Articles | Trust Mises and Gold, Not Keynes, Be . . .
Trust Mises and Gold, Not Keynes, Bernanke, and Fiat Money
April 23, 2009
A preference for a tangible gold currency is no longer
more than a relic of a time when Governments were less
trustworthy in these matters than they are now, and
when it was the fashion to imitate uncritically the
system which had been established in England and had
seemed to work so well during the second quarter of the
nineteenth century. -- John Maynard Keynes, 1913
This statement appears in the first book written by John
Maynard Keynes, Indian Currency and Finance. I regard this
statement as one of the early academic salvos against the gold
standard. It was an early phase of what I have called the gold
wars. You can download my 100-page study here:
In my recent article, "Why Gold Owners Are Targets of the Government," I
made the point that the international gold standard served as a
restraint on the ability of governments to defraud their citizens
through monetary inflation. With the destruction of the gold
standard, beginning in 1914 with the outbreak of World War I,
citizens around the world have seen the destruction of purchasing power
in every nation through monetary inflation. Not one currency has
maintained its purchasing power of 1914. There is a reason for
this: not one currency is redeemable on demand in gold.
In 1912, Ludwig von Mises' monumental book appeared, The
Theory of Money and Credit. The 20th century can be regarded as
confirmation of Mises' suspicion that governments cannot be
trusted to manage their monetary systems for the benefit of the
people. The 20th century is a lasting testimony to the naive
view asserted by Keynes that governments are more trustworthy
than they had been in the 19th century.
Keynes regarded the 19th century as a time in which
governments were constrained by the gold standard because they
were untrustworthy. Mises agreed with Keynes on this point.
Where they disagreed was with respect to the trustworthiness of
20th-century governments that were not restrained by a gold
standard. Keynes was wrong. Mises was right.
THE GOLD WARS
The gold wars have been conducted by governments because
Keynes was wrong and Mises was right. The reason why we are
living in a time of monetary inflation is because governments
escaped the restraints placed on them by a legal requirement that
anyone may present government-issued IOUs for gold at a bank.
These IOUs, called money in 1913, transferred power to the holder
of each IOU. The holder was in a position to demand payment in
gold at a fixed rate of exchange.
In the 19th century, voters did not allow governments to
expand the purchases of votes by means of expanding government
expenditures. There was a great hostility throughout the 19th
century to the idea that government can in any way successfully
regulate the economy. There was great distrust of government
spending generally, and the public's means of enforcing controls
over national governments involved the establishment of a gold
A government that adhered to the gold standard domestically
gained investors from around the world. People trusted the
government, and so the government was able to attract investors
for its debt at interest rates lower than the interest rates that
investors required from governments that did not adopt a full
gold coin standard. It was profitable for the British Empire to
adhere to a gold standard for 1815 to 1914. It gave the British
Empire a tremendous advantage because it enabled the government
and commercial enterprises to borrow money at low rates of
The power of holders of IOUs to gold coins was of enormous
importance in restraining governments in their spending.
Consider the motivation of all governments to get something (more
power) for nothing (higher taxes). When governments find that
they cannot tax their residents directly, because of the negative
effects of taxation on the economy, and also because of the
potential of a tax revolt, governments resort to monetary
inflation. They instruct their central banks to expand the
purchase of government debt or any other asset that can be
legally used as part of a central bank's monetary base. The
central banks follow these instructions, even though they
maintain the fiction that they are legally independent. The
central banks' purchase of the assets, especially government
debt, expands the money supply in order to make the purchase.
In the international gold standard that prevailed prior to
World War I, any gold standard government that failed to adopt a
policy of monetary restraint lost its competitive position. Such
a government would find that foreign governments, foreign central
banks, foreign investors, and domestic holders of IOUs called
money would begin to redeem these IOUs for gold coins. The
central bank or the treasury would find that it was losing more
gold than it was taking in.
At some point, it would be impossible for the government or
its central bank to deliver gold to a growing number of holders
of IOUs, who had lost faith in the word of the government or the
central bank that it would not inflate. The holders would call
the bluff of the central government or the central bank. They
would do so in the form of a run on the government's gold supply.
This run on gold began a traditional bank run. Commercial
banks bore the brunt of the outflow of gold. The banks would
then have to curtail their expansion of loans because their
capital would no longer permit any further expansion. If the
bank run continued, the bank would have to call in existing loans
and demand payment. This was unprofitable for the bank, and it
was also unprofitable for the companies that had borrowed money
from the bank and had expanded their production of goods and
services by means of credit issued by the bank.
