Thomas Paine on Paper Money
Paper, considered as a material whereof to make money, has none of the requisite qualities in it. It is too plentiful, and too easily come at. It can be had anywhere, and for a trifle....Paper money appears at first sight to be a great saving, or rather that it costs nothing; but it is the dearest money there is.
The only proper use for paper, in the room of money, is to write promissory notes and obligations of payment in specie upon. A piece of paper, thus written and signed, is worth the sum it is given for, if the person who gives it is able to pay it, because in this case, the law will oblige him. But if he is worth nothing, the paper note is worth nothing. The value, therefore, of such a note, is not in the note itself, for that is but paper and promise, but in the man who is obliged to redeem it with gold or silver. FULL ARTICLE
Comments (57)
Paine didn't understand paper money. Ben Franklin did, and you can google "Ben Franklin paper money" to see what Franklin knew that Paine didn't. If Paine was willing to admit that it's OK for a bank to accept 1 oz of gold and issue a paper receipt for it, then it's also OK to issue more paper receipts in exchange for miscellaneous assets that can sell on the market for 1 ounce. As long as banker and depositor both agree to it and understand it, it would be unlibertarian for the government to prohibit it.
Published: April 24, 2008 9:12 AM
If the bank had to sell all of its miscellaneous assets simultaneously, would it still be able to get 1oz. of gold for them?
Published: April 24, 2008 9:30 AM
I agree with Mike. If I want to give a Christian Scientist $100,000 dollars to treat my cancer, certainly I should be allowed to. The ignorant should not be saved from themselves, that's one of the biggest problems with government do-gooders. As long as banks are allowed to fail, I don't care if they accept horse manure and call it a gold nugget.
Published: April 24, 2008 9:36 AM
Mike Sproul,
While I do agree that a libertarian society would allow such a bank to exist, I think your argument founders with readers here because of one key point: what fool would do business with such a bank?
Published: April 24, 2008 9:38 AM
"Who would do business with such a bank?"
This is the essence of Paine's other point in this text, that _tender laws_ are themselves evil, even if it has nothing to do with paper.
Gold and silver were used world-wide for money not because people haven't used other things, but because gold and silver turned out to be the most reliable and least susceptible to abuse.
What always surprises me about people who decry "gold bugs" is how they can ignore 10,000 years of experience.
Published: April 24, 2008 9:49 AM
OK, now, this may be off target.
And I apologize if I am.
Paper money back then meant "paper".
Apparently from both Tom Paine and the German farmer's descriptions.
Am I right?
This wasn't about fiat money.
It is spoken of here in terms of how long a piece of paper lasts.
And how nefarious peoples can scare the government into printing more, then less, casting all types of economic disruptons and injustices on the unwary populus.
Really, my question today is in terms of relevance.
I am much more interested in whether the government should be issuing all money, especially new money, versus private banks, than I am in whether that government-issued, or private-bank(FED) -issued currency is in the form of paper(trust) versus mineral backing.
I see the mineral-backing as a non-starter.
Why use it?
Today we primarily rely on the workings under the Basel Accords to systematically adjust the value inter-relationships among currencies.
And I fail to see how the mineral-backing would have had any effect on the run-up of the money-supply that we are just beginning to pay for.
So, what's the point?
And, then, having said that, I think I am a believer in the government issuing the nation's money.
A la Franklin, Jefferson, Madison, Lincoln and a horde of others.
So, why not?
Why not do it like this?
http://www.neweconomics.org/gen/uploads/CreatingNewMoney.pdf
And what does it matter if it is trust-based or mineral-based, as long as it is tightly-controlled and serves the economic good of the country?
Thanks for listening.
Published: April 24, 2008 10:06 AM
Sorry, joebhed, but if you go back and read the article again you'll see that he does talk about laws which declare low-value things as high-value money: "fiat" currency.
Published: April 24, 2008 10:15 AM
PR:
"If the bank had to sell all of its miscellaneous assets simultaneously, would it still be able to get 1oz. of gold for them?"
A smart banker wouldn't promise that his "dollars" are always redeemable for 1 ounce of gold. He just has to promise that his dollars will be redeemable for gold 99.99% of the time, except when he becomes insolvent, and then the dollars will be a claim to whatever assets he has left. Customers who keep their gold in their mattress will probably only be able to retrieve their gold 99.98% of the time, what with robbery, fires, floods, etc., so they would accept the bank's offer, especially if the bank pays interest.
Scott D:
"what fool would do business with such a bank?"
The kind of fool who wants to earn interest on his money, and who thinks a bank is safer than a matttress
Joebhed:
"And what does it matter if it is trust-based or mineral-based, as long as it is tightly-controlled "
Trust-based (fiat) money is actually backed by the assets of the institution that issued it. The US dollar, for example, is backed by the Fed's gold and bonds. The dollar is not physically convertible (The Fed will not buy back its dollars for gold), but the dollar is financially convertible (The fed will buy back its dollars with bonds.). Fiat money, if it existed, would give a free lunch to its issuer, so people who believe that there's no such thing as a free lunch should ask themselves if there is any such thing as fiat money.
Published: April 24, 2008 11:10 AM
"And what does it matter if it is trust-based or mineral-based, as long as it is tightly-controlled and serves the economic good of the country?"
What serves the economic good is the accumulation of capital. Once something has evolved as money, there is no benefit in increasing the amount.Please explain why increasing the number of paper claims against an existing amount
of wealth will raise our standard of living.
The use of gold as money does not offer any barrier at all to capital accumulation and a rising standard of living, and this is true even if the supply
of gold stayed constant or even fell.
Paper money and central banks were created by a small number of people who perceived correctly that
they could have more out of life than they had earned if gold was demonetized.
The problem with paper money backed by tangibles
is that it would soon fade away on its own, no legal prohibition is necessary. Buyers might offer to pay, but sellers would refuse in favor of gold.Economic goods have declining marginal value in a growing economy, making it impossible for anyone to calculate the correct amount of new money to issue on the basis of increased production.Prices would tend to become less and less meaningful if the use of this type of currency was officially mandated.
The malinvestment currently being revealed reflects
just this.
Published: April 24, 2008 11:36 AM
Then why would a smart depositor use such a bank when another bank that held only gold could make such a promise? It may not be able to keep its promise in case of robbery, floods, etc., but that's equally true of the first bank. The first bank simply carries an extra risk of default if the value of its other assets falls. So, to use your numbers, the comparison isn't 99.99% vs. 99.98%; it's 99.98% * 99.99% vs. 99.98%.
As far as earning interest, neither bank can do that unless they make loans, which always carry a risk of default separate from anything else. This would add a factor of, say, 99.97% to both sides, which doesn't affect the comparison. Counting the loans themselves as backing doesn't avoid the problem because then you have to adjust the 99.99% value down to reflect the increased risk.
Published: April 24, 2008 12:03 PM
Tom Paine was right, if carefully read he talks about honesty in transactions, it's a matter of ethics.
Governments presently reserve the right to counterfeit,
by law, they are able to place any number on a piece
of paper and call it money, John Q. Public doing the same would be jailed and rightly so.
Lets not confuse an IOU with the real thing.
The public has been conditioned for many years into accepting the present system, however sooner or later ALL paper money becomes worthless as long as governments have the power to counterfeit.
Zimbabwe is the latest example.
Published: April 24, 2008 2:15 PM
To Mike Sproul,
Thanks, but I am still not sure I understand the answer. It’s probably in the definitions. And, my density. If I have this right .......
On the one hand, “Fiat money, if it existed, would give a free lunch to its issuer,”
On the other hand, “Trust-based (fiat) money is actually backed by the assets of the institution that issued it. The US dollar, for example, is backed by the Fed's …….will(ingness to) buy back its dollars with bonds.”
With bonds? How many dollars are out there in the world to be redeemed, and how many $bonds$ does the government hold? Isn’t it true that the only option available to the government, in redeeming and therefore providing any semblance of backing to the US dollar, is the issue of more dollar-denominated debts payable by the taxpayers?
And that in borrowing those dollars the debt-service costs actually payable to the HOLDER of the bond will be triple the nominal amount of the bonds issued?
And, that Debt Service Cost is payable in dollars?
Redeemable in bonds that the government doesn't have, but for which it can put the taxpayer further on the hook?
Et cetera?
The taxpayer?
Who have no redress to the invisible hand, nor the seats of monied corporatocracy.
Is this the system that is supposed to be providing the confidence to the rest of the world that the United States dollar is a good “coin of the realm”? Not that its diferent elsewhere. It’s just that I’m one of those taxpayers.
I know I probably have this wrong.
