary products such as crude oil and foodstuffs may initially rise, there is no purchasing power in the hands of the consumers, nor can they borrow as they used to in order to pay the higher prices much as though they would have liked to do. The newly created money has gone into bailing out banks, and much of it was diverted to continue paying bloated bonuses to bankers. Very little, if any of it has “trickled down” to the ordinary consumers who are squeezed relentlessly on their debts contracted in the past.

It follows that price rises are unsustainable, as the consumer is unable to pay them. As a consequence the retail and wholesale merchants are also squeezed. They have to retrench.

Pressure from vanishing demand is passed on further to the producers who have to retrench as well. All of them are experiencing an ebb in their operating cash flow. They lay off more people, aggravating the crisis further as cash in the hand of the consumers is diminished even more through increased unemployment. The vicious spiral is on.

But what is happening to the unprecedented tide of new money flooding the economy?

Well, it is used to pay off debt by the people who are desperately scrambling to get out of debt. Businessmen in general are lethargic; every cut in the rate of interest hits them by eroding the value of their previous investments. In my other writings I have explained how falling interest rates make the liquidation value of debt rise, which becomes a negative item in the profit/loss statement eating into capital that has to be replenished as a consequence. Worse still, there is no way businessmen can be induced to make new investments as long as further reductions in the rate of interest are in the cards. They are aware that their investments would go up in smoke as the rate of interest fell further in the wake of “quantitative easing”.

### Self-fulfilling speculation on falling interest rates

The only enterprise prospering in this deflationary environment is bond speculation.

Speculators use new money, made available by the Fed, to expand their activities further in bidding up bond prices. They pre-empt the Fed: buy the bonds first before the Fed has a chance; then turn around and dump them in the lap of the Fed. This activity is risk-free.

Speculators are told in advance that the Fed is going to move its operations from the short to the long end of the yield curve. It will buy \$300 billion worth of long dated Treasury issues during the next six months, and probably much more after that. Speculation on falling interest rates becomes self-fulfilling, thanks to the insane idea of open market operations of the Fed making bond speculation risk-free. Deflation is made selfsustaining. (For another view of risk-free bond speculation, see the article by Carl Gutierrez’ in Forbes mentioned in the References below.)

Note also the crescendo of the dumping of equities and the desperate attempt to redeem toxic assets by private parties, sending the demand for cash sky high. The dollar, at least the Federal Reserve note variety of it, will be increasingly scarce. Rather than falling through the floor as under the hyper-inflationary scenario, the purchasing power of the dollar will soar. You say that Ben Bernanke and his printing presses will take care of that? Well, just consider this. The market will separate vintage Federal Reserve notes from the new issues with Bernanke’s signature on them. In a classic application of Gresham’s Law people will hoard the first, bestowing a premium on it relative to the second variety, which will fall by the wayside.

### Bernanke can create money but cannot make it flow uphill

Already some tip sheets openly advise people to hoard Federal Reserve notes in amounts up to twenty-four months of estimated household expenditure, while cleaning out all deposit accounts. Depositors are urged to forget about the \$250,000 limit on deposit insurance, which is rendered literally worthless as the resources of the F.D.I.C. have been hijacked by Geithner and diverted to guaranteeing the investments of private parties that were foolish enough to buy into toxic debt at the behest of the Obama administration.

Karl Denninger envisages unemployment in excess of 20%, with cities going “feral” as showcased by downtown Detroit (see References below).

What has all this got to do with the marginal productivity of debt? Well, once it is negative, any further addition of new debt will make the economy shrink more, increasing unemployment and squeezing prices. Bernanke can create all the money he wants and more, but he cannot make it flow uphill.

### Bernanke is risking something worse than a depression

The newly created money will follow the laws of gravity and flow downhill to the bond market where the fun is. Risk-free bond speculation will further reinforce the deflationary spiral until final exhaustion occurs: the economy will collapse as a pricked balloon.

Instead of hyperinflation and the destruction of the dollar, you’ve got deflation and the destruction of the economy.

Denninger says that the “death spiral” will lead to fire sales of assets in a mad liquidation dash and, ultimately, to the collapse of both the monetary and political system in the United States as tax revenues evaporate. He opines that probably not one member of Congress understands the seriousness of the situation. Bernanke is risking something much worse than a Depression. He is literally risking the end of America as a political, economic, and military power.

Indeed, the financial and economic collapse of the last two years must be seen as part of the progressive disintegration of Western civilization that started with government sabotage of the gold standard early in the twentieth century. Ben Bernanke, who should have been fired by the new president on the day after Inauguration for his part in causing irreparable damage to the American republic may, in the end, have the honor to administer the coup de grâce to our civilization.

### References

No Time for T-Bonds by Carl Gutierrez, March 28, 2009, [www.forbes.com](https://www.forbes.com) Bernanke Inserts Gun in Mouth, by Carl Denninger, March 20, 2009, [market-ticker.denninger.net](http://market-ticker.denninger.net) Debt and Delusion: Central Bank Follies That Threaten Economic Disaster, by Peter Warburton, first published in 1999; WorldMetaView Press (2005)

---

# The Gold Standard Institute

URL: https://newaustrianeconomics.com/archive/fekete/the-gold-standard-institute/
Date: 2009-03-22
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, real-bills, new-austrian-economics, sf-school, sound-money
Description: An overview of the Gold Standard Institute, its mission, and its relationship to the New Austrian School of Economics. Fekete explains the Institute's approach to monetary reform, its theoretical foundations in basis analysis and Real Bills theory, and why he believes institutional advocacy for the gold standard is necessary alongside academic research.
Editorial Note: Written March 2009. Provides useful context for Fekete's institutional activities and the organizational expression of his monetary reform program.
Original PDF: https://professorfekete.com/articles/AEFTheGoldStandardInstitute.pdf

According to John Maynard Keynes (1883-1947) the deeper roots of the gold standard are to be found in psycho-pathology. There is something pathological in man’s desire to palm the metal. Keynes says that whenever he is digging to find the rational basis for man’s wanting gold, he always runs into Virgil’s dictum from the Aeneid:

Auri sacra fames, “that accursed hunger for gold”, at which point he is forced to give up and “pass on the case to the psycho-pathologist with a shudder”.

Keynes’ jeremiad pretty well sums up the official position on gold to-day. You may try, as I have, to engage politicians and mainstream economists in a discussion on the subject of the gold standard, and get a polite refusal saying that their plate is full with ‘real’ problems, leaving no room and time for ‘imaginary’ ones.

---

In spite of Keynes and officialdom, there is a scientific theory of the gold standard. Gold is not wanted because of a bestial instinct in man.

Nor is it desired because it is scarce. After all, there are substances even scarcer than gold. Gold is in general demand because its marginal utility is constant (or, at least, it declines more slowly than that of any other substance). This is a technical expression that could be rendered in plainer English by saying that while the satiation point for most substances is not too far, for gold, it is receding farther than for any other.

It is clear that there must be a substance with this property; it just so happens that it is gold that fills the bill. It is also clear why the substance with the fastest receding satiation point is important economically. It is this property that makes gold ‘most hoardable’ or ‘most marketable in the small’. Man is mortal and subject to the curse of senescence. He needs a substance that can help him to transfer wealth over time, that is, a substance he can hoard in confidence in order to provide for his old age. Or here is another example: man has a need to transfer wealth over time as he wants to provide for the education of his offspring. This is especially important at a time when the credit system breaks down (sounds familiar?), or when no one can trust the currency any more for fear of depreciation or debasement. If the government bans ownership and trading in gold, as it has done in history on certain occasions, another substance will take over the role of the most hoardable commodity.

---

We may approach the problem from the other end by posing the following question: what is the ultimate extinguisher of debt? If there is debt, then there must be a way to liquidate it. Granted that one type of debt can often liquidate another type; we still need an ultimate extinguisher of debt. If we weren’t allowed to have one, then debt would sooner or later start its fast-breeding accelerator cycle and toxic debt would ultimately overwhelm the system (sounds familiar?)

The ultimate extinguisher of debt is gold. It is that financial asset that has zero counterparty risk. All other assets do carry such risks since that selfsame asset must also occur as a liability in the balance sheet of someone else.

If you say that the national currency backed by the wealth of the country is the ultimate extinguisher of debt, then you need to be reminded that the writ of the government stops at the border. There is no way to legislate legal tender that is enforceable abroad.

---

The theory of interest is a part of economic science that has never achieved a “state of finality” in the sense that the majority of economists would accept it, at least in its broadest outlines, as valid.

The theory of interest is still very much at the percolating stage.

Ludwig von Mises (1881-1973), a solid gold standard man, denies that gold has constant marginal utility. He says that this would imply ‘infinite demand’ for gold which is contradictory. Mises is wrong. It is true that for all commodities the obstruction to infinite demand is declining marginal utility. Gold is an exception, the only one there is. For gold, the obstruction to infinite demand is not declining marginal utility but the phenomenon of interest. As the rate of interest is increasing, ever more people will give up their gold in exchange for income in the form of a stream of interest payments.

It is important to note here that the converse is also true. As the rate of interest is falling, ever more people will find the income from interest payments insufficient and will want to hold gold. Yes, they do want to palm gold, as opposed to paper promises to pay gold. There is nothing psycho-pathological about that. If people dissatisfied with the low interest income accepted a wad of paper money in exchange, then they would be jumping from the frying pan into the fire. Their protest against the interest rate being too low ended up settling for zero interest which was as low as it could go, but it was exactly what they would get on their investment in paper money.

Mises also says that a promise by a credible promissor to pay gold coin to bearer on demand is a full and equal substitute for the gold coin in every conceivable economic transaction as it is accepted in lieu of the gold. He concludes that paper money is a present good just like the gold coin itself. Even if no longer redeemable in gold, according to Mises, paper money is a present good rather than a future good. Mises is wrong again. However you look at it, a gold certificate payable to bearer on demand is no more than a future good, never a present good. Here is the reason why. The marginal bondholder, who has set out to register his protest against the rate of interest being too low by selling his bond, will accept the gold coin in payment but will refuse to take the gold certificate.

---

I quote from the great American monetary scientist, Benjamin M.

### Anderson (1886-1949), who in 1948 wrote under the caption The

Tyranny of Gold as follows:

“Gold needs no endorsement. It can be tested with scales and acids. The recipient of gold does not have to trust the government stamp upon it, if he does not trust the government that stamped it. No act of faith is called for when gold is used in payments, and no compulsion is required.

“Men everywhere, governments everywhere, and central banks everywhere are glad to get it. When paper is offered instead of gold, it will be accepted on faith if the government or the bank which has issued the paper has proved itself worthy of confidence by a satisfactory record of redeeming the paper in gold on demand.

“Complaints are always made about gold and the behavior of gold when there is irredeemable paper money. Under Gresham’s Law, gold is hoarded, or leaves the country. It ceases to circulate, leaving the dishonored promissory note in possession of the field. Gold will stay only in countries which submit to its discipline. Gold is an unimaginative taskmaster. It demands that man and governments and central banks be honest. It demands that they keep their promises on demand or at maturity. It demands that they keep their demand liabilities safely within the limits of their quick assets. It demands that they create no debts without seeing clearly how these debts can be paid. If a country will do these things, gold will stay with it and will come to it from other countries which are not meeting the requirements. But when a country creates debt lightheartedly, when a central bank makes rates of discount low and buys government securities to feed its money market, and permits an expansion of credit that goes into slow and illiquid assets, then gold grows nervous.

Mobile capital funds of all kinds grow nervous. There comes a flight of capital out of the country. Foreigners withdraw their funds from it, and its own citizens send their liquid funds away for safety.

“When suspension of gold payments comes, speculators in the foreign exchange market treat paper currency most disrespectfully.

They sell it short. They buy it only at a discount. The amount of discount in a free gold market or in a free foreign exchange market will be governed primarily by speculative expectation as to whether and when resumption of gold payments is coming, whether or when the government and the central bank will reverse its unsound policy and work back toward orthodoxy. Gold is blamed, speculators are blamed, “hot money” is blamed…

“The prestige of a great government and a long-established government can go far in upholding the value of its paper money even if rational foundations for the value of paper money have waned…

“A country which is afraid of hot money, money which may suddenly jump to another country, has a very simple way of avoiding this danger. It does not need to control capital movements. It can protect itself against this danger by having a sound currency, firmly anchored to gold at a fixed rate, by keeping control of its money market so that its demand liabilities do not grow excessive in relation to its gold, by keeping a balanced budget – by making a financial environment in which money cools off and wants to stay…

“Gold’s greatest competitor is the confidence men have in the paper promises of governments and central banks to pay gold, and you could use that promise as a substitute for gold. The devaluation of the dollar has shaken that faith…

“There is no need in human life as great as that men should trust one another, and should trust their government, should believe in promises, and should keep promises in order that future promises may be believed in, and in order that confident cooperation may be possible. Good faith – personal, national, and international – is the first prerequisite of decent living, of the steady going on of industry, of governmental financial strength, and of international peace.”

---

No other institution has been subjected to more bad-mouthing and verbal abuse than the gold standard. An enormous amount of propaganda was deployed in order to discredit it by governments and banks. This is not surprising if we contemplate that the dishonored promises of banks to pay gold have immediately been promoted to legal tender status upon the suspension of the gold standard.

Moreover, academic scribblers could expect handsome stipends and other rewards such as early promotion if they are willing to sell their pen at the bid of governments and central banks.

When governments, strong in gold, broke their promise to pay gold to widows and orphans to whom they have sold government bonds with a pledge to pay gold coin of the present standard of value; and also broke their promise to redeem their paper money in gold coin of the present standard of value, it represented an act of absolute bad faith. It was dishonor.

The dishonor had to be covered up. Thereupon an adventurer, one John Maynard Keynes, comes along with a handy theory suggesting that the gold standard is pure superstition masked as science. He claims that prior saving is not really a prerequisite for spending, provided that you have a pliant central bank with an efficient printing press. He claims that interest could and should be abolished through the “euthanasia of the rentier”. He says he could take care of gold hoarders and eliminate gold from the monetary system, for being such a nuisance as the perennial obstruction to bad faith in high finance. He says he knows how to discredit the gold standard for once and all. Unfortunately for the government, Keynes died before he could reveal his secret.

Governments and their pliant central banks were eager to take the advice of Keynes. They sabotaged the gold standard by feeding the rumor-mills suggesting that the national currency will be presently devalued. When gold disappeared from circulation as a consequence, they threw up their hands in a hypocritical gesture saying: “See? It does not work. Gold does not behave. You can’t run a gold standard, given that accursed hunger for gold.”

---

The golden thorn in the flesh is still bothering devaluation-happy governments. The golden corpse still stirs. There is still this unfinished business, to take care of the gold hoarders. During the French Revolution they did it by enlisting the guillotine as an instrument of monetary policy. If they found you with undocumented gold, then your head would be chopped off in summary justice.

But maybe, just maybe, public opinion can force a Great Debate on the merits of the gold standard, a debate that has been resisted during the tenure of Keynesian economics for the past 75 years.

It is time to take stocks. Keynesian economists promised an end to bank runs, to deflations, depressions and lasting economic contractions on condition that they were allowed to demonetize gold.

Gold was duly demonetized, but the Keynesians could not deliver.

The worst depression of all times has burst upon the world on their watch in 2007, causing the greatest economic contraction, unprecedented economic pain, and untold damage to the social fabric, of which we have seen just a sample so far.

The Gold Standard Institute was established to prepare the worlds for this Great Debate. We are ready for a showdown now; are also the Keynesians?

---

One of the tasks the Gold Standard Institute will face is to deal with the views of the deviant friends of the gold standard, and convince them of the errors of their ways. Let me just briefly mention four points at issue for starters.

¶The main excellence of the gold standard is not that it can stabilize prices, which is neither possible nor desirable. The main excellence of the gold standard is that it can stabilize the rate of interest, which is all the stabilization the economy needs. Once this is done, other economic indicators including prices will be imparted as much stability – or flexibility – as is necessary for the smooth operation of a healthy economy.

¶The so-called 100 per-cent gold standard is a pipe-dream that would not survive the first Christmas shopping season. The theory of the gold standard, properly conceived, admits self-liquidating credit.

As Adam Smith’s Real Bills Doctrine reveals, short-term commercial paper drawn on fast-moving goods to the ultimate gold-paying consumer is the second best thing to the gold coin itself. Its emergence is spontaneous and contemporaneous with the emergence of new merchandise demanded most urgently by the consumers. It is not inflationary because together with the removal of the merchandise from the market the short-term credit is extinguished through the release of the gold coin of the ultimate consumer. It is the best earning asset that a commercial bank can have. In launching a gold standard you cannot ignore self-liquidating credit. If you do, you are inviting a humiliating failure, giving occasion for schadenfreude in the enemy camp.

¶The Quantity Theory of Money is a linear model that may be valid only as a first approximation. The real world is far from being linear, however. To the extent this is true, the Quantity Theory of Money is false.

¶The essence of the gold standard is not the fixing of the gold price. It is the taking the power to create money out of the hands of unelected bureaucrats and putting it into the hands of the people themselves, where it belongs according to the U.S. Constitution. It did not establish a central bank; it established the U.S. Mint and opened it to the free coinage of gold (and silver). This gave the power to people: those who felt that there was not enough money in existence could take new gold from the mines, or old gold from jewelry and plate, to the Mint and convert it into the coin of the realm.

Talking about fixing the gold price would be putting the cart before the horse. It is just the other way round: the price of paper instruments is fixed in terms of the gold coin of the realm.

---

These are the best of times, and these are the worst of times. Best of times because, for the first time in 75 years, it is possible to come out with a forceful defense for this magnificent institution that no one designed or planned, but that developed spontaneously creating a great harmony in the economy, matching investments with available savings and production with existing demand: the gold standard.

Worst of times, because great damage to the world economy and finance has already been done, and more damage will still be done by the destructive forces of society responsible for exiling gold from the monetary system for the past 35 years. The Gold Standard Institute has a formidable task ahead in carrying the torch to show the way out of the present darkness.

---

I send my hearty welcome to the Gold Standard Institute on occasion of its début wishing it a prosperous future. I pledge my support in the task of saving our great monetary heritage: the theory and practice of the gold standard, and in educating the world about the sound principles of money and banking.

### Antal E. Fekete

### Professor of Money and Banking

### San Francisco School of Economics

---

*March 22, 2009.*

### Further Reading

### The Gold Standard Manifesto, January 9, 2006

Götterdämmerung: The Twilight of Irredeemable Debt, April 27, 2008 see: [www.professorfekete.com](https://www.professorfekete.com)

---

# There Is More Where This Gift Has Come From

URL: https://newaustrianeconomics.com/archive/fekete/there-is-more-where-this-gift-has-come-from/
Date: 2009-03-21
Section: Popular Economics
Difficulty: accessible
Concept Tags: federal-reserve, monetary-policy, capital-destruction, fiat-currency, debt
Description: Fekete examines the Federal Reserve's money-creation operations during the crisis, using the sarcastic title to note that the Fed's gift of newly printed money comes with hidden costs: the destruction of the capital base that makes future wealth creation possible. Each dollar of stimulus money is borrowed against the productivity of future generations.
Editorial Note: Written March 2009 as quantitative easing was beginning. Fekete's sardonic title captures his view of QE as a poisoned gift.
Original PDF: https://professorfekete.com/articles/AEFThereIsMoreWhereThisGiftHasComeFrom.pdf

On Wednesday, March 18, another handsome gift was delivered by the Fed to the bond bulls.

It was the announcement that the Open Market Committee has made a unanimous decision for the central bank to buy \$300 billion in long-term Treasury bonds and notes over the next sixmonth period. The yield on the 30-year Treasury bond immediately fell from 3.8% to 3.5%, while the yield on the benchmark 10-year Treasury note fell more: from 3% to 2.53%, increasing the price of the note by 42/32 from 9726/32 to 10128/32 , the biggest one-day rise in years. The gift of risk-free profits is granted to the bond bulls through courtesy of the Fed, in telling them in advance about its intention of buying long-dated government debt.

Note that in the past Fed purchases of long-term Treasurys have been exceedingly rare. The last time the Fed resorted to it was in 1959. But half-a-century ago it was not meant to be a permanent fixture of monetary policy. This time is different. Wednesday’s announcement is the opening salvo in a brand new game of serial interest-rate cuts in the high-end of the yield-curve now that the Fed has chewed up the low end. It has used up all its ammunition in the short-term T-bill market where the rate is only microscopically greater than zero, rendering the Fed helpless and impotent. A new bag of tricks is coming into play: the monetization of long-term government debt. The market tells it all. The dollar index fell 3%, the biggest drop in more than two decades.

Actually, as I have suggested in several earlier articles, ‘serial cutting of interest rates’ is a misnomer. The correct phrase is ‘serial halving of interest rates’. The nuance is important.

Serial cutting comes to an end when you have cut it to the bare bones: all the way back to zero. Not so serial halving that can be fine-tuned like water-torture. It can continue indefinitely, while each halving causes the same devastation in the economic landscape as it doubles the liquidation value of total debt.

Central banks in Japan and the United Kingdom have announced similar monetary policies. The Bank of Japan has said that it will increase its volume of bond purchases by 30%. According to Mr. Shiraskawa, the governor of the bank, “bond purchases are not intended to finance the Japanese government’s spending. That would be too dangerous.” Who is the governor kidding? As long as the Japanese government spends more than its revenue from taxes, every act of buying a government bond is an act of financing the government.

Even in Switzerland, the paragon of monetary and fiscal rectitude, where the Swiss National Bank is hard put to find a government bond it can buy, they have to do something to enter the mad race to find out which country can increase the money supply at the fastest rate. The Swiss are resourceful: since they cannot increase the money supply through purchases of bonds, they will increase it through sales of Swiss francs. All masks are off. The Swiss will not let others outbid them in the game of bidding down the value of national currencies around the globe. This is competitive currency debasement at its most vicious. It is a cover-up for the underlying trade war.

---


Why should we worry about a monetary policy that depends on risk-free profits offered to speculators betting on higher bond values? Because it reflects the utter corruption of the profit-and-loss system on which capitalist production is based. It makes the businessman appear foolish who takes risks in the producing sector while trying to satisfy the needs of the consumers – when risk-free profits are available in the financial sector. As a matter of fact, the risk-free profits of the bond bulls do not come out of nowhere. They come right out of the capital accounts of the producers. These gains are the flipside of the capital losses suffered by the real risk-takers, the sitting ducks in this shoot-out.

I have been in a minority of one in my quest to inform the public about the single cause of the present economic disaster. In fact I have been predicting it for the past eight years. The single cause is the Fed’s deliberate policy to drive down interest rates through serial halving. This policy is animated by the economic theories of John Maynard Keynes, according to which interest ought to be abolished so that the stone can be turned into bread and water into wine. The miracle is worked by a central bank well-equipped with printing presses and a factory to produce green cheese in unlimited quantities, to shove it down the throats of savers who are trying to provide for their twilight years, or for the education of their offspring, or just for a rainy day.

Continuing or even accelerating that disastrous monetary policy of unlimited green cheese production will not alleviate the crisis. It will make it worse. Much worse.

Look at it this way. The present contraction of the world economy is not due to a glut in global savings for which businessmen can find no good use, and which consequently has to be mopped up through expanding the balance sheet of the central banks all over the world, as “explained” by Paul Krugman and his friend, mentor, and former boss Ben Bernanke. The contraction is due to the lethargy of businessmen who see their past investments turn sour one after another at each interest-rate cut. Businessmen will not make new investments, no matter how badly central bankers want to force-feed them at the trough of newly created money, as long as the mad driving-down of interest rates continues. Would you buy a car today if you were told that its price will be cut tomorrow? Of course you wouldn’t. Well, it is the same with businessmen. They would not make an investment today if they were told that tomorrow they could finance it at a cheaper rate and, the day after tomorrow at a rate cheaper still. It is as simple as that.

Now the Fed is saying that it has got a new toy-grenade to try on the economy: the Tbond purchase plan. Businessmen conclude that this is time to go into hibernation-mode. They just want to survive with their remaining capital intact until this madness runs its full course.

They will come back and start investing again in saner times, when interest rates are stabilized at their natural level. Those who listen to the siren song from the Fed and other central banks, and invest at today’s teaser-rate will get massacred at the next halving, when even lower teaser rates will be offered.

---


What we are witnessing is the closing of Keynes’ system. This system is based on the worst fallacy ever embraced by pretenders and impostors in science: the fallacy, inspired by Karl Marx, of over-saving and under-consumption. It was under this banner that the Fed introduced its illegal policy of open market purchases of government bonds that would be legalized retroactively later. But with this coup d’etat the Fed shot itself in the foot. It has forgotten to take the reaction of bond speculators into account. Of course, speculators would not sit idly by when they are told that, as a matter of high monetary policy, the Fed will have to make periodic trips to the bond market to purchase its quota of government bonds. Of course speculators would want to pre-empt the Fed. Of course they wanted to buy first so that they could dump their bonds on the Fed at a profit later. Of course bond speculators would lie in wait for the Fed and ambush it at the moment it was ready to pick up its next quota of government bonds in the open market.

The present monetary system promises risk-free profits to bond speculators. This guarantees that the interest rate structure will keep falling indefinitely. Astute businessmen who understand the interaction between finance and production will stay on the sidelines.

They will not join the mad tea party of teaser rates whether offered in the subprime mortgage market or whether offered on loans to finance future production. Teaser rates are there to tempt individuals and businesses to commit hara-kiri.

This raises the question just how sound a monetary system is that wants to create money, lots of it, but can only do it through bribes and blackmails. This also raises the question how it is possible to treat Keynes’ system with respect.

---


Mine is a cry in the wilderness. You had thought that the political system was rotten as it was a system of bribes, blackmails, and vote-buying facilitated by irredeemable currency. You had thought that the judiciary was rotten as no complaint about the fraud involved in the checkkiting conspiracy between the Treasury and the Fed would ever be heard in a court. You had thought that victims of the Ponzi-scheme whereby the government would sell bonds, which it had neither the means nor the intention to pay off, could have their day in court.

But look: the educational system, our only hope for the future, is equally rotten. Its faculties of criticism are so badly disabled that one can no longer hope for an open discussion of burning issues. Keynesians, in concert with their Friedmanite comrades, control everything: monetary policy, fiscal policy, the judiciary, appointments and the research agenda at universities and other think-tanks, the publication programs in the editorial offices of scholarly journals. A Cassandra such as myself would never get a hearing before the disaster struck.

Now, as it turns out, I won’t get a hearing even after disaster has struck. Keynesians and their Friedmanite cronies want to control the rescue effort and they certainly do not want to see their past errors and misdeeds, that lie at the root of the problem, exposed to public scrutiny.

The economic and financial crisis that is plaguing the world is extremely serious.

Damage to the social fabric could be even greater than that during the Great Depression. But a reasoned, high-level discussion on the genesis of the crisis is ruled out. You have to buy the official crap on the global savings glut. You are not allowed to challenge the official dogma of under-consumption even after the most wasteful episode of over-consumption in history, running up private and public debt to stratospheric heights.

The present crisis is about past, present, and future destruction of capital due to the Keynesians’ deliberate policy of driving down interest rates. Education of public opinion about these matters is sorely needed. Keynesians have been successful in convincing the public that their monetary policy to drive down interest rates is a blessing. But the truth is that falling interest rates erode capital, because the return from earlier investments proves insufficient to amortize debt contracted at higher rates. At the end of the capital erosion road comes the realization that production and finance stands bereft of any capital. The result is a credit collapse that can no longer be covered up with the usual Keynesian nostrums My conclusion is that the latest move of the Fed is going to entrench deflation through entrenching the trend of falling interest rates. The mechanism works through bond speculation, making risk-free capital gains available to speculators, who will then bid up bond prices unopposed to any high level.

Other observers may violently disagree with this view. For example Clive Maund had this to say: “So Treasuries spiked yesterday [on March 18], but the large gains were almost entirely erased by the drop in the dollar… So in an environment where the Fed and the Treasury are going to have to create dollars, i.e., to dilute the currency, to prop up financial instruments… who but a complete imbecile is going to buy them?… The Treasury market will collapse in due course anyway despite, and perhaps even because of, the Fed’s desperate and reckless attempts to backstop it.”

Not so fast, please. Ultimately the market for Treasury bonds will collapse in a hyperinflationary scenario, but this may be years down the road. In the meantime we have to face the music that keeps the game of musical chairs going: the serial halving of interest rates to enable bond speculators to earn risk-free profits. This stokes the fires of deflation, not the fires of inflation. Obituaries of the dollar are written prematurely. The death throes of the Dollar Almighty, as the U.S. currency was known not so long ago, will continue for quite a while yet and, unfortunately, will cause a lot more damage to the world economy, and a lot more economic pain to ordinary people.

It is an inane and malicious Keynesian propaganda that falling interest rates are good for the economy, for you, for me, for business. On the contrary, they are lethal. Only low and stable interest rates can help us to get out of the present mess – an unachievable goal under the regime of irredeemable currency.

### Reference

By the same author: That Accursed Propensity To Save, March 9, 2009, [www.professorfekete.com](https://www.professorfekete.com) .

### Calendar of events

### Szombathely, Martineum Academy, Hungary, March 27-29, 2009

Encore Session of Gold Standard University Live.

### Topics: When Will the Gold Standard Be Released from Quarantine?

### The Continuing Vaporization of the Derivatives Tower

### Labor and Great Depression II

### Silver in Backwardation: What Does It All Mean?

### Further details: GSUL@t-online.hu

This conference is the swan song of GSUL which has been succeeded by the Gold Standard Institute. For information about the latter contact: philipbarton@goldstandardinstitute.com

### Instituto Juan de Mariana, Madrid, Spain, June 18, 2009

Gold & Silver Meeting Madrid 2009. This one-day conference will be followed by a three-day seminar. For more information, contact: gcalzada@juandemariana.org

### San Francisco School of Economics, July 15-August 31, 2009

Money and Banking, a ten-week course based on the work of Professor Fekete who will be delivering 18 of the 20 lectures. Enrolment is limited; first come, first served..

The Syllabus for this course can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com) as well as that of the school: [www.sfschoolofeconomics.com](https://www.sfschoolofeconomics.com)

### National University of Australia, Canberra, November, 2009

Peace and Progress through Prosperity: Gold Standard in the 21st Century

This is the first conference organized by the newly formed Gold Standard Institute.

### For information please e-mail: feketeaustralia@gmail.com

Professorfekete on DVD: Professionally produced DVD recording of the address before the Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the Great Depression: Can It Happen Again? plus an interview with Professor Fekete, is available from [www.Amazon.com](https://www.Amazon.com) and from the Club [www.economicclubsf.com](https://www.economicclubsf.com) at \$14.95 each.

---

*March 20, 2009*

---

# That Accursed Propensity to Save

URL: https://newaustrianeconomics.com/archive/fekete/that-accursed-propensity-to-save/
Date: 2009-03-08
Section: Popular Economics
Difficulty: intermediate
Concept Tags: interest-theory, gold-standard, fiat-currency, mises, new-austrian-economics
Description: Fekete defends saving against Keynes's paradox of thrift, arguing that the propensity to save is not a macroeconomic vice but the source of all genuine prosperity. Under a gold standard, saving flows naturally into productive investment through the interest rate mechanism; under irredeemable currency, this mechanism is severed and saving is rendered unproductive.
Editorial Note: Written March 2009 as Keynesian anti-saving arguments were dominating policy discussion. A direct refutation of the paradox of thrift from a New Austrian perspective.
Original PDF: https://professorfekete.com/articles/AEFThatAccursedPropensityToSave.pdf

> “Thank Heaven for little Keynesian Nobel laureates… without them what would little Keynesian Treasury secretaries do?...”

At the long last we got the official explanation how we got into this mess. In his March 2, 2009, column in The New York Times under the banner title Revenge of the Glut Paul Krugman tells us, quoting the authority of the Chairman of the Federal Reserve Ben Bernanke, that it is all the fault of the Asians. They save damn too much. They test the endurance of unhappy Americans who bankrupt themselves in trying to work off all that darned excess saving fast enough before it can do more damage. Even though they do their level best, they could not keep up with the prodigious output of the Asians and “global savings glut” is the result. It was the cause of the U.S. current account deficits in the first place; now it is causing more mischief by creating turmoil in the financial markets and in the banking system. In this scenario, the good guys are the Americans. They are heroically trying to stave off disaster through their unselfish consumption. The bad guys are the Asians, tormenting their American victims in force-feeding them with overdoses of consumer goods all the way to the bankruptcy court.

Although Krugman does not say it, the implication is all too clear: there is one especially pernicious form of saving, namely, saving in the form of gold. Keynesians, through half a century of hard work, ably assisted by their Friedmanite comrades, have developed a highly efficient system to embezzle, unobserved, superfluous savings in an antiseptic way.

Their sophisticated contra-saving devices through currency debasement anesthetize those bastard savers so that they can be pilfered and plundered without touching a raw nerve. It is a clean job, causing a minimum of commotion.

Unfortunately, these methods do not work on those who do their vicious anti-social saving in the form of gold. These guys will have to be taken care of by other means, such as threats of central bank gold sales, bubble-bursting and price-busting techniques in the paper gold markets, and other similar tactics. If everything else fails, the guillotine could be reactivated as an instrument of monetary policy, last used in this way during the French Revolution. At that time, if you were found in possession of undocumented gold, your head would be chopped off in summary justice.

---


It is very doubtful that in the long and checkered history of science there is another episode comparable to this deliberate misuse and abuse of knowledge for the exploitation of those who do not have the full complement of it. What makes it particularly odious is that Keynesian obscurantism and anti-scientific propaganda is put in the service of a hidden agenda: to cover up the mismanagement of the economy through Keynesian precepts, the sabotaging of human cooperation under the system of division of labor, and the destruction of capital through the corruption of the monetary system.

The monetary system was developed to serve and protect society as a whole: savers as well as consumers. After all, at some point during our lives we are (or ought to be) savers, so that later, in our harvest years, we could be consumers. If it does not work in the opposite order, Mother Nature is to be blamed. Saving always and everywhere had to precede consumption. Saving has always been primary and consumption secondary, like it or not.

But Keynesians have overthrown Mother Nature. They say that it is possible to have consumption without prior saving. Having corrupted our monetary system and having destroyed society’s capital, Keynesians have rendered people unable to fend for themselves.

They treat them as they would treat livestock in the feedlot. In exchange for fattening them (in preparation for the slaughterhouse) livestock is being relieved from the need to gather feed in the summer for winter consumption. Keynesians, self-styled directors of the national economy, reserve the job of the feedlot operator to themselves. They declare savings and capital obsolete. Synthetic credit manufactured at the central bank in the service of collectivism is used as a substitute.

It would be well if Keynesians took to heart the astute observation of Glenn Prickett,

Senior V.P. at Conservation International, that “Mother Nature doesn’t do bailouts.”

---


Apparently it has never occurred to Krugman that the present disaster is not due to his imaginary savings glut but, rather, to the imperfections of the monetary system. Why can’t we have a monetary system that allows people to save to their hearts’ content? Why do we have to have one that sets up the Treasury and the Federal Reserve as partners in the crime of check-kiting? Maybe the idea of delegating unlimited power to these agencies was not such a good idea after all. Maybe the U.S. Constitution imposed a wise limitation on the power of government in refusing to sanction irredeemable currency. Maybe no one should have the privilege to issue liabilities without assuming countervailing responsibilities. Maybe our corrupt monetary system carries the seeds of self-destruction in allowing structures like the quadrillion-dollar strong derivatives tower to get conceived and grow beyond all limits until it topples on the people of Babel. Why is questioning the efficacy of our monetary system taboo anyway? All these questions are side-stepped by Krugman as he trots out that old Keynesian war-horse, the theory of oversaving.

---


There is just one disturbing element in Krugman’s centrally planned economy. It is the golden thorn in the Keynesian flesh. It is gold, the barbarous relic. Man’s greedy little palm is itching to touch the stuff. Visual contact in museums, churches and art galleries will not suffice.

Keynesians have a job here that has been cut out for them: they have to ‘educate’ people that wanting gold is like wanting the moon. They can’t have that; at any rate, green cheese is just as good, and the government has an efficient green cheese factory, the central bank, that can manufacture it in unlimited quantities. Those who like gold had better learn to like green cheese.

By the way, this is vintage Keynes. It is in the Bible: the moon, the green cheese factory and all, entitled The General Theory, written by the Prophet in 1936. Go look it up, and see it for yourself. It shows Keynes’ cynicism and his infinite contempt for the intelligence of others.

We are anxiously waiting to see how the pupils of the Prophet will deal with this piece of unfinished business: to cure man of auri sacra fames, “the accursed hunger for gold” *(Virgil, Aeneid, III. 57.)*

---


Krugman ends his piece on an alarmist note. The savings glut is still out there, ready to gobble us all up. In fact, it is bigger than ever, now that suddenly impoverished consumers have rediscovered the virtues of thrift; now that the worldwide boom which provided an outlet for all those excess savings has turned into a worldwide bust.

One way to look at the international situation right now, Krugman says, is that we’re suffering from the “global paradox of thrift”. Around the world savings exceed the amount that businesses are willing to invest. And the result is a global slump that leaves everyone worse off. The implication seems to be that we need a savior. We need someone to save us from ourselves and our own destructive saving habits. The government is our savior. It can tax savings up to 100 percent.


---

It is hard to imagine a worse way of standing facts upon their head. The exact opposite is true what Krugman has the cheek to suggest. The falling interest-rate regimen inspired by Keynes has destroyed capital across the board. The only way to replace or to replenish it is through saving. Krugman adds insult to injury when he suggests that there is too much saving in the world, where in fact there is too little, and that this glut is the reason why businessmen have stopped investing. So it falls upon the government to take up the slack and start spending ourselves into prosperity. Krugman’s is a recipe for the ruination of what is left of the world economy. The trouble is that he and his cohorts at the Treasury and the Federal Reserve have all the means of coercion at their disposal to finish off the job. They control the monetary system, they control taxation, they control the White House. They also control the guillotine that is being dusted off just in case it may be needed again as an instrument of monetary policy.

---


There you have it: Krugman’s theory of the savings glut, and my theory of wholesale capital destruction in the world as a result of serial halving of the rate of interest by Keynesian monetary policy. I am ready to submit my thesis to a public debate that it was Keynesian measures that started capital destruction I warned about already eight years ago. If they had any decency, Keynesians should admit that they were wrong and let others come in with the new Obama administration and repair the damage. After all, Keynesians have amassed unprecedented power in Washington with their savings glut fable once before. There is absolutely no reason why they should be given a second chance to try their half-baked theory of oversaving on innocent people. But the idea of giving up power has never crossed their mind. They just won’t, even if blood is flowing on the streets of Detroit and Los Angeles.

That’s the nature of the so-called Keynesian revolution. It is not a branch of economic science; it is a branch of Leninism, a blend of collectivist ideology reinforced with unmatched expertise on conspiracy, street fighting and barricades.

---


In a nutshell, here is my theory of wholesale destruction of capital as a result of Keynesian monetary policy of serial halving of the rate of interest. The regime of falling interest rates is lethal to businesses, whether financial or producing. It makes businessmen lethargic: they understand that the falling interest-rate environment makes their investments go sour. It clandestinely wipes out capital through increasing the liquidation value of debt on past borrowings. Lower rates are not helping business as Keynesian propaganda suggests, because the issue is not the cost of future borrowing. The issue is the historic cost of past borrowings that has rendered existing investments unprofitable.

Chartered accountants and bank examiners ignore the erosion of capital due to falling interest rates, most likely with the connivance of governments if not on direct order from them. So there is no advance warning, and the destruction of capital presents a surprise fait accompli. When it hits, it is already too late to do anything about it.

The wholesale destruction of capital is a social disaster of the first magnitude, in many ways worse than the destruction of physical capital due to war, precisely because wartime damage is expected and preparations are made to cushion it. Capital accumulation is the result of decades or even centuries of arduous saving by hundreds of millions of individuals that, nevertheless, can be frittered away in a matter of a few years. To rebuild the capital base of society will take a concentrated effort to save for decades to come. This great task of reconstruction is certainly not being helped, rather, it is being sabotaged by the vicious Keynesian agitation about a mythical savings glut.

---


Gold offers the only ray of hope in an otherwise thoroughly gloomy picture. Gold represents that hard core of capital that cannot be destroyed by the credit collapse. Gold is the only asset that survives any consolidation of balance sheets. Other bank assets tend to be canceled out upon the nationalization of banks. At any rate, they are subject to counter-party performance that becomes questionable in a credit collapse. Gold has no counter-party liability.

If our civilization is to survive, it will have to make a head start in rebuilding capital, the sooner the better. It cannot start capital accumulation from scratch. It must enlist gold in the reconstruction effort. One ounce of gold will go farther than all the make-belief credits created out of the thin air by all the defunct central banks of the world.

This is the triumph of gold: it can be bad-mouthed all the Keynesians want. But gold and those who control it will have the last laugh.

### Calendar of events

### Szombathely, Martineum Academy, Hungary, March 27-29, 2009

Encore Session of Gold Standard University Live.

### Topics: When Will the Gold Standard Be Released from Quarantine?

### The Continuing Vaporization of the Derivatives Tower

### Labor and Great Depression II

### Silver in Backwardation: What Does It All Mean?

### Further details: GSUL@t-online.hu

This conference is the swan song of GSUL that has been succeeded by the Gold Standard Institute, contact: philipbarton@goldstandardinstitute.com

### Instituto Juan de Mariana, Madrid, Spain, June 18- 21 , 2009

### Gold and Silver, Madrid 2009

### For information, contact gcalzada@juandemariana.org

### San Francisco School of Economics, July 15-September 30, 2009

Money and Banking, a ten-week course based on the work of Professor Fekete who will be on campus to deliver most of the 20 lectures. Enrolment is limited; first come, first served. The Syllabus for this course can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com) University House, Australian National University, Canberra, first week of November 2009

Peace and Progress through Prosperity: Gold Standard in the 21st Century

This is the first conference organized by the newly formed Gold Standard Institute.

### E-mail feketeaustralia@gmail.com

Professorfekete on DVD: Professionally produced DVD recording of the address before the Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the Great Depression: Can It Happen Again? plus an interview with Professor Fekete, is available from [www.Amazon.com](https://www.Amazon.com) and from the Club [www.economicclubsf.com](https://www.economicclubsf.com) at \$14.95 each.

---

*March 9, 2009*

---

# Iron Law of the Burden of Debt

URL: https://newaustrianeconomics.com/archive/fekete/iron-law-of-the-burden-of-debt/
Date: 2009-03-04
Section: Popular Economics
Difficulty: intermediate
Concept Tags: debt, interest-theory, capital-destruction, fiat-currency, monetary-crisis
Description: Fekete articulates an iron law: under irredeemable currency, the burden of debt grows faster than the economy can service it, because falling interest rates induced by central bank policy continuously expand the present value of existing debt obligations. There is no exit from this trap except through gold-standard restoration or debt default.
Editorial Note: Written March 2009. The iron law concept is one of Fekete's most powerful analytical formulations, explaining why debt deleveraging cannot succeed under irredeemable currency — each attempt to reduce debt is frustrated by the rising present value of remaining obligations.
Original PDF: https://professorfekete.com/articles/AEFIronLawOfTheBurdenOfDebt.pdf

1. You say that the liquidation value of debt depends on the rate of interest. In my opinion this is wrong. If I owe \$1000 to a bank, \$1000 in Federal Reserve notes plus interest specified on the note will always liquidate my debt, regardless how the rate of interest may have moved away from the rate specified on the note. I believe there is even a law in New Jersey prohibiting banks from demanding more money in settlement of a loan than the face value of the note plus pro-rated interest, in case the loan is retired before maturity.

2. I believe you confuse the “liquidation” value with the “present” value of the loan, that is, the amount for which the bank could sell the securitized debt to a third party.

3. You seem to worry about the problem of doubling the present value of debt when the rate of interest is halved. This raises the question ‘cui bono?’ Take the U.S. and China.

Why should the U.S. care if the present value of its debt to China doubles? The interest payment has not changed, nor has the amount due at maturity. And why should China worry? On the contrary, China should be happy. In case they wanted to sell their U.S. Treasuries, they could get twice the face value, according to your calculations.

Please regard these questions more as a feedback than a criticism. I wish you were right as, instinctively, I do like the thought that gold is the only ultimate extinguisher of debt, regardless of the outcome of this debate about the present value of total debt.

Perhaps you could give me some hints where I could find further reading material to help me understand your point.

Regards,

### Mario Rossi founder of “Umbria for Ron Paul”

Here is my answer:

Dear Mr. Rossi,

Thank you for writing. I greatly appreciate your interest in my work.

1. If as a corporate treasurer you have sold a \$1000, 30-year bond and the interest is halved next day, you could liquidate that debt only if you are willing to shell out a sum closer to \$2000, even in New Jersey. Nobody will sell your bond back to you for \$1000, because it yields twice as much as do the new issues of the same face value and same maturity.

I am not familiar with the laws of New Jersey governing personal bank loans, but if there is such a law, it is price fixing that will not work in the long run.

2. I am not confusing “liquidation value” with “present value” of debt. The two are one and the same, and depend on the rate of interest. What is involved here is the discounted value of the stream of payments capitalized at the current rate of interest. If the latter changes, so will liquidation value, and the relationship is inverse.

3. The U.S., China, and everybody else, ought to worry deeply about the runaway present value of total debt in consequence of serial halving of the rate of interest. Among other things, it means the sudden disappearance of liquidity. Both the U.S. and China would suffer, for different reasons, if the marketable U.S. debt became unmarketable.

As a practical matter, the Chinese hoard of \$1 trillion in U.S. paper is already dead as a doornail. It is impossible to liquidate any significant part of this investment without taking huge losses.

As far as the U.S. is concerned, the end of ready marketability for its debt would make the sale of its future issues on the present scale very problematic, if not impossible.

The only option left would be the direct monetization of Treasury debt by the Fed, but that would trigger hyperinflation in very short order.

I have been writing on the problem of the ballooning of liquidation value of debt in a falling interest-rate environment for the past eight years or so. My papers are archived on my website [www.professorfekete.com](https://www.professorfekete.com) .

Here is another letter from a correspondent in the U.S.:

Professor:

I have read your recent article discussing the liquidation value of debt with great interest (no pun intended). However, I was unable to follow your logic completely, although doubtless you will have a solution to my quandary.

It seems to me that your theory depends on the nature of the debt. Unless made up of perpetuals in the sense of British consols that never mature, which is clearly not the case here, the problem is hardly more than a minor irritant.

I fail to see how the U.S. public debt could be considered as equivalent to perpetuals.

While it may be perpetual in the sense that it will never be paid off, it is nevertheless composed of notes, bills, and bonds, each with a specific maturity date. Therefore, since as you maintain that the debt will never be paid off, with which I agree, it will have to be rolled over and replaced by new issues with more distant maturity dates.

The extent of the increase in liquidation value of total debt will not be inversely proportional to the decrease in the rate of interest as you suggest. We can only say that the difference between the aggregate debt and the present value of streams of discounted interest payments is inversely proportional to the difference between the old and new rates, surely a much smaller quantity.

Thank you in advance for your response.

Yours, etc.,

### Abe Cinderby

Here is my answer:

Dear Abe,

Nobody sees the future and we don’t know at what rate the maturing debt will be rolled over if, indeed, market conditions will even allow it to be rolled over. As standard accounting practice, under these circumstances the most pessimistic assumption short of outright default must be made, which is that the aggregate debt never matures and so its liquidation value is calculated as that of the defunct British consols.

Having said that, I grant you that to a large extent the liquidation value of total debt is in the eye of the beholder. Governments naturally put a most optimistic low value on it. If chartered accountants want to stay faithful to the well-tested ethical standards of their profession, then they will apply the most pessimistic assumption. Of course, in the present situation they don’t do that. Whether this is a well-reasoned decision on their part, or a result of arm-twisting, we are left to guess. There are alarming signs suggesting that the public perception is leaning towards the faithful accountant’s formula in assessing the liquidation value of total debt. Government projections on the future of debt is for the birds.

You must ask yourself the question why British consols were discontinued. If they were a reasonable way to finance government under the gold standard then, from the government’s point of view, they would be a trillion times more reasonable under the regime of irredeemable currency. Bonds that never mature? You just print up bank notes to pay the paltry interest a couple of times a year, surely a routine exercise with our present printing technology? Never worry about another refinancing? No greater bliss would be imaginable for a bailout-oriented government financing scheme.

British consols had to be discontinued soon after the pound sterling became irredeemable because of the public perception that, ultimately, the government will be unable to shoulder the implied runaway liquidation value of debt. The public forced the hand of the government to kill the consols. The bid/asked spread became so wide that it was no longer meaningful to talk about the market value of consols (in today’s lingo, consols became a toxic asset).

Exactly the same thing is happening to the 30-year, 10-year, 2-year, 1-year government debt as well, as the world is being treated to a spectacle of shrinking maturities.

The perpetual U.S. debt is not a well-thought-out construction. It is a makeshift to last only as long as the present incumbents at the Treasury do. The runaway liquidation value scares more and more investors. They know that they can never collect on their Ponzi-ticket. The marketability of government obligations is evaporating.

To be sure, that point has already been reached by the Chinese-owned portion. From the point of view of China the U.S. debt is a toxic asset. U.S. debt in Chinese hands has no definable value: any time the Chinese want to sell a sizeable amount, all bids are withdrawn.

The Chinese are stuck with it. They have to wait for their money until maturity. But who knows what the purchasing power of the dollar will then be? The best the Chinese can do is to “grin and bear it.” They can’t even say “ouch”, because this would further hasten the deterioration of marketability of their paper.

The periodic warnings from China that the U.S. government should display greater fiscal responsibility and it should follow a stricter monetary regimen sound like whistling in the dark.

Every refinancing of the fast maturing U.S. debt is a major disaster, considering the dwindling number of real investors. Entire new issues are taken up by bond speculators who are in it for the fast buck. They expect to reap risk-free profits when they turn around and dump the paper in the lap of the Fed. The Fed does not mind: it is happy to pay the blackmail, to maintain the façade of business as usual.

The perpetual debt is like nuclear fuel. There is a threshold beyond which chainreaction sets in and the debt-tower of Babel self-destructs. Under the regime of the irredeemable dollar the value of government bonds can vaporize just as easily and unexpectedly as stock values, and there is nothing the government can do about it (short of making the dollar redeemable). When the last holder of the bag gets scared the last bubble, the U.S. government bond bubble, will have burst.

The supply of fools in the world is very large indeed, but it is not infinite as the Big Fix cowboys in Washington assume. It takes more than starting an avalanche of bailout bonds to defeat the Iron Law of the Burden of Debt.

### Best, professorfekete

### Calendar of events

### Szombathely, Martineum Academy, Hungary, March 27-29, 2009

Encore Session of Gold Standard University Live.

### Topics: When Will the Gold Standard Be Released from Quarantine?

### The Continuing Vaporization of the Derivatives Tower

### Labor and Great Depression II

### Silver in Backwardation: What Does It All Mean?

### Further details: GSUL@t-online.hu

This conference is the swan song of GSUL which has been succeeded by the Gold Standard Institute, contact: philipbarton@goldstandardinstitute.com

### Instituto Juan de Mariana, Madrid, Spain, June 18, 2009

### Gold and Silver, Madrid 2009 gcalzada@juandemariana.org

### San Francisco School of Economics, July 15-August 31, 2009

Money and Banking, a ten-week course based on the work of Professor Fekete who will be delivering 18 of the 20 lectures. Enrolment is limited; first come, first served..

The Syllabus for this course can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com) University House, Australian National University, Canberra, first week of November 2009

Peace and Progress through Prosperity: Gold Standard in the 21st Century

This is the first conference organized by the newly formed Gold Standard Institute.

### E-mail feketeaustralia@gmail.com

Professorfekete on DVD: Professionally produced DVD recording of the address before the Economic Club of San Francisco on November 4, 2008, entitled The Revisionist History of the Great Depression: Can It Happen Again? plus an interview with Professor Fekete, is available from [www.Amazon.com](https://www.Amazon.com) and from the Club [www.economicclubsf](https://www.economicclubsf) at \$14.95 each.

---

*March 5, 2009*

---

# Growth and Debt: Is There a Trade-Off?

URL: https://newaustrianeconomics.com/archive/fekete/growth-and-debt-is-there-a-trade-off/
Date: 2009-02-12
Section: Popular Economics
Difficulty: intermediate
Concept Tags: debt, capital-destruction, monetary-policy, federal-reserve, interest-theory
Description: Fekete examines the Obama administration's assumption that debt-financed stimulus can produce economic growth, arguing there is no trade-off: beyond a certain threshold, additional debt destroys rather than creates growth by reducing the marginal productivity of debt below the rate of interest. The administration is looking at the wrong ratio.
Editorial Note: Written February 2009 as the Obama stimulus package was being debated. Fekete's concept of the marginal productivity of debt anticipates Lacy Hunt's later empirical work on diminishing returns to debt-financed stimulus.
Original PDF: https://professorfekete.com/articles/AEFGrowthAndDebt.pdf

II. When the war ended, government debt stood at 120 percent of the gross national product, twice what it is now. The rapid economic growth during the 1950’s and 1960’s quickly reduced the debt. This is offered as a justification for the \$800 billion stimulus package that is being railroaded through Congress, with more to follow later.

David Leonhardt writes in the February 1 issue of The New York Times Magazine that governments tend to err in making stimulus packages ‘too stingy’. This explains the chorus of cheerleaders shouting “Not enough! Still more!” Leonhardt says that governments fail to use the ‘enormous resources’ at their disposal to shock the economy back to life. Japan announced stimulus measures even as it was cutting other government spending. F.D. Roosevelt flirted with fiscal discipline midway through the New Deal, and the country slipped back into decline. The prescription of John Maynard Keynes works only if administered boldly, without fear or hesitation. We have the word of Treasury Secretary Geithner, as quoted by Leonhardt, that his Big Fix won’t make the same mistake that Roosevelt’s has. “We are not going to do that”, he said, “and we’ll keep at it until it’s done, whatever it takes.”

### Perpetual debt

In this article I shall argue that there is no trade-off between growth and debt under the regime of the irredeemable dollar lacking, as it does, an ultimate extinguisher of debt. Once new debt is piled on the top of the old, total debt is increased that will never be reduced, and will become perpetual debt. As protagonists of the stimulus package well know, retirement of the debt of the federal government is tantamount to deliberate deflation, that is, contraction in the money supply, by reducing the pool of bonds available for monetization.

After World War II it was possible to reduce the government debt and expand the money supply at the same time because of the presence of gold in the monetary system, which was the ultimate extinguisher of debt, until exiled by the Keynesians and Friedmanites. To recover the ability to reduce government debt and increase the money supply simultaneously, gold would have to be made part of the monetary system once more, an anathema to the Big Fix cowboys.

### Liquidation value

Perpetual debt is more than toxic. It behaves like nuclear fuel: once the threshold is reached and exceeded, chain reaction sets in and the monetary system explodes. To understand the dynamics, we need to refer to the liquidation value of perpetual debt. This is a concept that, for obvious reasons, is not recognized by mainstream economists. If it were, they would be far more careful with their recommendation of unlimited government spending as panacea for all economic ills. Recognized or not, the liquidation value of debt acts as a trigger to a cataclysmic destruction of the economy looming large on the horizon, of which we have had a foretaste in the recent past. The tragedy is that the Big Fix cowboys want to use the same remedy that has landed the country in the present predicament in the first place. Home owners with a mortgage, car owners with a loan, credit card holders, students, state and municipal governments, and yes, the federal government, are drowning in debt already.

### Burden of debt

The liquidation value of debt is the amount that would liquidate it here and now. It obviously depends on the rate of interest. The liquidation value of total debt is inversely proportional to the prevailing rate of interest. In particular, halving the rate of interest by the central bank is equivalent to doubling the liquidation value of total debt.

I have been writing about this Iron Law of the Burden of the Debt for many a year and have met with an almost total lack of understanding, judging by the feedback from readers.

The lack is due to the reluctance of the mind to admit that cutting interest rates increases the burden of debt contracted in the past, because it contradicts one’s intuitive expectation that it should decrease the burden of debt to be contracted in the future. To be sure, cutting interest rates does increase the burden of debt contracted in the past because liquidation value is calculated by capitalizing the stream of future interest payments. Since at the lower rate the present value of that stream is smaller, a shortfall is created that has to be amortized upon liquidation.

### Perpetual debentures

In order to understand the Iron Law let us consider the market value of perpetual debentures (or perpetuals for short; consols in British parlance). They are marketable securities that never mature: they convert a lump sum into a stream of annual payments in perpetuity. For example, a \$1000, 4% perpetual pays \$40 per annum to its holder, who can sell it in the secondary market at any time. The catch is that he may recover only part of his original investment if the interest rate has fallen in the meantime.

### Present value

In calculating the present value B of a perpetual with face value A, paying interest at a percent per annum, we have to discount the annual interest payments at the prevailing rate of interest b. Since the annual interest payment is Aa, the discounted value of the nth interest payment is Aarn, where r = 1 – b is the discount factor. We have 0 < r < 1, hence rn approaches zero as n gets arbitrarily large. The discounted value of the string of interest payments is:

### Aa

### Aa

### Aa

### B = Aa (1 + r + r 2 + r 3 + ... + r n + ...) =

### =

### = b

1 − r 1 − (1 − b)

We conclude that Aa = Bb. For example, the 4% perpetual with face value \$1000, yielding \$40 per annum, can be traded in the secondary market for \$1000 as long as the market rate of interest b is 4%. However, if it is halved to 2%, the same perpetual can be sold for \$2000, because at the lower rate it would take two debentures to generate the same income stream.

According to this pleasantly simple formula Aa = Bb, if the rate of interest b is halved to ½b, then the liquidation value of the perpetual is doubled. In case of a serial halving of the rate of interest from 4 to 2, from 2 to 1, from 1 to ½, from ½ to ¼ percent, etc., the liquidation value will be multiplied 2-fold, 4-fold, 8-fold, 16-fold, 32-fold, etc.

### Story of the British consols

This is no idle theorizing. Britain actually issued consols in the 19th century up to 1914. They were marketable instruments that traded at values determined by this very same formula.

Clearly, issuing consols would be sheer madness under the regime of irredeemable currency.

But in the halcyon days of the gold standard interest rates were stable. Cutting interest rates into half, or doubling them, were as unheard of as they were unthinkable. In the 20th century Britain stopped all payments in gold, and consols were discarded along with the gold standard. Nevertheless the formula survives and can be used to calculate the liquidation value of total debt since, under the regime of irredeemable dollar, total debt is perpetual debt.

### Serial halving of the rate of interest

In this new interpretation of our formula Aa = Bb, A is the total debt contracted at an average rate of interest a, b is the current market rate, and B is the liquidation value of total debt. We see that B is inversely proportional with b. In particular, every time the rate of interest is halved, the liquidation value of the total debt is doubled. If the interest rate is halved serially by the Fed (which has happened in the past, and may happen again, as interest rates can be halved any number of times without hitting zero or going negative) then, for example, upon a ten-fold serial halving, the liquidation value of the total debt is increased more than a thousand-fold (210 = 1024). This means that trillion is promoted to quadrillion, quadrillion is promoted to quintillion, and so on, in direct consequence of the serial 10-fold halving.

Those who argue that these frightening numbers are merely ‘notional’ and, as such, they have no relevance to the real economy, do not know what they are talking about. The size of the derivatives market is fast approaching the quadrillion dollar mark (if it hasn’t already surpassed it by the time this article is published). It has been talked down by mainstream economists and the financial media saying that “there is nothing to worry about, it is notional value anyhow”. Yet that notional value was able to break the back of the mighty American banking system (along with that of the British). This is so because the total notional value of derivatives represents the liquidation value of insured bonded debt.

We can expect much greater increases in the debt of the federal government, in the trillions of dollars, but the really frightening numbers are not so much the actual increases in the outstanding debt but, rather, the increases in the liquidation value of the total debt caused by the serial halving that the monetization of the increased federal debt will necessitate.

### Capacity to expand Treasury debt

Peter Orszag, the new budget director in the Obama administration has declared, as quoted by Leonhardt, that “one of the blessings of the current environment is that we have a significant capacity to expand and sell Treasury debt. If we didn’t have that, if the financial markets didn’t have confidence that we would repay that debt, we would be in even more dire straights than we are.”

The budget director is dreaming. The financial markets don’t have a shred of confidence that the U.S. government will ever repay its debt, certainly not in dollars of the same purchasing power. The Treasury paper is not being purchased by investors; it is bought by bond speculators pursuing risk-free profits. The Big Fix cowboys create unlimited demand for the bonds by holding out the carrot of risk free profits. Speculators plan to dump the paper in the lap of the Fed at the first given opportunity. They know full well that the Fed has to monetize the Treasury debt to provide the wherewithal to pay for the bailouts and stimulus packages. Without the promise of serial cuts in interest rates the U.S. Treasury paper is unsaleable.

Real investors, foreign governments and central banks, are already sitting on mountains of paper losses due to the loss of purchasing power of the dollar in their own currency. For them, U.S. Treasury debt is a toxic asset which has no real market value because there is no real market for it. Any sizeable offer to sell will result in a swift withdrawal of all bids. U.S. government debt has grown out of proportion to economic activity. It will never be repaid, except in the dreams of the budget director.

### The Obama White House has been hijacked

The outlook is very bleak. The Obama White House has been hijacked by a reactionary clique of Keynesians and Friedmanites before the new president even had a chance to take stock.

They are doctrinaires who would never admit that they have made a fatal mistake when they promised permanent prosperity, a world free of bank runs, panics, domino-style bankruptcies, mass unemployment and depressions, provided that they were allowed to quarantine gold and manage synthetic credit as they see fit. They now open all spigots and let all the genies out of their bottles, in particular, the genie from the monetary bottle and the genie from the fiscal bottle, to roam freely over the land and visit great disaster and suffering upon millions of innocent people.

It is the same clique that has landed the country and the world in this economic disaster that now arrogates to itself the right ‘to fix things’ according to its own failed blueprint. The Big Fix cowboys’ ideas of debt and its relation to production is a recipe for total economic ruination.

### Latter-day Moloch

The result of the bailouts and stimulus packages will be a vast expansion of government debt, and a serial halving of the rate of interest to accommodate it, followed by the escalation of the liquidation value of total debt to the quadrillion and quintillion dollar range and beyond.

Deflation will sweep through the land making prices and wages fall. The depression will surpass in severity any previously experienced. Industrial capital will continue to be destroyed along with finance capital. Pension funds will go up in smoke, unemployment will grow.

Meanwhile the threat of hyper-inflation will not be removed and will continue to threaten all countries, a ‘first’ in world history. When the liquidation value of government debt reaches a certain height where Federal Reserve notes in existence will no longer be sufficient to supply the bond market with gambling chips the Fed will, Zimbabwe-style, start adding serials of zeros to the face value of its notes. You don’t have to be a rocket scientist to be able to calculate the purchasing power of Federal Reserve notes denominated in the millions. You just make a field-trip to Harare.

There is no trade-off between growth and debt. Under the regime of irredeemable currency, debt is no longer a servant. It is a Moloch, devouring its children.

### Reference

By the same author:

How to stop the depression, [www.professorfekete.com](https://www.professorfekete.com) , February 2, 2009.

### Calendar of events

### Szombathely, Martineum Academy, Hungary, March 27-29, 2009

Encore Session of Gold Standard University Live.

### Topics: When Will the Gold Standard Be Released from Quarantine?

### The Vaporization of the Derivatives Tower

### Labor and the Unfolding Great Depression

### Gold and Silver in Backwardation: What Does It All Mean?

### Further details at: GSUL@t-online.hu

### Instituto Juan de Mariana, Madrid, Spain, June 18, 2009

### Gold and Silver, Madrid 2009 gcalzada@juandemariana.org

### San Francisco School of Economics, July-August, 2009

Money and Banking, a ten-week course based on the work of Professor Fekete.

The Syllabus for this course is can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com) University House, Australian National University, Canberra, first week of November 2009 Peace and Progress through Prosperity: Gold Standard in the 21st Century

This is the first conference organized by the newly formed Gold Standard Institute.

### E-mail feketeaustralia@gmail.com

---

*February 13, 2000*

---

# How to Stop the Depression

URL: https://newaustrianeconomics.com/archive/fekete/how-to-stop-the-depression/
Date: 2009-02-02
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, real-bills, self-liquidating-credit, federal-reserve, new-austrian-economics
Description: Fekete outlines a two-part program to stop the deepening depression: reopen the Mint to gold and restore the Real Bills market for self-liquidating credit. Unlike Keynesian stimulus, which accelerates capital destruction, these measures address the monetary root cause by restoring the mechanisms that naturally generate full employment without inflationary expansion.
Editorial Note: Written February 2009. Fekete's most direct policy response to the developing depression, bringing together his two foundational prescriptions in a single program.
Original PDF: https://professorfekete.com/articles/AEFHowToStopTheDepression.pdf

Q.:

What are the main roots of the present economic and financial crisis?

A.:

There is only one main root, the same as that for the Great Depression in the 1930’s: destruction of capital. Erosion or consumption of capital has been going on unnoticed for decades. The process ends when there is no more capital left to consume. After the seven fat years, a period of seven lean years must commence.

Capital erosion is not natural nor is it inevitable. Rather, it has been inflicted upon the world economy by the unmindful and irresponsible monetary policy of the United States in deliberately driving the rate of interest to zero.

Falling interest rates, which are lethal, must be carefully distinguished from low but stable interest rates, which are salutary. A falling interest rate structure, foisted upon the world by the Americans obsessed with the idea of preserving the hegemony of the dollar, works insidiously and unobserved. As the rate of interest falls, the liquidation value of debt rises. Far from decreasing it, falling interest rates increase the burden of debt. Economists, chartered accountants, and bank examiners do not recognize the concept of liquidation value of debt, let alone its inverse relationship to the rate of interest, although it is exactly the same inverse relationship that is well-recognized to exist between the market value of a bond and the rate of interest. As the interest rate falls, creditors refuse to accept the face value of the bond in settlement of debt. At the lower rate the income stream of coupons falls short of amortizing the face value of the bond. To compensate for the shortfall the market value of the bond must be increased. Accordingly, creditors bid up the market price of the bond. If debtors want to get out of debt before it matures, then they will have to pay the market price exceeding the face value of the bond. This conclusively proves that the fall in the rate of interest increases the liquidation value of debt.

As soon as the liquidation value of liabilities less assets surpasses capital, the firm becomes insolvent. Its capital is gone. It can no longer attract credit.

This is what has happened to the banks in the U.S. and the U.K. This is what has also happened to the American auto industry, and all the other American industries now extinct.

Those who dismiss my analysis of the present crisis in terms of capital destruction as an improbable single-cause explanation of a complex phenomenon must answer the following question. What are the statistical odds that the banks, financial institutions, as well as the three big automakers go bankrupt all at the same time? Well, the odds are virtually zero, unless they fail due to a single cause.

Q.:

Has Japan served as a ‘testing ground’ to combat stagnation-deflation or as a ‘lab’ experimenting with the cure for stop-and-go economic growth for the last two decades?

A.:

Your suggestion that Japan has been used as a ‘lab-experiment’ how to combat deflation through suppressing interest rates all the way to zero is interesting. But as the results of this experiment convincingly show, lowering interest rates is no cure for deflation, but poison for the economy. Lower interest rates reinforce deflation, making it worse. Japan should have ignored advice from the American money-doctors and follow independent monetary and fiscal policies. Instead, Japan embraced the prevailing blend of Keynesian and Friedmanite bunk and plunged headlong into a sea of deficits and debt. As a result, the plight of the country is prolonged. It is highly doubtful that the American money-doctors will learn from the failure of their Japanese experiment. But then, as Poor Richard’s Almanach says, experience runs an expensive school, but fools will learn in no other.

Q.:

Are credit bubbles and busts typical of the capitalistic system of production?

Has the manipulation of the money supply and the rate of interest by central banks been around since early times, or it is a more recent innovation of policymakers?

A.:

Credit bubbles and busts have nothing to do with the capitalistic system of production; they have everything to do with the suppression of the rate of interest by the government through its agent, the central bank. In the beginning the central bank was a relatively tame institution. It even denied that it is equipped or called upon to manipulate the money supply or tamper with the rate of interest except, perhaps, the overnight rate. Later unscrupulous politicians emboldened the central bank to grab unlimited power under the regime of irredeemable currency. To be sure, the power to print currency is unlimited power.

The real turn of events came with the clandestine and illegal introduction of ‘open market operations’ by the Federal Reserve banks (Fed) in the early 1920’s. The 1913 Charter of the Fed disallowed the monetization of the government debt and penalized violations by levying heavy and progressive fines. But as time went on, the Treasury ‘forgot’ to collect the fine and, in the end, the fait accompli forced Congress to legalize the Fed’s practice of purchasing Treasury bonds in the open market and using them as collateral for its note and deposit liabilities ex post facto.

With this Act the principle of limited government was thrown out of the window. Equally serious was an unintended consequence that remained hidden for half a century but burst upon the scene with full force after 1971 when the gold standard was finally overthrown. Bond speculation that resulted from this measure was confined to a playing field that was far from level. It gave a bias to bull as opposed to bear speculation. Bull speculators, armed with the knowledge that the Fed was in need of buying more bonds preempt the purchase in buying the bonds first, dumping them into the lap of the Fed later, thus pocketing riskfree profits. Now the sky was the limit to which speculators could bid up bond prices. The gates to the black hole of zero interest were thrown wide open, as shown by events of the past thirty years. As I have already explained, the main root of depressions is not vanishing demand as suggested by Keynes, but vanishing capital caused by the deliberate suppression of interest rates.

Q.:

Are ‘quantitative easing’ and the regime of near-zero interest rates a good medicine? Or will they fail to solve the credit crisis as it turns out that their impact on the real economy is nil?

A.: ‘Quantitative easing’ is an empty slogan designed to cover up the black hole of zero interest gobbling up the world economy. Consider that the total outstanding debt is in fact perpetual debt, because under the regime of irredeemable currency total debt can only grow but never contract. Even if all debtors could repay their loans, debt would still not be extinguished. It would be merely transferred to the banks and, ultimately, to the government.

Consider also the fact that the liquidation value of perpetual debt doubles every time the rate of interest is halved. So when under the slogan ‘quantitative easing’ the rate of interest is serially cut in half from 4% to 2, then from 2% to 1, then from 1% to ½, then from ½ % to ¼ , and so on, the liquidation value of debt will double from \$1 trillion to 2, then from \$2 trillion to 4, then from \$4 trillion to 8, then from \$8 trillion to 16, and so on. Soon you will be talking real money in the quadrillions of dollars. Mind you, this is just increase due to falling interest rates; additional debt assumed through bailouts would be extra.

The world has already passed the point where one more straw breaks the back of the camel, as witnessed by the collapse of the banking system. The next step is breaking the back of the dollar. ‘Quantitative easing’ is guaranteed to accomplish that, although it is impossible to say when.

The whole idea that the government can keep halving interest rates serially with impunity is insane. Bernanke and Geithner don’t know what they are doing and saying. ‘Quantitative easing’ has another arm, ‘quantitative backlash’, operating with a high leverage. Not only will ‘quantitative easing’ have zero impact on the real economy; it will bankrupt the U.S. government due to the serial doubling of the liquidation value of government debt.

You need gold in the world’s monetary and payments system because gold is the only ultimate extinguisher of debt, without which total debt becomes perpetual debt and the fast breeder of debt starts spinning out of control. As a consequence, the world will be sucked into one or the other of the two black holes: that of zero interest (deflation) or that of infinite interest (hyperinflation).

Q.:

Are we witnessing a repetition of the Weimar policy madness? Can we have deflation first, followed by the surprise of a hyperinflationary period?

A.:

Weimar Germany was hit by hyperinflation in 1923; then it was hit again by deflation seven years later, in 1930, when 8 million workers, or about one half of organized labor, were laid off. You may say that it is typical for deflation to follow hyperinflation. The world is ill-prepared for what may be unfolding before our eyes, namely, as you suggest, in a reversal of the typical order, deflation is followed by hyperinflation. Most observers’ forecast is that the dollar will soon succumb to hyperinflation ignited by the bailouts. Put me down in the deflation column. My forecast is: deflation now, hyperinflation later.

The important thing is not the trillions spent on bailouts, but the quadrillions in increase in the liquidation value of outstanding debt, thanks to the serial halving of interest rates. There are actually two camels: the banking system and the dollar. The last straw has already broken the back of the first camel. Straw is still being loaded on the second.

Q.:

In Europe, and also in the U.S., analysts are pruning the idea of the nationalization of the banking system as a measure to prevent its complete meltdown. Even the Russian President is making jokes at the expense of the West about ‘financial socialism’. What do you think about nationalization, the creation of ‘good banks’ and ‘bad banks’, and the ‘reverse securitization’ of toxic assets?

A.:

Nationalization is no solution to the banking crisis. It would do no more good than shuffling deck chairs on the sinking Titanic. The meltdown of the banks was not caused by the banks per se. It was caused by government sabotage of the gold standard. The idea of separating the assets of failing banks and dumping the toxic part on a ‘bad bank’ is utterly imbecile. Toxic assets should be written off outright and their securitization should be cancelled, not reversed. Securitization of mortgages and other bank loans was fraudulent in the first place as it was based on the false premise that the strength of a chain is determined by its strongest link.

As every child knows, it is determined by its weakest link.

There can be no ‘good bank’ under the regime of irredeemable currency. If you want to have good banks around, then you will have to reintroduce cancerfighting gold corpuscles into the monetary bloodstream. A diseased monetary bloodstream, which irredeemable currency is, will contaminate even the best of ‘good banks’.

Q.:

### What is your recommendation for an emergency package?

A.:

The emergency package pushed by the Obama administration is going to fail. It consists of the same nostrums that have landed the world in the present depression in the first place: the relentless pumping of money into the economy in order to drive down the rate of interest.

To be sure, the banks and industrial enterprise must be recapitalized. But to accomplish this something more substantial is needed than the irredeemable promises of a government that is the largest debtor in the world, let alone the fact that it is bankrupt itself, whose future tax receipts on the present scale become ever more illusory. The banks and industry must be recapitalized through the remobilization of the world’s monetary gold that has been lying idle for the past 35 years.

This feat can be accomplished through a plan that may be put into effect unilaterally even by a smaller country such as Portugal, which I shall use here as an example. Suppose the Mint of Portugal is opened to the unlimited coinage of gold. The standard gold coin weighing one ounce, 9999 fine (bearing no denomination) would be paid out by the Mint to the bearer of the same quantity and quality of gold (a modest seigniorage charge may be made to cover the cost of minting).

The Bank of Portugal must by law tariff the standard gold coin at a value no lower than that of its gold content as determined in the open market. In other words, the monetary value of the standard gold coin must be adjusted upwards every time the gold price makes a new high. As an aside I note that at present the Federal Reserve still tariffs gold at \$42.22, while in the market gold fetches more than twenty times that amount. This idiotic policy is one of the chief causes of deflation in the world today.

In case the gold price falls, the Bank of Portugal may leave the monetary value of the standard gold coin unchanged, or it may adjust it downwards with a lag. In either case there would be a gold flow to the Mint, and ever more standard gold coins would get into circulation as businessmen take advantage of profit opportunities presented by the favorable valuation of gold in Portugal.

The effect of my plan is that capital will start flowing to Portugal in the form of monetary gold from the rest of the world, but without suppressing the rate of interest. Portugal will be a most attractive place where to invest. It will escape deflation and the disastrous unemployment hitting other countries – except, of course, countries that follow Portugal’s monetary leadership and open their Mint to gold.

If an oil-producing country adopted my plan, then competition will force all the others to follow suit. Trade in crude oil would be billed and financed through gold devices. That would stabilize the price of oil, as well as the price of other world-class goods. At present these prices are unstable precisely because the value of the irredeemable dollar financing world trade is increasingly uncertain.

The new payments system emerging in this way would fall short of a fully-fledged international gold standard, as central banks would retain their power to tariff the standard gold coin according to their own national priorities.

If a country wanted to increase domestic employment, it would raise; if it wanted to curtail capital inflows, it would lower the tariff. In either case gold would serve as an outside currency against which the domestic currency could be devalued or revalued without triggering competitive currency devaluations.

Later, when the dust settled, leading countries could come together and agree on a new international gold standard in abrogating the power of their central banks to change their tariffs on the standard gold coin. This would mean a return to the system of fixed exchange rates which the world so foolishly abandoned in 1931 and, again, in 1971.

One objection to my plan, that the scheme is inflationary because of the remonetization of gold involved, can be safely dismissed as disingenuous.

Policy-makers at the Federal Reserve have been desperately trying to induce inflation, only to make deflation getting ever more entrenched.

Another possible objection is that in paying for imported gold the real wealth of the country would pass into the hands of foreigners. While there is a grain of truth in this to the extent that exports reduce the wealth of a country, Portugal could show something for it in the form of increased gold reserves and a decline in unemployment. What can China show for its immense transfer of wealth to countries absorbing its exports? A pile of I.O.U.’s, that’s what, that may ultimately be worth no more than the paper it is printed on. Under my plan it could show an increase in its gold reserves that China needs and badly wants.

Incidentally China, by the logic of its position as one of the world’s great exporting countries, is a likely candidate to adopt my plan. Otherwise it would face a horrendous unemployment and social unrest which the Chinese Wall may no longer be able to contain.

Continuing ostracism of monetary gold may mean plunging the world into a new Dark Age, the crumbling of civilization, vanishing law and order, mass starvation, the impoverishment of rich and poor alike. It may trigger an uncontrollable mass migration from East to West and from South to North of unruly millions in search of a place underneath the Sun.

The Obama White House has been hijacked by a reactionary clique of Keynesians and Friedmanites before the new president even had a chance to take stock. They are doctrinaires who would never admit that they have made a fatal mistake when they promised permanent prosperity, a world free of bank runs, panics, domino-style bankruptcies, mass unemployment and depressions, provided that they were allowed to quarantine gold and to manage the rationing of synthetic credit as they see fit. Now they want to be in charge of salvaging the train-wreck, the result of their sabotaging the natural monetary order based on a positive value, gold, rather than a negative value, debt.

Unless the world can extricate itself from the murderous grip of these unscrupulous saboteurs by putting gold back into monetary circulation, we are all doomed.

---

*February 2, 2009.*

---

# Open the Mint to Gold!

URL: https://newaustrianeconomics.com/archive/fekete/open-the-mint-to-gold/
Date: 2009-01-11
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, sound-money, federal-reserve, monetary-policy, real-bills
Description: Fekete argues that the immediate and practical path out of the 2009 depression is to open the U.S. Mint to the free and unlimited coinage of gold, reversing FDR's 1933 confiscation. This single constitutional act would restore monetary discipline, create a natural floor for interest rates, and eliminate the incentive for unlimited debt creation.
Editorial Note: Written January 2009 as the financial crisis deepened. One of Fekete's most focused policy prescriptions, arguing that a single constitutional reform — reopening the Mint — is both legally achievable and monetarily sufficient.
Original PDF: https://professorfekete.com/articles/AEFOpenTheMint.pdf

### How to rebuild the shattered credit system

People ask: “Isn’t the Mint already open to gold, producing Gold Eagles and Buffaloes?” Opening the Mint to gold has a technical meaning, namely, opening it to the free and unlimited coinage of gold on private account. The Gold Eagles and Buffaloes are produced on Treasury account in limited quantities and sold at a premium as souvenir coins. It is a ploy to show that gold coins would just not circulate as money. Well, they would if there was no premium and the market was saturated.

Not until that happens do I see any hope for the world’s greatest and most permanent asset, wealth tied up in gold, to leave its hiding place, get mobilized and start discharging its duty for which it is so superbly suited: rebuilding credit and refinancing world trade on a sound basis. Irredeemable promises to pay by default-happy governments can under no stretch of the imagination serve as a sound basis for world credit and world trade.

Unless the ice is broken and one country does open its Mint to gold, the same pattern that was established in 1971 (when the U.S. Government defaulted on its international gold obligations) would continue to the further detriment of the world’s prosperity. The output of the world’s gold mines, plus whatever gold trickles down from the public sector, will go into hiding and will not benefit society. The world economy is literally bleeding. It is bleeding credit that keeps factories humming and cargo ships sailing. There is no other way to stop the hemorrhage than opening the Mint to gold. The battle cry should be: put gold back into circulation to save our civilization and to save the world! People must be aware what the malady is and what the remedy should be.

### The full meaning of 1971

Apart from the enormity of a great government reneging on its solemn obligation, sealed by international treaties, confirmed by several sitting Presidents, to pay holders of its short-term debt gold at a fixed rate of exchange, we should remember another aspect of the 1971 default. It triggered the world’s greatest deflation ever to take effect with a lag lasting about one generation.

The world prospered before 1971 because it had the U.S. Treasury as its residual supplier of monetary gold. The wholesome effect of this arrangement was that people were willing to pay out gold. They were confident that they could get back their gold exactly on the same terms. Confidence permeated producers, banks, trading houses, shipping lines, right down to the lowliest consumer. They could make deals with one another in the belief that the world’s monetary system is not run by tricksters. It is run by upright men who know the meaning of the word ‘honor’.

But once the commitment to redeem dollars in gold was broken, people became reluctant to pay out gold. They were no longer certain that they could get their gold back on the same terms. This froze the stock of the world’s monetary gold. More ominously, newly mined gold started to go into hiding, and the world economy had to be financed through the creation of synthetic credit.

For those of us who do not subscribe to the Quantity Theory of Money, this was deflation waiting to happen. The synthetic credit was – what else? – the broken promise of the defaulting banker. People with a logical mind knew that this arrangement had to be temporary. Only a deranged man would reward default by promoting the dishonored monetary instrument from the bottom of the garbage heap to the position of the highest-powered money of the international monetary system. After all, the U.S. government did have the gold it needed to run the world’s credit system. What it did not have, but could easily get with incorruptible politicians, a matching foreign policy free from entanglements, and a matching social policy free from the ‘free lunch’ mentality.

The present deflation is open-ended, as it is not known how much devaluation the dollar will have to undergo before it can be tethered once more to gold – as it was done exactly 75 years ago. To stop deflation, the flight into gold must be stopped first, as it was done by the U.S. in January, 1934.

President-elect Obama has already named his candidate to run the Treasury. An historical opportunity has been missed. The very same people who engineered and orchestrated the present crisis will be put in charge to rectify it. They are dyed-in-the-wool Keynesians or Friedmanites.

### America’s antagonists are just as helpless

Of course, the Arab countries, the Muslim countries, as well as the Asian powers (including Russia), which do not have carry the heavy Keynesian and Friedmanite ideological baggage, would love to start a new currency based on gold, and then take credit for saving the world. If they could, that feat would pass the torch of human civilization back to the Orient, and thereafter the Western governments could be deservedly castigated as the selfish and stupid satraps that landed the world in this incredible economic mess. They would hardly be invited to sit in the councils of nations, let alone to lead them. Worse still, the fear is that without the free flow of gold the world may get lost in the quagmire of a New Dark Age, in which law and order disappears, along with the disappearance of gold and silver.

Yet all the attempts of the Arab, Muslim, and Asian powers to put gold back into the monetary system have misfired, precisely because they have ‘forgotten’ to open their Mint to gold, which is the key to a New Golden Age.

### Why gold?

I have dealt with that question several times in my earlier writings, but I shall say it again. Gold is absolutely indispensable for reconstruction, far beyond the limits imposed by gold’s present valuation in the markets. The reason is that, once remobilized gold, and only gold, could carry a weight thousands of times greater than its nominal value. Gold, once put back into circulation, will regenerate credit which, under Western tutelage, has been allowed to disintegrate. The Western powers have fallen victim to the most inept and stupid Ponzi-scheme ever inflicted on people who are otherwise not illiterate: the Ponzi-scheme of Keynesian and Friedmanite economics. The ‘miracles’ that these two so-called economic systems can work depend on what I have described as a check-kiting scheme between the Treasury and the Central Bank.

They conspire to accept each other’s irredeemable promises to pay. For a time the shills could whip up sagging gambling spirit by their spectacular off-take at the gaming tables. But, ultimately, this Ponzi scheme, like any other, depends on an infinite supply of new fools. While the supply of fools in the world is very great indeed, it is not infinite. That is the only weak point in Keynesian and Friedmanite economics.

Without rebuilding credit on a gold foundation there is no hope for reconstruction, president-elect Obama’s grandiose reflation plans notwithstanding. The U.S. Treasury is empty, nay, it is in a hole, of the size of several years’ GDP. Government revenues are fading. American industry has been dismantled. Foreign creditors of the U.S. have had enough of the makebelief world of giving up real goods and real services in exchange for irredeemable promises to pay. Even if you put them under duress using military blackmail, they badly need those goods at home because they are themselves in deep trouble.

### De facto opening of the Mint

I have been greatly discouraged and dismayed that the Western governments, in their dogged stubbornness, have refused to listen to the voice of reason and allowed their antagonists to advocate the return to a gold standard. The Western governments should have taken the initiative and made a coherent statement on their own position.

But then something unexpected happened, which gives us a ray of hope.

Canada has been my adopted country for over half of a century. In many ways it is a decent country in this world of indecent governments. Canada has not used conscription to coerce young men to become cannon-fodder in foreign imperial and colonial ventures. It did not succumb to the ‘Roosevelt-syndrome’ in confiscating the citizens’ gold. While taxes are high, on balance it may be a price worth paying in exchange for clean cities, sane banks, safe streets, and universal health care.

Canada’s gold policy was free of the neurotic aspects of the American.

Gold has never been declared contraband in Canada. While it is true that fools were put in charge of government-owned gold, and they sold it for a pittance to invest the proceeds in irredeemable obligations of the U.S. government, the Royal Canadian Mint started issuing gold coins as early as 1967 (to commemorate Canada’s centennial.) Later, in 1979, with the issue of the Canadian gold Maple Leaf coin of one Troy ounce, 9999 pure, the Royal Canadian Mint created a coin that may well become the standard coin of a new emerging international gold standard. By now, 30 years later, many other countries are issuing gold coins to the same standard of weight and purity. As I shall explain below, the world treats these coins as being as perfectly fungible as only money can be, and refuses to treat them as souvenirs, keepsakes, or as a conversation-piece, which was the intention of their designers.

To be sure, the Royal Mint of Canada is not open to gold in the legal sense of the word. If it were, it would have made a commitment to convert gold, 9999 pure, free of seigniorage charges, into Maple Leaf coins, ounce for ounce, in unlimited quantities, to all comers. If there is no de jure commitment, is there a de facto commitment to the same effect?

That’s what a Canadian firm decided to find out in 2007, and so far the results are encouraging. They show that the Royal Canadian Mint has taken upon itself the burden to provide the world with a reliable source of gold coinage at an acceptable cost. This firm buys the standard international “good delivery gold bar” of 400 Troy ounces or about 12.5 kg, 999 fine and exchanges it at the Mint for 400 Canadian Maple Leaf coins, paying a premium that, according to the firm, is small enough that it can sell the Maple Leafs profitably at the normal 7-9% premium, even during this latest rush into gold coins. As soon as the coins are sold, the firm is buying more good-delivery bars and converts them into Maple Leafs at the Mint. It keeps doing this. This is the exact opposite of the great coin melt of F.D. Roosevelt’s fame, who confiscated the citizens’ gold coins only to melt them down and to mark up the dollar value of the resulting ingots – a symbolic gesture to show that gold has been demonetized.

This Canadian firm leads the way to gold remonetization. It uses the agency of the Royal Canadian Mint to do it. Needless to say, there will be imitators both at the Mint level and at the arbitrage level. In particular, the premium on coined gold will decline. There will be a race of governments to offer the same service on a competitive basis. (Remember how the Kugerrand has found imitators in all major countries of the world?) Willy-nilly, the Mints are going to do what they have been conceived to do in the first place: put the citizens in charge to decide what the money supply should be. By the U.S. Constitution the power to create money is reserved directly to the people themselves, and should not be delegated.

As you can see, the Royal Canadian Mint is open to gold de facto. As more imitators enter the field, the de facto commitment to monetize gold will become permanent.

### Reason for optimism

I think it is impossible to exaggerate the importance of this fact. While the 7-9% premium is an eyesore and takes away from the purity of the scheme, and the lack of a de jure commitment to keep this facility open through thick and thin is deplorable, the bottom line is that the first tentative steps have been taken by a Western Country (blessed with a strong gold-mining industry, and with an unbroken history of gold trading and sound banking) to opening the Mint to gold. This gives plenty of reason for optimism.

### A new stage in gold’s evolution?

Two professors at Prince Sultan University in Riyadh, Saudi Arabia, H. Assenov and K. Petrov, have published a paper with the title: A New Stage in Gold’s Return to Money (see References below.) In this paper they put forward the hypothesis that the market monetizes the one ounce standard gold coins regardless of shape and country of origin, as long as they have the right weight and fineness, as witnessed by the uniform price at which they are traded. They say that this is a new phenomenon that first appeared in December, 2008, the same time when gold backwardation first appeared as a threat to close down Comex warehouses. It means a great leap in the marketability of these coins due to perfect fungibility. Now a much larger pool of coins backing the trade is available. Both buyers and sellers dismiss the coins’ idiosyncrasies that would be of interest to numismatists and collectors. The authors suggest that this is a proof that gold’s remonetization is in progress. Gold is not yet money, but it has cleared one of the most serious hurdles towards becoming money. The market for the standard gold one-ounce coin, 999 fine, is no longer fragmented.

The authors make no reference to the fact that the Royal Canadian Mint is de facto open to gold as shown by the activities of a private Canadian firm. This fact, in my opinion, plays a large part in the phenomenon the authors describe: the uniform valuation of all standard gold coins. However, it is significant that they noted the simultaneous appearance of backwardation in the December gold future contract at the Comex. They also quote Carl Menger’s theory on the origin of money, that is, the rise of indirect exchange. Both the ugliest and the most beautiful gold coins are traded in indirect exchange strictly by the quantity and quality of metal content, completely disregarding the outward appearance of the coin. Whether the coin features the effigy of a bearded man or a kangaroo is of no consequence. The authors conclude their paper as follows:

Under the current financial order we use paper tickets with the picture of a bearded man that are currently printed in the trillions by another bearded man. Those tickets have had no backing for many decades, so there has been no restraint in their printing. Up until recently there has been a modicum of self-restraint in the printing process. However, since the Summer of 2008 all restraint has been thrown out of the window by the bearded man, a.k.a. Bailout Ben, who has indulged Congress and the Bankers in an historic multi-trillion dollar printfest. In response, common-sense people have rushed into gold as a store of value. Now that the value of gold is driven entirely by its purity and quantity, it is only a matter of time before gold is used again as a medium of exchange. Gold coins are no longer a numismatic delight, nor do they appear to be a Barbarian Relic. Gold is becoming money once again.

### Dollar holders beware!

Sprott Money Ltd.

I tease my readers’ curiosity no longer. I disclose that the Canadian firm that has harnessed the Royal Canadian Mint to change the course of history is Sprott Money Ltd., established in 2007. The inspiration came from its founder, Mr. Eric Sprott himself. I salute him here as a man of great insight and courage. He firmly believes that gold should again be the international currency, by the choice of the people. He believes that the U. S. economy is in a state of total systemic failure. He says that we are in a depression today. He points out that the average bank is leveraged 25 or 30:1. He does not beat around the bush: he says that in a true mark-to-market, probably no bank would have any tangible capital left. He does not think that any economy that is paper-based can be insulated against the contagion of debasement that is the hallmark of the U.S. dollar.

In a recent interview (see References below) Sprott stated that during the past three years his organization has converted a lot of gold bars to gold coins at the Royal Canadian Mint, and then he went on:

We have lots of inventory; we are not seeing any signs that we are going to eat through our inventory of coins. But I always do worry that I’ve got to be able to buy the 400-ounce bars back, too. So we’ll see. If it happens that I can’t buy the bars back, I don’t think I’ll be selling the coins. (Emphasis added.)

I have included this quotation for its value as it so closely relates to the problem of backwardation in gold. When Sprott cannot buy any more 400-ounce bars, that’s it: the curtain has fallen on the Last Contango in Washington.

Backwardation is here to stay. And you will know it immediately because Sprott Money Ltd. will simultaneously withdraw its offer to sell Canadian Maple Leaf coins to retail customers. Not for sale at any price quoted in dollars, whether Zimbabwean or U.S.

We need lots of imitators for Sprott and lots of imitators for the Royal Canadian Mint, if we want to shorten the painful death-watch of this reactionary episode in the history of money, the experiment with the paper dollar backed, as it is, by the greatest collection of weapons of mass destruction: debt and thermonuclear warheads – if not much else.

### References

By the same author:

### The Rise and Fall of the Gold Basis, June 23, 2006

### Monetary and Non-Monetary Commodities, June 25, 2006

### The Last Contango in Washington, June 30, 2006

### Gold, Interest, Basis, March,7, 2007

### Gold Vanishing into private Hoards, May 31, 2007

### Opening the Mint to Gold and Silver, February 5, 2008

Has the Curtain Fallen on the Last Contango in Washington? December 8, 2008 These and other articles of the author can be accessed at the website [www.professorfekete.com](https://www.professorfekete.com)

### The Only Real Monetary Asset, [www.sprottmoney.com](https://www.sprottmoney.com)

Eric Sprott: Gold: The Go-To Asset in Any Environment,

### The Gold Report 01/09/2009, [www.theaureport.com](https://www.theaureport.com)

A New Stage in Gold’s Return to Money, by H. Assenov and Dr. K. Petrov [www.financialsense.com](http://www.financialsense.com/editorials/petrov/2008/1226.html)

### Calendar of events

### Szombathely, Martineum Academy, Hungary, March 28-29, 2009

Encore Session of Gold Standard University Live.

### Topics: When Will the Gold Standard Be Released from Quarantine?

### The Vaporization of the Derivatives Tower

### Labor and the Unfolding Great Depression

### Gold and Silver in Backwardation: What Does It All Mean?

### San Francisco School of Economics, June-August, 2009

Money and Banking, a ten-week course based on the work of Professor Fekete. The Syllabus for this course is can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com)

---

*January 12, 2009*

---

# An Unhappy New Year

URL: https://newaustrianeconomics.com/archive/fekete/an-unhappy-new-year/
Date: 2008-12-31
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, backwardation, fiat-currency, monetary-crisis, federal-reserve
Description: Fekete's year-end reflection on 2008 — the year gold went into backwardation, Lehman collapsed, and the financial system nearly disintegrated. He surveys what the year's events confirmed about his monetary analysis and what they portend: not recovery but the deepening of a monetary crisis that began in 1971.
Editorial Note: Fekete's end-of-year essay for 2008, written December 31.
Original PDF: https://professorfekete.com/articles/UNHAPPY.pdf

### An unhappy anniversary

Another forgotten anniversary that haunts the nation is the re-establishment of the gold standard in the United States by the Roosevelt administration on January 1, 1934. What? — you may ask incredulously. Roosevelt re-introducing the gold standard in the United States? You had better believe it. That’s exactly what he did. He fixed the statutory price of gold at \$35 per ounce 75 years ago.

This price was observed until 1971 as it was also incorporated in several international treaties, and confirmed by the solemn promises of several presidents following Roosevelt. It is a great pity that Roosevelt-worshippers frown upon the idea of following the leader. They should demand a return to the gold standard now, 75 years after Roosevelt showed the way out from the economic quagmire.

To be sure, this is an unhappy anniversary. Roosevelt’s gold standard was bad. He discriminated against American citizens so outrageously that the evil dictators of the day dismissed the idea of duplicating Roosevelt’s measures in their own fiefdoms. Roosevelt’s gold standard denied Americans the right to demand gold at the statutory price in exchange for Federal Reserve notes. Worse still, criminalization of the ownership of gold stayed on the books. At the same time, under Roosevelt’s gold standard, the Swiss, for example, could routinely take Federal Reserve notes to a Swiss bank and exchange it for gold at the statutory price (even though, after 1936, they could no longer get gold for their own paper currency at the statutory price!) Surely this was a national dishonor: the American government discriminating against its own citizens, giving monetary rights to foreign nationals that were denied to Americans, in clear violation of the letter and the spirit of the Gold Standard Act of 1900, let alone the American Constitution.

### Pigs making monetary policy

Nor is it possible to argue that the American government continued to serve the interest of the American people after March, 1933, when Roosevelt confiscated gold belonging to the American people, only to write up its value from \$20.67 to \$35 per ounce a few months later, allegedly “in the interest of the national economy”. This great government of this great nation, stealing from its own citizens in the national interest? And selling the loot abroad at a high mark-up?

Where will it all end? Never mind the Constitutional prohibition on confiscation without due process. Never mind that the Constitution does not recognize fiat money. Never mind that the only kind of money the Constitution recognizes is silver and gold. Just ask simple questions about basic morality. The moral standard of the U.S. government in its dealings with its own citizens has reached an all-time low, as shown by the new norms set in the monetary field.

This land of free men was turned into an Animal Farm where pigs have been running wild and making monetary policy for the past 75 years. It is small wonder that men of utter depravity, like Bernie Madoff, could operate Ponzi schemes unobserved and with impunity for as long as he did. Just how long could the legal system stand up to assaults of this width, this depth, and this magnitude? The name Bernie Madoff reads like the Biblical writing on the wall, suggesting that ours is a Madoff dollar; ours is a Madoff Social Security; and ours is a Madoff Medicare. What basis for optimism is there for the next 75 years? To find out, let’s review the past 75 years.

### Stabilizing interest rates

Rotten as the New Monetary Deal was from the point of view of the American citizen, the system it established has ensured prosperity for the post-World War II era. That is, until it was disrupted by a second episode of overthrowing the gold standard in 1971 which, regrettably, was not followed by a second episode of rehabilitation.

Roosevelt’s gold standard, for all its negative aspects, has succeeded in stabilizing interest rates. This was a major feat. There is only one way to stabilize interest rates: by setting up an international gold standard. And for a very simple reason, too. Gold is the ultimate extinguisher of debt, the only one there is. Governments can legislate to have legal tender, they can legislate to make ownership of gold a crime; but they cannot legislate to make their own debt serve as the ultimate extinguisher of debt. If they prevent gold from discharging this function, then debt will start proliferating until critical mass is reached. The debt implosion that follows is bound to wipe out prosperity. This is the God-ordained role of gold in the monetary system.

A stable interest rate structure is not to be confused with falling one. The former is a great blessing; the latter is a great scourge. It took 36 years after

1971 to find out how the difference feels on the hide. Falling interest rates mean falling prices and falling employment. Quite possibly, with a lag. They mean serial bankruptcies. They mean deflation and depression.

### Cassandra’s gift

The role of Cassandra is a thankless one. She was the daughter of Priam, king of Troy and his wife, Hecuba. Hers is one of the great stories of antiquity.

Cassandra fell asleep in the temple of Apollo, and the god fell in love with the sleeping beauty. He offered to give her the ability to see the future if she were to return his love. She promised to do that, but when time has come to deliver on the promise, she reneged. The god Apollo was furious, but there was no way for him to take back the gift of clairvoyance. The best he could do was to make other people to disbelieve her prophecies. And it so happened that, when she predicted the rape of Troy by the Greeks after the ten-year siege, she was ridiculed, discredited, even declared insane by the Trojans.

I may be forgiven if I feel like Cassandra. Having published my predictions on the Internet for the better part of this decade, I have been disbelieved and ridiculed. (I have not yet been declared insane.) I have warned that the Federal Reserve’s policy of relentlessly suppressing the rate of interest will lead to a disaster. I have consistently argued that a falling interest-rate structure is corrosive on capital. Having destroyed capital it will destroy employment. Having destroyed employment it will destroy prosperity. It will be the cause of serial bankruptcies. I was talking about the black hole of zero interest that tears limb from limb in swallowing all creatures approaching it. I specifically mentioned the example of the American auto industry as being the next likely major victim of the deliberate policy of driving interest rates ever lower. Rather than helping American auto-makers, falling interest rates have denuded the auto industry of its capital.

### Financial capital not spared

Let me pause here to make a confession. If anything, I did not see far enough to realize all the consequences of the Federal Reserve’s driving the economy into the black hole of zero interest. I failed to see the simultaneous destruction of financial capital. I thought that the devastation would be confined to productive capital. In fact, I thought that the banks were the beneficiaries of falling interest rates. They were the vampire sucking the life-blood of the producers. The financial sector was siphoning capital away from the accounts of the producing sector. I should have seen that exactly the same argument applies to financial capital as to productive capital. They are both being destroyed piecemeal by the falling interest rate structure.

The present banking crisis is the result of wiping out the capital of the financial sector, through the same process that has wiped out the capital of the producing sector: the Federal Reserve’s deliberate and declared policy to drive down interest rates. The banks could have saved themselves if they had just kept picking the fruits of capital gains on their bond portfolio. Bond values have appreciated in the wake of falling interest rates. Pocketing capital gains plus clipping coupons could have been a very profitable pastime for the banks still.

But in their infinite greed they were not satisfied. They coveted more. They had recourse to ‘securitizing’ toxic garbage and started peddling it, world-wide, as Madoff was peddling his Ponzi tickets. That was their undoing. As long as securitized garbage was kept in their balance sheets, the dirty little secret was safe. But when it was put into circulation, the scandal could no longer be kept under the bushel. “Look, Dad, the banks have no capital!” Following the cry of the little boy, other spectators at the parade, too, could see that the emperor had no clothes.

### Obama will not rock the boat

I was not so naïve as to expect that the rank and file of mainstream economists would give credence to my predictions. After all, these gentlemen cut their teeth by chewing on the Keynesian bunk that it is the sacred mission of governments ‘to turn the stone into bread’ by driving interest rates down, if need be, all the way to zero.

More surprising was the reaction of labor leaders and the captains of the auto industry. They treated me with thinly veiled contempt, refusing even to take the trouble of going through my logical argument point by point. In this argument there was nothing offensive to labor or to capital. My offensive comments were concerned with Keynesian dogmatism and the government’s embracing it without even a perfunctory critical examination. Apparently, the leadership of labor and the captains of industry are just as committed to the error of Keynesianism as the government. They will live to regret their obtuseness.

It gives me no pleasure to say, on this unhappy New Year’s Eve, that

“I’ve told you so”. The world is at the brink of the worst economic collapse ever, wiping out capital and employment indiscriminately. What makes this occasion especially unhappy is that the incoming administration of Mr. Obama, rather than starting from an ideological tabula rasa (clean slate) as it should, has already committed itself to the same destructive Keynesian ideology and Keynesian policies that are responsible for the financial and economic catastrophe in the first place. The Secretary of Defense appointed by president Bush is not the only one who will keep his post. Foxes in charge of the chickencoop at the Treasury will also be reappointed. There is not the slightest hint of an impending critical reappraisal to find responsibility at the highest echelons of the Treasury and the Federal Reserve for the gross mismanagement of the economy.

The same program of driving interest rates down to zero will be continued uncritically. The road-map has already been spread out for all to see. Having driven the short term rate of interest to the ground, the Fed is now set about the business of driving down medium and long term rates as well. Ben’s helicopters stand ready to take off and bombard the U.S. economy back into the Stone Age with freshly printed, crisp Federal Reserve notes.

### Evils of bond speculation

I have started Gold Standard University Live, now defunct, to resurrect the study of the role of gold in the economy, in particular, its inevitable interaction with the rate of interest. Mainstream economics has completely (not to say criminally) ignored the consequences of the systematic destruction of the gold standard by the government. The enormity of one of the consequences stands out in particular. The effects of speculation on the rate of interest have been deliberately ignored.

Clearly, speculation was not a problem under the gold standard. Interest rates were stable and speculators left them alone. No profitable bets could be made on their variation. But when currencies were cut adrift from their gold moorings, their future value has become uncertain, and interest rates started bouncing up and down madly like a yo-yo. Naturally, speculators welcomed the new game as manna from heaven. It opened up a new casino where bets could placed on the future course of bond prices. The result was predictable: speculators were betting that interest rates would keep trending upwards or, what is the same to say, bond values would keep trending downwards.

Speculators could drive up interest rates to double digits, and some more.

Understandably, they did not think that the U.S. government could maintain the purchasing power of the irredeemable dollar, once the gold prop was removed and discarded.

### Open market operations

This unintended consequence of destroying the gold standard was not welcome news in Washington. The Federal Reserve got busy to prove the speculators wrong, by driving down the rate of interest. As one U.S. senator put it, “we have to make the speculators burn their fingers right to the armpit!” In addition to vengeance, there was also the ideological legacy of Keynes that animated monetary policy, and has become the earmark of our age.

There was more. Back in the early 1920’s the Federal Reserve launched a new policy of monetizing government debt. To be sure, the practice was illegal.

Government bills, notes, and bonds were not included in the list of eligible paper that could be held against the note and deposit liabilities of the Fed, as stated in the Federal Reserve Act of 1913. If and when a Federal Reserve bank, having fallen short, had to have recourse to backing its note and deposit liabilities by its holdings of government debt instead of eligible paper, stiff and progressive penalties were supposed to be collected by the Treasury. That made the practice of monetizing the debt of government prohibitively expensive.

But what if the Treasury “forgot” to collect the penalty? Well, that would be too bad, a severe bout of absent-mindedness — but that’s just what an accomplice in the conspiracy to undermine the monetary order would do.

The new fraudulent practice was called ‘open market operations’. (It was legalized ex post facto in the 1930’s.) Economists have failed to analyze the effect of open market operations on bond speculation. “See no evil, hear no evil, speak no evil.” I leave the problem to future researchers to find out whether economists made an error of omission, or whether they knowingly became accomplices to the conspiracy of the Treasury and the Fed in a scheme to the aggrandize the power of the federal government.

Here is what happens when the Federal Reserve resorts to open market operations to buy government bonds as the preferred means to increase the money supply. Bond speculators are very much alive to the need of the Fed to make periodic trips to the open market to buy the bonds. They lie in wait for the Fed. They want to preempt it; they want to buy the bonds first. Later, they would dump them in the lap of the Fed, making risk-free profits in the process at the expense of the public. The Fed does not mind being ambushed. It condones the risk free profits of the bond speculators. It all comes to the same thing: lower interest rates by hook or crook.

### Destruction of bank capital

With the open market operations of the Fed providing a dependable tail-wind, the sails of speculators are bulging. The unison bullish response to monetary policy by the speculators has the effect of steadily driving down the rate of interest. The Fed could report to the boss: “mission accomplished”.

Nobody bothered to investigate the question whether the symbiosis of the Fed and bond speculators (mostly banks) might somehow have a detrimental effect on the economy. It certainly looked like a brilliant scheme of creating positive value out of nothing — nay, out of negative value! Nobody has raised the objection that there “ain’t no free lunch”, that in our world strict conservation laws govern and draw a line between what is possible and what is not. In particular, it is not possible to create value out of nothing. Any appearance to the contrary must involve the destruction of value somewhere else.

Indeed, creating bond values out of nothing has coincided with the destruction of capital. Capital consumption is an insidious process. It has no obvious symptoms. If anything, like narcotics, it has a euphoric effect on the economy. Its role is to desensitize the victim before picking his pockets. It may fatten the wage envelope, widen profit margins, jack up managerial compensation, but all that is charged to the capital account. As long as there is a capital account, that is. Trouble bursts on the economic scene when the bottom of the capital barrel has been scraped clean. Of course, by that time it is too late.

Nothing can be done to stop the rot.

This is what we have experienced in the fateful year of 2008. While the capital of the banking industry was eroding, there was a feeling of euphoria, a sense of weightlessness, the exhilaration of levitation as capital consumption has given banking operations an extra lift in defying gravity. But no sooner had the last crumbs of consolidated capital disappeared than gravity came back with a vengeance and the banking industry fell out of the sky. All banks, at the same time. It was not a consequence of local mismanagement. It was not primarily a consequence of too lenient lending standards, it was not primarily a consequence of reckless risk-taking. It would have been a statistical oddity if all banks had bankrupted themselves at the same time. There was a common cause: the erosion and ultimate destruction of capital.

### Recapitalizing banks with irredeemable debt

The U.S. Treasury has embarked on a policy of recapitalizing the banking industry with credits based on issuing more irredeemable debt of the U.S. government. This feeble-minded ploy has apparently been endorsed by the Obama team waiting in the wings. It may well work for a time. More specifically, it may work as long as foreigners continue to accept the irredeemable promises of the U.S. government in exchange for real goods and real services. But since foreigners are themselves in deep financial and economic trouble, concerted action of central banks to use the irredeemable debt of the U.S. as the ultimate extinguisher of debt is not promising, to say the least.

I am not predicting that the world’s payments system will collapse in a matter of a few weeks. I can see a prolonged agony ahead for the dollar. The dollar is on a life-support system, powered by the ongoing bull speculation in bonds. Virtually all non-conformist observers predict that the bond market is doomed and it is already on its last leg. They expect that bond values will fall into the abyss, followed by the dollar. When economic forecasters show such a high degree of unanimity, it is a warning that unfolding events will follow a different script.

The sudden death of the bond market is not a scenario that appears a likely outcome. Bond speculators have been enjoying a bull market for 25 years.

They are well-heeled financially, sitting on mountains of paper profits. They are not yet ready to cut and run. After all, theirs is the only bull market in town, the only game of musical chairs still going strong, after the dot-com, the real estate, the stock market games had the music stopped on them.

### Madoff Economics

The ‘grapes of wrath’ are ripening in Academia. Having exiled monetary science, agents of Madoff Economics (alias mainstream economists) have exposed society to untold dangers. All the people are going to be put through the wringer indiscriminately. No one will be spared.

What means Madoff Economics? It is the economics of “garbage in – garbage out”. It features the central economic doctrine of Keynes that capital is for window-dressing purposes only. The smart guy does not need capital. The guy who is even smarter can milk previously accumulated capital for his own purposes.

For the first time we shall witness global destruction of capital in an advanced economy. The fabric of society is breaking down. Madoff Economics will continue to have a monopolistic influence in the councils of government.

Adventurers will continue to be in charge, and will continue to display utter lack of responsibility for the damage they are causing to society. The script will be played out in full, to the bitter end. There will be no tabula rasa after Inauguration Day. Pigs will continue running Animal Farm, making monetary policy, until the fruit trees are picked bare of fruit, the barns are swept clean of grain, with nothing left in the cupboards or in the cookie jars.

### Calendar of events

### Szombathely, Martineum Academy, Hungary, March 27-29, 2009

Encore Session of Gold Standard University Live.

Topics:

### Is There Life after Backwardation?

### Will the Gold Standard Be Released from Quarantine?

### The Vaporization of the Derivatives Tower

### Labor and the Unfolding Great Depression

Further announcements will be made at the website: [www.professorfekete.com](https://www.professorfekete.com)

### San Francisco School of Economics, July-August, 2009

Money and Banking, a ten-week course based on the work of Professor Fekete, who will be in attendance. The Syllabus of this course is can be seen on the website: [www.sfschoolofeconomics.com](https://www.sfschoolofeconomics.com)

---

*December 31, 2008*

---

# Forward Thinking on Backwardation

URL: https://newaustrianeconomics.com/archive/fekete/forward-thinking-on-backwardation/
Date: 2008-12-21
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, permanent-backwardation, backwardation, gold-standard, monetary-crisis, fiat-currency
Description: The companion to Backward Thinking on Backwardation, this essay looks forward to the implications of permanent gold backwardation: the end of the international paper monetary system, the forced return to gold, and the possibility of a catastrophic rather than orderly transition.
Editorial Note: Written December 21, 2008 as a forward-looking companion to the backward-thinking piece.
Original PDF: https://professorfekete.com/articles/FORWARDTHINKING.pdf

*Forward Thinking On Backwardation*

**Antal E. Fekete**

*Gold Standard University Live*

In an earlier article Backward Thinking on Backwardation I explained that backwardation in gold is the flipside of the phenomenon of a drastic contraction of world trade and employment. This brings out the danger in denying the fact of gold backwardation or to belittle its significance, as most observers seem to be doing. I am reminded of the saying of the Swiss educator F.W. Foerster: “if you don’t use your eyes for seeing, later you will use them for weeping.” In this article I want to enumerate the reasons why I believe that permanent backwardation in gold would bring about the descent of our civilization into lawlessness similar to that following the collapse of the Western Roman Empire.

The consensus seems to be that, even if backwardation in gold occurred at one point, it would not be a significant event given the zero-interest environment. Forward thinking on backwardation shows that this is wrong.

Tom Szabo observes (see References below): “If somehow short-term interest rates were to go into significant backwardation, it should be no surprise that gold and silver may go into significant backwardation. **This would not be a sign of imminent monetary collapse** [his emphasis]. In fact, a pretty strong argument could be made for the opposite – that the negative interest rate is a sign of excessive monetary demand (in relation to demand for capital goods and investments). I’ve looked but have been unsuccessful in finding an historical example of a monetary collapse that occurred while money was actually in high demand. Of course, high demand for money could be extremely deflationary and the only known cure for this is to create a high supply of money, otherwise known as hyperinflation.”

While I would disagree with the use of the word “imminent” in describing the coming monetary collapse, I must maintain my stand that a durable backwardation, such as we have experienced for two weeks earlier this month, is a premonition that there will be repeated episodes of the same kind, ever more frequent, ever deeper, ever longer, each episode significantly weakening the monetary system – regardless of the zero or negative short-term interest rate. (Let us leave the question aside that zero or negative interest rates in and of themselves show an alarming pathology of the monetary system!)

I have argued that we must carefully distinguish between a fiat money regime with an undisturbed flow of gold to the futures market; and a fiat money regime where the flow of gold to the futures market has been blocked by an unprecedented surge in the demand for cash gold.

In the first case confidence in fiat money is high; in the second, it is low and waning fast. In the first case paper gold is an effective substitute for physical gold in most applications; in the second, paper gold has been unmasked as a fraud, and discredited beyond repair. In the first case the economy works pretty well the same way as under a gold standard; in the second, all hell is turned loose as the exchange of goods and services is on the decline and autarky on the rise.

Tom says that “it is incorrect to claim that gold and silver could be in true backwardation without at least some inversion of the futures price curve where the nearer contracts are trading at a higher price than the further out contracts. Well, exactly that’s what has happened at Tocom during the first two weeks of this month and is happening still. Tocom publishes its trading summary at the close of trading every day on the Internet: [www.tocom.or.jp/souba/gold/index.html](https://www.tocom.or.jp/souba/gold/index.html). I don’t understand how Tom could miss it. Backwardation is jumping off the Internet page covering the standard kilobar contract, even as I write this, on December 19.

Tom is complaining that the spot price for gold is difficult to ascertain: “the spot price for gold is elusive… because they are third-party quotes that suffer from a variety of problems that can make them unreliable and imprecise.” I disagree. I have asked my student, Mr. Sandeep Jaitly of Soditic, Ltd., London, U.K., who is tracking the gold basis for me, to explain. Here is what he had to say on December 15: “Tom Szabo comments that spot prices are difficult to obtain. Not true! They are not. You just have to be plugged into the right feeds.

My spot price quotes include all the five price fixers at the LBMA, plus everybody else worthy of quoting… The spot gold price I use is the best or highest bid (and the best or lowest offer) from 300 banks world-wide [list attached, not reproduced here]. The data I use is directly from the exchange, and the prints I see for the carry available are super precise. I can get 90¢ per oz profit on the December contract versus my spot quotes that come from every bank on earth…”

Sandeep goes on, dateline December 18: “Everybody of note is inferring that gold is in backwardation because of the zero interest. Let us explore that a little further. One can achieve 0.25% annualized by carrying gold for 190 days till June 26, 2009. 190 days in maturity is about equivalent to a 6-month T-bill with a current yield of 0.18%.

The cost of carry for 190 days is 0.25 – 0.18 = 0.07%. If we compare this with the cost of carry for 11 days till December 27, 2008, and, again, for 69 days till February 27, 2009, [calculation included, not reproduced here], then we get that the cost of carrying gold is as follows (all percentages are annualized) for 11 days: for 69 days: for 190 days:

1.005%

0.9%

0.07%

That is pathological without any need of further explanation! It costs more to carry gold for shorter periods of time than for a longer period – according to the futures market. That puts a hole in the zero interest-rate argument, and explodes the explanation that the extra-low contango or outright backwardation in gold is nothing more than “normal backwardation” of a non-monetary commodity!”

Tom says that he does not see things evolving in the same catastrophic manner as I do. For example, he believes that “there will always be willing buyers and sellers of gold in some quantity if the price is right.” Buyers – si, sellers – no! That’s just the whole point. The lack of credibility of irredeemable currency will be such that no one in his right mind will accept it in exchange for gold, the ultimate liquidator of debt. Previously, people were willing to trade their gold because they could always replenish their supply from Comex warehouses.

That means, in other words, that the irredeemable dollar could still be used as a liquidator of debt (i.e., gold still has a competitor). But let them close the Comex gold warehouses. This is a quantum jump; it means that the irredeemable dollar can no longer be used to liquidate debt, e.g., debt incurred by those holding short positions in gold futures. It is essential not to belittle the import of this observation.

Tom thinks that I am an alarmist in believing that the permanent closing of the gold window at the Comex will mean a cessation in gold mining, loss of segregated metal deposits, and institutionalized theft of ETF holdings.

To answer this I have to go back to the collapse of the Western Roman Empire after the abdication of the emperor Romulus Augustus on September 4, 476 A.D. It was followed by the Dark Ages when the rule of law, personal security, trade of goods against payment in gold and silver could no longer be taken for granted. Gold and silver went into hiding, never to re-emerge during the lifetime of the original holders. It is plausible to see a causal relationship between the fading of the rule of law and the complete disappearance of gold and silver from trade. Virtually all observers say that the first event caused the second.

I may be in a minority of one to say that causation goes in the opposite direction. The disappearance of gold and silver coins as a means of exchange was a long-drawn-out, cumulative event. In the end, no one was willing to exchange gold and silver coins for the debased coinage of the empire. At that point the empire was bankrupt; it could no longer pay the troops that defended its boundaries against the barbarians threatening with invasion. This is not to say that the empire did not have other weaknesses. It did, plenty of it. But the overriding weakness was the monetary weakness. Centuries after centuries the Mint of the empire could attract less and less gold and silver. Because of this, the empire was forced to debase its coinage and the deterioration continued until the bitter end, when the gold flow to the Mint completely dried up.

Compare this with the Eastern Roman Empire that lasted until the fall of Constantinople to the Ottoman Turks in 1453 A.D., or almost one thousand years longer than the Western half, and during most of this time it could keep its Mint open to gold, producing the gold bezant, which also became the coin of the Muslim world. Is this difference between the two empires trying to tell us something about the importance, from the point of view of political and economic survival, of keeping the Mint open to gold?

The history of the monetary system of the United States shows an ominous parallel to that of the Western Roman Empire. As long as gold and silver was still used in trade at least to some extent, the Western Roman Empire was limping along. The modern equivalent of the disappearance of gold and silver is epitomized by the progressive vanishing of the gold basis.

There is simply no continuous transition from the paper dollar cum contango to the paper dollar cum gold backwardation, Tom’s prayer notwithstanding. The transition will necessarily involve a sudden and fatal weakening of the legal system. Remember, the legal system works only as long as most citizens are law-abiding. It breaks down as soon as the majority of the citizens find that the law protects thieves in high places, but offers next to no protection for the honest hardworking middle class. I am not going to elaborate here on the proposition that irredeemable currency is a system that protects thieves in high places, but robs the little guy by plundering his savings.

Tom notes that it may be technically possible to delay the collapse of the fiat money system by “allowing” gold to appreciate in a hyperinflationary scenario. That is precisely the phase that will end with the entrenchment of backwardation in gold. Thereafter one can no longer talk about an “appreciating gold price”, or any gold price for that matter, as the pricing mechanism will have self-destructed, at least as far as the price of gold is concerned. As Tom himself observes in the same article, local prices in India, China, and in the jungles of Papua are not relevant. Only gold prices in New York and London are, and the arbitrage between the two.

I have nowhere said that the end of the fiat money system will follow the closing of the gold window at the Comex in a matter of days. Sure, finance ministers and central bankers will try to “muddle through”. It is not possible to predict how long the death throes of fiat money will continue. Tom may be right in suggesting that it will take many years, and claims of an imminent monetary and economic collapse will again turn out to be wrong.

But where Tom is certainly mistaken is his suggestion that all this agony will take place while the Last Contango in Washington is still going on. You can’t have contango and backwardation at the same time. Backwardation is like a black hole, once it grabs a currency, it will swallow it, and gold quoted in that currency will never return to contango.

I think Tom’s greatest mistake is to interpret the move into backwardation, or gold to enter the ‘fever phase’, as “gold’s regaining fully-recognized monetary status”. Unfortunately, just the opposite is the case. Whether officially recognized or not, gold’s monetary status was never in doubt. Gold has always been the monetary commodity par excellence, due to the fact that it has constant marginal utility (or, if you will, the fact that the marginal utility of no other commodity declines at a rate slower than that of gold).

What we are witnessing is a transition that deprives gold of its monetary qualities. Gold in hiding cannot and will not act as money.

More to the point, absent gold, nothing else can or will. The disappearance of money, that can be trusted, fatally undermines the legal system, the sanctity of contracts, habeas corpus, any and all provisions of law and order that we take for granted. Under these conditions nobody can operate a gold mine, nobody can run a gold refinery, nobody can guarantee segregated gold deposits, and nobody can prevent the institutionalized theft of ETF holdings. Welcome to the Madoff economy! (See References below: Paul Krugman’s column in The New York Times). Jail one Madoff, two others will jump into his shoes.

As a consequence of the permanent backwardation in gold, we shall have a world gone Madoff.

### References

### Tainted Research: Lysenkoism — American Style, June 4, 2003

### Monetary versus Non-monetary Commodities, April 25, 2006

### The Last Contango in Washington, June 30, 2006

### Red Alert: Gold Backwardation!!!

---

*December 4, 2008*

Has the Curtain Fallen on the Last Contango in Washington? December 8, 2008 There Is No Fever Like Gold Fever, December 10, 2008

### Backwardation That Shook the World, December 14, 2008

### Backward Thinking on Backwardation, December 18, 2008

These and other articles of the author can be accessed at the website [www.professorfekete.com](https://www.professorfekete.com) Backwardation Update – Still No in Gold, but Maybe in Silver! by Tom Szabo, [www.silveraxis.com](https://www.silveraxis.com), December 12, 2008

The Madoff Economy by Paul Krugman, [www.nytimes.com](https://www.nytimes.com), December 19, 2008

### Acknowledgement

The author wishes to express his thanks to Mr. Sandeep Jaitly of Soditic Ltd., London, England, (e-mail: Sandeep.Jaitly@soditic.co.uk) for tracking the gold basis for him.

### Calendar of events

### Szombathely, Martineum Academy, Hungary, March 28-29, 2009

Encore Session of Gold Standard University Live.

Topics:

### Is There Life after Backwardation?

### Will the Gold Standard Be Released from Quarantine?

### The Vaporization of the Derivatives Tower

### Labor and the Unfolding Great Depression

### San Francisco School of Economics, June-August, 2009

Money and Banking, a ten-week course based on the work of Professor Fekete. The Syllabus of this course is can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com)

---

*December 21, 2008*

---

# Backward Thinking on Backwardation

URL: https://newaustrianeconomics.com/archive/fekete/backward-thinking-on-backwardation/
Date: 2008-12-18
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, permanent-backwardation, gold-standard, fiat-currency
Description: Fekete responds to critics who argue that gold backwardation is normal and insignificant, explaining why gold backwardation is categorically different from other commodity backwardations. For gold, it signals the withdrawal of monetary trust — a permanent change in how holders view the paper money system.
Editorial Note: Written December 2008 in response to critics of the Red Alert analysis.
Original PDF: https://professorfekete.com/articles/AEFBACKWARDTHINKING.pdf

*Backward Thinking On Backwardation*

**Antal E. Fekete**

### Gold Standard University Live

On Monday, December 15, backwardation on gold was still in force at an annualized discount rate that narrowed to 1.55% in the December contract, but widened to 0.36% in the February contract. 12,673 contracts remain for tender in December, including an additional 37 contracts since last Friday. The discount on the December futures was 50¢ offered to those owners of physical gold who would transfer the carry to the market for the remaining 14 in December, or 60¢ for the 72 days deferred delivery for the February contract.

By Wednesday, December 17, backwardation on gold disappeared both in the December and February contracts, on an upwards spike in the price of gold worth \$50. At this point in time it appears unlikely that the December contract will default, although the threat to registered gold in Comex warehouses remains very disturbing.

---

The father of backward thinking on backwardation is undoubtedly John Maynard Keynes. In his 2-volume Treatise on Money published in 1930 he developed a theory of the futures markets and introduced the concept of normal backwardation. As the name suggests, backwardation is considered as the normal condition of the futures market so that, by implication, contango is ‘abnormal’. According to Keynes backwardation, or discount on the futures price as compared to the spot price, is a necessary incentive that is supposed to persuade speculators to buy forward. In his view the discount is just the ‘insurance premium’, as it were, that speculators collect for shouldering the risk that the price of the commodity may fall during the time-span to delivery.

It would be hard to misconstrue the meaning of backwardation in a way worse than Keynes’ “normal backwardation” does. His theory turns reality upside down. The truth is that the normal condition of the futures markets is that of contango whereby the futures price is at a premium compared to the spot price. The premium accrues to the warehouseman who carries the physical commodity while hedging it by selling an equal amount of futures.

The basis, or difference between the futures price and the spot price, is the signal telling the warehouseman about the state of demand for warehouse space. One may even say that the (positive) basis is the market price of available space in the warehouses. It tends to be low when warehouses have a lot of vacant space to fill, and high when they are close to full. Not only does it help to allocate scarce warehouse space between competing uses; the basis also guides the warehouseman telling him how fast he should fill his vacant warehouse space, or how fast he should make space available for alternative and more urgent uses; in other words, to decide which commodity to buy and which to sell. Other things being the same the warehouseman should buy the commodity with the higher and sell the one with the lower basis. Without the signal from the basis and the variable contango he would be in the dark shooting from the hip.

At any rate, backwardation is always indicating an abnormal condition: that of a shortage, whether it is due to insufficient production or prodigal consumption, or whether it indicates lack of foresight to carry sufficient supplies to cover future needs.

Keynes’ celebrated faux pas in introducing the misnomer ‘normal backwardation’ is second only to that of Karl Marx. As is known, Marx has made the worst blunder in the history of economic thought when he created his theory of value. According to him, labor is the exclusive source of value, so the value of merchandise is directly proportional to labor content. Thus, then, the government can create value by having bottle-caps buried in deep holes and let people prospect for them and dig them up at great cost in labor – as has in fact been suggested by Keynes. This shows the common thread in the thinking of these two ‘defunct’ economists.

The Keynesian mindset is obsessed with the idea of overproduction and with the need to fight it by all available means. At the same time it dismisses the idea that in the real world scarcity is the basic human problem one should worry about.

---

Keynesian economists never quote their mentor’s theory of the futures market as it is a major embarrassment. Still, it is hard not to agree with James Turk (see References) that much of what has been written on the Internet about backwardation “is total rubbish”.

The high level of ignorance about the basis and backwardation was the chief cause of the fiasco — and Turk is silent on this — of the gold mining industry falling into the trap laid by the government. It was the trap of ‘hedging’, more precisely, the selling of mine output forward up to fifteen years in advance. It was an insane collective hara-kiri of a major industry. It failed miserably because it left the reaction of speculators out of the equation. Yet it was perfectly predictable that the reaction would be negative — from the point of view of the industry itself. Speculators would abandon their traditional perch on the long side of the market, and they would hop over to the short side.

Gold mines and speculators would fall over themselves in competing for the privilege of being the first in selling gold short.

The net result was that the gold price was clubbed down every time it was trying to climb out of the hole. Gold prospecting was stifled. In addition, the grip on the world of the regime of irredeemable currency was reinforced — just as wished by the governments. Other results included the premature depletion of the ore reserves of the mines, the looting of shareholders by management, the insanity and waste involved in producing gold at peak rates of output only to squander it at \$250 an ounce, as recently as six years ago!

Had gold mining executives educated themselves about the gold basis and the threat of backwardation in gold, the disaster would have been avoided. Based on the correct principles of bilateral hedging, the mines would have developed a marketing strategy motivated by the trading of the gold basis — instead of trading the gold price. The vanishing of the gold basis would have prevented these executives from making the worst blunder: selling (borrowed) gold and buying the futures. They would have saved a bundle for their shareholders to whom the losses caused by the vanishing basis were charged. They could have maximized the useful life-span of their mines, instead of maximizing short-term paper profits of dubious value. Gold mining executives, just like the American bankers, are very good at paying themselves huge salaries and bonuses. They are not nearly as good at admitting their mistakes and learning from them.

---

According to Turk there have been three episodes of backwardation in gold as follows:

(1) The first occurrence was November 29, 1995. That backwardation lasted for a day and was probably the result of a hedge buy-back by Barrick Gold.

(2) The next occurrence lasted for two days, September 29–30, 1999. It was caused by a mad rush for physical gold to cover short positions in the wake of the Washington Agreement on central bank gold sales.

(3) The third occurrence happened last month, and continued for three business days, November 20, 21 and 24. Turk says that no special event triggered this latest backwardation.

Turk does not consider the possibility that the November episode could have been a premonition of a more durable backwardation on the way. He does not recognize the backwardation at the Comex that started on December 2 and lasted for two weeks, in spite of the fact that it has been confirmed by the Tokyo Commodity Exchange where backwardation was in force, not only between spot and nearby but between more distant futures as well.

The key to understanding the present upheaval in the world economy and the relevance of backwardation to it is that, regardless of official propaganda, gold circulation (such as it is) never ceased to be an important part of the world’s trading system. Backwardation means that gold circulation is stopped in its tracks, which is deflationary in the extreme, greatly contributing to the contraction of world trade.

Backwardation in gold causes, and is caused by, the cascading contraction of world trade. It is preposterous to suggest that no special event triggered the backwardation in gold last November. The special event was the onset of Great Depression II, just as sabotaging the gold standard by Britain on September 1, 1931, heralded the onset of Great Depression I.

The problem with Turk’s analysis is that he considers backwardation in gold in isolation, taken out of the context of the vanishing of the gold basis that has been going on for at least three decades. This is like trying to understand the eruption of a volcano while deliberately ignoring prior rumblings. Given the secular decline of the gold basis, it should be easy to interpret the backwardation episode last month as a warning of the crisis caused by the realization that the world was walking into a gold trap. The gold basis was bound to enter negative territory, because its relentless decline indicated that ever more gold was going into hiding, while it became ever more difficult to coax it out of hiding.

This is not a crisis of Comex. This is a crisis of the international monetary and payments system trying, as it is, to reduce global debt with irredeemable promises issued by central banks. This is a crisis caused by mainstream economics in putting monetary science beyond the pale, and cheering on the government for driving gold, the ultimate extinguisher of debt, out of the monetary system.

Borrowing Carl Menger’s admirable phrase ‘police science,’ alias Keynesian economics, must bear full responsibility for conceiving, giving birth to, and raising to maturity Great Depression II.

### References

### Tainted Research: Lysenkoism — American Style, June 4, 2003

### Monetary versus Non-monetary Commodities, April 25, 2006

### The Last Contango in Washington, June 30, 2006

### Red Alert: Gold Backwardation!!!

---

*December 4, 2008*

Has the Curtain Fallen on the Last Contango in Washington? December 8, 2008 There Is No Fever Like Gold Fever, December 10, 2008

### Backwardation That Shook the World, December 14, 2008

These and other articles of the author can be accessed at the website [www.professorfekete.com](https://www.professorfekete.com)

### A Treatise on Money, volume I-II, by John M. Keynes, 1930

The Nonsense about Gold Backwardation, etc., by Mike (Mish) Shedlock, December 7, 2008, [www.globaleconomicanalysis.blogspot.com](https://www.globaleconomicanalysis.blogspot.com) No Fever Like Gold Fever: Response, by Mike (Mish) Shedlock (ibid.) More on Gold Backwardation, by James Turk, December 12, 2008, [www.kitco.com](https://www.kitco.com)

### Acknowledgement

The author wishes to express his thanks to Mr. Sandeep Jaitly of Soditic Ltd., London, England, (e-mail: Sandeep.Jaitly@soditic.co.uk) for tracking the gold basis for him.

### Calendar of events

### Szombathely, Martineum Academy, Hungary, March 28-29, 2009

Encore Session of Gold Standard University Live.

### Topics: When Will the Gold Standard Be Released from Quarantine?

### The Vaporization of the Derivatives Tower

### Labor and the Unfolding Great Depression

### Is There Life after Backwardation?

### San Francisco School of Economics, June-August, 2009

Money and Banking, a ten-week course based on the work of Professor Fekete. The Syllabus of this course is can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com)

---

*December 18, 2008*

---

# Backwardation That Shook the World

URL: https://newaustrianeconomics.com/archive/fekete/backwardation-that-shook-the-world/
Date: 2008-12-14
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, fiat-currency, monetary-crisis
Description: Fekete's analysis of the historic December 2008 gold backwardation event — the first time gold futures went to backwardation and stayed there, signaling a crisis of confidence in the fiat monetary system.
Editorial Note: Written during the 2008 financial crisis, this article documents the first sustained gold backwardation in history. Fekete interprets it as a fire alarm for the international monetary system — a reading that has only grown more relevant.
Original PDF: https://professorfekete.com/articles/AEFBackwardation.pdf

On Friday, December 12, backwardation on gold was still in force at an annualized discount rate hovering around 2% in the December contract, and 0.3% in February contract. Many readers have asked me how it is that so many other observers fail to see the backwardation. The discrepancy is due to differences in methodology. Most analysts calculate the basis as the difference between February and December futures prices which gives them a positive reading. They use the December futures price as proxy for the spot price. This is clearly wrong. The December futures price is not the same as the spot price, even though we are in December.

My methodology is to calculate the basis as the difference between the asked price for the December futures and the bid price for spot gold. The logic behind this is that if you wanted to transfer your costs of carrying gold to the futures market, then you would have to sell physical at the bid price of spot gold and buy it back at the asked price of the December futures.

The opportunity cost of carrying physical gold is known as the carrying charge. It covers interest, insurance, cost of storage, and all other incidental costs including taxes and fees, if any. The carrying charge is the upper bound of the range within which the gold basis can vary. Arbitrageurs would never allow the basis to exceed the carrying charge. If it did, they would keep buying cash gold and selling the futures until their arbitrage would eliminate excess contango.

## Why Backwardation Should Be Impossible

The same theoretical argument can be used to prove that the basis cannot go negative. Holders of gold would keep selling cash gold and buying the futures until the backwardation disappeared. Indeed, backwardation never lasted for more than a few hours that it takes to send out a wake-up call to alert sleeping arbitrageurs. That is to say, not until December 2, 2008. On that ill-starred day gold went to backwardation for the first time ever in history, and got stuck there.

This gave rise to a controversy that is still raging. What is the significance of this event? The majority of observers shrugged: so what? Others, including the present writer, warned of the extremely serious consequences threatening the international monetary system and the world economy because of the highly corrosive nature of the backwardation in gold.

Why is it that the same theoretical argument is foolproof in the case of full contango, but it is fallacious in the case of backwardation? The reason is that **full contango in gold (maximum reading on the gold basis) implies full public confidence in fiat money; backwardation (minimum reading on the gold basis) implies the collapse of public confidence in fiat money.**

## The Vanishing Basis

Let us put this into context. We have had a strange and ominous phenomenon lasting well over three decades which mainstream economists have been utterly unable (unwilling?) to explain. When gold futures started trading in the United States in 1975, the gold basis was close to full contango. Since that time it has shown a stubborn falling tendency, steadily increasing its deviation from the carrying charge.

This is as if, after a brief honeymoon in 1975, holders of physical gold started to go on strike against the clearing house of the commodity exchange in ever greater numbers, refusing to take the ever increasing wage offers on the bargaining table. They would rather go without any wages at all.

Of course, strikes are not out of the ordinary, so the phenomenon of the vanishing gold basis could be, and was, swept under the rug. Mainstream economists could still lull themselves in the belief that the gold basis would never go negative. Come to think of it, if it ever did, it would be the equivalent of employers offering to take over from the unions the responsibility of making strike-pay available to workers on the picket line. Now, there, such a thing would truly be unheard-of!

Yet, surprise, surprise, it has now happened, although not in industrial but in monetary relations. Holders of physical gold, now on fully-fledged strike, are offered a strike-pay by the futures market, and the offer is left on the bargaining table, but the strikers still won't budge. There it is: the gold basis went negative, gold has been in backwardation for over a week, and physical gold is still not coming out of hiding.

## The Fire Alarm

In spite of all the propaganda aimed at discrediting me and my theory of gold backwardation, what we are hearing is the shrill sound of the fire-alarm indicating that the house of the international monetary system is on fire. For many a year I have been warning all those who cared to listen that such a fire-alarm was coming sooner or later, and the consequences of ignoring it would be disastrous. Well, it is sounding loud and clear now, and guess what. Fire-fighters brazenly ignore it. Yet you can ignore it at your own peril.

What does it all mean? Not only does it mean that the market is willing to pay all your carrying charges involved in holding physical gold, but it is also willing to pay you (allegedly) risk-free profits for the privilege of relieving you from carrying the burden! "Let me take over your yoke just for a few days; I shall pay you handsomely for the honor" -- so the clearing members of Comex plead.

It is as if the bank was paying all your utility bills without charging it to your account. Nay, the bank is actually offering you a bonus for you allowing it to do you the favor. Suppose, for the sake of argument, that all the banks in the world offered all their account holders to take over responsibility for paying their utility bills. Would it not evoke some searching questions about the hidden agenda of the banks? Wouldn't people become extremely suspicious of the preposterous offer? Yet here we go, the futures market in gold, the world's residual source of cash gold, is making the same preposterous offer, and nobody is asking questions. *Timeo Danaos et dona ferentes* (I fear my enemies most when they bring me gifts, Virgil, *Aeneid*, II. 49.)

## The Monetary Science Explanation

I warn the world again that the futures market would not go to backwardation in gold if the house of paper money were not on fire. There is just no prima facie reason for a shortage in physical gold. A very large part of all the gold produced throughout history still exists in monetary form, sitting in vaults doing nothing. (Under the gold standard it used to be doing heavy-duty work in financing production and world trade.) Unlike all other commodities with the exception of silver, for gold the stocks-to-flows ratio is a high multiple (by contrast, the stocks-to-flows ratio of copper is a small fraction). And, on the top of privately held gold, there is central bank gold amounting to one quarter of all the gold ever produced since the dawn of history.

Why are central banks unwilling to take advantage of risk-free profits by releasing gold? Could it be that, in possession of inside information, they have reason to be afraid that the regime of irredeemable currency may soon collapse and, with their gold gone, they don't want to be left holding the bag? Could it be that the Babeldom of the debt tower is already crumbling, but the fact is being covered up?

There is simply no explanation for the backwardation in gold, absent monetary science. And since monetary science has been exiled from the world's universities for the past fifty years (this is what I call "Lysenkoism -- American style"), people are dumbfounded. They don't understand the phenomenon of holders of gold passing up the opportunity to earn risk-free profits.

Monetary science gives a clear and unambiguous explanation. Here it is, and please remember that you have heard it here first. We are facing a pathology of the international monetary system based, as it is, on irredeemable promises to pay. People are enjoined through 'legal tender' legislation to use these irredeemable promises as if they were the ultimate means of payment, even though they are not, and the world would rather use gold and silver as the natural and ultimate extinguisher of debt. But gold and silver have been coercively eliminated from monetary circulation for the competition they offered to synthetic debt-liquidating devices. Mainstream economics pretends that the issue has been settled for once and all. It asserts that liquidation of debt through the coercively maintained payments system has no threat to the national and world economy. Yet what is happening is that the government keeps kicking the toxic garbage upstairs which keeps accumulating unobtrusively in the attic, only to come crashing down in its own good time to cause untold amount of social damage.

## The Debt Tower Is Toppling

In the real world it is natural law, rather than man-made coercive laws, that prevail. The pathology of the regime of irredeemable currency has not been attended to, and day of reckoning has dawned. Our pathological monetary system has allowed the burgeoning of debt beyond all rhyme and reason. It has no mechanism to extinguish debt. It pretends that transferring debt to the banks, and ultimately to the government, is tantamount to extinguishing it. However, the truth of the matter is that only gold circulation is able to extinguish debt. When it is stopped in its tracks, as it is under conditions of backwardation, debt explodes.

The debt tower is toppling. Central banks work overtime printing money to plug the holes in the leaky foundation, but their traction that they could once take for granted is gone. The money they print goes into either gold hoarding or into government bonds. The monetary system has short-circuited and is in the process of burning out. Practically no money is going into the production of goods and services. The bloated economy is contracting fast. Great Depression II is upon us. The monetary system is past the point of repair. This is the story that the backwardation of gold is trying to tell those of us who have ears for hearing and brains for comprehending.

Backwardation in gold is the sweet siren song that is trying to tempt Odysseus to his doom. But Odysseus was smart enough to have himself tied, fist and foot, to the mast and had the ears of his oarsmen be plugged with wax. His ship is sailing through the dangerous waters without unloading gold.

Backwardation also gives a signal to those who are not so fortunate as to have some of the precious yellow in hand. It tells them to be prepared for a thunderous collapse of the international payments system, worse than the collapse of the twin towers of the World Trade Center. Backwardation means the inevitable contraction of the world economy, the beginning of an era of diminishing enterprise and employment, an era of snowballing business failures and poverty. Printing more irredeemable promises to pay will make this condition worse, not better.

---

*December 14, 2008*

*These and other articles of the author can be accessed at the website [professorfekete.com](https://professorfekete.com)*

---

# There Is No Fever Like Gold Fever

URL: https://newaustrianeconomics.com/archive/fekete/there-is-no-fever-like-gold-fever/
Date: 2008-12-10
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, gold-standard, sound-money, fiat-currency
Description: Fekete examines the psychology of gold investment, distinguishing between rational monetary analysis and speculative gold fever. He argues that gold should be held not as a speculative asset but as monetary insurance — and that this distinction has profound implications for how individuals and institutions should approach gold.
Editorial Note: Written December 2008 as gold attracted intense speculative interest following the Lehman collapse.
Original PDF: https://professorfekete.com/articles/AEFGoldFever.pdf

## There Is No Fever Like Gold Fever

### Antal E. Fekete

### Gold Standard University Live

### Here is an update on the backwardation in gold that started on

December 2 at an annualized discount rate of 1.98% and 0.14% to spot in the December and February contracts. It continued and worsened on December 8, 9, and 10 as shown by the corresponding rates widening to 3.5% and 0.65%. It is nothing short of awesome. This is a premonition of a coming gold fever of unprecedented dimensions that will overwhelm the world as soon as its significance is fully digested by the doubting Thomases. The worsening of backwardation must be viewed in the context of the gold price bouncing back from the lows of last week. It shows that the ‘gold bashing’ on Friday was done in the December contract. It is quite revealing that the spot price bounced back more than the futures price. The bulls are on the warpath. They have unearthed the hatchet. They have stopped eating from the hands of the clearing members.

Mish Shedlock published a disdainful criticism of my theory on the worsening backwardation in gold, calling it “nonsense” (see References below). A friend of his owns a seat on Nymex (a branch of Comex) who had this to say:

I have seen countless commodities go into backwardation for numerous reasons, the most frequent being a radical temporary divergence between immediate and overall demand. I have seen backwardations that have lasted years. The article is based on the assumption that a backwardation will necessarily lead to a breakdown of the delivery mechanism. But for every breakdown of the delivery mechanism there have been thousands of backwardations without a breakdown. Only if and when an actual breakdown occurred would the conclusions that the author drew make sense.

Well, well, one can buy himself a seat on the Nymex for sure, and the price is hefty these days, but Nymex does not deliver the understanding of monetary science along with the seat. Nor does any university anywhere in the world. To fill this obvious gap, I founded Gold Standard University Live. It is defunct today, but not because my theories are “nonsensical”.

It is defunct because Mr. Eric Sprott of Sprott Asset Management withdrew his funding after only three sessions, saying that “results do not justify the expense”. Under these circumstances I do what I can to teach all those who want to learn, and pick the “forbidden fruits” of monetary science that have been blotted out from the curriculum ― and from the gold and silver pits of Nymex.

Mish says that “there is nothing special about backwardation, period.

OK, they are rare in gold. So what?” Here is what. There is a difference between “rare” and “non-existent”. Backwardation in gold has been non-existent, and for a very good reason, too, as I have explained in my articles. (I also pointed out that there have been ‘hiccups’, or short-lived instances of backwardation. They were temporary ‘logistical’ bumps, always resolved within a day at most, and they never ever spilled over to the next actively traded delivery month.)

Mish needs to educate himself on the fundamental difference between a monetary and a non-monetary commodity, before he can grasp the idea that lasting backwardation in gold is tantamount to the realization that ‘gold is no longer for sale at any price’.

The bottom line is that there is no fever like gold fever. It is akin to St. Vitus’ dance that swept through the Christian world just before the year 1000 A.D. affecting all the people who expected the end of the world to happen at the turn of the millennium. It was far worse than the mania that swept through the world affecting all the people who expected the 2K disaster to happen a thousand years later. The coming gold fever must be distinguished from tulipomania in February 1637, when one single tulip fetched the equivalent of 20 times the annual income of a skilled worker. Gold fever is as different from a bubble as real gold is from fools’ gold. It is visceral. It has to do with one’s instinct for survival. It has no patience with logical arguments. It is highly contagious, ultimately affecting everybody. A bubble that never pops.

You may ridicule the idea that, during a prolonged backwardation, all offers to sell gold will be withdrawn. But a serious analyst must answer the question why hundreds of millions of people having gold coins under the mattress and in the cookie jar refuse to take the bait of ‘risk-free’ profits offered by backwardation. Such a thing would never ever happen to a non-monetary commodity.

The only successful corners in history were gold corners, a.k.a. hyperinflation. Keynesian and Friedmaite economists in the pay of the government thought that gold futures trading will permanently shortcircuit the forces of gold backwardation thus preventing hyperinflation from ever happening. They were wrong.

In an article The Manipulation of Gold Prices (see References below), Professor Emeritus of Economics and former Dean of the School of

### Business Administration at the University of Indianapolis, James

Conrad argues that Bernanke is different. He understands that he needs a much higher gold price in order to increase the efficiency of his airdrops. There is no better way to distribute new money among prospective spenders than putting it into the pockets of the gold bugs. (Conrad admits that he is one.) This will induce a large spending spree, holding deflationary pressures back.

According to Conrad, Bernanke is well aware that the new money he is feverishly airdropping has not stopped and will probably not stop the bloodbath in the stock market. Further devastation of share prices will render pension funds insolvent. To prevent this, the dollar needs a massive devaluation, on the pattern of Roosevelt’s tinkering with the value of gold. I quote:

Anyone who reads the written works of our Fed Chairman will know that Bernanke’s long term plan involves devaluing the dollar against gold. This is the exact opposite of the position of most prior chairmen.

He has overtly stated his intentions toward gold, many times, in various articles, speeches and treatises written before he became Fed Chairman. He often extols the virtues of F. D. Roosevelt’s gold revaluation/dollar devaluation back in 1934, and credits it with saving the nation from the Great Depression. According to Bernanke, devaluation of the dollar against gold was so effective in stimulating economic activity that the stock market rose sharply in 1934, immediately thereafter. That is something that the Fed wants to see happen again.

It is only a matter of time before gold is allowed to rise to its natural level. Assuming that about one half of the recent increase in Federal Reserve credit is neutralized, the monetized value of gold should be allowed to rise to between \$7,500 and \$9,000 per ounce as the world goes back to some type of a gold standard. In the nearer term, gold will rise to about \$2,000 per ounce as the Fed abandons its hopeless campaign to support Comex short sellers in favor of saving the other, more productive, functions of various banks and insurers.

Revaluation of gold, and a return to a gold standard, is the only way that hyperinflation can be avoided while large numbers of paper currency units are released into the economy. This is because most of the rise in prices can be filtered into gold. As the asset value of gold rises, it will soak up excess dollars, euros, pounds, etc., while the appearance of an increased number of currency units will stimulate investor psychology; and lending and economic output will increase all over the world. Ben Bernanke and the other members of the FOMC Committee must know this, because it is basic economics.

It is to be regretted that more of Professor Conrad’s admirable paper cannot be quoted here because of lack of space. To summarize:

Bernanke is prepared to throw the issuers of paper gold at the Comex to the wolves, as they have become useless, even a nuisance, by now.

Besides, the wolves must be appeased lest they devour whatever remains of the U.S. banking and insurance system.

My own position is somewhat different from Professor Conrad’s. In my view we are facing a world-wide elemental grass-root movement: the flight into physical gold ― witness the backwardation in gold. It is irresistible, and will ultimately overtake all other market forces. It will overwhelm official resistance.

### An intriguing case can be made, as is attempted by Conrad, that

Bernanke is intelligent enough to realize all this thinking that he can harness, if not hijack, the grass-root movement for his own purposes.

This is a wee-bit more intelligence than I can give credit for to the Chairman, who is a former academic himself. I find the thought surrealistic that Bernanke wants to use gold as the safety-valve through which he can release steam from an overheating deflation one day, and from an overheating inflation the next.

Be that as it may, the Brave New World of irredeemable currency sans the paper gold factory at Comex will be an entirely different world from what we have been used to for the past thirty-six years. I highlight the differences as I see them. This should be helpful in the long run, even if this backwardation is temporary and gold futures trading will return to normal, since permanent backwardation is ultimately unavoidable.

Item 1: Barrick and other gold producers that still have an open hedge book will go bankrupt.

Item 2: Other gold miners will, one after another, stop selling gold altogether, and go into hibernation.

Item 3: Junior gold mines will put off starting production indefinitely. They will consider their gold ore reserves in the ground a safer store of value than paper money in an insolvent bank.

Item 4: The closing of the gold window at the Comex will furnish an excuse for other issuers of paper gold including the bullion banks to declare bankruptcy fraudulently.

Item 5: GLD and other joint depositories of gold will be under enormous pressure to default and let the owners of the ETF shares hold the bag. Let them sue for the gold. They won’t get it: their contracts give them no right to physical gold. They will get small change, in paper. The principals will cut up the gold pie among themselves. No crumbs will trickle down to shareholders.

Item 6: Even allocated and segregated metal account gold is not safe. The temptation on the account providers to default will be irresistible. They are not going to release the gold until expressly ordered by the courts, and will make sure that no gold will be left by then.

Item 7: Central banks forfeit their gold under leases due to backwardation, causing an uproar of citizens whose patrimony was sequestered and dissipated in such an ignominious manner.

Item 8: The only market for gold will be the fragmented black markets in various countries each charging a price whatever the traffic can bear. All legal protection of the ownership of and trade in gold will be suspended. The Dark Age will descend on the trading world, just as it did when the Roman Empire collapsed.

Our present experiment with irredeemable currency can last only as long as it is able to support futures markets in gold. The declining gold basis is the hour glass: when it runs out and the last grain of sand drops, gold fever will bleed the futures markets of cash gold, and the days of the regime of irredeemable currency are numbered.

Previous episodes of experimentation lasted no more than 18 years, or half as long as the present one which has taken 36 years so far, a world record. Of course, none of the earlier episodes were supported by futures markets. Forewarned, forearmed. Get ready and move closer to the doors. When the curtain falls on the last contango in Washington, there will be panic and some people may get trampled to death at the exit.

Dear Mish, lower your gun. The topic of gold backwardation is not for you.

### References

### Monetary versus Non-monetary Commodities, April 25, 2006

### The Last Contango in Washington, June 30, 2006

### Red Alert: Gold Backwardation!!!

---

*December 4, 2008*

Has the Curtain Fallen on the Last Contango in Washington? December 8, 2008 These and other articles of the author can be accessed at the website [www.professorfekete.com](https://www.professorfekete.com)

The Nonsense about Gold Backwardation, etc., by Mike (Mish) Shedwick, December 7, 2008, [www.globaleconomicanalysis.blogspot.com](https://www.globaleconomicanalysis.blogspot.com)

The Manipulation of Gold Prices, by James Conrad, December 4, 2008, [www.seekingalpha.com](https://www.seekingalpha.com) Gold in Backwardation? Not so fast…, by ‘Hard Asset Investor’, December 2, 2008, ibid.

The Battle against Contango, by Brad Zigler, November 20, 2008, [www.hardassetsinvestor.com](https://www.hardassetsinvestor.com)

### Calendar of events

### Szombathely, Martineum Academy, Hungary, March 28-29, 2009

Encore Session of Gold Standard University Live.

### Topics: When Will the Gold Standard Be Released from Quarantine?

### The Vaporization of the Derivatives Tower

### Labor and the Unfolding Great Depression

### Gold and Silver in Backwardation: What Does It All Mean?

### San Francisco School of Economics, June-August, 2009

Money and Banking, a ten-week course based on the work of Professor Fekete.

The Syllabus of this course is can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com)

---

*December 10, 2008*

---

# Has the Curtain Fallen on the Last Contango in Washington?

URL: https://newaustrianeconomics.com/archive/fekete/has-the-curtain-fallen-on-the-last-contango-in-washington/
Date: 2008-12-08
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, contango, backwardation, permanent-backwardation, gold-standard, monetary-crisis
Description: Three days after his Red Alert essay, Fekete asks whether the December 2008 backwardation signals the permanent end of gold contango. He analyzes the evidence and argues that while this episode may be temporary, the trend of the declining basis points to permanent backwardation as the eventual endpoint.
Editorial Note: Written December 8, 2008, three days after the Red Alert.
Original PDF: https://professorfekete.com/articles/AEFHasTheCurtainFallenLastContangoInWashington.pdf

*Has The Curtain Fallen On The Last Contango In Washington?*

**Antal E. Fekete**

### Gold Standard University Live

### Here is an update on the backwardation in gold that started on

December 2. It continued and worsened on December 3, 4, and 5. So far this is the most serious signal of the economic crisis: the world is rushing headlong into a Great Depression, possibly worse than that of the 1930’s. Please remember the following analogy: the serial devaluation of currencies starting with that of the British pound in 1931 meant a drastic drop in the velocity of gold circulation. This spelled a contraction in world trade that proved catastrophic to employment and economic health in general. The gold confiscation in America in 1933 only made things worse, in particular, it was the direct cause of the decline in interest rates that, in its turn, was the chief cause of the widespread destruction of capital and bankruptcies.

I have discussed this correlation elsewhere.

Right now the backwardation in gold also means another drastic drop in the velocity of gold circulation, and it will also cause a tragic contraction in world trade. It will also be catastrophic to employment and economic health in general. Interest rates will continue to fall with a deleterious effect on capital. I don’t see that confiscation of gold is in the cards this time. It could not be enforced. People would not comply. Gold confiscation is a trick that can only be pulled off once.

A con-game won’t work for the second time.

What I see coming is that gold will be declared ‘extralegal’ by the U.S. government to prevent gold from becoming a world currency, by withholding legal protection from contracts made in terms of gold. For example, if crude oil was bought for gold and the supertanker carrying it was hijacked, and if the U.S. Navy captured the boat from the pirates, then the U.S. government would confiscate the oil as ‘contraband’, arguing that it was paid for in gold. No court in the world would give relief to the rightful owners.

I have received several inquiries how to explain the simultaneous occurrence of gold backwardation and a further fall in the price of gold. Here is my answer. Comex is at the verge of bankruptcy, at least as far as its gold trading is concerned. The trouble is twofold.

First, Comex has a problem that the shorts are overextended opening themselves to a squeeze or, ultimately, to a corner. These are attempts on the part of gold bulls to buy up the gold certificates, instruments of delivery against gold futures contracts. These certificates give you legal title to the metal deposited in Comex-approved warehouses.

Such a squeeze would cripple the operation of the exchange and make Comex lose its credibility as a viable market. When the cupboard is empty, the game is up.

Second, Comex can no longer attract sufficient quantities of gold from investors to its warehouses which, in consequence, get more and more depleted. Such a gold flow is the lifeblood not only of Comex, but of the irredeemable dollar as well. There is a world of a difference between the irredeemable dollar with the gold window of Comex open, and the irredeemable dollar with the gold window of Comex closed. The institute of the gold futures market is the prop keeping the global game of musical chairs of fiat money going. The music stops when Comex closes its gold window.

But Comex will eventually have to declare “liquidation only” policy, effectively closing its gold window. The phrase means revoking the right of holders of contracts to demand delivery on their expiring gold futures under certain circumstances. Clients have to accept settlement on their contracts in cash. This has happened in the past, e.g., in silver and palladium, although it has never happened in gold. It is not widely known that Comex would not go bankrupt de jure if it declared

“liquidation only”. Small print in the contract makes allowance for this option in case of force majeure. Nevertheless, Comex would be considered bankrupt de facto in the eyes of the public if it declared

“liquidation only” on its gold futures contracts. Comex is the residual source of the world’s only currency that is not the liability of some government, gold.

Moreover, by implication, it would also be the end of the irredeemable dollar as we know it. I am convinced that the managers of the irredeemable dollar are not afraid that their prodigious dollar proliferation policy endangers the value of the currency, Quantity Theory of Money notwithstanding. What they are afraid of is that the gold bulls will force Comex to close its gold window by cornering the supply of gold certificates. When that happens, it will be not only “gold is not for sale at any price” but also “oil is for sale only against payment in gold”.

We have to understand that what has kept up the paper dollar’s value through thick and thin, through war and peace, and through the burgeoning trade deficits and budget deficits since 1975, is Comex.

This is the reason why the Chinese still take the irredeemable dollar in payment for real goods and services, and large quantities of food can still be purchased against payment in irredeemable dollars. But once Comex is forced to close the gold window, the dollar will lose its main prop and bearings and, with them, its purchasing power, even if miraculously the U.S. could cut its trade and budget deficit to zero.

The Quantity Theory of Money is no science. It is a model, a didactic tool. It is applicable to an imaginary linear world. This world of ours, however, is highly non-linear.

I am convinced that the clearing members of Comex are desperately trying to avoid permanent backwardation in gold. Not only is the gold futures market extremely profitable for them, but their bets have been backed by central banks gold sales and leases. All the central banks have a vested interest in maintaining the global regime of irredeemable currency. The clearing members want to have their cake and eat it: they are the consistent short sellers who keep the gold price from breaking out on the upside. But this makes gold cheap causing mass withdrawals of gold from the warehouses, gold which they want to keep in the warehouses for window-dressing purposes.

Please note that these are not naked short sales. The clearing members are convinced of gold’s upside potential, no less than you are. Their game plan is that, instead of gambling with their own gold, they want to gamble with yours and mine, and with the gold of the tech-funds.

They let us buy gold futures; they let us make money occasionally.

But they know that we have to take profit from time to time because we are undercapitalized. They know that we have to use stop loss orders to avoid bankruptcy. What is worse, our stop loss orders are an open book to them. We are sitting ducks which they shoot at for fun.

So we have to sell.

But whether we buy or sell, we buy into strength and sell into weakness, which is exactly the wrong way to do business. The clearing members’ advantage is that they always buy into weakness and sell into strength, as they take the other side of the trade we have initiated. They don’t worry about being undercapitalized, because they can change the rules of the exchange capriciously, and they enjoy a back-wind due to central bank policy. So far they have succeeded.

But something ominous is happening. Most recently central banks have changed their policy. They have stopped selling and leasing gold.

Their commitment to bail out the clearing members with gold has been changed to a commitment to bail them out with paper. This is not the same thing. Central banks have stopped feeding the market with gold sales and leases. Here is the proof.

### Take Mr. Gordon Brown, the prime minister of Britain. As the

Chancellor of the Exchequer he ordered the Bank of England to sell one half of the nation’s gold reserve in one fell swoop. He even overruled the Governor of the Bank who first refused. The sale took place at the average price of \$250 in 2000, a major multi-year bottom.

Nice shot, Mr. Brown! The Chancellor has earned the name of the bottom-picker of the century.

Now, as prime minister, he could order the Bag Lady of Threadneedle Street to sell the other half. If she did, it would be a sale fetching a price three times higher. Better still, she could buy back the gold in 30 days at a discount. (This is the meaning of backwardation in gold.) But look who isn’t selling on these unbeatable terms? Why, Me-too Gordy isn’t, that’s who. He has learnt that a bird in hand is worth a dozen in the bush. He knows that if he falls to the temptation of ‘riskfree profits’, he may never see his gold again. It would disappear in the black hole of irredeemable currency, where the other half did.

Gordy has made himself the laughing stock of the world once as the bottom-fisher of the century. He does not want to do it again. Who can blame him? If he did, he could earn a second nickname: the sweetestsinging crow of the century, and he doesn’t want that.

As you may recall, Aesop in one of his fables relates the story of the crow perched on a tree holding one big loaf of cheese in his beak. The fox beneath is hungry and salivating. He decided to get the cheese by hook or crook. He knew he could not get it by brute force, but he might get it through flattery, by massaging the bird’s vanity. The fox calls the crow his friend. He is telling his friend that of all the singing birds he loves the sweet singing of the crow best. Would his friend be kind enough to sing for him?

After a bit of coaxing the crow started crowing, but the fox did not stay to listen. He made off with the cheese as fast as his legs would take him.

Mr. Brown can print pounds galore, and even swap them for dollars.

But he cannot print gold. Neither can his colleague, Helicopter Ben.

That’s why he is willing to airdrop an unlimited amount of paper, but would not airdrop even one grain of gold to alleviate the economic crisis of his own making. These gentlemen still think that the present crisis is a subprime crisis and it can be tackled by flooding the system with newly created money. Scarcely do they see that, instead of being a real estate crisis, a stock market crisis, or a banking crisis, this is a gold crisis. It can only be resolved by involving gold, in particular, by remobilizing the world’s gold reserves. The most straightforward way of doing this would be to open the U.S. Mint to gold (more precisely, to the seigniorage-free and unlimited coinage of gold on private account), as Sir Isaac Newton, Master of the Royal Mint of London had done in the year 1717. Unfortunately, this option is no longer available because the trust in the irredeemable dollar has been fatally undermined by the backwardation in gold. No longer will people be coaxed out of their physical gold by the promise of risk-free profits, however large, payable in paper.

One possible explanation of the backwardation in gold is that the clearing members of Comex, who could have prevented it from happening by allowing gold to break out on the upside, have changed tactics and decided to step aside and let backwardation do the job.

They hoped that it would pull in gold from the moon. The risk-free profits that backwardation promises to yield would tempt holders to swap cash gold for paper gold.

Well, so far it is not happening. Fewer than 10,000 ounces of new gold was registered at the warehouses during this episode of backwardation so far, not enough to deliver on even 100 contracts. By contrast, an extra 132 December contracts were presented for delivery by their holders.

A second possible explanation of the backwardation in gold and the decline of the gold price to \$740 on Friday, December 5, is that the clearing members in desperation attempted to demoralize the bulls by their persistent selling of cash gold and December futures. Hefty margin calls went out to intimidate holders of the December contract.

But the tactic seems to have backfired: while both the cash price and the December futures price fell, the futures price fell more.

Backwardation was the result. The bulls refused to swap their cash gold for the December futures, in spite of further decline in the basis (making the swap more tempting still). The contest between the good guys (longs standing for delivery) and the bad guys (the clearing members) may not be resolved until December 31, the last day when the latter must deliver, or declare ‘liquidation only’. Right now it looks as if the longs are quite prepared to call the bluff. They are willing to face further decline in the gold price to force the issue. They know full well that the last thing the clearing members want is to declare force majeure, because that would kill the goose laying the golden eggs for them.

Please remember that the bad guys have another secret weapon. They can raise the margin requirement to any level higher than the value of the underlying contract. Nasty, isn’t it? The idea is to force the longs to sell their contracts and, in doing so, give up their right to take delivery. Such a measure, however, would betray the utter helplessness of the clearing members. It would be oil on the fire, triggering a world-wide rush into cash gold, ruining other paper gold markets (including ETF’s) in the process.

A third possible outcome is that all the gold demanded will be delivered in December, and the deterioration in the warehouses’ holdings will be papered over in January. No matter, the battle is already shaping up for the February confrontation when the bad guys will be in an even weaker position.

To sum up, the gold price is not the issue right now. The low gold price is a side show trying to scare the longs out of their cash gold positions. Here the iron rule of the commodity markets applies: you can squeeze the bears, but you can never squeeze the bulls. The reason is that the best you can do to shake the bulls out of their position is to tempt them with risk-free profits to give up physical gold against future gold. That is happening right now. But it appears that, for the first time, cash gold can no longer be coaxed out with paper profits.

After all, gold is gold, and paper is paper.

This is why this battle is so crucial: it is the first real confrontation between physical gold and the paper dollar. Paper gold is marginalized. We know that, in the long run, the paper dollar cannot stand up to physical gold. However, as Keynes has warned us, in the long run we are all dead. This time it’s different. The long run ends on December 31, 2008.

The “last contango in Washington” refers to the end of the hegemony of the irredeemable dollar that is in no position to throw its weight around any more. The advent of backwardation means that a writing has appeared on the wall: “Mene tekel, upharsin”: the dollar has been weighed and found wanting. On the last day of this year of economic and financial surprises we shall know whether the backwardation in gold is permanent, or whether it will become permanent only after the inauguration of the new president, at the expiration of the next active gold futures contract in February.

Either way, this is a contest the bad guys cannot win. They are at the end of their rope. The low gold price means that they are left with just enough rope to hang themselves.

### References

### The Last Contango in Washington, June 30, 2006

### Red Alert: Gold Backwardation!!!

---

*December 4, 2008*

This and other articles of the author can be accessed at the website [www.professorfekete.com](https://www.professorfekete.com) Note: the author is writing a follow-up piece:

### There’s No Fever Like Gold Fever

Stay tuned.

### Calendar of events

### Szombathely, Martineum Academy, Hungary, March 28-29, 2009

Encore Session of Gold Standard University Live.

### Topics: When Will the Gold Standard Be Released from Quarantine?

### The Vaporization of the Derivatives Tower

### Labor and the Unfolding Great Depression

### Gold and Silver in Backwardation: What Does It All Mean?

### San Francisco School of Economics, June-August, 2009

Money and Banking, a ten-week course based on the work of Professor Fekete.

The Syllabus of this course is can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com)

---

*December 8, 2008*

---

# RED ALERT: Gold Backwardation

URL: https://newaustrianeconomics.com/archive/fekete/red-alert-gold-backwardation/
Date: 2008-12-05
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, permanent-backwardation, gold-standard, monetary-crisis
Description: Fekete issues an urgent warning: gold has entered backwardation for the first time in recorded history. Spot gold prices exceeding futures prices signals that holders of physical gold are refusing to lend it into the futures market even for a profit — indicating a profound loss of confidence in the paper monetary system.
Editorial Note: Written December 5, 2008 as gold entered temporary backwardation during the post-Lehman crisis. This was the event Fekete had been predicting since his early basis analysis essays.
Original PDF: https://professorfekete.com/articles/AEFRedAlert.pdf

monetary system, yet it did not deserve to be reported in the press: gold went to backwardation for the first time ever in history. The facts are as follows: on December 2nd, at the Comex in New York, December gold futures (last delivery: December 31) were quoted at 1.98% discount to spot, while February gold futures (last delivery: February 27, 2009) were quoted at 0.14% discount to spot. (All percentages annualized.) The condition got worse on December 3rd, when the corresponding figures were 2% and 0.29%. This means that the gold basis has turned negative, and the condition of backwardation persisted for at least 48 hours. I am writing this in the wee hours of December 4th, when trading of gold futures has not yet started in New York.

According to the December 3rd Comex delivery report, there are 11,759 notices to take delivery. This represents 1.1759 million ounces of gold, while the Comex-approved warehouses hold 2.9 million ounces. Thus 40% of the total amount will have to be delivered by December 31st. Since not all the gold in the warehouses is available for delivery, Comex supply of gold falls far short of the demand at present rates. Futures markets in gold are breaking down. Paper gold is progressively being discredited.

Already there was a slight backwardation in gold at the expiry of a previous active contract month, but it never spilled over to the next active contract month, as it does now: backwardation in the December contract is spilling over to the February contract which at last reading was 0.36%. Silver is also in backwardation, with the discount on silver futures being about twice that on gold futures.

As those who attended my seminar on the gold basis in Canberra last month know, the gold basis is a pristine, incorruptible measure of trust, or the lack of it in case it turns negative, in paper money. Of course, it is too early to say whether gold has gone to permanent backwardation, or whether the condition will rectify itself (it probably will). Be that as it may, it does not matter. The fact that it has happened is the coup de grâce for the regime of irredeemable currency. It will bleed to death, maybe rather slowly, even if no other hits, blows, or shocks are dealt to the system. Very few people realize what is going on and, of course, official sources and the news media won’t be helpful to them to explain the significance of all this. I am trying to be helpful to the discriminating reader.

Gold going to permanent backwardation means that gold is no longer for sale at any price, whether it is quoted in dollars, yens, euros, or Swiss francs. The situation is exactly the same as it has been for years: gold is not for sale at any price quoted in Zimbabwe currency, however high the quote is. To put it differently, all offers to sell gold are being withdrawn, whether it concerns newly mined gold, scrap gold, bullion gold or coined gold. I dubbed this event that has cast its long shadow forward for many a year, the last contango in Washington ― contango being the name for the condition opposite to backwardation (namely, that of a positive basis), and Washington being the city where the Paper-mill of the Potomac, the Federal Reserve Board, is located.

This is a tongue-in-cheek way of saying that the jig in Washington is up. The music has stopped on the players of ‘musical chairs’. Those who have no gold in hand are out of luck. They won’t get it now through the regular channels. If they want it, they will have to go to the black market.

I founded Gold Standard University Live (GSUL) two years ago and dedicated it to research of monetary issues that are pointedly ignored by universities, government think-tanks, and the financial press, centered around the question of long-term viability of the regime of irredeemable currency. Historical experiments with that type of currency were many but all of them, without exception, have ended in ignominious failure accompanied with great economic pain, unless the experiment was called off in good time and the authorities returned to monetary rectitude, that is, to a metallic monetary standard. It is also worth pointing out that the present experiment is unique in that all countries of the world indulge in it. Not one country is on a metallic monetary standard, under which the Treasury and the Central Bank are subject to the same contract law as ordinary citizens. They cannot issue irredeemable promises to pay and keep them in monetary circulation through a conspiracy known as check-kiting.

Not one country will be spared from the fire and brimstone that once rained on the cities of Sodom and Gomorrah as a punishment of God for immoral behavior.

In all previous episodes there were some countries around that did not listen to the siren song and stayed on the gold standard. They could give a helping hand to the deviant ones, thus limiting economic pain. Today there are no such countries. If you want to be saved, you must be prepared to save yourself.

You cannot understand the process whereby a fiat money system self-destructs without understanding the gold and silver basis. The Quantity Theory of Money does not provide an explanation, because deflation may well precede hyperinflation, as it appears to be the case right now.

For these reasons I placed the study of the gold and silver basis on the top of the list of research topics for GSUL. These can serve as an early warning system that will signal the beginning of the end. The end is approaching with the inevitability of the climax in a Greek tragedy, as the heroes and heroines are drawn to their own destruction. The present reactionary experiment with paper money is entering its death-throes. GSUL has had five sessions and could have established itself as an important, and even the only, source of information about this cataclysmic event: the confrontation of the Titanic (representing the international monetary system) with the iceberg (representing gold and its vanishing basis) as the latter is emerging from the fog too late to avoid collision.

Unfortunately, this was not meant to be: GSUL has to terminate its operations due to a decision made by Mr. Eric Sprott, of Sprott Asset Management, to terminate sponsoring GSUL, saying that “results do not justify the expense.” I sincerely regret that our activities did not live up to the expectations of Mr. Sprott, but I am very proud of the fact that our research is still the only source of information on the vanishing gold basis and its corollary, the seizing up of the paper money system that threatens the world, as it does, with a Great Depression eclipsing that of the 1930’s.

Let me summarize the salient points of discussion during the last two sessions of GSUL for the benefit of those who wanted to attend but couldn’t. The gold basis is the difference between the futures and the cash price of gold. More precisely it is the price of the nearby active futures contract in the gold futures market minus the cash price of physical gold in the spot market. Historically it has been positive ever since gold futures trading started at the Winnipeg Commodity Exchange in 1972 (except for some rare hiccups at the triple-witching hour.

Such deviations have been called ‘logistical’ in nature, having to do with the simultaneous expiry of gold futures and the put and call option contracts on them. In all these instances the anomaly of a negative basis resolved itself in a matter of a few hours.)

In the commodity futures markets the terminus technicus for a positive basis is contango; that for a negative one, backwardation. Contango implies the existence of a healthy supply of the commodity in the warehouses available for immediate delivery, while backwardation implies shortages and conjures up the scraping of the bottom of the barrel. The basis is limited on the upside by the carrying charges; but there is no limit on the downside as it can fall to any negative value (meaning that the cash price may exceed the futures price by any amount, however large).

Contango whereby the futures price of gold is quoted at a premium to the spot price is the normal condition for the gold market, and for a very good reason, too. The supply of monetary gold in the world is very large relatively speaking.

Babbling about the ‘scarcity of gold’ reflects the opinion of uninformed or badly informed people. In terms of the ratio of stocks to flows the supply of gold is far and away greater than that of any commodity. Silver is second only to gold. It is this fact that makes the two of them the only monetary metals. The impact on the gold price of a discovery of an extremely rich gold field, or the coming on stream of an extremely rich gold mine, is minimal ― in view of the large existing stocks. Paradoxically, what makes gold valuable is not its scarcity but its relative abundance, which evokes that superb confidence in the steadiness of the value of gold that will not be decreased by a banner production year, nor can it be increased by withdrawing gold coins from circulation. For this reason there is no better fly-wheel regulator for the value of currency than gold. The same goes, albeit to a lesser degree, for silver.

Here is the fundamental difference between the monetary metal, gold, and other commodities. Backwardation will pull in stocks from the moon as it were, if need be. The cure for the backwardation of any commodity is more backwardation. For gold, there is no cure. Backwardation in gold is always and everywhere a monetary phenomenon: it is a reminder of the incurable pathology of paper money. It dramatizes the decay of the regime of irredeemable currency.

It can only get worse. As confidence in the value of fiat money is a fragile thing, it will not get better. It depicts the paper dollar as Humpty Dumpty who sat on a wall and had a great fall and, now, “all the king’s horses and all the king’s men could not put Humpty Dumpty together again.” To paraphrase a proverb, give paper currency a bad name, you might as well scrap it.

Once entrenched, backwardation in gold means that the cancer of the dollar has reached its terminal stages. The progressively evaporating trust in the value of the irredeemable dollar can no longer be stopped.

Negative basis (backwardation) means that people controlling the supply of monetary gold cannot be persuaded to part with it, regardless of the bait. These people are no speculators. They are neither Scrooges nor Shylocks. They are highly capable businessmen with a conservative frame of mind. They are determined to preserve their capital come hell or high water, for saner times, so they can re-deploy it under a saner government and a saner monetary system.

Their instrument is the ownership of monetary gold. They blithely ignore the siren song promising risk-free profits. Indeed, they could sell their physical gold in the spot market and buy it back at a discount in the futures market for delivery in 30 days. In any other commodity, traders controlling supply would jump at the opportunity. The lure of risk-free profits would be irresistible. Not so in the case of gold. Owners refuse to be coaxed out of their gold holdings, however large the bait may be. Why?

Well, they don’t believe that the physical gold will be there and available for delivery in 30 days’ time. They don’t want to be stuck with paper gold, which is useless for their purposes of capital preservation.

December 2 is a landmark, because before that date the monetary system could have been saved by opening the U.S. Mint to gold. Now, given the fact of gold backwardation, it is too late. The last chance to avoid disaster has been missed.

The proverbial last straw has broken the back of the camel.

I have often been told that the U.S. Mint is already open to gold, witness the Eagle and Buffalo gold coins. But these issues were neither unlimited, nor were they coined free of seigniorage. They were sold at a premium over bullion content. They were a red herring, dropped to make people believe that gold coins can always be obtained from the U.S. Mint, and from other government mints of the world. However, as the experience of the past two or three months shows, one mint after another stopped taking orders for gold coins and suspended their gold operations. The reason is that the flow of gold to the mints has become erratic. It may dry up altogether. This shows that the foreboding has been evoked by the looming gold backwardation, way ahead of the event. Now the truth is out: you can no longer coax gold out of hiding with paper profits.

If the governments of the great trading nations had really wanted to save the world from a catastrophic collapse of world trade, then they should have opened their mints to gold. Now gold backwardation has caught up with us and shut down the free flow of gold in the system. This will have catastrophic consequences. Few people realize that the shutting down of the gold trade, which is what is happening, means the shutting down of world trade. This is a financial earthquake measuring ten on the Greenspan scale, with epicenter at the Comex in New York, where the Twin Towers of the World Trade Center once stood. It is no exaggeration to say that this event will trigger a tsunami wiping out the prosperity of the world.

### References

By the same author:

### The Rise and Fall of the Gold Basis, June 23, 2006

### Monetary and Non-Monetary Commodities, June 25, 2006

### The Last Contango in Washington, June 30, 2006

### Gold, Interest, Basis, March,7, 2007

### Gold Vanishing into private Hoards, May 31, 2007

### Opening the Mint to Gold and Silver, February 5, 2008

These and other articles of the author can be accessed at the website [www.professorfekete.com](https://www.professorfekete.com) Note: the author is coming out with a follow-up piece:

### Has the Curtain Fallen on the Last Contango in Washington?

Stay tuned.

### Calendar of events

### Szombathely, Martineum Academy, Hungary, March 28-29, 2009

Encore Session of Gold Standard University Live.

### Topics: When Will the Gold Standard Be Released from Quarantine?

### The Vaporization of the Derivatives Tower

### Labor and the Unfolding Great Depression

### Gold and Silver in Backwardation: What Does It All Mean?

### San Francisco School of Economics, June-August, 2009

Money and Banking, a ten-week course based on the work of Professor Fekete.

The Syllabus of this course is can be seen on the website: [www.professorfekete.com](https://www.professorfekete.com)

---

*December 4, 2008*

---

# San Francisco School of Economics: Money and Banking

URL: https://newaustrianeconomics.com/archive/fekete/san-francisco-school-money-and-banking/
Date: 2008-12-05
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, real-bills, new-austrian-economics, sf-school, sound-money
Description: A syllabus and overview for Fekete's Money and Banking course at the San Francisco School of Economics (Gold Standard University), covering gold standard theory, real bills, the gold basis, and the history of monetary systems. The document outlines the New Austrian School's approach to monetary economics as an academic curriculum.
Editorial Note: The course syllabus for Fekete's Money and Banking program, published December 2008.
Original PDF: https://professorfekete.com/articles/AEFMoneyAndBanking.pdf

### Part One: The Origin of Money

1.

2.

3.

4.

5.

6.

### The Axiom of Declining Marginal Utility

### Direct versus Indirect Exchange

### The Dual Nature of Money

### Arbitrage

### The Disequilibrium Theory of Price Formation

### A Critique of the Quantity Theory of Money

### Part Two: The Origin of Interest

7.

8.

9.

10.

11.

12.

### The Two Sources of Credit: Saving and Clearing

### The Propensity to Save and the Rate of Interest

### Exchanging Wealth and Income

### The Productivity of Capital versus Time Preference

### The Market Process Determining the Rate of Interest

### The Structure of Capital Markets

### Part Three: The Origin of Discounting

13.

14.

15.

16.

17.

18.

### The Bill of Exchange

### The Propensity to Consume and the Discount Rate

### The Market Process Determining the Discount Rate

The Marginal Productivity of Social Circulating Capital The Discount House and the Acceptance House

### The Rise and Fall of Commercial Banking

Part Four: The Fall of and Rise of the Gold Standard 19.

20.

### The Error of Ludwig von Mises

### Adam Smith’s Real Bills Doctrine

### Volume II: Further Readings

### The Rise and Fall of Commercial Banking

Illicit Interest Arbitrage: Borrowing Short to Lend Long The Bond Market

### The Bill Market

### Self-Liquidating Credit

### The Origin of the Bank Note

### The Bill of the Goldsmith

### The Principle of Capitalizing Incomes

---

# Thou Shalt Not Crucify Labor on This Cross of Paper Money

URL: https://newaustrianeconomics.com/archive/fekete/thou-shalt-not-crucify-labor-on-this-cross-of-paper-money/
Date: 2008-11-27
Section: Popular Economics
Difficulty: accessible
Concept Tags: fiat-currency, capital-destruction, gold-standard, sound-money, real-bills
Description: Fekete updates William Jennings Bryan's 1896 Cross of Gold speech, arguing that it is now paper money — not gold — that crucifies labor. Irredeemable currency impoverishes workers through capital destruction and unemployment, and the essay calls on labor leaders to recognize that the gold standard is their natural ally.
Editorial Note: Written November 2008. The reversal of Bryan's famous phrase encapsulates Fekete's argument that gold now protects labor, and paper money exploits it.
Original PDF: https://professorfekete.com/articles/AEFLaborLeaders.pdf

### The “crime of 1873”

My title is a paraphrase of the 1896 battle-cry of William Jennings Bryan during his presidential bid. He was talking about ‘crucifying mankind on a cross of gold’. Bryan was protesting against the unconstitutional closing of the U.S. Mint to silver. Congress inadvertently suspended the unlimited coinage of the standard silver dollar, which it had no authority to do under the Constitution.

Bryan called it “the crime of 1873”.

No battle-cry was issued during this year’s presidential campaign by the finalists in protest against our present unconstitutional paper money system, even though it has started a wave of unprecedented unemployment that would sweep through the land in the wake of the current financial crisis and the official response to it: further serial cuttings of the rate of interest.

Politicians have long ago vacated the field of warning people about the danger caused by violations of the monetary provisions of the Constitution. It is now incumbent on the leadership of American labor to call the workers to rise in protest against the job-destroying policies of the government. Please take a few moments and bear with me as I go through a simple monetary explanation of the job-destruction process that has been going on in America for the past thirty years through serial cuttings of the rate of interest, that will reach fever-pitch next year.

### Serial rate-cuts destroy the wage fund

Suppose you are a worker taking home \$50,000 a year in wages. When your income-flow is capitalized at the current rate of interest of, say, 5 percent, you arrive at the figure of \$1,000,000. The sum of one million dollars or its equivalent in physical capital must exist somewhere, in some form, the yield of which will continue paying your wages. Capital has been accumulated and turned into plant and equipment to support you at work. Part of your employer’s capital is the wage fund that backs your employment. Assuming, of course, that no one is allowed to tamper with the rate of interest.

Suppose for the sake of argument that the rate of interest is cut in half to 2½ percent. Nothing could be clearer than the fact that the \$1,000,000 wage fund is no longer adequate to support your payroll, as its annual yield has been reduced to \$25,000. This can be described by saying that every time the rate of interest is cut by half, capital is being destroyed, wiping out half of the wage fund. Unless compensation is made by adding more capital, your employment is no longer supported by a full slate of capital as before. Since productivity is nothing but the result of combining labor and capital, the productivity of your job has been impaired. You are in danger of being laid off ― or forced to take a wage cut of \$25,000.

### Lemming-like rush into certain disaster

I have news for you. Employers are not in the habit of compensating for the destruction of capital caused by falling interest rates. Rather, they welcome the cut as manna sent from heaven. They are kissing the hand that is strangling them. They are as badly misinformed about the lethal effects of a falling interest rate structure as the rest of society. They confuse a low interest rate structure with a falling one. No less than employees, employers are hurt by the destruction of capital caused by serial rate cuts. After all, it is their capital, too, that is being destroyed. Nevertheless, they accept at face value the official propaganda line that “falling interest rates are good for you”. Employers are like lemmings running to their own certain disaster.

### The “crime of 1971”

In the euphoria of celebrating the advent of the irredeemable dollar in 1971, politicians and economists have ‘forgotten’ to look at the untoward consequences of the New Brave World of synthetic credit. Not only was the dollar destabilized by the ‘crime of 1971’; interest rates were cut adrift as well.

The U.S. Treasury was soon forced to print 16 percent coupons on its 30 year bonds which would not otherwise sell.

This did not present much of a problem to the Treasury, since interest on bonds was now payable in irredeemable dollars. The same paper, the same amount of ink, and the same printing press would produce the coupon at the same cost, whether it carried the figure 4 or 16, with which the obligation would be discharged.

However, bringing down the rate of interest from 16 percent to its normal level of 4 percent was a different story altogether. It meant that the rate had to be halved twice from 16 to 8 and from 8 to 4 percent, destroying three quarters of the wage fund. Is there any wonder why so many well-paid American industrial jobs were driven offshore in the intervening years, as production was being outsourced?

Academia and media were silent on the real cause of the de-industrialization of America: the destruction of capital through serial rate-cutting. They are still silent as they expect that the Federal Reserve will do more money magic and pump still more money into the economy, causing rates to fall still more. They are oblivious to the fact that this will destroy still more capital in the process, pulling more rug from underneath employment.

### Vanishing capital

The problem is vanishing capital. During the past thirty years capital was destroyed across the board as the long-term rate was pushed down from 16 to 4 percent, and the short-term rate from 22 to 1 percent. The process is insidious: only one in a million can identify the causal relation between vanishing interest and vanishing capital. As a result the captains of industry are not aware of what is happening to the capital of their enterprise until it is too late and they are forced to fold tent. Even then, they have no idea what has hit them. It would never cross their mind to blame irredeemable currency and the serial cutting of interest rates for the disaster. Hat in hand, they go to Washington to beg for bailout money with which they can shore up their capital structure. They don’t realize that Washington will claw it all back just as soon as the next round of rate cuts are announced.

Make no mistake about it: vanishing capital does not disappear without a trace.

It is being siphoned away clandestinely from the capital account of businesses, to benefit the issuers of irredeemable dollars and their cohorts. These honorable gentlemen cut rates with their right hand and grab the obscene profits thus generated on their bond portfolio with their left hand. It is legalized embezzlement. Keynesians say that the government can turn the stone into bread through driving down the rate of interest to zero. It would be more accurate to say that the government, in a vampire-like fashion, sucks the blood of labor through the bleeding of their wage fund.

### The fate of the auto industry

As a result of vanishing capital the American auto industry, not so long ago the envy of the world, is tottering at the brink. The statistical likelihood of the three giant auto-makers running out of capital at the same time is nil. The fact that they do is the evidence of outside interference. The capital of the auto industry has been eroded and ultimately destroyed by the serial rate cuts of the Federal Reserve. It is true that the industry has been adding new capital in the form of state-of-the-art technology. But it could not keep up with the relentless serial rate-cutting. The Fed can cut rates faster than the auto industry can build and equip new factories.

The blame for the suffering should be put squarely on the criminal check-kiting conspiracy between the Treasury and the Federal Reserve. They issue and swap liabilities which they are neither willing nor able to meet. It is a charade, pretending to serve the interest of the national economy when, in fact, they are destroying the nation’s capital.

The destruction is not visible to the naked eye. The details are in the bookkeeping. That’s why the sabotage is so hard to detect. As the rate of interest is being pushed down, it makes inroads on the wage fund. Employers are unable to meet their payroll because the falling interest-rate structure calls for ever larger capital to fund it. Unemployment is the result, which is becoming widespread and chronic.

Under a stable interest rate structure none of this would happen. The auto industry and its workers would have a bright future, as they did before the ‘crime of 1971’ hit them. Every worker who is being laid off should be reminded of that fact. They should know that they are being sacrificed on the altar of Mammon. They should understand that they are being crucified on the cross of paper money.

### Capital destruction at an ever faster rate

Please also note that the rate of capital destruction is accelerating as we are getting closer to the black hole of zero interest. In principle halving the rate can continue indefinitely. In reality, ever smaller absolute cuts will have ever greater destructive effect on the wage fund. While in the 1980’s it took an 8 percent decline to wipe out half of the wage fund, right now a 2 percent, and thereafter a mere 1 percent cut will do the trick, causing the same amount of damage to employment. This means that the level of economic pain increases ever faster, soon reaching the point where it will become unbearable.

The situation is more than desperate. The political process has failed. The president-elect has committed himself to the status-quo. He will not challenge the unlimited power usurped by the Fed, as his nomination of the president of the Federal Reserve Bank of New York to the post of Treasury Secretary indicates. This nomination evoked the comment, echoed in the New York Times on November 25, that “Geithner deserves retirement, not promotion”. (He is 47.) Obama’s utterances during the election campaign seem to suggest that he believes in Keynesian prestidigitation, turning the stone into bread through serial cuts in the rate of interest, and in Friedmanite money magic of the printing press.

### Labor’s finest hour

The only remaining hope the country has is that labor will not tolerate the ongoing destruction of capital. It will not take it lying down any more. It will take to the streets and confront the small reactionary elite running our monetary regime, including Geithner. This is the most destructive system ever devised: the regime of irredeemable currency. Every time it has been tried in history it failed miserably. As the current crisis clearly shows, this time is no different. What is different is that this time the entire world is on irredeemable paper money. That has never happened before. Accordingly, the stakes are immeasurably higher as irredeemable currency is getting ready to self-destruct.

Labor must take the initiative and demand that Congress put an immediate end to the mindless destruction of capital. Congress should stop the Federal Reserve from pursuing a monetary policy of open-ended deliberate interest-rate cuts. The economy is now like a runaway train with brakes disabled, entering a downhill section of tracks. Crash is certain. At the end of the run the country could be completely denuded of capital, with a large part of its labor force idled.

Labor could be the savior of the country in forcing a return to constitutional money at the eleventh hour, by demanding that the Obama administration open the U.S. Mint to gold and silver. That measure would enable the brakes on the money-train. It would stabilize foreign exchange and interest rates and stop the shredding machine, now spinning out of control, from destroying capital. This would be labor’s finest hour: saving the United States from financial ruin and ignominy.

This country has an intelligent, dedicated, and industrious labor force. The best in the world. It should step into the breach. Time for street action has come, if we want to prevent blood from flowing in the streets later.

### References

By the same author:

### Revisionist View of the Great Depression, May 11, 2002

The Central Banker, Quartermaster General of Deflation, January 1, 2003

### Gold Is the Cure for the Job-Drain, September 23, 2003

### Real Bills and Unemployment, September 26, 2005

Unemployment: Human Sacrifice on the Altar of Mammon, September 30, 2005

### Is Our Accounting System Flawed? June 16, 2008

Revisionist Theories of Depressions: Can It Happen Again? November 4, 2008

These and other articles of the author can be accessed at the website [www.professorfekete.com](https://www.professorfekete.com)

### Calendar of events

Szombathely, Martineum Academy, Hungary, last weekend of March, 2009

Encore Session of Gold Standard University Live.

As is known, Mr. Eric Sprott of Sprott Asset Management, Inc., has withdrawn financial support saying that, in his opinion, the results of Gold Standard University Live do not justify the expenditure. In consequence

GSUL is forced to terminate operations. However, in recognition of the unprecedented crisis of the regime of irredeemable currency presently unfolding, there will be an Encore Session in the form of a weekend seminar.

### Topics: When Will the Gold Standard Be Released from Quarantine?

### The Vaporization of the Derivatives Tower

### Labor and the Unfolding Great Depression

### San Francisco School of Economics, June-August, 2009

Money and Banking, a ten-week course based on the work of Professor

### Fekete

Further announcements will be made on the website: [www.professorfekete.com](https://www.professorfekete.com)

---

*November 29, 2008*

---

# Revisionist Theory of Depressions: Can It Happen Again?

URL: https://newaustrianeconomics.com/archive/fekete/revisionist-theory-of-depressions-can-it-happen-again/
Date: 2008-11-04
Section: Popular Economics
Difficulty: intermediate
Concept Tags: real-bills, federal-reserve, new-austrian-economics, capital-destruction, deflation, monetary-policy
Description: Fekete applies his revisionist theory of the Great Depression to the 2008 crisis, arguing that the same mechanism is operating: the Federal Reserve's destruction of self-liquidating credit has produced a deflationary spiral that monetary stimulus cannot reverse. The crisis can and will happen again because the underlying monetary disorder was never corrected.
Editorial Note: Written November 2008 as the financial crisis was at its most acute.
Original PDF: https://professorfekete.com/articles/AEFRevisionistTheoryOfDepressions.pdf

### Address before the Economic Club of San Francisco

---

*November 4, 2008*

### Those who refuse to learn from history are bound to repeat it

It is amazing how fast events unfold in the present crisis. When we picked our subtitle “Can It Happen Again” for this talk just a few months ago, it was merely an afterthought, looking at a remote possibility. Now, on this Election Day, we are in the midst of an unacknowledged depression possibly worse than that of the 1930’s.

The financial mayhem on Wall Street is spilling over every other street in America, nay, in the whole world. In all likelihood job losses currently reported are only the tip of a monstrous iceberg.

When Olivier Blanchard, the IMF’s chief economist, was asked the question whether the world was sinking into another Great Depression, he confidently replied that the chance was “nearly nil”.

He added that, after all, we have learned a couple of tricks in the intervening 80 years.

So we have, indeed, a couple of Keynesian tricks, and a few more Friedmanite nostrums ― while we were made to forget the accumulated economic wisdom of the ages. But we have not learned what mistakes, made by policy-makers, have caused the Great Depression of the 1930’s. And we certainly have not learned how to avoid the same mistakes again.

Keynesian and Friedmanite precepts rule economics, with no quarter given to traditional economics that has been exiled. It looks like the fulfillment of the prophecy: “those who refuse to learn from history are bound to repeat it”.

Promises to pay which the Treasury and the Fed are neither willing nor able to honor For the past eight years or so, in my writings and lectures, I have been advocating what I call the “revisionist theory and history of the Great Depression.” In the cacophony of Keynesian and Friedmanite propaganda on promoting the Brave New World of irredeemable currencies, my message was lost. Keynes and Friedman, for all their disagreements on the details how to “manage” the national and world economy, were in solid agreement on their categorical rejection of metallic monetary standards, that is to say, money based on positive rather than negative values. Our present monetary system, universally acclaimed by academia and media as the ‘wave of the future’, is based on negative values: the value of debt. Keynes and Friedman both have put the blame for the Great Depression on the “contractionist propensities” of the gold standard. And that is all that’s being taught at virtually all universities around the globe about the causes of the Great Depression.

The proposition is put under official taboo that there is no valid defense for giving the Fed and the Treasury the privilege to issue promises to pay which they are neither willing nor able to honor

(except insofar as they honor them as part of their the check-kiting conspiracy).

### Bonds minus gold equals interest rates halved again and again

My revisionist thesis is simple: the truth is the exact opposite of the officially upheld economic doctrine. The cause of the Great Depression was the forcible removal of gold from the international monetary system, including the suspension of the gold standard by Great Britain in 1931, and the confiscation of the gold coins of the citizens of the United States in 1933.

To see this clearly we have to contemplate the main role played by gold in the monetary system which is this: gold is the only asset that can successfully compete with government bonds for the savings of people with a conservative frame of mind. As long as gold is available as an alternative to bonds, the public purse is controlled by the people. If they don’t like government profligacy, they can sell their bonds and stay invested in gold. This is the only message that those in power would read or understand: the rise in the cost of borrowing by the government. The rate of interest goes up. The red lights in the corridors of power start flashing.

Confiscation of gold means cutting the wire to those red lights. It means the removal of the only effective competition of government bonds, gold coins. In the absence of gold government bonds have a captive market. They enjoy a monopoly. The government can afford to ignore all criticism of its monetary and fiscal policies. It can do with the public purse as it pleases. Conservative bondholders no longer have a choice: they have to buy and hold the bond. The public purse is no longer controlled by the people. The government can cause the public debt to go to any high level. The government can cause the cost of its own borrowing to fall to any low level. In formula: bonds minus gold equals interest rates halved, and halved, and halved; again, and again, and again:

### B – G = (½)np

Keynesians butt in: “Hey, wait a minute, that’s just it. Isn’t this a good thing to have? Isn’t it a wonderful thing to turn the stone into bread; to abolish scarcity, by making capital abundant through a low interestrate policy?” Confusing a low with a falling rate of interest Nobody denies that a low interest-rate structure, brought about by a high rate of voluntary savings, is a great blessing to society. What we face here is a fatal confusion of low with falling interest rates. If the fall is prolonged, then the net effect on the economy is lethal, as it causes the destruction of capital which, unless checked in time, could bring the entire economy to a screeching halt.

Capital destruction is a subtle process which even the victims themselves are unable to diagnose. The suggestion that pari passu with falling interest rates the market price of bonds rises is uncontroversial. It is an undeniable fact of the markets. It follows that as interest rates keep falling, bond speculators reap constant capital gains, a reward not for saving but for gambling. Their gains do not come out of nowhere. They are siphoned off from the capital accounts of the producers. Entrepreneurs are unsuspecting. They don’t know what has hit them when they find their enterprise denuded of capital.

The last thing they suspect is falling interest rates which they welcome, like everybody else, as a relief. Whatever it is, relief it is not. It is the kiss of death.

### Liquidation value of bonded debt

To see the causal relation clearly, let us go through the process of capital destruction step-by-step. As the name suggests, “liquidation value” is the lump sum it takes to liquidate debt, should it be necessary to retire it before maturity ― for example, in case of mergers, acquisitions, takeovers, shotgun marriages, not to mention nationalization. The point is that as the rate of interest falls, the liquidation value of debt rises. Rise it must, because the stream of interest payments, originally set when interest rates were higher, is now being capitalized at a lower rate. Since it represents a lower value, it falls short of liquidating the debt.

For example, when I repatriated to Hungary and sold my house with a mortgage in Canada, the bank would not accept the balance remaining in settlement. It insisted on my paying a ‘penalty’ arguing that the prevailing rate of interest was now lower, and the liquidation value of my mortgage higher. In other words, I suffered a capital loss on account of falling interest rates.

Here is another example. When the rate of interest falls, the market immediately bids up the price of bonds. The higher bond price represents the higher liquidation value of the underlying debt.

Creditors will not let debtors off the hook, unless they can take an extra pound of flesh for their consideration. If this is deemed unjust, then complaints should be lodged with the gods, who ordained that man be mortal. As is well-known, for immortal gods a future stream of payments need not be discounted, and full credit is given for each and every installment. On Mount Olympus, the rate of interest is zero.

Unfortunately, however, man is not immortal. For him, the rate of interest is positive. It is for this reason that falling interest rates, far from alleviating the burden of debt, aggravate it.

### Open market operations of the Fed

The grand scheme to make interest rates fall artificially started by the Fed’s breaking the law in the 1920’s. Open market operations were introduced clandestinely as a way to inject new money into the economy. The Fed was to enter the open market to buy government bonds, paying for them with newly created dollars.

It is important to understand that open market operations are illegal. They were not authorized under the Federal Reserve Act of 1913. In fact, the Act specifically stated that government bonds were ineligible for the purposes of collateral in backing Federal Reserve notes and deposits. Eligible collateral was confined to gold and real bills. Open market operation were ‘legalized’ ex post facto only later, in the 1930’s, and the practice went on to become the chief engine of inflation through the monetization of government debt on a massive scale. It should be noted that retroactive laws are not recognized by the U.S. Constitution.

Open market operations, apart from being illegal, are no less a hare-brained scheme. Authors responsible for developing this illegal practice have been ignorant of its effect on speculation, and the effect of the resulting speculation on the rate of interest. Bond speculators are very much alive to the Fed’s need to make periodic trips to the open market to buy the bonds. They lie in ambush to preempt it. They buy the bonds first, only to dump them in the lap of the Fed at a profit later. In effect, bond speculators get a free ride at public expense.

They pocket risk free profits. The entire playing field of the national economy becomes tilted, favoring parasites and penalizing producers.

This is the fatal flaw in the Keynesian edifice: the chrysophobic (anti-gold) monetary system has a built-in instability manifested by the unopposed bull speculation in the bond market. The net result is an interest-rate structure that is persistently drifting lower. Keynesians pretend that their idol has made a discovery in justifying deficit spending made possible through open market operations, thus benefiting mankind. But as my analysis shows, the goodies distributed by Keynesian economics are not costless. They come at the expense of society’s accumulated capital. Capital dissipation is masked by the euphoria of free lunch and pork. The damage to society dawns on the people later. By then it is too late to stop the rot. Irreparable damage has been done. The capital of society has been destroyed. Everybody is made to suffer because of Keynesian profligacy, justified under false pretenses.

### The banking panic of the 1930’s

The Great Depression was not caused by the vanishing of demand, as suggested by Keynes. It was caused by the vanishing of capital. Nor was the destruction of capital confined to the producing sector. It affected the financial sector as well. From 1930 to 1933 more than nine thousand banks closed their doors for good in the United States.

Depositors and shareholders lost about \$2.5 billion. As a share of the economy, that would be the equivalent of \$340 billion today.

Economic historians give credit to Franklin Delano Roosevelt for meeting the banking crisis head-on. Only a few days after he was inaugurated as president in March, 1933, he declared a bank holiday and ordered all the people under the jurisdiction of the United States to surrender their gold coins. Although Roosevelt promised to return the gold after the banking crisis has subsided, this promise was apparently made in bad faith. No sooner had he confiscated the gold than he marked up its value, leaving people with paper worth 56 percent less. This neat piece of presidential chicanery was called “devaluation of the dollar in the national interest.”

### Old Coppernose

Yet it was plain stealing, nothing less, as the great blind senator from Oklahoma, Thomas P. Gore, had told the president in his face in the Oval Office. Senator Gore, moreover, in a debate on the Senate floor, also said this: “Henry VIII approached total depravity as nearly as imperfections of human nature would allow. But the vilest thing that Henry ever did was to debase the coin of the realm!” Old Coppernose, as he was nicknamed, did not confiscate the people’s gold coins. He merely diluted them. When the gold wash wore thin, the effigy of Henry on the coin revealed a copper nose underneath. People suffered a loss as a result of this royal chicanery, to be sure, but at least they could keep their coin and have a good laugh at the expense of their sovereign.

Keynesian chrysophobes were jubilant. Roosevelt was their hero.

They celebrated the advent of synthetic money and credit, laying great stores on the ‘rational’ management of the national currency. The money supply was expanded and deflation halted. At least so the fable said. In reality, Roosevelt was pouring oil on the fire. Capital destruction got a new boost. As I have already explained, interest rates continued their free-fall as the only competitor to government bonds, gold, had been eliminated. Keynesian economists got the fallen god, the gold standard, to kick around. No one thought that the fallen god could, phoenix-like, rise from its ashes in the fullness of times and have retribution.

### Ominous parallels

It is hard to avoid seeing parallels to the current situation. Interest rates have been falling for 28 years from 16 percent in 1980 to 4 percent today. Capital destruction has taken a great toll on the producing sector, causing a large part of American industry fold tent and seek salvation overseas where wage rates are lower. As far as the financial sector is concerned, up until recently it appeared that the banks have escaped the death-trap of capital destruction. Well, we now know that they have not. Banking capital, just like industrial capital, has also been destroyed by the relentless fall of interest rates.

Banks no longer trust one other’s promises to pay, because they suspect that their counter-party has no capital backing those promises.

Banks are walking dead men, artificially propped up by the Fed and the Treasury, anxious to avoid the blame for inaction that ushered in the Great Depression in 1930. They are working hard to keep credit flowing. But the financial situation they face is incomparably more difficult than that of the 1930’s. This is not an illiquidity crisis. This is a solvency crisis. It is due to an insidious destruction of capital.

The Fed and the Treasury are trying to recapitalize the banks by infusion of new capital in the form of freshly created Federal Reserve credit. Incidentally, the Fed is just one of the walking dead men. It does not have the collateral necessary to create new credit to the tune of \$700 billion. The Treasury has to donate the Fed the bonds directly.

The last time this imprudent departure from the principles of sound central banking has been invoked was during World War II, when the exigencies of war finance were used to justify the bypassing of the open market. The vexing question is whether irredeemable promises by the Fed and the Treasury are sufficient to jump-start banking in the United States.

There are no contingency plans for the mobilization of gold reserves to recapitalize the banks. Gold is the ultimate liquidator of debt, toxic and non-toxic. Why not use the ultimate liquidator, if we really mean business in eliminating toxic debt from the system, and if we really want to proceed with the task of deleverage to shrink the bloated balance sheets of banks? Well, the ideological obstacles are insurmountable.

### Sword of Damocles

But the real difference between now and the 1930’s is the incredible deterioration in the credit of the United States, which makes the present situation far more dangerous. The international credit of the United States in the 1930’s was very strong. You were looking at the greatest creditor country in history. Today, four score years later, you are looking at the greatest debtor country in history, in need to borrow abroad to pay interest on its outstanding debt, in addition to borrowing in order to maintain consumption patterns. A large part of the debt is held by foreigners, not under the jurisdiction of the United States, and certainly not subject to its taxing power. This is the sword of Damocles hanging on a thin thread. At the drop of the hat sources of foreign credits could run dry. Nobody knows what will happen then.

Yet the dollar is not in immediate danger. Superficially it is strong and getting stronger. Treasury bonds are in great demand as the “flight to safety” continues. For a couple of years, maybe a little longer, the dollar will hang on “by the skin of its teeth”.

But the writing is on the wall: the strong dollar will be beaten down by the U.S. government in the course of the trade war, to revive American exports. In addition, the bill for the unprecedented bailouts will come in soon enough. The government deficit will reach stratospheric heights. When the critical mass is reached and the threshold of tolerance in total indebtedness is surpassed, the run on the dollar will become inevitable. In the meantime, serious challenges to the hegemony of the dollar may be presented from friends and foes alike. This is an explosive situation. We are on uncharted waters, aboard a rudderless ship.

Worst of all, we lack leadership. Those in charge of our monetary and fiscal system are dyed-in-the-wool Keynesians and Friedmanites. They have grown up on Keynesian and Friedmanite bunk no longer applicable in the 21st century. They were caught completely by surprise by the fast unfolding of events. They do not understand what is happening to this country, let alone the world, nor do they have any idea how further damage can be prevented. The only trade they know is to cut interest rates; to print more money, rain or shine, and airdrop it from helicopters indiscriminately. Their compass, economic forecasting, the pride of mainstream economics, has turned out to be tea-leaf reading. The only people who predicted this maelstrom were non-conformist economists beyond the pale. They will not be allowed to kick in the ball.

The outlook is bleak indeed. Keynesians and Friedmanites will continue at the helm. Their faulty perception will prompt them to throw even more bad money after bad money. They will beat down the ‘strong’ dollar. There will be competitive depreciation of currencies world-wide, an echo of the trade wars and beggar-thyneighbor policies of the 1930’s. At the end of the road lie the ruination of the world’s monetary and payment system, economic cooperation, and division of labor.

### The ”blame-it-on-the-gold-standard game” is over

We have been told that deflations, depressions, bank runs, massive unemployment, wholesale bankruptcies can only happen under the gold standard. In a modern, government-managed economy, equipped with scientific money-creating techniques, bolstered by the fine-tuning management of demand, these ills of society have been relegated to the history books.

A few months of the year 2008 exploded the myths nurtured for much of the twentieth century. The stark reality is that we have not conquered scarcity with interest-rate suppressing techniques. We have not succeeded fine-tuning the national economy with monetary and fiscal policy. We have not learned how to combine high wages with high employment. We cannot turn the stone into bread. We have only been tinkering at the edges, pretending that we can ladle out riches to all comers by government fiat.

This is not a subprime crisis. This is not a real estate crisis. This is not even a dollar crisis. This is a gold crisis. The gold standard was sabotaged in 1933 when the U.S. government reneged on its domestic gold obligations, and again in 1971 when it reneged on its international gold obligations. The gold standard strikes back ― with a lag measured not in years but in decades.

How naïve it was to believe that the gold standard could be abused and exiled with impunity! How dense it was to think that under the regime of irredeemable currency basic freedoms can be maintained! How insane it was to embrace the notion of legal tender as the ticket to a bright future!

### Events of this fateful year 2008 have dumped Keynesian and Friedmanite economics to the garbage heap of science, where Marxian economics, astrology, alchemy, and many other discredited and discarded theories, the names of which have by now faded from memory, already rest.

The sooner the world leadership realizes this, the better.

By the same author:

## Revisionist View Of The Great Depression

---

*May 11, 2002*

## Is Our Accounting System Flawed?

### It may be insensitive to capital destruction

---

*June 16, 2008*

## Deflation Or Runaway Inflation?

### The denouement of the gold-in-exile saga

---

*July 4, 2001*

## A Tale Of Three Lies

---

*July 11, 2001*

## The Central Banker As The Quartermaster General Of

## Deflation

---

*January 1, 2003*

## Tainted Research

### Lysenkoism ― American style

---

*June 4, 2003*

## The Bubble That Broke The World

---

*June 30, 2003*

## The Wrecker’S Ball Of Swinging Interest Rates

---

*August 27, 2002*

## Gold Is The Cure For The Job-Drain

---

*September 23, 2003*

## Burning Bridges And Halfway Houses

---

*March 22, 2005*

## Real Bills And Unemployment

### A revisionist theory and history of money

---

*September 26, 2005*

## Unemployment: Human Sacrifice On The Altar Of Mammon

---

*September 30, 2005*

## Confiscation Of Gold Coins And The Real Causes Of The

## Great Depression

The Real Bills Doctrine and the Quantity Theory of Money in Federal Reserve Lore

---

*August 11, 2006*

## When Atlas Shrugged

### Part 1: The lure and lore of risk-free profits

### Part 2: Gibson’s Paradox and the gold price

---

*October 11, 2006*

### THE GOLD STANDARD STRIKES BACK…with a 36-year lag

The way to resolve the credit crisis: Recapitalize the banks with gold October 3, 2008

## Monetary Reform: Gold And Bills Of Exchange

---

*November 3, 2008*

### Calendar of events

### Canberra, Australia, November 11-14, 2008

Gold Standard University Live, Session Five. (This is the last session of GSUL since our sponsor, Mr. Eric Sprott of Sprott Asset Management, Inc., has withdrawn his support saying that in his opinion the results do not justify the expenditure. Come along and judge for yourself.) This 4-day seminar is a Primer on the Gold Basis ― Trading Tool for Gold Investors, Marketing Tool for Gold Miners, and Early Warning System for Everybody Else.

### Inquiries: feketeaustralia@yahoo.com

### Canberra, Australia, November 15, 2008

Panel Discussions: The chickens of 1933 and 1971 are coming home to roost and take out bank capital.

### Inquiries: feketeaustralia@yahoo.com

### Szombathely, Martineum Academy, Hungary, March 2009

### Panel Discussions: When Will the Gold Standard Be Released from Quarantine? The Vaporization of the Derivatives Tower.

Further announcement will be made on the website: [www.professorfekete.com](https://www.professorfekete.com)

---

# Monetary Reform: Gold and Bills of Exchange

URL: https://newaustrianeconomics.com/archive/fekete/monetary-reform-gold-and-bills-of-exchange/
Date: 2008-11-03
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, real-bills, self-liquidating-credit, sound-money, new-austrian-economics
Description: Fekete outlines a complete monetary reform program based on two pillars: restoring gold as the monetary reserve and restoring the real bills market for self-liquidating credit. He argues these two reforms are inseparable — gold without real bills produces monetary contraction, and real bills without gold produces inflationary credit expansion.
Editorial Note: Written November 2008 in the depths of the financial crisis. Fekete's most complete programmatic statement of monetary reform.
Original PDF: https://professorfekete.com/articles/AEFMonetaryReformGoldAndBillsOfExchange.pdf

*Monetary Reform: Gold And Bills Of Exchange*

Address before the Civil Society Institute at Santa Clara University November 3, 2008

### Antal E. Fekete

### Gold Standard University

### Introduction

The Great Depression of the 1930’s was not due to the ‘contractionist propensities’ of the gold standard as alleged by John M. Keynes. Nor was it due to fractional reserve banking as alleged by Murray Rothbard. Rather, it was due to the government’s sabotaging the clearing system of the international gold standard, the bill market.

Adam Smith’s Real Bills Doctrine reigned supreme in monetary science throughout the 19th century, and rightfully so. It explained how it was possible to refine division of labor, and to lengthen production processes in making them ‘more roundabout’ in order to improve the efficiency of labor and capital ― without causing monetary contraction through unnecessarily invading the pool of circulating gold coins, and without tying up savings in order to finance circulating capital. Clearly, additional fixed capital can only be financed through increased savings. Additional circulating capital, however, need not involve savings: it can be financed through improvements in clearing. Circulating capital can be self-financing, provided that the goods involved are demanded urgently enough by the consumers.

In this address I look forward to the release of the gold standard from a forty-year quarantine, to become one of the pillars of the reconstruction after the present credit collapse has run its course. In order to be viable, the new gold standard has to have a valid clearing system. Bill circulation would spring up spontaneously. In other words, we have to have a gold standard of the type that prevailed in the world prior to 1914, when international trade was financed not through gold flows across national boundaries, but through trading bills of exchange drawn on London. It would not be a gold exchange standard as that of the years 1920-1971, with government promises to pay replacing real bills. But it would not be Murray Rothbard’s socalled 100 percent gold standard either, which is phantasmagoria.

### Self-liquidating credit

In spite of obvious differences between the two, it is customary to extend the concept of credit to include clearing. In more details, in addition to credit arising out of the propensity to save that finances fixed capital, we also consider self-liquidating credit arising out of the propensity to consume that finances circulating capital. The latter does not involve lending; it involves clearing.

Goods making up circulating capital must be in the final phases of production and distribution, and they must move sufficiently fast to the ultimate, gold-paying consumer. Thus, then, the bill of exchange is the embodiment of self-liquidating credit ― so called as the credit is liquidated directly with the gold coin surrendered by the consumer in 91 days or less (91 days being the length of the seasons of the year in the temperate zones, forcing a change of the types of merchandise in greatest demand).

Detractors of the Real Bills Doctrine studiously avoid reference to its prestigious pedigree and its author, Adam Smith. They also ignore the fact that, as a matter of merchant custom, producers and distributors hardly ever pay cash for the maturing merchandise as it is passed on from one hand to the next. Instead, they endorse the bill of exchange and, in doing so, assume liability to pay it at maturity. This transaction is called ‘discounting’ as the payee applies an appropriate discount, calculated at the current discount rate, to the face value of the bill, proportional to the number of days remaining till maturity.

Banks need not be involved.

### Chicken or egg?

Such a bill circulation was universal in the city-states of Italy during the Quattrocento and, more recently, in 18th century in Lancashire before the Bank of England opened its branch in Manchester. This was duly observed by Ludwig von Mises in his 1912 treatise The Theory of Money and Credit, although he stopped short of investigating the economic forces animating spontaneous bill circulation.

Unlike the question whether chicken was first or the egg, the question whether bills or banks came into existence first has a definite answer. Logically and historically, bills predated banks. What is more, it is perfectly feasible to have an economy without banks, where circulating bills emerge as suppliers deliver semi-finished consumer goods to the producers. Instead of recognizing this fact, detractors link bills and banks as if they were Siamese twins. They are not.

### A ‘fairy’ tale

Let us look at another historical instance of clearing that was vitally important in the Middle Ages: the institution of city fairs. The most notable ones were the annual fairs of Lyon in France, and Seville in Spain. They lasted up to a month and attracted fair-goers from places as far as 500 miles away. People brought their merchandise to sell, and a shopping list of merchandise to buy. One thing they did not bring was gold coins. They hoped to pay for their purchases with the proceeds of their sales. This presented the problem that one had to sell before one could buy, but the amount of gold coins available at the fair was far smaller than the amount of merchandise to sell. Fairs would have been a total failure but for the institution of clearing.

Buying one merchandise while, or even before, selling another could be consummated perfectly well without the physical mediation of the gold coin. Naturally, gold was needed to finalize the deals at the end of the fair, but only to the extent of the difference between the amount of purchases and sales. In the meantime, purchases and sales were made through the use of scrip money issued by the clearing house to fair-goers when they registered their merchandise upon arrival.

Those who would call scrip money “credit created out of nothing” were utterly blind to the true nature of the transaction. Fairgoers did not need a loan. What they needed, and got, was an instrument of clearing: the scrip, representing self-liquidating credit.

### Goods in bottoms

Another example of clearing in action is world trade prior to 1914.

Suppose a cargo ship is ready to sail from Tokyo to Hamburg carrying in its bottom consumer goods in urgent demand. The sea-voyage takes up to 30 days with several stops en route. Does the importer need to raise a loan to pay the supplier for the goods in the bottom prior to sailing? Hardly. The merchandise has a ready market upon arrival.

The cargo is insured against losses at sea. Accordingly, the supplier bills the importer for value received f.o.b. Tokyo, payable in 30 days in London. The importer endorses the bill, attaches the insurance documents, and sends it back to the supplier. The boat is now ready to sail. The supplier has an instrument he could use as ready cash to pay his own suppliers, or he can keep the bill to maturity as an earning asset. When the boat docks in Hamburg, the local wholesale merchant pays for the cargo with a sight bill on London with which the importer can meet his maturing obligation. No loan or lending is involved in all this, only clearing. The pool of circulating gold coins has not been invaded, nor are savings tied up for 30 days while the goods in urgent demand move from the Far East to Western Europe.

### The tale of the cuckoo’s egg

1909 was a milestone in the history of money. That year, in preparation for the coming war, the note issue of the Bank of France and of the Reichsbank of Germany were made legal tender. Most people did not even notice the subtle change. Gold coins and bank notes kept circulating as before. It was not the disappearance of gold coins from circulation that heralded the coming destruction of the world’s monetary and payments system. It was the advent of legal tender. It was the French and German government’s decision to stop paying civil servants in gold coin who were now forced to accept paper money. Private firms immediately followed suit: they also started paying their employees with bank notes. Never mind that the bank notes were redeemable in gold coin; this change effectively meant sabotaging the clearing system of the international gold standard. It short-circuited bill circulation. Bills were supposed to be paid at maturity in the form of a present good, the gold coin, obtained from the consumer who, in turn, was supposed to get paid in gold coin by his employer on every payday. Now they were paid in the form of a future good, the bank note. Legal-tender coercion created a leakage in the gold circulation process.

The banks continued using real bills as an earning asset to back the note issue. But other subtle changes were to alter the character of the world’s monetary system beyond recognition. The cuckoo has invaded the neighboring nest to lay her egg surreptitiously. In addition to bank notes originating in bills of exchange, bank notes originating in finance bills (including treasury bills) have made their appearance for the first time. In due course the cuckoo chick would hatch and push the native chick out of the nest. In five years, by 1914, the lion’s share of bank portfolios would be replaced by finance bills. The real bill has become an endangered species. In another few years it became extinct. Note that, unlike real bills, finance and treasury bills are not self-liquidating. The change-over from bank notes backed by real bills to bank notes backed by finance bills was the last nail in the coffin of the clearing system of the international gold standard.

### Borrowing short and lending long

Finance bills are backed by the odds, never the certainty, that a speculative inventory of goods, or equities, or investments in brick and mortar, may be unwound without a loss. If the odds do not play out in time, the finance bill will be ‘rolled over’. This is tantamount to borrowing short and lending long ― invitation to disaster. By contrast, a real bill are never ever rolled over. If not paid in gold upon maturity, the drawer of the bill will go bankrupt and his name will be blacklisted at the clearing house for good.

Finance bills made the portfolio of banks illiquid. Potential demand for gold coins, should holders of bank notes want to exercise their legal right to redeem them, could no longer be satisfied. To take away this right was the reason for making bank notes legal tender in the first place. Redemption would never be a problem as long as the banks’ assets consisted of real bills exclusively. Every single day oneninetieth of the outstanding bank notes would mature into gold coins, which were available for redemption. Normally this would suffice to satisfy daily demand.

But what about abnormal demand? Well, a real bill is the most liquid earning asset that a bank can have. At any time somewhere in the world there is demand for it. In particular, banks that have a temporary overflow of gold would be more than anxious to exchange it for real bills. Thus banks would not have the slightest difficulty to get gold in exchange for real bills in the international bill market. The assumption that there will always be takers for real bills offered is just as safe as the assumption that people will want to eat, get clad, keep themselves sheltered and warm tomorrow and every day thereafter.

### The chimera of fractional reserve banking

This explodes the blanket condemnation of fractional reserve banking.

Detractors are barking up the wrong tree. They should condemn the practice of discounting finance bills. Actually, ‘fractional reserve’ as applied to banks with nothing but real bills in their portfolio is a misnomer. The reserves are gold plus bills maturing into gold. The reserves are not fractional, as they fully back the note and deposit liability of the bank. By contrast, if the bank portfolio has a component of finance bills, the designation ‘fractional reserve’ is appropriate. It may not be possible to get gold in exchange for finance bills when the crunch comes.

### Reflux

The process of retiring bank notes, after the merchandise serving as the basis for their issue has been removed from the market by the ultimate gold-paying consumer, is called ‘reflux’. Some authors, including Ludwig von Mises, have ridiculed the concept of reflux calling it deus ex machina. They argued that banks were only interested in credit expansion, not in reflux. Not for one moment would they entertain the idea of voluntarily withdrawing bank notes from circulation when the underlying real bill matured. Instead, they would lend them out at interest again and again, to enrich themselves at the expense of the public.

This is not a valid argument. For the stronger reason, you could also ridicule the entire legal system in asking the rhetorical question: “what is the point of making laws when they will be broken anyhow?” You cannot judge the merit of an institution by the behavior of those who are set upon destroying it.

### The highest achievement of the human spirit and intellect

The havoc that the silent monetary revolution of 1909 ushering in legal tender bank notes would wreak upon society had not been foreseen. Nor was the causal relation recognized between the expulsion of real bills from bank portfolios and the massive unemployment that followed it. In Germany alone, 8 million people, or nearly 50 percent of the trade union membership lost their jobs after 1929. Economists have failed to point out the causal nexus between the two events 20 years apart. Here is the explanation of what happened.

Real bills finance the movement of consumer goods, including wages paid to people handling the maturing merchandise through the various stages of production and distribution. That part of the circulating capital paid out in wages is called the wage fund. The size of the wage fund needed to move the mass of consumer goods through these stages, if financed out of savings, would be staggering. Quite simply, it could not be done. No conceivable economy would produce savings so prodigiously as to be able to finance it as part of the circulating capital that society needed in order to flourish at present levels of security and comfort.

Fortunately, there is no need to employ savings in such a wasteful manner. Circulating capital can be financed through selfliquidating credit. The discovery of this fact is one of the great achievements of the human spirit and intellect. The impact on human life of the invention of the circulating bill of exchange is fully commensurate with that of the invention of the wheel. Detractors of the Real Bills Doctrine have missed one of the most exciting developments of our civilization: the discovery of self-liquidating credit as it emerges in the wake of the disappearance of risks at the end of the production process, when maturing goods get within earshot of the final gold-paying consumer.

### Destruction of the wage fund

This near-perfect system was allowed to disintegrate in the wake of the 1909 legal tender legislation. By ‘crowding out’ real bills from the monetary system, governments have inadvertently destroyed society’s wage fund. It was there to allow wages to be paid as much as 91 days in advance of merchandise being sold to the ultimate consumer. When real bills were replaced by non-self-liquidating finance bills, payment of wages has become haphazard. Employment was made touch-andgo, hiring, ‘hand-to-mouth’. This threatened with unemployment on a massive scale, unless governments were willing to assume responsibility for paying wages. Eventually, to avoid undermining social peace, they had to do just that. Governments invented the socalled ‘welfare state’ paying out so-called ‘unemployment insurance’ to people who could have easily have found employment had the wage fund been preserved through ensuring the proper functioning of the bill market, the clearing system of the gold standard.

What has been hailed as a heroic job-creation program appears, in the present light, a miserable effort at damage control by the same government that has destroyed the wage fund in the first place.

Economists share responsibility for the disaster. They have never examined the 1909 decision to make bank notes legal tender from the point of view of its effect on employment. They should have demanded that, instead of treating the symptom: unemployment, governments remove the cause of the disease: the destruction of the clearing system of the gold standard, the bill market. Had the governments allowed bill circulation to return at the end of the hostilities in 1918, the wage fund would have been replenished at once. Unemployment would not have arisen. Recall that it was not a problem before 1909.

### The greatest fiasco of all times

The problem of destroying the clearing system of the gold standard by expelling self-liquidating credit from the system in 1909 was further aggravated in 1971 when the gold standard itself was destroyed. By 2008 the festering crisis has become a fully blown credit collapse, encompassing the entire globe.

We must have the humility to admit that it was our reckless experimentation with irredeemable currency and synthetic credit that resulted in this fiasco greater than any other man-made disaster in history. The runaway Debt Tower of Babel is toppling, and the quadrillion-dollar-strong global derivatives monster is vaporizing.

There is no bottom to this collapse. The financial system is selfdestructing. It is in a death-spiral. Every wave of losses in the mortgage market, in the stock market, in hedge funds, or in derivatives triggers a new wave of losses. This will continue until total exhaustion is reached.

It is futile to expect the Fed and the Treasury to regain control of the careening financial system, even if all the central banks of the world pooled resources. There are not nearly enough dollars in existence to cover the derivatives losses, despite the Fed’s endless stream of bailout money, and despite the Treasury’s endless stream of bailout bonds donated to the Fed for collateral, which the latter needs but hasn’t got, to create more bailout money. Halving interest rates again and again is oil on the fire. It has been the main cause for capital destruction, and contributes directly to unemployment.

### The way out

In discussing the necessary monetary reform to be introduced after the dust settled, the rehabilitation of the gold standard and its clearing system, the bill market, must be a matter of first priority. The main cause of the disaster was the elimination of self-liquidating credit from the international monetary system, a process that started in 1909 with the introduction of legal tender bank notes. It took almost a full century to run its devastating course before the financial system started unraveling in February, 2007. That is the date, it will be recalled, when the cost of credit-default swaps shot up first, the salvo marking the beginning of the end.

During that unfortunate century, the 20th, self-liquidating credit based on positive value, gold, was forcibly replaced with ‘synthetic credit’ based on negative value, debt. Once the regime of irredeemable currency was in place there was no way to rein in the fast-breeder of debt in the system. We are forced to draw two conclusions:

(1)

There is just no alternative to self-liquidating credit. That is to say, the production and distribution of consumer goods must be financed through bills of exchange.

(2)

There is just no alternative to the gold standard. The regime of irredeemable currency is based on debt. Once adopted, the fast breeder of debt is engaged and will, before long, start spinning out of control.

Solving the problem of the monetary system will also solve the problem of unemployment. Once real bills start circulating, the wage fund will be replenished at once, out of which wages can be paid to all those eager to earn them for work in providing the consumer with goods and services in most urgent demand.

If we want to exorcise the world of the incubus of unemployment with which it has been saddled by greedy governments in making their bank notes legal tender, not only must we return to the international gold standard, but we must also rehabilitate its clearing system, the bill market. In this way the wage fund can also be resurrected. Then, and only then, can the so-called welfare state, paying workers for not working, and farmers for not farming, be dismantled.

---

*November 3, 2008.*

### Reference

The author has a course entitled The Real Bills Doctrine of Adam Smith that can be accessed at the website: [www.professorfekete.com](https://www.professorfekete.com)

---

# The Mechanism of Capital Destruction

URL: https://newaustrianeconomics.com/archive/fekete/the-mechanism-of-capital-destruction/
Date: 2008-10-16
Section: Popular Economics
Difficulty: scholarly
Concept Tags: capital-destruction, interest-theory, fiat-currency, federal-reserve, new-austrian-economics
Description: Delivered to the Committee for Monetary Research and Education, this essay provides Fekete's most systematic account of how irredeemable currency destroys capital. The mechanism: falling interest rates induced by open-market operations cause capital to be consumed rather than accumulated, gradually depleting the productive base until crisis becomes unavoidable.
Editorial Note: Originally presented to the Committee for Monetary Research and Education (CMRE) in October 2008. One of Fekete's most rigorous statements of the capital destruction mechanism.
Original PDF: https://professorfekete.com/articles/AEFCMRE.pdf

### Address at the Annual Dinner of the

Committee for Monetary Research and Education, CMRE on October 16, 2008

### New York City

Madam President, Ambassador Middendorf, Distinguished Guests,

Ladies and Gentlemen:

### Happy Birthday CMRE!

It was 75 years ago, in 1933, that the predecessor of CMRE, the Economists’ National Committee on Monetary Policy was formed by a group of monetary scientists in response to the Roosevelt Administration’s emergency measures such as suspending the gold standard and devaluing the dollar. The Committee pointed out that abandoning the gold-standard violated sound economic and moral principles, let alone the Constitution. Strong protests were lodged calling attention to the dangers involved in the regime of irredeemable currency, which invites management based on political opportunism or expediency, rather than on economic and market forces. The Committee also pointed out that monetary and fiscal measures designed to create purchasing power artificially not only served to perpetuate existing maladjustments, but could be expected to lead to new ones. The mission of the Committee was to study all pertinent issues in the field of money and credit, and to expose the weakness of unsound monetary proposals such as lowering interest rates or raising prices by fiat, monetizing the government debt and merging all monetary and fiscal control in the hands of a single authority.

In 1971 the successor Committee, CMRE, took over the torch holding it high as a beacon, and to spread light into the dark corners of the conspiracy of the U.S. Treasury and the Federal Reserve System.

CMRE pointed out the economically and socially harmful consequences of currency manipulation through unsound monetary and fiscal practices.

### Ladies and Gentlemen, please sing along with me “Happy

### Birthday To You!”

### Cassandra’s plight

Sad to say, as it turns out, the 75th anniversary is an unhappy one: CMRE’s Cassandra-role has come full circle. As you may recall Cassandra, the youngest daughter of King Priam of Troy, fell asleep in the temple of Apollo. The god was enamored with her beauty. He promised to teach her the art of prophecy in return for her love. She accepted the offer, but when it was her turn to deliver, she reneged on the bargain. Feeling double-crossed, Apollo was outraged. But it was too late now: there was no way to “un-teach” Cassandra. Still, the god thought of a way to revenge her: to the gift of prophecy he added the curse that, though Cassandra always spoke the truth, nobody would ever believe her.

CMRE’s fate is similar: the jealous gods stopped people from believing her dire predictions which were dismissed, even ridiculed, by the mainstream. Now, as some of these predictions have come true and credit collapse is a reality, the drama is unfolding before our very eyes. We are not reading history: we are living it. The global banking system has run out of capital and is in ruins, bringing the world to the brink of abyss.

### Remember the great antagonists at CMRE dinners of old: Hans

Sennholz and John Exter? Sadly, they are no longer with us. Their endless debates centered on the question whether it will all end in a hyper-inflation or a hyper-deflation. Now we know: we are going to have the worst of both worlds. The global banking system is disintegrating in hyper-deflation; the irredeemable dollar will survive only to succumb to hyperinflation later. In the meantime, it will be depression that may eclipse the Great Depression of the 1930’s.

My task here tonight is to point out the ultimate causes of the crisis, and to describe a viable resolution ― if my Cassandra prophecy is not drowned out in the cacophony surrounding the collapse of the economy.

Destabilization of interest rates ― wrecker of productive capital The problem goes right back to the U.S. government’s foolish decision to destabilize interest rates by cutting the dollar adrift from its gold moorings in 1971. It was a case of declaring bankruptcy fraudulently. The unintended consequences of the default were most serious, even though academia and media refused to analyze them.

They blithely assumed that the U.S. was free to renege on its international gold obligation with impunity.

As a consequence of the default interest rates shot up to 20 percent by 1980, from where they started their long descent that still continues.

The public’s perception is that declining interest rates are good for you, and they are good for the economy. Not so long ago academia and media were ecstatic in singing the praise of Alan Greenspan and his Fed for bringing about the Nirvana of the regime of falling interest rates.

This perception is a colossal mistake. A falling interest-rate structure is lethal. It is an insidious destroyer of capital. It means that wealth is stealthily siphoned away from the capital accounts of the producers, in order to enrich the latter-day pirates, the bond speculators who make obscene profits in the falling interest-rate environment.

As is well known, falling interest rates and rising bond values march in lock-step, albeit in opposite directions. We are all familiar with the fate of TV manufacturers and steel-makers in America. What has hit them? Well, their capital was destroyed by the relentless fall of interest rates. The writing is on the wall concerning the fate of the auto-makers. What is ailing them? The same thing: the fading of their capital. Well-paid jobs in car-manufacturing will also migrate to Asia, leaving the only jobs, hamburger-flipping that cannot be outsourced, for the American workers.

Destabilization of interest rates ― wrecker of financial capital For a time it appeared that capital devastation was confined to the productive sector, that it would spare the financial sector. After all, the latter was ready to try any and all innovations, fair and foul, in order to squeeze the last drop of profits out of the system by juggling mortgages, bonds, and equities. One of these innovations was derivatives, in particular, credit-default swaps.

The present crisis did not start in August, 2007, as widely assumed. It started half-a-year earlier, in February, when the price of credit-default swaps (essentially the premium on insuring bond values) took off like a rocket. It dawned upon the world that the financial sector had no immunity to capital destruction. Bank capital has been devastated just as insidiously as productive capital has.

Falling interest rates mean that bank capital has been financed at rates far too high. The resulting shortfall in capital should be compensated in the balance sheet by repeated injections of new capital. If banks fail to do this, then they are paying out phantom profits in dividends and compensation. They pile more losses upon losses. When they run out of capital, as sooner or later they must, capital dissipation stops, for there is nothing left to dissipate. For the banks it means sudden death.

### The wrecker’s ball of swinging interest rates

You may have seen the wrecker’s ball in action. It is lowered into the building through the roof. Once inside, it is made to swing wide enough to knock down the opposite walls. The action of swinging interest rates on the economy is similar. Rising rates destroy capital by rendering it submarginal. Falling rates, on the other hand, destroy capital by raising the liquidation-value of debt, making it an unbearable burden on the firm.

Interest rates have been falling for the past 28 years. The present banking and credit crisis is a direct consequence of this prolonged fall.

A glance at the interest rate chart will convince you of that. It shows a fairly stable curve leading up to 1971. At that point the swinging of the wrecker’s ball started, driving the rate of interest to unprecedented extremes, first up, then down.

### Liquidation value of bonded debt

Falling interest rates destroy capital in a way that is more subtle than destruction through rising rates. The liquidation-value of debt, contracted earlier at higher rates, rises. ‘Liquidation value’ is the lump sum it takes to liquidate debt, should it be necessary to retire it before maturity ― for example, in case of takeovers, mergers, shotgun marriages, bankruptcies, or the nationalization of the banking system.

The point is that as the rate of interest falls, the liquidation value of debt rises. Why? Well, the stream of interest payments now has to be discounted at a lower rate. Therefore at maturity it falls short of liquidating the debt.

Here is a familiar example, the liquidation value of bonded debt.

When the rate of interest falls, the market immediately bids up the price of bonds. The higher bond price represents the higher liquidation value of the underlying debt. The fall in the rate of interest, far from alleviating the burden of debt, aggravates it.

Bank capital has been eaten away by the fall of interest rates.

The impairment has been ignored and, after 28 years of negligence the global banking system stands denuded of capital. Those shareholders who can read balance sheets see through the fancy values banks are putting on their assets. They dump the stock before bank capital goes all the way to zero.

This is not a real estate crisis, nor is it a sub-prime crisis. This is a crisis caused by the destruction bank capital across the board, through the wrecker’s ball of swinging interest rates. In the final analysis, it has been caused by exiling gold from the banking system.

### Dissipating capital under false pretenses

People tend to have a religious faith in the Fed’s miraculous power to create something out of nothing. They think that the Fed is above capital requirement and accounting rules. They think that the Fed is above the law. They dismiss the idea that the Fed, too, can suffer from capital inadequacy, or that it may not be able to escape the ill effects of falling interest rates.

### The Federal Reserve Act (as amended) explicitly forbids the

Treasury from participating in the earnings of the Fed. The purpose of this provision is to retain the undivided surplus in the Federal Reserve System to meet emergencies precisely like the present crises. The conspiracy of the Treasury and the Fed ignores this provision of the law. Year in and year out the Fed remits about 90 percent of its earnings to the Treasury under false pretences, calling it the “franchise tax on Federal Reserve notes”. No sooner had the Treasury received the remittance than it spent the proceeds, and more, on consumption.

As a result, the Fed is left with no undivided surpluses and no cushion to fall back on in hard times. And the Treasury has debt far greater than it has resources to retire. This high-handed disregard for the law is motivated by the desire to foster a public image of the Fed as an institution with supernatural powers. The Fed has the magic wand and can wave it to solve any problem by throwing money at it. In this view the Fed is not a bank, but the embodiment of divine power.

### The printing press is sputtering

Chairman Ben Bernanke is given to boasting publicly that the government has given the Fed a tool, the printing press, with which it can print any amount of currency necessary to stop any deflation and any depression.

I submit that the Chairman is wrong. The printing press is not everything. The Fed has to operate under the same rules as all other banks. It has to have capital; it has to have an unimpaired balance sheet; it has to observe capital ratios. Above all, the Fed has to put up collateral before it can print new Federal Reserve notes, or create new Federal Reserve deposits. The fact is that the Fed, in addition to dissipating its earnings decades after decades after decades, has also been digging its own grave by pushing interest rates ever lower. Its capital has been destroyed just as that of all other banks. Right now it is near the point that it cannot put new currency into circulation in want of collateral. The printing press is sputtering. The magic wand is broken.

### Dead man walking

The Supplementary Financing Program of the Paulson-Bernanke duo means that, in preparation for the \$700 billion bailout, the Fed is given securities by the Treasury directly, bypassing the open market.

The last time this imprudent departure from the principles of sound central banking has been invoked was during World War II, when the exigencies of war finance were used to justify the bypassing of the open market.

But what does it all mean in practical terms, if we strip away the jargon created in order to mystify the public? It means that the Fed, just like all other banks, has virtually zero capital. It means that the Treasury must recapitalize the Fed by giving it \$700 billion worth of newly issued securities. It also means that the bad assets of the banks, some of which have been absorbed into the balance sheet of the Fed, are monetized through the back door.

But the worst part is that the Fed is now a dead man walking, propped up by conspirators who want to conceal from the people the fact of its demise. This is just the latest of conspiracies between the Treasury and the Fed. In creating a central bank in 1913, the government usurped powers not granted to it under the U.S. Constitution. One successful usurpation calls for another. Now, 95 years later, the government is frantically trying to resurrect its creature, the Fed, from the dead.

### Lipstick on a pig

One expert observer, Thomas Szabo, calls the \$700 billion bailout “putting lipstick on a pig”, in the form of the Supplementary Financing Program. Szabo does not beat around the bush. He tells it as it is: The Federal Reserve is bankrupt, and the U.S. Treasury Department quietly rescued ― actually, took over ― the world’s largest central bank on September 17, the day the Supplementary Financing Program was announced, which was nothing less than a clandestine federal bailout, a de facto takeover of the Federal Reserve. Szabo, who was a practicing auditor for 8 years, has gone on record in saying that the Fed, if it were an ordinary business enterprise, would have had to file for bankruptcy.

### Why gold?

If gold had been retained as a component of the banking system, there would have been no need to invent credit default swaps, and the unprecedented destruction of bank capital would have never occurred.

Gold is unique among financial assets in that it has no counterpart as a liability in the balance sheet of someone else. Gold is the only financial asset that will survive any consolidation of bank balance sheets. Gold will not be netted out, like paper assets are, in case of mergers, acquisitions and takeovers. The rescue effort is administering one wrong medicine after another. Consolidation of banks through mergers and takeovers is not the way to go. Cutting interest rates is not the way to go. These measures make the condition of the patient worse, as they accelerate the process of destroying capital.

All the measures to check the burgeoning credit crisis that have been proposed and put into effect are based on misdiagnosis. The shriveling capital ratios are not due to loose lending standards or to a reckless increase of bank assets. They are due to the destruction of bank capital through falling interest rates. Recapitalizing banks with irredeemable promises to pay will not solve the problem.

### Resolution: recapitalize banks with gold

The long-term solution is the recapitalization of the banking system with gold. This means the issuance of new gold-denominated bank shares. It means mobilizing the U.S. gold reserves for the backing of the note and deposit liabilities of the Federal Reserve banks. The new shares of the recapitalized banks will then circulate in trading the old assets of the banks.

This will accomplish at least two things. First, the banks will be recapitalized in such a way that takeovers, mergers, acquisitions will not endanger bank capital as they do now. Second, there will be a reliable norm to value the old banking assets. Those of them that can be salvaged will be salvaged, and will once more become marketable.

### The rest can go to the garbage dump of history, to join the

Continentals, the Assignats, the Reichsmarks, and the toxic assets of the 1930-33 banking crisis.

### Troubled Ass Relief Program (TARP)

Unfortunately, our leaders don’t have the wisdom and the moral fortitude to admit that they have been wrong all along about gold and its role in the financial system. Just last Saturday President Bush announced, before the finance ministers of the G-7 nations, that he is making a volte-face in discarding his earlier concept of buying toxic bank assets, and is embracing the concept of buying into the

“intoxicated banks” themselves. In plain English, he is turning his Troubled Asset Relief Program into a Troubled Ass Relief Program (no pun intended). No thought is given to recapitalizing banks with gold, the ultimate liquidator of debt.

### Ladies and Gentlemen, be prepared. The earth is shaking, the

Debt Tower of Babel is toppling and, it will bury prosperity underneath the rubble. The Titanic of the once proud American banking system has collided with the iceberg of falling interest rates, and is sinking.

### Sauve qui peut!

### Calendar of events

### Santa Clara, California, November 3, 2008

### Santa Clara University, hosted by the Civil Society Institute

Professor Fekete is the invited speaker. The title of his talk is: Monetary Reform: Gold and Bills of Exchange.

### Inquiries: ffoldvary@scu.edu

### San Francisco, California, November 4, 2008

### Economic Club of San Francisco

Professor Fekete is the invited speaker. The title of his talk is: The Revisionist Theory and History of the Great Depression ― Can It Happen Again?

### Inquiries: ifkbischoff@yahoo.com

### Canberra, Australia, November 11-14, 2008

Gold Standard University Live, Session Five. (This is the last session of GSUL since our sponsor, Mr. Eric Sprott of Sprott Asset Management, Inc., has withdrawn his support saying that in his opinion the results do not justify the expenditure. Come along and judge for yourself.) This 4-day seminar is a Primer on the Gold Basis ― Trading Tool for Gold Investors, Marketing Tool for Gold Miners, and Early Warning System for Everybody Else.

### Inquiries: feketeaustralia@yahoo.com

### Canberra, Australia, November 15, 2008

Panel Discussions: The chickens of 1933 and 1971 are coming home to roost and take out bank capital.

### Inquiries: feketeaustralia@yahoo.com

---

# Troubled Ass Relief Program (TARP)

URL: https://newaustrianeconomics.com/archive/fekete/troubled-ass-relief-program-tarp/
Date: 2008-10-10
Section: Popular Economics
Difficulty: accessible
Concept Tags: federal-reserve, monetary-policy, capital-destruction, fiat-currency, monetary-crisis
Description: Fekete's biting analysis of the Troubled Asset Relief Program, arguing it relieves neither the troubled assets nor the underlying monetary disease. The $700 billion bailout is a desperate attempt to paper over the consequences of irredeemable currency with more irredeemable currency — extending the crisis rather than resolving it.
Editorial Note: Written October 2008 in the immediate aftermath of TARP's passage.
Original PDF: https://professorfekete.com/articles/AEFTARP.pdf

## Troubled Ass Relief Program (Tarp)

### Antal E. Fekete

### Gold Standard University Live

As the precipitous drop of the Dow Jones index of industrial stocks to the 8600 level on Thursday shows, the \$700 billion bailout is an exercise in futility. The rescue effort administers one wrong medicine after another. Shunting rotten assets to the balance sheet of the central bank is not the way to go. Consolidating banks through forced mergers is not the way to go. Cutting interest rates is not the way to go. These measures make the problem worse, not better.

All the remedies to check the burgeoning credit crisis that have been proposed or put into effect are based on misdiagnosis. This is not a sub-prime crisis or a real estate crisis. It was not caused by loose lending standards, or by the banks recklessly and aggressively increasing their assets.

This crisis was caused by shriveling capital ratios due to the destruction of bank capital through 28 years of falling interest rates. As I have been saying again and again, falling interest rates destroy capital by increasing the liquidation value of debt ― an insidious process that has been missed by all other observers. Ignoring capital dissipation is possible only so long as capital lasts. As soon as capital is exhausted, dissipation stops. There is nothing left to dissipate. The problem at once becomes painfully noticeable.

The term ‘liquidation value of debt’ is self-explanatory, meaning the lump sum that will liquidate it before maturity, should it be necessary in case of a takeover, merger, shot-gun marriage, bankruptcy, or outright nationalization of the banking system. The point is that when the rate of interest falls, the liquidation value of debt rises. Why? Because the stream of interest payments is now discounted at a lower rate of interest. Therefore at maturity it will fall short of liquidating the debt.

Here is a familiar example. When the rate of interest falls, the market immediately bids up the price of bonds. This is the same to say that the liquidation value of the debt underlying the bond is raised. Debtors wanting to liquidate their bonded debt before maturity are not let off the hook on the same terms. The market demands more than the pound of flesh originally agreed upon for releasing the debtor from his bond. This example clearly shows that a fall in the rate of interest, far from alleviating the burden of debt, aggravates it.

Bank capital is debt, and it has been eaten away by persistently falling interest rates. Impairment of capital has been ignored and, after 28 years of negligence, the global banking system now stands denuded of capital. Those shareholders who can read balance sheets see through the fancy values banks are putting on their assets, and they dump the stock before bank capital goes all the way to zero.

The only way this crisis can be resolved is through recapitalizing the banks with gold. Contrary to Keynesian propaganda, gold is not a barbarous relic. It is not for decoration purposes. Nor does gold serve for the purpose of window-dressing in the balance sheet. Gold is unique among financial assets in that it has no counterpart as a liability in the balance sheet of others. It follows that gold, and gold alone, will survive any consolidation of bank balance sheets.

Gold will not be netted out like paper assets are in case of mergers, acquisitions, and takeovers, or the nationalization of the banking system.

The fatal weakness of the present rescue effort is precisely this: consolidation of banks, just as consolidation of the derivatives monster, far from stopping the rot, will accelerate it. For example, if you consolidate the derivatives monster, claims and counter-claims through credit-default swaps will cancel out, and all risks will be exposed as being uncovered. Recapitalization with more fiat money will not work. It takes something more solid than irredeemable promises to pay. It takes gold.

Unfortunately our political leaders and policy-makers are lacking the moral fortitude to admit that they have been wrong all along about gold and its role in the financial system. Nor do they have the wisdom to realize that in cleaning up the train wreckage they have to go back all the way to the point where the train was derailed: to the insane decision to discard gold from the monetary system in 1971. Politicians and their academic sycophants will stick to their pet-rock, TARP, the Troubled Ass Relief Program (if you pardon my pun of cutting off the tail of the word ‘asset’). This is their cover-up of the fact that the credit-crisis is their own making.

The first of the Twin Towers, the Derivatives Tower of Babel, has now toppled, although you cannot see it yet as the dust is still settling. The toppling of the second, the Debt Tower of Babel, will follow in due course ― unless banks are recapitalized with gold with all deliberate speed.

The collapse of the Debt Tower of Babel would spell a disaster of the first magnitude, adversely affecting everybody. It would trigger the Great Grand Depression of the twenty-first century, making the Great Depression of the twentieth look mild in comparison.

### Calendar of events

### New York City, October 16, 2008

### Committee for Monetary Research and Education, Inc., Annual

Fall Dinner.

Professor Fekete is an invited speaker. The title of his talk is:

The Mechanism of Capital Destruction.

### Inquiries: cmre@bellsouth.net

### Santa Clara, California, November 3, 2008

### Santa Clara University, hosted by the Civil Society Institute

Professor Fekete is the invited speaker. The title of his talk is:

Monetary Reform: Gold and Bills of Exchange.

### Inquiries: ffoldvary@scu.edu

### San Francisco, California, November 4, 2008

### Economic Club of San Francisco

Professor Fekete is the invited speaker. The title of his talk is:

The Revisionist Theory and History of the Great Depression ― Can It

### Happen Again?

### Inquiries: ifkbischoff@yahoo.com

### Canberra, Australia, November 11-14, 2008

Gold Standard University Live, Session Five. This is the last session of GSUL since our sponsor, Mr. Eric Sprott of Sprott Asset Management, Inc., has withdrawn his support saying that in his opinion the results do not justify the expenditure. Come along and judge for yourself. This 4-day seminar is a Primer on the Gold Basis

― Trading Tool for Gold Investors, Marketing Tool for Gold Miners, and Early Warning System for Everybody Else.

A more detailed description of this seminar is found at the end of my article Cut Off Your Tail to Save My Face! September 1, [www.professorfekete.com](https://www.professorfekete.com)

### Inquiries: feketeaustralia@yahoo.com

In view of the extraordinary events unfolding in world finance and on the banking scene right now, there will be an extra meeting to answer questions from participants and to have a discussion from our distinctive point of view, namely, that this is not a sub-prime crisis, not even a dollar crisis. This is a gold crisis that cannot be solved by continuing to muzzle gold.

### Canberra, Australia, November 15, 2008

Panel Discussions: The chickens of 1933 and 1971 are coming home to roost and take out bank capital.

### Inquiries: feketeaustralia@yahoo.com

---

*October 10, 2008.*

---

# The Gold Standard Strikes Back, Part Two: With a 36-Year Lag

URL: https://newaustrianeconomics.com/archive/fekete/the-gold-standard-strikes-back-part-two/
Date: 2008-10-03
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, bond-market, fiat-currency, monetary-crisis, deflation
Description: Part two examines the mechanics of the gold standard's revenge: the collapse of the bond market bull, the destruction of the derivatives pyramid built on top of it, and the approaching end of dollar hegemony. Fekete argues the crisis cannot be resolved by monetary policy alone — only restoring gold's monetary role can.
Editorial Note: Conclusion of the series, October 2008. Written days after TARP was passed.
Original PDF: https://professorfekete.com/articles/AEFTheGoldStandardStrikesBackPart2.pdf

## …With A 36-Year Lag

### (Part 2 of 2)

The way to resolve the credit crisis:

### Recapitalize the banks with gold

### Antal E. Fekete

### Gold Standard University Live

### Privatizing profits, socializing losses

The 0.7 trillion dollar bailout plan of Treasury Secretary Paulson must be seen for what it is: a scheme to privatize profits while socializing losses. The scare tactics with which he was trying to railroad it through Congress has failed and the world is better for it. The malady has to be diagnosed properly. I summarize the popular diagnosis in five points.

(1)

(2)

(3)

(4)

(5)

The bursting of the housing bubble has led to a surge of defaults and foreclosures which has, in turn, led to a plunge in the value of mortgage-backed securities ― assets which are in effect capitalized mortgage payments.

These losses have left many banks short on capital account. Their problems were compounded by the fact that as their capital ratios were shrinking, rather than reducing their debt exposure they aggressively increased it.

“Leveraging” is the word to describe the deliberate shrinking of capital ratios, i.e., making smaller capital support a larger amount of risks. Aggressive leveraging was characteristic of the pre-crisis boom.

When they recovered after the dizzying ride, banks needed a microscope to read their capital ratios and they reacted in a predictable way. They were unwilling (unable?) to fulfill their mission to provide the credit that the national economy needs for its day-to-day operation.

As a defensive measure financial institutions have been belatedly trying to pay down their debt by selling assets, including mortgage-backed securities, but as they were doing it simultaneously, they drove down asset prices. This has damaged their balance sheets even more. A vicious circle is engaged that some call the “paradox of de-leveraging.”

### Capital destruction

I should hasten to say that I disagree with this popular diagnosis which puts the cart before the horse. My diagnosis, described in the first part of this article, identifies the destruction of capital as the cause, and the credit crisis as the effect.

The problem goes back to the U.S. government foolish decision to destabilize the interestrate structure (and, hence, bond prices) in 1971. As a consequence, long-term interest rates shot up to 16 percent per annum by the early 1980’s, from where they started their long descent that still continues.

Falling interest rates destroy capital as they raise the liquidation-value of debt contracted earlier at higher rates. By ‘liquidation value’ is meant the sum that will liquidate the debt, should it be necessary to pay it off before maturity. In a falling interest-rate environment it will take a larger sum to retire the same debt. Why? Because the scheduled stream of interest payments is now capitalized at a lower rate of interest and, therefore, it falls short in liquidating the debt.

This means that, paradoxically, falling interest rates do not alleviate but aggravate the burden of debt. All observers miss this point as they blithely assume that debt is automatically refinanced at the lower rate. It is not. Falling interest rates create a deficiency on capital account since it takes a bigger bite to service existing debt than originally provided for, and the deficit is made up at the expense of capital. Over-leveraging is not the cause; it is the effect. What it shows is that the banks do not pay heed; they persist in error. They simply ignore shrinking capital ratios. This ultimately causes wholesale bankruptcies, leading to the vicious downwards spiral.

The banks should have made provision to compensate for eroding capital as interest rates were falling. None of them did. None of them understood the insidious process of capital erosion in the wake of declining interest rates. They reported losses as profits. Then they were hit by the negative feedback: capital eroded further. When the truth dawned upon them, it was already too late.

Interest rates have been falling for the past 28 years. The liquidation value of outstanding debt has been increasing by leaps and bounds. It reached the tipping point in February, 2007 as indicated by the unprecedented jump in the price of credit-default swaps. It revealed that any further decline in the rate of interest would plunge bank capital into negative territory. At this point capital dissipation stops: there is nothing more left to dissipate. For the banks, this is sudden death.

No commentator could explain why banks have all run out of capital at the same time, while making obscene profits. My explanation is simple. There have been no profits, obscene or otherwise. The banks were paying out phantom profits in the belief that their capital accounts were in good shape. They weren’t. The banks were unaware that the falling interest rate structure has been making inroads on their capital. Since all banks have been working with microscopic capital ratios as a result of 28 years of capital erosion, the failure of one single bank would trigger the ‘domino-effect’ on the rest.

### Why gold?

This puts the role of gold into high relief. Had gold been retained as a component of bank capital, credit-default swaps would have never been invented. Gold is unique among financial assets in that it has no corresponding liability in the balance sheet of others. Gold is the only financial asset that will survive any consolidation of bank balance sheets, in contrast with paper assets that are subject to annihilation (e.g., when the bank is consolidated with its counterparty holding the liability side of that asset). Suppose we consolidate the balance sheets of the global banking system. Then all assets will be wiped out with the sole exception of gold. But since the global banking system as it is presently constituted has no gold assets, under any consolidation the banks will be denuded of assets while note and deposit liabilities to the public remain. This is why the regime of irredeemable currency is susceptible to collapse that could be violent, taking place with lightening speed. It can also be seen that trying to save banks from collapsing through consolidation, mergers, takeovers, and shotgun marriages is pouring oil on the fire: it accelerates the meltdown of bank capital, rather than retarding it.

### Implosion of the derivatives monster

My thesis also explains the explosive growth of the derivatives markets. First round insurance against decline in the value of bonds in the banks’ portfolio can be had by selling bond futures. Those writing first-round insurance need to cover their assumed risk in the form of second-round insurance, they do so by selling call or buying put options on bond futures. But those writing second-round insurance also need to cover their risk: they do it in the derivatives market by purchasing credit-default swaps. The point is that an infinite chain of credit-default swaps is being built on every bond in the banks’ portfolio, as shown by the derivatives monster’s more than doubling in size every other year, already having reached the size of one half quadrillion dollars and still counting.

Why is the derivative monster so dangerous? Because it is subject to implosion that could destroy an inordinate amount of bank assets. If the derivatives tower is consolidated, then its value collapses to zero as claims are wiped out by counter-claims. It is possible that this implosion has already started, but the banks (and their supervisory agencies) keep the lid on this information to avoid a world-wide panic. The earth quakes badly under the foundations of the Derivatives Tower of Babel. Its toppling may be imminent. If gold had been retained as a component of the bank capital structure, then there would have been no derivatives monster to fret about.

Those who explain the proliferation of derivatives by the popularity of “dry swaps”, that is to say, swaps created for the sole purpose of speculative profits they promise in view of their ultralow price-to-reward ratio, are wrong. All those credit-default swaps were purchased by actual insurers insuring actual risks going with bond ownership, in trying to hedge their own risks.

### Recapitalizing banks with gold

The credit crisis could be solved through the recapitalization of banks with gold. The Treasury should pledge to match subscriptions of new private capital, in gold, at the ratio of two to one. This means that two gold shares of capital stock subscribed by the private sector (individuals, firms, and institutions) shall invite one share of capital stock subscribed by the Treasury. Gold subscribed by the private sector should be constitutionally guaranteed against capital levy and confiscation.

There is no better use to which Treasury gold can be put which has been foolishly idled for the past 36 years. What is needed is the mobilization of gold hoarded by the Treasury, as well as of gold hoarded by the private sector. The trouble is that much of the privately owned gold is in hiding and won’t surface for reasons of lack of confidence in the monetary system. But as soon as there is a market for the shares of the recapitalized banks, private gold can be coaxed out of hiding and made to participate actively in the great task of rebuilding world credit.

Capital stock of the recapitalized banks would pay dividend, in gold, at the rate of one tenth of one percent per annum to stockholders, exempt of all taxes. This would make it possible, even for people of modest means, to acquire gold earning a safe return in gold. The maliciously false propaganda of the past decades that gold is a sterile asset in that it earns no interest is easy to refute. Gold has been lent and borrowed at interest (facetiously called the ‘lease rate’) without interruption, in spite of its so-called ‘demonetization’ by the government. In fact, the gold rate of interest is the benchmark on which all other interest rates are still based, after adding a riskpremium reflecting the risk that the monetary unit may lose its gold exchange value.

The tax-exempt feature of dividends has great merits to recommend it, especially if no other exemptions across the economic landscape are granted. You could look at it as society’s protection of widows and orphans, and other members of society who are unable to fend for themselves in a competitive environment, to live in dignity away from the hurly-burly of the investment world.

What is the use of recapitalizing banks with irredeemable promises to pay? It has been tried for the past 36 years; it doesn’t work.

### No chain is stronger than its weakest link

The newly recapitalized banks must offer their old assets for sale to the public, in exchange for the gold shares of capital stock, through competitive auctions. In this way the true value of the old paper assets can be determined, and whatever can be salvaged will be salvaged.

The market for bank assets, presently frozen, would be made liquid once more. If a bank wants to retain a part of its old assets in the balance sheet, it must bid for it in the same way as if it were buying from another bank through competitive auction. If an asset cannot be disposed of in this way, then it must be written off. Any delay in validating bank assets through the sieve of competitive auction will only prolong and deepen the crisis.

The ‘securitization’ of bank assets was an idiotic strategy motivated by the fraudulent idea that in lumping sub-prime assets together with valid assets would somehow impart value to the former, and the marketability of the product would be enhanced. This, of course, is just a ploy to cheat the buyer. It is like trying to make a chain containing a weak link stronger by adding any number of strong links. The weak link must be replaced with a strong one. No chain can be stronger than its weakest link.

The re-liquefying of bank assets is a first order of business in the present runaway global credit crisis. We are past the point that the wild-fire can be localized. Mobilization of gold is the only way.

### Save the pension funds!

This crisis is a warning, possibly the last one, that the recapitalization of banks with gold cannot be further postponed without risking the total collapse of the financial system. If there was some hope that the Treasury might have a contingency plan to mobilize gold in case of a crisis such as this, the Paulson bailout plan has dispelled it. When the moment for the ‘break-the-glass’ rescue plan has arrived, what did we find behind the broken glass? More irredeemable promises to pay, to augment bank capital. All chaff, no grain.

Global credit collapse would bring enormous hardship in its train for ordinary people who have worked hard and saved hard through a lifetime only to see the fruits of their efforts going up in smoke. The result could be total social chaos and lawlessness. At risk are all the insurance companies, pension funds, money market funds. Also at risk is the taxing power of the government, as a prostrate economy won’t be able to bear the tax burden, but will spawn a grey economy that finds ways to evade taxes. The rejection by the U.S. House of Representatives of Paulson’s bailout plan can be viewed as a taxpayer revolt. Is it the first, with more to come?

### Close of Keynes’ and Friedman’s system

Understandably, it will be hard for policy-makers, academia and media, and the accountants’ profession to admit that they have been wrong all along about gold and its essential role in the economic bloodstream and in accounting. They have fallen victim to the charm of John Maynard Keynes, the prankster who invented the idea that gold was a barbarous relic, and the gold standard was a ‘contractionist fetter’ upon the world economy. Now we have proof that the blame for the contraction should be assigned, not to the use but to the misuse of gold. The debt collapse is the burial ground for Keynesianism.

After Keynes was gone, policy-makers, academia and media, and the accountants’ profession fell under the spell of another visionary and adventurer talking with a forked tongue, Milton Friedman. He was fond of posing as a free-market man, but in promoting irredeemable currency he did more than anybody, save Keynes, to destroy the free market. Friedman promoted the spurious idea that gold is superfluous in the international monetary system as floating foreign exchanges rates can mimic the operation of the gold standard and will balance the trade accounts. But as the record shows, Friedmanite nostrums have ruined the dollar, as well as the once flourishing and peerless American productive apparatus.

Politicians, academia and media, and the accountants’ profession must swallow their pride and get the confession off their chests that their prognostication, policies, and advice about gold have been in error. If they fail to do this, and continue to block the way of gold to make a return to the economic bloodstream, then their responsibility for the suffering caused by the credit collapse in this country and in the world will be total. They will be shown as doctrinaire wreckers of human cooperation under the system of division of labor, who muzzled their critics and usurped unlimited power, while paving the way to a world disaster akin to that of the Bolshevik revolution.

After the close of Marx’ system, the close of Keynes’ and Friedman’s system is inevitable.

But the wounds they have caused would take a long, long time to heal.

The mission of Gold Standard University Live is to do the research that academia refused or was forbidden to do: find out the consequences of ousting gold from the monetary system by the U.S. government, following its 1971 default on the Treasury’s gold obligations. Unfortunately our sponsor, Mr. Eric Sprott of Sprott Asset Management, Inc., has withdrawn his financial support saying that our “results do not justify the expenditure”. I am forced to terminate the sessions. Our last activity will be a panel discussion on the present credit crisis to be held in Canberra, Australia, on November 15, 2008, under the title: The chickens of 1933 and 1971 are coming home to roost and take out bank capital. I invite you to come and contribute to the success of Gold Standard University Live with your questions and comments. At any rate, the sessions will be taped and the DVD’s made available to the public, along with the conference proceedings.

### Calendar of events

### New York City, October 16, 2008

### Committee for Monetary Research and Education, Inc., Annual Fall

Dinner.

Professor Fekete is an invited speaker. The title of his talk is:

The Mechanism of Capital Destruction.

### Inquiries: cmre@bellsouth.net

### Santa Clara, California, November 3, 2008

### Santa Clara University, hosted by the Civil Society Institute

Professor Fekete is the invited speaker. The title of his talk is:

Monetary Reform: Gold and Bills of Exchange.

### Inquiries: ffoldvary@scu.edu

### San Francisco, California, November 4, 2008

### Economic Club of San Francisco

Professor Fekete is the invited speaker. The title of his talk is:

The Revisionist Theory and History of the Great Depression ― Can It

### Happen Again?

### Inquiries: ifkbischoff@yahoo.com

### Canberra, Australia, November 11-14, 2008

Gold Standard University Live, Session Five. (This is the last session of

GSUL since our sponsor, Mr. Eric Sprott of Sprott Asset Management,

Inc., has withdrawn his support saying that in his opinion the results do not justify the expenditure. Come along and judge for yourself.) This 4day seminar is a Primer on the Gold Basis ― Trading Tool for Gold Investors, Marketing Tool for Gold Miners, and Early Warning System for Everybody Else.

### Inquiries: feketeaustralia@yahoo.com

### Canberra, Australia, November 15, 2008

Panel Discussions: The chickens of 1933 and 1971 are coming home to roost and take out bank capital.

### Inquiries: feketeaustralia@yahoo.com

### Reference

Is Our Accounting System Flawed? ― It may be insensitive to capital destruction [www.professorfekete.com](https://www.professorfekete.com) May 23, 2008.

---

*October 3, 2008*

---

# The Gold Standard Strikes Back, Part One: With a 36-Year Lag

URL: https://newaustrianeconomics.com/archive/fekete/the-gold-standard-strikes-back-part-one/
Date: 2008-09-25
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, fiat-currency, monetary-crisis, deflation, capital-destruction
Description: Fekete argues that the gold standard is striking back 36 years after Nixon's 1971 abolition in the form of the 2008 financial crisis — the delayed but inevitable consequence of removing gold's discipline. Part one develops the theoretical case: deflationary forces suppressed in 1971 have been building ever since.
Editorial Note: Part one written September 2008 as Lehman Brothers collapsed. Fekete frames the crisis as vindication of his monetary analysis.
Original PDF: https://professorfekete.com/articles/AEFTheGoldStandardStrikesBackPart1.pdf

*The Gold Standard Strikes Back… …With A 36-Year Lag*

### (Part 1 of 2)

### Antal E. Fekete

### Gold Standard University Live

### “Two legs bad, four legs good!”

There were two main direct assaults on the gold standard by the American government: the first on the watch of a Democratic president, Franklin D. Roosevelt, when the U.S. defaulted on its domestic gold obligations in 1933; the second on the watch of a Republican president, Richard Nixon, when the U.S. defaulted on its international gold obligations in 1971. In each case, the gold standard struck back. Uncannily, in each case there was a lag of 36 years, signifying the fact that it takes that long for a new generation to acquiesce in the slogan “two legs bad, four legs good!” as in George Orwell’s Animal Farm, a parody of the Soviet Union and the Bolshevik revolution. It will be recalled that the pigs have overthrown the farmer and took over the farm, trying to run it under this revolutionary slogan.

The run on the dollar in the wake of the 1933 default started in 1969, wiping out more than one half of the value of the currency in a few years, the worst episode of monetary destruction in history of the dollar up to that point. The second run on the dollar in the wake of the 1971 default started in 2007, when American banks faltered as bond insurance premiums they were paying on their assets skyrocketed. The second run still continues as foreign dollar account holders have not been heard from. Make no mistake about it: the present financial crisis is a gold crisis, even though this fact is vehemently denied by the Establishment.

### Cause and effect

Causality may be camouflaged by lags, and the longer the lag, the more perfect the camouflage is. This is confirmed in the case of the government sabotaging the gold standard.

From the point of view of the Establishment, the causality nexus must be covered up by hook or crook. The propaganda line is that gold has long since outlived its usefulness and it was necessary for the government to make some housekeeping changes in order to get rid of this useless and annoying appendage. Note that this is exactly what you would expect to hear from a banker defaulting on his gold obligations: he would badmouth gold and promote his own dishonored paper. But if gold is really so useless, and so entangled with superstition, then why not pay it out as honor demands, and avoid the stigma of national dishonor?

The 36-year long lag is explained, in part, by the servility of academia and media in parroting government propaganda ― betraying their sacred mission to inform without fear and favor. The general public, even if indignant at the time of the default, gets desensitized to the enormity of gold confiscation and the government’s declaring default fraudulently. As Hitler said, propaganda does work, provided that it is diligently repeated year after year. Nazi Germany just was not given 36 years for its propaganda to sink in. The Soviet Union was; that’s why the tenets of international socialism are still treated as holy writ, and those of national socialism as garbage, regardless of the close similarity.

### “Four legs good, two legs better!”

Animal Farm could just as well be a parody of the regime of irredeemable currency. The pigs have overthrown the gold standard. They started to mimic its operation, prodded by the chief of pigs, Alan Greenspan. Their revolutionary slogan later gave way to a new one: “four legs good, two legs better!”, when the pigs tried to walk on their hind legs instead of all four, to the endless amusement of the other four-legged creatures on the farm. Unfortunately for them, their new manner of walking could not help the fact that they remained just as pig-headed and ham-handed as ever.

### Kill the Constitution to make it a “living document”

The role of gold in the monetary system is anchored in the U.S. Constitution. The Founding Fathers were no fools. They knew exactly what they were talking about when they insisted on a blanket denial of power for the government to monetize its own debt, or any debt for that matter. They knew perfectly well that a metallic monetary standard is the only effective prophylactic that can deny that power. The fact that the U.S. government never considered proposing an amendment to the Constitution to legalize fiat money is a telltale. Policy-makers could not muster the necessary moral courage to face counter-arguments in an open debate.

Irredeemable currency has no integrity: the issuer is given privileges with no countervailing responsibilities. He is granted unlimited power in a republic based on the principle of limited and enumerated powers. The principle of checks and balances is thrown to the winds. These features are all alien to the spirit of the Constitution, not just to its letter. Rather than facing a public debate, the government prefers to live with the odium that it is the destroyer of the Constitution.

The legislative branch usurped powers denied to it by the Constitution. The executive branch conspired with the legislative branch to pull it off. All presidents, starting with Franklin D. Roosevelt, have perjured themselves when they swore to uphold the U.S.

Constitution, and then turned around and signed bills into law to keep raising the limit on government debt payable in irredeemable currency, i.e., monetized government debt. The judiciary branch of the government, rather than exposing the conspiracy, has joined it, on the basis of the spurious doctrine that the Constitution “is a living document” which does not say what it says, but what the judiciary say it says. In other words, you have to kill the Constitution to make it a “living” document.

### Regulator of debt

To expect that the gold standard can be destroyed with impunity is a pipedream. The Establishment will never admit that the present monetary and financial crisis is a gold crisis, or that the day of reckoning has dawned. It will find any number of ad hoc explanations, such as too little regulation, too relaxed lending standards, naked short selling of financial stocks, etc., etc. The big picture is blackened out. For this reason, it is necessary to state the causeeffect nexus between ousting gold from the monetary system and the credit collapse that is now unfolding before our eyes, after a 36-year lag, in the clearest possible terms.

Gold has the same role to play in the monetary system as the fly-wheel regulator does in an engine, the brake does in a train, and circuit-breakers do in an electrical network. Gold is the regulator of the quantity of debt in the economy that can be safely created and carried. It is also safeguarding quality by rejecting toxic debt before it can start metastasis. Debt-based currency utterly lacks safeguards limiting quantity and vouching for quality of debt. Debtbased currency is an invitation to disaster, that of the toppling of the Tower of Babel. Its effects are far from being instantaneous. There is a threshold and there is a critical mass involved. We have long since crossed that threshold and passed that critical mass. By no rational calculus can the outstanding debt be expected to be repaid without inflationary or deflationary adventures, even if further increase were stopped dead in its track. The discussion of the present financial crisis by academia and media avoids all reference to this fact. Under the gold standard a fast-breeder of debt was unthinkable, and debt was retired in an orderly manner.

### Destabilizing interest rates

The significance of gold in the monetary system is not that it can stabilize prices, which is neither possible nor desirable. It is the fact that gold can stabilize interest rates. No debtbased currency can do it, because the value of the unit of account is left undefined and is subject to political manipulation by the pressure groups. The discussion of the present financial crisis by academia and media avoids reference to this fact as well. Under the gold standard interest and foreign exchange rates were so stable that there was no bond speculation ― for lack of volatility would make it unprofitable. There was no Debt Tower of Babel to threaten with burying the economy underneath. Under the gold standard there were no creditdefault swaps. There was no need for them.

### Barbarous relic or accounting tool?

The gold standard has been called a “barbarous relic”. However, the unpleasant truth, one that government propagandists have ‘forgotten’ to consider, is that the gold standard is merely a tool for sound accounting and, yes, for sound moral principles. Book-keeping under the regime of irredeemable currency is an exercise in prestidigitation. The gold standard is the only conceivable early warning system to indicate erosion of capital. It was not the gold standard per se that politicians and adventurers wanted to overthrow. Above all, they wanted to get rid of certain accounting and moral principles, especially those applicable to banking, that had become a fetter upon their ambition for aggrandizement and perpetuation of power.

Historically, sound accounting and moral principles had been singled out for discard before the gold standard was given the coup de grâce. Just how monetization of debt has led to unprecedented and previously unthinkable corruption of accounting and moral standards, this is a question that has never been addressed by impartial scholarship before.

In order to see the connection we must recall that any durable change of the rate of interest has a direct and immediate effect on the value of financial assets. Rising interest rates make the value of bonds fall, and falling interest rates make it rise. As a result of this inverse relationship the Wealth of Nations flows and ebbs together with the variation of the rate of interest.

### Capital destruction

Indeed, rising interest rates destroy wealth as they render the productivity of capital submarginal. Establishment economists and financial journalists preach the false doctrine that, conversely, when the government and its central bank suppress interest rates, new wealth is being created. This is the gravest error of all! Falling interest rates destroy capital in a most devious way, as they increase the liquidation-value of debt contracted earlier at higher rates.

All observers miss the point that as interest rates fall, the burden of servicing outstanding debt is increased. They blithely assume that all debt is automatically refinanced at the lower rate. This is definitely not the case. The issuer must continue to redeem the maturing coupons of fixed nominal value, regardless how far the rate of interest may have fallen after selling the bond. To that extent all issuers of bonds (along with other borrowers) are subject to impairment on capital account in a falling interest rate environment. If the impairment is ignored, the outcome is wholesale bankruptcies in due course.

Enterprises should make up for losses of capital due to falling interest rates whenever they occur. The trouble is that they don’t. As a result they report losses as profits. There is a negative feedback. Capital is eroded further. When the truth dawns upon them, it is already too late. I shall argue that this is the essence of the present banking crisis in America, and it was caused by the destabilization of the interest rate structure, the ultimate cause of which was the overthrow of the gold standard in 1971.

Interest rates have been falling for the past 28 years with the result that the liquidationvalue of outstanding debt has reached the tipping point, where capital is plunged into negative territory. Capital dissipation stops as there is nothing more to dissipate. This is sudden death for the enterprise. Producing firms fold tent and look for greener pastures in Asia where wage rates are lower, while financial firms and banks start falling like dominoes.

No commentator is able to explain how American banks could run out of capital in spite of obscene profits they have been making. My explanation is simple. Capital destruction has been going on stealthily for 28 years but the banks were not paying attention. The magnitude of the decline in interest rates, if not its length, is historically unprecedented. The banks have been paying out phantom profits in dividends and in compensation, in the belief that their capital accounts were in good shape. They were not. They were insidiously eroded by the falling interest rate structure, as it inevitably increased the cost of servicing capital already deployed. The banks were unwilling or unable to raise new capital to cover the shortfall. Under these circumstances they should have reduced their own exposure to borrowing. Instead, they were vastly expanding it. By the time they woke up, capital was gone and they were in the grips of bankruptcy.

This puts the importance of the gold standard into high relief. Both rising and falling interest rates are extremely harmful to enterprises, banks not excepted. The plight of General Motors is no different from that of Morgan Stanley. The environment in which they can safely prosper is that of stable interest rates, that only a gold standard can provide.

### Not all risks can be effectively insured against

Academia has failed to study and expose the untoward consequences of ousting gold from the monetary system. It dismissed the problem of fluctuating ― nay, gyrating ― interest rates by saying that insurance against those risks is available, just like insurance against the risk of fluctuating foreign exchange rates is, through the derivatives markets. If academia had done its job to research the problem properly, it would have discovered that there are risks against which no effective insurance is available. For example, there is no effective insurance against risks artificially created at the gaming tables in a gambling casino. Likewise, risks represented by fluctuating interest and foreign exchange rates have been artificially created by the government in ousting gold from the monetary system. Under the gold standard, there was no risk of fluctuating interest and foreign exchange rates. Bond values were stable.

Bond values are no longer stable, but there is no effective insurance against diminishing bond values. If you were to offer insurance against losses due to declining bond values or bond default, then you would have to look for second-round insurance to cover your assumed risk. Second-round insurers would need third-round insurance, and so on and so forth. This means an infinite chain of insurers, in effect, a Tower of Babel growing ever taller ever faster. Such a tower is not a figment of the imagination. It is real; it exists even though the earth is quaking under its foundations. This Tower of Babel is the derivatives market. At each level the instrument of insurance is a credit-default swap. The amazing thing is that there are far more credit-default swaps outstanding than there are bonds in existence that they are supposed to be insuring.

Observers make wild guesses in trying to explain this strange phenomenon. They suggest that most are “dry swaps”, that is, they have been created solely for speculative purposes. In this way speculators can gamble with almost no money down. This is the position, for example, of Floyd Norris of The New York Times (Reckless? You are in luck!

September 19, 2008.)

I reject this explanation. In reality all credit-default swaps were created to insure actual risks directly or indirectly connected with bond-holdings in the balance sheets of financial institutions. First-round insurance is usually the purchase of a bond futures contract; secondround insurance is the purchase or sale of a put or a call options on bond futures. Third- and fourth-round insurance can also be negotiated in the form of a credit-default swap in the derivatives market. I submit that all the credit-default swaps were negotiated by actual insurers to cover risks they have actually assumed in writing insurance at a lower round. They were not negotiated for speculative purposes. However, at bottom, these risks are artificial, as they have been created by the government in overthrowing the gold standard. This is the true explanation of the exploding derivatives market that doubles in size every second year, and has already surpassed the one-half quadrillion dollar (\$500,000,000,000,000) mark.

The derivatives market is the nemesis of government dishonesty and incompetence.

The gold standard is striking back ― with a lag of 36 years.

### Conclusion

The present credit crisis is the greatest ever in history. It burst upon the world in February, 2007, when insurance premiums on bonds in the banks’ portfolio shot up. However, the roots of the crisis go much farther back. They go back all the way to the ousting of gold from the monetary system 36 years earlier. Gold is an indispensable tool for the banks to manage risk.

The Federal Reserve can print its notes ad nauseam, and Helicopter Ben can air-drop them to the banks and bond insurers. It will not address the risks of declining or evaporating bond values. To do that you need something more substantial than irredeemable promises to pay.

In Part 2 of this article I shall look at the present crisis in greater detail from the distinctive perspective of the gold standard as an early warning system indicating capital erosion.

### Gold Standard University is closing down

Gold Standard University Live had its mission cut out for it: to do the research that academia refused or was forbidden to do: find out the consequences of ousting gold from the monetary system by the U.S. government. Unfortunately our sponsor, Mr. Eric Sprott of Sprott Asset Management, Inc., has withdrawn his financial support saying that our “results do not justify the expenditure”. I am forced to terminate the sessions. The last one will be Session Five to be held in Canberra, Australia, November 11-14, 2008.

In view of the extraordinary events unfolding in world finance and the American banking scene, I shall put on extra meetings in Canberra where I can answer the questions of participants. I shall show that this is not a sub-prime crisis, not a real estate crisis, not even a dollar crisis. This is a gold crisis: the chickens of 1933 and 1971 are coming home to roost. I invite you to come and contribute to the success of Gold Standard University Live with your questions and comments. At any rate, the sessions will be taped and the DVD’s made available to the public, along with the conference proceedings.

---

*September 25, 2008.*

### References

### It is not a dollar crisis: it is a gold crisis

---

*June 4, 2008*

Is our accounting system flawed? ― It may be insensitive to capital destruction

---

*May 23, 2008*

### Forgotten anniversary haunts the nation

March 25, 2008,

These and other articles of the author can be accessed at the website [www.professorfekete.com](https://www.professorfekete.com)

### Calendar of events

### New York City, October 16, 2008

Committee for Monetary Research and Education, Inc., Annual Fall Dinner.

Professor Fekete is an invited speaker. The title of his talk is:

The Mechanism of Capital Destruction.

### Inquiries: cmre@bellsouth.net

### Santa Clara, California, November 3, 2008

### Santa Clara University, hosted by the Civil Society Institute

Professor Fekete is the invited speaker. The title of his talk is:

Monetary Reform: Gold and Bills of Exchange.

### Inquiries: ffoldvary@scu.edu

### San Francisco, California, November 4, 2008

### Economic Club of San Francisco

Professor Fekete is the invited speaker. The title of his talk is:

The Revisionist Theory and History of the Great Depression ― Can It Happen

### Again?

### Inquiries: ifkbischoff@yahoo.com

### Canberra, Australia, November 11-14, 2008

Gold Standard University Live, Session Five. (This is the last session of GSUL since our sponsor, Mr. Eric Sprott of Sprott Asset Management, Inc., has withdrawn his support saying that in his opinion the results do not justify the expenditure. Come along and judge for yourself.) This 4-day seminar is a Primer on the Gold Basis ― Trading Tool for Gold Investors, Marketing Tool for Gold Miners, and Early Warning System for Everybody Else.

In view of the extraordinary events unfolding in world finance and the American banking scene right now, there will be extra meetings to answer questions from participants and to have a discussion, from our distinctive point of view, namely, that this is not a sub-prime crisis, not even a dollar crisis. This is a gold crisis: the chickens of 1933 and 1971 are coming home to roost.

Address inquiries to: feketeaustralia@yahoo.com.

A more detailed description of this seminar is found at the end of my article Cut Off Your Tail to Save My Face! September 1, [www.professorfekete.com](https://www.professorfekete.com)

---

# Has Hedging Killed the Goose That Was to Lay the Golden Egg? Part Two

URL: https://newaustrianeconomics.com/archive/fekete/has-hedging-killed-the-goose-part-two/
Date: 2008-09-16
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, gold-standard, monetary-policy
Description: Part two examines the systemic consequences of the mining industry's hedging: the suppression of the gold price has reduced exploration investment, accelerating the depletion of existing reserves and making the eventual supply squeeze more severe. Fekete argues the goose has indeed been killed.
Editorial Note: Conclusion of the two-part hedging analysis, September 2008.
Original PDF: https://professorfekete.com/articles/AEFHasHedgingKilledGooseLayGoldenEggPart2.pdf

*Has Hedging Killed The Goose That Was To Lay The Golden Egg?*

### Second, Concluding Part

### Antal E. Fekete

### Gold Standard University Live

### Introduction

The English language apparently doesn’t have words forceful enough to describe the pigheaded and ham-handed approach of the gold mining industry to the marketing of its unique product, the king of metals and the metal of kings. One is reminded of the words of the late conductor, Sit Thomas Beecham, who once publicly upbraided a cellist in his orchestra in these words: „Lady, you don’t realize that you have a most precious instrument between your legs, but all you can do with it is scratch it!”

I founded Gold Standard University Live with one main purpose in mind: to make the producers and long-term holders of gold aware of the importance of the basis. Mr. Eric Sprott of Sprott Asset Management, Inc., offered financial support without my soliciting it. Of course, I gladly accepted the offer and I thought that we now had a winning combination. Mr. Sprott sent out a circular to some eighty gold mining executives urging them to delegate representatives to the Gold Standard University Live Conference in Dallas, Texas, where the subject was gold basis and how it should play a role in marketing. Mr. Sprott could not attend the conference in person, but he must have received a negative feedback from the gold mining industry disdainful of my efforts, because he abruptly withdrew his financial support. As a consequence I felt obliged to suspend the operations of Gold Standard University Live. There will be just one more session in Canberra, Australia, November 11-14, 2008, the title of which is:

Primer on the Gold Basis ― Trading Tool for Gold Investors,

Marketing Tool for Gold Miners, and Early Warning Signal for Everybody Else.

The lectures will be taped and made available to the public together with the conference proceedings. This seminar will be of special interest to shareholders of gold mining companies who may feel that the marketing strategy of the industry is hopelessly antiquated. I make a case for shareholder revolt against management which should be forced to adopt the modern strategy for marketing gold with the battle cry:

### “Stop selling the gold price and start trading the gold basis!”

I expect that this last session will convincingly prove Mr. Sprott wrong, who has told me that the results of Gold Standard University Live do not justify the expenditure.

### A tale of two IQ’s

The gold basis is the difference between the nearby futures price of gold and the price at which the gold mine is selling its product. Thus the gold basis could vary from mine to mine.

The gold miner sells the basis when he sells cash gold and buys an equivalent amount of futures. He buys the basis when he buys cash gold and sells an equivalent amount of futures.

Clearly, a gold miner who is short the basis should strive to cover after the basis has widened.

Note that when his short position is covered, the gold miner’s net change of cash gold is zero, so in principle he can profit without selling any gold. In practice, some selling may be necessary, but the measure of good management is that it can successfully minimize the sale of cash gold. The prevailing ethos in gold mining executive suites is that they ought to maximize it. What a profound pitfall! Profits from short covering, rather than from net sales of cash gold, should be the mainstay of the gold mine’s income. The gold miner, if he was really smart, could also buy the basis even before he dug up as much as a bucketful of dirt. It is profitable to buy the basis when it is wide to sell it when it subsequently narrows ― replicating the procedure of the grain elevator operator.

There are still some old line grain elevator operators out there whose marketing strategy is exhausted by selling the grain price. They apparently do not understand the first principles of modern basis trading, which is the marketing strategy of the vast majority of grain elevator operators with a higher IQ. Modern marketing of grain is not about buying from farmers and selling with a mark-up to processors. Such a simplistic approach is antediluvian. Modern marketing is about trading the basis, that is, buying it whenever it is wide and selling it whenever it is narrow.

It is true that the basis for grain shows a pattern radically different from that of the gold basis. The former exhibits a pretty regular annual cycle, the guiding star the grain elevator operator. The latter exhibits a long-term secular decline which is destined to end in backwardation (“the last contango in Washington”), which should be the guiding star of the gold miner ― if only he had eyes to see and ears to hear. Trading the gold basis, however, does not belong to the repertory of gold miners. This, of course, is not meant to be a flattering comment on their IQ. If they did trade the gold basis, it would render market manipulation of the gold price, official or unofficial, real or imagined, a counter-productive exercise. Indeed, manipulation inevitably shows up as a widening of the gold basis, which should be immediately countered through spirited buying of the gold mines. Manipulators are facing a powerful head-wind: the secular decline of the gold basis, but it would serve as a tail-wind for the gold miner. This important source of energy is left fallow.

The cycle for the grain basis shows an annual peak at harvest time when the new crop is being brought in and cash grain is available at the farm gate in abundance. It shows an annual trough at the end of the crop year, just before the new harvest, when operators are scraping the bottom of their elevators. In practice, there are many cross-currents making the grain basis more unpredictable, although it would never be as unpredictable as the grain price.

The end-game is critical: every elevator operator would love to be the one selling the last truckload of the old crop, but if he waits too long, then the arrival of the new crop may make him suffer losses. Bottom-picking, at least in this instance, does not pay.

### Mesh marketing and basis trading

The gold basis, no less than the grain basis, is also subject to a number of powerful crosscurrents. These should be analyzed and studied in order to develop a profitable trading strategy. The gold mining industry is in a unique position to take advantage of the fluctuation in the basis. The opportunity is spurned. If gold mines meshed their trading strategy with their marketing strategy, they could greatly increase profitability while reducing attrition at all the producing sites.

Why is this important? Ideally, the gold mine should sell a minimum amount of gold from its mining operations, and cover its operating expenses from profits derived from trading the basis. The objective of prolonging the working life of the gold mine should be an overriding consideration. Ore deposits should be treated with almost religious respect. They are worth far more than their meager gold content. But to get that extra value out, the gold miner must be trading the basis. You cannot recycle tailings, but you can recycle ore deposits after you have extracted value from it through basis trading again and again.

Depletion of ore deposits should be reduced by all means available. The industry is doing the exact opposite: it seeks salvation in increasing its tailings heap by hook or crook. I can tell you, the market for gold shares does not like it a bit.

Any marketing strategy that results in a premature exhaustion of the gold mine is wasteful and indicates gross incompetence. It shows that managers either do not use basis trading or, if they do, then they don’t do it adroitly. In either case management should be fired and new managers should be hired who understand the importance of maximizing the working life of the gold mine, and are willing to learn the intricacies of basis trading, which is the number one tool to achieve that goal.

### Mistaking money for frozen pork bellies

The question arises why gold miners ignore the modern methods of marketing, through trading the gold basis, and prefer to stick with the old-line method of selling output hot from the shaft, with the result that their gold mine gets exhausted prematurely while the shareholder gets a pittance. My answer to this question is that mining executives are oblivious to the fact that gold is a monetary metal.

Shortly after the U.S. government defaulted on its gold obligations to foreigners in the early 1970’s, and started babbling about the desirability of “demonetizing gold”, futures trading started in Winnipeg, Canada, for the first time in history. The un-Austrian Austrian economist Fritz Machlup, professor at Princeton University, hailed that event saying that, at the long last, gold has become a commodity just like frozen pork bellies (he could not think of a more derogatory or more insulting example) and the two commodities are being traded in the same way, in the same market, sometimes in the same pit. The good professor did not know what he was talking about. He was blind to the fact that it is not the government but the market that makes gold money, and if you deliberately confuse gold and frozen pork bellies, you will suffer the consequences.

There are two kinds of mindset. The first looks at gold as money regardless what the government may say or do. The other fails to see any difference between gold and frozen pork bellies. It urges producers to dig the gold out with all deliberate speed and throw it on the market regardless of conditions prevailing there, and invest the proceeds in government securities for the yield they fetch. The first mindset realizes that, under the regime of irredeemable currency, bonds are just “certificates of guaranteed confiscation” (a phrase we owe to the late Dr. Franz Pick), and gold is the only life-saver available in turbulent times.

The second springs from a servile ideology worshipping government omnipotence. An extreme polarization has taken place between the two, and no meaningful dialogue is possible between the protagonists.

Instinctively, shareholders are of the first mindset, while gold mining executives are of the second. This bunch of usurpers has long since ceased to represent the interest of the shareholders. They have betrayed their trust. I may leave the question aside whether the managers have been bribed or blackmailed by the government. Their action of pursuing blatantly anti-conservationist policies at the expense of the shareholders condemns them.

They should be fired and replaced by new guys who are loyal to shareholders and are willing to learn modern efficient methods of marketing through utilizing the basis. This is the telltale that the shockingly low gold mining share prices are telling you.

### Shareholder revolution

The challenge to the gold mining industry is enormous, but there are no signs that it is up to it.

In retrospect, the industry has been selling gold for the past sixty years at ridiculous prices. It has frittered away the patrimony of shareholders, the top brass has been lining its own pockets and helping government profligacy. Shareholders are confused. They were hoping against hope that higher gold prices would ultimately change all that. Well, higher gold prices have come, but the wasteful exploitation and the rip-off continues. There is no noticeable change in the pittance gold executives dish out as dividends.

### The best little whorehouse in Nevada

Gold mining executives would do anything to blow money on irrelevant construction projects.

They build tire-factories, power-plants, even bordellos in Nevada. But they would not do the one thing they ought to do: conserving gold-bearing ore through basis trading.

Shareholders are disenfranchised. There is only one thing left they can do to protest against the gap between gold prices and gold share prices: vote with their feet. They should sell their gold-mining shares and put the proceeds into cash gold. In this way they can start a revolution to overthrow usurpers in the gold mining executive suites. But be warned: the gap will widen if a Lehman-size collapse of the gold mining industry is in the cards, so do the switch at your early convenience. If you wait, you will have to pay a steep price for procrastinating.

If there is a way to resuscitate the goose to lay the golden egg, this is it.

### Calendar of events

### New York City, October 16, 2008

Committee for Monetary Research and Education, Inc., Annual Fall Dinner.

Professor Fekete is an invited speaker. The title of his talk is:

The Mechanism of Capital Destruction.

### Inquiries: cmre@bellsouth.net

### Santa Clara, California, November 3, 2008

### Santa Clara University, hosted by the Civil Society Institute

Professor Fekete is the invited speaker. The title of his talk is:

Monetary Reform: Gold and Bills of Exchange.

### Inquiries: ffoldvary@scu.edu

### San Francisco, California, November 4, 2008

### Economic Club of San Francisco

Professor Fekete is the invited speaker. The title of his talk is:

The Revisionist Theory and History of the Great Depression ― Can It Happen

### Again?

### Inquiries: ifkbischoff@yahoo.com

### Canberra, Australia, November 11-14, 2008

Gold Standard University Live, Session Five. (This is the last session of GSUL since our sponsor, Mr. Eric Sprott of Sprott Asset Management, Inc., has withdrawn his support saying that in his opinion the results do not justify the expenditure. Come along and judge for yourself.) This 4-day seminar is a Primer on the Gold Basis ― Trading Tool for Gold Investors, Marketing Tool for Gold Miners, and Early Warning System for Everybody Else.

Inquiries: feketeaustralia@yahoo.com . A more detailed description of this seminar is found at the end of my article Cut Off Your Tail to Save My Face!

September 1, [www.professorfekete.com](https://www.professorfekete.com)

---

*September 16, 2008*

---

# Has Hedging Killed the Goose That Was to Lay the Golden Egg? Part One

URL: https://newaustrianeconomics.com/archive/fekete/has-hedging-killed-the-goose-part-one/
Date: 2008-09-09
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, gold-standard, monetary-policy, central-banking
Description: Fekete examines whether the gold mining industry's forward hedging programs have suppressed the very prices needed to incentivize exploration and production. Part one analyzes the mechanics of the forward sale programs and their effect on the gold basis.
Editorial Note: Part one of a two-part analysis, September 2008.
Original PDF: https://professorfekete.com/articles/AEFHasHedgingKilledGooseLayGoldenEgg.pdf

*Has Hedging Killed The Goose That Was To Lay The Golden Egg?*

### Part One

### Antal E. Fekete

### Gold Standard University Live

### Introduction

Gold mining executives would like to forget the hedging fiasco as you would the worst nightmare of your life. But the ghost of this greatest shareholder rip-off will not let them. It keeps haunting them, and for a very good reason, too. There are still more skeletons in the cupboard. Just take a look at gold mining share prices and their reaction, or rather the lack of it, to the unfolding banking crisis. They eloquently tell a tale of deep distrust in the veracity and competence of gold mining executives. This is an industry that is totally incapable of analyzing and admitting past mistakes, let alone learning from them. The full extent of the fiasco will not be known for many more years because we don’t know how high the gold price will go in the wake of the banking crisis. What is clear already is the disconnect between gold and gold mining shares. It will remain as long as the industry fails to get its past and present sins off its chest and reform itself.

According to a Hungarian proverb, dead fish stink because of the head. This can be readily applied to the gold mining industry which obviously stinks. Senior gold producers pretend that it is business as usual. It is not. The same executives responsible for the rip-off are still in charge. They are not trusted, and they are not to be trusted. The hedging fiasco was bad because it accelerated the aging process of producing gold mines. It was an appalling case of wasteful exploitation of a world resource. It was a case of robbing shareholders. Forward selling may be gone, but wasteful exploitation is still very much with us. It will be, until a new generation of managers is brought in to initiate a new program of forward buying. This means that at every major decline in the gold price (such as the present one, for example), the gold mines should step into the breach and buy gold forward with the same élan as they were selling it short under their hare-brained scheme of hedging. This strategy would accomplish three things: (1) it would slow down the aging process of their producing gold properties; (2) it would facilitate locking in a good price for new gold properties the purchase of which the management may be in the process of negotiating; (3) it would be the first step in replacing the obsolete marketing model of selling output hot from the mine, by the up-to-date marketing model of trading the basis.

### Hedging or speculation?

If the gold mining industry is reluctant to draw the balance sheet of its adventures in hedging, we shall be happy to do it for them. Hedging was a conspiracy to rob shareholders of their most durable long-term asset: gold locked up in ore deposits. It was a design to dissipate those assets in aid of government profligacy. Nor is it over yet. As the unresponsiveness of the share price to the banking crisis demonstrates, shareholders are still unconvinced.

The rest of this article is an excerpt (slightly edited) from the late Ferdinand Lips’ book Gold Wars published in 2002 by FAME ([www.fame.org](https://www.fame.org)), p 160-167.

„A closer look at hedging reveals that, in many cases, it has turned into outright speculation. Professor Fekete describes these practices as follows.

„The Hedging Revolution started in 1985. Barrick Gold (then called American Barrick) was one of the pioneers. Hedging looked like a brilliant idea when it was first conceived at Barrick. It put the gold mining industry in a category by itself as the only segment of the economy that could pull itself out of the debt-morass by its own bootstraps.

Barrick’s hedging policy as described in the company’s annual reports (see in particular those for 1994, 1995 and 1996) is not, strictly speaking, an exercise in hedging, but an exercise in speculation. Barrick is betting that the gold price will never again be able to repeat the feat it has performed several times since 1968, namely to break out on the upside, never again to fall back to those old levels.

Should it try, Barrick and others stand ready, and would promptly club it down with their persistent short selling. This was a revolution indeed. The gold miner cut a strange figure, showing him as gold’s worst enemy second only to the government. He made every budding rally abort through unilateral hedging. The result of Barrick’s innovation was competitive, industry-wide short selling. This was most demoralizing to the market, certainly on the supply side but no less on the demand side. It has turned the industry into a bunch of cannibals: everybody wanted to sell before everybody else. But it was even more demoralizing to potential buyers and all long-term holders of gold. The market perception was that the industry was being led down the primrose path to ruin. While selling gold short, these so-called hedgers were ultimately ruining their own market. They would kill the upside potential. They would kill the goose that was to lay the golden egg.

Even more ominously, there was also a bearish element in the picture. The powerful speculative following of the gold market, traditionally bullish, was alienated en bloc. They were chased away from the long end of the market to join Barrick on the short.

From Barrick’s own point of view, unilateral short selling appears to be a short-sighted and, in the long run, self-destructing strategy. It throws all conservative principles to the winds in an aggressive pursuit of short-term profitability. Whatever the short-term benefits may have been, the strategy ultimately shortened the working life of Barrick’s gold properties, hurting shareholders. Barrick had to close down operations at five of its ten working sites as they became ’mined out’ ― not through extraction but through evaporating payable ore reserves. It is for the first time in history that productive gold mines were forced to close down ― not through attrition but because the falling gold price was wiping out big chunks of payable grades of ore. These mine closures reflect a colossal destruction of capital represented by abandoned milling plants and other mining equipment. Nobody could predict the fiasco ― least of all the officers of Barrick. How could it happen? Observers stress the fact that while there is a physical limit on the production of cash gold, namely, milling capacity, there is no limit on the ’production’ of futures contracts, or paper gold, if its maturity dates are being pushed ever farther out into the future. Barrick’s anticonservationist mining practices and aggressive short sales were the flip-side of the inundation of the market with unlimited amounts of paper gold.”

Barrick’s cost of production from top grades may well be reduced to \$150 per ounce ― as boasted by management ― but how long will these top grades last? In Fekete’s view the only solution to the dilemma is bilateral hedging. The strategy of forward sales must be complemented with a strategy of forward purchases. As it is, every rise in the price of gold is countered by forward sales ― but nothing is done to counter a fall! Properly understood, neither forward sales nor forward purchases need to involve speculation, but are what they are: true hedging in the interest of the company and its shareholders.

### Unmitigated fraud

In the fall of 2000 I asked Professor Fekete whether he has revised his position regarding Barrick. He said that he has not changed his mind at all; quite the contrary. „You should bring in the very serious charge that Barrick knowingly misleads shareholders, creditors, and the general public. For several years in a row, in its Annual Reports, at its shareholders meetings, press conferences, Barrick has been reporting consistently higher profits, attributed to its mythical ability to realize higher prices for its newly mined gold than prices bid in the market during the entire year in question. These reports of higher profits have been duly certified by reputable accounting firms, and they have never been questioned by academia, let alone the financial press.

We all know what academia and the financial press would say if a company with publicly traded shares announced that it was manufacturing and marketing the 21st century version of perpetuum mobile.

Barrick boasts that it could accomplish the miracle of consistently selling gold at a price higher than the market has ever bid during the entire year through its ’sophisticated tool of hedging’.

Here is a sophisticated question I want to address to Barrick: „Why not share this ’secret’ with the American farmer? Would it not be wonderful if they, too, could consistently realize higher wheat prices than the market is willing to bid? Where are the farmers organizations to demand that they be told the secret of turning the stone into bread?

### Well, Barrick could not share its secret with anybody because the

’miracle’ can only be performed through fraud. If we wanted to be charitable, we would assume that the accounting firms did not understand what they were certifying. Otherwise they would not lend their good name to this chicanery aiming at misleading the public. It is hard to escape the suspicion that the accounting profession may be an accomplice in this conspiracy to defraud.

It is not, has never been, and will never be possible to sell gold forward consistently at a higher price than the highest price bid by the markets during the year under review, any more than it is possible to turn lead into gold profitably.

Here is what Barrick is doing. It sells gold borrowed at the low lease rate, and invests the proceeds into high-yielding U.S. Treasury paper. Then it recalculates its revenues boosted by the positive spread between the yield on Treasury paper and the gold lease rate, and reports its profits as if it had been earned through consistently reaping a higher price for its gold than that quoted by the market.

Why is this procedure an unmitigated fraud? Apart from reporting profits under false pretenses, observe the fact that the transaction remains incomplete.

Profits are merely ’paper profits’ as long as all deals have not been closed out and borrowed gold returned to the owners. It may not be possible to realize those paper profits, ever. It is quite conceivable that these forward commitments can only be closed out at hideous losses. For such a scenario, nothing more drastic need to happen than for the price of gold to return to a higher level where it has already traded for years or decades.

Barrick is speculating: it assumes that ’what goes up must come down’.

If the gold price goes up, say, \$200 per ounce, then it is duty-bound to come down at least that much in due course. Those with financial staying power (such as Barrick considers itself to possess in good measure) will be able to ride out any storm caused by temporary spikes in the gold price. Barrick lives in a fools’ paradise thinking that it can roll over all futures contracts showing a loss, several times if necessary, until the gold price comes down again and the commitment can be covered at a profit.

### Double standards

The truth remains, however, that all Barrick has accomplished was to sweep margin calls on its short positions of gold under the rug, thus concealing the potential liability from its shareholders and creditors. Therein lies the fraud which accountants should point out, and if they fail to do so, the SEC should uncover, expose, and prosecute. Instead, they adopt the ’hear no evil, see no evil’ attitude.

Barrick wasn’t around in 1968. But suppose for the sake of argument that it was. Assume further that Barrick had sold borrowed gold at \$38 per ounce

(which may have appeared an incredibly smart thing to do at the time) In that case Barrick would, a third of a century later, still be rolling over its gold loans in the forlorn hope that the gold price would be good enough to drop below \$38 in order to enable Barrick to unwind its losing position with a profit. In fact, after 1968, the year the U.S. Treasury defaulted on its obligation to pay foreign creditors, as contracted, in gold at \$35 an ounce, the price of gold took off never to come back again. Barrick could still be holding the bag, a bag of losses, and keep reporting huge profits, because the conspiring bullion banks allow it to roll over its losing short position on gold sold at \$38 an ounce. (It may be worth pointing out that today the position of the US Treasury vis-à-vis its foreign creditors is far worse than it was in 1968.)

It has happened any number of times in history that the gold price took off never ever again to come back to the level it has started from. For this reason, any accounting assumption that a commitment to deliver gold at a future date can be closed out profitably if one is willing and able to wait long enough, is simply fraudulent. It should never be allowed in a society with self-respecting legislators making meaningful contract laws. And the fraud should be exposed by selfrespecting accountants and other watchdogs of fair play.

Just as grain-elevator operators are not allowed to calculate and report profits derived from forward sales of wheat several years into the future in the same way as they calculate and report profits on the sale of wheat physically present in their elevators, gold mines should not be allowed to calculate and report profits on the forward sale of borrowed gold in the same way as they calculate and report profits on the sale of newly mined gold from their mines. There is a contingent liability on the short positions. Until and unless they are closed out there is no profit to report. As the proverb says, “there’s many a slip between cup and lip”.

It is disgraceful that public prosecutors allow this double standard to prevail. What is rightly prohibited to grain elevators should not be permitted to gold mines. It is to the eternal shame of our civilization that it allows this unsavory conspiracy between the banks, the gold mines, and the government (with the accounting profession, academia, and the financial press looking on) to defraud the general public through the hocus-pocus of ’hedging’ and forward selling.”


---


This was written in 2000. Writing in 2008 I can add that the worst-case scenario eventually caught up with Barrick. The gold price has been increasing so much and so fast that Barrick was unable to lift its short positions in an orderly manner.

Most of it is still on. The company’s finances still sag under the burden of selling gold short at \$300 and below. The president of the company had to eat his words that ’forward selling will always play a role in the marketing strategy of Barrick.’ Barrick did not sell as much as one ounce of gold short at \$1040 last April to take advantage of the coming fall by \$250 in August.

The company is trying to camouflage the financial mayhem by charging all its losses to just one producing unit and promote the remaining ones as hedgefree. But can shuffling really eliminate the bad card from the deck? This smacks just like another ploy to short-change shareholders. Those who buy Barrick shares are buying the warts, no matter how thoroughly management tries to shuffle the deck. The company is still hemorrhaging gold, and a better policy would be to close the hedge book and burn it for once and all.

In the second, concluding part of this article I shall explain that the marketing strategy of Barrick to sell newly mined gold hot from the shaft is obsolete and wasteful. It is a pig-headed and ham-handed approach in view of the fact that a more efficient modern marketing strategy is available. Barrick should stop selling the gold price and start selling the gold basis.

### Calendar of events

### New York City, October 16, 2008

Committee for Monetary Research and Education, Inc., Annual Fall Dinner.

Professor Fekete is an invited speaker. The title of his talk is:

The Mechanism of Capital Destruction.

### Inquiries: cmre@bellsouth.net

### Santa Clara, California, November 3, 2008

### Santa Clara University, hosted by the Civil Society Institute

Professor Fekete is the invited speaker. The title of his talk is:

Monetary Reform: Gold and Bills of Exchange.

### Inquiries: ffoldvary@scu.edu

### San Francisco, California, November 4, 2008

### Economic Club of San Francisco

Professor Fekete is the invited speaker. The title of his talk is:

The Revisionist Theory and History of the Great Depression ― Can It Happen

### Again?

### Inquiries: ifkbischoff@yahoo.com

### Canberra, Australia, November 11-14, 2008

Gold Standard University Live, Session Five. (This is the last session of GSUL since our sponsor, Mr. Eric Sprott of Sprott Asset Management, Inc., has withdrawn his support saying that in his opinion the results do not justify the expenditure. Come along and judge for yourself.) This 4-day seminar is a Primer on the Gold Basis ― A Most Important Trading Tool, Mining Tool, and Early Warning System. Inquiries: [www.feketeaustralia.com](https://www.feketeaustralia.com). A more detailed description of this seminar is found at the end of my article Cut Off Your Tail to Save My Face! September 1, [www.professorfekete.com](https://www.professorfekete.com)

---

*September 9, 2008*

---

# Cut Off Your Tail to Save My Face

URL: https://newaustrianeconomics.com/archive/fekete/cut-off-your-tail-to-save-my-face/
Date: 2008-08-30
Section: Popular Economics
Difficulty: accessible
Concept Tags: federal-reserve, monetary-policy, capital-destruction, bond-market, fiat-currency
Description: Fekete examines the Federal Reserve's policy of forcing banks to write down assets while propping up their balance sheets with cheap credit — a strategy he likens to cutting off a tail to save face. This approach destroys productive capital while preserving the financial institutions whose reckless lending created the crisis.
Editorial Note: Written August 2008, just weeks before the Lehman collapse.
Original PDF: https://professorfekete.com/articles/AEFSaveMyFace.pdf

## „Cut Off Your Tail To Save My Face!”

**Antal E. Fekete**

*Gold Standard University Live*

The title refers to Aesop’s tale about the wolf that has lost his tail in a trap. As he felt uncomfortable being so different from others in the pack, he tried to persuade his fellow wolves that they, too, should get rid of this cumbersome and useless appendage. He declared that „the tail of a real wolf is a barbarous relic”. Read on to find out how an experienced wise old wolf answered him.

Like all of Aesop’s tales, this one also has a modern message. When Uncle Sam in 1971 defaulted on his gold obligations, he did not want people to call a spade a spade. He wanted them to call the American default, more elegantly, the ’demonetization of gold’. He was trying to persuade others to demonetize gold, too, by discarding it as a „barbarous relic”. Yet he was disingenuous enough to keep the remnants of his gold while pushing others to sell theirs. He urged them to auction off that cumbersome and useless appendage and put the proceeds into US Treasury paper. „Cut off your tail to save my face!”

The late Mr. Ferdinand Lips asked me to write an introduction to his book „Gold Wars”. I was delighted and the outcome is reproduced below. In my dedicated copy Mr. Lips wrote the following kind words:

Dear Antal,

Your introduction, the intellectual input and professional insight you gave me for writing this book are the ’crown jewels’ of Gold Wars.

With warm thanks and best wishes,

**Ferdinand Lips**

*April 3, 2002.*

My introduction to „Gold Wars” follows.

A „gold war” is an attempt by the government upon the constitutional rights of the individual.

Why do governments resort to gold wars? Sometimes they want to wage shooting wars without raising taxes; at other times they want to indulge in „social engineering” through redistribution of income. But in every instance there is a common thread: governments have, correctly, identified gold as the only antidote in the hands of the individual against their effors to build the Tower of Babel of irredeemable debt.

This book is much more than a chronicle of gold wars. It is also an account of the historical failure of „Esperanto money”. Over a hundred years ago a Polish physician by the name Ludovik Lazarus Zamenhof (1859-1917) created a synthetic language in the hope of removing the curse of Babel from mankind. According to the Bible man had become so conceited as to challenge God by proposing to build a tower that was to reach to High Heaven. God’s punishment for the temerity was to confuse the tongues of nations. The tower could never be completed for failure of communication due to the confusion of different languages. Zamenhof called his artificial language „Esperanto”, meaning „the hopeful”. The hope was in vain, as the experiment attracted imitators, and other synthetic languages, e.g., „Ido”, sprang up. The confusion of tongues, and the curse of Babel, has remained.

Calling irredeemable currency „Esperanto money” is apt. The Biblical story may be interpreted allegorically as an admonition not to challenge God by attempting to build a tower of irredeemable debt that is to reach to High Heaven. The admonition fell upon deaf ears and, now, God’s wrath is upon us. Currencies of nations have been confused. The tower can never be completed for lack of compatibility among various means of payment. The hope of Esperanto money to remove the curse is in vain. Other synthetic currencies spring up such as the SDR (special drawing right), the Euro, and so on. The confusion of currencies, and the curse of Babel, remains.

Ownership of gold is not about lust: it is about liberty of the individual. The gold standard is not a „game”: it is the embodiment of the timeless principle: pacta sunt servanda (promises are made to be kept). Official hatred of gold bordering on the neurotic appears less irrational if we contemplate that gold, and gold alone, is capable of exposing the ever-present bad faith behind the irredeemable promises made by the powers that be.

The Americans who defaulted on their international gold obligations in 1971 have put great pressure on other countries that they follow suit and denounce gold. This brings to mind the fable of Aesop about the wolf that lost his tail in a trap. As he felt uncomfortable being so different from the others in the pack, he tried to persuade his fellow wolves that they, too, should get rid of this cumbersome and useless relic. But a wise old wolf pointed out to him that his proposal would have had greater merit if it had been made before his fatal encounter with the trap.

Switzerland was the only country to point out that the American demand to shed the ’obsolete’ gold reserves would have been less disingenuous if it had been made before the the gold dollar was dishonored in 1971. This tale, however, did not have a happy ending. Switzerland had to be humiliated for being so impertinent as to run a currency superior to the dollar.

Mr. Lips has written a wonderful book for the discriminating reader, who may want to understand better the challenge to God’s authority involved in the construction of the Tower of Babel of irredeemable debt. (End of Introduction to Gold Wars.)

### The Fifth and Last Session of Gold Standard University Live

It is scheduled to take place in Canberra, Australia, November 11-14, 2008. I invite readers of my column to come as this may be the last opportunity that I can offer to run a seminar of this type. As you may know, Mr. Eric Sprott of Sprott Asset Management, Inc., has withdrawn his sponsorship of Gold Standard University, saying that in his opinion the „results do not justify the expenditure”.

Fortunately we had Australian sponsors to finance and organize this last session.

Session Five will be a Primer on the Gold Basis, as the most important trading tool ever.

(Basis is the name for the difference between the nearby futures price and the cash price of gold.) I have championed the case for the gold and silver basis for many a year. I have also challenged investment advisors to recognize it and include basis-trading in their repertory. They have shied away, declining to take up my challenge. I can understand the reasons for their hesitation. To put it charitably, they prefer the endless regurgitation of COT reports and other tools of supply-demand analysis to breaking new grounds, because of their keen sense of lack of competence concerning the basis. Of course, I am not saying that there are no competent people who trade the gold and silver basis. To be sure, there are a few but, naturally, they keep their cards close to their chest. They will never spill the beans. Nothing is farther from them than the idea of sharing information. You will never hear them discussing the basis in public.

The latest severe correction in the dollar price of gold and devastation in the price of silver illustrates my point. The only rational explanation for this extraordinary decline in the midst of an extraordinary monetary crisis is the disconnect between the price of paper gold and the price of real gold. Of course, we have known all along that the government considers it as its sacred duty to manipulate the gold price by hook or crook. The best way of going about it at this juncture is to engineer a disconnect between paper gold and real gold in the hope that the fall of paper gold will demoralize the market with the result that real gold will be dislodged even from firm hands. The delivery mechanism of gold futures contracts, and that of other forms of paper gold such as ETF’s, is made subject to manipulation on purpose. However, they may manipulate the price of paper gold to their heart’s content; it is not and never will be in their power to manipulate the gold basis. Properly interpreted, variation in the basis instantaneously reveals the fact and extent of paper gold manipulation. I dedicate the last Session of Gold Standard University Live to the task of showing how to arrive at this proper interpretation of the basis, and how to turn manipulation to your advantage by making the basis a trading tool.

You must understand that the gold market, as it is presently constituted, is a gambling casino where the tail wags the dog. The casino owner is a secret agent of the U.S. Treasury. Shills abound.

Bluffing and false-carding is rampant, and the bluff is hardly ever called. The reason for this is the widespread assumption that the managers of the irredeemable dollar have near supernatural power.

They don’t, of course, but they have succeeded in eliminating the last vestiges of transparency on the gold holdings of the US Treasury, and they obscure the purpose for which it is held. They pretend that the purpose of Treasury gold is to keep the demand for real gold in check; in reality, without gold in the Treasury the U.S. could not keep garrisons in every part of the world even against the wishes of the local population, nor could it fight several wars at once in several distant theaters. There would be no local suppliers selling them ordnance.

Managers of the irredeemable dollar can double-count and triple-count Treasury gold with impunity in order to fool outsiders, in order to keep the demand for real gold in check and to shift all such demand to paper gold. In the meantime, all we have is the telltale mark of the basis ― if you know how to read it.

But the hour-glass for the endgame is filled with gold dust, not with sand. When the last peck of gold is gone, prestidigitation is up. That will be the most dramatic event in the entire history of money, an event that I have, tongue in cheek, called „The Last Contango in Washington”. The basis will give you an early warning signal. That is what Darryl Robert Schoon, who will also be lecturing and available for questioning at Session Five, calls „the silver canary singing in the gold mine”. Come to Canberra and hear Darryl as he explains the riddle.

Remember, basis is the specialty of Gold Standard University. No one else is willing to go public with research results concerning the basis. Prices, price ratios, volume and open interest statistics, COT reports can be, and probably are, manipulated and falsified in order to mislead market participants and scare them away from real gold. They can have paper gold as much as they want, provided that they are willing to settle in cash. They are offered a posh spot in fools’ paradise. But no matter how all these signals are manipulated or falsified, the basis is a pristine market signal that never lies. It can be neither manipulated nor falsified because it shows the divergence between paper gold and real gold. It is a seizmographic signal that picks up rumblings in the bowels of the earth half way around the globe, foretelling the coming of earthquake. The basis will tell you well in advance when all the offers to sell real gold or silver are about to be withdrawn in all the markets of the world. Once that happens, infinite demand will confront zero supply. Don’t say it can’t happen here. It has happened locally in France in 1796, in Germany in 1923, in China in 1947, to mention but three episodes. This time it will happen globally. I shall tell you all about it in Canberra. Just send us an email indicating that you are interested in attending. We shall answer you promptly telling you how to register. Attendance is limited; first come, first served.

Don’t let yourself be talked into mutilating yourself in order to save the face of the government!

### See you in Canberra!

---

*September 1, 2008.*

---

# Farewell Address

URL: https://newaustrianeconomics.com/archive/fekete/farewell-address/
Date: 2008-07-02
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, real-bills, new-austrian-economics, gold-standard, sf-school
Description: Fekete's farewell address upon retiring from his Gold Standard University teaching activities, surveying the key contributions of the New Austrian School — the gold basis, permanent backwardation, self-liquidating credit — and urging his students to continue the work of restoring sound monetary thinking.
Editorial Note: Delivered July 2008 as Fekete stepped back from his Gold Standard University teaching role.
Original PDF: https://professorfekete.com/articles/AEFFarewell.pdf

## Farewell Address

Gold Standard University Live: R.I.P.

**Antal E. Fekete** · [aefekete@hotmail.com](mailto:aefekete@hotmail.com)

The Inaugural Session of GSUL took place in February, 2007, at the Martineum Academy in Hungary. Subsequent sessions, including one in Dallas, Texas, showed a healthy increase in attendance, on average by fifty percent. Still, I am now forced to announce that Session Four in Hungary in July, and Session Five in Canberra, Australia in November will be the last. GSUL will fold tent as its sponsor, Sprott Asset Management, Inc., has withdrawn its financial support.

Mr. Eric Sprott said in his letter that “we weren’t attracting enough interest to justify that ongoing expenditure”.

To give you an idea of the odds I am facing let me quote from the article in Wikipedia (June 9, 2008) captioned under my name: “It should be noted that mainstream economic theorists criticize gold standard-oriented monetary economists and monetary reformers such as Professor Fekete as ‘fringe’ or ‘amateur’ economists, not worthy of serious study. Professor Fekete has never held a teaching position in the economics department of any prominent university”.

### A deep, searing corruption

Pre-1936 theorists of the gold standard are likewise dismissed by the mainstream as “not worthy of serious study”. I am proud that I have tried to continue that tradition in the footsteps of giants like Adam Smith, Carl Menger, Böhm-Bawerk, Ludwig von Mises, Frank Fetter, Benjamin Anderson, among others. Monetary scientist Walter E. Spahr, who served as Chairman of the Department of Economics at New York University from 1927 to 1956, wrote in The Commercial and Financial Chronicle on March 20, 1947: “A deep, searing corruption has afflicted monetary science. It may require many years of painful effort to overcome this disease if, indeed, it can be combated successfully. The well-being of our nation has been undermined by this affliction… When gold payments were suspended in 1933 and we embarked upon a sea of managed currency, a very large number of professors and organizations [list appended] urged a prompt return to a gold standard. The question arises what has become of those voices. Were they in error then? Did those 710 economists know so little about monetary principles in 1933 that they could not, a short time later, defend their earlier position? Or were they simply corrupted by a political movement which they found it inexpedient to oppose? There appears to be no valid defense that can be offered for men who pretend to be scientists but who adjust their so-called principles in accordance with changing political tides. A very great number of those who pass themselves off as monetary economists either have not understood the lessons of the past or have been willing to junk them, in the interest of expediency, for such personal gains as they may have supposed they might realize…”

### Perpetuation of an immoral and dysfunctional monetary regime

One representative of the mainstream, Professor Jeff Frieden of Harvard, says that “the topic of the gold standard has received massive attention from scholars since the 1980’s ― from Barry Eichengreen to Ben Bernanke with hundreds in between ― and a serious analysis of its implications requires a serious engagement with the existing scholarly literature.”

I have studied most of that literature and I have not been able to find one iota connecting our crisis-ridden monetary system to the forcible removal of gold from it. Rather, the gold standard is portrayed as an anachronistic monetary regime, the removal of which was due to popular demand. Moral considerations, sanctity of contracts, the honor of the government, the opprobrium of declaring bankruptcy fraudulently, the question of tormenting widows and orphans did not enter into it. Nor did long term economic considerations such as the ticking time-bomb of capital destruction. The question is never raised how well the gold standard succeeded as the protector of savings, as the instrument of capital accumulation and, above all, as the stabilizer of the interest rate structure. A façade that the mainstream has provided a reasonably complete and balanced view of the gold standard, past and future, is maintained but is outright mendacious. The existing literature is in fact a stumbling block in the way of impartial inquiry. It is dedicated to the maintenance of the status-quo, the perpetuation of an immoral and dysfunctional monetary regime: that of irredeemable currency. This has led me to found Gold Standard University Live, that is free to challenge the Keynesian and Friedmanite orthodoxy.

Let me mention just two broad areas of inquiry which have been overlooked by others, but which we have planned to tackle:

(1) Gold and the theory of interest. The latter cannot be understood without the former. We have to incorporate the theory of hoarding into the theory of interest. We have to study the problem of capital destruction in the wake of gyrating interest rates, the main consequence of ousting gold from the monetary system.

(2) Gold and the theory of speculation. To understand the causes of the Great Depression we must understand speculation. The theory of speculation covers such topics as arbitrage, futures trading, basis (especially gold and silver basis), contango, backwardation, short squeeze, corner. Speculation is virtually ignored by conventional economic theory. The hurly-burly on the floor of the exchanges apparently does not reach the ears of inhabitants of the ivory tower.

### The economic consequences of Mr. Keynes

Once these two gaps are filled, it becomes clear that the gold standard is naturally ordained as the only system that can stabilize interest and foreign exchange rates. By contrast, the regime of irredeemable currency has been inflicted upon the people through fraud and chicanery. Its foundation is no firmer than the gullibility of people who are, for the time being, willing to exchange real goods and real services for irredeemable promises to pay. But as the prices of crude oil and various foodstuffs convincingly show, there are definite limits to gullibility.

The claim of Keynes parroted by most mainstream economists, that the Great Depression was due to the “contractionist tendencies of the gold standard”, is untenable. Just the opposite is true. Here is what happened.

In 1933 the forcible removal of gold signaled to bond speculators that the one and only competition to government bonds has been knocked out. They were quick to realize that their chance to bid bond prices sky high has come. The result was continually falling interest rates causing widespread capital destruction, as well as falling prices. Producers were bankrupted en masse.

Economists have never bothered to study the untoward consequences of the forcible removal of gold, even though common sense would suggest that it cannot be done with impunity.

A careful and impartial examination of the record shows that the scuttling of the gold standard, as advocated by Keynes, was the main cause of the Great Depression and, unless it is rehabilitated with all deliberate speed, a new depression may be waiting in the wings.

### Janus-face of marketability

Gold and interest are intimately inter-related. The concept of marketability is due to Carl Menger. It was through the evolution of the most marketable good that gold has become money. Gold is most marketable in the large, that can also be expressed by saying that gold is more salable than any other commodity.

Silver is most marketable in the small, that can also be expressed by saying that silver (along with gold) is more hoardable than any other commodity. The Janus-face of marketability can be observed if we contemplate that gold is the preferred agent when one has to transfer value over space. The preferred agent in transferring value over time is silver. We may clearly recognize the dual nature of money throughout history, starting with cattle money versus salt money. This duality has to do with the paramount fact that space and time are absolute categories of human thought.

### A new theory of interest

As salability leads directly to the concept of value, so hoardability leads directly to the concept of interest. Interest arises out of the desideratum to optimize conversion of income into wealth and wealth into income. I have chosen the conversion problem as our point of departure in developing a new theory of interest. I have deliberately discarded the old-line theory based on the exchange of present for future goods that assumes, wrongly, that a present good is always valued more highly than an equivalent quantity and quality of future good. A more careful analysis shows this to be true only on condition that the delivery of factors is dove-tailed. Premature delivery of a factor could cause losses and, hence, may result in perverse valuation.

The solution to our optimization problem answers two of the greatest of human needs: planning for the education of one’s offspring, and providing for one’s old age. If the conversion of income into wealth is done through hoarding and the reverse conversion through dishoarding, also known as direct conversion, optimum is reached when choosing the most hoardable commodity as the agent of conversion. However, direct conversion can be further improved upon by passing to indirect conversion through the agency of exchange.

Typically, a younger man gives up income in exchange for wealth belonging to an older. The former is anxious to go into business for himself for which the latter puts up the capital. In this view interest appears as the value of improvement in efficiency through the exchange over direct conversion. In particular, direct conversion means zero interest. Interest becomes positive if social arrangements admit indirect conversion.

The following point is important. The nexus between gold and interest is established by the fact that if indirect conversion is hampered through secular or canonical proscription (e.g., usury laws), the economizing individual is not helpless. He can still achieve his goals by falling back on direct conversion through hoarding/dishoarding gold. He will do that even in the absence of proscription. In case interest is artificially lowered by the banks or by the government, he will hoard gold in protest and dishoard it as the rate of interest is allowed to rise. Thus gold is the agent to validate time preference. This aspect is almost always ignored by authors, including Ludwig von Mises to whom gold hoarding was a deus ex machina. He failed to see that time preference would hardly amount to more than a pious wish if gold hoarding did not give it teeth.

Moreover, this is true whether on a gold standard or off. When on, gold hoarding implies withdrawal of bank reserves whereby individuals directly force the banks to adjust the rate of interest to a level consonant with prevailing time preference. The main excellence of the gold standard is that it makes adjustment crisis-free. When off gold standard, hoarding makes the gold price soar, leading to monetary crises. Although the upshot is the same in either case, namely, higher interest rates, under the regime of irredeemable currency the adjustment is made in a crisis-prone environment. A swinging interest rate structure is generated that is most damaging to savers and producers.

Gold hoarding provides an escape route for the individual from the harsh consequences of predatory monetary and credit policies of banks as they plunge society into debt slavery. For those who fail to use the only prophylactic, gold, debt slavery is all but inevitable.

### Interest and marginal utility

The monetary metals are characterized by their great stores above ground. The stock-to-flows ratio is a high multiple for gold. The suggestion has been made that the world’s monetary silver has been consumed by industry and is gone.

However, we can account for the disappearance of monetary silver through a more plausible hypothesis, namely, that most of it has gone into hiding. Silver is a monetary metal in the first place; it is an industrial metal only in the second, propaganda to the contrary notwithstanding. Industrial uses of silver are marginal applications, subject to squeeze by the investment demand.

The case is different for non-monetary commodities. Here the stock-toflows ratio is a small fraction. The reason is declining marginal utility, in contrast with monetary metals having constant (near-constant) marginal utility.

Mises dismisses constant marginal utility as contradictory since it implies infinite demand. He is plainly in the wrong. Mises missed the nexus between gold and interest. Demand for gold would be infinite only in the absence of interest which acts as obstruction to gold hoarding. By contrast, demand for nonmonetary commodities is limited by declining marginal utility. Keynes made a colossal blunder when he talked about “wheat rate of interest”, ”coal rate of interest”, etc. Interest can only exist in relation to a monetary commodity with constant marginal utility. The marginal utilities of wheat and coal decline very fast indeed.

### Lysenkoism ─ American style

The reason why mainstream economics is silent on the connection between gold and interest is that it exposes the incredible mismanagement of the economy in the twentieth century, as well as the corruption of the monetary and credit system by the government and banks in the twenty-first. Universities no longer serve the cause of search for and dissemination of truth. Instead, they serve as the “intellectual body-guard” of Keynesianism and Friedman’s monetarism.

They provide refuge for a reactionary conspiracy that has succeeded in hijacking the world’s monetary system and putting it on a collision course with the welfare of the world’s population. Savers are pilfered and producers are plundered. Universities have betrayed people anxious to secure their economic survival in the face of untold dangers as indicated by the Babeldom of runaway debt and exploding derivatives markets. They are silent where they should be outspoken and critical. Apparently, they don’t want to embarrass their paymasters.

History will not be kind to mainstream economists. Keynes, Friedman, and their followers will be lumped together with Soviet biologist Lysenko, stooge and sycophant of Stalin. Lysenko sent his fellow biologists to the Gulag, never to be heard from again, whenever they opposed his hare-brained theories on genetics. Lysenko betrayed science just as he betrayed humanity. No less than Stalin, he was a monster.

### Theory of speculation

Speculation is man’s main tool to deal with risks and future uncertainties.

Mainstream economics fails to make a distinction between risks created by nature and risks created by man. The latter includes risks involved in foreign exchange and interest rate fluctuations. They are certainly not created by nature, witness the fact that such risks are non-existent under a gold standard. Clearly, they were created by governments while abandoning the gold standard, thereby destabilizing foreign exchange and interest rates.

It is untenable to assume that under the regime of irredeemable currency speculation can tame these fluctuations. Just the opposite is true. Futures markets make interest rates even less stable and more volatile. It is not possible to predict whether bond prices go to zero as they would under hyper-inflation, or whether they go sky high as they would under hyper-deflation. This problem is crucial and it can be approached only through understanding bond speculation, especially as it is helped by tail-winds provided by the central bank.

The following facts are either not widely known or not well-understood.

Open market operations of the Federal Reserve (Fed) were introduced in the 1920’s in violation of the Federal Reserve Act of 1913. They were legalized retroactively in the 1930’s. There was hardly any public discussion of the wisdom of the move or the stakes involved. Pre-1936 economics was categorical in its condemnation of the monetization of government debt. Introducing the catchy name “open market operations” has made it possible to monetize government debt through the back door.

Economists failed to predict the disastrous consequences of this ex post facto legislation. Bond speculators were given a risk-free opportunity to profit.

In pre-empting the Fed they would buy the bonds beforehand, dumping them after the Fed has completed the purchase of its quota. Risk-free speculation imparted a bias to the market favoring rising bond prices or, what is the same to say, falling interest rates.

It speaks volumes about the degradation of economics in the wake of the Keynesian revolution that an illegal trick could be elevated to the holiest of gestures whereby high-powered money is created, and nobody points to the downside of the prestidigitation.

### Revisionist theory of the Great Depression

Most importantly, economists have also failed to identify falling interest rates as the main cause of the Great Depression. They have concentrated on falling prices, not realizing that in doing so they are confusing cause and effect. The true chain of causation is as follows.

Persistently falling interest rates result in the erosion (ultimately, destruction) of capital deployed by the producing sector. In effect, bond speculators siphon off money stealthily from the capital accounts of the producers. The latter are unaware of being victimized by this vampirism of the financial sector. But they are, whether they recognize it or not. Profits of the bond speculators do not come out of nowhere. They are the flipside of the opportunity loss suffered by the producers who have to continue financing their capital at the higher rate. Unable to escape from the clutches of debt, the producers are squeezed. They scramble to sell more of their product at fire-sale prices in the hope to be able to service debt contracted at the higher rate. In this way a downward spiral of prices is created.

The prevailing optical illusion suggests that money is scarce. Everybody cries out for the Fed to create more money. The Fed complies and enters the open market to purchase more bonds. In doing so it provides bond speculators with another opportunity to make risk-free profits. Interest rates fall further and producers are squeezed more. A vicious circle is activated. At the end of the spiral producers go bankrupt in droves.

According to my revisionist theory the Great Depression, far from being caused by overproduction as suggested by Keynes, was caused by wholesale destruction of capital. The ultimate cause was risk-free profits granted to bond speculators through the Fed’s open market operations.

This is a most serious challenge with which the prevailing orthodoxy is confronted. The weakness of its position is shown by the unwillingness to take it up and have an open debate. It is with regret that Gold Standard University Live has to suspend its operation and let Keynesian orthodoxy win by default.

### Witch-hunt in Washington

High energy and food prices have given occasion for a witch hunt in Washington. Politicians are trying to push the blame on speculators, calling for legislation to limit long positions in the futures markets. These laws, if enacted, would be counter-productive. All this goes to show that economics is a complete ignoramus when it comes to speculation.

Speculating in crude oil and in grains is not risk-free. Profits are the incentive for speculators to lend liquidity to the markets and to temper price swings. Indeed, speculation stimulates production or retrenchment according as the threat is scarcity or overproduction.

It is a blunder to regulate speculators out of the commodity markets. The result is predictable: illiquidity, more volatility, more scarcity. Consumers would end up paying even more for energy and food.

So much for commodity speculation. Bond speculation is another matter.

As explained, bond trading does not address risks that exist in nature. It addresses risks created artificially by the government. Worse still, instead of promoting stability, it destabilizes the interest rate structure further. Worst of all, bond speculation is made risk-free by the open market operations of the Fed.

The cap on bond prices has been removed, and continually falling interest rates may push the world into another Great Depression, possibly worse than the last one in the 1930’s.

### Farewell message

These are just some of the questions GSUL has set out to investigate in depth.

Mainstream economics avoids these topics like the devil avoids holy water.

Other schools such as the Austrian, for example, appear to be more interested in cultism and in regurgitating old tenets than in new research of new problems to which mainstream economics turns a blind eye.

It is with regret that GSUL gives up its plans to discuss these burning issues in public just at a time when the need for such debate appears to be the greatest.

I take this opportunity to thank everybody, participants as well as sponsors, for their support of our cause. I wish everybody a prosperous journey through what promises to be truly hard times.

---

*June 26, 2008.*

---

# Putting Loin-Cloth on the Naked Bogeyman

URL: https://newaustrianeconomics.com/archive/fekete/putting-loin-cloth-on-the-naked-bogeyman/
Date: 2008-06-11
Section: Popular Economics
Difficulty: accessible
Concept Tags: fiat-currency, monetary-crisis, bond-market, capital-destruction, federal-reserve
Description: Fekete examines the financial system's attempts to clothe its naked vulnerabilities with regulatory fig-leaves — capital requirements, stress tests, and disclosure rules that do nothing to address the underlying problem: the absence of gold backing and the destruction of self-liquidating credit.
Editorial Note: Written June 2008 as financial regulators were proposing new rules in response to the crisis.
Original PDF: https://professorfekete.com/articles/AEFPuttingLoinClothOnTheNakedBogeyman.pdf

*Putting Loin-Cloth On The Naked Bogeyman*

### A Primer on the Silver Basis

### Antal E. Fekete

### Gold Standard University aefekete@hotmail.com

I started writing this piece as the sub-prime crisis was unfolding. I wanted to establish the connection between the silver basis and the budding banking crisis caused by phony bond insurance schemes and the lack of hedging irredeemable dollar debt with metal holdings. My original title was Putting Clothes on the Naked Bogeyman. As writing progressed I realized that it would take more than one article to dress up the bogeyman; hence the revised title.

### Trading hedged corn

When I tell my audience at Gold Standard University Live that huge quantities of commodities are bought and sold every day without any reference to the price, my words are received with an incredulous silence. It appears incredible to the uninitiated that the price risk can be neatly side-stepped. I have to explain to my listeners that when the professional grain trader gives an order to buy or sell corn, he may be unaware whether the price of corn is up or down. He doesn’t care. He is buying and selling hedged corn, and he takes his clues from the basis, not the price of corn itself. He has replaced price risk with basis risk which he knows how to handle as its behavior is less erratic and more predictable. Most people don’t realize that the bulk of grain trading on the futures markets is driven not by the price but by the basis.

In the grain market by basis is meant the difference between the futures price and the local cash price of the grain. Thus the basis varies from place to place, and from one delivery month to another. Trading the basis means buying or selling hedged grain. The merchant goes long on the basis by purchasing hedged grain when the basis is wide, and selling it when the basis is narrow (possibly negative). He goes short on the basis by selling hedged grain first when the basis is narrow (possibly negative), and selling it later when the basis is wide.

### The myth of naked shorts

The silver market is similar. Large quantities of silver are bought and sold every day without reference to the price. Professionals trade hedged silver on clues from the silver basis. They are not gambling on the price variation of silver: they want to earn a reliable income on physical silver already in store. They may do this on their own account or, more typically, on customer account. The ever growing inordinate and concentrated naked short position in the face of a strongly rising price is a myth.

I defined silver basis in my earlier articles as the difference between the nearest futures price and the cash price of silver (see references).

It is puerile to assume that most professional traders are naked short in silver, just as it would be sheer ignorance to suggest that most professional traders of grain are naked short in corn. They are not. You may rest assured that their corn is well in place in a grain elevator somewhere. If the elevator is registered with the commodity exchange, then the hedger may post a reduced margin on his position. But the elevator need not be registered, in which case the hedger posts full margin. While this is not typical in the grain trade, it is quite common in the silver trade. Rightly of wrongly, the silver trade is surrounded with far more secrecy than the grain trade. This has to do with the fact that silver is considered a monetary commodity by many in the first place, and an industrial commodity only in the second. We must understand that lots of people are accumulating silver not so much for the ride to \$1000, which may or may not happen, but in protest against low interest rates on passbook savings and certificates of deposit. They are happy to post full margin instead of the lower hedge margin on their short position in silver in exchange for anonymity. Of course, the exchange knows that theirs is a hedge position, but must treat this information as confidential. So must the C.F.T.C.

