If the U.S. was on a Gold Standard there would NOT have been a Financial Crisis in 2007

Posted by PITHOCRATES - June 9th, 2013

Week in Review

Counterfeiting money is against the law.  We all know this.  But do we understand why?  Today’s money is just fiat money.  The Federal Reserve prints it and simply says it is money.  So why is it okay for them to print money but not for anyone else?  Because the amount of money in circulation matters.

The goods and services that make up our economy grow at a given rate.  You hear numbers like GDP of 2%, 3% or more.  In China they had GDP numbers in excess of 8%.  The goods and services in our economy are what have value.  Not the money.  It just temporarily holds the value of these goods and services as they change hands in the economy.  So the amount of money in circulation should be close to the value of goods and services in the economy.  Think of a balancing scale.  Where on the one side you have the value of all goods and services in the economy.  And on the other you have the amount of money in circulation.  If you increase the amount of money on the one side it doesn’t increase the amount of goods and services on the other side.  But it still must balance.  So as we increase the amount of money in circulation the value of each dollar must fall to keep the scale in balance.

Now when we put our money into the bank for our retirement we don’t want the value of those individual dollars grow less over time.  Because that would reduce the purchasing power of our money in the bank.  Making for an uncomfortable retirement.  This is why we want a stable dollar.  One that won’t depreciate away the value of our retirement savings, our investments or the homes we live in.  We’d prefer these to increase in value.  But we can stomach if they just hold their value.  For awhile, perhaps.  But we cannot tolerate it when they lose their value.  Because when they do years of our hard work just goes ‘poof’ and disappears.  Leaving us to work longer and harder to make up for these losses.  Perhaps delaying our retirements.  Perhaps having to work until the day we die.  So we want a stable currency.  Like the gold standard gave us (see Advance Look: What The New Gold Standard Will Look Like by Steve Forbes posted 5/8/2013 on Forbes).

The financial crisis that began in 2007 would never have happened had the Federal Reserve kept the value of the dollar stable. A housing bubble of the proportions that unfolded–not to mention bubbles in commodities and farmland–would not have been possible with a stable dollar. The Fed has also created a unique bubble this time: bonds. It hasn’t popped yet (nor has the farmland bubble), but it will.

The American dollar was linked to gold from the time of George Washington until the early 1970s. If the world’s people are to realize their full economic potential, relinking the dollar to gold is essential. Without it we will experience more debilitating financial disasters and economic stagnation.

What should a new gold standard look like? Representative Ted Poe (R-Tex.) has introduced an original and practical version. Unlike in days of old we don’t need piles of the yellow metal for a new standard to operate. Under Poe’s plan–an approach I have long favored–the dollar would be fixed to gold at a specific price. For argument’s sake let’s say the peg is $1,300. If the price of gold were to go above that, the Federal Reserve would sell bonds from its portfolio, thereby removing dollars from the economy to maintain the $1,300 level. Conversely, if the gold price were to drop below $1,300, the Fed would “print” new money by buying bonds, thereby injecting cash into the banking system.

Yes, the subprime mortgage crisis and the Great Recession would not have happened if the Federal Reserve kept the dollar stable.  Instead, they kept printing and putting more money into circulation.  Why?  To keep interest rates low.  To encourage more and more people to buy a house.  Even people who weren’t planning to buy a house.  Even people who couldn’t afford to buy a house.  Until, that is, subprime lending took off.  Because of those low interest rates.  With all of these people added to the housing market who otherwise would not have been there (because of the Federal Reserve’s monetary policies of printing money to keep interest rates artificially low) the demand for new houses exploded.  As people tried to buy these before others could house prices soared.  Creating a great housing bubble.  Houses worth far greater than they should have been.  And when the bubble burst those housing prices fell back to earth.  Often well below the value of the outstanding balance of the mortgage on the house.  Leaving people underwater in their mortgages.  And when the Great Recession took hold a lot of two-income families went to one-income.  And had a mortgage payment far greater than a single earner could afford to pay.

So that’s how that mess came about.  Because the Federal Reserve devalued the dollar to stimulate the housing market (and any other market of big-ticket items that required borrowed money).  If we re-link the dollar to gold things like this couldn’t happen anymore.  For if it would put a short leash on the Federal Reserve and their ability to print dollars.  How?  As they print more dollars the value of the dollar falls.  Causing the value of gold priced in dollars to rise.  So they would have to stop printing money to keep the value of gold priced in dollars from rising beyond the established gold price.  Or they would have to remove dollars from circulation to decreases the value of gold priced in dollars back down to the established price.  Thereby giving us a stable currency.  And stable housing prices.  For having a stable currency limits the size of bubbles the Federal Reserve can make.

