Hard Money versus Paper Money

Posted by PITHOCRATES - March 17th, 2014

Economics 101

(Originally published April 1st, 2013)

Money would have No Value if People with Talent didn’t Create things of Value

Money is a temporary storage of wealth.  We created it because of the high search costs of the barter system.  It took a lot of time for two people to find each other who each had what the other wanted.  And we started trading things to have things we couldn’t make efficiently for ourselves.  Someone may have been a superb potter but was a horrible farmer.  So, instead, the potter did what he did best.  And traded the pottery he made for the things he wanted that he was not good at making.  Or growing.  Before that we were self-sufficient.  Whatever you wanted you had to provide it yourself.

As we go back in time we learn why money is a temporary storage of wealth.  For it was the final piece in a growing and prosperous economy.  And at the beginning it was people with talent, each creating something of value.  Something of value that they could trade for something else of value.  It’s the creative talent of people that has value.  And we see that value in the goods and/or services they make or provide.  Money temporarily held that value.  So we could carry it with us easier to go to market to trade with other talented and creative people.  Who may not have wanted what we made or did.  But would gladly take our money.

So we took our goods to market.  People that wanted them traded for them.  They traded money for our goods.  Then we took that money and traded for what we wanted elsewhere in the market.  Trade grew.  With some people becoming professional traders.  By trading money for goods from distant lands.  Then trading these goods for money at the local market.  People who didn’t spend time creating anything.  But bought and sold the creative talent of others.  Who were able to do that because of money.  The creative talent came first.  Then the goods.  And then the money.  For money is a temporary storage of wealth.  Which has no value if no one is making anything of value.  Because if you can’t buy anything what good is having money?

There were no more Gold Certificates in Circulation than there was Gold in the Vault to Exchange them For

These early traders used a variety of things for money.  Pigs, tobacco, grain, oil, etc.  What we call commodity money.  Which was valuable by itself.  As people consumed these commodities.  Which is what gave them the ability to store value.  But because we could consume these they did not make the best money.  Also, they weren’t that portable.  And not easy to make change with.  Which is why we turned to specie.  Such as gold and silver.  Hard money.  It was durable.  Portable.  Divisible.  Fungible.  For example, all Spanish dollars were the same while all pigs weren’t.  One pig could weigh 30 pounds more than another.  So pigs weren’t fungible.  Or durable.  Portable.  And, though divisible, making change wasn’t easy.

So in time traders big and small turned to specie as the medium of exchange.  For all the reasons noted above.  If you worked hard to produce fine pottery you trusted in specie.  You would accept specie for your pottery goods.  Because you knew this hard money would hold its value.  And you could use it in the future to buy what you wanted.  No matter how long that may be.  Why?  Because the money supply remained relatively constant.  As it took a lot of work and great expense to mine and refine ore to make specie out of it.  So there was little inflation when using hard money.  Which meant if you saved for a rainy day that hard money would be there for you.

Gold and silver could be heavy to carry around.  Anyone struggling under the weight of their specie were targets for thieves.  Who wanted that money.  Without creating anything of value to bring to market.  So we found a way to improve a little on using gold and silver.  By locking our gold and silver in a vault.  And carrying around receipts for our gold and silver to use as money.  These gold certificates were promises to pay in gold.  People could continue to use them as money.  Or they could take these receipts back to the vault and exchange them for the gold inside.  These gold certificates were as good as gold.  And there were no more gold certificates in circulation than there was gold in the vault to exchange them for.

Governments Today use nothing but Paper Money because it gives them Privilege, Wealth and Power

Some saw advantages of expanding the money supply with paper currency.  Money that isn’t backed by gold or any other asset.  Money easy to print.  And easy to borrow.  Allowing rich people to borrow large sums of money to buy more assets.  And get richer.  Giving them more power.  And if you were the one printing and loaning that money it gave you great wealth and power.  So having a bank charter was a way to wealth and power.  You could make it easy for those who can help you to borrow money.  While making it difficult for those who oppose you to borrow money.  So there were those in business and in government that liked un-backed paper money.  Because a select few could borrow it cheaply and get rich and powerful.

While some liked these banks and that paper money there were others who bitterly opposed them.  Some who didn’t like to see so much power in so few hands.  And the hard money people.  Who wanted a money that held its value.  The common people.  People who couldn’t borrow large sums of cheap money.  But people who had to get by on less as the inflation from printing all those paper dollars raised prices.  Leaving them with less purchasing power.  Making it harder for them to get by.  Often having to turn to the hated banks to borrow money.  Again and again.  Such that the interest on their loans consumed even more of their limited funds.  Making life more tenuous.  And more bitter between the classes.  The rich who benefited from the cheap paper money.  And the common people who paid the price of all that inflation.

Rich people, on the other hand, loved that inflation.  It helped them make money.  When they bought something at a lower price and sold it at a higher price they made a lot of money.  The greater the inflation the greater the selling price.  And the more profit.  Also, the money they owed was easier to pay off with money that was worth less than when they borrowed it.  Allowing rich people to get even richer.  While the common people saw only higher prices.  And the value of their meager savings lose value.  So this cheap paper money fostered great class warfare.  The hard money people hated the paper money people.  Debtors hated creditors.  The middling classes hated the large landowners, merchants, manufacturers and, of course, the bankers.  And those who had talent to create things hated those who just made money with money.  The greater the inflation the greater the divide between the people.  And the greater wealth and power that select few acquired.  This is what paper money gave you.  Privilege.  Which is why most governments today use nothing but paper money.

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The Austrian School of Economics

Posted by PITHOCRATES - March 3rd, 2014

Economics 101

(Originally published February 27th, 2012)

Because of the Unpredictable Human Element in all Economic Exchanges the Austrian School is more Laissez-Faire

Name some of the great inventions economists gave us.  The computer?  The Internet?  The cell phone?  The car?  The jumbo jet?  Television?  Air conditioning?  The automatic dishwasher?  No.  Amazingly, economists did not invent any of these brilliant inventions.  And economists didn’t predict any of these inventions.  Not a one.  Despite how brilliant they are.  Well, brilliant by their standard.  In their particular field.  For economists really aren’t that smart.  Their ‘expertise’ is in the realm of the social sciences.  The faux sciences where people try to quantify the unquantifiable.  Using mathematical equations to explain and predict human behavior.  Which is what economists do.  Especially Keynesian economists.  Who think they are smarter than people.  And markets.

But there is a school of economic thought that doesn’t believe we can quantify human activity.  The Austrian school.  Where Austrian economics began.  In Vienna.  Where the great Austrian economists gathered.  Carl Menger.  Ludwig von Mises.  And Friedrich Hayek.  To name a few.  Who understood that economics is the sum total of millions of people making individual human decisions.  Human being key.  And why we can’t reduce economics down to a set of mathematical equations.  Because you can’t quantify human behavior.  Contrary to what the Keynesians believe.  Which is why these two schools are at odds with each other.  With people even donning the personas of Keynes and Hayek to engage in economic debate.

