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May 20, 2006

Why the Global Financial System is About to Collapse Part 2
by John Law

Gold's weapons against government

Gold's main weapon is one we alluded to already: a sudden, self-reinforcing, and complete collapse of the dollar and all other artificial currencies (except maybe the Swiss franc). It's time to look at exactly how this would work.

In a nutshell, the problem with the dollar is that it's brittle. It's hard to imagine a Volcker-style, contractionary defense of the dollar today. When Volcker did his thing, the US was a net creditor nation with a balance-of-payments surplus. Its financial system was relatively small and stable. And it had much more control over the economic policies of its trading partners - the political relationship between the US and China is very different from the old US/Japanese tension.

Fed policy since the crash of 1987 has been to insure against risk by stabilizing crises with liquidity injections - that is, hefty dollops of new money. It's no secret that the financial industry has responded by taking on more and more risk. This vicious cycle of "moral hazard" is a policy that's hard to change. For today's Fed, short-term rates of 5% are dangerously high. 25% is not a serious option.

Any fractional-reserve banking and monetary system, like the US's, is destabilized by any outflow of dollars. For the Fed, what is really frightening is not a high gold price, but a rapid increase in the gold price. Momentum in gold is the logical precursor to a self-sustaining gold panic.

In a self-sustaining panic, flight to gold destabilizes the banking system and the bond market, causing waves of bankruptcy across the financial industry. The Fed's cure for bankruptcy is more liquidity - but monetary expansion only increases the incentive to buy gold. In the endgame, money flows out of the dollar as fast as the Fed can pump it in. This is the collapse scenario that leads to remonetization.

One of the reasons the gold price has been rising lately is that central banks' ability to inject gold into the market, whether by leasing or outright sales, has become quite limited. The US needs congressional approval to sell gold. European banks used to be enthusiastic sellers and leasers, but are not unconcerned about the longevity of the dollar, and agreed in the 1999 and 2004 Washington Agreements to restrict their gold disbursements.

And one problem with gold leasing is that a gold lease has to leave someone with the obligation to return that gold. If the gold is sold for dollars, the seller is short gold, and loses a dollar every time the gold price goes up a dollar. Central banks are not known for refusing to roll over gold leases, and their rates are very low (under 0.20% these days). But public companies have to report these losses on their balance sheets. In the '90s, when the gold price seemed to be under control, borrowing gold for a carry trade seemed like a good idea. The gold price is unstable and going up these days, and new leases are the last thing on most people's mind.

Of course, the US government can play the other side of the ball and - at the very least - limit purchases of gold. But this, as we've seen, means showing fear. Dogs have nothing on hedge funds when it comes to smelling fear. And it's an illusion to think that the US and its allies own the global financial system.

If the US imposed exchange controls on gold, the instant result would be a replacement of dollars with gold as a global reserve currency by China, Russia, and the Arab oil bloc. It is hard to imagine, for example, Dubai, closing its gold market. The result would be an international exchange rate between gold and dollars, and a black market in the US. Economists understand this very well, and I can assure you that no one wants to go there.

One significant mistake which makes a collapse much more likely was licensing the gold ETFs. It is easy to underestimate the value of mere insulation in protecting the dollar.

In 1980, to buy gold, you had to go to a coin dealer and pay as much as 10% in round-trip transaction costs - and then, of course, you had to store the stuff. If we imagine an ordinary corporate stock which you had to buy at a "stock dealer" in the same way as 1980 gold, it's easy to see how few investors it would attract. Similarly, bullion was off the reservation for almost all money managers. Sure, eccentric oilmen, Bond villains and South American dictators could hold bullion in Zurich. But how many South American dictators can there be in the world?