But governments love to print money.  Because they love to spend money.  As well as manipulate it.  For example, depreciating the dollar makes our exports cheaper.  But those export sales help fewer people than the depreciated dollar harms.  But helping a large exporter may result in a large campaign contribution.  Which helps the politicians.  You see, a stable dollar helps everyone but the politicians and their friends.  For printing money helps Wall Street, K Street (where the lobbyists are in Washington DC) and Pennsylvania Avenue.  While hurting Main Street.  The very people the politicians work for.

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Inflation and the Erosion of Savings

Posted by PITHOCRATES - February 4th, 2013

Economics 101

Some of the First Banknotes were Gold Receipts Redeemable for Gold on Deposit in a Goldsmith’s Safe

Money has a few important attributes.  It has to be portable so we can carry it to the store.  It has to be durable so we can use it and carry it without it wearing out.  It has to be divisible so we can buy things at a variety of prices and make change.  It has to be fungible so one $20 bill is the same as any other $20 bill.  And it has to be scarce.  Because above all else money has to store value.  For money is a temporary storage of value.  Which is why we don’t use garbage for money.  Because garbage isn’t scarce.  Nor is it portable, durable or fungible.  And it smells bad.  No one wants it.  And no one will take it in payment for anything.

Precious metals make good money.  They have all of the necessary attributes money should have.  Especially gold.  Which will last forever.  And it will never rust or lose its sheen.  And above all it is scarce.  No one can make gold.  It takes enormous costs to find it, mine it and process it.  So it’s not easy to make it NOT scarce.  Which means it will hold its value.  The only drawback to gold is that it’s not that portable.  It’s pretty heavy to carry around.  And a little dangerous.  As you can’t hide a large and heavy pouch full of gold very well.

So some people started thinking.  Who else has a lot of gold?  And needs to put it in a safe place where others can’t help themselves to it?  A goldsmith.  Who has a large safe they lock their gold in.  So, for a fee, the goldsmith would lock up other people’s gold in his safe.  And give them a paper receipt for the gold on deposit.  And the banknote was born.  People left their gold in the safe.  And used their gold receipts as money.  Paper currency.  Which were fully redeemable for the gold on deposit in the goldsmith’s safe.

The more we Increase the Money Supply the more we Depreciate the Currency and reduce Purchasing Power

Issuing banknotes for gold on deposit evolved into the gold standard.  Where we used paper currency that represented the gold on deposit.  And it was just as good as that gold.  Sharing all the same attributes.  Portable, durable and fungible.  As well as scarce.  If, that is, the amount of paper in circulation equals the amount of gold on deposit.  If so then the paper is as scarce as gold.  And as valuable.  So people will be willing to hold onto it.  Just as they are willing to hold onto the gold.  Because the paper currency is redeemable for the gold on deposit.

But as governments spent money they started to think.  They could spend more money if they just printed more.  And increase the amount of money in circulation beyond the amount of gold on deposit.  Allowing governments to spend more.  And they did.  But it made paper money less scarce.  And less valuable.  We can see how with the following table.  We start with $100 of gold on deposit.  And $100 of paper banknotes in circulation.  Then each year we increase the number of banknotes in circulation (the money supply) by 3% while the amount of gold on deposit remains the same.  Representing a 3% annual inflation rate.  ‘MSB’ stands for Money Supply at the Beginning of the year.  ‘New’ stands for the New money added to the money supply that year.  ‘MSE’ stands for Money Supply at the End of the year.  ‘100/MSE’ is the result of dividing the $100 of gold on deposit by the money supply at the end of the year.  And ‘Savings’ stands for the purchasing power of $750,000 in retirement savings after being adjusted for inflation ($750,000 X 100/MSE).

Inflation on Savings 3 Percent

When 100/MSE equals 1 the amount of banknotes in circulation equals the amount of gold on deposit.  Which means those banknotes are as good as gold.  For you can redeem every last one of them for that gold on deposit.  But when they start printing more banknotes the money supply grows greater than the gold on deposit that backs it.  Making each dollar worth less.  Depreciating the currency.  For the total amount of currency in circulation still equals the $100 of gold on deposit.  The more we increase the money supply the more we depreciate the currency.  Reducing the purchasing power of the currency in circulation.  Which erodes away the value of retirement savings over time.

