A Four Legged Paper Stool…?

My last article talked about the natural stability of the triangle, both as a structural element and as the basis for a stable, three legged stool. Clearly chopping off a leg or two will make a three legged stool unstable; but adding an extra leg, making it into a four legged stool, also undermines the stool’s natural stability.

If the floor is uneven, or if one leg is longer or shorter than the other three, a four legged stool will rock. This is a pretty good analogy for how the ‘Classical Gold Standard’ worked. ‘Rocking’ is seen in recurring ‘booms’, ‘panics’ and ‘recoveries’ experienced throughout the nineteenth and early twentieth centuries. This ‘rocking’ of the economy between overheat and collapse is generally called the ‘business cycle’.

This name is highly misleading; what correlation is there between cycles of widely disparate businesses making up the economy? What correlation is there between an apple orchard and a hair comb manufacturer… or between a shoemaking business and a ship line? In fact, there is only one; money, or more precisely credit.

Credit is the only factor that affects all businesses; thus the so called ‘business cycle’ is actually a credit cycle.  If we take a look at how credit influences all business, we can see that there is not only correlation but causality between the availability of credit, or rather excess credit, and the boom/bust credit cycle.

The roots of the credit cycle can be traced back to seventeenth century England. At this time, English common law set the noxious precedent that if anyone deposits money in a bank, that money is no longer the property of the depositor, but is deemed to have become the property of the Bank!  This precedent was confirmed by further British jurisprudence in 1811; see this link for more information: http://www.cobdencentre.org/tag/carr-v-carr-1811/ Remember, the depositor does not sell or trade his money to the bank, merely deposits it. This breach of property rights is staggering if you think about it.

Consider what happens to your furniture if you deposit it in a warehouse… does it become the property of the warehouseman, to do with as he sees fit? Suppose he sells your furniture, or lends it out while it is in his warehouse…? I think if you showed up to reclaim your furniture, and were told that it had been sold, but he has other furniture ‘just as good’, you would not be a happy camper. Or suppose it was lent out, and will not be available to you till next month… why you may call the police and have the warehouseman arrested.

Furthermore, the law sides with you. If the warehouse company went bankrupt, the bankruptcy trustee would separate the furniture being warehoused from the warehouse and its equipment, like the fork lift truck or the building… and after returning all the deposited furniture to the rightful owners, would sell the warehouse property to settle with creditors. As a depositor of furniture in a warehouse, you are not considered a creditor but a customer… and any property being warehoused belongs to you and to other depositors… not to the warehouse. So why is Money different?

Oh, you say Money is fungible, and any coin of the same weight and fineness (we are talking real Money here, Gold or Silver) is as good as any other… thus you have no claim to a specific coin or coins… and this is true. Just like a grain elevator in fact; if a farmer were to deposit 100 bushels of hard red winter wheat with a grain warehousing operation, then he will clearly not get the very same grains back; but he will get back 100 bushels of hard red winter wheat… not corn or oats, and certainly not an excuse that the grain has been sold or LEASED!

So why is Money different?

Is it just a simple coincidence that the Bank of England was franchised at about the same time this legal precedent was set? Indeed, this invasion of property rights goes quite against the times. England was leading the way in the recognition of property rights… an Englishman’s home was his Castle, and even the King of England had no rights there. The Magna Carta was written in England not long before this time. Even more tellingly, the Industrial Revolution took off in England, not elsewhere.

Sure, England had coal… but so did France and the rest of Europe. England had scientists… but so did the Continent. The fundamental reason that the Industrial Revolution started in England is that property rights in England were extended to intellectual property rights as well as physical property rights.  James Watt had a flash of genius in understanding how to radically improve the efficiency of Newcomen’s steam engine; but the years of effort it took to develop and manufacture the Watts condensing engine that kick started the industrial revolution took much capital and much perseverance.

