Joseph M. Miller
PROLOGUE
The goal of this discussion is to arrive at a point where reasonable projections can be made concerning the future of money during the last few years of the Twentieth Century and into the Twenty First Century. To do an effective job of this the reader needs to have a reasonable knowledge of the history of money from the early days of mankind. An abbreviated history of the development of money will be included here. Since it is not the intention of the writer to discuss this important subject in great detail, a reader who wants more detail on this interesting subject should read one or all of the sources listed in the appendix.
As early civilization developed in various parts of the world and the needs of humankind became more complex, it became painfully evident that the barter system for the exchange of goods was inadequate. The specialization of workers was hindered by the barter system and the much needed division of labor was not possible until a suitable money system evolved. Various forms of money were developed , which by trial and error over thousands of years evolved into a system of metal coins. The foremost reason metal coins won out over other forms of money was the convenience of their use by humankind. The metals of choice for these coins were gold, silver and copper. Gold and silver were chosen for their rarity and beauty. Copper for its usefulness in satisfying the need for coins of small value. Gold became the premier metal for coins because it is more rare than silver, and throughout history the ratio of gold to silver as it was found in nature and developed in value was about 20 to 1. In the late eighteen hundreds, a $20 dollar gold coin was about half the size of a silver dollar, yet the gold coin was worth 20 times as much as the silver dollar. It is obvious that the gold coin weighed much less than 20 silver dollars, which made gold coins much more convenient to use in large value transactions.
It was a rather small step to accommodate humankind with money that was both more convenient to use and vastly more portable than metal coins. This step was the introduction of paper money. When this paper money was issued as a certificate for actual gold or silver in the possession of the issuer of the paper money, the new system worked well and provided humankind a far easier means of carrying on business. Paper money in the United States was of this certificate type until the nineteen sixties. In that period, as we will discuss in greater detail in the main body of this work, the tie between paper money and gold and silver was broken, pushing the United States and the world into the era of fiat money. Fiat money is described in the dictionary as "paper money made legal by government decree, but not backed by silver or gold". See Appendix 2 for a more detailed discussion of this topic. A brief history of the use of gold in human affairs (money and otherwise) will be helpful for the reader prior to our main topic. The following quote from Vronsky and Westerman (GOLD-EAGLE website) on the history of gold will suffice for our needs.
EARLY HISTORY
The history of gold begins in remote antiquity. But without hard archaeological evidence to pinpoint the time and place of man's first happy encounter with the yellow metal, we can only conjecture about those persons, who at various places and at different times first came upon native gold. Experts of fossil study have observed that bits of natural gold were found in Spanish caves used by the Paleolithic Man about 40,000 B.C. Consequently, it is not surprising that historical sources cannot agree on the precise date that gold was first used. One states that gold's recorded discovery occurred circa 6000 B.C. Another mentions that the pharaohs and temple priests used the relic metal for adornment in ancient Egypt circa 3000 B.C. However, it is curious to note that the early Egyptian's medium of exchange was not gold but barley. The first use of gold as money in 700 B.C. is claimed by the citizens of the Kingdom of Lydia (western Turkey). Surely, you remember the kingdom of the famous fortune seeking King Croesus - circa 550 B.C.
MORE RECENT HISTORY
In 1792 the U.S. Congress adopted a bimetallic standard (gold and silver) for the new nation's currency - with gold valued at $19.30 per troy ounce. This remained essentially unchanged until 1834, when the price of gold was raised to the $20.67 level which held for the next 100 years. It was not until 1934 that President Franklin Delano Roosevelt devalued the dollar by raising the price of gold to $35 per ounce.
WHY IS GOLD CONSIDERED SO PRECIOUS?
To fully appreciate why 8,000 years of experience say gold is forever, we should review why the world reveres what England's most famous economist, John Maynard Keynes, cynically called the "barbarous relic." We think that the pragmatic ancient Egyptians were accurate in observing that gold's value was a function of its pleasing physical characteristics and its scarcity.
PHYSICAL CHARACTERISTICS
There are many physical aspects of the yellow metal which are truly amazing. Gold is the most malleable (able to be hammered into very thin sheets) and ductile (able to be drawn into a fine wire) of all metals. It is so malleable that a goldsmith can hammer one ounce of gold into a thin translucent wafer covering more than 100 square feet only five millionths of an inch thick. It would be so thin that 1,000 sheets would be needed to make up the thickness of one newspaper page. Its ductility is equally amazing. One ounce of gold can be drawn into a wire 50 miles long! Furthermore, ONLY one ounce of this marvelous metal is required to plate a thread of copper 1,000 miles long. That's really stretching it, wouldn't you say? And since time immemorial the noble metal's resplendent luster allows it to be exquisitely designed into the world's most coveted jewelry—fit for queens or kings.
