The Revenge Of The Gold Bugs – Part Two

May 1, 2025/by Neland Nobel

https://pricklypear.news/the-revenge-of-the-gold-bugs-part-two/

As we mentioned at the end of Part I, releasing the government from all spending restraints required a two-pronged approach.  Undermine the restrictive nature of the Constitution through judicial interpretation while concurrently undermining the mechanical constraints of the gold standard on the issuance of money.

The erosion of those restraints accelerated with the Founding of the FED in 1914, and the substitution of Treasury Bonds as the primary bank reserve. We now had a central bank like England or Germany that could purchase and hold government debt as the central reserve of the monetary system. The FED would continue to grow in power and influence until it evolved into the central planning bureaucracy it is today. Since the founding of the Federal Reserve, the dollar has lost about 97% of its pre-war value, using the government’s CPI as the standard from 1914.

If you view one of the primary functions of government as issuing a stable money, the FED and Congress have failed miserably. You can dismiss the gold bug as an anachronism, but they have sadly been proven right.

Part of the argument for the founding of the Federal Reserve was that more latitude was needed to expand the money supply when the banking system was under pressure. The experience of the Panic of 1907 led to the establishment of an official commission on the subject and much debate about the need for a more “elastic” monetary system. At the time, it was common practice for 40% of the money supply to be backed by gold. But that still made it challenging to expand the money supply, at least to the extent Progressives wanted.

Unlike most government agencies, the Fed is unusual because it is a hybrid agency, with both public and private characteristics. However, it has evolved much like any bureaucracy. It continues to grow in power and has expanded well beyond its original charter.

The discretion granted to the Fed was to prevent future financial panics and recessions. However, history shows that after the founding of the FED, panics and recessions not only continued but also increased in both frequency and, especially, severity.  Moreover, inflation, or the loss of purchasing power, accelerated and became a chronic condition.

This discretion to issue money during banking emergencies, however, gradually expanded as the FED used its power to assist funding various purposes, such as financing wars, the expansion of the welfare state, fighting recessions, and social causes. Like all discretionary power, the problem becomes how to limit that power to the original intent. The FED, we contend, has been a willing facilitator for Congress’s wild spending. With Congress as their partner, the dynamic duo has created the chronic budget crisis, inflation, and financial instability.

But, back to our story. Progressives did not like either the original intent of the Constitution’s restrictions on political power, any more than they liked the gold standard’s restraint on financial power.

President Franklin D. Roosevelt followed with the dismantling of the key features of a functioning gold standard. This included the ability of citizens to redeem their currency in gold whenever they felt necessary, the use of gold clauses in contracts and financial instruments, followed by the outright confiscation of private gold holdings in 1933. After confiscation, he revalued gold upward in price from about $22 per ounce to $35 per ounce, which increased the money supply and devalued the dollar, because he was convinced it would stop the Depression.  It didn’t.  The downturn in 1937, following our departure from the gold standard and the devaluation, was almost as severe as the one in 1933.  The economy did not recover because of the New Deal. The New Deal extended the Depression. It was the demand of World War II that brought us out of the Depression.

Thus, the major structural component of the gold standard was dismantled by the New Deal. However, remnants remained for international holders of dollars for about another 38 years.

President Nixon severed the remaining ties to gold in August 1971 by abrogating the Bretton Woods Treaty (1944), under which the dollar held by foreigners was still redeemable in gold. Since 1971, the dollar has lost approximately 85% of its purchasing power, based on the Consumer Price Index (CPI) from that year.

Why the final break with gold? The US was running up debt and deficits quickly due to the prolonged War in Vietnam, coupled with the enormous social expenditures for Lyndon Johnson’s Great Society. Foreign holders still had the right to redeem the dollars they held, a right that was denied to Americans. They began to estimate that there would not be enough gold to cover all the new bonds being issued, and some started to ask for the gold backing the dollars they held, slowly. They had good reason.  At the time, the US had about $10 billion in gold with claims against that of $40 billion. Like a game of musical chairs, many countries were fearful they would be left without a seat. Eventually, it turned into a “run on the bank,” as country after country decided they could wait no longer.

