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A Day of Reckoning

Since August 15, 1971, when President Richard Nixon closed the gold window, the entire world has been on a fiat paper money system. No country's paper money is redeemable in either gold or silver. History shows that whenever a country moves to a fiat paper currency, eventually politicians print that currency until it becomes worthless, resulting in hyperinflation, which destroys that nation's economy and impoverishes people who are ignorant of the dangers of paper money.

The consequences are horrible enough when countries go on paper money systems, but when the whole world goes on paper money, we do not know how bad things will get. Truly, we have been in uncharted waters for the last thirty years, and over the last few years, one crisis after another has risen, suggesting that the world's paper monetary system has been stretched to its limits. With each crisis, the politicians print more paper money, laying the foundation for future crises.

In the days following the terrorist attack on the World Trade Center and the Pentagon, the Federal Reserve "increased liquidity" by $200 billion. And, immediately before the reopening of the New York Stock Exchange the following Monday, the Fed lowered interest rates another half-point. On October 2, the Fed dropped rates still another half-point, the ninth rate cut this year. Most everyone is aware of the Fed's rate cuts for they are highly publicized, but "liquidity" increases are less known because the media do not make a big deal of them.

Money supply indicators measure the amount of money in the system. The table shows the percentage money supply increases in three widely used measurements for the first eight months of 2001, 2000, and 1999. The increases so far this year have been huge compared with the increases for 2000 and 1999. Greenspan has the throttle wide open.

2001 2000 1999 MZM 11.10% 3.40% 4.70% M2 13.60 4.00% 4.00% M3 8.00% 6.00% 4.00%

Will these efforts forestall a severe economic downturn and make less painful a stock market decline, or will these efforts, which are nothing but the printing of more paper money, compound the problem? It is possible that the dark clouds casting gloom across the world's economic landscape are signaling that a day of reckoning is upon us.

Not only have U.S. stocks suffered collapses comparable to those of 1929, but stock markets around the globe are sinking. Perhaps, plummeting stock prices are the first sign that the day of reckoning is imminent. On the other hand, falling stock prices may be wringing out the excesses that come with 18 years of rising stock prices.

Or, maybe, we are entering a severe recession that will correct the economic excesses that accompany years of prosperity. Americans have lived through bear markets and recessions and can do so again. However, maybe the marketplace is about to correct the mistakes that came with thirty years of cheap paper money.

Paper money, which can be created literally at will, has enabled governments to finance every feel-good program imaginable. With no constraints on how much paper money can be printed, politicians do not have to make difficult decisions between competing programs. During the Vietnam War, for example, no choice had to be made between "Guns and Butter"; we were given both. If we are facing a day of reckoning that includes the repudiation of paper money, then great pain awaits us all.

People who hang onto paper money and/or investments redeemable in paper money (bonds, CDs, savings account, etc.) will see the "fruits of their labors" destroyed. People who opt for gold or silver (and a few other tangible assets) will be protected--somewhat. No one will escape unscathed. No investment exists that covers all bases. No matter how much gold and silver you own, if the goods and services you need are not available because of a devastated economy, you suffer. However, historically, gold and silver have weathered economic and financial chaos. If paper money is repudiated, then a great ideological battle awaits us also.

The proponents of paper money--government bureaucrats, politicians, Federal Reserve lackeys, academicians and other hangers-on who benefit from government programs--will call for a continuation of paper money. In the United States, the paper money proponents will argue whether to keep the dollar or install a new currency.

Paper money proponents will, in all likelihood, dominate the debate, making most Americans believe that the decision is clear: either a continuation of the dollar or a new currency. Receiving less attention will be the advocates of a "hard currency," either the direct use of gold and silver or a paper currency redeemable in gold and/or silver.

While paper money has a dismal record, gold and silver have stellar track records. All enduring civilizations used gold and silver almost exclusively. Most famous is the Roman Empire, which lasted 1,300 years. Other civilizations that relied on gold and silver include the Greeks, ancient Egypt, the Macedonian Empire, the Persian Empire, the Eastern Empires of China, and the Byzantine Empire.

The quality of the Byzantine coinage was such that it was accepted without question from China to Brittany, from the Baltic Sea to Ethiopia. Bezants were used, not only by Byzantine travelers and merchants, but by those of other countries as well. Even medieval England's Exchequer rolls were kept in bezants.

