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Tuesday, October 07, 2008

Gold Standard Sigh

Or, why the gold standard (or lack thereof) is mostly irrelevant to the current financial crisis:

Someone said (in a bromidic defense of the gold standard as the bastion of sound monetary policy):
The US was not on a gold standard after the creation of the Federal Reserve. Although it was nominally still a gold standard, the Fed had the capacity to manipulate the money supply at will.

Whether you are on a gold standard is mostly irrelevant under fractional reserve banking (which long pre-dates the federal reserve). To wit:

You take your $1000 in gold to Bank A. Bank A puts it in their vault, gives you a balance sheet showing you have $1000 on deposit. That's $1000 gold-standard dollars, let's say exactly and always 1 oz.

Person A comes to Bank A asking for a loan for their business. Bank A writes them a demand-note ("cash") for $900, effectively loaning them 90% of your gold (though they keep it in their vault, they have promised to deliver the actual gold should someone bring the demand-note in for it). Person A pays $900 to Person B, who then brings that "cash" to Bank B and deposits it in their own account. Bank B sees this cash as equivalent to gold, since it's good for gold on demand, after all, and turns around and loans $810 of it to person C, who may bring it back to Bank A, and so on.

Eventually there's $10,000 in "cash" floating around, $9,000 in outstanding loans to the various banks, and 1 oz of gold in the vaults. Meanwhile, you are still on the "gold standard" because 1oz gold == $1k. If people start feeling insecure about the whole situation and decide they better just go get their gold and stick it in their safe at home, you have instant financial Armageddon, because there's $10k in cash and only $1k in gold to back it up.

And that's still technically on the gold standard.

The problem is fractional reserve banking, summed up in Alexey's condition that people should "1) not [be] allowed to take it back at any time you like;". That is, the fraud is in the banks telling you you have a cash (demand) balance when in truth they've lent out 90% of your gold to someone else who hasn't promised to bring it back on demand. It's a gamble of statistics that only so-many people will want their gold at any given time, and so you can convert term loans into demand deposits "on average". Except that systematic swings (e.g., housing market turns south) break the statistical assumptions and "on average" can move very quickly into the red.

And that's still technically on the gold standard.

What makes the gold standard a "standard" is merely that it's a defined reference point for what means "1 dollar". But the instant someone, anyone, writes a promissory note to deliver $100 in gold next week, they have just created new "money" that is not actually backed by gold today. And if they had promised to pay $100 in wheat next week, it would be exactly the same situation other than to the extent that the relative prices of gold and wheat might drift a bit during the week. Gold made a good standard in the past because unlike wheat it wasn't subject to crop failures or excesses and so its objective value was relatively stable from week to week. But its success here is its own undoing, because it has become a commodity of financial stability and ironically, coupled with modern technology and efficient markets, this makes the value (not just the price) of gold swing wildly.

Gold has also been useful in the past for currency because it is compact (relative to value) and non-perishable. However, stock (or other property such as land) certificates, especially in an electronic era, are even more compact, and have the advantage that, in many cases, the physical item stores itself and so can't be stolen from the vault. There's no reason a bank shouldn't be able to operate completely without reference to gold, without storing gold, and without promising to deliver gold -- they could just as well hold (and lend against, and do all the other banky things banks do) certificates for other sorts of value.

And, by the way, that's pretty much how the federal reserve works. Instead of backing the currency with gold, it's backed with treasury notes--which are essentially claims on the assets of the US govt and the possessions of its citizens (via taxation). And treasury notes are real, valuable property even though they have terms on them because they pay dividends in the meanwhile, so they're like little money-generating boxes. Better than gold, really, which just sits there taking up space. A gold meteor could hit the atmosphere and rain gold nuggets over half the planet rendering gold completely worthless, but your treasury notes will still allow you to extract wheat from a farmer next month.

The utility of a standard like the gold standard is pretty much limited to defining what the term "dollar" means so that everybody can price things against a single common reference, and hence any item against any other item via a common intermediary.

Yes -- it is a problem that the fed can just keep buying treasuries and thus debase the currency, hidden taxation through inflation and all that, but that's not the big problem. (If that was your only concern, just keep your money in stocks instead of dollars.) That's a book-keeping nuisance that makes it harder to put a dollar price on future promises (long term loans, etc) because the reference point for the dollar is largely at the whim of the fed. And inflation is annoying because basis prices for capital gain taxes are not inflation adjusted. And it opens up the possibility of hyper-inflation as a means of eradicating govt debt... But that's an after-the-fact issue, because in the absence of that option the govt simply defaults on treasuries which is just a different distribution of the same carnage.

The problem is treating bags of term notes as if they were demand notes on average--such as telling people they have a cash account when in truth they have a CD. People, and govts, are short-sighted and will spend the "cash" they have without regard to future obligations. So this conversion of term to demand leads to excess consumption, under-production, and eventual implosion.

Welcome to the implosion.


And, by the way, that's pretty much how the federal reserve works. Instead of baking the currency with gold, it's backed with treasury notes

[Correction: "worked". And they worked that way throughout the creation of the problem. It is only in the implosion that they have deviated from that, effectively choosing the hyper-inflation route vs. the treasury-default. But that's just a choice of carnage distribution, not the cause of the carnage.]

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Simon Funk / simonfunk@gmail.com