Keynesian economics is more mainstream than the Austrian school.  Because it calls for the government to interfere with market forces.  To manipulate them.  To make markets produce different results from those they would have if left alone.  Something governments love to do.  Especially if it calls for taxing and spending.  Which Keynesian economics highly encourage.  To fix market ‘failures’.  And recessions.  By contrast, because of the unpredictable human element in all economic exchanges, the Austrian school is more laissez-faire.  They believe more in the separation of the government from things economic.  Economic exchanges are best left to the invisible hand.  What Adam Smith called the sum total of the millions of human decisions made by millions of people.  Who are maximizing their own economic well being.  And when we do we maximize the economic well being of the economy as a whole.  For the Austrian economist does not believe he or she is smarter than people.  Or markets.  Which is why an economist never gave us any brilliant invention.  Nor did their equations predict any inventor inventing a great invention.  And why economists have day jobs.  For if they were as brilliant and prophetic as they claim to be they could see into the future and know which stocks to buy to get rich so they could give up their day jobs.  When they’re able to do that we should start listening to them.  But not before.

Low Interest Rates cause Malinvestment and Speculation which puts Banks in Danger of Financial Collapse

Keynesian economics really took off with central banking.  And fractional reserve banking.  Monetary tools to control the money supply.  That in the Keynesian world was supposed to end business cycles and recessions as we knew them.  The Austrian school argues that using these monetary tools only distorts the business cycle.  And makes recessions worse.  Here’s how it works.  The central bank lowers interest rates by increasing the money supply (via open market transactions, lowering reserve requirements in fractional reserve banking or by printing money).  Lower interest rates encourage people to borrow money to buy houses, cars, kitchen appliances, home theater systems, etc.  This new economic activity encourages businesses to hire new workers to meet the new demand.  Ergo, recession over.  Simple math, right?  Only there’s a bit of a problem.  Some of our worst recessions have come during the era of Keynesian economics.  Including the worst recession of all time.  The Great Depression.  Which proves the Austrian point that the use of Keynesian policies to end recessions only makes recessions worse.  (Economists debate the causes of the Great Depression to this day.  Understanding the causes is not the point here.  The point is that it happened.  When recessions were supposed to be a thing of the past when using Keynesian policies.)

The problem is that these are not real economic expansions.  They’re artificial ones.  Created by cheap credit.  Which the central bank creates by forcing interest rates below actual market interest rates.  Which causes a whole host of problems.  In particular corrupting the banking system.  Banks offer interest rates to encourage people to save their money for future use (like retirement) instead of spending it in the here and now.  This is where savings (or investment capital) come from.  Banks pay depositors interest on their deposits.  And then loan out this money to others who need investment capital to start businesses.  To expand businesses.  To buy businesses.  Whatever.  They borrow money to invest so they can expand economic activity.  And make more profits.

But investment capital from savings is different from investment capital from an expansion of the money supply.  Because businesses will act as if the trend has shifted from consumption (spending now) to investment (spending later).  So they borrow to expand operations.  All because of the false signal of the artificially low interest rates.  They borrow money.  Over-invest.  And make bad investments.  Even speculate.  What Austrians call malinvestments.  But there was no shift from consumption to investment.  Savings haven’t increased.  In fact, with all those new loans on the books the banks see a shift in the other direction.  Because they have loaned out more money while the savings rate of their depositors did not change.  Which produced on their books a reduction in the net savings rate.  Leaving them more dangerously leveraged than before the credit expansion.  Also, those lower interest rates also decrease the interest rate on savings accounts.  Discouraging people from saving their money.  Which further reduces the savings rate of depositors.  Finally, those lower interest rates reduce the income stream on their loans.  Leaving them even more dangerously leveraged.  Putting them at risk of financial collapse should many of their loans go bad.

Keynesian Economics is more about Power whereas the Austrian School is more about Economics

These artificially low interest rates fuel malinvestment and speculation.  Cheap credit has everyone, flush with borrowed funds, bidding up prices (real estate, construction, machinery, raw material, etc.).  This alters the natural order of things.  The automatic pricing mechanism of the free market.  And reallocates resources to these higher prices.  Away from where the market would have otherwise directed them.  Creating great shortages and high prices in some areas.  And great surpluses of stuff no one wants to buy at any price in other areas.  Sort of like those Soviet stores full of stuff no one wanted to buy while people stood in lines for hours to buy toilet paper and soap.  (But not quite that bad.)  Then comes the day when all those investments don’t produce any returns.  Which leaves these businesses, investors and speculators with a lot of debt with no income stream to pay for it.  They drove up prices.  Created great asset bubbles.  Overbuilt their capacity.  Bought assets at such high prices that they’ll never realize a gain from them.  They know what’s coming next.  And in some darkened office someone pours a glass of scotch and murmurs, “My God, what have we done?”

The central bank may try to delay this day of reckoning.  By keeping interest rates low.  But that only allows asset bubbles to get bigger.  Making the inevitable correction more painful.  But eventually the central bank has to step in and raise interest rates.  Because all of that ‘bidding up of prices’ finally makes its way down to the consumer level.  And sparks off some nasty inflation.  So rates go up.  Credit becomes more expensive.  Often leaving businesses and speculators to try and refinance bad debt at higher rates.  Debt that has no income stream to pay for it.  Either forcing business to cut costs elsewhere.  Or file bankruptcy.  Which ripples through the banking system.  Causing a lot of those highly leveraged banks to fail with them.  Thus making the resulting recession far more painful and more long-lasting than necessary.  Thanks to Keynesian economics.  At least, according to the Austrian school.  And much of the last century of history.

The Austrian school believes the market should determine interest rates.  Not central bankers.  They’re not big fans of fractional reserve banking, either.  Which only empowers central bankers to cause all of their mischief.  Which is why Keynesians don’t like Austrians.  Because Keynesians, and politicians, like that power.  For they believe that they are smarter than the people making economic exchanges.  Smarter than the market.  And they just love having control over all of that money.  Which comes in pretty handy when playing politics.  Which is ultimately the goal of Keynesian economics.  Whereas the Austrian school is more about economics.

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Bretton Woods System, Quasi Gold Standard, Inflation, Savings, Nixon Shock and Monetizing the Debt

Posted by PITHOCRATES - February 4th, 2014

History 101

(Originally published 2/5/2013)

The Bretton Woods System was a quasi Gold Standard where the U.S. Dollar replaced Gold

Government grew in the Sixties.  LBJ’s Great Society increased government spending.  Adding it on top of spending for the Vietnam War.  The Apollo Moon Program.  As well as the Cold War.  The government was spending a lot of money.  More money than it had.  So they started increasing the money supply (i.e., printing money).  But when they did they unleashed inflation.  Which devalued the dollar.  And eroded savings.  Also, because the U.S. was still on a quasi gold standard this also created a problem with their trade partners.

