Problems concering the implementation of a gold standard

I did not write the following message, but copied it from a Facebook forum. My intention is not to start a discussion on the efficiency/soundness of a gold standard vs. the current system, but the practical problem of re-implementing the gold standard today. I hope the message will inspire to some interesting debate:

 Does anybody know how much gold there is (or isn't) in Fort Knox? For all I know, that piggybank hasn't been audited since the 50's.

The US is a USD 13 trillion economy. I don't think there is USD 13 trillion of available gold to purchase in all the world. And if there were, with what kind of money is the Government going to purchase it? With dollars created out of thin air? You'll run into a hyperinfalion worse than Weimar.

So, to begin with, you cannot get the physical gold.

Even if you had it, the 13 trillion dollar US economy grows at a potential 3 to 3.5% per year. New gold dug out from the ground is much less in dollar terms than that. So you'll end up with a deflation if you run on a gold standard.

End of your gold standard backed by physical gold in a US vault.

What's next? You could say that the USD is backed by the price of gold at current spot prices. In other words, USD 800 will always buy one troy ounce of gold (how far we've come from the USD 35 per ounce). This has the same restrictive problem of growth creating deflation.

But there's a much bigger problem. And it's the problem that has caused all the debasement of your currency. And it's not the Fed.

It's the irresponsible politicians in your Legislative and Executive Branch. They have been spending far beyond their means. Like all Americans apparently also do (you have a negative savings rate).

Why does the Fed create money? Not to give it to those monopolic bankers and rich people like the J.P. Morgans or Rockefellers you depict in your alarmist videos. It is to give it to your Government who has spent much more than what they have collected in taxes.

Some of you may argue "but we have read of all the liquidity injections the Fed is pumping into the market to save the big Wall Street firms".

What the Fed does is "repos". I.e. repurchase agreements. The big banks who have access to Fed funds give the Fed a collateral of, say one billion dollars in debt they have due, and they receive a very short term loan of one billion dollars, for one day or two days. Maximun two weeks, after which they have to return the money back to the Fed PLUS interest and get their collateral back. These injections of cash are not money that stays in the market. It gets repaid. Yes, it's true that in these troubled times the banks roll over and over the repos. But that's the money that's being talked about when they say the Fed has "injected liquidity". It's the same money that comes out from the Fed and goes back in again in a couple of days.

But back to the problem when the Fed REALLY creates money out of thin air. Your politicians have created such an awesome number of entitlements, subsidies, pork barrel spending and other types of spending that what the Government receives in revenues, mostly from taxes, is not enough to cover the spending.

So in order to pay for that excess (over budget) spending the Treasury issues Treasury Bonds to be bought by the Federal Reserve, who buys these bonds and issues the money to the Government. They don't use dollar notes out of the printing presses like shown in your alarmistic videos. They automatically "deposit" the money by electronically increasing the cash & bank balance of the Treasury in exchange for the notes or bonds the Treasury gave to the Fed.

If your Government would spend less than it collects, or at most exactly what it collects, no more money would be created out of thin air.

Solving that problem, the only entities which create money will only be now the banks through the fractional reserve system. The fractional reserve can be manipulated at will by the Fed. Just as it can say that for demand deposits the required reserve is 10%, therefore multiplying the money in the banks' reserves by 10, it can decide to fix the required reserve in 50%, therefore multiplying the banks' money by only 2. And even require reserves to be 100% of deposits when no additional money can be created.

This is a bit more complicated in real life. Just to give an example, demand deposits may require 25% of reserve requirements. But time deposits, or CD's can require less than 25%, maybe only 10-15%, becausethe owner of the time deposit can only request his money after the time of his deposit has expired, whereas the money in a checking account (or demand deposit) can be retrieved right away. Therefore, a "run" on a bank can be triggered by demand deposits but not by time deposits. So the required reserves for demand deposits should be higher.

So by adjusting the fractional reserve requirements the Fed can increase or decrease the money supply depending on external factors such as money demand or price levels or whatever the Fed is mandated to do.

The Fed is really not a problem. The problem is that it is mandated to do two different things, as opposed to most other countries where it has only one mandate, which is price stability.

The US Fed is mandated to achieve price stability AND, to put it more simply, low unemployment. Actually, economic growth at reasonable interest rates with reasonable employment levels. Now, that is too much for a Fed to do, especially since in certain periods (like today) these can become mutually exclusive objectives.

I believe there is nothing wrong with a Fed mandated to maintain price stability only, like the European Central Bank (ECB) and many others, but ridden of it's power to set interbank overnight interest rates, commonly known as the Fed funds rate. I believe the Fed could control the price level purely manipulating the money supply and leaving the interest rates to the free market economy.

