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WEDN ESDA Y , SEPT EMBER 1 , 2 0 1 0

Predicting the Price LevelA key disagreement between the Austrian economists and Key nesianeconomists is ov er the consequences of expanding the money supply .Key nesians claim that increasing the money supply will cause abeneficial increase in economic activ ity , whereas Austrians claimthat increases in the money supply cause all manner of badconsequences, one of which is the lowering of the purchasing powerof all money currently in circulation. The most v isible sign of suchloss of purchasing power is a general rise in the price lev el. Therefore,it is important that the Austrians answer the Key nesians who say thatthe Austrian monetary theory is wrong, because the gov ernment’spump priming, trillion dollar stimulus spending and the Fed’s massiv easset purchases hav e not caused runaway price inflation. In thisessay I will answer this criticism by explaining the fundamentalforces at work to explain the relationship between the money supplyand the price lev el and the forces of gov ernment interv ention thatmake short term price level predictions impossible.

T he Quantity T heory of Money

At the foundation of our understanding of money and prices residesthe quantity theory of money . At this most basic lev el it is ax iomaticthat the price lev el is the intersection of the quantity of goods for saleon the market and the amount of money av ailable to purchase thesegoods. Prices can rise for only two reasons. One, the quantity ofmoney rises faster than the quantity of goods for sale. Two, thequantity of goods for sale drops faster than the quantity of money . Ofcourse the rev erse is true about a falling price lev el. Prices can fall foronly two reasons. One, the quantity of money falls faster than thequantity of goods for sale. Two, the quantity of goods rises faster thanthe quantity of money.

Let’s use a simple example. Assume that there is only one commodityfor sale in the economy . One hundred units of this commodity areproduced. The money supply consists of one thousand units ofcurrency; we’ll use dollars as our money supply unit. The only pricethat will clear the market of all goods offered for sale is ten dollars perunit. ($1 ,000 div ided by 100 units) Let us suppose that there is aproduction improvement that allows the market to produce twohundred units of the same commodity . Then the market-clearingprice will be fiv e dollars per unit. ($1 ,000 div ided by 200 units)Likewise, let us assume that the money supply increases to twothousand dollars while the ability of the market to produce goodsremains the same at one hundred units. Then the market-clearing

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Patrick Barron, an Austrian EconomistAn Austrian Economic View of the World

Showing posts with label Monetary Issues. Show all posts

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price will be twenty dollars per unit. ($2,000 div ided by 100 units)From this simple example one can clearly see that, if we admit thatthe U.S. economy produced more goods today than it did twentyyears ago, then the primary reason that prices hav e not fallen is thatthe money supply increased concomitantly . Likewise, if prices arehigher now than they were twenty years ago and real economicoutput is essentially the same, then the culprit must be an increase inthe money supply . But most of us grant that the U.S. economyproduces more “stuff” than twenty y ears ago. So if the price lev el ishigher, the only explanation is an increase in the money supply. Hadthe money supply remained stable, the only way that the marketcould have cleared the larger supply of goods would hav e been forprices to fall.

(Since 1990 M2 has increased by a factor of 2.62 while nominal GNPhas increased by 2.57 , which leads one to the conclusion that theeconomy has not really grown at all in terms of real goods andserv ices in two decades. All of the increase in GNP can be attributedto higher nominal prices caused by an increase in the money supply .)

T he T hree Uses of Money

The quantity theory of money is at the foundation of understandingmoney and prices, and it does explain long-term trends. But otherfactors operating within this foundational theory determine marketprices in the short-term. One of those factors is an explanation of thepurposes to which money can be used.

There are three and only three uses for money —to hold (hoard),spend, and inv est. Of the three, only the combined size of the spend-and-invest components determines the price lev el; i.e., spending andinv esting are those components of the money supply that are broughtto market to purchase goods av ailable for sale. As the total quantityof spending and inv esting increase in relation to the quantity of goodsand serv ices brought to market, prices will increase. If either or bothof these components decrease, prices will decrease. Importantly , ifthe money supply increases and all of the increase goes intohoarding, the price lev el will remain the same.

Suppose that the Fed printed enough paper money to give ev ery onein America one million dollars. Since there are 300 millionAmericans, the money supply would increase by 300 trillion dollars!Surely that would trigger higher prices! But let us also assume thatev ery American took the money and placed it under his mattress. Hedid not spend one cent. What would happen? Well, the money supplywould increase by 300 trillion dollars, but the price level wouldremain the same. All the new money would hav e gone into hoardingand would hav e no impact on prices.

An Ever-Changing Money Supply

So far our discussion of how money affects prices assumes that thereis no intervention by an outside, coerciv e agent that attempts tomanipulate both the total size of the money supply and the three usesof money . Unfortunately that is not the case. The gov ernment

interv enes regularly and inconsistently in monetary matters, makingit almost impossible to point to one or two factors that will hav e themost impact on prices.

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The most important interv entionist gov ernmental body is the FederalReserv e Bank, our central bank, which almost alway s attempts toexpand the money supply . It “adds liquidity ”, mostly by increasingbank excess reserves. Right behind the Fed is the TreasuryDepartment, which spends the money . Both attempt in v arious way sto stimulate the economy by ensuring that any increases in money gointo the spending and inv esting buckets and not into theholding/hoarding bucket. Currently the Fed and the gov ernmentwant all of the money to go into the spending bucket exclusiv ely , sothat the GDP numbers will rise. Y ou see, the gov ernment measuresthe size of our economy by how much we spend, so it tries tomanipulate this number in a v ariety of way s. The “cash for clunkers”program is a case in point. If nothing else causes one to question thiswhole paradigm, the gov ernment’s claim that destroying still useful,but older v ehicles adds to our economic well being should end suchnaiv eté.

It is bey ond the scope of this article to explain the many way s thatthe Fed increases excess reserves and the effect this increase canhav e over time on the size of the money supply . Let us just say thatalthough the Fed has less than perfect control ov er the money supplyin the short run (and the short run can be y ears long), it is the size oftotal reserves and the reserv e requirements that establish the outsideparameters of the money supply . Ty pically bank excess reserv es arearound only $2 billion or less, not a great deal in an economy the sizeof ours. As of July 28, 2010 bank excess reserv es stood at $1.012trillion dollars! Since we hav e a fractional reserve banking sy stem,the potential ex ists for banks to expand our money supply by manymultiples of these excess reserv es.

Conflicting Governm ent Interventions

But it gets ev en more complicated! While one department of the Fedtries to expand the money supply, there is another whose actionsprev ent it—the bank examining force. As the left hand of the Fedhands out reserv es to all comers, the right hand ensures that thosereserves will not be conv erted into money v ia lending. In fact theright hand of the Fed--and other bank regulatory agencies, such asthe FDIC--currently exercise a deflationary impact on the moneysupply . These agencies are forcing banks to charge off suspect loansagainst capital. When a bank’s capital ratio falls below that requiredby bank regulations, the bank has only two choices. It can attempt toraise capital, a difficult thing to do these day s, or it can reduce thesize of its balance sheet by reducing loans outstanding. Loanreduction has a deflationary effect on the money supply .

Add to this structural issue the fact that there really aren’t many goodloans out there, which would create new money as desired by theFed’s left hand, and you can see why all that additional liquidity hasyet to reach its potential as the basis of new money . The key wordhere is “yet”. The potential for a massiv e increase in the moneysupply ex ists, howev er.

T he Risk of Hy perinflation

Now we get a glimpse of what has been happening. The Fed has beenadding liquidity mostly in the form of excess reserv es. As y et these

excess reserv es hav e not been employ ed by the banking sy stem tosupport an increase in the money supply via new lending...the bankexamining force has blocked this route. The money that has found itsway into peoples’ pockets has stay ed in peoples’ pockets--it has beenhoarded. There is no way to predict the end to hoarding, the end tobank recapitalization, and the end to bank loan problems. But whenthese deflationary factors do end, American prices will rise as thehoarded money and the increased money created by increasedlending flow into spending and/or inv esting. At that point we willenter what Ludwig v on Mises called the “danger zone”. No one willwish to hold depreciating dollars; they will be spent as rapidly aspossible, creating the real possibility of what Mises called the “crack-up boom”. Despite the tough talk by Fed Chairman Bernanke, the Fedwill be powerless to prevent this debacle. Money will become

worthless.

Posted by PatrickBarron@msn.com at 7:51 AM No comments:

Labels: Monetary Issues

WEDN ESDA Y , A UGUST 4 , 2 0 1 0

Understanding the Relationship between Money andthe Price LevelOne of the conundrums of current economic life is why the increase inthe money supply had not caused runaway price inflation.Furthermore, the federal government has run a one-trillion-dollardeficit this year, with promises of more for sev eral more years, whileat the same time interest rates have fallen to unprecedented lowlev els. Both of these phenomena seem to v iolate economic law.Shouldn’t more money driv e up prices? And shouldn’t gov ernment’smassiv e borrowings cause interest rates to rise? Y et prices for mostgoods hav e remained stable and the interest rate is at historic lows.Has all economic law been shown to be fallacious?

In this essay I will explain the fundamental forces at work to explainthe relationship between the money supply and the price lev el, whichwill, coincidentally , help to explain the low rate of interest. There isno v iolation of economic law. The seeming anomalies stem from thefundamental error of placing economics within the realm of thephy sical sciences and not in the realm of the social sciences. The viewof economics as a physical science leads one to the conclusion thateconomics is mechanical and can be explained by formulas; whereasunderstanding economics as a social science leads one to understandthat human v olition cannot be predicted or reduced to mathematicalformula with substantiv e and temporal exactness.

T he Quantity T heory of Money

At the foundation of our understanding of money and prices residesthe quantity theory of money . At this most basic level it is axiomaticthat the price lev el is the intersection of the quantity of goods for saleon the market and the amount of money av ailable to purchase thesegoods. Prices can rise for only two reasons. One, the quantity ofmoney rises faster than the quantity of goods for sale. Two, thequantity of goods for sale drops faster than the quantity of money . Ofcourse the rev erse is true about a falling price lev el. Prices can fall foronly two reasons. One, the quantity of money falls faster than thequantity of goods for sale. Two, the quantity of goods rises faster thanthe quantity of money .

