Philadelphia Reflections

Origins, Causes and Mechanisms: (1): "A Rabble of Dead Money"

Let's start with the pirate era of the Seventeenth century. The Spaniards brought back boatloads of conquered gold, and "pieces of eight" became common international currency. Gold doesn't rust, it was universally attractive, and just biting a coin tested its purity. Since its own ancestry was unprovable, gold facilitated piracy. But its unchallengeable past created a difficulty: if boatloads sank at sea, wealth was mostly gone for good, as was gold-exchanging.

Anonymity was particularly useful in revolutions. Necker the Swiss banker suggested it for the French Revolution, just as Robert Morris had used it to good effect in the American Revolutionary War. Substituting paper gold certificates for the real thing, if a boat was captured or sunk, fresh gold certificates could be issued with the gold in vaults none the worse for it. Morris' partner William Bingham became the richest man in America at age 28 using the system in privateering adventures in the Caribbean. Keeping such a simple system private always had advantages. It had probably made Morris rich as well, while he was busy running finances for the patriotic benefit of his country. With a few embellishments, it allowed the British Empire to conquer the world.

As Walter Bagehot, the editor of The Economist magazine fifty years later, explained things in his book Lombard Street, the gold standard made it possible to conduct fair but profitable trading in Hong Kong, India, and Jamaica, between semi-hostile people who had no reason to trust each other. Furthermore, it was possible to trade pineapples for copper or to conduct wars with nations of vastly different size. The key innovation was to use durable, portable gold as a proxy for anything salable, anywhere in the world, never trusting strangers. The Industrial Revolution was probably a result, rather than a cause, of prosperity, generating revenue which figured in the lives of Jane Austen's ladies just as surely as it put diamonds in Queen Victoria's crown. Adam Smith put it differently: a seller preferred the money to the goods, while the buyer preferred the goods, so both sides were happier after the re-arrangement, whereas England was paid to be a croupier. Sufficient complexity added to finance kept the simple system both private as well as manageable from a single crooked alley in London's "city". It has been claimed no more than fifty people fully understood the concept of gold chips at the center of a trading casino. Probably it was more like a thousand, but pretending it was far too hard to understand was a big factor in success. Charles R. Morris has written the best book about it I think I have ever read. But it is no exception to the golden tradition of mysterious complexity in a title. A Rabble of Dead Money doesn't come close to hinting what it is all about.

The gold standard amounts to balancing billions of dollars on the head of a pin. If a country's total debts are larger than a country's total revenues, it has "inflation". If total revenues are larger than its debts, it has" deflation", once you substitute the real price of gold, for its nominal price. The focus is the balance between the two, not the gross quantities of either because the focus is on probable ability to repay its debts. In a zero-sum game, the imbalance identifies who might get stuck for some debtor's default, except if nobody is stuck, the whole system collapses in a crash, until such time as the losses are redistributed by a prolonged depression. The faster transportation and communication become, the tighter the match between revenue and debt which must be maintained; statistical obscurity greases the wheels, computerized globalization quickly spreads it. Imbalances are sometimes resisted by keeping wages from falling, leading to violent opposition by labor unions to any suggestion of lowering wages, thereby prolonging the pain of repairing deflations by keeping one factor out of balance. These two factors prolong depressions, deliberate inflating eventually makes it worse after temporarily relieving the pain.

The gold standard, organized and administered by the British Empire, allowed individual nations to select whatever industries dominated their economies, but the casino owner always had an advantage. With economies consisting of thousands of products, the negotiator with the best aggregate information could classify hotels or restaurants as exports or imports, because the customers were a mixture of citizens and foreign travelers; they could even shift champagne independently from table wine. Consequently, a "protective" tariff could alternately be called a trivial 5% penalty or a ruinous 95% subsidy in history books, newsmedia or politics. Monetary rules are a zero-sum game, but to a certain degree, they are a component of politics. Britannia ruled the waves.

In the 1929 crash (deflation) the collapse of the system was not exactly anyone's fault, certainly no American's. It was caused by converting prairies to farmland in order to replace wartime food shortages, then ending World War I with a sudden reversal of Ukrainian wheat. If bankers made mistakes, it was the Rothchild family in the Viennese Credit Anstalt Bank . At that time, agriculture was the largest industry in the world, (shrinking to 2% of the workforce today). This helps explain why "slaughtering little piglets" actually helped things somewhat although much ridiculed at the time. It also points today to unemployment caused by computer electronics and artificial intelligence -- as far more menacing than it seems. There is a little hope of reversing the automation process as there was in quickly lowering the price of food in 1930. It's the right idea, but politics won't let you do it.

Similarly, we have been futilely battling for a century to restrain the tendency of banks -- making more loans than there is gold in their bank vaults. The present ratio of 20 dollars in loans for one dollar of "reserves" seems to be very close to the natural un-safe limit. The experience of the Smoot-Hawley "protective" tariff ought to be sufficient warning, but it cuts both ways. There was a war between Congress and the President about this, and the President lost. A five percent tariff seems bearable until you realize that the banking system currently multiplies by 20, to result in a hundred percent effect on the manufacturer. Add the speeded-up "velocity" effect of computerized payment systems, and what appears to some people as harmless is actually totally destructive.

Since so many of these effects are based on overusing features which help a lot of people, things usually get pretty bad before they are fixed. But one man-made cause could be eliminated quickly just by a silver-tongued leader who is honest, (if you can find such a thing). Over and over it must be repeated so a third-grader understands: after a deflationary crash, never try to go back to universal pre-crash currency levels. Wealth has been destroyed, so the economy must rebalance it, in some way, at some rate. We had a wild ride, and we must somehow pay for it. The path forward is literally strewn with attempts to pay off fixed debts with inflated currency. You might get rich by being lucky, but someone else will be impoverished by your effort; so he may thwart it. Inflation caused the problem, but inflation cannot cure it.

The period between world wars taught two other lessons: 1.) The reactions to a crash may do more damage than the crash does. 2.) Winston Churchill's going off the gold standard did so little damage that it raised a question whether the world might get along without gold in the gold standard. Thus setting the stage for substituting the dollar as the international currency at Breton Woods in 1945, and Richard Nixon later going off any currency standard at all in the 1970s, after Charles de Gaulle tried to corner all the gold. After all, if one nation owns all the gold, retaining a gold standard means no one can buy anything.

Originally published: Thursday, January 04, 2018; most-recently modified: Wednesday, May 29, 2019