This capital only became available through the newly written patent laws. Profits for inventors… who are not tenured academics or government supported bureaucrats but entrepreneurs competing in a free, capitalist marketplace… only became available through the recognition of the inventor’s intellectual rights. The enormous burst of energy devoted to improving the machinery of the industrial revolution sprang from this new recognition and respect for intellectual property rights.

Why on Earth then were property rights to Money invaded… in the very same country and about the same time?

It is no coincidence that his was also the time the bank of England was chartered; had this invasion of property rights not been legalized, then fractional reserve banking as we know it could not have arisen, the classical Gold Standard would have remained a three legged, fully stable system… and the current catastrophic collapse of the world financial system would have been preempted. This is how critical the legal precedent regarding money, property rights and banking is.

With the unethical transfer of property rights to the banks, the banks could legally do what they pleased with the money, with the depositor having only a claim against the bank… but no control over what the bank does with the deposited money. Banks inevitably lend the short term cash deposits out for long term rates; the notorious and illicit practice of borrowing short to lend long is thus legalized… instead of being outlawed and punished. This practice leads to creation of excess credit, leads to the credit cycle and leads to runs on banks. A run takes place when depositors ask for their money back, but the deposit money is no longer there; it has been lent out for the long term.

The so called inverted yield curve, whereby short term credit commands higher interest rates than long term… a very unnatural event if you recognize that longer terms involve greater risk and should and naturally do command higher rates to compensate for this, is a direct result of the illicit practice of borrowing short to lend long.

Had property rights stayed where they belong, with the depositor, then the banks would be obliged to ask each depositor exactly what the depositor wishes be done with HIS money; the choices are simple, but critical. The banks could offer a vault service, like the warehouseman does. This service would incur storage costs for the depositor, but his money would be fully guaranteed, segregated, insured, etc… as safe as possible, perhaps safer than home storage; after all, banks have serious vaults, and guards, alarm systems etc. to protect your wealth.

Alternatively, they could offer a fully liquid demand deposit account. This account would offer a small but non zero return to the depositor. Money so deposited would be available in the form of demand notes drawn against the bank, and offset in the bank portfolio by only truly liquid current assets. The assets behind demand notes could be only cash Gold, Silver, or Real Bills that mature into Gold in not more than 91 days. In fact, German banks before WWI were expected to hold 1/3 Gold and 2/3 Bills against their demand notes. Real Bills are an earning asset… the face value or maturity value is higher than the current or discounted value… thus the depositor would receive a modest but worthwhile return.

Finally, if the depositor agreed to tie up his money for a more extended period of time, then the bank could offer interest, based on prevailing rates, which is always higher than the discount rate. The amount of money available to lend long is thus determined by the individual depositor’s time preference.

There cannot be a run on the bank, as all notes are backed by liquid real assets, and only long term time deposits are available for longer term loans. The term structures match perfectly, automatically. A simple example of how this works is to assume 10 depositors show up at the bank, each with 100 monetary units they wish to deposit.

The first depositor decides that he wants to keep 20 units in his demand account, the rest in a time deposit. Further, to keep the numbers simple we assume that all ten depositors decide to do the same thing; 20 units of demand deposit, 80 units long term. The result is that the bank will end up with 200 monetary units in its demand account, and 800 in its term account.

Now it is perfectly legitimate and proper for the bank to lend out the 800 units; after all, that is what the owners of the money want. Thus, 800 units of money are available to be lent into circulation… and the borrowers of this 800 units will also decide what they want with their newly borrowed funds; put some into demand deposit, some into term deposits.

If the ratio that new depositors use happens to be the same, that is 20% demand and 80% time, then the next cycle of this iterative process will allow another 640 units to be lent out… 80% of the 800 is 640. Then another round, 80% of the 640 etc… This is the famous ‘fractional reserve’ process… but done with no ‘printing money from thin air’, with no arbitrary ‘reserve ratios’ and no central bank needed to try and ameliorate bank runs.

