You Got to Be Kidding Me!

More On The Gold Standard v Fiat Money

Posted in Economics by Stacy McMahon on March 1, 2009

So besides my last post, I also had a status msg on Facebook with my reaction to Ron Paul’s rant about gold. Among others, a friend commented the following:

It’s not magic… money is only money because someone says it is. Fiat or gold/silver standard alike. The problem with a backed currency is that it is difficult to get liquidity as overall value increases. The problem with fiat currency is that the government just prints more money instead of raising taxes. If overall national wealth has not increased, this causes inflation, hurting the poor and working class the most. When a national debt is called in and the government prints it all, hyperinflation happens, wiping out nearly everyone. In the campaign, Ron Paul actually advocated competing currencies (NOT a pure gold standard), where you could buy your bread with a Federal Reserve Note, a euro, or a silver certificate. Keep in mind that FDR actually made it a crime for a private citizen to own gold from 1933 to 1971 (when we went to pure fiat currency), demanding it be turned over to the government. Of course, it’s not like the media or schools will highlight any of this…

“Fiat money” means paper money (or coins, or marbles, or any item used to represent value) that is declared by the government (by “fiat”) to be money.

My friend’s argument is that fiat money exists only as long as everyone agrees that it exists, and thus we’re each always at risk that the system will break down and our bank balance will disappear, wiping out our life savings without a trace. Only by physically possessing something like coins made out of an amount of gold worth their face value can you be sure that your money will survive an economic calamity.

It’s worth thinking about that a little bit. First, even if the only cash in circulation were gold coins, insuring yourself against a banking collapse would still involve keeping money under your mattress. As soon as you bank your gold, you’re right back where you were with paper money because your gold only exists as an IOU from the bank.

Second, and related, the idea of the money supply being controlled by the gold supply is an illusion anyway. If the bank kept every depositor’s full balance in the vault, there wouldn’t be anything available to lend. Of course they don’t keep everyone’s money under a giant mattress, they keep the amount they expect people to actually take out, and lend the rest. So for example, if the bank keeps 50% of all deposits in the vault and lends out the other half, the economy now contains 150% of the original deposits. When the lendees pay back the loans with interest, the money supply goes up even more.

So unless you’re also going to ban moneylending, I don’t see how a gold standard constrains the money supply. As I mentioned last post, though, it would constrain the government from printing money to pay down public debt, which would be a good thing.

More philosophically, fiat money isn’t really money ‘just because someone says it is’. Money – paper or gold – exists for good natural reasons, and people are going to use something as money no matter what else is going on. And whatever money is in circulation is always “backed” by the total value of goods and marketable skills present in the economy. Which goes to what I presume is Clint’s argument in his last comment (“no cash = fascism”) If the government actually denied individuals the right to trade in anything other than government-defined currency (call it “points”) then for good or ill you’ll be forced to use official channels for all your buying and selling.

Of course things like that have been tried from time to time (see “Soviet Union”) and the inevitable result is that, due to the aforementioned natural reasons, a black market always springs up (see “Prohibition”) And that’s why the whole notion of centrally planned economies doesn’t make sense. Economies are a natural phenomenon, exactly like an ecosystem, or a weather pattern. Trying to control it invariably leads to demonstrating that you don’t truly understand it.

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8 Responses

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  1. My name is Clint? said, on March 2, 2009 at 8:58 am

    // We’re each always at risk that the system will break down and our bank balance will disappear, wiping out our life savings without a trace. //

    I can think of at least three examples where essentially this happened: the Continental Dollar, the Confederate dollar, and the Zimbabwe dollar. I’m sure there are others. I’m not sure a complete collapse has ever happened to anything as relatively powerful as the USA; the best analogy for that might be the Japanese yen in the 1990’s, which took a pretty big hit.

    // So for example, if the bank keeps 50% of all deposits in the vault and lends out the other half, the economy now contains 150% of the original deposits. //

    Huh? If the bank starts with 100% of the money and you loan out 50% of it, how is 150% in circulation? I can see how 150% of _value_ might be in circulation but not of deposits.

    Also, a strange phenomenon of fiat currency is that it’s all debt. If all loans were paid off tomorrow, there would be no money in circulation at all (John Adams pointed this out as far back as 1787!).

    // And whatever money is in circulation is always “backed” by the total value of goods and marketable skills present in the economy. //

    Yes. Although given that the national debt ($10 trillion) is 60% of GDP, and total unfunded entitlement liabilities ($60 trillion) are over 400% of GDP, this is where we are running into danger.

    Also, as you print money, you lower the value of each unit, unless you can increase the total national wealth by the same amount. Because we’ve had reasonable growth, we’ve mostly gotten away with it; however, right now we are contracting sharply and STILL printing money, which is a recipe for inflation run amok. This, much more so than corporate greed (not that they’re helping either), is responsible for the decline in real wages among the working and middle class.

    // More philosophically, fiat money isn’t really money ‘just because someone says it is’ //

    Actually, that’s literally true, that it’s money because a government (or someone) says it is. Even if I were to dig up a Continental dollar and take it to a store, it would only be money if the shopkeeper and I agreed it was. But then it would only be money if he could find another taker. If nobody wants it, it’s worthless.