At the time the United States was still in the Bretton Woods System.  Along with her trade partners.  These nations adopted the U.S. dollar as the world’s reserve currency to facilitate international trade.  Which kept trade fair.  By preventing anyone from devaluing their currency to give them an unfair trade advantage.  They would adjust their monetary policy to maintain a fixed exchange rate with the U.S. dollar.  While the U.S. coupled the U.S. dollar to gold at $35/ounce.  Which created a quasi gold standard.  Where the U.S. dollar replaced gold.

So the U.S. had a problem when they started printing money.  They were devaluing the dollar.  So those nations holding it as a reserve currency decided to hold gold instead.  And exchanged their dollars for gold at $35/ounce.  Causing a great outflow of gold from the U.S.  Giving the U.S. a choice.  Either become responsible and stop printing money.  Or decouple the dollar from gold.  And no longer exchange gold for dollars.  President Nixon chose the latter.  And on August 15, 1971, he surprised the world.  Without any warning he decoupled the dollar from gold.  It was a shock.  So much so they call it the Nixon Shock.

To earn a Real 2% Return the Interest Rate would have to be 2% plus the Loss due to Inflation

Once they removed gold from the equation there was nothing stopping them from printing money.  The already growing money supply (M2) grew at a greater rate after the Nixon Shock (see M2 Money Stock).  The rate of increase (i.e., the inflation rate) declined for a brief period around 1973.  Then resumed its sharp rate of growth around 1975.  Which you can see in the following chart.  Where the increasing graph represents the rising level of M2.

M2 versus Retirement Savings

Also plotted on this graph is the effect of this growth in the money supply on retirement savings.  In 1966 the U.S. was still on a quasi gold standard.  So assume the money supply equaled the gold on deposit in 1966.  And as they increased the money supply over the years the amount of gold on deposit remained the same.  So if we divide M2 in 1966 by M2 in each year following 1966 we get a declining percentage.  M2 in 1966 was only 96% of M2 in 1967.  M2 in 1966 was only 88% of M2 in 1968.  And so on.  Now if we start off with a retirement savings of $750,000 in 1966 we can see the effect of inflation has by multiplying that declining percentage by $750,000.  When we do we get the declining graph in the above chart.  To offset this decline in the value of retirement savings due to inflation requires those savings to earn a very high interest rate.

Interest Rate - Real plus Inflation

This chart starts in 1967 as we’re looking at year-to-year growth in M2.  Inflation eroded 4.07% of savings between 1966 and 1967.   So to earn a real 2% return the interest rate would have to be 2% plus the loss due to inflation (4.07%).  Or a nominal interest rate of 6.07%.  The year-to-year loss in 1968 was 8.68%.  So the nominal interest rate for a 2% real return would be 10.68% (2% + 8.68%).  And so on as summarized in the above chart.  Because we’re discussing year-to-year changes on retirement savings we can consider these long-term nominal interest rates.

Just as Inflation can erode someone’s Retirement Savings it can erode the National Debt

To see how this drives interest rates we can overlay some average monthly interest rates for 6 Month CDs (see Historical CD Interest Rate).  Which are often a part of someone’s retirement nest egg.  The advantage of a CD is that they are short-term.  So as interest rates rise they can roll over these short-term instruments and enjoy the rising rates.  Of course that advantage is also a disadvantage.  For if rates fall they will roll over into a lower rate.  Short-term interest rates tend to be volatile.  Rising and falling in response to anything that affects the supply and demand of money.  Such as the rate of growth of the money supply.  As we can see in the following chart.

Interest Rate - Real plus Inflation and 6 Month CD

The average monthly interest rates for 6 Month CDs tracked the long-term nominal interest rates.  As the inflationary component of the nominal interest rate soared in 1968 and 1969 the short-term rate trended up.  When the long-term rate fell in 1970 the short-term rate peaked and fell in the following year.  After the Nixon Shock long-term rates increased in 1971.  And soared in 1972 and 1973.  The short-term rate trended up during these years.  And peaked when the long-term rate fell.  The short term rate trended down in 1974 and 1975 as the long-term rate fell.  It bottomed out in 1977 in the second year of soaring long-term rates.  Where it then trended up at a steeper rate all the way through 1980.  Sending short-term rates even higher than long-term rates.  As the risk on short-term savings can exceed that on long-term savings.  Due to the volatility of short-term interest rates and wild swings in the inflation rate.  Things that smooth out over longer periods of time.

Governments like inflationary monetary policies.  For it lets them spend more money.  But it also erodes savings.  Which they like, too.  Especially when those savings are invested in the sovereign debt of the government.  For just as inflation can erode someone’s retirement savings it can erode the national debt.  What we call monetizing the debt.  For as you expand the money supply you depreciate the dollar.  Making dollars worth less.  And when the national debt is made up of depreciated dollars it’s easier to pay it off.  But it’s a dangerous game to play.  For if they do monetize the debt it will be very difficult to sell new government debt.  For investors will demand interest rates with an even larger inflationary component to protect them from further irresponsible monetary policies.  Greatly increasing the interest payment on the debt.  Forcing spending cuts elsewhere in the budget as those interest payments consume an ever larger chunk of the total budget.  Which governments are incapable of doing.  Because they love spending too much.

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Keynesian Economics

Posted by PITHOCRATES - October 14th, 2013

Economics 101

(Originally published February 20th, 2012)

John Maynard Keynes said if the People aren’t Buying then the Government Should Be

Keynesian economics is pretty complex.  So is the CliffsNotes version.  So this will be the in-a-nutshell version.  Keynesian economics basically says, in a nut shell, that markets are stupid.  Because markets are full of stupid people.  If we leave people to buy and sell as they please we will continue to suffer recession after recession.  Because market failures give us the business cycle.  Which are nice on the boom side.  But suck on the bust side.  The recession side.  So smart people got together and said, “Hey, we’re smart people.  We can save these stupid people from themselves.  Just put a few of us smart people into government and give us control over the economy.  Do that and recessions will be a thing of the past.”

Well, that’s the kind of thing governments love to hear.  “Control over the economy?” they said.  “We would love to take control of the economy.  And we would love to control the stupid people, too.  Just tell us how to do it and our smart people will work with your smart people and we will make the world a better place.”  And John Maynard Keynes told them exactly what to do.  And by exactly I mean exactly.  He transformed economics into mathematical equations.  And they all pretty much centered on doing one thing.  Moving the demand curve.  (A downward sloping graph showing the relationship between prices and demand for stuff; higher the price the lower the demand and vice versa).