In retrospect, remonetization of gold in 1980 had no chance at all. What the goldbugs of 1980 failed to see was that physical currency of any kind, paper or gold, was a relic. Gold could not compete with dollars because there was no way to hold or move it electronically. The only electronic market for gold was the futures market. And since most futures market trades do not exchange actual metal, but are settled for cash, futures trading in gold did not perform the critical market function of shifting physical gold from people who valued it less to those who wanted it more. Retail investors certainly did go to their coin stores and buy Krugerrands, but the Fed could move faster and harder.

It's interesting to note that this kind of insulation, in the form of small overheads in shipping and redeeming gold, also played a large part in managing fractional-reserve gold currencies in the 19th century. If, as I think, it was also crucial in the Fed's 1980 victory, why do we have gold ETFs?

The gold ETFs (GLD and IAU) let anyone move any amount of money into or out of gold at minimal cost. Investors who value everything in gold can use the gold ETFs to treat the dollar the way our retiree in Argentina treated the peso. They can work and spend in dollars, and save in gold.

So why would a financial system that has spent the last century insulating itself against gold turn around and plug the dollar directly into the stuff?

The answer is just that the Fed didn't approve the gold ETFs. The SEC did. And yes, if the Trilateral Commission was still in charge, this never would have happened. But in reality, the US government is not a single big conspiracy, but an enormous jumble of individually gigantic agencies, each of which has its own internal culture and is utterly convinced that its own goals are identical to the public good.

To the SEC, free markets are always a good thing, and the idea that the dollar could owe its life to suppressing them is not one that comes naturally. Even at the Fed, I'm sure almost no one worries about gold, and those who do don't run their mouths off about it. The Fed certainly does communicate with the SEC, but there is a process for these things. Washington certainly has its secrets, and one man's secret is another man's conspiracy, but there is no such thing as an interagency secret.

If the US federal government was a perfectly executed and utterly malevolent conspiracy to dominate the world, let's face it. The world wouldn't stand a chance.

In reality, it's neither. So a lot of things happen in the world that Washington doesn't want to see happen, and that it could easily prevent. Anticipating surprises is not its strength.

The real surprise is not just the ETFs. It's the combination of the ETFs and the Internet.

In the end, gold is a democracy. The gold price is not set by the LBMA or the Comex. It's set by the opinions of all the people who have savings. If you could buy an ounce of gold for $1, pretty much everyone would buy all they could. If you could sell an ounce of gold for a villa in Portofino, pretty much everyone would sell all they could. Somewhere in between is the current price of gold, and all that sets it is public opinion. Of course, peoples' opinions are weighted by the size of their savings, but that's the free market for you.

The dollar is a democracy, too. I'm indebted to Dallas Fed President Richard Fisher for the phrase "faith-based currency." As we've seen, all money, natural or artificial, is faith-based. Gold is only different because no one can print it. The price of gold will never fall to zero because gold is good for capping teeth and plating plumbing fixtures. The price of dollars will never fall to zero because a dollar is made from fine rag pulp with quality recyclable fibers. But everything else is faith.

What can change this faith? And how fast can it change?

Right now, our assumption is that the answers are "very little" and "very slowly." But this may no longer be true.

I don't think it's an accident that the 20th century was the golden age of both artificial currency and broadcast news. When licensed airwaves and monopoly newspapers were the only ways for for people to update their knowledge of the world, paper money could sleep well at night.

For example, let's try a thought experiment.

Suppose the New York Times is taken over, tomorrow, by goldbugs. Let's say all of its editors, reporters, and columnists read this essay, find it plausible, and decide to really speak some "truth to power."

From tomorrow on, the Times puts all its weight into reminding its readers of the undeniably true and objective facts that the dollar is a faith-based currency; that new dollars are being created at about 10% a year; that the current US financial system was designed a hundred years ago, in the age of Morgan, Hearst and Rockefeller, to create a steady flow of new dollars for both federal spending and corporate welfare; that the global financial system is now completely dependent on money creation, and could not survive in anything like its present form with a static money supply; that remonetization of precious metals is a Nash equilibrium; and that if remonetization happens, the first people who move their money into gold will profit the most.

