By happy coincidence, two articles on a subject near and dear to our heart recently appeared within a day of each other. The first was Steve Saville’s Gold and Deflation (April 19, 2005). The second was Fred Sheehan’s “Gold and the ‘Flations,” in The Gloom, Doom & Boom Report (April 20, 2005). Both deal with the landmark empirical study of the performance of gold in inflation and deflation, Roy W. Jastram’s The Golden Constant. [1] Mr. Sheehan’s article does so directly and by name, presenting a balanced and nuanced treatment of the work. Mr. Saville’s essay does so indirectly, by expounding with unusual clarity and vigor a thesis that runs directly counter to Professor Jastram’s conclusions but has nevertheless become conventional investment wisdom: the notion that gold is a hedge against inflation, and conversely should be shunned in deflation.

We don’t have much to say about Mr. Sheehan’s article, other than read it. But we do have a few bones to pick with Mr. Saville’s. The inflation hedge thesis has bothered us for some time, and in light of the current flurry of related commentary, we think it worth reviewing it once more in some detail. [2] In so doing we don’t mean to pick on Mr. Saville. He can’t be fairly blamed for originating the thesis, and in fact he has done us a great favor in laying out this cadaver so accessibly.

Habeas Corpus

Although Mr. Saville doesn’t mention The Golden Constant by name, he does acknowledge its central point: that over the past several hundred years, gold has in fact performed well during deflations, and poorly during inflations:

Specifically, during deflationary episodes of the past gold was the official money of the land — gold coins either circulated as currency or the world’s senior currency was convertible into gold at a fixed rate — and, as a result, it represented liquidity. All taxes could be paid in gold, all debts could be repaid in gold, and almost all purchases could be made in gold. Under such a monetary system, when the purchasing power of the national currency rose as a result of deflation there was a concomitant rise in the purchasing power of gold.

But that was yesterday, and yesterday’s gone. It’s different now.

Under the current monetary system gold is not the official form of money and therefore does not represent liquidity. In particular, taxes cannot be paid with gold, debts cannot be paid with gold unless a special agreement to do so is made between the borrower and the lender, and more than 99% of purchases cannot be made with gold. Therefore, in a situation where dollar-denominated obligations were huge and the supply of dollars was contracting many private investors would probably be forced to sell their gold in order to obtain the dollars needed to meet their financial obligations.

To get a sense for how gold will perform during a deflation in this new world, Mr. Saville refers us to the record of another demonetized precious metal, silver, and to the performance of gold during Japan’s recent contraction:

The last remaining official link between gold and the dollar was severed in 1971 and, not coincidentally, deflation hasn’t occurred since that time. Unfortunately, this means there aren’t any historical examples of how gold performs during deflation when the metal is not the official form of money. However, we can get an idea of what to expect from gold if deflation were to occur now by a) looking at how silver performed during the 1930’s, and b) looking at how gold performed in yen terms during the first half of the 1990’s (the period following the bursting of Japan’s credit bubble).

Finally, we are told, gold can’t be a hedge against both inflation and deflation at the same time. Since it’s a hedge against one, it’s not a hedge against the other. One must know why one owns:

Before we re-visit our opinion that a bigger inflation problem is what the next few years hold in store we will quickly address the idea that gold, at the present time, is an effective hedge against both deflation and inflation. This idea violates the laws of logic because something can’t be itself and simultaneously be something else. Or, to put it more aptly, it is not possible for something to be a hedge against one financial outcome and to simultaneously be a hedge against the opposite outcome. What this means is that if you are an investor in gold you cannot avoid taking a position on the inflation/deflation issue. It certainly makes no sense to just buy gold and assume that you are going to be fine regardless of whether we get inflation or deflation.

Scalpel, Please

To most readers, the inflation hedge thesis no doubt seems straightforward and unremarkable. It accords not only with conventional wisdom, but also, for some of us at any rate, with what we thought we observed in the late 1970’s.

However, we have several problems with it. One, as noted above, the thesis is completely at variance with the considered conclusion of a serious empirical study. It seems to us the only way to dislodge The Golden Constant is on its own terms, i.e., statistical study utilizing consistent methodology. It’s not enough simply to assert that things are different now, even though that assertion may seem rational and have intuitive appeal. Two, more troubling, the inflation hedge thesis is largely the intellectual outcropping of several unexamined and unarticulated theories that are little more than spin supportive of contemporary monetary policy. Three, most troubling, the inflation hedge thesis focuses investors’ attention on the wrong issue, the intellectual dead end of the inflation-deflation debate, rather than the right issue, which is how best can people protect themselves against the no-longer remote possibility of monetary collapse. In New Era parlance, the debate is a box, while owning gold is an outside-the-box decision.