In macroeconomics (i.e., the ‘big picture’ of the national economy), Keynes said all our troubles come from people not buying enough stuff.  That they aren’t consuming enough.  And when consumption falls we get recessions.  Because aggregate demand falls.  Aggregate demand being all the people put together in the economy out there demanding stuff to buy.  And this is where government steps in.  By picking up the slack in personal consumption.  Keynes said if the people aren’t buying then the government should be.  We call this spending ‘stimulus’.  Governments pass stimulus bills to shift the demand curve to the right.  A shift to the right means more demand and more economic activity.  Instead of less.  Do this and we avoid a recession.  Which the market would have entered if left to market forces.  But not anymore.  Not with smart people interfering with market forces.  And eliminating the recession side of the business cycle.

Keynesians prefer Deficit Spending and Playing with the Money Supply to Stimulate the Economy

Oh, it all sounds good.  Almost too good to be true.  And, as it turns out, it is too good to be true.  Because economics isn’t mathematical.  It’s not a set of equations.  It’s people entering into trades with each other.  And this is where Keynesian economics goes wrong.  People don’t enter into economic exchanges with each other to exchange money.  They only use money to make their economic exchanges easier.  Money is just a temporary storage of value.  Of their human capital.  Their personal talent that provides them business profits.  Investment profits.  Or a paycheck.  Money makes it easier to go shopping with the proceeds of your human capital.  So we don’t have to barter.  Exchange the things we make for the things we want.  Imagine a shoemaker trying to barter for a TV set.  By trading shoes for a TV.  Which won’t go well if the TV maker doesn’t want any shoes.  So you can see the limitation in the barter system.   But when the shoemaker uses money to buy a TV it doesn’t change the fundamental fact that he is still trading his shoemaking ability for that TV.  He’s just using money as a temporary storage of his shoemaking ability.

We are traders.  And we trade things.  Or services.  We trade value created by our human capital.  From skill we learned in school.  Or through experience.  Like working in a skilled trade under the guidance of a skilled journeyperson or master tradesperson.  This is economic activity.  Real economic activity.  People getting together to trade their human capital.  Or in Keynesian terms, on both sides of the equation for these economic exchanges is human capital.  Which is why demand-side economic stimulus doesn’t work.  Because it mistakes money for human capital.  One has value.  The other doesn’t.  And when you replace one side of the equation with something that doesn’t have value (i.e., money) you cannot exchange it for something that has value (human capital) without a loss somewhere else in the economy.  In other words to engage in economic exchanges you have to bring something to the table to trade.  Skill or ability.  Not just money.  If you bring someone else’s skill or ability (i.e., their earned money) to the table you’re not creating economic activity.  You’re just transferring economic activity to different people.  There is no net gain.  And no economic stimulus.

When government spends money to stimulate economic activity there are no new economic exchanges.  Because government spending is financed by tax revenue.  Wealth they pull out of the private sector so the public sector can spend it.  They take money from some who can’t spend it and give it to others who can now spend it.  The reduction in economic activity of the first group offsets the increase in economic activity in the second group.   So there is no net gain.  Keynesians understand this math.  Which is why they prefer deficit spending (new spending paid by borrowing rather than taxes).  And playing with the money supply.

The End Result of Government Stimulus is Higher Prices for the Same Level of Economic Activity

The reason we have recessions is because of sticky wages.  When the business cycle goes into recession all prices fall.  Except for one.  Wages.  Those sticky wages.  Because it is not easy giving people pay cuts.  Good employees may just leave and work for someone else for better pay.  So when a business can’t sell enough to maintain profitability they cut production.  And lay off workers.  Because they can’t reduce wages for everyone.  So a few people lose all of their wages.  Instead of all of the people losing all of their wages by a business doing nothing to maintain profitability.  And going out of business.

To prevent this unemployment Keynesian economics says to move the aggregate demand curve to the right.  In part by increasing government spending.  But paying for this spending with higher taxes on existing spenders is a problem.  It cancels out any new economic activity created by new spenders.  So this is where deficit spending and playing with the money supply come in.  The idea is if the government borrows money they can create economic activity.  Without causing an equal reduction in economic activity due to higher taxes.  And by playing with the money supply (i.e., interest rates) they can encourage people to borrow money to spend even if they had no prior intentions of doing so.  Hoping that low interest rates will encourage them to buy a house or a car.  (And incur dangerous levels of debt in the process).  But the fatal flaw in this is that it stimulates the money supply.  Not human capital.

This only pumps more money into the economy.  Inflates the money supply.  And depreciates the dollar.  Which increases prices.  Because a depreciated dollar can’t buy as much as it used to.  So whatever boost in economic activity we gain will soon be followed by an increase in prices.  Thus reducing economic activity.  Because of that demand curve.  That says higher prices decreases aggregate demand.  And decreases economic activity.  The end result is higher prices for the same level of economic activity.  Leaving us worse off in the long run.  If you ever heard a parent say when they were a kid you could buy a soda for a nickel this is the reason why.  Soda used to cost only a nickel.  Until all this Keynesian induced inflation shrunk the dollar and raised prices through the years.  Which is why that same soda now costs a dollar.

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Bretton Woods, Nixon Shock, OPEC, Yom Kippur War, Oil Embargo, Stagflation, Paul Volcker, Ronald Reagan and Morning in America

Posted by PITHOCRATES - October 1st, 2013

History 101

(Originally published September 18th, 2012)

Under the Bretton Woods System the Americans promised to Exchange their Gold for Dollars at $35 per Ounce

Wars are expensive.  All kinds.  The military kind.  As well as the social kind.  And the Sixties gave us a couple of doozies.  The Vietnam War.  And the War on Poverty.  Spending in Vietnam started in the Fifties.  But spending, as well as troop deployment, surged in the Sixties.  First under JFK.  Then under LBJ.  They added this military spending onto the Cold War spending.  Then LBJ declared a war on poverty.  And all of this spending was on top of NASA trying to put a man on the moon.  Which was yet another part of the Cold War.  To beat the Soviets to the moon after they beat us in orbit.

This was a lot of spending.  And it carried over into the Seventies.  Giving President Nixon a big problem.  As he also had a balance of payments deficit.  And a trade deficit.  Long story short Nixon was running out of money.  So they started printing it.  Which caused another problem as the US was still part of the Bretton Woods system.  A quasi gold standard.  Where the US pegged the dollar to gold at $35 per ounce.  Which meant when they started printing dollars the money supply grew greater than their gold supply.  And depreciated the dollar.  Which was a problem because under Bretton Woods the Americans promised to exchange their gold for dollars at $35 per ounce.

