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How the Fiat Money is Being Defended?

May 5, 2003

During his press conference on 4 February 1965, President Charles de Gaulle openly challenged US dollar's "exorbitant privilege" under Bretton Woods order:

"Any workable and acceptable international monetary system must not bear the stamp or control of any one country in particular. Truly it is hard to imagine any standard other than gold. Yes, gold, whose nature does not alter, which may be poured equally well into ingots, bars, or coins, which has no nationality, and which has, eternally and universally, been regarded as the unaltered currency par excellence..."

The official website of the Foundation and Institute Charles de Gaulle explains the underlying controversy as follows:

"...while other nations were obliged to settle their trade deficits in a currency other than their own, the US could do so by paying their creditors in dollars which those creditors agreed to hold."

"The inequality of the system had been noted by a number of economists, including Robert Triffin in 1959, and Jacques Rueff had for many years been an ardent protagonist of reform involving primarily an increase in the price of gold."

"Initially, General de Gaulle was not opposed to the suggestion, made by French experts themselves, that an international instrument of payment should be devised, along the lines of the European Payment Union settlement mechanism (1950-1958), which would be based on both gold and a 'basket' of major currencies and which would be used by central banks in their reciprocal settlement procedures (the 'Collective Reserve Unit').

"After it proved impossible to reach agreement, and after having converted dollars into gold on a number of occasions in order to maintain pressure on the USA, de Gaulle adopted a harder position in his famous press conference of 4 February 1965 and proposed a return to the principles of the gold standard."

Three weeks later, on February 25, 1965, the Anglo-American take on President de Gaulle's proposal was presented by Professor Harry G. Johnson in his address "Should Gold be Scrapped?" to the Empire Club of Canada.

Dr Johnson was introduced to the members of the club as follows:

"Currently Professor of Economics at the University of Chicago, next year he will assume what is probably the highest academic post ever offered to a Canadian in the United Kingdom, the Chair of Economic Theory at the London School of Economics. He is provocative, controversial and topical and not the sort of economist who confines his discussions to problems we wouldn't have if there were no economists."

In his address, Dr Johnson said:

"The problem of gold and its international monetary role has been very much in the news recently. On the other side of the Atlantic, President de Gaulle has raised the issue with his attack on the special status of the pound and the dollar in the present international monetary system, and his invitation to other countries to join France in a return to the gold standard. Of more immediate significance, his Finance Minister, M. Guiscard d'Estaing, has announced a new policy of taking settlement of French balance-of-payments surpluses only in gold. On this side of the Atlantic, the US Administration had earlier moved to increase its supply of 'free' gold by eliminating the 25% cover requirement against Federal Reserve Deposits."

"The Europeans believe that the present system, in which the pound and the dollar serve as reserve currencies, enables the UK and the US to evade the necessity of prompt adjustment; and they desire revisions of the international monetary system that will reduce or remove the possibility of evasion. General de Gaulle's recent attack on sterling and the dollar is to be interpreted as an expression of this view - and it is erroneous to believe that his ideas are an eccentricity unrepresentative of European thinking - while his invitation to return to the gold standard involves an extreme of monetary reform that would, if it could be effected, establish a system of imposing ineluctable pressures for prompt adjustment on deficit and surplus countries alike. Nor can this proposal be dismissed, as US officials have dismissed it, as a return to 'the gold standard that broke down in 1931'; for the truth is that the standard that broke down in 1931 was not a gold standard of the classical type, but a gold exchange standard precisely like the present international monetary standard, and it broke down precisely because a few national currencies were being used on a large scale as substitutes for gold that did not exist. A return to the gold standard, if it could be effected, would eliminate this grave deficiency in the present international monetary system, since all reserves would be hard metal and not credit money whose use in place of gold depended on confidence. Nor is it really a valid argument against a return to the gold standard that, to make it possible without a sharp deflation of world prices, the price of gold would have to be doubled or tripled, and that this would involve undesirable capital gains to holders and producers of gold. It is simply silly to oppose a change that would promote the general good, on the grounds that some people will derive a windfall profit from it."

Because Dr Johnson was so fair in his introductory remarks we have just quoted, it would be natural to assume his concluding views would be equally fair and professorially impartial, but they were not. Professor Johnson rejected the return to gold as "a practical impossibility" and "simply inconceivable":

(The very long paragraph in the original address has been subdivided here into three for the sake of clarity.)

"The real arguments against attempting to return to the gold standard derive from the very characteristic of gold that gives the gold standard its virtue in the eyes of its proponents - the fact that gold is a commodity the production of which entails a real cost. This fact has two crucial implications.

