From Commodity Money to Representative Money to Fiat Money

Posted by PITHOCRATES - April 8th, 2014

History 101

(Originally published November 8th, 2011)

The Drawbacks to Using Pigs as Money Include they’re not Portable, Divisible, Durable or Uniform

They say we use every part of the pig but the oink.  So pigs are pretty valuable animals.  And we have used them as money.  Because they’re valuable.  People were willing to accept a pig in trade for something of value of theirs.  Because they knew they could always trade that pig to someone else later.  Because we use every part of the pig but the oink.  Which makes them pretty valuable.

Of course, there are drawbacks to using pigs as money.  For one they’re not that portable.  They’re not that easy to take to the market.  And they’re big.  Hold a lot of value.  So what do you do when something is worth more than one pig but not quite worth two?  Well, pigs aren’t readily divisible.  Unless you slaughter them.  But then you’d have to hurry up and trade the parts before they spoil because they’re not going to stay fresh long.  For pig parts aren’t very durable.

Suppose you have two pigs.  And someone has something you want and they will trade two pigs for it.  But there’s only one problem.  One pig is big and healthy.  The other is old and sickly.  And half the weight of the healthy one.  This trader was willing to take two pigs in trade.  But clearly the two pigs you have are unequal in value.  They’re not uniform.  And not quite what this trader had in mind when he said he’d take two pigs in trade.

Our Paper Currency Evolved from the Certificates we Carried for our Gold and Silver we Kept Locked Up

Rats are more uniform.  They’re more portable.  And they’re smaller.  It would be easier to price things in units of rats rather than pigs.  They would solve all the problems of using pigs as money.  Except one.  Rats are germ-infested parasites that no one wants.  And they breed like rabbits.  You never have only one rat.  Man has spent most of history trying to get rid of these vile disease carriers.  So no one would trade anything of value for rats.  Because these little plague generators were overrunning cities everywhere.  So rats were many things.  But one thing they weren’t was scarce.

Eventually we settled on a commodity that addresses all the shortcomings of pigs and rats.  As well as other commodities.  Gold and silver.  These precious metals were portable.  Durable.  They didn’t spoil and held their value for a long time.  You could make coins in different denominations.  So they were easily divisible.  Unlike a pig.  They were uniform.  Unlike pigs.  Finally, you had to dig gold and silver out of the ground.  After digging a lot of holes trying to find gold and silver deposits.  Which made it costly to bring new gold and silver to market.  Keeping gold and silver scarce.  And valuable.  Unlike rats.

But gold and silver were heavy metals.  Carrying large amounts was exhausting.  And dangerous.  A chest of gold and silver was tempting to thieves.  As you couldn’t hide it easily.  Soon we left our gold and silver locked up somewhere.  And carried certificates instead that were exchangeable for that gold and silver.  And these became our paper currency.

Governments Everywhere left the Gold Standard in the 20th Century so they could Print Fiat Money

The use of certificates like this is typically what people mean by gold standard.  Money in circulation represents the value of the underlying gold or silver.  And can be exchanged for that gold or silver.  Which meant that governments couldn’t just print money.  Like they do today.  Because the value was in the gold and silver.  Not the paper that represented the gold and silver.  And the only way to create money was to dig it out of the ground, process it and bring it to market.  Which is a lot harder to do than printing paper money.  So governments everywhere left the gold standard in the 20th century in favor of fiat money.  So they could print money.  Create it out of nothing.  And spend it.  With no restraints of responsible governing whatsoever.

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Coin Debasement, Currency Inflation and the Loss of Purchasing Power

Posted by PITHOCRATES - April 16th, 2013

History 101

The Roman Citizens welcomed the Barbarian Invaders as Liberators from the Oppressive Roman Regime

The Roman Empire pushed its borders out for centuries.  And when they did their legions conquered new territories.  And other civilizations.  Allowing them to send a lot of spoils back to Rome.  Providing the necessary funds for the empire.  With this lucrative stream of wealth flowing back to Rome they could leave the economy alone.  And did.  Economic activity was pretty much laissez-faire.  Then something happened.  The Romans had conquered pretty much all of the known civilized world.  And they stopped pushing their borders out.  Putting an end to that lucrative stream of wealth flowing back to Rome.

This created a problem.  For the empire was never larger.  With a greater border to protect than ever before.  And more territory to administer.  Which meant more soldiers.  And more civil servants.  Neither of which worked for free.  Which changed how the Romans handled the private sector economy.  They began to tax and regulate the hell out of it.  To raise the funds to pay the costs of empire.

Things got so bad that some people just started disappearing.  So the Romans introduced something that would evolve into European feudalism.  They forbade people from leaving their jobs.  Ever.  They even forbade the children from leaving their father’s profession.  While they were doing this they were debasing their coins.  The gold a little.  As it paid the soldiers and the civil servants.  And the silver a lot.  The money of the common people.  Who weren’t as important as the soldiers and the civil servants.  Until their silver was nothing but worthless slugs.  Causing prices to soar.  And the economy to collapse back into the barter system.  Hastening the fall of the Roman Empire.  As the Roman citizens welcomed the barbarian invaders as liberators from the oppressive Roman regime.

