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Source link: http://archive.mises.org/7377/go-for-gold/

Go for Gold

November 1, 2007 by

Why, after years of the market’s neglect of gold, is the paper money price of gold now on the rise? Would it be too far-fetched to assume that it could reflect market agents’ growing concern about a forthcoming great inflation of government controlled paper money?

Tensions in credit markets might indeed provoke fears that central banks could, by way of lowering interest rates, pump even more credit and money into the economies, in an attempt to fend off a credit crisis and potential losses in output and employment.

Mainstream economists may be relaxed about such a policy provided “inflation” — typically defined as a change in the consumer price index — remains “low.” Austrians, in contrast, not only consider an increase in credit and money supply inflationary; they would also point out that the very process of a relentless increase in government-sponsored credit and money supply is a recipe for disaster, that it will ultimately end in the destruction of the currency. FULL ARTICLE

{ 55 comments }

Mike Sproul November 1, 2007 at 10:02 am

1) Gold coins wear over time. Gresham’s law takes hold, and the new (full weight) coins will be hoarded while only the old worn coins will circulate. A shortage of coins results.
2) Gold notes, backed by 100% reserves of gold ( like the old Bank of Amsterdam) are expensive to keep in circulation, so about 2-3% of the value of each gold note is lost by the bank each year. Since such a bank earns no interest income, it either must reduce the value of its notes by 2-3% per year, or else suffer a bank run when people realize it does not have enough gold to buy back its gold notes.
3) A bank that issues gold notes in exchange for interest-bearing bonds equal in value to that gold note will cause no price inflation, since the bank’s assets will automatically rise in step with the quantity of money issued, and such a bank will always have sufficient assets to buy back any notes it has issued. Such a bank will also earn interest income, and is less vulnerable to robbery than a 100% reserve bank.
4) The Austrian use of the word “inflation” as a synonym for “money inflation” is not useful. If you mean an increase in the amount of money, then say “money inflation” or some such. If you mean “price inflation”, then say it. That way, the 99.9% of the economics profession that uses “inflation” to mean “price inflation” will understand you. Of course, this begs the real question, since an increase in the money supply, accompanied by an equal increase in bank assets, will not cause price inflation.
5) Read about the real bills doctrine at
http://www.csun.edu/~hceco008/realbills.htm

David Spellman November 1, 2007 at 10:05 am

The Problem With Gold

We all (should) know the qualities that made gold the medium of exchange of choice in history. But today gold suffers from a critical problem that holds it back from supplanting fiat currency in a debacle. That flaw is that gold is not fungible right now.

I would love to see a gold standard, even an informal (dare we say black market) circulation of gold as money. But after generations of dependency on paper currency, the general public is not in a position to use gold as money. Consequently, even though gold prices rise in response to inflation, gold does not inherently serve any better as a hedge against inflation than any other investment. In fact, it may be more of a barometer of investor fear than a true measure of inflation.

In our current civilization, gold is at best an industrial metal with useful properties. At the worst, it is a sucker’s refuge that can be manipulated by the shrewd to take advantage of those who put unwarranted trust in Gold with a capital G. What I mean is that gold sellers get a premium on gold simply because some people believe buying gold is intrinsically a virtue.

If the economy collapses, gold will have value and perhaps over the long term it will become common currency. But in the short run, the survivalists are probably right that a truckload of cigarettes would be more useful for trading. On the other hand, gold will probably buy you more than rare baseball cards and fine art will.

But don’t expect to get much for your gold in difficult times because people just don’t know how to value it in trade the way they can other commodities. Gold is only valuable in the context of a functioning paper money economy right now. If paper money becomes totally worthless, people will trade consumer commodities they understand how to price. Gold will be difficult to use because there is no established coinage for ordinary transactions.

Nathan Mayer November 1, 2007 at 10:15 am

Mike,

gold displaced all other monies for a reason.

RBD banks are free to accept assets and issue receipts against those assets as long as the receipt does not read “pay bearer on demand one dollar”. “Dollar” is just a name for gold.

The RBD bank must write “pay bearer on demand one gambler’s IOU”

In reality, RBD banks would just get displaced by 100% banks because gold money would displace IOU money which has positive maturity assets backing it.

David Spellman November 1, 2007 at 10:19 am

1) Gold coins wear over time. Gresham’s law takes hold, and the new (full weight) coins will be hoarded while only the old worn coins will circulate. A shortage of coins results.

This has never been a significant problem with gold money. Even if it were true, the obvious solution is that people would simply offer more goods in trade for “full weight” money and less goods in trade for “worn out” money. No one is going to horde newly minted coins just because there are worn coins around. But gold coins don’t wear out so fast that it is an issue.

an increase in the money supply, accompanied by an equal increase in bank assets, will not cause price inflation

True, true. If banks worked like that, we would have no problems, would we? But banks issue ever increasing amounts of money without any backing whatsoever. Rather than calling it inflation, I prefer to call it counterfeiting. To paraphrase a popular investment advertisement, “Banks make money the old fashioned way–they print it.”

TLWP Sam November 1, 2007 at 10:22 am

Well yous are probably not going to like this one:

http://www.optimist123.com/optimist/2007/05/sound_money_ver.html

Nor this one either:

http://www.optimist123.com/optimist/2007/01/stubborn_irony__3.html

But I still don’t see people, especially big business, clamouring for a gold standard en masse. To this I wonder what some of cataclysmic shock would cause people to go for gold? For every gold bar should you also get a case of ammo to go with it? I wonder at times if going for gold represents a mistrust in the future of modern society and a desire to rollback to the good ‘ol days of the 1800s?

