Trust Mises and Gold, Not Keynes, Bernanke, and Fiat Money

Gary North
Thursday, April 23, 2009

A preference for a tangible gold currency is no longer more than a relic of a time when Governments were less trustworthy in these matters than they are now, and when it was the fashion to imitate uncritically the system which had been established in England and had seemed to work so well during the second quarter of the nineteenth century. — John Maynard Keynes, 1913

This statement appears in the first book written by John Maynard Keynes, Indian Currency and Finance. I regard this statement as one of the early academic salvos against the gold standard. It was an early phase of what I have called the gold wars. You can download my 100-page study here:

In my recent article, “Why Gold Owners Are Targets of the Government,” I made the point that the international gold standard served as a restraint on the ability of governments to defraud their citizens through monetary inflation. With the destruction of the gold standard, beginning in 1914 with the outbreak of World War I, citizens around the world have seen the destruction of purchasing power in every nation through monetary inflation. Not one currency has maintained its purchasing power of 1914. There is a reason for this: not one currency is redeemable on demand in gold.

In 1912, Ludwig von Mises’ monumental book appeared, The Theory of Money and Credit. The 20th century can be regarded as confirmation of Mises’ suspicion that governments cannot be trusted to manage their monetary systems for the benefit of the people. The 20th century is a lasting testimony to the naive view asserted by Keynes that governments are more trustworthy than they had been in the 19th century.

Keynes regarded the 19th century as a time in which governments were constrained by the gold standard because they were untrustworthy. Mises agreed with Keynes on this point. Where they disagreed was with respect to the trustworthiness of 20th-century governments that were not restrained by a gold standard. Keynes was wrong. Mises was right.


The gold wars have been conducted by governments because Keynes was wrong and Mises was right. The reason why we are living in a time of monetary inflation is because governments escaped the restraints placed on them by a legal requirement that anyone may present government-issued IOUs for gold at a bank. These IOUs, called money in 1913, transferred power to the holder of each IOU. The holder was in a position to demand payment in gold at a fixed rate of exchange.

In the 19th century, voters did not allow governments to expand the purchases of votes by means of expanding government expenditures. There was a great hostility throughout the 19th century to the idea that government can in any way successfully regulate the economy. There was great distrust of government spending generally, and the public’s means of enforcing controls over national governments involved the establishment of a gold standard.

A government that adhered to the gold standard domestically gained investors from around the world. People trusted the government, and so the government was able to attract investors for its debt at interest rates lower than the interest rates that investors required from governments that did not adopt a full gold coin standard. It was profitable for the British Empire to adhere to a gold standard for 1815 to 1914. It gave the British Empire a tremendous advantage because it enabled the government and commercial enterprises to borrow money at low rates of interest.

The power of holders of IOUs to gold coins was of enormous importance in restraining governments in their spending. Consider the motivation of all governments to get something (more power) for nothing (higher taxes). When governments find that they cannot tax their residents directly, because of the negative effects of taxation on the economy, and also because of the potential of a tax revolt, governments resort to monetary inflation. They instruct their central banks to expand the purchase of government debt or any other asset that can be legally used as part of a central bank’s monetary base. The central banks follow these instructions, even though they maintain the fiction that they are legally independent. The central banks’ purchase of the assets, especially government debt, expands the money supply in order to make the purchase.

In the international gold standard that prevailed prior to World War I, any gold standard government that failed to adopt a policy of monetary restraint lost its competitive position. Such a government would find that foreign governments, foreign central banks, foreign investors, and domestic holders of IOUs called money would begin to redeem these IOUs for gold coins. The central bank or the treasury would find that it was losing more gold than it was taking in.

At some point, it would be impossible for the government or its central bank to deliver gold to a growing number of holders of IOUs, who had lost faith in the word of the government or the central bank that it would not inflate. The holders would call the bluff of the central government or the central bank. They would do so in the form of a run on the government’s gold supply.

This run on gold began a traditional bank run. Commercial banks bore the brunt of the outflow of gold. The banks would then have to curtail their expansion of loans because their capital would no longer permit any further expansion. If the bank run continued, the bank would have to call in existing loans and demand payment. This was unprofitable for the bank, and it was also unprofitable for the companies that had borrowed money from the bank and had expanded their production of goods and services by means of credit issued by the bank.

