Please, click here to read this article in pdf format: October 8 2012
As we pointed in our last letter, we
have lately noticed that there is an ongoing debate on whether (or not)
the world can again embrace the gold standard. We join the debate today,
with an historical as well as technical perspective. Today’s letter
will deal with the historic part of the discussion. In the process, you
will see that we side with some popular ideas, while we challenge
others.
The gold standard will be the last option: If adopted, it will be out of necessity and in desperation
We are not historians. In our limited
knowledge, we note however that historically, the experiment of adopting
a gold standard –or a currency board system- was usually preceded by
extremely trying moments, including the loss by a government of its
legal tender amidst hyperinflation.
The change to a commodity standard has
often been then out of necessity. We witnessed one of these episodes
first-hand, in Argentina, back in 1991. The local currency was decreed
convertible into US dollars (i.e. a currency board) at a rate of 10,000
to 1, and assigned a new name: peso argentino. The method with
which this was carried out challenges the current speculation regarding
gold, according to which gold bullion would be confiscated, in
order to provide reserves to a central bank daring to return to the gold
standard. In Argentina, US dollars were not confiscated to back the
peso. There was no need do that. On the same grounds, we don’t think
gold would need to be confiscated, although one must never, ever
underestimate stupidity.
How did Argentina implement its
convertible system? The central bank adopted two relevant measures: The
first was to change its charter to prohibit holding government debt. The
second measure was to commit to sell unlimited dollars at the established peg of 10,000 to 1. Of course, the first measure was later violated. But that’s a discussion for another day. What it matters is that they committed to sell the asset backing their liability (i.e. the peso), but not to buy it. From
then on, nobody dared to challenge the central bank until 1994-5, when
the Mexican peso was devalued. And even then, the system passed the
test.
The 10,000:1 peg was based simply on the
fact that that was back then, the amount of local currency per each US
dollar in reserves. It is very conceivable that, under an
inflationary spiral, the US government may proceed similarly. If at that
time there are x thousand US dollars per ounce of gold at the US
Treasury, a peg may be established to reflect that ratio. And just like
it occurred in Argentina, we would not expect the Fed to be challenged.
From those years, we also remember this: When
the peg was set at 10,000:1, there were many who thought that the US
dollar was still underpriced. However, think about this: Why would the
market have paid for your US dollars more than 10,000 (Australes), when
the market knew that, in the absence of a bid, all you could get from
the central bank was going to be 10,000? We can very much
foresee a similar situation where, the market price of gold collapses
from its peak to the established peg, leaving painful losses.
A gold standard with reserve requirements below 100% will not work
There were many flaws with the currency
board rehearsed by Argentina. But remember: It was established out of
necessity, without time to plan. Just like the European Union is
handling its problems today and just like the US will handle theirs
tomorrow…
The most important flaw, in our
opinion, was that it left the central bank in its role as lender of last
resort, while at the same time it allowed banks to have reserve
requirements below 100% (about 30%). Therefore, the credit multiplier
was after all still very much in place. The fact that the central bank
would later invest some of its US dollars in USD denominated (Argentine)
government debt was not critical. Nor was it relevant that banks were
coerced to buy government bonds with deposits (like they are in the Euro
zone today). The crux of the matter was that as both of these things
happened, the central bank was….well, the central bank! The lender of
last resort! Had the central bank been only a note bank for legal
tender, without any other responsibilities, the Argentine default of
2001 would have not triggered a systemic crisis. But it was not a note
bank, it was the lender of last resort and the crisis became
systemic….just like we fear will happen, if the US implements a gold
standard in a rush. Why do we fear this? Because if all plays out that
way, the world will lose faith in the gold standard for the wrong
reasons.
The Bank of Amsterdam and the Industrial Revolution of the XIX century
Popular wisdom has the birth of the
industrial revolution in XIX century England. Some, with a technological
emphasis, are willing to concede that already by the time of the French
Revolution, the years of the Enlightenment, the seeds had been planted
for the technical developments that would come later. The Napoleonic
Wars are thus regarded by these people as an interruption, a hurdle, in
the race by the West to conquer the world. Only a few point out and even
admit that, as a coincidence, during that industrial revolution and
particularly at the end of the XIX century, gold was money. But this is
treated as a mere coincidence. There are others too, who are convinced
that if gold had not been money, if Great Britain had not adopted the
gold standard, the speed of the industrial revolution would have been
even more impressive.