David White November 1, 2007 at 10:24 am

Sorry guys, but gold is already money — http://www.goldmoney.com — and only awaits the public’s acknowledgement of this fact, together with full technological implementation — http://www.cipe.org/publications/ert/e32/e32_2.pdf — for a new era of sound money to unfold.

As for the dollar, without its backing by oil — the petrodollar — it would be worthless, and soon will be. But don’t look for the powers that be to “go for the gold.” Instead, look for them to perpetuate their fiat fraud with the amero — http://www.youtube.com/watch?v=6hiPrsc9g98 — counting on Canada’s natural resources and Mexico’s human resources to back it up.

mike November 1, 2007 at 10:59 am

It is nice finally to see a proper inflation-adjusted analysis of gold/$. It exasperates me to no end to see analysts criticize the fraud behind the CPI, but then use it as the deflator for time adjusting the price of gold. All should agree that M2 is a fair (albeit to some conservative) measure of the amount of money. It is frightening to see the M2-adjusted price is $3,000.

But how strong is the correlation between M2 and God/$? The first chart appears to suggest not much of a correlation. That suggests other factors led to the spike shown in the second chart. (E.g., were other central banks buying gold during the spike, which demand factor likely would not exist today?) Those other factors must be addressed before believing gold is headed to $3,000.

Anthony November 1, 2007 at 1:20 pm

‘If you mean an increase in the amount of money, then say “money inflation” or some such.’

This is more or less what Austrians mean by inflation. My professor actually took marks off our paper last year if we referred to it as an increase in prices, i.e. relative scarcity. And he was a Hayekian, not a hardcore Austrian.

DC November 1, 2007 at 1:39 pm

I am an amateur, but Mike Sproul’s comment seems like a softball for anyone that has read Rothbard’s ‘What Has the Gvm’t Done. . .’

1) Gold coins wear over time. Gresham’s law takes hold, and the new (full weight) coins will be hoarded while only the old worn coins will circulate. A shortage of coins results.

Gresham’s law shows that under government-regulated systems of measurement, the good coins will be hoarded and the bad coins will remain in circulation.

But under a free market, people would be free to reject or revalue a coin that has obviously been worn with use. In fact, gold coins would often be melted and recast in other forms, either by other coin shops or by those seeking to store gold in bullion. See Rothbard’s book ‘What Has the Government Done to Our Money? / The Case for the 100% Gold Dollar’

The real problem is when the government forces you to accept a coin at X value, no matter how obviously worn it is.

2) Gold notes, backed by 100% reserves of gold ( like the old Bank of Amsterdam) are expensive to keep in circulation, so about 2-3% of the value of each gold note is lost by the bank each year. Since such a bank earns no interest income, it either must reduce the value of its notes by 2-3% per year, or else suffer a bank run when people realize it does not have enough gold to buy back its gold notes.

Another softball. You are assuming the current business model for a bank (i.e., we pay you for the privilege of allowing us to store your money here) and then adding to that a 100% reserve monetary system.

As Rothbard points out, banks would be run like any other business, and so petty concerns over the price of keeping notes in circulation would be accounted for in their prices for services. They couldn’t commit fraud by devaluing gold in the name of paying for bank notes.

3) A bank that issues gold notes in exchange for interest-bearing bonds equal in value to that gold note will cause no price inflation, since the bank’s assets will automatically rise in step with the quantity of money issued, and such a bank will always have sufficient assets to buy back any notes it has issued. Such a bank will also earn interest income, and is less vulnerable to robbery than a 100% reserve bank.

And there is more risk and uncertainty in this model of banking as opposed to banks serving merely as storehouses, since interest are not guaranteed for the simple reason that investments fail from time to time.

The concerns over robbery or generating income are unimportant and accidental to the subject at hand. (You don’t think banks would take sufficient steps to secure their holdings?)

4) The Austrian use of the word “inflation” as a synonym for “money inflation” is not useful. If you mean an increase in the amount of money, then say “money inflation” or some such. If you mean “price inflation”, then say it. That way, the 99.9% of the economics profession that uses “inflation” to mean “price inflation” will understand you. Of course, this begs the real question, since an increase in the money supply, accompanied by an equal increase in bank assets, will not cause price inflation.

In Austrian theory, inflation is an increase in the money supply, and the price increases are its symptom. I agree that the term hasn’t always been used precisely by all authors, but there is no reason to splice it into “money inflation” versus “price inflation” (although I see from point #5 your motivation for saying this here).

5) Read about the real bills doctrine at
http://www.csun.edu/~hceco008/realbills.htm

I’ve witnessed, but not discussed, this debate over real bills doctrine on these threads before. I have no intention of getting involved.

Those that see this as the cure for U.S. monetary problems over and above simple liberty are fooling themselves.

Mike Sproul November 1, 2007 at 2:14 pm

Nathan:

Gold had a brief run decades ago. It has now been displaced, for a reason.

So writing legal notices on a dollar would make a difference?

Mike Sproul November 1, 2007 at 2:21 pm

David:
“gold coins don’t wear out so fast that it is an issue.”

Wear happens because of clipping and sweating, where criminals rub or dissolve a small amount of gold from the coin and then pass it along. This wear is significant. The British pound, for example, was originally a silver coin weighing 16 oz. A few hundred years later, it weighed about 1/2 oz. Countries that used full-bodied coins often had to re-coin the entire money supply because of this wear.

