A Monetary Solution to Trade Imbalances? Gilder and the Gold Standard

The wait continues regarding the tax reform proposal to come out of the White House and be taken up by Congress. Despite the headlines dominated by more peripheral matters, tax reform is shaping up to be one of the cruxes to the success of the new administration. It is not simply a matter of reducing tax rates, or eliminating loopholes, or otherwise rendering the tax code more transparent and equitable, as important as those things might be. It turns out that tax reform is also crucial to combat the out-of-kilter trade arrangements that not only are strangling the US economy but also are perpetuating inequitable and exploitative terms of trade, at both ends of the trade relation, for both developed and developing countries.

How is tax reform relevant to this question? By virtue of one of the key proposals now being discussed: the border adjustment tax. We discussed this, and its importance in terms of trade relations, in a previous post.  As of this writing, the prospect of its being incorporated into the tax reform proposal taken up by Congress is up in the air. One report even speaks of it being on “life support.” If it, or something like it, does not come along, something else, most likely more draconian, will probably take its place. Something more like traditional protectionism.

But there are other proposals being floated likewise intended to counteract the cockeyed trade regime with which the world is now saddled. Conservative icon George Gilder has one for us that merits consideration. Gilder’s focus of late has been money, as evidenced by his 2016 book The Scandal of Money: Why Wall Street Recovers but the Economy Never Does. The burden of the argument is that floating exchange rates are the bane of the modern economy; our economic issues can only be rectified by a return to the gold standard. Floating exchange rates, in this version, are the product of government-controlled money, and as the Friedrich Hayek-authored epigraph has it, “The source and root of all monetary evil [is] the government monopoly on the issue and control of money.”

In his book, one of the claims Gilder makes is that the accusation against China as being a currency manipulator, is specious. Quoting John Mauldin, Gilder asserts that “Trump and all those who prattle on about Chinese currency manipulation have the economic comprehension of a parakeet” (p. 40). But Gilder, at least on this score, has had a change of heart. Writing in The Federalist, Gilder confesses “I was wrong.” Trump’s economic comprehension, apparently, does exceed that of a parakeet. In fact, he is on to something – though he does not quite know what. “World trade is no longer expanding for a reason, and Trump has put his finger on it. That reason is a combination of crazy quilt trade pacts, disguising wild and wooly monetary manipulation.”

So Gilder puts his finger on what Trump already put his finger, refining what he implies is a wooly argument. It is not the “crazy quilt trade pacts” that are the problem, so much as the “wild and wooly monetary manipulation” that they ostensibly conceal. Gilder’s vision is of a world in which speculators in the currency trade generate deranged exchange rates, wild swings that make a mockery of economic fundamentals. “Currency trading is a speculative orgy that fails to correspond at all with relative productivities of workers, or comparative advantages between countries, or purchasing power parities between different markets.”

For example, US workers have lost their jobs – because the Japanese yen went from 80 to the dollar to 300 to the dollar and back, and because the euro has fluctuated 20% vis-a-vis the dollar: “A worker who lost a job because of the global economy might as well have been hit by lightning. No rhyme or reason explained it. What we call a crisis of trade is really a scandal of money.” NAFTA was a big mistake, not because of the specifics of the deal, but because it led to Mexican peso devaluation: “No entrepreneurial creativity or worker efficiency or technological virtuosity could dent the overwhelming impact of the drastic relentless change in the unit of account. It emitted—as Ross Perot put it—a ‘giant sucking sound’ symbolizing a major reorganization of North American manufacturing. Yet the entire costly and tempestuous change was mostly an effect of monetary speculation.”

Hence, the global trade imbalances which have precipitated the mass transfer of production and capacity and thus jobs have been caused by floating exchange rates. The solution, as one might surmise from such a diagnosis, is to eliminate them. “So long as central banks possess the power to change currency values virtually at will, free trade cannot be either fair or efficient.”

Let us take note at this point, that we have added a person of interest to the list of currency malefactors. To the currency traders, the “10 international banks that do 77 percent of the exchanges,” Gilder has added central bankers. But this does not yet exhaust Gilder’s list. Where are the politicians? Here they are: “With money controlled by politicians in the guise of central bankers, it cannot serve as an objective measuring stick of commerce.” So central bankers are really politicians – essentially giving us three categories of malefactors. Which is why Gilder endorses Hayek’s assertion that it is government-run money that we are dealing with.

Gilder’s solution: “We Need A New Bretton Woods Agreement. ” Let’s take a look at that. Bretton Woods was the post-World War II monetary arrangement whereby the dollar, tethered to gold, served as the reserve currency for the countries of the world’s various domestic currencies. We will be exploring the concept of a reserve currency more fully in a future blog post (for now, these posts will suffice). The idea of a reserve currency is to function as “real” money in the banking system, so that monetary issue is limited to some multiple of reserve currency holdings. In other words, in the Bretton Woods framework, domestic currency issues were restricted by the amount of dollars held by the banking system, mainly the central bank. The amount of dollars, in turn, was restricted by the requirement of gold redeemability, with the price of gold fixed at $35 per ounce.

This would eliminate both inflation and deflation: “The best way to obviate both inflation and deflation is a global agreement to tie currencies to gold in the spirit of Bretton Woods.”

For all the respect I have for Mr. Gilder’s work – and it is a lot: his Wealth and Poverty made a permanent impression on my thinking, back when I was a wet-behind-the-ears Peace Corps volunteer – I think he claims too much here. The problem is that he posits precisely what he needs to demonstrate: that a commodity money standard, such as the gold standard, brings with it price stability. Certainly, tying domestic currencies to gold would eliminate their fluctuations vis-à-vis one another, but that is not the same thing as saying that prices would cease fluctuating. Quite the contrary.

During its heyday in the 19th century, the gold standard operated in terms of the so-called “automatic mechanism,” with gold flows settling imbalances between trading regions. Not between countries per se, but regions – because in the framework of the gold standard, borders vanish and the participating countries become locked into a single economic unit. At least, theoretically; practice was different, as we shall see.

So then, where countries tied their currencies to gold, and gold flows were allowed to occur without hindrance, and where corresponding trade flows of goods, services, labor, likewise were allowed to occur without hindrance, there you had the properly functioning automatic mechanism. And within this mechanism, gold flows are triggered by interest rates. Where interest rates are high, there gold flows. What leads to shifts in interest rates? Economic performance. Interest rates are raised where economic performance is lagging, and reduced were economic performance is buoyant.

What was the result of such actions? It has everything to do with the reserve function of gold in this system. The money supply is tied to gold; the more gold held by banks, the more money could be issued (a healthy multiple was considered to be two to three times the amount of gold reserves). Gold inflows allowed for monetary expansion, hence increased lending and thus increased investment and expenditure, while gold outflows reduced the money supply, tightened lending conditions, and throttled economic growth. In this way, economic regions were kept in balance: where growth was occurring it would automatically be restrained, and where contraction was occurring, the economy would automatically be stimulated.

Trade imbalances could not arise under such a system, but there was a price to pay: inflation and deflation. Where the money supply was allowed to expand, there you had inflation; and where the money supply was forced to contract, there you had deflation. Inflation and deflation was built into the gold standard with its automatic mechanism. Mr. Gilder’s assertion that a gold standard eliminates price fluctuations is totally mistaken. A gold standard functions precisely by triggering inflation and deflation.

There is more. The broader economy, in this system, is tied to the amount of gold held in reserve. In other words, economic growth, population growth, and attendant phenomena depended upon the vagaries of gold mining production as to whether they could even occur or not.

But of course, the 19th century was also the age of the social question, the silver question, the labor question, the suffrage question. All of these questions were tied to the gold standard with the restriction it inherently placed upon economic growth. The labor movement arose in response to that restriction, as did expansion of suffrage: for politicians realized that much hay was to be made by appealing to that ever-expanding voting bloc of disgruntled workers subjected to the whims of gold flows and gold reserves.

In response to incessant social and political agitation, there came the institution of central banking, the goal of which was to mediate between these social forces, on the one hand, and the dictates of the automatic mechanism, on the other. Increasingly, the pound sterling was considered to function as a substitute for gold, enabling money supplies to expand accordingly. But like the post-WW2 dollar standard, this made the world dependent upon sterling, and countries like Germany chafed under that dependency. The sterling standard gave the UK an “exorbitant privilege,” as they say, and provoked rivalry with Germany that ultimately led to the First World War.

Things got even worse in the aftermath, as war reparations along with the devastations of war led to the ascendancy of the US, which, in accordance with the dictates of the day, received in payment mountains of gold. But despite copious amounts of lip service, the automatic mechanism was not allowed to reassert itself. Instead, it was during the 1920s that the entire ideology of “price stability” and “full employment” began to be developed and implemented by central bankers, and the key to this was to keep all that gold from entering the financial system, provoking an unsustainable boom, or, even worse, allowing it to flow back to the countries from whence it came, as those countries tried to export their way to prosperity. The US, of course, had always practiced protectionism and now continued to do so, essentially consigning countries like Germany to relative penury and sowing the seeds for the Second World War.

What needs to be realized is that any system of currency which short-circuits the feedback mechanism (Jane Jacobs’ term) of currencies vis-à-vis one another, like the gold standard did, only substitutes another feedback mechanism. If one does not wish for fluctuating exchange rates, one should welcome the inflation-deflation whipsaw, because that is the alternative means for rectifying imbalances. And where such a whipsaw mechanism is politically unfeasible, as in any developed democracy it will be unfeasible, then the alternative is stagnation, as imbalances are allowed to build up on bank balance sheets in the form of unredeemed debt.

These are our alternatives. There are no others. The dream of a return to the gold standard should be laid to rest. Besides, the likelihood that such apparitions from the grave will be given new life is probably zero. Let’s spend our time talking about feasible alternatives.


More on the gold standard can be found in these posts and in these excerpts from my book Follow the Money: The Money Trail Through History. More on floating exchange rates can be found in these posts.

