5 – Sound Money
Having seen the nature and causes of unsound money, what can we say about sound money?
It is money that can be trusted, by anyone and everyone who uses it. Trusted to do what? Trusted to retain its purchasing power.
After all, what matters is what money can buy, not the money itself. Sellers of goods and services expect payment for their products in a medium that can be used for making purchases. (Our old friend Say’s Law over again.)
At 3 per cent, the current rate of inflation, the purchasing power of your money will be halved in 23 years. It was not always so. The pound took 164 years, from 1750 to 1914, to halve in value. One dollar today is worth one cent of a century ago!
It could be worse: think of the poor Zimbabwean farmer who wants to export his crop of delicious oranges. Unlike a German exporter, happy to accept payment in his own currency, our farmer will accept payment in just about any currency except Zimbabwean dollars, because they fail the crucial purchasing power test.
In Zimbabwe, the 100-trillion-Z$ note bestows purchasing power equivalent to 40 US cents. With which you may be able to buy a cup of coffee! [I am not making these numbers up – you can check for yourself!]
This, of course, is what we call “hyperinflation”, with a vengeance. Even barter makes more sense!
But we must take care over terminology. To refer to these insane processes as “inflationary” is a statement of the obvious – indeed it is the very definition of inflation. Rising prices is one manifestation of inflation, rather than inflation itself. The term “inflation” should be used in its strict sense as referring to inflation of the money supply, or inflation of credit (the same thing).
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The unrestricted credit creation called “quantitative easing” raises an obvious question: What happens to all the new money?
It is a mathematical certainty that if the quantity of money increases in relation to a given level of available goods, prices must rise. Not necessarily all prices, and not necessarily immediately. To see what its “first receivers” in financial institutions do with the money, you should simply identify the assets that have become dramatically more expensive after a few bouts of quantitative easing, coupled with cheap credit.
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The initial impact is evident in the adverts for luxury cruises; extravagant town-houses with underground swimming pools and gyms in the most prestigious locations; £50,000 timepieces; gleaming sports cars; hand-crafted yachts; branded clothes and bejeweled baubles exclusive to Bond Street arcades; Chateau-bottled wines (or the chateaux themselves) - all at asset prices pushed sky-high by the new zillions! Much of it finds its way into new skyscrapers; speculation on stocks and shares; private clinics and health spas; and, inevitably, obscene levels of executive pay, disgracing the integrity of boardrooms everywhere.
This well-known phenomenon is called the “Cantillon effect”, named after the 18th Century economist Richard Cantillon, who noted that the consequences of an inflationary supply of new money occur gradually, and that they have a “localized” effect on prices. By this he meant that the original recipients of the new money (banks, financial houses and City institutions close to the Treasury and central bank) enjoy hugely greater sudden wealth at the expense of later recipients who, at first, don’t notice much price inflation.
The next phase is a “filtering-down”, which dictates that the impact of new money on the price of foodstuffs, household goods and the basic ingredients in most people’s budgets takes longer to arrive, but its most noticeable effect is that prices are higher, having been pushed up by the earlier inflationary impact. [The same happens to ordinary domestic housing everywhere, making home ownership for the younger generation prohibitive. Uncomprehending politicians will scream about the need for “more affordable housing” – but causes elude them altogether!]
This process bites especially harshly in locations where shoppers, whose budgets are already stretched, are forced to seek out the lowest prices for essentials. The reduced “footfall” on the High Street causes many shops, already beleaguered by the competition of online shopping, to close. The insidious impact is transformative – just look at the changing composition of the typical High Street, where there used to be hardware stores, outfitters, hairdressers, decent restaurants, jewelers, fishmongers, professional offices, clinics, travel agencies, furniture stores, art and antique shops, bathroom showrooms. And now?
Apart from all the “to let” spaces where there used to be shops, there are charity shops, newspaper shops also selling cheap deli food and booze, cheaply appointed coffee-and-cake counters, kebab, burger and pizza bars, a couple of bank branches, estate agents advertising low-rent lettings, mini-cab call centres, mobile phone stores, clothing outlets with racks of cut-price clobber, traders in any rapid turnover enterprise.
[The impact of inflation can be more reliably observed over a period when measured against an essential commodity, such as oil.
