Until early in the 20th century, gold played a central role in the world of money. Gold had an incredible run – almost three thousand years. And why not? After all, Professor Roy Jastram convincingly documents in The Golden Constant just how gold maintains its purchasing power over long periods of time.

But, since President Richard Nixon closed the gold window in August 1971, gold has not played a formal role in the international monetary regime. Today, the “regime” is characterized by many as a chaotic non-system. In the past decade, gold prices have surged and there have been noises in some quarters that gold’s formal role should be re-established in the sphere of international money. Nobelist Robert Mundell has gone so far as to predict that “Gold will be part of the structure of the international monetary system in the twenty-first century.”

Automatic Currency Boards versus Central Banks

Gold-based currency boards could transform Professor Mundell’s prediction into a reality. Currency boards have existed in more than 70 countries and a number are still in operation today. Countries with such monetary institutions have experienced more fiscal discipline, superior price stability, and higher growth rates than comparable countries with central banks. An orthodox currency board is a monetary institution that issues notes and coins (some currency boards have, however, also accepted deposits).

Its monetary liabilities are freely convertible into a reserve currency (also called the anchor currency) at a fixed rate on demand. The reserve currency is a convertible foreign currency or a commodity chosen for its expected stability. For reserves, such a currency board holds low-risk, interest-earning securities and other assets payable in the reserve currency. Its reserves equal 100 percent or slightly more of its notes and coins in circulation, as set by law.

An orthodox currency board has no active role in determining the monetary base. A fixed exchange rate with the reserve currency and the requirement that the currency board hold foreign reserves equal to 100 percent of the monetary base prevents it from increasing or decreasing the monetary base at its own discretion. Nor does a typical currency board influence the relationship between the monetary base and the money supply by imposing reserve ratios or otherwise regulating commercial banks. An orthodox currency board system is passive and is characterized by automaticity. Regardless of the metric used, the money supply in a typical currency board system, therefore, is determined entirely by market forces — that is, the demands of money users who bring reserve currency to swap for local currency determine the amount of notes and coins that the currency board supplies.

In a currency board system and in a central banking system alike, commercial banks are entrepreneurs of credit. A commercial bank cannot lend more to borrowers than it can borrow from depositors (or credit markets), in the form of deposits held instead of spent. If a commercial bank lends excessively, the borrowers spend the excess, for instance, by writing cheques. In the payments system, more funds flow out of the bank than flow into the bank. To prevent the outflow from bankrupting it, a commercial bank holds reserves. The loans of commercial banks are limited by their need to maintain sufficient reserves to enable depositors to convert deposits into cash (or reserves) on demand and to withstand outflows of reserves through the payments system.

A typical central bank, in contrast, can at its discretion increase or decrease the monetary base. It can lend to commercial banks, creating reserves for them, even if its foreign reserves are decreasing. More reserves tend to enable commercial banks to make more loans, which they do by creating deposits for borrowers. The money supply then increases. Decreasing the monetary base tends to have the opposite effect. Besides changing the monetary base, a typical central bank can also influence the supply of commercial bank loans by changing the reserve requirements for commercial banks.

Despite the inability of an orthodox currency board to create reserves for commercial banks at its own discretion, the money supply in a typical currency board system is quite elastic (responsive) to changes in demand, because the system can acquire foreign reserves. The rules governing a currency board merely prevent it from creating reserves for commercial banks in an inflationary manner, as a central bank can. Other sources of elasticity in the money supply are variability in commercial banks’ ratio of reserves to deposits, the pooling of reserves among branches of commercial banks in the currency board country and the reserve country, interbank lending, and variability in the public’s deposit-to-cash ratio.

In the past, currency boards have issued monetary liabilities that were fully backed by gold and were fully convertible into gold at a fixed rate on demand. The following gold-based currency board law is presented to indicate how a modern, independent, gold-based currency board could be established and would operate. As drafted, the law would allow for the creation of a publically-owned entity. But, with slight amendments, the draft law could support the establishment of a purely private currency board.

(See the proposed text [Here].)

Steve H. Hanke is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute in Washington, D.C.

This article appeared in the May 2012 issue of Globe Asia and the version here is from the Cato Institute Web site, April 24, 2012
http://www.cato.org/publications/commentary/goldbased-currency-board-please.

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One of the most desired reforms of the libertarian movement would be to abolish the Internal Revenue Service. The IRS is perhaps the most despised Federal government agency, not only because it symbolizes the hated income tax but also because it is a spy center. Every employer and anyone who pays you more than $600 per year is supposed to “rat you out” to the IRS with a 1099 form (banks and brokerages do it at $10).

Although the IRS is mostly concerned with the collection of personal and business income taxes, the agency was not created in 1913 with the 16th Amendment. It was established during the Civil War and persisted even after the war ended, although the war income tax expired after 1871. The Internal Revenue Service collects revenue from inside the county, while the older Customs Service collects tariffs at the ports of entry. Before the IRS, the Treasury department had been running a bureau since 1791 to collect Alexander Hamilton’s whisky excise tax.

When president Richard Nixon imposed wage and price controls in 1971, the enforcement agency was the IRS. In my 1982 book, “The Income Tax Must Go,” the label that seemed most to fit the agency was America’s Secret Police. Although they like to trumpet the slogan that the filing of income tax returns is voluntary, and failing to file is only a civil violation of law, the force of guns and police are not absent. When you sign a tax return, the criminal penalty for perjury is attached to your signature. The IRS publicizes its enforcement powers every spring, as April comes, to use fear as a stimulant for people to file tax returns.

Misleading Proposals to Abolish the IRS

There are several misleading proposals to abolish the IRS floating in the blogosphere. One of the most prominent is the so-called Fairtax, which would eliminate the personal income tax and replace it with a national sales tax, combined with a socialist proposal first advocated by presidential candidate George McGovern in 1972 – the “prebate” to give money to everyone in advance, so they can pay the sales tax at the grocery store and gas station.

It seems the most popular part of the national sales tax idea is that individuals would be liberated from reporting to the IRS every year. But there are a number of questions about this “magic wand” interpretation of the Fairtax.

One of the questions about a retail sales tax is whether it covers the price paid for services. Many states do not tax services, and it is always a controversy whether their sales taxes, or “retail privilege tax” as in Arizona, should extend to cover the sale of services. One service a typical family might offer would be a yard sale or a garage sale. Would the Fairtax cover those activities? Would a family putting old clothes and used toys or furniture on their driveway in the spring have to register with the (what shall we call it?) the new IRS to collect the national sales tax?

The Fairtax is riddled with gimmicks to answer this question. For example, newly constructed houses would have to pay the national sales tax, but used houses would not? Maybe the yard sales are only selling used stuff, but what about the pottery or the quilting that is sold at local arts and crafts shows? What about the kids who mow lawns in the summer? Would they have to register with the IRS to collect the national sales tax? It seems the issue about collecting the tax is something the advocates of the Fairtax have some problems to explain. A government agency would be asking questions to anyone who creates a product with new labor.

Not least among the victims of the Fairtax revenue enforcement agency would be the retail stores, particularly the small retailers. Mom and pop have a small convenience store franchise. Today they submit monthly reporting tax returns to their local state sales tax agency, in most states, and sometimes they are audited. The national retail sales tax would dramatically increase the amount of money and the importance of auditing these tax collections. With every point-of-sale in the United States becoming the starting point for collecting the trillions of Federal revenue our over-sized government needs, it is hard to believe something as big and powerful as today’s IRS would not exist. The spy agency would still be there in some form, although its victims might be mom and pop instead of wage earners.