“banks issue ever increasing amounts of money without any backing whatsoever. Rather than calling it inflation, I prefer to call it counterfeiting.”

When banks issue a dollar they get a dollar’s worth of assets in return, and they stand ready to use those assets to buy back the dollars they issued. No counterfeiter does this.

DC November 1, 2007 at 2:23 pm

Gold had a brief run decades ago

Oh dear. . .where to begin?

Nathan Mayer November 1, 2007 at 2:34 pm

“So writing legal notices on a dollar would make a difference?”

yes, because a dollar today is a dollar tomorrow.

a bushel of wheat may fetch $100 today and $50 tomorrow – the RBD receipt must state what is backing that receipt. To call it a dollar would be fraud once it was spent.

Mike Sproul November 1, 2007 at 2:37 pm

DC:

“But under a free market, people would be free to reject or revalue a coin that has obviously been worn with use.”

When the difference in weight between coins is small, people will still pass them at par. As years pass, coins will wear and shortages will develop. A quick reading of the history of coins should convince you that this problem is real.

“petty concerns over the price of keeping notes in circulation would be accounted for in their prices for services.”

So the bank either charges 2% per year for storage or reduces the value of its notes 2% per year. The holder of the money loses just the same. But if the bank holds part of its assets in interest-bearing form, that loss can be reduced or eliminated. Isn’t that “petty concern” about inflation what got this thread started in the first place?

vulnerable to robbery than a 100% reserve bank.

“And there is more risk and uncertainty in this model of banking as opposed to banks serving merely as storehouses, since interest are not guaranteed for the simple reason that investments fail from time to time.

The concerns over robbery or generating income are unimportant and accidental to the subject at hand. (You don’t think banks would take sufficient steps to secure their holdings?)”

So leave it to banks and their customers to decide what form assets should be held in. Since hardly any banks in the world today hold 100% reserves, I think I’m safe in saying it’s an inferior option.

4) The Austrian use of the word “inflation” as a synonym for “money inflation” is not useful. If you mean an increase in the amount of money, then say “money inflation” or some such. If you mean “price inflation”, then say it. That way, the 99.9% of the economics profession that uses “inflation” to mean “price inflation” will understand you. Of course, this begs the real question, since an increase in the money supply, accompanied by an equal increase in bank assets, will not cause price inflation.

In Austrian theory, inflation is an increase in the money supply, and the price increases are its symptom. I agree that the term hasn’t always been used precisely by all authors, but there is no reason to splice it into “money inflation” versus “price inflation” (although I see from point #5 your motivation for saying this here).

5) Read about the real bills doctrine at
http://www.csun.edu/~hceco008/realbills.htm

I’ve witnessed, but not discussed, this debate over real bills doctrine on these threads before. I have no intention of getting involved.

Those that see this as the cure for U.S. monetary problems over and above simple liberty are fooling themselves.

George Gaskell November 1, 2007 at 2:39 pm

Wear happens because of clipping and sweating, where criminals rub or dissolve a small amount of gold from the coin and then pass it along. This wear is significant.

A dollar is a unit of weight, not a decree of the purchasing power stamped on the coin. “Value” is an assessment of weight, not purchasing power of the coin.

To the extent that loss of weight is significant, it can be accounted for by weighing. Any time that a monetary transaction justifies the cost and expense of weighing (i.e., larger transactions), the parties will do so.

When banks issue a dollar they get a dollar’s worth of assets in return

To the extent that the bank’s valuation of the “backing” asset is wrong, or to the extent that the “backing” asset is not liquid (i.e., a promissory note), or the value of the “backing” asset decreases over time (e.g., promissory notes that result in default), the promise to redeem every note for an actual dollar on demand becomes impossible to fulfill.

GuyF November 1, 2007 at 2:48 pm

I don’t understand the first chart (Figure 1). What do the numbers on the left represent? They don’t match up with the $ price of gold or the S&P 500.

DC November 1, 2007 at 2:54 pm

Mike Sproul, you write:

When the difference in weight between coins is small, people will still pass them at par. As years pass, coins will wear and shortages will develop. A quick reading of the history of coins should convince you that this problem is real.

Again, only if the measurement of those coins is upheld rigidly by the government. In what other area of the free market—where very often precision is crucial for proper functioning—does a free people fail to work out their problems?

A “quick reading of the history of coins” (whatever that means!—I suspect a touch of laziness here) reveals this. Only in societies where the government forced people to recognize (say) a dollar coin, no matter how worn or reduced in value, is this a problem. You haven’t dealt with my main point.

On bank charges:

So the bank either charges 2% per year for storage or reduces the value of its notes 2% per year. The holder of the money loses just the same.

Yes; that’s called a price for services.

But if the bank holds part of its assets in interest-bearing form, that loss can be reduced or eliminated.

Only with some degree of risk, which was the entirety of my point.

Isn’t that “petty concern” about inflation what got this thread started in the first place?

Who called inflation a “petty concern”? I said that your argument (that banks might have to charge for services) was a petty concern and not actually a criticism of the historical free market banking system.

So leave it to banks and their customers to decide what form assets should be held in.

I couldn’t agree with you more.

Since hardly any banks in the world today hold 100% reserves, I think I’m safe in saying it’s an inferior option.

Not a clever bit of reasoning here. I could likewise say “Since hardly any business in the world pay under the legal minimum wage, I think I’m safe in saying it’s the inferior option.” Or, “since almost every country in the world uses a central bank to control the money supply, I think I’m safe to say that [free markets] are the inferior option.”

