The central banks are clearly destroying the monetary system that emerged after Nixon went to Camp David in August 1971. So here we are 45 years later and we are nearing the end of an unstable fiat central bank driven system and the alternative is fairly obvious—at some point going back to real money. I don’t think governments will do that voluntarily, but certainly people trying to protect their wealth will. When that happens it will trigger a huge political crisis and hopefully an opportunity to change the regime and get back to some kind of viable and sound financial and monetary system.1
—David Stockman
The role of the dollar as the international reserve currency is an issue that has seemed of more pressing importance to investors than political economists. It is obvious why investors take an interest. The international standing of currencies forms a principal feature of the global monetary order, influencing a wide range of economic relationships. Despite the great impact of international currencies, however, political economists—with the notable exception of F. A. Hayek—have tended to neglect them. Perhaps this is because currencies are traded twenty-four hours a day, in view of which economists have found it wise to shy away from making heroic comments because of the nontrivial prospect of embarrassment by market movements.
This potential for embarrassment has been illustrated since June 2014, as the dollar rallied sharply in spite of many forecasts that it was destined to depreciate, even collapse, as the decay of US economic preponderance accelerated. If you look back as far as the 1960s, a flurry of investment commentary anticipating the demise of the dollar as the world reserve currency is stimulated each time the dollar has seemed poised to lose a lot of value.
William F. Rickenbacker’s 1969 book, Death of the Dollar, is the sole example among the more prominent works in this category to have been written before Richard Nixon repudiated the dollar’s link to gold. If you actually read this book, as I did almost half a century ago, you will be disappointed: it offers little insight into the current world monetary system and why it is flirting with collapse.
Rickenbacker made a name for himself pointing out that the industrial uses for silver made the metal too valuable to permit its continued use in coins at the low rates the US Treasury was willing to pay for it. Death of the Dollar was an extension of Rickenbacker’s argument to gold, which he also found to be too valuable to permit its price to remain set at thirty-five dollars an ounce (as contemplated by the Bretton Woods agreements that spelled out the ground rules of US hegemony at the end of World War II).
Rickenbacker pointed out that the annual industrial consumption of gold had tripled from 1.46 million ounces in 1957 to 6.1 million ounces in 1966. By the end of the 1960s, industrial consumption was four times the annual US gold production. Therefore, Rickenbacker’s conventional argument was that trends in supply and demand would make it difficult to achieve a sufficient deflation to preserve the dollar/gold peg at thirty-five dollars to the ounce. By implication, preserving fixed exchange would depend on a higher price for gold, and a devaluation of the dollar.
In that sense, Death of the Dollar was a very different kind of book than later volumes with similar titles; while Rickenbacker was writing it, during the final years of “The Great Prosperity,” the signal crisis of US hegemony was still to come. Unlike today, the United States was still the world’s greatest creditor nation. You may recall that the signal crisis begins with a negative judgment by capitalists on the possibility of continuing to profit from reinvestment in the material expansion of the economy. This isn’t because they are pessimists—it is because they respond rationally to falling returns.
A crucial feature of the prelude to financialization in the 1970s was a 40 percent plunge in the rate of return on the capital stock of US manufacturers between 1965 and 1973, as reported by Giovanni Arrighi in Adam Smith in Beijing.2 When Eisenhower left the White House, only a decade before Richard Nixon repudiated the dollar’s link to gold, total US business investment was just a shade less than 50 percent of GDP, stronger even than what we have seen recently in China (46.4 percent in 2012) but without the artificial stimulus from a credit bubble. Eisenhower was no friend of easy money.
More recently, even in the wake of unprecedented monetary stimulus since 2008, US business investment was at the bottom of the tables at just 12.8 percent in 2012.
Over a longer period, the percentage of profits earned in manufacturing in the United States fell from over 50 percent in the early 1950s to just about 10 percent by 2001. Meanwhile, the percentage of profits accounted for by financial returns among so-called FIRE (finance, insurance, and real estate) companies, rose from about 10 percent to about 45 percent.
Equally startling, the ratio of financial revenues to operating cash flow for nonfinancial American firms rose from around 10 percent in 1950 to a five-year moving average of 50 percent by the turn of the century. By far the largest component of financial revenues was interest, reflecting the growing saturation of the US economy with debt while real income growth petered out.
The signal crisis represents the turn away from capital commitment to business assets in favor of financialization. As such, it is the prestage of a worsening crisis and the eventual collapse of the dominant regime in the terminal crisis of hegemony.