Let’s dig in.

The Inflation Hedge Thesis vs. The Golden Constant

The Golden Constant examined Anglo-American price data over a period of 416 years, establishing a statistical relationship between a price series constructed for gold, on the one hand, and a price series constructed for wholesale commodities, on the other. It concluded that [p. 175]:
· Gold is a poor hedge against major inflations.

  • Gold appreciates in operational wealth in major deflations.
  • Gold is an ineffective hedge against yearly commodity price increases.
  • Nevertheless, gold does maintain its purchasing power over long periods of time. The intriguing aspect of this conclusion is that it is not because gold eventually moves toward commodity prices but because commodity prices move toward gold.
    The work is refreshingly free of bias: Professor Jastram approached the study without an agenda. He was neither an apologist for the fiat monetary system, nor a gold bug. Indeed, he explicitly noted that “…we are accustomed to thinking of gold, itself, as money. It is not.” [3]

For those who seek to read in its entrails a guide to the future, the work has two weaknesses. The first is definitional: as Mr. Sheehan notes, it uses a somewhat quirky variant of the mainstream concept of inflation/deflation: “any period of rapidly rising [or falling] prices.” We’ll consider the definitional issue in due course. But by far the biggest problem with it is the accident of timing of its release, the middle of the 1970’s. This truncation of historical perspective resulted in an apparent anomaly in relation to its core findings. This was the experience in the United States from 1951 to the date of publication. Although gold’s purchasing power followed the typical pattern up until 1970, after 1970, the price level rose, and so did gold’s purchasing power. This had never happened before.

This anomaly is what gives the inflation hedge thesis its opening. Mr. Saville maintains that 1971, the year the United States severed the last thin link between the dollar and gold by abrogating the Bretton Woods Agreements, represents a bright line for gold. Before that date, gold was on the money side of the ledger, and, since it was tied to money, it behaved like money. After 1971, gold was banished to the “stuff” side of the ledger. Since gold is no longer tied to money, it’s just another commodity, and will act like other commodities in inflation and deflation.

Professor Jastram did not see it that way. He had never viewed gold as being on the money side of the ledger in the first place. It was always just a commodity, albeit one that bore a special — a constant — relationship with other commodities over time [p.130]:

As we have said, the purchasing power of gold depends on the relation of commodity prices to gold prices. A close scrutiny of this relationship over time discloses an affinity of a curiously responsive character. It could be called the “Retrieval Phenomenon”, meaning that the commodity price level may move away higher or lower, but it tends to return repeatedly to the level of gold.

Professor Jastram made no special note of the end of Bretton Woods, although that event had occurred 6 years before publication. In fact, he did not mention it at all. For him, the significant date was 1968, which marked the end of the London Gold Pool, the ill-starred attempt by the Western central banks to control the market price of gold. The market distortions created by the price suppression of the London Gold Pool, rather than the abrogation of Bretton Woods, explained the price anomaly of the early 1970’s. Why didn’t Professor Jastram attach the same, or any, significance to 1971? It wasn’t because he was sloppy, as anyone who has read the book can attest. Nor was it because he was unaware that the abrogation of Bretton Woods was monetarily significant, as anyone who has read his testimony to the U.S. Gold Commission can plainly see. [4] No, the reason he didn’t mention Bretton Woods is that the “official” character of gold, in contradistinction to the assertion of the inflation hedge thesis, is not what drove the relationship between gold and other commodities over time. During the hundreds of years covered by his study, gold went in and out of relationships with official money. These official links were simply not relevant to his thesis.

