Saturday, January 02, 2010

The cross of gold

I notice that the nutcases advocating a return to the gold standard as the solution to all our problems are still rattling their antiquated 19th century chains. But that doesn't change reality. The biggest problem with gold-backed money is that it does not address the root cause of the inflationary/deflationary pressures inherent in the business cycle: fractional reserve lending. During the era of gold-backed money in the United States, we saw repeated inflation-deflation cycles that served to strip wealth from average Americans and transfer it to a group of oligarchs as debts taken out in cheaper inflated dollars could not be repaid in more expensive deflated dollars and thus the oligarchs took ownership of the real assets which secured the debts. The inflation-deflation cycles are inherent in the business cycle as banks expand lending during up times (thereby reducing their fractional reserves and thus inflating the money supply via the fractional reserve multiplier effect) and step back on lending in order to build up their reserves to cover losses during down times (therefore increasing their fractional reserves and thus deflating the money supply via the fractional reserve money multiplier). In short, a gold-based money supply in any economy that has fractional reserve lending is a recipe for transferring the wealth of the masses to a few oligarchs. Only a fiat money supply where money is printed during down cycles to prevent deflation, and where money is taken out of the money supply during up cycles, can prevent this inflation-deflation boomerang cycle if you wish to preserve fractional reserve lending as a part of your economy.

So fractional reserve lending is a fraud, you say? Uhm, no. Fractional reserve lending is where you loan your money to a bank for them to loan onwards. Still, it should be banned because of its inflationary/deflationary effects, you say? The problem then is that businesses no longer are able to leverage current economic activity in order to produce future economic activity, because you are greatly reducing the amount of money available to lend in an economy if you ban fractional reserve lending. Capitalism simply works better, responds to consumer demand more nimbly, if you can pay for the assets needed to satisfy consumer demands using the future income created by those assets, rather than requiring current cash sufficient to buy those assets. Any economy without fractional reserve lending is uncompetitive in the world marketplace and swiftly devolves to third world status. Just look at most of the Islamic world, where fractional reserve lending was largely banned as ursury for many, many centuries.

The end result is that for you to have a modern economy, a fiat money which can be inflated and deflated in inverse to the business cycle is necessary. The gold standard was a primary reason for why the Great Depression resulted in such a collapse of business activity between 1930-1933 -- the gold standard prevented the Federal Reserve from simply printing the fiat money needed in order to fill in the hole of all the money that disappeared due to the stock market crash and resulting contraction of the money supply, causing deflation, which caused people to default on their debts, which caused banks to collapse, which caused deflation, wash, rinse, repeat until most of the country devolved to a barter economy, which is incredibly inefficient at fostering business activity. A modern economy simply has too many intermediaries for barter to be an adequate method for handling the incredible series of trades needed in order to produce even the simple computer you're reading this tome on, that's the whole reason the Communist system collapsed, because it turns out that training an economy with tokens (currency) via the mechanism of the market simply works better. But this only works if the tokens have a reasonably constant value, slightly declining in value every year in order to keep them available for use rather than hiding under a mattress (where they foster no economic activity but, rather, simply serve as lumpy bed stuffing). Gold simply doesn't serve that purpose well if you have fractional reserve lending, thus why it's not used as the primary token of trade in any modern economy today -- NOT because of some secret conspiracy by Jewish bankers yada yada yada, but, rather, simply because it DOESN'T WORK.

- Badtux the Economics Penguin


  1. Hi BadTux,
    Help me out here. In a stock market crash, how does money disappear? Do people burn their money just because it will buy more?
    What difference is there between a gold crash/depression(1930) and a paper crash/depression(today)?
    The Fed was supposed to even out boom/bust cycles, but from where I'm sitting it sure doesn't seem effective.


  2. U. C. -

    The money disappears in two ways. First, the value of things declines. Your $100,000 stock portfolio becomes a $50,000 stock portfolio. Poof! Gone

    Second, deflation is a decrease in the money supply. Money doesn't literally disappear, It would be foolish to burn it today, because it will be worth MORE tomorrow. Thus - and totally opposite to the inflationary situation - there is no urgency to buy any discretionary item. But it stops moving. Lower wages, fewer purchases, etc. - the multiplier effect B.T. mentioned. The money supply is the total of cash plus credit. Credit dries up, the mutiplier drops, and the money supply declines.

    Differences between depressions: None.

