The word 'backing' has been bandied about for a while now, the implication being that if paper 'money' is 'backed' by something real, then that 'money' will somehow be perceived as being 'real money'.
Of course, the less welcome implication is that unbacked 'money' is less than real! This statement is really an understatement... but what does 'backing' actually mean?
Today there is talk about 'backing' currency with a 'basket' of commodities. There is even talk of 'backing' currency with... gasp... Gold. But all this is meaningless until we know what 'backing' means.
The historical record is less than encouraging; for one good example, under the auspices of John Law the French treasury... which was under great duress due to over spending... decided to issue Assignats, a form of paper currency, 'backed' by confiscated church lands.
Now clearly, land is a real and valuable asset... after all, 'they ain't making any more of it'... so the idea sounds reasonable. In any case, the French Treasury went ahead and issued several million newly created Assignats, backed by the land.
The deal worked so well, helping to restore the solvency of the treasury, that within months... guess what.... several million MORE Assignats were duly printed... and backed by... the very same lands. This in spite of solemn promises to issue a 'limited quantity' of the new currency.
Soon the pressure became irresistible... and still more bank notes were printed.
Of course, the cat was out of the bag; the quality of the currency was perceived to be falling as new issues were made against the very same backing... and the paper started to depreciate. In fact, the situation was now worse than before the paper was issued; instead of staying within budget, the promise of new paper 'money' allowed even more profligacy to prevail.
If you know history, you know that soon enough the French public was ready to lynch Mr. John Law. He attempted to flee the country, disguised as a woman, in a carriage packed with... no, not bags full of paper Assignats... but with bags full of real money... Gold and Silver!
In fact, the idea of backing money with a commodity is absurd to begin with, not just if the number of notes can increase on a whim. For example, the idea of backing currency with crude oil is talked about; imagine one of the most volatile commodities being used to 'back' money?! The value of the backing will vary with extreme volatility, and the value of the money with it.
Of course, if Gold is used as backing, then this problem of volatility disappears... as the stock to flows ratio of Gold is enormous; that is, there exists above ground Gold bullion in the quantity of at least eighty years' worth of primary (mine) production. In contrast, the stock to flows of all other commodities (except Silver) is measured not in years, but days. Like one hundred or so days for the stock to flow of crude oil... or platinum.
So, if Gold is great money, how about using it to 'back' a currency? Then only one problem remains, the same one Mr. Law faced; the inevitability of more paper being created, backed by the same quantity of Gold. Indeed, this is what happened to the US Dollar once Gold coin circulation was replaced by the circulation of paper 'backed' by Gold.
As more paper was printed, President Nixon had a choice; to admit this, and devalue the Dollar vs Gold... that is, admit that more Dollars were now backed by the same quantity of Gold... or simply default on the international obligations of the USA... and refuse to exchange American Gold for Federal Reserve Notes. We all know what he decide to do... he 'closed the Gold window'.
Sometimes silence is louder than words; while 'backing' is being loudly debated, there is another far more meaningful word that is not even being whispered, not even a faint echo of it may be heard... as of now. That word is 'redeemable'. Unlike backing, which is very vague and essentially meaningless, redeemable is very precise and full of meaning. The meaning of redeemable is that the holder of a redeemable Dollar bill may exchange his paper for the defined quantity of Gold at any time, no limits.
The US Dollar was redeemable before President Roosevelt defaulted on the domestic obligations of the US Government; an obligation to redeem Federal Reserve Notes, aka Dollars, in Gold. The paper notes are promises, they are future goods. The Gold coins they are redeemable in are present goods. Remember the adage 'a bird in the hand (present good) is worth two in the bush (a promise or a future good)'.
Think how absurd it would be to make a currency redeemable in crude oil; go to your friendly bank to redeem your notes and walk away with a couple of barrels of crude? I don't think so. Same with the Assignat; if thousands of hectares of confiscated land are used to 'back' millions of paper notes, will the holder of the paper note walk up to a bank and walk away with a title deed for 1/1000 of a hectare of land? Bah.
Of course, redeemability in Gold or Silver only works if the issuer forbears from printing more paper notes than it has Gold or Silver to back them with... thus the deafening silence on redeemable currency. Until people at large come to understand this, there will be no solution to the current Global Financial Crisis.
To be more specific, we need to look at the balance sheet of the Federal Reserve... or of any Central Bank. The liability side of the bank's balance sheets show all the bank notes it issues, i.e. Dollar bills, Pounds Sterling, etc. The asset side, that which in reality backs the liabilities, or more precisely balances them, are today simply more paper... paper promises in the form of Treasury bonds, commercial paper, and 'toxic waste' ie other promises, but promises that even our decrepit media admit are worthless.
For a truly sound currency to exist, the asset side of Central Bank's balance sheets must contain nothing but cash Gold, and Real Bills that mature into cash Gold in not more than 91 days. If this is done, we will in effect establish an Unadulterated Gold Standard... something like what the world was on during the nineteenth century... a century fondly remembered as the Golden Years of Peace and Prosperity.
Before the evil of WWI, the German Reichbank had guidelines for its banks; assets to be 1/3 Gold and 2/3 Bills of Exchange. Note that 'bills of exchange' are Real Bills, and Real Bills mature into Gold in not more than 91 days. If the bank does not actively discount (purchase) new bills, in 91 days its balance sheet assets will be 100% Gold. End of problem.
Finally, note that there is actually no need for Bank notes at all, that is for Dollar bills or any other form of paper currency; Gold coins will circulate just fine, along with smaller denomination Silver coins, and actual Real Bills to fund the flow of consumer goods on the way to consumers.
Bank notes are simply a convenience; after the World Financial Crisis plays out, paper money may be so hated that no one will accept any! No problem, the world economy did just fine before the introduction of circulating bank notes, and will do just fine again. Even better, as no government or Central Bank can print Gold, or create Real Bills out of 'thin air'
Rudy Fritsch
Editor in Chief The Gold Standard Institute
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