House of Cards and How to Start
Replacing It With Solid Gold
A credit crisis has been spreading
through the economic system. It began with the collapse of the housing bubble,
which was the result of years of Federal-Reserve-sponsored credit expansion.
This credit expansion poured hundreds of billions of dollars into the purchase
of homes largely by sub-prime borrowers who never had a realistic capability of
repaying their mortgage debts in the first place. And, not surprisingly, large
numbers of them in fact stopped making the payments required by their mortgages.
At first apparently confined to the
market for sub-prime mortgages, the credit crisis has spread to other portions
of the mortgage market, to the usually staid municipal bond market, and within
the last week or so has led to a run against a major investment bank (Bear
Stearns). Along the way, triple-A rated securities have overnight turned into
junk bonds, multi-billion dollar hedge funds have collapsed, and major
commercial banks have lost tens of billions of dollars of capital. All this,
despite massive infusions of funds into the market by the Federal Reserve System
and other central banks and a reduction in the Federal Funds rate from 5.25
percent in September of 2007 to 2.25 percent currently.
In the process, the triple-A rated
securities that turned out to be junk served to confirm the old truth that lead
cannot be turned into gold: the alleged triple-A securities were backed by
collections of mortgages that in the last analysis consisted largely or even
entirely of sub-primes. An important new truth also appears to have emerged:
namely, that Ph.Ds. in finance, the likely authors of the schemes for creating
such securities, can turn out to be far more costly than anyone had ever dreamed
Currently, untold billions more of
banks’ capital now hinge on the survival of bond insurers striving to insure
more than two trillion dollars of outstanding bonds on the basis of capital of
their own of roughly ten billion dollars. Collapse of the bond insurers would
mean that credit-rating firms, such as Moody’s and Standard and Poor’s, would
reduce the ratings of all the bond issues that would consequently be deprived of
insurance coverage. This in turn would serve to reduce the prices of those
bonds, because lower credit ratings would make them ineligible for purchase by
numerous investors, such as many pension funds. To the extent that the bonds
were owned by banks, the value of the banks’ assets would be correspondingly
reduced and with it the magnitude of the banks’ capital.
The decline in the assets and capital
of banks that has already taken place has served to reduce the ability of banks
to lend money to borrowers to whom they would otherwise normally lend. To the
extent, for example, that sub-prime mortgage borrowers have stopped paying
interest and principal on their loans, the banks do not have those funds
available to make loans to other borrowers.
The effects of such credit contraction
can already be seen in business bankruptcies precipitated by an inability of
firms to obtain refinancing of debts coming due. It can also be seen in the
growing difficulty even of sound firms to obtain financing required for
The Role of Leverage
Our present circumstances follow
decades, indeed, generations of almost continuous inflation and credit
expansion, in which almost everyone has become accustomed to assume that asset
values will always rise or at least will quickly resume their rise after any
pause or decline. This assumption not only played an important role in the
eagerness with which people lent and borrowed in the mortgage market, but also
in bringing about the very high degree of financial leverage that has come to
characterize practically all areas of our financial system. (Leverage is the use
of borrowed funds to increase the returns that can be earned with a given sized
capital. It equivalently increases the losses that can be incurred on that
Unduly high leverage explains the
failure of major lenders in the prime portion of the real estate market.
As the result of losses sustained in sub-prime mortgages, banks and other
lenders could no longer provide funds as readily for the purchase of prime
mortgages. The resulting few percent drop in the value of prime mortgages has
served to wipe out the entire capital of prime mortgage lenders whose capital
was so highly leveraged that it constituted an even smaller percentage of the
value of their assets than the few percent drop in the price of those assets.
For example, if a mortgage lender initially had assets worth $103 and debts of
his own of $100 incurred in order to finance the purchase of those assets, a
mere 4 percent decline in the value of his assets would wipe out his entire
capital and then some. Multiply these numbers by many billions, and the example
corresponds exactly to the real-world cases of Thornburg Mortgage and Carlyle
Capital reported on the front page of The New York Times of March 8, and
to that of Bear Stearns reported on the front page of The New York Times
just one week later.
The liquidation of the assets of such
lenders, which consisted mainly of prime mortgages, has meant a further fall in
the price of prime mortgages, to the point where the credit even of the
government-sponsored mortgage lenders Fannie Mae and Freddie Mac has come into
question. These two lenders have outstanding mortgage-backed obligations of more
than $4 trillion, which sum until recently was assumed also to be an obligation
of the US government. Now it has become uncertain whether the actual obligation
of the US government extends beyond the less than $5 billion in lines of credit
these lenders have with the US Treasury.