Published: April 24, 2008 2:33 PM
A smart banker wouldn't promise that his "dollars" are always redeemable for 1 ounce of gold. He just has to promise that his dollars will be redeemable for gold 99.99% of the time, except when he becomes insolvent, and then the dollars will be a claim to whatever assets he has left. Customers who keep their gold in their mattress will probably only be able to retrieve their gold 99.98% of the time, what with robbery, fires, floods, etc., so they would accept the bank's offer, especially if the bank pays interest.
Or, the bank could have a multi-billionaire insure the bank's solvency. For example, suppose the bank has liabilities of $20 billion. They could ask a filthy-rich guy to insure the bank against insolvency. They would pay him $500 million each year and allow him to audit their assets and liabilities. In return, he would be responsible to pay the bank's depositors if the bank went belly-up, and he would have his face printed on the paper dollars so people would know that he guarantees the currency.
There are so many options with the free market.
Published: April 24, 2008 3:13 PM
"he would have his face printed on the paper dollars so people would know that he guarantees the currency."
Bill Gates would so totally do that.
Published: April 24, 2008 5:19 PM
Thomas Paine understood neither paper money nor metallic money.
In both cases he argued that the value was a direct relationship with the quantity of it, rather than appealing to the fundamentals of supply and demand (in the case of metallic money), of the principals of valuation of financial assets (in the case of promissory notes).
Although he was right to object to legal tender laws that made bank notes or government paper a legal tender, he was not right in his analysis of the economics of money.
Published: April 24, 2008 6:04 PM
PR:
"why would a smart depositor use such a bank when another bank that held only gold could make such a promise?"
Banks that hold only gold earn no interest and so they pay no interest. In fact, they charge storage fees. They are also more vulnerable to robbery/fire/flood that a fractional reserve bank. That's why 100% reserve banks pretty much died out with the Bank of Amsterdam.
Matt:
"Governments presently reserve the right to counterfeit, by law, they are able to place any number on a piece of paper and call it money"
The Federal reserve is not a counterfeiter. Every dollar it issues is sold in exchange for a dollar's worth of bonds or other securities, and the Fed stands ready to use those bonds to buy back the dollars it has issued. No counterfeiter does that. The Fed's method of issuing money also assures that if the money supply rises 10%, then the Fed's assets, which back that money, also rise by 10%. As long as the quantity of money moves in step with its backing, there will be no inflation.
Joebhed:
My point was that there is no such thing as fiat money. The people who say the US dollar is fiat money are mistaken. The dollar is not physically convertible, meaning that the Fed won't buy back its dollars with gold, but the dollar is financially convertible, meaning that the Fed will buy back its dollars with bonds.
"How many dollars are out there in the world to be redeemed, and how many $bonds$ does the government hold? Isn’t it true that the only option available to the government, in redeeming and therefore providing any semblance of backing to the US dollar, is the issue of more dollar-denominated debts payable by the taxpayers?"
Check the Fed's balance sheet. I remember about $200 billion worth of gold and $700B in bonds, as backing for about $750B in paper dollars. The Fed could, if need be, sell $700B of bonds and $50B of gold, and retire all the paper dollars it ever issued. Remember that those dollars were issued in exchange for bonds in the first place, so they can be retired with those same bonds.
Published: April 24, 2008 7:36 PM
Mike,
You're "pushing shit uphill" arguing that a) the USD is not a fiat currency and b) the Fed could redeem all its notes.
The definition of a fiat currency is a money that is current (i.e. legal tender) by force of government fiat law, i.e. what would not otherwise be considered a good discharge is now a good discharge. As a result of this, the gold value of the USD has been reduced to about 2% of its former value. This is not a result of banking operations or the issue of the notes, but as a result of loss of metallic convertibility. The financial convertibility has enabled it to retain 2% of its value -- metallic convertibility would enable it to retain the other 98% as well.
The Fed could (and should) only restore metallic convertibility only at its current market price in terms of gold e.g. about 3 milligrams of gold per USD. The British experience of returning to the former gold value was difficult enough, but that would be nothing compared to revaluing the USD by 4800%.
Published: April 24, 2008 8:52 PM
Trust-based (fiat) money is actually backed by the assets of the institution that issued it. The US dollar, for example, is backed by the Fed's gold and bonds
The Fed doesn't have any gold. The treasury dept. has the gold (maybe, if it hasn't all been "loaned" out). Greenspan, when he was chairman, said the Fed doesn't have a single ounce of gold. Why do you keep saying the Fed has gold?
Published: April 25, 2008 2:17 AM
The Federal reserve is not a counterfeiter. Every dollar it issues is sold in exchange for a dollar's worth of bonds or other securities, and the Fed stands ready to use those bonds to buy back the dollars it has issued. No counterfeiter does that.
Well, hell, I'll do that! If the bond markets would accept PeteBucks, I'll gladly print up PeteBucks to sell for bonds, and "stand ready to use those bonds to buy back the PeteBucks I have issued". Acceptable? A boon to the economy?
Published: April 25, 2008 2:24 AM
"The kind of fool who wants to earn interest on his money, and who thinks a bank is safer than a matttress"
This is not really accurate. In a %100 reserve bank people can earn interest. When they give up ownership of the money for a certain time, that is.
Also people can keep their money safe in a 100% reserve bank, by paying the service charge.
But there would be people who would put money in a fractional reserve bank.
Those people are people, who wants to keep the ownership of money AND earn interest.
Since this situation is analoqous to eating your cake and still having it, thus not based on reality it is not sustainable. The bank would evetually fail, and the people who enjoyed eating their cakes and still have it will realize they have nothing left.
Published: April 25, 2008 2:46 AM
ktibuk:
People who hold bank notes or current account balances with a bank have a claim on the bank for repayment, i.e. they have loaned money to the bank, and can demand repayment (on demand).
This is similar to a person holding a marketable security that they can sell when they want to spend that wealth or convert it into another form. For example if I hold commercial paper, I don't have to wait any particular period of time or a loan period, before I consume that wealth or convert it into another form: I can just sell it for money and use the money to get something else. (Perhaps a more realistic or useful example would be a unit trust (similar to a mutual fund) that enabled investors to deposit cheques or cash to be invested in the assets of the unit trust, and that enabled unit holders to redeem units by drawing cheques (or negotiable redemption orders) on the unit trust.)
Thus these two methods can achieve the same result in different ways: way 1 is via issue and redemption of securities, way 2 is via purchase and sale of securities.
If you restrict fractional reserve banking then people can design analogous bearer and registered securities to replace bank notes and cheque accounts. For example, a unit trust could be constituted to issue three classes of units: senior units in registered form (i.e. book entries) that participate in the earnings of the trust assets to an interest rate that can be varied from time to time to track the market interest rate, senior units in bearer form that d not participate in the earnings of the trust assets, and finally junior units that are issued and redeemed at Net Asset Value and participate in the residual earnings of the trust assets. The unit trust could then offer its units through a branch network and offer access to senior registered units via negotiable orders of redemption (a substitute to the cheque), and it could also accept cheques (and other negotiable instruments for collection as agent with the proceeds credited in senior registered units to the unitholder's account. Thus the key banking instruments and technology (bank notes, cheques) can be replicated with forms that are commercially similar to fractional reserve banking but are legally structured to be units in a unit trust.
In regular fractional reserve banking customers and note holders of the bank give up title to money they deposit in exchange for a claim on the bank. The claim on the bank can then be transferred by negotiation (in the case of bank notes), redeemed when desired (via presentation of the bank note for payment or demanding payment of amounts owed on current account), or transferred (via drawing a cheque).
If you understand banking transactions and business correctly and analytically, you'll find nothing objectionable about unrestricted fractional reserve banking.
Published: April 25, 2008 4:40 AM
I addressed both of these points in my previous post. If you disagree, please explain why.
Published: April 25, 2008 8:19 AM
A "receipt" is not money and any effort to pretend that it is money is fraud (Murry Rothbard was right about that).
Of course any bank (indeed any person) should be allowed to issue bits of paper (or computer numbers, which is what most credit money is these days) as long as it is open that there is nothing in the faults for which these bits of paper are the "receipts" (and NO one ouce of gold for every receipt for one hundred ounces does not count as a receipt - it is one for one or it is a shell game). But then "who indeed would deal with such a bank".
In the end the game always leads to demands for government bail outs and for demands that banks be "protected" from having to live up to their contracts.
Money evolved over time (see Carl Menger "Principles of Economics") it was not the invention of government. And nor can any powerful man maintain its value by an act of will (see the inflation on both sides during the Civil War).
A pet irritation of mine "backing".
The gold (or the silver or whatever commodity people have AGREED TO USE IN THE CONTRACT THEY HAVE MADE) is the money - it is not "backing" for the money.
This is the danger of notes (or computer numbers) people confuse the receipts for the money with money itself.
