This created the precedent for fiat money as the Bank of England notes circulated as undated debt instruments. Given the heavy debt load of the government, there was some push to early in the eighteenth century to dispense with the convertibility of banknotes into specie altogether. Treasury officials consulted Sir Isaac Newton, the great physicist, inventor of calculus, and Master of the Royal Mint.
That discussion is described by Isabel Paterson:
Sir Isaac Newton was asked by the British Treasury officials and financiers of his day why the monetary pound had to be a fixed quantity of precious metal. Why, indeed, must it consist of precious metal, or have any objective reality? Since paper currency was already accepted, why could not notes be issued without ever being redeemed? The reason they put the question supplies the answer; the government was heavily in debt, and they hoped to find a safe way of being dishonest. But Newton was asked as a mathematician, not as a moralist. He replied: “Gentlemen, in applied mathematics, you must describe your unit.” Paper currency cannot be described mathematically as money.11
Preferring not to argue with one of the greatest geniuses who ever lived, the Treasury officials ratified Newton’s plan, and Great Britain went on the gold standard in 1717.
By most accounts, the gold standard under British hegemony was a great success. It contributed to the peaceful order and prosperity that characterized the nineteenth century. Of course, some qualifications to those happy generalizations are in order. For one thing, Pax Britannica was not total. The late years of the eighteenth century and the early nineteenth century (through Napoleon’s defeat at Waterloo, some two centuries ago on June 18, 1815) were a time of war.
Embroiled in the nineteenth-century approximation of world war, the British Treasury equivocated its commitment to the gold standard. When the financing requirements of the state escalated, the gold standard was suspended.
A Quarter of a Century Experiment with Fiat Money
The modern world’s first successful fiat money regime, an era of an inconvertible pound, began on February 27, 1797, when the Bank of England stopped converting its deposit notes to gold specie in order to forestall a gathering run on its gold reserves. Among the factors at work were the facts that the Napoleonic Wars had been under way for some time and the Bank of England had permitted the supply of pound notes to grow to approximately twice its holdings of bullion. By the mid-1790s, there were notes for £14 million in circulation as compared to about £7 million in bullion reserves. Consequently, the market price of gold had risen above the mint price. And as you would expect, there were a lot of redemptions.
Initially, the suspension of cash payments, the so-called Bank Restriction Period, was an emergency measure to counter panic following rumors of a French invasion. The public expected the suspension to continue only for a few weeks, or at most, until the end of the Napoleonic Wars. But in fact, suspension of the gold standard lasted almost a quarter of a century until May 1, 1821.
When the war ended in 1815, the circulation of paper was so large that it was apparent that resumption of pound note conversion into gold could only take place after a “period of adjustment.” This deflationary adjustment lasted for six years, at which point the gold standard was reestablished at the previous parity £3. 17s. 10½d an ounce. About which, the famous economist David Ricardo commented that “he should never advise a government to restore a currency which had been depreciated 30 percent to par.”12
But the British went through the necessary deflation. Once reestablished, the gold standard remained successfully in effect until the outbreak of World War I, when conversion of the pound into gold was again suspended. Until 1916, when its gold reserves ran out, Britain was funding most of the Allies’ war expenditures, including most of the empire’s, all of Italy’s, along with two-thirds of the war costs of France and Russia. Given these staggering costs, the money supply in Great Britain more than doubled while consumers experienced a 250 percent increase in prices.
