Letter: The impotence of gold and silver

The following is in answer to Brendan Trainor's RN&R Nov 6th column, The power of gold and silver.

http://www.newsreview.com/reno/power-of-gold-and/content?oid=15407117

Brendan Trainor's "Austrian School" theories won't add to his understanding of the real world of banking and finance.

First off, banks have operated on the fractional reserve principle since they first appeared in ancient Babylonia. It creates what's called the "multiplier effect," where the bulk of every deposit is turned into a loan, which is turned into a deposit at another bank, which is turned into a loan at another bank, and on and on. This has the effect of up- or down-scaling the supply of credit needed to satisfy demand for credit in a growing economy.

It's the job of the central bank to anticipate changes in the level of aggregate demand six to twelve months into the future so monetary policy can be calibrated accordingly and have time to work its way through the financial system. That approach to monetary policy has given us seven decades of unprecedented prosperity and financial stability. Gone are the panics and depressions that were a regular feature of economic history prior to the 1944 Bretton Woods conference, which established the US dollar as the international standard of value, replacing gold.

There are two main reasons the economic consequences of the 2008 financial crisis were far less severe as those resulting from the financial crisis of 1929. For one thing, in 2008 we had a president and treasury secretary who understood the urgent need for immediate fiscal intervention. We also had a congress which responded as requested with $800 billion dollars in TARP funds to shore up "too big to fail" institutions.

We were also lucky to have a Fed chairman who happened to be the world's foremost authority on the causes of the Great Depression. He knew exactly what needed to be done to head off a deflationary spiral and collapse of the world financial system.

In the aftermath of the 1929 crash, both the Fed and Treasury fiddled while Rome burned. As Nobel Prize-winning economist Milton Friedman said in 1998: "I think the Austrian business-cycle theory has done the world a great deal of harm. If you go back to the 1930s, which is a key point, here you had the Austrians sitting in London, Hayek and Lionel Robbins, and saying you just have to let the bottom drop out of the world. You’ve just got to let it cure itself. You can’t do anything about it. You will only make it worse. You have Rothbard saying it was a great mistake not to let the whole banking system collapse. I think by encouraging that kind of do-nothing policy both in Britain and in the United States, they did harm." That might have been the understatement of the century.

Brandon doesn't seem to understand that the subprime mortgage crisis was triggered by George W. Bush's flamboyant HUD Secretary Alphonso Jackson, who vowed to expand home ownership among African Americans. Karl Rove picked up on that idea as a way for Republicans to make inroads among minorities in the electorate and came up with the catchphrase "The Ownership Society."

Rove stage-managed a media event in which Alphonso Jackson appeared before the cameras with a chainsaw shouting that he was going to cut the "red tape" keeping people of color from owning their own home, red tape like having a decent credit score and a steady job.

To accomplish that goal, HUD told Fannie Mae and Freddie Mac they could not securitize bundled mortgages unless at least half were underwritten to be subprime-eligible. As subprime demand was far below that kind of supply, 80% of that free money went to real estate speculators who used it to flip properties.

That created a price bubble that burst and undermined the value of mortgage-backed securities purchased by investors with extreme leverage and hedged using derivatives that counterparties couldn't afford to make good on.

Rating agencies, realtors and appraisers added to the problem by creating an epidemic of outright fraud that made Enron look like a Sunday picnic. Yet unlike Enron, nobody has gone to jail. Yet. Stay tuned.

Brandon says: "Jackson waged war on the national bank of his day and won. He destroyed the Second Bank of the U.S., and after a sharp recession America prospered." Nothing could be further from the truth.

The Second Bank of the United States was plagued by scandals and gross mismanagement in the first few years after it was established in 1816. But after Nicholas Biddle took control in 1823, it fulfilled its charter quite well, creating a stable dollar and expanding credit in harmony with an expanding economy. But Andrew Jackson blamed the bank for the Panic of 1828, and after assuming the presidency in 1829, he attacked the bank as unconstitutional and ineffective in managing the money supply.

Hearings in both houses of congress demonstrated that neither of Jackson's allegation was true. Undeterred, Jackson characterized the bank as corrupt and dangerous to American liberties.

Playing on the public's ignorance of banking and finance, Jackson vetoed the bank's charter renewal and made abolishing it the central issue of his 1832 reelection campaign. He won by an overwhelming margin, and with that public mandate, he acted by executive order to transfer all federal assets and revenues to private banks.

The Second Bank of the United States was forced to become a private corporation under Pennsylvania law. As such, it lost its supervisory role over state banks, which caused their lending standards to be relaxed. The result was a huge real estate bubble and a period of inflation-fueled economic expansion that was clearly unsustainable.