Maggie’s Revenge

The British vote on June 23rd, 2016, to leave the European Union, is one of those events that will long be remembered. Yet there was another event involving Britain on the one hand and the European Union (then Community) on the other, that likewise came as a shock, and which likewise lives on in the memory, at least for those who, at the time, were political aware. I refer to Margaret Thatcher’s resignation of the prime ministry, exactly 25 years and seven months earlier, on November 23rd, 1990. Personally, I remember exactly where I was and what I was doing when I heard that bit of news over the radio.

Thatcher’s resignation resulted from her opposition to European union. She paid the price by being cashiered by her own party, not by the electorate. I wrote an article in 1991, discussing this event, its significance, and what I considered to be its historical relevance. In terms of the latter, the article was flawed in its diagnosis, but not in its recognition of that relevance. And today, I think that Margaret Thatcher is looking down with a sense of grim satisfaction.

To honor this event, I excerpt from that article, published in 1991.


It came so suddenly as to leave the world in a state of shock. Margaret Thatcher, the “Iron Lady,” the fighter who would rather die than quit, did just that: she voluntarily resigned her position as Prime Minister of the United Kingdom. She did so as she reflected on what “a funny old world” it should be that a party leader never defeated in a general election, still commanding a majority of her own party, who had led that party to three successive election victories, who had spearheaded a thoroughgoing reformation of public policy whose very name was synonymous with that reformation, should be forced by her own party to resign her post. Truly these were rather funny goings-on.

To top it all, it was not any strictly domestic issue but “European unity” that brought all this about. To many, she was the champion of a by-gone era of national sovereignty and “Little England,” “the prim and condescending leader of a has-been empire bent on turning back the tide of history, a latter day King Canute who actually believed the sea would heed her.”(1) So it was portrayed: Thatcher versus Europe, isolation versus community, proud independence versus peaceful cooperation. And it turned out to be an Achilles’ heel which her opposition lost no time in exploiting as soon as opportunity presented itself.

Her enemies’ strategy worked. But to characterize Margaret Thatcher’s position with respect to the European Community (E.C.) in these terms is, at the very least, open to question. She regarded herself the most pro-European of them all; nevertheless her approach to and her concept of unity differed – fundamentally – from theirs.

Perhaps the key element of difference lay in the goal of monetary union. Thatcher remained to the end staunchly opposed to the formation of a pan-E.C. single currency administered by an independent central bank. Most others see such an arrangement as the indispensable core of a truly common market. Across Europe as a whole, the goal of monetary union commands broad support. Certainly it was this issue more than any other which isolated her from her peer heads of state and made her vulnerable to attack at home.

Such issues have not heretofore been the stuff of dramatic controversy, at least if one follows standard historical accounts. Most historically-conscious folks have a vague recollection, for example, that the establishment of a central bank in the United States was a very hot issue from time to time and was finally brought to pass with the Federal Reserve in 1913 (which isn’t really a true central bank but rather a “federally organized” group of regional banks). But they remain supremely indifferent to the subject and would much rather look into the accounts of politics or war or class struggles, or perhaps “social” histories of “everyday life” in such and such a period. The history of banking and monetary policy is definitely a subject for the specialist. And thus supremely boring.

Yet as contemporary events should insinuate, a long look needs to be taken especially at the history of monetary union. Upon further inquiry that history proves to be decisively important to understanding our present and certainly what Margaret Thatcher would consider our predicament. One has consequently to go back to its roots and see how and why it has become so fundamental – as it truly has – to modern society….

Mrs. Thatcher … faced opposition on two major points – domestically, the poll tax issue, and in external affairs, her position concerning the European Community. The poll tax weakened her position with respect to the electorate, enabling her opposition in the Conservative Party to gain ground on her. But in the final analysis the poll tax is not what felled her.

The timing of events leading to her fall is conclusive here. At the annual party conference in early October [1990], the Conservatives showed themselves lackluster, despondent, without much enthusiasm for the upcoming elections which they feared they might lose. More than anything else, it was the Europe issue that divided them. Many in the party were leaning toward a strong pro-Europe stance; Sir Geoffrey Howe, for instance, argued for full acceptance of monetary union, and Michael Heseltine preached pro-union to a well-attended side meeting. On the other side were the anti-union forces worried that Mrs. Thatcher, who had been showing herself conspicuously indeterminate in the last months, would be “led gently to monetary union, like some doddery old lady, with Mr Major and Mr Douglas Hurd… at either elbow.”(2)

Thatcher herself was then “ambushed” at the E.C. summit in Rome at the end of October. Italy’s prime minister Giulio Andreotti presented a proposal with definite dates for achieving monetary union, something which caught Mrs. Thatcher by surprise. This seems to have woken her from her lethargy. Back home she gave a rousing speech in the House of Commons against monetary union and giving over national sovereignty to Brussels. Her old followers were delighted. Others wondered how long she would last.

It was this speech and her renewed hard line which led to the resignation of Sir Geoffrey Howe from her cabinet. And it was his resignation speech which solidified the opposition against Mrs. Thatcher, prompting Michael Heseltine to run against her in the party election. Howe vociferated against her “anti-Europe” position, arguing that it jeopardized the future of the nation and its role in a united Europe. And then of course Heseltine gained enough votes on the first ballot to force a second one, after which Thatcher resigned.

It was, then, undoubtedly the Europe issue which brought Thatcher’s downfall. That much is clear. In the final analysis, however, not even the politicians were ultimately the cause. The powers-that-be want monetary union, and if anyone stands in their way, they will simply remove him, or her, to get it. The politicians know this and act accordingly if they know what is good for them. The people do not know any better than to accept this goal because it is proffered to them by every available media source from which they derive their opinions.


1. Newsweek, Dec. 3, 1990, p. 22.
2. The Economist, Oct. 31, 1990, p. 43.

The Problem of Saving

When Schumpeter writes, “Now to the question: what is a savings account?”,[1] he is not being facetious. There is more to savings than meets the eye. Of course, the bare fact of saving is simple enough to understand. Rather than spend all of our earnings, we take some and put it to one side. What could be more straightforward?

Actually, the problem is not so much understanding what savings, or a savings account, is, but what kind of effect it has. And that is anything but straightforward.

Essentially, what is accomplished with the act of saving is the removal of circulating medium from the cycle which is what an economy is.

An economy is a cycle or a circular flow: this is one of the first lessons of basic economics, encapsulated in the principle originally put forward by Jean-Baptiste Say, “supply creates its own demand.” All this means is that, at the end of the day, the producers are the consumer and the consumers, the producers. It is the same people producing who do the consuming, and vice versa.

At least, this is the basic picture, before things get complicated with things like foreign trade and fiscal policy. And things like savings. For what savings does is remove some of the circulating medium by which this economic cycle does its cycling. There are two aspects to the cycle: the circulation of goods and service, and the accompanying circulating medium by which the goods and services are accounted. When a shortfall of the circulating medium crops up, the result is deflation. And so, saving on the face of it has a deflating effect on wages and prices. And a deflationary environment is noxious to economic growth.

As a result, we have what economists have dubbed the “paradox of thrift” whereby saving, normally thought of as an act of economic virtue, or at least efficiency, actually depresses economic activity. The details as to how this occurs differ depending on the analyst, but the upshot is that saving, far from being the benign, even constructive act that it may well be on the personal level, actually has, or can have, a negative effect on the economy at large.

So which is it? Do we really have a paradox here along the lines of moral man, immoral society? Is personal saving something good for the individual or the household or other economic entity, but bad for the economy at large?

To figure this out, we have to take a look at what actually happens in the act of saving. First, of course, there is the proverbial mattress, or, especially in the days of coinage, the chest. In such a case, we have the circulating medium definitively removed from the economy for however much time the saver desires. (Or for much longer than that, as witness contemporary discoveries of hoards of coins from e.g. Roman times.) We can call this form of saving “hoarding.” It is peripheral to the main discussion.

What happens in the modern world is something different. When we save, our first resort is not the mattress but the bank. And when we do this, our money earns interest. What is interest? Let’s just say that is another of those phenomena that economists have a hard time figuring out. Perhaps we can address that subject in a future article. For now, we mention it in passing with the caveat that in the contemporary zero-interest-rate environment, it is not the incentive for saving that it normally might be.

So we put our money in banks. What happens then? Does it just sit there, like in the mattress? Not in the modern system. Instead, it enters into a second market, which runs independently of the market for goods and services with which we are already acquainted. We speak of the financial market. Banks (and non-bank financial institutions) are the gatekeepers of this market. We include a graphic taken from the accompanying course to indicate the structure of this second market.

Figure 3:  Two Markets, Two Monetary Circulations
Figure 1:  Two Markets, Two Monetary Circulations

Savings, then, go into this market, where they are “put to use” to earn income for the bank or other financial entity. The differential between what these latter entities earn and the interest they pay out is their profit.

What happens on this market? There are several submarkets which determine this. The bond market is where corporate and government borrowers go to get ahold of some of these savings. The stock market is where corporate interests go to sell stock in their companies – the money that goes here is not savings in the strict sense, as is money lodged with banks, but it does fall under the same category of earnings set aside to earn a separate income and to be available for future use, so we include it in our discussion.

“For future use” – this already indicates that the so-called paradox of thrift need not be so paradoxical. The writers on the problem of saving often seem to talk as if the money put into saving will never come back. In fact, the whole point of saving is to put earnings aside for “a rainy day,” or for the later purchase of big-ticket items, or for retirement – at any rate, not to eliminate it but to return it to circulation at some future time. And in a developed economy, over time the money put aside as savings will be counterbalanced by money previously set aside as savings and now returning to circulation. In addition, this money may have been supplemented by earnings on the financial market, which means that more money will be returning to circulation than left it. So on the face of it, this shouldn’t be a problem.

But there is a problem, and it is this. In normal situations this flow of funds back and forth between the ordinary and the financial markets is not problematic. But in the contemporary situation, it is.