The Federal Reserve’s rescue of Bear
Stearns can be understood in part in the light of its desire to avoid further
declines in the assets and capital of Fannie Mae and Freddie Mac, which would
have resulted if Bear had had to sell off its holdings of mortgages. The
likelihood that the failure of Bear would have triggered the failure other major
Wall Street firms and thereby have resulted in even more massive sell offs of
mortgages, along with other assets, was a related important consideration.
Remarkably, at the very same time that
the Federal Reserve has been striving to cope with the consequences of excessive
leverage and possibly thereby help to prevent the collapse of Fannie Mae and
Freddie Mac, the government regulator of these institutions—the Office of
Federal Housing Enterprise Oversight—is not content with the fact that they are
already skating on dangerously thin ice. Thus, The New York Times of
March 20 reports that the regulator has just decided to reduce their
capital requirements, for the purpose of enabling them to take on still more
leverage. The effect of this will be that an even more modest decline in home
prices and mortgage values will be sufficient to drive Fannie Mae and Freddie
Mac into bankruptcy than is now the case.
As these examples illustrate, the
failure of debtors can serve to wipe out the capital of highly leveraged
creditors, who then become unable to pay their debts, perhaps causing the
failure of their creditors, and so on. In other words, one failure can set off a
domino effect of a chain of failures. What serves to end the process is when
someone in the chain finally accumulates enough salvageable assets from those
earlier in the chain to be able to satisfy his creditors.
Leverage and Bank
Operating alongside the process of
chains of failures is another, even more important aspect of the leverage
present in today’s financial system. This is the fact that reductions in the
capital of banks can result in multiple contractions of credit. As a rough
average, banks are normally required to possess capital equal to five percent of
their outstanding loans and investments. (Investments are purchases of
securities.) The implication of this is that reductions in banks’ capital below
the five percent level have the potential to result in contractions of credit
twenty times as large, in efforts to reestablish the five percent ratio.
For example, a bank with an initial
capital of $5 billion, could support $100 billion in outstanding loans and
investments, based on the requirement that its capital be at least 5 percent of
the credit it has granted. But if its capital falls to $4 billion, it must
reduce its outstanding loans and investments to $80 billion to be in compliance
with that requirement. In other words, a $1 billion reduction in bank capital
can cause a $20 billion reduction in outstanding bank credit.
Such announcements as that recently
made by Citibank, that it would reduce its holdings of home loans by 20 percent,
are entirely consistent with this phenomenon, as are the recent failures of
banks and brokers to make bids in markets for so-called auction-rate notes.
(These are credit instruments whose interest rates are set periodically on the
basis of auctions and that until recently were billed as the equivalent of cash.
Bidding for them would have placed banks at risk of acquiring additional assets
and indebtedness when they urgently needed to reduce their assets and
Credit Contraction and Deflation
Of the greatest importance is the
further fact that credit contraction by banks has the effect of reducing the
outstanding volume of checking deposits in the economic system and to that
extent the quantity of money in the economic system. This result follows from
the fact that when debtors repay their loans, they do so by means of writing
checks, the proceeds of which are subtracted not only from their accounts but
also from the balance sheets of the banks on which the checks are drawn. If
those banks do not then make equivalent new loans, accompanied by the creation
of equivalent fresh checking deposits for new borrowers, the amount of the
checking deposits used to repay the loans simply disappears. (The same result
occurs when banks sell portions of their securities holdings to members of the
public. The buyers of the securities pay for them by means of writing checks,
and the proceeds of those checks then disappear not only from the checking
accounts of the purchasers but also from the balance sheets of the banks on
which the checks are drawn.)
Such contraction of credit and money
operates to reduce the amount of spending in the economic system. The money that
is no longer present in the economic system, because the credit that would have
provided it has disappeared, is money that can no longer be spent. Money no
longer spent is business sales revenues no longer earned. A drop in business
sales revenues, in turn, causes a drop in spending by the firms that would have
earned those sales revenues.
This further drop in spending reduces
both the sales revenues of other firms, namely, those that would have supplied
the firms in question, and wage payments to workers, as employees are laid off
in the face of declining sales. And, of course, as wage payments fall, so too
does the spending of wage earners for consumers’ goods. The decline in spending,
sales revenues, and wage payments is repeated again and again throughout the
economic system, as many times in a year as the vanished sum of money would have
been spent and respent in that year.