Sadly one of the first acts of the French Revolutionary regime that Tom Paine supported was to issue fiat (i.e. order - command) money. The Assignats (December 21st 1789) supposedly "backed" by land that the regime had stolen from the Roman Catholic Church.
Have a look at the history of those Assignats sometime.
Published: April 25, 2008 8:58 AM
David Hillary says:
People who hold bank notes or current account balances with a bank have a claim on the bank for repayment, i.e. they have loaned money to the bank, and can demand repayment (on demand).
This is similar to a person holding a marketable security that they can sell when they want to spend that wealth or convert it into another form.
--------
The difference is simply this: when I buy a marketable security, I use existing money. When the bank buys it, it very likely creates new money.
You might say: "So what? The bank's notes and deposits are backed as well as before. It is not much different from the bank issuing a new banknote in order to buy more gold."
The benefit to the bank is obvious. If I buy the security, I have to borrow money for the purpose, or if I buy it out of my existing savings then I forego the interest that I would have earned. If the bank buys the security out of new money, then it need borrow nothing: it is awarding itself an interest-free loan for the purpose.
The problem with this transaction is that it reduces the bank's demand for borrowing. It reduces its reliance on (for example) time-deposits to finance its lending and its purchase of credit-instruments, and hence it depresses the price (i.e. the amount of interest) which the bank is willing to pay for time-deposits. In short, large-scale debt-monetization depresses interest-rates.
The depressed interest-rate both increases the market-demand for loans and decreases the supply of deposits. In a normal market this would apply upward pressure to interest-rates until they reach equilibrium, but in a market distorted by debt-monetization the bank is likely to misinterpret the extra demand for loans as the "normal" requirements of a booming economy. The bank therefore intensifes its debt-monetization, thus opening up an even wider gap between the depressed interest-rate and the rate which is now required to reconcile the increasing demand for loans with the diminishing supply of deposits.
Of course, this process cannot continue indefinitely, even if propped up as it has been by central banks and governemnts. Either the pool of real savings will be exhausted, or the bank will run out of reserves. Debt-monetization will be suspended, the market rate of interest will be catapulted upwards until the pool of real savings is replenished, and the market value of the debt-component of the bank-money's asset-backing will plummet.
I am not against free banking, because I believe that free banking will check credit expansion long before it reaches a critical stage. I agree that even if a ban is attempted, bankers could find loopholes to circumvent it, just as chain letters still seem to rear their head even though they are illegal.
Published: April 25, 2008 10:41 AM
David Hillary:
"The definition of a fiat currency is a money that is current (i.e. legal tender) by force of government fiat law, i.e. what would not otherwise be considered a good discharge is now a good discharge."
A government declaration cannot give value to paper money unless the government has something to back it up. That "something" could be the government's ability to pay out gold, or to take away gold (e.g., as taxes). But if the government has no such ability, its paper money will have no value. That's why it's best to define fiat money as money that has no backing. A government that has no power can issue all the declarations it wants, and its money will have no value. A government with power can declare something to be money, and that money is then backed by the government's power. But it's the power, not the declaration, that really backs the money and gives it value.
Given this definition, money that is backed (by gold, bonds, tax-collecting ability, etc) will have value. Money that is not backed (i.e., fiat money) will have no value--even if a (powerless) government declares it to have value. Thus, there is no such thing as fiat money.
"As a result of this, the gold value of the USD has been reduced to about 2% of its former value. This is not a result of banking operations or the issue of the notes, but as a result of loss of metallic convertibility."
Here again, it's backing that matters, not convertibility. If a bank backs each of its dollars with 1/2 ounce of assets, then those dollars will be worth 1/2 oz. If the bank tries to maintain convertibility at 1 ounce, then dollar-holders will run on the bank, the bank will lose its assets, and the last few dollars in private hands will lose all their value. So the loss of value of the US dollar is a result of loss of backing. (It is also possible that the Fed has simply chosen to maintain (financial) convertibility at a rate below what its assets could support. In that case the inflation wasn't a result of a loss of assets, but the Fed's simple refusal to use them.)
"The financial convertibility has enabled it to retain 2% of its value -- metallic convertibility would enable it to retain the other 98% as well."
Not if the loss of value resulted from a loss of backing. In that case any attempt to maintain convertibility at the higher level would fail.
"The Fed could (and should) only restore metallic convertibility only at its current market price in terms of gold e.g. about 3 milligrams of gold per USD. The British experience of returning to the former gold value was difficult enough, but that would be nothing compared to revaluing the USD by 4800%."
When I said the Fed could redeem all its notes, I didn't mean at the 1913 rate. I meant at today's rate. That's true on its face. A bank that holds $7B in bonds is obviously capable of selling those bonds for $7B paper dollars and retiring the paper dollars received.
Published: April 25, 2008 10:44 AM
A question for Sproule-Hillary. Do you believe that the money created by fractional reserve banking or by real bills can fund anything?That is, will productivity
be greater than otherwise? And if so, why?
Published: April 25, 2008 1:18 PM
Mikey:
Suppose the only money in some country is 100 paper dollars, backed by 100 ounces of silver held in the issuing bank. In normal times the $100 is sufficient to conduct the business of the country. Then comes the Christmas shopping season. To conduct the extra business with the same ease as before, the country needs $110. The bank can satisfy this extra demand by lending $10 in exchange for an IOU worth $10. The bank's assets rise in step with its liabilities, so there is no inflation, and the country has no trouble conducting the extra business of the Christmas season, because of the extra money. Had the bank been prohibited from issuing the extra $10, then people would have been forced to use some less convenient means of trading, and would suffer a loss that might be equal to $0.50. Thus the availability of fractional reserve banking makes this society richer by $.50. (After Christmas, the bank sells the IOU and retires the $10 plus interest received. If the payment of interest reduces the amount of money below what is desired, the bank can compensate by lending enough money to offset the interest.)
Published: April 25, 2008 2:15 PM
Here is an article that many should read, if not already by the late Hans Sennholz http://www.inflationomics.com/article.php?article=Gold%20is%20Shining%20Again - this article is dated from 2003;
enjoy
Jim B.
Published: April 25, 2008 2:17 PM
Mike: ". In normal times the $100 is sufficient to conduct the business of the country. Then comes the Christmas shopping season. To conduct the extra business with the same ease as before, the country needs $110."
So how did companies produce the extra goods for Christmas that people are going to buy without the additional $10 the bank will create out of thin air at Christmas time? Someone has to produce the goods long before consumers can buy them. In your scenario, that would be impossible. If $100 is not enough to purchase Christmas goods, it’s certainly not enough to produce them in the first place.
In the Austrian scenario, companies produced the extra goods for Christmas with savings from consumers, that is, lowered consumption. Then companies could borrow the savings and produce the Christmas goods. The wages of the extra employees hired to produce the Christmas goods, plus the savings of the rest would be sufficient to purchase Christmas goods. There is no need to counterfeit money in order to have enough of it for Christmas. People naturally save for future purchases, or borrow from those who save extra. As Austrian econ proves, any amount of money will do at any time. There never has been nor ever will be a shortage of money. Although as Payne pointed out, there is no shortage of people who want to spend more than they earn and cheat unwitting sellers by paying with depreciated money. Those people always rant about a shortage of money.
Published: April 25, 2008 2:33 PM
Mike Sproul,
The problem with fiat currency is primarily equitable: i.e. debts contracted can be discharged with lower value (in terms of metal) instruments.
The displacement of good money with bad money, and consequent devaluation of the monetary unit, or price inflation, are consequential to the primary evil of the inequity mentioned above.
Why don't you come out and say whether you favour a metallic standard and metallic convertibility? So far it appears you consider them needless, which appears to make you an endorser of a paper standard of money without legally certain rights to redemption in metal at par.
You complain that the 98% loss of metallic value of the USD is due to lack of use of asset backing rather than lack of asset backing. However, you don't seem to care to give issuers of paper money the legal obligation to redeem their liabilities in metal that would compel them to either use their assets to do so or to default and suffer liquidation.
Contrary to your position, I maintain that BOTH backing AND convertibility are essential and proper to the business of issuing and redeeming securities such as bank notes and current account balances.
Mikey
Yes, paper money and current account balances can, should and do provide funding to productive capital.
The capital stock consists of a) metallic money and b) buildings, plant and equipment, stock-in-trade and other forms. The sum of a) and b) is the total capital stock of society and requires equal social savings in order to finance.
The commerce of a closed economy requires money in order to be transacted. The function of money can be served by a) metallic money and b) issued money (i.e. paper money and cheque account balances with banks).
In a closed economy with no issued money, the commerce of the closed economy must be transacted entirely with metallic money. In a closed economy with a financial and banking sector that issues and redeems bank notes and cheque account balances, the stock of metal can be reduced, and the savings of the closed economy can be re-invested from metallic money into buildings, plant and equipment, stock-in-trade and other forms.