It is tempting to speculate on what an extrapolation of Professor Jastram’s analysis would do with the spike in the dollar price of gold at the end of the 1970’s, its dramatic decline over the period ending with the Bank of England sales at the end of the 1990’s, and everything in between and since. [5] We are unaware of any credible scholarship that has successfully attempted a “bringdown” to the present day; we’re not even sure it can be done, given the changes in the measurement of price data that have occurred since 1976. Nor are we sure that it would settle anything, because we’re so close in time. But that’s the sort of effort that will be needed to unseat the defending champion. In the meantime, in relation to The Golden Constant, the inflation hedge thesis is little more than an old wives’ tale. Unfortunately, that hasn’t stopped it sprouting like a weed. Lacking dispassionate empirical support, it rests instead on other theories that at root are political rather than economic.

The State Theory of Money

A critical element of the inflation hedge thesis is that gold is not money. Why not? Because it’s not “officially” recognized as such; the government has demonetized it. You can’t use it to pay taxes or to buy most things. It’s not linked to the national currency. The implicit corollary of this position is that money is whatever the State accepts as such: the State, not the market, declares what money is.

This concept of money, known as “chartalism”, has an interesting lineage. It was introduced to the world by an obscure German economist named Georg Friedrich Knapp at the turn of the 19th century, in a book fittingly entitled The State Theory of Money. [6] Its main point was that “[m]oney is a creature of law”, and that whatever the State deigns to accept as payment for its taxes is, ipso facto, money.

Knapp’s theory would probably have remained safely quarantined in the German-speaking world had it not been for the exertions of none other than the Pied Piper of Inflationism, John Maynard Keynes. Keynes warmly embraced chartalism. He described it as the pinnacle of monetary evolution near the beginning of his A Treatise on Money [7], first published in 1930 [pp. 4-5]:

It is when this stage in the evolution of Money has been reached that Knapp’s Chartalism — the doctrine that money is peculiarly a creation of the State — is fully realized. / Thus the Age of Money had succeeded to the Age of Barter as soon as men had adopted a money-of-account. And 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. To-day all civilized money is, beyond the possibility of dispute, chartalist.

Like many of Keynes’s high-handed, breezy assertions, this notion, that fiat is the grand culmination of the march of monetary progress, is ideological rubbish. It is serviceable, however, as the theoretical underpinning for his vision of a world run by boffins using gold as a stage prop, a vision that uncannily prefigures the one that was actually fashioned by Keynesians during the remainder of the 20th century [p. 300]:

Moreover, if we could once overcome the many obstacles in the way of a scientifically managed world system, it would not add much to our difficulties to give it a gold camouflage. Provided that the world’s currency system is managed with plenary wisdom by a supernational body, and provided that, as a part of this scheme, gold is everywhere excluded from the active circulation, then — since we can make the gold standard worth what we choose — the ideal standard of value, whatever that may be, is compatible with the forms of a gold standard of value; — it is only necessary for the Supernational Authority so to manage gold as to conform to the ideal standard. [Emphasis supplied.]

Chartalism is political theory, not economics; ideology, not financial analysis. Gold bugs have a rather different ideology. We take the position, pace Professor Jastram, that gold is permanent, natural money, which is precisely why it behaved like money in his study. That money is a creature of the market, not the State. That the regression theorem of von Mises put to rest the notion that money can derive from something other than commodities. [8] That the State’s off-again, on-again relationship with gold stems from the State’s desire to camouflage its paper, but only when convenient. That gold’s unique properties — indestructibility, rarity, malleability and divisibility — are what made it the market’s choice for money over the millennia, and that the State can no more demonetize gold than it can strip gold of those essential properties. That the acceptance by the State of a particular item in payment of its forced exactions is not probative, let alone dispositive, on the subject of what money is and whence it derives. That our 30-odd years of “demonetization” will turn out to be just a footnote in the broad sweep of monetary history, one of many suspensions of specie that have occurred from time to time, in each case with disastrous consequences.

The State Theory of Money imbues the inflation hedge theory with its arrogant, upside-down assertion that it was the State that gave value to gold. The reality was the opposite: the perception of gold backing is what gave value to the State’s paper. This is why Keynes recognized the necessity to use gold as camouflage in the Brave New World he had in mind for us.

The Commodity Theory of Gold

The flip side of the notion that gold is not money is that gold, having been demonetized, is now just another commodity. That is why it is a hedge against inflation: it can be expected to behave like other commodities.

