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The Golden Age of Paper

Most people have the misconception that the 1929 stock market crash caused the Great Depression of the '30s. Actually, the Crash of '29 signaled the Great Depression, which was brought on by the Federal Reserve's manipulations of the money supply during the 1920s and 1930s.

In the '20s, the Fed printed dollars in efforts to help Great Britain reestablish its pound sterling as a premier currency following World War I. Because the United States escaped the war unscathed and had supplied most of the Allies' materiel, huge quantities of gold flowed into the UP.SO. Treasury, making the dollar the world's number one currency. (In the aftermath of war, everyone knows the importance of gold.)

Britain, having long"ruled the world," wanted pre-war status for the pound, but overvalued it. This resulted in the pound being shunned for the dollar and for gold. To shore up the pound, the U.S. Treasury bought pounds with dollars freshly-printed by the Federal Reserve. But, those dollars did more than support the pound, they also flowed into the economy, bringing on the Roaring Twenties, a period of robust prosperity. The Fed's manipulations also produced a bull market in stocks like the world had never seen before.

To correct the excesses, in the late '20s the Fed shrank the money supply; consequently, prices fell. Businesses, which during the '20s had increased production capabilities, cut back and laid off workers. Small, regional banks collapsed as loans went unpaid and because depositors chose to withdraw their funds. To protect themselves, Americans were converting paper money to that"barbarous relic" gold. Consequently, President Franklin Roosevelt ordered banks to cease redeeming paper dollars in gold and Americans to turn in their gold.

At the depths of the Great Depression, the money supply had shrunk by a third, resulting in collapsed prices in nearly all sectors of the economy. With fewer dollars circulating, how could prices do anything but fall? The Great Depression was truly a deflationary collapse, as the Fed shrank the money supply. The Fed's actions also caused thousands of banks to fail, thereby wiping out still more dollars.

(Here is another point about the failed banks of the 1930s. Most were state banks that had not joined the Federal Reserve System. Few large banks in metropolitan areas failed. As a result, large city banks enjoyed reduced competition after the 1930s. In the 1980s, with the savings & loan crisis, more competition disappeared, and today the mega-banks are merging rapidly. In a few years, only five or so banks will control 85% of deposits. Congress seems oblivious to this dangerous concentration of power.)

Limited knowledge of the details of the Great Depression causes most Americans to think that a recession, or economic slowdown, must be accompanied by falling prices. This misconception is so widespread that some writers and economists often label a period of falling prices"deflationary."

For example, Richard Russell, noted author of Dow Theory Letters, writes about falling commodities prices and fears"we may be entering a deflationary period." At the same time, Russell was the first to point out that through the first six months of this year, the Fed increased the MZM (money of zero maturity) at an annual rate of 23.7%!

With the money supply exploding and seven interest rate cuts this year, how can prices fall? Easily: over capacity. If the copper industry is producing more than the market demands, copper prices will fall. If the markets see an economic slowdown, prices fall in anticipation of reduced demand. Now, admittedly, that sounds like a recession brings on falling prices, but here we're looking only at the trees (commodities prices) and not the forest (the whole economy).

Although commodities prices may be falling, housing costs continue to rise. Except the NASDAQ, stocks are still at lofty prices. Has anyone seen lower prices for automobiles, despite claims of excess capacity? Yes, rebates are being offered to reduce inventories, but after inventories are reduced, auto prices continue to climb 2%-3% a year. Don't forget medical and food costs. Has anyone seen lower costs in these two vital areas?

In the 1930s, the dollar had a 40% gold backing by law. This limited the number of dollars the Fed could print, but it still printed enough to bring on the Roaring Twenties, which were followed by the Great Depression. Today, the dollar is the legal tender by fiat, government command. You must accept dollars in exchange for"all debts, public and private." And, as everyone knows, the dollar is no longer backed by gold.