Let’s use a simple example. Assume that there is only one commodityfor sale in the economy. One hundred units of this commodity areproduced. The money supply consists of one thousand units ofcurrency ; we’ll use dollars as our money supply unit. The only pricethat will clear the market of all goods offered for sale is ten dollars perunit. ($1,000 div ided by 100 units) Let us suppose that there is aproduction improv ement that allows the market to produce twohundred units of the same commodity. Then the market-clearingprice will be five dollars per unit. ($1 ,000 div ided by 200 units)Likewise, let us assume that the money supply increases to twothousand dollars while the ability of the market to produce goodsremains the same at one hundred units. Then the market-clearingprice will be twenty dollars per unit. ($2,000 div ided by 100 units)From this simple example one can clearly see that, if we admit thatthe U.S. economy produced more goods today than it did twentyyears ago, then the primary reason that prices hav e not fallen is thatthe money supply increased concomitantly . If the money supply hadremained stable, the only way that the market could hav e cleared thesupply of goods for sale would have been for prices to fall. Since mostprice statistics show that prices hav e not fallen and in fact hav e risensomewhat, then the only explanation is that the money supplyincreased.

(Although the quantity theory of money knows no definitiv e authorand has been known for centuries, Professor George Reisman haswritten extensiv ely on the subject. I recommend pages 505 and 506of his magnum opus Capitalism for a brief explanation. Then thereader can continue elsewhere in this magnificent book for furtherand more detailed discussion of money , prices, and production.)

T here Are Only T hree Uses of Money

Y et my illustration abov e and recent experience seem to make amockery of economic science. I had said that economics was not aphy sical science, and y et I used mathematics to illustrate my point.Is not mathematics a phy sical science? Furthermore, my illustrationwould predict that prices must rise when the money supply increases,and y et in recent months the money supply HAS increased and priceshav e not followed. Should we discard the quantity theory of money ?No. The theory is at the foundation of understanding money andprices and it does explain long-term trends. (Since 1990 M2 hasincreased by a factor of 2.62 while nominal GNP has increased by2.57 , which leads one to the conclusion that the economy has notreally grown at all in terms of real goods and services in two decades.All of the increase GNP can be attributed to higher nominal pricescaused by an increase in the money supply .) But other factorsoperating within this foundational theory determine market prices inthe short-term.

There are three and only three uses for money —to hold (hoard),spend, and invest. Of the three, only the size of the spend-and-investcomponents determine the price lev el; i.e., spending and inv estingare those components of the money supply that are brought tomarket to purchase goods av ailable for sale. As the total quantity ofspending and inv esting increase in relation to the quantity of goodsand services brought to market, prices will increase. If either or bothof these components decrease, prices will decrease. Furthermore, ifthe money supply increases—that is, the total of all three uses

increases—and all of the increase goes into hoarding, the price lev elwill remain the same.

(As is the case with the quantity theory of money , the concept thatthere are only three uses of money was not discov ered by any singleeconomist, but I refer the reader to chapter seven of Hans-HermannHoppe’s The Economics and Ethics of Priv ate Property for anexcellent discussion of the subject.)

Here is an example that I use in my Austrian economics class at theUniversity of Iowa: Suppose that the Fed printed enough papermoney to give ev ery one in America one million dollars. Since thereare 300 million Americans, the money supply would increase by 300trillion dollars! Surely that would trigger higher prices! But let us alsoassume that ev ery American took the money and placed it under hismattress. He did not spend one cent. What would happen? Well, themoney supply would increase by 300 trillion dollars, but the pricelev el would remain the same. All the new money would hav e goneinto hoarding and would hav e no impact on prices.

Now we get a glimpse of what has been happening for sev eral years.Central banks around the world hav e been printing money , but mostof this money has been hoarded. When gov ernments spend moneywithout first borrowing it from the existing monetary stock or tax ingit from the citizenry , the new spending ev entually goes into bankreserves. Since the banks hav e not increased lending, the moneysupply has not increased. As of July 28, 2010 bank excess reserv esstood at $1 .012 trillion dollars. This is a form of money hoarding.Another form of money hoarding is the buy ing of sov ereign debt. Forexample, the U.S. gov ernment has sold hundreds of billions of dollarsof debt to our trading partners. This happens when foreignersfoolishly believ e that running large trade surpluses is somehow anational adv antage. But Frederic Bastiat exploded this fallacy ov er acentury and a half ago in his essay Gov ernment. By holding itscurrency cheap in order to export goods, a country impoverishesitself by shipping useful goods in exchange for depreciating papermoney . Since these foreign gov ernments hav e no use, so far, forAmerican products, they buy U.S. Treasury debt in order to “park”the money until some future date. This, too, is a form of hoarding,because the money does not finance spending and/or investing.

T he End to Hoarding

There is no way to predict the end to hoarding, but when it comesAmerican prices will rise: the hoarded money will flow into spendingand/or investing. At some point the hoarded money will burn a holein peoples’ pockets. The first holders of large amounts of Americanmoney will be able to exchange their dollars for goods, serv ices, andassets at today ’s prices. But as this hoarded money flows intospending and inv esting, prices will start to rise. Other holders ofhoarded U.S. dollars will realize that nothing can stop thedepreciation of the dollar, as illustrated by relentless price increases.Now we will enter what Ludwig v on Mises called the “danger zone”.Ev en if the central banks try to stop the flow of hoarded funds intospending and inv esting, they will be unsuccessful because marketpsychology has changed. No one will wish to hold depreciatingdollars; they will be spent as rapidly as possible, creating the realpossibility of what Mises called the “crack-up boom”. Moneybecomes worthless.

Just as the psychology of today’s market mitigates holding dollars,once the floodgates hav e been opened the psy chology of the marketwill rev erse. In The My stery of Banking Murray N. Rothbardexplained that market psy chology can change very slowly , as inAmerica for the first two decades after World War II, or very rapidly ,as in Germany after World War I, where in 1923 the world witnessedthe worst crack-up boom ev er to appear in a modern, industrialnation. Germany recov ered only when it exchanged the old mark forthe new Rentenmark at one trillion old marks for each newRentenmark and the Reichsbank pledged to hold the supply ofRentenmarks stable. When the Reichsbank kept its word gradually thepeople regained confidence in their currency . But the damage hadbeen done. The resources of the middle class had been wiped out,and, more importantly , the German peoples’ confidence in socialinstitutions had been shattered, opening the door to thedemagoguery of National Socialism.

It Can’t Happen Here

Americans are no less ruled by the iron laws of economics than areother, less fortunate peoples. Nev er in the history of the world has sodominant a world power engaged in such massive moneydebasement. The trillions of dollars held around the world representclaims upon the productiv e sector of the U.S. economy that simplycannot be met--at least not at today ’s prices. The Germanhy perinflation of 1923 wiped out the German government’s warreparation debt, but at the stupendous price of ushering in thefascists. Likewise, the U.S. could technically pay its national debt byso devaluing the dollar that it effectively robs dollar holders of theirgood faith claims upon American resources. I would remindxenophobic Americans, who may believe that robbing foreigners is ofno concern, that Americans hold dollar claims, too, and would sufferjust as much, if not more.

At the present time there is no better market alternative to holdingAmerican dollars. All currencies are fiat currencies, managed by thewhim of politicians buying v otes with more entitlements. But forcesare building to end American hegemony in monetary affairs. TheChinese, the Indians, the Arabs, and the Russians are floating rumorsof issuing a gold-backed currency, and the market alway s rewards abetter product. It would be the greatest tragedy to befall this nation,if our foolish gov ernment destroy ed our currency at the height of ourproductive capacity , making indirect, peaceful, cooperativ eexchange an impossibility . It can happen here!

Posted by PatrickBarron@msn.com at 11:15 AM 2 comments:

Labels: Monetary Issues

T HURSDA Y , J UN E 1 0 , 2 0 1 0

My Letter to the NY Times re: Blog Prophet of EuroZone DoomFrom: patrickbarron@msn.comTo: letters@ny times.comSubject: Letter-to-the-EditorDate: Thu, 10 Jun 2010 14:04:01 -0400

re: Blog Prophet of Euro Zone Doom

Dear Sirs:Mr. Edward Hugh may be correct that the Euro will fail, but it will notfail as a direct result of cultural differences among its members. It willfail because the European Central Bank (ECB) succumbed to politicalpressure to abandon its primary responsibilities to keep the currencystable and chose instead to destroy the Euro's purchasing power.Profligate nations can coexist in the same currency zone asfinancially responsible nations, but eventually the profligate nationswill be forced to mend their ways or they will run out of money . Thisis good--one of the benefits of a sound money is its use as a unit ofaccount, rev ealing when one is accumulating capital and when one isdestroy ing it.

The Greek financial crisis rev ealed that nation's path to destructionmuch earlier than otherwise because it was on the Euro and could nothide its problems by debasing the drachma. This was a Greek financialcrisis that is merely denominated in Euros; it was not a Euro crisis. Itbecame a Euro crisis only when the ECB bought Greek bonds andforced the European Union (EU) nations to guarantee them againstthe will of their citizenry . At that point it became obv ious that themore responsible nations might be forced to leav e the Euro Zone bythe ov erwhelming demands of their citizenry to do so.

It is not true that debasing one's currency is a means to restoringfinancial solv ency. Debasing the Euro may spur EU exportstemporarily , but it is no long term solution. By making importsexpensiv e a debased Euro will raise the cost of liv ing for the commonman in Europe and ev en raise the cost of those imports that are usedas factors of production in export industries.

The world's politicians should abandon their search for a quickfinancial fix that does not ex ist. If some claimed that they hav e foundone, y ou can bet that the costs either are hidden or will be borne bypolitically unpopular minorities. The EU had a golden opportunity toallow the free financial market to impose discipline upon the Greekgov ernment. The Greek people should demand that their leaders keepthem in the Euro Zone, because that is the surest and quickest path toforcing their government to abandon its destructiv e fiscal policies.More debt or currency debasement will only hide the problem, makeit bigger, and result in a worse situation in the future.