Let’s start by reviewing the differences between the grain and silver trade. As most grain is sold to the ultimate consumer within the year of production, the basis has a yearly cycle with trough just before and peak just after harvest. By contrast, the silver basis is not cyclic. Silver is typically accumulated year after year by investors and bullion banks. Instead of an annual cycle following the crop year, the silver basis has a long-term falling trend, a strong hint of a slowly developing shortage. It is impossible to predict when shortage will hit.

After every major price advance there is profit-taking by unhedged investors, and after every major price decline there is short covering by hedged investors and bullion banks. Net selling through profit-taking and net buying through short covering may or may not balance out.

Accordingly, the trend towards a permanent silver shortage is going to be uneven.

### Historical sketch of the grain trade

Farmers produce billions of bushels of grain every year. Most of this grain is sold several times in the futures markets as part of the basis-trading before it is consumed. An understanding of the historical development of the futures markets may be helpful.

Standardized futures contracts began trading on commodity exchanges in the late 1800’s.

Futures markets revolutionized the way cash grain was traded and gave the grain elevators and the farmers the ability to buy and sell more easily and profitably. Grain companies learned how to use futures contracts more effectively to manage risks, and to maximize income from their elevators. The big revolution was the advent of basis-trading, to replace price-trading. This revolution is not mentioned in school curricula; not even in university curricula. This is a pity. The story of basis trading is a story of capitalism triumphant. It teaches how the free market can overcome the capriciousness of nature. As more and more people learn the skills of basis trading, profitability grows and business expands.

The grain business prospered until the 1930’s when the Great Depression began and governments became heavily involved in grain trading. Government programs dominated the marketplace. Storage of grain was encouraged and construction of new elevators was subsidized. However, the market was stagnant, to a large extent precisely because the new elevator space was taken up by government-owned grain. This grain was just sitting there in the elevators, until it was ultimately given away to other governments or to charities.

In the 1970’s governments decided to reduce their presence in the grain market. A new era started when market forces were allowed to prevail once more. The grain business relearnt how to increase efficiency, manage risks, and generate income through basis trading.

Generally, the abundance of grain kept the market stable. Under these conditions the opportunity for trading was confined to buying and holding grain. This is known as the „carry trade”: buying when the basis is at its highest and selling when it is at its lowest. The basis was following a consistent pattern and as it declined from harvest to the end of the crop-year, the grain trade was provided with a reliable income.

It would take a sizeable drop in production to cause any significant move in the price and a deviation of the basis from the customary pattern. While it did not happen very often, the market came away with the flying colors proving the superiority of trading the basis over trading the price especially under volatile conditions.

The 21st century brought new challenges to the grain trade. The market became demand-driven. Increasing population and improved living standards around the world opened up markets to more people and boosted demand for processed food and other consumer products. There has been a tremendous growth during this first decade of the century. In addition to the carry trade, „value added trade” has put in an appearance and started growing. In this environment grain does not sit around in elevators for a long period of time. The market absorbs it and makes it into all kinds of products for human and animal consumption. Most recently grain has started trading also for use in energy production. All these changes contributed positively to basis trading as it has changed the dynamics of the marketplace.

Of course, not all grain traders are trading basis. A dwindling number still trade price.

Most of these traders are barely surviving. They will have to learn the skills of basis trading, or perish. It is a safe bet that no new grain elevator is being built with trading the price in mind. They are built with trading the basis in mind. Those who are still trading price are missing one of the great opportunities of the century by not understanding basis.

### Historical sketch of the silver trade

Second only to gold, silver is a monetary metal. This means that above ground silver represents several years’ output of the mines. One should not be misled by the propaganda line that this silver „has been consumed by industrial applications”. The recovery of scrap silver is a function of the price. As the price of silver rises, the rate of recovery will rise with it, sometimes dramatically. In addition, an unknown but substantial amount of silver still exists in monetary form. Owners do not want to reveal their identity, or the size of their hoard.

But this does not mean that monetary silver has disappeared in consumption. There is no support for the claim that silver is in short supply, or that silver has ceased to be a monetary metal. Any apparent shortage simply means that the carry trade holds back stocks from the market in hope of an early price advance. At the right price it will make the metal available.

Prior to 1873 the price of silver was stabilized through monetary legislation at \$1.29 per oz. After the Civil War the U.S. Mint was closed to silver. The German government also closed its Mint to silver in the wake of the Prussian victory over France about the same time.

Silver was dumped in the markets in unprecedented amounts, driving the price down to as low as 70 cents by the end of the 19th century. Although the price spiked back to \$1.29 at the end of World War I, it did not last and during the Great Depression it hit a low of 25 cents. We may add that upheavals in the silver market were a direct consequence of government meddling. Ultimately people have learnt how to neutralize the destructive influence of the government in an effort to control money, and they borrowed a leaf from grain merchandising manuals in trading the silver basis.

Through all this time up to 1965 there was no silver trading on the organized commodity exchanges for reasons of insufficient volatility. By 1965 the world market price threatened to exceed the statutory price, as demonstrated by the disappearance of silver coinage from circulation, and volatility perked up. Silver trading on the organized commodity exchanges started. However, secrecy continued to surround the silver trade as one monetary crises followed another at more or less regular intervals. There was a conception that silver could also be confiscated as gold was in 1933. In the event, the ban on gold ownership and trading was lifted in the U.S. at the end of 1975, allowing gold futures trading to start and giving a boost to silver futures trading already in progress.

Secrecy prevailed and manuals on how to trade basis in the gold and silver markets were never made public. Those anxious to learn basis trading of the monetary metals had to buy the manuals for basis trading in grains, and work it out for silver and gold on their own.

This is not as easy as as it sounds, because of pitfalls due to the fact that trading monetary metals differs from trading grains in almost every respect. Having said that, there is no question that basis trading in gold and silver is a wide-spread practice preferred by the most conservative investors, and even the more venturesome cannot do without at least a rudimentary understanding of the underlying principles. We have mentioned above that trading the basis for grain instead of trading the price was a triumph of capitalism. Man has learned how to overcome the capriciousness of nature. The same also happened in the silver market: trading the silver basis increasingly replaced the trading of the silver price. The difference is that here it was not the capriciousness of nature but the capriciousness of governments that has been overcome. Governments want you to believe that they can create and destroy value at will by monetizing debt while demonetizing silver and gold. In effect they cannot do either in a durable way. Government magic goes only so far as gullibility of the people.

Gold Standard University Live is a world leader in offering regular panel discussions and primers on basis trading of the monetary metals. There are plans to run workshops as well on basis trading. The next session is scheduled from July 3 through 6 at the Martineum Academy in Szombathely, Hungary, to be followed by a session in Canberra, Australia in November (see Announcement at the end of this article).

### The Last Contango in Washington

Volatility in the gold and silver markets is like a dormant volcano. Unannounced, it erupts periodically with increasing ferocity. As it does, trading the gold and silver price is becoming ever more treacherous. There can be no doubt that the answer is basis trading, that is, buying and selling hedged gold and silver. It is only a matter of time before a trading house or bullion bank will offer this service.

The significance of the silver and gold basis can be found in the role they play as an early warning system. Under normal circumstances backwardation in gold and silver is an aberration. Monetary metals must be sufficiently plentiful in order to serve as such. This translates into contango. But at the time of monetary disturbances, like the one triggered by the sub-prime mortgage crisis, the monetary metals tend to go into hiding. As they do, the cash price goes to a premium against futures prices, and the basis goes negative, indicating the extent of scarcity. If hyperinflation is in store, gold will go into permanent backwardation, foreshadowed by a steep decline in the basis.

In an earlier article I have, somewhat flippantly, described this momentuous paradigmshift as „the last contango in Washington” (with a bow to the movie The last tango in Paris.) The historic contango of gold will give way to permanent backwardation. It will mean that gold is not for sale at any price ― not against the irredeemable dollar. Note that while the gold price is open to government manipulation, the gold basis cannot be so easily falsified. It reflects the truth as it is. The basis never lies.

### Canary in the coal mine

According to one hypothesis, permanent backwardation in silver will precede that in gold.

Thus silver is the „canary in the coal mine”. But you have to have ears to hear the canary sing.

In other words, you must be able to read the message carried by the silver basis. If deflation and depression is in store, then the case for silver is not so clear-cut, in view of silver’s extensive industrial applications. It is possible that silver will be dumped by investors fearing that industrial demand is vanishing. But again, it is also possible that the rush into gold, a regular feature of depressions, will spill over as a rush into silver. Whatever happens, the silver basis will provide a reliable early warning sign. The return of contango in silver is an indication that bullion banks are dumping silver. Continued backwardation is an indication that investors and bullion banks are still accumulating silver. Investors and traders would do well to learn all they can about the silver basis to be able to interpret events correctly as they unfold, even if they never intend to trade the silver basis.

The inordinate size of the short commitment of traders indicate that bullion banks actively trade the silver basis. Among their customers are wealthy investors and, possibly, governments or government agencies. C.F.T.C. investigators insist that there is no market manipulation in silver. I am willing to take their word at face value. Basis trading is not a market manipulation, even if done on a large scale. It is dynamic hedging, and hedging is just what the futures markets are for. While futures trading would not work without an adequate speculative following, it is not primarily for the benefit of the speculators. It is for the benefit of the hedgers. Speculators are supposed to know this and they should stop crying „foul play!”

### What is seen and what is not seen

Those who hold that there is market manipulation are victims of an optical illusion. What appears as an oversize naked short position involving no more than eight trading houses or bullion banks, is just the visible side of basis trading in silver. But there is another, invisible side as well. The invisible side is hedged metal in private hoards, in the reserves of bullion banks and, possibly, in secret government depositories.

It is well-known, for example, that the Chinese government controls large stores of silver, remnants of the long-lasting silver standard in China. A lot of the silver that governments and private individuals dumped in the West after the 1873 demonetization found its way to the East, where the Chinese Mint was still open to silver. At that time China offered the only unlimited market for silver. There is some controversy about the question whether silver was flowing into or out of China between 1934 and 1949. Be that as it may, after the overthrow of the Nationalist government the Chinese Communists inherited untold amounts of silver. If there was an outflow of silver from China before the Communist takeover, it certainly stopped after 1949.

### Chinese hedges are no Texas hedges

It is a plausible assumption that the wily Chinese presently trade the silver basis under a seal of secrecy. Some of the world’s largest banks are in China, and they definitely have bullion trading desks. Unlike their opposite numbers in Japan and the West the Chinese banks are not brain-dead. While they also have a large portfolio of dollar-denominated assets, they are probably fully hedged by their holdings of silver and gold. The Chinese banks don’t have to carry the ideological baggage of anti-gold mentality, so prevalent in the United States. Their financial condition is incomparably superior to that of banks in the dollar orbit.

In order to understand the silver saga it is important that we put ourselves into the Chinese mindset. For the Chinese silver is money, and the US dollar is a dishonored promise.

They see no reason to exchange their silver for paper, of which they already have more than their fill. Their perspective on the market is entirely different from that of silver investors in the West. Their participation in the silver market is motivated by their desire to earn a return on their holding of silver in silver. A price explosion would frustrate their strategy. They don’t want a supply shock in silver. On occasion they have to pacify the restless silver market through selling, with the idea of buying the material back, preferably at a better price. This is not naked short selling; this is dynamic hedging. No crusade of the „insanely bullish” can reclassify it as market manipulation.

The difference between the Chinese banks and their Japanese and Western counterparts is that the Chinese hedge paper with metal, while the Japanese and their American mentors hedge paper with paper. Theirs are Texas hedges (with reference to the anecdotal rancher who hedges his herd with long live cattle futures contracts).

### Silver basis and the banking crisis

The present banking crisis necessitating unprecedented bailouts of multinational banks is not unrelated to silver basis trading. By now it is clear that the cause of the crisis is the banks’ inordinate portfolio of assets concentrated in debt denominated in the irredeemable dollar, unhedged by gold and silver. By contrast the Chinese banks, which also have large dollar assets, are hedged in metal. The Chinese banks are in no need of a bailout. So much for diagnosis. The prognosis: more bank failures in the West and in Japan; further relative strengthening of banks in China.

It is unreasonable to expect that exchange officials and C.F.T.C. investigators disclose the hedging activities of bullion banks, Chinese or otherwise. I repeat, trading the silver basis is not market manipulation. The high concentration of short positions is due to the fact that governments and wealthy individuals wanting to earn a return on their silver holdings prefer to take their business to a select few trading houses and bullion banks with the necessary expertise and capital to trade the silver basis on a large scale. This offers them the best chance to preserve anonymity. The sluggishness of silver deliveries is explained by the long lines of communication. It takes time to get the silver from the East for delivery in the West. One should not read imaginary shortages into this. Presently silver is not in short supply. If it were, silver could not drop in price as much as \$5 an ounce or 25 percent in a matter of days, and continue trading at the lower end of the range. Paradoxically, sluggishness of deliveries is the very proof that there is no corner in the offing ― not yet. If there were, the metal would move from East to West in supersonic aircrafts.

### The best little warehouse in Comex

I strongly disagree with the tactics of Comex in putting a limit on long positions in silver and on silver deliveries, which looks like an admission that there is a shortage. Silver in approved warehouses is there to be delivered on demand. Let the chips fall where they may, and let’s see what the market will do if the last bar of silver is removed from the warehouses. Limit on deliveries does not prove shortage; it only proves that the exchange is inefficient and does not favor transparency. In limiting delivery it undermines its own usefulness. The exchange should oblige hedgers to keep sufficient silver in the warehouses ready for delivery at all times, in return for protection of their privacy. Failure to comply should be penalized with margin call on short hedge positions, possibly higher than the value of the underlying contract. This would enhance the credibility of the exchange more than anything else. As it is, the best little warehouse in Comex is for window-dressing only. For serious business, such as you know what, you had better go to another warehouse.

### Bleeding to death in the bull ring

It is not in the interest of wealthy individuals, bullion banks, and governments with large stockpiles of silver that the price go to \$100 overnight, which could happen if secrecy were breached and anonymity blown away. As they can derive an income from their silver holdings already, these owners of silver prefer a controlled rise in the price. And that’s exactly what we’ve got.

Failure to understand this may lead one to all kinds of superstitious beliefs concerning the power of the bullion banks to manipulate the price of silver. The panicky short covering predicted when silver was trading below \$5 never materialized during the run to \$20 and higher. There has been and will be a lot of short covering, but nothing what could be called a short squeeze. Not until the curtain falls on the Last Contango in Washington.

As a quick back-of-the-envelope calculation shows, if the naked silver bogeyman were real, he would have by now lost an arm and a leg after losing his shirt. He would have bled to death in the bullfight. Let’s be generous and admit that he does have, at the very least, well, a loin-cloth to wear in confronting the charging bull.

### References

By the same author:

### It’s Not a Dollar Crisis: It’s a Gold Crisis, June 5, 2008

### The Saga of the Naked Bogeyman, November 2007

### Exploding the Myth of the Silver Shortage, September, 2007

### The Last Contango in Washington, June, 2006

### The Rise and Fall of the Gold Basis, June, 2006

### Monetary versus Non-Monetary Commodities, May, 2006

### Ultracrepidarian Musings, May, 2006

### Bull in Bear’s Skin? May, 2006

### What Gold and Silver Analysts Overlook, May 1, 2004

These and other papers of the author can be accessed on the website [www.professorfekete.com](https://www.professorfekete.com)

## Gold Standard University Live

Session Four is to take place in Szombathely, Hungary (at Martineum Academy where the first two sessions were held). The subject of the 13-lecture course is The Bond Market and the Market Process Determining the Rate of Interest (Monetary Economics 201). It will be followed by a panel discussion on the topic: The Silver Basis and the Present Banking Crisis: Phony Bond Insurance Schemes and the Lack of Hedging Irredeemable Dollar Debt with Monetary Metals.

The date is: July 3-6. For more information please see [www.professorfekete.com/gsul.asp](https://www.professorfekete.com/gsul.asp) or contact GSUL@t-online.hu. Registration can be made by e-mail upon payment of the preregistration fee. The remainder of the registration fee is due 3 weeks prior to the session.

Space is limited; first come, first served.

Preliminary announcement: Gold Standard University Live is planning to have its Session Five in Canberra, Australia, in November, 2008. This Session will include a Primer on the gold and silver basis, prerequisite for a Workshop on the basis offered at Session Six (planned to take place in the Spring, 2009).

---

*June 12, 2008.*

---

# It's Not a Dollar Crisis: It's a Gold Crisis

URL: https://newaustrianeconomics.com/archive/fekete/its-not-a-dollar-crisis-its-a-gold-crisis/
Date: 2008-06-04
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, fiat-currency, monetary-crisis, gold-standard, central-banking
Description: Fekete reframes the 2008 financial crisis: commentators call it a dollar crisis, but it is actually a gold crisis — caused by the systematic destruction of gold's monetary role. The symptoms (collapsing credit, failing banks, dollar weakness) are all consequences of removing gold from the monetary system.
Editorial Note: Written June 2008 as the financial crisis intensified.
Original PDF: https://professorfekete.com/articles/AEFItsNotADollarCrisisItsAGoldCrisis.pdf

*It’S Not A Dollar Crisis: It’S A Gold Crisis*

**Antal E. Fekete**

### Gold Standard University

The title is a bow to Peter Schiff for his admirable article It’s Not an Oil Crisis: It’s a Dollar Crisis.

Thirty-five years ago gold, symbol of permanence, was chased out from the Monetary Garden of Eden, replaced by the floating irredeemable dollar as the pillar of the international monetary system. That’s right: a floating pillar. The gold demonetization exercise was a farce.

It was designed as a fig leaf to cover up the ugly default of the U.S. government on its goldredeemable sight obligations to foreigners. The word ‘default’ itself was put under taboo even though it punctured big holes in the balance sheet of every central bank of the world, as its dollar-denominated assets sank in value in terms of anything but the dollar itself. These banks were not even allowed to say ‘ouch’ as they were looking at the damage to their balance sheets caused by the default. They just had to swallow the loss, obediently and dutifully join the singing of the Hallelujah Chorus of sycophants in Washington praising the irredeemable dollar and the Nirvana of synthetic credit.

For a time it looked like a clever coup as America has benefited at the expense of the rest of the world. It could now buy all the goods and services it wanted from foreign countries in exchange for little scraps of paper on which some ink has been sprinkled. More importantly, America could establish military bases and start wars on foreign soil paying for them with dollars created out of thin air. Foreigners had to put up and shut up. What used to be “deficits without tears” before, has now become “deficits with laughter”.

Few people realized at the time that America, far from giving itself a gift at the expense of foreigners, has fatally shot itself in the foot. At first the wound from this selfinflicted gunshot did not hurt and was quite invisible. Festering and pain came later. The long time-lag makes the causal relationship between the two events fade. Yet the connection exists creating ever more mischief, misdiagnosis, monetary quackery and, ultimately, the greatest credit collapse in history.

America had to foster an anti-gold psychosis in the world to cover up default. Milton Friedman was the high priest of the new paradigm with his monetarism, preaching the unmatched virtues of the floating dollar. It was supposed to eliminate the American current account deficit. It never did, instead, it killed the healthy American trade surplus, as American industry was pushed into an endless decline by the self-mutilation of the dollar.

The worst part of the anti-gold psychosis was its effect on the banking system.

American banks were deprived of a chance to hedge their assets, all of it held in the form of irredeemable debt (irredeemable in the sense that at maturity it was payable in irredeemable currency) by holding monetary metals, gold and silver, as a reserve. Those foreign banks that did were made the laughing stock of the banking industry. ‘Progressive’ banks were free to heap debt upon debt in the asset column of the balance sheet without any regard to reserve ratios, in a mad chase of illusory paper profits. If the balance sheet was not big enough, why, they could simply go ‘off balance sheet’ to add more debt. Foreign banks chimed in: “Me too, me too!” It was truly an incredible sight watching the Union Bank of Switzerland, a solid and liquid bank before 1973, throwing all caution to the winds in its zeal to embrace hare-brained securitization schemes, and to put a lot of bad debt made in USA on its balance sheet.

We were also treated to another incredible sight: the Bank for International Settlements (BIS), the only sane central bank left after the gold-demonetization farce, committing hara-kiri. Since its establishment the BIS carried its books in Swiss gold francs.

The implication was clear: the BIS wanted to stay above the hurly-burly of competitive currency devaluations which humiliated even the lofty Swiss franc in 1936. The BIS continued to carry its books in Swiss gold francs, never mind the vicious anti-gold agitation that started in 1973. Ultimately it threw away all good banking sense and caved in. On March 10, 2003, BIS abandoned the Swiss gold franc and embraced the SDR (Special Drawing Rights) as its unit of account. The SDR has the dubious distinction among fiat currencies that it does not even have an obligor. It is an out-and-out make-believe currency. It does not arise as an obligation. It arises as a free gift, manna from heaven, brought by Santa Claus alias IMF. In want of a definition of an accounting unit, not one bank in the world is subject to any meaningful accounting rules any more. The last central bank with the ability to step into the breach, offering sound credit in case of a world-wide credit collapse, has disappeared from the scene.

Because of the anti-gold psychosis the dollar went into a downward spiral, never to come out of it. The question arises whether gold is just an embellishment, a barbarous relic, a superstitious talisman, or whether gold is a real mooring without which the banking systems cannot safely manage risks in the long run.

To answer this question we must understand the first principles of hedging. Gold and silver, as monetary metals, are the two most important hedges banks can have to offset risks to the asset column of their balance sheets. You cannot hedge these risks through owning more debt ― the liability of someone else. A hedge that is subject to exactly the same risks would not diminish but magnify risks. It is a “Texas hedge”. For a true hedge, you need and ultimate asset that is not the liability of anyone. Such an asset is furnished by the monetary metals. It is foolish to suggest that gold and silver have lost their value as hedges since their prices fluctuate. The fluctuation of their price does not prove that the value of gold and silver fluctuates. On the contrary, it is the value of the dollar that does fluctuate in which gold and silver prices are quoted.

Because of this fluctuation it is inherently treacherous to trade gold and silver on the variation of price. Proper hedging replaces price risk with basis risk which is less erratic and more predictable. The basis is the difference between the nearest futures price and the cash price of the monetary metal, gold or silver. There is a long-term trend for the basis to fall, and ultimately to go negative. Traditionally the basis has been positive. The condition when the futures price exceeds the cash price is called contango. Permanent contango is a characteristic of the monetary metals indicating large above-ground stores relative to the annual output of the mines. But wear-and-tear causes fiat currencies to lose value. It makes the basis of gold and silver fall, and contango disappear. The opposite condition, when the futures price goes to a discount against the cash price, is called backwardation. It is equivalent to a negative basis.

It indicates that the monetary metals go into hiding.

The international monetary system is inevitably drifting towards the black hole of backwardation, and will ultimately succumb to its pull. Governments and central banks tell you that they are combating inflation. Their combat is a lonely one. They just cannot escape the pull of the backwardation of monetary metals.

The point is that the only way to measure the slow deterioration of the collective value of irredeemable currencies is the gold and silver basis. It is precisely the change in the basis that provides clues for hedging against the risk of monetary debasement. The outstanding fact is that the basis can be traded with greatly reduced risk, as compared with trading the price.

It should be clear that some banks in the world are doing just that. They are trading the gold and silver basis (as opposed to trading the gold and silver price) continuously. This means that they are buying hedged metal when the basis is high, and selling it when the basis is low. This enables them to earn a steady income on their gold and silver reserves in gold and silver. The proof that they indeed engage in this activity is furnished by the inordinate size of the short interest in the gold and silver futures market. It is altogether erroneous to attribute this short interest to the activities Jurassic Park creatures, and to that of the bogeymen of the ‘naked’ silver commercials. The inordinate size of short interest in gold and silver is just the visible side of the hedges of bullion banks and others, the invisible side of which is their metallic reserves.

Gold Standard University Live is the only organization that advocates paying attention to silver and gold contango, backwardation, and basis. The vocabulary of analysts and other observers of the passing scene does not include these terms. They follow statistics of production and off-take, the commitments of traders in the futures market, and are trying to divine the coming changes in the gold and silver price through supply and demand equilibrium analysis. Their approach is wrong-headed. Supply and demand equilibrium analysis is inapplicable to the monetary metals, both the supply of and the demand for which tend to be unlimited. That’s just what makes gold and silver a monetary metal. Nevertheless, the threat of a short squeeze or, if the worse comes to the worst, the threat of a corner, is real.

Corner in the precious metals also goes by the other name of hyperinflation. Reams and reams of supply/demand statistics and all the COT reports in the world will not predict when it will hit. Only the basis will. It provides an early-warning system indicating, with the precision of a seismograph, the coming shortages in silver and gold. And only Gold Standard University Live is willing to publish the results of research which tell you how to read basis signals.

In summary, the present crisis is far from over. Far from being an oil crisis, it is not even a dollar crisis. It is a gold crisis. It is preying on American and other banks for their failure to hedge paper assets with gold. The U.S. government is trying to bail out large multinational banks by stuffing them with more paper assets. The Federal Reserve has made history when it swapped U.S. Treasury bonds for asset-backed securities for which the market refuses to bid. The trick won’t work. And it is doubtful that the only meaningful bail-out that would work, namely, opening the U.S. Mint to gold and silver as advocated by presidential candidate Dr. Ron Paul, is in the cards. It would work as it would make U.S. Treasury gold available to American banks to save them from insolvency. What they need is not augmentation of capital in the form of more paper credits. What they need is metallic hedges to prop up the value of paper assets. Opening the U.S. Mint to gold and silver would mobilize the world’s metallic reserves, presently in hiding, and put them back into the public domain to assume their traditional role as the foundation of the world’s credit system.

### References

Peter Schiff, It’s Not an Oil Crisis, It’s a Gold Crisis, May 23, 2008, [www.321gold.com](https://www.321gold.com)

A. E, Fekete, The Last Contango in Washington, June, 2006, [www.professorfekete.com](https://www.professorfekete.com)

---

*June 4, 2008.*

## Gold Standard University Live

Session Four is to take place in Szombathely, Hungary (at Martineum Academy where the first two sessions were held). The subject of the 13-lecture course is The Bond Market and the Market Process Determining the Rate of Interest (Monetary Economics 201). It will be followed by a panel discussion on the topic: The Silver Basis and the Present Banking Crisis: Phony Bond Insurance Schemes and the Lack of Hedging Irredeemable Dollar Debt with Monetary Metals.

The date is: July 3-6. For more information please see [www.professorfekete.com/gsul.asp](https://www.professorfekete.com/gsul.asp) or contact GSUL@t-online.hu. Registration can be made by e-mail upon payment of the pre-registration fee. The remainder of the registration fee is due 3 weeks prior to the session. Space is limited; first come, first served.

Preliminary announcement: Gold Standard University Live is planning to have its Session Five in Canberra, Australia, in November, 2008. This Session will include a Primer on the gold and silver basis, prerequisite for a Workshop on the basis offered at Session Six (planned to take place in the Spring, 2009).

---

# Götterdämmerung

URL: https://newaustrianeconomics.com/archive/fekete/gotterdammerung/
Date: 2008-04-28
Section: Popular Economics
Difficulty: accessible
Concept Tags: fiat-currency, monetary-crisis, federal-reserve, permanent-backwardation, gold-standard
Description: Fekete invokes Wagner's Twilight of the Gods to describe the approaching end of the dollar-based monetary system. Like the Norse gods who know Ragnarok is coming, the Federal Reserve and Treasury are accelerating the system's destruction even as they claim to be saving it. The essay diagnoses the final phase of irredeemable currency's life cycle.
Editorial Note: Written April 2008 as the Federal Reserve was engineering the Bear Stearns bailout.
Original PDF: https://professorfekete.com/articles/AEFGotterdammerung.pdf

## Götterdämmerung

### The Twilight of Irredeemable Debt

### Antal E. Fekete

### Gold Standard University

Wagner’s opera Götterdämmerung is about the twighlight of pagan gods. The most powerful of the latter-day pagan gods that has been guiding the destinies of humanity for the past two-score of years is Irredeemable Debt. Before August 14, 1971, debts were obligations, and the word “bond” was to mean literally what it said: the opposite of freedom. The privilege of issuing debt had a countervailing responsibility: that of repayment.

On that fateful day all that was changed by a stroke of the pen. President Nixon embraced the woolly theory of Milton Friedman and declared the irredeemable dollar a Monad, that is, a thing that exists in and of itself. According to this theory the government has the power to create irredeemable debt ― debt that never needs to be repaid yet will not lose its value ― subject only to a “quantity rule”, e.g., it must not be increased by more than 3 percent annually. This idea is so preposterously silly that “only very learned men could have thought of it”. If the thief is thieving modestly, then he will not be detected. It never occurred to the professors of economics and financial journalists that a modest thief is an oxymoron, a contradiction in terms. How did they get to believing in irredeemable debt? The explanation is most likely found in Schiller’s dictum: “Anyone taken as an individual is tolerably sensible and reasonable. But taken as a member of a crowd ― he at once becomes a blockhead”. Economics professors and financial journalists are no exception.

For a time it appeared that Milton Friedman was right. The world has become dedicated to the proposition that it is possible, even desirable, to expand irredeemable debt in order to make the economy prosper. Never mind the default of the U.S. government on its bonded debt held by foreigners. Never mind people victimized by theft. Thanks to the quantity rule, they will never notice the difference.

For all its seductive attractiveness Friedmanite economics is ignoring the effect of irredeemable debt on productivity. It watches debt per GDP and is happy as long as this ratio stays below 100 percent by a fair amount. However, what should be watched is the ratio of additional debt to additional GDP. By that indicator the patient’s condition could be diagnosed as that of pernicious anemia. It set in immediately after the dollar debt in the world was converted into irredeemable debt.

The increase in GDP brought about by the addition of \$1 of new debt to the economy is called the marginal productivity of debt. That ratio is the only one that matters in judging the quality of debt.

After all, the purpose of contracting debt is to increase productivity. If debt volume rises faster than national income, there is big trouble brewing, but only the marginal productivity of debt is capable of revealing it.

Before 1971 the introduction of \$1 new debt used to increase the GDP by as much as \$3 or more. Since 1971 this ratio started its precipitous decline that has continued to this day without interruption. It went negative in 2006, forecasting the financial crisis that broke a year later. The reason for the decline is that irredeemable debt causes capital destruction. It adds nothing to the per capita quota of capital invested in aid of production. Indeed, it may take away from it. As it displaces real capital which represents the deployment of more and better tools, productivity declines. The laws of physics, unlike human beings, cannot be conned. Irredeemable debt may only create make-belief capital.

By confusing capital and credit, Friedmanite economics obliterates truth. It makes the cost of running the merry-go-round of debt-breeding disappear. It makes capital destruction invisible. The stock of accumulated capital supporting world production, large as it may be, is not inexhaustible.

When it is exhausted, the music stops and the merry-go-round comes to a screechy halt. It does not happen everywhere all at the same time, but it will happen everywhere sooner or later. When it does, Swissair falls out of the sky, Enron goes belly-up, and Bear-Sterns caves in.

The marginal productivity of debt is an unimaginative taskmaster. It insists that new debt be justified by a minimum increase in the GDP. Otherwise capital destruction follows ― a most vicious process. At first, there are no signs of trouble. If anything the picture looks rosier than ever. But the seeds of destruction inevitably, if invisibly, have sprouted and will at one point paralyze further growth and production. To deny this is tantamount to denying the most fundamental law of the universe: the Law of Conservation of Energy and Matter.

The captains of the banking system in effect deny and defy that basic law. They are leading a blind crowd of mesmerized people to the brink where momentum may sweep most of them into the abyss to their financial destruction. Yet not one university in the world has issued a warning, and not one court of justice allowed indictments to be heard from individuals and institutions charging that the issuance of irredeemable debt is a crude form of fraud, calling for the punishment of the swindlers issuing it, whether they are in the Treasury or in the central bank. The behavior of universities and courts in this regard could not be more reprehensible. Rather than acting to protect the weak, they act to cover up plundering by the mighty.

The inconspicuous beginnings of irredeemable debt have blossomed into a colossal edifice, a fantastic debt tower that is bound to topple upon the prevailing complacency and apathy. Actually ‘tower’ is a misnomer. Rather, what we have is an inverted pyramid, a vast and expanding superstructure precariously balanced on a tiny and ever-shrinking gold foundation ― the only asset in existence with power to reduce gross debt. The construction has no precedent in history, and no place in theory, whether Ricardian, Walrasian, Marxian, Keynesian or Austrian. As a matter of fact, no one is analyzing the process. Research has been placed under taboo by the powers that be, lest diagnosis reveal the presence of cancer caused by irredeemability. There is no known pattern or model that would apply to its mechanism in terms of equilibrium analysis. Two negative conclusions emerge.

One is that the edifice of irredeemable debt must grow at an accelerating pace as markets for derivatives providing ‘insurance’ to holders of debt proliferate. The insurer of debt must also be insured, as must the insurer of the insurers, and so on, ad infinitum. This is due to the fact that the risk of collapsing bond values has been created by man. In contrast, the risk of price changes of agricultural commodities are created by nature, and the futures market provide insurance, with no need to re-insure. The other conclusion is that the unwieldy size of the debt structure excludes the possibility of a normal correction: a major liquidation would dwarf the calamities of the Great Depression.

It is a delusion to think that the government can splatter debt all over the economic landscape to cover up its warts, and reap everlasting prosperity as a result. The stimulation and leverage of debt has always caused stock markets to boom, so that the impact of debt was aided and magnified by the added paper wealth which, in turn, increased the propensity to spend and borrow still more.

Businessmen are supposed to be more realistic in contracting debt. Yet the pattern of increase in corporate debt has also changed tremendously. Whereas traditionally corporations used to finance their capital needs in a ratio of \$3 in debt for every \$1 in stock, in the years leading up to 1971 they issued \$20 in debt for every \$1 in stock, with the ratio sky-rocketing thereafter.

We hear arguments that economists have by now learned how to control the economy with the so-called built-in stabilizers. Debt has largely lost its sting as a consequence, we are told. For example, bank deposits can now be insured. They couldn’t in the 1930’s. But when the government itself is loaded with debt, and runs boom-time deficits, the built-in stabilizers may backfire and destabilize the economy further. The government has commitments so great that its endeavor to offset a depression in our vast economy can only result in a loss of confidence. Anxious withholding of purchasing power in the private sector could far outweigh anything the government can add. To make matters worse, government income is highly dependent on a prosperous economy. The magnitude of the problem of offsetting a depression is grossly disproportionate to resources available.

One of the marks of great delusions is that nearly everyone tends to share them. It is a sorry tale ― any delusion gives rise to a rude awakening in due course. Public attitudes to debt have changed so radically since 1971 that today indebtedness is practically a status symbol, instead of a shameful condition it used to be in a by-gone era. The most striking reversal in traditional American attitudes towards debt is the widespread acceptance of perpetual national indebtedness, copied by perpetual personal indebtedness ― a never-ending lien on future income.

Perhaps the worst aspect of the regime of irredeemable debt is the lowest level of morals followed by governments in modern history. It is epitomized by an elaborate check-kiting conspiracy between the U.S: Treasury and the Federal Reserve. Treasury bonds, contrary to appearances, are no more redeemable than Federal Reserve notes. It’s all very neat: the notes are backed by the bonds, and the bonds are redeemable by the notes. Therefore each is valued in terms of itself, rather than by an independent outside asset. Each is an irredeemable liability of the U.S: government. The whole scheme boils down to a farce. It is check-kiting at the highest level. At maturity the bonds are replaced by another with a more distant maturity date, or they are ostensibly paid in the form of irredeemable currency. The issuer of either type of debt is usurping a privilege without accepting the countervailing duty. They issue obligations without taking any further responsibility for their fate or for the effect they have on the economy. Moreover, a double standard of justice is involved. Check-kiting is a crime under the Criminal Code. That is, provided that it is perpetrated by private individuals. Practiced at the highest level, check-kiting is the corner-stone of the monetary system.

But our world is still one of crime and punishment, tolerating no double standard. The twilight of irredeemable debt is upon us. The sign is that banks are reluctant to take the promissory notes of one another. Significantly, this also includes overnight drafts. The banks know there is bad debt at large, and they don’t want to be victimized by taking in some inadvertently. What the banks don’t yet know, but will soon learn, is that all irredeemable debt is bad debt, and there is no way to rid the system of poison through administering more.

Redeemability of debt is not a superfluous embellishment. It has a function of fundamental importance: the proper allocation of resources to the different channels of their utilization. The obligation to redeem debt hangs as the sword of Damocles over the government, just as it does over the head of every economic participant. It compels economy and foresight. It forces balancing of income and expenditures. It adjusts claims and commitments. It limits expansion by shifting resources away from the incompetent, and away from unhealthy projects. The regime of irredeemable debt creates an escape route from commitments by the promise of eliminating the pressure of solvency.

Whether it promises eternal prosperity, or it promises eternal subsidies, it does not matter. The results are the same. They consist in misleading people, enticing them to skate on thin ice, and luring them into financial adventures, private or public, which are not warranted by the ability to pay. The logical consequence is wholesale bankruptcy of individuals as well as that of the political setup. Losses breed more losses, until they become an avalanche. The present crisis is just the first sign of that denouement. More is on the way.

It is still possible to escape the catastrophe which this process would entail. The way out is to open the U.S. Mint to gold and silver, as advocated by presidential candidate Dr. Ron Paul. The logic of this remedy is that it would mobilize potentially unlimited resources, presently tied up in idled gold, and re-introduce the indispensable means of debt-retirement into the economy.

Failing to bring gold back, where are we heading? The short answer is: we are marching into the death-valley of collectivism. The alternative to re-introducing redeemable currency is that the debtbehemoth will force the imposition of a capital-levy type of taxation ― à la Solon, 594 B.C.

---

*April 27, 2008.*

---

# Gold in Hoards Versus Gold on the Go

URL: https://newaustrianeconomics.com/archive/fekete/gold-in-hoards-versus-gold-on-the-go/
Date: 2008-04-01
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, permanent-backwardation, gold-standard, fiat-currency
Description: Fekete distinguishes between gold held in private hoards and gold circulating as monetary reserve. As the gold basis collapses, more gold migrates from circulation to hoarding. This migration is irreversible under the current monetary regime and represents the progressive withdrawal of gold from the paper money system.
Editorial Note: Written April 2008. The hoard/go distinction explains why gold backwardation is different from other commodity backwardations and cannot be arbitraged away.
Original PDF: https://professorfekete.com/articles/AEFGoldInHoardsVersusGoldOnTheGo.pdf

### GOLD IN HOARDS versus GOLD ON THE GO

### Splitting the Roman Empire into two halves

### Antal E. Fekete

### Gold Standard University

### How much gold?

Many readers of my column have asked me how much gold I think there is in Fort Knox, and how much gold I think is being hoarded by Americans that may be available for coinage in case the U.S. Mint is re-opened to gold.

I don't have the figures or estimates. From my perspective these figures do not matter any more. What matters is whether confidence can be restored to the extent that gold will start flowing to the Mint. Here the situation is definitely sad, as shown by the treatment of presidential candidate Ron Paul by the establishment, his own party, the media, the investing public, and the electorate. He has been given the cold shoulder by all in these extraordinary times, just when the financial world started crumbling all around us. He might be God’s messenger, but he has been treated no better than any other before him who was sent out to be prophet in his own land. Even a debate on gold as money, let alone the realization of it, is strenuously opposed by everybody, including the people themselves who are going to suffer for their denseness and put-on deafness as the dollar is ignominiously removed from the stage.

### Gold on the go

Gold sitting in vaults is one thing, and gold on the go is another. Gold on the go is as different from gold in hoards as day is from night. The former suggests confidence in the present and radiant optimism about the future. You dare spend your gold coin as you fully expect it to come back to you on the same terms. The latter suggests fading confidence in the present and deep pessimism about the future. The gold coin is not to be spent. It may never come back to you.

Whenever gold is being hoarded, there is a danger that the economy will plunge to its worst levels, possibly all the way back to barbarism. If all the gold is hoarded, prosperity will collapse regardless of the state of knowledge and technology. But if the Mint is re-opened, gold will flow to the Mint and the economy may rise from the dead.

People will be talking about an „economic miracle”. Our leaders fail to see this. To them gold is still the „barbarous relic”, rather than the elixir of life, turning the moribund economy around from the brink.

### Key to confidence

Trade and commerce, and prosperity that depends on them, hinge upon two primal ingredients: integrity and confidence. It is the function of money to implement their existence and interaction. For 63 centuries they have worked together since the first gold slug was used in exchange by men. Gold is the key to confidence. The universal acceptability of gold throughout history has enabled the agencies of production, consumption, exchange, and distribution to bring about the highest level of prosperity commensurate with the prevailing level of knowledge and technology. Take gold out and, lo and behold: knowledge and technology will no longer uphold prosperity. Sinking back to the Dark Ages becomes inevitable.

### Terror of the error

The United States has missed its chance, in this election year, to have a grand national debate on the merit of a metallic currency, and how gold could be pressed into service at the eleventh hour, to stave off world disaster. The U.S. Mint will not be reopened to gold, and the „terror of the error” will run its course to the bitter end. A depression will engulf the world. Suave qui peut ― that's the message from the 2008 presidential election campaign that has aborted six months too early.

### End of the Roman Empire

Maybe a foreign country will open her Mint to gold and silver. The Chinese could do it, but like all Orientals they are too suspicious and secretive, and they totally lack the trust which is the characteristic of the Western way of doing business. Be that as it may, history appears to be repeating itself. It conjures up the split of the Roman Empire into an Eastern and a Western half in 395 A.D. By 476 the Western half ceased to exist, entering the Dark Ages. Civilization, as people had known it, was gone. However, the Eastern half, partly due to the fact that it could keep its Mint open to gold, continued in existence for another thousand years. Circulating gold represented confidence.

Confidence in production, confidence in trade, confidence in the future.

### Dark Ages

We no longer talk about deflation and depression. We face the Second Coming of the Dark Ages. At the time of the collapse of the Roman Empire all the gold was still available that had kept a munificent world trade going. The trouble was not a shortage of gold.

The trouble was that gold was going into hiding. Had it been put back into circulation, then the Dark Ages could have been fended off. It did not happen, because of the ignorance and selfishness of the leaders, and their self-conceit that a fast-depreciating monetary system will serve the purposes of their Empire. As gold was going into hiding, and there was no statesmanship to press it back into service, there was no way to save civilization in the Western part of the Roman Empire.

It is important to understand that the Dark Ages that followed, and gold going into hiding, are just two sides of the same coin. We have the same double threat facing us today. This time, too, the Dark Ages could last several hundred years.

### Bezant, savior of civilization

The Eastern half of the Roman Empire, Constantinople, fared better. There, they kept the Mint open to gold for another thousand years. Not only did people survive: they prospered. The gold coin of the Empire, the bezant (named for Byzantium, as Constantinople was called before Great Constantine renamed it after himself) saved civilization from ruin to which the Western part of the Empire succumbed so easily.

If history is repeating itself, then the Oriental half of our civilization, backed by the born-again economic strength of China, will have the wisdom to save the world by opening the Mint to silver. Unfortunately, it will not benefit the Occident.

### People crying out in despair

Our government leaders conducting our irredeemable currency and credit program do not understand that people can be faced with tragedy and disaster in the wake of the collapse of the monetary system. Until such a devastating catastrophe occurs, they proceed as though some special Providence will protect this nation from the monetary and social chaos in which the helpless and hopeless mass of people cry out in despair.

People can do little or nothing but suffer because inept men, in the area of monetary economics, threw the Constitution to the winds, usurped unlimited power, and took possession of the monetary program of the nation.

When monetary statesmanship is replaced by foolishness, recklessness, irresponsibility, and related examples of human misbehavior, catastrophe and chaos await the unfortunate nation caught in that frequent tragedy of mankind.

### Impostors sewing the Emperor’s invisible clothes

The common procedure is to avoid upright monetary scientists whose efforts in behalf of the helpless mass of people are generally resented, ridiculed, taxed out of existence and, sometimes, subjected to other forms of punishment such as ostracism or worse. At the same time currency manipulators attempt to persuade the public that they are intelligent and honorable men acting in the best interest of the nation, and on the basis of latest scientific evidence. Such people are wined and dined, given prizes and honors, and otherwise subjected to effusions of praise and appreciation. The media and financial press cannot find the superlatives to heap upon them. But all the hoopla won’t change the fact that they are celebrating impostors who pretend to sew the Emperor’s new clothes, “invisible to all but the wise”.

Gold, anathema to Communist creed as well as to fiat money ideology

The United States is illustrating once more how a nation, when sufficiently inept and presumptuous in the area of monetary economics, pursues the course based on irredeemable credit that ends in distress, tragedy, and despair. Unless, in the last minute, Western political leaders somehow come to see the light, and beat the Chinese to it, by opening the Mint to gold first. Don't ask where the gold will come from. If the Chinese can attract silver, anathema to their Communist creed, then surely Keynesians and Friedmanites can attract gold, anathema to their fiat money ideology.

### De-industrialization of the United States

Fiat money has de-industrialized the United States just as thoroughly as two world wars and fiat money in their wake had de-industrialized Germany. That country had to start capital accumulation from scratch at the end of World War I, only to waste it all in another futile war which left the country in ruins, divided, and under enemy occupation.

But Germany, at least its Western part, like the mythological bird Phoenix, rose from her ashes and became the richest country in Europe by 1965.

### Why the German economic miracle has forgone the gold coin

According to a story reported by Newsweek magazine on November 11, 1957, under the title Gold for Sale, Dr. Ludwig Erhard, the Minister of Economics in West Germany in 1947, even contemplated opening the Mint to gold. He reportedly said that “Germans prefer the clink of shiny gold coins to the prosaic rustle of paper money”. He desisted for one reason: he would not want to embarrass the wealthy, powerful U.S. where gold coins were taboo.

### Taking poorly concealed sips at the bottle of inflation

If the Newsweek story is true, Erhard has made an historic blunder. The attempt to avoid offending the powerful by pandering to its weaknesses and lack of respectability is a phenomenon one sees occasionally in social behavior. Erhard did not want to advertise the lack of respectability of the occupying power as revealed by its currency system, by introducing a thoroughly respectable one in West Germany. He preferred that we continue to regard ourselves as “just as respectable as the woman across the street” as we slop around in bedroom slippers, hugging a blousy dressing gown of irredeemable currency around our flabby figure, hair unkempt, while we continue “taking poorly concealed sips at the bottle of inflation” ― to paraphrase the words of Harold Wincott writing in The Financial Times of London (article No Laughing Matter, October 5, 1954.) Incessant talk about leadership of the Free World

The officials of the United States have been talking incessantly of her responsibility as a leader of the Free World, and of her unmatched know-how in all fields of human endeavor. Yet here we are treated to a most humiliating spectre. Germany, a defeated country with benevolent tolerance in the area of monetary science makes an inferior choice in reforming its currency system, for fear of embarrassing the mighty leader who is dissolutely lacking in regard of leadership in the field of money. So much for leadership of the Free World. So much for unmatched know-how.

### Floating by sinking

You don’t need a war on home soil to de-industrialize your country. The United States has accomplished that feat bit-by-bit since 1971, the apogee of her industrial power which, not surprisingly, coincided with severing the last link between the dollar and gold.

The most astounding part of it was that nothing has been done to arrest the decline during all those years. The warnings of monetary economists have been ignored, even ridiculed. The United States persisted with the Friedmanite program of ‘floating by sinking’. The dollar has been subjected to continuous and conscious debasement ever since 1972 in spite of the obvious damage it was doing to America’s industrial capital.

Devaluation of the currency is self-mutilation. Floating is devaluation under a disguise ― as if mutilation piecemeal were less painful. Be that as it may, Milton Friedman’s recipe for the floating of the dollar has caused the greatest capital consumption ever recorded by history. It turned Americans into prisoners of “instant gratification”. The lesson, that once industrial capital is consumed or otherwise dissipated it is gone and cannot be replaced by a click of the mouse (as can misused credit), has been ignored.

It is not war but declaring gold ‘taboo’ that destroys industrial capital

The real cause of de-industrialization of a once flourishing industrial power is not war, but declaring gold a taboo. Yet, as the example of the German example shows, the process is not irreversible. With a sound currency backing producers and savers, the country could re-generate her industrial base. It could regain its industrial capital. But it takes discipline, cutback on wasteful consumption, savings ― and, above all, monetary leadership.

It is still not too late to reverse the train of destruction.

Just open the U.S. Mint to gold.

---

*April 1, 2008.*

## Correction

The date for Session Four was incorrectly stated in the last announcement. Session Four is planned to take place in Szombathely, Hungary (at the Martineum Academy where the first two sessions were held) from July 3 to 6. The subject of the 13-lecture course is The Bond Market and the Market Process Determining the Rate of Interest (Monetary Economics 201). For more information please contact GSUL@t-online.hu. Further announcements will be made on the website [www.professorfekete.com](https://www.professorfekete.com).

---

# Forgotten Anniversary Haunts the Nation

URL: https://newaustrianeconomics.com/archive/fekete/forgotten-anniversary-haunts-the-nation/
Date: 2008-03-28
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, fiat-currency, federal-reserve, sound-money, monetary-policy
Description: Written on the 75th anniversary of FDR's gold confiscation order of April 1933, Fekete argues that this event haunts America to this day. The confiscation destroyed the constitutional monetary order and set in motion the debt accumulation that threatens systemic collapse, yet it is rarely discussed in mainstream economic history.
Editorial Note: Written March 2008 on the 75th anniversary of Executive Order 6102 (April 5, 1933).
Original PDF: https://professorfekete.com/articles/AEFForgottenAnniversaryHauntsTheNation.pdf

*Forgotten Anniversary Haunts The Nation*

**Antal E. Fekete**

*Gold Standard University Live*

Seventy-five years ago this month Franklin Delano Roosevelt was inaugurated as the 32nd President of the United States. Within days after swearing to uphold the U.S. Constitution, through a Presidential Proclamation he closed the U.S. Mint to gold. Recall that the Mint had been established by the Constitution to protect the people’s right to sound money.

Roosevelt had been elected on a platform of sound money. Barely in office, he reversed himself. He grabbed the gold of the people, marked up its value, leaving Federal Reserve notes in the hands of the people that were to lose 95 percent of their value during subsequent years. They stand poised to lose their remaining value before long.

That experience left behind a moral trauma that returns to haunt us 75 years later even if the establishment, the media, as well as academia, want us to forget the anniversary. They will not succeed. Roosevelt’s chickens will not let them. It has taken the chickens 75 years to come home to roost. Come home they will with a vengeance. The past 75 years were a period of unprecedented turbulence in the financial markets. Yet never during those 75 years has the nation faced a graver monetary crisis than it is facing now. The banking system of the country threatens to seize up. The credit system is facing a violent collapse.

You will hear a lot of ad hoc explanations of what has happened, from subprime mortgages to loose Federal Reserve monetary policy to profligate government fiscal policy. However, one explanation you will never hear from the establishment, from mainstream economics, or from the media. They will never ever mention the real culprit, the irredeemable dollar.

The tendency of virtually all businessmen, legislators, jurors, and even pastors to go with the tide is thoroughly established. Perhaps such men confuse position and power with wisdom or with competence in fields where they are not competent. As it stands, not one of our political leaders, judges, not one captain of business is competent in the field of money. They do not understand that a monetary crisis, such as the one threatening the irredeemable dollar right now, could totally wipe out its value. It is abundantly clear that the United States is in a most serious trouble as it can no longer produce the goods necessary for survival, nor can it buy them in the world’s markets, in a high degree because of its use of irredeemable currency. Worse still, in consequence of embracing irredeemable currency we have unprecedented dishonesty in government. Standards of dishonesty in government spreads like cancer throughout the nation, as support is given by unwise men to the use of such currency.

It is difficult to think of an unsound monetary practice that has not been embraced in some manner since 1933 by our modern John Laws of finance. The 18th century Scottish adventurer John Law should have felt thoroughly at home among the latter-day adventurers at the helm in the U.S. Treasury and the Federal Reserve.

When the U.S. Mint was closed to gold in March, 1933, by Roosevelt and the country embarked upon the sea of managed currency, a very large number of individuals and organizations urged a prompt return to the gold standard (which, believe it or not, included the Federal Reserve Board, the Federal Advisory Council, 37 members of the faculty of Columbia University, and 710 members of the American Economic Association, to mention but a few).

The question arises as to what has become of those opposing voices in the intervening years.

Why, some were silenced through bribe and blackmail. They were simply corrupted by a political movement which they found inexpedient to oppose. The upright individuals among them, on the other hand, were silenced through attrition and death. They were not allowed to pass on the torch to the next generation. All knowledge about gold money was systematically purged from university curricula and from institutes of advanced studies, replaced by a claptrap of pseudo-mathematical bunk.

Of course, one may expect groups, usually controlled by expediency, to shift their position with the changing political tides. But there is no valid defense that can be offered for men who pretend to be scientists and who adjust their so-called principles of science in accordance with the changes of political fashions, or invent fraudulent differential equations purportedly describing the behavior of money in the hands of the people.

The monetary policies of the advocates of irredeemable currency have in the main been those of charlatans. Those who are passing themselves off today as monetary economists either have not understood the lessons of the past; or have been willing to junk them in the interest of expediency, for such personal gains as they may expect to realize for parroting the official propaganda line.

A deep, searing corruption has afflicted monetary science during the past 75 years, comparable to Lysenkoism in the Soviet Union, now defunct. The only apparent difference is that opponents of the enfant terrible of Soviet genetics, Trofim Denisovich Lysenko, were carted off to the Gulag Archipelago, never to be heard from again. Still, it may take many decades of painful effort to overcome the damage caused by Lysenkoism, American style, that has expunged the once world-famous and respected American monetary science from the map. The well-being of our nation, nay, of the whole world, has been seriously undermined by this affliction. Whether the scientists who know the lessons of the past and the prescriptions suggested by evidence accumulated over centuries can do anything of importance to correct this sad state of affairs remains to be seen. The reception of the candidacy of Dr. Ron Paul does not leave us with a great deal of hope in this regard.

In his book Hell Bent for Election (Garden City, N.J., 1935) James P. Warburg quotes from a campaign speech given by Roosevelt in Butte, Montana, on September 19, 1932, as a basis for appraising the man who would violate his pledge on a matter as important as the people’s monetary standard:

“Remember that attitude and method ― the way we do things, not just the way we say things ― is nearly always the measure of one’s sincerity.”

This self-indicting speech was omitted from the Published Papers and Addresses of Franklin Delano Roosevelt compiled by Samuel I. Rosenman, as was another speech given by Roosevelt in Brooklyn. I quote Warburg: ‘On November 4, 1932, Mr. Roosevelt made this striking statement:

“One of the most commonly repeated misrepresentations by Republicans, including the President, has been the claim that the Democratic position with regard to money has not been made sufficiently clear. The President is seeing visions of rubber dollars. This is only a part of his campaign of fear. I am not going to characterize these statements. I merely present the facts. The Democratic platform specifically declares: ‘We advocate a sound currency to be preserved at all hazards.’ That is plain English.”

That statement could only mean, if it meant anything to the millions of people who voted for Roosevelt, a gold standard currency. Is there any defender of the irredeemable dollar, even among those who try to convey the impression that the majority of people wanted to abandon the gold standard in 1932, who has the moral courage to refer to these speeches? Roosevelt further said: “The businessmen of the country, battling hard to maintain their financial solvency and integrity, were told in blunt language by President Hoover in Des Moines, Iowa, how close an escape the country had had some months ago from going off the gold standard. This, as had been clearly shown since, was a libel on the credit of the United States… No adequate answer has been made to the magnificent philippic of Senator Glass the other night, in which he showed how unsound was this assertion. And I might add that Senator Glass made a devastating challenge that no responsible government would have sold to the country securities payable in gold if it knew that the promise, yes, the covenant embodied in these securities, was as dubious as the President of the United States claims it was.”

I quote Warburg: ‘On March 12, 1933 ― a week after Roosevelt had become President ― the United States Treasury issued \$800,000,000 of obligations payable “in United States gold coin of the present standard of value” ― the same covenant above referred to by Roosevelt a few days before he was elected. ‘Additional securities were issued shortly thereafter bearing the same covenant.

‘On May 7, 1933, President Roosevelt in a radio broadcast to the people announced his intention to repudiate this covenant.

‘And on June 5, 1933, the covenant was abrogated by Congress.

‘The point is not whether we agree or disagree with Roosevelt’s judgment or reasoning. The point is that if he had such a conviction in regard to the gold clauses and intended to act upon it, it would seem that the people had the right to know about it before they were asked to vote.’

The U.S. Mint was reopened to gold after the hiatus of the Civil War and Reconstruction, on January 2, 1879. In celebrating the event General James A. Garfield stated in an address delivered in Chicago: “We shall still hear echoes of the old conflict, such as the ‘barbarism and cowardice of gold and silver’ and the ‘virtues of fiat money’. The theories which gave them birth will linger among us like belated ghosts, but soon will find rest in the political grave of dead issues…” Garfield warned that the ‘periodic craze’ of fiat paper money might sweep over this country from time to time. The force of the present episode of craze has apparently never before been experienced by our people. The end of this great disease is not yet in sight. If past experience provides any worthwhile lessons, then the ultimate consequences of our failure to understand the nature of this craze promise to be extremely painful, involving the greatest monetary and economic devastation the world has ever seen.

Orval W. Adams, one-time president of the American Bankers Association, in his article Inflation ― The Termite of Civilization wrote in 1956: ‘Open the Mint to gold. Gold is a gift to the world from an all-wise Creator. There is no substitute. There will never be any. Without gold as a base for national and international exchange, civilization could not have emerged from its barter period of the Dark Ages. Gold is the only insurance against ruthless politicians debasing and corrupting the world’s exchange and money systems of a free people. I repeat, gold is a blessing from an all-wise Providence to prevent the tragedy that follows a debased, corrupted and politically managed medium of exchange. The gold standard is the automatic watchman on the tower of the government of free men, to guard against the poison of totalitarianism entering the bloodstream of sound money.’

On many an occasion was the gold standard gleefully, albeit prematurely, buried. One such occasion was the ’funeral oration’ before the Chamber of Deputies in Nazi-occupied Paris, delivered by one of the highest-ranking functionaries of the Nazi party. He declared ’with deep inner satisfaction’ that ’the gold standard is now as remote from the realities of life as the philosophy of the French Revolution: Liberty, Fraternity, and Equality of men…’

When Roosevelt confiscated our people’s gold and forced them to accept irredeemable bills of credit in exchange, the purpose was to provide the government with liberty to do as it pleased with the product of other men’s labor, while depriving people of the liberty to insulate themselves from government arbitrariness by converting the products of their labor into gold if they so desired. In doing so Roosevelt opened wide the door to government tyranny, which has shown itself in wild government spending, heavy taxation, radically depreciated currency, a huge national debt, much socialization and a high and increasing degree of government management of the economy, even in the suspension of civil rights.

Today a lot of people celebrate the advent of \$1000 gold. In their festive mood people are liable to forget an ominous consequence of this important milestone. It is the fulfillment of Roosevelt’s design to deprive people of the liberty to shelter the fruits of their labor from the claws of the government by converting their property into gold. At \$1000 an ounce, not many people can purchase gold to protect the fruits of their labor against confiscation.

\$1000 gold is a milestone ― on the road to hell.

---

*March 25, 2008.*

## Gold Standard University Live

Session Four is planned to take place in Szombathely, Hungary (at the Martineum Academy where the first two sessions were held). The subject of the 13-lecture course is The Bond Market and the Market Process Determining the Rate of Interest (Monetary Economics 201). The date is: June 19-22. For more information please contact GSUL@t-online.hu. Further announcements will be made on the website [www.professorfekete.com](https://www.professorfekete.com).

---

# Paper Tiger Preying on Gold Bugs

URL: https://newaustrianeconomics.com/archive/fekete/paper-tiger-preying-on-gold-bugs/
Date: 2008-03-01
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, central-banking, gold-standard, monetary-policy
Description: Fekete argues that naked short selling of gold futures has systematically preyed on gold investors by creating artificial supply through contracts that can never be delivered. He explains how this suppresses the gold price, distorts the basis, and ultimately undermines the credibility of the entire futures market.
Editorial Note: Written March 2008 as gold was rising through $1,000 for the first time.
Original PDF: https://professorfekete.com/articles/AEFPaperTigerPreyingOnGoldBugs.pdf

## Paper Tiger Preying On Gold Bugs

### The IMF and Its Phantom Gold Sales

### Antal E. Fekete

### Gold Standard University Live

### E-mail: aefekete@hotmail.com

### The IMF as the linchpin of the fixed exchange rate regime

The International Monetary Fund (IMF) was set up in 1944 by the victorious allied powers at Bretton Woods, N.H. It was designed to serve as the linchpin of the post World War II international monetary system based on fixed exchange rates. It was well-understood that there could be no fixed exchange rate system without a gold anchor. Thus gold was retained as a bedrock, but multiple credit expansion was permitted, even encouraged. The U.S. dollar was to be treated as equivalent of gold. This meant that gold was double-counted in the system. Member countries were called upon to subscribe their quota of IMF capital in gold, called the first tranche, which set the limit of each member’s line of credit with the IMF called drawing rights. A second tranche was also available to members in good standing in case of emergency (read: in case of a run on the central bank).

The system worked tolerably well for some 25 years. But it was flawed on the strength of double-counting the gold reserve. Every time a government imposes on the market two different standards of value to be enforced as equivalent, the market hits back through the operation of Gresham’s Law. The postwar international monetary system was no exception to this rule. The bad penny (the dollar) drove the good penny (gold) out of circulation. Gold hoarding by governments and individuals snowballed. By 1968 the dollar was being dumped all over the world in anticipation of a dollar devaluation (the favorite bet was the doubling of the statutory price of gold from \$35 to \$70 per oz. which was supposed to pacify the market at the time.) It should be noted that the original IMF Charter provided for the devaluation of the dollar in terms of gold (with all foreign exchange rates remaining unchanged) in case of “fundamental disequilibrium”.

On August 15, 1971, in a surprise move President Nixon, instead of devaluing the dollar, defaulted on the obligation of the U.S. to pay its debt to foreign governments and central banks in gold at a fixed statutory rate of exchange. In turning the dollar into an out-and-out fiat currency Nixon ignored monetary history and logic. The dollar became vulnerable to open-ended debasement and depreciation. Nixon also ignored moral considerations, as well as the long-standing commitment of the U.S. enshrined in a number of international treaties, including the IMF Charter, to keep the dollar convertible into gold on demand. Reneging on this solemn commitment was in shocking disregard for international rights and obligations. It released the genie of world-wide inflation from the bottle, never to be able to put it back. Worse still, interest rates were destabilized world-wide, a development without precedent. Like the wrecker’s ball, swinging interest rates were to demolish productive capital. The U.S. and world economy were now sailing in uncharted waters with no compass, no rudder, and no anchor; while the sea was growing stormy.

Nixon was badly advised. His mentor was Professor Milton Friedman, the high priest of monetarism, a man who would completely ignore things like good faith behind promises and the honor of governments in signing international treaties, in a single-minded pursuit of his obsession with the Quantity Theory of Money. This theory teaches, falsely, that the value of the dollar can be maintained by a “quantity-rule” in the face of chicanery, default, and reneging on promises, by means of keeping the annual rate of increase in the stock of “high-powered money” at a moderate 3 percent. Apart from the fact that it may not be possible to fix the rate at 3 percent because of the tendency of debtaccumulation to accelerate under the regime of irredeemable currency, the idea that the value of dishonored promises can be maintained through the stratagem of restricting their quantity is preposterous. If it were true, poverty could be abolished by training the poor to ration lies.

Time has proved other theories of Friedman wrong, too. His theory of equilibrating the balance of trade through the floating exchange rate mechanism is utterly wrong. Friedman asserted that there is such a mechanism which works analogously to that of the gold standard. According to him, if the foreign exchange value of the dollar falls, that will automatically decrease imports to the U.S. as well as increase exports from the U.S., and the favorable balance of trade will soon stop the fall of the dollar. Alas, that’s not what has happened. The exchange value of the dollar has kept falling ever since 1971, with the greatest part of the fall still in store, and the only observable increase in exports being the export of the well-paid industrial jobs due to outsourcing. Entire industries such as steel-making and TV-manufacturing have been closed down, with auto-making likely to be the next extinct industry in the U.S. The ordeal of American manufacturing is the handiwork of Friedman. The fact is that the value of dishonored promises cannot be artificially upheld by a “quantity rule”.

Predictably, the floating dollar turned out to be a sinking dollar, an insurmountable handicap on producers trying to compete in the world market. Their terms of trade is deteriorating while that of their competition is improving. Incredibly, mainstream economists and financial journalists still find it possible to treat the suggestion with respect that the weak dollar is a prop to the export industry, even after the devastation of America’s export industry through the disastrous experiment with the falling dollar.

### The IMF as the anti-gold war-horse in the Treasury’s stable

In 1971 the question arose what to do with the IMF which had been conceived as the antithesis of floating. With the advent of the New Brave World of flexible exchange rates the IMF lost its raison d’etre as the mainstay of the fixed exchange regime. The obvious course of action would have been to dismantle it and to return the subscribed quota of capital, gold, to the rightful owners, the member countries. However, it is easier to create a bureaucracy than it is to dismantle it.

Policymakers at the U.S. Treasury (which still controlled the world’s largest hoard of gold ever assembled) were girding up their loins to keep the gold price in check. The demand for gold was increasing by leaps and bounds after the American default and there was a clear and distinct danger that the dollar would in short order go the way of the Assignat of 1790 France and the Reichsmark of 1923 Germany. Policymakers thought that it would be a shame to dissipate the IMF gold by returning it to members. The IMF gold could come handy in suppressing the price of gold. After all, the IMF gold hoard was the second largest ever assembled in the world and the threat of dumping it could be formidable.

The U.S. Treasury started dropping broad hints that the scrap metal at the IMF should be auctioned off without further ado. Soon it became clear that members did not have a stomach for the Treasury’s plan. They argued that the IMF gold belonged to them and was not available, even for such a noble effort as to save the face of the dollar. The dispute was not allowed to continue in public and a compromise was reached. Member countries agreed not to press their claim to ownership. Instead, they agreed to extending the life of the IMF under a modified Charter, against U.S. commitment to auction Treasury gold instead of IMF gold, after a one-shot deal of auctioning off a token amount of the latter with part of the proceeds being restituted to members. By the new Charter members had the right to sell gold to the IMF at the official price of \$42.22 per oz, but they were forbidden to buy gold in the market at prices higher than the official price “at which the U.S. Treasury and the IMF was committed not to sell gold”. An exception was made in the case of South Africa, a pariah member of the IMF, which was deprived of its right to sell gold to the IMF at the official price. Thus South Africa was forced to dispose of its huge gold production in the market. This was done to scare the wit out of gold bugs threatening them with the prospect that the gold price could fall below \$42.22, or even below \$35. Needless to say that this was an empty threat based on the idiotic notion that the price of gold could permanently fall below \$35. The financial annals fail to show a single instance in which the dishonored paper of a banker went to a premium, instead of a discount!

Apparently, the compromise is still in effect. Treasury-inspired hints are occasionally dropped about future IMF gold sales trying to placate the stirring gold market, but no actual sales are conducted. At one point the Clinton administration asked Congress to approve an IMF gold sale, but it was voted down. In vain was the proposed sale couched in the language of a grant to developing countries, an odd combination of banking and charity. The puerile idea that “barren” gold reserves ought to be replaced by “productive” interest-bearing dollar reserves has been floated from time-totime, but did not fly, in view of a negative return to capital after inflation is taken into account.

The old Treasury war horse of looming IMF gold sales is trotted out from time to time more as a scare-tactic to threaten gold bugs than a serious proposal. A public showdown with the membership over the ownership claim is to be avoided at all cost. The latest episode was the announcement in early February, 2008, that the IMF plans to sell gold from its reserves. Another announcement from the G-7 meeting in Tokyo confirmed that the sale may come as early as April. It was not mentioned where the authority to sell would come from. These announcements are hardly credible. The established pattern shows that the IMF is maintained strictly as a paper tiger to prey on jittery gold bugs. However, while the G-7 can press for the restitution of gold, the minority of members have a veto power on the G-7 proposal to sell it. As the gold price climbs, selling IMF gold becomes less and less appealing to members. It appears that the U.S. Treasury is again flagging a dead horse for its propaganda value. It is time again to plant fear into the hearts of the gold bugs. But neither the probability that the sale plan will ever be approved, nor the actual size of the proposed sale (13 million ounces worth about \$12 billion) justifies fears that the price of gold will be shoved back down to the \$500 level by these announcements, as suggested by Mike Bolser in an interview published in the World Net Daily.

When on Monday, February 25, the Bush administration announced that it would give approval to the plan “to sell gold bullion in order to stabilize the IMF’s shaky finances”, the knee-jerk reaction of the market was to push down the gold price by \$20. However, the lost ground was more than recovered in the space of two days’ trading. It is also revealing that the Bush administration made its support conditional upon down-sizing the functionless IMF, such as reducing the number of its executive board members from 24 to 20, and its \$900 million annual budget by more than 10 percent to $ 800 million. The IMF is sinking further into limbo as its lending activities keep shrinking. Many of its former clients have repaid their debts and spurned IMF offers of further aggressive tutelage as they found IMF meddling in their internal affairs intolerable.

Quite clearly, the only reason the expensive IMF apparatus is maintained is the dubious proposal that gold bugs can be kept in check forever with threatened periodic gold sales, even if these sales never materialize. It is hoped that after a decent period of time the threat can be repeated, will be believed, gold bugs will retreat and, above all, the gold hoard will remain intact and could be used again and again for intimidation purposes.

On the subject of Treasury gold sales, they seem to be blocked by the top brass of the U.S. military, who know something about the sinews of war. They are fully backed by remarks uttered by Alan Greenspan while he was still in charge at the Fed reminding the forgetful that Nazi Germany could secure war materiel from abroad only against payment in gold after fortune has forsaken its armies in the field.

The U.S. Treasury is at the end of the rope of its anti-gold crusade. It painted itself into a corner: whatever it does will help gold and hurt the dollar. Its only way to escape from the trap of its own making is to come clean and admit the foolishness of its gold policies for the past 35 years, and open the U.S. Mint to the unlimited and free coinage of gold and silver on customer account. It would be a coup that would forestall the challengers of the U.S. monetary hegemony, the Russians and the Chinese among others, provided that it was pulled off before they did it. In this way the U.S. could retain its monetary leadership in the world. Time also seems to be propitious in this election leap-year when Congressman Ron Paul offers a sound and convincing blueprint to the electorate about fiscal and monetary reform.

Still, I am not holding my breath. There does not seem to exist a grain of intelligence or wisdom in the Treasury how to meet the current financial and banking crisis, not even to the extent of keeping a contingency plan on file for the mobilization of Treasury and IMF gold in a reconstruction of the international monetary system on the basis of fixed exchange rates.

Friedman’s floating exchange rate system has served the U.S. and the world badly. It’s been an unmitigated disaster. A return to the regime of fixed exchange rates should be considered most seriously, in order to fend off the collapse of the international monetary and payments system. The idea is resisted by a reactionary alliance between the policymakers at the Treasury, the Fed, and mainstream economists in academia, as such a plan would put gold back right into the center of the universe. These reactionaries have vested interest to hang on to their usurped power, enriching themselves and their friends in the process at the expense of the public at large.

However, there is silver lining to the IMF gold saga. It does have some effect in slowing down the meteoric rise in the price of gold. In my opinion this effect is positive. A sudden death of the dollar is not desired by any serious observer, nor is it in the interest of the savers and producers of the world.

A more controlled decline may spare many innocent people from utmost economic pain, and give a chance to latecomers to the gold party to gear up for the ultimate showdown.

And, who knows, it may give a little extra time to policymakers at the Treasury to wake up and prepare a contingency plan at the eleventh hour, to open the U.S. Mint to gold and silver, the only way to avert the coming of Armageddon.

### Reference

Antal E. Fekete, Opening the Mint to Gold and Silver, [www.financialsense.com](https://www.financialsense.com) , February 5, 2008

Jerome R Corsi, Gold Reserves To Hit Sale Block: IMF seeking to depress gold price, World Net

### Daily, February 11, 2008

Steven R. Weisman, Selling Gold at I.M.F. to Rebuild Its Finances, The New York Times,

---

*February 26, 2008*

## Gold Standard University Live

Session Three has just concluded in Dallas, Texas. The subject of the 13-lecture course was Adam Smith’s Real Bills Doctrine and Its Relevance Today. (Monetary Economics 102). The titles of the follow-up conferences were: 1. The Economics of Gold Mining and 2. Gold Profits in Troubled Times:Putting the Basis to Good Use. Course material will soon be available in print and in DVD format to all interested parties.

Session Four is planned to take place in Szombathely, Hungary (at the Martineum Academy where the first two sessions were held). The subject of the 13-lecture course is The Bond Market and the Market Process Determining the Rate of Interest (Monetary Economics 201). Tentative date: June 27-30. For more information please contact GSUL@t-online.hu . Further announcements will be made at the website [www.professorfekete.com](https://www.professorfekete.com) .

---

*March 1, 2008*

---

# The Anti-Gold Gospel According to Frieden

URL: https://newaustrianeconomics.com/archive/fekete/the-anti-gold-gospel-according-to-frieden/
Date: 2008-02-29
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, real-bills, new-austrian-economics, federal-reserve, monetary-policy
Description: Fekete rebuts historian Jeffry Frieden's argument that the gold standard caused the Great Depression, showing that Frieden conflates the genuine gold standard with the gold-exchange standard imposed at Genoa in 1922. The Depression was caused not by gold but by the destruction of the real bills market.
Editorial Note: Third in the Anti-Gold Gospel series, February 2008.
Original PDF: https://professorfekete.com/articles/AEFTheAntiGoldGospelAccordingToFrieden.pdf

*The Anti-Gold Gospel According To Frieden*

**Antal E. Fekete** · Gold Standard University aefekete@hotmail.com Jeff Frieden is professor at Harvard focusing his research on the politics of international monetary and financial relations. He has been quoted as saying that, if once more on a gold standard, the United States would be unable to respond quickly and effectively to sudden economic shocks. Recessions would be deeper and longer, and the economy would be biased towards deflationary spirals. Witness the fact that the United States, which remained on the gold standard till 1933, had a much longer and deeper recession than Britain which had gone off gold in 1931.

If the above quotation by Barron Young Smith (see appendix to my previous paper) is accurate, then the Harvard professor writes his monetary economics while standing on his head. He is ascribing a bad condition to a hypothetical gold standard, but the same condition presently obtains in an undiluted form as a direct consequence of the regime of the irredeemable dollar. The U.S. economy is presently biased towards a huge deflationary spiral in consequence of a long cycle of falling interest rates that started from the level of over twenty percent per annum in the early 1980’s, and still has not run its course. As is well-known, falling interest rates must ultimately culminate in falling prices. If we haven’t seen much evidence of actually falling prices yet, it is because policymakers have made the unforgivable mistake of using the irredeemable dollar as a tool to dismantle America’s industrial fortress. In other words, falling prices are present in disguise through the proxy of the wholesale shutdown of production and the elimination of entire industries. We already have the ultimate effects of a deflationary spiral, usually transmitted through falling prices, but in this instance brought about directly through falling interest rates.

Other proxies of a falling price level are also present. Most important is the loss of pricing power. Some firms have so far survived the hecatomb inflicted upon American industry by policymakers, for example, in the auto industry. But auto-makers have definitely lost pricing power. It is possible that, lately, they have been selling cars at a loss. This loss has been made up by the lucrative business of car-financing, at least prior to the subprime crisis. It is highly unlikely that automakers can long continue their subprime car financing business. Not at zero percent interest.

In the meantime American exports fall, in spite of the ongoing debasement of the dollar, with the exception of exporting highly-paid industrial jobs to low-wage countries. But much worse is to come. The real scourge on the economy of the falling interest rate structure has not yet shown up: wholesale bankruptcies of midsize businesses in the United States. I have been writing on this subject for some eight years, but failed to alarm public opinion.

Declining interest rates bestow huge unearned profits upon bond speculators. These profits do not come out of nowhere. They are being siphoned off from the capital accounts of the producers. We are looking at vampirism by the financial sector sucking the blood of the producing sector. It has been made possible by the regime of the irredeemable dollar as it destabilized interest rates. Under the gold standard with stable interest rates there is neither bond speculation nor vampirism. Under the gold standard the producing sector is the dog and the financial sector is the tail. The regime of the irredeemable dollar has turned things upside down: now the financial sector is the dog and the producing sector is the tail which, moreover, is in danger of being cut off altogether. The most appalling part of this vampirism is that producers are not aware that they are being victimized. Their capital is siphoned off stealthily and unobtrusively. Producing firms are paying out phantom profits to shareholders, further weakening their capital.

To understand this process fully we must make an excursion into accounting. Persistently falling interest rates decimate capital values as the present value of debt keeps increasing. The resulting capital loss should be recorded in the balance sheet and made up in the form of charges against future earnings. But nobody does it, as everybody prefers to listen to the sweet siren song: “falling interest rates are good for you!” In fact, the Fed’s policy of serial interest rate cuts is an insane policy cutting the ground under the producers further and providing a tailwind to bond speculation. It confuses a low interest rate structure with a falling one. While the former is beneficial to business, the latter is lethal as it is the root cause of depressions. Professor Frieden’s blaming the gold standard as being deflationary is entirely misplaced.

Open market operations of the Fed ― introduced as an illegal practice* in the 20’s and legalized retroactively in the 30’s ― is thoroughly destructive as it makes bond speculation risk-free.

Bond speculators stalk and forestall the Fed as it is making its regular trips to the bond market to purchase its quota of bonds. The Fed is helpless: it must purchase the bonds in order to increase the money supply. This illegal regime of risk-free profits to bond speculators was scandalously cheered on by mainstream economist, who declared that “taxation for revenues is now obsolete”. From now on, they rejoiced, taxation can be used to manipulate the taxpayers and the economy.

Professor Frieden’s suggestion that Britain escaped two years of recession in 1931 because it went off gold that much earlier is not valid. In Britain there was no confiscation of gold in 1931. (That particular leaf from the book of the U.S. was borrowed by the British later.) One consequence of the confiscation of gold in 1933 was the falling interest-rate structure, the root cause of the Great Depression. In the eyes of the most conservative investors gold was the only competition for bonds.

As this competition was forcibly removed, demand for bonds increased. This made bond prices rise and interest rates fall. Without gold confiscation interest rates would not have kept falling in the 1930’s and the Great Depression would have been avoided. Deflation in the U.S. was self-inflicted through the instrument of the gold ban.

The gold standard, if introduced, would increase government regulation of the economy. With no Fed, inexpert Congress will bear the onus of alleviating economic suffering. With deeper, longer recessions, Congressmen will inevitably succumb to pressure for more spending and regulation of the economy ― as they did during the Great Depression.

If the above quotation by Barron Young Smith is accurate, then Professor Frieden is putting on a poorly fitting garb and mask as a defender of the free market. But his hidden agenda cannot be masked: he wants to preempt at all costs a free and uninhibited discussion of the proposition to abolish the Fed. If he succeeds, a great opportunity will have been lost. The Fed has become conceited and obtuse. Its open market operations are kept above criticism by both the Keynesians and Friedmanites.

Yet open market operations are not only deflationary but counter-productive as well. The new money pumped into the economy to prevent prices from falling flows to the bond market and makes interest rates fall. Prices fall as a consequence, contrary to purpose.

The gold standard, if introduced, would increase our reliance on foreign credit and ship yet more jobs overseas. Ron Paul says “our economy and our very independence as a nation is increasingly in the hands of foreign governments such as that of China and Saudi Arabia.” But adopting the gold standard would actually exacerbate the problem, not alleviate it.

Assuming that this quotation is accurate, Professor Frieden is guilty of scarce-mongering. Our reliance on foreign credit cannot be further increased as this source of credit is more than exhausted, courtesy of the irredeemable dollar and its “spend now, pay later” ethos. It was the regime of the irredeemable dollar has landed the U.S. economy in a corner where the very independence of the nation is increasingly in the hands of foreign governments. It would have never happened under the gold standard. The only escape route from the corner is through the gold standard, provided the U.S. opens the Mint to gold and silver before the Chinese and the Russians open theirs.

Shipping jobs overseas is not a characteristic of the gold standard. It is a characteristic of the regime of irredeemable currency as it destroys capital so that industry can no longer compete with foreign labor. The lion’s share the outstanding marketable debt of the U.S. government is now in the hands of foreign governments such as that of China and Japan, mentioning but the two greatest concentrations. Such a development could have never taken place under the gold standard, and no self-respecting government should have ever allowed this to happen.

Insofar as it helps anybody, the gold standard would favor Wall Street bankers over entrepreneurs, businesses, and workers. Ron Paul likes to rail against Wall Street complaining that our money is being “inflated at the behest of big government and big banks” who “cause your income and savings to lose their value”.

If this quotation is accurate, then Professor Frieden betrays his fundamental ignorance about the nature of the gold standard which is the most even-handed monetary system that has ever existed, making all playing fields level. Under the gold standard people are the boss and the banks are the servant. The latter can be disciplined by the former withdrawing bank reserves in the form of gold. People have lost this power when the gold standard was forcibly overthrown by the government, which was also irritated by the control over the public purse that people could exercise through gold withdrawals.

Under the regime of the irredeemable dollar the banks are the boss and they plunge people into debtservitude. Control over the public purse by the people has also been removed, giving rise to endless budget deficits.

It is preposterous to suggest that the gold standard would favor bankers over entrepreneurs, businesses, and wage earners. If it ever looked that way in the past, it was because of a double standard in contract law, and not because of the gold standard per se. The banks were granted immunity from forcible liquidation in case they failed to perform on their contracts. The government declared a bank holiday if a number of banks became insolvent and could not pay gold on their sight liabilities. To add insult to injury, the defaulting banks’ paper was promoted to the status of legal tender in place of gold. So much for the perverse incentive system favoring banks bent on credit expansion. While the banks enjoyed immunity, the force of contract law was always applied in full force against other entrepreneurs, businesses, and wage earners, and home-makers.

I would welcome an open discussion on the merits of the gold standard and on the proposal that the Fed should be abolished. I sincerely hope that Professor Frieden will take up my challenge and, during this election year when both the efficacy of the gold standard and the Fed’s incompetence were made an elections issue, will give me the pleasure of participating in a continued debate. * The Federal Reserve Act of 1913 did not authorize it. It did not list government bonds, notes and bills among the eligible papers that could be held against the note and deposit liabilities of the Federal Reserve banks. In fact, the Fed was subjected to a stiff and progressive penalty tax to the extent its liabilities could be balanced only by counting its portfolio of government paper. If the U.S. Treasury has “forgotten” to collect the penalty tax, well, that’s just what Treasury Secretaries would do when T-bonds do not find ready buyers in the open market. —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  —  — -

### References

A.E. Fekete, The Anti-Gold Gospel According to Kaletsky, [www.professorfekete.com](https://www.professorfekete.com)

A.E. Fekete, The Anti-Gold Gospel According to Smith, Appendix: What Would Happen If We Adopted the Gold Standard? by Barron Young Smith, [www.professorfekete.com](https://www.professorfekete.com)

A.E. Fekete, Fiat Currency, the Destroyer of Capital, [www.professorfekete.com](https://www.professorfekete.com)

## Gold Standard University Live

Session Three has just concluded in Dallas, Texas. The subject of the 13-lecture course was Adam Smith’s Real Bills Doctrine and Its Relevance Today. (Monetary Economics 102). The titles of the follow-up conferences were: 1. The Economics of Gold Mining and 2. Gold Profits in Troubled Times: Putting the Basis to Good Use. Course material will soon be available in print and in DVD format to all interested parties.

Session Four is planned to take place in Szombathely, Hungary (at the Martineum Academy where the first two sessions were held). The subject of the 13-lecture course is The Bond Market and the Market Process Determining the Rate of Interest (Monetary Economics 201). Tentative date: June 27-30. For more information please contact GSUL@t-online.hu . Further announcements will be made at the website [www.professorfekete.com](https://www.professorfekete.com) .

---

# The Anti-Gold Gospel According to Smith

URL: https://newaustrianeconomics.com/archive/fekete/the-anti-gold-gospel-according-to-smith/
Date: 2008-02-25
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, real-bills, sound-money, new-austrian-economics
Description: Fekete rebuts modern anti-gold arguments attributed to Adam Smith (the economist), showing that contemporary objections to the gold standard repeat century-old errors. He uses the refutation to explain why the gold standard's alleged failures were consequences of its adulteration — the elimination of the Real Bills market.
Editorial Note: Second in the Anti-Gold Gospel series, February 2008.
Original PDF: https://professorfekete.com/articles/AEFTheAntiGoldGospelAccordingToSmith.pdf

*The Anti-Gold Gospel According To Smith*

**Antal E. Fekete** · Gold Standard University aefekete@hotmail.com Barron Young Smith is a financial journalist whose piece What Would Happen If We Adopted the Gold Standard? is appended below. He describes Ron Paul’s campaign to restore Constitutional money in the U.S. as being “populist”. He adds insult to injury in saying that “Ron Paul… is on a crusade to resurrect a great symbol of Wall Street-Washington dominance over the individual”.

I do not speak for Ron Paul or his campaign. I speak as an observer. Congressman Paul is the only candidate who tells the electorate as it is: the monetary and credit system of the U.S. that has been imposed on the American people and the rest of the world stealthily and unconstitutionally is in an advanced state of disintegration. The slur on his character and campaign is intolerable. Ron Paul calls for a return to Constitutional money by reintroducing full-bodied silver and gold coins into circulation. Far from crusading to resurrect the unholy alliance between Wall Street and Washington, he is the only candidate who exposes the conspiracy of the two to debase the dollar to their own benefit while inflicting great economic pain on the people in the process, the worst part of which is still in store.

Smith disingenuously asserts that “not only would the gold standard have disastrous effects on the U.S. economy; it would undermine liberty, increase debt, and weaken the country.” The kettle calling the pot black! The fact is that liberty in the U.S. has been undermined under the regime of the irredeemable dollar, not under the gold dollar. It was under the irredeemable dollar that a runaway debt-tower has been triggered making the United States the largest debtor in the world. Under the gold dollar it used to be the largest creditor in the world, while gold acted as an effective filter eliminating bad debt. The economy of this country, including its unparalleled manufacturing sector providing the best-paid jobs in the world, was built under the aegis of the gold standard. It was dismantled under the regime of irredeemable currency, replacing industrial jobs by low-paying service jobs such as hamburger-flipping. The de-industrialization of America, one of the most shameful episodes in economic history, is not the outcome of natural development. It is a direct consequence of the destructive nature of the irredeemable dollar. When the dollar was cut from its gold moorings in 1971, America started to run persistently increasing trade deficits. Friedmanites were counseling patience: it takes time to reap the “benefits” of the “floating” (read: sinking) dollar. Benefits galore did indeed come ― in the form of ever larger trade deficits. The lower value of the dollar did indeed help exports, notably, the export of manufacturing jobs and the shutting down of productive facilities.

If “populism” means putting the power of creating and extinguishing money directly into the hands of the people as demanded by the U.S. Constitution, rather than into the hands of perjurious politicians and usurping civil servants then, indeed, Ron Paul, and the U.S. Constitution, are populists.

In fact, the U.S. Constitution demands that the Mint be open to the free and unlimited coinage of silver and gold. Free and unlimited coinage means that people who think that there is not enough money in circulation should be able to do something about it: they can take new gold and silver from the mines, or old gold and silver from jewelry and plate, to the Mint and exchange it for standard coins of the realm free of seigniorage charges, with no limitation on quantity. Conversely, people who think that that there is too much money in circulation should be able to do something about that, too. Under the gold standard they can melt down their coins or export them without penalty.

A standard coin is a full-bodied coin: its monetary value cannot deviate from the market value of its metal content. If monetary value fell below market value, then people would melt it down and put its metal content to more profitable uses. If monetary value rose above market value, then gold and silver would keep flowing to the Mint until the trend was reversed and the two values were equalized once more. In this way the people themselves, and not politicians or appointed bureaucrats and bankers would decide what the stock of money ought to be. This is as intended by the Constitution that was crafted on the principle that the U.S. government is one of limited and enumerated powers.

Unequivocally, the Mint is the symbol of the tenet that the power to regulate the value of the coin is reserved directly to the people, as they regulate the flow of the monetary metals to the Mint. It will be recalled that the power to print money is an unlimited power, to be denied to governments at all hazards.

The production of coppers and nickels of course greatly surpasses that of silver and gold pieces. Yet the word “Mint” did not get into the Constitution because of that effort. The production of subsidiary coinage is entirely unimportant, even dispensable. Its production certainly does not affect the rights of individuals. By contrast, the constitutionally mandated task of the Mint to produce standard silver and gold coins is at the heart of the freedom issue. The number produced since 1933 is nil. The souvenir gold and silver coins offered for sale are not to be confused with full-bodied standard coins. This epitomizes the greatest fraud in the monetary history of the world: keeping up the pretence that the Constitution is strictly observed. Maybe it is too much to expect that financial journalists such as Smith see through the fraud.

Most significantly, the Constitution did not establish a Central Bank ― it established the Mint instead. Were the founding fathers forgetful? Mainstream economists, including Keynesians and Friedmanites, will never be able to talk down to the framers of the Constitution for their failure to enshrine the idea of a central bank in the Constitution. The monetary clauses of the U.S. Constitution have been and will continue to be the beacon of upright politicians in matters of money. Just compare the stature of Ron Paul, the only presidential candidate who dares call for the abolition of the unreconstructed Federal Reserve System, with that of Fed Chairman Bernanke and his impertinent boast that the U.S. government has given his Board a useful tool, namely the printing press, so that he can inundate this country, and the rest of the world to boot, with fast-depreciating scraps of paper called Federal Reserve notes.

The U.S. government has not been granted power to create money, still less to delegate such power to a banking concern. If it exercises or delegates such power, then it is in direct violation of the Constitution. It is a usurper. No amount of badmouthing the gold standard will cover up this fact.

Barron Young Smith, like everyone else, is entitled to his opinion that “switching to the gold standard is a terrible idea.” But he can’t escape the odium that will be his lot when the cry of people pauperized by the ultimate collapse of the irredeemable dollar will reach high heaven. These people have learned to work hard, save hard, and they created a unique Constitution in their new country in order to safeguard their freedom and to make sure that they will not suffer as did their ancestors in the old country because of monetary debasement inflicted upon the people by spendthrift kings.

Then destroyers appeared among the people in the form of perjurious politicians and other usurpers cajoling them into yielding their power to issue money, and bribing them with the idea of the welfare state. Now the people, bereft of their jobs as well as savings, are exposed to the greatest dangers brought to them by the irredeemable dollar. Congressman Ron Paul is the only candidate who has the courage to warn people of the coming disaster. Barron Young Smith’s slur on his character and campaign, I repeat, cannot be tolerated.

It is a siren song enticing people to their destruction.

### References

A.E. Fekete, The Anti-Gold Gospel According to Kaletsky, [www.professorfekete.com](https://www.professorfekete.com)

### A.E. Fekete, Uncle Sam Crying ‘Uncle!’, [www.professorfekete.com](https://www.professorfekete.com)

Barron Young Smith, What Would Happen If We Adopted the Gold Standard?

### (appended below)

## Gold Standard University Live

Session Three has just concluded in Dallas, Texas. The subject of the 13-lecture course was Adam Smith’s Real Bills Doctrine and Its Relevance Today. (Monetary Economics 102). The titles of the follow-up conferences were: 1. The Economics of Gold Mining and 2. Gold Profits in Troubled Times: Putting the Basis to Good Use. Course material will soon be available in print and in DVD format to all interested parties.

Session Four is planned to take place in Szombathely, Hungary (at the Martineum Academy where the first two sessions were held). The subject of the 13-lecture course is The Bond Market and the Market Process Determining the Rate of Interest (Monetary Economics 201). Tentative date: June 27-30. For more information please contact GSUL@t-online.hu . Further announcements will be made at the website [www.professorfekete.com](https://www.professorfekete.com) .

---

*February 25, 2008.*

What Would Happen If We Adopted The Gold Standard? by Barron Young Smith Thanks largely to Ron Paul, the idea of switching to the gold standard is back in circulation. Even on this website, libertarian Alvaro Vargas Llosa advocated it, complaining that "money was too important to be left to the politicians," and Tucker Carlson credulously speculated that Ron Paul's gold fixation might mean "the Ron Paul movement is more sophisticated than most journalists understand."

But it turns out that switching to the gold standard is a terrible idea. To clear up the issue, I called Professor Jeff Frieden, a monetary expert at Harvard, to find out exactly what would happen if we made the switch.

### •

The United States would be unable to respond quickly and effectively to sudden economic shocks. Recessions would be deeper and longer, and the economy would be biased towards deflationary spirals. Witness the fact that the United States, which remained on the gold standard till 1933, had a much longer and deeper recession than Britain, which had gone off gold in 1931.

Milton Freidman himself (often cited as the supreme authority by gold-standard bearers) warned about just this problem in his magnum opus, Monetary History of the United States, 1867-1960, instead advocating a steadily-expanding supply of paper money.

### •

It would increase government regulation of the economy. With no Fed, inexpert Congress will bear the onus of alleviating economic suffering. With deeper, longer recessions, Congressmen will inevitably succumb to pressure for more spending and regulation of the economy — as they did during the Great Depression.

Indeed, Fed management of the money supply was originally meant to stave off calls for socialism by rendering free-market capitalism more resilient, flexible, and humane. Switching back to gold would breathe new life into anti-capitalist politics.

### •

It would increase our reliance on foreign credit and ship yet more jobs overseas. Ron Paul says "our economy and our very independence as a nation is increasingly in the hands of foreign governments such as China and Saudi Arabia." But adopting the gold standard would actually exacerbate this problem, not alleviate it.

Assuming we're not in a recession, economic growth would then continually cause deflation, making domestically-produced products more expensive and foreign imports cheaper — increasing consumption of imports. The trade deficit would continue to balloon at the expense of American jobs.

### •

Insofar as it helps anybody, the gold standard would favor Wall Street bankers over entrepreneurs, businesses, and workers. Ron Paul likes to rail against Wall Street, complaining that our money is being "inflated at the behest of big government and big banks," who cause "[y]our income and savings [to] lose their value."

But banks, being creditors, benefit from deflation, not inflation — since inflation makes it easier for debtors to pay back their loans at lower prices. Credit card bills and business loans would become more expensive, increasing everybody's debt except the banks'.

One of the great ironies of Ron Paul's campaign is that it was the inflexibility of the gold standard during the 1890s spawned the anti-Washington Populist movement, led by William Jennings Bryan

(read his eloquent attack on the gold standard here).

Now, Ron Paul leads a movement with similar populist tendencies. But — perversely — he's on a crusade to resurrect a great symbol of Wall Street-Washington dominance over the individual.

Not only would the gold standard have disastrous effects for the U.S. economy, it would undermine liberty, increase debt, and weaken the country. Somewhere, Alexander Hamilton's ghost is cracking a smile.

---

# Opening the Mint to Gold and Silver

URL: https://newaustrianeconomics.com/archive/fekete/opening-the-mint-to-gold-and-silver/
Date: 2008-02-05
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, silver, bimetallic, sound-money, new-austrian-economics
Description: Fekete argues that the single most important monetary reform is reopening the U.S. Mint to the free and unlimited coinage of gold and silver, as the Constitution mandates. This reform alone would restore natural interest rate floors, eliminate the structural incentive for debt accumulation, and stabilize the dollar.
Editorial Note: Written February 2008 as the financial crisis was accelerating. A concise statement of Fekete's most fundamental policy prescription.
Original PDF: https://professorfekete.com/articles/AEFOpeningTheMintToGoldAndSilver.pdf

## Opening The Mint To Gold And Silver

### A sequel to “The Double Whammy of Geopolitical Global Gold Games”

### Antal E. Fekete

### Gold Standard University aefekete@hotmail.com

In my last article I suggested that the superpowers China, Russia, and the United States may be, without they knowing it, racing towards reopening their Mints to the monetary metals. The governments of these countries are like the heroes of Greek tragedies: they are drawn to their fate by destiny. There is no way for them to avoid Kismet, regardless of what they do. Many readers have asked me to explain what the term „opening the Mint to the unlimited coinage of gold and silver free of seigniorage charges” means.

I should start by stating that the Mint is a monetary institution far more important than the Central Bank. It is an ancient and venerable institution. The Central Bank is a relatively new invention, hardly venerable. It was conceived to make ordinary people absorb the unpaid and unpayable debt of kings. The importance of the Mint is not to be found in its altogether negligible role of coining small change, the so-called subsidiary coinage which people use to make small purchases.

The Mint is all-important because it is designed to produce real money. The origin of the Mint is intertwined with religion. From the point of view of political economy, the Mint is a reminder of the fact that, ultimately, real money is created (and extinguished) by the people and not by the government, or banks approved by the government. For example, the U.S. Constitution reserves the power to create money directly to the people themselves who convert gold and silver at the Mint into the coin of the realm (and extinguish money by melting it down). This is a power like habeas corpus that cannot be delegated, still less usurped. If the government grabs it, then, in the admirable phrase of Malcolm Muggeridge, it becomes the power of habeas cadaver. The Mint is the symbol of Constitutional Money, the only kind not subject to manipulation.

So much so, in fact, that the Mint had to be closed to gold forcibly in order to deny people access to constitutional money, and in the hope that the government could usurp their power to create money. History had to be falsified to conceal the fact of power-grab. According to the official version the Mint was never closed down as it continued to produce subsidiary coins. There were some housekeeping changes, yes. But nothing major.

This lie was exposed by William Jennings Bryan, the Democratic presidential candidate in

1896 when he denounced the power-grab in describing it as „the Crime of 1873”. He was referring to the closing of the U.S. Mint to silver in 1873, the first major violation of the Constitution’s monetary provisions.

People fell for the obfuscation. They were not interested in checking out the charges of Bryan.

What crime? What closing? What Mint? Lots of silver coins are in circulation, can’t you see? People didn’t understand the difference between the full-bodied silver coin, the constitutional standard dollar, and subsidiary silver coins that were not full-bodied. The nominal value of the full-bodied coin, produced on account of anybody tendering the right quantity and quality of metal, coincides with the market value of its metal content. By contrast, subsidiary coins are produced on account of the Treasury and their nominal value is always higher than the market value of their metal content. The difference between the two is called seigniorage, the profit going to the Treasury. There is no seigniorage on coining the standard dollar, the coinage of which is unlimited, in contrast with that of subsidiary coins with limited coinage, which explains why people accept them in circulation for the higher nominal value. (The cost of producing the standard coin, like that of constructing and maintaining public roads, is covered by taxes.)

The banks are supposed to be a handmaiden to the Mint. After the closing of the Mint to gold and silver the banks became the boss and the Mint was reduced to the status of a handmaiden. This was a violent revolution, the full meaning of which has never been explained by our institutes of higher learning. Slavery works best if people don’t think of themselves as slaves. The Mint is the symbol of freedom. It is the very antithesis of slavery. Yet imposing slavery on the people is as simple as closing the Mint to gold and silver. People are no longer free. They have lost their God-given right to create and extinguish money. They have become slaves since the government has extorted the right of first refusal on their produce and savings. As Keynesians famously boast: „taxes for revenue are obsolete”. Once closed to gold and silver, the Mint makes taxation for revenue superfluous. It is freed up for devious purposes. Now, for the first time, taxation can be used to manipulate the economy and to manipulate the people. The government can stamp an entire industry out of existence by taxing it to death. Less conspicuously, it can boost the income of one branch of industry, or one group of citizens, at the expense of another. The Mint, if people can keep it open to gold and silver in defiance of the machinations of the government and banks, is both the symbol and instrument of freedom. Once it is forcibly closed, freedom is lost and the way to the pauperization of people is thrown wide open.

I often come across the objection that the government does make gold and silver coins available to the people who care to have them. There are officially produced eagle coins in the United States, maple leaf coins in Canada, panda coins in China, and koala coins in Australia. This does not look like the Mint being closed to gold and silver, does it? People who use this argument only betray their ignorance and prove how easy it is for the government to fool public opinion. Gold and silver coins that governments currently produce are meant to confuse the issue. They are an eyewash. These are souvenir coins struck on Treasury account, sold at a premium prices including seigniorage charges.

People may feel good about having them, especially when gold and silver prices are buoyant. But their right to constitutional money has not been restored. The Mint is still closed to gold and silver. The people’s right to unlimited free coinage is still being usurped by the banks. Rather than celebrating, people ought to be upset that their government stoops so low as attempting to lead them by the nose.

As I said, the Mint is one of the most ancient political institutions brought about by our civilization. In the early history of Rome over twenty-five hundred years ago the Mint where gold and silver pieces were struck was a sacred and inviolable place. In fact, the Mint was housed in the Temple of Juno (wife of the chief god Jupiter). Our linguistic heritage shows this most clearly: the English word ’money’ is derived from the Latin word ’Moneta’, the surname of Juno. Juno Moneta, literally Juno the Vigilant, refers to the legend that Juno’s sacred geese on Capitolium saved the city from being sacked. With their loud cackling they alerted the sleeping town that enemy soldiers have scaled the walls under the cover of night and are ready to slaughter the inhabitants. Thus the English word money has connotation of vigilance. Vigilance, that is, to preserve freedom which is inseparable from constitutional money facing, as it is, constant threat from adventurers such as John Law, Keynes, Friedman, to name only a few. Sad to say, this connotation has worn off completely by now. People no longer have any idea that their freedom is being destroyed little-by-little, as their money has been corrupted.

### Oh Juno Moneta, where art thou? And where are thy sacred geese?

Oh sacred geese of Juno, whither migrated thee? Why are thee not cackling now as a new attempt is being prepared to murder innocent people in their sleep?

Compare the Mint of Juno to the Central Bank of the United States, the Fed, which is less than one hundred years old. During its brief existence it has done more monetary mischief than all the monetary mischief perpetrated by governments during the twenty-five hundred year history of the Mint, including the endless debasement of coinage through the dilution of metal content. The most recent follies of the Fed raise the question whether it will live to celebrate its centenary, or whether pig-headed and ham-handed central bankers will destroy the dollar that was entrusted to their care in 1913. Already, the dollar has lost 99 percent of its purchasing power, and is manifestly in danger of losing the remainder during the next five years or so. Quite obviously this could have never happened if the U.S. Mint had been kept open to gold and silver, which is the reason why the Constitution demands it.

The oldest central bank in Europe is the Riksbank of Sweden. It opened more than thirty years before the Bank of England. The early central banks in Europe were all established in order to fund the unpaid and unpayable royal debt. The newly chartered banks were in turn given privileges such as the monopoly of issuing bank notes, as well as immunity from being sued in case of non-performance on contracts.

Milton Friedman and his monetarist cohorts completely misrepresent the relationship between the Mint and Central Bank. They allege, falsely, that a price-fixing scheme is involved. In their topsyturvy world the gold standard, and the Mint, are institutions negating the free market. In fact, however, the truth is that bank notes are not money; they are merely promissory notes whereby the Central Bank promises to pay bearer money on demand. Only the full-bodied coins into which the Mint converts gold and silver on account of anybody tendering the right quantity and quality of metal constitute money. You cannot find price-fixing in this process with a magnifying glass. The charge of price fixing was planted maliciously by Milton Friedman in order to denigrate and discredit the gold standard. His suggestion that the Central Bank is the creator of money, and the Mint is merely an embellishment, wholly unnecessary to boot, is a shameless lie. Friedman is celebrated as the father of the floating dollar by the monetarists, who consider it as a triumph in having set the gold price „free”.

In fact, Friedman is the assassin of the dollar and will be remembered as such.

The fact of the matter is that the Central Bank is anxious to keep its notes competitive with full-bodied gold coins. Therefore it promises to redeem its notes by paying out gold at the statutory rate. So it is not the gold price that is fixed. Just the opposite: it is the value of the bank note that is fixed in terms of gold. The central bank that does the fixing has no other way of maintaining the value of its credit without coercion. The central bank, of course, wants to get rid of this restraint. It can, through coercion. The floating dollar implies coercion through legal tender laws. Full-bodied gold and silver coins never need legal tender protection. There is not one instance recorded in the monetary annals of a creditor ever refusing to accept the full-bodied coin in repayment of debt.

No doubt, for the Central Bank to live up to its promise to pay gold to bearer on demand takes knowledge, expertise, and discipline. When adventurers take over management backed by other adventurers at the Treasury, they engineer a default on the promise to pay out gold and promote the dishonored note as “money”. How do they get away with this highway robbery? They do because of the coercion of legal tender.

The term “legal tender” did not always indicate coercion. Originally it was a limited obligation to ensure smooth circulation of the subsidiary coinage. For example, the copper could be legal tender up to a dollar and, the nickel, up to five dollars. When adventurers took over the Treasury, the first thing they did was to torture the meaning of the term. They made it an unlimited obligation to accept irredeemable paper currency in discharge of debt.

After the default adventurers at the Central Bank and the Treasury initiated an elaborate check-kiting scheme whereby the latter issued irredeemable promises which were accepted by the former, and vice versa. According to Milton Friedman the depreciation of irredeemable currency can be avoided by restricting the issue through a quantity rule, e.g., the note circulation must be increased at a steady annual rate of, say, three percent. However, his thesis amounts to saying that fraudulently issued promises can be given permanent and enduring value, as though people were too dumb to understand fraud when they see it. In other words, Friedman confuses delayed exposure of fraud with inability to expose it. But what kind of a monetary system is it that so vitally depends on assuming that people are inherently stupid? Historically, no monetary fraud has ever succeeded. Every attempt to make the currency permanently irredeemable has been exposed as fraudulent and consequently collapsed. All irredeemable currencies, without exception, have ended up in the garbage heap of history. The irredeemable dollar is different only in so far as the unprecedented magnitude of the fraud necessarily takes longer to expose. But longer is not forever. After all, for the first time in history an attempt is made to fool all the people all of the time. And we have it on the authority of Abe Lincoln that this is not possible.

It is another matter if the irredeemable currency is stabilized before the final collapse, by opening the Mint to gold (or silver, or both). There are historical precedents such as the greenback of Civil War vintage. In that instance common sense and monetary science prevailed and came to the rescue of the moribund dollar. Today, both common sense and monetary science appear to be badly lacking. This would make the outlook rather gloomy.

However, there is a ray of hope: international competition in the monetary arena. Neither the Chinese nor the Russian central bankers do at heart believe in constitutional money any more than their American colleagues. They certainly enjoy their unlimited power to issue the currency in unlimited quantities. Nevertheless, they are not stupid. Both the Russians and the Chinese want to put an end to American monetary hegemony whereby the U.S. government can obtain real goods and real services from all countries of the world in exchange for irredeemable (read: fictitious) promises to pay.

They realize that the only road to defeating the American monopoly is the Yellow Brick Road. They have quietly embarked upon an ambitious program of remonetizing gold through the back door. They keep a low profile about it as it is in their interest to acquire as much gold as possible on the best terms possible.

No matter how you look at it, there is a Gold War going on in the world. The alignment of the antagonists is the same as it was in the Cold War. The name of the game is: who will end up with the largest pile of the precious yellow? Remember the adage: “He who has the gold makes the rules.”

The competition of the superpowers to acquire gold will ultimately lead to an infinite escalation of its price. As unlimited amounts of rubles and yuans are printed to buy up the limited amount of gold that is available, the competitive devaluation of currencies will reach a frenzied stage in destroying the value of all currencies. Competitive devaluation is a destructive process. American, Russian, and Chinese central bankers will find that their hands are forced by events. After all the false fits and starts they will hit upon the winning strategy: the constructive process of opening their Mint to the unlimited coinage of gold. This is the only logical thing they can do, whether they like it or not, after the stage is reached whereby cartloads of paper currencies fail to fetch even one grain of gold.* Opening the Mint will be the only way to attract all the available gold and silver in the world to their shores, benefiting their prostrate banking system that will be quick to issue gold instruments acceptable in global trade.

The U.S. will be forced to do the same, but it is questionable that being a follower rather than the leader will save the American economy from further disintegration.

There is no reason why the U.S. government could not retain monetary leadership in the face of the Russian and Chinese challenge. All it has to do is to open the U.S. Mint to both gold and silver before they open theirs. To do this would take fine statesmanship such as presidential candidate Ron Paul is offering to the American people.

Unfortunately, a great deal of damage has been done mainly because the educational system has been corrupted in exiling monetary science and sound economics from the curriculum. Keynesian and Friedmanite economics rule supreme in academia. Adventurers at the Treasury and the Federal Reserve take full advantage of the prevailing ignorance. Bad-mouthing of gold in the financial press continues unabated.

If the U.S. government fails to act and misses this last opportunity to stabilize the dollar, then the American people will be exposed to excruciating economic pain. People of other lands will not fare much better. When their dollar-denominated assets go up in smoke, they will blame America.

Anti-American feeling in the world will hit an all-time high. America will lose all her allies in the face of an increasing number of enemies. And, as famously stated by Alan Greenspan, America will be unable to procure war matériel for its military.

The only way to avoid catastrophe is to open the U.S. Mint to gold and silver while it is not too late, as advocated by presidential candidate Dr. Ron Paul.

* Note that I am not prophesying that cartloads of paper currencies will fail to fetch a loaf of bread. In fact it is perfectly feasible that the price of bread, along with other prices of consumer goods, will fall in the wake of deflation. The process herein described is not one of hyperinflation. It is one of competitive devaluation by the superpowers in order to corner gold.

### Reference

A.E. Fekete, The Double Whammy of Geopolitical Global Gold Games, [www.321gold.com](https://www.321gold.com) ,

---

*January 31, 2008*

## Gold Standard University Live

Session Three, will be held in Dallas, Texas, February 11-17, 2008.

For details, see: [www.professorfekete.com](https://www.professorfekete.com) .

---

*February 5, 2008.*

---

# The Double Whammy of Geopolitical Global Gold Games

URL: https://newaustrianeconomics.com/archive/fekete/the-double-whammy-of-geopolitical-global-gold-games/
Date: 2008-01-31
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, central-banking, monetary-policy, gold-standard
Description: Fekete examines the geopolitical dimension of gold suppression, arguing that central bank leasing and futures market naked short selling constitute a double whammy against gold. He argues the failure of both suppression mechanisms is already underway, and their unwinding will produce an explosive gold price adjustment.
Editorial Note: Written January 2008. Fekete brings geopolitical analysis to bear on his monetary framework, examining how coordinated international gold suppression has been maintained and why it is now failing.
Original PDF: https://professorfekete.com/articles/AEFDoubleWhammyOfGeopoliticalGlobalGoldGames.pdf

*The Double Whammy Of Geopolitical Global Gold Games*

**Antal E. Fekete** · Gold Standard University aefekete@hotmail.com Even the most rabid silver bugs admit the possibility that the Chinese are the Big Silver Shorts. This suggests that the Big Gold Shorts are also governments. Neither are naked by any stretch of the imagination. The double whammy of gold and silver accumulation by unnamed governments is the big puzzle of the present financial crisis in the world as it holds the key to the resolution.

For a better understanding of the Chinese silver picture you have to know a little background of the role of silver in China. The facts are as follows. China has been on a silver standard since time immemorial. China stayed on the silver standard after other trading nations of the world demonetized silver and embraced the gold standard at the end of the 19th century. China’s external trade was insignificant, but the volume of silver currency for domestic use must have been enormous. In addition, there was an avalanche of silver from abroad raining on China. As the silver price fell over 75 percent from \$1.29 in 1873 to \$0.25 by 1932 (with a brief spike back to \$1.29 at the end of World War I), other governments were dumping silver on China mercilessly. China was the only country on the silver standard and the Chinese central bank had to take all the silver offered to it at a fixed price.

This situation lasted right up to 1949 when the Communists took over the government. In fact, several Western historians blame the Communist victory on the unprecedented silver inflation that Western governments inflicted on the Chinese economy by their insane silver dumping policy before World War II.

Nobody knows how much silver the Chinese Communists found in bank vaults and in the safe deposit boxes of Chinese merchants who fled the country, when they took over the mainland. Nobody knows how much silver is still hidden in the mattresses of Chinese peasants. The amounts must be enormous. The best estimate is that most of that silver has never been consumed and still exists in monetary form. China’s primitive economy under Mao was in no position to put that silver to industrial use. All that silver is now at the disposal of the Chinese government that could easily buy up silver coins scattered around the cities and in the countryside, at the present rising price of silver.

China is the only country in the world that has consistently run trade surpluses since 1950. As far as it is known, silver never figured in China’s exports (except re-exporting foreign-owned refined silver.) Why should the Chinese export silver, when they could export almost anything else? Silver to the Chinese mind is money. You don’t export money unless you are forced to cover your trade deficit, of which China has none. China has always paid for its imports with exports, a smart thing to do, too.

The Chinese are alive to the fact that escaped the silver bugs in the West, that you can derive a silver income from your pile of silver by covered short selling, even while retaining physical control of your silver hoard. THIS IS AN UNPRECEDENTED BONANZA IN THE HISTORY OF

MONEY. It has never before happened that you earn interest while retaining physical control of your money. Typically you have to release control of money in order to earn interest income, that is, you have to assume risk. Lending money necessarily involves risks: the borrower may default. But if you don’t give up physical control, then you will escape the monetary debacle unscathed. Because of the imbecility of the managers of the paper dollar standard there exist durable risk-free profit opportunities in holding monetary metals in the balance sheet. The trick is: covered selling. That’s possible because the price of monetary metals has been allowed to fluctuate. The price fluctuation of a monetary metal, like the flow-and-ebb of the oceans, represents energy. Energy that can be harnessed. Energy that can be harnessed only by those who understand monetary economics.

The Chinese are not stupid. They looked askance at the silver and gold demonetization farce perpetrated on a gullible world by Western governments. (Gold was demonetized 100 years after silver had been, in 1973.) They are not falling for the cheap trick. They hang on to their silver. They make most of the stupidity of their adversaries. Nor are they in a hurry to push the silver price to three or four digits in order to sell their silver for a quick profit in irredeemable dollars (which is what the getrich-quick crowd plans to do). Rather, it is in their interest to derive constant and consistent income in silver from covered writing, or using other dynamic hedging strategies. Why should they trade their silver for dollars, when they have far more dollars already than they want?

From the point of view of the Chinese, a slow rise in the silver price (and a gradual rather than an abrupt depreciation of the irredeemable paper dollar) appears more desirable than an overnight jump in the silver price to three digits that would put an end to their lucrative silver income from covered writing. They certainly have the clout to dictate the pace of silver price appreciation, and probably also of paper dollar depreciation.

The Chinese are inscrutable. They don’t show you their blueprint for the new international monetary system which they plan to impose on the world after the inglorious end of the paper dollar era. It may be a born-again silver standard. The Chinese are using their cash silver and the silver income derived from covered writing as a hedge for their exposure to irredeemable paper dollars to the tune of \$1.3 trillion, by far the largest accumulation of dollars the world has ever seen. What they will lose on their paper portfolio they will gain on their cash silver position. They will probably gain much more. While the finance-capital of the world denominated as it is in paper dollars is programmed to self-destruct, the Chinese will control much of the liquid capital in the world after the dollar-debacle.

They will be a great source of capital exports, if you can pay their price, that is.

The Chinese can earn their way in the world. They can work when work is necessary, and they can save when saving is called for. They are doing fine, thank you very much. You need not worry about the Chinese losing their kitty of \$1.3 trillion invested in U.S. T-bills and T-bonds.

However, you had better start worrying about America which is no longer in control of its economic and financial destiny. It has let world monetary leadership slip out of its hands. America’s industrial capital is in shambles. From the largest creditor it turned itself into the largest debtor. The light has gone out at the great American universities as far as monetary science is concerned. Through bribe, blackmail, and attrition all upright and serious monetary economists were bumped from their academic chairs. The Great Chinese Cultural Revolution was a picnic in comparison to the Great American Cultural Revolution eliminating monetary economics from the curriculum. Courses on money presently taught consist of pure Keynesian and Friedmanite bunk.

It is a farce to blame the present financial crisis on lax lending standards and rogue traders.

What we see is the return of the chickens to roost. This crisis has been in the making for over a century, involving the so-called demonetization of both monetary metals. The move was inspired and led by the United States. In particular, the so-called demonetization of gold was designed to camouflage the default of the U.S. Treasury on its gold-obligations. The industrial nations of the West did not even say ‘ouch’ when America’s default caused them losses measured in hundreds of billions on their holdings of dollars in 1971. They became accomplices eager to start milking their own savers and producers by joining the paper-money farce. The day of reckoning dawns.

America’s plight is self-inflicted. Yet America could still turn the train of monetary events to its advantage, reclaiming monetary leadership, if it opened the U.S. Mint to gold and silver. It should do it before China or Russia opened theirs. Unfortunately, there does not seem to exist one grain of wisdom in Washington to see this, let alone to do this. It would take the election victory of the maverick candidate, Dr. Ron Paul, Minority of One in the House of Representatives, to pull it off. It is certainly a proof of the American genius that great crises produce great men who are capable of dealing with them. If the Chinese beat America to the finish line by opening their Mint to silver, then the silky metal would be the international currency of the future.

Next to the Chinese the Russians are the most inscrutable players, ganging up against America’s monetary hegemony. Their turf is gold. Perhaps it will be the Russians who will beat America to the finish line by opening the Russian Mint to gold, even before the Chinese open theirs to silver. Either way, America would be left in the lurch, denuded of its industrial capital, its savings, but left with a pile of worthless paper, and paper-worshippers in charge of the Treasury, and in charge of teaching monetary economics at all levels.

America can then embark on the arduous path to accumulate capital from scratch, while Russian and Chinese capitalists will be producing goods in spanking new plants, aided by spanking new equipment, complemented by shiny gold and silver pieces to trade their products world wide.

It is past wake-up call. To save itself, America had better listen to the message of Ron Paul who, in a counter double whammy, would open the U.S. Mint to both gold and silver if elected President.

## Gold Standard University Live

Session Three, will be held in Dallas, Texas, February 11-17, 2008. For details, go to [www.professorfekete.com](https://www.professorfekete.com) .

---

*January 31, 2008.*

---

# The Crash of the Bank of United States

URL: https://newaustrianeconomics.com/archive/fekete/the-crash-of-the-bank-of-united-states/
Date: 2008-01-28
Section: Popular Economics
Difficulty: intermediate
Concept Tags: real-bills, federal-reserve, new-austrian-economics, capital-destruction, monetary-policy
Description: Fekete examines the 1930 failure of the Bank of United States and its role in triggering the Great Depression, arguing that the crash was the predictable consequence of the Federal Reserve's destruction of the Real Bills market, which left banks without the self-liquidating credit mechanism to survive monetary contractions.
Editorial Note: Written January 2008 as the financial crisis was building. Fekete draws explicit parallels between 1930 and 2008, arguing that the mechanism is identical — central bank destruction of self-liquidating credit.
Original PDF: https://professorfekete.com/articles/AEFTheCrashOfTheBankOfUS.pdf

*The Crash Of The Bank Of United States*

### Benjamin M. Anderson*

By the fourth quarter of 1930 the trouble with the Bank of United States gave occasion to grave concern.

The Bank of United States was a bank which ought never to have existed, and which certainly ought never to have had the name it had. One leading banker of New York went personally to Albany to protest against the giving of such a name to that bank or to any other bank, and was told that there was a political debt to pay.

In the period 1924 to 1929, with excess reserves and rapid bank expansion, it was easy for plungers and speculators to grow rapidly. There was a heavy discount on sound banking, and a high premium on reckless plunging. One watched it with apprehension, afraid not merely that bankers would lose their judgment but also that in many cases moral standards would crack. In many cases judgment went bad, and in more cases traditional practices, sound and tested, turned out to be bad practices in such an abnormal money markets as then existed.

But the great majority of American bankers kept their integrity and tried to adhere to established and approved banking practices. However, it was an era in which the bold speculator and promoter could gain ground rapidly at the expense of the conservative banker, and it was a period in which departures from convention and approved banking practices would seem to be brilliant strokes of genius ― while the new era lasted.

The Bank of United States grew very rapidly down to 1929. The name itself meant, as it was designed to mean, to many of the ignorant people of Europe, that this was the national bank, the state bank, the official bank of the United States. Deposits came to it from a great many of those people and from a great many of the ignorant poor on the East Side of New York. And a great deal of business was brought to it, too, by men engaging in speculative activities who could get the desired accommodation from this bank which other banks of New York would not give.

Loans against mortgages were generally looked upon at askance by great New York banks. The first principle of commercial banking is to know “the difference between a bill of exchange and a mortgage”. Second mortgages and third mortgages were notoriously improper documents in a bank’s portfolio or as a collateral to its loans. But the Bank of United States went in heavily for these. It had an affiliate also ― the Bankus Corporation. This was engaged in many yet more questionable transactions, including manipulation of the stock of the bank and loans against the stock of the bank. In addition to the utterly unsound banking practices, there were definitely criminal acts for which the head of the bank subsequently went to prison ― not unaccompanied.

When the first mortgages grew shaky, when the second and third mortgages had no market, and when the bank’s stock was crashing, the Bank of United States and its affiliate, the Bankus Corporation, were in grave peril. Depositors grew very uneasy and they made heavy withdrawals of funds.

Unsuccessful efforts to save the Bank of United States. The great New York clearinghouse banks, the Federal Reserve bank, and the state superintendent of banking, Joseph A. Broderick (who had no part in giving the name to the bank and whose job was primarily salvage), made strenuous efforts to save the situation. The great clearinghouse banks were prepared, in the interest of preserving the good name of banking in New York, to stand part of the losses. On Monday, November 24, 1930, it was announced that there would be a merger of the Bank of United States with the Manufacturers Trust Company, the Public National Bank & Trust Company, and the Interstate Trust Company, with J. Herbert Case, Federal Reserve agent and chairman of the Board of Directors of the Federal Reserve Bank of New York, as the head of the merger.

This looked like an admirable solution of the problem. The financial community breathed a great sigh of relief when it appeared that J. Herbert Case thought that the situation could be solved in this way. It appeared that the aggregate capital funds of all these banks would suffice to absorb the losses and still leave a strong institution. But the agreement was a contingent agreement, and the other banks were to have time to scrutinize the assets of the Bank of United States. As they did, the merger became impossible. The officials of the other banks and J. Herbert Case could not assume responsibility for such a mess. The problem remained. The clearinghouse continued to work hard upon it.

A conference, lasting beyond midnight, of leading New York bankers sat with superintendent Broderick on the night of December 10 and the early morning of December 11. A plan was worked out by which a wholly new management, under the presidency of the head of one of the small but sound banks of the city, was to take over the Bank of United States with a guaranty of the great clearinghouse banks against loss.

But after this able young president and his associates, accustomed to clean, sound banking, looked at the assets of the Bank of United States, looked at the second and third mortgages, looked at the tangled and involved transactions they would have to deal with, they declined. They just did not know how to do that kind of banking. No other New York bank knew how to do that kind of banking.

And so it came to pass that, on Thursday morning, December 11, 1930, the Bank of United States was closed for good.

Cheap money could not help in a situation like this. To ease the shock and to relieve the plight of the depositors of the bank, the other banks of the city agreed to make loans against deposit accounts in the Bank of United States up to fifty percent of their face value.

With the announcement of the closing of the Bank of United States the stock market plunged still lower. Money remained extraordinarily cheap in this stock market crisis. Callloan renewal rates ranged from 2 to 2.3 percent between December 13 and December 27. But cheap money could not help in a situation where it was not liquidity but confidence that was vanishing. The stock market reached a wide-open selling climax on Wednesday, December 17. Then, as is usual, it rallied, and the rally carried over through the early months of 1931.

But, in the light of developments of the next two years, the American banking system was mortally wounded. By March, 1933, it lay prostrate. One rotten apple can make the entire pile of apples go bad.

* Benjamin McAlester Anderson, 1886-1949, author of the posthumously published treatise Economics and the Public Welfare, A Financial and Economic History of the United States, 1914-46 (Princeton: D.Van Nostrand Co., Inc., 1949; second edition: Indianapolis: Liberty Press, 1979) from which this excerpt was taken, slightly edited by Antal E. Fekete of Gold Standard University.

Editor’s comment. Professor Anderson was a distinguished scholar, historian, banker, financier, and economist. As a monetary historian he wrote about a period in which he was not only an astute observer but also a frequent participant.

What lends extraordinary timeliness to his observations about the 1930 banking scene is the now unfolding subprime mortgage crisis that has already metastasized from the United States to the rest of the world. Needless to say, in 1930 the American banks were in a far better shape than they are today when the entire banking system is guilty of unsound practices with which only isolated banks, such as the Bank of United States and the Bankus Corporation, indulged themselves eighty years ago.

Eighty years ago the fancy name of the bank was the lure to entice ignorant people to their doom. Today it is the fancy name of the product: “mortgage-backed securities”, “collaterized debt obligations”, “securitization of loans” and, most recently, “insuring bonds” that is supposed to do the same trick.

What makes the above reading so frightening is the fact that eighty years ago the credit of the United States was rock-solid. Today it is moth-eaten; the promises of the federal government are hardly worth the paper on which they are printed, in view of its repeated defaults and its embracing of the unconstitutional regime of the irredeemable dollar. Worse still, the credit of other countries is no better, given the fact that it is not backed by anything more solid than the credit of the United States.

Eighty years ago American institutes of higher learning offered the very best available by way of economic and banking knowledge. Today they are a sorry shadow of their former self. They are subject to bribe and blackmail. They are stooges of the banks. There is a gigantic cover-up and distortion of truth, as a consequence of our way of financing advanced studies through grants from the banks, including the twelve Federal Reserve banks, with a hidden agenda to perpetuate the regime of the irredeemable dollar.

If academia is the tamed lion of the banks, then financial journalism is their lapdog.

Eighty years ago one was afraid that moral standards may crack in consequence of questionable banking practices. Today we know that they have. The Bank of United States closed its doors for good on December 11, 1930. But it did not even have off-balance liabilities! Nor did it have nina mortgages! (nina = no income, no assets).

It is interesting to watch the Fed trying to meet the present crisis in the same way as it was in 1930: by administering liberal doses of cheap money. In 1930 the Fed made the crisis worse and it prepared the ground for the Great Depression. Cheap money in 1930 certainly did not stop the decline in the stock market.

Ruefully, one can say of the Fed the same what was once famously said of the Bourbons after the restoration of the monarchy in France: “they’ve learned nothing and forgotten nothing.”

---

*January 28, 2008.*

---

# The Anti-Gold Gospel According to Kaletsky

URL: https://newaustrianeconomics.com/archive/fekete/the-anti-gold-gospel-according-to-kaletsky/
Date: 2008-01-26
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, fiat-currency, new-austrian-economics, sound-money
Description: Fekete systematically rebuts Anatole Kaletsky's arguments against gold as a monetary standard, showing that Kaletsky's objections rely on quantity theory errors and historical misreadings — ignoring the basis, misunderstanding self-liquidating credit, and confusing the gold standard with the gold-exchange standard.
Editorial Note: First in a series of Anti-Gold Gospel rebuttals (January–February 2008). Fekete uses the genre of direct refutation to present his positive monetary theory through contrast with mainstream objections.
Original PDF: https://professorfekete.com/articles/AEFTheAntiGoldGospelAccordingToKaletsky.pdf

*The Anti-Gold Gospel According To Kaletsky*

**Antal E. Fekete** · Gold Standard University e-mail: aefekete@hotmail.com Anatole Kaletsky is the author of the most recent Anti-Gold Gospel ([www.gavekal.com](https://www.gavekal.com), January 21, 2008.) He is an establishment journalist, Associate Editor (formerly Economics Editor) of The Times. He says that he instinctively dislikes gold because “historically gold has been a terrible investment and, even in the short term, gold has failed as a store of value”. I am satisfied to leave this statement to stand on its own, and wish Kaletsky good luck in seeking a better store of value in fiat currencies.

It is patently disingenuous and unfair to compare the gold price to stock indexes. It would be fairer to compare stashed-away gold to passbook savings. A portfolio of equities takes managing. It may be beyond the reach of most wage-earners and pensioners while their savings is the main target of the pilferers who run the nation’s banks and monetary system.

Who said pilferers were after wealth invested in the stock market?

I strongly object to the idea that “gold is an investment”. Gold is better described as a non-investment, more precisely a place where you park your savings when you cannot find satisfactory investment outlets either because interest rates are too low, or because the risk of holding equities is too high, e.g., after a bull run of the stock market driven by printing-press money. Gold is not an investment any more than a fire-insurance policy is. Governments have a sacred duty to protect the value of funds of the weak, who cannot fend for themselves in the investment arena. Without protection their funds would melt away like butter left in the blazing sun. Governments have failed miserably in discharging this sacred duty. The Biblical curse is upon them for “tormenting widows and orphans”.

Kaletsky, like everyone before him preaching the Anti-Gold Gospel, studiously avoids the question why the Treasury and the Federal Reserve should have the privilege of issuing obligations that they have neither the means nor the intention to honor. If anyone else tried to run a business on that basis, he would land in jail like Charles Ponzi did in the 1920’s.

Kaletsky also dodges the fact that gold is the only balancing item in the asset column that has no countervailing liability in the balance sheet of someone else. It is this feature that makes gold impervious to defaults, devaluations, and deliberate debasement of the currency.

For this reason gold is universally sought after as a safe haven, especially when the seas get rough. There is simply no substitute for gold in this regard.

Gold is the indispensable regulator of debt in society. Kaletsky apparently believes that government bureaucrats should determine how much debt society is able safely to carry, and they should regulate the level of debt accordingly. Well, we have just tried this and found that whenever irredeemable promises are to be liquidated by issuing more irredeemable promises, debt proliferates beyond any limit. The derivatives monster and its bastard offspring, “bond insurance,” is the beacon luring the boat of the national economy to its doom on the reefs. Clearly, debt existing in the world today will never be liquidated through the normal processes of debt-retirement, that is, without detours into deflationary or inflationary territory (i.e., through default or depreciation). It is lunacy to think that the debt-pyramid can continue to grow indefinitely without causing a major catastrophe further down the line. All debt will be liquidated in the same way as subprime mortgages: through default ― or else, it will be inflated away.

By the way, did it ever occur to Kaletsky that there is absolutely no need for bond insurance under a gold standard? The reason is that interest rates and, hence, bond prices are confined to such a narrow range that bond speculation becomes unprofitable. Under a gold standard capital and talent are freed to pursue socially desirable goals.

Kaletsky’s argument that there is not enough gold in the world to serve as a means of exchange in our sophisticated global economy is the old war-horse of the Anti-Gold Gospel.

All the output of the gold mines for the past half-century, plus all the monetary gold disgorged by the central banks in a futile effort to contain the gold price, has been gobbled up by gold hoarding. This is an unmistakable sign that people do not trust the integrity of government promises, nor do they buy the academic claptrap about gold being a barren asset and a barbarous relic. Obituaries of gold money have been premature. The golden corpse still stirs.

People who sought refuge in gold have been amply rewarded for their foresight. More rewards are on the way. Others who did not avail themselves of the opportunity will have occasion to regret it. They are to be victimized by the welfare-warfare state and its unconstitutional power-grab in issuing irredeemable dollars. These dollars could not have been issued under a system of government of limited and enumerated powers. All present dollars have been issued unconstitutionally. They are the corpus delicti: proof of usurpation of unlimited power.

If constitutional money were re-established, then gold would come out of hiding and make itself available as a means of exchange. There is plenty of gold in existence to support a gold standard, provided that confidence in promises is re-established. There is no rigid rule limiting the amount of sound credit that can be safely built upon a given gold base, especially in this age of instantaneous and free communication. However, multiple credit construction and borrowing short to lend long as a banking technique must be renounced.

The last word whether gold is destined once again to become the pivot of the international monetary system, or whether it is hopelessly antediluvian and incompatible with economic progress, will not be pronounced by detractors of gold and devotees of fastdepreciating fiat money. Their time is up. Their schemes and nostrums have been tried. Now it is the turn of their victims to have their day in court to pass judgment on the fiat money experiment. “He laughs who laughs last”. The annals of monetary history do not know one single instance in which irredeemable currency survived the test of times. Either the currency was returned to its gold anchor in good time and its value stabilized, or it plunged to worthlessness within a generation. We are skirting these limits right now. The present experiment with the irredeemable dollar has been going on for just about a generation. You will not have to wait decades to witness the failure of this experiment.

The dollar is hemorrhaging on two counts: one is the trade deficit, and the other is the budget deficit. Both the political will and the economic know-how are missing to stop the bleeding. The U.S. is borrowing \$800 billion annually from foreigners to fund its consumption of foreign-produced goods and commodities. The federal government is running an annual budget deficit of almost \$600 billion. At one point foreigners will refuse to finance the burgeoning twin deficit, forcing the Federal Reserve to monetize all the additional debt.

The danger is real that the value of the dollar, both international and domestic, will collapse at that point.

Kaletsky says that the gold standard is totally anachronistic in our age of rapidly advancing technology and growing populations. He might as well say that good faith behind promises have been rendered obsolete by technological progress, and the more people there are the more the government is justified to cheat them out of their savings through currency debasement. Kaletsky is entitled to his belief that people will meekly continue in their assigned role of being victimized by spendthrift governments. However, the New Year 2008 brought with it signs aplenty that the open season of governments’ preying upon savers and producers of real goods and real services is coming to an end. People wake up and realize that they are surrendering real goods and real services in exchange for irredeemable promises.

The consequences of this awakening will be most painful. The responsibility for the coming credit collapse in the wake of the unconstitutional paper dollar rests with the U.S.

Treasury, and its partner-in-crime (partner-in-check-kiting if you will) the Federal Reserve. It may serve as a useful reminder to recall that the French, some seventy years before their bloody revolution, experimented with irredeemable currency under the management of the Scottish adventurer, John Law of Lariston. When Law’s system unraveled people wanted to lynch him. He had to leave Paris in a hurry. Under the cover of night. In a disguise. Disguised as a woman.

The finance capital of the world, denominated as it is in dollars, is in danger of being wiped out. There is only one way to take out insurance against this contingency: buying gold.

As I have explained above, the reason can be found in the balance-sheet concept of gold. The only financial asset that will survive any consolidation of balance sheets, any default, any devaluation, any depreciation is gold.

Gold holdings are the most negatively-correlated asset class to traditional financial assets. Portfolio-diversification can be achieved by balancing financial assets such as bonds, equities, and currencies by holding gold. The best timing to set up a gold hedge is when cyclical trends change, as they do right now. The Dow/gold ratio is presently indicating a change. It has turned from increasing to declining mode, which is a red-alarm signal warning wealth-holders that it is time to hedge financial assets and even to go overweight in gold.

The rising gold price and its implications have been largely ignored by the financial press and the investing public so far. The proposition that gold is still a monetary metal and still has a monetary role to play is ridiculed, while some central banks around the globe (e.g., that of Russia, China, India, Argentina, Brazil, to mention but the most important ones) are quietly remonetizing gold as they diversify out of dollars and build gold reserves from scratch. They keep this activity under cover as much as possible since it is not their intention to upset the golden apple-cart.

It is not too late to set up gold hedges as portfolio insurance. Private and institutional investors (including pension funds and insurance companies) have investments to protect worth some \$180 trillion. Not more than \$600 billion worth of gold bullion is presently earmarked as hedges for portfolio insurance. (Note that gold-mining shares are not eligible for this purpose.*) In other words, only about one-third of one percent of all the investments is protected by gold hedges while more than 99 percent is unprotected. Even this is a gross overestimate because most of the hedged portfolios are heavily overweight in gold, leaving that much less gold for the unprotected and thinly protected ones. Be that as it may, if global investors decided to allocate even a modest three percent of their assets to purchase portfolio insurance, the consequence would be that \$6 trillion paper assets would be chasing gold bullion worth \$0.6 trillion, or one-tenth, at the present price of gold. This means ten bidders for every ounce of gold available. Portfolio insurance is still cheap, but the cost may quickly go up ten-fold or more, once the stampede starts.

Kaletsky would serve his readership better if he advised caution at this juncture. It is still too early to dismiss the possibility that the Titanic of the world economy, having collided with the derivatives iceberg tearing a subprime hole in the hull, may go down. Golden lifesavers may yet come handy.

## Gold Standard University Live

Session Three will be held in Dallas, Texas, February 11-17. For further information, go to [www.professorfekete.com](https://www.professorfekete.com) .

* Gold mining shares are not eligible as portfolio insurance since they have an ambiguous correlation to traditional financial assets. While from time to time they may be negatively correlated, and there is no question of their ability to benefit from promising trading opportunities, long-term wealth preservation demands fully allocated, segregated, and insured gold bullion. The counterparty risk involved in owning gold mining shares is not zero. Worse still, the full extent of this risk is unknown. To complicate matters further, many a government (such as that of Ecuador) keeps a jaundiced eye on its gold mining industry and is trying to determine the most opportune moment to expropriate foreign shareholders. Gold bullion is not dependent on anyone’s promise, representation, or ability to perform (nor, if properly stored, is it dependent on the propensity of the government to expropriate), in a word: gold bullion is not someone else’s liability. Therefore it is the only agent that can provide the necessary protection against both contingencies: systemic collapse and slow monetary debasement, while incurring the lowest possible level of risk.

### Acknowledgement

The author hereby wishes to acknowledge his indebtedness to various writings of Nick Barisheff of Bullion Management Services, Inc., Canada.

---

*January 26, 2008.*

---

# Gold: How High Is High?

URL: https://newaustrianeconomics.com/archive/fekete/gold-how-high-is-high/
Date: 2008-01-17
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, backwardation, fiat-currency, gold-standard, monetary-crisis
Description: Fekete argues that questions about how high gold can go are the wrong framework: gold does not go up — paper money goes down. The real question is how low irredeemable currency can fall before the system collapses. He uses the gold basis to show that the gold price in dollars is less important than the convergence of spot and futures prices toward permanent backwardation.
Editorial Note: Written January 2008 as gold approached $900. Fekete characteristically reframes the question from a gold-bull perspective to a monetary-analysis perspective — the price matters less than the basis.
Original PDF: https://professorfekete.com/articles/AEFGoldHowHighIsHigh.pdf

*Gold: How High Is High?*

**Antal E. Fekete** · Gold Standard University e-mail: aefekete@hotmail.com Now that the sound of cork-popping and other signs of celebrating the New Year, and the new record highs in the price of gold, are dying down, some questions arise the answering of which brooks no delay. How high is high? Is it the nominal price or the so-called ‘real’ price of gold that gives us a valid reading of whence we came, where we are, and whither we go?

Chrysophobes have already started their dissonant chorus reminding gold bugs that the last time gold was trading at these levels, in January, 1980, it was a sign marking the onset of a bear market taking the price down by more than 75 percent, lasting over twenty years.

Goldbugs take comfort in the thought that the previous peak in the price of gold was much higher in “real terms”, so that the current price is not so high after all. However, this begs the question. The previous peak was the result of a blow-off, and further rise from here may make a new blow-off loom large on the horizon, with all the unpleasant consequences.

The chorus of chrysophobes will obviously get much louder as we may see fresh record prices in four digits. Just how serious is the danger that a blow-off could trigger another bear market lasting for decades?

Gold Standard University offers a unique perspective on the gold price issue, a perspective which is deliberately ignored, even denigrated, by virtually all investment advisory services. Ours is the perspective of monetary science as it existed prior to 1936, before Keynes and other charlatans gained academic recognition and prominence for peddling their pet monetary nostrums. Let’s review some of the principles that are indispensable in separating grain from chaff.

## The Value Of Gold

Gold is the senior monetary metal (silver being the junior). This has nothing to do with the denials, declarations, and desires of devaluation-happy governments. It has to do with the fact that the value of gold, unlike the value of other earthly wares, depends far less on scarcity, and is threatened far less by increasing supply. One may even say that the value of gold is exempt from the effect of the law of supply and demand. Often the rising price of gold causes a contraction of supply. A blow-off may indeed cause a withdrawal of all offers to sell. After that happens, gold is not for sale at any price. But again, a blow-off may bring out an avalanche of supply. The essence of the gold price is volatility. The essence of the value of gold, however, is stability. We conclude that the price of gold has nothing to do with the value of gold.

## What Makes A Monetary Commodity?

Monetary economics is the science of monetary commodities, which are necessarily quite different from the non-monetary variety. The latter are produced in order to satisfy consumption demand. The former are produced to satisfy demand for the ultimate asset that has no counterpart in the liability column of the balance sheet of someone else. The only default-proof asset is a holding of monetary metals.

The value of gold is more stable than the value of any non-monetary commodity, although this fact is deliberately obscured by the managers of global irredeemable currency, anxious to confuse the issue. They have the power to engineer temporary surges in the value of their product, irredeemable promises to pay, in order to put gold into the worst light. What makes a monetary commodity? It is the fact that existing supplies are very large relative to the flows of new metal from the mines. A discovery of new gold fields makes little impact as its effect on supply is small. On this basis gold has been far and away the leading monetary metal for most of the Modern Age. It still is.

## Gold Is Gold And Paper Is Paper

The managers of the global fiat currency system are helpless in facing the challenge of gold.

They can have their high-profile auctions, trying to demonstrate that gold is scrap and is being sold as such. But what these gentlemen accomplish is only to undermine the value of their fiat currency through the dilution of the assets backing it. Those who can read balance sheets understand that selling a monetary asset that is nobody’s liability such as gold, and replacing it with the irredeemable promises of coin-clipping governments, makes the balance sheet of the central bank weaker, not stronger. After all is said and done, gold is gold and paper is paper.

A paper promise cannot be better than the good faith behind it. This good faith is not a consequence of a quantity-rule advocated by the monetarists. It is a consequence of the promise being redeemable in something other than another promise. Gold is not a promise: it is the fulfillment of promise. You need not trust gold if you don’t trust the issuer who stamped it. The weight and purity of gold can be readily tested with scales and acids.

The history of good faith behind monetary promises could hardly be more dismal, as the monetary annals of the twentieth century reveal. There is not a single currency without at least one instance of breach of faith during the twentieth century. The Swiss defaulted on the Swiss franc once, in 1936. The U.S. defaulted on the dollar twice: in 1933 and in 1971. The British defaulted on the pound sterling at least three times: in 1931, 1948, and in 1968.

By 1971 it looked so bad that the world’s governments agreed to make the deciphering of their monetary record difficult through the stratagem of “floating”. The word is a misnomer designed to camouflage “sinking”. Floating obscures the underlying fact of competitive currency devaluations. The dam burst and the world’s stock of money started on an exponential track. Prices of consumer goods took flight. Interest rates were destabilized.

Derivatives markets proliferated.

## Monetary Debauchery Has Its Own Dynamics

But it was in the twenty-first century that monetary debauchery started in earnest. The scope of monetary destruction that goes on right now makes earlier episodes pale in comparison.

Worse still, monetary debauchery has its own momentum and is not responsive to monetary brakes. Everybody talks about the unprecedented rate of new money creation. Nobody is talking about the equally unprecedented rate at which money is being destroyed. No sooner had new money been printed than its value depreciated. The point has been reached that the more new money is created, the more its value declines; and the more it declines, the more new money has to be created. What you have is an irresistible spiral into the abyss.

As I was saying, the price of gold has nothing to do with the value of gold. It has to do with the disappearing value of fiat currencies in which the gold price is quoted. A falling price of gold ought to be interpreted correctly, like the fall of a piece of rock. Is that rock pulling the earth, or is it the earth that is pulling the rock until the latter crashes into the former, through the mutual attraction of masses?

A falling gold price is the market’s reaction in anticipating large-scale dumping of gold on official account. The dumping is politically motivated: it is designed to misinform and mislead. Naturally, the market obliges: it brings down the price to facilitate central bank unloading. But once dumping stops, as it obviously has to at one point, the market immediately adjusts the gold price back to its pre-dumping level or higher. Only ignoramuses swallow the propaganda line that gold is passé, and the millennium of global irredeemable currency is here.

## Gold As Insurance

Selling gold after a surge in the gold price is akin to canceling fire insurance after surviving unscathed a devastating fire destroying homes and property in the neighborhood. It can be confidently predicted that higher gold prices will bring out a lot of selling by woolly-thinking people, as if insurance against the danger of collapse of the international monetary system were no longer necessary after an initial tumble in the gold value of paper currencies.

The reason for this illogical behavior is greed that is often greater than the desire for security. A large part of the gold bug population is motivated by „get-rich-quick” mentality more than by the mentality of insurance policy holders. This type of behavior should not detain us here. We do know that there were passengers aboard the sinking Titanic willing to sell their life-savers for cash. “Profit-taking”, so-called, will ultimately dry up as the collateral risk (what I euphemistically call the dead-cat bounce of the dollar) will become clear even to people ignorant of the difference between monetary and non-monetary commodities.

## Supply-Demand Equilibrium Price Of Gold

One of the most controversial propositions that we here at Gold Standard University have to face, and the idea that appears to die hardest, is the supply-demand equilibrium price of gold.

The price of monetary metals is not governed by supply-demand considerations. Such a supposed equilibrium is just the figment of the imagination, lacking any scientific merit. The fact is that supply and demand in the case of monetary metals is indefinable. By their very nature the monetary metals are subject to the most intense and most concentrated speculative attacks, both from the long and short side of the market. Speculators in gold are not poring over production and exploration results. Rather, they are trying to divine how the largest holders of gold are going to react to a surge in the gold price. Accordingly, from sellers they become buyers and vice versa on a moment’s notice, moving the price as they do.

There are no scientific principles to support predictions about human behavior. There are only statistical laws, and we might as well admit up front that they are very imperfect. A statistical law is the more valid the larger is the number of cases it can catch within the net of sampling. It follows at once that when it comes to predicting the consequences of a single isolated, non-repeatable event, such as gold scoring a certain new record, statistical analysis is useless. As any upright scientist will admit statistical analysis has a congenital weakness: its validity and usefulness diminish in proportion with a decrease in the number of samples.

There is simply nothing science can do to eliminate or to assuage this weakness. Of course, quacks are ready to exploit our incurable ignorance and will try to impress the gullible public with mathematical hocus-pocus. They will pretend to make “scientific” predictions about the consequences of isolated, non-repeatable single events in the realm of human behavior.

I am a professional mathematician. Here I stand as a new Luther and bear witness that mathematics has not been in the past, is not at present, nor will it ever in the future be able to make predictions about human behavior based on minimal samples. I am fully aware of the significance of my statement and I am willing to stake my professional reputation on it. It is not possible to predict whether a surge in the gold price will bring out more sellers than buyers, or whether it will bring out more buyers than sellers.

Proliferation of mathematical symbols and studied gestures by pseudo-mathematicians do not science make.

## The Siren Call Of Profit-Taking

However, monetary economics is able to predict that the ranks of so-called ‘profit-takers’ in the gold market will be drastically thinned out by persistent losses they stand to suffer (as have the ranks of naked short sellers in the gold mining industry). Ultimately, when a certain threshold in the price of gold is passed, profit-taking will dry up altogether (as short selling by gold mines has A.D. 2007).

I say ‘so-called profit-taking’ because we are dealing with an oxymoron. Can one really take profits in the gold market by taking paper currency, destined to lose whatever value they may still have?

The call to take profit is a siren song. To neutralize it, you had better follow the example of Odysseus who had himself chained to the mast, and had the ears of his oarsmen plugged with wax.

## Silver And Gold Basis

When the profit-taking mentality is thoroughly defeated and discredited by the market, gold will go to permanent backwardation making the gulf between cash gold and paper gold unbridgeable. The gold basis will go negative, burning the bridge leading back to contango.

From then on gold is not for sale at any price. Just when this will happen is impossible to predict. There are a few clues nevertheless. One is the silver basis that acts as a precursor of the gold basis. Whatever little information we may glean from the markets, it all has to do with the basis. It is therefore all the more surprising that investment advisers cavalierly ignore the basis as an analytic tool, just as they ignore the coming backwardation.

Likewise it is impossible to pinpoint where the threshold price, past which the supply of gold will dry up completely, is located. History and theory confirm that there is such a threshold, but we are left to guessing how high it may be.

## Bribe And Blackmail In Economics

Governments have forcibly removed gold not only from the banks, but from academia as well. As a result, the level of ignorance in the world about gold is appalling. Gold has been relegated from economics to superstition, witchcraft, and soothsaying. It is treated like a narcotic agent. “Gold is addictive. Gold ought to be taken away from man’s greedy little palms by a paternalistic government”, as advocated by Lord Keynes’ New Economics. The advice is disingenuous. It is not given in the interest of people. It is given in the interest of the pilferers and plunderers of people. Here is how one author, Howard Katz, describes economics as it has transformed, nay, corrupted, American institutes of higher learning. “Something is rotten in the state of economics. In the middle of the 20th century a group of bankers bribed some of the nation’s top colleges to peddle a reactionary economic theory (which was to make bankers a lot of money). This theory swept American higher education with the result that pretty well everybody who has graduated with a degree in economics no longer has the slightest idea of what he is talking about… There is nothing wrong with the science of economics, but there is something terribly wrong with the kind of trash handed out by our nation’s colleges today. It is people dumb enough to imbibe such trash who are the reporters and columnists in most of the media, and these are the people giving most Americans economic advice.”

## The Aftermath Of The Next Blow-Off

Gold Standard University is fighting back. It is not motivated by the lure of making a fortune in gold speculation. Not as if it condemned efforts to salvage capital from the crumbling old monetary regime to transfer it to a new one. But salvaging won’t be a bed of roses as the idea of making a fortune in gold speculation seems to suggest. Gold Standard University is motivated by values held in the highest esteem. It is motivated by truth, the cause of which has been so pitifully betrayed by economists in taking bribe money from banks; and the dissemination of which has been so miserably compromised by economics departments in reacting to blackmail (namely the threat to discontinue grants and to purge truculent economists).

Making statements about the future course of the gold price is a most treacherous undertaking. Gold Standard University is committed to tell you all that can be supported scientifically. Making predictions about the timing of price moves up or down is beyond the pale. However, I am willing and happy to share with you my insight, for whatever it is worth, on the gold price issue as well as on the burning question how long the agony of watching the death throes of global fiat currency will take. I promise that I will always carefully delineate facts from opinion.

We can dismiss the suggestion out of hand that the next blow-off, if and when it comes, will ring in a new bear market in gold. At any rate, it will be very different from that witnessed in 1980. The credit of the United States was immensely stronger then. There was room for drastic increases in the rate of interest that helped restoring the dollar to strength.

Higher interest rate is a very strong and very effective medicine ― that is, if the patient has a constitution that it can be administered. If the patient is too weak, strong medicine would be lethal.

## Bank Capital And The Derivatives Monster

The dominant fact to understand is that yield varies inversely with the value of the underlying asset. Therefore increasing the rate of interest would further erode the capital structure of the American banking system, already badly shattered by the subprime crisis. It is out of the question that the Fed could follow the Volcker-recipe, 1980 vintage, of letting interest rates go double-digit. Contrariwise, if the Fed were able to lower interest rates by hook or crook, that would be a reprieve for the banks with melting capital. It is my considered opinion that the Fed is doing what it does because the effect of a falling interest rate on bank capital is instantaneous. By contrast, pumping money into the banking system works by way of trickledown. Talk about “stimulating the economy” is for the birds. The real reason why the Fed has to lower interest rates in a hurry when logic would call for increasing them is the emergency to stave off an implosion of bank capital.

How can the Fed engineer a falling trend in interest rates? This is the point where my own analysis diverges from that of others. Interest rates will fall because bond speculation in which the banks engage is risk-free, on the strength of the open market operations of the Federal Reserve. The banks preempt the Fed in buying the bonds. The consensus is that the ailing dollar can be bailed out only through a regimen of rising interest rates. But the banks bet at the roulette table that interest rates will fall, against everybody else betting that they will rise. Why, the \$500 trillion strong derivatives monster serves one purpose and one only, that the bull market in bonds may continue indefinitely. In other words, the infinitely elastic supply of interest rate derivatives is there to make sure that the shorts in the bond market will burn their fingers right to the armpit. Interest-rate derivatives did not come about by accident.

Like the original Tower of Babel, the Tower of Derivatives is being built deliberately. It was conceived and nurtured by megalomaniacs, in this instance the managers of the global fiat money system. They understand that bank capital hangs precariously on the cliff of vanishing confidence. They are confident that they can patch up even the largest holes in the balance sheet of banks on capital account, provided that the derivatives monster will not unravel in the meantime. The big unknown is whether the escalation of counterparty risk will trigger the self-destruction of derivatives before the managers are through.

Here is the strategy. The Fed will keep halving the rate interest as many times as necessary. Each halving nearly doubles bank capital. It worked in Japan where the authorities have kept the brain-dead banks in business through thick and thin. The Japanese merry-goround has been supported by the yen-carry trade; the American merry-go-round will be supported by the derivatives farce.

Both represent a game of musical chairs. It is a matter of opinion how long the music can go on. I am reminded of the sinking Titanic aboard which the orchestra continued playing even after all lights went out. I don’t see that the music would stop this year even if the lights go out and industrial production starts to sputter. The conundrum of a weak dollar cum strong bonds will continue to baffle all the experts, and lead a lot of gold bugs astray.

## Is Another Decades-Long Bear Market In Gold Possible?

The 1980-2000 bear market in gold was made possible by the Volcker-coup in pushing interest rates past 20 percent. It was designed to trick people out of their gold position. The Volcker-coup was an expensive gamble that succeeded, because the economy was fairly strong in 1980, a condition completely lacking today. If Bernanke tried to mount the Volckercoup now, the economy would go into a tailspin. We may conclude that another bear market in gold is well-nigh impossible.

## Gold Standard University Live

To summarize, in my opinion a blow-off in the gold market is not imminent. The dollar, however weak, is not yet a pushover. It will fight back, supported by a strong bond market.

The bag of tricks of the managers of global fiat currency is not empty. They haven’t yet played the Amero card, for example.

I advocate a new approach to investing in gold. This approach rules out profit-taking, but involves arbitrage between the two monetary metals. Cues must be taken from the silver and gold basis, not from the gold/silver ratio which is rigged.

Come to Session Three of Gold Standard University Live to be held in Dallas, Texas, from February 11 through 17. I will conduct the course and the seminars in person. Bring your questions with you. Details about the session can be found on the website [www.professorfekete.com/GSUL.asp](https://www.professorfekete.com/GSUL.asp) Be part of the uplifting undertaking to resurrect monetary science. Discover the truth about money as the giants of monetary science, Adam Smith, Carl Menger and others have handed it down to us, before bribe and blackmail have overtaken the search for and dissemination of knowledge in economics.

The world’s finance capital is on its way to total annihilation. The essence of the subprime crisis was not the slack in lending standards. The essence is that the worm of doubt is eating confidence away. Banks no longer trust the promises of other banks. Under a gold standard trust could quickly be restored by paying out gold. That’s what gold is for, to restore trust whenever doubt arises. But gold has been removed from the banking system. Now irredeemable promises can only be redeemed by issuing more irredeemable promises. In such a system the erosion of confidence cannot be checked. Lack of confidence becomes cumulative. It is like kicking garbage upstairs. When the attic can take no more, the day of reckoning has dawned, and the garbage comes crashing down.

What can the individual do under these circumstances? He can salvage the pieces of his capital from the moribund international monetary system through the Yellow Brick Road.

When you invest in gold, you transfer your capital, bit by bit, from Sodom and Gomorrah where it is doomed by the coming rain of fire and brimstone, to Emerald City of the New Gold Age.

### See you in Dallas!

---

*January 18, 2008.*

---

# Fiat Currency: Destroyer of Labor

URL: https://newaustrianeconomics.com/archive/fekete/fiat-currency-destroyer-of-labor/
Date: 2007-12-16
Section: Popular Economics
Difficulty: intermediate
Concept Tags: fiat-currency, capital-destruction, interest-theory, monetary-policy, real-bills
Description: The second part shifts focus from capital to labor: fiat currency destroys the purchasing power and security of wage earners through inflation, but more insidiously destroys the productive base that makes high wages possible. Fekete argues that workers are the ultimate victims of irredeemable currency — not because of direct inflation but because capital destruction eliminates the high-productivity jobs that would otherwise employ them.
Editorial Note: Second of the Fiat Currency series, December 2007. Complements the capital destruction analysis with a focus on labor's stake in monetary policy — arguing that workers, not just investors, have a fundamental interest in sound money.
Original PDF: https://professorfekete.com/articles/AEFFiatCurrencyDestroyerOfLabor.pdf

## Fiat Currency: Destroyer Of Labor

### Labor Leaders should issue a Mayday call

**Antal E. Fekete** · Gold Standard University Live · [aefekete@hotmail.com](mailto:aefekete@hotmail.com)

### Summary for the busy executive

Labor vitally depends on the state of industrial capital. Wage rates cannot increase except in consequence of an increase in the per capita quota of invested capital. Conversely, a decrease in that quota means capital decumulation that lowers wage rates, ultimately leading to unemployment.

The regime of fiat currency has destabilized the interest-rate structure with the result that bond speculators can siphon off capital from the balance sheet of productive enterprise surreptitiously.

There are laws against computer-hacking. There are no laws against hackers entering the balance sheet of industrial enterprise surreptitiously, and making off with illicit gains through risk-free profits in bond speculation.

The resulting insufficiency hurts labor even more than it hurts capital. Owners of capital can protect themselves through exporting their remaining funds to low-wage countries. The trouble is that well-paid industrial jobs are exported along with capital, never to return. American labor is stuck with low-paid service jobs such as flipping hamburgers. The outlook is even bleaker. As interest rates keep falling, even hamburger-flipping may go the way of steel-making. Mass unemployment, directly attributable to fiat currency destabilizing the interest-rate structure, is a real threat.

### Invisible arson

If a part of your industrial plant burns down, you have to report the capital loss in the balance sheet and charge the loss against future earnings. Intangible capital loss is caused by falling interest rates, because it reveals that past investment in physical capital has been made at too high a rate as shown by lower rates now available. There is no way getting around the fact that the cost of servicing debt, contracted earlier at a higher rate, is made more onerous by the falling interest-rate structure. The present value of outstanding debt rises, because capitalizing the same stream of payments at a lower rate of interest results in a higher capital value. Yet nobody is reporting a capital loss when falling interest rates decimate the value of industrial capital, and nobody makes provision for replenishing impaired capital by charging the loss to future earnings. Society lives in a fool’s paradise thinking that it can eat into capital, no tightening belts is necessary, and the day of reckoning will never dawn.

Why is there no requirement to report capital losses due to falling interest rates, and why is the firm allowed to get away without putting aside a loss reserve to compensate for losses arising out of the falling of interest rate structure? Why is a loss caused by real fire treated differently from a loss caused by invisible fire? Could it be part of the “invisible arson” to cover up the footprint of the central bank’s counter-productive monetary policy, namely, open-market purchases of bonds?

To be sure, the introduction of out-and-out fiat money in 1971 was invisible arson, without flames and smoke, but all the greater devastation of the capital of productive enterprise. Mainstream economists have „forgotten” to investigate the untoward consequences of the regime of fiat money, especially the damage it has caused through the destabilization of interest rates.

It is incumbent upon labor leaders to demand that damage caused by capital losses be repaired whether they were caused by real fire or by the invisible arson of falling interest rates. In either case capital supporting laborers in production has been impaired and unless the loss is charged to future earnings, wage rates will be squeezed and ultimately the economy will succumb to unemployment.

Owners of capital should not be allowed to bolt for greener pastures, leaving labor behind in the lurch.

### Silent textbooks

Textbooks on accounting do not mention the need for setting aside loss reserves to repair capital in the wake of falling interest rates. Hundreds of codes that have been written since Luca Pacioli invented double-entry book-keeping are silent on this subject as well. Why? The answer to this question is found in the fact that a move in the rate of interest used to be akin to continental drift: it would take decades before changes were noticeable. There is an additional problem. The decline in interest rates, if it ever occurred, was necessarily limited under the gold standard. Savers would never let interest rates fall indefinitely. They would step in, sell the overpriced government bond and would not buy them back until the trend in interest rates were reversed.

A rapid decline of interest rates that was unthinkable previously has been made possible after the introduction of global fiat currency in 1971. Moreover, beforehand the decline could not continue indefinitely as gold withdrawals would sooner or later put an end to it. But this obstruction had been removed by the global regime of fiat currency. Bondholders and depositors could no longer withdraw gold. The lack of obstruction to stop the fall of interest rates means that businessmen, once lethargic, stay lethargic. They understood what the threat of interest rates falling further meant for them. No matter how low interest rates were, they would not look attractive as further fall would make their investment fail. This is the conundrum of the deflation in Japan, where interest rates still keep falling from very low levels. Mainstream economists say that it is a reflection of the high saving propensities of the Japanese people. This is, of course, nonsense. It is the reflection of the lethargy of the Japanese businessmen. They do not see the light at the end of the tunnel. They do not see the end to the decline of interest rates.

By 1971 accounting was politicized. It was not in the interest of the powers that be to alarm people about dangers threatening them by virtue of fiat currency. Book-keeping rules were relaxed accordingly. The transition from the gold standard to irredeemable currency was hailed as a positive development, all benefits and no setbacks. The greatest con-job in all history was to foist the fiat dollar on an unsuspecting world.

### Anti-industrial revolution

Labor leaders should also demand an answer to the broader question: in whose interest does the U.S. government maintain a reactionary monetary regime, that of fiat currency with a one-hundred percent mortality rate, as proved by history? The introduction of this regime could be described, in the words of Ayn Rand’s Atlas Shrugged, as the “anti-industrial revolution,” the effect of which is the deindustrialization of America as shown by the disappearance of the apparel industry, shoe industry, steel industry, VCR and TV set manufacturing industry, with the auto industry not too far behind.

It is no use trying to explain the demise of these industries in America with „progress” in the international division of labor. It is no use trying to compare it to the demise of the horseshoe industry and candle-making in the 19th century. When horseshoe production was abandoned, no American jobs were exported. In the present instance steel jobs are exported and now steel has to be imported. Why?

Because the “paper aristocracy” of America finds the export of paper (read: paper money) more profitable than the export of steel.

The government and politicians take credit for “job-creation”. But the truth is that the jobs created are mostly make-believe jobs. What has been hailed as a heroic job-creation program appears, in the present light, a miserable effort at damage-control by the same government that has destroyed well-paid industrial jobs in the first place through the introduction of an unconstitutional and anti-labor monetary regime.

### “Thou shalt not push this crown of thorns on the brow of labor”

This regime was originally promoted as a savior of labor. „Thou shalt not push down this crown of thorns on the brow of labor; thou shalt not crucify mankind on this cross of gold!” cried William Jennings Brian, condemning the gold standard, during his failed presidential election campaign in

1896. These words have reverberated until 1933 when F.D. Roosevelt hit the war-path to knock out gold money for once and all. He sabotaged the constitutional monetary regime of the United States by grabbing people’s gold. It is important to understand why Roosevelt’s monetary tinkering was antilabor, in spite of it being promoted as a move to raise prices and to restore full employment.

By 1932 there were signs that the severe recession was over. During the presidential election campaign rumor-mongers spread the word that Roosevelt, once elected, was planning „to go off gold”, following the 1931 example set by Britain. Roosevelt never issued a denial and, after elected, he made himself unavailable for direct questioning. Apparently he was relishing the prospect of a banking crisis that was developing in the wake of those rumors. He could grab much dictatorial power if the country lay prostrate financially on Inauguration Day, which is exactly what has happened. Was it all planned?

Be that as it may, after inauguration he railroaded unconstitutional monetary legislation through a servile Congress, including the incredible measure of confiscating the gold of the people and writing up its value afterwards.

### “Legal and moral chaos”

The ‘profit’ from the government’s arbitrary measure of marking up the value of confiscated gold was taken right out of industrial capital. In 1935 Supreme Court justices McReynolds, Van Devanter,

Sutherland, and Butler wrote their minority opinion criticizing the majority in the case Nortz v. the United States, re: reneging on the promise of gold certificates issued by the U.S. Treasury.

“These were contracts to return gold left on deposit; otherwise to pay its value in currency… We conclude that, if given effect, the enactments here challenged will bring about confiscation of property rights and repudiation of national obligations.

Acquiescence in the decisions just announced is impossible; the circumstances demand a statement of our views. To let oneself slide down the easy slope offered by the course of events and to dull one’s mind against the extent of danger… that is precisely to fail in one’s responsibility.

“Just men regard repudiation and spoilation of citizens by their sovereign with abhorrence; but we are asked to affirm that the Constitution has granted power to accomplish both. No definite delegation of such power exists; and we cannot believe that the far-seeing framers, who labored with hope of establishing justice and securing the blessings of liberty, intended that the expected government should have authority to annihilate its own obligations and destroy the very rights which they were endeavoring to protect. Not only is there no permission for such actions; they are inhibited. And no plentitude of words can conform them to our charter.

“The federal government is one of delegated and limited powers which derive from the Constitution. It can exercise only the powers granted to it. Powers claimed must be denied unless granted… The fundamental problem now presented is whether recent statutes passed by Congress in respect of money and credits were designed to attain a legitimate end. Or whether, under the guise of pursuing a monetary policy, Congress really has inaugurated a plan primarily designed to destroy private obligations, repudiate national debts, and drive into the Treasury all gold within the country, in exchange for inconvertible promises to pay, of much less value.

“Considering all the circumstances, we must conclude they show that the plan disclosed is of the latter description and its enforcement would deprive the parties before us of their rights under the Constitution. Consequently the Court should do what it can to afford adequate relief… The end or objective of the Joint Resolution [of June 5, 1933] was not “legitimate”. The real purpose was not ‘to assure uniform value to the coins and currencies of the United States’, but to destroy certain valuable contractual rights…

“It was not intended to give Congress the power under the law to repudiate the obligations in question… No such power was ever granted by the framers of the Constitution. It was not there then. It was not there yesterday. It is not there today. We are confronted with a condition in which the dollar may be reduced to 50 cents today, to

30 cents tomorrow, to 10 cents the next day, and to 1 cent the day after…

“Under the challenged statutes it is said that the United States has realized profits amounting to \$2,800,000,000. But this assumes that gain may be generated by legislative fiat. To such counterfeit profits there would be no limit; with each new debasement of the dollar they would expand. Two billions might be ballooned indefinitely ― to twenty, to thirty, or what you will.

“Loss of reputation for honorable dealing will bring us unending humiliation. The impending legal and moral chaos is appalling.”

### Savior or saboteur?

Prophetic words! As a consequence of gold confiscation the recovery of 1932 aborted and the economy was plunged into the deepest depression ever. The value of government bonds shot up and interest rates started plunging. Industrial capital was decimated. The value of productive capital did not disappear without a trace. It was illicitly transferred to financial capital in the form of risk-free profits from bond speculation. It was arson that burnt down the industrial landscape, and made laborers fugitives on their home ground. Roosevelt was the invisible arsonist, as sentenced by the minority of dissenting justices on the Supreme Court of the United States in 1935. Today the saboteur is celebrated as the savior.

Roosevelt’s duplicity is unprecedented. In a Memo he stated: “Speculation, where

[participants] could earn money without work, was the pipe dream… which led to growth of special interest that did not coincide with the interest of the nation as a whole. We cannot allow economic life to be controlled by a small group of men… tinctured by the fact that they can make huge profits, not from production but from lending money and marketing securities… we cannot tolerate this opportunistic, selfish attitude…”

### Risk free bond speculation

It would be a mistake to believe that with the Great Depression behind us, the issue is settled. Far from it. An even greater scourge is upon us. The interest-rate structure is still acting as the wrecker’s ball on the economy. Falling interest rates still make it possible for speculators to derive risk-free profits or, in the words of the dissenting justices, ‘counterfeit profits’.

In fact, Roosevelt’s monetary legislation is ultimately responsible for making bond speculation risk free. Speculators take their clues from the open market purchases of bonds by the Federal Reserve (Fed). They know the Fed has to buy the bonds in the open market. All that bond speculators have to do is to forestall Fed action. They buy just before the Fed does, and sell just after. In this way they can consistently derive risk-free profits. Roosevelt created a situation which is a thousand times worse than what he has condemned. The “huge profits” to which Roosevelt referred to in his Memo were at least not risk-free. Roosevelt’s confiscation of people’s gold introduced an era of relentlessly rising bond prices, offering risk-free profits to bond speculators.

The worst part of the arson is that it is self-perpetuating. The fall in interest rates is openended. No matter how low they go, the threat that interest rates may go even lower acts as a deterrent to businessmen to take out the loan. Every attempt at recovery is nipped in the bud. By contrast under a gold standard a fall in interest rates is self-limiting. It is resisted by the savers who will progressively withdraw gold as rates fall. For this reason under a gold standard there is no bond speculation. Bond prices and interest rates are stable.

### Gold, the protector of the people

We must understand that gold is the only competitor that government bonds have. Savers, if not satisfied with the rate of interest offered by the government on its bonds, can hold on to the gold coin of the realm. Once gold is confiscated, the safest place to park one’s savings is the government bond.

People are at the mercy of the government (and adventurers in government). Gold is the protector of the people against financial dictatorship.

Similarly, if the rate of interest is pushed too far down by the banks, savers can register their protest by putting their savings into gold with the resulting squeeze on bank reserves. Paper currency is no substitute for gold coins in this regard. If dissatisfied savers had withdrawn their money from the bank and parked their savings in paper money, they would have been jumping from the frying pan into the fire: exchanging a low rate for zero rate. They would have acted contrary to purpose. The only effective way to protest low interest rates is to sell the overpriced bond and keep the proceeds in gold coins until interest rates rise. At that time savers could buy back their bonds at a lower price. Therein we find the rationale for gold. This is what gold coins are for: to give savers clout so that they may not be at the mercy of the banks and the government.

Grabbing the gold coin of the savers is highway robbery. What the Roosevelt administration did to them was even worse. It made people helpless in the face of the banks’ design to plunge them into permanent debt slavery. As Roosevelt forcibly removed the gold coin, there was an additional effect: destabilizing the rate of interest. Freed from competition, the price of government bonds soared and interest rates plunged. As explained above, plunging interest rates eroded capital values across the board. The weakening capital structure meant that firms lost pricing power. Prices fell together with interest rates. Falling prices caused interest rates to fall more. A vicious circle was set in motion. The effect was cumulative. The devastation of their capital by falling interest rates bankrupted firms, exacerbated by the domino-effect. Financially healthy firms were knocked down by the fall of the financially weak. The Great Depression hit the nation and the world.

### The World in the Grip of a Mistake

Keynes was ready with an explanation: the Great Depression was caused by the “contractionist bias” of the gold standard. Government propagandists took over from him and wore down upright monetary economists who made a case for maintaining the constitutional monetary standard. Through bribe, blackmail, and attrition upright monetary economists were eliminated from the scene. If allowed to write ‘without fear and favor’, they would have alerted the world that permanently falling interest rates not only plunge the economy into deep depression, but also kill any recovery attempt in the bud. No matter how low interest rates are, the prospect of a further fall will prevent businessmen to take the loans. That is why a permanently falling interest rate structure must be avoided at all hazards. Under the regime of fiat currency there is no guarantee that the fall will hit bottom, precisely because of the presence of risk-free bond speculation. By contrast under a gold standard rising bond prices invite profit-taking. Bondholders will sell, and stay invested in the gold coin of the realm. They will not buy back the bonds until interest rates come back to acceptable levels. The ‘black hole of zero interest’ is cordoned off. The gold coin in the hands of the people is a sine qua non of a durable monetary system.

Without it both runaway inflations and deflations are possible.

The world has been in the grip of a colossal mistake, the belief that the gold standard was the cause of deflation and that gold is the enemy of labor. The economic damage caused by this mistake has been enormous. But it has also served as camouflage for the real culprit: the regime of fiat currency. The amount of taxpayer money wasted on the altar of Moloch defies counting. There is no way to calculate the cost of all the counter-productive and self-defeating government measures inflicted on the nation and on the world. The damage caused by the consequences of destabilizing foreign exchange and interest rates is incalculable. The chief loser was labor. In order to see this clearly we must look at their effect on the marginal productivity of labor.

### Marginal productivity

Each worker has his or her productivity measured by the annualized percentage of value added to the product as it is passing through the production process. If we rank all workers in the labor force according to increasing productivity, we find that those at the low end of the spectrum may be left idle.

For example, some pensioners still wanting to earn wages may be too old to qualify. Similarly, people with physical or mental handicap could be judged unfit for industrial employment.

At the same time it should be pointed out that many handicapped people can still find industrial employment, provided that they are productive enough. However, it is not heartlessness to observe that the responsibility to provide meaningful occupation for handicapped people without means of self-support, in order to help them to become useful members of their community, rests with charity rather than industry. For example, charitable foundations could be established that created public parks and employed wardens, or to train handicapped people to become self-supporting as street vendors, etc. At any rate there is a marginal worker in the labor force who is still employed but others with a lower productivity are not because the opportunity cost of employing them is too high.

The productivity of the marginal worker is called the rate of marginal productivity of labor

(for short, marginal productivity of labor). The person playing the role of the marginal worker may of course change, even change frequently and with it changes the rate of marginal productivity of labor.

Contrary to popular misconception, an increase in the marginal productivity of labor is not a blessing.

It means that that some productive workers have been reclassified as submarginal and lost their jobs.

This happens routinely whenever industrial capital is eroded, plants and equipment are taken out of production as a result of insufficient capital maintenance and inadequate depreciation quotas.

### Obstruction to capital accumulation

The opposite case is that of falling marginal productivity of labor. Generally it is a welcome development as it is beneficial to society. It has the effect of making submarginal labor productive. We could describe it as equipping laborers with optimal tools so that their contribution to the social product is maximized. It is important to understand that to make the beneficial decline in the rate of marginal productivity possible, further accumulation of capital is necessary. Hitherto submarginal workers can then find employment, thanks to more or better tools made available to help them become more productive. As a byproduct, more physically or mentally handicapped people, along with many others, could find meaningful industrial employment as unskilled or semi-skilled laborers.

As long as no obstacles are erected in the way of capital accumulation, there will be no unemployment. The presence of unemployment in society necessarily implies that obstructions to capital accumulation exist, as not all workers eager to earn wages are given the tools needed to make their work productive. In a free labor market there is a tendency to make the marginal worker and the least productive worker to be one and the same person.

### Capital accumulation pilloried

In the real world there are many obstacles in the way of capital accumulation, which prevent the least productive workers from finding employment. The reason for this unfortunate state of affairs is mainly ignorance and envy. Capital accumulation is pilloried as proof of the uncontrolled “acquisitiveness of the capitalists”. It is hardly ever looked at from the point of view of its beneficial effects on labor.

Virtually all these obstacles have been created by a misguided effort to help the indigenous through the wrong means, with the result of leaving them worse off than they would be without the

“help”. Taxing enterprise and industry to raise revenues in order to fund direct payments to the ablebodied unemployed is the worst offender. This also includes the so-called “unemployment insurance” whereby the industrious is being taxed to subsidize the indolent. In so far as it is an obstruction to capital accumulation, unemployment insurance has the effect of increasing unemployment. In the absence of these schemes capital would be accumulated and suitable tools would be put in the hands of the unemployed. Similar arguments can be made to condemn a host of misguided labor laws and payroll taxes, including compulsory health insurance schemes. However, this is not the problem we want to discuss presently. It must be left as a topic for another occasion. Here we want to discuss the

### Devastation caused by falling interest rates

Why do falling interest rates make the marginal productivity of capital rise? As we have seen above, falling interest rates reveal that the capital in place has been financed at too high a rate of interest, in view of lower rates now available. The present value of debt rises. Firms with no debt are not exempt either. Falling interest rates decimate the value of all industrial capital already in place, in view of the lower cost of installing new capital.

As the rate of marginal productivity of capital rises, plant and equipment are idled. Their labor complement is idled, too. This is tantamount to an increase in rate of marginal productivity of labor.

The conclusion is that falling interest rates make the marginal productivity of both capital and labor rise, with the unemployment of capital and labor as the obvious results.

The Great Depression was not caused by “vanishing consumer demand”. It was caused by a fatal weakening of the capital structure of industry, which can be traced back to the confiscation of the gold coin of the realm by Roosevelt. The capital from the balance sheet of productive enterprise did not disappear without a trace. It was siphoned off by financial enterprise: it showed up as the illicit capital gains of the bond speculators.

Exactly the same process can be observed today. Bond prices have been increasing since the early 1980’s, rewarding bond speculators with obscene profits. These profits did not come out of nowhere. They were siphoned off the balance sheets of productive enterprise. As measured by the yield of 30-year Treasury bonds, interest rates fell from 16 to 4 percent. Many observers say that the fall is over and we are in for a steep rise, in view of the falling international value of the dollar.

However, there is reason to be cautious with jumping to conclusions. It is possible for the value of the dollar to fall while the value of dollar bonds rises. The fall in the rate of interest as measured by the yield of T-bonds may well continue, following the example of Japan. Worse still, the rate of decline may accelerate. This would mean more precipitous destruction of capital, more bankruptcies, more deflation, even a fully blown depression is not impossible.

### The finest hour of American labor

This presidential election year presents a unique opportunity for American labor leaders. If they rallied to the plank of Dr. Ron Paul, advocating Constitutional money and the rehabilitation of the gold standard, they would make history. It would be the finest hour of American labor to put an end to this reactionary, unconstitutional, anti-labor experimentation with the regime of fiat money. History is littered with the debris of fiat currencies. All of them were hailed in their time as the wave of future.

To no avail: they have all found their resting place in the garbage heap of history. But not before they have inflicted enormous economic pain, especially on working people. The present experiment is no exception.

The government of the United States has apparently abandoned its traditional role of protecting labor. Its insane experiment with fiat currency has a higher priority than the welfare of labor. The government has abdicated its Constitutional responsibility to retain a system of checks and balances. In delegating unlimited power to the Fed, it undermined the ideal of limited government.

Remember, the power to create money out of nothing is unlimited power. The government ignores the economic dangers that go with the experiment of fiat currency. The Fed has a bag of tricks to combat deflation and depression, but they are all counter-productive: they make the economic malady worse, not better. In particular, the Fed seems to be blissfully unaware of the extreme danger lurking behind a falling interest-rate structure: the danger of depression as the capital of productive industry is being plundered by scavengers, speculating risk free on the further rise in the price of government bonds.

Every dollar of profit made by bond speculators comes out of capital values supporting industrial labor.

Academia and financial journalism have embraced a servile attitude of Fed worshipping.

“Don’t bite the hand that feeds you.” The public is completely unprepared for the coming depression caused by the collision between the falling interest-rate structure and industrial capital, and its effect on the economy in general, and labor in particular.

Labor leaders should issue a Mayday call: the boat of industrial capital is sinking, captain and crew bailing out. America is being de-industrialized through the corrosive fiat money regime, and is in danger of disappearing as an economic and financial world power. Labor leaders should support the only presidential candidate, Ron Paul, who understands the problem and has the right plan to deal with it. The de-industrialization of America must stop at once. This means a return to the regime of stable interest rates and constitutional money.

### References

By the same author:

### Fiat Currency: Destroyer of Capital, December, 2007

### Gold Is the Cure for the Job-Drain, September, 2002

### The Root Cause of Unemployment, I-II, January, 2007

These and other articles of the same author can be accessed at: [www.professorfekete.com](https://www.professorfekete.com) Memo from F.D. Roosevelt to Trade Commissioner Landis, Nov. 14, 1933, as quoted in Blog

#28, comment on Floyd Norris’ column in The New York Times entitled “Fear at the Fed”, December 12, 2007.

---

*December 17, 2007.*

---

# Fiat Currency: Destroyer of Capital

URL: https://newaustrianeconomics.com/archive/fekete/fiat-currency-destroyer-of-capital/
Date: 2007-12-05
Section: Popular Economics
Difficulty: intermediate
Concept Tags: fiat-currency, capital-destruction, interest-theory, federal-reserve, monetary-policy
Description: Fekete presents a systematic argument that irredeemable fiat currency is not merely inflationary but fundamentally destructive of capital. The mechanism: falling interest rates induced by open-market operations cause capital to be consumed rather than accumulated, producing a progressive impoverishment that is invisible to GDP statistics but visible in declining real wages and deteriorating infrastructure.
Editorial Note: First of a two-part Fiat Currency series (December 2007). Focuses on capital destruction as the primary mechanism by which irredeemable currency impoverishes societies — a slower and less visible process than inflation, and therefore more dangerous.
Original PDF: https://professorfekete.com/articles/AEFFiatCurrencyDestroyerOfCapitall.pdf

## Fiat Currency: Destroyer Of Capital

### Captains of American industry should issue a Mayday call

**Antal E. Fekete** · Gold Standard University Live · [aefekete@hotmail.com](mailto:aefekete@hotmail.com)

### Summary for the busy executive

The true story of de-industrialization in America has never been told. The boat of American industry has collided with the iceberg of falling interest-rate structure. The damage to capital is great and the boat is sinking. Auto manufacturing could go the way of TV and VCR manufacturing that went down in the 1980’s without the captains knowing what has hit them. Commentators blamed the demise on Asian sweatshops, on American consumer preference for services, and on the alleged rigidity of foreign exchange rates. These explanations reflect warped official thinking as well as the false teachings of mainstream economics. The true explanation can be found in the phenomenon of ‘linkage’ that translates falling interest rates into falling prices. There is a vicious process of destroying industrial capital under a falling interest-rate structure. This observation also shows the way out. Remedy is to be found not in more flexibility of foreign exchange rates but a return to the system of fixed exchange rates. The only known way to stabilize interest rates is an immediate return to the gold standard. During this presidential election year we have, for the first time in half-a-century, the possibility to debate the merits of the gold standard, thanks to Dr. Ron Paul’s candidacy for the Republican nomination. The challenge is enormous. Conventional wisdom maintains that falling interest rates are good for capital. They are not. They are lethal. Fiat currency is the destroyer of industrial capital.

### Financial capital: vampire of productive capital

Fiat currency is a thoroughly toxic agent as it insidiously destroys capital through the destabilization of the interest rate structure. More precisely, the capital of industry is surreptitiously siphoned off to enrich bond speculators. Financial capital has become the vampire sucking the blood of productive capital. Here is what happens. The rate of interest measures the marginal productivity of capital. As I shall point out, capricious changes in marginal productivity, whether up or down, destroy productive capital to no better end than to prop up and perpetuate a reactionary and unconstitutional monetary regime that has the effect of exploiting savers, producers, and consumers alike for the benefit of simoniacal politicians, corrupt bankers, and parasitic bond speculators.

### A primer on productivity

There is a great deal of confusion in the public’s mind about productivity. For example, it is widely assumed that an increase in the marginal productivity of capital is beneficial to society. This is wrong.

Just the opposite is true. An increase in the marginal productivity of capital means that a lot of industrial plant and equipment has become submarginal, are idled, making their labor complement superfluous. Unemployment is the result. Some people who understand this believe that the opposite, decreasing marginal productivity, is beneficial to society for the opposite reason: formerly idled plant and equipment are now pressed into service, relieving unemployment. Wrong again. Under globalization decreasing marginal productivity means driving capital abroad in search for cheap labor.

Industrial capital and jobs are being exported. Unemployment becomes chronic.

### Fiat currency drives capital and jobs abroad

It is a mistake to blame „Asian sweatshops” for increasing unemployment. America has coexisted with cheap Asian labor for its entire history. The latter was a benefit rather than a threat to American prosperity under the gold standard. It only became a threat under fiat currency, since gyrating interest rates caused the divorce of American capital and labor. Capital goes abroad to look for a new labor partner. As it migrates, well-paid American jobs migrate with it never to come back. Notice that the exportation of American jobs would not have occurred if the interest-rate structure in America had been stable, as under the gold standard, bonding the partnership between labor and capital.

### Marginal productivity

Let’s see what is meant by marginal productivity and expose the popular misconceptions about it.

Each individual plant and equipment has its own productivity. It can be calculated as the annualized percentage of increase in value added: output minus input. We rank all plants and equipment in existence according to increasing productivity. Those at the low end of the productivity spectrum will be left idle since the opportunity cost of employing them would be too high. There is a cut-off point marking the marginal item in the productive apparatus of society. It is that (variable) piece of equipment or individual plant that is still employed in productive activity, but all others with a lower productivity are idle. The productivity of the marginal item is called the rate of marginal productivity of capital (for short, marginal productivity). If marginal productivity increases, productive plant and equipment become submarginal and get laid off, resulting in a divorce between labor and capital. The labor complement of submarginal capital also gets laid off causing unemployment. On the other hand, as marginal productivity falls, certain previously submarginal plants and equipments will become productive again ― in theory. In practice, however, capital is looking for new labor partners. Since it is not committed to remarry its previous partner, under our fiat currency system capital will migrate abroad in search of cheap labor. In effect, both industrial capital and jobs are exported.

### The rate of interest

Marginal productivity is determined by the rate of interest. The latter is that rate at which the stream of income payments from coupons plus the payment of principal at maturity amortize the (variable) market price of the bond. This means that the rate of interest is determined by the bond market. Hence, it is a market phenomenon. Moreover, it varies inversely with the bond price, since the present value of an income stream varies inversely with the rate of interest (or, saying it differently, capitalizing the same stream of payments at a lower rate of interest results in a higher capital value).

Clearly, bonds compete with industrial capital as an investment outlet to produce income.

Because of this competition marginal productivity can be identified with the ceiling of the rate of interest. To see this in more detail look at the arbitrage of the capitalists. They will not let the two rates deviate from one another. If the rate of interest is higher, they will sell industrial capital and put the proceeds into higher-yielding bonds. Even if they can’t sell, at the very least they stop production and capital maintenance, abolish depreciation quotas and use the savings to buy the low-priced bond. If consequently the rate of interest drops, that is, bond prices rise, then capitalists take profit in selling the bond, buy new industrial plant and equipment and start production again. Either way, the arbitrage activities of the capitalists will close the gap between the rate of interest and the rate of marginal productivity.

### Opportunism of Keynes

Keynesianism is no science. It is sheer opportunism trying to forge political capital out of badmouthing the gold standard and the regime of fixed exchange rates. It advocates the management of the national currency, ostensibly to manage the national economy for the benefit of society. In fact it is running the national economy into the ground. Keynesianism is based on the insane but appealing concept that driving the international value of the national currency down is beneficial to the export industry. It ignores the fact that even if you could derive ephemeral advantages through this ploy of „beggaring thy neighbor”, the fact of deteriorating terms of trade could not be talked out of existence.

If America exported x and imported y having the same value of z dollars, then after the devaluation of the dollar by, say, 50 percent, America would have to pay for importing y the sum of 2z dollars. In other words, America has to export twice as much of x in order to import just the same amount of y as before devaluation. America’s terms of trade has deteriorated by a factor of 2. Worse still, the terms of trade for America’s competitors has improved by a factor of 2. America is selling its national wealth on the cheap. Far from enriching the country, devaluation is impoverishing it. No wonder America has been on skid row ever since it has embarked on a policy of perpetual dollar-devaluation euphemistically called the floating dollar. Keynesianism is an unreconstructed mercantilist system. It is hard to see how mainstream economists and financial journalists have found it possible to treat it with respect.

### The culprit: destabilization of interest rates

Keynes attributes deflation and depression to the ’contractionist tendencies’ of the gold standard. He says the gold standard puts a squeeze on prices. The government should relieve tightness in the economy by deficit spending, and the banking system should monetize the resulting government debt.

This is called ’contra-cyclical monetary policy’. Keynes correctly recognizes the cumulative effect in the contraction of the economy once prices start falling, but he attributes it to the wrong cause: the vanishing of private demand which he wants to compensate with stepped-up public spending. In reality, the industry’s loss of pricing power and the subsequent downwards spiral of prices is not due to vanishing demand. It is due to the weakening of capital structure, bankrupting producers. To see this we have to provide a more sophisticated analysis of the effects of destabilizing interest rates than hitherto given.

The gold standard is sacrificed in order to make unbridled government spending possible. In Keynes’ one dimensional world this may have the effect of increasing prices, but it is all to the good as it is thought to revive the economy. However, the world is not one-dimensional and abolishing the gold standard has another effect: increasing interest rates. Bond prices and interest rates are destabilized.

### What caused the Great Depression?

Keep in mind that there was no bond speculation under the gold standard. None whatever. Mainstream economists disingenuously stone-wall this fact, thereby doing great disservice to the cause of science.

They have blocked research on the detrimental consequences of the removal of the gold standard.

Nobody has exposed the cause: destabilization of interest rates, and the effect: the Great Depression.

The Keynesian dogma that it was caused by a deflation-prone gold standard is almost universally accepted.

However, the very opposite is true: the Great Depression was caused by sabotaging the gold standard. When the ownership of and trade in gold was banned by F.D. Roosevelt in 1933, the biggest competitor of government bonds, gold, was forcibly removed. Bond prices rose and interest rates fell precipitously. As we shall presently see, prices are bound to follow interest rates down. Falling prices triggered a downward spiral. The depression was on. The root cause was the ban on gold ownership.

Mainstream economics is stone-walling that fact as well.

### Paying out phantom profits

We shall now show how falling interest rates translate into falling prices. Contrary to conventional wisdom, falling interest rates squeeze profits. Mainstream economists teach that falling rates are salubrious to business. However, they fail to distinguish between a low and a falling interest rate structure. Falling interest rates reveal that past investment in physical capital has been made at too high a rate in view of lower rates now available. The difference between the two rates hits the profit margin, and hits it badly. There is no way getting around the fact that falling interest rates make the cost of servicing debt contracted earlier more onerous. The present value of debt rises as a consequence of falling interest rates. Firms with zero debt are not exempt either. The value of industrial capital falls across the board as new capital could now be financed at lower rates.

Relaxed accounting standards under fiat currency allow firms to get away without reporting capital losses in the balance sheet incurred in the wake of fluctuating interest rates. However, a loss is a loss, reported or unreported. If the loss is not reported, the firm is paying out phantom profits in dividends, compounding capital losses and hastening collapse.

### Linkage

Critics find the statement that the present value of debt rises as the rate of interest falls counterintuitive. Yet it is just the flipside of the statement that the market price of a bond rises as the rate of interest falls ― a mathematically and statistically well-established fact of life.

Critics also object saying that losses in the liability column are offset by gains in the asset column. Falling interest rates, while increasing the present value of debt (hence causing capital losses) also increase the present value of future earnings which, they say, generate capital gains. The trouble with this argument is that it ignores the accounting rule that prohibits putting value on assets higher than historic costs, forcing the accountant to disregard any increase in anticipated future earnings. He has no choice: the accountant must charge the increased cost of potential liquidation against assets without making allowance for increased future earnings due to falling interest rates.

As profits are squeezed, firms are forced to retrench. They reduce inventory, causing prices to fall. We conclude that falling interest rates translate into falling prices. This is the missing link that all the great theorists on interest from Eugene Böhm-Bawerk to Knut Wicksell have missed. They observed the operation of linkage as it forced interest rates to follow ― apart from leads and lags ― the same path upwards or down as do prices. They could even prove that rising or falling prices caused interest rates rise or fall, and that rising interest rates caused prices to rise, too. But for all their efforts they failed to find the missing piece of the jigsaw puzzle: the proof that falling interest rates caused prices to fall as well. Our argument above furnishes the missing piece. This, we believe, is a major break-through in theoretical economics, making nonsense out of Keynesianism.

### Why aren’t airline wreckages investigated?

As linkage is activated, falling interest rates pull down prices. The deflationary spiral is on. Falling prices squeeze profits more. Many firms see their capital melt away. They fold in spite of falling interest rates.

The same forces that worked in the Great Depression are also at work today. When interest rates switched from rising to falling mode in the early 1980’s latter-day Icarus, the airline industry, was flying high. There was no Daedalus around to warn Icarus that he was flying too high, in view of being one of most capital-intensive industries. Falling interest rates were considered an incentive to increase operational altitude. Airlines went into debt to the hilt in financing spanking new fleets of planes. Then airlines, like Icarus, started falling out of the sky one after another. Among the victims were the American flagship, Pan American, as well as Swissair, envy of the industry and widely considered the best-managed airline that has ever cruised the skies. What caused these and other airlines to nose-dive just when they were getting ready to enjoy the ‘benefits’ of falling interest rates?

Plenty of ad hoc reasons were offered, none of them convincing.

Airlines were blown out of the sky because falling interest rates wiped out their capital.

Governments take great pains to investigate the wreckages of airliners meticulously. Experts find and reassemble even the smallest pieces of the wreckage in a hangar in search for clues of the cause of the crash. This effort is praiseworthy. There is much to be learned from each and every disaster. Curiously enough, governments never investigate the wreckages of airlines, lest the true causes of the air disaster be learned. The true causes are: the regime of fiat currency, and our faulty accounting system that allows the suppression of capital losses due to falling interest rates. So much for Keynesianism as a government ideology.

This example also illustrates that capital gains in the asset column can’t compensate for capital losses in the liability column. Why did Swissair fall out of the sky if it could capitalize its higher future earnings due to falling interest rates? Because it couldn’t: before it would have been able to collect the expected higher earnings, it had crashed (financially, anyhow).

### Risk-free profits in bond speculation

Keynes’ recipe makes the profits of bond speculators risk free. Contra-cyclical monetary policy calls for open-market purchases of bonds by the central bank. This makes central bank action predictable.

Bond speculators take advantage of it and preempt central bank buying. They buy the bonds first, only to dump them at higher prices later, after the central bank has completed the purchase of its own quota.

Risk-free profits create an artificial demand for bonds, and a falling tendency in interest rates. They are responsible for deflation. Under the gold standard interest rates and bond prices are stable, and there is no risk-free speculation.

### Contra-cyclical or counter-productive?

As our analysis shows, the counter-productive central bank monetary policy is responsible for the falling interest-rate structure, the deflationary spiral, and the depression. Keynes’ so-called contracyclical monetary policy turns out to be an unmitigated disaster. The central bank wants to combat falling prices through open-market purchases of bonds. But the new money it creates in the process does not flow to the commodity market to prop up prices there as hoped for by the central bank.

Instead, it flows to the bond market where speculators, teased by the lure of risk-free profits, use it for bullish bond speculation. Interest rates fall; linkage makes prices fall, too. The deflationary spiral continues one level higher.

Most analyst take it for granted that the decline in the value of the dollar will cause interest rates to rise. However, logic dictates that the value of dollar bonds should fall before the value of the dollar. That’s not what has been happening. The dollar has been falling for the past few years yet bond values, as measured by the 30-year T-bond, continued their march upwards that had started in the early 1980’s. The explanation is that the allure of risk-free profits sent the demand for bonds soaring so that it has far surpassed the vanishing demand for dollars. Paradoxically, there is a rising demand for dollar bonds and a falling demand for dollars. Risk-free profits in the bond market suggest that a continuation of the regime of falling interest rates, with all its deflationary implications, is more likely in the future than a new bout of price rises. Be that as it may, we can be sure that the price for central bank follies will be paid by the sacrificial lamb: the producers, regardless whether interest rates fall or gyrate.

### Confusing capital and credit deliberately

In the vast literature of mainstream economics there is not one sentence written about the deleterious effects of destabilizing interest rates on the value of industrial capital. This stems from a deliberate confusion between capital and credit. In the view of mainstream economists any talk about ‘capital decumulation’ or the destruction of industrial capital in the wake of destabilizing interest rates is arrant nonsense. After all, both credit and capital can be created at will, by a click of the mouse. The possibility that the dissipation of industrial capital might figure among the causes of the Great Depression is not even considered.

Capital strikes back. The apparition stuns non-believers and capital-deniers. “If you don’t use your eyes for seeing, then you will use them for weeping.” (F.W. Foerster.)

### Reclaiming our destiny from the usurpers

The market share of General Motors was 46% in 1980. Today it is 24% and falling, in spite of great improvements in productivity. Neither Ford nor Chrysler is doing any better. In 1980 the rate of interest was sixteen percent; it went as low as four. Having collided with the falling interest rate structure, the ship of industrial capital is sinking.

Captains of American industry should issue a Mayday call and rally to Ron Paul’s plank to restore the gold standard in America. The writing is on the wall: the regime of fiat currency, in the maintenance of which the Federal Reserve has a vested interest, is going to finish the job of deindustrializing America ― unless we reclaim our destiny from the usurpers, and return to the regime of stable interest rates.

### References

By the same author:

### Kondratieff Revisited, May, 2001

### Deflation or Runaway Inflation? July, 2001

### The Economic Consequences of Mr. Greenspan, December, 2001

### Japan’s Finest Hour, January, 2002

### Revisionist View of the Great Depression, I-II, March, 2002

### The Black-hole of Zero Interest Revisited, August, 2002

### The Wrecker’s Ball of Swinging Interest Rates, September, 2002

The Central Banker as the Quartermaster-General of Deflation, January, 2003

### A Bubble That Broke the World, June, 2003

Stop Greenspan from Plunging America into a Depression! June, 2003

### Tainted Research, June, 2003

### How to Protect One’s Pension with Gold, August, 2003

### The Gold-Demonetization Hoax, August, 2003

### Gold is the cure for the job-drain! September, 2003

### The Shadow Pyramid, November, 2007

### Fiat Currency: Destroyer of Labor, to appear

These and other papers of the same author can be accessed at: [www.professorfekete.com](https://www.professorfekete.com)

---

*December 8, 2007.*

---

# Our Diseased Monetary Bloodstream

URL: https://newaustrianeconomics.com/archive/fekete/our-diseased-monetary-bloodstream/
Date: 2007-11-24
Section: Popular Economics
Difficulty: accessible
Concept Tags: fiat-currency, capital-destruction, monetary-policy, new-austrian-economics, gold-standard
Description: Fekete uses the metaphor of a diseased bloodstream to describe an economy in which money — the medium of exchange that should flow freely and nourish every part of the economic body — has been poisoned by irredeemable currency. The disease manifests as capital destruction, misallocation, and the progressive withdrawal of productive individuals from commerce.
Editorial Note: Written November 2007 as the subprime crisis was unfolding. The bloodstream metaphor allows Fekete to explain monetary pathology to a broad audience, connecting the technical analysis of his other essays to a visceral diagnosis of economic disease.
Original PDF: https://professorfekete.com/articles/AEFOurDiseasedMonetaryBloodstream.pdf

Dear Fellow Deviants,

Dear Fellow Travelers standing by for the next flight to Genius,

Ladies and Gentlemen:

### Synergy Be With You!

One of the truly spectacular sights is from the airplane as it makes its approaches to Los Angeles International Airport at dusk. Down below is the illuminated “live” map of Los Angeles with its winding and intersecting freeways, with an endless flow of white headlights and an opposite flow of red tail-lights. It reminds me of the human bloodstream with its flow of white and red blood corpuscles. As I was flying in the other day I could not help but contemplate that possibly just a handful in a million people down there may realize what a fatal year 2007 has been, as the rest are completely oblivious to the great dangers awaiting the world on this Thanksgiving Day.

Over the last thirty-five or so years people have been de-sensitized to the ‘chill-andfever’ syndrome epitomized by the gyrating value of the dollar. It had its ups and downs but, here we are, still doing business using the services of ‘Old Trusty’. People appear to be forgetful that the dollar is steadily losing value, losing purchasing power, losing the allimportant respect of foreigners. They have been brainwashed into thinking that inflation, like continental drift, is God-ordained. There is nothing human beings can do about it. It would never occur to people that they are victims of deliberate plundering by their own government, and deceitful pilfering by their banks, covered up by the mendacity of academia and the financial media.

By this fall we have reached the threshold, we have crossed the continental divide, we have passed the ‘point of no return’ as it is becoming obvious that bad debt in the system has reached and surpassed ‘critical mass.’ The chain reaction has started. In the fullness of time the nuclear explosion is bound to occur.

The history of the dollar boasts two Waterloo’s. The first one was in 1933. That year marks the default of the U.S. government on its domestic gold obligations, accompanied by the confiscation of the people’s gold by F.D. Roosevelt. He appealed to patriotism saying that in complying with his Executive Order people were saving the country from economic ruin.

The bad faith behind this capricious and unconstitutional act was shown by the fact that no sooner were people forced to give up gold in their possession than the government would write up its value by 69 percent, pocketing the difference as ‘profit’. So much for the provision of the Constitution that “…nor shall private property be taken for public use without just compensation.”

The monetary bloodstream of this nation was given the cancerous qualities that characterized the currency of both Soviet Communism and Nazi Socialism, neither of which has survived the test of times. Nor will the irredeemable dollar.

There was a second Waterloo for the dollar, in 1971, marking the default of the U.S. government on its international gold obligations. In economic terms this event was even more devastating than the first. It triggered a snow-balling process as revealed by the price charts of commodities such as wheat, sugar, copper, not to mention crude oil, and the destabilization of foreign exchange and interest rates, making debt proliferate and rendering government bonds totally unsuitable for the purposes of saving.

I have been often asked the question: “why gold?” I avoid giving an answer in terms of the physical or chemical qualities such as weight, inertness, and the like. My answer usually refers to the nation’s monetary bloodstream which becomes corrupted as the diseasefighting gold corpuscles are removed.

Debt is an indispensable economic instrument. It has a great beneficial impact on human welfare. But like fissionable nuclear material, it is shot through and through with extreme danger. If its quantity exceeds critical mass, then chain reaction is bound to set in causing a nuclear explosion. The role of gold is precisely to prevent that from happening.

Gold is the agent that can detect bad debt and stop its proliferation in good time.

Thanksgiving 2007 is special because we are just re-learning the ancient lesson that no banking system can safely operate without gold. You cannot measure the quality and quantity of debt in terms of another, just as you cannot measure the length of an elastic band in terms of another.

What has happened this fall is that the presence of bad debt in the economy has been established. However, bad debt is in hiding. Who is hiding it? “Nobody alive is above suspicion!” One bank can no longer trust another in accepting an overnight draft. Maybe the other feller is trying to pass on bad debt. True enough, banking is based on trust. But if you are not allowed to test debt, or to spot bad debt through demanding payment in gold, then trust is not justified. All debt becomes sub-prime. Why should a client trust his bank, if banks cannot trust one-another?

Thus, then, my answer to the question “why gold?” is that the gold corpuscles fight incipient leukemia in the nation’s monetary bloodstream. It’s not that withdrawing them causes sudden death. But it inevitably causes death in the long run. A rather painful and ugly death.

Since currency touches practically all our people, everybody is contaminated by a corrupted monetary bloodstream. The effects of monetary leukemia are many and in some respects subtle. The withdrawal from the monetary bloodstream of the gold corpuscles which, within broad limits, keep other money and credit corpuscles in good order, has produced the typical results: profligate government spending, extravagant growth in public and private debt, the monetization of government debt, extensive socialization, artificial exhilaration (not to say irrational exuberance), bloating, intoxication, fever, chills, nervousness, irritability, irresponsibility, dishonesty, immorality, decline in the purchasing power of the currency and, characteristically, the insane fear of gold ― as the drug addict fears the withdrawal syndrome.

All these mixed with elements of a pronounced monetary revolution and the scattering of dollars and other resources among the nations of the world. The dishonesty involved in, and flowing from, the use of irredeemable currency permeates practically all aspects of our economic, social, and political system and provides yet another instance of how “corruption grows as naturally as fungus on a muck heap” (Andrew Dickson White in his classical book Fiat Money Inflation in France).

The pulsation of this corrupt monetary bloodstream through an economy finally weakens and undermines the nation involved; and unless removed before the logical and final consequences are reached, eventually brings destruction ― economic, political, and social.

When the people of a nation operate with a redeemable currency every individual is able to exercise direct control over the government’s use of the public purse to the extent of his purchasing power. If he is disturbed by government profligacy or unsound banking practices, he can conserve his purchasing power by converting it into the gold coin of the realm. He is not compelled to join forces with others to form a third political party in an effort, usually futile, to protest the profligacy of government and the duplicity of the banks.

But if a considerable number of people demand redemption of non-gold currency in gold, the banks experience the impact in the form of diminishing bank reserves which is passed on to the U.S. Treasury and thence to Congress. These demands for redemption are the flashing red lights on a central signal-board ― signals the banks and the government respect. The wires were crossed at the signal-board when gold corpuscles were removed from the monetary bloodstream. Ever since signals deliver the wrong message.

It is true that a redeemable currency may, and frequently does, depreciate in a pronounced degree because of the misuse of credit and debt; but it cannot depreciate to the same extent irredeemable currency can. The limit in case of the latter, as it will be most dramatically demonstrated by the dollar, is zero.

When the government cut all the wires from individuals to the central signal-board in Washington, it opened the way to an orgy of profligate spending, to an unlimited depreciation of the dollar, to the ultimate destruction of this nation, and to the overthrowing of world order.

The government and the banks, freed from their proper responsibility of meeting their promises to pay, now have an unrestrainable control over the lives of the people of this nation.

Freedom is lost. We have all become slaves. It is this control that the government and the banks want to perpetuate through the regime of the irredeemable dollar.

The fact that the people have lost control over the public purse constitutes a mortal danger threatening the well-being of the United States ― and that of the world as shown, for example, by the usurpation of war-making powers by the president.

The proof, if one is still needed, that the removal of gold corpuscles from the monetary bloodstream ultimately leads to cancer, is the exploding derivatives market. Its size has exceeded the $ ½ quadrillion (500 trillion) mark. Compare this with the annual GDP of the U.S. at about $ 14 trillion. Worse still, the derivatives market is growing at a pace of 40 percent per annum, roughly doubling in size every other year. This is cancer, which mainstream economists and politicians want you to ignore.

What is the solution? The answer is obvious. Put the gold coins back into circulation.

Restore a healthy monetary bloodstream. Unfortunately, this is easier said than done. The failure of the initiative of Malaysia to revive the Islamic Gold Dinar is a case in point.

Mainstream economists call me an old foggy-bottom and an unreconstructed belly-acher.

They point to the Gold Eagles, Gold Maple Leafs, Gold Pandas, and Gold Koalas, in addition to the Islamic Dinar. “See, they are all sitting out there and refuse to circulate. They go into piggy-banks and cookie-jars. Gold just does not behave as it used to, they say. Gold is passé.

You can’t put spent tooth-paste back into the tube”.

I want to explode this kind of disingenuous reasoning for once and all. The gold coins which governments have sold for profit were not meant for circulation. Governments don’t want them to circulate. They are souvenir coins, conversation pieces that people will not spend, and for a very good reason, too. People are not sure they can get them back on the same terms.

By contrast, gold coins issued constitutionally will circulate. The Constitution mandates the striking of the coin of the realm free of seigniorage. People surrender the exact weight and fineness of gold at the Mint in exchange for the coin of the realm free of charge.

The right to convert is unlimited. If the government opened the U.S. Mint to gold, then people would start spending their Gold Eagle coins because they would know they had a constitutional guarantee to get replacement for their coin on the same terms. This is the wisdom of Isaac Newton, Master of the Royal Mint in London, who put England on the gold standard.

We may take it for granted that usurpers at the Federal Reserve and the U.S. Treasury have no use for Newton. They will not relinquish without a fight their monopoly of charging 100% seigniorage, as against the constitutionally mandated 0%, on issuing new money.

So how are we to restore gold corpuscles to the monetary bloodstream? It may well be that the solution is in the hands of minorities such as native Hawaiians, American Sovereign Indian Nations, or the First Nations of Canada, to establish a Mint on their reservations or territory. They don’t need more gambling casinos or more liqueur outlets. They need a Mint in order to open it to gold. The police scientists at the Federal Reserve and the U.S. Treasury may stop short of putting the Mint owned and operated by minorities out of business using Waco-type violence.

If the minorities did open a Mint to gold, it would be “their finest hour.” A grateful posterity would remember them for their heroism in defying slavery insidiously imposed by a reactionary monetary regime on them as well as on the rest of the world.

If they did that, we could truthfully say that “never have so many owed so much to so few”.

## Gold Standard University Live

Session Three of Gold Standard University Live (GSUL) will take place in Dallas, Texas, U.S.A., from February 11 through 17, 2008. We are happy to announce that this program is sponsored by Mr. Eric S. Sprott, LL.D., C.A., CEO of Sprott Asset Management Inc. of Canada. The program is in three parts:

(1) A course on Adam Smith’s Real Bill Doctrine and its Relevance Today, consisting of 13 lectures. Professor Lawrence H. White of the University of Missouri, St.Louis, has been invited to represent the opposing view. Date: from February 11 through 14.

(2) A debate on the Economics of Gold Mining. The failure of Barrick Gold’s hedging program. True or Bilateral hedging. With industry participation. Date: February 15-16.

(3) A panel discussion entitled Gold Profits in Troubled Times where paraphernalia such as the gold and silver basis, gold and silver lease rates, NAV of gold and silver ETF’s, the bimetallic ratio, and the variation of these will be discussed with invited experts. Please note that this is a new departure in gold and silver investing through bimetallic arbitrage.

Date: February 16-17.

The registration fee for GSUL Session 3 covers participation in all three programs, the course during the week February 11-14 and the debates during the week-end of February 1517. It is also possible to register for the week-end programs separately at a reduced fee.

Participation is limited; first come first served. Participants pay their own hotel and meal bills.

The cost of the closing banquet is included in the registration fee.

For the benefit of European friends of Gold Standard University, Session Three will be repeated, March 10-16, 2008, at Martineum Academy in Szombathely, Hungary, where the first two sessions of GSUL were held, provided that a sufficient number of people register.

For further information please check [www.professorfekete.com](https://www.professorfekete.com) or inquire at

GSUL@t-online.hu.

We are pleased to announce that a new website [www.professorfekete.com](https://www.professorfekete.com) is now available. It contains e-books, archives, news about GSUL, and material of current interest.

---

*November 24, 2007.*

---

# The Saga of the Naked Boogieman

URL: https://newaustrianeconomics.com/archive/fekete/the-saga-of-the-naked-boogieman/
Date: 2007-11-01
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, fiat-currency, monetary-crisis, central-banking
Description: Fekete uses the metaphor of a naked boogieman — frightening precisely because he has nothing to hide behind — to describe the state of the paper money system as it approaches the end of its lifespan. Naked short selling of gold, naked money creation, and naked derivatives position-taking have created a system that is terrifying in its transparency once one knows how to look.
Editorial Note: Written November 2007 as a companion piece to 'The Shadow Pyramid.' Fekete uses accessible metaphor to explain the vulnerabilities in the financial system that his more technical essays document in detail.
Original PDF: https://professorfekete.com/articles/AEFNakedBoogiemanIsReadyToStrike!.pdf

## The Saga Of The Naked Boogieman

Exploding the Myth of Unbacked Silver Certificates and Phony Silver Storage

### Antal E. Fekete

### Gold Standard University Live aefekete@hotmail.com

### Executive summary

Analysts put their own construction on facts coming out of the class-action suit between Morgan-Stanley and 22,000 of its clients involving costs associated with the storage of precious metals. They jump to the conclusion that metal supposedly backing outstanding silver certificates does not exist and never has. Storing silver on clients’ account is a farce. From this they conclude that the net short commercial interest in silver on the COMEX, allegedly naked, must further be increased by adding the amount of unbacked silver certificates and phony storage, which they conservatively estimate at one billion ounces.

Analysts and the 22,000 owners of silver certificates ask the wrong question. The question that should have been asked before the Court is this: “By what right has Morgan-Stanley been using silver belonging to clients for covered writing, and to whom do the bounteous profits flowing from that activity rightfully belong?

### Earn interest on your funds without transferring control

Once more, analysts have fallen victim to their own propaganda, and thereby continue to play the role of the stooge to the large concentrated commercial short interest in the silver market. Because of their obsession with price manipulation and naked short selling of silver, a magnificent opportunity has been missed to expose the best-kept secret of the regime of irredeemable currency: monetary metals are capable of earning a return to capital consistently while the owner need not relinquish physical control of his metal. In other words, a strategy of adroitly using covered writing can generate a riskfree income. “Miracles” of risk-free gains are made possible through the courtesy of the regime of irredeemable currency. By contrast, under a metallic monetary standard you must give up physical control in order to earn interest on your money. The metal is at risk. In case of a default you will never see it again. The significance of the difference is enormous. The choice between freedom and slavery is involved.

### Symbiosis between the “naked bear” and the “insane bull”

It is interesting to watch commercial interest as it throws the pursuers off scent. It leads the analysts by the nose. Morgan-Stanley freely admits to the charge of selling unbacked silver certificates of which it is not guilty, and gladly refunds storage and insurance charges which it has rightfully collected — as long as the secret of the trade need not be revealed, and a much larger income to which it is not entitled can continue to be concealed: the consistent flow of risk-free profits from the ongoing covered writing.

Your certificates are fully backed, and the short sales are not naked. Your silver is safe: physical control is not released for one moment by the service-provider. Yet silver is being traded continuously according to the demands of the market: sold high and bought back low. Question: to whom do the profits from this trade belong? This is exactly the issue that the Court should have decided. But the service-provider succeeded in derailing the legal process. It did not want to disturb the existing symbiosis between the “naked bear” and the “insanely bullish”.

### Fabulous jackpot

From the point of view of the service-provider it is just as well that people do not understand that its activity merely mimics the power plant harnessing the ebb-and-flow of the oceans. The misguided analyst plays a symbiotic role in assisting the large commercial shorts. He fosters the belief in a fabulously large jackpot at the far end of the rainbow: the overnight doubling of the silver price. He believes it will happen when the naughty naked shorts are finally forced to cover. The jackpot makes people “insanely bullish” on silver. It makes them play the role of the “useful fool”. Without it, the task of fleecing the silver sheep would certainly be harder. A lot of silver is held on margin by the insanely bullish. Silver in weak hands is easy picking for the large commercial shorts.

### Waiting for Godot

Practically all analysts are devout believers in the miracle of the coming price explosion in silver, and they are doing their best to prepare their following for the field day. They admit that the large commercial shorts have a higher tolerance for financial pain than most, but when they do panic, they panic big. Analysts even divulge the trigger price: \$45. This sounds familiar, except for the figure.

When silver fetched only 5 dollars, cheer-leaders were talking about a trigger price of \$15. Fifteen dollar silver came and went, yet no explosion took place. Fifteen dollar silver is around the corner once more, but the trigger has been moved up to 45. We should not be surprised that, when forty-five dollar silver arrives, cheer-leaders will make the trigger recede farther still into the misty future.

Waiting for the explosion in the silver price is tantamount to waiting for Godot. (In Samuel Beckett’s play the characters keep waiting for a man named Godot who never arrives.)

### Phoenix rising from its ashes

I am a monetary scientist. My interest in silver is keen because it is the “most misunderstood monetary metal,” with far-reaching consequences for the overthrow of existing social order by the regime of irredeemable currency.

Some analysts brag that in their opinion silver is not a monetary metal. Yet the fact is that you cannot understand silver if you do not at least consider the possibility that it is on the way to become a monetary metal once again. A kind of phoenix, rising from its ashes. This would guard you against making the mistake of assuming that silver consumption is hand-to-mouth. In fact, you will never understand silver on the basis of supply/demand analysis alone. If you want to make a half-decent prognostication about the price of silver you must assume that hoards of monetary silver do exist, here and now, out of which silver will be released gradually as the price advances. In addition, there will be profit-taking by those holders of silver who follow a different strategy involving a shorter timehorizon. Short squeezes will occur, too, but it is most unlikely that you will ever be able to squeeze the large commercial shorts. They are not suicidal. They are not naked. They have a strategy far superior to naked short selling. They take advantage of risk-free profits available to holders of silver.

### Canary in the mine

Most importantly, silver is the canary in the coal mine that will sing just before the lethal seepage of poisonous gas, warning miners to escape. But the miner must have ears to hear silver sing. It sings the song of basis, the song of the last contango, the song of permanent backwardation. If you don’t believe that silver is the junior monetary metal, then you have no ears to hear the songs silver may sing, and may not escape from the mine disaster.

Analysts add whereas they should subtract. They should subtract what they call the “unbacked silver certificates and phony storage” from “naked short interest”. It never occurs to them that the first aggregate is merely a subset of the second. They ignore the possibility that the large concentrated short commercials offer a service to smaller service-providers who hold the silver for customer account, and profitably trade it for a fee. This explains the inordinate size and concentration of short interest in silver — without conjuring up the naked boogieman.

### “Bulls in bear’s skin”

It is understandable that those who draw an income from their control of silver (whom elsewhere I have called “bulls in bear’s skin”) are edgy. They wish to keep a low profile. They might even encourage speculation that they are naked sellers, and no silver to speak of exists above ground as all monetary silver “has been consumed”. These people are already using silver as a monetary metal drawing a silver income from their holdings through covered short selling, or through writing call options, or any other of the more exotic dynamic hedging techniques available. They want to guard their trade secret even at the pain of being duplicituous. Spreading the gospel of silver as a monetary metal is not in their interest. Bulls in bear’s skin have preference for a controlled increase of the price of the silky metal. They prefer evolution to a cataclysmic revolution.

### Fraud cannot be proved by the fraudster’s own admission of guilt

I have no expertise in law and cannot pass judgment on the contract Morgan-Stanley has with its clients. It is possible that it has been drawn up with fraudulent intent, but if so it has to be proved. I would suspect that there is plenty of small print and technical language in the contract making it opaque, designed to provide an excuse for the service-provider to use swaps and swaptions, futures and derivatures, or other exotic instruments to generate an income on silver which would otherwise lay idle. Fraud cannot be proved by referring to the fraudster’s own admission of guilt, which is a red herring. After all, the fraudster may be covering up an even bigger fraud by admitting to the smaller charge. I have no sympathy for Morgan-Stanley’s apparent attempt to pocket all the gains as a serviceprovider, to the exclusion of principals. I would wholeheartedly welcome an initiative to regulate the allocation of profits from covered writing between the principal and service-provider. Above all I want to see obscurantism and the use of smoke and mirrors in the silver trade dispelled which, I believe, would decisively show that in silver we behold a nascent monetary metal.

### The poison of lasting risk-free profits

While on the subject of fraud and morality, we must name the real culprit, the regime of irredeemable currency making, as it is, risk-free profiteering possible. Note that under a metallic monetary standard the opportunity to earn risk-free profits could never last longer than a fleeting moment. As long as it is ephemeral, risk-free profit plays a positive role in the economy. It is the driver of economic progress.

It is the reward reserved for the most progressive entrepreneurs for tracking down misalignments in economic relations, and for anticipating sea-change correctly. The problem is with the perpetuation of risk-free profits. Then they become poison that is injected into the body economic by irredeemable currency.

Exotic derivatives such as higher-order hedges would not be possible under a metallic monetary standard. First-order hedging would, but only for risks given by nature, as in the case of the price of agricultural products. Risks created by man would be confined to gambling casinos where they belong. Under a metallic monetary standard, tricksters could not gamble with the savings of people or with the funds of widows and orphans.

Analysts have gone wrong because of their dogmatic insistence that silver is not a monetary metal. The important fact to keep in mind is that under a metallic monetary standard lending is never risk-free. It involves the transfer of physical control, and the borrower may default. By contrast, under the regime of irredeemable currency it is possible to draw an income from the possession of monetary metals without surrendering physical control. It is this that makes the social poison of lasting risk-free profits possible.

Nature has provided a prophylactic against this poison that makes the beneficiaries of lasting risk-free profits into slave-drivers, and the rest of society into slaves. The prophylactic is: a metallic monetary standard. The regime of irredeemable currency is incompatible with stable social relations based on the system of division of labor. It allows the concentration of the monetary metals in a few hands, conferring unlimited power upon those in control. This is the main reason that militates against embracing irredeemable currency. It is a great historical tragedy that this socio-economic danger was not investigated before the official adoption of irredeemable currency by every country in the world in the wake of the U.S. default on its international gold obligations in 1971. The world then made its fateful U-turn back to slavery.

### Self-destruction of the regime of irredeemable currency

The regime would have come to an inglorious end already in the twentieth century but for the possibility of lasting risk-free profits, lending the parasitic regime exceptional staying power. Through the linkage between the rate of interest and the price level (a.k.a. Gibson’s Paradox) it may be able to rein in runaway inflation.

Paradoxically, it is precisely lasting risk-free profits that will bring about its downfall — but not without extreme social pain. As the monetary metals get concentrated in ever fewer hands, the rest of society is being condemned to slavery. Ultimately, slaves will rise and overthrow the tyranny of the slave-drivers.

These remarks put my disagreement with the analysts into high relief. We all see the menacing concentration. Analysts warn of dangers inherent in the concealed concentration of short interest. I warn of dangers inherent in the concealed concentration of long interest, a combination far more threatening to social peace.

### References

Ted Butler, Money for Nothing, [www.investmentrarities.com](https://www.investmentrarities.com), October 23, 2007

Antal E. Fekete, What Gold and Silver Analysts Overlook, [www.gold-eagle.com](https://www.gold-eagle.com), May 4, 2004

Antal E. Fekete, Bull in Bear’s Skin? [www.gold-eagle.com](https://www.gold-eagle.com), May 4, 2006

## Gold Standard University Live

Session Three of Gold Standard University Live (GSUL) will take place in Dallas, Texas, from February 11 through 17, 2008. The program is in three parts:

(1) a course on Adam Smith’s Real Bill Doctrine and its Relevance Today, consisting of 13 lectures, from February 11 through 14;

(2) a debate on the Economics of Gold Mining: the failure of Barrick Gold’s hedging program, with industry participation;

(3) a panel discussion entitled Gold Profits in Troubled Times where paraphernalia such as the basis, gold and silver lease rates, the NAV of gold and silver ETF’s and the variation of these will be discussed with invited experts.

Program (2) and (3) are scheduled for the week-end February 15-17. The registration fee covers participation in these debates during the week-end. It is possible to register for the week-end program separately at a reduced fee. Participation is limited; first come first served. Participants pay their own hotel and meal bills. The cost of the closing banquet and refreshments during breaks is included in the registration fee.

For the benefit of European friends of Gold Standard University, Session Three will be repeated, March 10-16, 2008, at Martineum Academy in Szombathely, Hungary, where the first two sessions were held, provided that a sufficient number of people register.

For further information please inquire at GSUL@t-online.hu.

We are pleased to announce that a new website [www.professorfekete.com](https://www.professorfekete.com) is now available. It contains e-books, archives, news about GSUL, and material of current interest.

---

*November 1, 2007*

---

# The Shadow Pyramid

URL: https://newaustrianeconomics.com/archive/fekete/the-shadow-pyramid/
Date: 2007-11-01
Section: Popular Economics
Difficulty: intermediate
Concept Tags: bond-market, fiat-currency, capital-destruction, monetary-crisis, federal-reserve
Description: Fekete analyzes the derivatives pyramid built on top of the global bond market — a shadow monetary system of staggering size with no gold or productive asset backing. He argues this shadow pyramid is inherently fragile: it can only be sustained as long as bond prices rise, and when they fall, the derivatives chain will collapse in a cascade that no central bank intervention can stop.
Editorial Note: Written November 2007 as the first signs of the subprime crisis were appearing. Fekete's 'shadow pyramid' analysis anticipated the 2008 derivatives crisis, though he located its cause in the bond market rather than the mortgage market specifically.
Original PDF: https://professorfekete.com/articles/AEFTheShadowPyramid.pdf

## The Shadow Pyramid

### Derivatives Made Easy

### Antal E. Fekete

### Gold Standard University Live aefekete@hotmail.com

### Executive summary

The derivatives market is not the outcome of a natural development, as falsely suggested by mainstream economics in picturing it as a creature of the market’s immune system fighting riskconcentration. Rather, it must be seen as a defensive measure on the part of the managers of the dollar, in order to perpetuate their power to issue irredeemable promises. They hope that by creating infinite demand for T-bonds they can prevent interest rates or, by implication, prices from running away. However, the managers are playing with fire. Interest rates may keep falling, dragging prices down with them. This spells deflation and depression not only in the United States but also in the world.

### Exter’s pyramid

John Exter, the six-foot tall „gnome” of the Federal Reserve Bank of New York and one-time custodian of earmarked gold locked up in the Liberty Street fortress in Manhattan, is best-known for his model of the money supply represented as an inverted pyramid. Exter belongs to the school teaching that the current experiment with irredeemable currency is more likely to lead to a deflationary than an inflationary catastrophe.

The inverted pyramid is delicately balanced on a tip of pure gold. Its upper layers consist of money of increasingly greater proliferation such as Federal Reserve notes, T-bills, bank deposits, as well as other bank liabilities. The layers are graded according to safety, going from the safest, gold at the bottom to the least safe, the layer of electronic dollars at the top.

While appearing placid, static, and monolithic, the pyramid comes alive every once in a while when a monetary or banking crisis erupts somewhere in the world. There is great commotion and agitation manifested by the scrambling of assets downwards to less prolific layers below, in the wake of owners trying to take a „flight to safety” — as it has been happening with increasing frequency in the twentieth century, especially during the fourth quarter, after the United States defaulted on its gold obligation to foreign governments in 1971. The pyramid is deflationary because, although it is increasing at a double-digit rate, it threatens to collapse to its low-lying layers in consequence of repeated monetary crises.

### The Derivatives Revolution

Exter’s pyramid casts a huge shadow which is increasing even faster than the pyramid itself, as you might expect the shadow of any pyramid to loom ever larger in the sunset. Make no mistake about it, the sun is setting on the irredeemable dollar. The shadow is none other than the derivatives market with its tip consisting of T-bond obligations of the U.S., followed by layers of interest-rate derivatives graded by remoteness from the tip.

In more details, calling the tip or the layer of T-bonds the first, the second layer consists of futures contracts to be settled by surrendering T-bonds below. The third consists of futures contracts to be settled by surrendering obligations belonging to the second layer. And so on, the n th layer consists of future contracts to be settled by surrendering obligations belonging to the (n  1)st layer. It is readily seen that only T-bonds can ultimately liquidate all liabilities. Thus a pyramid of liabilities, which is allowed to grow beyond any limit as n gets arbitrarily large, is being built on a limited supply of Tbonds.

As Floyd Norris writes in The New York Times on October 26, 2007 (see the article entitled Who’s Going to Take the Financial Weight?): “the transfer of risk was supposed to be the great advance brought to the world by financial engineers in developing exotic derivative products that enabled risks to be sliced and diced in all manner of ways. The risks have been transferred through a bewildering wilderness of futures: options, swaps, swaptions, specialized investment vehicles, collateralized debt obligations, variable interest conduits, and who knows how many other instruments”.

### Short squeeze and corner

But there is another side to the Derivatives Revolution. The market for interest-rate derivatives is not unlike an imaginary futures market in corn that allows unlimited short selling of the next crop regardless of its size. Of course, there are consequences: short squeeze and, ultimately, a corner — the classical example of the game of musical chairs. Every player is happy — until the music stops.

The origin and growth of the shadow pyramid is the great mystery of 21st-century finance. Its layers are subject to the same kind of scrambling during times of crisis as those of Exter’s pyramid, only worse. Those who have a long position are trying to swap it for another in the lower layers, closer to the „real thing”, the T-bond. The trouble is that the lower layers cannot satisfy potential demand simultaneously.

But why is the shadow pyramid growing at the break-neck speed of 40 percent per annum? At that rate it doubles every other year, presently representing liabilities in the order of ½ quadrillion or 500 trillion dollars, a sum that boggles the mind. In comparison, the annual GDP of the U.S. is a paltry \$14 trillion while that of the world is hardly more than \$60 trillion. What is the inordinate size and growth of the pyramid trying to tell us?

### Fast breeder of derivatives

It has been suggested that fewer than ten people in the world understand the shadow pyramid and its dynamics. It is further suggested that the $½ quadrillion is merely a „notional” value. Don’t be misled by the semantics. Every dollar of the ½ quadrillion is a real liability: the obligee cannot walk away from it any more than the issuer of a bond can walk away from his — except through default. The shadow pyramid is an ideal hiding place for bad debt. Gold doesn’t exist in sufficient quantities to liquidate Exter’s pyramid; neither do T-bonds to liquidate its shadow.

Why do managers of the regime of irredeemable currency allow the proliferation of liabilities greatly to exceed the means of settlement? How could such an insane construction come about and continue to prosper, nay, to accelerate, threatening the world with an avalanche of defaults? The question is a taboo by order of government, which pussyfooting economists are only too anxious to observe. Yet monetary science has the answer. Gold Standard University is proud to take the initiative in violating the taboo.

### Futility of price control

The irredeemable dollar is not a stable monetary standard. Like all irredeemable currencies in history, the dollar is facing periodic runs that will ultimately wipe out its value. The purchasing power of the dollar is being destroyed through relentless price rises. As long as the rate of average price rises can be kept under control, people don’t worry too much about the value of their money. They are lulled into believing that what goes up will come down. The problem, therefore, is whether the government can limit price rises to, say, 3 percent per annum.

Limiting price rises administratively through price control is a non-starter. Black markets would spring up and people would take black market prices as „real” rather than the managed prices at which supplies were either unavailable or of inferior quality. The government has to resort to a method more sophisticated than that. So it attempts to control prices by taking advantage of the so-called „linkage”, (a.k.a. Gibson’s Paradox), the well-observed albeit not so well-understood phenomenon that prices and interest rates are linked. Neither is free to move independently of the other, in particular one cannot, apart from leads and lags, run away while leaving the other behind.

The task facing the government is still daunting. In an inflationary scenario it is not enough to control short-term interest rates. But that is all the central bank is equipped to do: it is quite powerless to control long-term rates. So the government resorts to chicanery. It tries to enlist help from bond speculators to keep interest rates low by letting them bid up the price of T-bonds.

### Making bond speculation risk-free

But how can the government persuade bond speculators, arguably the smartest lot in finance, to do its bidding? Well, that’s just the thing. The government has to make bond speculation on the bull side of the market risk free. That is a tall order. How can it be pulled off?

Here is how. Speculators are encouraged to build up large inventories of T-bonds and „hedge” their long position in the futures market. That’s the tricky part. Simple hedging won’t do. The hedges must also be hedged.

In effect, the government legalizes unlimited short selling of T-bonds thereby creating unlimited demand for them. As any demand for bonds when fine-tuned is expected to result in a declining long-term rate of interest. To guard against the danger of falling interest rates spreading the fire to falling prices, the central bank stands ready to hose down the price-decline with liquidity. The arsonist is girding himself as a fire-fighter.

In the absence of unlimited short selling the value of dollar-denominated bonds would be devastated even before that of the dollar. But as the recent sub-prime crisis has demonstrated, this is not what is happening. There is hardly a ripple-effect in the bond market even after the value of the dollar is shattered. Bond hedges do work. Bond values can be insulated from the vicissitudes of the dollar by the layered structure of the shadow pyramid.

### Mendacity of mainstream economics

The question arises why it is that prices of agricultural products can be effectively hedged by firstround control, without constructing an infinite tower of hedges of ever higher order. Here I must point to the mendacious nature of mainstream economics. It teaches that hedging bond prices is no different from hedging agricultural prices. The very same principles apply in bringing about the same desiderata: stable bond prices and stable interest rates. This teaching is a shameless lie spread by mainstream economists who are paid to know better. The proof is: the Babeldom of interest rate derivatives. No infinite tower of hedges is needed to stabilize the prices of agricultural goods; by contrast, simple hedging will not stabilize bond prices. The fact is that the risks involved in fluctuating gold and bond prices, or fluctuating interest and foreign exchange rates have been artificially created. They are man-made: the same as risks created in gaming casinos. How do we know? Well, under a gold standard all of the above risks were absent. At any rate, variation in the gold and bond prices or in interest and foreign exchange rates were so small that no organized speculation could spring up spontaneously for lack of sufficient volatility.

### Speculation versus gambling

By contrast, risks involved in the variation of the prices of agricultural commodities are nature-given.

Herein lies the fundamental difference between speculation and gambling. Speculators address risks that exist in nature. But risks that are man-made cannot be cushioned by speculation, just as risks artificially created in the gambling casino cannot. Instead, risks are shifted (possibly after having been sliced and diced to the point of making them unrecognizable). In destroying the gold standard the government has created the whole gamut of artificial risks, from variable foreign exchange rates to variable interest rates, neither of which can be successfully addressed by speculation as can the risk of fluctuating agricultural prices. In other words, while speculation addressing nature-given risks is stabilizing, speculation addressing man-made risks is destabilizing. Just as at the roulette table: an increase in the number of players will in no way limit the risk involved in betting. Just the opposite: gambling frenzy will climb and, with it, risk exposure will be rising, too.

The successful speculator correctly diagnoses budding supply shocks. If he anticipates a crop failure, then he buys while prices are still low. He sells when prices rise after the crop failure has occurred, thereby augmenting supply, tampering the price rise. The consumer benefits. Alternatively, if the speculator anticipates a bumper crop, then he sells short while prices are still high. He covers his short position when prices fall after the bumper crop has been brought in, thereby augmenting demand, tampering the decline of prices. The producer benefits. The speculator is a benefactor of society — but only in so far as the risk of price-fluctuation is nature-given.

### Natural selection  central bank style

The case is very different when the risk is man-made. Take variable foreign exchange rates. Here central bankers pit their wit against that of the currency speculator. We may be confident that the wits of speculators are sharper. After all, they make it their business to outsmart the central banker. In the process they risk their capital. The central banker knows that his losses will be covered by the Treasury. The „natural selection” that shapes the skills of speculators, allowing only the smartest of the smart to survive while the rest, having lost their capital will fall by the wayside, fails to apply to central bankers. Instead, there is inbreeding and complacency. Central bankers are on salaries and risk no capital of their own. No natural selection is at work culling the herd of obtuse central bankers. The upshot is that central bank intervention in the futures and derivatives markets is more often a failure than a success. Nimble and wily speculators routinely win.

### Pump-priming to make speculation self-fulfilling

Jaw-boning will not persuade speculators to keep buying T-bonds. They see through and will sell the bonds rather than buying them if they expect interest rates to rise. However, there is something the government can still do, vicious as though it might be. If the government could only demonstrate that interest rates will keep falling or, what is the same to say, bond prices will keep rising, then speculators will naturally converge on the bull side of the market and the prediction of rising bond values will be „self-fulfilling”. Stable bond prices won’t do. It is necessary for the government to grant risk-free profits to bond bulls. The backdrop of a falling interest rate regime is essential.

The problem therefore is reduced for the government to engineer an initial falling bias for the rate of interest. That is a problem of pump-priming. Once a falling trend has been established, speculators will finish the job. They will perpetuate the trend by making bullish bets on bonds selffulfilling. Pump-priming is deviously accomplished through legalizing higher order hedges in the bond market. The demand for T-bonds is artificially boosted.

Just as a Ponzi scheme is fraudulent and dealt with by the Criminal Code accordingly, the infinite proliferation of bond hedges through authorizing ever higher order of hedging is no less fraudulent. There is no difference in substance between the two schemes, only difference in form.

Payoff is being promised to an ever larger population which cannot possibly be honored. Both schemes come to a sorry end when the supply of fools is exhausted. The supply of fools, however large, is still finite and there is no doubt that the Babeldom of derivatives will ultimately collapse.

### Sacrifice on the altar of Moloch

To recapitulate, the derivatives market has been created for the sole purpose of perpetuating the regime of the irredeemable dollar. It embodies demand for dollar-denominated bonds that can be augmented without limits. The government creates an infinite pyramid of liabilities that can only be liquidated by a finite supply of bonds.

The dollar-system would have disintegrated in the twentieth century already, but for the demand that has been artificially created for T-bonds. Through the derivative pyramid the demand for bonds is boosted in a seemingly endless merry-go-round. The public is unaware that the T-bonds are rotten to the core. They are, in the words of the late Dr. Franz Pick, „guaranteed certificates of confiscation”.

Once upon a time T-bonds were the safest investment vehicles on earth. Guardians of widows and orphans wouldn’t look at anything else when investing their wards’ inheritance. Savings were sacrosanct. But that was another age: the golden age of the gold standard when interest rates and bond values were stable. Only after the U.S. government single-handedly demolished the international gold standard did interest rates start bouncing up-and-down like a yo-yo. To the eternal shame of academia, the chorus of mainstream economists started parroting the propaganda line that, after all, it was the nature of interest rates to fluctuate wildly, just as it is the nature of prices of agricultural commodities, in response to changes in supply and demand — an unmitigated lie. T-bonds (and the inheritance of widows and orphans) have thus become a plaything in the hands of gamblers. The welfare of innocent children was sacrificed on the altar of Moloch. In the fullness of time, academia and the regime of irredeemable currency will be judged in the light of the Biblical admonition against tormenting widows and orphans.

### Playing with fire

The foregoing explains how bullish bond speculation has been made virtually risk-free by the government through the inverted pyramid of derivatives. The outcome was a falling trend in the yield of 30-year bonds, from 16 percent in 1981 to 4 percent 25 years later, in 2006. Every time the rate of interest is halved, bond prices approximately double. Every time the rate of interest is cut back to onequarter, bond prices approximately quadruple, as it has between 1981 and 2006. It is quite a windfall, with interest income at the rate of 16 percent kicked in as a bonus. Capital gains like this are not to be ridiculed, especially if they are available risk-free.

It is an open question whether the falling trend of interest rates will continue on its own, or it will be necessary to repeat the prestidigitation of 1980, printing another slate of 30-year bonds with 16 percent coupons attached to them. Let me suggest that the existence of the shadow pyramid makes this unnecessary. The pump has been primed already. The key ingredient, demand for T-bonds, is already given.

To be sure, in encouraging bullish bond speculation the government is playing with fire.

Falling interest rates could drag commodity prices down, regardless of injections of new liquidity.

Deflation and depression loom large on the horizon. The recent desperate attempt of the Open Market Committee to cut interest rates even in the face of a collapsing dollar shows a rare instance of brinkmanship.

The U.S. Treasury and the Federal Reserve have sold the nation’s birthright for a pottage of lentils. They are no longer in control. Their check-kiting scheme is up. They noisily yank the stickshift up and down, right and left, all in vain: it is no longer connected to anything. The future depends on the collective judgment of bond speculators, especially those not subject to the jurisdiction of the United States, into whose hands the fate of the dollar has slipped. It is a matter of guesswork to say how they will decide.

### “China shrugged”

This may not be the end of the dollar yet. We have the Chinese puzzle wrapped in mystery inside of an enigma to solve. I would certainly count the Chinese among not just the biggest, but the shrewdest and most skillful bond speculators ever, backed up by their unprecedented kitty of well over one trillion dollars in T-bonds. I would even go so far as suggesting that a large part of this kitty has originated, not so much in trade surplus but, rather, in bond speculation. After all, the Chinese have been active players at the blackjack table where the chips are U.S. bonds, since the early 1980’s. They have played their hand quite adroitly. It would be out of character if they all of a sudden turned into dummies.

How can you explain the fact, mentioned by Edmund L. Andrews in The New York Times on October 10, 2007, (see the article entitled U.S. Affects a Strong Silence on Its Weak Currency) that China’s central bank has stepped up its already huge purchases of dollar denominated securities?

According to recent data, China’s foreign exchange reserves have been climbing at a pace of \$40 billion a month, or twice as fast as last year. Don’t buy the ridiculous argument that China is trying to protect its market share in the U.S. by giving away its goods for next to nothing. Continued Chinese purchases of U.S. securities look more like an opening gambit than a stupid mistake.

Like Atlas carrying the globe on his shoulder, the Chinese carry the globalized dollar on theirs.

Let others dump the T-bonds in a rout. The inscrutable Chinese will enter the fray later, and clean up. „China Shrugged”. China’s central bank is a big-time bond speculator: the biggest ever in history.

Without fanfare it is following a script that promises a huge pay-off on T-bonds — in view of a growing shortage as the shadow pyramid of derivatives matures and demand for T-bonds intensifies.

As long as the payoff remains greater than dollar-depreciation, the Chinese are doing fine.

### Who is holding whom to ransom?

From now on the game of musical chairs is going to continue with the Chinese calling the shots. The dollar will be stabilized albeit at a level reflecting big losses, but not so big as to jeopardize the mountain of paper profits the Chinese have piled up during the past 25 years. Through their control of the shadow pyramid the Chinese hold the U.S. Treasury to ransom in spite of appearances, namely, that the U.S. Treasury is holding the Chinese to ransom. That’s the good news. The bad news is that this means deflation in the United States and the Western World, confirming Exter’s gloomy prognostications: falling real estate prices, falling banks, falling employment.

Don’t blame the bond speculators. Don’t blame the Chinese. Blame the managers of the global regime of irredeemable currencies for the disaster. First and foremost blame those in the U.S. government who trampled on the Constitution in issuing irredeemable promises to pay. Dollar bills and T-bonds are just that. Irredeemable promises are explicitly ruled out by the Constitution.

At first it appeared a smart thing to flood the world with them as foreigners were showing an insatiable appetite for irredeemable promises. But as it often happens, the smart thing turned into too much of a good thing. The chips started accumulating in one hand, the hand of a smarter guy who knew how to call the shots. We need not worry that the Chinese may never get full value for their exports. We have plenty to worry about mischief at home.

It is criminal how the managers of the dollar have ostracized gold. It is criminal how they have allowed the debt of the U.S. government to burgeon and private thrift to wither simultaneously. It is criminal how they have let American debt get concentrated in foreign hands, in particular, the hand of the enigmatic Chinese. It is criminal how they have permitted the unlimited proliferation of interestrate derivatives, in order to protect their power to flood the world with worthless paper — disregarding the possibility that falling interest rates may trigger worldwide depression.

It is criminal how the managers of the dollar have let monetary leadership slip out of the hand of the United States.

---

*November 1, 2007*

---

# Peak Gold! Part Five

URL: https://newaustrianeconomics.com/archive/fekete/peak-gold-part-five/
Date: 2007-10-04
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, permanent-backwardation, backwardation, gold-standard, fiat-currency, monetary-crisis
Description: The final installment of the Peak Gold series draws the conclusions: once peak monetary gold is reached, the paper money system has no mechanism for self-correction. The only options are either a managed return to the gold standard — restoring minting and real bills — or an unmanaged collapse through permanent backwardation that destroys paper money entirely.
Editorial Note: Conclusion of the five-part Peak Gold series (June–October 2007). Fekete presents the starkest version of his two-outcome scenario: orderly return to gold or chaotic collapse through permanent backwardation. Events since 2008 have validated the urgency of his warning.
Original PDF: https://professorfekete.com/articles/AEFPeakGoldPartFive5.pdf

## Peak Gold!

### A Primer on the Economics of Gold Mining, Part Five

### Antal E. Fekete

### Gold Standard University Live aefekete@hotmail.com

## Barrick Execs Continue To Exercise Options And Sell Shares

In Part Four I revealed that when it comes to owning Barrick shares, the two top Barrick executives, CEO Greg Wilkins and CFO Jamie Sokalsky have voted with their feet. In retrospect it looks more like a stampede of insiders out of Barrick shares and options.

As reported by the Canadian newspaper National Post on September 21 and 25, Barrick executive vice president Alexander Davidson exercised 25,000 options for company shares at \$23.85 each on Sept. 18 and then sold these shares for \$39 each the same day. Davidson exercised 5,600 more options at the same price on Sept. 20, then sold the shares. He exercised another 19,400 options at the same price the following day, then sold the shares for \$41 each.

Patrick Carver, executive vice president and general counsel at Barrick exercised 12,100 options at \$29.60 on Sept. 18, then sold these shares for prices ranging from \$39.35 to \$39.41 the same day. He exercised another 12,000 options at \$29.60 on Sept. 20, then sold these shares for

\$40.30 each the same day.

Peter Kniver, executive vice president and COO, exercised 40,000 options for Barrick shares at \$23.80 each on Sept.21, then sold these shares the same day for prices ranging from \$40.26 to \$40.32.

Executive vice president and CFO Jamie Sokalsky exercised 49,100 options at \$30,70 each on Sept. 19, then sold these shares the same day for prices ranging from \$39.45 to \$39.61. This is in addition to selling 135,000 shares between Sept. 1 and 14 as mentioned in Part 4 of this series. Many others at Barrick have exercised options and sold company shares. The National Post comments: „Looking for someone to pick up the tab for a night on town? Well, you might want to track down one of the 28 executives, directors and/or officers at Barrick who since Sept. 1, 2007 have exercised and sold more than 1.2 million options for company shares. Consider the

420,050 options that were exercised and then sold in four days, from Sept. 10 to Sept. 14.

They generated \$3,254,651 plus \$1,439,812 in total profits for the 15 Barrick officers who performed these transactions. That’s one helluva dinner for starters.”

More pertinently I ask the question: what’s the rush to get rid of Barrick shares? What is it that insiders do know but shareholders may not?

### Barrick throws in the towel

It could have very well been the impending bombshell timed to explode on September 28 when Barrick CEO Greg Wilkins was to announce that the company „has no plans to return to the futures markets to hedge its gold production”. This amazing announcement is in my opinion nothing short of an admission of guilt. Barrick’s hedging policy has caused a financial disaster that was perfectly foreseeable and avoidable. Barrick executives have been warned that their so-called hedge-plan was fraudulent and involved the company with unacceptable risks. I told CFO Sokalsky in person about the errors of his ways already ten years ago. My 50-page memorandum Gold Mining and Hedging — Will hedging kill the goose laying the golden egg? that I prepared for Barrick executives is in the public domain. Ferdinand Lips in his book Gold Wars quotes extensively from it.

Shareholders would be perfectly justified in launching class action suits against Barrick executives. Insiders are well aware of this. Hence the spectacular stampede to dump Barrick shares that may have their origin in illegally paid bonuses. Why, these bonuses could possibly represent paper profits rather than earned profits. It is criminally fraudulent to pay yourself a bonus out of paper profits. The contingent liability encumbering paper profits could turn into real losses for which the funds paid out in bonuses should have served as cover. Apparently this is what happened to Barrick: the rising gold price made paper profits from Barrick’s „hedges” evaporate while turning all remaining „hedges” into a loss-maker. Millions of dollars that Barrick executives have recently pocketed from bonuses could conceivably be part of the cover for losses embodied by the 9½ million ounces of „hedges” under water.

It is remarkable and noteworthy that CFO Sokalsky has got off from his high horse. He is no longer touting his so-called hedge plan that involved using paper profits for the purposes of windowdressing operational profits. Quite possibly company counsels have warned him that such a tactic may be deemed illegal and actionable by shareholders.

As reported by Reuters quoting an interview on CNBC, on Friday, September 28 company president Wilkins announced the end of the saga of „hedging” in gold mining. He still appeared to be defending the practice by promising that the company is going to continue to hedge its copper production. The red herring of copper hedging will lull nobody into believing that the discontinued gold hedging strategy was unobjectionable from the legal point of view. The objection is not against the use of the futures markets in hedging; it is against the practice of selling leased metal. There is no lease market for copper so Barrick cannot sell leased copper.

As this series Peak Gold!, a primer on the economics of gold mining, has set out to show, the economics of copper mining is as different from that of gold mining as night is different from day, on account of the different behavior of the underlying marginal utilities (see below).

Be that as it may, Barrick has thrown in the towel. Truth has won over falsehood. President Wilkins said in the interview: „Frankly, our investors are really looking to benefit from the upside of gold and we share that point of view.” He did not explain why it took him so long to come around to honoring the wishes of shareholders, nor did he say what other criteria than serving the interest of shareholders may guide his actions. Deafening silence surrounds the question what he is planning to do with the 9½ million ounces worth of „hedges”, now deeply under water as a direct result of the foolish hedging policies of management, and a potential source of further horrendous losses in case the price of gold advances further.

The fact is that Barrick is haemorrhaging gold, and the executives are trying to cover it up.

Rome is burning and Nero fiddles on the roof. A few days earlier, at the Denver Gold Group Forum, Wilkins talked to the assembled mining experts complaining about the high price of truck tires explaining how he was going to fix the problem. Not one word was said about the 9½ million ounces of „hedges” under water, or how they can be lifted before they do further damage to the company and its shareholders. The CEO talks about building a truck tire factory when the gold mine is on fire.

Perhaps, if he put out the fire first, then he could afford to pay the going price for truck tires.

Of course, he must have noted that „hedging was practically anathema” at the Forum, as niftily put by Citigroup analyst John Hill. Was Wilkins just trying to be considerate in avoiding an unpleasant subject? The gold price reacted to the news that Barrick has thrown in the towel by jumping almost \$10 to \$744, a 28-year high. That cost the company and its shareholders a cool 95 million dollars.

Still, Barrick shareholders have every reason to celebrate. I take this opportunity to congratulate them upon their victory over a fossilized management. I pledge my further support to them with my pen. I shall provide a post mortem on Barrick’s unilateral hedging strategy. I have changed the subtitle of this series to: A Primer on the Economics of Gold Mining, to indicate that a new era has started in the history of gold mining. The mindless rush of gold mining companies to play „follow the leader” is over. I could not find anybody willing to defend Barrick’s indefensible strategy of unilateral hedging. This strategy has been thrown where it belongs: to the garbage dump of history.

Make no mistake about it: this was the greatest mining disaster in the history of gold mining.

### Two-legged straddles

I shall now explain what Barrick has done wrong, and how it should have proceeded instead. What I have to say is basically no different from what I told Sokalsky ten years ago. Selling gold futures at price spikes in excess of annual output is no hedging, it is naked forward selling. As events have proved, I was right: naked short selling is a foolish strategy as it can make even the #1 gold miner suffer, not just a loss of face, but also the loss of billions of dollars.

Consider two hypothetical gold mines, AXY and XAB. Compare their operations which are very similar yet fundamentally different. Both mines work with two-legged straddles having a short and a long leg. With their short legs they both enter the gold futures market. The difference is in where they put the long leg. I wish to emphasise that this example is schematic, that is, oversimplified for easier comprehension. The actual situation is considerably more complicated, but simplifying it does not affect the underlying principle. AXY enters the long leg of its straddle into the bond market; XAB keeps the long leg anchored in the gold mine itself.

From this it should already be clear that XAB’s are true hedges in the sense that they are rooted in mining. By contrast, AXY’s hedges are false. The gold mine has been turned into a hedge fund. At any rate, its „hedges” have nothing to do with gold production. AXY needs gold only as a source of cheap financing for its gambling ventures.

### Fraudulent hedging

Suppose there is a \$10 upwards spike in the gold price. AXY reacts by selling 100 gold futures contracts. In doing so it locks in a selling price for gold, gold that it arranges to borrow from a bullion bank at 1 percent per annum interest, in order to sell it and invest the proceeds at 6 percent in the bond market for a net income of 5 percent per annum. AXY does not think that it is in any danger on account of a possible advance in the gold price. „What goes up must come down”. In any case it reasons that the gold sold forward is in hand: it can be scooped up from its mines at any time. But as we have seen in Part Three, this is a fundamental mistake. AXY does not have the gold in hand: it only has a bird in the bush. The hedge is fraudulent because the 5 percent net interest income is commingled with operative profits, disregarding the contingent liability that AXY still has on its open „hedges”. As we have observed, it is criminally fraudulent to represent paper profits as earned profits.

### True hedging

The other gold mine XAB reacts the same way to the initial \$10 upwards spike in the gold price: it also sells 100 contracts of gold futures, the short leg of the straddle. The difference, as already suggested, is in the long leg which in this case is entered into the actual production of gold from the mine.

In more details, XAB is alive to the opportunity offered by the fact that the upward spike in the gold price has promoted some of its submarginal grades of ore into the payable category. To fix our ideas suppose that XAB has a submarginal vein of gold bearing ore it affectionately calls Moonbeam. Even though submarginal, Moonbeam it is not barren. It is pregnant with profits which

XAB wants to capture.

A godsend, XAB finds that Moonbeam is now payable, thanks to the \$10 upwards spike in the gold price. The trouble is that the godsend may be available only for a couple of minutes, and it is not possible to get the gold out of the ore and take it to the market in such a short space of time. No problem. That is where hedging, in the true meaning of the word, comes in. Using the facility offered by the gold futures market XAB can lock in the spiking price now; mine and deliver the gold later.

Geologists at XAB know exactly how much of Moonbeam ore should be earmarked and mined in order to come up with the right amount of gold that must match the amount sold forward. The mine goes ahead and produces the gold. Never mind if the price of gold has fallen back in the meantime.

The higher selling price is locked in. When the gold produced from Moonbeam ore is sold, the mine lifts its hedges, i.e., covers the short position in the futures market.

In effect, XAB has sold gold at a profit from ore that, absent hedging, represents zero value. It looks like prestidigitation, but it isn’t. It is the same idea as harnessing energy from the tide-and-ebb movement of the oceans. XAB harnesses the fluctuating gold price which represents energy. The energy of tides, given the skill of engineers, can be put to use. Likewise, the skilled gold miner can squeeze gold out of worthless rock. That’s the challenge of the profession, challenge that not every gold miner can meet.

Notice that XAB does not care if the price of gold has increased between its selling of gold futures, and its selling cash gold later. It is true that any increase generates a loss on the short leg, but it is compensated dollar for dollar by the higher price it will receive for the gold extracted from Moonbeam. XAB only cares about the opportunity of selling gold profitably, gold, the production of which in the absence of hedging would involve the mine with a loss. If, on the other hand, the gold price fell back, then the short position of XAB in the gold futures market would show a profit. That profit could be taken immediately.

Suppose that the chance of the gold price moving up or down after every \$10 spike is 50-50.

Then the mine will enjoy an extra income from its hedging operations because 50 percent of its hedges will be closed out profitably without even touching any gold bearing ore. The other 50 percent is just as beneficial making it possible to extract gold profitably from submarginal grades of ore. Herein you have a win-win strategy. Quite unlike Barrick’s which is a lose-lose strategy — except in a bear market for gold.

### Fool’s gold future

This being a post mortem I want to explain most carefully what has made the boat of Barrick hit reef.

The #1 gold miner did not understand the subtle difference between selling gold futures and selling borrowed gold. While both come under the heading „selling gold forward”, there is an important difference. The gold mine selling gold futures has not sold the gold, so any possible mis-judgement in timing is self-correcting. On the other hand, the gold mine selling borrowed gold has thereby finalized the terms of the sale. Only delivery is put off. The self-correcting feature is missing. Any error in timing could be disastrous.

Barrick is totally ignorant of (true) hedging. Observe the difference between two operations:

(1) Selling gold futures for hedging purposes is one thing. It simply means booking a selling price now, with the actual sale of newly mined gold to follow later. A subsequent increase in the price of gold is not hurting because the gold mine has retained the right to sell gold at the higher price later. (2) Selling borrowed gold is another thing altogether. The actual sale of newly mined gold at a fixed price has been consummated, only delivery remains. Every cent of an increase in the price of gold is hurting because the increase means that the gold has been sold at the wrong price.

AXY acts as a hedge fund. Its straddles are fraudulent. Even if the financial results are positive in the end, it cannot report, still less pay out, a profit. Profits are paper profits. They will not be finalized until the „hedges” are lifted. There is a contingent liability which can turn into real losses if the gold price has a subsequent run on the upside. Paying out paper profits in bonus is a criminal fraud. The fact that AXY is a gold mine has nothing to do with its adventures in the world of gambling. Any hedge fund can do it (and will probably do a better job of it). The problem plaguing Barrick now is that it has commingled paper profits from gold and bond speculation with operating profits from gold mining and has, apparently, dipped into its treasury and paid hefty bonuses to executives and directors. The money is gone, but the contingent liability remains. When the gold price increases, it becomes a loss that gets larger with every cent of an increase in the gold price. The potential loss is open-ended.

### Double jeopardy

No wonder that the 28 Barrick executives are in such a mad hurry to cut and run before their bonuses are attached by court injunction in a possible class action suit. Damn whoever invented bonuses in the form of options. Cash bonuses would not have left such a stinking paper trail.

By contrast, consider XAB. It acts as any proper hedger does who is involved in the production of real goods. Its straddles are true hedges: they aim at benefiting the company from favorable price hikes by producing gold from ore body whose market value is zero in the absence of a hedging strategy. This operation is completely independent of the fickleness of interest rates and of the variation of the gold price.

Note that the profitability of the „hedges” of AXY is exposed to „double jeopardy”. It depends on the assumption that neither interest rates nor the gold price will rise. Should either do, the „hedges” will show an immediate loss. Higher interest rates make the market value of bonds fall, hurting the long leg of the straddle. A higher gold price will increase the cost of lifting the straddle.

### Maximizing the life of the gold mine

But the main difference between the two strategies has to do with the fact that true hedging (the strategy of XAB) extends the working life of the gold mine, while fraudulent hedging (the strategy of AXY) shortens it. True hedging spares the richest ore bodies and shifts mining towards the submarginal grades or ore. This also means the most efficient deployment of the capital of the mine.

Barrick-type hedges result in a ruthless exploitation of the mining resource. Naturally, AXY wants to squeeze the maximum amount of cash out of its „hedges”, regardless of the damage it may cause to the logevity of the mine, because it wants to buy as many bonds as possible. In consequence the richest grades of ore are extracted first and the mine is exhausted prematurely. When it is forced to close down, it will still have a lot of valuable gold-bearing ore left behind.

### Economics of Gold Mining

The economics of gold mining is as different from that of base metal mining as day from night. The aim of a copper mine, for example, is to maximize profits without regard for the working life of the mine. The reason is that the marginal utility of copper is declining. This means that if you do not market your copper at the earliest opportunity, then competition grabs your market share and runs with it. Tarda venientibus ossa — says the Latin proverb (late-comers to the meal get the bones). In the case of copper miners late-comers have to sell at a lower price.

By contrast, the marginal utility of gold is declining so slowly that it is practically constant.

There is no pressure on the miner to rush his product to the market. His concern is to get as much gold throughout the mine’s extended working life as possible, regardless how long it may take. If it takes longer, no harm done. The mine stands to benefit from deliberate currency debasement practiced by governments. Debasement has the unintended effect of promoting the submarginal ore bodies of the gold mines to the payable category.

Incidentally, this is the secret of the popularity of owning gold mining shares in spite of the meager returns to invested capital. Gold mining shares have a built-in option-feature. The option expires when the gold mine is exhausted. Thus given two identical gold mines with exactly the same geological features, the one worked more conservatively will command the higher share price and the higher market capitalization, because the underlying option has the longer maturity date. The market will assign the lowest market capitalizartion to the gold mines that go after the highest grade of ore, even if the dividends paid by that mine are higher.

Having said that, we find that the hedging stategy of XAB still has shortcomings and calls for further improvements. Both AXY and XAB are using unilateral hedging strategies. As a side-effect speculators are invited to converge on the short side of the market and compete with the gold mines to nip every gold rally in the bud. What is needed, clearly, is bilateral hedging and its four-legged straddles to eliminate that threat. This is the subject of the next instalment of Peak Gold!.

## Gold Standard University Live

Session Three of Gold Standard University Live will take place in Dallas, Texas, from February 11 through 17, 2008 (please note the change of place and date.) It will have three parts:

(1) a course on Adam Smith’s Real Bill Doctrine and its Relevance Today, consisting of 13 lectures, from February 11 through 14;

(2) a debate on the Economics of Gold Mining with industry participation;

(3) a panel discussion entitled Gold Profits in Troubled Times where paraphernalia such as the basis, the gold and silver lease rate, the NAV of gold and silver ETF’s and the variation of these will be discussed with invited experts. Program (2) and (3) are scheduled for the week-end February 15-17.

The registration fee covers participation in the debates during the week-end. It is also possible to register for the week-end program only at a reduced fee. Participation is limited; first come first served. Participants pay their own hotel and meal bills. The cost of the closing banquet is included in the registration fee.

For the benefit of European friends of Gold Standard University, Session Three, will be repeated in March, 2008, at Martineum Academy in Szombathely, Hungary, where the first two sessions were held, provided that a sufficient number of people register. More details will follow later.

For further information please inquire at GSUL@t-online.hu.

### References

### A.E. Fekete, Peak Gold! August 15, September 10, 19, 26, 2007

A.E. Fekete, Have Gold Bugs Been Barricked by the U.S.? July 12, 2007

### A.E. Fekete, Gold Vanishing Into Private Hoards, May 31, 2007

A.E. Fekete, To Barrick Or To Be Barricked, That Is the Question, August 11, 2006

### A. E. Fekete, The Texas Hedges of Barrick, May, 2002

Charles Davis, So Big It’s Brutal, Report on Business, The Globe and Mail: Toronto, June 2006, p 64.

Bob Landis, Readings from the Book of Barrick: A Goldbug Ponders the Unthinkable, [www.goldensextant.com](https://www.goldensextant.com) , May 21, 2002

Richard Rohmer, Golden Phoenix: The Biography of Peter Munk, Key Porter Books, 1999

Ferdinand Lips, Gold Wars, Will Hedging Kill the Goose Laying the Golden Egg? p 161-167,

New York: FAME,

George Bush’s „Heart of Darkness” — Mineral Control of Africa, Executive Intelligence Review,

January 3, 1997, see in particular:

### Barrick’s Barracudas

### Inside Story: The Bush Gang and Barrick, by Anton Chaitkin

### George Bush’s 10 billion giveaway to Barrick, by Kark Sonnenblick

### Bush abets Barrick’s Golddigging, by Gail Billington

### See also: [american_almanac.tripod.com](http://american_almanac.tripod.com/bushgold.htm)

## Disclaimer And Conflicts

THE PUBLICATION OF THIS ARTICLE IS SOLELY FOR YOUR INFORMATION AND

ENTERTAINMENT. THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT,

NOR IS HE SUGGESTING THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A

RECOMMENDATION TO BUY OR SELL ANY SECURITY. HE HAS NO POSITION, LONG OR

SHORT, IN BARRICK STOCK, NOR DOES HE INTEND TO ACQUIRE ONE. THE CONTENT OF THIS ARTICLE IS DERIVED FROM INFORMATION AND SOURCES BELIEVED TO BE

RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT IT IS COMPLETE OR

## Error-Free, And It Should Not Be Relied Upon As Such.

---

*October 4, 2007*

---

# Can We Have Inflation and Deflation at the Same Time?

URL: https://newaustrianeconomics.com/archive/fekete/can-we-have-inflation-and-deflation/
Date: 2007-09-23
Section: Popular Economics
Difficulty: intermediate
Concept Tags: deflation, hyperinflation, bond-market, capital-destruction, fiat-currency, interest-theory
Description: Fekete argues that under irredeemable currency it is possible — indeed likely — to have inflation in consumer goods prices and deflation in capital values simultaneously. The mechanism is the Kondratiev cycle operating under fiat money: as the bond bull market matures, capital is destroyed even as consumer prices rise, producing the stagflation and capital destruction that conventional economics cannot explain.
Editorial Note: Written September 2007, as the first signs of the 2008 financial crisis were appearing. Fekete's framework for simultaneous inflation and deflation proved useful in understanding the subsequent crisis, when commodity prices rose while real estate and financial assets collapsed.
Original PDF: https://professorfekete.com/articles/AEFCanWeHaveInflationAndDeflation.pdf

*Can We Have Inflation And Deflation All At The Same Time?*

**Antal E. Fekete** · Gold Standard University Live · [aefekete@hotmail.com](mailto:aefekete@hotmail.com)

### The curse of electronic dollars

Helicopter Ben has just made a most unpleasant discovery. Earlier he has promised that the Federal Reserve will not stand idly by while the dollar deflates and the economy slides into depression. If need be, he will go as far as having dollars air dropped from helicopters.

Time came to make good on those promises in August when the subprime crisis erupted. To his chagrin Ben found that electronic dollars, the kind he can create instantaneously at the click of the mouse in unlimited quantities, cannot be air dropped. They just won’t drop.

For electronic dollars to work they have to be able to trickle down through the banking system. The trouble is that when bad debt in the economy reaches critical mass, it will start playing hide-and-seek. All of a sudden banks become suspicious of one another. Is the other guy trying to pass his bad penny on to me? In extremis, one bank may refuse to take an overnight draft from the other and will insist on spot payment. A field day for Brink’s. The clearing house is idled, and armored cars deliver FR notes and certified checks on FR deposits in both directions up and down Wall Street.

Under such circumstances electronic dollars won’t trickle down. In effect they are frozen.

Ultimately, they may be demonetized by the market. How awkward for Helicopter Ben. He would now have to go back to the old-fashioned and cumbersome way of inflating the money supply via the printing press. Literally.

### Northern Rock and Roll

He had better, and do it double quick. The Northern Rock and roll fever may spill over across the Atlantic from England to the United States. Northern Rock is a bank headquartered in Newcastle with lots of branches in the Northern Counties. It was a high-flyer using novel ways of financing mortgages through conduits and other SIV’s, instead of using the more traditional methods of building societies through savings. (SIV or Structured Investment Vehicle is euphemism for borrowing short, lending long through securitization). Now a run on the bank has grounded the high flier. As long queues in front of the doors of branch offices indicate, a world-wide run on banks may be in the offing. Bank runs were thought to be a pathology of the gold standard. In England they haven’t seen the like of it since 1931 when the bag lady of Threadneedle Street went off gold. Surprise, surprise: bank runs are now back in vogue playing havoc on the fiat money world. Depositors want to get their money. Not the electronic variety. They want money they can fold.

There’s the rub. Pity Helicopter Ben. It looked so simple a couple of weeks ago. The promise of an air drop should stem any run. It sufficed that people knew he could do it. No reason to mistrust the banks since they are backed up by air drops. Now people have different ideas. The air drop is humbug. Can’t be done. Ben is bluffing. As calculated by Alf Field writing in Gear Today, Gone Tomorrow ([www.gold-eagle.com](https://www.gold-eagle.com), September 6, 2007) if only ten percent of the notional value of derivatives is bailed out by dropping \$500 FR notes the pile, if notes are stacked upon one another, would be nearly 9000 miles high. Helicopter Ben hasn’t reckoned that FR notes do not exist in such quantities. They will have to be printed before they can be dropped. Even if they existed, to drop them all would take years, and by that time the shaky house of cards of FR credit might be blown away.

And bailing out just ten percent of the derivatives mess is a conservative estimate. You may have to bail out a lot more than that.

### Devolution

What does it all mean? At minimum it means that we can have inflation cum deflation. I am not referring to stagflation. I refer to the seemingly impossible phenomenon that the money supply inflates and deflates at the same time. The miracle would occur through the devolution of money. This is Alf Field’s admirable phrase to describe the „good money is driven out by bad” syndrome. Electronic dollars driving out FR notes. The more electronic money is created by Helicopter Ben, the more FR notes will be hoarded by banks and financial institutions while passing along electronic dollars as fast as they can. Most disturbing of all is the fact that FR notes will be hoarded by the people, too. If banks cannot trust one another, why should people trust the banks?

Devolution is the revenge of fiat money on its creator, the government. The money supply will split up tectonically into two parts. One part will continue to inflate at an accelerating pace, but the other will deflate. Try as it might, the Federal Reserve will not be able to print paper money in the usual denominations fast enough, especially since the demand for FR notes is global. Regardless of statistical figures showing that the global money supply is increasing at an unprecedented rate, the hand-to-hand money supply may well be shrinking as hoarding demand for FR notes becomes voracious. The economy will be starved of hand-to-hand money. Depression follows deflation as night follows day.

### Decoupling tectonic plates

Side-by-side of deflation of hand-to-hand money there will be hyperinflation as the stock of electronic money will keep exploding along with the price of assets. You will be in the same boat with the Chinese (and the son of Zeus: Tantalus). You will be put through the tantalising water torture  trillions of dollars floating by, all yours, but which you are not allowed to spend. The two tectonic plates will disconnect: the plate carrying electronic dollars and the plate carrying FR notes, with lots of earthquakes along the fault line. No Herculean effort on the part of the government and the Federal Reserve will be able to reunite them. At first, electronic dollars can be exchanged for FR notes but only against payment of a premium, and then, not at all.

### The curse of negative discount rate

If you think this is fantasy, think again. Look at the charts showing the collapse of the yield on T-bills.

While it may bounce back, next time around the discount rate may go negative. You say it’s impossible? Why, it routinely happened during the Great Depression of the 1930’s. Negative discount rate means that the T-bill gets an agio, the discount goes into premium even before maturity, and keeps its elevated value after. This perverse behavior is due to the fact that the T-bill is payable in dollars. Yes, the kind you can fold, the kind that is in demand exceeding supply, the kind people and financial institutions hoard, the kind foreigners have been hoarding for decades through thick and thin: FR notes. Thus T-bills are a substitute for the hard-to-come-by FR notes. Mature bills may stay in circulation in the interbank market, in preference to electronic dollar credits*. Why, their supply is limited, isn’t it, while the supply of electronic dollars is unlimited! The beauty of it all is that we have an accurate and omnipresent indicator of the premium that cannot be suppressed like M3: the

(negative) T-bill rate. This is an indicator showing how the Federal Reserve is losing the fight against deflation.

### Inverted pyramid of John Exter

The grand old man of the New York Federal Reserve bank’s gold department, the last Mohican, John Exter explained the devolution of money (not his term) using the model of an inverted pyramid, delicately balanced on its apex at the bottom consisting of pure gold. The pyramid has many other layers of asset classes graded according to safety, from the safest and least prolific at bottom to the least safe and most prolific asset layer, electronic dollar credits on top. (When Exter developed his model, electronic dollars had not yet existed; he talked about FR deposits.) In between you find, in decreasing order of safety, as you pass from the lower to the higher layer: silver, FR notes, T-bills, Tbonds, agency paper, other loans and liabilities denominated in dollars. In times of financial crisis people scramble downwards in the pyramid trying to get to the next and nearest safer and less prolific layer underneath. But down there the pyramid gets narrower. There is not enough of the safer and less prolific kind of assets to accommodate all who want to „devolve”. Devolution is also called „flight to safety”.

An example of this occurred on Friday, August 31, 2007, as indicated by the sharp drop in the

T-bill rate from 4 to 3%, having been at 5% only a couple of days before. As people were scrambling to move from the higher to the lower layer in the inverted pyramid, they were pushing others below them further downwards. There was a ripple effect in the T-bill market. The extra demand for T-bills made bill prices rise or, what is the same to say, T-bill rates to fall. This was panic that was never reported, still less interpreted. Yet it shows you the shape of things to come. We are going to see unprecedented leaps in the market value of T-bills, regardless of face value! You have been warned: the dollar is not a pushover. Electronic dollars, maybe. But T-bills (if you can fold them) and FR notes will have an enormous staying power. Watch for the discount rate on T-bills morphing into a premium rate!

It is interesting to note that gold, the apex of the inverted pyramid, remained relatively unaffected during the turmoil in August. Scrambling originated in the higher layers. Nevertheless, ultimately gold is going to be engulfed by the ripple effect as scrambling cascades downwards. This is inevitable. Every financial crisis in the world, however remote it may look in relation to gold, will ultimately affect gold, perhaps with a substantial lag. The U.S. Government destroyed the gold standard 35 years ago, but it could not get gold out of the system. It was not for want of trying, either, as we all know. Gold remains firmly embedded as the apex of Exter’s inverted pyramid.

Vertical devolution is not the only kind that occurs in the inverted pyramid. There are similar movements that can be described as horizontal. Nathan Narusis of Vancouver, Canada, is doing interesting research on the Exter-pyramid. He noted that in addition to vertical there is also horizontal devolution. Within each horizontal layer of the same safety class there are discernible differences. An example is the difference between gold in bar form and gold in bullion coin form, or silver in bar form and silver in the form of bags of junk silver coins. Franklin Sanders in Tennessee is an expert on horizontal devolution of silver and has a fascinating study how the discount on bags of junk silver coins may go into premium, and vice versa. There may also be differences between FR notes of older issues and FR notes of the most recent vintage. There are obvious differences between the CD’s of a multinational bank and those of an obscure country bank. The point is that movement of assets horizontally between such pockets within the same safety layer is possible and may be of significance as the crisis unfolds and deepens.

### Dousing insolvency with liquidity

In a few days during the month of August central banks of the world added between \$300 and 500 billion in new liquidity in an effort to prevent credit markets from seizing up. The trouble is that all this injection of new funds was in the form of electronic credits, boosting mostly the top layer, where there was no shortage at all, if anything, there was a superabundance. Acute shortage occurred precisely in the lower layers. This goes to show that, ultimately, central banks are pretty helpless in fighting future crises in an effort to prevent scrambling to escalate into a stampede. They think it is a crisis of scarcity whereas it is in fact a crisis of overabundance.

I feel strongly that this aspect of research on the denouement of the fiat money era has been lost in the endless debates on the barren question whether it will be in the form of deflation or hyperinflation. Chances are that it will be neither, rather, it will be both, simultaneously. There is a little-noticed and little-studied continental drift beween the money supply of electronic dollars and the money supply FR notes. (Continental drift of the geological variety is invisible and can only be studied with the aid of high-precision instruments.) The tectonic plate of electronic dollars will keep inflating at a furious pace, while that of FR notes and T-bills will deflate because of hoarding by financial institutions and the people themselves. The Federal Reserve will be unable to convert electronic dollars into FR notes, as present denominations cannot be printed fast enough physically in times of a crisis. If it comes out with new denominations by adding lots more zero’s to the face value of the FR notes, then the market will treat these the same way as it does treat electronic dollars.

### Genesis of derivatives

Alf Field (op.cit.) is talking about the „seven D’s” of the developing monetary disaster: Deficits, Dollars, Devaluations, Debts, Demographics, Derivatives, and Devolution. Let me add that the root of all evil is the double D, or DD: Delibetare Debasement. In 1933 the government of the United States embraced that toxic theory of John Maynard Keynes (who borrowed it from Silvio Gesell). It was put into effect piecemeal over a period of four decades. But what the Constitution and the entire judiciary system of the United States could not stop, gold could. It was found that gold in the international monetary system was a stubborn stumbling block to the centralization and globalization of credit.

So gold was overthrown by President Nixon on August 15, 1971 by a stroke of the pen, as he reneged on the international gold obligations of the United States. This had the immediate effect that foreign exchange and interest rates were destabilized, and prices of marketable goods embarked upon an endles spiral. In due course derivates markets sprang up where risks inherent in the interest and forex rate variations could be hedged. The trouble with this idea, never investigated by the economic profession, was that these risks, having been artificially created, can only be shifted but cannot be absorbed. By contrast, the price risks of agricultural commodities are nature-given and, as such, can be absorbed by the speculators.

The important difference between nature-given and man-made risks is the very cause of the mushrooming proliferation of derivatives markets, at last count half a quadrillion dollars strong (or should I say weak?!) Since the risk involved in the gyration of interest and forex rates can only be shifted but cannot be cushioned, there started an infinite regression as follows.

The risk involved in the variation of long-term interest rates we may call x. The problem of hedging risk x calls for the creation of derivatives X (e.g., futures contracts on T-bonds). But the sellers of X have a new risk y. Hedging y calls for the creation of derivatives Y (e.g., calls, puts, strips, swaps, repos, options on futures and, with tongue in cheek: futures on options, options on options, etc.) Sellers of Y have a new risk z. The problem of hedging z will necessitate the creation of derivatives Z. And so on and so forth, ad infinitum.

### J’accuse

We have to interpret the new phenomenon, the falling tendency of the T-bill rate accurately. Maybe the financial media will try to put a positive spin on it, for example, that it demonstrates the strength of the dollar. However, I want to issue a warning. Just the opposite is the case. We are witnessing a sea change, tectonic decoupling, a cataclismic decline in the soundness of the international monetary system. The world’s payments system is in an advance state of disintegration. It is the beginning of a world-wide economic depression, possibly much worse than that of the 1930’s.

We have reached a landmark: that of the breaking up of centralized and globalized credit, the close of the dollar system.

J’accuse  said Zola when he assailed the French government for fabricating a case of treason against artillery captain Alfred Dreyfus in 1893. It is now my turn.

J’accuse  the government of the United States under president Roosevelt reneged on the domestic gold obligations of the U.S. in violation of the Constitution, and violated people’s property rights without due process by confiscating gold in 1933

J’accuse — academia has been pussyfooting the government by failing to point out the economic consequences of gold confiscation, namely, the prolonged suppression of interest rates that was ultimately the cause of prolonging depression**

J’accuse — the government of the United States under president Nixon reneged on the international gold obligations of the U.S. thereby globalizing the monetary crisis in 1971

J’accuse — cringing academia failed to point out the consequences of gold demonetization: price spiral of marketable commodities world-wide; roller-coaster ride of long-term interest rates, up to 16 percent per annum and down to 4 percent per annum or lower and back up again; the fact that interest rates may take prices along for the ride

J’accuse — foreign governments accepted Nixon’s breach of faith without demur, apparently because in exchange for their compliance they were given the freedom to inflate their own money supply with abandon on the coattails of dollar inflation

J’accuse — the banks have embraced the regime of irredeemable currency with gusto and greatly profited from it, instead of protesting that under such a regime it was impossible to discharge the bank’s sacred duty to act as the guardian of the savings of the people and the value of the inheritance of widows and orphans

J’accuse the accounting profession for their compliance in accepting gravely compromised accounting standards that convert liabilities into assets in the balance sheets of the government and the Federal Reserve.

In the words of Chief Justice Reynolds, in delivering the dissenting minority opinion on the

1935 Supreme Court decision, that upheld president Roosevelt’s confiscation of people’s gold, „Loss of reputation for honorable dealing will bring us unending humiliation. The impending legal and moral chaos is appalling.”

No less appalling, we may add, is the impending financial and economic chaos.

---

*September 23, 2007*

### ________________________

*An object lesson in negative T-bill rate is being presented as I write this on Thursday, September 20, 2007. The 30-day silver lease rate has gone to minus 0.1 percent. I wish analyst Ted Butler stopped bitching about manipulation and instead of telling fairy tales about raptors and dinosaurs explain to us what the negative silver lease rate means. My own explanation is panic short covering in silver.

Normally the price of silver moves in tandem with that of gold. In case the rising price of silver lags substantially behind that of gold, negative lease rate may develop, indicating that silver is delivered faster by the lessees than the lessors are willing or able to take (for example, if the lessors assumed until the last minute that the leases will be rolled over). Under these circumstances the lessor is happy to leave the silver with the lessee even after the lease expired. This seems to explode the myth about an acute shortage of silver, so ardently spread by Butler. The rising price of silver that may well follow the panic short-covering has nothing to do with shortages. Just the opposite.

Concerning the case of a negative T-bill rate, the pinching shoe is on the other foot. Here we do have a shortage, namely, a physical shortage of FR notes in which the bill is supposed to be paid.

But since the borrower is the government, there is no presumption of a default, so the mature T-bill is monetized by the market to alleviate the shortage.

** The causal connection between gold confiscation and the prolonging of the Great Depression should be clear. Gold must be seen as the main competitor of bonds. Once the competitor is forcibly removed, bond prices start rising or, what is the same to say, interest rates start falling. Linkage between falling interest rates and falling prices did the rest.

---

# Exploding the Myth of Silver Shortage

URL: https://newaustrianeconomics.com/archive/fekete/exploding-the-myth-of-silver-shortage/
Date: 2007-09-23
Section: Popular Economics
Difficulty: intermediate
Concept Tags: silver, bimetallic, gold-basis, sound-money, gold-standard
Description: Fekete argues that claims of a physical silver shortage are misleading because they apply industrial commodity logic to a monetary metal. The relevant question is not whether silver ore in the ground is running out but whether silver coins and bars are being withdrawn from circulation — and on this measure, silver is experiencing the same monetary withdrawal that gold is.
Editorial Note: Written September 2007. Fekete uses the silver shortage debate to illustrate the fundamental distinction between monetary and non-monetary commodities — a theme he had developed in 'Monetary versus Non-Monetary Commodities' (June 2006).
Original PDF: https://professorfekete.com/articles/AEFExplodingTheMythOfSilverShortage.pdf

## Exploding The Myth Of Silver Shortage

### What Does the Negative Silver Lease Rate Really Mean?

**Antal E. Fekete** · Gold Standard University Live · [aefekete@hotmail.com](mailto:aefekete@hotmail.com)

On Thursday, September 20, 2007, the lease rate of silver suddenly dipped into negative territory. It fell to minus 0.1 percent per annum. I wish Ted Butler stopped bitching about silver manipulation, and telling fairy tales about raptors and dinosaurs, and instead explain the behavior of silver lease rates and the silver basis to his readers. In particular, explain negative lease rates and basis. It may be more helpful in promoting an understanding of the silver market.

I have a long-standing disagreement with silver analyst Ted Butler. I hold the view that silver is a monetary metal, second only to gold in importance. Supply-demand analysis of price is not applicable to silver, still less to gold. The reason is that supply and demand are undefinable in case of a monetary metal. There is no way to quantify speculative supply and demand. Speculators make split-second decisions to become a seller from a buyer or the other way round.

Making price predictions for the silver price on the basis that it is allegedly scarcer than gold does not make sense. Silver has been, is, and will continue to be cheaper than gold for a monetary reason that is just the opposite of the scarcity argument. The monetary stockpiles of gold are much larger than that of silver. Therefore there is less of a threat for the value to drop on account of new additions to the stockpile in the case of gold than in the case of silver. It is not the absolute change in mine output, for example, that has an impact on the value of a monetary metal, but the relative change as a percentage of existing stockpiles. For this reason gold is more valuable than silver: the huge stockpiles of gold make the impact of a change smaller. Ergo the value of gold is more stable. In technical language, the marginal utility of gold declines more slowly than that of silver.

As a consequence, the specific value of gold is higher. This means that the value of unit weight of gold is higher than that of the same weight of silver. Once this fact has been firmly established by the markets, it is not likely to change for the following simple reason. The monetary metal with the higher specific value is more portable, both in space and time. In more details, the cost of transporting the unit of value as represented by gold is lower. For example, if the bimetallic ratio is 15, then the cost of transporting the unit of value as represented by silver is about 15 times higher. Roughly the same rule applies to the cost of storage as well. This makes gold the superior monetary metal, as it is more suitable for the purposes of transferring value in space as well as in time than silver.

But silver is still a monetary metal, and for certain application, such as parcelling out value in ever smaller bits, for example, silver could be superior to gold. And, of course, when it comes to industrial applications, silver has a very impressive array of those. In many cases there is no substitution for silver. However, do not make the mistake to think that gold has no industrial applications. It does but, because of its high specific value, these applications are mostly submarginal and as such they are ignored. In 1922 Lenin gave a textbook example of such a submarginal application of gold that became famous. He told a meeting of Communist party activists that, after the final victory of Communism world-wide, gold will be used for the purpose for which it is so superbly fitted, namely, to plate the walls of public urinals. He did not say that his plan could not be realized in the worker’s paradise because workers would pick the gold plate of urinals just as fast as the government was installing them.

Another common mistake people make when comparing gold and silver is to say that gold is „not consumed” and therefore practically all the gold produced is still available while silver is „consumed” and, hence, is getting scarcer relative to gold all the time. The truth is that both gold and silver are consumed, for example, in the arts (including jewelry). The difference is in the cost of recovery and refining, relative to the underlying value. Precisely because the specific value of gold is higher, the cost of recovery for gold is lower, so much so that gold in the form of jewelry is often lumped together with monetary gold for statistical purposes. By contrast, silver plate could not be lumped together with monetary silver. By the same token, the cost of refining gold is lower than the corresponding cost for silver expressed as a percentage of the underlying value.

Returning to the silver lease rate, this is not the first time it dipped into negative territory. Earlier in 2007, the 30-day lease rate was pretty consistently negative between May 25 and August 4, when it shot up and reached a high of plus 0.4 percent on August 31. The fact that negative silver lease rates are not impossible but a well-observed fact of the silver market has exploded the myth of a world-wide shortage of silver. Come to think of it: lessors of silver were willing to pay lessees a premium to borrow the metal. Before you rush over to ask lessors for free silver, you had better come to a correct understanding what negative lease rate means. The collapse of the silver lease rate on September 20 to negative territory meant panic short covering in silver. The shorts anticipated an imminent and substantial rise in the price of silver and were running for cover.

How did they know that the silver price was poised to rise? They were not led by crystal balls.

They acted on the historic correlation between gold and silver prices which customarily move „in sympathy” with one another. On September 10 the gold price was getting ready to break the resistance level at \$700, while the silver price lagged far behind in relative terms. The peak price of gold for the past 27 years, \$730 an ounce, was well within earshot. The corresponding peak silver price for silver, \$15, established in July, 2006, was not within earshot. Gold had a fair chance to make a new high soon, while silver, selling at \$12.75, didn’t. Nevertheless, if gold moved, it was reasonable to assume that silver would play catch-up. In the event the price of silver moved some (on Friday, September 21, it closed at \$13.50) and, according to analyst Clive Maund, „was set to go through the roof”

([www.321gold.com](https://www.321gold.com), September 20, 2007).

The point is that if this happens, the price move will not have been caused by any kind of shortage of silver. The notion that we have a silver shortage is preposterous. Most of the silver produced by the mines and sold by the U.S. Treasury during the past 60 or so years still exists in monetary form. Monetary silver is owned by private individuals, who entrust it to commercials skilled in making monetary silver yield a return. This is the reason why silver and gold are monetary metals: they can yield a (more or less consistent) return to their holder if traded adroitly and professionally.

This fact may not be too well known, but it is true nevertheless: „damonetization” has done nothing to destroy the unique ability of monetary metals to earn a return. Without a doubt, the best way of making this happen is through playing the short side of the market. To sit on a long position of silver will not hatch the silver egg and is not a very intelligent way to make silver yield a return. A better way is covered short selling which to the uninitiated appears to be naked short selling. It is not.

The commercials are neither stupid nor suicidal. They are professionals who make it their business to call the tops and bottoms in the price moves of monetary metals. It is well-known that they have an excellent track record in calling the market. This is not because they are vicious people who manipulate the market to their own advantage enticing the poor bulls to enter the slaughter-house.

They use methods that are well-known, pretty standard among professionals, and can be learned from textbooks. Using these methods they can turn the variable silver price to their advantage (or to the advantage of their clients on whose behalf they trade). You can join their ranks if you are willing to study those methods and go through the training which may be too rigorous to your taste.

If you are envious, or have moral objections against other people being able to make money consistently by trading the monetary metals, then you should lodge your complaint with the government which is responsible for „demonetizing” first silver (1873) and, a hundred years later, gold (1973). Before „demonetization” there were no commercials, speculators, and scalpers who made money by betting on the variation in the price of monetary metals. If they had tried to make a living that way, they would have starved to death. The prices of monetary metals were stable.

Whenever the price of silver significantly lags the rising price of gold, then there will be panic short covering and the leased silver will be returned to the lessors in a hurry. If the lessors were not prepared for this avalanche of silver (because they expected that the leases would be rolled over), then they may not be able to absorb the silver flowing back to them. In this case the silver lease rate drops dramatically and may even dip into negative territory.

It is important to be able to interpret this correctly. As I said, silver is delivered faster by the lessees than the lessors are able or willing to absorb it. Admittedly it is a market aberration, but whatever it means, it does not mean a shortage of silver. Far from it. It indicates a relative redundance of silver that momentarily cannot find lessors in view of an impending rise in the silver price.

Rumor-mongering about present or future silver shortages do not bring credit to the analyst.

He should go back to his textbooks and study the market in greater depth. Above all, he should learn the elementary differences between monetary metals and non-monetary commodities.

At Gold Standard University we study paraphernalia such as the gold and silver basis, the gold and silver lease rates and their variation. In addition we look at changes in the NAV (net asset value) of gold and silver ETF’s (exchange traded funds). We think the best way to make a profit consistently on silver and gold holdings in troubled times is bimetallic arbitrage At its crudest, this means selling silver to buy gold when the bimetallic ratio (gold price divided by silver price) falls, selling gold to buy silver when it rises. However, as a consequence of concentrated propaganda gold sales by central banks and governments, not only the gold price but also the bimetallic ratio is falsified. Therefore there is need for refinement and for other clues in addition to the bimetallic ratio. We believe that such more refined clues can be derived from the variation in the basis, the lease rate, the NAV of ETF’S, and the like.

As a preliminary announcement I mention that Session Three of Gold Standard University Live will have a feature discussion with the title GOLD PROFITS IN TROUBLED TIMES in February, 2008. As plans get finalized, further annouincements will be made.

---

# Peak Gold! Part Four

URL: https://newaustrianeconomics.com/archive/fekete/peak-gold-part-four/
Date: 2007-09-20
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, permanent-backwardation, fiat-currency, gold-standard
Description: Part four examines what happens after peak monetary gold is reached: the gold basis falls to zero and then goes negative (backwardation), signaling that no price can bring gold out of hiding. Fekete explains why this process, once begun, is self-reinforcing — the more the basis falls, the more gold is hoarded, which further reduces supply and pushes the basis lower.
Editorial Note: Fourth in the Peak Gold series, September 2007. Fekete develops the self-reinforcing dynamic of basis collapse and gold hoarding that he would later call 'permanent backwardation' — the irreversible withdrawal of gold from the monetary system.
Original PDF: https://professorfekete.com/articles/AEFPeakGoldPartFour.pdf

## Peak Gold!

### A Primer on True Hedging, Part Four

### Antal E. Fekete

### Gold Standard University aefekete@hotmail.com

"A hedged gold mine is a hole in the ground with a liar standing next to it"

### (With apologies to Mark Twain for refining his aphorism)

### Putting the cart before the horse

As discussed in Part One, a most unusual conference call took place on August 3 last.

Barrick President Greg Wilkins and Executive Vice President and CFO Jamie Sokalsky officially proclaimed Peak Gold! by disclosing that according to research commissioned by the company world gold production has peaked and will decline from now on. They suggested that we might expect a 10 to 15% drop in overall mine supply of gold within the next five to seven years, with obvious positive implications for the gold price. This was widely reported in the financial press.

What makes the announcement highly unusual, not to say suspect, is the fact that industry-leader Barrick still has 9,5 million gold ounces worth of open hedges and will suffer accordingly in the rising-price environment. It is just not logical, and even appears masochistic, to make such an upbeat announcement about the gold price first, and lift the hedges afterwards (as it is the destiny of all hedges to be lifted ultimately).

Since the company was in possession of such an explosive information impacting the gold price, the logical procedure should have been to lift the hedges first, and to release the report afterwards. The reverse-order procedure could hurt the company financially, hurting shareholders even more. Could it be that the top brass of the company has a hidden agenda and treats shareholders as dummies who do not understand the negative impact on the hedge book of a positive spin on the gold price by putting it even deeper under water?

### Captain and mate, first in the life boat

Well, we did not have to wait too long for the solution to the puzzle. On September 9 President Greg Wilkins exercised 100,000 options for company shares at \$27.30 each and sold all these shares the same day at prices ranging from \$38.30 to \$38.80. Next day, on September 10, executive vice president and chief financial officer Jamie Sokalsky turned up, and exercised 35,000 options for company shares at \$23.80 each. Then, between September 10 and 14, he exercised 90,900 more options for company shares at prices ranging from \$29.20 to \$30.70 each. He sold all these shares the same day at prices ranging from \$36.70 to \$36.74, thereby reducing his total company holdings to zero.

Total company holdings of president Wilkins was brought back to the original 47,500 shares ? according to the Canadian newspaper National Post, September 17 and 18, 2007.

After all, it is fitting that the president of a company own at least a few shares in the company, however reluctantly.

It is hard to escape the conclusion that the captain and his mate want to be the first to claim their seats in the life boat, ahead of women and children. By releasing that most optimistic report Wilkins and Sokalsky jacked up the share price artificially so that they could exercise their options, only to sell the shares right away while selling was still good ? and leave shareholders to their fate. If the share price collapses thereafter, too bad. The main thing is that captain and mate were home safe. Shareholders can be Barricked.

The sight of the captain and his mate grabbing the first seats in the life boat ahead of women and children is repulsive enough. But it is impossible to find the right words to express moral indignation if we consider that the mate is personally responsible for the calamity awaiting shareholders aboard the badly damaged ship, caused by the insane hedging policy of Barrick.

As reported in this column, I have challenged Sokalsky to explain why he had failed to heed my warning ten years ago that the unilateral hedging policy of the company is not only false but extremely dangerous for a gold mining company, in view of the 100% mortality rate of irredeemable currencies. I also gave him a copy of my 50-page memorandum entitled Gold Mining and Hedging - Will Hedging Kill the Goose to Lay the Golden Egg? which spelled out that there was such a thing as bilateral hedging. It is harmless and potentially just as profitable even in a bear market as unilateral hedging, if not more profitable. Above all, it is true hedging as opposed to false hedging.

My challenge has been ignored. Now we know why. Sokalsky and his boss were busy bailing out. Is S.S. Barrick sinking after hitting the iceberg of \$700 gold? Time will tell.

The ship is certainly badly damaged by the collision. The question Barrick shareholders must ask themselves is whether it is wise to entrust their fortunes to a heavily hedged company whose chief financial officer has just reduced his own exposure as a shareholder to zero and, together with the CEO, apparently has better ideas where to park his money. The case for owning Barrick shares speaks for itself.

In Part Three of this series I have explained the extremely precarious financial position of Barrick due to its 9,5 million ounces of open hedges, already deep under water, in a rising gold-price environment. Barrick's strategy is built upon the assumption, spelled out in the company's last Annual Report, namely, that gold lease rates remain stable. This assumption has now been fatally shaken by events in the gold market during the past couple of weeks. The specter of the supply of lease gold drying up looms large in the horizon. In consequence lease rates could explode, making one ounce of gold in hand worth several ounces in the bush (that is, locked up in ore reserves). There is no way to hedge against the risk that demand for cash gold will surpass supply of gold for lease. It is totally irrelevant what Barrick says about the flexibility of its arrangements with the bullion banks. Barrick's capital may turn out to be insufficient while bleeding gold in delivering mine output into the hedgebook for nothing. It is entirely possible that we are witnessing danse macabre, the last contango for Barrick. Backwardation of gold remains an enormous threat to Barrick's survival. After all, Messrs. Wilkins and Sokalsky should know best. They don't want to own Barrick shares. They have voted. With their feet.

## Disclaimer And Conflicts

## The Publication Of This Article Is Solely For Your Information

## And Entertainment. The Author Is Not Soliciting Any Action

## Based Upon It, Nor Is He Suggesting That It Represents, Under

## Any Circumstances, A Recommendation To Buy Or Sell Any

## Security. He Has No Position, Long Or Short, In Barrick Stock,

## Nor Does He Intend To Acquire One. The Content Of This Article

## Is Derived From Information And Sources Believed To Be

## Reliable, But The Author Makes No Representation That It Is

## Complete Or Error-Free, And It Should Not Be Relied Upon As

## Such.

### References

### A.E.Fekete, Peak Gold! Part Two, September 10, 2007

### A.E:Fekete, Peak Gold! Part Three, September 19, 2007

---

# Peak Gold! Part Three

URL: https://newaustrianeconomics.com/archive/fekete/peak-gold-part-three/
Date: 2007-09-19
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, permanent-backwardation, gold-standard, fiat-currency
Description: Part three examines the demand side of peak monetary gold, focusing on the accelerating withdrawal of gold into private hoards as confidence in paper money erodes. Fekete analyzes how eastern private demand — especially Indian and Chinese hoarding — is drawing gold permanently out of the Western monetary system and into private hands that will not recirculate it.
Editorial Note: Third in the Peak Gold series, September 2007. The demand-side analysis of eastern gold hoarding proved prescient — the surge in Asian gold demand that Fekete identified as structural has been a dominant feature of gold markets since 2008.
Original PDF: https://professorfekete.com/articles/AEFPeakGoldPartThree.pdf

### Double standard in gold hedging?

This is in answer to Mike Mish Shedlock's rejoinder Double Standard in Gold Hedging? [globaleconomicanalysis.blogspot.com](http://globaleconomicanalysis.blogspot.com) (September 11, 2007) to my Peak Gold! Part Two [www.gold-eagle.com](https://www.gold-eagle.com) (September 10, 2007). Mr. Shedlock challenges my claim that unilateral hedging by a gold mine, in particular, the practice of selling forward longer than one year, or quantities in excess of one year's mine output is, in effect, a naked short sale, involving unlimited risk. I have suggested that unilateral hedging and forward sale of several years' output are imprudent, fraudulent, and should not be allowed by the exchanges ? as they certainly are not in case of agricultural producers.

At this point I would like to remind my readers that the series Peak Gold! has not been concluded as I have not yet fully discussed what true (or bilateral) hedging as opposed to fraudulent (or unilateral) hedging is. But before I do that I feel it is necessary to answer the points raised by Mr. Shedlock, which I now do point by point in the same order he raised them.

### Unlimited risk is for real

### •

There is fraud involved in the practice of unlimited forward selling of gold beyond one year precisely because it may not be possible to deliver the gold as contracted. One year is the logical production cycle for gold. There is a difference between selling forward gold already in the pipelines moving towards the market, and selling forward gold still locked up in ore bodies. It is safe to assume that gold already in the pipelines will make it to the market. By contrast, gold locked up in ore bodies may not. The oft-quoted dictum that "there's many a slip between cup and lip" applies. Ore has to be extracted, pulverized, processed, and refined.

The company may not be there to do it if it goes bankrupt in the meantime ? for example, as a result of its foolish unilateral hedging policies.

### •

The idea of 'unlimited risk' involved in naked forward sales is real. The miner does not have the gold in hand. He has only a bird in the bush. In addition to the risk to potential profits there is the risk that the company will be foreclosed on its naked forward sales and go into receivership. Mr. Shedlock simply ignores the dynamics of the gold market. He ignores, for example, that forward sales as practiced by Barrick rely on gold lease rates remaining stable ? a fact admitted arrogantly in its last Annual Report. Perhaps Mr. Shedlock doesn't realize lease rates are nothing more thaín the fulcrum upon which the dollar-rate of interest and the future price of gold teeter in balance. But what if no more gold were available for leasing, as will surely happen when the central banks finally empty their cupboards? Lease rates would explode as one piece of gold in hand would be worth severalin the bush. I am grateful to Tom Szabo of [www.silveraxis.com](https://www.silveraxis.com) for pointing out to me that this could and would happen if the demand for gold becomes greater than the lease supply. There is no way to hedge against this risk.

The fact is that gold could go into backwardation so fast as not to allow time for the company to take defensive action. It will matter little then that Barrick claims a great deal of flexibility in its gold contracts since the very thing it has egreed to receive in exchange for gold ? U.S. dollars ? will have lost all of its value. Does Barrick have enough capital to deliver the "hedged" gold for nothing, and will it be given much time to do so? This is where Barrick would fing that backwardation poses a serious obstacle to its survival as the value of future gold production, and thus that of a gold mine, is but a fraction of the same amount of gold when held in the hand.

Bullion bankers are, no doubt, a nice bunch of people when they coax the gold miner into the trap of unlimited risk. They will not be nearly so nice when they get ready to make their margin call and take their pound of flesh, as any Shylock worth the name would.

### •

Sure, profit risk runs in both directions. This is exactly why true hedging must be bilateral involving forward purchases to complement forward sales. This is exactly why unilateral hedging is false hedging. It fails to be symmetric. Bullish sentiment is nipped in the bud, while the bearish variety is cheered on. It pretends to market a product at the best price available, but all it does is ruining its own market by inviting competitive short sales from other gold mines and speculators.

Profit risk running in both directions is the whole point of my series on Peak Gold!, a primer on true hedging, if you just have the patience to hear me out. I wonder if Mr. Shedlock has read the section in Part Two on bilateral hedging, namely, how a downstream short leg (forward sale) of a hedge ought to be complemented by an upstream long leg (forward purchase) representing down payment on gold bearing properties that the gold mine is in the process of acquiring. Bilateral hedging works with four-legged straddles, a short and a long leg downstream, plus a long and a short leg upstream. Unilateral hedging tries to get by with one-legged straddles: the only leg being the short one downstream. I ask you: which is going to win the race?

### •

A gold mine can never be smart enough to outsmart speculators who make it their business to forestall other market participants. It is outright stupid to pursue a market strategy of long-term forward selling, given the fact that in the futures markets nimble speculators make split-second decisions to turn from a buyer into a seller. By the time the gold mine, a dinosaur in comparison, has made its long- trumpeted forward sale, the speculators have run away with the best of the pick.

Unilateral long-term forward selling of gold could work, but only if governments or central banks have underwritten the losses that are almost certain to accrue.

### •

It is not a question of liking or not liking hedged mines. The demonstrable fact is that the leading hedger takes unfair advantage of all the other mines, hedged or unhedged, by forcing them to sell ahead of schedule at lower prices. Unilateral long-term forward selling is a predatory practice which enables the big fish to gobble up the small. No fair play is possible as long as the practice is allowed. For this reason the suggestion that if you don't like hedged mines you should short them is puerile. Shorting a predator may be suicidal.

### •

It is true that every production process has its production cycle. As Mr. Shedlock remarks, for agricultural commodities it is typically from harvest to harvest, or one year. Although for gold it is not so sharply delineated, it is reasonable to make the fiscal year to play that role. Once a year shareholders meet, elect new directors and there may be changes in management. Important decisions are made about acquiring new gold-bearing properties, prospecting, exploration, mine development. In this sense, yes, you plant in the first quarter to reap in the fourth, typically the busiest season for the gold mining concern.

### •

It is true that, as far as its fundamentals are concerned, gold production is far more stable than the production of agricultural commodities or, for that matter, the production of any other good. This is what makes gold such a superb monetary metal. It is foolish to suggest that gold, as a result of its 'demonetization', has ceased to have stable value ? fluctuating gold price notwithstanding. What the fluctuating gold price shows is not the lack of stability in the value of gold; it is the lack of stability in the value of paper currencies, issued by devaluation-happy governments, in which the price of gold is quoted. It is certainly not indicative of a mysterious disappearance of stability in the value of gold.

### •

The fluctuating price of gold, as well as fluctuating forex and interest rates, are not nature- given as are the fluctuating prices of agricultural products. They are man-made. They have deliberately been inflicted upon the people by governments in betrayal of their sacred mission to protect them. The fluctuating gold price and gyrating bond prices are the instrument of the most vicious exploitation the world has seen since chattel slavery. The government in regulating futures trading has approved "double standards" in an effort to create a practically infinite supply of ersatz gold, including paper gold (such as gold futures that can be sold greatly in excess of physical gold in existence), and unmined gold locked in ore bodies below ground (which can then be sold forward), in the hope of keeping the price of cash gold in perpetual check. This is not a myth. This is a well-established fact admitted, at one time or another, by many a government in its more sober moments.

### Niagara-on-Potomac

The world-wide regime of irredeemable currency would have come to a sorry end decades ago if it weren't for gambling casinos foisted upon the world by governments hell-bent to keep the game of musical chairs going non-stop. Governments, in the best tradition of casino owners, want people to gamble in gold, bond, and forex futures. The futures markets in gold, bonds and forex serve a purpose, and one purpose only: to provide an outlet for the Niagara-on-Potomac, money supply gushing forth from the Federal Reserve that could drown the entire world in a hyperinflationary deluge. If it hasn't, that's because excess money has been soaked up by the gambling casinos. So far.

People scramble for the excess because they could use them as chips at the gaming tables.

But as growth in the derivatives markets (the size of which doubles every other year and by now exceeds half a quadrillion dollars or \$500,000,000,000,000) shows, this is not a stable process secured with proper checks and balances. This is a runaway train on which the brakes (i.e., natural limitation on gold production) have been deliberately disabled.

Fraudulent hedging of gold mines, and double standards in regulating futures trading are part of the sabotage. This is a world disaster waiting to happen.

### Hedge fund masqerading as a gold mine

Mr. Shedlock has missed my point. We may honestly disagree on the question whether long-term unilateral hedges are prudent or fraudulent. But there is no ambiguity about the fraudulent nature of a hedge fund masquerading as a gold mine. If it is the world's biggest gold mining concern, then the masquerade assumes cosmic proportions.

I repeat the verdict: the gold carry trade is criminally fraudulent. In more details: to lease gold, to sell it for cash, to invest the proceeds like a hedge fund, and to report the income from these investments as profit to shareholders, as if they were profit from gold mining operations, constitutes fraud. Paper profit is no profit. It is encumbered with a contingent liability, the extent of which cannot be ascertained until the hedge is lifted and the hedgebook closed. The trouble is that by that time management will have spent the 'profit' taken out of the corporate treasury fraudulently.

The practice of window-dressing income statements using unrealized paper profits, especially as they are encumbered with unlimited liabilities, is a blatant fraud dealt with by the Criminal Code.

### Are Barrick's officers masochistic or incompetent?

In Peak Gold! Part One I mentioned that Barrick President Greg Wilkins and Executive Vice President and CFO Jamie Sokalsky announced extremely optimistic predictions about the gold price for the next five to seven years in a conference call that has been widely publicized. These predictions are based on a study of gold fundamentals commissioned by Barrick. (Reuters, August 3, 2007.)

Here is my parting shot to Mr. Shedlock. He says that he disagrees with Citigroup analyst John Hill, who publicly called on Barrick to rid itself of the remaining 9.5 million ounces left on its 'project' hedge book. According to Shedlock Barrick should not cover those hedges now at \$700. "If it did and the price of gold collapsed to \$500, Barrick would be in a world of hurt… Barrick would be betting the farm that prices are heading north of \$700 … and will stay there for quite some time… Is [this contingency] really worth betting the company on?"

I ask Mr. Shedlock what makes him think that Barrick's actual bet (namely, that the price of gold will collapse to \$500) is a more worthwhile contingency to bet the company on?

Who is Messrs. Wilkins and Sokalsky trying to fool in making prognostications potentially very damaging to the financial health of the company ? in view of its hedgebook deeply under water? Are they masochistic? Do they think that they have been hired by the shareholders to run the company aground? Why did they not lift all their socalled hedges, as John Hill suggested and Newmont has done, in good time, before releasing such a devastating report putting the company in jeopardy? This is what common sense would seem to dictate, to lift the hedge first, and make the announcement afterwards, is it not? If they did not have and could not raise the money to do it, at the very least they should have suppressed the optimistic prognostication on the gold price, in order to soften the blow to shareholders who are going to suffer one way or another the consequences of gold breaking above \$700, due to Barrick's insane hedging policy.

It is understandable that Barrick's officers are reluctant to admit publicly that they have made the most colossal blunder in the history of mining, by committing their company to the policy of unilateral downstream hedging through unlimited forward sales of gold.

Such an admission would be hard on the ego. They may hope against hope that their blunder will be quietly forgotten, and the shareholders will buy the desperate propaganda-line that a higher gold price is good for them, hedgebook or no hedgebook.

But you cannot keep kicking garbage upstairs to the attic forever, because it will keep rotting there until something gives and the accumulated garbage will come crashing down.

I have issued a public challenge to Barrick to explain why they ignored my warning ten years ago that unilateral downstream hedging is a dangerous trap they should avoid. I also pointed out to the top brass how their hedge plan could be made bilateral, a winning combination. Had they listened to my advice, they would have avoided having to carry the yoke of a millstone-size hedgebook around their neck. I take this opportunity to report that Barrick has so far ignored my challenge.

I am not sold on the conspiracy theory according to which Barrick is a front set up by governments to keep the gold price in perpetual check. Not yet anyhow. But then, the only conclusion is that the officers of Barrick are incompetent bunglers whose name will go down in ignominy in the annals of mining.

## Disclaimer And Conflicts

## The Publication Of This Article Is Solely For Your Information

## And Entertainment. The Author Is Not Soliciting Any Action

## Based Upon It, Nor Is He Suggesting That It Represents, Under

## Any Circumstances, A Recommendation To Buy Or Sell Any

## Security. He Has No Position, Long Or Short, In Barrick Stock,

## Nor Does He Intend To Acquire One. The Content Of This Article

## Is Derived From Information And Sources Believed To Be

## Reliable, But The Author Makes No Representation That It Is

## Complete Or Error-Free, And It Should Not Be Relied Upon As

## Such.

### Gold Standard University Live

As announced earlier, Gold Standard University Live, Session Three, is planning an open-ended debate and panel discussion on True versus False Hedging of Gold Mines, scheduled to take place during the weekend February 8-10, 2008. Sprott Asset Management of Toronto, Canada, has agreed to sponsor the event. Representatives of gold mines, hedged and unhedged, will be invited to participate. For further information please contact GSLU@t-online.hu .

---

*September 19, 2007*

---

# Peak Gold! Part Two

URL: https://newaustrianeconomics.com/archive/fekete/peak-gold-part-two/
Date: 2007-08-31
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, central-banking, gold-standard, monetary-policy
Description: Part two examines the supply side of peak monetary gold, analyzing how central bank leasing, forward selling by miners, and declining mine production have combined to reduce the flow of monetary gold. Fekete shows that the official supply statistics systematically overstate available gold because they count leased gold as if it were still in central bank vaults.
Editorial Note: Second in the Peak Gold series, August 2007. The specific claim about double-counting of leased gold in official statistics was controversial but anticipated later revelations about central bank gold accounting practices.
Original PDF: https://professorfekete.com/articles/AEFPeakGoldPart2.pdf

## Peak Gold!

### A Primer on True Hedging, Part Two

### Antal E. Fekete

### Gold Standard University Live aefekete@hotmail.com

### Hedging Fraudulent

In my previous papers I have explained that virtually all activities of gold mines that go under the name „hedging” are fraudulent. To the extent hedges go out into the future more than one year, or they exceed the quantity of one year’s production, they are naked forward sales, carrying unlimited risk (the risk that the gold price goes to infinity, as it has in the wake of every hyperinflation). To understand the motivation to resort to fraud, and to shoulder unlimited risk to boot, we must remember that the combined short positions in the futures and derivatives markets on gold greatly exceed monetary gold in existence. Without compulsively selling paper gold, a short squeeze and even a corner in cash gold could develop if the longs decided to call the bluff. Thus any exposure to the short side forces pyramiding to fend off the danger. On the other hand some shorts, especially bullion banks, have found the creation of ersatz gold a profitable business. They play a cat-and-mouse game with the longs. They have fashioned the rules of gold exchanges and ETF’s in their own favor in order to make delivery a cumbersome, expensive, and time-consuming procedure. As a result the price of gold could be thrown into a hole so that, whenever it tried to climb out, hedgers and speculators would rush in and club it down. The shorts can get away with it because the supply of paper gold (futures and option contracts) as well as unmined gold in the ground is virtually unlimited and can be mobilized in the anti-gold campaign. It speaks volumes of the inherent strength of gold that it could still climb out of the hole in 2001 in spite of a terrible assault to push it back. The 20th century belonged to the enemies of gold. There is no need to make predictions here about the 21st.

### Changing the nature of gold speculation

Significantly, the so-called hedging activity of gold mines has altered the strategic line-up in the gold market. Speculators have typically been on the long side. They have photographic memories and recall the propensity of governments to cry down the value of the national currency in terms of gold from time to time. The opposite procedure, writing up the value of the national currency in terms of gold is virtually unknown in the annals of monetary history. Given mine hedging, so-called, speculators have changed sides and compete with the mines to sell (paper) gold at the first sign of a bullish move in the price. The fraternity of speculators conceive of risk-free profits on the short side of the market as they attempt to forestall the mines. Having abandoned their traditional haunt on the long side, they are now converging on the short side of the gold market. Peak Gold is a predictible consequence. Unhedged gold mines, too, feel compelled under the threat of a falling gold price to produce gold at break-neck speed while neglecting prospecting and the development of gold properties. Once the producing mines get exhausted, the supply of new gold will decline.

In summary we might say that fraudulent hedging carries with it its own punishment: Peak Gold. It leads to ruthless exploitation of gold mining resources, with no prudent provision for replenishing them through prospecting and new mine development.

### ’Give a dog a bad name, might as well shoot him’

It is unfortunate that the perfectly honest and useful word „hedging” has been allowed to be abused and given a completely distorted meaning. As the saying goes, ’give a dog a bad name, might as well shoot him!’ It is difficult to explain the distinction between ’hedging true’ and ’hedging false’ when the connotation of the word ’hedging’ in the minds of the people is unsavory. It turns them off. Yet the mission of the monetary scientist obliges him to continue on the path of truth even if it is uphill all the way.

Hedging is a wide-spread practice of producers in all walks of the economy. To be valid and effective, it must be carried on at two levels: upstream and downstream. The former refers to the input, the latter to the output of production. At the input level the producer buys the resources that go into his final product. At the output level the producer is marketing his final product. The need for hedging arises as price fluctuations at either level, especially if they occur faster than adjustments can be made, may cause losses. Thus, worrying about the downstream, the producer is anxious to lock-in a favorable selling price as it may become available for his product prior to the end of the current production cycle. Worrying about the upstream, the hedger aims at locking-in a favorable buying price as it may become available for a major ingredient of his product prior to the beginning of his next production cycle.

### Upstream and downstream hedging

Hedging is most efficient if it is bilateral. As it has been practiced in gold mining hedging is unilateral. It involves forward sales by way of downstream, to the exclusion of the forward purchases by way of upstream hedging. It is a caricature of hedging. It pretends to overcome the fluctuation of the gold price as it affects the output of new gold. I say ’caricature’ because it is counter-productive.

Rather than allowing the producer to sell high while preserving the value of his unmined reserves, it forces him to sell low, and sell it fast, as the message is that the price is going to fall, and any delay in selling will involve losses.

Yet, if done properly, either type of hedge should contribute to profitability as well as husbandry. In combination they are a legitimate form of arbitrage, provided that the hedges are carried in the balance sheet, and profits (losses) from them are reported in the income statement. Hedges carried off-balance-sheet are not legitimate as they conceal a liability with the result that the income statement is falsified. Shareholders and creditors are misled. Directors and managers lock themselves into a fools’ paradise. Especially dangerous are downstream hedges carried off-balance-sheet, for reason that the short leg (forward sale) represents an unlimited liability. By contrast the long leg of an upstream hedge (forward purchase) represents but a limited liability. This difference is due to the fact that while the price of a commodity can never fall below zero, there is no identifiable limit above which it may not rise. Another way of expressing it is to say that the downstream hedge is subject to a squeeze and possibly to a corner. By contrast, there is no way to squeeze or to corner a producer with an upstream hedge.

I wish to return to the question why downstream hedges must be limited in size and in volume to one year. Total net short sales must never exceed one year’s output. The reason is that at the end of the fiscal year unsold output from the previous production cycle must be moved from the ’receivables’ to the ’stockpiles’ column, and the short leg of the hedge on them must be lifted. If they weren’t, then the arbitrage would be turned from hedging into outright speculation on the short side representing unlimited liability. Profits are paid out masquarading as dividends. It results in hiding paper losses.

Such antics constitute a fraud.

### Capital destruction

I must confess that I cannot understand the utter lack of business acumen on the part of gold mining executives, still less on the part of investment bankers that finance their activities, in embracing such a contradictory and self-defeating strategy of marketing gold. They should be interested in maximizing the price of their product. Instead, they engineer a falling price trend. They should be interested in maximizing the working life of their gold producing property. Instead, their marketing policy directly contributes to the premature exhaustion of the mines. A lot of observers jump to the conclusion that the gold mines and the bullion banks, in partnership with the government, form a conspiracy to club down the gold price. Theirs is a hidden agenda. The gold mine management is interested in defalcation, that is to say, to trick their stockholders out of their equity. The bullion banks think that they can harness perpetual motion in the artificially induced oscillating movement in the price of gold.

Governments look at the gold price as a messenger with an embarrassing message about the depreciation of currency. The messenger had better be shot. Governments know that a steep increase in the gold price will cause panic. Such a panic has historically served as the harbinger of hyperinflation. It must be prevented by hook or crook.

I find this reasoning unattractive. Such a conspiracy can never be proved or disproved.

Governments probably use more subtle methods.

### Double standard

Most ’hedged’ gold mines are in violation of the important restriction that downstream hedges must not exceed one year’s gold output and they must be lifted before the end of the fiscal year. Their practice transgresses not only the limits of prudence, but also the limits of upright business management. A gold mine selling forward in excess of one year’s output is guilty of fraud. It is concealing a potentially unlimited liability. The accounting profession, the commodity exchanges, and the government’s watchdog agencies have never offered an acceptable explanation for the double standard they apply, one for the gold mining industry, and another one for everyone else. While they allow gold mines to sell forward several years’ production, they would immediately blow the whistle if, for example, an agricultural producer tried to do the same. It is well understood that forward sales in excess of one year’s production are a predatory practice designed to hurt or destroy competition. It is also hurting other market participants downstream.

There is no justification for this double standard. It is scandalous that the government grants legal immunity to gold mines using fraudulent hedges. Worse still, the fraud is facilitated by central banks willing to lease gold which, as the bank well knows, the mine will sell for cash. Central banks are accomplices in the scheme of fraudulent hedging since they report gold that has been leased and sold as if it were still sitting in their vault. It is a form of double-counting gold by modern accounting techniques.

Selling forward more than one year’s output is no hedging. It is outright speculation on the short side of the market in anticipation of a decline in the gold price. Not only is such a ’naked bear speculation’ illegitimate as it falsifies the balance sheet and conceals an unlimited liability, but it also makes the prospectus meaningless. There is no mention in the prospectus of any intention to indulge in short selling that inevitably results in the premature exhaustion of ore reserves and in the dissipation of the most valuable resources of the mine at artificially low prices. On this ground alone the gold mine is open to class action suit by the shareholders.

### Shareholders being hit three times

Furthermore, naked bear speculation makes no economic sense for the mine. By virtue of its net short positions the gold mine assumes a vested interest in a lower and falling gold price which clashes with its main mission of selling newly mined gold at the highest possible price. Such division of loyalties is inadmissible for a firm commissioned by its shareholders to convert wealth represented by ore reserves into wealth represented by bullion in a most advantageous manner. The managers of the

’hedging’ gold mine have a schizophrenic stance as they are prompted to pray for a higher and a lower gold price all at the same time. No enterprise with a schizophrenic management team can survive the vicissitudes of market competition and the shareholders’ ire for long. Shareholders get hit three times through the schizophrenic action of the managers. First, income is shaved every time the gold price is forced lower through short selling. Second, capital is being destroyed as the falling gold price makes payable ore reserves to disappear (i.e., become non-payable). Third and most serious is the fact that the richest ore reserves are being frittered away for a pittance at the artificially suppressed gold price, thereby materially shortening the working life of the mine. Naturally, the share price will show not only the shaving of income and destruction of capital, but the premature aging of the gold mine as well.

### Paper profit no profit

Advocates of this senseless practice, in particular, the officers of Barrick Gold argue that these losses are more than compensated for by the extra income the firm generates from ’investments’ made with the proceeds of forward sales. But insofar as this extra income is encumbered with unlimited liabilities represented by the fraudulent downstream hedge, it consists of paper profits that should not be paid out in the form of dividends. In fact, they should not be reported as profits in the first place. „There’s many a slip between cup and lip”, as the proverb says. Hidden liabilities may force the firm out of business before it has a chance to realize its paper profits. The practice of window-dressing income statements using unrealized paper profits, especially as they are encumbered with unlimited liability, is blatant fraud and no amount of sophistry or government connivance will change that fact. It is the height of insolence on the part of management to treat shareholders as simpletons unable to understand the difference between paper profits on an open forward sale contract, and profits that have been consummated by closing out such a contract.

### Bilateral hedging

Apologists for the practice of naked bear speculation by gold mines try to push the blame on to the banks. They point out that mines could not get financing unless they heeded the bid of banks to sell forward several years of output as collateral for the loan. Let us leave aside the fact that the banks in setting conditions involving fraud become partners in crime. It is possible that they enjoy the same immunity from criminal prosecution as the mines. Even then the argument is not persuasive. The banks are not micro-managing the mines. The responsibility for fraudulent forward sale of several years of output rests with mining management. It could have used true hedging to satisfy the banks.

In the third, concluding part of this series I shall describe in full details bilateral hedging. It is proper hedging that gold mines can practice without harming anyone. It involves upstream hedging that consist of forward purchases of gold, to compensate for the forward sales of the downstream hedging. This will reveal that the compensating long leg of Barrick’s straddle is missing. Therefore the so-called hedges of Barrick constitute no valid arbitrage. They are merely tools for illegitimate naked short speculation. They invite severe punishment in a bull market. By contrast, bilateral hedging is for all seasons. The mine prospers in a bull market as well as in a bear market.

A unilateral short hedge can always be converted into a bilateral hedge through adding a compensating unilateral long hedge. Forward sales should be matched by forward purchases. A bilateral hedge is the combination of a downstream and an upstream hedge. It is a legitimate hedge, as forward sales are compensated by forward purchases. It never gives rise to unlimited liability.

For example, an upstream hedge is created by the gold mine when a sudden fall occurs in the gold price. Since management is on the look-out for new gold-bearing properties to buy, in order to replace ore reserves that are being exhausted by its mining activities, the sudden fall in the gold price represents an outstanding yet ephemeral opportunity. It knocks down the value of gold-bearing properties and that of the stakes of prospectors. However, the opportunity to buy the property or the stake at such an excellent price is likely to elude the gold miner who has to go through the lengthy process of searching the title and checking the quality and quantity of gold ore in the ground. By the time this process is completed, the gold price might have surged forward making the opportunity to add to ore reserves at a reasonable price disappear.

To lock in a favorable price is possible nevertheless through the forward purchase of gold. The miner creates a straddle or upstream hedge, the long leg of which is a long position in the futures market, while the short is the gold-bearing property under negotiation. Care is taken to match the value of the property with the number of futures contracts to purchase. When the deal is closed out and the property is bought, the long leg is lifted and the upstream hedge unwound. The point is that the miner is under no time pressure to close out the deal prematurely. Even if eventually he is paying more in consequence of the surging gold price, the miner is compensated for that by profits on the long leg of his straddle. It is true that there would be a loss on the long leg if the gold price fell further. This is no problem, since the lower price paid for the gold-bearing property will take care of that loss. Adding the upstream hedge converts unilateral into bilateral hedging. It makes the illegitimate forward sale of several years’ mine output legitimate. The short leg of the downstream hedge is compensated for by the long leg of the upstream hedge. The forward purchase removed the unlimited liability that was created by the forward sale of gold. The fraternity of gold speculators will return to their traditional haunt, the long side of the gold market. Gold investors are not hurt by the hedging activities of the gold mines, provided the hedges are proper.

Figuratively we may describe the proper hedges of a gold mine as a four-legged straddle. Two legs are in the upstream and the other two in the downstream market. The short leg downstream

(forward sales) is counter-balanced by the long leg upstream (forward purchases) — just as the long leg downstream (gold in the ground about to be mined) counter-balances the short leg upstream (gold property about to be acquired).

### Gold Standard University Live

Gold Standard University Live has just completed its Session Two at the Martineum in Szombathely, Hungary. Session Three is planned in Bessemer (nearest airport Birmingham), Alabama, U.S., in February 2008. It will feature a one-week course entitled Adam Smith’s Real Bills Doctrine. An advocatus diaboli from neighboring Mises Institute will be invited to come and challenge the wisdom of Adam Smith.

The session in Alabama will also feature a blue ribbon panel discussion on the subject of True Hedging for Gold Mines. Representatives of hedged and unhedged gold mines will be invited to participate. The present series Peak Gold! is a primer on true hedging, and a book is planned that would cover the proceedings of the conference.

For the benefit of prospective participants from Europe, Session Three may be repeated at the Martineum in early March, 2008, provided that a sufficient number register.

This is a preliminary announcement only. Stay tuned. For more information please contact:

### GSUL@t-online.hu

### References

A. E. Fekete, Peak Gold! (Part One), [www.gold-aegle.com](https://www.gold-aegle.com) , August 17, 2007

A. E. Fekete, Have Gold Bugs Been Barricked by the U.S.? [www.gold-eagle.com](https://www.gold-eagle.com), July 12, 2007

A. E. Fekete, Gold Vanishing Into Private Hoards, [www.gold-eagle.com](https://www.gold-eagle.com), May 31, 2007

A. E. Fekete, To Barrick Or To Be Barricked, That Is the Question, [www.gold-eagle.com](https://www.gold-eagle.com)

---

*August 11, 2006*

A. E. Fekete, The Texas Hedges of Barrick, [www.goldisfreedom.com](https://www.goldisfreedom.com) , May, 2002

Charles Davis, So Big It’s Brutal, Report on Business, The Globe and Mail: Toronto, June 2006, p 64.

Bob Landis, Readings from the Book of Barrick: A Goldbug Ponders the Unthinkable, [www.goldensextant.com](https://www.goldensextant.com) , May 21, 2002

Richard Rohmer, Golden Phoenix: The Biography of Peter Munk, Key Porter Books, 1999

Ferdinand Lips, Gold Wars, Will Hedging Kill the Goose Laying the Golden Egg? p 161-167,

### New York: FAME, 2001

Antal E. Fekete, Towards a Dynamic Micreoeconomics, Laissez-Faire (Universidad Francisco

### Marroquín, Guatemala City) No. 5, September, 1996, pp 1-14)

George Bush’s „Heart of Darkness” — Mineral Control of Africa, Executive Intelligence Review,

January 3, 1997, see in particular:

### Barrick’s Barracudas

### Inside Story: The Bush Gang and Barrick, by Anton Chaitkin

### George Bush’s 10 billion giveaway to Barrick, by Kark Sonnenblick

### Bush abets Barrick’s Golddigging, by Gail Billington

### See also: [american_almanac.tripod.com](http://american_almanac.tripod.com/bushgold.htm)

### Stop the Press!

There is wild speculation in Newmont stock on rumors that it is a candidate for a hostile takeover by Barrick. Barrick has denied the rumors; Newmont refused to comment. So it boils down to the question whether you can believe Barrick. A penny for my thought? Newmount is worth far more under the present management, that has courageously unhedged it, than it could ever be worth under the management of Barrick, which is grieviously lacking both in courage and vision. Barrick is still wedded to its idiotic hedge plan, stewing in its own juice as a consequence. Newmont could introduce bilateral hedging, the only true hedge plan for a gold mine, to be described more fully in the next instalment of Peak Gold! I cannot help but think that Barrick is acting out of desperation, in trying to dilute its hedgebook through hostile takeover. Barrick’s management could spend its money far more efficiently if it bought back its hedge book, rather than buying out Newmont, which has a vision Barrick is sorely lacking.

My fears have been sadly confirmed. Barrick does not have and is unable to borrow the money to buy back its hedge book, but it apparently tries to wriggle off the hook through acquiring a better-managed company. It would pay for the acquisition with Barrick stock. No, not again! Stockholders of Barrick are to be barricked to death!

If the rumors are true, the takeover drama is not without its humorous aspect. The poison pill has been swallowed by Big Fish and by now it is causing indigestion and cramps, so that Big Fish wants to feed on fish that have just regurgitated theirs!

## Disclaimer And Conflicts

THE PUBLICATION OF THIS ARTICLE IS SOLELY FOR YOUR INFORMATION AND

ENTERTAINMENT. THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT,

NOR IS HE SUGGESTING THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A

RECOMMENDATION TO BUY OR SELL ANY SECURITY. HE HAS NO POSITION, LONG OR

SHORT, IN BARRICK STOCK, NOR DOES HE INTEND TO ACQUIRE ONE. THE CONTENT OF THIS ARTICLE IS DERIVED FROM INFORMATION AND SOURCES BELIEVED TO BE

RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT IT IS COMPLETE OR

## Error-Free, And It Should Not Be Relied Upon As Such.

---

*August 31, 2007*

---

# Keeping Our Eyes Peeled for the Silver and Gold Basis

URL: https://newaustrianeconomics.com/archive/fekete/keeping-our-eyes-peeled-for-silver-and-gold-basis/
Date: 2007-07-26
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, silver, backwardation, contango, bimetallic
Description: Fekete provides a practical guide to monitoring the gold and silver basis as early-warning signals of monetary crisis. He explains what to watch for, what threshold readings signal danger, and why the basis tells you things about monetary conditions that price alone cannot — including the approach of permanent backwardation.
Editorial Note: Written July 2007 as gold prices were approaching $700. A practical companion to Fekete's more theoretical essays on the basis, this piece gives readers the tools to monitor what he considered the most important real-time indicator of monetary health.
Original PDF: https://professorfekete.com/articles/AEFKeepingOurEyesPeeled.pdf

*The Silver And Gold Basis*

**Antal E. Fekete** · Gold Standard University aefekete@hotmail.com

### Setting up the trip-wire

Gamblers shorting the dollar and bonds beware. Rumors about the imminent demise of the dollar and the bond market are grossly exaggerated. Bear in mind not only that the casino owner rigs your odds. He is also rigging the value of chips in which payoffs are made, thereby confusing the issue further.

The teetering of the dollar at the 80 mark, according to some the most important chart point ever in the history of charting, smells like a bear-trap. A lot of analyst predict that if the dollar violates that support, then it is bound to go into a free-fall. Nobody is seriously considering the possibility that this chart point, like everything else about the dollar, is rigged.

It is the trip-wire set to trip up the bears.

The demise of the US long-bond market has been talked about for years. Analysts are so busy in writing the post mortem that they have no time to look at the charts. Yet the charts clearly show that the price of the 30-year US Treasurys is in an upward channel, where it has been for past 25 years. This in spite of the dollar index being in a downward channel, where it has been for the past 35 years. How is it that nobody sees a contradiction here that cries out for explanation? That nobody sees the hand of the master-rigger setting up the trip-wire?

### Ticket to riskless profits

Here is a question for the discriminating observer. How is it that interest-rate derivatives do not obey the Law of Supply and Demand? The more there are of them, the more they are in demand. Half-a-quadrillion (500 trillion) dollars’ worth are out there at last count (in comparison the US GNP is a paltry 13 trillion), and it is increasing at the rate of 40 percent per annum. At that rate volume doubles about every other year.

Everything in human experience will tell you that such a thing is not possible. The more of anything exists, the less it will be appreciated. If the quantity of a security increases exponentially, then its value is bound to decrease exponentially for the stronger reason. Yet here we are, derivatives doubling in quantity every other year and, far from losing value, they are ever more in demand. Why?

Because derivatives are tickets to risk-free profits. As such they are the straw on which the world’s banking system swims or sinks. Swims, as long as interest rates are falling; sinks, as soon as they start rising in earnest.

### Have the Chinese been tricked?

Enormous fortunes have been made on the long side of the bond market by the bulls during the past 25 years, among them by the Chinese, of all people. Make no mistake about it: their \$1 trillion kitty is not all trade surplus. So much of it is the wages of adroit gambling on the long side of the bond market for the past 25 years. In 1982 the Chinese were astute enough to realize that US 30-year treasurys yielding 16 percent per annum were a fantastic bargain. Not only did they lock in an income at 16% for 30 years, but they held out a promise for capital gains by doubling in value at least twice as interest rates fell from 16% to 8%, and then again from 8% to 4%.

The Chinese are not naive as suggested by the analyst. They wrote the book on irredeemable paper currency when the paleface treasurers in the Occident were still experimenting with the alchemy of diluting silver and gold coins in circulation for the benefit of Old Coppernose. The Chinese invented paper without which Helicopter Ben could not do his air-drops of Federal Reserve notes.

Noises from China about their efforts ’to diversify’ the dollar portfolio is meant for the gullible. Whenever they are ready to diversify in earnest, the Chinese will not tell you about it in advance. Moreover, the fate of the dollar is already pretty well in their hands. The Chinese have the power, through their continued buying of US long bonds, to drive interest rates further down, all the way to the Japanese, chalking up fabulous capital gains on their bond portfolio in the process. Most importantly, they can do it even in the face of continuing erosion in the purchasing power of the dollar.

### Fast breeder of bonds not fast enough

The bond market today is immensely different from that of the 1980’s. Not only have T-bonds been created through fast-breeders, bond gambling has been further escalated through the creation of interest-rate derivatives. A new generation of derivatives is „invented” every few months. The first generation was to hedge the value of bonds. The second was to hedge the value of the first hedges. The third is to hedge the value of the second. And so on and so forth, ad libitum.

There is never enough of those derivatives because new risks crop up with the rise of every new generation of hedges. Academic economists see in them an admirable sophisticated instrument. Pity our poor forefathers. They had to do without them.

Financial journalists want to stay blissfully ignorant of the fact that derivatives have put the Law of Supply and Demand into abeyance. „See no evil, hear no evil.” Cockaigne is here. Perpetual motion has been invented. Enjoy it. Don’t ask questions. Sit down, sit down: you are rocking the boat!

### The con-conundrum

As I have said, the more of those derivatives have been created the more are demanded, because they are considered a ticket to riskless profits. So they are in Japan, and so they are in the United States. When the casino-owner sells tickets to riskless gains, the law of suppy and demand is suspended. Both supply and demand tends to become infinite. Ask Charles Ponzi.

He’s been there. Interest-rate derivatives are proxy for bonds. They are new chips that you can use at the casino. They augment a supply the size of which already boggles the mind. On that count alone bond prices should be approaching zero and, interest rates, infinity. Instead, what do we see? Bond prices are still marching upwards. A conundrum indeed, if there ever was one. A con-conundrum.

### Who says higher interest rates are necessary?

Those who still believe in the dictum of 19th century textbooks on bonds, that it takes higher interest rates and lower bond prices to perk up excitement in a lethargic bond market, are victims of the most brilliant confidence trick of all times. The gambling spirit in the twentyfirst century is being upheld, not by higher interest rates, but by issuing ever more tickets to risk-free profits, that is, ever more derivatives on interest rates. Those who still think that it is necessary to bribe foreign suckers to buy more US bonds by the stratagem of printing ever higher coupon rates on the new bonds are hopelessly antediluvian. They have never heard of the miracle of creating capital gains through pushing interest rates ever lower.

Analysts still fail to see the real purpose of the derivatives monster. It has been sprung on the world in order to keep bond values buoyant, so that the game of musical chairs could go on.

### The dollar has fallen through 80. So what?

But what about the US dollar index, allegedly showing that foreigners are getting tired of the infinite supplies of US dollars of diminishing value that keep coming at them? It is nibbling at the all-time low of 80 which, if taken out, you may never hear the dollar to hit bottom.

Analysts tell you that you cannot fool Mother Nature. The dollar’s value is closing in on its intrinsic value: zero.

Don’t buy that. The dollar index, just like the CPI number, is manipulated in order to fool the uninitiated. Should the dollar fall through 80 and approach 70, foreign central banks will see to it that their paper follow suit. They are all too eager to match every point of the fall of the dollar. That will reverse the trend. The Chinese, in particular, have a vested interest to keep the fall of the dollar controlled and orderly. What is more, they have the power to do so.

They don’t mind taking a loss on the dollar here and there, as long as it does not eat significantly into their mountain of paper profits on the bond portfolio.

### Central bank bag of tricks

There is no way to predict the future scientifically. I would be a fool if I tried. I am simply saying that a dollar collapse is extremely unlikely at this juncture. I am inclined to lay far greater a store by the chart showing the US long bond in a 25-year uptrend, than by the chart showing the dollar in a 35-year downtrend. Of course, I know that the dollar, the yen, the euro are all being manipulated lower, each by its own issuer. Why, the name of the game is „all fall down”, isn’t it? But fall they must at a controlled pace. Central banks have a bag of tricks with which they can slow down the depreciation of currency values. The bag is infinitely deep. Furthermore, central banks also have all the marbles. They make most of it. So you want to win by placing a wager against the dollar? Good luck to you, but your odds are infinitesimally small.

I stand by my earlier statement that US interest rates are likely to fall more, replicating that of the Japanese, violation of support at 80 notwithstanding. The world is not now at a crucial turning point in 2007, like it was 25 years ago, in 1982, when the Kondratyeff longwave cycle switched from rising to falling mode. I expect more of the same: falling interest rates, firms losing market-share and pricing-power, stockpiles of commodities ever more onerous to carry, which add up to a falling price level in disguise. The dollar index? Forget it.

It’s for the birds.

### The Volcker-bluff

Why am I so stubborn in sticking to the deflationary scenario? Here is my reasoning.

Hyperinflation almost engulfed the world in 1980. When in a spectacular coup interest rates were allowed to go to heights unheard-of at 20+ percent by the maverick Chairman of the Fed, Paul A. Volcker, virtually all the banks of the world became insolvent (as the value of their dollar assets was wiped out by the high-interest-rate regime). The banks were bailed out unexpectedly by the new regime of falling interest rates.

It is ridiculous to suggest that Volcker gave us a strong dollar in 1980 — a repeatable feat. In actual fact Volcker gambled: he staked the world’s banking system on saving the dollar from sudden death. Luckily for him, the gamble worked. Before the bluff could be called, the cascading of interest rates started fuelling bullish speculation in the bond market.

Please note that the Volcker-bluff is non-repeatable. In 1982 the world was riding high on the Kondratyeff long wave; 25 years later, in 2007, it is languishing in the depths of the trough. Helicopter Ben could not take his foot off the throttle. If he did, all deflationary hell would break loose, and he knows it. The debt-pyramid would collapse in a fashion more spectacular than that of the World Trade Center.

### Keep our eyes peeled for the basis

How could central banks work the miracle of making interest rates fall in the face of running the printing presses overtime, and keep them from rising again? That’s just the best part of it.