The commercial bank would then demand gold from the central bank by cashing its IOUs for gold (reserves at the central bank), and the central bank would have to curtail the expansion credit. All along the line, the bank run against gold would result in a contraction of the money supply. This was the great advantage of the international gold standard. It forced commercial banks, central banks, and governments to maintain policies of monetary stability. If they did not do this, the gold run would force their hand, and the result would be a contraction of the money supply and economic recession.

This system has not existed in most countries since 1914. It has not existed in the United States since 1933, when President Roosevelt unilaterally made it illegal for Americans to own gold. Finally, it has not existed anywhere ever since August 15, 1971, when President Nixon unilaterally announced that the United States would no longer honor its IOUs for gold that it had issued to foreign governments and central banks.

What we saw, beginning in August 1914 and extending to August 15, 1971, was that governments were as untrustworthy with respect to monetary policy as they had ever been in the 19th century or any other century.
Governments are inherently untrustworthy when it comes to monetary affairs. They do not wish to increase direct or indirect taxation on citizens, and they always want to expand spending by government agencies. The way to achieve both goals is to abolish the international gold standard, abolish the domestic gold standard, then expand the money supply whenever expenditures increase beyond what the domestic population is willing to accept as a legitimate level of taxation.

Without the gold standard to restrain government expenditures, governments around the world have found a way to expand the money supply, reduce the purchasing power of their currencies, and avoid tax revolts.


Monetary expansion is held in check today mainly by the bond market. The bond market puts pressure on every government Treasury by means of the interest rate. When bond investors believe that a government is going to expand the money supply long term, thereby raising prices, they demand a higher rate of interest on long-term loans. They do this because they want to protect their investment against depreciation by a falling currency unit.

The problem is, bond investors from 1940 to 1980 remained optimistic about government policy, in the same way that Keynes was optimistic about government policy. This is why, from 1940 to 1980, anyone who invested in United States Treasury bonds lost most of his capital to inflation. The dollar steadily declined during this period. Yet there were always buyers of Treasury debt, especially during World War II, when the government mandated that the Federal Reserve System purchase Treasury bonds at below market interest rates.

Today, bond investors do possess some degree of power over government spending. But, as we have seen since September 2008, we can have massive increases of government spending beyond anything known in the past, yet interest rates have not skyrocketed. This is because we are in a period of economic recession. There is fear about investing in real estate, stocks, and other forms of equity. People are willing to lend money long-term at low rates of interest, despite the fact that the monetary base has expanded at an unprecedented level. Banks continue to hold excess reserves at close to 0% per annum at the Federal Reserve System, thereby keeping the fractional reserve banking system from expanding M1 and thereby raising prices at double-digit rates.

In other words, fear of the recession has overcome fear of price inflation. This has been true over the last year in the gold market, the silver market, and the bond market. Investors believe that their investments are not safe in anything except high-rated government bonds, corporate bonds, or near-cash assets. They believe that the greatest threat to their net worth is the recession. So, the traditional restraining factor in the world devoid of a gold standard has not functioned: the bond market. National governments have expanded spending an unprecedented level, and they have not suffered the consequences in the capital markets. They are still able to sell their bonds to investors, despite the fact that the expansion of the monetary bases of every nation has continued with impunity.

This has encouraged governments to run deficits at a level that would not have been considered possible as recently as August 2008. The level of government spending, and the level of the Federal deficit, that has taken place since September 2008 is on a scale that is beyond the experience of economists, economic forecasters, investors, central bankers, and politicians. This has enabled politicians to expand spending more rapidly than we have ever seen in a comparable period of time, except during the world wars and their aftermath in losing nations.

Because no one has any familiarity with this level of government spending, the capital markets have not collapsed in what is the equivalent of a run on the banks. The public has no ability to make a run on the banks, because in order to get money out of one bank, they must transfer it digitally to another bank or institution that will immediately deposit the money in a bank. The traditional restraining factor of a bank run no longer exists with respect to depositors. It still exists, however. It exists because bankers have the ability to refuse to put the money into circulation. They can deposit at the Federal Reserve System, and in doing so, they keep the money from entering the general economy. Because they can do this, the expansion of the money supply that has taken place since September 2008 has not registered in the general economy yet.


