True, but a federal currency backed by the gold still requires faith in the government - faith that they will in fact provide the equivalent amount of gold on demand. If the government doesn’t do that, but says that the currency is backed by the gold reserves, you’re still looking at a currency that depends on faith.
It’s one thing to use gold as money. It’s another to use paper money “backed” by gold. All that means is that you rely on the promise of the government to exchange your paper for a certain amount of gold.
But what happens when the government changes it’s mind? The first thing that happens in a war is that governments go off the gold standard and convert their gold backed currency to fiat currency. The whole point of the gold standard is that the value of your paper money can’t vanish with the stroke of a bureacrat’s pen. Except it can.
If you don’t trust paper money, and only want to use gold and silver coins, then knock yourself out. You can do this yourself. Every time you get paid at your job, don’t take your paycheck to the bank, take it to the gold dealer, and buy gold and silver, and store the metals at your house. Then every time you want to buy something, sell metals to the dealer, and take the money right away to the grocery store to buy your food and pay your rent.
Or you could just pay your day to day bills with fiat money, and only convert your savings into gold. But that’s stupid unless you’ve only got a small amount of savings. If you’ve got a lot of wealth you need to invest it, not bury gold ingots in the backyard. And then you own real assets, not lumps of metal.
The thing is, money has two uses. It is a medium of exchange, and a store of value. Gold was used as money because it was a very useful key good. But it certainly isn’t unique. There’s nothing particularly special about gold. If you want a store of value you can buy any number of things other than gold. And if you want a medium of exchange you could use gold or silver, but what’s the point? Nobody else wants it, and so it isn’t a good medium of exchange anymore. They want paper–or really electronic–money nowadays. And so if you want to buy things you need to use what everyone else uses, which means fiat money.
Back in the 70s it was common to believe that double digit inflation was the inevitable result of fiat money, and that pretty soon the whole house of cards would collapse. Turns out that didn’t happen. We summoned up the testicular fortitude to stop inflating our currency, and for the last few decades we’ve had minimal inflation, so much so that some people have bothered to start worrying about deflation.
It’s certainly possible that we’ll decide to dig our way out of the recent massive deficits by inflating the currency so we can pay back the debts with less valuable dollars. But being on the gold standard wouldn’t stop this, it would just mean that the bureacrats would have to announce one day that gold payments were suspended temporarily.
Thing is, you can convert your fiat currency to gold today. You just can’t get the government to do it for you, you need to buy gold from a private dealer. During a crisis the amount of gold you can get for your fiat currency might change drastically. But the amount of gold you could get for your gold standard currency is pretty much guaranteed to change drastically during a crisis anyway, because the number will change from the agreed upon standard to zero whenever the government decides. So the “gold standard” is a fraud.
I suppose that if a particular economy wanted to, it could go to a physical standard.
It would have to tie it’s currency to something. I dunno, maybe oil. Or coal.
Of course, both of the above resources fluctuate wildly these days. This would play havoc on any currency that was tied to them.
I suppose further that a currency could be tied to energy - $1 = X KWH, or something like that.
The fact is - even with the incredible dive most economies took over the last two years, fiat currency has held up. Even with the world economy plummeting, there has been no serious challenge to fiat currency.
I think fiat currency is here to stay.
But gold is shiny.
Paradoxically, you want whatever you use for money to not have much intrinsic worth. It needs to be valuable as money simply because it’s money, not because it has a usefulness that can cause it’s value and availability to fluctuate widely. You especially don’t want your money to be something that’s expended in the course of being utilized. That and other properties are why gold and silver became the default for money in the first place.
Frankly the ideal for the gold standard would be if there was some inexhaustably huge source of gold- like a solid gold asteroid, or a mountain of gold buried in the Earth’s upper mantle- who’s cost of recovery was high enough that the supply relative to the market would be self-regulating. No such luck though.
Thanks for the post.
But…wow.
I have never seen such high confidence by SDMB posters (many of whom I recognize from other well-written posts) in such wrong assertions. Provably wrong assertions, I might add.
Looking at the posts above, I count at least a half-dozen completely wrong assertions, conclusions, or mis-statements of history.
Rather than try and respond to them all, I’ll throw out a few reactions here, and then hopefully come back later with some more.
- There cannot be a full discussion of the gold standard without joint consideration of fractional-reserve banking. It would be impossible to go back onto a gold standard, or any other commodity standard, if fractional reserve banking were allowed to continue.
The main reason the US went off the gold standard (I’m simplifying this, of course) is that because it borrowed too damn much money, and allowed the creation of too much fiat money via fractional reserve banking. It also kept the US exchange rate constant with the British pound following WWI, when there was no real reason to do so.