Jackson responded with an executive order called The Specie Circular of 1836, which mandated that land could only be purchased with gold and silver coin. This had predictably disastrous consequences. It set off a real estate and commodity price crash.

Then congress turned the crisis into a catastrophe by requiring that federal revenues be placed in local banks across the country. This moved gold and silver away from money center banks in the east, and with lower reserves those banks were forced to drastically scale back their lending.

The result was the Panic of 1837, which turned into a seven year long economic depression. Banks collapsed, businesses failed, asset prices crashed, and unemployment reached 25%. Between 1837 and 1844, wage and price deflation became the norm as no central bank was in place to facilitate lending or inject liquidity.

Brendan states that "During the Gilded Age, the crony capitalist Republicans created a National Banking System, which in 1913 was converted to the Federal Reserve System." That's not what happened at all.

The National Banking Acts of 1863-1864 created a system of federally chartered and regulated banks, in part to create a standardized currency (national banks were required to honor each other's notes at parity) and to create a secondary market in treasury securities to help finance the Civil War.

By 1870 there were 1,638 national banks and only 325 state banks, but in the Gilded Age the state-chartered banks regained their market dominance through the advent of checking accounts. By 1890, only ten percent of the money in circulation was in the form of bank notes from national banks. By the time the Federal Reserve banks opened their doors in 1914, over 30,000 currencies of all descriptions were in circulation. It was this monetary chaos the Fed was chartered to address, and it did so quite successfully.

Brendan claims that "every state is in violation of the Constitution" because Art. 1 Sec. 10 says, "“No State shall make any thing except gold and silver coin a tender in payment of debt.” That is patently ridiculous. As Madison explained in Federalist 44, the clause he quotes was intended to keep states from using or creating any currency other than that created by congress.

The Taxing and Spending Clause (Article I, Section 8, Clause 1) allows congress to borrow money on the credit of the United States, and this has been interpreted (Knox v. Lee, 1871) to mean that congress has the power to issue bills and make them legal tender. In 1913, this power was delegated to the Federal Reserve. Nothing there about making the dollar convertible into gold, silver or any other physical thing. It's an abstract measure of relative value, not a thing.

Gold was once a currency, but it isn't any longer and it can't become one in the future. To get that, you need to understand a little about the history of the gold standard.

Under the Bank Charter Act of 1844, the Bank of England's notes became fully backed by gold. That was possible because the British-owned mines in South Africa gave them a virtual monopoly of world gold production. The effect was revolutionary. Pound notes literally became as good as gold overnight, and were exported in exchange for foreign goods. That resulted in gigantic trade deficits and unprecedented levels of prosperity for the Great Britain. It also facilitated an expansion of international trade, as payment could be made with a universally accepted paper currency instead of gold and silver, which often ended up on the bottom of the ocean.

But it wasn't sustainable. Shackling a currency to the availability a commodity makes it next to impossible to scale, so the productive capacity of the real economy is artificially curtailed. Only a fiat currency managed by an independent monetary authority like the Fed is up to that job.

And no, the Fed isn't a "private bank" that works on behalf of its self-serving members. It was chartered by congress under a dual mandate to both control inflation and maximize employment. Those goals are often hard to square, but the Fed does a pretty good job nonetheless. This would be impossible under the gold standard, which is why not a single currency in the world is valued in grains of gold. Ron Paul and his minions will never be able to grasp any of this, because their cherished myths are essential to their skewed world view.

Speaking of Ron Paul, he successfully tacked an amendment onto the Dodd-Frank financial reform bill that called for an audit of the Federal Reserve's monetary operations; its banking operations had always been audited, both internally and externally. This new audit was opposed by both the serving chairman, Ben Bernanke, and the previous chairman, Alan Greenspan, on the grounds that liquidity facilities provided to dollar-based central and commercial banks around the world would undermine confidence because those kinds of transactions are always assumed to be confidential. The GAO's audit report revealed only what people paying attention already knew - that the Federal Reserve is the world's central bank, and that it gets all the dollars it creates out of thin air and makes available to dollar-based banks around the world is nothing but good for the United States, as it is indeed "created out of thin air," yet it is always repaid with interest, money that is transferred to the treasury. Fact is, the Federal Reserve has made a profit for the US treasury every single year since it was created.

Political meddling is always the enemy of public confidence in monetary policy, and there's always a fear-mongering demagogue like Andrew Jackson or Ron Paul around to spew ignorance ad spin conspiracy theories. It's best to ignore them.