It should not be a surprise that long-term investment in the United States fell off a cliff as financial assets proliferated. London-based financial analyst Paul Mylchreest, of ADM Investor Services, reported in March 2015 that “the stock of globally traded financial assets has increased from US $7 trillion in 1980 to something approaching US $200 trillion.”3 This huge proliferation of financial claims growing at a compound annual rate of about 10 percent over thirty-five years, while the nominal growth of the economy was poking along at barely half that rate (5.33 percent), hints at greater crisis to come. Indeed, recent computations by the Bank for International Settlements show that total global debt was almost three times greater than the whole world economy in 2014.
It would be ominous enough that debt has been compounding at almost twice the rate of nominal GDP over three and a half decades. But the situation has become even more grim in recent years. Total public and private debt has grown by $60 trillion to 300 percent of GDP since the last financial crisis. The pace of total debt growth has increasingly diverged from the corresponding rate of economic growth. In fact, nominal GDP growth in the decade since 2007 has averaged just 2.92 percent. Part of the reason for the slowdown is the fact the economy is overburdened with debt. Other factors, explored elsewhere in this book, have also contributed to smothering economic growth—with ominous implications. The burden of debt is building toward The Breaking Point.
If the average interest rate were merely 2 percent, then a 300 percent debt-to-GDP ratio means that the economy needs to grow at a nominal rate of 6 percent to cover interest. With nominal GDP growth lagging, we’re experiencing about a half trillion dollar annual shortfall in growth compared to what would be required to cover interest on outstanding debt. Far from growing out of the debt burden, the economy is sinking under it. The World Bank estimates that the ratio of nonperforming loans to total outstanding reached 4.3 in 2015. Compare that to 4.2 percent on the eve of the last financial crisis.4
A little-noted feature of the hypertrophy of debt in the fiat money system, where almost all our money is borrowed into existence as debt, is that the more money is borrowed, the stronger the deflationary trap is poised to snap shut. For one thing, debt drives production. Capitalists whose investments are financed by debt have incentives to continue expanding production, even at lower prices, to meet fixed debt payment obligations. When central banks encourage credit demand by slashing interest rates to invisibility, they stimulate a “cross-border carry trade” in which borrowers operating in countries with higher interest rates are tempted to borrow dollars at low interest rates. As of Q1 of 2015, according to the Bank for International Settlements, “nonfinancial” companies outside the United States had collectively borrowed $9 trillion. This is tantamount to a multi-trillion-dollar short position against the dollar. As the borrowers are obliged to buy dollars to repay their debt, the effect is equivalent to a short squeeze in currency markets.
When the Obama administration, with an eye on US elections in November 2014, amplified propaganda about a “vigorous recovery” in the late spring of 2014, an expectation of a coming interest rate rise in the United States helped compound a self-reinforcing rally in the dollar. The effect was to shrink demand for key commodities priced in dollars. Prices collapsed for a whole range of dollar-denominated commodities, undermining both cash flow and collateral, thus jeopardizing the ability of debtors to repay.
Also note that the ability of the real economy to support rapidly compounding financial claims (most of the financial assets are debt instruments) is exaggerated by looking at compound growth since 1980. Remember, from 1992 through 2000, reported US GDP growth only fell below 3 percent twice—in 1993 when it was 2.7 percent and in 1995 when it was 2.5 percent. But those days are past. More recent figures show that even by official accounts of growth it has dwindled to a standstill.
As David Stockman pointed out in his May 2015 article, “Wake-Up Call for B-Dud and the New York Fed Staff—This Isn’t ‘Transitory’,” April 2015’s number for manufacturing production represented a 0.33 percent annual growth rate since December 2007.5
In other words, financial claims have been multiplying more than thirty times faster than industrial production since the onset of the last recession. This underscores Tim Morgan’s thesis in his 2013 book, Life after Growth. Morgan states that “the total of financial claims has become vastly larger than anything that the real economy can deliver. . . . This divergence between real potential output and the scale of monetary claims helps explain why the world is mired in debts that cannot be repaid, and it also explains why the process of the destruction of the value of money is inevitable and is starting to gather pace.” Morgan concludes, “What it means is the that financial and real economies can be reconciled only if financial claims (meaning both debt and money) are destroyed on a truly enormous scale.” Unless you think like Obama in pretending that real economic growth is poised to surge, spiraling financial claims on a stagnant real economy imply an enormous wipeout of financial claims—hence my expectation of a coming “terminal crisis” of US hegemony.