When people lost confidence in the little pieces of paper in their hands, or demanded repayment of debts in gold, there wasn’t enough in the vaults. That’s why the US needed to devalue the currency (from $20 to $35 per ounce, at first) and ultimately go off the standard together.
FDR also voided contracts that said the creditor could be paid back in US currency or gold. Those contracts were commanding about a 15% premium in the days leading up to the Great Depression.
- The ‘shortage of gold’ argument is nonsense. Gold is almost infinitely dividable into measures of fractional grams, if necessary into tiny amounts. The ‘shortage of gold’ observation is a symptom of another problem, and not a cause.
One of the reasons commodity standards like gold disappear from circulation, and therefore create apparent ‘shortages’, is precisely the inflationary effect from government mismanagement of fiat money, as discussed in point 1 above.
When people lose faith in their currency as a store of value, and whilst that currency is still convertible to gold, they will hoard gold in order to safeguard their store of value. That creates the appearance of a ‘shortage of gold’. But what it really is, is a shortage of faith in the currency. That’s what happened during the early part of the 20th century, and is one of the reasons the gubmint needed to go off the gold standard. It’s important not to get cause and effect backwards.
- The notion that the Fed Reserve was created to avoid ‘booms and busts’ from the 19th century is also nonsense. There were no long busts and depressions in the 19th century that even began to rival the Great Depression, or perhaps even the present financial crisis. Why people keep repeating that as if it were gospel, I don’t know.
Data is not a robust from that time period, unfortunately. But the most painful contraction in the 19th century was the Long Depression of 1873, which was exacerbated by government meddling in the market for railroad bonds…not unlike today’s government meddling in the housing market via Freddie and Fannie. The other ‘booms and busts’ were relatively normal business cycle contractions.
- The Fed was created by a powerful coterie of bankers (primarily from New York) to backstop their practice of fractional reserve lending, thereby ensuring their continued profitability above-and-beyond what might be expected given their finite amount of reserve capital.
A highly readable, short, and enlightening tract is Murray Rothbard’s ‘The Case Against The Fed’. It’s painstakingly researched, and is chock full of names, dates, meetings, transcripts, quotes from newspapers and such during the time the Fed was first agitated for (around the turn of the 20th century) until its inception. You can probably plow through it in a 2-hour plane ride.
Read it for yourself, and then decide whether you still think the Fed was created to help us manage through the booms and busts so prevalent from the 19th century. You might roll your eyes, as I do, the next time someone presents that as an argument.
- In a stable economy, with a relatively stable currency, one would expect a long, slow, gradual deflation of unit prices. There is nothing inherently bad or good about this. In fact, it was observed for much of the 19th century. Deflating prices can be built into expectations for investment and savings.
It’s the large whipsaw from inflation, to deflation, and then back to inflation, that causes problems. It muddies investment and consumption decisions and distorts the value of money. When the Fed is called to ride into the rescue to ‘save us’ from deflation, we are already at step 2 of the problem. Step 1 was caused by the Fed itself.
There are lots of other misconceptions and errors in the posts above, but I’ll limit myself to the points above for now.
You’d still get economic upsets every time someone figured out a cheaper way to mine that mountain or asteroid, though.
IdahoMuleMan, can you provide a cite for, well, pretty much anything you just posted?
I think what IdahoMauleMan presented is some conspiracist’s notion of history. It bears no resemblance to mine.
Just a couple of points.
Does anyone disagree with this? It is the basis of banking. It existed hundreds of years before central banks were founded. It was true throughout the entire period of the U.S. being on the gold standard before the Federal Reserve system was established. The two have nothing to do with one another.
Recessions were at one time called Panics. Recession and depression were euphemisms used to lessen such a term. Major panics happened in the U.S. in 1837, 1857, 1873, 1893, and 1907. You might want to read about the Panic of 1907. That was so severe and scary that it led to the creation of the Fed.
The Fed, despite what conspiracy theorists claim today, had little power in its first decades. It couldn’t prevent the Great Depression, but changes to its power since meant that recessions since have generally been lesser than the major panic cycles of the 19th century.
Modern economy theory also states that countries who went off the Gold Standard the earliest recovered faster than those who went off later like the U.S. There are many explanations for the worldwide depression that occurred at the time, but a lack of faith in the currency isn’t one of them. It’s not a realistic explanation when it has to be applied to every currency in the world. That requires the lack of faith to be a secondary explantion to some initial cause.
There’s an old saying that if you ask twelve economists, you get thirteen answers. The thirteenth answer is apparently the conspiracy theory about the Fed. You can safely ignore it.