They have let the genie of the derivatives monster out of the bottle. The genie is mushrooming over the world economy, growing at a clip of 40 percent per annum. Right now it is half-aquadrillion dollar strong, doubling in about every second year. It is the derivative monster that keeps interest rates low, and makes them fall further. Remember, derivatives are just tickets to riskless profits in bond speculation on the long side. It is as simple as that.

Does this mean that the Ponzi-scheme of derivatives creation will go on forever? Of course not. We have it on the authority of the Bible. Read the biblical story of the Tower of Babel. But how do we know when the Derivatives Tower of Babel will start to unravel?

Forget the chart point 80, it is not your clue; nor is any other. Keep your eyes peeled for the silver and gold basis. This is the subject of a blue ribbon panel discussion at the next session of the Gold Standard University in August, 2007 (see below).

### Do central banks have all the marbles?

It may appear that central banks have all the marbles. Indeed they do — except for one. They have foolishly let the most important marble slip through their fingers. That marble is the gold marble. The only wager against the dollar that has a chance of winning in the long run is the one staked out by the gold marble. Ironically, it is also the simplest, and anyone can play it, even people of modest means. That wager consists in scale-down purchases of physical gold.

Buy on every dip of the gold price. Upon bigger dips, buy more. In doing so you may ignore all the indicators with the exception of the basis: the CPI, the dollar index, bond prices, foreign exchange rates, COT reports. You keep buying, and never sell. Your gold is fully paid for. It should be a source of infinite joy to give up worthless (well, make that ultimately worthless) paper against acquiring gold marbles.

The music stops when the basis turns permanently negative, heralding the curtain on the last contango in Washington. It tells the world that all offers to sell physical silver and gold have been withdrawn in the markets. The monetary metals are not for sale at any price.

The game of musical chairs is up. Fear not: your gold marble has reserved a chair for you.

If personal misfortune overtakes before that happens, you still won’t sell. In an utmost emergency you borrow, but not sell. Remember, interest rates are kept at an artificially low level by the managers of the con-conundrum, offering you a gift.

Theirs is a gift that you may accept.

### Gold Standard University Live

Session Two of Gold Standard University will take place between August 17 and 29, 2007, at Martineum Academy in Szombathely, Hungary. It will feature a one-week course (13 lectures) entitled Gold and Interest, as well as a blue-ribbon panel discussion entitled The Last Contango ─ Basis As an Early Warning Sign of the Collapse of the International Monetary System. Tom Szabo will be present. He is one of the world’s foremost expert on the gold and silver basis who on his website [www.silveraxis.com](https://www.silveraxis.com) has been tracking them for half a year.

He is a member of the research team of GSUL.

The second week is reserved for sight-seeing and recreation, including the famous Savaria Roman Festival featuring Roman togas and other habits, Roman cuisine, Roman games, etc. Enrolment is limited; first come first served. For more information please contact: GSUL@t-online.hu

### Reference

For a chart exhibiting the upward channel of the price of the 30-year US Treasury bond that has been in force since 1985, see:

Keeping Our Eyes Peeled on the Long Bond and the Dollar, Jay Taylor, [www.gold-eagle.com](https://www.gold-eagle.com) , July 21, 2007.

---

*July 26, 2007*

---

# Have Gold Bugs Been Barricked by the US?

URL: https://newaustrianeconomics.com/archive/fekete/have-gold-bugs-been-barricked-by-the-us/
Date: 2007-07-12
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, central-banking, monetary-policy, gold-standard
Description: Fekete asks whether the U.S. government, through its influence over Barrick Gold and other major gold miners, has effectively been running an operation to suppress the gold price at scale. He argues the evidence suggests a coordinated program to 'barrick' (destroy through hedging) the gold bull market, and examines why this strategy must ultimately fail.
Editorial Note: Written July 2007. Continues Fekete's long-running analysis of the Barrick hedging story as a window into government gold price suppression. The verb 'to barrick' — meaning to destroy through forward selling — had by this point become established in gold analyst vocabulary.
Original PDF: https://professorfekete.com/articles/AEFHaveGoldBugsBeenBarrickedByTheUS.pdf

## Have Gold Bugs Been Barricked By The U.S.?

### Antal E. Fekete

### Gold Standard University aefekete@iisam.com

### Battle of Titans

Newmont has eliminated its entire 1.85 million ounce hedgebook (Reuters, July 5) and, in doing so, it has catapulted itself into the position of the world's largest unhedged gold producer. As those who have followed the gold-hedge saga will know, this is a most serious challenge to Barrick since it has wrested for itself the title of the world' largest gold producer, even though at the expense of swallowing the poison pill of hedge-books worse than its own, for no better reason than propaganda. Whatever ephemeral advantage it may have bought is spent by now. Gold bugs are flocking (not to say stampeding) out of so-called hedged companies into unhedged ones. Newmont's coup is likely to be profitable to its shareholders - and unprofitable to the shareholders of Barrick who have been bleeding 24 karat gold by the ton ever since the bull market started back in 2001. If you believe in bigness and want to own a piece of the biggest gold mining concern, you go Newmont. Analysts have calculated that Newmont could recover the \$578 million it has spent on hedge buybacks, if the share price went up 1 or 2 dollars. After the announcement was made, the price jumped almost one dollar to 40½ on the kerb.

By contrast, Barrick is on record that it will never become totally unhedged, even though it has grudgingly reduced its hedgebook some in when the new gold bull was born response to shareholder unrest. In the words of President Greg Wilkins, a 'reasonable' amount of hedging is an 'essential risk-management tool' for the company. It is supposed to stabilize revenues. It is supposed to satisfy banks that finance its projects.

Newmont and Barrick have been arch-rivals not only on the Carlin trend, but also on the global battlefield. Barrick has been taking blows ever since its hedge-strategy, so called, started to unravel in 2001, when the new gold bull was born, as was predictable. I have pointed out in several of my papers that Barrick's hedging is no hedging at all under any circumstances. It is a fraud. As an unlimited forward sale program, it is the most stupid and dangerous kind of gamble, especially in an environment where the collapse of the international monetary system in the wake of the collapse of the burgeoning debt-tower is a distinct possibility. So much so that the question arises how responsible businessmen, such as the officers of Barrick, could commit the capital of their shareholders to such a demonstrably insane and self-defeating policy that would burden them with a liability that could never be lived down.

Contingency plan to keep the dollar as the world's reserve currency How? Why, it has been publicly suggested by some analysts that Barrick is a front. It is not a profit-seeking business. As such, it is used by the U.S. in order to cap the gold price. According to this view the strength of the dollar is that it has only one viable alternative as a global currency: gold. Therefore, if the U.S. wants to keep its enormously profitable privilege to issue the world's global currency, it has only to cap the gold price.

Conversely, if the U.S. failed to do it, sooner or later the rising gold price would lead to an ignominious collapse of the dollar, by far the worst currency debacle in world history.

It would be the height of naivité to believe that the U.S. would idly stand by watching monetary events to unfold, while doing nothing, regardless how daunting the task of stopping the gold train in its track may be.

I want to make it clear that this is not my view. I haven't bought into the conspiracy theory. At least not yet, but I think soon enough I shall know for sure. Newmont's coup may reveal that the Emperor has no clothes. We have to wait and see what Barrick's response will be. It is still possible that Barrick will throw in the towel and follow the lead of Newmont. Just watch the spread between the two stocks.

Be that as it may, the question arises naturally what the best procedure to cap the gold price may be from the point of view of the U.S. Obviously it would be self-defeating for the U.S. overtly to put the remnant of its gold reserves to risk in an effort to pacify surging demand. The ploy of the U.S. twisting the arms of other countries to sell their gold reserves, while retaining its, has been exploited for whatever it is worth. As the U.S. was preaching water while drinking wine, it was not very persuasive in the first place. A more intelligent and more promising strategy is to find a gold mining firm that would covertly put its unmined gold reserves to risk in support of the dollar. If a gold mine could convince the world that its unlimited forward sales program, promoted as an honest-to-goodness hedge plan, could attract imitators, then the fraud might never be exposed, and chances were that it could be perpetuated. The regime of the irredeemable dollar, like the Third Reich, could claim that it would last "a thousand years".

So it is at least a plausible assumption that the U.S. has enlisted Barrick to come out with its so-called hedge-plan to fool the world. Here is the deal: the U.S. would covertly underwrite the potentially unlimited losses of Barrick in exchange for its complicity in the scheme of capping the price of gold. As an incentive, Barrick would be given the green light to gobble up its weaker brethren to become the world's largest gold producer.

Neat, isn't it? Yes, if you bypass the ethical problem that the betrayal of shareholder trust on the global scale would be unprecedented in the annals of business. However, that problem could be managed by an ironclad stonewalling of the arrangement to guarantee secrecy.

I repeat that this is not my view. But the conspiracy hypothesis is being bandied about by sufficiently many observers that it is impossible to ignore.

### True versus fraudulent hedging

I have long realized that there was only one way to unmask the fraud, if there was one, and this was to prove that the so-called hedges of Barrick were in fact no hedges at all, but unlimited forward sales backed by gold as yet unmined, and in some cases might not be mined for as many as fifteen years. Never mind that such a commitment is meaningless because, while the gold may still be there fifteen years hence, Barrick may not be there to get it. It could be wiped out by the surging gold price.

To call Barrick's plan 'hedging' is not simply creating another misnomer. It is a terrible violence against language. It is a malicious distortion of the true meaning of perfectly honest word describing a prefectly honorable business activity.

True hedging for a gold mine must be bilateral. It must be a strategy involving balanced and limited forward selling cum forward buying in order to take advantage of the fluctuating gold price. Net forward purchases and sales must be limited to one year's output and, most importantly, forward sales must be balanced by forward purchases. In this way the loyalty of speculators would not be permanently anchored to the short side of the market. By contrast, under the hedge plan of Barrick speculators could rest assured that it was perfectly safe to go short because they had the benefit of the back-wind of the miners' forward sales. Note that this would no longer be the case if hedging was bilateral, since the next move of the miners could very well be forward purchase, catching the speculators off-guard. The unmitigated blemish on Barrick's hedge-plan is precisely this: it unilaterally commits speculators to the short side of the market. To the insult of short sales by Barrick, it adds the multiple injury of short sales by speculators whose appetite has been whetted by Barrick's example. Individual speculators would consider going long an unacceptable risk. Without any further ado, this fact alone makes the sincerity of Barrick's management suspect. It also brings the competence of banks into question that finance Barrick's projects. How come that heads at those banks haven't been rolling along with the head of Randall Oliphant, former president of Barrick, after the utter fiasco of unilateral hedging has become publicly known? Something stinks in those banks. If the real culprits are the financiers of Barrick, then perhaps the world has the right to hear from them, and get a clear policy-statement. Can it be that the banks, like dutiful shills, knowingly bet on losing horses on behalf of those who have rigged the race?

### Correction and apology

It could be objected against this argument that Barrick's management has acted in good faith all along. It was simply a mistake on their part to read only half of the dictionary entry on 'hedging', the half about forward sales. In their rush to cash in they have forgotten to read the other half on forward buying. Unfortunately, we cannot offer this excuse in defense of Barrick. I have positive proof that Barrick's top brass was conversant with both halves of the dictionary entry that defines "hedging".

Last year I published a paper with the title: To Barrick Or to Be Barricked, That Is the Question. In that paper I mistakenly stated that Chairman Munk fired CFO Jamie Sokalsky, along with President Randall Oliphant. While it is true that Randall was fired, Jamie was not. For this mistake I have been upbraided by a reader of my column, Doug Peter, who says he is the brother-in-law of Jamie. Here is his letter in its entirety:

Dear Professor Fekete:

Your last two articles appearing on gold-eagle.com have references to Barrick and contain misinformation on at least two counts.

First you stated that Jamie Sokalsky was fired by Peter Munk. He was not. In fact, he was promoted and is now Executive Vice President. I know this because he is my brother-inlaw, and his position can be easily verified by reference to the company's Annual Report.

Secondly, you claim that Barrick does not mark to market its derivative positions. In fact, the company must by law publish this information. Recently it was spelled out on page 25 of its Second Quarter Report (2006) showing the fair value of these positions in deficit to the extent of \$4.13 billion.

One can only wonder what other information you have misconstrued in your articles.

### Doug Peter

### Toronto, Ontario

Let me now discharge an old debt. I hereby publicly acknowledge that, indeed, Jamie was not fired; he was promoted. I offer my apology for this mistake. The reason I have waited for so long to state it in public is that I sent a message to Jamie through Doug. In that message I reminded Jamie that, at his invitation, we had had a long discussion on gold mining and hedging at company headquarters. At the time I was still a shareholder, and our meeting took place with the knowledge, perhaps even at the behest, of Peter Munk with whom I had corresponded on the subject previously.

I submitted a 50-page study for the benefit of Barrick management, entitled Gold Mining and Hedging: Will Hedging Kill the Goose Laying the Golden Egg?, written for the purpose. It covered the subject of both unilateral and bilateral hedging. Jamie promised that he would read it and let me have his comments in due course. That was almost ten years ago; his comments never came.

I apologized to Jamie for my mistake of stating that he was fired. I congratulated him on his promotion. I told him that I would be happy to receive his comments on my study even after a ten-year delay. I stated that an important public issue was involved. We have to clarify the real distinction between proper hedging that must be bilateral and limited, and fraudulent hedging that is unilateral and unlimited.

### Public challenge to Barrick

You might say that I was issuing a private challenge to Jamie through Doug so that, from his elevated position as Executive Vice President of the company, he could authoritavely refute my charges that the hedges of Barrick are fraudulent, and state his reasons why Barrick did not take my advice, in setting up proper bilateral hedges that would not commit speculators to the bear side of the market unilaterally and permanently. If it had, Barrick could have avoided horrendous losses and would have spared its shareholders from unending agony.

Jamie Sokalsky has not deigned to answer my private challenge for half a year. So I take this opportunity to re-issue my challenge, this time in the glare of full publicity.

I demand an answer why Barrick ignored my recommendation of ten years ago which I personally presented in writing to the then Chief Financial Officer Jamie Sokalsky. During those ten years my worst fears have materialized. It turned out that the hedging policy of the company was, as I had stated, deeply flawed. It was an unmitigated disaster of the first magnitude. It resulted in horrendous losses to shareholders. It is not clear why Jamie Sokalsky, widely rumored to be the author of Barrick' hedge plan, got rewarded with a promotion for executing a disastrous policy, and why his new boss, Greg Wilkins, has stated in public that the company is standing by its original hedging policy, if only on a reduced scale. I categorically state that Jamie Sokalsky had been thoroughly familiar with the alternative, what I called the correct principles of hedging, already ten years ago. He and I discussed the subject together at great length, and he received from me a Memorandum that spelled it all out. This Memorandum found its way into the book of the late Ferdinand Lips entitled Gold Wars and can be seen there by any interested party.

Two world-class companies, Barrick and Newmont, cannot be both right when one insists that unilateral and unlimited hedging is a valid management tool, and the other insists that it was a mistake from start and puts its money where its mouth is: it covers all net short positions, by taking the loss while it is not too late.

### An appeal to analysts and accountants

I hereby invite all gold share analysts and public accountants conversant with the dispute to help adjudicate. We must know the truth. Shareholders have the right to this information. Other people who are still vacillating between so-called hedged vs. unhedged gold mining companies also have the right to know the answer. It is not beyond science to provide an unambiguous answer to the question what constitutes a valid hedge and what does not. I pledge my sincere cooperation in this dispute and inquiry. I am staking my reputation as a monetary scientist in this challenge. I am willing to declare in advance that I shall abide by the verdict of a committee of unbiassed experts with impeccable credentials, even if it rejects my claim that unilateral hedging (perpetual net short positions) means taking of unacceptable risks with shareholder capital, while bilateral hedging (balanced forward sales and purchases) is limiting risks and could be potentially profitable. In fact it is the only permissible way of hedging, since it does not permanently line up the very considerable speculative following in the short camp, thus imparting an unacceptable bias to the bear side of the gold market. The chips shall fall where they may only if the hedge plan is bilateral and limited.

### Gambling with the funds of widows and orpans

My challenge is eminently reasonable. There is nothing frivolous about it. It is not negative. While it is critical, it offers an alternative. My alternative has been worked out in greater details than what Barrick has ever revealed about its own hedge plan in public.

I may add that I have been a student of gold since I immigrated to Canada in 1957 and could have access to the literature that was denied to me in my native Hungary. When the first gold futures market opened in Winnipeg in the early 1970's, while it was still illegal for Americans to trade gold futures contracts, I purchased a seat on the Winnipeg Commodity Exchange in order to have first-hand access to information. I am a careful researcher, and I have no axes to grind. I am interested in the truth, and nothing but the truth.

I am willing to grant that the government of the U.S. has the right to defend the value of its currency, provided that this defence is not based on outright fraud and massdeception. If the solution to the problem of gold is to sell out the U.S. Treasury stock to the last bar, as you often hear suggested in academic circles, then be it. But selling unlimited amounts of paper gold, or unlimited amounts of unmined gold instead, thereby surreptitiously placing the funds of widows and orphans in clear and present danger, is a procedure that is blatantly unfitting to the government of a great nation with a proud monetary heritage. Moreover, it is deeply immoral. It is contrary to scriptural admonitions.

### Barrick's barracudas

I keep an open mind about the dark suggestion that a conspiracy exists between the U.S. and Barrick to cap the gold price through a fraudulently conceived and falsely promoted hedge-plan with the side-effect of deceiving and harming innocent third parties. I shall continue doing so for a reasonable length of time, as I want to give a chance to Messrs.

Munk, Wilkins and Sokalsky to examine my challenge and accept it. This is not a request to open the secret minutes of Barrick's Advisory Board, of which such figures as former U.S. President Bush, former Canadian Prime Minister Mulroney, not to mention several former heads of various central banks are members, even though this body is unseemly to me as it evokes the epithet Barrick's Barracudas. This is merely a request to have a free and open academic discussion on the business question what constitutes valid hedging and what does not. I claim to be an expert on that question myself, as I have studied if for several decades. But I will accept the verdict of my peers against me if they can find a weak point in my reasoning.

It would please me if we could dismiss the bogeyman of a conspiracy between the U.S. government and Barrick Gold for once and all. Personally I would be greatly relieved to have a confirmation of the fact that the world is not governed by evil and vindictive men.

Declining or ignoring my challenge would not be a slap in my face. It would be a blot on the character of those who have done the ignoring.

### "Most compelling catalys for re-rating"

Earlier this year a report appeared from the pen of Dorothy Kosich, [www.web.com](https://www.web.com) :

Citigroup Analysts tell Barrick: Close Hedge Book, Then Stand Back. Reno, Nevada,

February 14, 2007. Citigroup metals analysts John H. Hill and Graham Wark urged Barrick Gold to reduce aggressively its hedge book or repurchase it in its entirety - an action that could be "one of the most compelling re-rating catalysts in the metals industry"… Apparently, Barrick is not interested in re-rating. Still less is it interested in the opinion of its shareholders. Could it be that its real bosses are not the shareholders, but those who sit on its Advisory Board? Shareholders, it seems, can only "vote with their feet".

Indeed they may and will. As the saying goes, the real proof of the pie is in the eating.

The market will ultimately decide this issue as well. From the feedback to my column on the Internet I know that present and prospective owners of gold mining shares are deeply troubled by these issues, and they reject the obfuscation that seems to be emanating from Barrick. I want to put the resources of my Gold Standard University at their disposal. I suggest to them that they should think twice before they buy Barrick stock, unless they are fully satisfied with its response to my challenge.

In case of no response, I have no advice whether to buy or to sell. The refusal will speak for itself.

We are at the cross-roads. People who seek protection in numbers will have to choose between Barrick and Newmont. The record of the so-called hedged gold mines appears dismal in comparison with that of the unhedged ones. Could it be that the former, in a rear-guard action, want to save their own skin by refusing my challenge because they know that by taking it up they would surely lose? I leave it to my readers to figure it out.

Here is my parting shot. Dr. Bernanke would not want to use Barrick as the helicopter from which to dispense Federal Reserve notes. The notes would end up in the wrong hands. No sooner had the Fed bought Barrick stocks than speculators sold them.

### Gold Standard University Live

Session Two of Gold Standard University will take place between August 17 and 29,

2007, at Martineum Academy in Szombathely, Hungary. It will feature a one-week course (13 lectures) entitled Gold and Interest, as well as a blue-ribbon panel discussion entitled The Last Contango - Basis As an Early Warning Sign of the Collapse of the International Monetary System. The second week is reserved for sight-seeing and recreation, including the famous Savaria Roman Festival featuring Roman togas and other habits, Roman cuisine, Roman games, etc. Enrolment is limited; first come first served. For more information please contact: GSUL@t-online.hu

## Disclaimer And Conflicts

## The Publication Of This Article Is Solely For Your Information

## And Entertainment. The Author Is Not Soliciting Any Action

## Based Upon It, Nor Is He Suggesting That It Represents, Under

## Any Circumstances, A Recommendation To Buy Or Sell Any

## Security. He Has No Position, Long Or Short, In Either Barrick Or

## Newmont Stock, Nor Does He Intend To Acquire One. The Content

## Of This Article Is Derived From Information And Sources

## Believed To Be Reliable, But The Author Makes No

## Representation That It Is Complete Or Error-Free, And It Should

## Not Be Relied Upon As Such.

### References

Charles Davis, So Big It's Brutal, Report on Business, The Globe and Mail: Toronto, June 2006, p 64.

Bob Landis, Readings from the Book of Barrick: A Goldbug Ponders the Unthinkable,

---

*May 21, 2002*

Richard Rohmer, Golden Phoenix: The Biography of Peter Munk, Key Porter Books,

1999

### A. E. Fekete, The Texas Hedges of Barrick, May, 2002

Ferdinand Lips, Gold Wars, Will Hedging Kill the Goose Laying the Golden Egg? p 161167, New York: FAME, A. E. Fekete, To Barrick Or To Be Barricked, That Is the Question, August 11, 2006

George Bush's "Heart of Darkness" - Mineral Control of Africa, Executive Intelligence Review, January 3, 1997, see in particular:

### Barrick's Barracudas

### Inside Story: The Bush Gang and Barrick, by Anton Chaitkin

### George Bush's 10 billion giveaway to Barrick, by Kark Sonnenblick

### Bush abets Barrick's Golddigging, by Gail Billington

### See also: [american_almanac.tripod.com](http://american_almanac.tripod.com/bushgold.htm)

---

*July 12, 2007*

---

# Peak Gold! Part One

URL: https://newaustrianeconomics.com/archive/fekete/peak-gold-part-one/
Date: 2007-06-15
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, permanent-backwardation, gold-standard, fiat-currency
Description: Fekete introduces the concept of 'Peak Gold' — analogous to Peak Oil but monetary rather than geological: the point at which the flow of gold to satisfy monetary demand permanently peaks and begins to decline. Unlike geological peak gold, this is driven not by ore depletion but by the progressive withdrawal of gold from circulation as the paper money system undermines incentives to lend it.
Editorial Note: First of a five-part Peak Gold series (June–October 2007). Fekete's 'monetary peak gold' concept is distinct from the geological peak gold debate and represents one of his most original analytical contributions to understanding the endgame of irredeemable currency.
Original PDF: https://professorfekete.com/articles/AEFPeakGoldPart1.pdf

## Peak Gold!

### A Primer on True Hedging, Part One

### Antal E. Fekete

### Gold Standard University aefekete@hotmail.com

### Maximize life, not profits!

In a previous article Gold Vanishing Into Private Hoards I have examined the future of gold from the demand side. Now in Peak Gold! I examine it from the supply side.

For the title I am grateful to Tom Szabo of [www.silveraxis.com](https://www.silveraxis.com) . He said in his comments dated August 3, 2007: "the unanswered question is: are we approaching 'Peak Gold'? We often hear the term 'Peak Oil', but there are probably some pretty good arguments against being able to predict when the 'peak' date will arrive. Certainly no oil company has put out a prediction of peak production, much less one predicting that oil output will drop by 10 to 15% within a decade."

In this new series of articles I wish to provide a definitive answer to Tom Szabo's question: yes, we are approaching 'Peak Gold' if we have not already passed it. The last twenty-five years in the history of gold mining has been a gross aberration during which gold was mined as if it were a base metal, namely, at the top grade of ore reserves (that is, most recklessly). This is in the sharpest contrast with how gold has been mined traditionally as dictated by the economics of gold mining, namely, at the marginal grade of ore reserves (that is, most conservatively). The world is witnessing a sea change: gold, having been mined qua a base metal, is once more being mined qua a monetary metal.

By marginal grade of ore is meant that grade which can still yield a profit (i.e., is payable), however, any lower grade is already submarginal (i.e., is non-payable). Clearly, marginal grade varies inversely with price: it goes higher as the price goes down, and vice versa. Gold mining used to be the very opposite of base metal mining which must, of necessity, maximize profits, just like any other enterprise. Not many people realize that gold mining is the only exception to this rule. The goal of the gold miner is not to maximize profits. Far from it. His goal is to maximize the life of the gold property. There are several reasons for this, the outstanding one being that gold is the monetary metal par excellence. Whenever private enterprise rather than the government or its central bank controls its creation, new money is not railroaded (should we say air-dropped by helicopter?) into circulation. Money creation is then guided by economic rather than political considerations.

### Worst grade first, top grade last

Historically, the propensity of governments is to debase the currency rather than maintaining its value. The longer gold stays underground locked up in the gold-bearing ore, the longer it stays outside of the government's reach. We must remember that gold in the ground can still be an efficient store of value. The aberration of the last twenty-five years of mining gold at break-neck speed, and selling it forward, in some case as much as fifteen years of mine production, is ending. All mines will realize that premature exhaustion of their gold property is suicidal. They will have to learn again the wisdom of gold miners of old: worst grade first, best grade last. Ben Franklin's dictum that "experience runs an expensive school, but fools will learn in no other" applies here as well and, therefore, the learning process may take some time. Be that as it may, the smartest gold miner has probably shifted back to mining at the marginal grade already.

He reasons as follows: "If I can only keep my mine operational long enough, dollar debasement will catch up with my submarginal grades and will make them go through a metamorphosis. My submarginal grades of ore will become payable. My expiring gold mine will be rejuvenated and given a new lease on life, thanks to the misguided monetary policies of spendthrift governments. Ergo I had better work my mine as conservatively as possible and lengthen its working life by all available means". This line of thinking is well summarized by the adage: "in and out of ground gold teaches man husbandry".

### Barrick bringing good tidings for gold bugs

The present negative roller coaster ride for monetary metals is leading to an increase in absolute terms of the price, which appears unstoppable. (Negative, because an ordinary roller coaster ride ends at the lowest, not the highest, level.) The latest confirmation has come from a most unexpected source. Barrick, the gold miner held in contempt by most gold bugs (for its presumed activities in trying to cap the gold price, nay, to club it down) is now saying that the price of gold will rise during the next five to seven years because supplies from the mines will drop more than anyone in the market can anticipate. This is an extraordinary statement coming, as it is, from a gold producer with a millstone-size and weight of a hedge book around its neck.

As Dorothy Kosich reports on Mineweb in her article Barrick Opines on Gold Supply and Price (Aug. 3, 2007), during a conference call Barrick delved into its future prospects including gold prices. President and CEO Greg Wilkins, and Executive Vice President and CFO Jamie Sokalsky revealed that Barrick has been "digging in very deeply on the supply side of the business" working with a research firm to uncover evidence and trends increasing Barrick's optimism for the future gold price. Mark the word optimism. Perhaps it should read pessimism. Barrick's hedgebook is so hopelessly under water that the company cannot afford to buy it back, as did Newmont making it the largest 'unhedged' gold mine, while the going is still good. The future gold price spells disaster for Barrick that cuts the pitiable figure of a moose standing on the train track fixated on the headlights of the fast approaching train.

### "Timeo Danaos et dona ferentes"

Barrick is still studying the research reports, but Sokalsky already told analysts that "our initial analysis shows the buy side (sic) is likely to drop a lot quicker and more than most in the market are anticipating." While he insisted that "it is still too early to talk about any specific numbers", Barrick's research has uncovered much that "should be a lot more positive for the gold price". Sokalsky has divulged that a 10 to 15% drop should occur in overall mine supply of gold within the next five to seven years. That's a volte-face if there ever was one. Ten years ago gold was fetching \$300 an ounce and Sokalsky boasted that if horribile dictu the gold price went to \$600, Barrick would still be O.K. It could not get a margin call on its gold leases for fifteen years. It need not sell into its hedge book at a loss. It could always sell its output in the open market at a profit. 'Barrick would make every cent of that increase'.

Every cent? The gold price presently is well over \$600, and the same Sokalsky is talking about much higher gold prices for the next five to seven years. He must have Santa Claus for bullion banker who carries Barrick's short position most cheerfully, regardless of staggering losses. (Since then we have been told that there is no Santa Claus, not in the gold mining business anyway. The bullion banks have barred Barrick from speculating in the bond market with the proceeds from the sale of leased gold. Moreover, they took away Barrick's freedom to sell its output in the open market without putting a prescribed amount of gold into the hedge book. In effect, Barrick's gold production is in escrow. In all but name the company is foreclosed on its gold leases. The 15-year moratorium on margin calls is a myth that has been exploded by the market.)

Tom Szabo seems to be a bit skeptical about Barrick being the first to report the bad news (bad, that is, from the point of view of those who have endeavored to cap the price of gold during the last decade of the last century. Who knows, maybe the research shows an even bigger than 15% decline in output, but Barrick has opted to tamper with the data in order to show a smaller anticipated decline in gold production than justified by the research, as part of its undending quest to keep the lid on the gold price. Tom Szabo adds that, joking aside, these projections are incredibly bullish for the long-term gold price.

What Barrick implies, in effect, is that despite billions of dollars thrown at exploration during the past 2 or 3 years, there are not enough new projects even in the early discovery stage (much less in the late development stage) to maintain the current level of output, as production at the existing sites will start to decline in the next few years.

I myself am also skeptical. "Timeo Danaos et dona ferentes" (Virgil, Aeneid, ii.49): I fear the Greeks especially when they bear gifts. President Wilkins is on record that, while reducing its hedge book some, Barrick will retain its hedge plan as an "essential riskmanagement tool" and a means of "stabilizing revenues". It gives Barrick "needed flexibility" and, Barrick's creditors, necessary collateral. I think Wilkins should have come clean during the conference call. The talk about 'risk-management' and 'stabilizing revenues' is for the birds. Wilkins should repudiate the hedge plan in no uncertain terms and put the whole unpleasant affair behind him for once and all. Barrick and its creditors need the so-called hedge plan as they need pain in the neck. Unless… unless… there are yet more skeletons in Barrick's cupboard.

Logic would dictate that Barrick lift its short hedges first, and release the research report afterwards. Doing it in the wrong order could cost a pretty penny. Barrick brings the dictum of Cicero to mind: Mendaci neque quum vera dicit, creditur (a liar is not to be believed even when he speaks the truth).

### Ruthless exploitation

During the past twenty-five years gold was mined following the worst traditions of ruthless exploitation of a resource. Barrick served both as brain-trust and ring-leader, by mining gold at the top grade of ore defying the tradition and economics of gold mining, and by promoting a thoroughly mendacious, false, and self-defeating forward sales program under the banner of 'hedging'. At one point during the past fifteen years Barrick had to close down operations at no fewer than ten of its gold producing sites as a result of exploitation, because ore reserves became submarginal in the wake of the falling gold price. For years, Barrick has been selling gold forward with wild abandon at ridiculously low prices, in effect blocking its own escape route to short covering should the need arise. It is hard to imagine a gold mine managed more incompetently from a global point of view. Of course, Barrick's highly touted 'hedges' are no hedges at all. In so far as they mature over one year, and their volume exceeds one year's mine output, they are naked forward sales misrepresented as hedges. The whole scheme has been a mindless and extravagant exploitation of a world resource.

In all likelihood it has also been a 'gold laundering' scheme. I have coined this expression to describe clandestine transfer of shareholder equity, either to management (a.k.a. embezzlement), or to an unnamed third party (a.k.a. defalcation). We do not know whether Barrick is guilty of embezzlement, defalcation, or both, and perhaps never will.

### Forewarned but not forearmed

We need not keep guessing. I submit that Barrick has been put on notice that its so-called hedge plan would invite charges of unfaithful stewardship as soon as the bear market in gold is over. I warned Sokalsky in person ten years ago at Barrick's headquarters. The meeting took place at the suggestion of Chairman Peter Munk with whom I exchanged letters on the matter. Sokalsky and I discussed Barrick's hedge plan for an hour and a half. I can testify that he understood my point very well. At the end of our meeting I presented to him a 50-page document entitled Gold Mining and Hedging: Will Hedging Kill the Goose To Lay the Golden Egg? which treated this issue exhaustively. He promised to read it and to pass his comments on to me within a month. I have never heard from him again.

In my document the process whereby a rising gold price inevitably makes world gold output shrink (in terms of tonnes) is very clearly demonstrated. To explain this, first I have to discuss another remarkable difference between the ways gold and base metals are traditionally mined. This is the deliberate variation of the rate at which mill capacity is being utilized. The base metal miner is under constraint to mine at the top grade of ore.

But he is free to vary the rate of mill capacity utilization in response to changing market conditions. Accordingly, he will increase it if he has to increase output, and vice versa.

Not so the gold miner, who is under constraint to run his mill full time, as close to capacity as practicable. But he is free to vary the grade of ore at the mill in response to changing market conditions. Whenever the price of gold rises he decreases, and it falls he increases the grade. He does this because the marginal grade of ore varies inversely with the gold price. If he is to run his mine economically, the gold miner is compelled to go after the marginal grade of ore and leave the better grades alone. He knows that premature exhaustion of his gold mine means dissipating shareholder equity and wasting capital resources. The prematurely exhausted gold mine would have a lot of valuable orereserves left behind that would become payable later when the dollar is sufficiently debased. But then it would be too late. Once the gold mine is closed down, it could be prohibitively expensive to re-open it.

### Mechanism of Peak Gold

For example, whenever the gold price rises, the marginal grade of ore falls as heretofore submarginal grades become payable. Since gold mines run their mills close to capacity, output shrinks every time the gold price has reached a new high plateau, provided that they are managed economically. Uneconomically managed gold mines get exhausted prematurely and fall by the wayside, as they well deserve.

Peak Gold can be confidently predicted since the increasing gold price (an inevitable consequence of deliberate dollar debasement) causes a world-wide shift in the marginal grade of every gold mine. The marginal grade of ore drops. Since the combined milling capacity of the world's gold mines is a given quantity, and it can only be increased slowly, after a great capital outlay which management may well be reluctant to make (as it would eat into profits and shorten the life of the gold property to boot), the upshot is that the gold content of mill output is falling. World production of gold shrinks (in terms of tonnes) with the rise in the price of gold.

But what about opening new gold mines? As Tom Szabo has hinted, the artificially induced bear market in monetary metals between 1981 and 2001 has resulted in a great reduction in prospecting, exploration of known sites, and development of mines at proven sites. We must realize, however, that the whole episode of explosive increase in world gold production from 1914 through the end of the century was a great anomaly. Even though it was engineered by governments on the warpath, the feat cannot be repeated.

The inflationary escapades of governments, either acting in solo or in concert will of course continue. The governments can stay on the warpath and can expand their pet welfare projects as long as they want. In vain: the nexus between the welfare-warfare state's inflationary design and the value of gold, or the tectonics of marginal gold ore underground, has decisively been broken. Governments have expended their ephemeral power to work the miracle of multiplying cash gold through multiplying paper gold.

Ditto, no longer can they pretend that gold locked up in ore deposits below surface is a valid substitute for cash gold. From now on it is "cash gold on the barrel". Falsecarding in the gold business has been exposed and discredited.

The great increase in world gold output during the twentieth century was a nonrepeatable event, largely due to the inflationary propensities of governments under the gold standard artificially suppressing, as they did, the value of gold. This has caused a world-wide shift in the marginal grade of ore in every gold mine. The marginal grade was boosted and, with it, the world's gold output. That is the background that has created Peak Gold in the first place: a reckless exploitation of a world resource whose production would have increased much more evenly in the absence of inflationary escapades.

But this is history. The present reality is that uneconomic increases in production and naked forward selling are over for good. On the supply side, limited and diminishing injections of newly mined gold shall replace unlimited and ever increasing dumping of paper gold. When you need gold, you demand cash gold, the supply of which from the mines is going to decrease from now on. It is satisfying to see Barrick acknowledge this first.

### Hedging proper

In the next part of this series Peak Gold! I shall explain, as I have explained to Jamie Sokalsky ten years ago, the principles of proper hedging. I suggested to him that Barrick should announce a bilateral hedge plan to succeed its notorious unilateral plan. The latter involves short hedges (forward sales) to the exclusion of long hedges (forward purchases). The former involves both.

Just as its forward sales are balanced by Barrick's need to market future production, forward purchases, had they been entered, could have balanced Barrick's future need to acquire new gold properties in anticipation of the exhaustion of its ageing sites. Had Barrick listened to my advice, Peak Gold would not have been to its chagrin. Not only would profits on the long hedges have outstripped losses on the short ones; they would have covered the hefty increases in the price that Barrick has now to pay for new gold properties. Barrick could have scaled Peak Gold with the flying colors, and without a penny loss on its short hedges. What is more, it could have plenty of money left on its long hedges to pay for the acquisition of fresh gold properties in preparation for a bright future bringing higher gold prices in its wake. Barrick would have been ready for the new bull market and could contemplate its own future with genuine optimism.

### Gold Standard University Live

Session Two of Gold Standard University is taking place between August 17 and 24,

2007, at Martineum Academy in Szombathely, Hungary. It is featuring a one-week course (13 lectures) entitled Gold and Interest, as well as a blue-ribbon panel discussion on the subject of Last Contango - Basis As an Early Warning Sign of the Collapse of the International Monetary System. Tom Szabo will chair the panel. He is the world's foremost expert on the gold and silver basis who on his website [www.silveraxis.com](https://www.silveraxis.com) has been tracking the basis for half a year. He is a member of the research team of GSUL.

Session Three is planned to take place in Bessemer, Alabama, U.S.A., in February 2008.

It will feature a one-week course entitled Adam Smith's Real Bills Doctrine. An advocatus diaboli from neighboring Mises Institute will be invited to challenge the wisdom of Adam Smith. The session in Alabama will also feature a blue ribbon panel discussion on the subject of True Hedging for Gold Mines. Representatives of hedged and unhedged gold mines will be invited to participate. The present series Peak Gold! is a primer on true hedging.

This is a preliminary announcement only. Stay tuned. For more information please contact: GSUL@t-online.hu

## Disclaimer And Conflicts

## The Publication Of This Article Is Solely For Your Information

## And Entertainment. The Author Is Not Soliciting Any Action

## Based Upon It, Nor Is He Suggesting That It Represents, Under

## Any Circumstances, A Recommendation To Buy Or Sell Any

## Security. He Has No Position, Long Or Short, In Barrick Stock,

## Nor Does He Intend To Acquire One. The Content Of This Article

## Is Derived From Information And Sources Believed To Be

## Reliable, But The Author Makes No Representation That It Is

## Complete Or Error-Free, And It Should Not Be Relied Upon As

## Such.

### References

A. E. Fekete, Have Gold Bugs Been Barricked by the U.S.? July 12, 2007

### A. E. Fekete, Gold Vanishing Into Private Hoards, May 31, 2007

Charles Davis, So Big It's Brutal, Report on Business, The Globe and Mail: Toronto, June 2006, p 64.

Bob Landis, Readings from the Book of Barrick: A Goldbug Ponders the Unthinkable, [www.goldensextant.com](https://www.goldensextant.com) , May 21, 2002

Richard Rohmer, Golden Phoenix: The Biography of Peter Munk, Key Porter Books,

1999

### A. E. Fekete, The Texas Hedges of Barrick, May, 2002

Ferdinand Lips, Gold Wars, Will Hedging Kill the Goose Laying the Golden Egg? p 161167, New York: FAME, A. E. Fekete, To Barrick Or To Be Barricked, That Is the Question, August 11, 2006 George Bush's "Heart of Darkness" - Mineral Control of Africa, Executive Intelligence Review, January 3, 1997, see in particular:

### Barrick's Barracudas

### Inside Story: The Bush Gang and Barrick, by Anton Chaitkin

### George Bush's 10 billion giveaway to Barrick, by Kark Sonnenblick

### Bush abets Barrick's Golddigging, by Gail Billington

### See also: [american_almanac.tripod.com](http://american_almanac.tripod.com/bushgold.htm)

---

*August 15, 2007*

---

# Gold Vanishing into Private Hoards

URL: https://newaustrianeconomics.com/archive/fekete/gold-vanishing-into-private-hoards/
Date: 2007-05-31
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, permanent-backwardation, gold-standard, fiat-currency
Description: Fekete observes that gold is being withdrawn from circulation and hoarded by private individuals and institutions — a process that accelerates as the gold basis declines. When gold disappears into private hoards, it is no longer available to settle international obligations, signaling the approaching end of the paper money system's ability to function.
Editorial Note: Written May 2007. The phenomenon of gold hoarding is for Fekete a key diagnostic indicator — when people stop dishoarding gold (lending it out for the carry trade), the basis collapses and permanent backwardation approaches. This essay tracks that process empirically.
Original PDF: https://professorfekete.com/articles/AEFGoldVanishingIntoPrivateHoards.pdf

## The Dollar: An Agonizing Reappraisal

### Part One of a New Series

## Gold Vanishing Into Private Hoards

### Antal E. Fekete

### Gold Standard University aefekete@iisam.com

Introduction. While doing research in the Library of the University of Chicago in the early 1980’s I came across the unfinished manuscript of a book with the title: The Dollar: An Agonizing Reappraisal. It was written in the year 1965. It was never published (although it received private circulation). The author, monetary scientist Melchior Palyi, a native of Hungary, died before he could finish it. Monetary events started to spin out of control in 1965, culminating in the default on the international gold obligations of the United States of America six years later in August,1971. Palyi had correctly prophesied that event which occurred after he died. He had also correctly diagnosed the malady and prescribed the remedy that could have arrested the train of events that would in all likelihood cause a crash further down the road. As part of the offering of the Gold Standard University, I shall publish the manuscript serially in the form of excerpts, along with with my commentary, concentrating on parts that are still timely.

That the title is more timely than ever is a fact that nobody can deny.

Biographical remark. Melchior Palyi (1892-1970), the internationally recognized educator, author, and economist was born and got his early education in Hungary. He was Professor Emeritus of the University of Berlin and also taught at the Universities of Munich, Göttingen, and Kiel. He was the chief economist of the Deutsche Bank of Berlin, the largest on the European continent at the time, and was adviser to the Reichsbank, the central bank of Germany, from 1931 to 1933. He was then guest of the Midland Bank, Ltd., in London, and visiting lecturer of the University College of Oxford.

Palyi moved to the United States in 1933. He was visiting professor and research economist at the University of Chicago, Northwestern University, the University of Wisconsin, and the University of Southern California. He was involved in broad literary and lecture platform activities. The bibliography of his literary output is extensive; let it suffice to mention the titles of some of his books: Compulsory Medical Care and the Welfare State

(1949; he is credited with the saying „where the Welfare State is on the march, the Police State is not far behind”), Managed Money at the Crossroads (1958), A Lesson in French: Inflation (1959), and his swan song: The Twilight of Gold (1970). Change of font to bold indicates quotations from the manuscript.

### The Gold Paradox

Nineteen sixty five will be remembered in the modern history of money. For the first time, private buyers absorbed almost the entire supply of new gold coming on the market. „Newly mined gold plus Russian sales amounted to approximately \$1.9 billion”, reported the First National City Bank of New York, but „only some \$250 million worth is believed to have reached officially recorded monetary stocks” (all quantities are stated in gold dollars, reckoned at the gold price of \$35 per Troy oz.) And none whatsoever accrued to U.S. monetary reserves ─ which has actually declined by a near record amount of \$1.66 billion.

What is happening to all that disappearing gold? Why does it refuse to go to official gold reserves? Why, in particular, is the U.S. Treasury on the losing side year after year, with no sign of terminating this process? And, above all, what does it say about the stability of the dollar, the economic health of the nation, and the future prospects of the Western World?

The central problem is the actual maintenance of the parity. The U.S.

Treasury is under obligation, in effect, to assure that on the world’s markets 35 dollar means the same value as one ounce of gold. Thereby the value of the dollar is anchored to the solid rock of a fixed quantity of gold. As long as this external convertibility of the dollar appears to be guaranteed, world public opinion will not question the equivalence between the currency unit and a set amount of the yellow metal. That is why to the world at large the dollar is „as good as gold”. In the words of President J. F. Kennedy, speaking in September, 1963, „We are determined… to maintain the firm relationship of gold and the dollar at the present price of \$35 an ounce, and I can assure you we will do just that.”

### Gold vanishing into private hoards

1950 is the watershed year marking the start of a new era in the relationship between gold and paper money. In the twelve year period ending in 1964 the Western World’s gold mines and Russian gold sales (about \$1 billion in 196364) combined, produced \$16 billion worth of gold, but official gold reserves have grown only by \$7 billion. More than 50 percent, on average, of the new gold bypassed official reserves and vanished in private hoards. On the top of that the prime reserve currency, the U.S. dollar (that is backing many other currencies) had lost close to one-half of its gold reserves. By the end of 1965 our reserves have declined from a peak of \$24.7 billion in September, 1949, to less than \$14 billion ─ of which \$835 million is a sight deposit of the Internationalk Monetary Fund. Not only has the richest country failed to attract any part of the new gold supply; it has actually lost more than \$10 billion’s worth. If continued, this process would herald the breakdown of the entire gold-based monetary setup of the West, with incalculable consequences.

To have some idea of the order of magnitude of gold vanishing into private hoards during the period 1950 and 2007, let us look at the following table .

### Gold Vanishing into Private Hoards

### (approximate quantities by source, in gold dollars at \$35/oz)

### Period

1950-51

1952-65

1966-68

1969-2007

## Total .

### New production Russian sales

### $ 2000 m

### $ 16 600 m

### $ 4500 m

### $ 3400 m

### $ 77 400 m

. . . . . . . . . . . .

### US/IMF auction

.

.

.

.

.

.

### Total

.

.

As is clear from the table, gold absorption into private hoards for the 15-year period from 1950 through 1965 was of the same order of magnitude as the U.S. gold reserve at its peak in 1949, the largest gold concentration ever in history, just short of \$25 billion. This private absorption of gold is unprecedented, both as to its magnitude and to its speed. The total amount of gold absorption for the entire 57-year period 1950-2007 was approximately $......., an amount greater than all the gold produced in history before 1950. Clearly, something ominous is happening to the dollar. Vanishing gold is trying to tell us something, that is, if we have ears for hearing.

More remarkable still than these extraordinary quantities of wealth shifted out of paper assets into phyisical gold, worth about $ … trillion at today’s gold price, a process that is still continuing at an accelerating rate, is the fact that mainstream economists and their paymasters in government are not asking questions about, nor offering explanations for this incredible movement of wealth going into hiding. The apparent lack of interest about the identity and intentions of the owners of this wealth on the part of the economists profession is in itself a worthy subject to investigate.

Put it differently, paper wealthin the world is being destroyed at the rate of the annual gold production, approx. \$2.8 billion gold dollars (equivalent to \$55 billion paper dollars at today’s gold price), but this earthquake-style destruction is allowed to go unnoticed by academia and the financial media. They are satisfied that paper wealth so destroyed will not be missed. The U.S. Federal Reserve banks are dutifully replacing these real assets, and more, by printing paper assets. „See no evil, hear no evil.” „What you can’t see won’t hurt you.” Nobody asks whether the large quantities of gold vanishing into private hoards could cause a crisis when its size reaches critical mass. Be that as it may, thinking people ought to realize that, the official ’propaganda of silence’ notwithstanding, the disappearance of such inordinate quantities of gold cannot help but, in the fullness of time, have an untoward effect on their lives and on their children’s lives.

Fifty percent of all gold in existence has been produced since 1960. The same fifty percent has been withdrawn during the same period of time from the public domain, and disappeared in private hoards. There is no way to account for this gold. We do not know the location, the identity of owners, nor their intentions what they wanted to do with it. This is a sea change portending a still greater sea change to come. This is a situation comparable to the disappearance of the gold and silver coinage of ancient Rome portending the fall of the Empire. For this sea change the public is totally unprepared. It is left in complete ignorance, due to the deep silence of the media.

### „The most uneconomical medium of circulation”

At this point the reader may raise some pertinent questions. Why is gold essential for the monetary system? Why should anyone want to hoard it? Is it not a useless gadget, good only for jewelry and dentistry? Why base the currency on such an odd commodity, or on any commodity for that matter? We have eliminated gold from hand-to-hand circulation; why not finish the job and dethrone the „barbarous relic”, as Lord Keynes called it?

Indeed, we seem to be on the way to wipe all traces of gold out of the monetary system. The first (1915) Annual Report of the New York Federal Reserve bank argued that „gold is the most uneconomical medium of hand-tohand circulation since, when held in bank reserves, it will support a volume of credit equal to four or five times its own volume”. (That was an unintended admission of the inflationary bias indigenous to American moneymanagement.) Twenty years later, in 1934, we proceeded to ’demonetize’ gold, forcibly taking it out of circulation. This was followed, in 1945, by the reduction of the Federal Reserve banks’ gold reserve requirements to 25 percent of total liabilities. By 1965 we had abolished gold as a mandatory backing of the deposit liabilities of the Federal Reserve banks altogether.

### The rationale of gold

The first thing to know about gold is that there is no alternative to it. Gold is the one and only commodity that has no marketing problem. There is no sales resistance and no competition to overcome. A gold reserve is as important for the nation as a bank account for the firm or individual. You keep part of your funds in idle bank balances in order to be ’liquid’ ─ to be able to pay your bills.

Gold is the ultimate and unquestioned world-wide ’liquidity’. It is accepted in payment of claims. Hence it is imperative that a country should possess gold, or to have access to gold, in order to take care of an unfavorable balance of foreign payments that arises when it has to purchase abroad more goods, services, and assets than other countries buy from it. This has been the chronic case for the United States in the post-World War II era, resulting in gold losses and in a huge volume of short-term debt to foreigners.

The gold reserve inspires confidence in the currency at home and abroad. „Even the most prejudiced managed-money advocate cannot deny that no form of paper or arrangement can ever command the confidence and trust inspired by gold, a store of value in itself” (The Statist, London, December 25, 1964.)

In addition to the monetary there is also a non-monetary demand for gold. The very promising metallurgical and medical applications of gold are still in their infancy. Its use in the arts is ancient history. In any case, the nonmonetary demand provides a substantial part of the value of the yellow metal, and is the root-cause of its use as the Number One store of value. This function loses its importance when the national currency is safely anchored in gold. But it is promptly revived and expanded whenever convertibility comes under a cloud.

Paper money can be multiplied sine fine, virtually at no cost. Gold is available only in limited quantity and at a substantial cost of production. This fact is not a negative but a highly positive factor for determining gold’s monetary fitness. Gold derives further strength from another circumstance.

The annual new production is a very small part of the accumulated total supply, hardly ever more than 3 percent at any given time. In 1965, for example, the \$1.9 billion new gold reaching the market was less than 3 percent of the total supply of over \$60 billion accumulated in the central banks of the West and in private hoards. (The latter has been ’guesstimated’ at \$17 billion.) No commodity known to man combines as gold does the qualities of durability, unlimited marketability, portability, homogeneity, steady demand, stability of supply growth, fitness for being stored, low cost of storage per unit of value and, last but not least, independence from authoritarian manipulation of the total supply. This is why totalitarians (and their dedicated or subconscious fellow-travellers) are violently opposed to its private ownership that provides the citizen with a large measure of freedom. By having gold he can hedge against arbitrary policies of the Omnipotent State, or even slip out from its clutches.

### Explanation of the gold paradox

The paradox of a chronic flight into gold, and out of the U.S. dollar which is tied to gold, is the outstanding symptom of a critical situation. The pat explanation for the paradox is to blame the recurrent runs on the ’speculators’. This is a characteristic throwback to medieval economics, confusing symptom and cause. In truth, responsibility belongs to the authorities who create opportunities to induce speculators to go short on the dollar or to buy gold on margin. A far more important factor may be the maneuvering of the cautious who do the exact opposite of ’speculating’: they are trying to protect their assets and incomes by hedging against a possible devaluation…

Another pat explanation relegates the problem to the fringes of the global economy. In areas where political, legal, or monetary insecurity prevails, there is a compulsive instinct to seek security in hoarding gold. No country can beat India in this regard. The hidden gold of her population has been estimated by India’s Reserve Bank at some \$6.4 billion (!), built up over a period of 100 years or longer.

But the less developed economies are altogether too poor to absorb each year the huge amount of vanishing gold. And why would they not hoard convertible currencies instead of gold, as they did in the past? Actually, an appreciable fraction of foreign aid dollars has been used by the recipients to acquire gold ─ another vote of no-confidence for the dollar, as well as for the respective local governments.

Even more significant is the fact that leading European central banks display definite signs of impatience with the dollar. Given the \$13.7 billion holdings of dollar claims by monetary authorities, not counting some \$6 billion held by international organizations, the danger this implies for the American gold reserve and the maintenance of the dollar’s convertibility can scarcely be overestimated.

It is more than a problem in monetary management. Our very prosperity, and the integrity of our economic system is at stake!

### Explanation, forty years later

In the following parts of this series I shall take the analysis of the gold paradox beyond the point to which Palyi has taken it. I shall ask the question who the hoarders are and what motivates their gold hoarding. My thesis is that gold hoarding is a win-win strategy, the only valid one as such. (All other win-win strategies are Ponzi schemes.) However, there is a strict condition, one that most would-be beneficiaries are unable to meet. The gold hoarder must be mentally capable of using gold exclusively as his numeraire in calculating asset values as well as pofit and loss. He must understand that profit/loss accounting in terms of the paper dollar is tantamount to trying to measure length with an elastic measuring-tape. The obvious result is a cover-up for the deficiency of length, akin to the cover-up for the deficiency of wealth, and to making losses parade as profit. Watch for the day when people wake up from their delusion.

Admittedly, very few people are able to adapt their thinking to the demand that the dollar be discarded as numeraire of wealth. The dollar is far too deeply ingrained in their psyche for that. As a result, very few people see the fragility of wealth under the regime of irredeemable currency. Those who can are not tempted by the spectacular profit opportunities in stock, bond, and real estate speculation. They know full well that yielding to the temptation would be tantamount to sitting in a crowded auditorium just before the fire alarm was ready to sound. Their chance to reach the fire exit alive would be practically nil.

This also explains the little guy’s agonizing watch on a hesitant gold price to go up.

He is conditioned by a host of cheerleaders of get-rich-quick schemes. The more enlightened hoarders of gold (whom in another paper I called ’bulls in bearskin’) ─ a tiny minority ─ are in no hurry to see the dollar to bite the dust, or the price of gold to go to outer space. They do have the philosopher’s stone, gold, well in hand. More importantly, they also have the matching wisdom without which gold is just another dead asset. They know that the most productive use of gold is not sitting on it, waiting for the miracle of a gold price in five digits to spring upon the world. They want to derive maximum advantage from their possession of the metal. In particular, they know how to make gold yield an income in gold, something even Aristotle believed was impossible. Most importantly, they need not release control over their gold while deriving an income from it. Mark that in all other cases deriving an income from an asset involves putting the asset to risk. The fact that gold income is an exception to that rule in that it can be harvested risk free even while the gold is locked up in one’s own vault, is due to the idiosyncracies of irredeemable currency.

The ’enlightened hoarders of gold’ prefer the security of a gold income, that they can enjoy in relative peace, to the insecurity of an exploding gold price. They understand that they could not enjoy their exploding wealth once the gold price escaped from the earth’s gravitation, because of the blood that would be flowing in the streets where the have-nots did battle with the haves over the bone of contention: gold.

The common perception is that commercial traders are selling gold short naked in order to drive down the gold price where they can cover their short positions at a huge profit.

Thus the bears are sucking the blood of the bulls. This is a myth. Commercial traders are mere agents. If they trade for their own account, the amounts are paltry in comparison. Commercial traders act on behalf of principals who do hold the gold and want to derive an income from their holdings. It is understandable that the principals wish to stay anonymous and, in an unexpected reversal of Andersen’s tale, The Emperor’s Clothes, they foster the misperception that they are naked!

### Historical precedence: vanishing gold in ancient Rome

The last time in history when huge amounts of gold were going into hiding occured during the twilight of the Roman Empire. It was an ominous portent of bad tidings. People were withdrawing gold coins from circulation. They declined to spend them hoping that saner and safer times would come. As a rule people do not spend their gold coins unless they see that they will be able to get them back on the same terms. As saner and safer times did never come, these ancient hoards were forgotten and remained buried in the ground throughout the Dark Ages. Present day archeologists still keep finding them fifteen hundred years later.

Owners of those ancient gold hoards were helpless. They could not enjoy their gold as they were unable to retard the coming of the evil day when the Roman monetary unit would become worthless, and the Empire would fall. In this respect latter day gold hoarders are better off. They seem to be able to retard the fall of the dollar towards worthlessness and, in the meantime, they could enjoy a gold income in relative security. Of course, this will not fend off the ultimate collapse of the American Empire, although it may materially postpone it.

The fortunes of empires tend to coincide with the fortunes of their currencies.

The present episode of gold vanishing into private hoards is no less ominous than the previous one that was followed by the collapse of the Roman Empire, and the going out of lights in the civilized world.

As this „agonizing reappraisal” shows, the days of the dollar are numbered. Regardless whether it be a large number or small, the next Dark Age looms large on the horizon.

---

*May 31, 2007.*

---

# The Golden Thorn in the Flesh, Part Two

URL: https://newaustrianeconomics.com/archive/fekete/the-golden-thorn-in-the-flesh-part-two/
Date: 2007-05-30
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, fiat-currency, debt, monetary-crisis, sound-money
Description: Part two examines the consequences of gold's removal from the monetary system: without the thorn, governments have been able to expand debt without limit, but this apparent freedom has produced the greatest accumulation of unpayable debt in history. Fekete argues the thorn must be reinserted — not because of ideology but because the alternative is systemic collapse.
Editorial Note: Conclusion of the Golden Thorn series, May 2007. Fekete turns from historical analysis to prospective argument: the debt accumulated since gold's removal is the delayed consequence of eliminating monetary discipline, and its eventual resolution will be either an orderly return to gold or a disorderly collapse.
Original PDF: https://professorfekete.com/articles/AEFTheGoldenThornInTheFleshPartTwo.pdf

*"Gold Standard University" The Golden Thorn In The Flesh*

### Concluding Part of a Series of Two

### Antal E. Fekete

### Gold Standard University aefekete@iisam.com

### The topsy-turvy world of central bank gold sales

Here is a passage from my 1998 book entitled Gold and Interest that will soon be released as an e-book.

As these pages are written (late 1997), chrysophobes make much of the weak dollar-price of gold and of the fact that more central banks, including the Swiss, join the company of those that have been dumping gold on the market. In addition, self-styled experts on deflation submit that, while under an inflationary spiral gold hoards may have been a reasonable investment, gold is the worst possible place to be under a deflationary spiral.

It is undeniable that the gold market has been highly charged psychologically for the past thirty years. This will likely continue into the 21st century. It is also true that the great bull market in bonds that started in 1980 has so far coincided with the great bear market in gold. From a high of \$850 in 1980 gold went to a low of $ 285 in 1985 and is trading near the low end of that range at the time of writing. However, it does not follow from this that the gold bear must march hand-in-hand with the bond bull, or that they must expire together. There are reasons to believe that the gold dumping is orchestrated and is meant as a scarecrow tactic. A central bank advertising its future gold sales stinks: it cannot be sincere about its real intentions. As every student of the market well knows, selling at low and falling prices is a sign of weakness - never a sign of strength. Central bank selling of gold is no exception.

### Hecatomb of currencies

At this juncture the gold market is a mere side-show. The main show is the foreign exchange market where a clandestine trade war is being waged. Presumably there will be a lot of casualties in the form of fallen currencies before it is all over. The dollar, for the time being, is the obvious refuge for the victims of the hecatomb of currencies. This makes it appear strong. But the dollar has its own problems. First, it suffers from exactly the same ills that are plaguing all falling currencies. Second, the American political establishment has a very low tolerance for a strong dollar. Recall that in 1985, under a conservative President, the dollar was diagnosed 'too strong' and was subsequently scuttled - making the price of gold rise from its lows. Rumors of the demise of gold are grossly exaggerated. At the risk of belaboring the obvious I would like to make the following points.

### The only financial asset that is nobody's liability

The volatility of the dollar-price of gold is not a reflection of the uncertainty in the value of gold. It is in fact a reflection of the uncertainty in the value of the dollar in which the gold price is quoted. A lower gold price shows a momentary strength of the dollar; not a reluctance on the part of people to hold gold. Nobody is suggesting that the world no longer needs a financial asset that is nobody's liability.

### A currency immune to debasement, default, and devaluation

The lower gold price also reflects the reluctance of the people to put the central bankers out of their misery. After all, they could call the bluffing of central bankers at any time if they wanted to. For the time being they don't. Central bank gold dumping may or may not be good politics, but it is certainly poor economics. Gold is the only sound asset in the balance sheet. It is the only asset in the balance sheet that is not at the same time a liability in the balance sheet of someone else. For this reason, gold is immune to deliberate debasement, defaults or devaluations. By contrast, dollars in the balance sheet represent irredeemable promises to pay, with the obligor having a history of deliberate debasement, defaults and devaluations. When a central bank discards a sound asset from its balance sheet at a low price, and replaces it with a dubious one at a high price, it makes its own currency weaker, not stronger. It is especially foolish to do this at a time when the world is entering shark-infested waters where the sharks are preying on paper currencies.

### Central bankers making themselves the laughing stock of the world

We must distinguish between gold sales by a weak central bank from that by a strong one. A weak central bank prefers to conduct its gold sales in perfect secrecy. It does not want the world to know about the timing and the extent of its selling program lest the market's unfavorable reaction cause the proceeds from the sale to suffer. Even so, the market has an uncanny way of bringing down the gold price ahead of the sale just long enough to accommodate the central bank eager to unload its gold, only to put the price back up once the sale is completed. By contrast, a strong central bank wants to show off that its gold is 'surplus'. All the same, the central banks has to proceed carefully lest it become the laughing stock of the world in selling its patrimony for a pittance.

Embarrassing questions might be asked such as this: "why is it that central bankers always sell at the bottom, and never at the top?"

### Hidden agenda?

Especially suspicious is a central bank drumming up its proposed sales. It is the height of incompetence and ineptitude to proceed this way - unless the central bank has a hidden agenda. It may want to camouflage its intention to buy, so it is bringing down the price to facilitate its purchasing program.

### External demand for dollars

The strength of the dollar, such as it is, is entirely due to external demand. This demand is, as it has been since 1971, subject to withdrawal without notice. Internally, there is nothing to justify the strength of the dollar. There is no end in sight to U.S. trade deficits.

All the optimistic predictions about eliminating the U.S. budget deficit that have been made in the past turned out to be ill-founded. It remains to be seen whether the latest optimistic prediction is better founded. If the deflationary cancer metastasizes across the Pacific, as appears likely, then the present falling trend in the U.S. budget deficit could make a nasty U-turn. The U.S. is still the greatest debtor in the world and in history. And it is still true that nothing comes from nothing.

### Misunderstanding economics and mismanaging public resources

The current rush of central banks to sell their shrinking gold assets in the face of their burgeoning liabilities is just another case of misunderstanding economics and mismanaging public resources as completely as only government bureaucrats can misunderstand and mismanage them.

35 years of Keynesian and Friedmanite agitation for confetti money

The folly of central bankers and Treasury officials managing the patrimony of their countries in the face of gathering storm is unprecedented. This is the result of 35 years of Keynesian and Friedmanite agitation in favor of irredeemable currency, and the systematic badmouthing of sound economics, finance, and debt-management. I am grateful to Dr. Theo Megalli of Germany for translating into English a paper of the late Hungarian monetary economist Melchior Palyi with the title Gold Standard and Economic Order that appeared in the book Geld, Kapital und Kredit - Festschrift for the seventieth birthday of Heinrich Rittershausen (Stuttgart, 1968) from which the following quotations are taken.

### The Gold Standard and economic order

The gold standard was sacrosanct to generations brought up on Adam Smith's ideal of the free market, free, that is, from arbitrary and discriminatory intervention by the powers that be. Indeed, it was an essential instrument of economic freedom. It protected the individual against arbitrary government measures by offering a convenient hedge against confiscatory taxation as well as against currency depreciation and devaluation. Gold provided essential mobility of funds beyond national boundaries. Above all it raised a mighty barrier to authoritarian interference with the economic process. In the words of Adam Smith: "That insidious and crafty animal calling himself 'statesman' whose councils are guided by the momentary fluctuations of affairs" was forced to keep the national budget in good order. Authoritarians of all denominations had to control their inflationary propensities and to refrain from excessive taxation in order to forestall the loss of confidence in the currency on the part of the people. The public purse had to be held tight. The business community had to learn to live with the salutary threat that illiquidity caused by short-sighted over-investment and irrational speculation could be penalized by loss of gold and an automatic tightening of the money-supply.

The gold standard in the classical sense was part and parcel of an economic order. It was the corner-stone of the system of public law, social customs and institutions that Marx pejoratively called "capitalism" - a system that rested on nearly unlimited freedom of consumer choice, of enterprise, and of markets…

### Unity of the economic world

The meaning of the gold standard - with unrestrained and uncontrolled private ownership of gold - cannot be appreciated in isolation from the institutional and psychological background that characterized the civilized world in the decades before 1914. The outstanding feature of that period was the unity of the economic world as it has not been achieved before or thereafter.

Quoting from Oscar Morgenstern's International Financial Transactions and Business Cycles, New York,1957, pp 17-19: "There was freedom of travel without passports, freedom of migration, no exchange controls or other monetary restrictions. Citizenship was freely granted to immigrants… capital could move unsupervised in any direction, and these movements could take any form… International trade had to overcome tariffs, yes, but… tariffs were exceedingly low. There were hardly any qualitative restrictions on international trade (quotas, import prohibitions, etc.)… It was a world of which recently many… would have been inclined to assert that it could not be created because it would never work…"

It was a world of low wages and lower still prices. Taxes were almost nominal. It was a world in which virtual freedom of enterprise, 'workable' competition and highly flexible wage-price structures prevailed in which private property and contracts were held inviolable. Defaulting governments had to face boycott or worse.

It was a world, by and large, of balanced national budgets. Public debt had to be amortized as a matter of course, just as private debts had to be repaid. Fiat money was anathema. Emergency public expenditures were financed by long-term bonds. There was no monetization of public debt.

### A world of steady real growth

Above all, it was a world of steady real growth - at an average annual rate of 5 percent during the six decades before 1914 - of steadily rising living standards for the masses, with 'social security' provided by the automatic protection of savings…

The role of the gold standard in unifying the civilized world can scarcely be overestimated. It was the sine qua non opening up the world for economic progress, for the diffusion of modern civilisation. Capital flows that were instrumental could allow the gold standard to operate with a minimum of actual gold transfer and with relatively modest gold reserves. The gold standard presupposed a high degree of freedom in foreign trade helping the debtor nations in liquidating their debt through exports to the creditor… Throughout the 19th century most major central banks remained privately owned commercial institutions and were supposed to conduct themselves as financial enterprises - to earn profits. They were to "suffer" the impact of gold flows, rather than influencing them…

### Real Bills - the safest earning asset

In Britain, the Banking School argued that no authoritarian control or discretionary power was needed to sustain the balance between the production of marketable goods and the creation of currency. Enlightened self-interest would compel the central bank to maintain the liquidity of its earning assets that were to consist of "real bills", that is, short-term self-liquidating commercial paper growing out of the actual sale of goods.

The Currency School on the other hand doubted that stability could be guaranteed by asset liquidity rules which, notoriously, could be violated when most needed - at times of business upturn and rising prices. Adherents of this school believed that the moneycreating power of the central bank was the crux of the situation and insisted on curtailing this power by requiring 100 percent gold reserve for the note issue. The idea was that the automatism of the gold standard was to be preserved by putting the central bank into a strait-jacket. The volume of the outstanding note issue was to expand and contract in exact proportion with the inflow and outflow of gold.

The Currency School won a Pyrrhic victory in 1844. By the Peel Act the Bank of England was obliged at all times to maintain 100 percent gold reserve behind its note issue beyond a modest amount… But the necessity to suspend limitation on the note issue in the monetary panics of 1846, 1858 and 1867 taught that tying the Bank of England to a formula was a senseless undertaking. Not only did the Peel Act fail to extend the 100 percent reserve requirement to the central bank's deposit liabilities, which grew faster than the note liability, but the tying of the bank's hands behind its back, as it were, left the problems of monetary policy unresolved.

### The flame of liberty

Before World War I economic considerations dominated political agenda, not the other way around. Wars could not be waged to the bitter end, bankrupting vanquished and victors alike. Peace following war was genuine, rather than a continuation of hostilities through other, economic means. The vanquished were allowed to recover through hard work and hard saving, thanks to the operation of the gold standard.

All this was to change with the outbreak of World War I. Economic considerations were sacrificed on the altar of political expediency. A new regime, one of prepetual and total war was inaugurated. When the gold standard refused to play along, it was given a bad name, and a dishonorable discharge. People were not consulted. Through a series of confidence tricks they had been weaned from the gold coin. The Warfare State went all out to bribe the electorate with the newly-invented Welfare State. The golden thorn in the flesh of the establishment remains. The Constitution of the United States of America, primarily because of its monetary provisions, was thrown to the winds. The powers that be wanted to unshackle themselves in preparation of enslaving the American people.

Confiscation of the gold coin of the people was the necessary first step. Trying to bribe people with an avalanche of confetti money was the second.

If the flame of liberty is to flare up again from the ember barely glowing underneath layers of ashes left behind by a century of total war, it will be thanks to the indelible mark that the gold standard, once the epitomy of unity of the entire civilized world, has left on human affairs as no religion, ideology, literary or scientific movement ever did.

### Gold Standard University

Session Two is scheduled for August 15-29, 2007, in Szombathely, Hungary. It will include a blue-ribbon panel discussion under the title The Last Contango: the First Sign of Disintegration of the International Monetary System, on the gold/silver basis as a most sensitive market indicator that is being developed by a team of researchers. For further information please contact: GSUL@t-online.hu .

---

*May 20, 2007*

---

# The Decoy of the Falling Dollar Revisited

URL: https://newaustrianeconomics.com/archive/fekete/the-decoy-of-the-falling-dollar-revisited/
Date: 2007-05-18
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, fiat-currency, bond-market, monetary-policy
Description: A brief revisit to the 2005 'Decoy' essay in light of subsequent events: the dollar continued falling while bonds remained elevated, confirming Fekete's earlier analysis. He reinforces his argument that focus on the dollar-gold exchange rate distracts from the more important signal — the falling gold basis and what it portends for the entire paper money system.
Editorial Note: A short follow-up to the February 2005 essay, published May 2007. The brevity reflects that events had largely confirmed his earlier analysis; this piece updates and reinforces rather than develops new arguments.
Original PDF: https://professorfekete.com/articles/AEFTheDecoyOfTheFallingDollarRevisited.pdf

## The Decoy Of The Falling Dollar

REVISITED by Antal E. Fekete,

### Gold Standard University

---

*May 18, 2007*

I have received the following letter from a reader of my column:

Mr. Fekete:

I have been reading your work for a number of years and always look forward to your thoughts, particularly when they run counter to conventional wisdom. In your latest piece you suggest that the falling dollar (or rising yen) actually strengthens the yen carry trade. My chartwork argues otherwise, and your logic escapes me. I would welcome clarification of one particular paragraph of yours, especially on the last sentence that, I believe, is central to your analysis. You wrote: „This is where I take issue with conventional wisdom… What they miss is the fact that the bear market in the dollar actually helps rather than hurts the yencarry. The terms of trade for those who sell yens to buy dollars is improved immensely by the fall of the dollar. The yen carry trade can be described as arbitrage with short leg in the yen bond market and long leg in the dollar bond market. Profits on the long leg increase faster than losses on the short as a result of dollar devaluation.”

I don’t follow this. Yes, borrow yen at 1 percent and go long dollar bonds at 4 percent. But over the holding period you lose on the dollar’s depreciation.

I agree that a falling dollar means that over time you can buy more and more dollars with borrowed yens. But for borrowers, who short the yen, the ever more ’favorable’ terms of trade work the opposite way in the end. It costs you more and more dollars ─ and then some ─ to buy those yens back and repay the loans (assuming that finally you do close the trade).

Concerning the last sentence quoted, it is true that as long as the US longer term rates stay low or, better still, fall further, there are capital gains that might override forex losses. You don’t explain it that way, though, so I am not sure that this is what you mean. If so, it is not the falling dollar that assists the carry, but the falling US interest rate. And I question whether long rates are are as closely tied to forex rates as short rates sometimes are.

Appreciatively,

### Peter Bond

Dear Mr. Bond:

The paper of mine you have quoted from was written two and one half years ago. You take me to task for saying that, contrary to widespread belief, the weak dollar helps rather than hurts the yen carry trade, adding that your chartwork argues otherwise.

The fact is that during the past two and a half years the dollar lost quite a bit of ground, yet the yen carry trade was not visibly hurt. If anything, it was further emboldened. In other words, my 2005 insight turned out to be correct. The question you should ask is whether there is any explanation, other than mine, of the conundrum that dollar bonds do not weaken, and may even strengthen marginally, in the face of the falling dollar.

Please notice that I am not an investment advisor and I am not writing manuals for the benefit of small time bond and forex traders. I am writing for the benefit of the intellectually curious, who want to understand the markets as they unfold under the global regime of irredeemable currencies. In doing so I am painting a broad-brush picture, ignoring minute details such as the question how bond bulls cover their forex risks through dynamic hedging or otherwise.

You would be justified to ask the question whether I still stand by my 2005 analysis, or whether I see reason to modify it in view of events in the interim. My original paper had the title „The decoy of the falling dollar”, suggesting that the real show is the bond market. The forex market is a side show at best. Neither market is free, far from it. Both markets are dominated by extremely powerful players (among which you can count China with a better than one trillion dollar stake). They are the puppet masters of the other show in the forex market. It is not in their interest, nor will it be in the foreseeable future, that the dollar be scuttled. Controlled decline, yes; collapse, no. They want to, and can, make sure that their long position in dollar bonds will continue to be profitable enough to cover losses on their short position in yen bonds. For these reasons I stand by my predictions of 2005. The bond bull is still alive and kicking. It may get ready to resume his charge. The dollar is sick, yes, in all likelihood terminally so. It is on the life-support system for the time being by a powerful clique of bond bulls that can well afford to keep the comatose dollar alive. They will pull the plug when it is no longer profitable for them to continue the yen carry.

The main point is that the sliding dollar helps rather than hurts the yen carry trade. That’s just the clever part of it, which confounds even experts such as Pimco’s Bill Gross. As I said in my 2005 article, the terms of trade for those selling yens to buy dollars is being improved as the dollar falls. Never mind how the arbitrage will be unwound eventually. As long as the dollar is not collapsing it hardly matters. Positions can be rolled over, while forex losses are taken care of through dynamic hedging. This is a cat-and-mouse game. Cats are the bond bulls. Mice are the dollar bears. You guess who will gobble up whom in the end.

Please don’t misunderstand. This is not an investment advice to you, or to anyone, to buy US dollar bonds. I am merely sharing my insight into the operation of the deceitful world of irredeemable currencies. In the end, like in games children play, ”they all fall down”. But there are differences. Differences in the timing of the fall, and also differences in the way they fall. Some may fall hard on a rock; others may have a soft-landing on a pillow.

Is it possible that I am wrong and the dollar will succumb sooner rather than later? While not impossible, it is unlikely. Why? Because the clique of the bond bulls has a vested interest in the charade to continue. Most importantly, it has the power to make its wishes stick. Its members were lucky enough to start riding the charging bond bull early. Make no mistake: China has been in it from start, since 1981 when US interest rates were over 16 percent. Don’t be fooled: the onetrillion-dollar kitty is not all trade surplus. So much of it is profits from China’s bond trading portfolio. Other bond bulls are similarly sitting on mountains of paper profits. In spite of appearances, the Chinese are not stupid. They will keep the game of musical chairs going. They are calling the shots. The music will stop when they stop it. But not yet.

The yen carry trade in my view still has a long way to go. It is the main prop that keeps the dollar from collapsing. It may even cause the price of US bonds rise some more. Why? The Bank of Japan will continue to feed the yen carry because it could not afford to let interest rates rise for fear of bankrupting the Japanese government, to say nothing of the Japanese banking system. The Fed will feed it because it is cornered: the alternative is ’sudden death’ for the dollar.

The yen carry represents the only steady and reliable international demand for dollars since America has effectively de-industrialized itself when the exporting of paper turned out more profitable and less bothersome than exporting manufactured goods. International speculators want the unilateral dollar export to continue and to stoke the furnaces of the yen carry trade.

If you try to rebut me saying that it smacks of a conspiracy between the Federal Reserve and the Bank of Japan, the answer is: „you have said it”.

Best regards,

### A. E. Fekete

### Reference

### The Decoy of the Falling Dollar, February 2005

---

# The Golden Thorn in the Flesh, Part One

URL: https://newaustrianeconomics.com/archive/fekete/the-golden-thorn-in-the-flesh-part-one/
Date: 2007-03-31
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, fiat-currency, central-banking, monetary-policy, sound-money
Description: Fekete argues that gold is a 'thorn in the flesh' for governments and central banks precisely because it cannot be counterfeited or created at will — it limits their power to spend beyond revenues. Part one examines the historical campaign to remove this thorn and the successive stages by which gold was expelled from the monetary system between 1913 and 1971.
Editorial Note: Part one of a two-part series from March–May 2007. Fekete uses the biblical metaphor of a thorn in the flesh (2 Corinthians 12:7) to capture gold's disciplinary function in monetary systems — a source of pain for governments, but also of strength.
Original PDF: https://professorfekete.com/articles/AEFTheGoldenThornInTheFleshPartOne.pdf

*"Gold Standard University" The Golden Thorn In The Flesh*

### Part One of a Series of Two

### Antal E. Fekete

### Gold Standard University aefekete@iisam.com

### Soldiers throwing away ammunition before combat

The guessing game among gold market analysts is still on: will central banks resume gold dumping or won't they, as the price of gold takes another shot at \$700? In arguing the case pro and con, virtually all analysts miss one important point. Central bank sales of gold against the backdrop of deflation looming in the horizon is akin to soldiers throwing away ammunition just before combat. They should be doing the exact opposite. Soldiers should replenish their supply of ammunition. Central banks should reinforce their balance sheets by purchasing gold (as indeed several important ones, including those of China and Russia, are on record of doing). This is the only way to keep the powder dry. In a deflation it may be necessary to inject massive amounts of new credit into the system, but the only way to make the national currency more plentiful without weakening it (let alone destroying it) is through gold purchases. They are by far the most effective weapon of a central bank to combat deflation. Are we to assume that our central bankers are dummies who do not know this piece of elementary truth?

### Dynamics of deflation

Gold reflects stability; both inflation and deflation reflect instability. It is a mistake to believe that currency values are only threatened during an inflationary spiral. Under the regime of irredeemable currency there is also a threat during a deflationary spiral, although it is more subtle. The deflationary scenario involves the impending danger of a domino-effect of insolvent firms falling, as they carry a crushing debt-burden which is further aggravated by falling interest rates and falling prices (or proxies of the latter: the loss of pricing power and market share). As Leon Fisher of Unknown News said in his piece The Future Looks Very Bleak (March 26, 2007): "The first indicators of economic collapse have already manifested themselves in the housing industry, and the Big Three automakers. Teetering on bankruptcy, they will be the first of the large economic dominoes to fall, and the rest will follow in short order. As a consequence, something on the scale of another Great Depression may be a possibility." When firms go under, when capital and jobs are wiped out on a large scale, then instability in the economy becomes pervasive. Trade war, heretofore waged clandestinely, becomes a declared war.

Competitive currency devaluations are made into a legitimate weapon to capture export markets. This is the most destructive tool in the hands of a government second only to starting a shooting war. In the present situation, it is coming with the inevitability of a Greek tragedy, drawing the protagonist to his doom.

### Golden thorn in the flesh

In the meantime gold is still a thorn in the flesh of Western governments. They have not been able to live down the disgrace of their wholesale defaulting on their domestic and international gold obligations. The 'dog in the manger' syndrome still prevails: if the governments cannot control gold, then they are bent upon destroying it. This neurotic attitude must change. Western governments should make peace with gold, as Eastern governments already have. They should accept the fact of gold hoarding as they accept the tide and ebb of the oceans. If Western governments really wanted to promote the welfare of the electorate (as opposed to that of special interest groups), then they should enlist gold on the side of construction, not on the side of destruction. With gold's help they could set on a course of stabilization. Foreign exchange rates could be stabilized without any further delay, removing the threat of a trade war; as could the rate of interest, removing the threat of exploding debt burden to producers due to a falling rate structure.

If Western governments did use gold constructively, then they could spare the electorate from much unnecessary economic suffering.

### Don't fix the gold price

In implementing a stabilization program the inevitable bone of contention is how to fix the gold price. This is a non-starter. You cannot build consensus that way. No gold price is ever high enough to the debtors and to gold bugs, nor is it ever low enough to the creditors and to the chrysophobic. The need is for restoring the people's constitutional right to convert gold into the coin of the realm at the Mint. The government should open the Mint to the unlimited coinage of gold free of seigniorage charges.

The objection that gold coins from the Mint are already available is lame. These souvenir coins will never circulate unless seigniorage is reduced to zero. People will not part with their gold coins unless they are absolutely sure that they can get them back on exactly the same terms. Souvenir coins could not be used as the monetary standard or unit of value, unless the right to unlimited coinage is unconditionally guaranteed. A constitutional right of the citizens has been usurped by the government. No move towards restoring that right has been made. Nothing short of full restoration will do.

Note the hypocrisy of mainstream economists in suggesting that gold is passé. They say: "the right of the people to own and trade gold was restored 30 years ago and, see, gold still refuses to circulate". Lifting an executive ban subject to withdrawal is not the same as restoring the constitutional right of the people. Only after opening the Mint to the free coinage of gold can the eagle coin be promoted from a mere conversation piece to monetary standard and unit of value.

The determination of the exchange rate between the paper dollar and the gold dollar ought to be left to the market which would then force the Federal Reserve banks to post buying and selling prices for the gold dollar. The spread between these prices would show the quality of Federal Reserve credit for everyone to see. The wider the spread, the lower the quality.

This would mean a fair and open competition between the gold dollar and the paper dollar. Let the people decide which one they prefer, or what they want the Federal Reserve banks to do before they accept their paper as equivalent of gold. Let the unconstitutional privileges of the U.S. Treasury and the Federal Reserve to issue obligations without having the means and the willingness to meet them be abolished for once and all. Let no one have privileges without countervailing obligations.

### Everlasting fair weather delivered by order of the government

The reason that the regime of irredeemable currency could survive so long (35 years, to be precise, longer than any previous experiment) is found in the uncritical embracing of the servile ideology of our age and the mindless faith in, or foolish longing for, government omnipotence. People cherish the myth of everlasting fair weather, and they fully expect their government and its central bank to deliver it. Awakening will be rude.

One may well deplore the hoarding of marketable commodities under the regime of irredeemable currency as wasteful, anti-social, and dangerous as it may ignite and stoke the fires of the inflation-deflation cycle. But for the marginal bondholder hoarding is a last resort. He has been disenfranchised, abused, and the credit system has been rigged to his prejudice. He is left out in the cold. He will not take it lying down. Disenfranchised as though he is, he won't be pauperized if he can help it. In every historical episode when hoarding was criminalized (sometimes punishable by death, e.g., in the various episodes of debasing the coinage of the Roman Empire; John Law's system, and under the regime of the assignats of the French Revolution) the people could ultimately prevail in forcing a return to sanity - or else the Empire collapsed.

### Indictment of the regime of irredeemable currency

These remarks spell a most devastating indictment of the regime of irredeemable currency. This regime is totally insensitive to the rights, the needs, and the wishes of the savers in spite of the fact that they are the very providers of the wherewithal of economic progress. It blots out danger signals sent out by the markets. It denies the power of disposal over one's savings to anyone outside of a small elite. The natural outcome of this insensitivity is the paucity of savings in socially usable or desirable forms that could be available for economic development. Spontaneous savings, such as there are, take the form of inventory-padding, leads at the input and lags at the output level, e.g., artificially slowing output at the well-head, the farm-gate, or at the mill of the mine, and other forms of hoarding, are motivated by sheltering savings from plunder. Thus savings are generally unavailable for economic development and capital accumulation, except as part of stockmarket speculation. To that extent the regime of irredeemable currency is guilty of turning savers into speculators, and accumulators of capital into gamblers. It is the most wasteful and uneconomic system of managing natural and human resources since the primitive food-gathering economies. To this injury to human cooperation must be added the insult to human intelligence. On the top of all that, the regime has inflicted and will continue to inflict great sufferings on innocent bystanders. The inflationary-deflationary cycle hits people indiscriminately.

Next to guns, irredeemable currency was the main tool of coercion of the totalitarian governments in the 20th century: soviet bolshevism and nazi socialism, before their downfall. It was utterly disgraceful and deplorable that Westerm democracies were willing, not to say eager, to stoop so low as to embrace such a tainted instrument with gusto. By now politicians are firmly wedded to the regime of irredeemable currency - in callous disregard of the constitutional issues involved such as the sanctity of contracts, the right of the individual to property and due processes of law and, last but not least, the ideal of limited government. As Gold Standard University has set out to show, no less callous is the disregard for sound economic principles.

Is it not time that the political leaders of Western countries finally admit that the regime of irredeemable currency was not the outcome of natural progressive forces, as formerly trumpeted, but the result of a calculated series of confidence tricks played on a gullible people? Is it not time to say publicly that the experiment was an abysmal failure, and to call it off? Is it not time to allow free discussion of the demerits of such a dubious, debasing, and derogatory tool, and of the eternal merits of a constitutional monetary system?

### Gold Standard University

The Inaugural Session of Gold Standard University took place at the Martineum Academy in Szombathely, Hungary, in February, 2007. Session Two is scheduled for August 15 - 29, 2007, which will include a blue-ribbon panel discussion on the gold and silver basis as a most sensitive theoretical tool of market analysis which is being developed by a team of researchers at Gold Standard University, under the title: The Last Contango - the First Sign of Disintegration of the International Monetary System. For further information please contact: GSUL@t-online.hu .

---

*March 31, 2007*

---

# Gold, Interest, Basis

URL: https://newaustrianeconomics.com/archive/fekete/gold-interest-basis/
Date: 2007-03-07
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, interest-theory, gold-standard, contango, backwardation
Description: Fekete develops the three-way relationship between the gold price, interest rates, and the gold basis, showing how they form an integrated system under a genuine gold standard. The basis serves as the connecting mechanism: when it falls, interest rates lose their natural floor and financial instability follows. Under irredeemable currency this integration is severed, producing the volatile interest rate environment of the modern era.
Editorial Note: Written March 2007. One of Fekete's most systematic treatments of the basis-interest-gold triad, serving as a technical companion to his more accessible popular essays on the same themes.
Original PDF: https://professorfekete.com/articles/AEFGoldInterestBasis.pdf

*Gold, Interest, Basis*

**Antal E. Fekete** · Gold Standard University aefekete@hotmail.com

### Introduction

The Inaugural Session of Gold Standard University was successfully completed at the Martineum Academy in Szombathely, Hungary, in February, 2007. By unanimous request the original program Gold and Interest was extended to include Basis as well. As those who follow my writings on the Internet well know, basis is the difference between the nearest futures price and the spot price. The gold basis is one of the most sensitive economic indicators with a seismographic predictive power. In particular, if taken in conjunction with other indicators such as the silver basis, volume, open interest, and the lease rates for the monetary metals, it is capable of predicting the beginning of the disintegration of the world’s payments system. No other scientific method can provide early warning. Moreover, basis could also be used as the guiding star of bimetallic arbitrage between the gold and silver market. If you have a program to accumulate gold and silver, and wish to get rid of a certain amount of irredeemable dollars regularly at every dip in the price of the monetary metals, then the basis will tell you whether at that moment in time it is more efficient to add to your gold or to your silver account. You always go after the metal with the wider basis.

It is nothing short of amazing that all the websites which concern themselves with the analysis of gold and silver, with the remarkable exception of [www.silveraxis.com](https://www.silveraxis.com), ignore the basis in spite of my repeated prodding to start tracking and reporting it. I have now proof that this is not due to lack of demand. Accordingly, I have made the announcement that at the next session of Gold Standard University scheduled at the Martineum for August 15-31, 2007, we present a blue-ribbon panel discussion with the title Last Contango: First Sign of Disintegration of the World’s Payments System. The present essay is a primer for prospective participants.

### The Janus-face of marketability

Gold, interest, and basis are strongly inter-related. At the Inaugural Session we have covered the concept of marketability. Gold and silver have become money through an evolution as the most marketable goods. In more details, gold is most marketable in the large. This can also expressed by saying that gold is more saleable than any other commodity. Silver is most marketable in the small. This can also be expressed by saying that silver, along with gold, is more hoardable than any other commodity. The Janus-face of marketability can be observed if we contemplate that gold is the preferred agent when one has to transfer value over space.

The preferred agent in transferring value over time is silver followed by gold. We may clearly recognize the dual nature of money throughout history. In the ancient world money was cattle -1- and salt. Cattle was most marketable in the large, while salt was most marketable in the small.

Later two other commodities, far more similar to one another, took over these functions, but the dual nature of money has been maintained to this day, in spite of the silver and gold demonetization farce. This is no accident. Duality has to do with the paramount fact that space and time are absolute categories of human thought.

### A new theory of interest

Hoardability leads directly to the concept of interest, which arises out of the desideratum to optimize conversion of income into wealth and wealth into income. In choosing the conversion problem as our point of departure to develop a new theory of interest we have deliberately discarded the old-line theory based on the exchange of present for future goods that assumes, wrongly, that without exception a present good is valued more highly than an equivalent quantity and quality of future good. A more careful analysis shows that this is true only if the delivery of the various factors to the site of production or consumption is dovetailed. Early delivery may result in a loss.

The solution to our optimization problem answers two of the greatest of human needs: providing for one’s old age, and planning for the education of one’s offspring. If the conversion of income into wealth is done through hoarding, and the reverse conversion through dishoarding ─ a process also known as direct conversion, ─ then optimum is achieved by choosing the most hoardable commodity as the agent of conversion. However, direct conversion can be further improved upon, by passing to indirect conversion, through the agency of exchange. Typically, a younger man will give up part of his income in exchange for part of the wealth of an older, as the former is anxious to go into business for himself for which the latter puts up the capital. Then interest appears as the value of improvement in efficiency through the exchange over direct conversion. In particular, direct conversion means zero interest. By contrast, interest becomes positive if social arrangements admit indirect conversion.

The following point is important. The nexus between gold and interest is established by the fact that if indirect conversion is hampered by secular or canonical proscriptions (e.g., usury laws), the economizing individual is not helpless. He can still achieve his goals by falling back on direct conversion through hoarding or dishoarding gold. He will do that even in the absence of proscription. In case interest is suppressed by the banks or the government, he will hoard gold in protest, and dishoard it as the rate of interest is subsequently allowed to rise. Thus gold is the agent to validate one’s time preference. This aspect of gold is almost always ignored by authors, including Ludwig von Mises to whom gold hoarding is a ”deus ex machina”. He failed to see that time preference would hardly amount to more than a pious wish if gold hoarding did not give it teeth. Moreover, this is true whether on a gold standard or off. When on, gold hoarding means withdrawal of bank reserves whereby the individual forces the banks to adjust their lending rate to the rate of marginal time preference. Thus the gold standard makes the adjustment crisis-free. That is its main excellence. When off, hoarding makes the gold price soar, leading to a monetary crisis. The upshot is the same: higher interest rates. The difference is that it is achieved in a crisis-prone environment.

Moreover, it generates a swinging interest rate structure, most damaging to savers and producers. Gold hoarding provides escape from the harsh consequences of the predatory monetary and credit policies of the banks and the government, as they plunge society into debt slavery. In the absence of the safeguards of a gold standard, debt slavery is inevitable for all those who fail to use the only prophylactic available against bank and government preying on the individual saver and producer, gold.

### -2-

### Paper boat on uncharted waters

Let us turn from the nexus between gold and interest to the nexus between interest and basis.

Mainstream economics made a fatal mistake when it failed to study the consequences of the emergence of the futures markets in monetary metals. It was not a spontaneous failure. It was inspired by the banks and the government that have taken upon themselves the ”burden” of financing research. They have a hidden agenda: to keep the public in deep ignorance and stupor.

Recall that there are no futures markets in monetary metals under a gold standard for lack of volatility, without which speculation cannot be profitable. But no sooner had volatility appeared than futures markets in silver and gold sprang up. As they did, a whole new field of tantalizing research opened up for investigation. Unfortunately, what it shows is an appalling and scary prospect for the Brave New World of global irredeemable currency. It shows dissipation and destruction of capital on a large scale through falling interest rates, and the drying up of new savings through rising interest rates. Recall that it is the first time ever in history that irredeemable currency has been foisted upon the entire world, causing gyration of the rate of interest. Humanity was herded aboard a paper boat named ”Dollar” and tossed onto a stormy sea with no anchor on hand. No wonder that the powers that be are anxious to put research under taboo. It is in their interest that the public stay in blissful ignorance about the fact that the captain of their paper boat has no navigational instruments while sailing on uncharted waters. Gold Standard University was started in defiance of that taboo.

### Primer on basis

The condition that obtains when the futures price is above the spot, or the more distant futures price is above the nearby, is called contango and, the opposite, backwardation. Thus the basis is positive or negative according as the market is in contango or in backwardation. The prevalence of contango is a necessary condition for the warehousing business. Unless there is an expectation for contango to return after sporadic and temporary backwardation, warehousemen would go out of business and supplies for future delivery would be all but unavailable.

The question arises what determines the basis. On the upside it is limited by carrying charges including freight, storage, insurance, and interest. In the case of gold and silver the lion’s share is interest. On the downside there is no limit: theoretically the basis can go negative and keep falling indefinitely. It indicates that a tightening supply is facing increasing demand. Ever larger number of sellers withdraw their offer to sell. This is the basis risk: the risk of hedging inventory in the futures market. The cash price may start going up faster than futures prices forcing hedgers to take an opportunity loss on inventory. A contemporary example is Barrick Gold Company with a phony hedge plan losing tons of shareholder money. Note that price risk behaves the other way round. It is limited in the downside (as the price cannot fall below zero) but is unlimited in the upside (as there is no theoretical limit above which the price may not rise).

### Interest and marginal utility

The monetary metals are characterized by great stores above ground. The stock-to-flows ratio is a large multiple for gold. Silver analysts deny that the same holds for silver. They are at a loss to account for the disappearance of huge stockpiles of U.S. official silver in any other

-3- way but assuming that it has been dissipated through consumption. There is no hard evidence that this is indeed the case. We can account for the disappearance of monetary silver through a more plausible hypothesis, namely, that most of it has gone into hiding. It shall resurface at the right time and right price, as indeed some of it already has after the silver price hit a high of 15 dollars per ounce.

The case is different for non-monetary commodities. Here the stock-to-flows ratio is a small fraction. The reason is declining marginal utility in contrast with monetary metals with near-constant marginal utility. Mises argues that constant marginal utility is contradictory because it implies infinite demand. He is plainly in the wrong. He ignores the nexus between gold and interest. In more details, interest acts as obstruction to gold hoarding. In case of nonmonetary commodities obstruction to hoarding is precisely declining marginal utility.

Demand for monetary commodities can only become arbitrarily large if interest is suppressed by the banks and the government. Thus interest is an exclusive characteristic of monetary commodities. John Maynard Keynes made a colossal blunder when he kept talking about the

”wheat-rate of interest”, ”coal-rate of interest”, etc. Interest can only exist in relation to a monetary metal with constant marginal utility. The marginal utility of wheat and coal declines very fast indeed.

### ”It takes three to contango”

Keynes made another terrible blunder when he talked about what he called normal backwardation. To him backwardation was the natural state of the markets, and contango, the aberration. He argued that speculators ”charge an insurance premium” for shouldering the price risk while carrying the commodity for future delivery. It is this premium that shows up in the futures price as backwardation. This shallow theorizing faithfully reflects the Keynesian mindset that is haunted by visions of overproduction, market gluts, deflations, depressions, and unemployment, in one word: the ”curse of capitalism”. The fact, however, is that ours is a world of scarce resources. Man is engaged in a constant struggle to overcome the niggardliness of nature. In particular, he has to have foresight to provide for future needs. If he succeeds, then future goods will be available to meet future demand in adequate quantities at the right time. This would not be possible without the services of the warehouseman and without contango in the futures market. We express this by saying that ”it takes three to contango”: the producer, the warehouseman, and the speculator. Keynes got it all wrong when he blithely ignored the second member of the troika.

Hoarding is not a dirty word, least of all gold hoarding, in spite of dark hints to that effect dropped by Keynes. The essential services of the warehouseman must be studied seriously and without prejudice on the same footing as those of the producer. The marginal bondholder who decides to sell his bonds in protest against low interest rates, and to invest the proceeds in gold, must not be depicted as Scrooge. He is a legitimate warehouseman who carries social savings at a time when banks behave like drunken sailors on leave at the waterfront, and governments engage in compulsive overspending as if there was no tomorrow. The resulting capital destruction is appalling. After Armageddon no one but the warehouseman, alias gold investor, will be in the position to supply capital for reconstruction.

Thank heaven for goldbugs. Without them we would have to go back and start from scratch as cavemen.

Backwardation can certainly occur, in particular, when supplies are drawn down just before the new crop of agricultural goods is ready to be brought in. However, backwardation for monetary metals is a gross anomaly, a red alert. It indicates cumulative mismanagement of the monetary and credit system in the past, and potential breakdown in the not-too-distant future. Gold Standard University has championed the cause of doing pioneering research to

-4- refine this tool, to take it in conjunction with other market indicators such as lease rates, or the yield curve and its various types of inversion. It is hoped that this research will help people to escape the worst when catastrophe strikes. Forewarned is forearmed.

### Lysenkoism ─ American style

The reason why mainstream economics is silent on the subject of gold, interest, and basis is that the interplay of these reveals the incredible mismanagement of the economy in the twentieth century, as well as the corruption of the monetary and credit system by the banks and by the government in the twenty-first. Universities no longer serve the cause of search for and dissemination of truth. Instead, they provide refuge for a reactionary conspiracy trying to cover up mismanagement and corruption reinforced by seventy years of Keynesian and thirtyfive years of Friedmanite brainwashing. No university in the entire world, save Gold Standard University, is prepared to study in a detached manner the subject of gold, interest, basis, and the theory of warehousing as it applies to the hoarding of monetary metals. Universities no longer serve the interest of the people anxious to secure their economic survival in the face of untold dangers, as indicated by the Babeldom of runaway debt and exploding derivatives markets. Rather, they are serving the interest of their paymasters.

History will not be kind to mainstream economists. Keynes, Friedman, and their followers will be lumped together with Soviet biologist Lysenko, stooge and sycophant of Stalin. Lysenko sent his fellow biologists to the Gulag for opposing his hare-brained theories, never to be heard from again. Lysenko betrayed science as he betrayed humanity. He was, no less than Stalin, a monster.

### The Quantity Theory of Money

I have never subscribed to the Quantity Theory of Money, nor have I ever believed that the downfall of the regime of irredeemable currency must necessarily take the form of hyperinflation. It could, of course, in the wake of wars and revolutions destroying supplies of goods and facilities of production. But the Quantity Theory of Money is a linear model that is wholly inapplicable to our highly non-linear world, now at the peak of its productive powers.

The dénouement of the present global experiment with irredeemable currency is not likely to involve hyperinflation (assuming that the world will not be plunged into another World War).

Unfortunately, a lot of innocent people will be led astray and ruined financially by the nearly unanimous propaganda predicated upon the Quantity Theory prophesying hyperinflation.

In order to see what is happening to our money a more sophisticated theory is needed.

The new theory must assume a thorough understanding of both monetary metals, warehousing, futures markets, basis. We must also have a new theory of interest that takes gold fully into account. We must develop a non-linear model for the global world economy.

This is what the Gold Standard University has set out to do. It will expose the central fallacy of mainstrean economics in assuming that producers will forever put up with the plundering of their capital accounts through driving interest rates down or will meekly keep accepting irredeemable promises to pay in exchange for real goods and real services, and that savers will forever put up with the pilfering of their savings accounts through driving interest rates up or will meekly turn over their right pocket when the banks and the government h ave picked clean the left.

In the same order of ideas, it is a grave mistake to explain rising gold and silver prices in terms of the supply/demand equilibrium model. There is simply no scientific way to define the speculative supply of and the speculative demand for monetary commodities, without which the model becomes meaningless. Speculators can jump back and forth between the

-5- supply and demand side of the market on a moment’s notice and, when they do, they are likely to act en bloc. The only thing that the supply/demand equilibrium model can predict is the ever increasing volatility of the price of monetary metals.

### Bull in bear’s skin

We must also exorcise the boogeyman of silver analysts: the naked short seller of monetary metals. The inordinate short interest in the futures markets is better explained in terms of the activities of a market maker whom I call ”bull in bear’s skin”. Typically, he is a superwealthy individual who has learned the trick how to derive an income in gold on gold ─ even while retaining physical control over his holdings. He is not a naked seller by any stretch of the imagination. He does have the gold and silver, but keeps them at a safe distance from the commodity exchange and its predatory policies favoring the shorts at the expense of the longs.

To his mind it pays to pose as a short. He hides his full armour underneath a mask showing him naked.

The proposition that it is possible to earn an income in silver on silver without relinquishing physical control of the stuff may sound like gaining something out of nothing, contradicting the Principle of Conservation of Matter and Energy. Yet we should not be too hasty in dismissing this possibility. It is true that income and risk go hand-in-hand. Income is the reward for consistently successful risk-taking. Show me a man who can generate an income without taking risks, and I show you one who has invented perpetual motion.

Yet there is no contradiction here. Paradoxically, it was mainstream economists themselves who made this black art possible. They promoted the regime of irredeemable currency with the result that the gold price fluctuates. If you keep your book in terms of gold units rather than units representing irredeemable promises, then it is indeed possible to earn an income in gold on gold, even without relinquishing your gold and thereby incurring the risk of losing it. To understand this we only need to refer to the possibility of harnessing the energy represented by the flow and ebb of water in the oceans. Likewise, it is possible to harness the energy represented by the fluctuating price of gold and silver. The best way of doing this is to buy on dips whichever monetary metal can be stored more efficiently at the going price. But how to determine the relative efficiency of warehousing different goods? This is the same dilemma facing the elevator operator when he is buying grain at harvest time. Should he buy more wheat or more corn? The price could easily mislead him. The basis would not. He solves the problem by always buying the grain with the wider basis. In this way he maximizes the efficiency of his warehousing operation.

What appears as naked short selling to silver analysts is more likely the activities of the ”bull in bear’s skin”. It is the tip of the iceberg, that can be seen. What is not seen, the bulk of the iceberg, is dynamic hedging of ever increasing gold and silver hoards, and covered option writing, where the principal wants to stay anonymous. He is actually very happy that analyts believe, and spread the belief, that he is naked short. The longer he can keep his ”cover” as being ”naked”, the better it is for his operations.

It is futile and puerile to wait for the naked short to cover in a panic, sending the price through the roof. This, of course, does not mean that the price may not go through the roof, but if it does, then it is also likely to go through the floor next time around when the pendulum swings back. It means that volatility is increasing. The get-rich-quick crowd waiting for the miracle of the silver price going to four digits overnight will be frustrated.

Rewards will go to the patient and industrious observer taking pains to study the market, and who has the right strategy that can handle increasing swings in the price of monetary metals.

He doesn’t subscribe to linear models. His guiding star is the non-linear model of the variation of basis.

### -6-

Gold Standard University is working out a strategy following these principles. It will be unveiled during the next session in August, 2007. At this point let’s just say that the strategy is essentially bimetallic arbitrage, but it uses the basis rather than the bimetallic ratio for clues.

### Conservation of matter and energy

But how do we answer the objection that our proposed scheme contradicts the Principle of Conservation of Matter and Energy? Simple. We don’t. We might as well admit up front that the contradiction is real. Chalk it up as an unintended gift from the managers of the regime of irredeemable currency. Helicopter Ben has air-dropped manna to the enemy camp by mistake.

Nor can he help but keep doing it. His navigation system is all screwed up.

The gold standard, when in force, is an instant reward/penalty system that rules out income generated without risk. Were our schools allowed to teach economics properly, the electorate would know this and it would demand the immediate scrapping of irredeemable currency as the most wasteful and iniquitous monetary system imaginable. It would also demand the immediate reinstatement of the gold standard as the only monetary system serving even-handed economic justice. Under a gold standard foreign exchange and interest rates are stable. So is the price of monetary commodities. There is no profit in gold, silver, and bond speculation. Interest rate derivatives and bond futures are unknown. Debt is reined in by the ability to service it. Banks cannot lend long while borrowing short with impunity. When they lend short, they are limited by the size of their quick assets. Under the gold standard all economic risks are created by nature, none by man. Helicopter Ben belongs to fairy tales, not to banking, let alone central banking.

As the regime of irredeemable currency defies natural law, it is digging its own grave.

This is the true explanation of the coming crack-up boom, not the ”overissuing” of the currency. The currency was overissued already a hundred years ago. What needs to be explained is the lag.

### References

### A.E.Fekete, What Gold and Silver Analysts Overlook, May 4, 2004

### Bull in Bear’s Skin? May 4, 2006

### Ultracrepidarian Musings, May 11, 2006

### The Rise and Fall of the Gold Basis, June 23, 2006

### Monetary versus Non-Monetary Commodities, June 25, 2006

### The Last Contango in Washington, June 30, 2006

Tom Szabo, The Silver Basis, [www.silveraxis.com/explain_basis.html](https://www.silveraxis.com/explain_basis.html) Further information on Gold Standard University can be obtained by writing to:

### GSUL@t-online.hu

---

*March 7, 2007.*

### -7-

---

# The Root Cause of Unemployment, Part Two

URL: https://newaustrianeconomics.com/archive/fekete/the-root-cause-of-unemployment-part-two/
Date: 2007-01-15
Section: Popular Economics
Difficulty: intermediate
Concept Tags: interest-theory, real-bills, federal-reserve, gold-standard, capital-destruction
Description: Part two develops the historical evidence for Fekete's unemployment theory, showing how central bank rate suppression since 1913 has produced the persistent structural unemployment of the 20th century. He argues that genuine full employment requires stable (not low) interest rates, achievable only under a genuine gold standard with functioning real bills.
Editorial Note: Conclusion of the two-part unemployment series, published January 2007. Fekete marshals historical evidence to support his theoretical framework, arguing that the relationship between interest rate suppression and unemployment has been systematically overlooked by economists of all schools.
Original PDF: https://professorfekete.com/articles/AEFTheRootCauseOfUnemploymentPartTwo.pdf

## The Root Cause Of Unemployment

### Part 2

Real Bills and Employment by Antal E. Fekete,

Professor, Intermountain Institute for Science and Applied Mathematics

---

*January 15, 2007*

In Part I we elaborated on the thesis of the German economist Heinrich Rittershausen that the appalling world-wide unemployment of the 1930's was caused by the coercive legal tender laws of 1909. The chain of causation is as follows: the French and German governments, in preparation for the coming war, wanted to concentrate gold in their own coffers. They stopped paying civil servants in gold coin. To make this practice legal they had to enact legislation that gave bank notes legal tender status.

Scarcely did these governments realize that in doing so they set a slow process into motion which, in the end, destroyed the wage fund out of which workers could be paid even before merchandise has been sold to the ultimate consumer. In this second part we examine in greater detail how the wage fund was financed before 1909. We shall see that the bill market is just the clearing system of the gold standard. If disabled, sooner or later the gold standard will collapse as a result.

We hope that detractors of the Real Bills Doctrine will read this analysis with an open mind, and give their best effort to find a weak point in the argument (if they can), to refute our conclusion, which is as follows. If the victorious powers had allowed the bill market to make a come-back, and they had rescinded legal tender laws at the end of hostilities in 1918, then the gold standard would not have collapsed in 1931, and there would have been no world-wide unemployment and no Great Depression.

### Bank notes as self-liquidating credit

Previous to 1909 circulating capital for the production of consumer goods in urgent demand had been financed, not out of savings, but through discounting real bills at a commercial bank, which would then rediscount them at the bank of issue that supplied the country with bank notes. To be sure, these bank notes represented self-liquidating credit. They were merely a more convenient form of the bill of exchange from which they derived their potency. They came in standard denomination round figures. Unlike the bill of exchange they could without hassle and loss be broken up into smaller units. The great convenience they offered was valued by the public so much so that people were willing to pay for it in the form of forgone discount.

When the bill matured and was paid, the bank note was retired. For this very reason it was not inflationary. The bank of issue would under no circumstances prolong credit beyond the maturity date of the rediscounted bill. If the underlying merchandise could not be sold in 91 days, then it would not be sold in 365 days, certainly not before the same season of the year came around once more. But by that time the merchandise would be stale and could only be sold at a loss, if at all. Prolonging credit on a mature bill would violate the letter and spirit of the law governing central banking in Germany prior to 1909.

Could a commercial bank, nevertheless, roll over a real bill at maturity? On strictly economic grounds it wouldn’t. First of all, it would forfeit its rediscounting privileges at the bank of issue if it did. Secondly, it would make its portfolio less liquid and so it could no longer compete successfully with more liquid banks. Having said this, we must admit that in practice some banks may have been guilty of rolling over mature real bills for various reasons. At the benign end of the spectrum the reason could be a false sense of loyalty to clients; at the malignant, conspiracy with them in speculative ventures. It was this latter practice that Ludwig von Mises could have properly condemned as ‘credit expansion’. Be that as it may, unethical behavior on the part of some banks should be no grounds for issuing a blanket condemnation of all banks and calling the legitimate practice of discounting real bills ‘credit expansion’ with a disapproving connotation.

The lesson from negative past experience must be learned and, in the future, full disclosure ought to be mandatory for commercial banks discounting bills. They should be obliged by law to publish their portfolio of real bills quarterly. Clients would thus be enabled to identify delinquent banks which habitually make their portfolio illiquid by sheltering dubious assets such as bills doing overtime after maturity, as well as finance or treasury bills. Thereupon discriminating clients could take their business elsewhere, to more liquid banks.

The retired bank note could not be re-issued until and unless a fresh bill representing new merchandise in urgent demand was offered for rediscount, or gold was offered for sale to the bank of issue. Re-issuing it under any other circumstances, say, lending it out at interest, or extending commercial credit to cover the unsold merchandise after maturity, would violate its charter. It would be tantamount to extending commercial credit under false pretenses.

### Real bills versus financial bills

The changeover from bank notes backed by real bills to bank notes backed by financial bills was the last nail in the coffin of the clearing system of the international gold standard. Monetary scientists and others with intellectual power to grasp the intricacies of bank note circulation raised their voice condemning the new paradigm. They objected to making financial or treasury bills eligible for rediscount, a practice that had previously been prohibited by law with stiff penalties for non-compliance. Most people could not understand what the fuss was about. But there was a world of a difference between rediscounting real bills and rediscounting financial bills. It was the difference between self-liquidating credit and non-self-liquidating credit. Real bills could rely on a huge international bill market with its practically inexhaustible demand for liquid earning assets.

Not so financial bills which were backed by the odds that speculative inventory of goods and equities or investment in brick and mortar may be unwound without a loss by the date of maturity.

Treasury bills were backed by future tax receipts. If anticipation attached to financial and treasury bills did not materialize in time, then at maturity they would have to be rolled over. This was borrowing short and lending long through the back door, carrier of the seeds of self-destruction.

### The chimera of ‘fractional reserve banking’

Financial bills have made the asset portfolio of the bank of issue illiquid. The bank could no longer satisfy potential demand for gold coins, should holders of bank notes decide to exercise their legal right to redeem them. To take away this right was the reason for making bank notes legal tender in the first place in 1909. We must remember that redemption wouldn’t be a problem so long as the portfolio consisted of real bills exclusively. Every single day one-ninetieth of the outstanding bank notes matured into gold coins which were available for redemption. This would normally satisfy daily demand. But what about abnormal demand for gold coins?

A real bill is the most liquid earning asset in existence. At any time somewhere in the world there is demand for it. In particular, banks that have a temporary overflow of gold would be more than anxious to exchange it for real bills. The bank of issue would not have the slightest difficulty to get gold in exchange for real bills in the international bill market. Once upon a time the Bank of England boasted that “it could draw gold from the moon by raising the rediscount rate to 5%.” The assumption that there will always be takers for real bills offered for sale is just as safe as the assumption that people will want to eat, get clad, keep themselves warm and sheltered tomorrow and every day thereafter.

This explodes the blanket condemnation of ‘fractional reserve banking’. Detractors are barking up the wrong tree. They should condemn the practice of rediscounting financial or treasury bills. Real bills were self-liquidating, while financial and treasury bills had impaired liquidity. Under certain circumstances the latter might become unsaleable. They are simply unsuitable to serve as bank reserves.

By contrast, real bills are the most liquid earning asset a bank can have, as already pointed out.

There is always a ready market for them as other banks with excess gold scramble to get liquid earning assets. It is a grave error to equate fractional reserve banking with liquid reserves (real bills) to that with illiquid reserves (financial bills and treasury bills). We may remark here that the term ‘fractional reserve banking’ is a misnomer when applied to a bank utilizing real bills. The note issue is fully backed partly by gold and partly by short-term gold instruments so that the sight liabilities of the bank are at all times are payable in gold.

This problem has been thoroughly researched by a host of competent experts in the 19th century.

There is a voluminous literature on this subject. It was not produced by “monetary cranks” or by “inflationists”. It was produced by the best minds dedicated to sound monetary and fiscal policy.

Their unanimous judgment still stands: real bills, to the exclusion of financial and treasury bills, are by far the safest earning asset that a bank of issue can have. Prior to 1909 charters of the banks of issue explicitly made financial and treasury bills ineligible for rediscounting. Moreover, the laws governing central banking prohibited the use of government paper for the purposes of backing the note circulation, and prescribed heavy penalties for non-compliance. This was the corner-stone of central banking of the liberal era which kept the lessons of the French revolution with its paper-money inflation in evidence. This was not a controversial issue. Informed people could distinguish between safe banking that utilized real bills, and unsafe banking that utilized financial and treasury bills to back the note issue. Their judgment is epitomized by the old saying that “the easiest profession in the world is the banker’s, provided that he can tell a mortgage and a real bill apart”.

It is regrettable that latter-day critics are not sufficiently familiar with this particular body of knowledge and confuse fractional reserve banking based on sound assets, with fractional reserve banking based on unsound assets. It is ironic that they do exactly the same, ostensibly in the name of sound money, what enemies of freedom have done and are doing in the name or irredeemable currency, namely, wipe out the important distinction between liquid and illiquid bank reserves.

### Deus ex machina

The process of retiring the bank note after the merchandise serving as the basis for its issue has been removed from the market by the ultimate gold-paying consumer is called “reflux”. Several authors, including Ludwig von Mises, ridiculed the concept calling reflux deus ex machina. They argued that the banks were only interested in credit expansion, not in reflux. Banks would not for one moment think of withdrawing a corresponding amount of bank notes from circulation when the real bill matured. Instead, they would lend them out at interest in order to enrich themselves at the expense of the public. This is not a valid argument. For the stronger reason, you could also ridicule the entire legal system asking the rhetorical question: “what is the point in making laws when they will be broken anyhow?” You can’t judge the merit of an institution by the behavior of those who are set upon destroying it.

Let us follow the trail of gold coins through the path of reflux. Our description that follows is necessarily schematic. For the sake of simplicity we assume that only wholesaler-on-retailer bills are discounted. This is reasonable as these bills are more liquid than producer-on-wholesaler bills, or higher-on-lower-order-producer bills. We also assume that the retailer is expected to pay his bill with gold coins flowing to him from the consumers. Gold serves as proof that the merchandise underlying the bill has been sold to the ultimate consumer and is not held, contrary to purpose, in speculative stores in anticipation of a price rise. Finally, our description follows the practice of the German banking system as it was before 1909. The practice elsewhere may have been different, but the essential idea would be the same: with the sale of merchandise the gold coin was recycled from the consumer through the retail merchant to the commercial bank, from where it would be withdrawn by producers in order to pay wages, thus putting the gold coin back into the hand of the consumers. Then the cycle of supplying the consumer with urgently demanded merchandise could start all over again.

In more details, as the gold coins flowed from the consumer to the retail merchant, the latter deposited them at the commercial bank. When he was ready to replenish his depleted inventory the retailer would order a fresh supply from the wholesaler and, after endorsing he would return the bill to the latter who would discount it at a commercial bank. The wholesaler would take the proceeds in the form of bank notes which the commercial bank obtained from the bank of issue through rediscounting.

The wholesaler would use the bank notes to pay the producer of first order goods. The latter would use them to pay the producer of second order goods, and so on. But when it came to paying wages, all these producers had to draw out gold coins from the commercial bank against bank notes. They could do no worse than the government that paid civil servants in gold before 1909.

Upon maturity the commercial bank used the bank notes to pay the rediscounted bill at the bank of issue. The latter was under obligation by law to retire these bank notes. It could not lend them out at interest. If it did, it would violate the law, and would have to pay heavy penalties. Retired bank notes could be used for only two legitimate purposes: either to buy gold, or to rediscount fresh bills drawn on new consumer goods moving to the ultimate gold-paying consumer. Since lending and discounting were two entirely different banking functions, this was not the same as lending the notes out at interest.

Now the gold coin was in the hands of the wage-earner. As he spent it on consumer goods, he enabled the retail merchant to make payments on his discounted bill at the commercial bank with gold. When paid in full, the bill was returned to the retail merchant. The bill’s ephemeral life as a means of payment has come to an end. But the march of gold coins would continue. They would be withdrawn by the producers to pay wages, and the cycle of supplying wage-earners with consumer goods against payment in gold coin could start all over again. Gold coin circulation in the production cycle is akin to water circulation through evaporation and precipitation in the atmospheric cycle. This cycle was short-circuited by the 1909 decision of France and Germany to make the note issue legal tender while paying civil servants in notes rather than gold coin.

### A stone mason called Michelangelo

The havoc that the monetary coup d’état of 1909 would wreak upon society had not been foreseen. Nor was the causal relation between the expulsion of real bills from the portfolio of the bank of issue and massive unemployment two decades later. Almost one-half of trade union members, or 8 million people, lost their jobs in Germany alone.

Real bills finance the movement of consumer goods, including wages paid to people handling the maturing merchandise through the various stages of production and distribution. The size of circulating capital needed to move the mass of consumer goods through these stages, if financed out of savings, would be staggering. Quite simply, it could not be done. No conceivable economy would produce savings so generously as to be able to finance circulating capital for the production of all the consumer goods that society needed in order to flourish at present levels of comfort and security.

Fortunately there is no need to employ savings in such a wasteful manner. It is true that fixed capital must be financed out of savings. As a result, creation of fixed capital depends on the propensity to save. Not so circulating capital, provided that the merchandise moves fast enough to the ultimate gold-paying consumer. It can be financed through self-liquidating credit which depends on the propensity to consume, and is independent from the propensity to save.

The discovery of this fact is one of the great achievements of the human spirit and intellect.

It was made by the giants of the Renaissance who believed that “man is the measure of all things”. Theirs was a feat on a par with the discovery of indirect exchange. The impact upon human life of the invention of the circulating bill of exchange is fully commensurate with that of the invention of the wheel. By the same token, banning of real bills is akin to outlawing the wheel.

What would have happened to the quality of human life if the use of the wheel had been banned by the governments in the middle ages?

Detractors have missed one of the most exciting developments in the history of our civilization, namely, the discovery of self-liquidating credit in the wake of the disappearance of risks in the production process as the maturing good gets within earshot of the final gold-paying consumer.

Their failure is not unlike dismissing Michelangelo as ‘just another stone mason’.

### Mistaking the back-seat driver for the boss in the driver seat

Pari passu with the emergence of the need for consumer goods the means to finance their production and distribution emerges as well. It is in the form of the bill of exchange. Retailers, wholesalers, and producers of first-order goods hardly ever pay their suppliers cash. “91 days net” is invariably part of the deal, to give ample time for the merchandise to reach the ultimate gold-paying consumer. Producers of higher-order goods could fold tent and go out of business if they insisted on cash payment for the supplies they were providing. It was the producers of lowerorder goods who were the boss and called the shots, by virtue of being that much closer to the ultimate consumer and his gold coin. They would laugh you out of court if you told them that they have just been granted a loan by the producer of higher-order goods, and the discount is just interest taken out of the proceeds in advance. They know better. They know that self-liquidating credit is theirs for the taking. They know that the discount rate has nothing to do with the rate of interest. For a consideration they may be willing to prepay their bill before maturity. The privilege is theirs, and theirs alone. Discount is just the consideration offered to tempt them. Those who insist that the producer of higher-order goods is the lender and the producer of lower-order goods is the borrower or, alternatively, the wholesaler is the lender and the retailer is the borrower, do not know what they are talking about. They are mistaking the back-seat driver for the boss in the driver seat.

### Quantity Theory of Money

If the victorious powers had realized that the wage fund was destroyed, then they would have tied the emergence of bank notes to the emergence of real bills once again after World War I. They would have also repealed the legal tender laws. This remark puts the Quantity Theory of Money in a rather dim light. This theory holds that “money is money”; it has one dimension only: quantity.

To talk about the quality of money is hallucinatory. Money can be produced in any quantity synthetically. If employment falls or prices decline, they can be compensated for by an increase of the quantity of bank notes outstanding.

The fact that this view reflects a grave error is proved by the bitter experience of the twentieth century. While it is true that the quantity of bank notes outstanding can be increased ad libitum, the bank of issue is absolutely helpless if it wants to prescribe how the public should use its freshly printed notes. They may flow to the bond market, but they could just as well flow to the stock market. Accordingly, they may bid up bond prices (drive down interest rates), but they could just as well drive up equity prices. The quantity theory blithely assumes that newly printed bank notes are duty bound to flow to the labor market to put people to work. However, it is always the quality of money, never its quantity, that will decide where new money will flow. Furthermore, the quality of bank notes cannot be examined without scrutinizing the assets which the bank of issue holds against them. Second only to gold, the best assets the bank of issue can have are the selfliquidating real bills.

If we want the newly printed bank notes to increase employment and production, rather than merely stoke the fires of speculation, then we have to restore the nexus between their printing and the emergence of new goods in the production process. We must rescind coercive legal tender laws. We must rehabilitate the spontaneous international bill market.

We must have a gold standard cum real bills.

### References

Antal E. Fekete, The Root Cause of Unemployment, Part I: Destroying the Wage Fund

---

# The Root Cause of Unemployment, Part One

URL: https://newaustrianeconomics.com/archive/fekete/the-root-cause-of-unemployment-part-one/
Date: 2007-01-11
Section: Popular Economics
Difficulty: intermediate
Concept Tags: interest-theory, capital-destruction, federal-reserve, monetary-policy, real-bills
Description: Fekete identifies falling interest rates — not insufficient aggregate demand or technological displacement — as the root cause of structural unemployment. When the marginal productivity of capital falls faster than wages can adjust, rational entrepreneurs stop hiring. Part one develops the theoretical framework linking interest rate manipulation to unemployment.
Editorial Note: Part one of a two-part series from January 2007. Fekete's theory of unemployment as an interest-rate phenomenon rather than a demand-side or labor-market phenomenon is one of his most original contributions, directly challenging both Keynesian and Rothbardian accounts.
Original PDF: https://professorfekete.com/articles/AEFTheRootCauseOfUnemploymentPartOne.pdf

## The Root Cause Of Unemployment

Part 1: Destroying the Wage Fund by Antal E. Fekete,

Professor, Intermountain Institute for Science and Applied Mathematics

---

*January 11, 2007*

### Introduction

Economists have failed to find the root cause of unemployment. Keynesians have looked for it in the paucity of government debt. Friedmanites have tried to blame it on the inadequacy of central bank credit. Both orthodoxies were promoted, one after another, as state religion in the United States, with appalling results: destabilizing foreign exchanges, interest rates, prices; wiping out nine-tenth of the purchasing power of the dollar; even more of the value of bonds; not to mention the triggering of an avalanche of debt.

The Austrian school maintains that unemployment is the result of the high-wage policies of governments such as minimum-wage legislation and granting monopoly power to trade unions.

However, this policy is more the effect than the cause. It prices less productive labor out of the market. We are looking for causes that hits the high-productivity end of the spectrum as well.

The root cause of unemployment is the coercive legislation making bank notes legal tender. It initiated a slow process that ultimately destroyed the wage fund out of which wages were paid to workers before the underlying merchandise has been sold to the ultimate consumer.

### Tale of the cuckoo’s egg

1909 was a milestone in the history of money. That year, in preparation for the coming war, the governments of France and Germany stopped paying civil servants in gold coins. To make this legally possible the note issue of the Bank of France and of the Reichsbank had to be made legal tender. Most people did not even notice the subtle change. Gold coins stayed in circulation for another five years. It was not the disappearance of gold coins from circulation that heralded the destruction of the world’s monetary and payments system. There was an early warning. The German and French government’s decision to make the note issue legal tender effectively sabotaged the clearing system of the international gold standard, the bill market.

European banks of issue were obliged by their Charter or by legislation to back at least 40 percent of their note and deposit liabilities by gold, and the rest by short-term commercial bills drawn on consumer goods moving apace to the ultimate gold-paying consumer. There was an international bill market trading bills drawn on London. It did not matter whether trade routes passed through British waters or bypassed them: financing international trade through London was the hallmark of the highest reliability. For most banks the use of government paper for the purposes of backing the note issue was explicitly disallowed by their charter. The bank had to pay stiff penalties if it could only balance its book with the help of government bonds in the asset column. Bills on London were preferred.

Bills drawn on consumer goods in urgent demand circulated world-wide without let or hindrance before 1909. As goods were moving to the ultimate gold-paying consumer, bills drawn on them ‘matured into gold coins’ as it were. That is to say, they matured into a present good. It is evident that the notion of a bill maturing into a legal tender bank note is preposterous. Both the bank note and the bill are a future good. Furthermore, ‘legal tender’ means coercion enforced within a given jurisdiction but unenforceable outside. Legal tender bank notes were incompatible with the voluntary system based on trade in bills payable in gold coin at maturity. They were bound to paralyze the bill market. The monkey wrench has been thrown into the clearing system of the international gold standard.

Banks of issue continued to use the bill of exchange as an earning asset to back bank notes.

Other subtle changes would, however, alter the character of the world’s monetary system beyond recognition. The cuckoo has invaded the neighboring nest to lay her egg surreptitiously. In addition to bank notes originating in bills of exchange, bank notes originating in financial bills have made their appearance for the first time. In due course the cuckoo chick would hatch and push the native chick out of the nest. In five years the entire portfolio of the banks of issue consisting of commercial bills would be replaced by one consisting of financial bills and treasury bills exclusively. The commercial bill has become an endangered species. Soon it would become extinct.

### Biggest job-destruction ever

Let us now see how governments have inadvertently destroyed the wage fund of workers employed in the sector providing goods and services to the consumer. The wages of these workers were financed through the trade in bills. The emerging consumer good they were handling might not be sold to the ultimate consumer, possibly for another 91 days. Yet in the meantime workers had to eat, get clad, keep themselves warm and sheltered. They could, thanks to bill-trading that would keep their wage fund replenished.

In order to create a job capital must be accumulated through savings. This applies to fixed capital deployed in making both producer goods and consumer goods. In case of the former it applies to circulating capital as well. But if circulating capital had to be accumulated through savings in the case of consumer goods production as well, then jobs in that sector would be few and far in between. In the event they were plentiful, for circulating capital supporting jobs in the consumer goods sector could be financed through self-liquidating credit that did not tie up savings. By contrast, jobs in the producers goods sector could not be financed in this way, explaining why they were not nearly as plentiful nor as easily available.

Starting in 1909 the governments of France and Germany stopped paying civil servants in gold coin, and made bank notes legal tender. Simultaneously, they let their banks of issue dilute the bill portfolio by admitting finance and treasury bills to back the note liability. People who are colorblind to the difference between liquid and non-liquid banking assets see nothing wrong with that.

However, when commercial bills were ‘crowded out’ of the system, the wage fund was effectively destroyed. Workers in the consumer goods sector could no longer be paid before merchandise has been sold to the ultimate consumer. The liquidity of finance and treasury bills was no match for that of commercial bill. For them, the bank portfolio was a shelter against “the slings and arrows of outrageous fortune”. They could not face the music on their own outside of the shelter.

At maturity they had to be rolled over if there were no voluntary takers for them. If they were paid, it would be at the convenience of the debtor, which had nothing to do with the needs of the workers. Financial, treasury, and other ‘anticipation bills’ were unsuitable for backing the wage fund. They served the convenience of the debtor, not the needs of the creditor, in this case, the workers. Workers had to eat. Unless bills in the wage fund were self-liquidating, they might as well go hungry until their products could be sold for cash.

What you need is highly liquid earning assets that the bank can sell by payday so that wages may be paid out of the proceeds. Commercial paper in the portfolio filled the bill. It represented the most liquid earning assets the bank could have. Banks all over the world were competing for them as they wanted to exchange their excess gold for liquid earning assets maturing into gold.

Commercial bills were universally acceptable as backing for bank notes. The wage fund was secure. But as backing for the note issue was diluted in the wake of legal tender legislation, the wage fund went up in smoke. This was the biggest job-destruction in history.

### Path of vindictiveness

Unless governments were prepared to assume responsibility for paying income to wage-earners, there would be unprecedented unemployment that would spill over to all other sectors and all other countries as well. Eventually the governments, to avoid undermining social peace, decided to do just that. They invented the so-called ‘welfare state’ paying so-called ‘unemployment insurance’.

Note that the unemployed could have found jobs, had the clearing system of the gold standard, the bill market, been allowed to make a come-back, and had legal tender laws been rescinded after World War I. The resurrection of bill-trading would have resurrected the wage-fund as well.

Instead, the victorious powers chose the path of vindictiveness. They did not want multilateral trade, which might have benefitted their former adversaries as well. They wanted to punish them with bilateral trade, even if it meant punishing themselves. What they have forgotten was to calculate the extent of punishment they were inflicting upon themselves. Their decision favoring bilateral trade and abolishing the international bill market was the cause of the collapse of the gold standard, and the cause of the world falling into the abyss of the Great Depression, making unemployment endemic.

The government started sponsoring ‘job creation’, mostly of make-belief jobs. But what has been hailed as a heroic job-creation program appears, in the present light, a miserable effort at damage control by the same government that has destroyed those jobs in the first place.

### Economists share responsibility for the disaster

---

# Forbidden Research

URL: https://newaustrianeconomics.com/archive/fekete/forbidden-research/
Date: 2007-01-05
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, real-bills, new-austrian-economics, central-banking, gold-standard
Description: Fekete argues that certain lines of monetary inquiry have become effectively forbidden in mainstream academia and journalism — specifically, investigation of the gold basis, the Real Bills Doctrine, and the role of central bank gold leasing in suppressing prices. The suppression of monetary research, he argues, is itself a symptom of the monetary disorder it conceals.
Editorial Note: Written January 2007. A wide-ranging polemic connecting Fekete's monetary analysis to the broader sociology of academic knowledge suppression. The title deliberately echoes the climate censorship of unorthodox monetary research.
Original PDF: https://professorfekete.com/articles/AEFForbiddenResearch.pdf

1. What is a gold standard?

A gold standard is a mechanism whereby people exercise their God-given right to create or extinguish money, while denying monopoly power of money-creation to would-be crooks. The individual, if he thinks that money is scarce, or the rate of interest is too high, can do something about it. He can take old jewelry or newly mined gold to the Mint and convert it into the coin of the realm free of seigniorage charges. If the individual thinks that money is too plentiful, or the rate of interest is too low, he can do something about that, too. He can melt down his coins or export them, and he can divert the flow of new gold from the mines away from the Mint, say, into jewelry-making.

Note carefully that in establishing a monetary system for the new country the U.S. Constitution did not make provisions for a central bank. It made provisions for a Mint.

2. Why is there no bond speculation under a gold standard?

The chief merit of the gold standard is not to be found in the stabilization of prices which is neither possible nor desirable. It is to be found in the stabilization of interest rates. Only a gold standard can guarantee the lowest level for the rate of interest that is still compatible with conditions in a free economy. Most significantly, there is no bond speculation under a gold standard for the simple reason that there is no sufficient volatility in the price of a gold bond to make speculation profitable.

Not only is bond and foreign exchange speculation wasteful as it diverts talent and capital to unproductive uses; it is also a surreptitious method to exploit savers and producers. When bond prices are driven down, savings accounts are pilfered; when driven up, capital accounts are plundered. Our grandfathers who wrote gold clauses into government bonds were not lunatics, as mainstream economics would have us believe. They understood that there was no other credible way of stabilizing the interest-rate structure for the benefit of everyone. Savers could save with confidence knowing that their savings will not be wiped out by rising interest rates. Producers could produce with confidence knowing that the value of their physical capital will not be wiped out by falling interest rates. Consumers and distributors were not threatened by capricious price volatility. Speculators could repair to the market in agricultural commodities where risks are created by nature, not by man as in the bond and foreign exchange markets. The inequity of risk-free speculation was exorcised.

3. How are savers and producers disenfranchised?

The regime of irredeemable currency is a scheme whereby savers and producers are disenfranchised. The former are deprived of their right of choosing the form in which they want to save. They are forced to save in terms of a depreciating currency. The latter are deprived of their right to sell to whomever they wish to sell. They are forced to give the right of first refusal to the issuers of irredeemable currency and their cronies.

Worse still, savings accounts are pilfered surreptitiously every time interest rates are driven up (bond prices are driven down). Savers and bondholders are creditors who are locked in at a lower rate than that the market is paying. They suffer capital losses as interest rates rise.

By the same token, capital accounts are plundered surreptitiously every time interest rates are driven down (bond prices are driven up). Producers and sellers of bonds are debtors who are locked in at a higher rate than that the market is offering. They suffer capital losses as interest rates fall. Please note that producers can’t protect themselves against plunder by getting out of debt. To the extent they need capital goods, they have financed their operations at the wrong rate of interest. In other words, when rates are driven down, the physical capital of the producers is made obsolete artificially and prematurely.

Note the perversity as mainstream economics hails lower interest rates as being “timely help” to beleaguered producers; or as it hails higher interest rates as being “godsend” to beleaguered savers. In fact, producers and savers are toast as the rate of interest is manipulated to their prejudice. It would never occur to Keynesians and Friedmanites to recommend the return to a gold standard in order to stabilize interest rates in promoting social equity.

4. Is there an ‘optimal rate’ of increasing the money supply?

The idea of increasing the stock of money by central banks based on scientific principles is chimerical. There is no scientific way of determining the optimal rate of increase in the money supply any more than there is a scientific way of predicting the future. The very notion of an optimal rate is contradictory and makes no sense except in the context of favoring political pressure groups at the expense of the rest of society. Increasing the stock of money at a fixed rate is no less chimerical. Creditors would inevitably find the fixed rate too high; debtors would find it too low. If the power to “manage” the stock of money is delegated to an agency dressed up in a scientific garb, then this agency is a front behind which impostors hell-bent to usurp unlimited power under false pretenses hide.

5. What is the ‘sudden death syndrome’?

The life-span of the regime of irredeemable currency may be extended through machinations such as the artificial stifling of demand for gold, or trying to satisfy this demand with paper gold.

Other stratagems serving the same end are: the manipulation of interest rates in order to boost demand for bonds artificially; the manipulation of interest-rate spreads to offer risk-free profit to the carry trade; allowing the derivative markets on bonds to grow beyond any conceivable limit.

These manipulations, machinations and stratagems can certainly put off the day of reckoning.

However, there is a cost: it makes the inevitable credit collapse, whenever it may come, a great deal more painful, and recovery ever more protracted. The one certain result is that the ‘sudden death syndrome’ will hit the currency when it is most vulnerable and disaster is least expected.

We should remember that every experiment in history with irredeemable currency has ended in a cataclysm unless the currency was stabilized in time by making it convertible into gold. The managers of the present experiment betray extreme conceit when they pretend to know something that their predecessors, the managers of the continental currency, of the assignats, mandats, or of the Reichsmark did not know. The only difference between the present experiment and its historical precedents is a more highly refined web of disinformation.

6. Why are open market operations fraudulent?

The so-called open market operations of the Federal Reserve (and similar practices of other central banks) are a thoroughly fraudulent scheme. They should have never been authorized. In fact, they were introduced illegally, in contravention of the Federal Reserve Act of 1913. Later the Act was amended to make the practice legal retroactively as a “temporary emergency measure” (Glass-Steagall Act, February 27, 1932). The purpose was to legalize check-kiting between the U.S. Treasury and the Federal Reserve. The floodgates were opened for the wholesale monetization of government debt in direct contravention of the Federal Reserve Act as originally enacted in 1913. Further amendments made these “temporary emergency measures” permanent, thus legalizing open market operations through the back door (Banking Act of 1945).

Open market operations are the main culprit for destabilizing interest rates in the world. The process is as follows. Speculators ‘crowd out’ savers and producers from the bond market.

Anticipating the impending move of the Federal Reserve to buy, speculators act en bloc to forestall official purchases of bonds in an effort to pocket riskless profits. As they rush from the buyers’ to the sellers’ side, they generate a destabilizing oscillation in the rate of interest to the great detriment of both the savers and the producers. Their action will ultimately cause the boat to capsize.

7. Why is the so-called 100 percent gold standard a pipe-dream?

The circulation of real bills, that is, short-term self-liquidating credit, is non-inflationary. The emerging credit does match, dollar-for-dollar, merchandise emerging in the last stages of production and distribution. Moreover, the credit is extinguished simultaneously with the removal of the underlying merchandise from the market by the ultimate consumer. A functional gold standard presupposes the flow and ebb of self-liquidating credit which facilitates the journey of maturing goods from the producer to the consumer. A rigid 100 percent gold standard, so called, which refuses to extend ephemeral monetary privileges to self-liquidating commercial credit, is a pipe-dream. It has never existed, save in the imagination of charlatans. If one were put in place, it would collapse during the first Christmas shopping season. It is futile to hope that a fixed quantity of gold coins handle all the extra demand that may be thrown upon the markets without prior notice by the consumers capriciously unless the gold coin circulation is cushioned with self-liquidating credit.

8. In what way is the discount rate different from the rate of interest?

The discount rate is not the same as the short-term rate of interest, nor is it determined by the propensity to save. Rather, it is determined by the propensity to consume. When the demand for consumer goods is high and increasing, the discount rate is low and decreasing, and vice versa.

The discount rate and the rate of interest move independently of one another, possibly in opposite directions. The discount rate is an indispensable part of the internal communication system of the free market whereby the consumer dispatches his order to the producer and distributor for consumer goods in most urgent demand. Without the discount-rate mechanism the producer would not know what to produce, when to produce it, and how much. Only those bills circulate spontaneously which are drawn on goods moving to the ultimate gold-paying consumer fast enough: goods that will be consumed before the season of the year is over (in 91 days or less). Slow bills, bills drawn on merchandise sold on installment plans, anticipation bills, and other financial bills will not be discounted by the market and consequently they will not enjoy spontaneous circulation.

9. Why is gold hoarding harmless?

Not only is gold hoarding under a gold standard harmless; it is a necessary part of it. Gold hoarding is the leash the public is meant to have (1) on the banks, and (2) on the government.

We deal with (1) here and with (2) under the next caption. Of course, it is always assumed that saboteurs are not permitted (let alone encouraged) to spread false rumors about the imminent suspension of gold payments by the government or by the banks.

Gold hoarding has an indispensable role to play in the economy. It is a tool in the hand of the marginal bondholder. He is the first to take profits in selling his overpriced gold bond, and hold the gold, until the bond price returns from outer space to earth, at which point he will buy his bond back. In this way the bondholder can assert and validate his time preference. The saver is not defenseless. He can fight back whenever banks try to suppress the rate of interest to his prejudice below the rate of time preference. If you take the gold coin away from him, then you have rendered the saver helpless.

Gold hoarding is also a legitimate tool in the hand of the depositor and the holder of bank notes.

In demanding gold he withdraws bank reserves forcing the bank to contract credit thereby allowing the rate of interest to find its proper level as determined by time preference. Gold withdrawal is the only effective means to remind the bank that it has extended short-term credit beyond safe limits set by its quick assets. Without it the savers’ time preference is mere wishful thinking. It is precisely gold hoarding that lends teeth to it. In the absence of a gold standard the banks are the master of savers and producers; the latter are mere servants. Their savings and capital accounts are open to pilfering.

It goes without saying that hoarding gold certificates or bank notes, whether redeemable or not, is not the same as hoarding gold coins. As a protest against low interest rates it is not only ineffective: it is outright counter-productive, because it is tantamount to extending credit at zero interest.

10. Why is gold hoarding an indispensable constraint to render governments limited?

Gold hoarding is also a legitimate and indispensable tool in the hands of the electorate to force the government to fulfill its election promises for greater economy in public spending. Gold withdrawal is an unmistakable sign that people are concerned about the condition of the public purse. In the absence of a gold standard the electorate is helpless. It is deprived of protection against the vote-buying tactics of cynical politicians. The individual voter is marginalized in the face of machinations by powerful organized pressure groups. The regime of irredeemable currency is a weapon in the hands of special interests to obtain economic advantages at the expense of the ‘silent majority’. In the absence of a gold standard the government is the master of the people, and the people are servants of the government, farcical free elections notwithstanding. There is no limited government without reserving the right of hoarding gold to the people. There is no substitute for gold, the ‘most hoardable’ good in existence. The power to print money is necessarily unlimited power, be it wielded by angels or by the devil himself. Unlimited power means unlimited corruption. And that is what we have in the United States today, in consequence of the high-handed treatment of the monetary clauses of the Constitution by the federal government and the Supreme Court.

11. Why is hoarding marketable commodities other than gold harmful?

In contrast to gold, hoarding other marketable commodities is definitely harmful. It destabilizes markets. It generates oscillating speculative money-flows between the commodity market and the bond market. This may trigger a self-boosting runaway vibrator between resonating waves of prices and interest rates. It would drive prices and interest rates up only to drive them down again. Such a linked roller-coaster ride of prices and interest rates is the invisible engine of the business cycle. Hoarding marketable commodities other than gold generates the Kondratieff longwave cycle that ultimately destabilizes the economy.

This does not mean that hoarding marketable goods other than gold ought to be outlawed. What it means is that artificial obstacles in the way of gold hoarding, the proper outlet and conduit for the propensity to hoard, ought to be removed.

12. What has ‘legal tender’ legislation got to do with unemployment?

The unprecedented world-wide unemployment that started in the 1930's and which is still very much with us but for the fig-leaf of the ‘welfare state’ which pays workers for not working and farmers for not farming, was a delayed consequence of the legal tender legislation of 1909. That fateful year France and Germany in preparation for the coming war decided to concentrate monetary gold in their own coffers. They stopped paying civil servants in gold coins. In order to make this legally possible they declared bank notes legal tender. Thus governments started sabotaging the gold standard cum real bills as early as 1909.

The effect was fatal. Finance and treasury bills gradually ‘crowded out’ real bills from the portfolio of central banks. Since the wage fund of workers in the consumer goods sector was financed by the bill market, and no other way of financing it was available, massive unemployment was threatening the world, as pointed out by the German economist Heinrich Rittershausen. He was the only one to see the causal relation between legal tender laws and unemployment. His prediction came true in the 1930's when up to one half of the work force in the consumer goods sector of all the countries of the world was idled. Economists were at a loss to find explanation for the catastrophe Conditions for full employment in the world will not return until the wage fund has been reestablished through the rehabilitation of an international gold standard cum real bills. However, researching this question is strictly forbidden. Young economists are brainwashed by the Keynesian and Friedmanite orthodoxy into thinking that the regime of ‘managed’ currency represents a great advance over ‘obsolete’ metallic monetary standards, and is a ‘great blessing’ to society. Austrians are not helpful either with their rigid refusal to examine the merits of the ‘Rittershausen syllogism’. Obstacles in the way of monetary education are enormous.

### ***

### Bonds bond. Question is: whom?

The global regime of irredeemable currency throws the inhabitants of Earth into bondage.

Monetary servitude is no better than other forms, long since discarded by history, such as slavery and serfdom. It may well be more odious, if for no other reason than for being covert. Historical forms of slavery made no effort to hide their coercive nature. Every attempt is made to conceal the fact that the regime of irredeemable currency is one of coercion. Latter-day slaves hardly realize that they are in bondage, although this does not make their yoke lighter. Under a gold standard bonds bond the debtor, not the creditor. All is turned upside down by the regime of irredeemable currency. The bond market furnishes the mechanism whereby issuers of and speculators in bonds throw the rest of society into slavery. This is a subtle process that “not one in a million may be able to diagnose“. It will take a great deal of educational effort to make the truth dawn upon the public.

The global clearing house for the regime of irredeemable currency is a highly secretive private company called the Deposit Trust and Clearing Corporation (DTCC). Its shares are closely held by multinational banks and financial institutions. DTCC’s turnover in 2004 exceeded \$1000 trillion or one quadrillion dollars (sic!). More than half of this amount was generated by trade in government securities and foreign exchange or derivatives thereof. In comparison, the combined GNP of all nations was a paltry \$40 trillion. In other words, two weeks’ turnover was all it took to clear transactions generated by the production and distribution of all the goods and services devoted to keeping the population of the world fed, clad, and sheltered for the entire year. The rest, fifty weeks’ turnover, was just froth whipped up by speculation in churning the derivatives markets.

### Pilfering Savings and Capital Accounts

In view of the fact that there was no bond and foreign-exchange speculation under the gold standard, to the uninitiated this might appear as a pointless exercise. Whatever else it may be, pointless it is not. It epitomizes the metamorphosis of bonds under the regime of irredeemable currency. Bonds are no longer an instrument of savings. They are an instrument of exploitation.

Bond speculators speculate and win big risk-free on the coattails of central bank open market operations. In doing so they pilfer the savers and plunder the producers. Here is how.

Bond speculation generates a long-wave interest-rate cycle linked to the price cycle (subject to leads and lags), known as the Kondratieff cycle. When in the rising mode, wealth is being siphoned off from the savings accounts of the savers; when in the falling mode, it is being siphoned off from the capital accounts of the producers, as explained above under (3). In either case, it is an irreversible process. Reversal of the trend will not put siphoned-off funds back into the account from which they have been pilfered.

While the pilfering of savings under the regime of irredeemable currency is fairly well understood, the plundering of capital is not. Yet the latter is the raw material of which deflations and depressions are made, as their chief characteristic is the destruction of productive capital. This highlights the urgency of research into the vulnerability of capital under irredeemable currency.

Producers are not aware that they are being victimized. They have been brain-washed into thinking that their losses are due to cosmic factors such as continental drift, to which monetary inflation is often likened, disingenuously, by mainstream economists. Producers are not even looking for the causes of growing deficiency in their capital accounts. If truth be told, the losses of producers are due to the threat that interest rates may be driven further down, while the losses of savers to the threat that they may be driven further up.

If truth be told, the losses of savers and producers are the gains of the multinational bankers and their lackeys, the corrupt politicians. They are the only beneficiaries of the regime of irredeemable currency that allows them to tap into the savings and capital accounts of society clandestinely.

They will not stop until they will have squeezed the last drop of blood out of the savings accounts of the savers and the capital accounts of the producers by chasing bond prices up and down, effectively enslaving the entire population of the Earth.

Prometheus had given his shivering creatures fire in order to save them from freezing to death in winter.

God has given his gold, in order to save them from perpetual debt slavery.

### References

### Announcement: Gold Standard University Live, Dec. 30, 2006

### The Gold Standard Manifesto, December 30, 2006

Heinrich Rittershausen, Arbeitslosigkeit und Kapitalbildung, by Jena: Fischer, 1930

---

# Can the Second Coming of Paul Volcker Save the Dollar?

URL: https://newaustrianeconomics.com/archive/fekete/can-the-second-coming-of-paul-volcker-save-the-dollar/
Date: 2006-12-14
Section: Popular Economics
Difficulty: accessible
Concept Tags: federal-reserve, monetary-policy, fiat-currency, gold-standard, debt, sound-money
Description: Fekete argues that even a Volcker-style high-interest-rate shock cannot save the dollar at this stage, because the debt accumulated under irredeemable currency has grown so large that rising rates would trigger immediate systemic default. The gold standard cannot be restored through interest rate manipulation — it requires the institutional restoration of open minting and real bills.
Editorial Note: Written December 2006 as the dollar was weakening and commentators speculated about Fed tightening. Fekete's argument that it was already too late for a Volcker redux proved prescient — the Fed's subsequent attempts to fight inflation while managing debt proved exactly as constrained as he predicted.
Original PDF: https://professorfekete.com/articles/AEFCanThe2ndComingOfPaulVolckerSaveTheDollar.pdf

*Thoughts on the eve of high level talks in Beijing*

**Antal E. Fekete** · “Dismal Monetary Science” · *December 14, 2006*

### History replaying

One of the most frequently asked questions from my readers is the title above. Conventional gold-bug wisdom holds that in 1979 the new Chairman of the Federal Reserve, Paul Volcker, raised interest rates drastically, thereby putting an end to the galloping inflation then raging, and aborting the bull market in gold. Volcker’s high-interest policies are credited with the feat of turning the dollar back from the brink where it looked into the chasm of worthlessness, the chasm into which the French assignat, the German Reichsmark, and the Chinese yuan (of 1949 vintage) among countless other national currencies have fallen. Conventional wisdom goes on to conclude that Bernanke, hopelessly committed as he is to a regime of low interest rates, will be fired. A new chairman with the outlook and resoluteness of Volcker will be named who will repeat the feat of his tall, cigar-smoking predecessor, in saving the dollar once more in a nick of time. History will replay itself.

### Lessons of Kondratieff

My view of the events then and now is quite different. History is not made by men, tall or short; rather, events are the product of cycles, in particular, Kondratieff’s long-wave cycle (K-cycle). By that standard the situation we find ourselves in now is diametrically opposite to that thirty years ago. In 1977 the world was approaching the end of an upswing in the K-cycle that had started in 1947. It took prices and interest rates to unprecedented heights. Now we are approaching the end of a downswing in the K-cycle. As a rule turning points in the K-cycle are calamitous events, resembling a blow-off. So it was in 1979. At that time interest rates and prices were sky-rocketing and hyperinflation appeared likely. But these events were just a smoke-screen camouflaging an incipient deflation that burst on the scene unexpectedly, bringing dramatically lower interest rates, wide-spread bankruptcies, and the folding of firms that have lost pricing-power. This deflation has not run its course yet. The worst is still in store.

The replay of history in 2007 will be similar except with the opposite signature. Interest rates are still declining, and so are prices adjusted for inflation. Deflation is being imported into the United States from Japan, through the mechanism of the carry-trade. It appears to confirm and surpass Bernanke’s worst fears. Lethargy is spreading. Businessmen decline to take the loans offered at historically low rates. Production keeps contracting; unemployment may follow with a lag. We may even see, horribile dictu, some genuinely falling prices! Yet these events could be just a smoke-screen camouflaging an incipient hyper-inflation that would wipe out the dollar for once and all.

### The China-enigma

I admit that China is in the position to render these predictions worthless. She could initiate a cascading of the dollar here and now, wiping out its value before a deflationary scenario could unfold. To the extent that this is a real possibility, my deflationary predictions are, of course, conditional on the outcome of the recent negotiations in Beijing. However, I would expect that Treasury Secretary Paulson and Federal Reserve Chairman Bernanke would cut a deal. Most likely the deal would save the dollar from an ignominious collapse just now. The dollar would get a new lease on life. All this would be in keeping with my motto: “expect the unexpected”. The U.S. will go to any length, pay any price, and meet any challenge to defend the dollar. On the other hand China has the power, and the skill, to extort a bribe. No bribe is too high. After all, it is just a matter of printing it, Bernanke-style. Considering the alternative, it is still cheap.

This is not to suggest that China is not in an incredibly strong bargaining position. She is. Even after a complete collapse of the dollar that could cost China up to \$1 trillion, her economy could emerge relatively unscathed, more so than any other economy on the face of the globe. Inflations and deflations could rage around; China could feel safe inside of a cocoon of autarky. She has done it before; she can do it again. You say that China cannot insulate herself from a world-wide depression? Oh yes, she can. By allowing the wage level to creep up, she could keep producing for her domestic markets without any major setback. China has the potential to absorb everything what she can produce domestically.

True, it is no fun to write off as worthless a \$1 trillion bank account. This is why a deal between China and the U.S., vastly favorable to China, is the most likely outcome of the current negotiations under way in Beijing. It would be naive to expect that details of the deal will be revealed to the public. But we may guess that no genuine progress towards stabilization would be made.

### Bond conundrums

I think most commentators on the bond market got it wrong. They take it for granted that any new bonds issued by the U.S. Treasury will be received negatively from now on, in view of the fact that the saturation point for dollars at large, in their opinion, has now been reached. The only thing foreigners consider worse than owning dollar balances is owning dollar bonds: promises to pay dollars in the future. Yet the bond market shows irrational exuberance in the face of persistent dollar weakness, even in the face of dollar-devaluation as part of the deal now being cut in Beijing. If there has ever been a true conundrum, the bond market it is.

A typical commentary is Peter Schiff’s, dated December 8, on “So what is really holding up the bond market? It could be foreign central bank buying; Fed monetization; hedging by the mortgage industry; speculative hedge-fund strategies; a combination of all these factors; or something entirely different. However, whatever the prop may be, it will not be there forever. The longer it remains, the bigger the deluge will be when it finally gives way. The bond market is in fact a powder-keg. The fuse is lit; we just don’t know its length. But when it blows, carnage in the bond market and, by implication, in an economy addicted to low rates will be brutal.”

No, I don’t think the fuse has been lit. What then is the explanation of the mystery? It is the \$400 quadrillion derivatives market growing exponentially. That’s what. It represents a latent demand for new bonds, unlimited quantities of it, so that the game of musical chairs could go on and on.

Moreover, demand is further fueled by the carry trade. The carry trade sells the high-priced Japanese bonds and buys the low-priced U.S. bonds. As I have pointed out, it is the mechanism whereby deflation is imported from Japan to the United States. This arbitrage results in a narrowing of the interest-rate spread. But that spread is still far from disappearing and, as long as it is positive, the carry trade will thrive and interest rates in the U.S. will keep falling. Bond speculation on the long side of the market will continue, giving further boost to the game of musical chairs. All this means deflation, even depression. Bernanke will keep stoking its fires by printing more dollars, hoping that the new money will go into commodity speculation, ending the depression. It won’t. The new money will go into bond speculation, deepening the depression.

That’s where smart money is made. In the bond market. On the long side. This is what makes the depression feed upon itself.

It is not likely, although neither is it impossible, that China will pull the rug from under the bond market. The game of musical chairs will probably go on, possibly for several more years. The sky is the limit for derivatives, and for the monetization of the U.S. government debt.

Part of that scenario is the price of gold. It will not be allowed to escape the gravity of earth, as it would do in the absence of clandestine official intervention. Although they will be able to limit the rise in the gold price, the powers-that-be will not be able to limit the rise in its volatility. Gyrations of gold will assume galactic dimensions, increasing uncertainty in its wake. Enormous fortunes will be made — and lost — both by the bulls and the bears betting that “the trend is their friend”.

The second coming of Paul Volcker is a myth. In 1979 the United States was in a much stronger financial and economic position than it is now and it could take the strong medication of high interest rates without danger of succumbing to the ‘sudden death syndrome’.

Presently, the United States economy is on a life-supporting system. China’s hand is on the switch. Paul Volcker’s regimen of high interest rates would be tantamount to turning the switch off.

---

*© 2006 Antal E. Fekete*  
*Professor, Memorial University of Newfoundland*

---

# Where Friedman Went Wrong

URL: https://newaustrianeconomics.com/archive/fekete/where-friedman-went-wrong/
Date: 2006-12-03
Section: Popular Economics
Difficulty: intermediate
Concept Tags: real-bills, gold-standard, monetary-policy, federal-reserve, new-austrian-economics, mises
Description: Fekete identifies the fundamental error in Milton Friedman's monetary theory: his dismissal of the gold standard and the Real Bills Doctrine led him to misdiagnose the Great Depression as a failure of money supply management rather than a consequence of destroying self-liquidating credit. Friedman's monetarism, Fekete argues, cannot explain why Fed money-printing failed to prevent the Depression — but Real Bills theory can.
Editorial Note: Written December 2006 shortly after Friedman's death in November. Fekete's critique of Friedman is characteristically respectful in tone but unsparing in substance, placing Friedman alongside Keynes as someone who correctly identified symptoms while misdiagnosing causes.
Original PDF: https://professorfekete.com/articles/AEFWhereFriedmanWentWrong.pdf

## Where Friedman Went Wrong

"Is a gold standard cum real bills an option" by Antal E. Fekete,

### Professor, Memorial University of Newfoundland

### "Dismal Monetary Science"

### Date

I was in Chicago on November 17 to address the MBA class of 2007 at the University of Chicago Graduate School of Business. I had a prepared address on Milton Friedman’s monetary theories concerning the adjustment mechanism of foreign trade under the floating exchange rate system. Before I could deliver it the announcement came that Friedman had died the previous day in San Francisco at the age of 94. Newspapers carried long obituaries calling him the man “who has changed economics, policy, and markets” and “made free markets popular again”. My address was sharply critical of the Nobel laureate Chicago economist. It would have been a dissonant chord in the cacophony of eulogies, so I decided to deliver an extempore address instead. However, I did not tear up my script. A dollar crisis was brewing. As I see it, Friedman has sowed the wind and the world is going the reap the whirlwind. Soon. When it does, I may want to publish my critique of Friedman’s monetary theories.

Here it is.

### Keynes and Friedman

Mr. Humphries, Graduating Class, Honored Guests, Ladies and Gentlemen:

You may call me reckless for daring to come here, the shrine of monetarism, to preach the antimonetarist gospel. I must confess that I do it with some diffidence, given the enormous prestige of the father of monetarism.

Along with John Maynard Keynes (1883-1947) Milton Friedman was the enfant terrible of twentieth-century economics. Thirty-five years apart, the two of them were the great wreckers of the gold standard. George Schultz, a friend of Friedman’s who served in the Nixon administration, says that in 1968 Friedman wrote a letter to president-elect Nixon suggesting that upon inauguration he should unilaterally take the United States off the gold standard (or whatever was left of it after president F. D. Roosevelt had wrecked it, on advice from Keynes, 35 years earlier in 1933).

In 1933 Keynes set out to persuade Roosevelt to default on the domestic gold obligations of the United States. He prevailed. In 1968 Friedman set out to persuade Nixon to default on the international gold obligations of the United States. He did not prevail. Not immediately, anyway.

Thus the glory for dealing the coup de grâce to the gold standard eluded him.

Demonetization of gold was not the only option available to Nixon. He could have also devalued the dollar in terms of gold. As is known, Mises was in favor of the latter. A new official gold price of \$70 per oz, amounting to a 50 percent devaluation, was the figure being bandied about.

Friedman’s unsolicited advice to Nixon tells us something about the character of the man. Rather than initiating a high-level debate among monetary economists on the disastrous monetary policies of the US government that has led to the 1968 crisis, Friedman preferred to work behind the scenes on his plan to plunge the nation headlong into irredeemable currency. He was determined to make the dollar an out-and-out fiat money, the worst type of currency known to man.

Friedman knew that people would be hooked on fiat money once it has been inflicted on them.

Here is a quotation from monetary scientist Walter E. Spahr [1], the Head of Department of Economics at New York University from 1927 to 1956.

"The majority, when given a taste of it, embrace irredeemable currency. The arguments offered in its defense are many and various, and constitute a sad commentary on human intelligence and character. The dilemma whether to give it up is much like that of the drug addict whether to give up dope. Even if he wanted to heed the advice of his understanding and experienced physician, often he will decide not to kick the habit. The run-of-the-mill speeches and articles on ‘inflation’ in this country provide a typical example of the majority reaction: they either evade the issue in ignoring that inflation is caused by fiat money, or they distort pertinent evidence, or they preach virtue where there is none, or they utilize currently popular platitudes, or they treat superficiality as though it should be accepted as wisdom. Rarely does one see a statement that an irredeemable currency is preferable accompanied by an attempt to give reasons for such an untenable belief.”

Friedman’s is such a statement.

“A nation in due course pays severely for the use of irredeemable currency. The United States is in a position analogous to that of a drug addict administering a law liked by all other fellow drug addicts.”

In this case the ‘understanding’ physician, Friedman, urges the addict to carry on with substance abuse.

### Irredeemable currency is massive fraud

The following quotation is also from Walter E. Spahr [2].

“Irredeemable currency means either fiscal or moral bankruptcy, or both. We are morally bankrupt now in so far as our monetary system is concerned. Both the U.S. government and the Federal Reserve have demonstrated that they wish to be free of pressure that people may put on them if our currency were redeemable. They are satisfied to hide behind irredeemable I.O.U.’s. Although a private citizen can expect imprisonment if he issues irredeemable bills of credit, our government and Federal Reserve banks have adopted as defensible a standard of morality that is not tolerated among honest people. They exercise power arbitrarily while refusing to accept the corresponding responsibility.”

Friedman has never addressed the question of morality in issuing obligations that one has neither the means nor the intention to meet — as demonstrated by the check-kiting scheme between the U.S. Treasury and the Federal Reserve.

“A nation is in serious trouble when that state of affairs exists. The federal spending orgy since 1933, the depreciation in the purchasing power of our dollar, the mounting federal debt, the centralization of power in Washington, D.C., the steady march into the Death Valley of socialism, these are some of the manifestations of what tends to happen when a government steals the people’s purse, having drugged them with the poison of irredeemable bills of credit.”

This was written in 1958. Much happened since that would have surpassed even the worst fears of the author had he lived to see it, including the dismantling of America’s once flourishing industries.

“Irredeemable currency is a massive fraud on the people. It is the chief and common means by which governments put shackles on free men.“

In spite of all his free-market rhetoric, this point was lost on Friedman.

“A government loses its moral standing among men of integrity when it employs irredeemable

I.O.U.’s. The regime of irredeemable currency is a monument to the dishonor of governments.” And, one might add, to the dishonor of advisors urging the government to carry on this abuse of power, in defiance of the Constitution.

“Irredeemable currency tends to expand and grow, and to carry abusers to their destruction. It is a potent contributor to international economic disintegration.”

To this day Friedman could not see the signs of disintegration, be it the accelerating increase of the money supply, or the Babeldom of foreign exchange derivatives trading at the rate of $ 500 trillion per annum, and rising exponentially, when the combined GNP’s of all the nations on earth is a paltry $ 40 trillion per annum.

"Irredeemable currency is a cesspool in which economic disease and human conflict are spawned. It is a wrecker of people, of families, and of nations. It is a road to the despotism of dictatorship.”

It was, in Russia in 1917; in Germany in 1933; in China in 1949, to mention but three outstanding examples. Does Friedman really believe that it cannot happen here?

In most cases irredeemable currency led to war or civil war. Does Friedman really believe that it won’t this time?

“Irredeemable currency is a symptom of a great national sickness. It ‘engages all the hidden forces of economic law on the side of destruction which not one man in a million is able to diagnose’ (according to Keynes, writing in 1919).”

Apparently, nor is Friedman the one in a million.

“What is the meaning of a gold standard and a redeemable currency? It represents integrity. It insures the people’s control over the government’s use of the public purse. It is the best guarantee against the socialization of a nation. It enables a people to keep the government and banks in check. It prevents currency expansion from getting ever farther out of bounds until it becomes worthless. It tends to force standards of honesty on government and bank officials. It is the symbol of a free society and an honorable government. It is a necessary prerequisite to economic health. It is the first economic bulwark of free men.”

It is a great tragedy of our age that Friedman, the self-styled defender of the freedom of the individual and the free market, could not see this. Nor could he see the wisdom of Thomas Jefferson’s warning: “If the American people ever allow bankers to control the issuance of currency, first by inflation and then by deflation, corporations growing up around them will deprive people of all their prosperity until their children wake up homeless on the land that their fathers have gained for them.

### Floating or sinking?

In the 1950's Friedman concocted his pseudo-theory purporting to show how the floating system of foreign exchange rates would provide an automatic adjustment mechanism to balance the external accounts of trading nations. By implication, a gold standard was not a prerequisite of bringing about equilibrium in foreign trade. To say that Friedman is not a friend of the gold standard is an understatement. He maintains that it is a “price-fixing scheme” and as such a gold standard is anathema to the free market.

A monetary scientist should know better. Friedman puts the cart before the horse. A gold standard does not fix the price of gold any more than the tail wags the dog. What happens is that, once gold is in circulation, it is the price of bonds and notes that governments and banks are all too anxious to stabilize in terms of the gold coin of the realm. If they can, gold gives their obligations unmatched respectability. If they can’t, then well-informed people will make their own conclusion about the quality of their paper.

According to Friedman’s theory, under freely floating foreign exchanges a country in deficit would experience a loss in the exchange value of its national currency vis-à-vis a country in surplus which would, in turn, experience a gain. The former would be a more attractive market to buy from and less attractive to sell in. It could now export more and import less. The latter would be a less attractive market to buy from and more attractive to sell in. It would now export less and import more. The resulting changes in the export-import cocktail would restore trade balance.

This is supposed to work as an automatic adjustment mechanism balancing foreign trade through the system of variable exchange rates.

This is an inept rationalization of the misfortune to have abandoned sound money. To say, as Friedman does, that debasement of the currency is a legitimate means of eliminating trade deficits, when carried ad absurdum, is saying that the worst currency is the best and the best the worst. Friedman’s theory was actually put to into practice by Nixon. The result judged from thirtyfive years’ of perspective was an unmitigated disaster. The monetary, financial, and economic stature of the United States is in shambles, thanks to Friedman’s floating dollar. As a matter of fact, the euphemism ‘floating’ should be interpreted as ‘sinking’. It was the sinking dollar that has turned the country from the greatest creditor into the greatest debtor the world ever knew. The dollar used to be a monetary giant, the envy of the rest of the world. Now, it is a dwarf treated with contempt abroad. And the worst is still to come. We are facing a credit collapse.

Floating did not solve problems that the United States was facing in 1968. It made them worse.

The devaluation and the deliberate debasement of the dollar did not make American exporters stronger. It made them weaker. The weak dollar was a huge bonanza for the foreign competitors of America. They were able to buy more imported goods per unit of exports. By contrast,

Americans were able to buy less. The deficit was financed by an unprecedented debt-pyramid spinning out of control. The terms of trade for America has deteriorated to such an extent that it necessitated the wholesale dismantling of once prosperous American industries. It is not just the foreign purchasing power of the dollar that is on skid row. So is its domestic purchasing power, official doctoring of statistics notwithstanding. The widely fluctuating value of U.S. Treasury bonds is a butt of some very unkind jokes by foreigners. True, the American people still appear to be well off. But this prosperity is resting on “thin ice” in the words of former Federal Reserve Board Chairman Paul A. Volcker.

### What caused the great Depression?

In their “Monetary History” published in 1963 Friedman and Anna Schwartz blamed the Great Depression of the 1930's on the ‘Great Contraction’ of the money supply in the United States during the period 1929 to 1933. This is where Friedman went wrong. He mixed up cause and effect. In reality the contraction of the money supply was the effect of the Great Depression, not its cause. Businessmen declined to borrow in spite of the extraordinarily low interest rate available, because they could not see any profitable business opportunities around. The Federal Reserve can print all the dollars bills it wants; what’s the use if there are no takers? The idea of putting crisp Federal Reserve notes into circulation through helicopter-drop, attributed to Friedman by Bernanke, is puerile. There is no synthetic substitute for the enterprising spirit of businessmen in search of entrepreneurial profits. You can’t push dollar bills down the throat of lethargic businessmen.

The real cause of the Great Depression eluded Friedman, as it did Keynes before him. It was found by the German economist Heinrich Rittershausen who in looking for it went farther back in history than any other economist.

Unnoticed by Friedman and Schwartz, 1909 was a milestone in the history of money. That year, in preparation for the coming war, France and Germany decided to concentrate monetary gold in government coffers. They stopped paying civil servants in gold coin. To make this legally possible the notes of the Bank of France and the Reichsbank were made legal tender. Most people did not even notice the subtle change. Gold coins stayed in circulation for another five years. It was not the disappearance of gold coins from circulation that heralded the destruction of the world’s monetary system. It was the making of bank notes irredeemable, even if they circulated side-byside with gold coins for the time being. There was an early warning sign: the fact that finance and treasury bills were ‘crowding out’ real bills from the portfolio of central banks in consequence of the French and German governments’ decision to make bank notes legal tender. Thus did the clearing system of the international gold standard fall victim to sabotage. It took twenty years before the chickens of 1909 came home to roost.

Well, come home they did with a vengeance. However, by 1929 the memory of the 1909 sabotage faded. No one suspected that a causal connection existed between the two events: making the bank notes legal tender and the wholesale destruction of jobs twenty years later.

Permit me to elaborate.

### Real Bills Doctrine

Friedman calls himself a ‘monetarist’, meaning that he is a devotee of the Quantity Theory of Money. Like all quantity theorists, he is a sworn enemy of Adam Smith’s Real Bills Doctrine. He has never understood completely the market in real bills as it existed before World War I, the function of which was to serve as the clearing system for the international gold standard.

When the victorious powers dictated their peace terms after the cessation of hostilities, they intentionally disallowed the international bill market to resume its former functions. They wanted foreign trade to follow a political rather than an economic agenda, in this case, to keep their former adversaries on short leash. At the same time, they wanted to retain the outward trappings of a gold standard. They failed to realize that sooner or later the gold standard would seize up without the support of its clearing system, the bill market. Worse still, they failed to see that world trade would contract severely as a consequence. Worst of all they were too obtuse to understand that the elimination of the bill market would be followed, albeit with some lag, by a horrendous and intractable unemployment problem confronting the entire world. This was correctly foreseen and predicted by Rittershausen in 1930. See [3] and [4].

Had the victors allowed the market in real bills to resume its proper functions after the signing of peace treaties, world trade would have recovered quickly and the international gold standard would have continued to hold sway over the world. On advice from upright economists sensible governments would have realized that legal tender laws were thoroughly bad and would have removed them from the books. The charters of central banks barring finance and treasury bills from the portfolio could not have been violated with impunity. In that milieu there would have been no great depression. World trade wouldn’t have vanished. The horrendous word-wide unemployment would have never occurred.

### Destruction of the wage fund

The fact of the matter is that prior to World War I wages of the majority of workers, namely all those engaged in the consumer goods sector, were financed by the international bill market. This is a point that eluded not only Milton Friedman but Ludwig von Mises as well. They missed the fact that the consumer was the ultimate paymaster and he would pay on the dot, provided that he had access to gold. It was his gold coin with which all wages were paid under the gold standard cum real bills. Tampering with the bill market, the clearing house of the gold standard, had an inevitable, if delayed, deleterious effect on employment.

Payment of wages is due long before the final sale of merchandise to the ultimate gold-paying consumer. In some cases the employer paying wages may have to wait as long as three months before he can collect his share of the proceeds from the sale of merchandise. Thus, then, there is the problem of financing wage payments. Unless this problem is solved satisfactorily, mass unemployment will ensue. The wage fund cannot be financed out of savings. Under the gold standard it was financed through the spontaneous circulation of real bills.

Whenever certain goods were in urgent demand, their movement through the channels of production and distribution was financed by self-liquidating credit. This also included all wages payable to workers handling consumer goods that were moving along on their way to the final consumer through the ‘assembly line’, as it were. The credit was liquidated out of the proceeds of the sale: the gold coin given up by the ultimate consumer when he removed the merchandise from the market. The system worked admirably well. Bills drawn on the retailer would circulate spontaneously. Real bills enjoyed ephemeral monetary privileges, which treasury bills and finance bills did not. Producers could buy supplies against this credit, and they could discount these bills at the bank to get gold coins with which to pay wages. Bills were the most liquid form of earning assets in existence. The competition of banks for them was keen.

It is no exaggeration to say that the discovery of the spontaneous circulation of self-liquidating credit is one of the great achievements of the human intellect, on a par with the discovery of indirect exchange. Without it the great economic progress in the Modern Age would be unthinkable.

After World War I the victorious powers, led by blind hatred for the vanquished, wanted to make foreign trade bilateral instead of multilateral. Exports and imports were made subject to political rather than economic considerations so that the victors could discriminate against their former adversaries. In this effort they unintentionally ruined the natural system of financing production and payment of wages. They dissipated the wage fund. They blocked the spontaneous circulation of self-liquidating credit in the world, the only safe and sound source from which wage payments could be financed. In doing so not only did they deal a mortal blow to the gold standard but, inadvertently; they brought upon the world the curse of massive and persistent unemployment.

This problem has been haunting the world ever since. There is still no satisfactory way of financing the wage fund of workers in the consumer goods sector in the absence of a gold standard cum real bills. There is no way bills could circulate under the regime of irredeemable currency. Not because real bills are anathema to Friedman; but because the idea of a real bill maturing into paper money is preposterous. A real bill is a future good. It must be maturing into a present good such as the gold coin in order to be able to circulate. It would just not circulate if it matured into another future good such as a bank note, redeemable or not.

The wage fund couldn’t be financed out of savings. Apart from the problem that saving takes time, the sums involved are far too large. The idea that the working class can save the funds out of which it can pay wages to itself is no less preposterous than the idea that soldiers in the field can lift themselves up by their own bootstraps.

The only alternative to a gold standard cum real bills is the regime of irredeemable currency. But then the government has to assume the responsibility for paying the handouts of the welfare state: it has to pay workers for not working, and farmers for not farming. Tertium non datur: there is no third alternative. The regime of irredeemable currency and the so-called welfare state are Siamese twins. Here, in a nutshell, is Friedman on the horns of a dilemma. He likes irredeemable currency while he dislikes the welfare state. But if you like irredeemable currency, then you had better like its corollary, the welfare state as well. Nor does the problem end there, since fiat money cannot be a permanent arrangement of society. Unless it is stabilized by returning to a gold standard, it will collapse after having caused a lot of mischief in the economy, as convincingly demonstrated by monetary theory and history.

### Optimal rate of increasing the stock of money

Of course, Friedman says he has a panacea in mind for all the economic ills of the world. Just entrust the issuance of high-powered money at a steady optimal rate to the Federal Reserve. He was jubilant when his mentor Arthur Burns was named as chairman of the Federal Reserve Board. If anybody, he could do it! He could put the tenets of monetarism into practice. Well, he didn’t. Neither could other chairmen, Bernanke’s ‘apology’ on Friedman’s 90th birthday notwithstanding. Central bankers consider Friedman’s prescriptions “impractical” and they have said so. Friedman retaliated by quipping that “even a clever horse can thrash out grain at a steady rate, so why can’t the dummies at the Fed?” There is neither inflation nor deflation in the never-never land of Friedman.

The idea that there is an ‘optimal rate’ of increasing the stock of money, and it could be determined scientifically, is chimerical. Creditors would challenge the ‘optimal rate’ saying it is too high; debtors would fight it saying it is too low. The federal government, being the greatest debtor of them all, would apply pressure on the Fed in support of the latter.

If the power to increase the money supply is delegated to an agency dressed in scientific garb, then this agency is a front behind which impostors hell-bent to usurp unlimited power under false pretenses hide. No matter how you look at it, the power to issue the currency is unlimited power.

Unlimited power means unlimited corruption.

### Mene Tekel Upharsin

In so far as Friedman has any coherent theory of money at all, it is the tenet that, even though the creation of wealth must be trusted to private hands and to the free play of the market, the creation of money must not — notwithstanding the monetary provisions of the U.S. Constitution. Money creation must be put squarely into the hands of the government — never mind the Constitution which is, after all, ‘just a piece of paper’ (with apologies to George W. Bush).

Naturally, the U.S. government and the Federal Reserve were all too eager to embrace unlimited power assigned to them by Friedman, in spite of the fact that this power was not ‘enumerated’ in, nay, it was explicitly denied by the Constitution of the United States. Friedman’s defense of a floating currency is pseudo-scientific claptrap, modernistic stuff designed to impress the mind untrained in monetary science (as opposed to ‘dismal monetary science’). The unfortunate part is that permanent damage has been inflicted to the social science faculties of our colleges and universities where so many have abandoned true science for the dismal kind, in pursuit of the scent of money.

When Friedman’s monetary theory is put on a scale against the U.S. Constitution, the verdict is: Mene tekel upharsin (you have been weighed and found wanting). Why the theory in the citation for Nobel Prize not was worth to merit a constitutional amendment is an interesting story. The credentials of Friedman were not strong enough to withstand public furor that would erupt if the paper dollar, hardly worth one constitutional gold cent, was supposed to be carved into the stone of the U.S. Constitution. The powers-that-be don’t want to rock the boat. It is too risky. ‘Let the sleeping dog lie’. Policy-makers could not muster the necessary moral courage to initiate a constitutional amendment. They would rather live with the odium of running a blatantly unconstitutional monetary regime. Be that as it may, the next dollar crisis will force the issue.

In “Two Lucky People”, written together with his wife Rose, Friedman said: “We do not influence the course of events by persuading people that we are right when we make what they regard as radical proposals. Rather, we exert influence by keeping options available when something has to be done at a time of crisis”.

Well, Mr. Friedman, crisis is knocking on our door right now. It is a dollar crisis dwarfing that of 1968, or any monetary crisis in all the history of money. Do you mean to say that the option to rehabilitate the gold standard cum real bills is open still?

### References

### [1]

The Real Culprit, by Walter E. Spahr, Monetary Notes, July 1, 1959.

### [2]

The Debate Is Not Over, by Walter E. Spahr, U.S.A., May 9, 1958.

### [3]

Arbeitslosigkeit und Kapitalbildung, by Heinrich Rittershausen, Jena: Fischer, 1930

### [4]

Unemployment: Human Sacrifice on the Altar of Mammon, by Antal E. Fekete,

---

*September 30, 2005*

---

# When Atlas Shrugged, Part Two

URL: https://newaustrianeconomics.com/archive/fekete/when-atlas-shrugged-part-two/
Date: 2006-10-07
Section: Popular Economics
Difficulty: intermediate
Concept Tags: fiat-currency, bond-market, capital-destruction, interest-theory, federal-reserve
Description: The second part deepens the Atlas Shrugged analogy by examining the specific mechanism by which irredeemable currency destroys productive capital. Fekete explains how the bond market's artificial bull run — sustained by central bank purchases — systematically misallocates capital away from productive enterprise and toward speculation, hastening the moment when Atlas shrugs.
Editorial Note: Part two of the Atlas Shrugged essay series, published in October 2006. More technically focused than part one, this installment explains the bond-market mechanism by which capital is drawn into speculation and away from production — the monetary dimension of Atlas's burden.
Original PDF: https://professorfekete.com/articles/AEFWhenAtlasShruggedPartTwo.pdf

## Usa.

---

*October 7, 2006*

My approach is different from that of other monetary scientists in that I take speculation into full account. The theory of speculation is conspicuous only by its absence from mainstream economics. (Keynes’ attempt to create one was a dismal failure.) But it is not a strong side of Austrian economics either. I reach back to Carl Menger and construct a theory of interest directly on his economic principles.

In this concluding part of my two-part series I suggest that the year 2006 has decisively changed the nature of gold speculation. Speculators no longer take the bait of riskless profits. They no longer short gold at the first sign of a rising gold price. It is only a matter of time before the marginal gold bull decides to short not gold, but the gold stock par excellence, Barrick.

### Faux pas of Mises

My theory of interest is centered around the constant marginal utility of gold. It is this property that makes gold ‘most hoardable’. That there is a limit to gold hoarding is due solely to the institution of interest. The opportunity cost of hoarding gold is just forgone interest. This is a distinctive property of gold. The hoarding of all other goods is severely limited by declining marginal utility.

Mises missed this fundamental connection between gold and interest. (This is not to mention David Ricardo. If Mises missed by inches, Ricardo’s ‘bullion plan’, adopted by Britain in 1925 and the by U.S. in 1934, missed by miles.) All this is fully worked out in my Gold Standard University lecture series, which has been in the public domain for many a year.

It follows that the rate of interest is just the rate of marginal time preference. In practical terms this means that the agent to regulate the rate of interest is the marginal bondholder*. He is doing arbitrage between the gold market and the bond market. As the rate of interest is falling below the rate of marginal time preference, he takes profits in selling his overpriced gold bond and puts the proceeds into gold. This action makes the rate of interest turn around. As it is rising above the rate of marginal time preference, the marginal bondholder will buy back his gold bond at a lower price.

It is interesting to note that Mises explicitly referred to this particular arbitrage, although without using that word.** So he was actually pretty close to discovering the real force driving the rate of interest. Yet he went astray because, for him, paper currency was a present good no less than the gold coin — a faux pas.

Should the marginal bondholder accept paper currency in exchange for his gold bond, he would take zero in exchange for a positive income. Thus his protest against low interest rates would be counter-productive. In effect, he would jump from the frying pan into the fire.

This irrefutably shows that the action of the marginal bondholder aims at hoarding gold, and not currency in general. Under modern conditions the meaning of the term ‘time preference’ is not preference for an apple available today as against two apples available ten years from now. It is, rather, preference for holding the gold coin, a present good, as against holding the gold bond, a future good — unless the rate of interest is sufficiently high to compensate for the unequal exchange.

### Key to Gibson’s Paradox

Imagine my surprise when I learned that mainstream economists have also discovered gold as the only instrument to give teeth to time preference that would otherwise remain but a pious wish.

See in particular the joint paper of Barsky and Summers. The correlation between the rate of interest and the price level under a gold standard was named ‘Gibson’s Paradox’. Paradox, because monetary theory according to Keynes would call for a correlation between the rate of interest and the rate of change (rather than the level) of prices. Gibson’s, because Irving Fisher named Gibson as the first author to make this observation. Keynes stated in 1930 that two centuries of data failed to confirm that a correlation existed between the rate of interest and the rate of inflation. Instead, between 1730 and 1930, the rate of interest and the price level showed a positive correlation which Keynes described as “one of the most completely established empirical facts in the whole field of quantitative economics”. No one has been able to come up with a full theoretical explanation. Friedman and Schwartz in 1976 concluded that “the Gibsonian Paradox remains an empirical phenomenon without a theoretical explanation”. It was not for want of trying, either. Irving Fisher wrote in 1930 that “no problem in economics has been more hotly debated”. Barsky and Summers also state that “Gibson’s Paradox has proven to be an especially stubborn puzzle in monetary economics”.

Yet to find the key to the ‘paradox’ we have only to observe that suppression of the rate of interest will intensify gold hoarding by the marginal bondholder which, under a gold standard, squeezes bank reserves and leads to a falling tendency of the price level. Conversely, we observe that when the rate of interest rises the marginal bondholder will, in buying the gold bond, release hoarded gold. Increase in the quantity of monetary gold increases bank reserves, and leads to a rising tendency in the price level. The ‘Gordian knot’ finds its ‘snap solution’ in Menger’s concept of marginal utility.

### The regime of the irredeemable dollar

The validity of Gibson’s Paradox clearly extends to the regime of the irredeemable dollar with a variable gold price. It varies directly with the price level. In particular, as the irredeemable dollar loses purchasing power, the price of gold will rise for the stronger reason. In terms of Gibson’s Paradox, the price level rises less if the rate of interest is suppressed; otherwise it rises more.

Properly interpreted, there has never been an episode in history when Gibson’s paradox failed to operate. It is the empirical description of the apodictic truth that suppression of the rate of interest brings about increased gold hoarding, subject to leads or lags. Every ounce of hoarded gold is a testimony to the fact that somebody, somewhere, has found the quality of savings instruments, and their yield, inadequate. By making the regime of irredeemable dollar non-negotible, the U.S. government has foolishly deprived itself of the possibility to channel people’s savings into ‘socially more useful’ applications. Therefore it is the government, not the people, that is to be blamed for the present negative savings rate in the United States.

### Government manipulation

In Part 1 I advanced the hypothesis that the U.S. Treasury and the Federal Reserve have been manipulating both the rate of interest and the price of gold. In more details, they encourage bull speculation in bonds and bear speculation in gold. They do it by making unlimited quantities of bonds available for the speculators to buy, and unlimited quantities of paper gold available for them to sell in the derivatives markets. Lures, in the form of risk-free profits, are planted along the path of the speculators.

Clandestine government policy to manipulate the bond and gold markets is revealed by statistics on the number of outstanding contracts in derivatives, showing an inordinate open interest in bonds on the long and in gold on the short side. Neither has any rhyme or reason to exist, in view of the underlying economic reality. What is more, the long interest in bond and short interest in gold derivatives are increasing exponentially, far outpacing the amount of bonds in existence, and the amount of gold available for delivery. Significantly, there is an extreme concentration of derivatives in the hands of three or four firms on the long side of the bond market, and on the short side of the gold market.

A most alarming development occurred recently as observed by Pinank Mehta on [www.goldeagle.com](https://www.goldeagle.com) (October 6). The net long open interest of the 10-year US bond contract, as reported by Morgan Stanley Research, has increased explosively and is now greater than six standard deviations. This level is unprecedented.

### The Twin Towers of Babel

In Part 1 I explained why the government was interested in manipulating speculators so that they compulsively construct such uneconomic Twin Towers of Babel. The purpose of Part 2 is to show that, in view of Gibson’s Paradox, there is a conflict involved in the dual manipulation. In fact, the two desiderata in the agenda of the government: the propping up of the bond price and the suppression of the gold price, are contradictory. In encouraging bull speculation in bonds the government prompts more gold hoarding, making gold scarcer and the gold price more buoyant still. On the other hand in encouraging bear speculation in gold, in so far as it is effective, gold hoarding is reduced pushing interest rates higher. Rather than canceling out, the two effects could ratchet up both the gold price and the rate of interest simultaneously. As a result, the Twin Towers will self-destruct in due course.

The regime of the irredeemable dollar is subject to the ‘sudden death syndrome’, a malady afflicting all fiat currencies with a 100 percent fatality rate. Creditors know this, and add a riskpremium to the rate of interest they charge on their loans. If it weren’t for bond derivatives, the dollar would have gone the way of the assignats and mandats already in the twentieth century.

But the government plants lures, to induce speculators to buy the bonds. This keeps interest rates low, and props up the dollar.

However, in terms of Gibson’s Paradox, the suppression of the rate of interest means increased gold hoarding. To counter that threat, the government has to have recourse to a devious scheme to induce speculators to sell unlimited amounts of gold through the gold derivatives market. In Part 1 I described an imaginary mining concern, Sarrick Gold, with a phony hedge plan involving forward selling, to the exclusion of forward buying, of gold. Speculators are offered risk-free profits on the short side of the market. All they have to do is to pre-empt Sarrick’s forward selling strategy, that is, sell before Sarrick does.

Thus the Twin Towers of Babel, the long-bond pyramid and the short-gold pyramid, are interdependent. Neither one will prosper without the other prospering. Conversely, if one topples, so will also the other. It follows from standard theory of speculation that, in commodities, a short position constitutes unlimited risks, as opposed to a long position the risk of which is limited as the price cannot fall below zero. This suggests that the inordinate, fast-increasing and extremely concentrated short interest in gold is vulnerable and will act as a trigger when it gets wounded (that’s what the word ‘vulnerable’ makes you expect to happen). Delivery may encounter difficulties, backwardation may develop in gold futures, and the weakest link in the short chain may snap. Some shorts may default. That would cause other short positions cascade and defaults spread. The collapsing gold basis will accurately gage the development leading to the toppling of the short gold pyramid. In an earlier paper entitled: The Last Contango in Washington I conjectured that the collapsing silver basis may act as an ‘early warning system’ to herald the coming collapse of the gold basis.

The long bond-pyramid is at the mercy of the bond-bears, and the short gold-pyramid is at the mercy of the gold-bulls. Moreover, in terms of Gibson’s Paradox, a run on gold still available for delivery against gold derivatives would cause a panic in the bond market to sell. Thus the equilibrium of the Twin Towers of Babel turns on the knee-jerk reaction of the marginal bull speculator in gold. When he decides that Barrick is in fact bankrupt as it will never be able to make good on its forward sales commitments, he will do two things: (1) short Barrick stock, (2) take delivery on his long positions in the gold derivatives market.

### Insatiable Appetite

Thus we have another ‘early warning sign’ for the collapse of the Twin Towers of Babel: the Barrick share price, already showing a profound shareholder disillusionment. It is significant that Barrick has worked up an insatiable appetite for further acquisitions. Its purpose is to confuse the issue through window-dressing of the balance sheet.

One might have expected that, having become No. 1 in the world, Barrick would want to catch its breath and rest on its laurels. Not so. Barrick is still looking for other gold producers to gobble up.

This looks like a sign of desperation to me. As long as you are No. 2, appetite for acquisitions is understandable. You try harder. But when you are No. 1, it no longer makes sense. However,

Barrick is in the limelight. The share price as compared with assets is lamentably low. It would be more fitting for the last than for the first in the business. The reason is the curse of the hedge book. It just won’t go away. Barrick will neither repudiate nor repair its faulty policy of forward selling of gold, in spite of dire warnings that it may eventually be the cause of its downfall. The hedge book is deep under water. It shows only forward sales, no compensating forward purchases.

Barrick has been challenged to mark its hedge book to market. The challenge was ignored. For all we know, there may be a good reason for that. Perhaps the rumors are true and, when liabilities are marked to market, all the assets of Barrick are wiped out. Barrick would be seen as being bankrupt. Could this be the very reason why Barrick is so desperate to acquire other gold mining assets? If it could buy badly needed time before share value declined more relative to assets, the worst could perhaps be averted.

Barrick loves to pay for its acquisitions with its own shares. From the point of view of its shareholders, this policy is disastrous. Not only does it mean further dilution of their share, but so low is the value of shares relative to assets that Barrick’s shareholders fear another attempt by management to fleece them. On the other hand, shareholders of the company targeted for a hostile takeover are increasingly reluctant to accept Barrick’s ‘stained’ shares in exchange for their ‘clean’ (read: not stained with forward sales) shares.

One wonders why targeted companies could not force Barrick to mark to market its existing commitments to sell gold forward. After all, the seller has the right to ask whether the check offered in payment by the buyer is backed as represented. Maybe they did try, whereupon Barrick decided to come up with the cash rather than make the uncomfortable revelation.

### Atlas Shrugged

One can only guess that the urgency with which Barrick acquired Placer Dome is explained by the 2006 surge in the gold price. We may take it for granted that Barrick anticipated the surge, but could not close out the deal in time before it happened. At any rate, the two events are connected and their concurrence has materially changed the course of history. First, the utter futility of the short gold pyramid has convincingly been demonstrated. Speculators no longer take the bait: they no longer mindlessly short gold on the first sign of strength in the gold price. Second, Barrick has changed its strategy from forward selling to unlimited acquisitions. This is symptomatic of the problems Barrick is going to face in the future. The new battle cry is: “Acquire or die!” However, in doing so Barrick will be racing against a buoyant gold price.

This is the unpredictable part. Can Barrick acquire gold properties fast enough to win the race against a rising gold price no longer fettered by forward sales? If it can, this may be a set-back for the gold price. Atlas may be able to carry the \$300 trillion derivatives market on its shoulder awhile longer.

But if it could not, and Atlas shrugged, then the short gold bubble would burst, triggering the collapse of the \$300 trillion derivatives bubble. We could then expect to witness the ruination of the credit of the United States, and the close of the dollar system.

### Endnotes

* In Human Action Mises treats time preference as if it were the same for everybody, paupers and nabobs alike. As I have found this too crude, I refined it by introducing the concept of the rate of marginal time preference, that is, the rate of the time preference of the marginal bondholder. He is doing arbitrage between the bond market and the gold market. The marginal bondholder is the first to reduce his bond holdings on the next downturn of the rate of interest.

Strictly speaking, there are two agents: the marginal bondholder regulating the floor, and the marginal entrepreneur regulating the ceiling of the range to which the rate of interest is confined.

The ceiling is the rate of marginal productivity of capital as it is regulated by the marginal entrepreneur in doing arbitrage between the bond market and the capital goods market. As the rate of interest is rising above the rate of marginal productivity of capital, he sells his capital goods and invests the proceeds in the bond market. This action will make the rate of interest turn around. As it is falling below the rate of marginal productivity of capital, the marginal entrepreneur takes profits and sells his overpriced bonds. With the proceeds he re-equips his productive enterprise and starts production once more. For full details, see my Gold Standard University lecture series.

In this paper I have, for the sake of simplicity, assumed that the rate of interest is the same as the rate of marginal time preference, and the agent to regulate it is the marginal bondholder.

** The word ‘arbitrage’ does not occur in the Index of Human Action or in that of The Theory of Money and Credit.

### References

Robert B. Barsky and Lawrence H. Summers, Gibson’s Paradox and the Gold Standard, The Journal of Political Economy, vol.96, no. 3(June 1988) p 528-50.

A. E. Fekete, Gold and Interest, Monetary Economics 102, The Gold Standard University,

---

*January 1, 2003*

A. E. Fekete, Gold Fever Trumps Gold-Hedge Fever, January 13, 2003

### A. E. Fekete, The Bubble That Broke the World, June 30, 2003

A. E. Fekete, The Last Contango in Washington, [www.gold-eagle.com](https://www.gold-eagle.com), June 3, 2006

### A. E. Fekete, When Atlas Shrugged..., Part One, August 24, 2006

Milton Friedman and Anna J. Schwartz, From Gibson to Fisher, Explorations Econ. Res. 3

(Spring, 1976) p 288-91.

### Announcement

I shall give a talk at the University of Chicago Business School on November 17, 2006 during the lunch-hour break. If you are interested to attend, please contact Ryan Humphreys at: ryan_humphreys@hotmail.com

## Disclaimer And Conflicts

THE PUBLICATION OF THIS ARTICLE IS FOR YOUR INFORMATION AND AMUSEMENT ONLY. THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING THAT IT REPRESENTS, UNDER ANY

CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL ANY SECURITY. THE CONTENT OF THIS ARTICLE IS DERIVED FROM INFORMATION AND SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO

REPRESENTATION THAT IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS TO BE TAKEN AS THE AUTHOR’S OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A STATEMENT OF FACTS.

THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT, IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.

---

# When Atlas Shrugged, Part One

URL: https://newaustrianeconomics.com/archive/fekete/when-atlas-shrugged-part-one/
Date: 2006-08-24
Section: Popular Economics
Difficulty: accessible
Concept Tags: fiat-currency, interest-theory, capital-destruction, gold-standard, monetary-policy
Description: Drawing on Ayn Rand's novel, Fekete argues that the productive class — the savers and entrepreneurs who create real wealth — are beginning to withdraw from the economy as the burden of irredeemable currency's distortions becomes unbearable. Part one traces how falling interest rates destroy the incentive to save and produce, setting the stage for an Atlas Shrugged moment.
Editorial Note: Part one of a two-part essay from August 2006, using Rand's framework to illuminate Fekete's economic analysis. The Rand reference reflects a shared emphasis on the productive individual's role in wealth creation, though Fekete's monetary analysis goes beyond Rand's focus on regulation.
Original PDF: https://professorfekete.com/articles/AEFWhenAtlasShruggedPartOne.pdf

## Usa.

---

*August 24, 2006*

I receive a lot of hate mail from loyal Barrick shareholders accusing me of “plunging my little dagger into Barrick’s back out of spite”. I can assure readers that my time is more precious than wasting it on petty revenge or indulging in Schadenfreude**. I am not trying to make Barrick appear smaller than it is. In fact, I am suggesting that Barrick is the modern Atlas carrying the entire derivatives market, currently estimated at \$300 trillion, on its shoulders. The global derivatives market and Barrick’s ‘hedging’ program stand or fall together. In particular when Altas shrugged, there would be an earthquake measuring ten on the Richter-scale, and the derivatives market would go down the drain causing unprecedented economic pain in the world through the destruction of bond, stock, and real estate values.

### Speculation versus gambling

It is amazing that the exploding derivatives monster finds apologists in the “free market” camp. This monster has been called “the most toxic element of the financial markets today” (Howard Davies, Chairman, U.K. Financial Services Authority), “a financial weapon of mass destruction carrying dangers that, while now latent, are potentially lethal” (Warren Buffett). Yet if you read the opinion of some people associated with the the Ludwig von Mises Institute and the Lew Rockwell website, then you get the impression that the \$300 trillion derivatives monster is benign, even ingenuous, if misunderstood and unfairly maligned. Derivatives are good because they allow banks, industrial companies, and private individuals to shift risk to speculators who are happy to shoulder it. Risk people are ill-equipped to deal with is “traded away” so that they “can focus on tackling tasks in areas in which they specialize”. A typical example is an import/export company using foreign exchange derivatives to neutralize risks inherent in buying and selling abroad due to the fluctuation of the exchange rate. Another example is provided by people carrying a variable-rate mortgage, who are allowed to switch to a fixed-rate mortgage when they expect a rise in interest rates. The free market helps those who help themselves. This is what ‘division of labor’ is all about, the source of economic efficiency of which Adam Smith spoke.

This apology is rather grotesque. It ignores the fact that gyrating foreign exchange and interest rates are far from being free market institutions. They were created by the government in order to strangle the free market. These rates were stable under the gold standard. It is one thing to shift risks created by nature to the shoulders of speculators who are better able to deal with them, for example, in the case of the futures markets for agricultures products. It is another thing if the risks have been created by men (read: the government). In the former case speculation has a legitimate role; in the latter, the word ‘speculation’ is a misnomer. Dealing with risks created by man is not speculation. It is gambling. Failure to make this distinction is to play into the hands of the enemies of the free market. They suggest that speculation in foreign exchange and interest rate futures has a ‘stabilizing’ effect on these rates, no less than speculation in grain futures has on grain prices. The message is that there is nothing to worry about. The regime of irredeemable currency is here to stay and it will create its own institutions to confront economic problems as they come along.

### The carry trade

This message is false. Speculation in foreign exchange and interest rates does not have a stabilizing effect. As in the casino, more bets do not subdue the gambling spirit; rather, it will heighten it. Moreover, not all derivatives have arisen out of ‘risk management’. An unknown but apparently very large part takes its origin in the ‘carry trade’, the practice of creating something out of nothing (more accurately described, clandestinely siphoning off value from the balance sheet of the producing sector and transfer it to that of the financial sector). It consists of borrowing at a low and investing the proceeds at a high rate of interest. For example, consider the yen carry-trade involving the sale of high-priced Japanese bonds and the purchase of cheap U.S. bonds with the proceeds, thus swapping a 2 percent per annum outlay for a 5 percent per annum income. Since it takes a long time for the interest rate spread between the U.S. and Japan to close, pyramiding can be continued indefinitely. It cannot be denied that the carry trade adds materially to the \$215 trillion ‘notional’ value of the Bond Derivatives Tower of Babel.

### Official check-kiting

Government bonds today are not a legitimate instrument of saving as gold bonds of yesteryear were. They are supposed to have value because they are payable in FR notes at maturity. But what gives value to the FR notes? Why, it is the fact that they are liabilities of the issuing FR bank, backed by assets such as government bonds. Thus, then, there is an official check-kiting between the US Treasury and the Federal Reserve. The former issues bonds with which FR notes are backed; the latter issues notes used to pay off the bonds at maturity. This is no free market. It is a parody of the free market or worse. It is a charade designed to fool and defraud people. In effect the government bond is irredeemable, no less than the FR note.

If the bond appears to have value it is solely because bond speculators are, for the time being, willing to bet that producers will continue to accept it in exchange for real goods and services, and that there will be a demand for the notes by taxpayers anxious to pay their taxes. But don’t take this willingness for granted. Bond speculators are not running a charity to bail out profligate and bankrupt governments. If, in their judgment, too many of those bonds are owned by foreigners who are not subject to the taxing authority of the U.S. government, or the producers of crude oil, for example, are increasingly reluctant to accept FR credit in payment, then bond speculators will, without prior notice, withdraw their bets -with fatal consequences to the fortunes of Treasury obligations. Note that the term “bond speculator” covers big-league banks and hedge funds with bond positions running into trillions.

Whitewashing illegitimate derivatives using free market rhetoric will not legitimize them. To sing a song of praise of ‘financial innovations’ designed to justify and perpetuate official check-kiting is not fitting for a defender of the free market.

### Big Bang

It was not until 1973 that the Chicago Board of Trade opened its Options Exchange to trade options on financial futures marking Big Bang, the beginning of the explosive growth of the derivatives market. Notice the coincidence of Big Bang with the U.S. government’s default on its international gold obligations. Incidentally, the same year marked the explosion of volatility in commodity prices as well.

The derivatives market grew from zero to \$865 billion during the 15 years from 1972 to 1987. During the next 15 years, from 1987 to 2002, it grew to \$100 trillion, or more than

100-fold. It trebles on average every four years. The latest report of the Bank for International Settlements states that the gross market value of amounts outstanding in the over-the-counter derivatives markets at the end of December, 2005, was \$285 trillion, of which the largest component, the interest-rate derivatives contracts was \$215 trillion.

The amazing thing is that the total value of bonds outstanding world-wide is estimated at only \$45 trillion. How can you write contracts to buy bonds, five times greater in amount than all the bonds in existence? Does this not give the lie to the word ‘derivatives’, meaning that these contracts ‘derive’ their value from the underlying assets? What kind of ‘musical chairs’ game is this? When the music stops, what will happen to those who are out of luck and hold the bag?

### ‘Telescope effect’

Defenders of the derivatives market insist that its growth is quite benign. Malignancy is explained away by the need of banks and other financial institutions, as well as industrial corporations, to hedge their interest-rate risk-exposure. The word ‘notional’ was introduced to cover up dangers involved in constructing this unprecedented Tower of Babel. The word means ‘fictional’, or ‘not having a real existence’. The idea is that behind the growth of the derivatives markets there is an increasing chain of swaps as companies are switching their debt-servicing back-and-forth between fixed-rate and fluctuating-rate income streams.

There is nothing to worry about that, the defenders of this Ponzi-scheme say, because of the ‘telescope effect’ operating on income-stream swaps. The notional value of swaps may appear very large and seems to be growing very fast. But all this is an optical illusion, they say, because swapped payment-streams net out or cancel. No party to the contract demands that non-existent bonds be delivered upon expiry.

One defender takes the example of a company wishing to change its floating-rate loan into a fixed rate loan because it expects that interest rates will rise. It could renegotiate the loan with lenders, or it could retire the debt and reissue a new fixed-rate debt. However, these are expensive maneuvers. It is cheaper to find a counter-party who will take over the floating-rate payments for a consideration, while the company will make fixed-rate payments to it. The two swap. They do not swap the actual underlying bonds. They swap income-streams represented by the semi-annual interest-payments.

Conversely, if interest rates are expected to fall, then the company will want to change its fixed back into a floating-rate loan.

### Dumping non-existent bonds

This argument ignores the problem of what happens in a panic when interest rates take off and bond values start falling like a rock. Then everybody wants to dump the obligation of making floating payments, but there will be no counter-party to assume it. An additional criticism is that the ‘telescope effect’ operates on the string of payment-stream swaps only if made between the same two parties, which is hardly ever the case. In general, the market value of the right to receive the fixed payment stream does not ‘telescope’. Every swap adds the value of the underlying bond to the balance sheet of one party or the other, without the benefit of the ‘telescope effect’. Yes, there is pyramiding of derivatives. It is foolish to think that ‘derivatives’ will retain their value when the bonds from which this value is supposed to have been ‘derived’ have lost theirs.

A third criticism concerns the fact that the bond and gold derivatives markets are interdependent. As in the former the long-interest and in the latter the short-interest gets bloated, disequilibrium keeps growing. It will ultimately act as a trigger. This will be more fully explored in Part 2.

In the absence of derivatives the panic would run its course and bond values, having absorbed the loss, would eventually stabilize at a lower level. In 1980 the runaway train could still be stopped before it derailed. But with a derivatives market of the present size such a panic would be tantamount to a stampede to sell up to \$200 trillion worth of bonds which nobody wanted to buy. Nothing could stop this runaway train. The credit of the U.S. government would be ruined.

The problem is not that delivery of non-existent bonds is expected at the maturity of contract. The problem is that there will be an irresistible run to dump non-existent bonds when the underlying bond starts losing value precipitously, that is, when interest rates repeat or surpass their 1979-80 performance of entering stratosphere. In that episode, it will be recalled, the largest American banks became insolvent as the value of bonds in their portfolios collapsed, making huge holes in the balance sheet.

### Fate of Sodom and Gomorrah

What is surprising is not that it could happen. Government bonds are the tangible result of check-kiting pretending that ‘NSF’ checks have value. For a time people accept them as such but sooner or later the truth will dawn on them. At that point the value of bonds, whether fixed or floating rate, is doomed and will be wiped out like the biblical towns of Sodom and Gomorrah have been.

What is surprising is that economists, among them free-market protagonists, fail to see in the derivatives market and in its unlimited exponential and cancerous growth the very mechanism, the fire and brimstone ordained by God that, in the fullness of times, will annihilate Sodom and Gomorrah. Instead, they sing a praise of “market innovation”, of

“economic efficiency”, of the “Wonderful Wizard of Risk Control”, and of the “neutrality and usefulness of derivatives”, when they should sound the alarm and forewarn people of the impending catastrophe.

### Gold derivatives

The latest report of the Bank for International Settlements on the over-the-counter derivatives of major banks and dealers in the G-10 countries for the period ending December 31, 2005, lists the total notional value of all gold derivatives outstanding as \$334 billion at year-end, an increase \$46 billion from \$288 billion at midyear. Gold available for delivery has not increased nearly at this rate and the total value of outstanding gold derivatives exceeds the value of gold available for delivery by a large and increasing factor.

Clearly, there is no ‘telescope effect’ at work here.

It is no coincidence that the amount of outstanding contracts is so much larger than the amount of underlying assets, both in the case of gold and bond derivatives. The dynamics of the growth of the derivatives market is hardly spontaneous. Here is the reason why.

The government has the following desiderata:

(1) to have a floor below the bond price;

(2) to have a ceiling above the gold price.

Indeed, without such a floor and ceiling, the bluffing epitomized by check-kiting could be called, and the international monetary system would unravel.

### The lure of risk-free profits

To promote these desiderata, the bond and the gold markets are manipulated. It is true that the Treasury and the Federal Reserve prefer not to play a direct role in it. Speculators are induced to do it for them through the lure of risk-free profits.

Simply put, the role of the derivatives market is to make phantom bonds available to buy, and phantom gold available to sell, for the benefit of speculators. It is no problem to make speculators want to buy phantom bonds. They have the incentives. They know that the Federal Reserve is going to buy, rain or shine. This offers a risk-free opportunity for profits. All the speculators have to do is to pre-empt Federal Reserve purchases, that is, to buy beforehand. So let them.

The tricky part is how to make speculators want to sell phantom gold. This problem is solved by setting up a gold mine as a front, beefing it up as the world’s largest gold-mining concern, and letting it introduce a phony hedge plan. Let’s call it Sarrick Gold. The hedge plan of Sarrick calls for selling but never buying gold forward. The plan is then promoted as an essential ‘risk-management’ tool for the company, which is supposed to ‘stabilize revenues’ and even enhance them. It is alleged that forward selling also serves ‘to satisfy the banks that finance Sarrick’s mining operations’. Other hare-brained gold mining companies chime in: “Me too! Me too!”

But since no forward purchases complement forward sales (as they should if it were an honest-to-goodness hedging program), speculators abandon their traditional spot on long side of the market, and make the short side their haunt. They now have a risk-free opportunity for profits in short-selling gold. Speculators know that Sarrick is going to sell whenever the gold price is itching to rise. All they have to do is to pre-empt Sarrick’s sales, that is, to sell beforehand. So let them.

### The lore of risk-free profits

You don’t have to go any further than that to explain the inordinate size of the derivatives markets in bonds and gold, and their cancerous growth. It is uninhibited pyramiding, pure and simple. Speculators pyramid on the long side of the bond derivatives market; and they pyramid on the short side of the gold derivatives market. In Part 2 we shall see that, far from supporting one another, the two activities tilt the imbalance more and more away from equilibrium so that, eventually, the pyramids will topple.

The gold standard rules out risk-free profits and unlimited pyramiding. That is its main excellence. The regime of irredeemable currency makes risk-free profits and unlimited pyramiding possible. That is the main reason that it will self-destruct in due course through the crash of the Derivatives Tower of Babel.***

To recapitulate, apologists suggest that the derivatives market is largely due to prudent risk-management, in the form of swaps between fixed and floating-rate paymentstreams. Other contributing factors can be neglected. At any rate, there is nothing to worry about: payments streams are netted out and will stay manageable.

I emphatically disagree. I argue that the bulk of the derivatives market is due to positions motivated by the lure of risk-free profits. The lure is planted by the Treasury and the Federal Reserve. In particular, there is no limit to pyramiding for bonds on the long and for gold on the short side of the market, since there is no limit to human greed and thirst for power. This is not a condemnation of the individual speculator who, like everyone else, is trying to eke out a living. He is not responsible for bringing about false incentives. The responsibility for that rests squarely with the government.

In the second and concluding part I shall draw attention to the fact that the bond and gold derivatives markets are interdependent: the former is subordinate to the latter. Gold plays a pivotal role in the operation of the bond market in terms of ‘Gibson’s Paradox’.

Default in gold derivatives will bring about the collapse of bond derivatives, with incalculable consequences to human welfare.

### Endnotes

* With apologies to Ayn Rand, author of Atlas Shrugged.

** Schadenfreude is German, meaning the pleasure felt over other’s misfortunes.

*** Derivatives per se are not necessarily evil. Futures markets functioned quite well during the gold standard. It is conceivable that a sophisticated derivatives market would function optimally again in a world with a working gold standard. Agents may partake in derivatives for insurance against risks created by nature. Also, speculators may use derivatives to offer liquidity services against such natural risks.

---

# To Barrick or To Be Barricked, That Is the Question

URL: https://newaustrianeconomics.com/archive/fekete/to-barrick-or-to-be-barricked/
Date: 2006-08-11
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, gold-standard, central-banking, monetary-policy
Description: Fekete revisits the Barrick Gold hedging controversy, arguing that Barrick's massive gold forward sales transferred shareholder wealth to bullion banks and suppressed the gold price. He asks whether other gold miners will follow Barrick's example ('to barrick') or become victims of the same hedging system that destroyed Barrick's shareholders ('to be barricked').
Editorial Note: A 2006 follow-up to earlier work on the Texas hedges of Barrick (2002). Written as Barrick's hedging losses were becoming impossible to ignore, using the Hamlet allusion to frame the gold mining industry's strategic dilemma.
Original PDF: https://professorfekete.com/articles/AEFToBarrickOrToBeBarrickedThatIsTheQuestion.pdf

*To Barrick Or To Be Barricked, That Is The Question*

**Antal E. Fekete**

Professor, Memorial University of Newfoundland aefekete@hotmail.com Dear Mr.Kingston:

Thank you for writing. You ask me whether Barrick is a 'buy' now that it has reached its long-time ambition of becoming the first: the largest gold producer of the world. Would it now start moving up from its place of being the last: the world's worst large-cap share price-performer in the gold-mining business?

I am a monetary economist and as a rule do not offer investment advice. Having said that, the name "Barrick" touches a raw nerve in me. I used to be a shareholder. In 1992 I took early retirement from my professorship, accepting bribe money (they call it 'golden handshake') from Memorial University of Newfoundland, my academic home for 35 years. At stake was about \$50,000 which I invested in Barrick shares and leaps, with the idea of arbitraging one against the other. As the gold price went up, I would sell leaps and put the proceeds into shares, and vice versa. Most of this investment has gone up in smoke as a result of Barrick's 'Brave New World of Hedging'. I decided that, in reply to your kind letter, I would tell my story.

### The Godfather

Barrick's founder and godfather, Peter Munk, like myself, grew up in Budapest.

Truncating the original 'Munkácsy', a name his family shared with one of the most famous Hungarian painters Mihály Munkácsy, Munk got himself a new name when he landed in the New World. We did not know each other but, as schoolboys we had the same experiences, spoke the same street jargon, and trod on the same cobblestones.

Above all, gold loomed large in our lives, making an indelible impression. In 1944

Munk's father bought their exit visas from German-occupied Hungary to neutral Switzerland, along with a train-load of other Jews, all paying for their escape with gold.

The Swiss government agreed to play the role of go-between.

I learned about the life-saving properties of gold a few months later in a different context.

When the Red Army placed Budapest under a siege those who had gold ate; those who didn't went hungry. My family did not have much gold, but there was a heavy gold chain that used to hold the gold pocket watch of my grandfather in better days. The watch itself had been bartered away in hard times for food before I was born during the hyperinflation following World War I. During the next hyperinflation, following World War II, dentists refused to take paper money for professional services rendered. My mother paid for dental work needed by my sister in gold. I still remember the dentist's delicate hands: he clipped off an agreed length of the chain. And his face: he had the smile of Shylock as he was preparing to take his pound of flesh. My mother gave me the remnants of that gold chain, thus abridged, before she died. My wife has it now. It has been fashioned into a pretty bracelet.

Munk came to Canada to study electrical engineering at the University of Toronto.

During the pre-Christmas shopping seasons, as a student he was arbitraging Xmas trees between the parking lots of various supermarkets. When I came to Canada in 1957 I already had my university degree and settled down to a teaching career in Newfoundland.

Munk as an electrical engineer went into producing high-end stereo systems and met his first Waterloo in Nova Scotia. He had made the bad decision of accepting government financing for his factory.'Never again!' he vowed after his business deal with the provincial government unraveled and he lost his entire investment. (This did not prevent him, years later, from courting retired politicians such as former Prime Minister Brian Mulroney of Canada, and Ex-President George Bush, both of whom took their seats on the 'Advisory Board' of Barrick.) The next bad decision was to design luxury hotels

(never actually built) in the shadow of the Egyptian pyramids, an idea about as brilliant as setting up a pork-chop stand in Jerusalem.

### A little bit of etymology

Munk initially conceived American Barrick in 1980 as a junior oil and gas company. In 1983 he reconstituted it as a gold mining company, renaming it Barrick Gold. I have an avid curiosity about the origin of words and I could not resist the urge to research the word 'Barrick'.

At an early brain-storming session, as described in the authorized biography of Munk, the question was raised how to name the fledgling company. Munk, who was obsessed with big and quick success had no patience with such trivial details, exclaimed: 'Call it Baszik, Szarik, Barrick, as you will; I couldn't care less'. The name Barrick stuck. Knowledge of the Hungarian language helps the etymologist. The first two words' English equivalents are 'f...ck' and 'sh...t'. In Hungarian four-letter words have six letters to sport and, as verbs, they are also distinguished by their '-ik' ending, forming a special conjugation class of their own.

### Gold mining and hedging: killing the goose laying the golden egg?

As a shareholder I was concerned about Barrick's preposterous ideas on hedging. Munk was fond of using innovative financing techniques and Barrick boasted that its credit standing is second to none, due to its unique hedging policy. I realized that the word 'hedging' as used by Barrick was a misnomer. It is not hedging at all, any more than a shill is winner at the poker table. The appearance is that she is winning big; in fact she has to surrender every cent of those gains to the casino owner at the end of the day.

Barrick was simply selling its production forward, at one point as far as five years out as measured by current output, with settlement postponed, at the option of the 'hedger', for as long as fifteen years. Imagine, no margin calls for fifteen years, no matter how much the price may move against your position! Barrick justified this insane policy by the statistical Principle of Mean Reversal asserting that all economic indicators, including prices (however volatile) ultimately tend to return to the mean. Fifteen years was considered sufficiently long for even the most 'absurd' spikes in the gold price 'to correct'.

I demurred. Gold was an exception to mean reversal. In a hyperinflation, after the 'dead cat bounce' of paper money, you could wait till doomsday for the gold price to correct.

I wrote a paper with the title Gold mining and hedging: killing the goose laying the golden egg? In it I explained that forward selling must be carefully distinguished from hedging. A proper hedging strategy would require that the mine channel production into a fund, which would then buy gold in the open market when the price was low and falling, and sell when the price was high and rising. The income from this arbitrage would more than make up for lost revenues from the outright sale of mine product. Above all, such a strategy would not impart a bearish sentiment to the market. Speculators knew that the gold mine would sooner or later step in as a buyer whenever the gold price weakened, and they would try to preempt it. They would want to buy first. And conversely. The chips could fall where they may.

But since Barrick had an established policy of selling forward, and never buying forward, speculators would abandon the long side of the market in droves. They would move to the short side en bloc, in trying to forestall Barrick. They would want to sell first. Under these circumstances the chips could no longer fall where they may. Fall they did alright, together with gold. The gold price was effectively capped. Worse still was the long-term effect. Just as you cannot 'cap' an active volcano, you can't cap the gold price forever either. It is bound to erupt and, when it does, you can kiss good-bye to the Principle of Mean Reversal. In the end Barrick could be saddled with a king-size liability that it may never be able to live down.

Shareholders do not need to have a PhD in vulcanology to find this out. As soon as they do, they will vote with their feet.

### Shareholder-proofing corporate governance

Indeed, they have no alternative. After the Nova Scotia fiasco Munk decided that he would construct a corporate structure that would be 'shareholder-proof'. He developed the 'perfect poison pill'. Not only will Barrick never be the victim of a hostile take-over bid, shareholders will have to eat from his hands. The corporate governance of Barrick epitomizes this. Shareholders are pariahs, sacrificial lambs on the altar of high management policy. They have the right to vote with management. But that's about all. In case of a disagreement they can go and fly a kite. Management lives in its own world of an unassailable bunker.

In 1994 I did not know this. I was naive. I wrote a letter to Munk asking him for a meeting. I wanted to present to him a copy of my paper with my compliments. In reply Munk told me that I had to show my paper to his Senior Vice-President and CFO, Jamie Sokalsky first. By the time I could see Jamie company headquarters were moved from Yorkville, a bohemian district of Toronto, to the Royal Bank Towers downtown, projecting an entirely different corporate image. The significance of this move was lost on me at the time. I believed that I could convince Sokalsky of the errors of Barrick's ways.

The meeting lasted for two hours. I could see from his occasional remarks that Sokalsky understood everything I have said. He did not argue with me. He said that what I was talking about was all very interesting and promised that he would read my paper carefully and give me a written answer. I have never heard from him since, nor have I heard from Randall Oliphant, the President of the company. Both men were fired later by Munk as shareholder dissatisfaction with the company's hedging policies, and with the low-altitude flight of the share price, could be heard inside of the bunker, sound-proofing notwithstanding. Scapegoats had to be thrown to the wolves to keep them away from the door.

I sold my shares and leaps, as did thousands of others. And I went back to my own den to lick my wounds.

### If forward sales, why not forward purchases, too?

Barrick never explained to the world what has happened, or how they would fix the flawed policy. Even today, the new guy at the helm President Greg Wilkins defends the policy of 'a reasonable level of hedging' as an 'essential risk-management tool for the company'. It is supposed to 'stabilize revenues and satisfy banks that finance its projects'.

But if this were true, then the policy should be made even-handed. Barrick has never admitted that its one-sided forward selling was responsible for the bearish bias in the gold market for the last decade of the century and the millennium.

In my paper I suggested an easy way to repair this bias. The company could complement its forward sales by forward purchases. These are triggered whenever the gold price is low and falling. Just as the gold mine lifts its short hedges as production is delivered into the hedge book, it can lift long hedges as deals to buy new gold properties are being closed out. In this way the mine can acquire new gold properties at the best possible price. I have evidence that Sokalsky understood my point perfectly well, the point being that the bias against the long side of the market would be removed as speculators would be coaxed back to it. Quite possibly my paper was in the hands of the top brass when they discussed the dismal failure of their policy of unilateral hedging, as it dawned on them with the new century and millennium. For all I know, Sokalsky could have proposed my idea of 'bilateral hedging' as a face-saving measure which, for him, could have been a 'skin-saving' measure as well.

### Is Barrick a front to cover up gold-laundering?

That is, unless Barrick was a front to cover up gold laundering by governments, in which case unilateral forward selling was not a mistake but a deliberate policy. I couldn't help but believe that the company had a vested interest in suppressing the price of gold. Its ambition to become No. 1 also points that way. It is not about vanity. It is about pricing power. The suspicion that Barrick is a front to cover up a gigantic gold-laundering operation, presumably on behalf of a government (or governments) that need more time to complete a gold-acquisition program in the order of thousands of tons of gold, is hard to escape. Incidentally, if you interpret 'gold laundering' as a polite expression for 'stealing shareholder gold', no harm done.

Unfortunately, such a conspiracy theory will be very difficult to prove or disproof. I was not the only one who suggested it. GATA and Golden Sextant named Barrick as a coconspirator in the illegal scheme to suppress the gold price.

When in the early 1990's Barrick sued the United States Treasury over a user-fee issue and, implausibly, won in the court, I failed to smell the rat. Only later did this lawsuit appear like a whale-size red herring to me, dropped to deflect suspicion away from Barrick lest someone think it was a front. "Behold, little David conquering the towering Goliath! What rubbish it is to suggest that David was bribed by Goliath to do it!" At about the same time Barrick moved its headquarters to shed its image as a maverick, to assume the image of a 'responsible corporate citizen'. No longer did it want to rub shoulders with hippies. Its credentials were established beyond the shadow of a doubt.

### ACHILLES heel, or noose around the neck?

One analyst has called its hedge book Barrick's Achilles heel. But to others it looks more like a noose around the neck that no amount of 'creative book-keeping' or 'off balancesheet financing' can hide forever. It has been stated publicly that Barrick would be bankrupt if it marked to market its liabilities. Wilkins gave himself till the end of 2009 to clean up the mess and reduce the hedge-book from 14,3 million ounces of gold to 9,5 million. But by that time the gold price could be well into four digits. The question is whether the kindly and gentlemanly bullion bankers will honor their 'no margin calls for fifteen years' pledge at those lofty prices. If shareholders can't throw the rascals out, maybe the bullion bankers can, and will.

### Maximize life, not profits

In the meantime an even larger business challenge is confronting Barrick in the shape of a cost-of-production squeeze. Under a gold standard, the gold miner typically mines his property most conservatively. He goes after marginal grades of ore, the most expensive to exploit, where a base metal miner would go after the highest grades, the least expensive.

The gold miner is not interested in maximizing profits as is the base metal miner. And for a very good reason, too. The marginal utility of a base metal declines. The miner wants to extract it from the bowels of the earth before the price may drop even more. By contrast, the marginal utility of gold is constant. There is no rush to dig it up only to bury it again in bank vaults. Therefore the gold miner wants to maximize the productive life of his mine, not profits. Barrick threw this wisdom of the trade to the winds as it has been mining the highest grades of ore available, and at break-neck speed to boot. Now it has to face the consequences. Its mined-out properties will have to be closed down prematurely, from which gold has been extracted and sold at what must, in retrospect, appear as giveaway prices.

My suggestion of forward purchases of gold combined with the miner's problem of premature exhaustion of gold properties, would have made a perfect fit. Barrick would have been in an extremely strong position to buy new gold properties while lifting the long hedges it had put on when the gold price was much lower.

### The Best Little Whorehouse in Nevada

Here is how a reporter described the scene at Barrick's annual meeting of the shareholders in Toronto's Metro Convention Centre last spring: "The sky is dull grey, but the mood inside is dazzling. Pockets of spontaneous applause break out during the presentations. Standing at a podium emblazoned with the Barrick logo before a cinemascope-sized graphic display of the company's global reach, Wilkins leads shareholders through the past year's triumphs, and hints at a long and prosperous future for a company that now has unprecedented size and clout.

"He is followed by the 78-year old Munk, resplendent in a dark grey pinstripe suit, pale blue shirt and a luminescent pink tie. Munk pauses for effect and then leans over the podium. In a gravelly voice speckled with traces of his Budapest childhood, he delivers a rumination that is both self-congratulatory and self-deprecating, at once a nod to Barrick's humble origins and a prelude to a glorious future. 'I can't help but sit back and say that what we have done here has been spectacular', he says. 'But it's not the mines, it's not the reserves, [and] it's not the credit rating that's the best in the industry. What makes me proud, what makes me exceptionally happy, are the intangibles...those intangible values of integrity from which every decision automatically springs. It's the culture that this company has had in its DNA from the time it bought Camflo Mines'.

"You should give as good as you get. Integrity, as Munk says, means many things in gold mining, including paying people fairly for their work and contributing to local communities. It can even mean, he says puckishly, funding and building housing projects for miners in places like Elko, 'that dusty, miserable Nevada town with one whorehouse'." Hey, Munk, wait a minute! It's all very well to fund and build posh whorehouses where miners and top brass can Barrick to their heart's content! But what about the share price?

### What about the patrimony of the shareholders?

Shareholders? They will be Barricked.

Again.

I know it. I have been there.

Yours, etc.

### Antal E. Fekete former Barrick shareholder

### References

Charles Davis, So Big It's Brutal, Report on Business,

### The Globe and Mail: Toronto, June 2006, p 64-73

Bob Landis, Readings from the Book of Barrick: A Goldbug Ponders the Unthinkable, [www.goldensextant.com](https://www.goldensextant.com) , May 21, 2002

Richard Rohmer, Golden Phoenix: The Biography of Peter Munk,

### Key Porter Books, 1999

A.E. Fekete, The Texas Hedges of Barrick, [shoemakerconsulting.com](http://shoemakerconsulting.com/goldisfreedom/archives/Texashedges).

2002

### May

Ferdinand Lips, Gold Wars: Will hedging kill the goose laying the golden egg? p 161-167, New York: FAME, 2002

## Disclaimer And Conflicts

## The Publication Of This Letter Is For Your Information And

## Amusement Only. The Author Is Not Soliciting Any Action Based

## Upon It, Nor Is He Suggesting That It Represents, Under Any

## Circumstances, A Recommendation To Buy Or Sell Any Security.

## The Content Of This Letter Is Derived From Information And

## Sources Believed To Be Reliable, But The Author Makes No

## Representation That It Is Complete Or Error-Free, And It Should

## Not Be Relied Upon As Such. It Is To Be Taken As The Author'S

## Opinion As Shaped By His Experience, Rather Than A Statement Of

## Facts. The Author May Have Investment Positions, Long Or

## Short, In Any Securities Mentioned, Which May Be Changed At

## Any Time For Any Reason.

---

*August 11, 2006*

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C 5S7 e-mail address: aefekete@hotmail.com

---

# Real Bills: "Waggon-Way in the Air"

URL: https://newaustrianeconomics.com/archive/fekete/real-bills-waggon-way-in-the-air/
Date: 2006-08-07
Section: Popular Economics
Difficulty: intermediate
Concept Tags: real-bills, self-liquidating-credit, bills-of-exchange, adam-smith, new-austrian-economics, sound-money
Description: Fekete defends the Real Bills Doctrine against the charge that it is an impractical 'waggon-way in the air' — Adam Smith's phrase for financially sound but apparently fanciful schemes. He argues that real bills are not speculative instruments but the natural monetary medium for moving urgently needed consumer goods, and that their suppression has impoverished both workers and entrepreneurs.
Editorial Note: Written August 2006. The 'waggon-way in the air' phrase comes from Adam Smith's Wealth of Nations, where Smith praised practical financial innovations dismissed by critics. Fekete uses it to frame real bills as one of the most practical and misunderstood monetary instruments in history.
Original PDF: https://professorfekete.com/articles/AEFRealBillsWaggonWayInTheAir.pdf

## Real Bills: "Waggon-Way In

THE AIR" by Antal E. Fekete,

Professor, Intermountain Institute for Science and Applied Mathematics, Missoula, Montana, USA.

---

*August 7, 2006*

Dear Mr. Princeton:

Thank you for writing. You ask me to comment on the article Real Bills, Phony Wealth — Financing Is not Funding ([www.lewrockwell.com](https://www.lewrockwell.com)), May 31, 2006. You also want to know how I would respond to the author's remark in a private communication to you that "one of the problems with Fekete's writings is that he does not distinguish between real bills — which are quite benign — and the Real Bills Doctrine (RBD), which is false and pernicious". I comply with your request with some reluctance as I am not in the habit of returning the ball to the court of mud-slingers.

A paper by the noted monetary economist Richard Timberlake also talks about ". . . the twist . . . that makes the ordinarily harmless real bills into the RBD [is] an advised policy for gearing the creation of new money to the money-value of new goods and services. What could be cooler? . . .

As a principle for a commercial bank's lending operations, [the RBD is just as] harmless; but as a theory for central bank monetary policy, it is disastrous." Timberlake's paper gave me the final push to return to this topic once more. Hence is this answer to your kind letter.

### "Daedalian wings"

The common earmark of latter-day detractors of the RBD is that they treat Adam Smith as a 'nonperson'. They just don't want to acknowledge that he is the father of the RBD. I can well understand their hesitation. It is a forbidding task to get into an argument with this giant of economic thought. I am happy to interpret The Wealth of Nations for their benefit. What they call 'false', 'pernicious', and 'disastrous', comes straight from this fountainhead. In explaining the operation of the bill market, Adam Smith describes the circulation of real bills as a "waggon-way in the air". He compares it with the circulation of gold coins in moving merchandise to the final consumer, which is like an earthly waggon-way winding through agricultural land, as it were. Land that had to be taken out of production. Land that cannot be turned "into good pastures and corn fields . . . to increase very considerably the annual produce of land and labor". Moreover, since the road from the producer to the consumer is getting ever more roundabout (as the the productivity of labor and capital increases), the amount of agricultural land taken out of production also increases by leaps and bounds with no end in sight. Therein lies a problem. We may end up with more land dedicated to waggon-ways, and less to growing produce. Either there is a limit to further increases in productivity, or the fruits of higher productivity will be gobbled up by doctrinaire insistence on a "100 percent gold standard".

The solution? As Adam Smith suggests, the "invisible hand" of the market has created a "waggon-way in the air". It has let circulating capital be financed through real bills, thus freeing up a large part of agricultural land which could then be put back into production. It has also stopped further incursions of productive land. The true meaning of Adam Smith's simile is that gold can be put to better use in financing fixed rather than circulating capital. Bills drawn on merchandise in urgent demand have "Daedalian wings". The reference is to the Athenian inventor Daedalus who, according to mythology, fashioned feathers, reeds, wax, and twine into wings for himself and for his son Icarus, in order to escape from the island of Crete where they were held against their wish. With the aid of those wings bills can fly under their own steam. It is true that bills arising out of the financing of fixed capital, for example: capital needed for further refinement in the division of labor, or for further perfecting the roundabout ways of production processes, won't fly (read: will refuse to circulate). Only bills financing circulating capital (that is, the movement of finished or semi-finished goods moving from the producer to the consumer) may. It is also true that every new division of labor, and every new twist in the roundaboutness of production, brings with it new demands for additional circulating capital. The point is that this would not take gold coins out of circulation, as it would in the absence of a waggon-way in the air.

Besides observing that real bills do fly we may add that fly they must sufficiently fast so that the goods will reach the ultimate gold-paying customer in less than 91 days. This number, 13x7, is not taken from cabal for reasons of being lucky. It is just the length of the seasons of the year.

Clearly, the type of merchandise demanded most urgently by the consumers changes with the seasons.

Interestingly, Adam Smith makes an apology to his readers of 1776 for having recourse to "such a violent metaphor" as the "waggon-way in the air" and the "Daedalian wings of paper money [secured by real bills]". No apology is necessary to readers of The Wealth of Nations 230 years later. New-Yorkers, and dwellers of other North-American cities are well used to enjoying seedless grapes picked on the sunny slopes of the Andes the day before, air-lifted to them via a waggon-way in the air, literally, in cargo jets, through several thousands of miles. Grape harvest in the middle of winter! This is something that even Adam Smith's vivid imagination might not fathom. If latter-day detractors of the RBD in the 21st century are unable to follow the reasoning in The Wealth of Nations, it cannot be blamed on Adam Smith's use of 'violent metaphors'. Could it, perhaps, be due to the obtuseness of the reader?

### Adventures of Robinson Crusoe on the Island of Manhattan

The ocean liner Titanic hit an iceberg off the coast of Newfoundland, and went down, in April, 1912. Survivors were taken by the freighter Carpathia to New York. Among them was one Robinson Crusoe, himself no stranger to shipwrecks. He was determined to put his survivalist tool-box to good use in telling the natives, apparently trapped and waiting to be rescued from the overcrowded Manhattan Island, how saving in the form of a subsistence fund would help them survive better. He saw a lot of paper-pushing on the island. Was this paper part of the subsistence fund? People's face went blank when he started telling them about the virtues of a renewal fund. He picked up a can of sardines in the grocery store and, showing people his torn coat, he proudly announced that he would eat the fish he bought with his savings while he was mending his garment. He thought this would motivate the natives to see the necessity of putting something into the renewal fund for a rainy day.

At that point a kindly economist pulled Crusoe away from the curious crowd and patiently explained it to him that on this island the distinction to be made was not between a subsistence and a renewal fund, but between circulating capital and fixed capital. People don't save because they plan to take time off from work in order to mend the fishing net or their garment. They save to pay for the education of their children, and for an old-age nest-egg. They may also save to accumulate capital, if they want to quit the labor force and become their own boss in their own business. In either case the purpose for saving is divorced from productive endeavor.

Circulating capital in the form of paper-pushing was what "could be seen". What "could not be seen" was the underlying goods moving in the opposite direction in the bottoms of vessels moored in the harbor.

The survivalist instinct in Crusoe made him to accept the explanation of the economist, and he settled down to learn the new paradigm. He realized that there are islands and islands, and the economics applicable to one may not be applicable to the other.

### The Principle of Clearing

I use an example of Ludwig von Mises to demonstrate that real bills involve neither funding nor financing. They involve the Principle of Clearing which states that each tradesman is paid for value added, after the sale of the finished product, from the proceeds.

The spinner is spinning cotton and wool into yarn that he delivers to the weaver who, in turn, weaves the yarn into cloth to be delivered to the clothier. The latter runs a store selling the cloth to the ultimate cash-paying consumer. Following merchant custom, the weaver does not expect to be paid in cash at the time of the delivery of cloth (a good of the first order). So he bills the clothier for the cloth delivered, who endorses the bill in writing across its face: "I accept". The bill stays with the weaver. When the spinner delivers the next consignment of yarn (a good of the second order), the weaver endorses the bill drawn on the clothier on the back and passes it on to the spinner (adjustment may be made in coin.) The bill is now in the possession of the spinner who keeps it as evidence of receivables pending settlement in less than 91 days, by which time the consumer will have bought the underlying first-order good, and the wherewithal for payment will be on hand.

Note the saving: the pool of circulating gold coins did not have to be invaded twice in making payment for the maturing good. It did not have to be invaded even once. The gold coin of the consumer was given up voluntarily and was available to do the job of clearing. Of course, the saving would be even greater if the production process was more roundabout. The single gold coin given up by the final consumer would liquidate all the claims, whether the production process had four, fourteen, or forty stages.

### "Neither a borrower, nor a lender be" (Shakespeare)

It is important to see that the spinner is not a lender, and the weaver is not a borrower. No funding and no financing is involved. The bill is not a collateral security. It is simply a receipt for goods of a stated quantity and quality that has been delivered. It evidences receivables. The face value of the bill is payable on settlement day. The usual term is "three months net". Tradesmen follow a long-established merchant custom in allowing for the time it takes to sell the underlying merchandise. Producers of semi-finished goods never (make that "hardly ever") quote or charge cash prices. They quote and charge discounted prices, payable at a later date specified on the face of the bill.

One day the banker calls on the spinner. He offers to purchase (he uses the word "to discount") maturing bills in his possession. The banker explains that he will shoulder the cost and the burden of collection at maturity. In the meantime the spinner can put the cash to immediate use.

The spinner cannot resist the temptation. He endorses the bills on the back, thereby transferring his rights to the banker. Again, it is important to see that there is no lending or borrowing involved, nor is financing or funding. None of the previous arrangements has been disturbed by the transfer. The banker’s role here is active rather than passive: he goes out and acquires an earning asset. It is incorrect to say that the banker has "monetized" the bills. If anything, it is the market, or the "invisible hand" of which Adam Smith spoke, that has imparted ephemeral monetary privileges to the bill. These privileges lapse at the moment the bill matures. The banker's role is that of the midwife.

The weaver could have sold the bill drawn on the clothier to another tradesman, say the loommaker. Even tradesmen who do not know the clothier in person would accept bills drawn him, or on any other merchant selling first-order goods for that matter, in payment for semi-finished goods. Nobody needs to worry that the clothier might default. In the unlikely event that the clothier has to take a loss, he would still pay the face value of the bill at maturity lest he be denied discounting privileges in the future.

### No funding, no financing

In summary, no funding or financing is involved in real bill circulation. Its dynamics is based on a different principle, other than that of combining capital and labor. The principle involved is that the value of a product may be greater than the sum total of the values of its component parts. Take, for example, pottery, the mainstay of trade in antiquity. Chief ingredients are: clay and fire. Clay is basically mud, representing little or no value. Fire is as common as water with no commercial value. But when put together, you have pottery which is in high demand. Because of this sudden, not to say miraculous, increase in commercial value, no financing or funding is needed to move the product. It would self-finance its own journey from the producer to the consumer.

### The Bill of Exchange Saga

Thus, then, did the saga of the bill of exchange replacing gold coin circulation begin.

There was no government coercion, no bank intrigues involved. Everything was done spontaneously and voluntarily. This clearing system worked perfectly and without a hitch for hundreds of years, before central banks were imposed on the people by spendthrift governments that were anxious to discount their own bills, too. They found to their chagrin that "anticipation bills" just wouldn't fly. They needed the assistance of a central bank to shelter their bills in the bank's portfolio against "the slings and arrows of outrageous fortune". Treasury bills, along with "accommodation bills", "pig-on-pork bills" or any other phony bills that could not face the scrutiny and the ravages of the bill market had to be sheltered. It was at this point, it may be noted, that periodic runs on banks (not excluding the central banks) have started.

### Discount rate versus interest rate

The banker applied a "discount" to the face value of the maturing bill when he purchased it from the producer. The discount was equal to the number of days to maturity times the "discount rate".

It is of utmost importance to distinguish the discount rate from the rate of interest. The former is always the lower of the two. Moreover, the discount rate tends to be low if consumer confidence is high, and high if consumer confidence is low. In other words, the discount rate varies inversely with the propensity to consume. By contrast, the interest rate varies inversely with the propensity to save. It is unfortunate that Mises has failed to recognize this difference which makes his theory of interest faulty. Several other errors can be traced to this fundamental mistake. For example, Mises said that a promise to pay gold on demand can substitute gold in every market where the maturity and security of the promise is recognized. Not so. The marginal bondholder would act contrary to purpose if he accepted a promise when he sold his gold bond in protest against low interest rates: he would take zero return in exchange for a positive one. Mises also held that paper currency, whether redeemable or not, is a present good rather than a future good. As far as it is known he has never commented on the question how this is reconciled with the fact that the government is ready to helicopter-drop any amount of it as it sees fit. Was Keynes right after all in suggesting that the government can turn stone into bread?

The discount rate makes the real bill an appreciating asset. Its value increases with the passing of every day, right up to maturity. This is why the real bill is in constant demand. In fact, real bills are the most liquid earning asset that the bank can have, second only to gold (not considered an earning asset). To discount a real bill is not a lending function of the bank. It is a clearing function.

The bank could never get into trouble on account of its clearing, although it can on account of its lending activities. This has important consequences. The borrower must invade the pool of circulating gold coins and withdraw an equivalent amount to repay the loan at maturity. If too many loans mature at the same time, there is a problem. Some borrowers may find it difficult or impossible to withdraw gold, and defaults may cascade. It is not the contraction of the money supply that causes prices to fall, but the financing of circulating capital through bank loans rather than real bills. As far as the clearing function of the bank is concerned, such an outcome is unthinkable. The real bill is a self-liquidating paper. The obligation is liquidated with the gold coin of the final consumer, not with a gold coin withdrawn from circulation by the borrower. It is a constant source of amazement for me why detractors of the RBD are unable to understand such a simple yet fundamental distinction, one that was so clearly explained by Adam Smith 230 years ago.

### The death of Icarus

Icarus was so thrilled with their flight that, ignoring his father's admonition, he was flying ever higher and ever closer to the Sun. The heat eventually melted the wax, his wings came unstuck, and Icarus plunged to his death in the Aegian Sea. Detractors of the RBD gleefully point out that this is exactly what happened to the U.S. economy in 1933 suspended, as it was, on the Daedalian wings of the RBD — due to the misguided monetary policies of the Federal Reserve.

What these detractors forget is that it was not faulty Daedalian wings, but the disobedience of Icarus that caused the tragedy. The RDB was made non-operational in violation of the law. The practice of "open market operations", euphemism for organizing the public debt into currency, was a further incursion of the law. Note that the ownership of government bonds was not made illegal by the Federal Reserve Act of 1913, only the monetization of it, that is to say, the practice of paying for the bonds with Federal Reserve notes or deposits created out of nothing for this purpose. The Federal Reserve banks were free to acquire the government bond in any other way, e.g., through buying it with gold. Furthermore, note that member banks were left free to monetize government bonds — a serious loophole that corrupt Federal Reserve officials were quick to exploit. When the unlawful inflationary monetary policy of the Federal Reserve caused a bubble in the government bond market, making bond prices collapse in 1921; the Florida real estate bubble, making real estate prices collapse in 1924; and the stock market bubble, making share prices collapse in 1929, Federal Reserve monetary policy made an "about-face", returning to the guidelines of the RBD as they were required to do according to the law as it then stood. It was too late: the Great Contraction of 1929-1933 could not be averted.

But the Great Depression of 1933-1941 could have. However, just when the economy made the first tentative steps to recovery, something terrible happened. The gold standard, and with it the RBD, fell victim to sabotage. On March 4, 1933, the day that "shall live in infamy", the newly inaugurated president of the United States took the law, and the Constitution, into his hands. He called in the gold coin of the realm so that later, after the citizenry has complied with his passionate appeal to patriotism, he could cry down the value of paper money that had been paid out "in compensation" for the confiscated gold. Enriching the government through defrauding the citizenry was bad enough. The appeal to patriotism made it a hundred times worse. As gold coin circulation is an absolute prerequisite for the RBD, no wonder that the Daedalian wings melted, waggons in the air were derailed, and the U.S. economy plunged. As it did, it took the world economy with it.

It was no coincidence that the beginning of the Great Depression coincided with the sequestration of gold. And that is the true story of the death of Icarus.

Yours, etc.,

### Aef

---

# Federal Reserve Follies: What Really Started the Great Depression

URL: https://newaustrianeconomics.com/archive/fekete/federal-reserve-follies/
Date: 2006-07-26
Section: Popular Economics
Difficulty: intermediate
Concept Tags: federal-reserve, real-bills, self-liquidating-credit, new-austrian-economics, monetary-policy, capital-destruction
Description: Fekete presents his revisionist account of the Great Depression's origins, arguing that it was caused not by monetary contraction or fractional reserve banking but by the Federal Reserve's destruction of the Real Bills market through open-market operations after 1913. By making self-liquidating credit illegal, the Fed severed the monetary mechanism that had kept employment high and prices stable.
Editorial Note: Written July 2006, distilling Fekete's revisionist history of the Great Depression for a general audience. A concise statement of why he disagrees with both the Keynesian and Rothbardian explanations — the Fed's destruction of the bill market, not fractional reserve banking or fiscal policy, was the decisive factor.
Original PDF: https://professorfekete.com/articles/AEFFederalReserveFollies.pdf

## Federal Reserve Follies:

WHAT REALLY STARTED THE GREAT DEPRESSION by Antal E. Fekete,

### Professor, Memorial University of Newfoundland

---

*July 26, 2006*

### The Sorcerer's Apprentice

The basic error underlying the Quantity Theory of Money (QTM) is the notion that central banks can command their newly created money to flow to the commodity market, or any other market of their choice. This is the pipe-dream of the Sorcerer's Apprentice. In reality, once the newly created money is off the premises it is no longer under central bank control. It has become a plaything in the hands of speculators. Far from being guided by the wishful thinking of central bankers, speculators follow their own agenda. They are motivated by profit potential as they see it emerge in various markets. It is true that, on occasion, the commodity market is their preferred playground and mischief to prices is the result. But it could just as well be the stock, bond, or real estate market. It is also true that there is a "trickle-down" effect on the commodity market as the newly created money is spent again and again by subsequent recipients who are not speculators.

But by the time money trickles down to the commodity market damage has already been done elsewhere. Whether peddled under the name "monetarism" or "neoclassical economics", the

QTM is utterly inapplicable to the modern economy and cannot explain changes in the price level.

The linear relationship between the stock of money and the level of commodity prices that may have held in more primitive societies up to medieval times has been replaced by a highly nonlinear one modulated by speculation.

Allow me to say here that the QTM is one of those bad ideas that will probably never go away because of its intuitive appeal. It can be grasped even by the most primitive intelligence not conversant with monetary economics. People not inclined to consult the more profound works of economists who have blasted the QTM to smithereens again and again as have, for example, J. Laurence Laughlin of Chicago University, Edwin Kemmerer of Princeton, Walter E. Spahr of New York, not to mention Adam Smith, want to have something they can understand even if it will, more often than not, distort the big picture beyond recognition.

### Condoning the violation of the law

This is a rejoinder to the paper of Richard H.Timberlake of the same title dated August 2005. For the sake of argument I shall adopt Timberlake's own division of the economic collapse into two distinct events: the 1929-1933 Great Contraction and the 1933-1941 Great Depression. They were preceded by the inflationary monetary regime under the domineering leadership of Benjamin Strong, Governor of the Federal Reserve Bank of New York, between 1922 and 1928.

Although Timberlake characterizes it as one animated by a high-minded "stable price level policy," it was an unlawful regime continuously violating the law. Strong introduced illegal "open market operations" for the first time. He established the Open Market Investment Committee of the New York Federal Reserve Bank in 1922 under his own chairmanship. It conducted buying and selling, mostly buying, of Treasury bonds for the account of the Federal Reserve Bank of New York as well as some other Federal Reserve banks. The bonds purchased in the open market were paid for in the form of Federal Reserve notes and deposits created out of nothing for this specific purpose. The advent of open market operations of central banks has changed the landscape of world finance beyond recognition. It made official manipulation of bond and stock prices possible. It turned traditional virtues and vices upside down: thrift into vice, sharp trade practices into virtue.

The monetization of Treasury debt was illegal according to the Federal Reserve Act of 1913. It was not authorized. As a matter of fact, the use of government bonds for the purpose of backing Federal Reserve notes and deposits was explicitly ruled out. Stiff penalties were prescribed in case, and to the extent, the liabilities of a Federal Reserve bank could only be balanced through its portfolio of Treasury paper. Of course, Strong and his cohorts were aware that they were breaking the law. They argued that this policy was not official; that it was designed to meet an emergency; and it would be terminated as soon as the emergency has passed and the international gold standard was made operational once more. No doubt, this was one of those 'emergencies' that was invented to become permanent. Strong himself was instrumental in preventing the gold standard from becoming operational again by sterilizing gold that had come to the United States from European belligerents in payment for war supplies. It would be closer to the truth to say that central bankers have tasted the elixir of power, and liked it. They have become addicted to it. Never mind that it was forbidden fruit for them. They wanted to exhaust the entire cup. They knew that they could manipulate Congress to legalize retroactively the power they had illegally grabbed.

The violation of the law as a substitute for changing it whenever its efficacy is brought into question is a serious matter in any case. But it is especially serious and pernicious when it affects the processes whereby money is created. Legal ends cannot justify illegal means under the law.

If an officer of the Federal Reserve can take liberties with the law, then so can anybody else, and the bottom line is counterfeiting the currency. Timberlake passes over the blatant violation of the law in silence, presumably because of his sympathies with the hidden monetary inflation that he (in unison with Milton Friedman and Anna Schwartz) admiringly calls "the Fed's stable price-level policy". Hardly did he notice that what he admired was not monetary policy under Strong, but a mere coincidence: the knack of the speculators who for reasons of their own put the newly created money to work, not in the commodity market where inflation would have been noticed immediately, but in the real estate and the stock markets where it could remain hidden for a longer period of time. In the event the Strong-inflation could not be swept or kept under the rug for too long. It soon showed up in the shape of the Florida real estate bubble (1924) and the stockmarket orgy (1929). In addition, it kept interest rates artificially low (and bond prices artificially high) with the effect that the investment-decisions of businessmen became distorted. Again, the concomitant misallocation of economic resources could not be detected immediately. But the writing was on the wall that the chickens would eventually come home to roost, as indeed they did during the Great Depression. To sing a song of praise of the Strong-inflation is not fitting to a monetary economist.

Condoning the violation of the law and blaming the consequences: the Great Contraction of 1929–1933 and the Great Depression of 1933-1941 on the Real Bills Doctrine (RBD) is, to say the least, disingenuous. This is not to suggest that the Federal Reserve Act of 1913 was a good law.

Most likely it was not, and the United States could have managed, thank you very much, without a central bank in the 20th century, as it did in the 19th. But this is another issue to be investigated separately. Here I want to condemn a procedure whereby the law is violated in order to create a fait accompli, forcing the hands of lawmakers to change it so that, in the end, the violation be justified, nay, rewarded. Once the Strong-inflation induced stock-market speculation was under way, money from abroad was sucked in causing a serious deflation in Europe and elsewhere.

Central bankers from around the world started making their regular pilgrimages to New York begging Strong for even more inflation. They had hoped that lower interest rates in America would bail them out. Strong was delighted to comply with their pleading. Thus the violation of the law created international complications and ultimately Congress had to amend the Federal Reserve Act of 1913 so as to legalize the practice of open market operations — euphemism for monetizing the the public debt. The cure for the ill effects caused by an illegal monetary inflation was to be more monetary inflation, not less, making sure that this time around it was fully licensed and legalized.

Today no economist would think of open market operations as being originally conceived and introduced as an illegal practice, or would dream of suggesting that the explanation for the Great Contraction that followed it can be found in the violation of the law. I hereby take the task upon myself to make this revelation. It has to be stated in unambiguous terms that the Strong-inflation of 1922-1928 celebrated by Irving Fisher, Milton Friedman, Anna Schwartz, Richard Timberlake, and other devotees of the QTM, was illegal. I am of course aware that the grant departments of the Federal Reserve banks will never support research to explore this episode more fully to confirm my accusations. I still hope that incorruptible economists, especially the younger generation, are motivated by the truth rather than bribe money, and will rise to my challenge in doing the necessary research.

### Exonerating the gold standard is not enough

Following Keynes it has been fashionable to blame "contractionist tendencies" inherent in the gold standard for the Great Depression. Timberlake, to his credit, makes a valiant effort to exonerate this venerable institution. As the German monetary economist Heinrich Rittershausen said, it was not the gold standard that failed but the people to whose care it had been entrusted. It is unfortunate that Timberlake's concept of the gold standard is faulty. He quotes Joseph Schumpeter approvingly who describes the international gold standard as an institution linking the price level in one country with that in all other countries 'on gold'.

But this is not what the gold standard does, nor is it the way it is supposed to work. The price level is too 'sticky' for adjustment through gold flows, however attractive the QTM model of price adjustment may appear. Gold flows were conspicuous only through their absence during 100 years of international gold standard ending in 1914. Furthermore, although the gold standard had a mechanism for the equalization of the discount rate between various countries, this did not mean an automatic equalization of interest rates. The two rates are conceptually very different, as are the forces governing them. They could move in the same or in opposite directions. The adjustment mechanism of the gold standard operates, not on the price level which is sluggish, but on the discount rate which is nimble. It is not gold flows but the flow of real bills, and the flow of underlying merchandise in the opposite direction, that perform the balancing act, keeping the economy on an even keel. Here is how. Suppose certain countries suffer from a natural disaster or experience crop failure, causing widespread shortages. The discount rate in these countries will rise above that prevailing abroad, making the stricken countries attractive on which to draw bills. Consumer goods are dispatched immediately to the high discount-rate countries from the low. Relief is instantaneous.

It was not a flow of gold but that of real bills on London, maturing into gold in less than 91 days, that financed world trade prior to World War I. Gold hardly ever left the vaults of the Bank of England. Its relatively small gold reserve could finance a world trade several times as large.

Without real bills world trade could have never expanded the way it did during this Golden Age.

By 1913 it reached a record high that could not be surpassed for the next 75 years. Timberlake commiserates that the gold standard was in 'remission' during the years following World War I. It is true that the garrison states that emerged after the signing of the peace treaties were pursuing highly protectionist policies. The efficiency of gold in financing world trade has fallen from the high level reached during the years prior to World War I. Lip service was still being paid to gold thereafter, but the garrison states embraced mercantilist ideas and they were determined to wean their subjects from the gold coin. They foolishly concentrated gold in official coffers rather than putting it to work in reconstruction and in refinancing world trade. They sterilized gold by letting their central bankers sit on it. The United States was no exception. Why should Governor Strong put excess gold reserves into circulation in the form of gold coins? He knew that the outcome would be losing his cherished dictatorial powers. Open market operations and gold coin circulations are incompatible.

### Gold inflation is a red herring

Of course, Strong argued that putting gold coins into circulation would be 'inflationary'. Timberlake agrees. They are wrong. Even if all the world's monetary gold had descended upon the United States and were put into circulation, there would have been no price increases. The (natural) discount rate would go to zero. As a consequence vendors could do their 'vending' with zero capital (i.e., they could sell first, and pay for the merchandise out of the proceeds). Marginal merchandise would be displayed on sidewalks, public squares offering shoppers a previously unheard-of variety of goods. The abundance of gold coins would call out an equal abundance of consumer goods. Circulating capital would expand, matching the increase in gold coin circulation to finance trade in marginal merchandise. Automatically and immediately. The maxim that 'more money chasing fewer goods brings higher prices' does not apply, provided that the color of the money is yellow and it has the right ring to it when plunked down on the counter. The collapsing discount rate will see to it that a sufficient abundance and variety of goods is always available.

Prices need not rise on account of a greater abundance of gold coins in circulation. 'Gold inflation' is a red herring.

Conversely, there would have been no deflation when European countries recovered after the war and started repatriating their gold. The contraction of the pool of circulating gold coins would make the (natural) discount rate rise in the United States. Vendors of marginal merchandise would fold tent. Circulating capital financing trade in marginal merchandise would shrink, matching the decrease in gold coin circulation. The variety of goods available to consumers would be reduced accordingly. Prices need not fall on account of a reduced abundance of gold coins.

### Discounting is not lending

It is not enough to exonerate the gold standard which cannot be fully understood without a proper understanding of the RBD. This Timberlake clearly does not have. In real bills he sees a 'false anchor' competing with gold in the balance sheet of the central bank. In his view the central bank monetizes real bills. The bill is merely a collateral securing the loan and could be replaced by bonds that could also be used for the same purpose. In reality they could not. Banks do not acquire real bills in consequence of a passive maneuver such as securing a loan. Just the opposite is the case: discounting (rediscounting) real bills is an active bank maneuver. The bank (central bank) takes the initiative and goes out to acquire an earning asset. The bill is not a collateral security for a bank loan, neither is the merchandise underlying it. The real bill is an earning asset that is second to none in liquidity (it is second to gold but gold is not considered an earning asset). For a commercial bank, asset liquidity is a primary concern because in a squeeze, or to meet a run on the bank, these assets may have to be mobilized and thrown on the market simultaneously and indiscriminately. Even government bonds cannot come close to real bills as far as their liquidity is concerned. If mobilized and thrown on the secondary market in a panic (as it happened after World War I in 1921), bond prices would collapse and interest rates would shoot up. Yes, even for government bonds. By contrast, real bills are always in demand as long as the underlying goods are. One-ninetieth of the portfolio of bills of every commercial bank matures on every single day of the year. To maintain revenues the bank has to replace them. If one bank has to sell, it will always find another that wants to buy. Even if the taste of consumers has changed, the short maturity of the bills, 91 days (or 13 weeks, or 3 months, or one quarter) makes it certain that bills in disfavor will expire and disappear quickly, long before they could cause mischief. In the worst-scenario case, the drawer of the bill would pay it at maturity even if he had to take a loss. He would do it lest he lose his discounting privileges for good.

The fact that real bills are the most liquid earning asset a bank can have, combined with the fact that the real bill 'matures' into gold coins released by the consumer in buying the underlying good, makes these instruments very special. In the asset pyramid they come right after the monetary metals. It is wrong to look at real bills as competition for gold. Real bills are supplementing gold in financing circulating capital, not competing with it. No prior saving is necessary. It is sufficient that the underlying merchandise be in urgent demand. On the other hand, real bills cannot and will not finance fixed capital. To do that you must have savings in the form of gold. People who insist that prior savings is also a prerequisite for the financing of circulating capital are myopic. There is no way society could save enough to finance the entire circulating capital of a modern economy, in addition to financing its fixed capital. A simple back-of-the-envelope calculation can convince any open-minded observer of that. Real bills, and only them, can make it possible that gold is not tied up unnecessarily in moving merchandise in urgent demand to the consumer expeditiously. Gold, thus released, can then be used to form new fixed capital in financing more roundabout processes of production. The great improvements in the productivity of capital in the 19th century would not have been possible without this division of labor between gold and real bills.

When a bank discounts a real bill, it is not making a loan (even though pro forma the transaction may be dressed up as such). Rather, the bank acquires a self-liquidating paper which at maturity is paid out of the proceeds of the sale of merchandise described on the face of the bill. The gold coin released by the ultimate consumer liquidates the bill. Other loans that the bank may make are not self-liquidating. In more details, at maturity the borrower has to invade the pool of circulating gold coins and withdraw the necessary amount. Should too many loans of this type wait in line to be liquidated simultaneously, there would be a problem. Unless banks could make snap loans to credit-worthy customers, there would develop a squeeze on the money supply.

Innocent third parties would find it difficult or impossible to discharge their obligations. Defaults could cascade. This is the stuff out of which depressions are made. This was the core problem after the stock-market collapse in 1929 which revealed that businessmen had been misled by artificially low interest rates. There were no profitable investments on the horizon. There were no credit-worthy borrowers to take the loans the banks were so desperate to make. As a result, the stock of money collapsed as a pricked balloon, replicating the collapse of the stock market.

The case is different with self-liquidating loans. As long as people want to be fed, clad, and sheltered in warm homes in winter, there will always be an adequate supply of real bills, and banks may compete for them. Nobody is squeezed and there is no threat of cascading defaults.

As I have said it is wrong to assume that the banks take the real bill, or its underlying merchandise, as a collateral for loan. It is wrong to say that the bank monetizes real bills. It is the market that in fact does the monetization. Discounting bills is not a lending funcion of the bank, but a clearing function. This was known to Adam Smith already well over two centuries ago. He said that real bills could circulate on their own wings and under their own steam. What the banker does is this: he goes out and buys them as the most eligible prime earning asset he can have, one that can always be liquidated in an emergency without fear of a loss, regardless of the vagaries of the interest rate and the economy.

### The gold standard and the RBD in the Federal Reserve Act of 1913

Timberlake states that the idea of a central bank was anathema to the newly elected Democratic Congress and president in 1912. The presumption was that a central bank is monolithic and monopolistic. It would not serve the public. Rather, it would further the interest of the bankers. We may be well-advised to take this view of Woodrow Wilson and his Congress with a grain of salt.

True, they may not have suffered the expanded power of the banking establishment gladly as it existed then. But this did not mean that they would not embrace unlimited power to monetize government debt, given the opportunity to do so. In particular, Secretary of State William Jennings Bryan was a dyed-in-the-wool inflationist. There is a painting on display in the Treasury Building on Pennsylvania Avenue depicting him as he gleefully signs the very first Federal Reserve notes ready to be rushed into circulation on Christmas Eve, 1913. This Santa Claus of the century has given the world the Federal Reserve, the income tax, no-sweat financing of wars (declared or undeclared), in one word: unlimited power concentrated in the Washington establishment, epitomized by the unlimited power to monetize public debt. This power was grabbed unconstitutionally through the unlawful introduction of open market operations less than ten years later. Even before that, the Federal Reserve was a tool in the hands of trigger-happy politicians who faced a country with no stomach for getting entangled in a fratricidal war on another continent an ocean apart. The warmongers were determined to get a piece of the action by hook or crook. For starters they were eager to finance the trade in war material, especially as it was being dispatched to the Entente powers in violation of the Neutrality Act. Needless to say, financing foreign wars fought by foreigners on foreign soil for foreign interests was not the purpose for which the Federal Reserve System had been established. But let us not make a shortcut in relating events as they unfolded.

It is true that Congressmen who sponsored and passed the Federal Reserve Act of 1913 sincerely believed that the commercial banks' and the Federal Reserve banks' faithful adherence to the RBD would make the monetary system self-regulating, so that the involvement of the Federal Reserve as a central bank could be kept at a bare minimum. Five years of diligent research, after the panic or 1907, had gone into the preparation of the legislation. As mentioned by Timberlake, prominent economists such as H. Parker Willis and Adolph C. Miller, both former students of J.Laurence Laughlin of the University of Chicago, played a crucial role in this research. Not mentioned by him was Paul Warburg, an immigrant from Germany with connections to banking circles there, who brought with him the experience and expertise of the Reichsbank, established a few decades earlier, after a careful study of banking principles with characteristic German thoroughness. The law governing the operation of the Reichsbank was animated by the RBD. Most of its provisions were also written into the Federal Reserve Act of 1913. Carter Glass was the Chairman of the House Banking and Currency Committee nursing the Bill that was to become the Federal Reserve Act. As Timberlake observes, Laughlin was a longtime opponent of the QTM. Miller, together with Willis, supported his criticism of this simplistic theory. In Congress, Carter Glass promoted the pro-RBD and anti-QTM ideas into law.

### Hijacking of the Federal Reserve by warmongers

The Federal Reserve Act of 1913 was not a perfect document. In many ways it was rather imperfect. It did not close loopholes whereby real bills could be made to do overtime and consequently become stale in the portfolio of Federal Reserve banks, that would be a drag on the system. The distinction between real bills and accommodation or anticipation bills was not made watertight. Above all, the very idea that the country's gold must be entrusted to 'reserve' banks, rather than to the people themselves by putting it into circulation, is a monstrosity. Be that as it may, the Act had the attributes of a reasonable legislation to prevent inflationary and deflationary adventures of an activist central bank. The idea of linking the emergence of new currency to the emergence of goods and services in urgent demand (and the retirement of currency at the time of the sale of merchandise or completion of service) was sound. Resisting the temptation to organize the public debt into currency was admirable. Under a more favorable constellation of the stars the experiment of founding a central bank of the people, for the people, by the people, may have succeeded.

Unfortunately, constellation was anything but propitious. The fledgling institution had no chance to succeed in its mission. The Guns of August shot the gold standard, and the bill trading supplementing it, to pieces. Enemies of private enterprise, free trade, and the ideal that the individual knows best what is good for him, together with collectivists of all spots and stripes, saw a great opportunity coming their way presented by the fratricidal war overseas. The socialist minorities sitting in European parliaments, without exception, voted all the war credits governments asked for and then some, in effect throwing out the gold standard as useless baggage inappropriate to carry along in wartime. In reality, the retention of the gold standard would have greatly shortened the war. As taxes to pay for the prolongation of war had had to be increased, the pressure on belligerent governments to make peace would have intensified.

At least in Europe where nationalistic fervor could reach fever pitch the blind sentiment to continue the war to total victory or death was understandable. But in the United States the European war did not make sense to ordinary people. Their ancestors came to this continent to escape the arbitrary war-making power of kings. No pet wars for presidents here, they had thought. The country stayed neutral for the first three years of the conflict, in spite of ongoing political intrigues to take the plunge. The Constitution had assigned the power to declare war to the House of Representatives, and congressmen would not antagonize their pacifist constituents by war-mongering. It was in the president's official family where warmongers found a niche and could prepare the ground for the United States' entry to the conflagration, through provocation if need be.

We shall never know what would have happened if two momentous events: the eruption of war in Europe, and the Federal Reserve banks' opening their doors for business, had not coincided in the fateful year of 1914. One thing is certain: the world would be quite different from what it is now.

### The Great Contraction

Strong died while in office in October, 1928. The removal of this tyrant gave a chance to his enemies to crawl out of the woodwork. They did not delay making the system conform to RBD guidelines as required by the Federal Reserve Act — a most unfortunate development in the view of Timberlake. Here is another interesting historical coincidence. Two events: the bursting of the stock market bubble fed by the Strong-inflation, and the death of Strong were separated by just one year. We shall never know what would have happened if Strong had lived to continue his open market operations in the 1930's. Timberlake says that the Great Contraction would have been avoided. Strong would have pumped even more money into the system, anticipating Greenspan's response to the "irrational exuberance" of the stock market. We may agree, for the sake of argument, that this could have postponed the crisis. Yet it is certain that the crisis caused by a growing amount of central bank money in circulation could not be put off forever.

Timberlake's assumption is tantamount to assuming that damage caused by inflation can be cured by more inflation ad infinitum. However, in our more sober moments we should admit that inflation cannot survive as a permanent monetary policy. The Fed combats falling prices by open market purchases of bonds, and it combats rising interest rates — you have guessed it — by more open market purchases of bonds. The cure is always the monetization of more government debt, regardless whether you are combating inflation or deflation. Just print more money, rain or shine.

We know from history how inflationary adventures inevitably end. There could be nuances of difference, but deflation that follows inflation as night follows day cannot be avoided, no matter how much government debt is monetized by the central bank.

The Federal Reserve Board minus Strong had the unenviable task to rein in the unbridled Federal Reserve credit that was feeding the stock market orgy. They tried to do this as gingerly as they could. Credit contraction is always painful. The pain that goes with contracting an unprecedented credit expansion is no less unprecedented. Timberlake is right in assuming that the Great Contraction has run its course by 1932 and there were signs of recovery in early 1933. Why did then the Great Depression follow so hard on the heels of the Great Contraction? Here the use the RBD as whipping boy that can be conveniently blamed for deflation comes handy. Timberlake does not pretend that his thesis is original. Indeed, it is not. You could have become a Nobel Prize laurate in economics for suggesting it first. But even a dozen Nobel prizes cannot overtake truth.

### Why the Great Depression?

Although the Great Contraction in the wake of the Strong-inflation was unavoidable, the Great Depression was not. The world was sucked into it not because of the RBD but in spite of it. If Timberlake does not see it that way, it is due to his faulty understanding of the RBD, which is inseparable from the gold standard. Real bills must mature into gold coins. Otherwise the RBD makes no sense. Why can't a real bill mature in Federal Reserve notes? If it could, it would not have come into existence in the first place. An omniscient and omnipotent Fed could helicopterdrop just the right amount of Federal Reserve notes, when needed, where needed, for the smooth functioning of the economy. They tried that approach in Bolshevist Russia, with results only too well-known. The experiment was discontinued in Russia's 'Evil Empire' in 1990. Now they try it again in the U.S. and its very own Evil Empire. As Benjamin Franklin has said, experience runs an expensive school, but fools will learn in no other.

Just as the world economy was making its first tentative steps to recovery in 1933, the international gold standard — and together with it the bill market — were mortally wounded by saboteurs. The newly elected Democratic President, no less strong a man than Governor Strong, took the law, and the Constitution, into his hands in March, just a few days after inauguration.

Under the threat of heavy fines and prison terms he called in all gold coins and gold certificates by issuing a Presidential Proclamation. Next, he cried down the value of the Federal Reserve notes in terms of gold, the very same notes that had been paid out 'in compensation' to holders of gold. In other words, the president used the strong arm of government to pauperize the citizenry.

Pity poor Henry VIII. He was being mocked as "Old Coppernose". Yet the vilest thing he ever did to the coin of the realm was to give it a gold wash. When the wash rubbed off after a few years of wear and tear, the copper nose on his effigy became plainly visible. Ownership of solid gold coins was not made illegal. People who could see through the cheap trick were not harmed. Those who were, could at least have a good laugh for their money whenever they looked at the coin counterfeited by their sovereign. But what this president did amounted to raping an entire nation.

People were deprived of their gold coin they needed to validate their demand for consumer goods. Thereafter producers of goods and services would not take orders directly from the consumer bereft of his gold coin. Instead, they would take orders from the issuers of purchasing media, the bankers. They were the ones to call the shots, and to pay the piper. The consumer must take it or leave it.

Timberlake does not see this. He insists that the 'gnomes' of the Federal Reserve have smuggled real bills back into circulation for doctrinaire reasons. Their plot could not possibly work.

Production has stopped (or nearly so) and the flow of real bills dried up, making the economy come to a screeching halt for lack of purchasing media. Meanwhile gold was piling up in the vaults of the Federal Reserve Bank of New York well in excess of reserve requirements, doing nothing. Surely, a strong leader such as Strong would have issued Federal Reserve credit against this gold, and the Great Contraction as well as the Great Depression would have been avoided, according to Timberlake. This betrays his incomplete understanding of the RBD, which makes the availability of gold coins to the consumer an absolute prerequisite.

Here is what would have happened, had the dictatorial-minded president not confiscated gold.

The RBD would have been allowed to operate. As foreign gold flowed to the country, it would be monetized, and the discount rate would be driven lower, perhaps all the way to zero. The United States would have become the clearing house for real bills originating from all over the world. The movement of goods in international trade would have been financed by real bills drawn on New York, just as prior to World War I world trade had been financed by real bills drawn on London.

The low discount rate would have revived the export industry of the United States. Recovery of production for the domestic market could have proceeded apace. The appalling unemployment would have never happened. The Great Depression would have been avoided.

None of this was going to occur because the boat of the international gold standard has been torpedoed and real bills, being tied to the mother ship, went down with it.

### Lionizing saboteurs

Timberlake is blaming the victim of a disaster for the disaster caused by sabotage. The RBD could have been the savior had it not perished along with the gold standard at the hand of collectivist assassins. Real bills could have revitalized world trade and revived the world economy. But the lion's share of world gold had been sequestered and made unavailable for any purpose whatever by a megalomaniac. Bereft of its gold, the world had no choice but go through the meat-grinder. It was no coincidence that the beginning of the Great Depression coincided with the incarceration of gold.

Timberlake should refrain from lionizing lesser saboteurs such as Strong. It appears that his hero is the Latter-Day Strong alias Alan Greenspan. Unfortunately, he says, Greenspan may have come too late and may have left too early. The task of enforcing the "stable price-level norms of Benjamin Strong" has remained unfinished. I quote: "The huge unfunded liabilities of the federal government, as they come due in coming decades, are going to require the U.S. Treasury to pay them. The Treasury will have to 'get the money' to do so. It will 'ask' the Fed for 'help' in keeping interest rates 'down'. Whereupon the Fed, unless it has a Chairman made of titanium steel, will buy those Treasury securities in the open market — yes, holding interest rates 'down' temporarily, but thereby creating new money and initiating an ongoing central bank inflation. The German model [of hyperinflation] of 1923 will be only too applicable."

Is this not exactly what Governor Strong, not having a constitution 'made of titanium steel', had done and would have continued doing had he not succumbed to tuberculosis in 1928? Can the policy of curing the ill effects of inflation with more inflation have any other ending?

### Abstract

"Federal Reserve policies were one hundred percent responsible for the Great Contraction and the subsequent Great Depression. The damage done both materially and ideologically was, and is, inestimable. Ignorant governmental reactions to the debacle resulted in vast expansions of incursions in the economy, and in a vast expansion of powers that no Supreme Court could stop.

Worse still, the common misconception of a market system that had 'failed', resulted in a popular ethos of anti free-market regulation and governmental interventions that have increased exponentially with no end, or even equilibrium, in sight."

My agreement with this assessment of Timberlake is complete. Our difference is centered on the question whether the follies of the Federal Reserve consisted of its abiding by the law, or violating it. This article makes the case that violation of the law, regardless whether you consider it good or bad, creates far greater problems than those it may hope to solve. It also points out that gold coin circulation is a sine qua non of the RBD. Timberlake ignores the implications of the fact that the newly inaugurated president confiscated the gold coins of the people on March 4, 1933. The coincidence of that day, which will 'live in infamy', with the beginning of the Great Depression was no coincidence.

### References

Richard H.Timberlake, Federal Reserve Follies: What Really Started the Great Depression, [mises.org](http://mises.org/blog/archives/timberlake.pdf), August, 2005

Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867-1960, Princeton U.P., 1963 Bill Koures, Real Bills: an Emergent Market Phenomenon, [www.safehaven.com](http://www.safehaven.com), September 26, 2005 Nelson Hultberg, Real Bills vs. Rothbard's 100 percent Gold System, [www.safehaven.com](http://www.safehaven.com), September 6, 2005

---

# The Last Contango in Washington

URL: https://newaustrianeconomics.com/archive/fekete/the-last-contango-in-washington/
Date: 2006-06-30
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, contango, backwardation, permanent-backwardation, gold-standard, fiat-currency
Description: Fekete argues that the gold market is approaching the end of contango — the normal state where futures prices exceed spot prices. When contango permanently disappears and gold enters backwardation, it will signal that no amount of gold at any price can satisfy demand, marking the end of the paper money era. The essay explains the mechanics of contango and why its disappearance is irreversible.
Editorial Note: One of Fekete's landmark essays, published June 2006. The title alludes to both the Clint Eastwood film and Washington's role in gold suppression. This piece introduced many readers to permanent backwardation as a concept and serves as a companion to 'Backwardation That Shook the World' (2008).
Original PDF: https://professorfekete.com/articles/AEFTheLastContangoInWashington.pdf

### When the silver corpse stirs, money doctors run

People from around the world keep asking me what advance warning for the collapse of our international monetary system, based as it is on irredeemable promises to pay, they should be looking for. My answer invariably is: "watch for the last contango in silver".

It takes a little bit of explaining what this cryptic message means. Contango is that condition whereby more distant futures prices are at a premium over the nearby. The opposite is called backwardation which obtains when the nearby futures sell at a premium and the more distant futures are at a discount. When contango gives way to backwardation in all contract spreads, never again to return, it is a foolproof indication that no deliverable monetary silver exists. People with inside information have snapped it up in anticipation of an imminent monetary crisis.

"Last contango" does not mean that the available supply of monetary silver has been "consumed" by industrial applications, as trumpeted by the cheerleaders of the get-richquick crowd. Such a notion is at odds with the fact that silver has always been, and still is, a monetary metal. Huge stores of monetary silver still exist, but are kept out of sight and availability by their current owners who, for obvious reasons, want to remain anonymous. "Last contango" is the endgame of the grand tug-of-war between the money doctors and "We, the People". The doctors exiled silver from banking to the futures market hoping that it will drown there in a sea of paper silver. But the silver corpse stirs.

People withdraw ever greater chunks of cash silver from exchange-approved warehouses.

The money doctors run scared. If futures trading in silver is unsustainable and must end in default, then the flimsiness of the house of cards built of irredeemable promises will be exposed for all to see. Following the last contango in Washington the money doctors, led by Helicopter Ben, will follow the example set by the 18th century Scottish adventurer John Law of Lauriston. He left Paris in a hurry. In a disguise. Disguised as a woman.

### Don't kill the goose laying silver eggs

My main argument justifying the claim that the bulk of monetary silver has not been consumed is that silver, just as gold, is far more useful in monetary than in industrial applications. Provided, I hasten to add, that you know what a monetary metal is, and you also know how to make it yield a return. Admittedly very few people do, and fewer still are willing to share their knowledge with others. Nevertheless, monetary applications of silver are real. Industrial applications kill the goose that lays silver eggs. We must also remember that silver consumption is a relative concept. In Newfoundland tiny silver pieces half the weight of a silver dime with 5 cent denomination had been in circulation before 1949. After the country was absorbed into Canada, these pieces were threaded onto a chain to form bracelets and necklaces. You may, of course, say that silversmiths have "consumed" silver but, clearly, these pieces could re-enter circulation if circumstances warrant it, as quickly as overnight. While the labor component of the price of silver cutlery and plate may be greater, again, this is relative. At a higher silver price it may become negligible. There is hardly any form of silver consumption the product of which could not be recycled, provided only that the silver price is high enough.

### The hairy tale of naked short interest

Every time the silver price rallies, selling appears and the price falls back. "Aha", the cheerleaders cry, "the 'silver managers' are at it again. They are selling silver naked!" Since the silver managers issue no denial, it is taken as a confirmation of the hairy tale of naked short selling.

According to this fable the silver managers gang up against silver investors in an effort to drive down the silver price, so that they may cover their naked short positions at a profit.

But if this were true, wouldn't they sell into weakness rather than into strength? The fact that an increase in the short commitment invariably occurs on rallies and it is then reduced on subsequent dips clearly indicates the absence of malicious intent. Traders simply take advantage of the variation in the silver price in order to derive profits from it, much the same way as hydro plants take advantage of the tides in order to harness its energy. Nobody suggests that the tide-ebb cycle is caused by the hydro plants. It is interesting that the cheerleaders don't complain when the silver managers buy on dips.

They put a different spin on it. Purchases are described as the last desperate attempt of the silver managers at short covering.

Soon enough this fable of a huge phantom naked short position will be put to the test.

According to the cheerleaders the short interest should cave in under the burden of unbearable losses. The silver managers will throw in the towel, and panic-covering will cause the silver price to go to four digits, non-stop. "Patience, fellow silver investors, patience! Hang on just a wee-bit longer! After this last sell-off the price will go straight up!" Well, we have heard that battle-cry often enough, long enough. It is getting monotonous, perhaps a little boring as well.

So where do we go from here? The cycle of profit-taking/bargain-hunting/short-covering will, of course, continue as before. Volatility will grow, quite possibly faster than the moving averages, maybe far exceeding anything we have seen so far. The silver price could be up \$100 one day, and down \$100 next day, so that a relative top may be indistinguishable from an absolute top. Lots of investors will be bumped from the bandwagon prematurely, and they may find it impossible to climb back. But silver to go to four digits in one fell swoop? No way. Unless Helicopter Ben's deeds are as good as his bluffing, and the air-drop of Federal Reserve notes does start in earnest.

### Hedging or streaking?

I do not deny that naked short sellers exist. They do. I prefer to call them "streakers".

Remember "streaking", the fad of the 1970's? Young men derived excitement through exhibitionism as they ran short distances stark naked in busy streets. If the commercial traders ever run naked, it is likewise for fleeting moments only. They cover at the first opportunity. Then they may streak again and cover again. It must be exhilarating. I am not so sure about its profitability, though.

I go further. What passes as "hedging" by gold and silver mining concerns is also streaking. If the miners were hedgers, then they would plow output into a monetary metal fund and write covered call options against it. But this is not what they do. They sell forward their future output, essentially selling naked, sometimes going out as many as 5 years. Then they cover part of their short position through purchases of call options. You can hedge cash gold, but you cannot hedge gold locked up in ore deposits deep underground that will take 5 years to bring up and unlock!

### "Hungry pig dreams of acorn"

To call the gold miners' forward selling "hedging" is a gross abuse of language. It should not be permitted by the watchdog agencies. It is an instance of wilfully misinforming the public. According to a Hungarian proverb "hungry pig dreams of acorn". The wheat farmer selling wheat futures before harvest is not hedging. He is selling forward in order to lock in a favorable price. He is barred from selling anything in excess of his current crop. It would be tantamount to selling dreams. Likewise, the gold miner should also be limited to selling forward one year's production.

In any case, it is not the producer who hedges but the warehouseman. If the producer calls his forward sales "hedges", then he is obfuscating. He wants the buyers of futures contracts to believe that they are buying something more substantial than the dreams of a hungry pig.

Streaking as practiced by gold and silver mining concerns, in contrast with hedging proper, is a deeply flawed strategy animated by Keynesian and Friedmanite precepts. The basic assumption is that spikes in the gold and silver price are an aberration and, hence, must be temporary. Prices, as everything in economics, are bound to revert to the mean.

The regime of irredeemable currency is here to stay. The money doctors have perfected methods whereby we can avoid the pitfalls into which the early pioneers of fiat currency fell. Take, for instance, the helicopter. The money doctors of the French Revolution had to labor without the benefit of air drops of assignats.

### Helicopter and guillotine in aid of monetary policy

This is not the place to refute Keynesian and Friedmanite fallacies. Suffice it to say that the helicopter is a dubious asset in the hands of the Federal Reserve Chairman anxious, as he is, to get his freshly printed "I-owe-you-nothing" notes into the hands of the public instantaneously. On the liability side the Chairman does not have the benefit of another great invention readily available to the managers of the assignat, namely the guillotine.

As is known, during the French Revolution the guillotine was used, among others, for the purpose to cap the price of gold with good effect. So much for hi-tech. As for lo-tech, absolutely nothing has been learned by monetary science during the past 200 years to justify the claim that money doctors can indefinitely entice people to give up real services and real goods in exchange for irredeemable promises to pay. The dictum of Lincoln still stands: you can fool some people all the time; you can even fool all the people some of the time; but you cannot fool all of the people all of the time.

Money is not what the government says it is but what the market treats as such. Silver and gold have been demonetized by the government through trickery and chicanery: silver in the 1870's and gold a century later, in the 1970's. Markets have never ratified these government measures and, presumably, never will in view of the disastrous record of fiat currencies. Witness the helicopter and the guillotine, the carrot and stick of monetary policy.

The principle of reversal to the mean doesn't work for monetary metals. Silver and gold mining concerns will find to their chagrin that their streaking strategy is backfiring. They are facing horrible losses on their naked short positions. They can thank their plight to their Keynesian and Friedmanite mind-set, and to the brainwashing that passes as research and education in economics departments at all the universities and think tanks of the world today.

### Basis, the best kept secret of economics

How many gold mining executives are familiar with the concept of basis? Maybe one in ten. And how many can use it effectively in marketing gold? Maybe one in a hundred.

Don't look for a chapter on basis in Samuelson's Economics. It is not there. Don't try to find its definition in Human Action of Mises. It is not there either. You have to go to obscure manuals on grain trading produced by professionals for the benefit of professionals to learn what it is. As far as I can tell no economist has ever written about it for the benefit of laymen.

The basis earns its name by serving as the most basic trading tool and precision instrument of the grain elevator operator. In buying and selling grain he is not guided by the price and its variation. He is guided by the basis and its variation. He stands ready to buy or sell 24 hours a day, 7 days a week. If you wake him up in the dead of the night with an offer, he won't ask your price. He will ask your basis. If he likes it, then it's a deal, regardless of the price. Professional buyers and sellers of grain do not quote their bid/asked price. They have no use for it. They quote their bid/asked basis.

Recall that basis is the spread between the nearest futures price and the cash price. The grain elevator operator buys cash grain during the harvesting season to fill his elevators to the brim. He tries to buy cash grain at the widest possible basis (known as carrying charge). He is planning to sell it when the basis is getting narrower. His profit is just the shrinkage of the basis. What is the explanation of this peculiarity? When the grain elevator operator buys cash grain, he sells an equivalent amount in the futures market. He must hedge his inventory because the capacity of his elevator storage space is so huge that even a minor fall in the grain price will wipe out his entire capital, if his cash grain is left unhedged.

During the growing season the basis keeps falling as inventories are being drawn down.

The grain elevator operator tries to sell cash grain at as low a basis as possible, because he expects to replace it at a wider basis when the new crop becomes available. It goes without saying that in tandem with selling cash grain he lifts his hedges, i.e., buys back his contracts to deliver cash grain in the future. I repeat, from the point of view of profitability, the prices at which he bought and sold cash grain don't matter. The only thing that matters is the variation of the basis. Sometimes he buys cash grain at a higher and sells it profitably at a lower price. How can he get away with this prestidigitation?

Well, he has correctly anticipated that the basis will shrink faster than the price will fall.

He is aware that he cannot predict the variation of the price, which is at the mercy of nature. But he may divine the variation of the basis that depends on human need, which is more predictable.

### Rationing warehouse space

Moreover, the basis also helps the grain elevator operator to decide what type of cash grain to buy and store. Other things being the same he will buy the grain with the higher basis, and sell the one with the lower. In this way he can maximize his profit derived from the shrinking basis. If the basis is higher for wheat than for corn, then he will keep buying cash wheat in preference to corn until the basis for corn catches up. Or, suppose, the news is that corn blight has hit the growing regions. The astute grain elevator operator will respond by accelerating his sales of cash wheat, in order to make room for more corn in his elevators.

The best way to think about the business of the grain elevator operator is to assume that he is marketing warehousing services, including the rationing of warehouse space between competing uses. His guiding star is the basis. High and rising basis tells him for which purposes the demand for scarce public warehouse capacity is the most urgent. Low and falling basis tells him for which purposes the demand is slack, as people prefer nonpublic solutions for their storage problem, e.g., by keeping supplies closer to home, as often happens in troubled times. Including digging holes in one's own backyard.

The idiosyncracies of the basis with regard to monetary commodities, since they can be buried in holes, are quite different from those with regard to non-monetary commodities, which cannot. This will be the subject of the last of this 3-part series on the basis. ********

### Acknowledgement

I am grateful to Dr. Theo Megalli for calling my attention to the work of the German monetary scientist Heinrich Rittershausen (1898-1984) who apparently was the first to make the distinction between monetary and non-monetary commodities, observing that the former fails to follow the conventional demand/price schedule, in his treatise Monetary Theory, now also available in English translation, see: [www.reinventingmoney.com/Ri_MT.php](https://www.reinventingmoney.com/Ri_MT.php) Dr. Megalli also quotes the remark that has earned many enemies to Rittershausen in banking, commercial, and industrial circles, not to mention political circles, a remark that deserves to be better known: "It was not the gold standard that failed, but those to whose care it had been entrusted".

---

*June 3, 2006*

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C 5S7 e-mail address: aefekete@hotmail.com

---

# Monetary Versus Non-Monetary Commodities

URL: https://newaustrianeconomics.com/archive/fekete/monetary-versus-non-monetary-commodities/
Date: 2006-06-25
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, silver, gold-basis, sound-money, new-austrian-economics
Description: Fekete develops a fundamental distinction between monetary commodities (gold and silver, which are hoarded) and non-monetary commodities (which are consumed). This categorical difference explains why gold and silver cannot be analyzed using ordinary supply-demand models and why the gold market is governed by different laws than copper or oil markets.
Editorial Note: Written June 2006, building on Menger's commodity theory. Fekete's distinction between monetary and non-monetary commodities is a cornerstone of his analytical framework, explaining why standard commodity economics misunderstands gold markets.
Original PDF: https://professorfekete.com/articles/AEFMonetaryVersusNonmonetaryCommodites.pdf

### MONETARY versus NON-MONETARY

### COMMODITIES by Antal E. Fekete

### Professor, Memorial University of Newfoundland

---

*May 25, 2006*

### Sorting out wheat from chaff?

In my last two articles (Bull in Bear’s Skin? and Ultracrepidarian Musings) I emphasized that gold and silver analysts make a blunder when they dismiss the monetary aspect of these metals.

Some of them even brag that they deliberately ignore it lest their vision be blurred by considerations other than supply and demand which alone determine price. To my criticism that supply and demand in case of a monetary metal are indeterminate because of the huge speculative following as it switches its loyalty back and forth between the long and the short side of the market, they mumble something to the effect that they have a unique ability to sort out the wheat from the chaff. Such a claim is preposterous. Speculation is anything but predictable. It is downright scandalous that these analysts doggedly ignore the basis and its variation as an analytic tool. Is it sheer ignorance? Or do they perhaps have a hidden agenda, such as the desire to keep the public in the dark? – I can’t say which answer is worse for them.

A monetary commodity is one that can, in most applications, be substituted by a promise to deliver it. Once endorsed, the promise can be passed on to a third party. The promise itself may take a variety of forms from a warehouse certificate through standard futures or option contracts to an ad hoc forward sales or swaps agreement. On a strict application of this definition there are only two monetary commodities: the senior one is gold, the junior one is silver. Sorry to disappoint platinum and palladium addicts: theirs are not monetary metals

### Armored cars in the streets of Geneva

The willingness to accept promise in lieu of the monetary metal itself evaporates if a commodity exchange goes into liquidation-only mode, meaning that the shorts are exempted from their obligation to deliver the monetary metal as contracted, and the longs can realize their gains only through cash settlement. A notorious example was the decision of COMEX in January 1980 to relieve what looked like an incipient corner in silver, by declaring that only liquidation orders for silver contracts would be entertained. As if by magic short squeeze disappeared. The longs were falling over themselves in trying to liquidate positions before their profits went up in smoke. This was a highly visible effect. But there was another, if you like even more highly visible effect, the import of which only one in a million could see. As luck would have it, I was given the opportunity to see it with my own eyes. It left a deep impression on my mind. I take this opportunity to share that experience with you.

In January, 1980, I happened to be in Geneva, Switzerland. I was visiting a private bank in the banking district. An unlikely number of banks were lining either side of the river Rhone. The office of my banker was on the first floor with a view of the river and several bridges spanning it. He looked out: “See those uniform trucks crossing the bridge underneath?” I said: “Yes, but I also see trucks crossing the river in the opposite direction through the next bridge. They are similar to those ugly armored vans of Brink’s which are ubiquitous in the streets of New York and other large American cities.” My banker continued: “That’s exactly what they are, making bank-to-bank deliveries. But you don’t often see two convoys simultaneously moving in both directions! After all, bankers have learned how to cross out liabilities at the clearing house a long time ago. It doesn’t take more than one convoy to settle the difference.” I innocently asked: “Actually what is it that those vans carry?” My man smiled: “I knew you would ask that. They carry silver.”

### Bring home the bacon and the steak

It took some time before the message sank in. COMEX had just declared “liquidation-only” on its silver contract. This had the immediate effect around the world that banks, traditionally accepting each others’ promise to deliver, refused to honor them and went into cash-and-carry mode. The finely woven fabric of credit, at least as far as the silken metal was concerned, had been blown away in Genev and elsewhere by a local storm brewing in New York. The laconic pronouncement at COMEX paralyzed the normal workings of finance. In less time than the blink of an eye promises to deliver have become worthless. The bulk of trading instruments disappeared, leaving cash silver to do work cut out for a widely-based credit system. Exchanges do not often have recourse to such an extreme measure, because it dilutes the potency of their paper instruments.

It has not been used for twenty-six years. Watch out for a dress-rehearsal.

The big unknown is how the crisis will be resolved when it happens again. In 1980 the longs’ knee-jerk reaction of “cut and run” resolved it quickly. Had they stayed the course, the outcome could have been different, with far-reaching implications for the health of the dollar. In that case the shorts might have had to do the cutting and running.

For a non-monetary commodity substitution of promises for the real thing is hardly possible. A live cattle futures contract cannot be slaughtered and served as steak at the dinner-table; a frozen pork belly contract cannot be thawed out, made into bacon, and served at the breakfast-table.

You have to bring home the bacon to eat it. Paper bacon won’t do (although Keynesian economists are still working overtime to finish the grand design in alchemy of their master, to turn the stone into bread, thereby making GDP edible for humans.) A breakdown of the delivery mechanism for a non-monetary commodity is no big deal. It is a local affair barely noticed even by other exchanges trading the same commodity in default.

But for a monetary commodity, it is a different story. A breakdown cannot be localized. It triggers a domino-effect. Trading of the monetary commodity at all other exchanges will also come to a screeching halt. Banks go into cash-and-carry mode without delay. No statistics are available showing the volume of credit instruments in use involving a monetary metal but, in view of the derivatives, it must be enormous. All this credit freezes up at the same time, with incalculable consequences as far as world finance is concerned. It is true that derivatives directly linked to gold and silver form but a minor part of the total. Nevertheless, the entire derivatives Tower of Babel is in danger of toppling. Why? Because gold and silver, whether demonetizing governments like it or not, are still part of the foundation of credit. If the credit financing gold derivatives goes, so will soon the credit financing interest-rate derivatives. The domino-effect will knock down all the other pillars supporting the credit structure.

### Big Lie Number One

The fact that monetary metals can readily be substituted by promises implies that the stocks-toflows ratio is a high multiple. Monetary metals are the most hoardable among all the commodities.

People want to hold the metal because it is the philosopher’s stone the possession of which allows them to “print their own money”. They don’t have to wait for Helicopter Ben and his airdrop.

For non-monetary commodities the ratio is a small fraction. The price-risk involved in hoarding them is unacceptably high. Supplies are hand-to-mouth. The phenomenon of interest, an exclusive feature of monetary metals, is explained by the observation that interest is the obstruction that checks the hoarding of a monetary metal. It is remarkable and important that this is true regardless whether the country is on a gold standard or not. It is none of the business of governments and central banks to set the rate of interest. Interest is intrinsic. It is inherent in gold and silver.

How does it work today when no country in the world is on a gold standard? Because of the high stocks-to-flows ratio for the monetary metal, contango develops in the futures market. People are willing to pay a premium for future gold up to a limit determined by the carrying charge. In other words, you can earn a return on your gold in gold. It accrues as you sell gold forward at a premium price and buy it back at the lower spot price at maturity. Most significantly, this has absolutely nothing to do with the dollar price of gold which can gyrate up or down in the meantime. Your return in gold is guaranteed. For this reason, the smartest of the smart will discard the dollar as numeraire and adopt a gold unit to gauge wealth.

Of course, contango occurs in case of non-monetary commodities as well, but this should not fool us. The point is that for non-monetary commodities contango is a sporadic occurrence. It can in no way be relied upon as a source of income. There is the basis risk. You may not be able to buy back your holdings at a cheaper price. In case of backwardation you take a loss at maturity. For gold, this danger is non-existent.

Here you have the Big Lie Number One about gold and interest. Mainstream economists mendaciously bad-mouth gold as a “barren” asset, incapable of generating an income. Just the opposite is true. Interest income in gold, on gold is a natural phenomenon while interest income in paper, on paper is an artifact, and there’s many a slip between cup’n lip. The mainstream economist is the stereotype of an ignoramus when it comes to gold. He appeals to the authority of Aristotle who declared: pecunia pecuniam parere non potest (in free translation: gold cannot beget gold). What Aristotle meant was that if you hang on to your gold, then you have to forgo income. Lending and investing, however, is another matter. Then there is a yield. Of course, lending and investing involve risks. For starters, your gold may not be returned to you at the end of the loan period. Be that as it may, there has never been a time in recorded history when it was not possible to lend out or invest gold at a positive rate of interest, whether on the gold standard or off. And it is still true today!

Mainstream economists disingenuously refer to the interest rate on gold loans as the lease rate.

Let the “useful fools” fall for the obfuscation. But a yield is a yield, by whatever name you may call it. You can’t overthrow economic law by tinkering with terminology.

### Big Lie Number Two

Mainstream economists further assert that you can never derive an income from an asset by sitting on it. Income accrues only to those who dare release control temporarily, i.e., assume risk.

We must admit that there is a certain intuitive appeal in all this. It sounds like the Principle of Conservation of Energy. Income and risk go hand-in-hand. Income is the reward for risk-taking. If you can really derive an income without shouldering risk, then you have invented Perpetual Motion. It is tantamount to gaining energy out of nothing.

Even so, this claim is a lie, at least under fiat currency. Paradoxically, it was mainstream economists themselves who created this exception to the rule when they promoted irredeemable currency without examining the question whether it would be in conflict with natural law. They pretend that we have arrived at Cockaigne, the country where fences are woven of sausages and dollar bills, like manna, fall from heaven (thanks to puppet-master Helicopter Ben making himself busy behind the scenes).

Oh, sweet dreams of a hungry pig! But it is no dream that you can derive an income in gold without releasing control over your gold holdings, including the physical possession of it! In other words, if you keep your books in gold units, then you can make gold yield an income in gold without incurring any economic risk whatsoever! This is a well-guarded secret still. Please remember that you heard about it here first.

Bulls in bear’s skin are practitioners of this black art. They keep writing covered options. Here is how it works. They buy gold whenever the gold price dips. They write covered out-of-the-money call options (nearest maturity) on their holdings whenever the gold price rallies. They set up stopbuy orders at every point where the option is called, should the gold price fall. (If they control a gold mine as well, then they reduce the stop-buy order by output). Then the bear puts his market position on auto-pilot and goes into hibernation. No sweat, no fret. He always buys into weakness and sells into strength. Pity poor bulls who buy into strength and sell into weakness. In addition they can hardly sleep at night, and have to have their diapers changed several times during the day. The bulls have what they think is a great device, the stop-sell, a.k.a. stop-loss order. Stoploss is the worst misnomer ever invented. It certainly does not stop the loss on a limit-down day!

Even if it does, it kicks in several ticks below where it has been set. Stop-loss orders are ferreted out by the bulls in bear’s skin. Thereafter it is a game of cat-and-mouse. Guess who the mouse is.

“Stop-loss” is not just a misnomer, it is an oxymoron, a contradiction in terms. Gosh, if you gotta sell, as you do since no bull market is straight up, then at least have the intelligence and the strategy to sell into strength, not into weakness! If Warren Buffett had asked me to manage his silver position, I would have done as spelled out above. True, he would have lost the friendship of Ted Butler. But, as a consolation prize, he could have kept his silver. And he would have made a bundle to boot. Warren Buffett is a genius, but he is getting rotten advice. His advisors cannot tell a monetary commodity apart from a non-monetary commodity.

You can be sure that lots of other well-heeled investors and gold mining concerns are getting better advice, and they happily keep drawing an income on their assets held in the form of monetary metals. The income is higher the greater the volatility. Just take a peek at the option premiums. The unmistakable beauty of the scheme is that at no time must they give up control over, or physical possession of, their assets. So there is no risk involved. Butler mislabels the activity of these bulls in bear’s skin as the “illegal naked short selling of the silver managers”. How they love that mislabeling! They don’t want to be identified. They don’t want to be imitated. They don’t want you to learn the secret how to earn risk-free income on silver in silver. It may spoil their free lunch.

But how do we account for the objection that this scheme contradicts the Principle of Conservation of Energy? We don’t. We might as well admit that the contradiction is real. Put the blame squarely on the regime of irredeemable currency. The gold standard, when in force, is an instant reward/penalty system. Were our schools allowed to teach economics properly, the electorate would know it, and would demand its immediate restoration as the only monetary system serving even-handed economic justice. Under a gold standard foreign exchange and interest rates are stable. Interest rate derivatives and bond speculation are unknown. Debt is reined in by the ability to service it. Under a gold standard all economic risks are created by nature, none by man. Helicopter Ben belongs to fairy tales, not to central banking. The gold standard is the only monetary system that rules out risk-free income. It also rules out free lunch.

As the regime of irredeemable currency defies natural law, it is the digger of its own grave. It is this that explains the crack-up boom, not the overissuing of the currency.

### Silver Jewelry and Cutlery

In summary, none of this makes sense unless you are able to distinguish between monetary and non-monetary commodities. You may ignore the teachings of monetary science only at your own peril. Supply/demand equilibrium analysis is not appropriate to gold and silver. The most you can say is that the supply of promises to deliver gold will grow to infinity, as will the demand for gold.

Under these circumstances the price of gold may approach any figure, including infinity for cash gold, and zero for the promise.

The big open question is what happens after COMEX goes into liquidation-only mode on its silver contract once more, after one last huge spike in the price. Will it lead to another bear market, as it did in 1980? Or will the bull market keep roaring until it turns itself into a crack-up boom?

Teddy and Izzy suggest that people will learn to love silver prices in four digits. They will gladly pay it if that’s the price of showing off. They will start bedecking, themselves with silver jewelry, their tables with silver cutlery.

This is puerile. Rather than displaying it, people will want to hide their silver lest small time pilferers and big time plunderers (read: governments) take it from them.

This question cannot be answered without a careful analysis of the basis and its variation. This I intend to do in a forthcoming article.

---

# The Rise and Fall of the Gold Basis

URL: https://newaustrianeconomics.com/archive/fekete/the-rise-and-fall-of-the-gold-basis/
Date: 2006-06-23
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, contango, backwardation, gold-standard, central-banking, interest-theory
Description: Fekete traces the historical rise of the gold basis under the gold standard and its systematic destruction after 1913. The basis — the spread between spot and futures prices — once provided a natural floor for interest rates and a brake on speculation. Its disappearance, engineered by central bank gold leasing and open-market operations, has left the financial system without anchor.
Editorial Note: Written June 2006 as gold prices rose through $600. One of Fekete's most important analytical essays on the gold basis, tracing its historical origins and the mechanism by which it was destroyed. Required reading for understanding his later work on permanent backwardation.
Original PDF: https://professorfekete.com/articles/AEFTheRiseAndFallOfTheGoldBasis.pdf

## The Rise And Fall Of The Gold Basis

### Antal E. Fekete

Professor, Memorial University of Newfoundland aefekete@hotmail.com

... And God created gold...

And God saw that gold was good, and he ordained it as primordial money. The gold coin was to be the savers' guardian angel and the producers' patron saint, they being the pillars of society. It was also meant to be the protector of the wage-earners, the most vulnerable protagonists of the drama of Human Action. The role of gold in the economy is that of regulator of the quantity and quality of debt. Gold has continued to be money as well as obstruction to the Debt Tower of Babel for over five thousand years. Until man in his infinite conceitedness wanted to be wiser than God. He sought to overthrow the monetary rule ordained by God. He set out to build the Debt Tower of Babel that was to reach to Heaven. Pilfering savers and plundering producers was the inevitable result of the activation of the fast-breeder of debt triggered by the elimination of gold money.

### Seven gaunt cows devouring seven fat ones

Not only did man overthrow what he called "the yoke of gold"; he also sought to obliterate whatever wisdom previous generations have accumulated through painstaking research and careful experimentation with the sharp instrument of credit, the cutting edge of progress but which can also hurt its careless wielder. The monetary system of the Brave New World has feet of clay planted in a pile of rotting paper. It is animated by a false doctrine, the Quantity Theory of Money, a.k.a. monetarism, preaching that gold can safely be overthrown provided that it is substituted by a "quantity rule". The fundamental error in this is the assumption that gold is there in the first place to limit the quantity of money. Yet the role of gold is to regulate the quantity, not so much of money, but of debt.

In falsifying science man has frustrated the only hope to rectify the error. This brings to mind the old adage that "if God wanted to punish someone, He would make him mad first".

In previous essays of this series I have discussed how speculation and warehousing combine to meet the ever-present challenge of the fickleness and niggardliness of nature.

Warehousemen must ration scarce storage space among competing uses. According to the Genesis the first warehouseman, Joseph of Egypt, provided for the seven lean years by storing the grain surpluses of the seven fat years, following his interpretation of the Pharaoh's dream: seven gaunt cows devouring seven fat ones.

### Supply-shocks

Briefly stated, man is in a continual struggle with supply-shocks in the market. They come in two varieties: bumper crops and crop failures. The former is the Nemesis of producers, the latter that of consumers. Either way, the whole society suffers. However, supply-shocks can be mitigated through foresight, organized speculation, and intelligent warehousing. The fulcrum is the activity of warehousemen who, following the example of Joseph, allocate scarce storage space in a most efficient manner in order to provide for future contingencies.

Their talisman, enabling them to perform this job successfully, is the basis. It is a seismographically most sensitive instrument to provide information in a most concentrated form. It makes for an early warning system exposing potential supply shocks threatening society. Moreover, the basis also digests information such as the producers' estimate of what is a good price for their product, comparing it with the speculators'. The basis picks up all signals, including producers' forward sales and speculators' purchases of futures contracts, bringing the two into balance. The question arises how this can be accomplished. After all, the basis is the spread between the nearby (rather than distant) futures price and the cash price. The answer is: through arbitrage.

Floor traders hedge their sales and purchases of distant futures as they simultaneously do the opposite transaction in nearby futures. The basis registers and harmonizes all signals coming from all markets trading that particular commodity. One cannot help but admire this fine communication system through which potential supply-shocks, ever present due to risks inherent in nature, are mitigated by the "invisible hand"as directed by the basis.

### Speculation versus gambling

But there are false prophets, in economics no less than anywhere else. They preach that in exactly the same way as speculation can counter the untoward effects of supply-shocks, it can also meet the challenge of demand-shocks. Just as speculation can face risks inherent in nature, it can also face risks artificially created by man. However, in God's own dictionary a fine distinction is made between speculation and gambling. When man meets risks artificially created by other men (including the government), it is not speculation. It is gambling. It is akin to bets placed by the gambler on future events which may appear to be random but aren't: they are rigged artificially by the casino owner for his own benefit.

The false prophets, being apologists for government-induced gambling, are anxious to blot out this distinction.

Why is speculation successful in reducing risks inherent in nature, but a miserable failure when used to reduce risks artificially created by men? Why is it that when the government wants the speculative markets to reduce the fluctuation of foreign exchange and interest rates, or that of gold and silver prices — all caused by foolish policies of the self-same governments — the result is always contrary to purpose?

To answer this question we need to consider that in the case of risks inherent in nature all speculators start off with an equal chance to be successful. No "inside information" is available to anyone. The playing field is level. Not so in the case of risks artificially created by government in deliberately destabilizing foreign exchange and interest rates.

Here speculators pit their wits against that of central bankers. The latter think they can manipulate the former. A closed group of men tries to outsmart an open group. But the closed group consists of paid hands who don't have to face the music of accumulating losses. All losses have been underwritten in advance by the government and are covered from the public purse. The open group on the other hand consists of speculators who risk their own capital which, if lost, will force them to quit. Their role is taken over by others with better mental equipment to outsmart the same central bankers. This is how George Soros could single-handedly bust the Bank of England while it was trying to uphold the value of the British pound. The Soros incident was not the first episode of devaluation in the wake of speculative onslaught, following solemn government pledges that the pound would never be devalued. Major landmarks are: 1931, 1948, 1968. Before 1931 a paper pound fetched exactly one gold sovereign. Seventy-five years later, in 2006, it took one hundred paper pounds to buy the same sovereign. Apparently, Mr. Soros knows something that Mr. Brown, the Secretary of the Exchequer, does not.

### The rise of the gold basis

When in the early 1970's governments in their wisdom discarded gold from the international monetary system, not only did they cut adrift foreign exchange and interest rates. They also let the genie of the gold basis out of the bottle. Treasury officials were confident that they could control it by giving speculators the run of the house. The fundamental feature of the gold market is contango. When threatened to go into backwardation, the falling gold basis would create powerful incentives for people to accept the futures market's offer to absorb all carrying charges and, on the top of it, to pay a handsome bonus. Surely speculators would fall over themselves in trying not to miss this bonanza in gold. In the event Treasury officials have misinterpreted market behavior so completely as only economists imbued with government omnipotence could. The genie has its own agenda. It will at one point refuse to take orders from Aladdin Greenspan or Helicopter Ben (or whoever is put in the Chair at the Federal Reserve Board). The rise of the gold basis will be followed by its fall, bringing about the downfall of the Establishment.

God created basis. He wanted to help men fend off blows from the prodigality or frugality of nature. Like the creatures of Prometheus they would perish without fire. The basis, in the case of agricultural commodities, is just that mythological fire stolen from heaven. It is the Creator's gift to his creatures to help them survive devastating supplyshocks.

### Demand-shocks

By contrast, the gold basis is not a gift of God. It is a scourge of God to punish conceited governments pretending to be omnipotent and omniscient. Powerful men want to manipulate their neighbors inducing them to behave in a way prejudicial to their own welfare. They want to enslave them by taking away their ability to protect themselves and to provide for their own happiness and survival, especially in view of the eventuality of disasters caused by foolish government policy. They hire economists who parrot the line that demand-shocks can be met in the same way as supply-shocks: through organized speculation.

Therein lies a great error. The gold basis has risen, but its rise is to be followed by a fall and, later, by the downfall of governments trying to play God as they gamble with the welfare of their subjects. The fall of the gold basis tells us that God's gold cannot be drowned in a sea of paper gold. The price of the former will tend to infinity while that of the latter will keep falling to zero. The genie of the gold basis will crush the government through demand-shocks waiting in the wings of the gold market.

### The fall of the gold basis

As a mental experiment let us arrange all goods in a linear order starting with agricultural commodities exposed to supply-shocks to the greatest extent, reflecting the fickleness of nature. Next in line are base metals and other minerals, as well as energy-carriers which are exposed to supply-shocks to a lesser extent. Finally at the far end of the spectrum we put the monetary commodities virtually immune to supply-shocks. Gold, in particular, has a stocks-to-flows ratio which is a high multiple variously estimated between 50 and 80. An increase in the flows, however large, would hardly cause a ripple, considering the size of stocks. To state the case differently, suppose new gold fields were discovered more prodigious than those of Witwatersrand. Or suppose that processes were developed whereby gold molecules suspended in the infinite oceans could be distilled and gathered economically. Such events could in no wise have an untoward effect on the value of gold, so huge are existing stocks relative to incremental flows. This fact alone shows that it was sheer madness to discard gold from the monetary system. The monetary commodity must be immune to both supply and demand-shocks. God has kept His side of the covenant by helping man control supply-shocks. Governments haven't: they have artificially magnified demand-shocks through foolish monetary policies.

The upshot is that the basis risk is much higher for gold than for non-monetary commodities. The fall in the gold basis, whenever it comes, will have nothing to do with assumed supply-shocks. Even if governments threatened to dump all their remaining monetary gold, the result (after the news wore thin) would be counter-productive. The dumped gold, and more, would be readily absorbed. People would not allow the government to trick them out of their golden life-saver. Rather, they would behave as predicted by the ancient Greek monetary scientist Xenophon. In his treatise entitled The Revenues of Athens he wrote that, after people had satisfied all their artistic and industrial needs for it, they would derive just as much pleasure in digging a hole in their own backyard and burying their surplus gold there, rather than entrusting it to public warehouses or, heavens forbid, to government treasuries.

It has always been that way. It will be that way in the future, too. Whenever the government wants to trick people out of their possession of gold, the basis turns negative.

It then falls into a pit and no one will hear it to hit bottom. The number of instances of this happening strains the counting ability of monetary historians. Every episode of a hyperinflation in which paper currency has self-immolated furnishes such an example.

### Putative gold basis

"Hey, wait a minute", you may interject. "Is this not an anachronism? How could you talk about gold basis under a gold standard?" Well, you are right. Gold basis is a new concoction, barely 35 years old. There was no gold basis before 1970, as there were no futures markets in gold. The world's first gold futures market opened in the Winnipeg Commodity Exchange in 1970. The contract called for the delivery of the 400 oz. (12.5 kg) international 'good-delivery' gold bar, the one central banks of the world have been using to settle international imbalances with one another in the good old days. I meant the putative gold basis in the previous paragraph, that is, whatever the gold basis would have been if there had been a gold futures market at the time of hyperinflation.

In 1971 I went to Winnipeg to be witness to history. I purchased a seat on the exchange. I was interested in studying the variation of the gold basis on the floor first hand. At that time gold ownership and trading was still a crime in the United States pursuant to a Presidential Proclamation dating from 1933. F. D. Roosevelt nationalized (read: confiscated) monetary gold. In Canada gold ownership and trading has always been legal.

Canada was chosen as testing grounds by the U.S. Treasury to see how the market would react, in preparation for the legalization of gold ownership in the U.S. four years later.

The gold futures market in Winnipeg was a robust carrying-charge market. Its wide basis reflected the popularity of gold futures with gold investors. Buy orders came in a steady stream from all corners of the world. In the absence of gold futures this demand would have shown up as demand for cash gold, the greatest threat to the value of the U.S. dollar.

The U.S. Treasury was satisfied that paper gold would do nicely, thank you very much, and gold futures trading in the U.S. was duly allowed to commence in January, 1976.

### Bribe money

I have always felt that the gold basis was an anomaly. It certainly did not belong to the same category as the basis of agricultural commodities. It was not a bonus rewarding good husbandry. It was more like the Trojan Horse planted by a bankrupt government that wanted to take through deception what it couldn't by force. I always looked at contango as bribe money, to induce people to take the promise instead of the real thing. It is remarkable and important that under the gold standard there was no need for bribes.

People were happy to accept the promise at face value. The credibility of central bankers has in the meantime been reduced to a zero. They are the spinmasters of the "greatest fool" game. The greatest fool is the player who will hold the bag of worthless banknotes when the music stops. Gold futures trading has been introduced in order to make people believe that the possibility of hyperinflation has been eliminated for good.

We may grant that gold futures trading has materially added to the longevity of the regime of irredeemable currency. But while the central bankers are buying time, sand in the hour-glass of the gold basis keeps trickling down. When it runs out, the trickle of cash gold from warehouses will have become an avalanche that could no longer be stopped.

The gold futures market will be bankrupt, along with the regime of irredeemable currency. Treasury officials will cry "foul play"and will scurry around looking for "rogue traders" everywhere. That is, everywhere except in the Treasury and in the White House where the real culprits hide. When the present unconstitutional monetary regime of the U.S. comes unstuck, the responsibility for the disaster will have to be assigned to the President and the Secretary of the Treasury. They have betrayed their oath to uphold the Constitution of the United States of America, as far as its monetary provisions are concerned.

I have never ever wavered in my conviction that such will be the denouement of the drama unfolding before our eyes. Any other outcome, however widely prophesied, whether the inflationary or deflationary variety, appears unlikely to me.

### Fools treat promises with greater respect than the issuer himself

I reject the Quantity Theory of Money. It is an essentially linear theory trying to explain an essentially non-linear phenomenon. Consequently, I do not believe that there is a causal relationship between the central bank's inflating the money supply and an increasing price level. No doubt, the newly created money could go into commodities; but it could, and would, also go into bonds, equities, and real estate. It is true that paper currency will ultimately self-immolate. An irredeemable promise to pay, it has been gushing forth in the aftermath of the break of the dam, the 1933 reneging on the promise to redeem the dollar in gold at the rate of slightly over 1/20 oz. It does not matter that hardly anybody alive today has any direct memory of that event. What does matter is that the central bank has neither the intention nor the means to meet this obligation. It simply refuses to give anything of value in exchange for its own notes. It should not come as a surprise then that these notes will, at one point, be unacceptable to the producers in exchange for real goods and real services. This is plain logic. There has never been an exception to the truism: if the issuer treats his own promises with disdain, then it is only a matter of time before the public will do likewise. Nor does the truth of this syllogism depend on the quantity of promises issued, or on the rate of increase in their issuance. It is still valid even if the rate of increase in the issuance of new promises is declining, or if no new promises are issued. It follows that a quantum increase in prices is not a necessary condition for the imminent self-destruction of the monetary system. Nor can the increase in prices be relied upon to predict the timing of such an event. Then what can?

I am suggesting it to you that the gold basis can.

### Aladdin Greenspan whistling in the black hole

Expect the regime of irredeemable currency to put up a desperate and vicious fight for survival. There may be times when the gold basis bounces back. But its decline, on the average, is relentless. The dead-cat-bounce is still to come. I have been a student of the gold basis for 35 years. In the early 1990's I made the pilgrimage to the World Trade Center in New York City to meet the Director of Research at Comex. I asked him what explanation he had for the vanishing contango and for the relentless fall of the gold basis.

He cited a couple of ad hoc reasons, having to do with the low and falling interest-rate structure, and its effect on the declining carrying charge. But he had to admit that he knew of no theoretical explanation for the phenomenon of continuing erosion even in the face of rising interest rates and increasing carrying charges.

My own explanation is that the shrinking contango and the persistent fall in the gold basis is a measure of the vanishing of gold into private hoards. Monetary gold together with the output of the gold mines is disappearing. Aladdin Greenspan was whistling in the black hole when he testified before a Congressional committee saying that central banks stood ready to sell more gold to quash flare-ups in the gold price. The irrefutable fact is that selling gold makes the central bank's balance sheet weaker, not stronger. The bank would replace its best assets for the worst. It would exchange an asset that is the liability of no one for the liability of devaluation-happy governments. Central bankers are helpless.

They are in a catch-22 situation. Selling gold into a rising market would be the coup-degrâce to their fiat money scheme. They hope against hope that inundating the world with paper gold in the form of gold futures, options, ETF's and other derivatives, existing or yet to be invented, will save their skin. It won't. Not forever, anyhow.

So I advise my audience to ignore the siren song of the Quantity Theory of Money. Focus attention on the falling gold basis. It is a foolproof indication of the disappearance of monetary gold still available to the public as insurance against economic disasters. The fact is that the vast majority of the people lives in a fool's paradise. They haven't given a thought to purchasing such insurance while they are busily building their homes right on the financial fault line.

As a further refinement I call attention to the silver basis which, if my analysis is correct, will fall first. Not because monetary silver has been "consumed", as trumpeted by the cheerleaders of the get-rich-quick crowd. It hasn't. But, as the silver basis shows, silver is going into hiding even faster than gold. Why? Basically because central bankers have less scope for bluffing in the silver market. The cupboard is bare and the kitty is empty when they are looking for more silver.

### Sapere aude!

I will not go out on one limb to make predictions about timing beyond repeating what I have already said. The indication for the imminent collapse of the international monetary system will be the "last contango in Washington": the fall of the silver basis. It will be followed by the fall of the gold basis. These events will indicate that the irredeemable dollar has entered its death throes — regardless what the inflation numbers say. Woe to all fiat currencies whose principal backing is the irredeemable dollar. Controlling their quantity can and will do nothing to save them.

I am fully aware that it is dangerous to question the validity of the prevailing Quantity Theory of Money. I am willing to stake my professional reputation, as Galilei has staked his when he saw no wisdom in the prevailing geocentric cosmology.

I close this series of essays on the basis with Horace: sapere aude! (In English translation: dare to be wise; Epist., I. ii .42.)

### References

A.E. Fekete, What Gold and Silver Analysts Overlook [www.gold-eagle.com/gold_digest_04/fekete050404pv.html](https://www.gold-eagle.com/gold_digest_04/fekete050404pv.html)

A.E. Fekete, Bull in Bear's Skin? [www.gold-eagle.com/gold_digest_05/fekete050406.html](https://www.gold-eagle.com/gold_digest_05/fekete050406.html)

A.E. Fekete, Ultracrepidarian Musings [www.gold-eagle.com/gold_digest_05/fekete051106.html](https://www.gold-eagle.com/gold_digest_05/fekete051106.html)

A.E. Fekete, Monetary versus Non-monetary commodities [www.financialsense.com/editorials/fekete/2006/0625.html](https://www.financialsense.com/editorials/fekete/2006/0625.html)

A.E. Fekete, The Last Contango in Washington [www.gold-eagle.com/gold_digest_05/fekete060306.html](https://www.gold-eagle.com/gold_digest_05/fekete060306.html)

### Tom Szabo, The Silver Basis [www.silveraxis.com/explain_basis.html](https://www.silveraxis.com/explain_basis.html)

---

*June 23, 2006*

### Antal E. Fekete

### Professor, Memorial University of Newfoundland

### St.John's, CANADA A1C 5S7 e-mail address: aefekete@hotmail.com

---

# Ultracrepidarian Musings

URL: https://newaustrianeconomics.com/archive/fekete/ultracrepidarian-musings/
Date: 2006-05-11
Section: Popular Economics
Difficulty: accessible
Concept Tags: new-austrian-economics, gold-basis, monetary-policy, federal-reserve
Description: Fekete responds to critics who dismiss his monetary analysis as outside his mathematical expertise, arguing that economists have become ultracrepidarians — cobblers opining beyond their last. The essay defends a rigorous analytical approach to monetary theory while skewering the pretension of mainstream economists who ignore the gold basis and its implications for financial stability.
Editorial Note: A polemical piece from May 2006, using the classical term 'ultracrepidarian' (one who opines beyond their expertise) to describe modern economists who dismiss monetary history and gold basis analysis. Characteristically combative and witty.
Original PDF: https://professorfekete.com/articles/AEFUltracrepidarianMusings.pdf

## Ultracrepidarian Musings

### Antal E. Fekete

Professor, Memorial University of Newfoundland aefekete@hotmail.com

A letter from a reader takes me to task for my missive "Bull in Bear's Skin?" saying that I am an "ultracrepidarian" out of my depth. This rarely used English word covers a person who exceeds his competence in passing judgment on matters about which he knows little or nothing. The etymology of the word goes back to the story of a cobbler who, while standing in front of a painting in a gallery, made loud and disdainful remarks about the sandals in the picture. Unaware that he was overheard by the painter Apelles standing nearby, he went on to finding faults with the legs, too. Whereupon he was upbraided by Apelles: "Ne sutor ultra crepidam judicaret" (don't let the cobbler criticize anything above the sandal). My correspondent Mr. Northeast, who is an off-the-floor professional speculator, suggests that I, too, have transgressed the limits of my competence when I called the shorts in monetary metals "arguably the smartest lot on earth" for they could what Aristotle had said was impossible to do: making gold beget gold. I include his letter in its entirety:

Professor:

Your latest commercial promoting the "smartest traders on the planet" is badly off the mark. Here is a recent headline from REUTERS: Fertilizer producer Agrium slips into red on natural gas hedging losses...

With all due respect, if I were you, I would take back the admiring words you have heaped upon commercial traders. You simply haven't got sufficient experience as a trader in the markets to be making these remarks. I have seen far too many examples of commercial floor traders who short the market habitually on every rally, only to get their heads handed to them on a platter in the end when the supply/demand fundamentals ultimately assert themselves. So, forgive me, but I can't take anyone with such outpourings of adoration seriously.

You may say that bona fide hedgers, as distinct from naked shorts, do not often miscalculate. But this is far cry from the glowing praises you heap upon the shorts ad nauseam in your essay.

A man of your intellect stands to lose credibility in no small measure whenever he makes unwarranted statements about something of which he knows nothing. Stick with economic theory and leave market analysis to us traders.

Sincerely, etc.

### Dan Northeast

### ***

Dear Mr. Northeast:

Your point is well-taken that an ultracrepidarian is running the risk of becoming the laughing stock of his peers. However, you yourself are in danger of becoming the pot that calls the kettle black. You are a commodity speculator who know about live cattle and frozen pork belly futures trading. That is your competence. I am a monetary scientist who know about monetary commodities such as gold and silver. That is my competence. You analyze the supply and demand for oxen and pigs before you make a trade. That is all very well. On my part, it is incumbent upon me as a monetary scientist to warn people (those who have ears to hear and brains to think anyway) that gold and silver are not at all like live oxen or dead pigs. They are monetary commodities to which the so-called supply and demand equilibrium model does not apply. If you criticize me for saying so, then my answer to you has to be: Ne sutor ultra crepidam.

To understand the dynamics of the gold and silver market you need a different kind of model and you must employ different concepts than supply and demand. You want to know about basis and backwardation. If you trade the gold and silver markets, then you may ignore the teachings of monetary science only at your own peril. You may suffer heavy losses, no matter how bullish you are in the midst of a bull market. For example, if you assume that all short covering in silver takes place in desperation by naked shorts and none in calculation by shorts acting on behalf of principals holding the stuff, then you are a pig-headed bull ready to have your head to be handed to you on a silver platter. You see, in addition to pig-headed shorts there are also pig-headed longs, and you may suit yourself to decide which are more numerous!

It is not my business to pass moral judgment on the shorts who deceive the market pretending that they sell naked and foster bearish sentiment deviously. Science is not concerned with moral considerations. But I reiterate my opinion that the shorts who sell covered calls and puts, whether on their own account or on that of others, act more intelligently than the longs who jump in and out of the long side of the market on signals generated by stochastic oscillators, or take cover behind their delta-hedges. Blind faith in the Black-Scholes formula for option pricing will not save their skin. Their defense is a fair-weather system: it breaks down under stormy market conditions, that is, just when needed most. It is not unlike a compass that only works in calm seas, but gives false readings in ship-wrecking storms.

All the shorts in gold and silver are certainly not geniuses. Nor are all the hedgers. Even geniuses among them make colossal blunders. You need not go farther than Warren Buffett who let himself be tricked out of his huge position in silver just before the ride was to become fun. His mistake was that he did not hide his intent to derive a silver income from his silver holdings. We can be certain that other similarly well-heeled bulls are not making the same mistake: they don bear's skin.

One should carefully distinguish between naked shorts and other sellers. A commercial who shorts the gold or silver market on behalf of his principal who owns the physical (but wishes to remain anonymous) cannot be considered a naked seller, even though he is represented as such in the COT reports. Nor can the trader who shorts the market against the unreported physical in his possession, putting up full margin rather than taking advantage of the reduced margin available for hedgers, in order to conceal his true identity as a bull. The bottom line is that the COT reports can in no way reveal the true size of net short positions in gold and silver futures because of the bulls camouflaging themselves as bears. Whatever it is, the true size must be much smaller than that conjectured by Butler and other analysts.

I am also dubious about the conspiracy theory of Butler, according to which the shorts collude and act as a "wolf-pack" in dumping paper silver in order to massacre the bulls.

While not impossible, this theory leaves a plausible explanation out of consideration. The idiosyncrasies of the regime of irredeemable currency are such that the smartest traders (and only the smartest) can read the mind of policy-makers, treasury officials, and central bankers. They set out to outsmart these gentlemen who, come to think of it, are just hired hands risking nothing, while they risk their entire capital. No wonder they come up with similar conclusions. Therefore it is quite possible that they act in a similar fashion, without deliberate collusion.

This observation does not make me a sycophant of the bears. I admire only the smartest of the smart.

Yours, etc.

### Antal E. Fekete

### ***

Here is a different kind of comment.

Dear Mr. Fekete:

Thank you for your thoughtful essay on Kitco entitled "Bull in Bear's Skin?"

I have been fully invested in gold since 1997. For most of that time I have been perched on the edge of my chair waiting for gold's meteoric rise that will wipe out those evil shorts for good.

Now you have made the whole picture much clearer. The parties that represent the short side of the market covet the gold, and covet it badly... all of it... yours, mine, and everybody else's... And the longs have been meekly and foolishly giving it to them... at bargain prices... with buckets of tears... and disbelief... and continue to do so even after their fellow longs have been devastated...

I am curious to know why you have waited so long to present such a compelling hypothesis? I would be interested to read more of your essays if they are available for public consumption. If so, then could I please ask you to provide a weblink for further investigation.

Thank you, Sir. Best to you.

Yours, etc.

### Kevin Southwest

Dear Mr. Southwest:

Thank you for your kind words. A much more detailed paper on the same subject entitled "What Gold and Silver Analysts Overlook", one of my lectures in the Gold Standard University series, was put on the Internet just over two years ago, see: [www.gold-eagle.com/gold_digest_04/fekete050404pv.html](https://www.gold-eagle.com/gold_digest_04/fekete050404pv.html) For your information, the Gold Standard University lecture series will resume publication under the aegis of the Lips Institute in Switzerland, starting in September next, as part of the inaugural celebrations. Stay tuned for further announcements.

Central to my thesis is the critique of Keynes' theory of speculation and of Friedman's monetarism. In spite of Keynes, markets are not symmetric. There is an inherent bias favoring the bulls to the prejudice against the bears. The limited risks of the former are contrasted with the unlimited risks of the latter. This explains the shorts' fox-like quality of cunning, deception, and wiliness, acquired in consequence of the Law of the Survival of the Fittest. On the other hand the longs may become complacent, even obtuse, pampered as they are by the inherent bias of the market favoring them. All this is convincingly demonstrated in the present situation by the profit/loss statement of the bullish tech-funds.

The market bias just described is well-known and goes under the name "price-risk", which is limited on the downside. Less well- known is the "basis-risk" which is limited on the upside. Let me elaborate. The basis, much like the price, varies up and down. But whereas the variation of the price is bounded from below (as the price cannot be negative), the variation of the basis is bounded from above. It can be negative (in case of backwardation), but it cannot exceed the upper limit set by the carrying charge (interest plus storage plus insurance costs). If it did, warehousemen could reap riskless profits. It would be cheaper for them to carry the commodity in their warehouses than in the form of futures and, accordingly, they would keep selling the futures while buying the physical until the contango dropped back to the level of the carrying charge.

However, there is no lower limit to contain the variation of the basis so that all the producers hedging their production face what is known the downside basis-risk which is unlimited, just as the upside price-risk is. This fact is extremely important if you want to understand the gold market. Ask Barrick how they could have forgotten about the fundamental law of the markets, the unlimited downside basis-risk. I do not speak for Barrick, but if they deigned to answer your inquiry, their answer would probably run along the following lines.

"The basis, like all economic indicators, is subject to the Rule of Mean Reversal. In the long run, even after extreme swings, the basis must revert to its mean, and if you are well-heeled financially, as Barrick most certainly is, then you can weather the storm.

### Remember, Barrick can never get a margin call for fifteen years!" Barrick is wrong. Gold is a monetary metal the basis of which is not subject to the Rule of Mean Reversal. Barrick may have to wait till doomsday for the gold basis to revert to the mean. Here is why. The Rule of Mean Reversal is valid for ordinary commodities because the shrinking basis acts as a powerful incentive for warehousemen to sell the cash commodity from inventory and replace it with futures. They can take profits and wait for the new crop to come out of the pipelines with which to replenish inventory. It is precisely this selling that makes the basis to revert to the mean. What makes gold a monetary metal is precisely the fact that its basis is exempt from the Rule of Mean Reversal, so that the downside basis-risk is in no wise mitigated. For ordinary commodities it is: the greater the fall in the basis, the more likely it is that it will be reversed.

The gold basis behaves perversely: the greater its fall, the more likely it is that further falls follow. The falling basis tells the longs to take delivery of their gold and stop recycling it in the futures market, however attractive the terms may be. It also tells owners to be most reluctant to exchange their gold for futures, no matter how cheap the latter may be relative to cash. As the gold futures market is not designed to make deliveries on 100 percent of the outstanding futures, it will go belly-up. And, incidentally, so will Barrick, as it will not be able to lift its hedges at a profit as hoped, not now, not in fifteen years, not ever. Unless Barrick is a front for a government, a hypothesis that cannot be ruled out, its name will go down ignominiously in the annals of gold mining.

The hypothesis that Barrick has been set up as a decoy by a certain government is tempting indeed. The 1 million ounce of hedge (out of a total of 20 million at peak) that was lifted recently cost the company \$384 per ounce, higher than the gold price was when the hedge was put on, yet the company reported a profit and declared an end-ofquarter dividend exceeding the previous. Just think of it: a gold producer goes into the market and buys gold at \$384 and promptly gives it away for nothing, to the tune of millions of ounces! Does this not smack of a gold laundering scheme, run for the benefit of a government? Clearly, that government could not accumulate tens of millions of ounces through buying in the open market without upsetting the apple-cart. Try gold laundering, then. No wonder that shareholders of Barrick shed buckets of tears.

The perverse gold basis constitutes the self-destroying mechanism for the regime of irredeemable currencies. Previous descriptions of hyperinflation purporting to explain the descent of a paper currency into the abyss of worthlessness do so in terms of the quantity theory of money, trying to explain a non-linear phenomenon in terms of a linear model. My theory is very different. The persistently falling gold basis explains how it is possible that, in spite of the huge stocks of monetary gold in existence, zero supply can indeed confront infinite demand.

Ted Butler thinks that the recent sharp rally in gold was due to the de-hedging activities of Barrick. It was the largest hedger by far when hedging was fashionable, it is the largest de-hedger by far now since fashions have changed. However, Butler is putting the cart before the horse. According to a regression analysis calculating the impact of de-hedging on the price, prepared by Mitsui Global Precious Metals and Virtual Metals, released by Mineweb, 1 million ounces worth of de-hedging boosts the gold price by a paltry \$5.50.

What then is driving the gold price? I suggest it to you that it is the gold basis, the shrinking of which is not mitigated by mean reversal.

What to expect now? Sooner or later exchange officials will declare "liquidation only" policy. Thereafter the longs can close out their profitable positions only through cash settlement. The shorts are absolved of their obligation to deliver as contracted. At that moment all offers to sell cash gold will be withdrawn around the globe. Gold is not for sale at any price. Producers of essential commodities such as grains and crude oil will refuse to accept payment in dollars and will demand gold in exchange for their product.

The same goes for providers of essential services such as doctors and lawyers. Scales will fall off their eyes and they will decline to give up real goods and real services in exchange for irredeemable promises to pay. The dollar, and all other paper currencies along with it, will go the way of the assignat and mandat.

Nowhere in this argument did we have to refer to supply, demand, or "more money chasing fewer goods". At any rate, Friedman's theory of monetarism won't tell you when exactly the metamorphosis of the dollar from money to trash will take place. Nor will the COT reports give you a clue or advance warning. The gold basis will. I hereby challenge all gold and silver analysts to start educating the public on this subject. I call on all PM websites to run yearly, monthly, weekly, daily, and hourly charts showing the variation of the gold basis.

Please add your voice to reinforce this challenge of mine.

Yours, etc.

---

*May 11, 2006*

### Antal E. Fekete

### Professor Emeritus

### Memorial University of Newfoundland

### St.John's, CANADA A1C 5S7 e-mail address: aefekete@hotmail.com

---

# Bull in Bear's Skin?

URL: https://newaustrianeconomics.com/archive/fekete/bull-in-bears-skin/
Date: 2006-05-04
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, central-banking, gold-standard, monetary-policy
Description: Fekete examines whether the apparent gold bear market of the 1990s and early 2000s was genuine or manufactured. He argues it was the latter: central bank gold leasing created an artificial supply that suppressed prices while the gold basis steadily fell — a bull market in gold disguised as a bear market. The falling basis was the signal that physical gold was being consumed, not genuinely sold.
Editorial Note: Written May 2006 as gold prices were rising strongly. Fekete uses basis analysis to explain why the 1990s 'bear market' in gold was illusory — central bank leasing masked physical demand — and why the subsequent rise was inevitable once leasing could no longer suppress the price.
Original PDF: https://professorfekete.com/articles/AEFBullInBearsSkin.pdf

## Bull In Bear’s Skin?

**Antal E. Fekete**

Professor, Memorial University of Newfoundland  
[aefekete@hotmail.com](mailto:aefekete@hotmail.com)

Dear Mr. Northwest:

Thank you for asking the provocative question whether the current bull market in gold is stage-produced by the powers-that-be in order to divert attention from the deliberate devaluation of all currencies. Your letter has given me an opportunity to sort out my own thoughts on the subject. Here is the result.

### Supply and demand

My analysis of the gold and silver market is very different from the conventional. I am a monetary scientist. Supply and demand equilibrium analysis means nothing to me. For a monetary metal both supply and demand are undefinable. There is no way to quantify speculative supply, still less demand. Yet without it the gold market is like Hamlet without the prince, to borrow a phrase from Samuelson.

Speculators can jump back and forth between the long and the short side of the market at a moment's notice, and in case of monetary disturbances they do. If you insist on using these concepts, the most you can say is that both the supply of and the demand for the monetary metal or its paper substitutes are infinite. Therefore the price can approach any conceivable figure, including infinity for the metal, zero for the paper substitutes. Of course, the banks and the government want to maintain the myth that futures markets provide a reliable link between the two. The fact remains, however, that this link is tenuous and illusory.

It follows that any scientific analysis of the gold market must sidestep concepts such as supply, demand, equilibrium price and replace them with concepts such as asked price, bid price, spread, basis, contango, backwardation.

### Corner and short squeeze

The literature on corners is scanty. Yet it is the possibility of corners and short squeezes that must be analyzed if we want to understand the present situation. The facts are as follows. While short squeezes are common, true corners are exceedingly rare. So much so that some authors flatly deny that successful corners are possible save under siege or blockade. By a corner I mean the attempt of longs in a commodity exchange to prevent the shorts from making good on their contractual obligations by forestalling supply.

However, the shorts are going to move heaven and earth to get supplies to the market in time for delivery. The higher the longs have bid the price, the greater the incentive for the shorts to deliver. If we examine the historical corners in the Chicago wheat pit we shall see that every one of them was a short squeeze that fell short of being a successful corner.

The shorts used every available means of conveyance from dinghies to triremes, from barrows to lorries to move supplies from distant places to the appointed elevators in time.