The US government has become the world’s greatest purveyor of economic lies since the Soviet Union. The government remorselessly overstates economic growth and exaggerates strength of the employment market. As pointed out by Zero Hedge in the May 2015 article “The Big Lie: Serial Downward Revisions Hide Ugly Truth,” the level of US retail sales has been chronically exaggerated. Between 2010 and 2015, over 20 percent of the initial gains in retail sales were removed by serial downward revisions in later months. According to the article, “For over 65 percent of the time, a ‘good’ number prints, stocks rally, the everything-is-awesome meme is confirmed, and then a month later (or more) retail sales data is downwardly revised.” (Along the same lines, the unemployment rate for April 2015, officially reported at 5.4 percent, is really 23 percent, as reported by Shadow Government Statistics, computed as Statistics Canada computes the unemployment rate in Canada.)
Then there is the dramatic 25 percent dollar rally that began around May 2014, which was triggered, in part, by the response of traders to statistical factoids that exaggerated the strength of the US economy. A stronger dollar, in turn, contributed to the systemic price reversal that cratered the price of oil and other economically sensitive commodities. These were second-order effects of China’s monumental credit bubble.
There has been no lack of alarm about the fact that we are dependent on paper money that could quickly lose value—or perhaps suck your livelihood and fortune into a deflationary vortex. The current monetary system is unsustainable, and it’s bound to collapse. To get a better perspective on this, let’s take a step back. The US dollar and the world monetary system need to be understood in the broader context of fading US hegemony.
The United States wrote the rules of the world economy when we were far and away the world’s richest and most powerful economy. Today, our luster has faded. One of the puzzles we must decipher as investors is how, and under what conditions, the US dollar’s role as a reserve currency is likely to end. Also, the current system should be understood as the culmination of a centuries-long process in the evolution of money and credit, as shaped by successive hegemonies. As Hayek pointed out in New Studies in Philosophy, Politics, Economics and the History of Ideas, the institutions of the moment are the latest attempt to cope with the demand for more, and cheaper, money—“a tradition of our civilization for centuries.”6
A review of the past stages of hegemony shows several points to bear in mind now:
As Hall of Fame baseball genius, the late Yogi Berra is famous for pointing out, “You can observe a lot just by watching.” What you can see if you look is that a distinctive feature of US hegemony in its twilight is the imposition of pure, fiat money throughout the globe. Although you can see some foreshadowing of the US monetary system in the period of British hegemony, no previous dominant regime had strayed far from commodity-based money. For perspective, let’s take a quick historical tour of previous hegemonies over the past five centuries. You can see how money and banking have evolved through half a millennium to permit banks to create money “out of thin air,” with the changes driven in large measure as expedients for financing ever-larger governments ever-more desperate for funds.
La Casa delle compere e dei banchi di San Giorgio
The financial hub of the first modern hegemony was Genoa, which specialized in finance capitalism, mainly extending credit to princes at a time when bankers did not create money, but only lent sums that already existed. How did that work?
You could learn a lot about banking in sixteenth-century Genoa by parsing the original name of Genoa’s leading banking institution—“La Casa delle compere e dei banchi di San Giorgio.” This is usually translated as “The Bank of Saint George.” But a literal rendition of the Italian is “The House of public debts & ‘banks’ (plural) of Saint George.” As Professor Giovanni Felloni elucidates, casa more or less approximates “corporation” as “it denotes a body with its own legal identity” that “survives the succession of those managing it.”7
The affinity for Saint George probably also needs explaining. “It was the norm in medieval life to invoke the protection of a saint.”8 The creditors who funded Genoa’s bank chose the warrior Saint George, whose cross not incidentally formed the design of the Genoan flag—essentially identical to that of England, as both incorporated the red Saint George’s cross on a white field.
And delle compere refers to a type of public debt, the compera, that enabled Genoa’s bankers to “finance the ambitions of foreign and local princes including the King of Spain.” Part of the magic of the compera in its time was that it entitled buyers of sovereign debt to receive dedicated streams of income from the proceeds of specific taxes, thus circumventing prohibitions of the medieval church against “usury.” Think of the contortions among Islamic banks today.
Note also that dei banchi, which literally means “the benches,” is a medieval designation of “banks” (plural), so named because in the Middle Ages, Genoan bankers did not do business not from workshops, as did the craftsmen, but from behind a table, a flat surface a (bancus) set up in the market square. Note that bancus is not only the root of “banks” but also of “bankruptcy.” The word bancus means “table or bench,” and ruptus means “broken.” When a merchant or banker could no longer honor his debts, his bancus or table in the market was broken to warn others not to conclude business with him.