The commercial bank would then demand gold from the central
bank by cashing its IOUs for gold (reserves at the central bank),
and the central bank would have to curtail the expansion credit.
All along the line, the bank run against gold would result in a
contraction of the money supply.
This was the great advantage of the international gold
standard. It forced commercial banks, central banks, and
governments to maintain policies of monetary stability. If they
did not do this, the gold run would force their hand, and the
result would be a contraction of the money supply and economic
This system has not existed in most countries since 1914.
It has not existed in the United States since 1933, when
President Roosevelt unilaterally made it illegal for Americans to
own gold. Finally, it has not existed anywhere ever since August
15, 1971, when President Nixon unilaterally announced that the
United States would no longer honor its IOUs for gold that it had
issued to foreign governments and central banks.
What we saw, beginning in August 1914 and extending to
August 15, 1971, was that governments were as untrustworthy with
respect to monetary policy as they had ever been in the 19th
century or any other century.
Governments are inherently untrustworthy when it comes to
monetary affairs. They do not wish to increase direct or
indirect taxation on citizens, and they always want to expand
spending by government agencies. The way to achieve both goals
is to abolish the international gold standard, abolish the
domestic gold standard, then expand the money supply whenever
expenditures increase beyond what the domestic population is
willing to accept as a legitimate level of taxation.
Without the gold standard to restrain government
expenditures, governments around the world have found a way to
expand the money supply, reduce the purchasing power of their
currencies, and avoid tax revolts.
THE BOND MARKET
Monetary expansion is held in check today mainly by the bond
market. The bond market puts pressure on every government
Treasury by means of the interest rate. When bond investors
believe that a government is going to expand the money supply
long term, thereby raising prices, they demand a higher rate of
interest on long-term loans. They do this because they want to
protect their investment against depreciation by a falling
The problem is, bond investors from 1940 to 1980 remained
optimistic about government policy, in the same way that Keynes
was optimistic about government policy. This is why, from 1940
to 1980, anyone who invested in United States Treasury bonds lost
most of his capital to inflation. The dollar steadily declined
during this period. Yet there were always buyers of Treasury
debt, especially during World War II, when the government
mandated that the Federal Reserve System purchase Treasury bonds
at below market interest rates.
Today, bond investors do possess some degree of power over
government spending. But, as we have seen since September 2008,
we can have massive increases of government spending beyond
anything known in the past, yet interest rates have not
skyrocketed. This is because we are in a period of economic
recession. There is fear about investing in real estate, stocks,
and other forms of equity. People are willing to lend money
long-term at low rates of interest, despite the fact that the
monetary base has expanded at an unprecedented level. Banks
continue to hold excess reserves at close to 0% per annum at the
Federal Reserve System, thereby keeping the fractional reserve
banking system from expanding M1 and thereby raising prices at
In other words, fear of the recession has overcome fear of
price inflation. This has been true over the last year in the
gold market, the silver market, and the bond market. Investors
believe that their investments are not safe in anything except
high-rated government bonds, corporate bonds, or near-cash
assets. They believe that the greatest threat to their net worth
is the recession. So, the traditional restraining factor in the
world devoid of a gold standard has not functioned: the bond
National governments have expanded spending an unprecedented
level, and they have not suffered the consequences in the capital
markets. They are still able to sell their bonds to investors,
despite the fact that the expansion of the monetary bases of
every nation has continued with impunity.
This has encouraged governments to run deficits at a level
that would not have been considered possible as recently as
August 2008. The level of government spending, and the level of
the Federal deficit, that has taken place since September 2008 is
on a scale that is beyond the experience of economists, economic
forecasters, investors, central bankers, and politicians. This
has enabled politicians to expand spending more rapidly than we
have ever seen in a comparable period of time, except during the
world wars and their aftermath in losing nations.
Because no one has any familiarity with this level of
government spending, the capital markets have not collapsed in
what is the equivalent of a run on the banks. The public has no
ability to make a run on the banks, because in order to get money
out of one bank, they must transfer it digitally to another bank
or institution that will immediately deposit the money in a bank.
The traditional restraining factor of a bank run no longer exists
with respect to depositors. It still exists, however. It exists
because bankers have the ability to refuse to put the money into
circulation. They can deposit at the Federal Reserve System, and
in doing so, they keep the money from entering the general
economy. Because they can do this, the expansion of the money
supply that has taken place since September 2008 has not
registered in the general economy yet.