Patrick Barron

Posted by PatrickBarron@msn.com at 11:16 AM No comments:

Labels: Monetary Issues

T UESDA Y , MA RCH 2 3 , 2 0 1 0

My Letter to the NY Times re: China's CurrencyManipulationRe: China Uses Rules on Global Trade to Its Advantage, by KeithBradsher--March 15, 2010

http://www.nytimes.com/2010/03/15/business/global/15yuan.html?scp=1&sq=China%20Uses%20Rules%20on%20Global%20Trade&st=cse

Dear Sirs:Mr. Bradsher gets the consequences of state currency manipulationexactly backwards. No country can inflict damage upon another bymanipulating its own currency; all harm accrues to the citizens of thatcountry alone. By holding its currency weak, China subsidizesexports at the expense of its own citizens. The citizens of China'strading partners enjoy cheaper and/or better quality goods, while theChinese experience higher prices due to trading more renmindi forforeign currencies than the unhampered market would allow. Ineconomic terms this is called "importing inflation". Mr. Bradshermakes another crucial error when he makes the claim that "unlikeextra gov ernment spending in the United States and other countries,currency interv ention does not expand global demand, but shifts itfrom other countries to China." No, the process is the same, whetherwithin one country or among sev eral countries; that is, thatgov ernments cannot increase total demand. Mr. Bradsher describesperfectly the "fallacy of composition", whereby it is assumed that,since a gov ernment can shower benefits on one economic entity , itcan shower benefits on all economic entities. On the contrary ,gov ernment spending rewards some at the expense of others. Neithercurrency manipulation nor government spending will increaseresources, but, instead, will transfer them--at a cost, of course--fromsome segments of the economy to others. The so-called stimulusspending in the United States does not increase total demand withinour country any more than China's currency manipulation increasesworldwide total demand.

Patrick BarronAdjunct Instructor in Austrian EconomicsUniversity of IowaIowa City , Iowa

Posted by PatrickBarron@msn.com at 9:03 AM No comments:

Labels: Monetary Issues

FRIDA Y , MA RCH 1 9 , 2 0 1 0

Fed Chief Wants to Eliminate Bank ReservesThe link below is a transcript of Federal Reserv e Chairman BenBernanke's Feb 10, 2010 testimony to Congress. The last line of thefinal note at the end of the letter has the pertinent statement that theFed may eliminate reserv es completely .

http://www.federalreserv e.gov /newsevents/testimony /bernanke20100210a.htm

Here is my analysis:

With ov er a trillion dollars in excess reserv es right now, the bankingsy stem is not limited by reserv es. Since its founding in 1 913 the Fedhas steadily destroy ed the public 's understanding of real money.Therefore, eliminating reserv es fits into the scheme of things as justanother mov e away from any semblance of sound money.

Without reserv e requirements, the banking sy stem would have nolimits to its manufacture of money; therefore, I see this as a steptoward gov ernment allocation of credit--the gov ernment's ultimategoal. Because the banks would be in a position to expand creditwithout limit, the gov ernment could claim that only it has the

foresight and the power to prevent another crisis. This is the bankingsy stem as it was practiced during the communist reign in EasternEurope. I taught many East European bankers at the Univ ersity ofWisconsin in the late '90's. They related that the role of bankersduring the communist era was simply to implement orders from thegov ernment; that is, allocate so much credit to the steel industry , somuch to agriculture, etc.

If sound money is eliminated and the banks are not required to holdany reserv es, there hardly is any other way to conduct banking.

Posted by PatrickBarron@msn.com at 11:35 AM No comments:

Labels: Monetary Issues , Regulation

MON DA Y , MA RCH 1 , 2 0 1 0

THE VELOCITY OF MONEY AND THE BUSINESSCYCLEThe v elocity of money is the one of the factors that determines GDP.The well-known formula is GDP = M x V; that is, Gross DomesticProduct equals the quantity of Money times its Velocity . Velocityrefers to how many times a giv en quantity of money is spent duringthe period under consideration, usually one y ear. Less understood ishow changes to money ’s v elocity come about. The formula makesclear that a decrease in velocity can adv ersely affect GDP and v iceversa. But, that just begs the question, what causes changes inmonetary velocity ?

The primary determinant of how often a giv en quantity of money isspent is the desire of the public to hold money; that is, the public’sdemand for money. When demand for money is high, meaning thatthe public wishes to hold more money in the form of cash balances,the velocity of money decreases. Likewise, when the public ’s demandfor money is low, velocity accelerates. Therefore, we hav e enteredthe realm of perception, which is not an exact science in the sensethat one can establish a formula of the magnitude and time frame forchanges in perception. Nev ertheless, it is possible to establish thefactors that ev entually will change perception and, therefore, willcause the demand for money to increase or decrease.

The demand for money is influenced primarily by the quantity ofmoney . This simple statement rev eals something very important—that if the quantity of money changes v ery little, then the demand formoney will change very little and the economy will experience stableconditions. Commodity money —that is, gold and silv er—experiencesvery small changes in its quantity; therefore, one would expect thatcommodity money v elocity would change very little. But ev en in theday s of the gold standard, the demand for money v aried. The reasonwas that the money supply was not backed one hundred percent bygold but, rather, only a fraction of the money supply was backed bygold. The rest of the money supply was anchored in bank loansinstead. As banks increased lending during temporary boom times,the quantity of the fiduciary media, as Ludwig von Mises called thismoney not backed by gold, increased, which caused the demand formoney to decrease and money’s v elocity to rise. This is the v erydefinition of a boom. Howev er, ev entually this increase in the moneysupply causes prices to rise, among other ev ils, rev ealing that theboom is unsustainable. There does not ex ist any new, real capital tofund it.

When bank loans become uncollectable, the quantity of fiduciarymedia decreases. Now the demand for money increases dramatically ,as the public scrambles to convert their fiduciary media—bankchecking accounts now of questionable v alue—into currency . Thisincrease in the demand for money causes a decrease in money ’svelocity , exacerbating the bust. The only way out of this predicamentis for prices to fall, so that the remaining, smaller supply of moneywill be sufficient to allow the market of goods and serv ices to clear.

All this can take quite some time. In today ’s fiat money , central bankmonetary sy stem the bust phase can be papered over for quite sometime with increases in fiduciary media. But the demand for moneydetects subtle changes, thusly precipitating changes in money ’svelocity . For instance, rising prices are a signal to money holders toreduce their demand for money . A reduction in money demandcauses its v elocity to increase, putting further upward pressure onprices. If there ex ist other assets in which the public can easily inv est,then one would expect to see upward price mov ements. Stock marketand commodity price increases are sy mptoms of such mov ementsout of money , reflecting reduced demand for money , furthering anincrease in money ’s v elocity .

It is typical of such boom periods that credit is readily available.Businesses, then, are more prone to reduce cash holdings in thecertainty that bank loans can be used as a substitute for ready cash tomeet business needs. This drop in business demand for holdingmoney is a further spur to an increase in money’s v elocity .Furthermore, since central bank manipulation of the interest rate in adownward direction was the precipitous cause of the temporaryboom, business has ev en less incentiv e to moderate its borrowing inlieu of holding cash. Better to invest in inv entories that may rise invalue than hold cash, especially when loans not only are easy toobtain but are cheap, too.

Therefore, what economists see as an increase in money ’s v elocity isactually a rational decision by market participants to reduce theirdemand for money following central bank intervention to lower theinterest rate and ignite a temporary boom. But, when the boom turnsto bust, the reverse happens. Now the market demands more cash ata time when fiduciary media is being wiped out by bank loan losses.Prices fall, making it wise to hold cash in the expectation of evenfurther price reductions. Businesses begin to hoard cash when banklending dries up in the face of falling bank capital ratios due to loanlosses. And they stop inv esting in inv entories that become lessvaluable each day . Finally , the public bails out of a falling stock andcommodity market in fav or of the comfort of cash holdings. Moneyvelocity drops even more.

In a free market, capitalist economy marked by little gov ernmentinterv ention and the ex istence of sound—that is, commodity —money , the demand for money and its inverse, the velocity of money,are of little interest to economists let alone the public. The demandfor money reflects real choices based upon market forces rather thanopportunistic or defensive choices based upon wild, temporaryswings in economic fortunes based upon government and centralbank intervention. Prices change v ery slowly . Banks are institutionsof probity and practice good asset-liability management; that is, theymatch loan maturities to deposit maturities. This may sound dull to

some, but it beats the wild boom/bust cy cles that create millionairesone day and paupers the next.

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Labels: Monetary Issues

MON DA Y , FEBRUA RY 8 , 2 0 1 0

Deadly Duo: Fiat Money and Fractional ReserveBankingThe government propaganda machine is in full swing. It denouncesbankers for making bad loans. It proposes more numerous and moreonerous regulations in addition to increasing the bureaucracy toimplement them. The message is that the free enterprise bankingsy stem itself is to blame, that without gov ernment regulation there isnothing to prev ent bankers from looting their depositors’ money inorder to line their own pockets. Bankers make loans that they KNOWwill not be repaid and cannot be repaid, all the while pay ingthemselv es enormous salaries and bonuses. When the house of cardscomes crashing down, the bankers give the bill to the governmentand the taxpay ers.

All the abov e is a lie.

The fact is that this current crisis, as with all prev ious crises in thepast one hundred y ears, was caused by government interference inthe financial markets. Specifically it is gov ernment’s creation of fiatmoney -- money backed by no commodity ; that is, nothing of intrinsicvalue—that is primarily responsible for our economic problems. Thismoney has two sources—the Fed’s printing press and bank creditexpansion. This “deadly duo” touches off the boom/bust businesscy cle. This business cycle is not something inherent in capitalism. Acommodity based money and a legal prohibition against bank creditexpansion will end these vicious, wealth destroying and, ultimately ,liberty destroy ing economic crises.

Money is as much a moral as an economic good. Real money is partand parcel of the market economy . It originates as a widely acceptedcommodity that comes to be used, through the market process, asindirect exchange. As such, its v alue increases beyond demand for itsintrinsic use to include a new demand as something to be exchangedlater for some other good. Thusly , real money facilitates theexchange of “something for something”. This is its moral component.But fiat money—that is, money manufactured by the gov ernment andbacked by nothing—alway s enters the monetary sy stem as acounterfeit “something for nothing”. There are two corrupt sources ofthis counterfeit ev il.

The first ev il source is Federal Reserv e monetization of thegov ernment’s debt, meaning that the Fed buys government bondswith money that it creates out of thin air. Government itself benefitsdirectly , when, for example, it pays bureaucratic salaries, buy s goodsand services, and when it rewards its constituents, such as politicalcontributors and v oters, through earmarked targeted spending. Thefirst recipients of this new money can purchase goods at the currentlower price. Subsequent recipients pay higher prices, because thesupply of money increased and pushed up the price level.

Furthermore, this money creates ev en more money v ia the

“fractional reserv e” banking sy stem. Recipients of governmentspending deposit the checks into their bank accounts; then theirbanks deposit the checks with the Fed. Bank reserves increase, andbanks are allowed to py ramid around ten times the amount of the newand excessiv e reserv es into new loans. These new loans are matched,dollar for dollar, with an increase in the money supply, because bankslend money by crediting the borrower’s checking account. Theborrowers spend the money , of course—that is why they borrowed itin the first place. Thusly , bank credit expansion creates new moneybased upon DEBT. We shall see shortly how fragile this sy stem can be.

