How to Return to Sound Money

There has been very little commentary in recent years about the benefits of sound money, being limited almost entirely to followers of the Austrian school of economics. Even less has been written about how to back out of inflation-ism, end unsound money and return to a monetary arrangement which cannot be corrupted by governments and the banking system.

The most notable attempt was by Ludwig von Mises who appended a chapter on the subject in his updated 1952 version of The Theory of Money and Credit[i] The circumstances were very different from that of today. At that time, the US had corrupted its gold exchange standard to progressively exclude the ability of individuals to demand gold for paper dollars. And both Keynesianism and socialism, in the West at least, were in their earlier days. Today, we face more of an end game where considerable damage has been done since to the status of circulating money, and we face the prospect not of reform but of a collapse of the entire fiat money system.

It is a situation which, if nothing had been done in the 1950s, von Mises predicted in his writings would eventually happen. We are now witnessing not just the failure of state currencies, but also the economic damage wrought. That the root of the problem is a combination of progressive inflationism fuelling a credit crisis is gradually becoming obvious to a small but growing number of critics.

Recent events, which are germane to all our economic prospects in 2020 and beyond, are now unmasking a deterioration in demand for manufactured output and declining credit quality consistent with the ending of the expansionary phase of the credit cycle. The increase of American trade protectionism at this point in the credit cycle has worrying echoes of 1929, when the Smoot-Hawley Tariff Act was passed by Congress and signed into law by President Hoover in 1930.

The opening months of 2020 should see yet more statistical confirmation that the world’s production is declining, only concealed by renewed monetary inflation. Recession and its consequences are the central banks’ worse fear and they are already in accelerated printing mode in yet another attempt to forestall it.

The immediate future of fiat currencies is centred on the dollar’s prospects as the reserve currency. Dollar-centric markets remain in denial, believing the dollar will always be supported by a flight to safety if things cut up rough. In the short-term, it might be a self-fulfilling prophecy. But after an initial Pavlovian reflex, the dollar’s future measured in other state currencies depends on the relative needs of economic actors on a national basis and the actual ownership position.

Here, the dollar fares badly, with dollar assets and cash in foreign hands totalling about $24 trillion, and US ownership of non-dollar assets less than half that at $11.297 trillion (end-2018). US ownership of foreign short-term debt securities was $502bn at that date, of which only $92bn was in foreign currencies the rest being in dollars, according to TIC data from the US Treasury. Other than foreign listed securities, which are small in total compared with foreign ownership of US securities, that $92bn is all the foreign currency American residents have to sell in a financial meltdown.

Of their $24 trillion total, foreigners owned $19.4 trillion of dollar assets, of which more than $8 trillion is in equities, and includes short-term debt securities of $980bn. Additionally, dollar deposits held through correspondent banks totalled $3.6 trillion last October. Dollar liquidity in foreign hands is therefore nearly $13 trillion, before one considers foreign investment in US Treasuries, which is mostly held by foreign governments and official organisations. Clearly, when foreign balances adjust to a world of contracting trade, dollars will be sold heavily, destroying its value and disrupting US capital markets with very little in the way of flows the other way to offset it.

In these circumstances it will be impossible for the US Government to fund its budget deficits through capital inflows as it is wont to do. And given the absence of domestic savings accumulation, which would detract from final consumption and therefore undermine the GDP statistic anyway, trillion-plus deficits will have to be financed almost entirely by monetary and bank credit inflation.

Sooner or later this is bound to lead to a severe crisis for the dollar and therefore all the fiat currencies that regard it as King Rat. The crisis will be further fueled by a mixture of escalating government debt, falling purchasing power for the dollar, and increasing interest rates, the last being driven by the market response to a declining currency in terms of its purchasing power. It is a debt trap which will be reflected at the very least in a substantial decline of the full faith and credit in the US Government.