The Spanish brought back so much Gold and Silver from the New World that it actually Depreciated the Money Supply

Europe met Asia on the Bosporus.  The straits that connected the Black Sea and the Mediterranean Sea.  And it was where the Silk Road brought the exotic goods of the Far East into Europe.  Which the Europeans just couldn’t get enough of.  Making the Mediterranean powers the dominant powers.  For they controlled this lucrative trade.  Until, that is, the European nations made better ships.  Ships that could cross oceans.  And were bigger than the ships that plied the Mediterranean.  So they could bypass the Mediterranean powers.  And sail directly to the Far East.  Fill their large holds with those goods the Europeans couldn’t get enough of.  Getting rich and powerful.  And shifting the balance of power to these European nations.

But the Europeans just didn’t go east.  They also went west.  And bumped into the New World.  The Dutch, the French, the British, the Portuguese and the Spanish all had colonies in the New World.  It was the age of mercantilism.  Colonies sent raw materials to their mother country.  Who manufactured these raw materials into finished goods.  And shipped them from the mother country on the mother country’s ships through the mother country’s ports.  For the name of the game was balance of trade.  Which meant you imported lower-valued raw materials and you exported higher-valued finished goods.  And because the value of their exports was greater than the value of their imports there was also a net in-flow of gold and silver.  Which was what mercantilism was all about.  Trying to accumulate more gold and silver than your trading partners.

And the Spanish hit mercantile pay-dirt in the New World.  Gold and silver.  Lots of it.  So they loaded it up on their ships.  And sent it back to Spain.  Where it entered the European money supply.  And none too soon as the Europeans were cash-starved.  Because of all those exotic goods the Europeans couldn’t get enough of.  While those in the Far East had no interest whatsoever in European goods.  Which meant that European gold and silver went to the Far East to pay for those exotic goods.  Leaving the Europeans starving for gold and silver.  But thanks to the New World, they were able to reverse that net outflow of gold and silver.  In fact, so much gold and silver arrived from the New World that it actually inflated the money supply.  Which actually devalued the currency.  And because the currency lost purchasing power prices rose.  Making food more costly.  And life more difficult.

President Andrew Jackson joined the Hard-Money People and refused to renew the Charter of the BUS

Responsible nations have chosen gold and silver as their currency as it is difficult to increase the money supply and cause inflation.  Because mining these precious metals, refining them and minting coins is very costly.  Unless you discovered a New World with gold and silver paving the streets.  But that didn’t happen every day.  The irresponsible government, though, figured out a way to make that happen every day.  By just getting rid of the responsible gold and silver.  And replacing it with paper notes.  Fiat money.

Fiat money dates back to 11th century China.  To the Song Dynasty.  Which allowed the government to spend more money than their taxes raised.  Especially during war time.  But printing money devalued the currency.  And when you make the currency worth less it takes more of it to buy the things it once did.  Reducing purchasing power.  And unleashing price inflation.  Making food more costly.  And life more difficult.  During the American Revolutionary War there was so little gold and silver available that the Continental Congress turned to printing money.  And they printed so much that they unleashed a punishing inflation.  Causing prices to soar because the money became so worthless.  People wouldn’t accept it for payment.  So the Continental Army had to take the provisions they needed.  Leaving behind IOUs for the Continental Congress to make good on.  Later.

Of course, not everyone suffered during times of inflation.  Speculators did very well.  For their friends in the government’s central bank could print money and loan it to them on very favorable terms.  The speculators then used this cheap money and bought and sold assets.  Pocketing handsome profits in large part because of that inflation.  As the currency depreciation raised prices.  Including the prices of the assets they were selling.  So the rich got richer during periods of inflation.  While the working class just lost purchasing power.  Which is why President Andrew Jackson joined the hard-money people.  Those who favored gold and silver over paper currency.  And refused to renew the charter of the Second Bank of the United States (BUS).  Being one of the first world leaders not to choose destructive inflationary policies.  Instead choosing policies that favored the people.  Not the state.

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Farming, Food Surplus, Artisans, Trade, Barter, Search Costs, Money, Precious Metals, Pound, Dollar and Gold Standard

Posted by PITHOCRATES - October 9th, 2012

History 101

Food Surpluses allowed Everything that followed in the Modern Age

Humans were hunters and gatherers first.  When the environment ruled supreme.  Then something happened.  Humans began to think more.  And started to push back against their environment.  First with tools.  Then with fire.  Bringing people closer together.  Eventually settling down in civilizations.  When the human race embarked on a new path.  A path that would eventually usher in the modern age we enjoy today.  We stopped hunting and gathering.  And began farming.

Throughout history life has been precarious.  Due to the uncertainty of the food supply.  Especially when the environment ruled our lives.  That changed with farming.  When we started taking control of our environment.  We domesticated animals.  And learned how to grow food.  Which lead to perhaps the most important human advancement.  The one thing that allowed everything that followed in the modern age.   Food surpluses.  Which made life less precarious.  And a whole lot more enjoyable.

Producing more food than we needed allowed us to store food to get us through long winters and seasons with poor harvests.  But more importantly it freed people.  Not everyone had to farm.  Some could do other things.  Think about other things.  And build other things.  Artisans arose.  They built things to make our lives easier.  More enjoyable.  And when these talented artisans and farmers met other talented artisans and farmers they traded the products of all their labors.  In markets.  That became cities.  Enriching each other’s lives.  By allowing them to trade for food.  For things that made life easier.  And for things that made life more enjoyable.

