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The Gold Paradox and the "War to End All Wars"

The Gold Paradox and the "War to End All Wars"
"""As the clouds of war gathered before the start of the Great War, the 'War to End Wars,' WWI, pundits predicted that any major war would last only a few months; the combatants' treasuries would quickly run out of money...
This was a wise observation; war is by far the most costly 'activity' that humanity can engage in... Not only is the direct cost of providing 'guns' enormous, but war also involves capital destruction, population loss, trauma, desolation... truly Hell on Earth.

Nonetheless, instead of a ""few months,"" the carnage lasted years... millions were killed and maimed, Europe was destroyed... how was this possible? After all, even though England had called its loans, there was still far too little money in the treasury to support years of war rather than months.

When the treasury is depleted, the government appears to have only two options for funding the war machine: raise taxes or borrow money. Neither option was viable; raising taxes would spark a revolution... if there was any taxable income left in the economy. Borrowing was too expensive, assuming there was any more money available to borrow.

Thus the paradox: how could the combatants pay for mayhem far beyond their treasuries' money (Gold) holdings? To understand this, we must look at the history of money and the 'classical' Gold standard that the world followed in the run-up to WWI.

A true or 'unadulterated' Gold standard is comprised of three components or 'legs'... Gold is, first and foremost, money, and only money... a la J. P. Morgan... with Silver and Copper serving as supplemental money to allow for smaller transactions. Gold coins are too valuable to be used for everyday purchases.

The other two legs are debt (borrowing) and credit (not borrowing); today, debt and credit are grouped together, which is a mistake because they are two distinct phenomena. The bond market or mortgages can both represent borrowing. Mortgages are merely collateralized loans, whereas bonds are unsecured (based on 'faith and credit').

For example, the Treasury may issue (sell) a bond, which is a promise to repay the principal in a number of years, depending on maturity, and to pay interest during the bond's life. The buyer pays cash to purchase this paper in order to earn interest... or so the buyer thought. Today, holding bonds is a fool's errand; most bonds are bought and sold in the hope of capital gains; a drop in interest rates makes the bond more valuable, and vice versa.

Credit, on the other hand, does not involve any money changing hands; credit is given rather than borrowed. For example, a tank truck carrying 20,000 liters of gasoline arrives at a gas station to replenish the tanks. Depending on the current fuel price, this delivery will cost around $40,000. There is no way the gas station attendant will pay this amount; there is no COD. A bill or invoice is signed instead, with payment due in thirty, sixty, or up to ninety days.

In effect, the funds to pay this bill will be derived from ongoing fuel sales. Meanwhile, the signed bill has value because it will be paid, redeemed in cash; only a true disaster would prevent the continued sale of gasoline... or beer, flour, cabbages... or any other consumer good in high demand.

Prior to WWI, these bills were known as Bills of Exchange, or Real Bills, as Adam Smith dubbed them. These bills were in full circulation, which meant they were used as payment for the majority of transactions... a critical monetary role. The Gold Standard's clearing system was represented by the Bill market. Importantly, unlike bonds, which could be printed and sold on the spur of the moment, bills could only be drawn against real goods delivered to retailers.

As more consumer-based purchases are made, more goods are delivered, and more bills are issued, providing monetary flexibility, which 'pure' (Rothbardian) gold money circulation lacks. Indeed, this lack of 'flexibility' is one of the excuses used by Gold haters to criticize Gold, despite the fact that the problem is clearly not Gold per se, but the lack of a Bill market; the clearing mechanism of a proper Gold standard... a market that was destroyed with the outbreak of WWI... and was never restored.

Furthermore, bills do not cause inflation; all bills expire (are paid) in less than ninety days, and bills mature into gold coins. In contrast, newly printed Fiat never disappears... but rather serves to fuel inflation. This is not just monetary theory; prior to WWI, world trade was cleared by Bills of Exchange in circulation; following the destruction of the Bill market, pre-WWII levels of international trade did not return until well into the 1970s.

The pre-World War I British empire, the one depicted in 'The Sun Never Sets,' was run from London, and the British central bank had only 250 tons of gold in its vaults; today, the US Fed allegedly has 8,000 tons, and various other countries each have several thousand tons. Of course, there is no gold in circulation, nor are there any bills of exchange.

Bonds are printed on the spur of the moment and purchased with cash; most last for years, if not decades. Bills are drawn against real goods delivered and mature in 90 days or less, responding instantly to market changes. This rapid feedback mechanism is critical for maintaining financial stability; prices and interest rates react far too slowly to market changes. The result is wild and growing fluctuations in the economy.

Unfortunately, we never had a pure gold standard; the 'Classical' Gold Standard, as it existed, had another 'leg' or component, usually referred to as the 'Fiduciary' component... Fiduciary refers to promises rather than bills or money.
Historically, banks provided products that were convenient. Banks, for example, issued letters of credit hundreds of years ago; a merchant planning a trip to make foreign purchases went to a bank and gave the bank Gold in exchange for a letter of credit. He could avoid carrying large sums of Gold coin on his travels by presenting the letter to a bank at his destination, redeeming his Gold, and conducting his business.