Of no less importance is the fact that
a decline in the quantity of money and volume of spending can itself cause
further declines in the assets and capital of banks. This is because as the
sales revenues of business firms decline, so too do their profits and their
ability to repay debts, including debts to banks. The resulting further declines
in the value of bank assets further reduce the capitals of banks, causing more
credit contraction, further reductions in the quantity of money and volume of
spending, and still more reductions in the asset values and capitals of banks,
on and on in a self-reinforcing vicious circle.
Bank Failures and Bank Runs
Historically, processes such as those
just described have not taken place smoothly and gradually, in a manner akin to
the air slowly leaking from some kind of giant inflated balloon. To the
contrary, they have been characterized by sudden massive ruptures in the fabric
of the system, namely, by bank failures, often precipitated by bank runs.
Sooner or later, the erosion of its
capital makes a bank actually fail. What is meant in saying that bank failures
were often precipitated by bank runs is merely that at some point depositors
woke up to the fact that a bank’s assets were no longer sufficient to guarantee
the repayment of its deposits, and so raced to withdraw their funds while it was
still possible to do so.
Bank failures, and even bank runs, are
by no means a phenomenon confined to history. Intermittent bank failures
continued to occur through the entire 20th century. And the present
Chairman of the Federal Reserve System has said that some bank failures are to
be expected in our present crisis. Only late last summer there was not only a
failure but also an actual run on a major British bank, Northern Rock. If our
own credit crisis continues and deepens further, it should not be surprising to
start seeing bank runs here in the United States as well. Indeed, what happened
to Bear Stearns—which is an investment bank—on March 13 and made it seek the
help of the Federal Reserve System was precisely a run, as large numbers of its
clients sought to withdraw their funds all at once. It is very possible that
what has just happened at Bear Stearns will also happen at one or more major
commercial banks, whose customers hold checking or savings accounts. (In this
connection, it should be kept in mind that federal deposit insurance is limited
to a maximum of $100,000 per account. The run would be on the part of those
whose accounts are larger than $100,000.)
When a bank fails, unless it is
immediately taken over by another, still solvent bank, its outstanding checking
deposits lose the character of money and assume that of a security in default.
That is, instead of being able to be spent, as the virtual equivalent of
currency, they are reduced to the status of a claim to an uncertain sum of money
to be paid at an unspecified time in the future, i.e., after the assets of the
bank have been liquidated and the proceeds distributed to the various parties
judged to have legitimate claims to them. Thus, what had been spendable as the
equivalent of currency suddenly becomes no more spendable than any other
security in default.
This change in the status of a bank’s
checking deposits constitutes a fully equivalent reduction in the quantity of
money in the economic system. Thus, for example, if a bank were to fail with
outstanding checking deposits of $100 billion, say, and not be taken over
immediately by another, still-solvent bank, the quantity of money in the
economic system would also immediately fall by $100 billion.
As a result of this fact, bank
failures have the potential greatly to accelerate and deepen the descent into
deflation and economic depression. For they represent much larger, more sudden
reductions in the quantity of money and volume of spending in the economic
system. And, just like lesser reductions, their effect, unless somehow checked
or counteracted, is to launch a vicious circle of contraction and deflation.
The period 1929-1933 provides the leading historical example.
In 1929, the quantity of money in the
United States was approximately $26 billion and the gross national product
(GNP/GDP) of the country, which provides an approximate measure of consumer
spending, was $103 billion. By 1933, following wave after wave of bank failures,
the quantity of money had fallen to approximately $19 billion and the GNP to
less than $56 billion. The failure of wage rates and prices to fall to anywhere
near the same extent resulted in mass unemployment.
The Potential for Deflation Today
In order to understand the potential
for deflation today, in 1929, or at any other time, it is necessary to
understand the concepts “standard money” and “fiduciary media.” Standard money
is money that is not a claim to anything beyond itself. It is money the receipt
of which constitutes final payment. Under a gold standard, standard money is
gold coin or bullion. Paper currency under a gold standard is not standard
money. It is merely a claim to standard money, i.e., gold.
Since 1933, paper currency in the
United States has been irredeemable. It has ceased to be a claim to anything
beyond itself. Its receipt constitutes final payment. Thus, since 1933, the
standard money of the United States has been irredeemable paper currency.
