“In a social order that is entirely founded on the use of money and in which all accounting is done in terms of money, the destruction of the monetary system means nothing less than the destruction of the basis of all exchange.” – Ludwig von Mises, The Theory of Money and Credit, p. 202.
In a recent email chain, some of my friends said the gold standard was crazy and wrote of the need for the Federal Reserve to manage our money supply—relying on appeals to “experts” to make their case. I wrote the following to try explain the problem with central banking. I hope you find it informative:
The fact that most economists and “experts” think returning to the gold standard to be crazy should be another reason to support such a move, given the competence of most economists these days.
But lest I rely too heavily on ad hominem attacks against them to make my case, let’s look at the facts.
Let’s say there are $100 total currency in circulation in the economy, and 10 people in the economy. The rich guy has $30, another guy $18, another guy $15, another guy $12, you have $8, the other five have their own share of the remaining $17. Everyone buys, sells, trades, and all is well. Now, all of a sudden, the government says, “we don’t have enough money, so we are going to put $50 more in circulation, come on down to the bank and pick up your share.” You do so, now you have $12. You think, “Wow, this is great. I am 50% richer!” But you go out and find out that since everybody now has 50% more money, and there is now $150 in circulation, nobody is actually richer, they just have 50% more money, so things just cost 50% more. Not great news, but at least there is no harm because everyone has 50% more than they did before.
That is just about—but not quite—what happens when the Federal Reserve decides to “print” more money through actions like the two rounds of quantitative easing as it has done recently. More money in the economy, i.e., inflation, means that prices go up. And if it operated just like this, no one would benefit and no one would be harmed. But as I mentioned, the way I described the way the money enters the economy isn’t quite the way it actually works.
What really happens is that the Fed gives the money not to all 10 people in the economy, but just to a few. So in our little world, the Fed gives the money to a bank owned by the Rich Guy. Then the Rich Guy lends $15 each to the guys who have $30, $18, & $15. Then, with all of money his bank is making off of these loans, he gives himself a $5 bonus. Now, all of a sudden, there is $50 more in the economy than there was before. Except, in this case, the money is in the hands of only four people. And those four people take that money and go out and start buying stuff. Oh, they are probably investing the money in new business ventures, but as they invest it results in the purchase of more capital goods and services. One guy is expanding his steel business, so starts buying more steel. Another expands his textile business, and starts buying more looms. The third expands his microbrewery, so starts buying more barley and hops. The problem is that no one else has any more money, and that they are not aware at first of more money in the economy and thus a higher demand for products, so you (the farmer with the $8) sell your barley and hops at the same price you did before, 10 cents a bushel. Same thing for the poorer folks in the economy, the laborers, who at first continue selling the labor to the rich guys at the same price. So the rich guys make their investments at pre-inflation prices, and the rest of the people in the economy have sold their goods and services to the rich guys at pre-inflation prices. So now, the rich guys have more stuff to sell, and the poorer folks have more money to buy with. The only problem is that now, everyone realizes there is a higher demand for the stuff (since there is more money in the economy), so the prices go up 50%. So the people are buying the products at the inflated prices that the rich guys produced at pre-inflated prices. So when all the buying and selling is done, there is still $50 more in the economy as in the previous example, but the distribution is different. The four rich guys have on average 65% more money in their pockets, while the other 6 people in the economy have only 35% more money, most of this new distribution being based on the results of inflation, not ROI. Yet prices are still 50% higher than they were before. So the rich guys are now richer because of the inflationary practices of the Fed, and the poor guys are poorer, that is, the poor guys have more money, but because prices have risen faster than the amount of money they have, they are actually poorer. And vice versa for the rich guys.
These are the results of the operations of the current system of fractional reserve banking.
A gold standard, on the other hand, is not subject to the whims of policymakers who desire to create more money. It is much more stable. Yes, the supply of gold does grow over time, but only incrementally (we’ll leave the discussion of the conquest of the Aztecs and Incas for another day), and only when people take their own hard earned money and go invest in more labor, mining equipment, etc. Much more measured and risky than printing new greenbacks. So while we would have inflation under a gold standard (inflation being an increase in the money supply, which then leads to a subsequent increase in prices), the inflation would be dramatically less and much less disruptive, in large part because the rich guys are investing their own money BEFORE there is more money, i.e., gold, in the economy, so the economy can anticipate the arrival of more gold in the economy and prices can adjust accordingly. In this way, the wealth of the rich man increases (if in fact he finds gold in the mine) much more because of his return on investment than because of inflationary gains.
So, you ask, “Well, Bill, that sounds just fine. But if this is the case, why do most economists, experts and politicians pooh pooh the gold standard and support fractional reserve banking?”
Good question!