Furthermore, banks kept not only gold in their vaults, but also bills in their portfolios... in fact, banks were frequently referred to as discount houses. Bills are the closest form of paper to physical gold... and they are also an earning asset. A bill with a due date ninety days in the future has less current value than the same bill on due day; this is the discount.
Like this; suppose the gas station has a spurt of sales, and sells the 20,000 Liters early; now has cash to pre-pay the invoice. Obviously, the gasoline wholesaler and the retailer can reach an agreement; the retailer will pre-pay for a consideration (discount) and be prepared to order a new gasoline delivery.

But there are a few inconveniences with Bills; in order to use a Bill to pay another party, the Bill has to be re-assigned... just like a letter of credit it's not a bearer instrument, but is assigned to one payee. Furthermore, Bills come not in round denominations, but in all manner of amounts; a truck load of Gasoline is rarely $40,000 in round numbers, but more like $38,672.80... Not so convenient when making payments.

Finally, every exchange of Bills involves (re)calculating the discount; every day closer to maturity increases the market value of the Bill... and this fact needs to be taken into account.

In the interest of convenience, banks started to issue bank notes; large denomination notes, bearer instruments, with round number values... and to balance their accounts, they held Gold (and Silver) in their vaults, as well as Bills in their portfolio.
Crucially, the books of the bank must balance not only in amplitude (assets = liabilities) but also temporally. Notes are fully liquid, a cash equivalent; to balance notes issued, assets held must also be cash equivalent (fully liquid) else we run into problems. Of course, Gold and Silver in the vault are cash... but Bills of Exchange in the portfolio are (almost) as good.

In order to keep Bills in their portfolios, banks had to constantly buy new bills as the old ones matured into Gold coin. One hundred percent of Bills mature in not more than ninety days... so, in case of unusually large demand for Gold, the bank would simply cut down on Bill buying... and allow Gold to accumulate and meet the demand. Worst case, stop buying... or even go into the superbly liquid Bill market and sell (re-discount) some bills even before they mature. No runs on the bank!

If we only stick to the three legs, we have a stable, market driven financial system; the Classical Gold standard came close. My father used to refer to pre-WWI days, with a fond faraway look in his eyes as 'The Peaceable Days'. Under the Classical Gold Standard, the world enjoyed the most peaceful and prosperous era in Human history. Unfortunately, the camel had his Note... er nose... in the tent. Chicanery began on two fronts.

On the bank liability side, small denomination Notes were issued; these had only one real purpose, to start convincing people that paper Notes (at first redeemable in Gold) were actually as 'Good as Gold'; a bare faced lie. IOU's are not real stuff; claims on Gold are not Gold.

On the bank asset side, more chicanery; in addition to cash equivalent assets like Gold and Bills, the banks started to use Bonds as assets. This is where the real trouble lies; bonds do not mature into Gold in ninety days or less, rather they mature (if they ever actually do mature) in years or decades. Thus, if there is a large demand for Gold (cash) Bonds must be sold.

Selling bonds causes bond values to drop; capital losses and ill-liquidity if not bankruptcy soon follow. Thus lethal runs on the bank become possible. To counter this, rather than forbid Banks from holding bonds in their portfolios, central banks 'lenders of last resort' were created... as if lending could resolve problems caused by too much lending!

The original law passed by Congress to create the Federal Reserve specified that the Fed's assets be constrained to commercial paper only... holding Bonds (that is, monetizing Government debt) was specifically forbidden... Of course, the law against the Fed not being allowed to hold Bonds was broken almost immediately; the law was changed retroactively.

There we have it; the camel has now taken over the whole tent. Treasuries issued bonds and banks issued Notes 'backed' by the Treasuries. No limits in sight, no market reality. Thus was funded the mayhem of WWI; fake money printed with no firm limits. But it did not stop there; WWII was also funded by Government bonds and paper Notes; the US had the highest debt to GDP ratio in history towards the end of WWII... and the game goes on. Now we come to the crunch; today the US debt to GDP ratio is even higher than it was at end of WWII... and so is the debt to GDP of Western countries.

What cannot go on forever will not. All the Fiat currencies ever issued have failed; and the current crop of Fiat is no different. At the rate Fiat is being created today, the end or as Von Mises called it the 'Crack Up Boom' is now upon us. The only question is, will the world again accept some IOU to play the role of money... say SDR's (special drawing rights issued by the IMF)... if so, the tragedy will repeat down the road. Or, will Gold be recognized as Money... and will an honest society with honest economics be restored.

Hope for the best and prepare for the worst."""

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"The Gold Paradox and the "War to End All Wars"" was written by Mark under the Finance category. It has been read 100 times and generated 0 comments. The article was created on and updated on 13 January 2023.
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