How many weeks do you think it'll take before the Gray Lady's pulp supply starts to turn a little green?

Of course we'll never know, because this will never happen. For the last century, the first commandment of the mainstream media has been responsible journalism. Promoting financial panics is not exactly responsible journalism.

I'm afraid anonymous bloggers have no such inhibitions. More on this in a little bit.

The silver factor

You'll notice that I mentioned silver at the start of this essay, but I haven't touched it since.

One question about remonetization that's essentially impossible to answer is, assuming remonetization of metals, which metals exactly will become monetized.

Over time, the Mengerian process of standardization will tend to reduce the number of monetized commodities, possibly to one. Standardization favors the leader, and it is an unstable game: since losers by definition delevitate, it makes sense to flee them as soon as possible. Since gold, just for historical reasons, is the leader, it may be the only survivor.

On the other hand, on a modern electronic market, it's not clear how important Mengerian standardization is. According to Menger's model, money standardizes because it is inconvenient to be constantly converting value between multiple moneys. But it's a lot easier with computers. And one effect that tends to counteract Mengerian standardization is the obvious desire to diversify one's savings.

What's interesting right now is that monetization seems to be affecting a wide range of nonferrous metals - not just those traditionally considered "precious." This makes sense, because the only reason precious metals are precious is that they are rare enough that it's easy to store and handle significant levels of collectible value. Since warehouse costs for base metals such as copper, lead, or zinc are not high, there is no reason why electronic claims to these metals cannot be monetized.

An alternative would be the equal monetization of all precious metals. The conventional precious metals are gold, silver, and the platinum-group metals: platinum, palladium, rhodium, iridium, ruthenium, and osmium. Perhaps, for example, an equal percentage of the global inventory of gold and osmium would have the same monetary value. If so, it's time to stock up on osmium.

But a good guess is that if a new monetary system levitates one metal, it will be gold. If it levitates two, it will be gold and silver. It's not the physical properties of these metals, but their historical and cultural associations, that make them more likely to displace the others.

Silver is interesting because it was demonetized before gold, and has (except for the 1980 episode) been priced mostly as an industrial metal in the modern era. However, because silver was a monetary metal for most of human history, central banks built up vast stockpiles. After World War II, banks felt the need to keep their gold but not their silver, and they sold the latter to industrial users, generally at very congenial prices. The silver market has seen net dissaving, mostly from these government hoards, for most of the last 60 years and all of the last 20.

The result is that most of the world's silver, certainly in the tens of billions of ounces, has been consumed in nonrecoverable industrial uses such as photography and electronics. Estimates for the global supply of silver bullion vary widely, but are generally under 1 billion ounces. Since the ratio of silver to gold price by weight is about 50 to 1 at the moment, by value there is perhaps 200 times as much monetary gold as monetary silver in the world.

The silver market has become very comfortable with net dissaving, and any serious reversal of this trend seems likely to cause an ugly increase in the price. The recent (April 28) opening of a silver ETF, SLV, makes such an increase likely; in fact, the silver price doubled while the ETF was going through the approval process. Since its approval the ETF has been sucking down about 3 million ounces of silver a day, which is clearly unsustainable.

So there are three factors favoring the parallel remonetization of gold and silver. One is the traditional monetary relationship between the two metals. Two is the fact that since central banks hold very little silver, it's hard for them to manage the price. Three is that since no one really has much silver at all, any flow back into the ETF will cause some serious levitation.

One Nash equilibrium strategy for gold and silver - we could call it strategy GS - is to value the extractable quantity of silver and the extractable quantity of gold on earth equally. This seems to be the strategy that people followed before the age of artificial currencies.

Obviously if silver is remonetized, silver stockpiles will have to increase, and the process may be chaotic. However, balancing the two diversifies against fluctuations in either, and natural fluctuations - for example, as a result of mining exploration or technology discoveries - are inevitable in any metallic monetary system. So a parallel standard may actually stick around.