When the Great War ended, it was again judged that a period of deflationary adjustment was required before specie conversion could be resumed. In the event, Britain went back on the gold standard in 1925 at prewar parity. Then the Great Depression hit, and Great Britain abandoned the gold standard in 1931. As Hayek noted, the British government abandoned the attempt to bring down costs by deflation just as it seemed near success. According to Professor James Morrison, “Great Britain’s abandonment of the gold standard in 1931 was one of the most significant and surprising policy shifts in the history of the international financial system.”13
Another way of putting it would be to say that by going off the gold standard, Britain effectively abdicated its hegemony. Morrison attributes the collapse of the gold standard a “mistaken monetary policy” by the Bank of England, and deliberate action by Keynes to confuse the suggestible Prime Minister Ramsay MacDonald about staying on gold. But the gold standard did have a drawback from Keynes’s interventionist perspective. As Elisa Newby, head of the market operations division of the Bank of Finland, spells out, “Under the gold standard the money growth rate cannot be regulated by governmental policy because the money stock can increase or decrease only if the commodity stock in monetary uses increases or decreases respectively.”14 In this sense, the gold standard was much more complementary to a laissez faire policy, which Britain came closer to following in the nineteenth century than in the depths of the Great Depression. That’s not to say that the interventionist policies really constituted an improvement.
The last monetary policy innovation, in the twilight of British hegemony was, in Professor Morrison’s words, “a flexible exchange rate regime,” a “policy of cheap money”—meaning a monetary stimulus—“intended to combat depression.”15 That British innovation was one the United States was to follow with alacrity.
The example of the Bank of England exemplifies the high-level crony capitalism involved in the melding of for-profit banking with the financing of the hegemonic state. Bankers with the right to create money out of “thin air” can earn staggering profits. This was highly visible in the case of the Bank of England. It was a public company traded on the London stock market for 250 years. Its investors pocketed big profits over the centuries. A sum of £100 invested in Bank of England stock in 1694, assuming all dividends had been reinvested and without consideration of taxes, would have grown to £41,870,819 by 1945 when the Bank of England was nationalized.16 It would be difficult to cite a comparable return in US banking because the gains in crony capitalist US banking have tended to be more veiled. But you will not be shocked at my suggestion that politically connected bankers make a lot of money.
4. Hegemony of the United States
The Reverse Midas Touch: Turning Gold into Paper
The monetary regime of US hegemony began after Bretton Woods in 1944, with the dollar as the denominator of international fixed exchange rates. Prior to World War II, during the twilight of British hegemony, gold had served as the anchor for fixed exchange rates. This meant each country guaranteed that its currency would be redeemed by its value in gold. After Bretton Woods, each member agreed to redeem its currency for dollars, not gold. The United States, in turn, agreed to redeem dollars for gold at the fixed price of thirty-five dollars to the ounce. At the time, the United States held three-quarters of the world’s supply of gold. This was the respectable beginning of the dollar’s role as the world’s reserve currency—before the signal crisis of US hegemony tipped the system toward financialization.
The “Nixon Shock”
Richard Nixon was not called “Tricky Dick” for nothing. In 1984’s After Hegemony, author Robert Keohane summarized the situation prior to the “Nixon Shock.” Keohane explained that by 1970–71, confidence in US economic policy had become undermined and perceived as inflationary, resulting in a loss of confidence in the strength of the dollar. Faced with the prospect of trimming government spending before the 1972 presidential election, Nixon did not hesitate. He repudi
ated the gold reserve standard and defaulted on the US promise to redeem dollars at the rate 1/35th of an ounce of gold.17
I have no doubt that principled and effective leadership in 1970–71 could have preserved the gold reserve system, at least for a time, at the cost of negative political feedback from voters unwilling to tolerate spending cuts that would have been required to turn the budget deficit into a surplus. A politician with the intellect and character of Lee Kuan Yew could have pulled it off, resisting what Hayek identified as “the ever-present demand for more and cheaper money.”
Richard Nixon was not the man for the job—Nixon was smart, but he lacked the self-assurance to save the gold reserve standard. He also had a limited and selfish perspective on monetary policy. Prior to the 1960 election, Arthur Burns, the first chairman of Eisenhower’s Council of Economic Advisors, warned Nixon that he was likely to lose because the Federal Reserve, at Eisenhower’s prodding, had tightened monetary policy, contributing to a recession that began in April 1960. In his memoirs, Nixon blamed tight money for his 1960 defeat. When he was finally elected in 1968, Nixon resolved to appoint Burns to chair the Federal Reserve Board at the first opportunity, which he did in 1970, on the understanding that Burns would assure that easy credit conditions prevailed for Nixon’s reelection bid in 1972.
