The Fallacy of Inflation Targeting
Recently some Federal Reserve officials have voiced their support for setting inflationary targets, writes Frank Shostak. They believe that this will not only stabilize the rate of inflation but will also help to stabilize economic activity around sustainable levels. In short, setting targets could eliminate the menace of boom-bust cycles. This is only the latest in a long series of policy fashions at the Fed. They recycle old errors when the newer ones turn out to fail as well. FULL ARTICLE
Comments (223)
RogerM
Very interesting. I have been reading Rothbards history of the Great Depression and Rothbard writes that this idea of price stabilization (inflation targeting) began with Irving Fisher right after WWI. As a result, the Fed believed it wasn't inflating during the 1920's because wholesale prices didn't rise, even though the stock market rose dramatically. It's odd that we're still fighting the same ignorance 100 years later. Many economists warned people throughout the 1990's that the Fed high stock market and housing values indicated that the Fed was inflating, but to this day the Fed doesn't believe it!
Published: May 16, 2007 8:56 AM
Bill
The only thing saving the Fed from really screwing up the economy is that it is so big and so diverse that only small portions of it get blasted.
There is no better example of this than the housing market. After years of easy credit, a large number of buyers were so over extended that small or large changes in their situations caused them to not be able to pay their loans.
As loan defaults increased the lenders become tighter on the next loans they make. As lenders become tighter (loan less) then buyers can loan less and sellers have to cut prices.
This happended to stocks in the late 90s, housing in the early 2000s and now back to stocks again for the late 2000s.
Published: May 16, 2007 10:20 AM
David Hillary
Shostak's biggest shortcoming in the article is his inability to provide evidence to support his conclusion. He concludes that inflation targeting makes things worse, and tries to explain why, but he doesn't provide a model or analysis of the alternative, thus no comparison can be made. In fact he doesn't even state what inflation targeting is supposed to be worse than.
Furthermore, his analysis of the inflation targeting practice contains fallacies of his own.
A lower interest rate does not merely 'increase the demand for goods and services' it specifically reduces the price of capital, the discount rate on capital assets (which consist of a risk free interest rate plus a capital asset risk premium). The reduced price increases the quantity demanded, and this is the so called 'transmission mechanism' of 'monetary policy.' It is the greater quantity of demand for constructing capital assets that bids up labour prices (wages) and property rents too, which shows up as localised inflation (consumer price increases).
The terminology of 'monetary pumping' is inappropriate, and fosters a misleading quasi-mechanical view of important economic matters. Central banks do not pump or inject money, they purchase assets on credit -- someone gives up an asset in exchange for another asset, a claim on the central bank. In practice this is the exchange of a non-monetary claim on the government (a government bond) for a monetary claim on the government (a central bank note or account balance). Thus changes in the quantity of monetary obligations of the government occur as capital transactions, and not income transactions. Of course this is the same as a private commercial bank that issues bank notes or accepts deposits on cheque account -- the funds raised or deposited are not income to the bank, rather give the bank an asset and an offsetting liability, a capital transaction. They do not exchange something for nothing in capital transactions, instead banks make money from the differences in the flows of interest between their assets and liabilities, i.e. from net interest margin income.
Aggregate demand for goods and services is not entirely funded from the production of final consumer goods and services. For example, suppose there was an hypothetical economy with a high savings rate: 50% of the net value of goods and services was saved, and 50% consumed. In this economy 50% of the demand comes from those who produce capital goods such as buildings, bridges, roads, tunnels, ports etc. that are not final consumer goods. Both those who produce final consumer goods and those who produce capital goods that are not consumer goods will demand a proportion of the production of each to consume or add to their wealth portfolios.
Central banks do not print money, in a legal or economic sense. All paper bank notes issued by central banks are issued as capital transactions, creating equal changes in the assets and liabilities of the bank of issue. Legally, promissory notes are 'made' (or issued), not 'printed' (bills of exchange are 'drawn' but most bank notes are promissory notes, not bills of exchange, despite American usage of the term 'bills').
For the record I do not support inflation targeting or central banking or fiat currency, I support the gold standard, free minting and free banking.
Published: May 16, 2007 11:07 AM
Geir
David,
I think your comments are helpful, but how can the so-called "amount of money in circulation" increase if there is no "pumping of money" into the economy? Why are housing markets and stock markings exploding in their upward surge in the boom-bust cycle if there is no injection of "fresh money"?
I will remind you that terms like "injection of money" and "printing of money" are probably used by Mr. Shostak the same way individualists refer to "society" where they really mean: Society = "a group of individuals living in some area, exchanging goods, services and conversations with one another on a daily basis". That is, as a concept which captures the essance without specifying every detail of it.
Published: May 16, 2007 2:13 PM
Eric Lansing
David Hillary,
that was terribly embarrassing. For someone who "support(s) the gold standard, free minting and free banking" your grap of gold standard (ie Austrian) economics is aweful.
I think you are an Ivy league liar.
Published: May 16, 2007 2:38 PM
Eric Lansing
David Hillary,
that was terribly embarrassing. For someone who "support(s) the gold standard, free minting and free banking" your grap of gold standard (ie Austrian) economics is aweful.
I think you are an Ivy league liar.
Published: May 16, 2007 2:38 PM
Eric Lansing
David Hillary,
that was terribly embarrassing. For someone who "support(s) the gold standard, free minting and free banking" your grap of gold standard (ie Austrian) economics is aweful.
I think you are an Ivy league liar.
Published: May 16, 2007 2:38 PM
Eric Lansing
(did not mean to post 3 times)
Published: May 16, 2007 2:44 PM
Björn Lundahl
Today central banks around the world have “inflation targets” or the objectives of keeping inflation (inflation defined as decreases of the purchasing power of money) around 2% yearly.
I do believe that the origin of these policies during the post-war period can be derived from the influence of Milton Friedman during the 70s and 80s. The means and objectives of the central banks are not exactly what Friedman once proposed as he wanted zero inflations and monetary rules, but they are similar as they focus on central banks as the determinants of inflation and therefore also monetary policy. The “pioneering” countries of such inflation targeting were Germany and Switzerland.
Some people declare Monetarism dead but they miss the very point, Monetarism is stronger than ever and, de facto, this theory powerfully influences central banker’s monetary policies around the globe.
The years just before the breakthrough of Milton Friedman and Monetarism, I spotted the following.
A/ A general ignorance among central bankers and economists that inflation is a monetary phenomenon.
B/ Fiscal policy and not monetary policy were considered the main instrument to promote economic stability. The main focus was not, therefore, on central banks.
C/ Central banks did not enjoy the independence from parliaments as they do today.
D/ Floating exchange rates were considered something exotic and unknown as an instrument in balancing payments between nations.
E/ Milton Friedman recommended to cut the link altogether between money and gold.
Today the story is quite different and all of mentioned points have changed because of Milton Friedman and Monetarism.
Keynesianism is played in a playing field apart from reality and the real world and fiscal policy has nothing to do with the business cycle at all. Keynesians do believe, naturally, that fiscal policies highly influence the business cycle but they are utterly wrong and live in some kind of dream world wholly apart from reality.
Monetarism is different as it focuses on monetary policies. It does it superficially, but still the Monetarists see a connection between monetary policy, inflation and the business cycle. The Austrian business cycle theory is the correct one and its implementations of a 100% gold reserve money standard would eliminate the business cycle once and for all, but despite this fact, it is not excluded that monetary policies around the world guided with the aim of about 2% inflation annually and a steady growth of money could keep business cycles relatively small and completely hinder the occurrence of depressions.
To put it another way; mentioned policies could actually keep a firewall around the fires and destructiveness that central banker’s and fractional reserve banker’s cause and in doing so might be quite effective.
It is not impossible that we will enjoy relatively stability and also have done so already without eliminating the very cause of business cycles.
The Federal Reserve:
“Remarks by Governor Ben S. Bernanke
At the Annual Washington Policy Conference of the National Association of Business Economists, Washington, D.C.
March 25, 2003
A Perspective on Inflation Targeting
One of the more interesting developments in central banking in the past dozen years or so has been the increasingly widespread adoption of the monetary policy framework known as inflation targeting. The approach evolved gradually from earlier monetary policy strategies that followed the demise of the Bretton Woods fixed-exchange-rate system--most directly, I believe, from the practices of Germany's Bundesbank and the Swiss National Bank during the latter part of the 1970s and the 1980s.”
http://www.federalreserve.gov/Boarddocs/Speeches/2003/20030325/default.htm
“The Library of Economics and Liberty
An Interview with Milton Friedman
Russ Roberts: I was an undergraduate and a graduate in the 1970s and my textbooks at the undergraduate level—not the graduate level, because I attended a small university in the Midwest I think you used to have an affiliation with, the University of Chicago—but as an undergraduate, my textbooks talked about all the different theories of inflation—cost push, cost pull, the role of unions, the role of industrial concentration and, of course, the possibility that Milton Friedman, this maverick thinker was right, that money had something to do with it.
It's my impression that's not true anymore; that the intellectual environment understands today that inflation is caused by a rapid growth in the money supply.
Milton Friedman: I think it does. I think that's clear and the last 30 years, last 20 years I should say, has done a great deal to rub that in because every central bank has come to accept the view that it's responsible for inflation.
Russ Roberts: And you're suggesting that the Monetary History was the beginning of a revision toward a different perspective.
Milton Friedman: Well, I don't know. On the ideological side, there were other things at work. Hayek’s Road to Serfdom, which was published in 1945 made the ideological case. I don't know what role the Monetary History played in the public at large but in terms of the monetary authorities, in terms of money, there's no doubt that it played a considerable role.
Russ Roberts: And that chapter on the Great Depression must have alarmed them greatly about their potential for doing harm.
Milton Friedman: Exactly, exactly.
Russ Roberts: Focusing on the central bank role, going back again to the '70s when I was in school and shortly after your book came out, the focus was on the money supply—the quantity of money, counting it, controlling it through open market operations.
Something changed in the last 25 or 30 years. That's not what Alan Greenspan or Ben Bernanke talk about. They talk about other things and they play with that short-term interest rate, not the so-called stock of money that you focused on so intensely in the book.
Milton Friedman: That's what the talk about but that's not what they do.
Russ Roberts: What do they do?
Milton Friedman: They use the short-term interest rate as a way of controlling the quantity of money. If you look at the statistics, the rate of change of the quantity of money from month to month, quarter to quarter, year to year, it has never been so low as it has been over the last 20 years.
I don't believe there's another 20-year period in the history of the country in which you can find so steady a rate of growth in the quantity of money and that can't all be an accident. That's because they use the short-term interest rate. Look at it in the simplest possible way.
The Fed says the short-term interest rate should be 4.5 percent. How do they keep it there? By buying and selling securities on the open market. Now you're Mr. Bernanke; you're Mr. Greenspan. You're watching that. And with the current short-term interest rate, you find that the quantity of money is starting to creep up more rapidly than you really want. Well, then you will tend to be favorable to raising to a higher rate of interest.
At that higher rate of interest, the demand for money is less and so the supply of money under that phenomenon, instead of having to sell government bonds to keep it there, they have to buy government bonds to keep it there or vice versa. Maybe I'm getting it mixed up. But in any event, the short-term interest rate is a tool with which you can control the quantity of money.
Russ Roberts: But they don't talk about it that way.
Milton Friedman: No, they don't talk about it that way.
Russ Roberts: Why do you think that is? Do you have any idea?
Milton Friedman: I don't know. I've always been puzzled by why they insist on using the interest rate rather than the quantity of money.
If you really carried out the logic concerning the quantity of money, you deprive the Federal Reserve of anything to do. Suppose the Federal Reserve said it was going to increase the quantity of money by 4 percent a year, year after year, week after week, month after month. That would be a purely mechanical project. You could program a computer to do that.
Russ Roberts: Like an indexed mutual fund takes away the fun of being a fund manager.
Milton Friedman: Right. That's part of the reason. But the main reason, I think, is different. It's that the central bank associates with banks. It regards itself as sort of a mentor of the banking system and, to the individual bank, it doesn't believe it creates a quantity of money. That doesn't make any sense to them.
What they deal with are interest rates and therefore, it's natural and so many of the central bankers are themselves from the banking industry. They're bankers. And so it's natural for them to think in terms of interest rates and, moreover, when they think in terms of interest rates, they've got all kinds of interest rates—short-term interest rates, long-term interest rates—all kinds of excuses for exercising power or thinking they're exercising power.
Russ Roberts: Taking credit for exercising power.
Milton Friedman: I've always been in favor of abolishing the Federal Reserve and substituting a machine program that would keep the quantity of money going up at a steady rate.
Russ Roberts: And over the last 20 years or so, they've approximated that.
Milton Friedman: Come closer to approximating it. Absolutely.
Russ Roberts: And I would argue, and I assume you would as well, that the relative stability of the U.S. economy over the last 20 years is a reflection of that steady growth in the money supply.
Milton Friedman: I think there's no doubt at all.
Russ Roberts: The non-erratic path.
Milton Friedman: It's a golden period. It's a period in which you had declining inflation but a fairly steady rate, a steady level. You had only three recessions, all of them brief, all of them mild. I don't believe you can find another 20-year period in American history. But it's interesting to note that so far as the international acceptance of monetary control is concerned, it was started by the Bank of New Zealand, not by the Federal Reserve Bank. It was some time in the 1980s when New Zealand essentially came close to privatizing its central bank. It set up a situation in which the governor of the Central Bank of New Zealand had a contract with the government in which he agreed to keep the price level—inflation—within a certain bound; 0 to 3 percent or 0 to 2 percent. And if he did not do so, he could be fired.
Russ Roberts: Not decapitated, merely fired.
Milton Friedman: Merely fired.
Russ Roberts: But it still concentrated his mind sufficiently.
Milton Friedman: Oh, yes. And Don Brash was appointed as the first governor of the Central Bank of New Zealand. He's now the leader of the opposition in the New Zealand Parliament. But at the time, he came from business. He was a businessman and he is an extraordinarily able and effective fellow and he took this job on at the time when New Zealand had a very high inflation rate and he succeeded in living up to his contract.
And that really set the pattern. It was the New Zealand experience, I'm sure, that had more to do with other central banks around the world adopting inflation targeting than the United States experience.
Russ Roberts: Because it was so dramatically effective in New Zealand?
Milton Friedman: It was the first time that anybody had explicitly adopted an inflation target. So that was something that everybody observed. And, secondly, it was so dramatically effective.
Russ Roberts: So are you optimistic about the role the central bank will continue to play in that inflation and price level story? You said we've had a golden era of 20, 25 years of stable prices, steady growth with only minor—by historical standards—minor recessions. Are you optimistic about the next 25 years?
Milton Friedman: I have great difficulty not being optimistic about it. All the evidence would seem to be optimistic. On the other hand, I can't hold back a doubt. Governments want to spend money and sooner or later, governments are going to want to spend money without taxing it and the only way to do that is to print money—to create inflation.
Inflation is a form of taxation. How long will governments be able to resist the temptation? And particularly as people become adjusted to being in a world of stable inflation. They will be bigger suckers as it were. It will be easier to get a lot out of it. If everybody anticipated inflation, you couldn't get anywhere by inflating.
Russ Roberts: But once you get people lulled into the expectation of a lack of it, there's the potential to exploit it. Let me ask the question in a different way. A lot of people credit Alan Greenspan with the expansion and success. They give Paul Volcker some credit as well at the early part of this period that we're talking about. But they make it sound like the key to success in monetary policy is you just got to get the right person in the job. When Ben Bernanke or whoever is following him comes in, there's this absurd microscopic examination of the aura and vapors around such a person. And you're suggesting it really has nothing to do with it.
Milton Friedman: Well, how is it that New Zealand can do it. How is it that Australia can do it. How is it that Great Britain can do it. These are all countries which followed New Zealand. New Zealand started it. But then Australia and Great Britain also adopted inflation targeting.”
http://www.econlib.org/library/Columns/y2006/Friedmantranscript.html
The Central Bank of Iceland:
Inflation target
The Central Bank of Iceland's main objective is price stability, defined as a 12-month rise in the CPI (Consumer Price Index) of 2½%.
http://www.sedlabanki.is/?PageID=179
Sveriges Riksbank (The Swedish Central Bank):
“The objective of monetary policy
According to the Sveriges Riksbank Act, the objective of monetary policy is to “maintain price stability”. The Riksbank has interpreted this objective to mean a low, stable rate of inflation.
More precisely, the Riksbank's objective is to keep inflation around 2 per cent per year, as measured by the annual change in the consumer price index (CPI). There is a tolerance range of plus/minus 1 percentage point around this target. At the same time, the range is an expression of the Riksbank’s ambition to limit such deviations. In order to keep inflation around 2 per cent the Riksbank adjusts its key interest rate, the repo rate.”
http://www.riksbank.com/templates/SectionStart.aspx?id=10602
ECB (European Central Bank)
“Quantitative definition of price stability
The ECB’s Governing Council has defined price stability as "a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Price stability is to be maintained over the medium term".
The Governing Council has also clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term.”
http://www.ecb.int/mopo/intro/html/benefits.en.html
“Inflation – a monetary phenomenon
In the long run a central bank can only contribute to raising the growth potential of the economy by maintaining an environment of stable prices. It cannot enhance economic growth by expanding the money supply or keeping short-term interest rates at a level inconsistent with price stability. It can only influence the general level of prices.
Ultimately, inflation is a monetary phenomenon. Prolonged periods of high inflation are typically associated with high monetary growth. While other factors (such as variations in aggregate demand, technological changes or commodity price shocks) can influence price developments over shorter horizons, over time their effects can be offset by a change in monetary policy.”
http://www.ecb.int/mopo/intro/html/role.en.html
Bank of England:
“A principal objective of any central bank is to safeguard the value of the currency in terms of what it will purchase. Rising prices – inflation – reduces the value of money. Monetary policy is directed to achieving this objective and providing a framework for non-inflationary economic growth. As in most other developed countries, monetary policy operates in the UK mainly through influencing the price of money – the interest rate. In May 1997 the Government gave the Bank independence to set monetary policy by deciding the level of interest rates to meet the Government's inflation target – currently 2%.
Low inflation is not an end in itself. It is however an important factor in helping to encourage long-term stability in the economy. Price stability is a precondition for achieving a wider economic goal of sustainable growth and employment. High inflation can be damaging to the functioning of the economy. Low inflation can help to foster sustainable long-term economic growth.”
http://www.bankofengland.co.uk/monetarypolicy/more.htm
Bank of Canada:
“The Bank of Canada aims to keep inflation at the 2 per cent target, the midpoint of the 1 to 3 per cent inflation-control target range. This target is expressed in terms of total CPI inflation, but the Bank uses a measure of core inflation as an operational guide. Core inflation provides a better measure of the underlying trend of inflation and tends to be a better predictor of future changes in the total CPI.”
http://www.bank-banque-canada.ca/en/inflation/index.html
Reserve Bank of New Zealand:
“The Reserve Bank's primary function, as defined by the Reserve Bank of New Zealand Act 1989 is to provide "stability in the general level of prices."”
“The Reserve Bank Act requires that price stability be defined in a specific and public contract, negotiated between the Government and the Reserve Bank. This is called the Policy Targets Agreement (PTA). The current PTA signed in September 2002, defines price stability as annual increases in the Consumers Price Index (CPI) of between 1 and 3 per cent on average over the medium term. Previously, price stability was deemed to be 0 to 3 per cent inflation over 12 months.”
http://www.rbnz.govt.nz/monpol/pta/index.html
Reserve Bank of Australia:
“Since 1993, these objectives have found practical expression in a target for consumer price inflation, of 2-3 per cent per annum. Monetary policy aims to achieve this over the medium term and, subject to that, to encourage the strong and sustainable growth in the economy. Controlling inflation preserves the value of money. In the long run, this is the principal way in which monetary policy can help to form a sound basis for long-term growth in the economy.”
http://www.rba.gov.au/MonetaryPolicy/about_monetary_policy.html
The Swiss National Bank (SNB):
“Price stability
Price stability is an important condition for growth and prosperity. Inflation and deflation are inhibiting factors for the decisions of consumers and producers; they disrupt economic activity and put the economically weak at a disadvantage. The SNB equates price stability with a rise in the national consumer price index of less than 2% per annum. Monetary policy decisions are made on the basis of an inflation forecast and implemented by steering the three-month Libor.”
http://www.snb.ch/en/iabout/snb/id/snb_tasks
“Review of monetary policy based on the inflation forecast. If the inflation forecast indicates a deviation from price stability, monetary policy needs to be adjusted. Should inflation threaten to exceed 2% permanently, the National Bank would consider tightening its monetary policy. Conversely, it would loosen the monetary reins if there were a danger of deflation. The National Bank does not, however, react mechanically to the inflation forecast. To determine the nature and scale of its response, it also takes account of the general economic situation.
If inflation temporarily exceeds the 2% ceiling in extraordinary circumstances, for example following a sudden massive rise in oil prices or in phases of strong exchange rate fluctuations, monetary policy does not necessarily need to be adjusted. The same applies to short-term deflationary pressures.”
http://www.snb.ch/en/iabout/monpol/id/monpol_strat/9
Video:
http://www.snb.ch/e/welt/video/mov/mpeg/snb-p-e.mpg
INTERNATIONAL MONETARY FUND
Inflation Targeting and the IMF
Prepared by Monetary and Financial Systems Department, Policy and Development Review
Department, and Research Department1
Approved by Mark Allen, Ulrich Baumgartner, and Raghuram Rajan
March 16, 2006
http://www.imf.org/external/np/pp/eng/2006/031606.pdf
Inflation targeting in New Zealand, 1988-2000
By Donald T Brash
Governor of the Reserve Bank of New Zealand
to the Trans-Tasman Business Circle
Melbourne
9 February 2000
http://www.rbnz.govt.nz/speeches/0086932.html
Central banks pursuing a 2% yearly inflation rate is not and far from a perfect substitute for a 100% gold reserve money standard. Such a system will probably still cause stock market crashes and will also and this surely, promote some malinvestments in the economy that never will be fully liquidated. In other words, new doses of credit will prevent their liquidation. I believe that despite this inbuilt destructiveness of such a system it will “only” cause minor recessions and probably also stock market crashes but deep recessions and depressions will be avoided. Such a system combined with flexible prices and wages, is therefore preferable to what we experienced during the 70s and will be stable compared to what we then experienced. Such a system will not cause riots in the streets and could keep the public from demanding any further actions and also something which they can live with and accept.
My points are not that that the Austrian business cycle theory is correct or not as I believe it is, but that the world is to a great extent ruled by Monetarist ideas and despite of the errors in such systems, they can still be quite successful.
Credit expansion cannot increase wealth only real savings can increase investments and wealth, and a controlled inflation of 2% per year can only give rise to a relatively stability compared to a less controlled inflation like during the 70s.
As a libertarian I cannot accept Monetarist ideas and we can always be proud of supporting true economic and ethical principles which will deliver a system without any business cycles and stock market crashes combined with true justice. The Federal Reserve and fractional reserve banking is, of course, also based on fraud. But knowing all this does not mean that we need to propagate that a Monetarist system will inevitably fail and cause a world depression as this is not true. As mentioned, the truth is on our side, but is that not also enough? Do we need to say anything more than what we can rationally justify?
Björn Lundahl
Published: May 16, 2007 2:47 PM
Eric Lansing
good post...
re:
"But knowing all this does not mean that we need to propagate that a Monetarist system will inevitably fail and cause a world depression as this is not true."
... ever since I read Ian Gordan's "Long Wave Analyst" which David Tice has called "an historical masterpiece" I have thought the opposite of what you say.
http://www.thelongwaveanalyst.ca/pdf/V5_1.pdf
and then I read Mr Duncan's book and it seems to affirm these ideas...
http://www.business-in-asia.com/dollar_crisis.html
Published: May 16, 2007 3:19 PM
Björn Lundahl
Whether we believe in the conclusion I made in my above comment or not that is believe that a 2% inflation targeting pursued by central banks or Monetarism can bring relative stability compared to none targeting as, for example, during the 70s, I think it is important that we supporters of the Austrian economics and Austrian business cycle theory debate this very thing.
It is easy to see that it will be an extremely bad substitute for a 100% gold money reserve standard, but will it bring relative stability compared to rest of the post-war period?
Björn Lundahl
Published: May 16, 2007 7:34 PM
Jim
Björn says "The Federal Reserve and fractional reserve banking is, of course, also based on fraud". He does not explain that fraud. Let me try to explain it.
Can we agree that to "give credit" is not the same as to "lend money"? To see how the two are confused, let's examine a specific example - I'll try to defraud Björn of money by giving him credit!
If I give Björn credit, I am trusting him to fulfil a commitment [within a specified time]. If I lend him money (or anything else), I may trust Björn to fulfil a commitment to REPAY me (perhaps with interest). I may trust him only because I have (or he gives me) "security". So! Would Björn give me a commitment to pay me some money in future, if all I did was trust him to pay me (& keep a record of his commitment to pay me some money as a "debt" owed - with interest!)?
If Björn would give me a commitment to pay me money on such terms, then I accept! How much money [even fiat money) can Björn commit to pay me in future (and with how much interest)?
If Björn gives me a written commitment to pay me (or someone authorised by me) say USD 100,000 in 2 years, I am sure I could find a buyer to exchange say USD 80,000 now, for his [secured] written commitment to pay me later. The buyer would be "giving credit" - trusting him to fulfil his commitment - and I would immediately be 80,000 USD richer!
The obvious question is why would Björn give me a commitment to pay anyone money in future?? Did he believe I did, or would, "lend money" to him? Why? Did I say so? Or did I trick him into giving me a written commitment to pay me, by misleading you (with terms like interest &
repayments) to believe I was "lending money"? Bankers know the difference between when they "give credit" and "lend money", but do they ever tell customers (even US presidents) which type 'transaction' they have entered in their accounts, & we have 'agreed' to?
Published: May 16, 2007 11:51 PM
David Hillary
Geir asks 'how can the so-called "amount of money in circulation" increase if there is no "pumping of money" into the economy?'
The stock of money in a free market economy consists of two forms: coin, a non-financial capital asset, and bank liabilities (bank notes and cheque account balances), a financial asset of the holder. The former can be increased by mining metal and minting it into coin. The latter can be increased by a banking transaction such as a bank issuing a bank note or accepting a deposit on a cheque account of a customer. The latter, as discussed, is a capital transaction involving financial intermediation, whereby the bank has, generally, an interest bearing asset (e.g. a loan, promissory note or commercial bill of exchange) and a non-interest bearing liability (a bank note) or interest bearing liability (cheque account balance (sometimes not interest bearing)). Thus people can use bank liabilities for indirect exchange, rather than coin.
The non-financial capital stock is thus allocated between coin and other forms such as buildings, and the financial capital structure enables non-financial non-coin capital assets to be partly financed by bank loans that are partly financed by monetary liabilities of banks (i.e. bank notes and cheque account balances).
Eric Lansing makes some disparaging comments including a claim that gold standard economics is equal to Austrian school economics. While Austrian school economists generally support the gold standard, gold standard supporting economists don't all support Austrian school economics. Perhaps it is Eric Lansing here who is the one who doesn't understand what he is talking about.
Published: May 17, 2007 12:05 AM
Björn Lundahl
The main reason why central bankers and governments have chosen to pursue 2% inflation rates yearly instead of a zero inflation rate as Milton Friedman suggested is that they are afraid of deflations. They want to be sure that deflations will be avoided and wants to have a margin.
The main reason why they have not chosen a strict monetary rule as Milton Friedman recommended, is that they are not convinced that the demand for money is stable (in their terms; velocity of circulation) and if the central banks mechanically injects a certain amount of money, prices could still fall or rise (more than 2% yearly). By pursuing a 2% inflation rate yearly, the central banks, for example during deflations, could inject more money into the system and make up the difference. The other reason might be that they do not know which monetary definition they should be guided by. To master a certain inflation rate “solves” the problems handsomely.
I think that they logically and cleverly are reacting in a rational manner as they believe that the condition is true and that is that business cycles are caused be changes in aggregate demand.
For an Austrian economist the business cycle is caused by increases of the money supply (bank credit) through the process of fractional reserve banking and create an artificial economic boom that misleads businessmen to invest as if savings have increased and the solution of the problem is therefore quite different or in other words; stops injecting money into the system at once. You cannot either trust central banks and governments that they will ever do that so we should adopt a 100% reserve gold money standard. This would also be extremely more fixed and difficult to later alter than a change in the constitution would be.
Over the longer term when the economy is adjusted to a very slow growth of the money supply as under a 100% gold reserve money standard (not accomplished, though, through increases of bank credit) or adjusted to a faster growth of the money supply as under a fiat monetary system with a yearly inflation rate of 2% accomplished mainly through increases of bank credit (again inflation here is defined as decreases of the purchasing power of money), I do believe that the demand for money would also be quite stable. That is also why Jesús Huerta De Soto in his masterpiece Money, Bank Credit, and Economic Cycles, page 776 wrote that “there would be slight annual “deflation” of approximately 2 percent” under a gold standard. He too expects, therefore, the demand for money to be quite stable. The expectation that the demand of money being quite stable is only an observation and not a praxeological fact and the demand for money can always, therefore, change.
As so many nations today pursue a policy of a yearly inflation rate of 2%, it will be quite interesting to observe what the effects this will have on the world economy.
During the 80s, for example, when Switzerland pursued that policy it had, if I remember it correctly, some severe recessions. Today when all “important” economies follow a similar policy, external negative impacts on each other will be much smaller. So what we have in front of us is really a great laboratory test of Monetarism and floating exchange rates.
We could expect only minor recessions and therefore relative stability of employments and economic outputs compared to other periods during the post-war area but still, stock market crashes, won’t probably be avoided. An imperfect monetary system can at best deliver this mentioned scenario.
Björn Lundahl
Published: May 17, 2007 2:13 AM
Björn Lundahl
My view is that fractional reserve banking should be considered fraudulent because of the reason that bankers cannot fulfil their obligations against all their depositors. This is a logical proof by itself.
It does not matter if bank depositors are well educated in fraudulent banking procedures or not. Reality and logic sets the limit and real laws should be in accordance with reality. Otherwise they are destructive and wrong. No contracts can invalidate reality and logics.
It is not, logically, possible to contract terms that are contradictory. For what is contracted if the terms are contradictory? This is essentially my point. If we have a “libertarian view” is beside the point: contradictions cannot be contracted as contacts are voluntarily agreements between the parties involved and all terms should harmonize with each other.
If, for example, someone rents a commercial facility and the lease stipulates that the landlord should maintain the ceiling, it is not, logically, possible in the same lease to contract that the landlord has no responsibility if he has been careless in his maintenance and the ceiling leaks. That is also a logical contradiction. Maintenance and some minimum responsibility go hand in hand.
Fractional reserve contracts are a contradiction in terms as they are demand deposits that are redeemable on demand and are at the same time also “regarded” as monetary “loans” to the banks and on top of this absurdity, these “loans” are lacking any maturity dates.
A true monetary loan is an exchange of present goods for future goods, whereby “the future” is defined as an agreed upon time between the parties when the loan expires.
If a “depositor” really wants to lend out his money, he should also comply with what a true loan is and “not try to eat his cake and still try to keep it.”
An Austrian economist has all the reason in the world to be against fractional reserve banking as he wants the economy to correspond to a true voluntarily saving ratio and not to a vague (and therefore fraudulent) one. Because of the fact that fractional reserve banking is relied upon this vagueness and therefore swindle, he also knows that this very vagueness and swindle are the really causes of horrible and anti social depressions and business cycles, which he therefore wants to end once and for all.
Apart from mentioned logical proof of why fractional reserve banking is fraudulent, another logical proof should also be mentioned and that is that the Austrian business cycle theory by itself proves that “savings” through fractional reserve banking does not harmonize with true voluntarily saving ratios of individuals as business cycles are still existent in a fractional reserve economy and are, also, the very cause of them. The Austrian business cycle theory teaches “that recessions and depressions are caused by initially lowering of the rate of interest which do not correspond to true saving ratios, but by increases of the money supply. When the economy adjusts to true saving ratios, malinvestments are liquidated.”
Well, if demand deposits are not true savings they cannot be true loans.
In other words the depositors have been deluded that is being exposed of fraudulent actions by the banks.
We could, also, say that slave contracts should not, in a libertarian society, be allowed for the same reason i.e. they are contradictory and not in accordance with reality and logics as;
“A man cannot renounce his right to self-ownership, since a man in his very nature controls his own mind and body (natural disposition), that is, he is a natural self-owner of his own will and person (having a free will) and he will still be so even if he has “tried” to renounce his natural self-ownership to another person. He cannot renounce something which is a biological and physical fact of his very own life and which will never, as long as he lives, leave him.”
Björn Lundahl
Published: May 17, 2007 2:28 AM
Björn Lundahl
I do not consider, though, that the demand for money in regards to the business cycle is important at all.
But in a world economy “based” on targeting a 2% inflation rate it will indirectly so be.
If the demand for money increases and the inflation rate falls below the target of 2% because of this, central banks will accelerate the rate of growth of the money supply which in turn will create an artificial boom. If consumers later on and for whatever reasons, decrease their demand for money and inflation rises above the target of 2% because of this, monetary authorities will decelerate the growth of the money supply and the mentioned boom will be ended by a bust.
Björn Lundahl
Published: May 17, 2007 3:20 AM
RogerM
David Hillary,
Are you a banker? or follower of the Real Bills Doctrine, sometimes referred to as the Banking School? If not, what do you think of franctional reserve banking?
The reason I ask is that I find that bankers get really offended by the Austrian condemnation of fractional reserve banking and the role of banks in artificially inflating/contracting the money supply.
Published: May 17, 2007 9:20 AM
Paul Marks
It looks like that the same debates are comming up in different threads - due to the postings being on much the same thing (there is is a similar odd thing above - where there are three postings all on the same Ron Paul incident).
Still I will repeat here what I have said elsewhere.
No Austrian economists do not have to support gold as money (using the words "the gold standard" can use to confusion).
If people want to use silver (or any other commodity) as money and their contracts are drawn up that way, this is fine.
It is even possible (perhaps) that government fiat money could be "Austrian" - if there was never any increase in the supply of fiat money (which does not seem likely - but there we go).
As for the boom-bust cycle:
The basis of this is the effort to reduce inerest rates (for borrowing) below the level that would come about by time preference.
So instead of borrowing being 100% financed from real savings (i.e. people choosing not to consume all of their income and lending part of it out), some borrowing is financed by complex credit expansion schemes (which sometimes involve the misuse of the word "savings").
Normally fractional reserve banks (and other enterprises) look to government from time to time to prop them up (in various complex ways).
But such practices go back before the Federal Reserve Board in 1913. Government support for credit expansion was sometimes in different forms (such as trying to protect banks from people comming to them and demanding the gold or silver they claimed to have in the vaults covering all bank drafts and other such).
There were boom-bust events before 1913. Indeed even before the National Banking Act of 1861.
Murry Rothbard's first major book was (after all) "The Panic of 1819".
Published: May 17, 2007 10:18 AM
David Hillary
RogerM asks some questions:
Are you a banker? Yes, I operate a business that endeavours to engage in the business of banking later this year. I'm a free banker both in business and in theory. I don't accept the real bills doctrine. Fractional reserve banking is, as far as I see it, the regular and ordinary form of banking, since banking is about credit intermediation as well as conducting current accounts with balances payable to the customer's order. Although many Austrian school economists are hostile to fractional reserve banking, not all are, and I don't subscribe to the Austrian school in any case. I don't get offended by Austrian school anti-fractional reserve bankers, and their claims, I just disagree with them and their analysis.
Published: May 17, 2007 12:11 PM
Geir
RogerM:
Of course a bank or any other entity in the business of loaning out money can engage in "fractional" banking. No Austrian is demanding law to ban this. The whole point is that IF a fractional banker/lender gets trapped in a bank-run, there should be no tax-funded escape for him. A fractional banker could buy insurance (probably at a very high cost) or take his chances, but that's it. His business entirely.
Fractional banking is a very understandable risk taken by businesses who attempt to increase their clientele without having the 100% back-up for loaned out money. In a free market however, banks will tend to stay close to the 100% backing, or else face bankruptcy in the case of a bank-run.
Published: May 17, 2007 6:10 PM
Paul Marks
No one could accuse me of being a fanatical follower of Murry Rothbard , but his arguments against the idea that there can be any free market "insurance" for fractional reserve banking are sound (I advice people to look them up - sorry I am no good at "links").
But we go back to the basic point that borrowing must be from savings.
The whole point of fractional reserve banking (and all the other games) is to try and lend out more money than there is in REAL savings.
Violating the borrowing must be entirely from real savings rule is asking for trouble.
"But not all Austrians opposed fractional reserve banking" - but Mises and the others did oppose efforts to reduce interest rates (below the rates time preference would lead to) and reducing interest rates for borrowers ("having more money to lend") is the whole point of games like fractional reserves.
"But I am a free banker, I oppose Federal "insurance" and all other subsidies open or hidden".
Jolly good - but there is still the problem of the bust (for credit expanision must lead to a boom-bust cycle).
Will not people demand all sorts of statism during a bust?
Published: May 17, 2007 9:32 PM
Jim
When Björn said yesterday "The Federal Reserve and fractional reserve banking is, of course, also based on fraud", I tried to explain it by pointing how banks by confusing giving credit with lending money have been defrauding "borrowers". While my example did not say so, that is how fractional reserve banking works.
For some reason, none of the subsequent posters have even acknowledged the point of my 1st post, which I'll repeat below. Please comment.
Björn says "The Federal Reserve and fractional reserve banking is, of course, also based on fraud". He does not explain that fraud. Let me try to explain it.
Can we agree that to "give credit" is not the same as to "lend money"? To see how the two are confused, let's examine a specific example - I'll try to defraud Björn of money by giving him credit!
If I give Björn credit, I am trusting him to fulfil a commitment [within a specified time]. If I lend him money (or anything else), I may trust Björn to fulfil a commitment to REPAY me (perhaps with interest). I may trust him only because I have (or he gives me) "security". So! Would Björn give me a commitment to pay me some money in future, if all I did was trust him to pay me (& keep a record of his commitment to pay me some money as a "debt" owed - with interest!)?
If Björn would give me a commitment to pay me money on such terms, then I accept! How much money [even fiat money] can Björn commit to pay me in future (and with how much interest)?
If Björn gives me a written commitment to pay me (or someone authorised by me) say USD 100,000 in 2 years, I am sure I could find a buyer to exchange say USD 80,000 now, for his [secured] written commitment to pay me later. The buyer would be "giving credit" - trusting him to fulfil his commitment - and I would immediately be 80,000 USD richer!
Published: May 17, 2007 10:00 PM
David Hillary
Gier,
Bank assets in a gold standard and free market for banking services consist of:
1. Metallic legal tender reserves
2. Bank notes and demand deposits with other banks
3. Marketable securities (e.g. corporate bonds)
4. Net loans and advances
5. Other assets such as land and buildings, plant and equipment, either used by the bank or from the realisation of security.
The reserve ratio is the ratio 1. to demand deposits and bank notes payable.
Obviously a bank's liquidity position is not as simple as the reserve ratio. The bank also gets liquidity from items 2-3. The bank's liquidity position is normally assessed by using a maturity ladder, where the bank's assets and liabilities are put into maturity buckets e.g. today, tomorrow, 2-5 days, 6-30 days, 31-60 days, 61-90 days, 91-180 days etc. Assets are placed in the earliest bucket they can be reliably liquidated or will contractually mature, while liabilities are put into the bucket of their contractual maturities. This allows the bank to smooth out its net funding (re-borrowing) requirements. The actual management of liquidity operates by monitoring various liquidity ratios, and progressively escalating the responses to reduced liquidity. The responses are to borrow funds and to sell assets.
Since the bank's primary function is credit intermediary, most of a bank's assets will consist of net loans and advances. For example ANZ National Bank Limited's assets as at 31/03/2007 were listed as:
Liquid Assets $5741m
Due from other financial institutions $3067m
Trading securities $1917m
Derivative financial instruments $3041m
Available for sale assets $45m
Net loans and advances $82258m
Shares in subsidiaries $190m
Current tax assets $28m
Other assets $800m
Deferred tax assets $353m
Premises and equipment $225m
Goodwill and other intangible assets $3292m
Total assets $100958m
Thus over 80% of the banks assets is net loans and advances, and about 10% of the bank's assets appear to be liquid.
