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The Deep Myth at the Heart of the Gold Standard
One political/policy fallout from the Global Financial Crisis — and the accompanying monetary easing and rise in public debt — has been the reemergence of the gold standard as something the center-right talks about. Unlike the fiat money US dollar, a gold-backed dollar — a dollar linked to something tangible — would prevent monetary mischief by government.
On a recent EconTalk podcast, this issue came up as host Russ Roberts chatted with Yuval Harari of Hebrew University, the author of Sapiens.
Harari: Modern money has no value in itself. But as long as everybody believes in the same authority — let’s say, the Federal Reserve in the United States — and everybody trusts the stories that are told by the Federal Reserve and by the Treasury and by the President, then this trust enables them to trade effectively. At the most basic level, I think all money is made of trust. It can be in physical terms, money can be gold or silver or paper or even electronic data. But at a deeper level, all money is made simply of trust.
Roberts: I think a lot of people have a misunderstanding of where the value of money comes from. I think you have it almost 100 percent correct, and I think you have an insight that is, that is very, very deep about money and I want to get to. … Because most people think, “Well, there is value to money. There used to be — because it used to be backed by gold.” And it’s no different today. “Backed by gold” doesn’t have any meaning whatsoever. It’s still a trust system. What the “backing by gold” did was make it more probable that you could trust it, as long as there wasn’t a lot more gold discovered. And so I think people don’t like paper money. They want real money. There’s no such thing.
Harari: Gold, just like paper – I mean, you can do more things with paper than with gold. Today in electronics maybe you can do something with gold. But for most of history, gold was a completely valueless metal. The only things you could make from gold were artifacts with cultural value, like jewelry or statues or crowns. You couldn’t make a sword or a plowshare out of gold. It’s a very soft metal.… The only value, again, is people trust it.
There might be a reasonable case for returning to the gold standard — I’m not a fan — but it’s really just another trust-based currency and should evaluated as such.
Published in Economics
You are precisely correct that under US law, your checking balance is credit: not a deposit, but a loan.
How do we know that? If a checking account is a deposit, then every time there’s a run and the bank declines to give you the money that you deposited, they are guilty of fraud: they lent out money that was legally yours.
Under US law, that is not what happens: the bank merely defaulted on a loan, which is not a criminal offense. Under US law, a checking balance is a demand loan from you to the bank, not a “tandundem” deposit (a tandundem deposit is the deposit of an amount of indistinguishable (fungible) goods, which remain the legal property of the depositor, as opposed to deposit of specific goods)
You are wrong that a checking account isn’t “money”, unless you have your own definition of money:
DEFINITION of ‘M1’
A measure of the money supply that includes all physical money, such as coins and currency, as well as demand deposits, checking accounts and Negotiable Order of Withdrawal (NOW) accounts.
Read more: M1 Definition | Investopedia http://www.investopedia.com/terms/m/m1.asp#ixzz3vqyVFnsp
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Would the US deflation between 1870 and 1895 count? There is also the case of the Great Depression, where it is generally believed that the Fed made a mistake in reducing the supply of money in response to the decline in demand, which further reduced output.
Let me preface by saying that I haven’t studied this issue deeply, and I don’t know the relevant numbers, but: Since we went off the gold standard and allowed US currency to float (I believe this happened during the Nixon administration), haven’t we expanded the money supply a huge amount, without a corresponding increase in gold supplies owned by the government (although the price of gold has gone up a lot)? So to re-establish currency backed by gold at a fixed price, seems like it would create an instant deflationary (or perhaps inflationary) shock, depending on the ratio between the declared gold price and the market price. Unless confidence in the government is so high that they can get away with not actually owning enough gold to back all of the currency in circulation, you would have to contract the money supply to match the gold supply (deflationary), or raise the guaranteed price above the prevailing market price (inflationary). Either way, it seems to me that returning to the gold standard could be a highly disruptive event.
I could be wrong, I am not an economist. Tell me why.
Tuck and Mark you are both correct with a subtle distinction.
The difference between money and money supply.
A checking deposit is a liability to a bank and it is also money as defined in M1.
When the bank loans a portion of that balance via fractional reserve banking the loan becomes an asset of the bank and money supply increases. That doesn’t change the fact that the original despot is still M1 money.
The Federal Reserve monitors this stuff weekly. The Assets and Liabilities of Commercial Banks is detailed in Friday’s H8 report.
Money Stock Measures (money supply) is reported on Thursday’s in the H6 report.
That is the most curious, well crafted, fanciful discussion I’ve seen on the matter.
Any rule that imposes discipline requires discipline and political will to be established and followed. The political process drives the money creation because the political class gets to spend the money creation first.
An important lesson I learned this year is how money creation also drives taxation enabling political spending.
That is a good question. I believe when Nixon closed the gold window the price was fixed at $35/ounce (I was born in 67) per Bretton Woods.
February Gold (GCG6) is $1,058.3 as 0700 CDT and would drive where the peg would be set. $35 doesn’t seem practical.
