Mises Daily Articles
A Creditors' Protection Bill
Today, in the world of financial celebrity, anyone who is anyone is a billionaire. By the same token, millions upon millions of people are or soon will be mere, everyday millionaires in the United States. Millionaires are on the way to becoming a dime a dozen.
Similarly, new cars cost what new homes did only a few decades ago. Men's neckties often sell nowadays for as much as men's suits did not so very long ago. To have a pair of soles and heels put on a pair of shoes today costs as much as a new pair of shoes did not too many years ago.
All of this is the result of continuous inflation of the money supply by the Federal Reserve System. As a result of the "Fed's" actions, tens and hundreds of billions of new and additional dollars have poured into the economic system, correspondingly increasing spending and driving up prices. There are more and more billionaires and millionaires and shockingly high-priced goods simply because of the flood of new and additional money coming from the Fed.
It's not such things as "oil shocks" or diverting food crops to fuel production that's responsible. Without the flood of new and additional money, increases in the price of oil and farm products would be accompanied by decreases in the price of practically everything else. This is because practically all of whatever additional money was spent in buying oil et al. would have to be taken away from spending elsewhere, since the overall total ability to spend in the economic system would be limited by a limited quantity of money. And the rise in the price of oil and farm products would also not be nearly as great as it has been.
To confirm the fact that the source of today's high and rising prices lies in the rapid increase in the supply of paper currency and checkbook money, it's helpful to calculate prices in terms of the currency sanctified by the US Constitution, namely, the gold dollar. A gold dollar contains approximately one-twentieth of an ounce of gold. Today an ounce of gold sells for more than $800 (it's actually $907 at present). That means that one gold dollar has the value of more than $40 paper dollars, because one-twentieth of $800 is $40. The result is that the price of everything stated in gold dollars is currently one-fortieth, or less, of its price in paper dollars.
Thus, a $1 million home is $25,000 in gold dollars. A $50,000 automobile is $1,250 in gold dollars, and so on. The rise in prices is the result of the fact that we express prices in paper money, whose supply can be increased virtually without limit and without cost. Prices can never rise to anywhere near the same extent when stated in gold. That's because gold is rare in nature and costly to extract.
Today, we have a credit crisis emanating from the collapse of the real estate bubble that the Fed launched in order to cope with the effects of the collapse of the stock market bubble that it had launched only a few years earlier. Now, in order to cope with the effects of the collapse of the real estate bubble, the government and the Fed are looking for yet another program of monetary "stimulus." This time it's to be in the form of cutting taxes while financing an undiminished, indeed, an increased amount of government spending by means of the creation of still more new and additional money.
The Fed and the rest of the government seem to think that their job is always to be sure that the stock market averages and the price of homes is never to be allowed to fall too far below their most recent peaks, and to flood the economy with as much new and additional money as may be required to accomplish this. Keeping up housing prices is an especially remarkable goal, inasmuch as only a year or two ago, all of the complaining was about how far housing prices had climbed relative to the ability of people to afford them. One would think that a sharp reduction in home prices is the very thing needed to solve that problem and that the process needs to go a good deal further than it has, in order to do so.
For the present and the foreseeable future, there is probably nothing that will stop the Fed from continuing with its inflation. Leading pressure groups are ardently in favor of it: tens of millions of share owners want it; the great majority of businessmen large and small want it; bankers and brokers want it; homeowners want it; labor unions want it; the political establishment wants it. If there is another terrorist attack, let alone another war, inflation will be used to pay much of the cost. To the extent that the environmentalist agenda of declining energy production is imposed, inflation will be used to finance subsidies to the growing numbers of Americans who will be impoverished by it. Their expenditure of those subsidies will drive up prices for everyone else and cause further impoverishment and the need for more subsidization and for still more inflation to pay for it.
In the face of such prospects, people around the world who have been willing to hold dollars because dollars were superior to their own, more rapidly inflating currencies, will lose their desire to hold dollars. They're already losing that desire. The world's supply of dollars will sooner or later reside exclusively in the United States. Indeed, the reflux of dollars appears to have already begun.
The dollar has begun the kind of slide taken in the past by such currencies as the Italian lira. In the 1930s, one lira was worth 20 cents. Twenty cents in that era had a buying power equal to several of today's dollars. Before the lira was replaced by the euro, its value was less one-twentieth of one US cent. A few days' food and lodging at an undistinguished hotel cost more than a million liras. The fall of the lira took place in essentially the same way that the dollar is falling today — through the reckless increase in its quantity in response to widely held beliefs in the necessity of such increase.
Is there anything that can be done to stop the potential destruction of the real value of all dollar-denominated savings and long-term contracts by a flood of inflation? Is there anything that can protect people from a possible tsunami of inflation in the United States?
There is something that could be done. There is a financial life raft, as it were, that could be made available to everyone, that would enable people to salvage at least some significant portion of the real value of their savings and contracts denominated in fixed sums of dollars. It is something much more urgently needed, aimed at a much more realistic danger, and much more feasible than efforts to control global warming, say.