Thus far, bank credit expansion has triggered a boom. New projectsare started, because the increased quantity of money lowers theinterest rate, making long term projects—those for which the cost offunds is most important—now appear to be feasible. Factoriesexpand, mines open, etc., all of which may take y ears before bearingany real fruit. The problem is that the consumer has not changed hisspending habits. He has NOT decided to sav e more. He purchasesimmediate, consumer-type goods in the same relationship to hissav ings as before. In fact the boom may prompt him actually toincrease his consumption-to-sav ings ratio. Therefore, there is no newcapital for the successful and profitable completion of these longer-term projects, so these “malinv estments” must be abandoned. Sincethe projects are abandoned, they never generate rev enue for pay ingoff their bank loans. As loans default, the money supply drops,because a large component of the malinv estment was funded by loangeneration--when the loans fail, the money disappears.

Now the banks are in trouble. Their capital is reduced dollar for dollarby the loan defaults. It is foolish to ask them to resume lending,because their capital-to-asset ratio is so low. They must build capitalbefore they can begin lending again. But this is not the worstconsequence of building the money supply out of debt. The reductionof the money supply reduces ov erall spending in the economy . Thisimpacts even businesses that did not expand and that previouslywere healthy and profitable. Their rev enue decreases too, driv ingthem to unprofitability . The total amount of goods and services in theeconomy cannot be sold with this lower v olume of spending UNLESSPRICES DROP. Therefore, it is crucial that gov ernment do nothing toprev ent prices, including the price of labor, from falling. Only a lowerprice lev el can bring the economy ’s supply of goods and services intoequilibrium with less money . As Professor George Reisman ofPepperdine Univ ersity has explained, falling prices are the antidoteto deflation (where “deflation” is defined as a fall in the supply ofmoney ).

Perv ersely, the gov ernment recently raised the minimum wage andgave Fannie Mae and Freddie Mac its UNLIMITED guarantee!

Gov ernment’s current attempts to prop up prices are doomed tofailure. Supply can clear only at lower prices. The malinv estment,especially in housing, must be allowed to liquidate on as good termsas current owners, mostly dev elopers, can get. There is an excessiv esupply of housing in the economy in relation to other necessarygoods. Reports of gov ernment efforts to “reviv e housing” areindications that gov ernment is thwarting the necessary correctionvia its many bailout programs. A more encouraging report would bethat the price of housing is falling precipitously . This would bewelcome news to all seeking housing—don’t we all lov e a sale?

We are doomed to repeat these boom and bust cy cles, probably withev en greater intensity due to gov ernment’s foolish interventions, aslong as gov ernment can print money out of thin air and banks cancreate ev en more money out of debt. No regulations can prev ent thiscy cle. In fact some gov ernment agencies, such as Fannie Mae andFreddie Mac, are trying to rekindle the boom while other gov ernmentagencies, such as bank regulators, claim that they can so regulatebank lending to prev ent any future malinv estment. This is impossible.The problem lies in the v ery nature of the monetary sy stem, whichsends false signals to bankers and bank regulators alike, inducingthem to fuel another unsustainable boom. Money is lent on the cheapto precipitate projects for which no real new capital ex ists. Thismoney built on debt will v anish as it has in the past, wiping out thehopes and dreams of tens of millions. The lower quantity of moneymeans that total spending will be inadequate to clear the productionside of the economy at current, boom-induced high prices. Y et, ev enthough lower prices are the only cure, gov ernment and organizedlabor fight this cure tooth and nail.

The answer lies in driv ing a stake through the heart of this deadlyduo. First of all, return to commodity money , most likely gold. Goldmoney can be neither created nor destroy ed. Once brought intocirculation, gold money remains in circulation. Total spendingremains the same; only prices change—usually downward, basedupon productiv ity gains—v ery gradually ov er time. Next, prohibitbanks from engaging in fractional reserve banking. All money must bebacked one hundred percent by gold. Loans must be based upon thetransfer of gold from sav er to borrower via a professional bankingsy stem, which exacts a small profit for its intermediation services.

There is no role for gov ernment in this sy stem bey ond insuring thatbanks do not engage in fraud by lending out more money than theyhav e gold on deposit. Gov ernment should not insure deposits orregulate lending in any way . There is no role for a central bank in thissy stem either. This is laissez faire banking based upon marketgenerated money. This is freedom. This is the cure.

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Labels: Monetary Issues

SA T URDA Y , DECEMBER 1 9 , 2 0 09

The Path to Sound Money and a Vibrant EconomyThe greatest challenge facing the United States and WesternCiv ilization—which includes all those countries engaged ininternational trade in order to facilitate social cooperation throughthe div ision of labor—is the destruction of money by central bankswho hav e the power to expand their fiat money supply to unlimitedproportions. Such fiat money expansion destroy s the usefulness ofmoney as a v ehicle for communicating v alue through time and space.What will the dollar be worth in terms of apples and oranges in thefuture and around the world? No one knows, ev en when we maypredict with a great deal of certainty the quantity of apples andoranges that will be produced in the future and market demand forthem. It is not the quantity of apples and oranges that makes futureexchange problematic; it is the quantity of money that makes it so.

Because societies hav e recognized that only a stable quantity ofmoney may perform these crucial services to the economy has

money alway s been a commodity itself with certain characteristics,chiefly among them being its scarcity in nature. For, as Ludwig v onMises has explained, any quantity of money may serve all thefunctions that are required of money regardless of the size orcomplexity of the economy . It is the crucial characteristic of scarcity—that is, its quantity —that has been undermined by central banks.Already we hav e seen the deleterious effects of this debasement ofmoney in the form of repeated and ev er more v iolent boom-bustbusiness cycles. These cy cles are the external manifestation of “sick”money ; they are NOT the external manifestation of “excessive greed”or any other failing of society ’s citizenry. “Sick” money hastransmitted its disease to society, not the other way around.Therefore, it is imperativ e that the United States and other Westernnations end the expansion of their money supplies and re-anchorthem in some commodity of lasting v alue, namely gold, silver, orsome combination of the two. But…how can this be done? That is thecrucial question…the elephant in the liv ing room, so to speak.

Let us first establish that the goal of any currency reform is to end at astroke the further expansion of the money supply . The expansion ofmoney confers no societal benefit whatsoev er. More money does notbring into ex istence, either in the near term or in the longer term,more goods and serv ices than would be produced without itsexpansion. The truth of this statement lies in its logic and also inhistorical experience. But these are subjects for another day. Theimportant point is that ANY further expansion of the money supplycauses harm; therefore, it is not a question of gradually reducing theexpansion of money . No, we must stop any further expansion by ev ena v ery small amount.

First, End Fed and Bank Fiat Money Expansion

In our current fiat money env ironment, two institutions hav e thelegal ability to expand the supply of money—the Federal ReserveBank (the U.S. central bank) and commercial banks. Most peopleunderstand that the Fed can increase the money supply , but fewunderstand that priv ately owned banks themselv es also hav e thelegal ability to increase the money supply. Although the manner inwhich money expands can be rather complicated (and needlessly so),I will explain the basics. The Fed can inject money into the economyby monetizing the federal debt; that is, it accepts the government’spromissory notes and credits its checking account. Then the federalgov ernment spends the money . This in itself increases the supply ofmoney , as can be easily understood, but there is more. When therecipients of the government’s money deposit their checks, bankreserves increase when the bank of deposit sends the check to the Fedfor deposit in its reserv e account (a checking account at the Fed thatis owned by the commercial, priv ate bank. The Fed is the “bankers’bank.) Now the banking system has “excess reserv es” upon which topy ramid more loans and deposits by a magnitude of from ten times toov er one hundred times! All the bank must do is make a loan andcredit the loan customer’s checking account. It is restricted in theextent to which it may expand its loans and deposits (in equalamounts) only by the amount of its excess reserves. Remember, theFed created excess reserv es when it monetized the gov ernment’sdebt. Here lies the danger—under normal conditions banks try toremain completely loaned up, utilizing ev ery penny of their excessreserves by making loans and, in the process, creating money out ofthin air. In our large economy , excess reserv es normally amount to

fewer than two billion dollars, an amount considered to be thefrictional amount that cannot be fully utilized. Ov er the past year theFed has injected massiv e reserv es into the banking sy stem, and nowexcess reserv es stand at ov er a TRILLION dollars, or fiv e hundredtimes the historically normal amount!

T he Reism an “First Step” to Neutralizing Excess Reserves

At a Mises Institute Seminar in Long Beach, CA last month, ProfessorGeorge Reisman presented an intriguing plan to prevent the banksfrom expanding their lending against this massiv e amount of excessreserves. He recommended that the Fed create even more reserv es!But here’s the twist—the Fed should insert enough reserv es of fiatmoney into the banking sy stem to equal the current lev el of bankchecking accounts, BUT at the same time also require 100% fiatreserves against those checking accounts and prohibit the Fed fromcreating any more reserv es thereafter. This step would do two things.Number one, and most importantly , the banks would not be able toconvert those trillion dollars in excess reserves into ten to onehundred trillion dollars of new money . Secondly, it would force thefederal gov ernment either to tax the people for what it spends orborrow honestly from them. Either method would create a naturallimit on gov ernment spending, forcing it to prioritize and moderateits plans to those more in line with society ’s means.

T he Barron “Second Step”--Convert Fiat Money toCom m odity Money

Gov ernments cannot be trusted to refrain from v iolating their ownlaws. They do so, of course, by passing another law to suspend“temporarily” the prev ious law which put what it considers to be anundue restraint upon its actions. Therefore, we must return tocommodity rather than fiat money . The gov ernment could do this bysimple arithmetic; it could div ide the money supply by the number ofounces of gold it holds to establish a legally binding exchange rate ofdollars for gold. Currently the most widely used definition of money —M2—stands at $8.4 trillion, and the gov ernment owns 260 millionounces of gold. Therefore, it could provide 100% backing of M2 withgold by agreeing to pay out an ounce of gold for $32,308 and,conversely , to buy gold for the same amount. Presently the price ofgold has fluctuated between $1 ,000 and $1 ,200 per ounce, so adecision to support the dollar at this dollar-to-gold ratio would hav eunknown economic consequences. Better for the gov ernment toestablish the ratio at a level closer to the current market lev el fornon-monetary gold. But how can the gov ernment do this? If it printsmore money to buy gold in the open market, it would not solv e itsproblem—it would have ev en more fiat dollars to back by the newquantities of gold it receiv ed. But, the government has otherresources! The government is like a cash-poor but property richrelativ e--it owns v ast expanses of valuable land. In fact thegov ernment owns roughly 30% of the landmass of the United States,mostly in sparsely populated areas west of the Mississippi and inAlaska. This is its ace-in-the-hole.

