Monetary reform: Gold euro as a way out of the “fiat trap”

_ Dr. Philipp Bagus, professsor, Universidad Rey Juan Carlos. November 2023. *

The current monetary and financial system remains one of the biggest problems facing society. The partially backed banking system causes severe economic and financial crises such as the one in 2008, encourages bad investments, changes social values through its culture of inflation, redistributes wealth to the detriment of the weak and allows the state to inflate immensely. There are two main problematic characteristics of our current monetary system. Firstly, in our fiat money system, money can be produced out of thin air to finance government spending. Secondly, an expansion of bank lending not covered by real savings can push interest rates below their natural level, leading to bad investments and economic cycles. Correcting these two system errors is difficult due to the interests involved.

The two main beneficiaries of the current system are the state and the banks. The state has no interest in giving up its monopoly on money, through which it is able to finance its expenditure more or less directly. The banks, on the other hand, have been given the precious privilege by the state of only being allowed to operate with partial cover on sight deposits. This allows them to create additional sight deposits by granting loans. This creates new bank money.

The partial cover bank system is in a symbiotic relationship with the state. This is because the banks use part of the newly created money to finance the state. In turn, the state supports the banks indirectly with central bank money or directly with taxpayers’ money in the event of difficulties. It is obvious that both the financial sector and the state are resisting reforms or even a departure from the existing system.

So are we trapped in this unfavourable system? Not necessarily, because there are historically unique opportunities in which the door for reform opens. This is currently the case in Argentina. Argentinian President Javier Milei has set himself the task of a far-reaching reform of the monetary and financial system. He wants to dollarise Argentina and abolish the Argentine central bank. This would solve the first of the two problems: the Argentinian state would lose its control over the money supply and would no longer be able to finance its generous spending programmes by printing new money. Milei also wants to tackle the second problem, that of the partially collateralised banking system. He wants to abolish the privilege of partial cover. According to his plan, banks should in future hold 100 per cent reserve cover on sight deposits. They would then no longer be able to create new money and thus distort interest rates.

Milei calls this system “Simons Bank”, after the Chicago economist Henry Simons. In 1933, Henry Simons, together with the Chicago economists Lloyd Mints, Aaron Director, Frank Knight, Henry Schultz, Paul Douglas and Albert Hart, launched an anonymous six-page document entitled “Banking and Currency Reform”. In this document, the authors called for one hundred per cent reserve cover for sight deposits. The Chicago economists later expanded their proposals. Irving Fisher published his proposal in book form with the title “100 Percent Money.” Milton Friedman also advocated full cover for sight deposits in his 1959 work “A Programme for Monetary Stability”.

In addition to the Chicago School, a large part of the Austrian School of Economics also favours a fully backed banking system. Nobel Prize winner Friedrich A. von Hayek advocated a gold standard with 100 per cent reserve cover for banknotes and sight deposits, particularly in his earlier works such as “Monetary Nationalism and International Stability”. His teacher Ludwig von Mises also advocated the same, adding a reform plan to the English edition of his work “Theory of Money and Circulation” in 1953, in which all future sight deposits had to be fully backed by gold. Mises’ student Murray N. Rothbard, and today Joseph Salerno, Hans-Hermann Hoppe and Jesús Huerta de Soto are also defenders of a fully backed commodity currency such as a gold standard and have formulated corresponding reform proposals. In contrast to their Chicago colleagues, however, the Austrian economists not only want to take away the banks’ privilege of creating money with 100 per cent reserve cover, but also see it as essential that the state’s influence on money is removed. A commodity currency such as gold would achieve this goal.

The dollarisation of Argentina is an intermediate step in this respect. Although Argentina’s national currency, the peso, is disappearing, another national currency is coming in the form of the US dollar. Milei therefore wants to enable free currency competition. If Milei has his way, everyone will be allowed to use whichever means of payment they prefer, be it gold, silver or a cryptocurrency such as Bitcoin. Ultimately, Milei’s reform could lead to a one hundred per cent gold currency after all. In addition to an evolutionary gold currency created through competition, it can of course also be introduced through a currency reform, as I proposed in 2018 in the Finance Committee of the German Bundestag with the gold euro.

A fully backed gold euro would have several advantages: systematic recurring economic crises triggered by artificially low interest rates, monetary redistribution and the culture of inflation would be a thing of the past. The state would also have to tighten its belt without financing through fiat money. The gold-euro countries would not be able to devalue their currencies, which would maintain the current currency stability within the eurozone. The southern countries in particular, which are so accustomed to inflation, would have to reduce their government spending and introduce market reforms. The gold euro would unleash tremendous growth in the eurozone.

Is the introduction of a gold euro even feasible? A frequently raised objection is the fear that there is not enough gold to fully cover the euro with gold. This objection often overlooks the fact that backing is purely a question of definition. In June 2023, the eurozone money supply M1 (sight deposits and cash) totalled 10.7 trillion euros. This amount is to be covered by the available gold. The Eurosystem is the largest holder of gold in the world and, curiously, holds around 10,700 tonnes of gold in total. That is 10.7 trillion milligrams of gold. The gold euro could therefore be defined as 1 mg of gold. In order to increase the weight per gold euro, the central banks of the eurozone could exchange their government bonds for gold. In addition, gold loans could be taken out to borrow gold internationally. The gold weight of the euro would rise accordingly.

The charm of the gold-euro proposal for Germany would lie in the recovery of the Bundesbank’s Target2 claims, which amount to around one trillion euros. At present, these claims are irrecoverable and reflect economic output lost to the eurozone. A gold euro would suddenly make these claims worth their weight in gold. They would become a debt payable in gold in favour of the Bundesbank. However, there are further hurdles. The national central banks in the eurozone do not have the same proportion of gold on their balance sheets. Some central banks, such as in Germany or Italy, hold a relatively large amount of gold in relation to the amount of central bank money they issue; other central banks hold less. For reasons of fairness, every country that participates in the gold euro should also contribute gold in proportion to its share of the central bank money supply. In order to equalise the quantities, the central banks that hold relatively little gold per euro issued could receive a gold loan from the central banks that hold relatively more gold. For example, the Bundesbank (around 3,300 tonnes of gold reserves) could lend gold to the Banco de España (282 tonnes of gold reserves). The subsequent repayment of this loan in gold would earn the Germans a gold dividend, in addition to the one trillion gold euros corresponding to the Target2 claims.

The gold could be put into circulation in the form of coins or gold banknotes (so-called gold backs) so that the population becomes accustomed to the physical use of gold again. Once the currency reform has been completed and the equalisation and Target2 loans have been repaid, the national central banks could also be dissolved. This is because with 100 per cent reserve cover, there is no longer any need for a central bank to rescue banks from liquidity bottlenecks. Banks can always pay out sight deposits in cash. If the other euro countries were not prepared to participate in the gold euro and pay Target2 claims in gold, then going it alone with a gold mark would be an option. Although the Target2 claims would then be lost, it would be easier to justify going it alone politically. One would have bought oneself out of the euro.

The gold euro therefore fulfils several objectives at the same time. The states would no longer be able to manipulate the currency. Southern European countries can no longer monetise their national deficits to the detriment of other countries. Banks would no longer be able to create money out of thin air. Finally, the Target2 claims that have already been lost could be rescued. You just have to do it.

* Translatet with kind permission of the author from the original publication “What one can`t buy. Gold as a lever for reform in the financial and economic crisis” by the German newspaper Junge Freiheit.

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