This particular conspiracy theorist, mentioned in IdahoMauleMan’s post, is an ‘economist’ named Murray Rothbard, father of the “austrian school.” Haven’t heard of it? Neither had I–to say his ideas aren’t generally accepted would be kind.
I’ve seen such arguments before–when I see them, they tend to contend that some strange misconception of fractional-reserve banking is the source of all the economy’s ills. (for example, i’ve never seen someone putting forward this argument actually give an accurate description of fractional reserve banking–they tend to argue that it is “fraud”).
Just to emphasize what Exapno Mapcase points out–without Fractional-Reserve banking, banks don’t exist. They have to keep 100% of the money deposited with them–in effect, becoming glorified safe-deposit boxes. This is why you don’t pay for a checking account–or why they can even earn interest–because you are, in effect, lending the bank your money. If you wanted them to store it in a box, it’d cost you money.
I wouldn’t call it simplistic, but a fallacy that shows lack of understanding how any currency works, at the level of say, an 8-year old.
Gold has value because it’s rare, you can test if it’s unadulatered, and people are willing to accept it.
Paper money or electronic money has value because people agree to accept it.
If you sit in the desert, gold is worthless, because a bottle of water has much more worth. If you arrive in a country like the old Inca empire, where cocoa beans have worth, and gold is abundant and reserved for the Inca because it’s yellow, gold is worthless.
Well, to be charitable, although I certainly don’t agree with Idahomule, there’s a grain of truth (1 carat) in there. The problem isn’t fractional reserve banking itself, as noted, that was around for hundreds of years, before banks were regulated and oversawn by the government to make sure they didn’t crash easy. But part (not all, but part) of the current ecnomic mess/ banking crash, besides greed and bad investing practices, was that banks went below the reserve stipulated. So if Smith deposited one real dollar from his paycheck into the bank, the old practice was to lend out 3 times (just examples here). But with electronic money, it became easier to lend out 5 times, and suddenly, at 10 times, the system couldn’t hold up any longer.
That doesn’t mean that fractional reserve banking itself is bad, just that the reserve itself needs to be high enough to be safe, just like other measures need to be taken to protect against greed and crash.
Well, what is money? Money is a particular type of good. If you are bartering and want chickens, but have clay pots, what happens if the guy who has chickens doesn’t want clay pots?
The solution is that there are key goods. These are valuable goods that people accept in trade, even if they don’t actually want those goods at this moment. So you could trade cigarettes for the chickens. And even if the guy doesn’t want cigarettes, he knows that other people do, and he can trade those cigarettes later for what he does want. Lots of goods have been used as key goods throughout history–cacao beans, cowrie shells, cows, cigarettes, whiskey, buckskins, and so on. But one particularly useful form of key good was precious metal. Gold doesn’t get used up, it doesn’t age, it can be divided, it’s portable. And so for centuries you could take lumps of gold to the other side of the world, and be confident that you would find someone who would trade you useful goods for those lumps of metal.
But gold standard paper currency isn’t gold, it’s a piece of paper promising to trade the bearer a certain amount of gold for the paper. The whole point of paper money is that you don’t need the actual gold on hand. In fact, the amount of gold you need is zero.
Cite?
For one thing, the current market crash had little to do with bank deposits as I understand it. It had a lot to do with collateralized debt obligations, illiquid real-estate securities that were mispriced, combined with a sudden crash in the underlying assets they were securitizing loans on, and so on.
For another thing, banks are highly regulated, and the reserve levels are set by the (Fed, I think, but maybe federal law–one of those two). So if banks were playing fast and loose there, a lot more people would be in prison.
Now if you looked at the S&L crash of the 80s, you’d have better luck–because there, one of the problems was that Savings and Loans kept up to the legal level of reserves–but were able to do so with investments that later turned out to be of little value.
But even so, the problem wasn’t that banks were keeping assets that were valued at less than $x (the reserve limit) in the bank, but that the value on paper wasn’t accurate–that the assets valued at $x for accounting purposes weren’t actually worth $x.
This is true. Again, I’m not sure how it has anything to do with our current financial crisis isn’t a run on the banks (depositors try to get money out, and can’t)–which reserve limits fix. It’s a freezing of credit markets–that people who loaned money out (in this case, mostly on mortgages) find the mortgages default at a much higher rate than expected, and go broke, which means that others can’t borrow money from those same markets, which drags the economy to a halt.
[Morbo] THAT IS NOT HOW FRACTIONAL RESERVE BANKING WORKS [/Morbo].