On the liability side of the balance sheet, the bank owes $21659m in demand deposits bearing interest, and $3953m in deposits not bearing interest (presumably repayable on demand). This gives a broad liquid assets to demand deposits ratio of about 39%.
The bank has $19061m in assets maturing in less than three months, and $54889m in liabilities due within three months, a ratio of about 35%.
Legal tender reserves (in this case central bank notes) are only $245m, that is just 0.24% of assets and 0.1% of demand deposits.
So, one may conclude that in an advanced and free market financial system, the bulk of bank assets will be net loans and advances, and that banks will get most of their liquidity from demand deposits with other financial institutions, and marketable securities, rather than metallic reserves. I'd expect under a gold standard banks would hold about 1% of their assets and 3% of their demand liabilities as gold coin, and about 10-15% of their assets as other liquid assets (30-45% of their demand liabilities), with the bulk of the remainder of their assets being net loans and advances.
Published: May 17, 2007 10:14 PM
Björn Lundahl
What Has Government Done to Our Money? By Murray Rothbard:
“Defenders of banks reply as follows: the banks are simply functioning like other businesses—they take risks. Admittedly, if all the depositors presented their claims, the banks would be bankrupt, since outstanding receipts exceed gold in the vaults. But, banks simply take the chance—usually justified—that not everyone will ask for his gold*. The great difference, however, between the "fractional reserve" bank and all other business is this: other businessmen use their own or borrowed capital in ventures, and if they borrow credit, they promise to pay at a future date, taking care to have enough money at hand on that date to meet their obligation. If Smith borrows 100 gold ounces for a year, he will arrange to have 100 gold ounces available on that future date. But the bank isn't borrowing from its depositors; it doesn't pledge to pay back gold at a certain date in the future. Instead, it pledges to pay the receipt in gold at any time, on demand. In short, the bank note or deposit is not an IOU, or debt; it is a warehouse receipt for other people's property. Further, when a businessman borrows or lends money, he does not add to the money supply. The loaned funds are saved funds, part of the existing money supply being transferred from saver to borrower. Bank issues, on the other hand, artificially increase the money supply since pseudo-receipts are injected into the market.
A bank, then, is not taking the usual business risk. It does not, like all businessmen, arrange the time pattern of its assets proportionately to the time pattern of liabilities, i.e., see to it that it will have enough money, on due dates, to pay its bills. Instead, most of its liabilities are instantaneous, but its assets are not.
The bank creates new money out of thin air, and does not, like everyone else, have to acquire money by producing and selling its services. In short, the bank is already and at all times bankrupt; but its bankruptcy is only revealed when customers get suspicious and precipitate "bank runs." No other business experiences a phenomenon like a "run." No other business can be plunged into bankruptcy overnight simply because its customers decide to repossess their own property. No other business creates fictitious new money, which will evaporate when truly gauged.
The dire economic effects of fractional bank money will be explored in the next chapter. Here we conclude that, morally, such banking would have no more right to exist in a truly free market than any other form of implicit theft. It is true that the note or deposit does not actually say on its face that the warehouse guarantees to keep a full backing of gold on hand at all times. But the bank does promise to redeem on demand, and so when it issues any fake receipts, it is already committing fraud, since it immediately becomes impossible for the bank to keep its pledge and redeem all of its notes and deposits. [15] Fraud, therefore, is immediately being committed when the act of issuing pseudo-receipts takes place. Which particular receipts are fraudulent can only be discovered after a run on the bank has occurred (since all the receipts look alike), and the late coming claimants are left high and dry. [16]”
http://mises.org/money/2s12.asp
Björn Lundahl
Published: May 18, 2007 1:21 AM
Björn Lundahl
I quote from the book For a New Liberty, by Murray Rothbard:
9 Inflation and the Business Cycle: The Collapse of the Keynesian Paradigm
The Federal Reserve and Fractional Reserve Banking
”By far the most important route for the Fed's determining of total reserves is little known or understood by the public: the method of "open market purchases." What this simply means is that the Federal Reserve Bank goes out into the open market and buys an asset. Strictly, it doesn't matter what kind of an asset the Fed buys. It could, for example, be a pocket calculator for twenty dollars. Suppose that the Fed buys a pocket calculator from XYZ Electronics for twenty dollars. The Fed acquires a calculator; but the important point for our purposes is that XYZ Electronics acquires a check for twenty dollars from the Federal Reserve Bank. Now, the Fed is not open to checking accounts from private citizens, only from banks and the federal government itself. XYZ Electronics, therefore, can only do one thing with its twenty-dollar check: deposit it at its own bank, say the Acme Bank. At this point, another transaction takes place: XYZ gets an increase of twenty dollars in its checking account, in its "demand deposits." In return, Acme Bank gets a check, made over to itself, from the Federal Reserve Bank.
Now, the first thing that has happened is that XYZ's money stock has gone up by twenty dollars—its newly increased account at the Acme Bank—and nobody else's money stock has changed at all. So, at the end of this initial phase—phase I—the money supply has increased by twenty dollars, the same amount as the Fed's purchase of an asset.
"If one asks, where did the Fed get the twenty dollars to buy the calculator, then the answer is:
it created the twenty dollars out of thin air by simply writing out a check upon itself. No one, neither the Fed nor anyone else, had the twenty dollars before it was created in the process of the Fed's expenditure".
But this is not all. For now the Acme Bank, to its delight, finds it has a check on the Federal Reserve. It rushes to the Fed, deposits it, and acquires an increase of $20 in its reserves, that is, in its "demand deposits with the Fed." Now that the banking system has an increase in $20, it can and does expand credit, that is, create more demand deposits in the form of loans to business (or to consumers or government), until the total increase in checkbook money is $120*. At the end of phase II, then, we have an increase of $20 in bank reserves generated by Fed purchase of a calculator for that amount, an increase in $120 in bank demand deposits, and an increase of $100 in bank loans to business or others. The total money supply has increased by $120, of which $100 was created by the banks in the course of lending out checkbook money to business, and $20 was created by the Fed in the course of buying the calculator.
In practice, of course, the Fed does not spend much of its time buying haphazard assets. Its purchases of assets are so huge in order to inflate the economy that it must settle on a regular, highly liquid asset. In practice, this means purchases of U.S. government bonds and other U.S. government securities. The U.S. government bond market is huge and highly liquid, and the Fed does not have to get into the political conflicts that would be involved in figuring out which private stocks or bonds to purchase. For the government, this process also has the happy consequence of helping to prop up the government security market, and keep up the price of government bonds”.
“So here we have, at long last, the key to the mystery of the modern inflationary process. It is a process of continually expanding the money supply through continuing Fed purchases of government securities on the open market. Let the Fed wish to increase the money supply by $6 billion, and it will purchase government securities on the open market to a total of $1 billion (if the money multiplier of demand deposits/reserves is 6:1) and the goal will be speedily accomplished. In fact, week after week, even as these lines are being read, the Fed goes into the open market in New York and purchases whatever amount of government bonds it has decided upon, and thereby helps decide upon the amount of monetary inflation.”
* The reserve requirement set by the Federal Reserve on banks is exemplified by the ratio 6:1 (the required maximum multiple of deposit to reserves).
http://mises.org/rothbard/newliberty9.asp
Björn Lundahl
Published: May 18, 2007 1:29 AM
David Hillary
Björn Lundahl quotes Rothbard:
'The great difference, however, between the "fractional reserve" bank and all other business is this: other businessmen use their own or borrowed capital in ventures, and if they borrow credit, they promise to pay at a future date, taking care to have enough money at hand on that date to meet their obligation. If Smith borrows 100 gold ounces for a year, he will arrange to have 100 gold ounces available on that future date. But the bank isn't borrowing from its depositors; it doesn't pledge to pay back gold at a certain date in the future. Instead, it pledges to pay the receipt in gold at any time, on demand. In short, the bank note or deposit is not an IOU, or debt; it is a warehouse receipt for other people's property.'
Unfortunately this analysis is based on an incorrect understanding of the legal character of bank notes. Bank notes are a form of promissory notes, as documented below.
Promissory Notes
Definition
The legal definition and required components of notes have been codified in legislation: ‘A promissory note is an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay on demand, or at a fixed or determinable future time, a sum certain in money to or to the order of a specified person or to bearer.’ (Bills of Exchange Act 1908 (NZ), Section 84).
Characteristics
A note is a number of different things:
1. It is a species of contract
2. It is a formal obligation to pay a money, with a standard and exhaustive set of terms – sum, to whom, when, where, by whom
3. It is a documentary intangible – the right to be paid requires possession and presentation of the document
4. It is a negotiable instrument.
As a species of contract, any person with capacity to contract has capacity to make or indorse a note. ‘Capacity to incur liability as a party to a bill is co-extensive with capacity to contract:’ (Bills of Exchange Act 1908 (NZ), section 22).
As an obligation to pay money, the note is a credit contract, with the payee being the creditor and the maker (and any indorsers) being the debtor (or joint and several debtors). ‘The maker of a promissory note, by making it,— (a) Engages that he will pay it according to its tenor: …’ (Bills of Exchange Act 1908 (NZ), Section 89). Because the note has a standard and exhaustive set of terms, there are no further obligations on the maker other than to pay the specified sum to the payee/holder, on demand or at the fixed or determinable due date in the future. Any other financial covenant or security for the obligation is considered a separate collateral contract.
As a documentary intangible, ‘A promissory note is incomplete until delivery thereof to the payee or bearer.’ (Bills of Exchange Act 1908 (NZ), Section 85), and the rights to payment require possession of the instrument. Negotiation requires physical delivery of the document (see below). This is different from a written contract evidencing a debt, where the debt exists independently of the document, which has no value in and of itself. A promissory note is a valuable document in and of itself, nominally worth the sum payable on the instrument.
As a negotiable instrument, a note can be negotiated by indorsement and delivery, in the case of a note payable to order (that is, to a specified person), or by mere delivery, in the case of a note that is payable to bearer.
Negotiation enables the holder to sue in his own name and to have good title to the instrument even if it is obtained in good faith for valuable consideration from someone who had defective title. (Bills of Exchange Act 1908 (NZ), sections 31 and 38). Negotiation is therefore a superior transfer and delivery of the right to payment on the instrument, and enables the instrument to be easily sold or pledged as security. Another characteristic of negotiable instruments is standardisation and simplicity – because these instruments can and are intended to be bought and sold in trade, they must conform to a simple and standard form.
Usage
Promissory notes are commonly used to document loans and other money debts. For example financiers advance money in exchange for promissory notes, and then use the notes as security to borrow money from a bank. Loans documented as notes can also be sold ‘as is’ or sold to a special purpose vehicle that issues asset backed securities, as a means of securitising the loans. Thus the use of notes provides maximum flexibility to the financier in funding, liquidating or repackaging debts into more marketable, liquid or investable forms.
The other major usage of notes is bank notes, which are addressed in the next section.
Bank Notes
Definition
A bank note is a promissory note issued by a bank, payable to bearer on demand. Although the definition strictly does not admin non-banks to issue bank notes, non-banks issued metal (copper, tin or lead) disc tokens, payable to bearer on demand, and intended for use as small change.
For the purposes of regulation, the definition is also frequently extended to include bills of exchange as well as promissory notes, however the ‘payable to bearer’ and ‘on demand’ character of bank notes should be considered essential.
In supporting this definition evidence from both contemporary and historical sources will be presented.
Contemporary bank notes in Hong Kong are issued by three bank note issuing banks in Hong Kong: HSBC, Bank of China , and Standard Chartered Bank. In each case the notes contain an explicit promise to pay to the bearer on demand the sum of money printed on the note. The Bank of China also issues bank notes in Macau, which also contain an explicit promise to pay the bearer on demand (in Chinese and Portuguese). Images of contemporary bank notes from each note issuing bank in Hong Kong are available on request.
Under Hong Kong legislation the terminology used is ‘bank notes payable to bearer on demand’ which in turn are defined as ‘a bill of exchange or promissory note, issued by any bank, payable to bearer on demand’ (Legal Tender Notes Issue Ordinance, Section 3).
The mention of bills of exchange is a ‘catch all’ to avoid banks structuring what have traditionally been promissory notes as bills of exchange instead. This type of catch all extension is also used in the restrictions on bank note issue in the UK, New Zealand and some other commonwealth countries, but the definitions all state that bank notes are negotiable instruments comparable to promissory notes, and most of them restrict the definition explicitly to instruments payable to bearer on demand.
Contemporary bank notes in the Stirling zone are issued by 14 issuers: 1 central bank (the Bank of England), 3 Scottish commercial banks, 4 Northern Irish commercial banks, and 6 governments of British dependencies. Except for two British dependency government issued notes (Gibraltar and Falkland Islands) all Stirling bank notes are explicitly payable to bearer on demand. Images of contemporary Stirling bank notes are available on request. The Gibraltar and Falkland Islands bank notes are instead listed as being legal tender notes. This is also found in many other commonwealth countries. The absence of a payee legally makes the instruments inchoate (incomplete) and enables the holder to complete it however he thinks fit (Bills of Exchange Act 1908 (NZ) section 20). The absence of a payable date makes the instrument payable on demand (Bills of Exchange Act 1908 (NZ), section 10).
Some other commonwealth jurisdictions have more traditional definitions recited in legislation that is still in force as presented below.
‘“bank note” means a promissory note or engagement for the payment of money to bearer on demand issued by any person carrying on the business of banking.’ (Penal Code (Singapore), 498A. (see also Currency Act, section 14))
‘"Bank note" or "note" means the instrument commonly known as a bank note, that is to say: a promissory note (in whatever form or by whomsoever drawn or made) issued by a bank and entitling or purporting to entitle the bearer or holder thereof, without endorsement, or without any further or other endorsement than may be thereon at the time of the issuing thereof, to the payment on demand of the sum named therein’ (Banking Ordinance 1960 (Samoa), Section 2)
Historical sources include early bank notes and goldsmiths’ ‘running cash notes’ and early writings on the topic of banking, a selection of which is presented below.
The Bank of England was the first major joint stock commercial bank in England, established in 1694. According to the bank’s website, ‘Almost immediately the Bank started to issue notes in return for deposits. Like the goldsmiths’ notes, the crucial feature that made Bank of England notes a means of exchange was the promise to pay the bearer the sum of the note on demand.’ The bank’s notes remain promises to pay the bearer on demand to this day.
The first major Scottish joint stock commercial bank was the Bank of Scotland, formed in 1695, a year later than the Bank of England. The earliest preserved Scottish bank note was issued by the Bank of Scotland and it is a promissory note payable to bearer on demand dated 16th April 1716, is available as an image on request.
To this day the Bank of Scotland’s bank notes remain promises to pay the bearer on demand.
In Adam Smith’s Wealth of Nations, written in 1776, he states:
‘A paper money consisting in bank notes, issued by people of undoubted credit, payable upon demand without any condition, and in fact always readily paid as soon as presented, is, in every respect, equal in value to gold and silver money; since gold and silver money can at any time be had for it.’ (Book II, 2.95)
And elsewhere refers to them as promissory notes, e.g. ‘It is chiefly by discounting bills of exchange, that is, by advancing money upon them before they are due, that the greater part of banks and bankers issue their promissory notes.’ (Book II, 2.43)
Absence of officially minted small coins lead British traders to issue promissory notes in the form of copper discs, such as the one shown below dated 1795 (one halfpenny, payable at the India tea warehouse): (image available on request)
The Bank Notes (Scotland) Act 1845 refers to bank notes as ‘promissory note payable on demand to the bearer thereof’ (section 18).
Thus it is clear that bank notes have been both structured as, and considered as, promissory notes issued by a bank payable to bearer on demand for more than 300 years of English and commonwealth banking law and practice.
Characteristics
Bank notes, as a species of promissory note, have the same legal characteristics as other promissory notes.
Being bearer instruments, they are negotiated by mere delivery.
Usage
Bank notes are used by banks to borrow money and by holders for use as short term wealth holdings, negotiable by mere delivery, and useful as a medium of indirect exchange.
The basic market structure and characteristics will also be listed to document the usage where commercial banks are free to issue them and the notes are not subject to any statutory legal tender privileges.
Bank notes are issued by banks as an alternative form of obligation than cheque account balances, with transfer by delivery of the note rather than through the process of drawing a cheque which requires presentation. The bearer form of bank liability is a more immediate and flexible form of payment. The disadvantage of the bank note compared to cheques is the inability to restrict the instrument to safely pay an intended payee, as can be achieved by drawing a cheque to a named payee, and by crossing it and/or marking it non-transferable.
The market for bank notes is characterised by:
1. Standardised denominations to aid counting and in making change (although this feature took some time to develop, with early notes being for odd sums)
2. Security features such as special paper or polymer, threads, transparent windows, raised printing etc. to make counterfeiting difficult and verification easier
3. Maintaining branch networks to issue, bank and redeem bank notes
4. Large banks with high name recognition and trust in the community
5. Mutual recognition and acceptance of participating rival bank notes at par, typically by the leading banks in the market
6. Exchange and net deferred settlement of bank notes through a note exchange or exchanges operated by participating banks
This market structure enables bank notes of large strong banks to provide a proportion of the bearer form of money used by banks and non banks, with easy access to redemption, directly with the issuing bank, or indirectly through another bank.
Published: May 18, 2007 3:10 AM
Björn Lundahl
Naturally, Rothbard´s example in my above post” What Has Government Done to Our Money?” refers to a gold standard, but indirectly the same principle is meant to apply for a fiat money reserve standard and that is when fiat money are deposited in a bank, the banker is obliged to pay in cash on demand.
Demand deposit=A bank deposit that can be withdrawn without advance notice.
Björn Lundahl
Published: May 18, 2007 7:34 AM
Eric Lansing
why are people responding to David Hillary?
The guy is an ivory tower crank.
Published: May 18, 2007 8:08 AM
David Hillary
Björn Lundahl is now talking about balances of customers with banks that are repayable to the customer's order, i.e. the core of the 'business of banking' legally defined. A bank, legally, is a person who conducts current accounts for customers, pays the customer's cheques and collects the cheques deposited by the customer to the credit of the customer's account. So let's examine them separately.
Current Accounts
Definition
A current account is an accounting record maintained by one person, the account keeper, of the credits, debits and the resulting balance owing from or owed to another person, the account holder, in the course of a relationship. Normally the account keeper makes a periodic statement of account to the account holder, showing the opening balance, record of debits and credits and what they were for, and the closing balance.
Current accounts are also called open accounts and other terms depending on the industry, country and/or type of account holder.
Characteristics
The current account records the transactions and resulting balance with a single counterparty from the perspective of the account keeper. Generally this is therefore, on its own, just the view of the account keeper and has no legal effect. However, inasmuch as the account records the transactions correctly and they are binding and valid on the parties, the balance of the account is the amount legally owing from one party to the other.
Under most circumstances, mutual debts between parties from separate transactions cancel out, and only the net amount is legally owed. The device of an account enables all the transactions to be recorded in a way that calculates the net balance.
For entries to be made on the same account, they should be between the same two persons in the same capacity. For example transactions with an account holder acting both in his personal capacity and in his capacity as trustee of a trust should be recorded on separate accounts, and in the same way the account keeper is a single person acting in a single capacity.
By stating an account on an account statement, the account keeper could be estopped from later backing out of its position to the disadvantage of the account holder, however this does not apply in all cases. For the account holder, an account statement is not, legally, an ‘account stated’ and binding on the account holder, as striking the definitive and agreed financial position between the parties, since the account holder is not obliged to check the accuracy of such account statements. This leaves an ongoing burden and risk for the account keeper to document each entry on the account and risk disputes about entries, and therefore, the balance.
Usage
Current accounts are normally used to provide or obtain short term credit and to administer transactions when the transactions between the account keeper and account holder are ongoing.
Many small companies survive on loans from their shareholders, and these loans are often made and repaid on an as needed and as available basis. For this type of transaction, the company’s accounting records show an account labelled ‘shareholder’s current account’, or ‘current account with [shareholder name]’ to record the advances and repayments, and interest charged (if any).
Many businesses that provide goods and services to customers on an ongoing but ad hoc manner conduct current accounts for their customers as follows. Sometimes the customer is required to place a deposit, which puts the account into credit, if the business is not willing to provide the goods or services to the customer on credit. Whenever the business delivers goods or services it charges the amounts payable to the customer’s account. The business sends the customers monthly account statement, which also operate as an invoice (often called an ‘invoice statement’) and the customer is required to pay the outstanding balance by a due date. Thus a current account enables for periodic net deferred settlement of the balances owing. When the relationship finishes, the customer settles the final amount owing or the business refunds any credit balance. If the customer overpays, or otherwise has a credit balance, the customer can demand repayment, but this demand is normally only made if the credit balance is substantial. A current account of this nature is to be distinguished from a trust account, which is a device to segregate the funds from the funds of the business accepting them.
Some businesses provide loans to their employees in the form of salary advances, which are repaid via deduction from the salary of the employee. These advances and deductions, and the resulting balances are shown on the employee’s payslip, and are recorded on the businesses accounting records under a current account.
Banks conduct current accounts for their customers in respect of deposits, withdrawals and payments which are addressed in the next section.
Cheque Accounts
Definition
A cheque account is a current account with a bank that can be drawn on by cheque, and to which cheques may be deposited for collection by the bank.
Characteristics
The cheque account, as a current account, has the same characteristics as other current accounts. The account keeper is the bank and the customer is the account holder. Unlike non-banks, banks often conduct more than one account for the same customer; however the bank retains the right to combine accounts for various purposes. The right of the bank to combine accounts shows that the different accounts of the same customer with the same bank have an administrative rather than a legal effect. Were the accounts in the nature of distinct trust funds, no right of combination would exist.
The transactions of paying and collecting cheques have their own particular characteristics, and it is the conduct of these transactions that make banking distinct from non-banking business.
The legal definition of a bank is ‘Banker includes a body of persons, whether incorporated or not, who carry on the business of banking’ (Bills of Exchange Act 1908 (NZ), section 2). This definition, although circular, nevertheless does define the term bank functionally rather than institutionally, that is to say a bank is someone who carries on a particular business, rather than a person with a special structure or licence.
The business of banking, at common law, involves three necessary elements:
1. The bank must conduct current accounts for customers
2. The bank must pay cheques drawn on the bank by its customers, from available funds on the customer’s current account
3. The bank must collect cheques deposited by its customers, for credit to their current accounts.
Clearly it is not the conduct of current accounts for customer alone that makes a firm a bank – as detailed above many non-bank businesses conduct current accounts for their customers – it requires the payment and collection of cheques from and to such accounts to constitute the business of banking.
The legal definition of a bank customer is person who has a cheque account of his own with the bank, rather than a note holder or a person who receives other services from a bank without having a cheque account of his own with the bank.
The contemporary legal definition is somewhat outdated, cheques having been largely overtaken by other payment instruments, especially those that enable the customer to order payments from the account via an authenticated electronic message, and which are processed in favour of the payee’s account with the payee’s bank without the need to receive and bank paper instruments (i.e. cheques). Thus banking law theorists have suggested that sending/receiving third party payments to/from a current account replace the cheque based definition.
The bank-customer relationship is contractual, and the key implied terms of the contract have been subject to extensive litigation over hundreds of years of banking disputes, and as a result, are well known and established. Implied terms are terms that are considered necessary to make the contract work and so obvious that they go without saying.
The key terms of the bank customer relationship are:
1. Debtor-creditor terms in respect of the balance of the current account(s) and deposits of the customer
2. Principal-agent terms in relation to the payment and collection of cheques, with funds debited from and credited respectively to the customer’s current account
3. Right of the customer to appropriate a deposit to a specified account with the bank
4. Right of the bank to appropriate a deposit to any account of the customer if the customer has not specified an account the deposit is to be appropriated to
5. Right of the customer to secrecy by the bank in respect of the balance of the account and the transactions that go through the account (subject to exceptions)
6. Right of the bank to set off different accounts of the same customer
7. Duty of the bank to pay the customer’s cheques up to the available balance of the customer’s account
8. Liability to pay on a debt of the bank (or of the customer) on current account does not arise until a demand is made
9. The bank must not close the current account of the customer without reasonable notice, as cheques are normally outstanding in the ordinary course of business for several days
10. In the case of an overdraft, the bank is entitled to charge interest and compound it periodically, and a cheque for more than the available balance of an account is construed as a request for an overdraft
11. Bank’s lien on cheques in the process of collection to the extent that the customer is indebted to the bank
12. Duty of customer to exercise reasonable care in drawing cheques to prevent forgery.
13. Duty of customers to customer to notify the bank immediately if a fraud is discovered affecting the account.
Numbers 1, 5-7 and 10-11 are the ones that explicitly or implicitly acknowledge the debtor-creditor relationship in respect of the current account of the customer with the bank. As this matter is dealt with and supported by banking law texts, an example of the relevant sections and supporting references from Tyree’s Banking Law in New Zealand, will be quoted in full to argue the point:
‘3.2 Implied Terms
3.2.1 Debtor/Creditor
The key implied term of the banker-customer contract established in the landmark case of Foley v Hill is that, in relation to a customer’s deposit with a bank, the bank is the debtor of the customer, not a trustee of the funds. Lord Cottenham said:
'Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to return an equivalent by paying a similar sum to that deposited with him when he is asked for it. Money paid into a bank is money known by the principal to be placed there for the purpose of being under the control of the banker; it is then the banker’s money; he is known to deal with it as his own; he makes what profit he can, which profit he retains to himself. He has contracted, having received that money, to repay the principal when demanded a sum equivalent to that paid into his hands.'
Accordingly, when a banker receives money from a customer or from a third party for the account of a customer, the banker does so as borrower, not as trustee, bailee, or agent. The bank obtains title to the money and the income it generates. On the insolvency of the bank the customer ranks as a mere unsecured creditor and at best can expect the return of a fraction of the original deposit. The roles of debtor and creditor are reversed when the account is overdrawn. This implied term is necessary for business efficacy of the banker-customer contract. So, for example, if a bank were a bailor [sic, should be bailee] of the customer’s money, the bank would hold and return all of the same notes and coins deposited and keep them segregated from any other money in the possession of the banker. As bailors [sic, should be bailees], banks would have found it difficult to carry out their basic function of intermediation by on-lending deposits to borrowers. Alternatively, if the banker were a trustee or agent in relation to the money deposited, the banker would be obliged to invest the money prudently or at the direction of the customer, and to account to the customer for the actual income earned rather than pay interest at an agreed rate.’
Usage
Cheque accounts are used to provide finance and fee revenue to the bank and to provide a form of wealth to customers that can be used for savings and third party payments by drawing and depositing cheques.
Cheque accounts over time have eroded bank notes in importance in the banking business:
‘The system of banking has recently undergone an entire change. Instead of the bank issuing its own notes in return for the money of the customer deposited with him, he gives credit in account to the depositor, and leaves it to the latter to draw upon him to bearer, or order by what is now called a cheque.’ (Stevens Elements of Mercantile Law, 5th Edition, Butterworth & Co, London, 1911, p 294)
Additionally, and like current accounts with non-banks, a cheque account with a bank is used as a means of providing credit to the customer. Such debit balances are called overdrafts, and are a common means of providing personal and business customers with short term finance.
So, as with bank notes, cheque account balances are simple debtor-creditor terms.
Published: May 18, 2007 9:08 AM
Björn Lundahl
Eric Lansing
”why are people responding to David Hillary?
The guy is an ivory tower crank.”
I am at least not doing that.
Björn
Published: May 18, 2007 9:24 AM
RogerM
David Hillary: "Fractional reserve banking is, as far as I see it, the regular and ordinary form of banking..."
Since Geir, Jim and others seem to hold David's position, this question is addressed to them as well. What to you think of the quantity theory of money and fractional banking's role in inflating/deflating the money supply?
Eric: "why are people responding to David Hillary?"
Because his position is the dominant one in the world.
Like many Austrians, I think fractional reserve banking is fraudulent, but I oppose it more because of its disastrous consequences. I firmly believe we would not have the welfare state we suffer today had we squashed FRB a century ago.
Published: May 18, 2007 9:47 AM
David Hillary
RogerM asks: 'What to you think of the quantity theory of money and fractional banking's role in inflating/deflating the money supply?'
This moves the discussion from the legal nature of the bank-customer or bank-note holder relationship to the economic impact of it.
The quantity theory is expressed as P*Y=M*V, where P is the price level, Y is the real economic output rate, M is the stock of money and V is P*Y/M. Thus V cannot be measured or considered on its own account, and it is merely the function of the three other variables. V is also not a constant and thus does not imply any relationship between the other three variables. Thus the tautology is not helpful in understanding P, or, for that matter, M or Y.
Many anti-fractional-reserve-bankers appear to tacitly or explicitly follow the quantity theory, however their views are not consistent with it. Anti-fractional-reserve-bankers typically argue that fractional reserve banking commits a sin of providing money not 'backed' by equivalent quantity of specie, however the quantity theory of money does not even reference the quantity of specie.
The term 'money supply' should be used with caution. Normally the word supply refers to a FLOW rather than a STOCK, however money is a stock. Normally if the supply (flow) schedule moves to the right or downwards (i.e. 'increasing supply') the price will be reduced, however this does not apply to stocks but to flows (or if it applies to stocks, it applies differently). For example if the stock of cars increases, this may be consistent with an increase in the price of cars (if the increase was due to greater popularity of owning cars) or a decrease (if due to an increase in the supply flow of cars without an increase in the demand flow, resulting in a build up of unsold cars).
In the same way the word inflation (and the word deflation) requires caution. Normally these words are not used for changes in stocks, but to changes in prices.
To really understand the economics of money, the interest rate, capital and the exchange rate of money, requires clear thought processes and proper analysis. In particular, stocks should be distinguished from flows, non-financial capital from financial capital, and the process of obtaining equilibrium over time should be modelled. I have a theory about this but it would take a long time to explain.
Published: May 18, 2007 11:11 AM
Björn Lundahl
In my bookshelf I found an old book and looked into it “Dollars and Deficits, Inflation, Monetary Policy and the Balance of Payments”, by Dr. Milton Friedman published in 1968, chapter two, page 76:
“I cannot forbear a minor digression at this point. For a long time I have been a proponent of 100% reserve banking. Under this system, the depositary activities of banks would be separated from their lending and investing activities, and the depositary institutions would serve as pure warehouses of funds. For every dollar of deposits, they would be required to hold a dollar currency or its equivalent. Those of us who favour this scheme are accustomed to being labelled “unrealistic”; to being told that we are proposing a reform that has no chance of adoption and would require utterly impractical changes in the banking system if it were adopted.”
It seems that Milton Friedman gave up this idea of 100% fiat money reserve standard and instead proposed a monetary rule as this standpoint was more politically feasible.
Björn Lundahl
Published: May 18, 2007 12:18 PM
RogerM
David Hillary: "To really understand the economics of money, the interest rate, capital and the exchange rate of money, requires clear thought processes and proper analysis."
That's what I thought. You disagree with it. Forget the formula and focus on the general concept of the quantity theory of money which was discussed by scholars at the School of Salamanca over 400 years ago: increases in the money supply cause a general increase in prices, all other things being equal. Everyone in Europe noticed this phenomenon in the 17th century as Spain shipped received boatloads of stolen gold and silver from the Americas.
The largest part of money today exists as loans that are deposited in checking accounts. If those loans come from the savings of other individuals, then no increase in the money supply takes place. That would happen only under a 100% reserve system. A fractional reserve system creates loans out of nothing (or gives two people claim to the same saving, depending on how you want to look at it.) 100% reserve banking would fix the stock of money supply. FRB allows banks to inflate the money supply by ten times the reserve amount with a reserve requirement of 10%.
Proponents of FRB have to find a way to deny the quantity theory of money in order to justify their position. But it's one of the most solidly established principles of economics. Without the quantity theory, we're left with no explanation for price inflation other than the random shocks of Keynesian and Neo-Classical econ. And we're left without an explanation for business cycles, except the silly "expectations" of neo-Classics and "sticky prices and wages" of the neo-Keynesians.
The only reason to focus on gold as money is that gold can't be printed at will by banks or the government. But monetary inflation can still happen under gold money, as has for centuries, because of credit expansion. The only way to stop the horrendous economic events like the Great Depression is to stop FRB. The first century and a half of the US was nothing but one financial disaster after another, every ten years about, all caused by FRB expanding credit, then contracting it when firms went bankrupt, and all under a gold monetary system.
Published: May 18, 2007 5:52 PM
David Hillary
RogerM
we're in agreement that this area of economics requires clear thought processes and proper analysis.
If the P*Y=M*V formula is incorrect, what is the correct formula?
Under a free banking and a gold standard there are two forms of money: non-financial (gold coin) and financial (bank notes and cheque account balances). The correct relationship in connection with the quantity of money is the quantity of gold coin and the interest rate: the interest rate is a decreasing function of the gold coin stock. The interest rate is the rate of return on, and opportunity cost of holding, gold coin. The gold coin stock is subject to diminishing marginal returns, like every other form of non-financial capital.
Correlation is not causation. The exchange rate of gold coin can fall because of increase supply flows (downward and/or rightward shift of the supply flow schedule), and not because of an increase of the gold coin stock. During an adjustment period, the increased supply flow will increase the gold coin stock, which reduces the interest rate, and makes investments in substitute forms of capital (e.g. buildings) more economic. Increases in demand for labour and materials for construction of buildings pushes prices up and thereby, the exchange rate of gold coin down, over time. The decrease in the exchange rate of gold coin makes mining and minting coin less economic, reducing the rate of production. At the same time the reduced exchange rate makes the rate of scrapping coin to make ornaments and equipment increase, which together with the reduction in production flows will eventually reduce the stock of gold coin. The reduced stock of gold coin will increase the interest rate on money and make investment in buildings less economic. Reduced demand for labour and materials for constructing buildings makes the prices of labour and materials reduced, increasing the exchange rate of gold coin. And so on. Thus the exchange rate and interest rate of money take time to adjust, and the adjustment is in a cycle. If all the underlying supply, demand and rate of return functions are linear, mathematical modelling shows that the cycles are sinusoidal, and thus provide an explanation for the business cycle. By incorporating some forward looking responses in the form of the 'yield curve' and making longer rather than short term interest rate driving the demand for construction of buildings, the cycles become attenuating (also known as 'damped harmonic motion' similar to an automobile suspension system consisting of springs and shock absorbers). I wish I could offer a less complex model for the interest rate and the exchange rate, but this is where my analysis has lead me to. Thus there are other explanations to interest rate and exchange rate other than 'silly "expectations" of neo-Classics and "sticky prices and wages" of the neo-Keynesians'
Bank notes and cheque account balances are savings of their holders or the bank customers, savings that are in the form of a loan to the bank, and that the bank uses as finance for its assets. For example, if a worker earns $1000 during a month, and during the same month he spends $500, he has saved $500 during the month. This is a flow of savings which supports a flow of investment. Savings are also a stock, being the value of his holdings at any point in time. If the man's savings are in the form of bank notes or bank deposits on cheque account, he has invested in a financial asset, being the right of repayment against the bank. The bank thus borrows his savings, and uses them to invest in coin (non-financial capital) and loans to customers (financial capital). Thus banking operations consists of borrowing and lending money. Bank note holders and customers would rather lend to the bank than to commercial and personal borrowers because the bank will repay more conveniently (though its branch network and through the cheque clearing system and other payments systems), and more reliably (most major banks have AA credit rating (0.03% probability of default in 1 year), whereas most commercial borrowers have BB (about 1% probability of default in 1 year).
100% reserve 'banking' would not fix the stock of money, the stock of money would increase and decrease with mining/minting and melting/scrapping of gold coin.
Fractional reserve banking allows for the form of savings to be changed but it does not allow for their quantity to be changed. For example, if bank customers buy corporate bonds, bank bonds, or even make term deposits with the same bank, the form of the customer's wealth holding changes from a monetary form to a non-monetary form. Since the bank holds corporate paper and similar assets in its own portfolio, it simply sells such assets to fund such customer withdrawals. Thus it is as if the bank had repaid some of its financial assets directly to its customers as repayment of amounts owed on cheque account. In the same way a goods intermediary can be cut out of the transactions by consumers buying direct from the factory, credit intermediaries can be cut out of the credit transactions by savers investing directly in the obligations of commercial and industrial (and for that matter personal) borrowers. However, as with goods production and sale, borrowing and lending will always have a place for intermediaries. No one says that a goods intermediary creates products 'out of thin air' since it sells them without ever producing them. In the same way a bank loan does not come 'out of thin air' simply because it didn't fund the loan through equity but rather it funded it through borrowed capital.
The great depression was caused by trade protectionism/tariff wars, wage and price controls, banking regulation that thwarted the emergence of large strong multi-state multi-branch banks, and many other causes involving government intervention.
Published: May 18, 2007 10:11 PM
Björn Lundahl
Jim
I am sorry for not answering your comment. I thought some of my posts might give you answers and that I needed not, therefore, to directly answer your question.
Well, it is the depositors who are defrauded in a fractional reserve system and not the borrowers as fractional reserve bankers cannot fulfil their obligations against all the depositors. This is the main thing.
Björn Lundahl
Published: May 19, 2007 12:42 PM
Björn Lundahl
Well, here is some more heavy artillery. I have named it “bombe surprise.”
100 percent gold reserve money standard
I quote from America’s Great Depression, by Murray Rothbard:
Preventing Depressions
“Private banks, it is true, can themselves inflate the money supply by issuing more claims to standard money (whether gold or government paper) than they could possibly redeem. A bank deposit is equivalent to a warehouse receipt for cash, a receipt which the bank pledges to redeem at any time the customer wishes to take his money out of the bank's vaults. The whole system of "fractional-reserve banking" involves the issuance of receipts which cannot possibly be redeemed”.
And:
“But a 100 percent gold reserve requirement would not be just another administrative control by government; it would be part and parcel of the general libertarian legal prohibition against fraud. Everyone except absolute pacifists concedes that violence against person and property should be outlawed, and that agencies, operating under this general law, should defend person and property against attack. Libertarians, advocates of laissez-faire, believe that "governments" should confine themselves to being defense agencies only. Fraud is equivalent to theft, for fraud is committed when one part of an exchange contract is deliberately not fulfilled after the other's property has been taken. Banks that issue receipts to non-existent gold are really committing fraud, because it is then impossible for all property owners (of claims to gold) to claim their rightful property. Therefore, prohibition of such practices would not be an act of government intervention in the free market; it would be part of the general legal defense of property against attack which a free market requires.[28], [29).”
http://mises.org/rothbard/agd/chapter1.asp#preventing_depressions
Björn Lundahl
Published: May 19, 2007 1:15 PM
RogerM
David:"Thus the exchange rate and interest rate of money take time to adjust, and the adjustment is in a cycle."
Is this your own theory of business cycles or did you learn it from someone else? Essentially, you're saying that business cycles under gold money are caused by fluctuations in the production of gold mining. However, gold mining might fluctuate by +-3%, not nearly enough to cause the massive economic disruptions of the past. Still, the US hasn't been on a real gold standard since WWI, so how do you explain the Great Depression and the numerous recessions since then?
David: "100% reserve 'banking' would not fix the stock of money, the stock of money would increase and decrease with mining/minting and melting/scrapping of gold coin."
As I wrote earlier, 100% reserve banking would fix the stock of money, all other things being equal, that is, assuming no increase in gold from mining, melting, or scrapping. But the important point is that money supply increases from those sources are limited to about a 2-3% annual growth whereas credit expansion under FRB is unlimited. The unlimited expansion of money under FRB has resulted in the world's greatest financial disasters.
David:"The great depression was caused by trade protectionism/tariff wars, wage and price controls, banking regulation that thwarted the emergence of large strong multi-state multi-branch banks, and many other causes involving government intervention."
While those actions aborted the recovery from the Depression, they didn't cause it. Read Rothbard's account of the Depression for the best analysis of the causes. In summary, the cause was the malinvestment in the 1920's caused by massive credit expansion, and that was due to FRB.
David:"The bank thus borrows his savings, and uses them to invest in coin (non-financial capital) and loans to customers (financial capital). Thus banking operations consists of borrowing and lending money."