[By the way: Fractional reserve banking could have it's go in the free market (assuming full consent from involved parties). Austrian economics admits that people would be free to experiment with it, should they choose to do so. Austrian economists rightly point out in addition to this, however, that the fractional reserve banks would nearly certainly fail and lose out to 100% reserve banks. That's not prescription; just well-grounded observations based on history and observations on human nature.]

Fundamentalist November 1, 2007 at 3:02 pm

Mike: “But how strong is the correlation between M2 and God/$?”

I think the lack of correlation can partly be explained by changes in the FX rate of the dollar. As the dollar loses value against other major currencies, gold should rise, and vice versa.

In the 90′s the price of gold was kept low by central banks loaning huge amounts of their gold stocks.

The World Gold Council site has some interesting analyses of what determines the price of gold. A major factor is demand in India and China where gold is still used for savings and to hedge against inflation.

DickF November 1, 2007 at 4:23 pm

Mike Sproul,

There is no need to even have gold coins though there is no need not to have them either. Most people would rather have the convenience of a gold certificate defined in a specific weight of gold. That is all that is needed. If someone has a gold coin and attempts to offer it in exchange for goods it is the right of the seller to accept or reject it based on its wear. A coin that is significantly worn will not be accepted at full exchange value and will fall from circulation. So actually your objection is a red herring.

Similarly, if I wish to deposit my money in a bank that will lend it out to gain interest that is my business. As long as there is full disclosure a bank need not maintain 100% reserves. If I can earn more interest from a fractional reserve bank I should have the right. But if a bank wants to hold 100% reserves that is the right of the bank also. There are those who would rather have this safety. If the depositor and lender know the facts going into the transaction then each should be free to enter into a contract.

Finally, Mises is taken out of context when it is claimed that he believes that inflation is “an increase in the money supply.” Those who believe this have him confused with Milton Friedman. In chapter 8 of The Theory Of Money and Credit he clearly discusses that there are many aspects to the value of money. Supply and demand must both be considered not just supply.

A fiat currency like the US dollar exchanges because there is a demand for a medium of exchange, but if the demand for this fiat dollar ends the usefullness of the dollar as money will end. Now it is true that money does have to comply to the laws of supply and demand. If the supply exceeds the demand then the exchange value of money will fall, but it is more important than most give credit to understand that demand must be considered.

Mike November 1, 2007 at 6:14 pm

I’m glad that the very first thing posted in these comments is a gross misunderstanding of Gresham’s law by Mike Sproul. Everyone should read it before considering the rest of his arguments, he put it first after all.

Anthony November 1, 2007 at 7:45 pm

Dick, could you go into a bit more depth on Mises’s view on inflation?

pedrovoltaire November 1, 2007 at 7:49 pm

“Everyone should read it before considering the rest of his arguments”

everyone should read this before the rest of his arguments…

http://www.thelongwaveanalyst.ca/pdf/V5_1.pdf

Peter November 1, 2007 at 8:05 pm

The British pound, for example, was originally a silver coin weighing 16 oz.

You’re making that up. First, a (troy) pound is 12oz, not 16; second, there was never any silver “pound coin” minted. The first pound coin was the gold sovereign.

Mike Sproul November 1, 2007 at 8:53 pm

Peter:

From Wikipedia, although I first read about this in a more respectable source that I can’t recall.

“The pound was originally the value of one pound Tower weight of sterling silver (hence “pound sterling”). ”

Whether a pound consisted of 16 oz in those days I don’t know. But the original pound was definitely not the gold sovereign. That’s why they call it the “pound sterling”

Mike Sproul November 1, 2007 at 9:02 pm

George Gaskell:

“A dollar is a unit of weight, not a decree of the purchasing power stamped on the coin. “Value” is an assessment of weight, not purchasing power of the coin.”

Weird definition, and certainly not standard, but oh well…

“To the extent that loss of weight is significant, it can be accounted for by weighing. Any time that a monetary transaction justifies the cost and expense of weighing (i.e., larger transactions), the parties will do so.”

Not only were those coin shortages real, but money loses usefulness when it has to be weighed for every transaction. More important, clipping and sweating is theft, and it is ridiculously easy with full-bodied coins. That is one very good reason that gold and silver coins have disappeared

“To the extent that the bank’s valuation of the “backing” asset is wrong, or to the extent that the “backing” asset is not liquid (i.e., a promissory note), or the value of the “backing” asset decreases over time (e.g., promissory notes that result in default), the promise to redeem every note for an actual dollar on demand becomes impossible to fulfill.”

Of course. But as long as the bank and the customer agree to this there is nothing wrong with it.

TLWP Sam November 1, 2007 at 9:38 pm

What!? You would lose 2% value on your gold-back dollar as that represents the charge of the bank holding the gold?! Talk about why not use gold coins? Why not alloy gold coins with titanium for toughness? Likewise, if we’re talking about how money would work in Libertopia doesn’t that mean many small private banks printing their own notes? That the money you have is dependent on the honesty of the bank such if you have a $100 note from Bernie’s bank (good for 10oz of gold, let’s say) and you see Bernie in the news being arrested for fractional banking and find out all leftover Bernie bills are now null and void because others already got their gold out . . .

Wouldn’t that really mean gold is money and dollars are R.B.D clearing notes to transact gold for those who would find it more convenient to use paper? Which, in turn means it’s good to use the paper for ongoing transactions but when you want to save money for the long term you should really save literal gold in your own safe? If you want to spend the gold it may be best to take the gold to a bank and get dollar bills for it but still keep the gold for the long term? If so, then you’d be no better off than nowadays, just invest your spare change including gold and gold shares.

