A View from the Trenches

Martin Sibileau's market letter

Open letter to Ron Paul

We have followed and continue to follow with utmost interest the political career of US Congressman Ron Paul. We sympathize with Mr. Paul’s cause for sound money, but he and his political life reminds us of Cicero in the face of Rome’s final days as a Republic. Mr. Paul may be remembered by historians of the United States, just as Cicero is remembered by historians of Rome. There is however a small but relevant difference between Cicero and Congressman Paul: Cicero took sides. Cicero, in the end, sided with Octavivs. Yes, Octavivs betrayed Cicero, but Cicero, also saw that neutrality was a sterile path.

Congressman Paul is not taking sides. Having been repeatedly asked lately what his plan is as the new chairman of the Financial Services Subcommittee on Domestic Monetary Policy, with Congressional oversight of the Federal Reserve, Mr. Paul replied that he would simply seek to allow gold or any other asset to compete as legal tender with the US dollar (in addition to audit the Fed, that is). We understand the noble intention behind this, but we can’t support it. We have no idea as to what the real chance is for this innocent proposition to be enacted. But we can say that this plan will only have the unintended consequence of creating unnecessary discredit to the Austrian economics tradition. Why? Because it is no plan! No, we are not advocating to plan monetary policy. That is also very un-Austrian. We are simply noting that to “end the Fed”, a plan is required.

A simple example (among many others that this short space doesn’t allow us to elaborate on) should help visualize our point. If gold has a chance as an alternative asset, in simultaneous competition with the US dollar, it will only be natural that we witness once more Gresham’s law at play. Gresham’s law, simply put, states that bad money displaces good money out of circulation. In a leveraged system like the one we live in, this means that market participants would arbitrage the system. They would simply borrow in US dollars and save in gold . To some degree, this is starting to slowly occur, but today the speed of this change is driven by the deterioration of the paper money, not by the quality of gold as legal tender. However, if gold was allowed to compete, this process would take place faster. This would quickly lead to the bankruptcy of the entire financial system, as we know it , for the cost of borrowing would increase exponentially, in real terms (i.e. in gold). But, if Mr. Paul does not end the Fed, as long as this institution survives, it will be forced to provide liquidity to the financial institutions, creating hyperinflation along the way.

What is the problem with hyperinflation? That those who still earned wages in paper money would see their income (and possibly their wealth too) destroyed. Please, note the following:

1.-Fiscal deficits, as long as the government does not bail out banks, would have NOTHING to do with this hyperinflation Mr. Paul’s plan would bring.

2.-The Fed would create hyperinflation by providing liquidity, not bailing out banks as in 2008, when it bought defaulted liabilities. In fact, as inflation spikes, it would be extraordinary to see defaults in paper money (i.e. bad loans), for the cost of paying off US denominated debts would decrease along with the higher rate of inflation

The only way to prevent hyperinflation would be to create fiscal surpluses and use them to buy gold to back the US dollar, for the Fed to be able to compete against gold-backed notes. Now, if you think the public and the financial lobby would allow monetary developments to get to this stage, you really are an optimistic in life. In the process, Mr. Paul and the rest of the Austrian movement would be blamed for creating inflation and making the poor poorer.

Given the impossibility to save the Fed, the next stage, which would see the Tea Party ousted from Congress for decades, would be to unwind the Fed. And the United States would have a multitude of unregulated banks issuing gold-backed notes, lending more than they have in deposit. It would only be a matter of time, until the next Ponzi scheme is uncovered and by then, given the absence of a lender of last resort, the public would seek to solve the problem with regulation. Someone would remind Americans of the good old times when there was a lender of last resort and the United States was the global power, and we would see central banking back in place.

We can’t let that happen, Mr. Paul. We need a plan to unwind the Fed without creating hyperinflation. The good news is that it is technically possible.

 

Martin Sibileau

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Posted: Mon, Dec 20 2010 10:58 PM by Martin Sibileau | with 6 comment(s)

Comments

bionic mosquito said:

"Gresham’s law, simply put, states that bad money displaces good money out of circulation."

Only if the exchange rate values one over the other by force of law. Otherwise, both monies will trade appropriately in the market.

"But, if Mr. Paul does not end the Fed, as long as this institution survives, it will be forced to provide liquidity to the financial institutions, creating hyperinflation along the way."

In and of itself, not a bad thing. The hyper-inflation will be limited to the Fed-backed fiat currency, further driving the market to the alternative, gold currency.