Banchi is the plural form of banco. In late medieval and early modern Genoa, “dei banchi di San Giorgio” “signified ‘bank counters,’ since each banco had its own cash desk and set of accounts; the word in the plural form ‘banchi’ indicated the existence of several bank counters at the same time and, in fact, there were 3 from 1408 to 1445, rising to 8 between 1531 and 1805.” Among them were a gold bank, one that worked in silver and another in Spanish “real de a ocho” coins.9
The “real de a ocho,” or the piece of eight (Spanish peso de ocho), was a silver coin, worth eight reales, that was minted in the Spanish Empire after 1598. It was conceived to correspond in value to the German thaler. The Spanish dollar was widely used by many countries as international currency because of its uniformity in standard and milling characteristics.
As you know, the Spanish dollar was the coin upon which the original US dollar was based, and it remained legal tender in the United States until the Coinage Act of 1857. It was also the origin of the “peso” currencies in use in many countries, as well as the Chinese yuan. Because it was widely used in Europe, the Americas, and the Far East, it became the first world currency.
In short, the first modern hegemony, the Genoan/Iberian regime, involved a continuation of medieval money and banking in the service of the new Iberian empires. It was all about the importation of gold and silver from the New World. Spanish and Portuguese banking was primitive, but as described above their coin was good. This formed the basis of a symbiotic relationship with the Most Serene Republic of Genoa, the small city-state that became the financial partner with the Iberian powers, in their period of hegemony in the sixteenth century.
Most of the money that circulated in Genoa was minted by other states. But as discussed, Genoa did have a prominent and hyperactive financial institution, of medieval vintage, the Bank of Saint George, one of the oldest banks in the world. Run by Genoan oligarchs—who, like beer drinkers in the Bud Light commercial, were “up for anything”—the banks were major players in the slave trade and even administered their own colonies in Corsica, Gazaria in Crimea, and the Taman Peninsula on the Black Sea in present-day Russia.
Ferdinand and Isabella, as well as Christopher Columbus, maintained accounts at the Bank of St. George. The bank specialized in financing the Hapsburg sovereigns in anticipation of erratic shipment of silver from Peru. They lent especially vast sums to Spanish king Charles V, upon which Spain repeatedly defaulted—in 1557, 1560, 1575, and again in 1596—making it the first modern nation to default and signifying the signal crisis of Genoan/Iberian hegemony.
Amsterdamsche Wisselbank (Bank of Amsterdam)
The period of Dutch predominance began with an innovation during the rebellion against Spanish rule—the creation of the Bank of Amsterdam. Acting through the bank, the Dutch “provincial government minted and supported two good coinages, the guider (golden) and stuiver (silver)” worth one-twentieth of a guilder.
The Bank of Amsterdam served as a clearinghouse for currencies, acting much like a pawnshop for debased coins. It accepted deposits of any currency, or bullion, and then assessed the gold and silver content of such assets and gave the depositors an equivalent value in guilder and stuivers. This was important, because as Francis Turner put it, seventeenth-century “Europe was filled with coins of varying values, issued by governments of varying degrees of trustworthiness. To make it worse, each system had different ratios of the numbers of coins of one denomination that made up the next.”10 The Bank of Amsterdam became a financial clearinghouse. “The guilder and stuiver became the preferred currency for international exchange.” Other currencies then in use were deposited in accounts of the Bank of Amsterdam and translated into the preferred “guilder and stuiver.” In effect, the bank provided liquidity to debased currencies, crediting their holders with their precious metals content.
In short, the Bank of Amsterdam provided liquidity to any holder of gold and silver, even in the dilute form afforded in coinage of jurisdictions that seriously debased their currencies with base metal alloys. In so doing, the Bank of Amsterdam facilitated trade and encouraged in the inflow of funds to Bourse of Amsterdam.
Note that the Bank of Amsterdam practiced “warehouse” banking. Depositors paid the bank for the service of safekeeping their money rather than earning interest on deposits. This reflected the fact the Bank of Amsterdam was not engaged in fractional reserve banking—lending out some fraction of deposits, as goldsmiths had traditionally done and the banks we are familiar with do.
The prime monetary innovation of British hegemony was the advent of central banking and legal sanction for the creation of money ex nihilo “out of thin air.” The Bank of England received its Royal charter on July 27, 1694 (while Dutch hegemony was still in place), with the explicit purpose of creating money to fund the rebuilding of the English fleet.