Most of the money supply of the United
States, today as in 1929, is not standard money of any kind, but rather
fiduciary media. Fiduciary media are transferable claims to standard money,
payable on demand by their issuers, accepted in commerce as the equivalent of
standard money, but for which no standard money actually exists.
What precisely fits the description of
fiduciary media are checking deposits insofar as they exceed the reserves of
standard money held by the banks that issue them. Checking deposits are, first
of all, transferable claims to standard money, payable on demand by the banks
that issue them, and accepted in commerce as the equivalent of standard money.
To the extent that they exceed the currency reserves owned by the banks that
issue them, they are fiduciary media.
At the present time, there are
approximately $2.5 trillion of checking deposits in one form or another. These
checking deposits are those reported as part of the M1 money supply
($625 billion), plus those reported as so-called sweep accounts by the Federal
Reserve Bank of St. Louis ($765 billion),
and those reported as retail money fund accounts ($1078 billion).
In addition to these checking
deposits, our present money supply consists of approximately $800 billion in
currency outside the banking system. Our total money supply is thus currently
$3.3 trillion. Of these $3.3 trillion, the quantity of standard money is
approximately $840 billion: the currency outside the banks plus $40 billion of
currency reserves of the banking system.
There are no reserve requirements on
either sweep accounts or retail money fund accounts. Supposedly there is a basic
10 percent reserve requirement against the checking deposits counted under M1.
Nevertheless, the actual reserves held against these checking deposits are not
$62 or $63 billion, but merely on the order of $40 billion, which implies an
overall effective reserve requirement of less than 7 percent against these
checking deposits. When compared to the total checking deposits of the economic
system, the roughly $40 billion of reserves constitute a reserve on the order of
less than 2 percent. This is the measure of the leverage of today’s banking
system with respect to reserves.
In an ongoing process of a vicious
circle of bank failures, a falling quantity of money and volume of spending, and
thus falling business sales revenues, mounting business losses and business
failures, resulting in still more bank failures, the volume of checking deposits
might ultimately be reduced all the way down to the system’s $40 billion of
standard money reserves. This last is the actual currency either in the
possession of the banks or belonging to them while held by the Federal Reserve
System. This currency is the only asset of the banks whose value cannot be
reduced by the failure of debtors.
The potential deflation of checking
deposits, if nothing were done to stop it, is the difference between their
present amount of $2.5 trillion and the $40 billion of reserves that stand
behind them. The potential deflation of the money supply as a whole, if nothing
were done to stop it, is the difference between $3.3 trillion and $840 billion,
i.e., approximately 75 percent.
Why Massive Deflation Must Be Prevented
Massive deflation is always something
that should be avoided if it is humanly possible to do so. The surest and best
way to avoid it is to avoid the prolonged credit expansions that set the stage
The only way that the economic system
can adjust to deflation once it has occurred is by means of corresponding
reductions in wage rates and prices. These serve to increase the buying power of
the reduced quantity of money and the reduced volume of spending that it
supports. If they were sufficient, they would enable the reduced quantity of
money and volume of spending to buy all that the previously larger quantity of
money and volume of spending had bought.
Yet there are powerful obstacles in
the way of wage rates and prices falling. Not the least of these is the
prevailing belief that rather than it being the reduction in the quantity of
money and volume of spending that is deflation, it is the fall in wages rates
and prices that is deflation. This incredible confusion leads to misguided
attempts to combat deflation by means of preventing the only thing that would
make possible a recovery from deflation, namely, a fall in wage rates and
This confusion is joined by the even
more influential errors of the Marxian exploitation theory, which claims that
employers would arbitrarily set wage rates at the level of minimum subsistence
if not prevented from doing so by government intervention. The result of this
stew of ignorance is the existence of laws such as pro-union and minimum-wage
legislation, which make it extraordinarily difficult or plain impossible for
wage rates to fall. These laws are tantamount to simply making it illegal
for the process of recovery to proceed.
To these laws must be added the
virtual paralysis of our present-day judicial system. Not only do convicted
murderers often sit on death row for years or even decades before their
sentences are carried out or finally set aside, but ordinary law suits now
normally take years to wind their way through our court system. A leading
consequence of a massive deflation would be millions upon millions of business
and personal bankruptcies, which our court system is simply not equipped to
handle. The functioning of an economic system depends on clear knowledge of who
owns what and who has the legal right to do what with what property. It cannot
wait years for judges to make clear and final decisions about such matters,
which is the likely period of time it would take them if the present typical
performance of our judicial system is any guide.