Contrary to popular beliefs, the shorts are not stupid. Nor are they suicidal. They are responsible businessmen well able to calculate, including calculation of the cost of transportation by the fastest conveyances available such as supersonic aircraft if need be to carry supplies half-way around the globe. Whenever they sell short, they are not acting on impulse. They act on cold facts. They know full well that the futures markets fail to be symmetric. They know that there is a built-in bias favoring the longs at the expense of the bears: the risk shouldered by the former is limited (as the price cannot fall below zero) while that shouldered by the latter is unlimited (as the price can theoretically go to infinity). Whereas an individual short seller might miscalculate, it is virtually impossible that the shorts collectively would.

### Are the shorts really naked?

It is a fatal mistake to underestimate your opponents, in this case the short sellers in precious metals, arguably the smartest lot on earth. They know how to do what Aristotle and latter-day economists have said was impossible: to make gold beget gold. I don't for a moment give credence to the fable that the commercials are selling short naked. Most of their short position is hedged most of the time, if not directly by metal in their possession, then certainly indirectly by metal in the possession of the principals, i.e., for whom they act as a man of straw. The commercials are agents. They act on behalf of their customers, be they wealthy individuals who want to sell call options or futures on their gold hoard anonymously, or banks and governments that do not want you to find out what they are up to. The fact is that selling covered calls and puts is a more efficient way for a bull to husband his resources than buying gold and sitting on it.

Consider the hypothetical scenario that the government of Israel wants unobtrusively to accumulate gold. Or, to furnish an example of a more populous country, let's assume that the government of China wants unobtrusively to accumulate silver in any conceivable amounts. The task is cut out for both countries. They have respectable hoards to begin with. Gold is the most portable form of wealth and the most frequently mentioned word in the Bible after God. China has been on a silver standard since time immemorial and did not participate in the silver-demonetization farce of the 19th century. The best course of action for a government wanting to accumulate gold or silver is to mislead the market by fomenting the bearish case. The net short position in gold represents its stake that it is willing to risk in an effort to get more gold and silver through market manipulation. In other words, the net short position is only apparent, a red herring to throw gold bugs off the scent. It is the tip of the iceberg that you can see and touch. What you don't see and can't touch is the bulk of the iceberg submerged: the huge physical gold and silver hoards that the owner wants to increase further by hook or crook. It can be done by hiring agents in the commodity pits. The commercials sell the metals short in excess of visible supplies, acting on behalf of their faceless principals. They sell more gold than the future output of the mines going out five years. They sell more silver than the total inventory held in exchange warehouses. The longs take the bait eagerly. They buy and hold in the hope that the shorts are overextended and will not be able to deliver. The point is that this is exactly what the shorts want them to believe.

It is easy to predict what will happen in such a situation. The longs are sitting ducks and the shorts keep preying on them. They raid them periodically so that, after the shake-out, they can pick up gold and silver dropped by weak hands. Not only do they buy back what they have sold short as bait; they pick up a lot more. It is a wolf in sheep's skin or, if you like, a bull in bear's skin. The name of the game is to mislead the public and induce it to give up monetary metals for a pottage of lentils. I am not putting this forth as a thesis. It can never be proved or disproved. It is merely a hypothesis more plausible than the one suggesting that the shorts are as stupid as they are suicidal.

Ted Butler believes that mountains of surplus silver, remnants of silver demonetization six score years and fifteen ago, that were still around in 1945, have long since been dissipated and "consumed". Of course, the shorts welcome such beliefs and help foster them by all means. Aided by this myth they accumulate still more silver by fleecing the naive and overconfident longs who are cocksure that they are facing naked shorts in the pit. Meanwhile the watchdog agencies know that physical silver exists and can be delivered if necessary. One should not be so sardonic as to think that he was the only one to discover that silver was dirt cheap at \$3. The "wolf pack" has also discovered it and started accumulating, albeit very, very quietly. Theirs is quite different from Butler's "buy and sit" strategy. They are not waiting for the miracle of silver in four digits to happen.

They do something in order to start drawing benefits from their investment immediately.

From their vantage point the longer the price rise is stretched out, the better. Why?

Because they know something that Butler apparently doesn't: how to make silver yield an income provided that you can hide it under a bushel.

There is no need to cry "foul play". It will do nicely if you credit the shorts with more wits than you assign to the longs.

### Short covering and profit taking

Granted that the shorts are bluffing to tease, taunt, and bait the bulls, it is clear that at one point short selling must become counter-productive. Large bait tickles small fish. When it does, the shorts pull in their nets. They cover. But the fact stands out that it is they, the shorts who call the shots even though their paper losses appear to be staggering, not the longs. Unknown to the public, these losses are far surpassed by gains on physical gold that the shorts have been amassing clandestinely at the expense of the longs for half a century. When the shorts pull the plug and cover their position, the longs are jubilant amidst cries of "cornered rats". Yet all the longs can show for their effort is paper gold, while the shorts control an increasing slice of physical pie. The price of paper gold is destined to go to zero; that of physical to infinity. Who is fooling whom?

The shorts realize that in any bull market there is bound to be periodic profit-taking. They don't have to induce one. It will happen on its own accord. It is spontaneous and unpredictable. While it scares the daylight out of the longs; it is picnic for the shorts. It provides a reliable steady income for them, one that the longs sorely miss. Moreover, the shorts tend to sell into strength and buy into weakness. This is their strength. The longs typically buy into strength and sell into weakness. This is their weakness.

### Backwardation and basis

Instead of the COT reports Butler should concentrate on such direct indicators as backwardation and basis. Backwardation is the market phenomenon whereby nearby futures are selling at a premium over the more distant. The normal condition for monetary metals is the opposite, contango, indicating that supply is plentiful.

Backwardation in monetary metals is a foolproof indicator that supplies are getting tight.

Basis is the name for the spread between the nearby futures price and the spot price. Its shrinking reveals that short selling is becoming counter-productive so that the shorts may be getting ready to cover. Conversely, the widening of the basis tells you that shortages may soon end the shorts are likely to start selling once more. Butler will write a hundred pages about the COT reports while writing half a sentence about backwardation. As far as I can tell, he has never written even a quarter of a sentence about the basis, in spite of a challenge I issued to him privately two years ago. Perhaps he has never got around to take a refresher course, so busy he was poring over reams of COT reports. Be that as it may, the basis is a most sensitive market indicator. When negative, it is a red-hot alarm indicating that offers to sell gold are drying up fast, and may be withdrawn at any time.

Please don't take me wrong. I am not against studying COT reports. All information is useful if you know how to interpret it intelligently. But it is not a very intelligent construction to put on the COT reports to assume that the bulk of the short position of the big commercials is naked.

Having said this, I must credit Butler for advocating the ownership of metal fully paid for as against futures positions or ownership of unallocated metal in public warehouses. He also admits the possibility that the "wolf-pack" may engineer another sell-off even after having suffered horrendous paper losses during the latest run-up of the price.

### Can depression be averted?

Where does all this leave us? The short-covering and profit-taking charade will continue, possibly for several years to come. There will be no disorderly cut-and-run by the shorts and no meteoric rise in the price. Spectacular rises, yes. But they will be followed by equally spectacular and sometimes protracted corrections testing the stamina, staying power, and intestinal fortitude of the longs. Volatility will increase faster than the moving averages. Exchange rules may be changed unilaterally favoring the shorts, prejudicial to the longs.

Obituaries of the dollar are a bit premature. We cannot rule out the possibility that policymakers favor a controlled devaluation of the dollar in terms of gold. By now they must realize that bilateral devaluations against selected currencies will never work. They would provoke trade wars and competitive currency devaluations. By contrast, a 1979-80 style devaluation of all currencies against gold should be acceptable to all governments, even though the outcome would be the same. The dollar would be devalued against other currencies at various rates, higher for the yen, less for the euro, and least for the renminbi.

The trading partners of the U.S. would tolerate that without retaliating with discriminating tariffs and quotas.

You see, my position is close to your own. Yes, as you say, there is an iceberg of gold and silver which is unseen that never enters the market. Yes, the watchdog agencies know this (as well as the identity of the principals of the short sellers who fool the market in posing and parading naked while in full armor, in a reversal of Andersen's amusing tale) but they are sworn to secrecy. And yes, it is not impossible that this bull market in gold is stage-produced in order to devalue all currencies deliberately without the policy-makers making a scape-goat of themselves. The purpose of the exercise? Why, it is to get rid of the debt-incubus short of deflation, defaults, and depression. Come to think of it, a measured devaluation of all currencies against gold is the only hope to avoid an enormously destructive and protracted depression of the world economy that would be triggered by the sudden toppling of the Debt Tower of Babel. A planned melt-down, well-entombed inside of a golden sarcophagus, is the preferred way to go.

What if I am wrong and policy-makers are getting more band-aid out of the medicine cabinet to patch up the disintegrating international monetary system? In that case may God help us survive the coming Armageddon.

---

*May 4, 2006*

### Antal E. Fekete

### Professor Emeritus

### Memorial University of Newfoundland

### St.John's, CANADA A1C 5S7 e-mail address: aefekete@hotmail.com

---

# Gold Standard Manifesto (II)

URL: https://newaustrianeconomics.com/archive/fekete/gold-standard-manifesto-two/
Date: 2006-01-09
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, fiat-currency, monetary-crisis, new-austrian-economics, real-bills
Description: The second Gold Standard Manifesto develops the argument that the gold standard is not merely preferable but necessary for civilized commerce. Without it, the accumulated debt of governments and corporations cannot be serviced, and the deflationary depression that must follow will be of unprecedented severity. The manifesto calls for immediate steps toward monetary reform before collapse makes the choice for us.
Editorial Note: The second of two manifesto essays published in January 2006 (AEFGoldStandardManifestoTwo.pdf). Published under the 'Dismal Monetary Science' series banner. Complements the first manifesto by emphasizing the urgency of reform and the consequences of inaction.
Original PDF: https://professorfekete.com/articles/AEFGoldStandardManifestoTwo.pdf

### Dismal Monetary Science

THE GOLD STANDARD MANIFESTO by Antal E. Fekete,

### Professor, Memorial University of Newfoundland

---

*January 9, 2006*

### Specter of the Gold Standard

A specter haunts executive mansions, chambers of legislatures, and halls of universities: the ghost of the gold standard. Governments and academia have utterly failed in discharging their sacred duty to provide a serene environment for the search for and dissemination of truth regarding economics in general and monetary science in particular.

This failure has to do, first and foremost, with the incestuous financing of scientific research ever since the Federal Reserve System was launched in the United States in 1913. The formula for distributing the profits and undivided surpluses of the Federal Reserve banks has made it possible for the United States Treasury to grab the lion’s share (in spite of explicit prohibition of Treasury participation in the earnings of these banks by the Federal Reserve Act as amended), with far-reaching consequences. As a result the bond market has been reduced to a gambling casino where shills, in order to whip up gambling frenzy, conspicuously make obscene gains at the gaming tables.

### Check-Kiting by Another Name

But unknown to the public, at the end of the day the shills (the Federal Reserve banks) are obliged to hand over their gains to the casino owner (the United States Treasury). There is nothing open about what is euphemistically called “open market operations” of the Federal Reserve. It is in fact a covert conspiratorial operation. It has come about through unlawful delegation of power without imposing countervailing responsibilities. It was never authorized by the Federal Reserve Act of 1913. It defies the principle of checks and balances. It is immoral. It is the most lucrative business second only to highway robbery. It is a formula to corrupt and ultimately to destroy the republic.

Even though later amendments to the Federal Reserve Act retroactively authorized it, the constitutionality of open market operation has never been put to the test. It is clear that such an examination would not be in the interest of the conspirators, and they would use every means at their disposal to prevent it. The folksy name for open market operations is check-kiting, whereby two conspiring parties issue obligations that neither one has the intention or the means to honor but, when they come up for payment, the phantom obligation of one party is covered with that of the other.

### Incest in Financing Research

The side effect that concerns us here most is the fact that the junior partner in the conspiracy, the Federal Reserve, can only increase its share of the loot beyond the mandated limit of 6 percent per annum of subscribed capital if it increases its power in a way not measurable in dollars. It can readily do so by beefing up its “support” of research, namely, by spending pre-distribution dollars in making grants to anybody pretending to be able to write awe-inspiring, mathematically convoluted, nonetheless vacuous, papers on macroeconomics, or anything else of which the fraudulence and charlatanism is hard to detect.

As a result of this immoral way of financing research a veritable deluge of worthless papers has glutted the technical literature on money which has one common earmark: they all attempt to defend the indefensible. They try to defend the issuance of irredeemable promises to pay: the bonds issued by the Treasury and the Federal Reserve notes issued by the Federal Reserve banks. Thus, then, the basis for money creation is the flimsy check-kiting scheme whereby the Federal Reserve banks buy the bonds with the notes while the Treasury uses the notes to pay the bondholders at maturity. The bond is supposed to have value because it is ‘redeemable’ in the note which, in turn, is supposed to have value because it is ‘backed’ by the bond. In effect both instruments are irredeemable and both lack backing in the form of any verifiable wealth. At the heart of the money-creating process, however explained, analyzed or defended, is the stubborn fact that both the Treasury and the Federal Reserve banks are privileged to issue obligations that they have neither the intention nor the means to honor. For any other would-be check-kiters the running of such a scheme would constitute a crime dealt with by the Criminal Code.

This double standard of justice has, of course, an immensely demoralizing effect. But what concerns us here is that the grant departments of the Federal Reserve banks have effectively put themselves in charge of deciding what should and what should not be researched on the subject of money. While they control research on money directly, they control the appointment of heads of economics department and directors of research institutions and other think-tanks indirectly.

This incest in financing research stands without precedent in the entire history of science to the eternal shame of our “enlightened” age, regardless what yardstick we may choose to measure it, of which the dollar amounts of grant money is only the most conspicuous, but we should not ignore the more subtle yet more persuasive methods of arm-twisting: bribe and blackmail.

### Crime of Omission

The hijacking of the agenda for economic research has resulted in a distortion of traditional values. The new values favor ephemeral knowledge, short-horizon planning, consumerism, debtcreation without seeing how it will be retired, instant gratification, marginalization of savings, scientific charlatanism, spreading half truths and even outright falsehoods, while discriminating against durable knowledge, time-honored scientific values, work-hard/save-hard ethics, longhorizon planning. It is no less a crime of omission than it is a crime of commission, as revealed by the following.

1. Support for research on the merit of metallic monetary standards as a political

2.

3.

4.

5. arrangement of placing the power to create and to extinguish money directly into the hands of the people, rather than into the hands of elected representatives or appointed agents, in conformity with the demands of the U.S. Constitution, is nil.

Support for research on the burning question of the “sudden death syndrome” as it affects irredeemable currencies with a deadly 100 percent efficiency, is zero.

Support for research on the question of legality of the open market operations by the Federal Reserve as it was surreptitiously and illegally introduced and retroactively authorized, is unavailable.

Support for research on the scientific foundation of accounting and on the necessity of taking great pains to make the sharpest possible distinction between an asset and a liability, capital and credit, debt owing and debt owning, is naught, in contrast with generous support for research purporting to justify the practice of shunting items in the balance sheet of governments from the liability to the asset column.

Support for research on the code of inspecting financial statements in order to prevent overstating assets and understating liabilities, even in the balance sheet of banks, is nonexistent.

6. Support for the scientific examination of the curious tenet that it is possible to increase the volume of unpaid and unpayable debt in the world indefinitely, is denied.

7. Support for the examination of the question whether the issuance of promises to pay which the issuer has neither the intention nor the means to honor can have any justification, is not available.

### Inflicting Irredeemable Currency on the People

The above short list already makes it abundantly clear that something is woefully amiss with the principle of granting unlimited power, not subject to advice and consent, still less to control, review or withdrawal by the public, empowering one particular agency not only to issue purchasing media but also to direct, permit or inhibit all scientific research pertaining to the question of its own activity of issuing the purchasing media.

It is a sad commentary on the corruption of the flow of funds in support of research that neither a single court of justice, nor a single accredited university in the entire world has found it possible to place the justification for a world-wide regime of irredeemable currency on its agenda, after thirtyfive years of unprecedented economic and financial devastation, including the decimation of the purchasing power of all the currencies of the world, and the even more vicious decimation of the market value of all the bonds in the world, directly attributable to that regime.

It was this corruption of financing research that has disabled the immune system of society, that has made economics and monetary science open to the invasion of quackery and chicanery, ensuring that the success of the final assault on sound money would be a foregone conclusion. In the end the government of the United States could inflict irredeemable currency not only on its own subjects, but on the people of the rest of the world as well, without meeting any significant resistance.

### Integrity of Financial Journalism

It speaks volumes about its integrity that financial journalism has failed to alert the public to the imminent danger of a credit collapse arising out of the universal use of irredeemable currency which the governments of the world have blithely embraced and foisted upon their subjects, without bothering to examine the scientific and juridical arguments against it. In previous instances of experiments with this type of currency sane and self-respecting governments have always resisted the temptation of siren song to join others living in financial backwater. Whenever weak governments came to their senses and wanted to return to the path of monetary rectitude, there was no lack of countries around on the gold standard to lend them a helping hand.

No such luck this time. The world is a rudderless ship on uncharted waters, and the storm is fast approaching. When it strikes, it will be “everybody for himself”. No helping hand will assist survivors. All defenses against this type of disaster have been dismantled, and all life savers cast overboard, thanks to the diligence of the grants departments of the Federal Reserve banks.

Not only have financial journalists failed to alert the people of the dangers they are facing under the regime of irredeemable currency, they keep adding insult to injury. They lionize the Wonderful Wizard of US, King Alan who, unlike King Canute, has been able to order the tide of inflation back. Maybe after disaster has struck, it will be blamed on the ‘early’ retirement of the Wizard.

### Gold Standard University

In order to soften the coming blow, a group of concerned citizens have decided to establish, in the year 2006, Gold Standard University, home for the study of monetary topics placed under taboo by other institutions of higher learning. Here is a partial list: a. The gold standard is a mechanism whereby the people can exercise their power of b. c. d. e. f. g. h. creating or extinguishing money while denying monopoly power of money creation to would-be crooks.

The longevity of the regime of irredeemable currency can be extended through machinations such as the artificial suppression of the dollar price of gold, but only at the expense of making the inevitable credit collapse a great deal more painful and recovery ever more protracted.

The idea of increasing the stock of money based on scientific principles is chimerical.

There is no scientific way of determining the optimal rate of increase in the money supply any more than there is a scientific way of predicting future. If the power to increase the money supply is delegated to an agency dressed in a scientific garb, then this agency represents impostors hell-bent to usurp unlimited power under false pretenses. Unlimited power inevitably means unlimited corruption.

The regime of irredeemable currency is a scheme whereby savers and producers are disenfranchised. Savers are deprived of their power of choosing the form in which they want to save. They are forced to save in terms of a depreciating currency. Producers are deprived of their right to sell to whomever they wish to sell. They are forced to give the right of first refusal to the issuer of irredeemable currency.

The chief merit of the gold standard is not to be found in the stabilization of prices which is neither possible nor desirable, but in the stabilization of interest rates. Only the gold standard can guarantee the lowest level for the rate of interest that is still compatible with conditions in a free economy. There is no bond speculation under a gold standard. The resulting stable interest rate structure benefits both the savers and the producers.

The so-called open market operations of the Federal Reserve banks is a fraudulent practice short-changing every segment of society. It should have never been authorized.

It is a prescription to destabilize interest rates if not in the short then certainly in the long run. Bond speculators move in to preempt the Federal Reserve banks’ buying or selling bonds. They want to act before the banks in order to pocket riskless profits. Everybody rushes to the same side of market and the herd action will generate a destabilizing oscillation in bond prices and in the rate of interest.

Gold hoarding under a gold standard is harmless. (This assumes that saboteurs are not permitted or encouraged to spread false rumors about the imminent suspension of gold payments by the government or by the banks.) Gold hoarding is a legitimate tool in the hand of the bondholder to withdraw bank reserves thereby forcing banks to contract credit, thus allowing the rate of interest to rise and find its proper level. Gold hoarding is also a legitimate tool in the hands of the electorate to force the government to fulfill its election promises for greater economy in public spending.

By contrast, hoarding other marketable commodities is harmful. It is destabilizing as it contributes to oscillating speculative money flows between the commodity market and the bond market. It can only be prevented by removing all obstacles in the way of gold hoarding, which is the proper outlet for the propensity to hoard.

### ***

The Gold Standard University appeals to individuals: who cherish freedom and the ideal of government of limited and enumerated powers; who support the principle of checks and balances in public affairs as well as the notion of delegating power only if it is encumbered with countervailing responsibilities; who reject the formula to finance scientific research through an incestuous combination of the monopoly to create money and the monopoly to dictate the agenda for monetary research; who reject the prostitution of mathematics to be used as a smoke-screen with which to camouflage the enslavement of the entire population of earth; and it calls upon them to step forward and support the cause in exposing monetary deceit and mischief, to fight pseudo-monetary-science and the obfuscation of eternal monetary truths.

The world-wide regime of irredeemable currency has reduced the people of the world to bondage. Monetary servitude is no better than other forms long since discarded by history, such as slavery and serfdom. It may well be worse if for no other reason than being covert, whereas previous forms of bondage have been overt.

Disenfranchised scum of the earth, rise! Put an end to the usurpation of power by the clique of impostors pretending to be monetary experts! Chase the moneymongers out of the temple! Cast your jail-keepers into the sixth circle of the seven in Hell, to which Dante confined all counterfeiters of money, perpetrators of false pretenses, and other tormentors of widows and orphans! Scientific truth is on your side! It is you, not your slave-drivers, who command the high moral ground! You can win a world free of yokes! The only thing you may lose is your shackles!

### People of the world, unite!

---

# The Gold Standard Manifesto

URL: https://newaustrianeconomics.com/archive/fekete/the-gold-standard-manifesto/
Date: 2006-01-09
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, real-bills, self-liquidating-credit, new-austrian-economics
Description: Fekete presents a comprehensive manifesto for the restoration of the gold standard, arguing that sound money requires open minting, free coinage, redeemability, and a functioning bill market. The manifesto diagnoses the current monetary disorder and prescribes the institutional reforms needed to restore monetary stability before a catastrophic collapse forces the issue.
Editorial Note: One of two Gold Standard Manifesto essays published simultaneously in January 2006 — this is the first, longer version (AEFTheGoldStandardManifesto.pdf). Fekete's most programmatic statement of what a genuine gold standard requires, serving as a foundational document for the New Austrian School.
Original PDF: https://professorfekete.com/articles/AEFTheGoldStandardManifesto.pdf

## The Gold Standard Manifesto

### Antal E. Fekete

### Gold Standard University

### The Ghost of the Gold Standard

A specter haunts executive mansions, chambers of legislatures, and halls of universities: the ghost of the gold standard. Governments and academia have failed utterly in discharging their sacred duty to provide a serene environment for the search for and dissemination of truth regarding economics in general and monetary science in particular.

This failure has to do, first and foremost, with the incestuous financing of scientific research. When the Federal Reserve System was launched in the United States in 1913, the formula for distributing the profits and undivided surpluses of the Federal Reserve banks has made it possible for the United States Treasury to grab the lion’s share, with far-reaching consequences. The bond market has been reduced to a gambling casino where the shills, in order to whip up gambling frenzy, conspicuously make obscene gains at the gaming tables.

### Check-Kiting by Another Name

But unknown to the public, at the end of the day the shills (the Federal Reserve banks) are obliged to hand over their gains to the casino owner (the United States Treasury). There is nothing open about what is euphemistically called “open market operations” of the Federal Reserve. It is in fact a covert conspiratorial operation. It has come about through unlawful delegation of power without imposing countervailing responsibilities. It was never authorized by the Federal Reserve Act of 1913. It defies the principle of checks and balances. It is immoral. It is the most lucrative business second only to highway robbery. It is a formula to corrupt and ultimately to destroy the republic.

Even though later amendments to the Federal Reserve Act authorized it ex post facto, the constitutionality of open market operation has never been put to the test. It is clear that such an examination would not be in the interest of the conspirators, and they would use every means at their disposal to prevent it. The folksy name for open market operations is check-kiting, whereby two conspiring parties issue obligations that neither one has the intention or the means to honor but, when they come up for payment, the phantom obligation of one party is covered with that of the other.

### Incest in Financing Research

The side effect that concerns us here most is the fact that the junior partner in the conspiracy, the Federal Reserve, can only increase its share of the loot beyond the mandated limit of 6 percent per annum of subscribed capital, if it increases its power in a way not measurable in dollars. It can readily do so by beefing up its “support” of research, namely, by spending pre-distribution dollars in making grants to anybody pretending to be able to write awe-inspiring, mathematically convoluted, nonetheless vacuous, papers on macroeconomics, or anything else of which the fraudulence and charlatanism is hard to detect.

As a result of this immoral way of financing research a veritable deluge of worthless papers has glutted the technical literature on money which has one common earmark: they all attempt to defend the indefensible. They try to defend the issuance of irredeemable promises to pay: the bonds issued by the Treasury and the Federal Reserve notes issued by the Federal Reserve banks. Thus, then, the basis for money creation is the flimsy check-kiting scheme whereby the Federal Reserve banks buy the bonds with the notes while the Treasury uses the notes to pay the bondholders at maturity. The bond is supposed to have value because it is ‘redeemable’ in the note which, in turn, is supposed to have value because it is ‘backed’ by the bond. In effect both instruments are irredeemable and both lack backing in the form of any verifiable wealth. At the heart of the money-creating process, however explained, analyzed or defended, is the stubborn fact that both the Treasury and the Federal Reserve banks are privileged to issue obligations that they have neither the intention nor the means to honor.

For any other would-be check-kiters the running of such a scheme would constitute a crime dealt with by the Criminal Code.

This double standard of justice has, of course, an immensely demoralizing effect. But what concerns us here is that the grant departments of the Federal Reserve banks have effectively put themselves in charge of deciding what should and what should not be researched on the subject of money. While they control research on money directly, they control the appointment of heads of economics department and directors of research institutions and other think-tanks indirectly.

This incest in financing research stands without precedent in the entire history of science to the eternal shame of our “enlightened” age, regardless what yardstick we may choose to measure it, of which the dollar amounts of grant money is only the most conspicuous, but we should not ignore the more subtle yet more persuasive methods of arm-twisting: bribe and blackmail.

### Crime of Omission

The hijacking of the agenda for economic research has resulted in a distortion of traditional values.

The new values favor ephemeral knowledge, short-horizon planning, consumerism, debt-creation without seeing how it will be retired, instant gratification, marginalization of savings, scientific charlatanism, spreading half truths and even outright falsehoods, while discriminating against durable knowledge, time-honored scientific values, work-hard/save-hard ethics, long-horizon planning. It is no less a crime of omission than it is a crime of commission, as revealed by the following.

1.

Support for research on the merit of metallic monetary standards as a political arrangement of placing the power to create and to extinguish money directly into the hands of the people, rather than into the hands of elected representatives or appointed agents, in conformity with the demands of the U.S. Constitution, is nil.

2.

Support for research on the burning question of the “sudden death syndrome” as it affects irredeemable currencies with a deadly 100 percent efficiency, is zero.

3.

Support for research on the question of legality of the open market operations by the Federal Reserve as it was surreptitiously and illegally introduced and retroactively authorized, is unavailable.

4.

Support for research on the scientific foundation of accounting and on the necessity of taking great pains to make the sharpest possible distinction between an asset and a liability, capital and credit, debt owing and debt owning, is naught – in contrast with generous support for research purporting to justify the practice of shunting items in the balance sheet of governments from the liability to the asset column.

5.

Support for research on the code of inspecting financial statements in order to prevent overstating assets and understating liabilities, even in the balance sheet of banks, is non-existent.

6.

Support for the scientific examination of the curious tenet that it is possible to increase the volume of unpaid and unpayable debt in the world indefinitely, is denied.

7. Support for the examination of the question whether the issuance of promises to pay which the issuer has neither the intention nor the means to honor can have any valid justification, is not available.

### Inflicting Irredeemable Currency on the People

The above short list already makes it abundantly clear that something is woefully amiss with the principle of granting unlimited power, not subject to advice and consent, still less to control, review or withdrawal by the public, empowering one particular agency not only to issue purchasing media but also to direct, permit or inhibit all scientific research pertaining to the question of its own activity of issuing purchasing media.

It is a sad commentary on the corruption of the financing of research that not one court of justice, not one accredited university in the entire world has found it possible to place the justification for a worldwide regime of irredeemable currency on its agenda. This, in spite of thirty-five years of unprecedented economic and financial devastation, including the decimation of the purchasing power of all the currencies of the world, and the equally vicious decimation of the market value of bonds, directly attributable to that regime.

It was this corruption of financing research that has disabled the immune system of society. It has made economics and monetary science open to the invasion of quackery and chicanery, ensuring that the success of the final assault on sound money would be a foregone conclusion. In the end, the government of the United States did inflict irredeemable currency not only on its own subjects, but on the rest of the world as well, without meeting any significant resistance.

### Integrity of Financial Journalism

It speaks volumes about its integrity that financial journalism has failed to alert the public to the impending danger of a credit collapse, arising out of the universal use of irredeemable currency which the governments of the world have blithely embraced and foisted upon their subjects, without bothering to examine the scientific and juridical arguments against it. In previous instances of experiments with this type of currency sane and self-respecting governments have always resisted the temptation of siren song to join others living in financial backwater. Whenever weak governments came to their senses and wanted to return to the path of monetary rectitude, there was no lack of countries around on the gold standard to lend them a helping hand.

No such luck this time. The world is a rudderless ship sailing on uncharted waters, and the storm is closing in fast. When it strikes, it will be “everybody for himself”. No helping hand will assist survivors.

All defenses against this type of disaster have been dismantled, and all life savers cast overboard, thanks to the diligence of the grants departments of the Federal Reserve banks.

Not only have financial journalists failed to alert the people of the dangers they are facing under the regime of irredeemable currency, they keep adding insult to injury. They lionize the Wonderful Wizard of US, King Alan who, unlike King Canute, has been able to order the tide of inflation back. Maybe after disaster has struck, it will be blamed on the ‘early’ retirement of the Wizard.

### Gold Standard University

In order to soften the coming blow, a group of concerned citizens have decided to establish, in the year 2006, Gold Standard University, home for the study of monetary topics placed under taboo by other institutions of higher learning. Here is a partial list of these topics: a.

The gold standard is a mechanism whereby the people can exercise their power of creating or extinguishing money while denying monopoly power of money creation to would-be crooks. b.

The longevity of the regime of irredeemable currency can be extended through machinations such as the artificial suppression of the dollar price of gold, but only at the expense of making the inevitable credit collapse a great deal more painful and recovery ever more protracted. c.

The idea of increasing the stock of money based on scientific principles is chimerical. There is no way to determine the optimal rate of increase in the money supply any more than there is a way of predicting future. If the power to increase the money supply is delegated to an agency dressed up in a scientific garb, then this agency is a front for impostors hell-bent to usurp unlimited power under false pretenses. To be sure, the power to create money is unlimited power, and it inevitably leads to unlimited corruption. d.

The regime of irredeemable currency is a scheme whereby savers and producers are disenfranchised.

Savers are deprived of their power of choosing the form in which they want to save. They are forced to save in terms of a depreciating currency. Producers are deprived of their right to sell to whomever they wish to sell. They are forced to give the right of first refusal to the issuer of irredeemable currency. e.

The chief merit of the gold standard is not to be found in the stabilization of prices which is neither possible nor desirable, but in the stabilization of interest rates. Only the gold standard can guarantee the lowest level for the rate of interest that is still compatible with conditions in a free economy. There is no bond speculation under a gold standard. The resulting stable interest rate structure benefits both the savers and the producers. f.

The so-called open market operations of the Federal Reserve banks is a fraudulent practice shortchanging every segment of society. It should have never been authorized. It is a prescription to destabilize interest rates if not in the short then certainly in the long run. Bond speculators move in to preempt the Federal Reserve banks’ buying or selling bonds. They want to act before the banks in order to pocket risk-free profits. Everybody rushes to the same side of market and the herd action will generate a destabilizing oscillation in bond prices and in the rate of interest. g.

Gold hoarding under a gold standard is harmless. (This assumes that saboteurs are not permitted to spread false rumors about the imminent suspension of gold payments.) Gold hoarding is a legitimate tool in the hand of the bondholder to withdraw bank reserves thereby forcing banks to contract credit, thus allowing the rate of interest to rise and find its proper level. Gold hoarding is also a legitimate tool in the hands of the electorate to force the government to fulfill its election promises for greater economy in public spending. h.

By contrast, hoarding other marketable commodities is harmful. It is destabilizing as it contributes to oscillating speculative money flows between the commodity market and the bond market. It can only be prevented by removing all obstacles in the way of gold hoarding, which is the proper outlet for the propensity to hoard.

---

The Gold Standard University turns to individuals who cherish freedom and the ideal of government of limited and enumerated powers; who support the principle of checks and balances in public affairs as well as the principle of delegating power only if it is encumbered with countervailing responsibilities; who reject the formula to finance scientific research through an incestuous combination of the monopoly to create money and the monopoly to dictate the agenda for monetary research; who reject the prostitution of mathematics to be used as a smoke-screen with which to camouflage the enslavement of the entire population of earth;

It calls upon them to step forward and support the cause in exposing monetary deceit and mischief; to fight pseudo-monetary-science and the obfuscation of eternal monetary truths; to demand the reinstatement of the gold standard and the return to constitutional money putting the individual citizen in charge of money-creation at the Mint once more; to force the government to write gold clauses into its bonds.


---


The world-wide regime of irredeemable currency has reduced the people of the world to bondage. Monetary servitude is no better than other forms long since discarded by history, such as slavery and serfdom. It may well be worse if for no other reason than being covert, whereas previous forms of bondage have been overt.

Disenfranchised savers and producers of the earth, rise! Put an end to the usurpation of power by the clique of impostors pretending to be monetary experts! Chase the money-mongers out of the temple! Cast your jail-keepers into the sixth circle of the seven in Hell, to which Dante confined all counterfeiters of money, perpetrators of false pretenses, and other tormentors of widows and orphans! Truth is on your side! It is you, not your slave-drivers, who command the high moral ground! You can win a world free of yokes! The only thing you may lose is your shackles!

### Savers and producers of the world, unite!

---

*January 9, 2006*

---

# Silver Charade, Gold Charade

URL: https://newaustrianeconomics.com/archive/fekete/silver-charade-gold-charade/
Date: 2005-12-02
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, silver, bimetallic, gold-standard, backwardation, fiat-currency
Description: Fekete argues that both the silver and gold markets are charades: official prices bear no relation to underlying monetary reality as the basis collapses. The suppression of silver in the 19th century was the first charade; the suppression of gold since 1971 is the second. Both are symptoms of the same phenomenon — the displacement of commodity money by fiat currency — and both will end the same way.
Editorial Note: Written December 2005, closing out a remarkably prolific year of writing. Fekete draws a direct parallel between the 19th-century demonetization of silver and the 20th-century demonetization of gold, using both as evidence for his theory that commodity money suppression inevitably produces monetary crises.
Original PDF: https://professorfekete.com/articles/AEFSilverCharadeGoldCharade.pdf

### Not practicing what one preaches

I inadvertently opened a can of worms in writing the essay "Myth of the American Gold Standard." I suggested that the reason the dollar has remained the world's reserve currency in spite of horrendous trade deficits, and in the face of increasing reluctance of foreign central banks to absorb more of it, is Mr. Greenspan's steadfast refusal to authorize the sale of U.S. gold. I went on prophesying that as soon as Mr. Bernanke does authorize it, the dollar will ignominiously fall from its high perch.

My critics fall into two broad categories: First, those readers who think that the Fed cannot authorize the sale in any manner, shape, or form as title to the gold is vested in the Treasury.

Second, those readers who think that the gold stored at Fort Knox is long since gone: it has been sold or leased clandestinely. In answering the first group I can point out that, while it is true that the title belongs to the Treasury, the gold is encumbered by gold certificates held as an asset in the balance sheet of the Fed. The Fed was given them in exchange for gold fraudulently and unconstitutionally confiscated in 1933. To this extent the gold cannot be disposed of without explicit concurrence of the Fed. Mr. Greenspan demurred. He even went public with his demurral saying that the U.S. would be foolish to give up gold, hypocrisy of not practicing what it preaches notwithstanding.

### Pulling the rug out from under the dollar

The Treasury would not comment on rumors about the sale of gold in use as backing for Federal Reserve notes. Such a clandestine way of disposing of the patrimony of the American people would be a disgraceful piece of business. It would show the moral bankruptcy of the government that lacks courage to inform the electorate about plans to pull the rug out from under the value of the dollar in selling the monetary asset securing it, the only asset which is not at the same time a liability in the balance sheet of others, and is therefore not subject to default and debasement: gold.

Not as if it would be unprecedented. It wouldn't. During World War II silver was sold from under silver certificates. Because of this precedent it is not unthinkable that gold has been sold from under gold certificates in the balance sheet of the Federal Reserve banks. Gold may have been used to bribe governments to join American military adventures on foreign soil, for example. Such duplicity may be justified by a new twist in the interpretation of the word "globalization" to cover both military and monetary mischief.

### Silver charade

Let me relate the little-known episode of the Treasury Department lending silver to the War Department under Lend-Lease during World War II. The silver was promptly built into warships and sent into harm's way. The upshot was that silver certificates were backed by unrecoverable silver in the form of bearing and wiring aboard warships exposed to enemy fire.(At that time all the \$1 and \$5 bills in circulation were silver certificates, to the exclusion of Federal Reserve notes.) Nobody in authority batted an eyelid upon turning the legend into a cruel joke on the face of every one dollar bill, sporting a portrait of George Washington: "This certifies that there is on deposit in the Treasury of the United States of America one dollar in silver payable to bearer on demand." Come to think of it, what better way could there be in wartime to protect silver belonging to the creditors of the U.S. government than "storing" it aboard fully armed aircraft carriers? Creditors might sleep undisturbed: the value of the dollar was safe, the silver backing of the dollar was safe, regardless of the war. If the "storehouse" came under enemy fire and the silver was sent to the bottom of the ocean before the Treasury could perform on its promise to pay it to bearer on demand, well, that's too bad. At any rate, excuse would be readily available: "war is no picnic, you know."

No matter how you torture the facts, the truth of the matter remains: the silver backing the dollar was deliberately exposed to annihilation, rendering the legend on paper money utterly mendacious and dishonest.

### "Quod licet Iovi, non licet bovi"

The Latin proverb translates into English as saying: "What Jupiter May, Oxen May Not" Lest my story of the silver charade be dismissed as a product of fantasy, I wish to document it. For background I turn to an editorial in the August 4, 1942, issue of The New York Times.

"One of the strangest episodes of the war is government hoarding of silver. That metal has suddenly come into great demand. It is needed as a substitute for copper, zinc, and nickel. It is also needed for a wide variety of new war purposes. The use of silver bearings in airplanes, for example, makes possible increased speed and greater ability to withstand shock and vibration.

Silver and its alloys go into the manufacture of shells, bombs, tanks, torpedoes, trucks, and ships.

So great is the present demand for the metal that the War Production Board has just issued orders severely rationing the amount of silver available for industrial purposes. And all this time the Government of the U.S. has in its vaults more than 3 billion ounces of unused silver - sixty times an average year's production - of which it is making no use whatsoever.

"This remarkable situation is the result of the adoption by Congress of the Silver Purchase Act of 1934, which compelled the Treasury to buy silver - both domestic and foreign - until the monetary stocks of the U.S. consisted of one-third silver and two-thirds gold. The theoretical purpose of this law was "to provide a wider backing" for American currency. Its actual purpose was, of course, to line the pockets of the Silver States. For eight years - and in recent years over its own protest the Treasury has been forced to buy and store underground gigantic quantities of an unneeded metal at prices far above the current market price. Now the unneeded metal suddenly has become immensely useful - not as a "backing" for our currency but for purposes of war. And the obviously sensible thing to do would be to release from the Treasury the vast stocks of metal held for "monetary" purposes which is a sham. But the Silver Senators say no.

"So we arrive at a situation in which the same government that urges a patriotic public not to hoard sugar, not to hoard rubber, not to hoard gasoline, not to hoard useful goods of any kind, itself hoards a metal which is needed for planes and shells and tanks and ships. It is a fantastic situation. . ."

Three months later, on October 31, in another editorial the same paper noted that President Roosevelt has expressed his displeasure over the existence of very large hoards of critical material that owners refuse to sell at fair prices. The paper continued: "We know there is a very large hoard, virtually a monopoly, of an important metal needed in war work. This hoard amounts all told to nearly 3 billion ounces. The owner acquired it at average prices of less than 50 cents an ounce, but will not sell it for less than \$1.29 an ounce, although the market price until recently has been only 35 cents an ounce. Meanwhile this metal is needed in the manufacture of ships, airplanes, tanks, trucks, guns, shells, bombs, torpedoes, and other war equipment. It is needed as a substitute for copper, tin, and other metals now scarce. It is used to make airplane bearings, photographic films, surgical materials, and pharmaceutical products.

"This metal is silver. The hoarder is the United States Government."

Yes, indeed. Quod licet Iovi, non licet bovi.

The miracle of silver present at two different places at the same time No fewer than eleven bills dealing with silver, and how Treasury stocks of it might be made available to help the war effort, had been introduced in Congress. The lucky one that eventually made it after the Senate passed it on June 18, the House on July 5, and the president signed it into law on July 12, 1943, was the Green Silver bill S. 35. It did not provide for retirement of any silver certificates as silver held or owned by the U.S. was being released for war purposes. It was designed to let the same silver to be present in two different places at the same time. The actual wording, somewhat ambiguous, was that "at all times the ownership and the possession or control of an amount of silver of a monetary value equal to the face amount of all outstanding silver certificates heretofore or hereafter issued by the Secretary of the Treasury shall be maintained by the Treasury." Senator Green, in answering questions about the meaning of these and other words in the bill, said that "under the provisions of the bill it will be possible for the Treasury to take silver now retained for silver certificates, and which cannot be used for any other purpose, and use it for non-consumptive purposes." (Hearings of October 14, 1942, as reported in the Minutes, p. 11.) Senator Green went on to say that "It will make it possible to use silver now buried and used solely as security for silver certificates, and to transfer it from underground, where it serves no other purpose, to places where it will serve non-consumptive purposes. . . I cannot see where it would be any less security for the silver dollar if it is in a governmentcontrolled electrical establishment than if it is underground at West Point." (Ibid. p 14.)

### Dishonest and phony promises

It seems clear from this that the Green Bill proposed the use of the silver held against silver certificates for non-consumptive purposes and at the same time for "security" behind silver certificates. Under this arrangement the silver certificates were not redeemable into silver. They became dishonest and "phony" in every respect. If silver busbars in electrical plants (used as conductors to withstand very great electrical current) can serve as reserves of silver certificates, then so can unmined silver in the mines, including mines in the Moon. So can silver held in vaults abroad. For good measure, so can silver that has been sold to foreign governments. Since the government has engaged in this type of currency manipulation, to issue paper money carrying promises that cannot possibly be fulfilled, it has created a precedent which can be used in the future to issue obligations that the Treasury has neither the means nor the intention to fulfill.

Legislators have sunk to a new low level of degradation in dealing with the public.

The manner in which the issue of dishonesty was avoided in passing the Green Bill was peculiar and disturbing. It suggested that there was an intent "to put over a fast one" on the American people. It has since become a regular feature of monetary legislation in the United States. As a result, the once mighty dollar was reduced from a definite promise to pay a definite quantity of monetary metal of definite quality, first, to a phony promise that was impossible to fulfill. From there it was only a short step to reduce the dollar further to a scrap of paper promising, as a Federal Reserve note does, to pay nothing. And this is exactly what it will be worth in the fullness of times.

### Moral bankruptcy

We must see the Green Silver Act for what it is: the first step on the way to hell. It is a disgraceful piece of legislation, opening the way toward moral bankruptcy in the administration of the nation's currency. This lack of respect for the importance of maintaining the integrity of government promises where the people's money is concerned fully exhausts the meaning of dishonesty, fraud, and chicanery. It is tantamount to the rape of the American Constitution.

Not a single voice was raised in Congress or in Administration circles against this sorry piece of business. When a government begins to write false promises on the people's money it is notifying the world in unmistakable terms of the extent to which it is marked by the rot of moral bankruptcy.

Soon enough, financial bankruptcy may follow.

For over sixty years after the Green Silver Act, America has been fortunate enough to escape that fate. This should not give it comfort. America has never been closer to fully-fledged financial bankruptcy than it is right now, an event for which the banks, businesses, and the people at large are ill prepared, making the coming shock even more devastating. The economists' and financial journalists' profession bears responsibility for failure to forewarn and forearm the public. Short of a miracle, America cannot avoid its fate: credit collapse, the vanishing of the value of dollar and all dollar-denominated assets such as bank notes, deposits, bonds, insurance policies, and pension rights.

### "Help yourself to fire and brimstone"

My critics set great store by the openness in the administration of the currency. They point out that the debates about the wisdom of selling or leasing silver encumbered by silver certificates in support of the war effort was carried out in the light of full publicity. Opponents were given full opportunity to argue their case against the measure.

Unfortunately, soon enough, currency management was to become top secret. I close my essay with another quotation, this one from the October 28, 1945, issue of The New York Herald Tribune.

"In making the atomic bomb, the Army needed silver for giant current carriers known as busbars.

The Treasury had a lot of silver it wasn't using, so the Army borrowed 400 million troy ounces. "The Treasury puts out a daily statement about where its silver is, and prides itself on its honesty.

The necessity for Army secrecy posed a problem. Fortunately, silver also was being leased to the Office of Defense Plants and other agencies. So the daily Treasury report stated the number of ounces 'held by the Office of Defense Plants, the Reconstruction Finance Corporation, etc.' "The little word 'etc.' was big enough to cover the atomic bomb. Luckily, nobody asked the

### Treasury what it meant." Fancy bearers of silver certificates turning up at the Treasury and demanding delivery of silver.

Fancy they being taken to Los Alamos, shown a pile of radioactive debris, and told: "Help yourself!"

---

# The Fall and Rise of the Gold Standard

URL: https://newaustrianeconomics.com/archive/fekete/the-fall-and-rise-of-the-gold-standard/
Date: 2005-11-21
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, sound-money, fiat-currency, monetary-crisis, new-austrian-economics
Description: Fekete traces the history of the gold standard's destruction — from the First World War through Bretton Woods to the Nixon shock — and argues that the forces that destroyed it also planted the seeds of its restoration. The accelerating dysfunction of irredeemable currency will eventually make the return to gold not merely desirable but necessary for economic survival.
Editorial Note: Written November 2005, one of Fekete's more historically sweeping essays. The 'rise' part of the title is prospective — Fekete argues that the internal contradictions of irredeemable currency will force a return to gold, a process he sees already beginning in the declining gold basis.
Original PDF: https://professorfekete.com/articles/AEFTheFallAndRiseOfTheGoldStandard.pdf

## The Fall And Rise Of The Gold

STANDARD by Antal E. Fekete,

### Professor, Memorial University of Newfoundland

---

*November 21, 2005*

## Abstract

Our revisionist theory of the gold standard takes the bill market and the discount rate into full account. Greater availability of gold is no cause for inflation. The new gold flows to the bill market lowering the discount rate, which quickly puts a greater variety of consumer goods on the shelves of retail shops, thus preventing prices from rising. Nor is reduced availability of gold a cause for deflation. The gold is withdrawn from the bill market raising the discount rate, which quickly eliminates marginal merchandise from the shelves, thus preventing prices from falling. Rising prices are never the result of an abundance of gold. They are always the result of scarcity of goods, such as that caused by misguided credit policies of banks discounting financial bills not backed by maturing consumer goods. Falling prices are never the result of a scarcity of gold.

They are always the result of an overabundance of goods, such as that caused by misguided government policies creating unemployment.

## Unevenly Rotating Economy

The gold standard can only be understood in the context of its clearing system, the bill market, trading real bills that move in a direction opposite to the flow of maturing goods to the final goldpaying consumer. Authors looking at the gold standard in isolation got a cock-eyed perspective.

They have to invoke the quantity theory of money. The trouble is that, although it could explain linear changes, the quantity theory is helpless to explain non-linear phenomena such as dynamic changes. Whenever Mises talked about an “evenly rotating economy,” he was careful to rule out dynamics. To this extent his opus is incomplete and can only be finished by extending it to the “unevenly rotating” or dynamic economy wherein the quantity theory of money no longer applies.

The evenly rotating economy is strictly an abstraction that, by Mises’ own admission, nowhere exists in reality, not even as a first approximation.

## Classical Theory Of The Gold Standard

There is a natural tendency to minimize gold flows across international boundaries. Typically, balances are settled, not through gold remittances but through arbitrage in real bills. Arbitrageurs buy bills in a country running a deficit and sell an equivalent amount in a country running a surplus, to take advantage of the favorable spread in the discount rate. It is particularly effective if one country acts as a clearing house, as England has done prior to World War I.

This observation invites the following critique of the classical theory of the international gold standard according to which gold flows from a deficit to a surplus country, inducing changes in the relative price levels. According to the quantity theory of money prices are falling in the deficit country and rising in the surplus country. Higher prices are supposed to have the effect of discouraging exports while encouraging imports, with the opposite effect for lower prices. This purports to explain the adjustment mechanism of foreign trade. However, this pernicious theory has never worked in practice but it caused a lot of monetary mischief in the world after Milton Friedman persuaded governments to “float” their currencies in the early 1970's. Friedman’s theory of trade adjustments through currency devaluation, a variant of the classical theory of the international gold standard, was an unmitigated failure, although this was never publicly admitted.

If not corrected soon, it will destroy the international monetary and payments system through competitive currency devaluations and trade wars, or worse.

## Revisionist Theory Of The Gold Standard

In reality, the price level hardly ever reacts to trade imbalances. Economists have been at a loss to explain persistent trade deficits and blamed the gold standard for the anomaly. They should have blamed themselves and their flawed theories.

As our more sophisticated theory shows, if the supply of gold increases in one country, then the new gold first flows to the bill market where it will bid up the price of real bills. This makes the discount rate fall. Shopkeepers respond by filling their empty shelf-space with marginal merchandise. By the time new gold trickles down to the rest of the economy in the form of higher wages and greater dividend income, the extra merchandise will be in place waiting for the increased consumer-spending to materialize. Social circulating capital expands and soaks up extra demand for consumer goods. There is no inflation.

Conversely, if the supply of gold decreases in a country, then the gold is withdrawn from the bill market against selling real bills. Bill prices fall. The discount rate jumps. Shopkeepers respond by eliminating marginal merchandise form their shelves. Neither gold outflow nor increased gold hoarding will squeeze prices. Instead, they cause social circulating capital to contract and propensity to consume decline. Marginal merchandise is no longer available in every grocery store. The consumer who still wants it must search for it in speciality shops and be prepared to pay a higher price for it since moving these items can no longer be financed at the low discount rate; it must be financed through a loan at the higher interest rate. There is no deflation.

Karl Marx talked about the “anarchy of the market” under the capitalist mode of production, suggesting that producers act blindly and they inevitably glut the market through overproduction.

But as our analysis shows, assuming that the discount rate is not distorted by the banks and the government, producers and distributors have a sensitive inner communication system, the bill market. They know that by the time the new product reaches the shelves of the shopkeeper the sovereign consumer will be looking for it. Producers and distributors get their signals, not from the rate of interest or prices that are far too sluggish, but from the nimble discount rate. Its fall is heralding an increase, and its rise a decrease, in consumer demand.

## Fundamental Principle Of Retail Trade

This, then, is the fundamental principle of the retail trade. The adjustment mechanism which brings into balance the amount of gold in circulation with the supply of consumer goods works, not on prices but on the discount rate. The law of supply and demand is inoperative. An autonomous increase in demand has no inevitable effect on the prices of consumer goods but will, instead, lower the rate of marginal productivity of social circulating capital, i.e., the discount rate. The lower discount rate automatically makes the supply of consumer goods expand.

By the same token, an autonomous decrease in demand will raise the rate of marginal productivity of social circulating capital, a.k.a. the discount rate. A higher discount rate automatically makes the supply of consumer goods shrink. There is no such a thing as an autonomous change of supply in the retail trade. Supply is closely regulated by demand through the mechanism of the bill market and the discount rate.

The vulgar supply/demand equilibrium analysis fails to describe the process of supplying the consumer with urgently needed goods. It could not explain why prices were stable under the gold standard even in the face of great changes in demand. In a previous article I have explained this phenomenon in terms of increasing economic entropy.

## Coping With Natural Disasters

If a country is stricken with bad harvest or by some other natural calamity destroying property and consumer goods, then there will be an immediate increase in the discount rate. Retail prices of consumer goods will not rise inevitably. The stricken country, thanks to its high discount rate, is an attractive place on which to draw bills. This translates into an immediate influx of short-term credit from abroad in the form of the most urgently needed consumer goods. In comparison, the present system of politically motivated trade privileges bungles foreign aid hopelessly. By the time the amount and kind of aid is agreed upon by the negotiators, the need may have shifted. The gold standard is by far the best system for international division of labor, in good times as well as in bad. Governments have exposed their subjects to unnecessary deprivations when they first sabotaged the clearing system of the gold standard, the international bill market, and then destroyed the standard itself. Peoples of various countries will help one another to the fullest possible extent under the international gold standard, provided that its clearing system, the bill market, is not sabotaged by the governments, as it was in 1909 when bank notes were made legal tender in Germany and France. In the absence of a gold standard peoples are pitted against one another in a bitter competition and trade wars, often escalating into shooting wars.

## Coping With A Gold Avalanche

By the same token, the international gold standard and its clearing system the bill market allows nations to share the windfall of a sudden increase in the world’s stock of monetary gold in a way that rewards the industrious and penalizes the inept. Let’s assume that the output of gold mines increases by leaps and bounds, or that foreign gold invades one particular country. It need not cause an increase in prices, as predicted by the vulgar theory. Instead, it will benefit all countries adhering to the international gold standard, through a general lowering of the discount rate. It will first drop in the country hit by the gold avalanche. Suppliers will start drawing bills on foreign countries with a higher discount rate. Increased imports will repel the invasion of foreign gold and expel excess domestic gold. Social circulating capital expands with the lowering of the discount rate. The spinoff from higher incomes due to the greater availability of gold will be met by an expanded offering on the shelves of shopkeepers who are now able to display a greater variety of goods, thanks to the lower marginal productivity of social circulating capital. As excess gold is expelled, other countries will also participate in the windfall. Benefits are by no means confined to the country where the gold fields are located.

Now suppose that all countries except one close their Mints to gold, and all the monetary gold in the world descends upon that country. Even in this extreme case there is no need for the prices to rise. The rate of marginal productivity of social circulating capital will be approaching zero.

Retail stores will run out of shelf space and start using the side-walks to display marginal merchandise. The greater availability of gold will, in this case as in any other, call out an even greater abundance of merchandise. Price rises are always the result of a scarcity of goods, never of a greater availability of gold.

A bumper crop is often considered a disaster by producers who blame it for the collapse of prices.

But prices need not collapse under a gold standard. The cash crop is part of social circulating capital and, when available in great abundance, marginal productivity will be lowered and the discount rate fall. New products made of the same old ingredient will appear on the shelves.

Furthermore, exporters will take advantage of the lower discount rate. They draw bills on the bumper crop in shipping it to foreign destinations. Far from slashing prices, the gold standard will increase market share through slashing the discount rate. Everybody benefits.

## Legal Tender Bank Notes

Scarcity of goods is usually brought about by the banks and the government through their interference with the free flow of gold to the bill market and with the free flow of merchandise across international boundaries. An example of the former is the world-wide inflation of 18961914, mistakenly blamed on the increase in gold production after the opening of the mines in the Transvaal. The prodigious increase in gold production did not cause price increases per se. The new gold should have been allowed to flow to the bill market. It wasn’t. Banks intercepted it in order to construct a credit pyramid upon their greatly expanded gold reserves.

The bank credit, however, was not healthy. It was not of the self-liquidating kind, as it would have if it had been based on real bills drawn on goods moving fast enough to the final gold-paying consumer. Worse still, governments discouraged gold coin circulation instead of encouraging it.

They drove gold coins into the banks. Laws originally barring the bank of issue from discounting financial and treasury bills were changed. The note issue was made legal tender. This event was the salvo heralding the destruction of the bill market. Within five years, by the time the war broke out, the portfolio of the banks of issue consisted of financial and treasury bills, where previously only real bills were eligible as reserves for the note issue. The bill market was paralyzed. It has never been allowed to make a recovery.

A direct consequence of the unhealthy credit expansion was inflation world-wide, even before the war. It was conveniently explained away by the quantity theory of money, using gold as the whipping boy. Nobody pointed out that the expansion of bank credit has far outstripped the increase in the stock of monetary gold. Still more serious was the undermining of the international bill market. It could no longer prevent price rises through the discount rate mechanism, since bank reserves have been diluted through the discounting of fiduciary and treasury bills that, unlike real bills, would not mature into consumer goods. The fact remains that, in spite of government propaganda, it was not the inflow of new gold but the subversion of the bill market that caused the 1896-1914 inflation and price rises.

Economists are guilty of failing to point out that making bank notes legal tender has been tantamount to dethroning the sovereign consumer. It was a destructive act. The gold coin cannot be substituted, the dictum of Mises notwithstanding, by legal tender bank notes in its role as the regulator whereby consumers direct production. Legal tender confers absolute and unlimited power on the bank of issue. It is a great error indeed to classify, as Mises does, legal tender bank notes a present good with which consumers allegedly continue to guide production even after the recall of gold coins from circulation. Legal tender means that the power of consumers to decide which items to produce and which ones to discontinue is fatally compromised. This power is now usurped by the bank of issue. Only one economist, Professor Heinrich Rittershausen of Germany, realized the destructive nature of the 1909 decision to make bank notes legal tender.

Unfortunately, his cry has remained, to this day, a cry in the wilderness.

## Plunder, The Real Cause Of Inflation

We have seen that the 1896-1914 inflation was not due to the sudden increase in gold production, but to the hijacking of gold on its way to the bill market by banks hell-bent to build unsound credit on their greatly expanded gold reserves. The point is that this credit expansion was not matched by emerging consumer goods because it was the result of discounting financial and treasury bills, rather than real bills. Had it been, no inflation would have ensued. In the actual case credit expansion made consumer goods scarce. Prices rose as a consequence.

Going further back in time we may observe that the great historic tides of prices, originally blamed on gold, were really caused by military conquest and plunder as they made goods scarce. This was true of the sack of Persepolis by Alexander the Great in 331 B.C., as well as the sack of Cuzco by Pizzaro in 1533 A.D. The fact that looted gold was the instrument whereby goods were made scarce in other parts of the world does not change the validity of this observation. It was not the greater availability of gold per se, but the scarcity of goods due to plunder, that has made prices to rise.

## Fall Of The Gold Standard

The fall of the gold standard can only be understood in the context of the deliberate destruction of the bill market. After World War I the victorious governments in redrawing international boundaries would not allow the free circulation of real bills and consumer goods to resume. They did not want free trade. They wanted autarky. They also wanted to deny the gold coin to “man’s greedy little palms”, to use the cherished phrase of Lord Keynes. The bill market was scuttled.

Governments assumed control of foreign trade in consumer goods, which was thereafter animated by political rather than economic considerations.

This turned out to be the most disastrous public decision in peacetime. In an earlier article of this series I related how it led to the collapse of the gold standard and to unprecedented unemployment world-wide, as predicted by Rittershausen in 1930. It is a shameless lie that the gold standard collapsed because of its inner contradictions, after spreading unemployment in the world. The truth is that the gold standard was destroyed through deliberate sabotage. Legal tender bank notes made the bill market brain-dead. Bills drawn on maturing goods no longer reflected the will of the consumers. They reflected the will of the bank of issue that could print bank notes ad libitum to meet payments on real bills. We should not be fooled by the fact that a few gold coins lingered on during and after the war, as they did in the United States. The clearing system of the gold standard, the bill market, has been effectively destroyed. The international gold standard was bound to fall, too. In the post mortem it was falsely stated that the cause of death was exhaustion due to old age. No mention of the stab wound in the back was made, namely, the 1909 decision declaring bank notes legal tender.

The theory and history of the gold standard has been distorted and falsified by traitors such as Lord Keynes who was happy to take the thirty pieces of silver offered as reward for the betrayal. It is time to set the record straight and state the truth: mass unemployment in the 1930's was caused by the governments themselves. They destroyed the wage fund, however inadvertently, along with the bill market. Detractors of real bills at the Mises Institute must logically applaud the government hatchet job. They look at the government decision to scuttle the international bill market with satisfaction, as a needed “purification” purging the gold standard from its alleged imperfections. Advocates of the 100 percent gold standard are intellectual accomplices of the greatest job destruction of history. They approve of the abolition of the wage fund in the consumer goods sector, a corollary of the destruction of the bill market. You cannot have it both ways. If you deny self-liquidating credit, then you also deny jobs financed thereby.

## In Praise Of Gold Hoarding

The most serious charge against the gold standard, made by Lord Keynes, is that it is

“contractionist.” It encourages gold hoarding thus contracting the stock of money, the chief cause of unemployment. The truth, however, is that gold hoarding in the early 1930's was maliciously instigated by the enemies of the gold standard, first and foremost among them Lord Keynes himself. They started a whispering campaign that the national currency should be devalued to help the export industry. This was nothing short of advocating sabotage. The disingenuousness and hypocrisy of Keynes reminds one of the thief crying: “Thief! Thief!”

As an economic phenomenon, gold hoarding and dishoarding are natural and healthy. In fact, gold hoarding is part of the mechanism that regulates the (floor of the) rate of interest. The only way the public can prevent banks from expanding credit is through the withdrawal of bank reserves in the form of gold coins. Contraction of reserves is the only signal banks understand.

Jaw-boning is an exercise in futility. Banks should be prepared to pay out their bank reserves to note holders and depositors on demand. That is what bank reserves are for. Control over changes in the stock of money is, by the Constitution, reserved to the people. They exercise this power through their right to withdraw bank reserves in the form of gold coins. Gold hoarding of the marginal bondholder sets a limit to falling interest rates. Once this right to withdraw reserves was taken away from the people banks could, and would, drive interest rates down below the rate of marginal time preference, taking entrepreneurs into temptation to expand production facilities.

This would lead to overinvesting and the boom-bust cycle as explained by Mises and Rothbard.

If the government tries to stop gold hoarding by confiscating the monetary metal, then the propensity to hoard, instead of working through the natural conduit of gold, would find outlet in the hoarding of other marketable merchandise, an unnatural conduit, which is fraught with great dangers. In more details, there is the danger of generating a runaway vibrator through resonance between price fluctuations and interest-rate fluctuations. Therein is the explanation for the phenomenon known as Kondratiev’s long-wave inflation/deflation cycle to be found.

## Rise Of The Gold Standard

The gold standard shall, like the mythological bird Phoenix, rise from its ashes when the regime of irredeemable currency foisted upon the peoples of the world will self-destruct, as it must, after the time-bomb of ever-increasing unpaid and unpayable debt, having reached critical mass, goes off. The born-again international gold standard will be complete with its natural clearing system, the international bill market.

Advocates of the so-called 100 percent gold standard display a most profound ignorance of monetary science when they naively think that the clearing system of the new gold standard will consist of fleets of cargo planes flying gold around the world to satisfy their taste for purity. There is a great urgency to have a national debate on the burning questions how to prepare for the cataclysmic collapse of the regime of irredeemable currency that presently threatens the world.

The government has betrayed people in keeping them in ignorance. It is inexcusable that some self-styled advocates of sound money try to smuggle in their own petty agenda, derailing the orderly discussion of the main issue, the study of the operation of the gold standard in depth, including its clearing system the bill market, and its signaling system the discount rate (as distinct from the rate of interest).

The second coming of the gold standard and the bill market is inevitable, despite the charlatanism of the opponents of real bills. Their 100 percent gold standard will be rejected 100 percent by events as they unfold.

### References

Antal E. Fekete, Where Mises Went Wrong, September 16, 2005 Antal E. Fekete,

Unemployment: Human Sacrifice on the Altar of Mammon, September 30, 2005 Antal E. Fekete,

### Economic Entropy, October 9, 2005

---

# The Myth of the New American Gold Standard

URL: https://newaustrianeconomics.com/archive/fekete/the-myth-of-the-new-american-gold-standard/
Date: 2005-11-15
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, fiat-currency, monetary-policy, gold-basis
Description: Fekete dismantles the claim — made by some gold advocates — that U.S. monetary policy has de facto adopted a gold standard by keeping the gold price stable. A genuine gold standard requires open minting, redeemability, and a functioning basis market; administrative price stability is a counterfeit that retains all the vices of fiat money while providing none of the protections of gold.
Editorial Note: Written November 2005 in response to commentators who argued that stable gold prices indicated a de facto gold standard. Fekete's rigorous definition of what a genuine gold standard requires sets a high bar that modern proposals consistently fail to meet.
Original PDF: https://professorfekete.com/articles/AEFTheMythOfTheNewAmericanGoldSTandard.pdf

### Introduction

In 1999 The New York Times ran an obituary of the "barbarous relic" from the pen of Floyd Norris under the title "Greenspan Has Become the New American Gold Standard" (op-ed page,

International Herald Tribune, May 5, 1999). It alleged that the process of removing the glitter from gold has been a gradual but inexorable one and the world was more than happy to accept the greenback backed by Greenspan (no pun intended), just as earlier it had accepted the yellowback backed by the precious yellow. The earmark of the new millennium is people's unshakeable faith in the dollar. My rejoinder suggesting that "rumors about the demise of gold were grossly exaggerated", written over six years ago, is reproduced below. It goes without saying that The New York Times refused to publish it. The occasion for publishing it now is the impending historic changeover from the Greenspan standard to the Bernanke standard.

### Green cheese factory on the Potomac

There is nothing new about premature obituaries for the gold standard. In 1936 John Maynard Keynes noted in the book that has made his name world-famous (The General Theory of Employment, Interest, and Money; Macmillan, 1967, p 235) that people habitually scramble for gold, which is to say that they crave for the moon. But the government cannot let them have the moon. A good central banker, by definition, is one who can persuade people that green cheese (sic!) is practically the same thing, and will go on to parcel it up and dish it out for their delight and satisfaction. Nomen est omen: Greenspan was destined to be the first (and probably the last) green cheese monger on the Potomac. Mr.Greenspan certainly understands gold and the reasons why people habitually scramble for it. He also understands why the government wants people to take green cheese for gold. It is not my intention to ridicule the deep-rooted yearning in the human psyche for Santa Claus. But to me, instead of cutting a happy figure of Santa Claus, Mr.Greenspan cuts the sorry figure of the Sorcerer's Apprentice. He learned the magic word how to start green cheese production; his tragedy is that he has forgotten to learn the other magic word how to stop it when enough is enough. Apart from that, the problem is that too much green cheese is not good for you. It may cause diarrhea (inflation) and constipation (deflation), although it is impossible to say in which order.

Competition of gold to irredeemable promises is too telling for comfort

According to Norris, gold's reputation as a store of value has been eroded while its price fell by more than two-thirds from \$873 in 1980 to \$251 in 1999, in contrast with the Dow which at the same time increased more than 12-fold. This is not a new story either. Gold's reputation as a store of value had been eroded many times before, to wit, during such historical episodes as the Tulipomania, the South Seas Bubble, the Mississippi Bubble and, more recently, during the Roaring Twenties of the Twentieth Century.

Norris informs his readers that the IMF is to sell "surplus" gold, a move applauded (ordered?) by the U.S. Treasury, to help finance the laudable program to forgive debts owed by the very poor countries. He explains that money from gold sales is to be invested in U.S. Treasury securities and the income from the investment will pay off the loans. He concludes that "gold, which does not pay interest, is a lousy investment".

Here Norris betrays how badly misinformed he is. As every central banker and gold miner knows, gold can earn interest even in the Twenty-First Century, provided that you can find trustworthy borrowers. It is true that the interest rate on gold loans (euphemistically called the "lease rate") is but a small fraction of what the U.S. Treasury is forced to pay on its debt. Yet this does not make gold a lousy investment. Quite the contrary, it is this very fact that makes gold such a superb investment. Financial writers ought to know that yield varies inversely with quality. By Norris's logic a government bond is a lousy investment in comparison with a junk bond because the yield on it is lower. The reason why the U.S. government is so anxious to push gold out of the international monetary system is that the competition gold offers to irredeemable promises is too telling for comfort. The fact remains that when a central bank or the IMF sells gold, it is replacing the best kind of monetary asset, one that is nobody's liability, with the worst kind: the irredeemable promises of devaluation-happy governments. In selling gold central banks and the IMF make their balance sheet weaker, not stronger.

### Why strong central banks fall over themselves to sell gold

Norris gleefully reports that the Swiss National Bank has also joined the "let's junk gold" contest.

He mockingly adds that the Swiss defection is not unlike Rome embracing Protestantism. Of course, he fails to mention that the Swiss were put under duress: Paul A. Volcker was dispatched to Zürich to twist their arm. Even so, I concede that an explanation is in order. When a weak central bank is selling gold to meet its maturing liabilities, it is acting logically. It is using gold to maintain its credit standing. That is what gold is for. But when strong central banks, such as the Swiss National Bank and the Bank of England are falling over themselves to sell monetary gold from reserves under the full glare of publicity, knowing that the inevitable result of the fanfare will be the worst sales price for the asset on the block, then logic is turned upside down. The lame explanation that gold sales are designed to raise funds to perform good deeds is for simpletons only. If the motif were really charity, then there would be all the more reason to cut out glare and fanfare, lest the trustees open themselves to charges of unfaithful stewardship. We are fully justified in looking for a hidden agenda. I do not pretend to know the real reason for this "negative gold rush". I can only speculate: central banks are desperately trying to prevent a melt-down threatening the financial system. This crisis is largely unknown to the public, even though it is potentially more damaging than any previous one in the 20th century. It has to do with "naked" selling of call options on gold bullion and other forms of forward sales by banks. This activity has been officially encouraged by government as a way to finance the stock market and real estate bubble, the bursting of which would cause great damage to the world economy. Central bank gold sales are designed to bail out short interest in a futile effort to stave off a corner in gold.

### What maintains the value of irredeemable promises

Norris does say that gold has once served as protection against government plunder through deliberate currency debasement. Moreover, he admits that there is still plenty of it going on in the world. But he contends that, with Mr. Greenspan in charge of green cheese production and distribution, the answer to the problem is no longer gold. It is, in the lingo of the day, "dollarization", a sort of gold standard without gold. This is not a new story either. In the 1960's governments were experimenting with what they used to call "paper gold".

In order to appraise the idea of putting the whole world on a dollar standard, we may recall some basic facts. The American dollar is an irredeemable promise, no better and no worse than the Russian ruble. The value of either stands or falls on one thing, and one thing only: the support of currency speculators. It is a fable that the difference between the dollar and the ruble is the difference between the professionalism of the Fed and the dilettantism of its Russian counterpart.

Exactly the same knowledge is available to central bankers in Moscow that is available to Mr. Greenspan in Washington. Before currency speculators decide which currencies to support and which ones to dump they look at three factors as follows, in the same order of priority: (1) the balance sheet of the central bank issuing the currency; (2) the trade accounts of the country; (3) the history of the government honoring its promises to pay. On the last two counts the dollar is an unmitigated disaster. The U.S. has been running a horrendous trade deficit for decades which still keeps growing. Twice in the 20th century the U.S. government broke faith with its creditors: in 1933 it defaulted on its domestic and, forty years later, in 1973, on its international obligations. In the latter instance the U.S. government was the perpetrator of the debasement of all the currencies of the world, in wiping out more than 90 percent of the purchasing power of the dollar in less than a decade, including the non-gold reserves of central banks - the greatest monetary destruction on record.

The only count on which the dollar still shines in comparison with the irredeemable promises of other central banks is the balance sheet of the Federal Reserve banks, showing a higher ratio of gold assets to liabilities. In fact, one reason why American officials are pushing other governments to get rid of their gold while they themselves hang on to the "barbarous relic" is that, thanks to Mr. Greenspan's tutorials, they understand the role of gold in the balance sheet. They understand that the moment American gold reserves cease to be second to none speculators will unceremoniously dump the dollar. In the meantime the more other central banks can be pushed around to get rid of their gold the better it will be for the political, economic, and military hegemony of the United States.

### Investment or insurance?

The discriminating observer would look at gold not just as an investment the glitter of which can be tarnished by central bank gold sales. He would also look at it as an insurance against disaster caused by recklessness at the helm, whether the boat of the world economy is run onto a reef or whether it is run into an iceberg. For the prudent, gold is an insurance policy the importance of which increases with the dangers and uncertainties growing in the world with the passing of every day. The price of gold is of secondary importance. A low gold price simply means that insurance is momentarily cheap. Why is it cheap? To put it bluntly, it is cheap because foolish people are selling their life-savers while staring at the iceberg which is about to hit the "unsinkable" Titanic.

However, as long as some people are willing to hold on to their life savers, gold cannot be demonetized through wishful thinking.

This exposes the myth of the "new American gold standard". It is solely based on the hoard of fraudulently and unconstitutionally confiscated gold which the American government still retains while exhorting other governments to get rid of theirs.

Little needs to be added to update this piece written over six years ago. At the close of the Greenspan Fed the boat of the world economy is still buffeted between Scylla (inflation) and Charybdis (deflation). If it is not smashed to pieces on the rock of Scylla, then it will be sunk on the reef of Charybdis. Part of the myth is that we are having low inflation thanks to the adroitness of helmsman Greenspan. However, as the new helmsman Bernanke has warned, deflation may well be the greater danger of the two. He is getting ready to load the helicopters for the dollardrop while gearing up the printing presses for a fresh run.

In spite of all the anti-deflationary maneuvers the Bernanke standard is still vulnerable to deflation. This is because Mr. Bernanke, who is a devout believer in the quantity theory of money, sees the essence of deflation in falling prices rather than in collapsing demand and its corollary, vanishing pricing power. Obviously, the printing-press remedy of Mr. Bernanke does not address these. Because of collapsing demand and loss of pricing power, businessmen will remain lethargic regardless how much manna is dropped from Bernanke's helicopters. The dollar bills will be picked up by speculators who thereupon join the Fed's mad spending spree in the bond market offering risk-free bets. The result will be falling interest rates further deepening the deflationary crisis.

This is not to say that Bernanke's helicopters cannot frighten the speculators. They certainly can.

If and when they do, speculators will dump bonds, currency, and all. Mr. Bernanke is confident that he can cure deflation through hyper-inflation. He cannot. Under hyper-inflation the currency is losing value faster than can be replaced by printing more of it. That is precisely the difference between inflation and hyper-inflation. It spells further decline of demand and vanishing pricing power, that is, more deflation, not less.

The success of the Greenspan standard was due to Mr. Greenspan's steadfast refusal to authorize plans to sell U.S. gold. The downfall of the Bernanke standard will follow Mr.

Bernanke's decision to authorize it when he finds, much to his chagrin, that hyper-inflation is no cure for deflation.

---

# Economic Entropy

URL: https://newaustrianeconomics.com/archive/fekete/economic-entropy/
Date: 2005-10-09
Section: Popular Economics
Difficulty: intermediate
Concept Tags: fiat-currency, gold-standard, capital-destruction, new-austrian-economics, sound-money
Description: Fekete applies the thermodynamic concept of entropy to economics, arguing that irredeemable currency is an entropy-increasing system: it destroys the economic order (the complex structure of capital and credit) just as thermodynamic entropy destroys ordered energy. The gold standard, by contrast, is a low-entropy monetary system that preserves and channels economic energy productively.
Editorial Note: Written October 2005, one of Fekete's more creative analytical pieces. The entropy metaphor allows him to explain capital destruction in terms accessible to readers without economics training, and connects his monetary theory to broader thermodynamic principles.
Original PDF: https://professorfekete.com/articles/AEFEconomicEntropy.pdf

## Economic Entropy

*Revisionist Theory and History of Money* · **Antal E. Fekete** · Professor, Memorial University of Newfoundland

---

*October 9, 2005*

## Dedicated To The Memory Of Ferdinand Lips

*Dedicated to the memory of Ferdinand Lips, who ardently advocated the preservation of knowledge how to run a gold standard so that it can be passed on to future generations.*

### Abstract

Economists have neglected to study the phenomenon of vanishing uncertainties and risks in the production process as maturing goods approach the final consumer who is eager to buy them at established prices. We fill this gap in resurrecting Adam Smith’s long-forgotten notion of social circulating capital. Then the propensity to consume appears as the volume, and the discount rate as the marginal productivity of social circulating capital. It turns out that the rate of interest and the discount rate are entirely different concepts animated by entirely different forces. The fundamental error of Mises and Rothbard in confusing the two was due to insufficient research, in particular, ignorance of economic entropy, the measure of the disappearance of uncertainty and risk. It was also due to their denial of liquidity, the fruit of maximum entropy.

### Social Circulating Capital

When does a river cease to be a river? At the moment it gets within sight of the sea. As the river is descending to sea level significant and conspicuous changes occur. The salinity of the water increases sharply and, with it, the ecology changes. Water molecules lose their potential energy and their kinetic energy is converted to entropy.

Similarly, the flow of myriad goods from producer to market also undergoes a remarkable metamorphosis when it gets within sight of the consumer. Adam Smith was the first to notice this interesting phenomenon. He formulated the concept of social circulating capital. By this he meant the mass of finished or semi-finished consumer goods which has reached sufficient proximity and is moving sufficiently fast to the ultimate cash-paying consumer so that its destiny of being consumed presently can no longer be in doubt.

The analogy between the flow of goods to the final consumer and the river emptying into the ocean can be profitably extended to include economic entropy. The risks and uncertainties, so characteristic of processing in the earlier stages of production, all but disappear by the time the maturing goods become part and parcel of social circulating capital and sale at the going price can be taken for granted. Speculation and other forms of risk-taking give way to the highly predictable automatic processes of distribution. In particular, established retail prices do not normally change in response to changes in demand because of the increase in economic entropy, measuring the reduction of uncertainty and risk.

### Liquidity

The vanishing of uncertainty and risk, the emergence of social circulating capital, and increase in economic entropy are manifested in a most dramatic fashion through the appearance of liquidity.

To Adam Smith liquidity was tantamount to the spontaneous circulation of real bills that he observed in Manchester and Lancashire\. It refers to the qualitative difference between goods carried by the trade at virtually no risk in anticipation of sale to the final consumer at established prices, and other goods carried at considerable risk in anticipation of an eventual appreciation in value.

The importance of the market phenomenon that stabilizes values as economic entropy is maximized can hardly be overestimated. It is incumbent on the monetary economist to study it closely. The process of supplying the consumer with urgently needed goods cannot be described in terms of a black-and-white equilibrium model with circulating capital financed out of savings, as is done in textbooks for dummies. It is a transition, a metamorphosis, the description of which calls for the full spectrum of colors involving a wholly new gamut of means of payment which are legitimate substitutes for the ultimate extinguisher of debt, gold. Demand does not operate on prices; it operates on the discount rate. The vanishing of uncertainty and risk, along with the emergence of social circulating capital and the increase in economic entropy must be analyzed independently of any banks or the banking system. It is the disappearance of uncertainty and risks that gives rise to banking, not the other way around. We would never understand bank note circulation without liquidity and spontaneous bill circulation that appear in the wake of increasing economic entropy.

Liquidity can be measured by the spread between the ask and bid price. The smaller the spread, the higher liquidity is. The ultimate in liquidity is epitomized by the gold coin with zero spread.

Next in line is the consumer good in urgent demand that sits on the shelf of the shopkeeper waiting to be exchanged for the gold coin of the final consumer. The bill drawn on the retail merchant inherits liquidity from the collateralized merchandise on the shelf. Higher-order goods, while they may also be liquid, are progressively less so as we move farther away from the ultimate consumer and his gold coin.

The evolution of the bill market has made the circulating gold coin in the hand of the consumer extremely efficient, far beyond the limits of its physical mobility. Henceforth only finished consumer goods would be sold against gold coins at the retail counter. Semi-finished goods at various stages of production and distribution would be traded against bills of exchange. At the end of each quarter all transactions are cleared, and all outstanding bills paid from the proceeds of the final sale of first-order goods into which fast-moving higher-order goods have matured. The gold coins of the final consumer liquidate all claims that have arisen during the maturation of goods.

### Propensity to Consume

The volume of social circulating capital and changes in its composition are of the highest importance. They change as a result of arbitrage between the consumer goods market and the bill market. The arbitrageur is none other than the shopkeeper who makes the crucial decision which items to carry on his shelves and which ones to discontinue. In these decisions he is guided by one consideration alone: the wishes of the sovereign consumer. For this reason, propensity to consume can be identified with the volume of social circulating capital. If the latter is visualized as a great river emptying into the sea of consumption, then an increase in propensity to consume appears as the merger of some of the tributaries with the main river (tide). Conversely, a decrease appears as the separation of a new tributary from the main flow (ebb).These changes are not merely quantitative but, on a periodic basis, become qualitative following the change of seasons. The composition of social circulating capital is changing along with the change of volume. Above all, it is a change in the variety of its components. Interestingly, the mechanism whereby the wishes of the sovereign consumer are transmuted into changes of stock in the retail store, to wit, arbitrage of the marginal shopkeeper between the bill market and the consumer goods market, has escaped the attention of the economists. A detailed analysis follows.

### Marginal Productivity of Social Circulating Capital

Each merchandise on the shelf of every retail shopkeeper has a productivity of its own that can be measured by the ratio of the percentage of the retail mark-up (with due allowance being made for overhead) to the average length of its sojourn on the shelf. Thus if the retail mark-up on \$1 worth of sauerkraut is ½ cent and the average sojourn on the shelf of one bottle is three months, then the productivity of sauerkraut is (1/2)/(3/12) = 2% per annum. The merchandise on the shelf of the marginal shopkeeper with the lowest productivity is called the marginal item of social circulating capital. The marginal shopkeeper is the one who is first to change the composition of his stock at the first sign of change in the willingness, buying habits, and taste of the consumer. In other words, the marginal shopkeeper adjusts the volume of social circulating capital to the propensity to consume. The marginal item will disappear from the shelf as propensity to consume declines, because it will not be re-ordered by the marginal shopkeeper, and no more bills will be drawn against its movement from producer to consumer. Another item on the shelf with a higher productivity will take its place as the new marginal item.

The rate of marginal productivity of social circulating capital is the productivity of the marginal item. In more details, it is the rate at which the opportunity cost of carrying the marginal item on the shelf becomes critical to the marginal shopkeeper. The reference is to his opportunity to carry bills drawn on other shopkeepers with faster-moving merchandise, rather than carrying the marginal item on his shelf. Indeed, the marginal shopkeeper is doing arbitrage: he is letting his stock of marginal merchandise run down whenever the rate of marginal productivity of social circulating capital increases. This happens precisely when the propensity to consume declines.

The old marginal item with a low productivity gives way to the new with a higher productivity.

Through his arbitrage the marginal shopkeeper is able to escape a deep cut in his income due to seasonal and other changes in demand. He can, thanks to his portfolio of real bills, participate in the higher earnings of his colleagues operating with higher productivity. Conversely, the marginal shopkeeper will sell bills from portfolio and re-order some (heretofore submarginal) merchandise which he is now willing to carry in stock, provided that the rate of marginal productivity of social circulating capital decreases. This happens precisely when the propensity to consume rises.

Higher consumer spending will promote a submarginal item with a lower productivity to become the new marginal item. Thus we have proved our First Theorem asserting that the rate of marginal productivity of social circulating capital varies inversely with the propensity to consume.

### Discount Rate

The arbitrage of the marginal shopkeeper between the bill market and the consumer goods market is the centerpiece of the analysis of the discount rate. We shall now prove our Second Therorem asserting that the discount rate is equal to the rate of marginal productivity of social circulating capital. At every moment the marginal shopkeeper (who may be impersonated by a different shopkeeper from one point in time to the next) is guided by two indicators: (1) the rate of marginal productivity of social circulating capital; (2) the discount rate. If the former is higher, then he will sell real bills from portfolio and order a new marginal item to display on his shelf. As a consequence (1) decreases while (2) increases (since the fall in the price of real bills makes the discount rate rise). Conversely, if the latter is higher, then he will discontinue offering the marginal item and will purchase real bills to put in portfolio instead. As a consequence (1) increases while (2) decreases (since the rise in the price of real bills makes the discount rate fall). In either case the two rates get equalized.

A higher discount rate heralds to all shopkeepers a decline in the propensity to consume. Instead of re-ordering marginal merchandise they will in response buy real bills in order to benefit from the higher discount rate. Social circulating capital shrinks. Conversely, a lower discount rate heralds to all shopkeepers a rise in the propensity to consume. They can now beat the discount rate by offering a greater variety of goods to the consumer, so they will reduce their portfolio of real bills while ordering new merchandise to display on their shelves. Social circulating capital expands.

This arbitrage of the marginal shopkeeper between the consumer goods market and the bill market that regulates the discount rate is analogous to, but conceptually is very different from, the arbitrage of the marginal producer between the producer goods market and the bond market that regulates the (ceiling for the) rate of interest. Comparison of the two reveal that the discount rate is different from the rate of interest. The economic forces changing the two rates are different.

The force driving the rate of interest is the propensity to save. As is well-known, the rate of interest varies inversely with the propensity to save. The force driving the discount rate is the propensity to consume. It is immediate from our First and Second Theorems that the discount rate varies inversely with the propensity to consume: rising propensity to consume is tantamount to a falling discount rate and vice versa.

It is important to note that the two propensities are not complementary. A third one, the propensity to hoard, is sandwiched between them. Thus it is possible for the rate of interest and the discount rate to rise together. It simply means that people are hoarding goods. By the same token it is also possible for the two rates to fall together. It means that people are dishoarding previously hoarded goods. The propensity to hoard plays a pivotal role in the genesis of the Kondratiev longwave cycle. This is a topic for a forthcoming article.

There is only one constraint limiting the relative moves of the two rates. The rate of interest is not at liberty to fall below the discount rate. Having said that, we must admit that illicit interest arbitrage, or financing bond purchases through the sale of bills at the lower discount rate (a.k.a. borrowing short in order to lend long) could engineer such a fall. This has been a lucrative if illegitimate source of profits for banks quick to make a buck by short-changing the public. Illicit interest arbitrage plays a pivotal role in the genesis of the business cycle. Again, this is a topic for another forthcoming article.

### Supply/Demand Equilibrium

We conclude that the vulgar supply/demand equilibrium model is inoperative in the consumer goods market. Supply is not an independent variable: it is closely regulated by demand through changes in the discount rate. It is insulated from the “slings and arrows of outrageous fortune” by the paraphernalia of self-liquidating credit. An increase in demand lowers the discount rate, which quickly brings out a greater variety of consumer goods. Conversely, a decrease in demand raises the discount rate, which quickly eliminates marginal merchandise from the shelves of retail stores.

Consumers who still want them will have to look for them in specialty shops where they will be available albeit at a higher price, since moving them can no longer be financed through real bills, that is, through self-liquidating credit at the discount rate. It has to be financed through funds borrowed at the higher interest rate. Thus we observe the curious but pleasing fact that the price of goods belonging to the social circulating capital cannot be upset through supply and demand shocks.

Economists who are unable to distinguish between the discount rate and the rate of interest are at a loss to explain why retail prices under the gold standard were stable even in the face of changing demand. Their denial of concepts such as liquidity and economic entropy reduces them to play the role of stooges riding on the coattails of the enemies of freedom, the protagonists of irredeemable currency. The latter know full well that they have nothing to fear from a color-blind gold standard outlawing the bill market as it is doomed to failure anyway. Only a gold standard recognizing the full spectrum of colors in the light of liquidity and entropy that rehabilitates international trade in real bills will scare them.

### References

### Adam Smith, The Wealth of Nations, Book 2, Chapters 1-2

### Antal E. Fekete, Where Mises Went Wrong, September 16, 2005

---

# Unemployment: Human Sacrifice on the Altar of Mammon

URL: https://newaustrianeconomics.com/archive/fekete/unemployment-human-sacrifice-on-the-altar-of-mammon/
Date: 2005-09-30
Section: Popular Economics
Difficulty: intermediate
Concept Tags: real-bills, fiat-currency, federal-reserve, monetary-policy, capital-destruction, new-austrian-economics
Description: Fekete argues that mass unemployment under fiat money regimes is not a market failure but a policy outcome — the predictable result of suppressing the Real Bills market and manipulating interest rates downward. Those who lose their jobs are sacrificed on the altar of an irredeemable currency system that benefits financial institutions at the expense of producers and workers.
Editorial Note: Written at the end of September 2005, part of the cluster of essays launching the Revisionist Theory series. Fekete's framing of unemployment as a moral catastrophe caused by monetary policy — rather than business cycle fluctuation — is characteristic of his approach.
Original PDF: https://professorfekete.com/articles/AEFUnemploymentHumanSacrificeAltarOfMammon.pdf

## Unemployment:

### Human Sacrifice on the Altar of Mammon

"Revisionist Theory and History of Money" by Antal E. Fekete,

### Professor, Memorial University of Newfoundland

---

*September 30, 2005*

### Abstract

The Great Depression of the 1930s bringing unprecedented world-wide unemployment in its wake was not caused by the “contractionist nature” of the gold standard as alleged by John M. Keynes. Nor was it caused by “fractional reserve banking” as alleged by Murray N. Rothbard. It was caused by national governments sabotaging the clearing system of the international gold standard, the bill market, thereby destroying the wage fund of workers employed in the production and distribution of consumer goods. In throwing out the bath-water of real bills governments have thrown out the baby of full employment. Unemployment is the modern version of the earlier religious practice of making human sacrifice on the altar of Mammon

### The tale of the cuckoo’s egg

1909 was a milestone in the history of money. That year, in preparation for the coming war, the note issues of the Bank of France and of the Reichsbank of Germany were made legal tender.

Most people did not even notice the subtle change. Gold coins stayed in circulation for another five years. It was not the disappearance of gold coins from circulation that heralded the destruction of the world’s monetary and payments system. There was an early warning: the German and French government’s decision to make bank notes legal tender that would effectively sabotage the clearing system of the international gold standard, the bill market.

Real bills drawn on consumer goods in urgent demand circulated world-wide without let or hindrance before 1909. As goods were moving to the ultimate gold-paying consumer, bills drawn on them matured, as it were, into gold coins, that is to say, into a present good. It is readily seen that the notion of a bill maturing into a legal tender bank note is preposterous. The bank note is not a present good but, like the bill itself, a future good. Furthermore, legal tender means coercion enforced within a given jurisdiction but unenforceable outside. At any rate, legal tender bank notes were incompatible with the voluntary system based on the bill of exchange payable in gold coin at maturity. They were bound to paralyze the market in real bills. The monkey wrench has been thrown into the clearing system of the international gold standard.

The bank of issue continued to use the bill of exchange as an earning asset to back the legal tender bank note issue. But other subtle changes would alter the character of the world’s monetary system beyond recognition. The cuckoo has invaded the neighboring nest to lay her egg surreptitiously. In addition to bank notes originating in bills of exchange bank notes originating in financial bills have made their appearance for the first time. In due course the cuckoo chick would hatch and push the native chick out of the nest. In five years the entire portfolio of the bank of issue consisting of real bills exclusively would be replaced by one consisting of financial bills, including treasury bills. The real bill has become an endangered species. In another five years it would become extinct.

### Bank notes as self-liquidating credit

Previous to 1909 circulating capital for the production of consumer goods in urgent demand had been financed, not out of savings, but through discounting real bills at a commercial bank which would then rediscount them at the bank of issue that supplied the country with bank notes. To be sure, these bank notes represented self-liquidating credit. They were merely a more convenient form of the bill of exchange from which they derived their strength. They came in standard denomination round figures. Unlike the bill of exchange they could without hassle and loss be broken up into smaller units. The great convenience they offered was valued by the public so much that people were willing to pay for it in the form of forgone discount.

When the bill matured and was paid, the bank note was retired. For this very reason it was not inflationary, not any more than the real bill itself. The bank of issue would under no circumstances prolong credit beyond the maturity date of the rediscounted bill. If the underlying merchandise could not be sold in 91 days then, for the stronger reason, it would not be sold in 365 days, certainly not before the same season of the year came around once more. But by that time the merchandise would be stale and could only be sold at a loss. Prolonging credit on a mature bill would violate the letter and spirit of the law governing central banking in Germany prior to 1909.

Could a commercial bank, nevertheless, roll over a real bill at maturity? On strictly economic grounds it wouldn’t. First of all, it would forfeit its rediscounting privileges at the bank of issue if it did. Secondly, it would make its portfolio less liquid and so it could no longer compete successfully with more liquid banks. Having said this, we must admit that in practice some banks may have been guilty of rolling over mature real bills for various reasons. At the benign end of the spectrum the reason could be a false sense of loyalty to clients; at the malignant, conspiracy with them in speculative ventures. It was this latter practice that could be properly condemned as “credit expansion”. However, the unethical behavior of some banks should be no grounds for issuing a blanket condemnation of all banks and calling the legitimate practice of discounting real bills “credit expansion” with a disapproving connotation.

### Real bills versus financial bills

The changeover from bank notes backed by real bills to bank notes backed by financial bills was the last nail in the coffin of the clearing system of the international gold standard. Monetary scientists and others with intellectual power to grasp the intricacies of bank note circulation raised their voice condemning the new paradigm making financial bills eligible for rediscount, a practice that had previously been prohibited by law with severe penalties for non-compliance. Most people could not understand what the fuss was about. But there was a world of a difference between rediscounting real bills as opposed to financial bills. It was the difference between self-liquidating credit and non-self-liquidating credit. Real bills were backed by a huge international bill market with its practically inexhaustible demand for liquid earning assets. Financial bills were backed by the odds that speculative inventory of goods and equities or investment in brick and mortar may be unwound without a loss. If the odds did not play out in time, then at maturity the financial bills would have to be rolled over. This was borrowing short and lending long through the back door, carrier of the seeds of self-destruction.

### The chimera of “fractional reserve banking”

Financial bills made the asset portfolio of the bank of issue illiquid. The bank could no longer satisfy potential demand for gold coins, should holders of bank notes decide to exercise their legal right to redeem them. To take away this right was the reason for making bank notes legal tender in the first place. Redemption wouldn’t be a problem as long as the asset portfolio consisted of real bills exclusively. Every single day one-ninetieth of the outstanding bank notes matured into gold coins which were available for redemption. This would normally suffice to satisfy daily demand. But what about abnormal demand for gold coins?

A real bill is the most liquid earning asset in existence. At any time somewhere in the world there is demand for it. In particular, banks that have a temporary overflow of gold would be more than anxious to exchange it for real bills. The bank of issue would not have the slightest difficulty to get gold in exchange for real bills in the international bill market. Once upon a time the Bank of England boasted that “it could draw gold from the moon by raising the rediscount rate to 5%.” The assumption that there will always be takers for real bills offered is just as safe as the assumption that people will want to eat, get clad, keep themselves warm and sheltered tomorrow and every day thereafter.

This explodes the blanket condemnation of “fractional reserve banking”, a stand so popular nowadays in some circles. Detractors of fractional reserve banking are barking up the wrong tree.

They should condemn the practice of rediscounting financial bills on the same terms as real bills.

The latter were self-liquidating, while the former had impaired liquidity: under certain circumstances they might become unsaleable even in peacetime. They were simply unsuitable to serve as bank reserves.

Prior to 1909 the charter of every bank of issue explicitly made financial bills ineligible for rediscounting. The laws governing central banking prohibited the use of these bills for the purposes of backing the note issue, and prescribed heavy penalties for non-compliance. This was not a controversial issue. Informed people could distinguish between safe banking that utilized real bills and unsafe banking that utilized financial bills to back the note issue. That judgment is epitomized by the old saying that “the easiest profession in the world is that of the banker, provided that he can tell a bill and a mortgage apart”.

### Reflux

The process of retiring the bank note after the merchandise serving as the basis for its issue has been removed from the market by the ultimate gold-paying consumer is called “reflux”. Some authors ridiculed the concept calling it a deus ex machina. They argued that the banks were only interested in credit expansion, not in reflux. They would not for one moment think of withdrawing a corresponding amount of bank notes from circulation when the real bill matured. Instead, they would lend them out at interest to enrich themselves at the expense of the public. For the stronger reason, you could also ridicule the entire legal system asking the rhetorical question: “what is the point in making laws when they will be broken anyhow?” This is not a valid argument.

You can’t judge the merit of an institution by the behavior of those who are set upon destroying it.

Let us follow the trail of gold coins through the path of reflux. Our description is necessarily schematic. For the sake of simplicity we assume that only distributor-on-retailer bills are discounted. This is reasonable as these bills are more liquid than producer-on-distributor bills, or higher-order-producer-on-lower-order-producer bills. We also assume that the retailer is expected to pay his bill with gold coins flowing to him from the consumers. The gold is considered proof that the merchandise underlying the bill has been sold to the ultimate consumer and is not held, contrary to the purpose of bill circulation, in speculative stores in anticipation of a price rise.

Finally, our description follows the practice of the German banking system as it was before 1909.

The practice elsewhere may have been different, but the essential idea was the same: with the sale of merchandise the gold coin was recycled from the consumer through the retail merchant to the commercial bank, from where it would be withdrawn by producers in order to pay wages, thus putting the gold coin back into the hand of the consumers. Then the cycle of supplying the consumer with urgently demanded merchandise could start all over again.

In more details, as gold coins flowed from the consumer to the retail merchant, they were deposited at the commercial bank. When he was ready to replenish his depleted inventory, the retailer ordered a fresh supply and, after endorsing the bill he returned it to the distributor. The latter would discount it at the commercial bank taking the proceeds in the form of bank notes which the commercial bank obtained from the bank of issue through rediscounting.

The distributor would use the bank notes to pay the producer of first order goods for supplies. The latter would use them to pay the producer of second order goods for supplies, and so on. But when it came to paying wages, all these producers had to draw out gold coins from the commercial bank against bank notes. Upon maturity the commercial bank paid the rediscounted bill with bank notes which the bank of issue was under obligation to retire. It could not lend them out at interest. If it did, it would violate the law, and would have to pay heavy penalties. The only purpose the retired bank notes could be used for was to rediscount fresh bills drawn on new consumer goods moving to the ultimate gold-paying consumer. This was not the same as lending them out at interest, since lending and discounting were two entirely different banking functions.

Now the gold coin was in the hands of the wage-earner. As he spent it in buying consumer goods he enabled the retail merchant to make payments on his discounted bill at the commercial bank with gold. When paid in full, it was returned to the retail merchant and the bill’s ephemeral life as a means of payment has come to an end. But the march of gold coins would continue. They would be withdrawn by the producers to pay wages, and the cycle of supplying wage-earners with consumer goods against payment in gold coin could start all over again.

### Mistaking the back-seat driver for the boss in the driver seat

The havoc that the silent monetary revolution of 1909 would wreak upon society had not been foreseen. Nor was the causal relation between the expulsion of real bills and massive unemployment recognized in retrospect after the worst happened and almost 50% of trade union members, or 8 million people, lost their jobs in Germany alone.

Real bills finance the movement of consumer goods, including wages paid to people handling the maturing merchandise through the various stages of production and distribution. The size of circulating capital needed to move the mass of consumer goods through these stages, if financed out of savings, would be staggering. Quite simply, it could not be done. No conceivable economy would produce savings so generously as to be able to finance all circulating capital that society needed in order to flourish at present levels of comfort and security. To move a \$100 item all the way to the consumer may, in an extreme case, require savings in the order of \$5000, or 50 times retail value!

Fortunately, there is no need to employ savings in such a wasteful manner. It is true that fixed capital must be financed out of savings. As a result, creation of fixed capital depends on the propensity to save. Not so circulating capital, provided that the merchandise moves fast enough to the ultimate gold-paying consumer. It can be financed through self-liquidating credit which depends on the propensity to consume, but is independent from the propensity to save.

The discovery of this fact is one of the great achievements of the human spirit and intellect, on a par with the discovery of indirect exchange. The impact on human life of the invention of the circulating bill of exchange is fully commensurate with that of the invention of the wheel. The detractors of the Real Bills Doctrine have missed one of the most exciting developments of our civilization: the discovery of self-liquidating credit in the wake of the disappearance of risks in the production process as the maturing good gets within earshot of the final gold-paying consumer.

Pari passu with the emergence of the need for consumer goods the means to finance their production and distribution emerges as well. It is in the form of the bill of exchange. Retailers and distributors hardly ever pay cash for supplies of consumer goods. “91 days net” is invariably part of the deal, to give ample time for the merchandise to reach the ultimate gold-paying consumer.

Producers of higher-order goods could fold tent and go out of business if they insisted on cash payment for the supplies they provide. Producers of lower-order goods were the boss by virtue of being that much closer to the ultimate consumer and his gold coin. They would laugh you out of court if you told them that they have just been granted a loan and the discount is just interest taken out of the proceeds in advance. They know better. They know that self-liquidating credit is theirs for the taking. They know that the discount rate has nothing to do with the rate of interest.

For a consideration they may be willing to prepay their bill before maturity. The privilege is theirs.

The discount is just the consideration to tempt them. Those who insist that the producer of the higher-order good is the lender and that of the lower-order good is the borrower are mistaking the back-seat driver for the boss in the driver seat.

### The biggest job-destruction ever

Let us now see how the governments destroyed the wage fund of workers employed in the sector providing goods and services to the consumer. These workers’ wages were financed through the trade in real bills. The emerging consumer good they handled would not be sold to the ultimate consumer for 91 days at the latest. Yet in the meantime these workers had to eat, get clad, keep themselves warm and sheltered. If they could, it was only because real bills trading would keep replenishing their wage fund.

In order to create a job capital must be accumulated through savings. This applies to the fixed capital deployed in making both producer goods and consumer goods. In case of the former it applies to circulating capital as well. But if circulating capital had to be accumulated through savings in the latter case, too, then jobs in the consumer goods sector would be few and far in between. In the event jobs were plentiful in that sector because of the fact that circulating capital supporting them could be financed through self-liquidating credit that did not tie up savings. By contrast, jobs in the producers good sector could not be financed in this way, explaining why they were not nearly as plentiful nor as easily available.

When governments locked out real bills from the payments system, they inadvertently destroyed the wage fund of workers employed in the sector providing goods and services for the consumer.

Unless they were prepared to assume responsibility for paying wages, there would be unemployment on a massive scale that would spill over to all other sectors as well. Eventually the governments, to avoid undermining social peace, decided to do just that. They invented the socalled “welfare state” paying so-called “unemployment insurance” to people who could have easily found employment had the clearing system of the gold standard, the bill market, been allowed to make a come-back after World War I. What has been hailed as a heroic job-creation program appears, in the present light, as a miserable effort at damage control by the same government that has destroyed those jobs in the first place. Economists share responsibility for the disaster. They have never examined the 1909 decision to make bank notes legal tender from the point of view of its effect on employment. They should have demanded that, instead of treating the symptoms, the government remove the cause in reinstating the international gold standard and its clearing system, the bill market. They should have demanded that the government abolish the legal tender privilege of bank notes forthwith.

It took 20 years for the chickens of 1909 to come home to roost. But come home they did with a vengeance. However, by 1929 the memory of the 1909 coercive manipulation of bank notes faded, and virtually no one realized that a causal relationship existed between the two events: making bank notes legal tender and the wholesale destruction of jobs twenty years later.

### The father of revisionist theory and history of money

One man who did, and whom we salute as the father of revisionist theory and history of money, was Professor Heinrich Rittershausen of Germany. In his 1930 book Arbeitslosigkeit und Kapitalbildung (Unemployment and Capital Formation) he predicted not only the imminent collapse of the gold standard but also the wholesale destruction of jobs world-wide as a result of the explosion of the time bomb planted in 1909, wrecking the clearing system of the international gold standard, the bill market. The horrible unemployment Rittershausen predicted would continue to haunt the world for the rest of the 20th century and beyond.

If we want to exorcise the world of the incubus of unemployment with which it has been saddled by greedy governments making bank notes legal tender in their worship of Mammon, not only must we return to the international gold standard, but we must also rehabilitate its clearing system, the bill market. In this way the fund, out of which wages to all those eager to earn them for work in providing the consumer with goods and services can be paid, will be resurrected.

Then, and only then, can the so-called welfare state paying workers for not working and farmers for not farming be dismantled.

### References

Heinrich Rittershausen, Arbeitslosigkeit und Kapitalbildung, Jena: Fischer, 1930.

A Spanish translation of this volume including an essay of von Beckerath was published in Barcelona in 1934.

Heinrich Rittershausen, Zahlungsverkehr, Einkaufsscheine und Arbeitsbeschaffung, published in the Annalen der Gemeinwirtschaft, vol. 10, p 153-207, Jan.-July, 1934.

This paper is also available in English translation (by G. Spiller) under the title Unemployment as a Problem of Turnover Credits and the Supply of Means of Payment, in the volume: Ending the Unemployment and Trade Crisis, p 137-187, London: William and Northgate, 1935.

A French translation (apparently of a better quality) under the title Organisation des echange et creation de travail can be found in the volume Le chomage, probleme de credit commercial et d’approvisionnement en moyens de paiement, p 154-214, Paris: Recueil Sirey, 1934.

Antal E. Fekete, Adam Smith’s Real Bills Doctrine, Monetary Economics 101, Gold Standard University, 2002.

Antal E. Fekete, Detractors of Adam Smith’s Real Bills Doctrine, July 2005.

### Acknowledgement

The author is grateful to Dr. Theo Megalli of Plattling, Germany, for bringing the work of Heinrich Rittershausen to his attention. The biography of H. Rittershausen (1898-1984) by Dr. Megalli can be found on the website.

---

# A Revisionist Theory and History of Money: Real Bills and Employment

URL: https://newaustrianeconomics.com/archive/fekete/a-revisionist-theory-real-bills-and-employment/
Date: 2005-09-26
Section: Popular Economics
Difficulty: scholarly
Concept Tags: real-bills, self-liquidating-credit, bills-of-exchange, new-austrian-economics, gold-standard, capital-destruction
Description: The second installment of the Revisionist Theory series examines how the destruction of the Real Bills market caused the unemployment of the Great Depression. Real bills created the monetary circulation needed to move consumer goods from producers to retailers without drawing on gold — their elimination caused deflationary monetary contraction that manifested as mass unemployment.
Editorial Note: Second in the 'Revisionist Theory and History of Money' series. Fekete makes his most direct connection between the Real Bills Doctrine and employment theory, directly challenging Keynesian explanations of unemployment with a pre-Keynesian monetary mechanism.
Original PDF: https://professorfekete.com/articles/AEFRevHistRealBillsAndEmployment.pdf

### September, 2005

*"A Revisionist Theory And History Of Money" Real Bills And Employment*

**Antal E. Fekete** · Professor · Memorial University of Newfoundland e-mail: aefekete@hotmail.com

### The tale of the cuckoo's egg

1909 was a milestone in the history of money. That year, in preparation for the coming war, the note issues of the Bank of France and of the Reichsbank of Germany were made legal tender. Most people did not even notice the subtle change. Gold coins stayed in circulation for another five years. It was not the disappearance of gold coins from circulation that heralded the destruction of the world's monetary and payments system.

There was an early warning: the German and French government's decision to make bank notes legal tender that would effectively sabotage the clearing system of the international gold standard, the bill market.

Real bills drawn on consumer goods in urgent demand circulated worldwide without let or hindrance before 1909. As goods were moving to the ultimate gold-paying consumer, bills drawn on them matured, as it were, into gold coins, that is to say, into a present good. It is readily seen that the notion of a bill maturing into a legal tender bank note is preposterous. The bank note is not a present good but like the bill itself, a future good.

Furthermore, legal tender means coercion enforced within a given jurisdiction but unenforceable outside. At any rate, legal tender bank notes were incompatible with the voluntary system based on the bill of exchange payable in gold coin at maturity. They were bound to paralyze the market in real bills. The monkey wrench has been thrown into the clearing system of the international gold standard.

The bank of issue continued to use the bill of exchange as an earning asset to back the legal tender bank note issue. But other subtle changes would alter the character of the world's monetary system beyond recognition. The cuckoo has invaded the neighboring nest to lay her egg surreptitiously. In addition to bank notes originating in bills of exchange bank notes originating in financial bills have made their appearance for the first time. In due course the cuckoo chick would hatch and push the native chick out of the nest. In five years one consisting of financial bills and treasury bills would replace the entire portfolio of the bank of issue consisting of real bills exclusively. The real bill has become an endangered species. In another five years it would become extinct.

### Bank notes as self-liquidating credit

Previous to 1909 circulating capital for the production of consumer goods in urgent demand had been financed, not out of savings, but through discounting real bills at a commercial bank, which would then be rediscounted at the bank of issue that supplied the country with bank notes. To be sure, these bank notes represented self-liquidating credit.

They were merely a more convenient form of the bill of exchange from which they derived their strength. They came in standard denomination round figures. Unlike the bill of exchange they could without hassle and loss be broken up into smaller units. The great convenience they offered was valued by the public so much that people were willing to pay for it in the form of forgone discount.

When the bill matured and was paid, the bank note was retired. For this very reason it was not inflationary, not any more than the real bill itself. The bank of issue would under no circumstances prolong credit beyond the maturity date of the rediscounted bill. If the underlying merchandise could not be sold in 91 days then, for the stronger reason, it would not be sold in 365 days, certainly not before the same season of the year came around once more. But by that time the merchandise would be stale and could only be sold at a loss. Prolonging credit on a mature bill would violate the letter and spirit of the law governing central banking in Germany prior to 1909.

Could a commercial bank, nevertheless, roll over a real bill at maturity? On strictly economic grounds it wouldn't. First of all, it would forfeit its rediscounting privileges at the bank of issue if it did. Secondly, it would make its portfolio less liquid and so it could no longer compete successfully with more liquid banks. Having said this, we must admit that in practice some banks may have been guilty of rolling over mature real bills for various reasons. At the benign end of the spectrum the reason could be a false sense of loyalty to clients; at the malignant, conspiracy with them in speculative ventures. It was this latter practice that Ludwig von Mises could have properly condemned as "credit expansion". Be that as it may, the unethical behavior on the part of some banks should be no grounds for issuing a blanket condemnation of all banks and calling the legitimate practice of discounting real bills "credit expansion" with a disapproving connotation.

The lesson from negative past experience should be learned and, in the future, full disclosure should be made mandatory for commercial banks discounting bills. They should be obliged by law to publish their portfolio of real bills quarterly. Clients would thus be enabled to identify delinquent banks, which habitually make their portfolio illiquid by sheltering dubious assets such as bills doing overtime after maturity, whereupon they could take their business elsewhere to more liquid banks.

The retired bank note could not be re-issued until and unless a fresh bill representing new merchandise in urgent demand was offered for rediscount. Re-issuing it under any other circumstance would be tantamount to rolling over real bills at maturity, that is, borrowing short in order to lend long.

### Real bills versus financial bills

The changeover from bank notes backed by real bills to bank notes backed by financial bills was the last nail in the coffin of the clearing system of the international gold standard. Monetary scientists and others with intellectual power to grasp the intricacies of bank note circulation raised their voice condemning the new paradigm making financial bills as well as treasury bills eligible for rediscount. A practice that had previously been prohibited by law with severe penalties for noncompliance. Most people could not understand what the fuss was about. But there was a world of a difference between rediscounting real bills as opposed to financial bills. It was the difference between self-liquidating credit and non-self-liquidating credit. Real bills were backed by a huge international bill market with its practically inexhaustible demand for liquid earning assets. Financial bills were backed by the odds that speculative inventory of goods and equities or investment in brick and mortar may be unwound without a loss. Treasury bills were backed by future tax receipts. If anticipation attached to financial and treasury bills did not materialize in time, then at maturity they would have to be rolled over. This was borrowing short and lending long through the back door: carrier of the seeds of self-destruction.

### The chimera of "fractional reserve banking"

Financial bills made the asset portfolio of the bank of issue illiquid. The bank could no longer satisfy potential demand for gold coins, should holders of bank notes decide to exercise their legal right to redeem them. To take away this right was the reason for making bank notes legal tender in the first place. Remember that redemption wouldn't be a problem as long as the asset portfolio consisted of real bills exclusively. Every single day one-ninetieth of the outstanding bank notes matured into gold coins which were available for redemption. This would normally suffice to satisfy daily demand. But what about abnormal demand for gold coins?

A real bill is the most liquid earning asset in existence. At any time somewhere in the world there is demand for it. In particular, banks that have a temporary overflow of gold would be more than anxious to exchange it for real bills. In peacetime the bank of issue would not have the slightest difficulty to get gold in exchange for real bills in the international bill market. Once upon a time the Bank of England boasted "it could draw gold from the moon by raising the rediscount rate to 5%." The assumption that there will always be takers for real bills offered is just as safe as the assumption that people will want to eat, get clad, keep themselves warm and sheltered tomorrow and every day thereafter.

This explodes the blanket condemnation of "fractional reserve banking", a stand so popular nowadays in some circles. The detractors of fractional reserve banking are barking up the wrong tree. They should condemn the practice of rediscounting financial or treasury bills on the same terms as real bills. The latter were self-liquidating, while the former had impaired liquidity: under certain circumstances they might become unsaleable even in peacetime. They were simply unsuitable to serve as bank reserves.

The case is otherwise with real bills, which are the most liquid earning asset a bank can have. There is always a ready market for them as other banks with an excess of gold scramble to get liquid earning assets. It is a grave error to equate fractional reserve banking with liquid reserves (real bills) to that with illiquid reserves (financial bills and treasury bills). Those who do had better take a refresher course on liquidity.

This problem has been thoroughly researched by a host of competent experts in the 19th century. There is a voluminous literature on this subject. It was not produced by "monetary cranks" or by "inflationists". It was produced by the best minds dedicated to sound monetary and fiscal policy. Their unanimous judgment still stands: real bills, to the exclusion of financial and treasury bills, are by far the safest earning assets that a bank of issue can have. Prior to 1909 the charter of banks of issue explicitly made financial and treasury bills ineligible for rediscounting. Moreover, the laws governing central banking prohibited the use of these bills for the purposes of backing the note issue, and prescribed heavy penalties for non-compliance. This was not a controversial issue. Informed people could distinguish between safe banking that utilized real bills and unsafe banking that utilized financial and treasury bills to back the note issue. That judgment is epitomized by the old saying that "the easiest profession in the world is that of the banker, provided that he can tell a mortgage and a real bill apart".

It is regrettable that latter-day critics are totally unfamiliar with this particular body of knowledge, and confuse fractional reserve banking based on sound assets with fractional reserve banking based on unsound assets. It is ironic that they do exactly the same in the name of sound money what the enemies of freedom have done and are doing in the name of irredeemable currency, namely, to wipe out the important distinction between liquid and illiquid bank reserves.

At the very least these detractors of fractional reserve banking should familiarize themselves with the literature on the subject so that they could confront their antagonists intelligently. Issuing blanket condemnation and broadsides is no substitute for reasoning.

Calling everybody a "monetary crank" and "inflationist" who considers real bills payable in gold coin a proper and safe asset to hold in bank reserve to balance part of the note and deposit liability reflects negatively upon the name-caller far more than upon his target.

### Reflux

The process of retiring the bank note after the merchandise serving as the basis for its issue has been removed from the market by the ultimate gold-paying consumer is called "reflux". Several authors, including Ludwig von Mises, ridiculed the concept calling it a deus ex machina. They argued that the banks were only interested in credit expansion, not in reflux. They would not for one moment think of withdrawing a corresponding amount of bank notes from circulation when the real bill matured. Instead, they would lend them out at interest to enrich themselves at the expense of the public. For the stronger reason, you could also ridicule the entire legal system asking the rhetorical question: "what is the point in making laws when they will be broken anyhow?" This is not a valid argument.

You can't judge the merit of an institution by the behavior of those who are set upon destroying it.

Let us follow the trail of gold coins through the path of reflux. Our description is necessarily schematic. For the sake of simplicity we assume that only distributor-onretailer bills are discounted. This is reasonable as these bills are more liquid than producer-on-distributor bills, or higher-order-producer-on-lower-order-producer bills. We also assume that the retailer is expected to pay his bill with gold coins flowing to him from the consumers. The gold is considered proof that the merchandise underlying the bill has been sold to the ultimate consumer and is not held, contrary to the purpose of bill circulation, in speculative stores in anticipation of a price rise. Finally, our description follows the practice of the German banking system as it was before 1909. The practice elsewhere may have been different, but the essential idea was the same: with the sale of merchandise the gold coin was recycled from the consumer through the retail merchant to the commercial bank, from where it would be withdrawn by producers in order to pay wages, thus putting the gold coin back into the hand of the consumers. Then the cycle of supplying the consumer with urgently demanded merchandise could start all over again.

In more details, as the gold coins flowed from the consumer to the retail merchant, the latter deposited them at the commercial bank. When he was ready to replenish his depleted inventory, the retailer ordered a fresh supply from the distributor, and after endorsing it he returned the bill to the distributor. The latter would discount it at the commercial bank taking the proceeds in the form of bank notes, which the commercial bank obtained from the bank of issue through rediscounting.

The distributor would use the bank notes to pay the producer of first order goods for supplies. The latter would use them to pay the producer of second order goods for supplies, and so on. But when it came to paying wages, all these producers had to draw out gold coins from the commercial bank against bank notes. Upon maturity the commercial bank paid the rediscounted bill with bank notes, which the bank of issue was under obligation to retire. It could not lend them out at interest. If it did, it would violate the law, and would have to pay heavy penalties. The only purpose the retired bank notes could be used for was to rediscount fresh bills drawn on new consumer goods moving to the ultimate gold-paying consumer. Remember that this was not the same as lending them out at interest, since lending and discounting were two entirely different banking functions.

Now the gold coin was in the hands of the wage earner. As he spent it in buying consumer goods he enabled the retail merchant to make payments on his discounted bill at the commercial bank with gold. When paid in full, it was returned to the retail merchant and the bill's ephemeral life as a means of payment has come to an end. But the march of gold coins would continue. They would be withdrawn by the producers to pay wages, and the cycle of supplying wage earners with consumer goods against payment in gold coin could start all over again.

### Mistaking the back-seat driver for the boss in the driver seat

The havoc that the silent monetary revolution of 1909 would wreak upon society had not been foreseen. Nor was the causal relation between the expulsion of real bills and massive unemployment recognized in retrospect after the worst has happened and almost 50% of trade union members, or 8 million people, lost their jobs in Germany alone.

Real bills finance the movement of consumer goods, including wages paid to people handling the maturing merchandise through the various stages of production and distribution. The size of circulating capital needed to move the mass of consumer goods through these stages, if financed out of savings, would be staggering. Quite simply, it could not be done. No conceivable economy would produce savings so generously as to be able to finance all circulating capital that society needed in order to flourish at present levels of comfort and security. In an earlier article ("Detractors of Adam Smith's Real Bills Doctrine") I did the math to prove this. I calculated that to move a \$100 item all the way to the consumer may, in an extreme case, require savings in the order of \$5000, or 50 times retail value!

Fortunately, there is no need to employ savings in such a wasteful manner. It is true that fixed capital must be financed out of savings. As a result, creation of fixed capital depends on the propensity to save. Not so circulating capital, provided that the merchandise moves fast enough to the ultimate gold-paying consumer. It can be financed through self-liquidating credit which depends on the propensity to consume, but is independent from the propensity to save.

The discovery of this fact is one of the great achievements of the human spirit and intellect, on a par with the discovery of indirect exchange. The impact on human life of the invention of the circulating bill of exchange is fully commensurate with that of the invention of the wheel. The detractors of the Real Bills Doctrine have missed one of the most exciting developments of our civilization: the discovery of self-liquidating credit in the wake of the disappearance of risks in the production process as the maturing good gets within earshot of the final gold-paying consumer.

Pari passu with the emergence of the need for consumer goods the means to finance their production and distribution emerges as well. It is in the form of the bill of exchange.

Retailers and distributors hardly ever pay cash for supplies of consumer goods. "91 days net" is invariably part of the deal, to give ample time for the merchandise to reach the ultimate gold-paying consumer. Producers of higher-order goods could fold tent and go out of business if they insisted on cash payment for the supplies they provide. Producers of lower-order goods were the boss by virtue of being that much closer to the ultimate consumer and his gold coin. They would laugh you out of court if you told them that they have just been granted a loan and the discount is just interest taken out of the proceeds in advance. They know better. They know that self-liquidating credit is theirs for the taking.

They know that the discount rate has nothing to do with the rate of interest. For a consideration they may be willing to prepay their bill before maturity. The privilege is theirs. The discount is just the consideration to tempt them. Those who insist that the producer of the higher-order good is the lender and that of the lower-order good is the borrower are mistaking the back-seat driver for the boss in the driver seat.

### The biggest job-destruction ever

Let us now see how the governments destroyed the wage fund of workers employed in the sector providing goods and services to the consumer. These workers' wages were financed through the trade in real bills. The emerging consumer good they handled would not be sold to the ultimate consumer for 91 days at the latest. Yet in the meantime these workers had to eat, get clad, keep themselves warm and sheltered. If they could, it was only because real bills trading would keep replenishing their wage fund.

In order to create a job capital must be accumulated through savings. This applies to the fixed capital deployed in making both producer goods and consumer goods. In case of the former it applies to circulating capital as well. But if circulating capital had to be accumulated through savings in the latter case, too, then jobs in the consumer goods sector would be few and far in between. In the event jobs were plentiful in that sector because of the fact that circulating capital supporting them could be financed through self-liquidating credit that did not tie up savings. By contrast, jobs in the producers good sector could not be financed in this way, explaining why they were not nearly as plentiful nor as easily available.

When governments expelled real bills from the system, they inadvertently destroyed the wage fund of workers employed in the sector providing goods and services for the consumer. Unless they were prepared to assume responsibility for paying wages, there would be unemployment on a massive scale that would spill over to all other sectors as well. Eventually the governments, to avoid undermining social peace, decided to do just that. They invented the so-called "welfare state" paying so-called "unemployment insurance" to people who could have easily found employment had the clearing system of the gold standard, the bill market, been allowed to make a come-back after World War I.

What has been hailed as a heroic job-creation program appears, in the present light, as a miserable effort at damage control by the same government that has destroyed those jobs in the first place. Economists share responsibility for the disaster. They have never examined the 1909 decision to make bank note legal tender from the point of view of its effect on employment. They should have suggested that, instead of treating the symptoms governments should remove the cause. They should reinstate the international gold standard and its clearing system, the bill market.

It took 20 years for the chickens of 1909 to come home to roost. But come home they did with a vengeance. However, by 1929 the memory of the 1909 coercive manipulation of bank notes faded, and virtually no one realized that a causal relationship existed between the two events: making bank notes legal tender and the wholesale destruction of jobs twenty years later.

### The father of revisionist theory and history of money

One man who did, and whom we salute as the father of revisionist theory and history of money, was Professor Heinrich Rittershausen of Germany. In his 1930 book Arbeitslosigkeit und Kapitalbildung (Unemployment and Capital Formation) he predicted not only the imminent collapse of the gold standard but also the wholesale destruction of jobs worldwide as a result of the explosion of the time bomb planted in 1909, wrecking the clearing system of the international gold standard, the bill market. The horrible unemployment Rittershausen predicted would continue to haunt the world for the rest of the 20th century and beyond.

If we want to exorcise the world of the incubus of unemployment with which it has been saddled by greedy governments in making bank notes legal tender, not only must we return to the international gold standard, but we must also rehabilitate its clearing system, the bill market. In this way the fund, out of which wages to all those eager to earn them for work in providing the consumer with goods and services can be paid, will be resurrected. Then, and only then, can the so-called welfare state paying workers for not working and farmers for not farming be dismantled.

### References

Heinrich Rittershausen, Arbeitslosigkeit und Kapitalbildung, Jena: Fischer, 1930. A Spanish translation of this volume including an essay of von Beckerath was published in Barcelona in 1934.

Heinrich Rittershausen, Zahlungsverkehr, Einkaufsscheine und Arbeitsbeschaffung, published in the Annalen der Gemeinwirtschaft, vol. 10, p 153-207, Jan.-July, 1934.

This paper is also available in English translation (by G. Spiller) under the title Unemployment as a Problem of Turnover Credits and the Supply of Means of Payment, in the volume: Ending the Unemployment and Trade Crisis, p 137-187, London: William and Northgate, 1935. See the website:

A French translation (apparently of a better quality) under the title Organisation des echange et creation de travail can be found in the volume Le chomage, probleme de credit commercial et d'approvisionnement en moyens de paiement, p 154-214, Paris:

Recueil Sirey, 1934.

Antal E. Fekete, Adam Smith's Real Bills Doctrine, Monetary Economics 101, Gold Standard University, 2002, see the website: [www.goldisfreedom.com](http://www.goldisfreedom.com),

Antal E. Fekete, Detractors of Adam Smith's Real Bills Doctrine, July 2005, see the website: [www.financialsense.com](http://www.financialsense.com).

### Acknowledgement

The author is grateful to Dr. Theo Megalli of Plattling, Germany, for bringing the work of Heinrich Rittershausen to his attention. The biography of H. Rittershausen (1898-1984) by Dr. Megalli can be found on the website: [www.reinventingmoney.com](http://www.reinventingmoney.com/rittershausenBiography.php).

---

*September 26, 2005.*

---

# A Revisionist Theory and History of Money

URL: https://newaustrianeconomics.com/archive/fekete/a-revisionist-theory-and-history-of-money/
Date: 2005-09-22
Section: Popular Economics
Difficulty: scholarly
Concept Tags: real-bills, self-liquidating-credit, gold-standard, new-austrian-economics, federal-reserve, mises
Description: Fekete presents his revisionist thesis: the Great Depression was caused neither by gold's contractionary nature (Keynes) nor by fractional reserve banking (Rothbard), but by the destruction of the Real Bills market in 1909 when the Federal Reserve Act made self-liquidating credit illegal. The collapse of the bill market severed the link between production and monetary circulation, making depressions inevitable.
Editorial Note: The opening essay of Fekete's major series 'A Revisionist Theory and History of Money' (September 2005). This is foundational reading for understanding the New Austrian School's divergence from both Keynesian and Rothbardian accounts of the Great Depression.
Original PDF: https://professorfekete.com/articles/AEFRevTheoryAndHistoryOfMoney.pdf

### September, 2005

*"A Revisionist Theory And History Of Money"*

**Antal E. Fekete** · Professor · Memorial University of Newfoundland e-mail: aefekete@hotmail.com

The purpose of this new series is to show that the Great Depression of the 1930's bringing unprecedented world-wide unemployment in its wake was not due to the "contractionist" nature of the gold standard as alleged by John M. Keynes. Nor was it due to "fractional reserve banking" as alleged by Murray Rothbard. Rather, it was due to the national governments sabotaging the clearing system of the international gold standard, namely, the bill market.

Adam Smith's Real Bills Doctrine reigned supreme in monetary science throughout the 19th century, and rightfully so. It explained how it was possible to refine division of labor in order to improve the efficiency of labor, and to lengthen production processes making them "more roundabout" in order to improve the efficiency of capital, without causing monetary contraction through unnecessarily invading the pool of circulating gold coins and tying up savings to finance circulating capital. If the goods were demanded urgently enough by the consumer, then circulating capital would be readily available without raiding cookie jars for savings. The written document billing the producer of lower-order goods by the producer of higher-order goods for supplies shipped, when endorsed by the former, would become a means of payment in the hand of the latter. Indeed, bills of exchange circulated on their own wings and under their own steam, without any lending or borrowing involved, merely by virtue of the underlying merchandise moving sufficiently fast to the ultimate gold-paying consumer.

In addition, and most importantly, the Real Bills Doctrine explained how it was possible to pay all those eager to earn wages before the product could be sold, in some cases as many as three months earlier than the final consumer could purchase the finished good! It was not credit, it was clearing that made the realization of these desiderata possible. By abuse of language the bill of exchange is also called an instrument of credit. To guard ourselves against confusion we must carefully distinguish between the two types of credit in calling the latter self-liquidating. This will remind us that it is liquidated at maturity with the gold coin released by the final consumer of the merchandise underlying the bill.

Credit of the first type is not self-liquidating. It may have to be prolonged, if the light at the end of the tunnel still cannot be seen at maturity. All credit of this type must originate in savings. For example, the credit financing fixed capital, or the credit financing circulating capital in case of slow-moving consumer goods or big-ticket items sold on an installment plan must not be financed through the monetization of the bill drawn on the retail merchant. They must be financed through the bond market as distinct from the bill market.

Self-liquidating credit exists quite independently of savings. Its existence is not explained by the propensity to save. It is explained by the propensity to consume. These propensities are not inversely related. They are not the two sides of the same coin. In fact, they are independent variables. A third type, the propensity to hoard, provides a cushion between the two. Thus it is possible for the propensity to save and the propensity to consume to fall together. It means that people are hoarding goods. Conversely, if they rise together, it means that people are dishoarding previously hoarded goods.

The discount rate is not set by the banks. It is governed directly by the consuming public and varies inversely with the propensity to consume. In more details, the discount rate is the inducement to move the retail merchant to prepay his bill before maturity. It should be clear that the lower is the propensity to consume, the greater the inducement must be: it takes longer for the merchandise to clear the shelves. The converse is also true: the higher the propensity to consume, the lower is the discount rate. The cash flow of the retail merchant is greater and he is anxious to put some of his spare cash to work. He does it by prepaying his bills, to earn extra income in the form of saved discount. This also shows that the discount rate has nothing whatever to do with the rate of interest, which varies inversely with the propensity to save. The economic forces governing these two rates are entirely different. It is a grave error to suggest that the discount rate is but a subset of the rate of interest, namely, interest on short-term loans. The two rates must be studied separately if we want to understand the circulation of gold coins and properly issued bank notes in the economy.

---

When World War I broke out, international trade in consumer goods came to a virtual halt, and so did also trade in real bills. The garrison states that emerged after the war would not allow international bill trading to make a comeback. Their aims, to subordinate trade in consumer goods across boundaries to political rather than economic considerations, and to concentrate monetary gold in bank vaults, were not compatible with bill trading which assumed that the gold was outside of the banks in the hand of the wage earning and consuming public. In depriving them of their gold coin governments disenfranchised the wage earner and the consumer. Henceforth producers would not take orders from them. They would take orders only from the banks, the issuers of purchasing media, or from the government in which the new dispensation has vested the ownership of gold.

In vain did the governments try to keep the trappings of a gold standard after the war. It was only a matter of time before the gold standard, bereft of a clearing system, would break down under the strain of world trade, much reduced though it was as compared with its pre-war volume. Financing international trade with gold but without real bills put an enormous yet unnecessary burden on savings. In effect, the managers of this new "cash-and-carry-gold-standard" were attempting the impossible. They wanted to convert the head of a pin into a grand ballroom where all the angels of high heaven could dance together. They wanted to finance all circulating capital out of savings. They attempted to institute what Rothbard later called "100 percent gold standard". Their efforts were doomed to failure.

The international gold standard did not break down because of a shortage of gold, as alleged by government statisticians. It is true that as a result of the war prices and wages had moved to a higher level and they were too "sticky" to come down after war-time shortages were over and destruction healed. But there is no telling how much trade in consumer goods a given amount of gold can support at a given price level, provided that the clearing system of the gold standard is not being sabotaged.

Worst of all, under the regime of "cash-and-carry" wages could no longer be paid in advance of the sale of goods to the ultimate consumer. The wage fund of the sector providing goods and services to the consumer has been destroyed. Unemployment and bankruptcies followed. The world was plunged into the Great Depression. In throwing out the bath water of real bills governments have thrown out the baby of full employment.

We are not arguing here that the destruction of the clearing system of the international gold standard was the only cause of the worldwide unemployment in the 1930's.

Obviously, other causes played a role as well, for example, the monopoly power granted to trade unions, which used it to extort uneconomic wage settlements from the employers.

However, we shall argue that the expulsion of real bills from financing world trade in consumer goods was the major cause, one that has undeservedly been ignored by scholarship.

---

# When Mises Went Wrong

URL: https://newaustrianeconomics.com/archive/fekete/when-mises-went-wrong/
Date: 2005-09-16
Section: Popular Economics
Difficulty: scholarly
Concept Tags: mises, real-bills, gold-standard, new-austrian-economics, interest-theory
Description: Fekete identifies a specific error in Mises's monetary theory: his regression theorem, while valid as far as it goes, fails to account for the gold basis and the role of the bill market in maintaining monetary equilibrium. Mises's dismissal of the Real Bills Doctrine, Fekete argues, led him to misdiagnose the causes of the Great Depression and to overlook the deflationary mechanism that irredeemable currency sets in motion.
Editorial Note: One of Fekete's most significant papers, directly challenging the foundational monetary theory of Ludwig von Mises. Published September 2005 as part of the 'Revisionist Theory and History of Money' series. Fekete's critique has been controversial within Austrian circles but influential in the New Austrian School.
Original PDF: https://professorfekete.com/articles/AEFWhenMisesWentWrong.pdf

WHERE MISES WENT WRONG by Antal E. Fekete,

### Professor, Memorial University of Newfoundland

September 16 2005

Ludwig von Mises erred when he dismissed what is known as the Fullarton Effect. In 1844 John Fullarton of the Banking School described how low interest rates were resisted by savers in selling their gold bonds and hoarding gold instead. Mises ridiculed the idea, calling gold hoards a deus ex machina in Human Action (3rd revised edition, p 440). My theory of interest corrects this mistake in giving due recognition to the Fullarton Effect. I can well understand the frustrations of Robert Blumen, Sean Corrigan, and other detractors of mine reluctant to read the voluminous outpourings of this “inflationist monetary crank”. Rather than finding a weak point in my argument they call me names, stonewall Adam Smith, conjure up the bogyman of John Law, set up straw men only to knock them down again, and quarrel bitterly with my ad hoc examples while ignoring my comprehensive theory of interest. For the benefit of discriminating students of Carl Menger and Eugene Böhm-Bawerk I restate this novel theory in a concise form.

The rate of interest is a market phenomenon. It is defined as the rate at which the coupons of the gold bond amortize its price as quoted in the secondary bond market. The mathematician has shown us formulas expressing the rate of interest in terms of the price of the gold bond. They confirm that the two are inversely related: the higher the bond price, the lower is the rate of interest and vice versa. As a consequence, the lower bid price of the gold bond corresponds to the ceiling and the higher asked price to the floor of the range to which the rate of interest is confined. The question is what economic factors determine these constraints and how.

The floor is determined by the time preference of the marginal bondholder. If the rate of interest falls below it, then he takes profit in selling the overpriced gold bond and will keep the proceeds in gold coin. When the rate of interest bounces in response to bondholder resistance, he will buy back the gold bond at a lower price. The gold hoards are no deus ex machina: they are the very tool of human action in setting a limit to falling interest rates.

The ceiling is determined by the marginal productivity of capital, that is, the rate of productivity of the capital of the marginal producer. If the rate of interest rises above it, then he sells his plant and equipment and invests the proceeds in the underpriced gold bond. When the rate of interest falls back in response to producer resistance, he will sell the gold bond at a profit and use the proceeds to deploy his capital in production once more.

There is no valid reason to denigrate the productivity theory of interest following Mises. The theory of time preference and the productivity theory are not mutually exclusive. On the contrary, they are complementary. The fratricidal wars between the two schools have been in vain: they did not serve the advancement of science. They merely contributed to its retardation. Only a synthesis of the two theories can adequately explain the formation of the rate of interest I submit that my theory of interest brings about such a synthesis. It is in the spirit of Menger and is in harmony with the insights of Böhm-Bawerk. It represents a breakthrough that provides solid foundation for further development of the theory. In Mises, time preference is no more than a pious wish. It is the gold hoards that lend teeth to those wishes. Nothing else can. Mises was not alive to the arbitrage of the marginal bondholder between bonds and gold, the most potent form of arbitrage between present and future goods. Likewise, Mises failed to explain how changes in the rate of interest guide production, to wit, through arbitrage of the marginal producer between bonds and capital goods.

Mises also criticized the Banking School on the subject of reflux (op.cit., p 444). He charged that banks regularly short-circuit reflux by putting retired bank notes back into circulation: “The regular course of affairs is that the bank replaces bills expired and paid by discounting new bills of exchange. Then to the amount of bank notes withdrawn from the market through the repayment of the earlier loan there corresponds an amount of newly issued bank notes.” This ignores the fact that the credit to which each and every non-fraudulent bill gives rise is self-liquidating.

Moreover, if the Reichsbank of Germany, for example, had discounted new bills on the same old merchandise, then it would have violated the law. At any rate, the argument of the Banking School refers to the transparent case of bill circulation. Slow or fraudulent bills can take no refuge in the portfolio of conspiring banks. The bill market is fully capable of ferreting out delinquent bills and will refuse to discount them.

The nexus between drawer and drawee of the bill of exchange is not the same as that between lender and borrower. The drawer is no lender, discounting is no lending, and the discount rate is not the same as the rate of interest. The drawee is the active protagonist in the drama of supplying the consumer with urgently needed goods; the drawer is passive. It is the drawee who promptly reacts to changes in the height of the discount rate. These changes are governed by the consumers. The discount rate is not regulated by the savers, still less is it set by the banks. The drawee, typically a retail merchant, has the unconditional privilege of prepaying his bills. The discount serves as an incentive. If demand is brisk, it will take a lower discount rate to induce him to prepay; if sluggish, a higher one. Moreover, in the latter case, the marginal retail merchant will not re-order his usual quota of consumer goods from his suppliers. Instead, he will carry part of his circulating capital in the form of bills drawn on more productive merchants until demand picks up again. Evidently Mises misconstrued the problem of discounting. Insisting that retail inventory was financed through loans at the bank, Mises failed to notice that the marginal retail merchant was doing arbitrage between bills and consumer goods. He would thin out merchandise on his shelves while beefing up his portfolio of bills in response to the consumer’s reining back spending, while he would sell bills from his portfolio and use the proceeds to replace the missing merchandise on his shelves upon renewed interest of the consumer in buying. Wrongly, Mises blotted out the important distinction between the discount rate and the rate of interest which are governed by entirely different economic factors and move quite independently of one another.

Not until these three most important forms of human action, the arbitrage of the marginal bondholder, the arbitrage of the marginal producer, and the arbitrage of the marginal retail merchant are more widely recognized can further significant progress in the theory of interest be made.

### © 2005 Antal E. Fekete

### References

Robert Blumen, Real Bills, Phony Wealth, [www.financialsense.com](https://www.financialsense.com), July 2005.

Sean Corrigan, Unreal Bills Doctrine, August 8, 2005.

Sean Corrigan, Fool’s Gold, [lewrockwell.com](http://lewrockwell.com), August 9, 2005.

Sean Corrigan, Fool’s Gold Redux, [lewrockwell.com](http://lewrockwell.com), August 12, 2005.

Sean Corrigan, Clearing the Air, [lewrockwell.com](http://lewrockwell.com), September 8, 2005.

Antal E. Fekete, Gold and Interest, [www.goldisfreedom.com](https://www.goldisfreedom.com), January, 2003.

Antal E. Fekete, Towards a Dynamic Microeconomics, Laissez-Faire, Revista de la Facultad de Ciencias Económicas, Universidad Francisco Marroquín, No. 5, Sept. 1996.

### Note

The foregoing piece was written as a rejoinder to Sean Corrigan’s series of papers criticizing me by name, posted on the website LewRockwell.com. I sent it to Lew whom I have known for over twenty years and with whom I thought I have had a cordial relation. I asked him to post my rejoinder so that his readership could see both sides of the argument. Lew refused.

The late Percy Greaves, the author of the pamphlet “Mises Made Easier”, used to be upset whenever economic research was mentioned in his presence: “Research? What research? All the research has already been done by Mises. All that is left is to explain Mises to the public.

I am also an admirer of Mises. I have acknowledged my intellectual indebtedness to him many times. I have made a conscious effort to use his terminology in preference to others. I have approached the criticism of Mises carefully and modestly. I have not rushed into print with it. I even withheld the publication of my own theory of interest for several years because it was in conflict with that of Mises on several points.

Bettina Bien, the widow of Percy Greaves, is a good friend of mine. She used to invite me to her home in Irvington-on-Hudson for dinner. We discussed Mises and economics a great deal. She had attended the Mises seminar at New York University for 18 years. She is a serious, devoted, and honorable student of Mises. She painstakingly put together the most complete bibliography of Mises. Years ago I asked her if she could explain some inconsistencies that I thought I have discovered in Mises’ work. While she agreed that they appeared to be inconsistencies, she couldn’t offer an explanation.

I welcomed Lew’s founding of the Mises Institute because I believed that it was dedicated to the search for and the dissemination of scientific truth, as was Mises himself. I am sadly disappointed to see that Lew is outdoing Percy. Not only does he think that all the research has been done and all we need to do is to regurgitate it again and again; he also thinks that Mises needs an “intellectual bodyguard”.

Science has nothing to fear from an open debate. Feeling of insecurity is characteristic of a cult.

Mises would have abhorred the idea that his scientific heritage has fallen to the care of a selfappointed “thought police” that would censor and suppress all dissent.

The style and approach of Corrigan and Blumen fall short of the high ideals of Mises. These gentlemen cannot for a moment assume that their selected targets may write and act in good faith. They do not want to dispute. They want to discredit. In refusing to publish my rejoinder Rockwell has stooped to their level. I am sorry for him. He prefers sycophants to thinkers.

---

*September 9, 2005*

### Antal E. Fekete, Professor

### Memorial University of Newfoundland

---

# The Year of the Euro: The Missed Opportunity of the Millennium

URL: https://newaustrianeconomics.com/archive/fekete/the-year-of-the-euro/
Date: 2005-07-28
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, sound-money, fiat-currency, monetary-policy, irredeemable-currency
Description: Originally an address to the Athenaeum of Madrid in January 1999, this essay argues that the Euro was a missed opportunity to create a sound currency anchored to gold. Instead of instituting a genuine gold standard, Europe replicated the defects of the dollar system, creating a currency that will be subject to the same inflationary and deflationary pathologies as the dollar.
Editorial Note: Originally delivered as an address in Madrid in January 1999 at the moment of the Euro's launch, and published in July 2005. Fekete's prescient critique of the Euro's foundational design flaws reads differently after the Euro debt crises of 2010–2015.
Original PDF: https://professorfekete.com/articles/AEFTheYearOfTheEuro.pdf

### Gulliver in the land of the mad scientists

Jonathan Swift described the strange island of Balnibarbi and its capital city Lagado, governed by a committee of mad scientists, in his satire Gulliver’s Travels. The Grand Academy of Lagado, the citadel of arts and sciences, was more advanced than anything Gulliver had ever seen.

Thousands of scientists were engaged in hundreds of research projects believed to bring great benefits to the island nation. In one studio a painter employed blind helpers for the task of blending paints by smelling and tasting them. In this manner the olfactory and gustatory faculties could take their proper place in defining the spectrum of colors, a place long usurped by the faculty of vision. There was a studio where an ingenious architect was perfecting a new method to build human abodes from top to bottom. This was said to be justified by the kindred practice of those prudent insects, the bees and spiders.

What puzzled Gulliver most was an invention that the Balnibarbians hailed as the “floating system of timekeeping”. The inventor, the island’s greatest astronomer, replaced the rigid hand of the sundial by a flexible one, and attached it to the Great Weather Cock of Lagado’s town hall. In this manner the annual and diurnial movements of the Sun could be properly modulated by local conditions such as the twists and turns of the wind. The government was so impressed with the new timepiece, and still more with the fine research behind it, that it made the use of floating mandatory throughout the land. Reactionaries opposed the measure calling the new timepiece capricious and misleading. They argued that you cannot keep regular time by an irregular timepiece. But these people were roundly denounced as conservative belly-achers with a visceral contempt for progress. The great astronomer took pains to convince the incredulous Gulliver that floating was light-years ahead of that “barbarous relic”, the rigidly fixed standard of time-keeping. “The main excellence of floating is in its ready adaptability to changing conditions”, he said. “The importance of this innovation is not to be seen in the role it assigns to the wind in time-keeping, but in the newly-found freedom of mankind in guiding its own destiny”, he added. “We can now appoint competent managers who will direct an array of fans towards the weather-cock whenever stretching or shrinking time is deemed to be in the national interest by the government”.

He also explained that workers would strenuously object to lengthening the working day from 8 to 9 hours. “Naturally, we want to please them, so we shall shorten their working day from 8 to 7 hours. Their unions are too dumb to realize that each work-hour has been stretched by onequarter through floating.” The great man concluded: “There is nothing more absurd than trying to make local time synchronous with global time. We have learned, at great cost to us, that our complex world can brook neither simplistic explanations nor rigid standards.”

### The integrity of standards

Absurd though the idea of throwing the unit of time-keeping to the winds might be, something equally absurd did indeed happen to the unit measuring values. In 1971 the government of the United States threw the international monetary unit to the winds, and embraced the regime of floating exchange rates. It solemnly declared that the old unit was obsolete, rigid, as well as reactionary. Above all, it was irrational as it denied the advantages of rational management of the dollar. At the long last, the government was now in a position to assume full power in the discharge of its sacred duty unfettered by petty superstition, namely, managing the currency in the national interest.

Please note that this is not fantasy taken from Gulliver’s Travels; this is history. The essence of floating is the denial of standards. The folly of the exercise can be seen in its true colors if we consider that Western Civilization was built upon the foundation of integrity of standards. By the same token, civilization is endangered if that foundation is allowed to decay. In an earlier less enlightened age the unit of linear measure, the foot, was adjusted every time the king died, in order to match its length to the foot of the newly anointed king. If he happened to be an infant, woe to the consumers and cheers to the producers of lace and fabric. The former just had to absorb the losses concomitant with the shrinkage of the foot, while the latter enjoyed an undeserved windfall. Later more enlightened monarchs stabilized the length of the foot thereby promoting trade and strengthening contract law. Modern technology is unthinkable without a rigidly fixed standard of weights and measures. What would happen to safety of travel on land, sea, and air, if tolerance standards could be compromised in response to political pressures?

Efficiency of production is unthinkable without rigidly fixed standards. What would happen to industry and agriculture if the length of the meter and the weight of the gram were made subject to manipulation by the government? What would the effect on world trade be if the bushel and the barrel, units of measurement whereby grain and crude oil are bought and sold, were made subject to floating?

Fixity is the most basic characteristic of any good standard. We pride ourselves on being more scientific in defining units of measurement than were our predecessors. We have refined the definition of the meter several times. Originally intended to be one ten-millionth of the length of a meridian from the pole to the equator, the meter was later redefined as the distance between two marks on a platinum-iridium bar kept in Paris. The reason for the change was that the original definition proved to be too imprecise for measurements calling for greater accuracy. The choice of the material of the bar was guided by considerations that the alloy used was less prone to changes in response to heat influencing length than other substances known to man, and therefore less open to manipulation. The length of the meter was redefined again in terms of the wave-length in vacuo of the orange radiation of the krypton 86 atom. The purpose of this change was to make the unit more accurate, not less. Since 1983 the meter is defined in yet another way.

The International Bureau of Weights and Measures in Sèvres, France, keeper by treaty of the world’s standard units of measurement, has decreed that the meter is the distance that light travels through vacuum in 1/299,792,458 of a second. The increased degree of precision matters.

If astronomers treated a meter as most Americans do (“y’ know, ‘bout a yard”), the resulting inaccuracy would be prodigious. Just between Earth and Mars you would get an error in measurement four million miles long.

If draught depleted the water reservoir of Madrid by one half, the quickest way of restoring volume would be to cut the size of the unit of cubic measure by one half. Demagogues would advocate this course of action arguing that in this way anxiety of city-dwellers about water shortages would be assuaged. Yet we would resist the temptation to follow their advice as it would do nothing to restore water level in the reservoir. Worse still, it might encourage further waste in the use of water just at the time when greater economy would be the wisest course of action.

Exactly the same logic dictates that the government should ignore demagogues and refrain from tampering with the monetary standard in cutting the size of the unit of value at a time when wealth is being dissipated as a result of waste and collapse of savings. Such a foolish course of action would encourage further waste and profligacy just at the time when greater economy and higher rate of savings is called for. Here, however, demagogy gains the upper hand. As profligacy depletes the reservoir of wealth in the country, guardians of the Treasury and the central bank find it expedient to reduce the unit of value in an effort to conceal the disappearance of wealth and the drying up of savings, while masking the dire consequences of extravagance. The amazing thing is that we meekly accept such official tampering with the monetary unit, even though we would reject similar tampering with linear and cubic measures. The explanation of this peculiar inconsistency cannot be compressed sufficiently for presentation here. As if struck with some sort of mass madness, academia and the media are parroting the official propaganda line to the effect that a country with falling value of the monetary unit is better off than the country with a stable one. Consequently the worst currency is the best, and the best currency is the worst.

Should this perversity lead to even greater imbalances, waste, and destruction of wealth, then remedy is sought in more of the same: further devaluation of the monetary unit, never in its stabilization. The profligate country is digging itself ever deeper in the hole. Governments in their wild intoxication with this idiocy have never settled down to face the logical consequences of their position. If a debased currency is better for the nation than one based on a fixed monetary standard, then the best currency of all would be the one having no value at all, and that country would gain most in trade which simply gave away its goods and services in exchange for nothing.

### A milestone in the history of money

1971 was a milestone in the history of money. Previously in the world’s most advanced countries money and credit had been tied to a positive value, that of a well-defined quantity of a good of well-defined quality. In 1971 this tie was severed, the fixed unit of value discarded and replaced by a variable one. Today the value of currencies is no longer tied to a positive value; it is now defined in terms of negative values, the value of debt instruments. Through this stratagem governments have quietly seized the most pervasive power over the lives of their citizens: the power of disposal over their savings, and the right of first refusal to the fruits of their labor.

The innovation of linking the currency to negative rather than positive values had one immediate consequence, seldom recognized and studiously ignored in the technical and scholarly literature on the subject. The power to reduce total debt in the world through the process of orderly retirement has been lost. Henceforth total indebtedness could only be reduced either through default or through monetary debasement. As the tide of unpaid and unpayable debt grows, so ebbs the value of the monetary unit. This must ultimately spell disaster: the collapse in the value of the monetary unit, inflicting great economic pain and distress on the people.

That we have lost the facility of reducing total indebtedness short of default or monetary debasement can be demonstrated with absolute clarity through the example of the dollar. A debt of one dollar can no longer be extinguished. If it is paid by a check (or a Federal Reserve note) drawn on a (Federal Reserve) bank, the debt is merely transferred from one debtor to another: the liability of the bank has been increased by one dollar. The situation is no better if the debt is paid in coin. The coins of the United States have no intrinsic value. They are mere tokens and as such they, too, represent debt. When paid in coin, a debt of one dollar becomes the liability of the U. S. Treasury itself. It should be clear that substituting one debtor for another is not the same as extinguishing debt.

What we are facing here is an elaborate scheme to cover up default and making mockery of the full faith and credit of the United States. Since the 1971 repudiation the Treasury has not paid any part of its debt in any meaningful sense of the word. Instead it keeps piling new debt upon unpaid debt by juggling interest-paying and non-interest-paying debt instruments. When old debt matures, the Treasury simply replaces it with new, usually on inferior terms. Interest-paying debt is replaced by non-interest-paying debt. In particular, for the first time in history, the U.S. Treasury arrogates itself the power to sell debt to foreign creditors without assuming any responsibility for its redemption. It is issuing liabilities to foreigners which it has neither the intention nor the means to honor. This is a particularly dangerous confidence game, since foreigners are not subject to the jurisdiction of the United States and cannot be taxed as residents can. Foreign creditors are in better position to refuse to be victimized by the prestidigitation that consists in debt-retirement by paying out certificates of “IOU nothing”. If and when they stop buying U.S. government debt, as at one point they most assuredly will, the Ponzi-scheme will come to a halt and a world crisis will ensue. “Dollarization” of the world economy is the next step. Treasury officials aim at promoting the dollar abroad as the ultimate extinguisher of debt. However, this is no more possible than turning stone into bread. In the absence of coercive legal tender provisions foreign creditors cannot be forced to accept the irredeemable dollar in repayment of debt.

Ever since the make-believe arrangement for retiring debt by paying irredeemable dollars to foreigners was introduced in 1971, the United States has been running persistent trade deficits with the rest of the world. This is entirely natural and there is no need to look further for causes and explanations. It is a safe bet that these deficits will continue unabated and the foreign indebtedness of the United States will increase exponentially. The very notion of “debt maturity” has lost all reasonable meaning previously attached to it. At maturity, creditors are coerced into extending their original credit plus accrued interest, in the form of new credits (possibly to another debtor).

### Disenfranchisement and exploitation

It is true that, for the time being, the creditor has the option to consume his savings at the time the debt matures. But is it not a strange monetary system, to say the least, which forces savers to consume their savings whenever they are not satisfied with the quality of available debt instruments, or with the terms on which they are offered? More to the point: what is the guarantee that creditors will always have that option? Of course, there is no such guarantee. The option is available as long as only a handful of the creditors exercise it. Should their number increase, the option will fast lose its value, and if the rest of creditors get scared and try to exercise their option simultaneously, the music stops and the game of musical chairs will come to a screechy halt.

Creditors of the United States will be holding the bag.

To put it differently, creditors and savers are presently being lulled into believing that their savings exists somewhere, in one form or another, and will be available when they need it. In truth, these savings exist only as the irredeemable promise of a government that has defaulted on its promises to pay as contracted twice in a generation. For the time being, doubting savers are allowed to cash in and consume their savings. But when a sufficiently large number of claimants try to assert their claims simultaneously, the ugly truth will dawn upon the world. The drying up of savings in the United States is a natural phenomenon. It means that savers are not as stupid as the government would like them to be.

The international monetary system has been turned into a system of massive disenfranchisement, exploiting the world’s saving public, the ultimate providers of credit. The power of control over savings is being usurped by the U.S. Treasury. This is also a system of depriving the world’s producers of the uninhibited right of disposal of their products. As they are forced to grant first refusal to the issuer of irredeemable promises to pay, producers are disabled in the exercise of the right of free disposal of the fruits of their labor. The two pillars of world prosperity, savers and producers, are thus placed under permanent duress.

It is not possible to defend these arrangements as a paternalistic system benevolently guiding the destiny of the world in the best interest of the people. It is these same arrangements that expose the people to the threat of untold sufferings at the end of the road. The coercive nature of the regime of irredeemable currency is fully commensurate with the coerciveness of similar systems, long since discarded by history: slavery and serfdom. To the extent that coercion and bondage today is covert, whereas they were overtly admitted and practiced under slavery and serfdom, the present regime is even more odious than its historic forerunners. The consensus it represents is akin to that of the drug addict and his pusher. By playing off people’s propensity to consume against their propensity to save, and by promoting instant gratification, the regime of irredeemable currency makes people addicted to compulsive consumption in exchange for their acquiescence in coercion and pilferage.

### Sweet dreams, rude awakening

Dire predictions were made in 1971 about the future of the irredeemable dollar. It was predicted by many that its value would collapse and all paper currencies would become worthless in a matter of a few years. Events unfolded differently. After the international monetary system adopted dollar-debt as the standard of value, quite predictably, a fast-breeder of debt started operating in earnest. Theoretically, total dollar-debt must increase at least at the same rate as the dollar rate of interest, in order to make debt service possible. In practice, total debt has been increasing much faster than that. Rising commodity prices forced an increase in the stock of money, and the increase in the stock of money gave occasion to further price increases. A vicious circle has been engaged which is reflected in the increase of total dollar-debt. The propaganda machinery of the government, the media, and academia shifted responsibility for the priceexplosion to the oil-sheiks and to the “gnomes of Zurich”. It was considered impolite to suggest that the cause could, perhaps, be found in the flooding of the world with unwanted dollars. It was considered a sign of paranoia if anyone questioned the wisdom or legitimacy of tying money to negative values, the value of debt.

There were other consequences, too. The interest-rate structure in the world was destabilized, reflecting unprecedented volatility in the bond market. This was also explained away using ad hoc arguments such as crop failure and other natural disasters. Once more, the international monetary system escaped scrutiny, and the dollarization of the world economy could continue apace, putting ever more creditors as vassals into permanent bondage to the United States.

By 1981 it was the turn of other currencies to decline in value. Thereby the dollar regained a semblance of stability. An optical illusion was created that the dollar was “strong” again, even though it continued losing value in absolute terms. But a dollar appreciating in relative terms was poison in the international monetary system. It made the servicing and the repayment of the dollar-debt well-nigh impossible for foreigners. A debt-crisis engulfed the world. In 1985 governments declared that a “strong” dollar was against public policy. The value of the dollar had to be clubbed down. Thus, then, a monetary cycle has evolved: the dollar went from weak to strong, and from strong to weak again. It appeared that the value of the dollar was subject to a cyclical pattern, ergo, its fall meant no threat as it was bound to be followed by a rise soon enough to correct it. In reality, however, all currencies were falling in absolute terms, albeit at a variable rate.

The crisis of the international monetary system is concealed under a thin veneer of prosperity.

The world is consuming more. A wealth of new products is brought to the market year after year.

The world’s stock markets have, after being overrun by the tide of newly created dollars, soared to unprecedented heights. People are lulled into a false sense of security. They don’t understand or care what is happening to the value of their currency and savings. They act as if they have arrived to the land of Cockaigne where more consumption and less saving combine to bring greater prosperity.

The rude awakening in Japan did not disturb sweet dreams elsewhere. Yet it should be clear that the world economy is a big life-boat which, if leaking water in one corner, will endanger the lives of all occupants regardless where they may be seated. The original doomsday scenario of a dollar losing its purchasing power in one fell swoop has not materialized. The world goes on merrily constructing the Debt Tower of Babel, unmindful of the consequences. But the wise should guard themselves against concluding that the narrow escape of disaster has brought security. The debt crisis is far from over; in fact, it is more threatening than ever. Once the dollar has been destabilized, the path of least resistance is downhill. The roller-coaster ride should not conceal the fact that, when it comes to a stop, it will be at the bottom, rather than the top. All in all, the wild and mindless experimentation with debt money has been an unmitigated disaster, the full extent of which remains to be seen.

### The wisdom of redeemability

Throughout the long and sometimes painful evolution of civilization, coined money has always been linked to a metallic monetary standard, and paper currency has always been made redeemable in coin made of the standard metal. To be sure, sporadic experiments with irredeemable currency have occurred but, in every instance without exception, these experiments ended in a humiliating fiasco. Ultimately, sanity and monetary rectitude always prevailed as the deviant currency was made redeemable. Self-styled experts ridicule the requirement that debt be made redeemable in the monetary metal as hopelessly antediluvian. But the requirement to make currency and debt redeemable was not the outcome of backwardness, ignorance, or superstition on the part of our grandfathers. On the contrary, it reflected great practical wisdom as well as the spirit of freedom. It showed a deep understanding that debt was an indispensable pillar of civilization which, if abused, could cause its collapse.

The great creative role of debt is found in the fact it makes human enterprise possible, irrespective of the accident of birth. In this sense, debt is an agent of freedom. But it must also be well-understood that debt is a double-edged sword. If used improperly, it could do more harm than good. When allowed to accumulate, debt could become an instrument of enslavement. In this sense, debt is also an agent of bondage. For this reason debt ought to be handled with utmost circumspection, and its orderly retirement ought to be promoted by every available means.

Only if extinguishing debt was within the power of every individual of character and industry could debt bring its great blessings to mankind. Conversely, if extinguishing it proved to be difficult or impossible, then debt would become a great curse to society. Inevitably, debt would become an enemy of freedom and an instrument of bondage.

I have already discussed why irredeemable currency makes the reduction of total debt impossible, and how it leads to the snow-balling of debt, a process that is bound to end in a disaster. By contrast, under the regime of a gold standard, debt is reined back and men of character and industry may greatly benefit from it without facing the danger of permanent bondage. It is not surprising that enemies of freedom are inevitably enemies of redeemable currency. It was not an accident of history that the very first act of both the Soviet Bolshevik and the Nazi Socialist governments was the abolition of redeemable currency and the imposition of the most severe foreign exchange controls.

### “Take the current when it serves, or lose our ventures”

In 1971 the largest holders of dollar balances abroad were the members of the European Economic Community (EEC). A large part of the savings of the prosperous burghers in Europe was invested in dollar-denominated debt. When the U.S. government refused to honor its promise to pay its debt in gold as contracted and in doing so it defaulted on its obligations to overseas creditors, the central banks of the EEC countries were hit with huge losses, the size of which was unprecedented in the annals of international finance.

Determined that they will not be victimized again in this fashion, the EEC countries decided to create a new international currency of their own, the euro. On January 1, 1999, outstanding debt in most of the EEC countries was converted at a fixed rate into euro-debt. It was hoped that the new currency would be based on a thorough and careful analysis of the dollar-debâcle. Indeed, there was much to be learned from the ill-starred experiment with the fast-breeder of dollar-debt which has saddled the world with mountains of unpaid and unpayable debt.

As reflected by the volatility of the interest-rate structure, the value of debt has been destabilized and was subject to unprecedented fluctuations. In consequence, the seeds of deflation have been spread in the world. It is already consuming the economic vitality of Japan, and sapping the energy of other countries in Asia and Latin America. A low and falling interest-rate structure is no less dangerous than a high and rising one. One sucks businesses into bankruptcy just as readily as the other. There is no way to assert with any degree of certainty whether the deflationary or the inflationary danger is greater, as the pendulum is swinging from extreme high to extreme low interest rates. In spite of the deflationary threat, the specter of an inflationary collapse has not disappeared. It is still very much alive. The world’s hunger for dollar-debt could reach the saturation point at any time without prior notice (those old enough may recall that this saturation point was once reached in 1974 already). If and when the demand for dollars dries up, the debtmarkets will be thrown into a tailspin. This explains why the Year of the Euro has been hailed as a great historical opportunity:

### There is a tide in the affairs of men

Which, taken at the flood, leads on to fortune;

### Omitted, all the voyage of their life

Is bound in shallows and in miseries.

On such a full sea are we now afloat,

And we must take the current when it serves,

Or lose our ventures.

### (Shakespeare, Julius Caesar, 4-iii-217.)

Have the EEC countries taken the current when it serves? If they have, they could rid the world of the servitude of bad debt. They could disengage the fast breeder of debt sprung upon the world by the United States in 1971. They could enable people of character and industry to free themselves of bondage. In order to bring these great benefits the euro, unlike the dollar, is supposed to be defined in terms of positive rather than negative values.

### Robin Hood money in the reverse

That did not happen. The tide was missed, and a great historic opportunity to deliver the world from evil has been lost. The voyage of people’s life is now bound in shallows and in miseries. The euro that has been introduced is just another irredeemable currency, designed to entrench the Moloch of debt. It contributes nothing to the stability of the international monetary system. It merely replaces one kind of bondage with another. Authors of the euro expect that the new currency will be as strong as the German mark used to be. They forget that no chain is ever stronger than its weakest link. They hope that people will be more confident to lend and borrow euros than dollars. Given the fact that the euro is not tainted with repudiation, defaults, broken promises, bad faith, monetary mischief and duplicity as is the dollar, they are confident that they are making a positive contribution to the world economy.

Regrettably, this is not so. “The mountain has gone into labor and gave birth to a mouse”. The euro, another “Esperanto” currency, was conceived in sin. It is grounded in the belief that it is possible to fool all the people all of the time. It is trying to perpetuate the myth that a durable international monetary system can be constructed on the foundation of irredeemable promises.

The euro, in competition with the dollar, may succeed in plundering the savers and pilfering the producers. It is not Robin Hood money. It is Robin Hood money in the reverse.

Previous historical experiments with irredeemable promises to pay had been local and temporary.

It was the refuge of weak governments living in monetary backwater. Whenever they exhausted their credit lines, they defaulted on their promises to pay and declared their dishonored paper “money”. These episodes, designed to cover up the fact of repudiation, were ephemeral. Other countries with self-respecting governments refused to listen to the siren-song. They continued to deal with their creditors honorably. They paid their debt according to the terms of contract, that is, surrendering positive values at maturity. Wayward countries would feel obliged to return to the fold sooner or later, resuming redemption of their outstanding debt.

The euro represents a new adventure in bad faith. Its authors were promising emancipation from dollar-slavery. What they gave the citizens of EEC and the world instead is a choice between euro-debt slavery and dollar-debt slavery. We are treated to the spectacle of some of the richest countries offering competition to the United States in flooding the world with make-believe currency. They issue obligations that they have neither the intention nor the resources to pay.

They cover up the deceit by maintaining that their irredeemable promise to pay is “money”, the ultimate means of payment. They are coercing their domestic and foreign creditors, producers and savers, into accepting the irredeemable euro in final payment of debt.

The extent of corruption is clearly shown by the fact that there is not one court of law in Euroland with sufficient wisdom and moral fiber to challenge this fraud making mockery of debt-retirement.

Nor is there a university in Euroland with sufficient courage to establish the fact that the practice of issuing irredeemable promises to pay fully exhausts the definition of the crime commonly called fraud, regardless whether it is committed by an individual, by a government, or by a group of governments. Even those members of the EEC that declined to join the euro-scheme, namely the United Kingdom, Sweden, and Denmark, are guilty of deceit. They have failed to criticize the euro on grounds that its issuance violates the principles of common decency. They have failed to point out that the euro is a prescription for the pauperization of people at home and abroad through deliberate currency debasement.

### Authorship of the policy of deliberate currency debasement

The three decades since 1971 is not a great length of time when measured in historical terms.

But it is sufficiently long to warrant an examination of the deliberate policy of disenfranchisement and exploitation, the experiment with irredeemable currency in the light of its practical consequences. Has this policy served the people well? Or, perhaps, the negative results of the experiment justify a more careful examination of the principles involved than hitherto carried out?

The question is not raised, and the euro-scheme is launched without the slightest attempt at soulsearching in this regard. A great deal of obfuscation surrounds the issue. Officialdom has declared the topic off limits to scholarship and research. Anyone who dares to question the legitimacy of irredeemable currency, anyone who dares to challenge the official tenet that the paper monetary standard represents “progress” over “obsolete” metallic standards, is browbeaten and subjected to ostracism. Professional standing in the monetary field is reserved for those sycophants who pay lip service to official propaganda, to the dogma that metallic monetary standards “have been swept away by the progressive forces of history” and any effort to restore them is tantamount to trying to turn the clock back.

Let us bypass the question whether standards of honesty and upright dealing can ever become “obsolete”. Let us refrain from asking why the surrender of positive rather than negative values in discharge of obligations has become antediluvian just at the time when the United States was ready to default on its debt. Let us disregard the question what is the justification for double standards of justice allowing the United States and the EEC to issue promises to pay that they have neither the intention nor the means to honor, while the same conduct would constitute criminal fraud if committed by private parties. Instead, let us examine who the original authors and apostles of the “progressive” monetary system involving irredeemable currency were, and what their original intention was in proposing the disenfranchisement of the saving and producing public.

The euro is a leap towards the realization of the aims of The Communist Manifesto. In 1848 Marx and Engels published this document describing their design for a step-by-step transformation of the system of production based on free and voluntary cooperation into a command economy. The proletarians should “win the battle of democracy” and thus raise themselves to the position of ruling class. Then they should use their supremacy to wrest, by degrees, all capital from the bourgeoisie. Marx and Engels gave detailed instructions for the measures to be adopted, including the centralization of credit and the issuance of legal tender banknotes. They were fully aware that the measures recommended were destructive to social cooperation in the extreme.

They meant, in their own words, “despotic inroads on property-rights and on the conditions of capitalistic production”, moreover, they were “measures economically insufficient and untenable but which, in the course of the movement would outstrip themselves, necessitating further inroads upon the old social order, and are unavoidable as a means of entirely revolutionizing the mode of production”. Undoubtedly, the blueprint for the irredeemable dollar and euro were copied straight out of the Communist Manifesto.

It is noteworthy that the adoption of the monetary provisions of the Communist Manifesto in 1971 and 1999 was not received by public outcry and protest, nor was it resisted in any significant way by the people as, for example, the abolition of the freedom of press and assembly could have been. This lack of interest finds its explanation in the simple fact that the public still does not understand, even after the miserable record of the dollar during the past thirty years in losing nine-tenth of its purchasing power, that we are facing a gigantic scheme of embezzlement of savings. It also shows the extent of decay and corruption in the media and academia. Those not in thrall to the Communist Manifesto have been muzzled through bribes, blackmail, and other administrative measures. Their voices are not heard, so their arguments can safely be ignored. In the words of John Maynard Keynes (written before he joined the forces of destruction):

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily and, while the process impoverishes many, it enriches some. The sight of this arbitrary arrangement of riches strikes not only at security, but at confidence in the equity of distribution of wealth.

Lenin was certainly right. There is no subtler, no surer means of overthrowing the existing order of society than debauching the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. (Economic Consequences of the Peace, New York, 1920, pp 235.)

### “Timeo Danaos et dona ferentes”

The introduction of the euro must be considered as a victory for communism. It is an intriguing question to contemplate whether, in the final analysis, the 1991 defeat of communism will turn out to be less important than its 1999 victory. More intriguing still is the question whether or not both events are an organic part of the same grand strategy. Communism had only defeats to chalk up in every open contest. Its successes were confined exclusively to the field of clandestine operations and conspiracy. A hopeless bungler of construction, communism is a brilliant master of destruction. We may safely assume that this verdict of history was not entirely lost upon the the communist leadership that by 1991 was ready to cut its losses. If it felt forced to abandon enterprises where constructive skills were indispensable, by the same token, it must have felt encouraged to retain or even expand projects in the execution of which its expertise was unsurpassed. The Bolshevik leadership may have been eager to imitate deceit employed by the ancient Greeks. After laying siege to the city of Troy for ten years in vain, the Greeks decided that where brute force fails, cunning may go a long way. They pretended to give up their plan to destroy Troy and sailed away in their ships. But they left behind what has come to be known the Trojan Horse, with Greeks in its belly armed to the teeth. In vain did the high priest of Troy, Laocoon, warn his compatriots: “timeo Danaos et dona ferentes” (I still fear the Greeks, the more so as they are bringing gifts). The jubilant people of Troy dragged the horse inside of the walls of their city to celebrate what they thought was their victory. But after nightfall the armed Greek soldiers climbed out of the Trojan Horse and murdered the city-dwellers, tired of celebration, in their sleep.

The Bolsheviks ended the siege of Western Europe in 1991, pretending to give up their almost 75-year experimentation with command economy. However, they left behind the Trojan Horse in the form of Lenin’s monetary legacy. By 1999 the Trojan Horse was firmly implanted in the inner sanctum of the citadel of Western Europe, in the form of the newly created euro.

It is naive to suppose that the Bolshevik leadership accepted defeat and gave up their consummate passion of world-domination without a fight in 1991. It is more likely that they considered that Western Europe was fully capable of destroying the basis of its own prosperity. In discarding the principle of pacta sunt servanda (contracts are made to be honored), it would let the constitutional order be subverted. All the Bolshevik leaders would have to do now is to sit back and watch the drama as it unfolds. In the fullness of time the Trojan Horse will regurgitate the contents of its entrails. In fulfillment of Lenin’s prophecy the debauchery of the currency will eventually overturn the existing basis of society. Western Europe, softened up by currency debasement would fall, like a ripe apple, into the lap of Communism, just as Germany did fall into the lap of Nazi Socialism, after it had similarly been softened by currency debasement. The Bolsheviks must be superbly confident that, with the economic resources of Western Europe at their disposal, they will succeed where their predecessors have failed.

It is a cruel joke to suggest that “Capitalism is burying Communism”, and that “the philosophical tenor of our time is democracy and the free market, to the exclusion of totalitarianism and the command economy”, unless the world is willing to dump not just Lenin’s statues, but Lenin’s monetary legacy as well, in order to emancipate the savers and the producers of the world from their present servitude.

### Double-entry book-keeping and the euro

In order to assess the future prospects of the euro we have to reach back to basic principles. It is not good enough to present ad hominem arguments to the effect that the world is facing a monetary collapse as politicians and bankers, freed from the fetters of the gold standard, could not resist the temptation and would enrich themselves through monetary manipulation. We must have a scientific argument that would apply even if politicians and bankers were saints imbued with altruism.

I shall argue that the euro does indeed face an eventual collapse because its authors have recklessly ignored the basic principles of double-entry book-keeping. The euro is designed to confuse the concepts of liability and asset. It is true that the dollar also operates the same way, however, it was not so designed at inception. The collapse of the euro may take the form of an implosion of debt through default (deflationary scenario) or through depreciation (inflationary scenario) or, possibly, through a mixture of both. Since the value of the monetary unit is defined in terms of debt, and debt is bound to implode after reaching a certain threshold, the world is inexorably driven towards monetary collapse.

Double-entry book-keeping is one of the main pillars of society. Without it progress, indeed, production and distribution of the means of preserving human lives at present levels of security, health, and comfort, would be unthinkable. Double-entry book-keeping is based on the clearest possible distinction between an asset and a liability. It is true that a particular item may be a liability in the balance sheet of one while serving as an asset in the balance sheet of another.

What monetary cranks are advocating is an arrangement whereby governments are enabled to shift items freely from the liability to the asset column of the same balance sheet. Like alchemists of old, they could create wealth out of nothing (better still, out of less than nothing).

The job of the illusionists and the conjurer is to deceive the audience into believing that something contrary to the laws of reality has been accomplished before their very eyes. The essence of irredeemable currency is the same. The monetary unit is defined in terms of government debt. What has been a liability, through monetary prestidigitation and machination, is turned into an asset. The illusionist has succeeded in deceiving the public. Pretence can be maintained for varying lengths of time. People are lulled into a false sense of security. They are made to believe that their savings are there, and could be drawn upon any time when needed.

From time to time they may even test this assumption and withdraw larger or smaller amounts.

When they do, they are happy to conclude that their savings are safe.

But are they really? The harsh reality is that the government has long since spent their savings and would have to tax people to get it back if a sufficiently large number of savers tried to withdraw it simultaneously. This number may not be reached for a year, for a decade, or even for a generation. The supply of fools in the world is very great indeed. But it is not inexhaustible.

Eventually, after many false starts, the truth will dawn upon everyone. But then it will be too late to withdraw the savings that were never there in the first place, except as an irredeemable promise.

### Inflationary and deflationary phases

While the ultimate outcome may not be in doubt, the course of history is impossible to predict.

The inflationary phase of currency depreciation is well-understood. Less well understood is that it alternates with a deflationary phase. This will reinforce the illusion that the purchasing power of the currency, while it obviously fluctuates, is not really in danger of collapsing. Indeed, the government will be quick to take credit for the feat of “controlling inflation” every time another deflationary phase starts and, likewise, of “controlling deflation” when a new inflationary phase sets in. Needless to say, the government performed no feat of any sort. The only way to control the real value of the currency is to tie it to positive values. It may take a long time to find out this elementary truth, but the value of a promise promising nothing is exactly that, nothing. As long as the currency is tied to negative values, depreciation will be the inevitable outcome.

It is only to be expected that the process of depreciation will be opaque. It is hardly ever a oneway street. Currency debasement moves by fits and starts. It is never clear-cut nor easily understandable. It is always confusing. If it wasn’t, the party would be over before it got started.

Producers would refuse to exchange real goods and services for irredeemable promises to pay.

Savers would refuse to allow their savings to be denominated in a depreciating currency. But precisely because the process of currency depreciation is opaque, and because it moves by fits and starts, it will be prolonged and agonizing.

We can make another broad-brush picture of the shape of things to come. Apart from minor leads and lags, the price level and the rate of interest are going to move in tandem. A rise in the price level (hinting at currency depreciation) will be accompanied by a tendency of the rate of interest to rise as well. Likewise, a fall (hinting at a remission of currency depreciation) will be accompanied by a tendency of the rate of interest to fall. There is a simple explanation for this puzzling phenomenon called “linkage”. The process of currency depreciation can be pictured as an oscillating money-flow to-and-fro between the bond market and the commodity market. When fearful of the safety of their savings invested in debt, people move it en masse from the bond to the commodity market. This move makes the interest rate and the commodity price level rise together (inflationary phase). When stockpiles become so large that salability at exaggerated prices becomes problematic, people grow fearful of the safety of their savings invested in commodities. There follows a reversal of the tide: exodus of money from the commodity market and into the bond market. This makes the rate of interest fall together with the price level (deflationary phase). This is known as the Kondratiev long-wave cycle, that may take 60 to 70 years to repeat itself. The last inflationary phase started in 1947 and ended in 1980; we are apparently still in the deflationary phase that started in the early 1980's.

The oscillating money-flow between the commodity and bond markets, caused by the savers making the tide flow in one and ebb in the other before changing roles, is further aggravated by speculators who understand the dynamics of the Kondratiev cycle. They go long in commodities and sell bonds short during the inflationary phase. Just before the tide turns, they take profit by selling commodities and by covering their short positions in bonds, and get ready for the deflationary phase in going long in bonds and selling commodities short. Of course, speculators know full-well that the onset of the deflationary phase does not mean the end of currency depreciation. The wild roller-coaster ride is going to continue and get even wilder. Just as a coin has two sides: heads and tails, currency depreciation has two phases: the inflationary and deflationary phase. Neither phase can be understood without understanding the other. A onephase currency depreciation (inflation without deflation) is just as unthinkable as a coin missing one side.

### The hot-money cycle

We have seen how people try to protect their savings and in doing so they induce an oscillating money-flow to-and-fro between the bond and commodity markets. This pendulum-like swing conceals the underlying phenomenon of currency depreciation. But there is also a second pendulum: that of hot money jumping from one currency depreciating relatively faster to another that, for the moment, is considered safer as it is depreciating more slowly.

I do not hesitate to predict that the hot-money pendulum will focus on two currencies: the dollar and the euro. To begin with, the dollar will be preferred while the euro is considered an unknown entity. As the dollar-debasement will continue unabated, hot money is going to jump from dollars into euros, making the former fall and the latter rise. Then the pendulum turns, and hot money will jump back from the euro to the dollar. When it does, the illusion is created that the dollar is strong. In truth both the dollar and the euro are falling in absolute terms, albeit at different rates.

Since the “rise” is measured in terms of a falling standard, it is not a rise at all. The hot-money cycle, of course, has a different frequency from that of the Kondratiev long-wave cycle. I predict that it will be shorter, but we have to wait and see how events unfold before we can say more.

Foreign exchange speculators aggravate the hot-money cycle just as bond speculators aggravate the Kondratiev cycle. It goes without saying that both cycles aggravate the process of monetary destruction.

### The metamorphosis of speculation

It is important to note how the nature of speculation has changed since 1971. Beforehand bond values and the rate of interest were stable, along with foreign exchange rates, precluding speculative activity in the bond and foreign exchange markets. Speculation was confined to agricultural commodities where it had a stabilizing effect. All the risks were nature-given, none were man-made. Speculators were forced by the “invisible hand” to resist the formation of price- trends. Bull-speculators had to sell as prices rose; bear speculators had to cover their short positions as prices fell.

The nature of speculation changed dramatically when the monetary unit was redefined in terms of negative values. Bond prices and foreign exchange rates were destabilized. In response, for the first time, speculation emerged as a permanent feature of the bond and foreign exchange markets. However, significantly, speculation never had a stabilizing effect in the bond and foreign exchange markets. The reason for this is simple enough. The risks are not nature-given. They are man-made. Speculation in these markets has the character of a wager. One set of gamblers (the speculators) is setting their wits against those of another (the central bankers and treasury officials). Speculators are freed from their obligation to resist the formation of price trends. They are now inclined to ride price trends rather than oppose them. They jump on the bandwagon, thereby making volatility soar. Their job is no longer to compensate for nature’s fickleness, but to outwit central bank and treasury officials. And they usually do.

Central bank officials as a rule are very smart people. But they are civil servants on fixed salary.

Their personal stake in the outcome of the wager is limited. This is in contrast with that of the speculators, who risk their own wealth. Also, central bank officials were trained in a different school. Their mindset is different. They don’t risk their own money. They have virtually unlimited access to the public purse to cover their losses. Speculators must quit playing when they have exhausted their capital. Ever since currency devaluation was made “respectable” by the governments in the 1930's, a staggering amount of public money has been lost to speculators in the foreign exchange markets. After 1971 bond speculation made its debut and the losing streak of central bankers has continued.

It is not possible to understand the dynamics of currency depreciation without understanding the metamorphosis of speculation, from benign to malignant. It is noteworthy that this topic is off limits as far as subsidized economic research is concerned. The metamorphosis has been made “taboo” in the media and academia by the powers that be. Financial writers and researchers must parrot the official propaganda line that interest-rate speculation that drives the derivatives markets, and foreign exchange speculation that determines the relative values of the dollar and the euro, are a stabilizing factor in the economy, the same way as speculation in agricultural commodities, which is an absurd lie. The derivatives markets are programmed to self-destruct through explosive growth.

### The rubble of the ruble

The ruble is a reminder what is happening to all currencies based on debt. The savings of the Russian people has been wiped out. Job opportunities in the country, one of the richest in natural resources, are disappearing. Private foreign investments are going up in smoke choking off the flow of new capital. Russia is drowning in debt. Great economic hardship is visited upon hundreds of million innocent people. Life expectancy is on the decrease, infant mortality is on the rise. A similar scenario is unfolding in other parts of the third world. The self-immolation is due to a single cause: the mindless experimentation with currency tied to negative values. Opinion-makers blame the disaster on a plethora of loosely related ad hoc causes. However, they all have a hidden agenda: that of propping up the regime of irredeemable currencies, the most pervasive single corrupting factor of our times.

Exactly the same forces that devastated the Russian ruble will ultimately threaten the dollar and the euro. It is not inconceivable that the dollar may at one point lose half of its purchasing power within a month, as did the ruble. Self-styled experts dismiss this saying “it can never happen here”. But it could and did. America in the 1770's and 1860's, France in the 1720's ands 1790's, Germany in the 1920's and 1940's had gone through the same harrowing experience. More recently the currencies of these and other countries lost up to nine-tenth of their purchasing power during the 1970's. We may say categorically that the cure of cancer has not been discovered in the intervening years. Our money-managers have not acquired the know-how, if such exists, to avert similar disasters in the future.

Millennia come and go, but man still gains his bread by the sweat of his brow, and not by clever tricks in trying to shift entries from the liability to the asset column in the balance sheet of the government.

---

# Detractors of Adam Smith's Real Bills Doctrine

URL: https://newaustrianeconomics.com/archive/fekete/detractors-of-adam-smiths-real-bills-doctrine/
Date: 2005-07-12
Section: Popular Economics
Difficulty: scholarly
Concept Tags: real-bills, self-liquidating-credit, bills-of-exchange, adam-smith, mises, new-austrian-economics
Description: Fekete defends Adam Smith's Real Bills Doctrine against its modern critics — principally Milton Friedman and Murray Rothbard — who conflated real bills (clearing instruments) with credit instruments. He argues that self-liquidating credit arising from the production of urgently needed consumer goods is categorically different from inflationary credit, and that the doctrine's suppression has contributed to recurring monetary crises.
Editorial Note: Part of Fekete's ongoing series 'The Dismal Monetary Science.' The Real Bills Doctrine is the most contested element of Fekete's monetary framework, as it puts him at odds with both Rothbardian Austrians and monetarists. This piece is his most systematic defense of Smith's original conception.
Original PDF: https://professorfekete.com/articles/AEFDetractorsOfAdamSmithsRealBillsDoctrine.pdf

### Credit versus clearing

Strictly speaking a bill of exchange, pejoratively called “real bill” by Milton Friedman following his mentor Lloyd Mints, is not a credit instrument. It is a clearing instrument. It enables the market to clear goods in most urgent demand without needlessly invading the pool of circulating gold coins that would cause monetary contraction whenever division of labor is further refined and production processes are made more “roundabout” (to use the phrase of Böhm-Bawerk) by the most progressive elements in the ranks of entrepreneurs and inventors. Lending and borrowing are not involved. The real bill circulates on its own wings and under its own steam by virtue of the urgent demand for the underlying consumer good.

### Self-liquidating credit

In spite of the conceptual difference between credit and clearing, it is customary to extend the concept of credit to include, in addition to credit arising out of the propensity to save that finances fixed capital, self-liquidating credit arising out of the propensity to consume that finances circulating capital in the final phases of production of merchandise moving sufficiently fast to the final, gold-paying consumer. Thus, then, the bill of exchange is the embodiment of self-liquidating credit, so called as the credit is liquidated directly with the gold coin surrendered by the consumer in 91 days or less, 91 days being the length of the seasons of the year. With the change of seasons the type of merchandise demanded most urgently by the consumer also changes in the temperate zones where spontaneous bill circulation has taken its origin during the Renaissance.

For this reason bills of exchange are limited to maturities 91 days or less. Under no circumstances would a bill circulate after maturity. If the underlying merchandise couldn’t be sold during the current season, then it wouldn’t be sold until the same season comes around again the following year.

### Chicken or egg?

Detractors of the Real Bills Doctrine (RBD) studiously avoid reference to its prestigious pedigree and its author, Adam Smith. No less are they anxious to avoid reference to self-liquidating credit and to clearing. They also ignore the fact that, as a matter of merchant custom, producers and distributors would hardly ever pay the producers of higher order goods cash. The terms “91 days net” are standard and part of the deal. It is understood by everyone concerned that the bill will not be paid in full until the underlying merchandise is sold to the final consumer. Yet the supplier can use the bill to pay his own suppliers. Endorsed on the back, the bill can be passed along a number of times, the endorsement indicating that title to the proceeds has thereby been transferred from payer to payee. This transaction is also called “discounting” as the payee applies an appropriate discount, calculated at the current discount rate, to the face value of the bill proportional to the number of days remaining to maturity. Upon maturity the last payee presents the bill for payment to the producer on whom the bill is drawn.

Such bill circulation was wide-spread in the city-states of Italy in the Quattrocento and, more recently, in the 18th century in Lancashire, before the Bank of England opened its branch in Manchester, as observed by Ludwig von Mises in his 1912 treatise Theorie des Geldes und der Umlaufsmittel, although he stopped short of investigating the economic forces animating spontaneous bill circulation.

Unlike the question whether the chicken was first or the egg, the question whether bills or banks came first has a definite answer. There can be no doubt that the former did. Logically and historically, the bill predates the bank. What is more, it is perfectly feasible to have an economy without any commercial banks at all wherein circulating bills of exchange emerge as the supplier delivers semi-finished consumer goods to the producer. Instead of recognizing this fact, detractors link bills and banks as if they were Siamese twins. In refraining from ever mentioning the self-liquidating nature of the bill detractors of the RBD insist that credit has been created “out of nothing” and the bill is the engine driving paper-money inflation. Their methodology consists in summarily denouncing any and all as a “monetary crank” who is searching for and disseminating truth pertaining to bill circulation, without the slightest effort to examine the evidence for spontaneity. In doing so they betray their ignorance. Their blinkers do not let them notice the extensive body of scholarly literature on clearing and self-liquidating credit.

### A “fairy” tale

Let us look at another instance of clearing and self-liquidating credit that was vitally important in the Middle Ages: the institution of city-fairs. Among the most notable ones were the fairs of Lyon in France, and those of Seville in Spain. They were annual events lasting up to a month. They attracted fair-goers from places as far as 500 miles away who brought their merchandise to sell, as well as their shopping-list of merchandise to buy. One thing they did not bring was gold to pay for the purchase of goods on their shopping list. They would leave it home for fear of highwaymen. They hoped to pay for their purchases with the proceeds of their sale. However, this presented problems. The fact is that there were far fewer gold coins available at the fair than the total value of merchandise waiting to be sold. Fairs would have been a total failure but for the institution of clearing. Buying one merchandise while selling another could be consummated perfectly well without the physical mediation of the gold coin. Gold was needed to finalize the deal only to the extent of the difference between the purchase price and the sale price.

In the absence of clearing the merchant arriving from a far-away place would have to sell before he could buy. Moreover, he would have a hard time selling because of the dearth of gold coins in the hands of prospective buyers. But even if he could sell out his wares, by the time he has done so the cream of the offering at the fair would be gone, and he might be left with the choice between seconds and rejects.

To avoid this, organizers of the fair set up a clearing house. Merchants from afar registered their merchandise upon arrival and received a quota of scrip money in proportion to its value at the clearing house. Scrip money could be used right away to make purchases, even before the purchaser sold any part of his registered merchandise. The quota had to be returned to the clearing house at the end of the fair. Scrip money in excess of the quota was redeemed, and shortfall made up, in gold coin. The marvelous institution of the clearing house and the invention of scrip money could move a far greater amount of merchandise than scarce gold coins ever could.

Those who call the issuance of scrip money “credit created out of nothing” are utterly blind to the true nature of the transaction. Fair-goers did not need a loan. What they needed was an instrument of clearing. The clearing house was not an engine of inflation. Its scrip money represented self-liquidating credit that was extinguished just as soon as the fair was over. As this example clearly demonstrates, a loan is very different from an advance to the seller of wares with a ready market at hand. The advance, scrip money, circulated spontaneously at the fair, while other credit instruments such as loan contracts and mortgages would never do.

### Goods in bottoms

Or look at one other example of clearing that was important before World War I. Suppose a cargo ship is ready to sail from Tokyo to Hamburg carrying in its bottom consumer goods in urgent demand in Western Europe. The sea-voyage takes up to 30 days. Does the importer need to raise a loan to pay the supplier for the shipment prior to sailing? Hardly. The goods are known to be in high demand and to have a ready market upon arrival. The cargo is insured against losses at sea. Accordingly, the supplier bills the importer for value received f.o.b. Tokyo, payable in 30 days in London. The importer endorses the bill, attaches the insurance documents, and sends it back to the supplier. The boat is now ready to sail. The supplier has an instrument he could use as ready cash to pay for goods needed in order to replenish his depleted inventory. When the boat docks in Hamburg, the wholesale merchant pays for the cargo with a sight bill on London, with which the importer meets his maturing obligation. This is self-liquidating credit “on the go”.

No loan is involved. There is no need to invade the pool of circulating gold coins and to tie up savings for 30 days in moving goods in urgent consumer demand.

If you insist that this is credit expansion as money has been created out of nothing without recourse to saved funds to finance the movement of cargo across the high seas, and if you say that the bill drawn on the importer has been misused to fan the fires of inflation, then you have failed to grasp how foreign trade is financed.

### Vanishing risks

It is true that production and distribution of consumer goods, no less than that of producers goods, involve risks. However, there is a difference. Risks of dealing in consumer goods in urgent demand vanish as the “journey” of the “maturing” good is coming to an end, and the final cashpaying consumer is already in sight, so that the consummation of sale can no longer be doubted.

From this point on the last leg of the journey can be financed with self-liquidating credit. By contrast, for producers goods, risks do not disappear even after the sale.

Of course, not every consumer good has the quality that risks disappear during the last leg of its journey. Luxury goods and specialty items, for example, fall into this second category. So do consumer goods sold on installment plans. The production and distribution of these have to be financed out of savings through loans, as is done in case of producers goods. Merchandise of the first category may occasionally have to be downgraded to the second, if demand for it slackens.

Conversely, consumer goods of the second category could be upgraded to the first if demand for them picks up sufficiently. The bill market is the final arbiter to draw the shifting line of demarcation separating the two categories. If a bill can find takers and is readily discounted, then the underlying merchandise belongs to the first category. Otherwise it belongs to the second.

### “Telescoping” payments

We have seen that the RBD has nothing to do with credit expansion by the banks. On the contrary, the remarkable fact is precisely that the RBD works also in an economy bereft of banks.

It deals with the singular phenomenon that bills drawn on emerging goods sufficiently close to the ultimate cash-paying consumer circulate on their own wings and under their own steam, provided only that those goods are in urgent demand.

For this reason, if you want to refute the RBD, then it is not good enough to attack the banks for their part in credit expansion. You have to refute the phenomenon, acknowledged by Mises himself, that the bill of exchange is, in and of itself, fully capable of spontaneous monetary circulation. Typically, it is used in payment for higher-order goods by the producer of lower-order goods. In more details, bills drawn on the producer of an (n ! 1)-st order good, by virtue of his being that much closer to the ultimate gold-paying consumer, become a means of exchange in the hand of the producer of n-th order goods when he pays the producer of (n + 1)-st order goods for supplies. As the final product is sold to the consumer, his gold coin will liquidate all claims that have arisen along its journey through the various stages of production. Several payments have been, as it were, telescoped into one. This is clearing at work. This is the meaning of the assertion that the credit represented by the bill of exchange is self-liquidating. This is credit the volume of which flows and ebbs with the propensity to consume.

### Can circulating capital be financed out of savings?

Moreover, as I shall now show, it is not possible to finance all of society’s circulating capital out of savings. It would put inordinate demand on savings that simply could not be met. Consider a hypothetical product called “miltonic”. It is in urgent demand as a medicine that helps preventing cancer. Its production cycle takes 91 days, with as many as 90 firms participating, so that the sojourn of the semi-finished product at every one of the 90 stops takes one day. The ultimate consumer is willing to pay \$100 for a bottle while the producer of the 90th order good has paid \$11 for raw materials. We shall also assume that the value added to the maturing product at every stop is \$1. Now if you want to finance the movement of one bottle of miltonic through the various stages of production, then the pool of circulating gold coins will have to be invaded 90 times, and you have to withdraw savings in the amount of

11 + 12 + 13 + ... + 98 + 99 + 100 = ½(11 + 100)×90 = 45×111 or \$4995, almost 50 times retail value. In other words, there must be savings in existence in the amount of almost \$5000 to move just one bottle of miltonic through the production process all the way to the consumer. This sum does not include fixed capital that also has to be financed out of savings! And what about other items of food, fuel, and clothes, also urgently demanded by the consumer? Let me suggest it to you that no conceivable economy can generate savings so prodigiously as to move all the indispensable items to the consumer. I conclude that the division of labor could have never been refined, and the “roundaboutness” of the production process could have never been lengthened, beyond the level reached by the cottage industries of the medieval manors, wherein every family had to produce not only its own food and fuel, but also its clothes and shelter.

If it did not happen that way, and production has become vastly more efficient, was in large part due to the invention of the bill of exchange, heralding the end of the Middle Ages. Clearing has been put to work making it entirely unnecessary to invade the pool of circulating gold coins and divert savings, to finance the movement of consumer goods through an ever more refined and roundabout process, provided only that those goods be demanded by the consumer urgently enough.

Detractors of the RBD, above all Nobel prize laureate Milton Friedman, put his foot into his mouth when he ridiculed the idea of bill circulation suggesting that it was inflationary. It is hard to see how thoughtful people can treat the notion, that circulating capital no less than fixed capital must be financed out of savings, with respect.

### Rate of interest versus discount rate

Although Mises was fully cognizant with the bill of exchange, he failed to come to grips with the idea that there was no credit expansion involved in its spontaneous circulation. Bills emerged together with the emergence of marketable merchandise, and were extinguished when the latter was removed from the market by the consumer. At no point did the bill increase the amount of purchasing media relative to the available supply of merchandise. The bill is an instrument of clearing or, if you will, self-liquidating credit. It is one of the marvelous creations of the human genius, fully commensurate in importance with the evolution of indirect exchange, arising spontaneously and opening up new avenues to human progress. Unfortunately, Mises was not interested in the concepts of clearing and self-liquidating credit. He dismissed them as paraphernalia belonging to credit expansion. In this way Mises missed his chance to make his theory of money and credit withstand the ravages of times.

His error of omission led to several errors of commission, the most conspicuous of which was his assumption that the discount rate at which maturing commercial paper changed hands was simply a subset of the rate of interest, in particular, the rate on short-term borrowing. This was a most serious error indeed, as the rate of interest and the discount rate were governed by entirely different, sometimes diametrically opposing, economic forces. They could move independently of one another, frequently in opposite directions, subject to the only constraint that the rate of interest can never be lower than the discount rate. If it were, the propensity to save would outstrip the propensity to consume. But saving becomes pointless if human life cannot be sustained for lack of spending on the wherewithal of life. If you save too much, then you die of starvation. No one ever has done so, rumors notwithstanding. The anecdotal miser is just that, anecdotal. This also explains why the rate of interest cannot go to zero. However, the discount rate may, whenever consumer confidence becomes most exuberant making shop-windows spill over their contents to the curbside.

To recapitulate: the rate of interest is governed by the propensity to save and, by contrast, the discount rate is governed by the propensity to consume. In either case the rate changes inversely with the propensity. For example, the higher the propensity to save, the lower is the rate of interest; the lower the propensity to consume, the higher is the discount rate. That the two propensities are not rigidly linked is due to the existence of a cushion, the propensity to hoard.

### Irredeemable currency: present good or future good?

But Mises spurned the idea that there was a theory of an independent discount rate. In consequence his theory of interest is flawed. This fact cannot be swept under the rug, as it has led to further curious errors and contradictions. For example, Mises concluded that fiduciary money, i.e., money originating in the credit expansion of banks, was a present good on exactly the same terms as was the gold coin, and not a future good as was the bill of exchange. In his eyes even irredeemable currency was a present good, in spite of the fact that it could be created at the pleasure of the government ad libitum. Elsewhere Mises rightly ridicules irredeemable currency by saying that only the government is capable of the feat of taking two perfectly useful goods, such as paper and ink, and make the former perfectly worthless by sprinkling some of the latter on it. But if we declare irredeemable currency a present good, then we credit the government with power to create wealth out of nothing, a notion antithetical to Mises’ opus.

Had Mises admitted that a discount rate existed independently of the rate of interest, then he could have avoided such contradictions. Fiduciary money and irredeemable currency belong to the species of a promissory note and as such are not a present good but a future good. Even a gold certificate is a future good: “there’s many a slip between cup’n lip”. Only a gold coin qualifies as a present good among the multifarious forms of purchasing media. This makes the gold coin sui generis, one of a kind, in the context of the theory of interest. In fact, a theory of interest without gold is “Hamlet without the prince”. The interest rate on a loan repayable in irredeemable currency can never be the benchmark on which to build a theory of interest, no matter how many armored divisions the government foisting off currency on the world may have at its disposal.

Debt repayable in irredeemable currency is nothing but an interest-bearing promise to pay that is exchangeable at maturity for a non-interest-bearing one. Bonds at maturity are exchanged but for an inferior instrument, insofar as interest-paying debt is considered preferable to non-interestpaying debt. The time-preference theory of interest is vacuous unless it explicitly stipulates that interest and principal be payable in gold coin. Without this provision prestidigitation is involved: future goods are juggled to make the impression that debt is being retired through the surrender of a present good.

But debt can never be retired under the regime of irredeemable currency. At maturity it is shifted from one debtor to another. People are constructing a Debt Tower of Babel destined to topple in the fullness of times.

### The Lady of Threadneedle Street

It is commonplace to badmouth the Bank of England for her role in the corruption of the gold standard of Sir Isaac Newton, the Master of the Royal Mint from 1699 to his death in 1727. But whatever one can say of the low circumstances of her birth in 1696, and of her most recent role as the “Bag Lady of Threadneedle Street” in selling her gold reserve to the drumbeat from the paper mill on the Potomac, we must give the Bank of England credit for financing Pax Britannica for a period of one hundred years between the close of the Napoleonic Wars and the outbreak of World War I. Authors often wondered how the Bank of England could run the international gold standard on a shoestring of a gold reserve.

The mystery readily finds its solution if we contemplate that the Bank of England acted as the clearing house for real bills financing world trade between 1815 and 1914. This was history’s most successful episode demonstrating the power and the potential of the RBD. By 1913 world trade in consumer goods had reached a high mark that was not surpassed until the 1990's. In whichever countries they were domiciled, the exporter billed the importer and the terms of the bill “91 days net payable in London” were standard. The importer endorsed the bill, attached shipping and insurance documents, and sent it back to the exporter. Thereafter the bill circulated worldwide in lieu of gold till it matured. Hardly ever did a default occur, and even then it was in consequence of violations of bill trading rules. Gold was shipped only to the extent of the difference between imports and exports. The modest size of the gold reserve of the Bank of England was no fetter on a most prodigious increase in world trade, a monument to the triumph of clearing. Goods in bottoms did not have to sail anywhere near England to be eligible for financing through bills drawn on London.

It is incumbent on the detractors of the RBD to explain how the phenomenal increase of world trade in consumer goods, on which the remarkable prosperity of the world before World War I depended, was possible with only a negligible amount of gold changing hands.

### The permanent crisis of the world’s monetary system

The outbreak of World War in 1914 put an end to international bill circulation and wiped out world trade in consumer goods almost entirely. When the war ended, the garrison states that emerged did not allow real bill trading to recover. Bill trading assumes that the gold is outside of the banks, in the hands of the people. Strategic imperatives called for the concentration of monetary gold in bank vaults. People had to be weaned from the gold coin. Nor was the reintroduction of real bill trading considered an option at the Bretton Woods conference in 1944 that was charged with the task to regenerate the world economy and trade after the ordeal of World War II. The world is still doing without the benefits of real bills. Trade has been placed under the direct control of governments. Political, not economic considerations govern the flow of consumer goods across international boundaries. Government regimentation of the lives of the people has become virtually complete.

The expulsion of real bills and the failure of world trade to recover after World War I, together with the advent of “cash and carry” mentality, was one of the main causes of the failure of the international gold standard and the Great Depression about a dozen years after the cessation of hostilities. A strong case could be made that if bill circulation had been allowed to return, then world trade would have quickly recovered, too, and the international gold standard would not have collapsed. Collapse it did because, without the clearing mechanism provided by real bills, it could not cope with world trade, much reduced though it was. People were talking about an

“acute shortage of monetary gold”. Money doctors rose with a phony diagnosis that the malady was due to the increase in the price level that was not accompanied by a commensurate increase in gold reserves. This diagnosis holds no water. It is based on the Quantity Theory of Money, a flawed theory that is applicable only in a world where all changes are in a linear relationship with their causes. In reality, however, changes in our world are a non-linear function of causes. There is no way of telling how much trade a given amount of monetary gold can support at any given price level. The volume of trade depends, not on the stock of monetary gold, but on the clearing system which can be improved to meet the challenge. Instead of improving it, governments conspired to sabotage the clearing system by blocking international trade in real bills that had worked so efficiently before the war. The proper prescription should have been the restoration of the clearing mechanism through real bills. Please remember that you have seen it here first: the main cause of the Great Depression of the 1930's was government sabotage of the Real Bills Doctrine of Adam Smith. The world’s monetary and payments system is still limping from crisis to crisis, and will continue doing so until the RBD is fully rehabilitated.

### The pipedream of the 100 percent gold standard

Some detractors of the RBD advocate what they call the “100 percent gold standard” in which they leave no room for real bill circulation. They maintain that real bills must be superseded by loans financed out of savings.

This is a momentous issue that must be addressed adroitly and fairly by all protagonists of sound money. We must put aside prestige, rancor, and personal ambitions in order to bring about a consensus concerning the shape of the gold standard that we all hope will arise from the ashes of the regime of irredeemable currency. We must all cooperate that the new gold standard will not only survive but flourish as well.

The first thing to be observed about the “100 percent gold standard” is that nothing approximating it has ever been tested in practice. All historical metallic monetary standards had a supporting clearing system, more or less developed, which limited the actual payment in the monetary metal to net trade, that is, the difference between the value of total purchases and that of total sales. It follows from my analysis above that a “100 percent gold standard” will not be able to survive for reasons having to do with the burden it unnecessarily puts on savings. There isn’t, nor will ever be, savings in sufficient quantity to finance circulating capital in full, given our highly refined division of labor and roundabout processes of production. Luckily, this is no problem, as so much circulating capital to move merchandise in sufficiently high demand by the final consumer can be financed through self-liquidating credit. Advocates of the “100 percent gold standard” must realize that they have grossly underestimated the degree of sophistication of the structure of production in the modern economy. They must also come to grips with the fact that financing circulating capital with real bills is not inflationary. Real bills enter and exit circulation pari passu with the emergence and ultimate sale of consumer goods.

Only if we approach our differences with sufficient humility can we prevail against the evil forces opposing freedom armed, as they are, with the formidable weapon of irredeemable currency.

Given the stakes, I am convinced that Ludwig von Mises would, if he were alive today, put pride aside and admit that his 1912 judgment in dismissing the discount rate as an independent variable, distinct from the rate of interest, was a mistake.

---

### Further reading

In addition to Adam Smith’s The Wealth of Nations I recommend my Adam Smith’s Real Bills Doctrine that was published on the internet as Monetary Economics 101 in the Gold Standard University series in 2002, see the website.

### Xicotepec, Mexico, June 13, 2005

### Note

The Mises Institute’s broadside on Nelson Hultberg and myself, see Real Bills,

Phony Wealth by Robert Blumen () calling us “monetary cranks” fails to meet the standards of polite academic debate. Our sin: we had the temerity to suggest that a proper monetary system for the United States should incorporate not only a gold standard but also a clearing system based on Adam Smith’s Real Bills Doctrine (see: Breaking the Demopublican Monopoly by Nelson Hultberg, published by Americans for a Free Republic, P.O. Box 801212, Dallas, TX

75380, )

The present paper was written as a rejoinder, explaining why a “100 percent gold standard” was a pipedream, and that it was not good enough to put gold coins into circulation (which would promptly go into hiding). One would also have to make provisions for a clearing system, without which the gold standard could not function in a complex economy.

Unfortunately Lew Rockwell and Jeffrey Tucker at the Mises Institute have refused to post my rejoinder, letting the attack on my theoretical work go unchallenged making it appear that no reasonable answer to the detractors of the Real Bills Doctrine is possible. To say the least, this is a most peculiar procedure for an institute that pretends to support the search for and dissemination of truth.

It is difficult if not impossible to enter into a debate on the Real Bills Doctrine with people who are not conversant with the modern literature on clearing and self-liquidating credit. I just mention the names of a few 20th-century authors who have written on the subject: Charles Rist, Melchior Palyi, Benjamin M. Anderson, Heinrich Rittershousen, Ulrich von Beckerath, Henry Meulen; the complete list is too long for inclusion here.

In the 1930's University of Chicago economist Lloyd Mints wrote a book on real bills in which he reviewed the literature on the subject written in English only. This is not unlike writing a medical treatise on tuberculosis reviewing the contributions of English researchers only. If you cast your net so narrow, then you miss the German bacteriologist Robert Koch, the discoverer of what has come to be known the Koch bacillus which today is recognized as the cause of tuberculosis. It may be of interest to note that for a number of years Koch was ridiculed for suggesting a single cause for “consumption”, the earlier name for this devastating disease.

Latter-day detractors of the RBD have obviously missed the contribution of Ritterhousen who in 1934 published a paper Zahlungsverkehr, Einkaufsschaffung und Arbeitsbeschaffung in the journal Annalen der Gemeinwirtschaft. In it he makes a defense of the “Banking School”and the Real Bills Doctrine against the inflationists, deflationists, and adherents of the “Currency School”.

He also discusses how the first departure in 1909 from the RBD by Germany was later imitated verbatim by other countries, which was the major cause of unemployment world-wide in the

1930's. It is not fashionable nowadays to read papers that have been written and passed by the Nazi censorship during the Third Reich. Yet you may ignore them at your own peril. Economist and monetary scientist Rittershousen survived the Nazi witch-hunt by a fluke. He continued to teach after the war until his retirement as Dean at the University of Köln in 1966.

For all open-minded Americans my rejoinder will demonstrate why Murray Rothbard and the Misesians are mistaken in their denigration of the Real Bills Doctrine and the Banking School, and why their uncritical embracing of the never-ever-tried idea of the so-called “100 percent gold standard” would impart a congenital disease to the new metallic monetary standard after the collapse of the regime of irredeemable currency. In fact I would go so far as to suggest that no greater favor to the enemies of freedom in America could be done than pursuing the present policy of the Mises Institute. The enemies of freedom, the managers of the unconstitutional irredeemable dollar, are rubbing their hands in joy while getting ready to shout from the rooftop that “we have told you so”. They understand what the Misesians do not: the “100 percent gold standard” is doomed to failure. If implemented, it would cause depression, bankruptcies, and unemployment. The Great Depression of the 1930's would be repeated, which was due, not to fractional reserve banking, but to government sabotage of the market’s clearing system, the international real bill market.

The “100 percent gold standard” is but a blueprint to discredit the gold standard 100 percent.

---

# The Goldbug, Variations V

URL: https://newaustrianeconomics.com/archive/fekete/the-goldbug-variations-v/
Date: 2005-05-01
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, bond-market, deflation, gold-standard, capital-destruction
Description: The fifth and final variation synthesizes the series by explaining how the gold basis, the bond market, and the Kondratiev long-wave cycle interact. Fekete argues that the ultimate consequence of gold's demonetization is a once-in-a-century deflationary depression — and that the approaching collapse of the bond bull market will trigger it.
Editorial Note: Final installment of the Goldbug Variations series (March–May 2005). Fekete draws the threads together to present his most complete picture of how permanent backwardation, bond market collapse, and the Kondratiev cycle combine into a single deflationary endpoint.
Original PDF: https://professorfekete.com/articles/AEFTheGoldbugVariationV.pdf

### Recitativo

The United States abandoned its policy of stabilizing gold prices back in 1971.

Since then the price of gold has increased about 1000 percent while consumer prices have increased only about 250 percent or, roughly, a quarter of the increase in the gold price. If we had tried to keep the price of gold from rising, this would have required a massive decline in the prices of practically everything else — deflation on a scale not seen since the Depression. This does not sound like a particularly good idea.

### Rondo

What the United States did in 1971 was defaulting on its gold obligations to foreign creditors, the biggest act of bad faith in history theretofore. This default, and the making of the dishonored debt money, was the cause of the destabilization of interest rates, as well as the explosive growth in the volatility of prices that have been plaguing the world ever since and causing ever greater economic distress. Krugman’s euphemism in calling the greatest default ever “the abandoning of the stabilization policy of the gold price”, and calling the promotion of the dishonored paper as money “a measure designed to prevent deflation and the decline of prices” is doublespeak, the hallmark of dismal monetary science. Krugman suggests that an equilibrium now obtains that didn’t before. What we have is not an equilibrium; rather, it is a burgeoning disequilibrium, one that will continue its devastating course.

We must remember that the financial annals do not record a single case in which a default has not been followed by a progressive increase in the discount on the paper of the defaulting banker, until it reached 100 percent — possibly several years or even decades later. Obviously, the defaulting banker would try to slow down the process by hook or crook. However, ultimately economic law was to prevail and the remaining value of the dishonored paper would be wiped out.

There is no reason to believe that the dollar default will end differently. Suppose that the price of gold is \$420. Let us calculate the discount on the dollar.The gold value of the dollar has been reduced from 1/35 to 1/420 = 1/12×35. Therefore the loss is

### (1/35)(1 1/12) = (1/35)(11/12) = (1/35)0.9166...!

In percentage terms the loss, also known as discount, is 91.66 percent. Not yet 100, but close enough. Small comfort, as the last 8.33 percent of the loss, coincident with the death-throes of the dollar, is likely to be most violent and painful, revealing the full extent of the devastation. Remember, the loss affects not only cash holdings, but all dollar-denominated assets, including bonds, annuities, pensions, insurances, endowments, etc. As the discount on the dollar approaches 100 percent, the dollar price of gold will approach infinity. To assert that the dollar is going to escape this fate is tantamount to asserting that the laws of economics and logic have been turned upside down, and the penalty for default has been replaced by reward in perpetuity.

### Rondo

The discount as calculated above in terms of the price of gold is the leading indicator of the depreciation of the dollar. It is pretty accurate in registering the loss of purchasing power in terms of a wide array of other goods as well.

However, it is important to note that the discount on irredeemable currency, although obviously going to 100 percent, is never doing it along a straight line. It goes through fits and starts, sprinkled with ever more violent reversals.

Therein lies a great danger. Reversal confuses people and lulls them into believing that the currency has reached the end of skid-row, and is now entering respectable neighborhood. The explosive growth in the volatility of interest rates and prices is finally over. More astute observers will, however, realize that low interest rates and subsiding volatility won’t cure the malady the cause of which, default, has not been acknowledged, still less removed. Nor will asset bubbles cure it. Volatility is bound to return with a vengeance. Like the wrecker’s ball, it will keep swinging until the whole financial structure is reduced to rubble.

A reliable measure of destruction is the so-called “notional” size of the derivatives market trading interest-rate futures, options, and swaps. It now stands at a quarter of a quadrillion dollars and is increasing at an accelerating pace. The word “notional” is a euphemism suggesting that there is nothing to fear about it. As if it were a kind of financial mirage. Well, there is plenty to fear about. It is real enough as it measures the commitments of bond speculators, most of whom are betting that the rate of interest will keep falling in the U.S., too, as it has been in Japan. The bets are well-grounded. They reflect expectation that interest rates will be driven by the Fed into the bargain basement. This is what the Fed did in the 1930's, causing the First Great Depression. This is what it is doing now, causing the second. The Fed buys bonds in the open market when it wants to combat deflation and falling prices, and also buys them when it wants to combat inflation and rising interest rates. If the Fed ever sells bonds, the occasion is few and far in between and it is for window-dressing purposes only. Speculators know this and think that they can’t go wrong if they try to preempt or emulate the Fed in buying the bonds.

This raises the question: if the deflationary danger caused by the Fed’s open market operations is so great, because it makes bull speculation in bonds risk free, then why don’t economists warn us about it? The answer is that dismal monetary science blocks the free flow of information and an impartial scientific debate of the threat (which is caused by the regime of irredeemable currency alternating, as it does, between inflationary followed by deflationary excesses).

During the inflationary excess commodity speculation, and during the deflationary excess bond speculation is bleeding the economy white, but you are not supposed to know.

### Recitativo

It is true that a freely floating national money can create uncertainties for international traders and investors. Over a period of five years between 1991 and 1996 the dollar has been worth as much as 120 yen and as little as 80. The costs of this volatility is hard to measure but they must be significant.

### Rondo

It is disingenuous to say that in 1971 the United States made the dollar “freely floating”. What the United States did was nothing less than throwing away the yardstick measuring value.

It is truly unbelievable that, in our scientific day and age when the material and therapeutic well-being of billions of people depends on the increasing accuracy of measurement in physics and chemistry, dismal monetary science has been allowed to push the world into the Dark Ages by abolishing the possibility of accurate measurement of value. We no longer have a reliable yardstick to measure value. There was no open debate of the wisdom, or the lack of it, to run the economy without such a yardstick.

To throw away gold, a rigid yardstick, and to replace it with a shrinking and elastic yardstick, the dollar, idiotic as though it is, does nevertheless have a rationale as well as a precedent. In less enlightened times the length of the “foot”, as the name of this particular yardstick suggests, was adjusted every time the king died. If the new king’s foot was smaller, then the new official unit of length was made shorter. This allowed rope-makers, spinners, and weavers to sell a smaller amount of merchandise for the same amount of money. In this way inefficient producers were favored at the expense of the consumers who were legally short-changed.

The floating dollar does exactly the same. It shelters the inefficient producer who is enabled to sell the same quantity of products at progressively higher prices, to the detriment of the consumer at large.

### Interlude

During the course of his travels to many strange lands Gulliver also visited the Country of the Mad Scientists. A government spokesman took him on a guided tour in order to acquaint him with the marvelous achievements and great projects of that land. Among others Gulliver was shown a new procedure under development whereby the erection of buildings would start with the construction of the roof rather than the foundations and proceed from top down. In this way shelter was provided for construction workers in inclement weather.

In another part of Science City, the capital, Gulliver visited an experimental farm where research scientists were simultaneously breeding woolless sheep and milkless cows. They were motivated by the idea that the output of sheep milk could be increased greatly through the elimination of wool growing, thus making cow’s milk redundant. Wool for clothing could then be replaced by the sturdier cows’ hair, that could also be shorn more efficiently.

There was one invention in particular that fascinated Gulliver more than any other. They called it “floating time”. At the Institute of Horology the director explained that the idea of fixity of time is old-fashioned, even reactionary. In this respect musicians have been more progressive than scientists. They had long ago overthrown constant time, leaving its variation to the discretion of the conductor. Now he could set free the emotive energy implicitly present in the music, the release of which was forbidden by an earlier narrow-minded and reactionary age.

Floating time was implemented by connecting Big Ben in one tower of Parliament Building to Big Barb, the weather vane, in the other. Every time the direction of the wind changed, turning Big Barb one way or another, so did time, as indicated by a slow or a fast Big Ben. The director proudly pointed out that in this way their timepiece was imbued with cosmic power present in the universe, including sun spots and sun flares that have so far been foolishly ignored by clockmakers, but not by the wind.

The director was going to let Gulliver inspect the ingenious mechanism that made floating time possible. It would allow the Chairman of the Board of Time Reserve to overrule the prevailing wind whenever justified. At the Parliament Building they ran into the picket line of workers demanding higher wages. At that moment the town clerk announced that the direction of the wind has just turned Westerly, meaning that Big Ben would run fast, cutting the hour down from 60 minutes to 50. The workers burst into joyous cheering. They understood that the working day has been instantaneously shortened 16 percent by the change of the wind, without reduction in pay. The strike was called off. The director turned to Gulliver and winked: “See what I mean? Floating time is helpful even in settling labor disputes!”

### Finale

The great 20th century economist Ludwig von Mises famously predicted, shortly after the consolidation of Bolshevik power that, unless private ownership of the means of production was reestablished, the economy of Russia would collapse.

Without valid market prices for the means of production businessmen could not do the necessary economic calculations as to what, when, and where to produce, and how much to invest in production facilities, so rational allocation of scarce resources was no longer possible. For a while the economy could limp along but, eventually, the compounding of bad economic decisions would lead to so great an economic distortion that sudden death would become inevitable.

Well, it took three and a half score of years to reach the threshold beyond which economic abuse caused by bad decisions could no longer be tolerated, and the prophecy was duly fulfilled.

Mises made another famous prediction. If the United States left the gold standard, and failed to stabilize the dollar in terms of gold soon thereafter, then a “crack-up boom” would follow and the dollar would lose all its purchasing power, first internationally, then domestically. This prophecy has not yet been fulfilled but, as the Soviet example shows, sometimes you have to be patient when waiting for Mises’ predictions to come true.

Unfortunately, Mises justified his prophecy about the dollar in terms of the Quantity Theory of Money, which is a linear model and is not applicable in a non-linear world such as ours. He should have argued in exactly the same way as he did in predicting the demise of the Soviet Union. If the United States threw away the yardstick measuring value, namely the gold dollar, then businessmen could not do the necessary economic calculations as to what, when, and where to produce, and how much to invest in production facilities, so rational allocation of scarce resources would no longer be possible. For a while the economy could limp along but, eventually, the compounding of bad decisions would lead to so great an economic distortion that sudden death would, in the fullness of time, become inevitable. We don’t know where the threshold is beyond which the economic abuse caused by bad decisions can no longer be tolerated. What we do know, however, is that economic abuse cannot continue indefinitely, as the Soviet example so convincingly demonstrates.

### ***

The trouble with Krugman’s dismal monetary science is not that it can err. The trouble with it is that it functions as a “thought police”. It intimidates people in their pursuit of searching for and disseminating truth, and it bribes others to push propaganda as science.

Over a month ago I issued a challenge that Krugman open the columns of The New York Times to an impartial discussion of the future of the irredeemable dollar. I have evidence that the challenge has reached his desk.

It only remains for me to report that I have received no answer to my challenge.

### References

Andrew Dickson White, Fiat Money Inflation in France: How It Came, What It Brought, How It Ended (an online e-book) [www.financialsense.com](http://www.financialsense.com/editorials/reality/2005/4R0321.html) Paul Krugman, The Gold Bug Variations — The Gold Standard and the Men

### Who Love It [web.mit.edu](http://web.mit.edu/krugman/www/goldbug.html)

### Antal E. Fekete, The Goldbug Variations I-III

---

# The Goldbug, Variations IV

URL: https://newaustrianeconomics.com/archive/fekete/the-goldbug-variations-iv/
Date: 2005-04-20
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, interest-theory, bond-market, deflation, capital-destruction, gold-standard
Description: The fourth variation examines the relationship between gold, interest rates, and the bond market, arguing that the existence of a gold basis creates a natural floor for interest rates that disappears under irredeemable currency. Without this floor, interest rates can be driven to zero — or below — destroying the capital structure and producing the deflationary depression Fekete predicts.
Editorial Note: Fourth in the Goldbug Variations series, focusing on the connection between the gold basis and interest rate floors. This piece anticipates Fekete's later warnings about zero and negative interest rates as symptoms of irredeemable currency's terminal phase.
Original PDF: https://professorfekete.com/articles/AEFTheGoildbugVariationIV.pdf

1. The irredeemable dollar has been losing at least 90 percent of its purchasing power every 35 years.

2. Interest rates have been destabilized and could reach unprecedented high or low levels.

3. The volatility of commodity prices has increased explosively and continues to do so.

4. We are forced to live under the constant threat of disruptive corners, for example, corner in the crude oil market.

The volatility of the price of crude oil has been as high as 1000 percent per annum (i.e., the price increased eleven-fold within a year). It is blamed on the intrigues of OPEC to corner the market. However, this begs the question, as cartels prosper under the regime of irredeemable currency and wither under the gold standard. At any rate there are many other examples of explosive increases in price volatility. The price of sugar went from 6 cents per lb to 75 in 1975 (forcing Coca Cola to switch to corn syrup) only to fall back to 10 in the following year. The price of coffee underwent comparable gyrations. Nor was volatility confined to imported goods. Soybeans saw wild price movements up and down, as did most cash crops. This type of volatility was simply unheard-of under the gold standard. Also unheard-of was a cartel cornering a commodity such as crude oil, as long as the medium of exchange was gold.

In fact, one of the chief merits of the gold standard is that it eliminates the threat of disruptive corners by reining price volatility back. Suppose that under a gold standard there is an incipient corner in the crude oil market. Arbitrageurs would respond by selling crude oil forward at ever higher prices, and keep doing it until the corner is broken. I use the word “arbitrage“ advisedly. A short position in crude oil is balanced by a long position in gold and, as a consequence, the risk of the arbitrageur is limited. Price volatility is reined in through arbitrage long before a corner could materialize. By contrast, under the regime of irredeemable currency a short position in crude oil carries unlimited risk (since there is no obvious limit above which the price may not rise). As a consequence speculators are reluctant to resist price trends and swings. Volatility could become explosive.

Of course, you could resist the uptrend and keep selling forward crude oil at ever higher prices. But this would no longer be arbitrage. It would be pyramiding naked short positions at escalating losses, a most foolish market action. No speculator in his right mind would undertake it. For lack of arbitrage corners have become common, and volatility is left unchecked. Not just in crude oil. Not just in agricultural products. Also in metals: copper, lead, palladium, you name it.

Explosive increases in price volatility are in the making as I write this.

It is ridiculous to argue, as Krugman does, that changes in dentistry could adversely affect the monetary role of gold, presumably by causing deflation in case of an increasing, or inflation in case of a decreasing demand for dental gold. Gold is not merely a commodity. Its highest stocks-to-flows ratio, which is not materially affected by changes in dentistry or in any other marginal application, makes gold the monetary metal par excellence.

### Interlude

Let me relate my personal experiences concerning gold and dentistry. I can speak with some authority on this matter as a survivor of the Soviet occupation of Hungary in 1945 (which was to last 45 years, until the collapse of the Soviet Union in 1990.) Like most people of the middle classes, my father had gold in his teeth, a relic of more prosperous times. However, gold teeth had not much chewing to do in Soviet-occupied Hungary. The Red Army requisitioned all foodstuff it could lay its hands on for its own use, as well as for shipping it back home — without any regard for the starving local population.

So my father had his gold teeth removed. With the proceeds of the sale of gold he could have false teeth made of cheaper material, and still have money left to buy food for his family. This shows that the demand for gold in dentistry is priceelastic and can even go negative, just as it is in jewelry. Scarcity of money will not cause deflation under a gold standard. Rather, it will attract gold to the Mint, and not only from the mines and jewelry boxes, but also from people’s teeth — a further proof of the excellence of gold as monetary metal, contrary to what Krugman thinks.

It is just as silly to suggest that replacing gold in dentistry with other materials could cause the demand for gold decline which translates into inflation under a gold standard. In 1945 dental gold was replaced by cheaper materials in Hungary, without making the demand for gold decline. I remember very vividly the delicate hands of our dentist as he clipped off an agreed portion of the heavy gold chain that used to hold my grandfather’s pocket watch. (I still have the remnants of that chain in my possession. The watch itself has been bartered for food during hard times.) In doing so the dentist was taking his fee for professional services, which he simply refused to provide on any other terms. In particular, he contemptuously declined to take his fee in irredeemable currency, however profusely offered. The dentist did not need the gold in his dental practice as his patients could not afford it. He wanted the gold because he did not trust the value of irredeemable currency. On a more grisly note, high-ranking officials of Nazi Germany as well as of the Soviet Union did not trust it either.

They ordered gold teeth to be wrenched from the mouth of the victims they had killed, to be recycled as good-delivery gold bars.

Nicholas Deak, principal of Deak-Perera, a banking firm in New York specializing in precious metals and foreign exchange in the 1970s, was of Hungarian origin. He worked for OSS (predecessor of the CIA) during World War II out of his base in Switzerland. He has told me that agents operating in enemy territory were issued gold coins. Later in the Vietnam War American airmen were also issued gold coins. In each case the idea was that gold might buy them freedom in case they were captured, something that paper money would be decidedly unable to accomplish.

Deak believed that the top brass at the Fed carried part of their personal savings in the form of gold coins. They certainly appear to understand gold better than Krugman. Chairman Alan Greenspan is on record revealing the “shabby little secret of fiat money” as an agent of the Welfare State. It enables politicians to promise pie in the sky to the electorate, something they could not do under a gold standard without being found out in short order as imposters. Greenspan is also on record opposing U.S. Treasury gold auctions for reasons that in war the dollar might be useless, and gold will be needed to purchase war material abroad to support the fighting men and women of the armed forces. What he did not say was that the dollar could become useless in peacetime, too, under his own watch.

### Cadenza

In this Cadenza I give a brief refresher course on the subject of speculation versus arbitrage. The two are very different. In a sense they diametrically oppose one another. The speculator is willing to take large risks in the hope of large profits, while the arbitrageur is interested in reducing risks. The speculator is betting on changes in the price, while the arbitrageur is betting on changes in the spread (difference between two prices). The speculator’s basic tools are: 1. net long position (commitment to buy), 2. net short position (commitment to sell) at a predetermined price. The arbitrageur’s basic tool is the straddle

(combination of a net long and a net short position). To every straddle there corresponds a spread, the difference between the prices at which the commitments to buy and sell have been made. Reduction of risk is realized as movement in the spread is often more predictable than that in the price itself.

Unfortunately, the distinction between speculation and arbitrage as a rule is not kept clear, and confusion arises frequently. For example, strictly speaking, under a gold standard there is no speculation, only arbitrage. What looks like an outright position is really a straddle (in case of a long position, long in the commodity and short in gold; in case of a short position, short in the commodity and long in gold). This fundamental fact is ignored by virtually all authors writing on the subject, thereby obscuring the role of the gold standard as a regulator reining price volatility back. In more details, speculation is less risky under a gold standard than under a regime of irredeemable currency in view of the fact that speculators work with straddles rather than net long or net short positions.

Because of the smaller risk, they are not reluctant to resist price swings and trends. By contrast, under a regime of irredeemable currency speculators are often weary to enter a long or a short position because of the greater risks involved. Moreover, speculators seek protection in “herd instinct”. That is to say, they prefer to jump on the band-wagon in order to ride an established price trend. This is the exact opposite of what they might do under a gold standard where resisting trends may offer a greater profit opportunity than riding them.

To recapitulate, the gold standard has a built-in mechanism to restrain volatility in commodity prices. This is in contrast with the regime of irredeemable currency which is more likely to encourage volatility, as well as the formation of a price trend. By the same token, it is also far more hospitable to cartels than is the gold standard.

It goes without saying that establishment economists, including practitioners of the dismal monetary science, are simply not interested in these problems. The Federal Reserve banks would never sponsor research investigating the fundamental change in the nature of speculation after the dollar has been made irredeemable. This example alone should make it clear that establishment economics has nothing to do with the search for and dissemination of truth. It has to do with the maintenance and aggrandizement of establishment power.

### Interlude

The love of paper money may make Krugman the “modern King Midas in the reverse”. His gods could turn everything he touches, including food and drink, into paper. It is small consolation that the paper he must eat has a long string of zeros following the digit 1 printed on it.

It actually happened, among other places, in Hungary, where bank notes denominated in the billions, trillions, and quadrillions circulated in rapid succession in 1946. I know — I have been there. At one point they ran out of prominent people the image of whom could be printed on the bank notes.

Luckily, this is no problem in the United States where the supply of professors of dismal monetary science whose image can be printed on the \$1 billion, \$1 trillion, or \$1 quadrillion FR notes is unlimited, thanks to the foresight of the twelve FR banks in making generous research grants to qualified applicants.

Additionally, the game of “knocking off zeros“ can also be played by any country, big or small, with an equal and fair chance to win. The rules are simple. You could declare one New Peso equivalent to, say, one million old pesos, knocking off 6 zeros right there and then with one mighty swoop, and a crispy one New Peso note could be printed to replace one million of the old variety. In the game of knocking off zeros the current world champion is Yugoslavia, eliminating 22 zeros in 1994. The runner-up is Argentina that has gone through 13 zeros so far.

A recent upstart is Romania with 4 zeros. Not bad, considering that Romania is the only former Soviet satellite having started its “free market economy“ in 1991 with no foreign debt whatsoever!

### Recitativo

The current world monetary system assigns no special role to gold. Indeed, the Federal Reserve is not obliged to tie the dollar to anything. It can print as much or as little money as it deems appropriate. There are powerful advantages to such an unrestrained system. Above all, the Fed is free to respond to actual or threatened recession by pumping money. To take only one example, that flexibility is the reason that the stock market crash of 1987 — which started out every bit as frightening as that of 1929 — did not cause a slump in the real economy.

### Rondo

Rub it in, Krugman, rub it in! To the injury of trampling over their Constitution you now add the insult of telling the American people that it makes judicial and economic sense to give a banking cartel the privilege of issuing liabilities it has neither the means nor the intention to honor!

Your example stinks to high heaven. The stock market crash of 1987, just as the one of 1929 before it, were caused precisely by granting privileges without responsibilities to the banking cartel. For damage control you now advocate putting the fox in charge of the chicken coop. Has it not occurred to you that dirt swept under the rug keeps accumulating until it reaches critical mass, at which point damage control no longer works, but further accumulation will start the chain-reaction of dirt explosion?

### Recitativo

While freely floating national money has advantages, however, it also has risks.

Countries with a history of runaway inflation often come to the conclusion that monetary independence of the central bank is a poisonous chalice. A system that leaves managers free to do good also leaves them free to be irresponsible and, in some countries, they have been quick to take the opportunity.

### Rondo

“Some” should read “all”. First and foremost among those managers were the officers of the Federal Reserve. Children of a lesser god could not make their fiat money command purchasing power abroad. The United States could.

Accordingly, managers of the dollar were double-quick to take the opportunity to be irresponsible with the unlimited power they have usurped, as the diluted dollars still found eager takers abroad, especially in the Third World.

The Constitution of the United States was born of the ashes left behind a runaway inflation, that of the Continental Dollar, although it is not considered polite behavior to mention this bit of history in the presence of practitioners of the dismal monetary science. Thus, then, following Krugman’s logic, we may conclude that the United States has gulped down most of the content of the poisonous chalice. It just takes longer for the poison to act in this case than it would in the case of the children of a lesser god. Be that as it may, we can be sure that there is no way to make monetary managers possessing unlimited power to behave responsibly. Indeed, such a behavior even defies definition, as the last Interlude below will show.

You just don’t delegate unlimited power to anyone, be they politicians elected with large majorities, civil servants, hired experts, appointed judges, or even altruists and saints. You don’t calculate the odds whether unlimited power will be exercised responsibly or irresponsibly. If you are sensible, you will adopt a Constitution based on the principle of delegating limited and enumerated powers only, complemented with checks and balances. Then you keep your fingers crossed lest the powers that be won’t trample over it. To keep your Constitution alive and well is going to be an uphill battle still. Professors of dismal monetary science may pop in and chalk up differential equations to prove that great danger will befall the world, in the form of oversaving and overproduction, unless their sponsors are granted unlimited power to pump money in rapid response to recessions, actual or threatened. With that power, the professors say, they will be able to abolish the business cycle and, with a little bit of luck, scarcity, too, and will wipe out the difference between credit and capital to boot.

### Interlude

In the comedy masterpiece written in 1673 by the French playwright Molière entitled Le malade imaginaire the protagonist, Argan, is a hypochondriac. No physician can convince him that there is nothing wrong with his health. Finally, in desperation, someone suggests that he himself become a Doctor of Medicine.

Then he will be able to find out what is really ailing him and what to do about it.

Argan takes the advice, and the M.D. examination, which may go as follows.

### Examiner: What therapy do you apply in case of constipation?

Argan: I prescribe enema.

### Examiner: What if it is a stubborn case?

Argan: Definitely more enemas.

Examiner: A most excellent answer! What therapy do you apply in case of diarrhea?

Argan: I prescribe enema.

### Examiner: But what if the condition persists?

### Argan: Definitely more enemas, Your Honor!

Examiner: A most excellent answer indeed! Congratulations! You have met the requirements for the Degree of Doctor of Medicine. Welcome to the Club!

### Rondo

Exactly as in Le malade imaginaire, dismal monetary science prescribes enemas of new money to be injected into the economy in case of a deflation, actual or threatened, in order to prevent prices from falling. But it also prescribes enemas of new money to be injected into the economy in case of an inflation, actual or threatened, in order to prevent interest rates from rising. In this way money-doctors cannot be held responsible for the treatments they decide on except, perhaps, to suggest that they have failed to administer an adequate number of enemas to their patient.

### References

Andrew Dickson White, Fiat Money Inflation in France: How It Came, What It Brought, How It Ended (an online e-book) [www.financialsense.com](http://www.financialsense.com/editorials/reality/2005/4R0321.html) Paul Krugman, The Gold Bug Variations — The Gold Standard and the Men

### Who Love It [web.mit.edu](http://web.mit.edu/krugman/www/goldbug.html)

### Antal E. Fekete, The Goldbug Variations I-III

---

# The Goldbugs, Variations III

URL: https://newaustrianeconomics.com/archive/fekete/the-goldbug-variations-iii/
Date: 2005-04-01
Section: Popular Economics
Difficulty: intermediate
Concept Tags: silver, bimetallic, gold-standard, sound-money, monetary-policy
Description: The third variation takes up the question of silver's monetary role alongside gold, examining the historical bimetallic system and why silver's demonetization in the late 19th century set the stage for later monetary crises. Fekete argues that silver's exclusion from the monetary system removed a crucial safety valve that had historically moderated monetary contractions.
Editorial Note: Third in the Goldbug Variations series. Fekete's attention to silver distinguishes his monetary analysis from most gold-standard advocates, who focus exclusively on gold. He views silver's demonetization as a key unexamined cause of 20th-century monetary instability.
Original PDF: https://professorfekete.com/articles/AEFTheGoldbugVariationIII.pdf

### Recitativo

Why not assure monetary virtue by trusting, not in the monetary wisdom of men, but in an objective standard? Why not emulate our great grandfathers and tie our currency to gold?

Very few economists think this would be a good idea.

### Rondo

So few economists indeed, that it is a statistical oddity. It is all the more curious given the miserable record of the fiat dollar for the past 35 years while it has been trying to make do without a link to gold. What makes the loser the winner, and the winner the loser? My explanation is that the economists have been bribed. The bribe money can actually be tracked as the record is in the public domain. Please bear with me as it takes some time to relate this incredible story.

The Federal Reserve (FR) banks pay dividends at 6 percent per annum of subscribed capital to shareholders, the member banks. The Federal Reserve Act bars them to pay dividends at a higher rate, regardless how profitable the FR banks may be. And as you may have guessed, they are fabulously profitable. So what happens to the undivided surplus? The answer is this: the Federal Reserve banks remit most of the undivided surplus to the U.S. Treasury under false pretenses. In the income statement the remittance is called “franchise tax on the Federal Reserve notes outstanding”. Now every federal tax must be authorized by legislation duly passed by the Congress and signed into law by the President.

I urge you to ask your favorite professor of the dismal monetary science to identify the Act, and provide the date of its passing, which authorizes the franchise tax. But be prepared for a long wait while the professor is doing the search, because such an Act does not exist, has never been proposed or enacted. Incredible, isn’t it?

You are a taxpayer. Would you pay a tax that has never been authorized by law, but someone at the IRS invented a catchy name and started collecting it? No, you wouldn’t. You would fight the phantom tax in the courts, if need be, all the way to the Supreme Court. Now there are twelve FR banks in the United States.

Every one of them has a legal department, well-staffed with well-paid legal counsels. Do you think that one of the twelve might have challenged the unauthorized tax and withheld payment to test the legality of its collection?

Surprise, surprise. Not one of them ever has. Moreover, not one shareholder, not one member bank, has spoken out against the arrangement of paying an illegal tax. Why?

The professors of the dismal monetary science are at a loss to give you the answer. But I will. In the check-kiting scheme of the U.S. Treasury and the FR banks the latter are the junior partners.

The allocation of the loot is not on a 50-50 basis. The lion’s share goes to the senior partner. The junior partners must be satisfied with the crumbs. But crumbs are plentiful to throw a jolly good party still. Why complain when the FR banks themselves can set the rate at which the ‘tax’ is assessed? They are free to subtract any and all expenditures on frills before they come to the bottom line, undivided surplus.

And spend on frills they do. One item listed as legitimate expenditure is money subsidizing economic research. It is a big item, covering not only in-house research, but also research grants paid to outsiders on contract at various universities and think-tanks. Now please estimate if you will the percentage of research funds that goes to economists analyzing the failure of the fiat dollar and studying the possibility of return to the gold standard as a remedy. You’ve got it: exactly zero percent.

From the point of view of the FR banks the more money they spend on subsidizing economic research the less tax they pay. So funds are gushing forth abundantly, and are granted generously to subsidize research in dismal monetary science, taking good care to shut out any dissonant noise about the gold standard.

### Interlude

Lest my detractors charge that I have “the sour grapes complex” I mention an episode from my active days. In 1975 I spent a Sabbatical year as Visiting Fellow at Princeton University. By a strange quirk of fate Paul A. Volcker was also at Princeton University at the same time as Senior Fellow. Paul was cooling his heels between two jobs. After having served as Under-Secretary of the Treasury for Monetary Affairs, overseeing the devaluation of the dollar, he was awaiting a new assignment at the Fed. We didn’t know it at the time, but soon it turned out to be his appointment as President of the Federal Reserve Bank of New York, the most lucrative job in the entire establishment, certainly more lucrative, if less prestigious, than that of the Chairman of the Federal Reserve Board, which was to be Volcker’s next assignment a few years later. Paul ran a seminar for postgraduate students “on international monetary stuff” as he would call it. I was an irregular, occasionally dropping in to listen to Paul’s lectures and the presentation of papers by students. I even contributed a paper myself, as I recall, on gold in the international monetary system. Paul and I also met outside of the classroom. Once he invited me to dinner at the Faculty Club of which he was a member.

Concerning gold, Paul didn’t beat around the bush. He said that there was no objection against gold being the constitutional monarch. But gold must behave and abide by the decisions of Parliament. If gold started asserting itself, if it misbehaved, then it would be ousted and sent into exile. That’s what had happened in 1971. Gold would not be tolerated as an absolute monarch.

I did not argue with Paul’s anthropomorphism. I could have pointed out that it was not a question of gold being the sovereign but the people holding it, as they should according to the Constitution of the United States.

Paul never had any qualms about the loyalty of other countries following the leadership of the dollar, as vassals follow the feudal lord. Foreign central banks knew full well that their currencies are in the same boat as the dollar. If they scuttle the boat, then they all perish. It was a matter of hanging together lest they hang separately (with thanks to Benjamin Franklin for the felicitous phrase).

Paul of course knew that I was a professional mathematician. He asked me if I would be interested in setting up a differential equation to describe the relationship between the foreign exchange rate and the spread between the rates of interest prevailing in the two countries. I guess if I had said “yes”, then I could have made a career as a contributor of dismal monetary science, with a fat research grant from the FR bank of New York. But I said “no” adding that, in my opinion, there was no such a thing. Differential equations describe the relationship of causality. They are quite useless if what you want to grasp is the relationship of teleology. And the relationship between foreign exchange rates and interest-rate spreads was a problem of teleology, not one of causality. You can’t treat individuals who have free will as if they were inanimate particles in a physical experiment. That’s the trouble with macroeconomics as opposed to microeconomics. It assumes that economic aggregates have their own lives, and in their hands individuals are lifeless, inert matter that, like playdough, could be given any desired shape.

That’s how my brush with dismal monetary science ended, needless to say, to the great detriment of my remuneration. Yet I had no regrets. I had not left my native Hungary when Soviet troops overran it in 1956 because I wanted to exchange one sycophancy for another.

### Rondo

It should be clear that the funds dished out by the research departments of the FR banks are bribe money subsidizing dismal monetary science exclusively, having precious little to do with the search for and dissemination of truth but designed to entrench and aggrandize incumbent power. Small wonder that so few economists dare to express views that the regime of irredeemable currency is a disaster of the first magnitude, leading to an economic catastrophe worse than that following the experiment with fiat money in France at the end of the 18th century, admirably documented by Andrew Dickson White. Very few economists would express their view in public that tying the dollar to gold is the answer.

Consider once more how profitable the check-kiting scheme between the Treasury and the FR banks is. The latter can buy off an entire profession from the crumbs and trickle-down profits, and still have money left to award to economists from other countries willing to parrot the Keynesian demand-side theory of money.

This goes to show the utter insidiousness of the regime of irredeemable currency. Not only does it allow vampirism plaguing the savers and producers of society through check-kiting while throwing the gates wide open to vote-buying by politicians, it also corrupts the mind and frustrates any impartial discussion of the underlying scientific principles. Irredeemable currency is cancer on the body economic, body politic, and body academic as well.

### Recitativo

The argument against the gold standard is one of pragmatism, not one of principle. The gold standard would have all the disadvantages of any system of rigidly fixed foreign exchange rates.

### Rondo

Thus according to Krugman pragmatism trumps the Constitution, which mandates a metallic monetary system. Worse still, advocates of the dismal monetary science also think that it is pragmatic not to press for a Constitutional amendment. Why take a chance? People will not notice, still less bother, if their Constitution is trampled in the mud.

The Founding Fathers did not establish a central bank for the United States.

They established the U.S. Mint, and opened it to silver and gold. In doing so they elevated the principle of free coinage to the level of basic human rights. The power to create or to extinguish money was reserved for the people themselves by the Constitution. It was not delegated to the representatives of the people, nor to so-called experts hired by them. If people thought that there was too little money in circulation, or that interest rates were too high, then they could do something about it. They could take old jewelry and plate, or cause new silver and gold from the mines to flow, to the Mint to be converted into the coins of the realm. Conversely, if the people thought that there was too much money in circulation, or that interest rates were too low, then they could do something about that, too. They could melt down the coins and convert the monetary metals into jewelry and plate, or have them exported along with new gold and silver from the mines.

It is true that the international gold standard confines the foreign exchange rate between two countries adhering to it to a narrow range between the gold export and import points. This is not a drawback of the gold standard; it is one of its main excellence. It is responsible for the promotion of division of labor between countries. Each country will produce the goods and services for which it is best fitted, and import other goods and services which can be produced more efficiently abroad. The regime of floating exchange rates (that should be properly called the regime of sinking exchange rates) destroys international division of labor and promotes autarky.

But it destroys division of labor domestically as well. Previously the exporter could concentrate his talent and energies on production, knowing that as long as he is the best, no foreign competitor could harm his business. This is no longer true under floating. Foreign competitors could nail his business on the foreign exchanges. The central banks, as advocated by dismal monetary science, could manipulate foreign exchange rates to his detriment. It goes by the name “beggar thy neighbor”. To be successful as an exporter it is no longer sufficient to excel in production. The exporter also has to be a skillful speculator in foreign exchange. This is what has killed many a small business during the past 35 years. The principals could not cope with volatility in the foreign exchange market. Big business, on the other hand, decided that it was less risky to export jobs than goods, and this is exactly what they did. An unprecedented dismantling of production facilities on American soil was the result, because the price of the imported ingredients rose faster than export earnings, thanks to the deliberate dollar debasement.

Floating exchange rates were a giant step backwards in division of labor, discouraging talent from going into productive enterprise. Talent now goes into financial speculation, as witnessed by the snow-balling derivatives market where the commitment of speculators is estimated at more than two hundred trillion dollars, or more than the market capitalization of the entire globe.

One of the more imbecile ideas of dismal monetary science is that devaluation of the currency helps the country to export more and import less, thus rectifying the trade imbalance. It is absolutely amazing that economists do not find it repulsive to parrot this trash, apparently on order from the grant departments of the FR banks (in whose interest the policy of currency debasement clearly is). In 1968 the exchange rate with Japan was around 320 yens to the dollar and there was a huge trade deficit run by the U.S. To rectify it a dollar-debasement policy was put into effect promising that it would cure the deficit and turn it into a surplus.

That is not what happened. In the next ten years the value of the dollar was pushed all the way down from 320 to 80, or one quarter of the initial, while the trade deficit instead of turning into a surplus ballooned tenfold. The question arises how much more beating does the dollar have to take before a dent is made in the trade deficit?

The explanation for the perverse reaction of the patient to Keynesian therapy as advocated by dismal monetary science is actually quite simple. Naturally, it was never permitted to be publicized by the award-officers at the FR banks. Currency devaluation makes your terms of trade with the rest of the world deteriorate. This means that you can import less for every dollar of export earnings as a result of devaluation.

Virtually all export items have imported ingredients, so devaluation makes them more expensive to produce, not less. While it may let you sell your existing inventory at bargain-basement prices to foreigners, this is fool’s paradise. The boost in exports is strictly temporary. It is all at the expense of future production which is put in jeopardy by the higher cost of imported ingredients, as the experience of the American industry for the past 35 years has amply demonstrated.

Currency devaluation is not unlike self-mutilation. You don’t cut off one of your arms while trying to compete with foreigners in the world market. Yet this is exactly what America has done to itself. The country’s de-industrialization is the direct result of the deliberate debasement of the dollar for the past 35 years.

Keynesian demand-side monetary theory suggests, and Krugman agrees, that devaluing the currency has a benefit to offer to the export industry. It is the benefit of the grave. Power is being turned off at factories and plants that once were busy, humming and producing, while providing well-paid industrial jobs for Americans. The once prosperous and productive industrial heartland of America has been turned into a graveyard, thanks to the floating (sinking) dollar.

The trade deficit of the United States is at an all-time high and still increasing.

No economist has the courage to say it, but it is caused by the policy of deliberate dollar debasement, now in its 35th year. You have to pursue the argument of dismal monetary science ad absurdum to understand it. If a little bit of devaluation is supposed to be good for the country, then a big devaluation should be even better and, reducing the exchange rate to zero, Nirvana itself.

Then the country could give away its goods and services to foreigners free of charge. That, finally, will really perk up exports.

### References

Andrew Dickson White, Fiat Money Inflation in France: How It Came, What It Brought, How It Ended (an online e-book) [www.financialsense.com](http://www.financialsense.com/editorials/reality/2005/4R0321.html)

### Paul Krugman, The Gold Bug Variations — The Gold Standard and the

### Men Who Love It [web.mit.edu](http://web.mit.edu/krugman/www/goldbug.html)

---

# The Goldbug, Variations II

URL: https://newaustrianeconomics.com/archive/fekete/the-goldbug-variations-ii/
Date: 2005-03-28
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, contango, backwardation, gold-standard, interest-theory
Description: The second variation examines the gold futures market and the contango structure, explaining how the carry trade in gold relates to interest rates and why a falling basis signals that gold is being withdrawn from circulation. Fekete shows how the manipulation of gold prices through futures markets is gradually destroying the information content of the gold price itself.
Editorial Note: Second in the five-part Goldbug Variations series. This installment focuses on the mechanics of the gold futures market and how central bank gold leasing interacts with the basis — a topic Fekete would develop extensively in his later work on permanent backwardation.
Original PDF: https://professorfekete.com/articles/AEFTheGoldbugVariationII.pdf

### Recitativo

Gold is just another metal. If it sometimes seems to be more, that is only because society has found it convenient to use gold as a medium of exchange a bridge between other, truly desirable, objects.

### Rondo

Society has also found it convenient to use gold as a medium of savings. The demand-side theory of money of Keynes has not succeeded, after 70 years of intensive brain-washing and indoctrination, to wean society from the idea that money must unite in itself two properties: those of a medium of exchange and a medium of savings. This gold does admirably well, in fact better than anything that has been recommended in its place. Gold is not just another metal. It is the monetary metal par excellence.

Money promoted by the dismal monetary science of Krugman is a singular failure in that it loses at least 90 percent of its purchasing power in every generation, or 35 years, and its protagonists can do absolutely nothing about it.

Nor is it wear and tear that is responsible for the miserable record of the irredeemable dollar. The loss of purchasing power has not been dissipated in the universe without a trace. Where has it gone? According to the principle of conservation of matter, it must still exist. This is a question Krugman dare not confront. Well, I have asked it and shall answer it, too. What appears as a loss of purchasing power is value that has been embezzled. That's right, embezzled through a deliberate scheme designed to throw dust into the eyes of the victims.

It is the check-kiting scheme between the Federal Reserve banks and the Treasury of the United States.

Check-kiting is a conspiracy, generally between two banks. They are issuing checks which they haven't got the means or the intention to cover. That is to say, the checks are issued fraudulently. They issue them with the criminal intent to tap the float, the mass of checks in the process of clearing, and so to defraud the public. The checks issued by Bank A are cleared at the clearing house through earmarking the checks issued by Bank B, and vice versa. In more details, the first unbacked check is "backed" by an infinite string of subsequent unbacked checks.

The gold standard makes check-kiting highly unlikely to succeed. That is one of its chief merits. Every individual using gold substitutes such as checks, bank notes, or bank deposits can apply the "bubble-test" at any time: he can demand payment in specie. It is a basic human right to protect oneself against would-be criminals. To be able to exercise this right there must be an ultimate means of payment. Under a gold standard it is the gold coin of the realm. The regime of irredeemable currency has no ultimate means of payment, nor can it have one.

Before Krugman interrupts me objecting that the Federal Reserve notes are the ultimate means of payment under the monetary system he is pushing, I hasten to add that the Federal Reserve notes themselves are the product of a cleverly designed and disguised check-kiting scheme. Government coercion can make the Federal Reserve notes legal tender, but it can hardly make them the ultimate means of payment. There is a difference. An ultimate means of payment cannot be legal tender because it must be voluntarily accepted in final settlement of debt, while legal tender implies coercion.

To the best of my knowledge no one before has pointed out that the origin of Federal Reserve notes and deposits, as they are presently issued, is fraud and conspiracy that goes by the popular name of check-kiting. I want you to know that I am not making this charge frivolously, and I stake my professional reputation in support of it. People in the United States are inclined to believe that it is not possible to cover up theft, fraud, and conspiracy by legislation. But it is. I got my education, including the first university degree, under a Communist regime in Soviet-occupied Hungary, where legislation was routinely used to "justify" the violation of virtually every basic human right. If you think that it cannot happen in your country, then you are kidding yourself.

The original Federal Reserve Act of 1913 nowhere mentions open market operations whereby the central bank can inject new currency into the economy through purchases of government bonds. Monetization of government debt was not authorized. In fact, government paper was explicitly made ineligible for use as a reserve to back Federal Reserve notes and deposits. Those liabilities had to be covered by gold coins to the extent of no less than 40 percent; and the remainder by short-term self-liquidating commercial paper. If a Federal Reserve bank was short of gold or eligible paper to cover its outstanding note and deposit liabilities, and if it used government bonds in its portfolio to make up the shortfall, then a steep and progressive penalty had to be paid. The penalty made it virtually prohibitive to use government paper as cover for the note and deposit liabilities.

Open market operations were introduced clandestinely in violation of the law in the 1920's. It is true that later the Federal Reserve Act was amended to legalize the practice. It is possible that Congress was presented with a fait accompli and had little choice in the matter if it wanted to avoid a financial panic in a fragile international monetary environment. Be that as it may, the introduction of open market operations was a serious violation of the law. As it then stood, the law did not authorize it. And for a very good reason, too. If they had leave to do it, then the Federal Reserve banks could conspire with the U.S. Treasury to start a gigantic check-kiting scheme to defraud the public. The Treasury could sell bonds in the open market which it had neither the resources nor the intention to honor. The Federal Reserve banks could then purchase these bonds in the open market paying for them with newly issued currency which, likewise, they had neither the resources nor the intention to honor.

Guess what, this is exactly what happened once gold has been eased out of the system. The proportion of required gold reserves was reduced from 40 to 25 percent of liabilities, first for Federal Reserve deposits, and then for Federal Reserve notes as well. Then gold reserves were eliminated altogether, first for Federal Reserve deposits and then, in 1968 (appropriately enough, on the 35th birthday of the irredeemable dollar), for Federal Reserve notes as well. It was done in carefully staggered stages, through four or five separate amendments to the Federal Reserve Act.

There is no valid argument why the Treasury or the Federal Reserve banks should be given the privilege to issue liabilities which they had neither the means nor the intention to honor while the same, if committed by private parties, is treated as a serious crime punishable by severe penalties as specified by the Criminal Code. On the contrary, in jurisprudence the principle of double standard of justice is rejected, not just because it is unfair but, for the stronger reason, because it is self-defeating.

### Rondo

I have said that gold is not just another metal but it is the monetary metal par excellence. Nor is this an opinion, subject to dispute. This is an objective fact as I shall presently show. Today gold is still the monetary metal, and as such is immune to efforts by the United States government, or any combination of governments, to "demonetize" it. All that the governments can do is to deprive themselves, and their subjects, of the manifold benefits afforded by gold money.

As money, gold circulates, and circulate it may with various velocities, including the zero velocity. It had happened before, and it has been the case for the past 35 years, that gold "circulates" with zero velocity, meaning that monetary gold has gone into hiding. It typically happens when the Constitutional order breaks down and the administration of justice becomes arbitrary, so that owners of monetary gold have reasons to worry about the safety of their possession. That is what happened during the last decades of the Roman Empire when the government stopped protecting private property against highway robbers. That is what happened during the final stages of the French Revolution when possession of gold coins was made punishable by death. That is what is happening today in the world when private ownership of monetary gold is on a 24-hour basis. When in 1974 the politicians in the United States restored the citizen's right to own and trade gold, they "forgot" to give legislative guarantees that this right will not be disturbed in the future again, using any number of possible excuses, including the fight against terrorism.

Do not be misled by the trading of paper gold on a number of commodity exchanges. Very little monetary gold is involved as compared with the size of the commitments of speculators, and even that is provided by central banks as a way for them to influence the price of gold. In addition, gold miners are driven into the open embrace of the commodity exchanges. Not only are they denied freedom by their creditors, the bullion banks, to market their product as they see fit including withholding it from the markets, they are also forced to sell forward several years of future output, never mind that it is in violation of the laws governing futures trading in general, and the charter of the commodity exchange in particular. I find it hard to lay the blame on the commodity exchanges. They can't very well refuse to honor call options written by a central bank whose balance sheet, showing gold, is supposedly true to fact and open to public scrutiny.

I now come to the proof that gold is still the monetary metal par excellence (albeit with zero velocity of circulation). There is one, and only one, fundamental reason for this. It is the fact that gold has constant marginal utility. I am not going to quibble whether the marginal utility of gold is indeed constant, or whether it declines at the slowest rate, by far, among all the substances known to man - a fact that even Paul Krugman cannot deny (that is, provided that he is familiar with the concept of marginal utility). For the purposes of this discussion the two formulations amount to the same. At any rate, it is easier to refer to this property of gold as constant marginal utility, than rattling off the other description, even if it may be more accurate.

The marginal utility of any good used by man declines, with the possible exception of gold. This means that subsequently acquired units of the good in question are earmarked for uses with lower priority than units acquired earlier.

Carl Menger, one of the three economists generally credited with formulating this important concept in the late 19th century, gives the following example. Suppose an isolated farmer in the rain forests of Brazil brings in five sacks of corn at the end of the harvest. He earmarks the first sack to cover his and his family's need for food until the next harvest. The second sack is seed corn. The third sack he intends to use as animal feed. The fourth sack is for making beer and vodka.

The fifth or marginal sack he will use to feed the birds around his house whose antics are the only entertainment he and his family have. If he had more sacks available, then they would be surplus that could be used for the purposes of barter. At any rate, the value of corn for this farmer would be determined by its marginal utility, that is, the utility of his marginal sack. It follows that if the farmer lost one or more sacks to fire or any other mishap, then the marginal utility of corn to him would go higher. By the same token, if he harvested more sacks, then the marginal utility of corn to him would go lower. The same is true of any other good.

What makes gold coins different is that anyone receiving a number of them will earmark the first and the last coin with the same priority. He can use either one to purchase other goods in the market on exactly the same terms. This property of gold is not due to an accident. It is the result of a long evolution taking several millennia. As gold has been a means of savings in addition to being a means of exchange, and because of its constant marginal utility, the stock of gold in existence is huge relative to the flow of new gold from the mines (defined as the combined annual output of all the gold mines in the world). The stocks-to-flows ratio for gold is a high multiple, variously estimated between 50 and 80. This means that, at current rates of production, it would take 50 to 80 years to produce the same amount of gold that is now in existence. The stocks-to-flows ratio for all other goods (with the possible exception of silver) is a small fraction.

For copper, for example, it is around 0.3 meaning that the available supply of copper is equivalent to about four months' production. If the ratio went higher, the price of copper would most assuredly plummet, because of the relatively fast declining marginal utility of copper, even though it is an industrial metal with lots of uses.

To say that gold is the monetary metal of the world is not an expression of opinion. It is an objective observation justified by the size of the stockpiles of gold, the accumulation of millennia, that are known to exist. They are huge relative to the meager annual flows of new gold from the mines. Indeed, it was an evolution lasting for thousands of years during which the market has made its choice which particular good will have the slowest-declining marginal utility, allowing the accumulation of monetary stocks to take place. By the same token, gold cannot be dumped as the monetary metal by government decree, regardless whether it was countersigned by V.I. Lenin or by F.D. Roosevelt. If gold was really to be demonetized, then the enormous stocks relative to flows would have to be dissipated first through consumption. Literally, you would have to make people eat gold. King Midas couldn't eat it. Lenin and the commanderin-chief of the Cheka with his machine guns could not make people eat it. Not in the 73 years of their control of power in Russia, and not in another hundred years.

It is true that the government can outlaw gold as money, or ban the gold market.

It can even forbid or discourage the use of gold in jewelry (as the Indian government may be planning to do according to rumors). None of this will address the crux of the matter: the highest stocks-to-flows ratio for gold, which gives people that superb confidence to entrust their savings to gold, rather than to the gentlemen running the central banks and treasury departments of the world.

---

# The Goldbug, Variations I

URL: https://newaustrianeconomics.com/archive/fekete/the-goldbug-variations-i/
Date: 2005-03-25
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, gold-standard, backwardation, contango, sound-money
Description: The first installment of a five-part series examining what it means to be a 'goldbug.' Fekete distinguishes between goldbugs who understand gold's monetary role through basis analysis and those who simply distrust paper money. He argues that understanding the gold basis — the spread between spot and futures — is the key diagnostic for gold's monetary health.
Editorial Note: The Goldbug Variations series (March–May 2005) represents Fekete's most sustained attempt to explain basis analysis to a general audience. Drawing on Bach's Goldberg Variations as a metaphor, each installment explores a different facet of gold's monetary role.
Original PDF: https://professorfekete.com/articles/AEFTheGoldbugVariationI.pdf

### Overture

This is a rejoinder to a piece of the same title by Paul Krugman, MIT professor (now at Princeton) and staff writer of The New York Times. It was posted on the internet on November 22, 1996, with a note saying that it was to be composted two weeks later, on December 6. It wasn't. I came across it a few weeks ago while surfing the internet. At first I thought that it fully deserved to be composted in short order. But on second thought I decided that it called for a careful rejoinder. Bad-mouthing the gold standard is a periodically returning pastime for mainstream economists. Their arguments have never been put to rest by an authoritative rejoinder, which I therefore venture to present.

Krugman's piece was part of a series entitled "The Dismal Science". If I continue with these variations, which I am rather tempted to do, then I shall call my series "The Dismal Monetary Science". I apply this name to the monetary science, so called, of the Krugman variety, more precisely, the demand-side theory of money according to Lord Keynes, as well as the Quantity Theory of Money according to Nobel laureate Milton Friedman, also known as monetarism.

In what follows quotations from Krugman are under the caption "Recitativo", and my rejoinder under "Rondo".

### Recitativo

The legend of King Midas, the original goldbug, has been generally misunderstood. Recall that his prayers were answered by the gods: everything he touched turned into gold. The catch was that "everything" included food and drinks as well, and the poor king was starving to death as his system could not ingest gold. The gods wanted to teach him a lesson. Most people think that the lesson was in the perils of avarice. This is a mistake. Midas' true sin was his failure to understand monetary economics. What the gods were telling him was that gold was just another metal. If it sometimes seemed to be more, that was only because society has found it convenient to use gold as a medium of exchange - a bridge between other, truly desirable, objects.

### Rondo

Krugman is cutting down the difference between "sometimes" and "always" to microscopic size. Gold has been the preferred means of exchange since time immemorial. After barter was phased out as inefficient, and after a relatively brief period of experimentation with other goods such as oxen, shells, and tobacco to mention but three of them, the marketability of gold (and silver) snowballed relative to that of other contenders. Gold became king, and silver the queen.

Gold would still be king but for a coup d'etat overthrowing the Constitutional monetary order in the United States and imprisoning the king.

In 1933 it took all the violence and duplicity a government could muster against its own subjects to grab the gold belonging to the people. There was wholesale confiscation of monetary gold, under false pretenses. No sooner had the U.S. government laid its hands on the people's gold than it wrote up its value. This piece of chicanery was used to conceal the act of robbery. People were "compensated" for the confiscated gold in the form of paper money. In 1935 the Supreme Court of the United States dismissed charges that value was taken from the people without due process of law arguing that paper money continued to have the same purchasing power as gold coins. This flies in the face of the fact that the loss of purchasing power of the dollar abroad was instantaneous.

Domestically it was gradual and by the 35th birthday of the irredeemable dollar it amounted to 90 percent, an unprecedented monetary destruction in the history of the republic up to that point. (Much worse was to follow during the next 35 years.)

Gold's forcible removal as the monetary metal was done in two convenient steps, 35 years apart. (1) In 1933 the U.S. government defaulted on its domestic monetary obligations, including the dishonoring of the promise printed on every Federal Reserve note, to pay bearer gold coin of the specified weight and fineness upon demand, and the repudiation of the gold-bonded public debt held by its own citizens. To be sure, it was repudiation. If you contract debt payable in gold, and then at maturity you pretend to pay off your debt with another promise payable in never-never land in the never-never future, then you have repudiated the debt, haven't you? And the pretense that you have discharged the obligation has made the repudiation worse, hasn't it? (2) In 1968 the U.S. government defaulted on its gold obligations to foreigners as well (the initial de facto gold embargo was made official in 1971). To add insult to injury, the U.S. government (after some behind-the-scenes arm-twisting) put a gag-order into effect. The injured party was not allowed to call a spade a spade. An international obligation, solemnly agreed to at an international conference enjoying the widest publicity, duly ratified by Congress and subsequently affirmed by four sitting Presidents, was unceremoniously and unilaterally abrogated by a stroke of the pen. Foreign creditors of the United States, the primary victims, were not allowed to say "ouch". They were ordered to call it an "enlightened monetary reform," dropping nothing more substantial than the trappings of a "barbarous relic", in the words of John Maynard Keynes. Such a level of bad faith in monetary dealings, compounded by the gag-order, was surely unprecedented in the financial annals. Previously a defaulting government had to bear the shame, and live it down before it could rejoin the exclusive club of credit-worthy nations.

Now the offender's deserts were not only high praise for a courageous deed in fighting superstition, but also license to keep on plundering its neighbors' natural and human resources through the fiat money system.

Even today textbooks refrain from calling the 1933 and 1968 repudiation by its proper name, default. A new breed of professors, including Krugman (who was born after these defaults have taken place) lionize the U.S. for cheating its domestic and foreign creditors, and plunging the nation and the world into the worst experimentation with fiat paper. Some dismal monetary science, indeed!

### Recitativo

There are other possible mediums of exchange beside gold, and it is silly to imagine that this pretty, but only moderately useful, substance has some irreplaceable significance.

### Rondo

It is incredible that this monetary economist has apparently never heard of marginal utility. Every substance, in addition to its main applications, has a marginal application (which determines its marginal utility), as well as several submarginal applications. Bread, for example, has its main application as staple food for humans. The marginal application of bread was inadvertently found by Queen Marie Antoinette of France who later paid with her head for her discovery on the scaffold during the French Revolution. When she had heard that people had no bread to eat, she asked: "Well, why don't they eat cake?" Accordingly, the marginal utility of bread is determined by its marginal application which is to be eaten for dessert, instead of cake, if you have it. But bread could also serve as fodder to animals, and it could be used as fertilizer of agricultural land. If it isn't, it's because it is far too valuable for these "submarginal" applications.

It is no different with gold. Its main application is to serve as the monetary metal.

Marginal application is in jewelry. But the list of the submarginal applications of gold is endless, thanks to its fine physical and chemical properties such as malleability, ductility, conductivity, non-corrosiveness, among others. It is the last-mentioned property of gold which Lenin's fertile imagination used, dangling it before the hungry eyes of his starving subjects, to illustrate the blissful conditions prevailing under Communism. Lenin observed that there was no better material with which to plate public urinals. It was precisely this application to which the "capitalist metal" would be put after the final victory of Communism, Lenin said. You may object that gold is far too valuable for this submarginal application and, as a consequence, the gold plating of public urinals would be picked just as quickly as they were installed, by the beneficiaries of the Soviet paradise. Lenin, of course, would have an answer ready to meet this objection.

The Cheka (secret police) would take care of saboteurs who picked the gold plating of public urinals, and would shoot them on sight. To say that gold is only moderately useful betrays ignorance of Himalayan proportions. Ignorance of technology but, no less, ignorance of microeconomics.

Whether gold is irreplaceable or not as money remains to be seen. It will not be decided by quacks and imposters posing as doctors who have banned the use of gold as a thermometer, expecting that the patient will not run a temperature if he remains blissfully ignorant about his feverish condition. Can it be reasonably doubted that the patient, if he survives, will chase the quacks away, and rehabilitate the thermometer to its former use?

### Recitativo

There is a case to be made for a return to the gold standard. It is not a very good case, and most sensible economists reject it, but the idea is not completely crazy. On the other hand, the ideas of our modern gold bugs are completely crazy. Their belief in gold is, it turns out, not pragmatic but mystical.

### Rondo

I do not speak for the gentlemen named by Krugman as "modern gold bugs" but I am happy to present the case for the gold standard as I see it. I am prepared to submit it for general discussion before any competent and impartial forum to judge whether it is "completely crazy" or not.

The gold standard has nothing to do with stabilizing the price level that is neither possible, nor desirable. It has to do with the stabilization of the rate of interest at the lowest level compatible with savings and production, which is both possible and utterly desirable. Under a gold standard there is no bond speculation, just as there is no foreign exchange speculation. There are no derivatives markets in interest-rate futures the size of which, as measured by the liabilities of speculators, is in the hundreds of trillions of dollars, which is more than the market capitalization of the entire globe (or soon it will be). Under a gold standard talent must find outlet in productive enterprise rather than in gambling.

Bond speculation is the heel of Achilles for the regime of irredeemable currency, that will cause its self-destruction in due course. Like an incubus, it sucks all the economic resources of the world, and robs it of the best talent. The tricksters who grabbed the gold belonging to the people of the United States and its foreign creditors were unaware that their looting would let the genie of destruction, bond speculation, out of the bottle. How can we explain this colossal oversight?

Interest rates were stable under the gold standard, and the small variation in bond prices did not admit a profitable opportunity to speculate in bonds. But bond speculation started as soon as the gold anchor was cut in 1971, on the dot.

The "brain trust" of apologists for irredeemable currency can develop theories about bond speculation, suggesting that it has a stabilizing influence on interest rates, just as commodity speculation has on the prices of agricultural goods. Let us bypass, for the sake of argument, the fact that this stabilization was automatic under the gold standard. Any effort to prove that speculation has an analogous stabilizing influence in both the commodity and the bond market is doomed to failure. It ignores the fact that the supply of bonds is controlled by man, in contrast with that of agricultural goods which is controlled by nature. The analogy is flawed beyond the hope of repair. Commodity speculation is selflimiting. It is limited by the size of available supply. By contrast, bond speculation is not self-limiting. It is self-aggrandizing. The more it grows, the more bonds will be printed. Or, to save the cost of printing, the more bond-derivatives (futures, call options, put options, options on futures, etc., ad libitum) will be invented.

Thereby an avalanche is set into motion which will bury innocent villages down there in the valley. There is nothing that the protagonists of "managed money" can do about it. Bond speculation introduces distortions into the economy that will inevitably cause the downfall of the regime of irredeemable currency. It may or may not be through runaway inflation as in France during the last decade of the eighteenth century. It may be through runaway deflation. In either case, there will be enormous economic pain.

What Krugman calls "mystical", Keynes called "psycho-pathological". Another famous quotation from him is that "the desire to palm gold is a human aberration that the economist passes on to the psycho-pathologist for study with a shudder." Well, gold is the ultimate means of payment, such as the regime of irredeemable currency hasn't got and will never get. Gold is voluntarily accepted in final settlement of debts by all creditors. In this capacity, gold can be applied as the agent of the bubble-test. If an individual wanted to make sure that he would not be victimized in a check-kiting scheme, all he had to do was to demand that his check be paid in gold coin. Why is the joy one feels over one's ability to frustrate would-be criminals "psycho-pathological"? What is "mystical" about one's desire to protect oneself against check-kiting?

The litmus-test to find out whether a monetary economist serves the cause of the search for and dissemination of truth, or whether he has a hidden agenda such as to cover up for the looting of the people's gold, is to engage him in a discussion on the subject of interest rates under the regime of the irredeemable dollar as opposed to the gold dollar. Apologists for the gold-looting invariably wriggle out.

I hereby challenge Paul Krugman to open the columns of The New York Times for such a discussion.

---

# Burning Bridges and Halfway Houses

URL: https://newaustrianeconomics.com/archive/fekete/burning-bridges-and-halfway-houses/
Date: 2005-03-21
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, fiat-currency, monetary-policy, new-austrian-economics
Description: Fekete examines proposals for a partial or managed return to the gold standard — what he calls 'halfway houses' — and argues they are worse than either the current system or a genuine gold standard. Halfway measures preserve the defects of fiat money while eliminating the corrective mechanisms of gold, burning the bridges back to sound money without arriving anywhere safe.
Editorial Note: Written in late March 2005 as monetary reform proposals were gaining attention. Fekete's critique applies to various 'gold-backed' currency proposals that would retain central bank discretion, arguing there is no viable halfway house between irredeemable paper and a genuine gold standard.
Original PDF: https://professorfekete.com/articles/AEFBurningBridgesHalfwayHouses.pdf

### Liquidity trap

The corner-stone of my deflation theory is the observation that there is a double-bias caused by the central bank’s open market operations as it removes risks from bond (but not from commodity) speculation, and rewards bond bulls (while punishing the bears) [4]. This double-bias distorts the economy in favor of deflation. It is palpable only when deflation is present in the economy in the first place, in which case it is made worse than it need be by prompting speculators to buy bonds in tandem with the central bank. Interest rates fall and through the mechanism of linkage prices fall, too, as the flow of money from commodities to bonds accelerates. In the worst-case scenario a vicious circle is activated and the economy plunges into depression.

The question arises why mainstream economists didn’t discover the deflationary bias and alert central bankers to mend their ways. The answer is that they did.

However, they had to proceed gingerly. The bridge of the gold standard leading back to monetary sanity and rectitude had already been burnt. They were looking at the incurable congenital disease of the regime of irredeemable currency. Mainstream economists could not talk openly about the dangers of snowballing bond speculation without exposing the fatal inner contradictions of their monetary regime. The diagnosis therefore had to be couched in the language of the liquidity trap.

The term originated with Keynes himself who, in the second half of the 1930's, noted that his contra-cyclical prescription to inject new money in the economy through central-bank purchases of bonds in order to combat falling prices wasn’t working. In fact, it produced just the opposite effect of what he had hoped.

Deflation got worse, not better. As always, Keynes was ready with the explanation. The disease was so advanced that the patient didn’t readily react to medication as it was supposed to. The first dose of money-injection administered by doctors from the central bank could not spread through the diseased organism but, instead, accumulated in a “liquidity-trap”. Nevertheless, Keynes was for continuing the money-injection therapy. He was confident that, ultimately, prices would move higher, as they had to according to the Quantity Theory of Money. Of course, Keynes would not admit that the main cause of the malady was the surgical removal of the gold standard at his instigation earlier in the decade.

### Pallas Athena born in full armor

As the ownership of monetary gold was made illegal in 1933, the only competitor to government bonds was removed from the arena. Owners of monetary gold were forced by the strong arm of the government to invest in government bonds — not a very pretty sight in itself, even if the matter ended there. But the matter did not end there. As holders of gold were competing for the limited supply of government bonds, which rightly or wrongly they considered as the safest thing to have second only to gold, bond prices were driven to unprecedented heights and interest rates were plunged to unprecedented depths. The federal funds rate even went negative. Member banks were actually paid a premium for taking money overnight from the Federal Reserve banks.

At that point in time bond speculation was still unknown in the United States. But just as Pallas Athena was born in full armor when she sprang from the skull of Zeus after her father’s bizarre pregnancy ended in a splitting headache, so did bond speculators, a whole army of them, spring from the skull of Keynes in a remarkable replay of the mythological story. The speculators did not need any training. They were ready. They did not need any capital either. It was made superfluous by the forcible removal of gold as a competitor of government bonds. Speculators (read: the banks) were literally paid by the Fed to take the money to buy the bonds. Thereafter their only worry was to keep writing up their assets month-after-month, quarter-after-quarter. Why should the banks risk their money by lending it to ailing business on their way to recovery, if they could invest it in steadily appreciating bonds, risk-free? The world had never seen anything like that before: banks betraying their mission to finance business and shepherding their resources into bond speculation. And why not? Not only did the continuous injection of irredeemable currency into the economy by the Fed make bond speculation risk-free, it actually guaranteed capital gains on their bond portfolio, on the top of the interest-income. The stock-market craze of the Roaring Twenties was nothing in comparison. The largest speculative orgy in history was on. It was in the 1930's, and it was in the bond market.

Of course, the theory of liquidity traps does not mention bond speculation. The s-word is taboo. It talks about liquidity being mysteriously siphoned off and trapped. As the central bank fighting recession drove interest rates close to zero, the fruits of any further monetary expansion would be stuck away in mattresses and cookie jars where they could do nothing for the economy. The process is described in detail in the first edition of Samuelson’s textbook published in 1948 used in training Keynesian economists.

Truth be told, the “fruit” is not put in mattresses and cookie-jars. It is taken by the speculators to the bond market where the miraculous multiplication of money is taking place. But you are not supposed to utter the s-word as it would conjure up the fatal flaw of the regime of irredeemable currency.

The chapter on the liquidity trap did not stay in Samuelson’s textbook for long. It was deleted from subsequent editions. Interest rates were edging up, and the author didn’t think that there was a danger for them ever to come down again to the vicinity of zero. Surely inflation would see to that. The Fed convincingly demonstrated its power in ending recession after recession. There seemed no reason to doubt that it could always do so whenever needed [1].

The regime of irredeemable currency was firmly implanted in the economy, and the central bank could control practically everything with the possible exception of the weather.

### The interest-targeting cabal

While out of the textbooks, the liquidity trap was not out of the ivory towers. It was still being discussed in the rarified atmosphere of academia. The world center for liquidity-trap studies and for the inflation-targeting cabal is the Woodrow Wilson School at Princeton University in New Jersey. Under the leadership of department head Ben Bernanke a team consisting of Paul Krugman, Lars Svensson, and Mike Woodford has been busy investigating the liquidity trap and finding ways to unplug it through inflation-targeting should it get clogged again. The Princeton plumbers worked out esoteric mathematical models to show that, indeed, the danger of liquidity traps was real. Here is the verbalization of the mathematical hocus-pocus. (A less polite expression, the title of [1], could also be used. I stay with the more polite version. As the author points out, according to Goodwin’s Law the party that blinks first and mentions bodily wastes loses the argument.)

The cabal turns on the concept of “potential output”. It is defined as maximum output consistent with a stable inflation-rate. (Please don’t heckle the plumbers with interjections that a stable inflation rate is an oxymoron.) If actual output exceeds potential, then the rate of inflation will rise; if below potential, then it will fall. In the latter the Princeton plumbers sniff great danger. Suppose that, for whatever reasons, the economy is operating below potential output (there is an “output-gap”). Then the situation is no longer stable. We are staring right into the liquidity trap. Disinflation makes inflationary expectations fade, leading to more disinflation, whereupon inflationary expectations fade more. The vicious circle is on and pushes the economy right into the liquidity trap. Once that happens, the central bank can pump money into the economy as much as it wants, it will all end up in the liquidity trap. The output-gap will worsen, leading to even lower inflation, and so on. The thing to worry about is the spiral of declining output relative to potential, and fading inflationary expectations [1].

Krugman adds the punchline: “zero is not a big number whether for growth, or whether for inflation” [2]. In plain language, if you want growth, you had better target inflation, and target you must well above zero. The trouble with fading inflationary expectation is that it jerks the rug from underneath the interest-rate structure.

Please note how the Princeton plumbers studiously avoid any reference to bond speculation, a hard fact of the economy, and substitute for it “fading inflationary expectations”, a soft economic euphemism.

### The Japanese bubble bursts

So when the Japanese bubble burst, the Princeton plumbers were ready. The Fed quickly tapped Ben Bernanke, bringing him to Washington and making him the heir-apparent to Greenspan. Recent rumors have it that the threat of the Japanese sickness is so serious that Bernanke will have to be moved from Constitution Avenue to Pennsylvania Avenue, right into the White House, to head the council of the President’s economic advisors. Well, we won’t have to wait too long to learn where upstairs the head-plumber will be kicked.

By 1996 apan looked an awful lot like a country in a classic liquidity trap. And that was scary. It meant that “our grandfathers were not as stupid as we thought” in the words of Princeton plumber Paul Krugman, who is moonlighting as staff writer for The New York Times. A 1930-style slump may not be that easy to fix, after all. A disease we had thought was under control reappeared in a form resistant to all the known antibiotics. Japan’s trap was real.

But if Japan remains stuck in that trap, who cares? Well, you should. Not only is Japan the world’s second largest economy; until recently it seemed to be the economy of the future. Worse still, if it could happen to Japan, why not to us? [1] As the Princeton plumbers must not utter the s-word in public, talking about the mechanism whereby depression can metastasize across the Pacific is taboo, too. This mechanism is the notorious yen-carry trade, or bond speculators doing arbitrage between the Japanese and the American bond markets. They sell the ultra-high-priced Japanese bonds and buy the relatively cheap American. The net effect is to push interest rates in the United States down to the unprecedented low levels prevailing in Japan.

### Can Deflation Be Prevented?

This is the title of an article [3] also written by Paul Krugman six years ago when he was still at MIT, from which the following quotations are taken. What gives it timeliness is that those six years have not solved any of the underlying problems but, in many ways, the economy has deteriorated in the wake of the continuing exponential growth of debt and its symbiotic parasite, bond speculation.

The cover story from The Economist makes it more or less official. Deflation, not inflation, is now the greatest concern for the world economy. Over the past year, producer prices have fallen throughout the advanced world; consumer prices have been falling for the last 6 months in France and Germany; in Japan wages have actually fallen 4 percent over the the past year...

“So far none of these price declines looks anything like the massive deflation that accompanied the Great Depression. But the appearance of deflation as a widespread problem is disturbing, not only because of its immediate economic implications, but because until recently most economists — myself included — regarded sustained deflation as a fundamentally implausible prospect, something that should not be a concern.

“The point is that deflation should — or so we thought — be easy to prevent: just print more money. And printing money is normally a pleasant experience for governments. In fact, the idea that governments have a hard time keeping their hands off the printing press has long been a staple of political economy; dozens of theoretical papers have argued that the temptation to engage in excessive money-creation causes an inherent inflationary bias in fiat-money economies. It is largely to combat that presumed bias that most of the world has accepted the notion that monetary policy should be conducted by an independent central bank, insulated from political influence — and has been written into the charters of those central banks that they should seek price stability as their main, often only, goal.

“Yet here we are, with deflation turning out to be a serious problem after all — and with policymakers finding that it is not as easy either to prevent or to reverse as we all thought.

### “How can this be happening? What does it imply for policy? The purpose of this note is to argue that more or less conventional economic theory actually does suggest some answers to these questions — but that these answers fly in the face of conventional policy wisdom. And because the answers are so hard to accept, deflation is indeed a real risk.”

We may skip the hocus-pocus part of the article and go directly to its conclusions.

“The obvious answer to sustained deflationary pressures, then, is the now-notorious proposal for ‘managed inflation’... But the idea sounds crazy, and that is a problem. How can we get finance ministers and central bankers, who have spent their whole careers preaching the evils of inflation and the virtues of price stability, to accept the idea that price stability may not be an available option?

### “For if deflationary forces are as powerful as they are in Japan — and may soon be in the rest of the world, if The Economist is right — there is no middle ground... Attempts to find a halfway house — to aim merely for stable prices rather than sufficiently high inflation — will be doomed to failure.

“In short, if you really believe that deflation is now a global threat, you should also believe that only policies lying outside of the realm of what is conventionally regarded as responsible will contain that threat. And because unconventional thinking is not what one expects (or, in normal times, wants) from finance ministers and central bankers, there is now a real risk that deflation will indeed become a global scourge.”

Thus concludes the article. It nicely explains what has happened in the intervening six years. The powers that be were scared by the deflationary threat much more than they ever admitted. Without any hesitation they took the advice of Krugman, abandoned policies “conventionally regarded as responsible”, unilaterally betrayed their mandate, burnt the halfway house of price stability, and hit the warpath of inflation, euphemistically calling it “inflation-targeting”.

### One irresponsible monetary policy deserves another

What Krugman conveniently ignores is that inflation may not be ‘manageable’ like a pet dog. More like a hungry tiger smelling blood, it could get out of hand following reckless increases in the money supply. No less than burning bridges, burning halfway houses is not a very good idea. Mainstream economists burnt the bridge of the gold standard making it the whipping boy for the Great Depression. Through that bridge we could have retreated to monetary rectitude after the insane experiments with the fiat dollar. Now they burn the halfway house of price stability, too. Where will the Fed find shelter after the tornado of runaway inflation has struck?

The seriousness of the problem cannot be overstated. A steep rise in interest rates at this juncture would be the horror of horrors. Normally higher interest rates would strengthen the value of the currency as they attracted foreign investors. Not this time. Apart from the problem of pricking all the bubbles in the economy starting with the housing bubble, and ballooning the budget deficit into outer space, there is an even larger and more immediate problem. And that is the effect that steeply rising interest rates have on the value of bonds, widely held at home and abroad. The effect is inevitable and instantaneous. Higher interest rates make bond values collapse.

You have to be very clear in your mind about this, so I spell it out. The dollar losing value on the foreign exchanges because of the trade gap is one thing.

Dollar-bonds losing value due to higher interest rates is another thing.

Nevertheless it is entirely possible, and right now appears highly probable, that the two losses will be inflicted simultaneously. Losses on bonds will compound the loss on the dollar. The compounded loss shall exceed the critical mass of bearable losses, and will trigger a chain reaction of further losses. The confidence in the dollar will be fatally and irreparably shaken, domestically as well as internationally.

How likely is that to happen? In my opinion not very likely. The Fed must have a contingency plan to prevent a steep rise in interest rates. Krugman has convinced us that the money-managers at the Fed have got rid of their last scruples, if they ever had any. Paraphrasing him, if you really believe that runaway inflation is now a global threat, you should also believe that only policies lying outside of the realm what is conventionally regarded as responsible will contain that threat. One irresponsible monetary policy deserves another. The contingency plan to prevent a steep rise in interest rates will have to involve a conspiracy between the Fed and the Bank of Japan to punish speculators short-selling the dollar and dollar bonds. There is nothing else left in the Fed’s bag of tricks but the check-kiting scheme with the Bank of Japan that could hold back the forces of monetary destruction waiting in the wings. Never mind that it is “conventionally regarded” as irresponsible. Never mind that it is illegal. Never mind that it is criminal.

Nothing else will defer the day of reckoning.

## References

1. Elephant Shit, by Paul Krugman, May, 2003

### GOTOBUTTON BM_1_ [www.pkarchive.org/economy/042203Follow5.html](https://www.pkarchive.org/economy/042203Follow5.html)

2. Zero Is Not Enough, by Paul Krugman, May, 2003

### GOTOBUTTON BM_2_ [www.pkarchive.org/economy/042203Follow4.html](https://www.pkarchive.org/economy/042203Follow4.html)

3. Can Deflation Be Prevented? By Paul Krugman, February, 1999

### GOTOBUTTON BM_3_ web.mit.edu/krugman/www/deflator.html

4. Is “Linkage” Broken? No, the Symmetry of Speculation Is, by Antal E.

### Fekete, March, 2005

GOTOBUTTON BM_4_ [www.financialsense.com/editorials/fekete/2005/0313.html](https://www.financialsense.com/editorials/fekete/2005/0313.html)

---

# Is Linkage Broken? No, Symmetry of Speculation Is

URL: https://newaustrianeconomics.com/archive/fekete/is-linkage-broken/
Date: 2005-03-13
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, bond-market, fiat-currency, interest-theory, monetary-policy
Description: Fekete addresses the claim that the historical linkage between the bond market and gold has broken down. He argues the linkage is intact — what has broken is the symmetry of speculation. Under irredeemable currency, speculation in bonds is always bullish (central banks backstop falls) while gold speculation remains two-directional, creating an asymmetric dynamic that distorts all financial signals.
Editorial Note: Written March 2005 as readers pushed back on his Kondratiev and bond-market analysis. Fekete introduces the concept of asymmetric speculation — one of his more subtle analytical contributions — to explain why conventional finance theory fails under irredeemable currency.
Original PDF: https://professorfekete.com/articles/AEFIsLinkageBroken.pdf

### Letter to a critic of my deflation theory

Dear Mr. East,

Thank you for your letter and for your interest in my work. You challenge my conclusion that rising bond prices may eventually force commodity prices to fall.

We are talking about the mechanism of “linkage” here, the phenomenon that the price level and the interest-rate structure are linked, that is to say, apart from leads and lags they rise and fall together. This is a subject on which I have been writing for many years. Please allow me to repeat my argument in support of linkage.

My theory is in terms of the dynamics of money-flows from one market to another. In particular, I consider inflows/outflows of money to/from the bond market and the commodity market. I define deflation as the net flow of money from the commodity market to the bond market. This doesn’t preclude money from flowing to the commodity market causing prices to rise even under deflation. But since on balance more money flows to the bond market, bond prices rise more, and the corresponding fall in the rate of interest is the dominant fact of the economy, not the rise in commodity prices, however conspicuous the latter may be. Price indices may or may not catch the effect of the net outflow of money from the commodity market. Inflation is defined mutatis mutandis.

Now it is my contention that, as a result of the manner in which the central bank injects new money into the economy, and also as a result of Keynesian contra-cyclical monetary policy whereby the central bank combats falling prices, as well as rising interest rates, through open market purchases of bonds, there are two instances of bias, breaking the symmetry of speculation and thereby distorting the economy.

First, there is bias favoring bond speculation vis-à-vis commodity speculation. The symmetry between the two markets breaks down because whenever the central bank intervenes, it is always in the bond market, never in the commodity market. Speculators know this, and take advantage of it. They can reduce the risks in bond speculation, or even eliminate it altogether through adroitly forestalling central bank intervention, that is to say, buying bonds just before the central bank does. Even small-time speculators who cannot hope to fine-tune their purchases to forestall the central bank, prefer the bond to the commodity market where they feel sheltered in the shadow of that powerful operator whose moves they can, as a copy-cat, mechanically follow. This explains why speculative activity in bonds and interest-rate derivatives has been snow-balling for the past 35 years. There was no organized bond speculation before 1971 while the dollar was on the gold exchange standard. Speculators want to have a free ride and they’ve got it in bonds. There is no free ride in the commodity market because, as we have seen, there is no central bank intervention there. Of course, this does not mean that speculators abandon the commodity market en bloc in favor of bonds. Scarcity and oversupply still occur and continue to offer profit opportunities to the nimble speculator. He will calculate the risk-reward factor and place his bets accordingly on the long or short side of the commodity market. But it will not be a free ride. It is the speculator who must bear the full burden of risk. Less nimble speculators will congregate in the bond market where they can get away without bearing the full burden of risk.

Second, there is bias favoring bull speculators in the bond market vis-à-vis the bears. Speculation in the bond market is far from symmetric. This is so because the central bank is on the long side of the bond market most of the time. Its visits to the short side are rare and hurried, mainly for window-dressing purposes and, horribile dictu, to deceive the market. All the basic operations such as the periodic augmentation of the money supply, combating falling prices or rising interest rates (the two major threats to the economy as seen by the central bank) involve purchases of bonds in the open market, not sales. The playing field is not level. The bulls are helped by open market operations of the central bank at the expense of the bears. The behavior of speculators reflects this bias. They buy bonds whenever the central bank buys, but refrain from selling when the central bank sells. If they sell, it is for profittaking. They hardly ever go naked short. It would be suicidal to defy the central bank in shorting the bond market.

Combining these two instances of bias, which break the symmetry of speculation thereby distorting its role in the economy, we could schematize data as follows. There are four basic position that a speculator can take:

1. Long in bonds

2. Short in bonds

3. Long in commodities

4. Short in commodities

The odds that the speculator take any one of these basic positions should ceteris paribus be the same. But because of the bias introduced by open market operations of the central bank, the odds favor position number one: long in bonds. In equilibrium speculative money will still flow, namely, it flows into bonds. There is a prejudice favoring lower interest rates.

The managers of the regime of irredeemable currency are either unaware of or tend to ignore the bias they have themselves introduced into speculation. As a consequence, central bank intervention in the bond market tends to be counter-productive. For example, in trying to combat falling prices the central bank buys bonds, hoping that the new money will flow to the commodity market and stem the price slide. But speculators have a better idea. They take the new money to the bond market where they buy in tandem with the central bank. As a result interest rates fall, and linkage will cause commodity prices to fall further. The central bank’s intervention has made deflation worse, not better. An example is Japan where enormous increases in the money supply, designed to combat falling prices, has only caused prices to fall more. How could the central bank make such a colossal blunder?

Because it is ignorant of linkage, and of the bias that its own open market operations create in speculation.

To recapitulate, there is a fundamental deflationary effect in the economy caused by central bank open market operations favoring, as it does, (1) bond as opposed to commodity speculation, (2) the long as opposed to the short side of the bond market. This effect reinforces deflation in the economy whenever it occurs. The net inflow of money to the bond market from the commodity market is expanded as risks in bond speculation on the long side of the market are reduced or eliminated. There is no corresponding effect to reinforce inflation, the net outflow of money from the bond market to the commodity market is not expanded, and risks in bond speculation on the short side, and in commodity speculation on the long side are not reduced. As a result, in a deflation (but not in an inflation) bond prices tend to be higher, and interest rates lower, than justified by economic conditions. This is what baffles the Bond King, and this is the “conundrum” of King Al. Be that as it may, this effect ought to be taken into account in reading deflationary signals, or in searching for inflationary signals.

Now let’s turn to linkage, the phenomenon of commodity prices and interest rates moving together subject to leads and lags. We want to see how this is a consequence of the bias, breaking the symmetry between bond and commodity speculation, and between bull and bear speculation in bonds. The proposition that high and increasing prices cause higher (and low and decreasing prices cause lower) interest rates is not controversial as it is accepted by most economists. Therefore I shall focus attention on the case of interest rates being (1) low and falling, (2) high and rising.

In the first case bond prices are high and rising, as they would be in deflation. If there was no bias, then speculators would resist the rise and take profit in selling the bonds. But bias is introduced by the central bank’s buying of bonds in an effort to combat deflation.

Therefore speculators will let their profits ride. What is more, they will pyramid. Rather than opposing the central bank, they will join its buying spree with all what they have and finance their bond pyramiding through liquidating their holdings of commodities, causing prices to fall.

In the second case bond prices are low and falling as they would be in inflation. If there was no bias, then speculators would resist the fall and buy the bonds. But they find the risks unacceptable.

They already have worrisome paper losses on their bond portfolio due to rising interest rates. They consider the possibility that the central bank may fail in its efforts to contain inflation. Central bank buying of bonds is their opportunity to cut losses and exit the bond market. So they feed their bonds to the central bank and use the proceeds to pyramid in commodities, causing prices to rise.

This concludes my explanation of linkage. I realize that my theory is counter-intuitive and raises eyebrows right and left. Please remember that we have been conditioned by financial journalists and academic observers to ignore the dynamics of the interaction between changes in the rate of interest and price changes in terms of the underlying money-flows. They work on the basis of the simplistic formula that a low rate of interest perks up speculation whereas a high rate dampens it. My theory goes far deeper than that. It takes speculation fully into account, including the choice confronting the speculator whether he wants to deploy his capital in the commodity market, or whether he wants to deploy it in the bond market. The simplistic formula is flawed, as it ignores the fact that speculation itself has a feedback-effect on interest rates.

It is unrealistic to assume, as most financial journalists do, that speculators don’t take advantage of profitable opportunities in the bond market inadvertently created by central bank intervention. Actually they do, and have done so since the 1930's when the Fed first started using what has come to be known as open market operations, in line with Keynes’ contra-cyclical monetary policy prescriptions. It is not recognized in the existing economic literature that bullish bond speculation played a big role in prolonging and deepening the Great Depression. Unfortunately, the deficient understanding of the Great Depression will result in a repetition of the mistakes and may be instrumental in bringing about a Second Great Depression, worse even than the first.

My critics suggest that, as prices and interest rates move in opposite directions, linkage has now been broken. Don’t be hasty with your conclusions. It is possible that either the price level lags the interest rate structure, or the other way round. If either one forced the other to follow, then they would resume marching together once more. It is an open question whether they would march up, or they would march down. My guess is that, unless the world plunged into a full-scale war stretching supplies of commodities to the limit and destroying production facilities, they would march down, after commodity prices made an ‘about-face’, as they did in Japan. This guess is justified by the deflationary bias caused by central bank open market operations as explained above, and on the dynamics predicated upon it.

The deflationary bias in the economy is quite palpable. In spite of the reckless and record-breaking increases in the money supply under Alan Greenspan’s watch, price increases have been moderate. Without the deflationary bias we should have had massive inflation.

Don’t be fooled by Greenspan who is patting himself on the back in taking credit for turning inflation around through monetary policy that “cleverly mimics the gold standard”. Greenspan is not unlike the surfer on the beach boasting that it was he who turned the tide back through skillful surfing.

A steep rise in American interest rates and the corresponding destruction of bond values, at a time when central banks around the globe are itching to dump the dollar, would be catastrophic. It would be a financial earthquake measuring 9.9 on the Greenspan scale. That is strong enough to demolish the international monetary system based on the irredeemable dollar. Moreover, through the domino effect, reinforced by competitive devaluations, it could wipe out the value of a lot of weaker currencies.

Greenspan knows this. He won’t allow that to happen during the last nine months of his long tenure, if he can help it. Can he? You bet. How? Why, through conspiring with the Bank of Japan, of course. If they joined forces, they could mercilessly punish everybody who had the temerity to short the dollar and bonds, be they central bankers, bond kings, or individual speculators. But this is a topic for another letter.

Yours, etc.

### Reference

Antal E. Fekete, Causes and Consequences of the Kondratiev Long-Wave Cycle,January, 2005

---

# Tsunami in the Bond Market

URL: https://newaustrianeconomics.com/archive/fekete/tsunami-in-the-bond-market/
Date: 2005-03-07
Section: Popular Economics
Difficulty: intermediate
Concept Tags: bond-market, deflation, interest-theory, monetary-policy, capital-destruction
Description: Fekete warns that a tsunami of bond liquidation is building as the Kondratiev long-wave cycle approaches its deflationary trough. Speculators who have been riding the bond bull for decades will eventually sell en masse, and the resulting collapse in bond prices will trigger a cascade of debt deflation that no central bank action can prevent.
Editorial Note: Written in March 2005, continuing Fekete's analysis of the Kondratiev deflationary wave. The tsunami metaphor captures his argument that the long-suppressed natural forces in the bond market will reassert themselves violently once speculative positions reverse.
Original PDF: https://professorfekete.com/articles/AEFTsunamiInTheBondMarket.pdf

### Summary for the busy executive

### The check-kiting scheme between the U.S. Treasury and the

Fed, that has been going on quite openly for some 35 years, may have now been supplemented with another, this time between the Fed and the Bank of Japan, conducted in high secrecy. It involves the conspiratorial exchange of non-interestbearing yen balances for interest-bearing Treasury debt in ever greater volume, over and above the need to finance the American trade deficit with Japan, huge as the latter may already be. The purpose of the conspiracy is to forestall a run on the dollar by other central banks and foreign exchange speculators. If my assumption about the existence of this conspiracy is correct, then the end-game of the regime of irredeemable currencies will be stretched out by another decade or so. However, that decade will not be one of inflation most observers expect. It will be one of deflation and worldwide depression which hardly anybody expects. Speculators shorting dollar-bonds will be massacred, and people in debt hoping to find relief in inflation will be squeezed out of their possessions. Reports on the demise of the bond bull have been Grossly (sic) exaggerated. Bill Gross, the self-styled Bond King, now talks about tsunami in the bond market with several more waves to come.

### Aristotle’s axiom and the history of money

The history of money can be compressed into one line: man’s efforts to defeat Aristotle’s axiom asserting that it is not possible for any substance to be simultaneously present at two different places. Clearly, Aristotle meant physical substances. Intellectual substances such as a promise to transfer ownership of chattel, or title to real property, can be simultaneously present in two different balance sheets. This is why governments are so enamored with paper money, another intellectual substance very different from gold money, which is a physical substance subject to Aristotle’s axiom.

Stories about inspectors visiting rural banks in Scotland abound. The inspector’s carriage was preceded by another, drawn by the fastest horses available in the country, loaded with gold coins to be shown to the inspector when he arrives, then to be moved post-haste to the next bank on the inspector’s itinerary. In fact, companies existed to provide this important service to the banks. A worthy topic for research in economics could be the question to what extent the breeding of racehorses in England was financed by the desire of banks to defeat Aristotle’s axiom. If we still had a gold standard, we would probably read about bank inspectors flying with the speed of Mach 1, preceded by another airplane carrying gold with the speed of Mach 2. By the time inspectors caught up with progress and could also fly with the speed of Mach 2, there would be supersonic aircrafts, the development of which was financed by the banks, to fly gold ahead of bank inspectors with the speed of Mach 3.

### Invention of check-kiting

Luckily for the banks this was not necessary. Irredeemable currency made flying gold back-and-forth pointless. The banks soon found a less expensive way to defeat Aristotle’s axiom. They invented check-kiting which, if necessary, could be operated with the speed of light. This is how it goes. Two banks, A and B, conspire. Bank A issues an unbacked check payable to Bank B. Then Bank B issues a second unbacked check of similar amount payable to A that can be shown when the first check is presented for payment. Then A issues a third unbacked check of similar amount payable to B that can be shown when the second check is presented for payment. And so on and so forth. The game the two banks play can be continued indefinitely with the result that they have appropriated, quite fraudulently, the amount of the first check, the wages of conspiracy.

“Float” is the name of the sum total of checks in the process of clearing. It is obvious that banks A and B have tapped into the float to enrich themselves. In actual practice check-kiting is more complicated in that the two conspiring banks do not act under their own name but employ proxies in order to make detection more difficult. Naturally, the criminal code prescribes stiff penalties for this crime, a form of embezzlement. However, it is important to understand that detection is extremely difficult as the embezzled sum is extracted from a large number of accounts, and the loss suffered by any individual account holder is relatively small. Victims don’t notice their loss and no complaint is lodged.

To recapitulate: check-kiting consists in issuing an unbacked check that the conspiring banks “back” with an endless string of further unbacked checks.

These unbacked checks don’t bounce. At the clearing house each is offset by the next. Under a gold standard check-kiting is not possible because of the existence of an ultimate means of payment, the gold coin. Individuals can protect themselves against fraud by presenting checks for payment in specie.

The essence of the regime of irredeemable currency is that there is no ultimate means of payment, so the individual is deprived of protection against the crime of check-kiting.

### Check-kiting made legal

Before 1968 there was a legal requirement that Federal Reserve notes be backed by gold for no less than 25 percent of their face value. To that extent the public was protected against check-kiting, as an audit could be held at any time to ascertain that the gold was there. In 1968 Congress in its wisdom repealed the legal requirement to back Federal Reserve notes by gold. After F. D.

Roosevelt had made the possession of gold coins a crime by executive proclamation in 1933, the individual could no longer test checks against kiting.

Nonetheless, legal requirement for gold backing provided a modicum of protection of the public against large-scale fraud.

The repeal of gold backing was said to be justified by the need that Treasury gold should not be tied up for domestic purposes but be available to pay foreign creditors of the United States in order to bolster the international value of the dollar. This was deemed sufficient protection to domestic holders of dollar balances as well. If it was, this protection was soon taken away, too. President Nixon defaulted on the foreign-held debt of the United States three years later in 1971, and the dollar lost more than 90 percent of its purchasing power in less than 10 years.

The default removed the last obstacle in the way of the largest check-kiting scam in history. The conspirators were the U.S. Treasury, issuing obligations in the form of government debt, and the Federal Reserve, issuing obligations in the form of Federal Reserve notes and deposits. The former were supposed to be extinguished by paying out the latter, and the latter were offset in the balance sheet of the Federal Reserve banks by the former. Technically correct, but rotten to the core. A most incestuous relationship that is consummated through checkkiting.

As check-kiting between banks A and B taps into the float and victims are the account holders belonging to the same clearing house, so check-kiting between the U.S. Treasury and the Federal Reserve taps into the wealth of the nation and victims are all the producers, consumers and savers in the country.

There are several problems. First, the value of Treasury obligations is not fixed but varies inversely with the rate of interest. It could theoretically go to zero if interest rates rose beyond any limit, as indeed they threatened to do in the late 1970's. Since Treasury obligations balance the liabilities of the Federal Reserve banks, the dollar, too, is staring at the bottomless pit into which its value could fall in adversity. However, the main problem is that, although check-kiting is done quite openly, it is done in bad faith nevertheless. The U.S. Treasury and the Federal Reserve banks have neither the means nor the intention to meet their obligations value for value. Paying off Treasury debt with Federal Reserve notes, the backing of which is the same Treasury debt, is a scam to fool and plunder creditors, domestic and foreign. And among creditors we must count the poorest of the poor who has to have Federal Reserve notes to buy food for his children. It was no accident that the Big Bang marking the beginning of debtexplosion in the world occurred in 1968, the year of the legalization of checkkiting in the United States.

Federal Reserve notes may be made “legal tender” by capricious and coercive legislation, but they certainly cannot be made the “ultimate means of payment”.

They are the product of legalized check-kiting.

### Exportation of check-kiting

An early consequence was that the foreign central bank creditors of the United States suffered huge losses as their dollar-denominated reserves were depreciating both in absolute terms and also relative to the domestic currency.

Since the two most important creditors were Germany and Japan that had been vanquished in World War II and were technically still under military occupation, a little bit of arm twisting brought quick results. Losses on the books of their central banks were offset through a local version of check-kiting. The Japanese government issued special obligations to paper over the holes that the dollar default punctured in the balance sheet of the Bank of Japan. The problem was similarly “solved” in Germany. Thus the original check-kiting in the United States begot more check-kiting abroad through damage-control, which was done without much public fanfare. Financial journalists and academic experts “forgot” to quiz the Bank of Japan and the Bundesbank about the miraculous disappearance of losses due to default on the dollar.

Virtually all critics of irredeemable currency ground their objections in the Quantity Theory of Money arguing that as the quantity of paper money increases faster than goods and services, prices will increase and paper money will eventually lose all its value. I have never accepted this simplistic explanation as it ignores the fact that paper money can buy other things beside goods and services. In particular, it can buy bonds. And to the extent it does, it could cause the exact opposite effect to that predicted by the Quantity Theory. Instead of causing inflation, it could cause deflation, and worse. Much worse. Of course, blatant increases in the money supply will alert people and they will be reluctant to buy bonds, no matter how high a figure the government prints on the interestcoupons. Still, I can’t consider this an adequate protection against deflation because the loop-hole, check-kiting between central banks, remains and can trump the Quantity Theory. This is exactly the situation that we are facing right now.

### More check-kiting to save the dollar

This also explains why managers of the dollar-based international monetary system chose the roundabout way to monetize government debt in preference to the direct way. They certainly had the power to inflict pure fiat money on the people of the world, that is, the dollar could be non-interest-bearing, nevermaturing U.S. Treasury debt. This would bring large savings for the U.S. government that would not have to pay interest on the national debt to the extent it could be put in circulation. Arguably, a balanced U.S. budget would boost confidence in the value of the dollar like nothing else could. From the point of view of the advocates of irredeemable currency, the regime of pure fiat dollar would be superior to the present regime with its ghastly and worsening budget deficits due largely to interest payable on the national debt.

However, the managers are aware more than anybody else that pure fiat money has a record of 100 percent mortality through the sudden-death syndrome, the congenital disease of irredeemable currencies. The managers hope that, through chicanery and fraud, they could save the dollar from sudden death.

They are counting on people being too stupid to see through the scam of checkkiting.

But, as the accelerating avalanche of debt in the world shows, theirs is a forlorn hope. The managers must have a contingency plan to fend off a run on the dollar by central banks and foreign exchange speculators, thus defying the sudden-death syndrome. This contingency plan involves highly secret checkkiting between the Federal Reserve and the Bank of Japan.

### You can’t cry “conundrum” too many times

I have no other proof than logic, and so far events have justified my theory.

Bonds are defying gravity, even in the face of the Fed increasing short-term interest rates. The yield-curve is flattening as expected, but not because the intermediate and long yields are going up less than the short. It is flattening because they are going down in the face of the short which is going up. Bill Gross of PIMCO, who considers himself the best bond manager in the world, calls this extremely rare phenomenon bull flattener. He says it is as rare as Ahi tuna that never hits the grill. Of course, there is an element of self-justification in this observation. Last year Bill Gross, writing at length in the widely-followed Investment Outlook of PIMCO, declared the bond bull dead. However, the dead bull, like Mark Twain reading his own obituary, talked back saying that “reports of my demise are Grossly (sic) exaggerated”. One should think that Bill Gross owes an explanation to his followers who might have shorted bonds based on his analysis and suffered losses as a consequence. This is quite an embarrassment for someone who likes to picture himself as the Bond King. He is seeking solace in the words of Alan Greenspan, uttered before a Congressional committee, calling the bull flattener a “conundrum”. He concludes that the Fed King sitting on his throne, scepter in hand, is no less mystified than his subaltern who should be excused for the mistake in calling the bond bull dead.

Could the Bond King be so naive? Has it not occurred to him that the wily old hypocrite on the throne, scepter in hand, might pretend to be mystified because he has a hidden agenda? His carefully selected word “conundrum” could be red herring. While publicly pretending that he does not understand it, privately Greenspan may be congratulating himself upon his success in punishing those who shorted bonds, and intimidating those who were ready to short the dollar.

Here is my solution to Greenspan’s “conundrum”. The bull flattener was deliberately inflicted upon the yield curve by Greenspan himself through his highly secret check-kiting in conspiracy with the Bank of Japan. It involves the swap of non-interest-bearing yen balances and interest-bearing Treasury debt in ever greater volume, over and above the need to finance the American trade deficit with Japan, huge as though the latter may be. The purpose of the conspiracy is to confuse the issue, thereby nipping the run on the dollar in the bud.

Bill Gross now talks about a bond market tsunami with several more waves to come. Sorry, the bear market in bonds may not be in the offing for some time to come, because of the unscheduled tsunami. Oh well, if he has made a mistake once, he can be mistaken again. But an even greater mistake was made by Greenspan himself who let the genie of tsunami out of the bottle while crying “conundrum”. Call it tsunami or call it deflation if you like, it may not be possible to put the genie back into the bottle.

As Greenspan’s deceit dawns upon them, bond speculators will not let themselves be outfoxed. They will repurchase the bonds of the ownership of which they have been tricked out by the wily old fox. Worse still, they will buy more, expecting that nice back-wind from the Fed to make pyramiding risk-free.

As a result bond prices will rise, interest rates will fall, and linkage will cause commodity prices to fall, too. As they do, Greenspan will have the urge to cry “conundrum” once more, this time out of genuine fear. But just as you cannot cry “wolf” too many times because the wolf will appear to put an end to your crying, you cannot cry “conundrum” too many times either.

### The deflation-cat chasing its own tail

Greenspan will have a job to contain declining prices. Guess what will he do?

Use helicopter drop of Federal Reserve notes, as Milton Friedman has suggested? That makes a good joke, but now the situation is deadly serious. He will try to contain deflation through the old Keynesian recipe, open market purchases of bonds, putting new money into circulation in the hope that it will flow to the commodity market. But isn’t this just the nice back-wind speculators have been waiting for to make bond pyramiding risk-free?

The deflation-cat is now ready to chase its own tail. Bond speculators buy bonds causing commodity prices to fall, which prompts open-market purchases of the Fed trying to coax speculators into buying commodities. Instead, speculators will buy more bonds, risk-free, and the vicious circle is on.

Behold the deflationary denouement of the regime of irredeemable currency.

### References

Bill Gross, Too Much! (The weak dollar — causes and consequences),

### Investment Outlook, PIMCO, November 2004

Bill Gross, I’ve Got to Admit It’s Getting Better, Getting Better All the Time, Investment Outlook, PIMCO, March 2005

Antal E. Fekete, Causes and Consequences of Kondratiev’s Long-Wave Cycle,

### January, 2005

Antal E. Fekete, Stop Greenspan from Plunging America into a Depression,

### June, 2003

---

# Greenspan Has Taken the Horse to Water: But Can He Make It Drink?

URL: https://newaustrianeconomics.com/archive/fekete/greenspan-has-taken-the-horse-to-water/
Date: 2005-03-01
Section: Popular Economics
Difficulty: intermediate
Concept Tags: deflation, bond-market, interest-theory, monetary-policy, federal-reserve
Description: In a letter responding to a reader's challenge, Fekete defends his Kondratiev long-wave theory against the objection that it fails to account for the facts. He explains why speculative hoarding of commodities — not simple monetary expansion — is the engine of inflationary phases, and why the deflationary contraction phase must follow as speculators eventually liquidate.
Editorial Note: A companion to 'Causes and Consequences of Kondratiev's Long-Wave Cycle,' written March 2005 in response to reader pushback. The letter format allows Fekete to clarify the role of speculation — the 'sleeping dog' that mainstream finance ignores — in his long-wave framework.
Original PDF: https://professorfekete.com/articles/AEFGreenspanHasTakenTheHorse.pdf

Letter to a reader commenting on my theory of the Kondratiev long-wave cycle Dear Mr. South:

Thank you for writing. You don’t find my theory consistent with the facts. I understand this and I also see the reasons why. My theory aims at taking speculation fully into account, which neither financial journalism nor academic publishing presently does. They treat speculation as you would a sleeping dog.

Just let the sleeping dog lie. Yet speculation is everything but a sleeping dog. Its volume has been increasing exponentially since 1971, and right now it is spinning out of control. Small miracle that it hasn’t blown the financial world to pieces. I quote from your letter:

“Although I read your theory of the Kondratiev long-wave cycle with great interest, I cannot say that I find it consistent with observable facts. Commodity prices over the last five years have risen WITH bond prices, that is, IN

THE FACE OF falling interest rates, just the opposite of what your theory is predicting.

Your theory is counter-intuitive, to say the least. While there is an infinite supply of bonds and currencies under fiat regimes, the supply of commodities is certainly finite. A theory that places them on equal footing cannot be right.

We must take supply and demand dynamics in terms of its effect on prices and interest rates into account. I wonder if you can direct me to a fuller discussion of these ideas, since I am confused about some of the qualifications you make."

There is no fuller discussion of my theory than what you and I hereby provide.

For this reason I welcome your criticism and invite others, too, to participate. I have defined inflationary and deflationary spirals under the Kondratiev longwave cycle in terms of the huge oscillating speculative money-flow to-and-fro between the bond market and the commodity market, and not in terms of the effect of such a flow on prices and interest rates. There are other factors affecting prices, to be sure, first and foremost, as you point out, scarcity. And, true enough, should it offer serious resistance, speculation would be trumped by scarcity.

However, supply/demand is nothing but a figment of the imagination unless it includes speculative supply/demand which, rightly or wrongly, also participates in the price-discovery process. Speculators have no firm commitment to the long or the short side of the market. They may change sides at the drop of the hat, sometimes rationally, at other times not so rationally. Moreover, speculators can sell short, that is, sell commodities that they haven’t got, nor do they know how they are going to get. Their motto is “sell now, worry later”. The point is that speculation is capricious. Therefore the notion of supply/demand does not stand up to scientific scrutiny. It is an antiseptic concept having validity only in an environment free of the virus of speculation. Such an environment was approximated by the regime of the gold standard which successfully confined speculation to areas where it could do only good and no harm: to markets where supply was controlled by nature, not by man, such as markets in agricultural commodities. In these markets speculation is always stabilizing, and it makes sense to talk about supply/demand. But in markets where supply is controlled by man (read: government), speculation is necessarily destabilizing. Speculators risking their own funds can easily outsmart bureaucrats on salary, risking public funds. What are we to make of “supply” in the forex market where nimble speculators regularly forestall the central bank by selling forward before its agent can even pick up the telephone? Or what are we to make of “demand” in the bond market where nimble speculators regularly forestall the central bank by buying forward before its agent can even click on the “buy” button of his monitor? These hare-brained schemes of central-bank intervention in the markets are not serving any purpose beyond making speculation risk-free, thereby allowing speculators to tap into the public purse. One of the chief merits of the gold standard is that it is the only way to make it impossible for speculators to have a free ride at public expense.

Supply/demand is a deliberate oversimplification that may be applicable in fair weather, but is mercilessly blown away by the first storm. Under these circumstances an analysis of the Kondratiev long-wave cycle must be based on insight one can gain into the thinking of big-time speculators, and not on the spurious concept of supply/demand.

It is well-known that Greenspan&Co. does worry about deflation. In fact, they have made it clear that to combat deflation they can, and will, pump unlimited amounts of money into the economy, certainly by conventional means through open market purchases of bonds but, if need be, also by unconventional means such as through helicopter-drop of FR notes. Speculators are listening. While they do not take the helicopter-drop idea seriously, they are certain that for them manna will fall from heaven in the form of risk-free speculative opportunity. They know that the Fed is going to buy bonds in the open market in an effort to combat deflation. All they have to do is to buy the bond before the Fed does.

Why should they buy commodities, however attractive the idea may be? Scarcity or no scarcity, there is risk in buying commodities, namely the risk that you may be left holding the bag.

The Fed has already pumped an enormous amount of money into the economy.

In other words, Greenspan has taken the horse of speculation to the commoditypool of water. Can he now make the horse drink? We can be pretty sure that the horse will drink. Moreover, drink it will heartily, but from another pool, the bondpool of water. The bond market is the place where the fun is, where speculation is as nearly risk-free as it can ever be.

All the more is this true right now, given the strong yen. The weak dollar is the perfect smoke-screen to camouflage nefarious bond speculation that is going to drain the last drop of strength from the economy. In markets where the risks are created by man, not by nature, speculation is no longer a zero-sum game. No longer is it true that the gain of one speculator is the loss of another. When the nemesis of bond and forex speculation was unleashed by the authors of the irredeemable dollar, the entire wealth of the United States was put on the gaming table and into the jackpot to taunt speculators. Far from declining the bait, the discriminating speculator has accepted the challenge. He is placing the bet, except he may bet against the wishes of his “handlers”. He may bet in the bond market when his handlers want him to bet in the commodity market, and conversely.

This is exactly what he does in the present situation. The discriminating speculator engages in the yen-carry trade, that is, arbitrage from the yen bond market to the dollar bond market. He borrows yens at 1 percent, exchanges them for dollars to buy US bonds yielding 5. The purpose of the exercise is to drive up the price of dollar-bonds to the unheard-of heights of yen-bonds. Note the double-whammy. In addition to the unearned income of 4 percent the speculator will pocket huge capital gains after bond prices appreciate. Better still, the rising yen turns the double-whammy into a triple-whammy. The falling dollar makes the terms of trade for the speculator improve. He can now control a larger slice of the nicely appreciating bond-pie per unit of borrowed capital than before. True, he will have a loss on the short leg of the trade, namely, loss due to the rising exchange rate. In percentage terms this loss is in the order of onedigit. He reckons with that. But profits on the long leg, the portfolio of dollarbonds, are in the order of triple-digit. With these odds, why should he care about losses on the short leg?

Many of my readers have a difficult time to understand how the yen-carry trade can be profitable while the dollar is falling. “Borrow yens, a rising currency? Are you out of your mind? This is a ticket to guaranteed losses!” These comments only go to show the inherent ingenuity of the yen-carry trade as it frightens away potential competition. Not only does it offer a fantastic profit opportunity; it also offers obscurity in which those profits can safely be made. The best profitopportunity is the one that only one in a million can detect!

To recapitulate, the Fed’s well-advertised strategy to combat deflation is going to backfire through the cunning of speculators. They will not buy commodities as expected. Instead, they will buy dollar-bonds thereby making interest rates to fall even in the face of a weak dollar. As I have discussed elsewhere in full details, “linkage” will translate falling interest rates into falling prices. The Fed will have made deflation worse, not better, by its misguided intervention.

You have taken me to task in pointing out that as far as the eye can see there are price increases; price decreases are nowhere to be seen. I am not going to argue that prices of agricultural goods are already at depression level. Nor am I going to argue that the low prices offered by Wal-Mart on made-in-China gadgetry, and the falling price of computers and paraphernalia, are very much part of deflation. I just call attention to the fact that big multinational companies are losing pricing-power. Companies don’t respond in the traditional way, by beefing up capital. Quite to the contrary, they thin it out. That is to say, they redeploy capital from production into bond speculation, euphemistically called “consumer finance”. General Electric that pioneered the move out of production into speculation is now followed by General Motors. This redeployment of capital is responsible for outsourcing and the loss of well-paid industrial jobs in the United States which are replaced by low-paid service jobs. The trouble is that these service jobs won’t last. When the workers are at the end of the rope and can no longer refinance their mortgages to get spending cash, the hamburgerflipping jobs will go the way of the tool-making jobs. The signs portending deflation are all-around for those who have eyes to see.

Fed governors have found it necessary to shout from their rooftops that, yes, they do have contingency plans to combat deflation. So far so good, but what about contingency plans to combat inflation, and hyperinflation to boot? Here we meet with deep silence. The Fed is not saying how it plans to meet the emergency if the dollar hits skid-row and foreign holders of dollars start crying that the Emperor has no clothes. Let me tell you that the Fed’s silence on its ability to combat hyperinflation is extremely ominous. It is not that the Fed may have no contingency plans to meet such an emergency. It is that the plans it has are unorthodox, unethical, and they can only work clandestinely. They cannot succeed in the light of the day. The Fed plans to trap bond-bears and other speculators shorting the dollar.

Here I stumble into conjecture, hypotheses that nobody can prove or disprove because of the tight secrecy surrounding the plan. It is risky business to make conjectures about the clandestine operations of a government agency, but we are forced to take this risk in view of the web of lies the Fed weaves around itself.

The Fed’s contingency plan is essentially a check-kiting scheme in conspiracy with the Bank of Japan. The Fed swaps interest-bearing Treasury debt for noninterest-bearing yen balances over and above its needs to finance the trade deficit. As the Fed buys the bonds in the open market, it will pull the rug from underneath the bond-bears, and speculators shorting the dollar will burn their fingers right to the armpit. How do we know that this is what the Fed is planning to do or is already doing? By a process of elimination. Short of making the dollar gold-redeemable, and throwing all ethical considerations aside, this plan offers the best chance for saving the dollar from the sudden-death syndrome, the congenital disease of all irredeemable currencies. Note that the Fed’s plan is basically the elevation of the yen-carry trade to official status. It eliminates the risk on the short leg since there are no borrowing costs. The yens are not borrowed, they are simply created on the balance sheet of the Bank of Japan.

The rate of interest on dollar loans will continue to fall. Speculators will be forced to cover their short positions on the dollar with a loss; survivors will go long.

Here is the perfect example of “running on empty”. Just as check-kiting can tap into the pocket-book of everybody using the bank’s services, this plan of the Fed taps into the public purse. It plunders all the savers and all the producers in the United States in order to save the immoral regime of irredeemable currency.

Note that the Fed’s contingency plan to steer away from hyperinflation is essentially deflationary. It is designed to massacre all short sellers of dollars mercilessly by relentlessly pushing interest rates further down. The trouble with this plan is that it makes bond speculation on the long side of the market riskfree. If you now recall that speculators frustrate the Fed’s anti-deflationary measures by speculating, risk-free, also on the long side of the bond market, then you will understand why I am inclined consider the deflationary scenario as more likely than the inflationary, at least for the rest of this decade, but possibly for the next one as well.

Be prepared for further mind-boggling increases in the money supply as the Fed is desperately pumping liquidity into the economy. Contrary to expectations the dollar will not get much weaker, and may indeed get stronger because the new money, rather than flowing to the commodity market as the handlers of the speculators would hope, is flowing to the bond market where speculation has been made risk free by the Fed’s foolish policies. The deflationary spiral under the long-wave Kondratiev cycle is far from over, in spite of appearances. Please understand I don‘t suggest that you invest in bonds. I just suggest that you... well... fasten your seat belts...

Yours, etc.

---

# The Decoy of the Falling Dollar

URL: https://newaustrianeconomics.com/archive/fekete/the-decoy-of-the-falling-dollar/
Date: 2005-02-27
Section: Popular Economics
Difficulty: intermediate
Concept Tags: bond-market, deflation, fiat-currency, interest-theory, monetary-policy
Description: Fekete argues that the falling dollar is a decoy distracting observers from the real story: the paradoxical persistence of the bull market in U.S. Treasury bonds. A depreciating currency should push bond prices down, yet they remain elevated — a sign, he argues, of deflationary forces at work under the Kondratiev cycle that the quantity theorists and inflation hawks are missing entirely.
Editorial Note: Written in February 2005 as the dollar was weakening and commentators predicted rising interest rates. Fekete's contrarian analysis — that the bond bull market would persist despite the falling dollar — proved prescient. This piece ties together his Kondratiev cycle theory with his analysis of the bond market.
Original PDF: https://professorfekete.com/articles/AEFTheDecoyOfTheFallingDollar.pdf

A consensus is building among market observers that bonds defy all logic. The falling dollar should make dollar bonds fall, too. After all, bondholders stand to lose a large part of the value of their original investment as a result of the depreciating dollar. Yet the bull market in bonds that started almost 25 years ago is still intact. The following comments may help put some of the logic back. As a preliminary I would like to remind readers that a bull market in bonds is the sine qua non of the deflationary spiral under the Kondratiev cycle. Pimco’s Bill Gross is premature in writing the obituary of the bond bull. Other observers’ opinion that a dramatic rise in interest rates, which appears to be imminent, is likely to serve as the trigger for the Kondratiev winter is probably wrong as well. On the contrary, I shall argue that a continuation of the bull market in dollar-bonds will do that particular trick. I consider any weakening in dollar-bond prices a beartrap.

Here are my premises. The perspective on the bond and foreign exchange markets is distorted by the smoke-screen surrounding a gigantic speculative scheme known as the yen carry-trade. This is how it works. The Japanese are printing yens, not to support productive enterprise but to finance speculation.

Next, the ball is in the Fed’s court. The Fed obliges and prints dollars, again not to support productive enterprise but to serve as a drop-off point for speculators.

Japanese interest rates being so low, speculators can borrow yens at around

1.5%, sell them for dollars to be invested in US Treasuries yielding 4 to 5%. The speculators pocket the difference without performing any useful service whatsoever. The yen carry-trade is firmly in place, allowing the US debt markets to defy gravity. The question is when this scandalous charade might end. To answer it observers look at another key market, that of the dollar, and conclude that the obvious bear market will spell the end of the yen carry-trade. As the dollar falls, the Japanese and the Chinese may threaten to start dumping it and to put an end to its reserve currency status. Only a dramatic rise in interest rates may save the dollar as the world’s reserve currency.

This is where I take issue with the conventional wisdom of those observers who, like myself, think that the deflation threat is serious. What they miss is the fact that the bear market in the dollar actually helps rather than hurts the yen carrytrade. The terms of trade for those who sell yens to buy dollars is improved immensely by the fall of the dollar. The yen carry-trade can be described as arbitrage with short leg in the yen bond market and long leg in the dollar bond market. Profits on the long leg increase far more than losses on the short as a result of the dollar-devaluation. The faceless bond speculators are sitting on a huge pile of profits already that have been accruing for a quarter of a century.

They can well-afford to prevent Humpty-Dumpty (read: the dollar) from having a great fall from its perch as a reserve currency. This particular cash cow can be milked yet for quite a bit longer with careful husbandry. It would be a folly to let it be slaughtered just at the time when milk (and honey) output is at peak.

What I am suggesting is that bond speculators are calling the shots, and central bankers willy-nilly play balls with them. The alternative is sudden death. Without bond speculation the regime of irredeemable currencies would have come to a sad end thirty years ago. Speculators well-understand the dynamics of competitive currency devaluations. The present round started ten years ago when the yen was devalued 50%. In the intervening years the ruble collapsed along with other Asiatic currencies. Right now it is the turn of the dollar. It will be interesting to watch whether and when the euro will succumb to the temptation, as I predict it will, in spite of the brave talk we are hearing from Brussels. This is just a replay of the 1930's with the yen playing the role of the leading currency.

To recapitulate, if the yen carry-trade was profitable during the last ten years of a weak yen, then it would be a hundred times more profitable during the next ten years of a strong yen.

It is a mistake to look at the falling dollar as the result of the profligacy of the American consumers, and a direct outcome of the American trade deficit. This is just a decoy. Admittedly, it is a clever one as far as decoys go. It is designed to divert attention away from the real culprit, which is the yen carry-trade and its obscene profits. The falling dollar is part of the big picture of competitive currency devaluations, or of the even bigger picture of the Kondratiev cycle. But let us not forget that at the same time it is a powerful booster for the yen carrytrade. Let the public buy the nonsense of Milton Friedman that the falling dollar is just the manifestation of the adjustment mechanism balancing the American trade account. Or let it buy the equally fallacious Quantity Theory of Money predicting that the dollar will be printed into worthlessness. The truth is that there is an insatiable demand for dollars, especially for falling ones, by bond speculators.

According to the 19th century French economist Frederic Bastiat, economics is a game of distilling what you don’t see from what you do. In the present case what you see is the American trade deficit, which can easily be blamed on the appetite of the gluttonous American consumer. What you don’t see is the accumulating profits of the faceless bond speculators, sucking the life-blood from the world economy. This is exactly the same point that was missed in the Great Depression of the 1930's by all economists. They are going to miss it again. The world is going to repeat all the mistakes it made then, because it has allowed the government and the economists’ profession to fabricate a theory of the Great Depression that puts the blame squarely on the gold standard. The price has to be paid for pushing gold out, not just from the monetary system, but also from the research agenda of universities and think-tanks!

It is not hard to predict the further course of the ongoing depression if you can divine the strategy of the faceless bond speculators. They will definitely want to keep the irredeemable dollar as a reserve currency for as long as it serves their purposes, which may be for another decade or so. The dollar is not going to have a precipitous fall. It will decline further, but the decline will be controlled.

The important decline determining the course of deflation, however, is not that of the dollar, but that of the American rate of interest as it follows in the footsteps of the Japanese with a ten-year delay. The twin deficits will continue to baffle commentators who are too dim-witted to understand that they have fallen victim to clever prestidigitation.

It reflects woolly thinking to talk about a repetition at this stage of the Volckermiracle, 1980 vintage, in saving the dollar from sudden death by applying the shock-therapy of high interest rates. In the present situation the real miracle will be to save the dollar by a falling rather than a rising interest-rate structure.

Remember, 1980 marked the blow-off phase of the inflationary spiral, and the beginning of the deflationary. Right now the world is entering the depths of the deflationary spiral, and vintage therapy is out of place.

I define inflationary spiral under the Kondratiev cycle as the decades-long rise of prices and interest rates, and deflationary spiral as their similarly long fall.

Interest rates may lead and prices may lag, or the other way round. The important thing is the linkage. Prices and interest rates are inevitably linked.

Linkage epitomizes a huge oscillating money-flow back-and-forth between the bond and the commodity market. When the money-tide begins to flow at the commodity market and ebb at the bond market, we have the inflationary spiral.

When the tide is reversed and it flows at the bond and ebbs at the commodity market, we have the deflationary spiral.

These tides must run their course. They are too powerful to be diverted by contra-cyclical monetary policy. Central bank intervention is counter-productive.

It acts only to prolong the cycle and to make it even more devastating. During the inflationary spiral the main worry of the central bank is the high and rising rate of interest. To combat it, the central bank resorts to open market purchases of bonds in order to put money into circulation, hoping that it will flow to the bond market to bid up prices there. But speculators know better, and they divert the flow of money to the commodity market. Prices rise. Linkage will then make interest rates rise more, contrary to the wishes of the central bank.

During the deflationary spiral the main worry is low and falling prices. To combat it the central bank once again resorts to open market purchases of bonds in order to put money into circulation, hoping that it will flow to the commodity market to bid up prices there. But speculators forestall the central bank in buying the bonds first. Interest rates fall. Linkage will then make prices fall more, contrary to the wishes of the central bank. To recapitulate, in the inflationary phase of Kondratiev’s cycle the central bank wants to bring down interest rates but, instead, causes prices to rise which leads to still higher interest rates. In the deflationary phase it wants to raise the price level but, instead, causes interest rates to fall which leads to still lower prices. The contra-cyclical policy of Keynes backfired in either case, because Keynes was ignorant of the linkage.

Some years ago I put forward a new theory of Kondratiev’s long-wave cycle* revealing its cause as the fluctuation in the propensity to hoard. This fluctuation is in turn caused by the centuries-old wrong-headed policy of banks, aided and abetted by the government, in obstructing the flow of the gold coin to the saver whenever he finds the rate of interest unacceptably low. The flow of gold in and out of the banks is the mechanism whereby the saver regulates the rate of interest under a gold standard. You cannot take away the saver’s right to control bank reserves with impunity. Gold is the natural conduit for hoarding. If you obstructed gold hoarding, the saver would have recourse by hoarding other marketable goods. This would, however, have some serious side effects. It would generate the Kondratiev cycle with its devastating flow of money backand-forth between the bond and the commodity market.

The tide of money in the commodity market triggered a tsunami in 1980 when it dawned upon owners of commodities that their hoards could no longer be financed at high interest rates in view of high prices. When they panicked and ran to the exits, most were trapped. A painful process of decades-long inventory liquidation began. We are at the stage right now where businesses must reduce high inventories at falling prices, while speculators make a killing in bonds.

---

# Two Views on the Self-Immolation of Paper Money

URL: https://newaustrianeconomics.com/archive/fekete/two-views-on-the-self-immolation-of-paper-money/
Date: 2005-02-14
Section: Popular Economics
Difficulty: intermediate
Concept Tags: mises, fiat-currency, irredeemable-currency, interest-theory, gold-standard, new-austrian-economics
Description: In this letter to a reader, Fekete refines his critique of Mises's regression theorem and quantity theory of money, arguing that Mises correctly identified the self-destructive tendency of irredeemable paper money but missed the mechanism: it is the falling marginal utility of the gold bond — not quantity alone — that drives paper money toward collapse.
Editorial Note: A follow-up to 'The Gold-Demonetization Hoax,' prompted by reader correspondence. Fekete clarifies where he agrees and disagrees with Mises on paper money, laying groundwork for his broader project of correcting and extending Austrian monetary theory.
Original PDF: https://professorfekete.com/articles/AEFTwoViewsOnSelfImmolationPaperMoney.pdf

### Letter to a reader commenting on my criticism of Mises

Dear Mr. West:

Thank you for your interest in my work. Also thank you for giving me this opportunity to rethink my criticism of the monetary theories of Ludwig von Mises.

Believe me, I did not take the task of criticizing Mises lightly. I, too, hold that he was a giant among the great thinkers of mankind. So was also Aristotle. Yet neither is above criticism.

I have criticized Mises on two points in my piece “The GoldDemonetization Hoax”. One concerns the question whether constant marginal utility exists as a limiting case; the other whether subjective value can be measured objectively. The two are closely related and cannot be separated. I quote from your letter.

“You state Professor Mises denies the constant marginal utility of gold because it implies infinite demand that is contradictory. I believe what Professor Mises is saying is that those who argue against a limited demand for money based on their belief in constant marginal utility are erroneously confusing cash holdings (the subject he is addressing) with wealth. He goes on to make a distinction between the two and argues only that the demand for wealth, as denominated in money, is indeed unlimited. But cash holdings are limited to their usefulness in acquiring wealth. Cash will be spent as quickly as possible, leaving only a sufficient reserve. Mises does not argue against constant marginal utility.”

### “The second item is your statement that Professor Mises denies that there is a unit of value. The section you quote is a lead-in to his argument that monetary calculation in a socialist society is impossible. His argument is that without free trade you cannot establish value because there is no scientific way to construct a unit of value. That money by definition is both a unit and a store of value is not argued; only that value cannot be determined unless two parties agree on it. There is no “extrinsic” unit that can be placed on an item.”

I don’t think it can be disputed that Mises in fact rejected the idea of gold or any other substance having constant marginal utility whether absolutely or, as a limiting case, relatively. For him a yardstick measuring value simply could not exist. Value was subjective and as such could only be compared but not measured. As a consequence, the material itself of which the yardstick was to be made would be subject to declining marginal utility so that two different specimens would have different values, even to the same individual.

Consider, if you will, an imaginary world we shall call Rubberland where no substances of solid state exist. The nearest thing is elastic state, the state of rubber-like substances of which Rubberland consists. In such a world there is no possibility to measure length or distance, as an elastic yardstick is an oxymoron.

Physics would be a “subjective” discipline. Length and distance would still exist, subject to consensus and comparison but not to measurement. Anyone in Rubberland who believed that measuring distance was possible would commit a grave scientific error. Upon substituting “value” for “length” subjective economics is akin to the physics of Rubberland.

Mises’ views on gold are based strictly on supply/demand considerations. Gold has been promoted by the market to the status of money because of its supply/demand characteristics, not because of its unique marginal utility. By the same token, governments could deprive gold of this status by denying it monetary demand, the lion’s share of total demand. Mises thought that if gold was ever demonetized by the governments, then its exchange value would fall. He cited the example of demonetizing silver in the 1870's, followed by a sixty-year decline of silver’s value by more than 80 percent. To suggest that a causal relation exists between the two events is a fallacy that in logic goes by the name post hoc, ergo propter hoc (after it, therefore because of it).

In any event, Mises was proved wrong. A hundred years after silverdemonetization governments, brow-beaten by the US, declared that they were demonetizing gold, too. Yet, lo and behold, gold’s exchange value, far from collapsing, rose greatly in the wake of the announcement. By more than by 2000 percent, in less than ten years’ time. It is clear that Mises misjudged gold, as a result of his dogmatic insistence that all values, without exception, were subjective. To say that the value of gold was an exception would be considered heresy by him. Yet the truth is that gold has a property that makes its value objective. Gold is the only substance that has constant marginal utility.

In Rubberland the analogous development would be if explorers and prospectors had discovered a (for them) unique inelastic substance we shall call “solid”. Now it has become possible to construct a yardstick and start measuring lengths and distances, something that could not be done before. The subjective discipline of physics has now acquired an objective character. Needless to say, the discovery of solid has not changed the nature of other substances in Rubberland. Those of elastic state were still elastic after the introduction of the yardstick. What was different was that measurement has been made possible scientifically for the first time.