England’s Dutch King, William III, who was also Prince William of Orange, the hereditary “Stadtholder” of Holland, Zeeland, Utrecht, Gelderland, and Overijssel in the Dutch Republic, found the English Treasury bare when he invaded England and seized the throne from James II. Subsequently, the English Navy, along with the Dutch fleet had been decisively defeated by the French at the Battle of Beachy Head, an ill-advised encounter prompted by direct orders from Queen Mary, wife of King William who was away in Ireland at the time.
Without ready funds to rebuild the navy, you will not be shocked to know that some members of Parliament thought immediately of clipping coins—to raise funds by reducing the value of money. King William and his advisers preferred to raise funds by chartering a for-profit bank, two schemes for which were entertained. One that failed was for a “Land Bank,” proposed mainly by the king’s opponents, in which King William himself was to be the lead investor with a subscription of £5,000. But this plan was scrapped when only £7,500 was committed, whereas the Bank of England was chartered as a for-profit corporation, with an initial capital of £1,200,000, a sum that was raised in twelve days. Part of the reason for the king’s enthusiasm for the new arrangement was that the Bank of England offered a mechanism for transferring the personal royal debt into a public debt controlled by the Parliament.
In return for creating a limited liability corporation, which would act as a bank for the government and have the right to issue banknotes, the shareholders of the Bank of England loaned the bank £1,200,000 at 8 percent interest. Of this sum, lent in turn to the government, half went immediately to fund a shipbuilding project for the Royal Navy. The Bank of England was also given a special dispensation to suspend conversion of its bank notes into gold.
This created the precedent for fiat money as the Bank of England notes circulated as undated debt instruments. Given the heavy debt load of the government, there was some push to early in the eighteenth century to dispense with the convertibility of banknotes into specie altogether. Treasury officials consulted Sir Isaac Newton, the great physicist, inventor of calculus, and Master of the Royal Mint.
That discussion is described by Isabel Paterson:
Sir Isaac Newton was asked by the British Treasury officials and financiers of his day why the monetary pound had to be a fixed quantity of precious metal. Why, indeed, must it consist of precious metal, or have any objective reality? Since paper currency was already accepted, why could not notes be issued without ever being redeemed? The reason they put the question supplies the answer; the government was heavily in debt, and they hoped to find a safe way of being dishonest. But Newton was asked as a mathematician, not as a moralist. He replied: “Gentlemen, in applied mathematics, you must describe your unit.” Paper currency cannot be described mathematically as money.11
Preferring not to argue with one of the greatest geniuses who ever lived, the Treasury officials ratified Newton’s plan, and Great Britain went on the gold standard in 1717.
By most accounts, the gold standard under British hegemony was a great success. It contributed to the peaceful order and prosperity that characterized the nineteenth century. Of course, some qualifications to those happy generalizations are in order. For one thing, Pax Britannica was not total. The late years of the eighteenth century and the early nineteenth century (through Napoleon’s defeat at Waterloo, some two centuries ago on June 18, 1815) were a time of war.
Embroiled in the nineteenth-century approximation of world war, the British Treasury equivocated its commitment to the gold standard. When the financing requirements of the state escalated, the gold standard was suspended.
The modern world’s first successful fiat money regime, an era of an inconvertible pound, began on February 27, 1797, when the Bank of England stopped converting its deposit notes to gold specie in order to forestall a gathering run on its gold reserves. Among the factors at work were the facts that the Napoleonic Wars had been under way for some time and the Bank of England had permitted the supply of pound notes to grow to approximately twice its holdings of bullion. By the mid-1790s, there were notes for £14 million in circulation as compared to about £7 million in bullion reserves. Consequently, the market price of gold had risen above the mint price. And as you would expect, there were a lot of redemptions.
Initially, the suspension of cash payments, the so-called Bank Restriction Period, was an emergency measure to counter panic following rumors of a French invasion. The public expected the suspension to continue only for a few weeks, or at most, until the end of the Napoleonic Wars. But in fact, suspension of the gold standard lasted almost a quarter of a century until May 1, 1821.
When the war ended in 1815, the circulation of paper was so large that it was apparent that resumption of pound note conversion into gold could only take place after a “period of adjustment.” This deflationary adjustment lasted for six years, at which point the gold standard was reestablished at the previous parity £3. 17s. 10½d an ounce. About which, the famous economist David Ricardo commented that “he should never advise a government to restore a currency which had been depreciated 30 percent to par.”12
But the British went through the necessary deflation. Once reestablished, the gold standard remained successfully in effect until the outbreak of World War I, when conversion of the pound into gold was again suspended. Until 1916, when its gold reserves ran out, Britain was funding most of the Allies’ war expenditures, including most of the empire’s, all of Italy’s, along with two-thirds of the war costs of France and Russia. Given these staggering costs, the money supply in Great Britain more than doubled while consumers experienced a 250 percent increase in prices.
