Federal Reserve System, Great Depression, Banking Crises, Gold Reserves, Gold Exchange Standard, Interest Rates and Money Supply

Posted by PITHOCRATES - July 31st, 2012

History 101

The Gold Exchange Standard provided Stability for International Trade

Congress created the Federal Reserve System (the Fed) with the passage of the Federal Reserve Act in 1913.  They created the Fed because of some recent bad depressions and financial panics.  Which they were going to make a thing of the past with the Fed.  It had three basic responsibilities.  Maximize employment.  Stabilize prices.  And optimize interest rates.  With the government managing these things depressions and financial panics weren’t going to happen on the Fed’s watch.

The worst depression and financial panic of all time happened on the Fed’s watch.  The Great Depression.  From 1930.  Until World War II.  A lost decade.  A period that saw the worst banking crises.  And the greatest monetary contraction in U.S. history.  And this after passing the Federal Reserve Act to prevent any such things from happening.  So why did this happen?  Why did a normal recession turn into the Great Depression?  Because of government intervention into the economy.  Such as the Smoot-Hawley Tariff Act that triggered the great selloff and stock market crash.  And some really poor monetary policy.  As well as bad fiscal policy.

At the time the U.S. was on a gold exchange standard.  Paper currency backed by gold.  And exchangeable for gold.  The amount of currency in circulation depended upon the amount of gold on deposit.  The Federal Reserve Act required a gold reserve for notes in circulation similar to fractional reserve banking.  Only instead of keeping paper bills in your vault you had to keep gold.  Which provided stability for international trade.  But left the domestic money supply, and interest rates, at the whim of the economy.  For the only way to lower interest rates to encourage borrowing was to increase the amount of gold on deposit.  For with more gold on hand you can increase the money supply.  Which lowered interest rates.  That encouraged people to borrow money to expand their businesses and buy things.  Thus creating economic activity.  At least in theory.

The Fed contracted the Money Supply even while there was a Positive Gold Flow into the Country

The gold standard worked well for a century or so.  Especially in the era of free trade.  Because it moved trade deficits and trade surpluses towards zero.  Giving no nation a long-term advantage in trade.  Consider two trading partners.  One has increasing exports.  The other increasing imports.  Why?  Because the exporter has lower prices than the importer.  As goods flow to the importer gold flows to the exporter to pay for those exports.  The expansion of the local money supply inflates the local currency and raises prices in the exporter country.  Back in the importer country the money supply contracts and lowers prices.  So people start buying more from the once importing nation.  Thus reversing the flow of goods and gold.  These flows reverse over and over keeping the trade deficit (or surplus) trending towards zero.  Automatically.  With no outside intervention required.

Banknotes in circulation, though, required outside intervention.  Because gold isn’t in circulation.  So central bankers have to follow some rules to make this function as a gold standard.  As gold flows into their country (from having a trade surplus) they have to expand their money supply by putting more bills into circulation.  To do what gold did automatically.  Increase prices.  By maintaining the reserve requirement (by increasing the money supply by the amount the gold deposits increased) they also maintain the fixed exchange rate.  An inflow of gold inflates your currency and an outflow of gold deflates your currency.  When central banks maintain this mechanism with their monetary policy currencies remain relatively constant in value.  Giving no price advantage to any one nation.  Thus keeping trade fair.

After the stock market crash in 1929 and the failure of the Bank of the United States in New York failed in 1930 the great monetary contraction began.  As more banks failed the money they created via fractional reserve banking disappeared.  And the money supply shrank.  And what did the Fed do?  Increased interest rates.  Making it harder than ever to borrow money.  And harder than ever for banks to stay in business as businesses couldn’t refinance their loans and defaulted.  The Fed did this because it was their professional opinion that sufficient credit was available and that adding liquidity then would only make it harder to do when the markets really needed additional credit.  So they contracted the money supply.  Even while there was a positive gold flow into the country.

The Gold Standard works Great when all of your Trading Partners use it and they Follow the Rules

Those in the New York Federal Reserve Bank wanted to increase the money supply.  The Federal Reserve Board in Washington disagreed.  Saying again that sufficient credit was available in the market.  Meanwhile people lost faith in the banking system.  Rushed to get their money out of their bank before it, too, failed.  Causing bank runs.  And more bank failures.  With these banks went the money they created via fractional reserve banking.  Further deflating the money supply.  And lowering prices.  Which was the wrong thing to happen with a rising gold supply.

Well, that didn’t last.  France went on the gold standard with a devalued franc.  So they, too, began to accumulate gold.  For they wanted to become a great banking center like London and New York.  But these gold flows weren’t operating per the rules of a gold exchange.  Gold was flowing generally in one direction.  To those countries hoarding gold.  And countries that were accumulating gold weren’t inflating their money supplies to reverse these flows.  So nations began to abandon the gold exchange standard.  Britain first.  Then every other nation but the U.S.

Now the gold standard works great.  But only when all of your trading partners are using it.  And they follow the rules.  Even during the great contraction of the money supply the Fed raised interest rates to support the gold exchange.  Which by then was a lost cause.  But they tried to make the dollar strong and appealing to hold.  So people would hold dollars instead of their gold.  This just further damaged the U.S. economy, though.  And further weakened the banking system.  While only accelerating the outflow of gold.  As nations feared the U.S. would devalue their currency they rushed to exchange their dollars for gold.  And did so until FDR abandoned the gold exchange standard, too, in 1933.  But it didn’t end the Great Depression.  Which had about another decade to go.

