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starbucks4ever (94.15)

Gold standard and fractional reserve banking

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November 15, 2010 – Comments (19)

On the gold standard (and its twin GEP, i.e.  gold equivalence provision) proposal, I am agnostic. I don't think it would change much, and I don't think it would do any damage. Here is why.

The real disease is the habit of printing more money than you have goods and assets. This is what drives inflation. Printing can be accomplished directly - by minting coins and/or physical paper or indirectly, via fractional reserve banking (FRB). In our economy, FRB is the preferred way to print money. People railing against fiat currencies are in fact railing against FRB.

FRB is at least as old as banking. Already Philip the Fair, when he initiated the most famous bank run in the medieval history, found no gold in the bank, but only paper securities which he could not negotiate. But he probably wasn't the first victim of FRB either, because merchants have been using notes as paper equivalent of gold long before these events - perhaps as early as in the times of the Roman Empire, if not earlier. So you can easily have too much money printing and inflation under the gold standard.

FRB, or at least, the possibility if it, is born each time when you accept strings of 1 and 0 bits as gold's equivalent. When you trade stocks on the internet without actual bullion changing hands, you accept fiat currency. Under the gold standard, you can still deposit a ton of bullion with your broker, open a margin account and buy 10 tons' worth of stocks, which is certain to create inflationary pressures on the stock market. In 1929 the market crashed under the gold standard because of the excessive leverage used by the players.

On the other hand, if you decide to get rid of FRB, this doesn't have to be under the gold standard. You can always have 100% reserve requirements no matter if the main currency is in dollars, gold, seashells, or plain old paper. In the USSR banks did not give loans to consumers, so no inflation could take place unless the minister of finance literally printed too many paper bills. Then Gorbachev allowed enterprises to take unlimited loans in "cashless rubles" and hyperinflation spiked immediately. If rubles were literally made of gold, the end result would be the same because you could transact with cashless rubles, effectively using 1 and 0 bits as currency.

Even when it comes to physical money supply, there is no reason it can't be manipulated under the gold standard. First, government can always borrow gold from other governments and increase domestic money supply. Moreover, it can borrow more gold than it ever intends to repay on the theory that creditors won't demand their gold back at the same time. Another possibility is to start from a low base: when the gold standard is introduced, keep most of the gold out of circulation and then gradually expand gold supply during the next 30 years. As far as economics is concerned, the result will be the same as the result of 30 years of monetary expansion under the fiat currency regime. Then when all 100% of gold is in circulation, we go off the gold standard again and repeat the cycle.   

19 Comments – Post Your Own

#1) On November 15, 2010 at 12:17 PM, Valyooo (99.43) wrote:

Printing money is a good thing when done correctly. If there is more stuff in circulation there should be more dollars to represent that. Otherwise, investing in something like the SPY would lose you money even if your purchasing power increased. People would hoard money and never invest, nothing productive would get done

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#2) On November 15, 2010 at 12:19 PM, chk999 (99.97) wrote:

If you get rid of FRB there is no good way to turn the dribs and drabs of people's savings into useful capital. So you end up back in the capital starved state we were in prior to about 1860.

 

Changing the subject, you've mentioned that you think oil should be at about $30 a barrel a number of times. Why? 

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#3) On November 15, 2010 at 12:56 PM, starbucks4ever (94.15) wrote:

Valyooo,

what makes you think we need any more investment?

chk999,

Just a matter of supply and demand. 

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#4) On November 15, 2010 at 1:46 PM, whereaminow (< 20) wrote:

We were capital starved in 1860 because it was 1860!!!!!!

It had nothing to do with how many frb's there were.  Frb's have been around for two thousand years.  France tried to go entirely paper with frb in the 1700's.  They were still capital starved because it was the 1700's!!!!  All they got for their efforts was a capital starved country combined with high inflation.