The IRS today is also the collection agency for the Social Security Administration. One of my critics from an earlier article critical of the Fairtax idea celebrated the Social Security Administration, saying it would be the agency paying the McGovern “prebate” to citizens. It was not lost on me the emphasis on “citizens,” because many of the supporters of the Fairtax prebate idea want to stress the detail it would not be paid to non-citizens, even if they are legal residents and family members of Americans. Where does this particular concern come from? Maybe from the Ku Klux Klan inspired 1924 immigration quota law? But immigration reform is another topic.

The Only Way to Abolish the IRS

The only way to abolish the IRS for real is to abolish centralized Federal taxation. Now we are getting into serious political issues about the role of federalism in the United States Constitution. The 16th Amendment and the income tax has seriously crippled the relationship between the states and the Federal government, by giving the central government more power to collect more money, and to subdue the state governments with bribery. Barry Goldwater in his famous book, “Conscience of a Conservative” (1960), devoted more pages to the destruction of federalism under the New Deal, and years since, than he devoted to a discussion of the principles of limited government at the state and local level.

As part of the Compromise of 1787, the Founding Fathers set up the House of Representatives on a population-proportional basis. The House of Representatives was the part of Congress that wrote tax and spending laws, and the Senate was only allowed to amend those enactments. This is Article I, Section 2, of the Constitution, which is most famous for setting the tax rate on slaves at 60% of the tax rate on white people. Times have changed, of course, and now the Senate is in the driver’s seat, and deal making in conference committees is where the action happens. But the original idea of the Founding Fathers deserves a new look. There are not supposed to be any slaves any more. The census mandated every 10 years was the original basis for collecting Federal taxes, and the state legislatures were supposed to decide how to collect the money.

The proponents of a national retail sales tax are trying to get rid of the income tax with something that I think is worse, instead of trying to restore federalism and to really, really abolish the IRS. The Fairtax will not abolish some agency in the U.S. Treasury with police powers to collect taxes – if not from you, then from the Mom and Pop grocery or the neighbor boy who mows lawns. There will be no escape from the federal tax police as long as the Feds have the power to tax individuals and businesses. The constitution says “No capitation, or other direct tax” and that should be restored as the general rule. The national retail sales tax is a direct tax on Mom and Pop grocery and the neighbor boy who mows lawns.

Let us stop the deception about the Fairtax and its phony claim about abolishing the IRS. It is hardly a fair tax. It is reshuffling the chairs on the Titanic as the last great hope of mankind drifts on the waters of debt and totalitarianism.

(Published in American Breaking Point, Feb.21, 2012)

NEW YORK (CNNMoney.com) — A growing number of states are seeking shiny new currencies made of silver and gold.

Worried that the Federal Reserve and the U.S. dollar are on the brink of collapse, lawmakers from 13 states, including Minnesota, Tennessee, Iowa, South Carolina and Georgia, are seeking approval from their state governments to either issue their own alternative currency or explore it as an option. Just three years ago, only three states had similar proposals in place.

“In the event of hyperinflation, depression, or other economic calamity related to the breakdown of the Federal Reserve System … the State’s governmental finances and private economy will be thrown into chaos,” said North Carolina Republican Representative Glen Bradley in a currency bill he introduced last year.

Unlike individual communities, which are allowed to create their own currency – as long as it is easily distinguishable from U.S. dollars – the Constitution bans states from printing their own paper money or issuing their own currency. But it allows the states to make “gold and silver Coin a Tender in Payment of Debts.”

To the state legislators who are proposing state-issued currencies, that means gold and silver are fair game, said Edwin Vieira, an alternative currency proponent and attorney specializing in Constitutional law. And since gold has grown exponentially more valuable, while the U.S. dollar continues to lose ground, the notion has become increasingly appealing to state lawmakers, he said.

The state gold rush: Utah became the first state to introduce its own alternative currency when Governor Gary Herbert signed a bill into law last March that recognized gold and silver coins issued by the U.S. Mint as an acceptable form of payment. Under the law, the coins – which include American Gold and Silver Eagles – are treated the same as U.S. dollars for tax purposes, eliminating capital gains taxes.

Since the face value of some U.S.-minted gold and silver coins – like the one-ounce, $50 American Gold Eagle coin – is so much less than the metal value (one ounce of gold is now worth more than $1,700), the new law allows the coins to be exchanged at their market value, based on weight and fineness.

Local Currencies:
In the U.S., We Don’t Trust

“A Utah citizen, for example, could contract with another to sell his car for 10 one-ounce gold coins (approximately $17,000), or an independent contractor could arrange to be compensated in gold coins,” said Rich Danker, a project director at the American Principles Project, a conservative public policy group in Washington, D.C.

South Carolina Republican Representative Mike Pitts proposed a currency system that would allow people to use any kind of silver or gold coin – whether it’s a Philippine Peso or a South African Krugerrand – based on weight and fineness. Pitts said in the bill, which currently has 12 co-sponsors, that the state is facing “an economic crisis of severe magnitude.”

Republican representatives from Washington State followed suit in January, introducing a bill that would also allow any gold and silver coins to be considered legal tender based on metal values. Minnesota, Iowa, Georgia, Idaho and Indiana are also considering similar proposals.

Many of the bills would make it possible for residents to exchange the physical coins for goods and services, so you could use coins to buy anything from groceries to a car as long as the store chooses to accept them.

However, most people aren’t going to walk around with such valuable coins in their pockets, said Vieira. Plus, calculating the value of the coins – especially if they come from different parts of the globe and are of different sizes and shapes – will get tricky.

It’s more likely that the states will create electronic depositories and accounts for the coins to make transactions easier, when and if the initial bills are passed, he said.

Utah Gold & Silver Depository is already developing a system where customers could use debit cards linked to their gold holdings. When customers swipe their debit cards to make transactions, physical gold and silver coins would be transferred between accounts in privately-owned depositories (or vaults) based on the market value of the metals.

Before deciding on a specific form of currency, some states – including Minnesota, Tennessee, Virginia and North Carolina – are considering proposals that would first require a committee to review their alternative currency plan.

The future of U.S. currency: The states’ proposals have been gaining steam among Tea Partyers and Republicans, many of whom also endorse a nationwide return to the gold standard, which would require the U.S. dollar to be backed by gold reserves.

Tea Party “father” Ron Paul is sponsoring the “Free Competition in Currency Act,” which would allow states to introduce their own currencies, and rival Newt Gingrich is calling for a commission to look at how the country can get back to the gold standard.

But it will be the individual states that could really get the ball rolling, said Vieira. Even if several of the current proposals get killed, the introduction of so many bills at the state level is drawing national attention to the issue, he said.

Funny Money: 11 Local Currencies

Of all the state proposals circulating right now, Republican-controlled states including South Carolina, Georgia, Idaho and Indiana have the best chance of passing their proposed bills this year, said American Principles Project’s Danker. If just one or two states implement an alternative currency, it could have a Domino effect, he said.

“I think we could get a couple passed in this legislative session, and that would show this is mainstream, popular and it would be a justification for more of the risk-averse states for doing this,” he said.

There are, of course, many people who think the recent push for alternative state currencies should be stopped in its tracks. David Parsley, a professor of economics and finance at Vanderbilt University, said he thinks state-issued currencies are a “terrible” idea.

“Having 50 Feds” could debase the U.S. dollar and even potentially lead the country into default, he said. “The single currency in the United States is working just fine,” said Parsley. “I have no idea why anyone would want to destroy something so successful – unless they actually wanted to destroy the country.” [Or just wanted to destroy the monopoly of the Federal Reserve - Joe Cobb]

Copyright by CNNMoney.com, published February 3, 2012.

Mitt Romney released his tax returns and they showed he paid a lower income tax rate than Warren Buffet’s secretary. What a shame. And he lost the South Carolina primary election, and was challenged in the Florida primary election, as a result of this misleading “fact.”