We settled on using Precious Metals (Gold and Silver) for Money for they were Everything Money Should Be

As civilizations advanced artisans made a wider variety of things.  Putting a lot of goods into the market place.  Unfortunately, it made trading more difficult.  Because while you saw what you wanted the person who had it may not want what you had to offer in trade.  So what do you do?  You look for someone else that has that same thing.  And will trade for what you have.  And when the second person doesn’t want to trade for what you have you look for a third person.  Then a fourth.  Then a fifth.  Until you find someone who wants to trade for what you have.

This is the barter system.  Trading goods for goods.  And as you can see it has high search costs to find someone to trade with.  Time that people could better spend making more things to trade.  What they needed was a temporary storage of value.  Something people could trade their things for.  And those people could then use that temporary storage they received in trade to later trade for something they wanted.   We call this ‘something’ money.

We have used many things for money.  Some things better than others.  In time we learned that the best things to use for money had to have a few characteristics.  It had to be scarce.  A rock didn’t make good money because why would anyone trade for it when you could just pick one up from the ground?  It had to be indestructible and hold its value.  A slab of bacon had value because bacon is delicious.  But if you held on to it too long it could grow rancid, losing all the value it once held.  Or you could eat it.  Which would also remove its value.  It had to be divisible.  A live pig removed the problem of bacon growing rancid.  However, it was hard making change with live pigs.  Which is why we settled on using precious metals (gold and silver) for money.  For they were everything money should be.

The Key to Economic Activity is People with Creative Talent to make Things to Trade

Money came first.  Then government monetary systems.  Traders were using gold and silver long before nations established their own money.  And when they did they based them on weights of these precious metals.  The British pound sterling represented one Saxon pound of silver.  The U.S. dollar came from the Spanish dollar.  Which traces back to 16th century Bohemia.  To the St. Joachim Valley.  Where they minted private silver coins.  The Joachimsthaler.  Where the ‘thaler’ (which translated to valley) in Joachimsthaler became dollar.  The German mark and the French franc came into being as weights of precious metals.  People either traded silver or gold coins.  Or paper notes that represented silver or gold.

We used silver first as the basis for national currencies.  Then with new gold discoveries in the United States, Australia and South Africa gold became the precious metal of choice.  Using precious metals simplified trade by providing sound money.  And it also made foreign exchange easy.  For when the British made their pound represent 1/4 of an ounce of gold and the Americans made their dollar represent 1/20 of an ounce of gold the exchange rate was easy to calculate.  The British pound had 5 times as much gold in it than the U.S. dollar.  So the exchange rate was simply 5 U.S. dollars for every British pound.  Which made international trade easy.  And fair.  Because everything was priced in weights of gold.

The pure gold standard, then, was part of the natural evolution of money.  The state did not create it.  It does not require an act of legislation.  Or political decree.  The pure gold standard existed before the state.  And states based their currencies on the monetary system that already existed.  Using weights of precious metals as money.  That is, a pure gold standard.  Central banks and fiat money are only recent inventions of the state.  And bad ones at that.  For the thousands of years that preceded the last hundred years or so there were only traders mutually agreeing to trade their goods for precious metals.  Using these precious metals as a temporary storage of wealth.  To temporarily hold the value of the things they made.  So the key to economic activity is people with creative talent to make things to trade.  And a sound money like gold and silver to facilitate that trade.  Not a central bank.  Or monetary policy.

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Goldsmiths, Specie, Bank Notes, Bank Reserves, Spanish Dollar, Continentals, Bank of the United States and the Panic of 1819

Posted by PITHOCRATES - June 26th, 2012

History 101

When Spain came to the New World they Brought Home a lot of Gold and Silver and Turned it into Coin

Our first banks were goldsmiths’ vaults.  They locked up people’s gold or other valuable metals (i.e., specie) in their vaults and issued these ‘depositors’ receipts for their specie.  When a depositor presented their receipt to the goldsmith he redeemed it for the amount of specie noted on the receipt.  These notes were as good as specie.  And a lot easier to carry around.  So these depositors used these notes as currency.  People accepted them in payment.  Because they could take them to the goldsmith and redeem them for the amount of specie noted on the receipt.

The amount of specie these first bankers kept in their vaults equaled the value of these outstanding notes.  Meaning their bank reserves were 100%.   If every depositor redeemed their notes at the same time there was no problem.  Because all specie that was ever deposited was still in the vault.  So there was no danger of any ‘bank runs’ or liquidity crises.

When Spain came to the New World they brought home a lot of gold and silver.  And turned it into coin.  Or specie.  The Spanish dollar entered the American colonies from trade with the West Indies.  As the British didn’t allow their colonies to coin any money of their own the Spanish dollar became the dominate money in circulation in commerce and trade in the cities.  (Which is why the American currency unit is the dollar).  While being largely commodity money in the rural parts of the country.  Tobacco in Virginia, rice in the south, etc.  Paper money didn’t enter into the picture until Massachusetts funded some military expeditions to Quebec.  Normally the soldiers in this expedition took a portion of the spoils they brought back for payment.  But when the French repulsed them and they came back empty handed the government printed paper money backed by no specie.  For there was nothing more dangerous than disgruntled and unpaid soldiers.  The idea was to redeem them with future taxation.  But they never did. 