Chairman Bernanke has promised that when the recession ends, the
Federal Reserve will reverse its expansionary policies, sell
assets, shrink the monetary base, and restore the system to the
status quo ante. The problem with this is the problem that he
faced from the day he became Chairman in February 2006 until the
world economy began to fall apart in August 2007. Greenspan
lowered the Federal funds rate to 1% and kept it there for 18
months: June 2003 to June 2004. Then, when the Federal Reserve
System began to reduce the rate of expansion of the monetary
base, interest rates rose, and the result was what we have seen
since August 2007.
If the economic boom can be restored only by a gigantic
increase of the monetary base, which also involves a reduction of
the federal funds rate to approximately 1/10th of 1%, than any
attempt on the part of the Federal Reserve in the future to
restrict the expansion of the monetary base will raise interest
rates once again, and the economy will contract, just as it did
after Bernanke's first year and a half.
The promise is always that some day there will be a
restoration of the status quo ante. President Obama tells us
that he will be able to cut the Federal deficit by 50% in the
year 2012. Of course, it will still be in the range of $1
trillion. There is no evidence that he is going to be able to do
this, nor does he attempt to supply such evidence. He simply
promises that it will be done.
Chairman Bernanke has promised the same thing with respect
to Federal Reserve monetary policy. He said on April 3,
In pursuing our strategy, which I have called "credit
easing," we have also taken care to design our programs
so that they can be unwound as markets and the economy
revive. In particular, these activities must not
constrain the exercise of monetary policy as needed to
meet our congressional mandate to foster maximum
sustainable employment and stable prices.
There is no way that the Federal Reserve can reverse itself
by shrinking the monetary base in a recovery, unless it risks
pushing the world economy back into something a great deal worse
than what it has experienced over the past 18 months.
The economy collapsed internationally over the last 18
months. Why? Because of the monetary expansion that took place
after 2001. This rate of monetary base inflation then when
compared to today would be considered tight money. When tight
money reappears, if it ever does, the economy will be pushed back
into the same economic environment that we have experienced over
the last 18 months.
If it takes a doubling of the monetary base for March 2008
to March 2009 in order to keep the economy from completely
collapsing, what should we expect when the Federal Reserve sells
assets, shrinks the monetary base, and lets interest rates climb
in response to the new economic conditions? Why should we expect
the economy to continue to prosper, when the only basis of its
recovery, should that recovery take place, is a doubling of the
These are obvious questions, yet almost nobody is asking
them in the mainstream financial media. There is no attempt to
analyze Bernanke's promise in terms of Bernanke's own experience,
when he attempted to stabilize the monetary base from February
2006 until late 2007. We have been down that road of monetary
stabilization, and it has produced the worst recession since the
Now we face an economy that is barely functional and that
requires government spending on a scale never seen in peacetime
America, and monetary expansion on a scale also never seen in
peacetime America. These are the twin pillars, according to
Keynesianism, of government counter-recessionary policy today.
Take away these two pillars, as President Obama and Chairman
Bernanke promise will be done, and what becomes of the recovery?
If the recovery is based on massive government spending and
massive expansion of the monetary base, then how can it continue
when both of these stimulus programs are reversed by the
government and the Federal Reserve System?
We are now trapped by Keynesian policies of the expansion of
money supply and expansion of the Federal deficit. Investors
have some slight ray of hope that this twin stimulus package will
keep the economy from collapsing into full-scale depression.
They are somewhat optimistic that the government and the Federal
Reserve System have put the worst behind us. They are
Keynesians, and they believe in Keynesian deficit spending and
monetary expansion. They do not understand that a recovery that
is financed by government deficits and monetary expansion must
turn into one of two things: either mass inflation if the
policies are continued, or else economic depression when the
policies are reversed.
The public believes that it is possible to return to the
status quo ante. People believe that it is possible to go back
to business as usual. Yet the landscape that existed in August
2008 no longer exists. The banking system is owned and operated
by the Federal Reserve System and the Treasury Department. We
have moved from private capital markets operating in a Keynesian
economy to government-regulated capital markets that are
essentially not different from what prevailed in Italy and
Germany in 1935. The government business alliance is now openly
operated by the big brother in this alliance, the Federal
We cannot go back to business as usual because business as
usual relied on a level of Federal taxation and monetary
expansion that no longer sustains this new government operated
economy. We will not muddle through to the status quo ante,
because the status quo ante is gone with the wind.