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Money, Gold Standard, Banknotes, Bills of Exchange, Checks, Credit and Debit Cards, ATMs and Online Banking

Posted by PITHOCRATES - January 4th, 2012

Technology 101

People storing their Gold in the Goldsmith’s Safe was a Precursor to the Gold Standard

Money is a temporary storage of wealth.  It improved on the barter system.  Instead of having to find people to trade our wealth-creating talents for the wealth-creating talents of other people we just stored the wealth we created in money.  If you built a plow and wanted a sack of wheat you didn’t have to find someone who had a sack of wheat who wanted a plow.  You could just go to the city market and sell your plow for money.  And use your money to buy the wheat.

Money took many forms.  Animals.  Grain.  Tobacco.  Alcohol.  And other commodities.  All of which had drawbacks.  Grain can become cumbersome to carry to market.  And it can be difficult making change with animals.  The precious metals gold and silver solved these problems.  Easier to carry.  Easy to exchange for goods.  You just weighed out whatever amount needed.  Durable.  Not easy to get so it would hold its value.  It was uniform.  Gold was gold.  Silver was silver.  Not so with animals.  They can be big or small.  Old or young.  One breed or another.  Making the value of animals non-uniform.  On top of not being very divisible in making change.

So gold and silver became the money of choice.  As it gained universality it became even more valuable.  And a bit dangerous to carry around on you.  Or leave at your home in your sock drawer.  Because other people wanted it, too.  And not the kind looking to trade with you.  The kind of people who just want to take your gold.  Se we needed a safe place to store it.  And few places were safer than a safe.  And who had a safe?  Goldsmiths.  So people took their gold to the local goldsmith.  Who placed their gold into his safe.  And the goldsmith gave the person a note stating the value of gold stored in his safe.  A precursor to the gold standard.

Merchant Banks Specialized in International Trade and Foreign Currency Exchange

And the banknote was born.  A promise to exchange that note for the amount of gold or silver specified on the note.  These notes were much easier to carry around than the heavier metal itself.  So the metal stayed in the safe and people started using the notes for currency instead.

And there were other notes that held value.  Such as a bill of exchange.  Popular with international trade.  Because ships rarely travel empty.  Which means at each port they are unloading one cargo (the import) and loading one new cargo (the export).   The people who do this importing and exporting are merchants.  They buy and sell.  That is, they pay money for one cargo and then collect money for another.  A good portion of these payments and collections equal each other.  So instead of paying money for one import cargo only to get most of that money back on a subsequent export cargo, they used bills of exchange.  And the merchants added the sum of payments and the sum of collections for each account (import/export company).  And carry any amount remaining owed or due on a ledger.  Or the company owning would send money to the company with the outstanding balance due to clear the difference.   Merchant banks carried out these transactions.  Who specialized in international trade and foreign currency exchange and acted as a clearing house for these bills of exchange.  The bill of exchange was a very valuable temporary storage of value.  And sometimes used as money.  One could even take it to a bank and exchange it for money for a small discount fee.

Buying and selling without exchanging money turned out to be very convenient.  And it spread.  Instead of taking cash to a utility we could mail a check.  Instead of mailing cash to a mail order company we could mail a check.  And we do.  We write checks from our bank.  That others deposit into other banks.  We write a lot of checks.  The volume is so great that massive computerized clearing houses process these checks.  Where computers read the magnetic ink on these checks and post payments and receipts to the individual bank accounts.  Where most payments and receipts cancel each other out.  Much like those bills of exchange at the merchant banks.

The Economy took off because of Banking and International Trade

As technology advanced we found other ways to pay without using money.  Credit cards were very popular.  Until people realize they have to pay the bank back.  Which led to debit cards.  Which is like writing a check at the point of purchase.  The merchant processes your debit card and your bank transfers money from your bank account to the merchant’s account.  Very convenient.  And no growing credit card balances.  Just declining bank balances.  Then came the Internet.  Which has taken the cashless economy to new heights.  And for those who still need cash while out and about you can always visit a convenient ATM.  One swipe of your debit card and the machine gives you cash.  And the ATM’s bank networks with your bank to transfer money from your bank account to theirs.  Automated by computers operating 24/7.  Spending money has never been more convenient.

Today most of our money is just numbers on some ledger.  Inside some computer.  Many of our employers even pay us electronically.  From our ‘pay check’ to the economic activity we engage in there is a whirlwind of banking activity behind the scenes.  As the banking community settles these accounts.  They do it quickly.  And efficiently.  Allowing ever greater economic activity.  And mobility.  Wherever you are you can log into some computer network (credit/debit card, ATM or Internet) to access your money and engage in economic activity.

People may not like banks.  But one thing for sure.  None of this would be possible without banks.  The economy took off because of banking.  Starting with those great Italian city-states of the 14th century.  And their international trade.  Their great merchant bankers leading the way.  Giving the world modern finance.  A modern economy.  And the way to a higher standard of living.

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