November 18, 2005
Before Alan Greenspan retires I thought it might be worthwhile
hearing what he thinks of money. Three years ago he gave a speech at the
opening of an American Numismatic Society exhibition that I found on the
Federal Reserve Bank website(1).
Greenspan reminds us, in no uncertain terms, that a monetary
system based on fiat money amounts to no more than a confidence game.
The value of fiat money is determined solely by our confidence in the
issuers of that money or, more specifically, on how well the supply of
fiat money is managed. If too much money is created the public will lose
confidence in its purchasing power and the perceived value of the money
can collapse. Remember, fiat money has no intrinsic value; it only has
After you have read Greenspan’s speech, read the excerpts
from a speech that Ben Bernanke made later that same year, and remember,
he is going to be the next Federal Reserve Chairman.
The History of Money (1)
by Alan Greenspan
“The other day I told a spendthrift friend that I
had to deliver a short address on the history of money. He responded,
"I understand the history of money. When I get some, it's soon history."
Fortunately, not all market participants are as spendthrift as my friend.
Savers have been in sufficient abundance since the beginning of the Industrial
Revolution to enable investment to further material well-being. Money,
as a store of value, was an early facilitator of savings and one of the
great inventions of mankind. Saving and investment is very difficult in
a barter economy.
“The history of money is the history of civilization
or, more exactly, of some important civilizing values. Its form at any
particular period of history reflects the degree of confidence, or the
degree of trust, that market participants have in the institutions that
govern every market system, whether centrally planned or free.
“To accept money in exchange for goods and services
requires a trust that the money will be accepted by another purveyor of
goods and services. In earlier generations that trust adhered to the intrinsic
value of gold, silver, or any other commodity that had general acceptability.
Historians, digging deep into the earliest evidence of human practice,
link such commodities' broad acceptability to peoples' desire for ostentatious
gold and silver ornaments.
“Many millennia later, in one of the remarkable advances
in financial history, the bank note emerged as a medium of exchange. It
had no intrinsic value. It was rather a promise to pay, on demand, a certain
quantity of gold or other valued commodity. The bank note's value rested
on trust in the willingness and ability of the bank note issuer to meet
that promise. Reputation for trustworthiness, accordingly, became an economic
value to banks--the early issuers of private paper currency.
“They competed for reputation by advertising the amount of capital
they had to back up their promises to pay in gold. Those banks that proved
trustworthy were able to broadly issue bank notes, along with demand deposits,
that is, zero interest rate liabilities. The profit that accrued from
investing the proceeds at interest was capitalized in the banks' market
value. In the mid-nineteenth century, equity capital/asset ratios were
often several multiples of today's ratios.
“In the twentieth century, bank reputation receded
in importance and capital ratios decreased as government programs, especially
the discount window and deposit insurance, provided support for bank promises
to pay. And, at the base of the financial system, with the abandonment
of gold convertibility in the 1930s, legal tender became backed--if that
is the proper term--by the fiat of the state.
“The value of fiat money can be inferred only from
the values of the present and future goods and services it can command.
And that, in turn, has largely rested on the quantity of fiat money created
relative to demand. The early history of the post-Bretton Woods system
of generalized fiat money was plagued, as we all remember, by excess money
issuance and the resultant inflationary instability.
“Central bankers' success, however, in containing
inflation during the past two decades raises hopes that fiat money can
be managed in a responsible way. This has been the case in the United
States, and the dollar, despite many challenges to its status, remains
the principal international currency.
“If the evident recent success of fiat money regimes
falters, we may have to go back to seashells or oxen as our medium of
exchange. In that unlikely event, I trust, the discount window of the
Federal Reserve Bank of New York will have an adequate inventory of oxen.”
I suspect that Alan Greenspan deliberately used oxen, and
not gold, in the above paragraph so as not to cause panic buying of the
Now read Ben Bernanke’s comments and then decide for
yourself whether you should own some gold, or not. Bernanke was talking
about combating deflation, and we should not take his remarks out of context,
but they are still instructive of the way our new Federal Reserve Board
Chairman thinks. The full text of his talk is also available on the Federal
Reserve Bank website(2).
