Should we return to the gold standard?

We are living in what one could no doubt dub 'interesting times' ('May you live in interesting times' is a famous curse ascribed to the Chinese, although its origins are disputed). Our entire financial system is under siege – many eminent banks and broker-dealers , some of which survived even the Great Depression of the 1930's have either gone bankrupt or have barely escaped this ignominious fate by being taken over by stronger rivals (often at the 'suggestion' of officialdom).

Governments all over the world have taken steps to not only guarantee all bank deposits (a guarantee which probably only 'works' as long as no-one calls on its fulfillment), but have also force-fed 'capital' to not-yet bankrupt banking institutions in a bid to avert a total seizure of the credit system.
In the meantime, the crisis has begun to engulf entire countries – Iceland, Hungary, the Ukraine, Pakistan, Argentina (once again) are in various stages of extreme financial and currency distress, with some of them having been pulled back from the brink by emergency loans from the IMF (or in Hungary's case both IMF and ECB), and at least one apparently having entered a state of national bankruptcy already (Iceland).

As previously chronicled, there has been a tendency in the press to blame the free market for the calamity – in a sort of 'we had too much of it' manner. These days we are even treated to the spectacle of 'eminent Marxist historians' being released from their crypts and asked for their considered opinions.

However, one also notices that lately some have begun to question central bank policies – specifically those during the Greenspan era. Once upon a time the 'maestro' could do no wrong – congressmen even found it funny that they usually couldn't understand what he was saying (who once remarked: "I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said."). He himself once opined that the central bank under his guidance had 'managed to emulate a gold standard' , when questioned by Ron Paul regarding the apparent evolution in the beliefs he once held.

Naturally, one might ask: if the central bank's goal is to emulate a gold standard, why not just have a gold standard instead? Should we not, instead of leaving decisions about interest rates and the supply of money to a gaggle of bureaucrats , rather trust the historically well established monetary discipline of gold?

Actually, it is the wrong question to ask. It should be reformulated thusly: should money be regulated and administered by the State, or should it be left to the free market?

How much money is enough?

If one looks at modern monetary theories, some things immediately stand out: it is implicitly assumed that the central bank-led, state controlled money system is somehow 'inevitable', and that the money supply should always grow, just not by 'too much' (it is held that there are various ways of achieving this, like e.g. the 'gold price rule' favored by monetarists , which is criticized here).

Most people complain about inflation (this is to say, they complain about rising prices, one of the effects of inflation), but they regard it as a necessary evil that can't be helped – as if it were a sort of permanent natural disaster. As i have explained in my essay about fiat money on Mike Shedlock's blog, there is a reason why fiat money is seemingly workable at all, and there are political – not economic – reasons for why it exists.
It is important to realize that money is not a creature of the state. It did not come into being by state fiat, it has come into being via market processes. Historically, a commodity has been chosen as money, and such a commodity had to have a pre-existing demand, i.e. it had to be useful by itself – otherwise there would be no reason to accept it in payment.
The medium of exchange, which is money's primary role, is the foundation of the modern market economy, enabling the division of labor and a roundabout, complex production structure, something that would be nigh impossible in a barter system.

Often people assume that the money supply must grow, because otherwise, there would simply not be 'enough money' for all the goods and services that are produced in increasing abundance.

To this Ludwig von Mises said: ' No increase in the welfare of the members of a society can result from the availability of an additional quantity of money' (Theory of money and credit, p.102) and 'The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do. ' (Human Action, p.418,421),