"First, there will always be an incentive for the financial system to develop credit substitutes for gold, because on the one hand gold yields no interest to the holder whereas credit substitutes do, and on the other hand credit substitutes can be produced (though not maintained as efficient substitutes) at virtually zero real cost. In fact, the history of money is essentially a history of the gradual substitution of credit money for commodity money in response to the interaction of scarcity of the latter and ingenuity in devising the former. The economics involved ensure that a return to the gold standard would be a practical impossibility.

"Second, tying the international monetary system to a produced commodity - especially a mineral - as the basic money inevitably entails exposing the system to erratic changes in the stock of money resulting from the vagaries of technical change and new discoveries in the industry producing the monetary commodity; inevitably, rationality will suggest - as historically it already has - that these erratic changes can and should be avoided by deliberate monetary management, and that the costs of production incurred in gold mining can be escaped by resorting to credit money. A return to the gold standard would therefore involve a deliberate surrender of the chance to exercise rationality in monetary affairs, in favour of control by erratic and unpredictable forces; such a surrender by organized society of a realized possibility of conscious control is simply inconceivable."

Even though the ancient admonition "De mortui aut nihil aut bene" weighs heavily against it, we must say point-blank that Professor Johnson's views asserted here are not only patently false, but they must have been made knowingly, with intent to sow disinformation and ignorance.

Point I:

The argument "gold yields no interest while its credit substitutes do" is a sophistic argument, based on deliberate blurring of the meaning of "gold" and the meaning of "credit substitutes". To erase sophistry from this statement and to make it uniformly true, its narrow term "gold" must be replaced with a broader term "cash", and its overbroad "credit substitutes" must be narrowed to a more specific category "investment assets".

Cash, whether in the form of gold or in the form of Federal Reserve notes, will yield no interest if you will hold on to it. If you want to earn interest on anything at all, you have to give it to those from whom you expect your interest. Both gold dollars and their "credit substitutes", Federal Reserve paper "dollars", when kept under a mattress will yield no interest. Interest is the price of liquidity. Those who want to stay liquid and have their wealth instantly available for any unforeseeable contingency must keep their wealth in cash - again, it makes no difference if it is gold or Federal Reserve notes - but the price of keeping your wealth in cash is the loss of interest. In order to earn interest, cash must be invested, i.e., converted into less liquid assets. It is only because the general rule, that the less liquid the investment asset is the higher interest it pays, has been perverted by the unfortunate proliferation under fiat dollar regime of Treasury bonds, notes and bills - which are perfectly liquid but pay interest by courtesy of American taxpayers - it became possible for professors of economics to circulate their sophistry that "gold yields no interest and credit substitutes do". If central banks gold cash would be converted solely into fiat cash, such as Federal Reserve notes, and not into "investment assets", such as Treasury bonds, notes and bills, it would yield no interest either.

With this distinction in mind, the ostensibly plausible and self evident statement "gold yields no interest and credit substitutes do" becomes as preposterous as a statement "coin dollars yield no interest, and paper dollars do".

If Professor Johnson would have said that cash in all forms, gold or fiat, yielded no interest, and "investment assets" did, he would have said the trivial truth, and would have deceived no one. But then he would have undercut the official "argument" against gold, and for this reason he would not have been rewarded with the Chair of Economic Theory at the London School of Economics.

Point II:

When Professor Johnson speaks about "gradual substitution of credit money for commodity money in response to the interaction of scarcity of the latter and ingenuity in devising the former", he again resorts to sophistry; he deliberately confuses fiat money with legitimate banking instruments that have been used over the years to utilize all available supplies of silver and gold and to simplify payments in silver and gold.

It is one thing to use bank notes or checks for making payments in silver or gold, and it is quite another to inject into circulation the central bank or government notes which under legal-tender statutes must be accepted for all debts, public and private, INSTEAD OF silver and gold.

This most important distinction is necessary to comprehend that "fractional reserve banking" is perfectly compatible with honest money regime and free banking system. Misunderstanding of this simple fact effectively immobilizes the cause of honest money when some of its standard-bearing proponents - gentlemen of the Austrian persuasion, for example - simply cannot see the difference between legitimate fractional reserve banking and the central bank's counterfeiting, thus creating erroneous impression that the postulate to scrap the fiat money regime and to return to silver and gold also requires scrapping fractional reserve banking, which would undermine legitimate banking operations.