Romney is a rich man. His wealth is mostly in financial assets, which he trades and sells. He gets the long-term capital gains flat tax rate, 15%, when he sells and has gains from the sale of his property.

Warren Buffet’s secretary sells her labor. She falls into the “progressive income tax” category. The tax on labor is not a flat tax. The more she makes, the higher her tax rates go up. If Warren Buffet paid her more for her work, her tax rates might go up to 35% under current law and up to 39% under President Clinton’s law – not to mention Social Security taxes.

Mitt Romney doesn’t sell his labor. He sells his property, which he acquired with his labor some years ago, and gets the income (gains) from its value. If he doesn’t gain, he just gets some of his money back. The key detail is the “basis” of his property. That is what he paid for it, or originally invested to obtain it. If he sells his property for more than its basis, he has a gain. If he sells for less than he originally invested to obtain it, he has a deductible loss.

The Capital Gains Tax Rate

Back in the early 1920s, the Congress discovered the income tax was unfair to people who invested and held assets for many years, and then sold them for a gain. The income tax took all of the sales price and put it into their highest tax bracket the year they sold. This was especially unfair to people who had held their assets for many years, and for whom the inflation – depreciation of the “dollar” – meant their original basis was an irrelevant valuation in a unit of money that had gotten smaller.

If you paid a silver dollar for an asset in 1901 and sold the asset for $20.00 (paper) in 1946, did you make a real gain or not? The “dollar” had been depreciated to less than half its earlier value, possibly faster than the asset’s real value had gained. In the past 45 years the “dollar” has been reduced to about one-seventh of its value in 1966.

This is called “money illusion” and most people are fooled by it. A yardstick and a scale will measure weights and measures, with honest calibration. A bank account or an asset price, are floating on the sea of uncertainty because nobody knows what a “dollar” will buy next year. The measurement of value in “dollars” is a floating exchange rate with the future.

But the basis of an asset you purchased is fixed in time by the rules of accounting. Your capital “gains” might be fictional, and the real picture is that you lost value. Too bad. The current law is against you. They will tax your imaginary “gain.”

But there is a solution: “indexing” your basis for loss of value, measured in the accounting units of money. The tax code uses indexing each year to adjust for inflation (depreciation of the dollar). The tax brackets for labor are widened and the standard deductions and personal exemptions are numerically increased, which really just keeps them the same. For example, if you earmed $10,000 in 2005 and $12,800 in 2011 you would be earning the same real income, and the income tax recognizes this with indexing.

But the U.S. Treasury opposes putting something like “indexing of basis” into the tax code. They say it would “cost too much revenue.” The government wants to confiscate the phony “gains” from inflation when people sell property. This reminds me of an imaginary conversation between Hitler and Goebbels in 1943. Imagine if one of them had said, “Yes, I know it is wrong; but we need the labor.” When the government uses inflation to confiscate the value of your property, it is just like using phony tax accounting to confiscate your life’s work.

We don’t know if Mitt Romney came out ahead or behind, because we don’t know the inflation-adjusted value of his sales, from which he got his taxable income. But he paid the legal rate, which is 15%. Of course it is smaller than what would be his tax rate if the income was from punching a time clock, like Warren Buffett’s secretary. But is it “unfair”?

Stupid Idea: Flat Capital Gains Tax *

The tax rate on capital gains should be the same as the tax rate on labor, but the way capital gains are measured should be changed.

In the beginning, 1920s, the tax writers in Congress granted capital gains a special 40% tax exclusion as a concession to the idea that holding an asset for several years is a different thing than earning the same amount of income from current labor. It was current labor income, interest and dividends that the income tax was supposed to focus on.

Capital gains were an odd-ball factor that had to be treated differently, since several years were accrued in the capital gain. The tax on income is one year at a time. Congress realized there had been inflation during World War I and the capital gains exclusion was a “fix” for the accounting problems. Whatever your gain from the sale of property, held for more than a year, might be, you would only pay 60% of the top marginal tax rate on your gains.

Today there is not any “exclusion” for capital gains, but there is a special lower tax rate of 15% for that income. As Mitt Romney’s problem illustrates, there should be tax reform to have capital gains pay the same tax rate as labor income, but there should be an adjustment for the money illusion, the accounting value of the basis of the property that is sold. It should be indexed for inflation for all the years it was held.

Since the rate of inflation, the depreciation of the “dollar,” is an uncertain and variable thing, a far better idea would be to allow owners of assets to adjust their bookkeeping. If you purchase something for $100 you should be able to compute the inflation factor on that original amount when you sell it. If you held the asset for 10 years and the dollar shrank to half its value, you should be able to claim a basis deduction from your sales price of $200, and pay tax only on the real gain.

Does the Treasury department really “need” the revenue more than Americans need justice in the tax system?

Published in American Breaking Point, Feb.6, 2012
______
* A flat tax is not stupid, it is smarter than a “progressive” tax, but it is stupid to have a different tax system for labor. It only incites envy. I advocate dividing the issue and having a single tax rate for both labor and capital gains, and then to have a decentralized Federal system for them both. See my book in this web site.

In fact, 47 to 51 percent of people who file income tax returns do not even pay income tax, according to the Tax Foundation in Washington, D.C. They file tax returns to get the generous Earned Income Tax Credit (EITC) and the Child Tax credit for households with children. A worker with three children and an income of $12,750 can get a refund of $8,751 from these credits, and without any payroll withholding.

In essence, the income tax has become one of America’s largest welfare programs.

Bribed with Our Own Money

The payroll withholding system was created in 1942 to make working families pay for the war against Japan and Germany. Milton and Rose Friedman’s autobiography has an excellent story about how “pay as you go” was set up to make sure workers paid the higher war taxes.

Before the war, only wealthy people had to file tax returns, because most people’s incomes were less than their personal exemptions. But Congress and the War Department needed more money, so tax collections expanded. Collecting the money in advance, with payroll withholding, was a quick solution.

Today, since most people live on narrow budget margins, with little surplus from week to week, it can be stressful to owe the IRS a balance due on April 17. To avoid that stress, your paycheck tax withholding can be a bit larger each payday, and the surplus is returned in the form of a tax refund the following February. Some people use this refund as a form of a savings account, by splurging on something they normally wouldn’t with the unexpected money.

However, what many do not realize is that the payroll withholding tables published by the IRS for employers are actually tilted to give workers a refund. So, if a family of four chose four allowances on the W-4 form, which employers use, the formula the payroll department uses will guarantee a surplus, and thus, a refund next February.

This means that the withholding system bribes taxpayers with their own money to file tax forms on time, even early, to get their money back.

The EITC and the Child Tax Credit cause a mania among the lowest income Americans, who come to H&R Block and other tax companies as soon as their W-2 forms are released – because the refunds that include those tax credits are very generous.

The FairTax “Prebate” Is Worse

You might have heard of the FairTax, as its popularity was expanded during the brief presidential campaign of Herman Cain in the Republican debates, when he proposed his “9-9-9” version. Radio talk show host Neal Boortz also wrote on the subject in books that were on the New York Times best-seller list for several months in 2005 and 2008. And there has been legislation introduced in the Senate and House of Representatives to enact such a national sales tax—and many Congressmen are co-sponsors. It is a cheap thing for a member of Congress to co-sponsor such a bill, since it is very unlikely to pass. Boortz is based in Georgia, and the legislation’s chief sponsors are from that state.

FairTax.org and popular writers like Neal Boortz have promoted the FairTax as a way to get rid of the IRS and liberate Americans from the oppressive tyranny of government tax collections. However, take a closer look and you’ll find it is almost exactly the opposite kind of scheme than it claims to be.