Chairman Bernanke has promised that when the recession ends, the Federal Reserve will reverse its expansionary policies, sell assets, shrink the monetary base, and restore the system to the status quo ante. The problem with this is the problem that he faced from the day he became Chairman in February 2006 until the world economy began to fall apart in August 2007. Greenspan lowered the Federal funds rate to 1% and kept it there for 18 months: June 2003 to June 2004. Then, when the Federal Reserve System began to reduce the rate of expansion of the monetary base, interest rates rose, and the result was what we have seen since August 2007.

If the economic boom can be restored only by a gigantic increase of the monetary base, which also involves a reduction of the federal funds rate to approximately 1/10th of 1%, than any attempt on the part of the Federal Reserve in the future to restrict the expansion of the monetary base will raise interest rates once again, and the economy will contract, just as it did after Bernanke’s first year and a half.

The promise is always that some day there will be a restoration of the status quo ante. President Obama tells us that he will be able to cut the Federal deficit by 50% in the year 2012. Of course, it will still be in the range of $1 trillion. There is no evidence that he is going to be able to do this, nor does he attempt to supply such evidence. He simply promises that it will be done.

Chairman Bernanke has promised the same thing with respect to Federal Reserve monetary policy. He said on April 3,

In pursuing our strategy, which I have called “credit easing,” we have also taken care to design our programs so that they can be unwound as markets and the economy revive. In particular, these activities must not constrain the exercise of monetary policy as needed to meet our congressional mandate to foster maximum sustainable employment and stable prices. is no way that the Federal Reserve can reverse itself by shrinking the monetary base in a recovery, unless it risks pushing the world economy back into something a great deal worse than what it has experienced over the past 18 months.

The economy collapsed internationally over the last 18 months. Why? Because of the monetary expansion that took place after 2001. This rate of monetary base inflation then when compared to today would be considered tight money. When tight money reappears, if it ever does, the economy will be pushed back into the same economic environment that we have experienced over the last 18 months.

If it takes a doubling of the monetary base for March 2008 to March 2009 in order to keep the economy from completely collapsing, what should we expect when the Federal Reserve sells assets, shrinks the monetary base, and lets interest rates climb in response to the new economic conditions? Why should we expect the economy to continue to prosper, when the only basis of its recovery, should that recovery take place, is a doubling of the monetary base?

These are obvious questions, yet almost nobody is asking them in the mainstream financial media. There is no attempt to analyze Bernanke’s promise in terms of Bernanke’s own experience, when he attempted to stabilize the monetary base from February 2006 until late 2007. We have been down that road of monetary stabilization, and it has produced the worst recession since the Great Depression.

Now we face an economy that is barely functional and that requires government spending on a scale never seen in peacetime America, and monetary expansion on a scale also never seen in peacetime America. These are the twin pillars, according to Keynesianism, of government counter-recessionary policy today. Take away these two pillars, as President Obama and Chairman Bernanke promise will be done, and what becomes of the recovery? If the recovery is based on massive government spending and massive expansion of the monetary base, then how can it continue when both of these stimulus programs are reversed by the government and the Federal Reserve System?

We are now trapped by Keynesian policies of the expansion of money supply and expansion of the Federal deficit. Investors have some slight ray of hope that this twin stimulus package will keep the economy from collapsing into full-scale depression. They are somewhat optimistic that the government and the Federal Reserve System have put the worst behind us. They are Keynesians, and they believe in Keynesian deficit spending and monetary expansion. They do not understand that a recovery that is financed by government deficits and monetary expansion must turn into one of two things: either mass inflation if the policies are continued, or else economic depression when the policies are reversed.


The public believes that it is possible to return to the status quo ante. People believe that it is possible to go back to business as usual. Yet the landscape that existed in August 2008 no longer exists. The banking system is owned and operated by the Federal Reserve System and the Treasury Department. We have moved from private capital markets operating in a Keynesian economy to government-regulated capital markets that are essentially not different from what prevailed in Italy and Germany in 1935. The government business alliance is now openly operated by the big brother in this alliance, the Federal government.

We cannot go back to business as usual because business as usual relied on a level of Federal taxation and monetary expansion that no longer sustains this new government operated economy. We will not muddle through to the status quo ante, because the status quo ante is gone with the wind.

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