The Gold Standard

Posted by PITHOCRATES - March 12th, 2012

Economics 101

As long as Imports equal Exports the Balance in the Trade Account is Zero and there is no Trade Deficit or Surplus 

Imagine two wine shops in an affluent suburb.  Let’s call one Fine Wines.  And the other The Wine Shoppe.  They both feature a wide selection of wines from around the world.  And each specializes in wines from a specific region.  So they sell much of the same wines.  But some of the most exclusive and most expensive wines can only be found at one store or the other.  Now wine retailers typically have a loyal clientele.  There is a relationship between proprietor and customer.  To enhance the wine drinking experience.  So proprietors will cater to their customers to keep them as customers.  And provide whatever wine they wish.  Even if they don’t stock it.  Or don’t have a normal purchasing channel to the wine they wish to buy.

Both stores have similar relationships with their clientele.  And they share something else in common.  The wines one seller doesn’t sell the other seller sells.  Which produces a special relationship between these two stores.  They buy and sell wines from each other as needed to meet the needs of their customers.  So customers at either store can purchase any wine they sell in both stores.  Allowing each store to maintain their special proprietor-customer relationship.  Without losing customers to the other store.

Most of the time the value of the wine they buy and sell from each other in these inter-store sales net out.  Sometimes one store owes the other.  And vice versa.  But it usually isn’t much.  And the stores take turns owing each other.  The overall cost for this inter-store trade is negligible.  And pleases customers at both stores.  So maintaining this trade is a win-win.  With no negative impact on either store’s business.  As long as ‘imports’ equal ‘exports’.  And the balance in this ‘trade account’ is kept close to zero.  So they continue to ‘trade’ bottles of wine.  Without exchanging any money.  Most of the time, that is.  Until a trade deficit develops.  

If the Currency is Backed by Gold the only way to create new Dollars is to put more Gold into the Vault 

Let’s say for whatever reason Fine Wines runs a trade deficit.  Fine Wines sells more of The Wine Shoppe wines than The Wine Shoppe sells of theirs.  Which means Fine Wines imports more from The Wine Shoppe than they export to The Wine Shoppe.  Creating the trade deficit.  They’re not trading bottles for bottles anymore.  Fine Wines delivers one case of wine to The Wine Shoppe and returns with 3 cases.  And now has an outstanding balance owed to The Wine Shoppe.  Which they must settle by sending money to The Wine Shoppe.  If sales continue like this Fine Wines will become a net importer and run chronic trade deficits.  While The Wine Shoppe will become a net exporter.  And have a running trade surplus.

If the clientele of Fine Wines keeps buying the imported wine from The Wine Shoppe instead of the ‘domestic’ Fine Wines, Fine Wines will have cash problems.  Because they owe their distributors for the wine they bought and stocked.  But when they sell The Wine Shoppe’s wine it doesn’t bring any cash into their store.  Because Fine Wines has to give that money to The Wine Shoppe.  For it was, after all, The Wine Shoppe’s wine that Fine Wines sold.  That they sold as a courtesy to their customers.  To keep them loyal customers.  So a portion of their total sales doesn’t even count as income (income = total sales – imports).  And if Fine Wines divides their income by the total number of bottles they sold they see a sad truth.  The impact of those imports has lowered the average price per bottle of wine.  This price deflation will make it very difficult to pay the bills they incurred before this deflation.  As they are now selling wine at lower prices than they paid for it from their distributors.

And that’s similar to how the gold standard works.  We back the money in circulation (i.e., the money supply) by gold.  Which we lock away in some vault.  To increase the money supply you need to increase the gold supply.  To decrease the money supply you need to decrease the gold supply.  This makes it very difficult for governments to be irresponsible and print money.  Because if the currency is backed by gold the only way to create new dollars is to put more gold into that vault.  Ergo, responsible government spending.  And an automatic mechanism to fix trade deficits.

Fixed Exchange Rates based on Gold made International Trade Simple and Fair

This is where our wine stores example comes in.  If a government runs a trade deficit under the gold standard gold moves between countries.  Just like money did between the two wine stores.  And a net exporter of gold (a net importer of goods paying for the resulting trade deficit with gold) will see a reduction in price levels.  Just like Fine Wines did.  (And the net importer of gold will see the opposite).  But here’s what else happens.  Those lower prices now make the importer more cost competitive.  (And the higher prices make the exporter less competitive).  Because people prefer buying less expensive things.  So the net importer’s sales increase thanks to lower prices.  While the net exporter’s sales decrease because of higher prices.  Moving the balance in the trade account back towards zero.  Where it will always try to be under normal market conditions. 

