The Bear’s Lair: Nearly time for a Gold Standard Referendum

On June 10, Switzerland will vote on a new system of “Vollgeld” that would abandon fractional reserve banking and centralize money creation in the central bank. It appears to be an improvement on the current system, making bank runs almost impossible and reducing leverage, but its opponents are correctly saying that by centralizing all money creation in the central bank it is essentially Socialist. However, there is a better topic for a referendum: a full Gold Standard, removing almost all power from the bureaucrats and restoring sound money once and for all. In an era of Brexit and Trump, it just might succeed.

It is a superb tribute to the Swiss education system, clearly very different from our own, that the Swiss people are thought capable of deciding on the very complicated “Vollgeld” monetary proposal (the Gold Standard is simplicity itself by comparison). Under the proposal, which translates as “sovereign money” banks would be compelled to deposit their checking accounts as reserves with the Swiss National Bank, maintaining a 100% coverage of their immediately payable liabilities and preventing them from creating money. (When a bank makes a loan, it gives the borrower an immediate credit balance in his checking account, creating money thereby; under this system the proceeds of a new loan would immediately need to be re-deposited with the SNB.)

This system is admirable in reducing the leverage in the economy. Instead of the banks being able to create credit unhindered, which they inevitably do when interest rates are low and speculative activity high, they are restricted to lending only against savings deposits or against funds advanced to them by the SNB. With an appropriately conservative SNB, credit would become difficult to get, lending interest rates would rise, and leverage in the economy would finally, blissfully fall. Bank profits might suffer in the short-term, but the probability of a banking crisis or a run on an individual bank would be greatly reduced.

The problem with the system as it stands is that the SNB is by no means reliable as a custodian of monetary virtue. The sloppy-money Financial Times, which opposes the proposal, admits it would currently have little effect, since the SNB’s policy interest rate is negative, at minus 0.75%, and has been so since January 2015. (Since the Swiss Franc is a favorite international store of value, it tends to rise against the other rubbish, and the SNB is determined to hold the franc down through interest rate policy.)

With a profligate central bank, the virtues of Vollgeld are much less clear; it leaves credit creation wholly in the hand of a government institution, thereby potentially socializing the economy. One can imagine central bankers under whom Vollgeld would be a huge improvement; Montagu Norman, say or Paul Volcker. But with only the current feeble managers in charge, and with governments seeking to direct credit to their favorite boondoggles, it is potentially dangerous. Opinion polls suggest that the Vollgeld referendum will fail; from a monetary policy and financial freedom viewpoint it may even deserve to fail, though the principle of popular referenda being used to overrule the monetary experts is an excellent one.

One understands why 100,000 Swiss citizens voted to create the Vollgeld referendum; they sought a means by which the disasters of 2008 could avoid being repeated. Unfortunately, they blamed the banks primarily for that disaster, and thought that greater government control would mitigate against its being repeated. In this they were sadly misguided – 2008 was at least as much a creation of governments as it was of the private banking system.

To get a banking system where the checks and balances against excessive credit really work, we need to move away from government’s role as originator of money. Theoretically, this could be done by moving to a system of crypto-currencies, privately created through a blockchain or equivalent system, whose overall amount was strictly limited. However, experience has shown that, while the amount of any individual crypto-currency outstanding may be limited, the number of copycat crypto-currencies is essentially infinite (Bitcoin itself spun off Bitcoin Cash and an extraordinary 18 other “forks” in 2017 alone). Hence substituting private money creation for government money creation does not solve the problems of fiat money, even though in other respects crypto-currencies have many useful roles to play.

The solution is to hold a referendum on the Gold Standard, the one system in human history that takes money creation out of the hands of government. There are theoretical arguments for using something other than gold for the standard, or for using a basket of commodities, but those are outweighed by the simplicity of the Gold Standard concept, much simpler than Vollgeld, and hence potentially saleable even to non-Swiss referendum voters. The referendum would relate only to the principle of a Gold Standard; the details would be worked out if the referendum was successful (though there would be a pledge included in the referendum that if it won no phony Gold Standard system, like the Bretton Woods excrescence of 1944-71, would be passed off as the real thing).

Clearly, a Gold Standard referendum would be unlikely to win if proposed at the end of a long period of apparent stability and prosperity, such as we are in now (though you never know!) It would make more sense to wait until the funny money of the last decade has produced the inevitable crisis, with collapsing stock and asset prices, and bank bailouts at taxpayer expense, before proposing the referendum. At the same time, we should get prepared, draft a proposed wording etc.; we certainly do not want to miss the opportunity for a lack of preparedness. A referendum held within two years of a financial crash, when memories are fresh and before the world’s central banks have had time to wreck the economy yet further with funny money and over-regulation, would have a high probability of success.

A Gold Standard, to function properly, would need to be combined with tight restrictions on leverage, at least initially. Clearly, a Gold Standard that was combined with current banking leverage of 30 to 1 would lead to a financial crash in very short order. Banks today have no experience of operating in a Gold Standard economy, and would certainly regard the leverage levels of 1910, with equity at a minimum of 20% of liabilities, as barbarously restrictive. Once the Gold Standard had been operating for some time, over a minimum of two business cycles, the formal regulations could be lifted, as banks would have got used to the new order. Initially, however, allowing banks to choose their own levels of leverage is far too dangerous, given the moral hazard of them coming to the state whining for a bailout when things went wrong.

One possibility would be, as well as the Gold Standard, to adopt the “Vollgeld” system where banks had to deposit 100% of their current account balances with the central bank. If the central bank itself was forced to operate on a Gold Standard, so that its notes were redeemable on demand for gold, it would not be able to expand the money supply arbitrarily, even if its staff were grinding their teeth in fury about the adoption of the Gold Standard (as they might well be).

In either case, it would be essential for the Gold Standard to include the issue of gold coins, of perhaps $100 and $500 denomination (I assume the gold parity would be around $2,000 per ounce, somewhat above the current level, to avoid excessive initial deflation). This would ensure that the economy did not depend excessively on bank notes. The British crash of 1825, in which small banks had issued too many notes, showed the damage this could do. Even if note issuance is limited to the central bank, it can easily become excessive, if no actual gold circulates. Ideally, the largest note would become $50, with larger denominations represented by gold coins only.

In an ideal world, the move to a Gold Standard would be accompanied by the abolition of the central bank; while the Bank of England has got a few things right over 324 years the Fed’s track record over 105 years is sadly inferior. However, since nobody in the entire world except a very few theoretical economists, mostly currently unemployed, has any idea how to operate in a world without a central bank, this is probably a step too far in practice. The idea should be revisited after ten years or so, especially if the current central bank staff prove recalcitrant (it could usefully be held over them as a threat).

The economic effect of a Gold Standard would be highly salutary. It would collapse the value of the malinvestment of the last two decades, in real estate, stocks, junk bonds and elsewhere, and ensure that new investment was directed to productive purposes. Savings, given real rewards at last, would soar. A Gold Standard would also force the U.S. government and governments everywhere to mend their ways and stop relying on deficit financing; if debts do not disappear through inflation and positive real interest rates must be paid on them, budget balancing can no longer be put off for the next administration. Keynesian deficit spending would automatically disappear, in itself a huge blow for freedom.

Needless to say, the economic effects described above would not appear beneficial to those responsible for the current set of fiscal and monetary policies. That’s why the ordinary approach to a Gold Standard, attempting to elect politicians who will support it, has not worked – the politicians “go native” as soon as they attain power, as did even President Ronald Reagan in 1981. But a Gold Standard Referendum, timed right after the next financial crash – that might just work! We must prepare.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)