Whither Gold?

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Winner of the 1996 International Currency Prize

by Antal E. Fekete

October, 10 1999

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.

Table of Contents

Introduction

1. A Brief History of Money
Constant marginal utility
The role of plunder |
Plunder -- modern style
Whose standard?
Bimetallism -- stratagem to benefit a minority at the expense of the majority
A short course on demonetization
The dual nature of money
The Janus-face of marketability
Why bimetallism failed
Mene Tekel

2. Towards a New Theory of Interest
The chimaera of hoarding
Squaring the diagonal
The curse of unemployment
A short course on capital formation
The Shylock-syndrome
Instant reward, instant penalty
The welfare state as we know it...
The gold bond
The sterility of gold

3. The Redistribution of Losses
Crossing the wires at the traffic light
The dance of the derivatives
Sweeping losses under the rug

4. Whither Gold?
How to cork the genie in the bottle
References

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 opinion-makers. 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 non-monetary 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 Haberler-Pigou 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 today, 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 decision-makers 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-to-date 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 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 (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