One reason is because the ordinary market is being hit from various directions, making it unproductive and therefore unattractive. Firstly there are what Jane Jacobs (see this post for more on her) called “transactions of decline,” in which government removes money from productive activities, precisely because they are productive, and redistributes it to non-productive activities, precisely because they are unproductive. This can have a Keynesian motivation, whereby Say’s Law is turned on its head: demand then creates its own supply, and all government has to do is distribute money around to consumers (breaking the link between production and consumption) to generate productivity. According to Keynesians, this should in and of itself bring about prosperity, but as Jacobs points out, it only undermines productive activity and the human capital that underlies that productive activity, and so becomes a self-generating downward spiral.

Other things government engages in that undermine productivity are excessive taxation and regulation. All of this makes the ordinary market an unproductive affair, in which risks exceed rewards. The upshot is that savers put their money, not in ordinary investment, but in the financial market, which essentially is a zero-sum game, but in which at least the prospect of a decent return beckons.

And so more funds flow into the financial market than flow out, creating a dearth of liquidity in the ordinary market, which manifests itself in low interest rates combined with difficulty in borrowing (despite those low interest rates).

The flip side of the dearth of liquidity in the ordinary market is a glut of liquidity in the financial market. As funds pile into the market, returns there diminish and the quest for “alpha” (market-beating returns) becomes a frenzy. This is what happened during the 2000s in the run-up to the credit crisis. With the excess liquidity in the financial market, funds were available for lending that never would have been lent in a normal risk/reward analysis, often under political duress. An example is the subprime lending that took place. Michael Lewis (see this post for more on him) wrote about this in two of his most important books, The Big Short and Boomerang (the latter in particular gives a dramatic picture of the workings of the liquidity glut).

This was exacerbated by the trillions of dollars kept in the financial market by exporting countries like Japan and China (see this post this post for more on this), in their attempts to hold down the values of their domestic currencies. That in itself added substantially to the glut. But the very fact that what these countries were doing– looked at globally – was further undermining productivity by destroying productive capacity in rich countries while misdirecting investment in their own countries, only meant that another nail was being driven in the coffin of the ordinary market. Such “global value chains,” when established and maintained through currency manipulation and other fiscal and monetary policies designed to create unfair advantage for exporters at everyone else’s expense, only make the ordinary market even less attractive, which is another reason for the flight to financial markets, and even to inert investments like gold and other luxury items such as works of art.

A lot of work has to be done to restore ordinary markets to decent functionality. One of these is a return to an emphasis on the national economy as opposed to the lopsided emphasis on global-value-chain globalism such as obtains today. And within the national economy, a return to emphasizing the production side of the economy. Consumption does not magically engender productive activity; in particular, deficit spending to fund consumption is as pernicious a fiscal policy as can be devised. Various forms of capital are needed for that, various forms of infrastructure, from legal to educational (virtue versus entitlement) to religious. All of this is fodder for new discussions, so we’ll leave it at that for now.

This topic and more are dealt with more fully in the accompanying course.


[1] Treatise on Money, p. 147.

The Trouble with Exchange Rates

Do floating exchange rates work? By which we mean, do floating exchange rates bring countries, national economies, into equilibrium? Equilibrium here means that trade between countries is in balance. Thus, exports and imports of goods and services, although in constant fluctuation as economies progress along divergent paths, balance each other over time.

With this we do not refer to the total global trade balance. By definition, this will always sum to zero. The problem of imbalances crops up when certain countries run persistent surpluses and/or deficits. Because then, precisely by virtue of the zero-sum condition, other countries will have to run the reverse, a persistent mirror image, whether surplus or deficit. And the question then is, how is this possible in an age of floating exchange rates? In terms of theory, at least, floating exchange rates should compensate for such imbalances. If a country is running a trade surplus, the currency should appreciate, and vice versa if it is running a deficit, and this should result in the trade surplus or deficit being eliminated. But we have countries that run persistent surpluses or deficits. So what is going on?

The current regime of floating exchange rates has been in place ever since President Nixon eliminated the link between the dollar and gold back in 1971. Prior to that, we had the Bretton Woods system, in which the dollar was linked to gold, and was established as the reserve currency for the world’s monetary systems. Since then, the dollar has still officially played the role of the world’s reserve currency, but no longer like it used to. Back in the day, it was the means by which countries could maintain their currencies at the agreed-upon fixed rate: they needed to hold a certain level of reserves to maintain that exchange rate of their currency. Nowadays, of course, not being obligated to maintain a particular exchange rate, the need to maintain dollar reserves falls away. Or so one would think.

The fact is, even in an age of floating exchange rates, the “float” can be undermined and even negated, precisely by making use of dollar reserves. Two questions: how does this work? And, why would a country want to do this?

The first question, as to how it works: by resorting to techniques that were originally developed during the days of the gold standard (in order to short-circuit it) and have since been fine-tuned.

Essentially, since the dollar is the currency in which international trade takes place, a currency’s exchange rate with the dollar can be depressed by keeping dollar earnings from being exchanged into that currency. This is done by “sterilization,” the process of diverting dollar earnings from being converted into the domestic currency and repatriated into the domestic economy. This keeps the domestic economy from being “inflated” – from feeling the effects of prosperity, and, crucially, from importing more, which would force up the exchange rate. Therefore, export prospects remain undiminished, but at the expense of household consumption. The export machine is maintained at the expense of domestic prosperity. This is referred to as “forced savings,” which is really forced underconsumption.

There are other ways to accomplish the same goal. One is to impose a consumption tax. What this does is reduce spending without reducing production. There is then a surplus of production over consumption, and the surplus production is exported. The exchange rate depreciates, not by any active central-bank intervention, but because demand for the domestic currency declines on foreign exchanges – despite the fact that the country is running a trade surplus. Tariffs work in a similar manner. “Tariffs and consumption taxes always … increase net exports by reducing the real value of disposable household income [vis-à-vis importable goods] and so, presumably, by reducing household consumption.”[1]

Another way is through what Michael Pettis refers to as financial repression. Pettis in fact writes that “financial repression matters to trade even more than undervalued currencies.” Financial repression occurs when countries control the banking system and treat it like a department of state. In that case, the central bank sets interest rates that banks are required to follow, and these interest rates are set at a below-market level. Since households and consumers have no other place to put their money, they are required to accept this below-market interest income. This constitutes a subsidy forcibly paid by households to borrowers – companies. Business borrows at below-market prices, while consumers have interest income taken from them. The result is reduced consumption, and the same effect as discussed above with the consumption tax.

The question then is, why would a country want to do this? After all, we have been conditioned to think that an appreciating currency is a strong currency and a strong currency is a desirable thing to have. The fact of the matter is, for an exporting country which has built its prosperity on maintaining a trade surplus, a weak currency is a must.

This strategy is a staple of the Asian Tiger model of economic development. Starting with Japan, the Asian Tiger economies have pursued policies by which trade surpluses could be maintained. The following graphs give an indication of the success these policies have had in helping these countries’ export industries:

South Korea Balance of Trade Taiwan Balance of Trade Japan Balance of Trade China Balance of Trade Singapore Balance of Trade

Similar things can be said about Germany. This country likewise resorts to consumption-repressing policies, although nothing so drastic as the financial repression characteristic of countries like China. And as far as currency manipulation is concerned, Germany is part of the European Monetary Union and so shares a common currency, the euro, with the other member countries, and so cannot engage in currency manipulation. But Germany runs consistent current account surpluses with other member countries of the EMU. How? By virtue of the fact that its exchange rate was locked in at an artificially low level while those other countries were locked in at an artificially high level, and by voluntarily constraining wage growth (via agreement between labor unions, businesses, and government). The result can be seen in this post I wrote a couple of years back.

All in all, pretty much the same thing can be said of floating exchange rates as has been said of humility, Biblical welfare, conservatism, capitalism, even love: it works every time it’s tried. The problem is, it isn’t tried, even in this age of ostensibly floating national currencies. But there are signs that the problem is being recognized, as witness the spate of books dealing with currency wars. Even politicians are getting into the act: Donald Trump pledges to confront China’s currency manipulation. How this will play out going forward is anyone’s guess. But it will most likely continue to remain a bone of contention and true obstacle to realizing a more prosperous and equitable global order.


 

  1. Michael Pettis, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy(Princeton: Princeton University Press, 2014) , p. 30. Pettis is professor of finance and economics at Peking University.

An End to Alchemy?

Michael Lewis, the author of various illuminating accounts of the events and progressions of the great financial crisis of 2008 – one of which became an Oscar-winning Hollywood movie – this time provides us with an illuminating account of someone else’s book – Mervyn King’s newly published The End of Alchemy. The thesis is a familiar one: the banking system is fundamentally flawed, and this is the cause of most if not all of our economic misery.

As befits a governor of the Bank of England (2003-2013), King is of course a veteran of the various banking vicissitudes of the 21st century. It is on the basis of this tenure that he writes this book, analyzing problems and offering remedies. But he does not wish to come across as someone with all the answers. As he writes in the introduction, “Many accounts and memoirs of the crisis have already been published. Their titles are numerous, but they share the same invisible subtitle: ‘How I saved the world.’” King may not want to save the world, but he certainly wishes to subject the banking system to a thorough reworking.

This is because the situation is that bad. What was behind the Great Crash of 2008? “Bad incentives that are still baked into money and banking – and so quite likely to create another, possibly even greater, crisis.” Still baked into: for, despite the (“arguably”) biggest financial crisis in history, nothing that addresses fundamental problems has changed. Shareholder limited liability encourages risk-taking, as shareholders take advantage of that absence of liability; deposit insurance encourages depositors to lodge money with banks, without regard to the riskiness of said banks’ lending policies; too-big-to-fail remains entrenched, encouraging gigantic risks to be run in the knowledge that if they turn sour, a bailout will be forthcoming.