Selling Governm ent Land for Gold Is Doubly Beneficial!

The government has no just cause for owning more land that itsnormal day-to-day operations require, such as enough land for itsmilitary bases and other government office buildings. Its ownership

of lands in the western United States and in Alaska has prev ented thedev elopment of the resources on these lands for the benefit of theU.S. citizens and the world. Like an anorexic who prefers to starv ewith nutritious food close at hand, the gov ernment refuses to allowthe dev elopment of v aluable resources from its land holdings to feedthe resource starv ed economy of the United States. These lands arepotentially the most v aluable on the face of the earth. Not only dothey hold much mineral and vegetable wealth, but they are located ina capitalist country of entrepreneurs, skilled workers, an honestcourt sy stem, good infrastructure…in essence, all the factorsnecessary for successful capitalist development. So, not only wouldthe sale of gov ernment land for gold allow for the backing of the U.S.dollar by more ounces of gold and, therefore, ease the transition to a100% gold standard at a better dollar to gold ratio, it would unleashthe productive capacity of 30% of the nation’s land resource! This isnot rape of the land any more than a farmer rapes his fertile soil or atimber company rapes its well-managed forests. Selling land allows itto be capitalized and managed for productiv e benefit into perpetuity ,the opposite of gov ernment’s so-called management, which is nothingmore than locking land away as if it did not ex ist.

In conclusion, the U.S. can quickly take the necessary steps to returnto sound money and at the same time unleash a new, real economicboom. It needs to take steps first to freeze expansion of the moneysupply , followed by a judicious sale ov er time of its valuable landholdings for gold. The gold proceeds of the sale would allow thegov ernment to back its currency 100% by gold at fewer dollars perounce. The U.S. would once again hav e the world’s strongestcurrency and most productiv e economy . There is nothing preventingus from taking this action but our own foolish adherence to failedeconomic theory .

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Labels: Monetary Issues

MON DA Y , N OV EMBER 9 , 2 0 0 9

Reserves Poised to Destroy the DollarOur prosperity rests upon cooperation under the division of labor.We all produce just one or a few things, but we produce them inmassiv e quantities. Our productiv ity rests upon capital accumulationapplied to our work. We command the output of others’ work effortsby use of money , the indirect medium of exchange. Without moneywe would be reduced to a primitiv e barter economy . Most of uswould die. This is the bald fact about the need for a money economy .

T he Price Level Determ ined by the Supply and Dem and forMoney

How much money is required to purchase the output of society iscalled the price level, which is determined, in broad terms, by onlytwo things—the quantity of goods av ailable for sale and the quantityof money available for purchasing society ’s output. Because we usemoney as the mechanism for exchanging the goods and servicesproduced in our div ision of labor society , economists refer to theprice lev el as being determined by the supply and demand for money .But this does not change the nature of the issue. Money merelyrepresents the v alue the market places upon prev iously producedgoods. Rather than price things in terms of the number of apples anapple grower must exchange in order to purchase his necessities, he

uses money . Therefore, its quantity and its demand determine thepurchasing power of money .

Say ’s Law Explains Purchasing Power

Jean Baptiste Say explained this as clearly as any one, when he statedthat all economic activ ity tends toward the equilibrium lev el at whichall supply is demanded by purchasers. Most people understand thiseconomic law—Say ’s Law—as “supply creates its own demand”. This ismerely shorthand for explaining that it is what we produce thatbecomes the means by which we buy things. Instead of the applegrower exchanging apples for a necessity , he sells his apples formoney and then buy s his necessities with that money . Money is theintermediate exchange mechanism, but it was his apple productionthat gav e the apple grower purchasing power in the market.

One can now understand the importance of money . Not only do weneed something to use for intermediate exchange, but its quantity iscritically important too. Expanding the quantity of money prov idessociety with no utility; it merely lowers its purchasing power on themarket, disrupting commerce and making it more difficult to plan forour economic future. If we do not know what money will buy in thefuture—because its supply has been expanded or may be expandedarbitrarily to some unknown lev el—then inv estment in long termproduction processes becomes very risky and we get less of it. Andthe only way to have more goods av ailable in the future is to expandlong term production.

One can see from the above brief discussion of the nature of money asa medium of exchange that it is crucial that the quantity of moneyremain stable in order for it to prov ide us with its primary serv ice,which is as a communication mechanism of people’s preferences notonly in the near term but also in the future. Unfortunately , it is thequantity of money that is under sev ere attack today .

Expanding Reserv es Means Expanding Money Supply

The quantity of money available in the U.S. is controlled by ourcentral bank, the Federal Reserv e Bank (the Fed). Its primary meansof control is by manipulating bank reserv es, either by changing theratio of reserv es banks must keep at the Fed (increasing the reserv eratio would be deflationary and decreasing the reserve ratio would beinflationary ) or by adding to or subtracting from the lev el of bankreserves. The latter method is the more important of the two. Thereare several methods that the Fed uses to add to bank reserves--but itis not important to explain HOW the Fed adds reserv es as is the factthat the Fed has added MASSIVELY to bank reserves in the past y earand continues to add to reserv es. The outcome could be catastrophic.

Here are some statistics taken from the Fed’s own website. I willexplain their importance further down. All numbers are billions ofdollars.

M2 (Cash, checking accounts, sav ings and money market accounts):$8,333Total Reserv es: $1 ,122Required Reserves $62Excess Reserv es $1,060

Notice the lev el of “excess reserv es”. These are reserv es of the banksthat may be used in the future to increase the money supply .Currently the lev el of “required reserv es” is only $62 billion tosupport $8,333 billion of the most widely used measure of the moneysupply --M2. This means that the ratio of reserv es to money is only.7 4%-- less than one percent. Under normal circumstances theamount of excess reserv es banks hold is around $2 billion; this smallamount relativ e to our money supply being considered the frictionalamount that cannot be utilized in a dy namic banking sy stem. Excessreserves are now a whooping $1,060 billion! Just consider this fact: ifa money supply (as defined by M2) of $8,333 billion can besupported by “required reserves” of only $62 billion, then thecurrent lev el of total reserv es--$1 ,122 billion—will support a moneysupply of $149,7 84 billion, eighteen times the current lev el!

Remember our discussion earlier about how the price lev el isdetermined by the quantity of money and the demand for money ,where the quantity of money commands all the supply of a society ’soutput (its “demand”, as we now understand it according to Say ’sLaw). If the quantity of money can expand by a factor of eighteen, theprice lev el will expand right along with it, because no one expectsAmerica’s output--as measured in the number of real things, not itsinflated monetary v alue—to expand by eighteen times its currentlev el. If any thing, the environmental mov ement has brainwashed alarge percentage of our citizens to oppose any increase in Americanproduction as harmful to Mother Earth. But this is another issue.

End the Fed

Since the establishment of the Fed in 1913, there has been only oneprolonged time period in which the banks kept a significant amount of“excess reserves”. Y ou guessed it—the Great Depression years of the1930s. It is in their nature for banks to expand lending, whichconcomitantly expands the money supply , until all of the “excessreserves” become part of their “required reserves”. This is how banksexpand their business and their profits.

The current v ery high lev el of “excess reserv es” means that there isno institutional brake upon hy perinflation. The level of bureaucraticirresponsibility at the Fed is bewildering, since the Fed’s primarycommission is to safeguard our money . If the Fed bureaucrats hav eso inflated reserv es to the lev el that our money supply can increaseby eighteen times its current lev el, one is left to conclude either thatthey are hopelessly incompetent or that there is some malev olentintent to throw the nation, and the world, into chaos. Whatev er thereason, we now can see clearly why there is a growing movement inAmerica to “End the Fed”. For so many reasons in addition to theprimary one I have discussed here, the Fed has become whatPresident Andrew Jackson called a corrupt institution. Jackson did,in fact, “End the Fed” of his era, the Second Bank of the United States.His was a heroic effort that took both terms of his v ery popularpresidency . Ours is a much more difficult task, since our presidentshows little understanding of the danger the Fed posses to theAmerican economy and may actually be in fav or of taking adv antageof the corrupting powers of the Fed, such as the ability of gov ernmentto spend without taxation or honest borrowing in priv ate financialmarkets.

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FRIDA Y , A UGUST 2 8 , 2 0 0 9

WHAT IS FRACTIONAL RESERVE BANKING? Andwhy do most Austrian economists want to end it?There are few things more misunderstood than the practice offractional reserve banking and its impact on our economy. There arereputable Austrian economists on both sides of this issue. Most, likemy self, believ e fractional reserv e banking to be fraud and injurious tothe efficient and ethical working of the economy . (Read Jorg GuidoHulsmann’s excellent The Ethics of Money Production, av ailable atthe online bookstore at Mises.org.) Others, such as Ludwig von Miseshimself, would not ban fractional reserv e banking but would allow themarket to regulate it. Mises was more concerned with the prospect ofgov ernment intervention in the monetary sy stem and feared thatlaws against fractional reserve banking would be the camel’s noseunder the tent mitigating in fav or of more regulation.

It is difficult to understand fractional reserve banking withoutunderstanding some of the history of banking and how fractionalreserves originated, for our current sy stem maintains a fiction thathas long since been made irrelev ant. That irrelev ancy is thatsomething of lasting value backs our money ; that is, something thatwould ex ist ev en if the nation/state that issued the monetary unitceased to exist. Think of the difference in value between a gold coin ofancient Rome and the Confederate dollar, for example.

Fractional Reserves and Bank Runs

Historically banks came into existence as warehouses for gold andother precious commodities. Gold has alway s been a univ ersalmedium of exchange, ev en when other commodities competed with itfor acceptance in the market. The first bankers were goldsmiths, whoowned safes in which to store the raw materials of their profession.Wealthy indiv iduals paid goldsmiths a fee to store their gold, andgoldsmiths issued them receipts. Eventually these individuals startedusing the warehouse receipts as fiduciary media; meaning that ratherthan go to the goldsmith and redeem one’s gold in order to purchasesomething, these individuals started endorsing ov er their warehousereceipts. Thusly, the warehouse receipts circulated in the economyrather than the gold itself. Over time the goldsmiths realized that theycould issue warehouse receipts in excess of the gold held in theirvaults and reap a profit, because at no time did all the people whoowned warehouse receipts for gold travel to the bank at the sametime to redeem their certificates for gold specie. Now, the goldsmithsdid not simply spend the excess receipts on consumer goods; rather,they lent them to borrowers and earned interest. (Doubtless thegoldsmiths and even some economists today do not consider thispractice to be fraud.) Since there now were more warehouse receiptsfor gold circulating in the market than gold in the v ault to back them,it was said that the gold reserv es amounted to only a “fraction” of theoutstanding claims. Notice that two things had happened. One, thegoldsmith gains from his fraud; that is, he made a profit (if the loanwas repaid on time) from the use of goods that he did not own. Two,the money supply increased by the amount of the excess warehousereceipts. Howev er, the money supply could not increase by v erymuch, as we shall see.