If enacted, the FairTax would require every American to be registered with the IRS and keep a current address and bank account information on file with the government to receive regular tax “prebates.”

The FairTax is a national retail sales tax. And a national retail sales tax is a flat tax. Sales tax rates, which most states impose, are flat rates on all transactions subject to the tax. Some states tax goods and services; other states only tax goods sold at retail and exempt wholesale and intermediate products. A value-added tax is a sales tax that does not exempt intermediate products, but allows a rebate on subsequent sales for producers, so the tax is not compounded over many stages of production.

The FairTax is supposed to be a tax only on final sales, although it is sometimes not clear when a sale is “final” and not part of a continuing series of production steps.

The problem with a flat tax, in today’s political society, is that most people believe “the rich” should pay more and “the poor” should get tax credits and exemptions, particularly if they have children.

But a flat tax is the same rate for everyone.

Another problem with a retail sales tax is that it only taxes items purchased for consumption. It does not tax savings. Higher income families have savings for retirement and college funds, while lower income families are always in debt. The sales tax would exempt savings and collect taxes even when a family borrows money to buy a new TV or repair an old car.

So if you believe a family’s “income” is the proper way to think about tax rates, a sales tax is “regressive.”

The solution proposed by advocates of the FairTax is a rebate. They call it a “prebate” because the plan would give a rebate in advance to every American family. The families would be paying the national sales tax every day, at the grocery store and the gas station, so it would be hard for them to wait until next year to get a rebate. Since the “prebate” is paid in advance, Americans will have enough money to give to a cashier for the tax when they go shopping. The “prebate” would be received as a check in the mail, or deposited to a bank account, each month – similar to how Social Security payments are made, or how food stamps are distributed on debit cards.

It’s a frightening thought that every American would depend on the automatic gift of money each month from the government.

It is surprising to me that Neal Boortz, who calls himself a “libertarian,” would promote this idea. Recall that Libertarians are opposed to taxes, and they oppose the idea that people should become dependent on the government. But, clearly, after such a system of “prebate” payments was created, the main issue among voters would be how much political candidates would promise to increase the monthly payments when running for office. If any politician suggested cutting the payments, it would be like getting caught on Twitter with lewd photos. Nobody today proposes cutting Social Security benefits, not even Ron Paul or Gary Johnson.

Sound Familiar?
George McGovern’s “Demogrant” Proposal in 1972

The idea of a “prebate” for the FairTax is very similar to an idea that presidential candidate George McGovern proposed in 1972. He suggested that every American should be given a $1,000 tax credit, which would be refunded to poor people. This idea was widely criticized, not least by Sen. Hubert Humphrey who used it against him in the California primary election. Even liberals in the Democratic Party thought it was too “left wing” for prime time.

The Earned Income Tax credit was then enacted in 1975, and it has increased continually with each new tax law. The Republican administration joined with the Democratic Congress to enact a variation of the McGovern idea, because “fairness” in the tax system is always a political football. “Fairness” is commonly defined as taxing someone else who is not “paying a fair share,” and getting a tax cut for yourself and your friends. The McGovern idea of giving tax credits is at the center of the FairTax idea of a “prebate.” The tax is not “fair” if it is really a flat tax, as most people think about these things.

But the really important question we need to ask is about taxes in general. Is it “fair” to take money from some people, who earn it or receive it by trading with others voluntarily for a profit, and give it to others?

The question is never asked.

Opening Remarks, “What can we do to get out of the problem?”

Follow up, “What can any government do to solve a macroeconomic problem?”

First, the Euro was created as a credit unit managed by the European Central Bank. The governments of 17 European countries adopted it as their legal tender and discontinued their previous legal tender systems. The European Central Bank (ECB) was incorporated with a charter that made monetary value stability, in terms of what the Euro can buy in the future, its only objective. The ECB does not have additional political mandates, like the U.S. Federal Reserve, such as to promote economic growth or employment.

There are four distinct problems today in the “eurozone,” which does not encompass all of the European Union, but certainly affects all of the others, like Britain and Poland, which continue to use their older national currencies.

Distinguish among

1. The accounting unit itself, “Euro.”
2. Maintenance of the payments system using the Euro as a medium of exchange.
3. The solvency of banks, which are central to the payments system, that unwisely invested in the government bonds denominated in Euros.
4. The solvency of governments that issued bonds in Euro units. Those governments must somehow continue to borrow, both to keep on financing deficits and to pay off maturing bonds.

These are four entirely distinct issues, although the news reports do not make any distinctions. Because of the “money illusion” between credit markets, government accounting, and payments for goods and services, with banks at the center, the news reporters focus on the crisis as if the problem were the single currency instead of the foolishness of governments and bankers.

The crisis in Greece made the news when it became clear that government was insolvent. It has bonds maturing soon and it cannot pay principal and interest. Because of the distortion based on the Basel III Accords, designating government bonds as risk-free assets, not requiring any capital reserves, it was quickly discovered that major banks all over Europe and in the United States faced a massive solvency crisis as well.

One of the first victims was Jon Corzine and MF Global, which had invested heavily in the bonds of fiscally weak EU governments, because they paid higher yields. Those bonds were understood to be weak and were selling at slight discounts – as junk bonds ought to do – except former Governor and Senator Corzine, a man of great faith in the power of governments, believed his investments were safe and sound. After all, did not the Basel III Accords make them solid investments? Would governments allow them to fail?

At least MF Global was not linked into the EU payments system, as most major European banks seem to be. The failure of the payments system would be a major crisis for the entire world, and a disaster for Europe, so the European banks, and politicians, are working very hard for a massive bail out.

The German chancellor is not quite willing simply to coerce the ECB to bail out the banks, as the Federal Reserve chairman did do. The ECB was not given any charter to be a bail out agency, but the Federal Reserve since 1913 has always been a bail out agency; it was founded for that explicit purpose. (The corruption of Corzine and his managers, embezzling funds, is not the issue.)

The Fallacy of “Fiscal Union”

There is confusion in the news reports about items 3 and 4 in the list above. In a classical economic system that used gold coins as money, and both taxes and government bonds were denominated in gold coins, the integrity of the coins, and banks that operated with gold coins as accounting units, was never threatened when a government could not collect sufficient taxes to pay off maturing bonds. (The crude method of debasing or clipping coins is another story.)

Any banker who owned such bonds would, of course, take a hit, but like any other bad debt, it would be written off. The bank might become insolvent and have to close. The banker, like Jon Corzine, might go to jail for losing depositors’ money; customers might be shafted, like MF Global’s customers, but the payments system based on the coins would not be jeopardized.

The bankrupt government would keep on collecting taxes in gold coins and paying soldiers and police salaries, although it would not be able to run a fiscal deficit because nobody would trust it to sell honest bonds.

The irony of the situation is that if Greece had a government running a fiscal surplus, it could repudiate all its bonds and laugh at the bankers who had bought them. But Greece has to keep on borrowing because it runs a fiscal deficit.  Beggers cannot be choosers.

If Greece had had its own national currency, based on a gold standard, it would already have “gone off” and devalued. But there is no way Greece can go off the Euro standard and start now to issue a new fiat currency. Who would use it, even in Greece? Who would buy Greek government bonds promising only to repay in those new, politicized accounting units?  According to the news, even now in Athens people are bank-running to have Euros under their beds.  Trust in the ECB is greater than their trust in the Greek government. 

What is different in Europe today is the Euro payments system is jeopardized because it is a pyramid of bank credit based on government bonds. Saving the payments system is the really important task since all economic activity and growth depends on it.  Modern society can not be maintained on barter.