You're employing slight of hand here, as most bankers do. What does the bank do with the "borrowed" funds? It loans them out at interest to a borrower. If the bank were truly "borrowing" a depositor's savings, then the depositor would not have access to those funds until the borrowing customer repaid his loan. But in FRB, both the depositor and the borrower have access to the same funds. The banks then runs a shell game to cover demands for cash when two or more parties have claim to the same savings.
FRB is not unlike a car dealer selling the same car to two different people knowing that each consumer will only need the car a few minutes per day. So the dealer takes the car when one owner isn't using it and delivers it to the second owner. If both owners need the car at the same time, the dealer simply "borrows" one that looks like it from another unsuspecting customer who might not need it at the same time. The more customers the car dealer has, the easier it is to juggle cars and keep the shell game going. If all customers need their cars at the same time, the dealer goes bankrupt. In banking, we call it a run on the bank. The only difference between the car dealer and a bank is that the government will bail out the bank while it will send the car dealer to jail.
David: "No one says that a goods intermediary creates products 'out of thin air' since it sells them without ever producing them. In the same way a bank loan does not come 'out of thin air' simply because it didn't fund the loan through equity but rather it funded it through borrowed capital."
You may not think you follow the Real Bills Doctrine, but everything you write agrees completely with it. Banks are not intermediaries under FRB; they create money. If banks were intermediaries, they would charge a fee for storing people's money in checking and savings accounts and not loan out that money. They would pay interest only on time deposits.
Published: May 19, 2007 10:03 PM
David Hillary
RogerM asks several questions and makes several further comments.
The business cycle and monetary economics theory I mentioned before I didn't get from anyone else, and I can't find anyone else who has reached the same conclusion.
I'm not saying that business cycles under free banking and gold standard would be primarily caused by fluctuations in gold production schedules but by variations in any of:
1. gold production supply schedule
2. gold consumption demand shedule
3. demand schedule for holding gold coin for liquidity reserves etc.
4. the investment demand schedule for the construction of capital assets (e.g. buildings).
Variation can come from variation in any of these supply/demand factors. However the effect of such changes depends on which one changes. For example a change in the gold production supply schedule will not have an immediate effect on the short term interest rate, instead it will have an effect on the rate of surplus/deficit in the gold market, which impacts the stock of gold coin only slowly and over time. In the short run the system is not susceptible to volatility in the exchange rate of gold coin, since prices are not flexible in the short term, and there is no mechanism to foster across the board adjustments at the short term. Instead, any day to day variations show up in the short term market interest rate, which is perfectly flexible. For example, a change in the demand to hold gold coin shows up immediately in the short term interest rate: if banks and non-banks want to hold gold coin more urgently, since the gold coin stock can change only slowly over time, the existing stock is bid for at higher prices (interest rates), so allocates the holdings to those who are willing to forgo the highest returns for holding them. For example if some banks get into financial difficulty, the depositors and note holders of it will be less willing to maintain them or hold them, and some proportion of the funds will be re-deposited with other (stronger) banks, some proportion will be held as bank notes of other banks, and some proportion will be held as gold coin, thus increasing the overall demand for holding gold coin. This demand can only be met by other holders of gold coin (e.g. the bank in financial difficulty, other banks, and the public) being persuaded to hold less, something they will only do if the returns from holding less reserves or more bank deposits are higher. It takes time for the high interest rates to increase the exchange rate of gold coin, since the process of deflation takes time, and even when the exchange rate is higher, it takes time for the resulting surplus in the gold market to significantly increase the gold coin stock. This is why the process of adjustment can only be correctly understood as occurring through time. Of course it is possible that the more urgent demand to hold gold coin was only temporary, in which case the interest rate will quickly return to lower levels, and the long term impact of the change will be muted.
Thus, under the model explained, interest rate risk, and by implication building price risk, are the evidence of short term variations, and the interest rate is the mechanism by which the system is balanced in the short term (on this point I'm not the first to argue this, in fact is is quite conventional theory that the interest rate balances aggregate supply and demand).
Explaining business cycles in the 20th century should be considered in two phases: the gold standard and gold exchange standard era, and the unanchored floating fiat money era. During the gold standard system, in its various forms, the variations can be attributed to the changes in the four factors above, but also due to disruptive government interventions in the form of gold confiscations, currency devaluations, and banking restrictions and so forth. During the unanchored fiat money era, the primary means of monetary policy has moved from the exchange rate to the interest rate, and the central banks have tried to regulate the exchange rate by mimicking the interest rate-capital investment-inflation/deflation process. I.e. central banks today accommodate any demand for holding the replacement for gold coin, central bank notes, thus eliminating the short term variation in the short term interest rate, but then adjust the short term interest rate from time to time to regulate the rate of building capital construction, and thereby the rate of inflation or deflation, and thereby the exchange rate of their monetary unit over time.
The concept of access to savings is not sound. If I invest my savings in a marketable debt security, I can 'access' those savings by using the asset as security to borrow money, or from selling the instrument when I want to employ my savings for something else or to consume them on a wild party. Lending money to a bank that promises to repay them on demand has a similar effect of access, since I can simply demand repayment and thus liquidate my investment when I want to invest it elsewhere or consume it. Even non-financial assets are accessible savings through sale, e.g. cars and houses. But in the scheme of things, the most liquid and marketable assets are short term debt securities issued by financial institutions, and demand debt in the form of bank notes and cheque account deposits especially. Borrowings thus do not imply lack of access to the funds by the creditor, since the creditor can demand repayment or sell the obligation to someone else.
If a car dealer wants to give two customers access to the same car (or the same pool of cars), then there is a legal method to do this: issue to each customer a non-exclusive licence to use the car. This method is commonly used in car parks, where the number of licences issued exceeds the number of car parks. But a bank does not issue either title to any assets when it issues a bank note or accepts a deposit on cheque account, instead it engages to repay on demand.
Banks are credit intermediaries, borrowing and lending money on their own account, under fractional reserve banking. They don't borrow money for free, although sometimes interest free, not cost free. Use of money is consideration in and of itself. Banks don't need to charge storage fees because they don't undertake to store but to repay, and are free to invest their assets as they see fit. An agent is a form of intermediary but an intermediary is not necessarily an agent. Banks are agents in respect of the cheques of their customers and those deposited by their customers for collection, but are principals in respect of the balances owing from or to the customer or not holder by the bank.
The 'real bills doctrine' holds that only short term bills of exchange 'drawn by a real debtor on a real creditor' are satisfactory assets for a bank to invest in. I believe that banks can invest also in long term commercial loans and residential mortgage secured loans and bank bonds, corporate paper and specie reserves, in addition to 'real bills.' What matters is not the form of asset, but its risk. A financially sound bank is one that has a diversified portfolio of assets of reasonably good quality, and has a sufficiently large capital position to support, and a sufficient balance between maturity structures and asset liquidity to maintain liquidity. Of course this is a question of degree, and some banks are financially more safe (lower risk) than others.
Published: May 20, 2007 2:00 AM
Björn Lundahl
Recessions and The Great Depression were caused by Government Interventions!
In a purely free market (without Government intervention), the rate of interest is determined by people’s “willingness to save and invest” (which is called people’s time preferences) for future use, as compared to how much they are “willingly to consume now”. If people change their “willingness to save” (time preferences) and want to save more, the additional savings will cause the rate of interest to fall (increased supply of savings), and businesses will borrow and invest these additional savings. When the Central Bank (for example The Federal Reserve) increases the money supply and expands bank credit (which Central Banks does everywhere and all the time and always “out of thin air”), it initially lowers the rate of interest and thereby misleads businessmen to act in a manner as if true savings have increased, which in turn leads businessmen to invests those supposed savings in capital goods. New projects that were not profitable before, will now suddenly with this lower interest rate, be profitable. While this process is working, the economy is in an inflationary boom phase (expansion). Capital goods such as stocks, real estate etc, will be more demanded and invested in, and prices of those will rise faster and more intensely in relation to consumption goods. As these supposed savings have worked their way through the economy, prices of goods, services and wages have generally increased to a height which prices for them would have not reached without these supposed savings.
As mentioned, people’s “willingness to save and invest” have not changed (people’s time preferences have not changed) for it was only the Central Bank that increased, out of thin air, additional “savings”. When supposed savings have worked their way through the economy and are received, finally, in increased wages, people still spend their real wages in the same manner as before. They save/ consume in real terms and in same proportion to each other, as before mentioned increase in supposed savings. Because of this, a lack of savings will occur and the rate of interest will rise. Projects that businessmen have invested in and that seemed to be profitable when the rate of interest was lowered are now revealed to be unprofitable. All those investments are revealed to be malinvestments. Businessmen will stop investing in those projects and lay off workers. Prices of capital goods, real estate, stocks etc, will fall sharply and relatively to the fall in prices of consumer goods. The economy is in a depression phase. When those investments are liquidated, the economy is adjusted to people’s “willingness to save and invest” and to consume. The economic structure corresponds to the ratio which people want to save and consume. The economy is now healthy again.
Now then, in the 1920s the Federal Reserve, in the US, increased the money supply and bank credit, which in the 30s resulted in The Great Depression. The same story goes with Japan during the 1980s, which during the 90s, resulted in a depression, go to;
http://en.wikipedia.org/wiki/Japanese_asset_price_bubble
In Sweden we had banks lending out heavily during the late 80s, which also, led to a depression in the 90s.
All business cycles are caused by the same phenomenon. Economic crisis can occur because of other factors such as wars, boycotts, oil prices etc, but pure business cycles have in common the same cause.
I have tried, in a very few words and in a easy manner, to explain Ludwig von Mises business cycle theory, which is also called the Austrian theory of the business cycle. All faults are mine. Friedrich August von Hayek elaborated this theory and received in 1974 the Nobel Prize* for this. Go to;
http://nobelprize.org/nobel_prizes/economics/laureates/1974/
If you want to know more about this theory, go to;
http://mises.org/rothbard/agd/contents.asp
And to;
http://mises.org/money.asp
Björn Lundahl
* Information about the Nobel Prize in Economics, go to;
http://cepa.newschool.edu/het/schools/nobel.htm
Published: May 20, 2007 2:10 AM
Björn Lundahl
Increase of gold supplies does not either cause business cycles in a 100% gold reserve money standard.
America’s Great Depression:
“The potential range of such cyclical effects in practice, of course, is severely limited: the gold supply is limited by the fortunes of gold mining, and only a fraction of new gold enters the loan market before influencing prices and wage rates.”
Read the rest “Gold Changes and the Cycle”:
http://mises.org/rothbard/agd/chapter1.asp#problems_in_the_austrian_theory
Björn Lundahl
Published: May 20, 2007 2:35 AM
David Hillary
Björn Lundahl repeats the 'time preference' claim. People might as well be said to have a 'goods preference' or 'leisure preference' as a 'time preference' the three things are about equally unhelpful.
The interest rate is not about savings, investment and consumption because these are FLOWS. The interest rate is about the pricing of STOCKS of assets, i.e. the price of money loans. In the loan market people don't trade time, they trade deferred payment obligations, i.e. they are the interest rate on money, and not on goods and services generally.
Under a gold standard and free banking, the interest rate on money signals how strongly people want to hold gold coin given the existing stock thereof. If the demand is stronger, people pay a higher opportunity cost to hold it, and investment in other forms of non-financial capital becomes less economic. This results in less demand for labour and materials to construct buildings, and a higher exchange rate of gold coin. Higher gold prices result in more mining and minting and less scrapping and melting of coin, and increase the gold stock over time. In the same way a weak demand for holding gold coin reduces the interest rate, and fosters greater investment in buildings and other forms of non-financial capital, inflation, and a reduced exchange rate and gold stock over time, thus allocating the capital stock from gold coin to buildings. So the capital stock can flow between coin and buildings over time and in response to the stocks and demand to hold them.
Flows of savings, investment and consumption cannot be influenced by borrowing and lending money and other banking transactions. Borrowing and lending change the proportion of assets financed by debt vs. equity, but not the overall value of assets that can be financed, or the rate of savings, investment and capital formation. For example, suppose an economy has a savings rate of 50% of production and a capital stock equal to one year of production that was financed purely as equity. The 50% of output saved could be sold for money, and the money loaned to existing capital owners to increase their investments by 50%, or the savers could use their savings directly to fund the construction of an equal quantity of new capital. In either case the quantity of savings and investment and capital formation is the same.
Published: May 20, 2007 3:18 AM
Björn Lundahl
This might be interesting thoughts and information for the serious reader.
Time preferences
I have received the insight that time preferences are a part of human nature and cannot because of this be discarded in any situation involving human action and time.
Man, Economy, & State, by Murray Rothbard:
”[44]As has been the case with all theorists who have attempted to deny time preference, Clemence and Doody hastily brush consumers’ loans aside. As Frank A. Fetter pointed out years ago, only time preference can integrate interest on consumers’ as well as on producers’ loans into a single unified explanation. Consumers’ loans are clearly unrelated to “productivity” explanations of interest and are obviously due to time preference. Cf. Clemence and Doody, The Schumpeterian System, p. 29 n.”
http://mises.org/rothbard/mes/chap6d.asp#11._Time_Structure_Interest_Rates
As Jesús De Soto wrote in his book “Money, Bank Credit, and Economic Cycles”, page 271 and 272:
“Hence it is impossible to imagine a human action to which the principle of time preferences does not apply. A world without time preferences is inconceivable and would be absurd: it would mean people always preferred the future to the present, and objectives would be postponed, one after the other, just before they were reached, and therefore no end would ever be achieved and human action would be senseless”.
Where do interest rates come from?
Mises.org Updates
Frank Fetter was the great American Austrian who devoted a fantastic part of his professional life to arguing on behalf of the pure time preference theory of interest. His work is lucid and powerful, and largely would have been forgotten if Murray Rothbard had not assembled this excellent volume of his writings. It supports the Misesian case in every detail, and set it against the productivity theory and other false notions of interest.
Capital, Interest, and Rent is now available for free download or print on demand.
Download PDF:
http://mises.org/books/capital-fetter.pdf
Another proof of time preferences
When I was a kid, I waited passionately for Christmas. I loved battery cars and I dreamt about them, especially police cars. I knew that I would receive a few of them as Christmas presents. A few weeks before Christmas Eve, I was lying on my bed and with my head, I repeatedly hit my cushion for hours crying, I want it to be Christmas, I want it to be Christmas, I want it….
That was a practical example of time preferences.
Björn Lundahl
Published: May 20, 2007 4:24 AM
David Hillary
Preferences are about psychology. Economics is about revealed preference and the mechanics of commerce, labour and consumption etc. I'm not a psychologist and I'm not going to comment on why people might be willing to pay interest for borrowing money, whether for personal or commercial purposes. What is important is how the interest rate is determined, in a market and economics sense, not in a psychological sense. Automotive economists don't ask why people would rather drive than walk. Why do monetary economists spend more time discussing why people are willing to pay interest and less time about how the interest rate is determined in the market?
Published: May 20, 2007 5:08 AM
Björn Lundahl
Any great and sudden change in the economy that is not anticipated such as increased or decreased savings, increased hoarding etc can cause crises and problems. Murray Rothbard has also mentioned this.
But those are rather economic fluctuations, and are they anticipated, the business community can easily cope with them without causing any problems at all.
There is a time lag between increases of the supply of money and changes in the purchasing power of money.
If monetary authorities anticipate that aggregate demand will fall in the future, and therefore increases the supply of money today, there is a time lag between those actions and their impact on aggregate demand.
Changes in aggregate demand can be anticipated by the market. Businessmen are trained specialists in their capability to anticipate changes in the market place and anticipated changes of market prices in the future cause immediate changes of prices today and the necessary adjustments.
In other words what Keynesian economists proclaim and what Monetarist economists implicitly proclaim is that economic depressions are caused through a lack in aggregate demand, can easily be refuted by the conclusion that changes in aggregate demand can be anticipated and offset through the market price mechanisms.
If there is a fall in aggregate demand, monetary authorities cannot offset this by increasing the supply of money without causing a business cycle.
Increases of the money supply can not be neutralized even if they are anticipated because there is no way to distinguish them from real savings. They are borrowed funds and as they are, actually borrowed, businessmen are factually deluded to act as if savings have increased.
Speculators can in a short term with borrowed money, reap extremely large profits through extensive speculations.
Consumers can allocate their economic recourses in two ways: consumption versus savings.
The fact is that during recessions and depressions price falls are extremely much more severe in the capital goods markets than in consumer goods markets.
As mentioned, in Sweden during the early 90s we had an economic depression and only in one year we had an increase of the purchasing power of money of 1% while real estate prices decreased around 50%!
Stocks are titles of capital goods and prices of them fell extremely too.
The same story goes in the U.S. during the late 20s and early 30s and Japan during the very early 90s.
It is true that during depressions prices of some capital intensive consumer goods fall a lot too (durable consumer goods) but they are comparable to capital goods as they render services over a longer term of time and can be regarded as part of a economy’s fixed capital.
To put an end to business cycles, fractional reserve banking must be rejected and a 100% commodity money reserve standard adopted (such as gold and silver).
Björn Lundahl
Published: May 20, 2007 5:29 AM
Matt Harkerss
Some thoughts on inflation targeting:
Often New Zealand is held up as the model for which everybody should copy (and many have) in regard to inflation targeting, but I assure you this should not be the case. If I were an American I would be very concerned with Bernanke's drive towards the New Zealand model. If the “seat of your pants” type management employed by the Greenspan Fed wasn't bad enough then life in “Bernankeland” will be one of exhilarating ride. I might sound a bit grumpy; rest assured I’ll explain myself. (Please rest assured, I am certainly not pro-inflation).
The main problem is the range, if inflation creeps over lets say 3%, then interest rates need to go up, however, if inflation drops below, lets say 1%, then the central bank has a legislated right to lower interest rates and pump money, thus inducing ‘super consumption cycles’ within an already distorted economy (an accurate description of the Greenspan years). The only difference being that instead of being “unofficial” it will in fact be “official.” But as Murray Rothbard pointed out, when these “helicopter drops” take place, those with first access to the “counterfeiting” get something for nothing, thus creating even greater inequality within a country. In New Zealand this is no different at the moment the M3 is growing at a staggering 12.8% but the government claims that inflation is about 2.7%, (please follow this link http://www.rbnz.govt.nz/statistics/monfin/ and click on C1: historical series). The problem being created is that with a very sizable proportion of New Zealand’s goods are being made in Asian countries (who are essentially exporting deflation) which means the CPI says 2.7% etc but the currency is debasing itself at 12-15% p.a. So people are asking for lets say 4% pay increases thinking that they are receiving a 1% real wage return but then try saving for a house but can not understand why they are inflating 15% p.a. or that their power bill, thanks to non-renewable resources, keeps going up. Simply the cost of borrowing goes up in an inflation targeting arrangement but there is not necessarily any monetary tightening and if official price statistics are stacked with consumerist high tech gadgets, the scam can go on for a while.
Japanese influence:
Have you ever noticed that all these countries (Austria, Britain, Canada, and Sweden etc) officially adopted inflation targeting in the early nineties, but actually spent the entire 1980’s trying to achieve the same thing. Have ever you noticed how both inflation and interest rates came down so quickly in the early 1990s coincidentally at the same time Japan’s interest rates plunged towards zero? I wonder what would happen to interest rates in inflation targeting countries if all of a sudden they had to compete for (Japanese) capital. I think that this might have already started as interest rates around the world have begun to climb back towards 20-30 year average rates.
This leads me to another problem:
Many years ago Henry Hazlitt wrote an excellent book titled The Inflation Crisis and How to Resolve It. In this work Hazlitt paid closer attention to the comments put forward by Milton Friedman and the Monetarist movement. He cites Friedman as stating the money stock should grow at 3-5% p.a. (p.73 or Capitalism and Freedom p.54), but then Hazlitt points out that in the mid-1960's Friedman persuaded the Fed to grow the money supply as a policy at a rate of 4-6% p.a. (p.80) and as Hazlitt pointed out Friedman wanted these hard monetary rules as part of the US constitution, much like the Reserve Bank Act of 1989 in New Zealand. What Hazlitt never stated was that Friedman also stated in his 1969 book The Optimum Quantity of Money that the ideal money growth rate should be about 2% p.a. What is even more contradictory is some of the theories in his work with Anna Schwartz, A Monetary History of the United States 1867-1960 particularly in the period from 1869 to 1879 the money supply grew by 2.7% p.a. however prices declined by 3.8% p.a. but this was off set by US GNP per capita increasing at a very impressive 4.5% p.a. (very similar to S. Korea since 1960), so low and behold Friedman concludes that there wasn't enough money growth because there was deflation! (p.44). This happens again later when in one period (in the 1880’s if I can recall) the money supply increased by around 7% but prices declined. Then in the period immediately after, 1897-1914 the money supply grew at around 7% and prices went up by 2%. However, countries have achieved so called low inflation whilst growing the money supply at rates (7-20%) that are well above the rates that Friedman demanded in the 1960s by using short term interest rates.
The Fallacy of the Printers:
In fact many countries such as America, Australia, Britain and New Zealand saw their greatest periods of economic growth from 1865 to 1900, when prices under the gold standard declined by about a third. So the idea of an inflation target of between 1-3% is contrary to economic fact. Data I’ve seen suggests that New Zealand had the world’s highest standard of living in the 1890’s, a period of deflation.
Inflation targeting in the hands of New Zealand’s politicians:
Economists including Bernanke and Friedman talk/talked of New Zealand's revolutionary 1989 Act with a shimmer in their eyes, but only someone like Hazlitt (and other Libertarians) can understand what is really going on. Actually the New Zealand Reserve Bank Act of 1964, some 25 years earlier already stated that the RBNZ should focus on the "desirability of promoting the highest degree of production, trade and employment and of maintaining a stable internal price level" (italics added). What was to follow over the next two decades was some of the highest levels of inflation in the OECD (because the RBNZ wasn't given any tools to control inflation, as govt bond rates were fixed at rates below the level of inflation by successive governments). Here's where the New Zealand model unravels itself, on April Fool's Day 1988 New Zealand's controversial Finance minister Roger Douglas stated that inflation (then at about 16%) should be 0-1% p.a. he appointed Don Brash as RBNZ governor, but then lost his job as Finance minister shortly after and shortly afterwards the Labour government was voted out. The Reserve Bank Act come into force a year later with the aim of getting inflation within 0-2% by the Dec. Qtr 1992, it came in at 1.7% in the Dec. Qtr 1991. As you might have guessed this squeezed the life out of the N.Z. economy, just like the Volcker years (in fact Paul Volcker said to RBNZ bank officials at a conference that he was concerned that they were too brutal!!) and politicians didn't like it, as voters in pro-inflation jobs suddenly found themselves out of work and as Henry Hazlitt pointed out all those years ago, this would lead the rules to be soften to save politicians, bureaucrats and CEO’s.
After the 1993 Election (which the National Party narrowly clung to power but cost Finance minister Ruth Richardson her job) the target was changed to “2% core inflation.” A target which Don Brash struggled to achieve. Then after the 1996 Election, National again clung to power but had to form a coalition government with the N.Z First party, whose leader Winston Peters became Treasurer/Finance Minister. He being another socialist, widened the inflation target band to between 0-3%, in attempt to bring interest rates down and increase growth in the short term but the currency still appreciated hurting exporters. Brash and company still struggled and the Labour opposition publicly declared that if in government they would change the inflation target to between 1-3% thus gaining pro-inflation support. Then the Asian crisis came along and an El Nino drought ravaged the agricultural sector, ruining the economy at the same time. The Labour Party swept into power in 1999 bringing with them Marxism and a new inflation target of 1-3% on the proviso that it “shall seek to avoid unnecessary instability in output, interest rates and the exchange rate.” Then after two giant money drops Brash (Friedman’s mate) quit as RBNZ governor and joined the National party (which he later became leader of) just before the 2002 Election, which Labour won thanks to Brash’s money drops. After the election a replacement governor was found in Allan Bollard, and Finance minister Michael Cullen quickly made sure that the inflation target would be loosened once again, this time to 1-3% “over the medium term.” So here we are in 2007, interest rates have failed, the target range has been replaced and soften on numerous occasions by different politicians and inflation can cross the 3% upper limit at any time without consequences.
However, the events of the past two decades in New Zealand are nothing new one just needs to look back to Rome and the days of Julius Caesar when the Emperor’s minters had to mint the silver coins to official levels of pureness but slowly relaxed the rules until nothing was left.
In sum my argument is this, your currency is always being debased but under the inflation targeting scheme the government has created another illusionary way of getting away with theft. In short any interventionist attempts to control a free economy with boundaries will cause more harm then good. So please David don’t quote New Zealand’s banking system, we are embarrassingly inept.
Published: May 20, 2007 6:07 AM
Matt Harkerss
Oops I meant to say one exhilerating ride! Sorry
Published: May 20, 2007 6:10 AM
Björn Lundahl
Monetarist imperfections revealed:
THE ECONOMY'S NEW CLOTHES: Milton Friedman on the New Economy
Peter Robinson: Well, we better go into that for a moment. So the Great Depression was the fault of the Fed?
Milton Friedman: That's right. Now the stock market--I'm not saying that the stock market collapse was the fault of the Fed.
Peter Robinson: That was a genuine bubble.
Milton Friedman: The Fed may have contributed to it, but it was primarily a genuine bubble. And it was a bubble that was stimulated, a boom, the boom market of the 20s was stimulated by exactly the same kind of forces that have been stimulating our present bull market, technological development--
Peter Robinson: So there were real change--real changes in the economy, that were indeed impressive--
Milton Friedman: That's right.
Peter Robinson: They were objectively taking place; that wasn't nonsense. But the bubble--now you'd better actually define what you mean by a bubble?
Milton Friedman: I don't know that I want to talk about a bubble. I want to talk about a bull market that gets very high and then is reversed and comes down again.
We've had three comparable bull markets since the '20s. We've had the '20s in the United States, we've had the '80s in Japan, and the '90s in the United States. And if you pluck them one on top of the other they almost coincide, they have exactly the same pattern.
So if this is new, the '80s was new, if that was new, the '20s are new.
Peter Robinson: So we're inching our way toward the edge of the precipice?
Milton Friedman: No, that's a different question. What happens after--no doubt such a bull market tends to overshoot. By how much and when, those are much more difficult questions. And especially by how much, because that partly depends on what happens after the bull market breaks.
In the United States, in the three years after the bull market broke--
Peter Robinson: In '29.
Milton Friedman: '29, from '29 to '32 or '33, the Federal Reserve permitted or forced the stock of money to go down by a third. For every $100 in existence in money--I'm now talking about bank deposits and currency in your pocket--for every $100 in existence in 1929, there were only $67 in 1933.
And as a result, when that collapsed, I think it was a decline of 80 percent.
Comment made by me (Björn):
According to Friedman the stock market crash in 1929 was not caused by the Federal Reserve.
Alan Greenspan was an admirer of Milton Friedman and also vice versa. They did admirer each other for a reason; the admiration was built upon each others “insight” regarding monetary theory and policy. Alan Greenspan had a very different opinion regarding the very cause for the crash:
“The excess credit which the Fed pumped into the economy spilled over into the stock market-triggering a fantastic speculative boom”.
http://www.etherzone.com/2000/mors042600.html
It sounds really a little peculiar to refer the causation of the crash to “technological development” when at the same time the Fed is injecting money into the fractional reserve system which in turn are mainly lent out to businesses and invested in capital goods such as stocks.
Milton Friedman: Alan Greenspan doesn't need a note. He understands monetary affairs every bit as much as I do. But I will tell you what he will do. Not what he should do, but what he will do, is exactly what he did in 1988, '87, when you had the stock market decline, the big decline.
Peter Robinson: Right about 25 percent in a couple of days.
Milton Friedman: That's right. He poured in money. He had the Federal Reserve follow a very easy money policy. And that's what he will do again if the market tanks. Not indefinitely, but for a time, to give it some cushion.
Peter Robinson: The Fed knows now, we know now, what to do in the case of a serious fall.
Milton Friedman: Well, when I say, we know what to do, I don't mean to suggest it's an easy and obvious thing. How much? How rapidly? When do you overdo it? Do you move the economy into--see, you have to be careful. You don't want to restart the bubble.
Comment made by me (Björn):
So the Federal Reserve is at least capable, after all, according to Friedman to “restart” a bubble! Well if that possibility exists, why couldn’t the Federal Reserve have started it in the first place?
http://www.hoover.org/publications/uk/3391336.html
Björn Lundahl
Published: May 20, 2007 8:19 AM
David Hillary
Matt Harkerss:
Although New Zealand has free banking concerning deposits and cheque accounts, and bank formation (no licence needed) it does not have free banking concerning bank notes, and it has an unanchored fiat currency. This gives New Zealand one of the most competitive and efficient banking sectors, but one of the least stable exchange rates and the highest interest rates in the OECD. I can't see how it isn't obvious that targeting a stable exchange rate and not worrying about inflation, deflation and asset prices (as in Singapore) is a whole lot better (although I'd still go for a gold coin standard).
New Zealand's high living standards in the 1890s can't really be attributed to deflation or monetary policy, although at the time the commercial banks issued bank notes and the British monetary standard (gold coin) applied. Australia had a more liberal and successful banking system in the 1800s compared to New Zealand. The government policies of the day don't entirely determine the living standards, for example the recent economic boom in New Zealand wasn't the result of the Taxation (Tax Rate Increase) Act 1999, or the Employment Relations Act 2000, or the other Acts that have increased regulations and taxes in New Zealand during the period. Despite these policy changes, New Zealand is still the easiest place to do business in the world according to the World Bank (although Singapore most recently overtook NZ).
Published: May 20, 2007 11:15 AM
Björn Lundahl
A 100% gold reserve money standard
In other words, if there would be bank runs (which, naturally, would be extremely unlikely as the public knows that the gold is deposited in bank vaults under 100% gold reserve money standard), the banks could meet any claims of the depositors.
We should also be aware of the fact that fractional reserve banking by itself causes business cycles and, therefore, during recessions or depressions this also causes bank runs as banks are in trouble during this phase of the business cycle.
This, also, means that fractional reserve banks not only instantly cannot fulfil their obligations against the depositors, but that they won’t ever be able to do so during recessions or depressions (which they have created) as their assets have plummeted in value and the sale of them for the purpose of fulfilling the rightful claims of the depositors will not be possible.
Some consequences of not having a 100% gold reserve money standard:
•Panic of 1819
http://www.answers.com/topic/panic-of-1819
•Panic of 1837
http://www.answers.com/topic/panic-of-1837
•Panic of 1857
http://www.answers.com/topic/panic-of-1857
•Panic of 1873
http://www.answers.com/topic/panic-of-1873
•Panic of 1884
http://www.answers.com/topic/panic-of-1884
• Panic of 1890 http://www.answers.com/topic/panic-of-1890
•Panic of 1893
http://www.answers.com/topic/panic-of-1893
•Panic of 1896
http://www.answers.com/topic/panic-of-1896
•Panic of 1901
http://www.answers.com/topic/panic-of-1901
•Panic of 1907
http://www.answers.com/topic/panic-of-1907
Why should we have central banks and fractional reserve banks that mess things up in the first place? Why should we have business cycles and malinvestments just for the sake to please some perversive lust for power and fraudulent money? Do we really want to have malinvestments? Is unemployment that good? What is the justification?
Björn Lundahl
Published: May 20, 2007 3:02 PM
RogerM
David: "1. gold production supply schedule
2. gold consumption demand shedule
3. demand schedule for holding gold coin for liquidity reserves etc.
4. the investment demand schedule for the construction of capital assets (e.g. buildings).
Yes, but in your original post you started with an increase in production causing the other three items as responses to increases/decreases in gold production.
You might be a little concerned that you are the only one who sees this as a business cycle theory. After all, brilliant economists have been studying this issue for over a century and none of them came up with anything similar to your theory. That doesn't mean it's wrong, but if it were me, I'd be a little concerned.
The real problem with your theory is that the money supply never shrinks. Gold production, demand for gold, and construction demand may cause the supply of gold money to increase more slowly, or not at all, but it would never shrink. In other words, we would never have less gold money in circulation. But the history of financial disasters is one of a dramatic increase in the money supply (which raises the money stock) followed by a dramatic shrinking of the money supply (and a lowering of money stocks). You're theory can't possibly explain those changes.
David: "...in fact is is quite conventional theory that the interest rate balances aggregate supply and demand."
Yes, it's standard Keynesian and neo-Classical theory. But Austrian econ disagrees strongly, as Bjorn points out. You really ought to read at least an intro to Austrian econ. You'll be surprised and amazed. For a start, I would recommend Huerta de Soto's book "Money, Bank Credit and Economic Cycles."
David: "...the central banks have tried to regulate the exchange rate by mimicking the interest rate-capital investment-inflation/deflation process."
Exactly, but how does this cause price inflation and business cycles? According to the neo-Keynesians and neo-Classicals, it doesn't. Under those theories, the Fed is merely trying to regulate the economy against a hypothetical "natural rate" of GDP, i.e., a rate of GDP growth that doesn't cause price inflation. But the Fed gets it wrong regularly, as Milton Friedman pointed out repeatedly. Austrian economists would say that decreases in the Fed funds rate below the time preference rate causes the money supply to expand, which in turn causes two things: 1) price inflation and 2) poor investment decisions. (It also causes rapid increases in the stock market.)
David:"If a car dealer wants to give two customers access to the same car (or the same pool of cars), then there is a legal method to do this: issue to each customer a non-exclusive licence to use the car."
That would be fine, except that banks don't do issue non-exclusive licenses to people's money when they open checking and demand deposit accounts. Why did banks fail so regularly before the creation of the Federal Reserve (and during the 1930's)? Because too many people had claims on the same pool of money, right? If that's not fraud, I guess I don't know the meaning of the word. The Fed makes bank failures less likely, but only by increasing the size and scope of the fraud. Without the Fed, do you think anyone would place money in your bank if they realized that they were signing an agreement that gave up their exclusive right to their money? Or if banks were honest and told depositors that the bank would give 9 other people rights to every dollar they deposited and that chances were very good they would lose it all?
There were variations in the RBD. You just happen to cling to one of those. I highly recommend you read de Soto's book for a full explanation of what takes place under FRB.
Published: May 20, 2007 4:05 PM
Matt Harkerss
David, our recent economic growth is a scam follow this link http://www.rbnz.govt.nz/statistics/monfin/ and click on C1: historical series. All that has happened is that the Reserve bank in NZ has flooded the banking system twice 1999 & 2001 after they got all panicky about a slightly deflationary qtr and now we are feeling the effects of this overreaction in monetary policy. Essentially New Zealand is run by a banking cartel who agree where market rates should be.
Published: May 20, 2007 4:24 PM
Jim
Björn, in your reply to my comments, you thought some of your posts might give me answers. I now see that we are concerned about two different things. I see your concern is the confusion arising from confusing demand deposits & term deposits.
To be fair to bankers, there is a problem if [as they do] banks undertake to meet a demand for a withdrawal at other branches than the place than where it was deposited. That would require them to hold greater cash reserves than the sum of demand deposits. In theory each branch would need to hold cash equal to the sum of demand deposits at all branches! That would be prohibitive, particularly for banks with many branches. This problem does not arrive with term deposits. In fact the opposite is likely if a term depositer does not leave instructions to re-invest a maturing deposit.
Please read again my attempt to explain how banks, by confusing giving credit with lending money, have been defrauding "borrowers". Thanks.
Published: May 20, 2007 8:45 PM
David Hillary
Björn Lundahl
You're completely assuming what you're trying to prove. Economic cycles occured, fractional reserve banking existed, therefore fractional reserve banking caused it. Please!
RogerM
There is a difference between a supply or demand schedule changing, and the supply or demand changing because the price changed, or the price changing because the supply or demand changed. In comparative static analysis, one schedule is changed once at the beginning, and then the new equilibrium price and supply/demand are worked out. In this case it is not only the new equilibrium but also the adjustment process (cycle) that is worked out.
Sure, I'm a little concerned no one else appears to have come to the same conclusion I have, but not greatly. When I read economists others call brilliant I seem to find major faults with their analyses. The most serious fault being failure to consider and model supply and demand functions in the regular way, and failure to distinguish in what manner money is the same as other commodities and in what manner it differs from them.
Gold coin stock (what you incorrectly and probably inadvertently called money supply) can indeed shrink, and should do during the boom phase when demand to hold coin is weak and the exchange rate is low. During this time the gold coin production supply rate is low and the consumption demand rate is high, leading to a deficit in the gold market. Over time this increases the interest rate and eventually restrains the rate of capital investment in buildings. In a growing economy, on average the gold market will be in surplus, and possibly could remain in surplus the whole cycle. But this would be no different from what most theorists assume: gold is produced but never consumed. However, money, which includes cheque account deposits with banks and bank notes, can increase and decrease easily, in response to changes in demand to hold money (as a store of wealth of wealth as well a means of payment), through expanding or contracting bank balance sheets. My theory does not directly explain demand to hold wealth as money balances compared to as fixed deposits, corporate paper etc. For this one needs a theory of financial intermediation, where the net interest margin of financial intermediaries is the price of their service.
I have read Austrian school theory on the capital markets but I have not been 'surprised or amazed', more like disappointed.
You are correct I have not explained why business cycles appear to exist under floating currencies and central banking. I think there is some combination of real and monetary factors behind economic variation under this system but I can't really stylise them into a coherent theory. I think they are more in the nature of random shocks and adjustment mechanisms between countries (differential interest rates and currency exchange rate variations) that transmit and absorb variations in different ways. For example Hong Kong and Singapore fixed their exchange rates, while New Zealand and Australia try to fix their domestic price levels. The former have more variation in their consumer price levels and asset prices, while the latter have more variation in their currency exchange rates. I'm not going to defend the Fed or central banking in general, so I don't see why I should be required to provide a theory for their flaws.
Banks are less financially risky than non-banks provided the market for banking is free. In the US the market for banking has been regulated in quite pernicious ways, especially in ways that restrict branch banking and inter-state banking and the development of large banks. Small banks are substantially less efficient and sound than large banks due to inferior diversification (especially geographic diversification). Under free banking bank failures are rare, with most major banks having a probability of failure of about 0.03% per year.
You are correct that you don't know the meaning of the word fraud. Fraud is using deception for obtaining property. Banks do not hold out that their notes or deposits are anything other than claims on the bank, which is, legally, exactly what they are. Failure to pay debts is not fraud, it is, legally, breach of contract (or default on a judgement debt). The risk of default on financial obligations is an ordinary commercial risk, and not unique to banking. And as noted above, major banks in a free market have a lower probability of default than ordinary industrial firms. Bank note holders and bank depositors on cheque account do not have a claim on a pool of money, they have a claim on the bank itself. There is no security or pledge of assets, and no allocation of assets to liabilities. I'm not sure what, for you, qualifies as a safe investment. For me an AA credit rating is safe in the extreme, and I'd rather take more risk for a higher return.
Despite what you say, the real bills doctrine is incompatible with banks providing long term loans such as commercial and industrial instalment loans and residential property mortgage secured loans.
Matt Harkerss comments that NZ economic cycle recently is caused by RBNZ policies and over-reactions. Don't you think high milk prices and other agricultural commodity prices and favourable growing conditions are the major driver of the NZ economy? Would you also say the Norwegian economy's performance in the same period is explained not by the oil price but by their monetary policy?
Published: May 20, 2007 9:13 PM
Jim
David Hillary, you say "Fraud is using deception for obtaining property." and while that is a simplification, it is relevant to my comments on Björn's posts. The latest was a few hours ago but I'll repeat that of the 17th below for ease of reference. I'd be pleased to get your response to both of my points.
When Björn said "The Federal Reserve and fractional reserve banking is, of course, also based on fraud", I tried to explain it by pointing how banks by confusing giving credit with lending money have been defrauding "borrowers". While my example did not say so, that is how fractional reserve banking works.
For some reason, none of the subsequent posters have even acknowledged the point of my 1st post, which I'll repeat below. Please comment.
Björn says "The Federal Reserve and fractional reserve banking is, of course, also based on fraud". He does not explain that fraud. Let me try to explain it.
Can we agree that to "give credit" is not the same as to "lend money"? To see how the two are confused, let's examine a specific example - I'll try to defraud Björn of money by giving him credit!