Furthermore, the steps that have been taken ostensibly to mitigate the problem have only served to conceal it. Or, as Lewis puts it, “it’s being used to disguise how little has actually been done to fix that system.” Lewis quotes King: “Much of the complexity reflects pressure from financial firms. By encouraging a culture in which compliance with detailed regulation is a defense against a charge of wrongdoing, bankers and regulators have colluded in a self-defeating spiral of complexity.”

On this score we have a framework that seems designed for failure. There is the problem of moral hazard, which basically refers to the fact that when something is insured for, it is actually fostered or encouraged. Insurance against risk actually encourages risk. This problem is not restricted to the banking sector; it is endemic to any form of insurance. And then there is the web of ineffective regulation that seems to make a mockery of attempts to improve the situation.

King has an alternative. It is to revamp the banking system so as to eliminate risk-taking with other people’s money. “Deposits and short-term loans to banks simply need to be separated from other bank assets. Against all of these boring assets, banks would be required to hold government bonds or reserves at the central bank in cash. That is, there should be zero risk that there won’t be sufficient cash on hand to repay people wanting to flee any bank at a moment’s notice.”

So these deposits would be kept separate from other bank assets. These latter indeed could be used to finance the risky business of trading. These assets would have to be acceptable to the lender of last resort, the central bank, in case of financial crisis. And this acceptability will have been determined beforehand. “The riskier assets from which banks stand most to gain (and lose) would … be vetted by the central bank, in advance of any crisis, to determine what it would be willing to lend against them in a pinch if posted as collateral. Common stocks, mortgage bonds, Australian gold mines, credit default swaps and whatever else.”

The upshot is what Lewis calls “the King Rule.” As Lewis describes it, a bank must have on its balance sheet enough assets to cover withdrawals of its short-term liabilities (deposits plus short-term loans to the bank (one year or less)). But of course, you say, of course it has assets to cover those liabilities – that’s what double-entry bookkeeping is all about: every liability on the balance sheet has a corresponding asset. But here’s the rub: in the process described above, of the central bank vetting collateral, these assets would be given a “haircut” – assigned a discount at which the central bank would be willing to rediscount (buy) the asset, in case of a liquidity shortage. And it is this “haircut” valuation that banks in future would have to respect before putting funds out in quest for returns.

How exactly would this work? In the example Lewis provides from King’s book, a bank has $100 million in assets. Of these, $10 million are reserves deposited with the central bank, $40 million are “relatively liquid securities” and $50 million are “illiquid loans to businesses.” The central bank values these assets at 100%, 90%, and 50% of full value, respectively – these are their “haircuts.” Thus, in the eyes of the central bank, the bank’s assets “in a pinch” are worth $71 million, not $100 million. And therefore it cannot have more than $71 million in short-term liabilities. What other liabilities are there that could fill the $29 million gap? Lewis answers, “a lot more equity and long-term debt” than currently is the case.

With all due respect to both Mr. Lewis and a former governor of the Bank of England, I don’t think this is how banks really work. The suggestion is that banks receive deposits and short-term loans and turn around and invest them, sometimes in riskier material, sometimes less risky. So that banks don’t do anything except play with “other people’s money.” But banking doesn’t work that way. The very fact that they engage in what is referred to as fractional-reserve banking, in which they are allowed to “create” a multiple of amount of reserves they hold at the central bank, belies the notion that they only act as passive receivers of money.

In the case referred to above, the bank with $50 million in “illiquid loans to businesses” has on its asset side these loans; but on the liability side, it has deposits it created when it made the loans. That $50 million was not already in its coffers, waiting to be lent out. Not all of it, at any rate. Much if not all of it wasn’t there at all.

This is not to say that banks do not receive deposits. Of course they do. But these deposits, in turn, had to come from somewhere. Those funds weren’t always “just there.” It was in fact created, in the very process of credit extension. This is what Joseph Schumpeter clearly saw, and integrated it into his theory of economic development.

Unlike the deposits created by the bank to lend to businesses (“illiquid loans”), these deposits do run the risk of being removed and placed with another bank, and for that eventuality the bank has to have a contingency plan, e.g., only use that money in ways that can be quickly recovered. But for the loans to businesses, that money will always be replenished: the businesses will be depositing future income even as they withdraw for expenses, and this will remain in a rough balance. This is not the danger to the banking system, and it is hard to see why, on the face of it, these loans should require such a “haircut” as 50%. They are long-term investments by the bank. They are the beating heart of the capitalist system. They are not the problem. The problem lies elsewhere.

The argument of King’s book, then, is to put an “end” to “alchemy.” But this “alchemy” is already built into the very nature of the system. It cannot be gotten around by mandating certain levels of “safe” asset holdings. The focus on quality of collateral is good, but it needs to be done properly. Banks certainly need to ensure that the collateral they accept is marketable, is liquid. But that is easier said than done: because this is not a function of banks, but of markets. And market dysfunctionality goes far beyond bank policies.

There has been a glut of liquidity on world markets in recent decades. Lewis himself knows this all too well: he himself chronicled it in his excellent book Boomerang. Another excellent chronicler and serious economist to boot, Michael Pettis, in his book The Volatility Machine, shows just how this liquidity deranges markets. We like to think of markets as being driven by economic fundamentals, but Pettis shows how, rather than this, they are liquidity-driven, tossed about by massive flows of funds in pursuit of shrinking returns. And banks, together with the burgeoning shadow banking system, are at the forefront of trying to place these funds, running ever increasing risks in the process. This is the dysfunctionality, not so much “illiquid loans to businesses.”

The effect of liquidity-driven markets is to make market valuations go awry. We get asset bubbles and collapses, gyrating valuations, and therefore gyrating bank balance sheets. The collateral-based banking system is struck in its heart. But this is not the banking system’s fault per se, but an ever-increasing oversupply of liquidity.

Where did this global liquidity glut come from? A good portion of it has been the result of the collusion of transnational corporate interests with governments (and central banks!) of low-wage countries by which exchange rates are pegged to favor export industries. The method by which this is accomplished is sterilization – the practice of preventing foreign-exchange earnings from being converted into domestic currency. This has resulted in trillions of excess dollars. Japan and China have been at the forefront of this. The accompanying graphs tell that tale.

Figure 19: China's Foreign Exchange Holdings, 1997-2016
China’s Foreign Exchange Holdings, 1997-2016
Figure 14:  Japan's Foreign Exchange Holdings, 1975-2016
Japan’s Foreign Exchange Holdings, 1975-2016

For the rest, the very existence of debt overhang that afflicts the global economy also spells excess liquidity. The so-called law of reflux explains why. In a nutshell, when debt is repaid, liquidity is extinguished in the same amount. This is a function of the way our banking system creates money. So then, when debt is left unrepaid and instead is constantly rolled over, that liquidity is not withdrawn from the system. It lingers. Hence, excess liquidity.

To make a long story short: what we need is not so much an end to alchemy but an end to the range of toxic fiscal and monetary policies intended to rig the system in favor of various interests. Debt rollover is one of those, as it is simply a result of the too-big-to-fail approach. All of these interests are conflicting. But they have now coalesced in a globalist order that enriches the few at the expense of both workers and entrepreneurs, in both the developed and the less-developed worlds. That’s where we need to focus our attention.

Isaac Newton and the Alchemy of Finance

Western Christendom experienced a sea change in the late 17th century. On one side of that divide was theological dogmatics, scholastic philosophy, the divine right of kings and priests, and, seemingly in their train, wars of religion; on the other side, there was theological indifference, mechanical philosophy, government by consent of the governed, latitudinarian and sectarian church polity, and the political balance of power. Not that these things came all at once; but the tendencies were clear. The mood and temper of the peoples had swung; religion lost its position of overriding importance, to be replaced by economic and political considerations, reason of state, and the wealth of nations.

A pantheon of figures has been elevated to apostolic status as trailblazers in the transition from the Darkness of the one side of this great divide to the Enlightenment of the other. Hugo Grotius, Rene Descartes, Baruch Spinoza, John Locke, Pierre Bayle, Montesquieu, Voltaire, all figure in enumerations of enlightened progenitors of the new era. Paired with these names was a new theoretical orientation which determined the mindset, the Zeitgeist, the Weltanschauung of this new dawn: a new science putting the categories “nature” and “natural law” on a new footing, providing the essential authoritative basis for the new order.

Thus “nature” was the determining factor. The “imperative of nature” came to dominate all areas of inquiry and practical philosophy. The “state of nature” became the orientating condition; rights in a state of nature came to be the touchstone of all just legal and political order; natural religion, religion in accordance with the dictates of nature, came to be touchstone to judge revelation, or at least to form a stand-alone, autonomous body of knowledge alongside revelation; and a new school of thought, economics, arose from out of the disarray of “mercantilist” controversy, basing itself upon – you guessed it – nature, with the initial iteration provided by Richard Cantillon and François Quesnay, and which issued forth as “physiocracy”: the rule of nature.

Perhaps one figure above all others represented and personified this trend. That would be Isaac Newton, the progenitor of the paradigm that anchored all these areas of thought in terms of a unified theoretical construct. Newton put science on a new plane, providing an integrated theoretical explanation for phenomena that had stumped scientists for generations; and it was upon this foundation that the orders of religion, law, politics, and economics were shunted. Alexander Pope’s well-known “Epitaph on Sir Isaac Newton” was, if anything, an understatement of the sentiment of the age:

Nature and Nature’s Laws lay hid in Night:

God said, “Let Newton be!” and all was light.

Christian theology became wedded to Newtonian physics, which in particular served as a tool of apologetics.[1] The philosophy of law and politics, already argued in terms of the individual and consent, received a powerful support from the notion of an atomistic universe. And this very same Newtonian construct likewise served to buttress the budding school of classical economics with all of its “natural laws” of wealth and poverty centering on the individual and self-interest.

In all of these areas, Newton’s philosophy, the “settled science” of the day, supplied a powerful sanction. But this is not everything there is to know about Newton. Some areas of his labor, to which he devoted at least as much time as his scientific investigations, have come to light of late, after having languished in the obscurity they were left in by hagiographic biographers determined to highlight the rational character of one of the chief developers of the scientific method, while ignoring what they deemed to be irrational. And Newton exhibited this “irrationalism” in spades.