The stock of metallic money can be reduced in a closed economy by a reduction in metal mining efforts, and putting those efforts into the construction of buildings and other forms of capital for some period of time. In the case of an open economy, the metallic money can be exported in exchange for foreign goods or assets.
Adam Smith explains the basis for banking (i.e. the issue of bank notes and cheque account balances) providing more capital for industry quite well:
'It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country. That part of his capital which a dealer is obliged to keep by him unemployed, and in ready money, for answering occasional demands, is so much dead stock, which, so long as it remains in this situation, produces nothing either to him or to his country. The judicious operations of banking enable him to convert this dead stock into active and productive stock; into materials to work upon, into tools to work with, and into provisions and subsistence to work for; into stock which produces something both to himself and to his country. The gold and silver money which circulates in any country, and by means of which the produce of its land and labour is annually circulated and distributed to the proper consumers, is, in the same manner as the ready money of the dealer, all dead stock. It is a very valuable part of the capital of the country, which produces nothing to the country. The judicious operations of banking, by substituting paper in the room of a great part of this gold and silver, enables the country to convert a great part of this dead stock into active and productive stock; into stock which produces something to the country. The gold and silver money which circulates in any country may very properly be compared to a highway, which, while it circulates and carries to market all the grass and corn of the country, produces itself not a single pile of either. The judicious operations of banking, by providing, if I may be allowed so violent a metaphor, a sort of waggon-way through the air, enable the country to convert, as it were, a great part of its highways into good pastures and corn-fields, and thereby to increase very considerably the annual produce of its land and labour.' See http://econlib.org/library/Smith/smWN7.html#B.II,%20Ch.2,%20Of%20Money%20Considered%20as%20a%20particular%20Branch%20of%20the%20General%20Stock%20of%20the%20Society for the full chapter on this.
Published: April 25, 2008 3:34 PM
David Hillary:
Smith also says: "What a bank can with propriety advance to a merchant or undertaker of any kind, is not either the whole capital with which he trades, or even any considerable part of that capital; but that part of it only, which he would otherwise be obliged to keep by him unemployed, and in ready money for answering occasional demands. If the paper money which the bank advances never exceeds this value, it can never exceed the value of the gold and silver, which would necessarily circulate in the country if there was no paper money; it can never exceed the quantity which the circulation of the country can easily absorb and employ."
In other words, the amount that a bank can lend to a merchant is not the net worth of that merchant, but only the amount that the merchant used to keep by him in coins. (!!!) For all Smith's brilliance, he misunderstood paper money.
"The problem with fiat currency is primarily equitable: i.e. debts contracted can be discharged with lower value (in terms of metal) instruments."
That's just the chance that borrowers (and lenders) take in a free society, and that's why interest rates adjust for inflation.
"Why don't you come out and say whether you favour a metallic standard and metallic convertibility? "
I favor letting people hold their money in whichever form they and their banks agree on. The problem with metallic convertibility is that it makes banks vulnerable to bank runs. Banks that maintain only financial convertibility are immune to runs. Given the problems bank runs cause, I don't see the advantage of maintaining physical convertibility.
"However, you don't seem to care to give issuers of paper money the legal obligation to redeem their liabilities in metal that would compel them to either use their assets to do so or to default and suffer liquidation."
If the issuers want to subject themselves to such an obligation, they are free to do it. Private banks do exactly this when they issue checking account dollars. Central banks have tried repeatedly to subject themselves to this obligation, but usually a loss of assets makes them unable to perform. Given a choice of liquidating the bank or letting it devalue its money (or suspend convertibility), most governments have chosen devaluation or suspension as the less painful path.
"BOTH backing AND convertibility are essential "
Backing yes, of course. Convertibility? Which kind? Physical or financial? instant or delayed? certain or uncertain? All have been tried and all have worked.
Published: April 25, 2008 4:12 PM
Mike,
Thanks for your frankness in stating that you do not, all things considered, favour metallic (what you call physical) convertibility. You have stated you believe that, all things considered, metallic convertibility raises more problems (bank runs, you think) than is worth the benefit of having it.
Thanks also for your comments supporting as equitable, government interference in debtor-creditor relations. Being an American, I would have thought you would have appreciated how important, historically, the sanctity of contract was to liberty: the US constitution explicitly forbade States from impairing the obligations in contracts and making anything but gold and silver a tender in payment of money debts. These provisions were obviously intended to uphold contracts to pay money were to be discharged, legally, in metal. Furthermore, States were restricted from issuing paper money ('bills of credit'). Yet for you it is quite tolerable, morally and legally, for governments to charter banks or issue paper money directly, make it legal tender, and dishonour it by non-payment (in the legal sense relevant to promissory notes).
Your claim to support free market or libertarian positions can fairly be criticised as being not of full measure and quality, at least concerning government interference in contracts for the payment of money, which incidentally seems to be your main area of interest and comment.
You say you favour letting customers and banks decide on the form and substance of their contracts for the payment of money, but don't have a problem with government intervention to change the terms agreed.
Your position is also at odds with monetary and banking history: under historical free market banking and monetary systems, there were no central banks, and individual private commercial banks maintained their own metallic reserves in their branches and treasuries, and these systems and banks were not suffering from systematic bank runs: failed banks often failed with a run, but there was flight to quality (i.e. to other, sound, banks), rather than to specie. Quality competition between competing issuers of bank notes leads to the highest certainty and quality winning out (price competition doesn't apply to non-interest bearing securities). Competition (price and quality) between competing cheque account banks likewise lead to high quality debtors that paid good interest on balances while providing the access to funds by drawing cheques. There was no move away from convertibility either by customers or banks. By 1844 the legal and commercial status of bank notes was very well established: 'according to practice, according to law, according to the ancient monetary policy of this country, that which is implied by the word "Pound" is a certain definite quantity of gold with a mark upon it to determine its weight and fineness, and that the engagement to pay a Pound means nothing, and can mean nothing else, than the promise to pay to the holder, when he demands it that definite quantity of gold.' Sir Robert Peel, in the House of Commons, 6th May 1844, HANSARD (LXXIV [3d Ser.], 720-54)
So, Adam Smith's understanding of banking had some flaws. Notwithstanding the flaw you've mentioned, his exposition of the advantages gained through banking, the resource movements, the price stability of money, and the manner in which a bank maintains its liquidity are profoundly well developed and articulated. His main flaw seems to be making a wrong connection between the quantity of bank notes there is a demand to hold and the quantity of funds the banks can prudently lend: while he is basically correct that there is a limited demand to hold non-interest bearing bank notes, related to the commerce to be supported, he was basically incorrect that this should be considered the primary source of funding for a bank or the quantum of its lending/investment activity. Today we know that bank notes are just one source of funding, and that banks can and should fund their borrowing needs with a combination of bank notes, cheque account balances, term deposits, commercial paper, bonds and other forms of borrowings, and that they can prudently lend on the security of land, buildings and other assets that do not turn to cash in the short term.
Published: April 25, 2008 5:44 PM
Fallacy: Erroneous definition of "MONEY", and confusion of wealth with money.
Most of Thomas Paine's thinking and writings on Government are superb. However, in this case Paine was a victim of Adam Smith's improper definition of money as precious metals.
For the truth about money, see:
http://www.monetary.org/henrygeorgeconceptofmoney.htm
or
MoneyMasters: http://video.google.com/videoplay?docid=-515319560256183936
Money as Debt: http://video.google.com/videoplay?docid=-9050474362583451279
Web of Debt: http://www.amazon.com/review/product/0979560810/ref=dp_top_cm_cr_acr_txt?%5Fencoding=UTF8&showViewpoints=1
The Lost Science of Money - Mythology & Power:
http://www.amazon.com/review/product/1930748035/ref=dp_top_cm_cr_acr_txt?%5Fencoding=UTF8&showViewpoints=1
Video: America: Freedom to Fascism :
http://www.amazon.com/review/product/1930748035/ref=dp_top_cm_cr_acr_txt?%5Fencoding=UTF8&showViewpoints=1
Carrol Quigley - Tragedy and Hope:
http://www.amazon.com/review/product/094500110X/ref=dp_top_cm_cr_acr_txt?%5Fencoding=UTF8&showViewpoints=1
"All of the perplexities, confusion, and distress in America arises, not from the defects of the Constitution or Confederation, not from want of honor or virtue, so much as from downright ignorance of the nature of coin, credit, and circulation." -- John Adams, Founding Father
"History records that the money changers have used every form of abuse, intrigue, deceit, and violent means possible to maintain their control over governments by controlling money and its issuance." - President James Madison
"You are a den of vipers and thieves and I intend to rout you out, and by the eternal God, I will rout you out. If Congress has the right to issue paper money, it was given them to be used by themselves, and not to be delegated to individuals or corporations.." -- Andrew Jackson's address to Congress 1829
"I believe that banking institutions are more dangerous to our liberties than standing armies." - Thomas Jefferson.