If I give Björn credit, I am trusting him to fulfil a commitment [within a specified time]. If I lend him money (or anything else), I may trust Björn to fulfil a commitment to REPAY me (perhaps with interest). I may trust him only because I have (or he gives me) "security". So! Would Björn give me a commitment to pay me some money in future, if all I did was trust him to pay me (& keep a record of his commitment to pay me some money as a "debt" owed - with interest!)?
If Björn would give me a commitment to pay me money on such terms, then I accept! How much money [even fiat money] can Björn commit to pay me in future (and with how much interest)?
If Björn gives me a written commitment to pay me (or someone authorised by me) say USD 100,000 in 2 years, I am sure I could find a buyer to exchange say USD 80,000 now, for his [secured] written commitment to pay me later. The buyer would be "giving credit" - trusting him to fulfil his commitment - and I would immediately be 80,000 USD richer!
Published: May 21, 2007 12:14 AM
David Hillary
Jim:
The word 'credit' can be a verb or a noun. As a noun, the creditor gives credit to the debtor. As a verb, credit is an accounting term, which in the case of a liability account, is an increase in the liability of the reporting entity. Thus on the liability account of the debtor, a credit entry is made to record credit given by a counter party to the reporting entity.
So to give credit (noun) by way of advancing money a creditor records a debit (verb) in its asset account (account receivable from the counterparty), while the debtor records a credit (verb) in its liability account (account payable to the counterparty) for the amount advanced.
To give credit (noun) can be to actually advance funds or goods for the promise of later payment, or to undertake to do so. To lend money is to actually provide credit (noun). Thus one can give credit (noun) without lending money (an off balance sheet commitment) but one can't advance funds without also giving credit (noun).
Björn won't give you a promissory note except for consideration, money or money's worth paid or loaned to him now. However you may offer him credit, which offer would remain available for his acceptance until withdrawn by you (remember offer and acceptance are the means by which contracts are entered into). Such an offer would be for consideration in the event it was accepted and became a contract. If Björn gave you a promissory note without receiving consideration in return, the note may be void (although the onus would be on Björn to show this), since consideration is required to make a simple contact, and a promissory note is a simple contract.
No buyer would pay anything for a negotiable instrument except if you negotiate it to the buyer. No one in their right mind would advance money to A in exchange for A's promise to pay B, unless B were to offer the instrument to the buyer as consideration, or B was the buyer or B undertook to pay the buyer.
Published: May 21, 2007 1:45 AM
Björn Lundahl
Term deposits
Alex MacMillan I seem to by using the term "time deposit" in a different sense than you are, and that Rothbard was. I apologize as this no doubt causes confusion. Perhaps if I change my term to "term deposit", that is a deposit contracted to be withrawn only after a specific term (e.g. 30 days, 365 days, 5 years). Suppose a bank accepts a $100, 365 day, term deposit and lends the $100 out for 365 days, there would be no need for reserves against such a deposit until it matures. This would be all right by you, wouldn't it? When a person lends another $100 for 365 days, the lender never expects the borrower to hold the $100 as reserves. So, in this case, the fact that the deposit borrower happens to be a bank would be no different, right?
Björn Those “term deposits” that you mentioned are acceptable.
Björn Lundahl
Published: May 21, 2007 1:54 AM
Björn Lundahl
America’s Great Depression, by Murray Rothbard, chapter 4:
The Definition of the Money Supply:
“In recent years, more and more economists have begun to include time deposits in banks in their definition of the money supply. For a time deposit is also convertible into money at par on demand, and is therefore worthy of the status of money. Opponents argue (1) that a bank may legally require a thirty-day wait before redeeming the deposit in cash, and therefore the deposit is not strictly convertible on demand, and (2) that a time deposit is not a true means of payment, because it is not easily transferred: a check cannot be written on it, and the owner must present his passbook to make a withdrawal. Yet, these are unimportant considerations. For, in reality, the thirty-day notice is a dead letter; it is practically never imposed, and, if it were, there would undoubtedly be a prompt and devastating run on the bank.[2] Everyone acts as if his time deposits were redeemable on demand, and the banks pay out their deposits in the same way they redeem demand deposits. The necessity for personal withdrawal is merely a technicality; it may take a little longer to go down to the bank and withdraw the cash than to pay by check, but the essence of the process is the same. In both cases, a deposit at the bank is the source of monetary payment.[3]”
http://mises.org/rothbard/agd/chapter4.asp#definition
Björn Lundahl
Published: May 21, 2007 3:20 AM
Björn Lundahl
The definition of the money supply is a logical conclusion and is not an empirical conclusion.
As time deposits can be withdrawn at once, they too should consist of 100% reserves.
The principle is that anything that could add to the money supply should be ended by being composed of 100% fiat reserves (or gold reserves in a 100% gold reserve money standard).
Frank Shostak is the expert in defining the money supply. Please read his article of money AMS (Austrian Money Supply).
http://mises.org/daily/1397
Björn Lundahl
Published: May 21, 2007 3:24 AM
Björn Lundahl
That increases of the money supply through fractional reserve banking causes business cycles, I have in my above comment “Recessions and The Great Depression were caused by Government Interventions!” explained. For a deeper explanation and understanding I have also posted a link which leads to the book “America’s Great Depression”, by Murray Rothbard.
That there exist a connection between the money supply and the business cycle is, today, a well known fact and is shared, for example, among central bankers throughout the world. This despite of the fact that their “knowledge” are not built upon the Austrian business cycle theory.
No further explanation is, therefore, needed.
Björn Lundahl
Published: May 21, 2007 6:10 AM
Matt Harkerss
David Hillary states
"Don't you think high milk prices and other agricultural commodity prices and favourable growing conditions are the major driver of the NZ economy?" Actually, New Zealand's commodity prices (beef, butter, lamb, milk, wool, timber etc) are inversely related to world commodity prices, hence the terms of trade blowout in recent years. I can tell from this that you are unaware of New Zealand's agricultural sector because milk payouts have delivered negative real returns over the last 4-5 years (I have family working in the Dairying sector) and lamb exporters are claiming that they are falling behind the dairying sector! This also forgets the fact that NZ's main export sector is still manufacturing, which has also gone nowhere. In fact New Zealand's productivity measure is offically negative (2006).
As for "favourable growing conditions" this current government is the most interventionist and freedom denying government in New Zealand's history. You can't have seen the Budget last week? Anyhow economic growth has totalled only 2% in the last 7 Qtr's. You're not a Helenite socialist are you David?
Also "Would you also say the Norwegian economy's performance in the same period is explained not by the oil price but by their monetary policy?"
First of all a big chunk of Norway's oil funds go directly into their National Pension Fund which is the largest in Europe (which is as big as CALPERS) and is invested all around the world see http://en.wikipedia.org/wiki/The_Petroleum_Fund_of_Norway
Secondly, I never said anything about Norway's economic growth (I wouldn't have a clue what it currently is but I do know that they have a major demographic crisis coming). Thirdly, the rising oil price has alot do with the global reduction of interest rates after the tech wreck and 9/11, which induced consumption by Americans and Westerners, enticed to take on debt and buy goods made in countries like China etc, this in turn helps to fuel China's growing appetite for oil and commodities, so they can export more goods. I noticed in John Train's 'The Money Masters' George Soros once said that when the dollar is weak, oil is strong and vice versa. Whilst I disagree with Soros'interventionist political beliefs, when it comes to oil and currencies it pays not to argue with the man. Basically if the world was on a 100% gold standard the money (gold) Norway receives from selling its oil would enter into its economy, expand its money supply and cause inflation. Hence this is the reason why they are reinvesting these funds all around the world, this is also why the central banks in surplus nations (East Asia, Mid. East and Russia) are reinvesting US Dollars back into US Treasuries, to avoid "Dutch Disease." The only way that Norway can expand it's money supply under the "Dollar Standard" is if the Norwegian Central Bank uses its reserves as collateral to print local money or the main banks grant credit on dollar reserves.
You must ask yourself, why in countries around the world is the money supply growing at rates of 8-25% p.a. to deliver 2-3% growth, when in the days of gold, money grew at 1-3% p.a. and economic growth was 3-4% p.a.? And remember productivity was at it's highest in the late 19th century.
Published: May 21, 2007 6:36 AM
RogerM
David Hillary: "Gold coin stock (what you incorrectly and probably inadvertently called money supply) can indeed shrink, and should do during the boom phase when demand to hold coin is weak and the exchange rate is low."
Where does the gold go? Do people eat it? And how are gold coins different from the money supply when gold coins are money?
David: "However, money, which includes cheque account deposits with banks and bank notes, can increase and decrease easily, in response to changes in demand to hold money (as a store of wealth of wealth as well a means of payment), through expanding or contracting bank balance sheets."
Exactly! And it's that artificial increase in the money supply that FRB makes possible that reduces interest rates below the natural rate, increases the money supply, causes business people to make investment mistakes on a large scale even though we initially see a booming economy. But eventually those mistakes cause businesses to go bankrupt. That's called the business cycle. Without FRB, business people would not make investment mistakes on the scale or scope that they do when the Fed artificially lowers interest rates.
Published: May 21, 2007 9:39 AM
David Hillary
Matt Harkerss:
New Zealand's terms of trade have increased from about 950 in March 2000 to about 1100 in December 2006 according to statistics NZ, an increase of 15.8%.
New Zealand's largest export items are:
Dairy (19.11%)
Meat (14.27%)
Fat, oil (6.52%)
Machinery (4.82%)
Aluminium (4.52%)
Fruit (3.67%)
Fish (3.65%)
Electrical machinery (2.96%)
Starch (2.86%)
Beverages, liquor (2.3%)
Vegetable preparations (2.06%)
Pulp (1.96%)
Cereal preparations (1.7%)
Mineral fuels (1.68%)
Iron and steel (1.6%)
Paper (1.45%)
Hides (1.41%)
Obviously the overwhelming majority of New Zealand exports are agricultural, horticultural, and mineral related, rather than being manufactures. I think all the Aluminium comes for Australian bauxite.
New Zealand's largest export commodity is dairy products, and Fonterra, New Zealand's largest company and the world's largest dairy exporter this month announced 'Unprecedented prices during the past month in the global dairy market have led to Fonterra Co-operative Group increasing its forecast payout for the current season by 20 cents from $4.15 to $4.35. .. Our early indications for 2007/08 were that the payout would be closer to $5 than $4. We're now confident that if current exchange rates hold, next season's payout will have a $5 in front of it.' Milk prices are high because of the Australian drought and the increase in grain prices (most other countries produce milk from grain fed cows).
According to the the Real Estate Institute of New Zealand the median dairy farm price has risen from NZ$2.5m in March 2005 to NZ$3.275m in March 2007. True they might only earn a couple of percent per annum but I'm told dairy farming is nevertheless profitable (although myself and anyone else I talk to agrees that dairy farm prices are crazy for the profit they make). 'Favourable growing conditions' means favourable weather conditions for farming, if you look at what I said in context, too.
The current government of New Zealand is not very interventionist, although it surely is somewhat interventionist, it is not the most interventionist in NZ history. That was the Muldoon National government. If you're not aware of what they did, just to remind you it included a wage-price-interest rate-rent freeze that lasted for years, a 'think big' programme of active and large scale government investment into business enterprises, massive government budget deficits that brought the country to an IMF bailout in 1984 immediately after his government fell after a snap election he called when visibly intoxicated on national TV. Margarine was a controlled product and you needed a doctor's prescription to buy it, or so I'm told. I'd rather have Helen Clark than Piggie Muldoon any day!
Published: May 21, 2007 9:56 AM
Ozzie
David Hillary.
I am afraid the following is pure MACROMANCY!!!!!!!
"A lower interest rate does not merely 'increase the demand for goods and services'
it specifically reduces the price of capital,
the discount rate on capital assets
(which consist of a risk free interest rate plus a capital asset risk premium).
The reduced price increases the quantity demanded, and this is the so called 'transmission mechanism' of 'monetary policy.'
It is the greater quantity of demand for constructing capital assets that bids up labour prices (wages) and property rents too, which shows up as localised inflation (consumer price increases). "
DUDE.
Don't be throwing us no (IS-LM) Curves.
You have confused yourself by losing sight of REAL FACTORS OF PRODUCTION and instead have imagined that rigging the system will magically bring some big rock candy mountain goodies into existince.
But we know where this JIVE leads.
Its leads to trade deficit blow-outs and investment asset inflation.
Which means of course that there will be greater barriers to entry if you need to buy some of these investment assets in order to start your own business.
So this here macromancy only leads to debt being sprayed everywhere and the bigger end of town being advantaged over the little guy.
Published: May 21, 2007 11:36 AM
Ozzie
"Central banks do not print money, in a legal or economic sense. "
RRRRIIIIIIIGGGGGGGGGGGGHHHHHHHHHHHTTTTTTT says Dr Evil.
Dr Evil says RRRRIIIIIIIIIIIIIIIIIIIIIIIGGGGGGGGHHHHHHHHHHTTTTTT.
Look economics-boy-101.
We've all been through this something-for-nothing fantasy.
Why nots just all run big surpluses and then print money (but to ensure the dignity and piety of the monetary authorities we'll throw a cosmic veil over all that)...
...... print money and funnel it towards extra investment.
I would say that there is even many Austrian bigshots that as undergraduates thought of this something-for-nothing scheme.
But it doesn't work.
You were looking at interest rates. But you lost site of real resources.
You were looking at loanable funds.
But you lost site of savings.
Published: May 21, 2007 11:46 AM
Jim
Thanks David Hillary, for your reply to my point to Björn, on confusing giving credit with lending money. I agree that credit can be a verb or noun, but I am concerned only with it as a noun [& the difficulty of conversing via this blog!].
You state: "To give credit can be to actually advance funds or goods for the promise of later payment, or to undertake to do so." We agree, & I am particularly interested in the latter.
Also you add: "To lend money is to actually provide credit (noun)." Can you cite any authority for this? I've used Answers.com [see http://www.answers.com/credit?gwp=11&ver=2.1.1.521&method=3&au=1 ] but none of its 10 noun meanings is like yours.
You go on: "Thus one can give credit without lending money (an off balance sheet commitment) but one can't advance funds without also giving credit." We agree and I'd add that unless it is for a small amount &/or a short period, credit is not given lightly.
To give credit one requires confidence that the person receiving it will honour "the promise of later payment". My point is that they are two separate actions and the giving of credit must come first. If one can give credit without lending money [as you say & I tried to do in my hypothetical explanation], how does the "borrower" know when an undertaking to "advance funds" has been honoured unless he takes delivery of cash [you say funds]? I say cash because a bank cheque is no more cash than yours or mine. Björn may as well written his own cheque instead of asking me for a loan. As long as the person he pays with it does not present it before the hypothetical 2 years [and by then he is able to honour it], Björn's cheque is as good as [if not better than] a bank cheque.
I hope I've made my concern clearer, but fear I've not.
Published: May 21, 2007 6:31 PM
Matt Harkerss
David, so sad, I mean if your entire theory on our recent economic growth is based on a 15% increase in terms of trade 'over seven years' can explain a 100% increase in the M3, considering the CA deficit is running at around 10% of GDP and we have run trade deficits through most of the period. In fact international trade volumes according to global trade data (in say the CRB) suggests that we are actually exporting less then in the mid-1990's. In fact NZ has declined in importance on almost every countries Trade Weighted Index. You need to read Ozzie's comment above, some of Roger Garrison's recent works and go back to basics ie read Mises, Hayek, Rothbard and Hazlitt. Or Ernest Hemingway who once said, "the panacea for a mismanaged nation is inflation of the currency; second is war. Both bring temporary prosperity; both bring permanent ruin. Both are the refuge of political and economic opportunists."
If you're a fan of our corrupt socialist government and it's blind belief in Keynesian Economics, the Phillip's Curve and Leviathan you're probably in the wrong place. For others reading this the NZ Labour party is slightly worse then the interventionist extremists within the Democrats. It sounds like David has been sucked into their massive real estate bubble, which has been fueled via money expansion and massive welfare schemes.
Published: May 21, 2007 7:42 PM
David Hillary
Jim
'Credit' as the word originally meant, is belief or confidence. Thus it is a mental state rather than a concrete action. Lending money or providing goods in exchange for a promise to pay is a concrete action. Obviously the latter requires some degree of the former. I don't have an authority for the claim that the creditor gives credit to the debtor. The creditor must have had some belief and confidence in the debtor in order to allow him to be indebted to him in the first place. Is an authority needed for this claim?
Matt Harkerss
I'm not a fan of the present NZ government, and I don't credit their policies for the good times during their time. The good times haven't been particularly good, and, as you say, the last year or so has been quite low economic growth rate. But I'm not going to demonise them either, at least they're not as bad as the Bush government in the US or the Blair government in the UK, and they are practically libertarians compared to the Muldoon government. New Zealand and Australia have been running current account deficits for something like 150-200 years (or most of the time). The New Zealand policy makers don't follow or hold the Phillips curve, despite Philips having been a Kiwi. If you must know I don't own any NZ real estate assets, although I did predict the NZ property boom back in '99, although I also wrongly predicted it would have ended by now. I predict the property market boom will end within 1 year and that the exchange rate will take at least 3 years to get to its next cyclical low (maybe it will take 6 years). Perhaps I'll buy some NZ real estate about 2011.
Published: May 21, 2007 10:07 PM
Björn Lundahl
speculativebubble.com
http://www.speculativebubble.com/videos/real-estate-roller-coaster.php
Björn Lundahl
Published: May 22, 2007 3:32 AM
Jim
David Hillary
The action associated with credit is give [or withhold]. Any time after it has been given, it can also be withdrawn. In this it is different from a promise. I am not sure how the [adjective] concrete is relevant. Certainly if Visa withdrew my credit, it would have a "concrete" impact on my finances, particularly if it was picked up by a credit rating agency.
Your statement that I queried was "To lend money is to actually provide credit (noun)." It was not that "the creditor gives credit to the debtor".
You seem to be getting confused, which is understandable when we are blogging rather than conversing. It took me some time to compose this response, so I hope it is clear.
Published: May 22, 2007 8:21 AM
David Hillary
Jim,
The distinction is still obvious: credit (faith, trust, belief, confidence) enables you to get credit (debt finance or loaned capital). If the former is cut off, the latter may be demanded for repayment (if repayable on demand), or not rolled over.
Thus if the credit is lost, the availability of debt finance is also lost. Actions are based on beliefs.
Published: May 23, 2007 5:57 AM
Björn Lundahl
Fed Chairman Ben Bernanke said on Friday
04 Mar 2007 | 12:27 PM
"Empirical studies also find that U.S. monetary policy actions retain a powerful effect on domestic stock prices," he said.
http://www.cnbc.com/id/17452788
Björn Lundahl
Published: May 23, 2007 7:01 AM
Clayton
So that people don't get me wrong, I'm a huge fan of Schumpeter, I think Mises' The Theory of Money and Credit was way ahead of its time (albeit only about 90% right from a modern perspective).
But the argument in this thread borders on rediculous.
Take a simple proposition... that "money" is a unit of measure on which loans and trades are made. If the future natural interest rates and prices are all anticipated correctly (no matter where they go), then every trade can be made fairly and it doesn't matter what actually happens to the money "peg". Also consider that the critical prices for an individual micro decision maker is (1) wages and (2) consumption goods.
But the real world isn't this simple... in the real world, consumers can't anticpate fluctuations that accurately. So compare your standards:
Gold Standard (any commodity standard) -- We peg all our prices to a commodity that is considered "safe" but has no practical consistency relative to the prices that individuals care about (wages and consumables). People spend tons of money and time anticipating or predicting these changes. Alternatively, they don't spend the money, consider these fluctuations "risk", and add that risk premium to every transaction (reducing trade).
Basket of goods. If we momentarily assume that a government can peg zero inflation against a basket of goods, we now have a unit of account that is perfectly correlated with half of the prices that matter to micro-participants. We eliminate the risk (or cost) in all transactions, eliminating the associated dead weight loss (perhaps not technically the right
term but how I prefer to think about it).
In order to maintain this low risk, it is necessary to peg the inflation rate. This rate need not be zero, just the anticipated rate.
Obviously, the interest rate will fluctuate (with the natural rate a la wicksell) to maintain these prices.
I'm happy to explain more thoroughly, but I don't want to drag on in a first post.
Published: May 23, 2007 9:12 AM
Björn Lundahl
Clayton
"I think Mises' The Theory of Money and Credit was way ahead of its time (albeit only about 90% right from a modern perspective).”
As modern “economists” do not know much about economics, Mises was way ahead of them as well.
I think you should study the Austrian business cycle theory.
I will post this again:
Recessions and The Great Depression were caused by Government Interventions!
In a purely free market (without Government intervention), the rate of interest is determined by people’s “willingness to save and invest” (which is called people’s time preferences) for future use, as compared to how much they are “willingly to consume now”. If people change their “willingness to save” (time preferences) and want to save more, the additional savings will cause the rate of interest to fall (increased supply of savings), and businesses will borrow and invest these additional savings. When the Central Bank (for example The Federal Reserve) increases the money supply and expands bank credit (which Central Banks does everywhere and all the time and always “out of thin air”), it initially lowers the rate of interest and thereby misleads businessmen to act in a manner as if true savings have increased, which in turn leads businessmen to invests those supposed savings in capital goods. New projects that were not profitable before, will now suddenly with this lower interest rate, be profitable. While this process is working, the economy is in an inflationary boom phase (expansion). Capital goods such as stocks, real estate etc, will be more demanded and invested in, and prices of those will rise faster and more intensely in relation to consumption goods. As these supposed savings have worked their way through the economy, prices of goods, services and wages have generally increased to a height which prices for them would have not reached without these supposed savings.
As mentioned, people’s “willingness to save and invest” have not changed (people’s time preferences have not changed) for it was only the Central Bank that increased, out of thin air, additional “savings”. When supposed savings have worked their way through the economy and are received, finally, in increased wages, people still spend their real wages in the same manner as before. They save/ consume in real terms and in same proportion to each other, as before mentioned increase in supposed savings. Because of this, a lack of savings will occur and the rate of interest will rise. Projects that businessmen have invested in and that seemed to be profitable when the rate of interest was lowered are now revealed to be unprofitable. All those investments are revealed to be malinvestments. Businessmen will stop investing in those projects and lay off workers. Prices of capital goods, real estate, stocks etc, will fall sharply and relatively to the fall in prices of consumer goods. The economy is in a depression phase. When those investments are liquidated, the economy is adjusted to people’s “willingness to save and invest” and to consume. The economic structure corresponds to the ratio which people want to save and consume. The economy is now healthy again.
Now then, in the 1920s the Federal Reserve, in the US, increased the money supply and bank credit, which in the 30s resulted in The Great Depression. The same story goes with Japan during the 1980s, which during the 90s, resulted in a depression, go to;
http://en.wikipedia.org/wiki/Japanese_asset_price_bubble
In Sweden we had banks lending out heavily during the late 80s, which also, led to a depression in the 90s.
All business cycles are caused by the same phenomenon. Economic crisis can occur because of other factors such as wars, boycotts, oil prices etc, but pure business cycles have in common the same cause.
I have tried, in a very few words and in a easy manner, to explain Ludwig von Mises business cycle theory, which is also called the Austrian theory of the business cycle. All faults are mine. Friedrich August von Hayek elaborated this theory and received in 1974 the Nobel Prize* for this. Go to;
http://nobelprize.org/nobel_prizes/economics/laureates/1974/
If you want to know more about this theory, go to;
http://mises.org/rothbard/agd/contents.asp
And to;
http://mises.org/money.asp
Björn Lundahl
* Information about the Nobel Prize in Economics, go to;
http://cepa.newschool.edu/het/schools/nobel.htm
Published: May 23, 2007 9:53 AM
Björn Lundahl
To Clayton
Alex MacMillan “How would business cycles ensue in a world of perfectly understood zero inflation, according to Rothbard?”
During the 20s the purchasing power of money was relatively unchanged, but the money supply was still increased and brought about a depression.
http://mises.org/rothbard/agd/chapter4.asp#inflation
What bring about the business cycle are not changes in the purchasing power of money but the expansion of bank credit (increases of the money supply).
Expansion of the money supply through bank credit does not reflect “consumer’s willingness to invest and save”, but, still, this expansion of bank credit initially lowers the rate of interest as if consumers have saved more. This process brings about a business cycle.
Always remember that the greatest proportions of bank credit are loans that are borrowed to businesses and do not reflect consumers saving ratios. Consumers spend a much greater proportion of their incomes on consumer goods.
Please read my above comment “Recessions and The Great Depression were caused by Government Interventions!”
Please read also “Bank Credit and the Business Cycle”, (chapter from the book “For a New Liberty”, by Murray Rothbard):
http://mises.org/rothbard/newliberty9.asp
Björn Lundahl
Published: May 23, 2007 9:59 AM
Björn Lundahl
”TO PEG THE INFLATION RATE” (inflation targeting)
Man, Economy, & State, by Murray Rothbard:
B. Stabilization
The knowledge that the purchasing power of money could vary led some economists to try to improve on the free market by creating, in some way, a monetary unit which would remain stable and constant in its purchasing power. All these stabiliza¬tion plans, of course, involve in one way or another an attack on the gold or other commodity standard, since the value of gold fluctuates as a result of the continual changes in the supply of and the demand for gold. The stabilizers want the government to keep an arbitrary index of prices constant by pumping money into the economy when the index falls and taking money out when it rises. The outstanding proponent of “stable money,” Irving Fisher, revealed the reason for his urge toward stabiliza¬tion in the following autobiographical passage: “I became in¬creasingly aware of the imperative need of a stable yardstick of value. I had come into economics from mathematical physics, in which fixed units of measure contribute the essential starting point.”[61] Apparently, Fisher did not realize that there could be fundamental differences in the nature of the sciences of physics and of purposeful human action.
It is difficult, indeed, to understand what the advantages of a stable value of money are supposed to be. One of the most frequently cited advantages, for example, is that debtors will no longer be harmed by unforeseen rises in the value of money, while creditors will no longer be harmed by unforeseen declines in its value. Yet if creditors and debtors want such a hedge against future changes, they have an easy way out on the free market. When they make their contracts, they can agree that repayment be made in a sum of money corrected by some agreed-upon index number of changes in the value of money. Such a voluntary tabu¬lar standard for business contracts has long been advocated by stabilizationists, who have been rather puzzled to find that a course which appears to them so beneficial is almost never adopted in business practice. Despite the multitude of index numbers and other schemes that have been proposed to businessmen by these economists, creditors and debtors have somehow failed to take advantage of them. Yet, while stabilization plans have made no headway among the groups that they would supposedly benefit the most, the stabilizationists have remained undaunted in their zeal to force their plans on the whole society by means of State coercion.
There seem to be two basic reasons for this failure of business to adopt a tabular standard: (a) As we have seen, there is no scientific, objective means of measuring changes in the value of money. Scientifically, one index number is just as arbitrary and bad as any other. Individual creditors and debtors have not been able to agree on any one index number, therefore, that they can abide by as a measure of change in purchasing power. Each, ac¬cording to his own interests, would insist on including different commodities at different weights in his index number. Thus, a debtor who is a wheat farmer would want to weigh the price of wheat heavily in his index of the purchasing power of money; a creditor who goes often to nightclubs would want to hedge against the price of night-club entertainment, etc. (b) A second reason is that businessmen apparently prefer to take their chances in a speculative world rather than agree on some sort of arbitrary hedging device. Stock exchange speculators and commodity specu¬lators are continually attempting to forecast future prices, and, indeed, all entrepreneurs are engaged in anticipating the un¬certain conditions of the market. Apparently, businessmen are willing to be entrepreneurs in anticipating future changes in purchasing power as well as any other changes.
The failure of business to adopt voluntarily any sort of tabular standard seems to demonstrate the complete lack of merit in compulsory stabilization schemes.
http://mises.org/rothbard/mes/chap11d.asp#14B._Stabilization
Björn Lundahl
Published: May 23, 2007 12:08 PM
Björn Lundahl
Clayton
“Gold Standard (any commodity standard) -- We peg all our prices to a commodity that is considered "safe" but has no practical consistency relative to the prices that individuals care about (wages and consumables). People spend tons of money and time anticipating or predicting these changes. Alternatively, they don't spend the money, consider these fluctuations "risk", and add that risk premium to every transaction (reducing trade).”
Consider, instead, all the risks which the dreadful fiat money standard and fractional reserve banking imposes upon us through business cycles. Those risks can’t even be avoided, no matter how much they are “anticipated.” There is, of course, a way we could actually avoid them and that would be by not doing any business at all. Compared to that, even a government fiat money standard would be a good thing.
By the way, “modern economics did not discover inflationary expectations.” Mises knew about the formation of prices with and without any inflation:
Human Action
XII. THE SPHERE OF ECONOMIC CALCULATION
1. The Character of Monetary Entries
“The acting individual either anticipates changes which will occur without his own interference and wants to adjust his actions to this anticipated state of affairs; or he wants to embark upon a project which will change conditions even if no other factors produce a change. The prices of the past are for him merely starting points in his endeavors to anticipate future prices.”
http://mises.org/humanaction/chap12sec1.asp
Björn Lundahl
Published: May 23, 2007 4:42 PM
Björn Lundahl
Clayton
Any great and sudden change in the economy that is not anticipated such as increased or decreased savings, increased hoarding etc can cause crises and problems. Murray Rothbard has also mentioned this.
But those are rather economic fluctuations, and are they anticipated, the business community can easily cope with them without causing any problems at all.
There is a time lag between increases of the supply of money and changes in the purchasing power of money.
If monetary authorities anticipate that aggregate demand will fall in the future, and therefore increases the supply of money today, there is a time lag between those actions and their impact on aggregate demand.
Changes in aggregate demand can be anticipated by the market. Businessmen are trained specialists in their capability to anticipate changes in the market place and anticipated changes of market prices in the future cause immediate changes of prices today and the necessary adjustments.
In other words what Keynesian economists proclaim and what Monetarist economists implicitly proclaim is that economic depressions are caused through a lack in aggregate demand, can easily be refuted by the conclusion that changes in aggregate demand can be anticipated and offset through the market price mechanisms.
If there is a fall in aggregate demand, monetary authorities cannot offset this by increasing the supply of money without causing a business cycle.
Increases of the money supply can not be neutralized even if they are anticipated because there is no way to distinguish them from real savings. They are borrowed funds and as they are, actually borrowed, businessmen are factually deluded to act as if savings have increased.
Speculators can in a short term with borrowed money, reap extremely large profits through extensive speculations.
Consumers can allocate their economic recourses in two ways: consumption versus savings.
The fact is that during recessions and depressions price falls are extremely much more severe in the capital goods markets than in consumer goods markets.
In Sweden during the early 90s, as mentioned, we had an economic depression and only in one year we had an increase of the purchasing power of money of 1% while real estate prices decreased around 50%!
Stocks are titles of capital goods and prices of them fell extremely too.
The same story goes in the U.S. during the late 20s and early 30s and Japan during the very early 90s.
It is true that during depressions prices of some capital intensive consumer goods fall a lot too (durable consumer goods) but they are comparable to capital goods as they render services over a longer term of time and can be regarded as part of a economy’s fixed capital.
To put an end to business cycles, fractional reserve banking must be rejected and a 100% commodity money reserve standard adopted (such as gold and silver).
Björn Lundahl
Published: May 23, 2007 4:48 PM
RogerM
Bjorn: "Any great and sudden change in the economy that is not anticipated such as increased or decreased savings, increased hoarding etc can cause crises and problems."
I would just add that the savings rate (time preference) and the demand for money are pretty stable across time. However, both will change dramatically in response to changes in the money supply. Savings will decrease with monetary inflation. Hoarding usually occurs only in response to a crash when people are trying to rebuild their stock of money.
Published: May 23, 2007 10:39 PM
Björn Lundahl
RogerM
Yes, I agree with what you say. I did just want to be strict praxeological in my posts to Clayton. I have, though, written something similar in a post further above:
“Over the longer term when the economy is adjusted to a very slow growth of the money supply as under a 100% gold reserve money standard (not accomplished, though, through increases of bank credit) or adjusted to a faster growth of the money supply as under a fiat monetary system with a yearly inflation rate of 2% accomplished mainly through increases of bank credit (again inflation here is defined as decreases of the purchasing power of money), I do believe that the demand for money would also be quite stable.”
Björn
Published: May 24, 2007 1:45 AM
Jim
RogerM, Björn & David Hillary etc
A week ago RogerM's post included "Since Geir, Jim and others seem to hold David's position, this question is addressed to them as well. What to you think of the quantity theory of money and fractional banking's role in inflating/deflating the money supply?"
Even though I do not hold David's position, I did not answer then as I was still trying to explain to David that money & credit are two different things. In my post of 22 may, I said that he seemed to be getting confused. In particular I disputed his statement: "To lend money is to actually provide credit (noun)."
David opened his reply with "The distinction is still obvious: credit (faith, trust, belief, confidence) enables you to get credit (debt finance or loaned capital). ..." This was after he had introduced the distinction between the noun & verb forms of "credit" [& I'd indicated that I am concerned only with it as a noun]. Please read David's sentence again, noting its use of credit as subject & object both of which must be nouns.
To me, David's obvious error is that he's trying to give/have two quite different definitions of the noun "credit". In asking David to cite any authority for his "To lend money is to actually provide credit (noun).", I included this link: http://www.answers.com/credit?gwp=11&ver=2.1.1.521&method=3&au=1 and added that "none of its 10 noun meanings is like yours".
Does anyone [including David] agree with me that David [or any of you] is confused? I suspect that even Mises was confused. The confusion of credit & money has prevailed for centuries.
Published: May 25, 2007 12:25 AM
Clayton
Sorry guys I was on a vacation with limited internet access. First off, I agree that we have to take the risks of the Fed into consideration, but that only alters the final decision of which of many models is preferred, but does not impact a discussion of the potential weaknesses of a commodity peg. To specific points:
"I think you should study the Austrian business cycle theory."
I'm familiar with the theory. I think you can show that misallocation (usually presented as lengthening from what I've read) can be shown to exist within standard economic frameworks if you take certain factors into consideration (primarily the impact of GAAP on asset allocation -- see Baxter's 1955 article The Accountant's Contribution to the Trade Cycle)
===
To the rest of Bjorn's first post:
The rate of profit is a structurally determined value. However, as Hayek points out, the rate of profit is really only relative to the yardstick you use. If the price of good 'a' doubles compared to good 'b' over the relevent period of time, the interest rate in a money pegged to each unit will be different. By stating that you can use any commodity, it appears that the we implicitly agree that the actual monetary peg (unit of account) is irrelevent.
===
"Now then, in the 1920s the Federal Reserve, in the US, increased the money supply and bank credit, which in the 30s resulted in The Great Depression."
I wish I could cite you the right book off hand. I believe it was Friedman's that pointed out that the depression was triggered when the Fed chairman contracted the money supply suddenly despite a large influx of gold (an indicator that the value of the dollar was already too strong). Wikipedia cites Ben S. Bernanke's "Essays on the Great Depression" (2000) regarding the point. With care to my language -- I believe that you can convincingly show (and prove even under praxaeology) that a "liquidity trap" (though *not* what Keynes means) was triggered by the high deflation rates as, "Prices fell 25%, 30%, 30%, and 40% in the UK, Germany, the US, and France respectively from 1929 to 1933." (http://blog.mises.org/archives/006636.asp)
Basically, the rate of return of cash was so high that noone wanted to spend it and the price couldn't be "bid up" to the natural rate, breaking the cycle of trade that would have been avoided in a commodity/barter market -- where the rate of interest on any single good, net storage costs, could not exceed the rate of profit, else the good would be bid up to return that rate. This incident was a severe mistake by a Fed chariman, but one that can be recognized and avoided in the future (making it a poor point-argument againts a managed monetary unit)
"What bring about the business cycle are not changes in the purchasing power of money but the expansion of bank credit (increases of the money supply)."
I don't want to quibble over the definition of a business cycle, but any model where productivity/ technological progress (or any factor for that matter) can alter the natural rate (rate of profit) will, by definition, have variations in the rate of growth. This could easily be called a real business cycle (though I don't necessarily mean to lay credence to Kyland/Prescott).
Then, take poorly informed decision makers that assume that the current rate of growth (rate of profit) is the best estimate for permanent growth (like a random walk hypothesis) and sudden changes in the growth rates will generate significant adjustments in the desire for current commodities (as people realize they need to significantly adjust their current spending to new data).
Now, I believe that monteary factors severely exacerbate this process (via the "GAAP transmission process" that generates misallocation), but I don't believe you can prove that any arbitrary commodity peg would alter the productivity and individual decision making factors.
===
Regarding the general argument about tabulation... and a clarification of my transaction cost/ information cost focused argument:
I am not a physicist and I couldn't care less that a peg is necessarily fixed in any framework (consistent with my argument that any inflation rate is ok so long as it is anticipated). My argument is not about the harm necessarily done to debtors or creditors either.
Instead, focus on Rothbard's statement "Yet if creditors and debtors want such a hedge against future changes, they have an easy way out on the free market."
This is certainly true in a perfectly efficient market, but what is the real cost to 280 million Americans to do this on a monthly basis? They have to (1) determine the level of risk to know whether or not the transaction costs are justified and (2) transact the net risk.
Consider worse yet Rothbard's idea that, "When they make their contracts, they can agree that repayment be made in a sum of money corrected by some agreed-upon index number of changes in the value of money. Such a voluntary tabu¬lar standard for business contracts has long been advocated by stabilizationists, who have been rather puzzled to find that a course which appears to them so beneficial is almost never adopted in business practice."
Now we're also exacerbating contracting costs. Further, since each contract could end up in a different adjusted unit of account (Rothbard even states this), we risk greater transaction and information costs in the future (have to get this info every time we have to make a payment). This is hardly an "efficent" alternative.
What if, instead, we eliminated the cost for 280 million Americans by offering them a unit of account that roughly tracks their desired framework/point of reference (basket of goods). Then we let the businesses that are still impacted by fluctuations in the factor markets worry about the risk and pass these costs to the end consumer via product cost. This concentration of responsibility seems rational (at least in theory) as they have economies of scale and can hire experts.
Now the market efficient passes *responsibility* for transacting the risk to businesses -- via a managed unit of account. Perhaps more importantly, additional costs of indexing (contracting, transacting, information) are avoided via a single, relatively good unit. In fairness, the Fed may not be the best group to manage this unit of account, but this point is different from the relative merit of such a unit. All of the sudden, Rothbard's statement can be spun to support the position:
"A second reason is that businessmen apparently prefer to take their chances in a speculative world rather than agree on some sort of arbitrary hedging device. Stock exchange speculators and commodity specu¬lators are continually attempting to forecast future prices, and, indeed, all entrepreneurs are engaged in anticipating the un¬certain conditions of the market. Apparently, businessmen are willing to be entrepreneurs in anticipating future changes in purchasing power as well as any other changes."
By focusing on transaction costs, I think we can establish that the seemingly perfect "perfect market solutions" are dominated in practice by a basket of goods unit of account system (though we don't necessarily argue a specific unit of account or managing body).
I'll come back to some of the other arguments in a bit (I do dislike posting too much at once anyway cause it makes it hard to thoroughly address the issues.).
Published: May 30, 2007 8:30 AM
Clayton
Finally back to address remaining points:
"In other words what Keynesian economists proclaim and what Monetarist economists implicitly proclaim is that economic depressions are caused through a lack in aggregate demand, can easily be refuted by the conclusion that changes in aggregate demand can be anticipated and offset through the market price mechanisms."
I'm not sure what basis this argument is made on. Uncertainty (stochastics) is uncertainty. We can hedge for risk but we cannot anticipate the direction or magnitude the outcome will actually take. This is precisely why monetary impacts (and real impacts incidentally) are lagged. I have a very very rough working paper on the stochastic mechanisms (and how these mechanisms contribute to price rigidity). The paper is designed to illustrate the general principle, but I believe a derivative model will go a long way to eliminating the current debate over the sources and reality of price rigidity.
"Consumers can allocate their economic recourses in two ways: consumption versus savings."
And this is the point where the fundamental argument of the working paper becomes relevent. The question is whether the observed behavioral changes are draws from the expected distribution or indicators of a new distribution and this uncertainty delays adjustments in these prices (interest rates).
Either noone can anticipate these adjustments or the Fed (as your ultimate economies of scale businessman) can anticipate these changes on behalf of the market (and 280 million individuals) and act to drive reality towards expectations (or expectations towards reality, as appropriate).
