But banks are still a problem. They profit from lending, but there is no decent mechanism to keep them from overlending. Banks are as dead as gold. Neither is any good anymore at allocating capital. Stock markets, on the other hand, are quite good at providing access to capital for great companies and starving those that have dim prospects. Banks still loan to son-in-laws!
Ask the Japanese still burdened by non-performing loans. Some argue that half of Chinese bank loans are non-performing. We don’t have to ship gold around anymore, yet gold is still considered a currency in modern international commerce. Gold is no longer the reserve of central banks, it is dollars.
You say wages? What did president hoover do Mish? Or England before him regarding wages - Kessler below thinks all the gold bugs are silly buffoons.
bankdersysrisk.blogspot.com
The last time broad based deflation was seen in America was during the depression. During this period President Hoover convinced US businesses to keep wage rates at pre-depression levels instead of reducing wages as had been done during other depressions. As a result of Presidents Hoovers action American companies tried very hard to keep wage rates from falling. As a result real earning power was increased for those who remained employed.
A popular myth of this time period is that The Federal Reserve allowed the money supply to contract after 1931, taking money out of circulation and producing broad based deflation whereas prices in almost all goods, services, and assets declined, increasing the buying power of money.
...Therefore the Federal Reserve did not in fact provide a policy of contraction of the money supply. The facts support that the Federal Reserve in fact tried to hyper inflate the currency by holding US sovereign debt and using this as the basis for creating money through lending. This tactic backfired when people and governments lost faith in the US banking system and pulled their money and gold out of the system.
Angered by the inability of the Federal Reserve to inflate the money supply and inflate prices back up to pre depression era prices President Hoover then began his war on Hording.
andykessler.com
David Hume argued in 1752 that more gold and more money supply didn’t necessarily mean an increase in wealth for England. Ask Spain. He had a good point, but no one listened.
Manufacturers got wealthy, but landowners, who still controlled Parliament, were being left behind. One reason was that while English exports were growing, countries on the Continent, including post war France, had nothing to pay for these goods with, except corn and grain. Parliament, in the pocket of landowners, passed stricter and stricter Corn Laws. This had the effect of raising food prices for workers in factories, who demanded higher wages, but it also decreased the market for goods from these factories, because there was no way to pay for them, except with the grain that was more or less banned from England. How stupid is that? This was a double knock on both mercantilism and the gold standard.
This set up a huge debate between Bullionists, who demanded convertibility to check inflation, and anti-Bullionists, who argued against it. The anti-Bullionists conjectured that banks would only issue banknotes as merchants turned in their “bills of exchange,” sort of like selling their accounts receivables. This was known as the Real Bills Doctrine, stating money was credit, and money supply would only grow to the level of actual credit in the system. John Law first developed it in 1705.
John Law proved economists shouldn’t be businessmen and his reputation killed the Real Bills Doctrine. Even when “invisible hand” Adam Smith backed Real Bills the Bullionists weren’t swayed. Too bad. Real Bills was only slightly flawed in that it didn’t check the amount of speculative loans a bank could issue, since loans are the source of bank profits. A floating reserve requirement, putting limits on fractional reserve banking in good times, could have fixed that flaw. Perhaps a Real Bills Doctrine could automate the creation of money supply today, in a modern non-gold standard world. But Reserve Bank chairmen have too much fun adjusting interest rates and turning on and off money supply at their whim to entertain the thought.
The protectionist Corn Laws were inflationary. Workers demanded higher wages to pay for higher food costs. Add to that the unrestricted loans from banks, which increased the money supply, and it was no wonder that inflation was rampant during Napoleonic War England. Peel, who had implemented the Bank Restriction halting convertibility, knew something had to be done. But he couldn’t pass anything through Parliament, to either cancel the Corn Laws, which would hurt landowners, or restrict bank loans, which would hurt bankers.
Peel turned to gold for the magic he needed to kill inflation. He put together a Bullion Committee filled with, you guessed it, Bullionists who pushed through a repeal of Restriction, meaning a return to convertibility.
After Wellington whacked Napoleon and ended the war, like magic, a period of deflation or dropping prices, occurred. This strengthened the anti-Bullionist’s case: A fixed price of gold is no way to run an economic system; especially when the output drops in price. Nonetheless, a Resumption Act (they should have called it anti-Restriction) passed in 1819, and mandated convertibility by 1821. Memory of John Law’s buffoonery cast a long shadow and convertibility was the damper on runaway money supply.