None of this, in our opinion, could be
farther from the truth. We are not historians and we expect many to
challenge our comments today, but we offer this view: The
industrial revolution did not begin in England, but in what was then
known as the Low countries, and was enabled in a decisive way by a gold
standard with 100% reserve requirement established by the city of
Amsterdam. There are two parts in this conjecture: The first
one is that the industrialization began in the Low Countries. We side
here with Henri Pirenne and suggest that this birth was brewed by the system of Hansastädte, and in particular, in Brugge, where very early, for instance, the Medici opened a branch.
If our view is correct, the
counterfactual argument therefore lies in proving that the development
from that stage into the XIX century would have been possible, had the
city of Amsterdam not established the Bank of Amsterdam (Amsterdamsche Wisselbank). We leave to our readers to do their own research on this speculation.
The Bank of Amsterdam took upon itself
to accept bullion in deposit, issue notes in exchange for circulation
and charge (yes, you read well, charge!) depositors for their bullion as
well as a “liquidity” fee for making such deposits liquid, thanks to
the issuance of their (i.e. the bank’s) notes.
In his book, “The Ascent of Money”, Neil Ferguson makes a few interesting observations about this period:
Inflation (don’t ask us how Mr. Ferguson
measured it, but this is what we read) fell from 2% p.a. between 1550
and 1608 to 90bps pa between 1609 and 1658 and 10bps p.a. between 1659
to 1779! This represents no less than 229 years of price stability! With
the low life expectancy of those years, this period would have easily
encompassed 9 generations. Can you even begin to picture that? In
today’s terms, this would mean that the currency held by an American
living back at the time George Washington was president would have kept
its purchasing power to this day, had a similar financial stability
taken place!
In 1602, the Vereenigde Nederlansche
Geoctroyeerde Oostindische Compagnie (East India Co.) had its IPO.
Between 1602 and 1733 its share price rose from par (100) to 786, in
spite of the fact that between 1652 and 1688 they had to face, with
violence, the attacks of Britain at their trading posts. By 1650, with
the dividend payments the company made, buy-and-hold IPO holders would
have earned an annual compounded rate of return of 27%. Given how
popular this IPO was, this context of financial stability brought about
perhaps the most widespread capitalization ever witnessed by a nation.
This stability was based on a 100%
reserve requirement. With it, when the East India Co. began to fall, its
decadence was gradual: It took 60 years and by 1794, it was still worth
120 or 20% above par, in terms of a currency that had preserved its
value all along! In other words, it was still 20% up in real terms. In
real terms also, by 1690, the company was bringing back to the harbours
of the Netherlands about 156 ships per year, all loaded up with
consumption goods for the enjoyment of the Dutch people. In other words,
on average, one ship every two days was being loaded up in a trading
post in Asia. There were no cranes, no trains, no telecommunications.
In summary, the Argentine case
and the Dutch Golden Age suggest that the elimination of the credit
multiplier (i.e. extinction of shadow banking) is more important than
the asset backing a currency. The Argentine case shows what can go
wrong, when a currency is asset backed, but reserve requirements are
allowed below 100%. The Dutch case shows what can go well, when a
currency is commodity-backed and reserve requirements are held at 100%. Bear in mind that the notes of the Bank of Amsterdam were not enforced upon the people, they were not legal tender.
Unlike today’s policy makers, the Dutch
of the XVII century had the luxury of planning their system, based on
the collective wisdom of their merchant class. Does anybody think that
the Dutch Golden Age would have taken place had the Bank of Amsterdam
not existed? Does anybody think that England would have been able to
accumulate capital from its natural resources (wool, meat), without the
demand of the early industries of Brugge, Liege,Amsterdam or Antwerp?
We don’t!
Therefore, the question that lies before
us is: How can we replicate the success of the Bank of Amsterdam, in
today’s context? How can we not fall prey to necessity, just
likeArgentinafell back in 1991? That remains the subject for our next
article.
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