"I would just add that the savings rate (time preference) and the demand for money are pretty stable across time. However, both will change dramatically in response to changes in the money supply. Savings will decrease with monetary inflation. Hoarding usually occurs only in response to a crash when people are trying to rebuild their stock of money."
While I certainly agree that the savings rate is theoretically stable, the rate of profit (interest) is not. If the nominal interest rate in the market does not immediately adjust to the rate of profit (again my rigidity argument), it will generate an over- or under-production of goods (or in austrian terms a tendency to misallocate efforts into inappropriate length processes).
I think I've addressed enough angles here that either I'll produce questions or challenges and will not draw out the argument further.
Published: May 30, 2007 6:29 PM
Björn Lundahl
"In other words what Keynesian economists proclaim and what Monetarist economists implicitly proclaim is that economic depressions are caused through a lack in aggregate demand, can easily be refuted by the conclusion that changes in aggregate demand can be anticipated and offset through the market price mechanisms."
What also are included in the market “price mechanism” are profit margins that is to profitable cut prices when demand for products and services are decreasing. Volatile changes in supply and demand in certain businesses and for certain products and services will be generally registered by entrepreneurs and needed profit margins to cope with this uncertainty will be implemented.
I guess that for Keynesians and Monetarists the computer industry, for example, could not a priori exist, because of “price rigidity”.
Secondly, what I am defending here is a “free market” and not status quo. Market reforms are needed in all areas of the economy and especially regarding wages where regulations are all over the world supporting “wage rigidities” and, therefore, unemployment.
The adoption of a 100% gold reserve money standard would lead to mass unemployment if those necessary reforms regarding wages would not be performed.
Björn Lundahl
Published: June 2, 2007 11:40 AM
RogerM
Jim: "I suspect that even Mises was confused."
I doubt it. Obviously, the word credit has many different definitions, but when most economists speak of "credit expansion" they mean an increase in money loaned.
Published: June 2, 2007 12:10 PM
RogerM
Clayton: "I believe it was Friedman's that pointed out that the depression was triggered when the Fed chairman contracted the money supply suddenly despite a large influx of gold (an indicator that the value of the dollar was already too strong)."
I think you'll find Mises's and Rothbard's acccounts of the Great Depression much more comprehensive, and if I remember correctly, the Fed attempted to contract the money supply when it saw gold leaving the US around 1928. However, the Fed did some things to contract the money supply (raise interest rate), but did other things to expand it (buy gov bonds and other things). The Depression would have happend whether the Fed raised interest rates or not. The farm economy was in terrible shape throughout the 1920's because low interest rates had caused massive overproduction on farms. Then, in 1928, manufacturing hit the wall because of overproduction, also caused by excessively low interest rates. The stock market boomed because business people couldn't find good investments for the excessive amount of money, so they stuck it in the stock market. When capital intensive industries began to fail in 1928, people began to take money out of the stock market and it began to collapse in early 1929. The resulting bank failures are what really contracted the money supply. But no matter how low interest rates went, people couldn't borrow because they already had too much debt to pay. In addition, people wanted to hold gold rather than paper money because of the massive bank failures.
Clayton: "I don't want to quibble over the definition of a business cycle, but any model where productivity/ technological progress (or any factor for that matter) can alter the natural rate (rate of profit) will, by definition, have variations in the rate of growth."
Variations in the rate of growth don't fit the generally accepted definition of a business cycle(The NBER has a technical definition). In the downward part of a cycle, real output has to shrink, not just slow down. Productivity will generally grow or not grow, but it rarely becomes negative, which is what it would have to do in order to cause economies to shrink. Neo-Keynesian and neo-classical economists have refused to even consider the role of money in business cycles, but the head of the European central bank recently commented in FT that money must play some role and economists should consider it. Neo-Keynesian and neo-Classical economists are fixated on "shocks" and "sticky prices/wages" but they never get behind the causes of the shocks.
Clayton: "What if, instead, we eliminated the cost for 280 million Americans by offering them a unit of account that roughly tracks their desired framework/point of reference (basket of goods). Then we let the businesses that are still impacted by fluctuations in the factor markets worry about the risk and pass these costs to the end consumer via product cost."
Hasn't that been the policy since the founding of the Fed? The Fed has always tried for price stability using a basket of goods to provide an index of price inflation (except for the 1970's when Keynesians convinced the Fed that price inflation was no problem). And that's the real problem. When productivity increases, as it did in the 1920's and 1990's, prices will fall if the money supply is fixed, but desiring price stability, the Fed inflates the money supply to keep prices from falling. The lower interest rates persuade businesses to invest in activities that would be unprofitable under the older, higher interest rates. This leads to wide-spread overproduction, as with the telecomm industry in the 1990's. There are many other problems caused when production is expanded by artificially low interest rates instead of increased savings.
Another problem with inflation indexes is that they contain just consumer products (or producer one's). But monetary inflation can also appear in price inflation of assets, such as the stock market, real estate and commodities. But the Fed pays no attention to those, even when they cause enormous harm when those asset markets collapse. Had the Fed paid attention to asset inflation of the 1920's and 1990's, the recessions that followed may not have happened.
You really ought to check out any article or book by Roger Garrison because he compares Austrian econ with Keynesian and neo-Classical econ and has a good response to all of your points above.
Published: June 2, 2007 12:56 PM
Björn Lundahl
YouTube:
Ron Paul vs. Ben Bernanke Feb 2007
http://www.youtube.com/watch?v=QSs69qNJ5oc&mode=related&search=
Björn Lundahl
Published: June 2, 2007 1:37 PM
Clayton
"Variations in the rate of growth don't fit the generally accepted definition of a business cycle(The NBER has a technical definition). In the downward part of a cycle, real output has to shrink, not just slow down. Productivity will generally grow or not grow, but it rarely becomes negative, which is what it would have to do in order to cause economies to shrink."
Except this argument sounds like Hayek under the assumption of a fixed and constant supply of input. In the case of high marginal productivities (high interest rates) it is reasonable to argue that the dollar value of labor is also inflated (via its ability to produce capital, even at a lower unit productivity). People substitute labor & the goods it can purchase for leisure and the raw output rises.
During a lower growth period (with lower productivity and lower interest rates), the value of labor falls and people substitute leisure for labor & consumption.
While the capital productivity may never become negative, I believe the change it labor could be adequate to imply a negative growth.
I tried to put together data on the two, but what I could find was inadequate to test the point. Real interest rates seem to fluctuate from 3% down to as low as 1%. Naturally, a rising unemployment rate (or more accurately a falling employment rate) could easily exceed the 1% capital growth in a year.
I absolutely agree that a failure of the Fed to decrease the nominal interest rate (to mirror the rate of profit) accentuates this fall and exacerbates the depression. However, I am unconvinced that a currency tied to gold or any commodity would better reflect this natural rate and thus avoid the failure of the fed or any participant to adjust to the new price (interest levels).
Published: June 2, 2007 2:34 PM
Clayton
Which lets me address the second point:
"The Fed has always tried for price stability using a basket of goods to provide an index of price inflation (except for the 1970's when Keynesians convinced the Fed that price inflation was no problem). And that's the real problem. When productivity increases, as it did in the 1920's and 1990's, prices will fall if the money supply is fixed, but desiring price stability, the Fed inflates the money supply to keep prices from falling."
Assuming my real interest rates estimates (1-3%) and inflation data (1%-3%) are approximately correct, gold fell from a high of $400 in 1996 to $250 in 1999 or a nominal CAGR of -21% during a period of 1-3% inflation. Real interest rates in gold would therefore have been in the low 20%s.
If you concede any price (interest rate) rigidity, the bigger problem is in early 2000s when the CAGR for gold went from -21% (nominal late 90s) to -4% (nominal, 2000 to 2001) and then up to 7.5% (nominal, 2001 to 2002). This represents an 11% swing in gold based interest rates in one year (30ish over several years) that could only possibly be offset by a few percentage points of actual interest and inflationary shift.
If there is any price rigidy with regard to interest rates, an 11% (30%) change in interest rates would seem to cause far more risk/uncertainty than an unjustified 1-6% nominal swing in basket of goods rates.
In fact, I'll repeat the statement I made earlier:
"The rate of profit is a structurally determined value. However, as Hayek points out, the rate of profit is really only relative to the yardstick you use. If the price of good 'a' doubles compared to good 'b' over the relevent period of time, the interest rate in a money pegged to each unit will be different. By stating that you can use any commodity, it appears that the we implicitly agree that the actual monetary peg (unit of account) is irrelevent."
Almost by definition, the willingness to accept any commodity basis is a willingess to accept any arbitrary peg. The interest rate in gold over the period would have fluctuated from 20% to 0%. How is a 20% interest rate in gold any less problematic (contractive) than a 1% interest rate in fiat (exansionary). People adjust for inflation expectations in both cases and the only difference is, under price stickiness, they have a harder time working in gold denominated units (and thus incur a higher cost to transact).
Published: June 2, 2007 2:40 PM
Björn Lundahl
If the government printed dollar bills and gave them in cash to each citizen, that wouldn’t either cause a business cycle as it would not distort the market in the same way as bank credit expansion. Bank credit expansion initially lowers the rate of interest, or alternatively, makes it lower than it otherwise would be which induces businessmen to act in a manner as if savings have increased. By printing of dollar bills and handing them over in cash to each citizen, does not produce such a result as consumers voluntarily use these monies in the way they want, and the economy responds to their preferences accordingly. In other words, consumers decide how much they will save/consume in proportion to each other and the economy adjusts to these preferences correspondingly. The economy need not, therefore, at a later date be exposed of consumer retribution, or at least not in a 100% fiat money reserve standard. Such a standard would also be, logically, the only one that could be acceptable to analyze in an example like this, as we wouldn’t want any influence of fractional reserve banking. What we instead want to analyze is only the impact of printing of dollar bills in regard to the business cycle.
In contrast to the printing of dollar bills and handing them over in cash to each citizen, the central bank could increase bank reserves which will multiply the money supply (bank credit expansion) and initially lower the rate of interest. This is a concentrated action which will give businessmen the wrong signals that the pool of capital is larger than it really is and will in a illusory manner effect their calculations in such a way that it will seem profitable to invest in certain capital goods and thereby distort the economic structure to not respond to consumers voluntarily saving ratios. This is a phase when the economy “booms” and prices rise (relatively to what they otherwise would be without injections of bank credit) as the economy is initiating the realization of malinvestments. Prices of capital goods such as stocks, real estate etc will rise further and relatively to consumer goods. In phase II when the money supply decreases or decelerates a contraction in output and an economic bust will dominate the economy and illusory made malinvestments will be liquidated. Prices of capital goods will fall and proportionately to consumer goods. The economy is now back to health again and economic structures have a tendency to reflect consumers voluntarily saving ratios.
The recipe for avoiding this anti social phenomenon, the dreadful business cycle, is to hinder any political manipulations of a nation’s monetary system through the transformation of the present monetary system to a true 100% gold reserve money standard (or silver standard) and thereby cut the link, all together, between government and money.
If mentioned necessary monetary reforms were undertaken, for example, in the USA with its enormous economic, cultural and psychological influence on the rest of the world, many other nations might follow suit.
Apart from fraud and other distortions, the printing of dollar bills would be similar with respect to the business cycle as a newly arrived inflow of gold would be in a 100% gold reserve money standard.
I would also like to additionally mention why expectations of “zero inflation” or unchanged purchasing power of money does not at least prevent the occurrence of the business cycle, as increases of bank credit gives the borrowers (businessmen) a command over economic recourses and thereby influence the production of capital goods and the economic structure.
Alternatively, if you would have a printing press and printed dollar bills, it surely would give you a command over economic recourses and this regardless of inflationary expectations and as money supplies increase to a greater extent than inflations, people first receiving them will have steady increases of their purchasing powers and an ever greater command over economic recourses.
Björn Lundahl
Published: June 2, 2007 3:47 PM
Björn Lundahl
Money must originally be developed out of a commodity with a previously existing purchasing power, such as gold and silver had.
Man, Economy, and State, by Murray Rothbard:
“One of the important achievements of the regression theory is its establishment of the fact that money must arise in the manner described in chapter 3, i.e., it must develop out of a commodity already in demand for direct use, the commodity then being used as a more and more general medium of exchange. Demand for a good as a medium of exchange must be predicated on a previously existing array of prices in terms of other goods. A medium of exchange can therefore originate only according to our previous description and the foregoing diagram; it can arise only out of a commodity previously used directly in a barter situation, and therefore having had an array of prices in terms of other goods. Money must develop out of a commodity with a previously existing purchasing power, such as gold and silver had. It cannot be created out of thin air by any sudden “social compact” or edict of government.”
http://mises.org/rothbard/mes/chap4b.asp#5B._Money_Regression
Björn Lundahl
Published: June 2, 2007 3:57 PM
Clayton
"In contrast to the printing of dollar bills and handing them over in cash to each citizen, the central bank could increase bank reserves which will multiply the money supply (bank credit expansion) and initially lower the rate of interest. This is a concentrated action which will give businessmen the wrong signals that the pool of capital is larger than it really is and..."
I was going to point out that the low interest rates also drive mortgaged houses and increased consumption but I still think this is the wrong battle to fight.
Supporters of the gold standard usually do so on the basis of a theory that functions (at least theoretically) with any durable commodity.
So how/why does this argument change when the commodity is automobiles. Storing them in a warehouse doesn't cause significant rust that reduces their value (they are not perishable in that sense), but they would decline in value on a continual basis over many years.
As technology improved in fits and starts, the value of those cars would fall in fits and starts (I'm assuming the value falls at a higher rate when technology improves and slower when technology stagnates).
This would create an "inflation" of the basket of goods and cause nominal interest rates to fluctuate around some arbitrary peg that is in no sense a constant value. If the cost of storage of an auto was as small as gold (per dollar of value, making it practical), would the artifically high nominal interest rates caused by the depreciation of the car have some kind of inappropriate impact on the economy?
Would a technological advance that caused the value of cars to plummet somehow break the economy? Would the scarcity of automobiles (and the consequently lower interest rates) cause mass investment in other goods?
So how is a fiat peg any different?
Published: June 2, 2007 4:54 PM
Clayton
"Money must develop out of a commodity with a previously existing purchasing power, such as gold and silver had. It cannot be created out of thin air by any sudden “social compact” or edict of government."
Ok... I'm going to loan you my computer. Since we agree that my computer is worth 30,000 hybiscus leaves, after two weeks, you will return to me payment of the value of 30,100 hybiscus leaves. I have never traded these leaves and have no idea what they're worth. Are you and I prevented from making this trade in a unit of exchange of hybiscus leaves just because the hybiscus leaf, for all intents and purposes and to our knowledge, has never before been bartered?
I think the answer is "no we are not prevented, but at least one of us (and probably both) would be stupid to transact (loan in this case) in this unit of exchange." Hybiscus leaves are essentially as common as pieces of paper, but it's still be worth more to you to find a good that I want (versus picking or acquiring 30,100 leaves) and more to me to have that good than lots of useless hybiscus.
Indeed, the essential transaction is the loan. If you must cede to me my computer unless you pay me in hybiscus leaves, you'll find something that I'm willing to accept (and you're willing to give up) in exchange for my forgiving your debt.
All of the sudden, we have given these things value... by social contract alone. Now these leaves are potentially a problem because someone could probably acquire enough in some way to inflate our market... which is why the government actively limits the amount of fiat, despite the fact that it is now a social contract and nothing more. We demand them for payment of our debts (and the government ultimately holds enough debt to clear the market) which gives them value.
Since I have a model with this general idea as one of its precepts, I'd be happy to clarify or learn where this doesn't work.
Published: June 2, 2007 5:09 PM
Mike Sproul
Clayton:
Consider for a moment that there might be no such thing as fiat money, and that all money is actually backed by the assets of the bank that issued it. If this is true then all the puzzling about how "fiat" money can acquire value becomes irrelevant. The US dollar is physically inconvertible (meaning the Fed won't buy back its dollars with gold), but the dollar is still financially convertible (meaning the Fed will buy back its dollars with bonds). There is a big difference between money that is backed but inconvertible and money that is actually unbacked.
More at
www.csun.edu/~hceco008/realbills.htm
Published: June 2, 2007 5:55 PM
Clayton
"There is a big difference between money that is backed but inconvertible and money that is actually unbacked."
Oh I quite agree. However, supposing that a dollar denominated bond is adequate to back a dollar is a uselessly circular argument because the bond is denominated in the same units as the dollar. Inflating one inflates the other and thus you get no peg.
But I do agree that ultimately dollars are backed by something. Securitized debt (in concert with other socially generated reputation costs) *is* adequate to create value for dollars in the eyes of the debtor. This is the peg on which subsequent iterations of value are hung. If the Fed puts too much money into the system, then it does so at an inappropriate price and "waters down" the value of this security -- somewhat like the real bills doctrine without the direct math.
Published: June 2, 2007 6:38 PM
Björn Lundahl
A 100 percent fiat money reserve standard
If we lived under a system which banks are required to maintain 100 percent reserves of fiat money against all demand deposits and the Central Bank did not print more money (including minting) than those that are worn-out, that would, also, bring an end of the business cycle and inflation. Banks would no longer be able to create money out of thin air.
Some implications:
A/ The government still has the power to change the reserve requirements.
B/ Fiat money would still be counterfeited money (as money can arise only out of a commodity previously used directly in a barter situation).
C/ People would still not be allowed to choose which medium of exchange (money) they want to use.
D/ The government would still influence the market and the society, because it deviates from pure liberty and a pure free market.
Björn Lundahl
Published: June 2, 2007 8:04 PM
Clayton
"A 100 percent fiat money reserve standard
If we lived under a system which banks are required to maintain 100 percent reserves of fiat money against all demand deposits and the Central Bank did not print more money (including minting) than those that are worn-out, that would, also, bring an end of the business cycle and inflation. Banks would no longer be able to create money out of thin air."
First,
"A/ The government still has the power to change the reserve requirements"
Unless I missed something, this is a contradiction since the reserve is the reserve requirement.
Further, and I hate to pick the fight cause I seriously doubt it's gonna get fair consideration, but this would totally screw up the financial system.
100% reserve currency makes it 100% unloanable so, in order to loan physical capital, people would have to sign long term debt. Now fundamentally this is great because it gets rid of the strange confusion that is fractional reserve (part reserve part loaned). If we want to loan our capital we buy long term debt.
But this makes changes in the liquidity preference (recognized even by Austrians like Hayek) disastrous. Instead of loaning capital (through long term debt), we converting loaned capital into unloaned capital but then don't acquire the capital by spending the money. Visually:
a) Loaned money:
Money => bank => Borrower => Demand
b) Spent money:
Money => demand
c) 100% reserve fiat:
Money => bank
Converting a to c causes a gap in demand that (due to a 100% reserve) cannot be resolved by the Fed. Instead, increased liquidity preference would require a huge deflation in order to equate the amount of loaned money (demand for capital) with the amount of capital individuals desire to loan.
BTW, can anyone clarify the best way to get the single blank space... I seem often to get too much.
Published: June 2, 2007 8:40 PM
Björn Lundahl
America´s Great Depression, by Murray Rothbard:
"Savings and investment are indissolubly linked. It is impossible to encourage one and discourage the other. Aside from bank credit, investments can come from no other source than savings (and we have seen what happens when investments are financed by bank credit). Not only consumers save directly, but also consumers in their capacity as independent businessmen or as owners of corporations. But can't savings be "hoarded"? This, however, is an artificial and misleading way of putting the matter. Consider a man's possible allocation of his monetary assets:
He can (1) spend money on consumption; (2) spend on investment; (3) add to cash balance or subtract from previous cash balance. This is the sum of his alternatives. The Keynesians assume, most contrivedly, that he first decides how much to consume or not, calling this "not-consumption" saving, and then decides how much to invest and how much to "leak" into hoards. (This, of course, is neo-Keynesianism rather than pure Keynesian orthodoxy, which banishes hoarding from the living room, while readmitting it by the back door.) This is a highly artificial approach and confirms Sir Dennis Robertson's charge that the Keynesians are incapable of "visualizing more than two margins at once."[2] Clearly, our individual decides at one and the same stroke about allocating his income in the three different channels. Furthermore, he allocates between the various categories on the basis of two embracing utilities: his time preferences decide his allocation between consumption and investment (between spending on present vs. future consumption); his utility of money decides how much he will keep in his cash balance. In order to invest resources in the future, he must restrict his consumption and save funds. This restricting is his savings, and so saving and investment are always equivalent. The two terms may be used almost interchangeably.
These various individual valuations sum up to social time-preference ratios and social demand for money. If people's demand for cash balances increases, we do not call this "savings leaking into hoards"; we simply say that demand for money has increased. In the aggregate, total cash balances can only rise to the extent that the total supply of money rises, since the two are identical. But real cash balances can increase through a rise in the value of the dollar. If the value of the dollar is permitted to rise (prices are permitted to fall) without hindrance, no dislocations will be caused by this increased demand, and depressions will not be aggravated. The Keynesian doctrine artificially assumes that any increase (or decrease) in hoards will be matched by a corresponding fall (or rise) in invested funds. But this is not correct. The demand for money is completely unrelated to the time-preference proportions people might adopt; increased hoarding, therefore, could just as easily come out of reduced consumption as out of reduced investment. In short, the savings-investment-consumption proportions are determined by time preferences of individuals; the spending-cash balance proportion is determined by their demands for money."
http://mises.org/rothbard/agd/chapter2.asp#liquidity_trap
Björn Lundahl
Published: June 3, 2007 1:23 AM
Björn Lundahl
Term deposits
Alex MacMillan I seem to by using the term "time deposit" in a different sense than you are, and that Rothbard was. I apologize as this no doubt causes confusion. Perhaps if I change my term to "term deposit", that is a deposit contracted to be withrawn only after a specific term (e.g. 30 days, 365 days, 5 years). Suppose a bank accepts a $100, 365 day, term deposit and lends the $100 out for 365 days, there would be no need for reserves against such a deposit until it matures. This would be all right by you, wouldn't it? When a person lends another $100 for 365 days, the lender never expects the borrower to hold the $100 as reserves. So, in this case, the fact that the deposit borrower happens to be a bank would be no different, right?
Björn Those “term deposits” that you mentioned are acceptable.
Björn Lundahl
Published: June 3, 2007 1:26 AM
Björn Lundahl
“If we lived under a system which banks are required to maintain 100 percent reserves of fiat money against all demand deposits and the Central Bank did not print more money (including minting) than those that are worn-out, that would, also, bring an end of the business cycle and inflation. Banks would no longer be able to create money out of thin air.
Some implications:
A/The government still has the power to change the reserve requirements"
”Unless I missed something, this is a contradiction since the reserve is the reserve requirement.”
When I use the word government in a debate like this and this is also very common use of the word “government,” I am obviously referring to the broader definition that is a state and, of course, a state have the power to change the institutions in a given territory.
It is, of course, true that if the government (or the state) is still existent in a given territory which has a monetary system based on a 100 percent gold reserve money standard, the government could then too abolish it and adopt a fiat monetary system and fractional reserve banking. But such a mission would be a lot more difficult for the government to realize as the system of 100 percent gold reserve money standard is self-regulating and the central bank would not be needed and therefore also abolished (or should be abolished in such a system). To implement a fiat monetary system and fractional reserve banking under those mentioned conditions is much more difficult for the government to carry out as it would be exposed that the government is intervening and the public awareness of what the government is up to would be for them easily tracked.
To change the reserve requirements under a 100 percent fiat money reserve standard to less than 100 percent would be in the eyes of the public only a question of technicality and something which economists would debate. In the eyes of the public, “money” would still be something which the government creates and control and a change in such a system would therefore be legitimate and not as strongly opposed as the abolishment of a 100 percent gold reserve money standard would be if such a system would be adopted.
Björn Lundahl
Published: June 3, 2007 3:26 AM
Mike Sproul
Clayton:
"supposing that a dollar denominated bond is adequate to back a dollar is a uselessly circular argument because the bond is denominated in the same units as the dollar. Inflating one inflates the other and thus you get no peg."
Surprisingly, this is not correct, although it is the same criticism of the RBD that has been used since Henry Thornton & Lloyd Mints popularized it.
Suppose, for example, that GM has issued 1 million shares of stock and backed them with nothing but a bank account with $60 million in it. We'd all agree that GM stock will be worth $60 per share. Now suppose Merrill Lynch issues a call option on GM with a zero striking price--essentially an IOU that says "IOU 1 share of GM". Technically, GM could issue one more share, sell it for $60, and use the $60 to buy that IOU. In the end, GM would be backing its shares with call options denominated in GM stock. It wouldn't be great financial wisdom on GM's part, but it is certainly possible, and certainly not circular.
Extending the same argument to money, a bank might have issued 100 paper dollars, each of which is a claim to 1 ounce of silver. Then it can issue another $200 in exchange for an IOU worth $200. By doing this they are, as you say, backing a dollar with something denominated in dollars. Letting E=the exchange value of the dollar (oz./$), setting the bank's assets (100 oz. + an IOU worth 200E oz.) equal to its liabilities ($300 worth E oz. each) yields 100+200E=300E, or E=1 oz./$. If the value of the IOU fell to $150, the same procedure gives 100+150E=300E, or E=.67 oz./$.
Here's the thing: Backing dollars with dollar-denominated assets makes the dollar more volatile. If the bonds lose value, then the dollars backed by those bonds lose value, so the bonds fall still more, etc. But there is a limit to that process, which is given by the equations above.
Published: June 3, 2007 9:02 AM
Clayton
"Suppose, for example, that GM has issued 1 million shares of stock and backed them with nothing but a bank account with $60 million in it. We'd all agree that GM stock will be worth $60 per share. Now suppose Merrill Lynch issues a call option on GM with a zero striking price--essentially an IOU that says "IOU 1 share of GM". Technically, GM could issue one more share, sell it for $60, and use the $60 to buy that IOU. In the end, GM would be backing its shares with call options denominated in GM stock."
There is nothing inconsistent here except you do not have a real peg for the stock or money. If the value of the dollar halves tomorrow, the stock, the $60, and the option are all worth half as much. We haven't had to create money, and there's nothing implicit in this argument to prevent the real purchasing power of the stock from falling. It's not until GM actually buys a real thing that there's any bottom to the real value of the whole network
Conversely:
"a bank might have issued 100 paper dollars, each of which is a claim to 1 ounce of silver."
You have now given the problem a commodity peg and are consequently working with a real (though possibly later diluted) peg. The value of the money can't arbitrarily halve because people would redeem a share of the silver.
But our dollar is no longer substantially backed by a commodity. Indeed, the reserve has $11b in gold and $40b in other assets to back $815b in active circulation. I'll submit to you that the the Fed could sell these $50b in assets to retire $50b in currency and not only would the dollar retain its value (despite zero real asset backing), but its value would rise (tightening money is the same whether facilitated by bond or asset sales).
Published: June 3, 2007 12:08 PM
Clayton
Bjorn:
"If people's demand for cash balances increases, we do not call this "savings leaking into hoards"; we simply say that demand for money has increased. In the aggregate, total cash balances can only rise to the extent that the total supply of money rises, since the two are identical. But real cash balances can increase through a rise in the value of the dollar. If the value of the dollar is permitted to rise (prices are permitted to fall) without hindrance, no dislocations will be caused by this increased demand, and depressions will not be aggravated."
In a world with no rigidity, I would submit that the two views are 100% equivalent. Whether we view a leaking of savings driving up the equilibrium value of money or a demand for money driving up the equilibrium is irrelevent, both models recognize the equilibrium condition between the amount of capital savings and the amount of wealth put into savings (versus money held as currency or reserve on demand deposits).
Unfortunately, there are real rigidities in the world. Consequently, changes in prices (both unit prices and interest rates) cause disruptions in the efficient operation of the monetary system. It doesn't matter how you view the transmission mechanism because all models agree that a world with a natural rate of 5% and a real rate of 4% will cause overinvestment.
Consequently, the key to minimizing this distruption is to minimize price changes so as to minimize the long run impact of these rigidities. This stability is not achieved using gold (as the history of gold clearly points out). While fiat has other risks, there is no immediate evidence that this peg, like any other randomly moving commodity peg, is somehow useless -- find a fault in my depreciating automobile argument and I'll either cede the point or address the weakness.
It appears then that you are disagreeing on one of a few points, concluding:
-Real rigidities do no exist
-Fiat is somehow different from a commodity peg (automobiles) with the same behavior
-Fiat has less price (and interest rate) stability than gold
If you take one of these three positions, let's address it directly rather than cite chapters out of Rothbard as gospel (since he may have considered this perspective). Or if you agree with all three positions and can tell me your complaint, I'll try to address it directly.
Published: June 3, 2007 12:27 PM
Mike Sproul
Clayton:
"But our dollar is no longer substantially backed by a commodity. Indeed, the reserve has $11b in gold and $40b in other assets to back $815b in active circulation. I'll submit to you that the the Fed could sell these $50b in assets to retire $50b in currency and not only would the dollar retain its value (despite zero real asset backing), but its value would rise (tightening money is the same whether facilitated by bond or asset sales)."
Apparently, "substantially backed" means the same thing as "physically convertible" in your eyes. This is plainly false.
The fed has $11B in gold, but it is officially valued at $42/oz, so the fed has more like $100B in gold. The Fed also holds $790B in treasury bonds, plus a few other things. Together this is more than enough backing for the $814B in cash that shows up on the fed's balance sheet. Of course if you consider that the cash figure works out to $2700 per capita, while the average person actually holds something like $50, you might pause to wonder if $2650 per person has actually been lost in fires, landfills, etc, over the last century. In any case, the point is that the fed has backing for the dollar.
As for retiring the dollars: If you assume the correctness of the quantity theory, then retirement will cause deflation. But the QT is the point in dispute. You can't just assume its correctness. On RBD principles, retirement of dollars would reduce backing right in step with the number of dollars, so there would be no effect on the value of the dollar. There would, however, be tight money conditions, which would be recessionary. This happened in the American colonial era. Once again, you should check out:
www.csun.edu/~hceco008/realbills.htm
Published: June 3, 2007 1:11 PM
Björn Lundahl
The very causes of business cycles are increases of the supply of money through fractional reserve banking and to put an end to this, a 100 percent gold (or silver) reserve money standard should be adopted.
A commodity standard such as gold or silver are to prefer as you cannot print gold or silver. This is better than a written constitution, which could serve as a constraint on the government to not increase the supply of money, as it imposes economic costs to increase the supply of gold or silver.
Gold or silver used as a medium of exchange are no arbitrary choices as they are historically voluntarily chosen by individuals. It is this historical fact that makes them good choices when a commodity based system would be implemented. A truly free society would at the same time allow individuals to choose any commodity as money.
The gold standard was flawed during the 20s, but not because of the reason that it was a gold standard but due to the fact that it was not 100 percent gold money reserve standard. Bank credit was increased many times more than what banks held as reserves (fiduciary media). Rothbard supported a 100 percent gold money reserve standard and in such a system the money supply could never contract as banks could meet any withdrawals. The cause of the great depression was the Federal Reserve System and fractional reserve banking.
It is true that history is full of examples of depressions prevailing long before the establishment of the Federal Reserve System in 1913, but not any depression was so severe and more importantly, mentioned destructive seeds of fractional reserve banking were still prevalent during all those depressions. In other words, if the U.S. had adopted a 100 percent gold reserve money standard before all mentioned depressions, the money supplies would never have contracted.
The only way to seriously argue that there exists an error in the Austrian business cycle theory is to logically prove so.
Video "Money, Banking and the Federal Reserve":
http://mises.org:88/Fed
Björn Lundahl
Published: June 3, 2007 3:34 PM
Clayton
"The only way to seriously argue that there exists an error in the Austrian business cycle theory is to logically prove so."
That's what I've tried to do. If it can be shown that there exists a commodity backed system that behaves (with respect to the value of money and the nominal interest rate) exactly like a fiat system, then you cannot claim that the relative changes in the value of money (or the associated interest rates) are a weakness of fiat.
I believe I have done this with the automobile example.
If I can show that there are rigidities then it is a simple matter to show that price (interest rate) instability within a monetary system can exagerate business cycles.
I believe I have done this.
If I can establish that the consequences of fiat are indistinguishable from a commodity standard and that fiat can reduce the distortions that arise from rigidity, I can establish that a fiat system could/would be superior to a gold standard.
I believe I have done this.
The only flaw in this proposition is the few times when fiat behavior has behaved in a way that could not have occured under a commodity system. The one major example is the huge deflation that occured during the great depression (referenced earlier). However, I argued (and continue to argue) that this was an instance of a mistake that will not be repeated and thus is not a forward looking argument against fiat.
This chain of argument can only break down at a few points and I've challenged you to select one and establish where the argument is false: the equivalent rate/value behavior of fiat and a theoretical commodity (automobile), the existence of rigidities & their impact on the economy, or the lower instability of fiat (data clearly shows this is true)
Published: June 3, 2007 4:12 PM
Björn Lundahl
Clayton
I think that you should study the Austrian business cycle theory instead of being obsessed of price rigidities. There is no way that they could explain a sudden occurrence of a depression.
Deflations (increases of the purchasing power of money) are of course examples of none rigidities and should not be avoided.
I have already argued that technically a 100 percent fiat reserve standard could work as well as a 100 percent gold money reserve standard but that such a system would not be safeguarded against the government. So you need not to bother about proving that anymore. People should also have the right to choose any medium of exchange as they see fit.
Björn Lundahl
Published: June 3, 2007 4:55 PM
Clayton
"The fed has $11B in gold, but it is officially valued at $42/oz, so the fed has more like $100B in gold. The Fed also holds $790B in treasury bonds, plus a few other things. Together this is more than enough backing for the $814B in cash that shows up on the fed's balance sheet. Of course if you consider that the cash figure works out to $2700 per capita, while the average person actually holds something like $50, you might pause to wonder if $2650 per person has actually been lost in fires, landfills, etc, over the last century. In any case, the point is that the fed has backing for the dollar."
First off, something like 70% of currency is outside the country (this number is somewhere on the Fed's pages). While this still leaves $800 per person, the $50-$100 in each pocket (more for people I know who work mostly in cash) plus reserves on deposits plus hoards make this number at least reasonable.
If the Fed always creates money by buying bonds and bonds are sufficient to back the money, how does the government inflate the money in this model?
Published: June 3, 2007 5:15 PM
Björn Lundahl
”For instance, inflation would be needed to allow real wages and employment to adjust more smoothly to changing market conditions”.
If wages were determined by the free market (without union privileges and minimum wage laws), employment would adjust smoothly to changing market conditions.
“A more recent argument in favour of central banks pursuing positive "inflation targets," or at least "zero inflation targets," is the alleged necessity of preventing nominal interest rates from hitting zero. Such an outcome, it is widely feared, would run the risk of making monetary policy ineffective in terms of influencing real and nominal magnitudes”.
It would be a good thing if “monetary policy” would be ineffective. Expansion of the money supply means the creation of a business cycle.
Björn Lundahl
Published: June 3, 2007 5:27 PM
Clayton
"I think that you should study the Austrian business cycle theory instead of being obsessed of price rigidities. There is no way that they could explain a sudden occurrence of a depression."
If the rate of profit on capital changes from 5% to 10% and the interest rate signal to individuals does not immediately adjust to the new level (10%), then there will be overinvestment. I have no objection to the Austrian interpretation of the results of this misallocation; in fact, I think the Austrian school has done the best job in analyzing and addressing the impact on capital and investment (capital gains and losses, specificity of investments, replacibility, etc.).
But in the end, it's the difference between expectations regarding the rate of profit and the actual rate of profit that cause misallocation (an inaccurate pricing signal).
Take a gold backed money. All of the sudden, the rate of profit in the economy goes from 5% to 10%. If people are still loaning out gold at 5%, more gold is going to be borrowed than should have been borrowed under perfect information. Since gold is loaned by consumers to producers, this will cause investment in inappropriately lengthed (or shaped) processes.
Until this pricing signal is accurately updated, people will continue to invest in projects that are profitable with a return
Gold bugs appear to argue that a gold backed money will be less likely to produce unanticipated changes in the rate of profit becuase it's a commodity. If gold really eliminated unanticipated changes in the rate of profit, I believe you could accurately predict the exchange rate between gold and a single good (and by extension every good), which we know is impossible.
What am I missing?
Published: June 3, 2007 5:32 PM
Clayton
that's supposed to be... a return <10% causing misallocation... but the html character broke the line
Published: June 3, 2007 5:35 PM
Mike Sproul
Clayton:
"If the Fed always creates money by buying bonds and bonds are sufficient to back the money, how does the government inflate the money in this model?"
Inflation is caused by inadequate backing. Either the amount of money rises relative to backing, or backing falls relative to money. One example would be if the Fed lent $100 at a 5% interest rate when the market rate was 6%. In effect, the Fed would have issued $100 for an IOU worth only $99. Or the fed could simply overpay for the bonds that it buys. For example, a certain bond is selling at auction for $100, and one day the fed shows up at the auction, and the bond price is bid up to $101. The fed pays $101, but the next day the value of the bond falls to $100. Or maybe the fed tries to support the value of the dollar in international markets. One dollar is really worth 1 pound, but the fed deliberately pays 1.01 pound for 1 dollar, losing .01 pounds in the process, thereby losing backing, and thereby causing inflation.
At the risk of being annoying:
www.csun.edu/~hceco008/realbills.htm
Published: June 3, 2007 5:39 PM
Björn Lundahl
The purchasing power of money, the gold standard and fiat money
If the gold supply will, on the average, increase as much as total output in a 100% gold reserve money standard or not, is not a praxeological fact but a speculation. It might be a relatively good speculation, but it still is a speculation.
Technological advancements that favour increased gold supplies have, of course, been going on since the beginning of the industrial revolution.
Historically, prices have on the average fallen when economies were on a gold standard and those economies were not even based on a 100% gold reserve money standard.
Deflation defined as increases of the purchasing power of money is not, at all, harmful for the society and the economy.
Rothbard saw falling prices as a natural condition of a market economy, For a New Liberty:
“Thus, falling prices are apparently the normal functioning of a growing market economy.”
“And, indeed, if we look at the world past and present, we find that the money supply has been going up at a rapid pace. It rose in the nineteenth century, too, but at a much slower pace, far slower than the increase of goods and services; but, since World War II, the increase in the money supply—both here and abroad—has been much faster than in the supply of goods. Hence, inflation.”
http://mises.org/rothbard/newliberty9.asp
Now when another masterpiece has been added to the great family of books in Austrian economics with the title “Money, Bank Credit, and Economic Cycles” written by Jesús Huerta De Soto, I am pleased to quote the author’s comment about the purchasing power of money under 100% gold reserve money standard page 776:
“Consequently one aspect we can foresee is that in the proposed model, nominal interest rates would reach historically low level. Indeed, if on average we can predict an increase in productivity of around 3 percent and growth in the world’s gold reserve of 1 percent each year, there would be slight annual “deflation” of approximately 2 percent.”
And on page 777:
“The model of slight, gradual, and continues “deflation” which would appear in a system that rests on a pure gold standard and a 100-percent reserve requirement would not only not prevent sustained, harmonious economic development, but would actively foster it.”
I quote from the book “Democracy The God That Failed”, by Hans-Hermann Hoppe, page 58:
“During the monarchical age with commodity money largely outside of government control, the “level” of prices had generally fallen and the purchasing power of money increased, except during times of war or new gold discoveries. Various prices indices for Britain, for instance, indicate that prices were substantially lower in 1760 than they had been hundred years earlier, and in 1860 they were lower than they had been in 1760. Connected by an international gold standard, the development in other countries was similar. In sharp contrast, during the democratic-republican age, with the world financial center shifted from Britain to the U.S. and the latter in the role of international monetary trend setter, a very different pattern emerged. Before World War I, the U.S. index of wholesale commodity prices had fallen from 125 shortly after the end of the War between the States, in 1868, to below 80 in 1914. It was then lower than it had been in 1800. In contrast, shortly after World War I, in 1921, the U.S. wholesale commodity price index stood at 113. After World War II, in 1948, it had risen to 185. In 1971 it was 255, by 1981 it reached 658 and in 1991 it was near 1,000. During only two decades of irredeemable fiat money, the consumer price index in the U.S. rose from 40 in 1971 to 136 in 1991, in the United Kingdom it climbed from 24 to 157, in France from 30 to 137, and in Germany from 56 to 116.