One of these areas was biblical study. Newton devoted a great deal of time and effort to biblical chronology and to deciphering the Temple of Solomon. The latter in particular he held to be an expression of hidden truth to be unraveled by the initiate. This interest in the Bible and in theology, along with Newton’s clear belief in the biblical version of events regarding, e.g., six-day creation and the Flood, were enough to put a serious dent in Newton’s reputation as the objective enlightened scientist. But the most egregious offense in this regard was provided by the realization that Newton dabbled in alchemy. More than that: he spent a major portion of his investigative life, not in scientific experimentation, but in alchemic explorations, pursuing the transmutation of elements.

It was John Maynard Keynes who first lifted the lid on this aspect of Newton’s legacy. “Newton was not the first of the age of reason,” Keynes wrote in his posthumously published and delivered lecture, “Newton the Man.” Rather, “He was the last of the magicians, the last of the Babylonians and Sumerians, the last great mind which looked out on the visible and intellectual world with the same eyes as those who began to build our intellectual inheritance rather less than 10,000 years ago.”

Keynes discovered the “real” Newton while perusing a box of forgotten documents he obtained at an auction in 1936. This led to a radical reevaluation on his part. “In the eighteenth century and since, Newton came to be thought of as the first and greatest of the modern age of scientists, a rationalist, one who taught us to think on the lines of cold and untinctured reason. I do not see him in this light. I do not think that any one who has pored over the contents of that box which he packed up when he finally left Cambridge in 1696 and which, though partly dispersed, have come down to us, can see him like that.”

That box revealed Newton the alchemist. Alchemy is the pursuit of transmutation, and Newton avidly pursued it. What the alchemists were after was gold. What one needed for that was the philosopher’s stone; with that in one’s possession, one might convert base metal into the precious yellow metal.

It goes without saying that Newton never came into the possession of such a stone, nor did he ever successfully transform base metal into gold. But it cannot be said that he was altogether unsuccessful in his manipulations in favor of the yellow metal. And here comes the part of the story that is never told, because insufficiently understood. It is the story of how Newton participated in one of the great transformations of world history: the shift of England’s currency from silver to gold, which precipitated the change from a coinage- to a banking-based monetary system. He did so as Master of the Mint, a position he occupied from 1699 until his death in 1727.

A little background is in order at this point. The 16th century witnessed the development of a new order of trade, or, in Immanuel Wallerstein’s terminology,[2] a world-system integrating far-flung areas of the world into a trading network. At the center of this trade network was the fledgling Dutch Republic. In the face of the mercantilist imperative – policies to maximize the retention of precious metals in order to maintain a viable domestic circulation – the Dutch Republic instituted a novel arrangement with regard to currency, dictated by this trading network.

This arrangement facilitated trade with the East. This was because the West ran a chronic trade deficit with the East. There was nothing new about this; from the early medieval period on, the West basically had nothing to offer the more advanced East than such things as furs and slaves, the latter until the slave supply from the Western countries dried up. But there was great demand in the West for what the East had to offer: for instance, silks and spices. How to finance the importation of these luxury goods? Silver.

The one thing the West had that the East wanted, especially since Spain’s discoveries in the New World, was silver. Silver in the East carried a premium vis-à-vis the West, making it profitable to export: this was what made it effective as a means to settle up the trade deficit.

Thanks to new mining techniques and Christopher Columbus, silver became abundant in the 16th century, precipitating the so-called Price Revolution of that century. But in the 17th century the supply began drying up, one of the factors behind the so-called General Crisis of the 17th century and one of the spurs to the spate of policy proposals and implementations summed up in the term “mercantilism.” For one thing, the mines of New Spain were not producing as much as they once did. For another, the flow of silver to the East, primarily China – that bottomless pit, “the World’s Silver Sink”[3] – was beginning to have its effect.

The Dutch Republic served as the funneling mechanism for this flow. Its counter-mercantilist policy allowing the free import and export of specie, and the demand for silver for export exerted a magnetic attraction from all over Europe, with the resulting abundance of coin even precipitating the Tulip Mania of the 1630s.[4] Much of it simply went to offset the burgeoning import business.

English merchants watched all of this with proverbial Argus eyes. They looked on as the Dutch East India Company established its trading network, helped by its special advantage of readily available specie. They sought ways to get around the royal prohibition on the export of currency, and chafed under the restriction.

The breakthrough came in 1663, with the passage of legislation establishing a regime of free coinage. Del Mar finds the impetus for this legislation in the intrigues of Barbara Palmer, Duchess of Cleveland, Charles II’s mistress.[5] With this opening, the East India Company worked diligently to build its own trading network. The needed silver it obtained, among other places, from the domestic circulation, precipitating a dearth of coin. Together with the wars against Louis XIV conducted by “King Billy,” the Dutch stadhouder become King of England, this precipitated an economic and budgetary crisis.

This decimated the coinage, which suffered from debasement at minting as well as the techniques of clipping and sweating. As a remedy, the wise men of the age recommended a restoration of the coinage to the condition it enjoyed under Queen Elizabeth a century earlier. According to Whig historiography, the great men who recommended this measure, occupants of the Enlightened Pantheon, men like John Locke, here once again displayed their sagacity. Post-Whig reassessment has been less kind.[6]

The attempt to restore the coinage to the silver content of days when silver was abundant had, as its detractors predicted it would, a strongly deflationary effect. And it had the opposite result than hoped, for it simply provided a prime source of silver for export. Full-weight silver coins were simply too juicy to let pass. On these terms, it was quite simply more profitable to export silver than allow it to continue in circulation.

So the result of the so-called Great Recoinage was virtually to establish gold as the currency standard for England.[7] Here is where Newton comes in. As Master of the Mint, Newton ensured the continuation of this trend, maintaining a ratio of silver to gold (15 ½ to 1) that upheld the continued priority of gold over silver. By pricing gold favorably against silver, this ratio ensured that the export of silver in favor of gold would continue to be profitable. Both Newton and Locke indicated the direction that the natural philosophy was going to take with regard to economics: the commodification of money, with all the consequences that this would entail.

But the establishment of gold at the heart of the English currency system had another consequence of a different order: it established fractional-reserve banking in place of coinage as the “money method.” This system of banking had a magical working. It turned paper into gold, or gold into paper, for it multiplied a bank’s specie holdings and circulated a currency “as good as gold” albeit many times the actual amount of gold. This alchemical process actually worked, contrary to Newton’s experiments with the philosopher’s stone. And so Newton stood at the cradle of a new alchemy with far-reaching consequences.

It is one of those curious coincidences of history that Keynes, considered by many to be the modern progenitor of the alchemy of finance, was the first to discover and publicize Newton’s own alchemical wizardries. Keynes’ alchemy consisted in the magical transformation of fiat currency into productivity, growth, and wealth, simply by wielding “effective demand.” Newton’s consisted in the more mundane magic of the multiplication of gold reserves. “Their works follow after them,” for their alchemy lives on. In our day and age, the paradigm of alchemical transmutation has crossed over even into biology and gender. As such, it is the pulsating heartbeat of the age in which we live, all pretensions of scientific rationality notwithstanding.


 

[1] See in particular Margaret C. Jacob, The Newtonians and the English Revolution 1689-1720 (Ithaca, NY: Cornell University Press, 1976).

[2]  Immanuel Wallerstein, The Modern World-System I: Capitalist Agriculture and the Origins of the European World-Economy in the Sixteenth Century, with a New Prologue, vol. 1 (Berkeley, CA: University of California Press, 2011 [1974]).

[3] Dennis O. Flynn and Arturo Giráldez, “Born with a ‘Silver Spoon’: The Origin of World Trade in 1571,” Journal of World History, Vol. 6, No. 2 (Fall, 1995), p. 206.

[4] Doug French, “The Dutch Monetary Environment During Tulipmania,” in The Quarterly Journal of Austrian Economics (Vol. 9, No. 1, Spring 2006), pp. 3-14.

[5] Alexander Del Mar, Barbara Villiers: or, a History of Monetary Crimes (New York: Cambridge Encyclopedia Co, 1899).

[6] For instance: Peter Laslett, “John Locke, the Great Recoinage, and the Origins of the Board of Trade: 1695-1698,” in The William and Mary Quarterly, Vol. 14, No. 3 (July 1957), pp. 370-402.

[7] A recent article making this case is Charles James Larkin, “The Great Recoinage of 1696: Charles Davenant’s Developments in Monetary Theory” (2006), available at https://goo.gl/JtcWCH.

Honest Money?

“Honest money” is a phrase bandied about as a self-evident truth. As the accompanying graph indicates, its incidence coincides with the heyday of the gold standard. As such, it is the pithy summary of a strongly-held view on the nature of money, which at the time of the gold standard had a highly political charge. The only honest money was gold.

Incidence of the usage of the phrase “honest money” in books, 1800-2000. Source: Google Books Ngram Viewer

As an example, Stanley Waterloo’s Honest Money: “Coin’s” Fallacies Exposed, published in 1895. Here, silver currency is made out to be a dishonest con game: “The Silverite Argument: 1/2=1.”

Modern defenders of “honest money” are not as fastidious. In this, they have forgotten, or at least laid to one side, the controversy of the 19th century as to gold versus silver. Nowadays, according to a leading proponent of this doctrine,[1] honest money is metallic money, preferably gold, but also silver; the only honest money is either a coinage of pure gold or silver composition, or a paper issue 100% backed by such money metal; banks that do not adhere to this are a fraud; the state has no role to play here except enforcement of contracts.

The role of the state is reduced, because honest money is commodity money. In the jargon of the economic historians, money is the “most marketable commodity.” It has developed from the give-and-take of trade as the commodity, or form of merchandise, that proved to be most liquid, i.e., most current, most acceptable to any market participant, not as something directly desired, but as something that could be held and used at a later time in a later exchange.