The genesis of this viewpoint is also interesting. Professor Jastram considered the question back in 1977 [p. 178]:

Andre Sharon, head of the international research department at Drexel Burnham, Inc., notes, “the value of gold essentially derives from its capacity to preserve real capital and purchasing power.” I select this particular quotation because of the prestige of the organization and the position of the spokesman, but statements in this vein can be found in great numbers. They can be traced back for generations and in many countries. / How can this proposition so contrary to statistical fact become so widely believed and quoted? Possibly because gold has preserved capital in cataclysmic cases it is easy to infer that it can be trusted to do the same in less severe circumstances. To extrapolate from gold’s protection in singular catastrophes to its use as a strategy against cyclical inflation is an example of faulty inductive reasoning.

Our own take is somewhat less charitable, at least insofar as the commodity theory gained currency in the years following 1971. Rather than excuse the theory as an example of faulty inductive reasoning, we tend to think it was developed largely as spin placed on the unilateral decision by the United States no longer to honor requests to redeem its currency in gold. The commodity theory once again advances the notion that the State gives value to gold, and not vice versa, in maintaining that the unbacked paper of a defaulting debtor is in fact more valuable than the real money that backed it prior to the default. [9]

In any event, we think the commodity theory of gold is as wrong as the State Theory of Money. We turn once more to Professor Jastram, and while we get no joy from his view that gold is not money, we take comfort from his empirical evidence that gold acts like money. We turn also to common sense, and note the fundamental economic difference between other commodities and gold: all other commodities are produced for consumption, whereas gold, precisely as a function of its money-like qualities, is produced for accumulation. [10] Virtually all the gold ever produced still exists somewhere, albeit not necessarily where governments claim it does. Set aside for the moment the massive empirical evidence marshaled by Professor Jastram that demonstrates how differently gold and other commodities have behaved over time. How is it even reasonable to expect such fundamentally different things to act alike?

The Dollar Short Theory

The commodity theory of gold has a twisted sister, the “dollar short” theory. Mr. Saville alludes to it, but to his credit doesn’t hang much on it. The theory, which recently enjoyed a brief vogue among several prominent investment letters, holds that in a deflation, fiat dollars, not gold, will become precious and rare, because everyone will need them to pay off the gargantuan dollar-denominated debts that lard the planet. Effectively, the credit expansion will have left the world in a short position vis-à-vis dollars.

If the Fed didn’t invent this little gem, it should have.

Consider why it was we went onto fiat in the first place: so the State could escape the discipline of gold, and print its way to nirvana. Consider what the Fed has already done to stave off the commencement of a credit contraction: it has presided over the greatest expansion of money and credit in history. Consider the threat (promise?) by Mr. Bernanke, the Fed chairman apparent, to take unconventional measures should the need arise, made in the remarks we somehow never tire of citing [11]:

But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Finally, consider how long today’s public would tolerate a central bank that failed to carpet bomb it with fresh fiat once a credit contraction gets under way: about as long as an average American Idol audition.

The dollar short theory is simply not consonant with political reality. We are comfortable asserting that there will be no shortage of fiat “dollars”. Ever.

Having said that, we must concede that the dollar short theory does allude, however unwittingly, to a real possibility. In the type of hyperinflation that would likely issue from the Fed’s manic efforts to stop a liquidation cycle, it is perfectly possible that fiat money will seem scarce. It always does in hyperinflations, which is why the printing presses have to run all night. This is because nobody wants to hold it; people buy whatever they can, as soon as they can, because whatever they buy will lose its value less rapidly than the depreciating currency unit they use to buy it. But this is a velocity issue, not a true cash shortage issue. The currency unit’s apparent scarcity in such circumstances is not typically associated with an increase in its purchasing power.

The Silver Example

Mr. Saville suggests that silver’s record during the deflation of the 1930’s shows what gold may be expected to do under similar circumstances. The comparison, it seems to us, is inapposite. Silver is different. It has had a unique and difficult history as money, exacerbated by the negative consequences of fixed ratio bimetallism, prolonged government intervention and massive private market manipulation. [12] More important, it is a commodity with an enormous number of industrial applications. It is thus produced both for consumption, as it is used up in military and industrial processes, and for accumulation. We don’t doubt that it too will someday make a comeback as a monetary metal. We can even speculate that it may do so as gold’s nearer equal in value than has been the case historically, as a result of scarcity caused by the exhaustion of above-ground stockpiles over the years. [13] Indeed, silver is currently the basis for Mr. Salinas Price’s important monetary reform effort in Mexico. [14] However, both its history and its nature are so unique as to make it a questionable guide to gold’s behavior in a deflationary setting.