Given these legal obstacles, the
effect of massive deflation would be long-term mass unemployment and economic
paralysis. Literally tens of millions would be unemployed, with no way to find
new employment. Such conditions, in combination with the massive economic
illiteracy that prevails in our culture, would likely result in the adoption of
many new and additional acts of destructive government interference. It would
not by any means be out of the question that the likes of a native-born Hugo
Chavez could be elected president of the United States.
True and False Remedies
It should be obvious from much of what
has been said in this article that what is driving our impending deflation is
the lack of capital on the part of the banks, resulting from the losses they
have thus far sustained on their assets. This is what has been impelling them to
contract credit, and which, if unchecked will serve to reduce their assets and
capital further and further, until much or all of the banking system and the
checking deposit money it has created collapses under its own weight for a sheer
lack of monetary reserves.
In the light of this knowledge, such
solutions as the recently enacted “stimulus package” designed to promote
consumer spending should be dismissed as laughably naive. The economic system is
not going to be rescued by consumers, let alone by consumers so incapable of
producing that they require government handouts in order to consume. No one
benefits by giving people the money with which to buy his products. Yet this is
the position such programs force taxpayers to assume.
Likewise, when one keeps in mind that
the problem is a lack of capital, such alleged solutions as the Federal
Reserve’s current policy of reducing interest rates must appear as clearly
counterproductive. Reductions in interest rates in the United States relative to
those in Europe and elsewhere serve to keep badly needed capital out of our
country by making investment there more profitable than investment here. In
keeping down the overall supply of capital in the United States, they contribute
to the lack of credit and to making it more difficult for banks to obtain the
additional capital they need. The Federal Reserve has carried this policy a
large step further, with its most recent reduction in the Federal Funds rate
from 3 percent to 2.25 percent.
Similarly, the rescue measure proposed
for homeowners faced with foreclosure, namely, forcibly reducing interest rates
on sub prime mortgages in violation of the contractual terms of the mortgages
and against the will of the mortgage holders, would serve further to reduce the
earnings, assets, and capital of the banks. Decisions of judges to place
obstacles in the way of the foreclosure process, such as insisting on the
presentation of the original mortgage documents, even though it is undisputed
that the borrower is in default, also serve to weaken the financial position of
banks. It can do so not only directly but also indirectly, by contributing to
the bankruptcy of non-bank mortgage lenders with debts to banks.
The sympathy expressed for the
families threatened with foreclosure is very largely misplaced. It is forgotten
how many of them purchased their homes without making any down payment of any
kind, and often without being obliged to make any payments of principal on their
mortgages. Many of the homes now being foreclosed were purchased by such buyers
not for the purpose of having a place to live, but for the purpose of profiting
from a speculative investment.
Of course, there are also some
homeowners who did make substantial down payments in purchasing their homes,
even during the housing bubble. But there are many more who purchased their
homes before the bubble began but who in recent years foolishly chose to consume
their equity, by incurring additional debt to finance consumption in excess of
their incomes. At the time, these people were lauded as pillars of the economy’s
strength, on the basis of the same ridiculous beliefs that underlie the
proposals to rescue the economy now by still more consumption on the part of
people who can’t afford it.
The effect of the years of
Federal-Reserve-sponsored credit expansion and the resulting spending binge on
housing that people could not afford was to make housing unaffordable by
millions of other people. It was to raise median house prices in many places to
the point where only the top 15 or 20 percent of income earners in the area
could afford the median priced home. To make housing affordable once again by
the mass of people who normally could afford to buy a home, housing prices need
to fall to whatever extent their rise in recent years has exceeded the rise in
median family incomes. The foreclosure process is an essential step in bringing
that about. It should not be prevented in any way from taking place.
How to Increase the Capital and Reserves
of the Banking System
Since the problem behind our impending
deflation is the lack of capital on the part of the banks, and beyond that the
lack of monetary reserves to maintain the supply of checkbook money when banks
fail, it should be obvious that what is needed to avoid the threat of deflation
is an increase in the capital and reserves of the banks.
When the problem is stated this way, a
thought that is likely to occur to many people is that the banks should simply
go out and raise additional capital. They should sell stocks and bonds, for
example. And, in fact, that has actually happened in some cases, for example,
that of Citibank, which raised $14.5 billion in new capital from foreign
investors this last February.
