The coming fiat money cataclysm and the case for gold.

• Author: Dowd, Kevin
• Position: Essay

An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense ... that gold and economic freedom are inseparable.

Alan Greenspan (1966)

The Age of Chartalist or State Money was reached when the State claimed the right to declare what thing should answer as money to the current money-of-account--when it claimed the right not only to enforce the dictionary but also to write the dictionary. Today all civilised money is, beyond the possibility of dispute, chartalist.

John Maynard Keynes (1930)

A recurring theme in monetary history is the conflict of trust and authority: the conflict between those who advocate a spontaneous monetary order determined by free exchange under the rule of law and those who wish to meddle with the monetary system for their own ends. This conflict is perhaps most clearly seen in the early 20th century controversy over the "state theory of money" (or "chartalism"), which maintained that money is a creature of the state. The one side was represented by the defenders of the old monetary order--most notably by the Austrian economists Ludwig von Mises and Friedrich Hayek, and by the German sociologist Georg Simmel. The other side was represented by the German legal scholar Georg Friedrich Knapp and by John Maynard Keynes. They argued that on monetary matters the government should be free to do whatever it liked, free from any constraints of law or even conventional morality.

States have claimed the right to manipulate money for thousands of years. The results have been disastrous, and this is particularly so with the repeated experiments with inconvertible or fiat paper currencies such those of medieval China, John Law and the assignats in 18th century France, the continentals of the Revolutionary War, the greenbacks of the Civil War, and, most recently, in modern Zimbabwe. All such systems were created by states to finance their expenditures (typically to finance wars) and led to major economic disruption and ultimate failure, and all ended either with the collapse of the currency or a return to commodity money. Again and again, fiat monetary systems have shown themselves to be unmanageable and, hence, unsustainable.

The same is happening with the current global fiat system that has prevailed since the collapse of the Bretton Woods system in the early 1970s. The underlying principle of this system is that central banks and governments could boost spending as they wished and ignore previous constraints against the overissue of currency and deficit finance; implicitly, they could (and did) focus on the short term and felt no compunctions whatever kicking the can down the road for other people to pick up. Since then loose monetary policies have led to the dollar losing over 83 percent of its purchasing power. (1) A combination of artificially low interest rates, loose money, and numerous incentives to take excessive risks--all caused, directly or indirectly, by state meddling--have led to an escalating systemic solvency crisis characterized by damaging asset price bubbles, unrepayable debt levels, an insolvent financial system, hopelessly insolvent governments, and rising inflation. Yet, instead of addressing these problems by the painful liquidations and cutbacks that are needed, current policies are driven by an ever more desperate attempt to postpone the day of reckoning. Consequently, interest rates are pushed ever lower and central banks embark on further monetary expansion and debt monetization. However, such policies serve only to worsen these problems and, unless reversed, will destroy the currency and much of the economy with it. In short, the United States and its main European counterparts are heading for a collapse of their fiat money regimes. (2)

The Impact of a Low Interest Rate Policy

The impacts of state intervention in the monetary and financial system are subtle and profound, but also highly damaging and often unforeseen. A good place to start is Hayek's well-known analysis of the impact of a lower interest rate policy in Prices and Production in 1931. Hayek focuses on the "malinvestments" created by such policies--the unsustainable longer-term investments that would not otherwise have taken place that are eventually corrected by market forces that manifest themselves in a recession in which earlier malinvestments are abandoned and the economy goes through the necessary but inevitable painful restructuring (see also O'Driscoll 2011).

Low interest rate policies not only set off a malinvestment cycle but also generate destabilizing asset price bubbles, a key feature of which is the way the policy rewards the bulls in the market (those who gamble on the boom continuing) at the expense of the sober-minded bears who keep focused on the fundamentals, instead of allowing the market to reward the latter for their prudence and punish the former for their recklessness. Such intervention destabilizes markets by encouraging herd behavior and discouraging the contrarianism on which market stability ultimately depends. A case in point is the Fed's low interest rate policy in the late 1990s: this not only stoked the tech boom but was maintained for so long that it wiped out most of the bears, who were proven right but (thanks to the Fed) too late, and whose continued activities would have softened the subsequent crash. The same is happening now but in many more markets (financials, general stocks, Treasuries, junk bonds, and commodities) and on a much grander scale. Such intervention embodies an arbitrariness that is wrong in principle and injects a huge amount of unnecessary uncertainty into the market.

Another unexpected and almost unnoticed effect of artificially low interest rates has been to replace labor with capital, leading to unemployment and attendant downward pressure on wage rates. This effect is very apparent if one contrasts recent low interest rates with the very high interest rates of the Volcker disinflation 30 years ago:

* Then, high real interest rates reduced the level of capital applied to the economy and made obsolete a high proportion of the existing capital stock. However, demand for labor remained high in the areas of the country that were not suffering from bankruptcy of their capital stock, in particular on the East and West coasts. Once the recession lifted, therefore, job creation was exceptionally buoyant.

* With recent low interest rates, on the other hand, it is labor that is substituted out: hence, job loss levels in the winter of 2008-09 were far above those of any recession since the early 1930s, and the level of long-term unemployment is far above that of the early 1980s, especially when one takes into account the legions of discouraged workers who have exhausted their benefits and dropped out of the unemployment statistics.

This effect is overlooked by Keynesians who maintain that lower interest rates lead to lower unemployment via greater spending, and is another example of the need to take account of relative prices and not just focus on aggregates alone.

A related effect is to encourage excessive outsourcing, as capital is excessively substituted for overseas labor and jobs and even innovation are moved offshore. Outsourcing a product or service to Asia not only makes it cheaper but also increases the capabilities of the overseas workforce, raising its capability still further and making it competitive in more sophisticated products and services. To some extent, outsourcing is a natural and beneficial aspect of globalization, but excessively low interest rates push this process too far. This happens in part by making capital too cheap, leading to too much overseas investment and excessive substitution of overseas for U.S. labor. This also happens by depressing yields, which leads yield-seeking investors into higher-risk investments such as emerging markets. If Vietnam, for example, can then raise money almost as easily as Ohio, then capital will be diverted to lower-cost Vietnam and manufacturing jobs that would otherwise have remained in the United States will migrate with it. This latter channel is a perfect example of the law of unintended consequences that illustrates how subtle the damaging consequences of low interest rate policies can be.

Artificially low interest rates also reduce the productive efficiency of the U.S. economic engine by adversely affecting productivity and the rate at which technological advance translates into living standards. This effect shows up clearly in the multifactor productivity data. The most recent data show that during 2005-09 annual average multifactor productivity grew by only 0.2 percent, well below the post-1948 average of 1.17 percent. Had multifactor productivity in 2005-09 risen at its long-term rate, output in 2009 would have been perhaps 5 percent higher.

Taking these effects together, we can see that lower interest rates have damaging effects on capital accumulation, output, and living standards. These effects come through (1) the misallocations of capital and long-term decapitalization associated with repeated destabilizing boom-bust cycles; (2) the damaging effects of policy-induced uncertainty; (3) the loss of capital, jobs, and innovation overseas; (4) reductions in productivity growth; and (5) reduced savings rates which discourage the accumulation of capital in the first place (see Dowd and Hutchinson 2011).

State Intervention and the Financial System

State intervention also has a profoundly damaging effect on the financial system. Government deposit insurance, for example, creates a well-known moral hazard that encourages banks to take more risks than they would otherwise take and increase their leverage, which weakens the whole banking system. Less well understood is that it creates a race to the bottom, in which banks take more and more risks and become ever more leveraged over time, culminating eventually in the...