Due to its constant marginal utility gold has become the “most hoardable” good. This means that the opportunity cost of hoarding gold is lower than that of any other. As a consequence the stocks-to-flows ratio (existing stocks divided by annual flows of new production) for gold is a high multiple, while for all other goods it is but a small fraction. This is what makes gold’s value objective. The individual’s trust in gold’s value is not simply subjective as it would be in the case of other commodities. In the case of gold it is reinforced greatly by an objective fact, namely the stock of monetary gold in the world, the accumulation of millennia, reflecting the superb confidence in gold’s value by generations that have gone before us. This also shows that governments are helpless in their effort to demonetize gold. To do so they would have to dissipate existing stocks of monetary gold in order to bring its stocks-to-flows ratio in line with that of other goods, a job that would take centuries to accomplish.

I myself treat every supply/demand argument, including the quantity theory of money (QTM), with the greatest suspicion. The notion of supply and demand does not stand up to scientific scrutiny. It is anecdotal, and has only metaphorical merit. Any argument using it is necessarily ad hominem.

Conclusions are valid only in so far as the existence of speculation in the commodity under consideration can be ignored. Speculators never have a firm commitment either to the long or the short side of the market. They could, and often would, change sides at the drop of the hat, sometimes rationally, at other times not so rationally. Furthermore, they could sell short. That is, they could sell something forward that they haven’t got, nor do they know how they will liquidate their commitment. Their motto is: “Sell now, worry later.” Speculators on the short side of the market can be squeezed and, in the worst-case scenario, cornered by the longs (although not the other way round). Supply and demand, if they are to have any meaning, must include speculative supply and demand, as they also participate in the price-forming process. But this inclusion makes supply and demand bereft of any scientific merit, on account of the capricious nature of speculation.

The QTM is demonstrably wrong. In every historic hyperinflationary episode that ultimately reduced the value of irredeemable currency to naught the demand for money, far from vanishing, actually outstripped supply. When the rate of depreciation of paper money reaches a certain threshold, the government printing office can no longer produce, and the banking system can no longer deliver, the bank notes fast enough to the consumer who needs them if only for the purpose of buying food. Yet the short supply of, and the desperate demand for, paper money could not protect its value against further losses, nor could it avert its ultimate demise. Where does this leave the QTM? Well, it is not a scientific theory by a long shot. At best it is a mechanical metaphor that may work as long as fair weather lasts. But it is mercilessly swept away by the first storm. It is certainly not an adequate scientific tool with which to investigate the one hundred percent mortality rate afflicting irredeemable currencies through the sudden death syndrome. The QTM is a linear model that is entirely inapplicable in a non-linear world such as ours. If you really want to understand why an irredeemable currency is bound to lose all its value in due course, then you need a non-linear model.

I don’t disagree with Mises that there is a confusion about “money” and “wealth”, and that people limit their cash-holding to their actual needs for it. But I don’t think this has any relevance to the problem of gold’s marginal utility.

Consider the proverbial man “who has everything”. What can you give him on his birthday that would not make him even more bored? There is only one possible answer to that question: give him a gold coin. No matter how many he may already have, he would accept the additional coin on exactly the same terms as he has accepted the previously acquired ones, including the first. His cash-holding has nothing to do with it. Also irrelevant is whether he would keep it or spend it. What solely matters is the fact that if you gave him anything else, he would value your gift less than he would the previously acquired unit of the same.

I am sorry to say, Mises’ stand on the unit of value is a case of one wanting to have his cake and eat it. On the one hand, according to Mises, it is not admissible to assume the existence of an objective unit of value as it would contradict the fundamental principle of subjective economics whereby all values are subjective. On the other hand, Mises wants to endow businessmen with the power to be able to calculate the probability of future prices and profits which is not possible without an objective unit of value. Free trade has nothing to do with it, unless we assume that under a regime of tariffs and quotas economic calculation was no longer possible as a subjective unit of value would only have validity between consenting adults, and as such would be useless in economic calculation.

I submit that a more consistent solution to the problem is to admit the existence of an objective unit of value, by virtue of the constant marginal utility of the monetary metal as it has spontaneously evolved through the well-known process described by Carl Menger. This admission does not contradict the subjective nature of value. The monetary commodity is the only exception. The value of everything else is subjective. Exchange takes place when the seller of a certain item values it less than the buyer who values it more, as measured by the unit of value. The fact that in the monetary economy this leads to the formation of a market price (or, more correctly, two prices: the lower bid and the higher asked price) will of course not invalidate the principle of subjective value.

The mathematician has no difficulty with the dichotomy of comparison versus measurement. He has always distinguished between two kinds of numbers. Ordinal numbers (subject to such axioms as reflexivity, symmetry, and transitivity) are only used for comparison. Cardinal numbers (subject to axioms such as commutativity, associativity of addition and multiplication, as well as distributivity of the latter over the former) are used for counting. In the barter economy values were expressed in terms of ordinal numbers. Measuring values was not possible, nor was their addition or multiplication. Only their comparison was. However, with the evolution of the monetary economy it has become possible to measure, add and multiply values according to the rules of cardinal arithmetic, while retaining the facility of comparing them as before.

I consider the contribution of Mises, that economic calculation in a socialist society without private ownership of the means of production is not possible, as one of the greatest, if not the greatest, result of twentieth-century economics. Values do exist in a socialist economy also, since individuals can exchange chattels just as they would in a barter economy. But values cannot be measured for lack of an objective unit of value. (Illegal ownership of gold may carry the death penalty.) Still less can values be added or multiplied. As a result the socialist economy is ultimately doomed for lack of possibility to do economic calculation.

Mises did not live to see the collapse of the Evil Empire coming, as it did, hard on the heels of the collapse of the Soviet economy which he predicted, after three score of years of Bolshevik officials doing their level best to refute his theory through propping it up by hook of crook.

Mises also predicted another event, no less momentous, namely the demise of the regime of irredeemable currencies. However, he argued the case on the strength of the QTM, a non sequitur. Mises missed the fact that exactly the same argument applies here as well. No less than in the case of a socialist economy, under the regime of an irredeemable currency businessmen ultimately lose their ability to calculate for lack of an objective unit of value. Gold is prevented from fulfilling its foreordained function because of coercive legal tender laws domestically, bribe and blackmail internationally. For thirty-five years now central bankers have been burning the midnight oil to find ways to fend off the impending catastrophe threatening the world, as a result of the impossibility of economic calculation under a US-imposed regime of irredeemable currency.

Their efforts are in vain. This Evil Empire, too, is doomed, and for the very same reason. The world economy, as the Soviet economy before it, will also succumb to the sudden death syndrome, because it has lost the faculty of economic calculation.

It is amazing that the latter-day adherents of the Austrian School have all missed this point. They are preparing to witness the hyperinflationary selfimmolation of the dollar, an event that may or may not take place. It may be wellworth noting here that hyperinflations so far, at any rate those which culminated in the total destruction of the value of irredeemable currency, have all occurred in the wake of wars (or civil wars) destroying supplies and production facilities.

We have yet to witness a hyperinflation in peacetime with supplies and production facilities intact.

The Austrians and other hard money advocates are totally unprepared for the self-immolation of the dollar through economic paralysis due to the inability of businessmen to calculate. This would mean deflation in the form of business failures, imploding debt, domino-effect of bankruptcies, unemployment, destruction of wealth and values, a scenario more likely than inflation.

Self-immolation of the dollar? Certainly. Through inflation? Possibly but not inevitably. Then through deflation, perhaps? Yes indeed, if the dollar turns out to be a tough cooky, and refuses to roll over in a way prescribed by sycophants and cultists.

Yours, etc.

---

# Causes and Consequences of Kondratiev's Long-Wave Cycle

URL: https://newaustrianeconomics.com/archive/fekete/causes-and-consequences-of-kondratievs-long-wave-cycle/
Date: 2005-01-24
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, deflation, hyperinflation, bond-market, interest-theory, capital-destruction
Description: Fekete offers a new theory of the Kondratiev long-wave cycle grounded in gold and commodity hoarding rather than conventional debt-cycle mechanics. He describes a massive oscillating money-flow between the bond market and commodity markets — inflation phases arise when money tides flow into commodities, deflation when it reverses — and argues that removing gold from the system has made these waves more destructive.
Editorial Note: Published in January 2005 as part of a series on the Kondratiev cycle. Fekete's framework diverges sharply from both Keynesian and conventional Austrian accounts, placing gold hoarding and basis dynamics at the center of long-wave economics. The theory informs his later warnings about a deflationary depression.
Original PDF: https://professorfekete.com/articles/AEFCausesAndConsequencesKondratievs.pdf

### Summary for the busy executive

Here we offer a new theory explaining the causes of Kondratiev’s long-wave economic cycle in terms of gold and the hoarding of commodities. Our description of the cycle itself is also novel and very different from the conventional. We shall be talking about a huge oscillating money-flow to-and-fro between the bond market and the commodity market. When the money-tide begins to flow at the commodity market and ebb at the bond market, we have the inflationary phase of rising prices and interest rates. When the tide is reversed and it begins to flow at the bond and ebb at the commodity market, we have the deflationary phase of falling prices and interest rates. In one word, Kondratiev’s long-wave cycle is the manifestation of the fluctuation in the propensity to hoard. The key question is this: what causes this fluctuation? Is it a natural phenomenon outside of man’s control or, perhaps, it is induced by wrong-headed government policy?

### Economic Cycles

Economists recognize four major cycles, or regular fluctuations, in the economy as follows:

(1) Kitchin’s short-wave cycle of average duration 3-5 years, discovered in 1930;

(2) Juglar’s cycle of average duration 7-11 years, discovered in 1862;

(3) Kuznets’ medium-wave cycle of average duration 15-25 years, discovered in 1923;

(4) Kondratiev’s long-wave cycle of average duration 45-60 years, discovered in 1922.

J. Schumpeter, who was born in Austria and came to the United States where he also served as President of the American Economic Society in the 1950's, was an outstanding student of economic cycles. He believed that the various cycles are inter-dependent, in contrast with the view of others such as Forrester, who believed that the cycles act independently of one another. Schumpeter baptized three of the four cycles by naming them after their discoverers. The exception was Kuznets’ cycle, which he did not recognize.

At any rate, Kuznets got a “consolation prize” for being passed over by Schumpeter, namely the Nobel Prize for economics. Moreover, he is the only Nobel-laureate among the four name-giving economists. Kuznets noticed that residential and industrial buildings have an average useful life of 21-23 years.

His medium-wave cycle is about fluctuations caused by the amortization-cycle and the problem of replacing ageing buildings. It is interesting to note that all the students of cycles among the four whose name begins with a K were Russian.

### Kondratiev’s Long-Wave Cycle

The long-wave cycle in the capitalist economy was discovered by the Soviet economist N. D. Kondratieff (1892-1930) in 1922. He had been anticipated by J. van Geldren in 1913 and, even earlier, by Jevons in 1878 and H. Clarke in 1847, among others. Independently of Kondratiev, De Wolfe proposed a theory involving the idea of a long-wave cycle in 1924.

As we have noted above, some important students of cycles believed that they were inter-dependent. In particular, they noted that the average length of each of the four cycles is slightly longer than double the length of the immediately preceding shorter cycle. In the 1930's historians F. Braudel, F. Simiand, and E. Larousse looked at changes in the “secular trend” that was taking place roughly every 100 years. This suggests that Kondratiev’s cycle might also be followed by a centennial cycle of approximately twice the duration.

Kondratiev’s methodology involved the analysis of 21 statistical series, that is, 21 economic indicators such as the price index, the rate of interest, wage rates, rents; volume of production, consumption, exports, imports, employment, etc., as well as their standard deviations. In studying volumes Kondratiev used per capita data. He calculated deviation from the trend through the method of least squares. In order to filter out noise caused by the shorter cycles he employed nine-year moving averages. He took his data-base from the French, British,

German, and the U.S. economy.

Only in 6 of the 21 series could Kondratiev not confirm the presence of a long wave-cycle. Significantly, in the case of the price level and the rate of interest the evidence was strong. Kondratiev’s ultimate conclusion was that he obtained sufficient empirical basis to support the hypothesis of the existence of a longwave economic cycle in the capitalist economies he studied, with an average duration of 54 years. He allowed a 25 percent deviation from this average. In particular, Kondratiev identified three historic waves: i.

First wave: rising phase from 1780-90 to 1810-17; falling phase from

1810-17 to 1844-51. ii.

Second wave: rising phase from 1844-51 to 1870-75; falling phase from

1870-75 to 1890-96. iii.

Third wave: rising phase from 1890-96 to 1914-20; falling phase started

1914-20.

Kondratieff was exiled to Siberia by Bolshevik officials who flatly rejected his conclusions. To the faithful there could only be one falling phase of the capitalist economy, followed by the socialist revolution and the dictatorship of the proletariat. And, following that, there was to be only one rising phase, leading to eternal bliss under communism.

Kondratiev died in the Gulag in 1930 at the age of 38. His work was later updated by other economists using his original methodology. They found that the falling phase of the third wave ended 1947-48, and that there is a iv.

Fourth wave: rising phase from 1947-48 to 1973-80; falling phase started

1973-80.

### Jackson’s Linkage

In 1947 the British-born Canadian economist Gilbert E. Jackson studied the behavior of just two economic indicators, that of the price level and the rate of interest. He found that the two are linked. Sometimes the price level leads and the rate of interest lags; at other times, the other way around. In his own words just like two hounds on a leash holding them together, while one can get a little bit ahead, they cannot come apart, the leash obliging them to follow the same path, uphill or down. Jackson’s calculations yielded the same long-wave cycle established by Kondratiev. He called this phenomenon “the linkage”.

Jackson was probably unaware of Kondratiev’s work. Therefore it is quite remarkable that two economists working independently came to virtually identical conclusions. Yet Jackson’s contribution is all the more significant as he focused on just two economic indicators instead of twenty-one, to get the same conclusion. Jackson’s methodology used British data, namely wholesale prices in Britain and the yield on British consols for a period of over 150 years from 1782 to 1947. In order to iron out short-term fluctuations in the data-base due to the business cycle and other factors, Jackson replaced the raw figures by eleven-year moving averages. He then charted both indicators in the same coordinate system showing two curves with the rising trend of both curves indicating an inflationary spiral, and their falling trend the deflationary spiral, alternating with one another. We reproduce Jackson’s original chart at the end of the paper. As the chart clearly shows, sometimes prices lead, and sometimes they lag the rate of interest. Neither Jackson, nor anyone else who studied the phenomenon of linkage, could offer a full theoretical explanation. The most they could say was that it appeared to be an “accidental coincidence”.

Jackson’s results were published in 1947 in a paper The Rate of Interest that was barely noticed by the profession at the time. By now it is largely forgotten in spite of the renewed great interest in Kondratiev’s long-wave cycle to which Jackson’s linkage is closely related. Nobody ever bothered to update Jackson’s chart using his original methodology.

Since prices and interest rates are by far the two most closely watched and studied economic indicators, the possibility of a connection between the two has attracted a great deal speculation among economists. A host of excellent thinkers such as Knut Wicksell, Wilhelm Röpke, Gottfried Haberler, to mention only three who have studied it, found the phenomenon of linkage “puzzling”.

Irving Fisher went as far as saying that “it seems impossible to interpret [the linkage] as representing an independent relationship with any rational basis”. In their 1932 book Gold and Prices G. F. Warren and F. Pearson claimed that they have found the causal relationship explaining linkage. They asserted that rising (falling) prices are the cause, and high (low) interest rates are the effect. They argued that creditors note the rise in the price level and demand compensation from debtors for the loss of purchasing power in the form of higher interest.

Conversely, when the price level falls and the purchasing power of the currency rises, competition of creditors forces reduction in lending rates.

Jackson rejected this line of reasoning. He pointed out that linkage works both ways. While sometimes the price level leads and the rate of interest lags giving impetus to lenders to change the lending rate, at other times the rate of interest leads and the price level lags. Do Warren and Pearson suggest that lenders are clairvoyants who can divine what direction prices will take in future years?

### The Propensity to Hoard

Mainstream economics bypasses the problem of hoarding altogether. It suggests that in the modern economy with a well-developed capital market hoarding is either non-existent, or if it is practiced at all, then the practice is confined to boorish and uninformed people whose action can be safely ignored as unimportant. However, economists can dismiss the phenomenon of hoarding and its consequences only at their own peril.

There may be more to hoarding than boorishness. It is well-known that informed producers regularly use sophisticated inventory-management techniques involving the speeding up or the slowing down of input and output at either end of their production line. The means of hoarding are just as ingenious as its objects are varied. The practice is certainly not confined to housewives buying more sugar to fill up their pantry, nor to small-time smugglers holding contraband merchandise in mountain-caves. They also include big multi-national firms using the most up-to-date techniques such as inventory-padding or the deliberate use of leads and lags in warehousing. In recent times cutbacks in production quotas of highly marketable goods such as crude oil have been utilized for the same purpose with dramatic effect. The Japanese are known to import far more lumber and coal from Canada than they need for current consumption. Having treated the excess with an impregnating solution, they sink the lumber and coal to the bottom of their mountain lakes. Nor is hoarding of fuel confined to energypoor countries. The U.S. government is filling up disused salt mines with crude oil. They call it “strategic stockpile”, but in the vernacular it is called hoarding, even if the word has a pejorative or boorish connotation. The supertanker construction boom in the 1970's was not an exercise in efficient transportation.

Its purpose was to build floating warehouses. The supertankers filled to the brim with crude set sail without the captain having the slightest idea of its final destination. If the highest bid for the crude in the tanker was not high enough, no problem. The supertanker just had to keep cruising a little longer. Futures and options trading opened up new avenues for the general public to participate in the hoarding game. These examples illustrate the phenomenal increase in the propensity to hoard in the period preceding 1980, which was manifested not only in rising prices but rising interest rates as well. Since 1980 the world has been experiencing a fall in the propensity to hoard, and even “dishoarding” previously hoarded goods. The process of reducing stockpiles at falling prices, which have been built up in expectation of higher prices, is a painful one.

It would be an impossible task to estimate, however tentatively, the size of existing stockpiles of goods held not for impending consumption but, rather, for some other reason, notably in protest against low interest rates, reckless government spending, and the banks’ plundering the savings of individuals. This is where the statistician must plead ignorance. The only way to grasp the hoarding instincts and habits of people is through theoretical understanding The divorce of hoarding from saving took place in response to the conspiracy of the banks, aided and abetted by the government, in order to defraud and dispossess the saving public. Over long periods of time the propensity to hoard has been gaining ground as an independent economic force at the expense of the propensity to save (i.e., save money) in response to deteriorating bank practices, in particular, the banks’ sheltering of illiquid government debt in their balance sheet, and the government’s protecting the banks against depositors withdrawing the gold coin.

By now the U.S. has reached the point that the savings rate is negative. It is wrong to blame the American people for this unfortunate state of affairs. The blame should be assigned to American politicians and officials who have corrupted the monetary system to such an extent that people refuse to put their savings into instruments the banks have to offer. No one knows what the savings rate would be if the value of marketable goods hoarded by Americans could be calculated.

### Gold as the Monetary Metal

What makes gold the monetary metal par excellence is that it is the most hoardable commodity. This means that the opportunity cost of hoarding gold is lower than that of hoarding any other commodity. Gold is held in the balance sheet even if the promise of return to capital is nil. No other commodity is held in the balance sheet unless there is some promise of return to capital. This property puts gold outside of the power of governments. The pronouncements of the government about the “demonetization of gold” is empty gesture. More antigold propaganda will only increase the propensity to hoard gold.

Consider the proposition that the greater is the propensity to save, the lower will the rate of interest be. This proposition in itself is not controversial. The mechanism whereby the flow of savings regulates the rate of interest under a gold standard is quite transparent. Savers who feel that the rate of interest is too low will exchange their bank notes and deposits for gold coins. In this manner savers retain direct control over the level of bank reserves as they confront the bank with the choice of either raising the lending rate or contracting bank credit.

Thus the mechanism that regulates the rate of interest is the savers’ privilege to hoard gold. Any effort to tamper with this mechanism is certain to introduce distortions in the economy.

Governments in their wisdom have removed the gold coin as a regulator of bank reserves. They did this in order to disenfranchise savers who no longer have a say in setting the rate of interest. The government and the banks usurp this privilege. The government wants to project an image of itself as a “do-gooder” in keeping the rate of interest low, purportedly in order to benefit the general public.

The banks, in their turn, want to pursue a credit policy motivated by political rather than economic considerations. No cost-and-benefit analysis has ever been carried out, and the costs have been conveniently ignored. To be sure, there are costs connected with pushing gold out of the monetary system.

As the government has assumed power over monetary policy in contemptuous disregard of the expressed wishes of the savers (to say nothing of the provisions of the Constitution), it aggrandizes power. Since by its very nature the power to issue money is unlimited, the new monetary regime flies in the face of the principle of representative government of limited and enumerated powers.

But for our purposes more important than the destruction of the gold standard is the abridgement of the savers’ rights and privileges that has predated their total disenfranchisement by several hundred years. The banks have always kept a bag of tricks on hand (other than raising the rate of interest) to dissuade their depositors from taking the gold coin. When they reached the end of the rope, they could always count on the government “to go off gold” in order to save the banks’ face — and skin — in declaring the banks’ bad liabilities legal tender.

Thus the banks were rewarded, rather than punished, for their wrong-headed credit policies. No wonder that more credit abuses were heaped upon credit abuse for the centuries.

### Double Standard of Justice

The legal right of savers to demand gold coins in exchange for their bank notes and deposits whenever they get worried about the condition of banks or about the profligate spending habits of the government is eminently just and equitable.

It is the little man’s protection against the powerful and mighty without which, as history has made abundantly clear, the former would get plundered by the latter for all his worth.

This protection has been compromised by a double standard that was surreptitiously introduced in contract law. Creditors were free to press for the liquidation of firms that have failed to perform on their contractual promises.

Originally there were no exceptions. Later, however, the banks got exempted from this provision of contract law. They were made immune against the wrath of their creditors, including depositors. A bank that refuses to pay gold on its sight liabilities could no longer be sued for breach of contract.

There is no defensible justification in jurisprudence for extending special privileges to banks, or for protecting them against the consequences of their own folly. A law setting up double standard of justice is bad by definition. The argument that bank failures cause too much economic and social pain is spurious. All should stand equal before the law. Compromising this principle lets the bad effects of bank policy accumulate and will ultimately cause far more harm and economic or social distress than the immediate punishment of the bank that has gone astray.

Later the banks got still more protection from the government in the form of compromised standards of inspection. When they overstate the value of their assets and understate that of their liabilities, bank examiners look the other way. “See no evil, speak no evil”. Banks can get away with fraudulent accounting practices that would trigger harsh punitive action if practiced by other firms. Bank examiners exonerate guilty banks upon the tacit approval, if not at the outright request of the government.

Economists are not famous for their curiosity about this peculiar tolerance for fraud that governments the world over have displayed for centuries. Yet the explanation is rather simple: “If you scratch my back, then I shall scratch yours.” The banks have ample opportunity to return the favor of the government when they are expected to buy up treasury paper, which the market is no longer willing to take at the yields offered, and to deliver similar sweetheart deals.

It would be naive in the extreme to assume that the savers meekly acquiesced in such acts of double-dealings and coercion. They could not prevent the government and the banks from sabotaging and ultimately destroying the gold standard. But they could do something about it. Instead of (or in addition to) hoarding gold, savers thereafter started hoarding other marketable commodities.

The list of marketable goods is endless. There are the conventional ones such as salt, sugar, spices, spirits, tobacco, tea, and coffee. To this, one has to add the non-conventional ones, energy carriers such as crude oil, and narcotics such as heroin and cocaine. (Note that as long as governments tolerated the gold standard there was little problem with drug trafficking. The suggestion cannot be easily dismissed that the escalation in illegal drug trade in the twentieth century was in direct response to the destruction of the gold standard.)

### Causes of the Kondratiev Cycle

We can now present our own explanation for the linkage and, simultaneously, our own description of the genesis of Kondratiev’s long-wave cycle. Frustrated savers sell their bonds and put the proceeds in marketable commodities. Thus rising commodity prices and falling bond prices are linked and they reinforce one another. The linkage is best described as a huge speculative money-flow. The money-tide begins to flow at the commodity market while ebbing at the bond market. This epitomizes the inflationary phase of Kondratiev’s long-wave cycle.

But falling bond prices are tantamount to rising rates of interest. Thus a rising price level and a rising interest-rate structure, if they do not march in lockstep, at least they are closely linked. The money-flow from the bond to the commodity market, while it can go on for decades, will not last indefinitely. Holders of commodities will find that it is not possible to finance ever increasing inventories at ever increasing rates of interest. At one point they will panic and sell. Not all can get through the exit doors at the same time, however. Some will get trapped.

Inventory reduction is a long-drawn-out and painful affair.

This means that the speculative money-flow has reversed itself. Now the moneytide begins to flow at the bond market while ebbing at the commodity market.

Prices of commodities fall while bond prices rise. Again, rising bond prices are tantamount to falling interest rates. The falling price level and the falling interestrate structure are linked and they reinforce one another. This reversed moneytide epitomizes the deflationary phase of the Kondratiev cycle.

Note the role of speculation in all this. Speculators are prominent in both the inflationary phase in which they go long in the commodity and short in the bond market, as well as in the deflationary phase in which their long and short legs are switched around. Just about the only way to make money in a depression is to speculate in the bond market on the long side. The bull market in bonds in a deflation is completely ignored by mainstream economists. Yet this is the key to the understanding of the reversal of the money-tide. Speculators do arbitrage between the bond and commodity markets. When they think that the saturation point has been reached, they reverse their position. They replace their existing straddles with the opposite ones. That is, they enter their long leg in the commodity and short leg in the bond market. This then heralds the end of the deflationary and the beginning of the inflationary phase.

The linkage and Kondratiev’s long-wave cycle are explained in terms of fluctuations in the propensity to hoard. Since hoarding gold, the natural conduit, is obstructed by the banks and the government, the propensity to hoard manifests itself as the hoarding of other marketable goods. Already in 1844 Fullarton recognized that gold hoarding is just a protest-vote of the savers against low interest rates, the banks’ loose credit policy, and profligate government spending. Nevertheless, almost a hundred years later John Maynard Keynes looked at gold hoarding as a psycho-pathological aberration.

He invoked the authority of David Ricardo. But Ricardo had also missed the economic significance of gold hoarding, and he proposed the gold bullion standard to combat it.

To explain gold hoarding with psycho-pathology is nothing but scientific obscurantism. Keynes had a hidden agenda. He wanted to forge a weapon against the gold standard out of the fact of gold hoarding. The British economist was a bully. He was determined to sell the idea that the gold standard was unworkable, first to F.D. Roosevelt, and then to the rest of the world. In this he did succeed.

Mainstream economics is still at the retarded level of Keynes when it comes to assessing the gold standard. It refuses to recognize the protest-aspect of gold hoarding, it is forgetful about the axiom that saving must precede spending, and it ignores the fact that without saving there is no economic development. Gold is the leash on which the frugal must keep the prodigal. It is this leash that the banks and the government have always wanted, and eventually managed, to escape from when they first sabotaged and then junked the gold standard.

Although the sabotage started several hundred years ago, the world economy being run entirely without the leash of the gold standard has only a brief history of barely 30 years. It is not a glorious history.

In the great tug-of-war between the frugal and the prodigal the former appears to be the perennial loser. This is explained by the fact that the playing field is not level but tilts against the frugal, that is, the saving public. This includes not just creditors but, above all, the little man who is forced to keep his meager savings in the form of cash, i.e., paper money open to plunder by the prodigal which is the consortium of the banks and the government. In spite of this bias we cannot take it for granted that the tug-of-war will end with the ultimate defeat of the frugal, just because the prodigal has succeeded in knocking the weapon of the gold coin out of his hand. The frugal has something else up in his sleeves. It is the propensity to hoard, an extremely efficient weapon which, however, is not free from some very dangerous side-effects.

A jump in the propensity to hoard can siphon off enormous amounts of money from the bond market. This will make the rate of interest jump, too. The last time it did that was in the years 1971-81. Those ten years that shook the world heralded the deflationary spiral in Kondratiev’s long-wave cycle, the spiral that is still continuing.

### Contra-Cyclical Policy

As already noted, the rise in the propensity to hoard has its limits. The hoarding of goods reaches its saturation point when it dawns on people that a high price structure and a high interest-rate structure cannot be maintained in the presence of high inventories. Declining marginal utility kicks in, ending the inflationary and ushering in the deflationary spiral. The long and painful process of inventory liquidation begins. The money-flow from the bond to the commodity market makes an “about face”. The deflationary spiral may turn into a depression in which innocent firms start falling like dominoes.

Keynes’ contra-cyclical policy should properly be called “counter-productive policy”. It has been dogmatically applied by central banks since the 1930's only to make things worse. Following the Keynesian script, during the deflationary spiral the central bank is trying to contain weakening prices through open market purchases of bonds. Bond prices rise, in other words, the rate of interest falls.

Bond speculators take the clue and they buy the bonds, too. Linkage causes the price level to fall (or at least stay weak). The central bank is unable to stem the deflationary tide of money flowing from the commodity to the bond market. In fact contra-cyclical monetary policy just pours oil on the fire.

Exactly the same is true of the inflationary spiral. The main worry now is the high rate of interest. To bring it down the central bank resorts to open market purchases of bonds. In doing so it puts new money into circulation which it hopes will flow to the bond market. Instead, it quickly finds its way to the commodity market and bids up prices there. Linkage does the rest. Higher prices bring about higher interest rates. Contra-cyclical policy fails in this case as well.

In the deflationary spiral the central bank combats weakening prices. This causes the rate of interest to fall, which leads to still lower prices. In the inflationary phase the central bank combats high interest rates. This causes prices to rise, which leads to still higher interest rates, all because of the linkage.

The contra-cyclical policy of Keynes backfires in either case. For example, during the 1947-80 inflationary spiral the rate of interest rose five-fold and the price level ten-fold in the United States, in spite of vigorous contra-cyclical intervention by the Federal Reserve banks. Dr. Keynes prescribed medication that made the condition of the patient worse. He was ignorant of the linkage.

To recapitulate, the long-wave economic cycle is caused by a huge speculative money-flow back-and-forth between the bond and commodity markets. The flow is further aggravated by mindless contra-cyclical intervention. The oscillating money-flow is induced by fluctuations in the propensity to hoard. It is futile trying to correct these money flows. At best one can re-direct them into channels where they can do no harm. Keynes was so obsessed with gold hoarding that he missed the hoarding of other marketable goods, a problem potentially far more menacing. Keynes was the high priest of anti-gold agitation. He preached that if “the gold coin was kept away from man’s greedy palms” then there would be no gold hoarding, no economic contraction, no deflation, no unemployment. His was a colossal mistake, the kind that only a doctrinaire could make.

After the destruction of the gold standard by the government hoarding did not cease. It only changed form. The benign tumor turned malignant. Not only did the withdrawal of gold coins from the monetary bloodstream through government coercion fail to stop deflation: it set off a huge suction pump in the bond market siphoning money off from every nook and cranny of the economy. In particular, it created a devastating liquidation and depression from which only a world war could pull the economy.

We can’t help but notice that gold is the philosopher’s stone. In its possession the propensity to hoard is directed into its proper channels. Without it the world economy becomes a plaything in the hands of bond and foreign exchange speculators.

### Competitive Devaluations

Since 1981 the world appears to be in the grips of a deflationary spiral, right on schedule as predicted by the Kondratiev cycle. This spiral hasn’t run its course yet. Some liquidation has taken place, but the worst seems still to come. The politicians and economists congratulate each other for ”having squeezed inflationary expectations out of the system”. Whatever they have squeezed, the inflationary and deflationary spirals are not caused by expectations, but by actual money-flows between the commodity and bond markets. The international monetary system is still the same rudderless ship it has been since 1971, and it is still exposed to the same monetary storms. The only difference is that the direction of the gale has changed.

The dangerous deflationary spiral threatening the world’s prosperity started in Japan where the stock market collapsed followed by the real estate market. The sun has set on the Land of the Rising Sun. The next sunrise is probably a long way off. The devastation caused by deflation in the Japanese economy is of the same order of magnitude as that in the American during the previous cycle in the 1930's. Both deflations can be characterized as an irresistible money-flow from the commodity to the bond market, drying up resources in all departments outside of the bond market. In Japan, the rate of interest fell practically to zero.

Ten years ago the Japanese government reacted in the same way as the American in 1933. It devalued the yen by fifty percent. This measure has been just as futile as the devaluation of the dollar was seventy years ago. It triggered competitive devaluations of the world’s currencies in the 1930's. The yendevaluation has the same effect. It was the cause of the collapse of the ruble and other Asiatic currencies. Right now it is the turn of the U.S. dollar to devalue.

It remains to be seen whether the euro will also succumb to the temptation.

The Japanese deflation-tumor could very well metastasize across the Pacific.

There is a carry-trade between the Japanese and American bond markets.

Overpriced Japanese bonds are sold and the proceeds are put in the relatively underpriced American bonds. Note that this carry-trade is not hindered but rather helped by the devaluation of the dollar. At any rate, the outcome is a further fall in the rate of interest in the U.S. The deflationary spiral is alive and kicking.

The stock market boom in the 1990's was not justified by increases in productivity and profitability any more than it was in the “roaring twenties”. If the stock market crashes, the already irresistible money-flow to the bond market would be reinforced, just as after the 1929 crash. Falling interest rates would cause over-indebted firms to scramble in an effort to get out of debt. Creditcollapse may ensue. Already, the long-term rate of interest has been pushed down from 16 to 6 percent. The danger is that it may keep falling to 3 percent or lower, due to the speculative orgy in the bond market. Like a gigantic vacuum cleaner, the bond market siphons off resources from the real economy, just as it did in the 1930's. As noted already, it is not generally realized that a depression, creates boom-conditions for the bond speculator who makes a killing while everyone else is bleeding to death.

### Mutations and Catastrophes

Kondratiev’s long-wave cycle forces us to give up the earlier, optimistic models of uniform growth of the capitalistic economy, at least until the world is ready to return to the principles of classical liberalism and limited government, including its harbinger the gold standard. The following is a paraphrase of the thoughts of the Hungarian philosopher Béla Hamvas (Secret Minutes, 1962, see: The Works of B. Hamvas, vol.17, Budapest: Medio, p 104-106, in Hungarian).

“Our government, without the limitations imposed upon it by the principles of classical liberalism, makes for a fair-weather system. Under such a paternalistic, omnipotent and omniscient government modern civilization may appear to work productively and humanely enough, that is, as long as the fair weather lasts. “But let drought strike, or let flood engulf the land. Then our democratic unlimited government will at once show its feet of clay. No sooner does social disturbance, civil strife, or distrust raise its face than will centralized government lose its grip and get entangled in one crisis after another, all of its own making. The government that was omnipotent in fair weather would be helpless in foul. The government that was omniscient during the smooth evolutionary phase would plead ignorance at the first sign of a mutation. The fair-weather system of unlimited government is forever unable to cope with catastrophes.

“Older schools of evolution did not assume continuous progress. They were not given to thinking in terms of growth curves rising uniformly forever. They made allowance for mutations, they admitted the possibility of setbacks, abrupt reversals and tumbles. Older philosophers assumed that nature abhorred uninterrupted continuity, as much as she abhorred vacuum. They knew that in nature there was no continuous transition from the lower state to the higher. We should do well to remember the teachings and emulate the humility of those older philosophers. They were wise men, immeasurably wise. Certainly far wiser than ourselves. Their thinking had one great advantage: they were not afraid to warn of the day when the weather would turn from fair to foul. They dared to think mutations. They dared to think catastrophes. While they were aware that dull times called for dull theories, they believed that critical times called for theories altogether alien to and different from those dull theories. In critical times you must think deeper, you must be wiser and more imaginative.

“We are in the habit of slighting and disparaging the accomplishments of older philosophers. We seem incapable of benefiting from their wisdom. They bequeathed a theory of limited government to us, a theory we have passionately rejected in favor of dull theories suitable for dull times... Yet the days of fair weather are numbered... We have lost our compass and the sea is growing stormy... Our boat of government omnipotence is now in waters teeming with dangerous reefs under the surface... We are in deep trouble... Que sera, sera....”

### What is to be done?

We need not conclude our review on such a pessimistic note. We are able to temper the deleterious effects of Kondratiev’s long-wave cycle, even though we are unable to eliminate it. If we cannot legislate the propensity to hoard out of existence, we may at least confine it to its proper channels and secure it with a safety-valve. The role of gold in the world is to provide just such a safety-valve.

God created gold in order to render the propensity to hoard harmless. Gold hoarding has no effect on essential consumption, its only effect is on jewelry consumption. Under a gold standard there is no bond, still less foreign exchange speculation. The only road to stabilization is to put speculation into its proper place, confining speculators to fields where they can do no harm, but they may do some good: to the market of agricultural commodities with supply controlled by nature, not by man. The greatest blunder that Keynes committed was that he failed to foresee the forces that his policies would unleash. In particular, he was oblivious to speculation unleashed in markets where supply is not controlled by nature but by man (read: governments and central banks), such as the bond and foreign exchange markets.

The significance of a gold standard is not to be seen in its ability to stabilize prices, which is neither possible nor desirable. It is, rather, seen in its ability to stabilize the rate of interest at the lowest level that is still compatible with the requirements of the saver. The stabilization of the rate of interest and foreign exchange will then impart as much stability to the price level as is consonant with a dynamic economy. By letting the saver withdraw the gold coin (read: bank reserves) when the rate of interest falls to a level he considers unacceptable, the irresistible speculative money-flow to-and-fro between the commodity and bond markets — the engine of inflationary and deflationary spirals — would be shut down at source. Benign bond/gold arbitrage would replace the malignant bond/commodity speculation. Since the former is self-limiting while the latter is self-aggravating, economic stability would be enhanced.

The alternative to a gold standard is too horrible to contemplate. Unemployment more devastating than that of the 1930's, an earthquake shaking the international monetary system to its foundations, the construction of protective tariff walls and, in the end, a world war in which governments hope to find an escape route from economic chaos.

---

# The Supply of Oxen at the Federal Reserve

URL: https://newaustrianeconomics.com/archive/fekete/the-supply-of-oxen-at-the-federal-reserve/
Date: 2005-01-20
Section: Popular Economics
Difficulty: accessible
Concept Tags: federal-reserve, central-banking, bond-market, monetary-policy, deflation, capital-destruction
Description: Fekete uses Greenspan's quip about oxen as currency to lampoon the Fed's bond-buying operations, arguing that the Fed and the Bank of Japan are conspiring to prop up the U.S. bond market and protect the dollar. Their intervention, he warns, is accelerating the destruction of sound credit and pushing the financial system toward a deflationary collapse.
Editorial Note: A short, sharp essay written in January 2005. Fekete quotes Greenspan's own words back at him to devastating effect, using the 'oxen' metaphor to highlight the absurdity of a central bank whose interventions destroy the very market mechanisms they claim to stabilize.
Original PDF: https://professorfekete.com/articles/AEFTheSupplyOfOxenAtTheFed.pdf

Are the Fed and the Bank of Japan conspiring to protect the dollar by propping up the American bond market?

"If fiat money... falters, we may have to go back to oxen as our medium of exchange.

In that event, I trust, the Federal Reserve... will have an adequate inventory of oxen."

### (Alan Greenspan, The History of Money)

Hey, Mr. Chairman, in case you haven't noticed, the Federal Reserve already has a goodly supply of oxen!

My father was fond of relating a story about a professor lecturing on geography. A short fellow, he was extolling the agriculture of Switzerland. "In our country oxen are not even as tall as I am. In some countries you see oxen just as tall as myself. But, believe it or not, on the fat pastures of Switzerland there are even greater oxen than myself". For emphasis the good professor stood on his tiptoes and stretched his hand upwards above his head. "We don't believe so!" - shouted someone from the back benches of the lecture theater.

The reason for my dusting off this (not at all funny) wisecrack of the Chairman is that a conjecture of mine got published inadvertently. Rather than recanting, I elaborate on it lest there be any misunderstanding about what I mean. In a private letter I have conjectured that a conspiracy may exist between the Federal Reserve and the Bank of Japan. The latter is buying U.S. Treasury paper through the good offices of the former, over and above the deficit America is running in its trade accounts with Japan. These highly secret transactions are reported nowhere, as they are on custodial account.

I am well aware that this conjecture can be neither proved nor disproved. The conspiracy, if one exists, is part of the highly classified contingency plan hatched out at the Fed. It calls for bribing (blackmailing?) the Bank of Japan to get its cooperation in forestalling a run on the dollar led by other foreign central banks. If such a run were to take place, it would destroy the dollar as well as the international monetary system, and drive the rate of interest to stratospheric heights, rendering the Japanese hoard of American paper worthless.

The run is widely expected by many a knowledgeable observer, and the bond market is girding itself for a rise in interest rates more vicious than that 25 years ago. The obituary of the bull market in bonds has in fact been written already by the world's foremost bond trader, Pimco's Bill Gross. However the market, like Mark Twain reading his own obituary, talked back saying: "the reports of my demise are Grossly exaggerated". Chances are that this particular bull, taunted by the oxen at the Fed, is getting ready for another run.

The conjecture is eminently plausible. Why, the Chairman of the Fed is so well conditioned that, even while thinking the unthinkable, the faltering of the irredeemable dollar, he will not think of gold. He compulsively thinks of oxen as the obvious alternative for defunct fiat money. Any contingency plan prepared under his watch must likewise ignore gold. I hereby issue a challenge for anybody to come up with a better contingency plan to save the moribund dollar (barring to make it gold-redeemable) than conspiring with the Bank of Japan to extend the bull-run in bonds in order to massacre the Cassandras, on either side of the Pacific, who bet on the collapse of the American bond market.

The conspiracy may be to the liking of the Bank of Japan which has a reputation of dealing most ruthlessly with speculators who oppose its policy of a weak yen. It prints yens clandestinely at no cost to itself. The Bank's acquisition of bonds is therefore a windfall. Thrown in as a bonus is the appreciation of the Bank's inordinate hoard of bonds in the wake of falling American interest rates. These bonds were accumulated during earlier decades, in consequence of the U.S. government twisting the Bank's arm not to buy gold with unwanted dollars, which is what Charles De Gaulle would have done. The Japanese know only too well that their hoard is so enormous that the chances of getting rid of it in case of a dollar crisis are nil.

But isn't this conspiracy, if it exists, immoral? Yes, of course it is! It is the epitome of the total depravity of the fiat money regime. Printing yens to support productive enterprise is one thing; printing yens to support bond speculators who have insider knowledge is another. It must also be clear that, if such a conspiracy exists, it is nothing but a rape of the American taxpayer who will have to be skinned alive by the Treasury to pay the maturing coupons on the bonds given away by the Fed.

I have said that the Bank of Japan in printing the yens was supporting bond speculators with insider knowledge. That's right, there is a huge speculative scheme afoot called the yen carrytrade. Speculators borrow yens at 1.5%, sell them for dollars, and buy U.S. Treasury bonds yielding up to 5%. Not only do they pocket the difference, they are also the beneficiaries of the huge appreciation of bond prices in the wake of the falling dollar rate of interest. That is no conjecture. That is a fact. The conjecture is that speculators are acting on insider information. The conspiracy of the Fed and the Bank of Japan provides the favorable back-wind to their speculation which, without it, would be nothing short of suicidal. But with the back-wind, it is extremely profitable, especially in view of the weak dollar which improves the terms of trade of yen sellers and dollar buyers beyond their wildest dreams.

This takes us back to the supply of oxen at the Fed. If the conjecture is correct, the Fed has engineered a scheme to push the rate of interest lower in defiance of the falling dollar. Such a policy is bovine. It spells disaster. It stokes the fires of deflation as I shall now explain.

Let's define inflationary spiral under Kondratiev's long-wave cycle as the decades-long rise of prices and interest rates, and deflationary spiral as their similarly long fall. Interest rates may lead and prices may lag, or the other way round. The important thing is linkage. The long-term movements of prices and interest rates are inevitably linked. Linkage epitomizes a huge oscillating money-flow back-and-forth between the bond and the commodity markets. When the money-tide begins to flow at the commodity market and ebb at the bond market, we have the inflationary spiral. When it is reversed and flows at the bond and ebbs at the commodity market, we have the deflationary spiral.

Chairman Greenspan in a speech on the History of Money, from which I took the quotation above as well as the title of this article, congratulates himself and his central banker colleagues in other countries for "the success in containing inflation during the past two decades and raising hopes that fiat money can be managed in a responsible way." This is akin to the surfer on the beach boasting that he has turned the flow of the tide back through skillful surfing. What the Chairman calls "containing inflation" is nothing but the receding money-tide from the commodity market that started in 1980, now flowing at the bond market. The Chairman did not cause it but could make it a lot worse and more devastating. In particular, if such a conspiracy between the Fed and the Bank of Japan exists, the receding money-tide could become a tsunami, repetition of the Great Depression of the 1930's wiping out sound businesses and the life savings of most people.

A bull market in bonds is the sine qua non of the deflationary spiral. Deflation is greatly aggravated by central bank intervention in putting more money in circulation through open market purchases of bonds. The central bank hopes that the new money will flow to the commodity market. Speculators forestall it buying the bonds first. The new money, thus intercepted and diverted, flows to the bond market, instead of the commodity market as hoped by the central bank. Interest rates fall, and linkage makes prices to fall with them. Contra-cyclical policy backfires. No wonder, its author, Keynes, was ignorant of the linkage. If the conjecture about the conspiracy between the Fed and the Bank of Japan is correct, there is an insatiable demand for dollars, especially for falling ones, by bond speculators. The Fed is the quartermaster general for the coming depression that may make the Great Depression rather tame in comparison.

In 1980 the dollar had a close brush with sudden death. It was saved, barely, by the shocktherapy of ultra-high interest rates, quite openly administered by Chairman Volcker. The dollar now appears to have another death-spell. Is it possible that there is a similarity between the two episodes, except this time the attempt to save the dollar will be through the shock-therapy of ultra-low interest rates, clandestinely administered by Chairman Greenspan? If so, it won't save the dollar, only prolong the agony.

In his History of Money speech Chairman Greenspan observes that "savers have been in sufficient abundance since the beginning of the Industrial Revolution to enable investment to further material well-being. Money, as a store of value, was an early facilitator of savings and one of the great inventions of mankind. The history of money is the history of civilization or, more exactly, of some important civilizing values." We may add that it was the savings of the people that has made America great. In the nineteenth century the American people working hard and saving hard created an economic and financial giant on the continent. America was the world's greatest creditor nation. Now, America is a financial and economic dwarf. It has dismantled its great industries with the exception of the industry producing military hardware. Now the capital, embodying the great savings of earlier generations, is being dissipated. Now, thanks mainly to Chairman Greenspan's long tenure, America is the world's greatest debtor nation. Now, savers in America are no longer in abundant supply. In fact they are an endangered species, at the verge of extinction. Now, the dollar is no longer a store of value. It is a certificate of guaranteed confiscation of value. The most recent history of money is a history of decline of civilizing values.

In his speech Chairman Greenspan related a story. He had met a friend and told him about the speech he was going to make on the history of money. The friend's response was: "I know all about the history of money. When I get some, it's soon history." He could have added: "And if I save some, its value is soon history!" The Chairman called his friend "spendthrift". He failed to mention that it was precisely his policies at the Fed that had made his friend, and many millions of others, spendthrift by turning the dollar into the peso of a banana-consuming republic.

Chairman Greenspan said in his speech that "the early history of the post-Bretton Woods system of generalized fiat money was plagued, as we all remember, by excess money issuance." The cheek of the kettle that dares to call the pot black! The excess money issuance under all his predecessors combined is eclipsed by the excess money issuance during this Chairman's tour of duty at the Fed! Nor can he have the excuse that he was misled by the siren-song of the welfare state. As his earlier article "Gold and Economic Freedom" will testify, he is one of the precious few who understands the gold-freedom nexus.

The Chairman is traitor to the cause of sound money.

### References

### Alan Greenspan, Gold and Economic Freedom (1967)

### Alan Greenspan, The History of Money (2002)

Antal E. Fekete, The Causes and Consequences of Kondratiev's Long-Wave

### Cycle, The Technical Analyst, January, 2005, London

---

# What Gold and Silver Analysts Overlook

URL: https://newaustrianeconomics.com/archive/fekete/what-gold-and-silver-analysts-overlook/
Date: 2004-05-04
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, contango, silver, bimetallic, gold-standard
Description: Most gold and silver analysts fixate on supply and demand fundamentals while ignoring the basis — the spread between spot and futures prices. Fekete argues the declining basis is the decisive early-warning signal of an approaching backwardation, and poses the overlooked question of what happened to China's vast silver reserves after its silver standard collapsed.
Editorial Note: Published in May 2004 as part of the Gold Standard University Spring Semester series. This piece introduces many readers to basis analysis for the first time, contrasting it with the supply-demand framework that dominates mainstream gold commentary.
Original PDF: https://professorfekete.com/articles/AEFWhatGoldAndSilverAnalystsOverlook.pdf

*Extra! Special! What Gold And Silver Analysts Overlook*

### Executive Summary

Analysts keep talking about supply/demand factors, instead of concentrating on the falling basis and looking for other signs of the coming backwardation in the gold and silver markets. They should also answer the question: Whatever happened to the Chinese silver, remnants of China’s defunct silver standard?

### Phantom Supply and Demand

As his starting point in trying to explain prices Ted Butler, among other analysts, chose the supply of and the demand for gold and silver. This is a mistake. Under the regime of an irredeemable currency the supply and demand of a monetary metal are indeterminate. In other words, they cannot be quantified in any meaningful sense of the word. For example, the supply of gold from official sources is on a 24-hour basis, in spite of the Washington agreement and similar declarations largely drafted in order to obfuscate rather than to enlighten. Supply from private sources, too, can change on a moment’s notice together with demand as speculators have no firm commitment either to the long or short side of the market. It is a mistake to assume that the dealers are committed to the short and the tech-funds to the long side. Such commitments, to the extent they exist, are subject to many an overriding consideration such as profit-taking, stoploss, to say nothing of herd-instinct that may induce a massive stampede from one side of the market to the other based on nothing more substantial than a rumor. It is futile to analyze the gold and silver markets in the same way as one would other commodity markets. It is dangerous to ignore the fact that gold and silver are monetary metals.

### Phantom “Free Market”

To call for a free market for gold or silver is calling for the impossible. Once again we must remember that we have irredeemable currency. The gold market could only be free if the official supply were available on demand to the private sector at the official price. This is clearly not the case as a result of the wholesale default of governments to pay their gold obligations in the 20th century. Never mind if governments are shouting from the rooftop that silver and gold as money are passé since the former was demonetized in 1871 and the latter a century later. At best, this is wishful thinking, at worst, malicious misinformation. It is not up to the governments to monetize or demonetize a commodity. It is the prerogative of the market. In picking a monetary commodity the market will make its marginal utility decline at a rate more slowly than that of any other. There is always such a commodity, no matter what the government says. It can be recognized by the fact that its above-the-ground supply is a large multiple of annual output, whereas that for a non-monetary commodity is a small fraction.

We shall express this by saying that the stocks-to-flows ratio is the largest for the monetary commodity. For this reason, once it has been picked, it is virtually impossible to change. Such a change would involve the dispersion of the large existing hoards of the old, and the accumulation of similarly large hoards of the new monetary commodity. That would take centuries to complete, longer than the week-end declaration of a default-prone government.

### What Is the Value of a Broken Promise?

In prehistoric times the market picked the monetary metals: gold and silver. The rest is history, replete with government bluffing. It is easy to see through this.

Paper money was originally issued as a promise to pay a definite amount and fineness of gold to bearer on demand. Later the government reneged on its promise, which promptly started losing value in terms of gold. There have been ups following downs, but the downtrend is unmistakable. Why the ups?

Nothing is more natural than for a banker to try to keep his dishonored promises in circulation by hook or crook lest their value go to zero, as it has happened every time in history. It makes no difference whether the banker runs a wildcat bank or whether he runs the most powerful government in history with the most formidable armor and weaponry imaginable at its disposal. The banker may be able to pull new tricks from his sleeves and thereby to fool the public a little longer. But no tricks will turn upside down the natural law that written evidences of broken promises are destined to end up in the garbage bin. Regardless how fine the paper and how beautiful the print is.

Under the regime of irredeemable currency the price has nothing to do with the value of gold. It has to do with the success of the government to fool the public. It has to do with the failure of the people to see through government bluffing. It helps if the government (or central bank) has a large hoard of gold. It can be used to intimidate other holders, bombarding them with propaganda that the supply/demand fundamentals for gold are most unfavorable.

The existence of such hoards will induce speculators to place bets as to the ultimate disposal of the official stocks. Those who bet that these hoards will eventually be used by the government to stabilize paper money will go long.

Those who bet that the government will commit harakiri in bluffing its way down to the last bar of gold in its coffers will go short. The contest of the longs and shorts will cause the price of gold to fluctuate. As we shall see below, ultimately, the shorts are destined to be the losers but, in the meantime, they can make a lot of mischief. Especially if they are right in assuming that the government really intends to bluff its way down to the last gold bar.

### Keynes’ Blunders

The enfant terrible of British economics John Maynard Keynes assumed that there was inherent symmetry in speculation that was supposed to furnish a natural limit to the size of the markets in derivatives. By derivatives we mean futures contracts (or options thereon) to make or take delivery of a definite quantity and quality of a commodity at the price prevailing at the time of contracting. Those who contract to take delivery are the longs (a.k.a. bulls) and those who contract to make it are the shorts (a.k.a. bears). Keynes argued that, since to every long there must correspond a short, the net effect of the derivatives on supply and demand is neutral. According to him derivatives-trading is a zero-sum game: the gain of one speculator is the loss of another. Samizdat* economists (my term for those publishing on the internet) see it differently. If we depict the underlying cash market as the dog and the corresponding derivatives market as the tail, it is foolhardy to suggest that always the dog wags the tail. The trouble with the regime of irredeemable currency is that under it the tail may often be wagging the dog.

It is patently false to suggest that symmetry prevails in trading derivatives. The risks taken by the longs and shorts fail to be symmetric. In case of commodities the risk of the longs is limited while that of the shorts is unlimited. Nor is it hard to see why. The risk of the longs is that the price will fall. But fall as though it may, it will definitely not fall below zero. This limits the exposure of the longs. Compare this with the risk of the shorts, which is that the price may rise. As there is no obvious limit above which the price may not be allowed to rise, the risk of the shorts is unlimited. The lopsided nature of speculation in commodities is revealed. Another way of expressing this is to assert that the longs can squeeze, and sometimes corner, the shorts. By contrast the shorts cannot squeeze, let alone corner, the longs in the commodity markets (although, of course, they are free to bluff that they can).

Speculation in interest-rate derivatives is no less lopsided, albeit with a switch between the roles played by the longs and the shorts. Here the risk of the shorts is limited while that of the longs is unlimited. Indeed, the risk of the shorts is that the rate of interest may fall (so that bond prices will rise). But fall as though it may, the rate of interest will definitely not fall below zero. Compare this with the risk of the longs, which is that the rate of interest may rise (so that bond prices will fall). As there is no obvious limit above which the rate of interest may not be allowed to rise, the risk of the longs is unlimited (in comparison to that of the shorts). Another way of expressing this is to assert that the shorts can squeeze, and sometimes corner, the longs. By contrast, the longs cannot squeeze, let alone corner, the shorts in the financial markets (although, of course, they are free to bluff that they can). Examples of the bond-bears cornering the bond-bulls are provided by the various historic episodes of hyperinflation.

Keynes was wrong in declaring that the net effect of derivatives on the cash markets is neutral, and thereby the volume of derivatives trading is capped. Just the opposite is true. Derivatives trading in gold and silver has grown beyond rhyme and reason. The growth in trading interest-rate derivatives has been even greater. These cancerous growths are part of the self-destroying mechanism of the regime of irredeemable currency.

### It Takes Three to Contango

Keynes’ theory of speculation is wrong beyond the possibility of repair. He insisted that the natural condition for the futures markets for commodities is to be in backwardation. This is the name for the condition that the market quotes a lower price for a more distant and a higher price for a nearby delivery date. The opposite condition, one that obtains when the market quotes a higher price for a more distant and a lower price fore the nearby delivery date is known as contango.

Keynes called what he saw as the natural condition for the futures markets in commodities “normal backwardation”. He reasoned that there is a risk involved in carrying a commodity, namely, the risk that the price may fall. The producers and distributors want to unload this risk onto the shoulders of the speculators.

However, the speculators will shoulder the price-risk only for a consideration, as manifested by the backwardation. The role of the speculator, according to Keynes, is analogous to that of the insurer who charges a premium for insuring specific risks.

This is a complete misrepresentation of the facts of the markets. The speculator is no insurer shouldering specific risks in return for a premium represented by backwardation. Just the opposite is the case. The speculator is interested in taking small risks in the hope of a large payoff. He will not be bribed with a pittance. The speculator is willing to take a number of small losses because he expects the few bets he will win to be big. Keynes’ analogy between the roles of the speculator and the insurer is a colossal blunder.

It is interesting to note that the market for monetary metals seemingly justifies Keynes’ theory. The shorts appear to be the master who takes the initiative, while the longs appear to be the servants who take orders. The shorts are the aggressors while the longs are on the defensive, whereas the asymmetry of speculation would justify the opposite cast. This reversion of roles will not ofcourse determine the final outcome that must be the utter defeat of the shorts and the apotheosis of the longs. What it suggests is that the road ahead is going to be arduous, full of backtracking that will often raise doubts in the hearts of the longs. In particular, it is not likely that silver will go straight up after one last short squeeze forcing traders to cover all short positions for good, as predicted by some analysts. More likely the market will follow the classical zig-zag pattern of lots of profit-taking and stop-losses on the long side. Meanwhile the shorts will continue to stand guard at the gates of the Underworld in their role of Cerberus, the triple-headed dog. The blow-off is presumably still a long way away.

Contrary to the teachings of Keynes, the normal condition of the futures markets is one of contango, not backwardation. The proper way to view the futures markets is a place where warehousing services are traded. Contango is the premium from which the warehouseman derives the fee for his services. If there is no contango, no warehousing is possible. Accordingly, it takes not two but three to contango: the producer, the speculator, and the warehouseman.

This is especially clear in case of the monetary metals, of which a supply many times larger than annual demand for consumption exists. We have expressed this by saying that the stocks-to-flows ratio for a monetary metal is a large multiple (it is estimated to be greater than 50 for gold), whereas the same number for a non-monetary commodity is a small fraction (it is estimated to be less than 0.25 for copper). The large stocks-to-flows ratio reveals the willingness of people to carry the monetary metal, in spite of carrying charges, and defying government propaganda. The longs have a choice. Either they carry the monetary metal in inventory, or they replace it with a futures contract. In the latter case they sell the metal and invest the proceeds at interest (taking care that maturities match). In the normal situation arbitrage between the two ways of being long in the monetary metal will bring about contango. It tends to equalize the carrying charge with the premium over the cash price. Therefore it is not “normal backwardation” as preached by Keynes. If anything, it is “normal contango”. Here a very important question arises: Can contango in a monetary metal turn into backwardation, and if so, under what condition?

### Abnormal Backwardation

It appears to be a theoretical impossibility for the gold and silver market to be in backwardation for any extended period of time. Such a situation would guarantee unlimited and riskless profits for all those holding gold and silver. They could replace their cash holdings with futures at a lower price. When their futures contract matured, they could take delivery and repeat the procedure. The mere possibility of unlimited and riskless profits suggests that there is an error in the calculation. And indeed, there is. The profits are not riskless. As the ancient adage says: “A bird in hand is worth a dozen in the bush”. When cash gold or silver is replaced with futures, a risk is created, namely, the risk that it may not be possible to convert the futures contracts back into cash gold or silver at maturity.

There is the risk of default in the futures markets. Of course, exchange officials, bullion bankers, and government watchdog agencies vehemently deny the existence of such a risk. But the fact remains that under the regime of irredeemable currency it is possible to corner a monetary metal. It is true that cornering a monetary metal goes by another name: that of hyperinflation. There have been any number of hyperinflationary episodes ever since paper was invented by the Chinese. What people don’t generally realize is that every one of these episodes was a corner in gold or silver. It is foolish in the extreme to suggest that in the 21st century we are immune to the threat of a corner in gold and silver, since we have the wisdom of Keynes and Friedman at our disposal.

These men were writing for the benefit of their employers, the British and the U.S. governments. They were not committed to the truth any more than the government that had hired them was. Governments are committed only to perpetuating and aggrandizing their own power, if need be, by trampling on the Constitution. Inflicting irredeemable currency on the people is part of this aggrandizement.

### The Basis for the Basis

In order to understand how the monetary metals may go to backwardation we need to refine our investigative tools. We need the concept of a basis. First we raise the question of how the warehouseman knows what and how much stuff to put into his warehouses. Well, his guiding star is the basis, the term he uses for the difference between the futures and cash prices of the commodity. If the basis for corn is higher than for wheat, then the grain elevator operator will fill his elevator with corn in preference to wheat, regardless of prices. He will cover his need for wheat by purchasing wheat futures rather than cash wheat. It is more profitable for him to carry wheat in the form of futures than cash, in view of the basis.

The basis is the measure of contango. If it is greater than the carrying charge, then the warehouseman will increase his stocks in warehouse and sell an equal amount of futures; if less, then he may sell stocks from his warehouse and buy an equal amount of futures. Note that, once again, a lack of symmetry obtains between these two cases. If the basis is greater than the carrying charge, then the warehouseman is treated to riskless profits. If less, then the warehouseman has a dilemma. On the one hand the already quoted adage: “a bird in hand is worth a dozen in the bush” applies. On the other, he has a powerful incentive to sell the cash commodity and buy the futures. Because of this asymmetry the basis hardly ever goes higher than the carrying charge while it may well go lower.

In fact, there is no theoretical limit below which the basis may not go. It may even go negative creating backwardation. The warehouseman will have to be very careful in choosing the point where he sells cash commodity and buys the futures. He must remember that shortages are always heralded by a falling basis.

This is called the basis-risk.

The important fact to keep in mind is that a low and falling basis and, in particular, backwardation, are always a warning signal indicating tightness in the cash market. The size of the shortfall of the basis from full contango is an indication of the magnitude of the shortage. In a nutshell, cash prices always appreciate relative to futures prices in case of a shortage, showing that delivery problems exist as the warehouseman is unable to replenish his dwindling supplies fast enough. The basis-risk of the warehouseman who sells the cash commodity against buying the futures is unlimited.

### Up and Down the Elevator

All this may be illustrated through the cyclical business of the grain elevator operator. In the harvest season he is buying grain. Selling futures against grain in the elevator is called hedging, with the short futures position being the hedge.

The objective of hedging is to neutralize the price-risk that goes with holding the grain in storage. The elevator operator has only a limited amount of capital available to cover various risks in his business. The amount of grain in the elevator is so huge that even a small decline in the grain price could wipe out his entire capital and bankrupt the grain elevator operator. Hedging highlights the economic significance of the futures markets. They make it possible for the operator to ignore price variations, and concentrate on what he does best, the handling and distribution of grain until the new crop is brought in. He can focus his attention on the basis, from the variation of which he derives his income. As he puts the new crop in his elevators, the basis will go higher. If it didn’t, then the elevator operator would buy the futures instead of the cash grain. As the elevator is filled to capacity, the basis approaches the carrying charge.

During the course of the year grain is gradually consumed, supplies at the elevator are drawn down, and the basis falls. The successful elevator operator anticipates these changes correctly. He will sell grain just before the bounceback in the basis after every major fall, simultaneously lifting his hedges in the futures market. Moreover, he will sell only so much, as he is trying to sell most of his grain at the end of the season when the basis is the lowest, and there may even be backwardation. It bears repeating that the grain elevator operator must keep it in mind that in selling cash grain against buying futures he is incurring a basis-risk that is unlimited.

### Speculation versus Gambling

Speculation in grains is legitimate business as it addresses risks given by nature.

Both the price-risk and the basis-risk are nature-given. They are influenced by the weather, the possibility of floods and other natural disasters. We have no other means to alleviate market dislocations such as shortages caused by crop failure (hurting the consumer) and price busts caused by bumper crops (hurting the producer) than organized speculation.

By contrast, organized speculation in the monetary metals is an aberration due to irredeemable currency. In fact, to call it speculation is a misnomer. Speculation in gold and silver is of the nature of gambling. The risks it addresses are not naturegiven but man-made, like those addressed by foreign exchange and interest-rate speculation. We use the term “man-made” in its broadest sense, to include manipulations by the government and central bank. If we compare the government to the casino owner, then the speculators are the gamblers. The government creates the risks artificially in the gold and silver market for the speculators to place their bets on. Few people today realize that under the gold standard there was no organized speculation in foreign exchange and interest rates, as the variation in these rates were too small rendering speculation unprofitable. And, of course, there was no organized speculation in gold. This, incidentally, is one of the merits of a gold standard. It channels talent and manpower away from gambling and into productive enterprise. The main negative effect of the destruction of the gold standard by the government was the creation of a long list of artificial risks that had not existed before, e.g., the foreign-exchange risk and the interest-rate risk. The regime of irredeemable currency is seen as a most wasteful one. It creates phantom markets, phantom supply and demand, channeling talent and manpower away from socially desirable production into socially undesirable gambling. The derivative markets trading gold, silver, foreign exchange, and interest-rate futures (options) are a monument to government obtuseness and inefficiency. Rather than reducing, as it should, the number of ever-present risks that man has to face in his struggle for survival, the government in embracing irredeemable currency creates new and wholly unnecessary risks, thereby undermining the efficiency of production, distribution, and saving. Worse still, the government also exposes society to unimaginable dangers such as the sudden impoverishment and permanent pauperization of the majority of the people, as it happened in pre-Hitler Germany.

Hedging the monetary metals is also of the nature of gambling. The risks addressed here are all man-made. While exchange officials and government watchdog agencies strictly enforce the rule that the total short position in grains must at no time exceed annual production, they look the other way when gold mining companies sell several years’ of future production forward. In no way does hedging by the gold and silver mining industry serve the shareholders. On the contrary, it is a scheme whereby the management dispossesses them.

Having made the point that speculation in monetary metals is of the nature of gambling, we want to understand it as it vitally influences our own well-being and financial security. We wish to study it based on sound economic principles rather than the phony ones pronounced by so-called economists in the hire of the government.

Recall that the normal condition of the markets in the monetary metals is that of contango. Backwardation is abnormal, yet it may occur. When it does, the regime of irredeemable currency will start to crumble. People in trying to save their financial future will take flight to the monetary metals. They will scramble to mop up the dwindling supply that is allowed to trickle down. Then all of a sudden all offers to sell the monetary metals are withdrawn. Supply goes to zero, facing an infinite demand. That such a development is not fanciful but a true description of economic reality as it unfolds is confirmed by history. Supply of the monetary metals went to zero and demand to infinity many times before, in France (the assignat and mandat inflations), in the United States (the continental inflation), in Germany (the Reichsmark inflation), to mention but a few of the notable cases.

Analysts of the gold and silver markets make a mistake when they use monetarist models, try to balance a phantom demand with a phantom supply, and cry for a free market. Instead, they should be watching the gold and silver basis as they fall, and look for other signs of the coming backwardation, first in the silver, then in the gold market. For practical purposes the basis for gold and silver is the difference between the two nearest futures prices, in more detail, it is the settlement price for the nearby future month less the settlement price for the current cash month. We shall see that the basis for gold and silver behaves perversely when compared to the basis for agricultural commodities. This fact is quite important as it explains the self-destroying mechanism for the regime of irredeemable currency.

### Understanding the Silver Market

By no stretch of the imagination can the silver market be called free at any time since 1871. In that year two powers demonetized silver: Germany and the United States. The governments of both were cashing in on the war-booty from their respective victories. Prussia had just defeated France, and in the United States the North had just defeated the South. These governments were dumping silver in order to raise the gold needed to run a gold standard. The price of silver fell from \$1.29 an oz and continued falling for more than 60 years to a low of 0.25 ¢, or less than one-fifth of the old official price (although there was a brief spike back to \$1.29 at the end of World War I) as all other countries with the significant exception of China followed suit in abandoning silver and turning to gold. In the meantime the U.S. Treasury was made by law to purchase silver from the Western states at prices above market. The silver-purchasing program of the United States remained in effect for over 75 years, after which the Treasury initiated a silver-selling program at prices below market. All in all, 6 billion oz of Treasury silver was sold during the past fifty or so years and, by now, the U.S. is allegedly out of silver. Well, maybe out of silver, but not out of the silver business.

Holding the line on the silver price, or at least yielding ground to higher prices only gradually, is considered the first line of defense by the U.S. government protecting the dollar. If silver were allowed to be cornered, then gold would follow and that would be the end of the dollar, and the financial domination of the world by the U.S. government.

Ted Butler and other silver analysts have properly noticed the structural deficit for the past twenty years or longer, the draw-down of the visible supply deliverable against futures contracts, all in the face of stable or declining silver prices. They have also noticed what they took to be naked short position of traders that is increasing by leaps and bounds. The analysts say that behind it all there is illegal price manipulation. They contend that silver prices would be much higher by far if it wasn’t for the traders’ selling of unlimited amounts of silver futures naked illegally. The analysts claim that the naked short position of a few big traders amounts to several years of mine production. At any rate, it is a high multiple of the existing stores of deliverable cash silver in existence. It is a disaster waiting to happen. And happen it will before the last bar of deliverable silver is gone.

In trying to explain these anomalous developments Ted Butler and other silver analysts charge that there is a conspiracy involving the “silver insiders” (namely, the four to eight largest traders), the exchange officials and, possibly, the government watchdog agencies. The insiders have made obscene profits at the expense of the outsider investors and the shareholders of the mines. They could do it as they enjoy special privileges and may get off scot-free with violating both the exchange rules and the laws of the land. Dark hints are dropped about the possibility of kickbacks to officials whose duty it is to enforce the rules and the law. It has also been suggested that silver mine executives have been bribed not to complain about low silver prices but to keep producing at a loss.

Without trying to refute these accusations I should point out that, before charges are made, one ought to make sure that all other possible explanations have been exhausted for the aberration that the price of silver declined significantly in the face of structural deficits and the draw-down of visible supplies. Even if there is no other explanation, the existence of a conspiracy does not logically follow.

Without trying to refute the conspiracy theory I should point out that the market behavior of the shorts may find a spontaneous explanation. Speculators may be prompted to congregate on the same side of the market by the idiosyncrasies of the regime of irredeemable currency. It is not an outrageous assumption that all speculators read the mind of government and central bank manipulators in the same way. While uniform behavior would not be possible in the case of speculation in agricultural commodities where the risks are nature-given, it is quite possible in the case of speculation in monetary metals precisely because here the risks are man-made.

### Whatever Happened to the Chinese Silver?

The most populous country, China has one of the oldest civilizations on earth. It had been on a silver standard since time immemorial before the Communists overran the mainland. Nobody knows how much silver was involved in running China’s monetary system, but the amount must be mind-boggling. In addition, China was forced to absorb enormous amounts of silver (both through legal channels and through smuggling) after silver was demonetized by the rest of the world and the price of silver collapsed. We do know that this addition to the Chinese money supply created an inflation horrible enough to cause the fall of the Kuo-min-tang regime and the ascension of the Communists to power in 1949.

We do not know what proportion of the monetary silver the Communist government left in the hands of the people while confiscating the silver in the banks with characteristic ruthlessness. Finally, we do not know whether or not China was buying silver clandestinely during the twenty-year period between 1980 and 2000 when the price was falling.

Be that as it may, the silver left over from the silver-standard days, plus the silver subsequently flowing into China, is largely unaccounted for. The question is: where is this Chinese silver? It appears that China does hold the silver wild card, and hasn’t played it yet. We cannot lithely assume that China will play it stupidly.

The possibility exists that China will play it intelligently. For all we know, China may already be active, if only clandestinely, in the silver market and has been deriving handsome profits from it. The alleged naked short positions in silver may in fact be genuine hedges for Chinese-owned silver. In other words, China may have decided upon a strategy to derive a steady income from her silver treasure, at least for as long as prices remain low, in preference to the alternative strategy of driving up the price of silver and then cashing in. I haven’t examined the evidence and I am not suggesting that this is the case. All I am saying is that there is another possibility that could explain the anomalous market behavior for silver. One reason why I find the theory of inordinate and growing naked speculative short positions unattractive is because it assumes that the insiders are either stupid or suicidal or both. It is dangerous to underestimate one’s opponents.

### Serial Crimes of 1871, 1933, and 1971

The right of the people to free and unlimited coinage of silver at the Mint is carved into the corner-stone of the U.S. Constitution. This right was abolished with a sleight of hand in 1871. “The Crime of 1871“, as William Jennings Brian called the unconstitutional demonetization of silver, may get its just punishment after a 130-year hiatus before our eyes.

It wasn’t an isolated crime. It was a serial crime through which politicians deprived the American people of all their Constitutional rights and prerogatives pertaining to money, that started even before 1871. The crime was repeated on a bigger scale in 1933 when a Democratic president tricked the American people out of their gold. The crime was crowned in 1971 when a Republican president tricked the rest of the world out of its gold, while inflicting a regime of irredeemable currency on the American people and everybody else. Although through the betrayal of the economists the people were left in darkness about what has happened to their money, these crimes cry to high heaven for justice.

While I am somewhat doubtful about the theory of conspiring private parties, I find the theory of a secret government plot to suppress the price of silver plausible, even persuasive. This plot may also include collusion between the governments of the United States and China to fend off a price explosion.

According to this scenario China would supply cash silver to deliver against futures contracts, in return for the right to collect the income flowing from her short positions in silver.

Even the obvious delivery problems cannot serve as conclusive proof that the insiders (also called “silver managers”) have rigged the silver market in an effort to cap the price. After all, the silver to be delivered may have to be brought in from China. That takes time. Silver analysts would do well to compile intelligence as to what percentage of the delayed deliveries to the Central Fund of Canada and other longs has originated in China. If it was a large percentage, then we would have evidence that the silver managers were neither stupid nor suicidal.

They merely acted as the agents of the government China.

### Understanding the Gold Market

Before the United States defaulted on its obligations in 1968 and subsequently demonetized gold in 1971 all economists, including the arch-conservative Ludwig von Mises, predicted that demonetization would send the price of gold way down.

They pointed to the episode of silver demonetization one hundred years earlier, followed by the collapse of the price of silver. They also adduced a pseudotheoretical argument that the disappearance of the lion’s share of demand, namely the monetary demand, cannot help but make inroads into the gold price.

Of course the economists fell on their face when gold was demonetized yet its price, instead of falling, rose more than twenty-fold in less than ten years.

Nobody dared to confront the economists with their embarrassing failure. Why did they fail so miserably? I shall now give the answer to this so far unanswered question. The economists fell victim to one of the most elementary fallacies known as post hoc ergo propter hoc (after this, therefore because of this). When silver was demonetized in 1871, no government default was involved. Owners could continue to redeem their silver certificates without let or hindrance. Since its price showed a falling trend, a lot of people rushed in to sell silver. Even the silver mines redoubled their efforts to produce all the silver left in the shafts, before they had to be closed down and abandoned for good. Genuine silver mines have all but disappeared. Whatever silver production survived was byproduct from the gold and copper mines. It was not demonetization that caused the price of silver to fall but dumping, official and unofficial, that followed it.

By contrast, the demonetization of gold a hundred years later was a default on the gold obligations of the U.S. government. Nobody has ever seen a dishonored promise to go to a premium. Yet this is exactly what the economists were predicting that would happen to the dollar. The gold obligations of the U.S. were internationally recognized. By the Bretton Woods Treaty of 1944 that was responsible for hatching the IMF, foreign governments could treat their dollar balances as gold-equivalent at the rate of \$35 to one oz of gold. These gold obligations were solemnly reconfirmed by three sitting presidents. Browbeaten by Washington, foreign governments wouldn’t dare to protest the breach of faith and the unilateral abrogation of international obligations. They meekly swallowed the loss that arose. They pretended that nothing much happened and the dollar was still as good as gold. They ignored the market and continued to count their dollar balances at “the official price at which the U.S. Treasury refused to sell gold”.

They called it the “two-tier monetary system”. Of course, that hare-brained scheme could not endure. The market trumped the governments, as it always does when they do something foolish. It is interesting to note that the financial annals are silent on the biggest default in history. Well, you can get away with it if you are the paymaster of the annalists.

As there was no point in pretending any more that the dollar was as good as gold, the U.S. government put measures in effect designed to drive down the price of gold or, at least, to prevent it from rising further. IMF gold auctions were followed by U.S. Treasury auctions. Both backfired badly. The market obliged in bringing down the price of gold temporarily to allow the IMF and the US Treasury to unload the bothersome surpluses. But no sooner had the auction been completed than the price of gold returned to its pre-auction level to resume its upward march.

It is hard to find another example of such an inane market action in the long catalog of government blunders. If a bank needs to sell an asset, then it does so discretely in order that it may fetch the best possible price. Fanfare and the Dutch auction method were used for their propaganda value in demonstrating how the price falls when gold is put on the block. It is clear that these gold auctions were not an exercise in high finance but one in low propaganda. More recently the Bank of England auctioned off more than half of her gold reserves at record low prices, to replace it with U.S. government securities at record high prices. In doing so the Bag Lady of Threadneedle Street was replacing her best asset gold, that is nobody’s liability, with the worst, obligations of a default-happy government. This made the portfolio of the bank weaker, not stronger. Once again, the completion of the auction gave the green signal to gold that it may resume its upward move.

It should be abundantly clear that in sacrificing their remaining ordnance governments are fighting a desperate rear-guard action in an effort to fool the public. In this situation it is puerile to call for a free market in gold and to go to court accusing the government of price manipulation. Once more without trying to refute the conspiracy theory I wish to point out that, given the idiosyncrasies of the regime of irredeemable currency, the uniform action of the shorts may find a spontaneous explanation. The gold mining executives, the bullion bankers, and other speculators may read the mind of the government and central bank manipulators in the same way.

### Self-Destruction of Irredeemable Currency

The explanation of hyperinflation in terms of the quantity theory of money is untenable. You cannot explain non-linear phenomena in terms of a linear model.

The proper explanation must be sought in terms of a non-linear model. Such a model can be developed using the concepts of basis and backwardation. If applied to the monetary metals, we shall see the cataclysmic conflict that will bring about the end of the regime of irredeemable currency. No one can predict the future, but science makes it possible for us to find the most likely course of events. It is in this spirit that I offer the following observations.

As the regime of irredeemable currency threatens to crumble under the weight of the inordinate debt tower of Babel, people increasingly take flight to gold.

Supplies will get tight and the gold basis will fall. The gold futures market may even go to backwardation briefly at the triple-witching hour, i.e., the hour when gold futures, as well as call and put options on them expire together. Later, flirtation with backwardation may occur even more often, at the end of every month when gold futures expire. Gold will get caught up in a storm.

Backwardation in gold has a perverse effect. In the case of agricultural commodities backwardation provides a most powerful incentive for traders to sell the cash commodity and buy the futures. Not so in the case of gold. Rather than bringing out deliverable supplies of gold, backwardation tends to remove them.

The more the gold basis falls the less likely it becomes that owners will exchange their cash gold for futures. Please remember that you have seen it here first. This perversion of the gold basis constitutes the self-destroying mechanism of the regime of irredeemable currency. The longs tend to take delivery on their gold futures contracts in ever greater numbers, and refuse to recycle cash gold into futures, regardless how low the gold basis may go. As it is not set up to satisfy demand for delivery on 100 percent of the open interest, the gold futures market will default. Exchange officials will declare a “liquidation only” policy to offset long positions in gold. At that point all offers to sell cash gold will be withdrawn. Gold is not for sale at any price. The shorts are absolved of their failure to deliver on their gold futures contracts.

Previous descriptions of hyperinflation purporting to explain the descent of a currency into the abyss of worthlessness do so in terms of the quantity theory of money. My explanation of the hyperinflation that is staring us in the face is very different. I dismiss the quantity theory of money as a linear model that is not applicable. Every previous episode of hyperinflation took place in the context of a war replete with shortages caused by the destruction of stockpiles and productive facilities. In this situation it is not possible to sort out the effects of an increasing demand (due to a flood of printing-press money) and a decreasing supply (due to the destruction of stockpiles and production facilities). We want to show that prices may also explode in the presence of unsold stockpiles and ongoing production.

Moreover, previous episodes of hyperinflation affected isolated countries which had embraced the regime of irredeemable currency out of desperation, while the rest of the world stayed the course of monetary rectitude. In the present situation the entire world has been inflicted with irredeemable currency. There are no gold standard countries around that could lend a helping hand to countries that want to stabilize their currency. My description of hyperinflation is not in terms of the quantity theory of money, but in terms of a model where the relentlessly declining gold basis leads to backwardation destroying the gold futures market. When all offers to sell cash gold are withdrawn, producers of essential commodities such as grains and crude oil refuse payments in dollars, and demand gold in exchange for their product. The dollar and other irredeemable currencies will go the way of the assignat.

Backwardation in gold should therefore be considered the self-destroying mechanism for the regime of irredeemable currency that “only one man in a million may identify and understand” (my thanks to Keynes for the felicitous phrase). This is where supply/demand analysis is utterly useless. The huge stocks of monetary gold are still in existence, yet zero supply confronts infinite demand.

The only way to fend off this outcome is for the government of the U.S. to come up with a credible plan to stabilize the dollar in terms of gold. Presently there is no hint that contingency plans for the rehabilitation of the gold standard exist. It doesn’t matter. Any country, e.g., China, India, Iran, could do it through the back door by opening the Mint to the free and unlimited coinage of gold and silver. The alternative may be mass starvation in the midst of plenty as world trade comes to a halt for want of a universally acceptable medium of exchange.

Here is a question for the U.S. President and Treasury Secretary to contemplate: How many innocent lives are they willing to sacrifice on the altar of doctrinaire purity in defense of their untenable gold policies?

*Note. I have taken a pause in my lecture series on Gold Standard University in order to bring you this essay on the failure of gold and silver analysts to include the basis as an instrument of analysis. My lecture series Gold and Interest will be resumed in June..*

### (* Ed: Samizdat' is Russian for "self-printing/publishing")

---

# Contrarian Roundtable on the Fed

URL: https://newaustrianeconomics.com/archive/fekete/contrarian-roundtable-on-the-fed/
Date: 2004-04-02
Section: Popular Economics
Difficulty: accessible
Concept Tags: federal-reserve, central-banking, gold-basis, monetary-policy, interest-theory, sound-money
Description: Seven analysts examine the Federal Reserve's origins, ownership structure, and effects on the American economy. Fekete's contribution traces how the Fed's open-market operations systematically destroy the gold basis and with it the natural rate of interest, replacing sound money with a regime of permanent monetary instability.
Editorial Note: Third in the FSU Contrarian Roundtable series. Contributors were asked 'Who really owns the Federal Reserve and is it good for America?' Fekete uses his answer to explain the open-market mechanism by which the Fed has destroyed the gold standard's automatic interest-rate stabilizer.
Original PDF: https://professorfekete.com/articles/AEFContarianRoundtableOnTheFed.pdf

### On The Fed

April 2, 2004 with Sol Palha & Janice Dorn, Antal E. Fekete, Alan Lunt, Chuck Cornell, Art Soukup, Gale Bullock, and Janice Dorn

“Contrarian Round Table” contributors discuss THE FED.

Who REALLY owns the Federal Reserve? How did it originate and how has it evolved? Is it a good thing for the people of the United States or not?

Sol Palha & Janice Dorn M.D., Ph.D.

### Proprietor & Contributor [www.tacticalinvestor.com](https://www.tacticalinvestor.com)

I won’t waste too much time dealing with who the Fed is or how they were created, but I am going to spend more time dealing with the last part of the Question. Is the Fed good for the people?

There is a great site that can answer the first two parts of the question. I am going to put a link to this site. [www.federal-reserve.net](http://www.federal-reserve.net/whatisthefederalreservebank.htm)

A banker is a fellow who lends his umbrella when the sun is shining and wants it back the minute it begins to rain.

### Mark Twain 1835-1910, American Humorist, Writer

THE FEDERAL RESERVE: LOVE IT, HATE IT, BUT NEVER TAKE YOUR EYES OFF OF IT.

It is rumored that Alan Greenspan (Chairman of the Federal Reserve) spends two hours every morning soaking in a tub while he pours over economic data. A photograph from the book "Maestro: Greenspan's Fed and the American Boom" by Bob Woodward, shows Mr. Greenspan working in his office where, on a calm day, he checks 50 charts every half hour. The charts relate to the bond market, the Dow, the foreign currency markets, gold and oil prices. Alan Greenspan is 78 years old, and has been Fed Chairman since age 61 when he was appointed by Ronald Reagan. Whether you approve or disapprove of Mr. Greenspan's ideas and policy making decisions, you have to admire his longevity, tenacity and devotion to his work. How many of us would think about reading economic data while soaking in the bathtub? Sports Illustrated Swim Suit edition, or Playboy or even a novel, perhaps? But economic statistics? We don't think so.

Mr. Greenspan is a target. He is targeted by economists, many of whom have, as their raison d'être, interminable discussions of inflation vs. deflation vs. stagflation. In a March 29, 2004 article from the Financial Times, renowned economist Marc Faber accuses Mr. Greenspan of creating" a series of bubbles in the U.S. economy, the New Zealand and Australian dollar, emerging market debts, government bonds, commodities, emerging market equities and capital spending in China" and warns of impending deflationary collapse. Others say that we are headed for runaway inflation. Everyone has an opinion and the debate rages on.

Good bankers, like good tea, can only be appreciated when they are in hot water...

### Jaffar Hussein

Mr. Greenspan is target by market pundits who dissect and parse his every phrase. He is ridiculed and called names such as E-Z Al, Sir Greenspin, Alan Green Kool-Aid, etc. Endless streams of verbiage spew from business television networks on the days before and after that the Fed meeting. Market participants wait with baited breath as that same old picture of Mr.

Greenspan in what appears to be the old same suit, carrying the same old briefcase and walking down the same old street is shown over and over. Waiting on the Fed. Fed day. Major drama in the markets.

So much drama, in fact, that the market almost seems to go into a state of suspended animation just before the meeting's minutes are released. The moment the pronouncement on interest rates is made, the markets appear to convulse and flail as if thrown into a state of chaos. This is high drama played out in the financial area. Then, after a while, the reactions settle down, and markets are back to “normal." We move on with the knowledge that this same scene will be enacted during the next Fed meeting. Like a bad hangover, we are subjected to endless discussions of what Mr. Greenspan said, what Mr. Greenspan meant, what Mr. Greenspan might have been implying or what Mr. Greenspan might say the next time. One such example was the ad nauseum interpretation of the meaning of the phrase:" we will be accommodative for a considerable period of time." This particular utterance was dissected, vivisected and bantered about for weeks. One cannot help but be reminded of similar discussions, albeit on another topic, which occurred surrounding of the meaning of the word "is" which played out in a previous political drama and filled up countless hours of TV and radio air time.

If I care to listen to every criticism, let alone act on them, then this shop may as well be closed for all other businesses. I have learned to do my best, and if the end result is good then I do not care for any criticism, but if the end result is not good, then even the praise of ten angels would not make the difference...

### Abraham Lincoln

What is the point of all of this? Other than entertainment value and slotting the time on business TV and radio, this is yet another opportunity for people to either embrace Mr. Greenspan and his ideas or to continue the criticism of Mr. Greenspan and his policies. It never changes. The supporters stay the same and get more vociferous. The critics stay the same and get more vociferous. In the end, everyone pretty much knew what was going to happen, (the markets anticipate everything anyway) so the whole thing was a non-event. Chaos in the markets, commentators spouting predictions, rampant speculation — all for a non-event. This is the way it is, it is what it is and it will be so until it changes (not expected soon).

So be it.

So why do we care at all about the Federal Reserve, Mr. Greenspan and policy? We are not advocates for nor fans of Mr. Greenspan. We are not economists, nor do we cater to any cults of personality. Rather, we are students of market philosophy and psychology and our mission is to empower individual investors to strengthen, enrich and protect their personal and financial foundations.

Whoever controls the volume of money in any country is absolute master of all industry and commerce...

### President James A. Garfield

Once again from Bob Woodward: "The title of this book, Maestro, was chosen carefully, and was intended to convey that Greenspan is conducting the orchestra but does not play an instrument.

He sets the conditions for the players to play well, if, they choose to do so and if they are capable”.

That is the point we are making here. It doesn't matter at all what the Fed does or does not do. It only matters if you are ready with your instrument in tune and ready to perform. It's up to you to make the decisions about what to do with your money. AND — the Fed can help you make those choices.

The sad reality is that 90% or so of investors lose money in the stock market. So taking it one step further, why don’t we examine the issue backwards and ask the question does anyone benefit from the Feds actions. The answer is a resounding yes. The Gold bugs have profited enormously from Fed action over the past few year. The fact that all of you are looking for higher prices, means you want the Fed to continue with their inflationary actions and keep increasing the money supply. Those of you who jumped on the gold bull bandwagon and "followed the money train" have made in excess of 600% on some of your gold and silver shares. Are you ready to give all those gains back in return for a Gold standard? Remember that your purchasing power has increased several times over. The price of most goods has not gone up as much as your shares. So this inflationary process has been one that has rewarded you tremendously.

How about real estate? Those of you who were smart enough to correlate extremely low interest rates with higher property prices made a fortune if you bought real estate from 1999-2001.

And then, there are those who made bags of money by going short the US dollar and the list goes on and on. So the real question should be is do we really care if the Fed is good for the People of America or are we more concerned with the issue of is the Fed good for me or not. There are many individuals out there, who will state that the Fed has been nothing but good for them as far as their financial health is concerned.

Personally, I think that if we were to get rid of the feds, some other rotten evil force would replace them, as human nature still has not changed. The desire to get everything for nothing is still within most of us and until that desire is eliminated or controlled, getting rid of a group of individuals, will do nothing but temporarily stop the problem.

The desire to get everything for nothing is everywhere. Just look at the frivolous law suits being raised. One of the most incredible ones to date was when this individual won several million dollars against McDonalds because she spilled coffee on herself. What was her excuse? She stated that they did not put a label stating that the coffee was hot; otherwise she would have been more careful.

Personally, I would like nothing better than to see the abolishment of the Fed and a return to some sort of Gold standard, where the amount of money that governments are allowed to print is limited by the amount of gold at hand. I don’t think that getting rid of the Fed will cure anything right now. Corruption, greed and the “me only principal” rule everything now. As the world stands if we were to get rid of this bunch of devils, we will simply open a power vacuum, where all the other sharks out there will try to rip everyone to pieces in their quest to get it all. At least for the moment we have one foe as opposed to a bunch of little nefarious evil miscreants.

How often have you heard: "Don't fight the Fed?" What kind of a message is that anyway? If we aren't supposed to fight, what are we supposed to do? The message "Don't Fight the Fed" implies that one should do nothing. Just run away or wait for the Fed to run over them. We propose to change this to "FLOW WITH THE FED." That is a positive message because it requires that we do something. Respond, don't react. Do something. Go with the Fed and make money by following the money. Make money by being positive and going with the trend. The most money in the markets is made by identifying major tends, be they bullish or bearish and riding them to their natural, highly profitable conclusion.

This is not a moral, ethical or political discussion. This is not about liking someone or something or hoping and wishing for events to occur. Naturally, we care about the future and the fate of the world and world markets and humanity. However, our goal as investors is to make money. For that reason, it is unimportant to us if policies are inflationary or deflationary. We are concerned with taking up our instruments, making certain that they are tuned, and getting ready to play as soon as the Maestro raises his baton. We care that each of you is prepared to do this, ready for any change in pitch or intonation or rhythm. We want you to listen to the music of the markets, watch the Maestro closely and prepare to be carried away by the music. You may find yourself immersed seamlessly in a beautiful and most profitable symphony.

You are the music while the music lasts...

### T. S. Elliot

This article was jointly written by Sol Palha and Janice Dorn, M.D., Ph.D.

© 2004 Sol Palha & Janice Dorn, M.D., Ph.D.

### FSU Archives

### Tactical Investor

### Email

### Antal E. Fekete

### Professor, Memorial University of Newfoundland

### St. John’s, Canada, A1C 5S7

### Red Herring

The Federal Reserve System (Fed), the guardian and advocate of the regime of the irredeemable dollar, is very different from the Fed as it was created by Congress in 1913 at a time when no sane man would have questioned the legitimacy or even the indispensability of the gold standard.

The Fed was set up to provide an elastic currency for the United States that flowed and ebbed together with commerce, industry, and agriculture which, according to Adam Smith’s “Real Bills Doctrine”, was fully compatible with a gold standard. The Fed was conceived as a commercial paper system. Assets balancing the note and deposit liabilities of the Federal Reserve banks were supposed to be no less than 35 percent gold, with real bills (also known as self-liquidating bills of exchange) making up the rest. Treasury bonds could only be held in the asset portfolio if a penalty tax was paid, which provided a powerful incentive to replace them with real bills at the first opportunity. The alternative was, horribile dictu, the contraction of credit.

It is preposterous to suggest that the Fed, as it exists today, has come about through evolution rather than revolution. In fact, the change has involved nothing less than the overthrowing of the U.S. Constitution making it incumbent upon the federal government to establish the U.S. Mint and to keep it open for the free and unlimited coinage of gold and silver by the people. In this way the Constitution has delegated the power of creating money directly to the people. It is this power that, as a result of the revolution, is now usurped by the Fed. As all usurpers, the Fed is a law unto itself that tolerates no restriction on its power.

The question who really owns the Fed, no less than the question who really owns the gold confiscated from the people in 1933 and now held at Fort Knox, with gold certificates against it held by the Fed, is a red herring. The Fed is nominally owned by its member banks, but its modus operandi betrays the truth. After the gold standard was destroyed by the U.S. government, the Fed has been hijacked by a clique that runs it without any regard to ownership, the Constitution, the law or, for that matter, to the vital interests of the American people.

### Who Gets the Loot?

I shall justify this outrageous claim by discussing the real question how the earnings of the Federal Reserve banks are disposed in violation of the law. The Federal Reserve Act, Section 7 (as amended, June 16, 1933) mandates that the net earnings of each Federal Reserve bank be paid into the surplus account of that bank. Note that this provision does not add to the profits of the member banks, which is limited by law to 6 percent per annum of the value of their paid up stock. It merely strengthens the capital structure of the Federal Reserve banks and, therefore, increases their capacity to serve commerce, industry, and agriculture. The law as it stands does not allow the U.S. Treasury to participate in the earnings of the Federal Reserve banks.

Yet in 1947 Fed Chairman Marriner Eccles set a precedent, establishing a practice that has continued year after year down to this day, to hand over 90 percent of net earnings to the U.S.

Treasury. Instead of presenting to Congress a proposal for amendment of the Federal Reserve Act, as proper procedure required, Chairman Eccles decided to violate the law and to dissipate the earnings of the Federal Reserve banks.

An ethical issue makes this official violation of the law particularly significant. The bulk of the Federal Reserve banks’ assets, contrary to the original intention to run the Fed as a commercial paper system, are Treasury bonds. The bulk of their earnings are interest income derived from Treasury bonds. Most of these interest payments are quietly and illegally refunded to the Treasury. Thus the assets backing Federal Reserve notes are, for the most part, non-interestbearing Treasury bonds or “strips”, the value of which is grossly overstated in the balance sheet.

The interposition of the Fed between the U.S. Treasury and the public in the money-creating process is a sham. The “open market operations” of the Fed is a sham. The dollar is being created in violation of the law, by pure fiat, at the whim of appointed officials arrogating unlimited power to themselves; this in a republic where government is supposed to be based on limited and enumerated powers. The roundabout nature of the dollar-creating process serves the purpose of fooling people. The Fed could very well be abolished, and the U.S. Treasury could issue fiat dollars directly, reducing the budget deficit of the federal government in the process. If it doesn’t, it is because it wants to pull the wool over the eyes of the public. It wants to maintain the pretense that a central bank independent of the government does the issuing as dictated by market forces.

Hereby the true fiat nature of the dollar is revealed. Only simpletons believe that there are solid assets backing the dollar.

### A Tale of Twelve Shills

The bond market has been turned into a casino. The gamblers are bond speculators, including all the major banks. The manager of the casino has hired twelve “shills” who play and win big at the gaming tables in order to perk up gambling spirit and to keep it high. At the end of the day the shills must return their winnings to the owner of the casino. These shills are none other than the twelve Federal Reserve banks.

The value of Treasury bonds is maintained through fraud. Today nobody in his right mind would hold his savings in bonds, as was the case before 1913 when the rate of interest and bond prices were stable and, hence, bond speculation was non-existent. Thus the logical basis of the value of bonds has been shattered. In the present environment the value of Treasury bonds is maintained by virtue of letting them serve as chips at the casino. People have to buy them if they want to play. As more and more chips are issued, the shills must become more and more active to prevent gambling spirit from sagging. The fraud of pretending that Treasury bonds have any real value at all, and that the destiny of the underlying debt is to be paid, is exposed. If it wasn’t for the

\$100 trillion derivatives markets in bond futures and options, Treasury bonds would become worthless, and so would the dollar. These derivatives markets must spin ever faster in order to keep the value of Treasury bonds from collapsing. The shills can postpone the day of reckoning but cannot avoid it. Messrs. Greenspan and Bernanke could be reckless in using the printing press, as they have publicly said that they would do, but that should only make the dénouement, whenever it came, even more horrible.

### © 2004 Antal E. Fekete

### FSO Expert Page

### Email

### Alan Lunt

### Contributor [www.tacticalinvestor.com](https://www.tacticalinvestor.com)

### About the Fed

Others writing on this topic will have stated the facts as G. Edward Griffin laid them out in the excellent book "The Creature from Jekyll Island." Suffice to say that Aldrich hoodwinked Congress and set in motion the founding of the Fed. What interests me is how the Fed policies in America affect the globe, and American nationals in the global sense.

I suspect that the Fed was a long term plan created by the moneymen, for the benefit of the moneymen, to the detriment of the common man. So I will skip the first part and go on to the piece about how the Fed affects people.

The Federal Reserve of the USA is nothing more than a modern day "Merlin the Magician", a conjuror, an illusionist and a manipulator. What the Fed does is interrupt the natural cycles by tightening then loosening monetary policy. If it did not do one then it could not do the other. Like Merlin, Alan Greenspan and his sidekick Ben use fresh air to make money. That money is valueless, but because it smells like money, acts like money and looks like money, the existing money pool is diluted, it is counterfeit. The illusion is that we are better off financially.

Poppycock!!!! We, you and me, are being raped of our savings, but at the same time are holding more assets. What an illusion. The illusion is wealth. The effect is indebtedness.

Was it Aldrich's plan to part us all from our money, if so it seems to be working. The printing press money is debt creation, that is the only way money can come into existence. But the problem is further compounded by the fractional reserve banking system whereby the money issued is loaned out in multiples. What happens when the banks want that money back? You got it, a credit squeeze.

The interesting thing is, as I see it, that the money has not all stayed in America. The carry trade and speculation has created a flight of newly printed money to offshore. This is born out by the spectacular performance of the currencies of commodity nations. Far and beyond what is reasonable. In the case of New Zealand lending to primary production has remained fairly static, but lending to the consumer has surged ahead. The basis of wealth is production, and the policies of the Fed is curtailing production in foreign lands. (Except China where the currencies are linked.) The effect is that the business cycle is interrupted offshore. That is the long arm of the Fed working. There is nothing our Government or Central Bank can do to stop it, we are at the mercy of the Fed and the printing press. The Fed has deemed it that all other nations will have a strong dollar policy whether they want it or not. Natural transitions that take years are now taking months, there is no way any producer can adjust or plan in such an environment. All they can do is batten down the hatches.

The Fed seems to be the banker to the world. To have so much power residing in one place is not a good thing. As George Orwell said, "All power corrupts, absolute power corrupt absolutely".

The owners of the Fed are out to get your money. Be prudent, don't willingly give it to them. On a global scale I will use Jim Puplava's words, this has the makings of a "Perfect Financial Storm".

All created by Greenspan's Federal Reserve.

Protect yourselves now, buy as much gold and silver as you possibly can. All other money is going to be trash when people wake up to what inflation really is.

### © 2004 Alan Lunt [www.tacticalinvestor.com](https://www.tacticalinvestor.com)

### Email

### Chuck Cornell

### Edmonton, Washington USA

The question of the Federal Reserve Bank is an important one. When trying to communicate, it is necessary to agree on the basic facts. If I believe point A is north and you think it is south, there is no point in talking about the best way to get there.

The following facts are easily verifiable in various books and many other sources. If you have never spent any time looking at alternative and other sources of information, you are probably not aware of these facts. Assuming this information is true, what effect it has on the country is for each to decide on their own.

Firstly, the Fed is not federal in any sense of the word. It is a PRIVATE COMPANY. It consists of twelve Central banks owned by international bankers in Europe and New York. They are all connected to the Rothchild banking interests centered in London. However, it actually makes no difference who the owners are. The effect on the world and us is the same.

As far as Reserve is concerned, they can print as much money as they want any time they want.

Other than that, I am not sure what reserves they really have. Certainly none that are guaranteed.

The Federal Reserve Bank was formed in 1913 on Jekyll Island, Georgia. In top secret meetings, where some of the participants arrived in disguise, chief architect Paul Warburg, along with other international bankers plotted the creation of a national bank. While Congress was on vacation, using their vast influence, it was passed into law.

I do not think this bank is different from other central national banks in the past, like those opposed by Andrew Jackson and Thomas Jefferson. The purpose of the banks is to create money with no backing, by either printing or computer blips. That money is then loaned out with interest. The banks have no interest in you paying back the loan. The worthless money you borrowed is worthless to them. The idea is to have you contractually obligated to them, hopefully not being able to pay back the loan, under threat of imprisonment, taking from you real value, your tangible assets.

The same thing occurs at all levels. Internationally through the IMF and World Bank, poorer countries are put into debt that they cannot repay. For relief of some of the debt, the bank takes over the land, resources and labor. Nationally, the Fed has our government indebted to them, and locally banks have the same relationship to individuals.

If the country wants to be in the banking business, creating money and loaning it with interest, why doesn't the government print the money itself. That alone would be a savings of billions of dollars to the citizens.

Obviously, at one point, the debt to the Fed will officially not be repaid. What will happen then?

For those taking the equity out of your homes and spending money you do not have, beware.

Perhaps, owning gold, silver, other precious metals, and tangible items is one of the better strategies to have.

### © 2004 Chuck Cornell

### Edmonds, Washington

### Email

### Art Soukup

I did some research on this very subject a long time ago. All of the found answers shocked me.

The shock is caused by finding out that the "History" or "Civics" class that you were probably taught in school did not tell the whole story. Therefore, you may wish to slow up on the publication date, to allow for plenty of reading time (a couple of months or so) and then plenty of pondering time (a couple of years or so), because it has very, very, deep implications because there is a lot more to the story. I have put some links at the very end. When you have read them, it would bee a good idea to save a copy as "web page complete". Just in case they vanish. It’s up to you, of course. Still... it is hard to learn, without the correct data, so here is some input for your article. Thread it together as you see fit.... something like, Wow look what I discovered while surfing the net.

The data is the definitions of three words, "issue", "issued", "rent”; and "something said" in a pdf file that I dug up on the net. It’s important to not look at the pdf file. (Just save it for now.) Until AFTER you have studied the words. So going a little deeper we need an understanding of the words as follows:

### The IMPORTANCE of the words "issue" and "issued" and "rent."

### A web link to the definitions: [dict.die.net](http://dict.die.net/issue/)

When you get there look at the definitions for the word "issue” as a NOUN, as a past participle, and as a verb tense. Guiding insight: I have picked a few of the definitions out to point your mind along a certain thought thread of thinking. Guiding insight: I have changed certain phrases to all UPPER CASE to serve as focus and pivot points of the mind. Inserted insight: I have inserted a few thoughts along the way. definitions numbers ” issue n 1: an important question that is in DISPUTE and MUST BE settled;...." "2. The ACT of sending out ... the issue of money from a treasury."

ACT Hmmm.... Congress is always passing an "ACT" via HR (House Res) or HB (House bill). If you watch c-span for a long time, you notice something, ... some strange words sometimes at the end of the reading done by the Clerk of the House on a great many of the acts. It goes something like this. The Clerk of the House reads the act. Clerk speaking: "HR-1234 An ACT to establish landing ponds for migrating birds along migration paths,...bla,bla,bla,....increases public safety...bla,bla,bla... AND FOR OTHER PURPOSES."

You can never seem to dig out just what the "OTHER PURPOSES" are. I have tried. Maybe I am looking in the wrong place. Then Congress votes and we go into the hole deeper.

Clearly, there is something going on here; things that are announced and things that are secret (the OTHER PURPOSES STUFF).

"Issue \Is"sue\, v. t.

“1. To send out; to put into circulation; as, to ISSUE NOTES FROM A BANK." "9. A point in DEBATE or controversy on which the parties take affirmative and negative positions; a presentation of alternatives between which to choose or decide." DEBATE....

### Hmmmmm. Like "The Declaration on Independence."

"11: the ACT of issuing printed materials [syn: publication] ACT...Hmmmm. like when they issue Federal reserve notes, a form of publication. "v 1: prepare and issue for public distribution or sale; "publish a magazine or newspaper" [syn: publish, bring out, put out, release]" "8: the income arising from land or OTHER PROPERTY; "the average return was about 5%" [syn: RETURN, proceeds, TAKE, TAKINGS, yield, PAYOFF]" TAKINGS....Hmmmm...Like when they take your income through taxation.

### The IMPORTANCE of the word "RENT": [dict.die.net](http://dict.die.net/rent/)

"2: GRANT use of OCCUPATION of under a term of CONTRACT; "I am leasing my country estate to some foreigners" [syn: lease, let] GRANT Hmmm... sounds like some kind of treaty to me. OCCUPATION under CONTACT Hmmm... Like "The Declaration of Independence,"

FOLLOWED by some treaties, then the Constitution of the United States.

"Rent charge (Law), a rent reserved on a conveyance of land in free simple, or granted out of lands by deed; — - so called because, by a COVENANT or CLAUSE in the deed of conveyance, the land is CHARGED with a DISTRESS for the payment of it. — Bouvier." Hmmm... Wonder if a covenant is a treaty??? "Rent (Isa. 3:24), probably a rope, as rendered in the LXX. and Vulgate and Revised Version, or as some prefer interpreting the phrase, "girdle and robe are torn [i.e., are 'a rent'] by the hand of violence."

Look at that, Right from ISAIAH number 3 statement number 24. Actual verse is: "And it shall come to pass, that instead of a sweet smell there shall be a STINK; and instead of an ornamental girdle, a worker's apron; and instead of curled hair, baldness; and instead of purple robes, a girding of sack-cloth; for their beauty shall be destroyed." Hmmmm. Purple robes, long white curly hair wigs, barrister court...

So when "Something" is issued, the issuer still deems ownership, and can RENT its use through an internal re-venue service;” I am leasing my country estate to some foreigners"; because "it is just a hobby."

The IMPORTANCE of the attached pdf file.

In the attached pdf file (filename opnot0004.pdf) you will find "some strange words" on page 6 of 48 pages. The words start with: "(vi) .....debt ISSUED BY ....." Amazing!!!! You now KNOW who owns the debt as in” This note is legal tender, for all debts public and private"

Your title has four questions. It probably should have five questions; with question number five being: "Is it a good thing for the people of The United States of America, or not?"

So for a small thumbnail picture, permit me to re-paint your article title with the fifth question added to the title.

### "Who REALLY owns the Federal Reserve? [Answer] Via the Bank of England, the Queen of England, via the house of Windsor.

### "How did it originate?"

[Answer] Continuation of the money changers in the temple that J.C. got angry about, which set the origin of the first common wealth. And how has it evolved? [Answer] skipping over tons and tons of back data, the current events are: [www.rense.com](http://www.rense.com/general50/king.htm)

### "Is it a good thing for the people of the United States or not?"

[Answer] Yes, but only for a while longer.

"Is it a good thing for the people of The United States of America, or not?"

[Answer] No, but only for a while longer. "The United States" and "The United States of America" are two groups of people.

Here are the links that you should save a copy of, maybe print out and discuss.

THIS IS A MASSIVE COMPLEX SUBJECT THAT CAN NOT BE COVERED IN A E-MAIL.

Except for the home page top link, each link has a cut and paste from the article that the link points to. [www.yale.edu](http://www.yale.edu/lawweb/avalon/avalon.htm) < — -HOME TOP LINK

Hamilton Opinion as to the Constitutionality of the Bank of the United States, 1791 <<<< "Every contract which has been made for moneys borrowed in Holland, induces stipulations that the sum due shall bedded from taxes, and from sequestration in time of war, and mortgages all the land and property of the United States for reimbursement." [See]

The first six letters of the word "stipulations" contains an anagram. It is "TULIPS" as in Dutch tulip bulbs. That's why the phrase"...the sum due shall BEDDED from taxes”. If you have any tulips growing on any of the property that you” THINK YOU OWN"... well... get a shovel, dig them up and destroy them. Then "the STIPULATION" does not attach. Mortgage in French language is "Mort" "Gage" ,a.k.a. "Death" "Pledge".

### Preliminary Articles of Peace: November 30, 1782

".....but so soon as the same or either of them shall be settled, it shall not be lawful for the said Fishermen to dry or cure Fishat such Settlement, without a previous Agreement for that purpose with the Inhabitants, Proprietors or Possessors of the Ground." "The Navigation of the River Mississippi from its Source to the Ocean, shall for every remain free and open to the Subjects of Great Britain and the Citizens of the United States."

Most important article:

### "ARTICLE 9th In case it should so happen that any Place or Territory belonging to Great Britain, or to the United States, should be conquered by the Arms of either, from the other, before the Arrival of these Articles in America, It is agreed that the same shall be restored, without Difficulty, and without requiring any Compensation." [See]

The "In case it should so happen" allowed the delay of part two of the treaty (The Paris Peace Treaty of 1783) till the 20th century. It stayed on the kings mail boat for over 125 years!!!!

The ship never docked anywhere. Re-supply, re-crewing, re-pair all done on the high seas.

"The Paris Peace Treaty of 1783" top page. Many related articles here.

Actual Treaty: ". But which treaty was not to be concluded until terms of peace should be agreed upon between Great Britain and France..." NOTE: I'm still digging for the this "terms of peace" treaty. It is a missing third leg of the puzzle. So far I have not been able to find it. "It is agreed that creditors on either side shall meet with no lawful impediment to the recovery of the full value in sterling money of all bona fide debts heretofore contracted." "The navigation of the river Mississippi, from its source to the ocean, shall forever remain free and open to the subjects of Great Britain and the citizens of the United States." [See]

Well, that's about it for now Sol. There is much more involved in your article title, but I'm getting tired of writing. The Avalon takes a long time to read. A very important book to read that can shed more light on the whole Fed issue is “The coming battle.”

### © 2004 Art Soukup

### Email

### Gale Bullock

### (AKA Ole Bear)

### Proprietor, [www.pgtigercat.com](https://www.pgtigercat.com)

### Pox Americana

"Who REALLY owns the Federal Reserve? How did it originate and how has it evolved? Is it a good thing for the people of the United States, or not?"

### Pox Americana – Mr. Wilson, you are a Traitor!

President Woodrow Wilson was a Traitor to the U. S. Constitution. Mr. House from Texas saw to that. The Fed is owned by key American Family Interests, and there are linkages to the House of Rothschild in the United Kingdom, and the Bank of Rome in the House of Europe. There is nothing Federal about it, and it is not a reserve, nor a depository of any kind. The name of this American central fractional reserve bank is a Fraud. It can rig the heavy metals markets on the COMEX and in NYC through JPChase Manhattan, Goldman Sachs, and the other Neanderthals, if you know how to follow the money at [www.gata.org](https://www.gata.org) and [www.lemetropolecafe.com](https://www.lemetropolecafe.com). Chairman Mao, aa the Grand Vizier, and his pack of thieves are the greatest monetary Charlatans since John Law. Nope, this is not an original idea — I stole it from Reg Howe, Howe versus BIS [www.goldensextant.com](https://www.goldensextant.com). I have no respect for the Green Man, as Sage Richard Russell calls him at [www.dowtheoryletters.com](https://www.dowtheoryletters.com), and the Green Man’s continued destruction of the Founding Fathers’ Republic. I hate the word Democracy, for all democracies since the Ancient Greeks, have failed. Benjamin Franklin indicated at the time of the Constitution, that we created a Republic… as long as we could keep it. Our Founding Fathers created a Constitutional Republic.

These were some of the most brilliant minds of the 18th Century… assembled in 13 Original Colonies under the Bank of England, the first central bank on the planet… with linkages to the Bank of Rome. I like to call Chairman Mao, the Grand Vizier, because I understand his game of the prime directive of total banking consolidation in the united states in america… but then, Folks, I read Larry Becraft down in Huntsville, Alabama.

Being a Southerner from the Mississippi Delta, I have an affinity for President Andrew Jackson and his delicious fight to kill Nickolaus Biddle and the Second Bank of the United States in his second bid for the Presidency of the united states in America. I don’t have much use for Alexander Hamilton and his creation of the First Bank of the United States, the first central bank.

The american educational system dumbs us all down, saying how Kool Woodrow Wilson was helping establish the League of Nations and fighting the war to end all wars. You, Morons! Mr. Wilson was a Traitor to the U. S. Constitution and the legacy of the Founding Fathers of This Republic. All democracies eventually fail. All legal tender fiat paper funnie monie currencies, eventually fail. History wins! You lose!

Nope! I don’t have much respect for the American dumbing down on mr. lincoln, either. It was the War of American Secession, and it was street legal under the U. S. Constitution. It was, in fact, Mr. Lincoln’s war. It was an economic war of the Northern Manufacturing/Industrial States against the Agrarian Economy of the South. Nope, it wudn’t about slavery until it became expedient in 1863 with the Emancipation Proclamation as a political maneuver — (Nope, I don’t like the slavery thing either – morally wrong, in my view, and against the Bible, Jesus, and the Almighty!). mr. lincoln, when quoted a usurious interest rate by the House of Rothschild in Great Britain, and the Bank of Rome, decided to finance the War of Northern Aggression, by printing his own federal reserve funnie monie…. It was called the Greenback. Nope, you ain’t gonna find this stuff in the American educational system or in any college or university, especially Harvard or Yale. Mr. Lincoln did some other really nasty stuff like suspend habeas corpus, shut down some anti-war newspapers in the free states which were unionists, and locked folks up much like that AG from Missouri, Ashcroft. Bless his Religion and we all fall down and pray to his patriot acts, complete with the New Internment camps for terrorists, or the new alternative for debtors prison, thank you Law Professor Jonathan Turley at George Washington University – Liberty Ebbs by Degrees for Camps for Citizens – essays by a Patriot!

What does all this have to do with Pox Americana, you ask? I am laughing to myself. Since I am a also a pianist, and a composer, let's compose a tango, and do a Picardy Third, Folks!… taking you where the composer will lead, not where you think I composed the music!

Let’s compose a tango! Let’s begin by the Histories of the Markets, shall we? All legal tender fiat paper funnie monie currencies, aka Ponzi Shell Games, eventually collapse. Fact. All democracies, which is synonymous with mobocracy, eventually fail. Fact. The United States in America are currently somewhere between a socialist state and a totalitarian state, economically speaking. I have a dictionary-linked essay on this subject called Government and Politics 101 for you dummies out there.

Today in ‘Merca (thank you, LBJ for correcting all of us) – we call it social capital – at the hands of the politicos and elitists inside the Beltway in DC. We have the makings of the modern socialist welfare state where the Neo-Cons can pull the fraud of pre-emptive war on Iraq, and hide the shams and cover-ups to Ma and Pa Kettle on Main Street America regarding the truthout on 9/11.

These are crimes against the U.S. Constitution and The Republic. These crimes wouldn't be possible without the Mandrake Mechanism and the symbiotic relationship of the Big Central government and that which is nothing Federal, nor a Reserve of any kind — nothing but a private central bank, run for the bank and their interests. This private central bank is everything contrary to the intent of the Founding Fathers, the Constitution, and the Bill of Rights. This Pox American is stealing your wealth and prosperity, and that of your children under the Mandrake Mechanism of printing monie out of thin air – using dept to Ponzi the Scheme. Thank you my good friend G.

Edward Griffin, author of The Creature from Jekyll Island – a second look at the federal reserve.

Fact – Since the inception of the Federal Reserve Act in December 1913 with Wilson asleep at the switch, the Jackass FED, including the current smoke and mirrors privateers Bernanke who has a helicopter’s license to throw money out of a jet helicopter with a FRN printing press onboard, McTeer who urges us to all hold hands and buy a new SUV, and the multifarious obfuscations from the Grand Vizier on the economy, has destroyed about 95% of the purchasing power of the Constitutional U.S. Dollar, as a weight of measure at 371.25 grains of fine silver.

Add to that, Socialist Franklin Delano Roosevelt’s Great Scam and Rape of the wealth of America by recalling the gold money, and then, redefining the value at gold from \$24+- per ounce to \$35+per ounce, after the banking holiday just after his first term election – and you realize just how ignorant folks really are on Main Street America. Behind the scenes, the Federal Reserve, the House of Rothschild, the Bank of Rome... And the big American families were smiling…. Shipping their gold to the House of Rothschild. Grin! See how this works? See how to follow the monie?

Yeah Fast Mel Martinez at HUD… We are watching your behind, too! Where is that \$59 Billion you lost at HUD? How’s that Senate Election going in Florida where you can rig an election on a dangling chard, Pal? Mel, ya know, if the Grand Vizier hadn’t pumped and dumped so much, you probably would have less to account for!

If you, Dear Reader, are lost, you might as well turn on the TV and watch a FED induced silly sitcom to dumb you down through the web of media control. If you think you are a smart because you graduated from Harvard Magna Cum Laude, or have a Ph.D. in economics or business on Wall Street, and you don't know this stuff, you have been dumbed down also, by the FED. The fact is I read Dr. Larry Parks, Dr. Edwin Vieira, G. Edward Griffin, James Ewart, and Larry Becraft. I real some really esoteric stuff by Lawrence Reed, Thomas DiLorenzo, Frank Shostak, Ludwig von Mises, Murray Rothbard, Beverly K. Eakman, Catherine Austin Fitts, Lt. Colonel Karen Kwiatkowsi, William Rivers Pitt, Jonathan Turley, Lew Rockwell, Charlie Reese,

Christopher Mayer, Thomas Fryer, and a global cast of characters….

Ed Vieira wrote a great piece called The Federal Reserve: A Fatal Parasite on the American Body Politic….

Here is my summary:

### =

### La Bastille

### = The Federal Reserve

The Federal Reserve will continue until the Constitution is shredded by the AG’s hands, along with it, the Bill of Rights, in the game of the prime directive of total banking consolidation in the united states in America. As my other research and essays indicate — through a methodical and controlled burn in real estate using the GSE money pump mechanism of the GSEs, in the wonderful game of smoke and mirrors called two-tiered structured finance….. while the FED hides behind the curtain like the Great Oz pulling the levers. Welcome to Debtors’ Prison Stalag 13!

### That was a Picardy Third!

I would like to see Ole Hickory challenge Mr. Wilson to a duel on the Money Issue… I know where I am placing my bets! Black Jack, Baby!

Here are some great companion essays from some great minds:

### The Power to Destroy — William H. Peterson

### Law of the Sea Treaty and… — Devvy Kidd

Inflation or Deflation? How about just 'Flation'? — Alex Wallenwein

### How Healthy are the Banks — Frank Shostak

### Gale Bullock, aka Ole Bear [www.pgtigercat.com](https://www.pgtigercat.com)

### •

### •

### •

### •

Internet Linked Essay Version at [www.pgtigercat.com](https://www.pgtigercat.com) will have the linked html as: [www.pgtigercat.com](http://www.pgtigercat.com/FEDFraud/PoxAmericana.htm) For the Prime Directive of Banking Consolidation in the USA, See page 51 of

### Memorandum of Law: The Money Issue

Additional Support linked here on my website on the Definition of Market Value — Fatally

### Flawed?

### The World of the Mafioso Fed — Enervate, Pal!

Janice Dorn, M.D., Ph.D.

### Contributor [www.tacticalinvestor.com](https://www.tacticalinvestor.com)

## Monetary Reform

For thousands of years, the establishment has claimed that chronic rises in the cost of living have been a mystery; or resorted to faulty logic such that soaring CPI is due to rising energy prices.

Over recorded history, there are many examples of appropriate explanation of the "mystery" of "inflation". The earliest known was by Aristophanes in his play, "The Frogs", who explained the phenomenon as due to over-issuance of bad money. This was rediscovered by Oresme in the

1300s and Copernicus in the early 1500s.

The public has shown a surprising tolerance to the rip-off of chronic inflation, but it has also shown the ability to eventually figure it out and react to the scam.

In medieval Russia, "false moneyers" were eventually attacked and had molten metal poured down their throats. Dante even reserved a special place in Hell for false moneyers. The Father of Modern Central Banking, John Law, was lucky to escape the mob when the 1720 bubble burst.

In a slightly different format, the following essay was published in the Financial Post on December 29, 1999 and, for new readers, it includes a vivid description of a monetary reform conducted during one fateful Christmas.

## Princely Finance

One would have hoped that financial rip-offs committed by medieval princes would have been permanently shelved when liberal enlightenment ended the divine right of kings.

Nineteenth Century liberals, so rational and principled in their views, could not have imagined the greedy craft developed by many modern governments in confiscating private wealth earned by productively working citizens. Are we seeing medieval financial tyranny replicated by today's proponents of the divine right of bureaucrats? A look at history provides perspective.

Although outrageous when imposed, the passage of time makes early examples of princely finance somewhat amusing: the colourful Richard I (1189-1199) sold property to finance his joining the crusade of Peter the Hermit. Upon returning, he took it back on the pretense that originally he had no right to sell it.

The infamous King John (prompted the Magna Carta in 1215) introduced the clever plan of imprisoning and ransoming the mistresses of priests; confident that the funds he could not obtain from their greed he would from their lust.

Edward I (1272-1307) confiscated money and silver or gold plate from monasteries and churches, faked a voyage to the Holy Land and, in keeping the money, refused to go.

Edward IV (1461-1483) was described as the handsomest tax-gatherer in the country; and when he kissed a widow because she gave him more than he expected, it is said she doubled the amount in hopes of another kiss.

The fiscally sound Henry VII (1485-1509) approached wealthy families with two arguments. If the household was not extravagant in expenditure, then he attacked what they had saved by thrift; while if they lived extravagantly they were considered opulent and could afford any exaction.

Named after his minister of finance, the ploy was called "Morton's Fork".

A broader form of wealth confiscation capable of tapping even the poor was accomplished by currency debasement and extreme examples in ripping off everyone provoked severe social disorder. No matter what method employed, financial outrage prompted the evolution of parliament as a necessary means of constraining fiscal ambitions of the governing classes.

The struggle between individual freedom and authoritarian state proceeded until the late 1600s when growing commercial wealth and political power in London began to become influential with its financial common sense. The specific event that formalized the victory over the ancient status quo was the "Glorious Revolution" of 1688, which maneuvered the pro-business and Protestant William of Orange into the British Crown and displaced James II as the last absolutist king. How refreshing this was is indicated by the oppressive politics of his and his predecessor, Charles II.

Starting with the restoration of the monarchy with Charles in 1660, both kings were bribed by France to change the culture of England - consistently in an authoritarian direction. Scornful remarks by miffed establishment were similar to those directed to the pro-business "religious right" today.

No matter how imaginative or despotic princely financing was, it can't compare with the longrunning compulsion to spend other people's money by bureaucrats in Washington, unrestrained by the checks and balances of congress, constitution, or mainstream media.

But before expanding this point, consideration should be given to the other event that formally ended the old world, which was the beginning of modern finance with the incorporation of the Bank of England in 1694. As history shows, central banking is fine when disciplined by a convertible currency and, when not, it becomes a tool of state ambition to confiscate wealth though currency depreciation. That the dollar has lost 90% of its value in only 50 years exceeds most princely devaluations and, like those, has been no accident. Regrettably, modern financial agencies such as the Federal Reserve and Treasury have become almost medieval in function.

As outlined in The Federal Reserve System, Purposes and Functions, the Fed Board of Governors touted the usual claims that high growth in consumption and high unemployment could be accomplished with "stable values". Obviously, price stability was impossible due to the insatiable demands of the state which, even with a 90% depreciation in the dollar, has yet to be satisfied. Corruption is chronic.

Today, princely cunning really comes together with Washington's finesse in running the currency down and moving everyone up the confiscation ladder of "progressive" taxation. Sadly, until recently no matter which party sat on the other side of the House there was no serious opposition to today's intemperate collusion of state and religion (interventionist government). Without desperately needed constraint, the combination of currency depreciation and bracket creep with eventually force those below the "poverty line' into unconscionable tax rates.

Fortunately, history provides some antidotes to governmental abuse of the productive sector.

Short of rebellion, the most effective of course has been a parliament accountable to the taxpayer. As for those who have wrecked the currency (also a parliamentary responsibility), Dante, in his Inferno, reserves a special place in hell for "false moneyers".

The Anglo-Saxon Chronicles record something equivalent, albeit more temporal: "1125 A.D. In this year before Christmas King Henry sent from Normandy to England and gave instructions that all moneyers ... be deprived of their members ... Bishop Roger of Salisbury commanded them all to assemble at Winchester by Christmas. When they came hither they were then taken one by one, and each deprived of the right hand and the testicles below. All this was done in twelve days between Christmas and Epiphany, and was entirely justified because they had ruined the whole country by the magnitude of their fraud which they paid for in full." - The Laud Chronicle (E)

Taxpayers deserve reliable protection and with sufficient outrage will likely move rationally to at least limit financial adventurers in government.

© 2004 Janice Dorn, M.D., Ph.D.

### Contributor [www.tacticalinvestor.com](https://www.tacticalinvestor.com)

Special credits are to be given to Bob Hoyle for the above article.

## Bob Hoye, Institutional Advisors

### E-MAIL bobhoye@institutionaladvisors.com

### WEBSITE: [www.institutionaladvisors.com](https://www.institutionaladvisors.com)

### Contrarian Round Table Series

04/02/2004 The Fed

03/19/2004 Bear Market Etiquette

01/21/2004 Inflation has some serious benefits. True or False?

12/15/2003 Have Central Bankers Won the War on Against Gold and Silver Bullion?

11/19/2003 The Dow has never been in a true bear market. True or False?

## Disclaimer

The information contained herein is deemed reliable, but no guarantee is made about its completeness or accuracy. The reader accepts this information on the condition that errors or omissions shall not be made the basis for any claim, demand or cause for action. Any statements non-factual in nature constitute only current opinions, which are subject to change. The authors/publishers may or may not have a position in the securities and/or options relating thereto, and may make purchases and/or sales of these securities relating thereto from time to time in the open market or otherwise. Neither the information, nor opinions expressed, shall be construed as a solicitation to buy or sell any stock, futures or options contract mentioned herein.

The authors/publishers of this article are not qualified financial advisors and are not acting as such in this publication. Investors are urged to obtain the advice of a qualified financial & investment advisor before entering any financial transaction.

---

# Contrarian Roundtable on Central Bankers and Gold

URL: https://newaustrianeconomics.com/archive/fekete/contrarian-roundtable-central-bankers-and-gold/
Date: 2003-12-15
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-basis, backwardation, central-banking, federal-reserve, gold-standard, monetary-policy
Description: A multi-author roundtable from FSU in which nine analysts — including Fekete — debate whether central banks have won their war against gold and silver. Fekete's contribution argues that the gold basis reveals a suppression campaign that is ultimately self-defeating: the lower the basis falls, the closer gold approaches permanent backwardation, which would end the paper-money era.
Editorial Note: Part of a series of FSU (Financial Sense University) Contrarian Roundtable discussions from 2003–2004. This installment gathered nine prominent gold analysts to assess the state of central bank gold suppression. Fekete's section stands out for its basis-analysis framework.
Original PDF: https://professorfekete.com/articles/AEFContrarianRoundtableCentralBankGold.pdf

## Have Central Bankers Won the War Against Gold and Silver Bullion?

December 15, 2003 with Sol Palha, Chris Sanders, George Paulos, Gale Bullock, Bill Murphy, Ed Bugos, John Tyler, Peter Spina and Antal Fekete

### Sol Palha

### Proprietor, [www.tacticalinvestor.com](https://www.tacticalinvestor.com)

### Samuel Johnson — “To have gold is to be in fear, and to want it to be sorrow.”

The answer to this rather provoking question is the central bankers have won and continue to win all the battles on their declared war on Gold. Let's look at the battlefield right now.

Gold bullion is really dropping in every strong currency and has been dropping for a while. It only appears that the central bankers are losing here at home, but that is an illusion for people who have no comprehension of the inflation process. Right now the central bankers are still in charge, though as each day passes, they are getting very close to the edge of a very steep cliff. A picture is said to explain a 1000 words, so I hope the 3 charts will save me from writing a few extra pages.

I will examine this topic in more detail in my follow up articles which will be debuting soon here.

Their titles will be “The Sneak Fed attack on the Metals Market and “The Silent correction in Bullion” where I will examine the fall in the price of gold in over 13 currencies.

### Gold in South African Rand

880 Rands or a whopping 124 US dollars

### “Gold makes the ugly beautiful."

### Molifre 1622-1673, French Playwright

### “Gold's father is dirt, yet it regards itself as noble.”

### Yiddish Proverb

“Gold like the sun, which melts wax, but hardens clay, expands great souls.”

### Antoine Rivarol 1753-1801, French Journalist, Epigrammatist

### Namibian Dollar

800 Namibian Dollars less or a whopping 123.24 US dollars

### Lesotho Loti

800 Loti less or whopping 125.26 US dollars less Is it not coincidental that all these 3 countries are neighbors and all three of them show the largest price differential in gold when it is priced in US dollars? Hum, be careful. We are entering a new era in the financial markets. I would hazard a guess that 90% of the analysts out there have no clue on how to price in currency wars into the financial equation. I will attempt to provide you with some clues as to how this war progresses.

So far looking at gold in 13 different currencies, it appears to be losing the battle in 12 of them. I am able to only show 3 charts here. The rest will be shown in my follow up essay. In my next article, The Sneak Fed attack on the Metals Market, I will examine certain schemes where by the central bankers could have made and probably have made a fortune as a result of the rise in the price of Gold in US dollars.

### Conclusion

Look at the evidence above and you answer the question. Have the central bankers won the war on Gold to Date? The answer is right there. It hurts, it bites, it stings, but it does not lie. Do whatever you want, but the plain cold hard nail biting truth is staring you right in the face. Don’t blink if you are trying to find an excuse.

### “Fear has its use but cowardice has none.”

### Mahatma Gandhi 1869-1948, Indian Political, Spiritual Leader

Will the central bankers win forever? No, they won’t. A war is a composition of many many battles. So far the central bank penguin warriors have won all of the battles, but the day will come when they will lose battle after battle and finally they will lose the war. But they will fight tooth, nail and claw to the very bitter end. The war has just begun and the stakes have been increased be prepared for anything now.

In addition, be careful of those so-called Gold advisors who are forever bullish on Gold stocks.

As you will notice, I keep driving my point home with Gold and Sliver bullion. I don’t mention stocks very often, because stocks — no matter what they are — are nothing but speculation. Does that mean that I do not deal with them? Of course I do and I deal with them a lot. But when I do, I realize that I am speculating. I prefer Gold and Silver bullion because they are in your possession once you buy them. You don’t have to worry about the CEO and the directors lying about earnings or earnings being diluted or illegal shenanigans.

If you chose to speculate, that is fine. But make sure that if you listen to advice that appears to be free, you do so with a healthy dose of salt, especially if there are several hundred thousand people listening to it. Individuals or corporations with that kind of power are known as market movers, meaning that they could shout out that it is a good time to invest in horse manure and the price would spike just because of their large following. As contrarians, you should know that the ones who are not very big are the ones to listen to and there are many such people who post articles on these sites. [www.financialsense.com](https://www.financialsense.com), [www.gold-eagle.com](https://www.gold-eagle.com), [www.freebuck.com](https://www.freebuck.com), [www.goldseek.com](https://www.goldseek.com), [www.goldisfreedom.com](https://www.goldisfreedom.com), [www.solari.com](https://www.solari.com) etc.

Do your own work and research and make sure you check everything — including my advice.

The bottom line is this: there is a huge war going on, there will be many casualties along the way, the strong and the brave will finally win, and the rest will be vaporized. This time round, Gold will finally win the war, but it won’t come without many losses in the battlefield. Nothing good ever comes easy.

“An education obtained with money is worse than no education at all.”

SocratesBC 469-399, Greek Philosopher of Athens“Soap and education are not as sudden as a massacre, but they are more deadly in the long run.

Training is everything. The peach was once a bitter almond; cauliflower is nothing but cabbage with a college education.” Mark Twain 1835-1910, American Humorist, Writer

### "If money could talk, it would say Goodbye!"

### ...Unknown

### © 2003 Sol Palha [www.tacticalinvestor.com](https://www.tacticalinvestor.com)

### Email

### Chris

Principal,

Buy others for news. Buy us for judgment.

### Sanders

### SandersResearch.com

Have Central Bankers Won the Fight Against Gold and Silver Bullion?

The question of whether or not the US Treasury and Federal Reserve can successfully suppress the price of gold on the open market is, by its nature, not susceptible to a yes or no answer. The reason for this conundrum lies at the intersection of politics and economics. The fact that the government and its quasi-governmental allies in banking, brokerage and mining have been

“successful” in gold price manipulation at all has been largely a function of a long-term shift in the consensus of politically acceptable fiscal and monetary behaviour.

It should be immediately apparent from the preceding paragraph that I accept the idea that the gold price has been and is manipulated by a consortium of interested parties, to include the Federal Reserve, the US Treasury, assorted hedge funds, bullion banks, central banks, and mining companies. Absent the ability to subpoena records and the officials responsible, it is highly unlikely that it will ever be possible to prove the case that such a collusive manipulation has indeed been taking place on a systematic basis over a number of years. The reason for this is that the American courts have, since the government defaulted on the gold clause of its bond obligations in the 30s, consistently supported the government in cases of “national interest” as defined of course by the government. The legal issues notwithstanding, there is also a broad consensus in the economics profession that accepts gold price manipulation on the basis that it can be equated to intervention in the currency markets.

However widely accepted this equation is, it is nevertheless false. In the wake of the abrogation by the United States of the Bretton Woods Agreement, gold was demonetised and relegated to status as a commodity like any other. Now, government intervention in say, the coffee market, might be countenanced under certain conditions, but it is hard to imagine it being conducted under the conditions of strict secrecy and questionable accounting such as surrounds its gold operations. Moreover, central banks print fiat money; they do not print gold or even mine it. It is clear that what is desired by those who control them is a situation in which they are released from the burden of accountability, the last vestiges of which were shed with apparent impunity with the destruction of the Bretton Woods edifice of law and transparency.

Related to the desire for zero accountability is the holy grail of infinite leverage. Authoritarian regimes from remotest antiquity have attempted to debase the coinage they issued. It is only in our age that technology, in the form of dirt-cheap processing power, has made possible a hightech form of coin clipping via the derivatives markets. Not only can a derivative not be touched, smelled or seen, but the banks that use them are not even required to report their derivatives books on balance sheet. Banks have many regulators, but these are all concerned with the onbalance sheet borrowing and lending businesses that are their “traditional” businesses. The ban king industry self-regulates derivatives with the enthusiastic support of the Federal Reserve, a private corporation that they, the banks, own.

This confers enormous power to manipulate quarterly earnings simply by altering the assumed discount rate used in calculating the net present value of expected future cash flows. In tandem with the regulatory edifice that has been built up over the past thirty years, this constitutes a formidable engine with which to drive the consolidation of the world banking industry. The model for this was the first Basel agreement on capital adequacy, which allowed the right of selfregulation to the handful of large financial institutions that operated interest rate swap warehouses and granted them higher credit ratings on the basis that they were able to hedge their balance sheets. At a stroke this gave them a strategic funding advantage, and forced anyone else who wished to compete to come to them for the tools with which to do it. Today something similar is happening thanks to Basel Two, which will confer similar advantages on the same cast of characters except this time with respect not to market related risk, but to credit itself.

This can be confidently expected to drive yet another wave of international banking consolidation.

Yale economist Robert Shiller has drafted what must count as the manifesto of infinite leverage.

This is his book, The New Financial Order: Risk in the 21st Century. In Shiller’s New Order cash will be criminalized, the better to canalise all flows of money. Derivatives contracts on all manner of “risks” will be traded and indeed citizens will be required to use them to hedge their incomes, careers, and so on. It doesn’t take a genius, much less an economist, to work out that such a system is workable only by compulsion and that with Shiller Orwell’s nightmare is set to become ours.

The technology to drive this world is already with us and the bureaucracy is not far behind. The regulatory edifice created to combat “money laundering” is no such thing. It will not catch the Enrons of the world because it is not meant to, but it is admirably suited to control individuals.

Married to this are a handful of firms such as AMS, Dyncorp, Lockheed and IBM that manage the software development and financial control and accounting functions for most of the Federal government. AMS, as an example, took over HUD’s internal financial control and accounting systems in 1996, and within two years had racked up \$60 billion in “undocumentable transactions.” It was then brought into the Treasury, where it presumably has worked the same sort of magic.

If this seems a little far afield of the gold market, it is not. Physical gold is flowing into the hands of those with the cash to buy it as is evidenced by more than a decade of a widening disparity between demand and mined supply of physical gold. That gap has been financed as it can only be financed, by the recycling of scrap and by the supply of physical gold from national reserves.

This is the point. The Robert Shillers of the world can criminalize cash, I suppose, but they cannot suspend the workings of the international economy. The functions of audit and control can be subcontracted to “safe” hands, but this does nothing to alter the basic relations of value and risk.

Indeed, what all this really represents is an invitation to racketeering, tax evasion, fraud, and ultimately a breakdown in the social compact. Gold is flowing out of national reserves and into the hands of individuals. Who are they, one wonders? Can it all be going to satisfy the desire for jewellery in China, India and the Middle East? I think not.

The question that really should be asked is not whether the gold “intervention” has worked, but how long will it work. The answer is presumably until citizens of the democracies restore the rule of law and accountability. Barring that, it will go on until all of those reserves are gone and all that is left is the question, cui bono.

### ©

Principal,

### Email

2003

### Chris

### Sanders

### SandersResearch.com

### George J. Paulos

### Editor/Publisher

### Alternatives for Financial Freedom

### Proprietor, [www.freebuck.com](https://www.freebuck.com)

### Central Banks Have Lost the War on Gold

Since Nixon closed the so-called “gold window” in 1971, effectively defaulting on the US government’s obligation to redeem dollars for gold, the world has been operating on a “fiat” currency standard with the US dollar as the prime reserve currency. Previously, international currency transactions were ultimately payable in gold. Now, all payments are made with currencies that are not backed by anything but the authority of government. After some fumbling around with various international currency standards, the world’s major economies settled on an arrangement called the “Basel Accord” which stipulated that central banks will diversify their assets away from gold and into baskets of national currencies. This process necessitated liquidating large quantities of gold from central bank coffers in exchange for currency and treasury securities. Since central banks initially held much of the world’s gold bullion, this large supply of gold coming into the markets depressed the price for many years.

Now, however, world central banks do not have the huge gold reserves of years past and have slowed down liquidation. In 1999, an agreement (the Washington Agreement) was signed that limited gold sales and leasing by central banks. Reduced gold supplies coming to the markets from central banks have lessened the influence that they hold over the gold price. This fact in combination with trend changes in global financial markets has ended the bear market in gold.

Many practices such as the “gold carry trade” and gold mining company “hedging” relied heavily on central bank leasing of gold. In the gold carry trade, investors are allowed to “lease” gold from central banks at very low interest rates (often under 1%), sell the gold and invest the money in higher yielding securities. As a hedge against declining prices, gold mining companies can lease metal from the central bank and sell it for current operating income, agreeing to return the gold from future production. Both the carry trade and hedging had the effect of further depressing the gold price. However, these same practices cause big losses when the gold price rises so they have now been essentially discontinued. The Washington Agreement expires in 2004 and there will be much debate on the future of central bank gold when it comes time to renew.

Why do central banks care about the gold price? I don’t think that they care about the price of gold as much as the stability of the current currency regime. Gold is not so much an enemy of the central bankers as it is an annoyance. A strongly rising gold price implies trouble with the currency regime. However, rising gold does not in itself constitute a crisis for central bankers unless they have leased out too much of their gold inventory and the gold loans default. This would be a public relations fiasco but not an economic disaster since no economically significant transactions are currently made in gold.

Certainly, central banks would prefer a stable gold price. But they have squandered their only tool to control it: their own gold supplies. The central banks should be able to coexist quite well with a much higher gold price; they have already survived a tenfold increase since the 1970s. The real enemies of the central banks are their own monetary mismanagement and the spendthrift fiscal policies of their associated governments. If there is still a central bank war on gold, then they have run out of ammunition.

I think that it is just dandy that central banks are slowly liquidating their gold. This means that they are taking back their own paper in exchange for real gold. Gold is a tool for individuals to defend their wealth against the paper hurricane of the central bankers. Gold in the hands of central bankers is an instrument of oppression. The less gold in the possession of central banks, the better gold will perform its wealth preservation function. One ounce of gold in your hands is worth at least two in the bank!

### George J. Paulos

### Editor/Publisher

### Alternatives for Financial Freedom

### Proprietor, [www.freebuck.com](https://www.freebuck.com)

### Email

---

*December 11, 2003*

### John Tyler

### Quantal Theory

### Proprietor: [www.infognome.com](https://www.infognome.com)

### The Fed’s War on Gold

### “The sinews of war, unlimited money”

### - the Fifth Philippic.Cicero 106-43 BC

War is an organised conflict, rather than the sort of skirmish you might have with the IRS or parking officer. It is seen by some as a stimulus to social and technological progress, and Nietzche even saw it as ennobling. Others condemn war as a destroyer of material wealth and ultimately civilisations. Is this at stake with the Fed’s war on gold?

There is always something at stake, and it’s usually not what is stated. The name a war is given is to act as a container for our thoughts: nothing more, nothing less. “The War of the Roses”, “The Vietnam War”, and “The War on Terror” are examples. Every war has victors, victims and collateral damage.

Polemics aside, what then are we to make of “the War on Gold”? What is at stake?

Let me state clearly that it is not gold itself. Gold is just the battleground.

Sun Tzu, in his classic work “The Art of War” recognizes nine varieties of ground over which a battle is fought. The tactics must vary according to the ground. The last of these nine types of ground is called “desperate ground.” This is ground on which we can only be saved from destruction by fighting without delay, is desperate ground.

Gold, for the Fed, was desperate ground. It had to be conquered for the Fed to survive and retain its master franchise over money. It is this master franchise that is at stake.

### Sun Tzu’s strategy: “On desperate ground, fight.”

Who fought to hold gold’s ground as a means of exchange? GATA and a few gold bugs?

A later commentator on “The Art of War,” Chia Lin, remarks: “if you fight with all your might, there is a chance of life; where as death is certain if you cling to your corner. A lofty mountain in front, a large river behind, advance impossible, retreat blocked.” Another commentator, Ch‘en Hao, says: “to be on ‘desperate ground’ is like sitting in a leaking boat or crouching in a burning house.” My friends, we have been burnt. We are sunk. The Fed has won the war, for now. They have maintained their franchise of total control over the monetary system.

However by winning this war, The Fed is creating the means of its own destruction. The conquering of Gold’s territory as a means of exchange, is the loss of one more restraint on this group of despotic profligates that are destroying the value of their own stock of trade-money!

What can we do? Joseph Hertz, when discussing the probabilities of victory in the Second World War with King George VI said “ All the same Sir, I would put some of the Colonies in your wife’s name.” In other words, he was even telling the King to spread his bets!

This will earn the ire of every true gold bug, but I doubt whether a gold standard will ever return.

Times have changed; the battleground has moved on. Gold can still be a good investment, but like every investment, we should not become attached and regard it as a saviour.

I will leave the final words to Sun Tzu:

### “O ne w ar c an not mak e s ure of c on qu er ing”

### © 2003 John Tyler [www.infognome.com](https://www.infognome.com)

### Email

### Gale Bullock

### (AKA Ole Bear)

### Proprietor, [www.pgtigercat.com](https://www.pgtigercat.com)

### RMS Titanic

### Heavy Metal Ain’t No Rock Band…

My answer is no… the central bankers have not won the war against heavy metal. Since most central bankers in our view fall into the category of Monetary Charlatan Greenspan and his Jackass Buddies, McTeer who predisposes couples to hold hands and buy a SUV, and Bernanke who thinks he’s Gutenberg reincarnate, we suppose that their age is generally 55-60 or older.

Although we feel that the younger jackasses probably do know who Elvis Presley was, and can recognize Jailhouse Rock and You Ain’t Nothin’ But a Houndog, and that they may, in fact, recognize such lyric persuasion as Iron Butterfly's In a Gadda Da Vida (however, you spell it), they probably don’t understand much in the way of the Rollin’ Stones’ Jumpin’ Jack Flash or Get Off of My Cloud. Although we can envision Mr. Greenspan being able to recognize the 3rd Beethoven Eroica Symphony as possibly Beethoven?, (his Fed$peak would convince us that it was Haydn’s rework of Mozart in a new productivity paradigm?), we find it hard to believe that any of these central bankers, or their other G7 or G50 counterparts, ever heard of Commander Cody and the Lost Planet Airmen, Dream Theater, or Yngwie Malmsteen. For them, heavy metal is the electronic Ka-Khing of electronic funnie monie, being created out of thin air. Well…heavy metal is music to my ears, and not all heavy metal is a rock band, Sports Fans!

### Dumb, Dumber, and Dumbest?

Certainly central bankers aren’t dumb, or dumber, but they take my vote for dumbest…

Let’s talk about dumb… the federal reserve system and its tentacles created in 1913 has been able to rewrite history books, influence the economic curricula at every major college and university in the USA, influence elections, produce economists who pontificate on the virtues of the FED, and have dumbed down a Nation under a once Constitutional Republic. The American People don’t understand economics, money, heavy metal, bullion as money or as a commodity (it is both), and everyone in this country believes Abraham Lincoln was the second Jesus Christ.

That’s dumb. Well it has been going on for 90 years since 1913. Secession, and the right to secession from the federal union of the united states, was guaranteed to the states in the U.S.

Constitution, or did you miss that one in the 8th Grade, Sports Fans? If you missed that one, you probably missed the money issue, the U.S. Dollar defined in the Constitution as a measure of weight at 371.25 grains of fine silver, as well. Ho, Humm! Ho! Ho! Ho! Merry Federal Reserve!

### Being from the Mississippi Delta, Ah didn’t…

Now let’s talk about dumber…. There are a lot of folks in this country and on the planet, who are a helluva lot smarter than I, who just don’t get it. Creating money out of thin air under the Mandrake Mechanism? Money backed by debt is sheer lunacy. That’s what central bankers do.

They create money out of thin air. Federal Reserve Notes are the greatest Ponzi shell game in the history of the world, and very few Americans in this country know the smell of bacon

(Bernanke and that printing press smokin’ the bacon, aka inflating the currency, and destroying your wealth, dear reader) that’s burnt to a crisp. Mr. T says it best: “You Fool!”

The dumbest? That’s easy. The central bankers. All legal tender fiat paper funnie monie currencies, which are not backed by specie, aka heavy metal or bullion if you wish, ultimately inflate ‘til they disintegrate into thin air, as they were initially created. That is written in stone as the history of paper money unbacked by specie, and it will repeat, according to our study of the Histories of the Markets. Central bankers are merely re-arranging the deck chairs in our view on the RMS Titanic. Our politicians inside the Beltway should also take heed to our next sentence.

There are a helluva lot of pick ‘em up trucks with gun racks, little ole ladies with 38 snub noses, and other folks who firmly believe in the right to bear arms under the Constitutional Republic. The corollary is: there is also a helluva lot of tar and feathers available in all 50 states, but I am not so sure about Iraq. Dumbest is in our view, is the cigar smoking pot bellied silk suit Gucci shoe position that the central bankers are going to hoodwink a Nation in perpetuity. Perpetuity means Forever, or until the Twelfth of Never. Sports Fans, it just ain’t gonna happen. The days of central banking are numbered. Dumbest are central bankers not coming to grips with reality… there’s not enough police, sheriff departments, or military in the United States of America to protect them from the Mob of Citizenry that may have the propensity to chase them with the Second Amendment… and the unwritten amendment of tar and feathers, when all hell breaks loose, and folks realize their Ponzi shell game of wealth stealing and destruction. That’s a fact, Jack.

McTeer and Bernanke, wake up! Just how fast are your SUVs? Mebbe you Fat Cats need to phone home to the Roadrunner at Warner Bros., and get some extra tips for more ponies for those gas guzzlers? You Kool Kats, may need ‘em, unless you guys run faster than your

SUVs.

### Et Tu Brute, et al Cronius Americanus?

Central bankers to be sure, and our privately owned banking cartel linked to the Bank of Rome, the House of Rothschild, and the House of Rockefeller, et al Cronius Americanus, have won many ignoble battles over the past 90 years destroying the Bill of Rights, the U. S. Constitution, and the Constitutional Republic. This cartel is so linked to the current moral decay of our DemoPublican (See: Nelson Hultberg) political fabric, that it makes me sick of the deception. (See: McFadden’s 1934 Speech and 1932 Speech on the Federal Reserve)

When our Nation under God, whom I implicitly Trust, wakes up and smells the foul stench caused by the federal reserve as the ultimate destruction of our basic freedoms (the root of freedom is sound money), the final battle will be in the streets. It will not be a good time to have ever been associated with banking, or central banking, whatsoever. “What difference does it make if a market is a bull or bear? What’s important are your options in playing the cards dealt, and winning the war against the monetary charlatans at the federal reserve.” – Miss Paula Bear Heavy metal music is always part of my bride’s, and, my listening pleasure…

### Conclusionary Remarks

Heavy metal is not a generally well understood music, very akin to bullion, or the physical ownership of commodity and fiduciary money. We have been dumbed down and tricked into believing that pictures of Washington, Lincoln, Jefferson, Jackson, Hamilton, Grant, and Franklin on pieces of green paper imprinted as FEDERAL RESERVE NOTES are real money. They are not true notes of any kind, as they lack redeemability on demand to the bearer in specie, aka heavy metal. They are a Ponzi shell game…. The biggest in economic history. Our Forefathers who created the Constitutional Republic understood sound money systems in creating the Republic (eh… these are the same Forefathers that despised the word Democracy, all of which have failed since ancient Athens)…. And defined in the Constitution the US Dollar as a measure of weight at 371.25 grains of fine silver based on the Spanish Piece of Eight in circulation in Colonial Times. They understood, what we do not as a Nation dumbed down by the central banking cartel called the Federal Reserve…. Sound money is economic freedom and liberty.

It is our position that central bankers have so far been most victorious in the 90 year war on economic freedom… the final battle on Main Street America remains to be fought by all those that I affectionately call, Ma and Pa Kettle, and their kids, Joe Six Pack and Sally SUV. These Main Streeters aren’t dumb at all… they just haven’t yet been given the right educational materials.

This Bull market in heavy metal, which is caused by the global markets manipulations of the central bankers themselves, is to be believed in our view. I love it when fractional reserve bankers wet their silk suits and Gucci shoes. Jackasses, McTeer and Bernanke… just how frigging fast can you turkeys really run in a Gold Derivative Banking Crisis? Heavy Metal? Be in it, or lose it!

### Selected Bibliography

### © 2003 Ole Bear [www.pgtigercat.com](https://www.pgtigercat.com)

### Email

### Bill Murphy

### Chairman, Gold Anti-Trust Action Committee (GATA)

### Proprietor, Le Metropole Cafe

The Gold Anti-Trust Action Committee (GATA) was formed five years ago to take on a Gold Cartel which has been manipulating the gold price since the mid-1990’s. Gold was trading below \$300 then, the price artificially suppressed hundreds of dollars an ounce below where it would have been in a free trading market.

GATA received the support from some of the major gold producers, mostly South African, and many individuals around the world. With a substantial amount of funds we retained one of the foremost anti-trust law firms in the US, placed adds in various newspapers, held our GATA African Gold Summit in Durban, South Africa in which five sub-Saharan nations attended, and presented our case around the world to all those who would listen.

During the past five years we accumulated substantial evidence the gold price was manipulated by a Gold Cartel consisting of various bullion banks such as JP Morgan Chase and Goldman Sachs, the Exchange Stabilization Fund, the Fed, the IMF and the BIS in Switzerland. The scheme to rig the gold price was put into high gear by former Treasury Secretary Robert Rubin. It was the essence of his “strong dollar policy.” His underling at the time, future Treasury Secretary Lawrence Summers, co-authored a paper while a professor at Harvard titled, “Gibson’s Paradox and The Gold Standard.” The bottom line of the analysis is that “gold prices in a free market should move inversely to real interest rates.” By suppressing the gold price, the US kept the dollar stronger than it would have been, kept interest rates lower they should have been and fueled a stock market bubble. Those were the motives for the price rigging operation.

To accomplish their mission, they surreptitiously dumped 10,000 tonnes of gold into the market place to suppress the price. Most of the gold world believes the central banks still have 28,000 to 32,000 tonnes of gold reserves in their vaults. They do not. They only have about half that much.

Frank Veneroso, Reg Howe and James Turk all used different methodologies and discovered the central banks have lent/swapped out around 15,000 tonnes of gold. They have hid this fact from the world. We know that is the case because the IMF has instructed its member central banks to count lent/swapped gold as gold reserves . In other words, various central banks count gold that has been sold into the market place as gold reserves on their books. This is blatant deception.

The gold is gone. Much of this gold has been hoarded by people all over the world. There is only one way they can get it back and that is for the price of gold to go high enough that the citizens of the world turn the gold back in as scrap to be refined.

This is very important. The central banks only have around 17,000 tonnes of gold left in their vaults. Gold demand exceeds supply by about 1500 tonnes per year. The gold price was suppressed for many years because The Gold Cartel fed enough gold into the market place to satisfy the yearly supply/demand deficit. But now they are hitting a wall. Much of the remaining gold still in the vaults is unavailable for their scheme. Meanwhile, demand for gold is picking up in various parts of the world. For example, China has just opened up the gold market to its citizens.

The surging demand for physical gold is eating the cabal’s lunch and is the main reason the gold price has rallied \$140 per ounce the past two years.

The price of gold is close to breaking into 14-year new high ground, which is going to stun a great many people. What will stun them more is when the price explodes like a volcano. This is going to occur because many of the price riggers will be forced to cover. They and others have massive short derivatives positions which are going to blow up. It could happen at any time. The Gold Cartel did all they could the past two weeks to take gold back down below \$400 and they failed.

Bullion closed above \$400 for ten days in a row. This has to have the big shorts extremely nervous. My guess is some of the big ones are going to run for the hills very soon.

The gold fundamentals don’t get much better than this. Besides an enormous short position out there, part of which must be covered, we have:

Interest rates not far from zero in the US which makes gold a compelling investment Negative interest rates – inflation is greater than the Fed Funds rate, which has always been gold bullish Surging gold demand led by the Indians, Turks, Koreans, Arabs, Russians and Chinese

### A disappearing dollar

Gold producers covering their hedges with Barrick Gold declaring they will do no more hedging ever, which means they will not be bombing the market with gold supply Meanwhile a New Orleans Federal Court judge is allowing Blanchard & Co to sue JM Morgan Chase and Barrick Gold for manipulating the gold price. The case is now into Discovery.

Ramifications from this trial alone could send the price of gold soaring.

Have “Central Bankers Won the War Against Gold and Silver bullion?” Hardly! The reverse is true. The gold price is going to explode and when it does it will expose the nefarious scheme of some of those central bankers. This includes the US, Britain and Germany among others. It is going to be quite a scandal. These central bankers are about to go down to their worst defeat ever. Can’t happen soon enough for me.

### © 2003 Bill Murphy

### Ed Bugos

### Editor, The Golden Bar Report

### Proprietor, [www.GoldenBar.com](https://www.GoldenBar.com)

### Have central bankers won the war on gold and silver bullion?

### An Existential Matter

The central bankers’ war on gold is really a war on money. It is a war on markets, discipline, and progress. In any society based on private property and free exchange the need for money arises. It’s a market phenomenon, the market’s choice if you will.

Central banks, however, exist in order to protect a monopoly on bank notes – a banking cartel – from the discipline of the market, in order to control the process of inflation… to fool the market about its consequences… to redistribute incomes… and to finance the welfare / warfare state.

On the Federal Reserve’s website is the slogan, “The Federal Reserve, the central bank of the United States, was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system.”

By this graph they’ve failed. Or maybe stability isn’t their true aim. Maybe it’s their biggest lie.

Indeed, the reason that the banking system failed in the panic of 1907 (which was the rationale for the creation of the FRB) had nothing to do with the vagaries of the market. It’s true that a market is inherently unstable in the sense that it is always changing. But it is a false claim to suggest that the volatility of the pre-Fed banking system in the United States was the result of the inherent weakness of a free market banking system (see Rothbard’s many works on this).

It was but a system of State banks whose inflation policies were decentralized. There was some centralization due to the National Bank Act after the Civil War, but most banks operated outside of its jurisdiction. 1907 proved only that a central bank was necessary to control this process – i.e. too many different kinds of bank notes produced at different rates proved disastrous. Thus a central bank was the next step in the war on gold.

Indeed, while it is true the annual production of gold is not fixed, the concept of sound money is not in the least intended to mean the “unattainable idea of stable money.” It just means to exclude government from influencing money and empowering the banking cartels in the process.

It means to suggest that a free market, unregulated banking system would produce a money (and financial environment) much more stable than it has become since the Fed.

This truth is what the Fed wages its war on! If people knew that a free unhampered market – or banking system – could produce a more stable money, central banking would rollover and die.

Unlike the wars between nations, however, the wars Statists wage on markets are unwinnable.

It is only possible to appear to win the war on any market for as long as it doesn’t bite back. Even the outlawing of markets (or exchange) within entire societies has historically resulted in the same, which is why communist economies ultimately collapse. We don’t have to engage in war to defeat communism. We just have to sit back and wait – if that’s at all possible.

However, to the extent the unhampered market does not choose gold as its money today, it would appear that central bankers have won their war on gold since their bank notes enjoy a wider circulation than gold does (as money), and owing to the size of government.

But in reality this war too is not winnable because it is a war on the market’s preference. At best, it can only be prolonged. That is the closest that central bankers and Statists will ever come to winning their war on gold – by keeping it alive. It is lose-able after all.

The war can be prolonged so long as governments can grow in size without producing a crisis, and so long as the central banks can find new ways to centralize banking and monetary policy in order to solve the problems they themselves produce, and extend their life span – or the war.

Yes I believe it’s an existential question. The existence of a central bank implies a constant state of warfare with the market in matters of money.

For a current real world example of the existence of increasing centralization look no further than the gradual dismantling of Glass Steagall and the global implications for banking under the Fed’s revamped Basel Accord, as well as recent activities surrounding the BIS – which many fear may become the world’s next lender of last resort, or central bank.

The central banks’ current war on gold reached its pinnacle of apparent accomplishment in 1999 with the announcement that the Bank of England planned to auction off its remaining gold, and with the speculative bubble on Wall Street – fueled by a manic expansion of fiduciary media – reaching a climax of its own, one of historic proportions I might add.

But rather than exemplary of their true success it produced positive consequences that could not be sustained, and negative consequences that in many instances remain invisible to this day – in the extent of resulting dislocation and systemic risk that has accumulated in the economy, the banking system, and for the value of (confidence in) the Federal Reserve Note.

In short, by what has been happening to the value of gold since 1999 we can only surmise that they are gradually giving up ground in this war, which has produced conditions that appear to be biting them in their proverbial behinds (conditions increasingly working against their policy aims).

And in fact, measuring the success of this war by what has happened to the value of the dollar against gold during the entire 20th century relative to its value in pre-Fed days it could be argued that central bankers have actually been losing their war on gold all along despite their success in restricting free coinage, advancing legal tender laws, and persuading commercial agents that a consistently devaluing bank note is still a superior medium of exchange to gold-based money.

In the final analysis, although it may ebb and flow, this war on gold is no more winnable than is a war on money or markets… it is winnable so long as it can be prolonged. If it appears that central banks have won, it is only because they are still in the game.

Hence, central banks are winning this un-winnable war by virtue of the fact that they live solely to fight it.

### © 2003 Edmond J. Bugos

### Editor of The GoldenBar Report [www.GoldenBar.com](https://www.GoldenBar.com)

### Email

### Peter Spina

### Proprietor, [www.GoldSeek.com](https://www.GoldSeek.com)

Gold is money! For over 2,000 years, gold has served a purpose as a medium of exchange. In the history of the United States, the U.S. Dollar was directly redeemable from the U.S. Treasury for gold. During the 1930s depression, gold was outlawed by Presidential Executive Order 6102 (April 5, 1933) which made it illegal for U.S. citizens to own gold bullion coins, bullion or certificates. Months latter, the dollar was devalued from the official \$20.67 per troy ounce to \$35 (i).

In 1944, the Bretton Woods Agreement set the U.S. Dollar as the world’s Reserve Currency and officially adopted the \$35/ounce to one dollar ratio. Decades later, with growing international gold demand for their debt-note obligations, President Nixon was forced to close the “Gold Window.” In early 1973, the global reserve currency lost its official link to gold and the price began to rise, soon reaching the \$200 mark.

Then in 1975, Presidential Executive Order 6102 was reversed allowing the private ownership of gold once again by U.S. citizens. Demand grew and to satisfy this golden appetite, the Treasury Department, along with other Central Banks sold off large amounts of their holdings plunging the value of gold vs. the dollar by nearly 50%. Yet, the inflationary era of the late 1970’s destroyed the dollar’s value by ¼ against other global currencies sending a surge of demand for even more of the yellow metal. In just a few years time, gold soared to a high of \$850 an ounce in early 1980 (in 2003 dollars, inflation adjusted high of gold translates into about \$2,000 an ounce).

With the global financial system teetering in total financial disarray, Federal Reserve Chairman Volcker led a charge to save the falling value of the U.S. Dollar against global currencies, including gold. A series of rate increases were instituted to combat rampant inflation. Eventually, the prime rate reached 20%! This resulted in the soaring demand for U.S. Dollars and the gold rally was crushed.

### Chart courtesy of Kitco.com

Over 20 years have passed with gold in a bear market decline. Central Bank selling, forward selling by producers, gold leasing by Central Banks and a return to the U.S. Dollar as the gold standard of the financial system sent gold to a low of \$250 an ounce in 2000. In 1999, the Washington Agreement, which is up for renewal in September of 2004, capped the amount of gold the participating Central Banks could sell into the market at 400 tones per year.

"This is the shabby secret of the welfare statists' tirades against Gold.

Deficit spending is simply a scheme for the hidden 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 towards the Gold Standard."

### Alan Greenspan - Gold and Economic Freedom (1966)

Central Banks have been a major force in the history of gold. In a monetary system where gold acts as a checks and balance tool revealing the value of the paper currency no longer backed by it, gold is revered as a barometer of the health of a paper currency, thus its economy it represents. It should be of no surprise central banks would be inclined to keep gold’s value in check to avoid any hints of financial tribulation.

GATA has discovered evidence which supports the suspicions central banks were involved in a policy to suppress the price of gold. One piece of evidence GATA uses is a paper by former Treasury Secretary Lawrence Summers from 1988. Mr. Summers’ report refers to Gibson’s Paradox and discusses the effects of declining real interest rates and the positive impact on the price of gold. During his reign as Treasury Secretary under the Clinton administration, such an event occurred as the Federal Reserve was creating trillions of dollars. So why did the price of gold not reflect this event in financial history?

We already know of the documented gold sales by global central banks during this period. If indeed the allegations brought about by GATA can be proven correct, the central banks were victorious in their attempt to control, manipulate and depress the gold price. In a market where there is a supply deficit, central bank selling of their gold reserves has been a major attribute to artificially maintain the global price of the metal subdued.

The question posed whether central banks have been successful in controlling the gold price is yes in this author’s view. In the brief history introduced above, one can see the intervention central bankers have had on the gold price. Yet, it is a question of a short-term success. As central bank supply of gold is limited and their ability to print paper currency is not applicable to gold, eventually free-market forces will prevail. The true value of gold related to the price of paper currencies will ultimately be revealed, yet patience may be required.

### © 2003 Peter Spina [www.goldseek.com](https://www.goldseek.com)

### Email

### Antal E. Fekete

### Professor, Memorial University of Newfoundland

Central bankers are paid hands hired by governments to speculate on their behalf in volatile markets, including the gold market. There they are facing, not other straw men, but flesh-andblood speculators who risk their own money and are in no position to pass on their losses to the taxpayer. The incompetent speculator is eliminated in short order and only the most astute ones survive. In contrast, central bankers have job security and their losses are not personal losses as they are underwritten by the government. Thus the confrontation between them and real speculators is one-sided, and becomes ever more so as time goes by.

There is no wonder that central bankers are virtually always on the losing side. They are like dullwitted and clumsy bears competing with clever and nimble foxes. Long is the list of battles lost by central bankers. Every currency devaluation is a landmark of one, and they number in the hundreds. Preceding each devaluation the central banker is obligated to shout from the rooftop that his currency is never going to be devalued. The louder he shouts, the more convinced do the speculators become that the central banker will soon have to eat his word. Accumulated profits made by speculators at the expense of the central bankers defies counting, so huge are the numbers.

Take the celebrated case of the Bank of France that ended up with an enormous hole in its balance sheet in 1931 in the wake of the devaluation of the British pound. Employees were scurrying like mice to find assets to plug the hole. They added the value of the building, the desks in the building, and the paper clips on the desks to the asset column — in vain. Eventually the French government had to print up non-marketable bonds to make the Bank of France solvent once more. Central bankers learned their lesson from this episode, and they never again allowed their accounting practices become the focus of publicity. The Deutsche Bundesbank never disclosed how it plugged the hole in its balance sheet after the devaluation of the dollar in 1971.

The central bankers’ battle with the speculators over gold is not substantially different.

Speculators have been playing cat and mouse with the central bankers, the role of the mouse being assigned to the latter. After each highly publicized gold auction (whether by the U.S.

Treasury, the IMF or, more recently, by the Bag Lady of Threadneedle Street otherwise known as Me-Too Bank of England) the central bankers have become the laughing stock of the world. The speculators have allowed the gold price to come down nicely to accommodate the central banker wanting to unload. But no sooner had the last bar been sold than speculators bid up the gold price to ever higher levels in order to allow their newly acquired wealth to shine.

It is true that central bankers have tried to enlist the loyalty of the speculators by using bribe and blackmail for the first time. They did not mind squandering the nation’s patrimony, the gold under their control, in defense of an indefensible position. As a result speculators have abandoned their traditional perch on the long side of the gold market and switched to the short. Central bankers had a hearty laugh, congratulating themselves that they have succeeded in finishing off gold for good. They have forgotten that the loyalty of the speculators is ephemeral. At a point — no one knows where it is — speculators will decide that the central banks no longer have sufficient gold under their control to call the shots, and will switch sides once more. He laughs best who laughs last.

### © 2003 Antal E. Fekete

### Email

## Disclaimer

The information contained herein is deemed reliable, but no guarantee is made about its completeness or accuracy. The reader accepts this information on the condition that errors or omissions shall not be made the basis for any claim, demand or cause for action. Any statements non-factual in nature constitute only current opinions, which are subject to change. The authors/publishers may or may not have a position in the securities and/or options relating thereto, and may make purchases and/or sales of these securities relating thereto from time to time in the open market or otherwise. Neither the information, nor opinions expressed, shall be construed as a solicitation to buy or sell any stock, futures or options contract mentioned herein.

The authors/publishers of this article are not qualified financial advisors and are not acting as such in this publication. Investors are urged to obtain the advice of a qualified financial & investment advisor before entering any financial transaction.

---

# Contrarian Roundtable on Inflation

URL: https://newaustrianeconomics.com/archive/fekete/contrarian-roundtable-on-inflation/
Date: 2003-12-15
Section: Popular Economics
Difficulty: accessible
Concept Tags: fiat-currency, irredeemable-currency, monetary-policy, federal-reserve, capital-destruction
Description: Eight financial analysts debate whether inflation has genuine benefits. Fekete's contribution dissects the illusion of inflationary prosperity: rising prices redistribute wealth from savers and wage earners to debtors and asset holders, destroying the productive capital base while creating a mirage of growth.
Editorial Note: A companion piece to the Central Bankers roundtable, also published through FSU. Each contributor addresses the question 'Inflation has some serious benefits — true or false?' Fekete's answer is characteristically unambiguous: inflation is a wealth transfer mechanism that destroys the foundations of genuine prosperity.
Original PDF: https://professorfekete.com/articles/AEFContrarianRoundtableOnInflation.pdf

Inflation Has Some Serious Benefits — True or False?

January 21, 2004 with Gale Bullock, Chris Sanders, George Paulos, Grant Noble, Sol Palha, Alan Lunt, Antal E. Fekete, Ed Bugos

### Gale Bullock

### (AKA Ole Bear)

### Proprietor, [www.pgtigercat.com](https://www.pgtigercat.com)

### RMS Titanic

A Night at the Chicago Lyric Opera? or, Opera is for Sissies….

Have you ever hit a skunk at 70 MPH in a 1994 Lincoln Town Car on I-55 cruising to Chicago to go the Lyric Opera? Your choices are: Yes, No, Mebbe (maybe), and Hell’s Bells — Nah, I don’t like Opera! What’s inflation? More legal tender fiat paper funnie monie chasing fewer goods and services…. aka, Gutenberg Bernanke and his printing press!

Yes, I stunk up the Town Car, but damn those new Kelly Springfield All Season Radials are great…. didn’t hurt ‘em a bit! No, I missed the sucker completely… was that really a 65 MPH zone? Or, Mebbe, but Damn, I was actually doing 85 in an Illinois mandated 65 MPH zone and I didn’t get caught….? Eh? For speeding! Hell’s Bell’s… I would hit a skunk anytime to avoid a night at the opera – Opera’s for Sissies, anyway!

You all see the point here, Don’t You? It is all a matter and manner of Perspective… and ehhhh… Semantics…. Welcome to Fed$peak 101… Welcome to Skunk 101.

Yes, I stunk up the Town Car, but damn those new All Season Radials are great….

Our friend Nelson Hultberg down in Dallas has penned Invasion of the Mind Snatchers and Economic Meltdown, Secessionist Crackup? Scott Trask at [www.mises.org](https://www.mises.org) recently penned The Fed’s Predecessors in American History. Andrew Dickson White penned Fiat Money Inflation In France in the mid 1870s. James R. Cook just penned Funny Money. Timeless essays know no century. Inflation is good if you are the one creating it, manipulating it, telling the citizenry that it is under control and to beware the deflationary Bogeyman! It works for creating and waging wars.

Examples are the Continental, the Greenback, the Revolutionary Guillotine French Assignat, and the Federal Reserve Note. The Continental was the silly paper issued by the Continental Congress to finance the American Revolution. When the House of Rothschild wanted something usurious like 20% for financing the War Against Southern American Secession, Mr. Lincoln pulled a Bernanke and did his own Gutenberg creating the Greenback. The Guillotine Artists of the French Revolution made it a lose thy head crime to own and trade in heavy metal, forcing paper assignats down the Citizens' gullets, while they wrecked their country for the next two centuries…. Leading to Mr. Bonaparte, who mucked things up a bit further. However, Mr.

Jefferson, not completely asleep at the switch, was able to finance Mr. Bonaparte’s traipse into Russia for a mere \$3 million Pieces of Eight, then called in 1803, the U.S. Dollar by the U. S.

Constitution. Mr. Monticello, aka President Jefferson, pocketed the Louisiana Purchase leaving Napoleon with a PUD (Russia) in his hand. This leads to Manifest Destiny, the Teddy Bear Doctrine of Speak Softly, Carry a Big Schtick, and the Bushian Doctrine of Pre-Emptive War.

Welcome to History 101. History is nothing, but the history of money systems anyway. Ask those Romans about the Emperors' coin clipping…

The Federal Reserve Note financed WWI, WWII, the Korean Conflict, the Viet Nam War, and other silly military missives… such as Iraq Crusade I and currently Iraq Crusade II. This coin clipping has been going on since the Garden of Eden or Paradise Lost. Financing wars is a mere drop in the bucket. Yes to inflation and the moral decay of societies, the great giver of social welfare capital, the keeper of politicians and big government, and all of those that will take care of you… Lemme give you a clue – the Crusades were a total flop! The proof? Israel and the PLO -these folks will be killing each other — after Armageddon! Inflation is the central bankers’ means to ensure the Ponzi shell game continues as debt service is serviced like a perfumed, bosomed lady of the night as more patrons seek the heavenly pleasures of more debt in the bed of luscious night. For if debt be repaid, the money supply would thus contract, making illegitimate…. All those stealth Johns and Tricksters of the Night (central bankers, hint … hint). Baron Rothschild, the founder of the Banking Cartel, said something to the effect that given the ability to print money, he could control any government. Smart Dude!

The Continental became worthless paper…. So too the Greenback for most of its life and so too the FRN… the world’s ultimate Ponzi Shell Game. We’ll all know the jig is up when a good lady of the night will not accept the Buck for a Buck… but demands a little heavy metal on the side for a slide, Klyde. Prostitution has a reputation of being the oldest profession….? Probably is, but I suspect that the moneychangers and the politicians mentioned in the Bible, and the clipping of the coins of the realm evolved in that, self same… good night. Dear Reader, did you make the connection? Central Bankers are nothing but prostitutes… and since most are men, that means male prostitutes — of their money systems.

### No, I missed the sucker completely… or Ode to John Denver!

Again, this viewpoint is a matter of perspective. If Joe Six Pack and Sally SUV believe that their new SUVs are great investments purchased by adding more debt on their real estate, which has been making them rich, and they are watching the FED rig the DOW by Mike Bolser’s work at [www.gata.org](https://www.gata.org) on how the repurchase agreements aid Wall Street being suspended by a slender FRN, then all is well in LA LA Land, aka Main Street America.

Who cares about inflation when we are rolling in the dough…. Who cares if our groceries, utilities, gasoline, insurance, and other goods and services cost more paper? We’re rich and rolling in the dough. Our appraiser just said our house was worth \$500,000 on our re-finance, and gosh a golly, we only paid \$250,000 for it three years ago. Thank you realty appraiser and [www.appraisalinstitute.org](https://www.appraisalinstitute.org) for all your Delphi Scams, AVMs, and dive by (drive by or drive bye bye!) appraisals on our realty the past three years. Can you make it \$600,000 this time next year?

Thank you Lord Jumpin’ Jesus Raines at Fannie Mae for Credit Scoring (aka Credit Scouring), and for teaching the world about two-tiered structured finance (aka two-teared structured finance). Should Joe and Sally live in the several county area surrounding and inside Denver with a 15 year high on the Foreclosure Flood, Composer and singer, John Denver, probably says it best in Rocky Mountain High! — Rocky Mountain High…. Colorado! I don’t foresee many ladies of the night in Denver accepting real estate 4th and 5th Deeds of Trust as chattel promises to pay for their services in such a micro realty market. Perhaps I did miss this skunk completely? But, who's the Huckleberry?

Mebbe, but Damn I was actually doing 85 in an Illinois mandated 65 MPH zone…

Illinois is the Land of Lincoln. Chicago is considering passing another \$1 tax on packs of cigarettes. Interstate speed limits on I-55 from St. Louis to Chicago are 65 MPH. We hit Illinois at Louisiana, MO at the Mississippi River on US Highway 54 for our December 2003 pilgrimage to the Lyric Opera in Chicago. Illinois is a trip. It is one of the most agricultural and rural states in the Great Mid-West, yet it has the cultural center of the Mid-West at Chicago on lower Lake Michigan.

It is the home of [www.appraisalinstitute.org](https://www.appraisalinstitute.org).

Chicago rivals New York City in the world of opera as well as the European Capitals. Some of the best opera singers on the planet tour through the Lyric Opera. Currently some Illinois politicians are in the hot-seat for political trickery and taking nice folks’ money. Mebbe inflation of the money supply by the monetary charlatans Bernanke, McTeer, Greenspan et al, the fleet elite Ponzi-ists at the Federal Reserve do deserve some credit and credence for the City of Chicago and the State of Illinois. It costs me more to go to the Lyric Opera now than it did five years ago.

Now I won’t even get near an airplane, Columbia Regional Airport, or Midway Airport in Cicero… because of monetary policy, which creates Fatherland Insecurity, the shredding of the Constitution and the Bill of Rights… If I don’t take my own tobacco, I buy a new bridge over the Chicago River. I suppose for the opportunity to hear world class opera in Chicago, costing me more, making me more self-reliant to drive my 1994 Lincoln Town Car avoiding Mr. Ashcroft’s Gestapo, paying for higher food, lodging, opera tickets, and gasoline… is worth the erosion of my money. Besides, CNBC, the Wall Street Journal, Peoples Investor Daily, and the Government

(BLS, aka Bureau of Lying Spats) tell me I am rich. Hummm…. Mebbe I missed the skunk on I55… but I have a sick feeling that Social Security should be more appropriately called Social Insecurity and maybe the City of Chicago should just go ahead and pass a \$100 tax per pack on cigarettes. Perhaps the City of Chicago also plans to tell Daniel Barenboim how to conduct the Chicago Symphony and play his Steinway next!!??

Inflation is good. When folks is rich, you can tax their assets to death — as long as the ladies of the night accept 4th and 5th Deeds of Trust on real estate as chattel payment for services… play some Eine Kline Nachtmusik for me, á la Mozart! – with all those notes, if you don’t know how to listen, the fleecing is a great trick, or treat, ain’t it, Joe Six Pack and Sally SUV? Big Grin!

Hell’s Bells — Nah, I don’t like Opera… It is for Sissies….

Perhaps, my friends, you all are forgetting the Parable of I-55 and the Skunk…. You hit it, you stink… You miss it, you may miss other stuff… You can’t remember hitting or missing it? — you were driving too fast… not paying attention! So, if you don’t like opera…. Go listen to Billy Ray Cyrus and that trash from Nashville, Achy Breaky Heart.

Nobody considered you worthy enough to teach you how to appreciate opera or the Money Issue. That’s what inflation is all about at the Federal Reserve, Bubba! These rascals have been controlling the educational system from grade school to the university level since 1913 and making sure that their pundit economists get Nobel prizes in economics and that all the American economists visit the ladies of the night at the Federal Reserve, so they can pontificate on the good sex of monetary policy, inflating the un-Holy Hell out of the money system, aka the BUX, to steal your wealth and savings. It keeps the politicians in office, erodes the U. S. Constitution and that silly Bill of Rights and protects the Bank of Rome and the House of Rothschild.

Inflation provides the vehicle for the social welfare capital state in the process of wealth destruction. Inflation ensures that the debt service may be paid. For Alas, Poor Yorick, if the money system contracts in a deflationary spiral, the debt service will not be paid… hence the jig, the Ponzi Shell Game of the central banker charlatans is up. The mechanism of inflation is the Mandrake Mechanism of creating money out of thin air by adding more debt behind the money system… a smoke and mirror… an illusion of wealth, power as a Nation, and prosperity. If you read Dr. Antal Fekete’s work, you will understand that low interest rates and deflation through debt payoff put pin holes in the prophylaxis of the central bankers' skunk… low interest rates tender the present worth of debt much, much higher than it actually used to be. It’s a hard concept to get…. But once the pin-prick is in the Trojan, you will understand how the Horse really works.

Conclusionary Remarks…. Hitting a Skunk with a Deuce and a Quarter?

1970 Buick Electra 225, aka, Deuce and a Quarter… I drive a 1970 Deuce and a Quarter. In

1970, my Deuce stickered and retailed at your local Buick GM Dealer for about \$4,900+ as a Deuce Custom with a 455 with a 4-barrel carb, electric windows, power seats, AT, PB, PS, AT, vinyl top, fender skirts, electric trunk release, AM/FM, and AC. You didn’t get radial tires then, but you did get the fancy naugahyde interior, speed alert (before cruise control), plush carpet, arm rests on the front seat and metallic paint with real Honest-to-God lead in it — go price a GM Buick Electra in today's legal tender fiat funnie monie….

1994 Lincoln Town Car… Given the Choice of hitting the Federal Reserve skunk with a 1994

Lincoln Town Car… or a real Deuce and a Quarter… I should prefer the Deuce to hit the Skunk…. When I hit a skunk in a Deuce…. I don’t need silly FED RESERVE mandated airbags…

(aka the ability to control an industry or crush it…) Buy a Deuce today… if you can find one (heavy metal…. Hint…hint…) Inflation does have some serious benefits and a few pitfalls… for the downside, go talk to your parents about the social welfare state of affairs, the Federal Reserve and Bureau of Lying Spats robbing them blind on increases to their Social Security checks. Mother-in-law (aka Miss Melanie Bear) just got notice of a \$2/month increase in her Social Security check, but an increase in her Medicare deduction. You all, see how this works, Don’t You? It is all a matter and manner of Perspective… and ehhhh… Semantics…. Welcome to Fed$peak and Skunk 101. Answer to Question: True and False, depending on your perspective, whether or not you own, and drive… a 1970 Deuce and a Quarter for hitting skunks. © 2004 Ole Bear [www.pgtigercat.com](https://www.pgtigercat.com)

### Email

### Chris Sanders

### Principal, SandersResearch.com

Buy others for news. Buy us for judgment.

### Does inflation have some serious positive benefits?

The view of many economists that inflation can be a good thing is, from an economic point of view, unobjectionable. Indeed, it is hard to see why, from a theoretical standpoint, that it should be at all controversial. Inflation in the sense that it is most commonly understood is just a way of looking at changes in the prices of traded goods and services. Clearly, from the standpoint of those selling those goods and services, higher prices are welcome. And that is precisely the point. Whether or not it is “good” depends really on who is receiving and who is paying those higher prices.

There are nevertheless problems associated with this way of looking at things because changes in goods and services prices do not actually represent inflation or deflation. These are correctly understood to be states of change in the value of money, and this is a very different thing than changes in the prices of goods and services. All the consumer price index tells you is how profits are shifting in the markets for goods and services. Of itself, it tells you nothing about the value of the unit of account.

This point is far from academic. It has been correctly pointed out over the years by a number of observers that by arbitrarily excluding changes in the prices of certain assets that conventional inflation measures only capture part of the change in monetary value. In the modern American economy this can be readily seen in action. Money in its modern format can be exchanged for bananas or stocks, which is to say that stocks and bananas are substitutes for one another. Over the last ten years or so it has been fashionable on Wall Street to talk about deflation, as in “China is exporting deflation because of its low wages.” At the same time, the price we have had to pay for future earnings of the S&P 500 has soared. Do low or falling wages represent deflation? Not necessarily. They may be symptomatic of it, but they are not proof.

A more serious discussion of inflation requires that its legal, institutional, ethical and moral dimension be examined. It is not for nothing that in ancient times the priestly caste monopolised the business of money and the truth of the matter is that in some ways things have not changed much. Because money has varied functions as medium of exchange, unit of account, and store of value, it is important, indeed vital, that it be dependable. That is the reason, and in my opinion the only reason, why gold is attractive as money. Because of its unique characteristics, it is dependable.

That is why inflation is problematic, and why even those who argue that it can be positive base their conclusions conditionally on inflation being both moderate and predictable. This may well be so over the course of the ordinary business cycle, but it is far from obvious, at least to me, that it is so or even can be so over a longer credit cycle. The reason for this is that such cycles are long.

To get a feel for this consider: the last time the US economy was in a similar position as it is in today was some thirty-five years ago. Does anyone seriously think that the Federal Reserve has a planning horizon that long? In the mid ‘80s Paul Volcker was asked why he had done such and so and he replied that in central banking one deals with yesterday’s problems today, not with tomorrow’s, or words to that effect. This was nothing more than an honest description of the realities of politics.

Indeed, the real problems with inflation do flow from politics, because there is no more political act that the granting of the right to issue money. Today we are living with the consequences of the Federal Reserve Act of 1912, which created the Federal Reserve System, a collection of private corporations owned by the very institutions that it supposedly regulates, and which profit from the money monopoly that Congress granted the Fed.

The creation of the Fed represented the triumph of expedience over principle and of partisan profit over national interest, so what else is new? The Trusts that the Fed’s creation was nominally meant to control were granted ownership of the Fed. The demand of some reformers of the day that the trusts should not be allowed to control the nation’s money but that the government should do so was met by Congress in the breech: Congress nominally accepted the responsibility and then delegated it back to the Trusts. And that is where matters still rest.

The significance of this to the question before us here is that this laid the groundwork for a changed attitude toward debt and inflation both amongst the captains of industry and in society generally, and the Fed’s primary role during the 30s became that of debt accommodation. To be sure, this was at first exercised with circumspection but after America emerged unchallenged for all intents and purposes from the Second World War, circumspection crumbled. The result was Nixon’s expedient abrogation of America’s international treaty obligation, and expedience has governed national monetary and fiscal policy since, as it has for a century at least.

That expedience has led to the progressive consolidation of monopoly control over industry after industry, and the wholesale looting of public assets on a scale not seen since the land grabs in the early days of the Republic. Monopoly control over the monetary system has made easy the financing of all this with debt ultimately backed by the obligation of citizens to pay taxes, which is to say with other people’s money. Another way of putting this is that in monetary terms this has been financed by inflationary debt accommodation by the Fed.

The Fed’s ability to do this rests on the degree of prevailing popular belief in the legal fiction that it is independent of political control, and that it will perform its duties in a proper fiduciary manner.

This is the most transparent fiction, and has resulted in laughable expedients over the years by both the Fed and the government to maintain its “credibility.” So, for instance, in the early ‘80s when house price inflation was soaring, it was dropped from the inflation indices in favour of “imputed rents” that were not soaring. Hedonic pricing was another wheeze that has allowed the harnessing of Moore’s Law in computer performance to the price indices. The Treasury together with the Fed seeks to control the prices of gold, exchange rates and so on, but piously intone that targeting asset prices (i.e. stocks) when they are going up is improper, but supporting them when they go down is responsible behaviour. The Fed has “granted” to its owners the right to selfregulate their market derivatives businesses, which is to say to value their own balance sheets, in flagrant disregard of its Congressional charter, and promoted the extension of this right to include credit derivatives under the terms of the new Basel II Accord.

I doubt that even JP Morgan, who reportedly once told a friend that he lost sleep at nights worrying about an antitrust suit being brought against him, would have in his wildest dreams imagined that he and his kind could, never mind would, get away with this. That the Bushes and the Rubins of our world are not only getting away with this but with much else besides says volumes.

It is no accident of course that as the Fed has pushed interest rates toward zero and the administration has opened the bond floodgates that corporate profits have soared. Workers have not participated in this, and wages are stagnant. Jobs are being created, but in other countries, such that the Fed’s inflationary debt accommodation flows straight through to the bottom line. The Wall Street euphemism for this is that this is higher “productivity” but this is nonsense in any economically meaningful sense of the term. When one looks at personal debt statistics in the United States it is not “productivity” that comes to mind but “predatory lending.” This is a straightforward inflationary siphoning of money from one end of the economic spectrum into the pockets of the other end.

So, gentlemen, in answer to the question at hand I can only answer: it depends on which end of that spectrum you are.

### © 2004 Chris Sanders

### Principal, SandersResearch.com

### Email

### George J. Paulos

### Editor/Publisher

### Alternatives for Financial Freedom

### Proprietor, [www.freebuck.com](https://www.freebuck.com)

Inflation: It’s Not Just a Good Idea, It’s the Law.

The law in question is the Federal Reserve Act of 1913. By giving a small cartel of bankers the exclusive right to create unlimited money and credit, the Act virtually guaranteed long term price inflation. Since 1913, the US dollar has lost almost 95% of its purchasing power. This loss in purchasing power is a direct result of a massive increase in the supply of money that has occurred since the founding of the Fed.

Historically, spokespeople for the Federal Reserve always maintained an illusion that the Fed was dedicated to fighting the forces of inflation using its power to set short-term interest rates.

Nowadays, there is not even a pretense of fighting inflation. Fed governors have now declared deflation, a fall in the money supply and general price levels, to be public enemy number one.

Recently, Fed governor Bernanke stunned the world by admitting that the central bank could and would use the power of the mythical money printing press to create inflation if necessary. Fed Chairman Greenspan publicly lamented that “an unwelcome fall in inflation” would be disastrous to the economy. What is an “unwelcome fall in inflation” anyways? Heck, I would gladly welcome some deflationary relief against sharply rising energy, food, insurance, housing, and medical costs. Why is to my advantage to pay more for everything that I buy?

To be fair, Messrs. Greenspan and Bernanke actually have something to worry about. The massive increase in “money” that I mentioned at the beginning of this essay was a little misleading. The Fed actually creates relatively little money in the sense of the dollar bills that you hold in your wallet. That is true fiat currency. Created from a printing press and backed by nothing, these bills at least have some tangible reality and carry no hidden obligations or interest liabilities. Most of what we call money that is carried in bank accounts, money market funds, brokerage accounts, etc. are actually just credits. There are few, if any, actual bills backing any if this “money.” Money today is almost entirely a balance sheet entry. The money that you and I hold in our various accounts is actually just somebody else’s debt. These debts are packaged as securities and traded as money. They come in the form of Treasury bills, commercial paper, repurchase agreements, and a menagerie of other exotic debt securities that people and institutions accept as payment in lieu of actual cash. Since these are all just debts, they posess the two fundamental characteristics of debt: interest payments and maturity. All issuers of these securities are obligated to pay interest and to reimburse the creditor full face value at maturity. So what happens if some of the issuers of these debt securities default on their obligations? Big Trouble.

The quirky design of the Federal Reserve System makes it rather inefficient at creating and distributing cash-type money, but in coordination with member banks it is fabulously efficient at creating debt. This is called “fractional reserve banking” and it allows your local bank to create gobs of new money via lending, all mediated and facilitated by the Fed. Fractional reserve banking is something like a pyramid scheme (remember Mr. Ponzi?). As long as only a few people try to cash in, the system works fine. But like all pyramid schemes, it needs a constant flow of new funds to keep the game going. Since almost all of the money in existence carries a compound interest rate, the supply of new money or debt must increase by at least as much as the interest expense to support the system. This is where the inflation comes from. Don’t believe me? Look at the chart of M3 broad money supply.

Since 1960, there has hardly been a single year when this broad measure of money materially declined. This is a good thing because it allowed the money game to continue and the country to prosper and grow. Should the money supply start to decline, there would not be enough money to pay interest expense so debts would start to default at an increasing rate. Since debt is also money, disappearing debt will further shrink the money supply in a vicious circle. This is what Greenspan and Bernanke are so worried about. They MUST keep inflation above a minimum level to ensure the proper functioning of the monetary system. It’s not their fault; they did not design the system.

Eagle eyes looking at the above money supply chart may see a little “hook” at the end of the graph. Is that a downturn in the most recent money supply data? Let’s zoom in and see.

Yes, it’s true. M3 money supply has been contracting since Sept 2003. All of the other money measures M1, MZM, and M2 are also contracting. What’s worse is that money velocity is falling also, making the existing money stock less potent. If this trend continues there will almost certainly be trouble in the US economy. This is because the US is incredibly indebted at all levels.

Personal, corporate, municipal, state, and federal debt are at record levels and growing at an increasing rate. Increasing debt requires increasing money to service the debt. If insufficient money is available for debt service, much debt will default and the economy will spiral downward.

Why is the money supply falling? It seems that nobody really knows for sure but there are probably a number of causes relating to overcapacity, global competition, trade deficits, bubbles bursting, etc. Maybe the country just can’t take on any more debt.

What is the Fed to do? Unfortunately, they have already exhausted almost all of the tools at their disposal to “reinflate” the system. They have reduced interest rates to near record low levels in an effort to entice even more borrowing. But as we have seen, more borrowing only increases the strain on the system and the Fed is near the end of its effectiveness using its conventional policy tools. They have threatened to go “unconventional” using untried and aggressive tactics but this will only further weaken an already battered US dollar and may destabilize financial markets. The Fed is in a box and there is little left for them to do except to jawbone the economy into recovery.

It seems that we are near an endgame of some sort. There are people who think that it will end in hyperinflation and those who argue for deflation. It’s possible that we may experience both simultaneously in different markets. The debt situation can only be resolved by either depreciating the currency (inflation) or liquidating the debt (deflation). Investors must prepare for either scenario. This is why many thoughtful advisors are stressing the need for some precious metals and hard assets as part of a sound portfolio. These are the few asset classes that will weather this storm.

### George J. Paulos

### Editor/Publisher

### Alternatives for Financial Freedom

### Proprietor, [www.freebuck.com](https://www.freebuck.com)

### Email

### Grant Noble

### Publisher [www.tradestars.com](https://www.tradestars.com)

In my opinion, we are shifting from gold to TIPS or inflation adjusted bonds as the reserve of choice for the world central banks. That's why talk of them running out of gold is nonsense because they are going to sell it all and a weakening economy will take care of the rest. Factoring out inflation and the fall of the dollar, gold has been in a bear market since last February and will continue to be in one until there is a collapse in the world banking system.

We are not going to repeat the 1970s because there is too much debt around (in the 1970s inflation and lack of deficits made debt a much smaller % of the world economy so leverage in commodities and ignoring bonds was possible — -not today!) The situation is very similar to the early 1930s — -after a stock boom and massive debt accumulation due to 70 years of prosperity and government wars, there was a great struggle for liquidity and the first asset sold was gold.

Gold went down under \$17 an ounce in 1931 and then doubled to \$35 in 1934 revaluation. Gold didn't start to recover until the Bank of England repudiated the gold standard in September 1931.

My research over 300 years shows that gold is not the asset to own in a financial debt crisis (vs. an inflation boom after debts have been liquidated) until the very end. I do believe gold is heading back near 1000 sometime after this year, but it looks like it will get to a dollar/inflation adjusted bottom near 300 before that happens.

### © 2004 Grant Noble

### Sol Palha

### Proprietor [www.tacticalinvestor.com](https://www.tacticalinvestor.com)

There are plenty of good five-cent cigars in the country. The trouble is they cost a quarter.

### Franklin P. Adams 1881-1960, American Journalist, Humorist

Inflation, according to Merriam-Webster online dictionary, is an increase in the volume of money and credit relative to available goods and services resulting in a continuing rise in the general price level.

We all pretty much have felt the effects of inflation in one form or another. However economists and the central bankers chose to define inflation as an increase in price of goods. This is a very clever way to actually hide what they are doing. If they are able to inflate the money supply but keep the cost of certain good suppressed mainly those that the common Joe uses everyday, they have more or less won. The simple reason being that the average person has come to view inflation in terms of price increases.

One mechanism to keeping the cost of common goods down is through the use of heavy subsidies. This is used everywhere in the farming sectors, Manufacturing and industrial sectors, etc. I will elaborate on this in more detail on a follow up essay as this would a deviation from the topic at hand.

There are some incredibly positive attributes to inflation. As an investor/trader I am interested in trying to find the best investment and make the most money I can on that investment and inflation actually plays a big role here. The only problem with inflation is that for the most part the poor actually become poorer and the unprepared move down 1-2 ranks. That is why the saying originated the “poor become poorer and the rich get richer” while the middle class get wiped out.

Since we have greedy slugs at the helm of the banking system, their inflationary tactics are designed to produce unequal benefits. Normally if one inflates and spreads the money equally there is no net change as the price of goods move in equal percentages to reflect this increase in the money supply. However the central bankers will have none of this. They want to inflate as much as possible and at the same time redistribute as little as possible of the new money they have just created out of thin air. The net result is that if you are unable to see in which direction they are moving, you will simply be left paying the tab. Your purse that was once full is now ¾ full and the prices of goods have moved up unevenly.

This is what is happening now. Manufactured goods are extremely cheap; yet look at the price of houses. Commodity prices have shot up, housing is getting to be beyond the reach of most in big cities. Salaries have not kept up with the level of monetary inflation. The only way people are able to buy houses is because of the low artificially controlled interest rates. This fools many a new buyer into taking a debt that he/she really does not have the means to pay of.

However despite all these negatives the astute investor can make a tremendous killing if they take a little time to look at what is going on. For example the astute investor would have started to notice that prices of houses started to increase rather drastically towards the end of 1999 and early 2000. They would have also noticed that Gold actually broke its Downtrend in 2000. They would have noticed that basic raw materials broke their down trend in Early 2003. They would have also noticed the trend of printing more dollars, if they bothered to read what this new administration was proposing. So the middle class family could have taken a mortgage and bought one house as the price inflated they could have possibly taken a loan on the existing house say at the end of 2000 or early 2001 and used it to buy a second home. They could have put some of their money into Gold bullion and a little into some gold stocks, many of which are up over 600% since 2000.

Let me give you a real example of prices, in one neighbor hood in New York and how someone really did something to preserve his way of life. I am not going to mention specific names. This person was a cab driver and in New York one can earn a living driving a cab. He noticed that houses were increasing in price and so bought his first home in 2000. In the middle of 2001 his home had increased in value by over 10%, so he took a second mortgage and bought another home and then rented this unit out. In 2002 both his properties were now really shooting up in value. So he quit his job and bought two foreclosures homes, fixed them up and rented them.

Well to make a long story short. He has now sold all the homes and has enough money to retire and take it easy.

What did he do? He spoke to several knowledgeable individuals to get as much information as possible on the subject of inflation. He then read as much as he could. Remember we are talking about someone who really was not highly educated but took the time to educate himself. He has now spared himself from the insidious effects of inflation that many of his co-workers are now experiencing.

Let's now look at the true full range benefits of Inflation. In this world if you do not spend time educating yourself the price you pay is extremely high.

If you thought education was expensive, try ignorance for a lifetime.

Almost every Gold bug is secretly rooting for inflation. Why do I say this? If they are expecting Gold to reach 800, 1000, 1500 etc they are rooting for inflation. Gold prices are one of the main indicators that there is something seriously wrong with the banking system and that the monetary supply is going out of control. In the later stages we have the fear factor that actually tends to push the price of Gold right into the stratosphere as everyone panics and looks for away to protect their assets.

Those that have bought real estate are also secretly rooting for inflation, as they want the prices of their property to increase. If you really take the time to think about it inflation is very beneficial to the astute investor. Those that are investing in the stock market are also rooting for inflation. It is the free money policies that push people and business to risk more of their money in the market. Look at the present market, it keeps going higher and higher, but when you price it in Rands or any other strong currency it has done nothing. But the astute investor was able to see that the central crack head bankers were out of control and knew that not only would Gold prices rise but there would be a rise in the price of general equities to.

These prices increases have more then compensated for the inflationary practices of the central bankers. However the only ones to have received this benefit are a small group of elite investors and the cronies of the central bankers who were privy to this information, long before these Junkie started to run the press.

When you think about it, life is nothing but one huge market place and in the end someone needs to lose in order for someone else to win. Not everyone can win and not everyone can lose. The sad part is that it takes a lot of someone’s to lose to make one someone wealthy. The net effect is zero. Money is not really lost it simply moves from many pockets to one big fat pocket.

When the NASDAQ crashed everyone was made to believe that several trillions dollars of wealth were lost. That was and is a fat huge lie. Those trillions of dollars simply moved out from hundreds of thousands if not millions of pockets into a select few thousand pockets.

It’s a net 0 game. So when people scream about the negatives of inflation. They are doing so because they have not taken the time to educate themselves on the many tools that are available to protect themselves against this insidious disease. This once again brings life to the saying, “A Empty Tin makes the most Noise.”

In spite of the cost of living, it's still popular.

### Kathleen Norris 1880-1966, American Novelist

Do I condone inflation? No I don’t. Do I really think it is something great? No I don’t. But what I think and what can me or others rich are two different things. The central bankers are not going to change; they have been doing this for far to long. . They are masters at this game, one day they will lose but I might be dead and gone by then. So rather than being an empty can screaming from the top of my lungs about the negatives of inflation, I would rather be a silent full can smiling on some sunny beach with a margarita in my hand and reading a good book. I will leave the screaming to the Empty cans, who seem to have plenty of time on their hands.

In the end all that really matters is for one to find a way to take care of themselves and their loved ones. And if you take the time to educate yourself on how inflation works, on how the central bankers work you can ride on their backs for free and increase you net worth while you are doing so.

Next to inflation, majority rule is the most ingenious scheme ever contrived by government.

Most people have never dared to question the basic morality or logic in the assumption that the majority should have power over the minority. A majority of the people in the South once believed in black slavery. Did that make it moral? A lynch mob is majority rule stripped of its fancy trappings and its facade of respectability. In a community where homosexuals outnumber heterosexuals, should the majority have the right to outlaw sex between married partners of the opposite sex? In a community where atheists outnumber non- atheists, should the majority have the right to outlaw the practice of religion? ... a dictatorship allows only a small number of people to interfere with the rights of others, a democracy makes it possible for great numbers of people to impose their will on others -through the force of government. Is an act of aggression more right if carried out by the majority than by a dictator? Since approximately half the eligible voters vote this means that approximately 75% of the people are ruled by 25% of the people. Robert J. Ringer,

### American Writer

### © 2004 Sol Palha [www.tacticalinvestor.com](https://www.tacticalinvestor.com)

### Email

### Alan Lunt

### Contributor

### Tactical Investor

It was an honour to be asked by Sol to contribute to the discussion, as I am an unknown. Before I entered the markets I spent 27 years farming and seven years on and off in forestry cutting trees off at ground level. I learnt a cartload. From forestry it was that there are 2 really dangerous times, the first is when you are learning and the second is when you know how. From farming it was the firsthand knowledge of how inflation works in a primary industry. On 3 separate occasions I saw the value of my farm double in the space of 2 years, and saw it halve in value once. Those are not conditions of stability, which are needed in order to make sound business judgments, particularly from a long term prospective.

I define inflation as an increase in monetary aggregates; an increase in volume and an unsustainable condition. When a animal dies on a farm, if it is not disposed of quickly, it inflates into a putrid, rotten, seething mess before it collapses into nothingness. It is a natural cycle, one that cannot be tampered with. In monetary inflation there comes a point when inflation will implode on itself too.

All the increase in the value of my farm did was give me the ability to borrow more so I could pay for the increase in costs, it did nothing like the same orders of magnitude to my income. Inflation stole my profitability. It is a sneak thief, a plunderer and a slowly tightening vice. At some point the production of goods has to become profitable or the production ceases. The laws of diminishing returns turns into a race for economies of scale. Inflation causes farm prices to rise but the value of what comes off the land does not increase. All that has happened is there is one more sole out there looking for work and one more deserted dwelling.

I saw, I felt, but didn't understand the dynamics of inflation. My learning came when I was a practical farmer, does this mean that now I have to face dangerous times? I think the answer is yes. I look around this town and see house prices that are double from this time two years ago.

The house is still the same, it has not earned t its increase in value, sure the owners are happy but what they don't see is that the value of their cash money has been cut in half in relation to house prices. We do not measure money against things, we measure things against money.

What is the constant? What is the one thing that does measure money?

I view Sir Alan Greenspan as the world’s most powerful man. His decisions affect the globe. His open spigot policy is harming commodity nations. He has increased liquidity to such an extent globally that the world is sloshing around in paper money. That money must find a home, too date it is stocks and property. Also the ingrained psyche is demanding that money must be spent before it looses value.

Each country has an individual business cycle and Keynesian Theory demands a loosening of liquidity by the central bank of the country affected by business weakness. In New Zealand the business cycle was not in trouble, we were coming off a currency low, there was no need for added liquidity. But the money pump from the Fed spilled over into this country. The flight of US dollars literally poured money in. That money has found a home here and property. Prices have rocketed. In communication with Dr Brash, the past Reserve Bank Governor, he said to me "that he thought a little inflation was not a bad thing". That may be true when you are being paid in local currency, but when your income is from the international markets and you are battling currency rises as well any increase in costs inflation is destructive. Greenspan's policy is slowly but surely destroying our primary sector. Money is coming here because we are a commoditybased nation that same money is destroying the base it came here looking for. When that money leaves again it will leave a spent carcass and people wondering what on earth happened. It will leave a debased currency.

Is inflation a good thing? I view it as destructive, insidious, mercurial, hidden and most of all debilitating. Gold is the only weapon we have for protection.

### © 2004 Alan Lunt

### Email

### Antal E. Fekete

### Professor, Memorial University of Newfoundland

The chief salutary effect of inflation, ironically, is deflation. Of course, this is contrary to the designs of the inflationists who in 1971 advised the government of the United States to destroy the gold standard. They justified inflation as "the lesser of two evils." They abhorred deflation, a beast they admittedly could not control, but thought that inflation was a tame beast that they could. Their utter failure to grasp the fact that the destruction of the gold standard would, albeit with a lag, cause deflation once the pendulum swung the other way, has landed the world in the present precarious position. Their policies have made the Kondratieff long-wave cycle, consisting of alternating inflationary and deflationary spirals, to get out of control. It was criminal negligence of gigantic proportions on the part of the inflationists that they have never investigated the more remote consequences of the destruction of the gold standard .

Of course, the inflationists realized that their anti-gold policies would destabilize the dollar, and unleash speculators in the foreign exchange market. They welcomed this as a salutary development, and they recommended the manipulation of monetary and fiscal policy as a means to save the dollar from immediate and complete destruction. What they did not realize was that their anti-gold policies would also destabilize the interest-rate structure, and unleash speculators in the bond market as well.

Interest rates, no less than foreign exchange rates, were stable under the gold standard.

Speculation in the bond market, no less than in the foreign exchange market, was non-existent.

There was only benign arbitrage which kept foreign exchange and interest rates stable in the face of temporary disturbances such as crop failures or earthquakes.

No inquiry was held into the problem what consequences gyrating interest rates may have on the world economy. In particular, the deflationary danger inherent in a prolonged fall of interest rates was completely ignored. The point is still not widely appreciated, and the world is totally oblivious of the mortal danger of a depression that might come about as a delayed side-result of the destruction of the gold standard thirty years earlier. Economists of the current vintage have been trained to parrot the slogan that "the gold standard was the direct cause of depressions." This is the exact opposite of the truth, as the following discussion will reveal.

Bond speculation is no zero-sum game. Virtually all speculators are on the long side of the bond market. They follow the lead of the Fed in buying the bond (or interest-rate derivatives). In fact, the Fed makes bull-speculation in bonds risk-free through its open-market operations. The question arises: who are on the short side? Why, the producers, of course. They are passive participants, whether they like it or not, with their capital at stake, who stand to lose as the rate of interest falls. Literally, they have no choice in the matter. They are the sitting ducks in this unconscionable shoot-out arranged for the benefit of speculators by deliberate government policy. Moreover, the producers are quite unaware of what's going on. In particular, they are completely oblivious to the fact that they are being served up as the sacrificial lamb on the altar of government omnipotence. Bond speculation aided and abetted by government is responsible for denuding producers of their capital and for transferring their wealth to the bond speculators in the form of unprecedented profits. As the producers lose their capital, the domino-effect of falling firms paralyzes the economy, causing unemployment and collapsing prices.

The present deflation, caused by inflation, is most conspicuous in Japan. It should be our signal heralding the coming depression. We should heed the warning and stabilize the interest-rate structure forthwith by opening the U.S. Mint to the free and unlimited coinage of gold. If we fail to do this, then we may have to pay a terrible price as history's worst depression will engulf the world economy, wiping out prosperity.

### © 2004 Antal E. Fekete

### Email

### Ed Bugos

### Editor [www.goldenbar.com](https://www.goldenbar.com)

### Does the Policy of Inflation Have Positive Benefits?

### None its Proponents Would Admit To

Debating that question from a Contrarian point of view (i.e. that it does) is a tall order for me because I’ve argued relentlessly – as many of my peers have – that inflation has at best no benefit, and at worst, enormous negative consequences. Though I’ve considered many of the alleged benefits, I’ve discovered none that could qualify as a real economic or social gain (for the purpose of brevity we’ll assume the reader accepts the definition of inflation solely as it applies to the growth of money and credit – rather than prices or a price level).

Clearly, at any rate, mine is a controversial position today, because it implies in absolute terms that even the slightest change in the supply of money is “undesirable.” While undesirable may be a good word to conform to the common lay interpretation of that concept, it is exactly the wrong word to describe a sound objection to the policy of inflation.

Untenable or futile might be better. Lacking any utility would be accurate. But claiming that inflation is undesirable is technically incorrect, because many people actually desire it. Implicit in that fact is that they think they can obtain a benefit, and for some period of time they probably can. It’s merely a matter of being in the right place in line. The real trouble is keeping your place.

Real estate developers routinely tell me how they love inflation – because their properties go up in value while they’re developing them. There must be gold bulls, that underneath the surface at least, secretly worship inflation because they own a few gold stocks, or like to hoard bullion, and despite what they say in public (Kudlow is an exception). The same applies to many industries and segments of the economy. Most people must think they benefit from the inflation of money supply on one level or another, else there would be no sustainable mandate for it in a democracy.

Yet most of these benefits are largely self-interested, and illusory. Or at least I claim they are.

For, in a time where even some of the most ardent hard money types accept a degree of inflation as for one reason or another necessary or beneficial, or not worth disputing, where inflation has reigned almost year in and year out for more than a century, and where most economists both public and private impute some degree of validity to the concept, the assertion that inflation confers no economic benefit on society must also sound relatively reactionary, or outdated.

Are we to believe that everyone else has got it wrong? How arrogant!

Well, there’s more. The fact that everyone has got it wrong is partly deliberated. The theoretical framework for most policy is either Monetarist or Keynesian on some level. Indeed, our argument is basically that the credibility of the theoretical constructs used to justify inflationary policies rests not with their validity, but rather with their convenience to the interests of the proponents of easy social policies, which don’t benefit anyone. If making that charge is arrogant, so be it.

We live in a world that is governed by the market’s laws, but which refuses to accept the market’s discipline. Instead we’ve erected huge institutions to challenge or control the market. Through shared interests we have come to accept their flawed theories, and related alchemy.

But rather than reiterating the Libertarian and Austrian School argument that inflation confers no benefit whatsoever in the first place, I’d like to instead point out that I’ve found few instances where even the proponents of inflation (in terms of money and credit) are willing to argue directly that it confers a true economic benefit.

It seems their preferred strategy is to ignore such arguments, and to redefine the concept of inflation such that it is okay to despise it without arguing against an expansion in money/credit.

In other words, because inflation is generally defined as currency debasement or a quickening pace of increase in the general price level, rather than an increase in money supply, the debate over the benefits (or drawbacks) of money supply expansions specifically loses relevance.

Notwithstanding, rationalizations exist. The following benefits are commonly cited:

1.

2.

3.

4.

5.

6.

7.

8.

### We need a lender of last resort

A growing economy needs more money (suggesting a positive impact on productivity)

### Price stability (ironically)

### Credit / monetary cycles can last indefinitely

### Markets need liquidity

### Everyone should have the opportunity to own a house

The socialist’s goal of achieving full employment on its terms rather than the market’s

### Money supply as a general tool of economic policy

Forgive some of the overlap. For example, numbers 2, 3, 5, 6, 7, and 8 are inherently the same because they all suggest that money is part of society’s productive capital (as opposed to merely the medium of exchange). Nevertheless, these seemingly positive rationalizations differ markedly from the benefits that the proponents of the policy actually aim for.

Once it is seen that the theoretical support for the veracity or efficacy of the rationalizations above breaks down easily, we’re left wondering, either the government is dumb, or those aren’t the real reasons they prefer the policy of inflation.

Of all the various groups that favor the policy of inflation for its perceived benefits, the two most influential sectors are the nation’s banking system and government.

The positive direct benefits that governments actually believe they can obtain (but never quite can, and never admit to aiming for) are generally recognized as follows:

1.

2.

3.

4.

5.

Policy exculpation and utility in sustaining deficit spending generally

### The financing of programs incapable of passing taxpayer scrutiny

The financing of election campaigns (by using it as champagne for the economy)

The financing of emergencies such as war is seen as a productive use of inflation policy

### Growing the dependency of society on the welfare-warfare state

6.

7.

Wealth redistribution to bureaucrats, politicians, regulators, and/or unions

### Empire building

Some of the benefits a banking cartel might secretly strive for, from inflation, are:

1.

2.

3.

Control over wealth and its redistribution to financial sector / banking czars

The subsidization of extravagant lending practices (and fractional reserve banking)

Concentration of power (since centralization is required to sustain any inflation policy)

However, just like the real estate developer would only admit to desiring inflation in confidence, these influential groups aren’t likely to admit to these particular benefits any time soon, for fear of implicating themselves and undermining the credibility of the fallacious theories they peddle.

Instead, they pretend that the growth in money supply is but a byproduct of economic progress, and growing wealth. They attribute credit to the market system for inducing the creation of money all on its own, as if it could be sustained without a central bank to influence and alter values (i.e. to control/postpone the consequences), and as if the government’s spending demands caused none of it. And they readily attribute credit to the central bank for stimulating an expansion in employment through its manipulation of interest rates (the price of credit). Socialist governments in particular tend to promote the benefits of inflation for everyone but themselves.

Thus they justify inflation by lying to you about the nature of the benefits it produces (because the wealth is denominated in a currency that ultimately devalues according to the laws of supply and demand and the basic theory of the value of money), but rarely claim to pursue any of the more insidious self-interested benefits gold bugs claim they strive for via the policy.

For instance, in the paragraph before last, the reality is opposite; the market should be credited for producing any kind of real recovery, and central banks should be blamed for their influence in the market of sustaining a policy of below market interest rate levels – easy money – leading to the creation of too much money (and credit), which really undermines the market’s potential to efficiently satisfy society’s true needs.

In conclusion, it is the monetarist idea that is victorious, in so far as the academic world does not attribute any significance to the most significant single influence on the value of the currency, and consequently, on the price structure of the economy – the growth of money and credit. In such an environment of denial, the question of the benefits of inflation is incidental to the fantastic claim that inflation is low or nonexistent.

The reason this path is chosen, in my view, is that we are in fact in the 21st century. The nature of information has changed, people should be increasingly less easily fooled, and perhaps it is easier to argue something is black when its white than to argue the veracity of some of the traditional but increasingly discredited rationalizations in favor of the policy of inflation.

But the question remains, if even the benefits that inflation’s proponents secretly pursue confer no true or sustainable benefit, why has the policy lasted so long, and why is it still so popular?

Either our basic argument is incorrect, or the proponents of inflation are too dumb to understand the consequences of their actions, or they are flat out enemies of money, and consequently, the free market. If our argument is sound, the remaining two options are sobering thoughts.

### © 2004 Edmond J. Bugos

### Editor, The GoldenBar Report

### Email

### Contrarian Round Table Series

12/15/2003 Have Central Bankers Won the War on Against Gold and Silver Bullion?

11/19/2003 The Dow has never been in a true bear market. True or False?

## Disclaimer

The information contained herein is deemed reliable, but no guarantee is made about its completeness or accuracy. The reader accepts this information on the condition that errors or omissions shall not be made the basis for any claim, demand or cause for action. Any statements non-factual in nature constitute only current opinions, which are subject to change. The authors/publishers may or may not have a position in the securities and/or options relating thereto, and may make purchases and/or sales of these securities relating thereto from time to time in the open market or otherwise. Neither the information, nor opinions expressed, shall be construed as a solicitation to buy or sell any stock, futures or options contract mentioned herein.

The authors/publishers of this article are not qualified financial advisors and are not acting as such in this publication. Investors are urged to obtain the advice of a qualified financial & investment advisor before

---

# The Gold-Demonetization Hoax: Gary North Is Wrong On Gold

URL: https://newaustrianeconomics.com/archive/fekete/the-gold-demonetization-hoax/
Date: 2003-09-25
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, gold-standard, fiat-currency, irredeemable-currency, monetary-policy
Description: Fekete contends that gold was never truly demonetized — it continues to function as monetary reserve at central banks and its basis (the spread between spot and futures) still governs interest rates. He directly rebuts Gary North's claim that gold's monetary role is permanently finished, arguing that basis analysis exposes the ongoing monetary reality.
Editorial Note: A direct response to Gary North's arguments on gold demonetization. Fekete introduces readers to basis analysis — the spread between spot and futures prices — as the key tool for understanding gold's continuing monetary role, a concept central to his later work on permanent backwardation.
Original PDF: https://professorfekete.com/articles/AEFTheGoldDemonetizationHoax.pdf

### Introduction

According to official doctrine gold was demonetized in 1971 by the "Group of Seven", governments of the most important trading countries of the world. Demonetization was meted out as a punishment for "bad behavior". In the words of Paul A. Volcker gold has been tolerated as long as it was content to act as a constitutional monarch. No sooner had gold asserted itself as an absolute monarch than it was dethroned. Indeed, by a stroke of the pen the 5000 year old monetary reign of gold was unceremoniously terminated over the entire globe, never again to return.

But was it really? This is the question that Gary North is grappling with in his paper "The Remonetization of Gold" ([www.LewRockwell.com](https://www.LewRockwell.com), August 14, 2003). North is happy to accept the official doctrine that gold is no longer money. Moreover, he doubts that it ever again will be - short of an economic cataclysm. Even though the world needs gold as money, he contends, the transition costs would be astronomical. "Everybody wants to go to heaven, but nobody wants to die." North blames the consumer, not the government. He asserts that there has been a huge, historically unprecedented collapse of demand for gold since 1914. "Demand for gold today is for industrial and ornamental uses, not monetary uses."

In this rejoinder I take issue with North and show that no combination of governments or consumers has the power to eliminate gold as money, any more than they can eliminate nature.

The dictum of Horace applies: "Naturam expellas furca, tamen usque recurret" (Expel nature with a club, return how it will). I also reject North's simile that the pill of gold circulation is a pill of suicide. In reality going to heaven would take nothing more drastic than opening the Mint to the unlimited and free coinage of gold, as mandated by Constitution of the United States of America.

### What makes gold the monetary metal?

Gold is the monetary metal par excellence because it has constant marginal utility. While the marginal utility of every other commodity declines at a more or less rapid rate, gold has over the millennia displayed a rate of decline lower than that of any other. This fact has made gold leapfrog as the substance of preference when it comes to hoarding. Existing gold hoards have a feedback effect on the hoarding decision of individuals and, as a result, gold's marginal utility by now declines so slowly that it is practically constant. Gold hoards are so huge that they constitute a high multiple of annual output at present rates of production. We express this by saying that the stock-to-flow ratio is by far the highest for gold. By contrast, existing hoards of other metals constitute a fraction of annual output. Their stock-to-flow ratio is low. No sooner had a good other than gold been produced than it did disappear in consumption. By contrast, hardly any gold is consumed. When it is, as in jewelry, the monetary form is never too far away and can be restored through relatively inexpensive processes of recycling.

To put the unprecedented hoards of gold into context we must point to the superb confidence that individuals and institutions have placed in its value over the ages. While obviously this fact is subjective, it has over a long period of time translated itself into the objective fact of a high stockto-flow ratio. In this sense the value of gold is objective while that of other goods is subjective. If a government really wanted to demonetize gold, then first it would have to dissipate accumulated gold stocks through consumption. Lenin understood this better than our Western leaders. He suggested a most ingenious way to demonetize gold. Under communism, Lenin said, gold would be used to plate the inner surfaces of public urinals - an application for which gold is superbly fitted for reasons of its chemical inertness, surpassing that of any other substance known to man.

Note the condition "under communism". Under any other system the gold plates would be picked.

Lenin certainly knew how to prevent the picking of public urinals. He had the Cheka.

### How to make the value of gold fall

Unlike Lenin, superficial thinkers assumed that demonetization could be effected merely by the issuance of a government edict. Before such an edict was issued in 1971 a number of economists, Ludwig von Mises among them, were thinking aloud what would happen if the unthinkable did indeed happen. They concluded that as monetary demand was cut off the value of gold would fall, and fall it would precipitously since monetary demand constituted the lion's share. Economists cited the example of demonetizing silver a hundred years earlier. When Germany, victor of the Franco-Prussian War did it in 1871 and the United States government, victor in the Civil War followed suit ("The Crime of 1873"), the rest of the governments reluctantly toed the line (with the only exception of China which refused). The price of silver went into a long and steep decline from \$1.29 in 1871 to 25 cents in 1933, less than one fifth of the original value.

Apparently the only time the government of the United States listened to Mises was on August 15, 1971, when Nixon decided to prevent the value of gold from going to outer space by demonetizing it. Subservient governments hastily joined in issuing an edict to the effect that they considered their combined gold reserves as "adequate" and, from then on, they would refuse to buy gold from any outside source, and would ostracize governments that did. Newly mined gold, having lost its biggest customers: governments and central banks, would have to go begging.

Those who had speculated that the official gold price would be increased ought to burn their fingers "right to the armpit" in the words of a U.S. Senator. The world must be taught a lesson who is in charge.

### Causality versus Teleology

The economists couldn't be more wrong on gold. No sooner had governments embargoed it than the price of gold soared. The economists never answered the question how they could ever make such a colossal blunder. We must do it for them. Doctrinaire belief in the supply/demand equilibrium theory of price has led them astray. Economists reasoned that if the demand for gold is cut abruptly then the value of gold is duty-bound to fall. However, the equilibrium theory of price is a linear model having a limited range of applicability. The world is non-linear. As long as causality prevails, monetary circulation can be approximated with linear models. But when teleology becomes dominant, as it sometimes does, the world no longer behaves linearly. As teleology replaces causality linear models, including the equilibrium theory of price, fail to be applicable. It is incumbent upon the scientist to examine the range of applicability of his model before applying it. This the economists have forgotten to do in studying the probable effects of gold-demonetization.

If we really wanted to understand the gold-demonetization episode of 1971, then we would have to look for the teleological context. We would find it in the fact that gold-demonetization was just a hoax, designed to cover up the fact of default on gold obligations and so to save the face of the United States. It has never ever happened in history that the paper of a defaulting banker would go to a premium. Yet that is exactly what the economists predicted. They forgot that the dishonored paper would always, without exception, go to a discount. This would happen even if further issues of the paper were drastically curtailed. The circulation of the dishonored paper is definitely not governed by the laws of causality, the quantity theory of money, or the equilibrium theory of price. Rather, it is governed by the laws of teleology. Frightened holders of the paper would try to get rid of it at whatever price they could, as they expected the discount to widen and, ultimately, to go to 100 percent. Time has nothing to do with it. Depreciation can take days, but it can also take decades to run its full course. It is not possible to forecast how long. The only thing certain is that time will not cure whatever ails the dishonored paper. Once in default, always in default. True, the banker may not be at the end of his rope. He may still have tricks up in his sleeves. He could use bribery, blackmail, and other forms of coercion to keep his dishonored promises in circulation. He may even be able to expand circulation. By hook or crook he might slow the rate of depreciation, or even stall it. Sometimes he might succeed in reversing the trend temporarily through false signals to the market. No matter. The ultimate outcome is inevitable.

The value of the dishonored paper will eventually approach the marginal cost of its production, which is greater than zero only by a negligible amount.

It is important to realize that the quantity theory of money has nothing to do with monetary depreciation. Like the equilibrium theory of price, the quantity theory of money is just another linear model that is valid only as a first approximation. But where causality ends, teleology begins and first approximations become useless. More sophisticated models such as the disequilibrium theory of price, and the depreciation theory of dishonored promises are called for. Value is not collapsing because paper money has been "over-issued". It is collapsing in consequence of the original sin, the act of default. Monetarists and quantity theorists of all stripes, please pay attention. Regulating the rate of increase of the stock of high-powered money (e.g., by entrusting it to a "clever horse" on the tread-mill as once suggested by Milton Friedman) may postpone but will not avert the ultimate humiliation of the dollar, which is to join the assignats, mandats, Reichsmarks, and other dishonored promises in the garbage heap of history. From there, as from Hades, no currency has ever returned.

### The concept of marketability

North says that gold is no longer money because it is no longer the most marketable commodity.

The irredeemable paper dollar is. I challenge this. Back in 1960 I carried out a little experiment. I obtained a \$1000 bill (in those days equivalent purchasing power would be more than \$10,000 in today's money). This was in Canada, and the bill had a light pink color as I recall. The vast majority of people have never seen a bill of such denomination. My experiment consisted in trying to pass on the bill. Retailers flatly refused to touch it. It wasn't that they could not make change.

The price of a Volkswagen Beetle was around \$1000 then, but the dealer would still not take my bill. He would be glad to take a personal check, but not the \$1000 bill issued by the Bank of Canada. He suggested that I go to the bank around the corner and come back with ten \$100 bills.

The bank would take the bill only on condition that I opened an account. I would have to provide three ID's, one of which would have to be a picture ID. So much for the marketability of paper money.

I followed up with another experiment. I offered a kilobar (1000 grams of fine gold, then worth about \$1200) to a Swiss bank. Without a bat of the eyes the teller paid me at the going rate. No questions asked. No need to call the manager. No need to open a bank account. No need to produce three different ID's. So much for the marketability of gold. I am aware that things have changed since. Swiss banks, as a result of some arm-twisting from Washington, no longer deal in gold over the counter. They don't want to be open to the charge that they facilitate moneylaundering. You have to go to a large city where some banks have special departments for dealing in precious metals, and they certainly won't buy from you unless they know you.

The scientific concept of marketability is due to Carl Menger (Absatzfähigkeit). He based it on the distinction between the bid and asked price. Menger pointed out that it is not possible to buy something in a market, then turn around and sell it at the same price. You always buy at the higher asked price and sell at the lower bid price. The difference is the spread. Obviously, the spread is a function of the quantity of merchandise under negotiation. It is the behavior of the spread that determines marketability. According to the Principle of Declining Marginal Utility the bid price is a decreasing function of quantity. Further insight shows that, by contrast, the asked price is an increasing function. Market-makers are reluctant to deplete their inventory too fast before securing further supplies. If they must quote an asked price for an unusually large quantity, they naturally add a risk premium. The upshot is that the spread is an increasing function of quantity.

Commodity A is more marketable than commodity B if the rate of increase in the spread for A is lower than that for B as ever larger quantities are thrown on the market. On that basis gold was, is, and will be, as far in the future as the eye can see, the most marketable commodity available.

So much so that the market, when not rigged by the banks or the government, would make the spread practically zero. Thus gold is the only commodity that could, in the absence of official sabotage, be bought and sold back-to-back without losses in any quantity, however large. It is this property that has made gold the monetary metal. Irredeemable currency certainly does not have this property, as a quick check with a foreign exchange dealer will reveal. Please do not be confused by the volatility of gold price. It is not an indication of the uncertain value of gold.

Rather, it is an indication of the uncertain value of the dollar in which the gold price is quoted.

### Is Gold Money?

This is a semantic issue as the answer depends on how we define money. If you, following North, define money as something Wal-Mart will take in exchange for made-in-China junk then, for you, gold is not money. But if you adopt Carl Menger's more scientific definition according to which money is a commodity for which the spread between the asked and bid price stays small as ever larger quantities are traded, then gold is money. It is not the consumer or the retail market that decides the issue. It is the wholesale market trading as it does unlimited quantities, that is privileged to make that determination.

It also follows that people and institutions are, even today, willing to carry unlimited amounts of gold in the balance sheet without any promise of return to capital, in preference to any other asset. There is obviously no contest between gold and the dollar in this regard. Apart from the fact that the dollar is but a dishonored promise to pay, at best it is an asset that also shows up as a liability in the balance sheet of a third party. As the only asset in the balance sheet that is not at the same time the liability of someone else, gold provides the only effective portfolio insurance against default.

The final monetary showdown between gold and the dollar may be close at hand. As dollarholdings of individuals and institutions not subject to the jurisdiction of the United States grow by leaps and bounds in consequence of increasing American trade deficits, the ultimate test of "moneyness" is being applied to the dollar. Are foreigners really willing to hold unlimited amounts of dollar balances indefinitely? Euro-balances as an alternative are not relevant. After all, the euro is just another irredeemable promise to pay. The contest is not between the dollar and the euro.

Ultimately, it is between the dollar and gold. When all is said and done, it turns out that at one point owners of dollar balances will cry "enough!" By contrast, history and logic show that there is no such point for gold. This qualifies gold, and disqualifies the dollar, as money.

### Gold and Interest

Yet the strongest argument proving that gold is still money, the best available, is its relation to interest. According to Carl Menger, subsequent units of a commodity are valued less by the economizing individual than units acquired by him earlier. This is known as the Principle of Declining Marginal Utility. If we rank commodities according to the rate of that decline, then we shall find that the marginal utility of one of them declines more slowly than that of any other. The commodity with this property is none other than gold. In fact, the marginal utility of gold declines so slowly that it is practically constant. It follows that gold hoarding must be limited by something other than declining marginal utility so that demand for it may not become arbitrarily large, and gold coins may stay in circulation. The fact is that demand for gold is limited by the positive rate of interest channeling gold into monetary circulation, away from hoarding. This makes gold the corner-stone of both the theory money and the theory of interest.

Ludwig von Mises in Human Action denies that the marginal utility of gold is constant (second edition, p 404). His reasoning is that constant marginal utility would mean infinite demand which is contradictory. Elsewhere in the book (op. cit., p 205) Mises also denies that it is possible to construct a unit of value because two units of a homogeneous supply are necessarily valued differently, according to the Principle of Declining Marginal Utility. Yet gold has successfully furnished the unit of value for thousands of years to many a flourishing civilization, including our own, and when it was removed it had to be done by travesty, trickery, and police force. Mises failed to grasp the connection between gold and interest. Interest is obstruction to gold hoarding: but for the presence of interest gold hoarding would be unlimited, since gold's marginal utility is constant. It is interest that keeps gold hoarding within bounds. Interest is the opportunity cost of gold hoarding. By contrast, hoarding of a non-monetary commodity is kept within bounds by declining marginal utility. In this sense interest is analogous to a parking meter on a busy street which limits the demand for parking space that would be unlimited otherwise. Be that as it may, interest is specific to gold and no demonetization hoax can change that fact. The gold-rate of interest (disingenuously called "lease rate") is still the benchmark to which the dollar-rate and all other paper-rates of interest are related by the application of a depreciation premium.

### Monetary demand for gold

North makes the point that demand for gold today is for industrial and ornamental uses only; there is practically no monetary demand. Thus North, a self-declared gold bug, forgets that his very own demand for gold is nothing more or less than a monetary demand. He refers to gold as an "inflation hedge". The demand for gold as an inflation hedge, too, is a monetary demand. The investment-demand for gold, too, is a monetary demand. If Alan Greenspan owns gold, which seems more than likely, his demand for gold, too, is a monetary demand, like it or not.

By monetary demand is meant demand for medium to circulate as money with whatever velocity, including zero velocity. Therefore hoarding demand for gold that originates in protest, whether against low interest rates, or against the banks' loose credit policy, or against the government's fiscal policy, or against the central bank's monetary policy, is part of the monetary demand.

Furthermore, hoarding demand that originates in fear, whether fear of devaluations, monetary depreciation, or any other form of embezzlement of private wealth through monetary manipulation, is also part of the monetary demand. Protest- and fear-related demand started burgeoning in 1947, the first year when United States hemorrhaged gold. Some of that gold went to central banks that would keep it in circulation; most of it went to satisfy private demand that would keep it out of circulation. In retrospect, hoarding demand was justified by competitive devaluations triggered by the British pound barely one year later in 1949. It was also justified by unprecedented peace-time budget deficits ran by the United States that forced the debasement of the dollar. The monetary history of the intervening years can be described as a tug-of-war between the two demands for gold: that of central banks and that of private holders of cash balances. Don't be fooled by the rhetoric that central banks no longer need gold and they are anxious to get rid of this barren asset by exchanging it for "earning assets". Central banks, like individuals, need gold for the stronger reason. They need a default-proof asset to balance their monetary liabilities. As gold keeps disappearing from the asset column of the balance sheet of a central bank, so does public trust in the value of the bank's notes in circulation.

Private monetary demand is gradually winning the tug-of-war. It is enormous and it keeps growing: not only does it absorb the entire world production of gold, it also picks up all the gold dropped by central banks to keep the wolves away from the door. True, the price of gold falls whenever the U.S. Treasury, the IMF, and "me-too" Bank of England announce their gold auction rituals. This fall certainly does not mean that gold is in over-supply. It means that the market is willing to play chicken with the protagonists of the demonetization-hoax. Above all it means that the market exacts a price for foolish market-behavior. If the desire to exchange a non-earning asset for an earning asset were genuine, then gold would not be auctioned with the loudest fanfare and widest publicity designed to suppress the price. Instead, it would be quietly fed into the market in order to fetch the highest possible price. But there is a hidden agenda: to discourage private demand by the threat of a falling price. However, the ploy to manipulate expectations is a failure, as shown by the fact that the gold price always returns to a higher level the day after the official gold-shedding program is completed. This was true for the auctions of the U.S. Treasury, those of the IMF and, most recently, those of the Bag Lady of Threadneedle Street. The exercise of dissipating official gold is a hoax. It misleads simpletons only. Gold disgorged by central banks is quickly absorbed by private monetary demand. In auctioning off monetary gold the managers of irredeemable currency are trying, in vain, to buy time to save their tottering regime.

### The First and Second Decline of the West

When the barbarians overran Rome, the government of the Western half of the Roman Empire ceased to function. We may side-step the question whether the policy of deliberate currency debasement which Rome had pursued for centuries was ultimately responsible for the collapse.

Be that as it may, after the barbarian invasion there was no authority to re-introduce gold coinage that would circulate. Gold coins of old had long since ceased to circulate in the wake of debasement. They were hoarded or exported to the Eastern half of the Empire, where the supply of gold coins by the Mint of Constantinople continued uninterrupted for another thousand years.

The fact remains that the First Decline of the West had been foreshadowed by the disappearance of gold coins from circulation. Only later was it followed by a cataclysmic shrinkage of trade.

The Second Decline of the West, in our days and age, has also been foreshadowed by the disappearance of gold coins from circulation. We may take the year 1914 to mark the beginning of that process. We are worse off than were people during the First Decline, insofar as there is no Eastern half where gold coins would still circulate. The threat is that the disappearance of gold coins from circulation will again be followed by a fatal collapse in world trade and the survivors of wars will be forced to live from hand to mouth. Nobody can deny that competitive currency devaluations and trade wars, not to mention shooting wars, are presently a threat to our survival and welfare. No one knows how long producers will continue to accept irredeemable promises to pay in exchange for real goods and real services. No one knows how long savers will continue to accept a depreciating monetary unit as numeraire for their savings. The vanishing of gold coins from circulation have historically been followed by a collapse of trade if not immediately, then certainly in a century or so. If the Second Decline isn't turned around soon by the re-introduction of circulating gold coinage, we may again experience a cataclysmic shrinkage of world trade, similar to that during the First Decline.

Defeatist North considers a return to gold circulation most unlikely, even undesirable. But remember, the First Decline was stopped in its track and reversed by two amazing developments: (1) the opening of the Mint to unlimited coinage of gold by Venice and Florence; (2) the financing of the trade of Italian city-states with one another and with their trading partners overseas through the invention of the gold-redeemable bill of exchange. Corresponding developments could halt and reverse the Second Decline and save our civilization from ruin. It is not the cost of returning to gold circulation that is astronomical as North suggests, but the cost of not returning.

### Reference

Gold and Interest, A Course in Monetary Economics, by A. E. Fekete,

Gold Standard University, January, 2003.

---

# Gold Is The Cure For The Job Drain

URL: https://newaustrianeconomics.com/archive/fekete/gold-is-the-cure-for-the-job-drain/
Date: 2003-09-22
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-standard, interest-theory, federal-reserve, monetary-policy, sound-money
Description: Fekete diagnoses the de-industrialization of America as a symptom of chronically falling interest rates, which destroy the marginal productivity of capital and cause it to migrate abroad. The only durable cure, he argues, is reopening the U.S. Mint to free gold coinage, which would stabilize interest rates and stop the capital flight taking industrial jobs with it.
Editorial Note: Written in September 2003 as the outsourcing debate was intensifying. Fekete locates the cause not in trade policy or corporate greed but in the interest-rate distortions created by irredeemable currency — an analysis ignored by mainstream economists on both sides of the debate.
Original PDF: https://professorfekete.com/articles/AEFGoldIsTheCureForTheJobDrain.pdf

### Executive Summary

Falling (as opposed to low but stable) interest rates are lethal to the economy, especially if prolonged. They make the rate of marginal productivity decline. As it does, it prompts capital export. Migrating capital takes industrial jobs with it. This paper analyzes job-drain that is threatening America with de-industrialization. The process will continue as long as wild swings in the rate of interest do. The cure is to be found in the stabilization of interest rates. It can be effected by opening the U.S. Mint to the free and unlimited coinage of gold, as mandated by the U.S. Constitution.

### De-Industrialization of America

The true story of the de-industrialization of America has never been told. It started with the U.S.

Treasury defaulting on its gold obligation to foreigners in 1971, thereby foisting a regime of irredeemable currency upon the world. An unanticipated side-effect was the setting of the rate of interest adrift. It then started its wild roller-coaster ride, first up well into double digits by 1981, then down to zero, a move that twenty years later is still in progress. Greenspan takes credit for the low rates as a measure of his success in “licking inflation”. The claim is an empty one. The credit belongs to bond speculators, the big money-center banks among them, that have got away with obscene profits on their bond holdings and long positions in the derivatives markets. It is too early to say that the plunge of interest rates is over. There is more dough still where these profits have come from.

At whose expense are those obscene profits made? Why, at the expense of the producers and laborers, naturally. Economists have missed the curious coincidence that pari passu with the unprecedented swings in interest rates America is being de-industrialized. Of course, they noticed the migration of industrial jobs from America to Asia. But they blamed it on the sweatshops in China and India. However, Asian wage rates had been lower for the entire period of modern age, causing no migration of jobs as long as industrialized countries adhered to the gold standard. The difference in wage rates in itself does not establish a cause for the job-drain.

Greenspan in a testimony before a Congressional committee stated that the de-industrialization process is market-related as Americans demand ever more services. This is as false as it is selfserving. The real cause of the de-industrialization of America is the mega-swings in the rate of interest. They are far from over. Unless interest rates are stabilized soon, America will be denuded of its park of capital goods and American labor will be reduced to poverty. Labor leaders should pay attention and demand that interest as well as foreign exchange rates be stabilized forthwith by opening the U.S. Mint to the free and unlimited coinage of gold, as mandated by the U.S. Constitution.

### Marginal Productivity

Here is the evidence that causal relation exists between the swinging dollar-rate of interest and progressive de-industrialization, as manifested by the massive export of industrial jobs from America to Asia. To understand it we have to make the concept of productivity precise.

Every industrial plant and equipment has its own rate of productivity that can be calculated as the annualized percentage of increase in the value it imparts to the goods under production. Not all plant and equipment will find employment, however. Even though in each case the value of output is greater than that of input, the opportunity cost of employing certain capital goods may be too high. This is a point that has been missed by all discussions of productivity so far. If we rank all capital goods according to their rate of productivity, then we find that there is a lowest-ranking one that can still be employed profitably in production, but all others with a lower productivity must remain idle as their application would be uneconomic in view of their high opportunity cost. It is the marginal item of industrial capital, and its productivity is called the rate of marginal productivity. It goes without saying that the marginal item shifts constantly, and with it changes the rate of marginal productivity.

The key question to ask is what determines this rate. This is important because capricious changes in it could play havoc with the economy. Contrary to conventional wisdom, an increase in the rate of marginal productivity is not beneficial. It is actually harmful to the economy when prolonged, as it is the chief cause of unemployment. Indeed, the new marginal item has a higher ranking than the previous one, therefore all capital goods below its rank must be idled, making the labor-complement superfluous. Superficial thinking may suggest that a decrease in the rate of marginal productivity is beneficial as it would press idle plant and equipment back into service restoring employment. Not so. Actually, the decrease is also harmful if capital is mobile internationally, as it is today under globalization. When the rate of marginal productivity drops, capital will be exported to foreign countries with abundant cheap labor. Note that the only way to keep industrial jobs in the country is to keep the rate of marginal productivity relatively stable.

Violent changes in the rate cause capital and labor to divorce, whereupon capital migrates abroad taking industrial jobs with it, and leaving domestic labor unemployed.

What then determines the rate of marginal productivity? Since capital goods are an earning asset, they are in direct competition with other earning assets. In particular, capital goods compete with bonds. When the yield on the bond rises (the market price of the bond falls), the opportunity cost of employing capital rises with it. Arbitrage from physical capital to bonds takes place. Seeking a better return owners of capital goods sell their plant and equipment, and buy bonds with the proceeds. From producers of real goods they become coupon-clippers. Moreover, not only do increasing interest rates discourage production, they actually destroy domestic capital. This is so because an irreversible process is at work. Please note the difference between finance capital that is mobile, and domestic capital consisting of producer goods that is not. If and when interest rates turn around and start falling again, arbitrage goes into reverse. Bondholders take profit.

They sell their bonds and want to put the proceeds into capital goods. They look for the most profitable applications. They will find them abroad where labor costs are a fraction of that at home. They will send their capital abroad. Thus capital goods at home that have been idled earlier when interest rates were rising will not be re-employed. They are doomed. Falling rate of marginal productivity is the leading cause of the export of industrial jobs, the destruction of domestic capital, and unemployment.

We conclude that FED policy of purchasing bonds in the open market in order to combat deflation is not only counter-productive; it is distinctly anti-labor. The FED bids up bond prices, which is tantamount to driving down interest rates. Falling interest rates do, in turn, lower the rate of marginal productivity. The upshot is that capital is exported along with industrial jobs to low wage countries.

### Falling Interest Rates and Deflation

In earlier papers I showed that while a low and stable interest-rate structure is beneficial for producers of goods and services, a falling one is an unmitigated disaster. Not only does it fail to stimulate economic growth but will, in fact, underwrite deflation by actually increasing the cost of capital for established producers. I must confess that most of my readers have found my argument utterly counter-intuitive and contrary to their personal experience. They have not seen any evidence of falling prices during the period of twenty-two years of falling interest rates.

This is because they ignore the invasion of American super-stores by cheap consumer goods made in China and elsewhere in Asia. They also ignore the sales tactics of those stores in keeping the sticker price high while selling merchandise at deep discount. Be that as it may, the fact remains that capital has been exported from America to China and is used to assist Chinese labor to produce merchandise which is then re-imported to America and sold at incredibly low prices. There is no way American manufacturers using domestic facilities and domestic labor can possibly match those prices, and they are going bankrupt in droves. American domestic manufacturing and employment shrink. If that is not deflation, then I don’t know what is.

Moreover, the deflation has not been caused by cheap foreign labor. That has always been available. The cause is the falling interest-rate structure that has, for the past 22 years, made the rate of marginal productivity decline. This decline would, in and by itself, have produced deflation even in the absence of export of capital and jobs. Suppose for the sake of argument that the government controls the export of capital. In that case the falling rate of marginal productivity would have pressed previously idled plant and equipment back into service, using new labor component at lower wages. The additional supply of consumer goods would have depressed prices and caused bankruptcies as well as unemployment. It is foolish to blame Chinese sweatshops for the plight of American producers using American labor. You should blame our unconstitutional monetary system that allows the rate of interest to shoot up to 20 percent and then to plunge to 1 percent.

There is no comfort in the thought that the rate of interest is already so low that it can hardly go any lower. In view of the Japanese experience, it can. In fact, it can go on falling indefinitely. This is because the effect of a move in the rate of interest on the economy is commensurate, not with the size of the move itself, but with its logarithm. In other words, cutting the rate of interest in half has the same effect, whether it started from 20% (a 10% move) or from 1% (which is only a 0.5% move). There are still lots of industrial jobs available for export in America — for example, in the auto industry. What if China wants a piece of the auto market in America? Well, just cut the rate of interest in half three or four more times and: bingo! Auto jobs, too, are gone to China.

### Gold Standard: Protector of Labor

Keynes disparaged the gold standard as “contractionist” and “deflation-prone”. He also charged that it has failed to stabilize prices. However, the great merit of the gold standard must be seen not in its power to stabilize prices that is neither possible nor desirable, but in its power to stabilize interest rates at the lowest level compatible with the productivity of capital and labor available in the country.

Why are interest rates stable under a gold standard? We may define the going rate of interest as the rate at which the market price of the bond is amortized by the stream of interest payments plus the payment of face value at maturity. Under the gold standard a gold bond has a stable market price because it promises to pay a definite value. Compare this with a dollar bond that is exchanged for an irredeemable promise of uncertain value at maturity. The dollar returned to the bondholder is not the same as the dollar he paid for the bond. Its value is lower thanks to monetary debasement that has taken place in the interim. The market price of such a bond changes with the fortunes of the issuer and is therefore inherently unstable. Since the market price of the gold bond is stable, the rate of interest under a gold standard is stable. Historical charts fully bear out this theoretical conclusion. The wild swings we have seen in the dollar rate of interest since 1971 have no precedent under the gold standard. Noteworthy also is the fact that there was no bond speculation, just as there was no foreign exchange speculation, under the international gold standard.

This means that the gold standard is a source of great benefits to labor. It doesn’t allow the rate of marginal productivity to change capriciously. Compare this with the regime of irredeemable dollar where the roller-coaster ride of the rate has wiped out whole industries such as the manufacturing of TV sets and, by the same token, threatens to wipe out auto manufacturing. In the end only the defense industry may remain. As we have seen, an increasing marginal rate of productivity idles plant and equipment, while a decreasing one drives capital and jobs to low wage countries. In either case, unemployment is the result. Keynes did great disservice to labor when he instigated the overthrow of the gold standard. Far from being contractionist or deflationprone, the gold standard is the sole source of stability in an unstable world. Only when the government lends credibility to unprincipled adventurers such as Keynes by paying attention to agitation against the gold standard, does gold get nervous and go into hiding. But when the government firmly stays the course of monetary and fiscal rectitude, gold comes out of hiding and partakes in the great work of building up the productive and financial strength of the country to benefit all segments of society, first and foremost labor that needs protection most.

It is customary to make a case for the gold standard by referring to features such as relative price stability; protection of the value of savings, pensions, and life insurance; obstacle to the “beggarthy-neighbor policy” of predatory governments using foreign exchange rates as a weapon promote exports; protection of the assets of individuals against encroachment by banks and the government; obstruction to credit abuse and unlimited debt creation; keeping fair play between the productive and financial sectors, etc. The merit of the gold standard in protecting the individual’s right to work, and as an obstruction to exporting capital and jobs and so to prevent the impoverishment of labor, is never mentioned. It is time to lay out these merits as well before American labor is put through the wringer as it is being robbed of the industrial jobs remaining in the country.

Under the gold standard the rate of interest and, by implication, the rate of marginal productivity, are not set by politically motivated central bankers and Treasury bureaucrats. They are stable. If they change, they do so almost imperceptibly, reflecting capital accumulation and its effect on productivity. Recall that in the early 1980's the U.S. Treasury cavalierly printed double-digit figures on the interest-coupons attached to its bonds, because they wouldn’t otherwise sell. But these double-digit figures were a death sentence on capital goods that consequently became idle as higher interest rates pushed up the rate of marginal productivity, causing wide-spread unemployment. It was a capricious transfer of wealth from the productive sector to the financial sector. It was highway robbery. This puts the gold standard in a new light: the policeman to prevent highway robberies.

### “Honey, I have shrunk the jobs by mistake!”

Greenspan himself admitted that the FED’s war plan against deflation is wholly experimental, as it has never happened in history that deflation had to be confronted under a regime of fiat money. It is atrocious and revolting that unelected bureaucrats are allowed to experiment with American society in pushing laborers, producers, and savers around like the player pushes pawns around on the chess board, in an effort to prop up an unconstitutional monetary regime. As a result of this experimentation American capital and jobs are being exported. America is in the process of being de-industrialized. America has been turned from the greatest creditor to the greatest debtor country. All for no better end than protecting the turf of the FED. How much more experimentation, sacrifices, and suffering is needed before we are allowed to conclude that the fiat money regime established by deceit and stealth is an abysmal failure? Greenspan, being responsible to no one but himself, can shrug. If he is compassionate, he may utter words to the effect: “Sorry, a mistake has been made”, and get on with another experiment.

It is time for a wake-up call. Under the fiat money system the FED has arrogated unlimited powers to itself, namely, the power to print unlimited amounts of money. The justification offered for this unconstitutional arrangement is the woolly theory of a monetary adventurer from Britain, one John Maynard Keynes, who has been dead for over 50 years and can no longer be summoned as a witness. But Keynes was willing to admit that he might be wrong, in which case he would have let us fall back on the gold standard. Greenspan, on the other hand, stands in the way of drawing that conclusion.

If You Don’t Use Your Eyes for Seeing You Will Need Them for Weeping It is not well-known that Keynes published a eulogy of the gold standard in the Manchester Guardian Commercial (Reconstruction Supplement, April 20, 1922). This eulogy, of course, is never cited by latter-day Keynesians.

“If gold standards could be reintroduced throughout Europe we all agree that this would promote, as nothing else could, the revival of not only production and free trade but of international credit and the movement of capital to where it is needed most. One of the greatest elements of uncertainty would be lifted. One of the most vital parts of pre-war organization would be restored.

Any one of the most subtle temptations to improvident national finance would be removed; for if a national currency had once been stabilized on a gold basis, it would be harder (because so much more openly disgraceful) for a Finance Minister so to act as to destroy this gold basis.”

No one has the right to gamble with the welfare of the American people, neither the President, nor the Chairman of the FED, not the politicians, not the judges, not the bureaucrats. That is why the Republic has been given a Constitution. The Constitution denies power to the government to monetize its debt. As we have seen, this provision is the first line of defense to protect labor, as it acts to keep capital and jobs together and within the country’s own borders.

The Constitution’s monetary provisions have served this country well, and the unconstitutional monetary experiments conducted by the FED have served it badly. The latter were a series of unmitigated failures that have gone a long way to de-industrialize America, and threaten to drive the remaining capital and industrial jobs abroad. Open your eyes and see for yourself. God gave us eyes so that we may see.

As Friedrich Wilhelm Foerster (1869-1966), the great Swiss pedagogue once said: “if you don’t use your eyes for seeing you will need them for weeping”.

---

# How To Protect One's Pension With Gold

URL: https://newaustrianeconomics.com/archive/fekete/how-to-protect-ones-pension-with-gold/
Date: 2003-08-23
Section: Popular Economics
Difficulty: accessible
Concept Tags: gold-standard, federal-reserve, monetary-policy, capital-destruction, debt
Description: Fekete argues that pension funds are being destroyed by the Fed's suppression of interest rates, which causes companies to underfund their defined-benefit obligations. Gold mining stocks — not bullion — offer a way to hedge this danger, but only for companies that refuse to hedge their gold production.
Editorial Note: Written in August 2003 as concern about pension fund solvency was growing amid prolonged low interest rates. Fekete uses the Vista Gold case to illustrate how companies that sell gold forward (hedge) transfer wealth from shareholders to bullion banks.
Original PDF: https://professorfekete.com/articles/AEFHowToProtectOnesPensionWithGold.pdf

### Carting away Mt. Price

Stock analyst Clive Maund, in an article entitled Vista Gold Corp Takes No Prisoners

([www.321gold.com](https://www.321gold.com) July 10, 2003) confessed as follows: "My fundamental knowledge of the company is restricted to the memory of a photo in a vast open pit of a huge mining truck of the type that carted away Mt. Price in Australia." I may add that the truck, along with three others, plus a hydraulic shovel Vista used to own, were sold back in 1998 and have not since been replaced, even though the company could produce gold at a cash cost of \$183 an ounce. As

CEO Ronald J. (Jock) McGregor explained, mining and selling gold at present prices would mean dissipating company assets irresponsibly.

Yes indeed. If all gold mining companies adopted the policy of Vista, the price of gold wouldn't be where it is. But even the so-called unhedged companies are falling over themselves to produce and sell all the gold the traffic can bear, cheered on by a crowd of dividend-hungry shareholders.

They don't realize that they eat the seed corn, nay, they cook the goose that would lay the golden egg. So why conjure up the boogie-man of official gold-price manipulation? It is the gold mining industry as a whole, hedgers and non-hedgers alike, that must accept blame for the low gold price. But for the greed of managers the industry would have far more clout than the pricemanipulators, real or imagined. It is the gold miners who have the ultimate weapon: strike action.

Threatening to shut down the flow of new gold to the market would bring this point home like nothing else. Gold miners could, single-handed, cart away the mountain of depreciating paper money with Mt. (Low Gold) Price to boot, if they only treated their product with a respect appropriate to the monetary metal. Unfortunately, most have fallen victim to the official golddemonetization hoax and they treat gold as if it was just another commodity such as frozen pork bellies (this being the example favored by economists in the pay of central banks).

### Greed overtaking husbandry

Greed is as old as human race. The last time it overtook husbandry in the realm of gold was over 35 years ago. In 1968 you could still buy gold at \$35 per oz. The price had not changed for 35 years, since 1933, in spite of six years of depression; six years of World War II; six years of Marshall give-away; six years of Korean War; six years of escalation of the Vietnam War; the Berlin blockade, the Cuban missile crisis and other Cold War battles. All these historic events have contributed to monetary depreciation in the order of 75 percent. The gold mining industry was badly hurting. Yet it kept producing and selling gold at break-neck speed as if there was no tomorrow. The gold producers of the 1960s, just as those of today, were doped by the papermoney magic. They were coaxed out of their possession of a real asset to exchange it for a phony one. In giving it up at a ridiculous price they were unwitting stooges helping postpone the day when gold could break its shackles. Nobody then or since has bothered pointing out the folly of the inmate who would ingratiate himself to the jail-keepers by assisting them to make his yoke heavier.

Once more gold miners are ingratiating themselves to Dollar Almighty just at the time when the halo is fading and the crown is about to fall. The volume of gold production is increasing as gold miners zealously feed the beast. It looks as if history repeats itself.

After 1968 the price of gold ran up more than three-fold in less than three years, leaving gold miners with egg on their face for their zeal to produce and sell all that gold at the uneconomic monopsony price dictated by the government. They had frittered away the best assets of their shareholders. One might have hoped that, after the fiasco, gold-mining executives would learn their lesson. It wasn't meant to be.

### The economics of gold mining

The lesson gold-mining executives have failed to learn in 1968, so that they are now condemned to repeating the same old mistakes, is that of the economics of gold mining which is very different from that of base metal mining. The reason for the difference is that gold is the monetary metal. It is this fact that makes the marginal utility of gold constant, while that of a base metal is declining (as is the marginal utility of anything else, for that matter).

It is declining marginal utility that compels the miner of base metals to go after the top grade of ore available. Only in this way can he protect his market share. In base metal mining "the fastest gun prevails". In gold mining, by contrast, the fastest gun invariably shoots himself in the foot.

The gold miner has no market share to worry about. Husbandry takes precedence over speed and volume. The successful gold miner reaches not for the top but for the marginal grade. This is the lowest payable grade that can, at the current price of gold, still be mined profitably while the mining of lower grades would result in losses. As can be seen, in this way the gold miner maximizes not his profits but the useful life of his mine. The best grades are saved to the end.

When an exhausted gold mine is abandoned no payable grade of ore is left behind, unlike in the case of an abandoned copper mine.

It also follows from this cardinal rule of gold mining that if the gold price falls, the defensive step the miner ought to consider will be the lowering of mill-capacity utilization, all the way down to zero if need be. Normally he would keep mill-capacity utilization constant at 100 percent as only in this way could he guarantee the profitability of his enterprise. But a falling gold price calls for extraordinary measures such as cutbacks in production to prolong the fast-shrinking life of the mine, even if it meant accepting losses as the price of protecting mining assets. It is clear that this choice is not available to the copper miner facing falling prices. He must produce in order to survive. Copper has declining marginal utility, and the miner's strategy is to bring it to market with all deliberate speed. The gold miner has no such constraints. His product has constant marginal utility. Gold locked up in underground ore bodies is valuable no less than gold locked up in bank vaults. It must be produced most sparingly in order to preserve wealth represented by mining assets. Falling gold price is a double whammy: it pushes payable grades of ore into the submarginal category, thereby causing further losses in addition to the direct loss due to the lower price of the product.

In and out of the ground, gold teaches husbandry to mankind.

### Perpetual option

I fully anticipate violent objection to my thesis. My detractors will argue that no enterprise, not even a gold mining operation, can long survive while making losses. The price of shares will plunge to zero and, shorn of its source of capital, the enterprise is forced to fold. My argument is that a well-managed gold mine is an exception to the rule. Share prices will not fall to zero even if the gold mine is losing money, because the well-husbanded inventory of gold-bearing ores, free from attrition, retains its value indefinitely.

This leads me to the subject of a gold-mining share as a perpetual call option on gold bullion. All analysts recognize the fact that the price of a gold-mining share (but no other type) has a built-in option premium. Gold-mining shares normally trade at a premium over book value. The book value of a (debt-free) gold mine is defined as the value of gold represented by its payable grades of ore plus plant and equipment minus extraction costs. Unlike in base metal mining, depreciation of payable ore reserves is conspicuous by its absence. No one has attempted to provide a scientific explanation for the fascinating phenomenon how gold-mining shares manage to defy the law of gravity. The sole reason for the option premium is the fact that gold is the monetary commodity, a distinction shared by no other. Stockholders bid up the stock price to the point where it will reflect the full option premium, provided that managers operate the mine most conservatively, that is, they maximize the life-span of the mine rather than profits.

### The balance-sheet concept of gold

In a well-managed gold mine only marginal grades of ore are exploited. It is remarkable and important that economy can be further enhanced by processing a blend of marginal and submarginal grades of ore. Thus the value of submarginal grades, normally considered to be zero, becomes positive even without assuming higher gold prices in the future. Another source of the option premium is the balance-sheet concept of gold. The fact is that gold is kept in the asset column of the balance sheet of individuals and institutions without any promise of return to capital. No other asset is treated in this fashion. Why? Because gold is the only financial asset that can balance a liability without itself showing up as a liability in the balance sheet of someone else. That someone else may happen to default, leaving one holding the bag. This makes gold the ultimate agent of portfolio insurance. It makes little sense to talk about the day-to-day "performance" of an insurance policy. Performance comes after disaster has struck. Likewise, it makes little sense to talk about performance in relation to a gold stock, except as a measure of the extent to which the full option premium is realized. And this depends solely on how conservatively the gold mine is managed.

Gold mines that husband their resources less conservatively (typically by producing and selling all the gold that the traffic can bear) are punished for their profligacy by a fast-shrinking or even zero option-premium. It is true that the share price of a producing gold mine also incorporates another, the income-premium representing the present value of the flow of expected dividends. Be warned, however, that nowadays income-premium eclipses option-premium as most gold mines pursue quick profits to the detriment of mine life-expectancy. But dividends come at the expense of attrition of ore reserves and, therefore, the income-premium is programmed to self-destruct, regardless whether the mine is put in or taken out of production. The income-premium is ephemeral and has no part to play in protecting the value of pensions. By contrast, the optionpremium is durable and it is crucial for the pensioner.

Not only have gold miners failed to manage their mines more conservatively for the past fifteen years than the miners of the 1960s, they have in fact greatly accelerated attrition through mindless short-selling, misleadingly called "hedging". We must distinguish between "hedging false" as practiced by some of the most glamorous gold mining companies today, and "hedging true" as it should be practiced by conservatively managed companies. "Hedging false" is in fact unilateral short selling. It is nothing but self-fulfilling speculation in the expectation of a lower price. There is no way to get around this basic truth. We should clear up the confusion about what constitutes proper hedging or "hedging true", and what distinguishes it from short speculation in the expectation of a lower price, or "hedging false".

### "Hedging true"

Proper hedging would have to be bilateral, that is, it should involve forward buying in addition to forward selling. The two taken together is justified by the same principles as those justifying the harvesting of energy represented by the tides and ebbs of the seas. When the tide comes in, (i.e., the gold price swings to the plus side) it is proper for the mine to sell gold for future delivery, assuming that this policy is complemented by another: when the ebb goes out (i.e., the gold price swings to the minus side) the mine will buy gold forward. In this way the futures trading activity of the gold mine remains well-balanced and will not give impetus to speculation to weigh the market down on the short side, creating a falling trend in the gold price as is the case with the present socalled "hedge plans" of some large producers, which only induce speculators to keep selling gold at the first sign of strength in the gold price but refrain from buying at the first sign of weakness.

Let us look at the economic justification of forward buying and selling in detail. Paradoxically, forward selling is an economy measure designed to lengthen the useful life of the gold mine. It permits the miner to extract his submarginal grades and spare the payable grades of ore. Every time the gold price goes up, certain submarginal grades of ore in the mine temporarily become payable. Theoretically they could be mined profitably. However, technically it is not feasible to shift ore extraction back and forth between various sites on short notice following the whims of the gold market. Such shifts are time-consuming and expensive. By the time they are completed, the gold price may have fallen back and the opportunity to mine submarginal grades profitably gets lost. This is where forward selling comes in. Every time the fluctuating gold price swings into plus territory, the company sells gold forward in the futures market as a proxy for selling cash gold obtained from submarginal grades. Notice the quantitative limit imposed on forward selling by the inventory of submarginal grades. Each forward sale must be accompanied by the earmarking of a definite part of that inventory. The short position created by the forward sale must be covered when the earmarked inventory is extracted, milled, refined, and sold (or earlier, if it can be done profitably).

The miner works the miracle of turning stone into bread. He takes a worthless piece of rock, the submarginal grade of ore, and out of it creates a most valuable asset, gold. This seemingly impossible feat can be performed for two reasons: (1) gold is the monetary metal, (2) mindless government policy has made the price of gold fluctuate. It is this fluctuation that allows the gold miner to sell forward whenever the price-swing is in plus-territory, temporarily making submarginal grades profitable to mine.

Forward buying, no less than forward selling, is also an economy measure. It allows the gold miner to replenish his diminishing ore reserves at the best possible price. A forward-looking gold mining company is always prospecting for new gold-bearing properties to replace spent ore reserves. However, the checking of the quality and quantity of gold-bearing ore at the new site, the searching of title, and the negotiating of a price is a long, time-consuming process. By the time it is completed the gold price may have moved up, rendering the new acquisition uneconomic. This is where forward buying comes in. Every time the fluctuating gold price swings into minus-territory, the company buys gold forward as a proxy for the purchase of new gold fields. Notice the quantitative limit imposed on forward buying by the scope of prospecting. Each forward purchase must be matched by a prospective new gold field under negotiation. The long position created by the forward purchase must be covered as the new gold field is acquired (or earlier, if it can be done profitably).

There is no speculation involved in "hedging true." It is neutral as to the future price of gold. It does not provide speculators with a clue about falling trends in the gold price. It does not involve fraudulent reporting of questionable profits. It does not constitute manipulating assets and liabilities off balance sheet to the detriment of the shareholders. But it does make a positive contribution to extending the life of the operation.

### "Hedging false"

What passes for hedging today is a scam based on another scam: that of fiat money. Why is fiat money a scam? Because it is grounded in the notion that it is proper to allow the U.S. Treasury and the Federal Reserve to issue liabilities which they have neither the means nor the intention to meet. Nobody has ever offered a valid argument showing that there are defensible grounds for these privileges without counter-wailing responsibilities. There are none. Here we come up against a double standard: if an individual or a private firm tried to issue liabilities which they have neither the means nor the intention to meet, then they would be facing criminal prosecution. Fiat money is a gigantic legalized Ponzi-scheme.

The Constitution of the United States properly recognized the inequity and dangers inherent in such an arrangement, and forbade the government to monetize its debt. It says volumes about the shaky grounds for the dollar, and portends ill about its future, that its managers are willing to go to the length of contemptuously trampling on the Constitution in order to protect their turf. "Hedging false" works as follows. The gold mine borrows gold from a bullion bank at the low goldrate of interest. It sells the gold bullion in the cash market and uses the proceeds to buy U.S.

Treasury securities yielding at the high paper-rate of interest. The difference between the two rates is then added to revenues, and the mine is reporting higher mining profits year in and year out. The pretence is maintained that the mine has increased revenues by selling its product forward "to take advantage of a high gold price." But what are the criteria by which it can be established that the price is high? Any price is a high price that can be pushed down by the threat of an artificial oversupply. The gold miner puts a marketing policy into effect that deliberately makes the price of gold fall and then poses as a hero who has invented hedging.

The whole procedure that passes under the name of "hedging" today is fraudulent. A forward sale is a transaction that will not be closed out for several years, when the borrowed gold is returned to the lender. But until closed out it will not be possible to determine the profitability of the deal.

Not only does the gold mine indulging in "hedging false" declare profitability fraudulently, it is actually paying out phantom profits in the form of stock options to executives, thus robbing the shareholders. Ignored is the possibility that the borrowing arrangement may not be extended for a further period by lenders and the mine must buy gold in the open market at a loss to cover the liability. Also ignored is the scenario that the gold price may advance so fast, never to return to its level where forward selling occurred, that the gold mine is unable to cover its short positions profitably and must incur horrendous trading losses. Be that as it may, the premature reporting of questionable profits is a clear fraud to mislead shareholders. It should be stopped by the government's watchdog agencies. It isn't, and this makes "hedging false" a conspiracy involving the gold mine, the bullion bank, and the government. It is a scheme to manipulate assets and liabilities off balance sheet to the detriment of shareholders.

Why would the government risk the odium of being an accomplice to fraud stinking to high heaven? My guess is that it is led by the desire to perpetuate the regime of irredeemable fiat currency. The low gold-rate is the benchmark to which the paper-rate of interest is invariably compared. The spread between the two measures the decay in paper currencies. "Hedging false" is designed to manipulate this spread by closing it. That makes fiat currencies appear healthy when in fact they all suffer from the effects of advanced and possibly terminal decay.

### Tormenting the elderly

My grandfather and, a generation later my father, accumulated pension rights in the service of the Hungarian government that should have made their retirement years care-free. Instead, they were both reduced to abject penury. In their productive years they were paying good money into the government-managed pension fund, and the government managed to pay them bad money that was hardly sufficient to buy food when they were old, helpless, and no longer able to fend for themselves.

I had served at the same Canadian university for 35 pensionable years before I retired. My university is on record that it reduced professors' salaries and pensions in the 1930's, ostensibly to compensate for the appreciation in the value of the monetary unit. There is no guarantee that the same trick will not be pulled again. In addition to my university pension I also have a smaller pension from the Canadian government. This unfunded pension plan is compulsory to all Canadian wage-earners, but it will clearly be bankrupted by the fact that the ratio of contributors to pensioners is falling dramatically because of fewer births and longer life-expectancies. To compensate for this the government considers raising the contributions as well as the age of eligibility of wage-earners, but is facing considerable resistance on both counts. My pension may go the way of my father's and grandfather's. Church doctrine holds that tormenting widows and orphans is a sin "crying to high heaven." By the same token so is tormenting the elderly.

In planning my own retirement I had to find a way to protect the value of my pensions against the ravages of both inflation and deflation. I decided that the best protection was the purchase of outof-the-money call options on gold bullion. (An out-of-the-money option is one having no intrinsic value, only time value, and are less expensive for that reason. By contrast, an in-the-money option has both intrinsic value and time value.) However, publicly traded options on gold bullion don’t exist. (In the 1970's there was a Geneva-based investment firm Valeur-White-Weld, later acquired by Credit Suisse-First Boston, that used to trade call options on gold bullion, but apparently it no longer does.) But even if you could have them, call options on gold bullion would be too expensive and would not go out far enough into the future. I then hit upon the idea of leaps (long-dated call options) on Barrick stock. When on closer scrutiny I realized that Barrick's so-called hedge plan was utterly fraudulent, I tried to meet the (then) CEO, Peter Munk whom I didn't know in person, but knew that he was a fellow immigrant from Hungary. Not surprisingly he declined to see me. Instead, he directed me to the company treasurer Jamie Sokolsky in charge of hedging operations. During a session with Sokolsky lasting an hour and a half I presented to him my Memorandum entitled "Gold Mining and Hedging", explaining the difference between unilateral and bilateral hedging (as above). He promised to study it and would call me in a month's time. I have never heard from him again. This convinced me that Barrick was not serving the interest of its shareholders, but was probably acting as an agent for a third party (such as a government or a central bank). This assumption seemed to have been confirmed recently at the trial Blanchard vs. Barrick et al. where Barrick refused to answer questions on its dealings with central banks on the strength of confidentiality (indicating that Barrick has been acting as a front to cover up central bank activities in the gold derivatives markets).

### Pensioners’ gold

But let's go back to my original story. I exercised my leaps, sold my Barrick stock, and looked for an alternative. I asked a number of stock-broker friends of mine if they could recommend goldmining companies that have deliberately reduced or, better still, stopped production in the face of falling gold prices. To my amazement, in each case my friends said that they were unaware of the existence of any such company. They are still looking.

I find it obnoxious that practically all the advice available to gold investors today is of the “get rich quick” variety. What about people who just want “to live and let live”? What about the retired people who want to protect the modest pension they have earned during their working lives?

What about those on wages and salaries who in planning their retirement realize that the government-sponsored “old age security” just won’t be there for them when they will need it, so that they ought to provide their own? These people are not motivated by the thought of getting rich quick. They just want real protection, because they don’t trust the phony protection loudly propagated by plans sponsored by governments and employers. These plans are all suspect, because the benefits are denominated in an irredeemable currency, such as the dollar that managed to lose a record of 90 percent of its purchasing power during the very first decade after it was “cut free” from gold in 1971. There is no reason to believe that the dollar may not repeat or even beat that record in the new century! The point of my article is that these people are not being well-served by investment advisors who advocate the ownership of gold mining stocks with a management hell-bent to push up share prices by producing and selling all the gold the traffic can bear at the expense of mine-life (and there are lots of “non-hedged” companies in this category). The trouble with these companies is that they are exhausting their gold reserves prematurely, and their policy to replenish them is likely to fail as they do not reinforce prospecting with forward purchases of gold (as explained above under the caption “hedging true”).

Pensioners should be very selective, and they should only look at the most conservatively managed gold mines with a declared policy of cutting back production (or withholding produced gold from the market) in response to falling gold prices. Once invested in the stock of such a gold mine, there are several strategies that (prospective) pensioners may choose from. The simplest is to sit back and collect the ever-increasing dividends the company is expected to pay once the gold price makes sufficient advances, to supplement their shrinking pension.

Another strategy is to keep "exercising the perpetual option" as the price of gold waxes and the value of pensions wanes. After each major surge in the price of the conservatively managed gold mine the pensioner would sell part of his holdings and convert the proceeds into gold bullion. This play is based on the expectation that the price of the stock of a conservatively managed gold mine will go up much faster than the gold price. This expectation is well-grounded. There is a double bonanza at work. In addition to the value of payable ore reserves, the volume of those reserves has to increase, as submarginal reserves enter the payable range thanks to the higher gold price. In this way the pensioner acquires gold ever more advantageously. In spite of paying an ever higher dollar-price for each ounce, every subsequent share sold is buying him more ounces. The conservatively managed gold mine produces gold for him. If he owned the stock of a less conservatively managed gold mine, the company would be producing gold for others.

Pensioners have no use for a gold mining operation that prefers to make a quick profit at the expense of the life expectancy of the mine. They are not suitable as protection for one's pension against inflation or deflation. Pensioners don't need additional income while their pension still has value. They will need additional income when their pension is cut because of deflation, or loses its purchasing power because of inflation.

A third strategy involves borrowing against the stock, rather than selling it, to get compensation for the decreased value of one's pension. This strategy is designed to address the problem of taxes. Since there is no selling, there are no capital gains to be taxed.

Conservatively managed gold mines are hard to find. They are not glamorous, they never hit the headlines. It is likely that they do not presently pay dividends or, worse still, they report losses as holding gold properties involves costs (such as providing security, keep renewing mining licenses, paying a skeleton crew, prospecting for new properties, etc.) On the other hand, the price of the stock of such conservatively managed gold mines tends to be low and, initially, it may not increase spectacularly as that of a glamorous gold stock would. However, the policy of postponing exploitation will pay rich dividends at the time when the glamorous companies approach the point of exhausting their mines and must get ready to shut them down, as a result of premature depletion of reserves.

I am not getting paid for writing this article by anybody. In doing it I am trying to be helpful to my fellow pensioners facing the same problem that the value of their pension may evaporate due to deflation or inflation just at the time when they need it most. This should be considered as a thought provoking exercise to challenge conventional wisdom. Pensioners and prospective pensioners should do their own due diligence to find conservatively managed gold mines that would suit their needs best in protecting the value of their pension against the ravages of deflation or inflation.

---

# The Bubble That Broke the World

URL: https://newaustrianeconomics.com/archive/fekete/the-bubble-that-broke-the-world/
Date: 2003-06-27
Section: Popular Economics
Difficulty: accessible
Concept Tags: interest-theory, bond-market, deflation, capital-destruction, federal-reserve, debt
Description: Drawing on Garet Garrett's 1932 book, Fekete traces the common thread between the Great Depression and the 2003 credit bubble: bond speculation enabled by central bank intervention transfers wealth from the productive sector through falling interest rates — the same mechanism in both episodes.
Editorial Note: Companion piece to 'Stop Greenspan,' written two days later. The title is borrowed from Garet Garrett's 1932 book of the same name.
Original PDF: https://professorfekete.com/articles/AEFTheBubbleThatBrokeTheWorld.pdf

*The Bubble That Broke The*

**WORLD by Antal E. Fekete** · Professor, Memorial University of Newfoundland

---

*June 25, 2003*

### It won’t be easy to put the genie back in the bottle

The date May 21, 2003, should be remembered as a historic landmark. On this day Aladdin Greenspan let the genie out of the bottle. The genie is now at large, entirely on its own, roaming around the world, visiting disaster upon the economies wherever it may go: a depression possibly worse than that in the 1930's. Aladdin hasn’t got a clue how to put it back in the bottle because, if he tried, the genie would threaten to plunge the world into another bottomless pit: that of hyperinflation. Aladdin sowed the wind to let the world reap the whirlwind.

As the reader probably gleans it from the above, the genie symbolizes bond speculation.

Greenspan testified before the Joint Economic Committee of Congress on that fateful day, explaining the strategy the Fed has developed to combat deflation. He would climb the yield curve, that is, go out to buy government bonds of all maturities, if need be up to and including the 30-year Treasury bonds, in an effort to push interest rates down thereby enlarging the monetary base that would, according to him, contain the weakness in prices.

It is a long shot from open market purchases of bonds to a buoyant price level. After all, once in circulation, the new money created by the Fed is no longer under its control. It is under the control of the speculators. They will not necessarily deploy it in the commodity or stock markets, as the Fed is hoping. They may see a better opportunity for profitable speculation elsewhere, say, in the real estate or the bond markets. The trouble is not that the Fed is following a script that has become stale. The trouble is that the Fed has given away the store by telling speculators that all remaining risks have been taken out of bond speculation. They can now bid up bond prices to unimaginable heights unopposed. This could also be an act of desperation on the part of the Fed.

According to this script, the speculators are being bribed by risk-free opportunities not to dump the bonds that would reduce them to worthlessness.

### This bet is on the house!

Bond speculators are sitting on a huge pyramid of paper profits they have accumulated as short term rates of interest rates were pushed down from over 20 percent in 1980 to a little over 1 percent in 2003. A measure of the pyramid is the Derivative Bubble, now \$140 trillion strong, consisting mostly of bets that interest rates will fall further. We are witnessing the biggest bull market ever, in anything, anywhere, at any time in all history. There has never been a bubble of that size and ferocity before. Tulipomania, the South Sea Bubble, the Mississippi Bubble, the bubble of the Roaring Twenties all pale in comparison.

Lately, speculators have been itching to cash in on their huge winnings, especially in view of the fact that foreign private and official holders appear poised to reduce their holdings of U.S.

Treasury securities. Greenspan knows that a bubble so big as this cannot be safely deflated. It could trigger hyperinflation. So he has recourse to a desperate gamble: he is bribing the bond speculators. As the barker at the fair, he is crying to them: "Hang on! The bond bull is far from getting tired! Don’t get out, the fun has just started! Your next bet is on the house! Profits are free for the taking! No risks involved!"

Surely this is an unprecedented sight: the central banker bribing the speculators with promises of untold riches free for the taking. Nothing like this has ever happened in history before, and probably never will. The central banker tips you off to place your bet that the bond price will go up, and, bingo! You have won the jackpot.

### Firms falling like flies in autumn

It sounds crazy but is true nevertheless. All this would be very comical if there wasn’t a sad part to it. The Greenspan announcement was designed to prevent prices from weakening and the stock market from collapsing. Yet its effect will in all likelihood be highly deflationary. Falling interest rates will ratchet down prices, and falling prices will ratchet down interest rates even more. As prices fall, the Fed raises the ante and buys more bonds, giving away more free gifts to the speculators. Both prices and interest rates fall into the abyss, and the economy is plunged into deep depression. The capital structure of productive enterprise is fatally weakened. Firms fall like flies in autumn. There is great pressure to cut debt and inventory. Cutting debt lowers interest rates, and cutting inventory lowers prices more. Those firms that can’t do it fast enough are mercilessly forced into liquidation. There is growing unemployment, and falling demand will kick prices down further. Even some of the healthiest firms succumb as they could not collect receivables from their fallen brethren.

How is it that Greenspan, in command of an army of research economists, could make such an enormous blunder? Well, these people are just a bunch of sycophants. They will say only what the boss wants to hear. Just read the report Deflation: Determinants, Risks, and Policy Options (April 30, 2003) on the website [www.imf.org](https://www.imf.org). These so-called economists are steadfast in their determination to ignore the bubble. They look at the pro’s, but not at the con’s. They deny the ratchet-down effect. They vehemently object to the suggestion that falling interest rates may cause prices to fall rather than rise. Therefore I now take great care to explain the ratchet-down and its operation in detail, and hereby challenge anybody to find a weak point in my argument.

### The Iron Law of Payrolls

Suppose we take the example of a stream of payments at the annual rate of \$60,000. It could be visualized as the income of a bread-winner. In order to attach a value to it, we capitalize it at the going rate of interest. If it is 6 percent, then the capitalized value of the payments stream of \$60,000 is \$1 million. That is the capital sum one must have in order to reap the given paymentstream at the given rate of interest.

The capitalized value of the same stream of payments will be higher or lower, according as the rate of interest is lower or higher. In particular, if the rate of interest falls, the capitalized value of the payments stream rises. There is no mystery about this inverse relationship. At the lower rate it will take a larger capital sum to generate the same stream of payments. In our example, as the rate of interest falls from 6 to 3 percent, the capital sum required will rise from \$1 to \$2 million, assuming that you want to generate the same annual income of \$60,000. That’s right, by a stroke of the pen (or, shall we say, by a click of the mouse) capital values can be drastically altered, without adding to or taking away from the park of physical capital in the economy. Moreover, these changes will affect all productive enterprises across the whole spectrum, and affect them in the same way: adversely.

Every productive enterprise must earmark part of its capital for the purpose of backing payroll.

That part of capital is called the wage fund. The size of the wage fund is proportional, not to the payroll itself, but to its capitalized value calculated at the current rate of interest. If the rate of interest changes, so must the wage fund. The Iron Law of Payrolls tells you how: if the rate of interest is cut in half, then the wage fund must be increased two-fold. This is so because capital tends to flow from the less to the more promising applications. As the rate of interest falls, capital will adjust to the new environment. The way to keep it is to augment it. In case the enterprise hasn’t got sufficient capital reserves to answer this need, or if it can’t increase its capital in a hurry, then there are three choices. Either wages must be cut, or some workers must be laid off, or the firm must go out of business. It’s no use pretending that you can get around the Iron Law by continuing ‘business as usual’ with an impaired wage fund. Creditors will force you into bankruptcy. Of course, this is harsh justice. Of course, you are not responsible for cutting the rate of interest in the first place. Of course, you are an innocent victim, the whipping boy to be punished for other people’s crimes. However, creditors are not running a charity: they will not advance new credits to a firm suffering from deficiency of capital.

### Incredibly low level of scientific understanding

Nor is this all. Payroll is just one of the many streams of money payments the firm has to meet.

Another is payment of interest on past borrowing. If it cannot immediately refinance debt then, again, the firm must have sufficient capital reserves to meet the increased burden. Then there are taxes, rents, utility bills, or any other regular payments that arise in the ordinary course of doing business. If they are not cut immediately, then the firm must have capital reserves sufficient to cover the increase in the capitalized value of these payment-streams as well. In most cases, such huge capital reserves are not available. The alternative is retrenchment or liquidation.

Please note that falling interest rates hit all productive enterprise at the same time, by making new demands on their capital structure. The burden of doing business is increased across the entire economy. Few firms go out of business voluntarily. Most choose to retrench. They downsize. This means cutting inventory and debt, hoping against hope that they can get away without cutting wages. We have already observed that as they cut inventory, prices fall; and as they cut debt, rates of interest fall. When all this comes to naught, firms must cut wages and jobs.

Demand weakens further. The pit of depression is dug, ready to swallow the national economy.

The initial push comes from the central banker giving the green light to speculators. That Greenspan has done. The rest, the sliding down through the chute of the deflationary spiral, is automatic.

It is, of course, incredible that Greenspan refuses to see the potential threat to the economy. To add insult to injury, he has the cheek to pretend that he is fighting depression (of his own making) by cutting interest rates, the very act that will activate the deflationary inferno. The only explanation for his lack of insight is the extraordinarily low level of scientific understanding which managers of the regime of fiat currency have, or must have. That regime is capable of unleashing the most horrendous forces of economic destruction: deflation or hyperinflation. Managers qualify for the job only if they have a demonstrated ability to remain blind to these dangers. Incidentally, hyperinflation is also caused by unlimited bond speculation, in this case, on the short side of the market. We have reached the point where deflation and hyperinflation are separated only by the knee-jerk reaction of the marginal bond speculator. The regime of fiat currency has a congenital disease, namely, its complete lack of immunity against destabilizing speculation which will ultimately destroy it. The only thing managers can do is to try to put off the evil day by hook or crook. The grandiose act of Greenspan to go out on one limb and climb the yield curve must be seen as a desperate effort to postpone the day of reckoning.

To summarize, falling interest rates fatally overload the capital structure of productive enterprise across the board by imposing new demands on it. These new demands have to do with the inescapable fact that at a lower rate of interest it will take a higher capital sum to generate an undiminished income-stream expected of productive enterprise. These new demands crowd out net worth in the balance sheet. Bereft of capital, productive enterprise goes down in defeat.

Collapsing demand is not the cause of deflation. It is the effect. The cause is collapsing capital for which the falling interest-rate policy of the central bank alone is responsible.

### Greenspan the alchemist

"Many of us can recall a picture of bewhiskered dabbler in the occult, surrounded by intricate apparatus, engaged in an attempt to turn base substances into gold. He was known as the alchemist, and he practiced his art over the course of centuries. Modern streamlining has dispensed with the whiskers and the gimcracks, but all present-day governments keep solemnly turning paper into gold and naively believe that they have accomplished something new, ingenious, and important. These governments tell their populations that there is no difference between paper and gold. In fact, they expatiate on the benefits of liberation from gold, insisting that government deficits are in reality a national investment, that the public debt is merely a book-keeping entity since we owe it to ourselves, and that printing-press money is a synonym for purchasing power. This propaganda has been going on for sufficiently long in time and sufficiently broadly in space that all young people in the United States, who have had no personal experience with the gold standard, will buy it. Our money magicians of today may, in retrospect, cut as pathetic a figure as the alchemists of ancient times."

The above quotation is from an address delivered on September 8, 1949, by Dr. William W.

Cumberland, of Ladenburg, Thalmann & Co., New York. It shows Greenspan the alchemist, and all past, present, and future managers of fiat currency, in the correct perspective.

### The ordination of a more expansive liturgy

"The Heroic Age of the free nations of the world was accomplished under the aegis of metallic monetary systems. The Industrial Revolution, with all the material benefits it created, has flourished largely in an environment of scrupulous devotion to classic precepts. Gold was universally accepted as surveillant deity which safeguarded society against fiscal and monetary temptations. The sanctity of contracts was embodied in the ritual, and gold clauses were inserted to discourage sacrilege. Then - all inhibitions were swept away. The nation officially espoused a critical view of sanctions formerly imputed to an impersonal monetary conscience. It renounced all forms of allegiance to what was regarded as outmoded superstition or regressive piety, in order to enjoy greater freedom in pursuing the New Mysteries of Money Magic. For it was assumed that monetary crises could be prevented more effectively by purely secular policy - by the rule of reason, as they called it - than by the compulsion of a once respected but now disavowed morality. Money was said to have become a compliant servant, rather than the traditionally stern guardian against the siren call of financial indulgence." "The radical change in official attitudes towards gold was consummated in response to the doctrine that the Great Depression had been accentuated by blind obeisance to the gold deity, and economic recovery was being retarded by a literal interpretation of the gold-standard commandments. Accordingly, it was ordained that a more expansive liturgy should replace what was regarded as the too-Spartan code of monetary ethics to which the nation had long adhered, and all references to gold were expunged from the transubstantiation ritual for money. It is quite possible, however, that time has been too short to reveal the many ways in which the diluted devotional practice can make itself felt."

The above quotation is from an article "An Eagle for Christmas?" by Merle Hostetler, Manager,

Research Department, Federal Reserve Bank of Cleveland, in Business Trends published by that bank, December 20, 1952. Greenspan would not tolerate in his organization free-thinking researchers like Hostetler. The new researchers must parrot slogans such as: "Among the causes of deflation we find adverse expectations and confidence effects." "We must develop a communication strategy highlighting the ability and commitment of policymakers to contain deflation." "From now on we must target inflation aggressively but with a buffer zone." "Fiscal policy must be tailored to credibly boosted aggregate demand." "More symmetric attention to risks of falling as well as rising prices is warranted." "Aggressive policies to contain and eradicate deflationary expectations are essential." "The liquidity trap is defined as the combination of a large output gap calling for monetary stimulus, with zero interest rate blocking monetary stimulus." "We must be shaping expectation through the manipulation of central bank balance sheet."

I have culled these slogans from the proceedings of the forum Should We Be Worried about Deflation? held on May 29, 2003, in Washington, D.C., as posted on [www.imf.org](https://www.imf.org). What do these slogans tell you about the quality of research conducted at the Fed and the IMF?

### Seizures of ecstasy and mass delusion

In 1932 financial journalist Garet Garrett published a book with the title A Bubble That Broke the World. In it he gave a better perspective of what is happening in the wake of credit expansion. "Organized credit is relatively strange in economic life. New and experimental forms of it are continually being invented and we love to deceive ourselves with them. We forget that credit in any form represents debt in some other form. We know about ourselves, that we have seizures of ecstasy and mass delusion. We know that a time may come when the temptation to throw the monetary machine into wild motion, so that everybody may become infinitely rich by means of infinite debt, will rise to the pitch of mania as it did, for example, in 1928 and

1929.

For a while the difficulty of not knowing what anything is worth inflames the ecstasy. Everything will be priced higher and higher to make sure that it is high enough; there will be the illusion that things are becoming dear and scarce. They seem to be dear because the value of money in which they are priced is falling; they seem to be scarce because people are buying in the expectation that prices will go higher still. Suddenly doubt appears, then comes awakening, and - panic.

The faith is lost... This is the financial crisis... All of it has happened. It was not the gold standard that did it; it was breaking faith with the gold standard that did it."

### ‘Political silences’

But the speculative orgy in 1928 and 1929 was rather mild in comparison to what was to take place under the watch of Greenspan Fed in the 1990's. The reaction in 2003 can therefore be that much more devastating. Here is a quotation from an article "Political Silences" by the same author that appeared in The Wall Street Journal, September 30, 1952.

"In a gingerly manner the presidential candidates talked about some of the effects of irredeemable paper currency, but about how to restore the honesty of the dollar they have said, if possible, less than nothing. They are like diagnosticians who have agreed beforehand on one point. They will ignore the fact of cancer. Irredeemable paper money, that is, money redeemable in nothing but more of itself, is a fatal disease with a record of one hundred percent mortality unless halted in time by radical surgery. It has already cost the people control of government. It has enabled the government to convert its own debt into ‘money’ and thereby to fill its own purse.

It is the stuff upon which the self-exalting executive principle of government feeds. It is morally devastating and corrupts men by cumulative temptation. It hurts everybody - the rich, the poor, and the dependent."

Greenspan is such a diagnostician well-trained in the discipline of ‘political silences’. Our body economic appears to have cancer as indicated by the speculative bubble in the bond market. It feeds upon itself and will, if unchecked, destroy the entire productive sector. Efforts to engage Greenspan in a meaningful discussion of the bubble and how to stop the spread of cancer by radical surgery have failed. He is guided by ‘political silences’. As boasted by his lieutenants, Greenspan has unlimited power: the privilege of printing unlimited amounts of fiat money without any countervailing responsibility. He is badly abusing that power. Greenspan is nursing a bubble that may break the world. History will be the judge.

---

# Stop Greenspan From Plunging America Into a Depression

URL: https://newaustrianeconomics.com/archive/fekete/stop-greenspan-from-plunging-america-into-depression/
Date: 2003-06-25
Section: Popular Economics
Difficulty: accessible
Concept Tags: interest-theory, federal-reserve, deflation, bond-market, capital-destruction, monetary-policy
Description: The Fed's zero-interest-rate policy is a one-way road to depression — falling rates raise the present value of existing debt, squeezing productive enterprise while rewarding bond speculation. Fekete calls for ending rate-suppression before capital destruction becomes irreversible.
Editorial Note: Written in June 2003 during Greenspan's aggressive rate-cutting after the dot-com bust. One of Fekete's most pointed warnings about Fed policy, anticipating his later analysis of the 2008 crisis.
Original PDF: https://professorfekete.com/articles/AEFStopGreenspanDepression.pdf

## Stop Greenspan From Plunging

AMERICAN INTO A DEPRESSION by Antal E. Fekete,

### Professor, Memorial University of Newfoundland

---

*June 25, 2003*

Open letter to Congressman Ron Paul, member of the Joint Economic Committee

### Antal E. Fekete

### Memorial University of Newfoundland

### St.John’s, Newfoundland, CANADA A1C 5S7

### E-mail

### To the Honorable Ron Paul

### U.S. House of Representatives

Washington, D.C.

---

*June 10, 2003*

Dear Dr. Paul:

I have been a student of monetary science for almost fifty years and I am greatly disturbed by the explosive and malignant growth of bond speculation which I attribute directly to the inept monetary policy of the Federal Reserve.

One-sided bond speculation fully explains collapsing interest rates and burgeoning depression in Japan for the past ten to twelve years. Before 1971, when the world was on the gold exchange standard and interest rates were relatively stable, there was no bond speculation. None whatsoever. Moreover, the amount of long positions in bonds was limited by the amount of issues outstanding. This was changed drastically (although without much fanfare) in 1971 when the world embraced fiat money. (Or was it fiat money that embraced the world?) Now interest rates can move in and out of double digits, or even fall to zero. More ominously, the amount of long position in bonds is no longer limited by the amount of issues outstanding (large as it may be). Derivatives have removed that limit. Speculators can now pyramid in pursuit of higher bond prices. At last count the size of the derivatives market was \$140 trillion. Let’s assume that the total of interest-related derivatives is \$100 trillion in ‘notional terms’. This means that speculators have paid premiums to benefit from a rise in the value of \$100 trillion worth of bonds (never mind that the total value of all the outstanding issues is a small fraction of that incredible sum). Therefore speculators stand to rake in \$1 trillion in profits every time bond prices increase an average of 1 percent due to a drop in interest rates. Nor are these profits ‘notional’: they are payable in cold cash.

The next domino, after Japan, is the United States. Contrary to conventional wisdom, a falling interest rate structure is no boon to the economy. A low and stable interest rate structure is. All thoughtful economists would agree that lower prices with stable interest rates (as obtain under a gold standard) are no threat. On the contrary: they are a welcome fruit of increased efficiency. It is the combination of falling interest rates and falling prices that is deadly: if prolonged, they could lead to depression.

The Federal Reserve has been conducting unreformed Keynesian monetary policy for the past decades, but it has now reached the end of the rope as the federal funds rate was pushed down almost to zero. At the May 21, 2003, hearing of the Joint Economic Committee, Mr. Greenspan testified as follows.

Senator Robert F. Bennett (Chairman): Last November when you were here we discussed the downward pressure on prices, and options available to the Federal Reserve to combat it. Yet some still seem to believe that low short-term interest rates limit the potency of monetary policy... Could you explain how the Fed could address unwelcome downward pressures on prices through the purchase of long-term Treasury securities?

Mr. Greenspan: As I and a number of my colleagues have stated recently, we have chosen to act solely in overnight funds, essentially addressing the reserve balances of the banks. Should it turn out that, for reasons which we don’t expect, but we certainly are concerned may happen, the pressures on the short-term markets drive the federal funds rate down close to zero, that does not mean that the Federal Reserve is out of business on the issue of further easing and expansion of the monetary base. We can, indeed, as you point out, move out on the yield-curve because, as you are well aware, even though shortterm rates are slightly over 1 percent, longer term rates are up significantly above that.

And we do have the capability, should that be necessary, of clearly moving out on the yield-curve, essentially moving longer-term rates down and in the process expanding the monetary base and the degree of monetary stimulus. And since there is such a significant amount of potential in that longer-term maturity structure, we see no credible possibility that we will, at any point, run out of monetary ammunition to address problems of deflation or anything similar to that which disrupts our economy.

The testimony of Mr. Greenspan reveals that the Federal Reserve has no creditable plan to combat deflation. The plan it has is a colossal mistake that could very well plunge America headlong into deep depression. The bubble of speculative long positions in bonds is so huge that it can no longer be safely deflated. Now the Federal Reserve is gearing up to climb the yield-curve in order to expand the monetary base and stimulate demand. But this is to pour oil on raging fire. The Federal Reserve can create as much new money as it wants, but will have no control over it once it has entered circulation. It is up to the speculators. This is how they read the message: “Hey, here is another godsend. The old boy has pulled out all the stops, there is no more risk in pyramiding bond derivatives! You had better believe it! Just watch the price-indicators. Every time one falls, or demand weakens, Greenspan & Co. is going to buy bonds. Forestall them, how we will! We buy first. Profits guaranteed, courtesy of the Fed. Thank you kindly,

### Mr. Greenspan!”

There was always political pressure on the Federal Reserve Board to reduce interest rates.

But as shown by the volumes of the Federal Reserve Bulletin for the years 1950-1970, the Board was always very clear on the point that the reduction of interest rates (other than the federal funds rate) is not within the Board’s power. If Mr. Greenspan now promises to work the miracle that his predecessors were frank enough to call impossible, it is because he, like the Sorcerer’s Apprentice, relies on others to do the job for him, namely, on the speculators. The explosive growth in bond speculation is explained by the greatly reduced risks involved. Now, given Mr.Greenspan’s testimony, the remaining risk is being taken out as well. But he won’t be able to control speculators once he has allowed them free rein. Mr. Greenspan will, like the Sorcerer’s Apprentice, be swept away by the tide he has fomented.

The consequences are terrifying. The pact Mr. Greenspan has made with the devil is a most dangerous kind. Further drop in interest rates would, albeit with a time lag, cause a fall in prices, and falling prices would cause interest rates to fall further, spelling deflationary spiral for the country.

I respectfully submit that the Joint Economic Committee, in search for an answer to Senator Bennett’s query, may wish to hear the testimony of independent witnesses as well. Mr. Greenspan’s testimony is self serving, and it shrouds the extreme danger implicit in his counter-productive plan. There are opposing views that may be worthy of the attention of your Committee. I take the liberty of enclosing a brief representing those views.

I remain,

Your most obedient servant,

### Antal E. Fekete

### Professor Emeritus

### Enclosure

## Deflation Under Fiat Money

According to Mr. Greenspan almost no economists believed that you could create deflation with fiat currencies because, by definition, the ultimate supply of those currencies comes from the government. This brief represents the view of those very few economists he refers to, never before carefully spelled out in detail.

### Genesis of the long wave inflation-deflation cycle

In the Keynesian view, the gold standard is “contractionist” or “deflation-prone”. The truth is the exact opposite. The gold standard is the flywheel regulator of the economy: it makes for stability.

It was precisely the sabotaging of the gold standard by the banks and the government that started the inflation-deflation long-wave cycle. With the connivance of the government, banks expanded credit beyond the limits set by their gold reserves. When they could no longer pay their sight liabilities, the government came to their rescue by declaring a “bank holiday”. Worse still, a double standard was introduced in the application of contract law. While every other firm was liable to be liquidated by its creditors in case it failed to deliver on its contracts, banks were given a privilege. They were exempted. Nay, they were rewarded for breaking their contract with their creditors. Their dishonored promissory notes were elevated to the status of money, at first temporarily, then permanently. This perverted system of incentives did not fail to have consequences.

The immediate effect was inflation. This was a sellers’ market and the new cash caused prices to rise. Higher prices caused interest rates to rise as well. Lenders demanded compensation for their expected losses in the form of an “inflation premium” to be added to the going rate of interest. As interest is a major cost for the producers, higher interest rates in turn caused further price rises.

### The Spiral

In this way an inflationary spiral was set into motion: higher prices causing higher interest rates causing higher prices, and so on. Sooner or later the spiral would run its course and come to an end. When growing stockpiles remained unsold, there was panic. Retrenchment, alias deflation, started in earnest. Prices fell. Lenders were forced to drop the inflation premium. Interest rates fell. This was now a buyers’ market. Producers were squeezed by competition, and they had to cut prices further. Thus a deflationary spiral was set into motion: lower prices causing lower interest rates causing lower prices, and so on.

### Oscillating money flows

The inflation-deflation cycle can be visualized as a money-flow oscillating back-and-forth between the bond market and the commodity market. In the inflationary phase money flows from the former to the latter. Prices are bid up. Bondholders sell their bonds. The tide in the commodity market is coupled with an ebb in the bond market. After the panic the flow is turned around. It now flows from the commodity market to the bond market. Bondholders buy their bonds back.

Commodities are sold at fire-sale prices. Consumers hold back their purchases awaiting still lower prices.

Note that organized speculation has hardly any role in all this as long as the gold standard remains intact. Bond speculation is ruled out: interest rates are relatively stable under a gold standard and, as a result, there is not enough variation in the bond price to make speculation profitable. Commodity speculation exists only insofar as it addresses risks created by nature, to the exclusion of risks created by man. As a consequence, the inflation-deflation cycle is relatively moderate.

### Destabilizing speculation

Everything changes drastically with the advent of fiat currency. In addition to stabilizing speculation (addressing risks created by nature) we now have to face destabilizing speculation (addressing risks created by man). This is what Keynesians have “forgotten” to take into account.

None of the risks in the foreign exchange and bond markets is created by nature. These risks have all been created by man, in particular by the government, through the instrumentality of overthrowing the gold standard and imposing fiat currency. In the battle of wits more often than not it is the nimble speculator who outsmarts the clumsy central banker and other hired hands of the government.

The consequences of destabilizing speculation are enormous. Limits on the amplitude of price moves have been removed. Worse still, the natural limit on the total commitments in the bond market has also been removed: speculators can now amass long (or short) positions in bonds in any amount, regardless of the combined value of all outstanding issues. It is this fact that is at the heart of the problem of the explosive and malignant growth of bond speculation which has by now brought the total commitments of speculators to $ 140 trillion in the derivatives markets, a figure that boggles the mind. The total value of bonds outstanding falls far short of the notional value of derivatives on bonds. This is as though speculators are allowed to hold futures contracts calling for delivery of wheat before the next crop in the amount several times greater than wheat in all the barns, freight cars, and elevators of the world combined!

Where the risks are man-made, speculation is not a zero-sum game. The total gains of successful speculators are not equal to the total losses of unsuccessful ones. Speculators in bonds and derivatives make money not by resisting the formation of price-trends (as they would in the commodity market under a gold standard). They make money by inducing and riding price trends. They congregate on the same side of the market, whether long or short, and create exorbitant price swings before they move in for the kill. The profits of bond speculators are at the expense of society at large. They come out of the hides of innocent people.

### The Ratchet

The deflationary spiral changed its character under the regime of fiat currency. While it had its benign aspects before the gold standard was overthrown such as correcting the excesses of credit expansion, it has become totally malignant after. Speculation and bonds constitute an explosive mix which will, sooner or later, cause economic disaster. Oscillating money-flows get out of control. The process replicates the operation of a runaway vibrator, except the wave length is measured in years or decades, rather than seconds.

Ratchet is the name for the phenomenon that rising prices pull up interest rates and rising interest rates pull up prices (creating inflationary spiral). This is ratchet-up. But you can ratchet-down as well: falling prices pull down interest rates and falling interest rates pull down prices (creating deflationary spiral). Under the regime of fiat currency these ratchets are irresistible as they are powered and amplified by speculation.

Ratchet-up is uncontroversial and is accepted by most economist. It is ratchet-down the validity of which has been called into question. Critics say that falling interest rates need not cause falling prices, and they cite our current experience: falling interest rates have not produced a major fall in the price level. In fact, people in every walk of life complain about unwarranted price hikes.

However, the jury is still out on this. Prices did drop in the 1980's when sugar fell from 70 cents a pound, silver from \$45 an ounce, and crude oil from \$40 a barrel. During the 1990's prices of computers and communication equipment have come down dramatically. Ford has recently reported that the company has lost its pricing-power, something it could formerly take for granted.

Senator Bennett and Chairman Greenspan would not polemicize about downward pressure on prices and potential deflation if they were a mere figment of the imagination.

The reluctance of the mind to admit that the principle of ratchet-down is a valid one is due to the sway Quantity Theory of Money holds over economics. Under the regime of fiat currency ratchetdown appears as an oxymoron. People think that prices can only go up because the quantity of money in circulation is never reduced but always increased. However, the Quantity Theory is a very crude device. It presents a linear model that is valid only as a first approximation. New money can flow not only to the commodity market, but also to the stock, bond, and real-estate market. For a clue as to which one it will, we must study the behavior of speculators. In today’s complex world we need a non-linear model such as the theory of oscillating money-flows. Without it we remain blind to the fact that Mr. Greenspan’s anti-deflationary plan is counter-productive.

### Falling interest rates squeeze profits

To understand the mechanism of ratchet-down consider the fact that falling interest rates squeeze profits. Conventional wisdom would suggest otherwise: lower interest rates are salubrious to business. However, we must distinguish between a low interest-rate structure and a falling one. Only the former is salubrious, the latter can be lethal. Falling interest rates reveal that past investments in physical capital have been made at too high a rate in view of lower rates now available. The difference of the two hits the profit margin, and hits it badly. There is no way to get around this if you want to keep your books straight. Falling interest rates make the cost of servicing debt on past investments soar. The present value of debt rises. As it does, the cost of liquidating liability rises as well. If you want to retire a loan of \$1,000 taken out at 6% after the rate has fallen to 3%, then you have to come up with \$2,000. As a consequence the value of capital falls. Firms with zero debt are not exempt either. Their capital is also decimated since its replacement can now be financed at lower rates. This should be reflected by writing down capital.

Relaxed accounting standards do, however, allow firms to get away without reporting capital losses in the balance sheet. But a loss is a loss, admitted or not. Ignoring it won’t eliminate it but will expose the firm to the danger of “sudden death”. Like any other loss (such as physical destruction of plant and equipment during war, for example), capital loss should be charged against future earnings. If it isn’t, the firm is reporting phantom profits. Creditors will not let themselves be hoodwinked. Long before capital is reduced to zero they will cut off debtors, forcing them into liquidation.

Some of my critics argue that companies refinance their debts to their advantage. Well, some debts may be refinanced, some may not. As things are, more and more lenders are reluctant to comply with requests to refinance. At any rate, debt that has been paid off cannot be refinanced.

Yet paid-up capital should be written down in the same manner as capital financed by debt, since it was also subject to losses if it had been put in place when interest rates were higher. Most of the losses plaguing companies are of this variety. For example, several airlines (regardless whether well or badly managed) got blown out of the sky as falling interest rates wiped out their capital.

If you bought a house yesterday only to find out today that comparable houses have been reduced in price by half, then you have suffered a capital loss. No amount of sophistry can make the loss disappear. Nor does it make a difference whether you financed your purchase, or whether you paid cash. The situation is the same with plant and equipment owned by corporations.

Other critics say that falling interest rates drive real estate prices higher, especially that of homes, because buyers don’t care how high the price is as long as the monthly payments fall within their budgets. Thus falling interest rates do not squeeze profits in the housing industry. However, this is a rather short-sighted view of deflation, leaving growing unemployment and escalating consumer debt out of the picture. And what about the scenario that the housing bubble may burst, too, as it probably will?

Another frequent criticism maintains, while confirming that losses occur in the liability column as a result of falling interest rates, that these are offset by gains in the asset column. Not only do falling interest rates increase the present value of debt, causing losses, they increase the present value of future earnings, too, leading to capital gains. Capital losses are compensated by capital gains — something, my critics say, I have overlooked. The trouble with this argument is that it ignores the accounting rule that prohibits putting values on assets higher than historic costs, regardless of any anticipated increase in future earnings. As the proverb says: “there is many a slip between cup and lip”. Unforeseen liquidation of the enterprise would reduce all future earnings to zero. Why did Swissair fall out of the sky if it could capitalize its higher future earnings due to lower interest rates? Because it couldn’t: by the time it would collect them it was no longer flying. The (upright) accountant has no choice. He must charge the increased cost of liquidation to the liability column — without making any allowance for increased future earnings in the asset column. Net worth must be written down.

As profits are squeezed, firms are forced to retrench. They reduce inventory, causing prices to fall. Falling prices squeeze profits further. Some firms may be able to reduce labor costs through wage-cuts. Most will lay off workers. Either way, payrolls shrink, making demand weaken. This will reinforce the fall in prices. Many firms see their capital melt away and have to fold, in spite of low interest rates. You have to have capital in order to borrow. This is the mechanism whereby falling interest rates cause prices to fall.

To recapitulate: falling interest rates cause a blanket decrease in the net worth of the entire productive sector while the wide-spread capital losses go unreported. Instead, phantom profits are paid out, undermining capital further. Such is the true explanation of the wholesale failure of firms. In a depression collapsing demand is secondary; the primary effect is collapsing production due to fatal weakening of the capital structure, caused by falling interest rates.

### The Linkage

Linkage is the name for the phenomenon that the price level and the rate of interest, apart from leads and lags, move in the same direction. Just as when a man is walking his dog on a leash: while it is possible for either one to get ahead of the other by a few steps from time to time, it is not possible for them to move in opposite directions for any great length of time. Linkage (also known as economic resonance) was recognized by several distinguished economists such as Knuth Wicksell, Wilhelm Roepke, Gottfried Haberler, Irving Fisher, and others. Apparently,

Keynes himself recognized it under the name “Gibson’s paradox”. Economists who studied the phenomenon also agree that there is a causal relation between rising (falling) prices and rising (falling) interest rates.

But as far as the relation between rising (falling) interest rates and rising (falling) prices are concerned, they found linkage “puzzling”. Fisher went as far as saying that “it seems impossible to interpret this as representing a relationship with any rational basis”. He attributed the phenomenon to freak coincidence. In 1947 Gilbert E. Jackson in a little-known paper The Rate of Interest pointed out that causality works in both directions. He plotted the price level and the rate of interest in the same coordinate system with the horizontal axis representing time. The inflationary spiral appeared as a rising, and the deflationary as a falling trend of the curves.

Inflationary and deflationary spirals alternated. Sometimes the price level led and the rate of interest lagged, at other times the rate of interest led and the price level lagged.

Jackson was writing at a time the country was still on the gold exchange standard, before the advent of the fiat dollar. We can augment his reasoning as follows. Speculation amplifies the oscillation of money-flows greatly. In 1971 the advent of the fiat dollar gave impetus to prices to rise. Speculators, ready to move in for the kill, kept buying commodities and hedged themselves by shorting the bond market. Commodity prices rose while bond prices fell. But this is the same to say that the rise in the price level caused interest rates to rise as well. The converse is also true.

Rising interest rates, that is, falling bond prices, cause prices to rise as well. Speculators keep selling bonds and hedge themselves by establishing long positions in the commodity market. The inflationary spiral is on and assumes formidable dimensions.

When panic occurred in 1980, speculators switched allegiance. They closed out their short positions in the bond market and their long positions in the commodity market. They kept on buying bonds and hedged themselves with short positions in the commodity market. The speculative money-flow reversed. The deflationary spiral is definitely on, and we still don’t know where it will end.

### Monetary policy: contra-cyclical or counter-productive?

The so-called contra-cyclical monetary policy invented by Keynes has been the guiding star of the Fed. Following the Keynesian prescription the Greenspan Fed is trying to contain weakening demand and falling prices through open market purchases of bonds, if need be, by climbing the yield curve. Contra-cyclical monetary policy backfires in the case of the deflationary spiral. To forestall the Fed speculators go long in bonds and hedge their exposure by going short in commodities. The Fed is helpless: it cannot stem the rising tide of money flowing to the bond market. As far as bond prices are concerned the sky is the limit. Interest rates in the United States will plunge to zero, as they have in Japan. Mr. Greenspan, like the Sorcerer’s Apprentice, can make speculators charge, but has no idea how to stop them when enough is enough.

Incidentally, contra-cyclical monetary policy backfires in the case of the inflationary spiral as well.

There the Fed’s concern is rising interest rates getting out of hand. To rein them in and turn them back it resorts to open market purchases of bonds. Speculators correctly perceive that the new money so created will flow to the commodity market, reducing the risks of speculating. They go long and hedge their exposure by going short in the bond market. Once again, the Fed is helpless: it cannot stem the rising tide of money flowing to the commodity market.

To recapitulate, in a deflationary spiral the Fed combats weakening prices, causing the rate of interest to fall — which leads to still more weakness in prices. In an inflationary spiral it combats the high rate of interest, causing prices to rise — which leads to still higher interest rates. In either case, the contra-cyclical policy is counter-productive. For example, during the 1947-1980 inflationary spiral the rate of interest rose five-fold and the price level rose ten-fold in the United States, in spite (because?) of constant and vigorous contra-cyclical intervention of the Fed. In the present deflationary cycle that started in 1980 long term interest rates as measured by the yield on the 30-year Treasury bond have fallen by three-quarter (from 16 to 4 percent). So far apart from the initial fall in 1980 prices haven’t fallen much, and some may have risen. But remember, Mr. Greenspan has just given the green light to speculators. Nobody knows how low prices will go by the time Mr. Greenspan and his speculators are through.

To recapitulate, the long-wave economic cycle is caused by huge money-flows oscillating backand-forth between the bond and commodity markets, amplified by speculation and reinforced by the mindless and inept contra-cyclical monetary policy of the Fed.

### Compulsive currency devaluations

Keynes was so obsessed with the idea of gold hoarding that he missed the key point that hoarding other goods, inevitable under the regime of fiat currency, is infinitely more menacing.

Keynes is the prophet of anti-gold agitation. He preached that if the gold coin were taken away from “man’s greedy palms”, then there would be no economic contraction, no deflation. This was a monumental mistake, the kind only a doctrinaire can make. The Fed, blindly following the prophet, has brought the country to the brink of depression, fiat money notwithstanding. Gold is the philosopher’s stone: in its presence hoarding is directed into its proper channels but, without it, the world becomes a plaything in the hands of speculators.

The deflationary spiral that started in 1980 has not run its course yet. Some liquidation of inventories has taken place, some producers have been eliminated. The worst may still lie ahead.

Politicians and central bankers around the world congratulate each other upon their success of “squeezing inflationary expectations out of the system”. They are unaware that, right now, they are fostering deflationary expectations. Otherwise they would not be tempting speculators so recklessly with reduced risks.

Mr. Greenspan has done nothing to neutralize the causes of world-wide deflation. The international monetary system is still the same rudderless ship it was in 1971, and it is still exposed to the same monetary storms, except for the direction of the gale that has changed course from inflationary to deflationary. This will lead to competitive devaluation of the fiat currencies of the world. The dollar has just been devalued, if not de jure then de facto. Other countries cannot afford to be priced out of the American market, and they will have to debase their currencies as well. Compulsive currency debasement is the hallmark of world depression.

We know how ruinous that course is from the earlier episode in the 1930's. Yet the prospect of it is staring us in the face right now.

### What is to be done?

The only road to stabilization and the removal of the threat of depression is through putting speculation into its proper place and confining speculators to fields where they can do no harm while they may do some good. Gold money eliminates foreign exchange and bond speculation not through the barrel of the gun but through the persuasion of reason. It confines speculation to the commodity market where supply is controlled by nature, not by governments or central banks.

The significance of the gold standard is not to be seen in its ability to stabilize prices, which is neither possible nor desirable. It is, rather, to be seen in its ability to stabilize interest rates at the lowest level that is still consonant with the state of the economy. The stabilization of interest and foreign exchange rates will then impart as much stability to the price level (and to all other important economic indicators) as is compatible with progress.

The solution is: open the U.S. Mint to the free and unlimited coinage of gold. Double standard in contract law should be abolished, together with bank privileges. Banks that cannot pay their sight obligations in gold coin should be allowed to fail. Nobody will miss them. Letting the saver withdraw gold coins (that is, bank reserves) whenever the rate of interest falls to a level that he considers unacceptable represents no danger, indeed, it would nip malevolent speculation in the bud. Benign bond/gold arbitrage would replace malignant bond/commodity speculation. Since the former is self-limiting and the latter is self-aggravating, economic stability would be restored. Time has come to conclude, for once and all, that the wild experiment with fiat currencies has failed, and failed completely. It should be terminated forthwith before it causes further damage to the economy.

The alternative is to continue the experiment. Naturally, Mr. Greenspan is in favor of that course.

The consequences are too horrible to contemplate: unemployment more devastating than that of the 1930's, wholesale bankruptcies of productive enterprise, competitive currency debasement, collapse of the international monetary system, construction of unscalable protective tariff walls, world war in which governments are hoping to find the escape route from economic chaos.

## ~ Note On Runaway Vibration ~

The phenomenon of vibration is studied in physics. The most common varieties are even vibration (oscillation) and damped vibration, according as the amplitude remains constant or it is decreasing exponentially. But there is also a third variety, not as well known, called runaway vibration, where the amplitude is increasing exponentially. The collapse of the Tacoma suspension bridge in the State of Washington in 1940 was an example. Gusting winds caused the bridge to vibrate at one of its harmonic frequencies. The increasing amplitude of the runaway vibration ultimately caused the suspension cables to snap, and the whole structure was plunged into the river. The event has been preserved on film - it must be seen to be believed.

In general, the small parcels of energy represented by each thrust would get dissipated harmlessly through damping. In the case of resonance, however, not only are they not dissipated, they are allowed to be built up to a formidable force capable of causing huge destruction.

Resonance in economics, no less than in bridge design, is a problem to reckon with. I have discussed linkage in my talk Kondratieff Revisited. The price level and the rate of interest move together up or down, as they resonate with huge oscillating speculative money flows to and fro between the bond and commodity markets. Bond speculators try to maximize their profits. For them the problem is correct timing: they want to be the first to switch positions when the expected turn of the flow of money materializes. This is just the point where the runaway vibrator starts spinning out of control. As soon as speculators find that point, the oscillating speculative moneyflows will become too big and too destructive for anybody to control, and they will drown the economy.

### References

The Rate of Interest, address by Gilbert E. Jackson at the Annual Meeting of the Dominion Mortgage and Investments Association in Waterloo, Ontario, Canada, on May 29, 1947.

Reprinted in: Bulletin #132 (1947) by Melchior Palyi (archived in the Library of the University of Chicago).

History of Economic Analysis by Joseph A. Schumpeter, 1954, New York: Oxford University

### Press

Deflation: Retrospect and Prospect by Antal E. Fekete, Monograph #45, April, 1986, Committee for Monetary Research and Education, 10012 Greenwood Court, Charlotte, NC 28215

---

# Tainted Research: Lysenkoism — American Style

URL: https://newaustrianeconomics.com/archive/fekete/tainted-research-lysenkoism-american-style/
Date: 2003-06-10
Section: Popular Economics
Difficulty: accessible
Concept Tags: fiat-currency, irredeemable-currency, gold-standard, monetary-policy
Description: Fekete compares mainstream monetary economics to Soviet Lysenkoism — a politically mandated orthodoxy that suppresses contradicting evidence. The irredeemable currency regime has corrupted monetary scholarship as thoroughly as Stalinism corrupted Soviet biology, with catastrophic practical consequences.
Editorial Note: Written in June 2003. The Lysenko comparison — state-enforced scientific fraud — became a recurring motif in Fekete's writing about the suppression of sound monetary theory.
Original PDF: https://professorfekete.com/articles/AEFTaintedResearch.pdf

*Tainted Research Lysenkoism - American*

STYLE by Antal E. Fekete,

### Professor, Memorial University of Newfoundland

---

*June 10, 2003*

### Religion, the drug of exploited masses?

All power-structures in human society face the problem of keeping the majority of population both in relative poverty and in dutiful submissiveness, so that the power-elite could enjoy relative affluence undisturbed by popular unrest. Karl Marx suggested that capitalist society has solved this problem by calling upon religion to promise people rich rewards in the transcendental world as compensation for deprivations in this valley of wailing, provided only that they are borne with peaceful resignation. As there is no way to assess scientifically the validity of its teachings, the claims of religion can never be proved or disproved. Concerning the genuineness of its promises, to the faithful no proof is necessary and, to the non-believer, no proof is sufficient.

Be that as it may, Marxist anti-religious propaganda had one undesirable side effect for the power-elite. From now on it has to call upon science, rather than religion, to deliver the promise to the masses that would keep them satisfied with their lot. Clearly, in this case, there are scientific methods available to test the validity of claims with which a restless population can be kept at bay. While reward for meekness may not be postponed to the after-life, it may still be removed sufficiently in time so that the ultimate validity of the promise cannot be tested, at least not in one’s lifetime.

### The enfant terrible of Soviet biology

An outstanding example of this was the demand of the Soviet government under Stalin upon biology to disown classical genetics, and to deliver pseudo-scientific principles to the effect that it is possible to transmit acquired traits biologically, along with inherited ones, perhaps not to the next, but certainly to some other future generation. The Soviet regime needed to propagate this fable in order to keep a nearly starving population in check with promises of fabulous increases in agricultural productivity and abundance of food production at some unspecified future date.

Soviet propagandists found a willing collaborator in the person of Trofim Denisovich Lysenko (born in Karlovka, Ukraine, in 1898), the enfant terrible of Soviet genetics. On the basis of a borrowed discovery that the phases of plant growth can be accelerated by small doses of low temperature, Lysenko built up a quasi-scientific creed, combining Darwinism with the Michurinian thesis that heredity can be changed by good husbandry. However, this effort was more in line with Marxism than with genuine scientific theorizing. Failing to obtain scientific recognition and pre-eminence in the usual manner Lysenko, with the approval of the Communist Party, declared that the accepted Mendelian theory of genetics was in error. Outstanding Soviet scientists who resisted Lysenko’s methods and theories were banished or, worse still, sent to the Gulag never to be heard from again. In 1949 Lysenko was awarded the Order of Lenin as well as the Stalin Prize for his book Agrobiology published a year earlier. With the rise of Khrushchev and his agricultural policies Lysenko faded from the limelight, but was reinstated in 1958. Finally he resigned from the presidency of the Academy of Agricultural Sciences of which he was in charge between 1938 and 1956, then again between 1958 and 1962, on grounds of ill health. In 1965, after Khrushchev’s downfall, Lysenko was also relieved of his post as head of the Institute of Genetics.

Our term “lysenkoism” will refer to the servile, not to say obsequious attitude of scientists ready to cave in to the demands of the powers-that-be, even at the price of betraying the integrity of their own discipline. Under lysenkoism scientists are intimidated and forced to profess and propagate tenets that they would reject on purely scientific grounds. It is generally assumed that lysenkoism is possible only under a regime of brutal dictatorship. Scientists, at least when it comes to their confirmed scientific beliefs, have the probity of obeying incorruptible standards. They will not adopt a hidden agenda, nor will they knowingly abet misinformation or expound false theories in the hope of official approbation and personal glory. They are supposed to abhor pusillanimous or sycophantic behavior.

### “Why, that’s plain stealing, isn’t it, Mr. President?”

It was thought that the freedom of expression for the individual guaranteed by the American Constitution would prevent lysenkoism from spreading to the United States. Sadly, this hasn’t been the case. As the American government repudiated its domestic gold obligations in 1933 and, again, its foreign gold obligations in 1971, new generations of economists were all too eager to comply with the request to justify the breach of faith or, to put the matter somewhat less charitably, to find excuses for the government to have declared bankruptcy fraudulently. I use the adjective “fraudulent” advisedly. In both 1933 and 1971 the American government had ample gold resources to meet its obligations, as later auctions of U.S. Treasury gold would convincingly demonstrate. When asked by Franklin D. Roosevelt of his opinion regarding the matter, the great blind senator from Oklahoma, Thomas P. Gore, replied: “Why, that’s just plain stealing, isn’t it, Mr. President?” (See: Economics and the Public Welfare by Benjamin M. Anderson, second edition, 1979, Indianapolis: Liberty Press, p 317.) Roosevelt, using the excuse of the banking emergency, and appealing to the patriotic feelings of the citizenry, recalled the gold coins in circulation against payment in Federal Reserve notes. He stressed that the measure was to be “temporary”, and the gold should be returned to the rightful owners once the emergency has passed. But after the citizens complied, Roosevelt cried down the value of Federal Reserve notes (that is, he wrote up the value of gold in terms of paper) and nothing further was ever said about returning the gold to its rightful owners. This, and the later episode of dishonoring gold obligations under President Nixon in 1971 (also described as “temporary”), were instances of deliberate sabotage of the gold standard with the aim of “making America safe for socialism.”

### Turning stone into bread and water into wine

The American government was in obvious need of economic and social theories to justify the chicanery on grounds of “higher moral imperative”. It was necessary to show that the gold standard was not sabotaged and then forcibly overthrown but it had become obsolete and collapsed under the weight of its own inner contradictions. Many economists were anxious to come to the rescue of government in this face-saving exercise. They concocted theories to the effect that the gold standard was unworkable anyway. First and foremost among these apologists was Lord Keynes of Britain. Later he was followed by Nobel Laureate Milton Friedman of the United States, to name only the two most prominent.

Keynes built his theory on the notion that the difference between a liability and an asset becomes academic when related to the balance sheet of the government. As a consequence, provided that care is taken not to increase liabilities too greedily, items can be shifted adroitly from the liability to the asset column, while remaining confident that people won’t notice the prestidigitation. Thus the debt of the government can in principle be increased beyond any limit. Moreover, government debt is no longer a curse. It is a benefit to society, the more the better, as it is the very asset upon which purchasing media can be built. Retiring government debt is an old-fashioned idea. Keynes was fond of bragging that his theories can make it possible to turn stone into bread and water into wine, while the gold standard only gives you bankruptcy, unemployment, and misery.

It is easy to see through this sophistry. In reality, government debt is balanced by the power to tax. But as the birth of the American republic so brilliantly demonstrates, the taxing power of the government is far from being unlimited. At one point taxpayers will rise and overthrow the government in protest against unreasonable and unfair taxes. No less, a durable and stable monetary and payments system cannot be based on irredeemable currency. Such a currency depreciates year in and year out. Government doublespeak calls this process “inflation” suggesting inevitability, as if it was caused by continental drift. But after a time people will refuse to take the depreciating currency in payment for real goods and services, causing paper money to lose the remainder of its value abruptly.

The deliberate confusion between assets and liabilities was followed by other serious obfuscation: the confusion between wealth and debt, as well as capital and credit. This had a most profound effect on speculation. The creation of assets, wealth, and capital is subject to certain limitations by nature, whereas liabilities, debt, and credit can be churned out at will. Thus the stage is set to the grandiose act of “abolishing scarcity”, as well as to remove the limits on speculation imposed by nature. Today speculation is no longer under the control of the real economy, rather, the economy is under the control of speculation. Through trading derivatives and other make-believe assets bond speculators are permitted to rake in gains many times greater than those that the real economy is able to produce. Speculation addressing risks created by man, as opposed to risks created by nature, has the tendency to snowball: speculators pyramid (that is, use their profits to increase their commitments on the same side of the market).

Thereby the economy is turned into a Ponzi-scheme that is bound to topple. This is the weak point in the Keynesian edifice, which does not recognize the existence and danger of destabilizing speculation.

### The thief trying to get away by crying “thief!”

Friedman argued that it is a fatal shortcoming of the gold standard that it makes the currency out of an expensive commodity that could be replaced by credits created virtually at no cost. No sooner is the gold standard established than the movement to dilute it with paper credits is afoot.

To Friedman’s mind this is as plausible as the human impulse to make laborsaving devices.

When this movement reaches maturity and the payments system becomes saturated with credit substitutes, the gold standard must of necessity collapse. Friedman’s sophistry is no less disingenuous than that of Keynes. In reality, the creation of credit is subject to real and strict limitations, in particular, redemption in specie upon maturity, which, in the case of sight liabilities, is redemption on demand. But if the banks are allowed to obstruct the free flow of gold, and if the government is protecting the banks with privileges and exemptions from the effects of contract law, then trouble lies ahead. If double standard in contract law is established whereby banks failing to deliver on their promises to pay gold are routinely let off the hook with impunity through “bank holidays”, “standstill agreements”, and similar devices while all other firms stand to be liquidated by their creditors when they fail to deliver on their contractual obligations, then collapse of the gold standard in due course is indeed to be expected. However, this is not a fault of the gold standard, but that of the banks and the government. Here we have the textbook example of the thief trying to get away by crying “thief!”

### Buying shares at infinite P/E ratio

Recently the phrase “tainted research” has gained currency. It was introduced by journalists referring to the practice of a bank falsifying the results of in-house research in order to promote a stock, which the bank is about to dump. The glowing reports of analysts should help the bank get rid of assets turned sour without losses. Another instance is related to IPOs. Banks are supposed to nurse along baby companies before their shares can be traded publicly in the stock exchanges. This involves investing the banks’ own funds in the shares (called underwriting) and then offering them to the public (IPO = initial public offering). In a bull market people expect IPO shares to increase greatly in price, and they are eager to buy the banks’ offering. They would buy them even if the company has never turned a profit and has zero earnings (thus infinite P/E ratio), because people have confidence in the integrity of the banks, in their in-house research and underwriting experience. When the new dot-com shares were listed on the NASDAQ, the banks made huge amounts of money, while investors ended up holding the bag. Logically, they should have bought shares in the expectation of increasing P/E ratio, but tainted research led them to buy shares at infinite P/E ratio, only to see it collapse to zero.

### Whoever pays the piper will call the tunes

The phrase “tainted research” is new, but the practice is as old as governments. We have seen that the United States used tainted research to justify the overthrow of the Constitutional monetary order in 1933. Economic theories concocted by Keynes and Friedman were promoted, and sound theories of money and credit were unceremoniously discarded. The Federal Reserve System has been hiring economists not so much to gather and sort statistical data, but to develop new economic theories justifying irredeemable currency, synthetic credit, and central bank intervention in the markets. All this research is tainted. The Constitution still prohibits the use of irredeemable currency and synthetic credit. Apparently, Federal Reserve officials are not too confident that their theories could stand up in the light and heat of debate on the wisdom of changing the Constitution so as to justify the monopoly and unlimited power given to the banking cartel.

Equally tainted is research financed through government grants. Here the adage applies that whoever pays the piper will call the tunes. The tunes of the government are seductive like the songs of the sirens, promising eternal bliss in exchange for freedom. There is a great conflict of interest here. The government is sponsoring research in order to justify the removal of limitations restricting its own power.

### Prostitution of the universities

It is to the eternal shame of this age that our great universities have prostituted themselves to the government and the banks in pursuit of research funds. The universities gave up their most precious asset, independence, in exchange for money. They will probably never again be able to act as a free agent. Lysenko-types have taken over at the helm. They decide priorities, hiring and admission policy, and set the agenda to please the Leviathan. They even politicize course offering, sanctioning the introduction of gay and lesbian studies, for example. They are in favor of unionizing faculty, thus reducing professors from the status of a trustee to that of a hired hand.

The larger issue motivating these changes seems to be the desire to let the government and its agencies wrest the direction of higher education away from the community of scholars. The net result is a great deterioration of standards. Students are kept in ignorance as the study of the classical languages and literature, undiluted mathematics, true economics, and undoctored history is moved to the back burner.

The separation of the government and academia is scarcely less important than that of the state and church. They both act to prevent the concentration and abuse of power.

### Propping up wealth-destroying schemes

The most pernicious instance of tainted research is that offered in support of the preposterous thesis, by now firmly planted at the foundation of monetary policy, that deliberate currency debasement can make the export industry prosper and the trade deficit shrink. If this theory were true, then countries should reduce the value of their currencies to zero and give away their products to foreigners free of charge. But let us dig a little deeper and expose the sophistry involved. Suppose that the country is on the gold standard and has tried everything to improve its export business, but the best it could manage to bring in is \$9 in revenue for every \$10 in expenditure. In other words, the export industry is not a business but a wealth-destroying scheme. It needs to be dismantled, and its capital ought to be deployed elsewhere. But wait, Keynesian sophists come to the rescue. Scrap the gold standard, and debase the currency sufficiently to make the export industry profitable. As you are now paying labor in debased dollars, your expenditures will go down and, lo and behold, the money-losing export industry is turned into profitable business.

As can be seen, this is just a trick based on the manipulation of the accounting unit. Nothing in the real economy has been changed to make the enterprise profitable. Incidentally, this also reveals why gold must go. As an accounting unit, gold is incorruptible, the only one as such. Gold tells as it is. Honest bookkeeping standards and gold are inseparable. The trouble is that politicians of the new deal, and of the new world order, could not live with an incorruptible bookkeeping standard.

In the wake of the recent accounting scandals the search is on to find the small-time crooks in the accounting departments responsible for the embezzlements. The search is in vain. When the accounting unit is open to manipulation at the highest level, then the breeding ground for crooks at the lowest is most prolific, and balance sheets are hardly worth the paper on which they are printed.

### Is deflation possible under fiat money?

Mr. Alan Greenspan understands gold. (Neither Keynes, nor Friedman really understood it.) Many decades ago he wrote papers describing how the gold standard had been sabotaged and then discarded because it was an obstacle in the way of disenfranchising the saving and producing public. Recently he confirmed that he stood by every word he has ever written on the conflict between gold and fiat money. On May 21, 2003, Mr. Greenspan in a testimony before the Joint Economic Committee of Congress had this to say in answering the question of Rep. Paul Ryan on deflation:

“With the elimination of the gold standard in the 1930's and the development essentially of worldwide fiat currencies, almost no economist believed that you could create deflation with fiat currencies because the supply of those currencies, by definition, comes from government fiat. We went through most of the post World War II period with the expectation that fiat currencies were essentially inflation-ridden and that the major focus of central banks was to suppress inflation.

The notion that deflation could emerge just never entered our minds until the Japanese demonstrated to us otherwise.”

“As a consequence of that, not having had any experience in the modern world with dealing with deflation under fiat currencies, our knowledge-base was virtually non-existent, in the sense that we know how to deal with inflation.”

“Inflation, obviously, is something that for half a century we have been struggling with. We know how to suppress it. We know the consequences of suppressing it. We know the impact of various monetary policy decisions on the levels of output growth and of unemployment. So we are familiar with the mechanism. It’s not that we can very easily and automatically just suppress inflation; it has been a struggle of very great dimensions for most central banks in the world.

What’s happened now is that since I guess the middle of the 1990's we’re beginning to see that it is possible for deflation to coexist with a fiat currency and, in a way, it is, I suspect, credit to central banks, which essentially have restrained the expansion of credit enough that many aspects of the gold standard, which induced deflationary patterns in past periods, had been replicated in our monetary system and that, frankly, is quite good. We at the Federal Reserve recognize that deflation is a possibility. Indeed, we now have been putting very significant resources in trying to understand, without actually seeing it happen, what this phenomenon is all about. We cannot say that in the market place there is a severe increasing concern of deflation.

Indeed, the various expectations of price by both business and consumers has been relatively flat for recent years, so this is not something which the markets are beginning to sense that it is about to erupt and something which we must address.”

“Nonetheless, even though we perceive the risks as minor, the potential consequences are very substantial and could be quite negative. So we have created fairly significant resources to try to address this problem, increasing our knowledge of what actually happens, what’s the process and what tools are necessary to fend it off. I think we have made very substantial progress in that intellectual endeavor. We do, obviously, have the problem that we never dealt with it before. We know as a consequence that when we don’t deal with something, we have a large element of uncertainty, which strangely we do not have with the implementation of policies against inflation because we’ve dealt with it over so many decades. We believe that because in the current environment the cost of taking out insurance against deflation is so low that we can aggressively attack some of the underlying forces, which are essentially weak demand. And, indeed, we’ve done that since we started a very aggressive easing in monetary policy in early 2001. So long as the costs of engaging disinflation are so low, we have moved fairly considerably, and in statements we have recognized this not as an imminent, dangerous threat to the United States but a threat that, even though minor, is sufficiently large that it does require very close scrutiny and maybe, maybe, action on the part of the central bank.”

### Godfather of deflation

In spite of Mr. Greenspan patting himself on the back for his success in replicating many aspects of the gold standard, the record of the fiat money experiment in the United States could hardly be more miserable, and it threatens to become abysmal. Rather than admitting that research at the FED has been tainted, Mr. Greenspan is promising more of the same. He would not delegate the research on deflation to independent scholars. He would reserve the right to himself to act as the defense attorney, the prosecutor, and the trial judge, all in one person, at the court case where charges against the FED are heard, charges that the FED is directly responsible for the chill-fever economy and the inflation-deflation cycle caused by the mishandling of the issuance of money.

The most amazing thing about Mr. Greenspan’s tainted research is that it shies away from subject of bond speculation. Mr. Warren Buffett, the “sage of Omaha”, considers it a time-bomb.

He calls derivatives “financial weapons of mass destruction”. Mr. Greenspan demurs: “The benefits of derivatives, in my judgment, have far exceeded their costs”. What he fails to see is the explosive and malignant growth of the bubble of speculative long positions in bond futures, call options, and other derivatives. It is so huge that it can no longer be safely deflated. Worse still, the contingency plan of Mr. Greenspan to combat deflation will have the effect of greatly accelerating that growth. In fact, the entire problem of runaway bond speculation and collapsing interest rates can be blamed on the unreformed Keynesian monetary policy as conducted by the Federal Reserve during the past 23 years.

### Traitor to science

Mr. Greenspan stoops so low as to repeat the claims of Keynes that the gold standard is

“deflation-prone” and “contractionist”. He would not recommend that the U.S. House of Representatives, in whose sole competence the matter falls, return the country to a Constitutional metallic monetary standard in view of the fact that it was scrapped as a result of a terrible mistake.

Mr. Greenspan could have been the savior of the nation from the slavery of fiat money. Instead, he leads the world up the garden path into economic disaster. Now he wants to go on wielding unlimited power, to print unlimited amounts of money and to spring it on the economy, allegedly to protect us against deflation, which his own policies have brought about.

Mr. Greenspan richly deserves the third place in the Hall of Fame of Lysenkoism, right after Keynes and Friedman. In the fullness of time the three of them will go down in ignominy, as has Lysenko before them for being one of the most contemptible figures of the twentieth century: traitor to science.