When the Great War ended, it was again judged that a period of deflationary adjustment was required before specie conversion could be resumed. In the event, Britain went back on the gold standard in 1925 at prewar parity. Then the Great Depression hit, and Great Britain abandoned the gold standard in 1931. As Hayek noted, the British government abandoned the attempt to bring down costs by deflation just as it seemed near success. According to Professor James Morrison, “Great Britain’s abandonment of the gold standard in 1931 was one of the most significant and surprising policy shifts in the history of the international financial system.”13
Another way of putting it would be to say that by going off the gold standard, Britain effectively abdicated its hegemony. Morrison attributes the collapse of the gold standard a “mistaken monetary policy” by the Bank of England, and deliberate action by Keynes to confuse the suggestible Prime Minister Ramsay MacDonald about staying on gold. But the gold standard did have a drawback from Keynes’s interventionist perspective. As Elisa Newby, head of the market operations division of the Bank of Finland, spells out, “Under the gold standard the money growth rate cannot be regulated by governmental policy because the money stock can increase or decrease only if the commodity stock in monetary uses increases or decreases respectively.”14 In this sense, the gold standard was much more complementary to a laissez faire policy, which Britain came closer to following in the nineteenth century than in the depths of the Great Depression. That’s not to say that the interventionist policies really constituted an improvement.
The last monetary policy innovation, in the twilight of British hegemony was, in Professor Morrison’s words, “a flexible exchange rate regime,” a “policy of cheap money”—meaning a monetary stimulus—“intended to combat depression.”15 That British innovation was one the United States was to follow with alacrity.
The example of the Bank of England exemplifies the high-level crony capitalism involved in the melding of for-profit banking with the financing of the hegemonic state. Bankers with the right to create money out of “thin air” can earn staggering profits. This was highly visible in the case of the Bank of England. It was a public company traded on the London stock market for 250 years. Its investors pocketed big profits over the centuries. A sum of £100 invested in Bank of England stock in 1694, assuming all dividends had been reinvested and without consideration of taxes, would have grown to £41,870,819 by 1945 when the Bank of England was nationalized.16 It would be difficult to cite a comparable return in US banking because the gains in crony capitalist US banking have tended to be more veiled. But you will not be shocked at my suggestion that politically connected bankers make a lot of money.
The monetary regime of US hegemony began after Bretton Woods in 1944, with the dollar as the denominator of international fixed exchange rates. Prior to World War II, during the twilight of British hegemony, gold had served as the anchor for fixed exchange rates. This meant each country guaranteed that its currency would be redeemed by its value in gold. After Bretton Woods, each member agreed to redeem its currency for dollars, not gold. The United States, in turn, agreed to redeem dollars for gold at the fixed price of thirty-five dollars to the ounce. At the time, the United States held three-quarters of the world’s supply of gold. This was the respectable beginning of the dollar’s role as the world’s reserve currency—before the signal crisis of US hegemony tipped the system toward financialization.
Richard Nixon was not called “Tricky Dick” for nothing. In 1984’s After Hegemony, author Robert Keohane summarized the situation prior to the “Nixon Shock.” Keohane explained that by 1970–71, confidence in US economic policy had become undermined and perceived as inflationary, resulting in a loss of confidence in the strength of the dollar. Faced with the prospect of trimming government spending before the 1972 presidential election, Nixon did not hesitate. He repudiated the gold reserve standard and defaulted on the US promise to redeem dollars at the rate 1/35th of an ounce of gold.17
I have no doubt that principled and effective leadership in 1970–71 could have preserved the gold reserve system, at least for a time, at the cost of negative political feedback from voters unwilling to tolerate spending cuts that would have been required to turn the budget deficit into a surplus. A politician with the intellect and character of Lee Kuan Yew could have pulled it off, resisting what Hayek identified as “the ever-present demand for more and cheaper money.”
Richard Nixon was not the man for the job—Nixon was smart, but he lacked the self-assurance to save the gold reserve standard. He also had a limited and selfish perspective on monetary policy. Prior to the 1960 election, Arthur Burns, the first chairman of Eisenhower’s Council of Economic Advisors, warned Nixon that he was likely to lose because the Federal Reserve, at Eisenhower’s prodding, had tightened monetary policy, contributing to a recession that began in April 1960. In his memoirs, Nixon blamed tight money for his 1960 defeat. When he was finally elected in 1968, Nixon resolved to appoint Burns to chair the Federal Reserve Board at the first opportunity, which he did in 1970, on the understanding that Burns would assure that easy credit conditions prevailed for Nixon’s reelection bid in 1972.