What is it? It is the enactment of a creditors' protection bill, whose essential provisions would be the insertion into all outstanding contracts of a limited, contingent gold clause, and the removal of all legal obstacles to the inclusion of such clauses in all future contracts.
Here's an example of how it would work. Imagine someone who owns $1 million of corporate bonds that he bought several years earlier and that are scheduled to be redeemed in another 25 years. Perhaps 25 percent of this sum, i.e., $250,000, would be designated as representing the quantity of gold that the owner of the bonds could choose to receive when the bonds came due, instead of the $1 million he is presently entitled to receive at that time. The actual quantity of gold he would be entitled to receive would be the amount that $250,000 could buy at the price of gold prevailing on some specified date within 12 months prior to the enactment of the law.
If that price of gold were $1,000 per ounce, say, then the $1 million dollar contract would contain a contingent liability calling for the payment of 250 ounces of gold. This payment would be at the creditor's option. The creditor would have the right to choose to be paid 250 ounces of gold rather than $1 million dollars.
Obviously, no creditor would exercise this option if the price of gold remained at $1,000 per ounce, let alone if it fell below $1,000 per ounce. He would not exercise it if the price of gold rose to $2,000 per ounce. Nor would he do so if it rose to $3,000 per ounce. But when and if the price of gold exceeded $4,000 per ounce, then it would be to the advantage of the creditor to choose to be paid 250 ounces of gold, or the sum of dollars then necessary to buy 250 ounces of gold, for at that point 250 ounces of gold would represent more than $1 million.
If gold reached, say, $5,000 per ounce, the 250 ounces of gold that the creditor was entitled to would be worth $1,250,000, i.e., $250,000 more than the million he had lent. This would not represent any real gain to the creditor, however, if over the same period of time, prices in general had also increased by a factor of 5. In that case, the actual buying power of the 250 ounces of gold would be no greater than it had been when the price of gold was $1,000 per ounce and prices in general were where they were at that time.
But even in this case, the creditor would not be quite as badly off as he would have been without the protection afforded by the 25 percent gold clause. For in its absence, he would have been repaid merely his original $1 million, that now had a buying power only one-fifth as great as it was originally. With this gold clause and his consequent receipt of $1,250,000, the buying power he receives is one-fourth as great as the sum he lent.
The difference between a fourth and a fifth is, of course, not very great. It would amount to our creditor incurring a loss in buying power of 75 percent rather than 80 percent, which is not an outcome to be particularly happy about.
But the odds are great that the protection afforded by such a gold clause would be equal to more than 25 percent of the real value of the sum originally due the creditor. This is because if prices were to start rising rapidly, the price of gold would almost certainly rise even more rapidly. Thus, for example, if prices in general were to rise on the order of 5 times over the course of a decade or two, say, the price of gold might very well rise by 10 or even 20 times. In that case, the 250 ounces of gold that the creditor would have the option of choosing, would be worth $2.5 million or even $5 million. In the face of a fivefold rise in prices, these sums would have the buying power of 50 percent or even 100 percent of the real value of the sum originally due the creditor.
What would serve to make the price of gold rise faster than prices in general is that in periods of rapid inflation, and in the absence of any reliable alternative paper currency, such as the dollar once appeared to be, gold is the ideal inflation hedge for most people. Even though its ownership entails some costs of storage and safekeeping, those costs are very modest. At the same time, incurring them represents a far lesser loss than does practically all the usual forms of investment in a period of rapid inflation, including ownership of common stocks and family businesses. In these cases, capital gains taxes and income taxes consume funds needed for replacement at higher prices. As a result, a growing demand for gold as an inflation hedge appears, which operates on the price of gold alongside of and in addition to the forces operating to raise prices in general. In addition, the price of gold could be increased by the desire for accumulations of gold on the part of those who had agreed to accept contingent liabilities in gold.
A potential consequence of a system of such partial gold clauses could well be the development of substantial opposition to rapid inflation on the part of debtors, however paradoxical that may sound. This is because once the number of dollars payable under gold clauses started to exceed the number of dollars originally owed, debtors would be in a position in which further inflation served to increase their burden of debt rather than decrease it. Gold prices rising more rapidly than prices in general would mean that debtors would be in a position in which the additional inflated money they took in could not keep pace with the additional money they owed. They would do better to take in less additional inflated money and not be confronted with debt obligations rising even more rapidly. (This seemingly paradoxical effect of inflation under a system of gold clauses is a matter I discuss more fully in Capitalism.)
Enactment of a creditors' protection bill along the lines I have described should be an essential part of the near-term political agenda of all defenders of economic freedom. It would offer a potentially valuable two-fold protection against the ravages of inflation. First, it could provide substantial protection to the real value of the assets of individuals. Second, it also might also ultimately turn debtors, who typically have a vested interest in inflation, into opponents of inflation, once they came to be faced with debts payable in gold, which would become harder to repay as inflation reduced the ability of paper money to serve as the means of repayment.