Hence, the market takes care of money as a sort of automatic by-product. And, according to this version of events, silver and gold constituted the most marketable commodities.

The standard is weights and measures, as befits a commodity. This explains the biblical insistence on honest scales. The shekel, mentioned in the Bible as a unit of currency, was a unit of weight.

Coinage came in later on, as a means of simplifying matters. Instead of weighing out the money commodity for each transaction, coinage was developed in terms of standardized units, in various denominations, unvarying in each denomination, presumably with the weight stamped on each exemplar by way of convenience.

Presumably – because in actual fact, there is no historical example of a coinage stamped with its weight, the way a modern ingot is. What’s more, this version of events is without basis in historical fact.

Not that money did not start out as commodity money. It did, only it did not function in the way the “honest money” proponents would have us believe. The earliest records show a functioning commodity system, but one entirely different from this. In ancient Mesopotamia, a commodity money system developed, but it was, primarily, barley that was the “most marketable commodity.” The barley standard seems to have developed out of the need to store and dispense barley by the cities of the Fertile Crescent, which were more or less autonomous and had to provide for their own citizens. This storage took place in the temples, and was centrally organized. Silver was the other mainstay in monetary transactions. It was used for more high-end and inter-local transactions, while barley was used for local, lower-end transactions.[2]

The important thing to note here is that these commodities were used as units of account. “The temples in Babylonia from the Ur III period through the Achaemenid period use barley like money, especially as a unit of account.”[3] A unit of account serves to facilitate transactions on paper, not actual hand-to-hand transactions. In other words, the commodity was stored away to serve as a basis for monetary transactions, while not actually changing hands. Here we see beginning to take shape before us the basis for the banking system that is the bane of the “honest money” proponents: fractional-reserve banking.

“These institutions were in a position to store grain. They needed it to feed their dependents, and it is clear that they could turn it rather easily into all sorts of other things they might need, ranging from labor-services to commodities.”[4] As Powell notes, the majority of the population was relatively poor and dependent upon these temples for work and sustenance. If payments were made in barley, these could be made on paper (actually, clay tablets) rather than in kind; and as such, they could be expanded far beyond the actual holdings. This in turn would feed indebtedness, which is what a fractional-reserve banking system generates.

The indebtedness is attested by the innumerable cuneiform tablets on which these transactions were recorded. And indebtedness led ineluctably to all manner of social oppression, up to and including debt slavery. This, in turn, led to “clean slate” legislation in which debts were cancelled, debtors were freed from slavery, confiscated lands were returned to the original owners. In fact, the first instance of the word “liberty” – the Sumerian amargi, used by Liberty Press as its logo – does not refer to liberty in the abstract, or to economic freedom, but to the very specific act of debt cancellation. “The term should not be translated vaguely as ‘liberty’ or ‘freedom’ in the abstract, but as an economic ‘Clean Slate.’”[5]

The point here is the one I made in my book Follow the Money: “This practice [of fractional-reserve banking] … follows in commodity-based banking’s wake” (p. 15). Commodities used as money do not circulate freely, at least not nearly as much as other commodities, and the more valuable they are, the less freely they circulate. In fact, they have a habit of disappearing from circulation. They wind up in temples or in chests or in vaults, and they circulate only among the very wealthy.  Abraham may have had 400 shekels of silver – “Abraham weighed to Ephron the silver, which he had named in the audience of the sons of Heth, four hundred shekels of silver, current money with the merchant” – but Abraham was a rich man, for a single shekel of silver was the equivalent of a laborer’s month’s wages.[6]

The biblical prohibition on interest needs to be understood in this context. North argues that the Old Testament does not outlaw the taking of interest. He does so by distinguishing between “usury” and “interest” as two different things. “The Hebrew word ‘usury’ was a term of criticism. Usury referred only to interest taken from a poor fellow believer, in other words, interest secured from a charitable loan. Such usury is prohibited by Biblical law. But interest as such isn’t prohibited.”[7] This suggests there are two words for the phenomenon of interest in the Old Testament, or that the word is used in two senses. This is not the case. There is only one word, and it used in only one sense: interest on loans, not just charitable loans but all loans. By the Law of Moses, any interest at all was illegal, at least to fellow Israelites.

How to understand this? The biblical prohibition on interest was part of a larger complex of institutions, such as the Jubilee, aimed at mitigating the effects of indebtedness. Abraham had been called from “Ur of the Chaldees,” one of the leading cities of “the Mesopotamian Way”; God called him to found a new nation, one that would be able to stand against these nefarious institutions and ward off their debilitating effects. The prohibition on interest was there to keep these institutions from gaining a foothold in Israel. Later on, the Phoenicians, through Jezebel, would introduce their land law into Israel and corrupt it from that end. But the prohibition on interest was intended to prevent Israel from falling under the sway of these foreign influences.

So the Old Testament, while not prohibiting commodity money, mitigated the effects of its use, for it is precisely this that the prohibition on interest provided. Honest money, indeed.

But one might object that this was an aberration. Commodity money as the basis of a fractional-reserve system is not at all what is intended (even though that is what the modern gold standard entailed); commodity money which circulates and/or which forms part of a warehouse-deposit banking system is.

This is problematic. For one thing, it flies in the face of recorded history. Coins valued at weight have hardly ever been able to sustain a circulation. They get removed from circulation precisely because there is no difference between the coin and the commodity. In order to keep coinage in circulation, the value of the coin has to be set at a level higher than its market (intrinsic) value, otherwise it will disappear. This is Gresham’s Law looked at from the other side: it is not that bad money drives out good, but that only “bad” money circulates at all. Which is why nearly all systems of coinage have been fiduciary. Contrary to popular belief, coinage was never a system established to make it easier for commodity money to function, with a coin’s weight stamped on it to simplify matters. Rather, it was established precisely to escape the system of commodity money with its accompanying inconveniences and injustices.[8]

There have been attempts to maintain an “intrinsic” value coinage. But what is clear from them is that their purpose was not to provide for a wide domestic circulation, but only for the upper levels of the economy, for high finance and international trade. During the Dutch Golden Age, for example, the Dutch produced what they called negotiepenningen, “trade pennies,” which were pure silver coins of a certain weight to facilitate trade. These were minted exclusively for international trade and were not meant for domestic circulation – hence the name. Similar examples are the Venetian ducat and the Florentine florin.

The greatest example of such a currency was the Byzantine solidus or bezant, a gold coin maintained for hundreds of years in Byzantium, minted at the rate originally set by Constantine: 72 coins per pound weight of gold. But this coin was part of an intricate system of coinage formed of three metals, copper, silver, and gold. The day-to-day economy ran on silver and copper; the upper reaches of the economy made use of gold. And the empire sacrificed prodigiously to maintain that gold coinage. The state strictly controlled trade to ensure that gold was not exported. It spent massive amounts of resources on gaining and maintaining gold mining regions. Tax rates were high to pay for all of these state activities, to control trade and maintain far-flung armies, all for the sake of maintaining the coinage. And economic development stagnated while economies in neighboring Islamic countries bounded forward: The Muslims, for their part, maintained a silver standard and reaped the benefits of it.

Now let’s suppose that we followed the hard money advocates’ advice and introduced a strictly commodity money based on the precious metals. And further, let’s suppose that we followed their advice and maintained this currency on a basis of strict 100% backing, i.e., without engaging in any fractional-reserve banking or making use of any sort of credit instruments that did not have a strict monetary backing. For one thing, this would call for a heavy dosage of state oversight to ensure that all transactions were conducted on the “up-and-up.” Credit would be eliminated, because credit intrinsically expands the money supply. No lending with the promise of money repayment could take place even on a personal basis, that did not have strict 100% monetary backing. For every such “credit transaction” would in essence expand the money supply. Even the corner grocer’s provision of groceries with a promise of repayment when the paycheck comes in, would be illegal and punishable.

So the state would be heavily involved in the administration of such a standard. But beyond that, it would mean an enduring and drastic deflation, with all the traumatic consequences of such a deflation. This is because the money supply, being limited to the amounts of precious metal that are available to be put into circulation, is by the nature of the case kept at a more or less constant level, while the broader economy, with its innovation, its new technologies, its expanding workforce, its expanding output and consumption, continually outstrips that circulation. With expanding goods and services and a constant money supply, the only direction for prices to go is down. And a deflationary environment is one in which spending collapses, consumption collapses, and everyone holds onto the money they have, to spend it only on things of pressing importance. That is the nature of a deflationary economy. The holders of precious metal would see their holdings appreciate in value daily, while those without such holdings would be left to the mercies of a contracting economy and the opportunities, or lack thereof, it affords.

The attraction of “honest,” i.e., market-based commodity money, is that it seems to be immune to the manipulations of dishonest actors, whether they be bankers, or merchants, or minters, or the state. But this is a mirage. Such an institution never has existed and probably never will. Money needs to be adaptable to the needs of the economy. The money supply needs to be capable of expansion. How that is to be achieved is another question, one which I answer in my oft-mentioned book Follow the Money, to which I refer the reader for further investigation.


 

[1] Gary North, Honest Money: The Biblical Blueprint for Money and Banking (Auburn, AL: The Ludwig von Mises Institute, 2011 [1986]).

[2] A helpful summary of Mesopotamian money can be found in Marvin A. Powell, “Money in Mesopotamia,” Journal of the Economic and Social History of the Orient, Vol. 39, No. 3 (1996), pp. 224-242.

[3] Powell, “Money in Mesopotamia,” p. 229.

[4] Powell, “Money in Mesopotamia,” p. 229.

[5] Michael Hudson, The Lost Tradition of Biblical Debt-Cancellation (New York: 1993), p. 16. Download here.

[6] Powell, “Money in Mesopotamia,” p. 229.

[7] North, Honest Money, pp. 81-82.

[8] My book Follow the Money contains much more on this topic.

Weighing the Gold Standard

Seeing as how the gold standard is a “money method”[1] by which all exchange value is made dependent upon the weight of a certain substance, viz., gold, it would seem appropriate to “weigh it up” to determine whether or not, “weighed in the balance,” it is “found wanting.”

