Sunday, February 03, 2008

Re: A Creditors' Protection Bill: The Legitimacy of Inserting a Gold Clause in Existing Contracts

My recent article "A Creditors' Protection Bill" has been criticized because of its call for the insertion of a partial gold clause into existing contracts, with or without the consent of debtors. The criticism is that this would be an interference with the freedom of contract.

This claim is made on the grounds that the parties may have contracted precisely on the basis of the government's having arbitrary power over the purchasing power of the monetary unit and one of them (the debtor) may want it to continue. In the words of one critic, "Lots of people contracted with the intention of taking advantage of inflation, and the counter parties are responsible for evaluating their own risk. Changing the rules of the game is cheating someone."

This criticism, which appears to be the assertion of some sort of divine right to the continuation of inflation, is based on a failure to understand what the actual rules of the game are today. Superficially, the rule is that contracts are payable in fixed sums of dollars, the purchasing power of which the government steadily depreciates through the use of its power to increase the money supply.

More fundamentally, however, the actual rule of the game today is that the purchasing power of what is paid and received in the fulfillment of contracts is determined by the government. This wider, more fundamental and abstract rule of the game remains unchanged when the government inserts a gold clause into existing contracts. And it was this rule which the parties implicitly accepted when they signed contracts in a world in which the government determines the purchasing power of money.

What the insertion of gold clauses into existing contracts signifies is the use of government power to determine the purchasing power of what is paid and received in the fulfillment of contracts in a way that diminishes the further such use of its power. Henceforth its power of money creation will not serve to enrich debtors at the expense of creditors, or at least not to the same extent. Creditors will have a measure of protection from the exercise of the government's power. The case is analogous to the government using its power to enact and maintain a Bill of Rights.

Furthermore, the fact is that no creditor has ever entered into a contract payable in a fixed sum of paper money in anticipation of the purchasing power of that money so radically declining that what he will receive is likely to be of substantially less purchasing power than what he lent. If that were the anticipation, credit markets would soon cease to exist in that money.

The existence of credit presupposes a monetary unit whose future purchasing power can be more or less be reliably estimated. When the government accelerates inflation even to the level seen in the United States in the 1970s, credit markets break down, as witness the virtual disappearance of long-term fixed rate mortgages in 1979, after a few rounds or prices rising more rapidly than could be compensated for by inflation premiums in interest rates. The market was beginning to form the idea that no inflation premium would be sufficient, because, however high, inflation could soon be even more rapid.

The implication of this is that once inflation becomes more than modest, it necessarily violates creditors' rational understanding of the terms of the contracts into which they entered. It thus represents a defrauding of creditors and therefore a violation of their freedom of contract. Stopping that process is not a violation of the freedom of contract but an attempt to uphold it.

I find it the very height of gall for anyone to believe that his freedom is any way violated because he is deprived of such opportunities as being able to pay the proceeds of a life insurance policy with less purchasing power than is required to pay for the postage stamp needed to mail said proceeds. (This is an example out of the German inflation of 1923.) If he borrowed money in this kind of expectation, then he deserves to be disappointed. His freedom is certainly not violated because he his prevented from fulfilling it. To the contrary, the freedom of those whose wealth an unrestrained policy of inflation would have brought him is given a measure of protection.

Postscript: It may be objected that the insertion of any kind of gold clause into existing contracts would serve to protect the rights of creditors only by means of shifting the violation of rights to debtors, who, in some cases at least, might be obliged to suffer unanticipated real and substantial additional burdens of debt. This objection falls if it is held in mind that the proposal I made was for the introduction only of a partial gold clause. The example I used, purely for the sake of illustration, was a 25 percent gold clause that at a price of gold of $1,000 per ounce would impose a contingent gold debt of 250 ounces on the borrower of $1,000,000. Such a gold clause would not increase the number of dollars actually owed unless and until the price of gold reached $4,000 per ounce. Twenty-five percent may be too high a percentage. Ten percent might be a better number. In that case, starting at $1,000 per ounce, the price of gold would have to reach $10,000 per ounce before the number of dollars owed by any debtor actually increased.

Such an arrangement would give debtors ample time to join with creditors in opposing increases in the quantity of paper money of such magnitude as to drive the price of gold beyond $10,000 within the life of existing contracts. It would serve simply to remove debtors from the category of a vulture-like pressure group seeking to feast on every last scrap of meat left on the financial bones of creditors. Hopefully, it would gradually serve to make debtors join with creditors in demanding an end to inflation, which would then be perceived as harmful to both groups instead of to just one.

This article is copyright © 2007, by George Reisman. George Reisman is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. His web site is