To save the payments system, saving the banks seems to be necessary.  The political drama is all about preserving the ability to borrow for the governments of Greece, Italy, Spain, and Portugal, and to pay off their bonds as they mature.  This is basic for saving the banks, who own the bonds. 

The fallacy of “fiscal union” is that it confuses the Euro, the accounting unit, with the overspending (or under-taxing) of the governments whose bonds are exposed as junk. The complaint about lacking a “fiscal union” is that Greece has no power to increase taxes in Germany or France to pay its debts. With the Euro, like the gold standard case above, the insolvent governments cannot resort to printing-press inflation to keep going. “Fiscal union” is a fancy name for a systemic “Robin Hood” solution.

The German chancellor and French president are trying to devise a way to bail out the insolvent governments because they want to save their own banks. They need to save their banks in order to save the payments system, and themselves. The common Euro currency itself is not a problem – the Euro is just the accounting unit. The “problem” is that it cannot be debased to make the junk bonds payable, as some hypothetical national Greek currency could have been ["coin-clipped"].

The Proposal for Joint EU Bonds

Since Greece cannot tax Germans, and since Germans do not feel like taxing themselves to bail out the Greek government, the gimmick in the news is for (1) the entire European Union to issue bonds and (2) give the money to the Greek, Italian, Spanish, and Portugese governments, but only if (3) those irresponsible politicians give up their “sovereignty” to bureaucrats in Brussels and submit to fiscal austerity.

This would bail out the banks, which is why it is the preferred political solution. It would preserve the payments system, which is why it is necessary. But the cries about “democracy” and “sovereignty” are loud and emotionally attractive. What is at stake is 100 years of European social welfare and labor union dominance, finally crashing into the stone wall of economic reality.

Consider the alternatives, which nobody wants to discuss because millions of innocent people would suffer and the EU, as well as much of the world, would probably face a massive credit collapse. Since the world is a single capital market, neither the United States nor Brazil/Russia/India/China would get out of it unharmed.

Let the bonds default?
Assume the banks could be compensated separately, or penalized separately, which is a huge political assumption. In the defaulting countries, pensioners and government workers then would not be paid more than tax collectors could gather at the point of a gun. Civil disorder might follow, and economic activity would certainly be disrupted. Thousands of people would try to emigrate. Ayn Rand fans might look approvingly at the logical consequences of the collapse of a parasite state, which might describe Greece and others, but the other European countries would not welcome large-scale immigration by economic refugees.

Compensate the Banks Separately?
There might be no justice in compensating the bankers who made stupid investments under the rules of the Basel III Accords in junk government bonds, but depositors and creditors of those banks are not to blame, and the payments system is administered by the banks. Perhaps the banks could be taken over by their governments and merged with the postal savings (giro) system.

The bank bail out in Ireland a few years ago tried something like this, but the debts almost overwhelmed the Irish government. It was given some assistance by the EU and Ireland seems to be recovering. But the problem in Ireland pales in comparison with the banking crisis in the rest of Europe if Italy and Spain go under – and the fear this problem might expand has caused the capital markets to choke. The United States is enjoying a flood of frightened capital, which is one reason U.S. government bonds are paying negative real interest rates.

Break Up the Euro Zone, or At Least Expel Greece and a Few Others?
This idea solves no problem, and is not different in substance from either of the two previous suggestions. Hyperinflation would hit Greece within a day of the attempt to introduce a new currency there, and no Greek government bonds would be purchased by any private investor.  The bank runs in Greece show what the people think about it.

Was the Single Currency a Mistake?

There is an interesting question in economics about what might be the size of an “optimal currency area,” and how it would work with floating exchange rates among regional currencies – not just “national” currencies. Much of this analysis looks at labor markets and natural resource markets and considers how local conditions might make different circumstances work better. An exchange rate that devalues can make labor cheaper, due to money illusion, and an economy mostly based on exports of natural resources might want some local immunity from shifts in world demand or supply conditions that can cause wide price swings in commodity markets.

In macroeconomics, if central banks can control money and credit, and national governments can finance deficit budgets without depending on free international capital markets, sometimes a serious social crisis can be manipulated to create different winners and losers. Politicians and socialists love this idea because it gives so much power to the governing elite.

The real question, of course, in any social crisis is why the situation needing “management” arose in the first place? And why are the losers almost always the weakest and least powerful in society – as the politicians and fat cats get away with it?

In the Euro crisis, it would be good if a result can be found to cushion the punishment of the innocent, and instead ruin the lives of the political leaders who created the insolvent governments in the first place. The most likely result, however, will be the opposite. The bad judgment of the European bankers will probably become as profitable as the bad judgment on Wall Street did when the housing bubble collapsed.

Of course, Wall Street a century ago created the Federal Reserve to ensure that happy outcome. We shall see if the European Central Bank holds fast, or caves under the pressure to pollute the Euro.

The concept of “money illusion” was identified by John Maynard Keynes in his masterly book on the Economic Consequences of the Peace (1919), and the brilliant American economist, Irving Fisher, also wrote a book with that title (1928). Economists have used the term to describe the tendency for people to think of money in terms of its face value. Money, of course, does not have any fixed value since what money can buy depends on what prices producers and sellers ask for real things. [ See this discussion from Wikipedia for a general introduction to the ideas of economists on money illusion. ]

Money illusion was famously described by Thomas Mann in a story about a friend in Germany, after the first World War, who had borrowed 10,000 marks from the famous author before the war. After the great German inflation of the 1920s had begun, Mann’s friend gave him a nearly worthless 10,000 mark note. That the paper money could not possibly repay the debt he owed he failed even to understand.

John Maynard Keynes seriously proposed using inflation as a way to reduce unemployment in his General Theory of Employment, Interest and Money (1936) because he believed workers would be too stupid to figure out that nominal wages, even after pay increases, could be lower in real terms if the pay increases did not keep up with inflation. Cutting the wages of labor is one prescription for reducing unemployment, since with lower wages employers can find it economical to hire more workers or to forego layoffs.

Keynes knew a major cause of the massive unemployment in Britain in the 1920s was due to the deflationary collapse of the money supply, which also happened in the United States in the 1930s. The purchasing power of a U.K. pound and the American dollar skyrocketed. The U.S. consumer price index in 1929 was 53.1 but by 1933 it had deflated to 38.8 and didn’t return to its pre-Depression level until 1943. Anyone who had money could buy a lot more with it in 1933.

Since there was a national effort under presidents Hoover and Roosevelt not to reduce wages paid, it is no surprise unemployment skyrocketed in that decade. A worker receiving $1.00 per hour in 1929 enjoyed a 37 percent real wage increase, if he still had his job in 1933 at the same $1.00 per hour. Keynes understood if you double the prices a worker has to pay for food and rent, it is a real pay cut. Cutting wages by inflation could get the unemployed back to work. Keynes was not a friend of the working class. Karl Marx, by contrast, supported the gold standard as did other famous socialists like George Bernard Shaw.

A Different Form of Money Illusion

Yet a more serious form of money illusion has seldom been noticed by economists due to one of the most useful things about money itself: You can add it up. Money (and credit) have a mathematical property that apples and oranges do not have. You cannot add up apples and oranges. If an accountant combines the dimes and quarters in a bag of coins with the Federal Reserve notes in his wallet, he can calculate his money supply. Adding apples and oranges does not create a “fruit supply.” Accountants will disregard the differences between the coins and paper money, although it might be impossible to spend the coins to buy many things in the market. Some things require different forms of payment.

When a market system operates smoothly and many people are willing to trade different forms of money at zero or minimal expense it is easy to disregard this essential difference between the forms of money. But consider the example of someone offering to sell a bag of pre-1964 silver dimes and quarters. Most people would immediately recognize the greater value of the old coins, but it took more than a decade after 1964 for people no longer to receive old silver coins in change as most retail cashiers failed to understand the difference between copper clad quarters and old silver quarters.