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Fifty-two years ago the price of a barrel of oil was $3.1. Today it hovers around $70 and rising. Although it appears as though the price of oil has gone up, hugely, that apparent rise is rather a measure of the loss in the dollar’s purchasing power over that period – over 95 per cent.
But what happens if you measure the price of that same barrel of oil against a stable commodity, such as gold, instead of the volatile dollar? Fifty-two years ago that barrel equated to 2.75 grams of gold. Now it equates to 1 gram of gold. Therefore the purchasing power of gold, measured in barrels of oil, has all but trebled.]
Let’s return once more to the subject of “sound money”, which cannot be separated from the question of interest rates, which we have now covered.
Under a bartering system there could be no inflation because there is no money supply to inflate. Prices of different products and services in relation to each other can still vary enormously due to changes in respective demand and supply caused by seasonal availability, the effect of drought causing scarcity – not only of materials and products, but labour too.
Money and gold
When money, as both a convenient medium of exchange and a reliable store of value, gradually superseded barter, the commodity used as a medium for settling domestic and international debts was gold because it possesses the key attributes that serve so well as currency: relative rarity; durability; limited alternative utility; recognition and acceptance.
Most important of all, it is immune from the ravages of the government’s printing presses and under the gold standard there can be no “inflation” as we know it today.
The only serious debasements to afflict gold are the practices (at which Henry VIII was expert) of “coin-clipping”, and the mingling of inferior alloys, often to pay for foreign wars.
The Gold Standard
Under a gold standard a country’s unit of currency is defined by a specified quantity of gold held by its central bank, and into which its convertibility is guaranteed without restriction. Its unrestricted export and import makes it ideal for settling international obligations.
A country on the gold standard cannot increase the amount of money in circulation without also increasing its gold reserves. Because the global gold supply grows only slowly, being on the gold standard holds government spending and inflation in check.
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[In 1844 the Bank Charter Act ruled that Bank of England notes were fully backed by gold, marking the establishment of a full gold standard for British money that lasted until 1931, when poor financial management led to rising trade and budgetary deficits, in turn causing the pound to be devalued on the foreign exchanges and hence a rise in import prices. The promise of convertibility into gold of pounds held abroad risked material depletion of Britain’s gold reserves – and so the gold standard was abandoned.]
In 1944 representatives of the allied nations and their central bankers met at Bretton Woods in New Hampshire, where it was agreed that (a) the US dollar would be accepted as the settlement currency for international trade; (b) that the US dollar would be redeemable in gold on presentation at the fixed rate of $35 to the ounce; and (c) the International Monetary Fund (IMF) would be formed to ensure that that the USA behaves itself fiscally and maintains the agreed ratio by controlling the supply of its dollars – a task which the IMF spectacularly failed to achieve.
Redeeming those dollars
Throughout the 1950s and early 1960s the USA just kept on printing dollars regardless of whether they could redeem them in gold at $35 to the ounce. They were effectively paying for their imports with fake currency.
In 1958 General de Gaulle became President of France and over the next few years he noted with increasing alarm that the French Central Bank was stuffed full of US dollars, and French exports to the USA (wine, cheese, machinery, cars, clothes, etc) were being paid for, not in francs, but in still more dollars. In 1969 De Gaulle started to redeem the dollars France was holding against gold at the official rate of $35 to the ounce.
Other central bankers duly noted this redemption and soon began to follow suit. By 1971 America’s gold reserves had become seriously depleted, and President Nixon took the coward’s way out of the problem by simply declaring that debts denominated in dollars were no longer redeemable in gold – effectively taking America off the gold standard.
[Nixon could, of course, have faced up to the damage inflicted by the Federal Reserve’s systematic dollar destruction over decades. He could have devalued the dollar by restating its revised value in terms of gold, and then desisting from further debasement. It is reliably estimated that the true relationship between dollars and gold in 1971 was around $400 to the ounce.
This means the dollar lost almost 90 per cent of its purchasing power over the 27 years from 1944 to 1971. Reinstating the gold standard at that conversion rate could have arrested this slide – subject to acceptance of monetary discipline.
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Today the “gold conversion price” (the price the Fed would have to set to redeem dollars for gold AND NOT RUN OUT OF GOLD) would be over $14,000 per ounce for base money, or, if savings and short-term bank liabilities are also to be covered, a staggering $53,000 per ounce!]