England might have bought foreign fixed assets, maybe land or buildings, but they weren’t necessarily for sale. Even if these assets were for sale, the legality of a foreign ownership or even getting legal title was questionable. The best solution to England’s gold buildup would have been to use it to set up factories in France or Germany or America. Politically, this was a dead issue. No way was that going to happen.
The more gold England had, the higher its bank reserves. With no outlet, this led to more banknotes in circulation, whether the economy needed that increased money supply or not. Too much money chasing too many goods meant price inflation. Wages went up. Interest rates went up, another byproduct of too much money and inflation, which often caused banks to fail, and resulted in runs on those banks. The fractional reserve banking was anything but stable, all because too much gold was in the British banking system. England had become Spain, laden with gold and not enough to spend it on.
So England devised a way to get rid of gold. It turned out, at least in my opinion, to be the wrong way.
It’s one of those brilliant concepts that works perfectly in a vacuum, but breaks down in real life. The problem with the classical gold standard is that the whole concept was based on the competitiveness of workers’ wages. When some rich flaneurs (idlers, slackers) in France began buying too many British pots and suits, and the gold flowed out of France, all the lower class French workers had to take a pay cut or get laid off. That wasn’t what they’d signed up for. No one puts up with a cut in wages without a fight. “But gold is flowing out” is a little tough to explain to the common worker. So they revolted and formed unions. Marxism, socialism and anti-productivity political regimes would soon flourish. All for some shiny metal.
The wrong thing was held constant. If wages had been held relatively constant and the exchange rate of money into gold allowed to float (like today), then workers would not have been as disaffected. In an uncompetitive country, instead of wages going down, the value of the currency would drop, import prices rise, and the blame laid on the foreigners for increasing prices. The flip side would have worked well for England. With a rising currency from a floating exchange rate, products like textiles would have gotten cheaper in both England and foreign markets, but not quite as cheap. So what? The market would still grow. National wealth would be created from a rising currency and money supply could grow at its natural Real Bills rate, rather than be affected by too much gold.
Rather than lowering wages and disenfranchising their customers, the British should have been working on ways to increase the wealth of all these other countries, because they were the end markets for the goods. And the more gold they collected, the smaller the markets became for their products. Pretty stupid.
The classical gold standard fixed the wrong problem. Success from selling $15 shirts for $5 meant gold moved into England, increasing money supply, and causing inflation. The inevitable increased wages theorized by the classical gold standard would make England’s goods less competitive, until gold flowed out and trade was balanced. But that would in no way close the gap between the $15 handmade shirt and the $5 power-loomed shirt. But why penalize progress? In the end, France and Germany industrialized and killed off their own cottage industry anyway. And closed the gap. Price gaps are to be exploited, not closed, but all the classical gold standard could do was level the field.
The reason to spend so much thought on the gold standard and its holding back of money supply is that elasticity renders a gold standard useless. In fact, a gold standard becomes dangerous as it distorts the real market for products and holds back increases in living standards in two ways: 1) It hurts shirt producers by decreasing the available market for the $5 shirt seller, and 2) It hurts buyers as they must pay more to the old $15 shirt maker, rather than buy the cheaper shirts and spend money on something else.
To be fair, England did have a problem. Bankers did lend out too much money in good times. It was profitable to do so and impossible to stop them. Regulation might have helped, but I doubt it. The Bank of England in 1870 and beyond needed a way to track money supply in the country, and make sure it didn’t expand beyond a Real Bill-like pace. There were no computers to track such things, instead just those Dickensian men in visors and green eyeshades at the banks. It was trial and error. The information just wasn’t available to determine an overheated inflationary economy until it was too late, so the classical gold standard was the less than ideal but workable solution.
Between 1865 and 1912, it is estimated that the capital markets in London raised 6 billion pounds. Of that total, 4 billion was invested outside of England, in “bond-based infrastructure ventures, such as Railways.” Hmmm. By 1865, England no longer had any decent investments at home? Perhaps not - the industrial revolution had played out. Capital, backed of course by that accumulated gold, flowed out to lend money to American railroads. The echo from the South Sea still kept the Brits risk averse.