One of the primary services banks provide in a modern economic system is to provide what seems to be a par value payments system. Indeed, one of the primary requirements of the National Banking Act of 1863 was to establish a uniform currency, issued by private banks. Other national banks had to accept deposits of the “national currency” at face value. Prior to the Civil War, it was common for money issued by private banks to be discounted when it was used in trade or deposited in banks a few miles away.

It is of course very useful not to have to worry about different forms of money circulating in a “floating exchange rate” system, but since 1971 this is exactly what has changed in the world economy. Under the broken Bretton Woods Agreement, national governments were supposed to keep their money units fixed for international trade and finance, just as the National Banking Act did for trade between different cities and states in America.

Today it might seem to be more complicated to make international payments, exchanging between yen and euro and dollar (often requiring derivative contracts to hedge against exchange risk) but the system is also more transparent now. When a currency grows weaker, buyers and sellers immediately see the change in the market. Sellers of the weak currency have to pay more to buy stronger valued money.

The attempted ideal of a par value payments system is the source of this more subtle form of money illusion. Under par value payments, weakness of a currency is only seen – after a delay – in rising retail and wholesale prices. The delay is eliminated by arbitrage in basic commodities, as prices of gold and oil in different currencies reflect the strengths and weakness of currencies themselves under flexible exchange rates.

The Changing Role of Banks

The popular idea of a bank is symbolized by the bank vault. Children are taught you deposit your money in a bank and it will be there when you want to take it out. Banks have always solved the problem of robbery or forgery by offering people a more secure way to save their money. But savings is not the most important service the banks perform. Only a child would believe a bank will take his deposit and keep the money in its vault, like a toy chest, and give it back when the child demands it.

The banker does not operate a warehouse for money.

Bankers are “community bookkeepers” who make it easier for people to make payments to each other and to keep track of how much different parties owe each other (measured in terms of accounting units).

Bankers fundamentally perform accounting as a free public service, while managing investments for their own account – like an insurance company.

A bank customer comes to do business not by “depositing” but by “purchasing” from his banker a line of credit. A customer may not know the difference when he pays $100 cash in exchange for a $100 line of credit, but the difference between what bankers do for the economic system and what government coins and paper money do are very different. A bank offers its credibility as a payor, and it will pay your bills when you ask – if you buy its line of credit.

One of the truly misleading ideas from the British Neo-Classical School of economics, which dominates economic journalism and universities worldwide today, is the idea that bank credit, coins, and government money can be added up like “the fruit supply” to measure M-1, M-2, etc. In the past 30 years, this idea has proven less and less useful in making economic forecasts. In the United States today, even our understanding of what causes price index inflation is seemingly disconnected from “money supply,” mostly because credit has entirely displaced money and the “supply” of credit defies measurement.

By servicing the payments activity of millions of customers, bankers perform one of the essential roles in our modern economy. A banker is always the largest debtor in town, because he owes every one of his customers the nominal value of their bank balance. He does not owe them “money”; he maintains for them lines of credit, which they can switch among themselves in the market for goods and services. When you buy gasoline with your debit card, the banker switches some amount he formerly owed to you and now he owes it to the oil company. Nothing changes hands, except a bookkeeping entry is switched in the bank’s ledgers.

These bank services are not free, of course. Even though bank customers may enjoy fixed exchange rates between different bank services, the bankers are covering their costs in different ways. For merchants, accepting your debit card will mean paying a fee to the bank for the transaction. Logically the bank could charge you, the spender/buyer, for the service, but Congress has passed laws since the 1960s to make the use of cards, checks, and electronic payments look like free services to most bank customers. The banking industry requested these legal restrictions in the early days because introducing credit cards was difficult in the 1960s when store keepers wanted to charge the bank fee to the customer, like a sales tax, on top of the prices marked on goods. Even today one can sometimes see a sign at a cash register that says “Discount for Cash” but it is against the law to say openly your price will be higher for payment by credit card.

The Banker as an Investment Manager

The modern banker operates like a money market mutual fund. Banks own specific assets with less than perfect liquidity and perform “community bookkeeping” for customers with abstract units of credit providing superior liquidity. Liquidity can be understood as the narrow degree of the bid/ask price spread for an asset.

It is a common misconception to say that “banks create money when the make loans.” The standard illustration in economics textbooks will have a bank accept a deposit for, say, $100 and with the magic of the “money multiplier” turn around and expand that amount to $1,000 by making loans to other customers.

If you model the business of a bank like an insurance company, you can understand this model of a bank, but it doesn’t fit today’s banking system.

What banks do is to invest in less-than-perfectly liquid assets and create more-nearly-perfectly liquid liabilities for others to use as assets in payments.

An insurance company is an example of a fractional reserve institution. It takes your deposits and promises to pay you back under certain conditions, like an accident or your death. The insurance company knows all its customers will not have accidents or die on the same day, so it keeps reserves on hand for daily payments and invests the rest.

A banker keeps enough cash in his vault to make daily payments and invests the rest. To the extent that a government requires a certain level of reserves, it might appear to make the bank safer, but actually when reserves are sterilized, they are no longer available to make daily payments. Bankers used to invest only with borrowers, who pledged mortgages or inventories, but the communications revolution has built financial markets that make it possible for banks to invest in any asset of value. Arrangements among banks permit efficient operations with nearly zero reserves for daily cash payments. When governments enforce central banking monopolies they substitute regulations for private agreements, and expose the system to “crony capitalism.”

Under the Bretton Woods system of fixed exchange rates, governments enforced controls on international capital payments to try to hold back pressures to devalue or revalue, which nevertheless happened frequently. Following the abandonment of the Bretton Woods Agreement in 1971, the newly freed international financial markets allowed much more fluid movement of capital among different economies around the world. Flexible exchange rates unmasked and destroyed protection from competition that had profited bankers for centuries.

Under the guise of safety and consumer protection, interest rates and bank costs had been regulated to restrict competition. During the 1970s, however, regulated interest rates were not able to keep up with the rapid depreciation of government money. The non-bank investment community was less severely regulated.

Mutual funds had operated for a century by pooling small investors and buying a portfolio of assets. A mutual fund would issue and redeem its own shares and manage its assets for profit. Wall Street entrepreneurs discovered the trick of investing in high grade, liquid government bonds and issuing shares for a fixed price of $1.00 each. As their bonds went up in value, the mutual funds would issue new “stock dividends” at $1.00 face value.

This looked exactly like what banks called “paying interest on savings,” and indeed the only difference was how each type of company was regulated. There was no economic difference. The regulated bankers begged for deregulation so they could compete, and government changed the rules.

The Payments System

In fewer than 30 years, the banks have been transformed from conservative community bookkeepers who made nearly risk free investments within their own local regions, like credit unions, to an international assets trading system. The old “legal tender” idea that money comes from governments is misleading.

Today you have to ask what is “money”?

Although there are many ongoing regulations imposed by governments regarding banks and what people can use to pay taxes, the old idea that governments “print money” is simply not true today. Governments print bonds. And banks turn them into liquidity.

The crisis in Europe over the debt of Portugal, Italy, Greece, and Spain highlight the fallacy that governments can leverage their power to tax and issue risk free bonds. It was an international government regulation, the Basel III Accord, that set the stage for the current Eurozone crisis. The Basel agreement designated all government bonds as risk free and encouraged banks to buy them. Now it is clear the PIGS bonds will probably default, and the banking system is threatened with collapse. Unfortunately the important role the banks play, as agents in the payments system, is also jeopardized.