Thomas Jefferson believed that the Combination of Money and Politics was the Source of all Evil in Government 

During the American Revolutionary War the Americans were starving for specie.  They were getting some from the French but it was never enough.  So they turned to printing paper money.  Backed by no specie.  They printed so much that it became worthless.  The more they printed the more they devalued it.  And the fewer people would take it in payment.  Anyone paying in these paper Continentals just saw higher and higher prices (while people paying in specie saw lower prices).  Until some just refused to accept them.  Giving rise to the expression “not worth a Continental.”  And when they did the army had to take what they needed from the people.  Basically giving them an IOU and telling the people good luck in redeeming them.

Skip ahead to the War of 1812 and the Americans had the same problem.  They needed money.  So they turned to the printing presses.  With the aid of the Second Bank of the United States (BUS).  America’s second central bank.  Just as politically contentious as the First Bank of the United States.  America’s first central bank.  The BUS was not quite like those early bankers.  The goldsmiths.  Whose deposits were backed by a 100% specie reserve.  The BUS specie reserve was closer to 10%.  Which proved to be a problem because their bank notes were redeemable for specie.  Which people did.  And because they did and the BUS was losing so much of its specie the government legislated the suspension of the redemption of bank notes for specie.  Which just ignited inflation.  With the BUS.  And the state banks.  Who were no longer bound by the requirement to redeem bank notes for specie either.  Enter America’s first economic boom created by monetary policy.  A huge credit expansion that created a frenzy of borrowing.  And speculation.

When more dollars are put into circulation without a corresponding amount of specie backing them this only depreciated the dollar.  Making them worth less, requiring more of them to buy the same stuff they did before the massive inflation.  This is why prices rise with inflation.  And they rose a lot from 1815 to 1818.  Real estate prices went up.  Fueling that speculation.  Allowing the rich to get richer by buying land that soared in value.  While ordinary people saw the value of their currency decline making their lives more difficult.  Thanks to those higher prices.  The government spent a lot of this new money on infrastructure.  And there was a lot of fraud.  The very reason that Thomas Jefferson opposed Alexander Hamilton’s first Bank of the United States.  The combination of money and politics was the source of all evil in government.  And fraud.  According to Jefferson, at least.  Everyone was borrowing.  Everyone was spending.  Which left the banks exposed to a lot of speculative loans.  While putting so much money into circulation that they could never redeem their notes for specie.  Not that they were doing that anyway.  Bank finances were growing so bad that the banks were in danger of failing.

Most Bad Recessions are caused by Easy Credit by a Central Bank trying to Stimulate Economic Activity 

By 1818 things were worrying the government.  And the BUS.  Inflation was out of control.  The credit expansion was creating asset bubbles.  And fraud.  It was a house of cards that was close to collapsing.  So the BUS took action.  And reversed their ruinous policies.  They contracted monetary policy.  Stopped the easy credit.  And pulled a lot of those paper dollars out of circulation.  It was the responsible thing to do to save the bank.  But because they did it after so much inflation that drove prices into the stratosphere the correction was painful.  As those prices had a long way to fall.

The Panic of 1819 was the first bust of America’s first boom-bust cycle.  The first depression brought on by the easy credit of a central bank.  When the money supply contracted interest rates rose.  A lot of those speculative loans became unserviceable.  With no easy credit available anymore the loan defaults began.  And the bank failures followed.  Money and credit of the BUS contracted by about 50%.  Businesses couldn’t borrow to meet their cash needs and went bankrupt.  A lot of them.  And those inflated real estate prices fell back to earth.  As prices fell everywhere from their artificial heights.

It was America’s first depression.  But it wouldn’t be the last.  Thanks to central banking.  And boom-bust cycles.  We stopped calling these central banking train wrecks depressions after the Great Depression.  After that we just called them recessions.  And real bad recessions.  Most of them caused by the same thing.  Easy credit by a central bank to stimulate economic activity.  Causing an asset bubble.  That eventually pops causing a painful correction.  The most recent being the Great Recession.  Caused by the popping of a great real estate bubble caused by the central bank’s artificially low interest rates.  That gave us the subprime mortgage crisis.  Which gave us the greatest recession since the Great Depression.  Just another in a long line of ‘real bad’ recessions since the advent of central banking.

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Monetarism, Laissez-Faire Capitalism, Augusto Pinochet, Chile, Hyperinflation, El Ladrillo, Chicago Boys, Milton Friedman and Miracle of Chile

Posted by PITHOCRATES - March 6th, 2012

History 101

During the 19th Century Mercantilism gave way to Laissez-Faire Capitalism and Free Trade

Portugal and Spain were superpowers around the 16th and 17th centuries.  Great monarchies with mercantilist economic policies.  Which was all about trade.  Maximize exports.  Minimize imports.  Settle colonies to mine/harvest raw material.  To ship back to the mother country.  Where they manufactured goods from the raw materials.  And exported them to other countries.  Selling them for gold and silver.  Which was key.  Maximizing the trade surplus in the balance of trade.  Finished goods going out.  Gold and silver coming in.  For the nation that gathered the most gold and silver won in the zero-sum game of mercantilism.  Where the monarchy works with business.  Picking winners and losers.  And rewarding the winners who help enrich the monarchy.