High Inflation Rates greatly Discourage Savings and Encouraging Consumption

This was at a 3% annual inflation rate.  Which is something you may find in the United States or Britain.  Some countries, though, really inflate their currency.  Especially nations that have abandoned the gold standard.  Which removed all restraint from printing money.  The following table shows what happens to that retirement savings at a 25% annual inflation rate.

Inflation on Savings 25 Percent

Even though there is no longer an exchange mechanism between gold and dollars to keep the monetary authorities responsible they are still supposed to exercise restraint.  As if there was still a gold standard.  Because whether there is gold or not a massive inflation of the money supply still depreciates the currency.  And the greater the inflation the greater it erodes that retirement savings.  At this rate a person’s retirement savings loses over half of its value in 4 years.  It loses 74% of its value in 6 years.  And loses 89% in 10 years.  Greatly discouraging savings.  And encouraging consumption.  Graphing these results we get savings curves for these different inflation rates.

How Inflation Erodes Savings

Note that the higher the inflation rate the steeper the curve.  And the steeper the curve the faster your retirement savings lose their purchasing power.  Here you can see why people living in countries with high inflation rates don’t want to hold onto their currency.  They try to spend it as soon as they get it.  Buying things that hold their value.  Or exchanging it for a stronger currency.  Like U.S. dollars.  British pounds.  Or Eurozone euros.  Anything to avoid their wealth eroding inflation.

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Keynesians, Gold Standard, Consumer Price Index, Money Stock, Nixon Shock, 1973 Oil Crisis, Gasoline Prices, Hidden Tax and Wealth Transfer

Posted by PITHOCRATES - April 24th, 2012

History 101

With the Increase in the Money Supply came the Permanent Increase in Consumer Prices that Continues to this Date

Keynesians hate the gold standard.  Because it puts a limit on how much money a government can print.  Keynesians believe in the power of government to eliminate recessions.  And their cure for recession?  Inflation.  The government prints money to spend in the private economy.  To make up for the decline in consumer spending.  But it turned out this didn’t work.  As the Seventies showed.  They printed a lot of money.  But it didn’t end the recession.  It just raised consumer prices.  Because there is a direct correlation between the amount of money in circulation and consumer prices.  As you can see in the following graph. 

 Source: M2, CPI

 The consumer price index (CPI) data comes from the U.S. Department of Labor.  The data is at 5 year intervals.  The CPI is a ‘basket’ of prices for a selection of representative goods and services divided by another ‘basket’ of prices from a fixed date.  The resulting number is a price index.  If you plot these for a period of time you can see inflation (a rising graph) or deflation (a falling graph).  M2 is the money stock (seasonally unadjusted).  M2 includes currency, traveler’s checks, demand deposits, other checkable deposits, retail MMMFs, savings and small time deposits.

The Breton Woods system established fixed exchange rates for international trade.  It also pegged the U.S. dollar to gold.  The U.S. government promised to exchange U.S. dollars for gold at a rate of $35/ounce.  Making the U.S. dollar as good as gold.  This set the rules for international trade.  Made it fair.  And prevented anyone from cheating by devaluing their currency to make their exports cheaper to gain an economical advantage in international trade.  The system worked well.  Until the Sixties.  Because of the Vietnam War.  And LBJ’s Great Society.  These increased government spending so much that the U.S. government turned to printing money to pay for these.  Which depreciated the dollar.  Making it not as good as gold anymore.  So our trading partners began dumping their devalued dollars.  Exchanging them for gold at $35/ounce.  Which was a problem for the Nixon administration.  For that gold was far more valuable than the U.S. dollar.  They could print more dollars.  But once that gold was gone it was gone.  So Nixon acted to keep that gold in the U.S.

On August 15, 1971 Nixon decoupled the dollar from gold.  Known as the Nixon Shock.  Reneging on the solemn promise to exchange U.S. dollars for gold.  And ramped up the printing presses.  Which you can see in the graph.  After August 15 the money supply began growing.  And continues to this date.  With the increase in the money supply came the permanent increase in consumer prices that, also, continues to this date.  In lockstep with the growth of the money supply.

Prior to the Nixon Shock Gasoline Prices were Falling at a Greater Rate than the Rate Consumer Prices were Rising 

Since August of 1971 the U.S. has maintained a policy of permanent inflation.  Which caused a policy of permanently increasing consumer prices.  Those high prices we complain about, then, are not the fault of greedy businesses.  They’re the fault of government.  And their easy monetary policy.  In fact, if it was not for government’s irresponsible monetary policy the high price we hate most would not be as high as it is today.  In fact, because of the efficiency of the industry bringing us this one product its price has not followed the general upward trend in consumer prices.  And what is this product?  Gasoline.  Which, apart from two spikes in the last 60 years or so has either been falling or holding steady in comparison to consumer prices.

