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Copyright
© 2008
A. E. Fekete
All rights
reserved
…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 cause-effect 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. Debt-based 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 debt-based 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 credit-default
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 liquidation-value 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; second-round 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.
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
Antal E. Fekete
Professor,
Intermountain Institute of Science and Applied Mathematics, Missoula, MT
59806, U.S.A.
Gold Standard
University
aefekete@hotmail.com
Professor Antal E. Fekete was
born and educated in Hungary. He immigrated to Canada in 1956. In addition to
teaching in Canada, he worked in the Washington DC office of Congressman W.
E. Dannemeyer for five years on monetary and fiscal
reform till 1990. He taught as visiting professor of economics at the
Francisco Marroquin University in Guatemala City in
1996. Since 2001 he has been consulting professor at Sapientia
University, Cluj-Napoca, Romania. In 1996 Professor Fekete
won the first prize in the International Currency Essay contest sponsored by
Bank Lips Ltd. of Switzerland. He also runs the Gold Standard
University.
DISCLAIMER AND
CONFLICTS
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 AUTHORS 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.
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