Of course, these policies force a kingdom’s subjects to pay higher prices.  By keeping out lower-priced imports.  And with special deals favoring some domestic industries so they can sell at monopoly prices.  They nationalized their Industries.  Creating an aristocratic class.  Composed of government officials.  And their partners in the nationalized industries.  Living the good life on the backs of the poor.  Who paid high taxes.  And high prices.  To support those mercantilist policies.  And it was these policies that settled South America.  Taking all of their gold and silver (bullion).  Shipping it back to the mother country.  The surge in bullion in Europe made it less scarce.  And less valuable.  Meaning it took more of it to buy the same things it once did before this surge.  Resulting in higher prices.  And inflation.  Hurting the consumer more.  And leading to the development of the quantity theory of money.  And monetarism.  Which held that the amount of money in circulation had a direct impact on prices.  The more money the higher the prices.

With the rise of Parliament in Britain power shifted from the king to the people.  Via their representatives in Parliament.  Instead of rule by dictate there was rule by consent.  Which made the business of choosing winners and losers more difficult.  Parliament had the power.  But Parliament was more than one person.  It was full of special interests.  Which made it more and more difficult to choose any one special interest over another.  Unable to curry favor for one’s own interest one didn’t support another’s interest.  At least not when that support came at the expense of your interests.  So there was another power shift in addition from the king to parliament.  There was also one from the king to the markets.  So during the 19th century mercantilism gave way to laissez-faire capitalism.  And free trade.  An economic system that let the British Empire dominate the world during the 19th century.  Making it rich.  And powerful.  Thanks to that vigorous economic activity that could build the world’s most powerful navy.  And pay for an army to garrison an empire.  Meanwhile the old school mercantilist empires fell from superpower status.  And became shadows of their former selves.  Soon the Spanish and Portuguese colonies would gain their independence from these dying empires.

Milton Friedman’s Monetarism turned the Chilean Economy Around

The South American nations may have hated their European masters but they liked one thing about them.  Their mercantilist policies.  Which survived into the 20th century.  Where government partnered with business.  In the worst of crony capitalism.  Where special interests that favored the ruling powers received government favors in return.  Usually protected markets.  And favorable legislation.  That allowed them monopoly prices.  Giving them great profits.  Generous union wages and benefits.  And generous health care and pensions.  At least, for those politically connected.  So the government rigged the game for them.  And they made it worth the government’s while to rig the game.  All of this paid for on the backs of the poor.  Who paid high taxes.  As well as high prices.  And suffered abject poverty.  Which made for an unhappy people.  And a large amount of government turnover through revolution as dictatorships and military juntas overthrew other dictatorships and military juntas.

In 1973 it was Augusto Pinochet’s turn in Chile.  Who came to power in a military coup.  At the time the country wasn’t doing so well.  And in full mercantilism.  The economy was in the toilet.  There was abject poverty.  And hyperinflation (peaking at 1000% or so) as the government printed money to pay for its out of control spending.  To try and bribe the angry mob and keep them from overthrowing the latest dictatorship.  Pinochet was the guy to fix that.  Like everybody that came before him.  And after his military junta failed as the previous military juntas failed, he tried something new.  Thanks to something called El Ladrillo.  And economic plan so thick and heavy they called it ‘the brick’.  A plan prepared by the Chicago Boys.  Chilean economists schooled in the Chicago school of economics.  Pinochet even met with Milton Friedman.  Prominent economist of the Chicago school.  And monetarist.  Who came down to give a speech.  (Interestingly, for the American left roundly criticized Friedman for giving a speech in a right-wing dictatorship.  Though he received no such criticism for giving the same speech in a left-wing dictatorship – communist China.  Showing that the political left was okay with human rights violations as long as they were committed in the left-wing dictatorships they so admired). 

Pinochet asked for some economic advice.  Friedman gave it.  And Pinochet followed it.  He ditched the mercantilist policies.  Embraced laissez-faire capitalism.  Privatized the state industries.  Established free trade.  Cut government spending.  And stopped printing money.  Ending the hyperinflation.  Replacing it with a strict monetary policy.  This didn’t please the politically connected as they lost their privilege.  But Friedman’s monetarism turned the Chilean economy around.  Creating a prosperous market economy.  With a growing middle class.  The strong economic growth led to some healthy tax revenue.  Which in later years funded antipoverty programs.  The Miracle of Chile even replaced the military junta with a democratic government.  Chile now has one of the healthiest and freest economies in the world.  An economy better and stronger than their former colonial master.  Spain.  Who maintained enough of their mercantilist policies to pull them into the Eurozone debt crisis.  And probably could learn a thing or two from their one-time colony.  Who is doing very well these days.  Thanks to the Miracle of Chile.  Milton Friedman.  And the Chicago Boys.  Those great Chilean economists given a chance by of all people a military dictator.

Everyone does Better under Free Market Capitalism, not just the Politically Connected

In 2010 a 7.0 earthquake hit Haiti.  A country rife with political corruption.  With little, if any, free market capitalism.  And even less rule of law.  Where most people live in abject poverty.  In ramshackle housing.  This earthquake claimed 230,000 lives.  A heart-wrenching loss of life.  Especially sad because the impoverished masses suffered the most.  As is often the case in countries with poor economic and political institutions. 

Later that same year, an 8.8 earthquake hit Chile.  Thanks to the economic reforms that rebuilt Chile into a healthy and prosperous democracy, Chileans did not live in ramshackle housing.  The higher standard of living created by the Chicago Boys’ economic reforms created better housing.  And safer cities.  Because of this the far stronger earthquake in Chile killed far fewer people than the lesser earthquake in Haiti.  The death toll in Chile was less than 1,000.  Which is impressive considering that was one of the most powerful earthquakes in recorded history.