In the event, as recorded in Burns’s diary, his relationship with Nixon proved rocky, as Nixon felt that Burns’s monetary policy was inadequately inflationary. After a 1971 meeting with Nixon, for example, Burns made this startling note: “The President looked wild; talked like a desperate man; fulminated with hatred against the press; took some of us to task—apparently meaning me or [chairman of the Council of Economic Advisors, Paul] McCraken or both—for not putting a gay and optimistic face on every piece of economic news, however discouraging; propounded the theory that confidence can be best generated by appearing confident and coloring, if need be, the news.”
In short, Nixon was far too insecure and obsessed with his reelection to have led the country into a deflationary retrenchment to forestall full-scale financialization. It may well have been true, as F. A. Hayek later contended, that retrenchment and deflation in the early ’70s might have spared the world from a deeper and more convulsive crisis—the worst part of which still lies ahead.
The Inescapable Crisis
Speaking of the escape from fixed exchange rates, Hayek said that we should have no illusion that we can escape the consequences of our mistakes and that we had missed the opportunity to stop a depression from coming. He thought that we had used what he called our “newly gained freedom from institutional compulsion” (the dollar fix to gold) to act more stupidly than ever before, postponing an inevitable crisis and making things even worse in the long run. He confessed that he wished for the crisis to come soon.18
Thus Nixon unleashed what an early director of the Bank of England described as “the formidable weapon of unrestricted money creation.” I suspect that he was more right than he knew to frame his discussion of pure fiat money in military terms. As we saw underscored by Great Britain’s suspension of the gold standard, first in the Napoleonic Wars and second in World War I, the big impetus for fiat money was a strategic imperative to fund crucial war costs that apparently could not be met within the restraints of sound money. Equally, as Elisa Newby pointed out in her 2007 paper, “The Suspension of Cash Payments as a Monetary Regime,” a key feature of the success of Britain’s temporary abandonment of the gold standard during the Napoleonic Wars was the credible promise that the suspension of specie payment would, in fact, be temporary.19
As mentioned, the US system of fiat money reflects the unprecedented scale of the US government as the largest the world has ever seen and the declining marginal returns (accelerating inefficiency) of a system that cannot pay its way. Just as the British flirted with fiat money on two rare occasions—spaced about a century apart, when the survival of the state depended upon outlays that would have been more difficult to afford under ordinary conditions—the United States has evolved a pure fiat system of creating money out of thin air because that is the only expedient for paying its truly gargantuan operating expenses.
In the current case of the United States, vast military outlays in combination with welfare state spending at a historically unprecedented scale, compose the heaviest fiscal load the world has ever seen. There is compelling evidence in plain view that the US government does not pay its way. Proof of declining returns is evident in the fact that the US national debt grew by more than $1 trillion between September 2013 and September 2014. It surged from $16,738,183,526,697.32 to $17,742,108,970,073.37, reflecting an operating shortfall of more than $2.7 billion a day. Multiplying the increase in the official debt are the compounding accrual obligations of the United States of more than $200 trillion.
Furthermore, as computed according to Generally Accepted Accounting Principles (GAAP), the annual federal budget deficit runs in the trillions. For example, for 2012, the GAAP deficit was $6.9 trillion, 42.6 percent of nominal GDP.
Just as a survival imperative dictated the move to pure fiat money by the United States, so a similar imperative prohibited the smaller states operating at earlier stages in the sequence of hegemonies from attempting to employ fiat money. They could never have funded their debts or financed their militaries with cash created ex nihilo in earlier stages of economic development. These earlier stages took place before the introduction of fossil fuels increased the economic growth rate, permitting the real economy to support a larger sum of claims represented by money and debt. (As I endeavor to explain in a coming chapter, historically unprecedented economic growth propelled by exogenous hydrocarbon energy amounted to a hidden BTU content of fiat money.)
