The Federal Reserve system & "fiat money" vs. the gold standard

[BrainGlutton]

I would have thought goldbuggery were a dead issue in this day and age, but apparently in some circles it’s very much alive – in this recent thread, about global warming, at the second or third page the OP, jrodefeld, started talking about the evil Federal Reserve and how much better the American economy would be if we had never gone off the gold standard. The connection of this to global warming is unclear to me and so are the economic arguments. Does anyone care to defend the proposition that a gold standard, or other metallic-backed standard, inflexible and deflationary as it is, is preferable having a “fiat” currency with its value determined (to some extent) as a matter of policy by a central bank or government agency?

From what I’ve seen, distrust of the Fed is a form of economic populism based on a general distrust of the financial sector based in turn on producerism, the idea that people who make things you can hold in your hands are the only makers of “real” wealth and all others are parasitic on them. This kind of thinking is actually very old in America. British conservative Paul Johnson commented in his A History of the American People:

The Founders, particularly the Virginians, Washington, Jefferson, Madison, Monroe, et al., equated property, as a moral force, with land. Their views were articulated by John Taylor (1753-1824), like them a Virginia landowner who served in the Senate and published in 1814 a monumental work of 700 pages, An Inquiry in the Principles and Policy of the United States. Taylor distinguished between ‘natural’ property. such as land, and ‘artificial property’ created by legal privilege, of which banking wealth was the outstanding example. He saw the right to issue paper money as indirect taxation on the people: ‘Taxation, direct or indirect, produced by a paper system in any form, will rob a nation of property without giving it liberty; and by creating and enriching a separate interest, will rob it of liberty without giving it property.’ Paper-money banking benefited an artificially created and parasitical financial aristocracy at the expense of the hard-working farmer, and this ‘property-transferring policy invariably impoverishes all laboring and productive classes.’ He compared this new financial power with the old feudal and ecclesiastical power, with the bankers using ‘force, faith and credit’ as the two others did religion and feudality. What particularly infuriated Taylor was the horrible slyness with which financiers had invested ‘fictitious’ property, such as bank-paper and stock, with all the prestige and virtues of ‘honest’ property.

Taylor’s theory was an early version of what was to become known as the ‘physical fallacy,’ a belief that only those who worked with their hands and brains to raise food or make goods were creating ‘real’ wealth and that all other forms of economic activity were essentially parasitical. It was commonly held in the early 19th century, and Marx and all his followers fell victim to it. Indeed plenty of people hold it in one form or another today, and whenever its adherents acquire power, or seize it, and put their beliefs into practice, by oppressing the ‘parasitical middleman,’ poverty invariably follows. Taylor’s formulation of this theory fell on particularly rich soil because American farmers in general, and the Southerners and backwoodsmen in particular, already had a paranoid suspicion of the ‘money power’ dating from colonial times, as we have seen. So Taylor’s arguments, suitably vulgarized, became the common coin of the Jeffersonians, later of the Jacksonians and finally of silver-standard Democrats and populists of the late 19th century, who claimed that the American farmer was being ‘crucified on a cross of gold.’ The persistence of this fallacy in American politics refutes the common assumption that America is resistant to ideology, for if ever there were an ideology it is this farrago.

It is especially interesting that, although the political-cultural resemblance between 19th-century advocates of “free silver” and today’s goldbugs is unmistakable, their strictly economic goals are antithetical: The point of free silver was to inflate the currency; the point of going back on the gold standard at this point, near as I could figure, would be to deflate it. And deflation is generally not good for an economy.

SF writer Robert Heinlein, BTW, was a hard-money man. See this CS thread from 2006.

[Larry_Borgia]

This thread, with the same OP as the one you linked to, is more on topic. Hellestal’s posts are a very enlightening and thorough examination of the topic.

http://boards.straightdope.com/sdmb/showthread.php?p=12272268#post12272268

[BrainGlutton]

@Larry_Borgia

This thread, with the same OP as the one you linked to, is more on topic. Hellestal’s posts are a very enlightening and thorough examination of the topic.

http://boards.straightdope.com/sdmb/showthread.php?p=12272268#post12272268

Yeah, but it’s all over the place. Let’s focus this one on monetary policy.

[GIGObuster]

This Professor of Economics, Brad DeLong, has some points that proponents of the gold standard should not ignore:

http://econ161.berkeley.edu/Politics/whynotthegoldstandard.html

Why Do Some Still Advocate a Gold Standard?