Eventually, possibly in a matter of only a few years, the dollar could become worthless. The few commentators aware of this danger have for some time been arguing for a currency reset without much idea how it can be implemented. It is almost certain that central banks will convene to cook up a new monetary plan as the dangers to the current system increase. But given the statist culture behind the problem, the basis of any state-initiated plan will surely include an attempt to secure the state’s monetary role and to extend its powers over markets. With the same underlying characteristics, any new currency arrangement based on a modification of the state-issued currency system is guaranteed to fail. History tells us that when the fiat route is pursued a second time, the public is already aware of government trickery and the second failure is swift (cf. France 1789-97 – assignats followed by mandates territoriaux which hardly lasted six months).

From an economic standpoint, the introduction of sound money will yield immediate benefits for the population compared with a failing currency regime. The problems obstructing it are a lack of understanding of catalytic theory by professorial economists and the establishment’s relentless grip on bureaucratic and political power.

To illustrate the required scale of the whole socio-economic and monetary reform involved, a solution which works must be proposed. Such a proposal must have sound incorruptible money at its heart, because no other arrangement will survive over time. It requires the termination of the central banking model. That central banks will be required to make their policy roles redundant virtually guarantees that the destruction of the fiat currency system, and its immediate replacement on a reset, are bound to occur before a sound money system of money and credit can be contemplated.

We should proceed with this assumption. Our sound money will be a phoenix rising from the ashes of monetary and economic destruction.

This article provides a template for how a new monetary system based on sound incorruptible money can be implemented. It addresses the following topics: the reintroduction of gold as circulating money handing all monetary power to its users, dealing with existing government debt, reforming the banking system, and resetting economic theory to where it was before Keynes worked up fallacious roles for the state. Properly addressed and planned, its implementation should be less difficult than it at first appears, and any nation following the courses of action in this article is likely to see substantial economic benefits in less than a year.

Sound money – it can only be physical gold

For the avoidance of doubt, a gold substitute is a currency in all its forms fully backed by and convertible into gold on demand by all of its users. A gold exchange standard permits the expansion of unbacked bank credit and does not prevent governments inflating total money supply.

Before critics jump to the conclusion that I am promoting a role for gold, it should be clear that my primary interest is sound money, which happens to be gold. So, yes, I am promoting gold but only as sound money; the order is sound money first, gold second. This is why I (and my colleagues at Goldmoney) insist the proper role of physical gold is as money, and it is not to be regarded as an investment, though related media, such as ETFs, derivatives and mining shares are properly classified as gold-related investments.

There should be no need to reiterate why gold emerged as the money of people’s choice, ever since the division of labour progressed beyond the exchange of goods through barter. But it is worth making the point that the difference between today’s money of the state and gold is that the state uses the debasement of its currency as a means of wealth transfer from the people to itself and those in its favour. It is an instrument of funding additional to taxation.

With sound money monetary debasement is strictly limited. The quantity of gold required as money in the global economy is only part of above-ground stocks and its quantity and distribution is decided by economic actors, not the state. The obvious source of global supply is mining, which runs at about 2% of above-ground stocks, in line with long-term population growth. The other source of deployment is scrap, recycling gold to and from other uses. This is why prices measured in gold are inherently stable.

As a common form of trusted money, gold also facilitates trade across borders, and when trade is settled in gold or gold substitutes which a government or bank cannot magically create out of thin air, there are no trade imbalances other than temporary shifts in the ratio of gold to goods that align price levels across jurisdictions.

Clearly, the reintroduction of sound money requires a radical change of socio-political and economic culture. Constrained by a sound money regime, the inability of a government to run continual deficits will remove considerable power from the state. Sound money also forces governments to abandon socialising legislation and makes ordinary people more responsible for their own actions.

Since the abandonment of the Bretton Woods agreement, the degree of monetary inflation has been substantial. The rise in the price of gold from the pre-war peg of $35 has to an unknown degree corrected earlier monetary inflation when the dollar was first put on a gold exchange standard, following the Gold Standard Act of 1900. It has continued to reflect monetary inflation thereafter, particularly following the suspension of all convertibility in 1971. The adjustment to date has not compensated for all of the increase in the quantity of fiat dollars in existence, but that matters less than a conversion price which can be maintained for all time, because if it is to succeed the new dollar must be a proper gold substitute.