What you really have to get rid of is politicians (except Ron Paul). You are now facing such an enormous future debt that your only chance is to inflate yourself out of it. That is, you'll have to tax all your people and your descendants with a 15%+ rate of annual inflation. Inflation is a tax. The IRS doesn't come to collect it, but it takes away your purchasing power anyway.

There is no way your current entitlements for Medicare, Medicaid and Pensions could be funded by taxes. We'll leave that decision to Ron Paul.

As for the future, you'll have to curb your politicians from spending. Where I hail from there is a law that mandates Government to maintain a minimum structural 2% surplus of the Government's annual budget. I don't know if something like this will work in the US. Especially when a President can decide to invade a foreign country and spend one trillion dollars without, for one moment, worrying where that money is going to come from. (From you, of course, dear taxpayers).

I know Ron Paul wouldn't do these unconstitutional things. But, then again, you already have a big mess to fix. He should have been elected 30 years ago. Now, if he gets elected (let alone nominated), he will first have to mend a broken country. But I don't think he will be President. He doesn't have the necessary political skills. He is not a populist. He won't promise things that he knows the country can ill afford. He has to do these things. He has to lie to the people. That's how politicians get elected. And then keep on lying. And I don't think he would do that. He has to promise healthcare to everybody. And when healthcare money runs out, the politicians of the day willl just order the Fed to print the necessary money.

It's not the Fed that has to be eliminated. It's those rotten politicians. But don't forget: It is YOU who elect them.


Ernst

Yes, I debated with that gentleman, but gave up when he stopped responding to what I said, and instead launched into long lectures which did not respond to my points.  Anyway:

lebear:

The US is a USD 13 trillion economy. I don't think there is USD 13 trillion of available gold to purchase in all the world. And if there were, with what kind of money is the Government going to purchase it? With dollars created out of thin air? You'll run into a hyperinfalion worse than Weimar.

I have no idea what this is supposed to mean.  What is USD 13 trillion of gold, when the dollar is not denominated in gold?  This is like saying there isn't 2 pounds of smell available, i.e. nonsensical.  And why would I want the government to purchase all the gold in the world with printed dollars?  I'm for free market money, not some absurd government run gold standard. 

lebear:

Even if you had it, the 13 trillion dollar US economy grows at a potential 3 to 3.5% per year. New gold dug out from the ground is much less in dollar terms than that. So you'll end up with a deflation if you run on a gold standard.

And? 

lebear:

What's next? You could say that the USD is backed by the price of gold at current spot prices. In other words, USD 800 will always buy one troy ounce of gold (how far we've come from the USD 35 per ounce). This has the same restrictive problem of growth creating deflation.

Let's see, people will go to work, earn money, save that money, and it will go up in value.  How terrible.  The problem with a fixed value is that the government cannot be trusted, will continue to print dollars, and Gresham's Law will kick in, de facto eliminating the gold standard. 

lebear:

But there's a much bigger problem. And it's the problem that has caused all the debasement of your currency. And it's not the Fed.

It's the irresponsible politicians in your Legislative and Executive Branch. They have been spending far beyond their means. Like all Americans apparently also do (you have a negative savings rate).

Well, claiming that all Americans spend beyond their means because the net savings rate is negative is a simple fallacy, but that's beside the point.  Yes, politicians spend a lot of money.  That's one reason to get rid of the government.  But how does this show that the debasement of the currency is not caused by printing more of it?  It's just an explanation as to why more is printed (as if that needed an explanation.) 

lebear:

So in order to pay for that excess (over budget) spending the Treasury issues Treasury Bonds to be bought by the Federal Reserve, who buys these bonds and issues the money to the Government. They don't use dollar notes out of the printing presses like shown in your alarmistic videos. They automatically "deposit" the money by electronically increasing the cash & bank balance of the Treasury in exchange for the notes or bonds the Treasury gave to the Fed.

We know how open market operations work.  If you can spend more than you have, and print the rest, what will you do?  Will you limit your expenditures?  The point is that the existence of this mechanism allows for such behavior, and encourages it.  But wait a second - none of this is the stated reason the Fed gives when it monetizes debt.  It gives reasons like price stability and preventing recession.  Is he claiming that they are simply lying?  The fact is, though, their bonds are (somehow) rated AAA and they do let them sit and sit - it is not the case that ALL debt is bought by the Fed.  So what controls the rate at which the Fed buys debt?  The desire to inflate the currency.  It's also a stretch to claim that this means the bankers don't get anything.  As currency is introduced into the economy, the bankers are the second to get their hands on it, the government being first.  The faster you get new money, the more you profit from inflation.  So, yes, they still profit from inflation. 

lebear:

This is a bit more complicated in real life. Just to give an example, demand deposits may require 25% of reserve requirements. But time deposits, or CD's can require less than 25%, maybe only 10-15%, becausethe owner of the time deposit can only request his money after the time of his deposit has expired, whereas the money in a checking account (or demand deposit) can be retrieved right away. Therefore, a "run" on a bank can be triggered by demand deposits but not by time deposits. So the required reserves for demand deposits should be higher.