Banks do not get to lend out more money than they have. You don’t deposit a dollar, and they then loan out three. I deposit $100 with Bank “A,” which loans out $90. (keeping a ten percent reserve). Then the person who borrowed that $90 buys something with it–and the seller deposits it in bank “B”.
So after two steps, I have $100 in my account in bank “A”. Somebody else has $90 in his account at bank “B”–there is now $190 in the economy, even though we started with $100.
Bank “B” now has $90, and lends out $81, and so on ad infinitum.
(I don’t mean to sound harsh–but if we’re discussing fractional reserve banking, it’s essential to understand how it works. No individual (commercial) bank can create money–they can’t wave a magic wand and turn $100 into $200. They can borrow 100 dollar bills, and lend out 90. (leaving them with assets of $100, ten dollar bills, and a loan for $90, and liabilities of $100, a deposit account) Repeating the process creates money–but no individual bank can turn $100 of assets into $200 of assets)
Sure. ‘America’s Great Depression’, also by Rothbard, is available free online
It’s nice to see the ad hominem attacks on Nobel-winning economists like Hayek (also of the Austrian school, and Rothbard’s mentor) as weird ‘conspiracy’ theorists.
And I especially like the quote above from the Fed itself, saying that fractional-reserve banking is important to the economy. What else would it say? ‘No…our role is unimportant in the economy, therefore we shouldn’t exist.’ The Fed exists to regulate fractional-reserve banking!
There is no immutable law of nature that says you must be able to deposit money a bank and be able to withdraw it at any time, on demand, whilst also
- Not incurring any charges for that service
- Giving the bank the ability to loan the money out at the same time
Many of the posts above assume that steps 1 and 2 must be a given for a functioning credit market, and then deduce that fractional-reserve banking is a logical consequence of that given assumption.
There are many, many other ways to intermediate savings, investment and credit. There are time deposits. There are investment vehicles like venture capital and private equity funds. There is simply giving money as a loan to someone else, with a contract to pay it back later plus interest (like a time deposit).
The modern notion of a DDA ‘for free’ (or even better, earning interest) is so ingrained as a ‘right’ in everyone’s mind that it unfortunately confuses the issue.
And I’m sorry, but this is at best totally misleading.
Yes, banks do need to keep a reserve for everyday expenses and availability. But.
Say that the original depositor, Z, puts $100 into the bank. The bank now loans $90 to A. And $90 to B. And $90 to C. And $90 to D. And $90 to E. That’s $450 and $350 has been created. (Money is an asset, although I don’t want to get into bank accounting, where loans are as you say liabilities. In the larger economy they become assets.) Interest is paid on each loan. The bank repays some of the money to the depositor as interest, spends some on its own expenses, and the rest is profit.
How can the bank do this? Because it gets regular payments on the loan from A, B, C, D, and E. With luck and good judgment about who the loans went to, Z always has money in the original account to borrow from. The bank makes money, the borrowers have money to spend, the economy whirls merrily on its way.
You can expand this fable if you want. A, B, C, D, and E deposit the money into accounts in their banks or the original bank. The recipients of their spending put money into their accounts. This is economic expansion.
Perhaps C can’t repay the loan. Perhaps A and E now seem like poor credit risks. The next set of loans therefore don’t get made. The ripple effect is less. The economy is in recession.
The recent bust was not, it is true, part of this cycle because it was a collapse of investment income, which is usually not based on loans from banks. However, a similar effect was at work. The derivatives market did go up to 30 times the collateral, and when that happens only a tiny amount has to fail for the whole thing to go bust.
Banks create money out of nothing. They do so by careful lending and the recapture of interest from the loans. That’s what fractional reserve banking is and has always been. How much money banks are allowed to lend is controlled by the central bank of a country in a variety of ways in order the keep the lending careful. The principle doesn’t change. If there is a run on the bank and all depositors ask for their money back, the bank always fails because that money is not there. It has been loaned at multiple times what has been taken in. It’s that multiple that is the killer.
I have to disagree-you’re quite simply wrong on this one.
In your example, Bank A loans out $350 more than it has. Where does that money come from? Not even a conceptual question–let’s imagine A, B, C, D, and E all want their loan in cash. Where does that cash come from? (for one thing, the bank has no reserve–it has loaned out $350 more than it has. That’s not a reserve–that’s an overdraft)
Or if it’s electronic, you’re saying bank X can snap its fingers, and lend out $350. Isn’t that just accounting fraud?
Fractional reserve banking is not accounting fraud. My explanation shows how it works without any bank “creating” money out of thin air.
In other words, my explanation doesn’t require any “magic.” It works even if a bank isn’t able to create money out of thin air. Yours does (as I have bolded).