David in Qatar  

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#5) On November 15, 2010 at 1:57 PM, nonzerosum (89.59) wrote:

Good summary of FRB.  As you point out, banks have been doing it for ages and an balance I think its probably not a bad thing. Reason is that it does enable more borrowing, and if banks lend wisely it can create wealth.

I think it is different from govt printing because FRB is more like leverage.  It works both ways: if a borrower under FRB defaults then that default has a multiplicative money destroying domino effect, i.e. highly deflationary.  The bankers carried all that risk and that's why they used to be conservative people (today, of course, they just get bailed out). 

I think printing/diluting money is different because the govt carries no risk.  It is simply dilutes/prints and its a done deal - cannot be unwound. 

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#6) On November 15, 2010 at 1:59 PM, leohaas (31.35) wrote:

Nice try, but I am not buying.

"In the USSR banks did not give loans to consumers, so no inflation could take place unless the minister of finance literally printed too many paper bills."

That has got to be the worst argument ever used by an FRB opponent. I don't think anyone here is the US is interested in going the way of the USSR. Most people will read this statement as "the USSR did not have FRB, so FRB must be good..."

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#7) On November 15, 2010 at 2:00 PM, starbucks4ever (94.15) wrote:

Also, Valyooo is wrong because people will still have an incentive to invest in SPY because of dividends.

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#8) On November 15, 2010 at 2:03 PM, chk999 (99.97) wrote:

Here's what I'm not seeing about your price for oil:

I can see no way that oil usage won't go up over the next few decades as the standard of living in China and India rises. So the only way I can get 30 dollar oil is if there are vast supplies with all in lifting cost less than 30. So where are these supplies? 

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#9) On November 15, 2010 at 2:10 PM, starbucks4ever (94.15) wrote:

leohaas, 

I don't care what people will think. The ones who are rational will read it correctly. And for those inclined to draw false analogies, I will suggest the following logical argument: It is well known that Hitler took a shower every morning, so shouldn't be taking shower because that will make you a Nazi :)

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#10) On November 15, 2010 at 2:35 PM, Valyooo (99.43) wrote:

I am not wrong.  I will use the example of fish, because it is what Schiff uses in his book.

 

Lets say everybody on an island fishes.  Fish is the only product right now.  There are 3 people on this island.  Each person can only catch 1 fish per day.  Fish is eaten and also used as currency  One person, Abe,  underconsumes to spend a few days building a net.  Once it is built, he can catch 2 fish a day.  He stockpiles fish so he only eats 1 per day and after a year he has 365 saved up.  He makes a loan to Joe, one of the other guys of 5 fish so that Joe doesnt have to underconsume while he builds his net.  Joe builds his net, eating in the meanwhile.  Now hecatches 2 a day. etc etc etc

After a year, there are soooo many more fish in existence.  Since fish is also used as currency, there is also more currency around, resulting in a stable money supply, i.e. 1 fish = 1 fish.

 There would not be dividends in an unchanging money supply, because there would not be new money to pay out in dividends.

If we used an unchanging money base, and there was 1 fish note (lets call it a bar of gold) when there were 0 fish stockpiled, and still only 1 bar of gold when there was 100,000 fish stockpiled, how would Joe pay out dividends to Abe?  He would now be catching so many more fish than he could have because of Joe's loan, however since the mony supply is unchanged he only pays him back the 1 bar of gold he borrowed.  So now fish are cheaper, but Abe still only has 1 bar of gold.  So where is the incentive to loan?

And without loaning/investing we would still be in the stone age.

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#11) On November 15, 2010 at 2:37 PM, Valyooo (99.43) wrote:

BTW, this is not me sticking up for FRB...I don't know enough about it.  To me it makes no sense, because things are still proportional.  If you lend 10x more than you have things will be 10x more expensive.  Why not keep it at 1x with a 1x price level, should be the same, whatever, like I said I don't know enough.  My point is just that there needs to be a changing money supply for lending to work

 

Think of "money" as "stuff".  there is more stuff produced, why shouldnt there be more money?