If all of the M2 money (12 trillion dollars) were backed by all of the US Governments gold holdings (260 million troy oz.) then gold would be worth around 45,000 dollars per oz.
The government would have to buy whatever amount was offered at this price, by printing the money. That would be a huge amount of new dollars and would be very inflationary and disruptive.
Why use M2?
It was somewhat arbitrary. Regardless of the “M” chosen, there would be a big inflation. If we used Fed liabilities, the 12 T would become 4.3 T. and the exchange rate would be smaller, but same order of magnitude.
Thoughts?
Fiat money, unbacked by anything tangible, is government’s attempt to outlaw scarcity. Tangible wealth has grown in linear fashion, while paper claims against that wealth (including paper money) have increased exponentially.
The most recent collapse is a cautionary tale. Various imaginative paper debt instruments overwhelmed the actual value of the underlying houses. A few individuals recognized the fraudulent nature of the scheme, made a fortune by shorting them, and nearly brought down the financial system. How many other schemes are presently at work in other markets? The paper gold futures market is, at best, a game, where people pretend to buy gold – whose possession is uncertain – for future delivery from sellers who pretend they could actually deliver it. This continues only because it pleases officials intent on furthering the paper money con game, by which they steal yet more, surreptitiously, from savers, via inflation.
Sure, all value is ultimately subjective but scarcity eventually trumps myth as to what value is agreed upon. So, which myth is more likely based in reality and likely to resist major “discontinuities”? That gold (and gold-backed currency) is more likely to retain purchasing power over time or that central bankers can create currency at will out of nothing at near-zero marginal cost?
When I first read your comment my reaction, was “wow, yes, that is an important consideration” then my days with Prof. Johnson in Money and Banking started gnawing at me.
Allow me to ramble and please respond and challenge:
When the Fed delineated M1 and M2 there was a distinction I seem to remember that M2 partially captures the results of fractional reserve banking. Is it possible to convert those results into a fixed gold price or conversion rate?
I am still missing something and don’t have a better solution than yours, thus my question to align with your thinking.
I think M2 overstates, but M1 understates, the money supply and/or monetary base that would be included in the conversion rate you calculated.
The monetary base increases when the Fed buys debt from banks, or directly from the Treasury so it’s part of M1, but it doesn’t get expanded by the money multiplier until there is credit expansion. So Dodd Frank by restricting lending, and Obama by causing stagnation in the credit dependent new and small business sector has allowed a 500% increase in the monetary base but no run away inflation. That will end if we get rid of Dodd Frank and other regulatory burdens and cut taxes. We must brace ourselves. Gold or a gold rule probably won’t fix it. We must cut and cut deeply.
M1 and M2 money both include money created ex nihilo by commercial banks through fractional reserve banking. Both include checking account balances, which by Fed regulations can be up to 90% created from nothing, and historically always were. (At the moment, the Fed can’t persuade the banks to run their “counterfeiting rate”, as some would describe it, to the permitted 90%, much to its dismay.)
Sometimes the (admirable) desire for sound money is expressed as a desire for gold-backed money, in the belief that the thing that makes current money unsound is the lack of backing by a tangible good. In fact, the thing that makes our money unsound is the fact that it can be arbitrarily created at will by selectively entitled classes, often to their (unfair) benefit but always to the (unfair) detriment of most other people. “Gold-backed” money and fiat money can both be unsound given some combination of bad laws and dishonest bankers, and conversely either can be sound in the presence of good laws or honest bankers.
I’m sure that economists have proposed and discussed solutions to the “inflationary shock” problem of switching to 100% gold-backed money. Just haven’t read about it myself yet.
That’s not quite right. With gold you always have the option to exit the credit-based monetary system, and go to the real money.
I have to chuckle when people use the Fed’s definitions of money. That’s really begging the question, isn’t it? Of course they include credit in their definitions of money, as their entire purpose is to define money such that the Government can degrade it at will.
Great comment #46. Happy New Year.
Tuck, it is almost always a good thing to be suspicious of the Fed, but in this case, I’ve learned recently that you have to look beyond.
Actually, in the early days of economics, all economists believed as you do (and I did) that fractionally-backed demand accounts were not money. Only real gold was money in their view. I don’t remember which one, but one of the economists of –maybe the early 1800’s??– wrote that this was incorrect in his view, and explained why. It was controversial at first I think, but soon pretty much all economists came to regard this as one of the great discoveries of economics.
I think you may be assuming that people who have concluded that checking balances in our (corrupt) system are by any meaningful definition “money” (i.e., they act almost exactly like gold coins) are approving of the system. We aren’t. We are simply observing that in fact, when I have a dollar in my checking account and a dollar bill in my pocket, I think I have two dollars, not one dollar. The utility company and the vet both think when I send them a check for 125 dollars that they have gotten 125 dollars.
This was discovered long before there was a Fed, and would be (I believe) true whether it pleased the Fed or not.
Well done, Sir!
Isn’t the real object of trust the economic system behind the currency–the legions of workers, the machinery, the power and transportation and communication infrastructure?
