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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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