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#12) On November 15, 2010 at 2:39 PM, Valyooo (99.43) wrote:

What would drive down the demand for oil?  The supply will get lower, boosting the price if anything.  Also, XOM is the highest market cap company in the world, not sure why you keep saying its near bankruptcy

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#13) On November 15, 2010 at 2:58 PM, starbucks4ever (94.15) wrote:

"So the only way I can get 30 dollar oil is if there are vast supplies with all in lifting cost less than 30. So where are these supplies?"

In the ground :) 

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#14) On November 15, 2010 at 3:27 PM, chk999 (99.97) wrote:

Well, there may be multiple undiscovered super-major fields out there with low lifting costs, but that's not how i'm going to bet. Time will tell which one of us is right. 

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#15) On November 15, 2010 at 7:50 PM, rfaramir (29.33) wrote:

Real money IS stuff, whether gold or fish. Fiat money is not stuff, not real, or only as real as people believe it to be and act on that belief.

Dividends can be paid in fish, why not? Interest on loans can be paid in fish, or gold, or whatever the two parties mutually agree on. The interest on a loan is the cost of getting the money now, while the loaner goes without it. The loan recipient gets the use of the money now and promises to pay back more later. He is becoming twice as efficient a fish-producer by building his capital equipment (the net), so he will have the ability to pay as soon as it is done (begin paying). If he borrowed 5 fish to build a net in 5 days, still eating 1 fish a day, he then starts catching 2 fish a day, but still eats 1 a day for 6 days, giving the other to the loan originator.

Fractional reserve banking is fraud on its face. When you deposit a fish (or gold bar) and the bank gives you a receipt for it, you might be able to use that receipt as money in payment to others. They would later take the receipt to the bank and redeem it when they want the real money, instead of the money substitute. (Perhaps they are paying for something imported and the importer wants to take the fish or gold with him back overseas where they have no easy access to your fish or gold bank.) So far so good, the fish notes are a money substitute, technically, and do not constitute an inflation of the money supply, since there is a one-to-one correspondence between a money item being put into the bank for safe keeping and a money substitute (note/receipt) being released into circulation.

The fraud comes in when the bank notices that is has a whole lot of fish (or gold) in its vaults and only a fraction of that amount going out each day in redemptions. They see their receipts being treated as money outside the bank and decide to print a few more than they really have, since no one is likely to notice. They are defrauding the recipients immediately, though they do not know it, since they are presenting what they claim is a claim on fish (or gold) in the bank, but there is already a claim on the same items. They are lying, saying that the recipient has effective ownership of a fish (or gold bar), when they actually have a fractional and shared or conflicting ownership stake. They are selling the same fish twice; quite profitable a fraud for as long as you can get away with it.

Once the fraud is discovered, there is bank run, and only the first N notes redeemed actually become fish, the rest are suckers. (ha ha pun discovered) Unfortunately not enough bankers were then lynched, or fractional reserve fraud would never have taken hold. But too many bankers got away, formed a cartel which mutually supported each other with temporary fish (or gold bars/coins) to be redeemed by potential bank runners. The cartel became the Federal Reserve Bank in 1913.

Note that throughout, it did not matter whether the real money was fish or gold, so long as it was a commodity. And the paper receipts were fine, so long as they were truly redeemable on demand. Not just allowed to be redeemed, but the bank had to actually have the commodity in the vault with exactly one outstanding receipt per item. When we go back to a gold standard, we will still deal with paper, but it will be redeemable paper, money substitutes, not unbacked, worthless, fiat paper.

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#16) On November 15, 2010 at 8:56 PM, starbucks4ever (94.15) wrote:

#15,

So, gold standard AND 100% reserve requirements? That will do the trick. But can't we then skip the gold part, print a fixed quantity of Quatards and close the printshop? 