One problem with such a procedure is
how much of the bank’s ownership has to be given to the new investors to make
their investment worthwhile for them. And, as indicated, raising the necessary
capital is made more difficult by Fed’s policy of low interest rates, which
keeps down the supply of capital by discouraging foreign investment in the
United States. Another, deeper problem for many banks is that in the minds of
potential investors the bank’s actual capital may be negative, requiring
investors to put up not only new and additional capital but also capital
required to overcome the bank’s negative capital. (Negative capital can easily
result when on the left-hand side of a bank’s balance sheet there are tens or
hundreds of billions of dollars of assets whose value can decline, while on the
right-hand side there are tens or hundreds of billions of dollars of deposits
whose value is fixed. As we saw earlier, when capital is only a very few percent
of assets to begin with, even a modest decline in the value of assets can turn
The existence of negative capital
entails requiring first an investment sufficient to reach the point of zero
capital. And only then the investment of the capital that will enable the bank
to maintain and increase its operations. Moreover, the extent of the capital
deficiency may not even actually be knowable. Such considerations make the
raising of additional capital by conventional means extremely difficult or
altogether impossible. It’s a case simply of having to invest too much in order
to receive too little.
In these circumstances the only party
willing to provide the needed capital funds is the government, i.e., the
Federal Reserve System, which has the power simply to print them if necessary.
At present, the Federal Reserve is
already supplying the banking system (and the major investment banks as well)
with capital. But it is doing so only to the extent of overcoming negative
capital, and perhaps doing that less than fully. This is the essential meaning
of the Fed’s acceptance of billions of dollars of assets of dubious value in
exchange for its own assets of relatively secure value, i.e., US government
bonds and Treasury bills. (The Fed now even accepts assets for which there is no
market because finding a market would require a radical reduction in the price
of the assets compared to what was originally paid for them, and correspondingly
wipe out capital on the books of the banks.)
The Fed has committed almost half of
its own principal assets to this project: $400 billion out of its most recently
reported total holdings of government securities of $828 billion. It will not be
able to commit much more of those securities. Indeed, however ironic it may be,
the Federal Reserve—the “lender of last resort,” the alleged bailer-outer of the
banking system and of the whole economy—is or may fairly soon be itself
technically bankrupt as the result of this operation. (This would be clear if
the assets it receives had to be valued at their actual market value. The result
would be that the assets of the Fed would be less than the face value of its
outstanding US currency and other liabilities.)
Unless the Fed’s actions up to now
prove sufficient to end the financial crisis, its next step will be the printing
of money to prop up the banking system. Indeed, even if the crisis were to end
as of now, there would still be the problem that the Fed’s infusion of capital
has thus far been only on a temporary basis. The banks are supposed to take back
their low-grade and non-performing assets within a month or so and return the
Fed’s securities. Clearly, a solution to the problem of a lack of bank capital
needs to be long-term, not something that must be renewed month by month.
Moreover, a proper solution to our
present crisis should do more than merely overcome the difficulties of the
moment. It should, in addition, provide a guarantee against the recurrence of
such crises in the future. Above all, a proper solution to this or any other
economic or political crisis should also meet the criterion of serving to
advance the cause of economic freedom and should be designed with that objective
There is a means of accomplishing all
three of these objectives.
That means is the use of gold as a
major asset of the banking system.
Despite the certainty that a proposal
of this kind will be almost completely ignored and has virtually no chance of
being enacted in the foreseeable future, it still must be made. This is because
the most fundamental and important consideration is not what people are willing
to accept or reject at the moment but what would in fact accomplish the
objectives that need to be accomplished. Using gold as a major asset of the
banking system, in the way set forth below, would in fact safeguard the banking
system from possible deflationary collapse, prevent the recurrence of any such
threat, and do so in a way that substantially advanced the cause of economic
freedom. Making the proposal is necessary in order to uphold the philosophy of
economic freedom, by providing a demonstration that that philosophy offers the
solution to the growing monetary problems we face and is not their cause.
Gold as the Source of New Bank Capital
and of Reserves
The Federal Reserve System holds
approximately 260 million ounces of gold. The market price of gold recently
reached $1,000 per ounce. This means that the Fed’s gold can easily be thought
of as an asset with a market value of roughly $260 billion.
As an initial approach to
understanding the solution to our problem, let us assume that the Federal
Reserve declared its gold holding as being held in trust for the benefit of the
American banking system, and proceeded to allow every bank to enter on the asset
side of its balance sheet a portion of this gold corresponding to its share of
the total of the $2.5 trillion of checking accounts presently in the economic
system. The banks would not physically possess the gold but only book entries
corresponding to it.