The one drawback I see of Dr. Paul's position is that the government would likely continue to require taxes be paid in the fiat currency. This will therefore always create a demand for the currency, and would at least provide some support for the operation of Gresham's law.

However, I don't believe Dr. Paul is advocating this as a "plan." It strikes me he is using this discussion, as he uses most of his discussions, for education. In this, he has been wildly successful.

# December 20, 2010 11:10 PM

Martin Sibileau said:

@bionic mosquito: Thanks for the comment. A few observations here:

-The assumption here is that gold is allowed to compete with the US dollar. Therefore, Gresham's law would apply. You are right about the market deciding how they will trade, which is why I say that market participants will save in gold and borrow in US dollars.

-If you think hyperinflation is not a bad thing, then I rest my case. But you are not alone here. Other participants, particularly those whose income would remain denominated in US dollars and carry a vote, will probably have a different view.

-I disagree with your view on taxes being required in US dollars. If gold is allowed to compete as legal tender, by definition, gold-backed notes should be allowed as payment for taxes. The problem is that people would not use them to pay taxes. As per Gresham's law, they would pay, in arrears, in depreciated US dollars, as the Olivera-Tanzi effect tells (en.wikipedia.org/.../Olivera%E2%80%93Tanzi_effect ). This in itself would further fuel the inflationary spiral.

-I disagree with your view that Dr. Paul is just seeking to educate the public. Many, many times, has he been asked what his next steps would be and as many times has he answered the first thing he has in mind is to allow free competition between gold and US dollar.

Don't take me wrong. I am very interested in seeing sound money succeed. But I think Dr. Paul's good intentions would yield the opposite effect. This time, we are facing a historical opportunity and we must take a side by explictly stating a way out. There has to be a plan for a way out or the whole thing will fail and the Austrian school will be left to oblivion.

# December 21, 2010 12:41 PM

bionic mosquito said:

@Tincho, thank you for your courteous reply. Please allow me further comment:

If gold is allowed fully and in every way to compete with the dollar, Gresham's law (in its incorrect and common usage) will not apply. Good money will drive out bad, or more accurately both will trade fairly at values representing the market's unobstructed view of their respective worth. Just like every other paired transaction, unfettered supply and demand will find a market-based clearing price.

From: en.wikipedia.org/.../Gresham&

"Gresham's law is commonly stated: "Bad money drives out good", but is more accurately stated: "Bad money drives out good if their exchange rate is set by law.""

My point about hyper-inflation is as follows, and perhaps I was not so clear initially: It will not be bad, because it will help bring about the demise of fiat that much quicker. More people would more quickly move to the stable currency. Of this, I cannot complain. For those whose income remains denominated in dollars, they can always exchange fiat dollars for gold currency every pay-day in order to minimize the impact of the hyper-inflation. But, given a fully free and flexible alternative, their employers likely would have done this already in their own dealings as they could not stay in business long transacting in a rapidly depreciating currency.

On taxes being paid in fiat dollars, I have no strong opinion, nor can I. It is purely a policy decision. It would be magnanimous of the government to allow taxes to be paid in either currency, as this will surely put the nail in the coffin of the fiat dollar. Requiring taxes paid in the coin of the realm is a sure way to place a demand floor under the value of that coin…no matter how bad the coin is.

As to Dr. Paul and steps he might otherwise take: there is absolutely zero chance of him succeeding via policy and politics toward anything close to what you are proposing. There is no doubt Dr. Paul recognizes this. His value is in educating the public.

The only chance for success toward free markets is when the death of the current system is finally realized by the population with all its associated terrible consequences, and the system has breathed its last. Who knows what will replace it, but with proper education we have a chance at a move toward a more market driven economy and market based money.

# December 21, 2010 3:42 PM

Martin Sibileau said:

@bionic mosquito:

I don't think both gold and paper money, if given same legal status, would be able to co-exist, at a market clearing relative price. In the end, one has to win over. Otherwise, we should believe in the indifference and utility curves the mainstream economics professors teach in universities nowadays. We both know they are nonesense. That's the point of Von Mises' "Human action". Man is not indifferent. Man acts. Man will not be indifferent in terms of its demand for money. That's my point and my assumption too: Once man picks gold as money, the rest of the story: Bankruptcy of financial system AS WE KNOW IT, for it could as well survive in a different form, brings about hyperinflation, since the Fed, which would not be wound down as Dr. Paul proposes, would have the fiduciary duty of providing liquidity to the system.