The setting of the conversion price is the most important decision to be exercised by the issuer of new dollars. But as we have seen, an arm of the government is always ill-equipped to take monetary decisions, so the sensible policy would be to announce the decision to return to gold as the primary form of money and allow the market a period of time to approximately settle the pricing of gold relative to that of the new state currency. At the same time, consolidation terms for exchanging old dollars for the new should be announced, which will stop the old currency sliding into worthlessness, if it hasn’t already, and ensure the new currency is widely distributed at the outset.

During the period between announcing the scheme and its implementation, the central bank or Treasury department (in the case of the US) should cause an independent metal audit of its gold stocks to be conducted, having established an oversight committee drawn from neutral observers to oversee the process.

It is vital to ensure markets trust the existence of gold reserves from the outset. In the case of the US Treasury, with a stated 8,134 tonnes in possession a proper metal audit may take too long. A metal audit has to confirm the existence, identity, weight and purity of every bar and coin held in or allocated to the reserve backing the currency. In any event, there may be more gold in the Treasury’s possession than needed to back the new currency at the outset.

As soon as sufficient progress in the metal audit has been made for the auditor to indicate the degree of discrepancies (if any) then the approximate rate will have been set by markets in the knowledge there is sufficient gold to allow the new currency to circulate as a substitute. The remaining gold stocks (if any) can be held in abeyance.

Once the ratio between the new currency and a weight of gold is fixed, decisions can then be taken over matters such as the form of coinage. A dollar/gold rate would have been defined. For example one gram of gold might be represented by 10 new dollars. A new dollar therefore would be ten centigrams of gold. And every new dollar issued electronically, in paper or coinage form would only exist if it is 100% backed by gold held at the central bank.

All restrictions on gold ownership must cease. In order to ensure the state does not surreptitiously elide from a currency substitute system towards a gold exchange standard, it is vital to have gold circulating alongside its substitutes. This is easily facilitated by issuing high-value gold coins, the basis of the British sovereign, which ties a face value to a weight of fine gold. Depositors withdrawing funds from a bank must have the facility to withdraw them either in gold coin or paper substitutes.

Coins for small amounts would circulate as token money, instead of gold itself. This would permit the monetary authorities to issue practical, hard-wearing alloy coins for circulation, being fully backed by gold. The issuance of these tokens will also replace small-denomination banknotes to downplay the role of bank notes generally, thereby enhancing the role of gold as the true circulating medium. With the elimination of unbacked bank credit (see below) cheques and electronic transfers will also be fully backed by gold and be recognized as gold substitutes...

- Source, James Turk's Goldmoney

Why is Bank Credit so Destructive?

At the outset it should be understood that a cycle of bank credit leads to alternate booms and slumps and much debate has occurred over the years as to how to deal with it. This topic is becoming important again, since there are growing signs that the expansion of bank credit is faltering, a tendency for it to contract will follow and a business recession, or even worse, is now increasingly certain.

For many neo-Keynesians, the issue comes down to unpredictable private sector bank credit behaviour compared with more certain central banking control over base money. Some, such as the supporters of the 1935 Chicago plan, have argued that the way to deal with it is to introduce 100% reserve banking and to hand a monopoly of monetary creation to the central banks, targeting price stability, or simply managing a steady growth rate for money supply.

The Chicago plan was cooked up during the great depression, which was blamed by the inflationists on the gold standard. In the context of the controversy in the nineteenth century between the currency and banking schools the Chicago Plan was something of a hybrid, leaning towards the currency school but without the discipline of gold upon which the currency school based its proposition. Anyway, banking interests ensured the plan lay dead in the water.

It was also naïve, assuming that the relationship between the quantity of money and the general level of prices was simply mathematical, when we should know through empirical evidence and reasoned economic theory that it is not. There is enormous subjectivity in the general level of prices, reflected in relative preferences between the public’s desire for consumption relative to holding money. Furthermore, following the great depression, in debating these issues there was, and still remains, an unquestioned assumption that leaving any form of money at the mercy of free markets is dangerous and that it should be under the control of the state.

