Paper and Promise, Part II

The Daily Reckoning PRESENTS: Yesterday, James Turk shared an excerpt from his book, The Coming Collapse of the Dollar, which showed the origins and true nature of money. In the conclusion of this two-part essay, Mr. Turk examines the roots of the U.S.’s monetary system. Read on…


The U.S. would eventually join the classical gold standard, but as a developing country, achieving monetary stability involved the predictable growing pains. To ?nance the Revolutionary War, for instance, the Continental Congress issued paper currency called Continentals, denominated in dollars and backed only by the anticipation of future tax revenues. Inevitably, wartime pressures forced the authorities to run the printing presses ?at-out, and the notes soon became virtually worthless. As George Washington is said to have lamented, “A wagonload of currency will hardly purchase a wagonload of provisions.”

Returning to the tried and true, the newly independent U.S. began minting gold and silver coins in 1793, de?ning the dollar as 3711?4 grains of pure silver. But early on, whatever coin was offered and voluntarily accepted circulated without government interference. A patron of a Boston pub might as easily have tipped the barmaid with a coin minted in Spain, England, or France as one from Philadelphia. The Spanish dollar, in fact, is described by one historian as “the unofficial national currency of the American colonies during much of the 17th and 18th centuries.” To make change, it was actually cut into eight pieces, or “bits,” hence the terms “pieces of eight” and “two bits.”

As the memory of its ?rst disastrous ?ing with government-issued ?at currency began to fade, the U.S. tiptoed back into the money-substitute game early in the nineteenth century, chartering the Bank of the United States and Second Bank of the United States to issue notes and perform some other central-bank-like functions. The banks, however, drew the ire of sound-money advocates, including Andrew Jackson, who – like Isaac Newton before him – understood the risks of using money substitutes instead of money itself. Elected president in 1828, Jackson declined to renew the Second Bank’s charter, ushering in the “Free Banking Era,” a quarter-century of banking and monetary practice largely unfettered by government interference. Banks began issuing paper currency against their precious-metal reserves, and by 1860, an estimated 8,000 different privately owned banks were circulating dozens of different private currencies. Most held their value fairly well within their issuing banks’ territory, though the realities of travel and communication caused them to trade at discounts that grew along with the distance from the issuing bank. All things considered, it was an interesting experiment that, given the chance to evolve along with communications and transportation technologies, might have produced a very different modern economy. But like so many other promising things, free banking ended when war, this time the Civil War, was declared.

In 1861, the ?nancially strapped Lincoln administration began issuing paper currency (which, by the way, is emphatically not one of the enumerated powers the Constitution delegates to Washington). The new currency, called the greenback, though not directly backed by the Treasury’s gold, was initially accepted by northerners. But as the war depleted Washington’s precious-metals stocks and massive quantities of greenbacks were printed, the notes plunged in value. President Lincoln then opted for centralization, signing the National Banking Act of 1863, which chartered a national banking system to create a single national currency. Two years later, the federal government levied a 10 percent tax on currency issued by state-chartered banks, driving non-federally chartered banks out of the currency-printing business and restricting the right of currency creation to the newly formed national banks.

In the post-Civil War years, the U.S. operated its now-centralized monetary system on a “bimetallic” standard, in which the dollar was de?ned as a weight of silver, and gold was measured in terms of silver. As western miners began discovering huge deposits of silver like the Comstock lode in Nevada, the supply of silver surged, and silver’s purchasing power began to decline. Pressure began to mount from western states for Washington to support silver by buying up that region’s growing silver production. The Sherman Silver Purchase Act of 1890 required the U.S. government to double its annual purchases of silver and turn this metal into coin. But fear that such a huge increase in the money supply would throw the relationship between gold and silver out of whack produced a ?nancial panic in 1893, and President Grover Cleveland called a special session of Congress to repeal the act. The U.S. then adopted a monometallic system, at last joining Britain, Germany, and most other countries in the classical gold standard in 1900.

Because it represents such a departure from what came before and after – and because it was by far the most successful monetary system the human race has yet conceived – the classical gold standard bears closer examination. Under its terms, currencies were de?ned as a weight of gold, the way a length of cloth is measured in an unvarying unit we call the inch. Unlike today’s world, where each government controls a country’s internal money supply, the gold standard’s adjustment mechanism was automatic and independent. Say, for instance, that British consumers ran a trade de?cit with their German counterparts (that is, they bought more stuff from Germans than Germans bought from them). Under the gold standard, British gold would ?ow to Germany, causing Britain’s money supply to shrink. The resulting reduction of credit would slow its economy and make its citizens feel less prosperous, causing them to buy less from abroad. Germans, meanwhile, would have extra money to spend and invest, thus lowering local interest rates and boosting economic growth. Some of this new wealth would be spent on foreign goods, bringing trade and capital ?ows back into balance.