The gold entered on banks’ balance
sheets could also count as equivalent new and additional bank reserves. Thus the
measure would simultaneously add $260 billion of new and additional bank
reserves in the form of gold as well as $260 billion of new and additional bank
capital. The reserves and the capital would both be essentially permanent.
In order to prevent the monetization
of the gold reserves, the Fed could mandate a permanent required gold reserve
against all checking deposits—those counted in M1, those counted as
“sweeps,” and those counted as retail money funds—in the ratio of $260 billion
to $2.5 trillion, i.e., a little over 10 percent.
A major shortcoming of this very
simple solution is that the addition of $260 billion in gold to bank assets
would probably be insufficient. It almost certainly would be if the Fed decided,
as it should, to take back its government securities from the investment banks
and give them back their securities of far less value. That would probably
bankrupt most or all of the investment banks. Furthermore, because the
commercial banks are their main creditors, the assets of the investment banks
would move into the possession of the commercial banks and do so, of course, at
a far lower value than the loans that had been made to the investment banks.
Thus, the present capital of the commercial banks and much more would be wiped
Accordingly, the book value placed on
the Fed’s gold holding needs to be substantially higher than $1,000 per ounce,
if it is to result in the creation of sufficient bank capital and reserves. The
question is, how much higher?
The most logical answer to this
question was supplied as far back as the 1950s by the late Murray Rothbard, who
argued for the establishment of a 100-percent-reserve gold standard by means of
pricing the Fed’s gold stock at whatever price was necessary to make it equal
the outstanding supply of money.
Taking the outstanding supply of money
today as being $3.3 trillion, Rothbard’s proposal implies a gold price of
approximately $12,700 per ounce. At such a price, the Fed’s gold stock would be
sufficient to provide a 100 percent reserve against both all US checking
deposits and all US currency.
The provision of a 100 percent reserve
would be an immediate guarantee against any reduction in the supply of checkbook
money. This would obviously be the case if the banks simply paid out gold in
response to customers’ demands for the redemption of their checking deposits. At
$12,700 per ounce, the banks and the Fed would have enough gold to redeem every
single dollar of checking deposits and currency in the economic system. (That’s
the meaning of a 100 percent reserve.)
Of course, in the circumstances
envisioned here, the banks would not pay out physical gold. But they would have
the ability to pay out paper currency to the full extent of outstanding checking
deposits, and that currency would have an undiminished gold backing at the price
of gold of $12,700 per ounce. Thus whatever the recession that might develop in
the months ahead, it would be contained, insofar as the money supply of the
country would not be reduced. That would guarantee a major reduction in the
possible severity of what might otherwise develop.
This 100-percent-reserve gold standard
as thus far described would obviously be a long way from the full-bodied
100-percent-reserve gold standard that Rothbard envisioned, and which I myself
have elaborated upon and advocated. It would be a standard that for some time
was largely just nominal, in that the actual gold of the of monetary system
would still be in the possession of the Federal Reserve System. Nor would there
yet be any obligation of the Fed to buy or sell gold at the price of $12,700 per
ounce or at any other price. The purpose of the system I have described would
simply be the twofold one of providing reserves sufficient to prevent any
possible reduction in the supply of checkbook money and also of providing
capital to banks sufficient to substantially more than offset the losses
otherwise resulting from a decline in the value of banks’ assets.
Indeed, given that what would be
present is an addition to the assets of the banking system in an amount equal to
the full magnitude of outstanding fiduciary media, i.e., of $2.5 trillion of
checking deposits minus $40 billion of presently existing standard money
reserves, the overwhelming likelihood is that the banks would be handed far too
much capital. Even with losses of $1 trillion on their existing assets, they
would still stand to gain practically $1.5 trillion in new and additional
capital. Such a bonanza would not be justifiable. The solution would be to pass
most of it on to the banks’ depositors in the form of bank stock or bonds paid
as a dividend on their accounts.
It is not possible in the space of one
article to explore, beyond the very limited extent to which I’ve done so,
the problems and the solutions entailed in moving on to the full-bodied
100-percent-reserve gold standard that is the ultimate objective of my proposal.
Under such a gold standard, paper currency and checking deposits will, of
course, be fully convertible into gold, physical gold coin will enjoy wide
circulation, and the supply of gold in the country will be free to increase or
decrease simply in response to market forces.