Whenever a paper currency has been unlinked from gold, eventually the politicians (or central bankers) print it until it becomes worthless. Why will it be different this time? Because we're smarter? Because Alan Greenspan,"Maestro," as Watergate author Robert Woodward calls him, heads the Fed? Because we have computers and can collect data more easily? Not hardly. Evidence supports the position that computers will facilitate the destruction of the dollar.

During the hyper-inflation of the Weimar Republic (1917-1923), the Germans had to fell trees, turn the trees into pulp, make paper, and then slap ink on the paper to increase the supply of reichsmarks. Today, not nearly as much effort is required. A few people sit at computer keyboards and type in some numbers, and billions of dollars are created.

With money creation being so easy, why not do it? After all, hasn't it become a maxim that 6 to 12 months after the Fed increases the money supply, the economy will grow? Unfortunately, over the long-run, paper money has a miserable track record.

In fact, the Great Depression occurred as the world was moving from gold to paper. It is also significant that the Great Depression started less than 20 years after the establishment of the Federal Reserve System. Ironically, one of the primary reasons given for establishing the Federal Reserve System was to avoid panics.

Before the Great Depression, economic crises were called panics, and generally they were caused by excessive printing of paper money by big banks, but the panics were generally localized to the areas served by the banks. With the advent of the Fed, the Great Depression spread nationwide.

Now that we're on a pure paper system, who knows how bad the next depression will be. But, indications are we could be sitting on the precipice a big one. A little background is in order.

From about 1815 to 1915, when World War I got really rolling, the world was on a gold standard, which meant the world's major currencies were redeemable in gold and that foreign trade was settled in gold. Even The Economist, the anti-gold weekly news magazine published in London, admits it was a"golden era." Business flourished, world trade expanded, and prices fell.

Yes, prices fell as productivity increased. This rewarded savers, who built investment pools from which businesses could borrow, or from which savers could start new business. The world's economy was sound because it was built on savings and based on gold, a sound money. Unfortunately, after WWI the world abandoned the gold standard.

At the 1922 Genoa Conference, world leaders adopted the gold exchange standard. Under this bastardized version of the gold standard, currencies were backed by gold but also the U.S. dollar and the British pound. Because the dollar and the pound were fully convertible into gold, the gold exchange standard, its architects asserted, would"economize on gold."

The establishment of the gold exchange standard was a giant step toward demonetizing gold and moving toward a paper money system. In 1931, the Brits stopped redeeming pounds in gold, and in 1944, as agreed at Bretton Woods, the mighty dollar stood alone as the only currency that could be considered a reserve to back other currencies.

In 1934, Franklin Roosevelt took another swipe at gold with his April 5, 1933 executive order that prohibited Americans from owning gold. The final blow, of course, was Richard Nixon closing the gold window on August 15, 1971. Since then, the world has been on a pure paper system, one that has seen many confidence crises and currencies collapses. Some currencies, such as the Mexican peso, have collapsed several times.

The cheap money of the 1920s resulted in temporary prosperity, much like a family living on borrowed money. When time came to pay for the excesses of the '20s, it was the most devastating depression the world has ever seen. There are some eerie parallels between the 1920s and the 1990s. Will this decade parallel the 1930s? Do today's recessionary signs signal serious problems ahead?

Just as in the 1920s, when the Fed had a loose money policy to support the faltering British pound under the new gold exchange standard, today the Fed is pumping out money at record rates. Since the first of the year, MZM has grown at an annual rate of 23.7%. Like the '20s, we've had a loose money policy for years, and always in attempts to avert a crisis.

In 1997, a financial crisis spread turmoil throughout Asia and devastated several currencies. In 1998, with the world's financial structure still weak >from the Asian flu, the Fed had to put together the rescue of Long Term Credit Management, an aggressive hedge fund whose liabilities threatened the world's banking system. The year 1998 also saw the Russian debt crisis, which the Fed alleviated with still more money. In 1999, the Fed"increased liquidity," i.e. printed massive quantities of money, in fear of bank runs because of Y2K concerns. Now, the Fed is lowering interest rates and increasing the money supply to avert a recession.