Gold is also one of the heaviest metals known. It has a specific gravity of 19.3, which means it weighs 19.3 times as much as an equal volume of water. Therefore, one cubic foot of gold weighs 1,206 pounds. More than half a ton! This probably explains why there has NEVER been any large armed robberies of gold bullion throughout history. Who the hell could carry it?
S C A R C I T Y
More unbelievable than its physical characteristics is its scarcity. It is well documented that the world's holdings accumulated during all recorded history to the present is only about 120,000 metric tons. Understandably, it is rather difficult for the average person to relate to this measurement. Suffice it to say that the total world's hoard of the shiny metal will occupy a single cube 60 feet by 60 feet by 60 feet - which is equivalent to the approximate volume of three 12-room homes. This is indeed a small volume of matter to have influenced the toil and destiny of so many people since biblical days. In fact the total world's holdings of the rare metal could be transported by a single solitary oil tanker - that's if Lloyds of London would ever accept the insurance risk on this priceless cargo. The value of this priceless cargo would be approximately $1.4 TRILLION! Another way to appreciate its scarcity is to compare it to the annual steel production in the United States. According to the Iron and Steel Institute in Washington D.C., the American industry poured an average of 10,500 tons of steel per hour during all of 1995! Please appreciate that's 24 hours per day and 365 days per year - indeed, a lot of steel. In sharp contrast the world's annual gold mine production increases the total holdings by only 2.0% per year. That's an average increase in the world's gold supply of a mere 2,000 tons per year - versus 10,500 tons of American steel per hour. Gold is indeed very, very rare.
There is very little mystery in understanding why gold has been chosen as the ultimate money over thousands of years. Now on to what has happened to Monetary Gold in the Twentieth Century.
Chapter 1
When the United States entered the Twentieth Century, money was on a sound footing and based on gold. The Classical Gold Standard had been in effect since 1815 throughout much of the Civilized World. This meant that each major national currency (pounds, marks or dollars) was defined as a certain actual weight of gold. The dollar was defined a 1/20th of an ounce of gold. Gold was valued at $20.67 per ounce from 1834 until the nineteen thirties.
Each of the other currencies was similarly fixed, the British Pound was about ¼ of an ounce of gold. This provided the happy result that there was no mystery in converting from one currency to another, because you could peg each currency by its weight in gold. This greatly facilitated world travel and commerce. Another very happy outcome of this system was that it provided an automatic market mechanism for holding back the inflationary tendencies of each world government. As we progress through this discussion, we will see just how valuable that was to the world economy.
Although money was sound in the beginning of this century, there was trouble in the banking industry. These troubles led to the introduction of the Federal Reserve System and the Federal Reserve Bank, which started in business in November, 1914. The Fed as it came to be called, was and is a complex organization which has been shrouded in a veil of mystery. Its introduction to the business world was not universally hailed as a blessing, the reason being that many people then and now feel that all central banking systems are inherently inflationary. It is not in the purview of this paper to discuss all of the facets of the Fed. There are many sources that can be tapped to learn more about this powerful organization, but we do need to discuss the Fed's inflationary potential, as well as the inflationary potential of the entire banking system and the fractional reserve aspects of the system.
The Fed has the right and the ability to create money out of literally "thin air". This right and ability has the potential to be highly inflationary when their creation of this "thin air" money is created without restraints. The fact that in emergencies the Fed has the ability and the responsibility to be the lender of last resort, can be highly inflationary if a large sum of "thin air" money is created to get through a crisis. The Fed can pump up the money supply through Open Market operations which can be inflationary if not restrained. They also have the ability to change member bank reserve requirements, which can greatly expand the money supply when these reserve requirements are lowered, thereby freeing up much money for use in the economy.
Member banks of the Fed can also create money legally through the fractional reserve banking system. A very simple but incomplete explanation of this activity is this: let's assume bank A receives a $1,000.00 deposit, and let's further assume that the current reserve requirement is 10%. Bank A can then loan 90% of this $1,000.00 to another party. The borrower can then take his $900.00 loan and deposit it in bank B. Bank B can then loan 90% of this deposit to another customer who can then deposit his money in bank C, where the process can continue. From this chain of events, one $1,000.00 deposit can become many times more as this process evolves. In just three transactions our original $1,000.00 has become ($1,000.00 + 900.00 + 810.00 = 2,710.00). Multiply this by all of the loans made in this country and you get into serious money quickly. Pause to consider the huge mountain of debt that is outstanding in this country, and the inflationary potential this creates. For an excellent review of this topic, read pages 72-89 of "What has Government Done to Our Money?", by Murray N. Rothbard.