Economists who favour state control over the economy claim that the chief drawback of a gold standard is that it restricts government's ability to control the money supply when, in their view, state intervention is warranted.
However, economists who consider that markets are preferred arbiters of what, if anything is needed, regard this restriction on monetary meddling as the gold standard’s greatest strength!
“Fiat” Money
In 1971 the gold standard was replaced by a system of “fiat” money under which the currency is not linked to the value of any commodity, but is instead allowed to fluctuate dynamically against other currencies on the foreign-exchange markets.
The term “fiat” is derived from the Latin “fieri” - meaning arbitrary act or decree. In keeping with this etymology, fiat currencies are accepted only because they are defined as legal tender by government decree, not because they retain purchasing power, which they do not!
Finally, you will hear politicians opining on the effect of individual currencies: “If only the Italians ditched the euro and returned to the lira their exports would be more competitive…..” And the same sentiment is voiced over the Greek drachma, Spanish peseta, etc. This is all nonsense. It is not currencies that that need to be made more “competitive”, but production. German cars are not world-beaters because they are cheap, but because their production methods guarantee value for money – any money!
6 - Free trade
In essence, the huge Brexit ideological battle is being waged between upholders of free trade and believers in protectionism.
The waters are muddied by misunderstandings on the part of politicians on both sides. For example, many proclaiming themselves to be free trade supporters emerge on closer questioning to favour free trade between members of a “group”, a “customs union” or “association” of countries. Yet, restricting your “free trade” agreements to those within your trading circle remains grossly protectionist, and is not at all what any true free trader means by free trade.
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Free trade means “unilateral” (“one-sided”) free trade. Nations like New Zealand, Singapore and Hong Kong regularly enter into free trade agreements with any nation who wishes to do so. It does not take two to tango and any other view is protectionist and perverse. Unilateral free trade is unconditional and unrestricted.
Protectionists’ instruments of torture are tariffs, if they are protecting domestic trade from cheaper imports; and subsidies, if they are helping their own exporters to compete with cheaper products in the target country.
Here’s what happens:
1 – Protectionist lobbies urge the government to compel its own citizens to pay higher prices so that domestic producers are favoured and are thus able to maintain their current revenues.
2 – Protectionists will claim that the foreign producers are subsidized by their own governments, and are therefore not competing “on an even playing field”. This can only mean that our domestic population is receiving the gift of lower-priced goods from foreign producers. It is not the role of government to make consumers poorer by preventing them from accepting this gift.
3 – Protectionist lobbies are quick to warn government that an entire industry’s viability is at stake if it doesn’t act to retaliate against the artificially low-priced goods from abroad. With free trade and a sound currency importers (on behalf of consumers) will always seek the best products at the lowest prices, regardless of where they are sourced.
4 – Advocates of protectionist policies view trade economics through an upside-down prism. It is the function of consumers to consume - not to serve producers. The function of producers is to serve consumers. If consumers, in exercising their free choice, are spending their money in ways that do not please domestic producers, it is not government’s role to intervene to end such “perverse” spending preferences!
5 – There is a tariff wall around the EU designed mainly to protect its agriculture and manufacturing. The tariffs cause EU citizens to pay prices higher than in world markets. Because of the tariff barrier, overseas producers are effectively barred from sending their goods to any EU countries. Caribbean sugar producers, African agricultural exporters, Asian cloth-makers, and many other overseas producers, cannot sell their cheaper products into EU markets. Businesses that are protected by the EU tariffs benefit – but the losers are the overseas exporters and every EU consumer! [And then we finish up paying billions in overseas aid to the very countries that would not have needed it, had we not imposed barriers against their goods!]
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6 - Forget concepts like “multilateral” or “bilateral” trade agreements that imply government has a role in negotiating on behalf of individuals and businesses perfectly capable of reaching their own agreements. Only “unilateral” free trade is optimal. It needs to be “declared” – not “negotiated”!
7 - It is all based on mythology anyway! The myth is that governments and countries trade. They don’t trade, ever! In any case, they wouldn’t have a clue. Only people - representing real businesses - trade! Trade comes into action when there is a product, a willing buyer and a willing seller. All they want from government is to get out of the way so that they can get on with it!
8 – Protectionism never works. The only people it punishes are the citizens of the countries that impose it!