Modern society cannot survive a disintegration of the payments system, since prices are the information data that makes worldwide division of labor possible. What is occuring in the Eurozone is a crisis threatening the payments system because too many banks hold questionable government bonds.

The governments that operate central banks, like the Federal Reserve, could impose a drastic reform that would stabilize and preserve the payments system, but even to describe it shows why it is not desirable: The government could take over every bank and make it a branch office of the Federal Reserve. Like the old postal savings system, so popular in Europe and even in Japan today, it could function with checking accounts and debit cards effortlessly. Private banks would still work as mutual funds or investment managers, but they would no longer be connected with the payments system – and bailing out banks from bad investments would not be a public policy issue.

Of course, to make the government the monopoly for payments would open the door for the Treasury printing press to cover the Federal deficit, and the next question in everyone’s mind would be a situation like Thomas Mann’s story in 1923 Germany. Before that, the French Revolutionary government had also tried to finance itself by establishing a payments system based on seized church land (assignats), and it failed with a massive inflation.

Some people who want to abolish the Federal Reserve think replacing Fed chairman Ben Bernanke with Treasury secretary Timothy Geither would be an improvement. [see H.R. 6550] They don’t see there is no example of monopoly government banking, even with legal tender laws, that has succeeded in providing a stable payments system.

The solution for monetary and economic stability has to be found in the other direction, more deregulation and freedom for banks to transform assets into liquid payments media.

Escaping the Money Illusion

The money illusion that dominates the world financial crisis is the mistake that money issued by governments – the government accounting system itself – provides a stable basis for private accounting systems. The illusion is sustained by the legal institutions of a par value payments system within countries, even though such a system does not exist between countries.

The crisis in Europe is rooted in the mistake of attempting to manage a single unit of accounting for both payments and investments, as well as for each government’s tax and accounting system. In the early days of the European Union, discussions of how to coordinate currency exchange rates were set upon the idea of creating a common currency.

The British Treasury, which wisely kept the U.K. out of the Eurozone, proposed an alternative. John Major, head of the Treasury under Margaret Thatcher, proposed a parallel currency in which the Euro would serve as a transnational unit for financial assets but not as a unit for local and consumer transactions. The legal tender status of the Franc, Mark, Lira, Peseta, and Drachma would have remained unchanged. In retrospect, it is a sad result the proposal didn’t command wider respect among European finance ministers.

Consider again the example of apples and oranges. An asset is something of value and it can have a market price. A financial asset is denominated in accounting units, but financial assets often do not sell at their nominal face value. Many financial assets do not have a face value. Since many financial assets in today’s market are worth less than their value at maturity – and their value at maturity is uncertain due to flexible exchange rates in currency markets – the concern about what information is actually conveyed by bank balance sheets is quite well placed. Government regulations don’t help to give clear information, and bank and bond rating agencies are growing more important in the role of economic policemen.

The Eurozone crisis is based on the uncertainty about the value of government bonds, which used to seem like nuggets of gold in portfolios of rising and falling private equity values. Private promissory notes and bonds were always at some risk, and their nominal yields reflected the risk, as well as discounts in the market from their face value. But now more than ever, it is clear that financial assets are more like apples and oranges and government bonds are more like Ponzi or Madoff investments.

The more distrust the common man can come to accept in his view of the payments system, the healthier the system will become.

Free Banking as a Model for the Future

Conventional wisdom changes slowly, and the system of central banks, national currencies, par value payments, and fixed exchange rates is still very recent in historical and social memory – only a few hundred years old. Flexible exchange rates are new.

The world as a whole does not have a central bank or a single currency. Par value payments and fixed asset values are impossible to create by governments, even by international regulations.

There is a reasonable case to make about preventing fraud and deception in financial markets, but looking at the Eurozone today it is clear that governments cannot be the source of those reasonable expectations against deception and fraud.

In a banking system that is not organized as a cartel, not based on a government central bank with a government monetary unit to defend, the model of free banking described in Adam Smith’s Wealth of Nations (1776) offers more stability. If all banks were private investment institutions, trading assets in a global market and offering “community bookkeeping services” in more than one legal tender unit of accounting, ordinary people as well as larger players would be able to look critically at what the exchange rates in the market are telling them about economic values and the risk of assets.

The private payments system has already developed the technological network, with the debit and credit card. A single card can make payments in any currency a merchant might want, and a bank customer could still keep his line of credit denominated in something else, or even multiple units of accounting.

Some card issuers hold liquid non-monetary assets instead of government money for customers, which might be how we escape from the curse of government bonds. Scottrade manages my assets and I can spend from my account using a Visa card or checkbook – in any and every monetary unit currency on earth, wherever I travel. “What’s in Your Wallet?”

The key to a more stable payments system is more information. Government regulation and government accounting are sources of disinformation. Protestors may stage publicity stunts decrying “crony capitalism,” but the real problem is the centuries-old relationship between bankers and the government, with its power to offer favors for funds. The story Adam Smith tells about the original charter of the Bank of England in 1694 is an illustration of what has evolved in 300 years (the bankers gave King William a deal in exchange for a monopoly charter).

Worldwide competition in the financial markets has the power to restore the stability of dynamic equilibrium to financial markets, but only if a transition away from government accounting and fictional financial assets (such as PIGS bonds) is allowed to evolve.

Any government guarantee of purity should be the signal of secret toxic ingredients.

Democracy is the worst form of government except for all the others that have been tried. – Winston Churchill

For tyranny is a kind of monarchy which has in view the interest of the monarch only; oligarchy has in view the interest of the wealthy; democracy, of the needy: none of them the common good of all.

Tyranny, as I was saying, is monarchy exercising the rule of a master over the political society; oligarchy is when men of property have the government in their hands; democracy, the opposite, when the indigent, and not the men of property, are the rulers. – Aristotle, Politics

Democracy and Debt

The U.S. debt-limit “crisis” is dominating the news on television and in the print media. The problem is that democratically elected governments will vote for spending programs and then will resist tax increases to finance them. Governments sell bonds to get the extra funds. Then the savings of millions of people are absorbed in “safe” government bonds. How much economic progress in the world economy is retarded by the ability of governments to borrow money, which is then not available to use for productive private investment?

To be sure, some government investments are productive, like building highways, sewers and hydroelectric dams – but the question is always what cost-benefit calculations are made, and what artificially low rates of discount are used? Any cost-benefit analysis will show a net present value benefit if you do the math to get a desired result. Government funded projects that are “estimated” to be profitable are often based on false math, just as the benefits of new aircraft carriers for the navy are based on very subjective theories about the future “need” for them.

Democratic government is a collective system of decisions. Nobel laureate Kenneth Arrow of Stanford University proved that democratic systems of voting cannot make coherent selections of priority in choosing among alternatives. For example, a democratic voting process can choose Option A in preference to Option B, and Option B in preference to Option C, but then choose Option C in preference to Option A. [A>B>C>A] That would be considered dysfunctional in a single family or business, since it does not confront economic reality.

So the U.S. Congress, and in Greece, Portugal, Italy and almost everywhere else, governments choose to run deficit budgets and borrow money from the investors who have a surplus, and who believe governments will never default. Greece and Portugal are today testing that theory, and the United States government is making investors hold their breath.

The Moral Argument against Debt

Maybe if one of the big governments, like the United States, simply defaulted it would change the “faith” in sovereign debt. Maybe as Thomas Jefferson believed, the system of government borrowing is actually immoral. He wrote that for a current legislature to borrow money, which would be repaid by yet unborn taxpayers, the current generation is committing the worst form of taxation without representation. The Tea Party spokesmen are talking about government debt and saying much the same thing about grandchildren. Maybe repudiating it would be a moral thing to do, in spite of good arguments about respecting contracts and property rights.