Wow. Much worse than I ever imagined.
A doctor, an engineer, and an economist all die at the same instant and find themselves before the pearly gates. St. Peter meets them there with some bad news, “There is only room for one of you. But, here’s the deal, whichever one of you can prove that you have the oldest profession gets in.” The doctor says, “that’s easy, in Genesis it says that God took a rib from Adam to make Eve, that is surgery, therefore, I have the oldest profession.” The engineer says, “Not so fast. Before that, Genesis says that God created the world from chaos. That’s engineering, oldest profession.” The economist says, “Who do you think created the chaos?”
With that in mind, here are a couple more theories on why money has any value.
The is the Appeal-to-Authority fallacy, but without providing the authority. You might find this Wikipedia page on fractional reserve banking helpful.
It’s almost a species of fraud, aided & abetted by the gov’t. If you or I did it, say borrow an asset (a gold bar for simplicity) and then loan it out to three or four other people for compensation, on the assumption that they won’t all ask for it at the same time, we would be committing fraud. You need a banking license to engage in this species of fraud.
So regardless of what “some economist” says, gold is the money, paper (the deposit slip that says you gave the bank your gold) is not, it’s credit. It’s the belief that the bank will give you the gold when you ask for your money.
We indulge the fraud of fractional reserve lending because it’s convenient, until there’s a run on the bank.
Tuck, my point wasn’t clear. I wasn’t saying that X is money because authorities say it’s so. That would be fallacious, as you say.
Rather I was responding to your point:
“I have to chuckle when people use the Fed’s definitions of money.”
I was trying to explain (not so well, as it turns out) that I am using “money” in the traditional economics sense of the word. Meaning, the fact that the Fed also uses the word this way is irrelevant.
You jumped to the conclusion (quite understandably) that the Fed had tricked me into accepting a devious, self-interested definition of their own making.
As an analogy, if we found that the Boston Strangler and Bozo the Clown used “money” in a way that included dollar bills, we shouldn’t dismiss everyone else who does so without some other cause.
Fair enough, but they may well have tricked you, for as far as I can find they invented these measures—no doubt some economist on their payroll, but still:
As someone who does budget, accounting and financial planning for a living and one who has dealt with long term financial contracts I can tell you there is only one thing I really care about when it comes to the value of money, long-term Stability. I could care less about everything else related to money other than maybe how willing banks are to loan money because of the money supply. Now I think the Central bank actually plays a lot smaller role than most monetary economist think especially over the long term but I will admit the Fed does have some control over this segment of the economy.
So in the end this is all that a vast majority of people care about, does money keep its value. Everyone argument on this post is against the current system is about the fear of instability in the value of money. So you agree with me also about this.
Volatility is risk and removing long-term risk from the value of money is the important function (and I believe only function) a Central Bank should perform. I happen to agree with Milton Friedman and think the supply of money should be run by a computer program whose model should only be change sparingly (no more than a couple of times every generation of which most would be tweaks).
Gold would do the exact opposite of this. The history on a gold and silver standard proves it has way more volatility it results in short-term hyper deflation and inflation.
I am sorry but you are stupid if you want to go back to a gold standard. I think stupid is a perfectly valid response to this idea and here is why. It is like going back to sail. Did sail work, yes but it was a lot more inconstant and slower therefore more expensive to utilize. Why we would want to give up a better technology (which is what modern process of money supply is, it is technology) for an older technology?
Secondly, some of the more contentious issues Intelligence Design verses Evolution, Global Warming verses none, Free Market verses Socialism, you find expert on both sides of the coin. Yes one side might dominate the other but you still find a decent amount of well informed intelligent people about the subject matter arguing the less popular stance.
However this is not so with a Gold Standard. Anyone who has study economics or does it for a living does not want to go back to a gold standard. I challenge you to find one practicing economist who thinks a Gold standard is better let alone a small group of them.
Now that is not to say we can’t improve the current system with better accountability and transparency. However throwing out a vastly superior technology to go back to an older one that will cost more and have way more risk is just stupid.
They may well have. They are required to report regularly on the various “money supplies” as most economists (rightly or wrongly) call them, and obviously they must publish their definitions in great detail, and present their justifications as they make changes from time to time. The information on their public website is detailed enough for you to calculate your own version of the “money supply”. For example, if you consider only coin and currency to be “money”, then you can find those figures month by month, year by year.
One of the things that defines money is that it is a store of value, so I mostly agree with you.
From Scott Sumner, (emphasis mine)
This is an excellent left-wing analysis of what happened!
The “imaginative” debt instruments were routine mortgages that have been around since the 1960s. What was imaginative was giving these mortgages to people with poor credit, on a low money-down basis. This policy was pursued vigorously by Democrats in the Clinton administration and their allies, including a lawyer working for Acorn named Barack Obama.
They collapsed not because of the shorts, but under their own weight.
This is a basic misunderstanding of what the Fed’s role is. We had near-perfect price stability prior to the creation of the Fed. The Fed’s job is to ensure inflation, and to make sure that price stability is not possible.