Published: April 25, 2008 6:54 PM
Thanks so much, everyone.
I have been away, and cannot really get caught up here.
I don't know if everyone agrees, because some are more knowledge than others, but the page is very educational and informative, as far as I am concerned.
Seems it might make a good course on Mis-economics.
Likely there are only half a dozen more books to read to actually determine the answers to my earlier questions, which have thankfully gone by the wind.
I think it is now pretty-well settled that there is at least a great degree of misunderstanding, if not disagreement, among the posters with regard to certain monetary functions.
Things have evolved to a certain level of - get to the point, or, "where's the beef?" here.
So, I wanted to be clear.
I do not believe in any of the physical-base requirements for a nation's money.
I think they are unnecessary and pretty much irrelevant. Just my thought.
Having said that, when I speak of money, I do not ONLY speak of that which is minted and redeemable FOR ANYTHING by bringing in a note, I speak of the whole shebang - everything that has ever been issued, and entered into an account as dollar-denominated.
Some may call that wealth or whatever, but I would find the discussion of the "coins" as irrelevant to monetary policy options.
Having said that, I lose all my learned Libertarian friends when I say that I agree with Jefferson and Lincoln with regard to who SHOULD have the power to create nation's money.
Again, that would be the government, acting for the sovereign people.
Regarding the government's creation powers, by my definition, this year, would include whatever increase in the supply of money is needed and useful to properly expand the economy over last year's level.
This is my best, latest example of the legal and structurally-mechanical aspects of that policy.
http://www.neweconomics.org/gen/uploads/CreatingNewMoney.pdf
Here's my only qualifier. While I do think that physical-metallic backing is unnecessary and irrelevant, we experience many other such unnecessary and irrelevant things on a regular basis.
So, if there are those who would insist that the only provision for soundness of the nation's currency is through such a backing, my objection would not be strong. It would more be a concern that the fact of the existence of that backing does not in any way lead to a potential for private manipulation of the money system for that same private gain.
Again, the fiat or mineral backing isue is to me a small part of the monetary policy discussion.
The New Economics Foundation paper is only 107 pages.
Not a book.
Respectfully hoping that we keep the page going...
Published: April 25, 2008 7:57 PM
Mike Sproul quotes Adam Smith as saying:
consequently, the paper money, which they had circulated by his means, had not at any time exceeded the quantity of gold and silver which would have circulated in the country had there been no paper money.
And Smith repeats later:
If the paper money which the bank advances never exceeds this value, it can never exceed the value of the gold and silver, which would necessarily circulate in the country if there was no paper money.
Mike Sproul says:
For all Smith's brilliance, he misunderstood paper money.
David Hillary says:
Adam Smith's understanding of banking had some flaws.
Actually, it shows that Adam Smith understood paper money very well, and he realized the dangers of unconstrained credit expansion. It is not an assertion of 100% reserve banking, but it would be almost as effective.
It is Mike Sproul and David Hillary who misunderstand the dangers of paper money backed by an unlimited quantity of debt.
Published: April 25, 2008 9:08 PM
Mike Sproul says:
The problem with metallic convertibility is that it makes banks vulnerable to bank runs.
It certainly does, for fractional-reserve banks.
If you bank with Sproul, make the most of the interest which he pays on your demand deposits. But don't complain if you end up losing your principal ...
Published: April 25, 2008 9:10 PM
LanceH
So long as the bank notes are payable in coin on demand, any stock of them in excess of demand will return to the issuers thereof for redemption.
For example, if a person wants to hold 10 grams in notes of bank A, and he actually holds 20 grams in notes of bank A -- supposing his retail takings for the day included the unwanted excess of notes --, he will deposit the notes with his banker, who will return them to bank A through the note exchange (or less likely he will take them directly to bank A for redemption). By depositing the notes with his banker, he converts his holding from unwanted notes to funds in his account that pay interest and that he can use to pay suppliers or to invest in other assets or whatever.
A person can control exactly the composition of his portfolio that is made up of bank notes: he need not receive or accept any notes he does not want, and if he does choose to accept them but does not want to hold them, he can bank them and his bank will present them to the bank of issue for payment through the note exchange (the banker too, has a choice to accept and present, or to refuse notes issued by other banks). Thus at no point does a person hold more bank notes than he chooses to. Of course bank notes are primarily in asset portfolios for immediate indirect exchange, for any significant sum or period of time most agents will rather hold interest bearing or profit generating assets rather than non-interest bearing bank notes.
Smith appears to understand that the amount of money people wished to hold was the amount they thought they needed to transact their business or purchases, and that any excess will, in his words, overflow the channel:
'Let us suppose, for example, that the whole circulating money of some particular country amounted, at a particular time, to one million sterling, that sum being then sufficient for circulating the whole annual produce of their land and labour. Let us suppose, too, that some time thereafter, different banks and bankers issued promissory notes, payable to the bearer, to the extent of one million, reserving in their different coffers two hundred thousand pounds for answering occasional demands. There would remain, therefore, in circulation, eight hundred thousand pounds in gold and silver, and a million of bank notes, or eighteen hundred thousand pounds of paper and money together. But the annual produce of the land and labour of the country had before required only one million to circulate and distribute it to its proper consumers, and that annual produce cannot be immediately augmented by those operations of banking. One million, therefore, will be sufficient to circulate it after them. The goods to be bought and sold being precisely the same as before, the same quantity of money will be sufficient for buying and selling them. The channel of circulation, if I may be allowed such an expression, will remain precisely the same as before. One million we have supposed sufficient to fill that channel. Whatever, therefore, is poured into it beyond this sum cannot run in it, but must overflow. One million eight hundred thousand pounds are poured into it. Eight hundred thousand pounds, therefore, must overflow, that sum being over and above what can be employed in the circulation of the country. But though this sum cannot be employed at home, it is too valuable to be allowed to lie idle. It will, therefore, be sent abroad, in order to seek that profitable employment which it cannot find at home. But the paper cannot go abroad; because at a distance from the banks which issue it, and from the country in which payment of it can be exacted by law, it will not be received in common payments. Gold and silver, therefore, to the amount of eight hundred thousand pounds will be sent abroad, and the channel of home circulation will remain filled with a million of paper, instead of the million of those metals which filled it before.'
Smith used a similar analogy for the bank's pool of reserves: if the bank of issue is issuing the amount of its notes that there is a demand to hold, then this pool will not become depleted -- the outflows will be offset by inflows. His discussion is fairly extensive and the point of it is that the bank should be sure to maintain the stability of its reserves by issuing only so much in notes as its experience indicates it will be able to maintain in circulation, and to make sure also its assets are turning to cash fast enough to provide for the bank's liquidity.
Although Smith had some flaws in his banking theory, in the main his analysis and commentary are both correct and illuminating and to be recommended for study.
Published: April 25, 2008 11:51 PM
David Hillary says:
So long as the bank notes are payable in coin on demand, any stock of them in excess of demand will return to the issuers thereof for redemption... For any significant period of time most agents will rather hold interest bearing or profit generating assets rather than non-interest bearing bank notes.
I agree. People prefer to invest any funds in excess of their demand for cash holding.
And I agree also with Adam Smith, as quoted by you, that a country's demand for cash holding is simply the sum of individual demands for cash holding, and that as long as there is unquestioned trust in a banknote it will be considered equal to coin. (I'm less confident that a 20% reserve-ratio would suffice for the long term.)
I agree wholeheartedly that "although Smith had some flaws in his banking theory, in the main his analysis and commentary are both correct and illuminating and to be recommended for study", though we might disagree on the identification of those flaws.
At the same time, I believe that the issue of banknotes or demand deposits backed by debt instruments is harmful to the extent that it depresses the market rate of interest, but that the discipline of free banking will limit the harm that it does. It is tragic that the Scottish experiment was cauterized by the Acts of 1844-1845.
What makes free banking successful and not simply a competition to extend unlimited credit is just as you say: the unconditional redemption of banknotes and demand deposits in coin on demand.
In the words of Adam Smith:
If bankers are .. subjected to the obligation of an immediate and unconditional payment of such bank notes as soon as presented, their trade may, with safety to the public, be rendered in all other respects perfectly free.
The last word should go to Mises:
Free banking is the only method available for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular — one is tempted to say normal — feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.
Looking backward upon the history of the last two centuries, one cannot help realizing that the blunders committed by liberalism in handling the problems of banking were a deadly blow to the market economy. There was no reason whatever to abandon the principle of free enterprise in the field of banking.