 Source: CPI, Gas $/Gal

 These prices are from DaveManual.com.  And reflect generally the price at the pump over this time period.  Using at first leaded gasoline.  Then unleaded gasoline.  Using inflation adjusted average prices.  Then chained 2005 dollars.  These prices are not exactly apples-to-apples.  But the trending information they provide illustrates two major points.  The two spikes in gas prices were due to demand greatly outpacing supply.  And that even with these two spikes gasoline prices would be far lower today if it wasn’t for the government’s policy of permanent inflation.

Note that prior to the Nixon Shock gasoline prices were falling at a greater rate than the rate consumer prices were rising.  These trends stopped in the Seventies for two reasons.  The Nixon Shock.  And the 1973 oil crisis.  When OPEC punished the U.S. for their support of Israel in the Yom Kippur war by cutting our oil supply.  These two events caused gasoline prices to spike.  But then something interesting happened with these high prices.  It brought a lot of oil producers into the market to cash in on those high prices.  This surge in production coupled with a falling demand due to the U.S. recession in the Seventies caused an oil glut in the Eighties.  Bringing prices back down.  Where they flat-lined for a decade or so while all other consumer prices continued their march upward.  Until two of the most populous countries in the world modernized their economies.  India and China.  Causing a spike in demand.  And a spike in prices.  For it was like adding another United States or two to the world gasoline market.

Inflation is a Hidden Tax that Transfers Wealth from the Private Sector to the Public Sector

Keynesians love to talk about how great the economy was during the Fifties when the high marginal tax rate was 91-92%.  “See?” they say.  “The economy was robust and growing during the Fifties even with these high marginal tax rates.  So high marginal tax rates are good for the economy.”  But they will never comment on how instrumental the gold standard was in keeping government spending within responsible limits.  How that responsible monetary policy kept inflation and consumer prices under control.  No.  They don’t see that part of the Fifties.  Only the high marginal tax rates.  Because they don’t want to return to the gold standard.  Or have any restrictions on their irresponsible ways.

Keynesians believe in the power of government to manage the economy.  And they really like to tax and spend.  A lot.  But taxing too much has consequences.  People don’t like paying taxes.  And don’t tend to vote for people who tax them a lot.  Which is why Keynesians love inflation.  Because it’s a hidden tax.  The higher the inflation rate the higher the tax.  Because government also borrows money.  They sell bonds.  That we buy as a retirement investment.  But if there’s been a good amount of inflation between the selling and redemption of those bonds it makes it a lot easier to redeem those bonds.  Because thanks to inflation those bonds are worth far less than they were when the government issued them.  Even Keynes noted that inflation was a way to transfer a lot of wealth from the private sector to the public sector.  Without many people understanding that it was even happening.

If you ever wondered why it takes two incomes to do what your father did with one income this is why.  Inflation.  This never ending transfer of wealth from the private sector to the public sector.  Leaving us less to retire on.  Making it harder to save for our children’s college education.  Not to mention the higher cost of living that shrinks our real wages.  While they tax our higher nominal wages at ever higher income tax rates (income tax bracket creep is another inflation phenomenon).  Everywhere we turn the government takes more and more of our wealth.  All thanks to LBJ increasing the government spending (for his Vietnam War and his Great Society).  And Richard Nixon decoupling the U.S. dollar from gold.  Instead of doing the responsible thing.  And cutting spending.  But much like high taxes you don’t win any friends at the voting booth by cutting spending.  So thanks to them we’ve had permanent and significant rising inflation and consumer prices ever since.  And as a result a flat to a falling standard of living.  Where soon our children may not have a better life than their parents.  Thank you LBJ and Richard Nixon.  And thank you Keynesian economics.

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Inflation, Prices and Wages (Real and Nominal)

Posted by PITHOCRATES - April 23rd, 2012

Economics 101

Inflation is Good for those who Owe Money but Bad for Bankers 

There is a direct correlation between the amount of money in circulation and prices.  The more money the higher the prices.  The less money in circulation the lower the prices.  During the Great Depression the Federal Reserve contracted the money supply and prices fell.  And it caused havoc in the economy.  Low prices a problem?  Yes.  For some.  It was good for anyone buying anything for their money was worth more and could buy more.  But it wasn’t good for people who owed money.  Or banks.