Many people would probably consider these to be extraordinary claims at first glance. Consider though what money is supposed to do: its function is to facilitate exchange. From this flows its secondary function as a 'store of value'.
If for instance a producer of perishable consumer goods wants to save, money facilitates this act of saving for him. No-one holds money for its own sake – it is held for the function it promises to fulfill - namely to make the exchange of goods and services possible.
Let us now in this light look at the idea that an increase in the quantity of money confers no social benefit on society as a whole. Assume that for instance, the Federal Reserve were to credit every one of us overnight with an amount of money equal to the amount we already possess – effectively doubling the money supply. Would we be richer than before? Not if the supply of goods and services had not also magically doubled overnight. It stands to reason that such an act by the Fed would almost immediately simply lead to a doubling of prices, given that the supply of goods and services would stay the same and everybody would soon be aware of the doubling of the money supply. This is of course only a hypothetical thought experiment intended to show that it is not the quantity of money that determines our wealth – wealth consists instead of the amount of real capital and real goods and services available.
The workings of inflation are a bit more complicated – and a lot more damaging - than suggested by this thought experiment.

With regards to the first statement – that the total amount of money in the economy at all times is sufficient to secure for everybody all that money does and can do – let us consider a hypothetical free market in which gold is used as money.
It should be clear that like any other good, the money commodity is subject to the laws of supply and demand as well. Thus the money supply would not be entirely stable in a free market either, and both the value and the supply of money would respond to market-based changes in the demand for money.
It is probably safe to assume that a gold-based money supply would only change slowly overall. What then, if the demand for money were to rise, removing some money from circulation? The market response would be two-fold: the value of the money unit would rise, and gold mines would thereby be induced to produce more gold to satisfy the higher demand. The existing stock of money would continue to be able to fulfill its function of securing the services expected of it – after all, what people care about is not the number of gold ounces (or money units, generically) they possess, but what those ounces or money units can actually buy.

We can conclude that Mises was correct – in a free market dispensation there could never be 'not enough' or 'too much' money – the market itself would regulate the supply of money and money's value though market based supply and demand processes.

As an aside, one of the reasons why we know that the market still regards gold as money, even in our modern , legal tender fiat money world, is that exactly the same thing happens nowadays during periods of increased monetary demand. Take for instance the current economic bust, which is characterized by a sharp rise in the demand for money due to increasing uncertainty about the future and the need to repay debt.
One of the things that has happened is that while gold's nominal price has corrected from previous highs, its real price – as measured by the amount of non-gold commodities gold can buy – has risen sharply. This increase in gold's purchasing power is raising the profit margins of gold mines, giving them an incentive to increase production.
How can we explain that gold still acts as if it were money, even though it is not used anymore as an officially sanctioned medium of exchange?
Presumably this is because the market regards gold as the 'money of last resort' – the pinnacle of the inverted monetary pyramid, that would revert to becoming the money supply if the fiat money system were to falter.



gold versus commodities - gold's purchasing power has increased. click on chart for larger image.


The problems of the centrally planned money system

It is odd that modern-day economists seem to be largely of one mind when it comes to the benefits imparted by the capitalistic free market system – for instance, there is almost universal agreement that it is a bad idea for the government to run any kind of business – but they all stop short of extending that thought to money itself. Somehow they seem to believe that bureaucrats are more capable of managing money than the free market would be. For a mainstream economist to suggest otherwise is almost akin to farting in church – it is a taboo subject.

If one wants to understand why this is so, one must consider the reason for the establishment of a fiat money system. As mentioned above, the reason is political, not economic. It is the fiat money system that allows the almost unchecked growth of the state, by enabling it to borrow money into existence that it would otherwise have to garner by taxation alone. Inflation of the money supply is a tax that is not declared as such, and it is a way of redistributing wealth – after all, inflation of the money supply is not instantaneously transmitted to everyone by increasing everybody's money by the same percentage at once as in our thought experiment above, but there are 'first receivers' of the new money being created, which enables them to bid for resources before the rest of the world realizes that money has been diluted. They therefore enjoy an advantage insofar as they can buy goods and services before their prices rise. In short, the fiat money system is one of the ways in which favored groups within society can be bought off, at no cost to those in control of the money system (the economic cost for society as a whole is however grave).