Similarly, during more than seventy years, from 1845 until the end of World War I in 1918, the British money supply had increased about six-fold. In distinct contrast, during the seventy-three years from 1918 until 1991, the U.S. money supply increased more than sixty-four-fold.”
Björn Lundahl
Published: June 3, 2007 5:42 PM
Clayton
First to the deflationary topic:
"Deflation defined as increases of the purchasing power of money is not, at all, harmful for the society and the economy."
I agree with Bjorn that a commodity money is not harmed by deflation, but there's a very specific reason that this is true for commodity monies:
If the price of gold is expected to rise at a faster rate than the (risk adjusted) rate of profit, people bid gold up to the risk adjusted rate of profit. This occurs by definition so the risk adjusted interest rate in a commodity money can never fall below zero (thus there is an absolute limit to the preference of gold over other investment opporutnities).
This is a meaningful advantage of a commodity money.
A fractionally backed commodity money begins to illustrate the problem that becomes complete with fiat. For example, the commodity gold might have a zero interest rate only *after* storage costs. If you were to partially back money, the full amount would not face storage costs and it could obtain a rate of return higher than the rate of profit (there would be a negative rate of profit of captial relative to the gold peg).
Consequently, people would expand the money supply because it would obtain a rate of return greater than the rate of profit. Presumably, this would eventually bid the price of gold up so that the return on gold (less the fractional storage expense) would be equal to the rate of profit.
Fiat money does not have this stop-gap. If the rate of return of money rises above the rate of profit, there's no implicit way to "bid up" money in a way that eventually drives this rate down. Increasing amounts of money are demanded and this drives up the price (and the rate of return) in a dangerous spiral. Since the rate of return on fiat is presumably near the rate of profit (as the interest rate is nearly zero), it only takes small expansions in the demand for money to maintain this excessive return and increase the dmeand for fiat.
Of course, sooner or later, this pyramid scheme topples. People eventually want to spend money and its price crashes. But this is the same irraitonal exhuberance that drives every asset bubble. Complicated by the fact that few people actually understand money and thus the ultimate consequence of this spiral, and you can see how this is WAY more dangerous when fiat is involved.
Published: June 3, 2007 6:10 PM
Clayton
www.csun.edu/~hceco008/realbills.htm
I've actually read this before (and previously collected several papers on the real bills doctrine) so you need not repeat yourself.
"One example would be if the Fed lent $100 at a 5% interest rate when the market rate was 6%. In effect, the Fed would have issued $100 for an IOU worth only $99. Or the fed could simply overpay for the bonds that it buys..."
This is one of the places where I believe the arguments of the real bills doctrine have some merit. I agree that discounting bills at an inappropriate rate is the reason why inflation happens.
But the demand for currency is not generated by the Fed who has no obligation to conversion. Instead, its the federal government and the individual debtors who have to trade their goods and services for the currency. If this currency becomes plentiful, they will acquire it more easily (inflation) to make their debt payment. Conversely, if it's rare, it will become more valuable (deflation). I believe it's this ratio that is the 'basis' that matters.
Of course, like gold in a gold basis, it's also bid up by people desiring it strictly for transactional purposes... so I expect that the equation is not so strait forward.
I'd be interested in other materials on the topic if there's anything in specific you'd suggest.
Published: June 3, 2007 7:00 PM
Mike Sproul
Clayton:
"But the demand for currency is not generated by the Fed who has no obligation to conversion."
The fed has no obligation of physical convertibility (buying back dollars with gold) but the fed does have an obligation of financial convertibility (buying back dollars with bonds). As long as the fed maintains financial convertibility--conducts ordinary open-market operations--physical convertibility is normally irrelevant.
"Instead, its the federal government and the individual debtors who have to trade their goods and services for the currency. If this currency becomes plentiful, they will acquire it more easily (inflation) to make their debt payment. Conversely, if it's rare, it will become more valuable (deflation). I believe it's this ratio that is the 'basis' that matters."
If GM used some of its cash to buy back some of its shares, GM stock would become more "rare", but I think you'd agree that it won't become more valuable. That's because GM stock is a financial security--not an ordinary good. Money is also a financial security, and is valued in the same way.
BTW: The QT implies that money has value in excess of its backing--in other words, it yields a free lunch to its issuer. The RBD implies no such free lunch. Why believe the theory that implies the free lunch when there's a better theory (RBD) that dispenses with the numerous paradoxes raised by the QT?
Published: June 3, 2007 7:15 PM
Björn Lundahl
My review of the book America’s Great Depression, by Murray Rothbard at Amazon.com:
This book explains the Austrian business cycle theory with regard to the great depression. Buy it for it is the only book existing that really does that.
The only way to put an end to the dreadful business cycle is to adopt a system of 100 percent gold money reserve standard and to abolish the Federal Reserve. In such a system fractional reserve banking is also abolished and the money supply, when implemented, will never contract again.
I, unlike most Austrian economists, do believe also that Milton Friedman's and Ben Bernanke suggestions that the great depression could have been avoided if the Federal Reserve had not let the money supply contract during the years 1929-1932 are correct.
I also, unlike most Austrian economists, do believe that inflation targeting of 2% that many central bankers do today, will and already has brought low inflation rates (low decreases of the purchasing power of money) and a relative stability compared to the situation during the 70s. Inflation targeting should be supported if the alternative is unfettered central banks.
The difference, though, between Murray Rothbard and Milton Friedman and Ben Bernanke is that Murray Rothbard was a true Austrian economist who knew the very cause of the business cycles and therefore also knew the final solution for it that is, as mentioned, to adopt a system of 100 percent gold reserve money standard.
The gold standard was flawed but not because of the reason that it was a gold standard but due to the fact that it was not 100 percent gold money reserve standard. Rothbard supported a 100 percent gold money reserve standard and in such a system the money supply could never contract as banks could meet any withdrawals. The massive amount of bank failures would also, therefore, have been avoided. The cause of the great depression was the Federal Reserve System and fractional reserve banking.
It is true that history is full of examples of depressions prevailing long before the establishment of the Federal Reserve System in 1913, but not any depression was so severe and more importantly, the destructive seeds of fractional reserve banking were still prevalent during all those depressions. In other words, if the U.S. had adopted a 100 percent gold reserve money standard before all mentioned depressions, the money supplies would never have contracted.
Nothing could substitute a 100 percent gold reserve money standard.
I will now in a few words explain the Austrian business cycle theory so you can get a hint of what it is all about.
Recessions and The Great Depression were caused by Government Interventions!
In a purely free market (without Government intervention), the rate of interest is determined by people's "willingness to save and invest" (which is called people's time preferences) for future use, as compared to how much they are "willingly to consume now". If people change their "willingness to save" (time preferences) and want to save more, the additional savings will cause the rate of interest to fall (increased supply of savings), and businesses will borrow and invest these additional savings. When the Central Bank (for example The Federal Reserve) increases the money supply and expands bank credit (which Central Banks does everywhere and all the time and always "out of thin air"), it initially lowers the rate of interest and thereby misleads businessmen to act in a manner as if true savings have increased, which in turn leads businessmen to invests those supposed savings in capital goods. New projects that were not profitable before, will now suddenly with this lower interest rate, be profitable. While this process is working, the economy is in an inflationary boom phase (expansion). Capital goods such as stocks, real estate etc, will be more demanded and invested in, and prices of those will rise faster and more intensely in relation to consumption goods. As these supposed savings have worked their way through the economy, prices of goods, services and wages have generally increased to a height which prices for them would have not reached without these supposed savings.
As mentioned, people's "willingness to save and invest" have not changed (people's time preferences have not changed) for it was only the Central Bank that increased, out of thin air, additional "savings". When supposed savings have worked their way through the economy and are received, finally, in increased wages, people still spend their real wages in the same manner as before. They save/ consume in real terms and in same proportion to each other, as before mentioned increase in supposed savings. Because of this, a lack of savings will occur and the rate of interest will rise. Projects that businessmen have invested in and that seemed to be profitable when the rate of interest was lowered are now revealed to be unprofitable. All those investments are revealed to be malinvestments. Businessmen will stop investing in those projects and lay off workers. Prices of capital goods, real estate, stocks etc, will fall sharply and relatively to the fall in prices of consumer goods. The economy is in a depression phase. When those investments are liquidated, the economy is adjusted to people's "willingness to save and invest" and to consume. The economic structure corresponds to the ratio which people want to save and consume. The economy is now healthy again.
Now then, in the 1920s the Federal Reserve, in the US, increased the money supply and bank credit, which in the 30s resulted in The Great Depression. The same story goes with Japan during the 1980s, which during the 90s, resulted in a depression.
In Sweden we had banks lending out heavily during the late 80s, which also, led to a depression in the 90s.
All business cycles are caused by the same phenomenon. Economic crisis can occur because of other factors such as wars, boycotts, oil prices etc, but pure business cycles have in common the same cause.
I have tried, in a very few words and in a easy manner, to explain Ludwig von Mises business cycle theory, which is also called the Austrian theory of the business cycle. All faults are mine. Friedrich August von Hayek elaborated this theory and received in 1974 the Nobel Prize for this.
Björn Lundahl
Göteborg Sweden
Money, Bank Credit, and Economic Cycles
Published: June 4, 2007 1:44 AM
Clayton
"If GM used some of its cash to buy back some of its shares, GM stock would become more "rare", but I think you'd agree that it won't become more valuable. That's because GM stock is a financial security--not an ordinary good. Money is also a financial security, and is valued in the same way."
Interesting that you select this example. In theory, this makes sense (indeed it trying to justify the counter example, I had trouble finding a rational explanation).
At the same time, companies buy back their stock as a way to support their share price so clearly there's some perceived value in it.
Investopedia offers:
"Because a share repurchase reduces the number of shares outstanding (i.e. supply), it increases earnings per share and tends to elevate the market value of the remaining shares. When a company does repurchase shares, it will usually say something along the lines of, 'We find no better investment than our own company.'"
So does the buyback signal that the shares are undervalued? Perhaps, and this at least would be rational. Does the increase in EPS also come with an increase in risk per share? It does. Should this risk result in a higher discount rate that makes the transaction price-neutral? Probably, so I'm with you in principle. Does it increase the price of the share? Pretty consistently yes.
===
"BTW: The QT implies that money has value in excess of its backing--in other words, it yields a free lunch to its issuer. The RBD implies no such free lunch. Why believe the theory that implies the free lunch when there's a better theory (RBD) that dispenses with the numerous paradoxes raised by the QT?"
I skimmed some sources to figure out where this assertion comes from and I don't think it's as simple as this summary sounds. However, I suspect that part of the issue here is how you define the quantity of money.
For specific model reasons (that I won't get into), I exclude any sort of loan (including non-reserve parts of demand deposits) because I presume that this loaned money represents loaned capital and is not subject to the same issues (as I will explain). This leaves currency (in hand and in reserve) as the basis for money and I suspect we'd both reach the same conclusion given this definition -- when I double money (currency), you halve backing. If you assume money is a broader concept, I suspect the arguments won't work as well.
Having a single unit of account creates value for its users (network externalities). Anticipated inflation, no matter how high, is neutral to borrowers/lenders because they adjust their nominal rates so that real + inflation = nominal (why I leave them out). Consequently, the cost of anticipated inflation is limited to people holding non-interest bearing currency (basically in hand, in horde, or in reserve).
Now people will only hold currency when the benefit of currency (usually cited as shoe-leather cost) exceeds the cost of currency (seignorage, inflationary tax). If inflation becomes high enough (still anticipated), they will turn to alternative payment methods (including checks on interest bearing deposits so that interest is never lost) or direct barter.
Once quantity theoriests include this liquidity preference "demand curve" for currency (a schedule of shoe-leather costs), there appears to be a supply-demand relationship here, scarcity creates value. I would argue that the issuing body is just capturing part of the value it creates and no longer faces a scenario where it's creating value (the free lunch).
A more real example of the same concept: By most sentiments you pay more for a Microsoft product despite the fact that it's inferior to alternatives. Microsoft isn't getting a free lunch, it's monetizing network externalities.
... or did I miss a more subtle point?
Published: June 4, 2007 10:18 AM
Clayton
"it initially lowers the rate of interest and thereby misleads businessmen to act in a manner as if true savings have increased, which in turn leads businessmen to invests those supposed savings in capital goods"
If poeple had perfect information, the sellers would know instantly that the rate of return they would get on their deposits would be equally reduced and would instantly increase all prices proportionately, preserving the exact same returns structure for all participants and goods.
And before you argue that the prices can't raise proportionately, I've got that chapter of Hayek's book and have already reread it once trying to figure out why he claims this is the case (I have yet to sort out the basis for the claim).
It's the fact that nominal prices (in that unit of account) do not update immediately that causes the problem, not the arbitrary rate of profit in the unit of account -- Hayek even points out that the rate of profit will be different (as a percentage of that unit value) depending on the good you select as a the unit of account, but that the relative prices of the goods to ensure equilibrium (actually that it's a network so that the rate of profit in a value is equal even if the value of other units change).
The only remaining (and real) issue is that the issuer extracts a "tax" for the use of the money and you should reference my previous post to see that there exists and argument where that is rational.
Published: June 4, 2007 10:39 AM
Mike Sproul
Clayton:
If GM's only asset i s$60 mil in cash, and its only liability is 1 mil shares, then if GM spends $60 to buy back one share, then, assuming that the buyback creates no new information for the market, there will be no change in share price. This can be made more complicated if you start talking about how the buyback sends signals, etc., but this is beside the point. The important point is that when assets move in step with liabilities, there is no change in share price, and the same is true of money.
Also, all money can be said to be created by loan, so I think you're setting up a distinction without a difference.
The issue of money demand is addressed my paper "There's no such thing as fiat money", at
www.csun.edu/~hceco008/nofiatmoney01192007.doc
speficically pp. 10-17.
Sorry, but it's too long for a discussion post.
Published: June 4, 2007 11:43 AM
Björn Lundahl
"it initially lowers the rate of interest and thereby misleads businessmen to act in a manner as if true savings have increased, which in turn leads businessmen to invests those supposed savings in capital goods"
Yes this is true as increases of the money supply can not be neutralized even if they are anticipated because there is no way to distinguish them from real savings. They are borrowed funds and as they are, actually borrowed, businessmen are factually deluded to act as if savings have increased and this regardless of the rate of interest.
This is an obvious fact and only a crank would deny it.
Björn Lundahl
Published: June 4, 2007 4:39 PM
Clayton
"Yes this is true as increases of the money supply can not be neutralized even if they are anticipated because there is no way to distinguish them from real savings. They are borrowed funds and as they are, actually borrowed, businessmen are factually deluded to act as if savings have increased and this regardless of the rate of interest."
If the amount of borrowed funds increases in the same proportion as the price, then no additional real capital is purchased (implicitly borrowed) and the real economy is not changed.
Thus if people instantaneously react to the change in discount rate by increasing the price, there is no real effect to investment... except, of course, the minor changes resulting from the actual reallocation of wealth due to the rate change (from borrowers to lenders or vice versa depending on the direction of the unanticipated change). This minor reallocation, as I understand it, is not the fundamental argumetn of the Austrian theory, but rather the businessmen acting on the wrong belief (imperfect information after an unanticipated change)
Nor do insults improve the strength of your argument.
Published: June 4, 2007 5:03 PM
Clayton
Mike,
I'd be happy to take this conversation elsewhere (if appropriate) as I have no interest in spamming the other participants in the inflation discussion. However, the first thing I read in your paper was:
"Economists all recognize that the value of a convertible (“American”) call option is always equal to the value of an inconvertible (“European”) call option."
Since your argument seemed likely to hinge on this statement, I decided to confirm that assertion and too quickly found:
"Where an American and a European option are otherwise identical (having the same strike price, etc.), the American option will be worth at least as much as the European (which it entails). If it is worth more, then the difference is a guide to the likelihood of early exercise. In practice, one can calculate the Black-Scholes price of a European option that is equivalent to the American option (except for the exercise dates of course). The difference between the two prices can then be used to calibrate the more complex American option model." (http://en.wikipedia.org/wiki/Option_style)
In fairness, I'm not a finance expert to judge the statement in isolation and I take everything on Wikipedia with a grain of salt. However, this was too quick/easy to just ignore so I wanted to give you a chance to clarify the assertion.
Published: June 4, 2007 5:40 PM
Björn Lundahl
Clayton
Sorry, I was not aiming at you as it was only a general statement that a crank would deny what I wrote. If you write or comment something I might make a general comment myself about that without addressing it to you. I assume that there are other people reading what we write and think and I want them to receive my thoughts as an alternative to yours, others and to their owns.
Now then (and this is not especially addressed to you):
An alternative way to explain what I just wrote could be that if some of us had a printing press and printed dollar bills, it surely would give us a command over economic recourses and this regardless of “inflationary expectations” and the “rate of interest” and as money supplies generally all over the world are, year after year, increased to a greater extent than inflations, people first receiving them will “also” have steady increases of their purchasing powers and an ever greater command over economic recourses.
I also think that this is quite obvious. For why counterfeit if it does not give the counterfeiter command over economic recourses? But if it is true that the counterfeiter would have a command over economic recourses, it is also equally true that he by spending the “money” changes the economic structure in society compared to if he did not counterfeit and did not spend the counterfeited money.
Now it is very late here in Gothenburg, Sweden so good night!
Björn Lundahl
(By the way, Björn = Bear in Swedish, that is the large mammal of the family Ursidae)
Published: June 4, 2007 6:10 PM
Björn Lundahl
Sorry, I meant:
Björn = Bear in English, that is the large mammal of the family Ursidae)
Björn (or Bear)
Published: June 4, 2007 6:18 PM
Mike Sproul
Clayton:
I'm at sproulmike@yahoo.com
I'm ok with either way of corresponding, but I think we might be generating a public good if we keep it on the blog.
I've been told by a few reputable economists (Bob Geske, David Hirshleifer) that an american call will sell for the same as a european call, the reason being that early exercise of an american call means sacrificing whatever premium the call might have had. I expected I'd find a confirmation of that in Gary Gastineau's stock option manual, but I don't see it in there. I also think I remember it in Cox and Rubenstein's book, but I don't have a copy. Unfortunately, I don't see any holes in that wikipedia quote, so I'll have to back off from that statement for now.
In any case, I don't think anyone would dispute that there is little, if any, difference in price between american and european calls. Thus when the dollar switched from being convertible (i.e., american) to inconvertible (i.e., european) there was no significant change it its value.
Published: June 4, 2007 9:40 PM
Clayton
No worries... I'm sorry I took it personally
"I also think that this is quite obvious. For why counterfeit if it does not give the counterfeiter command over economic recourses? But if it is true that the counterfeiter would have a command over economic recourses, it is also equally true that he by spending the “money” changes the economic structure in society compared to if he did not counterfeit and did not spend the counterfeited money."
Counterfeiting is strictly the wealth transfer part of the equation (like theft of the actual money, just in small bits from lots of people). Even the introduction of counterfeit money need not change real variables (create misallocation). If the counterfeiters and the public have the same marginal preferences (so they invest/spend the wealth in the same way) and the economic variables correct themselves (i.e. all prices rise proportionately), the same amount of consumption and savings would occur... real variables would be unaffected and it would create no misallocation.
Of course, you could relax the equivalent time preference (used to simply the argument so that the new equilibrium would be the same as the old) and argue that the transfer of wealth (albeit illegal) results in a new optimal equilibrium that could be achieved through the same pricing adjustments. And fiat is not necessarily any more prone to counterfeiting than gold (by fools gold or underweight/impure coins in its day) or any other commodity (i.e. Gucci bags).
===
Without adjustment (I still believe the key element in the puzzle), the proposed system is essentially the same as a sudden fall in long term trend for gold prices (due to new technology perhaps) that is not immediately reflected in gold denominated interest rates and prices. If the public assumes that the relative price of gold will continue to increase (closely tracking the rate of profit), the interest rate in gold denominated units would remain low. In reality, a steady decline in the relative price of gold over the next year (due to the new technology) would necessitate that the equilibrium interest rate *should* be much higher.
Until the implication of the new technology sinks in to the public, society will continue to lend (and borrow) an ever increasing supply of gold at the artificially low nominal interest rate. The gold would also buy too many goods because the traders would have yet to recognize the new price trend (and price level). The combined effect of too much lending (due to the low interest rate and high supply) and too much purchasing power would be a misallocation of capital to production.
This seems (at least to me) to be the exact same situation (in gold units) that somehow produces a supposedly different (or I argue the same) outcome for fiat.
Published: June 4, 2007 10:26 PM
Clayton
I'm happy to keep the conversation around here (unless someone else complains -- and they should feel free to do so). From what little I read, it's true that in most cases the option (on an equity) would still have positive value (prior to the exercise point) so there would be no good reason to exercise it (with the few cited exceptions being mostly related to financial peculiarities).
After thought (and several revisions), I believe the critical error in this assumption is not the few financial peculiarities but certain assumptions regarding equities. Put simply, equities expect a positive rate of return... equities are priced to return (on average) the risk free rate plus a risk adjustment which means over half of this distribution is always above the strike price (if the strike price is the current price). Higher uncertainty drives the positive part up (and offsetting negative values go "unexercized" raising its value). Black Scholes assumes this positive risk free interest rate.
But would an unconvertible 10 year option have any value if the expected return was negative (say losing half its value over the next decade) with relatively low volitility?
I'm pretty sure the answer to this is that it would have trivial or no value. Specifically, the value of an option is the part of the normal distribution that is above the strike price.
If money has a negative return over time, the amount of this distribution above the strike price would be essentially zero and this is even more true as time passes. I'm not sure if the Black Scholes model would accurately reflect a negative risk free rate to illustrate this (but it might).
With this negative expected return... In the first period, a small expected decline could be offset by a large volatility to create a sizable section of the distribution above the strike price. Over time, the expected declines would accumulate and the relative volatility would decline -- relative to return, volatility declines at a rate of 1/sqrt(n)
Consequently, an option that could be exercised sooner would have a higher value so the American Option would be vastly superior to the European option. I have no idea what this does to your logic (as I hadn't reached it yet), but I think the assumptions built into Black-Scholes when applied to equity (the expectation of a positive rate of return) will not function as an adequate representation of reality with regard to money.
BTW... if there is any way you can delete your email from the page, you probably should as you'd rather a spam crawler not "find" it in plaintext.
Published: June 4, 2007 10:53 PM
Björn Lundahl
A free market economy is a voluntarily arrangement between individuals. Violations of individual rights are always necessarily deviations from this voluntarily arrangement and one of the consequences (apart from the ethical consequences) are that the economic structure will reflect “malinvestments” because of them.
The introduction of counterfeited money into a free market economy is violations of the free market arrangement and will therefore always necessarily cause malinvestments and there is no way, as long as the counterfeiting goes on, that this can be undone.
Even the introduction of a 100 percent gold reserve money standard will not entirely undo the wealth transfer that already have taken place before the introduction but will stop further misallocations.
Clayton will of course deny this but anyone knowing elementary Austrian economics will know that this is true. I do not really want to “discuss” this further as it cannot change this truth and I will not make any further comment about it. The silent and honest reader will probably spot the truth anyway.
Bear Lundahl
Published: June 5, 2007 1:36 AM
TLWP Sam
Are you saying Björn Lundahl that the financial world should just stick to simple cash transfers and strictly defined bank loans? As in, 'If you don't want a hangover then don't drink so much the night before.'? If people can't get access to all manner of dubious credit from seemingly nowhere then there can be no speculation, false feelings of wealth and no big, bad crash tomorrow?
Published: June 5, 2007 2:56 AM
Björn Lundahl
TLWP
Yes, that is a good way to say it.
Björn
Published: June 5, 2007 3:03 AM
Björn Lundahl
I said that I would not make any more comment regarding counterfeited money but I will still emphasize this:
As increases of supplies of money through the process of fractional reserve banking initially “lowers the rate of interest” it also necessarily sets in motion investments that would not be done without those increases. Austrian economics teaches us that mentioned investments will be done in the higher order goods and that this is not an arbitrarily choice as it unavoidably must be so (because of time preferences) and that they will collapse when further credit expansion is hindered.
Secondly, the relocation of wealth from a group of people to another group because of counterfeiting is, naturally, by itself deviations from a pure market economy.
Björn Lundahl
Published: June 5, 2007 4:03 AM
Björn Lundahl
TLWP
As the phenomenon of inflation targeting of 2% has brought some general economic stability it is, though, quite obvious that it will not stop “bubbles” such as stock market crashes or “housing bubbles” (as is felt in the U.S. right now). The only way to stop that is to hinder increases of the supply of money that are accomplished through the process of fractional reserve banking. Look at China right now: it is “bubbling everywhere” in that country despite of the inflation targeting that is implicitly followed by the People’s Bank of China:
Objective of the Monetary Policy
The objective of the monetary policy is to maintain the stability of the value of the currency and thereby promote economic growth.
http://www.pbc.gov.cn/english/huobizhengce/objective.asp
Right now the CPI in China is about 3% on a yearly basis.
And we know how their stock market is performing:
http://www.businessweek.com/ap/financialnews/D8PIJTS02.htm
http://finance.yahoo.com/q/bc?s=000001.SS
Even the inflationist Ben Bernanke recognizes this fact that monetary policy influences the stock market:
Fed Chairman Ben Bernanke said on Friday
04 Mar 2007 | 12:27 PM
"Empirical studies also find that U.S. monetary policy actions retain a powerful effect on domestic stock prices"
http://www.cnbc.com/id/17452788
Björn Lundahl
Published: June 5, 2007 6:25 AM
Mike Sproul
Clayton:
"But would an unconvertible 10 year option have any value if the expected return was negative (say losing half its value over the next decade) with relatively low volitility?
I'm pretty sure the answer to this is that it would have trivial or no value."
This is also covered in my "No Fiat Money" paper. Briefly, if a green paper dollar is an inconvertible claim to 1 oz of silver, to be delivered in n years, and if the interest rate is R, and the cost of maintaining the dollar in circulation for 1 year is C, then on the date of issue, the value of that dollar will be 1/(1+R-C)^n. If this weren't true there would be arbitrage opportunities. If R=C (which is probably approximately true) then the value of the dollar is 1/1 oz. for the entire period that it circulates. Note that it is an illusion that the dollar bears no interest. The correct view is that the cost of issue eats up the interest. If dollars could be costlessly issued (e.g., if they were electronic receipts for 1 oz of silver) then they would bear interest, or else there would be arbitrage opportunities.
BTW: Another result from option theory holds that if merrill lynch issues calls on GM stock, the value of GM stock will be unaffected (with a few exceptions). A dollar in a checking account is a call option on a green paper dollar. Thus the issue of checking account dollars, (and credit card dollars, gift certificates, etc.) does not affect the value of the dollar.
Published: June 5, 2007 9:37 AM
TLWP Sam
But surely there still has to be some risk in investing Björn Lundahl? In asmuchas you don't know whether a startup business is going to prosper or fizzle out and lose your money. Therefore the financial system can't really truly be stable unless there is no improvement nor degradation, which indicates a strictly circular economy, no?
Published: June 5, 2007 9:47 AM
TLWP Sam
Hey M. Sproul? Since you try to say how there is no such thing as fiat money and stuff. Can you see any differences or disadvantages with using gold or a strict gold standard? Or alternatively where fiat ('fiat'?) currency has certain advantages that gold or a gold standard does not? Or is it all pretty much the same?
Published: June 5, 2007 9:51 AM
Björn Lundahl
TLWP
Yes there will always be pure business risks and a great need of entrepreneurs, capitalist etc but recessions/depressions and even stock market crashes are general phenomena not derived from pure business risks and those should be deleted.
Björn
Published: June 5, 2007 10:18 AM
Mike Sroul
TLWP:
Gold coins are vulnerable to wear and clipping, so if new coins contain 1 oz., then pretty soon the old ones are only .9 oz. Gresham's law makes it hard for new coins to circulate, so a persistent shortage of coins develops. This was a constant problem in gold standard economies.
That problem is solved by trading with gold certificates and locking up the gold, but then if someone wants to borrow one ounce (or a certificate for 1 oz.), then a strict 100% reserves policy would prohibit the loan and needlessly tighten the money supply.
Fiat money solves the first problem, but is still vulnerable to the second. Misguided 100% reserves policies will insist that private banks maintain 100% reserves of the fiat money against any money they issue, and you have the same needless tightening of the money supply again.
Published: June 5, 2007 3:11 PM
Björn Lundahl
TLWP
“Gold coins are vulnerable to wear and clipping, so if new coins contain 1 oz., then pretty soon the old ones are only .9 oz. Gresham's law makes it hard for new coins to circulate, so a persistent shortage of coins develops. This was a constant problem in gold standard economies.”
Gresham’s law is only working in a regulated economy with price controls on money.
Thus Rothbard wrote in his book "What Has Government Done to Our Money?"
“Champions of the government's coinage monopoly have claimed that money is different from all other commodities, because "Gresham's Law" proves that "bad money drives out good" from circulation. Hence, the free market cannot be trusted to serve the public in supplying good money. But this formulation rests on a misinterpretation of Gresham`s famous law. The law really says that "money overvalued artificially by government will drive out of circulation artificially undervalued money." Suppose, for example, there are one-ounce gold coins in circulation. After a few years of wear and tear, let us say that some coins weigh only .9 ounces. Obviously, on the free market, the worn coins would circulate at only ninety percent of the value of the full-bodied coins, and the nominal face-value of the former would have to be repudiated. [8] If anything, it will be the "bad" coins that will be driven from the market. But suppose the government decrees that everyone must treat the worn coins as equal to new, fresh coins, and must accept them equally in payment of debts. What has the government really done? It has imposed price control by coercion on the "exchange rate" between the two types of coin. By insisting on the par-ratio when the worn coins should exchange at ten percent discount, it artificially overvalues the worn coins and undervalues new coins. Consequently, everyone will circulate the worn coins, and hoard or export the new. "Bad money drives out good money," then, not on the free market, but as the direct result of governmental intervention in the market.”
http://mises.org/money/2s7.asp
Björn Lundahl
Published: June 5, 2007 4:33 PM
Björn Lundahl
TLWP
Rothbard´s theory in action:
A person that I know of worked about 25 years ago during summer time in the amusement park ”Liseberg” here in Gothenburg. He sold tickets for different attractions and received a lot of kronor (unit of currency in Sweden) coins and many of them consisted partly of silver. In the evening when Liseberg where closed he and his friend counted the money and replaced the silver coins with the ones that did not consist of any silver. They then later sold those silver coins on the black market and received a better exchange ratio.
I have heard that the silver coins were later exported to Germany and were melted down to silver bars.
Liseberg:
http://www.liseberg.com/NR/exeres/ABE9129C-ECE1-49AF-9DA7-E562867C1E07.htm
http://www.youtube.com/watch?v=SK2DDauf6pE&mode=related&search=
Uppswinget:
http://www.youtube.com/watch?v=KehTj50y5Fs
http://www.liseberg.se/Liseberg/Engelska/Liseberg+Island/Amusement+Park/Attractions/uppswinget.htm
Björn Lundahl
Göteborg We Love You (despite of the fiat money):
http://www.youtube.com/watch?v=LOsme0cTgcw
Published: June 5, 2007 6:06 PM
Clayton
"Thus the issue of checking account dollars, (and credit card dollars, gift certificates, etc.) does not affect the value of the dollar."
All other things being equal, if I deposit a paper dollar from a hoard (so I don't replace it) into a bank in anything but a 100% fiat reserve, it becomes available for loan and enters the math -- adds to the units of purchasing power that goto the market to be used against the finite amount of capital/labor available. Assuming a fixed supply of goods and input (and putting aside for a moment my debate with Bjorn over the actual allocation to consumers/businesses), there is an average "bidding up" that causes inflation.
That's why I distinguish between cash/the reserve part of deposits and everything else.
Published: June 5, 2007 10:06 PM
Clayton
Bjorn,
I'm trying to run a thought experiment before I waste any more of your time, but I want to make sure I'm not assuming the wrong thing (since I'm getting too tied up in the monetary side). Here's a question in strictly capital terms:
There are two commodities, gold and capital. Say that the price of gold (measured in units of capital) is expected to decline over the next few years by a rate of 3% per year. For arguments sake, this can be due to an ongoing incrase in supply (if the reason matters, I'll think about it more). Further assume that the rate of profit on a piece of capital is 5%. What rate of interest would you demand on your gold?
Obviously, let me know if I've introduced some kind of contradiction or left out any missing information.
Published: June 5, 2007 11:15 PM
Björn Lundahl
Clayton
I am not a kind of snob that thinks that other people are “wasting my time” when they are asking me a question and I am not either “a monetary expert”. I am just a laymen interested in economics.
For sometime I wrote this and it might give you an answer:
Deflation (defined as increase of the purchasing power of money)
If the money supply is constant and prices on the average fall and this is also expected, the factors of production, land and labour will be discounted accordingly throughout the production structure (various stages of production) and capitalists will earn interest on their investments.
For example:
If a capitalist makes an investment of 100 million dollars (in gold) in real estate, and is happy with 5% net profit yearly when the purchasing power of money in society is zero, this happiness will be maintained, logically, if the same capitalist makes an investment with 5% net profit yearly plus a premium of the value lost per year of the initial investment in real estate when the purchasing power of money in society is increasing. This premium is brought about by purchasing the real estate in question for a price of 90, 80, 50 million dollars etc or whatever price that fully compensates him for the value lost because of deflation.
Björn Lundahl
Published: June 6, 2007 3:25 AM
Björn Lundahl
Clayton
Man, Economy, & State:
G. The Purchasing-Power and Terms-of-Trade Components in the Rate of Interest
http://mises.org/rothbard/mes/chap11b.asp#5G._Purchasing_Power_Terms_of_Trade
Björn
Published: June 6, 2007 3:35 AM
Björn Lundahl
Sorry "laymen" should instead be layman.
Björn
Published: June 6, 2007 3:44 AM
Björn Lundahl
Clayton
I am often referring to Rothbard but you know he was a total genius.
Some people might not listen to Rothbard because he was too extreme but I think that they make a mistake by doing so. Even if they do not share his values they should listen to him despite of that. It is very narrow minded to not listen to people who do not share your values, for it is counterproductive as it will not develop any insight.
Many years ago I reflected a little about Karl Marx’s “theories” but I must say it did not take me very long to realize that he didn’t deliver much insight at all. People who supports communism do not know much about economics and they usually do not know much about Karl Marx’s theories either, which makes them bad and unjust from the start that is before they start speaking. They just do not like business people and capitalism.
If we want to be just we should listen and make up our minds.
That does not mean that everything Rothbard said was correct. No man is perfect and everything should be questioned. Nothing should be taken for granted. That is very important.
Björn
Published: June 6, 2007 5:14 AM
Björn Lundahl
Is it not obvious that historically kings have successively and therefore successfully counterfeited gold and silver money and during the “democratic area” this have extremely been intensified and that the modern confused and mixed up economists have in a twisted way “received the insight” that this is a very “efficient and stabilizing” thing?
They are like this guy:
http://www.youtube.com/watch?v=vy3FnA3mJHE&mode=related&search=
Björn Lundahl
Published: June 6, 2007 6:26 AM
Mike Sroul
Clayton:
"if I deposit a paper dollar from a hoard (so I don't replace it) into a bank in anything but a 100% fiat reserve, it becomes available for loan and enters the math -- adds to the units of purchasing power that goto the market to be used against the finite amount of capital/labor available."
That loan does not raise anyone's net worth, and the money created might be hoarded, retired at the bank, might displace other kinds of money, etc. There is thus no reason to think that the money will act on prices. I could take a share of GM stock from a hoard, lend it to a broker who uses it a partial backing for several call options on GM stock (i.e., the calls are issued on fractional reserves). This would add to the amount of "purchasing power" (shares of GM stock), but nobody would claim that this would affect the value of GM stock.
The real bills view is that money is just like GM stock. The quantity theory implies that money is completely different from any other commodity, and in fact has some properties that are illogical.
Published: June 6, 2007 11:08 AM
Björn Lundahl
Clayton
What determines decreased purchasing power or inflation is the quantity of money and not if it is “backed”.
One of the reasons that fiat money is a bad thing is that the central bank can print as much of them as they like.
As I said gold cannot be printed and to increase the supply of gold imposes costs. This is what it is all about: restrictions of its supply.
If the central bank just increased bank reserves by giving away fiat money as a gift to the banks or lending them to the banks and demanding bank “assets” in return makes no difference out of an inflationary perspective. That is if the quantity of money is the same. That the central bank demands “assets” in return for loans made and by charging interest rates are only technical devices to regulate its supply. Central banks have “developed” methods or techniques to flood the economy with fiat money and they probably are “fine tuning” the techniques all the time.
Björn Lundahl
Published: June 6, 2007 5:28 PM
Clayton
Mike:
I have to admit I'm still not sure an option is a clean way to regard fiat. The benefit of an option is that you can obtain a fixed amount of a good/equity (at a particular strike price) no matter what its current price is. You would fail to exercise the option when the price falls. I'm not clear what the long term strike price is of this option called fiat.
I'm also unconvinced that money has an imminent convertibility into a stable basis. For the sake of argument, however, let's assume it does have an imminent convertibility, but that the government has (clearly) shown a commitment to debasing money. Consequently, even if it were eventually convertible, an option to claim 1/100th of your value in 50 years doesn't justify the present value today. Even if I have a certain (convertible) claim to 1/100th of the current value (with a zero strike price), it should be worth 1/100th of its current basis (at the anticipated future price) discounted by 50 years at my time value.
In order for it to be worth more than that discounted value in the interim, it must produce a stream of services. If we continue to debase currency, the terminal value is essentially zero and the value of money becomes the present value of its stream of services.
In that respect, I'll momentarily take what I think is Bjorn's position (returning to gold not fiat of course) that the value of a good (interest rate required to forgo use of a good) is the marginal stream of services it generates minus its anticipated fall in value.
This makes sense for gold as its stream of services is the ostentation is provides (or alternately the shoe-leather savings). Its fall in value (regardless of the reason) subtracts from the total value realized by the end-user. So the price of gold = services at t0 + discounted expected value in t1. (Feel free to ring in Bjorn if this is inconsistent with your understanding).
Naturally, the marginal stream of services of both ostentation and shoe-leather savings must be equal.
Let me know if I appear to have erred on any of my statements so far.
Published: June 6, 2007 6:51 PM
Clayton
Bjorn:
Extending the previous argument into your domain. The stream of services produced by money is the shoe-leather savings it generates. If the shoe-leather savings is an structurally defined real value, I think money would adhere to the quantity theory (each unit explaining the total real savings / M). Thus the rate of inflation arises from changes in the absolute shoe-leather savings and the absolute quantity of money.
For the price of money to fall (regardless of the reason, but in reality driven by an increase in the quantity of currency/money), the rate of interest on money must be lower than the services it generates. Consequently, the rate of interest on money must be less than the shoe-leather savings. If this were not the case, we would have arbitrage. The growth in money (as the cause of the fall in the price of money) causes the lower interest rate.
Naturally, our ability to convert money from shoe-leather savings into shares of assets (even if it involves bidding up that price) ensures that the rate of profit on captial and the rate of profit on shoe-leather is equal.
However, this model would argue that the rate of interest on money is lower than the rate of profit on capital (that being equal to the larger shoe-leather savings). Both, naturally, could be expressed as a percentage of the fiat unit. However, this differential does not drive the rate of profit on capital down and thus does not *necessarily* cause misallocation.
I appologize if I've gone totally off the deep end (particularly if I have lost you).
Published: June 6, 2007 7:12 PM
Björn Lundahl
Clayton
I have not the slightest idea of what you are talking about. But I suggest that you rethink your ideas.
Even the inflationist Bernanke has received the insight that monetary policy has a powerful effect on stock market prices.
Stocks are titles to capital goods and that suggests malinvestments. He might not be aware of that. Monetarists and Keynesians neglect misallocations altogether.
During recessions/depressions prices of capital goods fall relatively to prices of consumer goods which also suggest that the Austrian business cycle theory is correct.
I work in the real estate business here in Gothenburg and during the 90s, as mentioned, prices of real estate decreased about 50 percent while CPI decreased in one year of about 1 percent. During those years I received the insight that the Austrian business cycle theory is correct.