For this reason, we will take a digression here to explain this issue with utmost simplicity. If the cause of honest money is to go anywhere, the issue of fractional reserve banking must be put to rest, i.e., easily understood by millions of voters from all walks of life:


Twin brothers operate two corn farms side by side, and they are married to twin sisters whose brother owns industrial alcohol distillery. They just sold the entire output of their farms to him, and they placed the proceeds, $100,000 in gold coins each, into their strongboxes. Then, late in October, the alcohol manufacturing brother approached his sisters with a business proposition:

"I just got an extra contract for alcohol fuel sealed and delivered. I need money to expand my operations to make delivery on schedule. I will pay commercial paper rate for 90 days, and then will roll these loans over for another term of 90 days. At 7.3 percent per annum, it will come to 3.65 percent by the end of April (or 1.825 percent by the end of January if you can accommodate me for one term only)."

The first sister said: "You know how tightfisted my husband is. I'm sorry."

The other sister said: "We may need no more than one-sixth of our one-hundred thousand dollars before May. I can lend you $83,000 till the end of April provided you say nothing to my husband."

Do you know what just happened? The second sister has become a fractional reserve banker! She lent the not-needed fraction of her husband's cash to a third party to earn interest.

Predictably, the first sister, upon seeing her brother returning the borrowed $83,000 with $3,000 interest to her sister in April, will become an Austrian economist, and will be calling her sister an embezzler and a thief, who was fraudulently inflating the nation's money supply to the tune of half a million dollars ($83,000 X 6 = $498,000).

Does the fractional reserve banking actually increase the money stock by the combined amount of bank notes (deposits) created to cover fractional reserve lending?

No, it does not! It merely prevents the shrinkage of the existing money stock. Newly created bank notes, or checks, are circulating in lieu of the gold sitting in bank vault, not in addition to it.

Example: ABC Bank receives deposit of $100,000 in gold. With fractional reserve at one-sixth, it can lend $83,333. It will extend this loan by issuing its own bank notes to the borrower. (Under free banking conditions, without a central bank to rely on, bankers hold on to gold and silver, and transact their business in bank notes, checks and other credit instruments.) When borrower's supplier will accept these notes (at a nominal discount because gold is a legal tender and bank notes are not) and will deposit them in his bank, they of course will be returned to ABC Bank for redemption in gold. Thus when bank notes are in circulation, the gold they were issued against is out of circulation in the lending bank vault. When the bank notes are returned to the lending bank vault, the gold is put back into circulation, only to be withdrawn from circulation by the receiving bank, which will use it to make $69,444 loan in bank notes to someone else, only to be asked to redeem them in gold to yet another bank, which will use it to make $57,870 loan in bank notes, and so on, and on.

Under honest money regime and free banking system, bank notes circulate for the duration in lieu of gold withdrawn from the circulation. The same is true if the gold is moved by way of a check. While bankers strive to hold on to gold and use bank notes instead, they are quickly forced to surrender gold for the bank notes they issued, and they inevitably end up with their fractional reserve in gold, held for contingency of the original depositor's limited withdrawal, and with their hope that the lent gold will be repaid. For this reason, fractional reserve loans are always short term loans for secured and sound commercial transactions. In other words, not to loose their depositors gold, the bankers must make their fractional reserve loans to the most creditworthy enterprises. Long term loans and pie in the sky ventures must be financed with full disclosure what they entail, i.e., by way of selling bonds rather than by bank loans.

What is the difference between fractional reserve banking under honest money regime and fractional reserve banking under fiat money regime?

Under honest money regime, the lent fraction must come from someone's deposit of gold; under fiat money regime, bank can also lend "money" that were never a part of anyone's deposit, but were created out of thin air and added to the money stock just like counterfeits. Under honest money regime, with fractional reserve loan, the borrower receives possession of temporarily available part of depositor's gold, while depositor holds valid claim to the same gold (often, he thinks his gold is in the bank's vault all the time). This arrangement is not a fraud, because the loan is usually a secured short term loan not likely to be defaulted upon. With gold discipline, banks cannot lend more than gold deposits on hand minus fractional reserve (which varies from time to time and from place to place) nor can they afford to make long term, improvident loans because the banks which are unable to redeem their notes in gold are deemed insolvent and must close their doors. Only under fiat, banks can continue to extend loans as long as the printing of new "money" continues, because they are not under discipline to redeem their notes in gold.

