Debt, Money, Gold, and History

The Daily Reckoning
Weekend Edition

January 4-5, 2003
Paris, France
By Addison Wiggin

MARKET REVIEW: Debt, Money, Gold and History

“The 19th century gold standard was the highest monetary achievement of the civilized world. The gold standard was neither conceived at a monetary conference, nor was it the brainchild of some genius. It was the result of centuries of experience.”

Ferdinand Lips

The first two trading days of the year found the Dow 260 points higher… and a host of analysts predicting the bear market can’t possibly last another year. “Four in a row? The odds are against it,” says a headline on CNBC’s website. Of course, if you want to get technical from a statistical point of view, the odds of the Dow ending 2003 up or down have absolutely nothing to do with last year’s downer ending… or the year before… or the year before that.

What concerns us so far this year with respect to the stock market is the same thing that concerned us last year: Mr. Bear hasn’t completed his work.

In fact, as far as we can see, he’s only made a half-hearted attempt at bringing stocks down to a valuations where it makes sense to buy them again. Based on ‘core earnings,’ S&P stocks are still trading at 40 times earnings. Or, as Barron’s calculates it, based on last year’s reported earnings, they sell at a P/E of 28. Either way they are expensive. And Mr. Bear usually lumbers off to hibernate when they reach a P/E range of somewhere around 8 to 10 times earnings. Gold lept up to $352 Friday before settling back a buck. The dollar index fell back to 102. According to a chart on the Fed bank of Atlanta website, it has dropped 25 points since Bernanke made the now infamous “printing press” speech on November 21, 2002.

Here at the Daily Reckoning, you may have heard us say on occasion, we’re not interested in gold and the dollar because we claim to know what is going on in the world markets… but precisely because we don’t. The ‘gold standard’ simply provides us with a convenient intellectual escape hatch.

In fact, if you pressed us on the issue, you might get us to agree with F.A. Hayek, who suggested that nobody – not the celebrated central banker who claims to know where the keys to the printing press are, not a president with a rising approval rating and a penchant for fighting foreign wars, not even a handful of cranky economic critics hammering out daily market commentary from their desks overlooking Le Paradis cafundefined in Paris – could possibly have at their finger tips all the necessary data to set ‘rates’ for millions of buyers, sellers, lenders and borrowers acting independently. Forthwith, a few incomplete thoughts about history, money, and debt… staggering levels of debt.

“Modern banking,” a treasury official explained to a Daily Reckoning reader, who subsequently posted the explanation on the DR discussion board, “is often explained by analogy with the practices of goldsmiths in early seventeenth century England.”

“In both the goldsmith’s practice and modern banking, new money is created by offering loans to customers. A private commercial bank which has just received extra reserves from the Fed can make roughly six dollars in loans for every dollar in reserves it obtains from the Fed. How does it get six dollars from one dollar? It simply makes book entries for its loan customers saying you have a deposit with us.”

In other words, to create a new dollar, the Fed simple makes a promise to pay. They can make as many promises to pay as they like. without anything to back up the promise, but further promises.

“The Fed has several ways of controlling the total amount of reserves in the system,” the fearless treasury official goes on. “The Federal Reserve Banks can lend reserves to the private, commercial banks. To do this, the Federal Reserve Bank simply makes a new entry on its books showing that the borrowing bank has more dollars in its account with the Federal Reserve bank.”

That is the nature of the system. ‘Money’ is debt. Every physical “dollar” in existence represents six dollars owed by somebody. plus interest. The Fed “manages” the debt load, the way a washing machine manages the spin cycle; sometimes the loads get out of whack and the whole machine becomes unstable, but for the most part it runs smoothly and your clothes come out without stains. “Unfortunately,” the economist Ferdinand Lips observed during a speech at the Humanitarianism at the Crossroads Congress in Feldkirch, Austria in early September (also sent to me by a Daily Reckoning reader), “it is not widely known that the 19th century was a period of prosperity and economic growth without inflation.”

“It strikes us like a fairytale [in the age of Keynesian and Monetary school economics],” says Lips, “when we discover that in those days the most important currencies were stable over a long period. The French franc, for example, remained solid for one hundred years.”

That hundred year stretch was the era of the gold standard. Lips provided the following, “Life Span of Currencies”:

French Franc 1814 – 1914 ……..100 years
Dutch Guilder 1816 – 1914 ……..98 years
Pound Sterling 1821 – 1914 …….93 years
Swiss Franc 1850 – 1936 ………..86 years
Belgian Franc 1832 – 1914 ………82 years
Swedish Krona 1873 – 1931 ……58 years
German Mark 1875 – 1914 ……..39 years
Italian Lira 1883 – 1914 …………..31 years

“The basic rule of the gold standard,” suggests Lipps, “was a fixed amount of gold for each money.”

In other words, rather than each unit of money representing a debt owed, it represented a specific weight of gold. Paper currencies were redeemable in gold at any time. And a nation’s “monetary reserves” consisted of only gold.

Curiously, many of these currencies were destroyed in favor of debt-money currencies, so their representative governments could finance World War I. Acting within the confines of the gold standard, it would have been impossible to raise the “money” needed to conduct such massive destruction over a sustainable period. Better centralize, create debt at will, and then, carefully, manage the supply of debt.

Best regards for the weekend,

Addison Wiggin,
The Daily Reckoning
Paris, France
January 4-5, 2003

P.S. Indeed, “world history proves,” Lips says, “that there is a close relationship between monetary systems and war and peace.” Would, for example, this administration be able to afford to send its armies to every corner of the globe with or without support from the nations its promising to protect?

P.P.S. One might also suggest that there is a close relationship between an nation’s choice of monetary system and its habits of consumption. “On an international level, [during the age of the gold standard],” says Lips, “importing and exporting gold was unrestricted. All balance of payments deficits were settled in gold.” If the US dollar did not now constitute 76% of the world’s central bank reserves, would it be possible for the US economy to consume 5% more than it produces year after year?

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THIS WEEK in THE DAILY RECKONING

01/03/03 BAD BETS

“…Today, we hear the rattle of dice everywhere. It is the end of one year and the beginning of another. People are regretting what they did last year…and warming up the dice in their right hands for another throw. What are the odds of this…or that…they wonder, as if they could know…”

01/02/03 GRAHAM’S NUMBER

“…The concept of a perfect investment is not a new one. It has been encapsulated in a long-forgotten ‘indicator’…something I call ‘Graham’s number.’ When it’s positive, it means that a company could pay off all its debts and obligations and still have liquid assets like cash left over…not many companies can make that claim…”

01/01/03 A YEAR IN THE DAILY RECKONING, 2002

The Daily Reckoning’s Top 12 Essays for the Year…well, maybe not the TOP 12, but some reasonably entertaining ones we hope you’ll enjoy…

12/31/02 THE BUCK STOPS

“…The news from Europe seems to become bleaker by the day…but the euro’s run-up is a reminder that there’s more to the value of currency than economic growth. The euro’s strength is nothing more than dollar weakness, and there’s nothing baffling about the greenback’s struggles. Our prediction: more euro “strength” to come…”

12/30/02 DEFLATION VIGILANTES

“….With goods prices falling and the rate of rise in services prices abating, overall inflation rates are the lowest in decades. Government yields are the lowest since the Kennedy administration. And now, with Bernanke, bond bulls have been warned that the Fed can – and if duty called, would – wreck their bull market without remorse…”