### © 2003 Antal E. Fekete

---

*June 1, 2003.*

*Note. I would like to call the reader’s attention to my earlier writings in which I warn that it is not the gold standard but, rather, the sabotaging of it, that is responsible for the inflation-deflation cycle by inducing huge oscillating money-flows back and forth between the commodity and the bond markets. The result is either inflation or deflation, according as these flows, amplified by speculation, spill over in the commodity market or in the bond market. Central bank intervention is counter-productive and makes matters worse. In particular, in a deflation, as new money is being injected into the system to bolster “weak demand”, it will refuse to flow uphill to the commodity market as intended. Instead, it will flow downhill to the bond market where the fun is as bond speculators run riot. The central bank can create as much fiat money as it wants, but will have no control over it once it has entered circulation. It is up to the speculators. Misguided Keynesian monetary policy could land the country in a depression by providing money for bond speculators who will then use it to drive interest rates down to zero; alternatively, it could trigger runaway inflation by frightening speculators out of their long positions in bonds. It is not possible to predict scientifically which way the cat will jump. In particular, see:*

### The Economic Consequences of Mr. Greenspan (July 19, 2001)

### Japan’s Finest Hour (January 16, 2002)

### Revisionist View of the Great Depression, Part I-II (March, 2002)

### The Wrecker’s Ball of Swinging Interest Rates (August 26, 2002)

The Central Banker as the Quartermaster-General of Deflation (January 1, 2003

---

# The Texas Hedges of Barrick

URL: https://newaustrianeconomics.com/archive/fekete/the-texas-hedges-of-barrick/
Date: 2002-05-02
Section: Popular Economics
Difficulty: intermediate
Concept Tags: gold-basis, backwardation, gold-standard, monetary-crisis
Description: Fekete examines Barrick Gold's massive forward-sales program as a symptom of the collapsing gold basis. When gold miners sell forward at such scale they act as agents of permanent backwardation — suppressing the monetary signal that gold provides — and the strategy will ultimately destroy the company's own value.
Editorial Note: Written in May 2002, at the height of the gold producer hedging debate. Fekete's analysis proved prescient — Barrick spent years unwinding its hedge book at enormous cost.
Original PDF: https://professorfekete.com/articles/AEFTheTexasHedgesOfBarrick.pdf

## The Texas Hedges Of Barrick

There is a fundamental difference between speculation and arbitrage. The speculator deliberately takes large risks in the hope of large profits. The arbitrageur is not interested in increasing risks, in fact, he wants to reduce them. His main instrument is the straddle with two legs: a long leg representing purchase in one market, and a short leg representing a compensating sale in another. In closing out the straddle both legs must be lifted simultaneously, otherwise the arbitrage is turned into speculation. The activity of the arbitrageur is also known as hedging, and another name for a straddle is a hedge. As the objectives of speculation and arbitrage are diagonally opposite to one another, it is a bad mistake to confuse the two, as is the case all too often. This confusion is epitomized by the story about the Texas rancher. When it was pointed out to him that the long positions in cattle futures he was affectionately calling "me hedges" were in fact no hedges at all because they lacked the short leg, he proudly answered: "them are Texas hedges." The title of this paper suggests that the hedges of Barrick are no hedges at all because they lack the long leg.

### Limited versus Unlimited Liability

Worse still, the Texas hedges of Barrick represent an unlimited liability, in contrast with those of the rancher which represent but a limited liability. This difference is due to the fact that while the price of a commodity can never fall below zero (thus limiting risks involved in a forward purchase), there is no identifiable limit above which it may not rise (thus making risks involved in a forward sale unlimited). Another way of expressing the same fact is that Barrick's Texas hedges are subject to a short squeeze and, possibly, a corner. By contrast, there is no way to squeeze or to corner the rancher on account of his net long position. It is a fundamental fact of commodity markets that only the bears can be squeezed and, if the worst comes to the worst, cornered. Bulls are immune.

Total net short sales must never exceed one year's output. If Barrick and its epigoni limited their forward selling activities to one year's output, then one could argue that their hedges were legitimate. But the hedging program of Barrick and its imitators call for the forward sale of several years' output. The justification for limiting net forward sales to one year's output is that a hedge larger than that is programmed to self-destruct within a year. Mine output is sold and the long leg lifted by the end of the fiscal year, so the short leg must be moved forward to the next. If the open short leg is profitable, paper profits are paid out in the form of dividends. Paper losses, if any, are suppressed. This exhausts the concept of a fraud. The practice transgresses the bounds of prudence and integrity. A gold mine selling forward in excess of one year's output is concealing a potentially unlimited liability. The shareholders and creditors are misled.

### Barrick's Apology

Barrick argues that all its hedges are proper, regardless whether one or more years' output is sold forward. In either case there is a long leg, namely, gold in the ground owned by the company.

The apology is lame. In case the hedge plan is limited to one year's output the gold sold forward is no longer in the ground but already in the production pipeline. It is gold on the move. It will reach the market and be sold to the cash-paying customer in less than a year. It is very different economically from gold sold forward under an unlimited hedge plan. This gold is tied up in ore bodies deep down below surface. It is no use describing it as the long leg of a Texas hedge. This gold is not available, and the Texas hedge has no long leg. We want to make this distinction very clear. Gold in the pipelines that will reach the cash-paying customer within a year is one thing, and gold sitting maybe a mile down below surface is another. The latter cannot be considered as a proper long leg for hedging, nor as a proper collateral for gold loans. The company may go bankrupt before it can be dug up and put into marketable form. Borrowing gold short-term against such a phony collateral in the hope that the gold loan can be rolled over several times until many years later the borrowed gold can be replaced out of mine production is gambling, not hedging.

### Spot-Deferred Contracts

This also exposes the fraud involved in Barrick's much-vaunted spot-deferred contracts.

These can be characterized as a forward sale with the margin call swept under the rug.

Barrick has the option of either delivering the newly mined gold into the hedge book, or selling it in the open market, according as the gold price is below or above the forward sale price. This sounds too good to be true, as normally an embarrassing and financially onerous margin call would be in order whenever gold was trading above the forward sale price. But we are told that there would be no margin call (note that we are not allowed to read the small print in the contract). After all, what goes up must eventually come down, mustn't it? Margin calls are for the financially weak, who cannot ride out storms. The financially strong can. They just wait until the gold price comes down to make the forward sale profitable again. Barrick boasts that the final settlement of its spot-deferred contracts can be put off as much as 15 years. But what if the gold price doesn't come down in 15 years? Come, come, don't be ridiculous. The price chart for the past 15 years clearly shows that every time the price goes up, sooner or later it will come down, making the spot deferred contracts profitable. But gold has been around a lot longer than 15 years. Wouldn't it be advisable to examine charts covering a longer period? Barrick is not interested: history started when Barrick was established.

Jamie Sokalsky, Senior Vice President and CFO, is on record as saying that Barrick has the unique flexibility to defer settlement on its contracts up to 15 years, which is ample time for the high-flying gold price to return to earth. "If the price of gold shot up to \$600 and stayed there for 15 years, we would still realize every cent of that increase." Every cent? Bob Landis is pondering the unthinkable (see References below). Assuming that annual production stays at the same level of 6 million ounces, Barrick's proven and probable ore reserves of 82 million ounces would be more than exhausted in 15 years.

The situation would then be as follows. The 82 million ounces have been sold in the open market. Barrick would have 0 ore reserves left, and a liability to return 18 million ounces of borrowed gold to the owners. Goodness knows what Barrick would have to pay for new gold-bearing properties in the \$600 per ounce gold environment, and goodness knows what Barrick's bidding for 18 million ounce of cash gold would do to the gold price. I may add a small correction to the study of Bob Landis: Barrick's proven and probable reserves would actually be larger at \$600 gold than they are now. But his point is well-taken: the cost of liquidating the liability of owing 18 million ounces of gold, if the gold price goes from \$300 to more than \$600 and never drops below \$600 for 15 years, is so huge that it may well ruin the company financially. This cost cannot even be estimated, as we haven't got a clue what the cost of replacing ore reserves will be when gold is selling above \$600, nor do we have a clue where Barrick's well-known liability, to restore to the owners 18 million ounces of gold it hasn't got, would take the gold price.

The prospect that the gold price may never ever fall below \$600, so that the spot-deferred contract can never ever be closed out profitably even if Barrick gets perpetual deferral, cannot be ignored. Rather than being a wonderful flexible marketing tool, doesn't the spot-deferred contract look like an invitation to bankruptcy?

### Margin call by another name

On May 8, 2002, at its Annual Meeting, Barrick made an important announcement. It is simplifying its Premium Gold Sales Program. It will close its book on gold call option writing and variable price sales, to go back to the simple spot deferred program, "to be better positioned to take advantage of rising gold prices". But there is also a change in the spot deferred program. The company will no longer invest part of the proceeds from the spot deferred contracts in the bond market, but "will instead leave all proceeds invested with its bank counterparties."

This gives the lie to earlier boastful statements that margin calls are for the financially weak, but not for Barrick. Lo and behold, the modest recent gains in the gold price have resulted in a margin call on the call options written by Barrick, so it is closing them out.

But, more surprisingly, there is a margin call if by another name on the cherished spot deferred contracts, too. The "bank counterparties" no longer allow Barrick to do as it may see fit with the proceeds from the spot deferred sales. They are put in escrow, pending on performance on the delivery schedule of newly mined gold into the hedge book.

Nice try, Barrick, to put a positive spin on the margin calls you have been innocent so far.

But it won't work, because your shareholders are not stupid.

### Hedges off balance sheet are fraudulent

No wonder that it is off balance sheet where Barrick keeps its Texas hedges. They could not suffer the light of the day. They cover shady deals that may benefit management, but certainly not the shareholders. As a matter of principle all hedging activity should be reported openly and fully on the books. It should be transparent, and everybody should be able to see for himself that the hedges remain profitable after both legs have been lifted and the hedge unwound. But this is impossible for a contract that has 15 more years to run. So off balance sheet we go. Never mind that hiding an unlimited liability constitutes a fraud.

The accounting profession, the commodity exchanges, and the government's watchdog agencies have never offered an acceptable explanation for the double standard they apply, one for the gold mining industry and another for everyone else. They allow mines to sell forward several years' gold production, but they would immediately blow the whistle if, for example, an agricultural producer tried to do the same in selling forward several years' grain production. There is no justification for this double standard. It is a scandal that the government grants legal immunity to gold mines using fraudulent hedges. Worse still, the fraud is facilitated by central banks willing to lease gold which, as the bank well knows, will end up being sold for cash and which, for that reason, the borrower may never be able to replace. Gold in the ground is no collateral for the gold loans of Barrick.

The company may go bankrupt before it can dig it out. Central banks are accomplices in the scheme of fraudulent hedging as they report gold that had been sold as if it was still sitting in their vaults.

To recapitulate, selling forward more than one year's output is no hedging. It is outright speculation on the short side of the market in anticipation of a decline in the gold price.

Such a 'naked bear' speculation is not only illegitimate as it falsifies the balance sheet and conceals an unlimited liability. It also makes the prospectus meaningless as no mention in it has been made of any intention to indulge in short selling that will inevitably result in the premature exhaustion of the ore reserves and in the dissipation of the most valuable resources of the mine at an artificially low price. On this ground alone Barrick is open to class-action suits by the shareholders.

### Competitive Short Selling

Furthermore, naked bear speculation makes no economic sense. By virtue of its short position Barrick assumes vested interest in a lower and falling gold price, which clashes with its main mission to sell newly mined gold at a higher and rising price. Such division of loyalties is inadmissible for a firm commissioned by its shareholders to convert wealth represented by ore reserves into wealth represented by bullion in a most advantageous manner. The managers of Barrick have a schizophrenic stance as they are prompted to pray for a higher and a lower gold price all at the same time. No enterprise with schizophrenic managers can survive the vicissitudes of market competition and the shareholders' ire for long. Shareholders get hit three times through the schizophrenic action of the managers of the mine they own. Firstly, income from the mine is shaved every time the gold price is forced lower through short selling. Secondly, capital is being destroyed as the falling gold price makes payable ore reserves to disappear (i.e., to become non-payable). Thirdly and most seriously, the richest and most valuable ore reserves are squandered for a pittance at the artificially suppressed gold price, thereby materially shortening the working life of the mine. The share price will ultimately show not only the shaving of income and destruction of capital, but the premature ageing of the mine as well. The Texas-type hedging policy of Barrick gives rise to competitive short selling every time the gold price may be ready to break out of its coffin. This is extremely damaging to the interest of the shareholders. No producer with such an inflexible and self-defeating marketing strategy can, or deserves to, survive.

### Paper Profit is No Profit

Advocates of this senseless practice, the most articulate of whom are the officers of Barrick, argue that these losses are more than compensated by the extra income the firm is generating from 'investments' made with the proceeds of forward sales. But insofar as this extra income is encumbered with unlimited liabilities represented by the Texas hedges, that is to say, naked short positions masquerading as legitimate straddles, this income consists of paper profits that should never be reported as profits, let alone paid out in the form of dividends. "There's many a slip between cup and lip," as the proverb says. Hidden liabilities may force Barrick to go out of business before it has a chance to realize its paper profits. The practice of window-dressing the firm's financial statements using unrealized paper profits, especially as they are encumbered with a potentially unlimited liability, is blatant fraud and no sophistry or government connivance will change that fact. It is the height of insolence on the part of Barrick to treat its shareholders as simpletons unable to understand the difference between paper profits on an open short position, and profits that have been consummated by closing out a short position.

That you can never fool all the people all of the time is borne out in the case of Barrick.

Shareholders are voting with their feet. From the bottom in November, 2000, the XAU index of gold stocks rallied about 73% while the stocks of gold mines without a hedge book on average rallied a remarkable 185%. Meanwhile Barrick hardly managed to add a paltry 33% during that 17 month period. This repudiates the absurd claim of Barrick's officers that they could con the market by selling gold at prices well above the highest price the market has been able or willing to quote during the year under purview. If they could, they should have opened a farm advisory agency showing farmers how to sell grain at prices much higher than those quoted by the grain market.

### The Bearish Case

Market sentiment turned decidedly bearish when Barrick introduced its Texas-type hedge program some fifteen years ago, and a large part of the industry mindlessly followed the leader. Although the scheme was hailed as proper arbitrage for the benefit of the shareholders, in reality it was naked bear speculation on the gold price enormously harmful to shareholder interest, and most detrimental to the mines as their working life was drastically shortened and their best ore reserves frittered away.

Speculators have traditionally been bullish on the gold price. They were well aware that the irredeemable currency in which the price of gold is quoted is historically nothing more than a dishonored promise to pay a fixed quantity of gold. After the default it could be exchanged only for diminishing quantities. That is, to be precise, until no gold whatever would be offered in exchange for it by anybody, anywhere. At that time the banker responsible for issuing the promise would feel compelled to leave the scene of his business (usually in disguise and under the cover of the night). Speculators knew this, and were willing to keep a cushion under the price of gold.

However, the cushion was removed as speculators started abandoning the long side of the gold market in droves. Who can blame them? They were not the first to betray the yellow metal. When producers of gold join the bearish camp, the speculator who tries to eke out a living by trading gold has no choice but to become active on the short side of the market. As a consequence, there was competitive selling every time the price of gold showed the slightest sign of life. Gold miners and speculators were falling over each other while rushing in to club down the price of gold as it was trying to climb out of the hole. Thus was every single budding rally beaten back in the gold market for the past fifteen years, in consequence of the hare-brained scheme of Texas hedging.

Speculators were not the only ones to be alienated from gold. Investment demand has practically dried up. Not very long ago every Swiss banker advised his clients that common prudence dictates to keep 5 to 10 percent of one's assets in gold or gold-related investments. Today no Swiss banker will make a loan on gold collateral security. The consensus is that the so-called hedging program of the gold mining industry has effectively capped the price of gold.

Worse still, the central banks' selling and leasing policy has opened up an abyss. Into this, in the opinion of many, the gold price must ultimately fall. Gold has been demonetized, they say, first by the governments, then by the market as well. By now it has become scrap metal which central banks are still foolish enough to spend a fortune to store. It would make better sense to sell it if need be at scrap values, the doomsayers insist, and invest the proceeds in earning assets such as government bonds, or even common stocks as the president of the Bundesbank has recently suggested.

### The Bullish Case

The fraud involved in Texas hedges carries with it its own punishment. It may not be immediate, but it is certainly coming. Barrick and other gold bears are digging the very ditch in which the gold bulls will trap them. Don't ask the question when; the bulls won't tell you. But the grand squeeze is coming with the same certainty as day follows night.

When the first signs of the squeeze appear, market sentiment shall suddenly change.

Alienated gold speculators will abandon the short side of the market and will return to their traditional spot on the long side. They are alive to gold's continuing monetary role.

They have not been taken in by the silly propaganda about gold de-monetization.

Speculators are keenly aware of the fact that paper currencies of the world are but dishonored promises to pay gold. They understand full well that fluctuations in the gold price, far from representing an uncertain value for gold, reflect the uncertain value of fast-depreciating irredeemable paper currencies. Speculators make it their business to know that the value of everything, including that of paper money , approaches the marginal cost of its production - which is just a polite way of saying that ultimately all fiat money is destined to become worthless, so colorfully demonstrated by history tolerating no exceptions. When it happens again the monetary metals, gold and silver, will be the only refuge for the hapless citizen trying to secure a financial future for himself and for his family.

### Mene Tekel

The investment demand for gold will, Phoenix-like, rise from its ashes. As the bearish bias created by Texas hedges disappear, friends of the precious yellow (alias gold bugs) will be rewarded for their patience and perseverance. The bogey-man of central-bank gold sales will be exposed as a scarecrow. At any rate, it could scare unsophisticated crows only. People with an analytic mind did always see through the cheap trick. They understood that the threat of central bank gold sales was empty gesture. A central bank selling gold can in no way strengthen its balance sheet. Quite the contrary, it weakens it gravely, perhaps fatally, with incalculable consequences to the value of its bank notes.

The central bank gives up the best possible monetary reserve in the asset-column: gold that is nobody's liability as it never enters the liability-column of the balance sheet of another central bank, in exchange for the worst: the irredeemable promises of devaluation-happy governments. It discards a default-proof asset and replaces it with a default-prone one.

It is not known whether or not officers of Barrick see the Biblical writing on the wall that reads: "Mene tekel upharsin" (you have been put on the scale and found wanting). It can be allegorically interpreted as an admonition, relating to the value of irredeemable currencies. It is possible that these officers are blockheads wrapped up in their own glory who do not understand the very nature of the product they help bring up from the bowels of the earth.

### Barrick, the hit man

But it is also possible that they are not free agents. Barrick could be a front, that is, a hedge fund masquerading as a gold mine, set up in order to promote the aims of another conspiracy, far bigger in scope. We are referring to the conspiracy of bond speculators to drive the rate of interest down to zero in order to pocket the immense capital gains on their bond holdings. Don't laugh. Bond speculators in Japan already succeeded in achieving that goal. Moreover, the mechanism to drag down American interest rates in the wake of Japanese is already in place. It is called the yen-carry trade. The \$100 trillion derivatives monster expanding exponentially may give you a foretaste of the power of bond speculators. That monster serves one purpose only. The purpose is to make the super-fast breeding of long positions on bond futures possible, well beyond the limits set by the amount of bonds in existence. (Goodness knows, dollar debt is being created by fast-breeders, but they are still not fast enough to serve the needs of bond speculators!).

It appears likely that the big American and Japanese banks are the anonymous leaders of this conspiracy to drive down the rate of interest to zero. For the Japanese this is a matter of life and death, so badly do they need the capital gains from their bond portfolio to mend the enormous holes in their balance sheets. The big American banks were in the same tight spot twenty years ago, and they mended theirs by the same techniques. The gold carry-trade is just a small albeit indispensable part of this global conspiracy. As long as gold can be shut out as an investment vehicle, there will be a captive market for bonds.

This captive market is essential for the elimination of risks facing the bond speculating conspiracy. I have written in greater details about this in my paper "Revisionist View of the Great Depression."

According to this script Barrick was hired as the hit man, trying to hold the gold price in perpetual check. If the price of gold could somehow escape from the coffin whose lid was nailed down with Texas hedges, then the investment demand for gold would turn the bond market into a "killing field." Field where the big banks are slaughtered, and the value of the dollar is wiped out. It is clear that the hit man carries on his shoulder the entire $ 100 trillion derivatives monster, as Atlas used to carry the universe on his.

### Corner by another name

Thus the questions about the conspiracy to plunge the world into another depression by driving interest rates to zero boils down to this: Can the hit man do his job? This takes us back to the question of squeezes and corners.

Scholarship on corners is scant. Most experts agree that historic corners were successful only in the light of superficial analysis. A deeper understanding shows that a true corner is an historical rarity. Economic theory also suggests that corners are no longer possible, certainly not in the 21st century economy supported, as it is, by instant telecommunication and same-day door-to-door delivery, world-wide.

But is it really a fact that there have been no true corners in the past and, as far as the future is concerned, no commodity can ever be cornered in peacetime? Well, whatever can be said of other commodities, there is certainly one for which it is not true. At least one commodity is exceptional in that it could be cornered, same-day delivery notwithstanding. Never mind that the corner does not come about by design, but is brought about spontaneously, by gut reaction and fear.

Gold has been cornered several times in the past. There is no reason to believe that it could not be cornered again in the future whenever conditions are ripe. Consider the following scenario. The Federal Reserve is desperately trying to combat deflation brought about by bond speculators out in force to drive the rate of interest to zero. The Fed is printing dollars working the presses overtime, but these dollars are snapped up by the bond speculators just as fast as they are printed. So the process must accelerate and will start spinning out of control. At one point the Federal Reserve will go overboard and print too many of them. The bond speculators will get scared and decide to cut and run. As they dump the bonds, they trigger a credit collapse. The government's credit will be ruined. Interest rates will go to outer space together with the price of marketable commodities. There will be a fatal, irreversible loss in the purchasing power of the dollar.

In short, there will be a runaway inflation. A runaway inflation is but a corner in gold by another name. It is rather naive to believe that the Texas hedges of Barrick can stem the tsunami of the coming gold corner.

### References

Gold Wars, by Ferdinand Lips: Will Hedging Kill the Goose Laying the Golden Egg? pp 160-167, New York (FAME), 2002.

### Revisionist View of the Great Depression by A. E. Fekete

Readings from the Book of Barrick: A goldbug ponders the unthinkable, by Bob Landis, [www.goldensextant.com](http://www.goldensextant.com/), May, 2002

### Antal E. Fekete

### Professor, Memorial University of Newfoundland

### St.John's, Canada A1C 5S7

---

# Revisionist View of the Great Depression, Part Two

URL: https://newaustrianeconomics.com/archive/fekete/revisionist-view-great-depression-part-two/
Date: 2002-03-13
Section: Popular Economics
Difficulty: intermediate
Concept Tags: interest-theory, bond-market, deflation, capital-destruction, federal-reserve, gold-standard
Description: Fekete completes his revisionist account by showing how Roosevelt's gold confiscation turned the bond market into a vehicle for invisible capital destruction — enriching the financial sector while bankrupting productive enterprise. Capital consumption, not demand collapse, caused the Depression.
Editorial Note: Part two of two, published one week after Part One. Fekete traces the Depression's mechanism through his accounting-based theory, culminating in an indictment of Roosevelt's gold ban as the trigger for the worst phase of capital destruction.
Original PDF: https://professorfekete.com/articles/AEFRevionistViewOfTheGreatDepressionPartTwo.pdf

## Iii. Invisible Pilferage

### The Pharaoh's Treasure

According to the ancient Greek historian Herodotus the treasure of no Egyptian pharaoh was comparable in either size or value to the enormous hoard of Rhampsinitos. His treasury was housed in a huge stone building adjacent to the palace, and it was considered burglar-proof. The door was sealed by the pharaoh's personal seal and manned around the clock by armed guards. Rhampsinitos was present in person every time the seal was broken and the building entered. Therefore it was extremely disturbing when the pharaoh discovered that his treasure was being pilfered, albeit without any sign of unauthorized entry into the building. To find out what was going on the pharaoh caused a trap to be placed inside to catch any would-be thief as he was approaching the treasure-bins. To his utter amazement, on his next visit the pharaoh found that, while the trap had done the job of catching the would-be thief, yet this did not help him one iota to solve the mystery.

More treasure was missing, together with the head of the would-be thief. There was no sign showing how the missing objects had been spirited out of the building. The identity of the thieves could not be established. It appeared as if someone had supernatural power to enter the building invisibly and pilfer the treasure without leaving any trace.

### Pilfering the Wealth of Nations

The Great Depression seems to have presented a similar mystery. Productive enterprise came under pressure to liquidate debt and inventory, so excruciating had the debt-burden become. Those firms that could not liquidate fast enough were themselves liquidated. The Wealth of Nations was decimated as scores of once flourishing firms were going bankrupt. Nobody suspected that the loss of wealth might be due to plunder and pilferage.

For a time governments bought nostrums prescribed by Keynesian and Friedmanite soothsayers to prevent similar disasters from happening in the future in the belief that the destruction of wealth was due to natural causes. But as depression struck Japan in spite of taking the prescription, and as other countries appear also to succumb to the Japanese disease, the peddlers of nostrums became suspicious as being impostors. In the absence of an acceptable theory explaining the Great Depression the danger of future depressions looms larger than ever in the horizon.

Our revisionist view presented here for the first time suggests that, far from being due to natural causes, the Great Depression was unquestionably the result of plunder and pilferage. The Wealth of Nations was being pilfered invisibly. Those responsible couldn't be caught because the thievery involved no physical movement of property. Whenever a dead body was found (such as that of LTCM, or that of Enron), the head was missing and the investigation could proceed no further. Public opinion has been lulled into the false belief by the economists' profession and by the financial media that there was in fact no pilferage, the phenomenon must be explained by the idiosyncrasies of the capitalist system of production.

### Capital Consumption

It is a daunting task trying to change a consensus that has been nurtured through generations. Yet we must not shrink from exposing the crime if we know who the culprit is, even if our evidence will be laughed out of court. Here is our analysis. The thievery involved no physical transfer of property; it involved book-keeping transfers from the balance sheet of the productive sector to that of the financial sector. The root cause of the wholesale bankruptcy of productive firms was not the falling price structure (although it certainly helped) but, primarily, the falling interest-rate structure. As interest rates fell, bond prices rose, and with them rose the present value of debt. This caused the cost of servicing productive capital already deployed to rise as well. However, no allowance for the increased costs was made in the balance sheet. There was no recognition of the fact that falling interest rates caused the liquidation-value of firms to snowball, materially adding to liability. In other words, there were losses that were never realized and no charges to income against them were made. Moreover, this was the practice across the board. The failure to realize losses in the national economy meant that society has been consuming capital over a period of time. In the end productive enterprise was operating on the strength of phantom capital. Not only was capital consumption universal affecting all firms engaged in productive enterprise, it was going on unnoticed. The viciousness and violence of the reaction, when it finally came, was unprecedented. Productive firms were falling right and left, regardless of the demand for their products. Firms that were certified as being sound one day would go bankrupt the next. One of the lessons of the Great Depression is that capital consumption is the most treacherous form of credit abuse that may plague society, chiefly because it can go on unnoticed for so long before anyone can recognize it. Corrective action, when it comes, is too late. This highlights the importance of maintaining the highest accounting standards. Any attempt at compromise is a crime not only against the shareholders, but against society as a whole.

Once we have identified capital consumption as the cause of the Great Depression, the focus must be shifted to the question why the rate of interest was falling as long and as much as it did, making capital consumption possible. To be sure, without such a prolonged and pronounced fall in interest rates there would have been no universal mistake in accounting. Here we have to refer to chronology in order to establish the direct responsibility of politicians, in particular, the responsibility of one person, F.D.

Roosevelt. The banks in the United States lay prostrate between Election Day, November 1932, and Inauguration Day, March 1933. As a consequence of the economic boom of the "roaring twenties" interest rates were steadily increasing, and bank capital was greatly weakened by the proliferation of non-performing loans. Rumors had it that Roosevelt, the Democratic candidate for the presidency would, in spite of his repeated pledges during the campaign to the contrary, "go off" the gold standard and devalue the dollar. There was a run on the banks. People wanted to withdraw their savings before the monetary mischief was sprung upon the nation. They trusted neither the integrity of the banks nor that of the politicians - not entirely without reasons as one might add in retrospect. Some revisionist historians even go as far as suggesting that rumors of devaluation were deliberately planted by Roosevelt himself. He did want the banks to fail so that upon inauguration he could declare a state of emergency and assume dictatorial powers. (Note that these allegations of revisionist historians have no bearing on my argument. Be that as it may, it is a fact that Roosevelt made himself unavailable during the interregnum, and refused to deny the rumors of an imminent devaluation, in spite of repeated appeals from Hoover.)

### Wiping out Negative Net Worth

In the event, shortly after inauguration Roosevelt closed the banks. Later most of the banks were reopened and given a clean bill of health but, in reality, they were in a very sorry state rather similar to that of the Japanese banks today. They had a negative net worth. There were huge holes in their balance sheets. They could open for business only by virtue of the government's connivance allowing bank inspectors not to enforce the accounting rule that assets be carried at market value in the balance sheet. The banks had a strategy to wipe out negative net worth by mending the holes in their balance sheet - a Herculean task. On the assumption that interest rates would fall further, they could keep buying government bonds to let capital gains in the bond portfolio take care of capital insufficiency.

There was just one problem with that strategy. It was the risk that interest rates may turn around and start rising This would not only hurt the banks, it would turn the bond market into a "killing field". Field where the banks would be slaughtered. There were plenty of reasons, too, why interest rates could indeed turn around and start rising again. There was the continuing threat of devaluation of the dollar. There was the added threat of a huge inflation. (In the fullness of times, both threats became a reality.) There was a flight of capital from the country. The banks could not have concocted a riskier strategy to save their skin. But there was a godsend, turning the risky bet into a safe one. The risk threatening the banks' strategy was removed by a Presidential Proclamation.

### Save the Banks, Ban Gold

Roosevelt called in gold coinage. He made trading in and owning gold (in forms other than jewelry) a crime. What has all this got to do with the banks' strategy for survival?

Here is the connection, which has never been adequately explained by scholarship. The risk that interest rates might turn around frustrating the banks' strategy to wipe out negative net worth was eliminated by Roosevelt's ban on gold hoarding. Predictably, the ban had a deflationary effect on the economy as it started a downward spiral in the rate of interest. Before the ban those who wanted to manage their liquid wealth most conservatively would park it in gold. After the ban they were forced to park it in government bonds. The captive clientele for government bonds guaranteed that bond prices would keep rising, and interest rates would keep falling, for several years to come.

The banks were given the green light to go ahead with their massive bond-speculation scheme. An orgy of speculation in the bond market followed.

Everybody knows about the bull market in stocks in the 1920's. Reams of books have been written on that subject. But nobody has ever heard about the bull market in bonds in the 1930's. Yet it is a fact that the volume of the latter surpassed that of the former by a factor of ten. The banks made obscene profits in the form of capital gains in the bond portfolio. For the next six years, while interest rates continued to fall, the banks and other firms in the financial sector got fabulously rich, while firms in the productive sector were being put through the wringer. The banks' profits were more than enough to wipe out negative net worth. Banks that had been technically bankrupt at the beginning of the decade were in ultra-strong financial position by the end of the decade.

### Financial Vampirism

However, the banks' newly found wealth did not come out of nothing. It was not newly created wealth. It was existing wealth that was siphoned off the balance sheet of productive enterprise forcing it into bankruptcy in consequence of this financial vampirism. We may do well to remember that the banks' pilfering the Wealth of Nations was possible because of the falling interest-rate structure which, in turn, was engineered by the crudest form of government intervention in the market: the unconstitutional confiscation of the people's gold without due process.

This is not to suggest that Roosevelt was an accomplice or a stooge of the banks, or that he declared his ban on gold hoarding for the purpose of bailing out the banks. It is possible that there was a fortuitous coincidence. We may never know, and it does not matter. The fact remains that tampering with gold is tantamount to tampering with interest rates. It is a most dangerous expedient as it may have many unforeseen and untoward consequences.

This, then, is the revisionist view of the Great Depression. Without the gold ban the recession that started with the 1929 stock market crash would have been over by 1932.

With the gold ban, the recession was turned into the greatest depression of all times. The man who was celebrated as savior ridding the nation of the curse of depression was in fact the one who had brought the disaster about. He pulled the gold trigger that released the murderous forces of bond speculation to prey upon the productive sector. It heralded the continuing fall of the rate of interest. Bond speculators, first and foremost the banks among them, were listening and got ready to move in for the killing. The vultures picked the bones of productive enterprise clean. And all this was done under the veil of anonymity. Nobody guessed that the Great Depression was a happy time for some. Well, for the bankers it was time for popping corks. Not only was their skin saved, but they became so strong financially that they could thereafter dictate government policy.

### Don't Entrust Your Money to Desperadoes

Thus the chief culprit and the only beneficiary of the Great Depression was the banking fraternity. They profited from the disaster devastating the world economy. I now pick up the thread I left off in part two, and continue my discourse on the consequences of relaxing accounting standards. It was a colossal mistake to reclassify insolvent banks as merely "illiquid" and letting them open their doors for business. An illiquid bank, by definition, is one that can be considered solvent only by virtue of relaxing accounting standards, allowing the bank to carry an asset (usually a government bond) at acquisition price, regardless how low the current market price of that asset may have fallen. Why is this a mistake? Well, illiquid banks are desperadoes ready to take unreasonable risks with the people's money entrusted to their care. Illiquid banks have nothing to lose but their stigma of being insolvent. They should be closed down by bank inspectors without hesitation. Any compromise in relaxing accounting standards is foolish in the extreme. It invites great dangers affecting not only shareholders and depositors, but society as a whole. It is hard to imagine a dictum more insane than the one: "Bank X is too big to fail".

### Cui bono?

We have argued that the Great Depression of the 1930's was caused by illiquid banks in the United States as they became the engine of an unprecedented speculative orgy in the bond market to drive down interest rates. We could also argue that the depression in Japan today is caused by illiquid Japanese banks as they have become the engine of another huge bull market in bonds to drive the rate of interest to zero.

There is more to this story than revisionist history. Our insight may help explaining the passing scene of our day. For the time being, there is no ban on gold hoarding today. But it is apparent that the gold market is being manipulated, possibly with government connivance. In trying to understand an unexpected or puzzling historical event, historians used to ask the key question: cui bono? (who is the possible beneficiary?)

It ought to be understood well that gold manipulation (i.e., conspiracy to keep the price of gold permanently in a low range) is deflationary. Just as Roosevelt's ban on gold hoarding, the present exercise in gold manipulation also has the effect of restricting demand for physical gold. The result is the same: interest rates keep falling, and for the same reasons. Liquid capital all over the world is seeking out the 'next best' alternative to gold as a conservative investment medium. It will find it in the form of government bonds. Once more, a captive market for government bonds has been created. As bidding for bonds continues, interest rates keep falling. Bond speculators are invited to jump on the bandwagon: the risk that interest rates might turn around and start rising, thereby frustrating the speculation, has been reduced by the gold manipulation. Before our very eyes (and not everyone has eyes to see this sort of thing) there is an orgy of bull-market speculation in bonds that started twenty years ago. The end may not be in sight yet. In 1980, interest rates in the United States were around 16 percent per annum. They have come down to around 5 percent. If the example of Japan is any guide, they still have a long way to go. American interest rates could follow the Japanese into the abyss. Why not? The mechanism to link the two rates is already in place. It is called the yen-carry trade. The speculator sells the Japanese bond and buys the American. This amounts to borrowing yens at zero percent (or thereabouts), converting the proceeds into dollars and lending them at 5 percent. The reward? Almost 5 percent - not bad for shuffling paper.

Clearly, the effect of the yen-carry trade is to drive down the rate of interest in America, too.

The consequences of a falling interest-rate structure today are no different from those in the 1930's. There is capital consumption in the productive sector. There is a stealthy transfer of wealth from the productive to the financial sector. Cui bono? Why, for the benefit of the banks, of course. American and Japanese banks. Banks of any stripe or color. The worst part of it all is that the public is still in the dark about the invidious consequences of falling interest rates. It is told a tale about free markets deciding bond values and the value of gold. The ominous fact, however, is that both markets are rigged.

They are like a casino where the dice are loaded for the benefit of the house.

### $ 100 trillion worth of hot air

The truth is that there is no public benefit in bond, foreign exchange, and gold speculation. None whatsoever. The world could still go on without any of this trading, and no one would be any worse off. The overwhelming majority of the people, including all savers and producers, would be better off. Interest and foreign exchange rates were so stable under the regime of the gold standard that no speculator in his right mind would hold bonds or foreign exchange in the hope of speculative gain. Today not only do we have speculation in bonds and foreign exchange; since 1971 we have also allowed speculators to construct derivatives markets on the top of the bond , foreign exchange, and gold markets. The combined volume of these derivatives markets has snowballed and its size has hit and surpassed the \$100 trillion mark! No misprint here. There is commitment to pay compensation for the fluctuation in the value of \$100 trillion worth of paper. (Never mind that there is isn't nearly as much paper in existence, not even if we include the scum of the junk bond market.) For centuries before 1971, the grand total of paper so 'insured' was exactly $ 0 (zero dollar). In other words, in 1971 the world all of a sudden developed an insatiable appetite for insurance. In thirty years the world came up with $ 100 trillion worth of 'insurables' to bolster security. What security? Maybe financial security? No, we can't very well say that, not after the collapse of Enron, and not after the dollar having lost 90 percent of its purchasing power during the same thirty years. Then physical security, perhaps? No, not physical security. Not after the destruction of the twin towers of the World Trade Center, and not in the middle of a drama in two acts: oil war against Iraq. Then what kind of security is it that the insuring of $ 100 trillion represents? Search as you may, but you will find only hot air. The world was a much better and safer place for hundreds of years with stable interest and foreign exchange rates, and with a stable gold price, and without any insurance on hot air. Had it kept them that way, it could have earmarked funds for the eradication of poverty, hunger, diseases, illiteracy, or for any other noble cause.

The $ 100 trillion dollar market in derivatives created by the big American banks serves no purpose consonant with the interest of the national or world economy. It serves one purpose only: the aggrandizement of the profits of the financial sector, at the expense of the productive sector. The big American banks were as insolvent twenty years ago as the Japanese banks are today. Then they started their desperate bond-market gamble, trying to drive down interest rates. They badly needed capital gains in their bond portfolio to mend the enormous holes in their balance sheets. The gamble has paid off. Today the American banks are in a better financial shape. However, a high price for saving the banks' skin was paid by the productive sector. American firms producing hardware have been put out of business. Solid jobs in the productive sector were eliminated and replaced by soft jobs in the service sector. The plight of the American breadwinner who is now flipping hamburgers instead of pouring molten steel (and who may soon be out of any job) is in direct consequence of the orgy in bond speculation. Nor is this all. The depression in Japan may not stop at the Pacific. It may well portend to engulf America and the rest of the world.

### Bond Speculation is No Zero-Sum Game

I am well aware that the sum $ 100 trillion is a 'notional' amount. We are not talking about $ 100 trillion worth of bonds being traded. We are talking about the combined stakes of bond speculators who have placed bets on the rate of interest, and want to profit as if they have owned bonds in that amount. But the profits, provided the speculators' bet comes off, are not 'notional'. They are payable in cold cash. Suppose, for the sake of argument, that most of the bets call for lower interest rates. In other words, most speculators would buy bonds as they expect their value to rise further. (This is a plausible assumption. No doubt this is exactly what Japanese banks scrambling to get out of bankruptcy are likely to be doing right now.) If interest rates did in fact go down and the price of bonds did go up, say 1 percent, then the speculators' profit would be $ 1 trillion in cash. Who is going to pay that?

Economists will tell you that the profit of one speculator is the loss of another. Don't buy that. It is arrant nonsense. It would be true only if speculation were a zero-sum game.

This is the case for stabilizing speculation dealing with risks created by nature, for example, in the futures markets for agricultural commodities. Here speculators make money by resisting the formation of price trends. As there is no consensus whether the formation of an up-trend or a downtrend is more likely, speculators will be betting on either side of the market. But in markets where risks are man-made, speculation is not a zero-sum game. This is the case of destabilizing speculation. For example, in the market for bonds and its derivatives speculators make money by inducing and then riding price trends. They are on the same side of the market, which is practically always the winning side. Remember, speculators can influence the outcome by throwing their weight around. (Try to do that against the blind forces of nature!)

Why are risks in the bond market man-made? Because under the gold standard interest rates were stable. There was little risk that bond values might change. Risks were injected artificially when politicians forcibly removed the gold standard.

But if the profit of the speculator who bet on higher bond values and won is not paid by another speculator on the other side of the bet, then who is paying it? This is a crucial question and we must answer it very carefully. The other side of the bet was probably taken by a banker for hedging rather than speculative purposes. He sold the bond in order to hedge his exposure in lending money to productive enterprise. His is a neutral position with regard to the bond market. He has a straddle: the loss on one leg is cancelled out by the profit on the other leg of the straddle. The loss is passed on to the party on the other side of the hedging banker's bet. Therefore, ultimately, the losers paying the $ 1 trillion profit to bond speculators are the firms in the productive sector. They are sitting ducks in this speculative game. They have no choice. They must carry the risk of owning productive capital, without which there will be no consumer goods for you, for me, or for any other member of society. The foregoing argument demonstrated conclusively that as speculators drive down the rate of interest to zero, the value of productive capital is surreptitiously siphoned off the balance sheets of the producers and will show up as capital gains in the balance sheets of bond speculators. Firms in the productive sector are condemned to bankruptcy for the benefit of parasites. This is the essence of depressions.

### Monument to Folly

The $ 100 trillion derivatives market is a monument to the folly of man. Derivatives trading serves no purpose other than benefiting a parasitic class, that of the bond speculators, chief among them the banking fraternity, at the expense of the productive sector. Producers meekly accept their role of sacrificial lamb. They do so because they lack understanding of what is happening to them, just as lambs herded in the slaughterhouse do.

This exposes the enormity of the folly of having destroyed the gold standard thus allowing interest rates to fluctuate. Thereafter bond speculators would, whenever the opportunity presented itself, drive down the rate of interest all the way to zero while, in the best tradition of vampires, they suck the life-blood out of the producers. The $ 100 trillion monument ought to be our reminder that bond speculators are hell-bent to plunge the world into a depression once again, as they did in the 1930's.

Unless governments can muster their brain- and will-power, demolish that monument, stop the deadly game, and stabilize interest rates once more by opening the Mint to gold.

---

*March 13, 2002*

*Note. This paper is based on a series of talks with the same title given by the author at Sapientia University, Csikszereda, Romania, in March, 2002.*

---

# Revisionist View of the Great Depression, Part One

URL: https://newaustrianeconomics.com/archive/fekete/revisionist-view-great-depression-part-one/
Date: 2002-03-06
Section: Popular Economics
Difficulty: intermediate
Concept Tags: interest-theory, bond-market, deflation, capital-destruction, federal-reserve, gold-standard
Description: Fekete argues the Great Depression was caused by bond speculation driven by central bank intervention — which squeezed profits by raising the present value of liabilities while denuding the productive sector of capital. He introduces the Law of Liabilities: in a falling interest-rate environment, firms must mark up liabilities or report phantom profits.
Editorial Note: Part one of two, based on talks at Sapientia University, Romania in March 2002. Fekete's revisionist account of the Great Depression challenges both Keynesian and Friedmanite explanations by identifying bond speculation as the real mechanism.
Original PDF: https://professorfekete.com/articles/AEFRevisionistViewOfTheGreatDepressionPartOne.pdf

## I. Introduction

### Fly in the Ointment

There are two standard views of the Great Depression of the 1930's. Keynesians maintain that the capitalist system is, by its very nature, prone to overproduction and, in the absence of government intervention, excessive inventories will periodically lead to falling prices and to growing unemployment which will further compound the collapse in demand. They advocate public works financed, if need be, by massive deficit spending.

The central bank must be instructed to buy up all the government bonds that the market is unwilling to absorb. According to the Keynesian view in the early 1930's the current economic fetish, the balanced budget, prevented an increase in public spending to boost demand. Thus, then, faulty fiscal policy is to be blamed for the economic collapse that followed. On the other hand Friedmanites maintain that, although the central bank should churn out new money at a steady rate, something that even a "clever horse could be trained to do", yet the Federal Reserve was issuing money erratically. Sometimes it issued too much as in the stock-market frenzy of the 1920's, and sometimes too little as after the stock-market collapse in the 1930's. In the latter episode the economy was squeezed through a shortage of money causing prices to fall. Thus, then, faulty monetary policy is to be blamed for the economic collapse that followed.

For some time it has been increasingly clear that both views fall short of the mark. The Friedmanites ignore the fact that while the central bank has the power to issue money at any preconceived rate through open market purchases of bonds, yet it is utterly powerless to determine how this money shall be used by market participants. Commodity speculation is not the only use to which newly created money can be put. Another possibility is bond speculation which instead of raising the prices of goods will raise the prices of bonds or, what is the same to say, will lower interest rates. Thus the sorcerer, the central bank, finds itself in competition with its apprentices, the bond speculators, and control will shift to the latter. On the other hand, the Keynesians ignore the fact that financing public works is a depressant on enterprising exuberance. Entrepreneurs are not prepared to compete unconditionally with the government for funds to finance projects.

They want to be convinced that theirs will be profitable before they commit funds to increase inventory and productive capacity. Deficit spending by the government brings profitability of enterprise into question.

Although superficially these two approaches to the problem appear to argue from different angles, they are in fact the same, if in different disguises. Both the Keynesians and the Friedmanites advocate the application of the same nostrum: central bank purchases of bonds, for the same purpose: to suppress the rate of interest for political ends. But there is a fly in the ointment prescribed by quacks of either persuasion, namely, the bond speculator. The so-called fiscal and monetary stimulus to boost demand is a myth. Either stimulus, rather than boosting demand for commodities, shall only boost speculative demand for bonds. If the bond speculator knows that tomorrow the central bank will buy bonds in the open market, then he will buy bonds today. Come tomorrow, he wants to feed them to the central bank at a hefty price advance.

### Loading the Dice

Here is the description of the process in more details. The bond market is destabilized by the extraneous demand for bonds for purposes other than saving, in particular, for political purposes. There is an increase in the volatility of bond prices, and a corresponding increase in the volatility of interest rates. Bond speculators, dormant while the interest-rate regime is stable as under a gold standard, will come to life with a vengeance as soon as volatility appears. Individual speculators as well as financial institutions will duly note that big money is to be made by trading (as opposed to holding) bonds. There is more. In the new casino (the bond market) the dice are loaded.

Those armed with this intelligence can take advantage of a free ride to riches. How?

Since the central bank is a buyer practically all the time and hardly ever a seller, the risk inherent in bond speculation has been eliminated, or at least greatly reduced, by the socalled contra-cyclical monetary policy. All the speculator has to do is buy before the central bank does, and sell afterwards. Little wonder that speculation will snowball and become rampant, exceeding even the worst excesses of the earlier stock-market speculation.

### Stabilizing or Destabilizing Speculation?

The observation that both the Keynesian and Friedmanite nostrums (allegedly suitable to prevent depressions) are counter-productive in that they aggravate rather than alleviate the crisis, has been ignored by economists. They accept the conventional wisdom that speculation tends to dampen volatility in any market. However, this generalization is patently false. One must distinguish between two kinds, stabilizing and destabilizing speculation, according as it deals with risks created by nature, or with risks created by man. The thesis that speculation is smoothing out fluctuations is true only of the first variety, for example, speculation in market for agricultural commodities. With regard to the second, speculation in markets dealing with risks created by man (including risks created by governments and central banks) fluctuations will increase as a result of speculation. For example, in the bond market more speculation means more volatility, not less, as speculators seek to induce and ride price trends, rather than resisting them. They do not act randomly as speculators in the commodity markets do. Bond speculators march in lockstep.

### Falling Interest Rates Squeeze Profits

We shall see that bond speculation has a pivotal role in the genesis of depression and deflation. The buying of bonds for speculative purposes tends to depress interest rates.

The mechanism that transmits the fall in the interest-rate structure to a fall in the commodity price structure is the rising bond price. It makes the present value of debt rise.

As it does, the liquidation-value of enterprise also rises. Here is a paradox: falling interest rates squeeze the profits of productive enterprise. This is also the missing link economists have failed to find: the rise in the liquidation-value of enterprise causes an uncontrollable increase in the cost of servicing capital deployed in production. As costs increase, profits fall. We conclude that the squeeze on profits is not caused by the falling price-structure as previously assumed. Falling prices are themselves an effect, not a cause. The real cause is the falling interest-rate structure which reveals that productive capital has been financed at rates far too high. As a result of the squeeze, profits are turned into losses. Many firms fail, taking others down with them in a domino-effect as receivables get harder to collect.

Demand collapses, prices fall.

The central bank is desperately trying to apply damage-control by putting more money into circulation. However, more money is just oil on fire. It is not flowing to the commodity markets as expected. It flows to the bond market where the action is. By bidding up bond prices to ever higher levels bond speculators push the rate of interest to ever lower levels. This puts further pressure on profits and makes more productive enterprise fail. A vicious circle is set into motion. As already mentioned, once Keynesian fiscal policy and/or Friedmanite monetary policy have become official, bond speculators face virtually no risk. Central bank intervention will provide a nice tail-wind to make their sails bulge.

### Stealthy Wealth-Transfer

It is not hard to identify the chief culprit of bond speculation. It is the banking fraternity trying to rebuild bank capital that has been devastated during the preceding boom. The banks suffered huge capital losses in the bond portfolio, thanks to the relentless rise in interest rates. Further serious losses were sustained in the investment portfolio due to the proliferation of non-performing loans, in consequence of commercial borrowers having become over-extended in the face of rising interest rates. Now the rate of interest is falling, and the banks once more have the upper hand. Bankers are determined to make most of it.

The point is that the wealth of failing productive enterprise does not go up in smoke during the depression, as it has been wrongly assumed by earlier writers. It is being siphoned off and will show up as capital gains in the banks' bond portfolio. In this revisionist view, the Great Depression appears to have been caused by a massive wealthtransfer from the productive sector to the financial sector, denuding the former of its capital. The stealthy wealth-transfer has been made possible in the first place by the destabilization of the interest-rate structure. For this, mistaken government policies caving in to anti-gold propaganda and agitation for unlimited deficit-spending are squarely responsible.

### Collapse of Demand or Collapse of Production?

In the second part of this essay we shall put the patience of the reader to test by a detour to discuss some fundamental book-keeping principles. This will be necessary for a full understanding of the stealthy wealth-transfer from the productive to the financial sector, that would never be possible if the balance sheets of individual firms in the productive sector showed the true financial picture at all times and the accounting profession raised the alarm about the ongoing capital consumption. But in a falling interest-rate environment the balance sheet ignores the huge increases in liquidation-value and the corresponding destruction of capital, of which all productive firms are suffering. Worse still, phantom profits are being paid out which further eats into capital, ultimately leading to the downfall of the productive sector of the economy.

In the third part, out of these elements we construct the revisionist theory of the Great Depression, and warn of the consequences concerning the present falling interest-rate environment in which the same forces are again at work. The conclusion is that causes of the Great Depression are to be found in the fatally relaxed accounting standards, the creation of the Federal Reserve banks in 1914, and the destruction of the gold standard in 1933. They interacted to cause wholesale capital destruction in the productive sector. It was not the collapse in demand that caused the collapse of production, as asserted by the currently fashionable Keynesian and Friedmanite orthodoxy. It was the exact opposite: the collapse in production causing the collapse of demand. As pointed out already, the collapse in production occurred in response to the invisible destruction of capital due to the falling interest-rate structure which, in turn, was engineered by the bond speculators, chief among them the banking fraternity.

## Ii. The Book-Keeper'S Dilemma

### The Finest Invention of the Human Brain

One of the plays of George Bernard Shaw branded "unpleasant" by the playwright himself is entitled The Doctor's Dilemma. The protagonist is a physician who comes into conflict with the Oath of Hippocrates (fl. 460-377 B.C.) He has developed a new treatment for a fatal disease, but the number of volunteers for the test-run exceeds by one the number of beds in his clinic. Unwittingly, the doctor finds himself in the role of playing God to decide who shall live and who shall die. By the same token, Shaw could have written the "most unpleasant" play of them all entitled The Book-Keeper's Dilemma. In it the protagonist, a chartered accountant, finds himself in conflict with the norms and rules of book-keeping as set out by Luca Paciuoli (fl. 1450-1509). As a result of compromising the high standards of the accounting profession, the book-keeper will unwittingly become the destroyer of Western Civilization.

Luca Paciuoli taught mathematics at most universities of Quattrocento Italy including those of Perugia, Napoli, Milan, Florence, Rome, and Venice. In 1494 he published his Summa Arithmetica. Tractatus 11 of that work is a textbook on book-keeping. In it the author shows that the assets and the liabilities of a firm will exactly balance out, provided that we introduce a new item in the liability column that has been variously called by subsequent authors "net worth", "goodwill", or "capital". This innovation makes it easy to check the ledger by finding that, at the close of every business day, assets minus liabilities is exactly equal to zero. Otherwise there must be a mistake. But what Paciuoli discovered was something far more significant than a method to find errors in the arithmetic. It was the invention of what we today call double-entry book-keeping, and what Goethe has called "the finest product of the human brain" (cf. Wilhelm Meister's Apprenticeship).

Why was this discovery so important in the history of Western Civilization? Because, for the first time ever, it was possible to calculate and monitor shareholder equity with precision. This is indispensable in starting and running a joint-stock company. Without it new shareholders couldn't get aboard and old ones could not disembark safely. Stock markets, mergers, acquisitions would not be possible. The national economy would be a conglomeration of cottage industries, unable to undertake any large-scale project such as a transcontinental railroad construction or an intercontinental shipping line.

The invention of the balance sheet did to the art of management what the invention of the compass did to the art of navigation. Seafarers no longer have to rely on clear skies in order to keep the right direction. The compass has made it possible for them to sail under cloudy skies with equal confidence. Likewise, managers no longer have to depend on risk-free opportunities to keep their enterprise profitable. The balance sheet tells them what risks they may take and which ones they must avoid. It is no exaggeration to say that the present industrial might of Western Civilization rests on the corner-stone of double-entry book-keeping. Oriental (Chinese) or Middle-Eastern (Arab) Civilizations would have outstripped ours if they had chanced upon the discovery of the balance sheet first.

### Barbarous Relic or Accounting Tool?

For the past 70 years the world has been fed the propaganda-line that the gold standard is a "barbarous relic", ripe to be discarded. The unpleasant truth, one that propagandists have 'forgotten' to mention, is that the gold standard is merely a proxy for sound accounting (as well as moral) principles. It was not the gold standard per se that politicians wanted to overthrow, but certain accounting and moral principles that had become an intolerable fetter upon their ambition for aggrandizement and perpetuation of power. Historically, accounting and moral principles had been singled out for discard before the gold standard was given the coup de grâce. The attack on accounting standards and the corruption of the gold standard were heralded by the establishment in 1913 of the Federal Reserve System, the engine for monetizing government debt. Just how the monetization of government bonds led to a hitherto unprecedented, even unthinkable, corruption of accounting standards - this is a question that has never been addressed by impartial scholarship before.

In order to see the connection we must recall that any durable change in the rate of interest has a direct and immediate effect on the value of all financial assets. Rising interest rates make the value of bonds fall, and vice versa. But while a rise makes the Wealth of Nations shrink and a fall in the rate of interest makes it expand, the benefits and penalties are distributed capriciously and indiscriminately, without regard to merit.

This was hardly disturbing under the gold standard as the rate of interest was remarkably stable and the corresponding changes in the Wealth of Nations were negligible. A lasting increase in interest rates could only occur in the wake of a national disaster such as a flood, earthquake, or war. In all these cases higher interest rates were beneficial. They had the effect of spreading the loss of wealth due to the destruction of property more widely. Those segments of society that were lucky enough to escape physical destruction still had to share the loss through the increased cost of servicing capital due to the higher rate of interest. Everybody was prompted to work and save harder in order that the damage might be repaired more quickly and expeditiously. As interest rates gradually returned to their lower level, the Wealth of Nations expanded. Again, everybody would benefit through the reduced cost of servicing productive capital. It is not widely recognized that the chief eminence of the gold standard is not to be found in a stable price structure (that is neither possible nor desirable) but in a low and stable interest-rate structure, maximizing the Wealth of the Nations, while ruling out capricious and disturbing swings in it.

The gold standard ruled supreme before World War I. But once general mobilization was ordered in 1914, it was put at risk by the manner in which belligerent governments set out to finance their war effort. These governments wanted to perpetuate the myth that the war was popular and there was no opposition to the senseless bloodshed and destruction of property that could have been avoided through better diplomacy. The option of financing the war effort through taxation was ruled out as it might make the war unpopular. The war had to be financed through credits. In more details, war bonds were to be issued in unprecedented amounts, subsequently monetized by the banking system. Naturally, these bonds could not possibly be sold without a substantial advance in the rate of interest.

Accordingly, the Wealth of Nations shrank even before a single shot was fired or a single bomb dropped.

### Tormenting Widows and Orphans

Under the gold standard bondholders are protected against a permanent rise in the rate of interest (which in the absence of protection would decimate bond values) by the provision of a sinking fund. In case of a fall in the value of the bond, the sinking fund manager would enter the market and keep buying the bond until it was once more quoted at par value. Sinking fund protection was offered by every self-respecting firm issuing bonds. Even though governments did not offer it, it was understood and, in the case of the Scandinavian governments explicitly stated, that in case of a permanent rise in the rate of interest the entire bonded debt of the government would be refinanced at the higher rate.

Bondholders who had put their faith in the government would not be allowed to suffer a loss. The banks, guardians of the people's money, could regard government bonds as their most trusted earning asset. Such faith, at least in the case of Scandinavian government obligations, was justified. The risk of a collapse in their value was removed.

Governments, at least those in Scandinavia, occupied the moral high-ground. They had borrowed money which, in part, belonged to widows and orphans. They took to heart the admonition and did not want to bring upon themselves the Biblical curse pronounced on the tormenters of widows and orphans.

### The Law of Assets

But there was a problem with war bonds issued by belligerent governments. These bonds were quickly monetized by the banking system making the refinancing of bonded debt impossible. This created a dilemma for the accounting profession. According to an old book-keeping rule going back to Luca Paciuoli that we shall here refer to as the Law of Assets, an asset must be reported in the balance sheet at acquisition price, or at the market price at the time of reporting, whichever is lower. In a rising interest-rate environment the value of all financial assets such as bonds and fixed-rate obligations are falling, and the fall must be faithfully recorded in the balance sheet. There are excellent reasons for this Law. In the first place it is designed to prevent credit abuse by banks and other lending institutions. In the absence of this Law banks could overstate the value of their assets that could be an invitation to credit abuses to the detriment of shareholders and depositors. If the credit abuse went on for a considerable period of time, then it could lead to the downfall of the bank. In an extreme case, when all banks disregarded the Law of Assets, the banking system could be operating on the strength of phantom capital, and the collapse of the national economy might be the result. For non-banking firms the possibility of overstating asset-values also existed and could similarly serve as an invitation to reckless financial adventures. Even if we assume that upright managers would always resist the temptation and would not intentionally get involved in such adventures, in the absence of the Law of Assets the balance sheet would still cease to be a reliable compass to guide the firm, materially increasing the chance of making an error.

Managerial errors could compound and the result could again be bankruptcy.

Economists of a statist persuasion would argue that an exception to the Law of Assets could safely be made in case of government bonds. The government's credit, like Caesar's wife, is above suspicion. The government's ability to retire debt at maturity cannot be doubted. As a guarantee, these economists point to the government's power to tax, as well as to its right to seigniorage in the process of issuing money. However, the problem is not with the nominal value of government bonds at maturity, but with the purchasing power of the proceeds. Currency depreciation is a more subtle and hence more treacherous form of default. The government, however powerful, cannot create something out of nothing any more than an individual can. It cannot give to Peter unless if has taken it from Paul first. Nor is the taxing power of the government absolute. Financial annals abound in cases where taxpayers revolted against high or unreasonable taxes, thereby causing the overthrow of government and forcing the cancellation of bonded debt. If the taxing power of the governments had been absolute, then World War I could have been financed out of taxes, and no loss of purchasing power to bondholders through debt-monetization would have occurred.

A strict application of the Law of Assets would have made most banks and financial institutions in the belligerent countries technically insolvent. The dilemma facing the accounting profession was this. If accountants insisted that the Law be enforced, then they could be considered "unpatriotic", and be held responsible for the weakening financial system of the country. Demagogues could charge that the accountants were undermining the war effort. On the other hand, if they allowed the banks to report government bonds in the asset column at acquisition-value rather than the lower market value, then they would compromise the time-tested standards of accounting and expose the firm, and the economy, to all the dangers that may follow from this, not to mention the fact that they would also bring the credibility of their profession into question.

### Insolvent or Illiquid?

The story of how the accounting profession solved the dilemma has never been told. It appears a safe assumption that the dilemma was solved for it by the belligerent governments in making it clear that public disclosure of the banks' true financial condition would not be tolerated. Nor could a public discussion of the subtle changes in accounting theory, following those in accounting practice, be entertained. These included the throwing of the Law of Assets to the winds, replacing it with a new and more relaxed one allowing the banks to report government bonds in the asset-column at acquisition value, regardless of true market value, as if it were a cash item. A new term was introduced in the dictionary to describe the financial condition of the bank with a hole in its balance sheet, provided that it could still meet the new relaxed criteria for solvency.

Such a bank was henceforth called "illiquid". We shall see below why the practice of allowing illiquid banks to keep their doors open is a dangerous course to follow, as it has far-reaching consequences threatening, as it may, the very foundations of Western Civilization. (The recent scandal involving the American giant Enron is in fact a scandal involving the entire accounting profession, which stems from the unwarranted relaxation of accounting standards back in 1914.)

While I am in no position to prove that a secret gag-rule was imposed on the profession, I am at a loss to find an explanation why an open discussion of the wisdom of changing time-honored accounting principles has never taken place. Apparently there were no defections from the rank and file of the accounting profession denouncing the new regimen as unethical and self-defeating. These underhanded changes in accounting standards have opened the primrose path to self-destruction. The dominant role of Western Civilization in the world was due to the moral high-ground staked out by the giants of the Renaissance, among them Luca Paciuoli. As this high-ground was gradually given up and the commanding post was moved to shifting quicksand, and as rock-solid principles gave way to opportunistic guidelines, Western Civilization has been losing its claim to leadership in the world. It comes as no surprise that this leadership is facing the most serious challenge of its history.

The chickens came home to roost in 1921 when panic swept through the U.S. government bond market. Financial annals fail to deal with this panic (exception: Benjamin M.

Anderson's posthumous Financial History of the United States published in 1949). Nor was it given the coverage in the financial press it deserved. Information was confined to banking circles where the panic hit hardest. Clearly, it was in the interest of the government and the banks to hide the news under the bushel. There was an unprecedented peace-time jump in long-term interest rates, causing devastation in the market for long-term U.S. government bonds. Upright bankers looked at bond quotations in disbelief and desperation. The strongest pillars of their balance sheet were subjected to an unprecedented meltdown, taking place before their very eyes.

The crisis of 1921 was swept under the rug as the Federal Reserve banks stepped in the breach and shored up the balance sheet of their member banks. An historic opportunity was missed to mend the ways of the world that had gone astray in 1914. It was the last opportunity to avert the Great Depression, already in the making.

### The Law of Liabilities

Purely by using a symmetry-argument we may formulate another fundamental principle of accounting, the Law of Liabilities. It states that a liability must be reported in the balance sheet at its value at maturity, or at its liquidation value, whichever is higher.

Since liquidation would have to take place at the current rate of interest, in a falling interest-rate environment the height of liabilities of all firms are rising. The possibility of a simultaneous rise in the liabilities of all productive firms represents a great danger to the national economy. This danger has been completely disregarded by the economists' profession. As we know, economists have failed to raise their voice against the folly of allowing the interest-rate structure to fluctuate for reasons of political expediency, implicit in the application of both Keynesian and Friedmanite nostrums. It is possible that the reason for this failure was the fatal blind spot economists appear to have in regard to the danger of overestimating national income in a falling interest-rate environment.

The proposition that a firm must report liabilities at a value higher than that due at maturity whenever the rate of interest falls is, of course, controversial. Let us review the reasons for this crucial requirement. If the firm has to be liquidated for whatever reason, then of course all liabilities become due immediately. Sound accounting principles demand that sufficient capital be maintained at all times to make liquidation without losses possible. If the interest rate were to fall, then clearly earlier liabilities had been incurred at a rate higher than necessary. For example, if an investment was to be financed through a bond issue or a fixed-rate loan, then better terms could have been secured by postponing the investment. In other words, a managerial error in timing has been made.

This is a world of crime and punishment, and even the slightest error brings a penalty in its train. The increase of liability in the balance sheet is just the penalty for managerial error. If the investment had been financed out of internal resources, penalty is still justified. Alternative uses for the resource would have brought better financial results.

But even if we assume that the investment was absolutely necessary to make at the time it was made, and we absolve management of all responsibility in this regard, the case for an increase in liability still stands. After all has been said and done, there still is an obvious loss due to the fact that servicing investment must be made at a rate higher than that available in the market. This loss ought to be realized if we want the balance sheet to continue to reflect the true financial position. Any other approach would create a fools' paradise. To see this more clearly we may point out that these losses are analogous to losses due to an accidental fire destroying physical capital which the insurance company for whatever reason fails to cover. The loss still has to be realized, as it is absolutely necessary that the balance sheet reflect the changed financial picture caused by the fire.

The proper way to go about it is a three-step adjustment as follows:

(1) Create an entry in the asset-column called "fund to cover fire loss".

(2) Create an equivalent entry in the liability-column.

(3) Amortize the liability through a stream of payments out of future income.

It is clear that if the accountant failed to do this, that is, if he failed to realize the loss due to fire, then he would falsify future income statements. As a result, phantom profits may be paid out (or losses may be reported as profits). Not only would this weaken the financial condition of the firm, but it would also render the balance sheet meaningless, which may lead to further errors.

Exactly the same is true if the loss was due not to fire but a fall in the rate of interest. The way to realize the loss is analogous. A new entry must be created in the asset-column called "fund to cover overpayment in servicing capital, made necessary by a fall in the rate of interest", against the creation of an equivalent entry in the liability column, to be amortized by a stream of payments out of future income. This is not an exercise in pedantry. It is the only proper way to realize a real loss which has been, I repeat, incurred as a result of the inescapable increase in the cost of servicing productive capital already deployed, in the wake of a fall in the rate of interest. Ignoring that loss would not erase it, while it might certainly compound it.

### The Historic Failure to Recognize the Law of Liabilities

I anticipate a torrent of criticisms asserting that there is no such a thing as the Law of Liabilities in accounting theory and practice. I submit that I have no formal training in accounting, or in the theory and history of accounting. Nor do I recall having seen the Law of Liabilities in any of the textbooks on book-keeping that I have perused (although I have seen the Law of Assets in many older books that have long since been discarded by practicing accountants as well as professors of accounting). But I shall argue that either Law follows the spirit, albeit, perhaps, not the letter of Luca Paciuoli. Affirming one while denying the other makes no sense. Every argument that supports one necessarily supports the other. There is a perfect logical symmetry between the two Laws, arising out of the symmetry of assets and liabilities in the balance sheet. Ignoring either Law is a serious breach of sound accounting, possibly with extremely grave consequences. For example, if the rate of interest keeps falling for an extended period of time, as it has in Japan for almost a decade now, then present (in my opinion, deeply flawed) accounting standards will allow losses to be reported as profits. The resulting wholesale capital destruction, which the country may not realize until it is too late, could bring the national economy to its knees spelling depression, deflation, or both (as it seems to be occurring in Japan right now).

Even if the fact can be established that the Law of Liabilities has never been spelled out in any official accounting code going back all the way to that of Luca Paciuoli, we should still not jump to the conclusion that there is no justification for it. A convincing argument can be made explaining why this Law might have escaped the notice of upright and knowledgeable accountants in the past, with the consequence that the Law has never been codified. For centuries, the powers that be have shown a persistent bias in taking the side of the debtors' class against that of the creditors', as demonstrated by their desire to suppress the rate of interest by hook or crook. However, this effort has remained counterproductive before the advent of open-market operations. Indeed, the usuriously high rates charged on loans in pre-capitalistic times were not due to an alleged greed of the usurers.

They were due to the usury laws themselves. The charging and paying of interest had been outlawed. The result was not zero interest as the authors of the usury laws had foolishly hoped. On the contrary, the result was rates higher than what the free market would have charged. The excess represented compensation for risks involved in doing an extra-legal business transaction. For these and other reasons, the problem traditionally was not lower or falling rates. It was higher or rising rates. But the Law of Liabilities remains inoperative in such an environment. Furthermore, when open market intervention of the central bank came into vogue with the establishment of the Federal Reserve System, the United States was still on the gold standard which set a limit to the lowering of interest rates for political purposes. The Law of Liabilities continued to be inoperative.

It is hard indeed to discover a Law that has been inoperative all through previous history.

The picture changed decisively in the 1930's when agitation against the gold standard started in earnest. Britain abandoned the gold standard in September, 1931, and the United States, in March, 1933. Finally, the last obstacle has been removed, and the door to suppressing the rate of interest for political purposes through central-bank open-market purchases of bonds was thrown wide open. Interest rates were falling throughout the 1930's. Considering its magnitude, the fall appears to be unprecedented by historical standards. Thus, then, we have the first instance ever in history that the Law of Liabilities could become operative. I think it did. The proof is that the Great Depression did indeed take place.

---

*March 6, 2002*

*Note. This paper is based on a series of talks with the same title given by the author at Sapientia University, Csikszereda, Romania, in March, 2002.*

---

# Whither Gold?

URL: https://newaustrianeconomics.com/archive/fekete/whither-gold/
Date: 1996-10-02
Section: Popular Economics
Difficulty: scholarly
Concept Tags: gold-standard, interest-theory, fiat-currency, irredeemable-currency, gold-bonds, capital-destruction, debt, menger, mises, sound-money
Description: Fekete's prize-winning 1996 essay arguing that the gold standard's essential function is not price stability but interest-rate stability — and that without gold-bonded debt, the world's Debt Tower of Babel must eventually collapse.
Editorial Note: Winner of the 1996 International Currency Prize sponsored by Bank Lips. Written at Memorial University of Newfoundland, this is one of Fekete's earliest and most comprehensive statements of his monetary philosophy.
Original PDF: https://professorfekete.com/articles/AEFWhitherGold.pdf

## Introduction

The year 1971 was a milestone in the history of money and credit. Previously, in the world's most developed countries, money (and hence credit) was tied to a positive value: the value of a well-defined quantity of a good of well-defined quality. In 1971 this tie was cut. Ever since, money has been tied not to positive but to negative values — the value of debt instruments.

This innovation has had two immediate consequences, both of which are pointedly ignored in the technical and scholarly literature on the subject: (1) the power to reduce the world's total debt in the course of normal payments has been lost: total indebtedness can now be reduced only through default or through currency depreciation; (2) countries have lost the option to balance their current accounts with the rest of the world: each country has to cope with unending deficits.

The exception is a couple of countries that have been coerced into holding the debt of the world, upon which the burden of default and currency depreciation will eventually fall: Germany and Japan. As a result of these two features the world's monetary system, which previously was patterned on the model of an anchor, is now patterned on the model of a weather vane. As the tide of unpaid and unpayable debt grows, so the value of money ebbs.

That we have lost the facility to reduce the world's total indebtedness without resorting to default or monetary depreciation becomes clear at once if we consider the fact that a debt of x dollars can no longer be liquidated. If it is paid off by a check, the debt is merely transferred to the bank on which the check is drawn. The situation is no better if it is paid off by handing over x dollars in Federal Reserve notes, ostensibly the ultimate means of payment. In this case the debt is transferred to the U.S. Treasury, the ultimate guarantor of these liabilities. But substituting one debtor for another is not the same as liquidating the debt. The very notion of `debt maturity' has lost all reasonable meaning previously attached to it. At maturity the creditor is coerced into extending his original credit plus accrued interest in the form of new credits, usually on inferior terms. It is true that the option to consume his savings remains open to him — but is it not a strange monetary system, to say the least, which forces the savers to consume their savings whenever they are dissatisfied with the quality of available debt instruments, or with the terms on which they are offered?

Mainstream economic orthodoxy teaches that a depreciating currency is a boon to the country, and a valid tool in the hands of the government to increase competitiveness and thus to reduce or to eliminate the current account deficit. A debased currency makes the country an attractive place for foreigners in which to buy and an unattractive place in which to sell. Exports are boosted, imports curtailed; thus the deficit is narrowed. This is one of the most pernicious doctrines ever concocted — as demonstrated both by theory and practice. Deliberate currency depreciation puts the country at a clear disadvantage, causing its terms of trade to deteriorate. As all items for export have imported components, no one can maintain for long low export prices in the face of ever rising cost of imports. This theoretical remark is fully borne out by history as shown, for example, by the experience of the United States during the past 25 years. As the American government has been crying down the (yen) value of the dollar, the terms of trade of the U.S. vis-a-vis Japan is greatly undermined, creating an unending stream of trade deficits which the Japanese are obliged to finance. To be sure, the Japanese are also depreciating the value of their currency. But as long as they do it at a lower rate, which is what the Americans demand that they do, Japanese trade surpluses will continue unabated.

The grievous faults of the prevailing monetary arrangements raise serious questions about the regime's stability and durability. The governments are busily constructing an enormous Debt Tower of Babel, apparently without giving the slightest thought to the wisdom or safety of their construction. The year 1996 marks the twenty-fifth anniversary of the Brave New World of reckless debt breeding. A quarter of a century is not a great length of time in the course of history. But it might be sufficiently long to warrant an examination of this deliberate policy of heaping more debt upon unpaid and unpayable debts.

Has the policy of unbridled credit expansion, blindly embraced by the governments of the world some 25 years ago, served the people well? Or do the negative results of this experiment call for a more careful examination of the principles involved than hitherto provided? The question is not raised, and the anniversary is being ignored by the opinionmakers. A great deal of obfuscation surrounds the issue. Officially, the topic is off limits to scholarship and research. Anyone who dares to question the legitimacy of the world's present monetary arrangements, or challenges the doctrine that the regime of irredeemable currency represents `progress' over `obsolete' metallic monetary regimes, is browbeaten; his reward is official ostracism. Professional standing is reserved for those who pay lip service to the dogma that `emancipation' from a metallic monetary standard was a progressive, even necessary, historical development. This essay attempts to defy the odds. It intends to show that the essence of the gold standard is not to be found in its ability to stabilize prices (that is neither desirable nor possible). It is to be found in its ability to stabilize the interest-rate structure at the lowest level compatible with economic conditions, and thereby to keep debt within limits. In the absence of a gold standard, efforts to keep the rate of interest under control are doomed. Rising and gyrating interest rates bring about a wholesale destruction of values, as can already be seen in the bond and real estate markets (not to mention the Japanese stock market). Further delay in putting the cancer-fighting gold corpuscles back into the monetary bloodstream may bring about a credit collapse and chaotic conditions in the world economy, eclipsing the memory of the Great Depression.

## 1. A Brief History of Money

It was Carl Menger who in his epoch-making book Grundsätze der Volkswirtschaftlehre (first published in 1871) elucidated the origin of money in terms of an evolution from direct to indirect exchange. Menger introduced the Principle of Declining Marginal Utility asserting that anybody acquiring subsequent units of the same economic good will earmark the last unit for uses with lower priorities than those assigned to previously acquired units.

This is paraphrased by saying that the marginal utility of an economic good is declining. It is possible to rank goods according to the rate of decline in marginal utility. The economic good with a marginal utility declining more slowly than that of any other is destined to become money.

### Constant marginal utility

In fact, the decline in the marginal utility of money is so slow that it may be considered negligible, so that the marginal utility of money is constant. In 355 BC a keen observer of antiquity, Xenophon, in his work Ways and Means, a Pamphlet on the Revenues of Athens, described what we herein call the constant marginal utility of money in these words: "Of the monetary metal, no one ever possessed so much that he was forced to cry "enough!" On the contrary, if ever anybody does become possessed of an immoderate amount, he finds as much pleasure in digging a hole in the ground and hoarding it as in the actual employment of it. And, from a wider point of view, when the state is prosperous, there is nothing that people so much desire as money. Men want money to expend on beautiful armor, fine horses, houses, and sumptuous paraphernalia of all sorts. Women betake themselves to expensive apparel and ornaments. Or, when the states are sick, either through barrenness of corn and other fruits or through war, the demand for current coin is even more imperative (whilst the ground lies unproductive) to pay for necessaries or for military aid. And if it be asserted that another metal is after all just as useful as the monetary metal, without gainsaying the proposition I may note this fact, that with a sudden influx of the former, its value is depreciated, while causing at the same time a rise in the value of the latter. "

The practical significance of the constant marginal utility of money can best be seen through examples. The government may open the Mint for the free and unlimited coinage of a certain metal only if the marginal utility of that metal is constant. Equivalently, the Central Bank may post fixed bid/asked prices for an economic good only if it has constant marginal utility. This quality alone will guarantee an orderly and controlled flow of the metal into circulation in the form of coined money, and will make the orderly exchange of coined money for credit instruments possible. If the government violates this principle, then the Mint and the Central Bank will be buried under an avalanche of inferior metal.

This in fact happened in the 1870's. People continued to overwhelm the mints and central banks of the Latin Monetary Union with silver, while draining away their gold. In the end the governments threw in the towel, closed the mints to silver, and instructed their central banks to stop the deluge by lowering the price of silver in terms of gold. In doing so the governments were eating their words, as this effectively demonetized silver — something they had said they would never do. The demise of bimetallism is an interesting episode in monetary history, yet it is not well understood by authors. Ludwig von Mises writes in Human Action:

In the second part of the nineteenth century more and more governments deliberately turned toward the demonetization of silver . . . The important thing to be remembered is that with every sort of money, demonetization — i.e., the abandonment of its use as a medium of exchange — must result in a serious fall of its exchange value. What this practically means has become manifest when in the last ninety years the use of silver as commodity money has been progressively restricted (op.cit., PP 428-9).

This appears to confuse cause and effect. In reality, the demonetization of silver was not the cause but the effect of the decline in the relative value of silver. Moreover, it was not the governments but the markets that did the demonetizing. Elsewhere in the same book Mises confirms this: "The emergence of the gold standard was the manifestation of a crushing defeat of the governments and their cherished doctrines. In the seventeenth century the rates at which the English government tariffed the coins overvalued the [gold] guinea with regard to silver and thus made the silver coins disappear. Only those silver coins which were much worn by usage or in any other way defaced or reduced in weight remained in current use; it did not pay to export and to sell them on the bullion market.

Thus England got the gold standard against the intention of its government. Only much later [did] the laws make the de facto gold standard a de jure standard. The government abandoned further fruitless attempts to pump silver into the market and minted silver only as subsidiary coins with a limited legal tender power . . . . . Later in the course of the nineteenth century the double standard resulted in a similar way in France and in the other countries of the Latin Monetary Union in the emergence of de facto gold monometallism. When the drop in the price of silver in the later seventies would automatically have effected the replacement of the de facto gold standard by the de facto silver standard, these governments suspended the [unlimited free] coinage of silver in order to preserve the gold standard (op.cit.,pp 471-2). "

It would be more accurate to allude to government efforts "to pump silver back into the market" — silver that people were dumping at the doorstep of the mints. It was, of course, not any affection for gold, nor lack of affection for silver, that caused governments to abandon the latter. Governments were silverite by instinct.

Moreover, bimetallism had been a lucrative, if illegitimate, source of revenues to them. They fought a fierce rear-guard action. But at one point they realized that the battle to save bimetallism had been lost as silver no longer had the necessary characteristic of a monetary metal: it no longer had constant marginal utility. Further resistance to market forces would have meant unsustainable losses. The lesson from this historical episode is that the hands of the governments can be forced by the people. It was the market that brought about the de facto demonetization of silver in the 19th century. The writing is on the wall that it may bring about the demonetization of irredeemable currencies in the 21st.

The fixed bid/asked prices the Central Bank may post for the monetary metal, gold, are also called the lower/upper gold points, respectively. These points are not determined arbitrarily; they are, in fact, market prices. The upper gold point is closely related to the gold export point above which the standard gold dollar is worth more in melted than in coined form (making it profitable to export it); the lower gold point is closely related to the gold import point below which gold is worth more in coined than in bullion form (making it profitable to deliver imported gold to the Mint — which explains how these points earn their names).

The most important consequence of constant marginal utility is the fact that the utility of money is proportional to its quantity, and money is the only economic good with this property. This fact was instrumental in the disappearance of barter. Because of declining marginal utility, barter involves losses. One can minimize these losses by bartering for goods with more slowly declining marginal utility. Clearly, the best terms of trade are reserved for those who barter for (with) the good having constant marginal utility. It is a misunderstanding to suggest, as Ludwig von Mises does (op. cit., p 404) that the concept of constant marginal utility is contradictory because it is synonymous with infinite demand. Rather, it is the concept of demand that is contradictory, and should not be used in deductive science except, perhaps, in a metaphorical sense. The appropriate interpretation of constant marginal utility is this: people are willing to accept money in discharge of debt in unlimited quantities, not because they want to hold wealth in the form of unlimited quantities of money, but because they understand that the way to minimize the inevitable losses inherent in any exchange is to execute it through the agency of money.

Under the gold standard all the gold above ground is deemed to be on offer for sale, as it is deemed to be in demand. The value of the unit weight of gold is independent of the number of available units. By contrast, consider the value of the unit weight of iron. Certainly not all the iron above ground is on offer for sale. The first unit weight of iron has a much greater utility to its owner than the one acquired last. The value of iron is determined by its declining marginal utility, making it depend on the quantity available. The difference in the behavior of the two metals in exchange is obvious. Menger introduced the concept of marketability of goods (Absatzfähigkeit) in order to elucidate the emergence of indirect exchange. A commodity with a lower rate of decline in its marginal utility is more marketable than another with a higher rate. The monetary commodity is the most marketable good, preferred by all market participants, even if they have already satisfied all their personal needs for it. `Most marketable' is synonymous to `having constant marginal utility'. There is no need to quibble about the use of the word `constant' in this context.

The lowest rate of decline will result in a marginal utility that is constant for all practical purposes, as the marketability of the commodity with that property will `snowball' in time. The first gold coin received by an individual certainly has the same utility to him as the last: he can exchange both coins on exactly the same terms.

The evolution of the monetary standard as the economic good with constant marginal utility or highest marketability is the crowning event in the transition from direct to indirect exchange, replacing the barter system with the monetary economy. The subjective theory of value, which explains price formation as a convergence phenomenon (as opposed to the quantity theory of money that explains price formation as an equilibrium phenomenon) is a consequence of that evolution.

Convergence is a process, while equilibrium is state. The market is narrowing the price range within which transactions take place, in response to the activities of arbitrageurs. This analysis of price formation shows how the market process ultimately translates marginal utilities into market prices.

The rise of indirect exchange has also made it possible for the first time to distinguish between buyers and sellers. Under barter no such distinction could be made. The emergence of money separates the buyers who give up and the sellers who expect to receive the monetary commodity in the exchange. It is precisely his command over the monetary commodity that puts the buyer in charge — making the sellers his servants. His control over the monetary commodity gives the buyer a choice. He can buy, or he can refrain from buying. Sellers don't have the luxury of choice. If they don't sell, then they admit to failure and have to drop out of the rank of sellers. It is interesting to note that the regime of irredeemable currency attempts to abolish this prerogative. It puts pressure on the buyers to buy indiscriminately, before their buying power is further eroded by currency depreciation.

### The role of plunder

There is a certain confusion prevailing among authors in regard to the objective versus subjective nature of the value of money. It cannot be denied that all economic phenomena, including the value of money, find their ultimate explanation in the subjective value-judgments of individuals.

However, through a long chain of causation taking place over very long periods of time, a cumulative economic process has lent an objective character to the value of the monetary commodities. The value of a monetary commodity is the result of an evolution that took millennia to complete. Consumers, producers, and other actors in the economic drama tend to keep sizeable stores of the monetary commodity on hand (partly because constant marginal utility makes money an ideal place where to park one's assets). The cumulative effect of this causes the combined stocks of the dispersed monetary metal to reach a singularly high level, relative to the rate of annual production. As a consequence, the stocks-to-flows ratio (total stocks divided by annual production) eventually becomes a high multiple, quite unheard-of for other commodities. In the case of gold this ratio has been estimated to be 50. This means that the total world stock of gold is about 50 years' production at present rates of output. The same ratio for a nonmonetary commodity is usually a small fraction, at any rate, no higher than 1. The ratio 1 may be reached in case of staple food items harvested once a year, at harvest-time. This means that society is not willing to carry in store more than a few weeks' or months' supply of most economic goods. The only exceptions are the monetary commodities. As the stocks-to-flows ratio for the monetary metal is so high, the likelihood of an upstart commodity displacing it is remote. In order to bring about such a change it would be necessary to accumulate stocks — a process that might take hundreds of years. (The displacement of silver by gold in the second half of the 19th century was, in effect, a case of monometallism replacing bimetallism — not a case of one monetary commodity replacing another, as explained above.)

Thus the hegemony of the monetary metal, once established, can hardly be challenged. It is possible to argue that the value of gold, unlike that of other goods, is objective. It is rooted in the objective fact that the world's accumulated stock of gold is a high multiple of the annual flow of new metal from the mines — a fact independent of subjective value judgments. As already stated, this is not to deny that ultimately value must be explained by subjective considerations; but in assigning a subjective value to gold the human mind first must deal with the objective fact that large and well-dispersed stocks of gold exist, relative to which the flow of new gold from the mines is small.

The suggestion that the value of the monetary metal has often fallen, constant marginal utility notwithstanding, reflects a confusion of ideas. Historical examples cited in support of that suggestion are the dispersal of Persian gold after the sack of Persepolis by Alexander the Great in 331 B.C., and the dispersal of the Inca's silver and gold after the sack of Cuzco by Francisco Pizzaro and the conquistadores in 1533 A.D.

Both events have been followed by periods of pronounced and prolonged price rises all over the trading world, making the impression that the monetary metals have lost value. The pat explanation offered for this phenomenon is the quantity theory of money. The value of silver and gold is no different from the value of other commodities — so the argument goes. They are determined by available quantity. Whenever they become more abundant, as they did in 331 B.C. and again in 1533 A.D., these monetary metals suffer a loss of value.

However, the suggestion that the value of gold may decline under a gold standard is preposterous. The length of a measuring rod in terms of itself as unit is always 1. The correct interpretation of these historical episodes has nothing to do with the quantity theory of money, which is a pernicious doctrine. An across-the-board increase in prices is one thing, and loss of value of the monetary unit is another. The former may occur in case of general scarcity, quite independently of the latter. In analyzing these historical episodes we must carefully note the role of plunder in each case.

Wherever large stores of certain goods fall prey to plunder, scarcity results. The prices of these goods rise, and will stay high as long as scarcity persists. An apparent exception to the general rule is the plunder of stores of precious metals that is never followed by a rise, but is often followed by a fall in value. Can this paradox be reconciled with the Principle of Declining Marginal Utility? Well, I argue that the value of gold cannot fall, any more than the value of other commodities can, as a result of plunder. The key to the paradox is the fact that plunderers do not want gold for its own sake — just as the bank robbers do not want bank notes for their own sake. What they ultimately want is a host of goods. Bank robbery is the quickest way to loot society's store of marketable goods. Likewise, when a large store of gold is plundered, it is economically equivalent to the plunder of stores of all kinds of marketable goods. Thus, then, price rises in the wake of plundering gold are explained by the subsequent scarcity of marketable goods. Higher prices always and everywhere indicate greater scarcity of goods — never a greater abundance of gold.

### Plunder — modern style

In the same light I wish to examine the across-the-board price rises that occurred under the gold standard in 1896-1921 and, again, in 1934-1968. These episodes are no more explained by a greater abundance of gold than are those of 331 B.C. and 1533 A.D. The key to the understanding of these, surprising as it may sound, is also plunder — making marketable goods relatively scarcer. It is true that the plunder involved is of a subtler kind than the brutal events of 331 B.C. and 1533 A.D. Subtle or not, plunder remains plunder. Here is what happened.

As monometallism was gaining ground over bimetallism, there was a great increase in gold prospecting and production. However, a funny thing happened to gold on its way from the mines to the mints. Central banks hijacked it, in order to build a credit-pyramid, up to twenty times as great, upon their increased gold reserve. Without this interference from the banks there would have been no extra demand for marketable goods and, hence, no price increases — regardless how fast output of new gold may have grown. The new gold would have entered circulation in coined form. The Haberler-Pigou effect, to be described in the next paragraph, would have prevented any across-the-board price increase. The real cause of price increases in the inflationary episodes of 1896-1921 and 1934-1968 was not the pronounced increase in gold output. It was the unwarranted credit expansion engineered by the central banks that hijacked the gold.

The same is true of the California gold rush and other similar episodes. Prices of goods and services rose in California in the wake of the 1848 discovery of gold because of the scarcity caused by the influx of newcomers. But why did prices also rise in New York and elsewhere a little later? Well, they did because of the unwarranted credit expansion that the banks in New York and elsewhere constructed upon the hijacked gold that was not allowed to flow into circulation. If anyone denies this proposition, then he assumes the burden of proof that no credit expansion took place following the California gold rush — clearly an impossible task.

Consumers controlling the gold coin could effectively resist price rises either in delaying purchases, or in buying alternative products and in shifting custom. An across-the-board price increase would represent a capital loss inflicted upon holders of the gold coin, who would scramble to recoup their losses by restricting purchases. Voluntary restraint on consumption is the ultimate factor blocking price increases. Note, however, that the Haberler-Pigou effect operates only on the gold component of the money supply, but not on the credit component.

As far as the latter is concerned, restricting purchases is an empty gesture. It is true that the holders of bank notes also suffer capital losses represented by the price rise but, because they are creditors to the extent of their holdings of fiduciary media, another group of people — their debtors — will have experienced an equivalent capital gain. The stepped-up spending of the latter group will offset the spending restraint of the former, and the net result is an across-the-board increase in prices. (For more on the HaberlerPigou effect see: R. Hinshaw, ed., Monetary Reform and the Price of Gold, Baltimore, 1967.)

Abolishing the gold standard because it could not prevent price rises due to plunder (followed by a collapse in prices) is akin to putting the bearer of bad news to death. Gold was simply doing its job in reporting the extent of economic disruption caused by plunder, credit expansion, flood, earthquake, war, etc. In no way can gold be held responsible for the disruption itself.

Rumors about the death of the gold standard are grossly exaggerated. In 1930 Keynes correctly described the impact of the two great historic dispersals of gold on the future monetary role of the metal in his book A Treatise on Money. He made a convincing case that dispersal of gold from fewer to more numerous hands has always been instrumental in promoting the monetary qualities of the yellow metal. But Keynes went on to prophesy that the exact opposite would take place in the 20th century — probably having a fatal effect on gold's future prospect to continue as the monetary metal par excellence. What he referred to was the weaning of the public from the gold coin, the concentration of gold in central bank vaults, and the unprecedented increase of bank notes in circulation. We need not be surprised that Keynes avoided using the word `plunder' to describe this process: he himself was the chief instigator of the trick of "taking gold away from man's greedy palms".

However, Keynes' prophecy concerning gold's future fell short of the mark. Keynes failed to foresee the coming of the third (and so far the greatest) dispersal of gold a generation after his death in 1947. It took the form of a great official gold dumping, ushered in by the U.S. Treasury gold auctions in 1974, followed by further auctions of central bank gold under the aegis of the International Monetary Fund (IMF). Later the auctions were suspended — possibly because it was belatedly realized that the U.S. Treasury and the IMF had made themselves the laughing stock of the world.

They were throwing away their most reliable asset in exchange for irredeemable promises to pay — at ludicrous prices to boot. Still, official holders such as Canada, Belgium, and the Netherlands occasionally dump gold on the market. Moreover, in 1995 there was more talk about new IMF gold give-aways (ostensibly to raise funds for economic aid to support the less developed countries). Thus the third great dispersal of gold is still continuing. It may be confidently predicted that the ultimate effect will be the same as that of previous historic dispersals: a reconfirmation of gold's position as the paramount monetary asset of the world.

The irony is that the authors of these gold dumpings were the most ardent students of Keynes, but they completely misunderstood the teachings of their prophet about the consequences of gold dispersal. When all has been said and done, these authors will appear as foolish as King Canute ordering the ocean to recede.

### Whose standard?

It is the task of the government and the legal system of the country, in order to preserve civil conduct in the market place, to define the standard of weights and measures, and to define the standard of value by issuing coinage and, in case of non-performance on contracts or in case of fraud, to compel the delinquent party to live up to his side of the bargain, through the use of the government apparatus of coercion. However, this ideal has often been corrupted by governments misusing their prerogative, in defining the standard of weights and measures capriciously, in order to favor a minority at the expense of the majority. This type of government intervention in the voluntary exchanges of market participants is no longer practiced. Public opinion would not tolerate the arbitrary shortening of the standard unit of length through the device of crowning an infant king, and declaring the length of his foot the new standard.

Just how much this improvement in government policy is due to enlightenment and proper sense of justice, and how much to the changing parameters of public ignorance, can be decided only after considering the fact that it is still not below the dignity of governments to tamper with the standard of value capriciously, in order to favor a minority at the expense of the majority. Governments have found that the level of general ignorance concerning the nature of value is such that public opinion can suffer the affront of manipulating the standard of value.

Out of sheer ignorance, people meekly accept the consequences of this policy of victimization. In fact, governments of the 20th century have carried the practice to its ultimate. They have accomplished what no government in the long history of civilization has been able to do, hard as they may have tried. Governments can now tamper with the standard of value on a monthly, weekly, daily, or hourly basis with impunity, through the instrument of irredeemable currency, and through open-market operations in the foreign exchange and bond markets. Governments not only get away with this dangerous prestidigitation: they are lionized for performing it. (Part of the explanation for the anomaly of our "ignorance amidst informational bounty" is the subtle control governments have over education — but that is another story.)

Before the tampering with the standard of value was developed into the high art of deception it is to-day, governments wishing to alter the terms of trade in favor of a minority at the expense of the majority could only do so at their own peril. They always had the prerogative to coin money. But in attending to this task governments did not create money, still less wealth. An economic good becomes money only by virtue of the public's preference in making its marginal utility constant. Governments don't select the monetary metal: that is the market's prerogative. The government stamp placed upon a piece of metal does not create value; all it does is to certify the weight and fineness of the coin. The purpose of stamping is to obviate weighing and the application of the acid test to each gold piece at every exchange. It is to facilitate the circulation of coins by tale rather than by weight.

Whenever governments have resorted to debasing the standard of value by issuing coins of a baser alloy, but with the same stamp, the same name, and the same outward appearance of coins, they knew full well that they were engaging in a fraudulent attempt to cheat the public. To the extent that it took time to expose the fraud, governments have been making an illegitimate profit, and they have been enriching a favored minority (the export merchants) at the expense of the unsuspecting majority (the domestic consumers). But after the fraud is exposed, as sooner or later it must be, the debased coins go to a discount representing the extent of debasement. Governments have insisted that it is not the alloy but the stamp that has made the coins valuable. They have declared it illegal to discriminate against light coins in favor of the heavy ones. They have declared maximum prices. Violation of the `law of maximum' has sometimes been made punishable by death. But as the government's writ stops at the border, and people on the other side are free to separate the light from the heavy coins as they see fit, the coin debasers are forced to admit that their policy is a failure. However, tampering with the standard of value continues. Techniques do change — the intent to benefit a favored minority at the expense of the unsuspecting majority does not.

### Bimetallism — stratagem to benefit a minority at the expense of the majority

As two precious metals, silver and gold, were used side-by-side as money, governments declared a statutory bimetallic ratio at which the monetary metals were to be valued at the Mint. We may bypass the question whether it was ignorance or deviousness which motivated governments to enforce a rigid bimetallic ratio, in pretending that value could be created or altered by legislation. Be that as it may, bimetallism was dear to the heart of governments as it offered an opportunity to tamper with the standard of value on a regular basis. This is how it worked.

The public would deliver the overvalued metal to the Mint, making this metal the de facto monetary standard, while using the undervalued metal for payments abroad where it commanded a higher value. In this way one monetary metal always appeared to be abundant, while the other appeared to be scarce before disappearing altogether. It was the inconvenience to trade caused by the abundance-cum-scarcity of bimetallic coinage that gave occasion to repeated tampering with the standard. To grant relief, governments would alter the bimetallic ratio in favor of the scarce metal. This would cause the abundant coins to become scarce and the scarce coins to become abundant. The wrong shoe was now on the other foot, and the game of changing the bimetallic ratio could start all over again.

It should be clear that whenever a change in the standard unit of value is proposed, some people stand to gain (namely those net long in the metal to be overvalued, or net short in the metal to be undervalued by the impending change), while others stand to lose (namely those net long in the metal to be undervalued, or net short in the metal to be overvalued). Since the general public is always long in the metal to be undervalued, it is always on the losing side. A minority of insiders with advance knowledge of the timing and extent of the devaluation stands to gain from it at the expense of the general public. Yet the game of dropping one shoe after the other, only to repeat the trick afterwards, was wearing one shoe thin faster than the other. The alternating standard resulted in a progressive depreciation of silver in terms of gold.

In antiquity the gold/silver ratio was about 10. Five hundred years ago, at the time of the discovery of America by Columbus, the ratio was still only 11. The decline in the value of silver continued during the next three hundred years. On April 2, 1792, the U.S. dollar was defined as 371.25 grains of fine silver or 24.75 grains of fine gold. This was bimetallism at the ratio of 15 at a time the market ratio was closer to 15, thus overvaluing silver and putting the dollar on a de facto silver standard. On June 28, 1834, the U.S. Congress increased the official bimetallic ratio from 15 to 16.

This new ratio was higher than the market ratio, overvaluing gold and putting the dollar on a de facto gold standard. By 1870 the accelerating decline in the value of silver threatened the U.S. Mints with a deluge of the silky metal. To meet this threat Congress in the Coinage Act of 1873 dropped the standard silver dollar from the list of coins that could be minted freely on private account. Thereafter, silver was to be coined at the pleasure of the government. This would have put the dollar on a de jure gold standard, had the U.S. Mints been open to gold. But they were not. In 1873 the U.S. government still maintained a regime of irredeemable paper currency, the greenbacks — a legacy of the Civil War. This fact explains why the 1873 demonetization of silver went unnoticed by the general public, including the powerful silver lobby.

The fall in the value of silver continued to accelerate as the gold/silver ratio rose from 16 to 19 by Resumption Day in January 1879, when the U.S. government reopened the Mint to gold, and resumed gold convertibility of the greenback. Thereafter the value of silver was falling precipitously, the gold/silver ratio almost reaching 40 by the turn of the century. The silver lobby woke up and started crying `bloody murder', bitterly denouncing `the crime of 1873'. During the 1896 Presidential election campaign the Democratic candidate, William Jennings Bryan, in his famous `cross of gold' speech on the stump, pledged to return the country to a bimetallic monetary standard. He failed to understand, as did most other observers, that demonetization was the effect rather than the cause of the collapse in silver's value.

With the demise of bimetallism in the 1870's the ability of the government to benefit a minority at the expense of the majority was greatly curtailed — albeit not for long. Hijacking gold on its way from the mines to the mints by the central banks opened up new possibilities for credit manipulation, making it easy for governments to defraud the unsuspecting majority in favor of a minority.

In our days the deception that governments can create value and wealth out of thin air, through a judicious monetization of their own credit, is an article of faith at virtually all chanceries and universities. The opposing view, represented by this essay, that credit manipulation cannot create but can indeed destroy capital, and so it cannot lead to prosperity but can ultimately pauperize the entire society through credit collapse, as it did during the Great Depression, appears to be but "a lonely cry in the wilderness" (Isaiah, xl: 3).

A short course on demonetization Quantity theorists widely predicted that the demonetization of gold would seriously undermine gold's exchange value. (A representative of this view is the first quotation from Mises on p 3 above.) They argued that the removal of the lion's share of the demand could not help but make gold cheaper. As a reinforcement of this argument, quantity theorists were fond of recalling the episode of silver demonetization in the last century. They claimed that demonetization had caused the prolonged decline in the price of silver that has been continuing ever since.

It is not known whether these views had any influence on the thinking of the decisionmakers who `demonetized' gold in 1971. Be that as it may, the idea that dishonoring promises to pay gold would somehow cause the dishonored paper to go to a premium in gold is preposterous. It is true that insolvent bankers have in the past often tried to promote their discredited paper (sometimes using such extreme measures as the threat of the death penalty, as did John Law of Lauriston in France) — to no avail. Logic and history prove that dishonored promises to pay always and everywhere go to a discount -never to a premium. Indeed, this is exactly what happened after gold was `demonetized' word-wide in 1971.

In less than a decade the U.S. dollar went to a 90 per cent discount in terms of gold. The discount is fully commensurate with the 90 per cent loss in purchasing power that the dollar has suffered during the same period. Even though the discount on the dollar fluctuates, the hope that it would ever disappear is a forlorn one. The disarray in the nation's budgetary and trade accounts suggest that currency depreciation is likely to continue, if not to accelerate. The only way to stop the rot would be to adopt a credible plan to resume gold redeemability of the dollar — but no party has so far mustered the political courage to propose it.

The comparison between the demonetization of silver in 1873 and the so-called demonetization of gold a century later is disingenuous. In fact, the use of the word `demonetization' in connection with the latter is quite inappropriate: it is but a euphemism for debt-abatement or partial debt-repudiation inflicted upon the foreign creditors of the United States of America. In 1971 these creditors were deprived of a valuable property right to a fixed amount of gold, or to the dollar equivalent thereof.

This unilateral and capricious act has done nothing to benefit the citizens or the government of the U.S. On the contrary, the debt abatement had one predictable consequence: harsher terms on future borrowings, as measured by the higher and unpredictable rate of interest at which the government and the people of the U.S. can borrow at home and abroad.

It is true that the burden of the debtors who had contracted debt prior to the abatement was lightened. But insofar as they were the same people and the same government on whom the burden of the harsher terms on further borrowings fell for the indefinite future, there were no beneficiaries — only losers. In particular, the big loser was the American taxpayer. The international credit of the United States government, which had been the envy of the world for over a century, was grievously damaged — as manifested by the unprecedented interest rates the Treasury was forced to pay upon its obligations after the debt abatement.

The stubborn insistence the credit of the U.S. has not been damaged in the demonetization exercise of 1971 is the centerpiece of mainstream economic orthodoxy. Yet this is a world of crime and punishment and no one, not even the government of the mightiest nation on earth can exempt itself from the consequences, which are numerous. America's industry has lost its international competitiveness. Due to the high rates of interest a large segment of America's park of capital goods has become submarginal, as producers were either unwilling or unable to maintain it or to replace it by more up-todate equipment.

As capital became submarginal, so did the producers using it. They were forced to sell their businesses at a loss, and to invest the remnants of their former wealth in high-yield Treasury bonds. This is a textbook-case showing that a government can only harm itself by harming its own taxpayers. Printing high coupon-rates on its bonds the U.S. government turned former producers of wealth into coupon-clippers. The world is witnessing the progressive de-industrialization of America, as a large segment of the producers find themselves unable to compete with those capricious coupon-rates the government high-handedly prints on its bonds. At the same time, the main competitors of American industry in Japan and Germany are the beneficiaries of a low interest-rate structure, made possible by those countries' more stable currencies.

While the so-called demonetization of gold was a farce staged by the U.S. government in order to cover up its own insolvency, the demonetization of silver a hundred years earlier was a genuine market-phenomenon. Government action in demonetizing silver amounted to little more than a belated acknowledgement of a fait accompli.

There was no dishonoring of promises to pay. There was no deterioration in the public credit, no destruction of private capital. On the contrary, by virtue of its cooperating with market forces, the government greatly enhanced its credit. The United States was well on its way to become the world's greatest creditor nation. One hundred years later the government, in demonetizing gold, was moving against market forces, and the credit of the U.S. government suffered its greatest setback in the history of the nation. The deterioration of the credit of the United States still continues, with unforeseeable consequences. This is not generally acknowledged by financial writers at home and abroad. But one palpable and indisputable consequence of the `demonetization' of gold was that, in a few short years, the U.S. has turned itself from the world's greatest creditor into the world's greatest debtor nation. The United States was forced to borrow enormous sums abroad at exorbitant rates of interest. The gross mismanagement of credit has created enormous problems for which there are no painless solutions.

The dual nature of money

The evolution of a dual monetary standard involving both silver and gold was no accident. In every treatise on money, in one form or another the proposition is advanced that money (whatever else it may be) is a transmitter of value through space and time. Thus the concept of money is directly linked to these two absolute categories of human thought. The space/time dichotomy explains the dualistic nature of money — explicitly observable throughout the ages, right up to the demise of bimetallism.

In its first capacity money must be able to transfer value through space, over great distances, with the smallest possible loss. In antiquity, cattle were especially suitable for this purpose, and became money. In its second capacity money must be able to transfer value through time with the smallest possible loss. Cattle-money was scarcely suitable for this second task.

This explains the emergence of another kind of money, suitable for hoarding and dishoarding with the greatest ease, in order to facilitate the transfer of value over time. Originally this other kind of money was salt. Not only was it less perishable than other marketable goods, but salt was also the most important agent of food preservation. As the threat of periodic food shortages loomed large in antiquity, the agent of food preservation was destined to have a monetary role.

To people of the antique world it appeared natural that two vastly different commodities answered their money-needs, and they took the coexistence of cattle-money and saltmoney for granted. Our linguistic heritage clearly reflects this fact. The English adjective pecuniary and noun salary were derived from the Latin words pecus (cattle) and sal (salt). Even though gold and silver which later replaced cattle and salt were far more similar to one another, the dual nature of money persisted throughout the ages. Only towards the end of the 19th century did advances in metallurgy make it possible that one monetary metal, gold, could answer both money-needs of man better than any other commodity. This was the development that made it possible to produce or recover gold in molar quantities economically. The practical outcome was the recognition that the best monetary system was gold monometallism.

As Bruno Moll put it in his book La Moneda, "gold is that form of possession which is of the highest elevation above time and space". The dualism of monetary systems is the central theme of this essay, as we explore the two sources of man's need for money. The first, man's need to transfer value over space, was used by Carl Menger to build his theory of value on it. The second, man's need to transfer value over time (or as we shall more specifically describe it, man's need to convert income into wealth and wealth into income) is used here to build a new theory of interest on it.

The Janus-face of marketability In developing his theory of value, Menger described the origin of money in terms of the evolution marketability. But as the ancient Italian god Janus (in whose honor the first month of the year is named) marketability has two faces. The first is marketability in the small — or hoardability. The second is marketability in the large — or salability. The latter is synonymous with Menger's term Absatzfähigkeit, the cornerstone of his theory of value. Hoardability has not been independently analyzed before. In isolating this concept I propose to lay a new cornerstone for the theory of interest.

A commodity is more marketable in the large (or more salable) than another if the bid/asked spread increases more slowly for the former than for the latter, as each is brought to the market in ever larger quantities. For example, perishable or seasonal goods show the lowest, durable goods or goods for all seasons show the highest degree of salability. It is easy to see how cattle became the most salable commodity in antiquity. People had superb confidence that there could never develop a situation in which there was a disturbing surplus of cattle.

Long before anything like that could happen, owners would drive their herds to regions where there was a shortage of cattle. The cost of transporting the unit of value represented by cattle over great distances was lower than that of transporting the same value represented by anything else, due to the self-mobility of cattle. This fact, too, is preserved in our linguistic heritage. A herd is also known as a drove of cattle, and a herdsman as a drover (both are derived from the verb to drive). Thus mobility or, better still, portability is an important aspect of salability. The more portable a commodity is, the more easily it can seek out havens where it is in greater demand.

The term salability refers to the quality of a good which allows very large quantities of it to be sold during the shortest period of time with minimal losses — which explains how the term earns its name. Among the most salable goods we find the precious stones and metals. A long historical process promoted gold to become the most salable of all goods. For gold, the spread between the asked and bid prices is virtually independent of the quantity for which it is quoted. It only depends on the cost of shipping gold to the nearest gold center. Under the gold standard the spread is constant, and is equal to the difference between the gold points. By contrast, for all other goods, different spreads are quoted for different quantities, and the larger the quantity, the wider the spread. Thus the gold standard is seen as the product of a market process in search for the most salable commodity. Some authors deliberately confuse the issue insisting that the constant spread of gold is due to institutional factors, i.e., the statutory requirement that the central bank should stand ready to buy at the lower, and to sell at the upper gold point unlimited quantities of gold. Once again, this is a confusion of cause and effect. In reality, institutional constraints would sooner or later break down, and the commodity with less than perfect salability would be demonetized by the market, if the authorities tried to promote it to be the monetary standard — as indeed happened to silver in the 19th century, to copper in medieval times, and to iron in antiquity.

It is common knowledge that, although they have a high degree of marketability in the large, precious stones have poor marketability in the small. The process of cutting up a large stone into a number of smaller pieces often results in a permanent loss of value. (This is just another illustration of the paradox that the value of a parcel is not necessarily the same as the sum total of the values forming part of that parcel.) Even for precious metals whose subdivision into smaller parts is fully reversible, marketability in the small cannot be taken for granted. A penetrating example due to a 19th century traveller is cited by Menger in the Grundsätze:

When a person goes to the market in Burma, he must take along a piece of silver, a hammer, a chisel, a balance, and the necessary weights. `How much are those pots?' he asks. `Show me your money', answers the merchant and after inspecting it, he quotes a price at this or that weight. The buyer then asks the merchant for a small anvil and belabors his piece of silver with his hammer until he thinks he has found the correct weight. Then he weighs it on his own balance, since that of the merchant is not to be trusted, and adds or takes away silver until the weight is right. Of course, a good deal of silver is lost in the process as chips fall to the ground. Therefore the buyer prefers not to buy the exact quantity he desires, but one equivalent to the piece of silver he has just broken off. (Principles of Economics, op. cit., p281.)

A commodity is more marketable in the small (or more hoardable) than another if the bid/asked spread increases more slowly for the former than for the latter, as each is brought to the market in ever smaller quantity. The term `hoardability' refers to the quality of goods which allows large stores to be built up piecemeal through hoarding, or to be drawn down through dishoarding, with minimal exchange losses. It is this property that matters most when individuals are trying to convert income into wealth, or wealth into income. They succeed best if they employ the most hoardable commodity. It is easy to see how salt became the most hoardable commodity in antiquity. People were confident that exorbitant surpluses of hoardable foodstuff would never develop. Everybody who could afford it would hoard it. People would recall the Biblical teaching that the seven fat years would always be followed by seven lean ones.

For the stronger reason, people were supremely confident that their hoards of salt — this foremost agent of food preservation — would not lose its value, whatever the fortune may hold in store. In antiquity it was not possible to transfer value over time with smaller losses than those involved in hoarding salt.

Other examples of commodities that have been highly hoardable at one time or another throughout history are: grains, tobacco, sugar, spirits. It is interesting to note that there has been heavy government involvement in the production and trade of all these. Thus we see that an historical process, similar to the one making gold most salable, has promoted silver to become most hoardable. Gold was the money used for paying princely ransoms and for buying territories (such as Louisiana and Alaska), and silver was the money used by people of small means for accumulating capital (Maundy money).

Why bimetallism failed As long as the necessary technology was lacking, gold could not challenge silver's position as the most hoardable commodity. The cost of producing or recovering a small fraction of the unit of value represented by gold could involve expensive molar processes. The recovery of the same small fraction of the unit of value represented by silver incurred no such extra cost as the amounts involved were not molar, thanks to the lower specific value of silver. However, by the second half of the 19th century, with the progress of metallurgy, the cost of molar processes was lowered and commercial dealings in gold on the molar scale became economically feasible. Thereafter gold could effectively challenge and ultimately displace silver as the most hoardable commodity. The demonetization of silver by the market was a logical consequence.

To see clearly why it was gold, and not silver, that was destined to win the race for hegemony we have to consider the specific values of the monetary metals, and their relation to the spreads between the export/import points. Gold has a high and silver a low specific value, implying that the unit of value as represented by gold is lighter than the same as represented by silver (in fact, 15 times lighter if we assume that the gold/silver bimetallic ratio is 15).

We have seen that the gold export (import) point is the melted value of the standard coin above (below) which it becomes profitable to export (import) gold. The meaning of the silver export (import) point is analogous. Clearly, the spread between the gold export/import points depends on the cost of shipping the unit of value as represented by gold to the nearest gold center abroad. The same is true, mutatis mutandis, for the spread between the silver export/import points. But shipping costs depend on the weight of the shipment. As the weight of the unit of value as represented by gold is relatively small, the spread between the gold export/import points will be relatively small. (It was approximately 1 percent of value between New York and London in the heyday of bimetallism, while the spread between the silver export/import points was 15 percent of value.)

For example, assume that the statutory gold price is \$20 per Troy ounce, and the upper and lower gold points are at \$20.20 and \$19.80, respectively. Assuming further that the official bimetallic ratio is 15, the statutory silver price will be approximately \$1.33 per Troy ounce (20 divided by 15). Let us calculate the gold and silver export/import spreads. The cost of shipping the unit of value, \$1, as represented by gold is 1 cent (because the cost of shipping 1 ounce of gold is \$20 — \$19.80 = twenty cents; this we have to divide by 20 as the standard gold dollar weighs 1/20 of one ounce).

The melted value of the standard gold dollar may therefore fluctuate between 99 cents and \$1.01 before it will induce a corrective movement of gold. The gold export/import spread is 2 cents. But the same unit of value, \$1, as represented by silver, is 15 times heavier, so the cost of its shipping will be 15 cents, or 15 times the cost of shipping the standard gold dollar. The melted value of the standard silver dollar may therefore fluctuate between 85 cents and \$1.15 before it will induce a corrective movement of silver. It follows that the silver export/import spread is 30 cents, or 15 times wider than the gold spread. We see that under bimetallism the export/import spread for the monetary metal of the higher specific value is narrower by a factor equal to the bimetallic ratio. It is certainly true that under a monometallic monetary regime most large transactions will not involve shipment of the metal as long as the price of gold stays within the range between the gold points. Clearing is effected through the exchange of warehouse receipts. However, the case under bimetallism is different. Here the arbitrageur profits by actually shipping the undervalued metal out of, and the overvalued metal into, the country maintaining a rigid bimetallic ratio.

What this shows is that silver is inferior to gold as a standard of value. Those who park their wealth in silver stand to lose 15 times more than those who use gold for that purpose, due to variations in the market ratio between the silver and gold prices. The upshot is that people will gradually move out of silver and into gold. In due course the market will demonetize the metal with the lower specific value, in this case, silver. Gold monometallism was no accident: it was brought about by inexorable market forces. For the first time ever in human history one commodity, gold, became the undisputed monetary metal, combining the characteristics of the most salable and the most hoardable assets.

### Mene Tekel

But the distinctive property of gold, that it is the only remaining monetary metal around in the closing decade of the 20th century, should not blot out entirely the dualistic nature of money. In fact, it is monetary dualism that provides the only rational explanation for the occasional breakdown of the monetary system. During periods of great monetary disturbance, such as a hyperinflation, the distinction between the two kinds of marketability is most dramatically revived by the market.

For shorter or longer periods, the government may succeed in forcing the circulation of irredeemable bank notes, which may retain the characteristics of the most salable asset. Yet, at the same time, the government is patently unable to make these credit instruments the most hoardable asset. Although the fast-depreciating bank note is still usable in transmitting value through space, it suffers from a fatal paralysis when trying to transmit value through time. It is inevitable that, ultimately, gold should assert its position as the most hoardable asset. Nor is there anything governments can do to save their irredeemable paper from monetary destruction. Even if they succeed in banning the ownership of and trading in gold, a number of other commodities stand ready to step into the golden slippers to assume the role of the most hoardable asset.

The most conspicuous defect of the quantity theory of money is its utter failure in explaining the hyperinflationary episodes of history. Over-issue of the fiat currency certainly cannot be the cause of the malady. It has been convincingly demonstrated that (especially in the final phases) there was always a desperate shortage of the doomed currency. Hyperinflation has nothing to do with quantity it has everything to do with quality of money. The true cause of hyperinflation is the inexorable human need for a most hoardable asset. It is the relentless search for a reliable transmitter of value through time. Those who believe that the millennium of irredeemable currency has arrived must believe that governments have found a way to change human nature by legislative fiat. Under the regime of irredeemable currency hyperinflation is inevitable — unless gold is once more allowed to play its historical role that has been taken away from it through government coercion: the role of the most hoardable asset. The full implications of the inevitability of a breakdown in the regime of irredeemable currency are not yet clear to most people. Purveyors of goods and services are still willing to give up real value in exchange for irredeemable promises. This ignorance may, of course, help postpone the moment of truth. In the meantime, Lincoln's dictum should be remembered, according to which it may be possible to fool some people all the time, even to fool all the people some of the time; but it is not possible to fool all the people all of the time. Certain monetary economists can see the writing on the wall mene tekel: your days are numbered — you have been weighed in the balance and found wanting (Daniel v:26-28)

announcing the verdict on the regime of irredeemable currencies. They propose a solution that would `tie' the value of the currency to that of a basket of commodities. Some go as far as suggesting that — horrible dictu — even gold may be put into the basket. There is nothing new in these proposals. F.A. Hayek suggested it in 1943 in a paper entitled Commodity Reserve Currency. It is extremely doubtful that Hayek's scheme would work. Let us disregard the utter naivete of the scheme in ignoring the cost of warehousing perishable goods, and ignoring the problem of quality-control. Let us consider the scheme in its simplest form known as symmetalism (originally proposed by the British economist Alfred Marshall a hundred years ago, but never tried in practice) whose unit of value is a basket consisting of a fixed amount of gold and a fixed amount of silver. Unlike bimetallism, this arrangement would let the prices of the monetary metals vary. We now show that symmetalism, no less than bimetallism (which Milton Friedman called preferable to gold monometallism in his book Money Mischief) would be shipwrecked on the rock of gold's constant marginal utility. The market would stamp out symmetalism even faster than bimetallism, precisely because of the price flexibility the former affords. The gold/silver ratio would widen further for reasons already discussed. The profit opportunities offered by symmetalism would result in a relentless arbitrage out of silver and into gold. The arbitrageur would redeem his currency in gold and silver; then he would sell the silver and keep the gold. When the anticipated rise in the price of gold materialized, he would buy back his silver for less, and unwind his arbitrage by surrendering the same amount of gold and silver in exchange for symmetallic currency, showing a net profit in gold.

Let us note in passing that the scheme concocted at Maastricht (introducing yet another irredeemable monetary unit, the Euro, defined as a basket of irredeemable currencies) is doomed for the same reason. The currency that depreciates at the lowest rate, in this case the German mark, far from imparting strength to other currencies in the basket, would make them even weaker. Arbitrage would act as a centrifuge, separating the components of the basket, throwing away the soft and keeping only the hardest of hard currencies. (If marks, liras, etc. were no longer available for trading, then the object of arbitrage would be the central bank assets that had been used to balance liabilities in marks, liras, etc.) The authors of the Maastricht scheme turned the ancient wisdom — that no chain can be stronger than its weakest link — upside down. They have invented a chain that is as strong as its strongest link.

## 2. Towards a New Theory of Interest

The nature of interest is one of the great problems of humankind, as old as money itself. It has engaged the greatest minds, from Aristotle through the church fathers to Menger. The lack of a satisfactory solution to the problem has rocked empires, contributing to their destruction. This author hopes that his essay can make a modest contribution to the ultimate disposal of this great and vexed problem.

Part of the difficulty is in the way the question has traditionally been presented, namely: what happens when a man with a need to borrow meets another with money to lend? It has always been in this context that usury was condemned by both criminal and canon law. It has not occurred to the philosophers and moralists — or, for that matter, to most economists — that the nature of interest could be better grasped if the question was reformulated thus: what happens when a man with income to spare but who is in need of wealth meets another with wealth to spare but who is in need of an income? The resulting exchanges provide a passage from direct to indirect conversion of wealth and income. Indirect conversion represents a great improvement in efficiency over direct conversion, interest being the manifestation of the market value of this improvement. Thus the proper setting for the study of interest is the indirect conversion of income into wealth (just as the proper setting for the study of price is the indirect exchange of goods). It now appears that condemnation of usury is akin to condemning a man for charging or paying the going price for bread.

Traditionally, interest is conceived as a steady income in perpetuity which is exchanged for the unit of wealth. It can be measured as a percentage of the unit of wealth accruing as income to its owner after the exchange. If the unit of wealth is one gold dollar, and it is exchanged for an income in perpetuity amounting to one gold cent per quarter, then the rate of interest is four percent per annum. Of course, an income in perpetuity is an abstraction, but it has great theoretical importance as the standard measuring interest. The mathematician has shown us exact formulas expressing the rate of interest involved in exchanges of wealth for income for a set period of time, as well as formulas expressing the rate of interest involved in exchanging present for future wealth, in terms of this standard — making arbitrage between various credit markets possible.

I shall not pause here to give an iron-clad definition between "wealth" and "income'. Suffice it to say that an inexorable need exists, second only to the need for food and shelter, urging man to convert income into wealth in order that later, when past his prime, he may convert his wealth back into income. As the comedy of King Midas and the tragedy of King Lear show, a most important difference exits between controlling wealth and controlling income, and the possibility of converting one into the other must not be taken for granted. Income is an ultimate end for man, insofar as without it he may have no other ultimate ends on earth. (If denied an income he, as King Midas, is in danger of starving to death.) Since wealth is an indispensable means to that end in the twilight years of his life, man's need for a reliable conversion mechanism is beyond doubt. (Without such he may, as King Lear, end up losing both his wealth and income.)

The theory of private property ought to take full account of the fact that conversion of income into wealth is the rational and characteristically human manifestation of the law of the biosphere whereby all living things can only survive and prosper by hoarding their substance. In the case of man this substance, as we have seen, is the most marketable commodity, gold, which is always in demand, whether it is offered in the largest or in the smallest practically realizable quantity — since it can always be traded with the smallest possible exchange losses.

The chimaera of hoarding Here we come to a paradox which utilitarian philosophy has failed to solve. An apparent contradiction exists between the needs of the individual and his society. There is a time in the life of every man when he wishes to draw on his savings accumulated earlier. Yet hoarding and dishoarding are widely considered as anti-social. They are unsettling as the former affects demand and the latter affects supply unfavorably, possibly at a time that is inopportune from the point of view of society. The utilitarian philosophers could not clarify how the market provides for the conflicting demands of society and its ageing members. Utilitarian philosophy has failed to solve the problem of hoarding and dishoarding.

In particular, it has failed to explode the arguments of Silvio Gesell, John Maynard Keynes and other inflationists, according to which the contractionist and deflationary pressures inherent in a metallic monetary system are the source of poverty and chronic economic distress, as they invite hoarding. At the same time these authors described the promised land of the inflationist paradise in glowing terms. There, the miracle of "turning the stone into bread" would be routinely performed by monetary technicians in the service of the government for the benefit of the people. In what follows I refute the inflationist argument in the spirit of utilitarian philosophy, hoping to remove an obstacle which has blocked the advancement of monetary science for a hundred years. The invention of double-entry book-keeping in Italy of the Trecento was a momentous landmark in economic history. Göthe called it "one of the finest inventions of the human mind" (Wilhelm Meister's Apprenticeship). Double-entry book-keeping is of utmost economic importance, second only to the appearance of indirect exchange much earlier that had made direct exchange of goods obsolete. The new invention made the indirect accumulation of capital via the instrument of contract possible, thus making the direct accumulation of capital via hoarding obsolete. Previously, there was only one way for people to convert income into wealth or wealth into income outside of family bonds: hoarding and dishoarding. (For much of the Orient, which was slower in developing the institutional framework to protect contractual rights, it is still the only way.) This immobilized large amounts of gold, and made capital accumulation an arduous and protracted process in which reward was far removed from effort, dampening incentive. The invention of double-entry book-keeping made possible a heretofore unprecedented increase in the efficiency of gold as the catalyst of capital accumulation. Gold's physical presence was no longer necessary in every conversion. From then on gold could act by proxy, as its role in the conversion has become residual.

Thanks to this breakthrough, partnerships could now be formed representing an exchange of income (of the junior partner) for wealth (of the senior partner). Later, with the gradual acceptance of `sleeping' partners in the firm, it became possible to buy and sell shares in the enterprise as if they were fixed-income securities. Indeed, this they were in all but name, in order to avoid censure by canonical and secular authorities under the usury laws. It is clear that without double-entry book-keeping, balance sheets and income statements, trade in shares would not have been possible, nor could a departing partner have been bought out. There would have been no precise and objective way of attaching value to the assets and liabilities of the firm short of liquidation.

The new development released huge amounts of gold from private hoards as people began to accumulate and carry wealth in the form of securities disguised as partnership equity. (By contrast, in the Orient, where the social and institutional arrangements were far more inimical to the individual and his freedom to choose, the demand for gold and silver for hoarding purposes continued unabated.) During the Quattrocento gold disgorged by the Occident flowed to the Orient to finance the trade in exotic goods. Myrrh, spices, silk and satin enjoyed exceptionally high marketability in the Occident where all the great banking houses engaged in financing this lucrative trade. The world was treated to the curious spectacle that the Occident was thriving while losing gold to the Orient, because it had learned how to get by with less. It had learned to exchange wealth and income.

This shows that gold is merely the whipping boy at the hand of the inflationists. Gold is not scarce (in fact, as measured by the stocks-to-flows ratio mentioned above, the monetary metal is more abundant than any other economic good) but it quickly goes into hiding at the moment inflationists gain the upper hand. There is no contradiction between the interests of society and its ageing members. Very little if any gold is needed to complete all the exchanges of income and wealth in the course of normal business, provided that the free choice of individuals is allowed to prevail. Only when government interference is feared or expected does the demand for gold become disturbing. The correct policy is `hands off' — let the market decide what is best for its participants.

### Squaring the diagonal

The next advance came with the Reformation, during which the canonical and secular strictures on interest were eased, the definition of usury narrowed and, later, the prohibition against both repealed. Whereas the partnership contract had originally been designed with the concealment of interest in mind, then it became possible, for the first time in history, to openly engage in the exchange of income and wealth, with the payment of interest freely admitted, and the rate of interest explicitly quoted. The bond market was born as a result of these historical changes. The right to income reserved by the bondholder could now enjoy the same legal protection as the right to rent-charges enjoyed during the prohibition era. Thus, it remained for the Reformation to crown the great economic advances of the Renaissance, to free the exchange of income and wealth from its former fetters. For the first time in history, the rate of interest could manifest itself as a market phenomenon.

The analysis of the formation of interest rates is usually given in terms of a diagonal model featuring just two participants in the market: the supplier and the user of `loanable funds'. This model is woefully inadequate, as it blots out the time element and the crucial process of capital formation, it ignores the principle of capitalizing income, and it confuses saving and investment. The present analysis will replace the diagonal model first with a square, then a pentagonal and, finally, with a hexagonal model, in order to gain a more penetrating insight into the process of capital formation. First we take a look at the square model which has the merit of identifying the supply of and demand for wealth and income.

In considering the problem of converting income into wealth and wealth into income, we may isolate two fundamental needs: (1) the annuitand's need to convert income into future wealth; and (2) the annuitant's need to convert wealth into income. Typically, the annuitand is a young man who is looking forward to getting married. He tries to provide for the future needs of his family: for the education of his children, and for his and his wife's old age. By contrast, the annuitant is a man in his harvest years, looking forward to his twilight years with equanimity.

He has by now accumulated the wealth which he is ready to convert into a suitable income. If the annuitand (or the annuitant) is restricted to direct conversion, due to institutional restraints on the exchange of income for wealth (or wealth for income) then the optimum conversion is provided by gold hoarding (dishoarding). By definition of marketability in the small, no further improvement in efficiency is possible. However, if the institutional constraints on exchange are removed, then a whole new game comes into play and, indeed, further improvements become possible, for the benefit of all participants.

On the one hand, the annuitant's need is answered directly by the entrepreneur who is anxious to give up income in exchange for present wealth. The latter could profitably invest the former's wealth in his business which would then generate a greater income that he could afford to share. On the other hand, the annuitand's need is answered directly by the inventor ready to give up future wealth in exchange for an income. The latter is working on a new production process that may take several years to perfect before it can be put into place. In the meantime he has to maintain himself and has to defray the cost of his research and development (R&D).

The new tool or process the inventor is perfecting represents future wealth which he is willing to share with his partner, the annuitand, who puts the necessary income at his disposal in the interim. Both the entrepreneur and the inventor are engaged in the business of capital formation; the difference is seen in the method of amortization. The capital formed by the entrepreneur is scheduled to begin its amortization cycle immediately. There is a more-or-less prolonged waiting period before the capital formed by the inventor can start its amortization cycle.

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 Shylocksyndrome 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-interestbearing 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 longterm 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 lossmakers. 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 goldbonded. 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 goldbonded 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.

=========================
Scholarly Economics
=========================
# Is Our Accounting System Flawed?

URL: https://newaustrianeconomics.com/archive/fekete/is-our-accounting-system-flawed/
Date: 2008-05-20
Section: Scholarly Economics
Difficulty: scholarly
Concept Tags: capital-destruction, interest-theory, bond-market, fiat-currency
Description: Fekete argues that conventional double-entry bookkeeping is blind to the destruction of capital caused by falling interest rates. When bond prices rise, unrealized capital gains mask the erosion of productive capacity, making the accounting system an instrument of self-deception for firms, banks, and governments.
Editorial Note: A scholarly critique of accounting conventions delivered in the context of the 2008 financial crisis, showing how standard bookkeeping conceals the Fed-induced capital destruction Fekete had been warning about for years.
Original PDF: https://professorfekete.com/articles/AEFIsOurAccountingSystemFlawed.pdf

## Is Our Accounting System Flawed?

### It may be insensitive to capital destruction

### Antal E. Fekete

### Gold Standard University aefekete@hotmail.com

The accounting principle, the Law of Liabilities, asserts that a firm must carry its liabilities in the balance sheet at its value upon maturity, or at liquidation value, whichever is higher. This Law is universally ignored by present accounting standards, which threatens the economy with massive deflation through the destruction of capital, in view of the persistent fall of interest rates for the past 25 years, as it keeps increasing the liquidation value of debt.

### The Book-Keeper’s Dilemma

One of the plays of George Bernard Shaw branded “unpleasant” by the playwright himself is entitled The Doctor’s Dilemma. The protagonist is a physician who comes into conflict with the Oath of Hippocrates (fl. 460-377 B.C.) He has developed a new treatment for a fatal disease, but the number of volunteers for the test-run exceeds the number of beds in his clinic.

Unwittingly, the doctor finds himself in the role of playing God as he decides who shall live and who shall die.

By the same token Shaw could have written another “most unpleasant” play entitled

The Book-Keeper’s Dilemma. The protagonist, a chartered accountant, finds himself in conflict with the letter and spirit of book-keeping set out by Luca Pacioli (fl. 1450-1509). As a result of compromising the high standards of the accounting profession, the book-keeper becomes the destroyer of Western Civilization.

### Finest Product of the Human Brain

Luca Pacioli taught mathematics at all the well-known universities of Quattrocento Italy including that of Perugia, Napoli, Milan, Florence, Rome, and Venice. In 1494 he published his Summa Arithmetica, Tractatus 11 of which is a textbook on book-keeping. The author shows that the assets and liabilities of a firm do balance out at all times, provided that we introduce a new item in the liability column that has been variously called by subsequent authors “net worth”, “goodwill”, and “capital”. This innovation makes it easy to check the ledger for accuracy by finding that, at the close of every business day, assets minus liabilities is equal to zero. If not, there must be a mistake in the calculation.

But what Pacioli discovered was something far more significant than a method of finding errors in the arithmetic. It was the invention of what we today call double-entry book1 keeping, and what Göthe called “the finest product of the human brain” (Wilhelm Meister’s Apprenticeship.)

Why was this discovery so important in the history of Western Civilization? Because, for the first time ever, it was now possible to calculate and monitor shareholder equity with precision. This is indispensable in starting and running a joint-stock company. Without it new shareholders could not get aboard, and old ones could not disembark safely. There would be no stock markets. The national economy would be a conglomeration of cottage industries, unable to undertake any large-scale project such as the construction of a transcontinental railroad, or the launching of an intercontinental shipping line.

The invention of the balance sheet did to the art of management what the invention of the compass did to the art of navigation. Seafarers no longer had to rely on clear skies in order to keep the right direction. The compass made it possible to sail under cloudy skies with equal confidence. Likewise, managers no longer have to depend on risk-free opportunities to keep their enterprise profitable. The balance sheet tells them which risks they may take and which ones they must avoid. It is no exaggeration to say that the present industrial might of Western Civilization rests upon the corner-stone of double-entry book-keeping. Oriental (Chinese) and Middle-Eastern (Arab) civilizations would have outstripped ours if they had chanced upon the discovery of the balance sheet first. By the same token, the continuing leadership of the West depends on keeping accounting standards high and isolated from political influences.

### Barbarous Relic or Accounting Tool?

There is cause for concern in this regard. For the past 75 years the West has been fed the propaganda line, attributed to John Maynard Keynes, that the gold standard is a “barbarous relic”, ripe to be discarded. The unpleasant truth, one that propagandists have ‘forgotten’ to consider, is that the gold standard is merely a proxy for sound accounting and, yes, for sound moral principles. It is an early warning system to indicate erosion of capital. It was not the gold standard per se that politicians and adventurers wanted to overthrow. They wanted to get rid of certain accounting and moral principles, especially as they apply to banking, that had become an intolerable fetter upon their ambition for aggrandizement and perpetuation of power. Historically, accounting and moral principles had been singled out for discard before the gold standard was given the coup de grâce.

The attack on accounting standards and on the gold standard was heralded by the establishment in 1913 of the Federal Reserve System (the Fed) in the United States, the chief engine of monetizing government debt. Just how the monetization of government bonds has led to a hitherto unprecedented, even unthinkable, corruption of accounting standards ― this is a question that has never been addressed by impartial scholarship before.

### Bonds and the Wealth of the Nation

In order to see the connection we must recall that any durable change of interest rates has a direct and immediate effect on the value of financial assets. Rising interest rates make the value of bonds fall, and falling rates make it rise. As a result of this inverse relationship the Wealth of the Nation flows and ebbs together with the variation of the rate of interest.

Benefits and penalties are distributed capriciously and indiscriminately, without regard to merit.

This was hardly disturbing under the gold standard, as the rate of interest was remarkably stable and the corresponding changes in the Wealth of the Nation were negligible.

A lasting increase in the rate of interest could only occur in the wake of a national disaster such as an earthquake, flood, or war. In all these cases a higher rate of interest was beneficial.

It had the effect of spreading the loss of wealth due to the destruction of property more widely, easing the burden on individuals. Those segments of society that were lucky enough to escape physical destruction had to share in the loss through the increased cost of servicing capital due to higher interest rates. Everyone was prompted to work and save harder in order that the damage might be repaired quickly and expeditiously. As the rate of interest gradually returned to its lower level, the Wealth of the Nation expanded. Once again, everybody shared equally, as the lower interest rate benefited all, through the reduction in the cost of servicing capital.

It is not widely recognized that the chief eminence of the gold standard is not to be found in stabilizing the price structure (which is neither desirable nor possible). It is to be found in stabilizing the interest-rate structure. By ruling out capricious and disturbing swings, the Wealth of the Nation is maximized.

The gold standard ruled supreme before World War I. It was put into jeopardy when general mobilization was ordered in 1914 by the manner in which belligerent governments set out to finance the war effort. Governments wanted to perpetuate the myth that the war was popular and there was no opposition to the senseless bloodshed and destruction of property that could have been avoided through better diplomacy. The option of financing the war through taxes was ruled out as it might make the war unpopular. The war was to be financed through credits. In more details, war bonds were sold in unprecedented amounts, subsequently monetized by the banking system. Naturally, these bonds could not possibly be sold without a substantial advance in the rate of interest. Accordingly, the Wealth of Nations shrank even before a single shot was fired or a single bomb dropped.

Under the gold standard bondholders are protected against a permanent rise in the rate of interest (which in the absence of protection would decimate bond values) by the provision of a sinking fund. In case of a fall in the value of the bond the sinking fund manager would enter the bond market and would keep buying the bond until it was once more quoted at par value. Every self-respecting firm issuing bonds would offer sinking-fund protection.

Even though governments did not offer it, it was understood and, in the case of Scandinavian governments explicitly stated, that the entire bonded debt of the government would be refinanced at the higher rate, should a permanent rise in the rate of interest occur.

Bondholders who have put their faith in the government would not be allowed to suffer losses. The banks, guardians of the people’s money, could regard government bonds as their most trusted earning asset. They were solid like the rock of Gibraltar. Such faith, at least in Scandinavian government obligations, was justified. The risk of a collapse in their value was removed. Governments, at least those in Scandinavia, occupied the moral high ground. The money they borrowed belonged, in part, to widows and orphans. They took to heart the admonition and did not want to bring upon themselves the Biblical curse pronounced on tormentors of widows and orphans.

### Law of Assets

However, there was a problem with war bonds issued by belligerent governments. They were quickly monetized by the banking system making the refinancing of bonded debt impossible.

This created a dilemma for the accounting profession. According to an old book-keeping rule going back to Luca Pacioli that we shall refer to here as the Law of Assets, an asset must be carried in the balance sheet at acquisition value, or at market value, whichever is lower. In a rising interest-rate environment the value of bonds and fixed-income obligations are falling, and this fall must be faithfully recorded in the balance sheet of the bondholder.

There are excellent reasons for this Law. In the first place it is designed to prevent credit abuse by the banks and other lending institutions. In the absence of this Law banks would overstate their assets that could be an invitation to credit abuses to the detriment of shareholders and depositors. If the abuse went on for a considerable period of time, then it could lead to the downfall of the bank. In an extreme case, when all banks disregarded the Law of Assets, the banking system could be operating on the strength of phantom capital, and the collapse of the national economy might be the ultimate result. For non-banking firms the danger of overstating asset values also exists, and can serve as an invitation to reckless financial adventures. Even if we assume that upright managers would always resist the temptation and stay away from dubious adventures, in the absence of the Law of Assets the balance sheet would be an unreliable compass to guide the firm through turbulence, materially increasing the chance of making an error. Managerial errors could compound and the result could again be bankruptcy.

Economists of a statist persuasion would argue that an exception to the Law of Assets could be safely made in case of government bonds. The government’s credit, like Caesar’s wife, is above suspicion. The government will never go bankrupt. Its ability to retire debt at maturity cannot be doubted. As a guarantee these economists point to the government’s power to tax. However, the problem is not with paying the nominal value of the bond at maturity, but with the purchasing power of the proceeds. Currency depreciation is a more subtle and, hence, more treacherous form of default. Governments, however powerful, cannot create something out of nothing any more than individuals can. They cannot give to Peter unless they have taken it from Paul first. Nor is the taxing power of governments absolute. Financial annals abound in cases where taxpayers have revolted against high or unreasonable taxes, sometimes overthrowing the government in the process. If the taxing power of governments had been absolute, then they could have financed World War I out of taxes. Bondholders would have suffered no loss of purchasing power as a result of debt-monetization, at least on the victors’ side.

It is true that governments as a rule do not go bankrupt, but this could be a disadvantage. Putting a value on bonds higher than what they would fetch in the market is a fool’s paradise. Governments could use methods, fair or foul, to stave off ill effects of their own profligacy. Awakening could be postponed, but it would be made that much ruder.

A strict application of the Law of Assets would have made most banks and financial institutions in the belligerent countries insolvent. The dilemma facing the accounting profession was this. If book-keepers insisted that the Law be enforced, they would be called “unpatriotic”, and be made a scapegoat held responsible for the weakening financial system.

Demagogues would charge that the accountants were undermining the war effort. On the other hand, if they allowed banks to carry government bonds in the asset column at acquisition rather than at the lower market value, then they would compromise the time-tested standards of accounting and expose the firm, and ultimately the national economy, to all the dangers that follows from this, not to mention the fact that they would also draw the credibility of the accounting profession into question.

### Illiquid or Insolvent?

The story of how the accounting profession solved the dilemma has never been told. It may be a safe assumption that the dilemma was solved for it by the belligerent governments in prohibiting the public disclosure of the banks’ true financial condition. In the meantime a new accounting code was created, far more lenient in adjudicating insolvency. The Law of Assets was thrown to the winds, and was replaced with a more relaxed one allowing the banks to carry government bonds at face value, regardless of true market value, as if they were a cash item. A new term was introduced to describe the financial condition of a bank with a hole in the balance sheet punctured by government bonds. Such a bank was henceforth considered

“illiquid”, but still solvent. Never mind that the practice of allowing the illiquid bank to keep its door open is a dangerous course to follow. It has far-reaching consequences, including the threat to the very foundations of Western Civilization. The scandals involving Enron and Bear-Sterns may be only the beginning of the unraveling of the financial system. It is clear that the recent “sub-prime crisis” is a delayed effect of the unwarranted relaxation of accounting standards back in 1914.

While I cannot prove that a secret gag-rule was imposed on the accounting profession,

I am at a loss to find an explanation why an open debate of the wisdom of changing timehonored accounting principles has never taken place. Apparently there were no defections from the rank and file of the accountants denouncing the new regimen as unethical and dangerous. The underhanded changes in accounting practice have opened the primrose path to self-destruction.

The dominant role of the West in the world was due to the moral high ground staked out by the giants of the Renaissance, among them Luca Pacioli. As this high ground was gradually given up, and the commanding post was moved to shifting quicksand, rock-solid principles gave way to opportunistic guidelines. Western Civilization has been losing its claim to leadership in the world. It comes as no surprise that this leadership is now facing its most serious challenge ever.

The chickens came home to roost as early as 1921 when panic swept through the U.S. government bond market. Financial annals fail to deal with this crisis (exception: B. M.

Anderson’s Financial and Economic History of the United States, 1914-1946, posthumously published in 1949, see reference at the end). Nor was it given the coverage it deserved in the financial press. Information was confined to banking circles. An historic opportunity was missed to mend the ways of the world gone astray in 1914. It was the last chance to avert the Great Depression, already in the making.

### Law of Liabilities

Purely by using a symmetry argument we may formulate another fundamental principle of accounting: the Law of Liabilities. It asserts that a liability must be carried in the balance sheet at its value at maturity, or at liquidation value, whichever is higher. Since liquidation would have to take place at the current rate of interest, in a falling interest-rate environment the liabilities of all firms are rising. This spells a great danger to the national economy, one that has been completely disregarded by the economists’ profession, as it also has by the accountants’ profession.

Economists have failed to raise their voice against the folly of allowing the interestrate structure to fluctuate for reasons of political expediency, implicit in the application of both Keynesian and Friedmanite nostrums. It is possible that the reason for this failure was the fatal blind spot that economists appear to have in regard to the danger of overestimating national income in a falling interest-rate environment.

The proposition that a firm must report liabilities at a value higher than that due at maturity whenever the rate of interest falls is, of course, controversial. Let us review the reasons for this crucial requirement. If the firm is to be liquidated, then all liabilities become due at once. Sound accounting principles demand that sufficient capital be maintained at all times to make liquidation without losses possible. If the rate of interest were to fall, then, clearly, earlier liabilities had been incurred at a rate higher than necessary. For example, if an investment had been financed through a bond issue or fixed-rate loan, then better terms could have been secured by postponing it. A managerial error in timing the investment had been made. This is a world of crime and punishment where even the slightest error brings with it a penalty in its train. Marking the liability in the balance sheet to market is penalty for poor timing. If the investment had been financed out of internal resources, penalty is still justified.

Alternative uses for the resource would have generated better financial results.

Even if we assume that the investment was absolutely essential at the time it was made, and we absolve management of all responsibility in this regard, the case for an increase in liability still stands. After all has been said and done, there is a loss that must not be swept under the rug. If the balance sheet is to reflect the true financial position, then the loss ought to be realized. Any other course of action would create a fool’s paradise. To see this clearly, consider losses due to an accidental fire destroying physical capital uncovered by insurance.

The loss must be realized as it is absolutely necessary that the balance sheet reflect the changed financial picture caused by the fire. That’s just what the balance sheet is for. The proper way to go about it is a three-step adjustment as follows:

(1) Create an entry in the asset column called “fund to cover fire loss”.

(2) Create an equivalent entry in the liability column.

(3) Amortize the liability through a stream of payments out of future income.

It is clear that if the accountant failed to do this, then he would falsify future income statements. As a result phantom profits would be paid out and losses would be reported as profits. Not only would this weaken the financial condition of the firm, but it would also render the balance sheet meaningless, which may compound the error further.

Exactly the same holds if the loss was due not to accidental fire but to a fall in the rate of interest. The way to realize the loss is analogous. A new entry in the asset column must be created under the heading “fund to cover overpayment in servicing capital, due to a fall in the interest rate”, against an equivalent entry in the liability column, to be amortized through a stream of payments out of future income. This is not an exercise in pedantry. It is the only proper way to realize a loss that has been incurred as a result of the inescapable increase in the cost of servicing productive capital already deployed, in the wake of a fall in the rate of interest. Ignoring that loss would by no means erase it. It may well compound it.

### Historic Failure to Recognize the Law of Liabilities

I anticipate a torrent of criticism asserting that there is no such a thing as the Law of Liabilities in accounting theory or practice. I submit that I have no formal training in accounting, or in the theory and history of accounting. Nor do I recall having seen the Law of Liabilities in any of the textbooks on book-keeping that I have perused (although I have seen the Law of Assets in older textbooks that have long since been discarded by professors of accounting as obsolete). But I shall argue that either Law follows the spirit if not the letter of Luca Pacioli. Affirming one Law while denying the other makes no sense. Every argument that supports one necessarily supports the other. The Law of Liabilities is a mirror image of the Law of Assets, arising out of the perfect logical symmetry between assets and liabilities.

Ignoring either Law is a serious breach of sound accounting principles, possibly with grave consequences. For example, if the rate of interest keeps falling for an extended period of time, as it has in Japan for over fifteen years, then the present (in my opinion, deeply flawed) accounting rules will allow losses to be reported as profits. Wholesale capital consumption/destruction may be the result, which the country may not realize until it is too late. Banks and producing firms would operate on the strength of phantom capital, and would ultimately collapse. This could bring the national economy to its knees, spelling deflation, depression, or worse (as it seems to be occurring in Japan right now). This depression appears to be metastasizing across the Pacific to the United States through the yen-carry trade, foolishly encouraged by both central banks concerned.

Even if the fact were established that the Law of Liabilities has never been spelled out in any accounting code going back all the way to Luca Pacioli, we should still not jump to the conclusion that there is no justification for it. A convincing argument can be made explaining why the Law of Liabilities has escaped the notice of upright and knowledgeable accountants in the past with the consequence that it has never been codified. Since time immemorial the powers-that-be have shown a persistent bias favoring debtors against creditors, as demonstrated by their desire to suppress the rate of interest by hook or crook. However, this effort has remained counter-productive before the advent of central bank open market operations in the 1920’s championed by the Fed. Indeed, the usuriously high rates charged on loans in pre-capitalistic times were not due to an alleged greed of the usurers. They were due to the usury laws themselves. Charging and paying interest had been outlawed, but the result was not zero interest on loans as the authors of the usury laws had foolishly anticipated. On the contrary, the result was rates higher than what the free market would have charged, representing compensation for risks involved in doing an extra-legal business transaction. For these and other reasons the problem, traditionally, was not falling but rising rates. In such an environment the Law of Liabilities remains inoperative and is easily overlooked. It is hard to discover a law that has been inoperative through all previous history.

The situation changed drastically when the Federal Reserve started its illegal open market operations. (The practice was later legalized through retroactive legislation.)

Speculators were happy to jump on the bandwagon of risk-free profits. They could easily preempt the Fed by purchasing the bonds beforehand. After the Fed has bought its quota, speculators dumped the bonds and pocketed the profits. The net result was a falling interest rate structure.

In fact, the opportunity for risk-free profits from bond speculation due to the introduction of open market operations was a major cause of the Great Depression. Yet to this day textbooks on economics hail open market operations as a refined tool in the hands of monetary authorities “to keep the economy on an even keel”. Only one other mistake economists have made surpasses this one in enormity. Textbooks blame the Great Depression on the “contractionist bias” of the gold standard.

This is just the opposite of the truth. The Great Depression was largely caused by the governments sabotaging the gold standard in preparation for its overthrow, as I shall now show. The persistent fall of interest rates in the 1930’s has never been properly explained.

What happened was that the only competition for government bonds, gold, has been knocked out through confiscation and other measures of intimidation. Freed from competition, the value of government bonds started to rise, making interest rates fall, causing prices to fall, too.

The Great Depression was self-inflicted. Governments in their zeal removed the gold standard, the policeman cordoning off the black hole of zero interest to prevent interest rates from falling in. Speculators were quick to understand that this also meant the removal of a ceiling on bond prices. For the first time ever, there was an opportunity to bid bond prices sky-high. Speculators abandoned the high-risk commodity markets in droves and flocked to the bond market to reap risk-free profits made available by the regime of open market operations. You cannot understand the Great Depression without understanding how speculators reacted to the removal of competition for government bonds. Only by searching for the consequences of the forcible removal of gold from the system can the unprecedented fall in interest rates and the Great Depression be explained.

### Threat of a New Depression

Superficial thinking may suggest that if the rise of interest rates is bad, then their fall is good for the economy. Not so. A falling rate is even more damaging than a rising one. I am aware that my thesis is highly counter-intuitive. I have been challenged by many other economists who deny the validity of my contention. They argue that if the present value of future income is lower when discounted at a higher rate, then it must be higher when discounted at a lower rate of interest. We may admit that this statement is true. However, obviously, the firm has to be around to collect the higher income. Many of them won’t be, as they succumb to capital squeeze caused by falling rates. My critics hold that falling rates are always beneficial to business and it is preposterous to suggest that they aggravate deflation. These critics confuse a falling structure of interest rates with a low structure. While the latter is beneficial, the former is lethal to producers. When interest rates are falling, the low rates of today will look like high rates tomorrow. A prolonged fall creates a permanently high interest-rate environment. This paradox explains the reluctance of the mind to admit that falling rates spell deflation and, in an acute case, depression.

Falling rates mean that businesses have been financed at rates far too high. This fact ought to be registered as a loss in the balance sheet, and be compensated for by an injection of new capital. If businesses choose to ignore the loss, and they merrily go on paying out phantom profits in the form of dividends and executive compensation, then they will further weaken capital structure. When they finally plunge into bankruptcy, they wonder what has hit them. They don’t understand that they have failed to augment their capital in the face of falling interest rates. Their downfall is due to insufficient capital. In a falling interest rate environment all producers are affected by the elusive process of capital destruction. This was true in the 1930’s; it is still true today. Incidentally, this also explains why American producers have been going out of business in droves since the mid-1980’s, resulting in the export of the best-paying industrial jobs to Asian countries such as China and India where labor costs were lower.

The U.S. government may be unconcerned about the fact that the liquidation value of its debt is escalating by several orders of magnitude due to falling interest rates. After all, the Fed has the printing presses to create dollars with which any liability can be liquidated, however large. American producers are not so fortunate. They have to produce more and sell more if they don’t want to sink deeper in debt. But selling more may not be possible in a falling interest-rate environment, except at fire-sale prices. What this shows is that the cause of deflation is not falling prices: it is falling interest rates. As they fall, a vicious circle is set in motion. Bond speculators take advantage of the opportunity created by the central bank’s open market operations. They forestall central bank buying of government bonds. The resulting fall in interest rates bankrupt productive enterprise that could not extricate itself from the clutches of debt contracted earlier at higher rates. The debt becomes ever more onerous as its liquidation value escalates past the ability to carry it. The squeeze on capital causes wholesale bankruptcies among the producers.

What central bankers never consider is that, while they have the power to put unlimited amounts of irredeemable currency into circulation, they have no power to make it flow in the “approved” direction. Money, like water, refuses to flow uphill. In a deflation it will not flow to the commodity market to bid up commodity prices as central bankers have hoped. Rather, it will flow downhill, to the bond market, where the fun is bidding up bond prices. As the central bank has made bond speculation risk free, the bond market will act as a gigantic vacuum cleaner sucking up dollars from every nook and cranny of the economy. A sense of scarcity of money will become pervasive.

In feeding ever more irredeemable currency to the markets the central bank cuts the figure of a cat chasing his own tail. More fiat money pushes interest rates lower; falling interest rates squeeze producers more. They cut prices in desperation, and cry out for the creation of still more fiat money, completing the vicious circle. The interest rate structure and the price level are linked. Subject to leads and lags, they keep moving together in the same direction.

The Fed through its open market operations generates a deflationary spiral that may ultimately bankrupt the entire producing sector. Like the Sorcerer’s Apprentice, the Fed can start the march to the black hole of zero interest, but hasn’t got a clue how to stop it when the pull of the black hole becomes irresistible. At that point the deflationary spiral gets out of control.

### Stop the March to the Black Hole of Zero Interest!

Restoring sound accounting standards is imperative if we want to avoid the pending disaster.

We must stop turning a blind eye to the deleterious effect of a falling interest rate environment on capital deployed in support of production. Open market operations of the Fed, the chief cause of deflation as demonstrated by the pull of the black hole of zero interest, must be outlawed.

Only the gold standard can effectively cordon off the black hole of zero interest. By opening the Mint to gold, the U.S. government must restore the gold standard.

### References

By the same author:

### Kondratieff Revisited, May, 2001

### Deflation or Runaway Inflation? July, 2001

### The Economic Consequences of Mr. Greenspan, December, 2001

### Japan’s Finest Hour, January, 2002

### Revisionist View of the Great Depression I-II, March, 2002

### The Black Hole of Zero Interest Revisited, August, 2002

### Wrecker’s Ball of Swinging Interest Rates, September, 2002

Central Banker As the Quartermaster-General of Deflation, January, 2003

### Bubble That Broke the World, June, 2003

Stop Greenspan from Plunging America into a Depression! June, 2003

### Tainted Research, June, 2003

### Gold Demonetization Hoax, August, 2003

### Gold Is the Cure for the Job-Drain, September, 2003

### The Shadow Pyramid, November, 2007

### Fiat Currency: Destroyer of Capital, December, 2007

### Fiat Currency: Destroyer of Labor, December, 2007

These and other papers of the author can be accessed at: [www.professorfekete.com](https://www.professorfekete.com) Benjamin M. Anderson, Economics and the Public Welfare, A financial and economic history of the United States, 1914-1946, (first published in 1949); Indianapolis, 1979: Liberty Press, p 80 ff.

---

*May 23, 2008*

---

# Interest and Discount

URL: https://newaustrianeconomics.com/archive/fekete/interest-and-discount/
Date: 2007-11-21
Section: Scholarly Economics
Difficulty: scholarly
Concept Tags: interest-theory, real-bills, self-liquidating-credit, gold-standard, new-austrian-economics
Description: Fekete draws a sharp distinction between interest and discount — two phenomena that mainstream economics conflates. Interest governs the exchange of income and wealth across time; discount governs the marketability of short-term self-liquidating bills. Confusing the two, he argues, is the root error of modern monetary theory.
Editorial Note: Part of the Gold Standard University lecture series, this paper elaborates the theoretical foundation of the real bills doctrine by grounding it in the distinction between two fundamentally different rates: the interest rate and the discount rate.
Original PDF: https://professorfekete.com/articles/AEFInterestAndDiscount.pdf

### Telling apart a bill of exchange and a mortgage

Charles Rist writes in his History of Money and Credit from John Law to the Present Day that “identifying the discount rate with the rate of interest, which is frequent among English writers, is an unfortunate source of confusion”. One English writer who is free from that blemish is John Fullarton. In the great debate between the Banking School which he represented, and the Currency School which he opposed, he wrote in 1844:

“It is a great error indeed to imagine that the demand for…a loan of capital is identical with the demand for additional means of circulation, or even that the two are frequently associated. Each demand originates in circumstances peculiarly affecting itself, and very distinct from the other.”

The confusion of which Rist talks about is the thinking that “discount rate” is just another name for short-term rate of interest, and the difference between the two does not go beyond the difference in the manner collecting it, either by charging it at the end of the loan period, or taking it out from the proceeds of the loan in advance. As a matter of fact, the difference goes far deeper than that. The two rates are entirely different conceptually. Their sources are different. Forces formatting them are different.

There are two sources of credit, with a continental divide between them. To recognize this fact is especially important for the banker’s profession. As the old aphorism says, there is no easier profession than that of a banker, as long as he can tell apart a bill of exchange and a mortgage.

### Fixed versus circulating capital

According to Adam Smith “there are two different ways in which capital may be employed so as to yield a revenue…to its employer…: circulating capital… and fixed capital.” As a first approximation may we just say that one source of credit has to do with fixed capital and its scarcity is measured by the rate of interest, while the other has to do with circulating capital and its scarcity is measured by the discount rate. Both rates are a market phenomenon: the former is regulated by the bond market, and the latter by the bill market. The rate of interest varies inversely with the propensity to save, and the discount rate varies inversely with the propensity to consume. A common mistake is to assume that the two propensities are antithetical, that is, when people save more they must consume less, and vice versa. This simplistic view ignores the propensity to hoard. In monetary economics hoarding is not a subset of saving. Hoarding is more like the opposite of saving: it originates in protest against low interest rates. I shall not go into the problem of hoarding here which is a topic for another occasion. Suffice it to say that it is possible for both the propensity to save and the propensity to consume to fall at the same time. The paradox finds its explanation in the simultaneous rise in the propensity to hoard.

### Social Circulating Capital

Recall Adam Smith’s concept of social circulating capital from The Wealth of Nations. It is that mass of finished goods demanded most urgently by the consumer, plus the mass of semifinished goods that go into their production. Social circulating capital must move through the various stages of production and distribution sufficiently fast so that the end-product will have been sold to the ultimate cash-paying consumer in less than 91 days (or 13 weeks, or 3 months: the length of the seasons of the year).

Social circulating capital does change both as to its volume and its composition. The latter follows the change of seasons. Volume changes with the propensity to consume: it expands or contracts according as the propensity gets higher or lower. The criterion to decide whether an item does or doesn’t belong to the social circulating capital is whether the bill of exchange on that item will or will not circulate spontaneously.

### Marginal productivity of circulating capital

Every finished good belonging to the social circulating capital has its own rate of productivity measured by the ratio between the percentage or retail mark-up and the average length of sojourn of that item on the shelf of the shopkeeper. For example, if the markup on \$1 worth of sauerkraut is ½ cent, and the average length of sojourn of a bottle of sauerkraut on the shelf is 1 3 12

3 months, then the productivity of sauerkraut is / =

### = 2 percent per annum. The item

2 12 6 with the lowest productivity on the shelf of the marginal shopkeeper is called the marginal item of social circulating capital. It is the item that will first disappear from the shelf if the propensity to consume declines, as it will not be reordered. Another item on the shelf with a higher productivity will take its place as the marginal item. The marginal shopkeeper is the first among the shopkeepers to change the composition of his stock on display following a change in the propensity to consume.

The rate of marginal productivity of social circulating capital is that rate at which the opportunity cost of carrying the marginal item on the shelf becomes critical to the marginal shopkeeper. The reference is to his opportunity to carry bills drawn on other shopkeepers handling faster-moving merchandise, rather than carrying the marginal item on his shelf.

Indeed, the marginal shopkeeper is the arbitrageur who lets his stock of marginal merchandise get sold out without replenishing it, and who buys bills with the proceeds whenever the propensity to consume declines. Conversely, the marginal shopkeeper will sell bills from portfolio and reorder some heretofore submarginal items which he is willing to display on the shelf once the propensity to consume increases. This arbitrage enables him to eliminate variations in his income due to seasonal and other changes in demand. At the same time he can, thanks to his bill portfolio, participate in the earnings of other shopkeepers operating with higher productivity.

### Marginal productivity of fixed capital

My readers will recognize the obvious analogy between the arbitrage of the marginal entrepreneur trading bonds against capital goods deployed in production, and that of the marginal shopkeeper trading bills against consumer goods displayed on his shelf. In my earlier paper The Paradox of Interest Revisited I have described the ceiling of the rate of interest as the rate of marginal productivity of fixed capital. It is the rate at which the opportunity cost of carrying capital stock becomes critical to the marginal entrepreneur. The next increase in the rate of interest will prompt him to sell his capital stock ― in view of his opportunity to carry his capital assets in the form of the higher-yielding bond. Thus the rate of interest is regulated by the arbitrage operations of entrepreneurs between the bond market and the market for capital goods. They will not let the rate of interest go through the ceiling. They will stop production, discontinue maintenance of capital stock, abolish depreciation quotas, and with the savings they will keep buying the undervalued bond whenever the rate of interest is too high (the price of bond is too low). They will refrain from buying new capital equipment and refuse to expand production until bond prices recover. At that time they sell their bonds at a profit, re-equip their factories, and join productive enterprise once more. We see that persistent buying of bonds by entrepreneurs will cap the rate of interest at the ceiling.

We also see that the marginal entrepreneur can, thanks to his bond portfolio, participate in the earnings of other entrepreneurs operating with higher productivity. This is just the wellknown interest-rate cycle demonstrating the damping effect of high interest rates, and the stimulating effect of low interest rates, on production.

### A symbiosis

Changes in the marginal productivity of social circulating capital reflect changes in the propensity to consume. But they also help financing the stockpiling of seasonal merchandise.

For example, winter is the season for selling vast quantities of fuel in the temperate zones.

Come spring, merchants sell out their inventory of fuel without replenishing stocks. They invest their funds in the bills of other merchants who are just entering their main season, say, those who sell gardening equipment and flower seeds. It is this symbiosis that makes the shopkeeper’s job possible in the face of the seasonal nature of the business, and in the face of the proverbial capriciousness of consumers. When in their main season the shopkeepers’ income is generated by selling merchandise in high demand. When in their slow season, their income is augmented by the discount earned while holding bills drawn on merchants in their high season. At the same time they help their colleagues finance stockpiles.

It is important to realize that social circulating capital constantly changes its constitution as various items of consumer goods fall in and out of it, due to changes of the seasons of the year, or to changes in the propensity to consume. Classical economics maintains that it is the price mechanism that brings about equilibrium between the supply and demand of consumer goods. The fact, however, is that the price mechanism is too sluggish and cannot keep up with the capriciousness of the propensity to consume. The supply/demand equilibrium theory of price also fails to explain why the cost of fuel in winter does not go sky high. In fact, it is not significantly higher than in summer.

### Second source of credit

In other words, we are looking for an explanation how the market for consumer goods deals with the problem of seasonality of merchandise and capriciousness of consumer demand. The explanation can be found in the nimbleness of the discount rate, and the fact that bills of exchange drawn on goods moving fast enough to the ultimate cash-paying consumer enter monetary circulation spontaneously. As semi-finished goods keep “maturing”, and as producers pass them along, one to the next, they accept bills of exchange in payment. This epitomizes a second source of credit namely clearing. It is in addition to the first which is saving. The maturing consumer good is in sufficient proximity to the ultimate cash-paying consumer so that its removal from the market can hardly be doubted. The usual risks associated with production disappear. At that point the market “monetizes” the bill lending it ephemeral monetary qualities.

### Credit independent of lending and borrowing

Indeed, credit can and does arise independently of lending and borrowing. Take the example of wool and its journey from the sheep-farm to the cloth store, involving the sheep-farmer, the wool merchant, the spinner, the weaver, and the cloth merchant. When the weaver draws a bill on the cloth merchant calling for payment in 91 days, he is certainly extending credit. Yet in spite of appearances the weaver is not a lender and the cloth merchant is not a borrower, and it would be wrong to look at the transaction as a loan. The perception that the drawer of a bill grants a loan to the acceptor which the latter repays at maturity is entirely fallacious and must be resisted. It is preposterous to suggest that the producer of higher-order goods is lending when he supplies semi-finished goods to the producer of lower-order goods. The semifinished good hardly has a marketability, although it will improve greatly in the hands of the producer of the lower-order good. It is always the producer of the lower-order good, by virtue of standing that much closer to the ultimate cash-paying consumer, who is instrumental in the rise of this type of credit arising, as it is, from clearing rather than from lending. The credit is an integral part of the deal to supply producers of lower-order goods with semi-finished products by producers of higher-order goods. By merchant custom the term “91 days net” is part of every such commercial deal. Stated otherwise, prices quoted by the wholesaler to the retailer are discountable prices. The amount of discount depends on the number of days the credit is being used, and on the discount rate prevailing at the time of the commercial transaction.

### “Wagon-way in the air”

The bill drawn on the cloth merchant by the weaver, properly endorsed, is acceptable in payment by the spinner for the yarn. The same bill is further acceptable in payment by the wool merchant for the wool delivered. (Accepting a bill in payment is also called

“discounting” it, since the face value is discounted by the number of days remaining to maturity.) In fact the demand for bills is such that they are acceptable even outside of the nexus of the wool and cloth trade. Producers of higher-order goods will accept them when delivering semi-finished products to their customers. With two good signatures and a string of subsequent endorsements on the back, the bill is a potent form of means of exchange. In a “violent metaphor” which looked so outrageous in 1776 that Adam Smith thought he ought to apologize for its use in the Wealth of Nations, the bill of exchange is a “wagon-way in the air” freeing up valuable land for growing produce. The meaning is that the use of bills as a circulating medium frees up funds and makes them available for use as fixed capital.

### Achillean heel of monetarism

The foregoing illustrates the contact between interest and the marginal productivity of fixed capital, and the analogous contact between discount and the marginal productivity of circulating capital. The latter is embodied by the marvelous instrument that emerged in the trading Italian city-states of the Trecento, the bill of exchange.

The idea that the bill of exchange can circulate on its own wings and under its own steam has been ridiculed by devotees of the Quantity Theory of Money. The vicious attacks on the Real Bills Doctrine expose the Achillean heel of monetarism. It reveals that an increase in the quantity of purchasing media will not always and necessarily cause a rise in prices. If the new purchasing media emerges simultaneously with the new merchandise, and the two disappear together as the merchandise is removed from the market by the ultimate cashpaying consumer (as is the case whenever the production and distribution of consumer goods is financed through bills of exchange), there will be no price rises on account of an increase in the volume of bill circulation.

### The most liquid earning asset in existence

After discounting bills has become a universal practice, demand for them increased greatly.

Tradesmen found it to their advantage to hold the bills drawn on retail merchants to maturity.

They looked at bills as a unique instrument combining two seemingly contradictory features, that of being (1) an earning asset, and (2) a medium of exchange. In fact, bills provided the only way of generating an income on cash holdings temporarily idled by seasonal factors or by an unexpected fall in the propensity to consume. As a rule, earning assets are illiquid. It takes time to liquidate them, to say nothing of possible losses. With the appearance of discounting all this has changed. Now tradesmen could earn an income on that part of their circulating capital which they had to carry in the form of cash temporarily. As most businesses are cyclical in nature, tradesmen have faced great fluctuations in their cash needs.

Now they can enjoy an income generated on their idled circulating capital as they are entering their slow season. The bill of exchange is the most liquid earning asset in existence.

### Theorem on the Formation of the Discount Rate

The discount rate is equal to the rate of marginal productivity of social circulating capital.

Indeed, if the discount rate rises, the marginal shopkeeper no longer finds it profitable to carry the marginal item on his shelf and will discontinue it. Social circulating capital shrinks and another item with a higher productivity will take over as the marginal item. The rate of marginal productivity of social circulating capital therefore increases along with the discount rate. Conversely, if the discount rate falls, the marginal shopkeeper can afford to display hitherto submarginal items on his shelves. Social circulating capital expands as the marginal item is replaced by another item with a lower productivity. We conclude that the rate of marginal productivity falls together with the discount rate.

Shopkeepers will not let the discount rate deviate from the rate of marginal productivity of social circulating capital. Such a deviation would offer profitable risk-free arbitrage opportunities. If the discount rate exceeded the rate of marginal productivity, then shopkeepers would sell out marginal merchandise and put the proceeds into bills. In the opposite case, when the rate of marginal productivity exceeded the discount rate, shopkeepers would sell bills from portfolio and use the proceeds to display more marginal merchandise on their shelves. In either case the spread between the two rates would close and the opportunity for risk free profits would disappear. It is clear that the discount rate is regulated by the shopkeepers who follow orders issued by the sovereign consumer.

### Real Bills Doctrine

The market economy comes equipped with a natural built-in clearing system that will generate all the credit necessary to move goods in high demand from the producers to the retail outlets. These credits do not originate in savings. They originate in clearing. They originate in the very process whereby producers of higher-order goods pass along the maturing semi-finished good to producers of lower-order goods.

A real bill is a bill of exchange drawn by the wholesale merchant (the drawer of the bill) on the retail merchant (the acceptor of the bill) specifying the kind, quality and quantity of merchandise shipped, and specifying the sum (the face value of the bill) and the date on which it falls due (the maturity date of the bill, in any event no longer than 91 days from the date of billing). In order to be valid, the bill has to be accepted by the retail merchant writing across its face over his signature “I accept”.

The Real Bills Doctrine of Adam Smith states that a real bill can, before its maturity date, circulate as a purchasing medium. Specifically, the wholesale merchant can use the bill he has drawn on the retail merchant to pay his suppliers by endorsing the bill on the back.

Everyone who subsequently receives the bill in payment can use it in a similar fashion.

Endorsement signifies that one endorser has assigned the proceeds to the next. Upon maturity bearer will mark the bill “paid” over his signature, and will turn it over to the retail merchant against payment of face value.

The real bill is a non-inflationary purchasing medium which the market has endowed with limited monetary privileges. Non-inflationary, because the face value of the bill is matched dollar-for-dollar by the value of the emerging merchandise. Limited, because upon maturity the purchasing medium expires while the underlying merchandise is removed from the market by the ultimate cash-paying consumer.

In many ways the spontaneous circulation of real bills is a miraculous process.

Nobody has designed this system of clearing that makes goods in demand move along from the producer to the consumer without outside financing. Emerging goods finance their own production and distribution without taking one penny out of the piggy-banks of savers, and without legal-tender coercion, as long as they are demanded urgently enough by the consumer.

### Self-liquidating credit

For this reason the real bill is said to represent self-liquidating credit. The ultimate sale of the underlying merchandise will liquidate all the credits that have been granted in moving it forward to the consumer, whether there are four, fourteen, or forty hands involved in the process. Progress in division of labor, making the journey of goods from producers to consumers ever more “roundabout”, will never cause a shortage of purchasing media (as it would under the so-called 100% gold standard).

### Gold Standard

Under the international gold standard there arises a tendency for gold to flow from a country with a lower discount rate to another with a higher one. As a result the discount rate tends to get equalized in all those countries adhering to the gold standard. The gold flows are induced by arbitrage in bills drawn on various foreign centers. Continuing arbitrage would keep up the gold flows until the spread between the various discount rates disappeared. This observation invites the following critique of the classical theory of the international gold standard (due to Cantillon), according to which gold flows across international boundaries induce changes in the relative price levels between countries ― purporting to explain the adjustment mechanism of international trade by claiming that the price level is supposed to rise or fall according as the country is gaining or losing gold.

In reality this is not what happens. As our more sophisticated model shows, if the country gains gold, the new gold will first flow to the bill market and bid up the price of bills.

The greater relative abundance of gold will lower the discount rate. In response shopkeepers will fill their empty shelf-space with marginal merchandise. The gold inflow will not pump up the price level. By the time the new gold trickles down to the rest of the economy in the form of higher wages and profits, the extra merchandise will be in place waiting for the greater consumer spending to materialize. Conversely, if the country loses gold, the gold is withdrawn from the bill market. There is an immediate increase in the discount rate, causing shopkeepers to eliminate marginal merchandise from the shelves. The gold outflow or increased gold hoarding will not result in a squeeze on prices. Instead, it will cause social circulating capital to contract. Marginal merchandise will no longer be available in every grocery store. The consumer who still wants it will have to search for it in specialty shops, or order it directly from the producer.

### International gold flows

Economists are still wondering how the Bank of England could run the international gold standard on such a paltry gold reserve during the one-hundred-year period between the Napoleonic Wars and World War One, and how the enormous volume of pre-1914 world trade could be financed with such meager gold flows as recorded by statisticians.

The explanation is that it is not the difference in relative prices but the difference in the discount rates that is the real driving force of world trade. You couldn’t do better than exporting to a country with the highest discount rate. This particular profit opportunity is ephemeral and will disappear momentarily due to competition. Imports are financed by exports, not by gold flows. Even capital movements from one country to another are financed by trade flows under the gold standard. Just as the discount rate, the rate of interest also tends to get equalized among countries that adhere to the gold standard. Capital flows piggyback trade flows. The capital-importing country has, of necessity, a higher discount rate that will not fall until after the capital import has been completed. Gold flows hardly ever cross international boundaries.

It is hard for the contemporary observer to fathom just how efficient the international gold standard had been, thanks entirely to the spontaneous monetization of real bills, before the Guns of August shot it to pieces in 1914.

### Fundamental Principle of the Retail Trade

The adjustment mechanism which brings into balance the amount of gold in circulation with the supply of goods in retail trade does not operate on the price level, as wrongly suggested by the Quantity Theory of Money. It operates on the marginal productivity of social circulating capital or, what is the same, on the discount rate. In particular, the law of supply and demand is not applicable to the retail trade. An autonomous increase in demand for consumer goods has no inevitable effect on prices but will, instead, lower the discount rate.

This is synonymous with an increase in the volume of social circulating capital. Under the gold standard increased demand automatically brings out an equivalent increase in supply. An autonomous decrease in demand has the opposite effect. There is no such a thing as an autonomous change in supply as far as the retail trade is concerned: supply is strictly regulated by demand through the mechanism of the bill market and the discount rate.

### Failure of the Quantity Theory

If a country is stricken with an earthquake or some other calamity destroying property and goods, there will be an immediate increase in the discount rate. Retail prices will not rise inevitably if the country is on the international gold standard. The stricken country, thanks to its higher discount rate, is an attractive place on which to draw bills. This translates into an immediate influx of short-term capital from abroad in the form of the most urgently needed consumer goods.

If the output of gold mines in a country increases by leaps and bounds, or if there is an invasion of foreign gold, there will be no inevitable increase in retail prices as predicted by the vulgar theory of the gold standard. The discount rate will drop at once, and merchants will start drawing bills on foreign countries with a higher discount rate, thus repelling the invasion of foreign gold and expelling the excess of domestic gold. If they run out of shelf-space, shopkeepers will use the sidewalk. At any rate, the spin-off from higher incomes due to the greater availability of gold will be met by a commensurate expansion of the offering of marginal merchandise which shopkeepers are able to display, thanks to the lower marginal productivity of social circulating capital. The greater availability of gold will, in this case as in every other, call out an appropriate increase in the supply of marginal merchandise. Retail price rises are always and everywhere the result of the scarcity of goods, and never a greater availability of gold.

The Quantity Theory of Money as it is applied to the retail trade under a gold standard is false.

### References

Charles Rist, History of Money and Credit from John Law to the Present Day, 1940, p 97

John Fullarton, On the Regulation of Currencies, New York: A. M. Kelly, publishers, 1969, p 315

Adam Smith, The Wealth of Nations, Chapter 17.

Antal E. Fekete, The Paradox of Interest Revisited, Revue Bancaire, December, 2007.

---

*November 21, 2007.*

### Abstract

No penetrating new study of the gold standard has been offered for the past 50 years.

This article makes a fresh start. It uses the methodology of Carl Menger. It establishes the Fundamental Principle of Retail Trade: the adjustment mechanism that brings into balance the amount of gold in circulation with the supply of goods in retail trade does not operate on the price level, but on the discount rate ― invalidating the Quantity Theory of Money as it is applied to the retail trade.

---

# The Paradox of Interest Revisited

URL: https://newaustrianeconomics.com/archive/fekete/the-paradox-of-interest-revisited/
Date: 2007-09-11
Section: Scholarly Economics
Difficulty: scholarly
Concept Tags: interest-theory, time-preference, marginal-productivity, real-bills, new-austrian-economics
Description: Fekete revisits the classical Böhm-Bawerk/Schumpeter paradox of interest — why present goods command a premium over future goods — and argues the standard time-preference explanation is incomplete. He reframes the paradox in terms of marginal productivity of gold, showing that interest emerges from the productivity of capital deployed through the real bills market.
Editorial Note: A scholarly engagement with the Austrian theory of interest, challenging Böhm-Bawerk and Schumpeter on their own terms. Fekete develops his alternative marginal-productivity account as part of his broader New Austrian Economics program.
Original PDF: https://professorfekete.com/articles/AEFTheParadoxOfInterestRevisited.pdf

*The Paradox Of Interest Revisited*

**Antal E. Fekete** · Gold Standard University aefekete@hotmail.com

The classical formulation of the paradox of interest is due to Böhm-Bawerk and Schumpeter.

Its modern formulation is due to Hausman and Kirzner. I quote Kirzner:

Much – perhaps all – will turn out to depend on the way in which the interest problem is formulated. For present purposes we adopt a modern formulation of the problem, but wish to emphasize that this formulation is very similar in spirit and character to classic formulations… The modern formulation we cite is that of Hausman. Hausman points out that an “individual’s capital . . . enables that individual to earn interest. If the capital is invested in a machine, the sum of the rentals the machine earns over its lifetime is greater than the machine’s cost. Why?” Common observation, that is, tells us that possession of a given stock or capital funds can, by judicious investment (say, in a machine) yield a continuous flow of income (annual rentals net of depreciation) without impairing the ability of the capital funds to serve indefinitely as a source of income. The problem is, how this can occur. Why is not the price of the machine (paid by the capitalist at the time he invests in the machine) bid up (by the competition of others eagerly seeking to capture the net surplus of rentals over cost) – to the point where no such surplus remains? We are seeking, then, an explanation for an observed phenomenon which is, in the absence of a theory of interest, unable to be accounted for. Absent a theory of interest, no interest income ought to be forthcoming, except as a transient phenomenon; competition ought to squeeze it out of existence.

In this note I propose to solve the paradox by suggesting that the exchange of wealth and income should be made the cornerstone of the theory of interest, replacing the exchange of a present and a future good.

To say that the capitalist “invests” his wealth is too simplistic. Investing is bound to confuse the issue. Moreover, possession of wealth does not automatically guarantee access to income. There is an implicit exchange of wealth and income interposed between the capitalist and entrepreneur that needs to be made explicit. Here is what happens.

The capitalist exchanges wealth for income. Income is yielded by the entrepreneur, who converts wealth into capital goods (such as a machine or a fruit tree) and hires a manager to tend them (including the task of setting depreciation quotas in anticipation of having to replace the capital goods at the end of their useful life without further charges to the capitalist). The entrepreneur sets up three accounts for the distribution of the yield after depreciation, namely, one for each of:

(1) a fixed interest income payable to the capitalist,

(2) wages payable to the manager,

(3) the remainder, or entrepreneurial profit, payable to himself.

In this way it is revealed that “investing” involves an exchange of wealth for income, and it is no longer a mystery that the sum total of income payments exceeds the wealth subject to the exchange. If entrepreneurs were not prepared to pay the capitalist an income in exchange for wealth at positive interest, then the latter would simply withdraw his offer to make the exchange and fall back on direct conversion of wealth into income through dishoarding

(ideally, dishoarding gold). From his point of view direct conversion is preferable to, and less risky than, indirect conversion or exchange at zero interest. In this light the modern formulation of the interest problem and the language of “investing” appear rather naive, if not outright boorish. It ignores the triple partnership of the capitalist, the entrepreneur, and the manager underlying the enterprise. It bypasses the problem of managerial compensation, and obscures the emergence of entrepreneurial profit. These, plus the interest income, must come out of the gross yield of capital (after depreciation). Only the last-named, profit, could fall to zero in the process, and it is the task of the entrepreneur to bolster it by looking for more promising production targets, possibly involving the application of a different set of capital goods.

Thus the act of investing is ridden with all sorts of specifics. Therefore it is eminently justifiable that we cut through the maze of irrelevant details with our abstraction of exchanging wealth and income. “Investing” is far too imprecise a term to be useful in developing theory.

Even if the owner of wealth is prepared to take the role of the entrepreneur, or that of the manager, or both upon himself, we still have to assume that there is an underlying exchange of wealth and income. Suppose, for the sake of argument, that the capitalist is acting as his own manager and also as his own entrepreneur. He must still break down his operation into that of three departments: (1) the bondholding, (2) the managerial, and (3) the entrepreneurial departments. Accordingly, he would oversee three accounts: the interest account, the managerial compensation account, and the entrepreneurial profit account. If he wants to have sound financial controls, he must assume that an exchange of wealth and income has taken place between the bondholding and the entrepreneurial departments, and he must not blend the three accounts into one. Only in this way can he be sure that the fixed income is not out of line with the rate of interest prevailing in the market and that, similarly, his managerial compensation is fixed at a level which is consonant with what he could get in the competitive market. Any shortfall in gross income must then hit the entrepreneurial profit account first – a penalty for the poor choice of the line of production, or of capital stock employed. If profit is wiped out, further shortfall would hit the managerial compensation account – a penalty for setting depreciation quotas too low. In this way the interest income is cushioned twice. Repairs must be made before further deterioration could threaten it.

A different order of priorities would make repair, indeed, economic survival, difficult if not impossible. For example, if entrepreneurial profit and managerial compensation were allowed to continue unabated while interest income was reduced to zero, then the operation would no longer have economic justification. The owner-manager would be better off if he sold his capital stock, bought the bonds of other firms, forgot about his own entrepreneurship, and took a managerial job elsewhere. Without such an internal accounting procedure assuming an underlying exchange of wealth and income the investor would lose financial control of his enterprise. He would be at a loss in trying to compare the efficiency of his entrepreneurship and managerial talents with those of others.

### Triple-Entry Revenue-Accounting

I submit that the triple partnership of the capitalist, entrepreneur, and manager is so important in the context of the theory of interest that it ought to be formulated as an independent principle, on a par with the Principle of Double-Entry Book-Keeping.

The Principle of Triple-Entry Revenue-Accounting asserts that the capitalist who goes into partnership with the entrepreneur and the manager will succeed best if he adopts the following formula for the distribution of revenue (after depreciation) from the enterprise. He sets up three accounts, in order of seniority moving from the senior to the junior: the interest account; the managerial compensation account; and the entrepreneurial profit account.

Whereas insufficient revenue affects the junior before affecting the senior accounts, all surpluses accrue to the junior (profit) account. Triple-entry revenue-accounting is applicable par excellence in case the capitalist acts as his own entrepreneur or manager. Rather than plowing the three accounts into one, the successful capitalist-entrepreneur shall keep the exchange of wealth and income that underlies his enterprise in evidence.

Triple-entry revenue-accounting is necessary in order to keep the enterprise competitive and economically healthy, to ensure that it is capable of self-correction and selfimprovement. Any different order of priority in revenue distribution makes the enterprise economically vulnerable and less competitive.

Synthesis between the time preference and productivity theories of interest Re-setting the paradigm from exchanging present and future goods to exchanging income and wealth has other important consequences besides disposing of the paradox of interest. It is the point of departure towards a synthesis between the time preference and productivity theories of interest.

It is commonly assumed that an irreconcilable conflict obtains between the two. But as we shall now see, the time preference and the productivity theories are in fact complementary.

The instrument of exchanging income and wealth is the gold bond. By definition the rate of interest is that rate which amortizes the market price of the bond by maturity when the face value of the bond falls due. If the bond sells at par, then the rate of interest coincides with the coupon rate. It is higher or lower than the coupon rate according as the bond sells below or above par (so that the rate of interest varies inversely with the bond price).

However, following Carl Menger, we ought to consider not one but two market prices: the higher asked price and the lower bid price. The former determines the floor and the latter the ceiling of the range to which the rate of interest is confined. These two rates are regulated by two independent market processes with different protagonists in charge, as we shall now spell out.

The floor for the rate of interest is determined by the rate of marginal time preference.

This is just the rate at which the opportunity cost of holding the bond becomes critical to the marginal bondholder. At the next down-tick in the rate of interest he will sell the bond — in view of his opportunity to carry wealth in the form of a present good, gold, rather than a future good, the gold bond.

The ceiling for the rate of interest is determined by the rate of marginal productivity of capital, that is, the rate at which the opportunity cost of carrying capital stock becomes critical to the marginal entrepreneur. At the next up-tick in the rate of interest he will sell the stock — in view of his opportunity to carry his earning assets in the form of a higher-yielding gold bond. Thus the rate of interest is regulated from below by the arbitrage operations of bondholders between the bond market and the gold market, and from above by the arbitrage operations of entrepreneurs between the bond market and the market for capital stock.

In more details, bondholders will not let the rate of interest go through the floor. In selling their overvalued bonds they will take profit and put the proceeds into gold — until bond prices fall and the rate of interest bounces back to the rate of marginal time preference.

At that time they will buy back their bond.

Likewise, entrepreneurs will not let the rate of interest go through the ceiling. They will stop production, discontinue maintenance of capital stock, abolish depreciation quotas, and put their savings into the undervalued bond — until bond prices rise and the rate of interest falls back to the rate of marginal productivity of capital. At that time they sell the bond at a profit and put the proceeds back into capital stock. The persistent selling of bonds at the floor, and the persistent buying of the same at the ceiling, will confine the rate of interest to a range and keep it on an even keel.

Note that the arbitrage of the marginal bondholder between the bond and the gold market lends teeth to time preference as it forces the banks and the government to yield to the wishes of the savers. Without it time preference would remain a mere prayer, just a cry in the wilderness.

Gold withdrawal by bondholders, and also by holders of bank notes or deposits, is not a drawback of the gold standard. Rather, it is its main excellence placing as it does the ability to install or to retire capital, and the power to create or to extinguish money, squarely where they belong: into the hands of the people. It is precisely these spontaneous gold flows that prevent the government from usurping the power to create money, and the banks from usurping the privilege to form capital. The idea that the government can organize debt into currency, and that the banks can organize credit into capital, is pernicious and will ultimately lead to the self-destruction of the monetary system and the economy.

### References

Israel M. Kirzner, The Pure Time-Preference Theory of Interest: An attempt at clarification, in the volume: The Meaning of Ludwig von Mises, Norwell (Mass.): Kluwer,

1993, p 166 ff.

A. E. Fekete, Gold and Interest, A Synthesis between Time Preference and Productivity Theories of Interest, Memorial University of Newfoundland, St.John’s,

Newfoundland, 1998, p 14, 52-54, 58-59.

### Notes

My 1998 treatise Gold and Interest is out of print. Photocopies of the 120 page book can be obtained for € 75 per copy (€ 50 per copy on multiple-copy orders), postage included.

Send your order and check to: A. E. Fekete, H-1025 Budapest, Ali utca 9/B, Hungary.

While my theory of interest is applicable to the regime of the gold standard, this does not mean that no lesson can be extracted from it in studying the problem of interest under the regime of irredeemable currency. For example, Gibson’s paradox can be considered as a corruption of it, just as irredeemable currency is a corruption of the redeemable variety. I shall deal with this issue in a forthcoming article.

---

*September 11, 2007.*

---

# Disequilibrium Analysis of Price Formation

URL: https://newaustrianeconomics.com/archive/fekete/disequilibrium-analysis-of-price-formation/
Date: 1999-01-01
Section: Scholarly Economics
Difficulty: scholarly
Concept Tags: new-austrian-economics, menger, mises
Description: Fekete presents a disequilibrium framework for understanding price formation that departs from the equilibrium-based models of mainstream economics. He argues that prices are continuously formed through the interaction of marginal buyers and sellers, and that any theory ignoring the process of coordination in real time will misrepresent how markets actually work.
Editorial Note: An early theoretical paper from Fekete's New Austrian Economics program, laying groundwork for his process-oriented approach to value theory and market coordination — a critique of both mainstream equilibrium economics and naive quantity-theory monetarism.
Original PDF: https://professorfekete.com/articles/AEFDisequilibrium.pdf

## Introduction

Jesús Huerta de Soto writes that economics, far from being a theory of choice or decision, is a theory of processes describing social interaction that bring about coordination displacing disorder; see [6]. It establishes the fact that, through the intervention of entrepreneurship, disorder (a state of coordination at a lower level) is promoted to a state of coordination at a higher level. Economics also establishes the fact that entrepreneurs generate and disseminate information through a system of various indicators such as prices, wages, rents, interest and discount rates.

But how do entrepreneurs diagnose disorder and, having done so, how do they bring about coordination at a higher level?

How do they generate and disseminate information through the price system or other systems of economic indicators? And how does the market integrate fragmented bits of information and power residing in individual entrepreneurs, making it the driving force of coordination? These are some of the questions we wish to answer in this essay.

One important effect of entrepreneurship is the modification of the perception of means-ends nexus. New ends emerge and means for their attainment must be perfected. New means are discovered while old ones are abandoned. Coordination dispels disorder here, creating new disorder there. The parade of new opportunities for entrepreneurial action is unceasing. The never-ending sequence of disorder-coordination-disorder is the driving force of economic progress and civilization.

Of particular importance is the coordinating activity of the shopkeeper. He is in constant touch with the consumer, learning at first hand the extent to which the latter is dissatisfied with the kinds and prices of consumer goods displayed on the shelves.

How is information represented by the scattered knowledge residing in individual shopkeepers processed? How is intelligence about the changing mood of the sovereign consumer transmitted? Only when the problem is presented in this way does it become clear that simplistic models such as the equilibrium theories, the equation of exchange and the quantity theory of money, are wholly inadequate and can never account for the complex processes involved in the formation of prices.

The static supply/demand equilibrium analysis of price formation and its offspring, the quantity theory of money, are one-dimensional. They project a black-and-white image. They look at goods in total isolation.

They admit no insight into the effect on the price of alternative products either at the input or at the output end of the production line. They make no allowance for deliberate variation of product quality on the part of the producer. Horizontal arbitrage using one-legged straddles has a role to play in retrospective (backward-looking) or defensive strategies designed to protect profitability, including deliberate variation of product quality to increase capacity utilization. Vertical arbitrage using four-legged straddles has a role to play in prospective (forward-looking) or aggressive strategies designed to uncover hitherto unexplored spreads. Pure entrepreneurial profits depend on the producer's skill in meshing these strategies.

The third part of this essay deals with the coordination problem as it confronts the retail trade, as well as international trade.

Neither the law of supply and demand nor the quantity theory of money applies in these markets: we must appeal to a disequilibrium model. An increase in the volume of purchasing media due to higher spending or an influx of foreign exchange has no inevitable effect on prices but will, instead, lower the discount rate. We must analyze short-term capital movements in terms of the widening spread between the discount rate and the marginal productivity of social circulating capital. We must take arbitrage between the bill market and the consumer goods market into account. The lowering of the discount rate is equivalent to an increase in the marginal productivity of social circulating capital. Increased demand brings out increased supply sufficient to accommodate it, with no increase in prices.

Price changes, whenever they occur, reflect coordination involving other factors.

In company with Jesús Huerta de Soto I maintain that it is possible to explain the market process: the formation of prices, rents, wages, interest and discount rates, without reference to equilibrium models, merely by focusing on dynamic processes.

As a first step, here we develop the disequilibrium analysis of price formation. A disequilibrium theory of price formation would have to be three-dimensional. It must project an image in full color. It must take the inter-dependence of the price with those of the substitutes at both the input and output level into full account.

In this essay we attempt to lay the foundations of such a disequilibrium theory.

In the first part we establish arbitrage as the very driving force of the market process.

We shall use the language of traders engaging in arbitrage on a daily basis. Their guiding star is the spread, that is, the difference in price between two goods

(baskets of goods or, better still, baskets of goods plus other resources). Their basic tool is the straddle, that is, the combination of a purchase and a sale. The arbitrageur is shuffling his straddles in pursuit of pure entrepreneurial profits. To the uninitiated it may look as though the arbitrageur is being guided by intuition of some sort. But theory can expose the basic facts governing arbitrage without appealing to intuition.

The disequilibrium analysis of price formation of consumer goods to be presented here isolates three basic types of arbitrage:

(1) horizontal arbitrage of the consumer using one-legged straddles responsible for the formation of the asked price;

(2) vertical arbitrage of the producer using two-legged straddles responsible for the formation of the bid price; and

(3) bid/asked arbitrage of the market-maker using four-legged straddles which is responsible for closing the bid/asked spread.

In the second part of the paper we discuss the coordination problem of economics in terms of the landscape of spreads.

Entrepreneurs are addressing themselves to selected spreads through arbitrage.

### Horizontal arbitrage, using one-legged

## Part One: Arbitrage

Whether recognized or not, arbitrage is the driving force of the market process. It is present in every market action, even though sometimes it may well be hidden. It is not generally recognized that barter — a sale and a purchase 'telescoped' into a single transaction — is an instance of arbitrage. By the same token so is every purchase, since an explicit choice always incorporates the implicit rejection of the nearest alternative.

In this paper the word arbitrage is used in the broadest possible sense, in order to unify seemingly fragmented entrepreneurial activities and seemingly unrelated sources of pure entrepreneurial profit. Arbitrage is a market strategy, shifting the emphasis from sales to straddles and from prices to spreads. of the price, is found in the fact that a single move in the price is mostly random. By contrast, in a well-traded market, a single move in the spread is not random. It is a signal carrying an important message. The knowledgeable arbitrageur can read it and make most of it. This ability of his is the true source of pure entrepreneurial profit.

Our starting point is the fundamental observation of Carl Menger in Principles of Economics [1] that there is no such thing as a monolithic price. Markets do, in fact, quote not one but two prices: one higher and the other lower. In market parlance the higher one is called the asked price, while the lower is the bid price. The two are never equal, so that the bid/asked spread

(asked minus bid price) is always positive.

The fundamental question is this: how are the bid and asked prices formed? We shall see that, in fact, two entirely different processes are involved. The asked price is the outcome of competition on the part of the consumers (sic!), whereas the bid price is the outcome of competition on the part of the producers (sic!). Either process can be properly described as arbitrage, attacking a certain spread, using a certain type of straddle.

### Spreads and straddles

A straddle is a market position with a long and a short leg. The long leg could be an outright purchase but, more typically, it is a commitment to buy or, just as typically, the liquidation of a commitment to sell. The short leg could be an outright sale but, more typically, it is a commitment to sell, or the liquidation of a commitment to buy. These commitments, as well as their liquidation, are always made at the current price. Each straddle belongs to a spread, namely, the difference between the prices at which the commitments to buy and sell have been made (sale price less purchase price).

The spread, like the price, is subject to change. But the information-content of a change in the spread, unlike that in the price, is highly significant. Indeed, the importance of arbitrage, and the reason why human action should be viewed from the vantage point of the spread rather than that

### Four-legged straddles

When the arbitrageur sees a profitable spread, say, he finds the price of an item x too low while that of a related item y too high, he moves to set up his initial straddle consisting of the initial long leg

(commitment to buy x) and the initial short leg (commitment to sell y) at the prevailing prices. In market parlance he has entered the market for x with his long and that for y with his short leg. The arbitrageur expects his spread to widen (to narrow in absolute value if the initial spread was negative). If the market moves in his favor, he takes profit by offsetting his straddle: he enters the same markets once more with long and short legs switched around. His opposite straddle consists of the terminal short leg

(liquidating the commitment to buy x) and the terminal long leg (liquidating the commitment to sell y) at the new prices. His profit is the net change in the spread

(terminal minus initial spread; if negative, he has made a loss). We refer to this as a four-legged straddle as profits from the arbitrage can be calculated only after all four legs are in place.

Four-legged arbitrage is the basic strategy of warehousing. Suppose a grain-elevator operator normally fills one of his two bins with corn and the other with wheat. Further suppose that as a result of poor weather in the wheat-growing regions he expects the corn/wheat spread (wheat price minus corn price) to widen. Acting on this insight he sells his corn (initial short leg) and buys wheat, filling his corn bin with wheat (initial long leg). When his expectation is fulfilled and the corn/wheat spread has widened, he sells his wheat in the corn bin (terminal short leg) and buys corn refilling his corn bin (terminal long leg). Since the profitability of the arbitrage can be established only after all four legs are in place, this is a four-legged straddle.

The bid/asked arbitrage of the marketmaker also uses four-legged straddles. In this case all four legs are in the same market. The market-maker, as it were, is 'warehousing' long and short positions in the same commodity, closing them out as the price is moving in his favor.

The foreign exchange trader's basic tool is also the four-legged straddle. His business also has the characteristics of warehousing.

To catch a glimpse of the true significance of the four-legged straddle, consider the fact that the volume of trade in the world's foreign exchange markets is estimated at a mind-boggling one and one quarter trillion dollars per day — more than the annual budget of the U.S. government! Virtually all of this trading is hedged, that is, transacted through the vehicle of four-legged straddles.

The importance of the four-legged straddle goes beyond these examples which are special in that the terminal legs liquidate the respective commitments of the initial legs. In the most general case this restriction is removed. In the second part of this paper we shall see examples of four-legged straddles with each leg in a different market.

### Two-legged straddles

Consider the vertical arbitrage of the producer. The long leg x of his straddle is in the producer goods market and the short leg y is in the consumer goods market, where x is the input and y is the output of his production line. This is an example of a twolegged straddle, since profits from the arbitrage can be calculated already when the first two legs are in place. We reduce this to a four-legged straddle by adding two terminal legs at zero prices (so that entering the phantom legs won't disturb the profitability of the arbitrage). The phantom legs are entered in order to satisfy the requirements of double-entry book-keeping.

The four legs are:

(1) placing an order for x (initial long leg)

(2) taking an order for y (initial short leg)

(3) taking delivery of x (terminal short leg)

(4) making delivery of y (terminal long leg).

Consumers are doing horizontal arbitrage all the time: they constantly shift their custom. Their guiding star is the constellation of horizontal spreads. As a result of their competition, horizontal spreads will widen. But the spreads which belong to the one-legged horizontal straddles with the same long leg x cannot continue to widen indefinitely. Their widening will be checked by the marginal consumer of x. His refusal to buy x, and his buying x' instead constitutes an opposite horizontal straddle and entering it will stabilize the spread.

Of course, the person of the marginal consumer, and the item x' he substitutes for x, are subject to change. Whenever another consumer takes over that role from the first the item x" he substitutes for x may well be different from x'. Indeed, over a period of time when the price of x is undergoing a change, hundreds of different people may, one after another, play the role of the marginal consumer of x, while x' sweeps through the spectrum of all possible substitutes for x. This picture can be simplified if we personify the marginal consumer of x and think of him as a figure skater skating in the rink of consumer goods. His long leg is anchored to x while his short leg is skating through the possible substitutes of x. This, then, is the mechanism whereby the market integrates the fragmented knowledge of and power over the price of x that resides in individual consumers, crystallizing it in the form of a single indicator: the asked price for x.

### One-legged straddles

Consider the horizontal arbitrage of the producer. He buys the favored producer good x (his present input) while he refrains from buying the disfavored one y (his former input). Thus he creates a straddle with long leg x and short leg y, and the corresponding spread shows the profit

(saving) that arises out of his switching from y to x. This is called a one-legged straddle, because the profit from the arbitrage can be calculated already when the single long leg x is in place. To satisfy the requirements of double-entry book-keeping, we reduce this to a four-legged straddle by entering three phantom legs. The four transactions are:

(1) placing an order for x

(2) cancelling the order for y

(3) taking delivery of x

(4) taking credit for cancelling the order for y.

As in the previous case, these form a four-legged straddle. The terminal legs are entered at zero prices so as not to disturb profitability. We are now ready to present the disequilibrium analysis of the price formation of consumer goods in three steps: the formation of the asked price, the formation of the bid price, and the closing of the bid/asked spread.

### Formation of the asked price

As noted already, the asked price is the outcome of the competition of the consumers. In more details, the asked price a of the consumer good x marks the point where the opportunity cost of buying an additional unit of x becomes critical to the marginal consumer. He is the first consumer to refuse to buy the uptick in the price of x

— in view of his opportunity to buy a substitute, say, the consumer good x'.

### Formation of the bid price

Recall that the asked price is the outcome of the competition of the consumers. Now we shall see that, by contrast, the bid price is the outcome of the competition of the producers. Here are the details.

The bid price b of the consumer good x marks the point where the opportunity cost of selling an additional unit of x becomes critical to the marginal producer. He is the first producer to refuse to sell the downtick in the price of x — in view of his opportunity to refuse to buy the producer good y, his input in the production of x.

All producers of x are doing vertical arbitrage between consumer and producer goods all the time: they constantly shift their production lines from one vertical straddle to another. Their guiding star is the constellation of vertical spreads. As a result of the competition of producers the vertical spreads will shrink. But the spreads which belong to the two-legged vertical straddles with the same short leg x will not keep shrinking indefinitely. Their shrinking is checked by the marginal producer of x.

His refusal to sell x and his refusal to buy y constitutes an opposite vertical straddle, and entering it will stabilize the spread.

Of course, the person of the marginal producer of x, and his input y, are subject to change. When another producer takes over that role from the first, the item y' he uses as his input for the production of x may not be the same as y. Indeed, over a period of time when the price of x undergoes a change, hundreds of different people may, one after another, play the role of the marginal producer of x, while y' sweeps through the spectrum of alternative inputs suitable for the production of x. This picture can be simplified if we personify the marginal producer of x and imagine that his short leg is anchored to x on the bottom rung of a ladder, while his long leg is trying to get a firm foothold on the next rung, touching the alternative inputs suitable for the production of x. This, then, is the mechanism whereby the market integrates the scattered knowledge of and power over the appropriate level of the price of x that resides in the individual producers, crystallizing it in the form of a single indicator: the bid price of x.

Our results can be summarized as follows.

The asked price is determined by marginal utility. It can be characterized as the lowest price at which consumers can buy as much as they want without haggling — explaining how the asked price earns its name. The bid price is determined by the marginal profitability of production. It can be characterized as the highest price at which producers can sell all they have without haggling — explaining how the bid price earns its name. It follows that marginal utility must be higher than marginal profitability (otherwise no production will take place).

### Closing the bid/asked spread

In the very nature of the case a > b, so there is a positive bid/asked spread a – b.

The existence of a positive spread, as always, invites arbitrage. The arbitrageur attacking the bid/asked spread is called the market-maker (on the floor of the New York Stock Exchange, the specialist). The marketmaker buys at the lower bid price and sells at the higher asked price (while everybody else must, unless prepared to haggle, buy at the asked and sell at the bid price). The guiding star of the market-maker is the bid/asked spread. Competition of marketmakers causes the bid/asked spread to shrink. But the process of shrinking the bid/asked spread will not continue indefinitely. It will be checked by the marginal market-maker, whose withdrawal from arbitrage will stabilize the spread.

Usually the spread is negligible (hence the impression of a single monolithic price). It clear that the spread is determined by the marginal profitability of the market-making business. Note the beneficial effect of the bid/asked arbitrage. Everybody benefits: the consumer enjoys a lower buying price, the producer is rewarded by a higher selling price. The analysis of the market process cannot be complete without the inclusion of the arbitrage of the market-maker.

Of course, the three components of arbitrage (horizontal, vertical, and bid/asked arbitrage) are carried on simultaneously and continuously — not one after another as the theory might suggest. The decomposition of market agitation into three separate components has purely methodological significance. This completes the marginal analysis of the price formation of consumer goods. The corresponding analysis of the price formation of producer goods can be given mutatis mutandis (see below). from being symmetrical. The fact is that a rise in the asked price has an additional consequence. Unlike the lower bid price, a higher asked price tends to widen the vertical spread. This will bring out fresh competition for the producers. While a price rise induced by increased consumer demand are mostly temporary, lasting only as long as it takes for the producers to adjust, a decrease in price due to increased production, to the extent they reflect technological improvements and increased productivity, are mostly permanent.

(Example: the dramatic fall in the price of personal computers). This is the feedback effect: increased competition on the part of the consumers brings about increased competition on the part of the producers.

But note the absence of a feedback in the opposite direction. We conclude that consumers have a veto power over the marginal producer. The predominant role in the process of price formation belongs to the consumers. The role of the producers is subordinate. Because of this bias in favor of the consumer, marginal utility may be considered the primary factor in the formation of the price, while marginal profitability is secondary. This lack of symmetry between horizontal and vertical arbitrage is often referred to as the Principle of Sovereignty of the Consumer.

### The sovereignty of the consumer

Competition of the producers may or may not have the effect of lowering the bid price of x. The marginal producer is confronted with the choice whether to compete or not to compete. If he decides to compete, he will adjust his selling price to that of his competition, and will try to restore profitability through horizontal arbitrage. If he decides not to compete, he will drop out of the ranks of producers and another man will take over as the marginal producer of x.

In either case, the bid price will get lowered, with the asked price (driven by bid/asked arbitrage) to follow hard on its heels. This is what happens in the case competition is keen. If competition is dull, the marginal producer may prevail in his effort to hold the bid price.

Analogously, competition of the consumers may or may not have the effect of raising the asked price. But the two cases are far

### Critique of equilibrium analysis

The superiority of our disequilibrium analysis over the conventional supply-anddemand equilibrium analysis of price formation is clear. The latter is a black-andwhite, one-dimensional shadow of reality. It looks at the consumer good (together with its price and quantity) in total isolation. It doesn't admit any insight into the effect on the price of alternative inputs or outputs, nor can it handle deliberate producer-induced changes in quality. By contrast, the disequilibrium analysis of price formation presents a three-dimensional image of reality in living color. It takes the interdependence of prices with those of alternative consumer goods at the level of output, as well as with those of alternative producer goods at the level of input, into full account. It can well handle the problem of deliberate producerinduced changes in quality. Disequilibrium analysis puts the market process, and the role of arbitrage in it, into high relief.

F. A. Hayek in Prices and Production [2] and Ludwig von Mises in Human Action [3] clearly recognized the entrepreneurial activity of producers in setting up vertical straddles to attack selected vertical spreads.

(Needless to say, they used a different terminology). The adjective "vertical" relates to the vertical structure of goods due to Menger, elaborated in Israel M.Kirzner's Market Theory and the Price System [4].

This is a classification of goods according to their remoteness from the final consumer.

Consumer goods are first order goods while those entering into the input of the production of consumer goods are of the second order. In general, goods that enter into the input of the production of nth order goods are of order n+1. Calling the straddle of the producer with commitments to buy an (n + l)st order good and to sell an nth order good "vertical" is just a plausible extension of Menger's original terminology.

Horizontal straddles and spreads are to be understood in exactly the same sense. The choice of the adjective here was inspired by Kirzner's concept of "horizontally related goods and markets" mentioned in [4]. In his book Competition and Entrepreneurship [5]

Kirzner also provides an important example of a horizontal straddle. It is the market position of the producer of a consumer good y who discovers that consumers are willing to pay more for y', another consumer good that he can produce out of the same input basket x. Accordingly, the producer switches production from y to y' to increase profitability. Notice that the producer has created a one-legged horizontal straddle at the level of first order goods, with the significant leg being the initial short leg y'.

Of course, the producer of nth order goods can also avail himself of one-legged horizontal straddles in order to improve profitability. Complementary to this there is another type of horizontal arbitrage that will play a role in the marginal analysis of the formation of the asked price of an nth order good. The producer may want to increase profitability by replacing his input basket x by a cheaper one x'. In the latter case the producer's horizontal straddle is at the level of (n + l) st order goods; in the former, it is at the level of nth order goods.

By a simple extension of this terminology to the level of first order goods we may also call the market position of the consumer, who is shifting his custom from one product to another, a one-legged horizontal straddle at the level of consumer goods. None of the aforementioned authors referred to these entrepreneurial activities by the name arbitrage. But to do so is helpful in the present context as it brings out the important common element in the seemingly unrelated activities of the entrepreneurs, and it makes the classification of entrepreneurial activities possible. By the same token, consumer buying should also be recognized as an instance of horizontal arbitrage. After all, every purchase is an explicit choice involving the implicit rejection of the nearest substitute. It is true that the savings that arise out of the consumer's horizontal arbitrage are not normally regarded as profits. There is no need to quibble over semantics. It would appear to be inconsistent to dismiss the consumer's activity of comparing prices and quality before buying as non-entrepreneurial in character, having accepted as entrepreneurial the producer's analogous activity of "shopping around" for alternative inputs — which certainly makes a direct contribution to profitability of the enterprise. order n+1, the input of the production line for x.

### We have noted earlier the Principle of

Sovereignty of the Consumer in the context of the production of consumer goods. The same principle extends to the production of higher order goods. The role of the producer whose product is less remote from the ultimate consumer is dominant, the role of the producer whose product is more remote is subordinate. (From this remark the Principle of Imputation can be easily derived.)

It often happens that a higher order good serves as input for the production of several goods of different orders. For a long time coal was a consumer good as well as a producer good. Platinum is a second order good in artistic applications (e.g., in making jewelry), but it also serves as a higher order good in industrial applications (e.g., in making catalytic converters). Whenever a product serves both as an mth and an nth order good we may assume that the formation of the asked and bid price takes place at both levels. Should there be a substantial difference, multilateral arbitrage would close the spread between the gaping prices. (Exception: negotiated prices for industrial applications. For example, it is known that the platinum mining industry sells most of its production at negotiated prices which are normally set below the free market price. Not only does the industry lock in a price in this way, but it also carves out a market share in advance. Industrial consumers are, by contract, barred from reselling platinum in the free market, as this would defeat the purposes of the producer.)

### Price formation of producer goods

Marginal analysis is readily extended to the price formation of nth order goods. The asked price is the outcome of competition of the users of an nth order good doing horizontal arbitrage in terms of one-legged straddles. In more details, the asked price of an nth order good x marks the point where the opportunity cost of buying an additional unit of x becomes critical to the marginal user of x. He is the first among the producers of goods of order n – 1 i n refusing to buy the uptick in the price of x

— in view of his opportunity to buy a substitute, another producer good x' of order n instead. The bid price of an nth order good is the outcome of competition of producers doing vertical arbitrage between goods of order n and n+1 using two-legged straddles. In more details, the bid price of an nth order good marks the point where the opportunity cost of selling an additional unit of x becomes critical to the marginal producer of x. He is the first among the producers to refuse to sell the downtick in the price of x — in view of his opportunity in refusing to buy the producer good y' of

PART TWO: THE COORDINATION PROBLEM IN ECONOMICS through arbitrage using the corresponding straddle.

The landscape of spreads is not to be visualized as rigid relief map but rather as a fine cobweb, every node of which is interconnected with every other. Disturbance at one node will affect the state of every other node. Accordingly, the entrepreneur attacking one spread through arbitrage will transmit information to and will influence the width of every other spread.

In order to understand the coordination process more fully we must look at various entrepreneurial strategies. We isolate two of them: the defensive or retrospective

(backward-looking) strategies utilizing horizontal arbitrage, and the aggressive or prospective (forward-looking) strategies utilizing vertical arbitrage. As we have seen, producers of n th order goods act as arbitrageurs on three counts: (1) they are doing vertical arbitrage between the n th and

(n + l)st order goods; (2) they are doing horizontal arbitrage at the level of output

(goods of order n); and (3) at the level of input (goods of order n+1). Different types of arbitrage have different roles to play in the market process. First we look at the role of horizontal arbitrage.

We are now ready to discuss the coordination problem of economics and to see how entrepreneurs approach it through arbitrage. It will appear that our introduction of arbitrage as the generic form of human action, that underlies all the multifarious activities of entrepreneurs in pursuit of pure entrepreneurial profits, is insightful. It focuses on what is important while deemphasizing what is less important or unimportant in the activities of entrepreneurs when looked at from the point of view of the market process. It also leads to the classification of entrepreneurial strategies as we treat the coordination problem.

### The coordination problem and the landscape of spreads

Lack of coordination or the presence of disorder in society represents an opportunity for gain, even though every instance of this remains hidden to most observers until it is exposed by entrepreneurship. Once the opportunity is being exploited, coordination overtakes disorder and the profit potential disappears. There prevails in society a spontaneous tendency for greater coordination driven by entrepreneurship. In fact, it is the existence of this process that makes it possible to have theoretical economics as opposed to economic history.

But how does the entrepreneur diagnose the presence of disorder? He surveys the landscape of spreads. The latter furnishes an accurate picture of the state of coordination or the lack of it. In more details, narrow spreads indicate a higher and wide spreads indicate a lower state of coordination. The entrepreneur picks a spread that appears unreasonably wide to him. He then exerts his coordinating influence on the spread

### Defensive strategies and horizontal arbitrage

As a direct result of production, vertical spreads will narrow, squeezing profits. This effect is natural, it is to be expected, and all producers ought to be fully prepared to meet the challenge presented thereby. Eroding profitability can be restored, at least to some extent, through horizontal arbitrage at either end of the production line. The alert producer explores alternative inputs, as well as alternative outputs, compatible with his existing plant and equipment.

As we may recall, this retrospective (or defensive) strategy aiming at the restoration of profitability can be described as horizontal arbitrage in terms of one-legged straddles. If the producer replaces his input basket x by a cheaper one x', he has created a one-legged horizontal straddle whose significant leg is the long leg x'.

Alternatively, if he replaces his output y by another y' which uses the same input but is expected to fetch better prices, he has created a one-legged horizontal straddle whose significant leg is the short leg y'.

One sign of eroding profitability is that the production plant is operating far below full capacity. Cutting the price of x outright at a time when profits are squeezed might be a short-sighted strategy and is likely to be counter-productive. (While not a suitable defensive strategy, price-cutting might be effective as an aggressive strategy aiming at increasing the market-share.) But the producer may have recourse to horizontal arbitrage as a more appropriate defensive strategy. Variation in product quality, complementing variation in price, is an important device to improve profitability.

The producer puts an alternative product on the market, say, a higher-quality edition x' of x that could be sold at a higher price with only a minor increase in cost.

Suppose that the production capacity of the plant is 100 units of x per day, but only 60 units can be sold at the price of \$3, grossing

\$180 per day. The producer tries to sell 30 units of x' at the price of \$4 while cutting the price of x to \$2 in the hope that he could increase his sale of x to 70 units. This would increase his gross intake to \$240 per day achieving, incidentally, full capacity utilization. The producer could afford to spend an additional \$1 per unit of x' to increase quality. If he did, his total profit would still be higher (as long as he could keep the cost of input down to less than

### \$1.25 per unit of x.)

Deliberate variation in product quality is an important tool in the hands of the producer to compensate for the erosion of profitability. Equilibrium analysis of price formation is designed to handle the problem of variation in quantity, but it is at a loss to handle the problem of variation in quality by the producer. We may note in passing that increasing sales will increase profitability in two ways: a larger number of units sold usually means (1) larger total profits, as well as (2) higher profits per units sold.

Indeed, as the depreciation schedule for capital equipment falls upon a larger number of units, the depreciation quota per unit of production becomes smaller. However, depreciation is a cost and as such it enters the input basket. A smaller depreciation quota implies higher profits per units sold.

### Aggressive strategies and vertical arbitrage

Prospective (forward-looking) or aggressive strategies become important when defensive strategies no longer suffice to protect profitability. As pure entrepreneurial profits are ephemeral and elusive, it is incumbent upon the alert producer-entrepreneur to make timely preparations for the day when his vertical spread has been exploited to the fullest, and profitability can no longer be restored through horizontal arbitrage. At that point he abandons his vertical spread and scraps his equipment. He must find a new, wider, and more promising vertical spread waiting to be exploited. To attack this new spread he must initiate the corresponding straddle. He must buy new equipment and must set up a new production line.

To be sure, it is possible to continue production without the benefit of pure entrepreneurial profits indefinitely. But this would involve taking capital losses periodically. Let us assume that the proceeds from sales are sufficient to cover the cost of all resources expended in the production effort in full, with the sole exception of the return to capital invested. This means that capital can no longer be amortized as called for by the original schedule: its value must be revised downwards so that the insufficient return can continue to amortize the reduced capital value at the current rate of interest. The resulting capital losses are simply passed on to the shareholders, who are forced to absorb it in the form of a reduced (or cancelled) dividend income. It is clear that marginally profitable enterprises are at the mercy of the rate of interest. A rise in the rate of interest would render the enterprise submarginal (i.e., a loss-maker).

The profit margin is seen as the very cushion sheltering the enterprise from an untoward rise in the rate of interest.

But of the greatest importance to us are precisely those enterprises that can, thanks to alert entrepreneurship, generate pure entrepreneurial profits consistently. Mark the word "consistently". It is one thing to make profit sporadically; it is quite another to make it consistently. As we have seen, the skill to make profit consistently is crucial: it is precisely this skill that shelters the shareholders from suffering capital losses. An important aspect, not sufficiently recognized in the scholarly literature, is the social role of pure entrepreneurial profits.

In the modern world most production takes place within the corporate framework, and most retirement pension plans depend on the integrity of the dividend income derived from the ownership of industrial shares. The pension plan will have to declare bankruptcy eventually if the stocks in its portfolio are exposed to periodic capital losses. One can hear a lot of exhortation concerning the need to prod firms to be "good corporate citizens" — to wit: worry about profits less, and worry about civic duties more. The loose talk about corporate citizenship and civic duties misses the point completely. Profits are to be worried about indeed, because they are ephemeral, elusive, opportunities to generate them are hard to find, and because profits play such an important social role in protecting the source of income for the retired segment of the population.

### Depreciation quotas

What is the "secret" of those entrepreneurproducers who can consistently generate pure entrepreneurial profits? The secret can be found in their strategy to shift their production line, in a timely fashion, through four-legged vertical straddles.

First of all, the provident producer must be aware that profits are ephemeral. He must understand that the more successful he is in producing consumer goods, the faster the vertical spread he is attacking will erode, and the greater his need to find an alternative vertical spread will become. The temptation is ever present for the successful producer to rest on his laurels, and to continue doing what he has been successful in doing. However, in the real world of ephemeral profits such an attitude is bound to back-fire. The initially successful producer will turn out to be a failure after all, unless he is on his toes at all times.

Secondly, the provident producer must set his depreciation quotas high enough: they must cover the possibility that his plant and equipment become obsolete prematurely.

The useful life of plant and equipment is not to be exploited. When the day comes, he will be ready. He will stop producing x and start producing x'.

It is a frequent objection that switching from one production line to another is a costly move. It involves scrapping old plant and equipment and buying new ones.

Scrapping may involve huge losses in view of low scrap values relative to the high price of new plant and equipment — hence the chimaera of inconvertible capital.

The objection is not valid. There is no such a thing as inconvertible capital — there are only insufficient depreciation quotas.

Had these quotas been set with greater foresight, the full value of the old capital and equipment would have been written off by the time switching fell due, and there would have been no losses on that account.

When plant and equipment are fully amortized, the vertical spread gets wider by the amount of depreciation no longer to be charged. But this once-in-a-lifetime shot-inthe-arm is no more than a temporary reprieve. The natural shrinkage of the vertical spread is going on unabated, putting the entrepreneur on red alert that the time to make the switch from one production line to another is fast approaching.

The aggressive (prospective) strategy in the pursuit of pure entrepreneurial profits can be described as vertical arbitrage in terms of four-legged straddles as follows.

When the producer finally makes his switch from the old production line with input y and output x to the new production line with input y' and output x', he has created a fourlegged vertical straddle with initial short leg y and initial long leg x; terminal long leg y' and terminal short leg x'. Note that this fourlegged vertical straddle is of the most general kind. The terminal legs are no longer backward-looking as in previous examples where they simply liquidate the determined solely by physical criteria having to do with wear-and-tear. It could also be shortened by virtue of shifting consumer preferences, which is impossible to predict.

To be sure, higher depreciation quotas will increase costs, thus reducing entrepreneurial profit. But this part of lost profits may be recaptured later, after the value of plant and equipment will have been written off completely, when depreciation costs no longer weigh down input. The producer who is in the habit of setting his depreciation quotas by relaxed standards is living in a fool's paradise. In addition, the provident producer will also set aside a quota dedicated to research and development

(R&D). These funds are dedicated to support the inventor and the technologist in developing new products and better production methods. This will help slowing down the erosion of profitability later, and offer a better chance of finding new profitable vertical spreads. To be sure, R&D quotas will increase costs and thus reduce profitability initially. But it would be shortsighted to do without them. They are the very goose to lay the golden eggs of future profits. If there is no room for R&D quotas in view of insufficient profits, then the production effort probably cannot be justified in its present form.

### The chimaera of inconvertible capital

Above all, the provident producer is very much alive to the fact that the vertical spread he has set out to attack is shrinking relentlessly, forever squeezing profits. He is making timely preparations for the day when his vertical spread is exploited to the fullest, forcing him to move on to greener pastures.

He is constantly on the look-out for wider and more promising vertical spreads waiting commitments created by the initial legs, but they are forward-looking as they enter new markets. In fact, each of the four legs is in a different market.

The calculation of pure entrepreneurial profit follows the same formula "terminal minus initial": the new vertical spread minus the old. This means that the producer can reap pure entrepreneurial profit consistently, provided that he makes a timely switch from one vertical spread to another as soon as the profitability of the former erodes sufficiently, and the profitability of the latter is sufficiently high.

Marx and Keynes have made the prophecy notorious that profitability will eventually become extinct and the capitalist mode of production will reach its state of "maximum entropy". Only people who are utterly unable to understand the true nature of entrepreneurship and the inventiveness of the human mind could believe that. It is true that finding more profitable vertical spreads is getting ever more difficult. But the alert producer will always find them, partly because of the providence of entrepreneurs earmarking funds for R&D, and partly because of the exploration of others in search of cheaper and better sources of raw materials and energy.

## Part Three: The Disequilibrium Analysis Of Retail Trade

In dismissing the supply/demand equilibrium theory we must explain price formation in the retail trade on the basis of disequilibrium principles. As we shall see, the adjustment mechanism works not on the prices of goods but on the marginal productivity of social circulating capital as measured by the discount rate. (We must sharply distinguish between the discount rate and the rate of interest. The former is regulated by the propensity to consume, the latter by the propensity to save. Either rate may move while the other is stationary; if both move, then they may move in the same or in the opposite direction.)

An autonomous increase in demand for consumer goods has no inevitable effect on prices but will, instead, lower the discount rate. A lower discount rate is synonymous with an increase in social circulating capital, that is, the supply of consumer goods. In other words, an increase in demand automatically brings out an increase in supply; a decrease has the exact opposite effect. There is no such thing as an autonomous change of supply in the retail trade: supply is closely regulated by demand through the discount rate.

The myriad of goods passing through the hands of the producers and distributors on its way to the market undergoes remarkable changes when it gets within sight of the consumer. The uncertainty and unpredictability characterizing production at the earlier stages disappear, as if by magic, and are replaced by increasing certainty and predictability to the effect that the goods will finally be removed from the market by the ultimate consumer. There is a dramatic reduction in the risks involved in handling merchandise as it enters the gravitation of consumption. This fundamental observation motivates the following concept.

### Social circulating capital

That mass of provisions and finished or semi-finished goods which has reached sufficient proximity, and is moving sufficiently fast, to the ultimate cash-paying consumer so that its destiny of being consumed presently could no longer be in doubt, is called social circulating capital. It does not include semi-finished goods that will not reach the consumers within 91 days

(the length of the seasons of the year). Nor does it include goods that are moving too slowly or not at all (e.g., a store of goods held in anticipation of a price rise; goods to be sold on an installment plan; specialty and collectors' items, such as the surgeon's knife or artwork, which may or may not find an ultimate buyer within 91 days).

As we shall see, the volume and composition of social circulating capital is completely flexible. The dividing line between items that do or do not belong to it is subject to the change of the whim and fancy of the sovereign consumer on the shortest possible notice. Skipping ropes, as a rule, are not a part of social circulating capital — except during periods of skippingepidemic among schoolgirls. are part of social circulating capital are liquid in their own right and on their own merit, merely by virtue of their proximity and fast pace of movement to the consumer, which is mirrored by the bills drawn on them. The emergence of the bill market has made the circulation of purchasing media elastic. Henceforth only finished goods are sold against cash at the retail counter; semifinished goods at various stages of production and distribution are traded against bills of exchange (equivalently, against bank deposits created by a commercial bank upon the collateral security of such bills). Before the end of each quarter all transactions are cleared, and all outstanding bills are paid out of the proceeds of the final sale of first-order goods into which fast-moving higher-order goods have matured.

### The marginal shopkeeper

For the purposes of our analysis changes in the volume of social circulating capital, and changes in its composition, are of the highest importance. We shall now see how those changes are put into effect through arbitrage between the bill market and the consumer goods market. The arbitrageur is none other than the marginal shopkeeper.

He makes the crucial decision which items to put on the shelf and which ones to withdraw. In these decisions he is guided by one considerations alone: the wishes of the sovereign consumer. For this reason, the propensity to consume can be identified with the volume or composition of social circulating capital. In fact, volume and composition are changing together. An increase (decrease) in its volume is manifested by an increase (decrease) in the variety of the component parts of social circulating capital.

### Liquidity

The risks and uncertainties, so characteristic of production in the early stages, all but disappear by the time the goods become part of social circulating capital. Speculation and other forms of risk-taking give way to the automatic and highly predictable processes of distribution. The reduction or disappearance of uncertainty and risks, occurring pari passu with the maturation of goods on their way to the final consumer manifests itself in a most dramatic fashion in the form of liquidity. The movement of merchandise in great demand is mirrored by the opposite movement of bills of exchange. Liquidity refers to the spontaneous circulation of goods and bills of exchange. Goods which It is curious that the agency translating the wishes of the sovereign consumer into changes in the stocks of retail shops through arbitrage between the bill market and the consumer goods market has escaped the attention of economists. The details are as follows. Each merchandise on the shelf of the shopkeeper has its own productivity measured by a ratio. This is the ratio between the percentage of the retail markup and the average length of the sojourn of this merchandise on the shelf (with due allowance to overhead costs). Thus, if the retail markup on \$1 worth of sauerkraut is

½ cent, and the average sojourn of a bottle of sauerkraut on the shelf is three months, then the productivity of sauerkraut is

½ ÷ 3/12 = 2% per annum. which the opportunity cost of carrying the marginal item on the shelf becomes critical to the marginal shopkeeper (the first shopkeeper to change the composition of his stocks in response to changes in the propensity to consume). The reference is to the marginal shopkeeper's opportunity to carry in his portfolio bills drawn on other shopkeepers against faster-moving merchandise, rather than carrying on the shelf a marginal item. Indeed, the marginal shopkeeper is the arbitrageur who lets his stock of marginal merchandise run down without replenishing it while buying bills with the proceeds from this saving whenever the propensity to consume declines. This is arbitrage between the bill market and the consumer goods market. It enables the marginal shopkeeper to participate in the earnings of others operating with a higher productivity, thereby smoothing out variations in his income due to seasonal and other variations in demand. The marginal shopkeeper is also doing arbitrage in the opposite direction. As the propensity to consume rises, he sells bills from his portfolio and orders some heretofore submarginal item which he may now be willing to carry on his shelves.

We shall now see that the rate of the marginal productivity of social circulating capital varies inversely with the propensity to consume: the lower the propensity, the higher is the rate of productivity, and vice versa. Slackening consumer demand increases the length of the sojourn of the marginal item on the shelf of the marginal shopkeeper. He will react by eliminating the old marginal item from the shelf. The new marginal item must have a higher productivity, otherwise it would also be eliminated. Thus lower propensity to consume brings about an increase in the marginal productivity of social circulating

### Marginal productivity of social circulating capital

Merchandise with the lowest productivity on the shelf of the marginal shopkeeper, called the marginal item of social circulating capital, is critical to this analysis. This is the first item that will disappear from the shelf.

As the propensity to consume declines, the marginal item will not be re-ordered by the marginal shopkeeper. No more bills will be discounted against its movement from the producer to the consumer. Another item on the shelf with a higher productivity will take its place as the marginal item. Conversely, as the propensity to consume rises, the marginal item is the new merchandise that is introduced on the shelf. Effective immediately, bills can be discounted against its movement to the final consumer. It replaces another item with a higher productivity.

The productivity of the marginal item is called the rate of marginal productivity of social circulating capital. It is the rate at capital. The converse is also true. In case of a brisker demand for consumer goods the marginal shopkeeper can afford to widen his offering of goods. He will display a new marginal item on the shelves with lower productivity than the old marginal item.

Thus higher propensity to consume thus brings about a decrease in the marginal productivity of social circulating capital.

This arbitrage of the marginal shopkeeper between the bill market and the consumer goods market is the centerpiece of disequilibrium analysis of price formation at the retail level. But what is the signaling system that carries information back-andforth between shopkeepers concerning the propensity to consume and the marginal productivity of social circulating capital? that the discount rate is in fact identical with the rate of marginal productivity of social circulating capital. In order to prove this, first assume that the rate of marginal productivity of social circulating capital falls short of the discount rate. Then there is a spread between the two rates and, hence, a profitable arbitrage opportunity exists for the marginal shopkeeper. He can sell out his marginal merchandise and buy bills of exchange with the proceeds. Clearly, this activity of the marginal shopkeeper lowers the discount rate while it increases the rate of marginal productivity of the social circulating capital. This arbitrage will continue until the spread between the two rates is closed. The same argument, mutatis mutandis, shows that the spread between the two rates will also be closed in the case when the discount rate falls short of the rate of marginal productivity of the social circulating capital. In any case, the two rates are equalized, and we are justified in identifying them.

It is important to realize that a rise in the discount rate is heralding a fall in the propensity to consume, telling the marginal shopkeeper to discontinue the marginal item, making social circulating capital shrink.

Conversely, a fall in the discount rate there is heralding a rise in the propensity to consume, telling the marginal shopkeeper to introduce a new item on his shelf, making social circulating capital expand.

The arbitrage of the marginal shopkeeper between the consumer goods market and the bill market is analogous to (but conceptually quite different from) the arbitrage of the marginal entrepreneur between the stock market and bond market, which is a regulator of rate of interest. Comparison of the two arbitrage operations reveals that the discount rate is fundamentally different from the rate of interest. The forces driving these

### The discount rate

This signaling system is embodied by the discount rate. It is a change in the discount rate which alerts shopkeepers that coordination between the propensity to consume and the marginal productivity of social circulating capital has become necessary.

The discount rate is determined by the rate of the marginal productivity of social circulating capital. This is just the rate at which the opportunity cost of carrying the marginal item on the shelf becomes critical to the marginal shopkeeper. He is the first one among the shopkeepers to eliminate the marginal item from the shelf at the next uptick in the discount rate (conversely, to display a new marginal item on the shelf at the next downtick) — in view of his opportunity to carry in his portfolio bills drawn on other shopkeepers against fastermoving merchandise, rather than carrying slow-moving items on his shelves.

The short version of this theorem asserts rates are different. The engine bringing about a change in the rate of interest is a change in the propensity to save, while the engine bringing about a change in the discount rate is the change in the propensity to consume. In either case, the rate varies inversely with the propensity.

Of course, the person of the marginal shopkeeper and his choice of the marginal item x are subject to change. In choosing x the marginal shopkeeper is simply trying to read the mood of the sovereign consumer.

When another shopkeeper takes over that role from the first, his choice of the marginal item x' may well be different from x. In effect, he is comparing the productivity of x' to that of x. Indeed, at the time when the discount rate undergoes a change hundreds of different people may, one after another, play the role of the marginal shopkeeper, while x sweeps through a large number of candidates to serve as the marginal item of social circulating capital.

This picture can be simplified if we personify the marginal shopkeeper and imagine that he is the gate-keeper acting on behalf of the sovereign consumer. He admits some items to social circulating capital while expelling some others. He constantly examines the credentials of items within his purview. He admits x whose productivity is higher, and expels x' whose productivity is lower than the discount rate. This, then, is the mechanism whereby the market integrates the scattered knowledge and power residing in individual shopkeepers concerning the marginal productivity of social circulating capital. This, then, is the intelligence whereby the mood of the sovereign consumer is perceived. The relevant information is crystallized in the form of a single variable, the discount rate.

### Theory of the retail trade

It follows from the foregoing disequilibrium analysis that the law of supply and demand does not apply in the retail trade. The adjustment mechanism works, not on the prices of goods, but on the marginal productivity of social circulating capital or, what is the same, on the discount rate. An autonomous increase in demand for fastmoving consumer goods has no inevitable effect on prices but will, instead, lower the discount rate. This is synonymous with an instantaneous increase in the volume of the social circulating capital, that is, the supply of consumer goods. Increased demand automatically brings out an equivalent increase in supply. A decrease in demand has the exact opposite effect. There is no such thing as an autonomous change of supply in the retail trade: supply is closely regulated by demand through the mechanism of the bill market and the discount rate. The coordination problem, as applied to the retail trade in consumer goods, is solved by arbitrage operations of the marginal shopkeeper between the bill market and the consumer goods market. He is the gatekeeper who regulates the entry of consumer goods into social circulating capital.

### Critique of the quantity theory of money

Equilibrium economics, more especially the quantity theory of money (the latter-day champion of which is Milton Friedman), holds that a regime of floating foreign exchange rates is absolutely necessary as a balancing mechanism of foreign trade. If a country imports more than it exports, then the value of its currency will drop in the foreign exchange markets. As a result, the price of imported goods will rise, limiting imports and, at the same time, the price of this country's exports in foreign markets will drop, boosting exports. These effects redress trade imbalance. As a corollary, it is further asserted that if a drop in foreign exchange rates does not occur on its own accord, then the government is fully justified in pushing them down by hook or crook.

This is a vicious theory concocted to justify the government in engineering a destruction of the value of the currency. For decades, the U.S. government has been trying to reverse its unfavorable trade balance with Japan by crying down the value of the dollar. However, in spite of the great "success" of the U.S. government to debase its currency, trade imbalance has continued to worsen. It showed signs of abating only when the Japanese government also started debasing its own currency, the yen.

Disequilibrium analysis shows that if a country runs export surpluses, this will not cause an inevitable increase in domestic retail prices as predicted by equilibrium theory. The discount rate will drop in response to the inflow of foreign exchange.

Merchants will draw bills on foreign countries with a higher discount rate. This will repel the invasion of foreign exchange.

Higher consumer demand will be met by an expanded offering on the shelves of the shopkeepers, thanks to the lower discount rate. By the time the consumer is ready to spend the extra income, the extra merchandise will be in place. Conversely, if a country is stricken with a bad harvest or by some other natural calamity destroying crops, property, and goods, then there will be an immediate increase in the discount rate. Retail prices will not rise inevitably.

The stricken country, thanks to its higher discount rate, is an attractive place on which to draw bills. This translates into an immediate influx of short-term capital from abroad in the form of the most urgently needed consumer goods.

Of course, if the bill market is sabotaged through government intervention (in allowing the banking system to preempt the spontaneous circulation of bills of exchange), then the influx of foreign exchange will spill over to the stock, bond, and real estate markets, where rampant speculation may cause huge price increases.

This may indeed lead, in due course, to a collapse — as it has happened in Japan, and as it will probably happen in the United States. The collapse must squarely be blamed on the vicious equilibrium theory of foreign exchange suggesting that trade imbalances can be cured by governmentinspired debasement of the currency.

Disequilibrium theory treats the problem of trade imbalances as a coordination problem. It analyses short-term capital movement as it responds to the widening spread between the discount rate and the marginal productivity of social circulating capital. It takes into account arbitrage between the bill market and the consumer goods market. The mechanical quantity theory of money and other equilibrium theories are blind, barren, and misleading.

## Summary

The disequilibrium analysis of retail trade and of short-term capital movements across international borders gives us an insight strikingly different from that offered by equilibrium economics and the quantity theory of money. In the retail trade, the law of supply and demand does not apply. An increase in the volume of purchasing media due to higher spending has no inevitable effect on prices but will, instead, lower the discount rate. This is equivalent to an increase in the marginal productivity of social circulating capital. Hence, increased demand automatically and instantaneously brings out an increased supply sufficient to accommodate it without an increase in prices. Price changes, whenever they occur, reflect other changes, having to do with the competition of producers and consumers.

In case of an influx from abroad of short19 term capital foreign exchange first flows the bill market. It causes bill prices to rise. This is tantamount to a fall in the discount rate.

Excess foreign exchange is absorbed by a commensurate increase in social circulating capital. Conversely, in case the country is losing short-term capital, foreign exchange is drained from the bill market. Bill prices fall, causing a rise in the discount rate. The outflow of foreign exchange corresponds to a shrinkage of social circulating capital.

There is no reason to assume that across-theboard price changes take place in unison with an inflow or outflow of short-term capital.

The static, black-and-white and onedimensional supply-and-demand equilibrium analysis of price formation is superseded by a dynamic, full-color, three dimensional bidasked disequilibrium analysis, provided that we put arbitrage into the center of inquiry.

Then can we present the problem in its proper context as a coordination problem.

The price-quantity nexus of old-line equilibrium analysis is replaced by the multivariate price-quantity-quality nexus.

Input and output become variables in their own right, as indeed they are in real life.

There is no need to pay lip-service to a spurious supply-demand equilibrium.

We have seen that the marginal shopkeeper is doing arbitrage between the bill market and the consumer goods market, the outcome of which is the discount rate.

Similar to this, although not treated here, is the arbitrage of the marginal producer between the bond market and the stock market, the outcome of which is the ceiling for the rate of interest; as well as the arbitrage of the marginal bondholder between the gold market and the bond market (i.e., between present goods and future goods), the outcome of which is the floor for the rate of interest. These are instances of arbitrage, examples of marginalism introduced by Menger, the prototype of which is the arbitrage of the marginal consumer between the consumer goods market and cash; and that of the marginal producer between the consumer goods market and the producer goods market the outcome of which is the asked and bid price. Every one of these instances of arbitrage is a manifestation of the coordination problem in economics as it starts from a state of relative disorder, or a lower state of coordination, and ends at a higher state of coordination, as measured by the asked and bid price of consumer goods, the asked and bid price of bonds (i.e., the ceiling and the floor for the rate of interest) the discount rate, etc.

We still have the two poles of contest. The formation of prices, the discount rate, etc., is still seen as the result of a reconciliation between a pair of opposing forces

(represented by the arbitrageur and the marginal arbitrageur). Yet it is more appropriate to describe ours as a disequilibrium model. The marginal arbitrageur is not a person but a role played by different protagonists changing the role from one moment to the next. Moreover, each protagonist playing that role may have a different set of values, different preferences, opportunities, foregone alternatives, and he may have a different time-horizon. Only the disequilibrium analysis of price formation can, when worked out in full detail, account for these differences. Only disequilibrium analysis can bring out the coordination problem confronting the entrepreneur, the producer, and the shopkeeper, not to mention the consumer himself.

Only the disequilibrium analysis of price formation can qualify as a theory of action.

The old-line equilibrium paradigm is a theory of non-action. It is tantamount to a stage production of Hamlet in which the Prince is not allowed to appear.

## References

### [1]

Carl Menger, Principles of Economics, New York: N.Y.U. Press, 1981 (Originally published in German under the title Grundsätze der Volkswirtschaftlehre in 1871)

### [2]

Friedrich A. Hayek, Prices and Production, New York: A.M. Kelley, 1967 (Originally published in 1931)

### [3]

Ludwig von Mises, Human Action, Chicago: Henry Regnery, 1963 (Originally published in 1949)

### [4]

Israel M. Kirzner, Market Theory and the Price System, Princeton: Van Nostrand, 1963

### [5]

Israel M. Kirzner, Competition and Entrepreneur ship, Chicago: U. Chicago Press, 1973

### [6]

Jesús Huerta de Soto, The Ongoing Methodenstreit of the Austrian School, Journal des Economistes et des Etudes Humaines, vol.8., no.l, Mars 1998, pp 75-113

### [7]

Antal E. Fekete, Towards a Dynamic Microeconomics, Laissez-Faire (Revista de la Facultad de Ciencias Economicas, Universidad Francisco Marroquín, no. 5.,

### Septiembre de 1996, pp 1-14

---

*January 1, 1999*

=========================
Money & Credit
=========================
# The Eighth Pillar of Sound Money and Credit: The Principle of Matching Maturities

URL: https://newaustrianeconomics.com/archive/fekete/the-eighth-pillar-of-sound-money-and-credit/
Date: 2005-09-01
Section: Money & Credit
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, real-bills, debt, bond-market
Description: The eighth pillar holds that the maturity of liabilities must match the maturity of assets. Borrowing short to lend long — the essence of modern banking — destroys the self-correcting mechanism of the gold standard and creates systemic fragility that can only end in collapse.
Editorial Note: Eighth in the ten-part Sound Money and Credit series (2005). Maturity matching is the microeconomic principle that prevents the banking system from pyramiding credit on top of illiquid long-term commitments.
Original PDF: https://professorfekete.com/articles/AEF8thPillarOfMoneyAndCredit.pdf

### September, 2005

*The Eighth Pillar Of Sound Money And Credit The Principle Of Matching Maturities*

**Antal E. Fekete** · Professor · Memorial University of Newfoundland e-mail: aefekete@hotmail.com

### A Venetian Tale

A Venetian merchant lost his ship of cargo on the reefs of the Dalmatian coast. As he was sitting in a cove lamenting his loss, a mermaid appeared and inquired what was the matter. Feeling sorry for the merchant who lost his entire fortune in the accident, she dived into the sea and brought up a boat laden with silver, and asked him if that were the boat he had lost. When the man said that it wasn't, the mermaid dived again and fetched up the merchant's own boat. "That's the right one." he said gratefully. The mermaid, so delighted with his honesty made him a present of the other boat as well.

When he returned to Venice and told his colleagues about his good fortune, one of them thought that he could pull off a similar coup. He loaded his boat with merchandise, sailed to the Dalmatian coast and scuttled his ship. Then he sat down in the cove and wept. The mermaid appeared again. Upon hearing the cause of his tears, she dived and soon produced a boat laden with gold. asking if it were the same one that had been lost. The man, who has never seen that much gold in his life. cried ecstatically: "0 yes, indeed!" The mermaid was so shocked at this unblushing impudence that, far from giving him the boat with its gold cargo, she did not even restore his own to him. "You are not only a liar," she said, "but also an impostor." She sailed away leaving the man alone in the deserted cove.

### The propensity to save

As we have seen in the Seventh Pillar, there is a significant difference between commercial banking and investment banking (including savings banks). The former depends on the people's propensity to consume, and the latter, on their propensity to save.

The banks pool the flow of savings from individuals, and make this pool feed the flow of investments to every part of the national economy. The banks borrow funds from the savers for various fixed terms, and lend them out to producers, entrepreneurs, speculators, for various fixed terms. The banks have a double balancing act; they must balance their liabilities with assets not only dollar for dollar, but also maturity for maturity. That is to say the banks must see to it that their assets mature no later than their liabilities. This is known as the Principle of Matching Maturities.

Since there is no investment without prior saving, the minimal rate of interest is determined by the propensity to save (or by its reciprocal, time preference). The higher the propensity to save, the lower is the minimal rate of interest (or, the lower the time preference, the lower is the minimal rate of interest) and conversely.

### Borrowing short and lending long

The Principle of Matching Maturities is often quoted in its negative form: a bank must not borrow short and lend long. This is the one commandment most often violated by the banking fraternity. To understand the underlying temptation, we have to examine the source of bank profits. The investment bank derives its profits from the spread between the interest it earns on its assets and the interest it pays on its liabilities. The bank could, illegitimately, increase its profits by borrowing short at an even lower rate, and lend long at an even higher rate because longer term borrowing and lending normally command higher interest rates. The bank guilty of this illegitimate practice is an impostor, as it misrepresents the true state of affairs in the balance sheet, just as the greedy Venetian sailor misrepresented his situation to the mermaid.

The practice of borrowing short and lending long is no less dangerous than it is illegitimate. The bank would obviously have to borrow again and again, before its assets matured. No one knows the future, and the bank is no exception. Future borrowing conditions may be worse than those at present. The bank may be confronted with borrowing costs higher than the earnings it has locked itself into or, in an extreme case, the bank may not be able to borrow at any price.

A bank guilty of borrowing short and lending long is not only an impostor but a liar as well. It lies in overstating the value of its assets and understating its liabilities in the balance sheet. The bank in fact pretends that it can use short term funds to balance its long term liabilities.

### Short debt makes long friends

The American banking system is in deep trouble on account of its long-standing addiction to the drug of borrowing short and lending long. Worst offenders are the savings banks loaded with mortgages maturing in 20 years or longer, held against liabilities maturing daily. That this situation is preposterous should be clear to every impartial observer. The bank has sunk liquid funds into brick and mortar, against which it holds liabilities subject to withdrawal without notice (or on short notice). The banks are sitting on mountains of paper losses, which will become real losses at the first test of extensive cash withdrawals.

Federal deposit insurance is hardly a fig leaf. The assets of the insurer cover only a minuscule part of its contingent liabilities. Worse still, these assets are carried in the form of government securities, and even a minor asset liquidation would embarrass the government and break the market.

Had the American banks taken to heart the ancient wisdom of the English proverb: "short debt makes long friends." They could have avoided diverting enormous resources into loan-loss reserves.

### Vicious circle

If bank liabilities mature faster than bank assets, then two things will happen. (1) Interest rates will rise, as the banks are forced to resort to asset-liquidation, and the public will acquire these assets only at a concession in price. (2) The maturity structure of the debt will shrink, as the banks are forced to issue short-term debt in exchange for long-term debt. In other words, the banking system, led by the central bank, is forced to finance a massive exodus of the savers from long to short term debt. As the banking system has to absorb more and more long-term debt, unwanted by the saving public, and give shortterm credit in exchange, it becomes clear that the only cure for the condition caused by that drug abuse is more drug abuse.

The central bank is helpless. Any hesitation on its part to make available the reserves needed to meet the maturing liabilities of banks would bring down the house of cards immediately. The central bank would therefore continue to buy the long-term bonds dumped by a disgruntled public. That is to say the central bank would continue to borrow short and lend long on an ever larger scale.

The vicious circle, however, cannot continue indefinitely as the average maturity of the debt cannot shrink to zero. Before that happens the bond market, like a rotten apple, will fall into the lap of the money market. The money supply will explode, the supply of savings will implode, and the new brave world of borrowing short and lending long will come to a sorry end.

---

# The Fifth Pillar of Sound Money and Credit: The Principle of Fiscal Policy

URL: https://newaustrianeconomics.com/archive/fekete/the-fifth-pillar-of-sound-money-and-credit/
Date: 2005-09-01
Section: Money & Credit
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, debt, capital-destruction
Description: The fifth pillar demands balanced budgets enforced by the gold standard: governments cannot run persistent deficits when they cannot print money. Fekete argues that deficit spending under fiat currency is a hidden tax that destroys capital and ultimately collapses into hyperinflation or hyperdeflation.
Editorial Note: Fifth in the ten-part Sound Money and Credit series (2005). Fekete's fiscal principle is that the gold standard is not merely a monetary arrangement but a constitutional constraint on government spending.
Original PDF: https://professorfekete.com/articles/AEF5thPillarOfMoneyAndCredit.pdf

### September, 2005

*The Fifth Pillar Of Sound Money And Credit The Principle Of Fiscal Policy*

**Antal E. Fekete** · Professor · Memorial University of Newfoundland e-mail: aefekete@hotmail.com

### A Chinese Tale

Once upon a time there were, in China, two great cities: Chin and Chan. They were connected by a magnificent canal. One day the Emperor sent for his chief mandarin, Ching, and said: "Look yonder". Ching opened his eyes and looked. And he saw scores of barges laden with cargo, plying between the ports of Chin and Chan. The Emperor then commanded: "We must stop that traffic, in order to increase employment in the Celestial Empire. You will have huge blocks of stone thrown into the canal to put it out of service." At first Ching did not see the point. and said: "Son of Heaven, you are making a mistake." However, the Emperor's mind was made up, and he said: "Ching. do as you are bid. We are going to stimulate the economy. You come back after three moons have passed, and take another look."

When he came back. the Emperor said: "Look yonder." As he looked. Ching saw thousands of carts and innumerable pedestrians carrying heavy burdens on their shoulders, as they were making their way from Chin to Chan, and from Chan to Chin.

They looked like a swarm of migrating ants. The Emperor declared: "It was the destruction of the canal that provided jobs for these poor people. We shall make it public policy to stimulate the economy by all available means." Chin remarked in admiration: "I should have never thought that the government could create so many jobs so quickly and so easily."

When the Emperor died, his successor sent for Ching and ordered him to have the canal reopened. Ching prostrated himself nine times and said to the new Emperor: "Son of Heaven, you are making a mistake." But the Emperor was adamant: "Do as you are bid.

We must facilitate the movement of people and goods between Chin and Chan, by making transportation less expensive. Then the people may have rice, tea, and silk at a lower cost." Ching thought he was ready with the answer: But what is the use of lower prices, if no one can pay them, because everyone is unemployed?" The Emperor was losing his patience: "Ching, you are talking like a fool. Come back after three moons have passed, and take another look."

When Ching came back, the Emperor said: "Look yonder." Ching looked and saw more traffic in the canal than anybody had ever seen before. The barges were moving day and night, bumper to bumper, there was no hint of unemployment. The Emperor dismissed Ching with these words: "You can divert and displace labor, but you can never create new employment by erecting obstacles. Remember the wisdom of the old sages, that the secret of good government is to leave people alone."

### Quality of credit

The sole aim of fiscal policy is to keep the credit of the government at the highest possible level and above all suspicion. This principle implies that the government borrows only if it can see the revenues which, in the years coming, will be available to retire the debt. If this principle is respected, then the rate of interest will be stable, and it will be the lowest possible rate consistent with economic conditions. Otherwise, the rate of interest will be higher and unstable. Moreover, the rise and instability will be commensurate with the extent to which this principle has been compromised. This will make it difficult for some and impossible for other private producers of wealth, to reinforce their enterprise by borrowing.

The quality of credit in a country cannot be higher than that of the government.

Therefore, the deterioration of the government's credit adversely affects every single producer in the country.

The canal carrying the trade between Chin and Chan symbolizes a national economy that respects the principle of fiscal policy. By deviating from this principle, the government puts the canal out of service. The blocks of stone symbolize the higher rate of interest which private producers of wealth pay after all the borrowing needs of the government are satisfied. This would not stifle the national economy but would certainly render it more inefficient. A dilution of the principle of fiscal policy is usually couched in a language which would appeal to those susceptible to demagogy. Deficit spending is called "priming the pump," "an essential stimulus to the economy," indispensable to the maintenance of full employment. Yet it is clear that the stimulus of deficit spending is at best dubious in the short run, and completely absent in the long run. The short-term effects have the nature of prestidigitation, as government spending can be targeted to pockets of slow economic activity in order to produce spectacular results. It is the longrun effects where the damage to the economy becomes visible.

### Accumulation of public debt versus accumulation of capital

The accumulation of public debt is a convenient trick through which a temporary semblance of prosperity may be achieved. In the long run, however, this policy will only aggravate the situation, as it harms the economy by weakening productive capacity. The longer the government succeeds in maintaining false prosperity by increasing public debt, the greater the ultimate damage.

Mainstream economists ridicule this concern about the negative effects of the rising public debt on future economic growth. There is no way - so the argument goes - to shift the economic burden to future generations. You can only consume what has been produced. Under these circumstances, how can a nation live beyond its means? This argument is designed to appeal to simpletons. The basis for all economic growth, rising real per capita income, increased production and consumption, is the result of entrepreneurs investing their own and other people's funds in more and better tools, which permits a steady increase in man-hour productivity. Economic growth, and a rising standard of living, are ultimately dependent upon uninhibited capital accumulation.

Capital accumulation, however, is not an automatic process regulated by mother nature.

To produce capital goods - factories and machinery - a corresponding amount of productive facilities must be released from other employment. It is not enough that technology and know-how is available to create new factories and modern machinery.

Investors and businessmen must be willing to accumulate capital by doing the necessary investing. Furthermore, the creation of credit must not be confused with capital accumulation. People see idle factories and wonder why they cannot be used to produce the much-needed goods, with the aid of easier credit, if necessary. They fail to understand that the plants have become obsolete because adequate reserves were not set aside for depreciation and replacement. Or, if it is a new plant, people fail to understand that its construction in the first place was based on a miscalculation due to the false signal of easy credit. Rising costs have made a profitable operation impossible. People find it hard to see the thin edge of the wedge between capital accumulation and capital decumulation.

Capital decumulation, therefore, is the result of government action, such as the departure from the principle of fiscal policy. As the government creates more money and credit through deficit spending, prices and wages rise. Operating costs tend to rise faster than revenues, thus reducing profits. The result is idle factories and idle men. In short, the effect of deficit spending is more of the same condition that it was supposed to eliminate in the first place. Thus a vicious circle is put into place: deficit spending creates idle capacity and unemployment, which then call for more deficit spending, to create still more idle capacity and more unemployment.

### Kick the garbage upstairs

There are those economists who suggest that the process of deficit spending can continue indefinitely. According to them, the public debt need never be repaid. It can go on growing indefinitely as long as a stable relationship between the debt and the gross national product is maintained. In the Ninth Pillar we shall see why this is a fallacy. Here we may content ourselves with the observation that accumulating debt at the expense of accumulating capital is like dumping garbage in the attic. At one point, the attic is bound to give way and all the garbage will come crashing down.

---

# The First Pillar of Sound Money and Credit: The Principle of the Gold Standard

URL: https://newaustrianeconomics.com/archive/fekete/the-first-pillar-of-sound-money-and-credit/
Date: 2005-09-01
Section: Money & Credit
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, fiat-currency
Description: Fekete introduces his ten-pillar framework for sound money and credit with the first and most fundamental pillar: the gold standard. Using a Chinese tale about imperial foot-length, he shows how any monetary standard that depends on government fiat is inherently unstable, while gold provides an objective, manipulation-proof measure of value.
Editorial Note: The first in a ten-part series from Gold Standard University (2005), laying out Fekete's comprehensive theory of sound money. Each pillar identifies a principle whose violation leads to monetary disorder.
Original PDF: https://professorfekete.com/articles/AEF1stPillarOfMoneyAndCredit.pdf

### September, 2005

*The First Pillar Of Sound Money And Credit The Principle Of The Gold Standard*

**Antal E. Fekete** · Professor · Memorial University of Newfoundland e-mail: aefekete@hotmail.com

### A Chinese Tale

Once upon a time the standard of measuring length, the foot, was defined in China as the length of the foot of the emperor. A change of the standard occurred upon the death of the old emperor, as a proclamation heralding the length of the foot of the new emperor was made. Later emperors discovered to their delight that they did not have to die in order to bring about a change of the standard. Imperial pleasure could proclaim a change in imperial footage at any time.

The ropemakers of the Celestial Empire learned to live with this capricious and whimsical system. They withheld production when they suspected that a shrinkage of the imperial foot was imminent. One day the ropemakers became even smarter. They formed a lobby in the Celestial Court, to persuade the Son of Heaven to have his toes amputated in order to make the imperial foot even shorter. This was thought to have a salutary effect on the ropemaking business. When, however, the people of the Celestial Empire found out what was afoot at their expense, they rose in anger, beheaded the emperor, and made the new emperor declare the length of a platinum rod as the official standard. It was thought that platinum was impervious to changes inspired by minority pressure groups.

### How to replenish water in New York City's water reservoir

The basic characteristic of any good standard of measurement is that of fixity. And a nation has no standard of measurement more important than its standard monetary unit, because its money reaches and affects virtually every activity of all its people in domestic commerce as well as in foreign trade.

Changing the standard of value, or the devaluation of a currency is like the amputation of one's arm or leg: it is a great misfortune. Informed people do not engage in either sort of amputation unless it is unavoidable. We pride ourselves on being infinitely more scientific than the Celestial Empire of old. as we define the unit of length in terms of the wavelength of the orange color in the light spectrum. Nowadays, we respect such standards of measurement as the foot, the pound, the gallon, etc.

For example, if the water supply of New York City is depleted, say by one-half, Congress could conceivably change the definition of the gallon to one-half of the original as the easiest way to restore the number of gallons in the reservoir and forestall panic among city dwellers. But Congress knows that such tampering would be unscientific. Changing the definition of the gallon would do nothing to restore the original amount of water in the reservoir, while it would cause havoc at the gas pump. Congress knows that people would see through the mischief and would react unfavorably to the farce.

### When best is worst, and worst is best

When it comes to the standard of monetary value, which also serves as the standard of deferred payments such as pensions and life insurance, a peculiar confusion and inconsistency reveals itself. As national profligacy depletes the reservoir of wealth in the country the Congress has found it expedient to resort to tampering with the standard measuring the quantity of wealth in the nation. Congress reduced the value of the monetary standard, the dollar, in order to conceal the alarming news from its constituents.

And in 1971, Congress abolished the standard altogether, when it abdicated its Constitutional responsibility by allowing the dollar to float. Today the length of the foot of the incumbent Chairman of the Federal Reserve Board is the effective standard, and it is up to him and his colleagues on the Open Market Committee to say what this length is.

The amazing thing is that we accept the alteration of the definition of the dollar when the things it is supposed to measure do not conform to their wishful thinking, although we would not accept the alteration of the definition of the gallon motivated by the same considerations. The explanation of this irrationality cannot apparently be compressed sufficiently for inclusion here. As though struck with a fever or some sort of madness, government officials and powerful groups of industrial and agricultural leaders took the position that a country with weak currency has an advantage over a country with a strong one, and that it is necessary to pull the strong currency down to the level of the weak. The worst currency is really the best, and the best currency really the worst.

### Squandering the wealth

In our wild embracing of this madness, we never settled down to state clearly just what is the target of currency depreciation or "goodness" in money The secret of that mystery is ostensibly in the hand of the currency manipulators who perform as though they had a hotline to Heaven. They never can bring themselves to face the logic of their basic position that, if a depreciated currency is better for our country than one based on a fixed monetary standard, the best currency would be the one having no value at all, and that country would gain most which simply gave away its goods and services. The extent to which the nation, and particularly its leaders in Washington, are afflicted by this phantasmagoria that we can maintain prosperity and increase our standard of living by giving away wealth should be apparent from the September 22, 1985 announcement of the plot by the Group of Five industrial nations to beat down the value of the dollar.

### The proper monetary standard

The typical currency system has various kinds of moneys in circulation, and it is the proper function of the monetary standard to keep the value of each unit of each kind of money equal to that of each unit of every other kind of money in the system. A standard monetary unit should be something which itself has value. It cannot be an abstraction, a legal fiction. It cannot be a promise to pay let alone an irredeemable promise. It must be material property commanding the most universal acceptability. To serve its purpose best, it should have a relatively high value in small bulk; it must be permanent, resistant to tarnish; it must be homogeneous, divisible without loss of value; and it must be readily recognizable. For these reasons gold has evolved, over thousands of years, as the material of which the monetary standard is made.

### Fate of a government prophecy

The value of gold is not derived from its monetary applications. Back in 1967 government economists prophesied that if the U. S. Treasury stopped bidding for gold. the dollar price of gold would drop, perhaps by as much as 50%. On March 15,1968, the U. S. Treasury and the cartel of central banks known as the Gold Pool withdrew their long-standing offer to buy unlimited quantities of gold - and the rest is history Refusing to fall, the dollar price of gold started rising immediately and has followed a checkered path upwards ever since. The government economists were wrong. The monetary economists who maintained that a dollar is a promise to pay a fixed amount of gold on demand, and that the repudiation of that promise cannot enhance the dollar's value, were right. Since March 15.1968, the dollar has lost almost 90% of its gold value - and a commensurate amount of its purchasing power.

### Marginal utility of gold

The most important quality of gold as monetary metal is its universal acceptability In technical economic language, the marginal utility of gold is constant in contrast with that of any other good, all of which have more or less declining marginal utilities. In other words, the acceptability of gold in exchange for goods and service does not depend on the amount of gold possessed by the parties to the exchange.

The recent collapse of the price of oil and tin* shows the rapidly declining marginal utility of these resources. Unlike gold. the acceptability of oil and tin depends on the amount in the possession of the market participants: the more they have. the less acceptable these resources become. Gold is the only commodity that can be offered in unlimited quantities in exchange for goods and services across all national boundaries.

Without apparently harming its exchange value. Moreover, gold is the only asset that individuals and governments will carry in the balance sheet without any promise of return to capital. Gold is the only asset that can balance a liability without being at the same time a liability of someone else. It is the only financial asset that can survive the consolidation of the balance sheets of any combination of individuals or governments. (*1985)

### Most abundant commodity on earth

Economics accounts for this anomalous behavior of gold. not by appealing to psychology or to human weaknesses such as vanity or superstition, but by appealing to logic. Even if we regard the choice of gold as monetary standard as an historical accident, by now gold is so firmly entrenched that its replacement is virtually unthinkable. Almost all the gold that has been produced since the dawn of history is still available in marketable form. The same simply cannot be said of other commodities. They all disappear in consumption.

The ratio of stocks of gold to annual production flows is a high multiple, estimated to be between 80 and 100. For other goods, the ratio of stocks to flows is a small fraction, e.g., 1:3 for copper. The latter is an interesting example because copper, like gold. also has a long and rich history including its history of monetary applications. Yet, if copper stocks were to double overnight, raising the stock/flow ratio to 2:3, then the price of copper would collapse and all but the most efficient producers of copper would be ruined. No matter how many marginal applications for copper we may find. the marginal utility of copper would be testing zero. i.e., copper would be a "free" good, like drinking water. By contrast, if the stock/flow ratio of gold went from 100 to 200, hardly anybody would take notice. Gold producers would continue to prosper. The increase in the ratio would be looked upon as another confirmation of the supreme confidence individuals have in gold as a store of value.

In these terms, gold is the most abundant commodity known to and produced by man.

Gold does not owe its value to its alleged scarcity On the contrary, gold owes its value to the fact that, in spite of its abundance and steady increase of abundance, gold continues to be in universal demand, and it continues to be acceptable in unlimited quantities. No other asset can match the record of gold in this regard. No other commodity can withstand the wear and tear the monetary standard is constantly exposed to.

Like the Chinese platinum foot, gold may not be a perfect standard, but it is the only conceivable monetary standard we have.

---

# The Fourth Pillar of Sound Money and Credit: The Principle of Monetary Policy

URL: https://newaustrianeconomics.com/archive/fekete/the-fourth-pillar-of-sound-money-and-credit/
Date: 2005-09-01
Section: Money & Credit
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, monetary-policy, federal-reserve
Description: The fourth pillar holds that there should be no monetary policy in the modern sense: no central bank discretion to expand or contract the money supply. Under a true gold standard, money supply adjusts automatically through the real bills market and the Mint, making activist monetary policy both unnecessary and dangerous.
Editorial Note: Fourth in the ten-part Sound Money and Credit series (2005). This pillar is the most directly polemical, targeting the Federal Reserve's mandate and the entire apparatus of discretionary central banking.
Original PDF: https://professorfekete.com/articles/AEF4thPillarOfMoneyAndCredit.pdf

### September, 2005

*The Fourth Pillar Of Sound Money And Credit The Principle Of Monetary Policy*

**Antal E. Fekete** · Professor · Memorial University of Newfoundland e-mail: aefekete@hotmail.com

### A Chinese Tale

Once upon a time the Treasury of the Celestial Empire was found empty The Emperor instructed Hwa, the Chairman of the Heavenly Research Council, to work out a plan to meet the emergency.

Hwa suggested that the Emperor assume the title "The Son of Heaven," thereby laying claim to supernatural powers. The Emperor would then inject words and phrases such as "targeting the money supply," "clean versus dirty floating," "the crawling peg," "semifixed standard," "snake in the tunnel," softening the bands of hard currencies," and so forth, into the public debate on money, thereby endowing these meaningless words with sacramental effects. The purpose of this exercise would be to induce men to give up actual goods and services in exchange for fictitious ones.

The Emperor went along with these proposals and debased the silver coins of the Empire, while retaining the coins' outward appearance. But the people refused to be duped, and they accepted the debased coins only at a discount. Hwa threw himself at the feet of the Emperor. "Son of Heaven, it is not enough for you to claim absolute power over the value of coins and over the destiny of the people. You must also forbid any examination of your claims. You must outlaw logic. All questions about currency depreciation must be tabooed. To ask them, to answer them, even to think of them must be declared an act of sacrilege, an unpardonable sin. Only then will people believe that coin-clipping is no self-mutilation, but rather the mutilation of their competitors. Only then will the coolie stop cursing and start blessing his yoke."

The Emperor was not impressed. "Hwa, you talk like a fool. Even a child can see through your theocratic fraud. All he need ask is whether the priest is the instrument of religion, or religion is the instrument of the priest. The proof that the people have been duped is that the priest is rich and powerful. He can taboo questions, he can adjust moral principles to suit himself. So your studied gestures and poses, your hieroglyphic messages are losing their effects because people observe your simony, the trafficking of relics. Seek as one may, there is no substitute for an informed and enlightened public opinion. It is the only remedy."

Then the Emperor recalled the debased coinage, and let it be known that hard times can be overcome if everybody worked, and saved, even harder. Before twelve moons had passed, the Treasury was once more replete with full-bodied silver coins.

### The biggest human exploitation

Today people take it for granted that "targeting the money supply" is a legitimate objective of monetary policy It wasn't always like that. In 1932, the Canadian economist and humorist, Stephen Leacock, could joke: "The gold standard has fallen into opprobrium. Awhile ago it looked as safe as the rock of ages, and now it is being relegated to the age of rocks. We have been learning some new economic truths. Consider the control of the money supply. What does it mean? A lot of flowery words have grown up around this. But if that means anything at all, it means that there will be a board, a committee of people who will, when they like, expand money or contract money and boost prices up or boost prices down. There will be three men in a room somewhere who will do that. If that time ever comes. I want to be one of the three, or at least a warm personal friend of all three." "Now I say this in all sincerity that the three-men-in-a-room stuff will do for the Soviets; it will not do for us. You cannot have a system of social controls dependent upon the will of three men in a room. You cannot have prices which can be moved up by a group in control. You cannot have wages which can be shifted down in their purchasing power by the good will of the men of the monetary caste. You must weigh that very very carefully.

The board, when it boosts prices up or down, would follow or be tempted to follow, all sorts of self-seeking ends. You cannot run society like that. If you try to have a money standard based on human interest or opinion, you have started the biggest human exploitations one can possibly imagine."

### The greatest virtue of the gold standard

The concept of the money supply is a spurious one, and the idea of targeting the money supply by open market operations of the Fed is a modern theocratic fraud, establishing the biggest scheme of human exploitation in history. The extent to which this method of plunder is practiced is in inverse proportion to the perspicacity of the people. It is in the nature of abuses to go as far as they can. Plunderers conform to the Malthusian law: they multiply in direct proportion with the means of existence - and the means of existence for knaves is the credulity of their dupes.

If God had made man a solitary animal, everyone would labor for himself, and individual wealth would be in proportion to the services that each man performed for himself. But since man is a social creature, services are exchanged for services. Moreover, to provide for certain needs such as security the members of society organize governments and agree to tax themselves in order to cover these needs. The government too is subject to the Malthusian law. It tends to expand in proportion to its means of existence which, in the last analysis, is nothing but the substance of the people. So when the government runs out of real services, it will continue to expand by offering fictitious services to the taxpayer. Targeting the money supply is one of the most reprehensible of these fictitious services.

In private transactions each party remains the sole judge of both values: the value of services rendered, and that of services received. The individual is perfectly free either to decline the exchange or to make it elsewhere. The greatest virtue of the gold standard is that the medium through which these services are exchanged is left outside of the political arena, and hence individual valuations remain as free of distortion as possible.

But when government starts targeting the money supply it interposes between the exchanging parties a medium which cannot be valued because it has, by design, no definable value. In combination with that fatal disposition, that one man could always be persuaded to live at the expense of others, this interposition by the government creates enormous disparities between the exchanging parties, while plundering both. The people are astonished to find that, while they hear of wonderful inventions that are supposed to save labor and multiply output without end, they are working as hard as ever and are still no better off than before. Meanwhile, things go from bad to worse and, at last, people open their eyes, not to remedy (for they have not yet progressed that far), but to the evil.

### Monetary policy under limited government

Targeting the money supply is an arbitrary and unlimited power, which is at variance with our Constitution and with the principles on which our government is based.

Constitutionally, the government has a carefully circumscribed responsibility in the realm of money. This is to see to it that the value of every kind of money in circulation, namely coins, bank notes, bank drafts, bank deposits, etc.. rigidly conforms to the standard unit of value, The government is charged with the responsibility of stabilizing the value of currency and is must not aggrandize its powers by destabilizing it.

---

# The Ninth Pillar of Sound Money and Credit: The Principle of Productivity of Debt

URL: https://newaustrianeconomics.com/archive/fekete/the-ninth-pillar-of-sound-money-and-credit/
Date: 2005-09-01
Section: Money & Credit
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, debt, real-bills, capital-destruction
Description: The ninth pillar holds that only productive debt — debt that finances the movement of goods from producer to consumer and retires itself from the proceeds — is compatible with sound money. Fekete condemns consumer debt, government debt, and speculative debt as forms of capital destruction that undermine the real economy.
Editorial Note: Ninth in the ten-part Sound Money and Credit series (2005). The productivity of debt criterion distinguishes Fekete's real bills doctrine from both hard-money absolutism and inflationist economics.
Original PDF: https://professorfekete.com/articles/AEF9thPillarOfMoneyAndCredit.pdf

### September, 2005

*The Ninth Pillar Of Sound Money And Credit The Principle Of Productivity Of Debt*

**Antal E. Fekete** · Professor · Memorial University of Newfoundland e-mail: aefekete@hotmail.com

### A Venetian Tale

Once upon a time a poor gondolier of Venice, having done a favor to the gnomes of the Piazza, was given a magic pepper mill that would grind out anything at a word. The gondolier, a modest man, used it only to keep flour and sugar in supply. But his brother, a wealthy salt merchant, upon learning of the mill, cajoled its secret word from the gondolier, stole the mill by night, and set out to sea for the markets in the Levant.

Eager to try his prize and fill his sacks he uttered the word, and the mill began to grind out salt. The vessel's holds were soon filled and salt began to cover the deck. The merchant now tried to stop the mill, but alas, he had forgotten to learn the other secret word. The ship began to settle, and finally sank, carrying with it the avaricious merchant along with the mill, where it still rests, at the bottom of the sea, grinding out salt.

And that, the tale concludes, is the reason why the sea is salty.

### Debt mill on the Potomac

Most observers worry about the inordinate growth of the money supply. But the growth of the money supply is merely a symptom, concealing a far more serious condition: the uncontrollable growth of dollar-denominated debt. The magic mill of the Venetian gondolier has been commandeered by the masters of the Federal Reserve System. They uttered the word, and enjoyed the sight of the uninhibited outpourings of cheap credit.

But the obverse of credit is debt, and the mill on the Potomac River started flooding the country with bad debt that can never be repaid. The new masters of the mill would like to stop it, but alas, they have forgotten to learn the other word. The nation's economy, overburdened with bad debt, has started sinking.

### In praise of debt

Debt is not bad per se. Debt embodies the symbiosis between the three progressive classes of people in the economy: the savers, the producers, and the inventors. Debt is the instrument facilitating the exchange of the wealth of the savers for income. Debt is the instrument facilitating the acquisition of state-of-the-art technology by the producers, in order that they may get the highest output per input of labor and capital for the benefit of everybody. Debt is the instrument facilitating the exchange of the future wealth of inventors for present income in support of research and development. Debt alone can make possible the extension of division of labor to generations that are far removed in time. Debt alone makes the emancipation of savings possible: saving is no longer antisocial as it was when the saving of a gold coin perforce meant a contraction of demand, prices, and output. Through debt as catalyst, saving is more beneficial than spending: the present wealth and income of savers find their way to the producers and inventors, and to the socially most beneficial applications.

### The danger of a debt meltdown

Debt, however, is not without its dangers. It is not unlike nuclear energy. It can be enormously beneficial if properly harnessed and constrained - but it can also be equally destructive if the harness and constraint are removed. Bad debt is like fissionable matter.

It can keep accumulating unobtrusively and without any apparent bad effects up to a point. But once this critical point is reached, a meltdown occurs. Proper safeguards in debt creation are therefore imperative.

The distinction between good and bad debt is not subjective or arbitrary. The quality of debt can be gauged by its productivity. This is the ratio of the net gain in GNP (gross national product) to the gain in debt. (The net gain in GNP is the excess of additional GNP over additional debt.) If this ratio is positive, then the new debt can be serviced out of current income, and the greater the ratio, the higher is the quality of debt. If the productivity of debt is allowed to decline significantly or, worse still, to become negative, then the debt can no longer be serviced out of income, and new debts have to be incurred to meet the maturing debt. The negative ratio is a clear signal that bad debt is now breeding more bad debt. A feedback is in effect, short-circuiting the economic process.

The debt-tower is growing out of control, and in due course it will self-destruct.

### Debt accumulation versus capital accumulation

The Principle of Productivity of Debt asserts that the ratio of net gain in GNP to the gain in debt must never be allowed to become negative. If this principle is observed, then debt is properly harnessed and constrained, and is socially beneficial, It makes a positive contribution to economic growth and public welfare.

We have long since passed the point when debt had a positive productivity in this country. Before 1960 it took less than one dollar of new debt to produce \$1 gain in GNP But in the 1960's, on average, it took \$2. in the 1970's it took \$5, and in the 1980's so far.

It's taken \$3.50 of new debt to produce the same \$1 gain in GNP. The growth of bad debt is accelerating.

It should be clear that this trend cannot continue indefinitely. The new debt has no economic justification. It does not produce the income to amortize itself, let alone a spendable income. Sooner or later the fantastic debt tower will topple, and bury the economy that prefers debt accumulation to capital accumulation.

### We owe it to ourselves

There are those economists who maintain that the public debt is just the other side of public investment and therefore its growth, far from alarming, is actually beneficial. The public debt need never be repaid. "We owe it to ourselves", they say pointing out that if a family goes bankrupt, it is never on account of internal family debts, but on account of debt owing to outsiders.

There has never been a more vicious misrepresentation of economic fact, The public debt is being serviced at the expense of the taxpayers, and if it will never be retired, then taxation can only grow worse. Moreover, the credit worthiness of the government can suddenly evaporate, if creditors lose all faith in the ability of the government to consolidate and eventually to retire the public debt.

Debt in the United States is presently (1985) increasing at the annual rate of 14%. Most of this inordinate increase can be accounted for by the high rate of interest, far in excess of the productivity of labor and capital. Interest payable on the debt must be created out of nothing, to keep the game of musical chairs moving. But the merry-go-round must stop sooner or later. The solution to the problem of debt is to bring down the rate of interest at once to the level of the productivity of labor and capital in this country. That part of the debt that can be serviced at the lower interest rate will be consolidated; the rest must be written off. Then creditors in the future will think twice before they lend to the government and businesses which bank on new credits to meet interest payments on old debts.

---

# The Second Pillar of Sound Money and Credit: The Principle of Free Coinage

URL: https://newaustrianeconomics.com/archive/fekete/the-second-pillar-of-sound-money-and-credit/
Date: 2005-09-01
Section: Money & Credit
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, gold-bonds
Description: The second pillar asserts that the Mint must be open to free and unlimited coinage of gold by anyone. Fekete argues that restricting coinage concentrates monetary power in the state and severs the link between the stock of money and the real economy's needs.
Editorial Note: Second in the ten-part Sound Money and Credit series (2005). Free coinage is the mechanism that makes the gold standard self-regulating rather than dependent on government discretion.
Original PDF: https://professorfekete.com/articles/AEF2ndPillarOfMoneyAndCredit.pdf

### September, 2005

*The Second Pillar Of Sound Money And Credit The Principle Of Free Coinage*

**Antal E. Fekete** · Professor · Memorial University of Newfoundland e-mail: aefekete@hotmail.com

### A Chinese Tale

Once upon a time money in China consisted of silver coinage issued by the Imperial Treasury. Since time immemorial, the main source of imperial revenue has been seigniorage, due to the limit the emperor placed on the number of silver coins in circulation. Consequently the Imperial Treasury could buy two pounds of silver from the people in exchange for coins containing only one pound, then turn around and mint it into twice as many silver coins. The difference was simply expropriated by the emperor.

As a result of this cruel exploitation, people of the Celestial Empire fell into the direst poverty. Money was exceedingly scarce. Parents were selling their children into slavery, and they killed their baby daughters when no takers were found.

The chief mandarin, Kwang, threw himself at the feet of the emperor, pleading thus: "Son of Heavens, have pity. People are suffering. Money is scarce."

The emperor made an edict providing for free coinage. From then on, people could take all the silver to the Treasury and get the same weight in silver coins in exchange.

Seigniorage was abolished. There was a great relief all over the Celestial Empire. A tremendous resurgence of agriculture and industry took hold. The humblest of coolies could pick and choose between jobs. People were becoming so prosperous that husbands started to embellish their wives with choice silver jewelry. Hardly twelve moons had passed when Kwang threw himself at the feet of the emperor once more and pleaded thus: "Sire, money is still scarce. The people want you to issue paper money in order to augment the circulation of silver coins."

The emperor, who was a wise man, answered: "Kwang, you are talking like a fool. You ask me to restore poverty that I abolished in this country twelve moons ago. I have given people the right to put their silver where their mouth is. If money is still scarce, they have only themselves to blame. Let them bring their jewelry to the Treasury, and we shall give them silver coins, pound for pound. If they really think that money is scarce, they have to prove it not by words, but by deeds. Remember, Kwang, it is not the abundance of money that makes people prosperous, but the unencumbered fruits of their own effort. By the same token, it is not the scarcity of money that impoverishes them, but exploitation that you now try to advocate."

And Kwang went off, tearing his beard, as he lamented: "0 Wo! 0 Fu! 0 Pe! 0 Li! And all the two-letter named gods of Cathay! Take pity on our people! For there has come to us an emperor of the Austrian School, who believes that people can lift themselves out of their misery by their own bootstraps! The emperor is deluded by the idea that wealth is created by the coolies! He no longer believes that the source of all wealth lies in the power to regulate the money supply."

### Beat scarcity

There will always be people who complain that money is scarce. Today, there is no answer to these complaints. In a true sense of the word, everything of value is scarce. The only way to abolish the scarcity of the dollar is to make it lose all its remaining value.

And there is a real danger that this is exactly what we are doing.

Money and money-substitutes have never been so abundant as they are today in the United States. Yet, if we are to believe the officers of Continental Illinois, and the directors of the savings banks in Ohio and Maryland, money is excruciatingly scarce in this country.

The only way to stop the vicious agitation against the scarcity of money is to put the power of issue where it belongs, namely into the hands of the people. This means free coinage of gold. When this is done, every citizen who believes that there is too little money in circulation can do something about it. He can take his old jewelry or his newly mined gold to the U.S. Mint, and convert it into the gold coins of the realm. After this fundamental right - guaranteed by the Constitution but abolished in 1933 - has been restored to the people, all cries about the scarcity of money can be exposed as frivolous gibberish.

### Latter-day slaves

The principle of free coinage also exposes the cruel exploitation to which the people of the United States have been subjected by the mandarins in the Treasury and on the Federal Reserve Board. The Constitution abolished bondage embodied by seigniorage in this country, but the bureaucrats have reimposed a more cruel seigniorage through the back door.

The rate of exploitation in the Celestial Empire of old was 2:1, as silver in the hand of the emperor was worth twice as much purchasing power as the same silver in the hands of the people. Today the rate of extortion in the United States is 35:1. As reported in The New York Times on July 21,1985, Michael Brown, a spokesman for the United States Mint in Washington, D.C.. explained that the Susan B. Anthony dollar, introduced in

1979, costs 3 cents each to make, allowing the government to pocket a profit of 97 cents.

Thus resources in the hands of the Treasury can create 33 times more purchasing power than the same resources in the hands of the people. The extra purchasing power is not created out of thin air: it is simply extorted from the people.

Mr. Brown used these figures to support his argument against melting down half a billion Anthony dollars which nobody seems to want. If the coins were melted down for the metal, the government would have to take a loss. "And we don't want to add half a billion dollars to the deficit," Mr. Brown was quoted as saying.

The rate of exploitation in the United States would be much higher if the calculation was based on the cost of printing bonds, which the Treasury can turn into cash at the Federal Reserve banks.

### Moloch of Managed Money

Irredeemable currency could be made to work in a free country only if every citizen were given the right to print and to dispose of his bonds on the same terms as the Treasury. But this would make the bonds and ultimately the dollar lose their remaining value. Therefore the regime of irredeemable currency can never be made to work, nor can it be made compatible with freedom.

The usurpation of the Constitutional right of the people to free coinage, and the reimposition of bondage embodied by the seigniorage, makes free citizens into slaves of the government. Moreover, the unemployed are like the innocent female infants in China, earmarked to be sacrificed on the altar of the Moloch of Managed Money.

---

# The Seventh Pillar of Sound Money and Credit: The Principle of Liquidity

URL: https://newaustrianeconomics.com/archive/fekete/the-seventh-pillar-of-sound-money-and-credit/
Date: 2005-09-01
Section: Money & Credit
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, real-bills, self-liquidating-credit
Description: The seventh pillar is liquidity: financial instruments must be graded by their liquidity, with only self-liquidating real bills qualifying as the most liquid form of credit. Fekete argues that the modern financial system has destroyed liquidity by allowing long-term illiquid assets to be funded by short-term demand liabilities.
Editorial Note: Seventh in the ten-part Sound Money and Credit series (2005). Liquidity in Fekete's sense is the ability of a bill to retire itself from the proceeds of the goods it financed — the foundational property of the real bills doctrine.
Original PDF: https://professorfekete.com/articles/AEF7thPillarOfMoneyAndCredit.pdf

### September, 2005

*The Seventh Pillar Of Sound Money And Credit The Principle Of Liquidity*

**Antal E. Fekete** · Professor · Memorial University of Newfoundland e-mail: aefekete@hotmail.com

### A Venetian Tale

Once upon a time, a wealthy merchant died in Venice. He was survived by his widow and three sons. His will listed a fortune consisting of 1000 gold ducats: and a wheat farm, a flour mill (both in Lombardy), and a bakery in Venice, each worth 1000 ducats. The old man's will ordered his whole fortune, worth 4000 ducats, to be divided equally among the four survivors. Another clause required that, in case of any disagreement between the survivors, the farm, the mill, and the bakery should be sold and the proceeds divided equally.

The eldest son wanted the farm, the middle son the mill, the youngest son the bakery while the widow was satisfied to have the gold.

The trouble was that no one knew where to find the gold mentioned in the will. Venice was full of the news that a spectacular lawsuit was in the offing, each survivor suing every other for embezzlement.

The Doge was a wise old man, who did not want to hear the survivors accuse each other.

So when they appeared before him and sued for justice, he asked the eldest son what kind of crop he expected to bring in. "At least 2000 bushels," was the answer. The Doge turned to the middle son and asked how much flour would 2000 bushels of wheat grind into. "At least 80,000 pounds," answered the middle son. Then the Doge asked the youngest son how much bread he can sell out of 80,000 pounds of flour. "At least 1000 ducats' worth," the youngest son answered.

At this point the Doge turned to the widow and said to her: "There is your 1000 gold ducats. You just have to help each other until the wheat matures into flour, the flour matures into bread, and the bread matures into gold."

As the Doge dismissed them, he said to the three sons: "According to the proverb, not all that glitters is gold. Your late father has now shared with you the last measure of his wisdom, which is this: A lot of things don't glitter at all, yet they may be well on their way to ripening into gold in your busy hands."

### Self-liquidating paper

Just as wheat ripens into gold by the time the flour is baked into bread, so does every other merchandise, at the time it is offered for sale to the ultimate, cash-paying customer.

We may express this ripening process by saying that, as the semi-finished goods become finished goods, they also become 'liquid.'

When a commercial bank makes a loan to a producer or distributor, the commercial paper that arises becomes the bank's asset. Commercial paper is considered liquid, if the underlying merchandise is liquid. Such paper is also called 'self-liquidating', because at the time the merchandise ripens into gold, the gold coin of the consumer will liquidate the loan.

By contrast, a loan to finance the construction of a building is not liquid, let alone selfliquidating, because it may take decades before the brick and mortar sunk into the building can amortize the construction costs. Further by contrast, a loan for carrying a speculative storage of goods is not liquid, because the goods are not moving, and they won't be sold before the bank loan matures. The financing of such slowly maturing projects should not be in the purview of the commercial banks; they should be left to the investment bank which uses actual savings for the purpose, as we shall see in the Eighth Pillar.

### Propensity to consume

Commercial banks do not depend on saved funds for their operation, as do investment banks. They finance trade by relying on the liquidity of maturing merchandise.

Commercial paper can and does circulate in the sense that a second bank will always be glad to acquire it as an earning asset if the first bank needs cash in a hurry.

Commercial paper is an earning asset because it is bought and sold at a discount below face value, the amount of discount being proportional with the number of days to maturity. The discount rate is inversely related to the "propensity to consume": the greater this propensity the lower is the discount rate, and vice versa. The commercial bank derives its profits from the fact that, while it has earning assets, it usually pays no return to its creditors on the corresponding liabilities (called bank deposits).

To summarize, whereas investment banking relies on the propensity of the people to save, commercial banking relies for its operation on the propensity of the people to consume. It is the propensity to consume that puts consumer goods on the move and makes commercial paper representing them liquid.

The highest quality commercial paper matures in 91 days or less. That time is just the length of the seasons, and consumer demand and consumption patterns do change with the seasons. If a certain type of merchandise cannot be sold in less than 91 days, then it cannot be sold for another 365 days, before the same season of the year comes around once again.

The Principle of Liquidity asserts that the earning assets of the commercial banks must consist of self-liquidating paper drawn on consumer goods moving from the producers to the market, which will be sold to the ultimate cash-paying consumer in 91 days' time or sooner. Commercial banks must keep away from finance paper, or commercial paper drawn on slowly moving merchandise, mortgages, stocks, bonds. etc. None of these has the liquidity to be eligible as an asset in the portfolio of commercial banks.

### The Real Bills Doctrine

As long as the commercial banks respect the Principle of Liquidity, they can't get into trouble, nor can the banking system as a whole. Should an individual bank experience unusually heavy cash withdrawals, it would find a ready market for its earning assets because other banks with excess cash would be happy to buy liquid assets. If the banking system as a whole experiences unusually heavy cash withdrawals, this can also be met without difficulty as the assets of the banking system get more liquid with the passing of every day and at least one-ninetieth of those assets mature into gold on each and every business day. The only scenario which would embarrass the commercial banks is the one in which the people stopped consuming altogether - but this is too far-fetched for serious consideration. Trouble only comes if banks yield to temptation, and get involved with slow paper.

We owe the Principle of Liquidity to the great 18th century Scottish thinker, the father of classical economics, Adam Smith. He was the first who expounded the "real bills doctrine," as this principle is also known, in his book, The Wealth of Nations. He noticed that before the Bank of England opened a branch office in Manchester, commercial paper drawn on the rapidly moving merchandise in Lancashire circulated very much as banknotes would, under their own steam and on their own wings. They did circulate, because their liquidity was the highest, second only to that of the gold coin.

There is no way to make stocks, bonds, and mortgages to circulate on the pattern of the circulation of commercial paper, for lack of sufficient liquidity.

The banking system in the United States is not just illiquid, but is in an advanced state of petrification. Only a small part of bank assets could be liquidated on short notice without great losses. The commercial banks rely on the Federal Reserve to replenish their reserves daily, rain or shine. The assets of the Federal Reserve banks are not much better: they consist of government securities. In case of a run, the Federal Reserve would be in no position to meet the demand for cash through honest asset-liquidation, because it would break the bond market. The Fed would have to monetize the bad assets of the commercial banks, which would make its own position even less liquid. Therein lies a great danger.

We may have to pay a high price for our contemptuous disregard for the Principle of Liquidity.

---

# The Sixth Pillar of Sound Money and Credit: The Principle of No Privileges Without Responsibilities

URL: https://newaustrianeconomics.com/archive/fekete/the-sixth-pillar-of-sound-money-and-credit/
Date: 2005-09-01
Section: Money & Credit
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, real-bills, self-liquidating-credit
Description: The sixth pillar holds that banks should enjoy no special privileges — such as the privilege of issuing demand deposits without full gold backing — without bearing corresponding responsibilities. Fekete uses Venetian banking history to show that the separation of investment and commercial banking, and the discipline of the real bills market, prevents moral hazard.
Editorial Note: Sixth in the ten-part Sound Money and Credit series (2005). This pillar draws on the history of Venetian banking to argue against modern fractional reserve banking and deposit insurance.
Original PDF: https://professorfekete.com/articles/AEF6thPillarOfMoneyAndCredit.pdf

### September, 2005

*The Sixth Pillar Of Sound Money And Credit The Principle Of No Privileges Without Responsibilities*

**Antal E. Fekete** · Professor · Memorial University of Newfoundland e-mail: aefekete@hotmail.com

### A Venetian Tale

Once upon a time, in the fair city of Venice, there ruled a wise and just Doge. He had observed and learned much about his people, about himself and his power. So he let his people go freely about their business, but he granted no privileges without charging the privileged with countervailing responsibilities. One day three men asked for an audience, "0 great and wise Doge," they cried, "we are sorely troubled and in need of your help." The Doge asked what was troubling them.

"I am a mason." said the first man. "I lay bricks for fine houses. Yet I am idle for the people will not pay my price." The second continued: "I am an artisan. I make many useful artifacts. I use great skill and labor, but the people refuse to pay my wage." The third man stepped forward and said: "And I am a banker. I advance monies I am entrusted with to the mason and to the artisan. But the people won't wait until the mortar sets and the artifacts sell. They demand their money back before my investments come to fruition." "I can see that your plight is great," said the Doge, and he ordered his attendant to bring forth three swords. "You shall go forth and compel those who will not deal with you voluntarily to submit to your terms, for the stronger reason of the sword." "No, no. your Honor," the three men cried, "this we did not ask. We are no highwaymen.

We are men of honor. We could not fall upon our fellow countrymen to compel them to our will with the force of the sword. It is you, O wise Doge, who must use power on our behalf. Your power is great." "Perhaps," said the Doge. "perhaps my power is great, but I must use it wisely or else it will be lost." He went on: "You ask me to do what you would not do because of honor." Then he turned to the banker: "Is honor one thing to the banker, and another to the magistrate?" He continued: "My power is a privilege encumbered with grave responsibilities. The charter of your bank confers a great privilege upon you. But your privilege is also encumbered with important responsibilities. You must invest the funds entrusted to you in a manner that they remain accessible to your patrons. You may not sink liquid funds into brick and mortar. You must invest in merchandise that keeps moving."

The Doge dismissed the three men with these words: "I, too, am an honorable man. What is dishonorable to you, will never be less dishonorable to your magistrate."

### The promises men live by

At the heart of the irredeemable paper money system of the United States is the fact that the Treasury and the Federal Reserve banks issue promises to pay which they do not redeem, do not intend to redeem, nor have they got the resources to do so. In other words, the Treasury and the Reserve banks have been given the privilege to issue promises and, at the same time, they have been freed from all responsibility to redeem these promises.

Both of them wish to keep their favored position.

A vitally important question arises here: On what defensible ground can any institution claim the right to issue promises to pay and at the same time insist that it should not be compelled to redeem those promises? We have built an intricate legal system in respect to contracts, based upon the elemental and widely- accepted standard of morals, ethics, and common honesty, to the effect that the maker of promises to pay must also assume the corresponding responsibility. We prosecute individuals and institutions when they attempt to avoid the fulfillment of their responsibility.

Harry Scherman, one-time president of the Book-of-the-Month Club, wrote a penetrating book called The Promises Men Live By. It dealt with some fundamental requisites of satisfactory and honorable social and economic intercourse. He noted that when men's promises cease to be good, trade and production are hampered, credit collapses, people cannot buy, sellers cannot or will not sell, chaos and social degeneration follow, if not immediately nevertheless, inevitably.

### Complacency and connivance

The commercial banks of this country create deposits against their assets, which are payable only in irredeemable currency. As a fraternity. these banks, by their failure to make any concerted effort to end irredeemability have become accomplices of the Treasury and the Federal Reserve banks. There have been a few concerned and upright bankers who fearlessly spoke up against the false and dangerous principle of privilege without responsibility. J.H. Frost, Chairman of the Board, Frost National Bank, San Antonio, Texas, in an address said, in part: "It would seem that bankers, as the custodians of the people's money, should be more interested than any other class of the population in the maintenance of sound money. Curiously enough, however, the history of most, if not all, of the disastrous inflations of the past indicates that bankers have usually been quite complacent - and often have cooperated in producing monetary inflation. This seems to be largely due to the fact that the liabilities of banks are all monetary and can be discharged by payment in the monetary unit no matter how far the depreciation of its purchasing power may have progressed. I believe that, if the bankers of America really understood what was happening to the people's money they would arouse themselves and demand and finally effect a return by this country to a sound currency redeemable in gold." (The Commercial and Financial Chronicle. May 27, 1948.)

### Holes in the balance sheet

It is an arresting and disturbing picture to see the banking fraternity supporting irredeemable currency seeking special privileges for themselves while avoiding the corresponding responsibilities and, as custodians of the people's money, resisting the most basic step that could be taken to terminate the depreciation of the people's money - a restoration of the obligation to redeem promises to pay.

This is not merely a moralistic observation, but a pragmatic one. Redeemable currency used to be the agent ferreting out unsound and uneconomic debt and liquidating it before it had a chance to metastasize. Banks were greatly limited in their power to shelter bad debt in their balance sheets through incompetence or design. Depositors could, by withdrawing the ultimate bank reserve, gold, force the bankers to maintain the highest standards of liquidity and solvency.

Irredeemable currency on the other hand, makes it impossible for the depositors to discipline the erring or dishonest banker. Previously, the depositor could opt out of the banking system altogether by withdrawing and holding gold, if he thought that the banks had become unsafe. By contrast, all he can do under the regime of irredeemable currency is to move his funds from one unsafe bank to another which momentarily appears less unsafe.

As a result, the banks now have huge holes in their balance sheets, as the market value of their assets is way below their liabilities. For the time being, they keep themselves afloat either by throwing good money after bad (that is, they increase the amount of nonperforming loans by the interest due, which is precisely the mechanism behind the metastasis of bad debt), or by tricks such as selling their headquarter buildings and paying out the proceeds as shareholders' dividend. But the day of reckoning, while it can perhaps be postponed, certainly cannot be avoided.

---

# The Tenth Pillar of Sound Money and Credit: The Principle of Productivity of Labor and Capital

URL: https://newaustrianeconomics.com/archive/fekete/the-tenth-pillar-of-sound-money-and-credit/
Date: 2005-09-01
Section: Money & Credit
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, capital-destruction, marginal-productivity, interest-theory
Description: The tenth and final pillar holds that sound money must allow the free interplay of capital and labor so that both earn their marginal products. Fekete argues that the fiat money system systematically distorts factor markets, suppressing the productivity of both capital and labor and leading to chronic unemployment and capital destruction.
Editorial Note: The concluding pillar of Fekete's ten-part Sound Money and Credit series (2005), synthesizing the preceding nine into a unified account of how sound money enables productive coordination and fiat money destroys it.
Original PDF: https://professorfekete.com/articles/AEF10thPillarOfMoneyAndCredit.pdf

### September, 2005

*The Tenth Pillar Of Sound Money And Credit The Principle Of Productivity Of Labor And Capital*

**Antal E. Fekete** · Professor · Memorial University of Newfoundland e-mail: aefekete@hotmail.com

### A Venetian Tale

Once upon a time a man by the name Shylock was the Public Treasurer in the prosperous city of Venice. The finances of the city state deteriorated grievously under his stewardship. Foreign entanglements and the mindless substitution of public largesse for private charity were to blame for the sorry state of the public purse. Shylock issued Treasury bonds supposedly paying interest at the usurious rate of 15 percent, not bothering to ask how payments of principal and interest, when they fall due, would be met.

Before he became Treasurer, Shylock was a heartless usurer on the Rialto, where other merchants, in particular one by the name of Antonio, openly reproached him for his covetousness. Thus there was great enmity between the two men and, although Shylock would bear the scorn with seeming sufferance, he secretly meditated revenge. His chance came when the combination of high tax and interest rates forced Antonio's business into receivership, and himself into the debtor's jail.

When the day of his trial arrived. Antonio's counselor, an unknown young lady doctor by the name Portia appeared before the Duke and his senators, while the Treasury was represented by Shylock himself. With the Duke's permission, Portia started the proceedings by addressing herself to Shylock. Admitting at once that he had the right, by the laws of Venice, to deprive Antonio of his property and personal freedom, she spoke sweetly of the noble virtue of mercy and how tax-forgiving was a double blessing, as it blessed the state that gained a future taxpayer, and the taxpayer that gained a chance to reorganize his business. But neither her reason nor her passionate pleas softened the heart of Shylock, who reiterated his demand for selling Antonio into servitude.

Portia gravely responded that the law once established, must not be bent. Hearing this, Shylock exclaimed: "0 learned and upright judge, I honor thee! A Daniel is come to judgment! Prepare. Antonio: we must not trifle time." "Wait," said Portia, "Before you sell Antonio into servitude, you must understand that his price shall cover not only his past but also his future tax liabilities. Otherwise you shall personally assume the burden." Hearing this. Antonio's friends in the audience cried out: "0 wise and upright judge! Mark the word, Shylock, a Daniel is come to judgment!"

Shylock, who would not for a moment think of assuming the future tax liabilities of Antonio under the tax laws of Venice which he himself fashioned for the discomfort of his rival, conceded defeat, saying: "Let me go in peace." "Not so fast", said Portia. "The laws of Venice protect her taxpayers against conspiracy and vindictive use of high public office. In driving up tax and interest rates to heights unheard of in the history of this city, you have attempted to exact a pound of flesh from every honest merchant of Venice. I plead with the Duke to deprive you of your high office as an exemplary punishment, for the edification of future generations."

The Duke, after considering the evidence, gave Shylock a dishonorable discharge from his duties as Public Treasurer. The tax and interest rates in Venice soon returned to a low and stable level. Labor and capital were no longer crucified on the cross of the public debt. Venice continued to prosper. And even today jurisprudence talks about the Shylock doctrine, when it refers to the natural law forbidding the exaction of payment for debt from a debtor in excess of the productivity of labor and capital.

(Adapted from: Tales from Shakespeare, by Charles and Mary Lamb, London, 1807.)

### The marginal worker

The pupils in a classroom can be ranked according to academic achievement, as measured by their marks. If the passing mark is 50%, then the marginal student is the one with the lowest mark above 50%; any student with a lower mark is sub-marginal. If the teacher now changes the passing mark from 50% to, say 65%, then this change would render a number of additional students submarginal, even though there was no deterioration of industry or aptitude on the part of these students.

The situation in the national economy is entirely analogous. Labor and capital can be ranked according to productivity. The worker with the lowest productivity rating above the rate of interest is called the marginal worker (and his tools, the marginal capital).

Workers whose productivity ranks below that of the marginal worker, are sub-marginal.

They are earmarked to be laid off as soon as their tools, the sub-marginal capital, will complete their amortization cycle. Indeed, no prospective employer would hire a submarginal worker if he could invest his funds and earn interest at a rate in excess of the rate of productivity of sub-marginal labor.

If the rate of interest goes up, there is an immediate effect of rendering additional labor and capital sub-marginal, regardless of whether or not the productivity of individual laborers has declined. Thus we see that the maximum rate of interest determines the marginal productivity of labor and capital. It arbitrarily decides who can keep his job and who shall lose it, which capital equipment can stay in production, and which shall be doomed to the scrap-yard. The Principle of Productivity of Labor and Capital asserts that the maximum rate of interest must be low enough to allow all those, who are eager to earn wages, to find employment; and also low enough to allow new capital goods to begin their amortization cycle.

### Depreciation premium

The carefully concealed truth is that interest rates are high today (1985) because they incorporate a large depreciation premium, designed to compensate the lenders of funds for loss of purchasing power due to the depreciation of the dollar. In fact, all regimes of irredeemable currency in history have pushed interest rates into outer space, as these currencies succumbed to their inevitable fate of accelerating depreciation. And as the rate of interest rose, so did unemployment widen; so did the destruction of capital spread.

### Class war

One of the most powerful arguments in favor of a gold standard is that it alone can make the marginal productivity of labor and capital low enough, so that all those eager to earn wages can find gainful employment, and so that capital will be accumulated and adequately maintained. No sooner is the gold standard removed than the Shylock syndrome will appear, rendering a large part of the labor force and a large part of the capital park of the country sub-marginal, and hence, unemployed. As the workers and the owners of capital goods are pitted against the lenders, social harmony and cooperation gives way to class war and social unrest. The only solution is the resumption of a gold standard. There are two ways to resume; targeting prices, and targeting interest. Targeting prices aims at a price level prevailing before suspension, and it involves increasing the metallic content of the monetary unit, while leaving interest rates alone. By contrast, targeting interest aims at a level of interest rates prevailing before suspension, and it involves decreasing the metallic content of the monetary unit, while leaving prices alone.

### Solon 's Seisachthea

Historically most resumptions were of the first type, causing economic contraction characterized by declining prices accompanied by declining interest rates. As a result, many observers concluded that the gold standard was deflation-prone.

The fact, however, is that there need not be any painful deflation, if the second type of resumption is carried out, Prices should be left alone, while interest rates are reduced overnight. This is what one of the greatest social reformers of all times, Solon (640-559 B.C.), Athenian law- giver, merchant and poet accomplished with his Seisachthea (in literal translation, disencumbrance). According to the historian Plutarch, he lowered the metallic content of the monetary unit. the drachma, to 73% of the original, and simultaneously reduced the rate of interest on the outstanding debt by law. There was great relief across the land, and Solon recorded his own deed in verse as follows:

### "The mortgage stones that covered her, by me Removed: the land, that was a slave, is free...

...Such power I gave the people as might do.

Abridged not what they had, nor lavished new:

### Those that were great in wealth and high in place

My counsel likewise kept from all disgrace.

Before them both I held the shield of might.

### And let not either touch the other's right."

### (The Dryden translation)

---

# The Third Pillar of Sound Money and Credit: The Principle of Redeemability

URL: https://newaustrianeconomics.com/archive/fekete/the-third-pillar-of-sound-money-and-credit/
Date: 2005-09-01
Section: Money & Credit
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, irredeemable-currency, fiat-currency
Description: The third pillar is redeemability: all paper money and credit instruments must be convertible on demand into gold coin. Fekete shows through historical example that the suspension of redeemability — however temporary — marks the beginning of monetary debasement and eventual hyperinflation.
Editorial Note: Third in the ten-part Sound Money and Credit series (2005). Redeemability is the disciplining constraint that prevents governments and banks from expanding credit without limit.
Original PDF: https://professorfekete.com/articles/AEF3rdPillarOfMoneyAndCredit.pdf

### September, 2005

*The Third Pillar Of Sound Money And Credit The Principle Of Redeemability*

**Antal E. Fekete** · Professor · Memorial University of Newfoundland e-mail: aefekete@hotmail.com

### A Chinese Tale

Once upon a time a revolution of lasting import took place in China: the invention of paper and the simultaneous invention of paper money. Silk products had long been used as the material on which documents and contracts could be written. The revolutionary character of paper was to be seen in the fact that it was a thousand times cheaper than silk, and it could still carry the same message just as efficiently.

The most potent message that paper was capable of carrying was the promise of the Imperial Treasury to pay the bearer a stated sum of silver coins on demand. The Treasurer, Ding, discovered that he could pay the suppliers of goods and services to the Celestial Court with such paper promises. People trusted the Treasury and accepted its promise to pay as equivalent to payment in silver coin.

Soon afterwards the Treasury ran out of free silver, as it found that all the silver coins in its coffers had been mortgaged in the form of outstanding promises. Ding refused to issue more paper money except in exchange for silver coins paid into the Treasury. In his view any other course of action would compromise not only the integrity of the promises of the Treasury but also that of all the contracts in the Celestial Empire, affecting a value far greater than the value of paper money in circulation. Contracts made by third parties in good faith would be rendered impossible of fulfillment and the standard, or measuring rod, of honest dealings among the populace would be destroyed. A decline in prosperity would follow in due course, as the cornerstone of economic well-being is the integrity of promises men live by.

But the Deputy Treasurer, Dong, was an ambitious man and he saw that Ding had painted himself into a comer. Dong threw himself at the feet of the Emperor, pleading thus: "Sire! Let me issue further promises to pay silver coins against the cutlery, candelabra, and other silverware of the Celestial Court!" The Emperor promptly fired Ding, and rewarded Dong for his resourcefulness by making him Treasurer.

Dong could not enjoy his newly found glory and power long. Other ambitious men in the Court took careful note of what happened at the Treasury. They got the ear of the Emperor in suggesting that even more paper money could be issued against silver that had not yet been brought out of the imperial mines, as well as against the silver in the Moon. Because the Moon was considered a province of the Celestial Empire, and it was thought to consist of silver 95% pure, a belief confirmed by a recent scientific study released by the Heavenly Research Council, there was a plausible case for expanding the issue of paper money. The Emperor fired Dong, and thereafter the change of the guard at the Treasury became a frequent ritual, each time a more unscrupulous adventurer succeeding a less unscrupulous one. The promises of the Treasury to pay silver coins on demand had lost all their remaining value.

In the aftermath of the depreciation of paper money a Great Cultural Revolution engulfed the Celestial Empire. People took to the streets, purged the Heavenly Research Council, and hanged all the past Treasurers on makeshift gallows erected along the Square of Heavenly Peace, stuffing their mouths with the paper promises that they had signed

.

### Not worth a Continental

The United States, in its infancy, attempted the same process by the issuance of Continental currency. This currency collapsed in the same way as its ancestor in China.

Later, one of the greatest orators of all times, Daniel Webster, denounced irredeemable paper money on the floor of Congress in 18?2 in these words: "Of all the contrivances For cheating the laboring classes of mankind none have been more effectual than that which deludes them with paper money. Ordinary tyranny oppression, excessive taxation... these bear lightly on the happiness of the mass of the community compared with fraudulent currencies and the robberies committed by depreciated paper." Today we reject the dictum of Daniel Webster, and indulge in the same national sin which promises to exact, some day, severe penalties for our belief that we can challenge with impunity such fundamental truths as those involved in the maintenance of standards of common honesty in the fulfillment of our promises.

### The ballot box is not enough

The principle of redeemability of the currency asserts that, if a citizen believes that there is too much money in circulation, he must have the right to do something about it. He should be allowed to hoard, melt, or export the gold coins in his possession, thereby redeeming the commodity value of the monetary standard. It also asserts that the citizen should be allowed to withdraw the gold reserves which form the basis of the monetary system, to the extent of his holdings of paper money or bank deposits. When a currency is redeemable in standard gold coins, any individual disturbed by the behavior of the government or banks can attempt to protect himself by presenting for redemption such paper currency as he may command. It is this power of individuals that holds, or tends to hold, banks and government in check. Without this power the people, as individuals, are helpless insofar as control over their banks and government is concerned. The power of the ballot box provides no protection, after the government has freed itself from the obligation to redeem its promissory notes, and acquired power to expand the volume of paper money without fear of adverse public reaction. The way to government dictatorship has been opened up. Human freedom has been endangered. The variety of ways in which freedom could be impaired or destroyed is practically countless as the government takes more and more power from the people and to itself. Limited government is not possible unless the principle of redeemability of the currency is respected.

### A nursery of tyranny, corruption and delusion

In his classic monograph Fiat Money Inflation in France, the distinguished scholar Andrew D, White, joint founder and first president of Cornell University, quoted Mirabeau of France as saying in 1789 that irredeemable currency is "a nursery of tyranny corruption and delusion: a veritable debauch of authority in delirium." His contemporaries ignored the admonition, issued the assignats and the mandats - and history has attested the accuracy of Mirabeau's prophecy.

The act of inflicting an irredeemable currency on a people is an act of dishonesty by the government, and the influence of that dishonesty spreads through an endless number of channels and in an endless number of forms to the mass of people who are then corrupted in countless ways. To use White's words: such corruption grows "as naturally as fungus on a muck heap. It was first felt in business operations, but soon began to be seen in the legislative body and in journalism." As to the corruption among legislators, he stated that "there was enough to cause widespread distrust, cynicism and want of faith in any patriotism or any virtue. Worse still was the breakdown of morals of the country at large, resulting from the sudden building up of ostentatious wealth and from the gambling, speculative spirit, spreading from large towns to small, and to rural districts. The disgraceful result was the decay of national good faith." White stated that "there came cheatery in the nation at large and corruption among officials and persons holding public trusts... Faith in moral considerations, or even in good impulses. yielded to general distrust. National honor was thought a fiction cherished by hypocrites. Patriotism was eaten out by cynicism." "It ended in the complete financial, moral and political prostration of France - a prostration from which only a Napoleon could raise it."

White concluded, in his Fiat Money Inflation in France, that "every other attempt of the same kind in human history under whatever circumstances, has reached similar results in kind if not in degree."

No doubt the authors of the assignat and mandat thought that they were acting on firmer scientific basis than the Treasurers of the Celestial Empire. Yet, from the perspective of the 20th* century observer, the only breakthrough was the replacement of the gallows by the more efficient guillotine.

### * (1985)

---

# Monetary Economics 102 — Lecture 6: The Hexagonal Model of Capital Markets

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-102-lecture-6-the-hexagonal-model-of-capital-markets/
Date: 2004-03-01
Section: Money & Credit
Difficulty: scholarly
Concept Tags: interest-theory, capital-destruction, bond-market, gold-bonds, gold-standard
Description: Fekete extends his pentagonal model to a hexagonal one by adding the investment banker, who intermediates between savers and entrepreneurs through the bond market. He analyzes the gold bond and its sinking fund as the ideal instrument for productive long-term investment, and shows how the elimination of gold bonds has destroyed the productive link between saving and investment.
Editorial Note: Concluding lecture of Monetary Economics 102 (Gold Standard University, 2004). The hexagonal model completes Fekete's capital market theory and introduces the gold bond — the monetary reform instrument he advocates in his later policy writing.
Original PDF: https://professorfekete.com/articles/AEFMonEcon102Lecture6.pdf

### Lecture 6

*The Hexagonal Model Of Capital Markets*

### ¶ Enter: the Investment Banker ¶ The Bond Market and the Rate of

Interest ¶ The Gold Bond and Its Sinking Fund ¶ The Euthanasia of the Bondholder ¶ The Rise and Fall of the Yield-Curve ¶ Arbitrage versus Speculation ¶ One Rate or Two? ¶ Deterioration in the Quality of Credit ¶

### Fleecing the Producers

### Enter: the Investment Banker

We have arrived at the final stage, what I figuratively call the “hexagonal model of capital markets” with its six participants: the annuitand, the annuitant, the entrepreneur, the inventor, the capitalist and, the last protagonist of the drama of human action, the investment banker. His entry was made necessary by the marginal annuitand and the marginal annuitant. The former is the one who has just missed his chance to form a partnership with the inventor, and the latter his, with the entrepreneur. Without the services of the investment banker the resources represented by the savings of the marginal annuitand and the marginal annuitant would be lost to society.

If the two formed a partnership whereby the former provided income for the latter, it would be net short of future wealth while net long of present wealth. It would take the skills of a specialist to nurture present wealth into future wealth of undiminished value.

This specialist was the investment banker. He would invest the wealth of the annuitant in such a way that its value would grow and it could in due course be exchanged for income to pay an annuity to the annuitand. Under the gold standard the investment banker would buy gold bonds, the safest paper available for the preservation of wealth.

### The Bond Market and the Rate of Interest

The hexagonal model of the capital market at last provides a sufficiently broad basis upon which the formation of the rate of interest can be explained. Since no two annuities and no two mortgages are similar, trading them without a common denominator would be virtually impossible and, as a consequence, the rate of interest would be highly volatile. A regime of stable interest rates is not possible without the services of the investment banker, nor without a common denominator, the gold bond, to facilitate the trading of annuities and mortgages.

As we shall see in the next Lecture entitled The Bond Equation and the Rate of Interest, the price of the gold bond is just the mirror image of the rate of interest. Although the two move in opposite directions, either one determines the other uniquely. For this reason we may define the rate of interest in terms of the price of the gold bond. Thus bond trading appears as the very market process responsible for the formation of the rate of interest.

There is no market quoting the rate of interest directly. In order to find out what the going rate of interest is one must go to the bond market, get a quotation for the bond price, and calculate the rate of interest from there. In dealing with the bond market we must not forget that it is the epitome of a far larger and far more pervasive capital market encompassing all conceivable exchanges of wealth and income. Every such exchange, not just the purchase or sale of gold bonds, has an effect on the formation of the rate of interest.

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 must be prepared to enter 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. At the end of the day he balances the net liability or asset resulting from this activity through the purchase or sale of his standardized instrument, the gold bond. In effect, the investment banker is doing arbitrage between the bond market and the other five corners of the capital market. The result is the emergence of a stable rate of interest.

The hexagonal model of the capital market brings about a great increase in scope for the most successful combination of capitalist production: the troika of the entrepreneur, the inventor, and the capitalist, already mentioned in the previous Lecture. 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 do the two of them in finding a suitable capitalist. If the invention is good and the enterprise sound, then they could start production on the most favorable terms immediately through the good offices of the match-maker, the investment banker. He will line up a capitalist to make the troika complete. 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. The problem of forming optimal triangles midstream can be safely entrusted to the bond market.

### The Gold Bond and Its Sinking Fund

We have seen that the success of the capital market depends on a versatile and standardized trading instrument, the gold bond, that can be used as (1) the standard of capital values, (2) the balancing item of a liability on capital account. The gold bond evidences debt payable at maturity in gold, plus it provides an interest income in the interim, also payable in gold. The income is represented by the coupons attached. The gold bond is traded in a broadly-based secondary market.

It is absolutely necessary that principal and interest be payable in gold coin. A bond that is payable at maturity in irredeemable currency is not a financial instrument; it is a cruel joke. It means that the underlying indebtedness will never be extinguished. It will keep growing forever, and the danger is that its growth will ultimately accelerate and get out of control. The bond in fact is irredeemable: at maturity it will be replaced by another irredeemable bond, usually of inferior quality. One should not be misled by appearances that the face value of the bond is paid at maturity in irredeemable currency. That type of currency is inferior even to the irredeemable bond in that it does not have a yield. In today’s world all bonds are irredeemable. Gold bonds have disappeared without a trace after Great Britain and the United States reneged on the last issues in the early 1930's.

One should keep in mind that this does not mean that there is no demand for them. It only means that the powers-that-be would like to extirpate the memory of the gold bond in order “to make the world safe for plunder”. We still don’t know whether the attempt has succeeded or whether, perhaps, truth and justice will ultimately prevail, as it always has in history so far.

A gold bond is supported by a sinking fund. It is established by the issuer in order to make sure that the market value of the bond does not erode with time, as it might, making the rate of interest take a “slide” on the yield curve, a concept I shall discuss in a moment.

It is incumbent on the issuer to keep the value of the bond stable, if need be, by retiring some of the outstanding issue prematurely. The manager of the sinking fund is a marketmaker who would buy the bond at the lower bid price and sell it at the higher asked price.

It follows that, under a gold standard, the sinking fund would not only protect the bondholder, but it would also be profitable to operate for the issuer.

A book on sinking funds published in 1967 (op.cit.) suggested that their operation incurred extra costs that bondholders had to absorb in the form of lower coupon rate. The drift of the argument was that the issuers of debt were actually doing a favor to the bondholders in issuing it without sinking fund protection, a practice coming into vogue just about at that time. Of course, the suggestion that the bondholder may be better off without the protection of the sinking fund is disingenuous. The book was written to prepare the public for dramatic changes. Gyrating interest rates and bond prices were about to replace stable interest rates and stable bond prices, due to the coming destruction of the gold standard that has cast its long shadow forward. In such an environment the sinking fund would be exhausted in a matter of a few weeks, if not days. New arguments had to be invented to justify new practices. The book was paving the way to the euthanasia of the bondholder that was about to take place.

### The Euthanasia of the Bondholder

The cynical phrase “euthanasia of the boldholder” was first used by John Maynard Keynes. He was well aware what the implementation of his schemes to sabotage the gold standard would mean to bondholder. Keynes treated the bondholder with contempt, as a parasitic element of society. He ridiculed coupon-clipping, calling it the only positive contribution the bondholder is capable of making to the commonweal.

In the event, euthanasia was turned into a bloodbath, the like of which the world has not seen since the night of St. Bartholomew. In view of the hexagonal model, to disparage the bondholder is tantamount to disparaging the annuitand and the annuitant, that is, one’s father and grandfather who, after a lifetime of faithful and diligent service expect to have a peaceful and secure retirement. The euthanasia of the bondholder means the euthanasia of dear old grandfather.

It is to the eternal shame of our Western Civilization that the crime of slaughtering the bondholders was permitted and even glorified, and no case study of the sufferings of the victims was ever allowed to be published.

The euthanasia of the bondholder was the ill star under which “social security” was born.

The latter is a compulsory scheme based on socialistic principles. There is no actuarially sound way to fund the liability incurred by a universal social security program. In fact, it is an unfunded system financed through an open-ended tax escalator. Such a system is easy to introduce, as in the early days a relatively large number of workers support a relatively small number of eligible beneficiaries and the tax rate is nearly negligible.

However, as the system reaches maturity a couple of generations later, the number of workers it will take to support one beneficiary declines drastically. This would happen in any case, but birth control, life-prolonging drugs and therapeutic procedures greatly accelerate the process. A reduction in promised benefits is out of the question and is regarded as political dynamite. The only alternative is to escalate taxes that finance the system. Just how long the taxpayers will be willing to carry the open-ended increases of burden is anybody’s guess. It will eventually dawn upon young people that they will never benefit as the scheme is bound to collapse before they reach retirement age.

Compulsion can never do what spontaneous association can. We have seen in the previous Lecture that the “social security” scheme introduced in the 1930's dissipates the wealth of the annuitant and induces the annuitand to stop saving. There is also the sinister problem of depriving the inventor of his traditional source of financing, with incalculable consequences as to capital accumulation, in particular the capitalization of incomes, which society depends upon in order to provide the benefits and comfort to the retired population. Note that none of the problems associated with the compulsory scheme arise under the voluntary cooperation of the annuitand, the annuitant, the entrepreneur, and the inventor discussed in the previous Lecture.

The usual objection is that the voluntary system is not universal and it leaves indigent people out in the cold. This is not the place to go into a discussion of the validity of the Biblical admonition that “the poor will always be with us” and there will always be a need for charity, regardless of the level of affluence that society may reach. We must reconcile ourselves to the objective fact that a compulsory social security scheme promising universal coverage is not viable and cannot be made viable. The idea could be sold politically only because people are prone to fall for Ponzi schemes, to the genus of which social security clearly belongs.

### The Rise and Fall of the Yield Curve

Nowadays one hears frequent references to the “yield curve” or, as the case may be, to the “inverted yield curve”. It may come as a surprise that there was no yield curve under a gold standard. Multiple interest rates along with multiple foreign exchange rates belong to the paraphernalia of the regime of irredeemable currency, wherein a change in the price of crude oil, for example, could move both rates, and an increase in prices could provoke another increase in prices, as currency debasement looms large. Under the gold standard the rate of interest and of foreign exchange are stable and well-protected from shocks such as that in the price of crude oil, for example.

The yield curve represents the rate of interest as a function of time to maturity. It is considered “normal behavior” for the rate of interest to increase as the time to maturity is increased. Moreover, the rate of interest asymptotically approaches a certain value, the theoretical yield of a perpetual bond, as the time to maturity tends to infinity. This means that the normal shape of the yield curve is that of a rising one which nevertheless is bounded from above by the theoretical yield on perpetual bonds. A rising yield curve means that as maturity increases, the yield also increases. This is supported by the Principle of Time Preference (a concept that I shall discuss in a future course Monetary Economics 202, The Bond Market and the Formation of the Rate of Interest) asserting that, when given the choice between funds available in the remote or nearby future, the economizing individual will, other things being the same, choose the latter.

However, under “abnormal” credit conditions it can and often does happen that, as maturity increases, the yield actually decreases. In this case the yield curve is called “inverted” as it is falling (apart from a brief sharp spike near zero maturity). It still approaches the same value asymptotically as the time to maturity tends to infinity, but in this case the yield curve is bounded from below by the theoretical yield on perpetual bonds. Abnormal credit conditions mean that, as a result of loose credit policies pursued by the banks and the government, too many short-term credit instruments approach maturity, which depresses their prices. Cash is scarce and the yield on short-term credit is high. The inverted yield curve may return to its normal state quickly, or it may last for an extended period of time, depending on the depth of the credit crisis which always accompanies it.

None of this may happen under a gold standard where the government and the banks are forced to keep their short-term liabilities safely within the limits of their quick assets. In fact, if all the gold bonds issued have sinking fund protection, as they should, then there is no yield curve. More precisely, the yield is the same constant value for all maturities (making the yield curve a horizontal straight line). The rate of interest is stable, both in time and across the maturity spectrum. A yield curve, if one existed, would create a temptation for the banks to borrow short in order to lend long. Such an activity would lead to periodic credit crises and the yield curve would get inverted as a result. I shall deal with these problems in more details later in this Course.

The fact that there is no yield curve under a gold standard does not mean that the rate of interest may not change. What it means is that all the adjustments are so gradual that they present no temptation for the banks to speculate in the bond market. On the other hand, if certain economic shocks (such as a continental crop failure, or pestilence wiping out a sizeable portion of the working force) calls for a big rise in the rate of interest, then it will be made quickly and expeditiously. Issuers of gold bonds will refund their obligation and sell a new issue with a higher coupon rate. In no case would they allow bondholders to suffer a loss. They take to heart the Biblical admonition that “tormenting widows and orphans is a sin that cries to high heavens for punishment”.

### Arbitrage versus Speculation

I have mentioned repeatedly that there is no bond speculation under a gold standard.

Subsequently I got several messages from my readers insisting that speculation actually has a role in stabilizing interest rates. However, what my readers referred to as

“stabilizing speculation” is no speculation at all. It is arbitrage. The two must be carefully distinguished, something that mainstream economics has failed to do. The distinction becomes clear at once when we consider the objectives of the speculator and the arbitrageur. The former is willing to take big risks in the hope of a big payoff. The latter is not interested in risk-taking at all. The arbitrageur steps in whenever the market shows deviant behavior. He makes his bet that the deviation will be corrected. Whenever a sufficient number of arbitrageurs do likewise, their market action will be self-fulfilling.

Examples are deviations in the foreign exchange rates, or those in the rate of interest, under a gold standard. The arbitrageur takes it for granted that the deeds of the government are as good as its words, and it wouldn’t knowingly mislead the market and pocket the illicit gains that originated in deception. Of course, any arbitrageur would quickly come to grief in today’s foreign exchange and bond markets where deception is practiced by governments on a regular basis. It is not by accident that mainstream economists have failed to make a distinction between arbitrage and speculation in the bond market. They are lame apologists for the government out to cover up bad faith and chicanery.

Arbitrageurs have vacated the field, and speculators have taken over, as a result of the destruction of the gold standard. Contrary to mythology, under the gold standard it wasn’t the central bank that kept the rate of interest and foreign exchanges stable. It was the arbitrageurs who believed in the good faith of the government in promising payment on their obligations in gold coin at a fixed rate. Without arbitrage the financial resources of the central bank would have been inadequate to stabilize the foreign exchanges, as well as the rate of interest. As I have said this is an issue that mainstream economics is unable to address. It has no mandate from its sponsors to use the language of good and bad faith in market dealings. However, there is no other way to deal with markets under the regime of irredeemable currency but through pointing out the deception regularly practiced by the government and its central bank in order to fool the public. This is why devaluations were always announced during the week-end when markets were closed. Prior to this government and central bank spokesmen had shouted from the rooftop that foreign exchange rates will “never” be changed. Next week politicians and central bankers had to eat their words. Nowadays this problem is avoided through the mechanism of floating foreign exchange rates. Note that “floating” is a euphemism for “sinking”, as the international monetary system is merely a cover for competitive currency devaluations.

At any rate, the outcome is the same: the fleecing of the producing sector (including the savers) and the enriching of the financial sector (including the treasury).

### One Rate or Two?

I have pointed out that the rate of interest is the marginal efficiency of the exchange of wealth and income. It is determined through a market process, similar to that determining the price of wheat. But whereas the formation of the wheat price can be described through a simple diagonal model with the two poles representing supply and demand, the formation of the rate of interest is more complicated as there are at least two types of exchanges involved. Following this line of reasoning we have arrived at the hexagonal model of capital markets clearing all the exchanges of income and wealth. Just as the sale of every sack of wheat has an effect on the price of wheat, every exchange of wealth and income has an effect on the rate of interest.

My critics point out that if my analysis were correct, then there would have to be two rates of interest, one regulating the exchange of the income of the annuitand for the wealth of the inventor, and another, regulating the exchange of the wealth of the annuitant for the income of the entrepreneur. One rate or two, that is the question.

It is true that for gold bonds, no less than for wheat, the market quotes not one but two prices: a higher asked price and a lower bid price. Transactions take place between these two extremes. The spread between the two has an extraordinary theoretical importance. It is instrumental in setting a limit to the volatility of the rate of interest. In more detail, the higher asked price for the gold bond translates into the floor, and the lower bid price into the ceiling, for the rate of interest.

The reason for the inversion is the fact that the price of the gold bond and the rate of interest move inversely. It is imperative that the reader have a good grasp and a good visual image of this inverse movement, and the inversion of its extremities. (One way of visualizing this inverse movement is a pair of pistons of a reciprocating steam engine as they run up and down in their respective cylinders, always in opposite directions. Another way is the see-saw, a piece of equipment for children to play on, consisting of a long flat piece of wood supported in the middle. A child sits at each end and makes the see-saw move up and down.) I shall make frequent references to the reciprocating movements of the rate of interest and the price of the gold bond, by calling it the “see-saw”.

Stable interest rates under a gold standard are explained by the small spread between the asked and bid price of the gold bond. We may verbalize this by saying that the stability of the rate of interest under a gold standard is the flip-side of the narrow bid/asked spread for the gold bond. By contrast, wildly gyrating interest rates, as experienced under the regime of irredeemable currency, reflect the yawning gap between the asked and bid prices of bonds. The gap is the only clue we have to explain unstable credit conditions.

So why is there a unique rate of interest under a gold standard when, on the face of it, there ought to be two, one at which income is exchanged for wealth, and another at which wealth is exchanged for income? Here is the reason why. Those who want to exchange wealth for income are the buyers, and those who want to exchange income for wealth are the sellers of the gold bond. To say that the two rates, one involved in exchanging wealth for income and the other income for wealth, are not equal is the same as to say that there is a wide gap between the asked and bid prices of the bond. The investment banker and the managers of various sinking funds act as market-makers in the bond market. They buy the gold bond at the lower bid price and sell it at the higher asked price. They profit from the existence of a wide spread between the two. As a result of their arbitrage the spread narrows and the two rates get closer. Even though profits from this arbitrage disappear together with the spread, the investment banker and managers of the sinking funds will continue in this business. Their primary task is not to profit from the arbitrage; it is to make a market in bonds. We conclude that under a gold standard the bid/asked spread of gold bonds is negligible, and for all practical purposes the rate of interest is one and the same for all maturities.

### Deterioration in the Quality of Credit

If the bid/asked spread for bonds widens, it means that the market-makers in the bond market are hampered in their bid/asked arbitrage. Either the sinking fund protection of bonds is being withdrawn, or the investment banker is intimidated by a torrent of new inferior bond issues. The widening in the bid/asked spread measures the deterioration of credit.

In these terms, the 20th century witnessed an unprecedented deterioration in the quality of credit, one that mainstream economists prefer to ignore. The landmark was the government’s default on its gold obligations. This was followed by the dismantling of the sinking fund protection of the bondholders. Finally, the gold clause on bonds were declared “contrary to public purpose” by the government. As a consequence arbitrageurs have abandoned the field and speculators have taken over. The latter are now in the driver’s seat, and bond speculation is increasing by leaps and bounds.

In the 19th century self-respecting governments and companies would not have tolerated that the value of their obligations become a plaything in the hands of speculators. As a matter of fact, there were no bond speculators since there was not enough volatility in the price of the gold bond to make speculation profitable. Things are very different today.

Ever since the last link between the dollar and gold was severed in 1971, the volume of bond speculation has been increasing at an exponential rate. Today gold bonds are historical relics. Governments won’t put up with any meaningful competition against their obligations denominated in irredeemable currency. They know full-well that their issues would not stand a chance in such an environment.

A gold bond is an obligation that is payable, not in terms of itself, but in value existing outside and independently of the promises of the issuer. A government bond of current vintage is an obligation redeemable in an inferior instrument: a non-obligation, to wit: in non-interest-bearing irredeemable currency. This shatters the logical basis supporting the value of the bond. But this is not all. Ostensibly the value of irredeemable currency is supported by the assets against which they are issued as a liability on the books of the central bank. As these assets are the very same government bonds which promise to pay irredeemable currency to the bondholder at maturity, the logical basis supporting the value of the currency is shattered, too. The relationship between the government bond and the currency is an incestuous one, on which it is not possible to build long-term prosperity. These are fundamental problems that are not being addressed while fair weather lasts. In the meantime forces promoting foul weather are gathering steam. It is doubtful that these fundamental problems can be dealt with after the storm has begun.

### Fleecing the Producers

If the logical basis for the value of government bonds has been shattered as it promises to pay its face value in nothing but itself, the question arises what then supports the value of these bonds? The answer is that government bonds are the very chips one needs in order to play in the casino otherwise known as the bond market.

The destruction of the gold standard by the government was thoroughly immoral, but the matter did not end there. It has corrupted the bond market right to its core. Today nobody in his right mind would try to save by holding the bond to maturity. The bond market is the haunt of speculators. It is a casino for gambling. The bond is the chip to be used at the gambling tables. Yet there is an important difference between the operation of the bond market under the regime of irredeemable currency, and the gambling casino. In the latter the gains of one gambler is the loss of another. This is also expressed by saying that gambling at the casino is a zero-sum game. Its effect on society at large is nil.

It is quite otherwise with bond speculation. Here we have a casino wherein the players can fleece outsiders. In a later Lecture I shall deal in full details with bond speculation and its effect on saving and production. Let it suffice here to state the bare fact that the bond market is a casino where speculators risk not their own funds but those of the savers and producers. As a result, the latter are always the losers, even when they haven’t the slightest intention to play. We have an insane arrangement whereby productive activity is penalized and gambling activity is rewarded. As a result, the volume of productive activity constantly shrinks while that of financial activity constantly expands. Moreover, the latter expands at an exponential rate, as the financial markets attract all available funds, gobbling up the capital of the producing sector. Most ominous of all, talent is no longer attracted to production, entrepreneurship, and inventive activity. Capable young people choose vocations related to the financial sector, the only place where they can hope to earn adequate rewards.

To recapitulate, under a gold standard capital markets function efficiently to channel the funds of savers to finance production for the benefit of the entire society. Their operation is accurately described by the hexagonal model which in particular explains the formation and stability of the rate of interest. Capital markets have been corrupted by the destruction of the gold standard. The rate of interest has been destabilized, inviting bond speculators to turn the capital markets into a gambling casino where the producers and savers can be fleeced. The moral responsibility for this subversion must be borne by the government and the profession of the economists for its failure to inform the public of what is happening.

### References

F. Corine Thompson and Richard Norgaard, Sinking Funds - Their Use and Value, New

### York: Financial Executives Research Foundation, 1967

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, NL, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand’s Hymn to Money

### Lecture 2: Don’t Fix the Price of Gold!

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told; (Chapters 1 - 3)

### Lecture 6: The Invention of Discounting; (Chapters 4 - 6)

### Lecture 7: The Mystery of the Discount Rate; (Chapters 7 - 8)

### Lecture 8: Bills of the Goldsmith; (Chapter 9)

Lecture 9: Legal Tender. Small Bank Notes.

### Lecture 10: The Revolt of Quality

### Lecture 11: The Acceptance House; (Chapter 10-11)

### Lecture 12: Borrowing Short to Lend Long; (Chapter 12)

### Lecture 13: The Unadulterated Gold Standard

## Winter Semester, 2003

### Monetary Economics 102: Gold and Interest

### Lecture 1: The Nature and Sources of Interest

### Lecture 2: The Exchange of Income and Wealth

### Lecture 3: The Janus-Face of Marketability

## Winter Semester, 2004

### Lecture 4: The Principle of Capitalization of Incomes

### Lecture 5: The Pentagonal Model of Capital Markets

### Lecture 6: The Hexagonal Model of Capital Markets

### Lecture 7: The Bond Equation and the Rate of Interest

### Lecture 8: Lessons of Bimetallism

### Lecture 9: Speculation

### Lecture 10: The Kondratieff Long-Wave Cycle

### Lecture 11: The Ratchet and the Linkage

### Lecture 12: Accounting under a Falling Interest-Rate Structure

### Lecture 13: Aristotle on Check-Kiting

## In Preparation:

Monetary Economics 201: The Bill Market and the Formation of the Discount Rate Monetary Economics 202: The Bond Market and the Formation of the Rate of

### Interest

---

# Monetary Economics 102 — Lecture 5: The Pentagonal Model of Capital Markets

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-102-lecture-5-the-pentagonal-model-of-capital-markets/
Date: 2004-02-01
Section: Money & Credit
Difficulty: scholarly
Concept Tags: interest-theory, capital-destruction, bond-market, gold-standard, new-austrian-economics
Description: Fekete presents his pentagonal model of capital markets, identifying five participants — the saver, the entrepreneur, the inventor, the capitalist, and the annuitant — and showing how they interact through the bond market to coordinate production over time. He argues that the Fed's destruction of the long bond market eliminates the entrepreneur and the inventor, causing chronic unemployment.
Editorial Note: Lecture 5 of Monetary Economics 102 (Gold Standard University, 2004). The pentagonal model is one of Fekete's original analytical contributions, extending Austrian capital theory to account for bond markets and the role of falling interest rates in destroying capital.
Original PDF: https://professorfekete.com/articles/AEFMonEcon102Lecture5.pdf

### Lecture 5

*The Pentagonal Model Of Capital Markets*

### ¶Squaring the Diagonal ¶The Annuitand and the Annuitant ¶The

Entrepreneur and the Inventor ¶On the Causes of Chronic Unemployment

### ¶The Pentagonal Model ¶Troika of the Entrepreneur, Inventor, and

### Capitalist ¶The Capitalist as the Patron Saint of the Common Man

### ¶Runaway Vibration ¶Rising Interest Rendering Capital Submarginal

¶Falling Interest: Good or Bad? ¶Bond Speculation is no Zero-Sum Game

¶The Shylock Syndrome ¶Instant Reward, Instant Penalty ¶Exploding the

### Myth of the Welfare State

### Squaring the Diagonal

The formation of the rate of interest is usually explained in terms of a diagonal model of the capital market between the supplier and the user of “loanable funds”. The rate of interest is the equilibrium rate at which the market clears supply and demand. This model is woefully inadequate as it blots out the time element and the crucial process of capital formation. To remedy this my analysis will, in the first approximation, replace the diagonal model with what I figuratively call “the square model of the capital market” having four participants: the annuitand, the annuitant, the entrepreneur, and the inventor.

This will grant us a more penetrating insight into the process of capital formation in terms of capitalizing incomes.

In considering the problem of exchanging income and wealth we may isolate two fundamental needs: (1) the annuitand’s need to convert income into wealth, and (2) the annuitant’s need to convert wealth into income. Typically, the annuitand is a younger man who is looking forward to getting married and starting a family. He tries to provide for the future needs of his family: for the education of his children, for emergencies caused by ill health, as well as for his and his wife’s old age. By contrast, the annuitant is an older man in his harvest years, looking forward to his twilight years with equanimity.

He has by now accumulated the wealth that he is ready to convert into a suitable income.

If the annuitand (annuitant) is restricted to direct conversion due to institutional restraints on the exchange of income and wealth, then the optimum conversion is furnished by gold hoarding (dishoarding). By the definition of marketability in the small, no further improvement is possible. However, if the institutional restraints are removed, then a whole new game will come into play and, indeed, further improvements in the conversion are possible for the benefit of all.

### The Entrepreneur and the Inventor

On the one hand, the annuitant’s need is answered directly by the entrepreneur who is anxious to give up income in exchange for wealth. He can profitably invest wealth in productive enterprise that will provide him with a larger income that he can easily share with his partner, the annuitant. On the other hand, the annuitand’s need is answered directly by the inventor anxious to give up future wealth in exchange for income. He is working on a new production tool or process that may take several years to perfect before it can be put in place. In the meantime he has to sustain himself and to defray the cost of his research and development (R&D). The new tool or process he is perfecting represents future wealth that he can easily share with his partner, the annuitand, who provides for him the necessary income in the interim.