The adjustment mechanism operated continuously, keeping individual nations from drifting too far from the straight and narrow. It didn’t, however, eliminate the business cycle; on the contrary, there were some spectacular booms and busts under the gold standard. But these were mainly due to another innovation called fractional reserve banking. Because of its role in today’s gathering storm, this is another concept you’ll want to understand. So let’s start with a look at its predecessor and polar opposite, 100 percent reserve banking.

In this system, when a resident of, say, ?fteenth-century Venice deposited his savings at the local goldsmith (banks hadn’t been invented yet), the goldsmith promised to keep enough gold on hand to pay his customer back on demand (though he might in the meantime use the gold to make jewelry, bars, or whatever). This kind of gold storage was more like the modern conception of a warehouse than a bank. Because the goldsmith didn’t turn around and lend his customers’ money to someone else, he often charged customers a small fee for keeping their savings safe.

In a 100 percent reserve system, the money supply grows at the rate of new gold and/or silver supplies, which is to say very slowly. So as technology progresses and workers become more productive, prices would be expected to fall rather than rise each year. This kind of de?ation, viewed through a sound-money lens, is normal and healthy. Such an economy would be capable – barring war or plague – of growing steadily for long periods of time without excessive debt accumulation or monetary instability.

But slow and steady rarely satis?es the more excitable members of the ?nancial class, and by the seventeenth century, Italian and English goldsmiths had discovered that they could lend out some customers’ gold for a pro?t. Since only a few of their customers demanded their gold back at any given time, the fraction of their deposits that the goldsmiths held in reserve (hence the term “fractional reserve”) was usually suf?cient to meet their obligations. And with the money they earned by lending, they were able to pay their depositors interest rather than charging them for storage, producing smiles all around.

Now let’s fast-forward to nineteenth-century Europe, where, under the guidance of the now-dominant Bank of England, fractional reserve banking had begun to operate on an unprecedented scale. Say, for instance, that a London bank received a deposit of 100 pounds and was required to hold 10 percent of its total loans as reserves. That means it could make 90 pounds of new loans, keeping 10 pounds in reserve. The recipients of those loans would then deposit them in other banks, which could then lend 81 pounds, keeping 9 pounds in reserve, and so on, until the total amount of credit in the system vastly exceeded the original deposit. The result was a “?exible” money supply, capable of expanding to meet the needs of a growing global economy. Of course, ?exible also means volatile. In good times, when citizens are willing to borrow and banks willing to lend, credit grows at a faster rate than the money supply. In hard times the credit machine is thrown into reverse, which explains how booms and busts were still possible under the seemingly stable gold standard.

Yet even with the destabilizing effect of fractional reserve banking, interest rates were low in most gold-standard countries, because the basic money supply – that is, the amount of gold – grew by only a couple percent each year. This limited the amount of paper that member governments could print, minimizing the risk of in?ation and making debt denominated in gold standard currencies attractive to investors. As a result, the four decades between 1870 and 1914 were, amazingly good times, unique in human history for their combination of economic growth and price stability.


James Turk
for The Daily Reckoning
October 18, 2006

Editor’s Note: James Turk has specialized in international banking, finance and investments since graduating in 1969 from George Washington University with a B.A. degree in International Economics.

He is the author of two books and several monographs and articles on money and banking. He is the co-author of “The Coming Collapse of the Dollar” (Doubleday, December 2004).

In addition, James Turk is the Founder and Chairman of Since 2001, thousands of individuals and companies have used GoldMoney® to buy gold to protect their wealth from today’s financial uncertainties. Many of them have also found GoldMoney’s patented process of digital gold currency payments to be an ideal payment solution for online commerce.

Learn more about GoldMoney®.


We checked the dictionary to see if the word was still there. We thought it might have been tossed out for lack of use.

But no. There it is.

“Wise economy in the management of resources; frugality” says the American Heritage Dictionary.

We looked it up because we thought it might be useful.

To every thing there is a season. Frugality’s time may be coming round.