The US lost almost half of its gold reserves in just a few years in the late 1960s and early 1970s. Nixon thought he would “temporarily” suspend the convertibility of dollars to gold with an executive order. Convertibility was never restored, and the last constraint, which foreigners had on US spending, became permanent. The gold standard was now completely gone.

The dollars foreigners held fell in purchasing power just like the dollars we had at home. However, even though the essential part of the treaty was broken, lacking any real alternatives, the world continues to use the dollar as the reserve currency and a primary debt settlement currency.

That lack of alternative still exists today, although there is a movement around the BRICS nations to find an alternative to the dollar.

The gold standard in practice severely limited both what the government could borrow and the amount of money it could print. If domestic holders of dollars or foreign holders of dollars felt that the government was overspending, they could request the gold backing the dollars, which would contract reserves and thus prevent the government from spending and borrowing excessively. Private market action, through the movement of gold reserves, when citizens, investors, and foreign counterparts demanded the gold backing their dollars, pressured governments to exercise prudence in both their fiscal budgets and their balance of trade.

This, along with key provisions of the Constitution, limited the size and power of the government. But as suggested before, the twin efforts of emasculating the Constitution by judicial interpretation and the destruction of the gold standard released the government from its legal and monetary restraints. Now, the government was free to grow, inflate, and go into debt. The only two remaining constraints were political will and investor unwillingness to finance the government.

Political will has yet to be found. It surfaces occasionally, as it did when President Clinton and Speaker Gingrich gave the country a few years of budget surplus starting in 1998. It was the first in 29 years. But even then, there was no real effort to pay down the accumulated debt, as it was challenging enough to get to a balanced budget. Notice, too, that it was fleeting, as we soon returned to running chronic deficits. After 2001, deficits started again and have continued for the past 24 years. It would be a fair historical statement to say that political will has not led to fiscal prudence. The gold bugs were correct again.

As for the discipline of the marketplace, like political will, it too has occasionally surfaced. During the 1980s, the economist Edward Yardeni coined the term “bond vigilantes,” which suggested that bondholders refused to buy bonds unless interest rates were high enough to protect them against inflation. Some at the time thought this was forming to act like a gold standard of sorts, restraining the government from spending and borrowing too much.

James Carville, the ever acerbic political aide to the Clintons, famously said, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a . 400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

But the supposedly ever-powerful bond vigilantes either went extinct not long after that or, at the very least, went into a prolonged hibernation. With the rolling financial crisis that began around 1999 and the Great Financial Crisis of 2008, bailouts and spending increased. However, the government was able to lower interest rates to almost zero for nearly 20 years, and the bond market was eager to buy them, continuing to fund the government. 

The market not only did not seem to care, many welcomed the bailouts and a chance to refinance at rates at or below the inflation rate.

With only occasional upward blips, interest rates were kept very low (and often negative when compared to inflation) from around 2003 to March 2022. The bond vigilantes went home to their families and gave up trying to threaten the financial markets, and by extension, rein in government spending and borrowing. You can see that rates were so low that, for almost 12 years from 2008 to 2020, they were almost always hovering around zero.

Just recently, the theory of bond vigilantes has resurfaced, with some contending that the market’s recent hissy fit, particularly in bonds, has caused President Trump to reverse course on tariffs. Maybe there is something to it, but the track record of market disciplining the government is spotty at best.

We would also like to note that if the bond vigilantes were really about to “hang” the financial markets, that means relief has come too late. The hanging of the financial markets IS the crisis. The government’s inability to borrow would leave only printing, or a combination of hyperinflation and high taxation, as alternatives to solve the problem. The bond vigilante theory may explain some historical episodes, but it does not answer the question of how to restrain spending before a crisis occurs. It is tantamount to arguing lung cancer is the best way to discipline a smoker. What is the difference in the end if you lose your wealth through inflation, financial market collapse, or taxation? You still lose.

