World War 1 and the Gold Standard that Was Really a Tax Revenue Standard

Ben Green said...
"I think it would be extremely useful to analyze throughout history the transition period where an Empire (England in WWI, etc.) began to decline and the effects on its currency. It seems to be a game - of wanting everything at once instead of realizing that you can pursue at most one economic objective at any given time.Please elaborate more on England's transition during WWI and the actual mechanics of the decline. I find your posts very informative but have been unable to read much lately as very busy with work/school.

Regards,"

Anon said...

"Chromatic, while you make a compelling case above, I feel that due to the sheer magnitude of the credit and derivatives markets, large-scale defaults (which, IMHO, are highly likely when real estate collapses and our asset-based economy tanks along with it) will overwhelm the government's ability to print us out of a deflation. It's not like our government isn't in enough deficit trouble already. China and Japan, who have been dependent upon our spending binge over the past several years, will no longer have the continuing flood of dollars with which to help bail us out. Your thoughts? "

Thanks for your post,

Lets first take on you first statement about deflation and how it arises. This would indicate that the money supply is declining inducing reduction in asset prices (housing). The US dollar is overvalued is as a result jobs are shifting to cheaper, but not less incapable countries. So it looks like deflation is not only possible, but the pressures all look for a decline in labor costs and prices due to international economic pressure.

However, the US dollar is the world’s reserve currency. This means that all currencies are compared to the US dollar before any two currencies are exchanged with each other. Also foreign central banks, the countries banks have a majority of their assets in terms of the US dollar. This situation is similar to the post World War One when most of the world was on the British pound standard.

During WW1 England and all of the other European countries left their gold standards in order to fund the war. They therefore expanded their respective money supplies greatly. After the war England, whom was one of the financial leaders of the time, decided that they would restore England to economic leadership if they returned to the British pound sterling relationship to gold at the pre-WW1 level.

The banking system had already been moving away from gold as a world currency and replacing government debt (this is really the ability to obtain tax money) as the banks core reserve (the banks basis for lending out credit). Because government bonds, sovereign debt, is now used as a basis for a bank reserve, this linked money created through fractional reserve banking to a countries debt load.

This lead to a situation whereas countries now had a gold standard in writing, but in actuality there was no possibility of redemption in gold on a mass scale due to currency created through over lending. The ratio of gold as the core holding of banks was being diluted by the promise of future tax revenues (i.e. government debt). Currencies of the world were basically severely overleveraged in relationship to gold even before WW1.

Therefore a system of agreements was in place between trading countries so that promises were made for payment is gold, but gold didn’t actually leave their country en-mass before WW1. This is not to say that gold didn’t leave the countries, only that the rate at which it left was very negotiable.

Why a gold standard? Countries wanted to tie their currencies to gold because tying it to future tax revenue has always been unstable and lead to unlimited creation of money through printing, leading of course to the devaluation of buying power of the currency. With the illusion of gold backing the currency, the countries of the world could claim their currency was stable as long as they could redeem the paper currency for gold coins to the population. They then enacted policies to drive hard currency out of circulation until the final outcome was that gold was really only used for international settlements.

So in order to redeem their place as the center of the financial world, England came up with a plan that called for the British pound to return to its pre-WW1 value with gold. They then made payments to other European countries with British pound sterling. Foreign banks could then redeem their British pound sterling for gold inducing a control mechanism to slow gold from leaving England and making the British pound sterling the world’s reserve currency, much like the US dollar today.

As the value of the British pound sterling was still overvalued to the comparable money supply of other countries in its relationship to gold, this forced a negative trade balance with the other countries of the world. English currency entered the other countries like locus in a biblical curse.

During the 1920’s England refused to deal with their negative trade balance and provided money for their welfare state as unemployment skyrocketed. English sovereign debt and money supply went into to steep rise. Overextended as the English were, they continued to inflate their currency, but still kept their currency overvalued per agreements they had made with other central banks. This situation finally collapsed upon itself when England went off of the gold standard right before they had exhausted their supply of gold. This caused massive inflation in England.

So, as history dictates, countries will gladly sacrifice the value of their currencies buying power in order to pay for the social programs and government expenditures. Even though the banks are very very powerful, they cannot compete with the voting populist. This is because politicians are elected and not by banks, but by people. And politicians generally get elected by promising the what ever it takes to win an election.

As to our current situation with housing in the US, and the world for that matter you can expect some initial deflation in terms of the asset prices, but then the banking system will become unstable as banks become insolvent. If the banks cannot clear money transactions then the economic system get paralyzed as this induces first general insolvency and quickly, very quickly leads to bankruptcy.

With enough bankruptcies, which make it harder to people to earn an honest living, social breakdown always occurs. To combat this and keep in power the government must bail out the banking system. In bailing out the banking system will certainly deflate the buying power of the dollar. However the corollary to this is that prices rise very quickly.

Since the US dollar is the world’s reserve currency, exchange rates may not change that much between countries because this would induce similar situations all over the world.

Therefore Deflation, if you define it as the buying power of the dollar increasing can only happen as a lasting outcome with the total destruction of the banking system. The US would never allow this situation to happen, due to the fact that politicians are always trying to get re-elected and they need the political system in tact to do it, but the buying power of the dollar is an acceptable causality.

As for your comment

“I feel that due to the sheer magnitude of the credit and derivatives markets, large-scale defaults (which, IMHO, are highly likely when real estate collapses and our asset-based economy tanks along with it) will overwhelm the government's ability to print us out of a deflation”

There is no limit to how much the US can print. All that happens is that the world hyper-inflates with us, stealing the paper saving private citizens all over the world have accumulated. This would not be the first time a world currency has failed. The country in question just inflates in order to prevent social disintegration.

As I stated before the only way with paper money you can have deflation is if you can

A.) A mass exodus from the banking system, this is really not possible any more

B.) A competing currency is available, all other currencies are based upon the US dollar and gold is no longer a currency that can be used.

C.) Loss off Faith in the banking system, possible, but you have to at least have A or B in order to derail the amount of money created through fractional reserve banking and fend off inflation by removing money from the banking system.

D.) Hyperinflation can happen regardless of anything else. The government just prints its way out of debt. This happens every few years somewhere on the globe. There is NO DEBT LEVEL TOO HIGH THAT A COUNTRY WITH DEBT DEFINED IN TERMS OF ITS OWN CURRENCY CANNOT HYPER INFLATE OUT OF. Hyper inflation causes problems, but not nearly as many as the collapse of the banking system, at least from a political point of view.

China and Japan?

These countries economic systems are at risk just like any other country that holds large amounts of our debt compared to their economy. All countries will be affected, and their currencies shall fail, meaning their political system is destroyed as well, or they will hyper inflate, with almost as many political dire consequences.

Chromatic Dispersion