Published: April 26, 2008 8:35 AM
David Hillary:
"You say you favour letting customers and banks decide on the form and substance of their contracts for the payment of money, but don't have a problem with government intervention to change the terms agreed."
If I borrow $100 at 5% and post my house as collateral, then if I default, the lender should be able to exercise his lien against my house. If the government refused to enforce his lien, then the government has breached its duty.
If I borrow from a credit card company at 30%, then if I default, the company should be able to yell at me and put a bad mark on my credit rating. That was what the credit card company and I agreed to. The government should not give the company a lien on my house. That would be a breach of contract in favor of the company.
If I make a loan contract payable in dollars, and if I know the dollar has a 90-year history of inflating at 4%/year, then I'm free to specify a fixed interest rate that compensates for the inflation, or a variable rate indexed to inflation, or I can specify payment in gold. If I know the government is too corrupt or inept to enforce those contracts, then I can act like a pawn shop and actually hold physical collateral for the loan. Borrowers and lenders should be free to set terms that suit their circumstances. Once those terms are set the government has no business stepping in and changing the terms.
Published: April 26, 2008 9:19 AM
Thanks David and Mike for replies, I just now had time.
Published: April 26, 2008 11:07 AM
LanceH,
In a small open economy on a gold standard, banking institutions cannot change the market interest rate. The interest rate is the world interest rate, regardless of the domestic arrangements for borrowing and lending of money, and the issue of bank notes and cheque account balances.
In a closed economy on a gold standard, the market interest rate is the opportunity cost of holding gold. By holding gold one gets the benefits of holding gold (liquidity etc.) but foregoes the market interest rate available by investing in interest bearing securities. However, in social terms, exchanging specie for securities has no effect: for every gram of gold exchanged for securities, some seller or issuer of securities is exchanging the security for the gram of gold. Thus, whatever the stock of gold coin (unlike redeemable securities), it will be willingly held by someone, since it cannot readily be converted into anything else. Conversion to jewellery or dental work or useful machines are regular flows, like mine production, that can only change the stock of gold coin over time and through changes to the purchasing power of gold.
The stock of gold coin is subject to the law of diminishing marginal returns, i.e. the greater the stock of gold coin, the smaller the marginal utility from holding it, and therefore the lower the interest rate needed to make it willingly held. Thus there is a negative relationship between the interest rate and the gold coin stock.
The true economic substitute for social holdings of gold coin is not financial securities but social holdings of buildings, plant and equipment, and inventories of goods, i.e. substitute forms of non-financial capital. This substitute form of capital is likewise subject to the law of diminishing marginal returns, but since it constitutes the majority of the social capital stock, its rate of reduction will be comparatively small: a 1% increase in the stock of buildings etc. is probably the same economic value as a 40%-80% of the gold stock under near equilibrium conditions (i.e. the gold coin stock would probably be only 1-2% of the capital stock).
If the interest rate is high, building prices will be low, and investment in construction of buildings etc. will be less economic, and demand for labour and materials will be weaker, prices of labour and materials will fall, increasing the purchasing power of gold. This increases the viability of mining more gold and reduces the viability of consuming gold by making jewellery, equipment etc. and puts the gold market into surplus. The surplus builds up the stock of gold and reduces the interest rate. This is how the interest rate and gold stock are determined in a closed economy, and it is nothing to do with borrowing and lending money, issue of securities, or banking operations.
Published: April 26, 2008 3:51 PM
David Hillary: "and therefore the lower the interest rate needed to make it willingly held."
Do you mind elaborating on this a bit? The lower the interest rate of what?
So far I've found this discussion very informative btw, so thanks for your contributions.
Published: April 26, 2008 6:21 PM
Inquisitor: The interest rate is the interest rate on money, i.e. on loans of gold coin, repayable in gold coin, under a gold standard.
The relevant interest rate is the 'risk free rate' as indicated by measures such as the LIBOR (London Inter-Bank Offered Rate) on short term wholesale deposits. I.e. it is the market interest rate in the wholesale market for short term obligations of very high credit quality issuers.
Suppose, for example a closed economy has annual output (GDP) of 2,000,000 tonnes of gold by value, and a capital stock of 4,000,000 tonnes of gold by book value (depreciated historical cost) that includes and 80,000 tonnes of gold coin. Now, that 80,000 tonnes of gold coin, will be held by banks and non-banks in their portfolios as reserves. This is equal to 2% of the capital stock, and suppose that the marginal rate of return, in the form of saved transaction and liquidity costs, was equal to 6% p.a. This is the benefit foregone by holding interest bearing securities, and since one can be exchanged for the other on the market, the market interest rate on interest bearing securities will therefore be 6% p.a.
Now, suppose that one day it rained down a further 80,000 tonnes of gold coin from heaven and everyone went out and collected them and added them to their portfolios. The capital stock has been augmented by 2%, but all that augmentation is in a particular form: gold coin. The commerce of society will be augmented slightly by this additional capital: suppose it could generate 6% p.a. the augmentation is 4800 tonnes of gold/year, i.e. a 0.24% increase in GDP -- not a whole hell of a lot. The real change will be in the credit market: now that the stock of gold coin is doubled, the marginal rate of return on this form of capital will fall, according to the law of diminishing marginal returns. Most people won't want any more gold coin in their portfolios than they had before, so they'll try to exchange it for interest bearing securities or profit yielding buildings etc. But in doing so they'll compete with each other to buy these assets and drive the market interest rate down, and building prices up. The economy can only re-allocate the capital from the gold stock to the building etc. stock by devoting less resources to gold mining and more to construction of new buildings etc. over time. In the mean time, the interest rate on money will be reduced. And the lower interest rate is the 'transmission mechanism' for the market to do this: increased building prices makes construction of more buildings more viable, which bids up materials and labour prices -- inflation -- that makes gold mining less viable and gold consumption more viable. In this way, over time, the gold stock will be depleted and the stock of buildings augmented.
Published: April 26, 2008 8:36 PM
David Hillary says:
"In a closed economy on a gold standard, the market interest rate is the opportunity cost of holding gold."
No.
The interest-rate for a given term is the outcome of the supply and demand for credit for that term.
The value of money is the outcome of the supply and demand for cash (i.e. currency & demand deposits). The demand for cash is purely what people want to hold to make potential impending payments at short notice.
"The stock of gold coin is subject to the law of diminishing marginal returns, i.e. the greater the stock of gold coin, the smaller the marginal utility from holding it, and therefore the lower the interest rate needed to make it willingly held. Thus there is a negative relationship between the interest rate and the gold coin stock."
No. Suppose the economy is closed, and suppose (for simplicity) that the stock of gold is fixed and that gold has no non-monetary uses. Then the size of the gold stock has no bearing on the interest-rate. The only difference between there being 20 tons of gold instead of 10 tons of gold is that prices will be half as great, when measured in grains of gold.
"The true economic substitute for social holdings of gold coin is not financial securities but social holdings of buildings, plant and equipment, and inventories of goods, i.e. substitute forms of non-financial capital."
No. The substitute for gold coin is liquid assets - e.g. other precious metals, liquid bonds or even shares of stock. I hold cash to make pressing payments, and I can't sell my house at short notice.
"If the interest rate is high, building prices will be low, and investment in construction of buildings etc. will be less economic, and demand for labour and materials will be weaker, prices of labour and materials will fall, increasing the purchasing power of gold."
Term interest rates rise if the demand for borrowing rises or the supply of lending falls. This has little bearing on the demand for cash holding.
If interest rates rise then, ceteris paribus, the value of buildings will fall because the discounted value of the anticipated rental will fall. Building materials will also fall in price insofar as they cannot be put to other uses. The price of labour will not change, insofar as laborers can be rotated from service-industries to capital-intensive industries.
However, high interest rates are not necessarily associated with reduced building activity. After a war, for example, in which resources have been diverted to the war-effort, there will likely be heightened opportunies for peacetime profits, coupled with a strong demand for consumption (after the wartime austerity). The combination of greater demand to borrow with greater reluctance to lend will raise market interest-rates, even while much of the investment might be directed into rebuilding.
Published: April 26, 2008 8:48 PM
David Hillary asks what would happen if the stock of gold in a closed economy doubled overnight.
Suppose that the stock of gold is fixed (before and after, that is), and that gold has no non-monetary uses.
Eventually this additional stock of gold will flow through the economy and, other things being equal, it will have no effect other than to double the price of everything.
The immediate losers will be creditors, and the winners will be debtors. The market value of long term debt, for example, will be immediately marked down to half its former value. There will no effect on interest-rates aside from the temporary disruption to the credit markets.