The U.S. House of Representatives is proposing a Balanced Budget Amendment as part of any debt-limit increase bill. The main argument against this idea is

(1) it would be about as effective as the 9th Amendment, which is wonderful but toothless;
(2) it is ephemeral, since it would have to be ratified by 38 State legislatures, all dependent on Federal money; and
(3) it would almost certainly end up justifying tax increases under a democratic system that seems to prefer welfare spending.

As much as I hate taxation, maybe the best system would be a constitutional mandate requiring every bill for government spending to be coupled with a specific excise tax. The current fiscal system generalizes tax collections assessed on wealth or income or sales price or property value assessments.

Generalized taxes are a big pot of money, commonly just forecast or estimated by “experts” on the basis of econometric models of future revenues. Those are all statistical guesswork, and they are frequently wrong. A brief examination of the accuracy of government revenue forecasting over the past 50 years provides no confidence in this magic art. What I want to suggest would be some very specific excise taxes, or even a capitation on every baby’s head.

Government spending is always very specific and detailed. Pork or earmarked spending would not be popular if it were not specific. Government spending is written into the law and beneficiaries can even sue in court to receive their payments. Thus, government deficit spending is built into the democratic process. Government borrowing and debt is required automatically by the incoherent system of “A > B > C > A” decision-making.

Milton Friedman pointed out the real burden of taxes on society is how much government spends, not how much revenue it collects. Spending uses up real resources and denies them to other economic activities. When a member of Congress or a State or city legislature votes for spending, they are voting at the same time for a tax collection. Somehow specific tax assessments ought to be tied visibly to the spending. When individuals go to the store and buy something, they see the cost and they evaluate the hoped-for benefits. It is a clear decision, not affected by the problem Prof. Arrow identified.

In a democratic system, the main process is deception, even self-deception. The French philosopher, Frederic Bastiat, described democratic socialism as the belief that each person can live at the expense of everyone else. For the survival of a free democratic society, or to avert eventual fiscal collapse, some way to clean up the deception is essential.

Democracy and Social Conservatism

But the problem of democracy is more serious than simply the irrationality of the fiscal system, which votes for spending but refuses to vote for taxes.

Consider the issues of individual rights, like freedom of religion or unpopular speech. If these were put to a popular vote, the social conservatives would vote against the specific examples that might be on a ballot. Socrates was put to death by a popular vote in classical Athens because he was accused to saying offensive things about religion and corrupting the youth. Many social conservatives today would vote without hesitation to ban Hustler magazine.

Even socially progressive voters want to ban what the Supreme Court has identified as First Amendment rights in political campaign financing. This should come as no surprise to students of the “progressive movement” that expanded democracy in the United States 100 years ago. One of its first achievements was the 18th Amendment and Prohibition – which were a triumph of feminism in that era.

Democratic referendum voting is the main political tactic for anti-gay activism. The gay rights movement has won its liberties primarily from court decisions, not from a vote of the people. When the Iowa Supreme Court declared marriage between gay partners to be legal, the justices were recalled by popular vote. In California, Proposition 8 by popular vote repealed private marriage vows.

In Egypt today, a new political party has been organized with surprising speed, the Nour Party, which reportedly is set to gain a majority in the upcoming elections. This is an ultraconservative Islamic party. According to a recent news report, it has been formed because the Muslim Brotherhood is seen as too moderate.

It should be no surprise that popular democracy is more likely to give political power to social conservative movements, as against individual rights or free speech – or freedom of religion. If the majority can vote for social or cultural conservatism, or for unlimited government debt, we get the result that Socrates died for.

Investors have long understood that money issued by governments is not a stable measure of value. Throughout history governments have debased money, clipped coins, repudiated debts, and used inflation for public policy. The 20th century saw the triumph of paper (credit) money after World War I and even the fiction of some link to gold was eliminated in the 1970s. Today, under the Articles of Agreement to the International Monetary Fund, governments can link their currencies to commodities except gold, although none do so.

The avowed mission of most central banks, like the U.S. Federal Reserve, includes a promise to control inflation and keep the value of money stable, but the success rate is nothing to be proud of. The current debt crisis in the Euro zone is always linked to whether the European currency will survive the stress if Greece defaults. The volatility in foreign exchange markets is testimony to the unreliability of the value of government-issued money.

Yet most people never think money could be different – money comes from government, and it is a government monopoly. This book suggests an alternative, entirely private, and hopefully safe from government policy. The classical gold standard evolved as a way to give stability to the value of money. During and after the Civil War, bonds and notes were almost always written with a gold clause to spell out a particular value in terms of gold coin because the Union and Confederate governments had both resorted to printing press inflation during the war.

Henry Mark Holzer has compiled a reference book with all of the important court cases in the history of gold clauses in U.S. law, including the 1935 Supreme Court decisions that nullified gold clause contracts. The book further analyzes the current situation with gold contracts and gold clauses once again having been legalized by Congress, and he offers some important conclusions for anyone seeking to use a gold clause in notes and bonds, leases, or other contracts for future payment.

In simple terms, Holzer recommends never to write a gold contract with any reference to legal tender or government money in any form. Although Congress made the ownership and use of gold legal in the 1970s, and some recent court cases have upheld gold clauses, the power to nullify them is still in the Constitution. But Holzer points out the Supreme Court has never ruled out the right of private parties to make contracts for delivery of particular weights or volumes of commodities. His concluding chapter, “How to Use the Gold Clause Profitably,” sets out the rules as he understands them: (1) never denominate the debt in currency dollars; (2) make the debtor owe repayment in kind, either by weight or by specific form of coin, such as Krugerrand or Maple Leaf. If the debt instrument is likely to be under the jurisdiction of a U.S. court, it might be wise to avoid gold coin from the U.S. Mint. He cautions against using the price of gold to be an index of value because that indirectly brings government money into the contract.

Holzer offers this suggested language on pp.170-171:

“Debtor hereby borrows from creditor 100 ounces of gold bullion, of .999 fineness, and agrees to repay same to creditor on or before December 31, 1987 [for example]. If, for any reason, it shall become illegal or otherwise legally impossible for debtor to repay the aforesaid gold, the event causing such illegality or impossibility shall automatically convert debtor’s obligation to one requiring the repayment of an amount of silver bullion which shall be equal to what the value of gold would have been at the time of repayment, all values to be established by the Zurich fixing.”

There are additional considerations in writing a debt contract, such as rates of interest, which have been regulated under usury or consumer protection laws. Holzer discusses these in historical perspective, but generally such regulations have only affected contracts written for repayment of amounts of government money.

Holzer suggests that standardized futures contracts might serve as a form of insurance for bullion-denominated debts but does not elaborate whether those also bring government money indirectly into the debt contract. If debtors or creditors felt the need to hedge a fluctuating gold price, it should be done independently of the debt instrument itself. Certainly this is how existing bonds and notes denominated in foreign currencies are hedged, although swap contracts, which are widespread in international currency transactions, are currently in doubt due to regulations required but not yet written under the Dodd-Frank statute.

One thing is clear, both in this book and others Holzer has written in his career as a law professor and expert on monetary history, government policy is always the source of financial uncertainty and legal tender laws make things worse. Movements in gold prices that may only be due to depreciation of paper money are taxed under capital gains rules and some governments impose sales or value added taxes on gold transactions. When it suits policy makers to prohibit or regulate private markets, property rights are threatened.

The uncertainty of property rights and future regulations are the principal cause of slow economic growth because people who need to plan for the future cannot predict what is coming. Using gold as a unit of value, measured only by its weight and fineness, has traditionally been one way to stipulate a definite future reference. After all, what will “one dollar” be worth next year? One troy ounce or one gram of gold will be exactly unchanged.