Farmers had borrowed a lot of money to mechanize their farms in the Twenties.  So they owed the banks a lot of money.  When prices fell so did their earnings as the crops they grew sold for less at market.  Good for the consumer.  But bad for the farmer.  For with that big ‘pay cut’ they took they could not repay their loans.  They defaulted.  And when a lot of them defaulted they left banks with a lot of bad loans on the books and little cash in their vaults.  Causing bank runs and bank failures.

This is why farmers are in favor of inflation.  Increasing the amount of money in circulation.  Instead of deflation.  Decreasing the amount of money in circulation.  For when you increase the money supply prices rise.  Meaning more money for them at market.  Making it easier for them to repay their loans.  For although the money supply increased loan balances remained unchanged.  Higher earnings.  Same old debt.  Therefore easier to pay off.  Even though the value of the dollar fell.  So inflation is good for the farmer.  But bad for the banker.  Because the dollars they get back when the farmer repays his loan now buy less than they did before the inflation.

To Fully Appreciate the Impact of Inflation we must talk about Real Prices and Real Wages

Think of a grocer.  He buys from a food distributor to stock his grocery store shelves.  His distributor buys from farmers and food processing companies.  These purchases and sales happen BEFORE a consumer buys anything from a grocery store.  Now BEFORE the consumer goes shopping let’s say the Federal Reserve doubles the amount of money in circulation.  So the consumer goes shopping with a dollar worth HALF of what it was worth when the grocer stocked his shelves.  So if the grocer doesn’t raise his prices to account for this inflation he’ll be able to replace only HALF of what he sells with the proceeds from those sales.  Because his distributors will have doubled their prices to reflect the halving of the value of the dollar.

Of course doubling prices throughout the food supply chain will ultimately lower sales.  Which no one in this chain wants.  Which creates somewhat of a problem.  Especially when consumers don’t like paying higher prices.  Food processing companies will raise their prices.  But they can do something else to make it look like they’re not raising their prices that much.  They can reduce their packaging.  So boxes of cereal and bags of chips get smaller while prices increase only a little.  This lessens the perception of inflation on both consumer and seller.  At least, for those who can do this.  We sell gasoline by the gallon.  Which means they have to pass on the full impact of inflation in the price at the pump.  Which makes it look like gasoline prices are rising faster than most other prices.  Which is why consumers hate oil companies more than food companies.

The price we pay in the grocery store and at the pump are nominal prices.  Prices noted in dollars.  Nominal prices rise to factor in inflation.  But they don’t tell us the real impact of inflation.  That is, how it reduces our purchasing power.  For prices aren’t the only thing that rise.  Our wages do, too.  And if our nominal wages rise at the same rate as nominal prices do we won’t really notice a difference in our purchasing power.  If our nominal wages rise faster than nominal prices then we gain purchasing power.  If nominal prices rise faster than our nominal wages we lose purchasing power.  So to fully appreciate the impact of inflation we must talk about real prices and real wages.  Not the dollar amount on the price tag.  But the affect on our purchasing power.  In times of increasing purchasing power a single earner may be able to meet all the financial needs of a family.  In times of declining purchasing power it may take a second income to meet the financial needs of the family.  This is what we mean when we talk about real prices and real wages. 

Government causes the Erosion of Purchasing Power Always and Everywhere

You may get a large raise at work giving you a high nominal wage.  But if nominal prices are rising (as in a higher price at the gas pump) real wages are falling.  Because you can’t buy as much as you once did.  Meaning you’ve lost purchasing power.  So even though you got a nominal raise you may have taken a real pay cut.  Pretty much everyone today earns more than their father did.  Yet today we struggle to have as much as our fathers did.  Even with a second income in the family.  This is the impact of inflation.  Which causes real prices to rise.  Real wages to fall.  And our standard of living to fall.

As real prices rise and real wages fall we have to make choices.  We can’t have the same things we once did.  If we lose too much purchasing power our spouse may have to provide a second income, spending less time with his or her children.  Or people may work more overtime.  Or take a second job.  Or simply cut back on things.  And enjoy life less.  Cut out movie night.  Or going out to dinner.  Not renew their season tickets.  Or give less to charity.  This is the true cost of inflation. 

This all goes back to the amount of money in circulation.  As Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.”  Meaning that only government can create inflation.  Because government controls monetary policy.  And the amount of money in circulation.  Which means government causes the erosion of purchasing power always and everywhere.  Even the price at the pump.  As oil is a global commodity priced nominally in U.S. dollars.  So whenever the Americans inflate their money supply the oil producers raise their prices to offset the devalued U.S. dollar.  So government causes much of the pain at the pump.  Whose monetary policies decrease real wages.  And increase real prices.   

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