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| THE GOLD STANDARD DEMANDED DISCIPLINE
IN AN UNDISCIPLINED WORLD.
IT IS GONE BUT IT WILL RETURN!
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On March 14, 1900, the Congress
of the United States passed the Gold Standard Act. This placed
our nation on an official gold standard and mandated that
the issuance of “greenbacks”, or Treasury notes,
could only occur if they were backed by gold. Further, Congress
created a gold reserve of $150 million that was to be expressly
used for the redemption of gold-backed greenbacks. Henceforth,
under the gold standard, our politicians were to be limited
in the ability to issue new banknotes by the amount of physical
gold that was set aside to redeem them.
When dollar creation was governed by this law,
the dollar’s strength or weakness was determined by
the health of our economy, interest rates and our monetary
gold stock. The stronger that our country appeared to the
rest of the world, the more desirous was our dollar. During
this era, the gold standard acted as a self-regulating mechanism
by dictating the size of our money supply. The larger our
gold stock, the greater the amount of notes that our country
could issue. Conversely, if our nation’s gold supply
dwindled, it was forced to reduce our money in circulation.
Further, the gold standard functioned to moderate and control
the expansion and contraction of the business cycle.
In 1934, President Roosevelt revalued gold from
its earlier official price of $20.67 to $35 an ounce. When
that occurred the gold standard redefined the dollar as being
worth 1/35th of an ounce of gold. Because the government could
only create as many dollars as their gold stock would provide,
this “official” rise in the gold price simultaneously
allowed our leaders to “legally” increase our
money supply. Our then current store of gold would support
a far greater dollar amount of paper money. In effect, they
devalued the dollar by reducing the quantity of gold that
was necessary to redeem it. This allowed our politicians to
increase our money supply with the hope that it would help
our country extricate itself from the throes of the Great
Depression
The gold standard formed the foundation of a
sound domestic monetary system. It prevented government officials
from arbitrarily increasing the dollars in circulation as
it limited their ability to create money from “thin
air”. This fostered greater confidence for our trading
partners in holding our dollars, as they knew that their value
was stable and that they could redeem them for gold.
The gold standard also facilitated smooth business
transactions between foreign nations. When the gold standard
was adhered to by our trading partners, gold was used to settle
balance of payments deficits between countries. When one nation,
the debtor, bought more goods and services from another than
it sold to it, the creditor, the former incurred a balance
of payments deficit. The net effect was the return of the
debtor country’s money and a transfer of some of its
gold stock to its creditor.
A growing American economy generates greater
wealth for both our domestic companies and our citizens. Further,
this condition increases the desire of foreigners to purchase
and invest in our nation. They are more confident in holding
our currency and they see value in doing business with us.
During periods when both our dollar was widely desired and
our economy was strong, U.S. companies imported greater quantities
of foreign goods than they sold. This was the result of our
citizens and enterprises using some of their increased income
to purchase more products from beyond our borders.
Under these circumstances dollars left our shores
and accumulated in foreign lands. As this process continued
a point was reached when we created a U.S. Balance of Payments
deficit. As stated earlier under the Gold Standard, if a foreign
nation desired to redeem their acquired dollars they could
receive gold in exchange. When this occurred, the transfer
of gold from the U.S. caused a decrease in our gold stock,
and forced a simultaneous reduction in our money supply. Thus,
the dollar’s increased value would make our goods progressively
more expensive in other currencies. This acted to curtail
foreign purchases in the U.S. The resultant decline in foreign
demand, and our reduced money supply, would act as a brake
to slow the economic expansion. It would also act to reign
in any inflationary pressures that were fostered by our strong
economy.
In contrast, during periods of weak U.S. business
conditions the dollar fell in value, and U.S. consumption
of foreign goods declined. The weakened dollar raised the
price of alien goods to Americans. Eventually, the cheaper
dollar and the greater bargains that our products represented
encouraged foreigners to consume a relatively greater amount
of U.S. goods and services. This caused a U.S. Balance of
Payments surplus as our trading partners acquired more of
our products than they sold us. When this occurred their accumulated
currencies were exchanged for gold by our country. The result
was a net increase in our governments’s gold stock.
This in turn would generate a rise in our money supply which
would stimulate business, help end the recession, and the
process would repeat itself.
THE REMOVAL OF THE LAST RESTRAINTS
UPON MONETARY CREATION
In 1944, the Bretton Woods Agreement was signed
by the U.S. and 43 other nations. This created the gold exchange
standard. Under this accord, these countries agreed to treat
the dollar as a substitute for gold in settling their Balance
of Payments deficits; both gold and the dollar could be used
interchangeably. Under the earlier gold standard these foreign
nations also utilized their gold hoards in determining the
size of their individual money supplies.
The gold exchange standard opened the door for
excessive world monetary creation and the inflation that it
inevitably produced. No longer would the money supplies of
the major countries be controlled by the amount of gold in
their depositories. Now, they could increase their local money
stocks by issuing additional amounts of their native currencies
based upon both their U.S. dollar holdings and their gold
reserves.
Finally, in August, 1971, President Richard
M. Nixon closed the gold window. This removed the last vestige
of gold backing from our currency and the final restraint
on our politician’s ability to arbitrarily create money.
Thus, the era of fiat money entered its heyday, and the dollar
became doomed.
