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Blockage to a gold standard, and a way through

By Daniel M. Ryan
web posted April 11, 2011

In last week's piece on the subject, I discussed a new Utah law that eliminated the state capital-gains tax on gold. It also mandated a study committee to explore ways to assess state taxes and fees in U.S. gold and silver. Although cheering the development, which has yet to be repeated in any other state, I concluded that it would likely take a few decades before Congress would be ready to take the step towards restoring the gold standard at the federal level.. That's the speed at which new ideas filter up from the states to Congress. It's as if the people who enact it at the federal level did so long after being captivated when youngsters by enactment at the state level. The "Ron Paul Nation" of youth has a long way to go before their cohort get a hold of the reins of power.

Moreover, restoring the gold standard is a much more difficult chore with a financial system that's continually close to overextending, and a federal government that's turned into a deficit machine. Depressingly, the same monetary, credit and fiscal fractures that make the gold standard so welcoming also make it far more difficult to implant onto a debt-choked economy. Below are the four main structural obstacles that ensure a gold standard would almost certainly be sloughed off right now. Sadly but truly, these same points are the ones that gold-standard boosters hold up as evincing weakness of fiat money. They're right on the weaknesses, but those same weak points make a gold implantation at present all-but-certain to be rejected by the body economic:

  1. A gold standard induces deleveraging, and there's way too much leverage in the economy to let the gold restraint back in. Doing so would provoke a credit collapse. The goldbugs who agree with this claim are over in the hard-libertarian Austrian school. They agree because they think that fiat money and consequent inflation has led to a lot of distortions in the underlying economy. To them, a credit collapse is like detox: a drawn-out, painful, enervating procedure, but one that's necessary for future health. Unfortunately, there's little support for full-out detox outside of those limited circles. Let's face it: people who wash out the effects of pleasurable or stimulating toxins through detox have to want it. Try getting a heavy smoker to quit by locking him in a room for a month without cigarettes. Unless said smoker picks up a pack of Stockholm Syndrome, he'll likely endure the deprivation like a kidnapping and resume the first moment he's set free. In order to go through the hell quitting entails, he has to want it beforehand. The same thing applies to a gold standard. Unless a majority of the public gets behind a restored gold standard, and is unfazed by an economic collapse, restoration will likely be shucked off when it begins to hurt. All the political effort gone into making a new gold standard would be wasted.
  2. A gold standard will restrict the federal government's ability to borrow, especially at a time when it most needs to. This one is questionable now, but until the Tea Party came along it was taken for granted almost everywhere. It still is in many circles. Again, the most principled gold-standard advocates agree and say it's a good thing. No more will the government be able to permanently warp the national fisc through perpetual deficits. Being punished by high real interest rates, as is almost sure to happen when a gold standard puts hard limits on imaginary capital, they see as a necessary check on a political system too irresponsible to do so voluntarily. This position, I need hardly say, is not popular right now. There's still a wide demand for deficit spending when the economy hits the shoals. Under a pure gold standard, the government could only deficit-spend in time of trouble if it accumulates surpluses in good times. Not unlike the Strategic Petroleum Reserve, the "national savings" would be drawn down in tough times and supplemented with modest new debts if things got really bad. Needless to say, this sketch is so far removed from fiscal reality as to be a chalkboard exercise. The Tea Party's made great strides, but even they are prone to criticizing President Obama for stimulus measures that are both expensive and ineffectual. They doing so shows that political reality and stimulus spending still go together.  
  3. A gold standard will force the government to renege on its entitlement promises. Like the others, this one gets a loud huzzah from hardcore libertarians. Outside of their circles, though, that necessity makes the gold standard synonymous with political suicide (except for Ron Paul, of course.) 
  4. A gold standard will tie the government's hands in times of war. This objection is the one most solidly grounded in history. Even back in the days of the classical gold standard, governments embroiled in a major war went off it. The U.K. did so during the Napoleonic War and World War I. The original greenbacks were Civil War money. Libertarian peace-lovers love the idea of gold limiting warfare, but it's hard for any ordinary fellow to see why a sound money system is worth losing a war for. Given the United States' insistence upon winning to unconditional surrender, this drawback's the killer. Even if the U.S. public accepts the need for restraints at the cost of the first three drawbacks, there's no way they'll accept tying a war effort's hands in this way. It's almost a certainly that any semi-feasible gold standard proposal will have a force de guerre exemption, which will make the other drawbacks bite when the gold standard is restored at war's end. Like it or not, war almost certainly implies devaluation even under a full gold standard.