The four participants: the annuitand, annuitant, entrepreneur, inventor and their exchanges make up the square model of the capital market. Both the entrepreneur and inventor engage in the business of capital formation; the difference is seen in the method of amortization. The capital formed by the entrepreneur is scheduled to begin its amortization cycle immediately. There is a prolonged waiting period before the capital formed by the inventor can start its amortization cycle. The invention introduces higher order production goods. The deployment of these is what Böhm-Bawerk called “more roundabout processes of production”. The R&D capital accumulated by the partnership of the annuitand 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.

### On the Causes of Chronic Unemployment

The presence of chronic unemployment in the economy indicates that the annuitand and the inventor are hampered by social and institutional arrangements in their effort to form R&D capital. From this perspective a government-run compulsory social security scheme appears 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, there is the more subtle and 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 talent wasted. The government-run social security scheme is retrogressive because it dissipates the annuitand’s income and the annuitant’s wealth without any redeeming features as to promoting capital accumulation, especially the accumulation of R&D capital.

We have seen that the four corners of the square model represent the annuitand, annuitant, entrepreneur and inventor. We have looked at two kinds of partnership that correspond to the formation of entrepreneurial capital (embodied by the partnership between the annuitant and entrepreneur), and that of R&D capital (embodied by the partnership between the annuitand and inventor). Often these partnerships are concealed under family bonds. The father is the annuitand (later, annuitant); the sons are the entrepreneur and, possibly, the inventor. The family is the social unit providing a primitive framework for the exchange of income and wealth among its members as the need may arise. Name-plates such as “Smith & Sons” herald exactly such an exchange.

The square model of the capital market is a great improvement over the diagonal. Still, there is room for further refinement. We shall now introduce what I figuratively call “the pentagonal model of the capital market” featuring a fifth protagonist. This refinement of the square model will demonstrate the impetus that further division of labor can bring to bear upon the process of capital formation.

### The Pentagonal Model

The relative bargaining position of the four participants in the square model fails to be symmetric. In particular, the providers of credit, the annuitand and annuitant, do not depend on the exchange in order to reach their ultimate ends, unlike the users of credit, the entrepreneur and inventor, who do. One fatal shortcoming of the diagonal model, and the equilibrium theory of the capital market, is the failure to reflect this fundamental lack of symmetry.

Zero interest means the denial of incentives to proceed with the exchange of income and wealth. Given this denial, the providers of credit shall abstain from the exchange and fall back on direct conversion. The annuitand will convert his income into wealth through hoarding, and the annuitant will convert his wealth into income through dishoarding. It would be absurd for the former to exchange income for wealth not greater than that he could himself accumulate through hoarding, and for the latter to exchange wealth for an income not greater than that he could himself generate through dishoarding.

The entrepreneur and inventor are the losers if exchanges dry up. For them zero interest is an un-surmountable obstacle to capital formation. The entrepreneur’s potential income would not be generated for lack of entrepreneurial capital. The inventor’s potential future wealth could not be realized for failure to accumulate R&D capital. He is forced to abandon his project to make the production cycle more roundabout, and hence more productive, as he lacks financing and sustenance.

We see that zero interest, i.e., the absence of credit, is equivalent to direct conversion of income into wealth and wealth into income. It forces the annuitand and annuitant to revert to the atavistic method of conversion via hoarding and dishoarding the most hoardable commodity. At zero interest there is no exchange, only direct conversion of income into wealth. While the annuitand and annuitant do have a choice, the entrepreneur and inventor do not. The latter are fully dependent on the agency of exchange and credit if they want to convert. The square model reveals that the exchange of income and wealth is inherently asymmetric. The annuitand and annuitant can still satisfy their need if the exchange fails; the entrepreneur and inventor cannot. For them it is no exchange - no conversion.

This impairment of the bargaining position of the entrepreneur and inventor can be somewhat assuaged by the services of a fifth protagonist entering the capital market. As we pass from the square to the pentagonal model the marginal entrepreneur and the marginal inventor, who have been left out in the cold, can be accommodated as follows.

They could form a partnership whereby the entrepreneur provides the income needed by the inventor to complete his project. The partnership will be net long of present wealth and net short of future wealth. But in as much as present and future wealth are not exchangeable in the absence of credit, the partnership is not viable. The entrepreneur and inventor must find a third partner who is willing to provide the needed credit in offering present for future wealth. This need has led to the emergence 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 capital markets.

### The troika of the entrepreneur, inventor, and capitalist

The rise of the capitalist is hereby explained not in terms of exploitation, but in terms of services only a specialist can provide. These services are demanded by the partnership of the marginal entrepreneur and the marginal inventor. The former is the entrepreneur who has just missed his chance to form a partnership with the annuitant, and the latter is the inventor who has just missed his to form a partnership with the annuitand. Without the services of the capitalist their talents would be lost to society. Thus capitalism must be seen as the social system which allows individuals to specialize in the exchange of present for future wealth in order to enlarge the scope for entrepreneurial and inventive talent. Before the advent of capitalism marginal talent was wasted. Now, with the participation of the capitalist, society is able to realize the full benefit of talent possessed by its members. The result is obvious if we look at the remarkable technological and commercial progress in the world after the advent of capitalism.

The triangular partnership of the entrepreneur, inventor, and capitalist, or troika for short, is the most potent and dynamic force in the economy that society has heretofore produced. Ludwig von Mises considers members of the troika the “most progressive elements” in capitalist society. They benefit the non-progressive majority in every possible way. The particular combination of talent, brain- and will-power represented by the troika 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 was wasted. The steam turbine was invented in the first century A.D., by Hero of Alexandria, and the airplane 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. The most ingenious technological inventions remain useless if the capital required for their utilization has not been, or cannot be, accumulated.

As I have mentioned in earlier Lectures, previous theories all derive interest from the need to exchange future for present wealth. Here we see that this need is far from being fundamental. It only arises at the margin, and the resulting credit is only the tip of the iceberg. The great bulk of credit is consummated through the less visible exchanges of income and wealth.

### The Capitalist as the Patron Saint of the Common Man

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 troika of the capitalist, entrepreneur and inventor. 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 partnership of the entrepreneur and inventor vis-a-vis the annuitand and annuitant, through encouraging the activities of the capitalist. If the latter is hampered in his business, then the partnership of the annuitand and annuitant will enjoy monopoly power and, as a result, the rate of interest will be high. The capitalist is the only actor that can offer competition for the monopoly. As a result of this competition the rate of interest has been reduced from the extremely high levels prevailing in pre-capitalistic times to a low level that puts all bona fide inventors and entrepreneurs in business. Even more remarkable is the fact that capitalism has accomplished the feat of reducing the rate of interest without harming the annuitand and annuitant. Every member of society, regardless of his contribution to the success of capitalism, 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 higher wages due to the increase in the marginal productivity of labor and capital, made possible by countless inventions.

Only with reference to capital accumulation can we explain the practically inexhaustible list of prodigious amenities, and previously unheard-of comfort and security, all benefiting the common man, which is due solely to the lowering of the rate of interest through the activities of the capitalist.

### Runaway Vibration

Many of these great achievements have been frittered away since 1971, the year governments of the industrialized world declared irredeemable currency “money”, thereby destabilizing the interest-rate structure. Starting that year the world has been treated to a spectacle of gyrating rates of interest the like of which has never been seen before. First, an arbitrary increase in the level of interest rates rendered a vast amount of capital and labor submarginal, causing the closure of production facilities, resulting in unemployment, inadequate capital maintenance and, ultimately, capital decumulation and destruction. To combat outrageously high interest rates governments unleashed the scourge of speculation. Let us bypass the fact that this intervention was disingenuous as the government itself was responsible for the destabilization of interest rates in the first place. Let us focus on the fact that not only has speculation aided and abetted by the government brought down the rate of interest, but it is also responsible for making it to plunge to zero. Speculation also makes the volume of activity in the credit markets to grow at an exponential rate as derivatives such as bond futures and options proliferate at a prodigious rate. By now speculative activity represents a high multiple of the volume of productive activity.

Previously, the former was a low percentage of the latter, as speculation was limited to addressing risks created by nature to the exclusion of risks created by man. In 1971 this limit was forcibly removed. Speculation addressing risks created by man, that is, by governments and central banks (e.g., interest and foreign exchange risks) started to overwhelm the economy and, by now, it is increasing at an exponential rate in good times as well as in bad. The artificial creation of risks has caused a chain-reaction of speculative activity with unforeseeable destructive consequences. As we shall see, volatility of the rate of interest is matched by that of the price level. Moreover, the two are linked. This linkage leads to resonance between the gyrating rate of interest and the gyrating price level. Resonance brings about runaway vibration as manifested by exponentially increasing amplitude (the exact opposite of the more common phenomenon of damped vibration). The runaway vibration of the rate of interest and the price level hits the economy with ever greater destructive force. Unless a valid policy of stabilization is put into effect, and soon, the ever widening swings in the rate of interest and the price level threaten the economy with collapse. I shall return to the problem of runaway vibration in the economy in a later Lecture entitled Bond Speculation.

### Rising Interest Rendering Capital Submarginal

I have mentioned that an increasing rate of interest causes capital invested in production to lose value. The reason for this is the mathematical fact that the present value of future income falls when capitalized at a higher rate of interest. Indeed, the present value of income is calculated by discounting future payments at the going rate of interest. Thus any increase in the latter immediately slashes values that owe their origin to capitalization of incomes. An unwelcome side-effect is that the value of all production goods falls pari passu with the rise of interest rates, regardless of their productivity. In particular, much of the park of capital goods society has is rendered submarginal and, sooner rather than later, their productive life must come to an end. Production and employment will shrink in consequence of rising interest. But since interest rates have risen capriciously as a result of the government’s embracing irredeemable currency, there appears to be no real justification for falling production and growing unemployment. Authors of the Brave New World of fiat money have forgotten to take the murderous effect of rising interest on production into account.

Suppose that you are a dealer selling tractors, and the rate of interest rises. As if by magic, all tractors on your lot lose value instantaneously. Nobody will pay the old price knowing that the contribution to production expected from the tractor is less than the sticker price. Thus, without any change in the tractor’s physical condition, or in the circumstances of its application in the field, the value of the tractor has been slashed. The new price is still determined by the present value of future income that buyers expect to derive from its use. But since that income is now discounted at a higher rate, the new price will be lower.

Of course, capital goods already deployed in production also lose value for the very same reason. The entire park of capital goods in the country is decimated. Moreover, this loss of value is irreversible. Submarginal capital withdrawn from production will no longer be maintained. Even if the rate of interest comes down later, value is gone, never to return.

Society has been inflicted a permanent loss of capital values which has no justification nor redeeming features. It is the result of insane monetary policies, in particular, the destruction of the gold standard and its consequence: the destabilization of the interestrate structure.

### Falling Interest: Good or Bad?

Superficial thinking may suggest that if a rise of interest rates is bad, then their fall is good. Not so. A falling rate of interest is even more damaging for the economy than a rising one. I am aware that my thesis is highly counter-intuitive. I have been challenged by other economists who deny the validity of my contention. They argue that if the present value of future income is lower when discounted at a higher rate of interest, then it must be higher when discounted at a lower rate. We may admit that this statement is true. However, it has no relevance to the case under consideration. The firm must be around in order to collect the future income whose present value would be higher as a result of lower interest rates. The point is that many of them won’t be, as they succumb to capital squeeze caused by falling rates.

My critics hold that falling interest rates are always beneficial to business and, as such, could not aggravate deflation. (Here deflation means the combination of falling prices and falling interest rates). They are confusing a falling with a low structure of interest rates. While the latter is beneficial, the former is lethal to producers. When interest rates are falling, the low rates of today will look like high rates tomorrow. A prolonged fall in interest rates creates a permanently high interest-rate environment. This paradox explains the reluctance of the mind to admit that a prolonged fall in the rate of interest spells deflation and, possibly, depression.

Worse still, falling interest rates mean that business has been financed at rates far too high. This fact ought to be registered as a loss in the profit/loss statement, and be compensated for by the injection of new capital (much the same as would losses caused by damage to plant and equipment due to war, for example). Instead, businesses choose to ignore the loss, and they merrily go on paying out phantom profits in the form of dividends, further weakening capital structure. When they plunge into bankruptcy, they wonder what has hit them. They don’t understand that they have failed to augment their capital in the face of falling interest rates, and their downfall is due to insufficient capital.

I shall return to this problem in a later Lecture entitled “Accounting under a Falling Interest-Rate Structure”.

### Bond Speculation is No Zero-Sum Game

Once more we see that damage is caused by the destabilization of the interest rate structure. Under the gold standard interest rates were stable, as were bond prices. Bond speculation was unknown. Arbitrageurs saw to it that bond prices remained stable in the face of temporary setbacks due to natural causes such as floods, earthquakes, and crop failures. Destabilization came as the gold standard was destroyed by governments advised by doctrinaire economists with vested interest in inflation. They justified inflation as “the lesser of two evils”. They abhorred the thought of deflation. What they utterly failed to grasp was that their policies were to cause both. In fact, they made the Kondratieff long-wave cycle, consisting of alternating inflationary and deflationary spirals, to get out of control. It was criminal negligence of gigantic proportions on their part that they never investigated the more remote consequences of the destruction of the gold standard. Of course, the inflationists realized that their anti-gold policies would destabilize the value of the national currency and unleash speculators in the foreign exchange markets. They welcomed this as a salutary development, and pointed to the manipulation of monetary policy as a means to their nationalistic and autarkic ends. What they didn’t realize was that the destruction of the gold standard would also destabilize the interest rate structure, and unleash speculators in the bond market. Fluctuations in interest rates due to the Kondratieff long-wave cycle would be aggravated. Nor did they realize that a prolonged fall in the rate of interest is extremely deflationary and could plunge the economy into a depression. This point is still not widely appreciated, and the world appears to be completely ignorant of the dangers of depression brought about by the destruction of the gold standard albeit with a thirty-year delay. Economists of the present vintage have been trained to see in the gold standard the direct cause of depressions. This is the exact opposite of the truth, as the following discussion will reveal.

Bond speculation is no zero-sum game. Virtually all speculators are on the long side of the bond market as they want to preempt the central bank in buying the bond. (Note that the central bank makes bond speculation risk free through its open market purchases of bonds.) Who are on the short side? Why, the producers, of course. They are passive participants with their capital at stake, whether they like it or not. They have literally no choice in the matter. They have been turned into sitting ducks in this unconscionable shoot-out for the benefit of speculators by deliberate government policy. Moreover, the producers are quite unaware of what is going on. In particular, they are completely oblivious to the fact that they are served up as the sacrificial lamb on the altar of government omnipotence. Bond speculation aided and abetted by government is responsible for denuding producers of their capital and for transferring their wealth to the speculators in the form of unprecedented profits on their long positions in bonds. I shall return to the destructive aspect of bond speculation in a later Lecture.

We may conclude that the best economic climate for all the non-parasitical elements of society is the one with a stable interest-rate structure, such as the one provided by the regime of a gold standard. It is charged that in the 19th and the 20th centuries the gold standard failed to stabilize prices. However, in a dynamic economy admitting growth the stabilization of prices is neither possible nor desirable. The great merit of the gold standard must be seen in the feat that it has stabilized the interest-rate structure so as to prevent the financial sector from becoming a vampire sucking the life-blood of the producing sector. It must be realized that this is an unstable world, and the best one can do is to stabilize interest rates (as well as foreign exchanges) by adhering to a gold standard. Prices will then take care of themselves.

### The Shylock Syndrome

The analysis of the phenomenon of interest in terms of the pentagonal model of the capital market is far superior to the conventional. While the latter admits only the exchange of present and future goods, the former incorporates the exchange of income and wealth as well. The exchange of present and future goods by itself is wholly inadequate as a basis on which to build a theory of interest. Apart from the fact that no one has ever exchanged an apple available today for 1 and 1/20th of an apple available a year from now (still less for 2 apples available 50 years from now), the problem of exchanging present for future wealth does not arise from any readily identifiable human need, except in the context of the activities of the capitalist in augmenting the exchange of income and wealth as discussed above. Other than this residual activity the exchange of present for future wealth has no basis in reality.

By contrast, the problem of exchanging of income for wealth arises out of a natural and universal human need: that of the elderly to live out their lives in relative comfort and security. This exchange explains the phenomenon and nature of interest in terms of 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 annuitand to the capitalist, are harmonious and complementary. There is no reason to detest the capitalist and depict him as Scrooge, any more than detesting the heart surgeon and depicting him as a butcher. They are both specialists, and their roles can only be understood 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 the annuitant or the inventor and the annuitand have already been formed. At this point further improvement would not be possible without the services of a specialist doing arbitrage between present and future wealth, as long as unemployed entrepreneurial and inventive talent may still exist.

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 was this Shylock-syndrome that the socialist movement was able to exploit with such consummate skill, appealing to the authority of Aristotle. In the present context is appears that this view is nurtured by a dismally inadequate understanding of division of labor.

The compact between lender and borrower demands that the latter be a superman, uniting in himself the talents of the entrepreneur and the inventor as he wants to meet the terms of his contract in full. How otherwise could he be expected to return a greatly enhanced wealth to the lender at the end of the loan period, and stay in business, without ruining himself? Surely the terms of his contract giving the lender the right to cut out a pound of flesh from any part of his body at the option of the latter was designed with the extinction of his life in mind - according to the socialist’s view. What this view disregards is the fact 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 into wealth and wealth into income, and its optimal solution via the agency of exchange, credit, and division of labor, then 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 and 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, which no longer plays an important role in the economy, then we shall find that capital can only be formed in one of three possible ways: through a partnership between (1) the annuitant and the entrepreneur, (2) the annuitand and the inventor, (3) the entrepreneur, the inventor, and the capitalist. Debt-creation can never create capital per se, it only shifts risks implicit in previously existing partnerships without producing new wealth. By contrast, the formation of capital in any of the three ways described above does create new wealth, in particular, through capitalizing incomes.

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 offering unprecedented efficiency. (This, incidentally, may be the reason why it is hated so by the indolent.) The priorities of capitalist society are not set by bureaucrats or zealots with the power of disposal over the fruits of the labors and savings of others, but by the laborers and savers themselves who stand to suffer losses if the project fails. Bureaucratic power under socialism means that mistakes can be heaped upon mistakes before correction is made, if ever. 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 capitalist in concert with the annuitant has veto power over the plans of the entrepreneur; the entrepreneur in concert with the annuitant and the capitalist has veto power over the plans of the inventor. The inventor has no veto power at all, but in so far as there are more annuitands than annuitants, as obtains under a positive population growth and is therefore a characteristic of a dynamic society, capitalism can employ more inventive than entrepreneurial talent. 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 governmentally sponsored research. It is these dynamic forces, measured by a surplus of R&D over entrepreneurial capital formed by the annuitand and the inventor, which create the educational facilities and equip the laboratories, without any trace of coercion. The government can hardly do more than coordinating and standardizing 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, in trying to dictate educational and research priorities, is far from being progressive. It is, in fact, retrogressive - as the present analysis shows.

### Exploding the Myth of the Welfare State

Finally, the pentagonal model 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 only arise at the margin, and they represent but the tip of the iceberg. The incomparably greater part of capital society depends on in order to provide annuity income for the aged is furnished by the less visible partnerships of the annuitant and the entrepreneur, as well as those of the annuitand and the inventor. Governmentally dictated social security eliminates, or at least severely curtails, voluntary exchanges of income and wealth, and thereby hampers capital accumulation. The Welfare State confuses charity with entitlement. Its huge commitment to place social security benefits on the basis of universality has 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 of projected benefits.

We cannot help but view the capitalist economy as a highly integrated welfare-machine: individuals voluntarily exchanging goods against goods, goods against services, and income against wealth. In the process they form voluntary partnerships, thus creating wealth by capitalizing incomes. The Welfare State cannot invade one part of this machine, taking over its functions, and expect that the other part will go on performing satisfactorily. This invasion means the forcible dissolution of partnerships and the dissipation of their capital. Yet the corresponding liability in the consolidated balance sheet of the nation remains. It will have to be balanced by new assets. The government pretends to do this by printing government bonds payable in irredeemable currency. As long as purveyors continue accepting irredeemable currency in exchange for real goods and services, the game of musical chairs will go on. There have been many precedents in history for such a game, and the music has always stopped at one point or another in all previous episodes. It will also stop in the present one, even though we may be unable to pinpoint the exact timing. Here is the reason why.

The capital of the nation is seriously eroded as it has been deprived of augmentation from capitalizing the income of the annuitand in partnership with the inventor. The deficiency of capital eventually shows up as increases in the cost of goods and services. Producers are squeezed and suffer losses. Some will succumb and get out of business; others will raise prices. Either way benefits promised are nullified by the side-effects of the blind policies of the Welfare State: capital destruction and currency depreciation. The alleged benefits must be set against this background: the so-called Welfare State has a hidden scheme to debase the currency and dissipate society’s capital.

The last étape in this analysis of the process of capital accumulation will take us to what I figuratively call the hexagonal model of the capital market, and the appearance of the last protagonist of the drama of human action, the investment banker, and his specialized instrument, the gold bond. This is the subject of the next two Lectures.

### ***

### The marginal utility of gold is constant. True or false?

Gold Standard University participant George Weinbaum wrote me as follows: “I disagree that gold’s marginal utility is constant. I believe its marginal utility declines more slowly than that of any other item, and so it most closely approximates what may be regarded constant marginal utility.”

I hasten to concede the point, and I congratulate George on his keen sense of understanding. The commodity whose marginal utility declines more slowly than that of any other is very special. It will be hoarded in preference to other substances. In fact, it is what I have called “the most hoardable commodity”. There is a feedback-effect: the more this substance is hoarded the more nearly its marginal utility will be constant, ahead of all others. Its marketability in the small will snowball and eclipse that of all others.

However, strictly speaking, there is no substance in existence with constant marginal utility, nor will ever be.

The most hoardable commodity, the one whose marginal utility declines more slowly than that of any other is, and has been since time immemorial, gold. In fact, this is the property that imparts to gold its quality of being money, and denies this quality to other substances or to debt instruments. The vast hoards (in terms of the stores-to-flows ratio) of gold in existence that were built up over thousands of years in response to gold’s unique property is the guarantee that no other commodity can displace gold in this regard, and no government or combination of governments can succeed in its efforts to

“demonetize” it.

I took poetic liberty in saying that gold’s marginal utility is constant. This is acceptable as a first approximation, and it has given me the opportunity to simplify presentation.

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, NL, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

Lecture 1:

Lecture 2:

Lecture 3:

Lecture 4:

Lecture 5:

Lecture 6:

Lecture 7:

### Ayn Rand’s Hymn to Money

### Don’t Fix the Price of Gold!

### Credit Unions

### The Two Sources of Credit

### The Second Greatest Story Ever Told; (Chapters 1 - 3)

### The Invention of Discounting; (Chapters 4 - 6)

### The Mystery of the Discount Rate; (Chapters 7 - 8)

### Lecture 8: Bills of the Goldsmith; (Chapter 9)

Lecture 9: Legal Tender. Small Bank Notes.

### Lecture 10: The Revolt of Quality

### Lecture 11: The Acceptance House; (Chapter 10-11)

### Lecture 12: Borrowing Short to Lend Long; (Chapter 12)

### Lecture 13: The Unadulterated Gold Standard

## Winter Semester, 2003

### Monetary Economics 102: Gold and Interest

### Lecture 1: The Nature and Sources of Interest

### Lecture 2: The Exchange of Income and Wealth

### Lecture 3: The Janus-Face of Marketability

## Winter Semester, 2004

### Lecture 4: The Principle of Capitalization of Incomes

### Lecture 5: The Pentagonal Model of Capital Markets

### Lecture 6: The Hexagonal Model of Capital Markets

### Lecture 7: The Bond Equation and the Rate of Interest

### Lecture 8: Lessons of Bimetallism

### Lecture 9: Speculation

### Lecture 10: The Kondratieff Long-Wave Cycle

### Lecture 11: The Ratchet and the Linkage

### Lecture 12: Accounting under a Falling Interest-Rate Structure

### Lecture 13: Aristotle on Check-Kiting

## In Preparation:

Monetary Economics 201: The Bill Market and the Formation of the Discount Rate Monetary Economics 202: The Bond Market and the Formation of the Rate of

### Interest

---

# Monetary Economics 102 — Lecture 4: The Principle of Capitalization of Incomes

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-102-lecture-4-the-principle-of-capitalization-of-incomes/
Date: 2004-01-01
Section: Money & Credit
Difficulty: scholarly
Concept Tags: interest-theory, bond-market, capital-destruction, gold-standard
Description: Fekete develops the principle of capitalization: the market value of any income stream is determined by dividing it by the prevailing interest rate. He shows that falling interest rates mechanically increase bond prices and measured capital values while simultaneously destroying the real productive capacity of the economy — a hidden capital destruction.
Editorial Note: Lecture 4 of Monetary Economics 102 (Gold Standard University, 2004). This lecture provides the analytical link between Fekete's interest theory and his diagnosis of modern capital destruction through Fed-induced interest-rate suppression.
Original PDF: https://professorfekete.com/articles/AEFMonEcon102Lecture4.pdf

### Lecture 4

*The Principle Of Capitalization Of Incomes*

¶ Optimizing provision for deferred consumption ¶ Teleology versus causality ¶ No usury is involved in the exchange of income and wealth ¶

The triple contract ¶ Turning the stone into bread and water into wine? ¶

Inflationary and deflationary spirals ¶ Double entry book- keeping ¶

### Oriental hoarding — Occidental dishoarding ¶ Interest and the

### Reformation

### Optimizing Provision for Deferred Consumption

We have seen that whenever provision for deferred consumption is made, it is done through converting income into wealth as the initial step, later to be followed by the conversion of wealth back into income as the concluding step. The question of optimizing the conversion arises naturally. In the last Lecture we discussed how the selection of the most hoardable good provides an answer to the problem of optimization on condition that we are confined to direct conversion, that is, hoarding and dishoarding. However, further optimization will be possible as soon as indirect conversion becomes available to augment direct conversion. Recall that indirect conversion means the exchange of income and wealth. It appears when the prohibition on such exchanges has been removed, making hoarding and dishoarding obsolete. Indirect conversion is the irreducible form of credit that represents a leap in efficiency over direct conversion. The party giving up present wealth in exchange for future income is the supplier of credit. Interest is seen as the measure in the increase of efficiency of conversion due to the appearance of credit, zero interest meaning direct conversion.

As history and logic suggests, income is primary and wealth is derived. This recognition was codified by the American economist Frank Fetter as the Principle of Capitalizing Incomes. It states that the value of wealth is due to the possibility of converting it into income (deriving an income from it). Thus income is the source from which the value of wealth flows. The capitalization of comparatively safe permanent incomes contains within itself all the factors for the independent determination of the rate of interest.

### Teleology versus Causality

The merit of the Principle of Capitalizing Incomes is that it puts the phenomenon of interest into its proper context. Without it the mistaken belief may take hold that wealth is primary and income is derived. Income is obtained by putting wealth out at interest. But how is wealth obtained? This is a question that cannot be side-stepped, and it is not a chicken-and-egg problem either. Wealth is obtained by capitalizing incomes.

The theory of interest holds a very special place in the history of human thought. Since the time of Aristotle the practice of charging and paying interest on wealth put out in loans has been stigmatized and, in many cases, criminalized. Even though the Reformation put an end to the latter, much of the stigma has remained and continues to be the source of anti-capitalistic agitation. Aristotle's mistake in ruling that taking and paying interest is against natural law (pecunia pecuniam parare non potest) was that he looked for the causes of interest — finding none. Instead, he should have looked for ends that interest might serve — in which case he could have found the Principle of Capitalizing Incomes. Here we have a most important means of wealth-creation: people with little or no wealth can get it by capitalizing (part of) their income. Indeed, ever since interest was decriminalized, the accumulation of productive capital has accelerated beyond belief, along with the proliferation of inventions finding industrial (not to mention therapeutical and recreational) applications.

Thus the Principle of Capitalization of Incomes exposes the teleological nature of interest. The sources of interest cannot be determined on the grounds of causality. Nor can interest be stamped out of existence by secular or canonical authorities as it is the result of purposive action, being inextricably involved with the conversion of income into wealth and wealth into income by economizing individuals, for whom it is indispensable for survival. Proscriptions against interest may eliminate the exchange, but never the conversion. The economizing individual may simply bypass the exchange and fall back on atavistic forms of conversion: hoarding and dishoarding. However, society would pay a high price for such wrong-headed policies. Wealth-creation would suffer a setback.

Industrious and frugal people would be prevented from accumulating capital. Efficiency would be sacrificed, and society penalized for the sake of "ideological purity".

The right approach to understanding the phenomenon of interest recognizes its teleological nature. It does not attempt to explain the nature and sources of interest on the grounds of causality. As Carl Menger has emphatically pointed out, all voluntary exchanges, such as that of goods for goods, or goods for services, are based on the mutual advantage of the parties. The exchange of income and wealth is no exception. Here, too, either party gets something it wants more in exchange for something it wants less. The Principle of Capitalization of Incomes was originally stated by the American economist Frank A. Fetter in his Principles of Economics.

There are two ways of looking at lending \$1,000 for ten years at 5% annual interest, although only one of the two, the loan, is normally recognized, in spite of the fact that the other is the more revealing. Thus the man who borrowed \$1,000 for ten years at 5% annual interest has, at that price, sold an income of \$50 per annum for a period of ten years. At the end of that period he has the right and obligation to repurchase the same income at the same price. It is clear that both the lender and the borrower are better off with the exchange than without. Typically, the seller of the income is a younger man, while the purchaser is older. The former is well able to generate the surplus income he has sold through physical or mental exertion. With the proceeds of the sale he will buy the necessary capital goods he needs in his enterprise to increase the efficiency of production. The latter, the buyer of the income, could hardly put his wealth to a better use than making a loan in order to augment his income. "He cannot take it with him", as the saying goes. He is no longer able to augment his income through increasing his physical or mental exertion. The reason for his accumulating wealth earlier was precisely the recognition that time would come when his surplus of physical and mental energy would give way to a deficit. These are his "harvest years", and the facility of exchanging wealth for income is his tool of harvesting. The Principle of Capitalization of Incomes recognizes the division of labor between successive generations. It is based on cooperation that is perfectly voluntary, quite unlike the coercive "social security system" sponsored by the government, whereby a shrinking number of younger workers are coerced into supporting one older retiree, while the population of retirees is exploding.

These considerations were lost in the heated debates about usury and other aspects of the nature and sources of interest, not to mention the debates about the merits and demerits of governmentally enforced “old age security”. It is time to recognize that voluntary division of labor has always been at the source of any act of exchange, including exchanging income and wealth.

### No Usury Is Involved in the Exchange of Wealth and Income

Contrary to the bad press it has been receiving in this age of "scientific culture", scholastic philosophy was way ahead of contemporary thought and, in many respects, it is also ahead of ours. An outstanding example is scholastic thought on the subject of interest and on the question of usury. The scholastic fathers were careful to distinguish between usurious interest charged on personal loans and on 'dry exchanges' on the one hand, and interest involved in the exchange of income and wealth on the other. They did not consider the latter usurious. The issue came to a head at the Council of Constance in 1414 that upheld the position of the schoolmen that the purchase and sale of rent-charges and annuity contracts involved no usury. Apparently, this decision did not satisfy the more dogmatically inclined (not to say economically more backward) segments of the Church. They raised the question again in Rome some ten years later. In 1425 Pope Martin confirmed the earlier decision made by the Council, thereby conclusively ending the debate.

Scholastic philosophy was on solid grounds with regard to its stand on the narrowing the definition of usury to exclude interest on the exchange of income and wealth. According to the Jesuit economist Istvan Muzslay, Thomas of Acquinas (1225-1274) determined that a modest interest (in our terminology, discount) was justifiable on short-term commercial credit as a risk-premium (damnum emergens), as well as compensation for lost income (lucrum cessans). We shall return to this point in a future course on the bill of exchange.

### The Triple Contract

In Lecture 2 I have examined "rent charge" as an important historical example of the exchange of income and wealth. A second example is the Triple Contract or contractus trinus that was popular in the Middle Ages and in the Renaissance. As its name indicates, it was a combination of three contracts in one as follows: (1) a partnership contract between the 'lender' and 'borrower' sharing the profit or loss in the borrower's business, (2) an insurance contract through which the borrower promised the lender compensation for any possible loss in the business, and (3) another insurance contract through which the borrower guaranteed the restitution of his share of the capital to the lender after a stated number of years, regardless of the fortunes of the enterprise, provided that the lender gave up his claim to the full share of profits. It can be readily seen that the triple contract rationalized interest as an insurance premium. Economically, capital stock in the enterprise has been legally converted into a bond paying interest to the owner of the bond at a fixed rate.

This construction is most revealing. It exposes the point of contact between the marginal productivity of capital and pure interest. It reveals that every investment is an exchange of wealth for income. It also reveals the character of pure entrepreneurial profit as an insurance premium that the entrepreneur must collect in order that his business may survive the vicissitudes of an uncertain economy. Comparing the triple contract to tripleentry accounting (mentioned in Lecture 2) we see that the lender is the capitalist and the borrower is the entrepreneur. It does not matter whether a manager is hired, or whether the entrepreneur acts as his own manager. The substance of the contract is the underlying exchange of wealth and income. The triple contract was also considered as an admissible use of credit that escaped proscription on grounds of the usury laws. The problem of exchanging wealth and income, and its relevance to the problem of interest, has also been treated by the British economist Philip Wicksteed.

### Turning Stone into Bread and Water into Wine?

As discussed above, the point of departure in this study of the phenomenon of interest is the recognition that an inexorable need exists, second only to the need for food and shelter, urging the economizing individual to convert income into wealth in order that later, when past his prime, he may convert his wealth back into income. For him, income is an ultimate end, insofar as without it he may have no other ends in this “valley of tears”. Since wealth is an indispensable means to that end in the twilight years of his life, his need for conversion is beyond doubt. The theory of private property ought to take full account of the fact that the conversion of income into wealth is the rational and characteristically human manifestation of the law of the biosphere where all living things can only survive by hoarding their substance in one form or another. In case of the economizing individual this substance, as we have just seen, is the “most hoardable” commodity, gold, which is in demand even as it is offered in the smallest practically realizable quantities, and can be traded with the smallest possible exchange losses.

In passing we may touch upon a paradox that utilitarian philosophy has failed to solve.

An apparent contradiction exists between the needs of the individual and society. There is a time in the life of every individual when he needs to draw on his savings accumulated earlier. Yet dishoarding (no less than hoarding) is being looked at with disapprobation, as an anti-social activity. It is unsettling as it allegedly affects supply unfavorably, possibly at a time considered inopportune from the point of view of society. (By the same token, hoarding allegedly affects demand unfavorably.) The utilitarian philosophers could not clarify how the market provides for the conflicting demands of society and its ageing members. Utilitarian philosophy has failed to solve the problem of hoarding and dishoarding. In particular, it has failed to explode the arguments of Silvio Gesell, John Maynard Keynes, and other inflationists, according to which the contractionist and deflationary pressures inherent in a metallic monetary system can be the source of poverty and chronic economic distress. In particular, the gold standard admits hoarding of the monetary metal which, according to inflationist doctrine, is deflationary and the chief cause of depression. At the same time these authors talk about the inflationist paradise, where the miracle of “turning stone into bread and water into wine” would be routinely performed by monetary technicians in the service of governments.

I refute the inflationist argument in the spirit of utilitarian philosophy, removing an obstacle that had for a hundred years blocked the advancement of monetary science, as follows. One must distinguish between two kinds of dishoarding. It is the dishoarding of marketable goods other than gold that is deflationary. Dishoarding gold does, on the contrary, ease the (real or imagined) shortage of purchasing media. To the extent gold is hoarded occasionally, if is offset by occasional dishoarding. The gold standard is far from being contractionist as asserted by the inflationists. Quite to the contrary: gold is the chief prophylactic that protects the economy against deflation. When the banks or the government sabotage the gold standard, they spawn a cycle known as the Kondratieff long-wave cycle. The hoarding instincts of the people are channeled away from gold, a natural conduit (as gold is not essential for human consumption), to other marketable goods, an unnatural conduit and a dangerous agent when hoarded (as they could be indispensable for human consumption). The cycle manifests itself through the destabilization of the price structure as hoarding (dishoarding) marketable commodities results in rising (falling) prices. The cycle of high and low prices gives rise to a resonating cycle of high and low interest rates, as further analysis shows. The Kondratieff long-wave cycle consists of inflation alternating with deflation. Resonance ultimately causes a “runaway vibrator” effect that is capable of destructing the economy.

### Inflationary and Deflationary Spirals

I define an inflationary spiral as the phenomenon of a rising price level causing people to hoard marketable goods which, in turn, causes further price rises forcing a repetition of the process. The definition of a deflationary spiral is analogous. It is a statistical fact, first observed by the Soviet economist N.D. Kondratieff (1892-1930) that, for the past two hundred years or so, inflationary and deflationary spirals have alternated, each lasting for a period of 25-35 years. I shall discuss the Kondratieff long-wave cycle in greater details later in these Lectures.

The most ominous consequence of the deliberate destruction of the gold standard is that the Kondratieff long-wave cycle is getting out of hand, becoming a runaway vibrator and threatening the world economy with a depression more devastating than any previously experienced. When gold is banned, people will not refrain from hoarding. On the contrary, their attention will forcibly be focused on the urgency of hoarding as they fully expect prices to rise in the wake of the government and the banks defaulting on their gold obligations. This triggers an inflationary spiral that must come to a violent end when prices over-react and threaten the value of hoarded goods with an imminent collapse of prices (in other words, the principle of declining marginal utility finally asserts itself). At that point hoarding gives way to dishoarding, and a deflationary spiral is triggered. As prices fall, more dishoarding occurs since owners of hoarded goods scramble to cut their losses. Producers go bankrupt in droves, and unemployment soars.

Many a book has been written on the microeconomic damage that the destruction of the gold standard by government sabotage has caused (such as damage to savings, capital accumulation and maintenance). Yet authors have not given sufficient attention to the macroeconomic damage for which the destruction of the gold standard is also responsible, such as the deflationary spiral, bankruptcies, debt repudiation on a massive scale, falling production, and growing unemployment. Paradoxically, the gold standard is blamed for causing depressions when, in fact, the sabotaging of the gold standard is the culprit.

At the present juncture the world economy is threatened by a treacherous deflationary spiral that could end in the worst depression ever. It is not possible to understand this development without realizing that the removal of the gold standard has destabilized the interest rate structure and, hard on the heels of the Japanese, American interest rates are inexorably plunging to zero. Falling interest rates decimate the balance sheet of the producers, forcing many into bankruptcy. Later in these Lectures I shall give a more detailed analysis of this hidden process in terms of failure in accounting practice. For the time being I confine myself to reiterating that the disaster is a direct, although much delayed, consequence of the deliberate destruction of the gold standard some thirty years ago.

### Double-entry book-keeping

The invention of double-entry book-keeping in Italy of the Trecento was a momentous landmark in economic history. Göthe called it “one of the finest produced by the human mind” in his Wilhelm Meister’s Apprenticeship. Double-entry book-keeping is of utmost economic importance second only to the much earlier appearance of indirect exchange, making direct exchange (better known as barter) obsolete. The new invention has made indirect accumulation of capital via the instrument of contract possible, thus making direct accumulation of capital via hoarding obsolete. Previously, there was only one way for the economizing individual to convert income into wealth outside of family bonds: hoarding (for much of the Orient, which was slower in developing the institutional framework to protect contractual rights, it is still the only way). This immobilized large amounts of gold, and made capital accumulation an arduous and protracted process, in which reward was far removed from effort, dampening incentive.

The invention of double-entry book-keeping made possible a heretofore unprecedented increase in the efficiency of gold as catalyst for capital accumulation. Gold’s physical presence was no longer necessary in every conversion. From then on gold could work by proxy as its role in the conversion has become residual. Thanks to the breakthrough, partnerships could now be formed representing exchange of income (of the junior partner) for wealth (of the senior). Later, with the gradual acceptance of “sleeping partners” in the firm, the formation of a joint-stock company has become possible. Shares in the joint-stock company could be traded as fixed-income securities (see the triple contract above). Indeed, this they were in all but name, in order to avoid censure by canonical and secular authorities under the usury laws. It is clear that without doubleentry book-keeping a departing partner could not be bought out, nor would balancesheets, income statements, and stock markets, have been possible. There would be no precise and objective way of attaching value to the assets and liabilities of a firm, short of liquidation.

### Oriental hoarding — Occidental dishoarding

The new development released huge amounts of gold from private hoards as people began to accumulate and carry wealth in the form of securities disguised as partnership equity, instead of gold. By contrast in the Orient, where the social and institutional arrangements were far more inimical to the individual and his freedom to choose, the demand for gold and silver for hoarding purposes continued unabated. During the Quattrocento gold disgorged by the Occident flowed to the Orient in payment for exotic goods. Spices, silk, and satin enjoyed exceptional marketability in the Occident where all great banking houses engaged in financing this lucrative trade. The world was treated to a curious spectacle. The Occident was thriving while trading its gold with the Orient for frankincense and myrrh — as it could use more of the latter, and it had learned to get by with less of the former. It was this migration of gold from West to East that gave the edge of industrial power to the Occident, an advantage it still has over the Orient.

This shows that gold is merely the whipping boy at the hand of the inflationists. Gold is not scarce, though it quickly goes into hiding the moment the government and the banks conspire to tamper with credit. There is no conflict between the welfare of society and that of its ageing members. Very little if any gold is needed to complete all the exchanges of income and wealth in the course of normal business, provided that the government does not interfere with the free choices of individuals and the banks do not engage in borrowing short to lend long. Only when such interference by the government and illicit arbitrage by the banks take place does the demand for gold become sizeable. The correct policy for the government is “hands off” — to let the market decide what is best for its participants, and to blow the whistle when banks are caught red-handed indulging in illicit interest arbitrage.

### Interest and the Reformation

The next advance came with the Reformation, during which canonical and secular strictures on interest were eased, the definition of usury narrowed and, later, the prohibition against both repealed. Whereas the partnership contract had originally been designed with the concealment of interest in mind, now it became possible, for the first time in history, to engage openly in the exchange of income and wealth with the rate of interest freely quoted. The bond market was born as a result of these historic changes.

The right to income reserved by the bondholder could now enjoy the same legal protection as the right to rent-charges (discussed in Lecture 2) enjoyed during the prohibition era. Thus it remained for the Reformation to crown the great economic advances of the Renaissance, and to free the exchange of income and wealth from its former fetters. For the first time in history the rate of interest could manifest itself as a market phenomenon.

### References

Carl Menger, Principles of Economics, New York: N.Y.U Press, 1981 (originally published in German in 1871 under the title Grundsatze der Volkswirtschaftlehre)

John Fullarton, On the Regulation of Currencies, New York: A. M. Kelley, 1969

### (originally published in London, 1844)

### Frank A. Fetter, The Principles of Economics, New York, 1905

Philip H. Wicksteed, The Common Sense of Political Economy, vol. I, London: Routlege & Keagan Paul, 1933 (originally published in 1910)

### A Message to the Friends of Gold Standard University

Last year I was, for personal reasons, forced to suspend publication of these Lectures in the course Monetary Economics 102: Gold and Interest. I am happy to have a chance to resume the series with Lecture 4. I shall do my best to avoid any further interruption. My Lecture series will continue at the rate of one Lecture per month.

I welcome my audience, wishing everyone a Happy New Year. It may turn out to be year of historical importance. 2004 may see the return of the discussion of the gold standard from the “lunatic fringe”, where it has been exiled, to the center of academic interest.

Let me take this opportunity to remind you that I have developed my theory of interest in the spirit of Carl Menger, the founder of the Austrian school of economics. Still, my theory is flatly rejected not only by establishment economists but, curiously enough, by latter-day Austrians as well. Their antipathy is presumably due to their belief that any criticism of Ludwig von Mises, whom I also respect greatly, is sacrilege calling for excommunication. My theory of interest rests on the thesis that the marginal utility of gold is constant (while that of all other commodities is declining). This is the very property that imparts to gold its quality of “moneyness”.

However, in the Gospel according to Mises we read that constant marginal utility implies infinite demand which is contradictory (I agree); ergo gold cannot have constant marginal utility (I disagree). Mises simply missed the interrelation between gold and interest. The demand for gold is not infinite because interest acts as an obstruction to gold hoarding. (For other goods, obstruction is provided by declining marginal utility). Coming to grips with this fact is the key to the understanding of the predicament in which anti-gold propaganda has landed the world. Tampering with interest ipso facto means tampering with gold, and vice versa. The two cannot be separated, and it does not matter whether the country is on the gold standard or not. If you ban gold, then people will start hoarding other marketable commodities, which brings in its wake great economic dislocation such as the destabilization of the interest-rate structure, the Kondratieff long-wave cycle, and the runaway vibrator of extreme swings in prices and interest rates.

I would like to draw your attention to the discussion in my Lecture 4 (see section under the caption “Inflationary and Deflationary Spirals”) of the so far unrecognized macroeconomic damage that the deliberate destruction of the gold standard has caused, in addition to the well-known microeconomic damage. The gold standard is blamed for causing depressions when in reality it is the best prophylactic against economic contractions. It was in fact the removal of the gold standard that has turned the Kondratieff long-wave cycle into a runaway vibrator programmed to self-destruct.

I believe what we are discussing in this course is very timely: we may be witnessing the turning of deflation into depression. The inflationary spiral that ended in 1980 was characterized by the hoarding of marketable commodities such as crude oil (incredibly, with the government of the United States as the greatest hoarder), grains, lumber, sugar, to mention but a few. 1980 also marked the beginning of the deflationary spiral of the Kondratieff long-wave cycle, characterized by dishoarding. It manifests itself as a slowing of price increases and outright price declines as producers are losing their pricing-power — the latter being so typical of the inflationary spiral. But the deflationary spiral is not over yet, as the plunge of interest rates to zero is still continuing. If American interest rates follow in the foot-steps of the Japanese, then we shall see the ugly face of depression, complete with bankruptcies, defaults, and wide-spread unemployment.

Contrary to conventional wisdom, falling interest rates are not helpful to business: they are lethal. A more detailed analysis of this hidden mechanism is one of the tasks of this Lecture series, so please stay tuned. Another danger is that the Federal Reserve, in an effort to check deflation, will run the printing press overtime. The paper mill churning out unlimited amounts of new dollars may cause runaway inflation as foreign holders of dollar-denominated assets are frightened into dumping their holdings. It is not possible to predict whether the economy will succumb to depression or to runaway inflation.

Ultimately, the issue will be decided by the bond-speculators and their risk-tolerance of carrying the burgeoning debt of the United States government in the face of the danger of a collapsing dollar.

There is still time for the United States government to steer clear of these dangers and, at the same time, to retain its monetary leadership in the world, provided that President Bush opens the U.S. Mint to the free and unlimited coinage of gold.

It will not be easy to admit that the Federal Reserve has pursued the wrong monetary policy for seventy consecutive years, cheered on by Big Government, Big Business, Big Labor, and Big Academia. Politicians, businessmen, labor leaders, and economists must swallow their pride, and accept history’s verdict that (whether they like it or not) gold is an integral part of the world economy and cannot be shunted into irrelevance. Gold will have a role to play in saving the nation and the world from a great disaster that is staring us in the face.

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, NL, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand’s Hymn to Money

### Lecture 2: Don’t Fix the Price of Gold!

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told; (Chapters 1 - 3)

### Lecture 6: The Invention of Discounting; (Chapters 4 - 6)

### Lecture 7: The Mystery of the Discount Rate; (Chapters 7 - 8)

### Lecture 8: Bills of the Goldsmith; (Chapter 9)

Lecture 9: Legal Tender. Small Bank Notes.

### Lecture 10: The Revolt of Quality

### Lecture 11: The Acceptance House; (Chapter 10-11)

### Lecture 12: Borrowing Short to Lend Long; (Chapter 12)

### Lecture 13: The Unadulterated Gold Standard

## Winter Semester, 2003

### Monetary Economics 102: Gold and Interest

### Lecture 1: The Nature and Sources of Interest

### Lecture 2: The Exchange of Income and Wealth

### Lecture 3: The Janus-Face of Marketability

## Winter Semester, 2004

Lecture 4:

Lecture 5:

Lecture 6:

Lecture 7:

Lecture 8:

Lecture 9:

### The Principle of Capitalization of Incomes

### The Pentagonal Model of Capital Markets

### The Hexagonal Model of Capital Markets

### The Bond Equation and the Rate of Interest

### Lessons of Bimetallism

### Speculation

Lecture 10:

Lecture 11:

Lecture 12:

Lecture 13:

### The Kondratieff Long-Wave Cycle

### The Ratchet and the Linkage

### Accounting under a Falling Interest-Rate Structure

### Aristotle on Check-Kiting

## In Preparation:

Monetary Economics 201: The Bill Market and the Formation of the Discount Rate Monetary Economics 202: The Bond Market and the Formation of the Rate of

### Interest

---

# Monetary Economics 102 — Lecture 3: The Janus-Face of Marketability

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-102-lecture-3-the-janus-face-of-marketability/
Date: 2003-03-01
Section: Money & Credit
Difficulty: scholarly
Concept Tags: interest-theory, gold-standard, gold-basis, real-bills
Description: Fekete introduces the concept of marketability as having two faces: salability (marketability in the large — the ability to sell any quantity without moving the price) and hoardability (marketability in the small — the premium on immediate delivery). He argues gold uniquely possesses both faces, and that the distinction between them explains the gold basis and the interest-discount spread.
Editorial Note: Lecture 3 of Monetary Economics 102 (Gold Standard University, 2003). The concept of the 'Janus-face' of marketability is one of Fekete's original contributions, providing a foundation for his analysis of the gold basis and backwardation.
Original PDF: https://professorfekete.com/articles/AEFMonEcon102Lecture3.pdf

### Lecture 3

*The Janus-Face Of Marketability*

Two kinds of marketability • Space-time duality • The subjective theory of value • Marketability in the large or salability • The subjective theory of interest • Marketability in the small or hoardability • The paper boy and his silver dime • The Fullarton-effect • The chimaera of hoardability

### Two Kinds of Marketability

It should not come as a surprise that the concept of marketability plays a central role in explaining both the origin of money and the origin of interest. The starting point of Carl Menger in studying the origin of money was the observation that the economizing individual who wants to exchange his surplus of X for Y may nevertheless exchange X for Z first, provided that Z is more easily exchangeable for Y than X, especially in large quantities. Never mind that he has no need, or he has satisfied all his needs, for Z. He will be closer to his ultimate end because Z is more saleable than X. When the usefulness of a commodity for the purpose of facilitating exchange is widely recognized, more and more economizing individuals will proceed along the same lines and, finally, the commodity that is most saleable (or, as we shall also say, most marketable in the large) becomes money. The connection between salability and marketability in the large becomes clear if we think of the great medieval fairs. Producers from far-away places brought their accumulated surpluses to the fair city. It was natural for them to quote their prices in terms of the commodity that was most marketable in the large, because they were hoping to buy and sell in bulk.

Following in Menger's footsteps, we choose our starting point in studying the origin of interest with a similar observation. The economizing individual who is producing surpluses of x and wants to create a store of y may nevertheless decide to create a store of z first, provided that z is easier to exchange for y than x, especially in small quantities.

Never mind that he has no direct need for z now or in the foreseeable future. He will be closer to his ultimate end because z is more hoardable than x. When the usefulness of one commodity for the purposes of hoarding and dishoarding is widely recognized, more and more economizing individuals will proceed along the same lines and, finally, the commodity that is most hoardable (or, as we shall also say, most marketable in the small) becomes money. The connection between hoardability and marketability in the small becomes clear if we think of the local craftsman who wants to save for his old age. It was natural for him to quote his prices in terms of the most marketable commodity in the small. He was adding small bits at a time to his retirement fund. And, after he started drawing on his fund, he would need to exchange small bits of it for food and other daily necessities.

Notice that the most hoardable commodity is generally not the most saleable one. This is the reason why throughout the ages, up to 1870, there existed two different kinds of money circulating side-by-side. In antiquity cattle became the most saleable commodity, and salt the most hoardable one. Later on these roles were taken over by others till, ultimately, the market has settled on gold as the most saleable, and silver as the most hoardable commodity.

### Space-Time Duality

This discussion reveals that money has a dual nature. We can also derive the duality of money from philosophical principles, notably from the duality of space and time. In every treatise on money, in one form or another, the proposition is advanced that money (whatever else it may be) is a transmitter of value through space and time. The concept of money is therefore directly linked to these two absolute categories of human thought. The dichotomy of space/time explains the dualistic nature of money, explicitly observable throughout the ages — right up to the demise of bimetallism scarcely over six scores of years ago. In its first capacity money transmits value in space, that is, over great distances with the smallest possible losses. In antiquity cattle were particularly well-suited for this purpose and have become money.

However, cattle-money was not particularly suitable for transmitting value over time with the smallest possible losses. This explains the emergence of another kind of money, more suitable for hoarding and dishoarding, that is, to facilitate the transmission of value over time. This other kind of money was salt. Not only was it less perishable than other marketable goods; salt was also the most important agent of food preservation. In antiquity the threat of periodic food shortages loomed large, and the chief agent of food preservation was destined to assume a monetary role.

To people of the antique world it must have appeared natural that two vastly different commodities answered their money-needs, and they took the coexistence of cattle-money and salt-money for granted. Our linguistic heritage clearly reflects this fact. The English adjective pecuniary and noun salary were derived from the Latin words pecus (meaning cattle) and sal (meaning salt). Even though gold and silver which have later replaced cattle and salt were far more similar to one another, the dual nature of money persisted throughout the ages. The main reason for that was the fact that the specific value of gold was high, and parceling it out in molar quantities added substantially to the cost of production. Only towards the end of the 19th century did advances in metallurgy make it possible that one single monetary metal, gold, could answer both monetary needs of man better than any other commodity. I refer to the development that has made it possible to produce or to recover gold in molar quantities at a cost competitive to the cost of producing the same value represented by silver (for which molar processes were not needed, thanks to the lower specific value of the silky metal). The practical outcome of this development was the recognition that the best monetary system was gold monometallism. As Bruno Moll put it in his book La Moneda, "gold is that form of possession which is of the highest elevation above time and space".

### The Subjective Theory of Value

The dualism of the monetary system is the starting point of my investigations as I explore the two sources of man's need for money. The first, man's need to transfer value over space, was put by Carl Menger in the center of his subjective theory of value. The second, man's need to transfer value over time (or, as I shall more specifically describe it, man's need to convert income into wealth and wealth into income) is at the center of my 'subjective theory of interest'. This is the preferred name we shall apply to the new theory of interest to be developed in this course here at Gold Standard University. In developing his subjective theory of value Menger described the origin of money in terms of the evolution of the marketability of goods. The unit of value could be chosen only after the most saleable commodity, gold, had been established as the monetary metal. Out of this monetary metal the unit of value, the standard gold coin, could be made.

But marketability, like the ancient Italian god Janus (in whose honor the first month of the year has been named) has two faces: marketability in the large (salability), and marketability in the small (hoardability). The former is synonymous with Menger's term Absatzfahigkeit which he has made the corner stone of the subjective theory of value.

Hoardability has not been isolated before as a scientific concept. Ours is the first attempt to analyze its role in the conversion of income into wealth and wealth into income, so that it may become the corner stone of the subjective theory of interest.

### Marketability in the Large or Salability

Menger observed that the market quotes not one but two prices: a higher ask price and a lower bid price (understood as unit prices). He placed the bid/asked spread, the difference between the two, right in the center of his analysis. We follow his insight and observe that as ever larger quantities of a commodity are offered for sale, the bid/asked spread widens. The market-maker takes a greater risk in buying or selling unusually large amounts. To work off a greatly expanded inventory, or to replenish a greatly reduced one, is time-consuming. In the meantime the price could change unfavorably for him. The market-maker compensates for his risks by quoting a wider spread. The behavior of the bid/asked spread is fundamental for the determination of salability.

A commodity X is said to be more marketable in the large, or more saleable than another Y if the bid/asked spread for X increases more slowly than that for Y, as ever larger quantities of X and Y are offered for sale in the market. For example, perishable or seasonal goods have a lower, while durable goods or goods for all seasons a higher, degree of salability. It is easy to see how cattle have become the most saleable good in antiquity. People had superb confidence that there could never develop a glut in the cattle market. Long before such a turn of events owners would drive their herds of cattle to regions where a shortage prevailed or, at least, there was no glut. The cost of transporting a given value represented in the form of cattle was lower than the cost of transporting the same value represented by anything else, due to the mobility of cattle. This fact is also preserved in our linguistic heritage. A herd is also known as a drove of cattle and the herdsman as the drover (both are derived from the verb to drive). Thus mobility or, better still, portability is an important aspect of salability. The more portable a commodity, the more easily it can seek out havens where it is in the greatest demand.

The term salability refers to the quality whereby a good is capable of being bought or sold in the largest quantities with the smallest possible losses — explaining how this quality earns its name. Among the most saleable goods we find the precious stones and metals. A long historical process has promoted gold to become the most saleable of all goods. For gold, the bid/asked spread is virtually independent of the quantity for which it is quoted. As we have seen, for non-monetary commodities different spreads are quoted for different quantities, and the larger the quantity the larger is the spread. For gold the spread only depends on the cost of shipping it to the nearest gold center. Under a gold standard the bid/asked spread is actually constant and is equal to the difference between the higher and lower gold points. (The lower gold point is that price at which it becomes profitable to melt down domestic gold coins in order to export the bullion; the higher gold point is that price at which it becomes profitable to import the bullion in order to have it coined at the domestic Mint.)

The gold standard is seen as the result of a market process in search of the most saleable commodity. Some authors deliberately confuse the issue insisting that the constant spread for gold is due to institutional factors such as the statutory requirement that the central bank stand ready to buy or sell unlimited quantities of the metal, namely, buy at the lower and sell at the upper gold point. But this argument is putting the cart before the horse.

Institutional constraints would sooner or later break down if another metal with less than perfect salability were substituted for gold as the monetary metal — as indeed happened to silver in the 19th century, to copper in medieval times, and to iron in antiquity.

### The Subjective Theory of Interest

We have studied the first source of man's need for money: his need to transfer value over space. The second source, man's need to transfer value over time or, as we have more specifically described it, his need to convert income into wealth and wealth into income, is at the center of the subjective theory of interest. The duality between the subjective theory of value and the subjective theory of interest is remarkable. The two are related through monetary duality that has prevailed through millennia.

It is common knowledge that, although precious stones have a high degree of marketability in the large, their marketability in the small is poor. The process of cutting up a large stone into a number of smaller pieces often results in a permanent loss of value. This is an example of the paradox that the value of a parcel may actually be greater than the value of its component parts. Even for precious metals, whose subdivision into smaller parts is fully reversible, marketability in the small cannot be taken for granted. A penetrating example due to a 19th century traveler is cited by Menger.

When a person goes to the market in Burma, he must take along a piece of silver, a hammer, a chisel, a balance, and the necessary weights. 'How much are those pots?' he asks. 'Show me your money', answers the merchant and, after inspecting it, he quotes a price at this or that weight. The buyer then asks the merchant for a small anvil and belabors his piece of silver with his hammer until he thinks he has found the correct weight. Then he weighs it on his own balance, since that of the merchant is not to be trusted, and adds or takes away silver until the weight is right. Of course, a good deal of silver is lost in the process as chips fall to the ground. Therefore the buyer prefers not to buy the exact quantity he desires, but one equivalent to the piece of silver he has just broken off." (Op.cit., p 281.)

I have in my possession the remnants of a heavy gold chain that had once held the pocket-watch of my grandfather. The watch itself was bartered away for food by my mother during hard times before I was born. But I remember very vividly the delicate hands of the dentist as he was clipping off an agreed weight from the chain with his fine pair of clippers in the year 1945. He would not take paper currency in exchange for doing dental work. Instead, his clippers went a long way to help my mother to discharge our debt. Examples such as these justify the isolation of the concept of hoardability as the corner stone of the subjective theory of interest. The buyer of pots in Burma, and my mother in Hungary, were converting wealth into income. They must have been painfully aware of losses due to chips of the precious metal falling to the ground.

### Marketability in the Small or Hoardability

The precious metals are more hoardable than precious stones, as the losses involved in parceling them out into ever smaller pieces are smaller. It is this common-sense experience that we want to generalize. Our first observation is that, as ever smaller quantities of a commodity are offered for sale, the bid/asked spread widens. A wider spread compensates the market-maker for the lack of incentives to deal in unusually small quantities. The bid/asked spread is of fundamental importance for the determination of hoardability as well.

A commodity x is more marketable in the small, or more hoardable than another y if the bid/asked spread for x increases more slowly than that for y, as ever smaller quantities of x and y are offered for sale in the market. For example, non-perishable foodstuff such as grains are more hoardable than perishable ones. Horse meat is more hoardable than live horses. It is easy to see how salt has become the most hoardable commodity in antiquity.

People were confident that disturbing surpluses of non-perishable foodstuff would not develop. Everybody who could afford it would be happy to hoard them. They realized that seven lean years would soon follow the seven fat ones. For the stronger reason, people were superbly confident that their hoard of salt, this foremost agent of foodpreservation before the age of refrigeration would not lose its value, come rain or shine.

Value could not be transferred over time with smaller losses than through the stratagem of hoarding salt. Other examples of highly hoardable commodities are: grain, tobacco, sugar, spirits, silver. It is interesting to note the heavy government involvement, at one time or another, with the production or trade of all these.

The term hoardability refers to the quality whereby a good is allowed to be bought or sold in the smallest quantity with the smallest possible losses — explaining how this quality earns its name. It is this property that matters most when the economizing individual is trying to convert income into wealth or wealth into income. It is this property that is most crucial for him in solving the problem of transferring value over time most efficiently. He will succeed best if he employs the most hoardable commodity.

### The Rise and Fall of Bimetallism

An historical process similar to the one making gold the most saleable has promoted silver to become the most hoardable commodity. Gold was the money used to pay princely ransoms and to buy vast territories such as Louisiana and Alaska. Silver, by contrast, was the money used by people of small means to buy food, or to accumulate capital (cf. the silver penny and Maundy money of England). As long as the necessary technology was lacking, gold could not challenge silver's position as the most hoardable commodity. The cost of producing or verifying a small fraction of the unit of value as represented by gold could involve expensive molar processes. As I have already observed, the same small fraction of the unit of value represented by silver incurred no such extra cost: the amounts involved were no longer molar, due to the lower specific weight of silver.

This explains the rise of bimetallism under which the dual monetary system that has prevailed since time immemorial assumed a highly symmetric form. The most saleable commodity, gold, and the most hoardable, silver, have become monetary metals spontaneously through the market process. Gold and silver coins continued to circulate side-by-side for millennia. As long as governments adhered to a "hands off" policy, the dual monetary system was highly successful. In the end it was government meddling, in trying to enforce a rigid exchange ratio for the monetary metals, that brought the system down. For thousands of years the bimetallic ratio has been remarkably stable, in fact, more stable than any other economic indicator. It was not constant, however. There was a secular trend making gold relatively more valuable with the passing of time, as the bimetallic ratio was slowly rising from 10 in antiquity to about 15 at the beginning of the Modern Age. Paradoxically, the reason for the secular rise in the bimetallic ratio was the fact that gold has become more widely available for monetary uses, partly through the violent dispersal of ancient hoards (e.g., the rape of Persian gold by Alexander the Great, and the rape of the gold of the Inca by Pizzaro), and partly through increasing output from the gold mines. However, it is important to note that the volatility of the bimetallic ratio has been so small that it has never provided speculators with an opportunity to make a profit. The wild orgy of speculation in precious metals, making windfall profits available, first started with the fixing of the bimetallic ratio which has destabilized the dual monetary system.

In fixing the official bimetallic ratio governments were led by greed. They thought that they could make their vast hoards of silver more valuable by stopping the slide in the relative value of the silky metal. It is not in the power of earthly governments, however powerful economically and militarily, to create value at will. Unfortunately, this simple lesson has not been learned even today, as governments are engaged in a mad race to flood the world with their own irredeemable currency before others could do it with theirs.

The measure to fix the official bimetallic ratio backfired. It signaled to people that time has come to switch from silver-hoarding to gold-hoarding. In response, people started dumping silver at the door of the Treasury while depleting its gold hoards. Governments solemnly declared that they would defend their official bimetallic ratio through thick and thin. However, eventually, they had to eat their words. Once more, the market proved to be stronger than governments. They were forced to replace bimetallism with gold monometallism. As the history of bimetallism is widely misunderstood and even misrepresented, I plan to return to it in a later Lecture to set the record straight.

### The Paper Boy and His Silver Dime

The mechanism of direct conversion of income into wealth worked as follows. A wage earner aspiring to become his own boss would, on every payday, put aside a silver dime or two not just for a rainy day but, more importantly, for the day when he would quit the labor force and become a businessman. Silver dimes were the agent of capital accumulation. Financial annals tell us about success stories such as that of the shoeshine boy setting up shop at the main entrance of the department store that he would eventually buy out. His secret was the silver dime which he could hoard with confidence. Some countries, especially poor ones, had even smaller silver coins in circulation, e.g., the halfdime of Newfoundland. Mr. Warren Buffett started his own fortune, reportedly among the greatest in the world today, as a paper boy in the streets of Washington, D.C. where his father the Hon. Howard Buffett served as a member of the U.S. House of Representatives from Nebraska. It is an interesting question to ask why paper boys are no longer on track to become multi-billionaires. Could it have something to do with the government's denying the silver dime to people? Ask Mr. Buffett whether he thinks that paper boys still had a chance of ending up as the owner of the newspaper empire whose papers they used to sell on the streets, by hoarding the 'clad' dimes of today?

### The Fullarton Effect

By far the most important example of gold hoarding in the modern world is furnished by the so-called Fullarton effect. This important topic I shall study in full details in a future course, Monetary Economics 202: The Advanced Theory of Interest — The Bond Market and the Formation of the Rate of Interest. John Fullarton of England published a book in 1844 entitled On the Regulation of Currencies in which he described the reaction of bondholders to a falling interest-rate structure. They would certainly not let the rate of interest fall through the floor. They would take profits in selling their overpriced bonds, and put the proceeds into gold, until bond prices have come back to earth once more. I shall refer to this market action as the gold/bond arbitrage of the marginal bondholder. He is guided by time preference. (Together with the productivity of capital, time preference is one of the regulators of the rate of interest, as we shall see in full details later.) It is important to understand that the sale of the bond is not in itself sufficient to bring about the desired effect: a reversal of the fall in the market rate of interest. For that it is necessary that the proceeds of the sale be held in the form of gold. The Fullarton effect depicts gold hoarding as a protest vote against interest rates being pushed down to unreasonably low levels through institutional means by the banks or by the government.

Holding gold as opposed to holding a promise to pay gold is absolutely essential, to make the protest effective.

### Mises on Gold Hoarding

Ludwig von Mises ridiculed gold hoarding calling it "the regular deus ex machina" in Fullarton's work (see Theory of Money and Credit, p 169). Mises maintained that secure and mature claims to gold money are complete substitutes for it and, as such, are able to fulfil all the functions of money in those markets in which their maturity and security are recognized. Mises has committed a great error in refusing to accept the fact that the gold coin, but no claims to it, is the indispensable agent of the marginal bondholder to validate his time preference. We may assume that the maturity and security of circulating claims to gold coins are fully recognized in the bond market. Even so, felt uneasiness on the part of the marginal bondholder caused by the abnormally low rate of interest (the flip-side of which is the abnormally high bond price) will not be assuaged if he exchanges the bond for another piece of paper. However mature and secure a claim may be, he wants to hold the metal (a present good), and not a mere claim to it (a future good). His ultimate end is to raise the rate of interest to the level of his time preference. It would be counterproductive (not to say foolish) to exchange the bond for bank notes. Such an exchange would mean extending credit at zero interest while forgoing the positive interest on the bond he had sold. By contrast, holding the gold coin does not involve extending credit -in fact it is the only way of denying it! The gold coin must be seen as the indispensable agent of the marginal bondholder in asserting his marginal time preference. No fiduciary media can ever be a substitute for the gold coin in this capacity. Time preference would be little more than a pious wish if it was not for the cutting edge of the gold coin which alone could validate it. In fact, time preference lacks any concrete meaning outside of the arbitrage-nexus between the bond and gold markets.

Mises categorically states that the bank note is just as much a present good as the gold coin. "A person who accepts and holds bank notes grants no credit — he exchanges no present good for a future good... A bank note is a present good just as much as gold money." (Op.cit., p 304-305.) I must part company with Mises over this point. The issue whether a bank note is a present or a future good goes right to the heart of the theory of interest. My view is that holders of bank notes or gold certificates are (voluntary or involuntary) grantors of credit, furthermore, their greater or lesser willingness to continue to hold the paper is an important component of the force determining the rate of interest. The only way for the individual to deny credit to the banking system is to divest himself of his holdings of bank notes and deposits in excess of his indebtedness. If we admitted that a bank note were a present good, then we would also have to admit that Keynes was right after all in suggesting that governments have the power to create wealth out of nothing, simply by sprinkling some ink on little scraps of paper. Gold hoards are far from being a deus ex machina. They are, rather, a sharp tool of human action by means of which the marginal bondholder can validate his time preference under a gold standard. They are the very mechanism through which savers exercise their franchise to regulate the rate of interest. It was precisely for this reason that governments first sabotaged and, finally, destroyed the gold standard. They wanted to disenfranchise the savers.

The culmination of these courses here at Gold Standard University will be a demonstration of my thesis that the apparent success of governments to disenfranchise savers and to usurp their prerogative to regulate the rate of interest will ultimately turn out to be a failure, and may even be the cause of an unprecedented economic catastrophe. Savers, frustrated, turn en masse from gold hoarding to marginal hoarding, that is, the hoarding of other highly hoardable commodities, with disastrous consequences. The Brave New World of synthetic credit, manufactured out of inextinguishable debt, is unworkable. While gold hoarding is self-limiting, marginal hoarding is not. It destabilizes the system of production and distribution and generates a long-wave cycle, also known as the Kondratyeff cycle, complete with ruinous deflations and depressions alternating with ruinous inflations, ultimately self-destructing in a crack-up boom.

---

### A Forgotten Anniversary

Other economists have also condemned gold hoarding. John Maynard Keynes said that he was prepared to pass the pathology of gold hoarding along to the psychiatrist for examination "with a shudder". Politicians were jubilant in welcoming this verdict.

Seventy years ago, in 1933 during one of his fire-side chats F. D. Roosevelt declared that he wanted to put an end to the "senseless practice" of shuttling gold back and forth between the banks and individual depositors. What he did not say was that he was going to rob both. He appealed to the people to yield control over gold temporarily to the government so that it may restore confidence in the monetary system. People responded, and surrendered their gold out of patriotic zeal. No sooner had Roosevelt plundered the gold belonging to the banks and their depositors than he wrote up the value of the loot.

There was no more talk about the temporary nature of the measure. Today, 70 years after the event, there is still no talk about guilt or reparation. The bad faith in this particular chicanery cries to heaven for justice.

### References

### Carl Menger, Principles of Economics, New York: N.Y.U Press, 1981

(originally published in German in 1871 under the title Grundsatze der Volkswirtschaftlehre).

John Fullarton, On the Regulation of Currencies, New York: A. M. Kelley, 1969

(originally published in London, 1844).

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, NL, CANADA A1C5S7 e-mail: aefekete@goldisfreedom.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand’s Hymn to Money

### Lecture 2: Don’t Fix the Price of Gold!

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told; (Chapters 1 - 3)

### Lecture 6: The Invention of Discounting; (Chapters 4 - 6)

### Lecture 7: The Mystery of the Discount Rate; (Chapters 7 - 8)

### Lecture 8: Bills of the Goldsmith; (Chapter 9)

Lecture 9: Legal Tender. Small Bank Notes.

### Lecture 10: The Revolt of Quality

### Lecture 11: The Acceptance House; (Chapter 10-11)

### Lecture 12: Borrowing Short to Lend Long; (Chapter 12)

### Lecture 13: The Unadulterated Gold Standard

## Winter Semester, 2003

### Monetary Economics 102: Gold and Interest

### Lecture 1: The Nature and Sources of Interest

### Lecture 2: The Exchange of Income and Wealth

### Lecture 3: The Janus-Face of Marketability

### Lecture 4: The Principle of Capitalizing Incomes

### Lecture 5: The Structure of Capital Markets

### Lecture 6: The Rate of Interest

### Lecture 7: The Gold Bond

### Lecture 8: The Bond Equation

### Lecture 9: The Investment Banker

### Lecture 10: Lessons of Bimetallism

### Lecture 11: Aristotle on Check-Kiting

### Lecture 12: Bond Speculation

### Lecture 13: The Blackhole of Zero Interest

## In Preparation:

Monetary Economics 201: The Bill Market and the Formation of the Discount Rate Monetary Economics 202: The Bond Market and the Formation of the Rate of

### Interest

---

# Monetary Economics 102 — Lecture 2: The Exchange of Income and Wealth

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-102-lecture-2-the-exchange-of-income-and-wealth/
Date: 2003-01-15
Section: Money & Credit
Difficulty: scholarly
Concept Tags: interest-theory, gold-standard, sound-money, time-preference
Description: Fekete examines the exchange of income and wealth as the fundamental transaction that gives rise to interest. He distinguishes converting income into wealth (saving) from exchanging income for wealth (trading a bond), showing that the latter involves a rate of capitalization that is determined by market competition, not by time preference.
Editorial Note: Lecture 2 of Monetary Economics 102 (Gold Standard University, 2003). The analytical core of Fekete's interest theory, introducing the triple-entry accounting framework that he argues resolves the 'paradox of interest.'
Original PDF: https://professorfekete.com/articles/AEFMonEcon102Lecture2.pdf

### Lecture 2

*The Exchange Of Income And Wealth*

• Direct and Indirect Conversion of Income and Wealth • Can a Present Good Go to a Discount against Its Future Counterpart? • The Concepts of

### Income and Wealth • Converting Income into Wealth and Wealth into Income • Exchanging Income and Wealth • Rent Charges • The Paradox of

### Interest • Triple-Entry Revenue Accounting •

### Direct and Indirect Conversion of Income and Wealth

The nature of interest is one of the great problems of humankind, as old as money itself.

It has engaged the greatest minds, from Aristotle through St. Thomas of Aquinas and other Church fathers to Carl Menger. The lack of a satisfactory solution to the problem has rocked empires, contributing to their destruction. Your lecturer hopes that his efforts can make a modest contribution to the ultimate disposal of this great and vexed problem.

Part of the difficulty is in the way the problem has traditionally been presented, namely: What happens when a man with a need to borrow meets another with money to lend? It was always in this context that usury has been condemned by both criminal and canon law. It hasn't occurred to philosophers and moralists — or, for that matter, to most economists — that the nature of interest could be better grasped if the question was reformulated thus: What happens when a man with wealth to spare but who is in need of an income meets another with income to spare but who is in need of wealth?

What is of great significance for our purposes is that the resulting exchange represents the passage from direct to indirect conversion of income and wealth. By direct conversion of income into wealth is meant hoarding, and by direct conversion of wealth into income is meant dishoarding of a fungible commodity. Since direct conversions are cumbersome and inefficient, the passage to indirect conversion or exchange represents an improvement. Interest can be thought of as the measure of this improvement. In particular, zero interest means direct conversion. Given zero incentive, those who have surplus wealth will obviously forgo indirect conversion or exchange and will, instead, fall back on direct conversion. That is to say, they will provide for deferred consumption by first hoarding and, then, dishoarding.

The passage from direct to indirect conversion of wealth and income is analogous to the passage from direct to indirect exchange of goods, that is, the evolution from barter to the monetary economy. This was the idea which Carl Menger used so brilliantly in explaining the origin of money in terms of salability. In this course we shall introduce an analogous idea in order to explain the origin of interest in terms of hoardability. In the next Lecture we shall see that saleability and hoardability are just sub-varieties of marketability (the German word, used by Menger, is Absatzfahigkeit). That these two concepts represent special aspects of marketability can be seen clearly if we contemplate that salability is "marketability in the large" and hoardability is "marketability in the small". Thus, then, the proper setting for the study of interest is the indirect conversion of income into wealth and wealth into income, just as the proper setting for the study of prices is the indirect exchange of goods. It now appears that blanket condemnation of usury is akin to condemning a man for charging (or paying) the going price of bread.

The exchange of a present good for a corresponding future good is not the irreducible form of credit. It can be reduced to two exchanges: first, the exchange of the present good for an income and, second, after a mutually agreed period of time, the return of the same income to its original beneficiary in exchange for the same quantity and quality of good.

In this way we see a second reason why the exchange of wealth and income, rather than that of a present and a future good, is the true centerpiece of the theory of interest. A third reason presents itself in the context of history. The act of exchanging a present good for a future good was hardly part of the repertory of our ancestors in the more primitive economic setting under which they labored. By contrast, we know for a fact that the exchange of present for future labor was widely practiced: "I help you build your house, and you help me build mine; we shall build yours first because I am not quite ready to start as yet." It is far from obvious, however, that interest was necessarily part of such exchanges. The practice of exchanging present for future goods, on the other hand, was a later development which already assumed the existence of a lively market for the exchange of income and wealth.

Can a Present Good Ever Go to a Discount against Its Future Counterpart?

The very idea of a dichotomy between present and future goods is false. The future is a closed book to man. He knows not what the future holds for him. He cannot know what his future needs and valuations will be. Even his taste is subject to change, and he is as ignorant about his own preferences in the future as he is of those of another person. His entire value-system may be revamped as a result of new products appearing in the market. The tenet that there is an intrinsic discount on the value of any future good in relation to that of a corresponding present good, which is independent of the choice of the good itself, is open to serious challenges. It is easy to give an example of a future apple having a value higher than that of a present apple. Take the case when the only apple orchard in the vicinity has been destroyed by a landslide, just after the apple-harvest. In our complex economy the idea of an automatic discount on future goods is even more absurd. Suppose that the construction of an observatory takes one year to complete. We may assume that the most expensive part of the project is the telescope itself that is being built elsewhere and would have to be delivered to the site. However, it can only be installed after the building is finished one year hence. If the telescope was delivered to the site today, it could be damaged during the year of forced idleness, so storage and insurance costs would be incurred, reducing its present value below its future value. The objection that the telescope could be rented out for one year is open to the same criticism.

We may assume that no building suitable for the installation of this particular telescope exists anywhere, and constructing one would also take one year.

This is no ice-in-summer/ice-in-winter counter-example to refute the thesis about an automatic discount on future goods. As the economy is getting ever more complex, the manufacture of big-ticket items is getting ever more roundabout and more timeconsuming. The delivery of the complementary factors of production must be dove-tailed with an air-tight schedule to assemble them. Serious losses may occur if the delivery of a factor is out of sync. The future value of such a factor is, therefore, represented not by a declining but by a bell-shaped curve. Along this there is an optimal value surpassing all other future values, as well as the present value. It follows that a present good can and does indeed go to a discount against its future counterpart.

The idea that this could never happen is the foundation supporting the theorem that the rate of interest can never be zero, let alone negative. What our argument shows is not that the rate of interest can sometimes be negative, but that the approach to the theory of interest through the dichotomy of present versus future goods is false. There is no apodictic reason to value a present good more highly than the corresponding future good.

We can show that the rate of interest is always positive by discarding the paradigm of present versus future goods, and replace it with the paradigm of income versus wealth.

Zero interest now appears possible, but only at the cost of stamping out indirect conversion or exchange.

### The Concept of Wealth and Income

We have seen that the dichotomy of present versus future wealth is false. We shall now see that the true dichotomy, giving rise to interest, is that of income versus wealth. By wealth we mean any desirable piece of property held for an extended period of time. As objects of human desire are varied, the concept of wealth is broad. But as it is always the case in human affairs, disadvantages offset advantages, and the ownership of wealth is no exception. The main disadvantages associated with wealth are illiquidity and declining marginal utility. Illiquidity refers to contingent losses, measured in money and time, that go with exchanging one form of wealth for another. As a result, the value of wealth may well erode with the passing of time. Thus, then, even the wealthiest individual has the thorny problem of husbandry to tackle. He had better make sure that the value of his wealth would not diminish, lest it disappear altogether. If he could not make his wealth grow, he might end up as a pauper.

The problem of wealth immediately leads to the problem of income. Wealth is unsuited for direct consumption. Before consuming it, wealth needs to be converted into income.

Indeed, we must sharply separate the two concepts. Income is conceived as a steady flow of goods and services. By its very nature, income is perishable. If not used presently, its value may evaporate. Therefore the economizing individual divides his gross income into two components: income-to-be-consumed and income-to-be-saved. He converts the latter into wealth which he plans to convert again into income later, as the need arises. There are problems with these conversions. The value of income and wealth must be secure.

The risk of letting the quality and quantity of goods and services that make up the income erode must be reduced to its irreducible minimum.

### Converting Income into Wealth and Wealth into Income

For the sake of simplicity the phrase: "converting income into wealth" will be used to mean "converting income-to-be-saved into wealth" and, correspondingly, "converting wealth into income" will mean "converting wealth into income-to-be-consumed". A typical wage-earner uses only part of his wage-income for consumption; the other part he earmarks for saving in order to increase his wealth. If his consumption needs are fully covered, then he will convert his entire income into wealth. Otherwise, he will augment his consumption using part of his wage income, and save only the remainder. If his wage income is not sufficient to provide for his consumption needs, then he will supplement it by converting an appropriate portion of his wealth into income in order to maintain his level of consumption.

From the point of view of mortal man wealth and income are distinct categories independent of one another. When accumulating wealth, man merely obeys the law of the biosphere according to which the demands of survival force one to save one's substance, in order to provide for the seven lean years ahead while the seven fat years last. In particular, the economizing individual wants to provide for his and his spouse's old age, knowing full-well that the time is coming when reward for his efforts will fail to cover his needs, and he will need wealth to convert it into income in order to maintain his consumption. Another typical activity is accumulating wealth that the economizing individual will need at the time his offspring comes of age. Whether he wants to give part of this wealth to his daughter as a dowry, or whether he wants to convert it into income to defray the cost of higher education of his children, his family responsibilities will prompt him to save. Even in the case of a miser it is a mistake to dismiss his saving habits as irrational. Maybe he has an undisclosed plan to donate his wealth to a particular charity after he has reached his savings goals. Or, maybe, he wants to leave his wealth to an eleemoosynary institution at the time of his death. Even if he has no plans how to dispose of his wealth, his savings are not wasted. Society is a beneficiary. One's savings may make another's investing easier. At the very least, savings contribute to price stability.

There is no such a thing as "oversaving" from the point of view of society. All savings are pooled in the form of wealth, and this communal pool is drawn upon whenever the saver, or the beneficiary of his estate, is ready to use the income for which his share of the wealth may be exchanged. This is also true for direct conversion. If the individual saves in the form of hoarding gold coins, for example, then the social benefits of his savings show up in lower prices and interest rates. Keynes' theory, according to which deflation (falling prices) is caused by collapsing aggregate demand due to oversaving, is thoroughly unscientific. Depression is caused by falling interest rates generating a bull market in bonds. It is the gravitational field of that bull market that diverts money away from the stock, commodity, and real estate markets, creating the optical illusion that 'money is scarce'.

### Exchanging Income and Wealth

Conversion of income into wealth is a broad concept that includes, as a special case, indirect conversion, that is, the exchange of income for wealth, and the same is true of the conversion of wealth into income. We have discarded the idea of exchanging present and future goods as the basic problem of interest, and replaced it with the irreducible form of credit: exchanging income and wealth. These exchanges arise out of identifiable, immediate, and concrete human needs — having to do with the problem of ageing. By contrast, the exchange of present for future goods is a barren concept. It is not grounded in any immediately identifiable human need. Insofar as it arises at all, it is always in the context of the irreducible forms of credit. Our innovation in considering indirect conversion immediately shows the great improvement in efficiency over direct conversion. A smaller quantity becomes the exchange-equivalent of a larger one, thanks to the intervention of time. Thus a certain quantity of gold exchanges for an infinite stream of payments in gold, that is to say, for an amount of gold that can be arbitrarily large, depending on time. Yet the exchange is fair, because of the commitment to reverse it at a specified future date. Before anyone may jump to the concludion that such exchanges are not possible because an infinite quantity is never equal to a finite one, I hasten to point out that they are in fact a common occurrence. For example, a fertile piece of land can be bought at a finite price in spite of the fact that rents derived from it will, if held indefinitely, add up to infinity.

The vital difference between wealth and income, from the point of view of mortals, is put into high relief in the comedy of King Midas and the tragedy of King Lear. The former was unable to convert his wealth into income and, as a consequence, was in danger of starving to death in spite of his great wealth. The latter exchanged his wealth for income unwisely and without proper guarantees and, as a consequence, he was left without food and shelter when he would need it most. These examples illustrate that conversion of wealth into income could, under certain conditions, become a matter of life and death.

Society has, therefore, a great responsibility to facilitate and guarantee the exchange, and to remove all obstacles that may frustrate the intentions of the contracting parties.

The distinction between income and wealth, inviting exchange, has been recognized throughout history. I would like to mention two examples: the rent-charge and the triple contract.

### Rent charges

From the twelfth to the sixteenth century the sale and the purchase of rent charges was the most common form of exchanging wealth and income. In the Middle Ages real estates were so encumbered with legal conditions that they could hardly ever be sold outright. All the owner could do was to sell the annual rental income from his estate, which the new beneficiary could in turn sell to a third party. The right to collect rent from a piece of property that you did not own was called a 'rent charge'. (For a modern example consider the 'strip bond', where the coupons have been separated from the bond itself and sold to a new beneficiary. There developed a lively market where income and wealth were exchanged. The market value of rent charges was expressed, not as a percentage as was interest, but as a multiple. In other words, it was quoted as the number of years the rent charge would take to amortize its purchase price. Thus when a rent charge was quoted at 'twenty years', the meaning was not that the right to collect the rent extended to a twenty-year period; but that the new beneficiary had the right to collect the rent, in perpetuity, against the payment of a sum equal to twenty times the prevailing annual rent. Of course, this was tantamount to saying that the purchaser of the rent charge has converted his wealth into income at a rate of interest of 5 percent per annum, but that mode of quoting rent charges for sale was shunned. The difference in the manner of quoting capital offered to prospective borrowers, and rent charges bid for by those in need of an income, confused the issue in the minds of the people who assumed that no interest hence no usury was involved in the rent charge. Usury, they thought, was present only when capital was put out at interest. It would disappear when income was to be capitalized — even though the two transactions were just the opposite sides of the same coin. To maintain this pretence was important during the prohibition era, when canon as well as criminal law forbade the charging and paying of interest on a loan of capital (while the transfer of the right to collect the rental against the payment of a lump sum was exempted).

Confusion about the capitalization of income still prevails, and is exploited by governments as they make frivolous promises to pay retired voters income for life, while passing the unfunded liability that had been created by the promise to future taxpayers (some of whom hasn't been, and may never be, born).

### The Paradox of Interest

Let us now see how the re-setting of the paradigm of exchanging present and future goods as the exchange of income and wealth will dispose of the modern formulation of the 'paradox of interest' as given by Kirzner (op.cit. p 167-168).

"Much — perhaps all — will depend on the way in which the interest problem is formulated. For present purposes we adopt a modern formulation of the problem, but wish to emphasize that this formulation is very similar in spirit and character to classic formulations going back to Schumpeter and Bohm-Bawerk. The modern formulation we cite is that of Hausman. Hausman points out that 'an individual's capital . . . enables that individual to earn interest. If the capital is invested in a machine, the sum of the rentals the machine earns over its lifetime is greater than the machine's cost. Why?' Common observation, that is, tells us that possession of a given stock of capital funds can, by judicious investment (say, in a machine) yield a continuous flow of income (annual rentals net of depreciation) without impairing the ability of the capital funds to serve indefinitely as a source of income. The problem is, how can this occur. Why is not the price of the machine (paid by the capitalist at the time he invests in the machine) bid up (by the competition of others eagerly seeking to capture the net surplus over cost) — to the point where no such surplus remains? We are seeking, then, an explanation for an observed phenomenon which is, in the absence of a theory of interest, unable to be accounted for. Absent a theory of interest, no interest income ought to be forthcoming, except as a transient phenomenon; competition ought to squeeze it out of existence." Here is the deciphering of the paradox of interest in the light of our new paradigm. To say that the capitalist 'invests' his wealth is far too simplistic. The specifics of 'investing' are bound to confuse the issue. Moreover, the possession of wealth does not automatically guarantee access to income. There is an exchange of wealth and income interposed between the capitalist and the entrepreneur that ought not to be ignored. Here is what actually happens. The capitalist gives up wealth to an entrepreneur in exchange for the latter's commitment to pay him an income at a fixed rate of interest. The entrepreneur uses the wealth to purchase capital goods (such as a machine or a fruit tree, for example), and hires a manager whose job it is to tend the capital goods, including the task of setting depreciation quotas for them in anticipation of the need to replace them at the end of their useful life without any further charge to the capitalist or to the entrepreneur. Now the entrepreneur sets up three accounts for the disposal of the yield (after depreciation) as follows: (1) the fixed interest income payable to the capitalist; (2) wages payable to the manager; (3) the remainder, or the profit, payable to himself.

In this way it is revealed that 'investing' implicitly involves an exchange of wealth for income. It is no longer a mystery that the sum total of interest payments exceeds the wealth subject to the exchange. If entrepreneurs were not prepared to offer the capitalist an income at positive interest for his wealth, then the latter would simply withdraw his offer to make the exchange. He could always fall back on the direct conversion of income into wealth through dishoarding. From his point of view, direct conversion would be preferable and less risky than the exchange, in the absence of incentives.

In this light the modern formulation of the interest problem and the language of 'investing' appears rather naive, if not outright boorish. It ignores the problem of managerial compensation, as well as that of entrepreneurial profits. These two, plus the interest income, must come out of the gross yield of capital (after depreciation). Only the entrepreneurial profit could be reduced to zero in the process of bidding for capital goods.

Furthermore, in addition to the bidding of entrepreneurs for partnerships (having the effect of diminishing the interest income) one must also consider the bidding of managers for managerial positions (having the effect of enhancing the interest income). We see that the act of 'investing' is a complex transaction, ridden with all sorts of specifics. For this reason it is eminently justifiable that we cut through the maze of irrelevant details with our abstraction of exchanging wealth for income. 'Investing' is far too an imprecise term to be useful in the development of a theory of interest.

Even if the owner of wealth is prepared to take the role of entrepreneur, or manager, or both, upon himself, we still have to assume that there is an underlying exchange of wealth for an income. Suppose, for the sake of argument, that a capitalist acts as his own entrepreneur and also as his own manager. In this case, to make his an efficient operation, he needs to break it down into three departments as follows: (1) the bondholding department; (2) the managerial department; and (3) the entrepreneurial department.

Accordingly, he would oversee the three accounts mentioned above: the interest account, the managerial compensation account, and the entrepreneurial profit account. Never mind that the earnings from each of the three accounts will ultimately flow into his pocket. In order to have sound financial controls, the three accounts must not be blended into one, and the capitalist must assume that an exchange of wealth for an income has taken place between the bondholding and the entrepreneurial departments. Only in this way can he make sure that the fixed income is not out of line with the rate of interest prevailing in the market and that, similarly, his managerial compensation is consonant with what he could get in the competitive market. Any shortfall in gross income must therefore hit the entrepreneurial profit account first — a penalty for the poor choice of capital goods. If the profit is wiped out, then further shortfall would hit the managerial compensation account — a penalty for setting the depreciation quotas too low. In this way interest income is cushioned twice. Repairs must be made before further deterioration threatens the interest income.

A different order of priorities would make repair, indeed, economic survival, difficult if not impossible. For example, if entrepreneurial profit and managerial compensation were allowed to continue unabated while the interest income was reduced to zero, then the operation would no longer have an economic justification. The owner-manager would be better off if he took another managerial job, bought the bonds of other firms in the bond market, and forgot about his own entrepreneurship. Without such an internal accounting procedure assuming an underlying exchange of wealth for income, the capitalist would lose financial control of his enterprise. He would be in the dark. In case of a setback he would be unable to make repairs. He would be at a loss in trying to compare the efficiency of his entrepreneurship and managerial talents with those of others.

### Triple-Entry Revenue Accounting

The above analysis is so important in the context of the theory of interest that I want to formulate it as an independent principle (on a par with the Principle of Double-Entry Book Keeping).

The Principle of Triple-Entry Revenue Accounting asserts that the capitalist who buys and successfully manages his own capital goods will carry three accounts in order to distribute the revenue (after depreciation) of his enterprise, namely, in order of seniority moving from the senior to the junior: the interest account; the managerial compensation account; the entrepreneurial profit account. Whereas insufficient revenues affect the junior before affecting the senior account, all surpluses accrue to the junior (profit) account.

Triple-entry revenue accounting is made necessary by the need to keep the enterprise economically healthy and to ensure that it is capable of self-correction and selfimprovement. It reveals that profits cannot be understood in isolation: they have to be considered together with losses. Moreover, both accrue to the entrepreneur, without directly affecting the manager or the capitalist. This principle also highlights the logic behind the Triple Contract that I shall discuss in a later Lecture.

The Principle of Triple-Entry Revenue Accounting is also applicable to corporate governance. In this case the bond department corresponds the Office of the CFO, the managerial department to the Office of the CEO, and the entrepreneurial department to the Board of Directors of the corporation. The order of seniority can be observed in the manner the revenues are distributed among the three accounts: (1) the most senior, the interest account compensates the outside investors, the bondholders; (2) the managerial compensation account pays the salaries and bonuses of the senior managers; (3) the entrepreneurial profit account pays the compensation of the directors of the company, and the dividends of the shareholders.

In modern times we see an unfortunate shift of power away from the entrepreneurial to the managerial department. By issuing class A, class B, etc., shares (some with multiple voting rights), convertible bonds, stock options, etc., the managers have diluted the authority of the shareholders, and inappropriately usurped the power of the entrepreneurial department and its right to dispose of the surplus. The subordinate relationship whereby managers are hired and fired by the entrepreneurial department has been compromised. Managerial power is enhanced, and entrepreneurship marginalized.

This was a regrettable development indeed, and the large number of bankruptcies of corporations that we are witnessing can, in part, be attributed to the power-grab of managers at the expense of the shareholders and the directors of the company.

### References

Ludwig von Mises, Human Action, Third Edition, Chicago: Henry Regnery, 1966.

Antal E. Fekete, Whither Gold, and Other Collected Essays,

Hammond, Louisiana: Ededge ([www.ededge.com](https://www.ededge.com)), 2002.

Antal E. Fekete, The Central Banker As the Quartermaster General of Deflation [www.goldisfreedom.com](https://www.goldisfreedom.com), January, 2003.

Israel M. Kirzner, The Pure Time Preference Theory of Interest: An Attempt at

### Clarification, The Meaning of Ludwig von Mises

Norwell (Mass.): Kluwer, 1993, p 166 ff.

With this I have concluded Lecture 2. In passing I wish to quote from the Introdution to the new edition of my Whither Gold? & Other Collected Essays, written by the creators of ededge, Marshall Thurber and Edwin H. Neill II. I believe that this quotation contains the the broad justification for my initiating the Gold Standard University on the Internet. "Until now ededge has focused on cutting-edge books for business people. This edition breaks with that policy because of the dramatic developments in our economy. Waiting for a book to be published on our current subject matter would be too slow and thus too late. Here is what is happening." "Recently, 373 companies of the S&P 500 (America's 500 most trusted companies) slashed their earning forecasts for the third quarter in 2002. That includes huge companies like Sun Microsystems, Radio Shack, and Best Buy. These same companies are also slashing their capital investments on new factories and equipment. What is going on?" "We, the creators of ededge, are by nature optimistic people. We both look for opportunities, not for pockets of safety. We are by nature bulls, not bears. However, we are both seeking understanding of what is happening, instead of blindly maintaining our bullish, optimistic behavior." "In seeking to understand our present economic situation and looking to predict present unfolding events, we have discovered the writings of a man who has a unique perspective and clarity of thought. He is able to shed light on areas previously misunderstood. His name is Antal E. Fekete."

With the advent of Keynesianism, in the late 1930's the teaching of economics, first in the English speaking countries and, after World War II in the whole world, suffered a break of continuity with the great traditions of economics. This break is most visible in monetary science, where a coherent and logical presentation of the theoretical foundations of the gold standard has been ostracised and exiled from the curriculum. In its place was implanted an incoherent and pseudo-theoretical collection of discourses that can be best described as a lame apology for the conduct of the governments of Britain and the United States in declaring bankruptcy fraudulently in 1931 and 1933 (the use of the word 'fraudulent' is justified by the fact that both governments had ample means to pay their gold obligations to domestic and foreign creditors as contracted, witness the subsequent auctioning off of US Treasury gold and the gold of the Bank of England).

During the intervening seventy years it has not been possible to teach monetary science.

A gag-rule, unprecedented in Western countries outside of the Soviet orbit, was imposed on all those professors who wanted to keep the flame of truth alive. Even the publication of scholarly works on money and credit was made very difficult for those who were not eager to parrot the official line that the government can create wealth out of nothing by piling debt upon debt, and that gold was but a 'barbarous relic'.

As a result of this blatant official interference with academic freedom, and obstruction of the search for and the dissemination of truth, generations have grown up who were denied the opportunity to learn the rudiments of monetary science. With the passing of my generation, the gold standard will be erased from living memory. In founding the Gold Standard University on the Internet I was led by the desire to pass on to the younger generations the glory, freedom, and progressive scientific thought that the gold standard represented, in order to keep alive interest in a monetary system which ordinary people could trust. They could spend their gold coins in confidence, and expect to get the same coins back — without fear that their purchasing power would be impaired. Or, alternatively, they could save their gold coins in confidence, knowing that "the little yellow household gods" are the very whip with which people keep the banks and the government in check, forcing them to stay within the bounds of decency and to observe the norms of upright dealings with their creditors.

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, NL, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand’s Hymn to Money

### Lecture 2: Don’t Fix the Price of Gold!

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told; (Chapters 1 - 3)

### Lecture 6: The Invention of Discounting; (Chapters 4 - 6)

### Lecture 7: The Mystery of the Discount Rate; (Chapters 7 - 8)

### Lecture 8: Bills of the Goldsmith; (Chapter 9)

Lecture 9: Legal Tender. Small Bank Notes.

### Lecture 10: The Revolt of Quality

### Lecture 11: The Acceptance House; (Chapter 10-11)

### Lecture 12: Borrowing Short to Lend Long; (Chapter 12)

### Lecture 13: The Unadulterated Gold Standard

## Winter Semester, 2003

### Monetary Economics 102: Gold and Interest

### Lecture 1: The Nature and Sources of Interest

### Lecture 2: The Exchange of Income and Wealth

### Lecture 3: The Janus-Face of Marketability

### Lecture 4: The Principle of Capitalizing Incomes

### Lecture 5: The Structure of Capital Markets

### Lecture 6: The Rate of Interest

### Lecture 7: The Gold Bond

### Lecture 8: The Bond Equation

### Lecture 9: The Investment Banker

### Lecture 10: Lessons of Bimetallism

### Lecture 11: Aristotle on Check-Kiting

### Lecture 12: Bond Speculation

### Lecture 13: The Blackhole of Zero Interest

## In Preparation:

Monetary Economics 201: The Bill Market and the Formation of the Discount Rate Monetary Economics 202: The Bond Market and the Formation of the Rate of

### Interest

---

# Monetary Economics 102 — Lecture 1: The Nature and Sources of Interest

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-102-lecture-1-the-nature-and-sources-of-interest/
Date: 2003-01-01
Section: Money & Credit
Difficulty: scholarly
Concept Tags: interest-theory, marginal-productivity, gold-standard, time-preference
Description: Fekete opens Monetary Economics 102 with a systematic critique of existing interest theories — time preference (Böhm-Bawerk), liquidity preference (Keynes), and loan-fund theories — and proposes his own: interest arises from the marginal productivity of gold in facilitating exchange, not from subjective time preference alone.
Editorial Note: Inaugural lecture of the Gold Standard University winter course on Gold and Interest (2003). This series develops the theoretical apparatus for Fekete's interest theory, which he argues mainstream and Austrian economics both fail to provide.
Original PDF: https://professorfekete.com/articles/AEFMonEcon102Lecture1.pdf

### Lecture 1

*The Nature And Sources Of Interest*

### •Hoarding and Dishoarding • Marginal Saving • Marketability • The

Marginal Utility of Gold • Critique of Existing Theories • Propensity to Hoard and the Rate of Interest • Dichotomy False: Present vs. Future Goods • Dichotomy True: Income vs. Wealth • Principle of Capitalizing Incomes • Structure of Capital Markets • The Square Model Featuring the

### Annuitand, Annuitant, Entrepreneur, and Inventor • The Pentagonal

Model Featuring the Capitalist • The Hexagonal Model Featuring the Investment Banker • The Concept of Interest • The Propensity to Save and the Rate of Interest • Gold Standard, the Stabilizer of the Economy •

Disequilibrium Theory of Price Formation • Disequilibrium Theory of the Formation of Interest Rates • The Gold Coin and the Rate of Interest • A

Tale of Two Schools • The Gold Coin and the Rate of Interest • Interest under the Regime of Irredeemable Currency • The Ratchet and the

### Linkage • Between Scylla and Charybdis •

### Hoarding and Dishoarding

In this course I set out to develop a new theory of interest. Very little of what I have to say can be found in the existing literature. Here I make a new departure in introducing interest as the obstruction to gold hoarding that would be unlimited in the absence of interest, since the marginal utility of gold is constant. (Recall that, by contrast, the marginal utility of a non-monetary commodity does decline, setting a limit to hoarding).

In this sense interest is analogous to a parking meter on a busy street which limits the demand for parking space that would be unlimited otherwise.

The cyclical nature of the physical and biological universe has prompted acting man to hoard the means of sustenance since time immemorial. While some animals also hoard

(such as bees, squirrels), they do so instinctively and may 'forget' the size and location of their hoards. Man does hoard consciously and systematically. As shown in the Genesis through the example of Joseph (41: 34-36), hoarding is necessary during the seven fat years in order to provide the wherewithal through dishoarding during the seven lean years that are bound to follow. Today it is customary to ridicule the innate hoarding habits of man as being primitive and atavistic, pointing out that savings denominated in irredeemable currency are far superior, and they can be used for the same purpose with good effect. However, man can ignore the Biblical admonition only at his own peril.

### Marginal Saving

As gold hoarding has been discouraged and sometimes severely punished by the powersthat-be, the theory of interest must also include a more general treatment of the hoarding of marketable goods which we shall call marginal saving. It is a proxy for gold hoarding and it has, for better or worse, survived to this day. The fact is that people always have saved in the form of hoarding marketable goods, regardless of the availability of gold and the attractiveness of fiduciary forms of savings and, probably, they always will. As we shall see, this residual hoarding or marginal saving influences, and is influenced by, the rate of interest. Unlike gold hoarding, marginal saving could not be prevented through coercion. No sooner does the government outlaw the hoarding of one marketable commodity than people will start hoarding another.

### Marketability

The twentieth century witnessed the dismal failure of governments to provide an honest and reliable currency to serve as the common denominator for savings. Savers are continuously plundered as their savings are siphoned off through currency depreciation and debasement. One can hardly fail to see in this the ultimate incentive to hoard marketable commodities as marginal saving. However, it is important to see that even under the most stable monetary system marginal saving is present. For example, under the gold standard provident and thoughtful people found it necessary, natural, and prudent to keep a hard core of their savings in the form of various highly marketable goods. Their foresight was justified by later developments, as unprincipled governments have resorted to surprise devaluations combined with the criminalization of the ownership of gold, in order to prevent savers from using the monetary metal as a prophylactic against plunder through currency debasement.

It is therefore logical and necessary that an investigation into the phenomenon of interest should start with the problem of marketability and its two variants, salability and hoardability — those qualities that were instrumental in promoting gold as monetary metal. Theory and history show that as a result of an evolution lasting for centuries if not millennia, gold has become the most saleable as well as the most hoardable asset. Demonetization in 1971 did nothing to change that fundamental fact. In particular, the value of gold, unlike the value of all other goods, is objective — as witnessed by the enormous size of the stores of gold (relative to current production) that private and public holders are willing and eager to carry in the balance sheet without any promise of return to capital, far in excess of their possible need for it. This is what makes gold the monetary metal par excellence. By contrast, the value of other goods is subjective. Of course, ultimately, the objectivity of the value of gold also has subjective roots. It has to do with the superb confidence of countless individuals (both living and deceased) in the reliability of gold as a store of value. Out of this subjective judgment has grown the objective fact that the store of gold in the world today is a high multiple of annual flows (at the present rate of output the stores-to-flows ratio for gold is in the order of 80, meaning that the stores of gold in the world are equivalent to eighty years of production). By contrast, for other goods the stores-to-flows ratio is a small fraction (in the case of copper, for example, it is about 0.25, meaning that the stores of copper in the world are equivalent to three months' production). If the stores-to-flows ratio for copper approached that of gold, then the value of copper would approach zero in the manner of that of drinking water, due to copper's declining marginal utility. Under these circumstances it is hardly reasonable to suggest that a theory of interest could ignore the fact of gold hoarding.

### The Marginal Utility of Gold

According to Carl Menger, subsequent units of a commodity are valued less by the economizing individual than units acquired by him earlier. This is known as the Axiom of Declining Marginal Utility. If we rank commodities according to the rate of this decline, then we shall find that the marginal utility of one of them declines more slowly than that of any other. The commodity with this property is none other than gold. In fact, the marginal utility of gold declines so slowly that it is practically constant. It follows that gold hoarding must be limited by something other than declining marginal utility so that the demand for gold may not become arbitrarily large, and gold coins may stay in circulation. The fact is that the demand for gold is limited by the positive rate of interest channeling gold into monetary circulation, away from hoarding.

Ludwig von Mises in Human Action denies that the marginal utility of gold is constant (op.cit., p 404). His reasoning is that constant marginal utility would mean infinite demand, which is contradictory. Thus, then, Mises failed to grasp the connection between gold and interest. Elsewhere in his book (p 205) Mises denies that it is possible to construct a unit of value because two units of a homogeneous supply are necessarily valued differently, according to the Axiom of Declining Marginal Utility. Yet gold has successfully furnished the unit of value for thousands of years to many a flourishing civilization including our own. Later we shall see that our theory of interest departs from that of Mises in a number of other respects, too.

### Critique of Existing Theories of Interest

Implicit in this approach is a critique of existing theories of interest. While they recognize that hoarding has been a primitive form of saving in earlier times, existing theories tacitly assume that in an advanced industrial society with well-developed capital markets hoarding is non-existent or, at any rate, not being practiced by intelligent and informed people, and so it can be safely ignored. However, as a little thought will show, marginal saving is present even in the most advanced modern economies. The objects of hoarding are as varied as the means are ingenious. The latter include inventory padding both at the level of input and output of production, as well as the deliberate use of leads and lags in warehousing. It also includes cutbacks in production quotas of marketable goods (such as crude oil, lumber, gold, etc.) which have been utilized for the same purpose in recent times with dramatic effect, as well as the slowing of the movement of goods in the pipelines by distributors. The list of marketable goods that are both hoardable and consumable is endless. It includes such items as salt, spices, spirits, sugar, tea, coffee, fragrances, drugs, etc., not to mention grains, energy carriers, and metals.

It would be an impossible task to estimate, however tentatively, the size of existing stores of marketable goods. Even if such estimates were available, it would be impossible to decide which parts of these stores were held for impending consumption and which were considered marginal saving by their owners. The only way to grasp the hoarding habits of people is through theoretical understanding.

### Propensity to Hoard and the Rate of Interest

The owners of stores of marketable goods periodically revise their quota of stored values held specifically for purposes of marginal saving. Various considerations will enter into their calculations, some of which obviously has to do with conditions prevailing in the markets where their surpluses can be traded. But there is one general and overwhelming consideration that invariably enters into their calculations and may move them to change the size of their hoards, always with the same signature uniformly for all marketable goods. This is none other than the height of the market rate of interest. If lower than the floor and falling, then people tend to increase; and if higher than the ceiling of the natural range and rising, then they tend to decrease their quota of marketable goods held for purposes of marginal saving (as distinct from hoards held for consumption).

The inescapable conclusion is that a relationship exists between the propensity to hoard and the rate of interest. If the latter is too high then there is a damping, and if it is too low then there is a buoyant effect on hoarding. The converse is also true: a change in the propensity to hoard does directly or indirectly influence the rate of interest through its effect on the relative prices of marketable goods on the one hand, and on that of bonds on the other.

### Dichotomy False: Present vs. Future Goods

Part of the difficulty that a comprehensive theory of interest must face is due to the way the problem has traditionally been stated. It can be formulated as a question: What happens when a man with present goods to spare but who is in need of future goods meets another with future goods to spare but who is in need of present goods? I shall discard this as an unsuitable basis for the theory of interest. The bargaining positions of these two men are so different that no fair exchange can be expected to result from the encounter. Not surprisingly, it has always been in this context that usury was condemned by both criminal and canon law. We must look around for a more reasonable basis on which to construct a theory of interest.

### Dichotomy True: Income vs. Wealth

It has never occurred to philosophers and moralists nor, for that matter, to most economists, that the nature and the sources of interest could be better grasped if the problem was presented in the form of a different question: What happens when a man with income to spare but who is in need of wealth meets another with wealth to spare but who is in need of an income? Fair exchange is indeed possible in this case. Just why the problem of converting income into wealth and wealth into income is important follows from the fact that man is mortal and he knows it. As he grows old, his former surplus of mental and physical energy will inevitably turn into a deficit. If he has failed to accumulate wealth in his prime years, then his twilight years are likely to be miserable.

His needs would overwhelm his resources. He would lack the means to have the diseases plaguing him treated. To add insult to injury, he would be wide open to humiliation.

However, if he has wealth, then he will be in control of his destiny despite his declining strength. He will be in a strong bargaining position: he can exchange a portion of his wealth for an income that will keep him in comfort and safety for the rest of his life.

That wealth is not everything becomes clear as soon as conversion into income is denied to the individual, so vividly portrayed in the comedy of King Midas and in the tragedy of King Lear. The importance of such conversions could under certain condition be a matter of life and death.

### Irreducible Form of Credit

The exchange of a present good for a future good is not an irreducible form of credit. Nor is a loan from A to B. These exchanges fall short of capturing the essence of interest.

They could be viewed as the combination of two exchanges. For example, the loan from

A to B is an exchange of the income of B for the wealth of A, later followed by the return of the wealth to A in exchange for restoring the income to B. Accordingly, we shall view the exchange of income and wealth as the irreducible form of credit to which all other credit transactions can, and must, be reduced. This also has the advantage of including the conversion (as distinct from exchange) of income into wealth through hoarding, and wealth into income through dishoarding, as a limiting case.

### Principle of Capitalizing Income

Whenever provision for deferred consumption is made, it is done through converting income into wealth as a first step, to be followed by a second, converting wealth back into income. In this view income is perishable: 'use it or lose it', and conversion into wealth is the way to conserve it. The question of optimizing the conversion of income into wealth and wealth into income arises naturally. The answer can be found in the agency of credit and exchange. As I have observed already, in traditional accounts the most primitive form of credit is the exchange of a present good for a future good. I have discarded this view and replaced it with a more natural one that can be considered as the irreducible form of credit: the exchange of income and wealth. This represents a leap in the efficiency of direct conversion of income into wealth through hoarding, and that of wealth into income through dishoarding. We shall see that interest appears as the measure of the efficiency of exchange (as compared with that of direct conversion).

Exchanging income and wealth is possible because incomes, although perishable, can in fact be capitalized. As history and logic suggest, income is primary and wealth is derived (secondary). This was formulated by the American economist Frank A. Fetter as the Principle of Capitalizing Incomes. Early on scholastic philosophy recognized the importance of exchanging income and wealth for the benefit of society. In 1414 at the Council of Constance the principle was upheld that exchanging income for wealth involved no usury per se. Even earlier, St. Thomas of Aquinas (1225-1274) declared that a moderate discount on short-term commercial credit is not usurious and is therefore admissible. He justified the discount as a risk-premium and a compensation for lost income.

### Structure of Capital Markets

From the point of view of mortal man income and wealth are distinct categories independent of one another. When he converts income into wealth, he merely obeys the law of the biosphere according to which all living things survive by saving their substance. There is no other way to go through the fat-year/lean-year cycle. In addition, the economizing individual must provide for his and his spouse's old age, as well as for the education of his offspring.

We have discarded the idea of exchanging present goods for future goods as the basic problem of interest, and replaced it with the irreducible form of credit: exchanging income and wealth. Unlike the former, the latter arises out of identifiable, immediate, and concrete human needs, having to do with mortality and the problem of growing old. By contrast, the concept of exchanging present goods for future goods is barren. It is not grounded in any immediately identifiable human need. Insofar as it arises at all it is always in the context of complementing exchanges of wealth and income. Our innovation of considering the exchange of wealth and income as basis for the theory of interest will pay rich dividends when we classify the various types of capital formation, and study the structure of capital markets.

The Square Model Featuring the Annuitand, Annuitant, Entrepreneur, and Inventor

The formation of the rate of interest is usually explained in terms of a diagonal model of the capital markets featuring two participants: the supplier and the user of 'loanable funds'. This model is woefully inadequate as it blots out the time element between the raising and repayment of the loan and, more fundamentally, the crucial process of capital formation. It ignores the Principle of Capitalizing Incomes. Our theory presented in this course will involve a step-by-step refinement of the diagonal model into a square, a pentagonal and finally a hexagonal model of the capital markets. The square model has four participants: the annuitand (the man who is accumulating capital to support his future annuity), the annuitant (the man who is already drawing an annuity), the entrepreneur and, finally, the inventor. They are distinguished by their respective needs that they bring to the capital market to satisfy as follows. The annuitand needs to convert income into future wealth; the annuitant needs to convert wealth into income; the entrepreneur needs wealth in order to convert it into future income; and the inventor needs income in order to convert it into future wealth. The square model has the merit of clearly identifying the ultimate sources of supply and demand for wealth and income.

The four corners of the square represent the annuitand and the inventor plus the annuitant and the entrepreneur. Two kinds of partnership arise: that of the first pair represents the formation of R&D (research and development), and that of the second the formation of entrepreneurial capital. Often these partnerships are concealed under family bonds. The father is the annuitand (later, annuitant) and the sons the entrepreneur (or inventor). The family is the primitive social unit furnishing a framework for capital accumulation (for exchanging income and wealth).

Notice that there is another way to form partnerships by pairing the annuitand with the annuitant, and the entrepreneur with the inventor. The former is a partnership to supply credit, and the latter is one to utilize it. It is highly important to note, however, that the bargaining position of the two partnerships fails to be symmetric. The providers of credit: the annuitand and annuitant do not depend on the exchange in order to reach their ultimate end, unlike the users of credit: the entrepreneur and the inventor, who do. Zero interest means the denial of incentives to proceed with the exchange of income and wealth. Given this denial, the providers of credit would abstain from the exchange and fall back on direct conversion. The annuitand would convert his income into wealth through hoarding; the annuitant would convert his wealth into income through dishoarding. It would be absurd for the annuitand to exchange his income for less future wealth than he could himself accumulate through hoarding; and for the annuitant to exchange his wealth for a smaller income than he could himself generate through dishoarding. The same is not true for the entrepreneur and the inventor. In the case of zero interest they are helpless. For them, zero interest is an un-surmountable obstacle to capital formation. The entrepreneur's potential income could not be generated in the absence of entrepreneurial capital. The inventor's potential wealth would not be realized in the absence of R&D capital. The square model of the capital market reveals that the exchange of income and wealth is inherently asymmetric. The annuitand and the annuitant could still satisfy their need to convert should the exchange fail; the entrepreneur and the inventor could not. For them it is no exchange - no conversion. The impaired bargaining power of the latter pair could be assuaged somewhat by admitting the capitalist as the fifth participant of the pentagonal model of the capital markets.

### The Pentagonal Model Featuring the Capitalist

The partnership of the entrepreneur and the inventor is net long of future wealth and net short of present wealth. In order to make the partnership viable we introduce a fifth participant who is net long of present wealth and net short of future wealth. He is none other than the capitalist specializing in the exchange of present wealth for future wealth.

This brings out the importance of the trinity of the entrepreneur, the inventor, and the capitalist. In the words of Ludwig von Mises, they represent the three most progressive elements in capitalist society, who benefit the non-progressive 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.

### The Hexagonal Model Featuring the Investment Banker

A final refinement is the hexagonal model of the capital markets and the introduction of the sixth and last protagonist of the drama of capital accumulation: the investment banker. The refinement is made necessary by the fact that no two annuities are alike. Yet trading them will still be possible if the differences are bridged over by the gold bond.

The investment banker's function is clearing and brokering. He matches the varied demands thrown upon the capital market from its other five corners. He must be prepared to enter into partnership with the annuitand, annuitant, entrepreneur, inventor, or the capitalist, as the case may be, through his specialized instruments of annuity and mortgage contracts. At the same time he will balance his net liability or asset resulting from this activity through the purchase or sale of the standardized instrument, the gold bond.

The hexagonal model of the capital market brings about a great increase in scope for the most successful combination of capitalist production: the triangle of the entrepreneur, the inventor, and the capitalist mentioned earlier. 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 does the entrepreneur in finding a suitable inventor. Neither of them is at the mercy of the capitalist. If the invention is good and the enterprise is sound, then 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. The problem of forming optimal triangles can safely be left to the bond market.

### The Concept of Interest

Interest is an income in perpetuity which exchanges for the unit of wealth. The rate of interest is measured as a percentage of the unit of wealth that accrues to the beneficiary of the income in each one-year period. Thus, if the unit of wealth is one gold dollar and it exchanges for an income in perpetuity amounting to one gold cent per quarter, then the rate of interest is four percent per annum. Of course, an income in perpetuity is an abstraction. The bond is a contract drawn up for a finite period. It involves two exchanges, with the second to reverse the first at the same rate of interest, so that the income flow becomes finite. In earlier times perpetual bonds (called consols by the British) were also offered to the saving public. Consols represented interest in its purest form. The British government defaulted on consols before defaulting on bonds, and withdrew the issue.

### The Propensity to Save and the Rate of Interest

There is a mathematical relation between the market price of the bond and the rate of interest, called the Bond Equation, that I shall discuss in a future Lecture. The bond equation makes it possible to define the rate of interest in terms of the bond price. Thus we must regard the bond market as the place where the formation of the rate of interest takes place. The bond equation shows that the rate of interest varies inversely with the bond price. The reciprocal movement of the two we can compare to the seesaw: as the rate of interest goes up, the bond price comes down, and vice versa. This is a mathematical, not a statistical law, tolerating no exceptions. The seesaw can be paraphrased by saying that the rate of interest and the propensity to save are in an inverse relationship with one another: the higher the propensity to save the lower will be the rate of interest and vice versa. The seesaw plays a fundamental role in our analysis of the formation of the rate of interest.

It is important that only gold bonds may enter these considerations. A bond payable at maturity in irredeemable currency is a promise that is fulfilled by making another irredeemable promise. In effect, it is a promise to defraud in exactly the same way as the promise of Charles Ponzi to pay interest at the rate of 100 percent per annum has been.

No serious student of interest can take such bonds for anything but a cruel joke on the public. The Criminal Code calls for severe punishment for deliberately defrauding the public through confidence games and Ponzi-schemes. The issuance of irredeemable promises to pay, be it interest-bearing such as a bond or non-interest bearing such as a bank note, fully exhausts the concept of fraud. Governments have interfered with the justice system by blocking citizens and creditors who wanted to sue it in court. Not only are injured parties denied justice, they are also denied a public hearing of their case.

Worse still, irredeemable currency violates the monetary provisions of the American Constitution. We are witnessing the shameful corruption of the justice system and trampling on the Constitution. For this not only the politicians but also jurors and legal scholars must share the responsibility. The day of reckoning will come when the economic system based on the house of cards of irredeemable currency will collapse causing the people to suffer excruciating economic pain.

### The Gold Standard as the Stabilizer of the Economy

One of the cardinal points about the gold standard as it is remembered today is that it was an attempt to stabilize the price level — an attempt that has failed. But it would be closer to the truth if the gold standard were remembered as an attempt to stabilize the interest rate structure — an attempt that has succeeded. While interest rates had their ups and downs as part of the long-wave economic cycle under the 19th century gold standard, these undulations were minuscule in comparison to the wild gyrations displayed after the link between currencies and gold was severed in the fourth quarter of the 20th century.

Stabilization of prices is neither possible nor desirable. Price changes are part of the signaling mechanism of the economic system that regulates both production and consumption. By contrast, the stabilization of interest rates is both possible and desirable.

Unstable interest rates lead to general economic instability, including that of prices, production, saving, and investment — all to the detriment of economic welfare. At worst, they could trigger uncontrollable resonance between commodity prices and interest rates.

That would create a runaway vibrator, bringing about economic collapse in the form of hyperinflation (with the economy succumbing to infinite interest) or deflation (with the economy succumbing to zero interest).

The stabilization of interest rates would benefit everybody. It was a tragic mistake to discard gold from the monetary system in complete disregard for the damage it would do to the stability of the interest rate structure. The extreme volatility of interest rates has been plaguing the world economy since 1971. In spite of appearances, current low rates don't spell stability. They are the quiet just before the approaching storm.

### Disequilibrium Theory of Price Formation

I conclude this Lecture with a preview of the follow-up course Monetary Economics 202 on the formation of the rate of interest. Carl Menger revolutionized economics by throwing out the equilibrium theory of price formation to replace it with a disequilibrium theory. He observed that the market quotes not one but two prices, a higher asked price and a lower bid price. Transactions may take place anywhere within the range determined by these two. We have to study two independent market processes, one responsible for the formation of the asked price, and another for that of the bid price. It turns out the asked price is the outcome of the competition of the consumers, while the bid price has to do with that of the producers.

Competition takes the form of arbitrage. Being the combination of a sale and a purchase, arbitrage is the most comprehensive form of human action. The market price is not the result of supply/demand equilibrium, but the outcome of a convergence process whereby it is confined to an ever-narrowing range determined by the vanishing spread.

Disequilibrium, or a lower state of coordination is being replaced by a higher one which, however, still reflects disequilibrium and calls for further adjustments. The disequilibrium theory of price formation is superior to the equilibrium theory as it does away with the spurious notions of supply and demand. It reflects reality more closely. It shows that the price is not a state but, rather, the outcome of a convergence process.

In more detail, the asked price is formed through the horizontal arbitrage of the marginal consumer, and the bid price is formed by the vertical arbitrage of the marginal producer.

The marginal consumer is the first to refuse to buy the uptick in price, and horizontal arbitrage means that he is ready to buy a cheaper substitute. The marginal producer is the first to refuse to sell the downtick in price, and vertical arbitrage means that he is ready to buy cheaper substitutes for the producer goods at his input. We see that the asked price is determined by marginal utility. It can be characterized as the lowest price at which consumers can buy as much as they want without haggling — explaining how the asked price earns its name. The bid price is determined by marginal profitability. It can be characterized as the highest price at which producers can sell all they have without haggling — explaining how the bid price earns its name. The spread between the asked and bid prices is closed by the arbitrage of the market makers. To recapitulate:

The asked price of a consumer good marks the point where the opportunity cost of buying an additional unit becomes critical to the marginal consumer. He is the first to refuse to buy the uptick, in view of his opportunity to buy a substitute.

The bid price of a consumer good marks the point where the opportunity cost of selling an additional unit becomes critical to the marginal producer. He is the first to refuse to sell the downtick, in view of his opportunity to substitute a new producer good at his input.

### Disequilibrium Theory of the Formation of the Interest Rate

The rate of interest, no less than prices, is a market phenomenon. Once again we find ourselves in disagreement with Ludwig von Mises. He postulated in Human Action that "the loan market does not determine the rate of interest, but adjusts it to the rate of originary interest as manifested in the discount of future goods" (op.cit., p 527). For us, the formation of the rate of interest is the result of a market process, analogous in every detail to that responsible for the formation of prices.

Our starting point is the observation that the bond market also quotes two prices, the higher asked and the lower bid price for bonds. In view of the seesaw, the asked price corresponds to the floor, and the bid price to the ceiling, of the range to which the rate of interest is confined. Bonds may change hands anywhere within the range determined by the asked and bid price. We have to study two independent market processes: one responsible for the formation of the asked price for bonds (or the floor for the rate of interest), and the other responsible for that of the bid price (or the ceiling for the rate of interest). It turns out that the former is the outcome of the competition of bondholders, while the latter is the outcome of the competition of entrepreneurs.

Competition takes the form of arbitrage. Bondholders engage in arbitrage between the bond market and the gold market; and entrepreneurs between the bond market and the stock market. In more details, the asked price for the bond is formed by the horizontal arbitrage of the bondholders, and the bid price by the vertical arbitrage of entrepreneurs.

Bondholders won't let the bond price go sky high. They will take profit in selling the bond and stay invested in gold until bond prices come back to earth. Entrepreneurs won't let the bond price to keep falling forever. They will step in and buy the bond out of the proceeds of selling their stock. Thus the floor for the rate of interest is determined by marginal time preference. It can be characterized as the highest rate of interest which savers still refuse to accept. The ceiling for the rate of interest is determined by the marginal productivity of capital. It can be characterized as the lowest rate of return on capital that entrepreneurs will still accept before they go out of production and invest the proceeds from the sale of their capital goods in bonds. The spread between the floor and ceiling is closed by the arbitrage of the market makers in bonds. To recapitulate:

The floor for the rate of interest marks the point where the opportunity cost of holding the bond becomes critical to the marginal bondholder. He is the first to sell his bond upon the next downtick in the rate of interest, in view of his opportunity to carry his savings in the form of a present good, gold, instead of a future good, the bond.

The ceiling for the rate of interest marks the point where the opportunity cost of owning capital goods becomes critical to the marginal entrepreneur. He is the first to buy the bond upon the next uptick in the rate of interest, in view of his opportunity to sell his stocks and carry earning assets in the form of bonds rather than capital goods.

I urge my audience not to get discouraged if this material appears to be too concentrated to digest at once. After all, this is a synopsis of a future course, Monetary Economics 202: The Bond Market and the Formation of the Rate of Interest. We shall treat this subject in much greater details in future Lectures.

### A Tale of Two Schools

Our new theory of interest can be described as a synthesis between two well-established schools: the time preference and the productivity school of interest. They are competing, antithetical schools, and a fratricidal war between their adherents has long retarded theoretical progress.

According to the time preference theory of interest a time premium exists, and is incorporated in the price of present goods over that of future goods. This time premium is a category of human thought in much the same way as our concepts of space and time are, and it exists independently (and even in the absence) of production. By contrast, the productivity theory of interest insists that it is the marginal productivity of capital that determines the height of the rate of interest, regardless whether capital is provided by nature or by savings. On the face of it irreconcilable antagonism exists between the two positions. Yet a synthesis between the two opposing schools is possible, as our disequilibrium theory of the formation of the interest rate shows.

### The Gold Coin and the Rate of Interest

To conclude, gold furnishes the mechanism whereby savers could have input in the formation of interest. If dissatisfied because rates were too low, they could force the banks to take their marginal time preference into consideration. The mechanism had teeth. Gold hoarding was effective. Not only was it a symbolic protest vote against credit policies suppressing the rate of interest to unreasonably low levels; it did bring about the desired changes. Since gold coins served as bank reserves under the gold standard, by withdrawing their deposits and converting their notes into gold coins savers could force the banks to contract outstanding credit. Moreover, a continuing squeeze on bank reserves could not help but alert legislators that people were unhappy with profligate government spending financed through the banking system. They could amend their ways by eliminating wasteful spending. The system of checks and balances worked well during the first 150 years of the American Republic. Not government bureaucrats but the saving public regulated the rate of interest. Regulation was for the benefit of everybody, not just for the benefit of a small minority, however influential. The tool of this regulation was the gold coin.

It is not surprising that the gold standard was unpopular with governments, for it has been a fetter on buying votes through public spending. Governments couldn't perpetuate their power by promising pie in the sky. Frugality was a virtue and profligacy a vice, especially when it came to the public purse. The electorate could express its displeasure with government spending and throw profligate governments out of power. Not only did it have the ballot paper, the electorate also had the gold coin with which to vote. And vote it did, on every business day. If it did not like the credit policies of the banks and the government the whip, gold hoarding, was at hand. It was not only the politicians with whom the gold standard was unpopular. Economists did not like the gold standard either.

They looked at it as you would at a naughty child who blurts out embarrassing truths.

The first attack on the gold standard came from the British economist David Ricardo

(1772-1823). In 1819 he proposed his 'bullion plan' according to which gold coins should be withdrawn from circulation. Gold should be held by banks in bullion form for the purpose of redeeming notes and deposits, the required minimum being the standard gold bar of 400 oz, or approx.12.5kg . Clearly, this plan was designed to short- circuit gold's role in the regulation of the rate of interest. The marginal bondholder would be frustrated whenever he wanted to protest the artificially low rate of interest. Of course, he could sell his bond, but in doing so he would be jumping from the frying pan into the fire. He would have to hold bank notes, so that he would get zero interest in place of the low rate of interest he wanted to protest. The marginal bondholder was denied the gold coin he would need in order to make his protest effective.

### Interest under the Regime of Irredeemable Currency

The synthesis between the time preference and the productivity theory of interest assumes that there is no government interference in credit relations. Our theory of interest is only a first approximation to the problem, as it is valid only under the regime of the gold standard. However, it can be extended to the regime of irredeemable currency which is characterized by massive intervention of the government and its central bank in the credit markets.

Since time immemorial governments have been predisposed to intervene on behalf of the debtors and to the prejudice of the creditors. There may have been ideological motivation for this, but it is more likely that governments were pursuing self-serving policies. They were debtors themselves. They wanted easy money in order to aggrandize and perpetuate their own power. They have done all they could to compromise the sovereignty of the saver. Through various measures such as fomenting credit expansion or inflation, and through obstructing the free flow of gold, they have tried to undercut the importance of saving and to promote the cause of spending. The regime of irredeemable currency must be seen as the fulfillment of those early aspirations.

### The Ratchet and the Linkage

Recall that when access to gold is inhibited or denied, as it has been with increasing frequency and intensity throughout the entire history of the gold standard, gold hoarding is superseded with similarly increasing frequency and intensity by the hoarding of marketable commodities. People would increase their marginal savings. This hoarding can also be characterized as 'inventory inflation' financed through the liquidation of bond holdings in response to artificially low interest rates. As I have pointed out, hoarding bank notes would be counter-productive. It would be practiced by simpletons only.

My notion of inflationary and deflationary spirals is very different from that of mainstream economics. It goes back to the Swedish economist Knut Wicksell (18511926). The initial impetus of credit expansion pushes the market rate of interest below that of marginal time preference, making the propensity to hoard increase. It triggers a first round of purchases of marketable goods for hoarding purposes with the proceeds from the sale of bonds. Marginal savings grow. While selling pressure on bonds increases interest rates, buying pressure on goods increases the price level. The higher price level will increase marginal time preference. When prices are expected to rise, the marginal saver will demand compensation in the form of higher interest rates. The net result is that, once again, the market rate of interest is below the rate of marginal time preference, and the propensity to hoard increases.

This will trigger a second round of purchases of marketable goods for hoarding purposes financed through further liquidation of bond holdings. The inflationary spiral repeats itself at a higher level of prices and interest rates. Thus a ratchet is engaged whereby subsequent rounds of increases in marginal savings pushes commodity prices as well as the rate of interest to ever higher levels. It may take decades for the inflationary spiral run its course. It is not possible to predict when the spiral will turn around. At any rate, high and increasing prices coupled with high and increasing interest rates will eventually lead to panic. People realize that further increases in the rate of interest would threaten the value of their marginal savings. Liquidation of marginal hoards of marketable goods begins. This spells a deflationary spiral, to which the inflationary spiral gives way, featuring ever lower propensity to hoard, or inventory deflation. There is a drawn-out process of dissipating excessive stockpiles.. The collapse in demand for newly produced goods causes business lethargy, as reflected by falling interest rates along with falling prices. It may take decades before business confidence can be rebuilt and economic expansion resumed, signaling the end of the deflationary spiral. It goes without saying that credit expansion will spark a new round of the cycle before long, and the process will go on and on. This, then, is the long-wave inflation/deflation cycle, also known as the Kondratyeff cycle.

Note that the ratchet-effect is also responsible for the linkage between the movement of the rate of interest and that of the price level. With due allowance for leads and lags, the price level and the interest-rate structure are linked, and must move in the same direction.

Linkage has been noted by several economists, but reasoning in terms of linear models (such as that of the quantity theory of money) has failed to provide an explanation of the phenomenon. Only partial explanations have been given, so that linkage is still something of a mystery. My explanation is in terms of a non-linear model. An increase in the propensity to hoard induces a long-term money-flow from the bond market to the commodity market, ultimately leading to panic, turning the money-flow back. Thus we have an oscillating money-flow between the bond market and the commodity market which was caused in the first place by the government in sabotaging and finally destroying the gold standard.

The linkage represents economic resonance between the price level and the rate of interest. The danger is that this resonance may cause amplitudes to increase without limit.

Just as in physics, resonance could cause runaway vibration culminating in the selfdestruction of the system. In economics, self-destruction is realized by hyperinflation (that may be described as the blackhole of infinite interest), or deflation (the blackhole of zero interest).

Note how the natural stability of the economic edifice has been perverted by the removal of gold. Hoarding makes for stability under the gold standard, as it is self- limiting through the interest-rate mechanism. But when gold is removed from the system, or when its free flow is inhibited by the governments, hoarding becomes cumulative, as a ratchet sends both the price level and the rate of interest ever higher which continues until panic puts an end to it. At that time a slow and painful process of dishoarding starts that will send the price level as well as the interest rate structure spiraling downwards. Each repetition of the cycle brings higher amplitudes in its wake for both the price level and the rate of interest, higher than those of the previous one. As the interest-rate cycle resonates with the price-level cycle, a runaway vibrator is activated.

### Between Scylla and Charybdis

The long-wave inflation/deflation cycle is aggravated rather than alleviated by central bank intervention. Directly or indirectly, contra-cyclical monetary policy amplifies the oscillating money-flow back-and-forth between the bond market and the commodity market. An accurate reading of the present situation is that after the inflationary spiral lasting for forty years, culminating in the 1980 price explosion, the world economy saw a panic ushering in the deflationary spiral that still continues. Prices and interest rates peaked in 1980 when dishoarding started. It is true that the downward ratchet of the interest-rate structure is more obvious than that of the price level, but you would be welladvised to watch for a very painful erosion of prices and profits as firms keep losing their pricing-power. Central bank intervention is counter-productive. As it tries to 'reflate' by injecting new cash into the economy, the central bank will only pour oil on the fire.

Whenever it wants to inject new cash, the central bank goes to the bond market to buy bonds. But in doing so it will only join the crowd of frenzied bond speculators already busy in bidding up bond prices and pushing down interest rates as part of the deflationary process. As a matter of fact, speculators have taken it for granted that the central bank will act that way thereby taking the risk out of bond speculation. The new money injected in the economy, which the government has hoped that it would flow to the commodity market and bid up prices there, does instead flow to the bond market where the fun is. It stokes the fires of the boom there pushing interest rates further down and, due to the linkage, it makes prices fall as well. Far from putting an end to the deflationary spiral, central bank action depresses the economy even more. Unless, of course, the deluge of new money injected in the economy scared bond speculators in causing them to cut and run. As they dumped their bonds, they would make bond prices, and the value of irredeemable currency, collapse.

There is not enough room between the Scylla of inflation and the Charybdis of deflation to squeeze through. Before the central bank can navigate the economy to safety, further slimming appears necessary.

### References

Ludwig von Mises, Human Action, Third Edition, Chicago: Henry Regnery, 1966.

Antal E. Fekete, Whither Gold, and Other Collected Essays, Hammond, Louisiana:

Ededge ([www.ededge.com](https://www.ededge.com)), 2002.

Antal E. Fekete, The Central Banker As the Quartermaster-General of Deflation, [www.goldisfreedom.com](https://www.goldisfreedom.com), January, 2003.

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand’s Hymn to Money

### Lecture 2: Don’t Fix the Price of Gold!

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told; (Chapters 1 - 3)

### Lecture 6: The Invention of Discounting; (Chapters 4 - 6)

### Lecture 7: The Mystery of the Discount Rate; (Chapters 7 - 8)

### Lecture 8: Bills of the Goldsmith; (Chapter 9)

Lecture 9: Legal Tender. Small Bank Notes.

### Lecture 10: The Revolt of Quality

### Lecture 11: The Acceptance House; (Chapter 10-11)

### Lecture 12: Borrowing Short to Lend Long; (Chapter 12)

### Lecture 13: The Unadulterated Gold Standard

## Winter Semester, 2003

### Monetary Economics 102: Gold and Interest

Lecture 1:

Lecture 2:

Lecture 3:

Lecture 4:

Lecture 5:

Lecture 6:

### The Nature and Sources of Interest

### The Dichotomy of Income versus Wealth

### The Janus-Face of Marketability

### The Principle of Capitalizing Incomes

### The Structure of Capital Markets

### The Rate of Interest

### Lecture 7: The Gold Bond

### Lecture 8: The Bond Equation

### Lecture 9: The Investment Banker

### Lecture 10: Lessons of Bimetallism

### Lecture 11: Aristotle on Check-Kiting

### Lecture 12: Bond Speculation

### Lecture 13: The Blackhole of Zero Interest

## In Preparation:

Monetary Economics 201: The Bill Market and the Formation of the Discount Rate Monetary Economics 202: The Bond Market and the Formation of the Rate of

### Interest

---

# Monetary Economics 101 — Lecture 13: The Unadulterated Gold Standard

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-101-lecture-13-the-unadulterated-gold-standard/
Date: 2002-10-28
Section: Money & Credit
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, real-bills, mises, new-austrian-economics
Description: In his concluding lecture, Fekete defines 'the unadulterated gold standard' — distinguishing it from all corrupted versions including Bretton Woods and the gold exchange standard. He argues only a system with free coinage, redeemable notes, and a functioning real bills market fully realizes the self-regulating properties of gold as money.
Editorial Note: The concluding lecture of Monetary Economics 101 (Gold Standard University, 2002). This lecture synthesizes the entire series and presents Fekete's positive vision for monetary reform, serving as the foundation for all his subsequent policy writing.
Original PDF: https://professorfekete.com/articles/AEFMonEcon101Lecture13.pdf

### Lecture 13 (Concluding Lecture)

*The Unadulterated Gold Standard*

- Corruption of the Gold Standard - The Haberler-Pigou Effect - Critique of the Quantity Theory - The Gold Standard and its Relevance to Capitalism -

### Corruption of the Gold Standard

The gold standard is a monetary system which, unlike the regime of irredeemable currency, is free of coercion. Its main significance is not to be found in the stabilization of prices, which is neither possible nor desirable, but in the stabilization of interest rates.

A gold standard is established when the unit of currency, or standard of value, is defined by the Constitution as a definite weight of gold of definite fineness. All other forms of currency are then redeemable in gold on demand at the statutory rate. To be effective, a gold standard must have a paraphernalia such as the standard gold coin, minted free of charge (exclusive of the cost of refining) at the Mint in unlimited quantities on the account of anyone tendering the metal. Furthermore, owners of the gold coins of the realm may hoard them, melt them, export them freely without penalty or the threat thereof. This right is part of the right to own property which cannot be curtailed, abrogated, or summarily suspended without due processes of law. It should be noted that, although the right of owning property in general may be subject to limitations and could be suspended temporarily in case of extreme emergency (a typical example is the ownership of grain in a town under enemy siege), gold is explicitly exempted from this provision. A shortage of gold, unlike a shortage of grain, never gives rise to an emergency. The consumption of gold is mostly in the arts and jewelry, and is never for the satisfaction of the most urgent needs of society. A shortage of gold is always a symptom of mismanagement of the credit system by the banks, usually under the sponsorship of the government. If gold is in short supply, it simply means that individual citizens and creditors of the government are dissatisfied with credit policy. Hoarding gold is the only way they can protest effectively. They will release gold in their control as soon as they have been persuaded that the banks and the government mend their ways and they will keep their promises to pay. They will keep their sight liabilities within the limits of their quick assets. They will create no debts without seeing clearly how these debts can be paid. A shortage of gold, therefore, is not a real shortage and can be ended quickly through corrective measures in bank and government credit policies. The Constitution and the legal system should recognize this by specifically exempting gold from arbitrary seizure under sections of the legal code governing eminent domain.

The gold standard has been criticized for reasons of variation in the exchange value of gold. Critics have charged that gold is not sufficiently stable to serve as the standard of value. To assess this charge we must observe that variations in the exchange value of gold during the past 500 years were the result of the over-issue of fiduciary media redeemable in gold. In the absence of this abuse the exchange value of gold would have conformed to its intrinsic value governed by gold's marginal utility. Gold was promoted to the status of a monetary metal by the markets over thousands of years of evolution that has made the marginal utility of gold as nearly constant as possible (while the marginal utility of other goods is subject to steep decline, more or less. No other commodity would be more stable when used as money. Least stable is the irredeemable currency based on debt. We may therefore conclude that if the exchange value of gold appears undermined, the culprit is to be found in the unwarranted issue of fiduciary media by the banks under the sponsorship of the government. Moreover, this abuse takes the form of illicit interest arbitrage as we have seen in this course (Lectures 11 and 12). The criticism must be re- directed from gold to the legal system of the country, which has failed to outlaw illicit interest arbitrage and borrowing short to lend long.

There is, therefore, need to re-define a gold standard in such a way that these credit abuses by the banks under the protection of the government are eliminated. In particular, the exemption of banks from the full penalty under contract law for breach of contract (including the right of creditors to sue for liquidation), and the double accounting standard aiding and abetting banks guilty of understating liabilities and overstating assets, must be abolished. The definition of the unadulterated gold standard must stipulate the removal of all special privileges for the banks. It was these privileges that allowed banks to carry on business as usual after they have defaulted on their promises to pay gold to their depositors. It was these privileges that have let banks borrow short to lend long. It was these privileges that made it possible for them to milk society through the practice of illicit interest arbitrage. The very idea that banks may be allowed to suspend payments in gold coin and continue in business is preposterous. The gold coin is there, in the first place, to protect the bank's creditors against unsound credit practices. Legalizing suspension is tantamount to condoning the practice of declaring bankruptcy fraudulently, and to confirming the thief in the possession of stolen goods. At any rate, legal protection of banks against the legitimate claims of creditors rewards incompetence and fraudulent behavior while penalizing competence and integrity. With such a code, problems will never be solved, only compounded.

### Arbitrage versus Speculation

Critics who argue that the gold standard is inherently unstable confuse the instability of a metallic monetary standard with that of the credit of government. They also betray their ignorance of the difference between arbitrage and speculation. No government per se can keep the value of the currency stable, except by the good offices of the arbitrageur. If he is persuaded about the good faith behind the promises of the government, then he will step in every time there is a deviation between the nominal and the market value of paper currency in order to restore parity. It is well-understood by students of metallic monetary standards that arbitrage is the catalyst whereby the value of paper currencies is maintained. But the arbitrageur will carry on his beneficial activities only if he is fully convinced of the good faith of the government. He will support the value of the government's promise only if it is worth supporting, the judgment being based on past performance, present policy, and future intentions. A government that has a record of periodic lapses into bad faith, that makes promises frivolously, that has inclination to declare bankruptcy fraudulently (more commonly known as devaluation) is inviting the arbitrageur to stop supporting its currency.

In actual fact, conditions influencing the credit of government can be even more precarious. Not only may arbitrageurs, whose support alone maintains the value of government paper, withdraw their services en masse and without notice. Worse yet, speculators would be happy to step into the shoes abandoned by the arbitrageurs, and cause massive harm to the credit of the government. The behavior of the speculators is as different from that of the arbitrageurs as night is different from day. The speculators are specialists in making a market in paper of dubious or uncertain value. They make it their business to study which currency is the weakest and is most likely to fall next. They are totally immune to double talk and the siren song appealing to "patriotism". Speculators treat paper currency most disrespectfully. They sell it short. They buy it only at a deep discount. They are very strong: they can make governments eat their words. They know exactly how to respond to the government's loud declaration that "the national currency will never ever be devalued". In this cat-and-mouse game, the role of the mouse appears to have been assigned to the government.

Currency speculation, just as bond speculation, was virtually unknown under the gold standard. There was only beneficial arbitrage. The sycophant chorus of financial writers and economics professors has never been able to grasp this fundamental fact governing the gold standard. The strength of the gold standard is not grounded in mythology. It is grounded in the superb confidence that arbitrageurs have in the government's promises to pay gold. Once the government destroys the basis for this confidence, arbitrageurs vacate the field which is subsequently occupied by a new breed, the currency and bond speculators. With arbitrage gone, speculators have a field day. They dictate currency values unopposed. They ratchet down the value of all irredeemable currencies, one after another, going after the weakest first. This may make the false impression that the strongest currency is indeed a strong currency. Well, it is not. In no way is it strong in the absolute sense of the word. One can only talk about relative strength: even the strongest currency is losing its value over time, albeit more slowly than the others, but losing it nevertheless.

### The Tyranny of Gold

Things are very different under a gold standard. If the government has a record of performing punctiliously on its promises to pay gold, if there is no reason to question its good faith, if it has a policy to balance its budget and it can show the revenue that will retire its outstanding debt, then gold comes out of hiding and will flow to government coffers in exchange for paper promises to pay gold. The only competitor gold money may have, and that is a formidable competitor indeed, is the promise of the government to pay gold. If the promise can be trusted, then the value of paper will be kept on a par by the arbitrageurs through thin and thick. Here is what Benjamin M. Anderson had to say about the tyranny of gold.

"Gold is an unimaginative taskmaster. It demands that men, banks, and the government be honest. It demands that they create no debt without seeing clearly how these debts can be paid. If a country will do these things, gold will stay with it and come to it from other countries. But when a country creates debt light-heartedly, when a central bank makes interest rates low and buys government securities to feed its money market, and permits an extension of credit that goes into slow and illiquid assets, then gold grows nervous.

There comes a flight of capital out of the country. Foreigners withdraw their funds from it, and its own citizens send their liquid funds away for safety." (Op.cit., Chapter 64.)

### Legal Tender

Under a gold standard the gold coin is the only legal tender. This means that only the gold coin is acceptable in unlimited quantities in discharge of debt, not by coercion but by the free choice of the contracting parties. Other means of payments are acceptable within legal limits or at the risk of the receiver. It is important to realize that the original concept of legal tender has nothing to do with coercion as it does today. It is a corollary of the principle of the sanctity of contracts. A search of financial annals fails to reveal an instance of a creditor ever protesting payment in gold coin as contracted. Originally, legal tender legislation referred to tolerance standards of circulating coins (see Lecture 9).

Commerce is greatly facilitated if gold coins circulate by tale rather than by weight, thus bypassing the cumbersome and time-consuming process of weighing. But then a practical problem arises: creditors may refuse to accept at face value coins that are worn more or less, thus undermining the efficiency of the gold standard. The problem is solved by introducing legal tolerance standards regulating the minimum weight of a gold coin that is still allowed to circulate by tale, while making substandard coins circulate by weight.

There is no coercion involved. Creditors are not coerced into accepting at face value gold coins with impaired weight. Legal tender legislation, as conceived originally, obliges the government to cover losses caused by wear and tear of coins in circulation. The Mint will accept at face value worn gold coins within the limits of tolerance, and will replace them with newly minted ones. The government absorbs the loss. This is comparable to its function of maintaining public roads in good repair. This wise provision is enacted to facilitate commerce. It is unfortunate that the meaning and purpose of legal tender legislation was later distorted and made an instrument of coercion. Today legal tender laws are a travesty of justice. They pretend to protect the public; in actual fact, they protect special interests. Today legal tender means that creditors are coerced into accepting dishonored promises to pay in final discharge of debt, and no amount of sophistry can change that fact. Everybody who accepts and holds an irredeemable bank note is a creditor of the government holding evidence of indebtedness that cannot be validated as a consequence of legal tender legislation. The general public stands to be victimized by this piece of chicanery changing the original meaning of the term legal tender, as the 90 percent loss in the purchasing power of the dollar during the 1970's has forcefully demonstrated.

### Unadulterated Gold Standard

Under a gold standard the stock of circulating medium has three components: (1) the gold component, (2) the clearing component, and (3) the fiduciary component. The gold component consists of the gold coins of the realm in the hand of the general public plus that part of bank notes and deposits which are covered by reserves in the form of gold.

The clearing component consists of maturing bills of exchange in the hands of the public plus that part of bank notes and deposits which are covered by assets consisting of such bills. The fiduciary component consists of that part of bank notes and deposits which belong neither to the gold not to the clearing component. The gold standard is called unadulterated if the stock of circulating medium has no fiduciary component. This means that the banks issue no bank notes and create no bank deposits except when buying gold or discounting a bill of exchange. Bills eligible for discounting is strictly limited to those drawn on merchandise on its way to the final cash-paying consumer, with maturity no longer than 91 days. In particular, the banks are not in the business of discounting finance bills, anticipation and accommodation bills, treasury bills, and they buy no stocks, bonds, or mortgages in excess of their liabilities on capital account.

### The Haberler-Pigou Effect

The most important consequence of establishing an unadulterated gold standard is that an across-the-board increase in the prices of consumer goods is no longer possible. Such an increase would immediately trigger the Haberler-Pigou effect as follows. The consumer controlling the gold coin could effectively resist higher prices by delaying his purchases, buying alternative products, or by patronizing outlets selling at the old price. This consumer action would roll prices back, should an across-the-board increase in prices ever occur. The fact is that such an increase would inflict capital losses on the consumer, which would show up in the consolidated balance sheet of the nation. He would have to recoup the loss by restraining consumption. This restraint is the driving force behind the roll-back of prices. Note, however, that the Haberler-Pigou effect does not operate on the fiduciary component of the stock of circulating media. To the extent that fiduciary media are in circulation, the effectiveness of the protection that the gold coin provides to the consumers is undermined. The consumers may, if they care, try to combat higher prices by delaying or limiting purchases or by shifting custom. It is still true that they have suffered a capital loss but, because they are creditors to the extent of their holdings of fiduciary media, another group of people ¾ their debtors ¾ will experience capital gains equal to their capital losses. The effect of the stepped-up spending of the latter offsets that of the spending restraint of the former, thus validating the price advances. The consolidated balance sheet of the nation shows no change, hence individual resistance to higher prices remains ineffective. The price level under the adulterated gold standard and, for the stronger reason, under the regime of irredeemable currency, is no longer stable. If a country wants a stable price level for consumer goods, it will have to adopt the unadulterated gold standard.

### The Quantity Theory of Money

Detractors of the gold standard argue that fluctuations in gold production influence the price level adversely. In particular, a decline in gold production causes deflation, economic contraction, and unemployment. This is false. In deflation prices fall and in response marginal gold mines go into production. The quantity theory is a very crude device which would be valid only in the antiseptic world where credit is non-existent, and all payments for consumer goods are made in gold coin, where merchandise is always consumed upon purchase and never re-sold. In reality, a large part of payments in a modern economy are for future delivery, often for products not yet in existence. Even if payments are for immediate delivery, the goods can be sold and re-sold several times before they disappear in consumption. As we have seen, the theory of social circulating capital is the exact opposite of the quantity theory. It demonstrates that the supply of consumer goods is determined by demand. Moreover, the mechanism that makes the adjustment of supply to demand operates, not on prices, but on the discount rate.

A second, even more serious objection to the quantity theory of money is that, as its name suggests, it is completely blind to the quality of circulating media, the stock of which has many components each of different quality. This is especially important in the case of components consisting of credit instruments. The government can, of course, make the quality of purchasing media uniform by centralizing credit. However, this can never improve the quality of the currency, but can make it deteriorate. It is well-known that credit instruments of inferior quality go to a discount in the markets. It is disingenuous to explain away currency depreciation by quantitative arguments. First, there are obvious examples showing that credit instruments of inferior quality can lose all their market value even if their quantity is constant or decreasing. Second, even if it were true that historically all currencies losing their purchasing power showed a simultaneous increases in their quantity, this would not establish a causality relation between the quantity and the purchasing power of money. The chain of causation may well run in the opposite direction. Several qualified observers noted that in hyperinflation an acute shortage of the circulating medium develops owing to the accelerating decline in the purchasing power of the monetary unit, and the central bank is under pressure to put more bank notes into circulation than originally intended, in order to alleviate the shortage.

This means that in fact there is no unambiguous causality relation between the quantity and the purchasing power of the circulating medium. The only way to get to the crux of the matter is to study the quality of the circulating media or, if they have been made homogeneous by the centralization of credit, then to analyze the history and the marketability of the assets on the books of the monetary authority balancing its note and deposit liabilities. Several authors argue that the quality of credit is of no significance because, thanks to legal tender legislation, creditors are obliged to accept irredeemable currency in discharge of debt in any amount without demur. This is a shallow, not to say cynical, answer to a problem that deserves a deeper and more earnest analysis.

Basically there are two sides to the problem: the behavior of domestic and foreign creditors. As the writ of the government stops at the border, the latter are not bound by legal tender legislation. Foreign creditors are not in the habit of giving advance notice of their intention to dump the paper of a government to which they owe no allegiance. This shows that the quantity theory puts the country's resources embodied in its foreign credit into jeopardy. This is a very serious matter even if the country in question is selfsufficient in essential raw materials. Considering the behavior of domestic creditors, the problem boils down to the question whether the producers of goods and services will indefinitely keep exchanging real goods and services for irredeemable promises to pay which, by their very nature, constantly depreciate in value. If history is any guide, then these merchants and workers will not allow the government to victimize them indefinitely. They can do something about it. They could re-invent bill-circulation.

### The World without Banks

People who handle the social circulating capital have, without realizing it, a most potent instrument in their hand, namely, the bills they still keep drawing on one another.

Presently the movement of goods to the consumer is financed by bank credit of questionable quality. However, as in Argentina and Brazil for example, banks are progressively discrediting themselves in the eyes of the population. When the payment system breaks down, there will be starvation amidst plenty and, rightly or wrongly, the banks will be made scapegoats. At that point bills drawn on merchandise in urgent demand will start to circulate, replacing irredeemable paper issued by the government.

It is futile to speculate about the future course that history may take. But it appears that the rise of an international bill market on merchandise in most urgent demand is ultimately inevitable, if an all-out trade war is to be averted. Such a bill market would be the most potent force in the preservation of international division of labor. It would be a precision-instrument activating instant changes in the direction, size, and composition of the flow of short-term capital to countries that need it most urgently. No time would be lost in negotiating government credits, doing legal work and other formalities. Moreover, short-term capital would be dispatched to the country in need in the form of consumer goods which were in most urgent demand. If the discount rate in a country rose above the level prevailing elsewhere in the world, consumer goods would be dispatched on the same day to that country, since it was a good place on which to draw bills. It would be the discount rate that would direct the flow of short-term capital world wide, rather than political considerations. The nimbleness of the discount rate, and the instantaneous response to its changes by drawers and acceptors of bills, would be the guarantee of each and every country adhering to the international gold standard that the full complement of international division of labor stood by in the hour of its need to help solve its problems quickly and efficiently. Far more quickly and efficiently than autarky or politically motivated inter-governmental assistance ever could.

### The Mistake of Sound-Money Advocates

This marvelous instrument, the bill market based on the international gold standard, was the first casualty of the guns of August in 1914. The governments of the garrison states that emerged after the cessation of hostilities did not allow the bill market to make a come-back. There has been no bill-trading on a world-scale for the past eighty-eight years. In spite of prodigious increases in world trade, it took eighty years to surpass the volume prevailing in 1913. Today foreign trade and relief is the business of the governments (i.e., none of your business). The direction, the size and composition of foreign trade is determined by political considerations, rather than by need. People who control liquid funds are intimidated. If they send their funds abroad in search of better returns, those funds may be frozen by foreign exchange controls, and may be subject to capital losses due to currency devaluation. Foreign trade is at the pleasure of the governments which could slam on tariffs, quotas, or punitive embargo without notice.

Even in countries that tolerate import and export on private account, trade is subject to lengthy licensing procedures and other government controls. By the time the permit is issued, the opportunity to import or export profitably may well be lost. Profits are impossible to calculate due to the daily (or hourly) variation in foreign exchange rates.

International division of labor and individual self-reliance are reduced to insignificance, while everybody is made utterly dependent on government largesse and ukase.

Advocates of sound money made a grave mistake at the end of hostilities in 1918 when, in demanding a return to the gold standard, they failed to call for a full rehabilitation of the international bill market. They allowed the banks to hijack the social circulating capital, thereby disenfranchising the producers and the savers. Instead of an unadulterated gold standard, the politicians set up an international gold standard of a most adulterated kind: the gold bullion and the gold exchange standard. In the 1920's there was much talk about the shortage of gold. In actual fact the shortage was caused by the deliberate policy to withdraw gold coins from circulation and to replace them with bank notes of small denomination. When people see that the government is out to grab the gold coin, their natural reaction is to clutch theirs ever so tightly. The correct policy should have been to place gold coins in the hand of the consumers, and trade should have been financed by bill circulation. The gold shortage would have disappeared as if by magic, facilitating reconstruction. Instead, an orgy of debt pyramiding, commodity, real estate, and stock market speculation followed. The debt pyramid collapsed at the end of the 'Roaring Twenties' giving way the Great Depression. Ever since the international monetary system is "on a 24-hour basis", meaning that it is a non-system based on constant government meddling. The gold standard was doomed, as it was no longer reinforced by a bill market linking the flow and ebb of circulating media to the flow and ebb of newly emerging merchandise in the markets.

These mistakes must not be repeated now. The Mint should be opened to gold at once. If the U.S. government refuses to do that, it will run the risk that the regime of the irredeemable dollar will collapse, causing enormous economic pain to the American people, similar to the pain the people of Argentina are now put through. As a solution to the problem, gold coins should be placed directly in the hand of the consumers, and trade should be financed by bill circulation. There is no need to give blood transfusion to the banks. Let them die in peace.

### The Relevance of the Gold Standard to Capitalism

This is the last Lecture of the course entitled The Real Bills Doctrine of Adam Smith. I conclude with a brief preview of the next course in our series entitled Gold and Interest.

Let us raise the question: what is capitalism? In its simplest form capitalism is an economic system which is based on the conception that individuals should and would produce as generously as possible and live on something less than they produce, in order that they may posses a residue in the form of property to insure the education of the young, the support of the elderly, and other future projects. However, in order to achieve these ends we must have a facility to exchange income for wealth and wealth for income.

Interest, in this view, is not a premium on present goods as opposed to future goods, but the indicator of the efficiency of converting wealth into income and income into wealth.

In particular, zero interest marks the least efficient way of converting, namely, the conversion of income into wealth by hoarding gold, and of wealth into income by dishoarding it.

Capitalism is an economic system that makes the spontaneous capitalization of incomes possible. In more details, capitalism means unobstructed and uninhibited capital formation through the voluntary partnership of the annuitant (typically an elderly man drawing an annuity) and the entrepreneur (who pays the annuity income from the return to capital put at his disposal in the form of wealth of the annuitant). Capitalism means a gold bond market where the residual savings of the people are pooled, parceled, and allocated. In the gold bond market the marginal producer is free to perform his function as arbitrageur between two types of earning assets: capital goods and gold bonds. It is this arbitrage that validates the marginal productivity of capital in fixing the ceiling for the rate of interest. Capitalism means a gold standard without which the marginal bondholder would be unable to perform his function as arbitrageur between present goods (gold) and future goods (the gold bond). It is this arbitrage that validates the marginal time preference of the saving public in fixing the floor for the rate of interest. Capitalism means a bill market where the marginal shopkeeper is free to perform his function as arbitrageur between the two forms of social circulating capital: fast-moving merchandise and bills drawn on them. It is this particular arbitrage that validates the marginal productivity of the social circulating capital, in fixing the discount rate.

Insofar as gold is the indispensable catalyst of spontaneous capitalization of incomes, the government's deliberate destruction of the gold standard is to be considered a major step towards the destruction of capitalism. Government intervention in the bill and bond markets may bring no possible benefit to society, and is likely to make conditions for human welfare worse. Intervention in the bill market falsifies the discount rate, and intervention in the bond market falsifies the interest rate. The falsification of these important indicators causes serious misallocation of resources and paralyzes the regenerative faculty of the economy. It will, little-by-little, destroy our distinctively human symbiosis: the peaceful and voluntary cooperation of individuals under the system of international division of labor. This symbiosis was the vision of the greatest practitioners of our science: Adam Smith, Carl Menger, and others. The invisible hand of the market, through the signal system of prices, discount and interest rates, guides the 'selfish' pursuits of individuals, and harnesses their efforts for the greater benefit of the commonweal. In the words of the Bard: "One for all, all for one we gage."

And this shall remain the best hope for mankind.

### Reference

Economics and the Public Welfare, a Financial and Economic History of the United States, 1914-1946, by Benjamin M. Anderson; Princeton, 1949.

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand's Hymn to Money

### Lecture 2: Don't Fix the Price of Gold!

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told; (Chapters 1 - 3)

### Lecture 6: The Invention of Discounting; (Chapters 4 - 6)

### Lecture 7: The Mystery of the Discount Rate; (Chapters 7 - 8)

### Lecture 8: Bills of the Goldsmith; (Chapter 9)

Lecture 9: Legal Tender. Small Bank Notes.

### Lecture 10: The Revolt of Quality

### Lecture 11: The Acceptance House; (Chapter 10-11)

### Lecture 12: Borrowing Short to Lend Long; (Chapter 12)

### Lecture 13: The Unadulterated Gold Standard

## Winter Semester, 2003

### Monetary Economics 102: Gold and Interest

Lecture 1:

Lecture 2:

Lecture 3:

Lecture 4:

Lecture 5:

Lecture 6:

Lecture 7:

Lecture 8:

### The Nature and Sources of Interest

### The Dichotomy of Income versus Wealth

### The Janus-Face of Marketability

### The Principle of Capitalizing Income

### The Pentagonal Structure of the Capital Market

### The Floor and Ceiling for the Rate of Interest

### The Gold Bond

### The Bond Equation

### Lecture 9: The Hexagonal Structure of the Capital Market

### Lecture 10: Lessons of Bimetallism

### Lecture 11: Aristotle on Check-Kiting

### Lecture 12: Bond Speculation

### Lecture 13: The Blackhole of Zero Interest

## In Preparation:

Monetary Economics 201: The Bill Market and the formation of the Discount Rate Monetary Economics 202: The Bond Market and the formation of the Rate of

### Interest

---

# Monetary Economics 101 — Lecture 12: Borrowing Short to Lend Long

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-101-lecture-12-borrowing-short-to-lend-long/
Date: 2002-10-06
Section: Money & Credit
Difficulty: intermediate
Concept Tags: real-bills, gold-standard, debt, bond-market, capital-destruction
Description: Fekete identifies borrowing short to lend long as the original sin of modern banking — the practice that makes banks inherently fragile and prone to bank runs. He argues that the gold standard, properly understood, prohibits this maturity mismatch by tying the money supply to self-liquidating short-term trade credit.
Editorial Note: Lecture 12 of Monetary Economics 101 (Gold Standard University, 2002). This lecture bridges the real bills doctrine to Fekete's later work on the destruction of capital through interest-rate manipulation.
Original PDF: https://professorfekete.com/articles/AEFMonEcon101Lecture12.pdf

### Lecture 12

*Borrowing Short To Lend Long*

- The Second Greatest Story Ever Told,

Chapter 12 - The Interest/Discount Spread - Non-Disclosure, Misrepresentation,

Lack of Transparency - Self-Liquidating Loans - In Praise of Scholasticism -

Chapter 12 in which the gentle reader learns why the miller and the baker did not succeed to commit the perfect crime Having burnt their fingers once before, the miller and the baker proceeded very cautiously. They understood very well the inherent danger that the bill market may reject their anticipation and accommodation bills. Therefore they insisted that their customers post collateral security.

"We can now print our own money" gloated the miller. "When we accept accommodation bills, we borrow at the lower discount rate in order to lend at the higher interest rate. We simply pocket the difference between the two. It’s manna from heaven." The baker added gleefully: "And if our customers fall upon hard times and can’t pay their debt, no harm done. We shall pay on their behalf out of the proceeds of their collateral."

The miller and the baker went on creating bills merely for the sake of discounting them, and so to provide their customers with ready cash, and themselves with an income. In order to make these accommodation bills more attractive to the prospective buyer, they invented goods and sent them on imaginary trips around the globe. They thought that chances of exposure of the fraud were nil. They would never ever allow their customers to default. Should they be unable to pay, the Acceptance House would routinely pay off their debt at maturity without demur, and get compensated by selling the collateral. Whenever the market value of the collateral fell, the Acceptance House would issue a ‘margin call’, that is, a call to restore market value to the original level by posting more collateral.

For a time it looked as if the baker and the miller have indeed succeeded in inventing the ‘perfect fraud’. The sky was the limit to the profits to be made in the acceptance business, as only human imagination could limit the type of goods to be invented for the purpose of discounting. Alas, there was a fly in the ointment. What the baker and the miller forgot to consider was that their profit depended on a positive spread between the interest rate and the discount rate. But their activities were undermining exactly this foundation. As more and more fictitious bills were put into circulation, the spread narrowed. The Acceptance House was forced to accept ever more fictitious bills in order to maintain its customary profit margin.

This, of course, made the spread to narrow further. Clients were caught up in the squeeze and were forced to forfeit their collateral. The burden of the fraud was shifted to the mortgage market and, ultimately, to the real estate market.

One day the miller came home with bad news: "You can buy real estate as cheap as stinking mackerel", he said to the baker. "We had better liquidate all the mortgages in our portfolio before the owners walk away from their properties." But it was too late. There were no more takers for first mortgage on prime commercial real estate than for a third mortgage on a farm in the moon.

The Acceptance House, too, was forced into liquidation. The conspiracy of the miller and the baker collapsed once more. The worst aspect of the disaster was that it victimized a lot of innocent bystanders, owners of real estate who had nothing to do with the fraud and the conspiracy, but who nevertheless suffered real losses because of it.

It is clear that accepting anticipation or accommodation bills amounts to illicit interest arbitrage. The drawers of these bills should properly go to the bond (i.e., loan) market and borrow at the prevailing rate of interest, making full disclosure to the lenders about the nature of their enterprise. Instead, they went to the Acceptance House where full disclosure was not a requirement. In this way they could keep their cards closer to their chest and escape scrutiny as to the nature of their business, as well as control that lenders would normally want to exercise over the activities of their borrowers. For its part, the Acceptance House welcomed this business because of its great profitability. It pocketed the spread between the rate of interest and the discount rate without assuming any risk, indeed, without rendering any useful service to society (such as the Discount House does).

### Borrowing Short to Lend Long

More generally, it is illegitimate to borrow short in order to lend long. To do so is tantamount to making unwarranted assumptions about future market and credit conditions. There is no way to predict what the consumer will demand most urgently in the future, nor to predict what items will fall out of his favor. There is no way to predict how tight credit conditions will be.

There are those ‘free market economists’ who call the denunciation of borrowing short to lend long a witch-hunt. They say that the practice cannot be condemned on economic grounds, any more than risk-taking can. "Let competition prevail", they argue, "and let the smartest guy win the jackpot!" They call our criticism, at best, a moral judgment; at worst, an effort to stifle competition. It is not for the economist to make moral judgments on what is and what is not an acceptable level of risk-taking.

There is no need to quarrel with the last statement. But to say that the case against borrowing short to lend long has nothing to do with economics shows a profound lack of understanding of the market process. It should be clear that the dispute is not about risktaking. The proposition that borrowing short to lend long ought to be outlawed does not aim at stifling competition, any more than the proposition that misrepresenting the quantity or quality of goods offered for sale ought to be outlawed does. Economics does not criticize speculation and other forms of risk-taking as long as risk-takers use their own funds, or they persuaded someone else to advance funds for this purpose.

Social circulating capital is not owned by any individual, nor by any group of individuals.

It is communal property, as it were. It is property ‘socialized’ in the best sense of the word. The flip-side of social circulating capital is the bill market. To dip into the bill market in order to raise funds without contributing anything in return is the same as stealing communal property. Just what is a valid contribution to social circulating capital and what isn’t, is a question that is decided by the bill market. If the bill, making full disclosure without misrepresentation, can be discounted at the going rate, then the underlying good belongs to the social circulating capital; otherwise it doesn’t. Bills that can be so discounted are capable of monetary circulation; others aren’t. This is an objective criterion setting apart self-liquidating bills from anticipation, accommodation, and other fiduciary bills. There is no appeal against the verdict of the market. There is no scientific argument that could overrule it. We may assume that according to the most authoritative scientific research "miracle product X" ought to have a place in everybody’s household. But, unless this opinion can convince consumers, product X will not be part of the social circulating capital, and bills drawn against it just won’t circulate. The bill market is the final arbiter on that matter. However, all statements on the face of the bill must be true to fact and to intention. Otherwise the bill is disqualified and becomes phony, and the drawer and acceptor become impostors and counterfeiters. They should be subject to the same punishment reserved for the conspirators in coin-clipping and forgery of bank notes.

### Baring Brothers

The textbook example of the fate of the Acceptance House guilty of illicit interest arbitrage is the collapse of the House of Baring in 1890. The firm Baring Brothers & Co. was established in 1763 in London by John and Francis Baring. They were the sons of John Baring (1697-1748), a successful German cloth manufacturer who in 1717 started a small business in Devon. At first the partners were import and export commission agents for other merchants, but they soon began to lend their credit in the form of trade acceptances. They were involved in financing the British war effort against revolutionary France and, later, that of the Union against the Confederacy in North America. In 1890 the firm was still controlled by the Baring family when it got involved in Argentinean and Russian government finances and collapsed. Baring Brothers & Co. was bailed out by the Bank of England. However, as an Acceptance House, the firm’s credit was effectively ruined. See The House of Baring by R.W. Hidy published in 1949.

### The Interest/Discount Spread

If the market knowingly discounted undisguised anticipation and accommodation bills at the same discount rate as that applicable to real bills, then there would be no basis for objecting against these fiduciary bills. But clearly this is not the case. Undisguised accommodation bills would never circulate. Disguised accommodation bills may circulate for a time, thanks to the conspiracy of the Acceptance House and its clients but, as a rule, the fraud will come to light sooner or later. The charge of non-disclosure, fraud, and misrepresentation concerning the nature and the status of goods on the face of the bill stands.

The positive spread between the interest and the discount rate is not there for the picking.

It is there to support social circulating capital. Supplying the consumer with urgently needed goods on the shortest possible notice and in the most efficient manner would become prohibitively expensive, were it not for the presence of the spread. Bread and milk would have to be supplied on the same harsh terms as the surgeon’s knife and the watchmaker’s precision instruments. The publisher of newspapers would have to apply the same mark-up as that of a Sanskrit grammar. Indeed, milk, bread, and newspapers are perishable. Incentives to produce and distribute them for the benefit of society are absolutely essential. Of course, we don’t mean subsidies. We mean the spontaneous incentive embodied in the undistorted spread between the interest and discount rates.

Damages caused by natural disasters, for example, would be far harder to heal (and, hence, far more devastating) in the absence of a positive spread. The productive apparatus of society would be less efficient, more wasteful, and less responsive to changes in the absence of a positive spread between the interest and discount rates. It should be evident that the market needs safeguards against illicit interest arbitrage causing the spread to vanish, much the same as it needs safeguards to prevent any other form of fraud. Alas, it was not done in the heyday of bill-trading and of the gold standard, before the outbreak of World War I. llicit interest arbitrage should have been outlawed, and fraud in bill-drawing punished. It should have been enshrined in legislation governing the bill market that drawing anticipation and accommodation bills is tantamount to falsifying public documents and, as such, constituted fraud. This would have put the Discount House in a stronger position to detect and expose fraudulent bills.

The Acceptance House could no longer safely accept bills known to carry false statements on their face. This is not just a legal and moral problem. It is also one of economics. It is most unfortunate that the economists’ profession contributed nothing to its solution. It took the ‘see no evil, hear no evil’ attitude, leaving the problem to solve itself ‘through competition’. It ignored the fact that fraud lends an unfair advantage to its practitioners, and it was futile to expect that competition could purge business of crooked practices.

The position of the Austrian School, inspired by Mises, suggests that credit expansion by the banks (which we could identify with the acceptance of anticipation and accommodation bills) would be forestalled by the institution of ‘free banking’: the bestmanaged banks would survive. It is a strange way to handle fraud in letting competition take care of it. The Austrian School must recognize the presence of fraud in credit expansion. The reason that it has failed to do so is its superstitious adherence to the Quantity Theory of Money, and its mindless rejection of the Real Bills Doctrine of Adam Smith.

### Non-Disclosure, Misrepresentation, and Lack of Transparency

We should realize that the problem has become worse, exposure of the conspiracy made more difficult, and the watershed between upright and fraudulent business conduct further obscured when the banks started emulating practices of the Acceptance House. As we know, earlier the banks emulated the practices of the Discount House. So long as they confined their activities to discounting self-liquidating bills only (or lent against business transactions moving salable merchandise to the ultimate cash-paying consumer only), they were merely supplementing the efforts of the Discount House, and no fraud would be involved. Fraud appeared when they started emulating the Acceptance House.

The banks, no less than the Discount House, cannot create credit. They negotiate it. The credit already exists by virtue of the underlying merchandise moving apace to the ultimate cash-paying consumer. In discounting only self-liquidating bills, or in lending only against such collateral, the banks merely make the credit more convenient and more negotiable. This is legitimate business, it is a healthy form of using credit. The Austrian School is mistaken in bundling it together with other forms of credit expansion causing economic harm, such as discounting anticipation, accommodation, and any other types of fiduciary bills, or in lending against such collateral, emulating the harmful practices of the Acceptance House. In doing so the banks practice illicit interest arbitrage. No longer are they engaged in legitimate business, but in a form of credit-abuse. Just like the Acceptance House, the banks fraudulently raise funds in the bill market at the discount rate and peddle them in the bond market at the rate of interest. In the process they appropriate the spread between the higher interest rate and the lower discount rate, to which they they are not entitled.

Notice non-disclosure, misrepresentation, and lack of transparency in the banks’ procedure. The fraudulently drafted paper and other dubious or illiquid assets are now sheltered in the banks’ portfolio. They are no longer available for public examination, as they have been earlier when the Acceptance House was trading them in the bill market. It is true that bank examiners could scrutinize these assets but, to the extent that they are paid by the government, they will follow norms adopted by their paymaster. It is clear that government wants to classify Treasury bills as paper eligible for discounting, or to be used for collateralizing loans. Therefore the stage is set for subverting the system of bank inspection. The problem of money and credit is thereby reduced to that of non-disclosure, misrepresentation of banking assets, and lack of transparency. The fictitious bills are withdrawn from circulation where they could be recognized and rejected by the public, and buried in the bank’s portfolio where they could not. Exposure of fraud and conspiracy has become more difficult, and illicit interest arbitrage harder to detect.

This raises questions of responsibility. Accounting standards and the agenda for bank examiners are set by the government. Inclined to favor a minority at the expense of the majority, the government has succumbed to the temptation, allowed compromising accounting standard and covering up fraud and conspiracy. Moreover, the government has embarked upon the path of promoting its own Treasury Bills as money. This is the worst kind of government incursion in the banking business, short of nationalizing it. The practice of the government furnishing illiquid assets for bank portfolios, while maintaining the pretense of liquidity, has been greatly expanded in the twentieth century, and is now more wide-spread than ever. It is further reinforced by distorting the theory of banking. The government is charged with the task of managing the nation’s economy as well as its money supply. By allowing its debt to be used for the purposes of monetization by the banks, the government has appointed itself as dictator of the economy. It can order economic participants to obey its orders, punishing those who resist, with the carrot of the money supply and the stick of high taxation.

Another way of describing what has happened is this. By overtaking the bill market, the banks have hijacked the social circulating capital. They have put all the producers and distributors as well as a large part of the consuming public permanently in debt to themselves. We may recall that the social circulating capital used to possess a great momentum of its own, so that lending could be replaced by clearing. The banking fraternity, under leave from the government, has reversed this. The spontaneity of bill circulation has now been replaced by the duress of bank lending. In other words the banks, through their control of the social circulating capital, hold society to ransom.

### Self-Liquidating Loans

According to Ludwig von Mises all the note and deposit liabilities of the banks in excess of capital accounts and vault cash are inflationary and contribute to credit expansion.

They tend to suppress the rate of interest below the level that would obtain in the absence of bank lending. Mises does not recognize the idea of self-liquidating loans that finance the movement of merchandise and are to be repaid in 91 days or less from the proceeds of the sale of that merchandise to the ultimate cash-paying consumer. Nor does he recognize the essential difference between the interest rate and the discount rate. Yet these two rates are entirely independent of one another as their changes are autonomous. Either may be stationary while the other moves. If both move, they may move in the same or in the opposite direction. The very forces governing changes of either are different. The discount rate is governed by the propensity to consume, while the rate of interest is governed by the propensity to save. As other quantity theorists, Mises holds that lower propensity to consume necessarily means higher propensity to save. Yet this is a palpably false proposition: it is possible that people decide to withhold gold from both the bill and bond markets. The only connection between the two rates is that the discount rate is not supposed to rise above the rate of interest. It is true that illicit interest arbitrage may drive the discount rate above the rate of interest temporarily. It will take a separate course of this University to investigate the consequences of this. We refer to the great topic of the business cycle.

Short-term self-liquidating loans by the banks are loans in form only. In substance they are instances of clearing, in exactly the same way as bills of exchange are. In effect, the bank discounts bills of the producers and distributors. The resulting ‘loans’ are definitely non-inflationary. The reason is that those bills could in fact circulate on their own. The bank has to withdraw them from circulation (or to preempt them from entering circulation) when making a self-liquidating loan. There is no net increase in the volume of purchasing media. The underlying credit exists on its own merit. It would exist even in the complete absence of banks. To put this differently, self-liquidating loans represent not lending but clearing activity. Only by abuse of language can they be called loans. This is most unfortunate, as the functions of lending and clearing ought to be kept separate, and should under no circumstance be confused. Only then can one see that there is no increase in the volume of purchasing media as a result of the bank extending a selfliquidating loan. I repeat: the bank is not issuing credit; it is merely negotiating it. The credit already exists on the strength of the urgent demand for the underlying consumer good. The bank merely substitutes its own credit (which is more convenient and more negotiable, and recognized more widely) for the credit of the producers and distributors (which may be less convenient and less negotiable, and recognized less widely). Whether the credit is in the form of a bill of exchange, or in the form of a self-liquidating bank loan, its circulation simply mirrors that of the underlying merchandise in urgent demand.

### Mises and the Social Circulating Capital

Of course, not every consumer good is such that its movement can be financed by selfliquidating bank loans. Slow-moving merchandise, durable goods sold on installment plans as opposed to cash payments in full are some of the examples that don’t qualify.

Such goods are no part of the social circulating capital, as Adam Smith characterized the mass of fast-moving goods on their way from the producers to the ultimate cash-paying consumers that will reach its destination in 91 days or sooner. Certain merchandise may at one point in time belong to the social circulating capital only to fall out of it later as a result of changing consumer tastes and habits. Other merchandise may regularly enter in and out of the social circulating capital following the seasons. Heating fuel and seasonal clothing are examples. This highlights the rationale for limiting the terms of selfliquidating loans to 91 days. Under no circumstances must the term for such loans be extended by the bank. Financing the movement of merchandise that may take longer than 91 days to reach the consumer is not the task of the commercial bank that ‘lends’ at the discount rate. It is the task of the investment bank that lends at the higher rate of interest.

Mises recognizes neither the bill of exchange nor the self-liquidating loan as a noninflationary source of credit. Neither does he make a distinction between the discount and interest rates. Most glaring is the failure of Mises to accept the existence of social circulating capital. Although Mises often talks about the importance of urgent consumer demand and the significance of consumer’s choice, he fails to draw the necessary consequence which is as follows. The most urgently demanded consumer goods are distinguished by the market in being given preferential treatment: their movement to the consumer need not be financed through lending. Items in the social circulating capital finance their own movement through clearing. It is indeed most unfortunate that Mises and other sound-money economists have failed to make the important distinction between self-liquidating loans of the commercial banks and other loans that investment banks may make. As a consequence of this failure they have to condemn all bank lending in excess of capital accounts and vault cash as inflationary, which is a grave error.

100 Percent Gold Reserve Banking Some sound-money theorists such as Murray Rothbard see the solution to the problem of credit abuse in the so-called 100 percent gold reserve banking. They suggest that banks should maintain 100 percent gold reserves against all their outstanding credit. No bank is supposed to lend in excess of capital accounts and vault cash. However, this dogmatic approach throws the baby out with the bath water. The prescription has been made on the wrong diagnosis of the problem. The problem is not that banks lend against assets other than gold. The problem is that banks borrow short in order to lend long. In their lending practices banks make commitments not justified by the quality and maturity of the assets they hold. Advocates of 100 percent gold reserve banking are barking up on the wrong tree. They have missed the real culprit, illicit interest arbitrage. The problem of bank illiquidity is not going to be solved by the 100 percent gold reserve requirement, but by prescribing that banks discount eligible paper only. Consumer demand is seasonal as well as unpredictable. Accordingly, the supply of purchasing media must be elastic. It must flow and ebb with consumer demand. It must vary with the seasons. Without an elastic supply of purchasing media the distribution of consumer goods may seize up amidst plenty. In addition, one must also face the problem of financing the production and distribution of consumer goods most efficiently, and without hindering technological progress. This progress can be illustrated in terms of refinements in the division of labor. 100 percent gold reserve banking would imply that every new refinement must mean another invasion of the pool of circulating gold coins. Under these condition the gold standard would be a fetter upon technological progress.

### Do Banks Create Credit out of Thin Air?

Banks do not create credit out of thin air, as suggested by Mises in his Theory of Money and Credit (op.cit., p 279, p 390). To the extent they restrict their portfolio to selfliquidating loans, they do not contribute to credit expansion. They merely make credit that already exists by virtue of the very movement of merchandise to the consumer more negotiable. This is certainly a legitimate activity of the banks. To the extent the banks lend against assets other than self-liquidating paper, they borrow short to lend long. They raise funds in the bill market to place them in the bond market. Alrhough this is an extremely lucrative business, it is illegitimate nevertheless. The banks pocket the spread between the higher interest rate and the lower discount rate to which they are not entitled: they make no contribution to the production process. In this case, no less than in the previous, bank credit is not created out of thin air. Borrowing short to lend long is no prestidigitation. It is fraud. It is fraudulent to arbitrage funds from the bill to the bond market. The way to see that the bank is guilty of illicit interest arbitrage is to examine the maturity dates in the bank’s portfolio of assets, including the maturity of the collateral. If the bank is willing to extend the maturity of its loans beyond 91 days, or if it lends against assets that are not self-liquidating, or if it buys such assets for its own account, then the bank is engaging in illicit interest arbitrage. Through non-disclosure and misrepresentation these illicit transactions are disguised so that they can no longer be detected by the public. Illiquid assets are buried deep in the portfolio and start to metastasize in the banking system. No longer is there a limit to the size of bank assets. (In the absence of illicit interest arbitrage social circulating capital set the limit.) Now that the limit has been removed, the pressure is on for the banks to increase their assets in order to maintain profit-levels. One bank drops an innocuous snow ball on the mountain slope, unmindful of the danger that the size and momentum of the innocuous snow ball could increase rapidly, eventually destroying entire villages down below in the valley.

The dropping of the snow ball is the beginning of the business cycle; the avalanche is the depression into which it may degenerate. As detection of credit abuse becomes harder, the business cycle started by the banks is even more devastating than that started by the Acceptance House.

Banks are guilty of usurping power over the social circulating capital. They are guilty of extortion: they pocket the spread between the rate of interest and the discount rate to which they are not entitled. The banks are guilty of conspiring against the public interest, just as the miller and the baker were in accepting anticipation and accommodation bills in the hope of illicit gains. The conspiracy of the banks is far more ominous: distortions and misallocations caused by the banks’ illicit interest arbitrage are cumulative and potentially very damaging. Ultimately, they must lead to a credit collapse.

We must conclude that the banks are not creating credit out of thin air. It must be made clear for once and all that nobody can do that. The banks, aided and abetted by the government and its bank examiners, arbitrage funds from the bill to the bond market illegitimately. In doing so they are committing a serious crime against the public.

### References

Borrowing Short and Lending Long: Illiquidity and Credit Collapse, by A. E. Fekete, CMRE Monograph Series No. 38, 1984. Committee for Monetary Research and Education, 10004 Greenwood Court, Charlotte, NC 28215-9621, United States, FAX:

(704) 599-7037

The Theory of Money and Credit, by Ludwig von Mises, Indianapolis: Liberty Classics, 1980 (first German language edition in 1912)

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand's Hymn to Money

### Lecture 2: Don't Fix the Dollar Price of Gold

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told, Chapters 1 - 3

### Lecture 6: The Invention of Discounting, Chapters 4 - 6

### Lecture 7: The Mystery of The Discount Rate, Chapters 7 - 8

### Lecture 8: Bills of The Goldsmith, Chapter 9

### Lecture 9: Legal Tender, Small Bank Notes

### Lecture 10: The Revolt of Quality

### Lecture 11: The Acceptance House, Chapters 10 - 11

### Lecture 12: Borrowing Short to Lend Long, Chapter 12

### Lecture 13: The Unadulterated Gold Standard, Chapter 13

---

# Monetary Economics 101 — Lecture 11: The Acceptance House

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-101-lecture-11-the-acceptance-house/
Date: 2002-09-16
Section: Money & Credit
Difficulty: intermediate
Concept Tags: real-bills, bills-of-exchange, gold-standard, sound-money
Description: Fekete examines the acceptance house — the institution that guaranteed real bills by 'accepting' them — as the linchpin of the 19th-century international monetary system. Acceptance houses provided creditworthiness assessments that allowed international trade to be financed without gold shipments, and their decline marks a key turning point in monetary history.
Editorial Note: Lecture 11 of Monetary Economics 101 (Gold Standard University, 2002). The institutional history of acceptance credit, showing how a sophisticated private credit infrastructure made the classical gold standard work in practice.
Original PDF: https://professorfekete.com/articles/AEFMonEcon101Lecture11.pdf

### Lecture 11

## The Acceptance House

- Illicit Interest Arbitrage - The Second Greatest Story Ever Told,

Chapters 10 -11 - The Discount Rate/Interest Rate Spread - Borrowing Short to Lend Long - Anticipation and Accommodation Bills -

### Illicit Interest Arbitage

There was nothing sinister about the appearance of the Discount House, as a precursor of the bank. Nor was there anything suspicious about the bill of the goldsmith, as a precursor of the bank note. Fraud came later, as the story of the bill of exchange unfolded, and illicit interest arbitrage and the practice of borrowing short to lend long appeared and spread.

The villain of the piece is the Acceptance House, as we shall see, another (and this time quite sinister) precursor of the bank. The Acceptance House conspired with impostors in order to put fictitious bills of exchange into circulation. As long as these fictitious bills remained in the public domain, with due diligence, the fraud could be exposed. But soon enough some banks joined the conspiracy and started sheltering the fictitious bills in their portfolio of assets. For the Acceptance House and the conspiring banks this was a lucrative business. It allowed them to pocket the spread between the higher interest rate and the lower discount rate, to which they were not entitled. They wanted to profit but without taking risks. Not only did they take no risks, neither did they provide a service to society that might have justified the profit. The business of selling fictitious bills against buying bonds is called illicit interest arbitrage. It means borrowing funds in the bill market at the lower discount rate and peddle them in the bond market at the higher interest rate. The arbitrage is illicit, as we shall see it in full details later. It is a case of extortion. It is fraudulent as it involves misrepresentation and non-disclosure. The scheme of illicit interest arbitrage would collapse if transparence of business transaction were maintained and safeguarded. Now I return to The Second Greatest Story Ever Told.

Chapter Ten in which the gentle reader learns why the miller and the baker were blacklisted at the Discount House One day the manager of the Discount House noticed that a bid/asked spread appeared in the trading of the miller-on-baker bills. Buyers consistently bid a lower price than that asked by the sellers of these bills. Normally, there was no spread in bill trading. A bill with two good signatures could be bought and sold back-to-back, often at the same price. This is explained by the fact that the bill was an appreciating asset. Its value increased daily as the date of maturity approached. A bid/asked spread, whenever it appeared, suggested trouble. It indicated that there were too many of that particular bill around, discouraging buyers.

The manager of the Discount House suspended the trading of the miller-on-baker bills, waiting for the situation to clear itself. Soon it turned out that the miller had conspired with the baker in putting bills into circulation supposedly representing flour on the move to the bread-consuming public. In fact, however, there was no flour and there was no movement. There was only grain sitting in the miller's bins, held back by the miller in hope for an increase in the grain price. The miller and the baker were speculating that the poor harvest could create a shortage causing higher prices in the grain market, from which they wanted to benefit. They were trying to finance their speculation by drawing miller-on-baker bills representing the grain withheld from consumption, sitting in the miller's bins.

The speculation ended in a fiasco. The miller's and baker's expectation of much higher grain prices didn't materialize. They 'rolled over' their credit, that is, they paid the maturing bill by drawing another on the same grain holdings. This was a very serious violation of the statutes of the bill market, because the limitation of 91 days on the maturity of bills was absolute. Under no circumstances must the bill on the same goods be redrawn.

In the meantime, the bill market grew less accommodating. As the fraudulent miller-on-baker bills were in addition to the regular ones supporting the supply of the consumer with bread (that is, on merchandise that did indeed move) a bid/asked spread appeared. When the Discount House suspended trading the miller-on-baker bills, the conspirators were squeezed. In order to extricate themselves from their situation they threw their grain on the market. The forced sale of such an abnormal quantity of grain temporarily depressed the price. The conspirators wound up their ill-fated speculation with a huge loss. In the end, they defaulted on some of their bills at maturity.

Default by merchants on their bills was exceedingly rare. Even loss of cargo at sea was no occasion for default. A bill drawn on merchandise in the bottom of vessels had to be accompanied by insurance certificates showing that the merchandise at sea had been insured to the extent of the full face value of the bill. In case of loss at sea the insurer would pay the bill at maturity.

If a merchant defaulted for reasons of personal financial tangles, then he could never again hope to discount a bill in his life. Nor could his sons. Their name was to remain on the blacklist for several generations. Being cut off from the bill market meant that the lifeline of the merchant was severed, as it were, his trading capital was confiscated. The merchant found himself out of business. This was exactly the fate awaiting the miller and his accomplice, the baker.

### Speculation in Agricultural Commodities

It is important to understand that there is nothing wrong per se with speculating in agricultural commodities. As long as the speculator is using his own funds, or legitimately borrowed money for this purpose, no one has the right to criticize him. But the miller and the baker in our story tried to use the bill market for the purpose of financing speculative stores. This is definitely wrong. The bill market is strictly for merchandise that moves, moreover, move it must fast enough to reach the cash-paying consumer in less than 91 days. It is fraudulent to represent that the merchandise held back for speculative purposes moves since, in fact, its movement has just been arrested.

Most tradesmen are sensible people realizing that, while speculation in agricultural commodities is a legitimate business, it must be financed properly. The speculator has no right to shift his risks onto the shoulder of society. For this is exactly what is involved in drawing bills on merchandise sitting in speculative stores waiting for a price-rise. The bill market, as we well-know, is a clearing system. It can only work if each bill faithfully represents the underlying transaction, and if the merchandise is moving as specified on the face of the bill. Accordingly, each bill is scrutinized by the market not only in regards of the credit standing of the drawer and the acceptor, and every subsequent endorser, but also in regards of the transaction represented on its face. Dubious bills, or bills which appear to be over-abundant, are rejected.

The miller and the baker did not try to defraud any particular individual. In drawing bills under false pretenses they tried to defraud the general public. They pretended that the underlying merchandise was moving and would reach the ultimate consumer in 91 days when, in fact, they were responsible for arresting the flow of goods. In doing so they were not merely hoping for speculative profits. They were also trying to shift the risks from their shoulders to the public at large. They wanted to pocket the difference between the higher interest rate and the lower discount rate. They would justify this as profits for shouldering risks. But they passed their risks on to the public. It is clear that they were not entitled to those profits.

The conspiracy of the miller and baker is an example of what we shall call illicit interest arbitrage. More generally, the term refers to arbitrage from the bill to the bond market. As interest rates are generally higher than the discount rate, the temptation is constantly present for tradesmen with ready access to the bill market to use bills for illegitimate purposes, such as selling them to invest the proceeds in bonds. Illicit interest arbitrage is a crime against the general public, the same as the crime of forging public documents.

Indeed, the bill of exchange is a public document, and false statements on its face must be treated as fraud. (Note that arbitrage in the opposite direction, from the bond to the bill market is not illegitimate. Such action is profitable in the rare and abnormal case when interest rates are pushed below the discount rate. For this reason, it is called 'natural interest arbitrage'.)

The market tends to expose illicit interest arbitrage, as it exposed the conspiracy of the miller and the baker. But in so far as the conspiracy remains unexposed, the public at large is victimized in the form of higher prices.

### Anticipation Bills

Chapter Eleven in which the gentle reader learns how the miller and the baker went on the warpath to strike back by establishing the Acceptance House.

Many years have gone by, but they couldn't remove the bitterness of the miller and the baker over their humiliating failure. They felt that in being blacklisted at the Discount House they have been unjustly victimized. They thought that they were the 'misunderstood innovators'. They were plotting to take a revenge. Their opportunity came when the manager of the Discount House died, leaving his business to the elder of his two sons. The other son, known by the nickname Prodigal, did not inherit any part of his father's business nor, apparently, his acumen and integrity. The miller and the baker moved to befriend him.

"Your inheritance is more valuable than you realize, if you had eyes to see your fortune", the baker said to Prodigal. "Your name is spelled in gold. Let me show you how you can pan it. You should start a business of your own." But Prodigal pleaded poverty; he has already spent his patrimony. He could not put up the capital. "Never mind capital", retorted the miller. "We shall teach you a new creative way to start a business with no capital."

The young man may have been prodigal but he was not stupid. "Why don't you start your own business if you know how to do it without capital?" he asked. The baker explained, sotto voce, that you need a name with high recognition value to do that. Prodigal was the scion of a merchant family that has been in business for over two hundred years, the last fifty of which in discounting. It had an impeccable name and enjoyed the respect and admiration of everybody. "You contribute your name, and we contribute the expertise", the baker cajoled him. "You don't even have to work if you don't want to. We give you 50 percent of the profits. My friend, the miller and I will be satisfied with 25 percent each."

The offer was too good to turn it down. The 'enterprise' was called the Acceptance House. It would take business turned down at the Discount House. It would endorse

- or to use the resurrected word, 'accept' - any bill presented to it, provided that two conditions were met. (1) The bill should have an air of demure respectability in referring to some goods about to be shipped. For this reason it was called an anticipation bill. (2) The face value of the bill should be posted as a collateral security in the form of mortgages on real estate or bonds. The Acceptance House was entitled to liquidate the collateral in case of a default by the drawer of the bill, but would return it upon payment of the bill in full at maturity. In addition, the Acceptance House stood ready to roll over the credit facility indefinitely upon advance mutual agreement.

Now the operators of the Acceptance House were in the position to bilk the general public out of its funds by taking advantage of the positive spread between the interest and discount rates. In effect, they were selling bills and buying bonds with the proceeds, pocketing the difference, while taking no risk at all. At any rate, that's what they thought.

### Accommodation Bills

The essence of the bill of exchange is that salable goods are moving to a place where there is a ready demand and market for them. The reason for making it payable at a later date is to allow for shipping and ultimate disposal, including the time needed for garnering the proceeds of the sale. The act of acceptance makes the bill of exchange immediately negotiable or convertible into cash through discounting. The bill had the advantage of 'paying itself'. The goods on which the bill was drawn, being certain of a market, are the guarantee to the bill's holder that "he is not holding the bag" containing nothing. The anticipation bill, promoted by the Acceptance House, was very different.

The underlying goods did not move, and there was only a vague understanding that they eventually might. The sale of merchandise to the ultimate cash-paying consumer by the maturity date could no longer be taken for granted. On the contrary: it was a foregone conclusion that the anticipation bill would have to be redrawn and redrawn again, at the end of each 91-day period. That redrawing bills was a dubious practice was already pointed out by Adam Smith. Even worse was the practice of drawing accommodation bills. These were bills drawn on fictitious goods shipped to fictitious vendors. But the impeccable name of the Acceptance House made them as good as cash, regardless of the fraud involved in drawing them.

### Debauching Accounting Standards

Banking has grown out of two separate roots: the business of the goldsmith, and that of the Acceptance House. The latter is the bad guy. Here is a conspiracy between the borrower and the Acceptance House with ready access to the bill market. Once the fraudulent anticipation and accommodation bills are removed from the bill markets and given shelter in the portfolio of the bank, then whatever possibility for the detection of the fraud had existed before was lost. The practice of shortchanging the public could be perpetuated.

The banks could create something out of nothing only through the fraud of accepting anticipation and accommodation, disregarding the fact that these bills were no longer self-liquidating. The banks could not care less how the borrowers would eventually get the money to repay the loan. In case of a default the bank would liquidate the collateral and satisfy itself from the proceeds.

The banks were in fact usurping and monopolizing social circulating capital. They could get away with it by virtue of the government patent exempting banks from the rigors of bank examinations and from the strict application of accounting standards. The banks could carry their assets at arbitrary values. They said it was their business and nobody else's.

Before the government exempted the banks from the provisions of contract law, strict accounting standards had been in force reflecting the desire to protect the public from the consequences of conspiracy such as (1) declaring bankruptcy fraudulently (by representing assets at artificially low values) or, its more common counterpart, (2) window-dressing the balance sheet fraudulently in an effort to stave off a run on the bank (by representing assets at artificially high values). Honest accounting demands that the bank carry assets either at historical cost or at market value, whichever is lower. The government patent protecting the banks has resulted in permitting the banks to carry assets either historical cost or at market value, whichever is higher. Non-disclosure or misrepresentation of the true state of affairs is, of course, a crime against the public interest. But the banks were protected against prosecution by the patent the government has given them.

The profession of chartered accountants and bank examiners ought to stand guard over the integrity of balance sheets and the quality of assets of the banking industry. But it has long since departed from this ideal. Accounting codes and norms have been changed in order to suit the interest of the government, as opposed to the interest of the public. The government has become an accomplice in the fraud and a party to the conspiracy against the public. The government, in betraying its sacred mission of standing guard over the public interest, is motivated by its consuming passion to have its own debt monetized through the banking system.

Neither the government, nor the banks, nor the accounting profession will be able to escape responsibility for compromising accounting standards and for corrupting the profession of accountants and bank examiners, when the day of reckoning finally dawns.

The present exercise of a witch-hunt to charge producers with accounting crimes is hypocritical in the extreme. The government should come clean of its own accounting crimes first.

### The Two Categories of Bank Assets

Illicit interest arbitrage in modern setting manifests itself through certain practices of commercial banks. Economists have failed to make a distinction between bank assets representing goods on offer for sale and others representing goods not on offer for sale in the markets. This distinction between the two types of bank assets is fundamental. The value of those of the first category is faithfully reflected in the balance sheet, as the market is continuously testing these values against existing and changing marginal utilities. In case of any discrepancy, correction is instantaneous and automatic. The same, however, is not true of assets of the second category. Here the balance sheet notoriously overstates values. These assets are sheltered from the trials and tribulations of the market place. They are protected against wear and tear due to the ravages of declining marginal utility, brought about by repeated market test.

For example, a house that is being built for the housing market by the contractor is on offer for sale, and a bridge-loan against it is a bank asset of the first category. By contrast, a home equity loan is a bank asset representing an item, your home, which is not on offer for sale (you hope) and, therefore, it is a bank asset of the second category. The seeds of a credit collapse are sowed by the banks themselves in loading their portfolio with assets of the second category. When the crunch comes, these assets are thrown on the market simultaneously and indiscriminately as the banks scramble to regain solvency. The market, which follows the law of declining marginal utility (rather than the wishful thinking of over-confident bankers) refuses to validate the fancy values at which these assets are carried in the balance sheet. The day of reckoning has dawned. The banks are confronted with the truth, and they are forced to absorb huge losses.

The practice of carrying assets of the second category is just another instance of illicit interest arbitrage. Once the banks usurp control over social circulating capital, they can borrow at the lower discount rate and peddle these funds at the higher interest rate to their clients. They can make this practice look legitimate with the connivance of the bank inspector who is trained to "hear no evil, see no evil, say no evil". But this activity cannot go on forever. Depositors who can read balance sheets will move their business from the illiquid bank (indulging in illicit interest arbitrage to a greater extent) to a more liquid bank (indulging in the practice to a lesser extent). The depositors' arbitrage (known in banking circles as 'disintermediation') will squeeze the illiquid banks. The liquidation that follows spawns the boom-bust cycle. It may take down sound businesses along with the shaky ones into bankruptcy. This reveals the most evil aspect of illicit interest arbitrage.

Along with the guilty, the innocent is also made to suffer.

The key to preventing the boom-bust cycle is not to allow banks to carry assets of the second category in excess of capital accounts. Bank assets of the first category include gold (as all gold above ground is deemed to be on offer for sale under a gold standard) as well as bills of exchange drawn on goods that will be sold to the ultimate cash-paying consumer in less than 91 days. These bills are the most liquid earning assets that a bank can have. By contrast, assets in the second category are not liquid. They include stocks, bonds, mortgages, finance and treasury bills, or loans collateralized by these. Unlike selfliquidating bills, they are all subject to great fluctuations in value. In case of forced liquidation (for example, when a number of illiquid banks are scrambling to get liquid) all bids for them may be withdrawn, creating a panic.

But if all banks limited their portfolio to assets of the first category, then no runs and panics could occur. Even unusually large cash-withdrawals could be met without forced liquidation of assets. As one bank experiences cash-withdrawals, another with surplus cash will be eager to buy the bills of the former. At any rate, more than one-ninetieth of all banking assets backing sight liabilities is maturing every day, obviating the need for asset-liquidations. If the cash-shortage was brought about events outside of the control of the banks, such as natural disasters (e.g., crop failure, flood or earthquake destroying property), then the banks can adjust smoothly to the changing circumstances by discounting fewer bills during the construction period. It is virtually impossible that all bids for bank assets of the first category be withdrawn simultaneously. Shortage of cash here always results in a surplus of cash somewhere else. The latter will then start scrambling for liquid earning assets such as bills of exchange.

### Crime and Punishment

This is a world of crime and punishment. The crime of illicit interest arbitrage cannot avoid receiving its just punishment eventually. It makes the positive spread between the interest and the discount rate vanish. This undermines not just the lucrative monopoly of the banks, but also the entire financial system. When the discount rate catches up with and surpasses the rate of interest, panic in the credit market will ensue. Bids for bonds are withdrawn. Bond prices will collapse, and the rate of interest will shoot up. This will render much of the productive capital of the country sub-marginal, causing depression.

Earlier I have quoted an old saying on Lombard Street that the easiest business in the world is banking, provided that the banker can grasp the difference between a bill of exchange and a mortgage. If bankers occasionally flunked this test in the 18th and 19th century, bankers in the 20th did not even understand what the fuss is all about. They shrug off the criticism. An asset is an asset is an asset... Money doesn't stink. It has no quality outside of its quantity. Ghosts that used to haunt bankers in their sleep, such as assets of dubious quality in the balance sheet, have been interned for good, thanks to government-administered safety nets.

However, it is doubtful that governments can legislate business risks and asset quality out of existence. The qualitative difference between a genuine bill of exchange and a mortgage cannot be denied (securitization of the latter notwithstanding). The former is easily negotiable before maturity without bribe or blackmail. At maturity it is cash by the sale of goods on which it is drawn. No safety net and no coercion is needed to promote its circulation. The latter is by no means readily negotiable. Mortgages or loans on real estate require two expensive and time-consuming processes: surveying and title search, before they can be transferred. Moreover, the real estate market, just as the bond market, could get demoralized as a result of the withdrawal of bids. The market in self-liquidating bills could never seize up the same way.

The quality of an asset cannot be improved by burying it deep inside of a bank's balance sheet. Non-disclosure and misrepresentation can only damage assets. For this reason, illicit interest arbitrage is even more dangerous when practiced by banks. The conspiracy in which the Acceptance House engaged was bad enough, but at least the dubious assets stayed in the public view. The bill market was still a level playing field, and the Discount House was still acting as an umpire, blowing the whistle whenever fair play was put in jeopardy. There was a feed-back which prompted self-correction, in so far as the quality of credit was concerned. No more. Commercial banks have removed the dubious assets from public view, sheltering them in their balance sheet. The public is no longer in the position to scrutinize those assets, and is powerless to prevent further deterioration in the quality of credit. Bank assets are diluted, and the self-correcting mechanism of the credit market is short-circuited. The effect is a cumulative deterioration of bank credit. When credit collapse finally comes, it will be all the more devastating. Recovery will be more painful and take longer.


---


### Small Is Beautiful after All?

Don Lloyd of Peabody, Michigan, comments on Mises' position on bank notes of small denomination (re: Lecture 9, "Small Is Ugly"). He disputes that there is a misprint on p 494 of The Theory of Money and Credit where Mises calls for the issuance of bank notes in denominations of one dollar, fifty dollars, and upwards. In other words, Mises thought it was admissible to issue bank notes of small denomination, in spite of objections of English authors finding the issuance of small bank notes detrimental to the interest of the working classes.

My own interpretation is that Mises was convinced that in the interest of the preservation of the gold coin standard he was advocating, and for the protection of the working people who would be cheated out of their possession of gold coins by small bank notes, the issuance of such notes should not be authorized. However, if Mises really meant that one dollar bank notes be circulated under the new gold coin standard he was describing, then he would appear to be condoning the practice of withholding gold coins from the working classes. I would regret it if it was true. At any rate, I think more research into the question of Mises' attitude with reference to bank notes of small denomination should be carried out to clarify this point.

### Money and Morality

One of the recurring themes of this lecture series is money and morality. Therefore it was very rewarding for me to receive the following message from Carl Luxem, Jr .

Dear Professor:

I have been reading your lectures at Gold-Eagle.com. They bring to mind something one of my mentors told me years ago, namely, that "God designed life so that it does not work without Him, nor without the order He established for it". Given how far the world has departed from the economic order you are describing, I expect the coming reality shock to be quite devastating. Your attempts to warn and educate us about the evil inherent in the present system are admirable. I have tried to do the same with some success by viewing the problem from a moral perspective. I deeply appreciate your work because, as a money manager and a student of economics, it has been a long time since I have been able to find anything that makes as much sense as your lectures.

Sincerely, etc.

Carl, I think we are getting through. Just keep up the good fight.

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand's Hymn to Money

### Lecture 2: Don't Fix the Dollar Price of Gold

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told, Chapters 1 - 3

### Lecture 6: The Invention of Discounting, Chapters 4 - 6

### Lecture 7: The Mystery of The Discount Rate, Chapters 7 - 8

### Lecture 8: Bills of The Goldsmith, Chapter 9

### Lecture 9: Legal Tender, Small Bank Notes

### Lecture 10: The Revolt of Quality

### Lecture 11: The Acceptance House, Chapters 10 - 11

### Lecture 12: Borrowing Short to Lend Long, Chapter 12

### Lecture 13: The Unadulterated Gold Standard, Chapter 13

---

# Monetary Economics 101 — Lecture 10: The Revolt of Quality

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-101-lecture-10-the-revolt-of-quality/
Date: 2002-09-02
Section: Money & Credit
Difficulty: intermediate
Concept Tags: real-bills, gold-standard, gold-basis, contango
Description: Fekete introduces his concept of 'the revolt of quality' — the periodic reassertion of gold's monetary premium over paper money as confidence in fiat currency erodes. He argues this phenomenon, visible in the gold basis and backwardation, is the market's way of signaling that the real bills circuit has broken down.
Editorial Note: Lecture 10 of Monetary Economics 101 (Gold Standard University, 2002). The concept of quality revolt connects Fekete's real bills doctrine to his later work on the gold basis, backwardation, and the collapse of paper currency.
Original PDF: https://professorfekete.com/articles/AEFMonEcon101Lecture10.pdf

### Lecture 10

## The Revolt Of Quality

- Deliberate Dollar Debasement - The Congenital Disease of All Paper Currencies - Omnipotent Government - Demonetizing Gold -

### The Portuguese Bank Note Case

At the end of the previous Lecture I ran out of time and couldn’t include the story of the Portuguese bank notes as I had intended. It is such an amusing and instructive story that I would not let you miss it, so I start with it this time.

Mises’ dictum that the bank note is a present good naturally leads to the tantalizing question whether an undetected counterfeit bank note is a present good as well. Exactly the same argument that made the genuine bank note a present good would make a counterfeit bank note a present good, too. Pity, this puts the bankers and counterfeiters into the same class: they are both in the business to create present goods out of practically nothing. I would be happy to rest my case there, however, it raises more questions than it answers. Should the practice of producing present goods out of nothing be outlawed along with quackery and witchcraft regardless whether this dangerous prestidigitation is practiced by honorable gentlemen, the bankers, or by disreputable crooks, the counterfeiters? Both the banker and counterfeiter are illusionists, mesmerizing the public into believing that their product, the bank note, is a present good and not merely a promise to deliver present good on demand. Both the banker and the counterfeiter are determined to escape any and all responsibility concerning the bank note after they have succeeded in putting it into circulation. The activities of the two are hardly different from an economic point of view. The difference is exclusively in our legal arrangements, aiding and abetting the former, while criminalizing the latter. It should criminalize both.

The following example, known as the Portuguese bank note case, is quite instructive and you will be pleased to hear it. In the late 1920's an astonishing and ingenious crime led to a fascinating civil suit that was not without its ironic side. A gang of international swindlers succeeded in convincing the well-respected London firm Waterlow & Sons, engravers of postage stamps and bank notes, that they were the representatives of the Bank of Portugal placing an order for the printing of a large quantity of fresh Portuguese bank notes. The order was duly filled and the bank notes were delivered to the swindlers.

When the fraud was finally discovered, the Bank of Portugal was forced to call in all its extant notes, replacing them with a new issue. The criminals were never apprehended, but the Bank of Portugal sued Waterlow & Sons in British courts, demanding compensation for losses resulting from the issue of fraudulent notes. In listening to expert testimony the Court discovered that the case involved issues of unusual subtlety and complexity. The Court admitted evidence of negligence, but the question of damages was another matter.

If it had been postage stamps instead of irredeemable bank notes in which the swindlers had trafficked, it would have been clear that the loss incurred by Portugal was equal to the face value of the fraudulent issue. With respect to bank notes, however, no such simple assertion could be made. Among the questions that troubled the experts the following stood out as particularly relevant to our study: would the Bank of Portugal have issued the same amount of bank notes even if the swindlers had not done so? If not, was the increase in the supply of paper currency resulting from the fraudulent notes beneficial or detrimental to the Portuguese economy? Some experts even testified that the swindlers may have done an unintentional favor to Portugal in helping fend off an imminent deflation. At any rate, why should the face value, rather than replacement value of a counterfeit bank note, govern considerations for damages, if the bank note is irredeemable anyway? These and other considerations led the high court to award only a small fraction of the damages claimed. See: C.H. Kisch, The Portuguese Bank Note Case, London, 1932, and Wilhelm Röpke, The Economics of Free Society, Chicago, 1963.

### The Yellowback Saga

My next example will, more than any other, demonstrate the difference between a present good and a promise to deliver a present good to bearer on demand. A U.S. \$20 gold certificate (nicknamed the "yellowback" in order to distinguish it from the "greenback") and a U.S. \$20 gold coin were both present goods, in the sense of Mises, on Saturday, March 4, 1933, the day of the inauguration of F. D. Roosevelt as the 31st president of the United States. The new president was elected to office in 1932 on a platform which contained the following preamble:

Believing that a party platform is a Covenant with the people to be faithfully kept by the party when entrusted with power, and that the people are entitled to know in plain words the terms of contract to which they are asked to subscribe, we hereby declare this to be the platform of the Democratic Party . . . and this declaration:

A sound currency is to be preserved at all hazards.

During the election campaign of 1932 Mr. Roosevelt chastised president Hoover for endangering the integrity of the dollar by uttering irresponsible remarks about the possibility of going off the gold standard. There appears to be no evidence that Mr.

Roosevelt favored the debasement of the dollar prior to his election. But debasement began very soon after inauguration. By the Emergency Banking Act, passed by Congress and signed into law on March 9, 1933, the president was empowered to prevent the hoarding and exportation of gold. Next day the Administration took the first step by refusing license to exporters of gold. With that refusal the dollar and the yellowbacks with it declined sharply in terms of gold and foreign exchange abroad. For all intents and purposes the yellowback ceased to be a present good. Lest there remain any doubt about the matter, on April 5, 1933, an Executive Order was issued requiring the owners of gold coins, gold bullion, and gold certificates (yellowbacks) to deliver these items to a Federal Reserve bank against replacement in the form of Federal Reserve notes (greenbacks) on or before May 1, 1933. The Executive Order specified heavy penalties for noncompliance.

### Deliberate Dollar-Debasement

Actual debasement of the dollar was authorized under Section 43 of the Agricultural Adjustment Act of May 12, 1933, the "Thomas Amendment", empowering the president to reduce the gold content of the dollar. On June 5, 1933, Congress passed a "Joint Resolution to assure uniform value to the coins and currencies of the United States". This recited that holding and dealing in gold affected public interest and were therefore the object of regulation; that the provisions of obligations which purport to give the obligee the right to require payment in gold coin obstructed the power of Congress to regulate the value of money and are inconsistent with the policy to maintain equal value of every dollar coined or issued. It then declared that "every provision in any obligation purporting to give the obligee a right to require payment in gold is against public policy, and directed that every obligation, heretofore and hereafter incurred, whether or not any such provision is contained therein or made with respect thereto, shall be discharged upon payment, dollar for dollar, in any coin or currency which at the time of payment is legal tender for public and private debts".

The final status of the yellowbacks remained unclear until 1935, when the U.S. Supreme Court decided against the creditors of the U.S. government (Nortz v. the United States).

In this landmark decision the high court ruled that the government of the U.S. did not act unconstitutionally in breaking its promise, stated on the face of the gold certificate: This certifies that there have been deposited in the Treasury of the United States of America twenty dollars in gold coin of present weight and fineness, payable to bearer on demand.

In the opinion of the Court:

These gold certificates were currency . . . Being currency and constituting legal tender, it is entirely inadmissible to regard the gold certificates as warehouse receipts. They were not contracts for a certain amount of gold as a commodity. They called for dollars, not bullion.

However, in the words of Justice McReynolds who formulated the minority opinion of the four dissenting justices,

These were contracts to return gold left on deposit; otherwise to pay its value in currency.

The majority of the Court argued that the Constitution granted monetary powers to the government, including the power "to coin money and regulate the value thereof".

Therefore, the breaking of this promise fell within the power to regulate the value of coin.

The Court side-stepped the issue whether another provision of the Constitution, denying the power to the government to deprive citizens of property without due process of the law, was violated or not. Incredibly, the high court even argued that no loss accrued to the citizens in consequence of the arbitrary action of the government, because the domestic purchasing power of the Federal Reserve notes remained identical to that of the yellowback which it replaced. In saying this, the high court ignored the immediate and sizeable losses of individuals under the jurisdiction of the United States who had obligations payable in foreign currency, as well as losses of citizens living in or visiting foreign countries.

### Appalling Legal and Moral Chaos

Justices McReynolds, Van Devanter, Sutherland, and Butler disagreed with the majority of the court. The dissenting opinion was delivered by Justice McReynolds. It should be taught in American schools along with the Emancipation Proclamation.

We conclude that, if given effect, the enactments here challenged will bring about confiscation of property rights and repudiation of national obligations.

Acquiescence in the decisions just announced is impossible; the circumstances demand a statement of our views. To let oneself slide down the easy slope offered by the course of events and to dull one’s mind against the extent of danger . . . that is precisely to fail in one’s obligations of responsibility.

Just men regard repudiation and spoilation of citizens by their sovereign with abhorrence; but we are asked to affirm that the Constitution has granted power to accomplish both. No definite delegation of such power exists; and we cannot believe the far-seeing framers, who labored with hope of establishing justice and securing the blessings of liberty, intended that the expected government should have authority to annihilate its own obligations and destroy the very rights which they were endeavoring to protect. Not only is there no permission for such actions; they are inhibited. And no plentitude of words can conform them to our charter.

The federal government is one of delegated and limited powers which derive from the Constitution. It can exercise only the powers granted to it. Powers claimed must be denied unless granted . . . The fundamental problem now presented is whether recent statutes passed by Congress in respect of money and credits, were designed to attain a legitimate end. Or whether, under the guise of pursuing monetary policy,

Congress really has inaugurated a plan primarily designed to destroy private obligations, repudiate national debts, and drive into the Treasury all the gold within the country, in exchange for inconvertible promises to pay of much less value.

Considering all circumstances, we must conclude they show that the plan disclosed is of the latter description and its enforcement would deprive the parties before us of their rights under the Constitution. Consequently the Court should do what it can to afford relief . . .

The end or objective of the Joint Resolution [of June 5, 1933] was not ‘legitimate’.

The real purpose was not ‘to assure uniform value to the coins and currencies of the United States’, but to destroy certain valuable contractual rights . . .

These words of Alexander Hamilton ought not to be forgotten: "When a government enters into contract with an individual, it deposes, as to the matter of its Constitutional authority, and exchanges the character of legislator for that of a moral agent, with the same rights and obligations as an individual. Its promises may be justly considered as excepted out of its power to legislate, unless in aid of them. It is in theory impossible to reconcile the idea of a promise which obliges, with a power to make a law which can vary the effect of it . . ."

It was not intended to give Congress the power under the law to repudiate the obligations in question . . . No such power was ever granted by the framers of the Constitution. It was not there then. It was not there yesterday. It is not there today.

We are confronted with a condition in which the dollar may be reduced to 50 cents today, to 30 cents tomorrow, to 10 cents the next day, and to 1 cent the day after . . .

Under the challenged statutes it is said that the United States has realized profits amounting to \$2,800,000,000. But this assumes that gain may be generated by legislative fiat. To such counterfeit profits there would be no limit; with each new debasement of the dollar they would expand. Two billions might be ballooned indefinitely to twenty, thirty, or what you will.

Losses of reputation for honorable dealing will bring us unending humiliation. The impending legal and moral chaos is appalling.

### Congenital Disease of All Paper Currencies

Thus did the yellowback cease to be a ‘present good’ at the stroke of a pen in 1935. At any rate, the market had long recognized the true state of affairs: it treated the yellowback as a dishonored paper. By contrast, the \$20 gold piece was still a present good after the Supreme Court decision as it is still today. So is the gold Napoleon. They continue to be a present good on the same terms indefinitely, whatever fate awaited the issuer. Paper money issued under the authority of Napoleon III, of course, no longer enjoys presentgood status. They and the yellowback have suffered from the same congenital disease of all paper currencies: their status is tied up with the fortunes and integrity of the issuing authority. The gold coin is free from this congenital disease precisely because, unlike the paper currency, it is a present good, not a promise.

I treated the saga of the yellowback at length because it shows, I think, that Mises’ concept of a present good is untenable. The yellowback lost its status as a present good, as the term is understood by Mises, for no cause more substantial than a stroke of the pen.

This not only violates one’s intuitive idea of a present good, but also obscures the real state of affairs. It appears to condone the mischief involved in the prestidigitation. There is no need to stretch the meaning of the term ‘present good’. A perfectly satisfactory term to cover bank notes and other varieties of paper currency redeemable in gold already exists: they are promises to pay bearer a definite quantity of gold on demand. The value of a present good can be protected against physical deterioration by its owner in taking precautions to prevent it. The value of a promise cannot be so protected: it depends on the integrity of the other party and that of the prevailing legal system. A promise can be broken, no matter how carefully one protects the paper on which it is written. Nor does it matter who the promisor is and what what resources are at his disposal. As our example shows, even if the promise has been issued by the government of the richest and ‘most democratic’ country on the face of the earth, with vast economic and military resources at its command, and even if the promise is backed up by Constitutional guarantees, a promise is still just a promise, and not a present good. Greater economic and military power won’t make a country less likely to stoop so low as to have recourse to fraudulent bankruptcy, in order to destroy the contractual rights of weaker countries or individuals.

Gold needs no endorsement. It can be tested with scales and acids. The recipient of gold does not have to trust the government stamp on it if he doesn’t trust the government that had stamped it. No act of faith is called for when gold is used in payments, and no compulsion is required. Gold is gold, and paper is paper. A present good is a present good, and a promise is a promise. Finally, whether the highest of high courts admits it or denies it, a broken promise is just that: a broken promise.

### Omnipotent Government

Apparently, Mises maintains that even an irredeemable bank note is a present good.

However, to call an irredeemable bank note a present good is to admit that the banks and the government can indeed create wealth out of little scraps of paper by sprinkling some ink on them. It is an admission that governments are omnipotent. But if we are to admit this, then we are forced to acknowledge that the regime of irredeemable currency, based on broken promises and on the prerogative of the government to declare bankruptcy fraudulently or, in most general terms, on contemptuous disregard for the rules of civilized dealings between individuals and the government, can endure indefinitely.

Apologists for the regime of irredeemable currency have no patience with this analysis of the historical origins of their regime. They refuse to face the fact that the viability of their regime is based on a deliberate confusion between present and future goods, that is, ultimately, on human gullibility. They try to assume a pragmatic stance. "Let bygones be bygones", they plead. "What alone matters is that the system works and will endure, because all that remains to clear up is this trifling matter of finding the ‘optimal’ rate at which the money supply is to be increased in order to stabilize the value of the monetary unit." I can dispose of the pragmatic argument that, indeed, there is a unique formula defining the optimal rate of increase in the quantity of irredeemable currency, in one sentence. The declining value of irredeemable currency is not a result of having the ‘wrong’ rate of increase in its quantity, but it is a result of surreptitiously smuggling an item from the liability column to the asset column of the balance sheet of the government.

The proposition that the regime of irredeemable currency can endure indefinitely flies in the face of historical evidence. No irredeemable currency has ever survived the test of times. If it was not made redeemable in specie in good time, then it ignominiously lost all its value in due course. Nor was the destruction of value caused by ‘overissuing’: it was caused by the original default. When the norms of honorable dealings between the people and the government are turned upside down, and the dishonored paper is being promoted as money, (that is, elevated from the bottom of the garbage heap to the position of the highest-powered monetary asset of the credit pyramid), then the progressive depreciation of the value of the currency is the natural course of events. First, the dishonored paper goes to a discount in gold. Then, for a time, the discount may move up and down, according to the expectation that reason might prevail and redemption might be resumed.

When all hope fades, the inevitable happens. The dishonored paper loses all its remaining value.

### The Revolt of Quality

The idea that the monetary regime based on irredeemable currency can endure indefinitely is the stuff of which the dreams of dictators are made. The list of attempts to translate that dream into reality is very long. Yet every one of those attempts in history failed, and did so miserably. There is no shred of scientific evidence that the substance of the present attempt is any different from that of the previous ones. It is true that this experiment has so far survived longer than previous ones. This proves nothing, nor is it necessarily an improvement, for it only prolongs the agony, and makes the end-game even more painful. The paramount fact is that the depreciation of currencies is continuing year in and year out, in good times and in bad, albeit at a varying rate. The linguistic innovation of introducing the euphemism ‘price inflation’ and the official pretense that monetary depreciation is a ‘natural’ phenomenon rather than the direct result of dishonorable dealings, will not make the outlook for the present experiment any brighter.

Nor is there any reasonable hope that some significant scientific discovery, or a breakthrough in data processing and information technology, will change the pessimistic longterm outlook for the regime. It cannot be emphasized too strongly that longevity of a monetary regime is a matter decided not on the basis of the quantity of money or the rate at which it is increased, but by the quality of assets in the balance sheet of the monetary authority. It is futile to pretend, as the Friedmanites do, that restricting quantity makes for quality. Restricting the quantity of a dishonored promise cannot make it more valuable. If the regime of irredeemable currency could be perpetuated, it would be tantamount to the overthrow of the fundamental principle of double-entry book-keeping. This principle demands that an item must appear either in the liability column, or in the asset column of the balance sheet, and it cannot be shifted from one to the other at pleasure. It is not possible to create a liability in the balance sheet of the government and pretend that, by increasing this liability at the ‘optimal rate’ one can, somehow, increase the assets in the same balance sheet, as the Friedmanites do.

If the revenues of the government consist exclusively of its own liabilities, as is the case today, then the implication is that the citizens are mere slaves of government authority with no power over their own affairs. It means that the citizens, their children, their chattels, their produce, all belong to the government. In order for them to buy food, shelter, medicine, etc., they have to get permission, in the form of a piece of government debt (itself subject to unilateral cancellation) to do so. Elections are meaningless. They are about deciding which party will collect the tithes, not about the question whether tithes should be abolished altogether. The pretense is maintained that the government is in debt to its citizens, and it is the destiny of the debt to be retired. This has no basis in fact. The government debt will never be retired: it is to keep growing indefinitely. It is the citizens who are in fact in debt to the government. It is no longer true that the government belongs to the people: rather, the people belong to the government. In the words of the currency expert, the late Dr. Franz Pick, government bonds are "certificates of guaranteed confiscation". Tax revenues can, in theory, reduce the rate of increase in government debt. However, to the extent that the government wants to translate tax revenues into tangible goods and services, the debt reduction is immediately canceled. In order to have command over real goods and services the government has to borrow, and borrow it must at an accelerating pace. The burden of debt can only be lightened through ongoing currency depreciation. This depreciation must occur in fits and starts. Otherwise people would see clearly what is going on, and would refuse to hold the currency, causing it to lose its value, as it were, overnight.

The unstated premise underlying the regime of irredeemable currency is the proposition that it is possible to keep borrowing with the right hand while destroying the value of the resulting obligations with the left. Governments trying to perpetuate the regime of irredeemable currency will ultimately find that they are destroying their own credit and their ability to borrow in the process. They will, sooner or later, reach the point where they can no longer borrow because they are no longer trusted. This is the revolt of quality.

Even with the most drastic quantity controls of money-creation, the destruction of the regime of irredeemable currency is inevitable.

### Gold Demonetization

In the late 1960's quantity theorists widely predicted that the de-monetization of gold would seriously undermine the exchange value of gold. Ludwig von Mises was among them: "The important thing to be remembered is that with every sort of money, demonetization, i.e., the abandonment of its use as a medium of exchange must result in a serious fall of its exchange value." (Human Action, p. 428, third edition, Chicago, 1963.)

To a quantity theorist, the disappearance of the lion’s share of the demand, the monetary demand, couldn’t help but make gold cheaper. It is a source of endless amazement for me that a quantity theorist could be so blinded to the other side of the de-monetization coin, namely the effect it has on the irredeemable bank note in which gold is quoted.

It is not known whether these views of the quantity theorists had any influence on the thinking of the decision-makers who demonetized gold on August 15, 1971. Be that as it may, the idea that dishonouring promises to pay gold on demand would, somehow, cause the dishonored paper to go to a premium in terms of gold is preposterous. It is true that insolvent bankers have in the past tried to promote their discredited paper (sometimes using extreme measures such as the death penalty to punish the owners of contraband gold, as proposed by John Law of Lariston and, later, by the issuers of the assignats and mandats), to no avail. Logic and history prove that dishonored promises to pay gold always and everywhere go to a discount, never to a premium. Indeed, this is exactly what happened after gold was demonetized world-wide in 1971. In less than a decade the U.S. dollar went to a 90 percent discount in terms of gold. Moreover, the discount was commensurate with the 90 percent loss in purchasing power that the dollar suffered during the same period. There is no use to blame that loss on the conspiracy of Arab sheiks and the gnomes of Zurich. The huge loss in the value of the dollar during the decade of the 1970's was due to one cause only: the de-monetization of gold. The hope that the discount on the dollar would ever disappear is a forlorn one. Domestically and internationally, a deflation of that magnitude is unthinkable. Furthermore, the disarray in America’s budgetary and trade accounts suggests that the currency depreciation is likely to continue, if not accelerate. The only way to stop the rot would be the adoption of a reasonable plan to resume gold redeemability of the dollar. Neither party has so far come up with a platform embracing the idea.

The use of the word ‘demonetization’ in connection with gold is inappropriate. It is but a euphemism for debt-abatement (partial debt-repudiation) inflicted upon the foreign creditors of the United States of America. These foreign creditors were deprived of a valuable property right: the right to a fixed amount of gold per dollar. This unilateral and capricious act has done nothing to benefit the citizens or the government of the U.S. On the contrary, the debt abatement had one predictable consequence: harsher terms on future borrowing, as measured by the higher and unpredictable rates of interest which the government and the people of the United States had to pay on new borrowings abroad. It is true that the burden of debtors who had contracted debt prior to the abatement was lightened but, insofar as they were the same borrowers on whom the harsher terms on further borrowing fell for the indefinite future, there were no beneficiaries, only losers. In particular, the big losers were the taxpayers. The international credit of the U.S. government was grievously damaged as manifested by the unprecedented interest rates

(e.g., 16 percent per annum on the 30-year bonds) the Treasury was forced to pay on its obligations.

### From Greatest Creditor to Greatest Debtor

The stubborn denial that the credit standing of the U.S. has been damaged in any way by the de-monetization of gold of 1971 is the centerpiece of mainstream economics. We must realize, however, that gold de-monetization is just a euphemism for the crime of pauperizing the laboring classes here and abroad, who are the main holders of the irredeemable dollar. Ironically, the ‘moneyed classes’ have the habit of holding irredeemable currency for as short a period of time as necessary. Then they get rid of it by investing their funds in something more reasonable.

This is a world of crime and punishment. No one, not even the government of the mightiest nation on earth can exempt itself from the consequences, which are numerous.

One of them is the fact that, in an incredibly short period of time, America turned itself from the world’s greatest creditor into its greatest debtor country. Another is that that part of the American industry which is not in the process of dismantling itself, is losing international competitiveness, just at the time the country would need a strong export industry to help pay for its burgeoning foreign debt. Due to volatile interest rates in the 1980's, a large part of America’s park of capital goods has become submarginal.

Producers were either unwilling or unable to maintain capital by replacing worn and obsolete equipment with new ones. As capital was becoming submarginal under a rising interest-rate structure, so were the producers. They were forced to sell their business at a loss, and invest the proceeds in high-yield Treasury bonds. This was a textbook-case how the government can despoil its own taxpayers. In printing high coupon-rates on Treasury bonds, instead of collecting taxes from the productive members of society, the government is now obliged to pay them for holding its debt. A large segment of the producers found themselves unable to compete with the high coupon rates the government so cavalierly printed on its bonds and, from producers of new wealth they became coupon-clippers. The consequences of wholesale destruction of capital are camouflaged by the burgeoning import of consumer goods. Foreigners accept the dollar for the time being, as in their judgment the dollar was depreciating more slowly than their domestic currency. Such a situation cannot continue indefinitely. The most visible sign of the progressive deterioration is the ever-growing trade deficit, the flip-side of the accumulation of U.S. Treasury paper in foreign hands. At one point, the world market will get saturated with the U.S. dollar. When that happens, another convulsion in the world’s commodity and financial markets will follow.

It is not widely understood that the dollar was given a stay of execution by the fortuitous demise of the Soviet Union and its Evil Empire in 1990. This unforeseen historic event turned the dollar-glut into a fresh dollar shortage. All of a sudden a new market, counting some 400 million souls, was thrown wide open to dollar-penetration a market that had earlier been hermetically sealed off by the threat of the firing-squad. Huge though this market for dollars may appear, it is not unlimited. At one point it would also become saturated as had markets in Western Europe done in the late 1960's. It is no use predicting that the present dollar-shortage would never turn into a dollar glut. Similar predictions were also made during the dollar-shortage of the 1950's at a time when America’s trade advantage over the rest of the world appeared unassailable. When the dollar-glut of the late 1960's hit the unsuspecting world, those predictions were totally discredited. Today America’s trade position is incomparably weaker, and getting weaker still. And, remember, America is no longer the world’s greatest creditor. Now, it is the world’s greatest debtor. Accordingly, the effects of the dollar glut, when it comes, will be that much worse.

### The Swing of the Wrecker’s Ball

Another great danger has unexpectedly appeared on the horizon, the blackhole of zero interest. It turned out that the volatility of interest rates, that was unleashed through the demonetization of gold, also has a long cycle measured in decades. At first, the pendulum was swinging towards infinite interest, threatening the dollar with hyperinflation. Right now the pendulum is swinging to the other extreme, to zero interest, spelling hyperdeflation. This is just as damaging to the producers as the swing towards infinite interest was in the early 1980's. It is impossible to predict whether one or the other extreme in the swinging of the wrecker’s ball will make the world economy to collapse. Hyperinflation and hyper-deflation are just two different forms of the same phenomenon: credit collapse.

Arguing which of the two forms will dominate is futile: it blurs the focus of inquiry and frustrates efforts to avoid disaster. In the meantime, the wrecker’s ball keeps swinging, with ever wider amplitude, and ever greater force.

The credit of the U.S. government suffered its greatest setback in history, as a result of the 1971 devaluation of the dollar, even though it was only by a relatively insignificant amount (the official price of gold was increased from \$35 only to \$38). The deterioration of the credit of the U.S. still continues, with unforeseeable consequences. This is not generally acknowledged by financial writers at home and abroad. The gross mismanagement of credit in the U.S. and in the rest of the world has created intractable problems for which there are no painless solutions.

Such are the consequences of the confusion between present and future goods, between capital and credit, between assets and liabilities deliberately fostered in the minds of the people by the proponents of mainstream economics.

### ***

### The Transition from Direct to Indirect Exchange

Don Lloyd of Peabody, Massachusetts, writes that I got the meaning of Mises wrong when I referred to the individual rearranging his scale of values in response to direct exchange being abandoned and replaced by indirect exchange (Lecture 8, Mises by North). Suppose that he preferred apples to oranges under direct exchange but, with the advent of indirect exchange, he finds that he reverses his preferences. The price of an apple being \$6 and that of an orange \$4 apiece, Don says that the difference in price, \$2, affords him enough extra market power to make the change worth his while. In contrast to my suggestion, that the individual would rearrange his scale of values to conform to the prevailing constellation of prices, he has rearranged his to oppose it.

Don, I appreciate your comment. Here is my answer. Apart from the fact that the changeover from direct to indirect exchange took hundreds if not thousands of years (so that no individual could observe the entire process), under indirect exchange you are no longer comparing apples and oranges. You compare one apple to one orange plus something you can buy for \$2, say a plum. In other words, you haven’t changed your preference for apples at all. One apple still ranks higher in your scale of values than one orange. The new element is that you can now measure the difference in values; you can actually subtract one value from another.

Your example does not weaken my position, it confirms it. Not only does the advent of money and prices give you everything you have had before (namely the possibility of ranking), it gives you more (the possibility of measuring). You can now answer the question by how muchyou prefer one apple to one orange. You always rank the more expensive item higher in your scale. You don’t always buy what you value higher, but if buy the cheaper instead, then it is because of your preference for saving the difference. It is a very common human experience to have to make do with the cheaper item, in spite of our preferences.

It is not enough to say that you oppose the valuation of the market. To give substance to your valuation, you have to do something about it. This is what the entrepreneur does, in going into production to bring down the price that, in his opinion, the market values too highly. Indeed, I am not saying that all individuals always conform their scale of values to the constellation of prices. On the contrary: the exceptions are enormously important, or should be, to an Austrian economist. These exceptions explain the origin and nature of entrepreneurship to us. The entrepreneur dares oppose conventional wisdom as he posits his own valuation against that of the market. If he values A less than B but finds that in the markets a > b (A is more expensive than B) then he will resort to arbitrage. This may take different forms, but the one that is important for our purposes is the entrepreneur’s.

He goes into the production of A using new materials, new production technologies, or even opening up new markets for A, so that he can bring a down and earn entrepreneurial profits. Please note that it is not only his entrepreneurial insight that serves as the source of those profits, but also the monetary economy which has helped him to spot an anomaly. Entrepreneurship has become easier under indirect exchange precisely because the entrepreneur can measure, add, subtract, multiply and divide values, none of which were impossible under indirect exchange.

Subjective economists, of course, have realized the great significance of the revolution represented by the transition from direct to indirect exchange. Nevertheless, they have failed to deal adequately with the aspect how this transition affected the subjective valuation of individuals. Ludwig von Mises devotes three sentences to this in The Theory of Money and Credit: "Nowadays exchange is usually carried on by means of money, and since every commodity has therefore a price expressible in money, the exchange value of every commodity can be expressed in terms of money. This possibility enabled money to become a medium for expressing values when the growing elaboration of the scale of values which resulted from the development of exchange necessitated a revision of the technique of valuation. That is to say, opportunities for exchanging induce the individual to rearrange his scale of values." (Op.cit., p 61.)

I submit that this "rearranging of values" was, in fact, a revolution in the subjective valuation of goods by individuals. The market harmonized subjective individual values, by codifying them in the price structure. As a result, values were lent the appearance of being ‘objective’. It may appear that subjective individual values were made to conform to 'objective’ values as manifested by prices. Of course, we know that subjective values had been first, and they were synthesized into prices, so we still talk about ‘subjective theory of value’. The harmonization of scattered individual values into the constellation of prices was a revolution of the utmost significance. Among others, it was responsible for the change that entrepreneurs started using market calculation. They could not have done it without being able to measure the value of goods and services.

Thank you, Don, for your stimulating observations. I hope you will eventually agree with me that this is a point where Austrian economists could carry science further.

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand's Hymn to Money

### Lecture 2: Don't Fix the Dollar Price of Gold

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told, Chapters 1 - 3

### Lecture 6: The Invention of Discounting, Chapters 4 - 6

### Lecture 7: The Mystery of The Discount Rate, Chapters 7 - 8

### Lecture 8: Bills of The Goldsmith, Chapter 9

### Lecture 9: Legal Tender, Small Bank Notes

### Lecture 10: The Revolt of Quality

### Lecture 11: The Acceptance House, Chapters 10 - 11

### Lecture 12: Borrowing Short to Lend Long, Chapter 12

### Lecture 13: The Unadulterated Gold Standard

---

# Monetary Economics 101 — Lecture 9: Legal Tender and Bank Notes of Small Denomination

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-101-lecture-9-legal-tender-and-bank-notes/
Date: 2002-08-26
Section: Money & Credit
Difficulty: intermediate
Concept Tags: gold-standard, fiat-currency, irredeemable-currency, sound-money
Description: Fekete examines legal tender laws and small-denomination bank notes, arguing that both represent government intrusion into the monetary system that distorts the natural hierarchy of money. He traces how legal tender forced inferior money on commerce and how small-denomination notes displaced gold coin from everyday circulation.
Editorial Note: Lecture 9 of Monetary Economics 101 (Gold Standard University, 2002). Focuses on Gresham's Law in operation: how legal tender laws systematically drive good money out of circulation and substitute government-issued substitutes.
Original PDF: https://professorfekete.com/articles/AEFMonEcon101Lecture9.pdf

### Lecture 9

*Legal Tender Small Bank Notes*

- Tolerance Standards - Special Privileges for Banks - Small is Ugly - Theory of Reflux - Sources of Government Conduct -

Today the concept of legal tender refers to coercion. The government orders its subjects to accept irredeemable promises in payment for the real goods and real services they produce. If people refuse to comply with the order, then they put themselves outside of the law. But the term legal tender hasn't always meant coercion. It originated in a right, not an obligation, of the people. As recently as in 1933, in the United States 'legal tender' referred to the right of the people to take their worn gold coins still within the established tolerance standards and exchange them free of charge for full-bodied ones. The government, by law, was obliged to pick up the cost of wear and tear in the coinage.

Unscrupulous employers were prevented from short-changing wage earners by putting underweight gold coins into the pay envelope. This refresher of the semantics of legal tender is a helpful reminder how the government uses the subtle process of twisting the meaning of words to introduce coercion where there was none before, to turn a right into an imposition and, ultimately, to help itself to the wealth of its subjects without due process of the law.

While irredeemable paper currency relies on the strong arm of the government for its circulation, full-bodied gold coins have circulated freely without any legal tender provision or other government interference. There was no need for coercion. Everybody was happy to take the gold coin in payment of wages or against the sale of goods. The government facilitated trade through non-coercive measures. Legal tender referred to measures to make it possible for the gold coin to circulate by tale rather than by weight.

Circulation by tale simplified commerce enormously. Instead of weighing coins you simply counted them. This was achieved by committing the government to absorb the cost of wear-and-tear of the coinage, just as it is committed to absorb the cost of keeping highways in good repair. Tolerance standards were introduced, that is, a threshold of weight was established above which worn gold coins would still be received at face value at the Mint for re-coinage. Only gold coins below the threshold were valued by weight and were received at their actual bullion value. Banks and traders followed suit in accepting worn coins within the tolerance standard at face value. They knew that the Mint and the Treasury would take these coins from them. Thus the term legal tender, in the old sense, simply meant that the government stood behind the value of the coin of the realm even if it was slightly worn.

Another legitimate use of the concept of legal tender was the regulation of the circulation of silver and other subsidiary coins under the gold standard. As the gold/silver bimetallic ratio was variable, two problems could arise. If the bimetallic ratio rose, there could be reluctance to accept silver coinage in large quantities. If the bimetallic ratio fell, there was another threat. Silver coinage could disappear from circulation through wholesale melting or exporting of coins. To counter these problems, subsidiary silver coins were not made full bodied any more by the Mint. This took care of melting and exporting. To ensure smooth circulation of subsidiary coins without discounting which was in the interest of everybody, the Treasury was obliged to take them at face value, up to a certain limit per transaction regulated by legislation. Again, the market followed suit: banks and traders accepted subsidiary coins up to the same limit. By and large, these legal tender provisions worked as intended. Domestic and international circulation of silver and gold coins grew with the growth of world trade.

### Serfs of the Leviathan

Legal tender legislation made the impression on the minds of some people that the government had the power to create value out of nothing by stamping a higher value on a lower-valued piece of metal. They saw the legislation, not as an obligation imposed on the government in accordance with the original intention but, rather, as an obligation imposed on the citizens. Out of this misrepresentation of the original legal tender legislation, which in no way intended to limit the freedom of the individual, grew the Leviathan. It disenfranchised the savers and laborers. If legal tender legislation can make worn gold coins and cheap silver coins circulate at a face value higher than that of metallic content, then it can also make paper circulate at arbitrary values.

Enemies of freedom argued thus: Making paper money legal tender could be used to subjugate a free people, reducing them to the status of serfs in the service of the Leviathan, without their realizing just what is happening to them.

Yet there was a problem. All the bank notes in circulation were issued in large denominations. They were used only by people knowledgeable about the market, the condition of the banks, and about the credit of the government. The goldsmith did not issue bank notes of small denominations. His clients would have no use for it and would not take them. If the Great Fraud was to succeed, then it was necessary for the government to pull off a coup. Small bank notes should be put into circulation, and the laboring classes had to be mesmerized into accepting them.

### "Small Is Ugly"

The introduction of bank notes of small denomination was inextricably intertwined with the granting of special privileges by the government to the banks of issue (banks authorized to issue bank notes). Invariably, these special privileges were highly detrimental to the public interest, and should have never been granted. The patent

(monopoly) was reward for the favor of banks to monetize government debt. In practice, this meant that the banks were allowed to have a fiduciary issue of bank notes against government paper in addition to (but indistinguishable from) bank notes issued against gold and self-liquidating bills of exchange. The paper backing the fiduciary issue included government bonds and notes that the Treasury was unable to sell to the general public. These bonds and notes were automatically reissued upon expiry. In effect, the bank was carrying a perpetual government debt. This it could do only because the bank was able to pass the burden on to the shoulders of the general public in the form of noninterest-bearing paper: small bank notes. Thus fiduciary currency, far from being a present good as suggested by Mises, is the worst possible type of future good one can have! The burden was passed on to the public, and the banks pocketed riskless profits in the form of interest payments by the government. Please note that it would not work with the issue of large bank notes. Holders of large notes would hang on to them for as short a period of time as was absolutely necessary, and then would pass them on to others, or would return them to the bank. Small is beautiful from the bank's point of view, but it is certainly ugly from that of the public.

A case in point is the establishment of the Bank of England. King Charles II had borrowed gold from the goldsmiths of London who held it on deposit from some 10,000 depositors. In 1672 the king refused to repay the loan and, naturally, the crown was having great difficulties in borrowing money thereafter. The goldsmiths presented their claims against the king in 1691 and, out of the agreement hammered out, the Bank of England was born. William Paterson, a Scotsman, offered to advance 1 million pounds to the government against its bonds on the following conditions: (1) the bonds were to pay interest at 6½ percent per annum, (2) there was also a management fee to be paid, (3) the government granted the bank monopoly to issue bank notes in the London area. The notes of the Bank of England became legal tender in 1694, and the intervening three centuries did not afford an opportunity for the government to retire the bond against which the original 1 million pound worth of bank notes were issued. It will probably be retired only when the pound will have lost the remainder of its value.

Mises also considers the problem of small bank notes. "For reasons which were connected with certain views on the nature of notes it was thought that the circulation of notes of small denomination ought to be opposed. The battle against the one pound note in England ended with the complete victory of the sovereign (the one pound gold coin)", op.cit., p 321. "Old British banking doctrine banned small bank notes (in their opinion, notes smaller than five pounds) because it wanted to protect the poorer strata of the population, supposed to be less familiar with the condition of the banking business and therefore more liable to be cheated by the wicked bankers", op.cit., p 494.

There is a disturbing misprint on p 494 where Mises talks about his proposed new gold standard for the United States (apparently this is no translation but was written in English by Mises himself in 1952). "It does not require any special mention that the new-stock legal-tender notes to be issued by the Conversion Agency must be issued only in denominations of one dollar or fifty dollars and upward". For this to make sense, I think, the words "one dollar or" should be deleted. That is to say, Mises in 1952 advocated a new gold standard for the United States which would have excluded small bank notes.

Unfortunately, he did not exclude legal-tender status for the larger ones.

### Special Privileges Granted to Banks

It should be clear at once that under the pact between the government and the banks of issue the smooth redemption of bank notes has been seriously undermined, if not made outright impossible. It was no longer true that one-ninetieth of the banks assets matured every single day of the year, bringing in plenty of gold coins to satisfy normal demand.

Nor was it likely that the banks could meet abnormal demand through liquidating assets.

Whereas real bills were highly marketable and could be easily liquidated through discounting at any time on short notice, government bonds had low marketability and their liquidation could involve the bank with losses. In fact, these losses could be quite substantial, in some cases they would wipe out the bank's entire capital. The banks were no longer in the position to operate on the same basis as before. They could no longer make good on their promise to redeem their notes in gold coin on demand.

The banks could continue operation only under special dispensation from the government. The dispensation was designed to protect the banks against the ire of their creditors in case of insolvency. The banks were given special privileges in the form of a patent which made it virtually impossible for their creditors to have legal recourse in forcing liquidation in case the banks failed to perform on valid contracts and obligations.

But for the patent, should the bank fail to live up to its promise to pay, creditors would satisfy themselves from the proceeds of the liquidation of the banks' assets.

In effect the new dispensation meant the establishment of a double standard, one for the banks, and another for everybody else, in adjudicating cases that involved contract law.

The banks, under the protection of the patent, enjoyed special privileges. They could disguise their breech of faith with creditors under solemn-sounding euphemisms. They could declare a 'bank holiday' or a 'suspension of convertibility', they could 'stand still' or 'go off gold' - and the use of any number of linguistic innovations to cover up the fact of fraudulent bankruptcy. By contrast, other firms had to face the music if they could not perform on their contracts: their creditors could force their liquidation.

### Mesmerizing the Laboring Classes

Still, the conspiracy between the government and the banks of issue would have been transparent and easy to expose if it wasn't for the trick that was employed to throw dust into the eyes and confuse the minds of the people. The trick was to maintain the pretense that there was a great unsatisfied demand for bank notes of small denomination out there.

It was the government's responsibility to mint gold coins for circulation, so it had to provide a substitute in case of a dearth of gold. The idea was to put over on the public the notion that the fiduciary issue was necessary in order to meet the demand for small bank notes.

The argument is disingenuous. The allegation that gold coins would be in short supply if they were dispersed in the hand of the saving and consuming public is spurious. As we have seen, the producers of consumer goods did not need gold to finance their operations.

They could use real bills as a means of exchange. Every urgent and legitimate business transaction in the service of the consumer gives grounds for drawing bills. The greater the urgency, the easier it is to discount commercial paper drawn against the movement of merchandise destined to satisfy consumer demand. Long-term business investments, on the other hand, should be financed by appealing to the saving public for accommodation, and the going rate on long-term funds should be paid. As long as these guidelines were followed, there could be no dearth of gold coins.

There was no genuine demand for bank notes of small denomination. Had there been such a demand, the goldsmith would have put them into circulation. The idea of a dearth of gold is a red herring. The issuance of bank notes of small denomination was clearly a ploy to fool labor. Gold and silver coins were drained from the pockets of laborers and other people of small means. When wage earners lost their right to demand gold and silver in exchange for their services, and dust was thrown into people's eyes in the form of bank notes of small denomination, the stage was set for the Great Fraud.

Thou Shalt Not Press down upon the Brow of Labor This Crown of Thorns!

We may paraphrase Daniel Webster (already quoted in Lecture 3) as follows: "Of all the contrivances for cheating the laboring classes of mankind, none has been more effective than that which deludes them with small-denomination paper money."

It was not the bank note per se, but the bank note of small denomination, that were instrumental in cheating the wage-earner out of his fair wages. The distinction is significant. The wage earner is supposed to be paid in gold or silver coin. This is his Constitutional right. With gold and silver coins jingling in his pocket he was the unquestioned master of the market place. His wishes were sacrosanct to all vendors and producers. He was the proverbial boss who was 'always right'. Bereft of his gold and silver coins he was reduced to the station of a serf. Important decisions such as what to produce, when, and how much, are now made without consulting him. He is now inundated with a lot of obnoxious merchandise from unhealthy food through gimmicks with built-in obsolescence, to the lowest quality entertainment including pornography.

As pointed out above, the excuse of a dearth of gold is lame. But even if we assume, for the sake of argument, that there had been a dearth of gold, for that the blame belongs to the government and the banks. A dearth of gold is always an indicator of one or both of the following:

### •

1. the banks are pursuing unsound credit policies, such as constructing a debtpyramid upon a slim or non-existent gold base, or conducting illicit interest arbitrage in borrowing short to lend long (this will be the subject of the last two Lectures in this course);

### •

2. the government is trying hard to monetize its debt, that is, make the banks buy the bonds it could not sell to the public.

The dearth of gold is merely a reflection of public distrust in the unsound and dangerous policies of the banks and the government.

William Jennings Bryan, fiery orator, populist politician, and unsuccessful presidential candidate said at the National Democratic Convention in Chicago in 1896: "Thou shalt not press down upon the brow of labor this crown of thorns. Thou shalt not crucify mankind upon this cross of gold." Bryan thought that gold was the enemy and silver the friend of the working people, and the gold standard was the rich man's ploy to enslave labor. Unfortunately, in looking for adversaries he missed the real enemy of the laboring classes: paper.

### Thou Shalt Not Crucify Mankind upon this Cross of Paper!

The Constitution of the United States provides for a metallic monetary standard for the country. This still stands. Those who run the monetary system of the country could not face a Constitutional debate to change that (although they forced Switzerland to change her Constitution). This is indicative of the bad faith that permeates our present monetary system. Its managers would sooner open themselves to charges that theirs is an unconstitutional monetary regime than muster the necessary courage to propose changing this provision of the Constitution. They obviously have something to hide.

The Constitutional provision for a metallic monetary standard was not a rich man's ploy.

It was grounded in the Founding Fathers' genuine regard for the welfare and advancement of the laboring classes. The gold and silver coins are the protectors of the wage earner.

The rich man can usually protect himself against monetary mischief even without them.

But collective agreements and wage contracts are not worth the paper on which they are written, if gold and silver coins in circulation do not give them substance. History proved the wisdom of the Founding Fathers. In 1971, as the Republic was approaching its bicentennial, there was nobody to cry loud and clear: "Thou shalt not crucify mankind upon this cross of paper money!" The world was quietly submerged in a sea of worthless paper.

The debasement of the dollar that started in 1971 has reached unprecedented proportions in American history. As a side effect, the labor movement in the United States was greatly weakened, unions getting decertified as bargaining agents by the hundreds, in no small measure because labor leaders have failed to stand up for the monetary provisions of the Constitution. This was a betrayal not only of the Constitution, but also the traditions of the labor movement, as shown by the leadership of Ely Moore, the first union official ever to have been elected to the Congress in 1834. The ploy of turning the Constitutional monetary regime into a paper-mill aimed at depriving wage-earners of their right to wages payable in silver and gold coins has succeeded beyond the wildest dreams of its authors. There was not one single labor leader, in 1971 or since, to protest and to initiate a public debate exposing the unconstitutionality of this high-handed and arrogant way of trampling on the people's most elementary rights.

### Tormenting Widows and Orphans

In forcing the issue and circulation of small bank notes the government has singularly failed in its solemn task to protect property rights of ordinary citizens against the crime of fraudulent bankruptcy. Traders in the bill market do not need government protection.

They make it their business to keep themselves informed about credit conditions, the credit-worthiness of merchants who draw and accept bills of exchange. It is the wageearners and other people of small means, the savers and, above all, the widows and orphans, who are in need of protection. They cannot be expected to have a clear notion of the risks involved in accepting bank notes purportedly equivalent to the gold coin. They cannot be expected to understand the intricacies of monetary circulation. They cannot be expected to realize that the privileged banks may indeed cheat the public by loading their portfolios with illiquid assets of dubious value. They cannot be expected to know about illicit interest arbitrage, balance sheets, matching maturities, borrowing short to lend long, or about a hundred technical tricks of the banking business which may adversely affect their financial well-being in the absence of gold and silver coins in circulation.

They can hardly be expected to understand the legal concept of fraudulent bankruptcy through which they stand to be victimized, not only by the banks, but also by the government, their alleged Lord Protector.

It is this failure of the government to protect the property rights of the economically weak and defenseless, against unsound banking practices that has subsequently adulterated the gold standard and created monetary and economic havoc. The circulating gold coin and uninhibited access to it is all the protection widows and orphans, wage-earners and others may ever need to protect their property rights. With gold coins at their disposal they were the unquestioned masters, the sovereign savers and consumers, holding vetopower over the distribution of loanable funds, and the disposal of the social circulating capital, as well as other banking decisions. Bereft of the circulating gold coin, they no longer need to be consulted and, worse still, their protection against plunder is gone. With the removal of the gold clauses from government bonds, they have become the prime target to be victimized by deliberate currency debasement and devaluations. In abandoning them to their fate, the government has ignored the repeated admonition to the tormentors of widows and orphans in the Bible.

The government is bringing upon itself the Biblical curse that all those found guilty of this crime that "cries to heaven" are predestined to suffer.

### Theory of Reflux

Not only did the government fail to protect legitimate property rights, but it became an accomplice in allowing insolvent banks to declare bankruptcy fraudulently. There is no need for government regulation of bank notes in circulation. Before they were given privileged status, the banks had not been in the position to 'overissue' their bank notes.

The unwanted bank notes flowed back to the issuing bank, and would be exchanged for gold or for highly marketable earning assets such as bills of exchange. In the absence of special privileges, the public would regulate the quantity of bank notes in circulation.

This "theory of reflux" was criticized by Ludwig von Mises and other monetary scientist, who ridiculed the idea that the public can regulate the quantity of bank notes in circulation. They argued that even redeemable bank notes stay permanently in circulation and can cause mischief. However, these critics ignore the fact that the theory of reflux refers to bank notes of large denomination only. Their holders will have them only as long as necessary, and will exchange them for earning assets or for gold as soon as practicable. To assume that bank notes of large denomination can stay in circulation indefinitely contradicts the basic assumption of rational behavior of actors in the market place, led by an 'invisible hand' to protect their own interest.

Mises and other critics of the theory of reflux confuse this problem with an entirely separate one, namely, the problem of small bank notes which, indeed, stay in circulation indefinitely after they have been issued. People of small means, who have been coaxed out of their possession of silver and gold coins, will hold them as a form of saving. Later on, bank notes issued by private banks have been adorned with government stamps and embellished with signatures of government officials to foster the public's (mistaken) belief that, even if there were crooks in the privately owned banks, the government was surely above the crime of fraudulent bankruptcy. Holding bank notes of small denomination as a form of saving was safe in the public's eye.

Critics also ignore the role of special privileges of banking institutions in discouraging the reflux. To the extent that they enjoy privileges the circulation of bank notes cannot be considered free. Bank notes of small denomination get into the hands of the great masses of people who know nothing of the need for protecting their savings through the redemption of idle bank notes. Using subtle (and sometimes not so subtle) methods the privileged banks can easily dissuade their small depositors and holders of small bank notes from exercising their right of redemption. If gentle dissuasion is not enough, the government is not far behind to help protect the interest of the privileged banks against that of the public by less gentle means. The legal obligation to redeem small bank notes

(or any bank note) in gold could be abolished by a government edict while still maintaining the pretense of a gold standard under the euphemism of gold bullion standard (respectively, gold exchange standard), as it was done in several countries including Britain in 1925 (respectively, in the United States in 1934). The history of bank notes clearly shows that governemnts are led by considerations other than protecting the legitimate interest of their citizens and creditors against fraud, upholding property rights, and the sanctity of voluntary contracts.

### Sources of Government Conduct Regarding Money and Banking

There is no valid reason why governments should exempt banks from the full weight of the provisions of contract law. There is no valid reason for granting special privileges to banks and other financial institutions. There is no valid reason for introducing and maintaining a double standard of conduct - one for the privileged banks and another for everyone else. There is no valid reason for granting privileges without imposing countervailing responsibilities.

The real sources of government conduct regarding money and banking are not hard to find. The government, notwithstanding its profession of high democratic ideals and dedication to public service, is first and foremost interested in perpetuating and aggrandizing its own power - most often by allying itself with a powerful minority against the interest of the powerless and ignorant majority. This matter is certainly not allowed to enter the domain of party-politics. With the rarest exceptions, the governing party is in collusion with the opposition party over the issue of exploiting the ignorance of the powerless majority on all matters pertaining to money, credit, and banking. The party in opposition expects to assume power before long; it is not going to spoil the broth that is cooking not only for the benefit the present incumbent, but also for that of future incumbents as well. Bank regulation, special privileges and exemptions granted to banks are ideally suited to throw dust into the eyes of the public.

### From Double Standard to Double Dealing

As suggested by John Maynard Keynes, only one man in a million may understand the subtlety of pauperizing people through the legalization of fraudulent bankruptcy, deliberate currency debasement, and in depriving people of small means of the protection of the gold coin. The past three hundred years, ever since the introduction of central banking in England, bear eloquent witness to this proposition. There is no length governments would not go on the slippery road of subverting voluntary contracts, breaking solemn promises, defrauding their own citizens and creditors when it comes to aggrandizing their own power. Moreover, all this is done in such a way as to maintain the pretense of legitimacy, even the high-mindedness of government action. The villain of the piece is always outside the government, the speculators, the arbitrageurs, the hoarders of gold and silver, the traders in foreign exchange, managers of productive enterprise they are the ones who display unpatriotic behavior and greed. They are the ones who must be punished for their 'anti-social' behavior. The party in power would never admit, and the party in opposition would never charge that this witch-hunt is designed to find scapegoats and pull the wool before the eye of the public.

The government has been successful in confusing the issue. Not only did the public fail to see the self-serving and self-aggrandizing intention: the government's image as the benevolent protector and the source of countless public benefits was preserved intact, if not enhanced. The truth, however, is that in the domain of contract law, money, banking, and credit, governments have always applied a double standard. Their motto is: "Do as I say, not as I do!" Governments did not stop at introducing double standards. They went on to use them as the basis for double dealings.

### Present versus Future Goods

Credit involves exchanging present for future goods. It is therefore essential for us to clarify where the dividing line between the two lies. I wish to return to what in Lecture 7 I called a mistake of Mises not to recognize clearing as a source of credit (Mises on Fiduciary Credit). In the Theory of Money and Credit he states: "A person who accepts and holds a [bank] note grants no credit; he exchanges no present good for future good . . . The [redeemable bank note] is a present good just as much [as the gold coin]" (op.cit., p 304-305). Elsewhere in the book Mises emphasizes the gratuitous nature of credit. The act of issuing a bank note (or creating a bank deposit) imposes no sacrifices on the part of the bank - apart from the insignificant cost of printing and book-keeping - so that, in this view, the bank has the power to create present goods virtually out of nothing.

This notion appears to be at odds with the author's well-known position that it is ludicrous to believe, as inflationists would have us believe, that the government can create wealth out of little scraps of paper by sprinkling some ink on them. But if the banks can do it, why can't the government?

You might argue that this latter view Mises expressed later, and it is not fair to set the contrast between two views of an author expressed half a century apart. Indeed, it wouldn't be fair if Mises had recanted his view he expressed in the 1912 first edition, that a bank note is a present good. But I found no trace of any intention to recant in later editions. I am at a loss to explain why Mises himself, or Mises scholars, have failed to focus on this apparent contradiction. I shall be grateful for any hints that can help dispel the mystery. It is possible that Mises, who was a careful thinker, dismissed the problem as a necessary semantic compromise. However, the problem is real and cannot be conjured away through semantic disputes. It goes right to the heart of the theory of money and credit. It will come back to haunt when we are ready to develop the theory of interest. If we blot out the difference between a present good and a promise to deliver a present good to bearer on demand - as Mises appears to be doing - then we give a powerful incentive to the banks and the government "to keep up the good work", and continue to create through credit expansion present goods out of nothing to abolish scarcity for the benefit of society. As we know, this is what the banks and the government have been trying to do in the twentieth century, with disastrous results.

### When a Liability Ceases to Be a Liability

Of course, Mises acknowledges the fact that the bank note issue is a liability of the bank and it must be so represented in the balance sheet (op.cit., p 305). I have dealt with this argument already in my Lecture 8 (The Holder of a Bank Note Is a Creditor to the Bank), and I wish to return to the problem once more. There are many other problems arising out of the assertion that a bank note as a present good. They gain new relevance now, in view of the accounting scandals on Wall Street. According to Mises the bank note is a 'present good' which, nevertheless, is a liability at the same time. Therefore the bank note is the only present good in our experience from which the 'producer' cannot walk away, it being also a liability. This does not seem to agree with our common-sense idea of a present good which, one may assume, should not be so encumbered. The producer of a present good ought to have unconditional right of disposal, including the right of walking away from it.

We may try to solve the problem by ruling that the bank note is a present good in the hand of the public, but not in the hand of the bank. But this line of argument raises awkward questions how it is possible that, of two bank notes with identical physical attributes, one is a present good and the other is not, and those attributes could not give you a clue to which of the two kinds it belongs. Actually, Mises maintains that the bank note is a present good in the hands of the issuing bank. It could be put into circulation even without loan transactions, e.g., by purchasing supplies or services with it.

But then it is legitimate to ask at what point in time the bank note has become a present good. Perhaps it was the moment the ink dried on the paper; or the moment when the bank took delivery of their shipment from the printing-shop. Either answer is unsatisfactory. In the latter case we would, once again, look at two identical bank notes one of which is a present good and the other is not. The former is even more awkward because it suggests that it is the printer, not the banker, who has the power to create present goods out of nothing.

Mises suggests that looking at the balance sheet does not reveal the true nature of the process of making a present good out of the bank note. A better approach is to go to the profit-loss account where we find a tell-tale entry: profit on loans. Since the profit accrues to the bank, and not to the holder of the bank note, Mises concludes that, in issuing the note the bank is granting credit rather than seeking it. And by the act of granting it, the bank has created a present good out of nothing, in the form of a bank note.

Upon closer scrutiny, we are still not closer to the solution of the problem. How do we know that the bank's profit is legitimate? Perhaps it is the result of extortion, and the bank is just pocketing it without having good legal, ethical, or economic title to it. In the last Chapter of The Second Greatest Story Ever Told I shall tell you about the Acceptance House that has conspired with the issuers of fictitious bills of exchange, and pocketed the difference between the rate of interest and the discount rate - a case of extortion. Could it be that the Acceptance House is the precursor of the illegitimate business of the banks of issue?

### Reference

Ludwig von Mises, The Theory of Money and Credit, Indianapolis (Liberty Classics),

1981

---

### Do Not Give in to Evil, but Proceed Ever More Boldly Against It

Bill O'Connor SanBill@aol.com tells me that I have the "wrong approach". He writes: "Sir, your intellectual approach will never work. It is a little like reading the Ten Commandments to Big Al Capone while he is in the midst of a bank stickup. The only thing we have on our side is time - if we live long enough. Bill.

Bill, I am addressing the younger generation. I am not preaching to the culprits. I will have achieved my goal if the young people start thinking about these problems. You are right in saying that time is on our side. I hope that by telling it as it is time I can shorten it.

It is part of our Western cultural tradition not to give in to fate as if it was inevitable, but fight evil by all means at our disposal, and redouble our efforts when our situation looks most forlorn and hopeless. This is also the characteristic of being human: we do it even if we know we shall not live long enough to see and enjoy the result of our efforts. I guess this is the meaning of the lifetime motto Ludwig von Mises chose as a student from Virgil: "Do not give in to evil, but proceed ever more boldly against it."

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand's Hymn to Money

### Lecture 2: Don't Fix the Dollar Price of Gold

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told; (Chapters 1 - 3)

### Lecture 6: The Invention of Discounting; (Chapters 4 - 6)

### Lecture 7: The Mystery of the Discount Rate; (Chapters 7 - 8)

### Lecture 8: Bills Drawn on the Goldsmith; (Chapter 9)

### Lecture 9: Legal Tender. Bank Notes of Small Denomination

### Lecture 10: Revolution of Quality; (Chapter 10)

### Lecture 11: Acceptance House; (Chapter 11)

### Lecture 12: Borrowing Short to Lend Long; (Chapter 12)

### Lecture 13: Illicit Interest Arbitrage

## Fall Semester, 2002

### Monetary Economics 201: Gold and Interest

### Lecture 1: The Nature and Sources of Interest

### Lecture 2: The Dichotomy of Income versus Wealth

### Lecture 3: The Janus-Face of Marketability

### Lecture 4: The Principle of Capitalizing Incomes

### Lecture 5: The Pentagonal Structure of the Capital Market

### Lecture 6: The Definition of the Rate of Interest

### Lecture 7: The Gold Bond

### Lecture 8: The Bond Equation

### Lecture 9: The Hexagonal Structure of the Capital Market

### Lecture 10: Lessons of Bimetallism

### Lecture 11: Aristotle and Check-Kiting

### Lecture 12: Bond Speculation

### Lecture 13: The Blackhole of Zero Interest

## In Preparation: Courses To Be Offered In

2003

Monetary Economics 201: The Bill Market and the Formation of the Discount Rate Monetary Economics 202: The Bond Market and the Formation of the Interest

### Rate

---

# Monetary Economics 101 — Lecture 8: Bills Drawn on the Goldsmith

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-101-lecture-8-bills-drawn-on-the-goldsmith/
Date: 2002-08-19
Section: Money & Credit
Difficulty: intermediate
Concept Tags: real-bills, gold-standard, bills-of-exchange, sound-money
Description: Fekete traces the evolution of the bill of exchange from medieval merchant finance to the goldsmith's note, showing how gold-backed credit emerged from voluntary commercial practice rather than government decree. The goldsmith's bill is the prototype of honest money: backed by specific goods, self-liquidating, and competitive.
Editorial Note: Lecture 8 of Monetary Economics 101 (Gold Standard University, 2002). Historical account of how private gold-based credit emerged, setting the stage for the later lectures on the destruction of the real bills market by central banking.
Original PDF: https://professorfekete.com/articles/AEFMonEcon101Lecture8.pdf

### Lecture 8

## The Bills Of The Goldsmith

- The Second Greatest Story Ever Told, Chapter 9 - Marketability of Goods M The Marketability of Paper - The Goldsmith as Banker -

### Evolution of Marketability

I dedicate this Lecture to the memory of Carl Menger (1840-1921), monetary scientist; the founder of the Austrian School of Economics; author of the greatest book ever on economics (Gundsätze der Volkswirtschaftlehre, 1871, translated into English under the title Principles of Economics); one of the discoverers of the concept of marginal utility.

He also introduced the concept of marketability upon which the theory of money and credit rests.

"The differences in the degree of marketability is of the highest significance for the theory of money. The failure to recognize this is one of the essential causes of the backward state of monetary theory. The theory of money necessarily presupposes a theory of marketability of goods."

### (Carl Menger On the Origin of Money, 1892)

In the next Chapter of The Second Greatest Story Ever Told we shall see that the bank note originated, not as a fraudulent warehouse receipt issued by the goldsmith against non-existent gold, but, quite legitimately, as a bill of exchange drawn on and accepted by the goldsmith. Just as the market promoted gold to the station of money through the evolution in its marketability, so the goldsmith's bill was promoted and became the bank note, through a similar evolution in its marketability among bills of exchange.

Chapter Nine in which the gentle reader learns why the traders picked the bills of the goldsmith Traders at the Discount House noticed that the bills drawn on and accepted by the goldsmith behaved quite differently from other bills. Although they were, just as any other bill, maturing within 91 days, they were coming back to the goldsmith after a few weeks or even a few days of circulation. Not as if anything about them was suspect. On the contrary: the bills were 'too good'. They circulated too fast.

Further circulation was hampered by the limitation of space on the back used for endorsements. When the bill's back was filled up with signatures, it had to be returned to the goldsmith who substituted another one with a 'clean back'. As this was a nuisance, soon the goldsmith solved the problem with a clever innovation. He instructed his suppliers that they bill him with the legend "payable to bearer" on the face of the bill. This innovation eliminated the necessity of endorsing, and the goldsmith's bearer bills were taken in and paid out almost with the same ease as were gold coins.

Then the goldsmith made a second interesting discovery. Now his bearer bills kept coming home 'late', sometimes weeks or even months after maturity. This was completely unknown in the experience of other merchants some of whom tried, unsuccessfully, to imitate the goldsmith in issuing bearer bills. Traders at the Discount House explained the mystery. As most people were holding the goldsmith's paper only for a fraction of a day, they did not bother calculating and charging the negligible discount due to them. The goldsmith's paper mostly changed hands at face value. In effect, the market segregated the bills according as the acceptor was the goldsmith or someone else. The goldsmith=s bearer bills were no longer treated as an earning asset but, rather, as a surrogate of the gold coin, which was easier and safer to carry and to transfer. These bills circulated very fast indeed, even faster than the gold coin itself. Other bills were circulating much more slowly, as they were sought after mainly as an earning asset by merchants in their slow season who wanted to participate in the earnings of their colleagues in their high season.

The promotion of the goldsmith's paper was a spontaneous development. It had no roots in legislation, government patent or monopoly (nor in the lobbying activity of the Goldsmiths' Guild). The reason was also clear. A bill is considered more marketable if the drawer stands closer to the head of the line waiting for the consumer=s gold coin. Thus the bill drawn on the clothier was more marketable than the one drawn on the weaver, which in turn was more marketable than the bill drawn on the spinner. Now the bill drawn on the goldsmith was more marketable than any one of those for the simple reason that the goldsmith was working with the very material of which the standard of value was made.

Soon enough people were making new demands on the goldsmith that were quite unrelated to his trade. Those who had to make several smaller payments but had only one large bill in their possession came to the goldsmith asking him to 'break' their large bill. Thereafter the goldsmith issued his bearer bills in standard denominations of \$100, \$500, \$1,000. He then balanced the liability arising out of this issue not by gold coins but, at least in part, by large bills drawn on other merchants that have been presented to him for 'breaking'.

In an unrelated development, the goldsmith dropped the maturity date on his standard-denomination bills, as it served no useful purpose any more. The maturity date was replaced by the legend "payable to bearer on demand". These were called the goldsmith's "bearer sight bills", the precursors of the bank note.

The market process promoting the bill of the goldsmith to become the most marketable paper in the bill market was analogous to the market process that had earlier promoted gold to become the most marketable good in the commodity market. The latter was studied by Carl Menger in his seminal paper On the Origin of Money in The Economic Journal, in describing the concept of marketability.

There is a phenomenon which has from old and in a peculiar degree attracted the attention of social philosophers and practical economists, namely, the fact that certain commodities became universally acceptable as media of exchange. It is obvious even to the most ordinary intelligence that a commodity should be given up by its owner in exchange for another more useful to him. But that every economizing individual should be ready to accept a certain commodity . . . even if he does not need it, or if his need for it is already satisfied, in exchange for all the goods he has brought to the market, while it is none the less what he needs that he first consults when acquiring goods . . . has been considered >outright mysterious - even by such a distinguished thinker as Savigny . . .

The difficulties of barter would have proved insurmountable obstacles to the progress of trade, had there not lain a remedy in the very nature of things, to wit, the various degrees of marketability (Absatzfähigkeit) of commodities. The differences in this degree are of the highest significance for the theory of money. The failure to recognize this is one of the essential causes of the backward state of monetary theory. The theory of money necessarily presupposes a theory of marketability of goods.

The person who wishes to acquire certain definite goods in exchange for his own is in a more favorable position if he first exchanges his own wares for highly marketable goods.

Then, through a second exchange, he can more easily acquire the goods he wants . . .

Men have been led, with increasing knowledge of their own individual interest, without convention, without legal compulsion, nay, even without any regard to the common interest, to accept highly marketable goods in exchange for their wares . . . The most highly marketable goods have thus become, over a considerable period of time, the generally acceptable media of exchange . . . (Op.cit., p 239-255.)

The most marketable good that, through the evolution described by Menger, has ultimately become the generally acceptable medium of exchange, is gold. In the bill market an analogous evolution has promoted the goldsmith's paper to become the bank note, the most widely acceptable form of a bill of exchange. Even though all properly constructed bills showed a high degree of marketability, there was a difference. Some bills lacking a high recognition value might be less negotiable, their discounting might run into problems, and they might have difficulty in circulating.

### What Is Involved in Selling a House?

Take the case of selling a house. As we shall see, the exchange involved in this sale is quite a bit more complicated than it may appear at first sight. It involves no fewer than five different exchanges, until the deal is complete. I wonder how the finer details in such a common deal as the sale of a house could have escaped the scrutiny of economic theoreticians.

The buyer and the seller of the house agree on a closing date by which the seller can vacate it and the buyer can come up with the full purchase price. Suppose the closing date is two months away. The buyer expects that in two months he can liquidate some of his investments, say stocks, which will enable him to cover the price of the house. He knows that a nearby closing date may not let him get the best price for his investment, due to the limited marketability of stocks. On his broker's advice he needs about one month to get the best price. After one month the buyer of the house sold the stocks and received bank notes in exchange. As he realized that holding such a large amount in the form of bank notes for one month would involve him with a loss of income, he decided to get a bill to mature in a month or more to derive an income on his funds for the interim period. On the day of closing the deal, the buyer of the house discounted his bill. Since this was a highly marketable paper, he knew he would be able to do it on any day of his choosing.

He discounted his bill against payment in the form of bank notes. There was no question about the acceptability of this instrument by the seller of the house, since the bank note was the most marketable paper there was. Later in the day the buyer of the house, in his turn, exchanged the bank note for another bill of exchange maturing in three months. He wanted to earn an income while he was finding a suitable investment for his funds.

Ultimately, he wanted to invest the proceeds from the sale of the house in bonds. They earned a higher income than bills, but they were not as marketable. It would take time get them at the best price. The bond dealer suggested to him that a new issue would be floated in three months. After three months he used the proceeds of the 3-month bill to pay for the bond.

We can see that the sale of the house took six months and five exchanges to complete. All five exchanges involved the bank note, the common purchasing medium. The five exchanges were: (1) selling the stocks, (2) buying the 1-month bill with the proceeds from the sale of the stocks, (3) paying for the house with the proceeds from the sale of the 1-month bill, (4) buying the 3-month bill with the proceeds from the sale of the house, (5) paying for the bond with the proceeds from the sale of the 3-month bill. At that point the market agitation caused by the sale of the house came to rest.

We can see that the goldsmith's bearer sight bill, alias bank note, plays an important role in facilitating the purchase or sale of real estate, stocks, bonds, bills, etc. The goldsmith through his money-changing business has become a banker. His bank notes were considered mature bills (sight bills) which could be exchanged for gold coins on demand at any time. There is no fraud involved. The bank note is not a warehouse receipt for gold on deposit. It is a bill of exchange that the market has promoted to the station of medium of exchange, for being more marketable than any other. People were happy to hold it, especially if they needed ready cash on hand for unexpected purchases, and they willingly paid for its use in the form of foregone discount. They were paying for the convenience to use a paper surrogate of the gold coin, in applications where the direct use of the gold coin would be less convenient.

### Where Paper Cannot Deputize for Gold

The bank note could be used as cash universally. The question arises whether it could serve as a surrogate of the gold coin in every application. Mises gives an unconditional "yes" as the answer. My answer is that there are several applications where it could not, two of which I have already mentioned earlier. The consumer must have gold coins, rather than bank notes, to pay for consumer goods the production and distribution of which has been financed with bills of exchange (or, what is the same to say, to buy goods belonging to the Social Circulating Capital). The gold coin is the consumer's 'ballot paper' with which he casts his vote on a daily basis, conveying a message of his satisfaction or dissatisfaction with their services to the producers and distributors of consumer goods.

(See Lecture 2.) He must have the gold coin, otherwise he would be deprived of his right to vote.

Another example where paper cannot deputize for gold is the payment of a bill of exchange at maturity (see Lecture 6, Chapter Five), for the same reason that a bill cannot be settled at maturity by redrawing it, and 91 days is the absolute limit for its maturity. In order to safeguard the integrity and solvency of the clearing system, gold coins must be used for this purpose. The gold coin in the possession of its ultimate guardian, the sovereign consumer, will retire the real bill at maturity.

A third and most important exception will be discussed in my next course in this series entitled Gold and Interest, to start in the Fall Semester. In it I shall introduce a character called the "marginal bondholder". He is the first to sell his bond when the rate of interest drops. He finds the low rate unrealistic and unacceptable. He is willing to take profits on his holdings of bonds, keep the proceeds in gold, and buy his bonds back at a lower price when interest rates rise again to a reasonable level.

If he were to accept the bank note instead of the gold coin in exchange for his bond, then he would be jumping from the firing pan into the fire. He must insist on payment in gold if he wants to assert his time preference, in protest against unreasonably low interest rates. Incidentally, as we shall see, this is a point that escaped David Ricardo as well as Ludwig von Mises. Mises specifically says that "claims [to gold coin] are complete substitute [for the gold coin] and, as such, are able to fulfill all the functions of [gold coins] in those markets where their essential characteristics of maturity and security are recognized" (op.cit., p. 300, emphasis added).

### Circulation of Bank Notes

The bank note, as I have mentioned already, is the most marketable among the bills of exchange. It is assumed that the banker (originally the goldsmith) holds a blend of gold and maturing real bills against this liability. As a bill matures in his portfolio, he has to follow one of three possible courses of action. Either he replaces it with its face value in gold coins; or he can discount an equivalent amount of fresh bills. As a third possibility, he may also retire an equivalent amount of bank notes from circulation. If he fails to do one of these things, then the bank note becomes a phony bill, and the banker a counterfeiter, just as the goldsmith in the fable who would issue fraudulent warehouse receipts against non-existent gold.

There is no mystery about the circulation of the bank note which, unlike a bill of exchange, is not an earning asset. It circulates because it satisfies a need very different from that of the bill of exchange. Unlike bills that cannot circulate after reaching maturity, that is, after they cease to be an earning asset, bank notes circulates indefinitely.

I have expressed this by saying that the bank note is a sight bill. It is more versatile and convenient than other bills. It relieves the holder of the chore of keeping track of the various maturity dates. It is accepted as hand-to-hand money without the need to check the credit standing of the drawer and acceptor at every time a payment is received. (It goes without saying that the banker must have an impeccable name.)

Combining the business of the goldsmith with that of the money-changer was no fraud.

As long as the bank note in circulation is properly backed by gold or by maturing real bills, there is no counterfeiting involved. The superficial similarity between the goldsmith's bearer sight bill (the bank note) and the warehouse receipt representing gold deposited for safe keeping (the gold certificate) is misleading. Both instruments are promises to pay bearer so much gold on demand. But the difference, although less apparent, is far more significant. The bank note is not specific about the asset held against its issue, that could be gold, or real bills, or a blend of the two. The gold certificate, on the other hand, explicitly states that a specified number of gold coins are held on deposit to balance the liability. The legal and economic differences between these two instruments were well-understood by the goldsmith's creditors. They trusted the goldsmith that he would balance his liability represented by the bank note with a blend of gold coins and maturing real bills drawn against consumer goods in urgent demand. On the average, one-ninetieth of the real bills in his portfolio would mature every single day, bringing in more than enough gold coins to satisfy normal demand for converting bank notes. Holders of the goldsmith's paper also knew that the marketability of the assets in the goldsmith's portfolio guaranteed that even abnormal demand for gold coins could be met. The goldsmith could discount his bills with people in need of earning assets, or at the Discount House. Thus real bills could be liquidated at any time, virtually without loss.

Bank notes were safe, and their issue did not give rise to credit expansion, as charged by Mises. For each bank note of face value \$1,000 issued, the goldsmith had to withdraw \$1,000 worth of real bills from circulation. For each \$1,000 loan issued to a merchant in the form of a bank note, the banker would put the bill of exchange drawn on the merchant into his portfolio C a bill which, with a little more trouble, the merchant himself could put into circulation.

### Run on the Bank - Wages of Dishonesty

There are those critics who assert that the removal of the maturity date from the goldsmith's bearer bill was a high-handed act. In any case, these critics say, it is impossible to make good on the goldsmith's promise if all the bearers of bank note show up at the cashier's window at the same time demanding gold. Critics conclude that the goldsmith's promise to pay bearer gold on demand is dishonest. It cannot be made good.

As a proof, they cite the periodic runs on banks, the suspensions of convertibility, and the 'bank holidays'. They assert that the so-called >fractional reserve banking' is unworkable and dishonest.

This is not a frivolous criticism, and it deserves a careful answer. The problem is in the double standard the government has in contract law. It gives special protection to banks, but not to other firms involved in bankruptcy. The government does this in return for the banks' cooperation in sheltering illiquid government paper in their portfolio. Unlike the bill of exchange, the government's treasury bill would not circulate. As part of a sweetheart deal, the banks would discount them along with the commercial bills of exchange. Incidentally, the real cause of bank runs is: illiquid assets such as treasury bills in the bank portfolio.

In the sequel we assume that the banks decline the government's request to discount treasury bills. In that case the phrase "fractional reserve" is a misnomer. The issue of bank notes is fully backed by reserves consisting of gold coins and bills of exchange maturing into gold coins. Nevertheless, it is true that if all holders of bank notes wanted gold from the bank simultaneously, there would not be enough to satisfy demand simultaneously. But what is the probability of this happening? In order to find the answer to this question we have to make certain assumptions about the intention of customers withdrawing gold. It is reasonable to assume that the majority wants gold because they would like to purchase earning assets. This part of the demand for gold presents no problem, as in retiring the bank notes the bank can sell an equivalent amount of earning assets. Other holders of bank notes may need the gold to make remittances abroad. This part of the demand presents no problem either. As the banks liquidates an equivalent amount of real bills from its portfolio, it is pushing up the discount rate at home relative to those prevailing abroad. Foreigners will find this country an attractive place where to buy real bills and, as a result, the gold will stay in domestic circulation. This leaves us to deal with the third and last group of holders of bank notes: those who are withdrawing the gold coin in protest against low interest rates. As long as this third group is a small minority, the bank can survive the run. It will sell a sufficient amount of assets in order to pay the holders of its bank notes in gold coins. Losses, if any, can be covered by canceling the shareholders' dividend for the quarter.

Thus the problem boils down to the case where a majority of people holding bank notes want to register a protest against low interest rates by demanding gold. If this protest is in response to the bank's hiding illiquid assets in the balance sheet, then, indeed, dishonesty is involved, and the run on the bank is just the wages of dishonesty. The protest is legitimate, and the resulting 'shortage' of gold is just a reminder who the boss is and what he thinks of the credit policy of the bank. The run is not an instance of a malfunction of the gold standard, nor is it a proof that commercial banks cannot operate on the basis of real bills as liquid earning assets backing the note issue. Quite to the contrary: it shows that the gold standard is functioning exactly as it is supposed to. The public has the gold stick, and is using it to force the bank to play by the rules. We are justified in suggesting that virtually all the runs in the history of commercial banking have been of this type.

### Stocks or Flows?

We shall now assume that the bank plays by the rules and it is not under pressure to monetize government debt, and that bank notes and deposits are balanced exclusively by gold and self-liquidating real bills. Can a run on the bank develop under those circumstances? History provides no guide in this regard: commercial banks have always been under pressure to monetize government debt. All we can say is that the possibility of a run on the bank is extremely remote. While remote, it cannot be ruled out. In order to put the problem in the right perspective we must look at analogous situations wherein the potential demand to use a facility, should it present itself simultaneously, cannot be met.

There are many such cases. It is true that the George Washington bridge joining New York City to New Jersey could not meet the potential demand if all the people living in the vicinity wanted to cross it simultaneously. Was it therefore a mistake to build the bridge in the first place? Of course not! Is the Port Authority acting dishonestly when it posts toll charges and promises the right to pass on demand, 24 hours a day and 365 days a year, against the payment of the toll? Of course not! All bridges, roads, railways, ferries, elevators, etc., are designed and constructed with the understanding that not all potential users will want to use it simultaneously.

Murray Rothbard advocates 100 percent gold reserves banking 'to eliminate dishonesty' in the promise to pay gold to the bearer of bank note on demand. Apart from the fact that there is no dishonesty in the promise as long as the bank is run properly, as explained above, even the 100 percent gold reserve would not remove the contingency that requests for redemption cannot be honored. There is always a remote possibility that an act of God, or human error, might temporarily prevent the bank from making good on its promise. In the realm of human existence no promise is ever free from such contingencies even if it is not explicitly stated C nor does honesty have anything to do with it.

The notion that the bank's promise, if it is to be honest, forces it to have a store of gold on hand equal to the sum total of its note and deposit liabilities stems from a fundamental confusion between stocks and flows. The promise of a bank, as that of every other business, refers to flows, not stocks. The promise is honest as long as they see to it that everything will be done to keep the flows moving. In the case of the bank, the promise is honest as long as the bank carries only self-liquidating bills, other than gold, in the asset portfolio backing its note and deposit liabilities.

### "You Can't Imagine How It Pleased the People!"

If the goldsmith's creditors had ever had any doubts about the security and integrity of his money-changing business, then they would have accepted his bills only at a discount, or not at all. The financial annals fail to reveal an instance of a lawsuit filed against the goldsmith for fraud in misrepresenting sight bills as gold certificates or warehouse receipts. Such a charge, if one had been made, would have been thrown out of court with a remark from the judge to the effect that "plaintiff ought to familiarize himself with the difference between a promise and a certificate".

So did the Commercial Bank grow out of the goldsmith's money-changing business, and such was the evolution of the bank note from the bill of exchange. It is not possible to understand the circulation of the bank note without understanding that of the bill, and the evolution in the marketability of the bill of the goldsmith. The special status granted to the goldsmith's bill was free from government intervention and coercion (at least before the advent of central banking).

The goldsmith's money changing business was legitimate and honest. He offered his own bills, which were more convenient, more marketable, and more negotiable, in exchange for bills drawn on other merchants "which were less convenient, less marketable, and less negotiable." This was a genuine service for which people were willing to pay a fee in the form of foregone discount.

The truth is that the goldsmith's money changing business was the great success story of the Renaissance. It was not the beginning of the Great Fraud perpetrated on the people, aptly described in the famous paper-money scene:

Damit die Wohltat allen gleich gedeihe,

So stempelten wir gleich die ganze Reihe:

Zehn, Dreissig, Funfzig, Hundert sind parar.

Ihr denkt euch nicht, wie wohls dem Volke tat.

### (Goethe's Faust, Part two, Act one)

(For an English translation, see Lecture 4). The Great Fraud, the disenfranchisement of the laboring classes, and the commissioning of the Invisible Vacuum Cleaner, was to come later. It was done in three stages: (1) making bank notes legal tender, (2) introducing bank notes of small denomination, as Mephistopheles astutely noted in the Faust story, (3) inventing the Acceptance House. The next Lecture will deal with the first two; the third will be the subject of Lecture 11.

### The Holder of a Bank Note Is a Creditor to the Bank

When someone accepts a bank note he becomes a creditor of the bank issuing it. This is clear if we consider that the bank note is basically a bill of exchange and the holder of a bill is a creditor. Making it a bearer sight bill does in no way change the creditor-debtor nexus. Mises demurs: "A person who accepts and holds [bank] notes grants no credit; he exchanges no present good for future good . . . The [bank] note is a present good just as much as the money" (op.cit., p 304-305). The fact that the bank lists the bank note outstanding among its liabilities in the balance sheet does not make Mises to relent. He proves his contention by going, not to the balance sheet, but to the profit and loss statement which shows that the profit from the outstanding bank note accrues to the bank, not to the holder of the bank note. I cannot accept this argument. The profit arises from the discount that the holder of the bank note could collect, were it not for his conscious decision to forego it. He finds it more convenient to hold the bank note instead of the bill of exchange. He deliberately confers that profit, which could be his, to the bank, in exchange for a service that he considers more valuable.

Mises continues: "Is it then correct to say that when the bank discounts bills it does nothing but substitutes a convenient note currency for an inconvenient bill currency? Is the bank note really nothing but a handier sort of bill of exchange? By no means" (op.cit., p 307). In the rest of the argument Mises goes into the question whether the bank, in extending a loan in the form of bank notes, contributes to the demand for or to the supply of credit. If it is the former, then the bank's action tends to raise the rate of interest; otherwise it tends to lower it. Here we got to the bottom of the disagreement. Mises does not recognize the difference between the rate of interest and the discount rate. My position is that as long as the bank holds only gold and self-liquidating bills to cover the bank note issue, it changes neither the supply of nor the demand for credit. There is no change either in the discount rate or in the interest rate. The case where the bank holds less marketable assets to cover the bank note issue will be discussed in Lecture 11 on the Acceptance House.

---

### Mises by North

Dear Gary:

I am struggling with your statement that "money is not a measure of value" (Gary North, Mises on Money, Part I: Money, a market-generated phenomenon) supported by various quotations from Mises.

We are in complete agreement that the value of goods had its origin in the comparison of utilities to the individual, and under barter there was just no way to measure it, although values could still be compared, subject to the rules of ordinal arithmetic. But then, through the evolution in the marketability of goods, gold has been catapulted into the position of the most marketable good, money. Prices emerged for the first time, which could be compared as well as measured. They are subject to the rules of ordinal as well as cardinal arithmetic.

Mises admits that the emergence of money, prices, and "the opportunity for exchange induces the individual to rearrange his scale of values" (op.cit., p 61). This, I take it, means that he rearranges it to conform to the constellation of prices. Since another individual will rearrange his own scale of values to conform to the same constellation, the valuation of individuals becomes universal. Prices harmonize individual values. Mises says that "if we wish to attribute to money the function to measure prices, then there is no reason why we should not do so" (op.cit., p 62). Thus the standard gold coin is rightly called the unit of value, and the price is rightly called the measure of value.

I am a professional mathematician and through my long career I have been trying hard to convince my layman friends that mathematics is much more than a science of counting and measuring. In particular, it is also a science of comparing. A large branch of mathematics called lattice theory, which also embraces ordinal arithmetic, is devoted exclusively to the study of comparing (ordering). In a typical lattice one cannot measure for lack of a metric. But then, there are also metric lattices in which both order and metric obtain, and the metric is compatible with the order. In these lattices comparing and measuring are both possible.

The mathematician is quite comfortable with the idea that in the beginning there was no metric in his lattice. Later, to his delight, he found a way to construct one, moreover, the metric was compatible with the order. To express this formally, let A, B denote goods and let a, b denote their respective prices. Furthermore, let A d B mean that A is valued less than B. Then compatibility can be stated as follows: A d B if, and only if, a < b. If there was a pair of goods A, B such that a < b but A e B (meaning that A is valued more than B even though it is the cheaper of the two) then arbitrageurs would buy A and sell B, and keep doing it until the anomaly in prices disappeared. This refutes Mises' dictum that it is "unscientific [to] attribute to money the function of acting as a measure of price or even of value" (op.cit. p 61). Money does more. Through the market, money harmonizes individual valuations to become a universal valuation, applicable to all individuals, as manifested by the constellation of prices.

I would be grateful if you could show me the weak point in this argument.

Yours, etc.

### Antal

### References

Carl Menger, On the Origin of Money, The Economic Journal, June 1892. Reprinted by

### CMRE, 10004 Greenwood Ct., Charlotte, NC 28215

Ludwig von Mises, The Theory of Money and Credit, Indianapolis (Liberty Classics)

1981

Murray Rothbard, The Case for a 100 Percent Gold Dollar, Mises Institute, Auburn,

### Alabama 36832-4528

Gary North, Mises on Money, Part I (Introduction) January, 2002, [www.lewrockwell.com/north86.html](https://www.lewrockwell.com/north86.html)

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand's Hymn to Money

### Lecture 2: Don't Fix the Dollar Price of Gold

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told; (Chapters 1 - 3)

### Lecture 6: The Invention of Discounting; (Chapters 4 - 6)

### Lecture 7: The Mystery of the Discount Rate; (Chapters 7 - 8)

### Lecture 8: Bills Drawn on the Goldsmith; (Chapter 9)

### Lecture 9: Legal Tender. Bank Notes of Small Denomination

### Lecture 10: Revolution of Quality; (Chapter 10)

### Lecture 11: Acceptance House; (Chapter 11)

### Lecture 12: Borrowing Short to Lend Long; (Chapter 12)

### Lecture 13: Illicit Interest Arbitrage

## Fall Semester, 2002

### Monetary Economics 201: Gold and Interest

### Lecture 1: The Nature and Sources of Interest

### Lecture 2: The Dichotomy of Income versus Wealth

### Lecture 3: The Janus-Face of Marketability

### Lecture 4: The Principle of Capitalizing Incomes

### Lecture 5: The Pentagonal Structure of the Capital Market

### Lecture 6: The Definition of the Rate of Interest

### Lecture 7: The Gold Bond

### Lecture 8: The Bond Equation

### Lecture 9: The Hexagonal Structure of the Capital Market

### Lecture 10: Lessons of Bimetallism

### Lecture 11: Aristotle and Check-Kiting

### Lecture 12: Bond Speculation

### Lecture 13: The Blackhole of Zero Interest

## In Preparation: Courses To Be Offered In

2003

Monetary Economics 201: The Bill Market and the Formation of the Discount Rate Monetary Economics 202: The Bond Market and the Formation of the Interest

### Rate

---

# Monetary Economics 101 — Lecture 7: The Mystery of the Discount Rate

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-101-lecture-7-the-mystery-of-the-discount-rate/
Date: 2002-08-12
Section: Money & Credit
Difficulty: intermediate
Concept Tags: real-bills, interest-theory, gold-standard, monetary-policy
Description: Fekete investigates why the discount rate is always lower than the interest rate — a fact he calls 'the mystery of the discount rate.' He argues the gap reflects the superior liquidity of self-liquidating bills over time deposits, and that the Federal Reserve's collapse of this spread has made the monetary system dangerously illiquid.
Editorial Note: Lecture 7 of Monetary Economics 101 (Gold Standard University, 2002). Fekete's explanation of the interest-discount spread is one of the distinctive contributions of New Austrian Economics and a key critique of central bank policy.
Original PDF: https://professorfekete.com/articles/AEFMonEcon101Lecture7.pdf

### Lecture 7

*The Mystery Of The Discount Rate*

- The Second Greatest Story Ever Told, Chapters 7-8 - One Discount Rate or Many? - Arbitrage - The Rise and Fall of the Discount House -

### One Discount Rate or Many?

In the previous Lecture I explained how discounting bills of exchange was invented, how the discount rate appeared, and how changes in the propensity to consume made it go up or down. I also presented the important argument that the discount rate is entirely different in origin and nature from the rate of interest.

We still have one mystery to solve, namely the question: Is there one discount rate or are there many discount rates? Is the clothier discounting at one rate and the baker at another, or are all retailers discounting at the same rate? The next Chapter in The Greatest Story Ever Told will answer that problem.

Chapter Seven in which the gentle reader learns why the baker discounts at the same rate as the clothier

The clothier noticed that his success in trading bills of exchange attracted imitators.

The miller was also drawing bills on the baker and used them to pay the grain merchant for the wheat, after the bill was accepted by the baker. In holding the miller-on-baker bill the grain merchant was earning an income on his idle cash, just as the spinner, holding the weaver-on-clothier bill, was earning an income on his.

Both men knew that they could use their bills to pay their suppliers, or anyone else for that matter. They were also confident that if they ever needed gold coins for any reason, they could get them by discounting their bills with another merchant experiencing a temporary overflow of cash.

The clothier had a penchant for inquiry. He was anxious to find out at what rate the baker was discounting the miller's bills. Was it the same rate he was using himself, or a higher/lower rate? To his amazement he found that the baker was discounting at exactly the same rate. Whenever he had reason to change the discount rate, so had the baker, moreover, the adjustment was by the same amount and in the same direction. As there was no collusion, it appeared to the clothier that an 'invisible hand' was guiding them and made the adjustment every time a deviation between their respective discount rates was in the offing. The clothier was fascinated by his discovery and was determined to get to the bottom of it.

It came to pass that the summer was unusually dry and it did great damage to the cotton crop while actually helping the wheat harvest. The clothier noticed that his suppliers were anxious to discount their bills, in spite of the higher discount rate he was posting. They would rather take the gold coin instead of holding the bill.

Meanwhile the discount rate posted by the baker actually went down. The clothier's reaction was immediate and dramatic: he sold all the miller-on-baker bills in his portfolio and used the proceeds to buy back all the weaver-on-clothier bills that were still floating out there. He reasoned that the discrepancy between the discount rates must disappear by the maturity date at the latest, and he could pick up some riskless profits by the maneuver of getting out of bills discounted at the lower and getting into bills discounted at the higher discount rate. In other words, the clothier sold bills at the higher and bought them at the lower price, and expected to profit from the equalization of the discount rates.

The weaver was following these maneuvers of the clothier with fascination, and offered a bet. He was betting that the price of bread would go down as a result of the good wheat harvest, and the price of cloth would go up as a result of the disastrous cotton crop. His thinking was conditioned by 'conventional wisdom' asserting that a good crop means lower and a bad one means higher prices. The clothier won the bet hands down. There was no change in the price of the bread, nor in the price of cloth.

Moreover, the spread between the two discount rates completely disappeared.

The clothier would not kid himself that all this was due to his intervention in the bill market. He was candid enough to admit that other factors were at work, too. Cotton merchants from other regions not affected by the dry summer were attracted by the higher discount rate. They drew bills against their shipments of cotton to the area afflicted by the drought. Meanwhile, merchants back home were drawing bills against their shipment of grain to other places with a poor grain harvest, where the discount rate was higher. These operations called 'arbitrage' had the effect of equalizing the discount rates on cloth and bread. They also explained why there was no rise in the price of cloth, nor a fall in the price of bread. The spread in the discount rate attracted cotton to the area of shortages, and expelled grain from the area of surpluses. The reason for price changes disappeared before they could materialize.

### Arbitrage

The clothier deserved to win the bet since he had the better grasp of the fundamentals of bill trading. The weaver failed to understand that a discrepancy between the discount rates on cloth and on bread is an aberration that was bound to disappear in short order due to the arbitrage of those who understood the bill-trading process. Arbitrage means buying in one market while selling in another (the two markets may also be the same as a special case) motivated by the arbitrageur's expectation of a certain change in the spread The spread is defined as the difference between prices at which he has bought and sold. In our example, the weaver-on-clothier bill was bought at a lower and the miller-on-baker bill was sold at a higher price (due to a higher discount rate on the former and a lower one on the latter). By maturity the prices, on average, would be equalized. The arbitrage opportunity of which the clothier availed himself promised him risk-free profits.

Economists haven't paid sufficient attention to the spread and arbitrage, concentrating their efforts on the price and speculation instead. Yet the fact is that arbitrage and speculation are diametrically opposed to one another. The speculator takes large risks in the hope of large profits. The arbitrageur is not interested in increasing risks: he is interested in reducing them. The fact is that the price is subject to so much diverse and capricious influence that predicting its changes is a risky business. By contrast, spreads filter out a good many of these capricious effects on individual prices. Well-informed businessmen know this and, with a solid understanding of the economic factors they can spot the spreads that are out of line and predict in which direction they will move. In these Lectures I shall concentrate on the guiding star of business: the spread, and describe arbitrage as the principal form of human action, the tool par excellence of successful businessmen who provide the driving force behind the changing economic landscape.

In the previous Chapter we saw several examples of arbitrage, and I am asking you to study each one separately. In addition to buying the weaver-on-clothier bill at the lower, against selling the miller-on-baker bill at the higher price, we also saw that if wheat was cheaper in country A and a more expensive in country B, then the arbitrageur would buy it in A and sell it in B. Also, if the discount rate was higher in A and lower in B, then the arbitrageur would buy the bills drawn on country A (where bills were cheaper) and sell the bills drawn on country B (where bills command a higher price). Arbitrage is the most important tool to reduce risks in economic activity. The previous examples are related to inter-spatial arbitrage. Warehousing provides examples for inter-temporal arbitrage.

Take a grain merchant who buys grain in the fall to fill his grain elevators. His problem is that he will need an exorbitant amount of capital in order to be able to shoulder the risk that the price of his grain in the elevators might drop. He solves the problem by going to the grain futures market where he sells forward an equivalent amount of grain. Using another word, he is hedging his inventory of grain in his elevators. As he is selling grain from his elevators, he will lift a matching number of his hedges in the grain futures market. Hedging gives the grain merchant protection against falling grain prices. For losses on grain held in the elevator he is compensated by capital gains on the hedges.

Chapter Eight in which the gentle reader learns why the clothier was in such a hurry to go out of the cloth business Soon afterwards the clothier sold his store and went out of the cloth business. He had a better idea. He would trade bills drawn by one tradesman on another against shipments of consumer goods. The clothier was in a hurry. He assumed that other clever traders might be planning to do the same thing, and he wanted to get a piece of the action.

With a good grasp of the needs of tradesmen the clothier knew exactly where and when to buy bills, or where and when to sell them. He would buy bills drawn on a tradesman whose business was slack temporarily, but who were about to enter their high season. He would sell bills to tradesmen whose wares were moving pretty fast at the moment, but who were about to enter their slack season. In September he would buy bills drawn on the coal-merchant, and offer bills for sale to the grain merchant. The former was building up an inventory of coal for the coming winter heating season, and bills on coal were relatively cheap. The latter was drawing down his inventory of grain and was looking for liquid earning assets where he could park his idling circulating capital until the next harvest.

The clothier knew from his own experience that the inventory of bills in the portfolio of a retail merchant was complementary to the inventory of merchandise on his shelves. Both were earning assets to the retailer, albeit in a different way. The incomes from the two inventories see-sawed with the seasons. The retailer, while keeping the combined value of the two at about the same level, would let the mix vary with the change of the seasons. In this way the retailer could, with the help of the special bill-trading services offered by the clothier, mitigate or eliminate the seasonal character of his business. He would compensate for the decline of income in his low season by increasing the income from his bill-portfolio consisting of bills drawn on merchants in their high season. Then at the start of his high season he would draw down his inventory of bills and use the proceeds to build up his inventory of merchandise. As his income from the bill portfolio declined, so would his income from the inventory of merchandise increase.

The clothier called his new business the "Discount House". He also offered other special services to his clients, such as collecting the face value of bills at maturity from the acceptor. He was making a market in outstanding bills: he would be ready to buy bills from one client who unexpectedly found himself short of cash, or to sell bills to another who unexpectedly found himself with more cash than he needed for the conduct of his business.

### The Role of the Discount House

This is how the Discount House specializing in market-making for bills of exchange was born. It has extended the scope of bill circulation greatly. Of course, bills could circulate in the absence of the Discount House, too, but circulation would be limited to a small circle of merchants in business contact with one-another, such as the spinner, the weaver and the clothier. Now, with the intermediation of the Discount House, one merchant could buy the bill of another even if he was not personally acquainted with him. He relied on the expertise of the Discount House concerning the security of the paper he was buying. A lot of new businesses sprang up to satisfy the seasonal needs of the consumer which could not formerly prosper as a result of the exorbitant capital costs involved in carrying seasonal merchandise. These capital costs were now drastically reduced, as a result of the expansion of bill circulation, thanks to the operation of the Discount House helping to finance trade in seasonal consumer goods.

It may help us understand the bill market better if we contemplate that the market process in effect gives temporary and ephemeral monetary privileges to the bill of exchange drawn of fast-moving merchandise on its way from the producer and distributor to the consumer, as I have suggested earlier. Indeed, consumer goods circulate, and their circulation is fueled by two of the most important human instincts, survival and recreation. Monetary circulation of consumer goods in natura is hardly possible. Bills of exchange make consumer goods circulate by proxy, as it were. There is no risk involved in holding the bill. Payment at maturity is a virtual certainty. The underlying consumer goods are know to exist and to be in demand. Shortages of gold, real or imagined, will not hamper the liquidation of the credit drawn against the movement of consumer goods.

At maturity the consumer's gold coin will liquidate not only the liability of the last endorser of the bill, but that of all the previous endorsers as well. This is what makes the credit represented by the bill of exchange self-liquidating.

### The Highjacking of the Social Circulating Capital

Compare two scenarios: the first in which the Discount House operates in the absence of a Commercial Bank, and the second the other way round, in more details, the Commercial Bank is the only place where merchants can discount their bills which then become the earning asset of the bank. One might say that the two credit systems are economically equivalent. However, there is a significant difference. Full disclosure is achieved only under the first scenario. Here bills are openly traded: everybody is free to inspect all the bills offered for sale. Fraud is nearly impossible, as traders would quickly spot a bill drawn on a stalled good, or a higher-order good, or multiple bills drawn on the same merchandise. Nor would it be possible to 'roll over' a bill at maturity. There is transparency, every trade in the credit market is under public scrutiny, and every trader is an umpire who would blow the whistle if he saw an irregularity.

Under the second scenario "banking secrecy" covers up most information that the public should be entitled to have. The portfolio of the commercial bank may shelter a lot of illiquid or slow bills that the Discount House would reject outright, such as bills drawn stalled goods, or on higher order goods, or multiple bills on the same good. At maturity a bill may be redrawn, in other words, the absolute ban on extending maturity beyond 91 days could easily be violated under the cover of secrecy provided by the Commercial Bank. The temptation to cheat would be great.

But perhaps the most important shortcoming of the second scenario is in the perverse perceptions created, making the banker the boss and the tradesmen discounting their bills at the bank merely his clients dependent on his favors. In reality the tradesmen are the boss and should be so perceived, while the banker is their servant. After all, the credit being traded is rooted in the momentum of the consumer goods that the tradesmen are moving to the ultimate cash-paying consumer. The banker's job is not that of rationing credit, which is the ruling perception, but that of clearing it, shifting it from one tradesman who no longer needs it to another who does in the task of moving merchandise most efficiently from the producer to the consumer.

But it is this perverse world is what we have got. The Discount House has been forced out of business by the Commercial Bank in a coup. The latter has preempted the business of the former, taking over and monopolizing its functions. The Social Circulating Capital has been hijacked. Formerly it was under the sole control of the tradesmen moving consumer goods along to the consumer with all deliberate speed. The tradesmen used to recognize only the sovereign consumer. Now they cringe before their new boss, the banker, who in turn does not recognize the sovereign consumer. In this way the tradesmen, like the mythological hero Anteus, have been cut off from their natural source of strength, the Social Circulating Capital. The source of strength of Anteus was Mother Earth, and he had to touch her every so often to replenish his strength during the fight.

His enemies, privy to his secret, could cause his downfall by holding him up in the air and wrestling him to death that way. The tradesmen are losing the fight as the monopoly of the Commercial Bank over the Social Circulating Capital has made it impossible for them to raise credit directly from it. The hijacking of the Social Circulating Capital was a very unfortunate development to which I should have to return in a future Lecture.

### Efficiency of the Gold Coin

The bill market has made the gold coin extremely efficient, far beyond its physical capability to circulate. The limitation on improvements in production and distribution technology through refining division of labor further has been removed. The bill market has made the monetary system more elastic and more responsive to the needs of the consumer. Any type of good can generate bill circulation, provided that the consumer demands it urgently enough. By the same token, bills representing goods that have just fallen out of the consumers' favor are immediately demonetized. As the bill market works only with short maturities (never ever exceeding 91 days) it will adapt itself quickly and smoothly to the changing whims of the consumer. The bill market is characterized by its near-perfect flexibility, adaptability, and elasticity. Consumer prices no longer depend on the greater or lesser availability of gold coins. If the consumer demands an item sufficiently urgently, then its production and distribution can be financed instantaneously through drawing bills against its movement. The volume of bills flows and ebbs with the volume of merchandise trade, eliminating both price squeezes and price explosions.

The principle of granting certain limited and ephemeral monetary privileges to the bill of exchange is a sound one. It recognizes the fact that a market relying solely on the circulating gold coin could not handle the extra, unexpected, or changing burden that might be thrown upon it by the proverbially erratic behavior of the consumer. Thanks to the flexibility of bill circulation, it is the consumer, and the consumer alone, who ultimately decides what ought to be produced, when, and how much. In the market every day is balloting day. The consumer's ballot paper is made of gold. He casts his ballot by plunking down the gold coin on the retail counter. The distributors and producers of merchandise in whose favor he has cast his ballot, no less than the others he chose not to favor, will certainly get the message.

It is very important for you to see that it is not the price-system that communicates this message from the consumer to the producer. Temporary changes in the demand for staple consumer goods (such as food, clothes, fuel) does not give occasion to changes in the price. The price-system in and of itself is neither sensitive nor quick enough to accomplish the task of alerting the merchants to the impending changes in the mood of the consumer. The message concerning changes in the propensity to consume is communicated to the distributors and producers, not through changing prices, but through changes in the discount rate (and the composition of the social circulating capital, as I shall explain it in a later Lecture). Changes in the discount rate respond quickly and sensitively to the changes in consumer demand. The lubricating mechanism that guards the movement of goods against seizing up when changing to high or low gear is the bill market. Without it, roundabout production processes (making the evolution of goods of ever-higher order possible) could not exist. Without it, the internal communication system of the economy would be overloaded.

### Mises on Fiduciary Credit

As I have suggested in earlier Lectures, my presentation of the evolution of fiduciary currency deviates substantially from that of Ludwig von Mises. It is now time to scrutinize this deviation more closely. Mises divides credit into two large categories, according as the party extending the credit does or does not have to make a 'sacrifice'. So credit belonging to the second category is created 'gratuitously'. Mises calls it fiduciary credit, while calling the currency to which it gives rise fiduciary currency.

Mises admits that the concept of fiduciary credit may appear "puzzling, even inexplicable; it constitutes a rock on which many an economic theory have come to grief" (op.cit., p. 297). The bank is creating something out of nothing. Mises specifically criticizes the opposite view (ours) suggesting that when the bank discounts a bill, it merely substitutes its own credit which is more negotiable and has a higher recognition value, for credit represented by the bill which is less negotiable and has a lower recognition value. "The fundamental error [in this explanation] lies in its failure to understand the nature of the issue of fiduciary media. When the bank discounts a bill . . . it exchanges a present good for a future good . . . [ T ]he issuer creates the present good . . . practically out of nothing" (op.cit. p 341).

Mises doesn't refer to clearing in connection with the emergence of fiduciary credit, although he uses the term 'circulation credit' (Zirkulationskredit) as an alternative name for it, as opposed to 'commodity credit' (Sachkredit) which is an alternative name for credit of the first category. Nor does Mises raise the possibility of fraud by the bank when it pretends that it has the power to create something out of nothing by extending fiduciary credit. I find it impossible to go along with Mises' view that the bank, or anyone else for that matter, can create present value out of nothing at (nearly) zero cost. There must be a cost born by someone. Those bearing it may not be aware that they are being victimized by the banks, as the prestidigitation is well-hidden by fraud. But there is a cost. The denial of it this is equivalent to asserting that the banks have supernatural powers.

The failure of Mises to distinguish between two types of fiduciary credit, namely, credit emerging as a result of clearing, and credit emerging as a result of fraud, has led him to dismiss Adam Smith's Real Bills Doctrine as a deus ex machina. Adam Smith's theory, unlike that of Mises, admits that circulation credit may arise through spontaneous bill circulation even in the complete absence of banks. This makes it plausible that fraud may appear when the banks enter the scene and establish their monopoly of creating fiduciary credit. I can only speculate that the aversion of Mises to the Real Bills Doctrine was due to his unconditional adherence to the Quantity Theory of Money. At any rate, this unfortunate aversion led Mises to create a faulty theory of credit.

For another recent interpretation of the monetary and credit theories of Mises see the Internet publication Mises on Money by Gary North, who presents the opposite view. My readers can compare the two and are in an excellent position to make up their own mind.

The great evil of our age, unlimited credit expansion, cannot be understood, still less corrected, on the basis of a faulty theory of credit. This is the reason why I have taken the trouble, and liberty, to develop a new theory which will restore Adam Smith's Real Bill Doctrine to its proper place, and will draw attention to the fact that it is possible to replace the banking system in a modern economy with real bill circulation, provided that the Mint is opened to gold first.

### References

Ludwig von Mises, The Theory of Money and Credit, Indianapolis: Liberty Classics,

1980 (first published in 1912)

Gary North, Mises on Money, Part 4: Fractional Reserve Banking, January, 2002, [www.lewrockwell.com/north86.html](https://www.lewrockwell.com/north86.html)

*Note. The characters of the cotton dealer, the spinner, and the weaver in my Second Greatest Story Ever Told were borrowed from Mises (op.cit. p. 345).*

---

### Just Leave Them Enough Rope to Hang Themselves

My efforts here at Gold-Eagle University to work out a blueprint for the return to a gold standard and thereby to escape credit collapse were rewarded by J.N. Tlaga. He came out with a critique of my plan (At First for Buses Only, [www.goldeagle.com/editorials_02/tlaga072902.html](https://www.goldeagle.com/editorials_02/tlaga072902.html)). Mr. Tlaga had also put forward a blueprint of his own (The Alternative Future, [www.gold-eagle](https://www.gold-eagle),com/editorials_01/tlaga112801.html).

My own credentials to devise a blueprint for monetary reform include a 5-year tour of duty on Capitol Hill. In 1985 Former Congressman W. E. Dannemeyer of California invited me to work in his Congressional office as his advisor on fiscal and monetary reform. Mr. Dannemeyer was to lead a delegation of ten Republican Congressmen to the White House. The only item on the agenda was monetary and fiscal reform. I was entrusted with the task of preparing a draft proposal for the perusal of President George Bush. We have considered the inclusion of an outright return to a gold standard. The stumbling block was the 'fixing' of the gold price. Whatever consensus might exist in favor of a gold standard, it would be wrecked as soon as a specific number was proposed as the official price of gold. Debtors and creditors would never agree on the same number. My proposal was that, as a preliminary, we should recommend a more modest plan. We should call for the refinancing of government debt in terms of gold bonds - a medicine American money doctors on an errand of mercy to Moscow had prescribed for the moribund Soviet economy only a few months earlier, at the eleventh hour. In other words, I proposed that the rate of interest should be stabilized first, and the dollar afterwards. In October, 1989, the delegation under the leadership of Mr. Dannemeyer met President Bush in the Oval Office and presented the Gold Bond Plan. The President listened intently, and instructed his Secretary of the Treasury, also present at the meeting, to schedule a conference of his staff and that of Mr. Dannemeyer to prepare the final draft on the proposal. The conference was scheduled and rescheduled three times by Treasury officials, before I realized that I was wasting my time in Washington and left. So much for the power of Presidents to make a first very tentative step to a gold standard, in the face of what Mr. Tlaga colorfully describes as the opposition of "armed gangsters".

In all the previous historic experiments with irredeemable currency there was competition: there were other countries still on a metallic monetary standard. In every instance, the experiment was a miserable failure, and irredeemable currency suffered an ignominious defeat, in full view of the whole world. The present experiment is the first in history in which the promoters of irredeemable currency take no chances and exclude competition altogether. Even the tiniest of countries is forbidden to adhere to a gold standard, by the revised statutes of the IMF. By opening the U.S. Mint to gold, and by revoking the legal tender protection of the irredeemable dollar (which the U.S. House of Representatives could order by a simple majority vote, on the strength of its Constitutional prerogatives) irredeemable currency could have competition once more.

This would not be an "At First Buses Only" experiment. It would be a challenge of gold money to the hegemony of paper money. If the challenge was turned down, it would in itself be a victory. The opponent would be seen not to have accepted it for fear of defeat.

For fear that the irredeemable dollar would lose against gold, as has every one of its predecessors: the continental, the assignat, the mandat, the Reichsmark, to mention but a few, did before it.

In Mr. Tlaga's blueprint "The Alternative Future", the monetary reform would have to live the odium down of robbing innocent people of their life savings through repudiation of paper currency, bank deposits, and debt. Why burden the new monetary regime with that odium, when the managers of the irredeemable dollar are so eager to shoulder it? Just leave them enough rope. There can be no doubt that, given free competition between the Gold Eagle coin and the irredeemable paper dollar (minus its legal tender protection), the depreciation of the latter will greatly accelerate, and the agony of "waiting for Godot" will soon be over. After all, gold is gold, and paper is paper.

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

Lecture 1:

Lecture 2:

Lecture 3:

Lecture 4:

Lecture 5:

Lecture 6:

Lecture 7:

### Ayn Rand's Hymn to Money

### Don't Fix the Dollar Price of Gold

### Credit Unions

### The Two Sources of Credit

### The Second Greatest Story Ever Told; (Chapters 1 - 3)

### The Invention of Discounting; (Chapters 4 - 6)

### The Mystery of the Discount Rate; (Chapters 7 - 8)

### Lecture 8: Bills Drawn on the Goldsmith; (Chapter 9)

### Lecture 9: Legal Tender. Bank Notes of Small Denomination

### Lecture 10: Revolution of Quality; (Chapter 10)

### Lecture 11: Acceptance House; (Chapter 11)

### Lecture 12: Borrowing Short to Lend Long; (Chapter 12)

### Lecture 13: Illicit Interest Arbitrage

## Fall Semester, 2002

### Monetary Economics 201: Gold and Interest

## In Preparation: Courses To Be Offered In

2003

Monetary Economics 201: The Bill Market and the Formation of the Discount Rate Monetary Economics 202: The Bond Market and the Formation of the Interest

### Rate

---

# Monetary Economics 101 — Lecture 6: The Invention of Discounting

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-101-lecture-6-the-invention-of-discounting/
Date: 2002-08-05
Section: Money & Credit
Difficulty: intermediate
Concept Tags: real-bills, bills-of-exchange, interest-theory, gold-standard
Description: Fekete examines the invention of discounting — the practice of buying a bill at less than its face value to provide immediate liquidity to the seller. He argues discounting is the self-regulating mechanism that determines the velocity of goods in the production pipeline, with the discount rate (not the interest rate) as the key variable.
Editorial Note: Lecture 6 of Monetary Economics 101 (Gold Standard University, 2002). The technical heart of the real bills doctrine: how discounting works, why it differs from lending at interest, and why its elimination destroyed the self-regulating capacity of the gold standard.
Original PDF: https://professorfekete.com/articles/AEFMonEcon101Lecture6.pdf

### Lecture 6

## The Invention Of Discounting

- The Second Greatest Story Ever Told, Chapters 4-6 - The Origin of Discount - The Discount Rate and the Rate of Interest -

### Why Is This Story Important?

I got several comments from my audience to the effect that the story on the invention of real bills and discounting has only historical interest, and hardly any relevance to contemporary affairs. Actually, if the world is ever to return to a gold standard, we have to understand how it worked in the past. My researches show that economists have not succeeded in explaining its operation. They approached the issue from the position of mercantilism and from that of the Quantity Theory of Money. For example, they explained the adjustment mechanism governing foreign trade in terms of the international gold standard as follows. A country running a trade surplus is gaining gold while another running a deficit is losing it. The money supply of the surplus country grows, and that of the deficit country contracts. Other things being the same, there will be an increase in the price level in the surplus and a decrease in the deficit country. In the absence of trade barriers the surplus country will export less and import more, while the deficit country will export more and import less. This process will continue until the trade surplus/deficit disappears. International gold flows tend to reestablish equilibrium in the foreign trade accounts of gold standard countries, through their effect on the price level. So goes the argument. However, the available trade statistics show that this was not at all what was happening. International gold flows were negligible, and they were moved by other factors than payment for net imports. In fact, the adjustment mechanism worked not on the relative price levels, but on the discount rates of the trading countries. We must have a new theory of foreign trade, purged from the influence of mercantilism and the Quantity Theory of Money. In these Lectures I intend to develop this new theory of the gold standard in terms of the Real Bills Doctrine. Let us now return to The Second Greatest Story Ever Told.

Chapter Four in which the gentle reader learns how discounting was invented

The weaver-on-clothier bill was singularly well-suited to play the role of means of exchange. The clothier came into daily contact with the gold coin in the course of his business (by contrast, the weaver and the spinner didn't see much gold in the pursuit of their trade). Often the clothier found himself in the position that he could prepay the bills he has accepted, sometimes well before maturity. But our clothier was a very shrewd man, with a perfect grasp of the reality that moved merchandise in one while moving bills in the opposite direction. The clothier would prepay the bills he has accepted only for a consideration. In more details, whenever people asked him to prepay a bill before maturity, as the weaver often did, he would offer to discount it, that is, to apply a reduction to the face value of the bill proportional to the number of days left to maturity. The weaver didn't object to receiving less than the face value of the bill. He needed ready cash, and he could not get it on any better terms than discounting his bills with the clothier. For his part, the clothier wanted the custom of the weaver as an obvious supplier of bills for his budding discount business, so he would offer the best terms to him he could. The discount was an income for him that the gold coins in his till could not otherwise generate. Clearly, both parties benefited from discounting. After this latest innovation people no longer talked about paying a bill; they talked about discounting it.

The origin of discount is merchant custom. The sale of cloth by the weaver to the clothier is not final until the bill is marked 'paid'. The cloth is on consignment.

Payment at maturity is subject to the sale of cloth to the ultimate, cash-paying customer. Payment before maturity is certainly not a matter of right; it is a matter for negotiation. The height of discount depends on the intensity of consumer demand as observed by the acceptor of the bill. If the demand is brisk, he will be satisfied with a smaller discount. But if the demand is slack, then the acceptor who still has an unsold inventory on hand to worry about - which he will, after discounting, carry entirely at his own risk - must insist on a larger discount. He wants to be compensated for the increased risk of carrying inventory that he may not be able to sell except at a loss.

Soon enough the clothier started posting his discount rate, that is, the amount of discount in cents, per \$100 face value per day. For example, if the discount rate is 4 ¢, then a bill of face value \$1,500 maturing in 50 days will be discounted to \$1,500 15x50x4¢ = \$1,500 - \$30 = \$1,470 since \$1,500 = 15x\$100. The clothier reserved the right to adjust his posted discount rate, every day if need be, to reflect the changing mood of the consumer.

### No Lending Is Involved in Discounting

It was a later development that an annualized discount rate became the norm of quoting it (even though the credit involved would never ever exceed 91 days). For example, if the bill with \$100 face value had 91 days to run to maturity, and was discounted to \$99.50, then the discount rate was 2% per annum. Indeed, 4x91 days = 1 year, therefore, on an annualized basis, the discount is 4x(100 - 99.50) = 4x½ = 2 percent.

The fact that the discount rate is quoted on an annualized basis, the same as the rate of interest (in spite of the fact that the bill will mature long before a year would go by) has led to a curious mistake that was not free from its more ominous consequences. It has been suggested that discounting a bill is just another way of making a short-term loan, and the discount is nothing more or less than interest on the sum to be loaned, taken out of the loan in advance. In this (erroneous) view the discount rate is just another name for the short-term rate of interest. It would follow that there are no new problems here to study: in this (erroneous) view the source of discount rate is the same as that of the rate of interest, namely time preference (or its reciprocal, the propensity to save).

This was one of the most damaging mistakes ever made by economic theoreticians. In fact, there is no lending and borrowing involved in the act of discounting. The clothier is not lending and the weaver is not borrowing (nor is the clothier retiring a loan owed to the weaver) when the former discounts the bill before maturity for the latter. The discount rate has nothing to do with time preference (or its reciprocal, the propensity to save). It has everything to do with the propensity to consume (or its reciprocal, the productivity of the Social Circulating Capital, a concept I plan to introduce in a later course).

All participants of the bill market take to heart the admonition of Polonius to his son, Laertes:

Neither a borrower, nor a lender be,

For loan oft loses both itself and friend,

And borrowing dulls the edge of husbandry.

### (Shakespeare, Hamlet, Act I., Scene 3.)

Shakespeare may sound hopelessly outmoded to our ears in the 21st century. Yet it is quite possible that he saw something that most others have failed to see. The advice of Polonius is not meant for everybody. If there is a lesson to be learned from the endless disputes about usury, usurers, and about the advantages or disadvantages of lending or borrowing, then it must be this. To make or take a loan is an art that cannot be profitably cultivated just by anybody. This art, no less than any other, has to be learned, practiced, refined, and rehearsed by both the lender and the borrower, each on his own turf. Implicit in Shakespeare's line is the fact that not every form of credit may involve a loan, lending and borrowing. It is precisely that form of credit we are studying here, that arises through clearing, epitomized by bill circulation and discounting, that ought to be available to everyone - whether one is artistically inclined or not.

Indeed, credit can and does arise independently of lending and borrowing. When the weaver draws a bill on the clothier, he is extending credit, yet he is not a lender and the clothier is not a borrower. Nor should the transaction consummated be regarded as a loan.

The perception that the drawer grants a loan to the acceptor when he delivers goods against payment in the form of the bill accepted, or the perception that the acceptor repays the loan to the drawer when he discounts the same bill before it matures, is entirely fallacious and must be resisted by all means. The credit is an integral part of the deal, by virtue of the momentum of the underlying merchandise moving apace. By standard merchant custom, the terms "91 days net" are part of every such commercial deal. Stated otherwise, prices quoted by the wholesaler to the retailer are discountable prices. The amount of discount depends on the number of days the credit is used, and on the discount rate prevailing at the time of payment.

### The Discount Rate Is Independent of the Interest Rate

Time preference, that determines the rate of interest, has nothing to do with the discount rate. Discounting is not governed by the sovereign saver. It is governed by the sovereign consumer. As we have seen, it is the consumer's slacker or brisker buying that makes the discount rate rise or fall. We express this by saying that the discount rate varies inversely with the propensity to consume. (By contrast, the rate of interest varies inversely with the propensity to save.) The conceptual difference between the two rates was observed by John Fullarton writing in his book On the Regulation of Currencies as follows: "It is a great error indeed to imagine that the demand for . . . the loan of capital is identical with a demand for additional means of circulation, or even that the two are frequently associated. Each demand originates in circumstances peculiarly affecting itself, and very distinct from the other. It is when everything looks prosperous, when wages are high, prices are on the rise, and factories are busy, that an additional supply of currency is usually required . . . whereas it is chiefly in a more advanced stage of the commercial cycle, when difficulties begin to present themselves, when markets are overstocked, and returns delayed, that interest rises, and pressure comes on the bank for advances of capital" (op. cit., p 97).

The confusion between the discount rate and the rate of interest has also been noted by Charles Rist in his History of Money and Credit Theory from John Law to the Present Day: "Identification of the discount rate with the interest rate, which is frequent among English writers, is an unfortunate source of confusion" (op. cit., p 315).

### Achillean Heel of the Quantity Theory

The idea that the bill of exchange can circulate on its own wings and under its own power is often ridiculed by advocates of the Quantity Theory of Money, as I have pointed out in Lecture 3. The vicious attacks of monetarists, including those of their high priest Milton Friedman, on the Real Bills Doctrine mark the Achillean heel of the Quantity Theory of Money. It shows that an increase in the quantity of purchasing media need not cause a rise in prices. If the new purchasing media emerges simultaneously with the new merchandise, and the two disappear together as the latter is removed from the market by the ultimate cash-paying consumer, as in the case of financing the production and distribution of consumer goods by bills of exchange, there will be no price rises on account of the increase in bill circulation.

Detractors of the Real Bill Doctrine argue that several bills can be drawn on the same merchandise on its way to the market. So they can. But as I have pointed out in the previous Lecture, only the most liquid one, the bill drawn by the supplier on the seller of first order goods will be put into circulation. Just what the order of the underlying good is should be clear from the information provided on the face of the bill. If an additional bill on the same good is put into circulation, then, clearly, fraud is involved. It is disingenuous to attack a theory arguing that it fails whenever fraud is present. On that basis, every theory can be dismissed as worthless.

### Demand for Real Bills

We have seen that the spinner and the cotton dealer were happy to hold the weaver-onclothier bill to maturity. As soon as discounting became a universal practice, the demand for these bills has greatly increased. Other tradesmen also found it to their advantage to hold the bills to maturity. They looked at bills as a unique instrument combining two seemingly contradictory features: (1) that of an earning asset, (2) that of a medium of exchange. In fact, bills provided the only way to generate an income on cash holdings.

Usually an earning asset is illiquid in that it takes time and, sometimes, monetary losses to liquidate them in a hurry. With the appearance of discounting this has changed. Now tradesmen could earn an income on that part of their circulating capital which they had to carry in the form of cash. As most businesses were cyclical in nature, they had to face a fluctuation in their cash needs. It was a most welcome development that they could generate an income on their cash holdings especially at the time they were entering their slow season.

In the next Chapter of The Second Greatest Story Ever Told we shall see how the demand for real bills snowballed as people discovered their great versatility.

Chapter Five in which the gentle reader learns how the wily clothier shifted his cross of gold onto the shoulders of the miller One day the weaver's loom broke down and was found beyond repair. The weaver had to get a new loom in a hurry. He did not have the ready cash, but he had a pile of maturing bills drawn on and accepted by the clothier. He visited his colleague and offered him the bills at a good discount. The clothier was anxious to help. An interruption in the supply of cloth would hurt his business, too. But he could not come up with the necessary sum in gold. However, as we have said, the clothier was a very smart man, and his advice was worth gold. "Why don't you offer these bills to the loom-maker in payment for the new loom?" the clothier suggested. "If the spinner found them attractive to carry to maturity, so should the loom-maker."

As predicted, the loom-maker was happy to take the weaver-on-clothier bills. He looked at these bills as a liquid earning asset which could be passed on easily if the need arose. The weaver found the discount rate offered by the loom-maker acceptable. He endorsed the bills, thus transferring the title to the proceeds to the loom-maker. Once more, there was no interruption in the business of satisfying consumer demand due to a shortage of gold coins. The versatility of the bill of exchange drawn on consumer goods in demand, and its potential for circulation, was proved again. The weaver-on-clothier bill could circulate even outside the small circle of tradesmen engaged in the production of cloth.

As it happened, next morning the clothier had a field day selling out his entire inventory of cloth. As his till was now flush with gold coins, he thought that his cash could with advantage be put to some use. He recalled that the previous day the weaver was offering his bills for discounting. So he emptied the contents of his till into a large purse, and walked over to the weaver's. There to his chagrin he found that his earlier advice to the weaver was 'too good'. The weaver told him that he had passed on all the weaver-on-clothier bills to the loom-maker. Since the clothier felt uneasy with that much gold on hand, he decided to walk over to the loom-maker and offered to discount the bills he had come into the possession of earlier. But the loom-maker had disappointing news, too. He had in the meantime passed on those bills to the bricklayer in payment for work on the extension to his loom-factory. "If you hurry you might catch him, he left the premises scarcely an hour ago".

The clothier was annoyed. He wasn't going to run after the bricklayer. He saw that he could only blame himself. Here he was, foolishly chasing his own bills. "And they call this division of labor", he fumed, looking at the heavy purse of gold he grew tired of carrying. "Someone ought to do something about it, and let me mind my own business!"

Luckily, the flour mill was next door to the loom factory. The clothier got an idea. "I shall be damned if I ever go on wild goose chase again", he said to himself. "They will surely come home to roost, on their own wings, in their own good time - and so will my bills!" He dropped in to see the miller, asking him whether he wanted to get rid of some of the miller-on-baker bills in his possession. "I just thought you need a few extra gold coins. You must be buying grain to fill up your bins. It's harvest time."

As far as the miller was concerned, it was a deal. They didn't quibble long about the discount rate. The clothier let out a sigh of relief as he exchanged his gold coins for the bills endorsed by the miller. "It is high time, too", he said to the miller and added, jokingly: "I got tired of carrying my heavy cross of gold. It is your turn now, to take up the burden."

The clothier was pleased with himself. He was the type of man who would always turn adversity into advantage, by looking for a moral. Just as he thought: he had no trouble, after all, unloading his 'cross of gold'. There were always willing takers around.

The fact that the loom-maker and the bricklayer were happy to take the weaver-onclothier bills in payment was a very significant discovery indeed. It proved that maturing bills of exchange on merchandise in great demand were perfectly acceptable as purchasing medium. Whoever got the bills had no doubts that he could also pass them on without difficulty, should he have to make an unexpected payment before the bills have matured. And if he kept the bills, he would earn a welcome return on his cash holdings.

While the bill of exchange was a good substitute for the gold coin, it was not a 'perfect' substitute, as the baker found out when he offered weaver-on-clothier bills in his possession to the grain merchant when the miller-on-baker bills came up for payment. "Don't take me for a fool!" the grain merchant told the baker angrily.

This paper clearly calls for payment in gold, and not in another piece of paper! If you haven't got gold, then you are in violation of your contract!

The grain-merchant was right. At maturity the miller-on-baker bill must be settled in gold. The idea of settling paper with more paper suggests fraud. A bill that at maturity can only be paid by drawing another stinks. The bill of exchange must be settled in specie at maturity. How otherwise could the holder of the bill be sure that he wasn't being taken for a ride? This reveals a function of the gold coin in which no other means of payment can deputize for it: gold is the philosopher's stone, the only one with which the quality of outstanding credit can be gaged. (In future Lectures we shall see other instances where the gold coin cannot be substituted by paper currency.)

### Social Circulating Capital

In Lecture 4 I introduced Adam Smith's concept of the Social Circulating Capital. It can be visualized as that mass of goods that society is appropriating strictly for the purpose of imminent consumption during the next 91 day period. This mass of goods is far from being static. It is dynamic in the sense that its size and composition is changing constantly, following the proverbially fickle demand of the consuming public. I also proved the theorem that an item belongs to the Social Circulating Capital if the bill drawn on it will circulate - or, using our new term just introduced, if the bill can be discounted; if not, then the underlying item does not belong to the Social Circulating Capital. In the next Chapter we shall see that the unique quality of a good to belong to the Social Circulating Capital has to do with the drastic reduction in uncertainty concerning the path that good will follow as it is moved closer to the ultimate consumer. The risks of tradesmen in moving that good have been reduced to their irreducible minimum.

Chapter Six in which the gentle reader learns why cloth can, but bricks cannot, fly It was the beginning of winter when somebody was knocking at the weaver's door. It was the bricklayer. He recalled that in the summer he had held some weaver-onclothier bills the loom-maker gave him in payment for work done. This time he wanted to get it right from the source. He has brought the gold coins along to save the weaver the trouble of carrying them himself.

The bricklayer was trying hard to please the weaver. His business was rather slow in the winter, and he wanted to earn an income on his idle cash. He looked at the bill of exchange as an appreciating asset: every day it was worth more, right up to the day of maturity. By its very nature, the bricklayer's own trade did not generate any bills of exchange. His bills could never hope to circulate. Money sunk into brick and mortar was not the same as money put into fast-moving goods such as cotton, or wheat, within earshot of the cash-paying consumer.