When a chart of the purchasing power of the dollar is examined showing the changes from 1914 to the present, it becomes readily apparent that the inflationary potential of the Fed and the banking system has been at work full time. The purchasing power of a 1914 dollar has dropped to less than 10 cents today. See Appendix 3 and Charts 1 and 2.
Let's take a look at what the Fed did during the First World War. From its beginning in 1914 until 1919, the Fed managed to double the money supply to finance WW I. Other countries engaged in the war, notably England and France, also expanded their money supplies to finance the war. These actions placed great strain on the pre-war Gold Standard and on the finances of most of the countries involved. The result was a break down of the pre-war system and a hodgepodge of individual country money systems after the war. This unsettled world monetary affairs and caused much mischief in the world.
From the end of WW I to 1929, the Fed expanded the money supply greatly, ostensibly in an effort to help rebuild some of the European Countries. This aided and abetted the speculative excess of the Florida real estate boom and the stock market rally, which ended in the Great Depression. So far the Fed was something less than a great success. A discussion of this period can be found in Chapter 4 of Money in Crisis, which was written by Barry N. Siegel.
The price of gold held steady at $20.67 per ounce from 1834 until the nineteen thirties when Franklin D. Roosevelt raised the price to $35.00 per ounce, and forced all US Citizens to turn in the gold they owned for paper money. The only gold coins citizens could keep were coins with numismatic value. This giving up of gold was not too onerous at first blush since the government agreed to maintain the value of the dollar at $35.00 per ounce of gold. It became onerous, however, because of subsequent actions by the FED and the US Government in the years of the forties, fifties, and sixties.
Chapter 2
It is probably unnecessary to point out that the end of the excesses and mistakes of the first 29 years of this century which resulted in the crash of 1929, brought much turmoil and change to all facets of human life, money certainly included. As we said earlier in the last chapter, FDR in the thirties raised the price of gold to $35.00 per ounce from the $20.67 which had been in effect for 100 years. This was a rise of 69.3%, and recognized the lowering in value of the dollar which had taken place in recent years. The act of requiring all US citizens to turn in the gold they held in their possession in exchange for paper money, brought the use of gold coins in everyday commerce to an end in the US. Silver and copper coins were still used for small payments, and very importantly, the paper money was in the form of silver certificates which could be redeemed for silver coins on demand. In this system, US money still had gold and silver backing which still gave validity to the saying that the US dollar was "good as gold". Unfortunately, events of the next 30 odd years would bring about the demise of that famous old saying.
As the US and the world worked out of the great depression, events took place in the late thirties and early forties that propelled the US into a dominant leadership role in world affairs. Again as in WW I, it was decided that the money supply needed to be expanded to meet the needs of fighting WW II. This money supply expansion and expanded war effort brought about upward pressure on prices. For the duration of the war, price controls were placed into effect which officially put a cap on price rises. As always happens, even during worthy events, price controls brought about a lively black market, which took place at prices above the official ceiling prices. This insured a price explosion after the end of the war, which did in fact take place, as prices moved upward to reflect the expansion of the money supply and inflationary pressures.
Between the price explosion at the end of WW II and the watershed year of 1971, we had intervening periods of relatively stable prices and two more wars. The Korean war brought more money expansion, but the really terrible monetary period was during the Vietnam war period described as the era of "Guns and Butter". This was the period that set the stage for the end of the tie between our US money and precious metals.
From 1945 until the late sixties, the US was engaged in the Marshall Plan, policing the world, and fighting two more hot wars and one cold war. This took a lot of money which in part had to be created by the FED. As this new money percolated throughout the US economy, and as dollars flowed overseas to Europe and Japan during this period, it became increasing apparent to many money watchers around the world and in the US that too many dollars were being created. As pressure built up in the money markets, foreign holders of dollars started deciding they would rather have an ounce of gold for $35.00 instead of the paper dollars. Keep in mind that gold had been forbidden in US domestic monetary transactions by laws passed in the thirties, but gold was still used for clearing international imbalances between the world's central banks. As the mountains of dollars flowed back to the US in exchange for physical gold, gold flowed away from the control of the US and into foreign treasuries. This caused the FED to increase purchases of US bonds to prevent a decline in the US money supply, which otherwise would have disrupted the domestic economy. This was the beginning of the era of fiat money creation in a big way and what has caused so much mischief in world markets as we leave the Twentieth Century. By the mid sixties, these actions had reduced by about one half the gold holdings used to back the US dollars in circulation. At this point in time the US Congress removed gold backing from the FED that had been required against member bank balances in 1966, and in 1968 removed the backing of Federal Reserve Notes. This removed the last discipline that gold had held over the inflationary tendencies of the FED.