Anthony November 1, 2007 at 9:55 pm

Do you think that banks will hold money for free? The current system is a hodge-podge.

Here is a good article by Hoppe on the matter:

http://mises.org/journals/rae/pdf/RAE4_1_3.pdf

Mike Sproul November 2, 2007 at 12:31 am

Dick F

One quibble, and one disagreement:
1) Coins can be of slightly different weights and still circulate, since most people don’t distinguish weight differences in the neighborhood of 2% or less. But the clippers and sweaters keep up their work (which is theft) and the coins continue to lose weight.
2) The dollar is not fiat money. There is no such thing. The dollar, like all goveernment paper money, is backed by the assets of the central bank that issued it. Otherwise you’d have to wonder why all central banks bother taking assets in exchange for the money they issue.

David Hillary November 2, 2007 at 3:29 am

1)
Gold coin wear is a particular problem of the gold standard, i.e. gold coin (not below legal mass), is the sole unlimited legal tender for money debts.

The problem is not unique to coinage: it happens whenever differing quality or quantities of things are represented as being the same.

The market solution is for some agents to discriminate between full mass and under mass coins, and others not to. Those who deal with large quantities of coin, and those whose transactions have small profit margins will discriminate, and those who deal with small quantities and those who use them for high profit transactions will not. Banks especially will discriminate, and bank customers will expect banks to only tender full mass coins to pay its debts. This leaves banks and other similar debtors with the expense and trouble of having under mass coins scrapped and re-manufactured into new coins. Thus, within a gold standard economy, part of the gross profit on money transactions is absorbed, directly or indirectly, by the transaction costs of coin wear and re-manufacturing. No shortage of gold coin results.

2)
I believe Mike is referring to banknotes by the term ‘gold notes’ A note is a promissory note. (Bills of Exchange Act, Interpretation section, any English common law jurisdiction, e.g. Bills of Exchange Act 1908 (NZ), Section 2)

‘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, Promissory Note Defined, subsection 1)

A banknote is a promissory note made by a banker, payable to bearer on demand.

Notes are not correctly referred to as ‘backed’ but may be secured or unsecured:
‘A note is not invalid by reason only that it contains also a pledge of collateral security, with authority to sell or dispose thereof.’ (Bills of Exchange Act 1908 (NZ), Section 84, Promissory Note Defined, subsection 3)

A note, therefore, is a claim on the maker thereof, and not a claim on any particular property or asset, although it may be secured by property. By way of analogy, a bill of exchange is not an assignment of funds held at the drawee:
‘A bill of itself does not operate as an assignment of funds in the hands of the drawee available for the payment thereof, and the drawee of a bill who does not accept as required by this Act is not liable on the instrument.’ (Bills of Exchange Act 1908 (NZ), Section 53, Funds in hands of drawee). For example a cheque does not assign the funds held on account with the bank to the payee, and in the same way a banknote does not assign the assets of the bank to the holder thereof.

Banknotes are normally unsecured. For example banknotes of the Scottish banks and the Bank of England simply promise to pay the bearer on demand the sum mentioned in the note, without any pledge of collateral security.

Thus there is no legal implication of reserves being held by the bank of issue. The bank of issue is liable to pay the banknotes it issued as and when they are presented for payment, in the same way it is liable to pay its customers their funds on current account as and when their cheques are presented or they demand payment. Their financial standing and condition to discharge their obligation is a quite different question.

A bank may not decrease the value of its notes, since a note is an engagement to pay a sum certain in money, i.e. some particular amount of money, not just the amount of money the bank feels like paying. Although it is legally possible to structure a note that was for a decreasing sum, no banknotes have ever been issued in this manner, as far as I know, and most banknotes are for a fixed sum.

3)
A bank that issues notes in exchange for interest bearing assets is not assured of profitability. The banks investments may or may not perform well, and depositors and noteholders are exposed to the credit risk that the bank may not repay. A bank’s financial condition and standing is a matter for ratings agencies and depositors and note holders etc. to assess. Seven finance companies in New Zealand have failed in the last few months due to various reasons such as too many bad loans, and lack of confidence leading to difficulties attracting deposit funding, and all these companies were primarily engaged in the business of lending money at interest.

The quantity of banknotes and cheque account deposits issued and accepted by banks is not restricted to growth based on the interest earned on loans. Instead, banks issue and repay such securities in a very elastic way: issue because they can, in general, always use additional funding profitably, and repayment because such securities are repayable on demand.

4)
You are correct that the term inflation is being defined in a way that is not accepted by either the economics profession or the general public, and those insisting on redefining this word to their own designs are ‘flogging a dead horse’.

The term ‘money supply’ should be used with care. Normally ‘supply’ refers to a FLOW not a stock, but with money ‘money supply’ and ‘money stock’ seem to be used interchangeably. If this was clear, the confusion between monetary economics, where price is supposed to be related to the stock of money, and non-monetary economics, where the price is supposed to be related to the flows of supply and demand. Go figure.