This built-in responsibility didn’t stop governments from misbehaving, though.  And some have printed more money than they had the gold reserves to back it.  For governments like to spend money.  Especially when they’re trying to buy votes.  So they have turned on those printing presses at times.  And increased the money supply.  Without putting more gold into the vault.  The result?  A larger money supply backed by the same amount of gold?  It depreciated the currency by inflating the money supply.  Which can be a problem when the money is backed by gold.  Especially when you have an exchange rate based on gold.

To buy goods from a foreign country you first exchanged your currency for theirs.  Because you buy foreign goods in the foreign currency.  And you based this exchange rate on gold.  And fixed each currency to an amount of gold.  Which made this currency exchange simple.  And fair.  Unless someone was depreciating their currency by printing it without putting more gold into the vault.  But if they did other nations would find out.  And stop exchanging their currency for the depreciated currency which would buy less.  They, instead, exchanged the foreign currency they had for gold instead.  So they could buy more.  Exchanging a depreciated currency at an exchange rate based on a non-depreciated currency.  Leaving the nation with a swollen money supply full of a depreciated currency.  And no gold.  Giving the nation runaway inflation.  And a crashed economy.  A very strong incentive not to depreciate your currency while on a gold standard.


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Carnegie, Rockefeller, Morgan, Interstate Commerce Act, Sherman Antitrust Act, Sherman Silver Purchase Act, Federal Reserve, Nixon and Reagan

Posted by PITHOCRATES - January 31st, 2012

History 101

Government Induced Inflation caused the Panic of 1893 and caused the Worst Depression until the Great Depression

Britain kicked off the Industrial Revolution.  Then handed off the baton to the United States in the latter half of the 19th century.  As American industry roared.  Great industrialists modernize America.  And the world.  Andrew Carnegie made steel inexpensive and plentiful.  He built railroad track and bridges.  And the steel-skeleton buildings of U.S. cities.  Including the skyscrapers.  John D. Rockefeller saved the whales.  By producing less expensive kerosene to burn in lamps instead of the more expensive whale oil.  He refined oil and brought it to market cheaper and more efficiently than anyone else.  Fueling industrial activity and expansion.  J.P. Morgan developed and financed railroads.  Made them more efficient.  Profitable.  And moved goods and people more efficiently than ever before.  Raising the standard of living to heights never seen before. 

The industrial economy was surging along.  And all of this without a central bank.  Credit was available.  So much so that it unleashed unprecedented economic growth.  That would have kept on going had government not stopped it.  With the Interstate Commerce Act in 1887 and the Sherman Antitrust Act of 1890.  Used by competitors who could not compete against the economy of scales of Carnegie, Rockefeller and Morgan and sell at their low prices.  So they used their friends in government to raise prices so they didn’t have to be as competitive and efficient as Carnegie, Rockefeller and Morgan.  This legislation restrained the great industrialists.  Which began the era of complying with great regulatory compliance costs.  And expending great effort to get around those great regulatory compliance costs.

Also during the late 19th century there was a silver boom.  This dumped so much silver on the market that miners soon were spending more in mining it than they were selling it for.  Also, farmers were using the latest in technology to mechanize their farms.  They put more land under cultivation and increased farm yields.  So much so that prices fell.  They fell so far that farmers were struggling to pay their debts.  So the silver miners used their friends in government to solve the problems of both miners and farmers.  The government passed the Sherman Silver Purchase Act which increased the amount of silver the government purchased.  Issuing new treasury notes.  Redeemable in both gold and silver.  The idea was to create inflation to raise prices and help those farmers.  By allowing them to repay old debt easier with a depreciated currency.  And how did that work?  Investors took those new bank notes and exchanged them for gold.  And caused a run on U.S. gold reserves that nearly destroyed the banking system.  Plunging the nation in crisis.  The Panic of 1893.  The worst depression until the Great Depression.