With respect to hyperinflation, I have a personal recollection of it, since I lived in Argentina until 2001. Let me simply say it is not "neutral". It has a huge, huge, social and political impact and I can't think of any government being able to survive it. Hence, my point with respect to Dr. Paul and the Tea Party.

Lastly, if Dr. Paul thought he has no chance, I am sure he would have stepped down. He didn't, which makes me happy. Therefore, there's a lot of work to do. I am simply throwing ideas here, to contribute. Because I am sure the central banking lobby must be preparing a formidable intellectual artillery and media op against the Austrian school.

# December 22, 2010 6:36 AM

bionic mosquito said:

@Tincho

Again, I thank you for your courtesy and indulgence with your replies to my comments.

I see no reason why multiple currencies cannot trade in a given jurisdiction. From a theoretical standpoint (and with no laws favoring any one currency), anything that two or more market participants view as a store of value and/or medium of exchange can act as such. Man may not be indifferent, but different men certainly have different preferences. If not, nothing would ever trade. Yet, I prefer the candy bar, and the shop keeper prefers my dollar. For money, it is not different and it is not proper to say that one or the other would be favored by all men regardless of price.

From a practical standpoint, I need look no further than Switzerland, where many business owners will accept Swiss Francs, Euros, or USDollars to settle a bill – the shopkeeper certainly is indifferent to the choice, at the exchange rates offered. Of course, in many societies, USDollars are accepted just as easily as local currencies.

With today's computing and communication technology, I see no reason that any transaction could not be settled in any currency that the two parties wish to use. A quick link to the bank would give a current price and off we go. An agreement could even be made with the bank beforehand to automatically convert all currencies taken in by the shopkeeper into a preferred currency, or some pre-determined basket of currencies representing the ratios of the shopkeeper’s costs.

With hyperinflation, please recall I am speaking of hyperinflation in the fiat currency while the other gold backed currency does not suffer this fate. As it stands today, with legal tender supporting the fiat currency, we cannot easily escape the inflationary threat. Therefore, Dr. Paul’s proposal offers a way out from this fear that you rightly have. With Dr. Paul's proposal, I don't see that the government is at much risk (too bad), but the government backed currency would be (good enough for me).

Finally, I cannot imagine why Dr. Paul would step down because there is no chance to pass a proposal such as you outlined. He has been successful in changing the dialogue beyond anyone's (even his) wildest dreams. As long as he is able to continue the education process, I am quite certain he would consider this a success (I certainly do), and would maintain the pulpit of his position in Congress.

Like you, I am also throwing ideas out there. I do not consider such dialogue anything other than a chance to expand my understanding as well to pass some of it along, if anyone finds any of the crumbs worth following!

Kind regards.

# December 22, 2010 11:09 AM

Martin Sibileau said:

@bionic mosquito: I think we are overlooking the following: When you speak of multiple currencies, you are not considering arbitrage. I am. Arbitrage means that there cannot be one good with different prices in a market. A fiat USD would have a different cost of production than a legal tender gold-backed note. Therefore, people would not remain indifferent and would arbitrage. That is only the rational and right thing to do.

That arbitrage does not exist for the tourism industry, as in your example. In that example, you have fiat currencies, which are stable.

In Latin America, that arbitrage existed and still exists. People pay their small, daily bills in pesos and save in US dollars. People, when they sell big items (cars, houses), only quoted you in US dollars (not anymore in the emerging markets like Chile).

This is how the banking system collapsed in Argentina in 2001 too. People repaid their loans in pesos...loans that had previously been funded in US dollars by banks. Why did the system collapse? Because the central bank was in convertibility. They could not act as lender of last resort. That was a great thing!!!! Because the system just had a good big puke, prices adjusted overnight, and within two years, the country went back to full employment!

But in our discussion, where Dr. Paul allows the Fed to compete with gold-backed notes, that puke would not take place. As I wrote, the Fed would have to provide liquidity to the banks who see the real value of their loans (assets) fall. That would creat the hyperinflation in fiat currency that we discussed in our correspondence. That would be painful and politically very unstabilizing.

So, in summary, my point is focused on arbitrage between a cheap-to-produce currency and an expensive one.

Cheers,

MS.

# December 24, 2010 6:57 AM