When other nations saw the dollar depreciate so that it would take more and more of them to buy an ounce of gold they simply preferred having the gold instead.  Something the Americans couldn’t depreciate.  Nations exchanged their dollars for gold.  And began to leave the Bretton Woods system.    Nixon had a choice to stop this gold outflow.  He could strengthen the dollar by reducing the money supply (i.e., stop printing dollars) and cut spending.  Or he could ‘close the gold window’ and decouple the dollar from gold.  Which is what he did on August 15, 1971.  And shocked the international financial markets.  Hence the name the Nixon Shock.

When the US supported Israel in the Yom Kippur War the Arab Oil Producers responded with an Oil Embargo

Without the restraint of gold preventing the printing of money the Keynesians were in hog heaven.  As they hated the gold standard.  The suspension of the convertibility of gold ushered in the heyday of Keynesian economics.  Even Nixon said, “I am now a Keynesian in economics.”  The US had crossed the Rubicon.  Inflationary Keynesian policies were now in charge of the economy.  And they expanded the money supply.  Without restraint.  For there was nothing to fear.  No consequences.  Just robust economic activity.  Of course OPEC didn’t see it that way.

Part of the Bretton Woods system was that other nations used the dollar as a reserve currency.  Because it was as good as gold.  As our trading partners could exchange $35 for an ounce of gold.  Which is why we priced international assets in dollars.  Like oil.  Which is why OPEC had a problem with the Nixon Shock.  The dollars they got for their oil were rapidly becoming worth less than they once were.  Which greatly reduced what they could buy with those dollars.  The oil exporters were losing money with the American devaluation of the dollar.  So they raised the price of oil.  A lot.  Basically pricing it at the current value of gold in US dollars.  Meaning the more they depreciated the dollar the higher the price of oil went.  As well as gas prices.

With the initial expansion of the money supply there was short-term economic gain.  The boom.  But shortly behind this inflationary gain came higher prices.  And a collapse in economic activity.  The bust.  This was the dark side of Keynesian economics.  Higher prices that pushed economies into recessions.  And to make matters worse Americans were putting more of their depreciated dollars into the gas tank.  And the Keynesians said, “No problem.  We can fix this with some inflation.”  Which they tried to by expanding the money supply further.  Meanwhile, Egypt and Syria attacked Israel on October 6, 1973, kicking off the Yom Kippur War.  And when the US supported their ally Israel the Arab oil producers responded with an oil embargo.  Reducing the amount of oil entering America, further raising prices.  And causing gas lines as gas stations ran out of gas.  (In part due to Nixon’s price controls that did not reset demand via higher prices to the reduced supply.  And a ceiling on domestic oil prices discouraged any domestic production.)  The Yom Kippur War ended about 20 days later.  Without a major change in borders.  With an Israeli agreement to pull their forces back to the east side of the Suez Canal the Arab oil producers (all but Libya) ended their oil embargo in March of 1974.

It was Morning in America thanks to the Abandonment of Keynesian Inflationary Policies

So oil flowed into the US again.  But the economy was still suffering from high unemployment.  Which the Keynesians fixed with some more inflation.  With another burst of monetary expansion starting around 1975.  To their surprise, though, unemployment did not fall.  It just raised prices.  Including oil prices.  Which increased gas prices.  The US was suffering from high unemployment and high inflation.  Which wasn’t supposed to happen in Keynesian economics.  Even their Phillips Curve had no place on its graph for this phenomenon.  The Keynesians were dumfounded.  And the American people suffered through the malaise of stagflation.  And if things weren’t bad enough the Iranians revolted and the Shah of Iran (and US ally) stepped down and left the country.  Disrupting their oil industry.  And then President Carter put a halt to Iranian oil imports.  Bringing on the 1979 oil crisis.

This crisis was similar to the previous one.  But not quite as bad.  As it was only Iranian oil being boycotted.  But there was some panic buying.  And some gas lines again.  But Carter did something else.  He began to deregulate oil prices over a period of time.  It wouldn’t help matters in 1979 but it did allow the price of crude oil to rise in the US.  Drawing the oil rigs back to the US.  Especially in Alaska.  Also, the Big Three began to make smaller, more fuel efficient cars.  These two events would combine with another event to bring down the price of oil.  And the gasoline we made from that oil.

Actually, there was something else President Carter did that would also affect the price of oil.  He appointed Paul Volcker Chairman of the Federal Reserve in August of 1979.  He was the anti-Keynesian.  He raised interest rates to contract the money supply and threw the country into a steep recession.  Which brought prices down.  Wringing out the damage of a decade’s worth of inflation.  When Ronald Reagan won the 1980 presidency he kept Volcker as Chairman.  And suffered through a horrible 2-year recession.  But when they emerged it was Morning in America.  They had brought inflation under control.  Unemployment fell.  The economy rebounded thanks to Reagan’s tax cuts.  And the price of oil plummeted.  Thanks to the abandonment of Keynesian inflationary policies.  And the abandonment of oil regulation.  As well as the reduction in demand (due to those smaller and more fuel efficient cars).  Which created a surge in oil exploration and production that resulted in an oil glut in the Eighties.  Bringing the price oil down to almost what it was before the two oil shocks.

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Counterfeiting in the Revolutionary War, the American Civil War and World War II

Posted by PITHOCRATES - September 24th, 2013

History 101

Governments often turn to Printing Money to Pay for War

It takes money to wage war.  A lot of it.  War spending is always a country’s greatest expenditure.  Because fighting wars is costly.  And the longer they last the more costly they become.  Pushing countries that are waging war to the brink of financial collapse.  Opening the door for another means of waging war.  Counterfeiting.

How do you wage war with counterfeiting?  By pushing a country’s economy into a financial collapse.  If you can’t defeat your enemy with bullets and bombs you destroy their ability to make bullets and bombs.  And everything else.  Including food.  And you do this by devaluing a country’s currency by flooding the money supply with counterfeit bills.  Increasing the money supply causes inflation by having more dollars available to buy the same amount of goods.  Requiring more and more dollars to buy those same goods.  Thus raising prices.

As people struggle with rising prices they buy less.  Because they lose purchasing power.  Businesses see their sales revenue fall.  As people have less disposable income to buy their goods.  With falling sales they lay off workers.  All of this causes a dramatic fall in tax revenue.  Just when they need more to pay the costs of waging war.  As well as providing relief for those no longer able to afford food and housing because they lost their jobs.  Which is why governments print money during wars.  As it is the only choice they have to pay for the high costs of a nation at war.

By the End of the American Civil War about Half of all Money in Circulation was Counterfeit

One of the problems the British had during the American Revolutionary War was that it turned into a world war.  The British were also fighting the French and the Spanish.  Their entering the conflict stretched the British resources thin.  So they turned to counterfeiting.  The Americans were already suffering a terrible inflation as the Continental Congress had little choice but to turn to printing money to pay for the war.  They printed so many continental dollars that people began to refuse to accept it in payment.  Making the continental dollar more and more worthless.  Hence the expression ‘not worth a continental’.  The British tried to push the American economy into collapse by adding to that currency devaluation.  It was so destructive to the American cause that General Washington hanged counterfeiters.