If gold does have non-monetary uses then its non-monetary use will increase, and hence the eventual price of gold will be slightly less than twice its former value.
If the stock of gold is not fixed, then, yes, gold mining will become less profitable, since the value of each oz of gold mined will be half what it would have been. If after many years the demand for cash holding doubles, e.g. due to a doubling of the population, then the miners' original level of profitablility will be restored.
Published: April 26, 2008 10:03 PM
Correction:
If gold does have non-monetary uses then its non-monetary use will increase, and hence the eventual price of gold will be slightly more than half its former value.
Published: April 26, 2008 10:09 PM
LanceH
I can't follow why you are objecting to the conclusion that the opportunity cost of holding gold coin reserves is the interest foregone on holding interest bearing securities. If the interest rate isn't the opportunity cost of holding coin, what is it?
If the stock of reserves are very small, competition to hold them will be very intense. For example if banks normally want to hold reserves of 10% of their demand deposit liabilities and bank notes on issue, but their actual reserve ratio is 5%, the bank will try harder to raise funds (pay higher interest rate) or sell assets (at deeper discounts) and to lock in funds for longer (i.e. borrow in the form of term deposits rather than demand deposits and bank notes) to restore its reserve ratio to where it wants it. However, since this action cannot increase the stock of gold coin in a closed economy, where the stock is small the only outcome can be a persistently high interest rate as banks compete more severely for the limited stock and expend more resources to cope with lower reserve levels.
If the stock of gold coin is more than ample, everyone can hold his desired levels easily, and competition for reserves is very limited, and attempts by everyone at the same time to exchange gold for securities depresses the yield on securities.
Thus supply and demand for loaned money cannot be looked at in isolation from the stock of the available stock of the commodity to be loaned.
The value of money under the gold standard is anchored by the relative costs of production and relative utility in consumption of gold compared to other goods.
You wrote: 'No. Suppose the economy is closed, and suppose (for simplicity) that the stock of gold is fixed and that gold has no non-monetary uses. Then the size of the gold stock has no bearing on the interest-rate. The only difference between there being 20 tons of gold instead of 10 tons of gold is that prices will be half as great, when measured in grains of gold.'
These suppositions are not appropriate. The stock of gold is not fixed and gold does have non-monetary uses. Your conclusion is also incorrect, and you have not provided any basis for coming to it -- you just state it as fact, without appealing to any economic laws or principles.
me: "The true economic substitute for social holdings of gold coin is not financial securities but social holdings of buildings, plant and equipment, and inventories of goods, i.e. substitute forms of non-financial capital."
you: "No. The substitute for gold coin is liquid assets - e.g. other precious metals, liquid bonds or even shares of stock. I hold cash to make pressing payments, and I can't sell my house at short notice."
You've really missed the boat here: note the words 'true' and 'social.' Society cannot increase or reduce the stock of gold coin by the issue or redemption of securities. Individuals can, but for every such conversion by an agent, another agent converts the other way in the same amount. If I borrow 10g of gold coin off you in exchange for a promissory note issued by me, I gain the 10g of gold you lose. If you demand repayment of 10g for the note because you want to convert your security into coin, when I pay the security I lose the 10g of gold coin you gain.
The capital tied up in the coin can only be divested by running a deficit in the gold market, i.e. consuming more gold than is produced/recycled. This can only happen if the price of gold falls below equilibrium.
Your final comments all depend on whether the cash interest rate is determined by the cash market, and from there permeates through to term and mortgage rates and building capitalisation rates or the other way around. I think we're on opposite sides of that question. To me it seems that the gold coin stock, and the demand to hold it as reserves drives the cash interest rate, which drives term, mortgage and building capitalisation rates, whereas to you it seems to be based on the rates of return available on buildings, and then is distilled through the mortgage rates to term deposits to cash rates.
Published: April 26, 2008 11:13 PM
LanceH,
So, you have conceded that the consumption of gold in non-monetary uses and the reduction in the production-supply of gold can eat away at the higher gold stock.
You've also conceded that the doubling of the gold stock, other things being equal, will have some disturbance to the credit market.
It appears, in principle, therefore, that you can't rule out the possibility that a doubling of the gold stock could be redeployed into other uses over time through a temporary reduction in the gold price, after which it would revert to and remain at its former price.
Published: April 26, 2008 11:24 PM
David, thanks for the explanation, it's much clearer now.
Published: April 27, 2008 5:26 AM
Ah, forgot to ask - do you have any detailed expositions of your monetary theory? Which school (or economist) is it mostly influenced by?
Published: April 27, 2008 5:37 AM
David Hillary
Perhaps we have been talking at cross-purposes.
By "cash holding" or "gold holding" I have been talking of individuals (or corporate entities), whereas it seems that you have been talking of bank-reserves. Hence your reasoning made as little sense to me as mine did to you. Even when you spoke of "social holdings" I assumed that you meant the collective holdings of all members of society.
Yet even allowing for that, we are still at odds.
Certainly gold has non-monetary value. When it became adopted as a medium of exchange, it acquired additional value due to the additional demand for monetary purposes. If gold becomes more common, while demand for cash holding remains the same, then the monetary value of each oz of gold will decline, while its industrial utility will be unimpaired, and so its industrial use will increase. If gold became as common as sand, then the monetary component would vanish, because it would be no better as money than sand.
You say of a closed economy "If the stock of gold coin is more than ample ..." But any amount of gold will serve the purpose of money, as long as it is not low that the coins fall through the holes in our pockets, nor so high that we need a knapsack to carry it. If the gold stock doubles overnight, then once the dust has settled in the credit markets, we shall eventually have to get used to carrying around almost twice as much gold in our pockets. But no one will be richer or poorer (in terms of purchasing power) as a result of the extra weight.
You suggest that the additional gold might be redeployed, let us say as jewellry. In that case the value of money would be unaffected, But I find it inconceivable that everyone would agree to do this except by government decree. The temptation to use it as money would be too great. You might as well ask why half of the gold stock was not converted to jewellry the previous year, for the worthy purpose of lightening everyone's pockets.
You say:
"I can't follow why you are objecting to the conclusion that the opportunity cost of holding gold coin reserves is the interest foregone on holding interest bearing securities. If the interest rate isn't the opportunity cost of holding coin, what is it?"
As a definition of interest rate, this is circular. As a "conclusion", it is a tautology. The "market" interest rate is not set by a bank or government or issuer of securities, but is formed by the relative preferences for consumption or saving by all market players. It is the rate at which the total supply of savings will fill the total demand for borrowing. In other words, the market interest rate (for any term) is the outcome of the supply and demand for credit (for that term).
The practice of debt-monetization (fractional reserve banking) reduces the bank's demand for savings deposits and so tends to depress interest rates below the market rate.
Cheers
Published: April 27, 2008 8:18 AM
Inquisitor: As far as schools of thought go, concerning banking and money, White outlines three schools: the currency school, the banking school, and the free banking school (Free Banking in Britain). He says that the currency school held that commercial banks or central banks could over-issue paper money, the banking school held that neither commercial nor central banks could over-issue paper money, and that the free banking school held that only central banks could over issue paper money. Now, as far as I understand this question, so long as all paper money is not legal tender, and is convertible to gold coin, and in a small open economy, then the banking school was right: the interest rate is fixed at the world interest rate, the demand to hold money is determined by the demand to hold it, the price of money is determined by the world purchasing power of gold, and therefore no over-issue can occur, and if it did occur it cannot influence prices or interest rates. Thus it appears my position is closest to the banking school, not withstanding my support for free banking. Incidentally I believe White provides the best contemporary theory, analysis and exposition of banking and money available today. However I do think he has not correctly understood the analysis of money in a closed economy, and it is here that it appears my theory is novel -- so far I have not found any other academic that has developed this theory concerning the exchange rate of and interest rate on commodity money in a closed economy. My own attempts to fully write up my own theory are also incomplete, although I have got as far as to derive my results both numerically and analytically.
LanceH: When a commodity becomes a selected medium of exchange, it does not, ultimately, add to its price: the demand to use the commodity as a medium of exchange is not a demand to consume it, but a demand to hold it: after a period of an elevated price, the stock of the commodity will have expanded sufficiently to meet the demand to hold it, and its price can return to where it was before. Supply and demand are flows, the demand to hold money is the demand for a stock, not a flow. So, the price of the monetary commodity should settle at that price that makes supply and demand flows equal, and maintains that stock of the commodity people wish to hold, under conditions of equilibrium in both goods markets and asset markets, other things being the same.
It is also a tautology that the stock of a commodity can only increase or decrease, other things being equal, by running surpluses or deficits in the market for that commodity, and that surpluses can only be run by having a price that is above equilibrium, and deficits by having a price that is below equilibrium.