In this light, as Keohane shrewdly observed in After Hegemony, there has been a deficiency of hegemonic stability theory in accounting for change in the international monetary system that “insofar as it relies on GDP figures as indices of power resources, it overpredicts regime collapse.”20
I believe that we are headed toward the terminal phase of the global financial system. What I doubt is that the reserve status of the US dollar can be displaced as an operating patch while business as usual proceeds in the global economy. To the contrary, the dollar will be displaced as part of Hayek’s inescapable crisis. Market adjustments the sort envisioned in Exter’s Inverted Pyramid will destroy money and debt on an enormous scale as a step toward the reconstitution of the global economy on a free market basis, probably incorporating the exchange of real money based on both silver and gold. These “barbarous relics” have the crucial feature of being assets that are not someone else’s liabilities.
My expectation is that the eclipse of US hegemony will close the curtain on fiat money at center stage of the world monetary system. If it is seen again after the Breaking Point brings US hegemony to a close, it will be a relic of backward closed economies, such as in North Korea.
Financial Cycle Growths in Amplitude
Part of the dynamic that will propel this inescapable crisis is the increasing imbalance associated with the growing amplitude of the financial cycle. This cycle has arisen from the accelerating expansion of credit over the past three decades, corresponding with increases and decreases in private debt, relative to income, and the prices of assets financed by that debt, including real estate. Mathias Drehmann and Claudio Borio, economists working at the Bank for International Settlements, have pioneered the concept of the financial cycle in current terms. (See graph on page 19 of BIS report at http://www.bis.org/publ/work380.htm.) But similar thinking can be traced to Hyman Minsky and before that to Hayek’s “Monetary Theory and the Trade Cycle” from the 1920s.
Measurement of the financial cycle is a challenge, but data compiled by the BIS economists shows that financial cycles can last as long as twenty years, with more pronounced swings of increasing amplitude over time. The imbalances accumulated and aggravated by rampant credit creation and the fuddling of price signals due t
o ZIRP threaten to crash the system as Hayek foresaw in the wake of the 1971 “Nixon Shock.”
With this in mind, I recommend that you accumulate both silver and gold. As hedge fund billionaire Ray Dalio of Bridgeport Associates puts it, “If you don’t own gold . . . there is no sensible reason other than you don’t know history or you don’t know the economics of it.”
Notes
1 Stockman, David, “We Are Entering the Terminal Phase of the Global Financial System,” Zero Hedge, May 18, 2015, http://www.zerohedge.com/news/2015-05-18/david-stockman-we-are-entering-terminal-phase-global-financial-system.
2 Arrighi, Giovanni, Adam Smith in Beijing: Lineages of the Twenty-First Century (London: Verso, 2007), 103.
3 Mylchreest, Paul, “Selling Time,” Equity & Commodity Strategy—Fulcanelli Report, March 25, 2015, 4.
4 Das, Satyajit, “Can the World Deal with a New Bank Crisis?,” Bloomberg, July 27, 2016.
5 Stockman, David, “Wake-Up Call for B-Dud and the New York Fed Staff—This Isn’t ‘Transitory,’” http://davidstockmanscontracorner.com/wake-up-call-for-b-dud-and-new-york-fed-staff-this-isnt-transitory/?utm_source=wysija&utm_medium=email&utm_campaign=Mailing+List+Sunday+10+AM.
6 Hayek, F. A., New Studies in Philosophy, Politics, Economics and the History of Ideas (London: Routledge & Kegan Paul, 1978), 213.
7 Felloni, Guiseppe, “A Profile of Genoa’s ‘Casa di San Giorgio’ (1407–1805): A Turning Point in the History of Credit,” 1. http://www.giuseppefelloni.it/rassegnastampa/A%20Profile%20of%20Genoa's%20Casa%20di%20San%20Giorgio.pdf.
8 Ibid.
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