During the early years of the American Civil War the North was running through her gold reserves.  So Congress passed the Legal Tender Act (2/24/1862).  Authorizing the printing of paper money to pay for war.  Just like they did during the Revolutionary War.  A new national currency was a counterfeiter’s dream.  Instead of different banks issuing different banknotes across the country there was now only one.  Counterfeits were easy to pass as few could tell a real one from a fake one.  And with the Confederate dollar worthless even the Confederates wanted these new dollars.  To buy things the Confederate dollar no longer could.  The new counterfeits were even easier to pass in the South as there was no official currency trading hands there.  Counterfeiting was so bad (by the end of the Civil War about half of all the money in circulation was counterfeit) that the Lincoln administration created the Secret Service to combat it.

The Nazis tried to bomb Britain into submission during World War II.  Or at least to weaken it enough for a cross-channel invasion.  The only problem with their plan was that the British had the Supermarine Spitfire.  One of the greatest fighter planes of the war.  And some of the finest pilots ever to fly.  Who had an able assist from the new radar.  Allowing these few to defeat the Luftwaffe in the Battle of Britain.  And made the cross-channel invasion impossible.  It’s these few Winston Churchill’s “Never in the field of human conflict was so much owed by so many to so few” refer to.

Counterfeiting is a very Effective Way to Wage War while being Cheaper and Less Risky than Conventional War

The Nazis took a beating in the Battle of Britain.  So Hitler turned his war machine eastward.  And invaded the Soviet Union instead.  But he did not give up on Britain.  For Britain was a great thorn in Hitler’s side.  They were in the Mediterranean and North Africa.  And they were producing oil in Iran.  They had the shipping lanes.  As well as the United States as an ally.  Who was feeding food and war material to Britain.  And using that island nation to base their bombers out of.  As well as building up an invasion force there that would one day open up a second front in the West.  Enter Operation Bernhard.

Operation Bernhard was a Nazi plan to flood the British economy with counterfeit money.  To destabilize the British economy.  And push it into collapse.  They set up operations in concentration camps.  And were printing about 1 million counterfeit banknotes a month.  The Nazis then laundered the money.  And used it to buy the war material they needed.  The counterfeits were so good that they were still turning up in Britain a decade after the war.  Forcing the British to withdraw all notes (larger than £5) from circulation and replacing them with a more counterfeit-proof money.

The Nazis turned to the American dollar in 1945.  They set up printing presses in February.  But they cancelled their plans.  The war ended later that year.  Allowing the Americans to escape the economic damage the British suffered at the hands of the Nazi counterfeiting program.  But the idea lives on.  We see ‘superdollars’ (counterfeits so good that their quality is higher than the original) all over the world.  The U.S. suspects the source of these counterfeits are criminal gangs in Iran, Russia, China or Syria.  While suspecting the government of North Korea producing a share of these superdollars.  We don’t know for certain who is creating this counterfeit money but there is a lot of it out there.  Some may be doing it for financial gain.  While others may be doing it to damage the United States economically.  Whatever the reason the result is the same.  Resulting in the scourge of paper money.  Higher inflation.  Currency devaluation.  Higher prices.  And less economic activity.  Possibly even sending the economy into a deep recession.  Everything an enemy of the United States wants to do to the United States.  Making counterfeiting a very effective way to wage war while being cheaper and less risky than conventional war.

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Quantitative Easing, Inflation and Gold

Posted by PITHOCRATES - September 23rd, 2013

Economics 101

The FOMC makes Money out of Nothing to Buy the Bonds for their Quantitative Easing

The Federal Open Market Committee (FOMC) decided to keep their quantitative easing.  Their monthly $85 billion purchase of Treasury Securities and mortgage bonds.  To stimulate the economy.  Which hasn’t stimulated the economy.  But it has greatly expanded the money supply.

When people buy Treasury Securities and mortgage bonds they have to first work and save up the money.  Then when they buy these investments they no longer have that money.  It’s how we buy things.  We exchange money for things.  So we can have the money or the things.  But never both.

Unless you’re the federal government.  That has the power to print money.  When they make these monthly $85 million purchases of Treasury Securities and mortgage bonds they pay for them with an electronic transfer of money.  They add money to the account of the holders of the Treasury Securities and mortgage bonds.  And that’s it.  They subtract no money from their ledgers.  Because they ‘printed’ that money.  Just made it out of nothing.  Literally.

The Danger of a highly Inflated and Devalued Currency is that it loses its Purchasing Power and People lose Faith in It

The Secret Service protects our presidents.  Ironically, the president that created the Secret Service was assassinated.  Abraham Lincoln.  Who created it not to protect presidents.  But to combat a great threat to the country.  Counterfeiting.  The scourge of paper money.

During the American Revolutionary War the Continental Congress had no hard money (i.e., precious metals) to pay the Continental Army.  So they resorted to printing paper money.  Igniting massive inflation.  The more money they printed the greater the inflation.  And the greater they devalued the dollar.  Requiring more and more of them to buy what they once did.  Until no one would accept them in payment anymore.  Forcing the army to take what they needed from the people.  Leaving behind IOUs for the Congress to honor.  Once they figured out how to do that.

This is the danger of a highly inflated and devalued currency.  It loses its purchasing power.  Until it gets so weak that the people lose faith in it.  And refuse to accept it anymore.  Returning to the barter system instead.  Trading things that hold their value for other valuable things.  But the barter system has high search costs.  It takes a lot of time for people to find each other that can trade with each other.  Greatly reducing economic activity.  And crashing a nation’s economy.  Which is what Abraham Lincoln wanted to prevent.  And why a lot of America’s enemies have tried to flood the American economy with counterfeit bills.

The Hard-Money Prices remained Relatively Constant during the Inflationary Periods of the Revolutionary War

With the FOMC’s decision to continue their quantitative easing the stock market soared.  As investors were instead expecting a ‘tapering’.  A reduction in their purchases of Treasury Securities and mortgage bonds.  And if the government stopped creating this money out of nothing to buy bonds from these investors these investors could not continue to buy and sell in the market like they were doing.  Pocketing handsome profits in the process.  Which is why they were so happy to hear the FOMC would continue their currency devaluation to continue buying like they had been.

But this continued currency devaluation has a down side.  For it can’t go on forever.  There will come a point when it ignites inflation.  Causing prices to soar.  Requiring more and more dollars to buy what they once bought before.  So with this possibility on the horizon and with continued currency devaluation some people were taking steps to protect their assets.  Especially their cash.  For there is nothing worse than having a lot of cash when it’s losing its purchasing power at an alarming rate.  So they convert that cash into something that holds it value better.  Such as precious metals.  Which is why when the dollar tanked (after the FOMC decision) the price of gold surged.