5)
Real Bills Doctrine is not really helpful and somewhat confused. If you put it into its historical context, what the proponents thereof seemed to be saying is that banks should be free to invest in commercial bills of exchange that are used to finance merchandise trade and mature within 90 days. In their day this form of credit was reasonably safe and liquid, and provided credit to merchants. But today the safest and most liquid assets are major issues of corporate, bank and government bonds that have a high credit rating and listed on a securities exchange — these are generally not structured as bills of exchange and not due within 90 days. Bank management methods have also developed a lot, with a lot more emphasis on managing a) exposures to individual counterparties, including collateral security, b) managing credit risk concentrations in terms of both industry and geography, c) managing capital adequacy and economic capital, d) diversification of funding sources, and e) management of liquidity through maturity ladders, net funding requirements analysis and tracking, cashflow forecasting, asset-liability management committees, and planned responses to shortfalls in liquidity. It should also be noted that bank lending today is dominated by residential mortgage secured lending (very long term), and that bank funding includes significant proportions of term deposits and term borrowing. Developments in securitisation, structured finance and derivatives have also made loans and finance receivables more liquid.

jp November 2, 2007 at 11:38 am

A question for all the Austrian economics experts out there.

Thorsten Polleit mentions the idea of asset price inflation. Other commentators like Robert Blumen have mentioned it to, see:
http://mises.org/daily/1579

The traditional Austrian view of inflation and the business cycle (as I understand it) is that a lowering of the interest rate affects producer goods and consumer goods in a different fashion. Producer goods prices rise relative to consumer goods and the business cycle begins.

My question is: how does the idea of asset-price inflation square with the traditional concept of producer vs consumer price increases? Does asset-price inflation add a third element to the Austrian equation? For example, might a lowering of the interest rate cause a relative rise in either consumer goods prices, producer goods, or financial assets?

Or is the idea of asset-price inflation redundant, because it is already captured by producer price rises?

George Gaskell November 2, 2007 at 11:47 am

Weird definition, and certainly not standard, but oh well…

Standard? Those are the original meanings of the words “dollar” and “value.” Dollar is like ounce or pound or gram. Value refers to the assaying of weight and purity.

The fact that, in your view, these meanings have become non-standard is a testament to the fact that government has co-opted, over the course of multiple generations, the meanings and essence of what was once money.

Calling two things by the same name is a way of arguing that they are, in fact, indistinguishable. When you control the language, you control opinion.

Of course. But as long as the bank and the customer agree to this there is nothing wrong with it.

Then don’t call the assets you give to a bank a “deposit.” Call them what they are: unsecured loans.

Fundamentalist November 2, 2007 at 12:46 pm

jp: “Or is the idea of asset-price inflation redundant, because it is already captured by producer price rises?”

I’m not an Austrian expert, but I’ll give it a shot. Asset inflation can include a lot of things, but generally people mean financial assets, such as stocks and bonds, and real estate. As for financial assets, as far as I know Mises and Hayek didn’t get into them to deeply with regard to the business cycle. You’ll have to go to Machlup for that.

I guess that you would include financial and real estate assets under producer prices. If the interest rate falls, the value of financial instruments automatically rises because if the stream of future income doesn’t change, a lower interest rate will cause the principal to become larger to adjust for it in the capitalization process. Then, as Machlup writes, demand for the instruments of ownership of businesses (stocks and bonds) will cause the value of business assets (land and equipment) to increase. Machlup has a lot of info on how the increase in the money supply causes the stock market to jump.

As for real estate, especially housing, I guess you could consider it producer pricing, too, because if a person buys a new home that’s larger or better quality, the production period is lengthened. Consumer durable like housing and cars are kind of a special case that seems to straddle the producer/consumer divide.

But another way to look at it might be to view the stock market as not affecting the real business cycle, but mirrorring it.

J.K. Baltzersen November 2, 2007 at 1:31 pm

Nice article and blog post, but has anyone else “jumped” at the image of a gold coin of the Austrian republic?

Since when was a relatively sound gold standard connected with the Austrian republic?

If the point is to have something Austrian, wouldn’t it be better to have a pre-WWI gold coin?

Mike Sproul November 2, 2007 at 1:33 pm

David Hillary:

“Real Bills Doctrine is not really helpful and somewhat confused. If you put it into its historical context, what the proponents thereof seemed to be saying is that banks should be free to invest in commercial bills of exchange that are used to finance merchandise trade and mature within 90 days.”

The RBD has been stated in many ways over the centuries, and your quote illustrates one of them. The correct version of the RBD is that newly issued money can be backed by anything of value–be it land or lottery tickets, and the physical form of that backing doesn’t matter. Once that is recognized, it becomes clear that money is valued according to the assets backing it, which is true of all financial securities.

jp November 2, 2007 at 1:34 pm

Fundamentalist, thanks for the response.

I would tend to agree that stocks and bonds fall in the producer category. When you buy a new bond or stock issue of a company, this money is soon spent on producer goods, say a new factory. So what seems like asset inflation is really producer inflation, with a lag (the amount of time it takes to spend the new money). If you buy old stock or bonds, this frees the seller to buy producer or consumer goods.

I have read Machlup but it looks like I will have to reread him. My question though is, what about derivatives? Machlup didnt mention these since he wrote in the 30s, before they were big.

A lowering of the interest rate below the market rate could lead to money flowing into consumer goods, producer goods, or financial assets (which will be spent on producer goods), and also into derivative markets like options and futures. But unlike a new stock issue, new options on stocks do not result in increased production. This increase in derivatives would therefore not be reflected in producer prices. Under what Austrian category would money flow into options and futures fall: consumer or producer goods inflation? Or are they part of a third hypothetical construct called financial assets?

I dont think I am nitpicking here. There seems to be a discrepancy between the core Austrian theory and the way it is presented by writers to explain current reality with respect to the idea of asset price inflation.