* A belief that governments and central banks should not control the average rate of inflation over decades, and that the world will be better off if the long-run drift of the price level is determined "automatically."
* A belief that bondholders and investors will be reassured by a government committed to a gold standard, will be confident that inflation rates will be low, and so will bid down nominal interest rates.
* Of course, if you do not trust a central bank to keep inflation low, why should you trust it to remain on the gold standard for generations? This large hole in the supposed case for a gold standard is not addressed.
* Failure to recognize the role played by the gold standard in amplifying and propagating the Great Depression.
* Failure to recognize that the international monetary system functions best when the burden-of-adjustment is spread between balance-of-payments "surplus" and "deficit" countries, rather than being loaded exclusively onto "deficit" countries.
* Failure to recognize how gold convertibility increases the likelihood of a run on the currency, and thus amplifies recessions.

[Llama_Llogophile]

@BrainGlutton

From what I’ve seen, distrust of the Fed is a form of economic populism based on a general distrust of the financial sector based in turn on producerism, the idea that people who make things you can hold in your hands are the only makers of “real” wealth and all others are parasitic on them.

I don’t wish to hijack, but I do want to say that this idea is very interesting in itself and may deserve a separate thread.

To a person like me, whose understanding of economics is akin to an ant’s knowledge of synchronized swimming, it’s hard to see certain parts of the financial system as anything other than parasitic. From what I can tell, a number of big banks asked themselves how they could make more money by monkeying around with various esoteric money products, and came up with mortgage backed securities. We all know the rest of that story.

I see that as organizations that do a lot of things financially, but employ some people who do nothing more than play around with money in ways that helps nobody but themselves, and occasionally hurts others. I call that parasitic. Not that I want to go back to the gold standard though…

Anyway, I’d like to be set straight on some of those issues if anyone would care to. End of hijack.

[Hellestal]

This isn’t an interesting question. It is not even a debate, as such, because all of the most relevant economic issues have already been resolved. So I’ll just repeat what I said about the gold standard in the other thread, with some slight editing for clarity:

The gold standard is a stupid stupid stupid system. We dig a yellow metal out of a cave in the ground. We then build another, artificial cave in a place called a “bank”. We then move the little yellow pieces of metal from one cave to the other. But that’s a key point. The gold is never truly “free” to be bought and sold in the market. It stays in its new cave, which raises the question: Why did we even dig it out of the first cave anyway? We then print pieces of paper, and promise that we will supply the yellow metal out of our new man-made cave for anyone who has our pieces of paper. But the system only works, see, if no one generally wants to take the metal. A person here or there is free to take their gold, sure. But if everyone would rather have the yellow metal than the paper, then the standard collapses. So in order for it to work, we must have that metal in the artificial cave be in such a way that it stays, perpetually, in that artificial cave. Doing nothing. If it were taken out of that cave, after all, it wouldn’t work. We’d just have gold currency, not a gold standard. And then we’d be left with all the problems of having gold currency, namely, that carrying around that much gold is a gigantic pain in the ass. So the yellow metal must sit in its new cave, gathering dust. Forever. That’s a functioning gold standard. I don’t want to discount the idea of a currency peg in all situations. It can work in some contexts. But reliance on the gold standard, for its own sake, is just dumb. It makes no bloody sense at all.

The Fed needs to “print money” in emergencies. Among professional economists, there are numerous topics of genuine disagreement. This is not one of those topics. If you take away the ability to expand the money supply at will, then you are dooming us to continually repeat the mistakes that caused the Great Depression. This is the view of everyone from hardcore libertarians like Milton Friedman to noted liberal economists like Paul Krugman. To deny this is to deny all of our modern economic theory and history.

Now here’s the actual interesting part: It is reasonable to believe that the Fed should not act on their own discretion when printing money, but rather work within clearly established guidelines and rules, e.g. 5% annual nominal GDP growth.