When you hear about deficits, you think of America’s great ‘twin’ deficits – one in federal finances, the other in its foreign trade. What is rarely considered, is a hidden triplet – America’s household deficit.

There are two ways to get rich, dear reader. You can do it the old fashioned way…or you can get lucky. Traditionally, the way to get rich was the same as the way to get a good night’s sleep. Families looked at two numbers: One was their revenue; the other was their expense. If the former was larger than the latter, they could sleep well at night. And getting rich was just as easy. It was just a matter of degree; the larger the spread between the former and the latter, the richer a family became.

But the housing boom of the early 21st century, following as it did the great stock market boom of the last century, changed everything. It was a new era, in that people got so lucky, they began to think that luck was the only way to get rich. Suddenly, the difference between income and outgo turned negative. American households began running deficits.

Household deficits are rare in American history. Never before did people have to go running to the dictionary to find out what the word ‘thrift’ meant. It was one of the first words people learned. Even without degrees in economics or financial management, they were nevertheless able to make sure outgoes did not exceed incomes – except in a few special circumstances.

One of those circumstances was the Great Depression, which pushed down incomes to the point where outgoes couldn’t readily keep up. In two years, during the ’30s, U.S. households ran in the red.

Another special circumstance occurred directly after WWII. So many new households were formed (returning GI’s couldn’t wait to get back to civilian life) and so much demand had pent up during the war years, that for four years in the postwar period, households dipped into savings to buy houses, cars, appliances and so forth.

Other than those special cases, from 1929 to 2006, the only other time American households ran deficits was in the last six years. And during these last six years, the deficits have not only been unusual in that they were financed by debt rather than savings, they were also unusual in that they were breathtakingly large. Last year’s household deficit – defined as personal disposable income minus personal consumption and residential investment – hit $477 billion. This year, households are on target to beat the $500 billion figure. In other words, American households are running bigger deficits than the U.S. government!

How long can this go on? Not forever. Borrowing against housing has financed the deficits. Now housing is going down.

“Five year rally in home prices ends in Ventura County,” says one headline.

“Phoenix: Prices, Sales Tumble,” says another.

“Home prices fall in some Calif. Markets,” adds the Associated Press.

If they are unable to continue borrowing, what will American households do?

Perhaps the word ‘thrift’ may come in handy.

More news:


Eric Fry, reporting from Laguna Beach…

“Squiggles on a graph rarely elicit an “Oh wow!” from your even-tempered California editor…But in this particular case, he simply could not stifle his amazement.”

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening.


And more thoughts:

*** Short Fuse, reporting from Los Angeles:

“You may be wondering, ‘Are those fools at The Daily Reckoning really making a documentary, or are they all talk?’

“Don’t worry, the documentary is still in ‘pre-production’…we’re in the very long process of looking for a director, which is why I’m writing you this note from West Hollywood.

“This week, we have a few meetings lined up with possible directors, and we’re happy to report that yesterday’s meeting went quite well (at least we think – but what do we know, really?).

“A good indication that our meeting went well? At one point, the director we met with described the documentary as ‘A black comedy about being in the red.’

“Hmmm…seems like he might understand the way we like to look at things over here at The Daily Reckoning, but we won’t get our hopes up too high…after all, it’s not ‘sho friends – its show business.”

[Ed. Note: More documentary updates to follow – and if you haven’t purchased the book that started it all, you’re in luck! Empire of Debt has just been released in paperback. Get your copy here:

The Most Feared Book in Washington!

*** Stocks may soon be following housing. John Hussman of Hussman Funds notes that the current bull market is one of the longest on record without a correction:

“Even barring a full-fledged bear market, it’s notable that the Dow has now gone over 900 trading days without even a 10% correction. The current advance is among the 5 longest uncorrected advances on record.”

His prediction? Look forward to dynamite returns…only, of a different kind:

“Suffice it to say that even if the market [were] to advance further by 10% or more (which I view as improbable), the likelihood of investors actually retaining the gain would be fairly negligible. We’ll accept those risks that are appropriate, but there’s no sense running off to juggle dynamite with the other kids, just because they’re having fun right now.”

*** We take it for granted that power and money are flowing from West to East. It is one of our Big E trends.

How much? How fast? We don’t know. But in both theory and headlines, the East is rising. There is also no theoretical or practical reason why this big trend should end any time soon.

At the same time, we also take for granted that anyone who invests casually in China will get what he deserves. You can be very right about a major trend, dear reader, and still lose all your money betting on it.