David Hillary November 2, 2007 at 1:54 pm

Mike:
So it should not be called the Real Bills Doctrine but the balance sheet solvency doctrine. Then again, if the bank is not cash-flow solvent, then the value of its demand liabilities will be less than par, so maybe it should just be called the bank solvency doctrine. The doctrine, restated, would be that so long as the bank remains solvent (i.e. balance sheet solvent (assets exceed liabilities) and cash-flow solvent (not in default on any payment obligation)), then the bank’s demand securities will be valued at par.

DickF November 2, 2007 at 3:59 pm

Dick F

One quibble, and one disagreement:
1) Coins can be of slightly different weights and still circulate, since most people don’t distinguish weight differences in the neighborhood of 2% or less. But the clippers and sweaters keep up their work (which is theft) and the coins continue to lose weight.

Just as counterfeiters do not invalidate the use of money in exchange those clipping and sweating gold coins would not invalidate their use. Just as counterfeiting has limits so do clipping and sweating. One who intentionally misrepresents a media of exchange is guilty of fraud and should be prosecuted by the state. Taking your argument to its logical conclusion all economic activity is invalid because of crime. Again, I believe your argument is a red herring.

2) The dollar is not fiat money. There is no such thing. The dollar, like all goveernment paper money, is backed by the assets of the central bank that issued it. Otherwise you’d have to wonder why all central banks bother taking assets in exchange for the money they issue.

I suggest you read a dollar bill. The dollar is not backed by any asset. If you doubt this I suggest you try to take a dollar to the Treasury Department and exchange it for an asset.

The FED can loan dollars to banks to satisfy the FFR without receiving any asset in return. They could set the interest rate to zeor then simply create money at will and distribute it to the banks to cover their reserve requirements.

While the discount window does have an asset requirement. The only restraint on the FED concerning the issuance of fiat money is their own internal procedures which can be changed with a simple vote of the governors.

DickF November 2, 2007 at 5:02 pm

Dick, could you go into a bit more depth on Mises’s view on inflation?

Anthony,

Sorry it took me so long to get to your request. If you have not read The Theory of Money and Credit I recommend it highly. Most of the book is dedicated to the determination of the value of money.

In TM&C Mises defines money as simply a medium of exchange. Such a medium can be anything that is accepted in third party exchange and the value attributed to it is determined by those who present it and those who accept it in exchange.

Now concerning the value of money Mises states in Chapter 11 section 3:

All determinants of prices have their effect only through the medium of the subjective estimates of individuals; and the extent to which any given factor influences these subjective estimates can never be predicted. Consequently, the evaluation of the results of statistical investigations into prices, even if they could be supported by established theoretical conclusions, would still remain largely dependent on the rough estimates of the investigator, a circumstance that is apt to reduce their value considerably. Under certain conditions, index numbers may do very useful service as an aid to investigation into the history and statistics of prices; for the extension of the theory of the nature and value of money they are unfortunately not very important.

Mises is saying that the value of money has so many components and the components are so variable that one can never know their impact on the value of money from moment to moment or from component to component. This totally refutes the monetarist view that a constant supply of money, or a constant increase in the supply of money, will always keep the value of money constant. It also refutes the Supply Theorists who say that an increase in money supply will always result in inflation and a decrease in the money supply will always result in deflation. The value of money is subjective not objective.

But the value of money is subject to marginal utility so one can say in a general way that an increase in the supply will decrease the marginal utility of money and so its value will decrease but this cannot be accurately measured.

The reason I make this point is that no one can manage the value of money and the theories of the academic economists who attempt to use the FED to manage money value will always fail because they simply do not have the tools to know what they are doing. No one does.

So are we lost with no solution? No!! We do have a solution. If money is defined in terms of a monetary commodity that will reflect the various components that affect the value of money then we do not need to know all the components of money value. The obvious solution is to use the commodity that has been recognized for thousands of years as the foundation of a monetary system. That commodity is gold. I will not go into all the reasons gold is the best monetary commodity. That can easily be found.

Now if the monetary unit, which we can call a dollar, is defined in terms of gold because gold is the most consistent commodity the dollars value will be consistent. Other commodities that fluctuate due to weather, rot, or rust can fluctuate around gold and by extension the dollar, but the dollar itself will remain stable, as good as gold. With a gold-based dollar you can see the change in marginal utitlity by watching the dollar-gold exchange value. Say that 400 dollars will exchange for one ounce of gold, the monetary authority can issue money substitutes (gold certificates for example) based on the defined dollar 400 per ounce of gold. If the dollar price exceeds 400 per ounce of gold on the open market a quantity of dollars can be removed from the economy until the marginal utility of the money substitute returns the exchange value to 400. Likewise if the price falls money can be added to decrease the marginal utility. This will keep the dollar in a very narrow range of value based on the stability of gold and the marginal utility of money substitutes. If changes in economic activity or population or other changes the demand for dollars it will be reflected in the exchange value of the dollar substitutes and the supply can be adjusted properly.

I hope this explains a little.

Mike Sproul November 2, 2007 at 7:00 pm

Dick F
“I suggest you read a dollar bill. The dollar is not backed by any asset. If you doubt this I suggest you try to take a dollar to the Treasury Department and exchange it for an asset.”

You are confusing backing with convertibility. A dollar might be backed and convertible into 1/35 oz of gold, but on weekends the bank is closed and the dollar is inconvertible. Over the weekend the bank still has the same assets as before, and the dollar is still backed. The dollar has been inconvertible since 1933, but the fed still has the gold and bonds it had then. The difference between suspending convertibility for a weekend and suspending it for 74 years is only one of degree.
Furthermore, the dollar is not physically convertible (the bank will not buy back a dollar for 1/35 oz.) but it is financially convertible (the bank will buy back a dollar with a dollar’s worth of bonds) As long as the fed maintains financial convertibility, physical convertibility is irrelevant. Clearly, anyone who has ever used dollars to buy bonds from the fed has exchanged a dollar for an asset.