The Federal Reserve is, indeed, a monstrously power institution. And it is perfectly reasonable for people to want to come up with methods to ensure that the Fed does not abuse its powers. One of these questions is the real classic, best formulated by the libertarian economist Milton Friedman, of discretion vs. rules. Discretion is giving the Fed leeway to operate based on their own readings of the situation. Friedman, as a libertarian who wanted to curb the power of government, did not favor discretion. He wanted the Fed to follow specific guidelines, predictable rules that everyone in the market could rely on. So which is better? Well, I’d say the libertarians like Friedman have a point. I’d say that a rules-based system of monetary policy can be generally better, depending on the specific rule chosen. Friedman’s original rule, for example, was wrong. It would not work. And that’s the real kicker, isn’t it? If you’re stick with the wrong rule at the wrong time, then you can end up with a monetary policy that exacerbates the problems your economy is currently facing instead of fixing those problems. So yeah, I do think a rules-based system is better, but I also believe that we must absolutely be certain to choose the right monetary rule.

And I think the right monetary rule is likely to be nominal GDP targeting, although I do not know for sure.

What’s interesting about this rule is that, even though the Federal Reserve has “printed” enough money to more than double the monetary base to fight this current downturn, (seriously, check this shit out), printing that money still was not enough. If you use nominal GDP targeting as a rule, then the Fed’s actions lately have been insufficiently aggressive. Which is a good way of putting into perspective how seriously our money supply had been damaged by the financial crisis. We suffered our biggest drop in nominal GDP since the Great Depression, and according to this rule, the Fed should’ve taken even strong measures to fight that drop in NGDP, to ensure that we reached our target of a 5% increase.

[DanBlather]

It should be noted for the less informed, that the reason you are quoting “printing” is because the Fed does not actually physically print money in response to increasing the money supply. They affect the money supply by doing things like setting the reserve rate.

[samclem]

It’s really rather simple.

The Gold Standard didn’t work. It had no elasticity. It didn’t allow for ups and downs of economies. This causes inflation and depressions. Many more, and more severe, than in the modern economies which have the Fed ready to tinker with the innards.

[Hellestal]

@DanBlather

It should be noted for the less informed, that the reason you are quoting “printing” is because the Fed does not actually physically print money in response to increasing the money supply. They affect the money supply by doing things like setting the reserve rate.

Well, they affect the money supply by creating more money, poof, out of the void, or by destroying money with the reverse process. This is what changes interest rates–they use their new money to buy assets to change the yield on those assets.

It’s just that they create more money with wire transfers instead of printing presses. It’s all electrons and computers nowadays. Push a button, and they’re done.

[Simplicio]

@Hellestal

What’s interesting about this rule is that, even though the Federal Reserve has “printed” enough money to more than double the monetary base to fight this current downturn, (seriously, check this shit out), printing that money still was not enough. If you use nominal GDP targeting as a rule, then the Fed’s actions lately have been insufficiently aggressive. Which is a good way of putting into perspective how seriously our money supply had been damaged by the financial crisis. We suffered our biggest drop in nominal GDP since the Great Depression, and according to this rule, the Fed should’ve taken even strong measures to fight that drop in NGDP, to ensure that we reached our target of a 5% increase.

Just curious if I’m interpreting this correctly:

So the Fed is creating much more money then it usually does, presumably to increase the rate of lending. But since the banks are resisting lending, less money is in the system then would normally be the case, which is why we don’t have a huge inflation spike to go along with the spike in creation by the Fed?

[Hellestal]

@Simplicio

Just curious if I’m interpreting this correctly:

So the Fed is creating much more money then it usually does, presumably to increase the rate of lending. But since the banks are resisting lending, less money is in the system then would normally be the case, which is why we don’t have a huge inflation spike to go along with the spike in creation by the Fed?

Precisely.

That graph tells an interesting story, but it’s only part of the situation. Another part, exactly as you say, is the unwillingness of banks to loan their money. If you look at a graph of “excess bank reserves”, that is, money held by depository institutions in excess of the minimum they need to keep on hand due to deposit regulation, you will see a similar spike. Hell, I might as well cite that graph too. Here it is. Notice that excess reserves is normally zero. Banks can’t make money on funds that they aren’t lending out, so they typically lend out as much as they can. But in our situation, they are essentially sitting on the money and not doing anything with it. It is gathering dust in the bank vaults (or on bank hard drives).

And what’s interesting is that this time the banks are, in fact, making money on those idle excess reserves, because the Federal Reserve has started to pay interest on excess reserves. They’re paying interest of 0.25%. Why? Well… I don’t know. It counteracts the purpose of printing the money. Why print it and give it to banks, and then pay banks not to use it? It’s an inflating fighting measure, and this particular measure will be very helpful to the Fed when it needs to stop inflation in the future when the economy heats back up again. But right now, just at present, we don’t need inflation fighting measures. So the Fed is actually pursuing two different contradictory courses. Why? Because they have the discretion to do so. I can’t speak about their underlying reasoning, but I believe it to be wrong. The Fed should not be paying any interest on bank reserves, in my estimation, until unemployment gets backs down to 7% or so, or nominal GDP gets back up to where we should be. I want to stress, though, that I could be wrong about that. It’s just my evaluation of the situation.