Indeed, weight measurement was the standard of value during the period when the gold standard held sway, and that standard was gold by weight: the dollar was set at 23.22 grains of pure gold (a grain being 1/7000 of a pound), the pound sterling at 113 grains, the German mark at 6.146 grains, the French franc at 4.98 grains, etc. In this manner, all the currency systems of the countries that adhered to gold standard were bound together by gold. Gold served as the currencies of the world’s reserve currency. This is likewise the origin of the modern system of reserve currencies, but we reserve that discussion for another opportunity (I discuss reserve banking in more detail here).

The gold standard is considered to be, well, the gold standard of money methods. Its great attraction lies in the discipline it lays on governments to conduct a strict and balanced fiscal policy. It does this because it ostensibly takes monetary policy out of the hands of the state. I say “ostensibly,” because the reality is a bit more complicated than that, as we shall see. Nevertheless, the gold standard system came also to be known as the “automatic mechanism” precisely because it functioned without government interference, indeed without any interference at all, guided by a veritable invisible hand. Again, this was not entirely the reality, but not entirely a departure from reality, either.

So the gold standard took currency management away from the state. Prior to it, the state did manage the currency. And that state-run currency system had its roots far back in history.

To be precise: with the advent of coinage in ancient Lydia (western Anatolia) around 700 B.C., the state became the manager of the monetary system.[2] Prior to this there were systems of commodity money – the Old Testament, for instance, speaks of silver as currency (a shekel being a weight measure of silver), and both silver and barley were used as commodity money in ancient Mesopotamia. These were not state-run but purely market affairs. Coinage was introduced, not as a form of commodity money, but precisely to counteract commodity money, which at that time was intimately tied up with the institution of debt slavery. It was introduced to insulate the domestic economy from foreign hegemony. It thus likewise accompanied the rise of the Western concept of freedom in the Greek city-states: coinage was one of the means which enabled the Greeks to wrestle their freedom from the Eastern (Persian) hegemonic empires.

Rome carried on the Greek tradition of coinage and introduced it throughout its empire (“Shew me a penny. Whose image and superscription hath it? They answered and said, Caesar’s. And he said unto them, Render therefore unto Caesar the things which be Caesar’s, and unto God the things which be God’s” (Luke 20: 24-25).) In so doing, it established for posterity the tradition of state management of the money supply. All of the Western European kingdoms took over this Roman institution and applied it as they waxed into independent sovereign states. But this system had its drawbacks. It required precious metals, mainly silver but also, secondarily, gold, to function. And during the entire period of medieval and early modern times, these metals were in short supply. The money supplies of these countries were subject to the vagaries of that supply – mines exhausted here, mines discovered there, new techniques opening new areas up for mining, the demand for silver from the East, in particular India and China – all of these factors played a role in the relative abundance or scarcity of the raw material needed to make the circulation go.

Add to this the practice of competitive devaluations conducted between currency regions, and one can understand the preoccupation for the provision of a supply of metallic currency; a preoccupation which later ages looked upon disparagingly. They even had a name for it: “mercantilism.” But this was no idle preoccupation, for the entire economic circulation depended on the existence of a metallic coinage; nothing else enjoyed the common consent and confidence necessary for a circulating medium.

Coinage was thus a state-run affair, and when the gold standard came around to supplant it, it actually supplanted the regime of coinage entirely. Where the gold standard became established, there coinage dried up. Gold coins never enjoyed the circulation the great silver pieces did, such as the Spanish pieces of eight, which in fact formed the bulk of colonial America’s circulation. No, the system of the gold standard was based on an entirely different “money method”: that of credit and banking.

This may come as a shock to those advocating a return to the gold standard. The common image is that of a rock-solid metallic currency that cannot be manipulated. But the reality of the gold standard was that, under its regime, credit exploded. This was not a bad thing; in fact, it was the way the Industrial Revolution was financed, and without it, that revolution probably would not have materialized. Still, the gold standard engendered a massive increase in banking and credit-derived bank money.

In this system, gold did not circulate in the sense of changing hands. Rather, it was locked up in bank vaults and served as the basis for the structure of credit. It was thus the reserve that every bank needed in order to issue credit. Theoretically, for every dollar of credit the bank issued, it could back in gold. Practice was different: reserve ratios were maintained depending on the likelihood of “cash,” i.e., specie, withdrawals. A ratio of 1/3 was common, at least initially. But with the practice of reserve banking, by which banks deposited their gold holdings with other “reserve” banks, the basis shrank.

So it was under the regime of the gold standard that we obtained an ever more “elastic” money supply. This was reflected in the explosion of credit. Macleod used the following example (from England) to show how the money supply there had changed under the gold standard.[3] He used the finances of the Slater house as representative of commerce in general. For year 1856, this is how its income statement looked:

macleod1

As Macleod noted, “Gold did not enter into their operations to even so much as 2 per cent. And this may furnish a clue by which we may obtain a rough estimate of the amount of Credit.” If this is representative, then credit amounted to 50 times the amount of gold. “This Credit produces exactly the same effects, and affects Prices exactly as so much Gold: and it is through the excessive creation of this kind of Property that all Commercial Crises are brought about.” It is a warning similar to the one Walter Bagehot made in his classic work Lombard Street: the entire edifice of credit was being erected on an ever slimmer basis.

Macleod avers that this lay at the heart of the commercial crises that repeatedly afflicted the economies under the gold standard. But it was the working of the gold standard during the times when it functioned automatically, the way it was supposed to work, that engendered the misery and resentment that led to the rise of the labor movement, political agitation, and the ultimate demise of the system.

This came about because of how the system affected wages and prices, enterprise, and employment. The automatic mechanism functioned through gold flows, and gold flows determined the money supply. Where gold flowed into the economy, the money supply could expand; where it flowed out of the economy, the money supply was forced to contract.

These flows occurred not only within countries but between them, given the international character of the gold standard. When economies, including national economies, ran trade surpluses or deficits, gold flowed to the surplus country, expanding its money supply and fomenting economic activity. By the same token, gold flowed out of the deficit country, restricting the money supply and depressing economic activity. The result was deflation in wages and prices.

So the gold standard worked by allowing inflationary and deflationary swings to redress trade imbalances. This resolved the underlying imbalance, but at what price? Severe bouts of unemployment, and consumption- (and thus production-) killing deflation. Schumpeter, perhaps the most thoughtful and nuanced defender of the gold standard, argued that deflation was not necessarily a bad thing, when all prices and wages moved in sync. Theoretically this might be true, but in practice, deflation has always been traumatic.

In fact, the only benefactors under a regime of regular deflation are creditors. This dynamic gave rise to the so-called social question and the various labor movements, socialism, and communism which characterized the later 19th century’s political landscape. The political unrest behind these movements found increasing recognition in the expansion of the suffrage, which brought the labor movement into the midst of the political arena, and put the interest of the workers on a line with those of the creditors. As a result, a new political calculus came to hold sway – called “stabilization” – consisting in the pursuit of price and wage stability. From this point on, governments pursued policies that could provide this kind of stability.

What then of the gold standard’s automatic mechanism? After all, it was based on the inflation/deflation model of rebalancing, and this new political agenda worked at obvious cross purposes to such rebalancing. The answer is, it was paid lip service as an ideal but was increasingly undermined in practice, first at the edges, later at its heart.

The first concessions to the new agenda were social programs and labor legislation. While they may have alleviated the working class’s lot, they did nothing to solve the underlying problem – the trade imbalance – and in fact hindered its resolution by devoting resources to perpetuating the status quo. Old-school conservatives recognized in this the first signs of state encroachment on the private sector, and they were right.

Along with this came central bank intervention. At first this was small-scale; but after World War I, it became de rigueur. Central banks came to master the art of “open-market operations” to control interest rates and, hopefully, changes in the money supply. But what really broke things open was the policy known as sterilization. By this policy, the automatic mechanism was entirely short-circuited. Sterilization entailed the removal of gold from circulation in the real economy to keep it from affecting prices and wages. This was done in the name of stabilization, but it effectively kept the gold standard from performing its rebalancing function. The countries from which gold flowed remained in a constrained economic situation, while the countries to which gold flowed were kept from expanding. Instead, that money went into the financial market. This precipitated the great bull run on the stock market in the late 1920s which ended in the Great Crash. After this, the gold standard system fell apart: some countries continued to adhere to it, allowing it to constrain their money supplies, while other countries went off of it and saw their money supplies expand and some degree of prosperity return. In addition, this period saw the advent of massive social programs administered by government, which required some degree of government influence on monetary policy in order to gain adequate financing. This dependence by government upon monetary policy, and the popularity this enjoyed among the electorate, sealed the fate of the gold standard.

What are the lessons to be learned from this history?

  1. The gold standard in its historic form as “automatic mechanism” will never be introduced as long as the electorate is democratic, i.e., as long as universal suffrage is the rule;
  2. The gold standard is not a coinage-based but a bank- and credit-based system;
  3. If it is a hard-money, coinage-based system that people are after, then a silver rather than a gold standard would be more feasible. For centuries, silver formed the backbone of the currency system, and for good reason: it is available in sufficient quantities to form an everyday circulation. When the gold standard was introduced, it displaced coinage, which brought great hardship on common people, who suffered from the lack of a circulating medium fitted to their needs.

 


 

[1] The term is Joseph Schumpeter’s: see his Treatise on Money (here and here).

[2] For the historical background to the following discussion, see my book Follow the Money. For more on this entire discussion, one may also consult the accompanying introductory course in economics, which goes into more detail.

[3] The following is taken from Henry Dunning Macleod, The Elements of Economics (New York: D. Appleton and Co., 1881), vol. I, pp. 324-325.

Another Look at Quantitative Easing

In a previous post (“Quantitative Easing and Substitutionary Atonement”), I discussed some of the underlying philosophy of quantitative easing, the latest of the Fed’s attempts to “stimulate” the economy.