Just as all the money the Fed created during Roaring Twenties had to go somewhere, so did the money of the 1990s. Actually, the Fed has had a relative loose policy since the early 1990s when it sought to bring us out of the last recession. Much of the money, from both the '20s and the '90s, found its way to the stock market, resulting in two great bull markets.

Now, we have to wait to see how serious the corrective bear market and the recession will be. If the stock market parallels the 1929 Crash, we still have a lot of downside in stocks. If the recession begins to approach the 30s, we have much economic pain awaiting us.

It is not pleasant to think that another Great Depression lies ahead. In fact, those who predict another Great Depression are quickly labeled extremists. So, let's consider the other possibility: the worst recession since the Great Depression. The Fed will, however, fight a recession with everything it has.

Unfortunately, all the Fed has is the ability to create money, and after being off the gold standard for some 85 years, we've seen the results of paper money: destroyed currencies and wasted economies. Over the past 30 years, Brazil has had three currencies: the cruzeiro, the cruzado, and the real. Mexico struggles from one crisis to the next but sticks with the lowly peso, which just keeps on sinking.

Conventional economic thinking is that the economy has to respond to Fed policies, but that's not always the case. During the 1970s, the term stagflation was coined to describe a stagnant economy and rising prices. In Japan, zero interest rates and massive government spending have failed to revive Japan's stagnant economy, another instance where central bank intervention has failed.

Stagflation for the U.S. economy is a real possibility. And, if the economy does not respond to recent interest rate cuts and increased liquidity, what's the next step? If the economy slips into a deep, prolonged recession, what will be the government's course of action? Will the Fed print more? Interest rates to zero, like Japan? Will Congress cut taxes? Tax hikes? A return to the gold standard? The last is quite doubtful. History shows that governments return to gold only after their people completely refuse paper money. We appear to be a long way from that. So, what will be the government's course of action? Probably more paper money.

Troubled times are on the horizon, and everyone with savings needs to take action to protect those savings. Historically, gold and silver have proven to be the absolute best forms of protection against economic and financial crises. It is true that during the Weimar Republic's hyper-inflationary period, Germans who secured dollars saw their savings survive. In those days, however, the dollar was"as good as gold." Today, the dollar is not backed by gold, and it is being printed in whatever quantities the Fed deems necessary. How many dollars will the next crisis require?

For the last thirty years, since Nixon closed the gold window, the world has been on a paper money system. Never before has the world tried such a risky venture, and now dark clouds are gathering on the horizon. Investors who ignore the clouds are whistling past the graveyard. Now is a time to be afraid and the time to take steps to weather the storm. Fortunately, gold and silver have proven to endure during hard times. Adjusted for inflation, gold and silver are trading at or near records lows, which means they hold little downside risk but great upside potential.

Bill Haynes

August 31, 2001

Mr. Haynes has been a precious metals dealer since 1973. Comments can be sent to bill@certifiedmint.com

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Thirty years ago President Richard Nixon put gold to rest: he closed the US"gold window", whereby foreign central banks could sell dollars for gold at a fixed rate. For some, it was the single most sensible thing he did. For others, it was the key step in opening the doors to the great inflation. Indeed, on the eve of gold's being fully phased out, Alan Greenspan, now chairman of the Federal Reserve, then an unmellowed libertarian, pronounced:"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."

Surely the inflation and deficits during the 1970s fully justified his angst. But today gold is redundant; the bond market has replaced it as the ultimate restraint on central banks' temptation to use monetary expansion as a short cut to prosperity. And, increasingly, inflation targets and institutions such as independent central banks create lastingly stable money. There are few certainties in international finance. But here is one: gold as part of the international monetary system is dead.