[Chief_Pedant]

@GIGObuster

This Professor of Economics, Brad DeLong, has some points that proponents of the gold standard should not ignore:

http://econ161.berkeley.edu/Politics/whynotthegoldstandard.html

Professor Brad missed one point opponents of a gold standard should not ignore:

There is an upper limit to how much money governments can borrow before they go broke. Decoupling currency from gold creates a giant tulip bubble.

CP is betting on gold, and frankly over the past few years the bet has done me good. Of course it’s a totally artificial, silly standard. It has stood the test of time, though, and there does seem to be a real attachment to it across the past few thousand years. Never bet on economic science to appease the masses around why gold actually has no value. When the wolf comes to the door, I’m betting gold wins over a dollar bill.

I am also betting the wolf will, in fact, show up in the next 25 years for the US economy. This year President Obama proposes we borrow about 1/3 of what we plan to spend. (1.2 Trillion out of 3.5 Trillion total). We are not in wartime–at least not fighting any war which threatens us militarily. We are not facing any world crisis (other than the financial one brought on by the greed of reckless borrowers and unregulated speculation). We have no physical crisis such as earthquake or famine. We are not even using any of the money to address what we have popularly come to perceive as the greatest of all threats: AGW. We are, in short, spending that kind of money in a time of plenty.

This should be a staggering and sobering number; it was not projected 5 years ago. Yet we take some sort of comfort in projecting a diminution of borrowing out in the vague future somewhere. Sure; that’s gonna happen.

Kids, what gold offers is a standard. Forget about whether the dollar should be tied to it; it’s just an artificial hold-in-your hand standard. And whose currency are you going to bet on when almost all the rich countries are borrowing like there’s no tomorrow and the countries who aren’t borrowing have economies completely dependent on countries which are?

This is the question I ask myself. It’s not whether or not gold is a good standard. It’s kind of a silly one. Rather, it’s whether or not our bankruptcy is inevitable in our lifetime. A real bankruptcy, where taxpayers walk away from the Union because their taxes only go to pay interest on a debt, with no return in services.

I’m betting it does. But hey, feel free to bet on the dollar instead and laugh me outta here for not understanding economics. IIRC, there was a good deal of similar mockery on the part of wall-street firms patting more conservative investors on the head a couple years back and explaining to them why they just did not understand the new paradigm for the financial world.

[Chief_Pedant]

I should have added that I agree that decoupling currency from gold worsens short-term pain, aka depressionary cycles.

Unfortunately, that’s what a bubble is: a completely artificial smoothing anesthetic salve which makes us all feel better until we realize collectively that there is no there there. And the wound which has been festering all along bursts with much a much greater catastrophic effect, since intermittent lancings were avoided because we just didn’t want to feel any pain.

[Der_Trihs]

@Chief_Pedant

Kids, what gold offers is a standard. Forget about whether the dollar should be tied to it; it’s just an artificial hold-in-your hand standard. And whose currency are you going to bet on when almost all the rich countries are borrowing like there’s no tomorrow and the countries who aren’t borrowing have economies completely dependent on countries which are?

This is the question I ask myself. It’s not whether or not gold is a good standard. It’s kind of a silly one. Rather, it’s whether or not our bankruptcy is inevitable in our lifetime. A real bankruptcy, where taxpayers walk away from the Union because their taxes only go to pay interest on a debt, with no return in services.

I’m betting it does. But hey, feel free to bet on the dollar instead and laugh me outta here for not understanding economics. IIRC, there was a good deal of similar mockery on the part of wall-street firms patting more conservative investors on the head a couple years back and explaining to them why they just did not understand the new paradigm for the financial world.

I don’t think that gold will be much if any more valuable than green paper in such a post-collapse world. Bullets and food yes; not gold. The vast majority of people won’t even have gold; so there’s no way it could be a standard. And when you get right down to it, the “standard of currency” in such a world is going to boil down to “do what I say and we won’t shoot you after we finish raping your women”. No government means no order.