The bricklayer was not jealous. He understood perfectly well that the preferential treatment given to the weaver-on-clothier and miller-on-baker bills, but not to the brickyard-on-bricklayer bills, was bestowed by the market for a good reason. The discrimination had to do with the nature of the underlying merchandise, and had nothing to do with character or personal honor. Brick is not consumed in the same way as cloth. It is used in building houses which are not bought and sold against cash payments representing the full purchase price. Therefore the production and distribution of bricks is financed quite differently from that of cloth. The fast movement of cloth to the consumer can generate bill circulation; the much slower movement of brick cannot. The movement of bricks to the consumer must be financed through lending and borrowing.

The weaver was pleased to comply with the request of the bricklayer. He even took a standing order for weaver-on-clothier bills to cover the winter months when the construction business was slow and the bricklayer needed a safe and profitable place to park his circulating capital idled temporarily.

It is crucial to understand the economic difference between cotton and brick. Cotton had the momentum which brick lacked. The financing of the movement of cotton could be done through bill-circulation. The financing of the movement of bricks couldn't: the brickyard-on-bricklayer bills could not fly for lack of momentum in the movement of bricks. The slower movement of bricks had to be financed through lending and borrowing, at the higher interest rate. This involved convincing the lender (saver) that the ultimate consumer of bricks, the buyer of the house, did have the means to retire the mortgage on his new house in time. As the proverb says, "there is many a slip between cup and lip". In case of the cloth (or any other item belonging to the Social Circulating Capital) the lip is already touching the cup and, accordingly, the chance of a slip is reduced next to naught.

A bill acknowledging receipt by the retailer of fast-moving merchandise can circulate in lieu of cash. The market extends limited and ephemeral monetary privileges to bills representing certain transactions while denying the same privileges to others. The decision whether to extend or deny it depends on objective criteria, having to do with the briskness of consumer demand, as well as the time-frame within which 'maturing' goods can be moved to the cash-paying consumer. Goods that are disqualified (as bills drawn on them would not circulate) are not left out in the cold. Their movement to the consumer is financed through lending and borrowing, at the higher interest rate. For example, the bill drawn on bricks being moved to the construction site will not circulate. Nobody who wants to park his liquid funds in quick earning assets would discount them for lack of liquidity. On the other hand, there are a lot of mortgage brokers who will be happy to arrange the financing for the purchase of bricks connected with the construction of a house. Other lenders would be happy to finance the construction and the operation of the brickyard at the going rate of interest.

In the 18th century there was a saying (long since forgotten) in Lombard Street in the financial district of London: "Nothing is easier than a banker's job, provided that the banker is able to tell a bill and a mortgage apart".

---

### Rothbard on the Origin of the Bank Note

My correspondent Robert writes: "I have enjoyed your articles on GOLD-EAGLE.com.

Good job! Keep up the good work! For the last three years I have been teaching economics myself. I started out by reading about the various schools of economics and finally happened upon one that resonated with what I understood intuitively which was, of course, the Austrian School. So for a few years now, in my spare time, I have been reading all I can absorb from the great authors of that tradition. So, as I was reading your installment of Monetary Economics 101 I noticed that you criticized Murry Rothbard's explanation (I don't know who he derived it from) of the evolution of paper currency from warehouse receipts. I actually questioned this as well when first reading his explanations, so I am wondering if you have a list of books you might recommend for learning more on the history of real bills. Also I'm curious what other criticism you have of Rothbard's work or on the Austrian School's in general."

Here is my reply: Stay tuned, Robert, there is lots more criticism to come whence this has come from. Although the Austrians are not monolithic, neither are they sufficiently hospitable to authors who are unable to reduce themselves to sycophancy and to tone down criticism of Austrian idols. Austrian journals never published my contributions, presumably for this very reason.

In addition to my criticism of Rothbard's diagnosis of the fraud in the origin of the bank note and of fractional reserve banking, I shall also criticize his proposed therapy of the malady, 100 percent gold reserve banking. It would never work. It would be unable to supply the elastic currency that the economy needs. It would open the gold standard to even more violent attacks for being 'contractionist' and anti-labor. It is based on a serious misunderstanding of the operation of the gold standard. At any rate, the issue cannot be decided until one has studied the Real Bills Doctrine in depth.

An Austrian by birth although not by affiliation, Joseph A. Schumpeter wrote a concise History of Economic Analysis. Chapter 7 on Money, Credit, and Cycles will give you reference to authors who wrote on the bill of exchange. See in particular the debate preceding Peel's Act of 1844 in Britain, p 695 and 725, and his discussion of the Real Bills Doctrine starting on p 729.

### References

John Fullarton, On the Regulation of Currencies (originally published in 1844), New York: A.M. Kelley, 1969.

Ch. Rist, History of Money and Credit Theory from John Law to the Present Day, 1940.

Joseph A. Schumpeter, History of Economic Analysis, New York, 1954.

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

Lecture 1:

Lecture 2:

Lecture 3:

Lecture 4:

Lecture 5:

Lecture 6:

Lecture 7:

Lecture 8:

Lecture 9:

### Ayn Rand's Hymn to Money

### Don't Fix the Dollar Price of Gold

### Credit Unions

### The Two Sources of Credit

### The Second Greatest Story Ever Told; (Chapters 1 - 3)

### The Invention of Discounting; (Chapters 4 - 6)

### The Mystery of the Discount Rate; (Chapters 7 - 8)

### Bills Drawn on the Goldsmith; (Chapter 9)

### Legal Tender. Bank Notes of Small Denomination

Lecture 10:

Lecture 11:

Lecture 12:

Lecture 13:

### Revolution of Quality; (Chapter 10)

### Acceptance House; (Chapter 11)

### Borrowing Short to Lend Long; (Chapter 12)

### Illicit Interest Arbitrage

## Fall Semester, 2002

### Monetary Economics 201: Gold and Interest

## In Preparation: Courses To Be Offered In

2003

Monetary Economics 201: The Bill Market and the Formation of the Discount Rate Monetary Economics 202: The Bond Market and the Formation of the Interest

### Rate

---

# Monetary Economics 101 — Lecture 5: The Second Greatest Story Ever Told

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-101-lecture-5-the-second-greatest-story-ever-told/
Date: 2002-07-29
Section: Money & Credit
Difficulty: intermediate
Concept Tags: real-bills, gold-standard, sound-money, bills-of-exchange
Description: Fekete narrates the history of the bill of exchange — what he calls 'the second greatest story ever told' after gold itself — tracing how real bills emerged spontaneously from trade to finance the movement of goods between producers and consumers without inflation or deflation.
Editorial Note: Lecture 5 of Monetary Economics 101 (Gold Standard University, 2002). The historical narrative of real bills, showing how they arose from trade necessity and how their suppression in the 20th century created chronic monetary instability.
Original PDF: https://professorfekete.com/articles/AEFMonEcon101Lecture5.pdf

### Lecture 5

*The Second Greatest Story Ever Told*

- Chapters 1-3 - Origins of the Real Bill - The Miracle of One Gold Coin Performing the Job of Three - A Small Step for One Man, But a Giant Step for Mankind - Clearing at the Great Medieval Fairs -

### The Evolution of Paper Currency

Fable has it that paper currency came into being as warehouse receipts issued by the goldsmith against gold left on deposit for safe-keeping. The owners found that they could make purchases with these warehouse receipts as easily as with gold coins. Then the goldsmith went on lending out at interest his fictitious warehouse receipts. According to this fable, the fraudulent business of the goldsmith in issuing warehouse receipts against non-existent gold was the embryonic form of the fractional-reserve banking of today.

The unsurpassable naivety of this fable raises the question how serious students of money and credit have found it possible to treat it with respect. We should credit our ancestors with more intelligence and acuity than assuming that they fell so easy a victim to such a crude swindle, or that they meekly continue to be victimized long after the fraud has been exposed. To be sure, there was fraud aplenty in the actual process of introducing bank notes but, as we shall see, it was far more subtle and far more sophisticated than the crude device of issuing warehouse receipts on non-existing gold.

In reality, the evolution of paper currency takes its origin in the invention of the negotiable bill of exchange, the real bill. This was a wonderful invention. There was nothing sinister about it. The process was perfectly natural. Some authors maintain that the bill of exchange has been around since time immemorial. Harley Withers in his book (The Meaning of Money, London, 1910, p 38) quotes an authority as saying that the bill of exchange was, in its original form, probably nothing more than a letter of credit from a merchant in one country to his debtor: a merchant in another, requiring him to pay the debt to a third party, namely, to the bearer of the letter who happened to be traveling to the place where the debtor resided. It turned out that the bearer could with advantage assign his letter of credit to another by endorsing, and there could be several such endorsements before the letter was finally presented to the debtor for final settlement.

The only evidence that indeed there might have been such a circulation of letters of credit is an obscure quotation from Cicero. In a letter to Atticus, Cicero asks whether he could send money to his son in Athens by exchange operations. This passage is, of course, not a proof that bills of exchange circulated in Rome and its overseas possessions. Be that as it may, in view of the voluminous trade between Rome and Athens, it is possible that the acute and quick-minded Greeks devised some exchange mechanism to clear the credits arising from the trade of goods between these two busy cities.

Here we assume that bills of exchange as we know them from the earliest extant specimens came into use in Florence, Venice, and Genoa in the 14th century. Either one of these cities could have been the scene of The Second Greatest Story Ever Told, an attempt to reconstruct the process whereby the bill of exchange, or real bill, was invented.

The story will be told in twelve chapters. I call it the 'second' greatest story (the 'first' being the Bible) in order to emphasize moral philosophy that continues to provide background to the history of money in the spirit of Adam Smith.

### The Second Greatest Story Ever Told

Chapter One in which the gentle reader learns about the miracle of one gold coin performing the job of three

The cotton dealer shipped cotton to the spinner and billed him for goods received.

The spinner 'accepted' the bill, that is, he acknowledged receipt of goods by writing across the face of the bill 'I accept' over his signature. This signified his acceptance of the responsibility to pay the face value of the obligation at maturity. He then returned the bill to the cotton dealer pending settlement in coins.

Having spun the cotton, the spinner shipped the yarn to the weaver and billed him.

The weaver accepted the bill and returned it to the spinner pending settlement in coins.

Having woven the yarn, the weaver shipped the cloth to the clothier and billed him.

The clothier accepted the bill and returned it to the weaver pending settlement in coins. The journey of the same cotton on its way to the consumer has spawned three separate bills, each held by a particular supplier, pending settlement at maturity.

Now the clothier had cash-paying customers, the ultimate consumers of cloth. After the cloth was sold, he had the gold coin given up by the consumer. When the bill drawn on him matured, and the weaver presented it to him for payment, the clothier passed on the gold coin of the consumer. After adjustment was made in small change for the difference in the face value of the bill and that of the gold coin, the weaver-on-clothier bill was marked 'paid'.

Soon afterwards, the spinner presented his bill to the weaver for payment who paid it by passing along the gold coin of the consumer. After adjustment in small change, the spinner-on-weaver bill was marked 'paid' by the spinner.

Finally, the cotton dealer presented his bill to the spinner for payment, who paid it by passing along the same gold coin of the consumer. After adjustment in small change, the dealer-on-spinner bill was marked 'paid' by the dealer. The cycle of supplying the consumer with cloth was complete. In the end, no one owed anybody anything.

The remarkable feature of this primitive clearing system is that the use of bills has increased the efficiency of the gold coin four-fold. In the absence of bills the pool of circulating gold coins would have had to be invaded and drawn upon four times in order to move cotton to the ultimate consumer. As it happened, the pool of gold coins wasn't invaded even once. The single gold coin of the consumer given up in exchange for the finished cloth was sufficient to extinguish all the claims arising along the journey of the cotton from the dealer to the consumer. It is also clear that, regardless how roundabout the journey of the cotton may, due to further division of labor, become in the future, the single gold coin of the consumer will always be sufficient to extinguish all the claims arising along the cotton's journey. To put the matter differently, the gold standard is no longer a fetter upon technological progress and further division of labor, as it would be in the absence of the bill of exchange. The number of hands engaged in the movement of cotton to the ultimate consumer can increase from four to fourteen, and later to forty if necessary, without adding any new demand for additional gold coins. The lengthening of the production and distribution process, of course, represents specialization, improved technology, better tools, cost reduction, in one word: greater efficiency. The bill of exchange has opened up new avenues for progress, leading to great improvements in the condition of human life on earth. Technological progress will never again be obstructed by a dearth of gold.

Time is obviously a factor in the cycle of supplying the consumer with cloth. We may assume that the journey of cotton from the dealer's warehouse to the consumer takes, on the average, three months to complete and, accordingly, the dealer-on-spinner bill is drawn to mature in 3 months. The journey of yarn from the spinner to the consumer takes two months to complete and, accordingly, the spinner-on-weaver bill is drawn to mature in 2 months. Finally, the journey of cloth from the weaver to the consumer takes one month to complete and, accordingly, the weaver-on-clothier bill is drawn to mature in 1 month. In this way, although the three bills have different life-spans, they will all mature on the same day, facilitating settlement.

Chapter Two in which the gentle reader learns about an innovation enabling the consumer to choose from a variety of cloth three times as great as before, without it costing anybody a penny One day the clothier told the weaver that he would be glad to carry an inventory of cloth three times as large, in order to enable his customers to select from a greater variety of cloth. Naturally, the weaver was delighted with the proposal, and agreed to draw 3-month bills on the clothier instead of 1-month bills as before, since an inventory 3 times as large may take 3 times longer to clear. Now the weaver needed different types of yarn to weave a greater variety of cloth. He figured that he could use half again as much yarn as before. His new inventory of yarn, being 1 and 2 times larger, may take 1 and 2 times longer to clear. Accordingly, the spinner agreed to draw 3-month bills on the weaver, instead of 2-month bills as before. In his turn, the spinner need not keep a larger inventory of cotton on hand because all yarn was coming out of the same bale.

Now all three merchants: the cotton dealer, the spinner, and the weaver were drawing bills not only with the same maturity date, but also with the same life-span of 3 months. The new system worked very well indeed. New supplies were ordered, and bills drawn on them matured monthly, instead of quarterly as before.

Consequently, adjustments to the changing taste of the consumer could be made more readily. The clothier had no plans to enlarge his inventory of cloth any further, and had no reason to request the weaver to extend the maturity date of his bills beyond three months.

At any rate, the weaver would have had solid grounds to resist such a request. If the cloth moved faster due to brisker consumer demand, the adjustment would have to be made, not through the size of inventory, but through that of the monthly shipments. Three months (or 13 weeks, or 91 days) is just the length of the seasons.

If the clothier could not sell a certain kind of cloth in 91 days, then he might not be able to sell it for 365 days, before the same season of the year came around once more. However, by that time fashion could change beyond recognition, and the clothier might not be able to sell the cloth out of vogue except at a loss. For this reason, there is an unacceptable risk involved in drawing bills of exchange with maturity 92 days or longer. A slow inventory of cloth that may take more than 3 months to sell cannot be financed through clearing. Its journey to the consumer must be financed through borrowing. A bill of exchange must always represent merchandise that moves, and move it must fast enough so that the shelves in the retail store can be cleared once every quarter.

Chapter Three in which the gentle reader learns about another invention: that of making one bill do the job of three.

The drawer of the bill is making his first tentative steps to put the bill into circulation "a small step for one man, but a giant step for mankind".

Some time later our tradesmen met in a pub, and over a pint of beer discussed the success in financing the production and distribution of their merchandise through real bills, as well as a new proposal of the clothier to simplify their billing further.

The clothier pointed out that one bill could in fact do the work of all three, as the title to the proceeds could easily be transferred to the next holder by endorsing. "At the end of the first month the weaver will endorse the bill", the clothier explained, "and pass it on to the spinner in payment for the yarn, after the necessary adjustment in the outstanding amounts is made in small change." The weaver got the point and added: "At the end of the second month the spinner, after endorsing the very same bill, will pass it on to the cotton dealer in payment for the cotton, not forgetting to make the adjustment in small change for the difference in the outstanding amounts." The spinner also chimed in: "And at the end of the third month the bill will mature. The cotton dealer can collect his receivables." The spinner raised his glass and, turning to the clothier continued: "And you, my friend, will have the gold coin to pay him! By that time the entire inventory of cloth will have been sold for gold coins. I salute you for your brilliant idea of turning the bill into currency!"

The tradesmen were enthusiastic. The experiment came through with the flying colors. This was a veritable breakthrough. The physical movement of the gold coin was reduced to its irreducible minimum - without any loss of mobility of goods. The payment of gold by the clothier to the cotton dealer, as it were, 'telescoped' the three payments occasioned by the movement of cotton from the producer to the consumer into one. The economy in the movement of gold was achieved by giving temporary monetary privileges to the bill drawn on the clothier. The weaver-on-clothier bill could henceforth 'circulate' before its maturity date. It was readily accepted by the spinner and the cotton dealer in payment, neither of whom was a party to the deal which formed the basis for drawing it. The significance of this discovery could hardly be exaggerated. Credit could now circulate among the tradesmen on the same terms as gold without a hitch. It was also clear that this circulation owed its existence to the movement of the underlying merchandise. The emphasis is on the word 'movement'. The clothier experimented with bills representing stalled merchandise (left unsold from the previous season). He found, to his great regret, that these bills just would not fly.

Of the three, it was the weaver-on-clothier bill that was at the head of the line waiting to be exchanged for the gold coin of the consumer. To use the technical term we say that it was "more liquid" than the others as it could circulate in lieu of cash. The other bills, being less liquid, fell by the wayside. There was no need to draw them any more as the endorsement of the weaver-on-clothier bill was considered payment in cash.

A finished good ready to be sold to the consumer is called a first order good. There are also higher order goods. An n-th order good is a semi-finished good that is n times removed from the consumer, e.g., the cloth is a 1st, the yarn is a 2nd, and the cotton is a 3rd order good. The acceptor of the bill (in our example, the clothier) is the retail merchant selling the first order good to the consumer, to whom the drawer of the bill (in our example, the weaver) is supplying the second order good. The same bill, after the n-th endorsement, is used to pay for the supply of the (n + 1)-st order good. We shall call this primitive circulation of bills vertical. It is confined to the circle of tradesmen engaged in the production of the same merchandise, where one is the supplier of the other. But as we shall soon see, this limitation is not essential. The circulation of the bill before its maturity date would eventually become universal.

I shall briefly interrupt relating The Second Greatest Story Ever Told in order to describe another variety of real bill circulation called horizontal.

### The Merchants of Seville

This is not the title of an opera, nor that of a drama; it refers to one of those great annual medieval fairs which used to attract merchants from very great distances to the fair city such as Leipzig in Germany, Lyon in France, and Seville in Spain, located at the crossroads of great trading routes. The fair itself could last a month or even six weeks.

Some of the merchants came from as far as a thousand miles away. All of them came to sell home-produced wares as well as to buy the wares of other regions that could lie another thousand miles away from the fair city in the opposite direction. We could imagine that it must have been well worth the effort of the merchants to travel and spend all this time so far away from home. This was the way to export and import in those days; there was no other. While they carried home-made merchandise in their carriages, one thing they did not carry with them. They did not carry gold. They expected to make their purchases with the proceeds of their sale. The trouble with that was that they had to sell first in order to be able to buy afterwards. This was a fatal limitation. It may have meant missed buying opportunities. This trouble was eliminated by the clearing house of the fair which made it possible for the merchants to buy first and sell afterwards, if they so desired, as we shall now see.

The remarkable thing about these medieval fairs was their clearing system. An enormous quantity of goods exchanged hands (some several times) facilitated by a very small pool of gold coins. How did they do it? Just think for the moment, if you will, about the enormous logistical problem they were facing. Barter was pretty well out. They quoted gold prices, but they realized that the buyer they were dealing with, just like themselves, did not carry gold with him. So how could they make the sale if a prospective buyer was willing to pay the price asked?

Well, they developed an ingenious clearing system using bills of exchange maturing on the last day of the fair. Every merchants registered his merchandise at the clearing house upon arrival. Registration gave them the right to accept bills payable at the clearing house where bills would be offset against one another and only the difference in face values would be paid in gold coins on the last day of the fair. This afforded an amazing economy in the use of the gold coin. It was this economy that was responsible for making the fairs so attractive to merchants coming from far-away places.

We may be certain that without the clearing system there would have been no fair, and trade would have been limited to that between next-door neighbors. If merchants traveling those great distances would have had to carry not only their merchandise for sale, but also the gold coins with which to make their purchases, they would not have undertaken the trip. For one thing, they probably would not have had the gold, which was needed for domestic use. For another, on the long trip they would have offered themselves as easy targets for highwaymen preying upon the purse of traveling merchants.

The circulation of bills of exchange generated at the fair may be described as horizontal.

They were all drawn on first-order goods ready to be sold to the consumer, and they were passed on from hand to hand between retail merchants (rather than from the producer to his supplier, as in the case of vertical circulation).

The medieval fairs were a marvelous institution promoting trade between far-away regions. Not enough research has been done on this subject, especially on the inner workings of the clearing and insurance facilities offered at the fairs.

### Real Bills Never Cause Inflation

We have seen that real bills may arise in different settings and facilitate exchanges of goods that may not otherwise come about simply because of the limited supply of gold coins available for trade. If people saw that the goods were in sufficiently urgent demand, and ultimate payment was guaranteed by the fact that the underlying goods would be soon (i.e., before the maturity date) removed from the market by the ultimate consumer paying gold coin for his purchase, then they would take the bill (provided it has been duly accepted) in payment and then use it themselves in paying for their own purchases. Thus bills became the preferred currency of the fair.

Detractors of the Real Bill Doctrine maintain that the circulating bill was inflationary in that it meant an expansion of the pool of circulating purchasing media. However, this position is demonstrably wrong. The bill emerged simultaneously with the emergence of new merchandise in urgent demand of the same value, and would disappear from circulation at the same time when the merchandise was sold. The net effect on the stock of purchasing media was therefore zero.

It is helpful to think of the bill of exchange as an instrument that automatically adjusts the stock of purchasing media to the stock of merchandise to be cleared by the markets.

During peak season, when the turnover of merchandise reaches its maximum, the means of payments to move it is readily available. Once the merchandise has been removed from the markets, the extra amount of purchasing media disappears. This means that in low season the pool of purchasing media contracts and there is no excess cash chasing non-existent goods. The whole process of adjustment is automatic, and works without direct intervention on the part of the banks or the government. In fact, the whole system of supplying the consumers with all the goods in high demand through bill circulation will work even in the complete absence of banks.

### World Trade Today

Another example of the horizontal circulation is the pre-1914 financing of world trade by drawing bills on London. In this case London acted as the clearing house of a non-stop fair. Merchandise was carried by the merchant navy directly from the exporting to the importing country. The volume of world trade was huge, it was a two-way street, consequently, the pool of gold coins to finance the movement of merchandise was tiny.

Yet the system worked beautifully, thanks to the horizontal circulation of self-liquidating commercial paper. The small and relatively stable pool of gold coins in London could finance the huge volume of world trade as it flowed and ebbed with the seasons.

Compare that with world trade today, which has been governed not by commercial, but by political considerations since World War I and, therefore, has been reduced mostly to one-way flows. The chits of the world's greatest military power are used, under duress, by all trading nations of the world. After the chits have done their job of financing trade they keep piling up, also under duress, in foreign central banks. The nations of the world are lulled into the false belief that these monetary reserves are real, usable when the need arises, and earn interest in a meaningful way. But the cruel truth is that they represent the permanent debt of the United States, the largest debtor of the world (it used to be the largest creditor before 1972, the year when the U.S. defaulted on its gold obligations to foreign central banks). It is a pipedream that the debt of the U.S. plus accrued interest will ever be repaid - certainly not in dollars of the same purchasing power. Take Japan, for example. It could use her enormous dollar reserves it has accumulated over a period of half a century in order to clean up the mess in the Japanese banking system. But while they are may be available to buy a Coca Cola bottling franchise, or use it for the purposes of making small payments to third parties, they are definitely not available for liquidation in larger quantity. It would wreck the bond market, and ruin the credit of the United States government, if Japan insisted on using its monetary reserves to solve its banking crisis. There is simply no way for Japan to liquidate its monetary reserves accumulated under duress.

The United States has dismantled its export industries (with the exception of those of strategic importance) just at the time when it should have expanded exporting capacity in order to service its huge and increasing external debt. It has exported industrial jobs to third world countries in exchange for consumer goods it no longer produces domestically.

This means that the trade deficit is to continue, and increase, indefinitely.

The costs of this perverse (not to say insane) system of financing world trade, based as it is on coercion, are enormous. Apart from it causing relentless currency depreciation, the piling up of U.S. government debt in foreign central banks makes overseas holders of dollar balances nervous. For the time being, foreign central banks play the game according to the rules dictated by the U.S. Treasury. They resist the temptation to cash their dollar balances, presumably motivated by thieves' solidarity, that "we had better hang together, lest we hang separately". But when a country breaks ranks and starts liquidating its dollar balances, as is inevitable, all others will run to the exit. The world's monetary system will crash.

Such a crash could never occur under the international gold standard with world trade financed by horizontal bill circulation. Bills of exchange are self-liquidating credit instruments. They cannot pile up in foreign central banks. Once the goods are sold to the ultimate cash-paying consumer, the bills of exchange that financed their trade simply disappears. Why can't the world return to world-trade to a system of payments using horizontal bill circulation? Because such a system must be a gold-based system, and gold is anathema to the United States Treasury.

Yet this system of bill-circulation is well-worth not only studying but also emulating. The big banks of the world from Japan through Germany to the United States are rushing into bankruptcy with break-neck speed. The central banks won't be in the position to bail them out. Their so-called assets, namely U.S. government debt, are strictly for windowdressing purposes. They are useless as a monetary reserve, if you have illusions to liquidate your holdings in order to pay off your own debts.

We may face an epoch in history without banks, a world in which people will refuse to trust bankers and their promises.

### Be prepared!

### ***

Correction:

In Lecture 3 under the caption "The Invisible Vacuum Cleaner" I referred to the recent accounting scandals and mentioned Enron and Westcom. The latter should read "Worldcom".

### Bravo for Monetary Economics 101!

Malik Yusuf of Edith Cowan University, Perth, Western Australia writes:

Sir,

Bravo for Monetary Economics 101. A standing ovation for each Lecture. Only the Internet made it possible for me to continue my education outside of the recognized institutions. I have started my studies in economics formally at the late age of 38 as a result of my discovery of your work. If the underlying cause for the excesses of this dark age is as you have diagnosed, then I feel that this is where I should begin my studies, even though I must start from scratch. It is a truly fascinating experience to receive one narrative from the official curriculum, and jostle for high grades with the current generation of students being groomed and indoctrinated with the same, and then, after hours, to obtain my real nourishment and hope for the future from studying your material.

Your most ardent pupil,

### Malik Yusuf

We are fortunate indeed that, thanks to the Internet, we need no longer be forced into the straitjacket of orthodoxy and subjected to the brain-washing of official indoctrination. In earlier ages universities were the focal points of intellectual dissent, and resistance to an ossified science and culture. No more. Virtually all universities in the world are now in the service pusillanimity, cringing in front of the thought police that discourages and persecutes independent thinking. Let's hope that there will be lots of initiatives like ours to break the thought-monopoly of governments, and let truth be the winner.

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

Lecture 1:

Lecture 2:

Lecture 3:

Lecture 4:

Lecture 5:

Lecture 6:

### Ayn Rand's Hymn to Money

### Don't Fix the Dollar Price of Gold

### Credit Unions

### The Two Sources of Credit

### The Second Greatest Story Ever Told; (Chapters 1 - 3)

### The Invention of Discounting; (Chapters 4 - 6)

### Lecture 7: The Mystery of the Discount Rate; (Chapters 7 - 8)

### Lecture 8: Bills Drawn on the Goldsmith; (Chapter 9)

### Lecture 9: Legal Tender. Bank Notes of Small Denomination

### Lecture 10: The Revolt of Quality; (Chapter 10)

### Lecture 11: Acceptance House; (Chapter 11)

### Lecture 12: Borrowing Short to Lend Long; (Chapter 12)

### Lecture 13: Illicit Interest Arbitrage

## Fall Semester, 2002

### Monetary Economics 201: Gold and Interest

## In Preparation: Courses To Be Offered In

2003

Monetary Economics 201: The Bill Market and the Formation of the Discount Rate Monetary Economics 202: The Bond Market and the Formation of the Interest

### Rate

---

# Monetary Economics 101 — Lecture 4: The Two Sources of Credit

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-101-lecture-4-the-two-sources-of-credit/
Date: 2002-07-22
Section: Money & Credit
Difficulty: intermediate
Concept Tags: real-bills, self-liquidating-credit, interest-theory, gold-standard
Description: Fekete identifies two distinct sources of credit: savings-based credit (funded by deferred consumption and carrying interest) and real-bills credit (self-liquidating, funded by the circulation of goods in the pipeline of production). Conflating the two sources, he argues, is the central error of quantity-theory monetarism.
Editorial Note: Lecture 4 of Monetary Economics 101 (Gold Standard University, 2002). This lecture introduces the central analytical distinction of Fekete's monetary theory — one that he argues Mises himself failed to maintain consistently.
Original PDF: https://professorfekete.com/articles/AEFMonEcon101Lecture4.pdf

### Lecture 4

## The Two Sources Of Credit

-Lending versus Clearing M Interest Rates versus Discount Rate - Uses and Abuses of Credit M Social Circulating Capital - Condemning the Regime of Irredeemable Currency M -

### Monetary System Tied to Negative Rather Than Positive Values

I dedicate this Lecture to the memory of Ludwig von Mises, monetary scientist and teacher, who exposed the motives for Gold Wars as follows: "The struggle against gold which is one of the main concerns of all contemporary governments must not be looked upon as an isolated phenomenon. It is but one item in the gigantic process of destruction which is the mark of our time. People fight the gold standard because they want to substitute national autarky for free trade, war for peace, totalitarian government omnipotence for liberty."

### (Ludwig von Mises: Human Action, Chapter XVII, Section 19)

1972 was a milestone in the history of money and credit. Previously, in the world's most developed countries, money (and hence credit) was tied to a positive value: that of a welldefined quantity of a good of a well-defined quality. In 1972 this tie was cut. Ever since, money has been tied not to positive but to negative values - that of debt instruments. This innovation had two immediate consequences, both of which are pointedly ignored in the scholarly literature on the subject:

### •

### •

1. The option to reduce the world's total debt in the course of normal payments has been lost: total indebtedness could only be reduced through default or through currency depreciation.

2. Governments have lost the option to balance their budget. When in need of real resources, governments borrow, and borrow they must especially from foreign creditors.

As a result of these two features the world's monetary system, which previously was patterned on the model of an anchor, is now patterned on the model of a weather-wane.

As the tide of unpaid and unpayable debt grows, so ebbs the value of money.

That the world has lost the facility to reduce its total indebtedness short of default or monetary depreciation becomes clear if we consider the fact that a debt of \$1,000 once contracted cannot be liquidated. If it is paid off by a check, the debt is merely transferred to the bank on which the check is drawn. The situation is no better if it is paid off by tendering \$1,000 in Federal Reserve notes, ostensibly the ultimate liquidator of debt. In this case the debt is transferred to the U.S. Treasury, the guarantor of the liabilities of the Federal Reserve banks (since it is clear that the latter have neither the intention nor the resources to meet these obligations). However, substituting one debtor for another is not the same as liquidating debt. The very notion of 'debt maturity' has lost all reasonable meaning previously attached to it. At maturity the creditor is coerced into extending his original credit plus accrued interest in the form of new credits, usually on inferior terms.

It is true that the option to consume his capital represented by the credit is open to him.

But is it not a strange monetary system, to say the least, which forces savers to eat the seed corn whenever they are dissatisfied with the quality of available debt instruments, or with the terms on which they are offered?

### Monetary Growth Must Exceed the Rate of Interest

This argument also shows that the stock of money must increase at least at the rate marked by the rate of interest. Every year monetary authorities must create at least as much new money as needed to service outstanding debt, in order to keep the game of musical chairs going. No monetary policy can be implemented that would cut the rate of monetary growth below the rate of interest on a net basis. So much for Milton Friedman's clever horse that he said he would train to tread out new money at the treadmill. Poor horsey will be confused mightily when the rate of interest goes to 16 percent, as it did in 1980.

Governments have lost not only their option to reduce indebtedness but, more ominously, the option to balance their budgets. There is a new item in the budget that is never named, that is well-hidden, but that is increasing by leaps and bounds year after year: that part of government borrowing that is needed to provide cover for the increase of the monetary base. In other words, the budget deficit has become an autonomous, non-discretionary item in the budget that has nothing to do with financing operations, or with husbanding resources. It has become indispensable without which there is no way to inject new money into the economy, and without which the dogs of deflation would be unleashed.

From a narcotic drug with all its negative side effects the budget deficit has become a standard prescription drug routinely provided for the stimulus to which society has become addicted. It is remarkable that this change in the character of the budget deficit had to be made clandestinely. The utterances of politicians about their resolve to eliminate the budget deficit is disingenuous - it cannot be done under the prevailing monetary regime on a net basis. This raises grave questions about the stability and durability of the regime. Governments are busy constructing an enormous Tower of Babel to reach to high heaven, the bricks of which are made of public debt - without giving the slightest thought to the wisdom or safety of their construction.

### Anniversary Ignored

The year 2002 marks the thirtieth anniversary of the Brave New World of reckless debt breeding. A third of a century is not a great length of time in the course of history. But it might be sufficiently long to warrant an examination of this deliberate policy of heaping more debt upon unpaid and unpayable debts. Has the policy of unbridled creditexpansion, blindly embraced by the governments of the world some 30 years ago, served the people well? Or do the negative results of this latest experimentation with the regime of irredeemable currency warrant a more careful examination of the principles involved than hitherto provided? The question is not raised, and the anniversary is being ignored.

A great deal of obfuscation surrounds the issue. Officially the topic is off-limits to scholarship and research. Anyone who dares to question the legitimacy and wisdom of the world's present monetary arrangements, or challenges the doctrine that the regime of irredeemable currency represents 'progress' over 'obsolete' metallic monetary regimes, is browbeaten or subjected to ostracism and contempt by the powers-that-be. Professional standing is reserved for those who pay lip-service to the dogma that emancipation from a metallic monetary standard was a progressive, even a necessary, historical development.

### Ludwig von Mises

One author whose work may help those undaunted in the pursuit of knowledge in the face of official disapprobation is Ludwig von Mises. He published his epoch-making treatise Theorie des Geldes und der Umlaufsmittel in 1912 at the age of 31. A second German edition was published in 1924. The work was translated into English and published under the title The Theory of Money and Credit in 1934. The first American edition in 1952 included an important essay entitled Monetary Reconstruction. Mises also developed a theory of interest contained in his magnum opus entitled Human Action (Chapters XIX and XX). He died in 1973 at the age of 92, just one year after the politicians, in the face of his persistent exhortation to the contrary, committed our planet to the regime of irredeemable currency. Ludwig von Mises was indeed a giant of monetary science in the twentieth century. It is a great tragedy of our age that world leaders deliberately ignored his teachings and advice when they chose this most perilous course, apparently irreversible, the global regime of irredeemable currency. Not a single country has been allowed to experiment with a metallic monetary standard. The world's monetary and payments system is based on coercion, probably worse than the bondage of vassals in the Middle Ages. No serious thought was put into the construction of this monetary regime.

It was shaped as the world was drifting from one monetary crisis into another, each step representing deterioration as compared with the previous stage.

### Missed Opportunities

Two unique historical opportunities have been missed to change course. One was marked by the collapse of the Soviet Union and its 'Evil Empire'. It is a fact not very well known that in 1989 a delegation of high-powered monetary economists from the United States traveled to Moscow and warned Soviet leaders that the collapse of their economy was imminent. They recommended that Soviet leaders issue gold-bonded debt in order to save their power at the 11th hour. The advice came too late. The Soviet Union collapsed, and the reason was the downwards spiral of its economy as predicted. This episode is interesting for two reasons. First, the same advice was not given to the new leadership of Russia. Saving Soviet Communism from self-destruction was apparently well-worth playing the gold card. But saving Russia from the consequences of the continuing downwards economic spiral is another matter. Russia is now target for globalization.

There is no place for gold-bond financing in the globalized world. But there is another reason, too, why the episode mentioned is interesting. It reveals that the gold card does have a place in the contingency planning of the managers of the world's monetary system.

They may play it if and when a systemic collapse of credit occurs.

The second missed opportunity was the adoption of the Euro by the European Community. It should have been an occasion for initiating a reform of the international monetary system. Unfortunately, European politicians were motivated by greed more than by a desire to pull the world out of the morass. They created a monetary system which appears to be a carbon copy of the defunct dollar system, trying to capture part of the 100 percent seigniorage the Americans collect as a tribute from the rest of the world on global monetary reserves.

I build on the monetary theories of Ludwig von Mises. However, I wish to point out to my audience that where I find myself in disagreement with him, I will be bound neither by false admiration nor by false devotion, but will state the truth as I see it. I am convinced that Mises would not want me to act in any other way. I have already touched upon my disagreement with Mises on the question of the Quantity Theory of Money. I shall mention two others later in this Lecture.

### Uses and Abuses of Credit

This long introduction to my topic on hand was necessary to set the stage. According to an old saying, a text-book on pathology makes you feel sick: in a healthy world you are bombarded with pictures of worst-case diseases. I may add that a text-book on credit will make you even sicker. In the real world as it exists today, there are only pathological varieties of money and credit to which we have all been thoroughly conditioned. In a sick world you are bombarded with pictures of healthy and wholesome varieties of money and credit. The experience will make you sick with jaundice. To lessen the shock you must be debriefed.

Credit is one of the great creative forces of civilization and one of the supporting pillars of human welfare. Next to knowledge and capital, credit is the paramount engine of progress. It can hardly be doubted that most of the prodigious amenities and inventions, technological and therapeutic advances available to modern society owe their origins to credit. To see this we have only to remind ourselves of the role of credit in capital accumulation and in capitalizing income. While capital accumulation would still be possible in the absence of credit, the amounts involved would be reduced to a pittance, subject to the physical limitations of their primitive form: hoarding. Not only would quantity be limited by physical factors, but also the reward would be far removed from effort, giving rise to psychological forces that would militate against saving. One of the great merits of credit is in the manner it works upon the time-element in the means-ends chain, shortening the effort/reward nexus, prompting the individual to work and save harder.

Credit abuse is one of the most difficult problems economics is called upon to study.

Exactly the same factors that make credit a great creative force and an engine of human progress will, when abused, render it a most dangerous and obreptitious agent of destruction. With credit, just as with any sharp instrument, the more beneficial the uses, the more devastating are the abuses. Yet precisely because of the way credit operates on the time element in the means-ends chain of human action, abuses obscure the causality nexus and corrupt the feedback mechanism. Consequently, abuses persist and penalties are deferred. While deferred, they are certainly not forgiven. When the credit system can take no more abuse, cumulative penalties are meted out all at once. If it were not for compounding, penalties would be lighter and immediate adjustment would avert further punishment. There would be self-correction. But as the feed-back mechanism has been corrupted, a veritable disaster in the form of credit collapse is periodically visited upon society. There is also a tendency to confuse the issue: a man-made disaster such as inflation (more appropriately called deliberate currency depreciation) is described as a natural disaster that mortal man can hardly control, still less eliminate.

### Positivism

Positivism is a philosophical school underlying the 'scientific culture' of our age. It fanatically denies the teleological nature of economics, and is largely responsible for the confusion between capital and credit. Positivists deny that there is anything wrong with the world economy and its financial underpinnings. According to them everything in economics is to be explained in terms of causality to the exclusion of teleology. Then of course the notion of credit abuse disappears, that is, becomes unscientific. So does the notion of honorable dealings, fair play, and the sanctity of contracts. No shame is attached to breaking a promise, to pulling a surprise devaluation of the currency, or to declaring bankruptcy fraudulently - if perpetrated under a dispensation from the government. The only thing that matters is that 'human molecules' respond positively to the stimulus provided by the injection of bills of credit with no ultimate obligor into the system. Goethe described this in his famous paper money scene:

We printed at once the notes, large and small,

Tens, twenties, fifties, hundreds and all,

### You can't imagine how it pleased the people, short and tall!

### (Goethe: Faust, Part II, Act 1)

To the positivist mind it is cantankerous hair-splitting to drag eleemosynary and educational institutions, widows and orphans - who are dependent on the integrity of the currency for their economic survival - into the debate. It is not the task of my Lectures to enter into a moral argument. It should be possible to establish scientific truth without reference to a value-system. We only need to establish the fact that credit abuse corrupts the feedback mechanism without which no adjustment is possible, that it undermines and ultimately destroys the free and voluntary cooperation of individuals under the system of division of labor; that it leads to capital consumption which is hard to detect but which, nevertheless, is a prescription for the wholesale pauperization of society.

### The Two Sources of Credit

In the first three Lectures I talked about short-term credit as it arises through clearing.

Now I want to put it into a wider context. There are two kinds of credit: in addition to short-term we also have long-term credit. It is very important to keep the two separate and avoid any possibility of confusion between them. Let us put the main features of the two varieties of credit side-by-side.

### Short-term credit

### Long-term credit

### Definition: 91 days or less

### Source: Clearing

### Motivation: Propensity to consume

### Instrument: The real bill

### Theater: The bill market

### Regulator: The discount rate

### Definition: 92 days or more

### Source: Saving

### Motivation: Propensity to save

### Instrument: The gold bond

### Theater: The bond market

### Regulator: The rate of interest

The dividing line of 91 days between the two is not arbitrary. It is one quarter, the length of the seasons of the year. The difference between the two kinds of credit is fundamental, and goes far beyond the difference in the maturities of credit instruments. Mises denies that sound credit can arise outside of the context of lending and borrowing. For him 'discount rate' is just another name for the rate of interest on short-term loans. Mises denies the validity of the Real Bills Doctrine of Adam Smith. He considers circulating real bills as inflationary as any other form of credit expansion.

In the following Lectures I shall show that there is no lending and borrowing involved in discounting a real bill, and that bills stand apart conceptually as well as functionally from bonds, as does the discount rate from the rate of interest. Real bills circulate on their own wings and under their own steam. To put it more succinctly, the negotiation of the bill is not a lending but a clearing function. One of the greatest shortcoming of Mises' theory of interest is his failure to recognize the discount rate as another independent and autonomous regulator of credit. It is a mistake to believe that saving is the only source credit. Clearing is a well-recognized second source. The rate of interest is the regulator of lending, grounded in the propensity to save. The discount rate is the regulator of clearing, grounded in the propensity to consume. The relationship in both cases is inverse: the higher the propensity the lower is the rate, and conversely. For example, the higher the propensity to save, the lower is the rate of interest; the lower the propensity to consume, the higher is the discount rate. We shall study these relationships in much greater details in later Lectures.

### Social Circulating Capital

Social circulating capital, a concept that we also owe to Adam Smith, is defined as that mass of finished or semi-finished goods in urgent need which is moving fast enough to retail outlets so that it is bound to be removed from the market in less than 91 days (the length of the seasons of the year) by the ultimate cash-paying consumer. A certain consumer good is part of the social circulating capital if, and only if, the bill drawn against it will circulate. The prospect of impending consumption of this goods makes it rather special. Its movement through the production and distribution channels is predictable. The uncertainty connected with the ultimate disposal of this goods is reduced to its irreducible minimum. For this reason the credit it generates will circulate Not every consumer good is capable of generating bill circulation, e.g., slow merchandise, goods sold on an installment plan, stores of goods held back in the expectation of speculative profits due to a rise in price. We shall see that certain type of merchandise may at one point start generating bill circulation indicating that they have just become part of the social circulating capital. At other times the same merchandise may drop out of the social circulating capital, the sign of which is that bills drawn on them no longer circulate, e.g., seasonal goods such as heating fuel or seed corn. This highlights the rationale for limiting the term of real bills to 91 days. We shall also see that the composition as well as the size of social circulating capital is subject to frequent changes reflecting the shifting demand of the consumer. Handlers of goods belonging to the social circulating capital can operate with a minimum amount of capital by virtue of the fact that bills on fast-moving goods are acceptable in trade as a means of exchange. These tradesmen are processing merchandise 'on the go', the further path of which is highly predictable. The risk that the goods won't be sold in time is negligible. Compare this with the risk of carrying merchandise that does not belong to the social circulating capital, goods that cannot be sold in 91 days. If merchandise cannot be sold in 91 days, then it may not be sold for a year until the same season of the year comes around once more. During the year fashion may change beyond recognition, and any other unforeseeable circumstance may make the merchandise unsaleable except at a loss. To cover this risk tradesmen must carry insurance in the shape of a larger capital.

### Present and Future Goods

The theory of interest of Mises is built upon the distinction between present goods and future goods. Interest is just the premium people are willing to pay for the privilege of getting the present good they prefer to the corresponding future good. Therefore it is very important to know where to draw the line between the two.

This is a point where I could not bring myself to agree with the position of Mises. He states in the Theory of Money and Credit that secure and mature claims to gold coins are complete substitutes for them and, as such, they are able to fullfil all the functions of the gold coin in those markets in which their security and maturity is recognized. Mises categorically states that a bank note is a present good just as much as the gold coin. "A person who accepts and holds [bank] notes grants no credit - he exchanges no present good for a future good... The note is a present good just as much as the money." (See the 1980 edition, p 304-305.) I must part company with Mises over this issue. My position is that the holders of gold certificates and, for the stronger reason, holders of bank notes are in fact (voluntary or involuntary) grantors of credit. What they hold is a promise to deliver a present good, not the present good itself. In other words, paper currency such as a gold certificate or a bank note is a future good. There is no point in wiping out the distinction between a present good and a promise to deliver a present good on demand, or a 'legal tender' readily exchangeable for a present good. If we admit that a bank note is a present good, then we also have to admit that Keynes is right after all in suggesting that the government has the power to create wealth out of nothing, simply by sprinkling some ink on little scraps of paper. This is no idle quibbling or hair-splitting. This is a fundamental issue on which the theory of interest turns (and to which I plan to return in 2003 when I offer another course on the bond market and the formation of interest rates.)

### The Regime of Irredeemable Currency

Both Mises and I condemn the regime of irredeemable currency. His reasoning has to do exclusively with its role causing progressive inflation. Mises subscribes to what he calls a refined version of the Quantity Theory of Money. (The refinement consists in taking into full account leads and lags in the increases in the stock of money and changes in the price level.) The difference between the position of Mises and that of Friedman is this: Mises believes that inflation caused by irredeemable currency inevitably leads to a 'crack-up boom', while Friedman believes that such an outcome can be avoided indefinitely, provided that the rate of increasing the stock of money is kept fixed at a suitably low level. If Friedman could prove his contention using cold logic then, presumably, Mises would no longer object to the regime of irredeemable currency.

My own objection is more fundamental. The Quantity Theory divorces money and credit from moral philosophy. It robs money of its ethical dimension. It makes the emergence of money a mechanical process devoid of any moral content. My own position concerning the role of money in society is closer to that of Ayn Rand. I regard the Quantity Theory a most vicious and dangerous doctrine. Its seductive simplicity and plausibility make it suitable to lull the vast majority of people into a false sense of security. It is responsible for the victims of inflation accepting the proposition that the government has a legitimate role in managing the nation's money supply, and inflation will be eliminated as soon as researchers come up with the right formula how to fine-tune it. Even if I granted that Milton Friedman were right in assuming that, with a judicious control of the money supply, the inflation could be completely eliminated (which I don't), I would still condemn the regime of irredeemable currency on moral grounds, as it disenfranchises savers and consumers. The saver can no longer control his savings. Bereft of his gold coin, his role is reduced to that of the bee: to gather honey for the benefit of the apiarist.

The consumer is no longer king. Bereft of his gold coin, he has been reduced to the status of a pawn. Producers and distributors of consumer goods are no longer his servants. They have all been put in hock to the banks. The regime of irredeemable currency represents a latter-day bondage and servitude, more vicious than any throughout the long history of humans exploiting humans. Previous forms of exploitation were overt. The slave knew he was a slave. The new forms of exploitation are covert. Slaves are encouraged to believe, as they do, that they are free or, what is more, that they are in charge.

### Extended Order of Information

The 'division of knowledge' and the related idea of the 'extended order of information' were introduced by F. A. Hayek in his last book The Fatal Conceit - Errors of Socialism (Chicago, 1988). The Nobel laureate economist compared the data-collecting and dataprocessing mechanism of the market system to a gigantic computer that could not be replaced, imitated, or duplicated by the human brain, still less by an artificial device conceived by the human brain. The extended order of information works with a data-base whose sheer size and information-density boggles the mind. It processes, propagates, and retrieves information so efficiently that we cannot even describe it in terms of examples borrowed from other fields. This particular form of organizing knowledge is sui generis, one of a kind. It cannot be realized except in the context of the market system, with its continually changing prices, interest and discount rates, and with the instantaneous reactions to these changes by market participants. Without it our civilization would cease to function, production and exchange of goods would be thrown into utter confusion.

Hundreds of millions would become homeless; famine and epidemic diseases would decimate the population. In future courses to be offered in 2003 on the program of GoldEagle University I plan to take a glimpse into the inner workings of this miraculous system of information-processing and communication, in describing the formation of the discount and interest rates in terms of marginal analysis and arbitrage.

Credit is of great interest to everybody with a modicum of intellectual curiosity, and my Lectures are designed to satisfy this curiosity. Unfortunately, the subject is usually treated in a polemic style generating more heat than light. While the literature on the subject is vast, most of it is one-sided and partisan. There are few studies explaining sine ira et studio the principles underlying credit and banking. I shall endeavor to relate the subject of credit to the larger problem of exchanging income for wealth and wealth for income, a new approach that I believe to be very fruitful. Only in this way can the economic functions of the rate of interest and the discount rate be brought to light.

It is hardly necessary to add that I shall try to make this study fair and candid. I have created this lecture series for the benefit of those open-minded readers who are looking for a disinterested treatment of the subject. Those who believe that government intervention in credit-relations can do no harm but that the government can, through judicious monetization of its own debt, create value and wealth, are asked to switch off the screen and read no further. My Lectures are dedicated to the refutation of latter-day orthodoxy. They represent the opposing view, however unfashionable, that the credit of the government, no less than that of the individual, can indeed be abused. The monetization of government debt and other forms of credit abuse ultimately lead to a wholesale destruction of capital, and hence to the pauperization of the entire society through credit collapse. It has happened before. The most recent episode was the Great Depression of the 1930's. It can happen again.

Today we are witnesses to the unfolding of an unprecedented historic event. The entire world is being engulfed by a tidal wave of credit expansion. The tsunami of the \$100 trillion derivative monster is just one example. The runaway Debt Tower of Babel, based on nothing more substantial than the irredeemable promises of the U.S. Treasury - itself empty (or worse), is another.

In all historical episodes of experimenting with the regime of irredeemable currency, while some governments were churning out irredeemable bills of credit with abandon, others continued paying their bills punctiliously as contracted - that is, in specie. When the day of reckoning dawned, the latter could help the former to find their way back to the path of fiscal and monetary rectitude. In the present episode all governments of the world are merrily destroying their own credit - and with it, their command over real resources. Which quarter will rescue come from when the Debt Tower of Babel topples?

### Open the Mint to Silver, Too!

Mr. David Shapley dshapley@dfwoffice.com asks how the monetary system I recommend compares with the bimetallic system of the U.S. Constitution. Should the

### Mint be open to silver as well?

First of all, a correction. Bimetallism prescribes an official fixed bimetallic ratio between gold and silver. As the normal state of prices is dynamic rather than static, bimetallism rests on the presumption that the government can create or destroy value by fiat. It is, therefore, a faulty monetary policy which is bound to fail. The U.S. Constitution never prescribed bimetallism. It merely ordered that the Mint should be open to both monetary metals, the implication being that there would be a parallel standard of both silver and gold (at a variable exchange rate). The monetary unit was specified as the standard silver dollar.

It was the Coinage Act of 1792 that, by fixing the price of gold in terms of silver, introduced the official bimetallic ratio of 15:1. It was a mistake that gave rise to a lot of monetary mischief later, threatening social peace. The mistake was never corrected. It would have taken a Constitutional amendment to drop the standard silver dollar as the monetary unit of the United States.

In a series of Lectures of this type it is not possible to discuss every minute detail of the plan for monetary reconstruction, such as the question of silver coins, subsidiary coins, gold and silver certificates, etc. Therefore I did not discuss the role for silver. But now that the question has been raised, I have to clarify my position which is this. The monetary system that I recommend for the United States is the Constitutional one: open the Mint to both monetary metals. I recommend that the one ounce Gold Eagle coin

(minus the silly reference on the coin to the dollar) should be adopted, instead of the standard silver dollar, as the monetary unit. This will take a Constitutional amendment.

This change reflects a greatly increased monetary role for gold and decreased one for silver that has occurred during the past two hundred years, and the great abuse to which the dollar has been subjected by the government. But I think that the wisdom of the Constitution should be respected and silver be given its monetary role back. Let the people decide whether they prefer a dual monetary standard or a monometallic one. Mr. Shapley continues his comments raising some very interesting possibilities.

"It seems that the purchasing power of gold would be very high. I would imagine that a loaf of bread would not cost a gold coin. What about small-ticket items? I would lay odds that people would also want to carry something lighter than coins. Perhaps cards with smithereens of perfectly weighed gold in them? Or gold certificates? However, if they choose paper once again, what is to stop the issuers of that paper to do what they have done to the old gold standard, i.e., issuing far more paper than they had gold to back it?" It seems to me that Mr. Shapley's idea of enclosing stamped gold smithereens in Lucite cards or coin-shaped holders is a most excellent one to provide fractional coinage. For that matter, the standard Eagle Coin could also be enclosed in Lucite holders to eliminate wear and tear. No doubt, there will be a lot of discussions on these proposals once the major hurdle, the opening of the Mint to gold and silver, has been cleared.

### Reference

F. A. Hayek: The Fatal Conceit - Errors of Socialism, Ed.: W. W. Bartley III, The

### University of Chicago Press, 1988

### Antal E. Fekete

### Memorial University of Newfoundland

### St.John's, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand's Hymn to Money

### Lecture 2: Don't Fix the Dollar Price of Gold

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told; (Chapters 1 - 3)

### Lecture 6: The Invention of Discounting; (Chapters 4 - 6)

### Lecture 7: The Mystery of the Discount Rate; (Chapters 7 - 8)

### Lecture 8: Bills Drawn on the Goldsmith; (Chapter 9)

### Lecture 9: Legal Tender. Bank Notes of Small Denomination

### Lecture 10: Revolt of Quality; (Chapter 10)

### Lecture 11: Acceptance House; (Chapter 11)

### Lecture 12: Borrowing Short to Lend Long; (Chapter 12)

### Lecture 13: Illicit Interest Arbitrage

## Fall Semester, 2002

### Monetary Economics 201: Gold and Interest

## In Preparation: Courses To Be Offered In

2003

Monetary Economics 201: The Bill Market and the Formation of the Discount Rate Monetary Economics 202: The Bond Market and the Formation of the Interest

### Rate

---

# Monetary Economics 101 — Lecture 3: Credit Unions

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-101-lecture-3-credit-unions/
Date: 2002-07-15
Section: Money & Credit
Difficulty: intermediate
Concept Tags: real-bills, self-liquidating-credit, gold-standard, mises
Description: Fekete examines the role of credit unions in the monetary system, arguing they embody the principle of self-liquidating credit: members pool their creditworthiness to finance short-term productive activity without creating new money. He contrasts this with the destructive credit expansion of modern fractional-reserve banking.
Editorial Note: Lecture 3 of Monetary Economics 101 (Gold Standard University, 2002). Dedicated to Ely Moore, the first union official elected to Congress, who championed the gold standard as a working man's bulwark against monetary manipulation.
Original PDF: https://professorfekete.com/articles/AEFMonEcon101Lecture3.pdf

### Lecture 3

## Credit Unions

- The Invisible Vacuum Cleaner - The Quantity Theory of Money - Destruction of the Gold Standard - And Discrediting the Real Bills Doctrine - Are Two Sides of the Same Coin - The Working Man As the Guardian of Sound Money -

### Lending versus Clearing

I dedicate this lecture to the memory of Ely Moore, the first union official ever to have been elected to the Congress in 1834. He was a solid gold-standard man who believed, with Daniel Webster, that "Of all the contrivances for cheating the laboring classes of mankind, none has been more effective than that which deludes them with paper money."

### Daniel Webster

In the first two Lectures I dealt with a new blueprint for a gold coin standard for America and the world, designed to avoid two great pitfalls: (1) the pitfall of breakdown of social peace between creditors and debtors, (2) the pitfall of entrusting gold coins that represent the savings of the people to the banks. In this Lecture I shall recommend that the guardianship to preserve the system of sound money should, instead, be entrusted to the laboring classes and their representatives, the Credit Unions, which would be the only financial institutions chartered to carry deposit accounts denominated in Gold Eagle coins, and which would act as clearing houses for the circulation of real bills.

Recall that real bills provide credits to move urgently demanded consumer goods from the producers to the retail outlets. We don't need banks for that. In any event, short term commercial credits arise not through lending but through clearing. As the supply of consumer goods emerge in production, purchasing media to finance its movement to the consumer emerge simultaneously through the process of clearing. No lending is involved.

Coin, credit, circulation, clearing - the four C's - are central ideas that economics has ignored. We are going to revive them here in preparation to pave the way to a new gold coin standard.

### The Invisible Vacuum Cleaner

Imagine that General Motors has come into the possession of a fantastic contrivance: an invisible vacuum cleaner capable of siphoning out of the pockets of every worker two dollars for every dollar that his union had won for him in wage contracts at the bargaining table. Further imagine that the invisible vacuum cleaner would operate secretly and unobtrusively (just like other contrivances did in the recent accounting scandals of Enron and Westcom) so that the theft or embezzlement could not be detected. What would be the result of the wholesale application of the new device? Well, labor would have to run twice as fast on the treadmill just to stay abreast, while the union could pat itself on the back for having negotiated a good contract. In the meantime the public would be told again that the process of collective bargaining was working fairly and efficiently.

This parable is, of course, far too fanciful to approximate truth. General Motors would find itself in the center of a devastating legal challenge and public relation fiasco if and when the theft eventually came to light. It is doubtful, to say the least, that the existence of a contrivance of this kind could be kept in secret forever. Another problem with the scheme is the tacit assumption that the workers and their unions is a bunch of illiterate boors unfamiliar with the four rules of arithmetic.

### Combating Inflation

Yet the parable is not quite as fanciful as it may appear at first sight. Actually, there is an invisible vacuum cleaner. It is called "deliberate currency debasement". Just substitute "government" for "General Motors", and pieces of the jigsaw puzzle immediately fall into place. Unlike General Motors, the government cannot be sued for siphoning off labor's gains fraudulently and surreptitiously. The modus operandi of the government's invisible vacuum cleaner is known to and condemned by many a courageous critic, but to no avail.

The media ignores the criticism and the public=s ire is not raised. Some monetary experts are blackmailed, and some economists are bribed with fat government contracts and grants. To add insult to injury, the funds used for bribing have come out of the loot. The chorus of servile economists suppresses the voice of the critics. To the former deliberate currency debasement, which they prefer to call "inflation" with a connotation that, far from being man-made, it is a natural phenomenon, is merely a minor irritant. They see no moral dimension to the problem. As long as inflation is barely noticeable, everything is fine. Economists cheer on the government for its valiant efforts to "combat inflation" - as if it weren't the same government that has been both the engineer and the beneficiary of what is being combated.

The invisible vacuum cleaner can only be operated by the government which is free to bend the legal system to its advantage. It can even violate the Constitution with impunity at pleasure. The Constitution of the United States expressly forbids the use of "bills of credit" as legal tender, but this has never inhibited the Treasury from printing the legend on every Federal Reserve note that it is "legal tender for all obligations, public and private". Since the executive arm of the government controls the judiciary (certainly as far as jurors' compensation is concerned), no wonder that the latter condones the fraud of siphoning off labor's wage gains, and no legal challenge to the operation of the invisible vacuum cleaner can ever succeed.

### The Pleasure of Being Cheated

Not only does the government bribe the economists' profession, it also uses its control over public education to throw dust into the eyes of every new generation of workers entering the labor force. Docile teachers fail to instruct their pupils about the importance of the virtue of thrift, about honesty in dealings between the government and its subjects, or between the government and its creditors. Instead, they preach the desirability, nay, the necessity for the government to manage the nation's money supply, which is just as absurd as the idea of the government's managing the nation's soap supply. The citizens are immersed in a barrage of government propaganda from womb to tomb. Small wonder that the workers are confused and their unions are blinded to official duplicity and chicanery.

The invisible vacuum cleaner reaches not only into the pockets and bank accounts of domestic workers: it is equally effective in siphoning off the savings of foreign workers.

It is the Moloch of the world. It can reach into the vaults of central banks and the mattresses of poor peasants the world over, wherever dollar bank notes or balances are held. U.S. Treasury bonds in the hand of foreigners are, in effect, irredeemable promises.

At maturity the holder of the old issue can only exchange it for another scrap of paper carrying another irredeemable promise. The promisor assumes no responsibility except for the quality of ink and paper to make counterfeiting harder. If at maturity the dollar is worth only a fraction of the value of the dollar with which the bond was purchased 30 years earlier, that's too bad. But it is entirely the problem of the foreign holder of the bond. Why under these circumstances are foreigners so foolish as to buy and hold U.S.

### Treasury securities?

"Doubtless the pleasure is as great of being cheated as to cheat."

### Samuel Butler (1600-1680), Hudibris, Part 2, Canto III

Foreign holders try to beat their own central bank. They are proud that they have outsmarted their home-grown looters as the securities of their own government lose value even faster than those of the U.S.

### Presidential Lies

Former president Clinton declared from the White House that the dollar's strength was due to the "impeccable record of the U.S. to pay its obligations meticulously". He claimed that "there has never been a case of the U.S. defaulting on its bonds in the entire history of the Republic." This, of course, is an outright lie. Financial annals record two cases of American default, the first under a Democratic, and the second under a Republican president. After the Roosevelt administration devalued the dollar in 1933, it paid bondholders in diluted dollars. It did this in spite of a gold clause written into the bond. Apart from an insignificant number of unimportant cases, Roosevelt failed to make amends after in 1935 the Supreme Court reviewed the case of abrogating the gold clause, and ruled that the government had no power to alter unilaterally the contract embodied by the bond, concluding that bondholders were entitled to the dollar-equivalent of the value reserved by the gold clause.

35 years later, in 1971, the Nixon administration defaulted on the gold obligations of the United States held by foreign governments. It did this in spite of the solemn commitment confirmed by four presidents to honor the gold redeemability of the dollar for foreign governments. The injured parties never sued C presumably as a result of some behindthe-scenes diplomatic arm-twisting. Yet this default was the root cause of the heartrending depreciation in the value of all the currencies of the world that followed, wiping out 90 percent of the purchasing power of savings denominated in paper currencies. First the dishonored dollar went to a deep discount in terms of gold and foreign exchange.

Then other governments, in an effort to protect their export industries, felt obliged to follow suit and debased their currencies to approximate the debasement of the dollar.

It is characteristic of the enormous deterioration in public morality that, while in 1935 workers and savers in the United States could still take the federal government to court charging that property was taken from them without due process of law, and in so doing they could draw attention to the official fraud and duplicity, such challenges were no longer possible in 2001. That year, when the workers' pension funds cashed in their 30year Treasury bonds issued in 1971, they received 10 cents on the dollar in purchasing power. The missing 90 cents represented wealth stealthily confiscated by the government.

But since the law does not allow a distinction between the 1971 and the 2001 dollar (in spite of the hypocrisy that the government's own Labor Department explicitly makes such a distinction for approved purposes), the government is unconstitutionally taking from the working and saving public.

Nothing shows the success of official brain-washing through public education and through the activities of economists in the pay of the government more clearly than the fact that the unions are not protesting the progressive and stealthy confiscation of wealth held by their pension funds, and neither the Congress nor the media took Mr. Clinton to task for lying publicly about the dismal history of the dollar.

### The Quantity Theory of Money

How could the government, to which the Constitution granted only limited and carefully enumerated powers, grab unlimited power symbolized by the invisible vacuum cleaner?

How could the government get away with robbing workers of their wage gains and savers of their savings, not only in this country, but world around? How could we account for the travesty that the government, while doing these things with impunity, earns high praise for "combating inflation?"

The short answer to these difficult questions is that the government has, over a period of time involving several generations, successfully indoctrinated people with a most dangerous and vicious doctrine, the Quantity Theory of Money. According to it the value of money is determined, not by its quality, but solely by its quantity. The obvious motivation of the Quantity Theory is the a priori removal of all moral considerations from the debate on debt-based money. Since regulating the quantity of money involves regulating the banking system, it follows that the task can only be entrusted to the government. Only the government can make the ponderous decisions impartially which are involved in the problem of increasing the quantity of money in uniform doses, year in and year out. The Quantity Theory of Money uses an impressive array of mathematics such as the Equation of Exchange MV = PQ (where M is the stock of money, V is the velocity of money in circulation, P is the price level, and Q is the physical volume of transactions). The purpose of the exercise is to persuade the uninitiated that human action, just like mechanical action, can be reliably predicted via mathematical formulas.

However, individuals are not molecules and, therefore, the essence of human action cannot be captured by equations. Human individuals have what molecules have not, namely, free will. You may plug in space, time, mass, force, etc., into your equations. But you can never plug in free will.

The trouble with the Quantity Theory of Money is that it is palpably false. Monetarists have utterly failed to come up with a universally acceptable definition of money. This is evident from the proliferation of the monetary aggregates M1, M2, M3,..., etc., ad nauseam. (Milton Friedman tried to get around the problem by confining his version of the Quantity Theory called "monetarism" to "high-powered money" defined as the deposit liabilities of the Federal Reserve banks. Nice try, but has anybody ever used high powered money to buy a loaf of bread?) If we cannot agree on what money is, then how can we expect to regulate its quantity? Monetary scientist Walter E. Spahr had this to say in 1954: "Apparently no quantity theory of money which has thus far been stated has validity...

The evidence alone is sufficient to dispose of such an assumption. But, the reasons for the lack of relationship between the supply of currency and prevailing prices need to be understood. Currency is a two-dimensional entity. Besides supply there is velocity. Often velocity - the rapidity with which the supply of currency is used - is a more important factor than is the supply of currency in affecting prices."

### The Federal Reserve Act of 1913

It could be objected that it is hardly fair to blame the government for the outcome of a scientific debate that has ended with the triumph of the Quantity Theory of Money. This triumph, it is alleged, has come about through meticulous statistical research, not through crude government interference with scientific inquiry. Or did it, really? To adjudicate this issue it will be necessary to examine how the competing doctrine, the Quality Theory of Money, also known as the Real Bills Doctrine, has been dethroned and ostracized through the crudest interference in science by the strong arm of government. The Real Bills Doctrine, as we know, has the most impressive credentials. Adam Smith made it the corner stone of his Wealth of Nations in 1776. It has served as the scientific basis on which the monetary system of the German Reich was constructed after it adopted the gold standard in the 1870's.

To tell the truth, the Federal Reserve Act of 1913 was also crafted on the scientific basis of the Real Bills Doctrine. The Federal Reserve was conceived as a commercial-paper based system with the real bill as the only asset category eligible for re-discounting. In more detail, real bills were the only type of paper the Federal Reserve banks were by law allowed to purchase from their member banks. Treasury bills were ineligible. The Federal Reserve banks were not allowed to monetize government debt. The original Act refused to give the Treasury a free ride. The idea was that government debt ought to be exposed to the vicissitudes of the market, without offering it refuge in the portfolio of the Federal Reserve banks. The only way these banks could come into possession of government securities was through a penalty-provision. Whenever gold reserves fell below the legal limit of 40 percent of note and deposit liabilities, the Federal Reserve bank was assessed a tax penalty on a progressive scale. It had to make up the deficiency by putting government securities in the asset portfolio, but there was a tax penalty on the interest income from those securities amounting to several hundred percent. The Act had a builtin disincentive for the banks to hold government securities in their portfolio.

However, the original Act was never put into effect. It was violated on the very day the Federal Reserve banks opened their doors for business in 1914. There was no way for the U.S. government to finance the war effort of the Allied Powers through a commercialpaper based banking system which made the monetization of government debt impossible. No problem. A subterfuge would do the trick. The Federal Reserve banks deliberately dropped their gold cover below 40 percent of liabilities, and started loading up on government securities, to punish themselves for the violation. Maybe the Treasury will 'forget' to collect the tax penalty. You guessed it: that's just what the Treasury would do. Why should it tax an activity that it liked and wanted by all means to encourage? You scratch my back, and I'll scratch yours.

Ever since 1914 every chairman of the Federal Reserve Board, and every dollar of research money spent by the banks, has served to undermine the original concept. With each amendment of the Act, the dollar was diluted. The amendments cast the net ever wider for eligible paper, with an unmistakable intent to make room for government securities in the portfolio of the Federal Reserve banks. Step-by-step, what was conceived as a commercial-paper system to furnish an elastic currency for the benefit of the people, was converted into a fiat money system to monetize government debt. The beneficiary was no longer the general public, but the federal government itself, transgressing its constitutional limits and assuming unlimited power.

Finally, the amendments to the Federal Reserve Act progressively reduced and ultimately eliminated the gold reserve requirement mandated for Federal Reserve notes and deposits in stages from 40 to 35 and then to 25 percent. On February 21, 1968, the U.S. House of Representatives voted 199 to 190, and on March 14, 1968, the U.S. Senate voted 39 to 37 to repeal all gold reserve requirements against Federal Reserve notes. (Those against deposits had been repealed earlier.) The president signed the bill on March 19, 1968, thereby converting the dollar into fiat money. Under the original Federal Reserve Act of 1913, the government would have been forced to compete with private borrowers for the savings of the people. By 1968 the government could sell all the debt it wanted. If people wouldn't buy it, there was always a cozy corner in the portfolio of one of the Federal Reserve banks where the Treasury paper could take refuge.

### Science by Government

Thus was the Real Bills Doctrine overthrown in the United States between 1914 and

1968, not by a committee of scientists acting in the service of truth, but by the same government that had overthrown the Federal Reserve Act. Scientific justification, so called, came later, to provide the fig leaf to cover up the power grab. This is a shameful chapter in the history of science showing how scientists may go out of their way to do the bidding of the powers-that-be in exchange for material advantage.

The written record of this piecemeal corruption of the banking system and dilution of the U.S. dollar is there for everybody to see, on the pages of the Federal Reserve Bulletins and research publications of the individual Federal Reserve banks, from 1914 to date. In reading these pages one cannot help but observe how the Real Bills Doctrine was gradually discredited, and the Quantity Theory of Money promoted in its place as the supreme fountain of truth and wisdom. Never ever was the question raised whether the dismal results (such as the loss of 99 percent of the purchasing power of the dollar during the 88 years on the Fed's watch) were due to the dethronement of the Real Bills Doctrine.

The pseudo-research was most generously funded by the invisible vacuum cleaner. The incestuous relation between the Federal Reserve banks, and academic activities sponsored by them, make it abundantly clear that we are dealing not with bona fide research, but with science by government.

### Human Action or Horse Action?

The Real Bills Doctrine, as well as The Wealth of Nations, were conceived by their author as merely one chapter in a more complete work on society. This work was to be written in the great tradition of Scottish moral philosophy. In addition to economics, it was to comprise natural theology, ethics, politics, and law. Unfortunately Adam Smith (who was the professor of Moral Philosophy at Glasgow University) could never complete his great project.

By contrast, the theory of money, as it is presented today, is entirely devoid of any ethical considerations, and is completely divorced from moral philosophy. Just as Milton Friedman has described it: "even a clever horse can be trained to tread out the new money supply at a steady pace at the treadmill". But honest money is not the result of horse action or mechanical processes symbolized by the treadmill: it is the outcome of human action. Honest money cannot be obtained as a solution to the Equation of Exchange.

Honest money, that the workers, widows and orphans, and other people of small means can fully trust, comes about as a result of the market process, the natural process of production aiming at satisfying the urgent and demonstrable needs of the consuming public.

### Returning the Looted Gold

Milton Friedman and Anna Schwartz in their "Monetary History of the United States,

1867-1960" write that gold was nationalized in order to capture profits for the government that were to accrue later to all holders of gold, after president Roosevelt has devalued the dollar from \$20.67 an ounce of gold to \$35. When a fellow Democrat of the president, Senator Gore from Oklahoma, described the same sequence of presidential moves of appealing to the patriotic feelings of the citizens to turn in their gold 'temporarily', and then writing up its value, he used a somewhat different language: "Henry VIII approached total depravity as nearly as the imperfections of human nature would allow. But the vilest thing that Henry ever did was to debase the coin of the realm!"

Earlier, when president Roosevelt asked the Senator for his opinion regarding these measures, he answered: "Why, that's just plain stealing, isn't it, Mr. President?" (As reported in Benjamin M. Anderson's "Economics and the Public Welfare", Indianapolis, 1979, p 317.)

Be that as it may, time has come to return the looted gold. Since there is no way to track down the beneficiaries of the wills of the original owners, the gold should be used for endowing the Credit Unions with capital consisting of gold. It will be the responsibility of the Credit Unions, whose shareholders are the working people of this country, to provide support for the circulation of Gold Eagles and to act as the clearing house for gold credits (real bills) to finance production and trade of consumer goods.

Only Credit Unions that have renounced the practice of borrowing short to lend long, and declared publicly that they were ready to support the new gold coin standard and the financing of the production and trade of urgently needed consumer goods through the circulation of real bills, will benefit from recapitalization in terms of U.S. Treasury gold.

Only real bills, to the exclusion of accommodation bills, anticipation bills, and others of a non-self-liquidating nature, are eligible for investment purposes by the Credit Unions.

### Closed Shop or Right to Work

Gold coin circulation is to be spontaneous and voluntary. No legal tender laws will force it, as those laws are presently necessary to force the circulation of the irredeemable dollar. People will be free to continue using the irredeemable dollar in exchange for their goods and services, and for the purpose of saving, if that is what they wish. But they will not be coerced to do so. The legal tender status of the Federal Reserve notes is withdrawn forthwith, effective on M-Day, the day the Mint is opened to gold. Debt contracted before M-Day could be retired either with paper dollars or with gold coins, at the option of the debtor. As far as debt contracted after M-Day is concerned, provisions in the contract apply.

Labor organizations would ask their membership to decide whether they want their wage contracts in Gold Eagle coins or in irredeemable dollars. Where labor is not organized, a committee with labor and management representatives (two labor votes for every management vote), would make that decision. This is a very delicate issue, and we must well understand that a great deal of educational effort is needed to make the labor force see the implications of what is involved, which I now proceed to outline.

Those laborers who want to retain closed shop, fixed minimum-wage rates, unemployment insurance and social security benefits, company pensions, health and other fringe benefits, as well as long-term collective agreements to fix wages, should opt for the irredeemable dollar. The downside for them is that the value of the dollar will continue to fluctuate in terms of gold, and if history is any guide, the dollar-value of those benefits will probably decline. Those laborers, however, who prefer right to work to closed shop, and who would prefer fully funded health insurance and pension benefits defined in gold units to unfunded government health insurance and pensions schemes defined in terms of the irredeemable dollar, should opt for the Gold Eagle coins in which their wages will have to be paid. Gold wage rates may fluctuate but, in return, the threat of unemployment will be removed, and workers would be free to make their own provisions for health care and pensions. Payroll taxes on gold wages (such as Social Security levies) will not be authorized. Laborers who have originally opted for wages payable in irredeemable dollars will be given a chance to opt for wages payable in gold every time their labor contract comes up for renewal (or annually, in case of unorganized labor).

Existing labor legislation to govern collective agreements in dollar terms would not apply to wages payable in Gold Eagles. However, new legislation should provide that gold wages should be at least ten percent higher than comparable dollar wages calculated at the floating exchange rate for the Gold Eagles, in order to compensate workers who have opted for wages payable in gold for the fringe benefits available only to those workers who have opted for wages payable in irredeemable dollars.

### Limited Charter of the Federal Reserve

I cannot condemn the Federal Reserve banks in strong enough terms for their part in the great embezzlement of the wage-gains of the workers for almost a century. The whole edifice of labor legislation involving monetary rewards, including fixed minimum wage rates, escalator clauses to supplement long-term wage contracts, unemployment insurance, etc., comes under what Daniel Webster described as cheating the workers, by deluding them with paper-money magic. The value of all these "achievements" is, in practice, diluted, nullified, or negated by the invisible vacuum cleaner, operated by the Federal Reserve banks. For their role in this travesty, their existing Charter must be revoked and replaced by a new one limited for a ten-year period. After that, it may be renewed for a further period of ten years only if demand for irredeemable dollars stays above ten percent of the total demand for currency made up by the gold money component and the irredeemable dollar component, as measured in terms of gold.

### Divorce the Mint from the Treasury

It is further understood that the regulation of the gold component of the nation's currency is not the task of the federal government, or central bank created by the federal government. The power to regulate the amount of gold money in circulation is reserved by the Constitution for the people of the United States of America. The symbol of this power is the United States Mint. To give better effect to this Constitutional provision than was done in the past, the U.S. Mint should be removed from the control of the U.S. Treasury and the Executive Branch, and placed under the sole authority of the Legislative Branch, specifically under the direct control of the U.S. House of Representatives. This is not only fitting but is also in line with the language and the spirit of the Constitution, which places all money-matters into the hands of the direct representatives of the people. It follows that a simple majority vote of the House of Representatives will suffice to originate this transfer. For the same reason, regulatory power over the Credit Unions must be retained by the U.S. House of Representatives, without the interposition of the U.S. Treasury.

### The Vampire

German mark banknotes are tossed into a garbage bin in 1923. At this point money was more valuable as scrap paper than it was in purchasing goods and services.

The above banknote, issued in 1922, was nicknamed by the German people as "The Vampire". Rotate it counter-clockwise through 90 degrees and see the vampire in the shape of an old hag (her pointed nose jutting behind the ear of her victim, and her black cap formed by his collar) as she is sucking blood from the neck of the worker.

Note: This interesting graphic coincidence was not the only reason why the German people nicknamed their irredeemable paper mark "The Vampire".

### ***

### "It is Grossly Offensive to Hear Such Ignorant Marxist Rantings

### Associated with the Name of Ayn Rand" From time to time I shall answer questions, comments and criticism from my audience related to these Lectures. Mr. Claude Cormier of Ormetal Inc., St-Basil-Le-Grand,

Quebec, CANADA J3N 1H2, complains that I have called foreign exchange and bond speculation "parasitic activity". He suggests that foreign exchange and bond speculation are honest market activities making the best out of a possibly bad situation. To call these economic participants 'looters' and 'parasites' is nonsense. He concludes his remarks by adding that "it is grossly offensive to hear such ignorant Marxist rantings associated with the name of Ayn Rand".

I have written about bond speculation in my earlier pieces (Economic Consequences of Mr. Greenspan, [www.gold-eagle.com/editorials](https://www.gold-eagle.com/editorials), January, 2002; Revisionist View of the Great Depression, parts 1-3, [www.gold-eagle.com/editorials](https://www.gold-eagle.com/editorials), March, 2002.) where I stated my views in greater details, and I said, in part:

Bond speculation is a parasitic activity on the body economic. Of course, this is not meant as a smear on the character of any individual. Speculators acting on their own can be, and we may assume that they mostly are, upright people. Like everybody else, they are trying to eke out a living. They are certainly not responsible for the establishment of this vicious system which, by staying the 'invisible hand', victimizes the majority. The blame is entirely on the government which is responsible for the institution of this iniquitous system which, rather than promoting social cooperation, pits one citizen against the other.

I made it clear that the real culprits are the big banks. Small speculators could never create and feed a \$100 trillion derivatives monster.

I find it interesting that Mr. Cormier posted the link to my Lecture, 'ignorant Marxist rantings' and all, on his mailing list without giving me the courtesy of prior notice.

### Reference

Relation of Currency Supply to Economic Growth, by Walter E. Spahr,

The Commercial and Financial Chronicle, New York, January 21, 1954.

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand's Hymn to Money

### Lecture 2: Don't Fix the Dollar Price of Gold

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told, Episodes 1 - 3

### Lecture 6: The Second Greatest Story Ever Told, Episodes 4 - 6

### Lecture 7: The Second Greatest Story Ever Told, Episodes 7 - 8

### Lecture 8: The Second Greatest Story Ever Told, Episode 9

### Lecture 9: Legal Tender

### Lecture 10: The Second Greatest Story Ever Told, Episode 10

### Lecture 11: The Second Greatest Story Ever Told, Episode 11

### Lecture 12: The Second Greatest Story Ever Told, Episode 12

Lecture 13: Borrowing Short to Lend Long and Illicit Interest Arbitrage

## Fall Semester, 2002

### Monetary Economics 201: Gold and Interest

## In Preparation: Courses To Be Offered In

2003

Monetary Economics 201: The Bill Market and the Formation of the Discount Rate Monetary Economics 202: The Bond Market and the Formation of the Interest

### Rate

---

# Monetary Economics 101 — Lecture 2: Don't Fix the Dollar Price of Gold

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-101-lecture-2-dont-fix-the-price-of-gold/
Date: 2002-07-08
Section: Money & Credit
Difficulty: intermediate
Concept Tags: gold-standard, sound-money, monetary-policy, real-bills
Description: Fekete argues that fixing the gold price in dollar terms is a fatal error: it subordinates the gold standard to the dollar and allows governments to drain gold reserves by buying at the fixed price. Instead, the dollar price should be allowed to find its own level through free-market forces, with the Mint open to unlimited free coinage.
Editorial Note: Lecture 2 of Monetary Economics 101 (Gold Standard University, 2002). Fekete critiques the Bretton Woods arrangement and proposals for a new fixed-price gold standard, arguing both miss the lesson of the classical gold standard.
Original PDF: https://professorfekete.com/articles/AEFMonEcon101Lecture2.pdf

### Lecture 2

## Don'T Fix The Price Of Gold!

- Let the Gold Eagle Coin Soar without the Heavy Baggage of Dollar Debt

- Don't Let the Banks Sabotage the New Gold Coin Standard - The World without Banks -

I extend a hearty welcome to my audience at the first university course offered in the 21st century on the gold standard, made possible by Gold-Eagle University, an educational website to offer you knowledge put under taboo by mainstream/establishment universities. Taking this course will not get you a degree, but it may get you something more precious: a better understanding of the world, its past, present, and future.

In last week's inaugural lecture I offered a blueprint for a new gold coin standard the features of which can be summed up as follows:

(1) Open the Mint to free and unlimited coinage of gold. The one-ounce Gold Eagle coin should be adopted as a monetary unit minted for the account of anyone tendering the right amount and purity of gold, free of charge.

(2) To get the grass-root circulation of gold coins going, labor organizations (including those of pensioners and retired people) ought to be involved through their Credit Unions offering gold-coin deposit facilities. Banks must be excluded.

(3) Short-term credit to move goods from the producer to the consumer should be provided by the bill market, rather than by the banks, on the pattern of the pre-1914 way to finance world trade with gold.

(4) Long-term credit to the economy should be provided by the gold-bond market. The primary demand for gold bonds comes from financial institutions offering gold life insurance and gold annuity policies to the people. The primary supply is from the government and firms that want to operate on the basis of gold capital. Gold bonds must have a sinking fund protection. Issuers of gold bonds must see the revenues with which to retire the liability.

### Parallel Monetary Standard

The first remark on this blueprint which, as far as I am aware, is new and radically different from any other that has been offered so far, is that it expressly avoids fixing the price of gold. At least for a transitional period that may last for several years, the paper dollar and the Eagle gold coins would circulate side-by side at a floating exchange rate.

In other words, there would be a parallel monetary standard and the paper dollar would be free to compete with the Gold Eagle. The market should in the end decide which of the two deserved to survive. This is a major departure from historical precedents, which have all involved the stabilization of the paper currency in terms of gold. The question arises: why should we have such a complicated blueprint when a simpler one, fixing the gold price, could accomplish the same objective?

In all previous historical precedents stabilization came relatively early when the depreciation of the irredeemable currency has not yet progressed far, and a relatively minor adjustment in the gold price could solve the problem. In our case, however, the depreciation of the irredeemable dollar has progressed very far indeed. The loss of purchasing power of the dollar is in the order of 99 percent, and the factor by which the gold price needs to be adjusted is 10 (say, from \$35 to \$350 per ounce) or higher. While not impossible theoretically, in practice such a huge adjustment is inadmissible. There is no way to find the "right" price of gold. Any price would be arbitrary. Since the gold market is not free as long as central banks still carry huge gold reserves and may use them for bribe and blackmail, it cannot be relied upon to furnish an 'equilibrium price'.

Central bank selling and leasing gold is motivated by desperation rather than by design to punish those who have put their savings in gold. Central banks have been involved in the paper gold markets trading futures, options, and other commitments to pay gold in the future from inception. Little did they realize at first that the paper gold market will snowball and they would be called upon to underwrite the burgeoning liabilities. Central banks are much like the Sorcerer's Apprentice, who knew how to start the flow of paper gold but didn't know how to stop the torrent when the flow was getting out of hand. I look at central bank gold sales and leases as a desperate effort at damage control, trying to put off the day of reckoning.

### Threat to Peace between Creditors and Debtors

The gold market is supercharged emotionally for a definite reason which is never spelled out but which cannot be evaded. I am referring to the threat to the uneasy social peace between creditors and debtors. Fixing the price of gold would destroy that peace.

(Incidentally, this was a problem at every previous historic episode of stabilization, too, and it would be worth while to study the history of stabilizing irredeemable currencies from this point of view.) Net creditors would insist on a lower, net debtors on a higher gold price. Nor is it hard to see why. If the official price of gold was fixed at a lower level, \$1,000 debt could only be discharged through great difficulty by the payment of a greater amount of gold which creditors would welcome but debtors would strenuously oppose. If it was fixed at a higher level, then the same debt could be retired relatively easily by the payment of a smaller amount of gold which the debtors would favor but the creditors would find unacceptable. There is no way to do justice between the two contending parties. Therefore in my opinion a blueprint that calls for the fixing of the price of gold is a blueprint for failure. It would only serve to discredit the gold standard.

### Banks Must Go!

But there is a second problem, too, that must be faced. Let us admit that public opinion in most countries, including the United States, is not ready yet to embrace a gold standard. (This is hardly surprising after 70 years of virulent anti-gold propaganda on the part of the government, the banks, and academia.) In those few countries where public opinion may be receptive such as Argentina or Russia, people have lost practically all of their life savings denominated in the national currency and, rightly or wrongly, they consider the banking system as the villain. We may assume that the situation in the United States and other leading industrial countries will unfold along similar lines. When the return to a gold standard comes up as a realistic alternative, savers in the United States will find out that most of their life savings denominated in dollars is gone, and debtors will realize that there is no way for them to escape from the deadly clutches of debt short of declaring bankruptcy. There will be a tremendous backlash. Rightly of wrongly, people will blame the banks for the disaster. In this poisonous atmosphere a blueprint that calls for the banks to carry deposit accounts denominated in gold coins that represent the savings of the people is a blueprint for failure. It would only serve to discredit the gold standard.

Banks must go. This includes the Federal Reserve banks as well. Clearly, it is not going to be easy to get rid of the Fed. What better way is there to do it than letting the Fed go down the tube dragged down by its monster creature, the irredeemable dollar, while society is saved from the economic pain through the life-saver of the Gold Eagle!

### The Dollar-Denominated Debt Is beyond Salvaging

The amount of outstanding dollar debt in the world is so huge that it boggles the mind. It cannot be salvaged. Either it will be 'inflated away' or it will be 'deflated away'. The latter phrase refers to bankruptcies and defaults wiping out a major part of the accumulated debt. I go further. Chances are that it is the further irresistible snowballing of debt that will turn public opinion around in favor of a gold standard. People will realize that without the golden flywheel regulator for debt creation no monetary system can last long.

It will err either on the side of being too permissive and then the system will soon start spinning out of control (as it does in our case), or on the side of being too restrictive, in which case the system will seize up for lack of lubrication. Gold plays the role of the doorman that lets some loan applicants pass, while turning away others.

Be that as it may, the dollar-denominated debt is so huge that its conversion into golddenominated debt at whatever official gold price may carry the seeds of self-destruction.

The "fixed" gold price would have to be adjusted several times, fanning the flames of anti-gold propaganda. It is just as well to let the Gold Eagle soar without the heavy baggage of dollar debt.

It is a safe assumption that there are not many bankers in authority in the United States who look at gold with an open mind. More likely they look at it as Public Enemy Number One. The tender plant of the new gold standard would have to be entrusted to the care of its worst enemies. It is just as well not to create an opportunity for the banks for sabotage.

### Coin, Credit, Circulation

Banks will be left in place only to the extent there is demand for irredeemable dollars on the part of producers and savers. Bankers could continue financing production and could channel savings into the economy only to the extent that producers and savers voluntarily choose the dollar as their unit of account. Another segment of producers and savers will voluntarily choose the Gold Eagle as theirs. Financing production and distribution of consumer goods with gold will have to remain outside of the domain of the banks. But if not the banks, then who will do the financing? The short answer to this question is: the four C's: Coin, Credit, Circulation, Clearing. Here is a key quotation: "All the perplexities, confusion and distress in America arise, not from the defects in the Constitution or confederation, not from want of honor or virtue, so much as from downright ignorance of the nature of coin, credit and circulation." — John Quincy Adams, 1829.

### The Real Bills Doctrine

This brings me to the title of this 13-week course in Monetary Economics, "The Real Bills Doctrine of Adam Smith". Although it may sound preposterous to 21st century ears, according to him you don't need banks to extend short-term credit to finance the production and distribution of consumer goods, real bills will do It. Adam Smith elevated the Real Bills Doctrine to scientific status in the Wealth of Nations in 1776. The market economy comes equipped with a natural, built-in clearing system that will generate all the credit needed to move goods from producers to retail outlets, provided only that the consumer wants the goods urgently enough. This credit is embodied by the real bill.

A real bill is a bill of exchange drawn by the producer (the drawer of the bill) on the distributor (the acceptor of the bill) specifying the kind, quality and quantity of merchandise shipped by the former to the latter, and specifying the sum (the face value of the bill) and the date on which the bill is payable (the maturity date of the bill, in any event, not more than 91 days after the date of billing). In order to be valid, the bill has to be accepted by the acceptor, by writing across its face and over his signature "I accept".

The Real Bills Doctrine of Adam Smith states that a bill of exchange can, before its maturity date, go into spontaneous circulation as the drawer will use it to pay his suppliers by endorsing the bill on the back. Everybody who receives the bill in payment thereafter can use it in a similar fashion. Endorsement signifies that the owner of the bill has assigned the proceeds to the next one. At maturity, the last owner will mark the bill "paid" and present it to the acceptor against the payment of the face value in gold coins.

Alternatively, anyone who accepts the real bill in payment for goods and services, can discount it at the Discount House at any time. Discounting means selling the bill for cash at a discount, which depends on the discount rate and the number of days the bill has to run to maturity. The Discount House makes a market in real bills and acts as the residual buyer. Indeed, real bills are the most liquid earning asset that a financial institution can have. At maturity the Discount House will collect the face value of the bill from the acceptor.

The point is that as goods in urgent demand emerge in production, the credit needed to finance their move to the consumer also emerges in the form of real bills drawn by the producer on the distributor. The real bill is a non-inflationary purchasing medium which the market has endowed with limited monetary privileges. Non-inflationary because the face value of the bill is matched by the value of the emerging merchandise. Limited because upon maturity the purchasing medium expires as the underlying merchandise is sold to the ultimate cash-paying consumer.

In many ways the circulation of real bills is a miraculous process. Nobody designed the system of credit and clearing that makes goods in demand move along from the producer to the consumer without outside financing. Yet there it is: the real bill will do the miracle of financing production and distribution spontaneously, without taking one penny out of the piggy-banks of the savers, and without legal tender coercion.

I hasten to add that the circulation of real bills assumes the underlying circulation of gold coins. To understand the concept a little better, I want you to look at a simple essential consumer good, bread, and assume that its production/distribution involves three stages: from wheat to flour to bread; handled by four tradesmen: the grain farmer, the miller, the baker, and the grocer. In the absence of clearing the pool of circulating gold coins would have to be invaded four times to finance the production and distribution of bread as the grain farmer, the miller, the baker, and the grocer, all four of them, would be trying to raise credit to finance their operations. But as it is, the pool of circulating gold coins need not be invaded even once. The consumer's single gold coin suffices to finance efficiently the journey of bread from the corn-fields to the dinner-table, even in the complete absence of banks. The movement of the "maturing bread" from the grain farmer to the grocer is matched by the parallel but opposite movement of the real bill from the grocer to the grain farmer. The three payments are made, not with gold coins, but with real bills.

When finally the grocer gets paid, the single gold coin of the consumer will liquidate all four credits to which the journey of the bread has given occasion.

### Self-Liquidating Credit

For this reason, the real bill is said to be 'self-liquidating'. The ultimate sale of the underlying merchandise in exchange for the gold coin of the consumer liquidates all the credit that was needed to move it forward to the consumer, whether there were four, fourteen, or forty merchants along the pipeline to handle the maturing good. We might say that as wheat "matures into" bread, so the real bill "matures into" the gold coin for which bread is ultimately exchanged. There is no need to divert gold coins to move the wheat or the flour. They will move under the steam that moves the bread, generated by the single gold coin of the consumer. Real bills are flying, as it were, on their own wings and under their own steam. That is, provided that you do have a gold coin standard. If you don't, then forget it. Irredeemable paper currency in the hands of the consumer has no steam-generating power, nor can it lend wings to to real bills representing maturing merchandise. Bills will no longer fly. They no longer mature into gold coins. There are simply no real bills under a regime of irredeemable currency. They have been replaced by a bloated money supply. The nature-ordained dynamics of monetary circulation has been destroyed. Now paper is shuffled against paper, and you need an army of parasitic bankers to do the shuffling. Credit is no longer self-liquidating.

Real bills do work. Prior to the outbreak of World War I in 1914 word trade was financed through real bill circulation with London acting as the discount house. The system worked smoothly and efficiently, showing that there is no limit on the amount of credit that could be built on a given gold basis. World trade was completely self-financing, and producers as well as consumers prospered. The volume of world trade before 1914 was so great that it took more than 75 years before it was surpassed in the 1990's, in spite of a much faster population-growth. We may conjecture that if the international gold standard and the trading system of the world financed by real bills had not been destroyed by World War I, then the volume of world trade would have increased to a level several times higher than what it is today, and the resulting prosperity would have by and large eliminated poverty from the face of the earth.

The lesson: it is not enough to give independence to the native peoples of former colonies. You also have to give them self-liquidating credit, the gold standard and real bills, which formerly made it possible for them to participate in world trade on equal terms!

### Critics of the Real Bill Doctrine

In spite of this great success story, and in spite of its impeccable genealogy and a most distinguished pedigree, the Real Bills Doctrine was subjected to vicious and unfair criticism both on left (e.g., by Milton Friedman) and right (e.g., by Ludwig von Mises).

Later on during this semester I shall go into the details of this great controversy between the Quantity Theory of Money and the Real Bills Doctrine which ended with the apotheosis of the former and discrediting the latter. I shall also go through the origins of the real bill and the distortions whereby the commercial paper system to furnish elastic currency for the benefit of the people was corrupted and turned into a fiat money system monetizing debt. I refer to the story of the origin of real bills circulation by the name "The Second Greatest Story Ever Told", to emphasize that its roots are embedded in moral principles. The story I shall tell in twelve episodes is a real treat which I have reserved as a reward for my faithful audience that won't give up as the going gets tougher occasionally when we have to fight our way through some abstract passages.

All I want at this point is to indicate the importance of real bills from the point of view of the future. A complete re-evaluation of the Real Bills Doctrine is necessary. The new gold coin standard can succeed only if it is implemented in conjunction with real bill circulation. Only in this way can we ensure the needed elasticity of purchasing media to follow the seasonal and secular fluctuations in the demand for it. It is unrealistic to expect that the gold coin standard, unaided by real bills circulation, can meet these fluctuations.

Indeed, the payments system would seize up during every Christmas shopping season, or whenever division of labor is refined by implementing new inventions, for reasons of dearth in the supply of purchasing media. We should remember that the supply of gold is highly inelastic (which is, paradoxically, the main reasons for gold to have become the monetary metal par excellence ). So the choice is between (1) retaining the banking system which is liable to issue unsound credit thereby undermining the monetary system as it has done in the past, or (2) replacing the banking system by real bills circulation, which will not only provide the needed purchasing media, but will do it with transparency, satisfying the requirement of full disclosure. In the interest of the soundness and durability of the new international monetary system, we should decide against the banks including central banks, and opt for real bill circulation including the financing of world trade with bills of exchange payable at maturity in Gold Eagles.

### Gold Coin, the Ballot Paper of the Consumer

The combination of a gold coin standard and real bill circulation is necessary if we want to put supreme economic power back into the hands of the people. The consumer must have gold coins, rather than bank notes, at his disposal as he goes to the market. The gold coin is his 'ballot paper' with which he casts his vote on a daily basis. If the consumer is denied the gold coin, then he is denied the right to vote. The act of purchasing goods with bank notes is not the same as purchasing with gold coins. In the former case the decision what to produce, how much, and when, has already been made by the issuer of the bank note. Too bad if the offering is not to the consumer's liking. He must 'take it or leave it'.

He must 'grin and bear'.

In the latter case the consumer is the decision-maker himself. He is in the driver's seat.

He has the whip: he can withhold the gold coin if he doesn't find what he wants. The producer and the distributor know this and they take the order directly from the consumer, not from the banker. The consumer is the boss; the producer and distributor are his most obedient servants who try to anticipate every wish of his.

It is important to see why the bank note couldn't be used to extinguish the liability at maturity. It would be tantamount to rolling the bill over, violating the absolute prohibition that maturity must never exceed the limit of 91 days. At any rate, it would take the power away from the consumer and transfer it to the issuer of the bank note, the banker. In order to safeguard the integrity and solvency of the clearing system, gold coins must be used to liquidate the credit represented by the real bill. The sovereign consumer, the ultimate guardian of the gold coin, will liquidate the credit at maturity in buying the consumer goods of his choice.

It was Lloyd W. Mints of the University of Chicago who coined the term 'real bill'. Later his student Milton Friedman popularized it in an effort to give the bill of exchange a pejorative connotation. However, the neologism backfired. The disparager hit upon a term that described the object of his scorn admirably well. A bill of exchange is a real bill in that it represents real goods making a real move to a real consumer holding a real gold coin as the carrot (if he spends it) or as the stick (if he doesn't). An irredeemable bank note is a phoney bill, representing bad faith on the part of the issuer, ignorance on the part of the producer who gives up real goods and services in exchange for irredeemable promises to pay, and bondage on the part of the saver who has been thrown into slavery by his government when his gold coin was confiscated.

### Why Gold?*

One hundred years ago, just after the turn of century, the gold standard ruled supreme in the world of public and private finance. No economist in good standing ever dared to question its underlying principles. Governments were eager to write gold clauses on their bonds so that they could get a higher price and a lower rate of interest. Great Britain prided itself of being the unchallenged world champion of sound money for centuries.

France had successfully defended its metallic monetary standard through a century of devastating social revolutions and foreign wars. Germany, a junior member of the club of great powers, and considered an upstart by the senior members, was busy emulating the monetary policies of its peers. Germany used gold extorted from France as reparation at the end of the Franco-Prussian War to convert its monetary standard from silver to gold.

The United States could do no less. After the Resumption of 1879 it enacted the Gold Standard Act of 1900 which was supposed to undo the questionable legacy of the Greenback Era for once and all, after a thorough public debate on the merits and demerits of the gold standard. Russia and Austria-Hungary were making economic sacrifices to appear every bit as credit-worthy as the other great powers in adopting a de facto if not a de jure gold standard.

Now we are at another landmark, the start of a new century and millennium. The gold standard has become a butt of jokes. It is bad-mouthed as the rich man's ploy. Little is it recognized that the gold standard, provided that its rules are meticulously observed by the banks and governments, has always been the best friend of the little guy, of widows and orphans, and in particular the wage earners. They have no time and inclination to follow the topsy-turvy world of the financial markets. The gold coin was the only form of capital to which the working man had access, until it was denied to him. It was the gold coin that had put the wage earner into the driver's seat, letting him decide what to produce when and how much. The gold coin was the ballot paper with which wage earners cast their vote of confidence or non-confidence concerning the performance of the captains of industry. When the gold coin was taken away from them, they have been disenfranchised, along with the savers and producers.

Why gold? Gold is needed as the essential agent for the litmus test of good faith in financial dealings. Gold needs no endorsement. It can be tested with scales and acids. The recipient of gold does not have to trust the government stamp on it if he does not trust the government that had stamped it. No act of faith is called for when gold is used in payments, and no compulsion is required.

Gold is highly unpopular with banks and governments. Why? Because gold is a most unimaginative taskmaster. It demands that not only men but also governments and banks be honest. It demands that they keep their promises. It demands that banks keep their demand liabilities safely within the limit of their quick assets. It demands that governments create no debts without seeing how they can be paid. If a country has a government and banks that will do these things, gold will stay with it and will come to it from other countries. But when a country's government creates debt lightheartedly, when its central bank makes the rate of interest artificially low in buying government securities to feed the country's money market, when it permits an expansion of credit that goes into slow and illiquid assets — then gold grows nervous. Mobile capital of all kind grows nervous. There occurs a flight of capital out of the country. Foreigners withdraw their funds from it, and its own citizens send their liquid funds abroad for safety.

When suspension of gold payments eventually comes, speculators in the foreign exchange market treat paper currency most disrespectfully. They will sell it short. They will buy it only at a discount. The amount of discount is governed primarily by the expectation as to whether and when the government and the central bank will reverse its unsound policy and work back to orthodoxy and monetary rectitude.

Can we have irredeemable currency in a free country with free markets? Paper money is not merely a promissory note, of course. It is also legal tender. The government will, moreover, receive it as tax collector. Then there are various elements of patriotic support from a loyal citizenry for the paper. But beyond that, irredeemable currency embodies coercion. Legal tender, as the word is understood today, is extortion. It requires producers to give up real goods and services in exchange for irredeemable promises of uncertain value. Promises which the issuer has neither the intention nor the means to keep. All the same, the prestige of a great government and a long-established government can go far in upholding the value of its paper money even if the rational foundation for the value of the paper, redeemability, has been overthrown.

Ever since 1931 there has been a great deal of 'hot money' or nervous money in the world, jumping about from country to country seeking safety, refusing to be committed to long-term investments in any one country. Hot money jumps from one country to another not because it has found safety but because, for the moment, the former appears less safe than the latter. The origin of hot money was the excessive bank expansion of the 1920's.

Bank balances had risen tremendously under the cheap money policy of the 1920's. The nervousness of funds was due to the deterioration in the quality of excessive credit.

Following World War II the policy of cheap money continued, and the problem of hot money became more pronounced, leading to a permanent state of currency crisis. The crisis continued even after the United States adopted extreme measures to let interest rates go stratospheric in the 1970's. Today, once more, cheap money is the order of the day, and hot money may be expected to resume its danse macabre any time.

A country which is afraid of hot money, money which may suddenly jump to another country, has a very simple way of avoiding that danger. There is no need for controlling the movement of capital. There is no need for foreign exchange regulations. The country can keep its liquid capital within its boundaries by creating a financial environment in which money cools off and wants to stay. In other words, by having a sound currency.

It was the prevailing doctrine among economists down to World War I that governments could not coerce their peoples into accepting at face value a dishonored paper money. But World War I and, even more so, World War II, brought an immense revival and intensification of governmental power over the lives of the people. A good many new techniques of price fixing and control of foreign exchange operations were introduced.

They were devised to prevent transactions which would reveal the depreciation of irredeemable paper money. After 1971 the character of these techniques changed.

Emphasis was shifted from foreign exchange controls to discouraging people from buying and holding gold as an instrument of saving. The earlier direct ban on gold ownership was lifted reluctantly, but in its place there is now an elaborate effort attempting to cap the price of gold through propaganda, through the escalation of the creation of paper gold (gold futures, options on gold futures, etc.) And, of course, producers of gold are bribed and holders of gold are blackmailed. It should be clear, however, that the psychological war on gold is counter-productive. More and more monetary gold is passed from official to private holdings in addition to newly mined gold, none of which finds its way into holdings any more. When a certain threshold is reached, the tables will be turned on the governments and central banks. They will no longer be in the position to dictate the future monetary role of gold in the world.

It is to be regretted that governments are not making the necessary preparations for a smooth transfer of power. The purpose of these lectures is to enlighten public opinion, if only in a modest way, that has been thrown into a great darkness by power-hungry governments.

* A paraphrase of Benjamin M. Anderson's "The Tyranny of Gold".

### Reference

An Inquiry into the Nature and Causes of the Wealth of Nations, by Adam Smith Economics and the Public Welfare — A financial history of the United States 1914-1946, Chapter 64: The Tyranny of Gold, by Benjamin M. Anderson, first published in 1949; second edition: Indianapolis (Liberty Press) 1979, p 414 ff.

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

### Lecture 1: Ayn Rand's Hymn to Money

### Lecture 2: Don't Fix the Dollar Price of Gold

### Lecture 3: Credit Unions

### Lecture 4: The Two Sources of Credit

### Lecture 5: The Second Greatest Story Ever Told, Episodes 1 - 3

### Lecture 6: The Second Greatest Story Ever Told, Episodes 4 - 6

### Lecture 7: The Second Greatest Story Ever Told, Episodes 7 - 8

### Lecture 8: The Second Greatest Story Ever Told, Episode 9

### Lecture 9: Legal Tender

### Lecture 10: The Second Greatest Story Ever Told, Episode 10

### Lecture 11: The Second Greatest Story Ever Told, Episode 11

### Lecture 12: The Second Greatest Story Ever Told, Episode 12

Lecture 13: Borrowing Short to Lend Long and Illicit Interest Arbitrage

## Fall Semester, 2002

### Monetary Economics 201: Gold and Interest

---

# Monetary Economics 101 — Lecture 1: Ayn Rand's Hymn to Money

URL: https://newaustrianeconomics.com/archive/fekete/monetary-economics-101-lecture-1-ayns-rand-hymn-to-money/
Date: 2002-07-01
Section: Money & Credit
Difficulty: intermediate
Concept Tags: real-bills, gold-standard, sound-money, fiat-currency
Description: Fekete opens his Monetary Economics 101 course with Ayn Rand's hymn to gold from *Atlas Shrugged*, using it as a springboard to argue that gold is not merely a commodity but the foundation of honest social cooperation. He outlines a blueprint for a new gold coin standard and introduces the real bills doctrine as its self-regulating credit mechanism.
Editorial Note: Inaugural lecture of the Gold Standard University summer course on the Real Bills Doctrine of Adam Smith (2002). This series became the foundational text of Fekete's New Austrian Economics program.
Original PDF: https://professorfekete.com/articles/AEFMonEcon101Lecture1.pdf

### Inaugural Lecture

## Ayn Rand'S Hymn To Money

- Gold Money Is the Root of All Good; Paper Money Is the Root of All Evil

### - A Blueprint for a New Gold Coin Standard -

Millions of people who have read Ayn Rand's 1957 monumental work "Atlas Shrugged" must have been impressed by an insert that could be entitled "Hymn to Money". This insert is buried in the 1600 pages of the novel and is difficult to find. However, it is a self-contained literary masterpiece in its own right. For these reasons it may be a good idea to publish it separately.

Some remarks may be in order. Ayn Rand uses the word "money" in the sense of gold money. This may not be in line with current usage, but it is certainly correct etymologically. The English word "money" is derived from the Latin moneta, meaning "forewarner", epithet of the goddess Juno. Her temple on the Roman Capitolium doubled as the Mint where the gold and silver coins of Rome were struck.

According to legend, during the siege of Rome by the Gauls, the sacred geese of Juno that lived around the temple forewarned the Romans with their loud cackling of the surprise attack the enemy has mounted. Under the cover of the night, the Gauls tried to scale the cliffs just below, thought to be an unassailable point of the Capitolium. The Romans, forewarned, could successfully repel the attack. In gratitude, they honored the goddess calling her Juno Moneta, or "Juno the Forewarner". And Rome went on to great things.

Irredeemable currency, in Ayn Rand's words "a counterfeit pile of paper", the output of the paper mill in Manhattan, does not deserve to be called "money". At any rate, you have been forewarned, and should be prepared for the attack of looters on your Capitol, already in progress.

We still don't know whether the 911 forewarning of Juno Moneta about the approaching collapse of society has been in vain or, perhaps, there is enough moral rectitude left in America's political and economic leadership to denounce globalization, and open the Mint to gold, in order to avert the coming tragedy.

### Hymn to Money

### Ayn Rand

### Must Give Value for Value

So you think that money is the root of all evil. Have you ever asked what is the root of money? Money is a tool of exchange, which can't exist unless there are goods produced, and there are men able to produce them. Money is the material shape of the principle that men who wish to deal with one another must do so by trade, and give value for value. Money is not the tool of the moochers, who claim your product by tears, or of the looters, who take it from you by force. Money is made possible only by men who produce. Is this what you consider evil?

When you accept money in payment for your effort, you do so on the conviction that you will be able to exchange it for the products of the effort of others. It is neither the moochers nor the looters who give value to money. Neither an ocean of tears nor all the guns in the world can transform those pieces of paper in your wallet into bread you will need to survive tomorrow. Those pieces of paper, which should really be gold, are a token of honor - your claim upon the energy of the men who produce.

Your wallet is your statement of hope that somewhere in the world around you there are men who will not default on the moral principle that is the root of money.

### Is this what you consider evil?

### Wealth Is the Product of Man's Capacity to Think

Have you ever looked for the root of production? Take a look at an electric motor and dare tell yourself that it was created by the muscular effort of unthinking brutes. Try to grow a seed of wheat without the knowledge left to you by men who had to discover how to do it for the first time. Try to grow food by means of nothing but physical motions - and you'll learn that it is man's mind that is the root of all the goods produced and of all the wealth that has ever existed on earth.

But you say that money is made by the strong at the expense of the weak. What strength do you mean? It is not the strength of guns or muscles. Wealth is the product of man's capacity to think. Does it follow, then, that money made by the inventor of the motor is at the expense of others who invented nothing? Is money made by the intelligent at the expense of the fools? Or by the able, at the expense of the lazy? Money is made - before it can be looted or mooched - by the effort of every honest man, each to the extent of his ability. An honest man is one who knows that he can't consume more than he has produced.

### Every Man is the Owner of His Mind and His Efforts

To trade by means of money is the code of men of good will. Money rests on the axiom that every man is the owner of his mind and his efforts. Money allows no power to prescribe the value of your effort, except by the voluntary choice of the man who is willing to exchange the fruits of his effort with you. Money permits you to obtain for your goods and labor what they are worth to men who buy them, but no more. Money permits no deals except those to mutual benefit by the free judgment of traders. Money demands of you the recognition that men must work for their own benefit, not their injury; for their gain, not their loss - the recognition that they are not beasts of burden born to carry the weight of your misery - that you must offer them value, not wounds - that the common bond among men is not the exchange of suffering, but the exchange of goods. Money demands that you sell, not your weakness to men's stupidity, but your talent to their reason; it demands that you buy, not the shoddiest they have to offer, but the best money can find. And when men live by trade - with reason, not force, as their final arbiter - it is the best product that wins, and the best performance. It is the man of best judgment and highest ability that wins, and his reward is commensurate with his productivity.

This is the code of coexistence whose tool and symbol is money. Is this what you consider evil?

### The Scourge of Men Who Attempt to Reverse the Law of Causality

But money is only a tool. It will take you wherever you wish, but will not replace you as the driver. It will give you the means for the satisfaction of your desires, but will not provide you with desires. Money is the scourge of men who attempt to reverse the law of causality - men who seek to replace the mind by seizing the products of the mind.

Money will not purchase happiness for the man who has no concept of what he wants. Money will not give him a code of values if he's evaded the knowledge of what to value. It will not provide him with a purpose if he's evaded the choice of what to seek. Money will not buy intelligence for the fool, admiration for the coward, or respect for the incompetent. The man who attempts to purchase the brains of his superiors to serve him, thus trying to replace judgment with money, ends up by becoming the victim of his inferiors. The men of intelligence desert him, but the cheats and frauds come flocking to him, drawn by a law which he has not discovered, that no man may be smaller than his money. Is this the reason why you call it evil?

### Money Will Not Serve the Mind That Cannot Match It

Only the man who does not need it, is fit to inherit wealth - the man who would make his own fortune no matter where he started. If an heir is equal to his money, it serves him; if not, it destroys him. But you look on and cry that money has corrupted him. Has it? Or has he corrupted money? Do not envy a worthless heir: his wealth is not yours and you would have done no better with it. Do not think that it should have been distributed among your cronies: loading the world with fifty parasites instead of one would not bring back the dead virtue embodied by the fortune. Money is a living power that dies without its root. Money will not serve the mind that cannot match it. Is this the reason why you call it evil?

### Money As a Means of Survival

Money is your means of survival. The verdict you pronounce upon the source of your livelihood is the verdict you pronounce upon your life. If the source is corrupt, you have damned your own existence. Did you get your money by fraud? By pandering to men's vices or their stupidity? By catering to fools, in the hope of getting more than you deserve? By lowering your standards? By doing work you despise, for others you scorn? If so, then your money will not give you a moment's joy or a penny's worth of happiness. Then all the things you buy will become, not a tribute to you but a reproach; not an achievement but a reminder of shame. Then you'll scream that money is evil. Evil, because it will not pander to your self-respect?

Evil, because it would not let you enjoy your depravity? Is this the root of your hatred of money?

### Money Is Always an Effect with You As the Cause

Money will always remain an effect and refuse to replace you as the cause. Money is the product of virtue, but it will not give you virtue and will not redeem your vices.

Money will not give you the unearned, whether in matter or in spirit. Is this the root of your hatred of money?

Or do you mean that it's the love of money that's the root of all evil? To love a thing is to know and love its nature. To love money is to know and love the fact that money is the product of the best powers within you, and your pass-key to trade your effort for the efforts of the very best among men. It's the person who would sell his soul for a nickel, who is the loudest in proclaiming his hatred of money - and he has good reason to hate it, too. The lovers of money are willing to work for it. They know that they deserve it. Let me give you this rule of thumb: the man who damns money has obtained it dishonorably; the man who respects it has earned it.

### The Only Substitute for Gold Money is the Muzzle of the Gun

Run for your life from anyone who tells you that money is evil. That sentence is the leper's bell of an approaching looter. So long as men live together on earth and need means to deal with one another - their only substitute, if they abandon money, is the muzzle of the gun.

### When Coercion Is the Standard, Murderers Win over Pickpockets

But money demands of you the highest virtue, if you wish to make it or keep it. Men who have no courage, pride, or self-esteem, men who have no moral sense of their right to their money, and are not willing to defend it as they would defend their life, men who apologize for being rich - will not remain rich for long. They are the natural bait for swarms of looters that stay under the rocks for centuries, but come crawling out at the first smell of a man who begs to be forgiven for the guilt of owning wealth. They will hasten to relieve him of his guilt, and of his life - just as he deserves.

Then you see the rise of men of a double standard - men who live by force yet count on those who live by trade to create value to back their looted money - hitch-hikers of virtue. In a moral society these are criminals, and statues are written to protect you against them. But when a society establishes criminals-by-right and looters-bylaw - men who use force to seize the wealth of disarmed victims - then money becomes its creator's avenger. Such looters believe it safe to rob defenseless men, once they've passed a law to disarm them. But their loot becomes the magnet for other looters who get it from them the way they've got it from you. Then the race gets under way, and the prize goes, not to the ablest at production, but to the most ruthless at brutality. When coercion is the standard, the murderer wins over the pickpocket. And then society vanishes in a spread of ruin and slaughter.

### Money Is the Barometer of Society's Virtue

Do you want to know whether that day is coming? Watch money. Money is the barometer of society's virtue. When you see that trading is done not by consent but by compulsion - when you see that in order to produce you need to obtain permission from men who produce nothing - when you see that money is flowing to those who deal not in goods but in favors - when you see that men get rich more easily by graft than by work, and your laws no longer protect you against them, but protect them against you - when you see corruption being rewarded and honesty becoming a self-sacrifice - then you will know that your society is doomed. Gold is so noble a medium that it does not compete with guns and does not make terms with brutality. It will not permit a country to survive as half property, half loot.

### Paper Money Is Mortgage on Wealth That Doesn't Exist

Whenever destroyers appear among men, they start by destroying gold money, for it is man's protection, and the base of a moral existence. Destroyers seize gold and leave to its owners a counterfeit pile of paper. This kills all objective standards and delivers men into the arbitrary power of an arbitrary setter of values. Gold is an objective value, an equivalent of wealth produced. Paper money is mortgage on wealth that does not exist, backed by guns aimed at those who are expected to produce. Paper money is a check drawn by legal looters upon an account which is not theirs: upon the virtue of the victims. Watch for the day when it bounces, marked: "account overdrawn".

When you have made evil the means of survival, do not expect men to remain good.

Do not expect them to stay moral and to become fodder for the immoral. Do not expect them to produce when production is punished and looting rewarded. Do not ask who is destroying the world. You are.

### Where Wealth Is Obtained by Conquest There Is Little to Conquer

You stand in the midst of the greatest achievements of the greatest productive civilization and you wonder why it's crumbling around you while you are damning its life-blood - money. Throughout man's history money was always seized by looters of one brand or another, whose names changed, but whose methods remained the same: to seize wealth by force and to keep the producers bound, demeaned, defamed, deprived of honor. That phrase about the evil of money which you mouth with such righteous recklessness, comes from a time when wealth was produced by the labor of slaves - slaves who repeated motions discovered long before by someone's mind and left unimproved for centuries. So long as production is ruled by force and wealth is obtained by conquest, there is little to conquer. Yet through all the centuries of stagnation and starvation, men exalted the looters as aristocrats of the sword, as aristocrats of birth, as aristocrats of the bureau, and despised producers as slaves, as traders, as shopkeepers - as industrialists.

### The Country of Money

To the glory of mankind there was, for the first and only time in history, a country of money - and I have no higher, more reverent tribute to pay to America, for this means: a country of reason, justice, freedom, production, achievement. For the first time man's mind and money were set free, and there were no fortunes-by-conquest but only fortunes-by-work, and instead of swordsmen and slaves there appeared the real maker of wealth, the greatest worker, the highest type of human being - the self-made man - the American industrialist.

### The Essence of Morality

If you ask me to name the proudest distinction of Americans, I would choose because it contains all the others - the fact that they were the people who created the phrase "to make money". No other language or nation has ever used this combination of words before; men have always thought of wealth as a static quantity - to be seized, begged, inherited, shared, looted, or obtained as a favor.

Americans were the first to understand that wealth must be created. The phrase "to make money" holds the essence of morality.

Yet these were words for which the Americans were denounced by the rotten cultures of the looters' continents. Now the looters' credo has brought you to regard your proudest achievements as a hallmark of shame, your prosperity as guilt, your greatest men, the industrialists, as blackguards, and your magnificent factories as the product and property of muscular labor, the labor of whip-driven slaves, no better than the pyramids of Egypt. The rotter who simpers that he sees no difference between the power of gold and the power of the whip, ought to learn the difference on his own hide - as I think he will.

### Blood, Whips, and Guns - or Gold

Until and unless you discover that money is the root of all good, you ask for your own destruction. When money ceases to be the tool by which men deal with one another, men become the tools of men. Blood, whips, and guns - or gold. Take your choice - there is no other - and your time is running out.

### Corruption of the Meaning of "Making Money"

Ayn Rand did not live to see the appalling corruption of the meaning of the phrase "making money" to include parasitic activities such as foreign exchange and bond speculation, trading options on futures, interest-rate swaps, repos, knock-in calls, knockout puts, and so on, ad libitum. As long as gold was an active part of the monetary system, there was little opportunity for looters to fleece the public using exotic trading vehicles making up the \$100 trillion derivative monster. But soon after gold was out of the way, white-collar looters could get the upper hand and lay the foundations of the Tower of Babel of derivatives. Watch for the day when it crashes and buries the production facilities of society underneath.

Shame on those who have polluted the English language by applying honest words to dishonest activities, in order to cover up their immoral nature. Shame on those who write scholarly books glorifying the globalized paper money system, the exotic trading vehicles, and the trading of hot air in the name of progress, but for no other purpose than to fleece the savers and the producers.

The brightest mathematicians have not been able to plug morality into their equations, and never will. You have to make money completely amoral before you can put it into your equations. And this is exactly what they have done.

Differential equations are the physicists' most powerful tool to predict with precision the outcome when force is applied to a collection of lifeless particles. But they are wholly inapplicable to predict, even in approximation, the outcome when the particles have free will. You have to deprive men of their free will, by depriving gold of all of its monetary qualities, before you can apply the method of differential equations to a society of human individuals. And this is exactly what they have done.

### Blueprint for a New Gold Coin Standard

Making money was the highest activity of men before looters invaded the nerve-center of capitalism and abolished the gold-reserve requirement for the issuance of Federal Reserve notes in 1968. Ever since "making money" has been the lowest activity of men whereby the savers and producers are fleeced of their substance. Watch for the day when the last meaningful productive job in America is exported to China. On that day American society will become a zoo, and American citizens will be reduced to the station of animals in the cage, totally dependent on the zoo-keeper for food and shelter.

Is it still possible that Americans will find their virtue, reinvent their Country of Money, and restart their essential activity of "making money" in the sense of Ayn Rand? Yes, provided that they open the Mint to gold, as ordained by the Constitution. In what follows we present a blueprint for the new gold coin standard for America.

### Open the Mint to Gold!

Fixing the price of gold in terms of the dollar is a non-starter. It would lead to endless bickering between creditors who want a low, and debtors who want a high fixed price of gold, guaranteeing failure. Luckily, there is no compelling reason to fix the price of gold in dollars. On the contrary, the dollar had better be left to fend for itself. The one-ounce Gold Eagle coin, already in existence, could serve as the new monetary unit. Let it soar, free of the heavy baggage of dollar-denominated debt! Let the banks, first and foremost the Federal Reserve banks among them, try to save the dollar from the ignominy of ending up in the garbage heap of history! They have totally discredited themselves as guardians of the value of the money of the people, allowing the dollar to lose 99 percent of ts purchasing power during the 88 years of operations of the Federal Reserve System.

Member banks should not be allowed to carry deposit accounts denominated in gold coins, lest they repeat the feat and make the value of these deposits disappear, too.

An Act of Congress on Opening the Mint to Gold will reestablish the constitutional right of the people to convert gold in their possession into coins of the realm. On M-Day, the Mint will be declared open to gold, and those who prefer to trade and save in terms of gold coins will, once more, be free to do so.

You may object saying that the Mint is already open to gold as shown by its production of Gold Eagle coinage, and laws are in place to allow you to make contracts in terms of gold. People have been given the choice, but they are not interested. Not so! The Gold Eagle coin program, as it exists, has been designed to throw dust into the eyes of the public. The fact is that the coins' denomination fails to be proportional to their gold content. To be sure, this idiotic provision is not the result of an oversight. It is the result of deliberate sabotage on the part of the Treasury, its own version of the "poison pill", to make these coins unfit for the purposes of a gold standard. More importantly, these coins are struck exclusively for the account of the Treasury, then promoted not as money but souvenirs. Opening the Mint to gold would mandate that the one ounce Gold Eagle coin, the monetary unit, be struck for the account of anyone tendering the correct amount and fineness of gold bullion free of charge. Once this is done, then - after a 70-year hiatus the Constitutional right of the citizen to free coinage will be re-established. The assertion that the public has been offered gold coins to trade and to make contracts in, but declined the offer, is a lie.

### Credit Unions: New Guardian of the Value of Money

The banks must not be given a federal charter to carry deposit accounts denominated in Gold Eagles for reasons spelled out above. A better guardian for the value of money will be the labor organizations of the country, including organizations of the pensioners and retired people. Each of these will be invited to apply for a federal charter to establish its own Credit Union that would carry deposit accounts in Gold Eagles. An Act of Congress on Credit Unions will authorize the mobilization of the gold reserves owned by the Treasury for the purpose of capitalizing Credit Unions, old and new. In order to be eligible for a federal charter, the Credit Union must eschew the practice of borrowing short and lending long.

### Bill Market and the Discount Rate

This grass-root movement to gold coin circulation is essential to ensure that laborers be able to make their purchases with gold coins so that, in turn, they be able to get paid in gold coins. There will be no banks to extend Eagle-currency credits to productive enterprise. Such credit will, nevertheless, still be available through the bill market. An Act of Congress on the Circulation of Bills of Exchange will provide for the limited monetization of self-liquidating bills of exchange, drawn by the producer on his distributor, representing merchandise shipped by the former to the latter that is moving sufficiently fast to the ultimate cash-paying consumer, so that the liability will be discharged in no more than 91 days (or 13 weeks, or 3 months) out of the gold coins released by the consumer. The number 13 is not arbitrary. Thirteen weeks is the length of the seasons, marking the change in the stock of merchandise in the temperate climates such as food, fuel, clothing, recreational equipment, etc.

The Act will give the needed buoyancy to the bill of exchange so as to enable it to circulate by endorsement almost as easily as cash. The producer who gets paid for his merchandise, not in the form of gold coins but of bills accepted by distributors, will be able to use it to pay his own suppliers by endorsing the bill once more. Thus each subsequent recipient will be able to use the same bill in payment for his own supplies by further endorsement. Alternatively, any one of the recipients could discount the bill of exchange at the discount window of his Credit Union. Discounting means selling the bill for gold coins at a discount. The amount of discount applied to the face value is determined by the discount rate and the number of days the bill has to run to maturity.

Credit Unions make a market in bills. They trade them. They will sell them to you if you want to have them as an earning asset. They will buy them back from you, and will be happy to carry them to maturity, as these instruments are their most liquid earning assets.

At maturity the Credit Union collects the face value of the bill from the distributor on whom the bill was originally drawn. The point is that, by that time, the distributor will have the gold coins from the sale of merchandise to the ultimate, cash-paying consumer.

In this way the source of gold coins with which to pay labor along the production channels of the merchandise, and with which to liquidate the liability upon maturity of the bill, is secure. It is for this reason that bills of exchange are called self-liquidating.

The Act provides that non-self-liquidating bills such as anticipation bills, accommodation bills, etc., drawn on imaginary merchandise sent on world-wide trips in imaginary bottoms, will be denied monetary privileges. Treasury bills are self-liquidating only to the extent that the Treasury has tax revenues coming to it, during the next 91-day period, in the form of gold coins. If it has cash needs in excess of these receivables, the Treasury has no authority to issue bills but must ask Congress for fresh appropriations. A bill drawn with maturity exceeding 91 days, or one that has been rolled over for a further period, is not self-liquidating and will be denied monetary privileges, too.

### Bond Market and the Interest Rate

An Act of Congress on Gold Life Insurance will authorize the federal government to charter financial institutions for the purposes of underwriting gold life policies and gold annuities. They would be holders of gold bonds issued by the government and by companies wanting to re-capitalize in Gold Eagles. The Act will specify that these institutions may only invest in gold bonds with sinking fund protection.

The Act will authorize custom duties and excise taxes to be levied in Gold Eagles, in order to capitalize the sinking fund the government will need to stabilize the value of its gold bonds. The total outstanding gold-bonded debt of the federal government must not exceed the level that can be serviced by the sinking fund.

The interest rate on the gold-bonded debt of the government will be the lowest possible, indicating that gold is the best money available to man. The depreciation premium on gold-bonded debt is zero. Lenders know exactly what will be returned to them at the end of the loan period. By contrast, in case of debt denominated in the irredeemable dollar there is a depreciation premium incorporated in the rate of interest, representing compensation lenders demand, and receive, for the expected depreciation in the value of the monetary unit.

### The Question of Legal Tender

It is understood that the paper dollar will circulate side-by-side with Gold Eagle coins, at a floating exchange rate. People can discharge their debt contracted before M-Day in either paper dollars or gold coins, at the option of the debtor. As concerning debt contracted after M-Day, provisions in the contract will apply.

Certified labor organizations will be free to bargain with the employers and sign labor contracts calling for wages to be paid either in paper dollars, or in gold coins, as decided by the membership. If the decision calls for wages to be paid in gold coins, the management of the company will immediately start drawing bills of exchange on the distributors of the products of its factories, and after a 91-day transitional period the gold coins will be available from the proceeds of bills with which wages can be paid.

Gold coin circulation is not compulsory. No legal tender laws force anyone to accept payment in the form of Gold Eagle coins. People will have the choice to demand irredeemable paper dollars in exchange for their goods and services, or in which to carry their savings, if this is what they want. But they shall not be coerced to do so: there will be no legal tender laws to force the circulation of the irredeemable dollar. The legal tender status of the Federal Reserve notes is withdrawn forthwith, effective on M-Day.

### New Charter for the Federal Reserve

The Federal Reserve banks would be given a new Charter which would automatically expire should the demand for irredeemable dollars fall below 10 percent of the total demand for money, as measured in terms of gold.

It is understood that, under the new monetary regime, there would be no central bank to regulate the stock of gold-denominated money, the discount rate, or the rate of interest.

These would be regulated by unfettered markets such as the gold market, the bill market, and the bond market.

### Not Enough Gold in the World?

Gold is the best foundation for credit. The present monetary system has immobilized gold. In this way the world economy has been deprived of its most potent and most wholesome source of credit, gold, forced to replace it with the most unsound and most depraved kind, the irredeemable promises of devaluation-happy governments.

One often hears the argument that there is not enough gold to cement the basis of the credit structure for a dynamic world economy. This argument is not grounded in fact.

There is no identifiable limit on the amount of credit that can be built on the monetary unit defined as a certain weight and fineness of gold. Another way of expressing this is that it is the flows of gold, as opposed to stocks, that matters. It is not a question how much gold a government (or, for that matter, any entity or individual) possesses, but how much it can attract. While there is a limit on the former, there is no limit on the latter, provided that gold flows fast enough.

Presently there appears to be a scarcity of gold in the world economy. However, this is merely an optical illusion. All it shows is that monetary policy lacks credibility as governments are unable to attract gold to their coffers. Worse yet, they are forced to let large chunks of their gold reserves go for a pittance as they are engaged in a desperate effort to prop up the world's shaky payments system. The anti-gold propaganda campaign has driven an increasing part of monetary gold underground. Governments have, rather unwisely, used the remaining monetary gold in their possession for backing the issuance of paper gold, that is, gold futures, options on gold futures, and other forms of forward commitments to pay gold. The outstanding commitments are in fact so huge, and they are growing so fast that, in the opinion of the private holders of monetary gold, there is no way to make good on them in an orderly way within the time period specified. The only way to keep the trading of paper gold going is through ever larger injections of central bank gold. But it is questionable that official gold will be available indefinitely for the purpose of propping up the trade in paper gold. They won't tell you this, but central banks are conscious of the fact that their bank notes may lose purchasing power precipitously if gold reserves fall below the comfort-level of the people.

### A New Golden Age

The problem therefore is to mobilize the world stock of monetary gold. This is what opening the Mint to gold is all about. Private holders of monetary gold have to be convinced that governments and central banks are ready to own up to the chicanery they have been practicing for a hundred years, and are finally ready to return to the international gold standard they abandoned in 1914. In that year they stopped using bills of exchange to finance world trade; since that time imports and exports have been the business of governments subject to quotas and official credits. In that same year the Federal Reserve System was established as the engine to monetize the debt of the U.S. government. With this kind of backing the U.S. government went ahead to finance a number of world wars in the twentieth century, bankrupting the international monetary system in the process. It is time, in the interest of the savers and producers of the world, to abandon that dysfunctional and exploitative monetary regime threatening to collapse and bury the productive facilities of the world economy under the debris.

Once a credible international gold standard is in place, private holders of monetary gold will be happy to release their holdings to the bill or bond market. The world's gold stocks will be mobilized, and the world economy will be refinanced in terms of wholesome gold-based credit. The crisis-prone financial system will be gone, replaced by the free flow of goods and capital represented by gold movements. A new Golden Age will have dawned.

America of Ayn Rand's vision, a country of reason, justice, freedom, production, achievement - a country of money - will emerge once more, and the regime of the irredeemable dollar will appear as a brief reactionary episode in the history of money.

### Reference

Atlas Shrugged, by Ayn Rand, New York (Random House) 1957, pp 410-415

(slightly edited, title and captions added).

### Antal E. Fekete

### Professor

### Memorial University of Newfoundland

### St.John's, CANADA A1C5S7 e-mail: aefekete@hotmail.com

## Gold Standard University

## Summer Semester, 2002

### Monetary Economics 101: The Real Bills Doctrine of Adam Smith

Lecture 1:

Lecture 2:

Lecture 3:

Lecture 4:

Lecture 5:

Lecture 6:

### Ayn Rand's Hymn to Money

### Don't Fix the Dollar Price of Gold

### Credit Unions

### The Two Sources of Credit

### The Second Greatest Story Ever Told, Episodes 1 - 3

### The Second Greatest Story Ever Told, Episodes 4 - 6

### Lecture 7: The Second Greatest Story Ever Told, Episodes 7 - 8

### Lecture 8: The Second Greatest Story Ever Told, Episode 9

### Lecture 9: Legal Tender

### Lecture 10: The Second Greatest Story Ever Told, Episode 10

### Lecture 11: The Second Greatest Story Ever Told, Episode 11

### Lecture 12: The Second Greatest Story Ever Told, Episode 12

Lecture 13: Borrowing Short to Lend Long and Illicit Interest Arbitrage

## Fall Semester, 2002

### Monetary Economics 201: Gold and Interest

=========================
Mathematics
=========================
# Putting Differential and Integral Calculus into Context

URL: https://newaustrianeconomics.com/archive/fekete/putting-differential-and-integral-calculus-into-context/
Date: 2010-04-18
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete responds to Strogatz's NYT column on calculus, arguing that high school and undergraduate teaching fails to give calculus its proper context as the mathematics of continuous change. He sketches a more historically and philosophically grounded approach that situates calculus within the broader development of mathematical thought from ancient Greece to Newton and Leibniz.
Editorial Note: Blog #6 in Fekete's math series (2010), the final entry in his New York Times Opinionator response series. Fekete argues for teaching calculus through its history rather than as a collection of computational techniques.
Original PDF: https://professorfekete.com/articles/BLOG6CALCULUS.pdf

## Putting Differential And Integral Calculus Into Context

### Blog #6

Steve Strogatz, in his Opinionator column in the April 18, 2010, issue of The New York Times published an article on differential and integral calculus with the title It Slices, It Dices.

High school and undergraduate mathematics hardly do justice to calculus. They get lost in the techniques of calculation, without revealing the underlying great ideas. To see the deeper interrelation between the differential (the derivative), the indefinite integral (the antiderivative) and the definite integral, and to put things into their right context, we must step out of one dimension and make ourselves at home in higher dimensional graded vector spaces.

Then the beautiful panorama of the world of integrals opens up, exhibiting the symmetry about which the one-dimensional case reveals nothing.

The grading of vector spaces involved is furnished by the degree of differential forms that are to be integrated, and by the dimension of the domain over which integration is to take place. The integral manifests itself as the scalar product 〈 α , ω 〉 of the domain α and the differential form ω where the dimension of α and the degree of ω must agree.

The scalar product is bilinear, i.e., it is linear in each of the two variables:

### 〈 α +α′,ω 〉 = 〈 α ,ω 〉 + 〈 α′,ω 〉 , 〈 nα ,ω 〉 = n 〈 α ,ω 〉

〈 α , ω + ω′ 〉 = 〈 α , ω 〉 + 〈 α , ω′ 〉 , 〈 α , r ω 〉 = r 〈 α , ω 〉

(n is an integer and r is a real number).

We also have a dual pair of operators ∂ and d. The boundary operator ∂ assigns to the domain α its boundary ∂ α of dimension one lower; the differential operator d assigns to the differential form ω its derivative d ω of degree one higher. These operators satisfy the relations ∂∂ = 0 and dd = 0.

If the differential form ω has an anti-derivative ϕ , i.e., ω = d ϕ , then ω is called an exact differential form. In this case the Fundamental Theorem of Calculus applies. It states that the operators ∂ and d are conjugates of one another, in formula:

〈 α , d ϕ 〉 = 〈 ∂α , ϕ 〉 where ∂α is the boundary of α and ϕ is the anti-derivative of d ϕ . The dimension of the domain α is n; the degree of the differential form ϕ is n –1.

Let us now see how the familiar special cases arise from the general concept.

(1) The case for functions of one real variable: b

### ∫ f ( x )dx = F (b) − F (a ) a

The domain α is a line interval with endpoints a, b; the differential form ω is d ϕ = f(x)dx; ∂α is the pair of endpoints of the interval from a to b; ϕ = F(x) is the antiderivative of d ϕ .

We should recognize that the right-hand side F(b) – F(a) is also an integral: that of F(x) over the pair of points a, b.

(2) Stokes’ Formula: ∫∫ curl ω = ∫ ω . The domain α is a piece of a surface in 3-space; α

### ∂α

∂α is the closed curve in space that serves as the contour for α ; d ω = curl ω .

(3) Gauss’ Formula:

∫∫∫α div ω = ∫∫ α ω . The domain α is a solid in 3-space; ∂α is the

∂ closed surface that serves as the boundary for α ; d ω = div ω .

### Indefinite integral

There is a semantic confusion arising out of the use of the term “integral” in two entirely different senses: the definite and the indefinite integral. Given an exact differential form ω of degree n, its anti-derivative, also known as indefinite integral, is the differential form ϕ of degree n – 1 such that ω = d ϕ .

Differential forms of degree 1 are of the form f dx where f is a function of a real variable. They are exact and their indefinite integrals F(x) are differential forms of degree 0, i.e., ordinary functions. For differential forms of degree 0 we have: dF = 0 ⇔ F(x) = C, constant.

Domains of dimension 1, over which differential forms of degree 1 are to be integrated, are arcs of (space) curves. Their boundary is the pair of endpoints a, b. Ordinarily by an integral is meant the integral of a differential form of degree 1 over a domain which is a straight line segment. We can now see the whole spectrum of integrals of higher dimensions, and the wonderful symmetry they represent.

The anti-derivative or the indefinite integral, as its name suggests, is not uniquely determined. In the special case of a differential form of degree 1 we can get all the antiderivatives from a given one by adding a constant C. In the general case the rule is not as simple. Let ϕ and ϕ ' be differential forms of the same degree. The necessary and sufficient condition that they have the same indefinite integral, in other words, ϕ and ϕ ' are cohomologuous, is as follows: ϕ ≡ ϕ ' ⇔ d( ϕ – ϕ ') = 0

The equivalence class of differential forms represented by ϕ is called the cohomology class of ϕ . We shall denote the quotient set of all cohomology classes by the symbol W; it is a graded vector space. Strictly speaking when we talk about differential forms, we always mean their cohomology classes.

The cohomology class of differential forms of degree 0 represented by the function f(x) is the set of all functions f(x) + C, where C is constant.

### Definite integral

Similarly, when we talk about domains of integration, we really mean homology classes. The meaning of homology is as follows. Let α and α ' be two domains of integration of the same dimension. We raise the question under what circumstances will the differential form ω have the same integral over the two different domains? The necessary and sufficient condition for α and α ' to be homologuous is this: α ≡ α ' ⇔ ∂( α – α ') = 0

The equivalence class of domains represented by α is called the homology class of α . We denote the quotient set of all homology classes by the symbol A; it is also a graded vector space. Strictly speaking, when we talk about domains of integration, we always mean their homology classes. The concept of a definite integral refers to the dual pairing of the graded vector spaces A and W through the scalar product 〈 α , ω 〉 . In more detail, the definite integral of ω (a cohomology class of differential forms) over α (a homology class of domains), where the degree of ω agrees with the dimension of α , is a real number that can be obtained as a scalar product. It only depends on the homology class of the domain α and the cohomology class of the differential form ω :

∂( α – α ') = 0 ⇒ 〈 α , ω 〉 = 〈 α ', ω 〉 d( ω – ω ') = 0 ⇒ 〈 α , ω 〉 = 〈 α , ω ' 〉 .

---

# The Greatest Slide Rule Ever Invented

URL: https://newaustrianeconomics.com/archive/fekete/the-greatest-slide-rule-ever-invented/
Date: 2010-04-04
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete argues for the educational and practical value of the slide rule in the age of pocket calculators, describing the design of a helical slide rule on a tin can that achieves essentially unlimited scale length. He uses this as an occasion to discuss logarithms, the mathematics of helical paths, and the nature of analog computation.
Editorial Note: Blog #5 in Fekete's math series (2010), a meditation on slide rules, logarithms, and the value of analog thinking in an age of digital calculation.
Original PDF: https://professorfekete.com/articles/BLOG5SLIDERULE.pdf

## The Greatest Slide Rule Ever Invented

### Blog #5

Apropos THINK GLOBALLY, and helical paths on tin cans. Slide rules have been crowded out by pocket calculators, which is a pity. During my travels I once purchased a circular slide rule which is in a way better than the straight one, e.g., when we have to multiply several numbers the result overflows the scale on the right, or when we have to perform serial division and it overflows on the left. When it is a mix of serial multiplications and serial divisions, we could overflow either end of the scale on the straight, but not on the circular slide rule. I have never come across an actual copy of the greatest slide rule, which would be one helix sliding along another of the same dimensions. It would be the most efficient and most compact slide rule ever, if it was constructed. Before I could patent my invention, the computer revolution put me out of business.

But what interests the differential geometer is that these three are the ONLY possibilities to construct slide rules. To prove this is as simple as it can be. There are only three self-sliding space curves, because they must have constant curvature and constant torsion. If both the curvature and the torsion are 0, we have the straight slide rule. If the torsion is 0 and the curvature is non-zero, we have the circular slide rule (incidentally, the radius of the circle is just the reciprocal of the curvature!). If both the curvature and the torsion are non-zero, we have the helical slide rule. The curvature is the numerical measure of deviation from a straight line; the torsion is the numerical measure of deviation from a plane curve. In general, they both vary along the flypath. The best way to visualize this is to think that we are flying in a space where there is no gravitation. Our plane has only two control knobs: one to control curvature and the other, torsion. If we lock both, the flypay will be a helix!


---


Apropos the shortest distance between two points on a curved surface, the idea of minimal surfaces is a generalization. Here a contour curve is given which is a closed loop, and we are looking for the surface with the smallest area resting on that contour. Clearly, this is a generalization of the shortest path problem. The interesting thing is that in the general case there is only one solution, just as in case of finding the shortest path where the role of the contour is played by a pair of points. I say in the general case, because in some special cases uniqueness may disappear, just as on the globe when the pair of points happens to be antipodal (e.g., the North and South poles) when there are infinitely many shortest paths, namely great circles (meridians).

Incidentally, the problem of minimal surfaces is a hard one. It involves solving a second order partial differential equation. When, several decades ago, I was teaching differential geometry the last time, it took a long time for the best computers available to solve those differential equations. Maybe today they could do it much faster, I don’t know. But the solution would not be instantaneous. Well, ours are digital computers, and we are fond of disparaging analog computers. Yet nature runs analog computers exclusively, and minimal surfaces offer a shining example how efficient they are. Fashion the contour out of a wire loop, attach a handle to it, and dip it into a soapy solution. When you pull it out, bingo! The minimal surface appears as a film inside of the contour! The solution is instantaneous (no pun intended: I don’t mean the soapy solution; I mean solution to the differential equation!), and if we find a way to manipulate the contour loop, then we can follow the change of the shape of the minimal surface as a function of the contour.


---


I posted a blog to the SQUARE DANCING article of Progessor Strogatz under the title

SQUARE DANCING ON SUQARE TILES. Unfortunately, my blog was misplaced and ended up as blog #268 attached to the article DIVISION AND ITS DISCONTENTS to which it is not relevant. Also, I posted a blog to the article FINDING YOUR ROOTS under the title FROM RATIONAL TO IRRATIONAL. It is in answer to Settembrini’s thoughtful comment expanded version) on my own website: [www.professorfekete.com/mathematics/blogs](https://www.professorfekete.com/mathematics/blogs) to avoid future mishaps.

#237 on my blog #230. In any case, I am publishing my blogs separately (preferably in an

---

# Square Dancing with Primes

URL: https://newaustrianeconomics.com/archive/fekete/square-dancing-with-primes/
Date: 2010-03-28
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete extends his square dancing exploration into prime number theory, examining which primes can be expressed as the sum of two squares. He uses Gauss's theory of Gaussian integers to show that primes of the form 4k+1 split into two Gaussian primes while primes of the form 4k+3 remain inert — a deep result with implications for the structure of the integers.
Editorial Note: Blog #4 in Fekete's math series (2010), extending the Pythagorean triple analysis into prime number theory via Gauss's Gaussian integers and the theory of sums of two squares.
Original PDF: https://professorfekete.com/articles/BLOG4.pdf

## Square Dancing With Primes

### Blog #4

Here is another refinement of square dancing that waltzes right into some pretty deep mathematics (see also SQUARE DANCING ON SQUARE TILES).

Carl Friedrich Gauss (1777-1855), arguably the greatest mathematician of all times, was intrigued by the identity a2 + b2 = (a + ib)(a – ib) = c2, for integral values of a, b, implying that there is a one-to-one correspondence between Pythagorean triples (a, b, c) and complex numbers whose real and imaginary parts a, b as well as absolute value c are integers.

Then Gauss went on looking at non-Pythagorean triples of the type (1, 2, 5 ) where the last component is the square root of a prime number (that is, the square of the hypotenuse of the right triangle is a prime number). Gauss took a hard look at the list of prime numbers

2, 3, 5, 7, 11, 13, 17, 23, 29, 31, 37, 41, 43, 47, 53, 59, 61,… and noticed that the odd primes fall into two classes according as they yield a remainder of 1 or 3 upon division by 4. In the list above this is indicated by printing them in red or black color, resp. Thus 3 = 4 × 0 + 3, 7 = 4 × 1 + 3, 11 = 4 × 2 + 3, 23 = 4 × 5 + 3,… and

5 = 4 × 1 + 1, 13 = 4 × 3 + 1, 17 = 4 × 4 + 1, 29 = 4 × 5 + 1,… Both classes have infinitely many primes (this is not obvious!) But the remarkable thing is that the black primes never split into the product of complex conjugate numbers. Conversely, all the red primes do, thus: 5 = (1 + 2i)(1 – 2i), 13 = (2+3i)(2– 3i), 17 = (1 + 4i)(1 – 4i), 29 = (2 + 5i)(2 – 5i), 37 = (1 + 6i)(1 – 6i), etc.

The only even prime number 2 forms a class by itself; it also splits into the product of complex conjugate numbers: 2 = (1 + i)(1 – i).

In honor of Gauss we call a complex number a + ib a Gauss integer, if a, b are integers (the absolute value a 2 + b2 may or may not be). The arithmetic of Gauss integers is rather similar to that of rational integers, if we consider the latter as special Gauss integers. We can talk about their divisibility, and we can talk about Gauss primes. We even have the Fundamental Theorem of Arithmetic asserting that every non-zero Gauss integer can be uniquely decomposed into the product of Gauss primes (provided that another decomposition which differs only in the order of factors, or in which Gauss primes may have been replaced by their mutual divisor, is considered the same). Examples of Gauss primes are: 1+2i, 2+3i, 1+4i, 2+5i, 1+6i, 4+5i; and also 1–2i, 2–3i, 1–4i, 2–5i, 1+6i, 4–5i. The interesting thing is that the squares of the absolute value of these complex numbers are just the red primes: 5, 13, 17, 29, 37, 41. We can see that the red primes are not Gauss primes; in contrast with the black primes, which are. Of course, 2 is not a Gauss prime either, but its factors 1 + i and 1 – i are.

Let us call a right triangle whose legs are integers and the square of the hypotenuse is a prime number, an instance of „square dancing with primes”. It follows from the foregoing that all such can be obtained from the factorization of the colored primes into Gauss primes.

This suggests that a survey of all possible instances of square dancing with primes is exactly the same as the survey of all Gauss primes with non-zero real and imaginary parts.

When it comes to prime factorization in Z, we do not make a distinction between the prime numbers 2 and – 2, 3 and – 3, etc. We treat them as if they were one and the same. In more details, we introduce an equivalence relation by calling two different integers equivalent if they are mutual divisors. This is the case if, and only if, either one is the negative of the other. Then we take the quotient set. Elements of the quotient set are equivalence classes or, as we shall call them, molecules consisting of an integer and its negative, called atoms. Thus all molecules have two atoms, with the exception of the zero molecule which has only one.

The Fundamental Theorem of Arithmetic refers to the quotient set consisting of molecules of integers. (Quotient sets of numbers were introduced in my blog MAIMING THE MIND.) The Fundamental Theorem may be stated as saying that, apart from order, a non-zero molecule of integers can be uniquely decomposed into the product of prime molecules.

Now we want to make the same distinction for the Gauss integer. We call two Gauss integers equivalent if they are mutual divisors. An example is 3 + 4i and 4 – 3i. The first is a divisor of the second because 4 – 3i = (– i)(3 + 4i), and the second is a divisor of the first because 3 + 4i = i(4 – 3i). But 3 + 4i has two other mutual divisors as well: – 3 – 4i and – 4 + 3i. As there are no others, the four Gauss integers (3+4i, –3–4i, 4–3i, –4+3i) form a molecule. In the complex number plane the four atoms of a molecule are simmetrically located, in fact, they are the four vertices of a square the center of which is 0.

The simplest molecule of four atoms is the unit molecule (1, –1, i, –i). The atoms of the unit molecule, 1, –1, i, –i, are called units. The product of any two units, and the reciprocal of any unit is also a unit. The rule to get the various atoms of any given molecule is to multiply one of the atoms by the units. The 0-molecule, of course, has only one atom. The Fundamental Theorem of Arithmetic refers to the quotient set consisting of the molecules of Gauss integers. It can be stated as saying that, apart from order, every non-zero molecule of Gauss integers uniquely splits into the product of prime molecules.

Another molecule that occurs frequently is (1+i, 1–i, –1+i, –1–i), the atoms of which are the Gauss prime divisors of 2. This is the only case where the complex conjugate of a Gauss prime belongs to the same molecule. In all other cases the complex conjugate of a Gauss prime with nonzero real and imaginary parts is a different Gauss prime.

There is a relation between Pythagorean triples and Gauss integers. Given a primitive Pythagorean triple (a, b, c), we can write the square of the hypotenuse as a product of complex conjugate Gauss integers: c2 = a2 + b2 = (a + ib)(a – ib). There is a theorem asserting that either factor is the square of a Gauss integer.

For example, for (3+4i)(3–4i) = 32 + 42 = 52 we have 3+4i = (2+i)2 and 3–4i = (2–i)2; for (5 + 12i)(5 – 12i) = 52 + 122 = 132 we have 5 + 12i = (3 + 2i)2 and 5 – 12i = (3 – 2i)2.

This can be proved using the unique prime factorization of Gauss integers, see: [wikipedia.org](http://wikipedia.org/wiki/Pythagorean_triple) To recapitulate, square dancing in general involves an arbitrary right triangle. Square dancing on square tiles involves right triangles with integral legs whose hypotenuse is an integer as well. Square dancing with primes also involves right triangles with integral legs, but the hypotenuse here is not an integer but the square root of a colored prime number.

There are some remarkable open problems in connection with Gauss primes. The real and imaginary axes contain infinitely many Gauss primes, namely, 3, 7, 11, 23, 31, 43,… and 3i, 7i, 11i, 23i, 31i, 43i,… Are there any other straight lines in the complex number plane which also do?

In particular, it is not known whether there are infinitely many Gauss primes on the line parallel to the imaginary axis a unit distance from it to the right.

In passing I mention a fascinating analogy between the extension of integers to Gauss integers, and the extension of the set R(x) of polynomials with real coefficients to the set C(x) of polynomials with complex numbers as coefficients. The latter resemble the number system of integers: we have divisibility; we have units, we have primes. The units of R(x) is the set of non-zero real numbers R*, those of C(x) is the set of non-zero complex numbers C* called scalars. Thus a molecule of polynomials, other than the zero polynomial, has infinitely many atoms, namely, polynomials which are non-zero scalar multiples of one another.

Corresponding to primes we have the irreducible polynomials. The Fundamental Theorem asserts that any non-zero molecule of polynomials can be uniquely decomposed as a product of molecules of irreducible polynomials (apart from order).

Just like in Z where there are black primes and red primes, in R(x) there are also two kinds of irreducible polynomials: linear and irreducible quadratic polynomials (those with a negative discriminant). When we pass to C(x), irreducible quadratic polynomials split into the product of linear polynomials with complex coefficients, just like the red primes split into the product of Gauss integers.

## Exercises.

(1)

Write the following primes as the product of a pair of complex conjugate Gauss primes: 41, 53, 61, 73, 89, 97, 101.

(2)

True or false? (a) 9– 3i is divisible by 1+i; (b) 24+21i is divisible by 1+ 3i;

(c) 10–47i is divisible by 2+3i.

(3)

Find pairs of mutual divisors among the Gauss integers 4–3i, 4+3i, 3+4i.

(4)

Show that if a + ib is a Gauss prime, then its complex conjugate a – ib is a

### Gauss prime as well. Are they mutual divisors?

(5)

Show that if a + ib is a Gauss prime, then so is b + ia.

(6)

Find all the divisors of the Gauss integers (a) 1 – 3i; (b) 1 + 4i

(7)

### How many divisors does a Gauss prime have?

## Answers.

(1)

41 = (4+5i)(4–5i); 53 = (2+7i)(2–7i); 61 = (5+6i)(5–6i); 73 = (3+8i)(3–8i);

89 = (5+8i)(5–8i); 97 = (4+9i)(4–9i); 101 = (1+10i)(1–10i).

(2)

(a) True. (b) False. (c) True.

(3)

4 – 3i and 3+ 4i are mutual divisors; 4 + 3i is not a mutual divisor of either one of the preceding ones.

(4)

If a + ib is a Gauss prime, then the square of its absolute value, a2 + b2 is a red prime. But the complex conjugate has the same absolute value, therefore it cannot help but be a Gauss prime itself. The complex conjugate of a Gauss prime is not a mutual divisor, hence they belong to different molecules. There is only one exception to that, namely 1+i, 1–i, the Gauss prime divisor of 2 which belong to the same molecule.

(5)

This follows from (4) and from the fact that the product of a Gauss prime by a unit (in this case, by i) is also a Gauss prime (they belong to the same molecule).

(6)

(a) 16;

(7)

There are two kinds of Gauss primes: the black primes p, and the Gauss prime divisors a + ib of the colored primes. In the first case the number of divisors is

4 (namely, p, –p, 1, –1); in the second case, 8 (namely, a + ib, –a – ib, –b + ia, b – ia, 1, –1, i, –i).

(b) 8.

### (Revised March 22, 2010)

---

# Square Dancing on Square Tiles

URL: https://newaustrianeconomics.com/archive/fekete/square-dancing-on-square-tiles/
Date: 2010-03-21
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete comments on Strogatz's article on the Pythagorean theorem, extending it back to Babylonian mathematics and showing how Pythagorean triples were systematically generated thousands of years before Pythagoras. He argues this history reveals mathematics as a living tradition of discovery rather than a fixed body of results.
Editorial Note: Blog #3 in Fekete's math series (2010), tracing Pythagorean triples from ancient Babylon through Gauss's complex number theory — a miniature history of mathematics in one equation.
Original PDF: https://professorfekete.com/articles/BLOG3.pdf

## Square Dancing On Square Tiles

### Blog #3

Professor Steve Strogatz published an article with the title SQUARE DANCING in the

OPINIONATOR column of The New York Times on March 14, 2010. In this blog I would like to discuss a refinement that waltzes thousands of years back into history to Babylonian times.

Draw a right triangle with sides 3 and 4 units long; then the hypotenuse will be 5 units long. Draw squares on the sides and on the hypotenuse and show how they are made up of 9, 16, and 25 unit squares, resp.

The result can be seen in [demonstrations.wolfram.com](http://demonstrations.wolfram.com/PythagoreanTriples) We call and denote this as the Pythagorean triple (3, 4, 5), and pose the problem of finding all possible ways of “square dancing on square tiles”.

Let’s look at the sequence of squares 1, 4, 9, 16, 25, 36, 49, 64, 81, 100, 121, 144, 169, 196, 225,… and pick two the sum of which is also in the list. We skip (6, 8,10) and (9,12,15) because they can be trivially obtained from (3, 4, 5) by doubling and trebling components. In other words, the components have a common multiple other than 1 and therefore are not coprime. A Pythagorean triple is called primitive if its components are coprime. Here is a genuinely new one that is primitive: 25 + 144 = 169, leading to the Pythagorean triple

(5, 12, 13). The next ones would be (8, 15, 17) and (7, 24, 25). If you tried to find more, you would see that square dancing on square tiles never comes to an end.

To find all possible solutions we go to Euclid’s formula stating that from

(m2 – n2, 2mn, m2 + n2) where m, n are coprime positive integers satisfying m > n, of which one is even and the other odd, we can get all primitive Pythagorean triples. From the primitive ones, in turn, we can get all of them by multiplying components with an arbitrary positive integer k. The special case n = 1 was already known to the Babylonians.

### For more, see: [www.wikipedia.org/wiki/Pythagorean_triple](https://www.wikipedia.org/wiki/Pythagorean_triple)

In one way or another all Pythagorean triples come from (3, 4, 5). One component of any Pythagorean triple is divisible by one of 3, 4, 5. Possibly the same component is divisible by all three, or by any two of them as in (11, 60, 61), (5, 12, 13), (8, 15, 17), (20, 21, 29). This occurs when one or two of the components are prime numbers. In particular, the product of the two smaller components is always divisible by 3×4 = 12, and the product of all three components is always divisible by 3×4×5 = 60. This could be useful as a check.

A beautiful example of contact between geometry and algebra is the theorem stating that all Pythagorean triples can be derived from the simplest one (3, 4, 5), also known as the parent-child relationship (ibid.) I describe it in an unusual way as changing the metric structure of the plane. Discard the Euclidean structure of the plane and replace it with a Lorentz structure (in which the circles are equilateral hyperbolas). Then there are three distinguished Lorentzian transformations of the plane, such that any given Pythagorean triple is obtained by applying one or more of the distinguished transformations to (3, 4, 5) once or several times.

## Exercises.

(1)

Show that there are no Pythagorean triples such that every component is an odd number.

(2)

Are there Pythagorean triples such that two components are prime numbers? If so, how to look for them?

(3)

Are there Pythagorean triples such that all three components are prime numbers?

(4)

Find Pythagorean triples one of whose components is (a) 56; (b) 35; (c) 42.

## Answers.

(1)

No. By Euclid’s formula the middle component must be even.

(2)

Yes. We find them by checking components for divisibility by 12, 15, 20, or 60.

(3)

No. All prime numbers with the exception of 2 are odd, so by (1) the only possibility is (b, 2, c), that is, b2 + 4 = c2, or (c + b)(c – b) = 4. But 4 can only be factorized as 2×2 or 1×4; either one is impossible as b, c are odd prime numbers.

(4)

(a) (33, 56, 65), another one: (56,783, 785).

(b) (12, 35, 37), another one: (35, 612, 613).

(c) There is none. To see this we observe that there are only 16 primitive Pythagorean triples with c < 100 as follows:

### (3,4,5)

### (9,40,41)

### (16,63,65)

### (36,77,85)

### (5,12,13)

### (11,60,61)

### (20,21,29)

### (39,80,89)

### (7,24,25)

### (12,35,37)

### (28,45,53)

### (48,55,73)

### (8,15,17)

### (13,84,85)

### (33,56,65)

### (65,72,97)

It can be seen that 42 does not occur among the components. If there was a Pythagorean triple with 42 as a component, then it would have to be the snallest component and we would have: u2 – v2 = (u + v)(u – v) = 42 = 7×6 = 14×3 = 42×1 ⇒ u + v = 7, u – v = 6 or u + v = 14, u – v = 3 or u + v = 42, u – v = 1. In neither case is there an integral solution for u, v.

### (Revised March 20, 2010.)

---

# From the Rational to the Irrational

URL: https://newaustrianeconomics.com/archive/fekete/from-the-rational-to-the-irrational/
Date: 2010-03-14
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete extends his analysis of irrational numbers, showing how they can be systematically constructed from rational numbers through the method of Cauchy sequences. He argues this construction — far from being a curiosity — reveals the deep structure of the continuum and the nature of mathematical infinity.
Editorial Note: Blog #2 in Fekete's math series (2010), filling in a gap left in the earlier Maiming the Mind blog with a more complete treatment of the construction of irrational numbers.
Original PDF: https://professorfekete.com/articles/BLOG2.pdf

## From The Rational To The Irrational

### Blog #2

No pun is intended; the title looks too good to pass it up. This blog describes the construction of irrational numbers from the rational, to fill a gap in my other blog MAIMING THE MIND with reference to Professor Strogatz’ article in The New York Times OPINIONATOR column of March 7, 2010, entitled FINDING YOUR ROOTS (blog #230). The gap was left for the sake of simplicity of presentation. The reader may pick up the thread by going to the fourth paragraph of my earlier blog.

We have seen that, although the two direct operations addition and multiplication could always be carried out in N, the inverse operations of subtraction and division ran into obstructions making it necessary to pass to an extension of the number system. In this way we were led to Q, the system of rational numbers wherein all four rules of arithmetic could be performed without obstruction.

Beside these four rules there are others, some also calling for an extension of the number system. The direct operation of raising a number to some power can be performed without obstruction. But it has two inverse operations, logarithm and root extraction (two, because the last-mentioned direct operation, unlike addition and multiplication, fails to be commutative: \(2^3 = 8 \neq 9 = 3^2\)). In each case we run into obstructions.

In finding logarithms, given a positive base \(b\) and a positive power \(a\), we seek to find the exponent \(x\) such that \(b^x = a\). It may or may not exist in Q. The obstruction can be removed in the same way as in the case of subtraction and division, that is, by constructing a tentative solution set, followed by taking its quotient set in which the solution is going to be unique.

However, unlike in the case of subtraction and division, where two numbers of the obstructed number system sufficed to construct the solution, in the case of logarithm the construction of an irrational number takes infinitely many rational numbers.

We consider the tentative solution-set consisting of Cauchy-convergent sequences of positive rational numbers \(x_1, x_2, x_3, \ldots, x_n, \ldots\). A sequence of positive rational numbers is said to be Cauchy-convergent (for short, a Cauchy sequence) if the difference between two members becomes arbitrarily small in absolute value, provided that we have gone far enough in the sequence.

For example, 1/2, 1/3, 1/4,…, 1/n,… is a Cauchy sequence; in fact, it converges to 0.

1/2, 2/3, 3/4, 4/5,…, (n – 1)/n,… is also a Cauchy sequence converging to 1. However, the point is that not all Cauchy sequences converge to a rational number. It is precisely such sequences that are Cauchy-convergent, but do not converge to a rational number, that will be used to define an irrational number.

The trouble is that, once again, there are too many candidates in the set of Cauchy sequences eligible to be a solution. For example, consider

$$
\begin{aligned}
 x_n &= \frac{\displaystyle\sum_{k=2}^{n} a^k/b^k}{\displaystyle\sum_{k=1}^{n} a/b^k}\,, \\[6pt]
 x'_n &= \frac{\displaystyle\sum_{k=2}^{n} a^k/b^k}{\displaystyle\sum_{k=1}^{n+1} a/b^k}\, \qquad (n = 1, 2, 3, \ldots)
\end{aligned}
$$

which are Cauchy sequences of rational numbers with \(0 < a, b < 1\) in **Q**. The first converges to the irrational number \(x\) such that \((1-b)^x = 1-a\) (as we shall explain in the NOTE below), i.e.\ \(x = \log_{1-b}(1-a)\). The sequence \(\{x'_n\}\) is also a Cauchy sequence and converges to the same irrational number \(x\).

To ensure uniqueness we introduce an equivalence relation in calling two Cauchy sequences equivalent if their difference sequence converges to 0. The quotient set R of equivalence classes is the number system consisting of both rational and irrational numbers, collectively known as real numbers. Once again, we have extended the number system from Q to R through constructing a quotient set, the same method as was used to extend N to Z and Z to Q. Logarithms can be found in R without obstruction, and they are uniquely determined.

Quotient sets provide a powerful and universal method to build the number concept.

## Exercises

(1) Find the limits of the Cauchy sequences

(a) \(1,\, 1.1,\, 1.11,\, 1.111,\ldots\)

(b) \(1,\, 1.01,\, 1.0101,\, 1.010101,\ldots\)

(2) Find three different Cauchy sequences of rational numbers each converging to \(\sqrt{2}\).

(3) Find a Cauchy sequence of rational numbers converging to \(\pi\).

(4) Find Cauchy sequences of rational numbers converging to \(e\) and \(1/e\).

(5) Find a Cauchy sequence of rational numbers converging to \(\log 2\).

## NOTE

To justify the statement that \(x_n\) is a Cauchy sequence of rational numbers that converges to \(x\) where \(x\) is the solution of the exponential equation \((1-b)^x = 1-a\) with \(1-a\) and \(1-b\) rational numbers between \(0\) and \(1\), we need a couple of facts from arithmetic and calculus concerning the function \(\log x\).

First, \(b^x = a \Rightarrow x \log b = \log a \Rightarrow x = \dfrac{\log a}{\log b}\).

Second, if \(0 < y < 1\) then \(\sum_{k=1}^n y^k = \dfrac{y-y^{n+1}}{1-y}\); in particular \(\sum_{k=1}^{\infty} y^k = \dfrac{y}{1-y}\) when \(|y|<1\).

Using these identities in the logarithms attached to the numerators and denominators of \(x_n\) (still with \(0 < y < 1\) in the pertinent partial sums), it follows that \(x_n\) is a Cauchy sequence of rational numbers converging to the irrational number \(x\) satisfying \((1-b)^x = 1-a\).

## Hints

(1) (a) The sum \(\displaystyle\frac{1}{10}+\frac{1}{100}+\frac{1}{1000}+\cdots\) is a convergent geometric series with sum \(\dfrac{1/10}{1-1/10} = \frac{1}{9}\), hence the Cauchy sequence closes in on \(\displaystyle\frac{10}{9}\).

(b) Likewise \(\displaystyle\frac{1}{100}+\frac{1}{10000}+\frac{1}{1000000}+\cdots = \dfrac{1/100}{1-1/100} = \frac{1}{99}\), hence the Cauchy sequence closes in on \(\displaystyle1+\frac{1}{99} = \frac{100}{99}\).

(2) (a) Use \(\sqrt{2}= 1.4142\ldots\) where the digits are obtained through the algorithm for extracting square roots of decimals.

(b) From \((x+1)^2 = 2\), rearrange step by step to \(x=\dfrac{1}{2+x}\). Keep substituting \(1/(2+x)\) for \(x\) (continued fraction):

\[
 \sqrt{2} = 1 + \dfrac{1}{2 + \dfrac{1}{2 + \dfrac{1}{2 + \cdots}}}\;.
\]

(c) Use the binomial series

\[
 (1+x)^{1/2} = 1 + \binom{\frac{1}{2}}{1}x + \binom{\frac{1}{2}}{2}x^{2} + \cdots + \binom{\frac{1}{2}}{n}x^{n} + \cdots\,,
\]

valid for \(|x| \leq 1\).

(3) Using \(\arctan x = x - x^3/3 + x^5/5 - x^7/7 + \cdots\) for \(|x| \leq 1\), substitute \(x=1\): \(\pi/4 = 1 - \tfrac{1}{3} + \tfrac{1}{5} - \tfrac{1}{7} + \cdots\) (four times the rational partial sums is a Cauchy sequence with limit \(\pi\)).

(4) Use the power series \(e^x = 1 + \dfrac{x}{1!} + \dfrac{x^{2}}{2!} + \dfrac{x^{3}}{3!} + \cdots\) for \(x = 1\) and \(x = -1\).

(5) From \(\log(1+x) = x - \dfrac{x^2}{2} + \dfrac{x^3}{3} - \dfrac{x^4}{4} + \cdots\) (valid for \(-1 < x \leq 1\)), substitute \(x=1\) to get \(\log 2 = 1 - \dfrac{1}{2} + \dfrac{1}{3} - \dfrac{1}{4} + \cdots\).

_(Revised March 22, 2010.)_

---

# Blog #1: From the Rational to the Irrational — A Response

URL: https://newaustrianeconomics.com/archive/fekete/rational-to-irrational-response/
Date: 2010-03-10
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: In response to a reader's blog comment, Fekete clarifies his earlier discussion of the construction of real numbers from rationals. He explains Cauchy sequences and Dedekind cuts as the two principal methods, arguing that appreciating this construction is essential to understanding what mathematics actually achieves.
Editorial Note: Blog #1 in Fekete's math series (2010), a follow-up clarification on the construction of the real number system written in response to a reader comment on his NYT blog.
Original PDF: https://professorfekete.com/articles/BLOG1.pdf

This is in answer to Settembrini’s blog of March 10, 2010 (#237).

In contrast with the fact that every rational number can be expressed as the ratio of two integers, my statement in my blog MAIMING THE MIND (#230): “the real numbers are constructed from the rational numbers” does not mean that any given irrational number can be expressed in terms of two rational numbers or, for that matter, finitely many rational numbers.

As a matter of fact, it will take infinitely many. What is true is that every real number can be determined as the limit of a sequence of rational numbers. This construction of the real number system from the rational is known as the method of Cauchy sequences named after Augustin Louis Cauchy (1798-1857), who used it first.

My blog MAIMING THE MIND has a gap, the details of the construction of irrational numbers in terms of rational numbers, left for the sake of simplicity. I congratulate Settembrini for picking it up. I fill in the gap in my blog FROM THE RATIONAL TO THE

IRRATIONAL that can be found in my website: [www.professorfekete.com](http://www.professorfekete.com/articles%5CBLOG2.pdf).

---

# Maiming the Mind

URL: https://newaustrianeconomics.com/archive/fekete/maiming-the-mind/
Date: 2010-03-07
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete responds to Professor Steven Strogatz's New York Times column on mathematics with an essay on the nature of irrational numbers and the real number system. He argues that modern mathematics education 'maims the mind' by presenting the real numbers as given rather than constructed, obscuring the deep intellectual achievement of Cauchy, Dedekind, and Cantor.
Editorial Note: Blog #0 in Fekete's math blog series (2010), written in response to Strogatz's NYT Opinionator column. Reveals Fekete's background as a professional mathematician alongside his economics work.
Original PDF: https://professorfekete.com/articles/AEFMathBlogNumber0.pdf

## Maiming The Mind

### Blog #0

In his article Finding Your Roots in the OPINIONATOR column of The New York Times, March 7,

2010, Professor Steven Strogatz suggests that the equation x2 = – 1 has caused an upheaval in mathematics. He goes on to say that such upheavals have been a regular occurrence.

Indeed. Altogether there were four such upheavals during the evolution of the number concept.

Each of them arose because of obstruction to the four inverse operations: subtraction, division, logarithm, and root extraction.

In subtracting, the sum and one summand are given, and we seek to find the other summand. It may or may not exist in N, the simplest number system consisting of the natural numbers. The obstruction to subtraction is removed by extending the number system. A tentative solution-set is constructed from the natural numbers by pairing the minuends and subtrahends. The trouble is that there are too many candidates for the difference. To ensure uniqueness we introduce a relation by calling two pairs equivalent if the first minuend and the second subtrahend yields the same sum as the second minuend and first subtrahend. The set of equivalence classes is Z, the number system that contains the positive as well as the negative integers and zero. In it subtraction can be performed without obstruction, and difference is uniquely determined.

In this extended number system we run into obstruction again on account of division, the inverse operation of multiplication. In dividing, the product and the multiplicand are given, and we seek to find the multiplier. It may or may not exist in Z. The obstruction to division is removed by a further extension of the number system. A tentative solution-set is constructed from the integers by pairing the dividend and the divisor (the latter must always be different from zero). Again, the trouble is that there are too many candidates for the quotient. To ensure uniqueness we introduce a relation by calling two pairs equivalent if the first dividend and the second divisor yields the same product as the second dividend and the first divisor. The set of equivalence classes is Q, the number system that contains the integers as well as the fractions. In it division can be performed without obstruction, and the quotient is uniquely determined.

We have seen that, although the two direct operations addition and multiplication could always be carried out, the inverse operations of subtraction and division ran into obstructions making it necessary to pass to an extension of the number system. In this way we were led to Q, the system of rational numbers wherein the four rules of arithmetic could be performed without obstruction.

Beyond these four rules there are other operations calling for further extensions of the number system. The direct operation of raising a number to some power has two inverse operations, logarithm and root extraction. (Two, because this direct operation, unlike addition and multiplication, fails to be commutative: 23 = 8 ≠ 9 = 32). We run into obstructions in each case. In finding logarithms, given a positive base and a positive power, we seek to find the exponent. Such an exponent may or may not exist in Q. The obstruction can be removed in the same way as in previous cases. From rational numbers we construct a tentative solution-set (for details, see the following blog FROM THE

RATIONAL TO THE IRRATIONAL). The trouble again is the presence of too many candidates. To ensure uniqueness we introduce a relation by calling two candidates equivalent if they both satisfy the equation. The set of equivalence classes is R, the number system consisting of both rational and irrational numbers collectively known as real numbers. Within R the logarithm operation can be performed (provided that the power and the base are positive and the latter is different from 1).

The method followed in each case is a quotient set construction. The set of equivalence classes is called a quotient set; it is conceived as a way of „simplifying” a given set. It is akin to the simplification of a fraction via dividing out a common factor of the numerator and the denominator — explaining how quotient sets earn their name („quotient” is Latin for the result of a division).

In mathematics folklore quotient set construction is also used to introduce complex numbers, thus making the development of the number concept a uniform procedure. The other inverse operation of raising a number to the power of another, root extraction, also runs into obstruction, as the notorious example of −1 shows. In R there is no number the square of which is –1. A tentative solution-set is offered by geometry. In the set of transformations of plane the quadratic equation x2 = –1 can be solved. There are two solutions ± x, the rotations through ± 90°; –1 is rotation through 180° or, what is the same, reflection in a point (explaining why it is not necessary to distinguish between two rotations through ± 180°). The trouble again is that there are infinitely candidates. To see this, let us discard the Euclidean structure of the plane, and replace it with another. The plane has infinitely many Euclidean structures, and every one of them comes with its own rotation i through 90°. While they are different from x, they all satisfy i2 = –1. So, once more, to ensure uniqueness we introduce an equivalence relation for the transformations of the plane. Two transformations are equivalent if they both satisfy the same equation. The set of equivalence classes, in other words, the quotient set of equivalent transformations of the plane is C, the system of complex numbers. In it, not only can root extraction be performed without obstruction, but the Fundamental Theorem of Algebra holds stating that every algebraic equation with complex coefficients has at least one root. Counted with multiplicities the number of roots agrees with the degree of the equation.

The evolution of the number concept through the phases N, Z, Q, R, C is hereby described through a uniform method: the construction of quotient sets. The picture that comes along is easy and lovely. A complex number no longer appears to be the odd man out. The mystery is taken out of “imaginary numbers” by pointing to the organic relation between algebra and Euclidean geometry.

Nevertheless, the “office of inquisition” does not allow a textbook into the classroom which uses this method of introducing complex numbers — presumably because of the prevailing anti-Euclid ethos of our age. The teacher is forced to toe the line, or out he goes. The student is forced to go through the rigmarole of introducing complex numbers in a wholly artificial and unilluminating way, making them appear to have arrived from the Mars. As they have an “imaginary” component, they can never be fully integrated in the community of “real” numbers. Students are forced to learn new paradigms for the arithmetic operations as applicable to complex numbers, instead of being told to do something they already know how to do: add and multiply them as if they were polynomials in the variable i, and in the end simplify by making the substitution i2 + 1 = 0.

Lest the reader thought it was too far-fetched to suggest that the “office of inquisition” could remove a teacher from the classroom for the offence of putting an unauthorized textbook into the hands of students, let it be stated here that the author of this blog suffered that fate. As a tenured professor at a Canadian university he was defrocked midstream, in full view of the students, for no better reason then refusing to make his students buy the prescribed textbook. Tenure notwithstanding, he was intimidated and threatened to be fired. The case took five years to resolve and the university teachers’ association had to be called in to mediate. The university never apologized.

The way complex numbers are being taught is a scandal and a blot on our “enlightened” educational system. In 1949 the new Chinese government in one of its first decrees outlawed the ancient practice of maiming and deforming the feet of little girls — an age-old cruel custom. But the maiming and deforming of the minds of talented young boys and girls via a thoroughly outmoded way of teaching complex numbers still continues in China, as it is in the rest of the world!

---

# Chapter 3: The Ardhaccheda of Virasena

URL: https://newaustrianeconomics.com/archive/fekete/ardhaccheda-of-virasena/
Date: 2010-01-01
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete examines the 9th-century Indian mathematician Virasena's concept of the Ardhaccheda — a precursor to the binary logarithm — showing how it anticipates modern information theory and the binary number system by over a thousand years. He argues this history reveals how mathematical ideas emerge independently across cultures when the underlying problems are universal.
Editorial Note: Chapter 3 of the Rainbow Slide Rule book (c. 2010), tracing the history of binary representations from ancient India through Leibniz to modern computing — situating Fekete's Rainbow digit system in a long mathematical tradition.
Original PDF: https://professorfekete.com/articles/CH-3 VIRASENA.pdf

### Chapter 3: ARDHACCHEDA OF VIRASENA (816 A.D.)

By a hair’s breadth the Romans missed inventing logarithms. As we have seen in Chapter 2, if you want to multiply any number by a power of two, say 2n, you just double that number n times. The desired product is the result of the last doubling. You may just forget about the adding part of the Roman method of multiplication. The exponent n actually tells you how many times you have to double the given number. It also tells you how many times you can halve 2n to get 1.

You can actually extend this result to the general case when the other factor of the product is not a power of two, by introducing the concept of “fractional doubling”. At any rate, that is what the Indian mathematician Acharya Virasena did. He considered 2x for fractional values of x to yield the number which, when halved x times, results in 1. In modern terminology we would say x = log2 2x (read: logarithm with base 2 of 2x).

In other words, the Romans could have introduced the definition: log2 n = the number of times n must be halved in order to get 1

### This definition would have led them to compile the table: n

1 2 4 8 16 32 64 128 256 512 1024 log2 n 0 1 2 3

With pro-rating of the increases in that table (or, to use the technical term, applying interpolation), they would have extended their table to cover all integers:

1 2 3 4 5

7 8 9 n log2 n 0 1 1.59 2 2.32 2.59 2.81 3 3.17 3.32

The fractional part of the value of log2n indicates that the last halving overshot the target 1, so it had to be reduced to “fractional halving” to put it back on target. In the same way they could have extended their table to fractional values of n > 1. Such a table can be found on the Internet, see: Base 2 Logarithms Table, [webcache.googleusercontent.com](http://webcache.googleusercontent.com). The 2-decimal place value, of course, is only an approximation. For a 16-decimal place value, see the website: [www.rapidtables.com](https://www.rapidtables.com). It is understandable that the Romans missed their chance to become the inventors of logarithms two thousand years ago. Their number system was just too clumsy. Virasena was enormously helped by the Hindu decimal number system that came into use in India at about the same time, between 800 and 825 A.D. Thus it took eight and one half of a century before the idea of counting the number of halvings in finding a product resurfaced.

Acharya Virasena was also an orator and a poet, and a student of the Jain sage Elacharya. He introduced the concept ardhaccheda, the number of times n could be halved before we reach 1 (or, if 0 < n < 1, the number of times n could be doubled before we reach 1, in which case the ardhaccheda of n is distinguished by giving it the negative signature). As we mentioned already, nowadays we call ardhaccheda “logarithm to base 2”. Virasena also worked out trakacheda and caturthacheda that nowadays would be called logarithms to base 3 and 4, denoted log3 n and log4 n, respectively.

Virasena knew how the tables above could be used to simplify calculations, e.g., multiply two numbers m and n by adding their logarithms and taking the “antilogarithm” of the sum, which means finding log2 m + log2 n in the second row of the table and pass to the corresponding value of n in the first.

For example, in finding 4 × 8 we write: log2(4 × 8) = log2 4 + log2 8 = 2 + 3 = 5 which we find in the second row just under n = 32, confirming that 4 × 8 = 32. “Taking the antilogarithm of log2 n ” is a perfectly superfluous term, as its meaning coincides with that of “taking 2 to the power of log2n”: 2log n = n . The two equalities 5 = log232 and 25 = 32 have exactly the same meaning, namely, x = 5 is the solution to the equation 2x = 32. To distinguish between the two expressions we call the first logarithmic form, the second the exponential form.

The contents of either one is that 2 must be raised to the power of 5 in order to get 32. Moreover, 5 is called the exponent or logarithm; 2 is the base; and 32 is the power.

In general, let the base be b (b > 0, b ≠ 1), the exponent x, and the power y (y > 0). Then x = logb y is the solution of the exponential equation bx = y. In this general case we can also see that logarithm is the exponent to which the base has to be raised in order to get the power. The logarithm satisfies the following identities: x blog x = x , logb b = x b logb (x1x2) = logb x1 + logb x2 logb ⎛⎜ ⎞⎟ = – logb x

### ⎝x⎠

### (x ≠ 0) logb xn = n logb x logb ( n x ) = log b x n

The special cases logb b = 1 and logb 1 = 0 deserve special mention.

Exercises:

1.

Write in logarithmic form the following:

### (a) 25 = 32, (b) 52 = 25, (c) 104 = 10000, (d) 2–3 = 0.125

2.

Write in exponential form the following:

(a) log10 100 = 2, (b) log2 0.0625 = – 4, (c) log5 0.0064 = –6,

### (d) log5 3125 = 5, (e) log2 2048 = 11

3.

Evaluate and provide reasons: (a) log2 128, (b) log5 0.00128,

(c) log10 0.0001, (d) log10 1000, (e) log2 0.25, (f) log5 0.16,

### (g) logb bn

4.

Evaluate and provide reasons: (a) log2 (¼), (b) log5 (1/25),

(c) log5 25, (d) log2 512, (e) log10 0.01, (f) logb bn, (g) logb( 3 b ),

### (h) log6( 3 6 ), (i) logb(x/y), (j) logb( x ), (k) logb ( m x n )

5.

Solve the exponential equations and check:

(a) 2x = 32, (b) 5x = 0.032, (d) 2x = 16, (e) 5x = 0.16,

### (f) 10x = 1/1000, (g) 22x – 1 = 1024

6.

Solve the logarithmic equations and check:

(a) log10 10x = 1/10, (b) log2 x = 128; (c) log5 x = 0.00128,

### (d) log10 (log10 x) = 1, (e) log2 53x+1 = 2

7.

Fill the blanks in the following tables:

### (a) n

1 0.2 0.4 0.8 0.16 log2 n

### (b) n

1 0.5 0.25 0.125 log5 n

### (c) n

1 10 102 103 log10 n

### (d) n

1 0.1 0.01 0.001 log10 n

### (e) n

1 5 25 log5 n 0 1

3 4 5 6 7 8 9

### Change of basis

There are direct and inverse operations. Direct operations are addition, multiplication, and raising one number to the power of another. Each of these have inverse operations. The inverse operation of addition is subtraction: given x + a = b, for the unknown x the solution is given by the difference x = b – a.

The inverse operation of multiplication is division: given ax = b (a ≠ 0), for the unknown x the solution is given by the fraction x = b/a. Addition and multiplication are commutative operations, and therefore there is just one inverse operation for either. This is no longer the case for the third direct operation which is not commutative (23 = 8 ≠ 9 = 32) and, therefore, in the equation bn = m either b or n can be unknown, and the choice gives us two indirect operations. If the unknown is b, then the inverse operation yielding it is root extraction, b = n m . If the unknown is n then, as we know, we have an exponential equation whose solution can be obtained by finding logarithm: n = logb m. We conclude that the direct operation of raising one number to the power of another has two inverse operations: root extraction and finding logarithm.

We have seen that logarithms simplify the operations multiplication, division, raising to powers, and root extraction by reducing them to addition, subtraction, multiplication and division, respectively. We now face the question: is the other inverse operation of the power operation also simplified, and if so, how. The answer to this question is that the other inverse operation is also simplified, namely, it is reduced to division as well.

This fact is usually stated in a different form, namely, as the problem of changing the basis of logarithms. Suppose we want to change the basis of logarithms from b to a (a > 0, a ≠ 1). It can be done by using the simple formula: loga x = log b x log b a

This rule is paraphrased by saying that logarithms to the bases a and b are proportional, the factor of proportionality is constant and is equal to 1/logb a. It follows that if we have the logarithm table for base b, then we can easily get the one for base a. We multiply every logarithm with base b by the proportionality factor 1/logb a.

### Example. Given the logarithm table for base 4, n

16 32 64 128 256 512 1024 log4 n 0 1/2 1 3/2

5/2

7/2

9/2 obtain the corresponding logarithm table for base 2.

We calculate the proportionality factor:

= 1/½ = 2 and multiply log 4 2 all the entries in the second row of the above table to get

1 2 4 8 16 32 64 128 256 512 1024 n log2 n 0 1 2 3

Note that the table for 2n in Chapter 2 is the same as the table above for log2n, except the two rows are interchanged.

### Exercise 8: Given the logarithm table for base 10: n

1 10 100 1000 10000 100000 1000000 10000000 100000000 log10 n 0 find the proportionality factor for base 5, given that log10 2 = 0.301 and log 10 5 fill the blanks in the table n

100 1000 log5 n 0 1.43

With the help of your table calculate 100×1000; 1,000,000/10,000; 1003;

1, 000, 000 ; 3 1, 000, 000 .

---

# Chapter 7: The Binary System of Leibniz

URL: https://newaustrianeconomics.com/archive/fekete/binary-system-of-leibniz/
Date: 2010-01-01
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete presents the binary number system through the lens of Leibniz's original 1697 formulation, connecting it to the Overflow Formula and the representation of subsets. He argues the binary system, though mathematically elegant, is practically uneconomical — the motivation for his alternative stepnumber system using infinitely many digits.
Editorial Note: Chapter 7 of the Rainbow Slide Rule book (c. 2010), presenting the binary number system as the foil for Fekete's stepnumber system. The chapter establishes why a system with infinitely many digits may be more efficient than binary for representing large numbers.
Original PDF: https://professorfekete.com/articles/Ch-5 BINARY SYSTEM.pdf

### Chapter 7: THE BINARY SYSTEM OF LEIBNIZ (1697)

## The Decimal System

Counting in the decimal system from zero upwards by serially adding 1.

Recall that if in adding 1 to the last digit the result exceeds the largest admissible digit which is 9, then we write 0 for the sum and carry the digit 1 to the next column. In writing binary numbers we shall use bold face type to distinguish them from decimals: 10 ≠ 10 = 2.

The Overflow Formula for decimals states that 999…9 + 1 = 1000...0 (the number of 9’s on the LHS = the number of 0’s on the RHS.) The Overflow Formula for the binary numbers states that 111…1 + 1 = 1000…0 (the number of 1’s on the LHS = the number of 0’s on the RHS,)

## The Binary System

### Table of the first one hundred consecutive binary numbers

1000

1001

1010

1011

1100

1101

1110

1111

10000

10001

10010

10011

10100

10101

10110

10111

11000

11001

11010

11011

11100

11101

11110

11111

100000

100001

100010

100011

100100

100101

100110

100111

101000

101001

101010

101011

101100

101101

101110

101111

110000

110001

110010

110011

110100

110101

110110

110111

111000

111001

111010

111011

111100

111101

111110

111111

1000000

1000001

1000010

1000011

1000100

1000101

1000110

1000111

1001000

1001001

1001010

1001011

1001100

1001101

1001110

1001111

1010000

1010001

1010010

1010011

1010100

1010101

1010110

1010111

1011000

1011001

1011010

1011011

1011100

1011101

1011110

1011111

1100000

1100001

1100010

1100011

Counting in the binary system from zero forwards by serially adding 1

1000

1001

1010

1011

1100

1101

1110

1110

1111

10000

10001

10010

10011

10100 continue

*Note. If in adding 1 to the last digit the result exceeds the largest admissible digit which is 1, then we write 0 for the sum and carry the digit 1 to the next column.*

We shall use the abbreviations 1000…0 = 10n (n copies of 0 following 1) and 111…1 = 1n (n copies of 1). We thus have: 100 = 1, 101 = 10 = 2, 102 = 100 = 4, 103 = 1000 = 8, 104 = 10000 = 16, 105 = 100000 = 32, 106 = 1000000 = 64, 107 = 10000000 = 128, 108 = 256, 109 = 1000000000 = 512, 1010 = 1024,…

We also have: 11 = 1 = 1, 12 = 11 = 3, 13 = 111 = 7, 14 = 1111 = 15,

15 = 11111 = 31, 16 = 111111 = 63, 17 = 1111111 = 127, 18 = 11111111 = 255, 19 = 111111111 = 511, 1010 = 1111111111 = 1023,… These abbreviations will also be used in combination: 1k0n = 111…1000…0 (k copies of 1 followed by n copies of 0), e.g., 1202 = 12, 1203 = 24, 1302 = 28.

The Overflow Formula for the binary system states that 1n + 1 = 10n

(compare with the Overflow Formula for decimals).

Exercises:

1.

Count backwards from 10000 to 1.

2.

Find the values of 1011, 1012 and 111, 112 .

3.

Find the values of 1205, 120312, 10214.

4.

Prepare a table for the values of 10n for n = 0 through 20.

5.

Find the values of 1n for n = 11, 12, 13, 14, 15.

6.

Show that 10n = 2n.

The milestones in the binary system are: 100 = 1, 101 = 2, 102 = 4, 103 = 8, 104 = 16, 105 = 32, 106 = 64, 107 = 128, 108 = 256, 109 = 512,…, in general: 10n = 2n.

These milestones have interesting applications. They can be used for counting: (1) the number of binary numbers of at most n digits

(2) the number of ways we can pick a selection of balls from a set of n balls (3) the number of ways to split a set of n balls into two sets.

Exercises:

7.

How many binary numbers have at most n digits? How many have exactly n digits? (Hint: start with the fact that that 10n counts the number of binary numbers from 1 through 10n inclusive.)

8.

In how many different ways can we pick a selection from a set of n different balls? (Hint: Start with the binary number 1n = 111…1 and identify the digits 1 with the balls. Replace 1 by 0 if you do not pick that particular ball.)

9.

In how many ways can we split a set of n balls into two sets. (Hint: consider the fact that in picking a selection from the n balls, you willy-nilly pick another as well.)

10.

A group of 5 children want to play a ball-game. In how many ways can they divide themselves into two teams? (Each team must have at least 1 player.) CONVERSION OF DECIMALS INTO BINARY NUMBERS

We learn two methods to do the conversion: the long and the short method. In checking the conversion the sum formula for the powers of 2 is helpful:

1 + 2 + 4 + 8 + … + 2n = 2n+1 – 1 or, more generally

2n + 2n+1 + … + 2n+m = 2n(2m+1 – 1)

First we take a look at long method. We start by determining the number of digits the decimal number N will have in the binary system. We do this by determining the two adjacent milestones (powers of 2) enclosing N. Of course, if N is a power of 2, then the conversion is obvious, e.g., N = 2 = 10; N = 8 = 23 = 1000. Otherwise we take the difference N – 2n > 0 with the largest n possible and repeat the process.

Example 1. N = 255. 27 = 128 < 255 < 256 = 28; N has 8 digits, 1st is 1. 2nd is 1.

255 – 128 = 127;

26 = 64 < 127 < 128 = 27;

127 – 64 = 63;

2 = 32 < 63 < 64 = 2 ;

3rd is 1.

63 – 32 = 31;

24 = 16 < 31 < 32 = 25;

4th is 1.

5th is 1.

31 – 16 = 15;

23 = 8 < 15 < 16 = 24;

15 – 8 = 7;

22 = 4 < 7 < 8 = 23;

6th is 1.

7th is 1.

7 – 4 = 3;

21 = 2 < 3 < 4 = 22; th

3 – 2 = 1; the 8 and last digit is 1.

N = 11111111. Check: 128+64+32+16+8+4+2+1 = 28 – 1 = 256 – 1 = 255.

Example 2. N = 254. The first six steps are very similar to those of Example 1, after which we get:

6 – 4 = 2;

21 = 2 = 6 – 4; the 7th digit is 1.

2 – 2 = 0; the 8th and last digit is 0.

N = 11111110. Check: 128+64+32+16+8+4+2 = 2(27 – 1) = 2(127) = 254.

Example 3. N = 135. 27 = 128 < 135 < 256 = 28; N has 8 digits, the 1st is 1. the 2nd digit is 0.

135 – 128 = 7;

26 = 64 > 7;

3rd is 0.

25 = 32 > 7;

4th is 0.

24 = 16 > 7;

5th is 0.

23 = 8 > 7;

6th is 1.

22 = 4 < 7 < 8 = 23;

7th is 1.

7 – 4 = 3;

2 =2<3<4=2;

3 – 2 = 1; the 8th and last digit is 1.

N = 10000111. Check: 128 + 4 + 2 + 1 = 135.

Exercise 4. N = 51. 25 = 32 < 51 < 64 = 26; N has 6 digits, 1st is 1.

51 – 32 = 19;

24 = 16 < 19 < 32 = 25;

2nd is 1.

3rd is 0.

19 – 16 = 3;

23 = 8 > 3;

22 = 4 > 3;

4th is 0.

5th is 1.

2 1 = 2 < 3 < 4 = 22 ;

3 – 2 = 1; the 6th and last digit is 1.

N = 110011. Check: 32 + 16 + 2 + 1 = 51.

Example 5. N = 2011. 210 = 1024 < N < 2048 = 211; N has 11 digits, 1st is 1. 2011 1024 = 987; 298 = 512 < 987 < 1024 = 9210;

2rdnd is 1.

3 is 1.

987 512 = 475;

2 = 256 < 475 < 512 = 2 ;

4th is 1.

475 256 = 219;

27 = 128 < 219 < 256 = 28;

219 128 = 91;

2 = 64 < 91 < 128 = 2 ;

5th is 1.

91 64 = 27;

25 = 32 > 27

6th is 0.

2 = 16 < 27 < 32 = 2 ;

7th is 1.

27 16 = 11;

23 = 8 < 11 < 16 = 24;

8th is 1.

9th is 0.

11 8 = 3;

2 =4>3

21 = 2 < 3 < 4 = 22;

10th is 1.

3 2 = 1;

11th is 1.

N = 11111011011. Check: 1024+512+256+128+64+16+8+2+1 = 2011.

While both the long and short methods are always applicable, the short method is especially useful if N is close to a power of 2. If N follows 2n closely, then we count forward from 2n to N; if N precedes 2n but by not much, then we count backward from 2n to N. To illustrate the short method, let us recalculate Example 3 and 2.

Example 6. N = 135 follows 27 = 128 = 10000000 by 7 steps. Accordingly, we count forward 7 times: 10000001, 10000010, 10000011, 10000100, 10000101, 10000110, 1000111 = N. Check: compare with Example 3 above.

Example 7. N = 254 precedes 28 = 256 = 100000000 by 2 steps. Accordingly, we count backward in two steps: 11111111, 1111110 = N. Check: compare with Example 2 above.

Exercises:

11.

Convert N = 253 into a binary number by using the short method, and check in two different ways.

12.

Convert N = 515 into a binary number by using the long method and check your calculation in two different ways.

13.

Convert N into a binary number by using the long method and check:

### (i)

## N = 21

### (ii) N = 73

### (iii) N = 273

---

# Rainbow Slide Rule: Introduction

URL: https://newaustrianeconomics.com/archive/fekete/rainbow-slide-rule-introduction/
Date: 2010-01-01
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: The introduction to Fekete's Rainbow Slide Rule book, explaining the historical significance of logarithms and the motivation for a slide rule built on rainbow digits. Fekete traces the four-century history of logarithms from Napier through their near-disappearance from school curricula, arguing for their restoration as a tool of mathematical reasoning.
Editorial Note: Chapter 1 of the Rainbow Slide Rule book (c. 2010), part of Fekete's Stepnumbers mathematical project. The introduction establishes the historical and pedagogical context for the rainbow digit system.
Original PDF: https://professorfekete.com/articles/RainbowINTRODUCTION.pdf

### Chapter 1: INTRODUCTION

For 400 years logarithms were the mainstay of mathematics. By now they have all but disappeared from the school curriculum. This is a pity. Logarithms were conceived as a method to simplify calculations. The logarithm of a product is the sum of logarithms; that of a fraction is the difference. Just as multiplication and division are reduced to addition and subtraction, raising to a power and root extraction are reduced to multiplication and division. In particular, square roots are reduced to division by 2; cube roots, division by 3.

It is true that our pocket calculators, not to mention our electronic computers can do more, and do it more quickly. Still, a great deal has been lost with logarithms, especially about the mechanism of simplifying calculation. We no longer understand (or are curious) why a particular type of simplification does work. We are no longer in command. Computers are.

Stepnumbers are designed to do calculations with extremely large numbers, the decimal representations of which have an inordinate number of digits, counted in the trillions, quadrillions, quintillions, etc., beyond the capability of the memory units of computers to handle them. The ‘milestones’ of the stepnumber system are the famous Bell numbers: 1 = 1, 10 = 2, 100 = 5,

1000 = 15, 10000 = 52, 100000 = 203, 1000000 = 877, 10000000 = 4140,

100000000 = 21147, 1000000000 = 115975, … The stepnumber system works with infinitely many digits, but it is most economical with the introduction of a new digit. It waits to the last moment. When this introduction can no longer be postponed, the new digit appears but once. A second and third appearance has to wait almost as long. Only after its fourth appearance will the new digit appear more frequently.

It is very likely that with the further development of science much larger numbers will be needed than those that have been used so far. It is true that, unlike the Romans, we can write any large number with the aid of number systems we already have. For example, a number with 44 decimals falls between 1044 and 1045 and 10n can be made arbitrarily large by making n sufficiently large. However, the ability to write down a very large number is one thing, and the ability to do calculations with it is another. The stepnumber system makes accurate calculations possible with those very large numbers that are beyond the reach of the present generation of computers.

As an example of the need for ever larger numbers and the need to do calculations with them consider the infinite sequence of prime numbers 2, 3, 5, 7, 11, 13, 17, 19, 23, 29, 31, 37, 41, 43, 47, 53, 59, 61, 67, 71, 73, 79, 83, 89, 97, 101,…, the building blocks of the natural numbers and their extensions, rational and real numbers. Prime numbers have important applications in chemistry and chrystallography, among other branches of science. A field of application where the need to have ever more of them is pressing is cryptology, the science of security codes. In order to improve security, there is need for ever larger prime numbers, to keep ahead of code-breakers and other hackers.

In 1876 the largest prime number known took 44 decimal digits to write, a record that stood for 75 years. In 1951 electronic computers were put in the service of finding ever larger prime numbers. Today, the largest known prime number takes almost 13 million decimal digits (!) to write, and it has been predicted that by 2024 the largest known prime number will take 1000 million decimal digits. In the past, similar predictions were pretty accurate. They may or may not be in the future. But it gives us some idea and warning: at this pace we shall run out of computer memory capacity, especially as the binary number system, the staple language of computer calculation, is the most uneconomical of all number systems. It takes more digits to write down a number in binary form than in any other.

Another possible application of stepnumbers is the transliteration of Chinese characters. Should the Chinese ever decide to reform their system of writing, they could use stepnumbers instead of characters. Frequently occurring characters could be substituted by stepnumbers using only the first few digits.

Characters that occur less frequently would then be replaced with stepnumbers using several digits. With nine digits the whole spectrum of Chinese characters could be covered, with plenty of stepnumbers left over to represent characters that haven’t come along yet.

This book reproduces the notes I have used in my interactive lectures to 715 years old pupils. The only prerequisite was that the pupils had to be familiar and conversant with the four arithmetic rules: addition, multiplication, subtraction and division, as well as inequalities. We faced the problem of inventing infinitely many digits. So we colored the available decimal digits: 0, 1, 2, 3, 4, 5, 6, 7, 8, 9 with ten monochromatic colours of the rainbow, the so-called basic colours: infrared (black), red, brown, orange, yellow, green, viridian (a colour between green and blue), blue, indigo (a colour between blue and violet), violet. In this way we got the first one hundred digits of the stepnumber system: 0123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890123456789

To get more digits, we proceeded as follows. The frequencies of the basic colours divide the spectrum into segments. Each segment contains various shades between adjacent basic colours. These frequencies are very large numbers, but this is a consequence of our choice for the unit of time, the second, that is relatively very large. By a judicious change to a smaller unit we can make the frequencies of the basic colours consecutive integers: 16 for infra-red, 17 for red, 18 for brown,…, 25 for violet, as shown by the table: infrared red brown orange yellow green viridian blue indigo violet

### █

### █

### █

### █

### █

### █

### █

### █

### █

### █

16-17

17-18 18-19 19-20 20-21 21-22 22-23 23-24 24-25 25-26 which also shows the ranges of fractional frequencies between the consecutive integers from 16 through 25 for the various shades between the basic colours.

We now simply use the colours with fractional frequencies to paint the decimal digits to get infinitely many digits needed for the stepnumber system.

During these interactive lectures we have reinvented logarithms. In fact, we have invented two new types: Cantor’s logarithms (motivated by Cantor’s number system) and, our main interest, “steplogarithms” (motivated by the stepnumber system). Each of these gives rise to a new type of slide rule, different from the conventional one, but working on the same principle. The slide rule of steplogarithms is appropriately called the rainbow slide rule. It has its stationary and sliding scales subdivided into ten equal segments coloured by one of the ten basic colours, arranged in the same order. The scales within each coloured segment are the same. They are neither linear nor logarithmic but are obtained through interpolation from the reciprocal Bell numbers. The advantage of the rainbow slide rule is that it works for extremely large numbers doing multiplication, division, the power operation and root extraction. It also furnishes the steplogarithms of numbers.

The pupils should enjoy working with steplogarithms as well as with the rainbow slide rule. Their understanding of the mechanism simplifying calculations should be greatly enhanced. They would also have a visual appreciation of the stepnumber system.

This is non-conventional mathematics at its best. In the computer age our pupils have been robbed of their opportunity to learn, understand and appreciate much good mathematics that an earlier generation of pupils could take for granted. This pioneering course is designed to compensate them for their loss.

At the same time I also hope that this course has also helped to prepare them for a new generation of computers, the so-called quantum computers which use the various energy states of atoms for coding purposes.

In more details, quantum computers code the stepnumbers by assigning various admissible orbits of electrons in the atom circling around the nucleus to various rainbow digits. Compare this to the present generation of computers which code the binary numbers by assigning the magnetic poles North and South to the binary digits 0 and 1.

It can be seen that the stepnumber system fits quantum computers like the glove fits the hand. Together they open a New Age in information science and technology.

---

# Rainbow Slide Rule

URL: https://newaustrianeconomics.com/archive/fekete/rainbow-slide-rule/
Date: 2010-01-01
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete presents the Rainbow Slide Rule — a novel mathematical instrument based on logarithmic scales using rainbow digits (an infinite system of digits he devised). The instrument exploits the visual and mnemonic properties of the rainbow color sequence to make calculation with very large or very small numbers intuitive.
Editorial Note: A standalone monograph on the Rainbow Slide Rule, part of Fekete's broader Stepnumbers project — a mathematical system he developed in retirement that applies his teaching for the blind to a novel number system with infinitely many digits.
Original PDF: https://professorfekete.com/articles/RAINBOWSLIDERULE2.pdf

### Slide

### Rule

### Rainbow

### Slide

### Rule

---

# Stepnumbers: Chapter 1 — Rainbow Digits

URL: https://newaustrianeconomics.com/archive/fekete/stepnumbers-chapter-1-rainbow-digits/
Date: 2010-01-01
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete constructs his inventory of infinitely many digits — the 'rainbow digits' — showing how they can be defined systematically using the decimal number system as a foundation. The rainbow digits form the alphabet of the stepnumber system, and their mnemonic properties (based on the spectral colors) make them practically usable despite their infinite number.
Editorial Note: Chapter 1 of Fekete's Stepnumbers monograph (c. 2010), constructing the rainbow digit system from first principles. This is the foundational chapter of his most technically original mathematical contribution.
Original PDF: https://professorfekete.com/articles/ASTEP1.pdf

1. Rainbow digits In this Chapter we solve the problem of constructing an inventory of infinitely many digits. We shall call them rainbow digits, as one of their defining properties is that they follow the colors in the rainbow from red to violet. The other defining property of the rainbow digits is their deep reliance on the decimal number system in general, and the decimal digits in particular.

To be sure, there are number systems that call for such an infinite inventory, for example,

Cantor’s (see Chapter 3). But the main application of the rainbow digits will probably be in the stepnumber system, which is eminently suitable for working with extremely large numbers. As we shall see, writing a sufficiently large number in stepnumber form takes fewer digits than it does in any other number system. This property can be expressed by saying that the stepnumber system enables one to write very large numbers in their most compact form. There is a reason why Cantor’s number system has never made an impact and remained essentially a curiosity. The reason is that it is using the available digits uneconomically, engaging them ‘too early’, even before lower-ranking digits could have done their work. By contrast, the stepnumber system is most economical with the use of digits: it expresses a number n, sufficiently large, in terms of the shortest string of digits among number systems of base k, however large k may be. Consider also that Cantor’s number system puts a new digit to a heavy use immediately after its introduction. By contrast, the stepnumber system uses new digits most sparingly. In this way the usefulness of stepnumbers is greatly enhanced. New digits are only used when absolutely necessary.

The rainbow digits are based on the decimal digits which, when printed in black bold face type, serve at the same time the first ten rainbow digits. They are followed by the same ten digits printed in red bold face type. Thus the first twenty rainbow digits, listed in their natural order, are: 01234567890123456789. In other words, 0 is the 10th, 1 the 11th, 2 the 12th, … , 9 the 19th rainbow digit (0 is the 0th). The red color is followed by the brown, thus 0 is the 20th, 1 the 21st, 2 the 22nd rainbow digit, etc.

The continuing reliance on the decimal digits has the great advantage of making rainbow digits mnemotechnically superior to any other inventory of infinitely many digits. The ten decimal digits are so deeply rooted in the human psyche that any deviation from them, however clever, would be a detraction. Here, then, are the first one hundred rainbow digits listed in their natural order: 0123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890123456789

The inventory of infinitely many digits that we are about to construct involves the ten decimal digits colored with the ten standard colors and their shades, with reference to the visible colors as they occur in the spectrum of the rainbow from infra-red to ultra-violet. The frequencies of the ten standard colors, in tHz units (1 tHz = 1 teraHertz = 1012Hz = 106megaHz; 1Hz = 1/second) are as follows:

### FREQUENCIES OF THE TEN STANDARD COLORS (in tHz units) infrared

### █ red

### █ brown

### █ orange yellow

### █

### █ green

### █ viridian

### █ blue

### █ indigo

### █ violet

### █

They are pure spectral monochromatic colors. With the exception of black they can be produced by visible light of a single frequency only. The frequency of black we have arbitrarily taken to be that of the invisible infra-red light, 400 tHz.

The visible spectrum of colors is in the range from 425 tHz through 750 tHz. Of this we shall use the range from 425 through 650 as various shades of the standard visible colors, arbitrarily assigning the shades of black to the frequency range 400-425 of invisible infra-red light, as follows: FREQUENCY RANGES OF THE STANDARD COLORS (in tHz units) infrared red brown orange yellow green viridian blue indigo violet

### █

### █

### █

### █

### █

### █

### █

### █

### █

### █

400425

425450

450475

475500

500525

525550

550575

575600

600625

625650

As is well-known from physics, the range for the visible light is but a tiny part of the much wider range of the electro-magnetic radiation, from radio frequencies (about 106 Hz at the low end) to cosmic rays (about 1024 Hz at the high end of the spectrum):

1010

2 3 4

(1) radio waves, AM

1011

1012

1013

1014

1015

1016

1017

1018

1019

1020

(2) radio waves, FM

(3) television

(4) radar

(5) microwave

(6) infra-red

(7) visible light

(8) ultra-violet

(9) x-rays

(10) gamma rays

(11) cosmic rays

1021

1022

1023

The fact that the spectrum of visible lights is minuscule is a consequence of the choice of the unit of time, 1 sec (the second). With a smaller unit we could zoom in. Herewith we change the unit of time.

We shall call the new unit “tooth” (plural: “teeth”), abbreviated “tth”. The conversion formulas are: 1 tth = 4(10−13)sec; 1 sec = 25(1011)tth. With this change the frequencies of the standard colors become the integers 16 (for the color black), 17 (for the color red), through 25 (for the color violet).

This reveals the reason for the choice of the new unit, which is mnemotechnics. The frequencies of the standard colors are easily remembered if we consider that 16 + 9 = 25 or, what is the same,

32 + 42 = 52 where 3, 4, 5 are the smallest non-trivial Pythagorean numbers. We have:

FREQUENCIES AND FREQUENCY RANGES OF THE STANDARD COLORS (in tth units) infrared red brown orange yellow green viridian blue indigo violet

### █

19-20

### █

20-21

### █

21-22

### █

22-23

### █

16-17

### █

### █

17-18 18-19

### █

### █

### █

23-24 24-25 25-26

For the sake of comparison, here are the lower limits of some other frequency ranges of the electromagnetic spectrum in terms of tth units: micro infrared

12(10−4) 12(10−2) light

### UV x-ray gamma

12(104) 12(106)

According to physics, every real number between 16 and 26 is the frequency of a unique monochromatic color. These colors are available to choose from in coloring rainbow digits with two modifications:

(i) at the lower end of the spectrum, the frequencies from 16 to 17 include the invisible infra-red light that we use as proxy for the standard color black (frequency 16) and its shades of grey. (ii) at the upper end of the spectrum, the higher range of the color violet from frequency 26 through 30 is excluded from consideration as colors for the rainbow digits for being redundant.

The set of colors with frequency from 16 through 26 is not countable and is, therefore, too big for the purpose of coloring the rainbow digits. We need only a denumerable subset. Fortunately, there is an obvious choice: the subset of monochromatic colors whose frequencies are rational numbers. Even though this means that we disregard the vast bulk of monochromatic colors, those whose frequencies are irrational numbers, no harm done. The eye will not be able to notice the loss.

Nor can it distinguish between colors whose frequencies are rational versus irrational numbers. After all, this distinction depends on the choice of the unit of time.

Thus we have a one-to-one correspondence between the colors of the rainbow digits and the rational numbers between 16 and 26, namely, the latter are the frequencies of the former in tth units.

Remember that for each color as specified by this one-to-one correspondence there are ten rainbow digits corresponding to the ten decimal digits.

When we deal with the rational numbers between 16 and 26, the old-fashioned mathematical terms of “characteristic” and “mantissa” come handy. The characteristic of a positive rational number is its integral part: the digits preceding the decimal point; its mantissa is the fractional part: the digits following the decimal point.

The grade of a color is the number of digits of the mantissa of its frequency. If the mantissa is zero, then k = 0 and we have one of the standard colors. If the frequency is an infinite repeating decimal (more precisely, if the rational number cannot be written as a finite decimal), then k = ∞.

The number of first grade colors is one hundred (ten for every standard color); there are one thousand second grade colors (ten for every first-grade color); there are ten thousand third grade colors (ten for every second-grade color). In general, the number of kth grade colors is 10k+1 (ten for every (10k−1)st grade color). It is left as an exercise for the reader to discuss the case k = ∞.

Even though the naked eye may not be able to distinguish between two shades of a color of the same grade, optical instruments and the computer can. Remember, the problem of telling apart shades of two rainbow digits is a theoretical problem, not a practical one. As we have already pointed out, the colors black and red are all we need for writing stepnumbers that occur in practice.

Recalling the pertinent facts from physics is sufficient to complete the proof of the existence of an inventory of infinitely many step-digits.

As we can enumerate the rational numbers, so we can enumerate the colors of the rainbow digits. We have infinitely many shades for each of the ten standard colors, and they are sorted out by the mantissas of their frequencies. Enumerating the consecutive colors of the rainbow digits is done through the enumeration of their frequencies grade by grade, thus:

16, 17, 18, 19, 20, 21, 22, 23, 24, 25,

16.1, 17.1, 18.1,…, 25.1, 16,2, 17.2, 18.2,…, 25.2,16.3,…, 16.9, 17.9, 18.9,…,25.9,

16,01, 17.01,…, 25.01,16.02, 17.02,…,25.02, 16.03,…, 25,98, 16.99, 17.99,…,25.99,

16.001,…, 25.001, 16.002,…, 25.002, 16.003,…, 25.998, 16.999,…, 25.999,…

Note that the enumeration preserves the natural order of rational numbers, as well as the natural order of colors in the rainbow. A break in the natural order only occurs when we reach the top frequency for the color violet, grade k, namely, 25.99…9 (k digits of 9’s), for k = 0, 1, 2,… At these points the frequency drops back to the range 16-17 of shades for the color black. In other words, the frequency 25.99…9 (k digits of 9’s) is followed by the frequency 16,00…01 (k digits of 0’s) as the starting frequency for the shade of black, grade k + 1.

Note that in the sequence of the top frequencies for the color violet, 25.9, 25.99, 25.999,… the general term, 25.99…9 (k digits of 9) tends to the frequency 26 as k → ∞. At the other end of the spectrum, in the sequence of the starting frequencies for the color black, 16.1, 16.01, 16.001,…, the general term 16.00…01 (k digits of 0) tends to the frequency 16 as k → ∞.

### The typographical rendering of shades of grade two

Again, the following problem has only theoretical interest because in practice the only two colors that are likely to occur are black and red. We have already seen the list of the first one hundred rainbow digits (e.g.,see the frieze on the title page of the book). We now want to have the list of the first one thousand rainbow digits. First we have to solve the subjective problem that the naked eye may not be able to tell apart different shades of the same grade of the same standard color. For this reason we have to use the typographical device of modifying the font by using a combination of italic, bold, strikeout, double strikeout face types in order to find substitutes for the different shades.

The ten suggested combinations of face types are as follows:

1234 1234 1234 12341234 1234 1234 1234 1234 1234

### (bold)

1234 1234 1234 12341234 1234 1234 1234 1234 1234

11234 1234 1234 1234 12341234 1234 1234 1234 1234 1234

1234 1234 1234 12341234 1234 1234 1234 1234 1234 1234

1234 1234 1234 1234 1234 1234 1234 1234 1234 1234 1234

1234 1234 1234 12341234 1234 1234 1234 1234 1234 1234

1234 1234 1234 12341234 1234 1234 1234 1234 1234

1234 1234 1234 1234 1234 1234 1234 1234 1234 1234

### (italics+bold)

### (strikeout)

### (strikeout+italics)

### (double strikeout)

### (double strikeout+italics)

### (normal)

### (italics)

### (outline+bold)

### (outline+bold+italics)

### The first one thousand rainbow digits

0123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890123456789 0123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890123456789 0123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890123456789 0123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890123456789 0123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890123456789 0123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890123456789 0123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890123456789 012345678901234567891234567890123456789012345678901234567890123456789012345678901234567890123456789 0123456789

Read as a single stepnumber, it is the largest one the expansion of which consists of 999 digits. The stepnumber expansion of the next number, b1000, consists of 1000 stepdigits. By contrast, the decimal expansion of b1000 consists of 1928 decimal digits, almost twice as many!

Recall the notation n! = 123...n and the formula n! + 1 = 10n . Thus we have:

1! = 1, 2! = 12, 3! = 123,…, 9! = 123456789; e.g., 9! + 1 = 123456789 + 1 = 1000000000 = 109

= b10. We extend this notation to the rainbow digits:

0! = 1234567890

0! = 12345678901234567890

1! = 12345678901

1! = 123456789012345678901

2! = 123456789012, etc.

2! = 1234567890123456789012, etc.

Then we have:

9! + 1 = b30 = 1029

9! + 1 = b40 = 1039

9! + 1 = b20 = 1019

9! + 1 = b50 = 1049

9! + 1 = b60 = 1059

9! + 1 = b70 = 1069

9! + 1 = b80 = 1079

9! + 1 = b90 = 1089

9! + 1 = b100 = 1099

To recapitulate, the colors of the rainbow digits are precisely those monochromatic colors of the rainbow whose frequencies are rational numbers from 16 through 26 in tth units. They furnish an inventory of denumerably many stepdigits which enable one to write ever larger stepnumbers without taxing the human memory (let alone computer memory that, contrary to myth, can be taxed, too).

The stepnumber system is most economical with the use of digits in two ways. First, the expansion of a number, sufficiently large, takes a shorter string of digits in the stepnumber system than it would in any other with base k, however large k may be. For example, every n-digit decimal can be expanded as a stepnumber of fewer than n digits whenever n is at least 57. This follows from the inequality bn > 10n valid for all n ≥ 57. In point of fact, the decimal expansion of b57 has 57 digits.

Second, the (n + 1)st digit is not pressed into service until the full potential of the first n digits has not been exploited and, even then, it is used as sparingly as possible. Let us demonstrate this economy through the following example.

Having counted to 1234567899 = b11 – 2 = 678,568 we have exhausted the black stepdigits.

In order to carry on we must introduce the red rainbow digits, the first of which is 0. Now we can write 1234567899 + 1 = 1234567890 = 0! In counting forward from here on we shall not encounter another red digit until we get to 10234567890, a block b11 – b10 = 562,595 long:

10000000000, 10000000001, 10000000002, 10000000010, 10000000011,…, 10234567899,

10234567890,… Between the second and third occurrence of 0, that is, between the stepnumbers

10234567890 and 11234567890, is another block of the same length. The next block from

11234567890 through 12034567890 is 372,939 long and this length occurs three times.

Lest one think that these are random numbers, we penetrate the matter further. In the following table we list the stepnumbers in which the only colored digit, 0, occurs exactly once (with the exception of the last, in which it occurs twice).

1234567890

10234567890

11234567890

12034567890

12134567890

12234567890

12304567890

12314567890

12324567890

12334567890

12340567890

12341567890

12342567890

12343567890

12344567890

12345067890

12345167890

12345267890

12345367890

12345467890

12345567890

12345607890

12345617890

12345627890

12345637890

12345647890

12345657890

12345667890

12345670890

12345671890

12345672890

12345673890

12345674890

12345675890

12345676890

12345677890

12345678090

12345678190

12345678290

12345678390

12345678490

12345678590

12345678690

12345678790

12345678890

12345678900

12345678910

12345678920

12345678930

12345678940

12345678950

12345678960

12345678970

12345678980

12345678990

12345678900

12345678901

12345678902

12345678903

12345678904

12345678905

12345678906

12345678907

12345678908

12345678909

12345678900

Note that the last 12 entries are consecutive stepnumbers. In the next table we have numbered the 65 blocks consisting of consecutive stepnumbers demarcated by the entries in the previous table. In the adjacent column we have indicated the lengths of blocks:

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

562,595

562,595

372,939

372,939

372,939

190,497

190,497

190,497

190,497

73,013

73,013

12.

13.

14.

15.

16.

17.

18.

19.

20.

21.

22.

73,013

73,013

73,013

20,878

20,878

20,878

20,878

20,878

20,878

4,516

4,516

23.

24.

25.

26.

27.

28.

29.

30.

31.

32.

33.

4,516

4,516

4,516

4,516

4,516

34.

35.

36.

37.

38.

39.

40.

41.

42.

43.

44.

45.

46.

47.

48.

49.

50.

51.

52.

53.

54.

55.

56.

57.

58.

59.

60.

61.

62.

63.

64.

65.

The lengths of blocks as given in this table are just the spectral coefficients in the rows of Pascal’s triangle for the spectral coefficients, see Chapter 4.

By way of checking, we add the lengths of all the 65 blocks and we expect to get the length of the big block from the first 0 to 00:

2(562,595) = 1,125,190

### + 3(372,939) = 1,118,817

### + 4(190,497) = 761,988

### + 5(73,013) = 365,065

### + 6(20,878) = 125,268

### + 7(4,516) =

31,612

### + 8(757)

### =

6,056

### + 9(101)

### =

### + 10(11)

### =

### + 11(1)

### =

### =

3,535,026 which is 1 less than b12 – b11 = 4,213,597

### − 678,570

3,535,027

We see huge gaps between any two occurrences of 0 in the beginning, an indication how sparingly 0 is used. By the end of the table these gaps will become minimal (in the last column the stepnumbers are consecutive.)

As the last table shows, in the sequence of the first 2 million consecutive stepnumbers 0 occurs no more than 4 times! In the sequence of the first 4,213,597 stepnumbers colored digits occur only 66 times, with a heavy concentration in the latter part.

The point of this example is to reveal the pattern followed by the appearance of every new digit as we count forward. The general rule is given by the Blockbuster Formula of Chapter 4. It shows how the block of stepnumbers ≤ (n + 1)! is split by the consecutive occurrences of the digit n.

In that Chapter a similar survey is carried out for the first 15 occurrences of the digit 4 (see Example, following the Overflow Formula on p 44), which can be easily followed on the Table of Consecutive Stepnumbers in the Introduction.


---


On the following page we list the names of the first one hundred (of the infinitely many) rainbow digits for the stepnumber system. The principle of forming these names was already mentioned in the Introduction. Recall the role of the five vowels a, e, i, o, u and their alphabetical order play.

In the Exercises we shall see how the list of the names of digits, as well as the list of the names of milestones, can be extended.

NAMES OF DIGITS ala ale ali alo alu alla alle alli allo allu alya alye alyi alyo alyu allya allye allyi allyo allyu ela ele eli elo elu ella elle elli ello ellu elya elye elyi elyo elyu ellya ellye ellyi ellyo ellyu ila ile ili ilo ilu illa ille illi illo illu ilya ilye ilyi ilyo ilyu illya illye illyi illyo illyu ola ole oli olo olu olla olle olli ollo ollu olya olye olyi olyo olyu ollya ollye ollyi ollyo ollyu ula ule uli ulo ulla ulle ulli ullo ullu ulya ulye ulyi ulyo ullya ullye ullyi ullyo ullyu

### Exersises

1.

Count forward and then count backward to find the next five stepnumbers in either direction, starting from every one of the 66 stepnumbers in the second last table of this Chapter.

2.

Count forward and then backward from the stepnumber 12345678950 and see that the next

100 stepnumbers in either direction are written without recourse to colored digits. Write the

101st stepnumber in either direction.

3.

Count forward and then count backward to find the next five stepnumbers in either direction, starting with:

(a) 0!0,

(f) 9!9,

(b) 0!0, (c) 4!4, (d) 4!4, (e) 4!4,

### (g) 4!04, (h) 4!44, (i) 4!04

(d) 9!9, (e) 9!9,

4.

After the first appearance of the nth digit, how far forward do we have to count in order to get to the second, third, and fourth appearance of that digit?

5.

What is the ordinal of the stepnumber 123456789012345678901234567890 ?

6.

The (b11 – 1)st stepnumber is 0! Write the (b31 − 1)st, (b41 − 1)st, . . . , (b91 − 1)st stepnumbers.

7.

### What is the ordinal of the stepnumbers 5!, 5!9!, 5!5! ?

8.

True or false? Every finite decimal fraction between 17 and 26 is the frequency of a shade of of the standard colors. If the answer is “yes”, describe how to find that shade of color.

9.

Write a few stepnumbers of each of the following shade of color, if their frequencies are given in tth units as 16.66, 17.76, 17.89, 18.48, 19.14, 19.45, 19.99, 20.01

10.

How many stepnumbers can be written without recourse to colored digits between the pair

123456789051 and 123456789061? What is the answer if the given pair is 123456789015 and 123456789016?

11.

### Write the following 100-digit stepnumber

123456789012345678901234567890123456789012345678901234567890123456789

0123456789012345678901234567899 in a more compact form. Write the next stepnumber in a more compact form.

12.

We have seen that 0 occurs in 66 stepnumbers ≤ 1010. In how many stepnumbers ≤ 1011 does

1 occur?

13.

14. n! is the first stepnumber in which the digit n occurs. Prove that the number of all

⎛ n + 1⎞ n ( n + 1) stepnumbers ≤ (n + 1)! in which the digit n occurs is ⎜

.

### ⎟=

### ⎝ 2 ⎠

Extend the table for consecutive stepnumbers in the Introduction from 300 to 600.

15.

Extend the table further from 600 to 900.

16.

Based on your extended tables, make a survey on the occurrences of the digit n among the consecutive stepnumbers ≤ (n + 1)! as the survey carried out above for the digit 0, for n = 2,

3, 4, 5, and 6.

17.

Check that the first occurrences of the digit n among the consecutive stepnumbers ≤ (n + 1)! conform to the same rule that governs the first occurrences of the digit 0, for n = 2, 3, 4, 5, and 6.

18.

Count up to the binary number 105, filling in the names for the dots, thus: ala, ale, mala, mala ale, bala, bala ale, bala mala, bala mala ale, trala, trala ale, trala mala, trala mala ale, trala bala,..., pentala.

19.

Count up to the stepnumber 104, filling in the names for the dots, thus: ala, ale, mala, ale ale, ale ali, bala, ale ala ale, ale ala ali, ale ale ala, ale ale ale, ale ale ali, ale ali ala, ale ali ale, ale ali ali, ale alia lo, trala, ale ala ala ale, ale ala ala ali, ale ala ale ala,…, quadrala.

---

# Stepnumbers: Chapter 2 — The Binary Number System and the Binomial Coefficients

URL: https://newaustrianeconomics.com/archive/fekete/stepnumbers-chapter-2-binary-and-binomial/
Date: 2010-01-01
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete reviews the binary number system and its connection to binomial coefficients before introducing the stepnumber system as its superior alternative. He shows how enumerating binary numbers is equivalent to enumerating all finite subsets of a set, and uses Pascal's triangle to illuminate the combinatorial structure underlying both binary and stepnumber representations.
Editorial Note: Chapter 2 of Fekete's Stepnumbers monograph (c. 2010), bridging classical binary arithmetic and combinatorics to set the stage for the stepnumber system. The chapter reveals the deep connection between the binary system and subset counting.
Original PDF: https://professorfekete.com/articles/CSTEP2.pdf

2. The binary number system and the binomial coefficients

Before we proceed with the introduction of the stepnumber system let us review the binary number system in this Chapter and Cantor’s, using infinitely many digits, in the next.

In enumerating binary numbers we are doing more than simply putting the natural numbers into binary code. We are also counting the number of finite subsets, as well as constructing them. For example, if we want to count the number of subsets of a set of four elements, we turn to the up-front-0 representation of binary numbers:

0000, 0001, 0010, 0011, 0100, 0101, 0110, 0111, 1000, 1001, 1010, 1011, 1100, 1101, 1110, 1111

Not only have we counted the number of subsets of a set of four elements (and found it to be 16) but we have also constructed every one of them, e.g., 0000 is the trivial subset and 1111 is the universal subset. The construction uses the idea of a characteristic function and the convention that the places which the digits occupy constitute the elements of an ordered set. In our example that set has four elements, namely, the four places we need to write a 4-digit number. A characteristic function is defined by postulating that the digit 1 indicates that the place in apposition is included in the subset; the digit 0 indicates that it is not. Thus 0101 represents the two-element subset consisting of the second and fourth elements of the 4-set. In this way every subset of the 4-set has been accounted for once, and only once. It is clear that we can also set up a one-to-one correspondence between the subsets of an n-set and binary numbers of at most n digits for all n.

In view of the foregoing discussion on representing subsets by binary numbers, we can give an equivalent definition of the binomial coefficients as follows. Given n and k, 0 ≤ k ≤ n ,

### ⎛n⎞

⎜ k ⎟ is the number of binary numbers of at most n digits of which exactly k are valuable.

### ⎝ ⎠

We proceed to review the basic properties of the binomial coefficients here in order to establish the language and pattern that we shall be using in treating factorial coefficients in relation to Cantor’s number system, and spectral coefficients in relation to the stepnumber system, as well as Stirling numbers of either kind. The equivalence of the two definitions of the binomial coefficients is a simple consequence of the fact that counting subsets can be done by counting characteristic functions, which in turn can be done by counting binary numbers in up-front-0 representation.

### ⎛n⎞

### ⎛n⎞

It is immediate that ⎜ ⎟ = 1 and ⎜ ⎟ = 1, as there is only one binary number with no

### ⎝ 0⎠

⎝1⎠ valuable digits, namely 0, and there is only one of exactly n digits all of which are valuable, namely 1n .We also have the

### Symmetry Property

### ⎛n⎞ ⎛ n ⎞

### ⎜k ⎟ = ⎜n − k ⎟

### ⎝ ⎠ ⎝

### ⎠

This property has no counterpart for factorial coefficients of Cantor’s number system, for spectral coefficients of the stepnumber system, or for Stirling numbers. To prove it we may observe that, given a binary number a of k valuable digits, the equation x + a = 1n has a unique solution which, as a binary number, has exactly n − k valuable digits.

### Recursion Formula

### ⎛ n ⎞ ⎛ n − 1⎞ ⎛ n − 1⎞

### ⎜ k ⎟ = ⎜ k − 1⎟ + ⎜ k ⎟

### ⎝ ⎠ ⎝

### ⎠ ⎝

### ⎠

### It is, in fact, a difference equation which, under the

### Initial Condition

### ⎛n⎞

### ⎜1⎟ = 1

⎝ ⎠ yields a unique solution, conveniently tabulated in the form proposed by Blaise Pascal (1623-1662), with ⎛n⎞ th th

⎜ k ⎟ standing in the k place of the n row (the counting of places and rows starts with 0).

### ⎝ ⎠

### Binomial coefficients in Pascal's triangle

715 1287 1716

1716 1287 715

78 13

.

.

.

.

.

.

.

.

.

.

.

.

A more extensive table can be found at the end of the book. Pascal’s innovation in tabulating the binomial coefficients in this format has become the source of a wealth of information.

### Summation Formula

### ⎛n⎞ ⎛n⎞ ⎛n⎞

### ⎛n⎞ n

### ⎜ 0 ⎟ + ⎜ 1 ⎟ + ⎜ 2 ⎟ + ... + ⎜ n ⎟ = 2

### ⎝ ⎠ ⎝ ⎠ ⎝ ⎠

### ⎝ ⎠

The familiar identity (1 + 2 + 22 + ... + 2n) + 1 = 2n+1 furnishes the

### Overflow Formula

1n + 1 = 10n To prove the Recursion Formula let us distinguish one place by calling it ‘zero place’, and survey the binary numbers according as they have the digit 0 or the digit 1 in the zero place. In this manner we have considered every binary number of at most n digits of which exactly k are valuable once and only once. This completes the proof. The binomial coefficients earn their name by the role they play in the

### Binomial Theorem

### ⎛n⎞

### ⎛n⎞

### ⎛n⎞

### (1 + x ) n = 1 + ⎜ ⎟ x + ⎜ ⎟ x 2 + ... + ⎜ ⎟ x n

### ⎝1⎠

### ⎝2⎠

### ⎝n⎠

### Sierpinski’s Triangles (mod p)

If we blot out the entries of Pascal’s triangle and replace them with dummies ○, ●, ●, ●,…, ● according as the entry in question is congruent to 0, 1, 2, 3, ..., p − 1 (mod p), then we get what is known as the (colored) Sierpinski triangle. Like Pascal’s, it is infinite.

Let p be an odd prime number. The binomial coefficients in row pn between entries 1 and n p − 1 inclusive, in row pn + 1 between entries 2 and pn − 2 inclusive, in row pn + 3 between entries 3 and pn − 3 inclusive, etc.,..., are divisible by p, for n = 1, 2, 3,... The pattern continues all the way down to row ⎛ 2 pn − 2 ⎞

2pn − 2 wherein the (pn − 1)st entry ⎜ n

### ⎟ is divisible by p. This is the low vertex of an inverted p

### −

### ⎝

⎠ n equilateral triangle of height p − 1 consisting of entries congruent to 0 (mod p). Further scrutiny reveals that they occur in other places as well throughout Pascal’s triangle. Each inverted triangle is uniquely determined by its apex at

⎛ 3 p n − 2 ⎞ ⎛ 3 p n − 1 ⎞ ⎛ 4 p n − 1⎞ ⎛ 4 p n − 1⎞ ⎛ 4 p n − 1⎞ ⎛ 5 p n − 1⎞ ⎛ 5 p n − 1 ⎞ ⎛ 5 p n − 1⎞ ⎛ 5 p n − 1 ⎞ ⎟,⎜ n

### ⎟,⎜ n

### ⎟,⎜ n

⎟;

### ⎜ n

### ⎟,⎜ n

### ⎟; ⎜ n

### ⎟,⎜ n

### ⎟,⎜ n

### ⎟; ⎜ n

### −

### −

### −

### − p p p p p p p p p

### −

### −

### −

### −

### −

### ⎠ ⎝

### ⎠ ⎝

### ⎠ ⎝

### ⎠

### ⎝

### ⎠ ⎝

### ⎠ ⎝

### ⎠ ⎝

### ⎠ ⎝

### ⎠ ⎝

(n = 1, 2, 3,...), making up an intriguing, repetitive, fractal pattern that was discovered by the Polish mathematician Waclaw Sierpinski (1882-1969). The fractal homothety ratios are: p, p2, p3..., pn,... with center at the apex of Pascal’s triangle. It is important to realize that this is true for prime numbers only. It fails for composite numbers, e.g., there are odd numbers in row 6 other than entry 0 and 6 (mod 6), divisible by 6.

### Sierpinski’s Triangle for Binomial Coefficients (mod 2)

### Code: ○ ≡ 0, ● ≡ 1 (mod 2)

### ●

### ●●

### ●○●

### ●●●●

### ●○○○●

### ●●○○●●

### ●●●○●●●

### ●●●●●●●●

### ●○○○○○○○●

### ●●○○○○○○●●

### ●○●○○○○○●○●

### ●●●●○○○○●●●●

### ●○○○●○○○●○○○●

### ●●○○●●○○●●○○●●

### ●○●○●○●○●○●○●○●

### ●●●●●●●●●●●●●●●●

### ●○○○○○○○○○○○○○○○●

### ●●○○○○○○○○○○○○○○●●

### ●○●○○○○○○○○○○○○○●○●

### ●●●●○○○○○○○○○○○○●●●●

### ●○○○●○○○○○○○○○○○●○○○●

### ●●○○●●○○○○○○○○○○●●○○●●

### ●○●○●○●○○○○○○○○○●○●○●○●

### ●●●●●●●●○○○○○○○○●●●●●●●●

### ●○○○○○○○●○○○○○○○●○○○○○○○●

### ●●○○○○○○●●○○○○○○●●○○○○○○●●

### ●○●○○○○○●○●○○○○○●○●○○○○○●○●

### ●●●●○○○○●●●●○○○○●●●●○○○○●●●●

### ●○○○●○○○●○○○●○○○●○○○●○○○●○○○●

### ●●○○●●○○●●○○●●○○●●○○●●○○●●○○●●

### ●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●

### ●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●

### ●○●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●○●

### ●●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●●

### ●○○○●○○○○○○○○○○○○○○○○○○○○○○○○○○○●○○○●

### ●●○○●●○○○○○○○○○○○○○○○○○○○○○○○○○○●●○○●●

### ●○●○●○●○○○○○○○○○○○○○○○○○○○○○○○○○●○●○●○●

### ●●●●●●●●○○○○○○○○○○○○○○○○○○○○○○○○●●●●●●●●

### ●○○○○○○○●○○○○○○○○○○○○○○○○○○○○○○○●○○○○○○○●

### ●●○○○○○○●●○○○○○○○○○○○○○○○○○○○○○○●●○○○○○○●●

### ●○●○○○○○●○●○○○○○○○○○○○○○○○○○○○○○●○●○○○○○●○●

### ●●●●○○○○●●●●○○○○○○○○○○○○○○○○○○○○●●●●○○○○●●●●

### ●○○○●○○○●○○○●○○○○○○○○○○○○○○○○○○○●○○○●○○○●○○○●

### ●●○○●●○○●●○○●●○○○○○○○○○○○○○○○○○○●●○○●●○○●●○○●●

### ●○●○●○●○●○●○●○●○○○○○○○○○○○○○○○○○●○●○●○●○●○●○●○●

### ●●●●●●●●●●●●●●●●○○○○○○○○○○○○○○○○●●●●●●●●●●●●●●●●

### ●○○○○○○○○○○○○○○○●○○○○○○○○○○○○○○○●○○○○○○○○○○○○○○○●

### ●●○○○○○○○○○○○○○○●●○○○○○○○○○○○○○○●●○○○○○○○○○○○○○○●●

### ●○●○○○○○○○○○○○○○●○●○○○○○○○○○○○○○●○●○○○○○○○○○○○○○●○●

### ●●●●○○○○○○○○○○○○●●●●○○○○○○○○○○○○●●●●○○○○○○○○○○○○●●●●

### ●○○○●○○○○○○○○○○○●○○○●○○○○○○○○○○○●○○○●○○○○○○○○○○○●○○○●

### ●●○○●●○○○○○○○○○○●●○○●●○○○○○○○○○○●●○○●●○○○○○○○○○○●●○○●●

### ●○●○●○●○○○○○○○○○●○●○●○●○○○○○○○○○●○●○●○●○○○○○○○○○●○●○●○●

### ●●●●●●●●○○○○○○○○●●●●●●●●○○○○○○○○●●●●●●●●○○○○○○○○●●●●●●●●

### ●○○○○○○○●○○○○○○○●○○○○○○○●○○○○○○○●○○○○○○○●○○○○○○○●○○○○○○○●

### ●●○○○○○○●●○○○○○○●●○○○○○○●●○○○○○○●●○○○○○○●●○○○○○○●●○○○○○○●●

### ●○●○○○○○●○●○○○○○●○●○○○○○●○●○○○○○●○●○○○○○●○●○○○○○●○●○○○○○●○●

### ●●●●○○○○●●●●○○○○●●●●○○○○●●●●○○○○●●●●○○○○●●●●○○○○●●●●○○○○●●●●

### ●○○○●○○○●○○○●○○○●○○○●○○○●○○○●○○○●○○○●○○○●○○○●○○○●○○○●○○○●○○○●

### ●●○○●●○○●●○○●●○○●●○○●●○○●●○○●●○○●●○○●●○○●●○○●●○○●●○○●●○○●●○○●●

### ●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●○●

### ●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

. .

### Sierpinski’s Triangle for Binomial Coefficients (mod 3)

### Code: ○ ≡ 0, ● ≡ 1, ● ≡ 2 (mod 3)

### ●

### ●●

### ●●●

### ●○○●

### ●●○●●

### ●●●●●●

### ●○○●○○●

### ●●○●●○●●

### ●●●●●●●●●

### ●○○○○○○○○●

### ●●○○○○○○○●●

### ●●●○○○○○○●●●

### ●○○●○○○○○●○○●

### ●●○●●○○○○●●○●●

### ●●●●●●○○○●●●●●●

### ●○○●○○●○○●○○●○○●

### ●●○●●○●●○●●○●●○●●

### ●●●●●●●●●●●●●●●●●●

### ●○○○○○○○○●○○○○○○○○●

### ●●○○○○○○○●●○○○○○○○●●

### ●●●○○○○○○●●●○○○○○○●●●

### ●○○●○○○○○●○○●○○○○○●○○●

### ●●○●●○○○○●●○●●○○○○●●○●●

### ●●●●●●○○○●●●●●●○○○●●●●●●

### ●○○●○○●○○●○○●○○●○○●○○●○○●

### ●●○●●○●●○●●○●●○●●○●●○●●○●●

### ●●●●●●●●●●●●●●●●●●●●●●●●●●●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●●○○○○○○○○○○○○○○○○○○○○○○○○○○●●

### ●●●○○○○○○○○○○○○○○○○○○○○○○○○○●●●

### ●○○●○○○○○○○○○○○○○○○○○○○○○○○○●○○●

### ●●○●●○○○○○○○○○○○○○○○○○○○○○○○●●○●●

### ●●●●●●○○○○○○○○○○○○○○○○○○○○○○●●●●●●

### ●○○●○○●○○○○○○○○○○○○○○○○○○○○○●○○●○○●

### ●●○●●○●●○○○○○○○○○○○○○○○○○○○○●●○●●○●●

### ●●●●●●●●●○○○○○○○○○○○○○○○○○○○●●●●●●●●●

### ●○○○○○○○○●○○○○○○○○○○○○○○○○○○●○○○○○○○○●

### ●●○○○○○○○●●○○○○○○○○○○○○○○○○○●●○○○○○○○●●

### ●●●○○○○○○●●●○○○○○○○○○○○○○○○●●●○○○○○○●●●

### ●○○●○○○○○●○○●○○○○○○○○○○○○○○●○○●○○○○○●○○●

### ●●○●●○○○○●●○●●○○○○○○○○○○○○○●●○●●○○○○●●○●●

### ●●●●●●○○○●●●●●●○○○○○○○○○○○○●●●●●●○○○●●●●●●

### ●○○●○○●○○●○○●○○●○○○○○○○○○○○●○○●○○●○○●○○●○○●

### ●●○●●○●●○●●○●●○●●○○○○○○○○○○●●○●●○●●○●●○●●○●●

### ●●●●●●●●●●●●●●●●●●○○○○○○○○○●●●●●●●●●●●●●●●●●●

### ●○○○○○○○○●○○○○○○○○●○○○○○○○○●○○○○○○○○●○○○○○○○○●

### ●●○○○○○○○●●○○○○○○○●●○○○○○○○●●○○○○○○○●●○○○○○○○●●

### ●●●○○○○○○●●●○○○○○○●●●○○○○○○●●●○○○○○○●●●○○○○○○●●●

### ●○○●○○○○○●○○●○○○○○●○○●○○○○○●○○●○○○○○●○○●○○○○○●○○●

### ●●○●●○○○○●●○●●○○○○●●○●●○○○○●●○●●○○○○●●○●●○○○○●●○●●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

### ○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

### Sierpinski’s Triangle for Binomial Coefficients (mod 5)

Code:

### ○ ≡ 0, ● ≡ 1, ● ≡ 2, ● ≡ 3, ● ≡ 4 (mod 5)

### ●

### ●●

### ●●●

### ●●●●

### ●●●●●

### ●○○○○●

### ●●○○○●●

### ●●●○○●●●

### ●●●●○●●●●

### ●●●●●●●●●●

### ●○○○○●○○○○●

### ●●○○○●●○○○●●

### ●●●○○●●●○○●●●

### ●●●●○●●●●○●●●●

### ●●●●●●●●●●●●●●●

### ●○○○○●○○○○●○○○○●

### ●●○○○●●○○○●●○○○●●

### ●●●○○●●●○○●●●○○●●●

### ●●●●○●●●●○●●●●○●●●●

### ●●●●●●●●●●●●●●●●●●●●

### ●○○○○●○○○○●○○○○●○○○○●

### ●●○○○●●○○○●●○○○●●○○○●●

### ●●●○○●●●○○●●●○○●●●○○●●●

### ●●●●○●●●●○●●●●○●●●●○●●●●

### ●●●●●●●●●●●●●●●●●●●●●●●●●

### ●●○○○○○○○○○○○○○○○○○○○○○○●●

### ●●●○○○○○○○○○○○○○○○○○○○○○●●●

### ●●●●○○○○○○○○○○○○○○○○○○○○●●●●

### ●●●●●○○○○○○○○○○○○○○○○○○○●●●●●

### ●○○○○●○○○○○○○○○○○○○○○○○○●○○○○●

### ●●○○○●●○○○○○○○○○○○○○○○○○●●○○○●●

### ●●●○○●●●○○○○○○○○○○○○○○○○●●●○○●●●

### ●●●●○●●●●○○○○○○○○○○○○○○○●●●●○●●●●

### ●●●●●●●●●●○○○○○○○○○○○○○○●●●●●●●●●●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

### Binomial coefficients in Sierpinski’s triangle (mod 7)

### Code: ○ ≡ 0, ● ≡ 1, ● ≡ 2, ● ≡ 3, ● ≡ 4, ● ≡ 5, ● ≡ 6 (mod 7)

### ●

### ●●

### ●●●

### ●●●●

### ●●●●●

### ●●●●●●

### ●●●●●●●

### ●○○○○○○●

### ●●○○○○○●●

### ●●●○○○○●●●

### ●●●●○○○●●●●

### ●●●●●○○●●●●●

### ●●●●●●○●●●●●●

### ●●●●●●●●●●●●●●

### ●○○○○○○●○○○○○○●

### ●●○○○○○●●○○○○○●●

### ●●●○○○○●●●○○○○●●●

### ●●●●○○○●●●●○○○●●●●

### ●●●●●○○●●●●●○○●●●●●

### ●●●●●●○●●●●●●○●●●●●●

### ●●●●●●●●●●●●●●●●●●●●●

### ●○○○○○○●○○○○○○●○○○○○○●

### ●●○○○○○●●○○○○○●●○○○○○●●

### ●●●○○○○●●●○○○○●●●○○○○●●●

### ●●●●○○○●●●●○○○●●●●○○○●●●●

### ●●●●●○○●●●●●○○●●●●●○○●●x●●

### ●●●●●●○●●●●●●○●●●●●●○●●●●●●

### ●●●●●●●●●●●●●●●●●●●●●●●●●●●●

### ●○○○○○○●○○○○○○●○○○○○○●○○○○○○●

### ●●○○○○○●●○○○○○●●○○○○○●●○○○○○●●

### ●●●○○○○●●●○○○○●●●○○○○●●●○○○○●●●

### ●●●●○○○●●●●○○○●●●●○○○●●●●○○○●●●●

### ●●●●●○○●●●●●○○●●●●●○○●●●●●○○●●●●●

### ●●●●●●○●●●●●●○●●●●●●○●●●●●●○●●●●●●

### ●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●

### ●○○○○○○●○○○○○○●○○○○○○●○○○○○○●○○○○○○●

### ●●○○○○○●●○○○○○●●○○○○○●●○○○○○●●○○○○○●●

### ●●●○○○○●●●○○○○●●●○○○○●●●○○○○●●●○○○○●●●

### ●●●●○○○●●●●○○○●●●●○○○●●●●○○○●●●●○○○●●●●

### ●●●●●○○●●●●●○○●●●●●○○●●●●●○○●●●●●○○●●●●●

### ●●●●●●○●●●●●●○●●●●●●○●●●●●●○●●●●●●○●●●●●●

### ●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●

### ●○○○○○○●○○○○○○●○○○○○○●○○○○○○●○○○○○○●○○○○○○●

### ●●○○○○○●●○○○○○●●○○○○○●●○○○○○●●○○○○○●●○○○○○●●

### ●●●○○○○●●●○○○○●●●○○○○●●●○○○○●●●○○○○●●●○○○○●●●

### ●●●●○○○●●●●○○○●●●●○○○●●●●○○○●●●●○○○●●●●○○○●●●●

### ●●●●●○○●●●●●○○●●●●●○○●●●●●○○●●●●●○○●●●●●○○●●●●●

### ●●●●●●○●●●●●●○●●●●●●○●●●●●●○●●●●●●○●●●●●●○●●●●●●

### ●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●●

### ●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●

### ●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●

### ●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●

### ●●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●●

### ●●●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●●●

### ●●●●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●●●●

### ●●●●●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●●●●●

### ●○○○○○○●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●○○○○○○●

### ●●○○○○○●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●○○○○○●●

### ●●●○○○○●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●○○○○●●●

### ●●●●○○○●●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●●○○○●●●●

### ●●●●●○○●●●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●●●○○●●●●●

### ●●●●●●○●●●●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●●●●○●●●●●●

### ●●●●●●●●●●●●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●●●●●●●●●●●●

### ●○○○○○○●○○○○○○●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●○○○○○○●○○○○○○●

### ●●○○○○○●●○○○○○●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●○○○○○●●○○○○○●●

●●●○○○○●●●○○○○●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●○○○○●●●○○○○●●●

●●●●○○○●●●●○○○●●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●●○○○●●●●○○○●●●●

●●●●●○○●●●●●○○●●●●●○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○●●●●●○○●●●●●○○●●●●●

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

### The Generalized Little Fermat Theorem

The Little Fermat Theorem states that a p ≡ a (mod p) where p is prime. If, in addition, p does not divide a then by the Cancellation Law we also have a p −1 ≡ 1 (mod p). The proof is by mathematical induction. For a = 2 there is a proof without words. Behold Sierpinski’s triangle (mod p) and see that there are only two non-zero dummies in row p, the first and the last, each equal to 1. On the other hand, by the Summation Formula, the sum of entries in the pth row is 2 p . We conclude that 2 p ≡ 2 (mod p).

To extend this to a we need the mod p version of the Binomial Formula: ( a + b) p ≡ a p + b p

(mod p) that can also be proved without words, just by beholding Sierpinski’s triangle. Now we can start the induction: 3 p = (2 + 1) p ≡ 2 p + 1 ≡ 2 + 1 = 3 (mod p); 4 p = (3 + 1) p ≡ 3 p + 1 ≡ 3 + 1 = 4 (mod p); etc., and the result follows. n

This is just a special case, for n = 1, of a more general result: a p −1 ≡ 1 (mod p), n = 1, 2, 3, … The proof of the full strength of the Little Fermat Theorem is left as an exercise. There are many other proofs of the type “behold!” They are all relegated to the Exercises.

### Newton’s First and Second Formula

It is curious that authors, among them pioneers such as the American mathematician Eric Temple Bell, were blind to the fact that the Binomial Theorem is valid not only for numbers but operators as well.

Their blindness might have been due to a notational stumbling block: they had thought that they were obliged to invent a new symbol (e.g., I or ι) for the identity operator, bypassing the obvious choice of 1. In this treatise we shall be concerned with several operators that apply to sequences, some of which we introduce right now. The shift operator E is defined such that for every sequence an we have Ean = an+1 (E ‘shifts’ the members of the sequence by one slot to the right). The powers of the shift operator E2, E 3,... called higher order shift operators will also be used. They make a right shift by 2, 3,... slots. The difference operator Δ is defined such that Δan = an+1 − an , and the identity operator 1 such that 1an = an for every sequence an. The fact that 1 has another meaning also, that of the number one, is not disturbing. The powers of Δ: Δ2, Δ3,... are called higher order difference operators. For example it is easy to show that, for the geometric progression an = 2n, we have Δk2n = 2n for k = 1, 2, 3,...

Indeed, Δ2n = 2n+1 − 2n = 2n(2 −1) = 2n (for this reason the sequence 2n plays the same role with respect to the difference operator Δ as the exponential function ex does with respect to the differential operator d/dx). One can also consider the inverse shift operator E–1 defined by the formula E–1(an) = an – 1 where an is a sequence with values for n = ...−2, −1, 0, 1, 2,... It satisfies E–1E = 1 = EE–1, where 1 is the identity operator.

The next two results are not usually treated in the context of the Binomial Theorem, even though that is where they properly belong. Correctly understood, they are not a formula but an algorithm.

### Newton’s first formula

### ⎛n⎞

### ⎛n⎞

### ⎛n⎞

### E n = 1 + ⎜ ⎟ Δ + ⎜ ⎟ Δ 2 + ... + ⎜ ⎟ Δ n

### ⎝1⎠

### ⎝ 2⎠

### ⎝n⎠

### Newton’s second formula

### ⎛n⎞

### ⎛n⎞

### ⎛n⎞

### Δ n = E n − ⎜ ⎟ E n −1 + ⎜ ⎟ E n −2 − +... + ( −1)n ⎜ ⎟

### ⎝1⎠

### ⎝ 2⎠

### ⎝n⎠

For example we calculate Ek2n via Newton’s first formula (even though manual calculation is

### ⎛k ⎞

### ⎛k ⎞

### ⎛k ⎞

### ⎛k ⎞

⎛k ⎞ ⎛k ⎞ quicker). Ek 2n = (1 + Δ)k2n = [1 + ⎜ ⎟ Δ + ⎜ ⎟ Δ2 + ... + ⎜ ⎟ Δk] 20.2n = [1 + ⎜ ⎟ + ⎜ ⎟ + ... + ⎜ ⎟ ] ⎝k ⎠

### ⎝k ⎠

### ⎝1⎠

### ⎝ 2⎠

### ⎝1⎠ ⎝ 2⎠ n

2 =

(1 + 1)k2n = 2n+k . As another example, we re-calculate Δk2n via Newton’s second:

### ⎛k ⎞

### ⎛k ⎞

### ⎛k ⎞

Δk2n = (E − 1)k 2n = [Ek − ⎜ ⎟ Ek-1 + − ... + (−1)k ⎜ ⎟ ] 20.2n = [2k − ⎜ ⎟ 2k-1 + − ... + (−1)k] 2n = ⎝1⎠

### ⎝1⎠

### ⎝k ⎠ k n n

(2 −1) 2 = 2 for k = 1, 2, 3,...

Newton’s formulas can be proved by observing that E = 1 + Δ, Δ = E − 1 and expanding

(1 + Δ)n, (E − 1)n via the binomial formula under the convention that Δ0 = E0 = 1, the identity operator. We can calculate the nth term of an arbitrary sequence via Newton’s first. For example, let us continue the entries in the slanting row a0 = 1, 4, 10, 20, 35,..., an,... of Pascal’s triangle and calculate 7th term. The higher differences are:

35 . . .

15 . . .

5...

1...

The third difference sequence is constant, so the fourth and each subsequent higher difference is the zero sequence. Hence in Newton’s first formula we have to write the first four terms only: a7 = E7a0 = (1 + 7Δ + 21Δ2 + 35Δ3)a0 = 1 + 7(3) + 21(3) + 35(1) = 120. To check, we continue the sequence an manually using the fact that Δ3an = 1 is constant. The sums 6 + 1 = 7, 21 + 7 = 28, 56 + 29 = 84 = a6 we enter in the 6th slanting row of slope +1, and continue to a7 :

120 . . .

36 . . .

8...

1...

Ours is an example of an arithmetic progression of order 3. More generally, members of a sequence ak are said to be in arithmetic progression of order n if the nth difference sequence is constant ≠ 0 (hence, all higher difference sequences are equal to the zero sequence). An ordinary arithmetic progression is of the first order. Pascal’s triangle furnishes an example of an nth order arithmetic progressions for every n, namely, entries in the nth slanting row. Furthermore, earlier slanting rows are exactly the higher order difference sequences, revealing that the nth difference sequence is constant equal to 1. In fact, Pascal’s triangle can be used as a ‘ready reckoner’ for the higher differences of binomial coefficients standing in a slanting row. They are the binomial coefficients standing in earlier slanting rows. In fact, rotation of Pascal’s triangle in the counter-clockwise sense through 135° will put these rows in the customary horizontal position. A most important arithmetic progressions of order n is the sequence of the nth powers: 0n, 1n, 2n, 3n,...,kn,... The nth difference sequence is constant and is equal to n!

It is not hard to prove the theorem that members of a sequence ak are in arithmetic progression of order n if, and only if, ak is a polynomial of degree n in the variable k.

As an application of Newton’s formulas we shall prove the following Theorem. The solution of the system of linear equations with infinitely many unknowns x0, x1, x2,... 1x0 = y0

1x0 + 1x1 = y1

1x0 + 2x1 + 1x2 = y2

1x0 + 3x1 + 3x2 + 1x3 = y3

. . . . . where on the left-hand side we have the binomial coefficients, and constants, is: x0 = 1y0 y0, y1, y2,... are arbitrary x1 = −1y0 + 1y1 x2 = 1y0 − 2y1 + 1y2 x3 = −1y0 + 3y1 − 3y2 + 1y3

. . . . . where on the right-hand sides we have the binomial coefficients with alternating signature.

Proof. By Newton’s first we may write the proposed solution in the form: xn

### = En x0 = (E − 1)n y0

### ⇒ En x0 = Δn y0 for n = 0, 1, 2, 3, ... Therefore

### ⎛n⎞

### ⎛ n ⎞

### ⎛n⎞

### (E + 1)n x0 = En x0 + ⎜ ⎟ E n - 1x0 + ... + ⎜

### E x0 + ⎜ ⎟ x 0

### ⎟

### ⎝1⎠

### ⎝n⎠

### ⎝ n − 1⎠

### ⎛n⎞

### ⎛ n ⎞

### ⎛n⎞

### Δy0 + ⎜ ⎟ y0

### = Δn y0 + ⎜ ⎟ Δn - 1 y0 + ... + ⎜

### ⎟

### ⎝1⎠

### ⎝n⎠

### ⎝ n − 1⎠ n

### = (Δ + 1) y0

= En y0 = yn by Newton’s second.

It follows that the values xn = (E − 1)n y0 satisfy the system, completing the proof.

The converse is also true: if the roles of the unknowns and constants are interchanged, then solution to the second system for the unknowns yk is furnished in terms of the constants xk by the first. As an example, consider the system of linear equations with infinitely many unknowns

1x1 = 0n

1x1 + 1x2 = 1n

1x1 + 2x2 + 1x3 = 2n

1x1 + 3x2 + 3x3 + 1x4 = 3n

. . . . . . . . . .

The solution is: x1 = 1(0n) x2 = 1(1n) − 1(0n) x3 = 1(2n) − 2(1n) + 1(0n) x4 = 1(3n) − 3(2n) + 3(1n) − 1(0n)

. . . . . . . . .

In order to interpret this result we note that 0n, 1n, 2n, 3n,... are in arithmetic progression of order n and Newton’s second formula applies:

### ⎛k ⎞

### ⎛k ⎞

### ⎛k ⎞

Δk0n = (E − 1)k0n = [Ek − ⎜ ⎟ Ek-1 + ⎜ ⎟ Ek-2 − + ... + (−1)k ⎜ ⎟ ] 0n

### ⎝1⎠

### ⎝2⎠

### ⎝k ⎠

We conclude that the solution to the above infinite system of linear equations is:

### ⎛k ⎞

### ⎛k ⎞

⎛ k ⎞ n xk = Δk0n = kn − ⎜ ⎟ (k − 1)n + ⎜ ⎟ (k − 2)n − + ... + (−1)k-1 ⎜

### ⎟1

### ⎝1⎠

### ⎝ 2⎠

### ⎝ k − 1⎠

The numbers Δk0n have an important (albeit little recognized) interpretation:

### Implicit formula for the number of surjective functions

Surj(n, k) = Δk0n where Surj(n, k) stands for the number of surjective functions from an n-set to a k-set (alternatively, the number of distributions of n unlike balls into k unlike cells with no cell to remain empty). Again, this is not so much a formula than an algorithm. (The properties of injective, surjective, and bijective functions will be discussed in Volume II, Chapter 15 on duality.)

For example, let n = 3 and calculate Surj(3, 2). Δ243 = (E − 1)2 43 = (E2 − 2E + 1) 43 =

E243 − 2E43 + 43 = 63 − 2(53) + 43 = 216 − 2(125) + 64 = 280 − 250 = 30 = Surj(3, 2). To check, we may calculate the higher order difference sequences of the cubes manually. Note that we can calculate the consecutive cubes (and, for that matter, the consecutive nth powers, for any n) using addition only, to the exclusion of subtraction and multiplication. Starting with the cubes 03 = 0, 1, 8, 27 and their differences

0 1

8 27

1 7 19

6 12

6 ... we enter the sums 12 + 6 = 18, 19 + 18 = 37, 27 + 37 = 64 = 43 in the 4th slanting row with slope +1 (counting starts with slanting row 0). Similarly, in the next slanting row we enter the sums 18 + 6 = 24, 37 + 24 = 61, 64 + 61 = 125 = 53, etc. We get:

216 . . . n3 . . .

91 . . .

30 . . .

6 ...

Thus we can find Δ243 = 30 in row 2, entry 4 (counting starts with row 0, entry 0).

As another example let us calculate Surj(6, 3). We only need the sixth powers 0, 1, 64, 729:

Surj(6, 3) = 729 − 3(64) + 3 = 732 − 192 = 540. To check, we may calculate the sixth powers using addition only (just as we did in calculating the cubes above):

4096 15625 46656 117649 . . . k6 . . .

3367 11529 31031 70993 . . .

602 2702 8162 19502 39962 . . .

540 2100 5460 11340 20460 . . .

1560 3360 5880 9120 . . .

1800 2520 3240 . . .

720 720 . . .

From the slanting row printed in red we also see that Surj(6, 2) = Δ206 = 62; Surj(6, 4) = Δ406 = 1560; Surj(6, 5) = Δ506 = 1800; Surj(6, 6) = Δ606 = 720 = 6! We also have the

### Explicit formula for the number of surjective functions

### ⎛k ⎞

### ⎛k ⎞

### ⎛ k ⎞ n

### Surj(n, k) = kn − ⎜ ⎟ (k − 1)n + ⎜ ⎟ (k − 2)n − + ... + (−1)k-1 ⎜

### ⎟1

### ⎝1⎠

### ⎝ 2⎠

### ⎝ k − 1⎠

Clearly, Surj(n, 0) = 0. We also have Surj(n, 1) = 1 for n ≥ 1 because, in this case, there is only one function (the constant function). Recall that the number of all functions from an n-set to a k-set is kn. We may survey them according to the number k of elements in the image, to find that

### ⎛k ⎞

### ⎛ k ⎞

### ⎛k ⎞

### ⎛k ⎞ n

⎜ k ⎟ Surj(n, k) + ⎜ k − 1⎟ Surj(n, k −1) +. . . + ⎜ 1 ⎟ Surj(n, 1) + ⎜ 0 ⎟ Surj(n, 0) = k

### ⎝ ⎠

### ⎝

### ⎠

### ⎝ ⎠

### ⎝ ⎠

This pleasantly transparent formula can be checked through direct counting:

1 Surj(n, 1) = 1n

1 Surj(n, 2) + 2 Surj(n, 1) = 2n

1 Surj(n, 3) + 3 Surj(n, 2) + 3 Surj(n, 1) = 3n

1 Surj(n, 4) + 4 Surj(n, 3) + 6 Surj(n, 2) + 4 Surj(n, 1) = 4n

. . . . . . . . . .

For example, if n = 3, we have 1(6) + 3(6) + 3(1) + 1(0) = 27 = 33.

As an example, let n = 5 and find Surj(5, 3). We only need the fifth powers 0, 1, 32, 243.

Surj(5,3) = 243 − 3(32) + 3 = 246 − 96 = 150. We also have Surj(5, 2) = 32 − 2(1) = 30. Let us continue the calculation of the fifth powers beyond 243 = 35:

1024 3125 7776 . . . k5 . . .

2101 4651 . . .

180 570

1320 2550 . . .

150 390

1230 . . .

240 360

480 . . .

...

From the slanting row printed in red we find that Surj(5, 4) = Δ405 = 240, and Surj(5, 5) = Δ505 =

120 = 5!.

It is important to note that the pattern exhibited by the Sierpinski’s triangles is a consequence of Newton’s formulas and of the fact that the slanting rows of Pascal’s triangle are in arithmetic progression (see Exercises).

In Chapter 6 we shall see the dual of Newton’s First and Second Formulas under the name Vertical and Horizontal Exchange Formulas. They are dual in the same sense as the lattice of quotient sets is dual to the lattice of subsets. In passing we draw attention to the fact that the Theorem above on the solution of the infinite system of linear equations with the binomial coefficients as coefficients can be formulated as follows. The solution of the matrix equation

### ⎛1

### ⎜1

### ⎜

### ⎜1

### ⎜

### ⎜1

⎜.

### ⎝

.

.

.

### . ⎞ ⎛ x1 ⎞ ⎛ y1 ⎞

### . ⎟⎟ ⎜⎜ x2 ⎟⎟ ⎜⎜ y2 ⎟⎟

### . ⎟ ⎜ x3 ⎟ = ⎜ y3 ⎟

### ⎟⎜ ⎟ ⎜ ⎟

### . ⎟ ⎜ x4 ⎟ ⎜ y 4 ⎟

### . ⎟⎠ ⎜⎝ . ⎟⎠ ⎜⎝ . ⎟⎠ can be obtained by the formula

### ⎛ x1 ⎞ ⎛ 1 0 0

### ⎜ x ⎟ ⎜ −1 1 0

### ⎜ 2⎟ ⎜

### ⎜ x3 ⎟ = ⎜ 1 −2 1

### ⎜ ⎟ ⎜

### ⎜ x 4 ⎟ ⎜ − 1 3 −3

⎜ . ⎟ ⎜ .

.

.

### ⎝ ⎠ ⎝

.

### . ⎞ ⎛ y1 ⎞

### . ⎟⎟ ⎜⎜ y2 ⎟⎟

### . ⎟ ⎜ y3 ⎟

### ⎟⎜ ⎟

### . ⎟ ⎜ y4 ⎟

. ⎟⎠ ⎜⎝ . ⎟⎠ where in the first infinite square matrix we have the binomial coefficients, in the second, the binomial coefficients with alternating signature. In other words, the product of the infinite square matrices ⎛1 0 0

### ⎜ −1 1 0

### ⎜

### ⎜ 1 −2 1

### ⎜

### ⎜ −1 3 −3

⎜ .

.

.

### ⎝

.

### . ⎞ ⎛1

### . ⎟⎟ ⎜⎜ 1

### . ⎟ ⎜1

### ⎟⎜

### . ⎟ ⎜1

. ⎟⎠ ⎜⎝ .

. is the unit square matrix.

.

.

### .⎞ ⎛ 1

### . ⎟⎟ ⎜⎜ 0

### .⎟ = ⎜ 0

### ⎟ ⎜

### .⎟ ⎜ 0

. ⎟⎠ ⎜⎝ .

.

.

.

### .⎞

### . ⎟⎟

### .⎟

### ⎟

### .⎟

### . ⎟⎠

### Exercises

1.

Calculate Surj(7, 5) in three different ways.

2.

Calculate the seventh powers of integers up to 107 using addition only.

3.

In how many different ways can we distribute eight unlike balls into five unlike cells in such a way that no cell shall remain empty?

4.

In how many ways can we have a street of ten houses painted with two, three, four, five, six, seven, eight, nine, ten given colors in such a way that, in each case, every color is represented?

5.

### Show, in at least two different ways, that Surj(n, n) = n!

6.

### For which values of k does the equality Surj(n, k) = 0 hold?

7.

### ⎛n⎞

### ⎛n⎞

### ⎛n⎞

Prove n n − ⎜ ⎟ ( n − 1)n + ⎜ ⎟ ( n − 2) n − +... + ( −1) n −1 ⎜ ⎟ 1n = n ! in at least two different ways. ⎝1⎠

### ⎝2⎠

### ⎝n⎠

8.

### ⎛k ⎞

### ⎛k ⎞

For which values of k is the formula kn − ⎜ ⎟ (k −1)n + ⎜ ⎟ (k −2)n − + ... = 0 valid?

### ⎝1⎠

### ⎝2⎠

9.

Prove the Binomial Theorem in at least three different ways.

10.

Show that the entries in the nth slanting row with slope ±1 of Pascal’s triangle are in arithmetic progression of order k. Find k in terms of n. Calculate the kth difference sequence.

11.

Show that the binomial coefficients in row p of Pascal’s triangle, with the exception of the first and last, are divisible by p provided that p is a prime number.

12.

Prove the formula (1 + 2 + 22 + ... + 2n) + 1 = 2n+1 in at least two different ways.

13.

Prove that the numbers ak are in arithmetic progression of order n if, and only if, the function

A(k) = ak is a polynomial of degree n in the variable k.

14.

Construct the first 40 rows of the Sierpinski triangle (mod 7) for the binomial coefficients.

15.

Prove the Summation Formula for binomial coefficients in at least two different ways.

16.

Prove the following version of the Binomial Theorem: for p prime, n = 1, 2, 3,…, n n n

### ( a + b) p ≡ a p + b p (mod p)

17.

Prove the Little Fermat Theorem stating that a p −1 ≡ 1 (mod p), provided that p is a prime number that does not divide a, in at least three different ways.

18.

Prove the Generalized Little Fermat Theorem stating that for a prime number p that n doesn’t divide a, a p −1 ≡ 1 (mod p), for n = 1, 2, 3,…

19.

Show that the binomial coefficients in row pn of Pascal’s triangle, with the exception of the first and the last, are divisible by p provided that p is a prime number and n = 1, 2, 3,...

20.

Are the previous statements true of false for composite numbers? If false, provide counter examples.

(a) Show that in an arithmetic progression of order k, if a member an is divisible by the prime number p, then so is an + p.

(b) What can you say about an + 2p, an + 3p, an + 4p,... under the same assumption?

(c) Investigate the validity of the statement for an + pm where m = 1, 2, 3,…

21.

Let a1, a2, a3,..., an ,... be an arithmetic progression of order k. Suppose that an = p < k is an odd prime number. Show that Δpan + 1 ≡ 0 (mod p).

22.

(a) Show that Surj(p, k) is divisible by p, provided that p is a prime number and k > 1.

(b) Investigate the validity of the above statement for Surj(pn, k), n = 1, 2, 3,... n

23.

Show that 2 p −1 ≡ 1 (mod p) where p is a prime number, for n = 1, 2, 3,.... Is this statement valid for a composite number?

24.

Prove the Theorem on the solution of the system of linear equations with infinitely many unknowns in another way: express x1, x2, x3,… from the 1st, 2nd, 3rd,… equation, substituting these values into subsequent equations.

25.

Solve numerically the system of linear equations with infinitely many unknowns, and check:

### (a)

1x1 = 0

1x1 + 1x2 = 1

1x1 + 2x2 + 1x3 = 2

1x1 + 3x2 + 3x3 + 1x4 = 3

. . . . . . . . . .

### (b)

1x1 = 1

1x1 − 1x2 = 1

1x1 − 2x2 + 1x3 = 1

1x1 − 3x2 + 3x3 − 1x4 = 1

. . . . . . . . . .

### (c)

1x1 = 0

1x1 + 1x2 = 1

1x1 + 2x2 + 1x3 = 4

1x1 + 3x2 + 3x3 + 1x4 = 9

. . . . . . . . . . where on the right-hand side we have the square numbers.

### (d)

1x1 = 0

1x1 + 1x2 = 1

1x1 + 2x2 + 1x3 = 8

1x1 + 3x2 + 3x3 + 1x4 = 27

. . . . . . . . . . where on the right-hand side we have the cubes.

### (e)

1x1 = 1

1x1 + 1x2 = 10

1x1 + 2x2 + 1x3 = 100

1x1 + 3x2 + 3x3 + 1x4 = 1000

. . . . . . . . . . where on the right-hand side we have the powers of 10.

1x1 = y1

1x1 − 1x2 = y2

1x1 − 2x2 + 1x3 = y3

1x1 − 3x2 + 3x3 − 1x4 = y4

. . . . . . . . . .

(f) where on the left-hand side we have the binomial coefficients with alternating signature, and y1, y2, y3, … are arbitrary constants.

26.

Calculate (mod p) where p is prime, the following sums:

### ⎛ k + p − 1⎞

∑0 ⎜ p − 1 ⎟ ,

### ⎝

### ⎠

### ⎛ p +k⎞

∑0 ⎜ p ⎟ ,

### ⎝

### ⎠ n n

### (a)

### (b)

### ⎛ k + p − 1⎞

### ⎟. k

0 ⎝

### ⎠ n

### (d)

### ∑⎜

### (c) n

### ⎛ p +k⎞

### ⎝

∑⎜ k ⎟ ,

### ⎠

27.

### Solve the matrix equation

### ⎛1

### ⎜1

### ⎜

### ⎜1

### ⎜

### ⎜1

⎜.

### ⎝

.

.

.

### . ⎞ ⎛ x1 ⎞ ⎛ 1 ⎞

### . ⎟⎟ ⎜⎜ x2 ⎟⎟ ⎜⎜ 2 ⎟⎟

### . ⎟ ⎜ x3 ⎟ = ⎜ 3 ⎟

### ⎟⎜ ⎟ ⎜ ⎟

### . ⎟ ⎜ x4 ⎟ ⎜ 4 ⎟

. ⎟⎠ ⎜⎝ . ⎟⎠ ⎜⎝ . ⎟⎠ where the entries in the infinite square matrix are the binomial coefficients. Write the matrix equation as a system of linear equations with infinitely many unknowns, and check your solution by substitution.

28.

Complete the coloring of Sierpinski’s triangles on p 23, 24.

---

# Stepnumbers: Chapter 4 — The Stepnumber System and the Spectral Coefficients

URL: https://newaustrianeconomics.com/archive/fekete/stepnumbers-chapter-4-spectral-coefficients/
Date: 2010-01-01
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete presents the full stepnumber system and introduces the spectral coefficients — the stepnumber analogs of the binomial coefficients. He shows how the stepnumber system organizes infinitely many digits through a constraint that no digit larger than k may appear in the k-th position, and how the resulting spectral triangle mirrors Pascal's triangle in the binary system.
Editorial Note: Chapter 4 of Fekete's Stepnumbers monograph (c. 2010), the theoretical culmination of the series. The spectral coefficients generalize the binomial coefficients and give the stepnumber system its distinctive mathematical structure.
Original PDF: https://professorfekete.com/articles/CSTEP4.pdf

4. The stepnumber system and the spectral coefficients

The stepnumber system, in contrast with the binary, epitomizes form as opposed to substance. We refer to the table of the first three hundred stepnumbers in the Introduction. Just as in the case of Cantor numbers, an n-digit stepnumber may involve only digits up to and including n. But in contrast with Cantor’s, for a stepnumber no digit larger than k may enter the kth slot (counted from left to right). In solving the practical problem of creating infinitely many digits one must rely on mnemonic principles. Digits must be such that the human (as well as computer) memory be able to recognize, store and retrieve them as needed. In Chapter 1 we have solved the problem of creating infinitely many digits, the so-called rainbow digits. Here we shall work with examples for the representation of which the color black and the ten decimal digits suffice. We have the Bell numbers bn so named after the American mathematician Eric Temple Bell who was one of the pioneers studying them

(however, see Dobinski’s 1877 paper [5]):

1 = 1 = 100 = b1

10 = 2 = 101 = b2

100 = 5 = 102 = b3

1000 = 15 = 103 = b4

10000 = 52 = 104 = b5

100000 = 203 = 105 = b6

1000000 = 877 = 106 = b7

10000000 = 4,140 = 107 = b8

100000000 = 21,147 = 108 = b9

1000000000 = 115,975 = 109 = b10

10000000000 = 678,570 = 1010 = b11

100000000000 = 4,213,597 = 1011 = b12

1000000000000 = 27,644,437 = 1012 = b13

. . . . .

A table containing the values of the Bell numbers up to b100 is appended at the end of the book. We shall see numerous different methods to calculate the Bell numbers, five of them later in this Chapter.

The Bell number bn+1 counts the number of stepnumbers of at most n digits. This can be seen from the fact that 10n is the very first stepnumber of n + 1 digits as it succeeds n!, the last n-digit stepnumber. Stepnumbers up to and including n! have at most n digits. Often it is desirable to treat this set as if its members had the same number of digits. This can, of course, be accomplished by attaching one or more 0 digits as needed in front without affecting the values of stepnumbers, while causing them to have the same n + 1 number of digits (the first of which being 0). For example, in the case of n = 3, 103 = b4 = 15, meaning that there are 15 stepnumbers of at most 3 digits. We can convert them uniformly into 4-digit stepnumbers thus:

0 = 0000, 1 = 0001, 10 = 0010, 11 = 0011, 12 = 0012, 100 = 0100, 101 = 0101, 102 = 0102,

110 = 0110, 111 = 0111, 112 = 0112, 120 = 0120, 121 = 0121, 122 = 0122, 123 = 0123

We shall call this the up-front-0 representation, to distinguish it from the conventional up-front-1 representation of stepnumbers. Unless stipulated otherwise we use the latter.

The Bell numbers bn = 10n−1 are pure stepnumbers. More generally we define a pure stepnumber of n digits as one of the form k!0n − k = 123...k0n − k . Next we introduce the important concept of a block of consecutive stepnumbers. They turn out, in the true sense of the word, to be the building blocks of the stepnumber system. Given n and 1 ≤ k ≤ n, the kth block of n-digit stepnumbers consists of those from k!0n − k through n! inclusive.

Thus, for a fixed n, block 0 contains all stepnumbers of at most n digits from 0 through n!

The remaining blocks consist of stepnumbers of exactly n digits. Block 1 contains those from 10n−1 through n!, block 2 contains those from 120n − 2 through n!,..., block k contains those from

123...k0n − k through n!,..., block n − 1 contains those from 123...(n - 1)0 through n! The last, block n, has a single element: n! It is apparent that there are n + 1 blocks of n-digit stepnumbers, one for each value of k = 0, 1, 2,..., n. These blocks are in fact ‘nested sets’, that is to say, each block contains every subsequent block, and all of them contain the last one, block n, having a single element, 123...n. For example, for n = 4, the 5 blocks are as follows: block 0: {0,1,..., 1234} containing 52 stepnumbers; block 1:{1000, 1001,..., 1234} containing 37 stepnumbers; block 3: {1200, 1201, 1202,..., 1234} containing 17 stepnumbers; block 4: {1230, 1231, 1232, 1233, 1234}; finally, block 5: {1234}.

Block k of the n-digit stepnumbers is completely characterized by its first member, which will be used in naming it. A stepnumber belongs to the block of k!0n-k if, and only if, it is of the form 123...kxy...z (the dummy digits x, y, ... , z can independently run through all admissible values). Thus we have a one-to-one correspondence between blocks and pure stepnumbers which, to each block, assigns its first element.

We now introduce the concept of a spectral coefficient as the length of a block. We arrange spectral coefficients in Pascal’s triangle for easy inspection. Our key result below is the Blockbuster Formula which shows how to calculate a spectral-coefficient from those in the previous row of Pascal’s triangle. The justification for the terminology ‘blockbuster’ is the fact that this formula reveals how the block of stepnumbers between the first occurrence of stepdigits n and n +1 splits n into smaller blocks by further occurrences of n. In more details, let 0 ≤ k ≤ n. The symbol , called k spectral coefficient, denotes the number of stepnumbers from 123...k0n −k to 123...n, inclusive, that is, the length of the block of k!0n – k . We have: n

### = 10n − 123...k0n – k k

### In particular, n

= 10n = bn+1 are the Bell numbers counting the stepnumbers of at most n digits; n

= 10n − 10n −1 = bn+1 − bn counting the stepnumbers of exactly n digits. In other words, it shows how far forward we have to count from (n – 1)! to get to n! We also have: n

= n+1 n −1 because there are n+1stepnumbers from (n − 1)!0 to n!, namely, (n − 1)!0, (n − 1)!1, (n − 1)!2,..., (n − 1)!n = n! Finally, n

= 1 n because the last block has only one element, n! By convention,

= 1.

### Recursion Formula n +1 n +1 n

### −

### = ( k + 1) k k +1 k

It can be used to calculate the spectral coefficients, see Exercises. Through repeated application we get: n +1 n +1 n n n n

### −

### = ( k + 1) + ( k + 2)

### + ( k + 3)

### + ... + ( k + j ) k k+ j k k +1 k+2 k + j −1

### This for j = n − k + 1 leads to the

### Blockbuster Formula for the spectral coefficients n +1 n n n n

### = ( k + 1) + ( k + 2)

### + ( k + 3)

### + ... + ( n + 1) + 1 k k k +1 k +2 n

An important special case is that of k = 0:

### Overflow Formula bn + 2 = 1 n

### +2 n

### +3 n

### + ... + ( n + 1) n

### +1 n

Example. (Compare this with the survey of occurrences of the digit 0 among the stepnumbers from 0 through 1! in Chapter 1, p 14-15. In following this example, refer to the Table of Stepnumbers, p 5.)

We want to see how the first appearance and further occurrences of a new digit, 4, splits the block of 203 stepnumbers of at most 5 digits from 0 to 12345. The first occurrence is in 1234. From there we may count forward

= 104 – 103 = 52 −15 = 37 stepnumbers without encountering 4 again to 10234, the second occurrence of 4. From there we may count forward another 37 stepdigits without encountering 4 to 11234, the third occurrence of 4. From there we can count forward

= 104 − 1200 = 52 − 35 = 17 stepnumbers three times to 12034, 12134, 12234, that is, the 4th, 5th and 6th occurrence of 4. The 7th occurrence of 4 is only 5 stepdigits away at 12304. Indeed,

= 104 − 1230 = 52 − 47 = 5. The 8th, 9th and 10th occurrence of 4 follows at the same interval of length 5 to get to 12314, 12324, 12334. Thereafter 5 consecutive stepnumbers contain 4, namely 12340, 12341, 12342, 12343, 12344 showing that

= 104 − 1234 = 52 − 51 = 1. By way of checking we write:

+ 2 + 3 + 4 + 5 = 52 + 2(37) + 3(17) + 4(5) + 5(1) = 202 = b6 − 1 .

The Overflow Formula earns its name by having the same content as n! + 1 = 10n = bn+1, as we shall see in Chapter 7 on the conversion of stepnumbers into decimals. This version lets us calculate the Bell numbers from the spectral coefficients, e.g., b5 = 1(15) + 2(10) + 3(4) + 4(1) + 1 = 52

### The Recursion Formula is a difference equation which under the

### Initial Condition n n

=1 yields a unique solution that can be presented in a format due to Pascal, with place of the n th row (counting rows and places starts with 0).

Spectral coefficients in Pascal’s triangle n standing at the kth k

203 151 77

877 674 372 141

4140 3263 1915 799 235 50

21147 17007 10481 4736 1540 365

115975 94828 60814 29371 10427 2727 537

678570 562595 372939 190497 73013 20878 4516 757 101

4213597 3535027 2409837 1291020 529032 163967 38699 7087 1031 122 12

. . . . . . . .

In Chapter 1 we have surveyed those stepnumbers which had exactly one red digit, 0. The length of blocks in that sequence correspond to the entries in row 10 (counting starts with 0) of Pascal’s triangle above. In fact, Pascal’s triangle gives the length of blocks indicating the frequency of every new digit. In the Example on the previous page, the length of blocks come from row 3.

The Recursion Formula can be verbalized as follows. The difference between any two adjacent entries in Pascal’s triangle is divisible by their neighboring entry in the previous row; moreover the complementary divisor is just the ordinal of the slanting row with slope +1 to which the larger belongs. For example, 77 and 26 are adjacent entries and their neighbor in the previous row is 17 and 77 − 26 = 51 = 3(17). Indeed, 77 is in the slanting row of ordinal 3. It is remarkable and important that entries in the slanting rows of slope −1 are in arithmetic progression of higher order (see Exercises).

In order to describe blocks in yet another way, we classify the digits of a stepnumber as either a stepdigit or a standstill digit. A digit is called a stepdigit if its left neighbor is exactly one higher than the highest digit that has previously occurred. Otherwise the digit is called a standstill digit.

Thus the immediate predecessor of a stepdigit surpasses all the digits standing to its left. By contrast, the left neighbor of a standstill digit is repeating a digit that has already occurred. For example, every digit of n! is a step-digit; all the digits of 10n , apart from the first two, are standstill, as are the digits of 1n . All the digits of the stepnumbers 1x, 12x, 123x, ... are step-digits (x stands for any admissible n counts the number of stepnumbers of exactly n digits of which at least dummy digit). For k ≥ 1, k the first k + 1 are step-digits.

Notice the ‘look-back’ feature of the concept: in finding out whether d is a stepdigit or a standstill digit we must look at the preceding digits to the left. It is not d per se that decides the issue.

For example, 0 is a stepdigit and 4 a standstill digit in 123045; the first 3 is a step-digit and the second is a standstill digit in 123123. The two leading digits (in up-front-0 representation, the three leading digits) of a stepnumber are invariably step-digits. The first k + 1 digits are stepdigits if, and only if, the n-digit stepnumber is of the form 123...kx...y (where x, ... , y are n − k admissible dummy digits).

Here is the proof of the Recursion Formula. For k = 0 the relation is obvious. Let k ≥ 1, the difference of two consecutive pure stepnumbers of n digits,

### (k + 1)!0n−k−1 − k!0n-k = n +1 n +1

− k k +1 is the same as the number of stepnumbers of exactly n + 1 digits of which the first k + 1 are stepdigits and the rest standstill digits. In other words, the difference of two adjacent spectral coefficients in the same row of Pascal’s triangle is the same as the number of stepnumbers of the form 123...kx...x where all the dummy digits with the exception of the first are standstill. For example,

1230 − 1200 =

4 4

### − = 17 − 5 = 12

2 3 is the number of stepnumbers of 4 digits of which the first 3 are stepdigits and the last is a standstill digit, namely, 1200, 1201, 1202, 1203, 1210, 1211, 1212, 1213, 1220, 1221, 1222, 1223 (the next, 1230, is discarded since its last digit is also a stepdigit).

4 4

The number of these stepnumbers, 12, is divisible by 3: − = 12 = 3(4) = 3. It is not hard

2 3 to see the reason for this. The set of 12 consecutive stepnumbers above splits into 3 sets each containing 4 stepnumbers: {1200, 1201, 1202, 1203}; {1210, 1211, 1212, 1213}; {1220, 1221, 1222, 1223}. They are just copies of the block of 120: {120, 121, 122, 123} in the sense that the last digits of corresponding members agree. It follows from the rule of lexicographic enumeration of stepnumbers that the same holds for any n and k. Thus we have proved the result that the number of stepnumbers of exactly n + 1 digits, of which the first k + 1 are stepdigits and the rest standstill digits, is divisible by k + 1; moreover, the complementary divisor is the length of the block of k!0n −k.

This completes the proof of the Recursion Formula.

The Blockbuster Formula can be used to calculate any spectral coefficient from those in the preceding row, e.g.,

= 2 + 3 + 4 + 1 = 37 ;

= 3 + 4 + 5 + 1 = 77 ;

This shows how the Blockbuster Formula earns its name: it reveals that a block in the row n + 1 of Pascal’s triangle splits into so many blocks of various sizes in row n.

There is another method of calculating spectral coefficients, namely, as the values of the socalled spectral polynomials that we shall now describe. Consider the spectral coefficients that stand along slanting rows of slope −1 in Pascal’s triangle. For example, slanting row 2 has entries 5, 10, 17, 26, 37, 50,... which are in arithmetic progression of order 2 (numbering starts with 0). We conjecture that, in general, entries in the nth slanting row are in arithmetic progression of order n, i.e., they are values assumed by a polynomial Bn(m) of degree n. We have, for n = 0, 1, 2, 3,... k row 0:

### = 1 (constant) k row 1: k +1

### = k+2 k row 2: k+2

### = k2 + 2k + 2 = (k + 2)2 + 1 k k +3

### = k 3 + 6k 2 + 15k + 15 = ( k + 2)3 + 3( k + 2) + 1 k

. . . . . . . . . . . . . . k+n row n:

### = ( k + 2) n + ... k

. . . . . . . . . . . . . .

The polynomials Bn(m) are called spectral polynomials. The calculation above suggests that we k +n should change the variable m to m = k + 2. Then

= Bn ( k + 2) . To see that, indeed, Bn(k) are k polynomials, we only need to re-write the Recursion Formula: row 3:

### Recursion Formula for spectral polynomials

### Bn+1(k) = (k − 1) Bn(k) + Bn(k +1)

Under the initial condition B0(k) = 1 (constant) this lets us calculate the

### Table of spectral polynomials

### B1(k) = k

### B2(k) = k2 + 1

### B3(k) = k3 + 3k + 1

### B4(k) = k4 + 6k2 + 4k + 4

### B5(k) = k5 + 10k3 + 10k2 + 20k + 11

### B6(k) = k6 + 15k4 + 20k3 + 60k2 + 66k + 41

### B7(k) = k7 + 21k5 + 35k4 + 140k3 + 231k2 + 287k + 162

### B8(k) = k8 + 28k6 + 56k5 + 280k 4 + 616k3 + 1148k2 + 1296k + 715

B9(k) = k9 + 36k7 + 84k6 + 504k5 + 1386k4 + 3444k3 + 5832k2 + 6435k + 3425

B10(k) = k10 + 45k8 + 120k7 + 840k6 + 2772k5 + 8610k4 + 19440k3 + 32175k2 + 34250k + 17722

. . . . .

Note that the coefficients of the second highest degree terms are zero. By the Recursion Formula, we have: n −1

### Bn(1) = Bn−1(2) =

= bn that is, the sum of coefficients of the spectral polynomial of degree n is the Bell number bn . This could serve as a method of checking the calculation of the Bell numbers. Alternatively, if we already know them, it could be used to check the calculation of the spectral polynomials. For example, B6(1) = 1 + 15 + 20 + 60 + 66 + 41 = 203 = b6,

B8(1) = 1 + 28 + 56 + 280 + 616 + 1148 + 1296 + 715 = 4140 = b8 ;

B10(1) = 1 + 45 + 120 + 840 + 2772 + 8610 + 19440 + 32175 + 34200 + 17722 = 115975 = b10

We shall now see a number of other ways to calculate the spectral polynomials. The first is via the binomial formula: (E + k)nb0 = Bn(k +1) where E is the shift operator and b0 = 1. Alternatively, we can use the so-called symbolic notation,

### Bn(k + 1) = (b + k)n

Authors prefer to use the symbolic notation where, in the expansion of (b + k)n via the binomial formula one writes bm = bm (even though the use of the shift operator E is more transparent). We ourselves shall also be using the symbolic notation in the sequel. The expansion is called the binomial linear combination of the Bell numbers. For example, we can calculate the spectral polynomials as follows: B1(k + 1) = (b + k)1 = b1 + k = k + 1;

B2(k + 1) = (b + k)2 = b2 + 2b1k + k2 = k2 + 2k + 2 = (k + 1)2 +1;

B3(k + 1) = (b + k)3 = b3 + 3b2k + 3b1k2 + k3 = (k + 1)3 + 3(k + 1) + 1;

B4(k + 1) = (b + k)4 = b4 + 4b3k + 6b2k2 + 4b1k3 + k4 = (k + 1)4 + 6(k + 1)2 + 4(k + 1) + 4

At the end of this Chapter we shall mention another, in fact the easiest, method of calculating the successive spectral polynomials using integral calculus. The following relations exist between spectral polynomials, spectral coefficients, and the Bell numbers:

### Bn(k)

### =

### (b + k − 1)n

### = n+k −2 k −2 n k

### =

### Bn – k(k + 2)

### =

### (b + k +1)n – k

### (b + k)n

### = n + k −1 k −1

### =

### Bn (k + 1)

In Chapter 8 on Dobinski’s representation we shall add yet another formula expressing the spectral coefficients in terms of infinite series. The middle formula above has a name of its own:

### Binomial Exchange Formula n k

### = (b + k +1)n –k = Bn – k(k + 2)

The choice of name will be made clear in Volume II in the Chapter on digital exchanges. The symbolic notation can also be used to calculate spectral coefficients in terms of the Bell numbers, e.g.,

= (b + 2) 4 = b4 + 8b3 + 24b2 + 32b1 + 16 = 15 + 40 + 48 + 32 + 16 = 151 ;

= (b + 3)3 = b3 + 9b2 + 27b1 + 27 = 5 + 18 + 27 + 27 = 77 .

Recall that the entries along the slanting rows with slope + 1 of Pascal’s triangle are: n n +1 n+2 n+3 n+k

= Bn(2) = bn+1 ;

= Bk(3) ;

= Bn(k + 2) ;...

= Bn(4) ;

### = Bn(5) ; ..., k

The case n = 0 deserves further attention. In symbolic notation: bk + 1 = (b + 1)k from where we get the

### Vertical Recursion Formula for the Bell numbers

### ⎛k ⎞

### ⎛k ⎞

### ⎛ k ⎞ bk +1 = bk + ⎜ ⎟ bk −1 + ⎜ ⎟ bk −2 + ... + ⎜

### ⎟ b1 + 1

### ⎝1⎠

### ⎝2⎠

### ⎝ k − 1⎠

There is a nice combinatorial proof of this. We distinguish one of the elements of the set X of k + 1 elements, say, by calling it black while the others are white. We also call that coset of a quotient set of X black which contains the black element of X. Then we count the quotient sets of X according as they have 1, 2, 3,…, k + 1 elements in the black coset, and add.

In Chapter 5 we shall also see another, called the Horizontal Recursion Formula. The terminology will be made clear in Volume II, Chapter 11.

Our formula can be used to calculate the Bell numbers, e.g., b6 = (b +1)5 = b5 + 5b4 + 10b3 + 10b2 + 5b1 + b0 = 52 + 5(15) + 10(5) + 10(2) + 5(1) + 1 = 203.

Yet another recursion formula for the Bell numbers will be given in Chapter 5 in terms of the Stirling numbers of the first kind. An even simpler method of calculation in terms of higher differences will be discussed in Volume II. It is interesting to note that E.T. Bell developed an elaborate but wholly superfluous ‘umbral calculus’ as a result of his failure to grasp the idea that one can transfer a shift from subscript to superscript by the shift operator E. Bell was not the only one to fall into this trap. G. T. Williams [8] suffered the same fate.

As noted above, the values for k = 2, 3, 4,... of Bn(k) are just the entries that stand in slanting rows 2, 3, 4,... with slope + 1 of Pascal’s triangle. In addition, Bn(1) = bn+1 are the entries in slanting row 1. This furnishes yet another method of calculating the Bell numbers, namely, by adding up the coefficients of the spectral polynomials. In the same order of ideas we mention the Theorem. The alternating sum of the first n Bell numbers is just the constant term in the spectral polynomial Bn+1(x):

### Bn+1(0) = bn – bn−1 + bn – 2 − + ... + (−1)n +1b1

Proof. By the Recursion Formula for the spectral polynomials, Bn +1 (0) = Bn (1) − Bn (0) . Hence Bn +1 (0) = bn − Bn (0) = bk − bn −1 + Bn −1 (0) = ... = bn − bn −1 + bn −2 − +... + ( −1) n +1 b1 .

For example,

52 −15 + 5 − 2 + 1 = 58 − 17 = 41 = B6(0)

203 – 52 + 15 – 5 + 2 – 1 = 162 = B7 (0)

877 – 203 + 53 – 15 + 5 – 2 + 1 = 715 = B8(0)

We note that the spectral polynomials satisfy the differential equation Bn′(x) = nBn −1(x) which makes it possible to calculate them through successive integration:

Bn+1(x) = (n + 1) ∫ Bn(x)dx + C where the constant C = Bn +1(0) can be obtained as the alternating sum of the Bell numbers. It can also be obtained as C = bn − Bn (0). For example, if we know that

B4(x) = x4 + 6x2 + 4x + 4, then we can write:

B5(x) = 5(x5/5 + 6x3/3 + 4x2/2 + 4x) + C = x5 + 10x3 + 10x2 + 20x + C where C = B5(0) = b4 − b3 + b2 − b1 = 15 − 5 + 2 − 1 = 11. In this way we can calculate the successive spectral polynomials from B1(x) = x through the indefinite integral, provided that we have the sequence of the Bell numbers.

To recapitulate, in the slanting rows of slope −1 of Pascal’s triangle for the spectral n+k −2 with n fixed and k = 2, 3, 4,… These numbers are coefficients (see p 47) we find Bn(k) = k −2 in an arithmetic progression of order n. One can check that the nth difference sequence is constant and is equal to n! For example, the entries in row 2: 5, 10, 17, 26, 37, 50,..., are in arithmetic progression of order two, and the second difference sequence is constant equal to 2 = 2!; those in row three: 15, 37, 77, 141, 235,...are in arithmetic progression of order three and the third difference sequence is constant equal to 6 = 3!; those in row four: 52, 151, 372, 799, 1540,... are in arithmetic progression of order four and the fourth difference sequence is constant equal to 24 = 4!, etc. The property that entries in the slanting rows of slope −1 are in arithmetic progression is shared by Pascal’s triangle for the binomial coefficients (see Chapter 2) and the Stirling numbers of either kind (Chapters 5 and 6).

Indeed, it is this fact that is responsible for the striking repetitive fractal pattern revealed by the Sierpinski triangles (mod p), where p is a prime number.

We have also treated entries in the slanting rows of slope + 1. They are, once more, the numbers Bn(k) = n+k −2 where this time it is k that is fixed and n = 0, 1, 2, 3,… is variable. Thus k −2 for k = 2, Bn(2) = n +1 n

= (b + yields the Bell numbers 1, 2, 5, 15, 52,…; for k = 3, Bn(3) =

2)n yields the numbers 1, 3, 10, 37,…; for k = 4, Bn(4) =

1, 4, 17, 77,…; for k = 5, Bn(5) = n+2

### = (b + 3)n yields the numbers n+3

### = (b + 4)n yields the numbers 1, 5, 26, 141,…

In this Chapter we have seen three roles that the spectral coefficients play: (1) they are the lengths of blocks of consecutive stepnumbers from a pure stepnumber to the highest pure stepnumber of the same number of digits; (2) they furnish the values of the spectral polynomials; (3) they are the binomial linear combinations of consecutive Bell numbers. To this we shall add two more roles that the spectral coefficients have. In Chapter 7 we shall see that the spectral coefficients furnish the variable the variable place value of digits in the stepnumber system. In Chapter 8 we shall discuss Dobinski’s representation of the Bell numbers in terms of infinite series. This representation can be extended to the binomial linear combinations of the Bell numbers with the result that the spectral coefficients also have their own Dobinski representation.

Further results on the Bell numbers can be found in the Exercises. Chapter 6 on the Stirling numbers the second kind has further information concerning the Bell numbers.

### Exercises

1. Show that the coefficients cn,m , cn,m+1 , cn,m+1 ,... of the spectral polynomials Bn(k) are in arithmetic progression of order k. Find k in terms of m. Calculate the kth difference sequence. 2. Derive the Recursion Formula for the coefficients cn,m of the spectral polynomials Bn(k).

3. Show that the coefficients of Bp(x), with the exception of the first and last, are divisible by p, provided that p is a prime number. Is this true or false for a composite number?

4. Show that the coefficients of B pn ( x ) , with the exception of the firs and last, are divisible by the prime number p.

5. Put the coefficients of Bm(x) for m = 1, 2, 3,... into Pascal’s and pass to Sierpinski’s triangle (mod p). Describe the pattern that comes along.

6. Show that cp,0 ≡ 1 (mod p), where cp0 is the constant term of the spectral polynomial Bp(x), provided that p is a prime number.

7. The smallest n whose stepnumber representation has fewer digits than its decimal is 58.

True or false: every number larger than n must have the same property.

8. Prove that 1n + 1n = 10n+1 + 1 for n = 0, 1, 2, 3,...

9. Show that (b − 1)n = bn – 1 − bn – 2 + ... + (−1)nb1 and, from this, get another recursion formula for bn . Use this result to calculate bn up to n = 6.

10. Show that the spectral coefficients standing in slanting row m with slope −1 of Pascal’s triangle are in arithmetic progression of order k. Find k in terms of m. Calculate the kth difference sequence.

11. Construct the Sierpinski triangles (mod p) of the spectral coefficients, for p = 2, 3, 5, 7.

Describe the pattern that comes along.

12. Prove that the spectral polynomials satisfy the differential equation

### Bn′(x) = nBn – 1(x)

### (Hint: Use Maclaurin’s Formula.)

13. Solve the system of linear equations with infinitely many unknowns

1x1 = b1

1x1 + 1x2 = b2

1x1 + 2x2 + 1x3 = b3

1x1 + 3x2 + 3x3 + 1x4 = b4

. . . . . . where on the left hand side we have the binomial coefficients, and check.

14. Solve the system of linear equations with infinitely many unknowns

1x1 = b0

### – 1x1 + 1x2 = b1

1x1 – 2x2 + 1x3 = b2

### – 1x1 + 3x2 – 3x3 + 1x4 = b3

. . . . . . where on the left hand side we have the binomial coefficients with alternating signature.

Check.

15. Using the Recursion Formula, calculate the entries in row 13 of Pascal’s triangle for the spectral coefficients, starting with 1 on the far right and proceeding to the left. For example, = 1 + 13

= 1 + 13 = 14 ;

### = 14 + 12

= 14 + 156 = 170 ;

= 170 + 11 = ...

16. Show that bn ≡ 0 (mod 2) ⇔ n ≡ 2 (mod 3). In other words, b2 and every third Bell number thereafter is even, and all the others are odd.

17. Show that, more generally, for any fixed k, n

### ≡ 0 (mod 2) ⇔ n ≡ 2 (mod 3) k

18. Show that Bk (0) + Bk −1 (0) = bk for k = 2, 3, 4, …

In the following exercises, p is a prime number.

19. Show that B p +1 (0) ≡ 2 (mod p).

20. True or false?

B pn +1 (1) ≡ 2 (mod p).

21. Put Cn = bn − bn −1 + bn −2 − +... + ( −1) p +1 b1 . Show that:

### (a) Cp ≡ 1

### (mod p); (b) C p +1 ≡ 1 (mod p); (c) C p + 2 ≡ 2 (mod p)

22. Show that: (a) B p (1) ≡ 2 (mod p);

### (b) B p + 2 (1) ≡ 7 (mod p)

23. Show that: (a) B p (2) ≡ 2 (mod p); (b) B p +1 (2) ≡ 3 (mod p); (c) B p + 2 (2) ≡ 7 (mod p); (d) B p +3 (2) ≡ 20 (mod p)

24. Show that: (a) B2 p (2) ≡ 5 (mod p); (b) B3 p (2) ≡ 15 (mod p); (d) B4 p (2) ≡ 19 (mod p) 25. Show that Bk+1(1) = Bk(2)

26. Show that Bk+1(2) = Bk+1(1) + Bk(3)

27. Solve the differential equation dn y

= n ! under the initial conditions y(k)(1) = k!bn−k dx n for k = 1, 2, 3,…, n.

28. Solve the system of linear equations with infinitely many unknowns

1x1 = y1

2x1 + 1x2 = y2

5x1 + 3x2 + 1x3 = y3

15x1 + 10x2 + 4x3 + 1x4 = y4

52x1 + 37x2 + 17x3 + 5x4 + 1x5 = y5

. . . . . . . . . . . where on the LHS the coefficients are the entries in Pascal’s triangle for the spectral coefficients, by the method of expressing the unknowns one after another from one equation and substituting the previously obtained values into it…

---

# Stepnumbers: Introduction

URL: https://newaustrianeconomics.com/archive/fekete/stepnumbers-introduction/
Date: 2010-01-01
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete introduces the Stepnumber system — a positional number system using infinitely many digits and variable positional values — as an alternative to the binary system. He argues the stepnumber system is more natural than binary because, like binary, it does not depend on an arbitrary base, but unlike binary, it represents large numbers far more compactly.
Editorial Note: Introduction to Fekete's Stepnumbers monograph (c. 2010), setting out the theoretical motivation for a number system with infinitely many digits and explaining its relationship to the binary system and Cantor's transfinite ordinals.
Original PDF: https://professorfekete.com/articles/BSTEP-introduction.pdf

1000. The rule of enumeration endows the binary number system with a natural order of magnitude.

The value of a binary number is just its ordinal under the natural order.

The table on the next page displays the first one hundred consecutive binary numbers in lexicographic order. The arrangement in ten columns helps finding their value quickly. For example, we have 1111 = 15 because 1111 stands in the first row and fifth column (the numbering of rows and columns starts with zero); 100000 = 32 as it stands in the third row, second column. The binary numbers 1, 10, 100,... are just the powers of 2: 10n = 2n.

### Table of the first one hundred consecutive binary numbers

1000

1001

1010

1011

1100

1101

1110

1111

10000

10001

10010

10011

10100

10101

10110

10111

11000

11001

11010

11011

11100

11101

11110

11111

100000

100001

100010

100011

100100

100101

100101

100110

100111

101000

101001

101010

101011

101100

101101

101110

101111

110000

110001

110011

110100

110101

110110

110111

111000

111001

111010

111011

111100

111101

111110

111111

1000000

1000001

1000010

1000011

1000100

1000101

1000110

1000111

1001000

1001001

1001010

1001011

1001100

1001101

1001110

1001111

1010000

1010001

1010010

1010011

1010100

1010101

1010110

1010111

1011000

1011001

1011010

1011011

1011100

1011101

1011110

1011111

1100000

1100001

1100010

1100011

The table can also be used for performing addition and subtraction of binary numbers, following the Slide Rule Principle. For example, in calculating the sum 10011 + 1001111 we locate the larger number in the table and move forward through a number of steps that corresponds to the smaller number 10011 = 19 to get 10011 + 1001111 = 1100010. To check, we write: 79 + 19 = 98 =

1100010, the binary number in row 9 and column 8. In calculating the difference 1001000 – 11100 we move backwards from 1001000 through 11100 = 28 steps to get 101011. To check we write:

72 – 28 = 44 = 101011, the binary number in row 4 and column 4.

There is a natural isomorphism between the binary number system and the graded lattice of finite subsets. In more details, consider

= {1, 2, 3,..., n,...}, the set of natural numbers, and its subsets n = {1, 2, 3,..., n}. n form a lattice for every n = 1, 2, 3,... under inclusion. The union of these is a graded lattice with grading furnished by n, the number of digits. A binary number of at most n digits can be interpreted as a characteristic function of n , provided that we add a sufficient number of 0 digits up front to make it a binary number of exactly n digits (which, of course, will not affect its value). This is a one-to-one correspondence between binary numbers and finite subsets. It can be extended to a lattice isomorphism. It does not depend on arbitrary choices. In enumerating binary numbers we actually construct all finite subsets. Thus binary numbers can be used to count the number of subsets. The great utility of the binary number system is due mostly to this fact, which is not widely recognized. The binary number system owes its naturality to the existence of this natural isomorphism.

---

In order to be able to count in the binary number system we introduce names for the two digits: 0 ala, 1 ale. We also introduce names for the numbers 10n called ‘milestones’ as follows. We adopt a variation of the paradigm million, billion, trillion, etc. modified and simplified by using permutations of the five vowels a, e, i, o, u. Using the names of the milestones on the following page we can count in the binary system on the same principle as we do in the decimal system, thus: 0 ala, 1 ale, 10 mala, 11 mala ale, 100 bala, 101 bala ale, 110 bala mala, 111 bala mala ale, 1000 trala, 1001 trala ale, 1010 trala mala, 1100 trala bala, 1101 trala bala ale,

1110 trala bala mala, 1111 trala bala mala ale, 10000 quadrala, 10001 quadrala ale, etc.

NAMES OF MILESTONES mala bala trala quadrala pentala hexala heptala octala novala

1050

1051

1052

1053

1054

1055

1056

1057

1058

1059 halla malla balla tralla quadralla pentalla hexalla heptalla octalla novalla

1010

1011

1012

1013

1014

1015

1016

1017

1018

1019 hale male bale trale quadrale pentale hexale heptale octale novale

1060

1061

1062

1063

1064

1065

1066

1067

1068

1069 halle malle balle tralle quadralle pentalle hexalle heptalle octalle novalle

1020

1021

1022

1023

1024

1025

1026

1027

1028

1029 hali mali bali trali quadrali pentali hexali heptali octali novali

1070

1071

1072

1073

1074

1075

1076

1077

1078

1079 halli malli balli tralli quadralli pentalli hexalli heptalli octalli novalli

1030

1031

1032

1033

1034

1035

1036

1037

1038

1039 halo malo balo tralo quadralo pentalo hexalo heptalo octalo novalo

1080

1081

1082

1083

1084

1085

1086

1087

1088

1089 hallo mallo ballo trallo quadrallo pentallo hexallo heptallo octallo novallo

1040

1041

1042

1043

1044

1045

1046

1047

1048

1049 halu malu balu tralu quadralu pentalu hexalu heptalu octalu novalu

1090

1091

1092

1093

1094

1095

1096

1097

1098

1099 hallu mallu ballu trallu quadrallu pentallu hexallu heptallu octallu novallu Second order milestones are the stepnumbers 1010n . Their names are as follows:

## Names Of Second Order Milestones

1010

1020

1030

1040

1050

1060

1070

1080

1090 hale hali halo halu halla halle halli hallo hallu

10500

10510

10520

10530

10540

10550

10560

10570

10580

10590 halya halye halyi halyo halyu hallya hallye hallyi hallyo hallyu

10100

10110

10120

10130

10140

10150

10160

10170

10180

10190 hela hele heli helo helu hella helle helli hello hellu

10600

10610

10620

10630

10640

10650

10660

10670

10680

10690 helya helye helyi helyo helyu hellya hellye hellyi hellyo hellyu

10200

10210

10220

10230

10240

10250

10260

10270

10280

10290 hila hile hili hilo hilu hilla hille hilli hillo hillu

10700

10710

10720

10730

10740

10750

10760

10770

10780

10790 hilya hilye hilyi hilyo hilyu hillya hillye hillyi hillyo hillyu

10300

10310

10320

10330

10340

10350

10360

10370

10380

10390 hola hole holi holo holu holla holle holli hollo hollu

10800

10810

10820

10830

10840

10850

10860

10870

10880

10890 holya holye holyi holyo holyu hollya hollye hollyi hollyo hollyu

10400

10410

10420

10430

10440

10450

10460

10470

10480

10490 hula hule huli hulo hulu hulla hulle hulli hullo hullu

10900

10910

10920

10930

10940

10950

10960

10970

10980

10990 hulya hulye hulyi hulyo hulyu hullya hullye hullyi hullyo hullyu For example, we have: 10401 mula, 10402 bula, 10403 trula, 10404 quadrula, 10405 pentula,

10406 hexula, 10407 septula, 10408 octula, 10409 novula; 10410 hule, 10411 mule, 10412 bule, etc.

### Table of the first three hundred consecutive stepnumbers

1000

1001

1002

1010

1011

1012

1020

1021

1022

1023

1100

1101

1102

1110

1111

1112

1120

1121

1122

1123

1200

1201

1202

1203

1210

1211

1212

1213

1220

1221

1222

1223

1230

1231

1232

1233

1234

10000

10001

10002

10010

10011

10012

10020

10021

10022

10023

10100

10101

10102

10110

10111

10112

10120

10121

10122

10123

10200

10201

10202

10203

10210

10211

10212

10213

10220

10221

10222

10223

10230

10231

10232

10233

10234

11000

11001

11002

11010

11011

11012

11020

11021

11022

11023

11100

11101

11102

11110

11111

11112

11120

11121

11122

11123

11200

11201

11202

11203

11210

11211

11212

11213

11220

11221

11222

11223

11230

11231

11232

11233

11234

12000

12001

12002

12003

12010

12011

12012

12013

12020

12021

12022

12023

12030

12031

12032

12033

12034

12100

12101

12102

12103

12110

12111

12112

12113

12120

12121

12122

12123

12130

12131

12132

12133

12134

12200

12201

12202

12203

12210

12211

12212

12213

12220

12221

12222

12223

12230

12231

12232

12233

12234

12300

12301

12302

12303

12304

12310

12311

12312

12313

12314

12320

12321

12322

12323

12324

12330

12331

12332

12333

12334

12340

12341

12342

12343

12344

12345

100000

100001

100002

100010

100011

100012

100020

100021

100022

100023

100100

100101

100102

100110

100111

100112

100120

100121

100122

100123

100200

100201

100202

100203

100210

100211

100212

100213

100220

100221

100222

100223

100230

100231

100232

100233

100234

101000

101001

101002

101010

101011

101012

101020

101021

101022

101023

101100

101101

101102

101110

101111

101112

101120

101121

101122

101123

101200

101201

101202

101203

101210

101211

101212

101213

101220

101221

101222

101223

101230

101231

101232

101233

101234

102000

102001

102002

102003

102010

102011

102012

102013

102020

102021

102022

102023

102030

102031

102032

102033

102034

102100

102101

102102

102103

102110

102111

The question arises whether there exist other natural number systems beside the binary. The decimal number system is clearly not natural as it depends on the arbitrary choice of the base 10. If we want to change it, we can go in either one of two directions. If we lower it, then fewer digits will suffice at the price of having to cope with longer strings of digits. If we increase it, then we get shorter strings of digits at the price of having to cope with a larger inventory of digits. In exercising the first choice we go to the extreme and get the simplest number system using only two digits: 0 and 1. This is the natural number system of the binary numbers. However, simplicity comes at a price: the string of digits has maximal length. All other number systems are more economical in that they work with shorter strings of digits. As one may expect, further development of science will necessitate the use of ever larger numbers. At one point the price we pay for simplicity may become prohibitive. The length of strings of digits may outpace the memory and manipulative capabilities of the best computers for very large numbers. The binary number system may well become obsolete. We should not be too complacent in this regard.

The other choice is to increase the base. As we do, the string of digits becomes shorter, but at the price that we shall need ever more digits. Can we minimize the string of digits for very large numbers? Does it make sense to talk about infinitely many digits? It turns out that the answer to these questions is “yes”. There is another natural number system at the far end of the rainbow: that of the stepnumbers. It minimizes the string of digits and so it is ideally suited for calculations with very large numbers.

The same conventions will be used for the stepnumbers as we have introduced for the binary numbers. In particular, we also print them in bold-face type: 1, 10, 11, 12, 100, 101, 102, 110, 111, 112, 120, 121, 122, 123, 1000,... Thus we may write 5 = 100 ≠ 100, 123 = 14, 14 + 1 = 15 = 1000.

The convention for subscripts applies, e.g., 102 = 100, 1203 = 12000, 13 = 111, 1322 = 11122.

We shall also write k! = 123...k where k is the kth digit for every natural number k.

Remember that n! ≠ n! We also use the notation k!0n – k for the n-digit stepnumber 123...k00...0 where the number of 0 digits is n – k. By convention 0! = 0. Note that k! can be characterized as the largest stepnumber with k digits, whereas the smallest one with k digits is 10k – 1 = bk , the kth Bell number, see Chapter 4. The consecutive Bell numbers are: b1 = 1, b2 = 10 = 2, b3 = 100 = 5, b4 = 1000 = 15, b5 = 10000 = 52, b6 = 105 = 203, b7 = 877, b8 = 4140, b9 = 21,147, b10 = 115,975, b11 = 678,570, b12 = 4,213,597,… A table of the Bell numbers can be found at the end of this book.

In Chapter 1 we shall continue the sequence of the ten decimal digits by adding infinitely many digits, the so-called rainbow digits. They are the decimal digits written in the colors of the rainbow. The table on the previous page lists the first three hundred consecutive stepnumbers in lexicographic order. Stepnumbers, just as binary numbers, can be introduced heuristically by enumerating them under the lexicographic order subject to the following restrictions.

(1) The Stepnumber Principle states that no digit can be higher than the highest digit to its left plus 1;

(2) the Overflow Principle states that in increasing a maximal digit by 1 we replace it with 0 and add 1 to the adjacent digit to the left.

The extreme case is furnished by the Overflow Formula: n! + 1 = 10n which is triggered by the stepnumbers 1, 12, 123,..., e.g., 123 + 1 = 1000.

The rule of enumeration endows the stepnumber system with a natural order of magnitude. The value of a stepnumber is just its ordinal under the natural order. The arrangement in ten columns is designed to help finding the value of stepnumbers in the table quickly. For example, we have 1111 = 29 because 1111 stands in the second row and ninth column (the numbering of rows and Just as for binary numbers, the table for stepnumbers can also be used for performing addition and subtraction, following the Slide Rule Principle. For example, in calculating the sum 100 + 10000 we locate the larger number and from there move forward through 100 = 5 steps to get: 100 + 10000 = 10012. To check we write 5 + 52 = 57 = 10012. In calculating the difference 101233 – 12233, in the table we move backwards from 101233 through 12233 = 176 steps to get: 101233 – 12233 = 11100.

To check we write: 276 – 176 = 100 = 11100.

The stepnumbers form another number system that is natural in the sense that there is a natural isomorphism between the stepnumber system and the graded lattice of finite quotient sets. In more details, consider = {1, 2, 3,..., n,...}, the set of natural numbers and its subsets n = {1, 2, 3,..., n} of n elements. The quotient sets of n form a lattice under rarefaction, the opposite of refinement (see Appendix). The union of the lattices n for all n is a graded lattice. Grading is furnished by the number n of elements of n , i.e., the number of digits. Every stepnumber of at most n digits can be interpreted as a characteristic function of n , provided that we add a sufficient number of 0 digits up front to make it a stepnumber of exactly n digits (this of course will not affect its value). There is a one-to-one correspondence between the set of stepnumbers and the graded lattice of finite quotient sets. The former is endowed by a lattice structure under this correspondence, and we shall refer to it as the natural isomorphism between the stepnumber system and the graded lattice of finite quotient sets. It is also natural in that it does not depend on arbitrary choices such as, e.g., the basis of the number system.

Thus the stepnumber system is dual to its analogue, the binary number system. In enumerating stepnumbers we actually construct all finite quotient sets. For example, there are 15 quotient sets of a set of 4 elements, and there are 15 stepnumbers of at most 3 digits:

0, 1, 10, 11, 12, 100, 101, 102, 110, 111, 112, 120, 121, 122, 123

In writing them in up-front-0 notation, they become uniformly 4-digit stepnumbers:

0000, 0001, 0010, 0011, 0012, 0100, 0101, 0102, 0110, 0111, 0112, 0120, 0121, 0122, 0123 exhibiting the quotient sets of the set of the four places of 4-digit stepnumbers, where the classes are marked by the digit 0, 1, 2, 3.

Stepnumbers can be used to count the number of finite quotient sets. This new number system is also expected to have great utility, especially in information technology. Indeed, it may well be the number system of the future to encode information by quantum computers. Unlike the present generation of computers which are based on classical physics, quantum computers are based on quantum mechanics. In particular, the state of an electron of the atom is the new bit, or unit of information, corresponding to a stepnumber digit. The variable admissible orbits of electrons in an atom, which are discrete and ordered according to increasing radius, epitomize the variable positional values of digits in the stepnumber system.

The stepnumber system overcomes the handicap of the binary of being unwieldy due to the inordinate length of the strings of digits for very large numbers. Writing a sufficiently large number in stepnumber form will take fewer digits than it does in the binary or in any other number system with base n, however large n may be. This property is expressed by saying that the stepnumber system enables one to write very large numbers in their most compact form.

In the decimal system we are forced to do rounding at the expense of accuracy every time an extra large number presents itself. Rounding is made unnecessary, and there is no loss of accuracy, if we are using the stepnumber system.

In order to be able to count in the stepnumber system we introduce names for the digits. For the first eleven, these are:

0 ala, 1 ale, 2 ali, 3 alo, 4 alu, 5 alla, 6 alle, 7 alli, 8 allo, 9 allu, 10 mala

This already suggests that, for the Bell numbers, we shall retain the names for the milestones and also that of the secondary milestones (see pp 3, 4):

10 mala, 102 bala, 103 trala, 104 quadrala, 105 pantala, 106 hexala, 107 heptala, 108 octala,… 1010 hale, 1020 hali, 1030 halo, 1040 halu, 1050 halla, 1060 halle, 1070 halli, 1080 hallo, 1090 hallu,… In Chapter 1 we shall see the rule how to obtain the names of the rest of the (infinitely many) rainbow digits. Here, once again, the permutations of the five vowels a, e, i, o, u will play a role. Counting in the stepnumber system uses a different principle from that used in the decimal and the binary systems. The reason for this is the variable place value of the digits, a feature of stepnumbers unknown for the decimals and the binary numbers. To count, we read out the names of the digits from left to right, including 0 ala, and repeating if necessary, thus:

0 ala, 1 ale, 10 mala, 11 ale ale, 12 ale ali, 100 bala, 101 ale ala ale, 102 ale ala ale,

110 ale ale ala, 111 ale ale ale, 112 ale ale ali, 120 ale ale ali, 122 ale ali ali, 123 ale ali alo, 1000 trala, 1001 ale ala ala ale, 1002 ale ala ala ali, 1010 ale ala ale ala, 1011 ale ala ale ale,…


---


One of the great remaining mysteries in mathematics is the question whether a formula exists whereby consecutive prime numbers can be calculated. The conjecture is still outstanding that such a formula does not exist in the same sense as the set of all sets doesn’t. If this is the case, then the best one can hope for is a rapid development of various algorithms to find ever larger prime numbers. This raises the possibility of decoupling between substance and form. Finding the substance, namely, ever larger prime numbers, may outpace the form in which the new information can be put. Information technology, in particular the binary number system, may be an obstruction. The physical limitations of computer memory could defeat our efforts to forge ahead with the theory, in want of a better facility to handle very large numbers. The quantum computer reinforced with the stepnumber system fitting as a glove opens up new perspectives in computing.

Philosophy has been grappling with the dichotomy of substance and form for thousands of years. It tacitly assumes that they are inseparable as guardians of the depository of knowledge.

Decoupling would most certainly create a crisis of the first magnitude. The discovery of stepnumbers opens a new chapter in philosophy in that it extends the tenure of the partnership of substance and form in storing, transmitting, retrieving, or otherwise manipulating and organizing information.

---

# Stepnumbers: Foreword to the First Edition

URL: https://newaustrianeconomics.com/archive/fekete/stepnumbers-foreword/
Date: 1998-01-01
Section: Mathematics
Difficulty: scholarly
Concept Tags: new-austrian-economics
Description: Fekete introduces his Stepnumbers project — a mathematical system devised originally for the education of the blind — explaining how abstract mathematics, when properly structured, can be made accessible to sightless students. He describes his motivations as a retired professor of mathematics and outlines the broader pedagogical principles behind the stepnumber approach.
Editorial Note: Foreword to the first edition of Fekete's Stepnumbers (1998), a mathematical monograph developed during his retirement. The Stepnumber system is his most technically original contribution to pure mathematics.
Original PDF: https://professorfekete.com/articles/ASTEP-foreword.pdf

## Foreword To The First Edition Of 1998

This is a personal note explaining the nature of this publication, outlining the larger design that has animated its writing. I took early retirement as professor of mathematics and subsequently decided that I wanted to dedicate myself to the cause of mathematics education of the blind. I am sighted and have, as most of my colleagues, had virtually no contact during my teaching career with sightless students. But the abstract nature of my discipline has often made me think about the problem how best to educate talented blind children in mathematics and information technology.

It has always been clear to me that the curriculum and the didactic aims of such a program would have to be radically different from its conventional counterpart. It must not be a mere adaptation of traditional material to the special needs of the blind. It ought to contain material the sightless can absorb and manipulate better than the sighted. I also believe that the problem must be approached not only with sensitivity but also with a great deal of humility. This is a case par excellence where the teacher must learn from the student. The sightless are less prone to succumb to what I call “the gravitation of atavistic visual imagery”, the greatest obstacle in the way of the single-minded pursuit of abstraction that permeates all mathematical enterprise. Some of the greatest cultivators of mathematics were blind (the names of Euler, Lefschetz, and Pontryagin readily come to mind) doing inspired work even in the field of geometry where eyesight had been thought to be a paramount prerequisite. It is a great pity that they did not leave reminiscences to posterity on the question whether or how their handicap may have helped them to sharpen their faculty of abstract thinking. Be that as it may, we must deem it possible that the sightless, given the nature of their handicap, may have more than an equal chance to develop their mathematical abilities to the fullest extent, granted ideal conditions. A lot of talent may have been wasted in giving blind children skills in basket weaving and massaging, rather than mathematics.

Early in my academic career I became fascinated with what Nicolas Bourbaki has in the first book of his series Elements of Mathematics, first published in 1937, called quotient sets. In particular I was interested in the ‘weak’ duality between the theory of subsets and the theory of quotient sets. (Duality is discussed in the projected Volume II.) In spite of the great popularity of Bourbaki, the subject has failed to stimulate interest in the mathematical community, nor has the term ‘quotient set’ gained currency since its introduction well over half-a-century ago. Equivalent but misleading terms such as "partitions" preferred by set theorists and "block design" preferred by combinatorists still dominate the literature. Unified notation for the number of quotient sets and quotient set types is still wanting. Deplorable as the lack of uniform terminology and symbolism may be, even more serious is the fact that the theory of quotient set is the Cinderella of mathematics, especially of mathematics education. If textbooks and treatises mention it at all, the effort hardly goes beyond paying lip service. A comprehensive bibliography of the subject is still waiting to be compiled. Its classification shows great inconsistency, even confusion. Authors, among others, Gian Carlo Rota, switch allegiance between competing schools with different terminologies, symbolism, and conceptual outlook, making it difficult for the researcher to follow their output. Editors, referees, and reviewers of learned journals are often ignorant about the central importance of the subject.

They tend to treat submissions trying to rectify the situation in an offhand fashion.

Yet a quotient set is one of the great unifying ideas in all mathematics. It cuts through various disciplines as no imposed structure on the underlying set is assumed. Quotient sets, like subsets, are natural in the sense of not being subject to prior choices such as structures (as do most vii mathematical concepts in the vogue today, causing fragmentation of the discipline). And, above all, set theory is not complete without an explicit recognition of a weak duality between the lattice of subsets and the lattice of quotient sets. We have every reason to believe that, sooner or later, information technology will embrace the concept of quotient sets as a vehicle towards improved information efficiency.

In addition, I find it hard to escape the conclusion that the very concept of a quotient set may furnish the missing link in the mathematics education of the blind. Louis Braille (1809-1852) used the non-trivial subsets of the six-cell MM as raw material for codes out of which he fashioned his system of reading for the blind. Nobody today would dispute the proposition that the adoption of the Braille code was one of the great success stories of the 19th century. Perhaps the abstract nature of the concept of subsets, de-emphasizing as it does the visual aspects of the code, has something to do with it. At any rate, with the development of science there was soon need for more codes to accommodate an increasing list of essential symbols. And it was here that a historical mistake was made by the experts. Encouraged by the success of Braille, they became his epigoni. They slavishly copied a successful idea, but without the inspiration animating the original. The experts replaced the six-cell with an eight-cell, thus increasing the inventory of available codes from 26 − 1 = 63 to 28 – 1 = 255. They failed to realize, however, that the eight-cell covers a larger surface area.

Therefore the blind reader will have to track codes vertically as well where previously horizontal tracking sufficed, with the result that the reading process would be slowed down considerably. The failure of the eight-cell system gave me the impetus to start advocating the use of quotient sets for the purpose of enlarging the inventory of codes. The original six-cell of Braille has 203 quotient sets in addition to the 63 non-trivial subsets already in use. The combined number 203 + 63 = 266 exceeds 255, the size of the inventory of eight-cell codes. Further augmentation of the system is still possible if we include the quotient sets of the three-, four-, and five-cells. Most importantly, none of the new proposed codes has a larger surface area than the original six-cell of Braille, so that there is no reason to believe that the efficiency of an experienced reader would be dulled on account of the increase in the size of the inventory. Horizontal tracking is all that is needed, as before. No vertical tracking — no handicap.

There is a larger issue here than that of parochial rivalries between the various competing systems to augment the original Braille. Quotient sets furnish the ideal tool for the mathematical education of the blind. They are completely non-visual and, for all we know, a sightless person may have a better chance to grasp their true nature and to manipulate them than a sighted one. Counting quotient sets is a rich source of meaningful exercises that could fill many hours devoted to homework. Quotient sets are also important for the promise they hold out to increase information efficiency when used in coding. The entire corpus of 10,000 Chinese telegraphic codes can be rendered as quotient sets of the nine-cell, with more than 11,000 quotient sets left over and available for other purposes.

While working on the problem to include the quotient sets of the six-cell in order to augment Braille, I stumbled over a novel number system: that of the stepnumbers. These numbers can deputize for quotient sets in exactly the same way as binary numbers do for subsets. Stepnumbers can be used not only to count the number of quotient sets, but also to calculate their superimposition and amalgamation (lattice operations, dual concepts of the union and intersection of subsets under weak duality). viii

Since the stepnumber system calls for an inventory of infinitely many digits, the problem has arisen how to furnish it in the most efficient way. In searching for a solution I discovered new digits, the so-called rainbow digits obtained by coloring the decimal digits with the standard colors of the rainbow spectrum in the following order: black red brown orange yellow green viridia n blue indigo violet

### █

### █

### █

### █

### █

### █

### █

### █

### █

### █

Further colors are derived from the standard ones by passing to their various shades. The first b21 = 474,869,816,156,751 stepnumbers involving black and red decimal digits only will admit the writing of stepnumber expansions of very large numbers already. Apparently, there is no practical need to go to the brown color and beyond, at least for the time being.

The rainbow digits have a mnemotechnical significance: in no way do they tax human memory. Large stepnumbers can be coded in rainbow digits with the same ease as smaller ones can in decimal digits. And they can also be deciphered with the same ease.

Out of these discoveries sprang the work Stepnumbers the reader now beholds. I have chosen an unconventional way to publish it, as part of a new series of occasional papers sponsored by the Mathematics for the Blind Foundation. Contributions from authors to this series are hereby invited.

The Foundation's main purpose is talent-education in the field of mathematics and information technology, aimed at directly benefitting the blind. It has plans to set up a comprehensive library of mathematical texts, monographs, and treatises, making it accessible for the blind world-wide through the internet. Other plans call for the establishment of an international school for talent-education of the blind in the field of mathematics and information technology. The school will probably be located in Budapest, Hungary, the home of my alma mater the Loránt

Eötvös University, where the Department of Information Technology is already doing praiseworthy work in this area.

---

*December 8, 1998.*

### Antal E. Fekete

### Memorial University of Newfoundland

### Acknowledgements

I wish to express my gratitude to my friend and colleague, Siegfried Thomeier, for drawing my attention to a 1697 letter of Leibniz and to the design of the medallion therein, now adorning this publication as a frontispiece, as well as for many hours of valuable discussion on the subject matter. I am indebted to Donald E. Knuth for the explicit formula for the factorial coefficients (Chapter 3). I also thank him for telling me that the ‘politically correct’ name for converting stepnumbers into decimals is “ranking algorithm for set partitions”. Armed with this knowledge I have been able to track down some pioneering papers on the subject by George Hutchinson [6] and by S. G. Williamson [7] published in 1976. ix

## Foreword To The Second Edition

The binary number system was invented in 1697 by Gottfried Wilhelm Leibniz (1646-1716) who gave expression to his jubilation with his cry eureka: “One has created everything from nothing”, engraved on a medallion of his own design (see Frontispiece).

I invented the stepnumber system 300 years later, in 1997. The reader may forgive my own cry eureka: “Substance perishes, but form lives forever!”. It suggests that the significance of the stepnumber system eclipses that of the binary that epitomizes substance as opposed to form, the latter being the epitomy of stepnumbers.

The significance of the binary number system was not really appreciated before the computer revolution. By this metric, the significance of the stepnumber system may not be recognized for a couple of centuries. The binary system, “the mother tongue of computing”, is far too entrenched. It may appear that the computer revolution has made the enthronement of the binary number system all but irrevocable.

Yet we ought to guard ourselves against making hasty predictions about the future. The binary number system owes its adaptability to three facts from physics. The first is that there are two kinds of magnetic charge: North and South. It is this fact that makes erasable magnetic disks and tapes suitable for recording information in binary code for storage. The second is that there are two possible states of a capacitor: uncharged and charged. It is this fact that makes transmitting information in binary code easy. The third is that there are two possible states in regard to an electric circuit: open and closed. It is this fact that makes retrieving information in binary code possible.

However, with the advent of semiconductors, erasable etching of information on a laser disk, and quantum computers — in particular, the possibility of using the orbit structure of electrons in the atom for coding purposes — one can no longer be certain about the permanent hegemony of a blackand-white binary system. The full spectrum of colors is threatening to displace it. With further advances of technology codes using an unspecified number of digits are conceivable.

The binary system may indeed become obsolete for most applications involving extremely large numbers which are not yet but may well become the staple of science in the future. Clearly, it is wasteful, inefficient, and uneconomic. We have to find the optimal number system employing more than two digits. It may appear that cultivators of mathematics have been tardy in preparing the stage for the next phase of the computer revolution. We don't seem to have a clear idea how to go about increasing information efficiency and economy by increasing the base of a number system, or where to stop. Can we admit infinitely many digits without losing the advantage of positional value, which is the mainstay of the economy and efficiency of a number system? Clearly, a new idea is needed before we can make further headway with the problem of improving information efficiency by graduating to a more versatile number system.

The stepnumber system is the dual of the binary number system. It furnishes the missing number system at the far-end of the spectrum: the number system with base n, as n → ∞. The stepnumber system compares to the binary as color TV does to the black-and-white. We may assume x that in the quantum computer of the future the fundamental unit of information will not be the bit of the binary system: the binary digits with their rigidly fixed positional value. It will probably be the new bit of the stepnumber system: the rainbow digits

0123456789012345678901234567890123456789012345678901234567890123456789012345678901234567890123456789… with their variable positional value.

The binary and the stepnumber systems are the only natural number systems in the sense that neither does depend on arbitrary choices such as that of the base number n. In fact, there exist natural isomorphisms, one peculiar to each. The binary number system is naturally isomorphic to the graded lattice of finite subsets; the stepnumber system to the graded lattice of finite quotient sets.

These natural isomorphisms reveal that both the binary numbers and the stepnumbers are in fact characteristic functions. Binary numbers are characteristic functions of finite subsets; stepnumbers are characteristic functions of finite quotient sets. This fact further reveals that the two number systems have a common genesis. It also indicates that the stepnumber system is a genuine piece of mathematics waiting to be discovered, even though the waiting has taken 300 years after the original discovery of Leibniz. In the opinion of the author quotient sets are still sadly neglected in mathematical education and in the epistemology of mathematics. This is perhaps the real reason for the unusual delay of three centuries between the two discoveries.

Digital information technology is usually thought of as a great improvement over the analog.

Yet rumors of the demise of the latter are ‘grossly exaggerated’. Nature still uses form, rather than substance, for encoding purposes when it comes to genetics. If it is true that the substance making up the human body is changed every seven years through metabolism, then our brain should not be thought of as an aggregate of molecules, but an arrangement of aggregates. In fact quotient sets may be the appropriate tool to investigate the structure and operation of the mind. What we are, our memory, our emotions, our psyche, are not encoded through the agency of substance. They are encoded through the agency of form. Substance is incidental and transient, and it can be substituted without changing the information content. More permanent than substance is form. To the extent it is, analog information technology will never be obsolete. Quotient sets along with stepnumbers will likely find a role in encoding and carrying analog messages efficiently, just as subsets along with binary numbers are already carriers of digital messages.

The same way as the lattice of subsets is weak dual to the lattice of quotient sets in the sense that every property of the latter has a dual property in the former (but not the other way round), the binary number system is weak dual to the stepnumber system.

The first edition of this work, published ten years ago, was intended as a textbook for pupils who were born blind. Although the project to test this material in a classroom setting was abandoned early on for lack of interest on the part of the educational establishment for the blind, I left the didactic features in the second edition of the book unchanged. This explains the copious in-text worked examples and end-of-chapter exercises which may be of little interest to readers who want to get acquainted with stepnumbers as quickly as possible. xi

I have relegated a large number of heuristic proofs (also known as ‘behold-type proofs’ or, sometimes, ‘proof without words’) to the Exercises, even though they would have deserved a more prominent place in the main text. Among these are the generalizations of the Little Theorem of Fermat, Wilson’s Formula, as well as Touchard’s Congruence. My search of the literature has failed to turn up evidence that these generalizations are already in the public domain. I state them here as results that are presumably new:

The Generalized Little Theorem of Fermat a p −1 ≡ 1 (mod p), p prime, p does not divide a n

### The Generalized Wilson’s Formula

### ⎡ p n +1 + k ⎤ n+1

### ⎢ n

### ⎥ + 1 ≡ 0 (mod p), p prime, k = 0, 1, 2,…, p – 1

### ⎣ p +k ⎦

⎡n ⎤ where ⎢ ⎥ denotes the kth entry in the nth of the Pascal triangle for the Stirling numbers of the first ⎣k ⎦ kind (the number of k-orbit permutations of n).

The Generalized Touchard’s Conrguence bpn + k ≡ bk + bpn −1 + k (mod p) and its consequence bpn + k ≡ nbk + bk +1 (mod p), p prime, k ≥ 0 arbitrary where n = 1, 2, 3, … The classical results are obtained as a special case for n = 1.

The proofs are heuristic. They involve counting non-zero entries in the rows of Sierpinski’s triangle (mod p) for the binomial coefficients, and for the Stirling numbers of the first and second kind. I leave the task of fully exploiting this method to a younger generation of mathematicians along with my strong suggestion that Sierpinski’s triangles have not yielded all their secrets yet.

By preserving the original flavor of the book I hope to appeal to the taste of both the educators and the philosophically oriented computer scientists.

Dear critic, lower your gun; the book is not for you.

---

*December 8, 2009.*

### Antal E. Fekete xii