Let me now ask you a question. Let’s say you are one of a majority of economists, experts, and politicians (pick one) who support the present practice of government of spending more money to fix the world’s problems. And you get to thinking, “Man. We’ve got to spend more money to get aggregate demand going to fix this economy, because it is falling apart.” Or, “If we don’t spend more money on this new Tsetse Fly Museum in my district, there is no way I am going to get reelected.” Or, “If we don’t spend more money on this job training program, nobody is going to get a job in my district.”
Whatever the case, you want the government to spend more money. But there is a problem. The government can only spend more money by taking it from taxpayers or by borrowing it. And those pesky taxpayers are getting a bit uppity because the government keeps taking their money, and both the lenders and taxpayers are getting noisy about the size of the government debt. You don’t know what you are going to do to get more money for the government to spend on your pet projects.
Then, some guy in a slick suit comes into your office one day and says, “Have I got a deal for you. I work over at the Federal Reserve. I can create money out of thin air by making an entry in my books. How about I create $105 billion more dollars. Then you get the government to issue $100 million more in federal debt. Then I’ll go tell the bankers that if they buy the $100 million in federal debt from the government, the Fed will immediately buy it from them for $105 million. That way, even though they buy the debt, they won’t have to hold it. In fact, they’ll be able to sell it the Fed for a profit! So the bankers will be happy, the government will have $100 million dollars more to spend, and the taxpayers won’t come complain to you about higher taxes. They will have no idea what happened! Of course, the taxpayers as consumers will eventually notice that prices have gone up faster than their own supply of money. But by that time, they’ll have no idea that the higher prices were caused by the government creating new money out of this air, and you can blame it oil speculators, OPEC, the war in the Middle east, and greedy industrialist. By the time you get done, their heads will be spinning so fast, they won’t know who to blame”
So my question to you is, if you were one of these politicians, experts, or economists, don’t you think you might, maybe, just a bit, be swayed to think something like, “Yeah.. that’s the ticket! Yeah, you betcha!”
That is why the majority of economists and “experts” oppose the gold standard and support fractional reserve banking.
Another simpler way of putting this is that factional reserve banking is simply a way of debasing the currency to support government spending, and other than being more sophisticated, is EXACTLY the same thing as the practice of shaving gold and silver coinage by kings and governmetns of the past when almost all money was not just based on gold and silver, but actually made out of gold and silver. The practice was that the sovereign would take a one ounce gold coin out of circulation, shave it around the edges, and return to circulation a .9 ounce gold coin. Do that ten times, and the crown gets a new gold coin out of thin air!
Yet a majority of politicians and experts (including those who would be the equivalent of economists in those days) supported such practices back then.
“In a social order that is entirely founded on the use of money and in which all accounting is done in terms of money, the destruction of the monetary system means nothing less than the destruction of the basis of all exchange.” – Ludwig von Mises, The Theory of Money and Credit, p. 202.
In a recent email chain, some of my friends said the gold standard was crazy and wrote of the need for the Federal Reserve to manage our money supply—relying on appeals to “experts” to make their case. I wrote the following to try explain the problem with central banking. I hope you find it informative:
The fact that most economists and “experts” think returning to the gold standard to be crazy should be another reason to support such a move, given the competence of most economists these days.
But lest I rely too heavily on ad hominem attacks against them to make my case, let’s look at the facts.
Let’s say there are $100 total currency in circulation in the economy, and 10 people in the economy. The rich guy has $30, another guy $18, another guy $15, another guy $12, you have $8, the other five have their own share of the remaining $17. Everyone buys, sells, trades, and all is well. Now, all of a sudden, the government says, “we don’t have enough money, so we are going to put $50 more in circulation, come on down to the bank and pick up your share.” You do so, now you have $12. You think, “Wow, this is great. I am 50% richer!” But you go out and find out that since everybody now has 50% more money, and there is now $150 in circulation, nobody is actually richer, they just have 50% more money, so things just cost 50% more. Not great news, but at least there is no harm because everyone has 50% more than they did before.
That is just about—but not quite—what happens when the Federal Reserve decides to “print” more money through actions like the two rounds of quantitative easing as it has done recently. More money in the economy, i.e., inflation, means that prices go up. And if it operated just like this, no one would benefit and no one would be harmed. But as I mentioned, the way I described the way the money enters the economy isn’t quite the way it actually works.