So what’s the difference between gold and paper money?  Well, the government can’t print gold.  They can’t create gold out of nothing and add it to someone’s account.  So they can’t devalue gold.  And because of this gold will hold its value during inflationary periods.  Which was why during the Revolutionary War people sold things with two prices.  One was in paper Continental Dollars.  With these prices increasing sometimes daily.  And one in hard money (i.e., precious metals).  The hard money prices remained relatively constant.  Even during the inflationary periods of the Revolutionary War.

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Rand Paul says Milton Friedman would oppose the Fed’s Bond Buying Program

Posted by PITHOCRATES - August 17th, 2013

Week in Review

What’s the difference between hard money (gold, silver, etc.) and paper money?  You can’t print hard money.  Which is why big-spending governments hate hard money.  And love paper money.  They use lofty economic explanations like having the money supply grow at a rate to support an expanding economy.  But the real reason they love paper money is because there is no limit on what they can spend.

This is why some people would prefer bringing back the gold standard.  To make the government as responsible as the rest of us.  Governments and their liberal friends hate this kind of talk.  And try to dismiss it with all-knowing condescension.  Because they sound so learned in their defense of their monetary policies despite a long record of failure they get to keep trying the same failed policies of the past.

Now it’s Rand Paul talking about the gold standard.  Invoking the name of Milton Friedman.  A monetarist.  And receiving the expected criticism (see Rand Paul is dead wrong about Milton Friedman by James Pethokoukis posted 8/13/2013 on the guardian).

Friedman understood the power of monetary policy, for both good and ill. He would almost certainly have been aghast that the Fed blew it again in 2008 by its tight money policies that possibly turned a modest downturn into the Great Recession. And he almost certainly would have been appalled at Republicans pushing for tight money – or, heaven help us, a return to the gold standard – with the economy barely growing and inflation low. It is certainly inconvenient for Paul that Friedman – a libertarian, Nobel-laureate economist – would have little use for the senator’s supposedly Hayekian take on the Fed or monetary policy.

Although the Bernanke Fed has imperfectly executed its QE programs, they are a big reason why the US is growing and adding jobs – despite President’s Obama’s regulatory onslaught and tax hikes – and the EU (and the inflation hawk ECB) is back in recession. Paul is wrong on Friedman and wrong on the Fed. It’s not even close.

One of Friedman’s criticisms of the gold standard is that to maintain the international price of gold—and price stability—governments would have to give up control of their domestic policies.  As a gold standard would prevent them from expanding the money supply at will.  So they couldn’t print money and devalue their currency to increase government spending.  To give themselves an unfair trade advantage.  And to monetize their debt from past irresponsible government spending.  But governments being governments they will do these things even with a gold standard.  As Richard Nixon and the US government did in the 1970s.  Rapidly devaluing the dollar.  Causing a great outflow of gold from the US as our trading partners preferred to hold onto gold instead of devalued US dollars.

The idea of monetarism was to have something similar like a gold standard while having the ability to expand the money supply to keep up with the growth in GDP.  And this would work if responsible people were in charge.  Who would resist the urge to print money.  Like Ronald Reagan.  Under the advice from none other than Milton Friedman.  Who served on the President Reagan’s Economic Policy Advisory Board.  Reagan shared Friedman’s economic views.  Believed in a limited government that left the free market alone.  So Reagan cut taxes, reduced government spending (other than defense) and deregulated an overregulated free market wherever he could.  All things Friedman endorsed.

It is unlikely that Friedman would endorse any quantitative easing.  Because a lack of credit is not causing our economic woes.  It’s a complicated tax code.  High tax rates.  And way too much governmental regulation and interference into the free market.  Especially Obamacare.  That has frozen all new hiring.  And pushed full-time workers into part-time positions.  Or out of a job entirely.  More money in the economy is not going to fix this anti-business climate of the Obama administration.  In fact, the only people making any money now are rich people.  Who are using all that new money to make more money in the stock market.  And when the government shuts off the quantitative easing tap those rich people are going to bail out of the stock market.  To lock in their profits.  Causing the stock market to crash.  And putting an end to the phony illusion of an economic recovery.  And the worst economic recovery since that following the Great Depression will get worse.

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Roman Denarius, New World Gold and Silver, American Continental and German Mark

Posted by PITHOCRATES - June 25th, 2013

History 101

Money that is not Scarce is a Poor Temporary Storage of Wealth

They say money doesn’t grow on trees.  And it’s a good thing it doesn’t.  For money is a temporary storage of wealth.  It temporarily stores value.  And one if its attributes is that it has to be scarce.  For example, let’s say you are a highly skilled tomato grower.  And you work in your garden 12 hours each day weeding, fertilizing, watering, tying, pruning, etc., your many fields of tomato plants.  Producing beautiful tomatoes that everyone just loves.  You love your tomatoes so much that you actually gave up your day job to grow them full time.  And support your family with the proceeds from selling your tomatoes.  Which you will exchange with others for money.  Provided that money is scarce.  And will hold the value of your tomatoes.  Until you can exchange that money for something you want.

Now let’s assume money grows on trees.  Anyone can plant one in their backyard.  And it grows like a weed.  That is, you don’t have to fertilize it or water it or do anything else for it.  And anytime you want something you just walk to your money tree and pick the bills you need.  We would never have to work again if we all had money trees in our backyard.  Wouldn’t that be great?  Or would it?  What would happen if everyone quit working because they, too, had a money tree in their backyard?  If no one worked then there would be nothing to buy with the money from your money tree.

But there is another problem.  If everyone had a money tree there would be such much money in circulation that it would no longer be scarce.  And if it’s not scarce it isn’t money.  It isn’t a temporary storage of wealth.  It won’t temporarily store value.  Because someone that has something of value, say delicious tomatoes, won’t want to trade them for something that he or she can just pick off of his own money tree.  Instead, he or she would rather trade those tomatoes for something that does have value.  Like, say, mozzarella cheese.  So a skilled cheese-maker and the skilled tomato-grower can meet to trade things of value with each other.  Tomatoes and mozzarella cheese.  And then each can make a delicious Caprese salad.  Which also has value.  Unlike money that grows on trees that anybody can pick whenever they want to.  Filling the world with people with lots of money but nothing to buy.  Because no one works to grow or make anything.

When Spain brought back New World Gold and Silver it unleashed Inflation in the Old World

For anything to be money it must be scarce.  Just think of the laws of supply and demand.  If there are droughts all summer long farmers have smaller harvests.  Which raises the price of what they bring to market.  Because demand is greater than the supply.  If there was a great growing season they have bumper crops.  Which lowers the price of what they bring to market.  Because supply is greater than demand.  So the scarcer something is the more valuable it is.  And so it is with money.