Anthony November 2, 2007 at 7:35 pm

Dick, thanks for the explanation. I am increasingly beginning to realize how much integration and deduction economics requires. I’ll read Mises’s works on the matter once I’ve covered more basic ground.

Peter November 2, 2007 at 8:48 pm

“The pound was originally the value of one pound Tower weight of sterling silver (hence “pound sterling”). “

That’s true – but there was never a coin of that weight. If you wanted to pay someone a pound in coins, you’d use several coins of lesser weight, not a “one pound coin”.

Whether a pound consisted of 16 oz in those days I don’t know.

A pound is now, and has always been, 12oz.
(The word “ounce” comes from the Latin word for “one twelfth”; the Troy ounce being 1/12 of a pound makes a lot more sense than the avoirdupois ounce being 1/16 of a pound – I don’t know how that came about. FWIW, a troy pound is lighter than an avoirdupois pound, too – but a troy ounce is heavier than an avoirdupois ounce)

George Gaskell November 2, 2007 at 9:25 pm

The difference between suspending convertibility for a weekend and suspending it for 74 years is only one of degree.

Please tell me that was a joke.

Mike Sproul November 3, 2007 at 10:55 am

George:
A difference of exponents, to be exact. A dollar that will be convertible into 1 ounce of silver in 1 year is worth 1/(1+R) today. A dollar that will be convertible in 74 years will be worth 1/(1+R)^74 today, except, as I said, if it is only physical convertibility that is suspended. As long as financial convertibility is maintained, both dollars can be held at 1 ounce today just by open market operations.

George Gaskell November 3, 2007 at 1:17 pm

The math isn’t making it any funnier.

They didn’t “suspend it for 74 years.” They suspended gold redemption permanently. The fact that it’s been 74 years since that was done is immaterial. The fact remains that governmental seizure of the monetary system has altered the expectations of all market participants indefinitely.

In other words, the difference between a bank’s suspending convertibility for a weekend and FDR’s action is the same as the difference between being asleep and being dead.

Mike Sroul November 3, 2007 at 3:59 pm

The fed suspended convertibility for an unspecified time period. The bank of england did the same thing from 1797-1821 and then resumed convertibility. In both cases, the assets remained in the bank.
More importantly, in both cases they maintained financial convertibility, which can make physical convertibility irrelevant.

Yancey Ward November 4, 2007 at 10:12 am

I would be very careful trying to extrapolate a future dollar price of gold, especially using bank credit as a predictor. If those debts default in the future, which they may well do, there will be huge increase in the demand for dollars and a decrease in the supply, everything else being equal- in other words, this inflation may have a deflation downside. I know many think the central bank will resort to mass inflation to prevent this, but if I were the central banker, I would be very reluctant to do this since it would likely lead to the demise of my currency. It seems to me the choice, in the end, is this- let the debts go bad, let some of the cartel members go under, but retain my ultimate possession- the currency; or inflate like mad and lose it all. Never assume that central bankers are stupid.

Don’t get me wrong, there is nothing wrong with holding some gold- it is the ultimate monetary insurance against a complete financial collapse or a runaway inflation, but don’t do it thinking you will get incredibly wealthy if and when the price goes to $10,000/ounce. Other real products and real assets- the things you would exchange your gold for- will also be rising in prices denominated in dollars.

George Gaskell November 5, 2007 at 12:02 pm

More importantly, in both cases they maintained financial convertibility, which can make physical convertibility irrelevant.

I imagine it’s not irrelevant to the holders of the notes.

Mike Sproul November 5, 2007 at 12:44 pm

It is irrelevant to the holders of the notes. If the public has unwanted dollars (say after the christmas shopping season) and those dollars are physically convertible into 1 ounce of silver, then the public will return their dollars to the issuing bank for 1 ounce. The bank can head off this demand for silver by simply selling bonds for dollars, thus soaking up the unwanted dollars before people start demanding silver. The maintenance of financial convertibility could keep the value of the dollar at 1 ounce, so if anybody really wants one ounce for a dollar, they can buy the silver on the open market for 1 dollar.

George Gaskell November 5, 2007 at 2:51 pm

The maintenance of financial convertibility could keep the value of the dollar at 1 ounce, so if anybody really wants one ounce for a dollar, they can buy the silver on the open market for 1 dollar.

How does any of this bear any resemblance to the situation where there is a 1-to-1 redemption? Who are you to substitute your estimate of value for theirs? What makes you think that the price of the ounce of silver (or dare I say, the dollar of silver, which is what the Thaler once was) on the open market will be equivalent to the redemption value?

You seem to have some kind of mental block against comprehending the existence and operation of risk and forecasting, as though you want to take all of the bank runs and failures that have every actually happened and wish them away.

Mike Sproul November 6, 2007 at 12:12 pm

Bank runs are caused when banks try to maintain 1-1 physical convertibility when their assets are insufficient to buy back all their money at this rate. That is a big reason why almost all banks have abandoned physical convertibility in favor of financial convertibility, since such a bank is immune to runs. If the dollar should then drop below 1-1, the issuing bank can sell bonds for its dollars and thereby raise the market value of the dollar back to 1-1.

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