Trade in technology today is not much different than it was in British textiles. As long as microprocessors and digital electronics get cheaper, it is a win-win for the producers and the consumers, as the cheaper functionality replaces something else. But as we saw with the British, how you get paid can help or hurt the creation of wealth and increase in living standards. Today, money sloshes around, but back in the 18th century money was a fairly local instrument. Precious metals such as gold and silver were the de facto currency for trade. But monarchies and their governments created their own currency, backed by gold. First as a convenience since a titan of industry would need wheelbarrows filled with gold to do his business, and then as a tool to control the economy. Today, the world doesn’t think about gold much, except around birthdays and anniversaries.
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The British pound’s convertibility to gold, predictably, was suspended during World War I. It took another seven years to get back on the gold standard. A guy named Churchill put England back on the gold in 1925, at the pre-War exchange rate. Heck, it was still Isaac Newton’s rate. Big mistake. It overpriced the pound, which got dumped, and gold quickly flowed out of the country. Banks had restricted money supply and England went into a nasty recession, a loud advertisement for floating exchange rates.
By 1928, the rest of the world went back on the gold standard, but not for long. Following the 1929 stock market crash, 1930 saw the introduction of the protectionist Corn Law-esque “Smoot-Hawley” tariffs (some say the market predicted the tariffs, which were debated in 1929.) Trade dried up as most other countries put up protective trade tariffs and increased taxes to make up for lost duties. A recession began in the U.S. and elsewhere, and the Federal Reserve, formed in 1912 to act as the central bank for U.S. currency, in effect mimicked the Bank of England. The Fed forgot, or didn’t know, that in a fractional reserve banking system, it was the lender of last resort, a concept that Brit Walter Bagehot had brought up years before.
In February 1930, it did cut the rate it would lend money from 6 to 4 percent. It also did expand money supply to a small extent. But the Fed chairman insisted that the situation would work itself out. That year saw the first wave of bank failures and each time a bank failed and deposits lost, the money supply was shrunk by that amount. By 1932, some 40 percent of all banks - roughly 10,000 of them, and $2 billion in deposits disappeared. The money supply dropped by over 30 percent. So did the gross national product, and just like that, 13 million people were out of work. If the Fed had just provided money as lender of last resort, most of the carnage might have been avoided. But no, the U.S. was back on the gold standard and not allowed to increase the money supply, lest gold leave the country.
Herbert Hoover vacuumed up whatever capital was left by increasing the top tax rate from 25 to 60 percent. In response, Franklin Roosevelt campaigned with “I pledge you, I pledge myself, to a new deal for the American people.”
In March 1933, just after FDR’s inauguration, unemployment hit 25 percent. After yet another bank run Roosevelt declared an 8-day banking holiday after which confidence in banks returned and deposits flowed back in. Later in 1933, the U.S. dropped the gold standard, following England, which dropped it in 1931. Unshackled, money supply could now increase and replenish banks. After a yearlong recession in 1938, New Deal spending kick-started the economy. A world war kept it going.
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Meanwhile, the Germans were stuck paying WW I reparations. In 1921, the victors presented a bill for 132 billion gold marks. With a crippled industrial base and dependency on imports for raw materials, the Germans were forced to print money to pay back debts. The mark was devalued by a factor of 481 billion. By November of 1923, the exchange rate was 4.2 trillion marks to the dollar. While the resulting hyperinflation left Germany without debts (and debtors learned a lesson to carry debt in dollars!), it wiped out the country’s savings and put the German economy into a severe depression, leaving the country susceptible to new political regimes.
On July 1, 1944, just 24 days after D-Day and well before World War II ended, a dollar standard was put in place, called the Bretton Woods agreement. It was considered a gold standard, but even economist John Maynard Keynes called it “the exact opposite of the gold standard.” The U.S. dollar was pegged to gold at $35 per ounce, and became the only currency allowed to convert into gold. The rest of the world’s currencies were pegged to the dollar at a “sort of” fixed rate. “Sort of” because the rate was fixed and stable until there was some trade problem, and then the currency would be quickly revalued to a new official/stable exchange rate. Stable and floating - quite the paradox. Banking continued as England or France would hold dollars, and lend against them as reserves.