A plan for structured remonetization

Who knows with these Internet things. I have no idea of how many people will read this essay. But I have never liked people who complain and don't offer constructive solutions.

And since it is, in theory, possible that this link will spread virally and actually cause a remonetization event, I think it would be irresponsible of me not to include a few simple suggestions for how to handle it right.

First, the financial markets should be closed. This is obviously not a permanent solution. But why operate without anesthetic?

Second, the US federal government should be restructured as if it were a bankrupt company, distributing the US gold reserve of 8139 tons among holders of US liabilities, including both dollars and debt, and both explicit liabilities such as Treasury notes and implicit ones such as Social Security.

The result will be a new financial system in which the legal currency is directly allocated gold without any fractional pyramiding. The new government should be fiscally stable as a long-term operating concern. It will have to be, because it will be unable to print money.

Some federal programs will probably have to be cut. At a minimum, the practice of defining national security as global security is probably unsustainable. The US should retain a small strategic and conventional force which can deter terrorist and other attacks by proportional response, and secure its borders. It should adopt Switzerland's foreign policy and modify it as circumstances demand.

All federally guaranteed liabilities of the United States should be valued equally at their price or estimated price before the crisis. For example, Federal Reserve Notes and FDIC insured bank deposits should have equal value and seniority, Treasury bonds should be valued at their current discounted price, and so on.

Both the Federal Reserve and the entire banking system should be treated as part of the US government, because they both are. Any institution that is not allowed to fail is effectively part of the government. Shares of stock in banks and other lenders engaged in mismatched-maturity (fractional-reserve) banking should become US liabilities at the current dollar price. Loans held by banks should be redenominated in gold according to the calculated exchange rate (see below) and sold at auction.

The entire US gold reserve should be converted to an electronic account system in which individuals and companies hold directly allocated gold and can redeem, deposit, and make payments. The system should also support accounting for silver and all other precious metals. Ownership of the gold should be distributed equally among holders of US liabilities, not discriminating between domestic and foreign creditors. This calculation will generate a final exchange rate between dollars and gold.

In some cases, as in Social Security, the US may hold its own liabilities, and it may maintain a small fiscal reserve. However, because of the inevitable temptation to create more virtual than physical gold, the US gold system should be broken into interoperable parts and privatized as soon as is practical.

The new US currency should be the gold milligram. Stock markets should be repriced in milligrams according to the dollar exchange rate, and reopened as soon as possible.

Property rights of existing gold holders (such as, of course, myself) should be respected. However, some gold confiscation is inevitable. Since the concept of capital gains on gold becomes meaningless with a gold currency, all holders of gold or silver who are US persons should pay an immediate 28% tax on their entire stash, in lieu of the existing rate on bullion gains. 28% is large enough to be significant and small enough that it won't stimulate excessive evasion. Similarly, mineral rights should be preserved, but a similar royalty should be applied.

There, that's my plan. I think it's a good one. But I would, wouldn't I?

By switching the currency completely to gold and converting US debt as well as US dollars, the plan provides one last blast of monetary expansion while precluding any further debasement, except of course as the result of new discoveries and technical advances in gold mining. Of course, people who hold dollars or dollar bonds will get jacked. But because of the volume of dollar claims, which must be handled fairly and equally, there is no way around this. And people who hold dollars or dollar bonds have been getting jacked for years, which is why they've been so eager to move them into stocks or housing.

I don't think there is a realistic way to only partially revalue the dollar, maintaining some kind of artificial currency, sovereign debt, and fractional-reserve banking system. I think any attempt to switch to gold that does not go all the way in one step is likely to collapse itself and cause further chaos. But of course, I'm sure others will disagree.

And of course, there is no way to remonetize to precious metals without either providing enormous profits to present holders of said metals (such as, again, myself), or installing a new police state that would treat gold as if it was cocaine. The reason I recommend buying gold ETFs, rather than burying Krugerrands in the backyard, is that I don't think the kind of grassroots political support for state power and central planning that allowed the confiscation of gold in 1933 exists these days. I hope I'm not wrong about this.