Björn Lundahl
Published: June 7, 2007 1:48 AM
Björn Lundahl
If someone finds a theory to be incorrect he or she should not try to convince people of an alternative theory but instead find errors in that theory which they believe to be incorrect on its own grounds. If they are unable to do this, they are also unable to prove anything.
If a theory seems to be logically correct it also remains so until someone has proven it to be logically incorrect.
Björn Lundahl
Published: June 7, 2007 6:17 AM
Björn Lundahl
Practical handling of inflation targeting.
The Swiss National Bank, video:
http://video.google.com/videoplay?docid=7261930636964013647
Björn Lundahl
Published: June 7, 2007 4:07 PM
Mike Sproul
Clayton:
"I have to admit I'm still not sure an option is a clean way to regard fiat."
A checking account dollar is an American call on a green paper dollar, with a strike of zero and no expiration date. A green paper dollar is a European call on gold with a strike of zero and no expiration date. Reasonably clean so far.
Remember the importance of financial convertibility. As long as the Fed stands ready to buy back its dollars with bonds, people won't care that it doesn't buy them back with gold.
"I'm also unconvinced that money has an imminent convertibility into a stable basis. For the sake of argument, however, let's assume it does have an imminent convertibility, but that the government has (clearly) shown a commitment to debasing money. Consequently, even if it were eventually convertible, an option to claim 1/100th of your value in 50 years doesn't justify the present value today."
Use the equation PV=1/(1+R-C). Assuming a dollar promises to pay 1 oz. after 1 year, and R=.05 oz./yr and C=.06 oz./yr, then at the start of the year the dollar will be worth 1/(1+.05-.06)=1.01. So yes, the dollar loses 1% of its value each year, but its price today is still 1.01--GREATER than its terminal value of 1 oz. Of course, people will only hold the dollar if the services they get from it exceed the 6% loss they suffer, relative to a bond yielding 5%.
Published: June 7, 2007 10:41 PM
Clayton
Mike:
If the government has shown a committment to debase the money, it might be worth 1oz (unconvertible in a year), but it could easily be worth 1/2oz unconvertible after a decade or two. Is the mathematics totally indifferent to calculating it from its 1oz terminal (say next year instead) or its 1/2 ounce terminal in 20 years?
Published: June 8, 2007 7:51 AM
Clayton
Bjorn:
Stocks are a claim to an income stream. This includes capital, labor, and knowledge/technology. Particularly when the knowledge is private or legally protected (i.e. patented), there should exist monopoloy profits independenet of (above) market forces. This is not necessarily evidence of ex post misallocation; if I understand the model correctly, it could arise from a "change in tastes".
And even where it certainly exists, misallocation is support for (but not prima facia evidence of) the idea of the Austrian theory. As I've said, Baxter's 1955 "The Accountant's Contribution to the Trade Cycle" offers alternative transmissions processes. One must weight the strength and weaknesses and preferrably find some theoretical compromise that captures both the strengths. If you think everyone should be read/respected, I'm shocked that you only quote one or two people as if noone else has anything to say on the matters.
So I'm trying to weight eveidence on the various sides. There are some things that are obviously contrary to facts (like the original phillips curve in the long run), but there are others that deserve comparison because no model has been a perfect predictors of reality.
Money as a stream of services is a well respected viewpoint. It seemed relevent to bring it into the debate where it met up with Mike's discussion (and my issues with it). I don't necessarily believe it to be right in its other forms, but it fit quite nicely inside a framework (Mike's) that's not outside the bounds of reality and consequently is worth tossing around (so long as I can find ties and assumptions that make sense to me).
All models describe the same world (except perhaps praxology that takes a more normative view) so I figure they're all worth sorting through for their strengths... since those are likely to be the pieces preserved in what eventually becomes the right model.
Published: June 8, 2007 8:03 AM
TLWP Sam
I guessing here, Clayton and Mike Sproul, that the impasse here is about what the currency should be. Mike Sproul, I'm guessing, is presuming that people want the paper money as the actual currency per se with some ratio calculation to prevent hyperinflation. Whereas Clayton (and Björn?) want full-on hard currency which presumably means 100% backed paper currency. Yet I cannot help but feel if the safest currency is the one where the coinage earns its value due it contents then why not just have precious metal coinage (or ingots)? Perhaps having coins made up of a gold/titanium/tungsten alloy and presume the face value is based on the varying gold content?
Published: June 8, 2007 9:06 AM
Mike Sproul
Clayton:
If a dollar pays 1 oz in 10 years, and if the interest rate is 5% while the cost of issuing the dollar is 6%/year, the price of the dollar today is
PV=1/(1+R-C)^10=1/(1+.05-.06)^10, or about 1.106 oz.
In other words, it's the same as the one-year case, but raised to the 10th power.
Note that the dollar has to yield liquidity service to its holders to get them to hold it in spite of its negative return.
Published: June 8, 2007 10:30 AM
Mike Sproul
TLWP:
For one thing, full-bodied coins are more vulnerable to robbery than are checking account dollars and credit card dollars. Coins are also harder to carry around and (surprisingly) easier to counterfeit than paper.
I'm always a little surprised that people with a libertarian perspective should make such a point of telling people what kind of money they should use.
Published: June 8, 2007 10:38 AM
TLWP Sam
How the heck can coins be that easily conterfeited M. Sproul? Naturally I included titanium for its strength and tungsten for its high melting point making a gold/titanium/tungsten a toughie to clip let alone counterfeit (yeah tough luck it rolls down a sewer grate!). Admittedly I don't know exactly what happens when you alloys metals together whether you get all of the strengths of each metal or all of the weaknesses or something in between. And when I think of precious metal forgery I pretty much think of the 'gold bars' in City Slicker 2. But I'm sure you long since got the reason some folks want precious metal coin currency. It's because they don't want to suddenly be holding legimate, yet worthless, money such as Confederate notes. And I'm sure there's plenty of old-timer stories from various Depression eras saying "dang how we should have listened to our old folks and stayed with the gold and silver instead of letting them slick city-folk giving up paper receipts, taking our precious metals and telling how we'd be getting rich quick, dang it!".
Published: June 8, 2007 11:01 AM
Björn Lundahl
TLWP
I am the only one among the people you mentioned that supports a 100 percent gold reserve money standard.
Björn
Published: June 8, 2007 12:52 PM
Mike Sproul
TLWP:
Don't ask where I remember this from, but back in frontier days, whenever they raided a bad guy's hideout, they'd find a coin press that he'd been using to stamp pieces of tin into fake coins.
Also, there were probably quite a few old-timers who said "Dang it! I should have put my money in the fractional reserve bank, instead of keeping it in coins that were so easily stolen!"
Published: June 8, 2007 3:07 PM
Clayton
TLWP
Yes. Bjorn is certainly decided on a 100% gold reserve. I would agree with Bjorn on most (if not all) of the benefits he would cite including its freedom from government influence and certain characteristics it exhibits such as the safety of banks and the behavior of the monetary unit. We would both agree that certificates on a 100% reserve would be superior due to the reduced cost of transport/handling/etc.
However, I am not convinced that gold is the *best* answer. I believe that much of the transaction costs for society are in anticipating changes in the interest rate and prices of money (or goods versus the monetary unit). I believe that a currency managed to a basket of goods (or constant inflation on a basket of goods) eliminates this huge cost. Clearly gold creates value as a transaction medium or we wouldn't take it from the obvious ostentation value. I believe a well managed monetary unit can free society to enjoy the ostentation services of gold while further reducing general transaction costs.
Obviously, I recognize that a managed currency has some risks including the "liquidity trap" instigated by the huge deflation of the great depression. I recognize that it may contribute to misallocation, though, as I've said to Bjorn, I don't consider the existance of misallocation prima facie evidence that it's caused by characteristics of the managed currency. However, these are costs on the cost-benefit chart.
Mike takes a different approach to money. The real backing school has passed from popular opinion (which may simply mean it needs a renaissance). This school argues that the quantity of currency is irrelevent; instead, a dollar is secured by a bond and a bond is secured ultimately by a hard asset such as gold. The difference between Bjorn and Mike is Mike's assertion that the dollar secured by a bond is non-inflationary. Bjorn argues that any additional units of money (regardless of the reason why they exits) will alter the equation and reduce the value of money.
This is a debate that it *should* be possible to solve. I think that a world of perfect information would tend to product a world like Mike suggests. People would refuse to trade a good for money that isn't receiving an adequate interest rate due to the expanded money supply. However, I believe the real world is distorted by imperfect information so that Bjorn would probably win this piece of the debate if it were empirically tested. People don't say "the interest rates at the bank are too low... I won't deposit/buy a bond/buy a CD cause equity should return more... i'm going to buy equity and hedge my risk." It just doesn't happen.
Not sure if that helps.
Published: June 8, 2007 11:07 PM
Björn Lundahl
TLWP
The Austrian business cycle theory
When real prices decrease or increase market participators will spot those changes and act accordingly. For example when prices of consumer goods fall consumers will consume more and vice versa.
Now then, when a central bank wants to “stimulate aggregate demand” and increase because of this, bank reserves (through for example by buying government bonds or by directly lending money to the banks, see my above posted link “The Swiss National Bank”, video ) out of thin air the banks increases the money supply and initially lowers the rate of interest. This misleads businessmen to act as if savings have increased. Businessmen might not know why the rate of interest is lowered but the important thing is not this but that they recognize that it is cheaper to borrow and this will cause them to act accordingly that are to borrow or to borrow more than before. If real savings would instead have increased by the same amount as the quantity of money had done, businessmen would have acted accordingly too. The difference, though, is that in this example savings have not increased and businessmen acts as if they have. When businessmen calculate which investments are profitable or not, not all investments are profitable but some are. When the rate of interest fall, several more investments will seem to be profitable and they will start investing in those projects. The problem is, though, that the rate of interest is only temporarily manipulated and lowered by the central bank and savings have not increased. Sooner or later the rate of interest will start to rise and those investments will turn to be unprofitable.
Why will, sooner or later, the rate of interest start to rise? That is because of the fact that inflation will start to climb (decreases of the purchasing power of money will be greater) as the money supply have increased and all the increases of the money supply will eventually be filtered down to the pockets of the consumers. Consumers ultimately determines how much will be consumed and how much will be saved/invested. They have not changed their willingness to save because of the fact that the central bank has increased the money supply and will save as much proportionally of their incomes as before that is before the increase of the supply of money and will restore this proportion when they spot that their real increases of their incomes were illusory that is because of inflation. When this restoration is taking place the rate of interest will rise. Businessmen will now stop investing in those projects that were sustained by the lower rate of interest and workers will be laid off. The economy is in a recession/depression phase and will be healthy again when the malinvestments have been liquated and the proportion savings/ consumption ratio have been restored and the economic structure corresponds to this tendency. It is especially very important that the government during this phase keeps their hands off that is deregulate the economy so that the economy and prices are flexible and can adjust as fast and smoothly as possible. Budget deficits should not be allowed as they consume a nation’s capital since they are financed by public borrowing and will keep the rate of interest higher and will cause, therefore, the recession/depression to be deeper as the ultimate cause of the recession/depression was a lack of capital/savings. Further cuts in government spending would also make the recession/depression milder as tax cuts will increase savings proportionally to consumption.
Empirically this theory is also supported by the facts that during the expansionary phase of the money supply real estate, stocks etc or in other words prices of capital goods (which savings are supporting) rise proportionally to prices of consumer goods and during contractionary monetary phase prices of real estate, stocks etc or in other words prices of capital goods decrease proportionally to prices of consumer goods. That is why recessions/depressions are coinciding with bursting housing bubbles, stock market crashes etc.
Why did we suffer a great depression during the 30s when the world was on a gold standard and the increases of the money supply therefore were restrained? The reason was that the money supply still increased during the 20s as the banks were allowed to issue bank credit on top of their gold reserves (fractional reserve banking) and in the U.S. the reserve requirements were also actually lowered on time deposits and when this was fully utilized and the money supply started to halt the depression phase also began.
Only a 100 percent gold reserve money standard will effectively stop fractional reserve banking and therefore also once and for all the dreadful business cycle.
Björn Lundahl
Published: June 9, 2007 7:35 AM
TLWP Sam
clear as mud
Published: June 9, 2007 8:45 AM
Björn Lundahl
TLWP
Surely you can understand that people can save more or less or consume more or less. If they save more, more factories, caterpillars etc (capital goods) will be built and if they consume more, initially more consumer goods will be made and consumed.
If people save more the rate of interest will be lower and prices of capital goods will be higher because they will be more demanded. If they save less the rate of interest will be higher and prices of capital goods will be lowered as they are less demanded.
So if the central banks through the banks increase loaned funds by “the printing press” real savings have not increased but will still initially lower the rate of interest and thereby increase the demand for capital goods and their prices will rise accordingly. But in this process, as mentioned, savings have not increased. The rest of the story I have already posted.
I can only deliver some “hints” and the actual thinking and reasoning must be, of course, done by you. Not anyone will grasp it in a few minutes. It can be a quite long thinking process.
Björn Lundahl
Published: June 9, 2007 9:25 AM
Clayton
"Why will, sooner or later, the rate of interest start to rise? That is because of the fact that inflation will start to climb (decreases of the purchasing power of money will be greater) as the money supply have increased and all the increases of the money supply will eventually be filtered down to the pockets of the consumers."
Bjorn,
If loose money accelerates inflation, I agree that it creates a problem -- but that would not happen under a theoretical model of pure inflation targetting. Do you believe the same misallocation would occur (albeit at a lesser degree) if the central bank succesfully hit/maintained their target inflation rates?
Published: June 9, 2007 7:30 PM
Björn Lundahl
Clayton
I think that inflation targeting is a good thing compared to central banks behaviour during, for example, the 70s. It will bring about relative stability.
Politically a libertarian could and should support it. It is like a tax cut, better to have a little tax cut than no tax cut at all.
The reason for that I believe it will bring about relative stability is that increases of the money supply will be more limited than compared to none targeting and also more stable increases of the money supply will be accomplished than none targeting. Empirically this position that it will bring about relative stability is also supported by the experiences, for example, in New Zealand, Canada, and Great Britain and also in the U.S. as it implicitly follows an inflation target.
As the world’s central banks are today more focused on inflation and monetary stability the gap might be smaller for them in the future to listen to Austrian economists.
Inflation targeting will, though, not eliminate business cycles and either stock market crashes or economic bubbles.
Politically, inflation targeting might, I am afraid, satisfy the public as it will deliver some stability but governments might also intervene in the world stock market exchanges with further taxes and regulations to hinder “excessive speculations”. A 100 percent gold reserve money standard would eliminate such “need”.
Yes I do believe that inflation targeting will cause misallocations but to a smaller degree. There is no way to not foster misallocations as long as money supplies increase through the process of fractional reserve banking. But as misallocations are encouraged to a smaller degree and also regularly with new doses of money, it might bring relative stability despite of the misallocations. That is my position.
At the moment Monetarism is ruling the world regarding economic policy. Inflation targeting is only technically different to Milton Friedman’s original prescriptions of “monetary rules” but is not a fundamental difference as it focuses on the connection between business cycles, inflation rates and monetary policy.
Less regulations, free trade and floating exchange rates are also widely supported. This is explicitly or implicitly Monetarist positions. That some people declare that “Monetarism as dead” is all wrong and they do not know what they are talking about as the opposite is true. Wishful thinking from their part as they are obsessed by the fact that Monetarists are usually regarded as right-winged. This they do not like.
Björn Lundahl
Published: June 10, 2007 3:42 AM
Björn Lundahl
If, for example, the demand for money (decrease of the velocity of circulation or increase of liquidity preference) unexpectedly and dramatically increases under a regime of inflation targeting and if the central bank tries to counteract this very thing, when the CPI because of this register deflationary tendencies (increases of the purchasing power of money), by sharp increases of the supply of money, the central bank will cause a business cycle.
It is also a very counterproductive thing to try to counteract deflationary tendencies as those tendencies are a consequence, in this example, of higher demand for money and will therefore keep “aggregate demand in equilibrium with aggregate supply of goods and services” in the economy. An increase of the supply of money will also take some time before it will affect aggregate demand while deflationary tendencies are working with its full force when deflation is spotted.
The implementation of central bank forecasting for the purpose to spot in advance such changes of the demand for money will only substitutes and hinder more effective market forecasts done by firms and individuals.
Björn Lundahl
Published: June 10, 2007 7:10 AM
rtr
Björn Lundahl: "If, for example, the demand for money"
Non-Austrian heathen. Non-Chicago-School heathen. "Demand" for a "medium of exchange" ... Mine's bigger, my cucumber.
Björn Lundahl: "by sharp increases of the supply of money, the central bank will cause a business cycle."
As opposed to less than "sharp" increases, for those that still wish to be humiliated by carp fish a fundamentalist belief in bicycles and raw fish thrown at their bodily persons, no smacked across the communicative facilities functions with raw carp fish.
Björn Lundahl: "It is also a very counterproductive thing to try to counteract deflationary tendencies"
B.S. Let the other kiddies *prove* {Keynesian} "tendencies" wrong. Meh, such overated 19th century foundational crap ...
So what is it Mr. Bjorn Lundahl? Stupidity, ignorance, or humiliation? Don't forget to "implement" your answer.
I don't know if Mises.org is ready for your sacreligious "money" demand.
"You see that paper there? Well pick it up!" Fine, pity post again if you must. Hinder. Effective. €WTF? Repetez-moi. You suck.
Published: June 10, 2007 7:38 AM
RogerM
Bjorn: "Inflation targeting will, though, not eliminate business cycles and either stock market crashes or economic bubbles."
Exactly! You've been doing a masterful job in your posts, so I don't have much to add. Clayton has been selling the idea of inflation targeting using a basket of goods. However, the Fed has been essentially doing that for decades. A few important points:
1) Price inflation targeting wouldn't have helped during the 1920's because the prices of consumer/producer goods did not rise due to productivity increases. The same thing happened in the 1990's. Greenspan flooded the world with cheap dollars and garnered praise for it because industry increased productivity and kept prices relatively low. Still, we had the recession of 1991 due to the malinvestment in many industries, but especially telecomm.
2) Price inflation doesn't appear in consumer/producer goods only. It appears first in assets, especially the stock market. This should be one of the first lessons anyone learns from the Great Depression.
3) Hayek points out that bankruptcies which precede a downturn in the business cycle are spread across many industries but concentrated in capital intensive industries as opposed to consumer ones. The pattern is very common and well known. Hayek points out that such a pattern begs us to look for the cause. Random bankruptcies wouldn't follow such a consistent pattern. Something is causing entrepreneurs in capital intensive industries to make more than their usual number of mistakes when expanding or investing in new projects. Also, if bankruptcies were randomly distrubted, they should be canceled out by similarly random successes so that no business cycle would exist. No one but Austrians have an answer for the pattern of bankruptcies found in business cycles, which is that the unnaturally cheap money fabricated by the central bank causes large numbers of entrepreneurs to make mistakes at the same time.
As for Mike's real bills doctrine, bankers have tried it since John Law applied it to France in 1720. It has failed everywhere it has been tried. The Fed tried it in the 1920's and the German central bank used it in 1920's, both with disastrous results. How many centuries and failures does it take to prove RBD wrong?
Published: June 10, 2007 7:39 PM
Clayton
RogerM (and Bjorn naturally):
Becuase inflation accelerates, I agree that misallocation will occur. However, I believe it's because people anticipate 2% inflation (and calculate this implication into their interest rates) and their expectations are sticky (thus do not update immediatley with policy changes).
For the inflation rate to expand to 3%, a higher than anticipated amount of money has been driven into the economy and this *will* cause misallocation by causing too much investment. Further, I think Hayek does a formidable job of explaining what misallocation happens and why. Obviously, since I agree that misallocation occurs (despite the differing opinion about why), I'm not surprised that the misallocation is sectoral and exactly where Hayek would predict.
However, I can build a simple excel model that allows for the arbitrary expansion of the money supply (leading to predictable monetary-driven inflation pressure) that doesn't implode when I vary the interest rate. In fact, reducing the interest rate (all things held equal) creates pressure to increase the purchasing power of money. This transition would counteract the inflationary pressure of money supply and "lag" the inflation rate. When the anticipated interest rate settles down the full brunt of the monetary expansion hits inflation. On the surface, this appears to match reality.
For example, a market where the anticipated rate of interest falls 1% over a year and the money supply increase 10% will see a 4% net inflation rate. If the rate were to fall 3%, the money supply would have to grow over 23.5% to still generate inflation.
Admittedly... This simple model does not explain the relationship between the federal funds rate and the natural rate. However, it does show that the rate of growth of money is independent of the interest rate... and that the rate of inflation is derived from the behavior of both. Consequently, the fed funds rate does not have to be below the natural rate for inflation to exist or be targetted. At the same time, I absolutely agree that a fed funds rate that causes an unanticipated acceleration of the inflation rate is below the natural rate and causes misallocation.
Published: June 10, 2007 8:32 PM
Björn Lundahl
RogerM
Thank you!
“Also, if bankruptcies were randomly distrubted, they should be canceled out by similarly random successes so that no business cycle would exist.”
Very good point.
Your interest and knowledge about history is a very good thing too.
Björn
Published: June 10, 2007 8:47 PM
Mike Sproul
"As for Mike's real bills doctrine, bankers have tried it since John Law applied it to France in 1720. It has failed everywhere it has been tried. The Fed tried it in the 1920's and the German central bank used it in 1920's, both with disastrous results. How many centuries and failures does it take to prove RBD wrong?"
Those episodes prove that inflation happens when money loses backing, just as the RBD says. The RBD also says that inflation won't happen as long as new money is only issued in exchange for adequate backing.
Published: June 10, 2007 10:11 PM
RogerM
Mike: "Those episodes prove that inflation happens when money loses backing, just as the RBD says. The RBD also says that inflation won't happen as long as new money is only issued in exchange for adequate backing."
I don't think that's historically correct. In most episodes I have studied, new money was backed by collateral or gold or stocks. For example, in the Mississippi Bubble in France, Law backed all new money with either gold or stock in the Mississippi Company.
Today, almost all new money comes about through loans of some kind, and all loans are backed by IOU's at least.
Published: June 11, 2007 11:03 AM
RogerM
Clayton: "Becuase inflation accelerates, I agree that misallocation will occur."
I'm sure that poor forecasting of the inflation rate causes some malinvestment, but in Austrian theory, the main source of malinvestment is the lack of available resources to justify the expansion. If new money for investing comes about because consumers are saving more, that means they have also cut back on consumption, which frees resources (labor and materials) for investment in capital intensive industries. If new money for investing comes about by artificial credit expansion, then entrepreneurs will have the money for expansion, but they won't be able to get the complementary resources; they will enter a bidding war with consumer goods producers for the resources. Many will not be able to get the needed resources and will fail.
Published: June 11, 2007 11:11 AM
Mike Sproul
RogerM
"in the Mississippi Bubble in France, Law backed all new money with either gold or stock in the Mississippi Company."
Yes; and as long as Law's firm was successful, the paper money it issued held its value. When the company started to fail, the money it issued lost value.
"Today, almost all new money comes about through loans of some kind, and all loans are backed by IOU's at least."
But when $100 is issued for an IOU that turns out to be worth only $99, inflation results.
Published: June 11, 2007 2:03 PM
RogerM
Mike: "Yes; and as long as Law's firm was successful, the paper money it issued held its value. When the company started to fail, the money it issued lost value."
Monetary inflation always looks successful in the early stages because it causes an artificial boom. But the malinvestment it caused shows up eventually in businesses going bankrupt for all the reasons given by the ABCT. Businesses going bankrupt in large numbers across many industries is an effect, not the cause of problems. The cause is the artificial credit expansion created by the RBD.
But the end to the Mississippi Bubble came long before the collapse of the Mississippi Company stock. It started when a few wise men insisted on redeeming their paper money for gold. One was the Irishman Cantillon who could see the fraud Law was perpetuating on the French people. John Law's bank didn't have sufficient gold to cover even 1% of the paper money. When people learned that truth, they started selling stock as well. The Mississippi Company never failed; its stock went up 1,300% in 18 months (price inflation in the asset market) and then went back down.
"But when $100 is issued for an IOU that turns out to be worth only $99, inflation results."
Price inflation or monetary inflation? It can't cause price inflation. The banker didn't value the asset properly. So what? That doesn't mean someone else will pay a higher price for the asset because the banker paid too much for it. As for monetary inflation, that began when the banked loaned the money, if the loan was based on a checking or demand deposit account. It caused monetary inflation because such loans increase the amount of money in circulation by about 80% under fractional reserve banking. The value of the asset backing the loan has nothing to do with price inflation or monetary inflation; the increase in the money supply has everything to do with both.
Published: June 11, 2007 9:46 PM
TLWP Sam
Hey RogerM? Does this reinforces my gripe that any paper money is prone to misuse and that trading in gold weights would remove that danger? Or am I being a grump?
Published: June 12, 2007 1:18 AM
RogerM
TLWP: "Does this reinforces my gripe that any paper money is prone to misuse and that trading in gold weights would remove that danger?"
I agree completely! Paper money has always, under all circumstances, been abused. I don't think anyone can find any time in history that the government didn't steal from the people when it used paper money. The abuses of the fractional reserve banking system under a gold standard was bad enough, but throw in paper money and the amount of theft becomes horrendous!
Published: June 12, 2007 9:53 AM
Clayton
"I'm sure that poor forecasting of the inflation rate causes some malinvestment, but in Austrian theory, the main source of malinvestment is the lack of available resources to justify the expansion. If new money for investing comes about because consumers are saving more, that means they have also cut back on consumption, which frees resources (labor and materials) for investment in capital intensive industries. If new money for investing comes about by artificial credit expansion, then entrepreneurs will have the money for expansion, but they won't be able to get the complementary resources; they will enter a bidding war with consumer goods producers for the resources. Many will not be able to get the needed resources and will fail."
I'm familiar with the Austrian theory on the matter.
However, as I've argued before, the actual price behavior of the monetary basis does not appear to be the relevent issue. My simple example was backing money with automobiles. Especially stored in a vault, they're highly durable; however, the advance of technology would slowly diminish their value. Antique value and the actual storate cost aside, Austrian theory would suppose that this would be a completely rational basis for money. Poeple would anticipate the fall in the value of money and act accordingly.
There appears to be no built-in reason why the backing of money (like the automobile example) can't diminish in value by a predictable amount every year. I'm even under the impression that you could actually back the currency in a basket of goods (again durability aside) that could be overweighted with computers and autos to generate similar behavior with respect to the value of the monetary unit.
Since the fall of the value of money would be ceteris paribus (all things being equal) related to an increase in the quantity available (like any typical good), I again see no specific reason why money necessarily creates any issues by its nature or behavior alone (money falls for the same reasons the price of gold would fall, quantity). As with the auto, technological advancement could create this behavior with any regular good.
This leaves me in a quandry. Since I believe the failure to correclty target inflation can create misallocation (with all the natural Austrian implications), the misallocation itself is no longer prima facie evidence that the Austrian theory is necessarily correct.
Since noone has attacked my auto criticism directly (falling back on misallocation as prima facie evidence), I'm not convinced that I'm necessarily wrong on any point. Naturally, if you have something to directly address it, I'm more than happy to hear it.
And of course I apprecaite everyone's participation as it challenged me to focus my arguments in ways that directly address existing schools of thought.
Published: June 13, 2007 4:21 PM
Björn Lundahl
Clayton
You are entirely missing the point and to bring in automobiles as an example does not make the case any better.
The main points are that in a 100 percent gold reserve money standard, gold is the money and they cannot be produced through the fractional reserve banking system. Most bank loans goes to businesses and when the money supply in the current fiat monetary system increases, it is mainly done so through the process of the fractional reserve banking system and does not therefore reflect the saving ratios of individuals or consumers.
As most loans goes to businesses and therefore supports investments in capital goods and are not lent for purchasing of consumers goods, this ratio of mainly investing in capital goods does not reflect the ratio which consumer spend on savings/consumption.
If people anticipate this is beside the point. Those loans are still mainly lent to businesses and have therefore purchasing powers and will be invested in capital goods and change the economic structure.
The rate of interest will always be lower than it otherwise would be without the increases of the money supply through fractional reserve banks as a greater supply of capital must equilibrate with demand.
Now it is probably true that misallocations are greater when increases of the money supply accelerates than when it increases at a steady rate, but even when it increases at a steady rate and the inflation rate (decreases of the purchasing power of money) increases because of this and this also simultaneously with a rise of the rate of interest, total spending on capital goods will still be greater than without the increase of the money supply and will not therefore correspond to the true saving ratio of consumers. Even with steady increases of the supply of money, under a system of fractional reserve banking, the rate of interest in the long run must be somewhat lower than it would be without any increases of the supply of money.
Under a regime of inflation targeting the money supply does not perfectly increase at a steady rate as the demand for money might be quite stable over time but will not be perfectly stable and the inflation rate will therefore vary and as the inflation rate is the target, the central bank will change the growth rate of the money supply accordingly, in other words the money supply will sometimes increase at a steady rare but will also sometimes decelerate and accelerate.
Björn Lundahl
Published: June 14, 2007 6:23 AM
Clayton
Bjorn:
I know exactly what point I'm making and you're missing it...
"The rate of interest will always be lower than it otherwise would be without the increases of the money supply through fractional reserve banks as a greater supply of capital must equilibrate with demand."
If the production of gold accelerated due to technology, the interest rate on gold would be lower than it would if the price wasn't falling (quantity wasn't rising). Quantity increases => price decreases (inflation) => lower nominal interest rates by definition.
Published: June 14, 2007 3:34 PM
Clayton
Since my point didn't necessarily conclude clearly... this of course leads to the question "if gold behaving the same way does not distort the economy, why does paper money behaving that way have a different impact?"
Published: June 14, 2007 3:40 PM
Clayton
And rather than wait for you to pose the obvious objection...
If the interest rate does not fall, the price would fall. If you discount the future price at the lower interest rate and add in the services, the price is higher. If you discount the future price at teh equilibrium interest rate and add back in the services, the price is lower.
Except this is what actually happens... the value of the dollar fall faster than the anticipated inflation (inflation rate is too high). Since it's sticky (like all goods) the adjustment doesn't happen instantaneously and, by the argument above, the monetary interest rate would be depressed (again by definition) until the equilibrium price is restored.
If the Fed actually hit the inflation targets, it could do so only by expanding the money supply in a way that would hit that target interest rate. Other conditions that cause price changes in the money (additional pressures beyond the raw expansion in supply) are the that deviate from inflation targets.
Successful inflation targetting is successful interest rate targetting even if fiat money is experiencing targetted inflation.
Published: June 14, 2007 6:51 PM
RogerM
Clayton: "If the production of gold accelerated due to technology, the interest rate on gold would be lower than it would if the price wasn't falling (quantity wasn't rising)."
This happened to silver in the late 1800's in the US. Massive new discoveries flooded the country with silver and people quit using it as money. Gold experienced a similar loss in value, but much milder, in the 1500's when the Spanish stole boatloads of gold from South America. Price inflation in Europe from the influx of gold was about 3% annually. The same thing is not likely to happen to gold today. Dr. Reisman estimates that gold production would increase 2-3% annually barring a major breakthrough in gold mining technology. If such a breakthrough in gold mining technology occurred, then we would have to quit using gold as money. That's why your car annalogy doesn't work. Cars are easy and cheap to produce relative to gold. Gold isn't perfect money; it's just the best anyone has ever come up with.
Even under a gold standard, such as what the US had in the 19th century, credit expansion via fractional reserve banking (FRB) causes exactly the same problems as does paper money. If a bank accepts my deposit of gold and then lends 80% of that to another customer simply by making a bookkeeping entry crediting that customer's account, then the bank has expanded the money supply by 80% without ever printing paper money. Such credit expansion caused massive devastation and even starvation in the US from 1800 to WWII.
The key to ending such devastation is to end FRB. Without FRB, the Fed has nothing but open market purchases of government bonds as a tool to expand/shrink the money supply. At that point, gold becomes important as money because it's difficult to produce and counterfeit. Anything that is easy to produce, such as paper money or cars, would immediately cause money to lose its value, prices to rise and malinvestment to begin.
Published: June 14, 2007 7:20 PM
Björn Lundahl
If the central bank instead of increasing bank reserves printed the money and handed over them to the consumers directly and if time preferences did not change, no change of the economic structure would occur. The same goes for increased gold production in a 100 percent gold reserve money standard.
This is the essence that bank loans are lent mainly to businesses and when central banks master increases of the supply of money by increasing bank reserves, the money composite will take the form of increased demand and time deposits in the fractional reserve system and are chiefly lent to businesses and therefore spent on capital goods and this deviate from consumer’s preferences.
Further: there is always a lag in time before changes in the supply of money will change the “price level”. Friedman estimated about 18 months. This can naturally change and is not a praxeological fact. There is of course no evidence that deflation (increases of the purchasing power of money) will occur later in time when the supply of money decreases than inflation will occur when the supply of money increases (the supply of money increasing more than total output of goods and services).
Status quo seems to always have a strong influence on some people and just now it is inflation targeting. If the state does something many people do think it is a good thing just because the state is doing it.
Björn Lundahl
Published: June 15, 2007 1:12 AM
Björn Lundahl
I wrote this:
“Even with steady increases of the supply of money, under a system of fractional reserve banking, the rate of interest in the long run must be somewhat lower than it would be without any increases of the supply of money.”
What I am referring to here is the real rate of interest and not the nominal rate of interest. The nominal rate of interest will rise because of decreases of the purchasing power of money.
Björn Lundahl
Published: June 15, 2007 2:58 AM
Björn Lundahl
Further reflection:
It is probably wrong that the real rate of interest will be somewhat lower in the long run when the supply of money increases evenly through the process of fractional reserve banking compared to a situation in which the money supply does not increase at all, as those increases of the supply of money raise the prices of capital goods which in turn will also increase the demand for monetary loans.
Björn Lundahl
Published: June 15, 2007 6:16 AM
Clayton
"The same thing is not likely to happen to gold today. Dr. Reisman estimates that gold production would increase 2-3% annually barring a major breakthrough in gold mining technology. If such a breakthrough in gold mining technology occurred, then we would have to quit using gold as money."
You can't have it both ways. Either you can use any durable commodity any time because there's something implicit and fundamental about using a real asset -- the presumption being that the economic function ensures that real goods never behave in an uneconomic or distortionary way. If this is true, you can argue that 100% reserve commodity money is superior, but you have to establish that money's behavior is going to be different going forward (as I've already pointed out was true during the 30-40% per year deflationary great depression, but due to poor comprehension not intentional mismanagement).
Or you're going to be selective about the precise asset at the precise time and argue that gold works because you don't anticipate it behaving in one of many ways -- If you're an oracle on the behavior of gold and technology you should start an investment fund. However, in this case, you can't defend against an argument that a paper money, managed to meet the same criteria, can't be equally efficient or even more efficient since a determined manager could ensure that it meets those characteristics for all time.
===
"This is the essence that bank loans are lent mainly to businesses and when central banks master increases of the supply of money by increasing bank reserves, the money composite will take the form of increased demand and time deposits in the fractional reserve system and are chiefly lent to businesses and therefore spent on capital goods and this deviate from consumer’s preferences."
I don't know if the US is somehow unique in this respect... but every time interest rates drop, our consumers refinance their homes, pull out tons of cash, and spend tons of money. Falling interest rates drive a lot of money into the consumption of goods. Naturally, I've argued that the sticky prices/interest rate disequilibrium causes misallocation, but the basic argument that the money flows almost exclusively to industry isn't necessarily as strait forward as it sounds. Hayek had some very interesting charts about the implications of changes of interest rates on the rate of savings in different wealth/interest rate scenarios that seem applicable.
===
The final point I want to be very clear about is the fall in the real interest rate due to monetary infustions. Simply, this formula must be true:
Real purchasing power today = shoeleather services for this time period + real purchasing power in next period / (1 + interest rate)
If the price of money today is 11 units, the anticipated price of money is 10 units, and the amount of shoeleatehr services produced by money is $1.55, the interest rate MUST be .55 units / 11 units or 5%. The value you get for holding the money is the service (1.55 units) - the change in price (1 units). You'd be willing to trade the dollar for any good or equity with a comparable or higher risk adjusted return.
If you can get more than 5% in an asset, you'll trade money for higher interest rate assets, bidding up prices. However, this doesn't change the math for the value of money in the next period -- this is still the real value of the services of money discounted at the anticipated natural rate.
Until the current price falls (or until the services produced increases), the real interest rate at which you'd be willing to forgo the use of the money must remain below the natural rate. However, the same thing (in principle) is true of any asset that's delivering an inadequate interest rate -- its price needs to fall. So I'm unconvinced that money is somehow unique in its ability to behave this way -- would you really argue that the fed is worse at anticipating the price of money (often off by tenths of a percent per year) than the economy in general is at anticipating the price of gold?
Published: June 15, 2007 8:38 AM
Clayton
I need a minor correction on the placement of (or seleciton of values for) the interest rate. However, the basic idea of the formula is correct. The interest is paid on the $11 (thus that's the correct basis for the rate) and it needs to compensate for the amount of the services - loss in price.
I believe there's something lost in the translation from continuous to discreet time. In the real world it should be:
rate of interest = rate of services - rate of price loss
Published: June 15, 2007 8:49 AM
Björn Lundahl
What Has Government Done to Our Money, by Murray Rothbard?:
"A most important truth about money now emerges from our discussion: money is a commodity. Learning this simple lesson is one of the world's most important tasks. So often have people talked about money as something much more or less than this. Money is not an abstract unit of account, divorceable from a concrete good; it is not a useless token only good for exchanging; it is not a "claim on society"; it is not a guarantee of a fixed price level. It is simply a commodity. It differs from other commodities in being demanded mainly as a medium of exchange. But aside from this, it is a commodity—and, like all commodities, it has an existing stock, it faces demands by people to buy and hold it, etc. Like all commodities, its "price"—in terms of other goods—is determined by the interaction of its total supply, or stock, and the total demand by people to buy and hold it. (People "buy" money by selling their goods and services for it, just as they "sell" money when they buy goods and services.)"
http://mises.org/money/2s3.asp
Björn Lundahl
Published: June 15, 2007 2:01 PM
Björn Lundahl
That most bank loans are lent to businesses means, of course, that some loans are not lent to businesses but to consumers.
As this is true it is also therefore true that most of the spending that fractional reserve banks cause through the process of making loans are spent on capital goods and does not reflect the same saving versus consumption ratio as consumers does. Consumers does the opposite that is save a very small proportion of their incomes and spend most on consumer goods.
Further: Most bank loans to consumers are probably financing durable consumer goods and they are compared to none durable consumer goods especially affected by the rate of interest and credit expansion mastered by the fractional reserve banking system.
From the book Money, Bank Credit, and Economic Cycles, by Jesús Huerta De Soto, page 301:
“In Spain José Castañeda Chornet reveals that perhaps he has been the one who has best understood this essential idea when he affirms that: Durable consumer goods, which generate a flow of consumer services over time, may be included in an economy’s fixed capital. In a strict sense they constitute fixed consumer capital, not productive capital. So capital, in a broad sense, comprises productive or true capital as well as consumer capital, or capital for use.
(Castañeda, Lecciones de teoría económica, p. 686)”
“Roger W. Garrison has put forward the additional argument that all consumer goods for which a secondhand market exists should be classified, from an economic standpoint, as investment goods.”
http://mises.org/books/desoto.pdf
Björn Lundahl
Published: June 15, 2007 3:37 PM
Clayton
“Roger W. Garrison has put forward the additional argument that all consumer goods for which a secondhand market exists should be classified, from an economic standpoint, as investment goods.”
So what even qualifies as a non-durable/ non-investment/ non-capital good for people to purchase from income (to contrast with borrowing).
Either way... if these goods do put off a stream of consumption services, then the purchase of these goods does increase the rate of consumption services experienced. Particularly with this expansive definition of investment, the net services generated by a new car, new TV, new appliances, or a home improvement would represnt a real and substantial increase in present consumption.
Whether the services are produced by a net increase in durable goods or the direct purchase of services, it's still consumption.