Economics matter.  Say what you want about free market capitalism.  Malign it all you will.  But you can’t change some facts.  In particular, everyone does better under free market capitalism.  Including the poor.  For if this wasn’t the case Chile would have seen the loss of life Haiti saw.  But they didn’t.  Because there were no impoverished masses living in ramshackle housing in Chile.  Because those economic reforms improved the standard of living for all Chileans.  Not just the politically connected. 

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The Chicago School of Economics

Posted by PITHOCRATES - March 5th, 2012

Economics 101

Monetarists believe in Laissez-Faire Capitalism and Fiat Money

Keynesian economics supports hands-on government management of the economy.  Using fiscal and monetary policy to move the aggregate demand curve at will to end business cycles.  The boom bust cycles between inflation and recession.  Leaving only the inflationary boom times.   Using tax and spend fiscal policies.  Or simply printing money for government expenditures.  For in Keynesian economics consumption is key.  The more of it the better.  And when people stop buying things the government should step in and pick up the consumption slack.

The Austrian school is a more hands-off approach.  The markets should be free.  Laissez-faire capitalism.  And the business cycle should remain.  For it is a necessary part of the economy.  Part of the automatic pricing mechanism that adjusts supply to meet demand.  When people demand more prices go up.  Encouraging businesses to expand production to sell at these higher prices (inflationary expansion).  Then when supply exceeds demand businesses have excessive inventory that they can’t sell anymore at those higher prices.  So they cut their prices to sell off this excessive supply (deflationary recession).  Also, that hands-off approach means no playing with monetary policy.  Austrians prefer a gold standard to prevent central bank mischief that results in inflation.

The Chicago school of economics takes a little from each of these schools.  Like the Austrians they believe that government should take a hands-off approach in the economy.  Markets should be free with minimum government intervention.  But unlike Austrians, they hate gold.  And blame the gold standard for causing the Great Depression.  Instead, they believe in the flexibility of fiat money.  As do the Keynesians.  But with a strict monetary policy to minimize inflation (which is why proponents of this school were also called monetarists).  Unlike the Keynesians.  For monetarists believe only a government’s monetary policy can cause runaway inflation.

(This is a gross simplification of these three schools.  A more detailed and comprehensive study would be a bit overwhelming as well as extremely boring.  But you get the gist.  At least, for the point of this discussion.)

We used Gold and Silver for Money because it was Durable, Portable, Divisible, Fungible, Scarce, Etc.

At the heart of the difference between these schools is money.  So a refresher course on money is in order.  Money stores wealth temporarily.  When we create something of value (a good or a service) we can use that value to trade for something we want.  We used to barter with other creative people who made value of their own.  But as the economy got more complex it took more and more time to find people to trade with.  You had to find someone who had what you wanted who also wanted what you had.  If you baked bread and wanted shoes you had to find a shoemaker who wanted bread.  Not impossible.  But it took a lot of time to find these people to trade with.

Then someone had a brilliant idea.  They figured they could trade their good or service NOT for something THEY wanted but something OTHER people would want.  Such as tobacco.  Whiskey.  Or grain.  These things were valuable.  Other people would want them.  So they could easily trade their good or service for one of these things.  And then later trade it for what they wanted.  And money was born.  For various reasons (durable, portable, divisible, fungible, scarce, etc.) we chose gold and silver as our money of choice.  Due to the inconvenience and danger of carrying these precious metals around, though, we stored our precious metals in a vault and used ‘receipts’ of that deposit as currency.  And the gold standard was born.

To understand the gold standard think of a balance scale.  The kind where you put weights on one side to balance the load on the other.  When the scale balances the weight of the load equals the sum of the weights needed to make the scale balance.  Now imagine a scale like this where the VALUE of all goods and services (created by talented people) are on one side.  And all the precious metal in the gold standard are on the other.  These must be in balance.  And the sum of our currency must equal the amount of precious metal.  (Because they are ‘receipts’ for all that gold and silver we have locked up someplace.)  This prevents the government from creating inflation.  If you want to issue more money you have to put more precious metal onto the scale.  You just can’t print money.  For when you do and you don’t increase the amount of precious metal on the scale you depreciate the currency.  Because more of it equals the same amount of precious metal.  For more currency to equal the same amount of precious metal then each unit of currency has to be worth less.  And when each unit is worth less it takes more of them to buy the same things they bought before.  Thus raising prices.  If a government prints more currency without adding more precious metals on the scale they increase the value of that precious metal when MEASURED in that currency.  It becomes worth more.  In other words, you can trade that precious metal for more of that depreciated currency than before they depreciated it.  You do this too much and eventually people will prefer the precious metal over the currency.  They’ll lose faith in the currency.  And when that happens the economy collapses.  As people move back towards a barter system.