The additional complexity of commodity money is that it is both a produced and consumed good, and an asset in asset portfolios (and part of the capital stock). Confusion between stocks and flows is the greatest barrier to understanding commodity money economics.
The adequacy of the stock of the monetary commodity is a very real question: one amount is not as good as another. If the commodity's relative price is ultimately anchored by primary market supply and demand functions, and disequlibrium is only temporary, then an inadequate stock of the commodity in society's capital stock will make commerce more difficult and increase transaction costs -- the society could enjoy substantial marginal benefits from an increased stock of the commodity. Conversely an excessive stock of the monetary commodity would come at a cost of fewer buildings etc. and for little marginal benefit.
Your analysis of my contention that excess gold can be worked off appears to misunderstand somewhat the proposed scenario. The scenario is that the gold price will fall temporarily, the gold market will go into deficit temporarily, and then the gold price will rise to its former value, and the equilibrium price and stock will be restored. I.e. any disequlibrium resulting from the excess of gold is only temporary.
You are correct that the introduction of fractional reserve banking will reduce the interest rate (in a closed economy), other things being equal. To consider this let us construct a closed economy and then introduce a banking system.
Annual output (GDP) 100,000 tonnes gold by value/year
Capital stock 200,000 tonnes gold by value, consisting of 10,000 tonnes in gold coin and 190,000 tonnes in gold value of other forms of non-financial capital (buildings etc.), at depreciated historical cost.
Suppose the interest rate on interest bearing securities was 6% p.a. and that 100,000 tonnes of interest bearing securities were issued.
So, wealth is held in the form of:
gold coin: 10,000 tonnes
interest bearing securities: 100,000 tonnes (yield to maturity valuation)
equities: 90,000 tonnes (depreciated historical cost less debt owed)
Total: 200,000 tonnes
Now introduce a banking sector that issues 5,000 tonnes in bank notes, 5,000 tonnes in cheque account balances, 5,000 tonnes in term deposits, and 5,000 tonnes in share capital. Thus total liabilities plus net worth is 20,000 tonnes. Assets is 18,000 tonnes in interest bearing securities and 2,000 tonnes in gold coin. Society's wealth is now held by non-banks as follows:
gold coin: 8,000 tonnes
Bank notes: 5,000 tonnes
Cheque account balances: 5,000 tonnes
Term deposits: 5,000 tonnes
interest bearing securities: 82,000 tonnes
equities (including bank shares):95,000 tonnes
Total 200,000 tonnes
So, the total wealth (book value) is the same, however the stock of money is increased from 10,000 tonnes to 18,000 tonnes. Since cheque account balances pay interest, the demand to hold money will have increased -- it is not more attractive to hold money that pays interest -- however, overall demand to hold gold coin will have decreased: bank notes are competing with coin to supply money in bearer form, and cheque accounts are also offering a substitute. The interest rate on money will therefore fall.
Suppose that, for some reason, this causes a bout of inflation. This will reduce the gold price and suppose this results in a deficit in the gold market of 500 tonnes/year. After 10 years the gold stock is reduced to 5,000 tonnes, suppose this restores equilibrium, and a bout of deflation returns the gold price to equilibrium. From here on, notwithstanding the introduction of fractional reserve banking, the interest rate and exchange rate on the monetary commodity are the same as they were before, and society has less gold than before, and correspondingly more buildings. Thus any reduction in the interest rate may be only temporary.
Published: April 27, 2008 3:30 PM
Interesting thread. Much better than the normal arguments that always seem to come up.
Published: April 27, 2008 5:53 PM
Lance H:
"The practice of debt-monetization (fractional reserve banking) reduces the bank's demand for savings deposits and so tends to depress interest rates below the market rate."
If you can find a copy of Jack Hirshleifer's "Investment, Interest, and Capital", or "Price Theory and Applications", or even Irving Fisher's "Theory of Interest", you'll see the equilibrium real interest rate determined as the rate that equalizes the slopes of each individual's intertemporal production-possibilities curve with the slopes of everyone's intertemporal indifference curves. That interest rate is determined independently of the existence of money, and thus is not affected by the practice of fractional reserve banking. Fractional reserve banking can be viewed as an efficiency-improving practice that reduces the spread between the borrowing/lending rates, but not as a practice that systematically leads to lower interest rates overall.
Published: April 27, 2008 7:56 PM
Mike,
Interest rates are interest rates on MONEY, not on inter-temporal production/consumption possibilities and the desire for them. Time preference is as meaningless to the money market as is speed preference for the market for automobiles. People don't desire, in economics, abstract goods, and preferences for them are economically meaningless -- preferences are for bundles of particular goods or assets, not for abstracts like time, space, love or power. The interest rate is determined in the money market, where loans or securities are bought and sold, issued and redeemed.
If the capital stock is small, according to the law of diminishing marginal returns, the interest rate should be high, as a rationing device to ration the small amount of available capital into the most profitable investments, even though society as a whole (or the median agent) might find that under such rewards it is better to save rather than spend. Perhaps over time the capital stock can grow and stable equilibrium reached, however at any one time the market clears at some price.
Zooming into the microscopic level of the monetary commodity market, it is the marginal rate of return on that form of capital (the stock of the commodity) that determines what the interest rate on the monetary commodity will be. As above, the larger the stock of the commodity, the lower its marginal rate of return, and therefore the lower the interest rate will be in order to make that stock willingly held.
Otherwise, how can you explain the motivation to hold stocks of the monetary commodity?
See White's Free Banking in Britain for a theoretical model that shows the bank's demand to hold specie in its portfolio. His model shows that the bank will, at the margin, equalise the rate of return from holding specie with the rate of return from holding bills (interest bearing assets (risk adjusted, of course)) and the rate of cost of obtaining funding from deposits and notes. I.e. the marginal rate of return on specie is the interest rate. If you can accept his model -- and it is sound -- and generalise it and apply it to all bank and non-bank agents in a closed economy, the conclusion that the interest rate is a decreasing function of the gold stock necessarily follows.
Published: April 27, 2008 10:43 PM
David Hillary:
In a world without money, people would still lend 100 bushels of wheat today, and be repaid 105 bushels next year. Maybe we are talking at cross purposes about the difference between real and nominal rates?
"As above, the larger the stock of the commodity, the lower its marginal rate of return, and therefore the lower the interest rate will be in order to make that stock willingly held."
That's a pretty mixed up statement. Normally I'm not one to fall back on higher authority, since the higher authorities in monetary theory are more confused than the rest of us. But the theory of interest, in the tradition of Irving Fisher, is well-developed and non-controversial, and it implies that the real interest rate is determined by the slopes of intertemporal production-possibilities curves and intertemporal indifference curves.
Published: April 29, 2008 11:13 AM
Mike,
Yes, we are talking at cross purposes, at least somewhat.
It is reasonably well known that the interest rate on different currencies and commodities differ. The question here is about the interest rate on one particular commodity: the monetary commodity in a closed economy on a commodity monetary standard.
The interest rate on money is of course the nominal interest rate, not the real interest rate. Other than inflation indexed bonds, the money market works on a purely nominal basis.
I guess the criticism of the Fisher theory of interest would be that it is not a monetary theory but a real theory, and concerns the real interest rate, but the interest rate is the interest rate on money, i.e. the nominal interest rate.
To get from the real market to the nominal market requires a theory of inflation or inflation expectations or similar. Which theory to use is far from obvious, which makes Fisher's theory of limited use.
The rates returns on different forms of capital need not be identical: the capital stock at any point in time may not be in equilibrium between any two or more forms of capital. How the capital market allocates and re-allocates capital between the monetary commodity and buildings etc. under a commodity money standard in a closed economy is presently lacking a coherent theory. This is where my theory comes in.
The connection between the interest rate and the size of the stock of the monetary commodity is actually quite evident and demonstrable.
Necessarily agents who hold the monetary commodity forego contractual interest available from lending it and holding an interest bearing security instead. This is almost self evident, a fairly trivial economic theory. Given no one is obliged to hold the monetary commodity, the fact that it is held demonstrates some benefit from holding it. When agents optimise their portfolios, their marginal rate of return on holding the monetary commodity must be equated to that on other assets in the portfolio (risk adjusted), including interest bearing securities.
The consequences of, other things being equal, the monetary commodity increasing, is not so obvious. How much one is wedded to the quantity theory of money is very important here: quantity theorists would expect inflation as a result of the increased stock of money and could expect that after prices rose equilibrium would be restored with the enlarged stock of the monetary commodity. Those who think, in principle, that the quantity theory of money is misguided, could come to a very different conclusion: that the increased stock of the monetary commodity would result in a diminished rate of return on that form of capital, in accordance with the law of diminishing marginal returns.
Published: April 30, 2008 12:11 AM