In order for a gold standard to be enacted, the public had to accept the first three drawbacks and be prepared for the pinch from the fourth. Wars will hurt the civilian economy a lot more, afterwards, should the gold standard be restored.

As for the first three, political common sense says that the best time to restore the gold standard is after a crisis. The first three potential calamities have to occur under a fiat regime. We know very well that an all-out Depression is quite possible under fiat money. In some cases amusingly, the same groups of people who claimed that chucking the gold standard made depressions obsolete howled "Depression!" when Lehman Brothers failed and the dominoes fell. We now know that a Depression-style deleveraging is quite possible under a pure fiat system. As for #2, we know that punishing interest rates on new government debt can occur in a pure fiat system. If you don't believe that a national government with its own fiat currency can't go through that kind of a squeeze, look long at the Swedish crisis of 1990. Canada went though the same kind of interest-rate squeeze, although to a lesser extent, in that same year. Both countries' currencies were and are sovereign and pure fiat.

As for the third, the squeeze hasn't come but it's looming. The fiscal difficulties of Social Security must qualify as the longest-running train wreck in the making: they were widely talked about when I was half my current age. This crisis has not yet visited the developed economies. Restoring a gold standard will only be politically feasible in a nation that's already been wrung by all three calamities. Having to go through those sorry experiences with a fiat-money regime will demonstrate that gold is in no way at fault for the tears that deficits and inflation bring. At the very least, a few more credit crises like '08's will show more plainly that overleveraging invites deleveraging, whether the currency is gold-backed or fiat. Only when experience has shown that fiat isn't a magic wand that obviates economic reality will there be enough support for seatbelting governments with a gold standard. As of now, most of the public would rather be thrown clear of the crash through deficit spending and inflation.   

With one possible exception, which would serve as a kind of currency insurance…

A Para-Currency Sandbox

For the reasons above, a gold standard is not even feasible until the entitlement state gets into a fiscal snarl. Even then – even if an all-out hyperinflation – there's no guarantee that gold will be restored as official money. What's to stop a government from replacing a wrecked currency with a new fiat currency, one with an iron-clad monetary rule like Milton Friedman's k-percent rule? Given that Friedman is at the centre of the mainstream nowadays, a hyperinflation in the next ten years would almost certainly be cleaned up with his rule and not gold. How would a gold standard advocate argue against a statute that enforces a k-percent rule with automatic firing of the central-bank chair if the k% is exceeded? Or one that mandates an impeachment trial?

No, the public has to see the benefits of a gold standard in action. So do government officials. The killer argument for the gold standard – distrust of the political system – isn't enough. We may distrust our politicians and legislatures, but we still depend on them. As long as we do, distrust and even hatred will only mean kicking the bums out. It doesn't lead to structural change, as the only ones who are convinced the whole system is rotten will become functionally apolitical. Swallowing whole a radical ideology like hardcore libertarianism, for all but a very few, is a way of sequestering oneself from the political system.

Instead of expending energy fighting for a gold standard now, when fiat money has yet to complete the cycle of spring flowers to fall cankers, a much better idea would be to lobby for a gold para-currency. That way, people who want to transact in gold can do so if they want to. If they'd rather not, they can stick to good ol' fiat money. A para-currency offers the option of both.

What I'm suggesting is a system of authorized transaction providers and para-banks that conduct business entirely in gold. Strange as it may sound, the Rothbard criteria are the best for implementing that system. Only, instead of a 100% gold dollar, there would be a 100% gold para-currency with a completely different name to avoid confusion. The conviction of Bernard von NotHaus explains why a new name and strict distancing would be needed.