Quantitative easing, to recap, is the term for central bank purchases of assets on the open market.

The difference with traditional “open-market operations” is twofold.

Firstly, the purpose: open-market operations normally have interest-rate manipulation as their goal. The Fed maintains what is called the federal funds rate, which is the interest rate (yield) the Fed targets in buying and selling short-term treasury paper, the most liquid asset on the money market. This sets a floor for interest rates generally. Quantitative easing, on the other hand, is not conducted to manipulate interest rates. Rather, it is conducted to amplify the money supply in the financial market, and in this manner to affect asset prices.

Quantitative easing comes into play when interest-rate manipulation has run its course — such as when interest rates have already been lowered to zero or near-zero, in which case those efforts come to resemble pushing on a string.

Secondly, and in line with the purpose, the quantity involved: as can be seen on the accompanying graph, quantitative easing involves a massive increase in asset purchases as compared with standard open-market operations. The latter were in operation prior to the credit crisis of 2008, and the asset level was stable at around $900 billion, reflecting the fact that buying and selling were conducted interchangeably. The former was initiated soon thereafter, as can be seen from the explosion in asset holdings. In the meantime, it has stabilized at $4.5 trillion (!).

fed balance sheet 2007-2016
Fed balance sheet, 2007-2016. Data obtained from the Federal Reserve Board.

What has been the effect of this? Well, as my previous post explained, it has simply increased the money circulating within the financial market. By contrast, it has done nothing to stimulate the ordinary market. This disconnect between the two markets is explained further in our course in economics, which outlines the relationship between these markets.

Now let’s juxtapose the Fed’s balance sheet with the Dow Jones Industrial Average, this time updated to March 2016:

Correlation of the Fed's balance sheet with the Dow Jones Industrial Average, 2007-2016
Correlation of the Fed’s balance sheet with the Dow Jones Industrial Average, 2007-2016. Data obtained from the Federal Reserve Board and S&P Dow Jones Indices LLC.

The correlation still seems to hold true. The Fed has not added to its holdings since late 2014, and the DJIA has been unable to break through the ceiling that inaction has formed. Whether or not the correlation is a direct one, or whether there is any real relationship between the two, is more a matter of theoretical plausibility than practical proof, but it would certainly seem that there is some causal relationship.

Assuming that there is such a relation, this would also indicate where the stock market is headed once the assets start being reduced, either by being sold or by being retired. This will take money out of the financial market, causing prices to drop. This in turn might lead investors to take out their own money, precipitating what could become a rout.

Thoughts on the Piketty Thesis

As is the case with the vast majority of commentators on this topic, I have not read Thomas Piketty’s book (Capital in the Twenty-First Century). The following is therefore gleaned from other sources, mainly this interview, from which, unless otherwise indicated, the following quotations are taken.

The first thing to say is that, on the face of it, Piketty’s exposition is capitalism-friendly. In fact, his approach would seem to be a capitalist prerequisite, for it requires wealth to be put to work, which is a capitalist imperative. In his own words “my point is not at all to destroy wealth. My point is to increase wealth mobility and to increase access to wealth.” Which sounds like a good thing.

But, for one thing, it would entail the capitalization of resources that otherwise would be kept out of the sphere of what is unkindly referred to as capitalist exploitation. For instance, forestry. Having been an undergraduate forestry student, I recall the discussion in forest economics class with regard to the exigency placed on forests by a property tax. All of a sudden, a landowner must generate a revenue from that forest simply in order to pay the tax, on a piece of land that otherwise might be left undeveloped, hence ecologically undisturbed. This could lead to the application of sustainable multi-use forestry practices, or it could lead to elimination of the forest, depending upon the ecosystem involved. The same thing applies to traditional, less-than-profitable land uses. Followers of the television series Downton Abbey will recall the difficulties put upon the estate by the imposition of a wealth tax, causing Lord Grantham to anguish over having to remove inefficient tenants in order to turn the land to more productive uses.

Furthermore, a wealth tax would penalize saving in favor of consumption. Piketty can argue that consumption is difficult to distinguish from investment: “What’s the consumption or income of Warren Buffett or Bill Gates when they are using their corporate jet? Are they consuming? Are they investing? Nobody knows.” But the fact of the matter is, the imposition of a wealth tax would establish a prima facie incentive to spend income rather than save it, especially given the bias against inheritance Piketty displays (“In order to get a zero capital tax result, you need basically two very strong assumptions. One is that wealth is entirely a life-cycle wealth; you have no inheritance at all. Once you have inheritance, you want to tax it”). The moral will be, “eat, drink, and be merry, for what is not taxed today will be taxed tomorrow, if you try to hold onto it.” In Holland, there already is a wealth tax, on top of the 52% income tax (highest bracket, which begins rather early), the 21% VAT, the gasoline tax that jacks the price of a gallon up over $10, etc. So the money that escapes the fevered clutches of the Belastingdienst the first time around gets hit at the rate of 2.5% a year in perpetuum. The moral: spend it before it gets eaten away. Or at least, invest it for a return in excess of 2.5%, which in this day and age is no mean feat.

Another point is that Piketty’s wealth tax would be tax on “net” wealth, in other words, assets minus liabilities, property owned net of debt. It thus incentivizes indebtedness. “If you own a house worth $500,000, but you have a mortgage of $490,000, then your net wealth is $10,000 so in my system you would owe no tax. Under the current system, you pay as much property tax as someone who inherited his $500,000 home or who paid off his debt a long time ago.” The anti-saving bias is evident here. What is also evident is the built-in incentive to take on debt so as to offset taxable property holdings.

Regarding Piketty’s discussion of inequality: the message is that inequality has been increasing over the past 20-plus years, precisely the period of time in which globalization and international trade have surged forward. While Piketty himself does not argue this point, his findings do prompt the conclusion that globalization and free markets lead to inequality, while protectionism and government intervention are needed to foster income equality. And Piketty’s wealth tax is precisely one form of government intervention.

Piketty argues that income and wealth inequality have been increasing (although his findings are disputed), and blames it on the “huge cut in marginal tax rates.” From the interview: “Matthew Yglesias: How do we know that high executive compensation comes out of the pockets of other wage earners? Thomas Piketty: Well, because the labor share including CEO compensation did not increase. It actually declined. Maybe it would have declined even more without the rise in CEO compensation, but that’s hard to believe. I think the rise of very large CEO compensation came at the expense of the workers.”

This does seem to be the case, but as a matter of fact, I would have been shocked if the effect of the globalization of the post-Bretton Woods period had not led to greater inequality. But that doesn’t entail a critique of globalization per se, nor excessively low marginal tax rates, but the way in which the international trading system has been manipulated. Let me explain.

Ever since Bretton Woods, we have had a system of ostensibly floating exchange rates. Ostensibly — because exporting countries have been resorting to various hooks and crooks to maintain their exchange rates at artificially low levels, thus to manipulate and subvert that float. The dollar being the reserve currency of choice, and the US being the export market of choice (referred to tongue-in-cheek as “the consumer of last resort”), the manipulation is conducted against the dollar, keeping the exporting country’s exchange rate low vis-à-vis the dollar, allowing the exporting country to sell its production to America at ongoing low-wage-maintaining levels. The result is that production capacity shifts towards the low-wage countries, because the exchange rate is not allowed to adjust upward like it should. So the low-wage countries remain low-wage. Meanwhile, production capacity shifts away from the US, leaving only service-economy jobs there, which likewise generally command lower wages than manufacturing jobs. So in both the exporting countries and the consuming countries, the tendency is to depress working-class wages. On the other hand, the profits from the exchange continue to flow, into the hands of exporting country elites and multinational corporation managements, along with (of course) investors in those enterprises. This works to expand the income gap and thus income inequality. No surprise, really.

So the solution to this problem is not to abolish globalization per se, nor to increase marginal tax rates. Rather, it is to get the countries involved to stop manipulating the global system in favor of various special interests and elites, be they domestic or foreign. After all, the working class in the exporting countries suffers just as much from this situation as does the working class in the importing countries. Both are having their wages depressed.

Again, from the interview: “Matthew Yglesias: I thought one of the most interesting graphics in the book is the one where you show the price-to-book ratio in Germany is quite a bit lower than in the other countries. Is there an important lesson the rest of the world can learn there? Thomas Piketty: Yeah. Actually, to me this was quite striking. Previously I didn’t take seriously this idea that there were different ways of organizing capitalism and the property of capitalistic firms. I think the lesson from this graph is that the market value of a corporation and its social value can be two different things. Of course you don’t want the market value to be zero, but the example of the German corporation shows that even though their market value is not huge, in the end they produce some of the best cars in the world. They export a lot, and they are very successful. I think getting workers involved on the board of German corporations maybe reduces the market value for shareholders, but in the end, it forces workers and unions to be a lot more responsible for the future of the company.” I don’t want to speculate as to the reasons why German companies have relatively low valuations, but I will point out that Germany is at the exporters’ end of the export-import imbalance, only this time the import partners are southern Europe. How did the southern European countries run up so much debt? Mainly by paying for imports from, in the main, Germany. Germany’s model parallels Japan’s and China’s, only it functions mainly within the European sphere, with the help of the euro. In essence, Germany’s currency is structurally undervalued, while Spain’s, Italy’s, Greece’s, is overvalued. That’s how Germany can display such favorable economic data. But as Michael Pettis has shown, Germany’s workers are structurally underpaid because of it. The surplus goes to Euro elites.

There is much more to this story than merely the level of marginal tax rates. As long as the causes of inequality are misconstrued, the solutions on offer will always have be more akin to political footballs than actual fixes. Piketty claims that his “point is not to increase taxation of wealth. It’s actually to reduce taxation of wealth for most people, but to increase it for those who already have a lot of wealth.” Which of course appeals to most of us, because most of us don’t have “a lot of wealth.” But this “fix,” like many others past, present, and future, will get nowhere unless based upon a proper evaluation of the causes of the problem it purports to address.