The Japanese Example

Mr. Saville suggests also that gold’s performance in yen terms during the recent Japanese deflation provides further guidance as to how gold will behave in a dollar-denominated deflation. The comparison is original and provocative, but troubling in several respects.

First, Mr. Saville acknowledges that what Japan experienced is not a deflation for purposes of his analysis. But here is where the definitional issues we touched on previously become important. Because, curiously enough, the Japanese experience probably was a deflation for purposes of Professor Jastram’s study. Only not during the time frame suggested by Mr. Saville. He adopts, correctly, in our view, the Austrian conception of deflation: “Genuine deflation is a sustained contraction in the total supply of money and credit, NOT a fall in the general price level.” But what happened in Japan appears to have been just that: a fall in price levels, not a sustained contraction in the money supply. [15] Mr. Saville presents an ominous chart showing a steady decline in the yen-based gold price from 1990 to yearend 1995. But this timeframe does not accord with the “deflation-like” situation in Japan. It was not until 1992 that the rate of increase in M1 staged its sharp — and short — decline, from 8.8% to 1.9%. [16] And it was not until 1995 that the Japanese CPI first went negative; that is, what mainstream economists associate with the Japanese deflationary experience did not even begin until the last quintile in Mr. Saville’s chart, when yen-gold appears to bottom and stage a sharp recovery.

Second, the Japanese comparison ignores aggressive management of the gold price under the rubric of the “strong dollar policy” that began in earnest in the mid-nineties, precisely, it is held in some circles, because of the danger that Japan’s distress posed to the viability of the post-Bretton Woods fiat monetary system. [17]

Third, to consider in isolation the yen-gold price in the context of that still-functioning dollar-based global monetary system seems unlikely to yield analytically useful information. Gold is, and was during the period considered by Mr. Saville, priced globally in dollars. Accordingly, to show that it took fewer yen to buy gold is tantamount to showing that it took fewer yen to buy the dollars needed to buy gold; this ratio seems merely to be a more roundabout way of expressing the dollar-yen exchange rate.

In fairness, Mr. Saville freely concedes that the silver and Japanese examples are not ideal, but rationalizes their use with the observation that “they’re all we have” by way of empirical examples to suggest how gold is likely to behave in a deflation at a time when gold is not officially accepted as money. We disagree: the span considered by Professor Jastram included a number of suspensions, notably including those during the Napoleonic Wars and the First World War. As noted above, Professor Jastram did not deem the official link to be relevant to his findings. And, for what it’s worth, our own view is that the current experiment in fiat money will turn out to have been just another suspension, and that some form of gold backing will be reintroduced to the currency unit within our lifetimes. We certainly can’t prove gold will return as official money. By the same token, however, Mr. Saville can’t prove it won’t.

Problems in Applied Theory

It is not just the thesis itself, or its components, or the examples adduced to support it, that give us pause. We are troubled also by the difficulty of applying it in the real world.

Mr. Saville’s final observation, that gold can’t be a hedge against both deflation and inflation, clearly illuminates the issue. It is his position that if we are facing inflation, gold will be a good investment, but that if we are facing deflation, gold will be a poor investment. As he believes we are facing inflation, he recommends gold.

Let us ignore for present purposes the contrary holding of Professor Jastram’s work, and accept for the sake of argument the contention that things are indeed different since 1971.

There are two problems in applying the theory in practice. The first is semantic. If we’re going to make an important decision based on which intellectual category best fits the current environment, we’d better get our categories right. But how much reliance can we put on the integrity of the terms “inflation” and “deflation”? As we have seen even in this brief exercise, the terms mean different things to different people. Professor Jastram used a variant of the mainstream definitions. Mr. Saville uses the Austrian (sustained contraction in money and credit) rather than the mainstream (lower prices) definitions of deflation. Marc Faber, in the investment letter in which Mr. Sheehan’s article was published, further distinguishes between asset inflations and consumer price inflations. While there’s a fair degree of overlap, there seems to be considerable scope for confusion.

The second is epistemological. Even if we get our categories down, how can we really know what’s going on out there? What is economic reality today? Our own view is that many economic statistics are politically motivated and transparently false, that much of what passes for market price discovery is political theater, and that the current investment landscape is little more than a reflection in a funhouse mirror in which all relevant information is savagely distorted.