Under fiat, fractional reserve banking has been altered beyond recognition. When XYZ Bank receives $100,000 deposit, with fractional reserve at one-sixth, it feels free to lend $500,000. Under gold, ABC Bank could lent only $83,333 on the basis of the same deposit because bank notes used to make that loan would be promptly returned for redemption in gold, and it would be this gold discipline that would prevent ABC Bank from re-lending the returned bank notes without a new deposit of gold on hand. Under fiat, there is no such discipline.

Contrary to what most people think, it was not the fractional reserve banking that was causing the periodic "money panics" and recessions that followed during the free banking era. The primary causes were the predatory operations of the London bankers and the resulting stock exchange upheavals, while the primary contributing factors were seasonal movements of savings from the farms that were improperly invested in the stock exchange speculative schemes. Both could be curtailed by the simple expedient of closing stock exchanges for good. See

(When in the early 1890s the British dumped hundreds of millions of dollars worth of American securities and shipped their gold to London, and in the ensuing crisis, John Pierpont Morgan gave his instantaneous guarantee on February 5, 1895 to President Cleveland that the gold that was to be repurchased with the new issue of US bonds was not going to be shipped to London again, he in effect admitted that he and London bankers had full control of the gold movements across the Atlantic.)

In short, fractional reserve banking is not a part and parcel of the fiat money regime. It's a legitimate method to utilize currently not needed cash to finance secured short term transactions. It should not be discarded together with fiat money regime merely because it has been used by fiat money regime.


Professor Johnson is right that "there will always be an incentive for the financial system to develop credit substitutes for gold".

For example, when state chartered banks were denied the privilege to issue bank notes for the benefit of nationally chartered banks, to facilitate financing of the Civil War, the state chartered banks had urgent need for "credit substitute" other than bank note (which by law was denied to them), and they resorted to checks as their primary instruments to move cash (whether it happened to be gold, silver or newly issued greenbacks) and from then on personal checks became the local "currency" for generations to come.

But Professor Johnson is wrong that there is some kind of law of history that honest money, silver and gold, must in time be replaced with "credit substitutes", which he skillfully commingles with legal tender fiat money for purposes of his argument. The need to create legitimate credit instruments, that are needed to move honest money deposits, should not be confused with any "need" to create counterfeited "money". Counterfeiting is never required by history. Counterfeiting always requires someone's act of will; a criminal act of will, if you will.

When Professor Johnson says, "The economics involved ensure that a return to the gold standard would be a practical impossibility", he refers to the fact that "credit substitutes can be produced (though not maintained as efficient substitutes) at virtually zero real cost". In other words, legalized counterfeiting is too profitable to be eliminated altogether. So they say about organized crime.

Point III:

Professor Johnson's third argument against gold focuses on "...erratic changes in the stock of money resulting from the vagaries of technical change and new discoveries in the industry producing the monetary commodity".

In other words, another great gold discovery, such as the one in California in 1848 or in Transvaal in 1886, or new technology similar to cyanide process that could recover previously unrecoverable gold, would be likely to increase money stock so rapidly that runaway inflation of prices would result. We have heard this argument long and often enough, haven't we?

The tables below are the US consumer price indices scaled in 1840 dollar. They show that whatever had cost $1.00 in 1840, it cost 90 cents in 1860, and whatever had cost 97 cents in 1880, it cost 83 cents in 1900. Could you tell, just by looking at price levels, that California gold discovery and Transvaal gold discovery (the biggest ever) were made in the years marked with asterisks?

1840 $1.00 1880 $0.97

1841 $1.03 1881 $0.97

1842 $0.97 1882 $0.97

1843 $0.93 1883 $0.93

1844 $0.93 1884 $0.90

1845 $0.93 1885 $0.90

1846 $0.90 1886* $0.90

1847 $0.93 1887 $0.90

1848* $0.87 1888 $0.90

1849 $0.83 1889 $0.90

1850 $0.83 1890 $0.90

1851 $0.83 1891 $0.90

1852 $0.83 1892 $0.90

1853 $0.83 1893 $0.90

1854 $0.90 1894 $0.87

1855 $0.93 1895 $0.83

1856 $0.90 1896 $0.83

1857 $0.93 1897 $0.83

1858 $0.87 1898 $0.83

1859 $0.90 1899 $0.83

1860 $0.90 1900 $0.83

Please make a copy of these tables, and the next time you'll hear yet another professor confidently asserting that ..."tying the international monetary system to a produced commodity - especially a mineral - as the basic money inevitably entails exposing the system to erratic changes in the stock of money resulting from the vagaries of technical change and new discoveries in the industry producing the monetary commodity"..., please present these tables to him and tell him you are from Missouri.