In the event, as recorded in Burns’s diary, his relationship with Nixon proved rocky, as Nixon felt that Burns’s monetary policy was inadequately inflationary. After a 1971 meeting with Nixon, for example, Burns made this startling note: “The President looked wild; talked like a desperate man; fulminated with hatred against the press; took some of us to task—apparently meaning me or [chairman of the Council of Economic Advisors, Paul] McCraken or both—for not putting a gay and optimistic face on every piece of economic news, however discouraging; propounded the theory that confidence can be best generated by appearing confident and coloring, if need be, the news.”
In short, Nixon was far too insecure and obsessed with his reelection to have led the country into a deflationary retrenchment to forestall full-scale financialization. It may well have been true, as F. A. Hayek later contended, that retrenchment and deflation in the early ’70s might have spared the world from a deeper and more convulsive crisis—the worst part of which still lies ahead.
Speaking of the escape from fixed exchange rates, Hayek said that we should have no illusion that we can escape the consequences of our mistakes and that we had missed the opportunity to stop a depression from coming. He thought that we had used what he called our “newly gained freedom from institutional compulsion” (the dollar fix to gold) to act more stupidly than ever before, postponing an inevitable crisis and making things even worse in the long run. He confessed that he wished for the crisis to come soon.18
Thus Nixon unleashed what an early director of the Bank of England described as “the formidable weapon of unrestricted money creation.” I suspect that he was more right than he knew to frame his discussion of pure fiat money in military terms. As we saw underscored by Great Britain’s suspension of the gold standard, first in the Napoleonic Wars and second in World War I, the big impetus for fiat money was a strategic imperative to fund crucial war costs that apparently could not be met within the restraints of sound money. Equally, as Elisa Newby pointed out in her 2007 paper, “The Suspension of Cash Payments as a Monetary Regime,” a key feature of the success of Britain’s temporary abandonment of the gold standard during the Napoleonic Wars was the credible promise that the suspension of specie payment would, in fact, be temporary.19
As mentioned, the US system of fiat money reflects the unprecedented scale of the US government as the largest the world has ever seen and the declining marginal returns (accelerating inefficiency) of a system that cannot pay its way. Just as the British flirted with fiat money on two rare occasions—spaced about a century apart, when the survival of the state depended upon outlays that would have been more difficult to afford under ordinary conditions—the United States has evolved a pure fiat system of creating money out of thin air because that is the only expedient for paying its truly gargantuan operating expenses.
In the current case of the United States, vast military outlays in combination with welfare state spending at a historically unprecedented scale, compose the heaviest fiscal load the world has ever seen. There is compelling evidence in plain view that the US government does not pay its way. Proof of declining returns is evident in the fact that the US national debt grew by more than $1 trillion between September 2013 and September 2014. It surged from $16,738,183,526,697.32 to $17,742,108,970,073.37, reflecting an operating shortfall of more than $2.7 billion a day. Multiplying the increase in the official debt are the compounding accrual obligations of the United States of more than $200 trillion.
Furthermore, as computed according to Generally Accepted Accounting Principles (GAAP), the annual federal budget deficit runs in the trillions. For example, for 2012, the GAAP deficit was $6.9 trillion, 42.6 percent of nominal GDP.
Just as a survival imperative dictated the move to pure fiat money by the United States, so a similar imperative prohibited the smaller states operating at earlier stages in the sequence of hegemonies from attempting to employ fiat money. They could never have funded their debts or financed their militaries with cash created ex nihilo in earlier stages of economic development. These earlier stages took place before the introduction of fossil fuels increased the economic growth rate, permitting the real economy to support a larger sum of claims represented by money and debt. (As I endeavor to explain in a coming chapter, historically unprecedented economic growth propelled by exogenous hydrocarbon energy amounted to a hidden BTU content of fiat money.)
In this light, as Keohane shrewdly observed in After Hegemony, there has been a deficiency of hegemonic stability theory in accounting for change in the international monetary system that “insofar as it relies on GDP figures as indices of power resources, it overpredicts regime collapse.”20
I believe that we are headed toward the terminal phase of the global financial system. What I doubt is that the reserve status of the US dollar can be displaced as an operating patch while business as usual proceeds in the global economy. To the contrary, the dollar will be displaced as part of Hayek’s inescapable crisis. Market adjustments the sort envisioned in Exter’s Inverted Pyramid will destroy money and debt on an enormous scale as a step toward the reconstitution of the global economy on a free market basis, probably incorporating the exchange of real money based on both silver and gold. These “barbarous relics” have the crucial feature of being assets that are not someone else’s liabilities.