In theory, the establishment of a nominally 'independent' central bank is designed to keep money supply growth in check – as the central bank is usually mandated to 'ensure price stability'. As we will see, this mandate makes no sense – it can not keep the central bank from inducing boom-bust cycles, in fact, it likely makes them more severe.

Whatever one may think of Ben Bernanke's economic theories, specifically his view of the depression era ( i believe he has come to the wrong conclusions about that episode), he has been trying up until recently to run a not-too-inflationary, relatively tight policy. For instance, the various special financing facilities by which he has transformed the Fed into a warehouse for suddenly illiquid bank assets of questionable value, have originally been put in place in such a way as to not increase the supply of money – the Fed simply exchanged one type of securities (t-notes and bonds) for another type (mortgage backed garbage).

In fact, both Ben Bernanke and probably even more so Jean-Claude Trichet who heads the ECB can be considered to be well-meaning civil servants who are taking their mandates seriously.
The problem is that the fractionally reserved banking system as such is geared toward inflation of money and credit. The moment a commercial bank extends a new loan, new money is created when the proceeds of the loan are deposited into the account of the borrower, a deposit that can then be used by the bank receiving it as the basis of a new loan, and so forth. Over the many decades this system has been in operation, an incredible amount of financial claims – and money - have been created.

Another problem is that no matter how well-informed the monetary bureaucrats are about the going-ons in the economy, and no matter how well they think they have adapted their methodologies to the needs of same (there have been various approaches adopted over time, from money supply targeting to interest rate targeting), their decisions regarding e.g. what interest rate to set, must perforce be inferior to a market-based outcome. Since there is political pressure to keep interest rates as low as possible (i.e. as low as they can be without raising the 'inflationary expectations' of the public at large) , there will be a tendency to undershoot the natural interest rate most of the time.

In short, the system will tend to inflate the supply of money and credit. Let us now consider why this leads to damaging boom-bust cycles . In a free market, banks would merely be middlemen helping to channel savings from those who have them to those that require credit.
Savings are not 'money' – they are production that has not been consumed. This unconsumed production can be exchanged for money, which obviously is quite practical. The fact remains though that what has been saved is not 'money' per se, but that money is a place-holder for saved production.
Saved production is what sustains the economy's complex structure of production – it is the real subsistence fund. How the subsistence fund works has been explained in detail by Frank Shostak here, using simple, easy to understand examples.

When deposits are expanded by credit created out of thin air, they are not backed by preceding production. In short, there is now money in circulation that is not a placeholder for saved production – but it can still be exchanged for real goods. These 'exchanges of nothing for something' then begin to distort the economy's structure.

The natural interest rate that would prevail in a free market imparts important information to entrepreneurs : it tells them of the state of time preferences and the consequent amount of real savings available to the economy. Time preferences have to do with the basic idea that present goods are more valuable then future goods – an apple available for immediate consumption is more valuable than one available for consumption at some point in the future. When people's time preferences are low, they will save more relative to what they consume, and the larger pool of available savings will lower the natural interest rate. This is a signal to entrepreneurs that they can undertake longer-lasting capital projects, involving the production of higher order goods – the production structure can be lengthened, and more roundabout production processes will come about. Investment will therefore gravitate toward such higher order goods production, while less investment will be available for lower order, i.e. consumer goods production.

This will ultimately make more consumption possible in the future – the growing amount of real savings sustains higher order goods production, which then increases productivity, making more consumer goods at lower prices available in the future. There is however a constant interplay in this allocation of resources along the production structure, whereby changing time preferences, which lower and raise interest rates, tell entrepreneurs whether to produce more capital or more consumer goods. Remember that the amount of consumption goods saved must be sufficient to sustain those involved in higher order goods production for the duration necessary to implement their investment plans.