So by adjusting the fractional reserve requirements the Fed can increase or decrease the money supply depending on external factors such as money demand or price levels or whatever the Fed is mandated to do.

Which is the first problem - manipulating the money supply to achieve ends the market doesn't desire.  It also prevents stupid bankers from going out of business. 

Today's article on Mises.org might also be pertinent to this debate.

The US is a USD 13 trillion economy. I don't think there is USD 13 trillion of available gold to purchase in all the world. And if there were, with what kind of money is the Government going to purchase it? With dollars created out of thin air? You'll run into a hyperinfalion worse than Weimar.

So, to begin with, you cannot get the physical gold.

Even if you had it, the 13 trillion dollar US economy grows at a potential 3 to 3.5% per year. New gold dug out from the ground is much less in dollar terms than that. So you'll end up with a deflation if you run on a gold standard.

The fundamental error with this argument is that the dollar cannot be defined as both a weight of gold and a Federal Reserve Note.  If gold were to replace federal reserve notes, it doesn't matter how much gold or federal reserve notes there are, only the ratio between the two.  This will give an exchange rate (and this is why gold prices go up as the ratio of supply between the two changes - and also why all attempts to peg FRN's to gold weights have failed).

Money is only valuable in what it can be exchanged for.  If gold replaces federal reserve notes as money, there should be no difference in the exchange rates between 2 different goods using gold as an intermediary as opposed to using federal reserve notes.  In terms of real goods and services, the total value of the total American gold supply (not already put to consumer use) would be equal to the total value of all federal reserve notes in circulation.

FINALLY, "dollars" tells us little about actual value.  It is a nominal term, not a real term.  13 trillion dollars sounds like a lot, but what does it mean?  You have to judge value by comparing the desire for one good in terms of other goods.  Money is supposed to serve as a master exchange rate, whereby other exchange rates can be determined by looking at both their prices (or exchange rates in money terms).  If we redefine the dollar to mean 1,000 ounces of gold, the real value of our economy won't suddenly shrink by 1,000,000 times, although in nominal terms it would.  Prices would simply change, in nominal dollar terms, to reflect the real values of the products, by way of their exchange ratios with other products.

If nominal and real value are one and the same, we could argue that any type of inflationary scheme, including hyperinflation, is a great thing, because it greatly increases prices, which increases our estimation of GDP in nominal (and thus) terms.  Yet if compare the output of real goods and services in a hyperinflation economy to a sound money economy, we will probably discover a much easier facilitation of trade and thus more output in the sound money economy.

Furthermore, there doesn't need to be the same amount of money in circulation as the monetary value of all the goods produced in a year.

This only presents a problem if for some reason everyone had to trade everything at the same time...or if someone wanted to buy the productive output of the entire annual economy in a single transaction.

Consider a bank loan of $1,000 with a fixed monthly fee for this loan of $50 until fully repaid.  If the $1,000 loaned is the only money in existence, it seems you can't pay back the $50 interest fees.  This is false, however.  If you pay the bank the first $50 out of the $1,000, then you can bury the remaining $950 and still make every monthly payment.  All you have to do is exchange labor for $50 every month.  Whether you directly labor for the bank, or you labor for those who the bank also finances doesn't matter.  The end result is the same, which is that one small amount of money can be repeatedly exchanged for products whose total wealth that far exceeds this amount.

Deflation in consumer prices without deflation in wage rates is the best possible thing for any economy.  It is comparable to wage rates going up with consumer prices remaining stable, which is similar to what is currently happening (although apparently not for too much longer).

Why do people who understand and know so little economics always turn out to be the ones who have the most to say on it? Some sort of sentiment of self-importance? Peculiar.

-Jon

I second meambobbo.

Also, you don't need the government to buy any gold.  Just get rid of legal tender laws and let the free market go to town.

The US is a USD 13 trillion economy. I don't think there is USD 13 trillion of available gold to purchase in all the world. And if there were, with what kind of money is the Government going to purchase it? With dollars created out of thin air? You'll run into a hyperinfalion worse than Weimar.

A $13 trillion economy does not necessitate that there be $13 trillion worth of dollars available - after all, with our $13 trillion GDP, there isn't anywhere near $13 trillion in printed dollar bills today. One dollar will be spent multiple times during the course of the year.

While I think most of the comments in here are justified, I just wish to reply to the single point, "There isn't enough gold."

I don't see how that is at all a viable point.  I mean.....if you were going to replace the dollar with gold by purchasing it, then as you buy gold, its price would go up.