My expectation is that the eclipse of US hegemony will close the curtain on fiat money at center stage of the world monetary system. If it is seen again after the Breaking Point brings US hegemony to a close, it will be a relic of backward closed economies, such as in North Korea.
Part of the dynamic that will propel this inescapable crisis is the increasing imbalance associated with the growing amplitude of the financial cycle. This cycle has arisen from the accelerating expansion of credit over the past three decades, corresponding with increases and decreases in private debt, relative to income, and the prices of assets financed by that debt, including real estate. Mathias Drehmann and Claudio Borio, economists working at the Bank for International Settlements, have pioneered the concept of the financial cycle in current terms. (See graph on page 19 of BIS report at http://www.bis.org/publ/work380.htm.) But similar thinking can be traced to Hyman Minsky and before that to Hayek’s “Monetary Theory and the Trade Cycle” from the 1920s.
Measurement of the financial cycle is a challenge, but data compiled by the BIS economists shows that financial cycles can last as long as twenty years, with more pronounced swings of increasing amplitude over time. The imbalances accumulated and aggravated by rampant credit creation and the fuddling of price signals due to ZIRP threaten to crash the system as Hayek foresaw in the wake of the 1971 “Nixon Shock.”
With this in mind, I recommend that you accumulate both silver and gold. As hedge fund billionaire Ray Dalio of Bridgeport Associates puts it, “If you don’t own gold . . . there is no sensible reason other than you don’t know history or you don’t know the economics of it.”
1 Stockman, David, “We Are Entering the Terminal Phase of the Global Financial System,” Zero Hedge, May 18, 2015, http://www.zerohedge.com/news/2015-05-18/david-stockman-we-are-entering-terminal-phase-global-financial-system.
2 Arrighi, Giovanni, Adam Smith in Beijing: Lineages of the Twenty-First Century (London: Verso, 2007), 103.
3 Mylchreest, Paul, “Selling Time,” Equity & Commodity Strategy—Fulcanelli Report, March 25, 2015, 4.
4 Das, Satyajit, “Can the World Deal with a New Bank Crisis?,” Bloomberg, July 27, 2016.
5 Stockman, David, “Wake-Up Call for B-Dud and the New York Fed Staff—This Isn’t ‘Transitory,’” http://davidstockmanscontracorner.com/wake-up-call-for-b-dud-and-new-york-fed-staff-this-isnt-transitory/?utm_source=wysija&utm_medium=email&utm_campaign=Mailing+List+Sunday+10+AM.
6 Hayek, F. A., New Studies in Philosophy, Politics, Economics and the History of Ideas (London: Routledge & Kegan Paul, 1978), 213.
7 Felloni, Guiseppe, “A Profile of Genoa’s ‘Casa di San Giorgio’ (1407–1805): A Turning Point in the History of Credit,” 1. http://www.giuseppefelloni.it/rassegnastampa/A%20Profile%20of%20Genoa's%20Casa%20di%20San%20Giorgio.pdf.
8 Ibid.
9 Ibid., 7.
10 Turner, Francis, “Money and Exchange Rates in 1632.”
11 Paterson, Isabel, The God of the Machine, quoted in http://www.anoopverma.com/2015/04/in-applied-mathematics-you-must-de.html.
12 David Ricardo to John Wheatley, September 18, 1821, quoted in Hayek, in New Studies in Philosophy, 199.
13 Morrison, James, “Keynessandra No More: JM Keynes, the 1931 Financial Crisis, and the Death of the Gold Standard in Britain,” APSA 2010 Annual Meeting Paper. Available at SSRN: http://ssrn.com/abstract=1641715.
14 Newby, Elisa, “The Suspension of Cash Payments as a Monetary Regime,” Centre for Macroeconomic Analysis Working Paper Series, June 2007, 4.
15 Morrison, “Keynessandra No More,” 6.
17 Keohane, Robert O., After Hegemony: Cooperation and Discord in the World Political Economy (Princeton: Princeton University Press, 1984), 208.
18 Hayek, New Studies in Philosophy, 205.
19 Newby, “The Suspension of Cash Payments as a Monetary Regime,” 4.
20 Keohane, After Hegemony.