Richard Nixon Decoupled the Dollar from Gold and the Keynesians Cheered 

J.P. Morgan stepped in and loaned the government gold to stabilize the banking system.  He would do it again in the Panic of 1907.  The great industrialists created unprecedented economic activity during the latter half of the 19th century.  Only to see poor government policies bring on the worst depression until the Great Depression.  A crisis one of the great industrialists, J.P. Morgan, rescued the country from.  But great capitalists like Morgan wouldn’t always be there to save the country.  Especially the way new legislation was attacking them.  So the U.S. created a central bank.  The Federal Reserve System.  Which was in place and ready to respond to the banking crisis following the stock market crash of 1929.  And did such a horrible job that they gave us the worst depression since the Panic of 1893.  The Great Depression.  Where we saw the greatest bank failures in U.S. history.  Failures the Federal Reserve was specifically set up to prevent.

The 1930s was a lost decade thanks to even more bad government policy.  FDR’s New Deal programs did nothing to end the Great Depression.  Only capitalism did.  And a new bunch of great industrialists.  Who were allowed to tool up and make their factories hum again.  Without having to deal with costly regulatory compliance.  Thanks to Adolf Hitler.  And the war he started.  World War II.  The urgency of the times repealed governmental nonsense.  And the industrialists responded.  Building the planes, tanks and trucks that defeated Hitler.  The Arsenal of Democracy.  And following the war with the world’s industrial centers devastated by war, these industrialists rebuilt the devastated countries.  The fifties boomed thanks to a booming export economy.  But it wouldn’t last.  Eventually those war-torn countries rebuilt themselves.  And LBJ would become president.

The Sixties saw a surge in government spending.  The U.S. space program was trying to put a man on the moon.  The Vietnam War escalated.  And LBJ introduced us to massive new government spending.  The Great Society.  The war to end poverty.  And racial injustice.  It failed.  At least, based on ever more federal spending and legislation to end poverty and racial injustice.  But that government spending was good.  At least the Keynesians thought so.  Richard Nixon, too.  Because he was inflating the currency to keep that spending going.  But the U.S. dollar was pegged to gold.  And this devaluation of the dollar was causing another run on U.S. gold reserves.  But Nixon responded like a true Keynesian.  And broke free from the shackles of gold.  By decoupling the dollar from gold.  And the Keynesians cheered.  Because the government could now use the full power of monetary policy to make recessions and unemployment a thing of the past.

Activist, Interventionist Government have brought Great Economic Booms to Collapse 

The Seventies was a decade of pure Keynesian economics.  It was also the decade that gave us double digit interest rates.  And double digit inflation rates.  It was the decade that gave us the misery index (the inflation rate plus the unemployment rate).  And stagflation.  The combination of a high inflation rate you normally only saw in boom times coupled with a high unemployment rate you only saw during recessionary times.  Something that just doesn’t happen.  But it did.  Thanks to Keynesian economics.  And bad monetary policy.

Ronald Reagan was no Keynesian.  He was an Austrian school supply-sider.  He and his treasury secretary, Paul Volcker, attacked inflation.  The hard way.  The only way.  Through a painful recession.  They stopped depreciating the dollar.  And after killing the inflation monster they lowered interest rates.  Cut tax rates.  And made the business climate business-friendly.  Capitalists took notice.  New entrepreneurs rose.  Innovated.  Created new technologies.  The Eighties was the decade of Silicon Valley.  And the electronics boom.  Powering new computers.  Electronic devices.  And software.  Businesses computerized and became more efficient.  Machine tools became computer-controlled.  The economy went high-tech.  Efficient.  And cool.  Music videos, CD players, VCRs, cable TV, satellite TV, cell phones, etc.  It was a brave new world.  Driven by technology.  And a business-friendly environment.  Where risk takers took risks.  And created great things.

History has shown that capitalists bring great things to market when government doesn’t get in the way.  With their punishing fiscal policies.  And inept monetary policies.  Activist, interventionist government have brought great economic booms to collapse.  Who meddle and turn robust economic activity into recessions.  And recessions into depressions.  The central bank being one of their greatest tools of destruction.  Because policy is too often driven by Big Government idealism.  And not the proven track record of capitalism.  As proven by the great industrialists.  And high-tech entrepreneurs.  Time and time again.


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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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