The goldsmith, now transformed into a banker, was limited by themarket in how many fractional reserv e receipts he could issue. A ll

would be well until the public became concerned that the bank hadov er-issued certificates. (Sometimes rumors were started by hiscompetitors.) Then the holders of the certificates would “run” to thebank to redeem them for gold. A bank run had been born. Then thebank’s only course of action was to call in its loans, get paid in gold,and then pay its depositors in gold. If his borrowers could not repay ,the banker would be forced to declare bankruptcy .

Sound Money and Credit Money

Notice that the certificates backed 100% by gold could always beredeemed without any difficulty . Thusly , such money could never bethe source of inflation or deflation. But the excess certificates werenot back 100% by gold; they were backed by the promise of theborrower to repay --that is, this money was backed by DEBT! If thedebt could not be repaid, these excess money certificates could notbe redeemed for gold. The money supply —composed ofindistinguishable certificates, some backed 100% by gold and somebacked only by debt—had been expanded when the goldsmith issuedthe excess certificates. Now the money supply shrank back to itsformer, sounder lev el.

Of course, money certificates today are backed by nothing—not gold,nor silv er, nor cockleshells. The money we use is fiat money , and y etgov ernments ev erywhere maintain the fiction that banks must holdreserves in some small percentage amount in order to cov er theircustomers’ deposits. But what are these reserv es? These reserv es aredebt, too. Let me explain.

T he Basis of All Fiat Money Is Debt

In the U.S. the only money that may be used legally “for all debtspublic and private” is a Federal Reserv e note. These notes—themoney we carry in our wallets—are referred to as “standard money ”.There is no recourse to any thing beyond these paper notes. If aperson wished to “redeem” his Federal Reserve note, he could go tothe nearest Federal Reserv e Bank and redeem it for…another FederalReserv e note. It might be one that was brand new off the printingpress, but it would be the same ty pe of note. If that person depositedhis Federal Reserv e note in a bank, the bank would create a demanddeposit, also known as a checking account. The bank would send tothe Federal Reserv e Bank the Federal Reserve notes that it collectedwhose numbers were abov e what it deemed necessary to meet thenormal needs of its customers for pocket cash. These notes would bedeposited in the bank’s reserv e account at the Fed. (A bank’s “reserveaccount” is nothing more than a checking account.) But the bankwould not be required to maintain a 100% reserv e account balance tomatch the total of all of its demand deposits. It is required to holdonly a fraction in reserv e--along a sliding scale, the fraction becominggreater for larger banks--to meet the withdrawal needs of itscustomers. The rest of his reserv e account balance is “excess”,meaning not required to meet his “reserv e requirement”.

Excess Reserves Becom e the Building Blocks of the MoneySupply

So what can a bank do with its “excess reserv es”? It can create a loanto another of its customers, credit that customer’s demand account,which will increase its reserv e requirement and reduce its excess

reserve position at the Fed by a fraction of the amount of the loan.The bank—actually , the banking sy stem--can continue to lend andcreate demand deposits in this fashion until its reserv e accountbalance matches its “reserv e requirement”. This is how banks createmoney out of thin air, and one can readily understand the enormousability of the banks to expand the money supply from this updatedfractional reserve banking practice.

The key point is that the bank created the new demand deposit bycreating a loan—the loan is an asset on the bank’s books and thedemand deposit is a liability . Thusly , money in our bright new worldof fractional reserv e banking is backed by DEBT! In order for adeposit to be redeemed would require that the loan be repaid. If theloan cannot be repaid, the bank cannot meet its withdrawalobligations and goes bankrupt. This has been the cause of bankfailures since the inception of modern banking.

T he Central Bank Creates Reserv es and Makes the BanksBankrupt-Proof

But, enter a new play er--the central bank. Our Federal Reserv e Bank(or European Central Bank, or Bank of England, or Bank of Japan, orBank of China) was created to prevent bank insolv ency . The centralbank stands ready to loan our bank unlimited funds so that it mayhonor its deposit withdrawal obligations. There are several way s thatthe central bank can accomplish this, such as purchasing bank assetsor simply by a direct loan (called the discount window). It reallydoesn’t matter as long as the Fed can place the proceeds in thereserve account of our troubled bank. Ah, but where did the Fed getthe funds to place in our troubled bank’s reserv e account? Why , itcreated them out of thin air, too! For example, it can credit thefederal gov ernment’s checking account in exchange for federal debt—called “monetizing the federal debt—or it can buy assets as discussedabove, or it can lend directly to the banks at favorable terms. Thecentral bank has become a money creation machine.

A T hing of Frightening Beauty —a Siren Song to Bankers andPoliticians

Thusly , all central banks are the source of what the public callsinflation, creating money out of thin air to prop up bank creditexpansion made possible by fractional reserve banking. The entireRube Goldberg mechanism is a thing of frightening beauty , belovedby college professors who force their students to understand all thegory details, but especially belov ed by bankers and politicians whocan literally paper ov er bad debt with massiv e increases in the moneysupply . It does seem as if we hav e entered a new era in which it can bemade impossible for banks to go bankrupt and fail to pay off theirdepositors. The central bank need only to inv ent some new rationalefor replenishing the troubled banks’ reserv e accounts; thus, theTroubled Asset Relief Program (TARP) and other such programs wereborn. The long-term harm to the economy is found on many fronts,from higher prices (perhaps ev en hy perinflation) to moral hazard tociv ic unrest as interest groups fight one another to feed at thegov ernment’s feed trough. Each dollar of new money, born of debtand not production, reduces the purchasing power of all other dollarsalready circulating in the economy. Nothing has been produced, notone nut or bolt, not one new car…nothing. But more money createsthe temporary illusion of prosperity . One’s home increases in v alue.

One’s 401K increases in v alue. Jobs are plentiful. New office buildingspop up to house all the new businesses that are born. The onlyproblem is that nothing has been built on true sav ings, only debt.Y es, it is a brand new world, but it is a frightening one that cannotlast.

Posted by PatrickBarron@msn.com at 5:16 PM 2 comments:

Labels: Monetary Issues

T UESDA Y , A UG UST 2 5 , 2 0 0 9

A Glimpse of Things to ComeOfficials from the Federal Reserv e Bank are touring the country—v eryquietly , it turns out—to gauge populist opinion of its handling of thecurrent financial crisis and to garner support to increase itsregulatory power to become the sole financial regulator in thecountry . I attended one such ev ent in Des Moines, Iowa, which washosted by Iowa Citizens for Community Improvement (CCI). Thisgroup has been around for sev eral decades and is aligned with anational organization called National Peoples’ Action (NPA). NPAclaims to hav e been instrumental in passing the CommunityReinv estment Act in the 197 0s, which extorted banks to make loansto those with less than stellar credit records and to make mortgageson properties in blighted areas. Both CCI and NPA are proud of theirachiev ements and see no linkage between their lobby ing efforts toforce banks to make marginal loans and the resulting sub-primelending crisis.

Several hundred people—my estimate is at least fiv e hundred—crowded into a Des Moines church and sat for two and a half hourswhile CCI and NPA officials berated the hapless consumer affairsrepresentativ es from the Federal Reserv e Bank’s Board of Gov ernorsin Washington, D.C. and consumer affairs representatives from theFederal Reserv e Bank of Chicago, the local Fed office for Des Moines.About a dozen people were paraded before the Fed panel, telling theirtale of financial woe. In this day of the tell-all reality show, no oneseems embarrassed to confess his personal financial ineptitude infront of hundreds of people and the recording cameras. And sorrytales these were. And like all tell-all reality shows, no one tookpersonal responsibility for his actions, which was just fine with CCIand NPA.

T he Link Between Personal Irresponsibility and BigGovernm ent

A Ms. Kathleen Keest, currently of the Center for Responsible Lendingand a CCI board member from its founding in the 197 0s, listed foursupposed fallacies that prev ent the common man from getting his fairshare of society ’s goodies: the acceptance of personal responsibility ,the desire for personal choice, concern ov er unintendedconsequences, and the free market. According to Ms. Keest, all fourare false gods. It is impossible for man to take personal responsibilityfor something as complex and important as borrowing money ;personal financial planning is too complex to allow the common manto exercise his free choice; the concern ov er the unintendedconsequences of gov ernment action should be dismissed out of hand;and, the free market is the cause of all our problems in the first place.

Now, consider how wonderfully Ms. Keest’s analy sis dov etails intothe Fed’s desire to increase its power. True, the poor punching bags

from the Fed’s consumer affairs offices had a rather nasty day beingyelled at for ov er two hours, but the benefit is that Ms. Keest and theother professional busy bodies actually called for INCREASING THEFED’S POWERS! Undergoing hours of tongue-lashings is worth theprice of obtaining ev en more power and bigger budgets.

Of course most of those in attendance at this meeting did notunderstand that the Fed itself is the underly ing cause of ourproblems. Speaker after speaker laid the blame squarely on theshoulders of the lenders, who forced their money upon anunsuspecting public, all the while knowing that the public could notrepay the loans. The logic of this argument is so ridiculous that I willnot take the time to refute it. But let me at least point out that all themany regulatory agencies also failed to detect the crime ofirresponsible lending at its inception. Now ev ery one’s hindsightvision is 20/20.

Despite the fact that few in the audience understood that massivemoney expansion, which led to massiv e credit expansion, was at theheart of the current crisis, there is one thing that ev ery oneunderstood perfectly clearly ; that is, that the Fed has enormouspower to transfer wealth. Speaker after speaker stated this fact as thereason for inv iting the Fed to the meeting—they all want the Fed toshower its benev olence upon themselv es and not others. Thecommon mantra was that it is time for the Fed to help Main Street andnot Wall Street. The Fed bailed out Wall Street and now all the bigbanks are paying big executiv e bonuses with their bailout money . It’stime for the same thing to happen on Main Street. Exactly what thismeans was not made clear, and I believ e it was left unclear onpurpose, so as not to alienate potential allies in calls for more moneycreation and more government economic intervention.