What really happens is that the Fed gives the money not to all 10 people in the economy, but just to a few. So in our little world, the Fed gives the money to a bank owned by the Rich Guy. Then the Rich Guy lends $15 each to the guys who have $30, $18, & $15. Then, with all of money his bank is making off of these loans, he gives himself a $5 bonus. Now, all of a sudden, there is $50 more in the economy than there was before. Except, in this case, the money is in the hands of only four people. And those four people take that money and go out and start buying stuff. Oh, they are probably investing the money in new business ventures, but as they invest it results in the purchase of more capital goods and services. One guy is expanding his steel business, so starts buying more steel. Another expands his textile business, and starts buying more looms. The third expands his microbrewery, so starts buying more barley and hops. The problem is that no one else has any more money, and that they are not aware at first of more money in the economy and thus a higher demand for products, so you (the farmer with the $8) sell your barley and hops at the same price you did before, 10 cents a bushel. Same thing for the poorer folks in the economy, the laborers, who at first continue selling the labor to the rich guys at the same price. So the rich guys make their investments at pre-inflation prices, and the rest of the people in the economy have sold their goods and services to the rich guys at pre-inflation prices. So now, the rich guys have more stuff to sell, and the poorer folks have more money to buy with. The only problem is that now, everyone realizes there is a higher demand for the stuff (since there is more money in the economy), so the prices go up 50%. So the people are buying the products at the inflated prices that the rich guys produced at pre-inflated prices. So when all the buying and selling is done, there is still $50 more in the economy as in the previous example, but the distribution is different. The four rich guys have on average 65% more money in their pockets, while the other 6 people in the economy have only 35% more money, most of this new distribution being based on the results of inflation, not ROI. Yet prices are still 50% higher than they were before. So the rich guys are now richer because of the inflationary practices of the Fed, and the poor guys are poorer, that is, the poor guys have more money, but because prices have risen faster than the amount of money they have, they are actually poorer. And vice versa for the rich guys.
These are the results of the operations of the current system of fractional reserve banking.
A gold standard, on the other hand, is not subject to the whims of policymakers who desire to create more money. It is much more stable. Yes, the supply of gold does grow over time, but only incrementally (we’ll leave the discussion of the conquest of the Aztecs and Incas for another day), and only when people take their own hard earned money and go invest in more labor, mining equipment, etc. Much more measured and risky than printing new greenbacks. So while we would have inflation under a gold standard (inflation being an increase in the money supply, which then leads to a subsequent increase in prices), the inflation would be dramatically less and much less disruptive, in large part because the rich guys are investing their own money BEFORE there is more money, i.e., gold, in the economy, so the economy can anticipate the arrival of more gold in the economy and prices can adjust accordingly. In this way, the wealth of the rich man increases (if in fact he finds gold in the mine) much more because of his return on investment than because of inflationary gains.
So, you ask, “Well, Bill, that sounds just fine. But if this is the case, why do most economists, experts and politicians pooh pooh the gold standard and support fractional reserve banking?”
Good question!
Let me now ask you a question. Let’s say you are one of a majority of economists, experts, and politicians (pick one) who support the present practice of government of spending more money to fix the world’s problems. And you get to thinking, “Man. We’ve got to spend more money to get aggregate demand going to fix this economy, because it is falling apart.” Or, “If we don’t spend more money on this new Tsetse Fly Museum in my district, there is no way I am going to get reelected.” Or, “If we don’t spend more money on this job training program, nobody is going to get a job in my district.”
Whatever the case, you want the government to spend more money. But there is a problem. The government can only spend more money by taking it from taxpayers or by borrowing it. And those pesky taxpayers are getting a bit uppity because the government keeps taking their money, and both the lenders and taxpayers are getting noisy about the size of the government debt. You don’t know what you are going to do to get more money for the government to spend on your pet projects.
Then, some guy in a slick suit comes into your office one day and says, “Have I got a deal for you. I work over at the Federal Reserve. I can create money out of thin air by making an entry in my books. How about I create $105 billion more dollars. Then you get the government to issue $100 million more in federal debt. Then I’ll go tell the bankers that if they buy the $100 million in federal debt from the government, the Fed will immediately buy it from them for $105 million. That way, even though they buy the debt, they won’t have to hold it. In fact, they’ll be able to sell it the Fed for a profit! So the bankers will be happy, the government will have $100 million dollars more to spend, and the taxpayers won’t come complain to you about higher taxes. They will have no idea what happened! Of course, the taxpayers as consumers will eventually notice that prices have gone up faster than their own supply of money. But by that time, they’ll have no idea that the higher prices were caused by the government creating new money out of this air, and you can blame it oil speculators, OPEC, the war in the Middle east, and greedy industrialist. By the time you get done, their heads will be spinning so fast, they won’t know who to blame”
So my question to you is, if you were one of these politicians, experts, or economists, don’t you think you might, maybe, just a bit, be swayed to think something like, “Yeah.. that’s the ticket! Yeah, you betcha!”
That is why the majority of economists and “experts” oppose the gold standard and support fractional reserve banking.
Another simpler way of putting this is that factional reserve banking is simply a way of debasing the currency to support government spending, and other than being more sophisticated, is EXACTLY the same thing as the practice of shaving gold and silver coinage by kings and governmetns of the past when almost all money was not just based on gold and silver, but actually made out of gold and silver. The practice was that the sovereign would take a one ounce gold coin out of circulation, shave it around the edges, and return to circulation a .9 ounce gold coin. Do that ten times, and the crown gets a new gold coin out of thin air!
Yet a majority of politicians and experts (including those who would be the equivalent of economists in those days) supported such practices back then.
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