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#17) On November 16, 2010 at 2:39 PM, rfaramir (29.33) wrote:

The market chooses what the commodity is, it has usually chosen gold, sometimes silver. If you like, you can substitute whatever you and your trading partner can agree on. That's the whole point of the free market, you have liberty to do what you want, so long as you don't force anyone else. So you and your partner have to agree or the deal doesn't go through, since neither of you should force it.

What you will likely choose is something that is highly divisible, since any quantity will do to serve the whole market, but some people want to trade small amounts, some huge amounts, so it needs to be available in a wide range of amounts. Gold is essentially infinitely divisible (as are other metals and liquids), fish, not so much.

What you will likely choose is something that has high value per unit weight. This is why gold is chosen over silver and either is preferable to rocks or wood or tobacco or whiskey or fish. Diamonds would win here, as refugees know. Paper can temporarily win here, but people catch on pretty fast to Zimbabwe trillion dollar notes, as it has no real value.

What you are likely to choose is something durable. Gold is slightly more durable than silver (corrodes less) and much more durable than fish.

And so on.

Quatards? However easy it was to set up shop to print them is a maximum on how easy it will be to set it up again. Trust no one to voluntarily refrain from it. Even if you don't set up the print shop again, someone else will (counterfeiters), and if they can find a copy of your design it will be cheaper for them than it was for you originally (less work to do), essentially guaranteeing that it will happen.

Gold cannot be printed, nor silver. Every commodity that is chosen by the market has value in and of itself AND takes effort to produce more of, preferrably LOTS of effort, as no one wants their store of money diluted in value easily. If you go to the effort (and risk) of actually finding and developing a gold or silver mine, you are producing a real commodity and the market will reward you, not look upon you as a counterfeiter. If you luck upon a big, high-quality mine (a la Petosi), your production will have some truly inflationary impact on the world market, but the free market can deal with this. It will not ever become hyper-inflationary, which is only possible with fiat currencies.

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#18) On November 16, 2010 at 5:37 PM, starbucks4ever (94.15) wrote:

Interesting. So you don't want to carry any paper equivalents of gold on the grounds that such equivalents could be counterfeited? That sounds like an extremist goldbug view. OK, let me ask you then, how you're going to pay the cashier for a pack of chewing gum? That's 1/4000 of an ounce of gold, mind you. Do you mind carrying an analytical balance with you to your grocery store? 

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#19) On November 17, 2010 at 12:55 AM, rfaramir (29.33) wrote:

1/4000th oz? 33 cents? Is gum really that cheap, or do you have a source of really small packs? ;-)

Paper that is convertible on demand for no fee into gold is fine. It is called a money substitute and is certainly more convenient to carry and trade. If market participants are willing to treat it as if it were as good as gold, it will work. A receipt for a particular bit of gold would be more secure, as it could be numbered (or in these days cryptographically signed) and verified for authenticity and uniqueness (no two people claiming the same bit of gold), but a bit more cumbersome. A receipt for gold at a particular bank would be a good compromise, as they would suffer a bank run if they overprinted, and counterfeiters would have a harder time redeeming them a long distance from that bank, but so would real customers, presumably.

Small purchases are also the main purpose of base-metal coins. They are redeemable in the higher denomination (specie in the case of a gold standard) on demand with no cost. In fact, in Britain, at one point, the free market had to come up with fractional pennies. They were so productive relative to their money supply that prices fell so much that a penny was too cumbersome for small purchases. Entrepreneurs made 'buttons' into a free market money substitute. They were useful in themselves, they were not free to produce, and people were willing to trade them for real pennies at whatever ratio was current in the market.

The free market can solve problems that come up.

Lastly, I'm not just a gold bug. Silver is fine, too. Or platinum or rhodium or uranium (maybe). I'm for liberty, private property, and responsibility, i.e., the rule of natural law. Fractional reserve banking is simply a gross violation of it.

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