So you say you want a revolution

I've tried to maintain some small shred of objectivity here. But I admit it; I would like to see a remonetization. I think our current system of government needs a serious reboot.

I respect and understand people who disagree with me on this, or who think it's a bad idea to work for change outside the normal political process. From my perspective, the influence of the political process over the actual operations of government is small. It does not strike me as increasing.

One interesting fact about US history in the postwar era is that since the 1930s there has been no effective force in American politics focused on resisting the growth of the US federal government. The last antifederalist Democrat was John Nance Garner. The last antifederalist Republican was Robert Taft.

In general it is always difficult for an antifederalist party to exist. It tends to get taken over by interests ambitious to use the power of state to some political advantage. But since federal institutions have grown continuously since the country was founded, and since an omnipotent national government is so obviously contrary to the intent of the founders, who set down their plans in documents that still exist and that anyone can read, reactions against the size and power of the state have been frequent, including the original Democratic-Republicans, the Democrats of Jackson and Van Buren, Grover Cleveland's hard-money Democrats, and Harding's "return to normalcy" Republicans.

In contrast, since World War II, the political dialogue in the US has pitted voters who think Washington should guarantee global security against those who believe it should insure general public prosperity. Of course, Republicans can reliably raise support by appealing to those who oppose welfare and central planning, and Democrats are happy to accept the votes of anyone who is unhappy with the Pentagon and its imaginative projects. But in practice, as the Bush Administration has shown, the path of least resistance is to expand both sides of government.

Not all the political rhetoric in the US today is positive. There is a lot of fear and loathing between "red-state" and "blue-state" factions.

It's very easy for red-staters to think that because blue-staters believe the US should not guarantee global security, that they do not believe in global security, but think that everyone can just be nice. In some cases, this may be true.

It's very easy for blue-staters to think that because red-staters do not believe the US should provide general public prosperity, that they do not believe in general public prosperity, but only in their own prosperity. In some cases, this also may be true.

But I have trouble believing that these stereotypes are broadly accurate. They seem too politically useful for that.

It's hard to avoid noting that this structure of opinion looks like a very effective strategy of divide and conquer. I am not suggesting that anyone had a meeting and came up with this strategy, any more than anyone has a meeting and decides what the price of gold should be today. The market tends to discover effective strategies and stick with them, and political power is no less a market than any other kind of human action.

Perhaps you are happy with the growth of the US government. Perhaps you feel it is not large and powerful enough, that it needs to be larger and more powerful. In that case, preserving its power to print money is clearly necessary, and you should oppose anything that would threaten it. You should under no circumstances buy gold. In fact, if you have a few dollars to spare, you should probably short it. If the world agrees with you, gold will probably go down.

Please excuse the snarky tone. In fact, I respect people who hold this perspective. It's a fact that the US government has done a lot of good things in the world. It's a fact that all, or at least almost all, the people who make up this organization have nothing but the best of intentions.

US foreign intervention has done away with all kinds of vicious thugs, from Adolf Hitler to Pablo Escobar to Slobo Milosevic. In many cases, these thugs were not replaced by new, equally vicious thugs. In other cases, due to US money and influence, the thugs never got past the Tony Soprano stage. Today's US military is the most principled and effective force the world has ever seen. US foreign aid has also provided famine relief, medical care and vital emergency services around the globe.

US domestic programs have controlled pollution, bought medical care for sick people, persecuted white supremacists almost entirely out of existence, paid for a lot of good scientific research, improved the living standards of the elderly, etc.

Perhaps none of these things would have happened if the US did not have the power to tax by debasement. Perhaps many similar good things will not happen in the future if it loses this power. And perhaps all the harmful actions the US government takes - always, in general, with the best intentions - will continue.