[Hellestal]

@Chief_Pedant

Professor Brad missed one point opponents of a gold standard should not ignore:

There is an upper limit to how much money governments can borrow before they go broke. Decoupling currency from gold creates a giant tulip bubble.

He didn’t miss the point. It’s simply irrelevant.

A government can only maintain the standard if people are willing to leave the gold in the cave. If the government has no public trust, then the standard is destined to fail. The standard, in other words, is not a check against excessive debt, nor does it provide an upper-bound of debt. Rather, a successful maintenance of the standard is merely one economic signal, among many, that the government at that moment has credibility. But there are other such signals of credibility that can be maintained. This is the paradox of attempting to return to the standard. Any government that lacked credibility would have difficulties in establishing the standard, because the fundamentals of the government would still be poor enough that people would have little to no faith that the standard would be maintained. Belief that the government could not maintain the standard would cause a run on gold reserves, a self-fulfilling process which would in turn destroy the standard that they were trying to create. They wouldn’t be able to keep the shiny metal in their caves.

But a government that’s successfully working without the standard has nothing to gain from going to the standard anyway. All the benefits that the standard is supposed to provide are already provided by a well functioning fiat money system. And if the government is tragically poorly managed, the money system is eventually going to fail, too, regardless of whether it’s a fiat system or based on gold.

This is not to say that, as general investment advice, gold is a bad choice. I’m not into the commodities markets myself, don’t know much about them, but gold has rallied lately. Of course, in the past, gold has rallied in recessions and inflationary situations, only to fall sharply again after economic recovery returns. Lots of people have lost a good chunk of money to gold bubbles–because, yes, gold itself is subject to the same irrational forces that push its current market price above long-term fundamentals. When the bubble pops, the losses can be tallied. Gold will never go to zero because of its universe-given scarcity, but it can nevertheless decline sharply in value, as past data in the gold market clearly shows.

[DanBlather]

@Hellestal

Well, they affect the money supply by creating more money, poof, out of the void, or by destroying money with the reverse process. This is what changes interest rates–they use their new money to buy assets to change the yield on those assets.

It’s just that they create more money with wire transfers instead of printing presses. It’s all electrons and computers nowadays. Push a button, and they’re done.

And how exactly do you maintain that they poof new money into existence?

[Hellestal]

@DanBlather

And how exactly do you maintain that they poof new money into existence?

By pushing a button. On a computer.

Seriously.

Money is what the Fed says it is. They are the central bank, and when they want to make new money, new money is made. The actual process is complicated, but the making money part is easy. It’s money because they have the power to make money. End of story. Kinda easy to see why libertarians would prefer a strict rule instead of Fed discretion, but right now, Fed discretion is how we operate.

[Lemur866]

If you don’t trust fiat currencies, then buy tangible goods or real property. If you think the dollar is going to inflate to worthlessness, gold is just one of thousands of different goods that will appreciate against the dollar.

And note that unless you’ve actually got the gold coins buried in your back yard, you’ve got nothing. A scrap of paper that says that someone promises to give you a certain amount of gold on such and such a date and under such and such conditions is going to be worthless in an economic meltdown.

And gold itself isn’t proof against government interference–witness how FDR made ownership of gold illegal. A currency with a gold standard is just another way of saying that the government can’t tolerate a free market in gold.

[msmith537]

@DanBlather

And how exactly do you maintain that they poof new money into existence?

That’s what banks literally do. When a bank loans out money, it only actually has to have a fraction of that money in deposits. So if say the banks reserve ratio is 10% and I deposit $1000, the bank can lend out $10,000. Where did that money come from? Nowhere. It literally created the money out of nothing. (Technically the Bureau of Engraving and Printing prints up the bills, but that is actually a tiny % of the total amount of money out there. Most money simply exists as entries in a database somewhere.)

The reason the system works is that the bank expects that you will eventually pay that money back with interest. And presumably you are borrowing the money to create something of value. Like improvements to your house or an education that will allow you to be a more productive member of society.

The system falls apart if all of a sudden you aren’t creating value and you can’t pay back the loan. Then the bank suffers a loss and is less likely to lend more money out.

Mach Tuck - The problem with RMBS is that it mixes all a bunch of loans together. That in itself is not an issue, but if not structured properly, the bank or whoever has no idea of how likely it is for the people who took out the loans to actually pay them back.

[Bryan_Ekers]

@samclem

The Gold Standard didn’t work. It had no elasticity.

It was fairly ductile, though.