But whether or not we are correct in that opinion, it is inarguable that there are many confusing cross-currents in today’s financial markets, such that even experts who spend all their time thinking about these things are at a loss as to which categories best fit the situation. We quote Doug Noland, a knowledgeable analyst who writes extensively on contemporary market phenomena [18]:

I have never experienced an environment with so many Major Uncertainties. Is the U.S. Bubble Economy slumping or in the midst of an intransigent inflationary boom? Are general inflationary pressures gaining critical mass, or is “deflation” waiting patiently to make its appearance?

If Mr. Noland is perplexed, what possible hope do the rest of us have of accurately discerning what’s happening?

Come Firewalk with Me

But our biggest problem with the inflation hedge thesis is that it takes our eye off the ball. The critical question today is not whether we face deflation or inflation, but whether and when we face monetary collapse. There was a time when just saying that would clear a room of decent, law-abiding citizens. We gold bugs had this sort of talk to ourselves. Today, however, a growing chorus of insiders is saying the very same thing, albeit in suit-speak. Consider the players and their statements:

Paul A. Volcker, former Chairman, Federal Reserve [19]:

I don’t know of any country that has managed to consume and invest 6 percent more than it produces for long. The United States is absorbing about 80 percent of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars.

I don’t know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change.

* * *

… I think we are skating on increasingly thin ice. On the present trajectory, the deficits and imbalances will increase. At some point, the sense of confidence in capital markets that today so benignly supports the flow of funds to the United States and the growing world economy could fade. Then some event, or combination of events, could come along to disturb markets, with damaging volatility in both exchange markets and interest rates. We had a taste of that in the stagflation of the 1970s — a volatile and depressed dollar, inflationary pressures, a sudden increase in interest rates and a couple of big recessions.

Peter G. Peterson, Chairman, The Blackstone Group; former Chairman, Council on Foreign Relations; former Chairman, Federal Reserve Bank of New York [20]:

The world is increasingly alarmed by America’s profligacy. It’s not just the staff of the International Monetary Fund who lecture us as if we were a banana republic. Global leaders at the Davos World Economic Forum and other venues speculate openly about how long the dollar will remain the world’s reserve currency, and about whether the U.S. financial system will take down the global economy when it implodes.

Stephen Roach, Chief Economist and Director of Global Economic Analysis, Morgan Stanley [21]:

The day is close at hand when US monetary policy must get real. At a minimum, that will require a normalization of real interest rates. Given the excesses that now exist, it may even require a federal funds rate that needs to move into the restrictive zone — possibly as high as 5.5%. Yes, this would cause an outcry — perhaps similar to that which occurred in the spring of 1997 on the occasion of the Original Sin. But in the end, there may be no other choice. Fedspeak has taken us into the greatest moral hazard dilemma of all — how to wean an asset-dependent system from unsustainably low real interest rates without bringing the entire House of Cards down. The longer the Fed waits, the more perilous the exit strategy.

Under normal circumstances, that is to say, at a point in time when the nation was not in the grip of magical thinking, comments like these could reasonably be expected to prompt editorial outrage, a hue and cry for investigation and reform, and a great deal of handwringing and fingerpointing on the part of politicians. It is a measure of just how far gone we are that when even icons of the establishment start talking like goldbugs, nobody will listen. Welcome to our world.

With mainstream luminaries now openly referring to the risk of monetary collapse, it can no longer be dismissed as an unthinkably remote possibility. So let’s think about it. What might a collapse look like? It could take many forms. Use your imagination. Our own pitch for the screenplay of Nightmare on Constitution Ave. would go something like this:

US Economy Brought to Standstill
Mon Apr 22, 5:27 PM ET (200_)

WASHINGTON, DC (Reuters) – Americans in major cities took to the streets again Monday, in protest against a sweeping set of financial measures ordered to shore up the country’s collapsing financial system.

The Bush administration, warned separately by the IMF and the Shanghai Club of international creditors again on Friday that it must take concrete steps to merit desperately needed aid, rushed a bill to Congress that would, among other things, repeal recent homeowner relief legislation, convert retirement accounts into unappetizing government bonds, tighten currency controls and levy increased penalties on burgeoning black market activities.