Based on these false assumptions, Professor Johnson proceeds to the conclusion that the logical end of the search for the alternatives to the existing gold exchange standard is "the eventual scrapping of gold as an international money, and replacement of it by some international monetary system based entirely on credit." But he predicted that adoption of any such system appeared to be "a long way off".

Instead, "...the demotion of gold from its monetary role could occur much more rapidly, [...] ...if pushed too far by the ingratitude and chicanery of countries it assisted generously in the postwar reconstruction period, the patience of the US Administration will snap, and the country will simply terminate the convertibility of dollars into gold (or of gold into dollars). In that event, gold would not be scrapped - judging by the 1930's experience of floating exchange rates, the demand for it could conceivably increase but it would become at best a commodity especially suitable for the conducting of intervention operations in foreign exchange markets."

This is the summary of Professor Johnson's address in just fifty words:

Gold heads into the sunset while global "credit currency" by agreement of nations is a long way off, so the Bretton Woods gold exchange standard will schlep along, but if the French will push too far, convertibility will be abruptly terminated, and gold function will revert to foreign exchange interventions.

The French policy of accepting settlements of trade surpluses only in gold operated to convert into gold not only French surpluses with America, but forced other nations to exchange their dollar reserves into gold in order to settle their trade deficits with France (on the occasion, they would also exchange their own surplus dollars into gold). Before long, the hemorrhage of gold from Fort Knox became very acute.

In 1966, France left integrated structure of NATO, while remaining a party to the treaty itself, and requested removal of all NATO forces from the French territory. NATO Headquarters were moved from Fontainebleau to Brussels.

In June 1967, France withdrew from London Gold Pool. The Pool was originally set up on Halloween day 1961. Its members (central banks of Belgium, France, Germany, Italy, Netherlands, Switzerland, UK and the New York Fed) undertook to sell and buy gold through the Bank of England as their agent in the London market to maintain prices at $35 par. In other words, the central banks of the nations that benefited the most from oil being bought with heavily depreciated US dollar (November 1961 dollar was worth only 56 cents at $35 gold parity), agreed to contribute their gold to maintaining the fiction that one ounce of fine gold was still worth $35, when in reality its US inflation value was $62.01. In June 1967, the French woke up to the reality that it did not make any sense to sell their gold for $35 per once, when its June 1967 value was already $68.83.

On November 18, 1967, British pound sterling was devalued from $2.80 to $2.40 by advance acquiescence of Lyndon Johnson. Pound still had 240 pence at that time, so one US penny became equal to one British penny. The purpose of that devaluation was to accumulate large hoard of US dollars from the export trade in the next few years in order to make last minute run on Fort Knox before the gold window would close for good. And by strange coincidence, the cretin "revolution" of May 1968, resulted in massive raises in wages and salaries in France, which effectively destroyed French exports, and led to political demise of President de Gaulle. English political precision is always without comparison.

(To eliminate similar upheavals in the future, Charles de Gaulle proposed to introduce federal structure to the French Government. In place of centralized Napoleonic departments, he proposed a return to the autonomous provinces in their historical borders. But he needlessly declared the plebiscite on that proposal to be a vote of confidence in his leadership. Most people in France were for the federal structure, but, emboldened by May revolution, they missed no chance to throw the political egg on their President's famous nose.)

Meanwhile, sterling devaluation opened massive run on gold in London. Those who kept sterling as reserve currency, woke up on November 18, 1967 to a 14% loss. The best vehicle in sight to make up for that loss, and to prevent even greater losses upon devaluation of US dollar, was gold. Its official price was still $35 per ounce, while its US inflation value was $69.86 and counting. Everybody and his brother was buying gold, except for law abiding US citizens. (It was still a felony to deal in gold bullion and monetary gold for US nationals.)

When March 14, 1968 demand exceeded a truly fantastic figure of 225 tons, London gold market was closed on March 15 for "holiday". When it reopened on April Fools' Day, the Gold Pool was no longer there, and gold had two prices instead of one: $35 between the central banks, and a market price between private parties.

On May 31, 1968, while France was still paralyzed by her cretin "revolution", International Monetary Fund adopted new reserve asset, the Special Drawing Right, worth 0.888571 gram of fine gold, $35 parity of US dollar, to supplement gold and US dollar. Heralded as "a paper substitute for gold", the SDR was in reality a paper substitute for paper Federal Reserve "dollar", for it's "gold parity" did not survive dollar's ultimate devaluation under float on March 19, 1973.

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