In the late sixties after the gold and silver backing of our currency was removed, Gresham's Law proved its accuracy in actual events. Gresham's Law stipulates that when two classes of money circulate side by side and one has more intrinsic value than the other, the bad money will drive the good money out of circulation and into private holdings; assuming that both classes of currency are legal tender. When the government decided to withdraw silver backed Federal Reserve Notes from circulation and substituted the fully fiat money we carry in our wallets today, they also decided they could no longer support silver coins. Therefore they started minting coins from base metals to supply the needs for small denomination money, which are still in use today. During the transition, people who knew what was happening would go to the bank and get $1,000.00 of half-dollars, quarters and dimes. They would take them home, separate the silver from the base coins, return the base coins and start the process all over again. It did not take very long for all of the good silver coins to be in private holdings. Many of these coins are still in private holdings and are bought and sold in bags of $1,000.00 face value. Silver dollars are highly prized and bring a very large premium in fiat paper money over their face value.
From 1966 to 1971 gold flowed out of the vaults of the US and into the vaults of foreign countries in such large amounts as to become a flood, which greatly distressed our government. The solution to this problem was for President Nixon in 1971 to stop the conversion of dollars into gold by foreign governments. This opened a worldwide furor in financial markets, and at the same time opened a true "Pandora's Box" of problems which still plague the world today.
Chapter 3
In 1971 when President Nixon stopped the convertibility of dollars for gold, the US dollar ceased to have any intrinsic value beyond what it was perceived to be worth in daily commerce; which is still very much the situation today. In reality it had(has) no more intrinsic worth than any other piece of paper. The world of money had changed overnight, and the US Government had defaulted on its financial and monetary obligations.
There are defining events that occur in the world that change it forevermore. Such events as the discovery of America by Columbus, the first atomic bomb explosion, the first satellite in space, man walking on the moon, are all examples. Nixon's closing of the gold window was one of these defining moments that changed the way the world uses money, at least until the new system falls apart. The evil Genie of instability was let out of the bottle, and to get the Genie back into the bottle will be a long and laborious process, if, in fact it can ever be done short of a major calamity.
In 1993, Joel Kurtzman wrote a book titled "The Death of Money", with a subtitle "How the Electronic Economy Has Destabilized the World's Markets and Created Financial Chaos". In the book he has some very good history of the period from 1971 to 1993, plus some very interesting insights that are worth exploring. He makes a very good case that money has been changed by the events of 1971, in fact, transmogrified (his word). His feeling is that money is no longer a thing, such as a coin or a dollar bill, but a system; and a rather ethereal system at that. He theorizes that this new money system is a network comprised of perhaps millions of computers of every type from the largest mainframes at the Fed, down to the lowly PC and even to the credit terminals at gas stations and grocery stores. He includes in the money network all of the world's markets, including stock, option, commodity, etc. He states that in this new world of network money that banks no longer need huge vaults because they store the network money on disk drives and computer tapes. Instead of guarding this new money by armed guards, they use highly intelligent mathematicians and computer whizzes to keep thieves at bay. He points out that this new system is much more volatile than the old system, and that all financial prices (stocks, bonds, interest rates, currency rates, etc.) fluctuate much more violently than ever before. He thinks that this new volatility has forced business people to shorten their time horizons and think about next quarter rather than next year, and certainly not next decade.
All of the foregoing ideas are logical and fairly easy to accept, especially in view of recent events. His next theories are more eccentric, but again in light of recent years his theories seem to explain the divergence between the inflation of asset prices and the lack of inflation in the raw materials arena. His ideas are so important, I am going to quote him exactly.
The death of money has also splintered the world into two economies. The smaller of the two economies I call the "real economy." That is where products are made, trade is conducted, research is carried out, and services are rendered. The real economy is where factory workers toil, doctors tend the sick, and where teachers teach, and where roads, bridges, harbors, airports, and railway systems are built. Tragically, in the United States, it is also the impoverished part of the economy, starved for investment, backward and in disrepair.