An important aim of the vastly unpopular plan is to halt unauthorized sales of dollar assets for foreign currency and precious metals by investors panicked by a tumbling currency and the specter of more political and economic chaos. The plan comes just months after passage of the Mortgage Relief Act (MRA), a broadly popular measure designed to protect homeowners from the steep rise in interest rates and severe plunge in real estate prices that followed the collapse of the dollar on the foreign exchange markets. It was passed as a stopgap measure pending formation of a national housing agency that would provide means-targeted support to the housing market.

Until recently the world’s largest economy and still the world’s largest military power, the United States is in total disarray after the effective collapse of the dollar on the foreign exchange markets in January. Credit has dried up since foreign lenders have refused to extend credit in dollars. There have been reports of isolated incidents of breakdown in discipline and morale among US forces overseas arising from related disruptions in supply. Domestically, commercial transactions involving foreign exchange and precious metals have since January required a special license under the terms of the PATRIOT Act III. But enforcement has been erratic, and the government’s efforts to stabilize the crisis have been hampered by an explosion in unauthorized currency exchanges.

“This package is definitely the lesser of two evils since the alternative was a total collapse,” said a Hong Kong banking analyst. “Ditching the MRA may save the banks. It sure isn’t going to win the government any popularity contests. But the real issue weighing on the markets right now is what happens militarily. The US right now is basically Argentina with nukes.”

The dollar has now fallen to parity with the yuan and currency fears have brought soaring inflation to a restive population that has expressed its anger initially in bloody rioting quelled only by martial law in the major cities, and nearly daily protests against politicians widely seen as corrupt and ineffective. Fed Chairman Bernanke has come under especially heavy fire for what many perceive to be his leading role in the monetary breakdown.

As a thought experiment, just try to apply the inflation hedge thesis to the foregoing scenario. You will quickly conclude that the theory is irrelevant and its application is impossible.

What is relevant is gold’s traditional role in the context of monetary collapse. This role is not, to our knowledge, in question. Gold is what you want when they seal the borders and you need to get across; it’s what’s accepted when there’s blood in the streets and nothing else flies.

Toward a More Fruitful Decision Tree

Whatever can be argued about its implications for gold’s behavior in inflation, the abrogation of Bretton Woods in 1971 did not change the fact that gold is the only money when the chips are down. This was a major conclusion of Professor Jastram’s research. [22] For the continuing validity of this proposition, we cite as an authority none other than Lord Greenspan, Tsar of All the Monies, Defender of the Fiat, Best Friend of Leveraged Speculators, who testified as recently as 1999 that [23]

… gold still represents the ultimate form of payment in the world. It’s interesting that Germany could buy materials during the war only with gold. In extremis fiat money is accepted by nobody and gold is always accepted and is the ultimate means of payment…

So rather than try to figure out whether we face deflation or inflation, then make a stab at executing the corresponding investment strategy, it seems to us the investor not desirous of losing money — or worse — in the days ahead should just step back and ask himself some simple questions:

Do I agree with Keynes that our fiat dollar, the Federal Reserve Note, is the end of monetary history? If yes, then I should pay no attention to that chorus of suits now speaking in tongues, and I should stay away from gold. I belong in my broker’s investment du jour.

Do I think it merely possible that our fiat dollar will someday collapse? If yes, then I should own gold. How much? As much as I can comfortably rationalize, perhaps using some sort of calculation of the gravity of the harm — i.e., financial wipeout — discounted by my sense of the probability of its occurrence.

Do I think it inevitable that our fiat dollar will suffer the fate of all paper currencies throughout history? If yes, then I am a gold bug, and it is my dollar exposure, not my gold “investment,” that I must rationalize.