Small Government [and its counterpart, low taxation]
When Keynes was asked, “Why pay them to dig and fill holes? Why not pay them to build roads and schools?” he replied: “Fine, pay them to build schools. The point is it doesn’t matter what they do – as long as the government is creating jobs.”
That, however, is not the role of government.
In essence, the proper role of government is to protect the lives, property and civil freedoms of its subjects, and few would resent paying taxes to cover those essentials. Moreover, sound money and free trade automatically reduce the role of government to those natural limits.
Note these basic truths:
(i) Whatever government spends has to be paid for in taxes raised from the private sector. The public sector cannot be taxed, as it is paid out of taxes.
(ii) In a sound-money economy government cannot print fiat money. For every pound it wishes to spend it must either tax or borrow honestly - bearing in mind that there is a natural limit to public tolerance for taxes; and increased borrowing drives up the interest rate, increasing the burden on the productive economy.
(iii) An economy running on unsound money creates an appearance of unlimited resources. This, of course, is the progenitor of the “entitlement culture”. To pay for the state’s unfunded promises and good works, all it has to do is print more money.
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(iv) Political animals with power to set priorities, and make spending decisions, forget all too easily that their own remuneration comes out of taxes and that they are public servants, not masters.
(v) Government expenditure is simply not susceptible to the kind of economic analysis that citizens apply when spending their own money. There is no incentive to raise productivity in the public sector. Only half of NHS employees are doctors or nurses; only one-third of the state education sector’s employees are teachers.
(vi) Politicians with unbridled power to spend their citizens’ money are the worst culprits. The more grandiose the project, the greater the potential for unchecked extravagance - whether it relates to new power generators, runways, high-tech university labs, bridges or tunnels.
The reason that no consideration is given to the questions that arise when private capital is involved (such as whether the project’s returns are likely to exceed its origination and operating costs) is that such questions are meaningless when the mindset is “bounty unlimited”.
This key question is rarely asked: “How will the nation suffer if this project is abandoned right now?”
Wherever tax-funded infrastructure spending is let loose on the basis of little more than political whim, the result is a pure gamble with taxpayers’ money:
§ How else is it possible to close a hospital operating theatre in Barcelona, yet keep open an airport with 40 employees, at which no plane has landed?
§ Or Portuguese electronic toll-roads that drivers avoid like the plague? [They have no tollbooths, and require drivers to buy transponders and variable-priced pre-paid cards!]
§ Or the World Bank aid project that diverted fresh water from Lesotha Highlands into South Africa at a cost of $3.5 billion to produce electricity that proved (a) too expensive for consumers; and (b) created environmental havoc downstream?
§ Or the Norwegian government’s $22 million development aid-funding of a fish processing plant on Lake Turkana to “create jobs” in Kenya? Did no one tell them that the Turkana people are nomads with no history of ever catching or eating fish? And the cost of operating freezers was prohibitive anyway! The empty plant stands as a monument in the “museum of well-meaning cock-ups”.
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Nor is there an end to the government’s “social engineering” meddling, as if it has an electoral mandate to apply our taxes according to its totally uncosted, unmeasured, political vote-catching agenda – whether imposing a sugar tax, printing health warnings on every surface in sight or building more lethal cycle lanes.
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[Allowing private sector entities to get in on the act can, in some instances, be an unmitigated disaster! Just look at the hellish chaos into which Britain’s railway systems have descended! The understandable response, especially from those beleaguered rail travellers directly affected, is that re-nationalisation is the answer.
Again, while it appears to commuters and others that almost anything would be preferable, the real fault lies with the business model, the brainless planning of the ministers charged with delivering a decent service, and their inept management supervision. Even running a railroad can allow for competition that raises standards and delivers a profit – but while the present batch of useless entrepreneurs are allowed to hold franchises that they should have lost years ago, all the time profiteering by manipulating prices ever-upwards, even nationalisation with its own brand of chaos is a preferred interim option until the right business operators materialise.]
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What it all comes down to is this. Provided that the principles of free trade and sound money are properly understood, and applied, government would be left with little to do beyond its primary raison d’etre of protecting the lives, property, liberty and civil rights of its citizens.
Limiting the role of government is difficult to visualize. But if we allow the subtle world of what is unseen to enter our consciousness, we’ll find it far more powerful than the chimera now frustrating our search for economic justice.