    The Fed failed because it is owned and run by the monied interests who win either way.

    B.T. - It's even worse than you said. Staying on the gold standard perpetuated the Great Depression for the counties that stayed on it the longest. I believe very country had to dump gold before it could recover.

    Barbaric relic!

  3. Carpenter, what you need to look at is the money multiplier created by the effective reserve ratio in an economy with fractional reserve lending. Scroll down that page and you'll see a nice chart showing how that works. If you increase the effective reserve ratio because banks are stashing money into their reserves rather than lending it out, you also decrease the money supply because the money multiplier decreases. Again, look at the chart on that page, it shows how the money flows back into the banking system as deposits after it's loaned out, and thus is on the books *twice* -- once from the original "mint money" deposited in the bank, and then the 90 cents of loaned-out money that flowed back into the bank (consider the entire banking system as one bank for simplicity's purposes). So $1 of money turned into 90c worth of loans (with a 10% reserve ratio) and $1.90 worth of deposits! Wait, we have $1.90 worth of deposits, meaning we can have $1.71 worth of loans outstanding at a 10% reserve ratio, yet we have only 90c worth of loans outstanding so lets loan out 81 cents to bring us up to $1.71 worth of loans outstanding. Yet that 81 cents flows back into the banking system so now we have $2.71 in deposits! And so on and so forth, until at the end we have $10 in deposits and $9 in outstanding loans.

    The money multiplier explains why, if banks increase their effective reserve ratio to 20% by stashing money into the Fed rather than lending it out, the amount of money in the banking system decreases from $10 to $5. You haven't seen this because the Federal Reserve has been backstopping it with quantitative easing -- i.e., they've printed the money that the banks put into their reserves, leaving the overall money supply largely unchanged. On the other hand, quantitative easing of this sort creates no economic activity thus can't be said to be a panacea by any means... thus the reality that we're still in a nasty recession. But there's a *major* difference between 1932, when the entire currency basically spiraled down in a deflationary cycle until major portions of the country were on a barter system, and today. This is a nasty recession, but if today's Fed had allowed the currency to collapse the way that the 1932 Fed did then we'd *be* in 1932 today -- and 1932 was a nasty, nasty year, filled with food riots, rumors of revolution, Federal troops attacking homeless veterans, and other things you don't read about in your history books today.

    - Badtux the Economics Penguin

  4. Jazzbumpa: You are correct about the effect the original 1929 stock market collapse had, but a little vague about the mechanism. The borrowing on margin meant that the money vanished off of banks' books as soon as the people defaulted on the loans they'd backed with those stocks. This required banks to cease lending in order to increase their reserves to backstop the losses, which decreased the money supply via the money multiplier above. Then loans taken out in inflated dollars could not be repaid in the now-more-expensive deflated dollars because businesses borrowed $2 to buy widgets to sell in their storefronts for $2.50, but now could only get $1.50 for them due to deflation. So they defaulted, which caused banks to fail, which instantly un-created all the checkbook money at that bank, which then caused *further* deflation, which then caused *further* loan defaults, which then caused *further* bank collapses, wash, rinse, repeat, until by late 1932 much of the nation had gone all the way down to a barter economy because dollars had effectively all fled to under mattresses for use as a store of value (since deflation rendered them a better instrument as a store of value than anything you could buy with them) and none were in circulation for commerce. Compare that situation today, and you'll see we're *much* better off... maybe unemployment sucks and the economy as a whole is in a mild deflationary cycle, but we're a long, long, LONG ways away from the disaster of 1932.

    -- Badtux the History Penguin

  5. JzB and BadTux,
    Thanks for the pointers. I think I need to chew on things awhile. My head is spinning.
    Good post, BT. Keep 'em comin'.


  6. Tux -

    You're right. I was concentrating on the gold vs money type depression, and didn't pay attention to the dates.

    I'm not at all convinced that we don't have a 1932 equivalent in our future.

    I think the whole scenario is playing out more slowly than it did in 29 to 32; that the stock market increase of '09 is a phony rally(like Q1, 1930); that the bottom is a long way down.

    Compare these charts:



    Bottom is a long way down.

    Maybe in 2012 - 2014


  7. Shit.

    Those Yahoo charts didn't come through right. First on should be Oct, 07 though now.

    Last should be Oct, 29 through Jan, 04.

    You can reset the dates in the From and To boxes at lower right.

    Lo siento.



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