    I liked Ron Paul’s idea of competing currencies because then there is more of an incentive to manage them responsibly.

    Aside – the biggest weakness of a gold standard is when people who use fiat money perform currency exchange with a backed currency, and then call in their certificates for gold. This is why Nixon moved us to pure fiat money (admittedly, because they were printing money to pay for the Vietnam War, but I think the point still stands).

    // Money – paper or gold – exists for good natural reasons //

    Agreed. I am just saying that if it is improperly managed, those good and natural reasons become warped, and bad things happen.

  2. Stacy McMahon said, on March 2, 2009 at 9:30 am

    No, you’re Steve. Clint is the guy who commented on the last post saying “no cash = fascism” 🙂

    Huh? If the bank starts with 100% of the money and you loan out 50% of it, how is 150% in circulation? I can see how 150% of _value_ might be in circulation but not of deposits.

    Also, a strange phenomenon of fiat currency is that it’s all debt.

    Well, call it value if you want. The point is that as far as anyone is concerned, both the bank deposits and the loans exist and can be used on demand, even though a lot of the lent-out money is just a double-count of the bank deposits. So my point stands – even with a gold-backed currency, the money supply expands and contracts on its own due to lending. The more lending goes on, the more money is in circulation. When lending contracts (or stops, like right now) the money supply suddenly drops.

    If banks lent out 100% of deposits, then a credit freeze would completely wipe out the money supply. That’s why the government regulator makes banks maintain a certain ratio of actual cash in the vault compared to the total value of loans they make. That system broke down in the subprime mortgage market because the risk models for the mortgage-backed securities turned out to be very, very wrong.

  3. Bree said, on March 3, 2009 at 2:39 am

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  4. Steve (Still not named Clint) said, on March 3, 2009 at 11:20 am

    I don’t think we disagree much on this, actually.

    // So my point stands – even with a gold-backed currency, the money supply expands and contracts on its own due to lending. The more lending goes on, the more money is in circulation. When lending contracts (or stops, like right now) the money supply suddenly drops. //

    Yes. The sudden contraction of the money supply kicked off the Depression. Even Bernanke admits it was a colossal mistake. However, hyper-accelerating the money supply is _also_ a mistake, just for different reasons.

    // If banks lent out 100% of deposits, then a credit freeze would completely wipe out the money supply. That’s why the government regulator makes banks maintain a certain ratio of actual cash in the vault compared to the total value of loans they make. //

    Agreed. Even more strongly than you put it; the banks are supposed to have enough money to cover expected withdrawals of deposits. If they lent out 100%, nobody could take out their deposits (unless the bank borrowed). I believe they have to keep at least 10-15% of deposits on hand, so they only lend out 85-90%.

    // That system broke down in the subprime mortgage market because the risk models for the mortgage-backed securities turned out to be very, very wrong. //

    No argument here. Lending money to people who can’t pay it back and then securitizing the payment streams (of the thing that won’t get paid back) is a bad thing. I’m confused why banks are failing though, shouldn’t it be more hedge funds and investors? If banks securitized the loans there should be no risk to the bank, just the certificate holders – because default risk and pre-payment risk is passed on. Or at least that’s how these things were structured when I was doing my MS in finance…

  5. Mark Herpel said, on March 3, 2009 at 5:11 pm

    Get rid of the dollar and bring back honest money or at least allow the states to use it. There are still 5 states with pending honest money legislation. We have devoted an entire issue to it this month on DGC Magazine

    Mark

  6. Stacy McMahon said, on March 3, 2009 at 9:22 pm

    Steve: “I’m confused why banks are failing though, shouldn’t it be more hedge funds and investors?

    The banks bought each other’s mortgage-backed securities at a level that they thought was safe, but the risk models turned out to be badly wrong and the banks had much more exposure than they thought. So much so that when all was said and done they had effectively lent out well over 100% of deposits – maybe (we may never fully know) over 100% in ‘toxic assets’ alone. So, that’s why you’re now hearing people saying banks and investment firms should be (re)separated, as well as more than a little upset over the bank bailout in general. It’s the old “screw up a little and it’s your problem, screw up a lot and it’s everyone else’s problem”

    Mark Herpel: “Get rid of the dollar and bring back honest money or at least allow the states to use it

    Well that would be Federalism in action, though I certainly hope Virginia won’t be the state to try such a retrograde system.

  7. Steve said, on March 6, 2009 at 12:58 pm

    // The banks bought each other’s mortgage-backed securities at a level that they thought was safe, but the risk models turned out to be badly wrong and the banks had much more exposure than they thought //

    This astounds me. How could banks think it was OK to buy these assets when they themselves were issuing them, specifically because they were too risky?

    Sounds like there’s plenty of blame to go around here: a dumb federal lending policy that opened the door to a problem, compounded with crazy circus speculation, and hypocritical idiots managing bank assets.

    I recognized the problem with the market in 2006 when I heard an advertisement on the radio for “a jumbo loan of $500,000 for only $700 a month!” Plug in a $500,000, 40-year, fixed rate mortgage into Excel — even at 0.1%, with no PMI or property taxes (which is absurd), the payment is still well over $1,000 a month. At a more accurate 4%, the interest alone on $500,000 is over $1650 a month!

    AND NOBODY FREAKING SAID ANYTHING ??

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