The insertion of a gold clause into existing contracts should by no means be regarded as any kind of new and additional government interference with the freedom of contract. To the contrary, it would be a major step in undoing such interference. Prior to their abrogation by the New Deal in 1933, full, 100-percent gold clauses were the norm in the United States in long-term debt contracts, and had been since the Civil War. They are something that comes about on the foundation of the rational self-interest of individuals when it is allowed to operate free of government interference.
Obviously, the degree of gold-clause protection would not by any means necessarily have to be the 25 percentage points that I have chosen for purposes of illustration. If a mere 5 or 10 percent protection could be enacted into law, it would be a major first step, simply by introducing the concept of gold clauses to the present generation. And, of course, it would still afford some actual measure of protection against the possible ravages of inflation.
The parties entering into new contracts should be free to include whatever degree of gold-clause protection is mutually agreeable. What presently stops such contracts from being made are considerations both of their enforceability in the courts and their likely treatment for purposes of taxation. As just mentioned, such contracts were abrogated on a mass scale in 1933 and the Supreme Court did nothing to uphold them. To be accepted with any degree of confidence, the enforceability of new, partial gold-clause contracts would have to have the benefit at the very least of a joint resolution of Congress directing the courts to uphold them.
The gold-clause contracts would have to be exempt from any possible application of usury statutes. Such statutes might come into play when creditors ended up being repaid sums of depreciated paper dollars that were greatly in excess of the sums originally lent — e.g., being repaid $2.5 million paper dollars when one had originally lent $1 million paper dollars. The contracts would have to be interpreted in terms simply of being repaid a fixed amount of gold principal — e.g., the 250 ounces of gold in the example above — irrespective of any increase in the price of gold.
Treatment of the gold-clause contracts in this way would preclude the payment of taxes on any paper money gains reflecting merely the repayment of larger sums of paper to maintain parity with the same physical amount of gold. Thus, for example, the $1.5 million paper gain in the repayment of $2.5 million on a $1 million loan would not be subject to any kind of income or capital-gains taxation. The applicable principle would be that the lender has merely received the same physical quantity of gold that he was always entitled to. He has no gain whatever in terms of gold. In effect, he has lent a sum of gold and has been repaid that sum, nothing more. Thus, he has no gold income or gold capital gain.
Gold-clause contracts would almost certainly become very widespread if the market could take for granted their enforceability and exemption from taxation based merely on the rise in the price of gold.
As a matter of principle, the parties entering into new contracts should be legally free to agree to whatever degree of gold-clause protection they wished, all the way to 100 percent. Nevertheless, little actual harm would likely be done, if for a short time legal limits were imposed on the percentage of the value of new contracts that could enjoy gold-clause protection. Such a limitation would probably make the enactment of gold-clause protection politically more acceptable in the beginning, since it would be an incremental change and thus not appear too radical. Even with such a restriction, the gain simply from enacting the principle of gold-clause protection would be profound, not to mention the substantive protection likely afforded to creditors.
However, even in the absence of any legal limitation, for some period of time it would almost certainly be highly advisable in most cases for the contracting parties to agree to fairly modest partial gold clauses rather than full, 100 percent gold clauses. This is because partial gold-clause protection is what will be necessary in order not only to give creditors an important measure of the protection they need, but also to avoid the development of widespread bankruptcies on the part of debtors.
The threat of debtors going bankrupt arises because continuing inflation is likely to drive the real value of gold far higher than it is today and at the same time greatly reduce the ability of earnings in paper money to pay debts stated in gold. As a result, entering into 100- or even 50-percent gold-clause contracts today, at today's price and real buying power of gold, would be an extremely risky proposition for debtors, one likely to result in their owing amounts of gold they simply could not pay.
Avoiding near-term widespread bankruptcies in gold is essential to gaining public support for gold's once again serving to protect the real value of contracts on a large scale. Hopefully, education about the risks of owing too much gold would serve to prevent bankruptcies in gold from being too frequent. Partial gold-clause protection is what would follow from such education and accomplish its objective.
The implication here is that the degree of gold-clause protection in contracts should increase only as the risk of further increases in the real value of gold in the economic system relative to that of paper-money declines.
Gold clauses, of course, would protect not only lenders, but also people dependent on pensions or annuities or who would be the beneficiaries of such retirement vehicles in the future. They would also protect the grantors of long-term leases of all kinds.
The widespread establishment of partial gold clauses is an essential step in the protection of the buying power of creditors. It would also be a major step on the path toward the establishment of sound money.
Of course, it is possible that the Fed will pull back from its increasingly inflationary course and reverse field as it did in the early 1980s. In that case, gold-clause contracts will simply have a status comparable to fire insurance for people whose homes do not suffer fire damage greater than their deductible. They will serve simply as a form of insurance policy. One that, unfortunately, looks like it is increasingly needed.