Published: June 15, 2007 4:57 PM
RogerM
Clayton: "However, in this case, you can't defend against an argument that a paper money, managed to meet the same criteria, can't be equally efficient or even more efficient since a determined manager could ensure that it meets those characteristics for all time."
You're absolutely correct that if the Fed could make the money supply (without gold) increase just 2-3% per year, the result would be the same as having gold as money. But that's the problem, isn't it? The Fed has never kept the money supply growth to such low levels.
Occasionally the money supply shrinks, as it did during the 1930's. But it never shrinks because the Fed determined it should shrink and applied the appropriate policy. The Fed always inflates the money supply. On the rare occasions when the money supply shrinks, the cause is business failures and bank failures. In the 1930's bank failures plus people's loss of confidence in banks shrunk the money supply. Sure, the Fed raised interest rates mildly, but it also increased its purchase of bonds in an effort to inflate the money supply. Also, under fractional reserve banking, any time a business defaults on a loan the money supply shrinks and a dominoe effect begins to happen that causes increased shrinking of the money supply as the affected banks call in loans. You can think of the money supply as a rubber band that the banking system stretches too far until it breaks and shrinks to its original size.
Clayton: "would you really argue that the fed is worse at anticipating the price of money (often off by tenths of a percent per year) than the economy in general is at anticipating the price of gold?"
You're kidding, right? Have you looked at a chart of prices from the 19th century (under a gold standard) and compared it with the 20th century (the Fed's century)? The Fed's handling of the money supply has been disastrous! The Great Depression is chief example, followed by the stagflation of the 1970's.
The reason Austrians prefer a gold standard is because technology and the shortage of gold in the world limits the growth of the money supply and puts that limit beyond the ability of human beings to inflate. While it's theoretically possible that humans could control the money supply in the same way that gold would control it, history has proven beyond doubt that human's can't resist the temptation to inflate. In a good year, the Fed inflates the money supply at a minimum rate of 8%. Friedman suggested using a computer to set interest rates so that the money supply would grow at a fixed rate of 3%. That might work, but I have no doubt that someone would tamper with the programming because history has proven that no man has the ability to resist the temptation to steal from his fellow man by inflating the money supply in the name of the public good.
Clayton: "The final point I want to be very clear about is the fall in the real interest rate due to monetary infustions."
I think we have a problem with definitions here. The real interest rate is the nominal interest rate (the posted one) minus a figure for price inflation. So if the posted interest rate is 8$ and prices have increased 3%, then the real interest rate is 5%. The natural rate, according to neo-classical econ, is the interest rate that causes neither price inflation nor price deflation.
However, in Austrian econ, the natural rate is the interest rate that would exist without banks monkeying with the money supply, and it's based on the time preference of capitalists, as Dr. Reisman points out. It has nothing to do with shoeleather or "rate of interest = rate of services - rate of price loss." The time preference of capitalists determines the rate of profit which in turn determines the interest rate.
Published: June 15, 2007 8:54 PM
Clayton
lost a response to the "seucrity code" link... i'll try to replicate it:
"You're absolutely correct that if the Fed could make the money supply (without gold) increase just 2-3% per year, the result would be the same as having gold as money. But that's the problem, isn't it? The Fed has never kept the money supply growth to such low levels."
This policy will not maintain constant prices. Conversely, the value of money will experience a wide countercyclical course. This eliminates the predictability that I think is a major component of money's "services".
"You're kidding, right? Have you looked at a chart of prices from the 19th century (under a gold standard) and compared it with the 20th century (the Fed's century)? The Fed's handling of the money supply has been disastrous! The Great Depression is chief example, followed by the stagflation of the 1970's."
Just a few points. The fed did not inflation target during much of this period -- using this criteria as a measure of its success is woefully inaccurate. However I'll cede (and have before mentioned) the two identified issues:
1. During the great depression, the monetary authority allowed singificant deflation (30-40% per year). This was (predicatably) disasterous since the deflation exceeded the nominal rate of interest.
2. During the 70s, the populist Keynesian movement and their fallacious long term Phillips curve failed brilliantly. While some of this school still influence public policy, these ideas have not gotten much tranction inside the fed.
I believe a fed that understands and desires to avoid these two damaging periods could do so with little effort. Witht that in mind, these specificl point-argumetns become somewhat impotent on a go forward basis. A Fed better informed and legally oblidge to target inflation rates (and hopefully one that succeeds) should be able to continue to provide low and realtively stable interest rates.
At minimum, during these inflation targetting periods, the government is rarely off by much. Gold on the other hand...
Published: June 16, 2007 12:20 AM
Björn Lundahl
U.S. home prices adjusted for inflation 1890 – present, video:
http://video.google.com/videoplay?docid=-2757699799528285056
Björn Lundahl
Published: June 16, 2007 12:22 AM
Clayton
"I think we have a problem with definitions here. The real interest rate is the nominal interest rate (the posted one) minus a figure for price inflation. So if the posted interest rate is 8$ and prices have increased 3%, then the real interest rate is 5%. The natural rate, according to neo-classical econ, is the interest rate that causes neither price inflation nor price deflation."
I'm gonna have to come back to it tomrrow when I'm fully awake. However, the natural rate of which you speak is in reference to flat prices for the average or basket of goods. I'm referring to the behavior of a very specific good in that pasket, a good that's epxeriencing lower costs of porduction and thus falling prices.
The price of existing inventory are influenced by anticipated changes in future prices. They will be worth the same amount in a month or year or whatever and must draw their additional value from the services they render in the meantime (while gold is less common).
Consequently, an interest rate would play an entirely rational role in a deicsion involving a good with changing prices. Indeed as I tried to illustrate (and I think Bjorn has before), people will cut the price of goods with low interest rates and increase the price of goods with high interest rates.
Thne the formula still holds. The value to the user of a good is the services value minus the change in price.
The value that must be obtained by trading it for something else is net services worth the same amount or more.
===
By extension, the value to the user of money is the shoe-leather services minus the change in price.
The value that must be obtained by trading it for something else is interest worth the same amount or more.
Any more clear?
Published: June 16, 2007 12:31 AM
Björn Lundahl
A 100% gold money reserve standard
If there would be bank runs (which, naturally, would be extremely unlikely as the public knows that the gold is deposited in bank vaults under 100% gold reserve money standard), the banks could meet any claims of the depositors.
We should also be aware of the fact that fractional reserve banking by itself causes business cycles and, therefore, during recessions or depressions this also causes bank runs as banks are in trouble during this phase of the business cycle.
This, also, means that fractional reserve banks not only instantly cannot fulfil their obligations against the depositors, but that they won’t ever be able to do so during recessions or depressions (which they have created) as their assets have plummeted in value and the sale of them for the purpose of fulfilling the rightful claims of the depositors will not be possible.
Some consequences of not having a 100% gold reserve money standard:
• Panic of 1819 http://www.answers.com/topic/panic-of-1819
• Panic of 1837 http://www.answers.com/topic/panic-of-1837
• Panic of 1857 http://www.answers.com/topic/panic-of-1857
• Panic of 1873 http://www.answers.com/topic/panic-of-1873
• Panic of 1884 http://www.answers.com/topic/panic-of-1884
• Panic of 1890 http://www.answers.com/topic/panic-of-1890
• Panic of 1893 http://www.answers.com/topic/panic-of-1893
• Panic of 1896 http://www.answers.com/topic/panic-of-1896
• Panic of 1901 http://www.answers.com/topic/panic-of-1901
• Panic of 1907 http://www.answers.com/topic/panic-of-1907
Why should we have central banks and fractional reserve banks that mess things up in the first place? Why should we have business cycles and malinvestments just for the sake to please some perversive lust for power and fraudulent money? Do we really want to have malinvestments? Is unemployment that good? What is the justification?
Björn Lundahl
Published: June 16, 2007 12:40 AM
Björn Lundahl
America´s Great Depression
"Another common feature of the business cycle also calls for an explanation. It is the well-known fact that capital-goods industries fluctuate more widely than do the consumer-goods industries. The capital-goods industries—especially the industries supplying raw materials, construction, and equipment to other industries—expand much further in the boom, and are hit far more severely in the depression.
A third feature of every boom that needs explaining is the increase in the quantity of money in the economy. Conversely, there is generally, though not universally, a fall in the money supply during the depression."
http://mises.org/rothbard/agd/chapter1.asp
Björn Lundahl
Published: June 16, 2007 4:27 AM
Björn Lundahl
Does credit expansion through fractional reserve banking increase investments and living standards?
If credit expansion could possibly increase investments it would be through forced savings, but savings that are forced lowers the livings standards as they are not voluntarily taken.
In a free market without any government intervention, all individual actions are voluntarily and increases of the standard of livings are therefore true.
But apart from this very fact, do credit expansion increase investments and physical output?
No, the prerequisite for increased investments are true savings that are financed by postponing consumption and factors of production are thereby released from producing consumption goods to produce capital goods which in the future will increase the output of consumption goods.
What actually credit expansion does is to distort the markets and produce the business cycle. This will make investments more risky and also waste resources (malinvestments) and this in turn will lower physical output and living standards.
Björn Lundahl
Published: June 16, 2007 7:03 AM
Clayton
Bjorn:
I don't disagree that 100% gold reserves prevent panics. But they do so at a cost -- you must forgo the ostentation services of gold (or services of the potential products made using gold) stored in a vault. Plus, you haven't listed a single panic in the last century. If this is by omission, then go get some newer ones. If this is due to the fact that people in the 1900s believed wrong things about money and banking (as was certainly true), it may no longer be a relevent point. That would be like saying you shouldn't use doctors today because they used to bleed people with leeches and leeches don't work
===
Next, you're referring to *real* credit expansion. All other things held equal, if the monetary agency has committed to 2% inflation per year (and people act under this belief) then the failure to expand the money supply by 2% will cause misallocation and artificially high interest rates. If everyone assumes that the prices will fall 2%, they need 2% more money (again all other things held equal) to make their decisions non-distortionary.
Nominal credit expansion does not mean real credit expansion. Your complain (rightly) is with real credit expansion, but you need to be more precise about when you're implying that it occurs.
As to wether or not it creates value:
If people have to spend $1b a year either anticipating the risk in a gold denominated investment or hedging the risk (transaction and information costs) or not transacting due to the transaction costs/risk, the ability to use a unit of account that eliminates these costs will increase the standard of living. In the simplest terms, you free up the labor that had to be spent on this activity to be put towards actual production, increasing the total quantity of goods produced by the same amount of aggregate labor. Plus they get the services of the gold that is now freed from the vaults for personal and industrial use. That's a real benefit to compare with other real costs/ risks.
===
The fact that it's fractional reserve is really a trivial point.
Eliminating fractional reserve does not eliminate inflationary pressure. If the government could purchase $10 trillion in bonds on 100% reserve, inflation would occur. The money would have to be saved in a bank (as it would collect no interest in a safe) or spent. Even in a 100% paper reserve, much of it would be put into long term savings (with zero reserve) and the bank would be obliged to lend the money in order to maximize profit and would lower the interest rate to do. This would create misallocation.
The key is alwyas having the option for convertibility, not the presence of the reserves. This works great with gold because people will trade their bills for gold when the gold is worth more (lowering the money supply) and vice versa when the gold is worth less. With bonds, there's no strait-forward spot discount rate (and thus price) for convertibility. Not that it's impossible, but I believe it requires each bank to trace a spot exchange rate (hello basically 50 versions of the Federal Funds rate).
To Bjorn specifically:
I'm going to be more careful here because you're usually advocating a 100% gold reserve. The primary complaint with this system is really the forgone services.
100% reserve on paper is a little more bizarre and I'm not clear if you advocate this as a better fiat state than fractional reserve. What really matters with paper reserves is where you apply the reserve requirements. Esseentially however, paper money held in 100% reserve at the banks is a fantasy. It doesn't participate in the economic system because it is not spend and not lent out to anyone else. Ok but in your world this isn't technically a problem so I continue...
With sticky prices, this causes real demand to fall (less purchasing power / higher prices) -- because prices should actually have fallen to respect the higher demand for/ value of money to produce the correct amount of real demand. If you believe in the existence (and negative consequences) of sticky prices in any context, you couldn't avoid this conclusion. In a fractional reserve system, by contrast, most of this money is lended out and prices need not fall as far to create equilibrium.
Of course this creates the opportunity for a run, but only because people have a juristic idea that a demand deposit is actually always available. In a fractional reserve system, this simply isn't the case -- most of their money has been lent out and it would be adequate simply to update the juristic definition of money (as they implicitly do when they allow banks to close their doors and stop redeeming demand deposits).
Published: June 16, 2007 11:52 AM
Clayton
Roger:
"Clayton: "The final point I want to be very clear about is the fall in the real interest rate due to monetary infustions."
I think we have a problem with definitions here. The real interest rate is the nominal interest rate (the posted one) minus a figure for price inflation. So if the posted interest rate is 8$ and prices have increased 3%, then the real interest rate is 5%. The natural rate, according to neo-classical econ, is the interest rate that causes neither price inflation nor price deflation.
However, in Austrian econ, the natural rate is the interest rate that would exist without banks monkeying with the money supply, and it's based on the time preference of capitalists, as Dr. Reisman points out. It has nothing to do with shoeleather or "rate of interest = rate of services - rate of price loss." The time preference of capitalists determines the rate of profit which in turn determines the interest rate."
Roger, "rate of interest = rate of services - rate of price loss" is a tautology that must apply to any good. We would be willing to give up a good for a value equal to the net real services that good produces.
For gold, the value we obtain from having the gold in our hand is the value of the ostentation services minues the fall in real value of the gold. If we can get this value "in interest", we'd be willing to give the gold to someone else. This is a real rate of interest because it's the real return in the good.
Money is no different. We're willing to forgo the physical posession of our money if the interest rate is equal to the services we obtain less the fall in the value of our money.
This is "by definition" in the praxelogical sense. This also illustrates the difference between the physical return on assets (the rate of services) and the interest rate (via the change in prices) that is common in Austrian lingo though rarely detailed out.
Now, if the interest obtained on one good is larger than the interest on another, we'd expect the relative price of the goods to adjust to restore equilibrium. This can occur in two places, the current exchange rate can adjust or the future exchange rate can adjust. If we assume that the future exchange rates are fixed as the discounted stream of future services, this adjustment must occur in the present prices.
Either a fall in prices on the low interest good will decrease the change in prices (increasing the interest rate in our tautology) or a higher price on the high interest good will increase the price change (lowering the rate of interest in our tautology). This should be an instantaneous calculation, but in a world of sticky prices it is not (as clearly is true in our world or the natural rate would be instantaneously restored by bouts of instant and notable inflation due to changes in money supply).
Until this price change happens, however, the praxelogical rate of interest on a good (the interest required to give up the good at the current price) is defined and can be different from the natural rate.
===
What should happen in a large network is that all goods should adjust prices and settle on the natural rate. This would be true of money like any other good. The price of money should fall quickly to restore balance. This fall in the price of money (or faster fall in a constant inflation scheme) would force an inflation targetting central bank to slow monetary expansion and restore the natural rate.
Consequently a successful inflation targetting central bank will maintain the natural rate and create no misallocation or distortion... period. What is left, then, is whether or not a central bank can do this with the right theory and, in a world of sticky prices, how much distortion will occur (or be prevented) by their attempts to do so.
Published: June 16, 2007 12:17 PM
Björn Lundahl
If the money supply does not increase at all and the purchasing power of money increases about 2% yearly, aggregate demand will be no more or less than if, for example, the money supply increases to support that the purchasing power of money decreases about 2% yearly.
To increase aggregate demand by increasing the money supply is only an illusion.
In a 100 % gold reserve money standard prices would also be less “sticky” than they are today as the implementation of such monetary reforms would probably simultaneously be made with other free market reforms.
I do not consider a fiat monetary system as an alternative to a 100% gold reserve money standard as it is derived and based on fraud. Theft and fraud are destructive actions and are not voluntarily taken and are therefore not market oriented but its opposite that is anti market actions. The free market is the only objective guidance that exists to tell if activities are productive or not. There is no other guidance, in other words, than profit or loss. Other considerations are totally arbitrarily made.
If we want to know if a fiat monetary system is “productive” or not we would need a pure free market to find out whether such a “system” would evolve.
Anyone could, though, a priori understand that such a “system” could never evolve in a pure free market.
Mises quiz:
http://mises.org/quiz.asp
Björn Lundahl
Published: June 16, 2007 4:50 PM
Björn Lundahl
In my bookshelf I found an old book and looked into it “Dollars and Deficits, Inflation, Monetary Policy and the Balance of Payments”, by Dr. Milton Friedman published in 1968, chapter two, page 76:
“I cannot forbear a minor digression at this point. For a long time I have been a proponent of 100% reserve banking. Under this system, the depositary activities of banks would be separated from their lending and investing activities, and the depositary institutions would serve as pure warehouses of funds. For every dollar of deposits, they would be required to hold a dollar currency or its equivalent. Those of us who favour this scheme are accustomed to being labelled “unrealistic”; to being told that we are proposing a reform that has no chance of adoption and would require utterly impractical changes in the banking system if it were adopted.”
It seems that Milton Friedman gave up this idea of 100% fiat money reserve standard and instead proposed a monetary rule as this standpoint was more politically feasible.
Björn Lundahl
Published: June 16, 2007 4:54 PM
Dennis
Mr. Lundahl, thank you for bringing the Milton Friedman quote to my attention. While I can not claim to be an expert regarding the evolution of Friedman's monetary thought, nevertheless, I am surprised that at one time he strongly supported 100% reserve deposit banking. Friedman's support of the 100% reserve requirement is quite Misesian/Rothbardian of him.
Forgive me if I am repeating what someone else has previously stated above, but to think that increasing the quantity of the medium of exchange will cause a sustainable increase in the quantity of consumers and/or capital goods is completely erroneous. To think that real wealth can be created by increasing the quantity of the medium of exchange is one of the most widely believed and pernicious fallacies in all of economics.
Published: June 16, 2007 7:16 PM
RogerM
Clayton: "Money is no different. We're willing to forgo the physical posession of our money if the interest rate is equal to the services we obtain less the fall in the value of our money." and "...'rate of interest = rate of services - rate of price loss' is a tautology
That is true only if by the "services we obtain" you mean future consumption. Otherwise it makes no sense at all.
Clayton: "For gold, the value we obtain from having the gold in our hand is the value of the ostentation services..."
What in the world is ostentation services? The only reason to hold gold as money, or any money, is if you need it to pay current expenses.
Clayton: "Now, if the interest obtained on one good is larger than the interest on another..."
Interest is paid on money, not goods. Investment goods can have an ROI, but no one calls that interest, and it has nothing to do with interest. You seem to be very confused.
Clayton: "This also illustrates the difference between the physical return on assets (the rate of services) and the interest rate (via the change in prices)..."
Austrian econ makes it very clear that the two have nothing to do with each other. Austrian econ equates interest with profit, not return on assets.
Clayton: "Consequently a successful inflation targetting central bank will maintain the natural rate..."
Your thinking and definitions don't follow any established system of econ, neither Keynesian, neo-Classical, monetarist or Austrian. It seems as if you're trying to create a new branch of econ. No one uses "natural rate" of interest as you do. I gave the definitions of the prominent schools above. Creating new definitions of commonly used words does not help at all. I'll repeat the Austrian definition of "natural rate": It's that rate that conforms to the time preference of capitalists and is most clearly recognized when the money supply remains constant.
As I wrote before, inflation targeting by the Fed has caused massive monetary inflation, even though price inflation has been mild or non-existent. That happens because under a constant money supply, prices will decline when productivity increases. So if prices don't increase when productivity increases, then the Fed is pumping too much money into the economy and causing the boom that leads to the bust. Even worse is that the Fed's "basket" of goods doesn't include assets, such as the stock market, where price inflation resulting from monetary inflation first appears. The 1990's provides a great example. The Fed met all its inflation targets and price inflation was very mild by modern standards. However, the stock market soared as a result of the Feds massive pumping of money into the system. As a result, there was a great transfer of wealth to the early receivers of the Fed's new money (those who purchased stocks early) from the late receivers of the money, just as Austrian econ predicts.
Published: June 16, 2007 8:12 PM
RogerM
Clayton, I may have been too hard on you in my previous post. I'm not certain, but on further reflection I think you may be giving the standard neo-Keynesian or neo-classical responses to the issue of money and prices. The differences between the Austrian and neo-schools have to do with the direction of cause and effect. In the neo-schools, price increases cause money to devalue, or purchase less, and cause nominal interest rates to rise. The money supply doesn't matter at all.
Cause/effect is exactly the opposite in Austrian econ: devaluation of money (through increases in the money supply) causes price increases. At first, the devaluation of money causes nominal interest rates to fall, but when price increases hit, nominal interest rates rise. Money is the main driver of business cycles.
Which school of econ is right? How can you know? Is it just another chicken and egg riddle? Encyclopedias have been filled with the debate, so I can't settle it in a blog. If you're coming from a neo-school position, then Austrian econ won't make much sense because it teaches exactly the opposite principles. That's why I highly recommend Roger Garrison's books in which he compares all three or four schools. You'll understand the neo-schools better than you do now and Austrian econ will make sense. The issue might even be simplified to a question of the direction of cause and effect in the quantity theory of money: MV = PQ. Assuming V (velocity) and Q (physical production) are constant, the neo-schools say that cause and effect flow from right to left; price (P) increases cause an increase in the money (M) supply. Austrians argue that the flow is only left to right; increases in the money supply cause price increases. (Of course, if M and V are held constant and Q increases because of technology, then P must fall.)
A few things have convinced me of the Austrian position:
1. Without an increase in the money supply, no mechanism exists to cause a general rise in the price level. The neo-schools talk about shocks causing price inflation, and they give the rapid rise of oil prices in the 1970's as an example. But logically, if the money supply is constant and a shock occurs in one or two products, then people will spend more for those higher priced products, and leaving them less to spend on other products. As a result, the prices of other products will fall and cancel out the effects of the higher priced products and no net increase in prices would happen. What could cause people to demand more of most products across the board? Where would the suddenly get the money to do so? Only through an increase in the money supply.
The past five years are a good example: where did people get the money to demand more commodities (oil, gold, silver, copper, etc.), more housing, more stocks, education, health care and more food at the same time so that the prices of all items increased in step? If the money supply had remained constant, consumers would have had to buy less of something (although what I don't know because not much is left) in order to buy more of the items listed above.
2. Historically, late Scholastic Scholars discovered that increases in the supply of gold caused a general price rise over four hundred years ago. The phenomenon was so consistant over centuries that few people doubted it until John Law came along and said it wasn't true.
3. Statistically, regression analysis has proven a cause and effect relationship between increases in the money supply and later rises in the general price level. I know that someone will respond that correlation does not equal causation, but it does if you have theory to back it up and you know how to run the appropriate tests on the regression equation. It has been well established that general rises in price levels, such as those given by the CPI, are preceded by a rise in the supply of money by 12-18 months.
4. The neo-schools explain business cycles by saying that sticky wages/prices prevent the economy from responding to shocks (supply and demand shocks), such as rises in oil prices. But they offer no explanation for the cause of the shocks, nor any for the wide-spread failure of businesses in capital intensive industries just before a recession/depression. Theirs is less a theory of how economies work than a simple statement that shocks happen and prices/wages don't adjust. The Austrian Business Cycle Theory explains so much more: Artificial credit expansion causes a large number of business people to make poor decisions at the same time due to artificially low interest rates, giving rise to a boom followed by a bust when they realize their poor decisions.
5. The neo-schools teach that demand for consumer goods drives economies; Austrians teach that savings drives economies by making funds available to businessmen to hire laborers. Demand for products does not equal demand for labor is an old econ principle. Keynes made fun of it so people ignored it, but he never refuted it and it's still valid.
How do neo-Keynesian and neo-Classical economists respond to the evidence above? They don't. They simply ignore it and continue talking about shocks and sticky wages and sticky prices.
Published: June 17, 2007 12:24 AM
Björn Lundahl
Dennis
”To think that real wealth can be created by increasing the quantity of the medium of exchange is one of the most widely believed and pernicious fallacies in all of economics.”
Yes true, it is totally erroneous.
Björn
Published: June 17, 2007 1:10 AM
Björn Lundahl
Economists like Friedman, I believe, can change their proposals nearly as they seem fit and as long as they “work” to please public opinion. If a “solution” doesn’t “sell” they compose another “solution” and everything is fine. Austrian economists on the other hand are much more bound of true principles and must rigorously defend them or else they are not any Austrian economists any more.
Björn Lundahl
Published: June 17, 2007 9:16 AM
Clayton
"1. Without an increase in the money supply, no mechanism exists to cause a general rise in the price level. The neo-schools talk about shocks causing price inflation, and they give the rapid rise of oil prices in the 1970's as an example. But logically, if the money supply is constant and a shock occurs in one or two products, then people will spend more for those higher priced products, and leaving them less to spend on other products. As a result, the prices of other products will fall and cancel out the effects of the higher priced products and no net increase in prices would happen. What could cause people to demand more of most products across the board? Where would the suddenly get the money to do so? Only through an increase in the money supply."
... and some other quotes I won't repeat
"Ostentation services" is the value of gold jewelry. Ostentation (from answers.com): "Pretentious display meant to impress others; boastful showiness." If gold is being used in money then its services are shoe-leather services (or other forms of efficiency) vis a vis a barter system. This value or these services justifies taking gold from its ostentation or industrial uses and placing it in services as money. While there are many examples of transaction efficiences offered by money, I've typically heard them referenced as "shoe-leather" as a way of categorically capturing the real savings (in valuable time) experienced by the economic participants.
To your direct question about prices changes w/o changes in the quantity of money:
Greater levels of exchange in the economy can increase the amount of shoe-leather services that money can potentially produce. If the quantity of money is fixed, this would increase the per-unit services generated by money (and thus the value of money). Other schools speak of an increase in the demand for money that increases its value. I'm indifferent to your phrasing as I believe the two approaches can be relatively easily equated.
Using a simple example, imagine everyone in the world wants to hold $100 in cash in their pocket to optimize their trading costs and that there is just enough cash in the economy to allow this to happen. Now, we double the number of poeple in society without touching the money supply. Each person can no longer keep $100 in their pocket because there isn't enough cash to go around. The best they can do is to go to the bank more often, taking $50 out each time, but this generates additional shoe-leather costs (losses in efficiency due to the incremental and suboptimal travel time now being invested). If, instead, the purchasing power of the unit of money were to double, they could each maintain the same real value in their pockets (albeit now $50 nominal) and obtain the same reduction in shoe-leather costs (what I call shoe-leather services).
Naturally, the reverse is possible. While it would seem unlikely in the current world of increasing population and increasing transaction quantities, the ability to make payments on credit cards could, if it occured fast enough, generate the opposite effect by reducing the shoe-leather services of cash and thus the "demand for money".
Further, if you assume that the shoe-leather services are present services (or more accurately a perpetual stream of services) and that money is valued as a discounted stream of these services, a fall in the interest rate would increase the value of money (thus decreasing prices). An increase in the interest rate would decrease the discounted value of these services, decrease the value of money, and increase prices. This is exactly what happens to bond prices (imagine if one bond was the unit of account instead of $1). Again, the aforementioned type of behavior without changing the quantity of money.
Published: June 17, 2007 11:47 AM
Clayton
"4. The neo-schools explain business cycles by saying that sticky wages/prices prevent the economy from responding to shocks (supply and demand shocks), such as rises in oil prices. But they offer no explanation for the cause of the shocks, nor any for the wide-spread failure of businesses in capital intensive industries just before a recession/depression. Theirs is less a theory of how economies work than a simple statement that shocks happen and prices/wages don't adjust. The Austrian Business Cycle Theory explains so much more: Artificial credit expansion causes a large number of business people to make poor decisions at the same time due to artificially low interest rates, giving rise to a boom followed by a bust when they realize their poor decisions."
Assuming that you've read my previous post, I have identified several reasons why the price of money (at least based on how I have defined money) would change, including changes in the natural rate and changes in real factors influencing the aggregate demand for money (supply aside, but equally true when supply is not fixed).
Now we have "shocks" or changes in the price of money that would need to instantaneously clear to cause no distortion or misallocation. If you accept that any sort of stickiness exists, you can get yourself into a "neo" framework where you recognize that misallocation will occur. If you then pull the Austrian understanding of misallocation back into the "neo" framework, you get the predictable capital intensifying (or de-intensifying) that is predicted by Austrian models and seen in reality.
I'm not trying to create a branch of economics... I think that the current branches can be unified in the perspective that I advocate. The "neo" school understands how and why misallocation occurs -- focusing on the anticipation and recognition of shifts in "prices", both goods prices and interest rates. The Austrian school then closes the loop on the implications of misallocation and vastly improves our undestanding of what to watch as an indicator of misallocation (versus the typical "neo" CPI). Of course, both schools have to give up some of their frameworks, but the merger explains the behavior normally cited by both sides of the argument.
Published: June 17, 2007 11:56 AM
Clayton
I realized my statement was going to seem counter-intuitive if I didn't clairfy:
"An increase in the interest rate would decrease the discounted value of these services, decrease the value of money, and increase prices. This is exactly what happens to bond prices (imagine if one bond was the unit of account instead of $1). Again, the aforementioned type of behavior without changing the quantity of money."
In this statement I refer to changes in the natural rate not changes in the rate of interest on money. Of course the opposite effect happens when the interest rate on money changes (while the natural rate remains fixed).
Published: June 17, 2007 12:00 PM
RogerM
Clayton: "I think that the current branches can be unified in the perspective that I advocate."
I didn't realize that was what you were attempting. I strongly doubt that's possible. Neo-Keynesian and neo-Classical are very close and can easily be reconciled, but Austrian econ is virtually the opposite of the other two in just about every regard. You're going to have to do a lot of damage to all three in order to achieve some kind of synthesis. But good luck!
Published: June 17, 2007 9:17 PM
Björn Lundahl
Apart from wages I do not consider “sticky pricing” as any problem at all in a free market economy.
Labour unions privileges should be removed and the “philosophy” that it is wrong to cut wages when it is needed should be fought.
Economists generally do not have a definition of what a free market economy is (definition of property rights) and very often criticise the market economy when they really should instead criticise the government and its regulations.
Free trade and deregulations should also increase competition.
Björn Lundahl
Published: June 18, 2007 2:55 AM
Björn Lundahl
I will post this again:
If the money supply does not increase at all and the purchasing power of money increases about 2% yearly, aggregate demand will be no more or less than if, for example, the money supply increases to support that the purchasing power of money decreases about 2% yearly.
To increase aggregate demand by increasing the money supply is only an illusion.
In a 100 % gold reserve money standard prices would also be less “sticky” than they are today as the implementation of such monetary reforms would probably simultaneously be made with other free market reforms.
I do not consider a fiat monetary system as an alternative to a 100% gold reserve money standard as it is derived and based on fraud. Theft and fraud are destructive actions and are not voluntarily taken and are therefore not market oriented but its opposite that is anti market actions. The free market is the only objective guidance that exists to tell if activities are productive or not. There is no other guidance, in other words, than profit or loss. Other considerations are totally arbitrarily made.
If we want to know if a fiat monetary system is “productive” or not we would need a pure free market to find out whether such a “system” would evolve.
Anyone could, though, a priori understand that such a “system” could never evolve in a pure free market.
A 100% gold money reserve standard would also hinder the government to increase the supply of money as they cannot print gold. Fiat money can be printed at nearly no costs and a monetary framework a la Milton Friedman can be changed. The imposition of costs, in other words, is the most effective way to stop the government from increasing the money supply.
Mises quiz:
http://mises.org/quiz.asp
Björn Lundahl
Published: June 18, 2007 6:29 AM
Björn Lundahl
Well, I found here some support for my views by Murray Rothbard.
The Case for the 100 Percent Gold Dollar:
“In this monetary system emerging on the free market, no one can create money out of thin air to acquire resources from the producers. Money can only be obtained by purchasing it with one’s goods or services. The only exception to this rule is gold miners, who can produce new money. But they must invest resources in finding, mining, and transporting an especially scarce commodity. Furthermore, gold miners are productively adding to the world’s stock of gold for non-monetary uses as well.
Let us indeed assume that gold has been selected as the general medium of exchange by the market, and that the unit of account is the gold gram. What will be the consequences of complete monetary freedom for each individual? What of the freedom of the individual to print his own money, which we have seen to be so disastrous in our age of fiat paper? First, let us remember that the gold gram is the monetary unit, and that such debasing names as “dollar,” “franc,” and “mark” do not exist and have never existed. Suppose that I decided to abandon the slow, difficult process of producing services for money, or of mining money, and instead decided to print my own? What would I print? I might manufacture a paper ticket, and print upon it “10 Rothbards.” I could then proclaim the ticket as “money,” and enter a store to purchase groceries with my embossed Rothbards. In the purely free market which I advocate, I or anyone else would have a perfect right to do this. And what would be the inevitable consequence? Obviously, that no one would pay attention to the Rothbards, which would be properly treated as an arrogant joke. The same would be true of any “Joneses” “Browns,” or paper tickets printed by anyone else. And it should be clear that the problem is not simply that few people have ever heard of me. If General Motors tried to pay its workers in paper tickets entitled “50 GMs,” the tickets would gain as little response. None of these tickets would be money, and none would be considered as anything but valueless, except perhaps a few collectors of curios. And this is why total freedom for everyone to print money would be absolutely harmless in a purely free market: no one would accept these presumptuous tickets.
Why not freely fluctuating exchange rates? Fine, let us have freely fluctuating exchange rates on our completely free market; let the Rothbards and Browns and GMs fluctuate at whatever rate they will exchange for gold or for each other. The trouble is that they would never reach this exalted state because they would never gain acceptance in exchange as moneys at all, and therefore the problem of exchange rates would never arise.
On a really free market, then, there would be freely fluctuating exchange rates, but only between genuine commodity moneys, since the paper-name moneys could never gain enough acceptance to enter the field. Specifically, since gold and silver have historically been the leading commodity moneys, gold and silver would probably both be moneys, and would exchange at freely fluctuating rates. Different groups and communities of people would pick one or the other money as their unit of accounting.
Names, therefore, whatever they may be, “Rothbard,” “Jones,” or even “dollar,” could not have arisen as money on the free market. How, then did such names as “dollar” and “peso” originate and emerge in their own right as independent moneys? The answer is that these names invariably originated as names for units of weight of a money commodity, either gold or silver. In short, they began not as pure names, but as names of units of weight of particular money commodities. In the British pound sterling we have a particularly striking example of a weight derivative, for the British pound was originally just that: a pound of silver money. “Dollar” began as the generally applied name of an ounce weight of silver coined in the sixteenth century by a Bohemian, Count Schlick, who lived in Joachimsthal, and the name of his highly reputed coins became “Joachimsthalers,” or simply “thalers” or “dollars.” And even after a lengthy process of debasement, alteration, and manipulation of these weights until they more and more became separated names, they still remained names of units of weight of specie until, in the United States, we went off the gold standard in 1933. In short, it is incorrect to say that, before 1933, the price of gold was fixed in terms of dollars.
Instead, what happened was that the dollar was defined as a unit of weight, approximately 1/20 of an ounce of gold. It is not that the dollar was set equal to a certain weight of gold; it was that weight, just as any unit of weight, as, for example, one pound of copper is 16 ounces of copper, and is not simply and arbitrarily “set equal” to 16 ounces by some individual or agency. The monetary unit was, therefore, always a unit of weight of a money commodity, and the names that we know now as independent moneys were names of these units of weight.”
http://mises.org/daily/1829
Björn Lundahl
Published: June 18, 2007 4:11 PM
Björn Lundahl
Inflation targeting is not 100 percent depression proof
If for instance the demand for money, under a regime of inflation targeting, strongly and suddenly decreases, the purchasing power of money would also powerfully decrease (inflation would sharply increase), and the central bank would then try to offset this by even bringing the increases of the money supply to a halt and the rate of interest would therefore reach enormously heights and all malinvestments would be liquidated (depression phase).
The central bank might then learn that something else is causing the business cycle than “aggregate demand”. But this might not be so as central bankers during the phenomenon of stagflation through the 70s did not learn anything.
Björn Lundahl
Published: June 18, 2007 6:07 PM
RogerM
Bjorn: "Apart from wages I do not consider “sticky pricing” as any problem at all in a free market economy."
You're right. Neo-Keynesians and neo-Classics had to come up with some reason for business cycles, so they invented the sticky prices/wages idea. According to the neos, shock happen, like acts of God with no explanation. Prices and wages should adjust and eliminate the effects of the shocks but they don't. Therefore the rationale for sticky wages/prices. Of course, with banks manipulating the money, there would be no "shocks" and therefore no need for price/wage adjustments.
The Neo's absolutely refuse under any circumstances to even consider the notion that fractional reserve banking might be a problem. But we're making progress. Some of the economists at the Fed Reserve of San Francisco write as if they're at least familiar with the ABCT. Also, I read recently that the head of the Euro central bank stated that it's ridiculous to think that money has no effects on the real economy.
Here's an interesting quote from Hayek in The Fatal Conceit:
"Money, the ver 'coin' of ordinary interaction, is hence of all things the least understood and - perhaps with sex - the object of greatest unreasoning fantasy; and like sex it simultaneously fascinates, puzzles and repels. The literature treating it is probably greater than that devoted to any other single subject; and browsing through it inclines one to sympathize with the writer who long ago declared that no other subject, not even love, has driven more men to madness. 'The love of money', the Bible declares, 'is the root of all evil' (I Timothy, 6:10). But ambivalence about it is perhaps even more common: money appears as at once the most powerful instrument of freedom and the most sinister tool of oppression. This most widely-accepted medium of exchange conjures up all the unease that people feel towards a process they cannot understand, that they both love and hate, and some of whose effects they desire passionately while detesting others that are inseparable from the first.
"The operation of the money and credit structure has, however, with language and morals, been one of the spontaneous orders most resistant to effort at adequate theoretical explanation, and it remains the object of serious disagreement among specialists."
Published: June 18, 2007 8:33 PM
Björn Lundahl
I wrote:
“Apart from wages I do not consider “sticky pricing” as any problem at all in a free market economy.”
My formulation should have been a little clearer. I will try again:
Apart from wages I do not consider “sticky pricing” as any problem at all and in a truly free market, wages would not either be a problem as labour union privileges and minimum wages laws would be removed. In such an environment the “philosophy” that it is wrong to cut wages when it is needed would also, probably, not exist.
Björn Lundahl
Published: June 19, 2007 1:39 AM
Björn Lundahl
So my conclusion is that inflation targeting will and has produced a greater economic stability compared to none targeting as during the 70s. As long as the demand for money is relatively stable, the growth rate of the money supply will also be fairly stable and malinvestments will to a certain degree be maintained. The relative stability is, in other words, sustained because of a relative stable growth of the money supply and not because of the inflation target of about 2 percent. Let us hope that the demand for money in the future also will be quite stable.
Inflation targeting is therefore a very bad substitute for a 100 percent gold money reserve standard as it causes misallocations and will not be a true guarantee against economic bubbles. The economy will not either be depression proof. I think it is “fair” to say and believe that depressions won’t be probable as the demand for money will not decrease in a manner that I have already mentioned as at least possible and which could and should, under a regime of inflation targeting, be counteracted by even bringing the growth of the money supply to a halt. But you cannot be 100 percent sure of it.
To bring the growth rate of the money supply to a halt is only a good thing if the ambitions of the central banks are to, once and for all, liquidate all malinvestments but will not be a good thing if the ambitions are not those and would the growth rate of the money supply be brought to a halt under a regime of inflation targeting, central banks would probably abandon inflation targeting when the depression starts and begin to inflate again, believing that something is inherently wrong with the free market economy and that their actions are needed for these “special circumstances”. As a “secondary policy”, central banks are also, under a regime of inflation targeting, obliged to ”keep an eye on” unemployment and the growth rate of the GNP and as those variables would react in a not wishful manner because of the fact that the money supply is not growing, they are obliged to inflate again.
Björn Lundahl
Published: June 19, 2007 6:59 AM
Björn Lundahl
RogerM
Let us hope that the world will change and that other economists will listen to the Austrian school of Economics.
Things can change. You and I have witnessed the great impact, for example, Friedman’s ideas have today compared to what they had 20 to 30 years ago. Quite a change!
Björn
Published: June 19, 2007 5:26 PM