Deposits come and go, and money owners decide on their split between demand and time deposits all the time. If we simply add up all the time deposits and demand deposits in the whole banking system, then we can come up with a single number: the ratio between demand and time deposits, as determined by the myriad bank customer.

Today this number is called the Reserve Ratio! But there is an enormous difference between a naturally occurring number as determined by market participants, and an artificial number set by interested parties such as greedy bankers and power seeking politicians. The difference is polar, as is the difference between debt and money; the two numbers are 180 degrees apart.

The power to influence the whole economy now rests with one authority; the central banker. The credit cycle is controlled by one party, the central banker. No longer does the reserve ratio reflect the wishes of the populace. Think about this for a minute; the economy is solid, jobs are plentiful, the future looks peaceful and rosy. As a result, most depositors would be willing to keep a modest sum in their demand deposit, and more in the time deposit, happy to collect the higher interest available. Thus the reserve ratio would remain low. Perhaps only 15% of all deposits would be in the demand account.

But suppose the economy is showing stress, the job markets look less positive, the future looks more risky; depositors would naturally want to keep more money on hand, ‘just in case’; and the ratio would automatically grow to reflect this concern. No need for anyone in ‘power’ to ‘set’ or adjust this ratio; all economic numbers like prices, interest rates, discount rates etc… in a truly free market… are self-regulating. The ‘reserve ratio’ is optimized by simple but vital market feedback mechanisms.

Today these natural feedback mechanisms have been cut, and replaced by ‘authority’. In effect, the ‘numbers’ are set at the whim of the powerful, in the interest of the powerful… and the whole economy suffers the consequences. Instability of the four legged Gold standard was caused by exactly this; the ‘reserve ratio’ was set at the whim of the central banker… and the banker’s interest is to create more credit than the market needs or can support; in order to collect more interest.

The Government backs this policy, because the Government needs ever more cash… to gain and keep power. The only place they can get more, virtually limitless cash is from the Central Bank… so the instability and monetary destruction proceeds apace. Excess credit is force fed into the system… and once the debt reaches a level where the economy cannot carry interest on debt outstanding, the artificially induced boom suddenly turns to bust. After the collapse, the destructive cycle starts anew.

To achieve Economic Nirvana, a stable and honest monetary system, we need to first restore property rights; then central banks can close their doors, and market participants can reclaim their legitimate power over reserve ratios, as well as over interest rates, over money supply… overall economic ‘aggregates’. The three legged stool of the Unadulterated Gold Standard has only three legs… Really.

Cash Gold and Silver (Money), Bonds and Real Bills are the necessary three legs. No fundamental need exists for bank note circulation; but if bank notes are to be used, then they must be issued against Money in the issuer’s vault, and Real Bills in the portfolio; not against long term promises… especially not against promises with no intent of being honored. Such false promises backing Notes were the ‘fiduciary’ (trust) component of the classical Gold Standard, the forth leg that causes instability. No fiduciary ‘money’, no excess credit; no excess credit, no credit cycle. It is as simple as that.

The invasion of property rights is a slippery slope; today not only customer’s money, but their futures contracts are being ‘commingled’ with the capital of the depositories. The ‘furniture’ held in the MF Global ‘warehouse’ was used by the criminals in charge to try and save their own bacon. This theft shows what road we are on; the odor of burning sulfur grows stronger every day! If we do not establish an unadulterated, stable Gold standard under the world economy, our civilization is doomed.

Rudy J. Fritsch

Editor in Chief

The Gold Standard Institute

About Rudy Fritsch

I was born in Hungary in 1947, and fled Socialist tyranny during the Hungarian Revolution of 1956. My family had lived through WWII and the consequent Hungarian hyperinflation, thus I have intimate experience with financial destruction. My Dad used Gold to buy our way out of Hungary. Paper money was as good as toilet paper. Later in life, during my studies of Austrian economics, I came to realize that only Gold could solve the Global Financial Crisis (which should be called the Global Monetary Crisis), just as Gold solved our otherwise insoluble problem of getting out of Communist Hungary.
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