“…under a fiat (that is, paper) money system,
a government (in practice, the central bank in cooperation with other
agencies) should always be able to generate increased nominal spending
and inflation, even when the short-term nominal interest rate is at zero.
“The conclusion that deflation is always reversible
under a fiat money system follows from basic economic reasoning. A little
parable may prove useful: Today an ounce of gold sells for $300, more
or less. Now suppose that a modern alchemist solves his subject's oldest
problem by finding a way to produce unlimited amounts of new gold at essentially
no cost. Moreover, his invention is widely publicized and scientifically
verified, and he announces his intention to begin massive production of
gold within days. What would happen to the price of gold? Presumably,
the potentially unlimited supply of cheap gold would cause the market
price of gold to plummet. Indeed, if the market for gold is to any degree
efficient, the price of gold would collapse immediately after the announcement
of the invention, before the alchemist had produced and marketed a single
ounce of yellow metal.
“What has this got to do with monetary policy? Like
gold, U.S. dollars have value only to the extent that they are strictly
limited in supply. But the U.S. government has a technology, called a
printing press (or, today, its electronic equivalent), that allows it
to produce as many U.S. dollars as it wishes at essentially no cost. By
increasing the number of U.S. dollars in circulation, or even by credibly
threatening to do so, the U.S. government can also reduce the value of
a dollar in terms of goods and services, which is equivalent to raising
the prices in dollars of those goods and services. We conclude that, under
a paper-money system, a determined government can always generate higher
spending and hence positive inflation.
“Of course, the U.S. government is not going to print
money and distribute it willy-nilly. Normally, money is injected into
the economy through asset purchases by the Federal Reserve. To stimulate
aggregate spending when short-term interest rates have reached zero, the
Fed must expand the scale of its asset purchases or, possibly, expand
the menu of assets that it buys. Alternatively, the Fed could find other
ways of injecting money into the system--for example, by making low-interest-rate
loans to banks or cooperating with the fiscal authorities. Each method
of adding money to the economy has advantages and drawbacks, both technical
and economic. One important concern in practice is that calibrating the
economic effects of nonstandard means of injecting money may be difficult,
given our relative lack of experience with such policies. Thus, as I have
stressed already, prevention of deflation remains preferable to having
to cure it. If we do fall into deflation, however, we can take comfort
that the logic of the printing press example must assert itself, and sufficient
injections of money will ultimately always reverse a deflation.”
As I mentioned, we should not take Ben Bernanke’s
comments out of context. At the time there was a real threat that the
US could collapse into a deflationary depression following the bursting
of the tech bubble. A deflationary depression is the last thing anyone
wants and so, to prevent it, the Fed was dropping interest rates as fast
as possible. The Federal Funds Rate (the rate at which banks lend federal
funds to each other on an over-night basis) fell from 6.5% in 2000 to
1% in 2003. It was during this time that Bernanke made the speech I quoted
above, in part to alleviate fears of a deflationary collapse.
The reason I think his speech is important is that the Federal
Reserve had to take extreme measures in the aftermath of the tech bubble
which, in the big scheme of things, was not all that big. To prevent a
slowdown the Fed dropped the Federal Funds Rate from 6.5% to 1% in just
three years and in doing so created a real estate bubble that dwarfs the
tech bubble in every imaginable way.
As I mentioned last week, I think the US real estate market
is ready to roll over and if it does the Federal Reserve will not have
5.5 percentage points by which to lower the Federal Funds Rate. The Effective
Federal Funds rate is currently at 4%, and that brings us to Ben Bernanke’s
speech. What will Ben Bernanke do to prevent a slowdown in the US economy
when the real estate market finally cools down?
Paul van Eeden
Paul van Eeden works primarily to find investments for his
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