In more recent times, the British Empire relied on its gold sovereign, a small coin (.2354 oz) which was minted at seven mints around the world. The Brits' use of gold sovereigns resulted in one hundred years (1815-1915) of economic growth, without the booms and busts that have become commonplace since the advent of central banks and paper money.

In the United States, before establishment of the Federal Reserve, regions of the US suffered "panics" when local banks abused their issuances of paper money, but widespread economic problems were not a problem. Within fifteen years of the formation of the Fed, the US suffered the Great Depression. Ironically, one argument for the Fed was that it would do away with "panics." (In a perverted way, the Fed was successful. It replaced regional panics with a worldwide depression.)

Unfortunately, most Americans do not know economic history. Worse, most Americans do not know what money is. Ask the average man what money is, and he will reach in his pocket and pull out some paper dollars. "I have money," he will say. Or, perhaps, a woman will wave her check book, showing that she has money. Indeed, they do have money, because the merchant down the street will take the man's paper dollars or the woman's check. Nevertheless, paper dollars are a poor form of money, which ultimately hurt, or even destroy, the unknowing.

What is money?

To serve as money, a substance must be a medium of exchange, a measure of value, and a store of wealth. Money missing one feature, or failing to be sound in any of them, is a poor form of money. The more features missing, or the weaker the features, the worse the money. Historically, gold and silver have met the requirements; paper currencies have not.

A Medium of Exchange

As the first requisite--a medium of exchange--paper dollars function well. They are readily accepted not only in the United States, but in most places in the world. Since the collapse of the Soviet Union, paper dollars have been the de-facto currency in Russia and most other former Soviet states. Some South American countries, with horrible records of having abused their paper currencies, have moved toward making the dollar their currency. Today, the dollar is the world's preeminent paper currency. However, it was not always that way.

In the 1970s, the dollar was under great pressure and was falling against other major currencies. Nixon had closed the gold window, leaving foreign holders stuck with "IOU Nothings." Additionally, the consequences of Lyndon Johnson's "Guns and Butter" policies during the Vietnam War were taking their tolls. The US had printed a lot of paper dollars. In Europe, at times, tourists could not pay taxi, hotel, or food bills with dollars. Europeans feared the dollar would drop further before they could convert to their local currencies.

The dollar's problems of the 1970s were solved when Ronald Reagan took office and Fed Chairman Paul Volcker raised interest rates, choking price inflation and making the dollar a more desirable currency (because of the higher interest rates and the likelihood that price inflation would be brought under control.) Paper money advocates often point to Volcker's policies as evidence that a "properly managed" paper money system can work. It must be remembered, though, that value the dollar held before the profligate 1970s was never regained--and will never be. In this instance, the dollar fails as a "store of value,"but we're getting ahead of ourselves.

Inflation, Monetary and Price

Today, rising prices are generally referred to as inflation. However, until the last two decades or so, inflation was defined as "increases in the supply of money or credit, resulting in higher prices." Higher prices were not inflation; they were the result of inflation. Word definitions change, however, and to effectively communicate, these changes must be taken into consideration.

Investors who choose to know what is really happening in the financial world need to recognize the difference between "price inflation" (rising prices) and "monetary inflation" (increases in the money supply.) Rising prices are signs that people are recognizing that monetary authorities are printing too many little pieces of paper. So, when the Europeans were refusing American dollars in 1970s, they knew that inflation (both price and monetary) was a problem.

A Measure of Value

In serving as "a measure of value," money delineates relative values. People living in $300,000 houses are more wealthy (in material things) than those living in $50,000 houses. A $60,000 BMW is more valuable than a $15,000 Chevrolet. Obviously, many people would never agree that a $60,000 BMW is a better value than a $15,000 Chevy, but here the dollar is used to measure value. Here, though, is where the dollar fails as a measure of value.

If you tell someone you paid $35,000 for your house and he hasn't seen your house, he has no idea what type of house you own, unless you tell him when you bought it. A $35,000 house purchased in 1960 is vastly difference than a $35,000 house bought last year. Because of price inflation, brought on by monetary inflation, the prices of houses keep rising when measured in dollars. It is not that houses are becoming more valuable relative to other items, such as automobiles, it is that the measuring stick--the dollar--is shrinking. The dollar is a poor form of money when used as a measure of value.