From the above, we can summarize the problems that a centrally planned fiat money system produces:

1.one of the effects of inflation, namely rising prices , leads to a redistribution of wealth to those who are first receivers of newly created money from those who receive it later. Prices will never rise uniformly, and will do so with a considerable time lag, and it will always be difficult to judge which price rises are a result of inflation and which are merely a market based signal of demand exceeding supply. However, some groups in society will profit from this, while others will pay for it. Those that pay are generally on the lower rungs of the economic hierarchy.

2.another – the even more damaging effect – is the one on economic coordination. Since entrepreneurs get false signals by means of artificially low administered interest rates, they will channel too much investment toward higher order goods production, distorting the production structure. Capital will be malinvested, as the artificially low interest rate implies levels of future demand that can not be sustained by the state of real savings. This will create a boom, but the boom will turn out to be artificial. The boom is really an artifact of capital consumption – this to say, previously accumulated capital will be consumed as artificial economic activities that would not be sustainable in a free market are undertaken on account of too low interest rates and the creation of money and credit 'out of thin air'. These activities bid scarce resources away from where they would be more profitably employed. Eventually, these economic errors will be revealed, either when the central bank tightens policy, or when the pool of real funding becomes so strained that malinvested capital can no longer be sustained no matter what.

The current situation

In recent decades, central banks have adopted interest rate targeting as their favored method of regulating money. This is best described as a price fixing scheme.
One of the goals officially pursued by this policy is 'price stability' – a very amorphous concept, since prices are supposed to fluctuate in a market economy, and a measurement of 'aggregate prices' is not really possible – we only pretend that it is (if you add up the price of a bag of rice, a car and a hair cut , the result will be a nonsensical number).

Still, the declared intent of the policy is to avert both a fall as well as an untoward rise in the mythical 'aggregate price level' – mind you, 'price stability' is not intended to mean that prices should not rise at all, only that the rise should be capped at some arbitrary percentage every year. In other words, the frog is supposed to be boiled slowly (you, dear reader, are the frog).

At times, increases in productivity will be very rapid – this happens usually when new industries and new industrial processes are introduced after a large leap in technological progress has taken place, and when global trade intensifies, making use of comparative advantages , and furthering the division of labor.

This happened e.g. in the 1920's ,when the car, the airplane and the radio changed the economic landscape, in addition to a modernization of factory production processes, and it happened again in the 1980's and 90's with the advent of the PC, the cell phone, the internet, and connected industries.
In both eras, central banks made the mistake to keep their interest rate policy too loose by pursuing 'price stability'.

In reality, the huge increases in productivity helped to mask inflation, as they exerted downward pressure on prices. Had interest rates reflected actual credit demand as well as time preferences during these eras (which were inter alia marked by sharply rising consumption), rates would have been much higher, and prices, instead of being 'stable' would have fallen instead, reflecting the strides made in productivity increases.

However, underneath the 'disinflationary boom' ('disinflation' is a term divorced from the real meaning of inflation and deflation, meant to describe aggregate prices that rise at a continually decelerating rate of change), inflation actually raged, as the money and credit supply literally exploded. Partly this was reflected in asset prices, which rose like never before, and helped support even more credit expansion, as inflated assets could be used as collateral for more credit. While this was going on, everybody was convinced that a virtuous cycle was underway, while in reality, capital was increasingly malinvested on a large scale.

The recent credit and asset boom reached pinnacles at different times in different parts of the globe, with Japan's combined equity and real estate boom the first to flame out in the late 1980's. The reaction of Japan's policy makers to the bursting of the Japanese twin bubbles helped to set off a fresh round of malinvestment elsewhere in the world, as the Japanese authorities began to inflate even more. Interestingly, although the BoJ eventually expanded base money by over 200% and the state went on an unprecedented fiscal deficit spending spree , Japan's commercial banking system was barely able to create more credit inside Japan (at one point, bank credit contracted for 60 months running). It was clear from this, and from the stock market's inability to re-inflate in spite of the lowest interest rates in the world, that Japan's pool of real funding had suffered enormous damage during the boom.