China is the same country that put up with Mao Tse-tung for three decades. Only a generation ago, mobs of lunk-headed Chinese filled the streets…dragging some poor ‘intellectual’ or ‘capitalist roader’ along so that he could be humiliated, tortured and even executed. What kind of a crime did you have to commit to deserve that treatment? None at all. You might have read a book. You might have made a comment such as “is it really necessary that I tell the party what my wife and I talk about in private?” You might have made the mistake of getting one pig too many in your backyard. Or you might have just been in the wrong place at the wrong time.

China was clearly the wrong place; and the 1960s was clearly the wrong time. Only a damned fool would have wanted to be there. But now, say the expensive suits, the new China is the place to be. Foreigners can’t wait to get there. And if they can’t get there in person…they send their money.

Fixed-asset investment as a percentage of GDP has reached nearly 50%. This is partly the reason the East is growing so fast…and partly the result of it. Rapid growth requires huge amounts of capital investment. Rapid growth also entices capital; investors want to get in on it. The result, dear reader, is the phenomena we live with…the world of what Nobel Laureate Edmund Phelps calls “thinking, expectant beings.”

That investors are expectant is beyond question. That they are thinking is perhaps debatable.

Investors in China expect to make a lot of money from the “rise of the East.” They’ve taken a trip or two to the middle kingdom, and they’re probably convinced that it is in the center of a vast transformation…and probably fairly sure they can make a buck on it. They’ve seen the building cranes, watched the factories going up, seen the numbers mushrooming, and perhaps a speeding Mercedes has almost run them down. Whatever the case, they can’t help but think that they’re onto something big. So they bring in more investment capital to take advantage of it.

But here is where the thinking seems to stop.

Yogi Berra once remarked of a restaurant – “Oh, nobody goes there any more; it’s too crowded.” When he said this, he was highlighting a problem for investors as well as diners. A good deal is only a good deal if not too many try to take advantage of it. In the restaurant world, good eateries soon become overcrowded…service deteriorates…prices rise. In the investment world, soon, too much capital is chasing too few good opportunities.

Initial investors in a new trend often do well. They are able to choose the best opportunities at the most reasonable prices. Those who come along later have progressively less and less choice…and progressively higher and higher prices. As prices rise, so do expectations. But as expectations rise, thinking declines. Logically, as the amount of money flowing into a market increases, prices should rise and the attractiveness of the opportunities should recede. But investors are not merely thinking beings…and not even primarily thinking beings. That they think at all is open to argument. But that they let themselves be driven by emotions rather than thoughts is beyond question.

Asia began pulling itself together many years ago. One country after another has picked itself up…dusted itself off…and zoomed to the top of the list for foreign investors. Singapore was the darling of global investors in the mid-’80s – with a ratio of fixed-asset investment to GDP equal to China’s today. Then, Japan hit the charts…and soared until 1990…when it dropped off for the next 16 years. The late ’90s brought Thailand, Malaysia, Korea, and Singapore to the financial headlines – first, because they were hitting ratios of fixed-asset investment to GDP over 40%, and then, because they were crashing.

And now it’s China’s turn. Such a big country it is…and such a big opportunity…that it is gobbling up a huge part of the investment capital of the whole region. China alone has a fixed-asset to GDP figure over 30%. And its (WHOSE?) figure is closer to 50%!

What comes next for China? A crash of some sort is our guess.

*** Meanwhile, at home, outflow rushes to catch up to income.

“I got a bid from Smallbone to redo the kitchen,” Elizabeth announced. “And yes, it includes granite countertops.”

The ‘bid’ was like no bid we had ever seen. It had been hand delivered, from London to Paris…and came in a large, black folder secured with ribbon. Smallbone is the market leader in custom-designed kitchens, we’ve been told. And the company – based in London – is eager to expand its business to France.

“How much was it,” we wanted to know.

“You don’t want to know,” was the reply.

When your wife answers ‘you don’t want to know’ to a question like that it makes you want to know even more. And when we found out, we realized why the estimate had been delivered in such a regal manner. Smallbone was proposing a kitchen fit for a monarch, not one suited to the needs of a poor scribbler.

“You’re just going to have to adjust your thinking,” Elizabeth explained. “If you want a nice kitchen, you’re going to have to pay for it.”

“But I’m happy with the kitchen we have now…”

“Oh never mind…I don’t want to talk about it.”

The Daily Reckoning