Subsequent to President Nixon’s refusal
to exchange gold for foreign U.S. dollar claims, the dollar
became the primary item that was used to back the currencies
of the world. Under the gold exchange standard our trading
partners gained great confidence in the dollar. This was the
result of the long period in which they could confidently
exchange it for gold. It is the prime reason that the U.S.
was able to convince the world to move from the gold standard
to a system which allowed a dollar substitute. This placed
the U.S. in an enviable position, and allowed it to wield
great power. It provided our country with the ability to settle
our balance of payments deficits with dollars that the Federal
Reserve could create at will. They no longer had to back the
dollar with gold. Had our leaders acted responsibly to limit
the creation of dollars, we would not be in the precarious
condition that the U.S. and the balance of the world now finds
itself.
During the ensuing four decades after the dollar
replaced gold, the U.S. has registered an enormous cumulative
balance of payments deficit. These dollars left our country
to acquire valuable goods and service which were gladly sold
to us. Many of these dollar credits then returned to the U.S.
and were invested in U.S. Treasuries which helped reduce our
interest rates. A substantial number of the dollars that went
overseas found their way into the coffers of the various central
banks. This kept them out of our money supply and reduced
pressure on our prices, thereby limiting domestic inflation.
Simultaneously, the dollar build up in foreign lands fostered
large increases in the money supplies of those nations.
All of these factors worked well for quite some
time. In the U.S., it allowed our citizens to lead a far better
lifestyle and enjoy a higher standard of living than would
have otherwise been the case. We did not have to sacrifice
our precious gold hoard, as we would have under the gold standard,
in order to settle our balance of payments deficits. We not
only weren’t forced to reduce our money supply, but
were able to expand it. Foreigners continued to treat the
dollar as if it remained as good as gold. We simply transferred
electronic dollar credits to pay for our foreign purchases.
Additionally, the abrogation of the gold standard forestalled
a serious economic decline that would have been mandatory
under its rule. Each time our economy has contracted the Fed
effortlessly expanded the money supply and reduced interest
rates. Even today this method appears to be working. However,
the time will come when the piper will have to be paid, and
time may be running out.
The other nations are beginning to recognize
the trap into which they have fallen. They see the dollar
declining and gold rising in value and have heard from the
lips of Fed Chairman Alan Greenspan and Fed Governor Ben Bernanke
that the U.S. has the ability to create dollars at will. Large
foreign dollar holdings have been converted into euros and
some into gold. Further, there is talk of not only repricing
oil in euros but in the creation of new gold backed currencies.
Either of these events will play havoc on the dollar as its
usefulness to the rest of the world will decline, and with
it both the dollar’s desirability and worth. For these
reasons, I believe that the dollar is destined to gradually
lose its global importance.
Additionally, Japan is aggressively purchasing
dollars with newly created yen credits. They are attempting
to support the dollar in an effort to maintain their competitive
trade advantage. This is acting to limit an increase in the
U.S. money supply because the dollars purchased are removed
from our domestic measures of money. Instead, the dollars
are used by Japan to acquire U.S. Treasuries. This is likely
the primary reason for our surprisingly strong bond market.
At some juncture I believe that it is
inevitable that the U.S. will be forced to again back the
dollar with gold. It will not likely occur until the dollar
appears to be in the process of or loses its status as the
world’s reserve currency. Or, if this is preempted by
an economic accident. That is likely the only fashion in which
the dollar will have the opportunity to again become universally
desirable. This will not occur overnight! Until that time
comes, gold and secondarily silver and gold and silver stocks,
as well as tangibles, will be the prime beneficiaries of the
termination of the gold standard.
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I publish Financial Insights. It is a monthly
newsletter in which I discuss gold, the financial markets,
as well as various junior resource stocks that I believe offer
great price appreciation potential.
Please visit my website www.financialinsights.org
where you will be able to view previous issues of Financial
Insights, as well as the companies that I am presently following.
You will also be able to learn about me and about a special
subscription offer.
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CAVEAT
I expect to have positions in many of the stocks
that I discuss in these letters, and I will always
disclose them to you. In essence, I will be putting my money
where my mouth is! However, if this troubles you please avoid
those that I own! I will attempt wherever possible, to offer
stocks that I believe will allow my subscribers to participate
without unduly affecting the stock price. It is my desire
for my subscribers to purchase their stock as cheaply as possible.
I would also suggest to beginning purchasers of these stocks,
the following: always place limit orders when making purchases.
If you don't, you run the risk of paying too much because
you may inadvertently and unnecessarily raise the price. It
may take a little patience, but in the long run you will save
yourself a significant sum of money. In order to have a chance
for success in this market, you must spread your risk among
several companies. To that end, you should divide your available
risk money into equal increments. These
are all speculations! Never invest any money in these
stocks that you could not afford to lose all of.
Please call the companies regularly. They are
controlling your investments.
FINANCIAL INSIGHTS is written and published by Dr. Richard
Appel and is made available for informational purposes only.
Dr. Appel pledges to disclose if he directly or indirectly
has a position in any of the securities mentioned. He will
make every effort to obtain information from sources believed
to be reliable, but its accuracy and completeness cannot be
guaranteed. Dr. Appel encourages your letters and emails,
but cannot respond personally. Be assured that all letters
will be read and considered for response in future letters.
It is in your best interest to contact any company in which
you consider investing, regarding their financial statements
and corporate information. Further, you should thoroughly
research and consult with a professional investment advisor
before making any equity investments. Use of any information
contained herein is at the risk of the reader without responsibility
on our part. Past performance does not guarantee future results.
© 2003 by Dr. Richard S. Appel. All rights are reserved.
Parts of this newsletter may be reproduced in context, for
inclusion in other publications if the publisher's name and
address are also included for credit.
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