Understanding economics leaves us with a profound sense of awe: these simple but irreducible principles hold the key to the ordering of human affairs as they might exist – a vision that is also a lifeline.
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Footnote – but would it work in practice?
I am often asked to provide an illustration or example of these fine principles being successfully applied in the real world. There are actually many examples, yet people tend to be distracted by examples of everything going haywire. However, what follows is an example of the application of sound principles –and it is a gem.
People rarely stop to consider the astonishing, unprecedented, economic turnaround that transformed Germany from its immersion in deep and desperate economic ruin in 1945 to become, in record time, one of the world’s most dynamic industrial powerhouses? If ever there was a case of an economic miracle, this was it.
How was such a thing possible? It was neither luck nor magic, though you could be forgiven for thinking so!
No, it happened only because one man, Ludwig Erhard, in the right place at the right time, understood and applied the principles I have outlined above.
Here’s the story, and I am grateful to Alasdair Macleod for the narrative.
By the mid-1940s both the Nazi war machine and allied bombing had destroyed Germany’s post-war economy. The country was in ruins and people were starving. The British and American military solution was to extend and intensify rationing and throw more aid at the problem.
Then Ludwig Erhard was appointed director of economics and in effect became finance minister. He decided, despite British and American misgivings, as well as opposition from the Social Democrats, to do away with price controls and rationing, which he did in 1948. These moves followed his currency reform that June, which contracted the money supply by about 90%, ending the reichsmark hyperinflation and instituting deutschmarks instead. He also slashed income tax from 85% to 18% on annual incomes over Dm2,500 (US$595 equivalent).
Erhard’s reforms went totally against the prevailing bureaucratic grain, and the military governor of the US Zone, General Lucius Clay, to whom he reported, duly upbraided him.
“Herr Erhard, my advisers tell me what you have done is a terrible mistake. What do you say to that?”
Erhard replied, “Herr General, pay no attention to them! My advisers tell me the same thing.”
Then a US Colonel confronted Erhard: “How dare you relax our rationing system when there is a widespread food shortage?
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Erhard replied, “I have not relaxed rationing, I have abolished it. Henceforth the only rationing ticket the people will need will be deutschmarks. And they will work hard to get those deutschmarks, just wait and see.”
The US Colonel did not have to wait long. According to contemporary accounts, within days of Erhard’s currency reform, shops filled with goods as shopkeepers recognized that the money they sold their products for would retain its purchasing power. People no longer needed to forage for the basics in life, so absenteeism from work halved, and industrial output rose more than 50% in the second half of 1948 alone.
Erhard had spent the war years studying free-market economics, planning how to structure Germany’s economy for the post-war years. His free-market approach made him a long-standing and widely recognised opponent of Nazi socialism, a fact that enhanced his credibility with the military authorities tasked with repairing the German economy.
[He became an early member of the Mont Pelarin Society, a grouping of free-market economists inclined towards the Austrian School, founded in 1947, and whose first President was Friedrich von Hayek, mentor to both Reagan and Thatcher.]
Erhard simply understood that ending all price regulation, introducing sound money and slashing the burden of taxation, were the basics required to revive the economy, and that the state must resist the temptation to “help”.
He remained a highly successful finance minister for fourteen years, before succeeding Konrad Adenauer as Chancellor in 1963.
Erhard not only allowed unfettered free markets to rapidly turn Germany around from economic devastation, but being publicly credited with this success he presided over the economy long enough to ensure that bureaucratic meddling was kept at bay. His legacy served Germany well, despite the generally destructive actions of his successors.
The contrast with Britain’s economic performance was stark. Rationing in Britain was not finally lifted until 1954, and her post-war socialist, anti-market government was nationalising key industries. The contrast between Germany’s revival and Britain’s decline could not have been more marked.
The point to note well is that free markets are demonstrably more successful than regulated markets as a means of ensuring economic progress.
The same phenomenon was observed in Hong Kong, where John Cowperthwaite succeeded in stopping his own local officials and London’s Colonial Office from imposing regulations on the island’s economy in the post-war years. Cowperthwaite was roughly contemporary with Erhard, retiring as Hong Kong’s Financial Secretary in 1971. Yet despite this indisputable evidence that free unregulated markets actually work best, both the central and local political classes can never resist the compulsion to regulate, and their efforts invariably have an effect diametrically opposed to what’s needed.