Bond vigilantism implies that the only real market discipline on the government can be achieved by creating a financial crisis, which destroys much of the country’s wealth. But the economic crisis itself produces the opposite of fiscal prudence.  During a crisis, bailouts are needed, along with government social support for those who need it.  Each crisis makes the situation worse. In the ensuing recession, government revenue falls, but social expenditures skyrocket, making public finances even worse. The financial crisis would be so severe that it would quickly spread to the rest of the economy. The financial bailouts that have followed each financial crisis have had the unintended consequence of breeding a confidence that huge financial risks can be taken, as the government is expected to intervene with bailouts. In insurance terms, it is called moral hazard.

We now have set precedent after precedent with a series of bailouts for banks, brokerage houses, real estate markets, and even auto companies.

But the main point is this: the bond vigilantes have not stopped the government from growing or spending. Each financial crisis causes greater debt.

What about the FED? Maybe they can control out-of-control spending and borrowing? No, they failed as well. The zero-interest-rate policy of the FED, by itself, is a stimulant to take huge risks. Capital should not be essentially free, and the return on savings for the public should not be zero. Look at it this way: if the FED made beer available for free, do you think it would increase drinking? If the FED makes credit free, would you believe it would increase the use of debt and financial leverage? If interest rates are zero, wouldn’t that encourage borrowing but discourage saving? Remember, the government is a borrower too, and it responds to incentives.

In short, over time, the Fed has become the source of financial crises by acting as a facilitator for the government, rather than its original role as the lender of last resort for the private banking system.

The old expression on Wall Street used to be that the Fed had the responsibility to “take the punch bowl away.”  In the last 20 years or so, the FED has arguably been spiking the punch bowl.  It has encouraged all manner of speculation, leverage, and financial engineering in the private sector as well.

And let’s not forget the world of money and politics. Remember, the wealthy 10% mainly own financial assets, the very donor class that makes significant contributions to politicians. Do you expect them to be quiet when their assets are being pummeled? Really, when would you call in political favors?

While we have had political battles over deficits, and markets have occasionally rebelled, it is also true that the gradual nature of inflation has essentially rendered these restraints ineffective. The markets have not rebelled with 5% inflation or 9% inflation, rates which have brought down previous empires. In terms of inflation rates, and we are sorry to mix metaphors, we don’t know when the bond frogs will decide to jump out of the boiling pot, if ever. The water is heated up slowly over time. They seem content regardless of the heat. And, as suggested before, when the bond frogs jump out of the boiling water, you’re having a financial crisis, and it’s too late.

As for politics, isn’t our two-party adversarial system the best way to control spending?  Again, the gold bug would say the answer is no. While fighting with each other rhetorically, both of our major political parties have run up deficits when in power.

The party that ran inflation up recently to 9% lost, but there is no assurance they won’t retake power. Democrats are only a few votes from controlling the House and Senate. Democrats who gave us the inflation of the late 60s and 1970s, and double-digit interest rates, were returned to power multiple times.

In the US, we operate on a two-year political cycle. That means Congress can make promises to deliver economic benefits today, but the cost is passed on to future generations. Many of the Congressmen and women will not even be in office when the final tab comes due. As a political equation, it tilts the system entirely toward excess and away from restraint. Rewards come today, the cost comes decades later.

The limitations on both borrowing and printing were removed when the gold standard was abandoned and Constitutional restraints were interpreted away. No subsequent combination of political, financial, FED action, or bond market fluctuations can seem to restrain government finances from excess.

And for Republicans who are now used to and eager to use big government for their purposes, they don’t bring the subject up.  Sound money is not a phrase we hear often today. Gold bugs are extinct in the political realm today.

You have to hand it to the classic gold bugs; they got it right. They understood human nature, both that of the voters and that of the political leaders. They knew the history of past empires. To paraphrase, Benjamin Franklin as he emerged from Independence Hall ‘ We have given you a Republic, if you can keep it. ‘

We didn’t.

So, the gold bug logically asks, what likely constellation of forces will ever restrain the government? And if not restrained, our money will continue to lose value. Is their pessimism unjustified?

In our third and final segment, we will examine the remaining gold bug ideas based on this admittedly grim outlook. Gold bugs are extinct in the political world, but live in small colonies in the financial world.

Our third segment will examine the history of the modern hard money movement and what they have to say to investors.