The other economy, the "financial economy", is somewhere between twenty and fifty times larger than the real economy. It is not the economy of trade but of speculation. Its commerce is in financial instruments. Mostly, it is concerned with the exchange of equities, such as stocks, and securities, such as bonds and other forms of debt. The latest and largest type of debt that the financial economy trades , from a technical standpoint, is money. (Editorial note: I feel he should have included the derivatives markets in this section, since they form the newest, most volatile, and one of the largest facets of the new financial economy he describes).
Unlike the real economy, the financial economy has been undergoing something of an investment boom for more than two decades. And while its ultra-high-tech infa-structure straddles the globe and moves several trillion dollars a day between the major and minor "nodes" on the network, it is largely unregulated.
Few people realize that money, in the traditional sense, has met its demise. Fewer still have paused to reflect on the implications of that fact.
It is our purpose now to do some serious reflecting on the implications of this new money era. To do this job of reflection properly, we need to start from the premise that the Fed and the various governments it has worked under since it was started, have had a very inflationary bias, with the result that now in the year 1998, an unbelievably large ocean of fiat dollar denominated money has been created and is circulating throughout the world. In addition, this has also been true in most of the major and minor countries throughout the world creating marks, pounds, francs, etc., with the result that no one really knows how much of this fiat money is really out there. Joel Kurtzman calls this new creation "Megabyte Money", which seems appropriate and therefore we will use the term as he does, to denote fiat funds that go sloshing around the globe daily in prodigious amounts, be they marks, dollars, or whatever.
It is well and good to talk about enormous sums of money, but in fairness we need to put some numbers in front of us to truly understand what is being said. Each day, through a major money center such as New York, London or Tokyo, several trillion dollars change ownership at nearly the speed of light as the megabyte money is flashed from one computer to another. It is estimated that in just a few days, a sum of megabyte money passes between computers in New York to total the output for one year of all of America's companies and all of its workforce. It is further estimated that in about two weeks time, the sum of money flowing through the computers in New York surpasses the annual product of the entire world, which is many trillions of dollar equivalent. What does that mean exactly? To understand better, let's look at a Trillion dollars. A single paper dollar bill is about 6 1/8 inches in length. If we place one trillion of these dollar bills end to end, we have a chain of dollar bills 96,669,821 miles long (If you have trouble believing this number, do the arithmetic yourself). How can we put such a distance into perspective? Well for a start, if we could anchor one end of this trillion dollar chain to the earth, it would stretch outward to beyond the sun; which is 92,960,000 miles from earth. That's a lot of money in anyone's estimation. Without computers connected in a network and megabyte money, transfers of this speed and magnitude would not be possible.
The changes in the way money is transferred around the world, has wrought another very important change in the power of governments. Prior to megabyte money, each national entity operated as an autonomous unit, isolated more or less from the rest of the world's woes. Now national boundaries have become somewhat irrelevant, where money is concerned. Megabyte money transfers routed through satellites or undersea cables do not stop at a national boundary or to clear customs. Heads of governments and central bankers have great difficulty controlling these megabyte money flows, and it has made some national leaders, especially in Asia during 1997, very unhappy. Some have called for methods to put the Genie back in the bottle, but it is next to impossible. Alan Greenspan in a December, 1997 speech in New York City had these things to say on the subject, as reported in the Wall Street Journal, December 3, 1997.
Greenspan Opposes Slowing Pace of Global Marketplace
By DAVID WESSEL
Staff Reporter of THE WALL STREET JOURNALFederal Reserve Chairman Alan Greenspan said it would be unwise and probably impossible to slow the increasingly rapid pace at which global financial markets move money from one place to another. In remarks made Tuesday night, Mr. Greenspan acknowledged that the financial earthquake shaking Asia has led some to seek to slow down global markets "and perhaps achieve a system somewhat more forgiving of mistakes." But that isn't feasible, he concluded.
The "massive government controls" required "would surely produce a far more negative impact on economic growth than would be acceptable to even the most ardent advocates of reining in the rapid expansion of our international financial system," he told the Economic Club of New York.
Controls on capital flows and price movements might have been feasible 50 years ago, but "would be very difficult to implement in today's more technologically advanced environment," the Fed chairman added. "Tinkering at the edges of our system in order to produce a less frenetic pace of change would be easily circumvented."
Joel Kurtzman says this on the subject. "The world in which the new economy functions is more akin to an electronic "commons" than it is to an economy. And like any commons - a grazing commons in an ancient English town, for example - this new electronic space is owned not by the governments but by the people who use it." Governments are losing control.
Part - II next week
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