A Store of Value

As a store of value, the dollar has performed miserably. In 1960, a man retiring with $100,000 in the bank thought himself set for life. However, if he lived too long, he soon found out that a shrinking dollar rendered his savings inadequate. The dollar shrinks in purchasing power year after year for one reason: the Federal Reserve keeps increasing the supply. The value of money--even paper money--shrinks as the supply increases. With no constraints on how many dollars can be printed, in time the dollar could--and probably will--be worthless.

What is a Dollar?

Most people think a dollar is a little piece of paper that says One Dollar on it. In fact, One Dollar appears on the front and the back. Yet, those little pieces of paper are not dollars, but are Federal Reserve Notes. A note is an IOU. If you borrow from a bank, you sign a note, which means you owe the bank. So, Federal Reserve Notes (FRNs) are really IOUs. The Federal Reserve owes the holder one dollar. But, if a dollar is a piece of paper that also is a FRN, what are you owed? This gets confusing because it was meant to be confusing. The government really does not want people knowing the difference between dollars, FRNs, and money.

To understand the situation, you need to know that a dollar is a weight of gold as defined by law. Today, a dollar is legally defined as 1/42.22 oz of gold. For most of this country's existence, a dollar was 1/20 oz of gold. In 1933, Roosevelt called in gold, gave the people $20/oz, and immediately devalued the dollar to 1/35 oz of gold. It was a 75% devaluation of the dollar. Viewed another way, gold's price was changed from $20/oz to $35/oz.

Some people have difficulty grasping why that move was called a devaluation when the price of gold went from $20/oz to $35/oz. That is because it was a devaluation of the dollar, which resulted in an upward revaluation of gold. Before Roosevelt's call-in, a dollar was redeemable for 1/20 oz of gold; after the devaluation, a dollar was worth only 1/35 oz of gold. As noted, it was a 75% devaluation, but it was worse than that. Before 1933, Americans could redeem dollars for 1/20 oz of gold. (Generally, a $20 bill was redeemed for a $20 Double Eagle.) However, after the devaluation, a dollar was worth 1/35 oz of gold, but Americans could no longer redeem dollars for gold. So, for Americans, it was a complete default by the government.

Before the 1933 call-in, the dollar was effectively a warehouse receipt where the warehouse operator (the government) held the asset (the gold) for the receipt holder. However, after Roosevelt's infamous April 5, 1933 Executive Order, the receipt holder could no longer claim his asset at the warehouse.

Imagine that you are a wheat farmer and that you have harvested your crop and delivered it for storage to a grain elevator. The elevator operator gives you a receipt, but when you return to claim you grain, the operator refuses to give your grain to you. In essence, that is what the government did. If a private warehouse were to do that, the principals would be tried for fraud. When the government does it, it is deemed "necessary."

How did we get in this mess?

People with large amounts of gold have always had the challenge of securing it, and throughout the world and the development of commerce, warehouses emerged where gold could be deposited. As with any warehouse, the depositors received warehouse receipts. Gold warehouses evolved into banks.

Commonly, in the early development of warehouse receipts, they carried the names of the depositors, and only the depositors could redeem the gold on presentation of the receipts. As time went by, receipt holders began to sign over the receipts to merchants, who would later redeem the gold backing up the receipts. Over time, instead of redeeming the receipts, merchants would pass the receipts to still someone else, and paper money began being used. Gold being bulky and somewhat heavy, the paper receipts were more convenient and gained popularity where the warehouse operators were trusted.

Throughout history, this scenario has been played out many times around the world. But, the important thing to remember is that, in all instances, it was the gold that had the value. The receipts were only paper, having no intrinsic value themselves.

Governments have long jealously guarded the right to be the issuer of money, be it paper or coin. This envious position has allowed governments to profit from the mintage of coins and to cheat the people with paper money. The esteemed Double Eagles are an excellent example of how our government profited from the mintage of gold coins.

When Double Eagles were minted, a dollar was 1/20 oz of gold; consequently, twenty paper dollars were worth one ounce of gold. However, a Double Eagle contains 0.9675 oz of gold, allowing the government a profit of 0.0325 oz on the mintage of a Double Eagle. This policy is known as seigniorage and is generally accepted as a proper function of government.

As the early empires approached their ends and were unable to directly tax their populaces, those empires typically debased their coinage. The Romans clipped edges from its coins as they passed through the treasury. (Anyone else found doing the same was subject to the death penalty.) The clippings were coined, thereby increasing the money supply. Other empires typically debased their coinage by reducing the gold content. As history shows, however, the government's control of paper money is where the real dangers lie.