Milton Friedman wanted the Responsibility of the Gold Standard without Gold’s Constraint on increasing the Money Supply

A healthy economy needs a stable currency.  One that people don’t lose faith in.  Imagine trying to shop without money.  Instead, taking things to trade for the groceries you need.  Not very efficient.  So we need a stable currency.  And the gold standard gives us that.  However, the thing that makes gold or silver a stable currency, its scarcity, creates a liability.  Let’s go back to that balance scale.  To the side that contains the value of all goods and services.  Let’s say it increases.  But the precious metal on the other side doesn’t.  Which means the value of that precious metal increases.  The currency must equal the value of that precious metal.  So the value of the currency increases.  And prices fall.  It takes less of it to buy the same things it bought before.  Not a bad thing for consumers.  But it plays havoc with those who borrowed money before this appreciation.  Because they now have to repay money that is worth more than when what is was worth when they borrowed it.  Which hurt farmers during the 1920s.  Who borrowed a lot of money to mechanize their farms.  Which helped to greatly increase farm yields.  And increased food supplies while demand remained unchanged.  Which, of course, lowered farm prices.  The supply increased on the scale.  But the amount of gold didn’t.  Thus increasing the value of the gold.  And the currency.  Making prices fall.  Kicking off the deflationary spiral of the Great Depression.  Or so say the monetarists.

Now the monetarists wanted to get rid of the gold supply.  The Keynesians did, too.  But they wanted to do it so they could print and spend money.  Which they did during the Seventies.  Creating both a high unemployment rate and a high inflation rate.  Something that wasn’t supposed to happen in Keynesian economics.  For their solution to fix unemployment was to use inflation to stimulate aggregate demand in the economy.  Thus reducing unemployment.  But when they did this during the Seventies it didn’t work.  The Keynesians were befuddled.  But not the monetarists.  Who understood that the expansion of the money supply (printing money to spend) was responsible for that inflation.  People understood this, too.  And had rational expectations of how that Keynesian policy was going to end.  Higher prices.  So they raised prices before the stimulus could impact unemployment.  To stay ahead of the coming inflation.  So the Keynesian stimulus did nothing to reduce unemployment.  It just caused runaway inflation.  And raised consumer prices.  Which, in turn, decreased economic activity.  And further increased unemployment.

Perhaps the most well known economist in the Chicago school was Milton Friedman.  Who wanted the responsibility of the gold standard.  But without gold’s constraint on increasing the money supply to meet demand.  The key to monetarism.  To increase the money supply to match the growth in the economy.  To keep that scale balanced.  But without gold.  Instead, putting the money supply directly on the scale.  Printing fiat money as needed.  Great power.  But with great power comes great responsibility.  And if you abuse that power (as in printing money irresponsibly) the consequences of that abuse will be swift.  Thanks to the rational expectations of the people.  Another tenet of the Chicago school.

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Goldsmiths, Gold Standard, Fractional Reserve Banking, Sherman Silver Purchase Act, Panics of 1893 & 1907 and the Federal Reserve System

Posted by PITHOCRATES - January 24th, 2012

History 101

Goldsmiths Encouraged others to Store their Precious Metals with them by Paying Interest on their Deposits

Goldsmiths were some of our first banks.  Because they worked with gold.  And needed a safe place to lock it up.  To prevent thieves from getting their gold.  Other people who had precious metals (gold and silver) also needed a safe place to put their precious metals.  And what better place was there than a goldsmith?  For a goldsmith knew a thing or two about securing precious metals.

People used gold and silver for money.  But they didn’t like carrying it around.  Because carrying a heavy pouch of gold and silver was just an invitation for thieves.  So they took their gold and silver to the goldsmith.  The goldsmith locked it up for a small fee.  And gave the person a receipt for his or her gold or silver.  Which became paper currency.  Backed by precious metal.  The first ‘gold’ standard.  These receipts could be inconspicuously tucked away and hidden from the prying eyes of thieves.  They were light, convenient and a nice temporary storage of value.  Sellers would accept these receipts as money because they could take these receipts to the goldsmith and exchange them for the precious metal held in the goldsmith’s depository.

As these receipts circulated as money the goldsmith noted that more and more gold and silver accumulated in his depository.  Few holders of his receipts were exchanging them for the deposited gold and silver.  The precious metal just sat there.  Doing nothing.  And earning nothing.  Which gave these early ‘bankers’ an idea.  They would invest some of these deposits and have them earn something.  Leaving just a little on hand in their depositories for the occasional few who came in and exchanged their receipts for the precious metals they represented.  It was a novel idea.  And a profitable one.  Soon storage fees became interest payments.  As goldsmiths encouraged others to store their precious metals with them by paying them interest on their deposits.

The Panic of 1893 was the Worst Depression until the Great Depression

But there were risks.  Because they only kept a small fraction of their deposits in the bank.  Which could prove to be quite a problem if a lot of borrowers asked for their money back at the same time.  It’s happened.  And when it did it wasn’t pretty.  Because all borrowers eventually get wind of trouble.  And they know about that limited amount of money actually in the bank.  So when there is trouble in the air they run to the bank.  To withdraw their deposits while the bank still has money to withdraw.  What we call a run on the bank.  Which often precedes a bank failure.  Hence the run.

In 1890 U.S. farmers were using technology to over produce.  And some miners discovered some rich silver veins.  Making farm crops and silver plentiful.  A little too plentiful.  The price of silver fell below the cost of mining it.  And farm prices fell.  Making it difficult for farmers to service their debt.  They wanted some inflation.  To be able to pay off their past debt with cheaper dollars.  And all that silver could make that happen.  With the help of friends in Congress.  And the Sherman Silver Purchase Act.  Which required the U.S. government to buy a lot of that silver.  And issue notes backed in that silver.  Notes that could be exchanged for silver.  As well as gold.  A big mistake as it turned out.  Because silver was flooding the market.  While gold wasn’t.  Investors clearly understood this.  They took those new notes and exchanged them for gold.  Depleting U.S. gold reserves.