Japanese monetary data, chart via Bruce Carman. Note how a large increase in Japan's monetary base via so-called 'quantitative easing' failed to increase the broader M2 measure or have any appreciable effect on economic activity (click on chart for larger image).


Next was the technology boom that flamed out a decade later, with stock prices in the Western world reaching unheard of levels and price/earnings multiples. Similar to Japan's situation a decade earlier, rationalizations for this phenomenon were plenty, but the truth was of course that inflation of money and credit drove asset prices to the stratosphere, just as had happened in Japan.
When this boom faltered, it soon became clear that the US pool of real funding had to be in trouble as well, as stock prices continued to precipitously decline in spite of the largest and fastest reduction in US and European interest rates ever.

This decision by the authorities to fight the bust of the inflationary boom with even more inflation managed to create a third boom phase, this time centered on real estate, commodities and emerging market economies. Given the extremely low US savings rate and the fact that the US current account deficit led to a sharp rise in the foreign exchange reserves of surplus countries (mostly in emerging market economies), and the often cited statistic that 'the US needs 80% of the world's savings to finance its current account' we can reasonably assume that this global third boom phase managed to deplete, resp. severely damage, the pool of real funding of the rest of the world as well. In other words, an inflationary expansion in money and credit has led to global capital consumption and malinvestment on a likely unprecedented scale.

Since we can not measure the state of the subsistence fund directly, we have to draw inferences from what happens when monetary and fiscal pumping is employed to counter the ongoing bust.
So far, the outcome is very sobering. Central banks have given up on the idea that they should not inflate, and are pumping all out – interest rates have been slashed to the bone, and various monetary measures under the central banks control are soaring. Governments have either already spent or pledged enormous amounts to turn the faltering economic and financial ship around. In spite , or maybe because of all these interventions, stock and commodity markets have crashed globally.



the US monetary base, 1918 to present, via Bruce Carman. the current amount of monetary pumping is unprecedented. click on chart for larger image




the current composition and growth of the asset side of the Federal Reserve's balance sheet. note that the US dollar is what the Fed's liabilities consist of. the dollar is beginning to resemble the French revolutionary assignat by now (the assignat was 'backed' by confiscated church property, the dollar is increasingle 'backed' by mortgage debt securities). click on chart for larger image.

The chances for re-igniting the boom must be regarded as slim in light of the above. The markets are signaling that economic activities that do not generate wealth can't be revived by means of monetary pumping, a strong sign that the global subsistence fund is in trouble and in need of rebuilding. The best way of achieving this necessary rebuilding would be to let the market do its work, as painful as that would be in the short to medium term in light of the previous excesses.
The point here is that the disease can not be cured by administering more doses of the poison that created the disease in the first place – easy money.
Should the boom against all odds be re-ignited quickly, it would merely set up an even bigger bust down the road – however, this does not seem probable, since this time we would have to draw on the subsistence fund of Alpha Centauri, or wherever it is the aliens live.

Conclusion

We can therefore give an answer to the reformulated question posed above: should the money system be freed from government control and be returned to a free market dispensation? The answer must clearly be yes.
Note that such a transition would not be painless either, but it would nevertheless help to restore the economy a sound footing very fast. We can not say for certain whether gold would be the basis of a free market money system, but considering the historical record, some sort of metallic standard (perhaps a mixture of various metals) would likely emerge. This would by no means mean the end of a modern financial system – on the contrary, since it e.g. seems unlikely that we would start lugging around gold coins in our digital world (the practical implementation of a return to sound money will be the subject of a future blog).

Under a free market money system, the world would likely enter a period of what some refer to as 'benign deflation' , which is to say, prices would fall over time, reflecting increases in industrial productivity. Everybody would gain in terms of real wealth. The same can not be said from a world in which inflation of money and credit continues to be the preferred, government-imposed policy.



Assignat of the French Revolutionary government click on chart for larger image



the form of money most likely to be used by the free market click on chart for larger image