The history of paper money is one of abuse

First, paper money is introduced as a convenience but is still redeemable in gold or silver. Sometimes later, as the people stop being diligent about the government's control of their money, the government issues more paper money than there is gold or silver to back it up. When the people realize what is happening, they present their paper for specie, money in coin form. This is, in effect, a "run on the bank." To thwart the people, the government suspends conversion. Roosevelt halted domestic redemption in 1933; Nixon stopped foreign redemptions in 1971. Now, we are stuck with a fiat money, which is "legal tender for all debts, public and private." (See the paper money in your pocket.) It is money, by order of government.

Following the terrorist attacks on the WTC Twin Towers and the Pentagon, the Fed "increased liquidity" by $200 billion. To do that, all the Fed had to do was buy debt instruments in the open market. The money to pay for those bonds was created by punching in numbers on a computer keyboard. No taxes were increased. No money was borrowed. Virtually no effort was expended. Yet, the money supply grew $200 billion. That's all there was to it.

Of course, as any economist or "sophisticated Fed watcher" will tell you, it was the right thing to do. The Fed had to avert panic. Besides, the government needs $40 billion to fight terrorism. However, those dollars now compete with the dollars you have in your checking account. Those new dollars also debase the dollars Americans have tied up in CDs.

Someday, Americans are going to realize that those new dollars the Fed creates to "avert crises" have equal purchasing power with those for which they had to work. Most Americans did not get their CDs participating in the stock market boom of the 1990s. They worked for their dollars. They watched their money, perhaps drove their cars a few years longer than they would have liked, wore their soles of their shoes a little thinner than they wanted, did not eat out as often as they would have liked, stayed home for vacations. Their frugality enabled them to put aside "a little for a rainy day" and for retirement.

Soon, those Americans will realize that their savings are tied up in investments redeemable only in paper dollars, which the Federal Reserve can create at will. Each dollar of the $200 billion in "liquidity" that the Fed "pumped into the financial system" after September 11 has the same purchasing power, the same claim to goods and services, as do the individual dollars for which average Americans worked and saved.

Someday, no one knows when, Americans are going to go down to their banks, tell the tellers, "Give me my money, those little pieces of paper. I'm going to buy something of value, something that the Fed cannot duplicate out of thin air." The rush will be to buy anything tangible--real estate, classic cars, firearms, antiques. The really misguided will buy stocks, thinking they offer protection against inflation. Informed investors, however, will buy gold and silver.

When the exodus for the dollar becomes widespread, we will suffer a devastating "confidence crisis," and the dollar will plunge on the world currency markets because foreigners will dump dollars as well. In fact, foreigners will probably lead the exit of the dollar.

Then, Americans owning gold will not say, "Wow! Watch gold climb; see silver soar. I'm getting rich." They will say, "I'm just glad I own some gold." That will be the day of reckoning for the paper dollar, the Federal Reserve Note, the IOU Nothing. That day of reckoning is unavoidable because the Untied States and the entire world have been on a paper money system for thirty years. The dollar and all the other paper currencies have been abused by politicians for three decades, inflated to levels never dreamed of in 1971.

The dangers of paper money and the value of gold were illustrated during the 1998 Asian Crisis. Across Asia, paper currencies sank as people lost faith in them. It was a classic "confidence crisis." In local currencies, gold skyrocketed in price. In South Korea, however, the importance of gold rose to the forefront as government agents went door-to-door asking the people to donate gold so that the government would have a "hard currency."

The late Franz Pick once said, "Government is the only agency that can take a useful commodity like paper, slap some ink on it, and make it worthless." We are nearly there. It is time to stop thinking of gold and silver as vehicles from which to earn profits recorded in paper dollars, but to view them as money. It is time to quit thinking, "I have $40,000 invested in precious metals," but to think, "Wow, I'm lucky, I have 100 ounces of gold and 3,000 ounces of silver to ride out the storm ahead." It is time to realize that gold and silver are the ultimate forms of money and that paper, albeit useful in many instances, eventually become worthless when used for money.

Bill Haynes

November 5, 2001

A Day of Reckoning first appeared in the October-November 2001 Monetary Digest, Certified Mint's precious metals newsletter. Bill Haynes, who wrote the article, has been a precious metals dealers since 1973. He may be reached at bill@certifiedmint.com