Aide-memoire: How bank credit is created

When a bank takes deposits onto its own balance sheet, it acquires possession of them and owes a debt to its depositors. Its balance sheet liabilities consist of the bank’s capital and what is owed to depositors and other creditors. Matching these liabilities are the bank’s total assets. The ratio between the bank’s own capital and its depositor liabilities is easily varied by the bank’s management. Technically, this can be done in one of two ways. Either a loan account with a matching deposit are created for a customer, so that the loan is offset by the deposit. Alternatively, a loan facility is made available, creating deposits as it is drawn down. Any imbalances at an individual bank are made up by deposits drawn from payments by other banks, or by borrowing from other banks through wholesale money markets.

Therefore, a bank can use possession of customer deposits to extend credit of its own creation. By expanding its balance sheet in this way, the gross income arising from the difference between loan charges and interest paid on deposits increases the ratio of earnings to the bank’s capital.

Equally, borrowers and depositors can cause the bank’s balance sheet to contract by the simple expedient of paying down their obligations, reducing their deposits. If a bank is to maintain an expanded balance sheet, it must repetitively find new business. Consequently, there is an inbuilt bias in favour of continual expansion of bank balance sheets and therefore of bank credit. But the expansion of credit distorts the price structure in the economy, lowering the cost of borrowing and discouraging savers from saving by reducing the time preference value of money.

Over time, an economy driven by bank credit expansion will move from being savings-driven, where investment capital for the wider economy is funded out of past profits and earnings retained as savings, to being driven by the creation of debt and matching deposits.

Putting aside the wishful thinking that bank credit can continue to expand on an even course in perpetuity, we should note that once an expansionary course is under way demand for bank credit starts off being less than the banks are prepared to finance. Spurred on by increasing banker confidence and growing bank competition for loan business, rates are then reduced to below where they would otherwise be in a savings-driven economy. This leads to an artificial boom that eventually generates more demand for credit than the banks are willing to provide, or are restricted from doing so by bank regulation.

When the banks call a halt to further credit expansion, borrowers can no longer fund their incomplete plans, and banks will want to protect themselves from the fallout by reducing loans and deposits to protect their own capital. The urgency of this change of course is due to the catastrophic impact on a bank’s own capital of an oversized balance sheet when bank credit expansion slows, stops and threatens to contract.

The consequence is a repetitive cycle of boom and sudden bust. (See here for a video further explaining the phenomenon).

The only way this can be prevented is to disallow the creation of bank credit in the first place, a solution so alien to today’s bankers and inflationist economists alike, that it is readily dismissed. The progression of successive cycles in Britain since the Napoleonic Wars, adopted increasingly by other jurisdictions has, for modern times, led to an end point in bank credit creation, where consumers have little or no savings left and the majority live on tick between salary payments. Having abandoned all forms of sound money in favour of fiat currency inflation, the creation of base money is now being accelerated in a final attempt by central banks to buy off the consequences of not just the current cycle of bank credit inflation, but all those leading up to it.

Nothing goes on for ever, so sooner or later the system that has flourished on the possession of depositors’ bank balances will end. A new system of banking will then be devised, and its success will require a return to sound money, money that cannot be created out of thin air on the whim of a commercial or central banker.

In the wider context of history, the current debate about the role and behaviour of banks has occurred in a moral and legal vacuum, ignoring issues which have been debated since ancient history. And it was the Romans who resolved it in the third century AD, differently from our modern assumptions...

- Source, James Turk's Goldmoney, read more here

Where, Why and How to Hold Gold and Silver For The Coming Collapse

The Money Bubble Will Pop, Gold is Real Money

One of the biggest names in the precious metals industry is here with us to discuss many gold related topics including the sound money history, ETF Scam and today's silver shortage. Of course we drill him down to get the most important aspects of how gold & silver will affect us today.