While this was happening there was a railroad boom.  They were building new railroads everywhere.  Financed by excessive borrowing.  In hopes to reap great profits from those new lines.  Lines as it turned out that could never pay for themselves.  Railroads failed.  Which meant they could not repay those great debts.  Which caused a lot of bank failures.  As this was happening people ran to their banks to withdraw their money while the banks still had money to withdraw.  Which only made the banking crisis worse.  Coupled with the depletion of U.S. gold reserves this shook the very foundation of the U.S. banking system.  And launched the Panic of 1893.  The worst depression until the Great Depression.

The Federal Reserve System did not work as well as J.P. Morgan

But this wasn’t the last crisis.  As soon as 1907 there was another one.  Involving another metal.  This time copper.  Not a metal backing the U.S. dollar.  But a metal that precipitated another rash of bank runs.  Including the downfall of the Knickerbocker Trust Company.  A New York financial powerhouse.   Instigated by someone who borrowed heavily to corner the market in copper.  Who failed.  Forcing his creditors to eat his massive loans.  Thus precipitating the aforementioned bank runs.

The bank runs of 1893 and 1907 were caused by liquidity crises as depositors pulled out more money than these banks had on hand.  That risk of fractional reserve banking.  At the time of these crises there was no central bank to step in and restore liquidity.  So a rich guy did.  J.P. Morgan.  Who on more than one occasion stepped in and used his wealth and influence to save the U.S. banking system.  The last crisis, the Panic of 1907, would be the last time for Morgan.  Who said another one would ruin him.  And the United States.

Shortly thereafter Congress passed the Federal Reserve Act in 1913.  Creating the American central bank.  The Federal Reserve System.  To prevent further bank runs by being the lender of last resort during future liquidity crises.  Which did not work as well as J.P. Morgan.  For the worst banking crisis of all time happened during the Great Depression.  Which followed the creation of the Federal Reserve System.  And just goes to show you that a smart rich guy is better than a bunch of government bureaucrats.

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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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From Commodity Money to Representative Money to Fiat Money

Posted by PITHOCRATES - November 8th, 2011

History 101

The Drawbacks to Using Pigs as Money Include they’re not Portable, Divisible, Durable or Uniform

They say we use every part of the pig but the oink.  So pigs are pretty valuable animals.  And we have used them as money.  Because they’re valuable.  People were willing to accept a pig in trade for something of value of theirs.  Because they knew they could always trade that pig to someone else later.  Because we use every part of the pig but the oink.  Which makes them pretty valuable.

Of course, there are drawbacks to using pigs as money.  For one they’re not that portable.  They’re not that easy to take to the market.  And they’re big.  Hold a lot of value.  So what do you do when something is worth more than one pig but not quite worth two?  Well, pigs aren’t readily divisible.  Unless you slaughter them.  But then you’d have to hurry up and trade the parts before they spoil because they’re not going to stay fresh long.  For pig parts aren’t very durable.

Suppose you have two pigs.  And someone has something you want and they will trade two pigs for it.  But there’s only one problem.  One pig is big and healthy.  The other is old and sickly.  And half the weight of the healthy one.  This trader was willing to take two pigs in trade.  But clearly the two pigs you have are unequal in value.  They’re not uniform.  And not quite what this trader had in mind when he said he’d take two pigs in trade.

Our Paper Currency Evolved from the Certificates we Carried for our Gold and Silver we Kept Locked Up

Rats are more uniform.  They’re more portable.  And they’re smaller.  It would be easier to price things in units of rats rather than pigs.  They would solve all the problems of using pigs as money.  Except one.  Rats are germ-infested parasites that no one wants.  And they breed like rabbits.  You never have only one rat.  Man has spent most of history trying to get rid of these vile disease carriers.  So no one would trade anything of value for rats.  Because these little plague generators were overrunning cities everywhere.  So rats were many things.  But one thing they weren’t was scarce.

Eventually we settled on a commodity that addresses all the shortcomings of pigs and rats.  As well as other commodities.  Gold and silver.  These precious metals were portable.  Durable.  They didn’t spoil and held their value for a long time.  You could make coins in different denominations.  So they were easily divisible.  Unlike a pig.  They were uniform.  Unlike pigs.  Finally, you had to dig gold and silver out of the ground.  After digging a lot of holes trying to find gold and silver deposits.  Which made it costly to bring new gold and silver to market.  Keeping gold and silver scarce.  And valuable.  Unlike rats.

But gold and silver were heavy metals.  Carrying large amounts was exhausting.  And dangerous.  A chest of gold and silver was tempting to thieves.  As you couldn’t hide it easily.  Soon we left our gold and silver locked up somewhere.  And carried certificates instead that were exchangeable for that gold and silver.  And these became our paper currency.

Governments Everywhere left the Gold Standard in the 20th Century so they could Print Fiat Money

The use of certificates like this is typically what people mean by gold standard.  Money in circulation represents the value of the underlying gold or silver.  And can be exchanged for that gold or silver.  Which meant that governments couldn’t just print money.  Like they do today.  Because the value was in the gold and silver.  Not the paper that represented the gold and silver.  And the only way to create money was to dig it out of the ground, process it and bring it to market.  Which is a lot harder to do than printing paper money.  So governments everywhere left the gold standard in the 20th century in favor of fiat money.  So they could print money.  Create it out of nothing.  And spend it.  With no restraints of responsible governing whatsoever.

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