April 29, 2005


  1. Roy W. Jastram, The Golden Constant (John Wiley and Sons, 1977). The heart of the study may be found in two charts that accompany remarks made by Professor Jastram in his Remarks to the Security Analysts Society of San Francisco, December 2, 1981.
  2. We considered aspects of this topic previously, in Gold Is Money – Deal with It!, (October 2, 2003).
  3. Roy W. Jastram, op. cit., p. 71.
  4. Roy W. Jastram, Testimony before the U.S. Gold Commission, Report of the U.S. Gold Commission, Volume II, Annex B.
  5. Our own hunch, for what it’s worth, is that the lag in the gold price since the initial overshoot in the late 1970’s to correct for the effects of the London Gold Pool would support Professor Jastram’s thesis: gold has been a lousy hedge against inflation as measured by the CPI. Our friend Antony Herrey notes that if one applies the Austrian definition of inflation favored by Mr. Saville, gold’s underperformance during this highly inflationary period is even more striking. Under either definition, it is difficult to imagine how an extension of the Jastram analysis could be supportive of the inflation hedge thesis. But since we are not statisticians, this must remain mere supposition on our part.
  6. Georg Friedrich Knapp, The State Theory of Money (English Edition, MacMillan and Co., 1924). The first edition was published in Germany in 1905; the English Edition was based on the fourth edition, published in 1923. Reading Knapp’s book today requires considerable patience. Most of the key terms bear his own definitions, and are less than memorable, e.g., “valuta”, “lytric”, etc. An exception is a term he invented altogether: “chartalism”, chosen to express the concept that money is a symbol, not a thing; all means of payment are “pay-tokens, or tickets used as means of payment” [p. 32]:
    Perhaps the Latin word “Charta” can bear the sense of ticket or token, and we can form a new but intelligible adjective — “Chartal.” Our means of payment have this token, or Chartal, form.
    Keynes not only embraced the theory but was instrumental in getting the work translated and introduced to the English-speaking world, as reflected in Knapp’s acknowledgement in his Preface to the English Edition [p. vi]:
    In particular my thanks are due to Messrs. Keynes and Bonar….
  7. John Maynard Keynes, A Treatise on Money (MacMillan and Co., 1958).
  8. See Ludwig von Mises, Human Action (Fourth Revised Edition, Fox & Wilkes, 1996), pp. 408-410. See also Murray N. Rothbard, Man, Economy and State (Mises Institute, 2001), pp. 231-237.
  9. For more on the purported demonetization of 1971, see Antal E. Fekete, The Gold-Demonetization Hoax, (September 5, 2003).
  10. James Turk has laid particular stress on this important distinction in many of his writings over the years.
  11. Remarks by Governor Ben S. Bernanke before the National Economists Club, Washington, D.C., November 21, 2002: Deflation: Making Sure “It” Doesn’t Happen Here.
  12. See Reginald H. Howe, Targeting the Gold Cabal with Silver Bullets, (February 17, 2004).
  13. See, e.g., Ted Butler, Weekly Commentary, (November 13, 2000).
  14. See Hugo Salinas Price, How to Introduce a Silver Coin into Circulation in Mexico: The Hybrid Coin, (May 13-14, 2004).
  15. See Richard Katz, Deflating ‘deflation’, The Oriental Economist (March 2002).
  16. See Richard C.B. Johnsson, Deflation and Japan Revisited, Working Paper No. 23, The Ratio Institute (2003).
  17. See Reginald H. Howe, War against Gold: Central Banks Fight for Japan, (July 1999).
  18. Doug Noland, Major Uncertainties, (April 22, 2005).
  19. Paul A. Volcker, An Economy On Thin Ice, The Washington Post (April 10, 2005), p. B07.
  20. Peter G. Peterson, Running on Empty (Farrar, Straus and Giroux, 2004), p. xiv.
  21. Stephen Roach, Original Sin, Morgan Stanley Research (New York) (April 25, 2005).
  22. Toward the end of The Golden Constant, Professor Jastram took note of the bigger picture [p. 177]:
    Historically, gold has served as a financial refuge in political, economic, and personal catastrophes. This I call the Attila Effect and examples are legion. To cite a few:
  • The Latifundia passed gold bars secretly to their heirs who thus survived barbarian invasions to become nobility under the Merovingian kings of the fourth century.
  • White Russians who escaped the Bolsheviks survived on treasures they carried in flight.
  • Austrian refugees, escaping Hitler’s storm troopers, often owed their survival in a new country to the gold and jewels they could carry on their persons.

The French peasant was astute when he buried his coins on the threat of invasion and pillage. Anyone who fears the collapse of his country’s currency is acting rationally when he shelters his assets in gold. It is when these judicious measures are translated into a strategy for protection against recurring price inflations that the reasoning breaks down. This is the lesson my statistics have taught me.

23. Alan Greenspan, Testimony before the U.S House Banking Committee, May 20, 1999, quoted in World Gold Council, Gold As a Reserve Asset, last updated June 2003 ( (year of testimony incorrectly cited as 2001).