All I have tried to show here is how
the twin problems of a lack of bank capital and of bank reserves, which are the
core of the threat of deflation, could be solved by means of establishing the
framework of a 100-percent-reserve gold monetary system.
Needless to say, such a system would
not only end the threat of deflation, but, equally important, it could end the
threat of inflation as well. For if it were actually followed, the increase in
the quantity of money would be limited to the increase in the supply of gold,
which is extremely modest compared with increases in the supply of irredeemable
paper money. This is because gold is rare in nature and costly to extract.
Irredeemable paper money in contrast is virtually costless to produce and is
potentially as abundant as the supply of currency-sized sheets of paper, indeed,
as abundant as the size of the largest number that can be printed on all such
sheets of paper.
Above all, the solution I have
proposed would constitute a major step toward the establishment of a full-bodied
precious metal monetary system and thus toward ultimately eliminating the
government’s physical control over the money supply and all of the violations of
individual freedom that that control represents and makes possible.
And what is more, it could be
accomplished at a cost to the Federal Reserve not of hundreds of billions of
dollars—the sums the Fed is risking in exchanging its government securities for
bank assets of vastly lower value—not for the $30 billion it has risked to bail
out just Bear Stearns, but for a little more than $11 billion! Just $11 billion
is the value at which the Fed carries its gold stock on its balance sheet, at a
price of gold of approximately $42 per ounce.
Thus, to say it all in one sentence,
the threat of massive deflation can be eliminated, the threat of inflation
ended, and the actual and potential domain of economic freedom greatly expanded,
for $11 billion—an $11 billion that would not even be an out-of-pocket expense
to anyone but merely a balance-sheet charge on the books of the Federal Reserve
System when it deducted its gold holding from its balance sheet and added it to
the balance sheets of the banks.
I am indebted to Prof.
William Barnett, II, of Loyola University, New Orleans. His recent internet
postings on the mises@yahoogroups list made me aware of the fact that the
capital requirements of banks under the Basel II Capital Accord, rather than
official reserve requirements imposed by the Federal Reserve System, is all that
has served to constrain the increase in the quantity of money in the United
States in recent years. His comments also served to provide important insight
into understanding the role of banks’ capital requirements in explaining
essential aspects of their recent behavior as well as their likely behavior in
the weeks and months ahead.
Sweep accounts are checking deposits that banks transfer
into savings deposit accounts overnight, on weekends, and on holidays,
in order to reduce their required reserves and thus be able to use any
given amount of reserves to support a larger volume of checking
Inasmuch as the accounts subsumed under this last head generally allow
the writing only of a limited number of checks per month, and sometimes
impose limits on the minimum dollar amount of the checks that may be
written, they probably should not be counted as part of the money supply
to their full extent. To precisely what extent they should be counted is
an open question. Nevertheless, it may be that counting them to their
full extent represents a lesser error than attempting to adjust them
downward. This is because doing so makes allowance for the extent to
which roughly $2.1 trillion of institutional money funds may also
actually serve as money.
The $800 billion of currency outside the banks is counted as part of the
M1 money supply along with the checking deposit component of
$625 billion previously referred to. Thus, at present, M1 is
approximately $1.4 trillion.
It should be realized that in the absence of any commitment of the Fed
to buy gold at $12,700 per ounce, the market price of gold would almost
certainly be radically lower. To the extent that additional gold could
be purchased at lower prices, the possibility would exist of increasing
gold reserves relative to outstanding checking deposits and currency and
thus of ultimately having a 100-percent reserve at a price of gold less
than $12,700 per ounce. Furthermore, it should be kept in mind that the
Fed would need to proceed with great caution in purchasing additional
gold. The danger to be avoided is that of initially drawing a
disproportionate share of the world’s gold to the United States, when it
alone was in process of remonetizing gold. If the US economy became
accustomed to such a large gold supply, and then, later on, if and when
the rest of the world remonetized gold and drew much of that gold back
out, the US would be in the position of experiencing first a virtual
inflation in terms of gold and then a virtual deflation in terms of
gold, the very kind of sequence of phenomena that a properly established
100-percent-reserve gold standard would permanently prevent. Further
discussion of these problems, and also of the major opportunity for
reducing the size and scope of government that would accompany
transition to a full-bodied 100-percent-reserve gold standard, can be
found on pp. 959-963 of the author's
Capitalism: A Treatise on
See above, the preceding note.
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