T he Slippery Slope to T y ranny

This trav esty of a supposed public meeting to gain the peoples’ inputperfectly illustrates the kind of society to which we are plungingheadlong. It has taken the demagogues a hundred years to realize thatcontrol of the money supply is control of people. Therefore, specialinterest groups like CCI and NPA do not focus their efforts on thepeoples’ representativ es. They lobby for increasing the power ofgov ernment agencies who then can be browbeaten into doing theirbidding. One of the most frightening moments of the meetingoccurred when a George Goehl, executiv e director of NPA, whippedthe crowd into a frenzy by showing a short v ideo of NPAdemonstrating in front of Fed Chairman Bernanke’s Washington, D.C.home. The demonstrators ev entually obtained a promise fromBernanke’s Secret Service body guards that they would deliv er a list ofdemands to the Fed chairman. Then Mr. Goehl told the audience thatjust hours before the meeting we were attending he had exacted apromise from the Fed consumer affairs representativ es that Fedrepresentativ es would meet sev eral times a y ear with CCI and NPArepresentativ es. The audience cheered wildly and Mr. Goehl baskedin the adulation.

So, welcome to the future, where public policy will be made by non-elected bureaucrats who make deals with special interest groups whointimidate public officials in their private homes. Do our bidding andwe will support y our efforts to obtain greater power and prestige foryourselv es. Of course, you must give us what we want and not what

other special interest groups want. Like the Bolshev ik revolution inRussia, the most radical groups will work cooperativ ely with otherspecial interest groups, such as farmers and small businessmen, toform a coalition with greater lobby ing power. But such coalitions aretemporary. The most radical groups will take ov er, just as the mostradical and charismatic members will take ov er the surv iv ingpressure group. This is consistent with Friedrich Hay ek’s explanationof why the worst rise to the top in politics—only the most amoralindiv iduals lacking all concern for the rights of others are willing topersecute their fellow man in the name of some supposedly greatersocietal good.

But, of course, there is no greater societal good that justifies the useof power and coercion to control the liv es of the many for the benefitof the few. Ms. Keest and Mr. Goehl struck me as of the ty pe whoalway s rise when a foolish people are willing to giv e control over theirliv es to self-designated masters in the hope of trading freedom forsecurity . It is only just that such a people lose both their freedom andtheir security .

Posted by PatrickBarron@msn.com at 9:43 AM 9 comments:

Labels: Monetary Issues

WEDN ESDA Y , J UN E 1 0 , 2 0 0 9

Dumping the Dollar—a Case of GovernmentSchizophrenia(This essay was written in collaboration with Benjamin Harnwell,Secretary General of the Working Group on Human Dignity, EuropeanParliament)

Many economists, both inside and outside of gov ernment, are v eryworried that foreign gov ernments may dump their dollar holdings,touching off massiv e price increases in the U.S. and possibly bringingdown our financial sy stem. It is a real danger.

According to the U.S. Treasury Department’s own figures, as of Juneof 2008 foreigners hold ov er $10 trillion as currency reserves. Chinaand Japan each hold $1 .2 trillion. The U.K. holds $.8 trillion. TinyLuxembourg and Ireland hold $.6 and $.4 trillion respectiv ely ! Ev enRussia holds huge amounts of dollars—ov er $.2 trillion.

Contrast these overseas dollar holdings with the Fed’s official tally ofthe domestic money supply as of April 2009. M1 (currency and othercheckable deposits) totaled $1.6 trillion. M2 (M1 plus sav ings, moneymarket funds, and small time deposits) totaled $8.3 trillion. So ev encompared to the most expansiv e measure of the domestic U.S. moneysupply (M2) foreigners hold more dollars than domestic holders.

If any country with significant dollar holdings decided to dump themfor some other currency , the result would be inflation in the U.S. onpar with the worst day s of the Carter administration and, if panic setsin and others join, hy perinflation and the destruction of oureconomy.

Jorg Guido Hulsmann explains the process with this example in TheEthics of Money Production. (Just insert the name "China" or "Japan"for his hypothetical country Ruritania.)

"If we assume that Ruritania is a v ery large country with substantialdollar reserv es ev en by world standards, then the mereannouncement that the Ruritanian government will switch to theeuro standard might incite other member countries of the dollarstandard to do the same. This could precipitate the dollar into aspiraling hy perinflation. The dollars would sooner or later end up inthe United States, the only country where people are forced to acceptthem because of their legal-tender status. Here all prices would soar,possibly entailing a hy perinflation and collapse of the entiremonetary sy stem." (Pages 232/3)

As Hulsmann explains, the "leadership of the U.S. Federal Reserve isaware of this situation." (Page 233) OK. That’s reassuring. But if U.S.officials are concerned about the terrible consequences of aPOSSIBLE dumping of dollars on the U.S. market, why are theyUNCONCERNED about the consequences of their own efforts tostimulate the economy , which inv olv es the same mechanism thatthey so fear from foreign actions; that is, massiv e expansion of themoney supply ?

The government has taken two actions that will expand the moneysupply ev ery bit as much as possible foreign actions to dump thedollar--expansion of the monetary base by the Federal Reserv e Bankand the Obama administration’s spending spree. Currently excessreserves held by banks in their accounts at the Fed total close to $1trillion. Reserv es are the building blocks of the money supply .Through their lending actions, commercial banks can create moneyup to many multiples of their reserv es…a good rule of thumb is tentimes. So the money supply could be increased by a factor of ten ormore when the banks start lending, as surely will happen ov er time.Furthermore, the Obama administration’s stimulus package of $.8trillion is funded entirely by fiat money ; that is, money printed fromthin air. Compared to the current lev el of M1 at $1 .6 trillion, thisaction alone will expand the money supply by 50%.

None of this makes sense from the perspectiv e of economicfundamentals. Ah, but it makes perfect sense from the perspectiv e ofexpanding gov ernment power and control!Through its stimulus program, the gov ernment can shower funds onits friends. It can buy v otes. It can reward labor unions by bailing outthe very industries that union action did so much to destroy. It cancreate bureaucratic jobs for its sycophantic hangers-on. Finally , theresulting budget deficits become justification for punishing onesenemies through tax increases.

If foreigners dump their dollars, the gov ernment will hav e no controlov er where they will enter the American money supply , and,therefore, the gov ernment will not be as able to direct the influx ofmoney to politically connected friends. This is the only difference.The American price level will rise tremendously , regardless of thesource, and hy perinflation and economic chaos are real possibilities.

Of course, no nation would be in this predicament had it remained onthe gold standard. Money spent on ov erseas goods (imports) wouldhav e reduced the domestic money supply , lowering domestic prices,and causing a rev ersal of the gold flow (v ia exports) as that country ’sproducts became bargains on the international market. But under thefiat money supply , by which the supply of money is limited only bythe prerogative of the monetary authorities—which means that there

is no real limit—the domestic money supply can continuously expandev en as dollars are sent ov erseas for decades, accumulating in thecoffers of foreign central banks until the dam bursts, so to speak.

The U.S. must take three actions immediately to prev enthy perinflation. Number one, it must rescind the stimulus package. Sofar less than fiv e percent of the stimulus package has been released.Good! Rescind the rest of it. Number two, the Fed must take back the$1 trillion in excess reserv es before the banks start lending. It can dothis buy raising the interest rate through open market operations,offering to sell the banks its huge holding of gov ernment bonds atreduced prices. Number three, the U.S. must reform its monetarysy stem—it must peg the dollar to gold, abolish the Fed, and prosecutefractional reserve banking. This will end the politicization of themoney supply .

With a gold dollar, inflation and deflation will become things of thepast along with the boom/bust business cy cle that credit expansion,not based upon true sav ings, is the primary cause. Unable tomonetize its debt, the gov ernment will be forced to control itsbudget. We will return to a limited rather than an activ ist, destructiv egov ernment. Our Founding Fathers will look down upon us withapprov al.

Posted by PatrickBarron@msn.com at 5:22 PM 1 comment:

Labels: Monetary Issues

SA T URDA Y , MA Y 1 6 , 2 0 0 9

The World Does Not Need a Reserve CurrencyIn last week’s essay I explained that the failure of the U.S. to upholdits commitments under the Bretton Woods Agreement to redeem thedollar for gold at $35 per ounce was the primary cause of the greatinflation in all the world’s currencies. Just to recap events: In 1944the allied powers agreed that the dollar would serve the same role asgold for the purposes of international currency settlements afterWorld War II. At that time the U.S. owned (or safe kept for alliedgov ernments who were at war and whose territories were threatenedby inv asion) most of the gold reserv es of the allied central banks. Aslong as the U.S. would keep its dollar to gold ratio at the agreed-upon$35 per ounce ratio, central banks around the world could settletheir trading accounts in dollars. These central banks would maintainan agreed-upon ratio of dollars to their local currencies just for thispurpose. The world would be on a "gold exchange standard". If onecountry inflated its currency , its trading partners would demanddollars in exchange far in excess of the profligate country ’s ability topay . It would be forced to deflate. Just as the case under a trueinternational gold standard, that country ’s prices would fall, itsexports would increase, thus generating dollar reserves and all wouldbe back to equilibrium. The key to this whole program was thepromise of the United States itself not to inflate. But, of course, this isexactly what it did.

Theoretically , the U.S. should hav e been placed in the same positionas any other country that inflated its currency --instead of runningout of dollars, the U.S. would run out of gold. Its gold reserv es diddwindle, which should hav e set off alarms at the InternationalMonetary Fund, which was charged with the job of auditing the goldsupplies of the U.S. and ensuring that it honored its obligations. Butthe IMF did not do its job. Why ? This enters the arena of psy chology ,

but I imagine that the Cold War had something to do with it. The U.S.alone was capable of protecting the Allies from the growing Sov ietthreat. Perhaps the Allies and the IMF felt an obligation not tocriticize their protector. Who knows? But once France got the atomicbomb and a president—Charles de Gaulle—who felt comfortableacting as an equal on the international stage, it no longer felt that itneeded to cow tow to the U.S. So in 1963 France demanded to berepaid in gold for its ev er-increasing stockpile of dollars. This shouldhav e instilled much needed fiscal and monetary discipline in the U.S.,but it did no such thing. President Johnson committed the U.S. tofighting a foreign war AND instituting new welfare entitlements—his"guns and butter" policy . In 1969 President Nixon could hav erev ersed this policy , but he feared that the inev itable recession wouldmean the loss of a second term, so he simply reneged on BrettonWoods and "closed the gold window" in 197 1 . So much for U.S. honorand prestige!