(also, loans are bank assets, not liabilities. A liability is something the bank owes someone (say, a deposit account). An Asset is something the bank has (cash), or something someone owes a bank (say, a loan it has issued).
Don’t take my word for it–let’s ask the federal reserve bank.
http://www.newyorkfed.org/aboutthefed/fedpoint/fed45.html
(bolding mine). The point is that the fed agrees that a bank can lend out some fraction of the amount deposited with it, not as you suggest, a multiple of the amount deposited with it
They go on to say lower reserve requirements (say with time deposits) lead to more monetary creation–but the one thing they don’t say is that a bank can ever lend $1 that has not first been deposited with it. Because that would be fraud–and fractional reserve banking isn’t fraud.
To point out another thing, if it were as you suggest, the multiplier of M0 would be ten times what it should be.
As you put it, bank A gets 100, and lends out 450.
Now, A,B,C,D, and E spend their $90, and the people they buy stuff from puts $90 in each of five different banks.
The cycle begins again. Each bank lends out $405.
I’ll spare you the math–but with two rounds, we have $955 of money from an initial deposit of $100. And as you can surely see, it will go on for a while.
However, the money multiplier is equal to one over the reserve requirement. (look at the example above in the New York Fed’s example)
So in your example, I assume you mean that the reserve requirement is 0.1 --the multiplier, at the end of the cycle, ought to be 10 (i.e. $100 in new money is multiplied up to $1,000 in bank deposits). (I assume this since the bank gets $100, and issues loans of $90–it’snot strictly true in your example, where the bank doesn’t actually keep any reserve…it loans out more than the $100 it starts with).
But in any event–look at what you think your reserve requirement is. Do the calculation for the multiplier based on that requirement, and compare it to the amount of money your explanation creates. You’ll find your explanation creates more money than the multiplier formula predicts–and hence, there’s something wrong with your explanation.
Doesn’t answer the question of where it gets the money to loan out to A,B,C,D, and E in the first place.
No, they don’t. The banking system as a whole creates money. Individual commercial banks do not.
To be clear–if you read my quote, I’m saying Rothbard is not generally accepted. Which is true. It’s not an ad hominem attack to note the fact that mainstream economists do not listen to Rothbard. One reason for this is his irrational attacks on fractional-reserve banking as fraudulent.
Perhaps it’s his argument that the solution to fractional-reserve banking is to go to “free banking,” where there are no regulations on what banks can do. Because no regulation at all will surely solve the problem of banks lending money, and only keeping a fraction of their deposits, rather than, say, regulating them so that they will keep 100% of their deposits.
Or, to use his own words, from the mystery of banking (as taken from his wiki page)
Can anyone see the inconsistency?
You’re the first one to mention Hayek. I make no attack on him. That being said, the austrian school is certainly not in the mainstream these days–although some, like hayek, are given more credence.
I am about the farthest thing from a conspiracy theorist. That is, if you define ‘conspiracy’ as cabals of the Trilateral commission, the Illuminati, or some other group trying to control and enslave us.
I think it was standard, run-of-the-mill use of government to artifically distort and tilt the balance in favor of an influential constituency, with lots of Unintended Consequences.
Just like steel and auto tariffs. Or the Wagner act. Or ethanol subsidies. Or Smoot-Hawley. Or Davis-Bacon. Or the establishment of the FDA. Or GE supporting ‘green lighting’, when it has already built the largest ‘green lighting’ manufacturing facilities in the world, and therefore will have a leg up on its competitors. Or a billion other things. If those things count as ‘conspiracies’, than I guess I’m a conspiracy theorist. But I sure wouldn’t call myself that.
If a bank wants to lend via fractional reserves, then as a libertarian, I say it is free to do so. AS LONG AS ITS DEPOSITS AREN’T BACKSTOPPED BY THE GOVERNMENT, and as long as it isn’t allowed to use a currency that the rest of us are tied to, by use of force. It can issue it’s own notes, backed by its own deposits if it wants to, and see if customers will bite. If it fails due to poor risk management, then it will go bankrupt, and its customers will lose its money.
None of those things are what goes on today, under the auspices of the Fed and the FDIC.
I agree with you that Rothbard’s ‘solution’ is a little unworkable. As I posted above, I am all for free banking, and even fractional reserve banking if those banks (and their customers) wish to give it a go.
Rothbard’s position is that the very nature of DDAs and fractional-reserve banking is illegal (because the government has ruled that it is illegal for other non-money commodities, like grain…an inconsistency he points out) and therefore should be outlawed.
My position is to let them go ahead, and if the bank fails, it and its depositors suffer the consequences.