The 19th century was a period of gold-based stable money and economic progress. No surprise that after the first world war gold returned, though not for long. With the onset of the Great Depression, inter- national reflation policy was missing and gold-based monetary systems left too little scope for national policy. Britain went off gold and soon much of the world joined; and those who left gold, historical research now documents, fared a lot better than those who hung on. Britain's leaving gold was for all purposes the end of gold; the rest is just rounding out.

Even though the US had gone off gold in 1933, it did not do so for foreign official holders. For them, the US maintained convertibility of the dollar into gold at $35 an ounce. That became the great issue of the 1960s, as official attempts to keep the free market price of gold down to $35 meant increasing sales from reserves.

That strained co-operation with the foreign official holders as the US dollar became overvalued and dollar shortage became dollar glut. Why hold dollars rather than gold when the free market price of gold rose above $35 an ounce? US gold losses to foreign governments increased; gold reserves were running off; crisis was around the corner. In typical French fashion, General Charles de Gaulle railed against the"exorbitant privilege" of the US financing itself by printing dollars while others had to accumulate them.

It was not long before the US became fed up with the moaning. In 1971, Nixon simply declared an end to all gold sales and devalued the dollar in the process. The remaining gold sits in Fort Knox to accumulate dust and no capital gains.

But, of course, gold has more lives than a cat and there was one more to account for. In 1980, in an obscure International Monetary Fund-quota appropriations bill, Jesse Helms, the Republican senator, slipped in a provision that called for appointment of a gold commission to explore the return to agold-based monetary system. President Ronald Reagan liberalised private gold holdings and appointed the committee. Gold prices reached $700 and beyond. And from there it was soon downhill: the gold bugs had their brief moment on the stage and bungled their lines - and the commission's 1982 report was an unceremonious funeral for any gold ideas.

Gold crashed in the free market and today its price is below $300. Soon inflation disappeared, flexible exchange rates became accepted as the best of all unsatisfactory arrangements and the topic disappeared from conversation, conferences and, ultimately, even from textbooks. The lone voice in support of gold is Robert Mundell, the Nobel prize-winning economist, who on occasion has it at the centre of his world money scheme.

In 1980 the idea of a gold standard was not altogether absurd because managed money - the claim that paper money could be even more stable than gold and dispense with the resource cost to boot - had failed. The US, and the world, had shifted into a massive inflation; expectations lost their anchor; bond prices exploded. Preaching sound money was becoming an industry, monetarists were coming out of the woodwork and stable anchors were in high demand.

An aggressive disinflation strategy did away with all that, at the cost of the deepest world recession since the 1930s, making credibility the new catchword. Two decades later, central banks have fully established their anti-inflation credentials and the bond markets hold them accountable by the hour just in case there is a temptation to lapse. No more need for gold - inflation targeting is the new answer and it has proved itself in the past decade.

The other reason gold has moved to the sidelines has to do with exchange rates. Neither the US nor Europe believes that a fixed exchange-rate system is convenient. Neither is willing to subsume domestic monetary and fiscal policy to the needs of maintaining a fixed rate.

True, large and persistent swings carry their costs - but going lockstep in growth with the rest of the world puts just one more constraint on policymaking, which is already overburdened. Neither Congress, nor the public, nor central bankers sees much use for fixed rates in future and they see even less for gold as part of any arrangement.

The role of gold in the past was to constrain policies to ensure price stability. What are the institutions today that prevent a recurrence of the 1970s? Even though we have sound money today, the US lacks institutions to ensure that this will last. Unlike in other countries, including the UK and Europe, US monetary policy is what the Federal Reserve deems wise that day. There is no explicit inflation target - chiefly because the chairman does not want one.

But now, with rumours of Mr Greenspan leaving by the end of this year, it is essential to put in place an explicit inflation target of, say, 1-2.5 per cent. That would help bond markets to have more confidence in US economic stability, regardless of who is at the top.

The writer is professor of economics and international management at Massachusetts Institute of Technology





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