But since most Americans seem to see their government as a supersized charity, which may waste a lot of money on the opposing party's imprudent schemes, but is otherwise out there doing the right thing, there are only two conclusions we can draw.

One is that if the US government lost its power to tax by silent debasement, Americans would vote to fund these valuable programs by ordinary taxation, or better yet support them directly and voluntarily as normal charities. (There is no reason military intervention cannot be run as a charity. For example, some have proposed exactly this to end the genocide in Darfur.)

Two is that Americans are a bunch of damned hypocrites. I hope it's obvious which one I believe.

What you can do

If you disagree with my economic analysis, or if you're not sure but you think this "remonetization" thing sounds like a really bad idea, nothing. You're probably a reasonable person. Most reasonable people will probably agree with you. I wouldn't worry at all.

If you have any amount of savings, I do recommend holding a little gold. All kinds of things can happen in this world. Even if gold goes down, I think it's always good insurance.

If you do buy the economics and the politics, you can take two steps.

One is to buy a prudent amount of gold and/or silver.

Two is to email this link to anyone you know who might find it interesting, especially to people who are active politically, work in the financial industry, or just have a lot of money.

Either of these steps will help. But if you're doing both, you might want to do step one first. I mean, you never know.

You can also post this essay yourself, anywhere you want. It's in the public domain.

Obviously "John Law" is not my real name. Freedom of economic speech does not seem to be a judicial priority at the moment. Maybe I'm just being paranoid, but I feel like I can write more freely with a pseudonym.

The best way to ask questions is to comment on this blog. But you can also write me at wal.nhoj@yahoo.com.

Further reading

An excellent primer on US monetary history in the 20th century, from the same general Austrian School perspective I follow, is Richard Ebeling's "Monetary Central Planning and the State":

http://www.fff.org/toc/monetarypolicytoc.asp

Wikipedia has a good rundown of Nash equilibria:

http://en.wikipedia.org/wiki/Nash_equilibrium

The best writers on gold anywhere on the Internet, in my opinion, are Bob Landis and Reginald Howe at Golden Sextant. All their essays are worth reading. Here's a fun piece about the real John Law:

http://www.goldensextant.com/GreenspanLaw.html

For an Austrian perspective on how a fractional-reserve banking system works, and how the Gilded Age saddled us with this strange creature, Murray Rothbard's "Mystery of Banking" rocks. Murray is not actually from Austria, but he does have a funny accent:

http://www.mises.org/mysteryofbanking/mysteryofbanking.pdf

A comprehensive history of money and banking from the Greco-Roman era till now, with an emphasis on legal principles, is Jesus Huerta de Soto's "Money, Bank Credit, and Economic Cycles":

http://www.mises.org/books/desoto.pdf

Ted Butler is a crazy man. You should know this. I'm a little crazy myself, obviously, so I don't say it lightly. But if you want to know what a crazy man thinks about silver, listen to Ted:

http://www.investmentrarities.com/tb-archives.html

The Silver Users Association didn't get what it wanted, but its opinion is still interesting:

http://www.sec.gov/rules/sro/amex/amex2005072/pamiller021306.pdf

If you too want to blog anonymously, I recommend the wonderful tool I use, the EFF's Tor. Send them a Krugerrand for me:

http://tor.eff.org

An invaluable resource for tracking dollar credit expansion is Doug Noland's Credit Bubble Bulletin. Doug capitalizes his nouns just like James Frey, but all his stories are actually true:

http://www.prudentbear.com/creditbubblebulletin.asp

If you're wondering what this thing called "the State" is and why all these people seem to hate it so much, Murray lays it down:

http://www.mises.org/easaran/chap3.asp

Here's what Alan Greenspan thought about gold in 1966. Or has he changed his mind? Maybe he'll let us know in his new book.

http://www.321gold.com/fed/greenspan/1966.html

And Carl Menger said it first:

http://www.mises.org/web/2692

John Law
http://johnlaw.wordpress.com/

Copyright © 2006 John Law

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