The world kept spinning ‘round, though, and the dollar continued tobe used as a reserv e currency --there simply was no other. In the1980s President Reagan and Federal Reserv e Chairman Paul Volckerput America’s economy on a two decade long, inflation-free growthpath. It appeared that the world could indeed operate with a fiatreserve currency ; that is, one not tied to gold. But administrationschange and now it is apparent to our trading partners that ourcontinued inflation means that the dollars they hold will becomeincreasingly less v aluable. We are cheating our trading partners.

China was so concerned that it floated the idea of creating an IMF-issued "super reserv e" currency to replace the dollar. A lthough theChinese gov ernment later claimed that it wasn’t really serious, no onebeliev es them. But China has pegged its y uan to the dollar at too low a(yuan) rate. Many state-owned industries in its export-orientedeconomy would go bankrupt if China rev ised its exchange ratio withthe dollar. This would mean lower spending in China and probablywould trigger a recession. So China demurs…at least for awhile.

But the answer to the problem--that has been brewing for more thansix decades now--is NOT to cobble together some new Frankensteinmonster than no one will be able to control. The answer is rightbefore our ey es—return to gold. Each country should set its own ratioof local currency to gold and settle all trades in the actualcommodity. Then no country —not the U.S., not the EuropeanCommunity , not China, nor Japan—will be able to inflate its currencywithout destroying its ability to import goods. It will run out of goldfor settlement purposes and be forced to deflate. No specialgov ernmental agreements are needed. Gold would settle just aschecks settle today —by debiting and crediting each nation’s goldaccounts wherev er they may be. Just as no business can operate withzero money —it is forced to economize—no nation would be able toimport continuously by papering the world with its currency, as theU.S. does today . As the profligate nation’s gold reserves dwindled, itsability to import would dry up; prices would drop, making its goods abargain for export; its gold reserv es would start to climb and allwould be well. Just as explained by Jean Baptiste Say , all trade tendstoward equilibrium.

IMF bureaucrats managing a super currency will be no more reliablethan were U.S. bureaucrats managing the dollar. They , too, willsuccumb to political pressure to ov er-issue an IMF reserve currency ,

and the entire world will be off and running in an inflationary bingethat will destroy world trade. As Professor Thorsten Polleit of theFrankfurt School of Finance and Management say s, we all must makeour peace with gold. It is in the best interest of the common man,because no one can manipulate it. Gold is money and money is gold.Gold is inflation and deflation proof, because it is not built upon debt,as is the current case with all the world’s fiat currencies. So it cannotbe inflated when banks lend against a small reserv e and it cannotsuffer deflation when those loans are not repaid. This is the cy clethrough which we hav e just passed—money supplies inflated byprofligate lending and now money supplies deflated when those loansgo sour. This cannot happen with gold as long as gov ernments strictlyenforce currency conv ertibility and shut down banks that engage infractional reserve banking.

So why doesn’t the world return to gold? Because gov ernmentsbenefit the most. The fiat money that we all use may be manufacturedin infinite amounts by gov ernments. Would we expect acounterfeiter, who was protected by law in his ability to print money ,to deny himself its benefits? Of course not. Gov ernments are nodifferent. They are the primary beneficiaries of their fiat moneymonopoly . They may spend as they please. They are not obliged totax the people or borrow honestly from them. It is a heady andcorruptiv e power that appeals to the ty rants among us. No, reformmust come from the people. Either that or reform will come only aftera total collapse of our monetary sy stem, which would cause untoldhardships and possibly ev en massive death around the world as theability of the people to engage in indirect exchange was destroy ed. Somonetary reform is no academic issue. It is a life and death issue.

A good start to reform would be for the citizens to become informedof monetary matters. Demand that real economics be taught in ourschools. Demand that our politicians stop lying to us about the causesof our problems. End the demagoguery that seeks out enemies in thebusiness class and attempts to place guilt upon the public, calling us"addicted to spending" and/or too "consumer oriented". This isnonsense. The people are perfectly capable of determining andguiding their own financial futures as long as the medium of exchangeallows them to plan and understand the reality of their situation. Ourgov ernment is the problem. We should demand that it confine itsactions to those enumerated in the Constitution. Our foundingdocument, the highest law of the land, does NOT giv e the gov ernmentthe power to print money. It assigns gov ernment theRESPONSIBILITY of protecting us from counterfeiters; it does notgiv e gov ernment the power to BECOME A COUNTERFEITER. Enforcethe Constitution. End the Fed. Return to gold. Restore our freedomsand our rights. Is this really such a radical demand?

Posted by PatrickBarron@msn.com at 6:58 PM No comments:

Labels: Monetary Issues

SUN DA Y , A PRIL 1 9 , 2 0 0 9

CAN WE RETURN TO SOUND MONEY?No one aliv e today has ever experienced sound money ; that is,money backed by a commodity of lasting v alue, such as gold orsilver. So it is not surprising that ev en many who understand theconcept and adv antages of sound money hav e many seriousquestions about the possibility of reinstating a gold standard. Theirquestions usually occur in this order: Is fiat money so ingrained in

our economy and our way of life that re-conv ersion is not possible?What are the obstacles? Would the U.S. be able to reconv ert on itsown or would most of the world have to join us? What would atransition entail?

If it really isn’t possible to reconvert and/or the obstacles andtransition costs are too great, lets just forget the whole thing andconcentrate our efforts on getting reformist politicians andbureaucrats in positions of power. In other words, get better men torule in a benign dictatorship. Regrettably this really is not an option.Our current fiat money sy stem will fail. No such sy stem has ev er metthe test of time. All…let me repeat that…ALL such fiat moneyexperiments hav e failed. Once men realize that they hold the powerto create and spend money in unlimited amounts, no appeal to thebetter angels of their nature will prev ent them from abusing theircommissions. So, our only option is to reconv ert.

Fortunately , fiat money is not so ingrained in our economy that itcannot be replaced by a gold standard. The main obstacle to doing sois not some mechanical barrier. A lthough such a transition would beeasier the more countries that agreed to participate in a coordinatedre-conversion, the U.S. could go it alone. And, finally , there aresev eral intellectually solid transition strategies from which to choose.

There is no question that many American institutions cannot surv iv ein their present form under a sound money env ironment. It is thesebeneficiaries of our fiat money sy stem that present the most seriousobstacle to re-conv ersion. I refer, of course, to gov ernment itself. Afiat money sy stem enables government to expand its power bystealing the product of the people’s effort without ov ert taxation orhonest borrowing. Such is the situation today. Our gov ernment--withthe cooperation of our central bank, the supposedly independentFederal Reserv e—spends money created out of thin air andinterv enes to driv e down the rate of interest. So far this strategyappears to work, and this is a shame. For the inevitable rise in pricesand the interest rate will be delay ed, perhaps for more than a y ear.Then the gov ernment’s apologists will blame price rises on ev ery onebut themselves—greedy oil companies, greedy oil sheiks, greedymerchants, etc. If y ou think that the people will not be so foolish as tobeliev e such nonsense, this is exactly the message that thegov ernment has so successfully spread as the cause of our currentfinancial crisis. Therefore, y ou can imagine the tremendouspropaganda effort from our gov ernment to discredit efforts to endtheir grav y train. Our response should acknowledge the source—suchcries of panic are to be expected and should be ignored.

So, we hav e determined that there really is no choice but to re-convert to sound money , and we hav e discounted the objectionsfrom gov ernment itself, the primary beneficiary of our fiat moneysy stem. Can we go it alone or do we hav e to get the cooperation of ourmajor trading partners? Professor George Reisman has addressed thisissue (and more) in great detail in his magnum opus Capitalism andmany other v enues. He concludes that an internationally coordinatedre-conversion would prev ent the likely rise and subsequent fall inprices in the U.S., a one-time cy cle caused initially by "outside gold"flowing into the U.S. and inflating the U.S. money supply to befollowed by a later fall in U.S. prices as our sound money regime takeshold. If the European Central Bank, the Bank of Japan, the Bank ofEngland, and the Bank of China coordinated re-conv ersion with us,

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there would be no such "outside" gold to initiate the cycle. But, even ifthese countries demurred in our re-conv ersion effort, Reismanexplains that the U.S. would be the ev entual winner, because thecy cle would end and the dollar would gain against all other currenciesas time progressed. Furthermore, the U.S. would not suffer thefrequent boom/bust business cy cles caused by our current,manipulated fiat money sy stem.

Finally , how would we do it? There are sev eral scenarios. Someeconomists claim that all the U.S. has to do is repeal its legal tenderlaws (laws that prohibit any other money from circulating within theU.S. other than our fiat dollar). A free money env ironment wouldallow the wonders of competition to work. The best monies woulddrive poor ones from the marketplace, a rev erse of Gresham’s Law.Good money would drive out bad in the same way that any superiorgood driv es lesser ones from the market. Whether only thosecurrencies backed 100% by gold would circulate or if some lessercurrencies also would circulate would be at the discretion of the realrulers of the marketplace—the consumer.

Most other scenarios giv e some role to gov ernment, at least for thetransitional period. The U.S. confiscated the gold of the U.S. citizenryin 1934, forcing them to surrender their gold in exchange fordepreciating federal reserve notes. So gov ernment, in effect, stole thenation’s gold and still holds v ast quantities of it in its v aults. This goldwould be returned to the people in proportion to their moneyholdings v ia some mechanism, of which there are many worthy ones.Then the U.S. dollar would be fully conv ertible to gold at somemarket determined parity price, such parity price then established bylaw as the legally enforced price of the dollar. Any dollar holder couldredeem his dollars for gold at the parity price. At this point the U.S.dollar would become, in essence, a warehouse receipt for gold. TheU.S. would be on the gold standard.

The sooner the U.S. re-conv erts to the gold standard, the sooner theU.S. economy will recov er and, more importantly , the sooner theliberties of the people will be restored. No longer will the governmentbe able to hide the true cost of its spending and blame others for theinev itable deleterious consequences. It must either tax the people orsuffer higher interest rates. Then the people can decide whether suchspending is warranted, because they will see first hand that they mustpay the cost of such spending. Of course, it has always been the casethat the people must pay for gov ernment spending, but now this factwill be immediately discernable and subject to the people’s control.That is the America in which I want to live. How about y ou?

Posted by PatrickBarron@msn.com at 6:34 PM No comments:

Labels: Monetary Issues

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