The problem was the dollar itself. The Vietnam War and LBJ’s Great Society welfare program helped create inflation in the U.S. Like the bank runs in England from having too much gold, and with inflation devaluing money, so too the U.S. had a run on the bank. In 1963, gold reserves in the U.S. were less than foreign liabilities - by 1971, they were barely 20% of the amount needed to cover liabilities. The run started as dollars were dumped, and despite efforts to kill inflation and shore up the dollar, Nixon halted convertibility on August 15, 1971. Finally, elasticity could run free of the restraints of gold. Mark this, then, as the birthday of the modern world.
With flexible exchange rates and relatively free trade in post-WWII (and to be fair, post the Bretton Woods gold standard), low margin tasks and low paying jobs moved out of the U.S. Displaced workers and union rhetoric screamed for something to be done about “lost jobs” but it probably was the best thing to happen to the U.S. since it allowed for high wages in the U.S. for high margin tasks. The stock market rewards high margin companies with high values, lowering their cost of capital. They can sell fewer and fewer shares to raise money instead of borrowing money from banks. High wages are taxed, to pay for social services, not the least of which is a military to protect the U.S. AND its trading partners.
Gold just gets in the way of the flow of funds.
You see, a new twist has been added to this system. Since the birth of the personal computer and the horizontalization of the industry, companies could focus on thin slices of intellectual property, which could have very, very high margins. Software, microprocessor architectures, semiconductors, network architectures, optical components, cell phone components, and databases are all pieces of intellectual property that could be licensed to others to build end products.
In fact, the U.S. is a huge exporter of these pieces of intellectual property, although these exports are hard to measure. Often, an entire architecture of a chip, valued at a billion dollars, can be emailed to a factory in Taiwan, without a cash register ringing or a commerce department employee around to measure the export. That chip and other intellectual property are then combined, using low cost labor with other low margin components, like a power supply and some plastic and turned into a laptop or DVD player. Oddly, this “margin surplus” run by the U.S. is the way to run an economy with declining price products. Gold won’t help. Instead, it requires a stock market to balance out world trade. Fortunately, we’ve got one of those! The money that leaves the country to buy those laptops and BMWs and Sony TVs comes back and invests in our high margin companies.
So after all that, what I am trying to say about gold? The British had no choice. They and the rest of the world needed a “hard currency” - something rare like gold as a baseline to base their own paper currency on. The Brits were certainly not going to take French or German paper currency and trust them not to devalue it by just printing more of it. So gold was necessary.
Fine. But the classical gold standard was a huge mistake. They held the wrong thing constant. Wages were never going to go down without more than a few pissed off laborers. It was currency rates that should have floated instead of wages and domestic prices. But that would have required rooms filled with computers, human or electronic, neither of which really existed in great numbers.
But they do now!
Currency rates do float. And there are 100,000 or more computer screens on Wall Street and around the world armed by bond and currency traders that keep countries honest. Countries caught cheating see their currencies plummet, their interest rates pop and their economies slow. It is a tightly wound system.
But banks are still a problem. They profit from lending, but there is no decent mechanism to keep them from overlending. Banks are as dead as gold. Neither is any good anymore at allocating capital. Stock markets, on the other hand, are quite good at providing access to capital for great companies and starving those that have dim prospects. Banks still loan to son-in-laws!
Ask the Japanese still burdened by non-performing loans. Some argue that half of Chinese bank loans are non-performing. We don’t have to ship gold around anymore, yet gold is still considered a currency in modern international commerce. Gold is no longer the reserve of central banks, it is dollars.
And these export economies have too much dollars. They have to give it back to us (investing in our high margin companies via the stock market) else they over lend. I know it sounds crazy, but it’s the new classical “insert your species” standard. When things heat up at home, you’ve got to ship out your species, in this case dollars, and they are all going to naturally flow back into the U.S. The Japanese periodically intervene and ship dollars back here to keep the yen down. The Chinese have a peg, so excess dollars go to banks, with awful results. The Europeans are just figuring out that $1.30 to the yen doesn’t do them any good, and they need to start intervening to get the euro down. This is the new economy, gold doesn’t flow, but dollars need to, in order to keep them away from dumb bankers. On the margin, it will invest in high margin companies in the U.S., that is our margin surplus. And I’d like to get in the way of that flow! |