In order for such a sandbox to be viable, there's one necessity that's not going to go over well with the power that be: dropping the capital-gains tax on some gold. Not all gold, but only gold sold through an "authorized transaction agent." Gold in all other forms would still be taxed the same way as before. Needless to say, any capital losses that come from gold sold through an authorized transaction agent would not confer any tax relief. If someone loses, then they're out of luck: no tax losses.

In order to be an authorized transaction agent, a gold seller would have to guarantee that any ownership claims (whether real or virtual) are backed 100% by gold in the vault. They would not be allowed to sell gold coins. Strict and regular audits would have to be mandated to ensure compliance with the 100% backing. No firm could be recognized as an authorized transaction agent without that proof. Thankfully, current digital-gold providers already observe such a regime voluntarily. The audit and control system used by GoldMoney serves as a useful guide as to what should be mandated.

As for gold-depositing and –lending para-banks, they should be subject to this set of restrictions, checked rigorously:

  1. No lending of demand deposits. Only time deposits of gold can be lent out. Breaching this rule should be treated as criminal fraud.
  2. When lending out time deposits, no mismatching of maturities. A six-month loan has to be financed in its entirely by six-month certificates of deposit or the para-bank's capital. A twenty-five-year mortgage has to be financed entirely by twenty-five-year gold bonds or capital. No exceptions. Like #1, breach of this provision would lead a charge of fraud.
  3. No more than ten-to-one leverage. At all times, bank capital has to be at least 10% of the loan base.
  4. No access at all to the central bank's rescue facilities. The para-bank would be obliged to inform any depositor of this restriction.
  5. No access at all to government deposit insurance. The para-bank would be obliged to inform any depositor of this restriction explicitly and clearly.

These five rules will make it difficult for para-banks to grow, 'tis true, but restricting growth would lay the foundation for more to be set up. Also, these restrictions – all but the third endorsed explicitly or by implication by Murray N. Rothbard – will go a long way to ensuring that gold para-banks will not get into trouble like regular banks do. If a para-bank can't make a profit operating under these rules, then so much the worse for the para-bank.

But Why Do It?

In a phrase, the Liberty Dollar conviction. Bernard von NotHaus, despite his shady business practices, tapped into an authentic demand for silver money. His operation grew large before it was shut down. Large enough to show that he has a public, which would be served by a precious-metals regime that operates in a legal and controlled way. Granting leniency to followers of rogues after clamping down on the rogues themselves is part of standard statecraft. It's a known fact that, after the Whiskey Rebellion was crushed, the U.S. government repealed the excise tax on alcohol.  

Moreover, having gold used as a para-currency would be a needed sandbox that would serve as an insurance policy against future monetary derangement. The loss of capital-gains tax revenue can be seen as a kind of insurance cost. Allowing gold to be used as para-money would not crowd the current fiat regime. Any experienced banker would wonder how to make a profit at all with the restrictions imposed on gold para-banks. Those restrictions would be the price of the capital-gains exemption on gold sold by authorized transaction agents, some of which would go into gold para-banking.

If the currency ever were deranged by future fiscal and leverage difficulties, a para-bank system would provide already-functioning alternate money that would help the national currency get un-wrecked. It would ease the economic agony of hyperinflation.

In addition, it would be a treat for mainstream monetary economists. Yes, I mean "mainstream." Watching a sandbox 100% gold standard would be an education in itself. Contrasting it with the operation of mainstream fiat money and fractional-reserve banking would indicate remedies to make the mainstream system less fragile. Should the gold para-banking sector take off, it would show that prudent restrictions on mainstream banking might hurt less than we think now. There's only one way to find out.   

And finally, it would give ever-complaining goldbugs something constructive to do other than recommending gold and gold stocks. ESR

Daniel M. Ryan is currently watching the gold market. He can be reached at danielmryan@primus.ca. (C) 2011 Daniel M. Ryan  

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