The main Roman coin was the silver denarius.  As the Roman Empire reached its zenith her borders stopped moving out.  The Roman legions stopped conquering new lands.  And without new conquest there were no spoils to send back to Rome.  So the Romans had to raise taxes to pay for the cost of empire.  The administration of it.  The protection of it.  And a growing welfare state to keep the people content.  To help with these great expenditures they began to debase the denarius.  Mixing more and more lead into the coin.  Reducing the silver content.  So they could make more coins with the available silver.  Thus making these coins less scarce.  And less valuable.  Unleashing an inflation so bad that it devalued the denarius so much that no amount of them could buy anything.   Eventually even the Roman government would refuse to accept it in payment of taxes.  Demanding gold instead.  Or payment in kind.

When Spain arrived in the New World they found a lot of gold and silver.  Which Europeans used as money in the Old World.  The Spanish brought so much gold and silver back to the Old World that it greatly expanded the money supply.  Making gold and silver less scarce.  And less valuable.  Requiring more of it to buy the things it once bought.  So prices rose.  Because of the inflation of the money supply.

The War Reparations the Versailles Treaty imposed on Germany led to their Hyperinflation

During the American Revolution there was little specie (i.e., gold and silver coin) in the colonies.  As wars are expensive this made it difficult to finance the war.  The Continental Congress asked for contributions from the states.  And could only hope the states would give them some money.  For they had no taxing powers.  But they never were able to raise enough money.  So they borrowed what they could.  And then started printing paper money.  The continental.  But they printed so many of them that they were far from scarce.  The massive inflation devalued the continental so much that it created the expression “not worth a continental.”  Which meant something was absolutely worthless.  The people would refuse to accept them as legal tender from the Continental Army because they were worthless pieces of paper.  So the army took what they needed from the people.  And gave them IOUs that Congress would settle at some later date.

The Germans paid for World War I by borrowing money.  The increased debt of the nation during the war devalued the currency.  The German mark.  It took more and more of them to exchange for stronger currencies.  Like the U.S. dollar.  The Versailles Treaty that ended the war saddled Germany with the responsibility for the war.  And made them pay enormous amounts of war reparations.  In gold.  Or foreign currency.  So the Germans turned up the printing presses.  And printed marks like there was no tomorrow.  Making them less scarce.  And worth less.  It took more and more of them to exchange for foreign currency to make their reparation payments.  But they didn’t care what the exchange rate was.  For whatever amount of devalued marks they needed to exchange they just turned to their printing presses.  And printed whatever they needed.  This rapid inflation devalued the mark more.  Requiring them to print more.  Which just fed into the inflation.  Eventually bringing on a hyperinflation where it took enormous amounts of marks to buy anything.  For example, it was cheaper and easier to burn marks than it was to buy firewood to burn.

Anytime you make money less scarce you make it worth less.  The inflation of the money supply devalues the currency.  Which raises prices.  Because it takes more of the devalued currency to buy what it once did before the inflation.  So expanding the money supply leads to price inflation.  Good if you’re a rich investor.  But if you’re someone just trying to buy firewood to keep from freezing to death during the winter?  Not so good.  The Romans, the Europeans, the Americans and the Germans all suffered from bad inflation.  Some worse than others.  If the inflation is so bad, such as in the case of hyperinflation, people may lose all confidence in the currency.  And simply stop using it.  Going to a barter system instead.  Like when a tomato-grower trades his tomatoes for a cheese-maker’s mozzarella cheese.

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Quantitative Easing

Posted by PITHOCRATES - June 24th, 2013

Economics 101

The Gold Standard prevented Nations from Devaluing their Currency to Keep Trade Fair

You may have heard of the great gamble the Chairman of the Federal Reserve, Ben Bernanke, has been making.  Quantitative easing (QE).  The current program being QE3.  The third round since the subprime mortgage crisis.  It’s stimulus.  Of the Keynesian variety.  And in QE3 the Federal Reserve has been ‘printing’ $85 billion each month and using it to buy financial assets on the open market.  Greatly increasing the money supply.  But why?  And how exactly is this supposed to stimulate the economy?  To understand this we need to understand monetary policy.

Keynesians hate the gold standard.  They do not like any restrictions on the government’s central bank’s ability to print money.  Which the gold standard did.  The gold standard pegged the U.S. dollar to gold.  Other central banks could exchange their dollars for gold at the exchange rate of $40/ounce.  This made international trade fair by keeping countries from devaluing their currency to gain a trade advantage.  A devalued U.S. dollar gives the purchaser a lot more weaker dollars when they exchange their stronger currency for them.  Allowing them to buy more U.S. goods than they can when they exchange their currency with a nation that has a stronger currency.  So a nation with a strong export economy would like to weaken their currency to entice the buyers of exports to their export market.  Giving them a trade advantage over countries that have stronger currencies.

The gold standard prevented nations from devaluing their currency and kept trade fair.  In the 20th century the U.S. was the world’s reserve currency.  And it was pegged to gold.  Making the U.S. dollar as good as gold.  But due to excessive government spending through the Sixties and into the Seventies the American central bank, the Federal Reserve, began to print money to pay for their ever growing spending obligations.  Thus devaluing their currency.  Giving them a trade advantage.  But because of that convertibility of dollars into gold nations began to do just that.  Exchange their U.S. dollars for gold.  Because the dollar was no longer as good as gold.  So nations opted to hold gold instead.  Instead of the U.S. dollar as their reserve currency.  Causing a great outflow of gold from the U.S. central bank.

Going off of the Gold Standard made the Seventies the Golden Age of Keynesian Economics

This gave President Richard Nixon quite the contrary.  For no nation wants to lose all of their gold reserves.  So what to do?  Make the dollar stronger?  By not only stopping the printing of new money but pulling existing money out of circulation.  Raising interest rates.  And forcing the government to make REAL spending cuts.  Not cuts in future increases in spending.  But REAL cuts in current spending.  Something anathema to Big Government.  So President Nixon chose another option.  He slammed the gold window shut.  Decoupling the dollar from gold.  No longer exchanging gold for dollars.  Known forever after as the Nixon Shock.  Making a Keynesian dream come true.  Finally giving the central bank the ability to print money at will.

The Keynesians said they could make recessions a thing of the past with their ability to control the size of the money supply.  Because everything comes down to consumer spending.  When the consumers spend the economy does well.  When they don’t spend the economy goes into recession.  So when the consumers don’t spend the government will print money (and borrow money) to spend to replace that lost consumer spending.  And increase the amount of money in circulation to make more available to borrow.  Which will lower interest rates.  Encouraging people to borrow money to buy big ticket items.  Like cars.  And houses.  Thus stimulating the economy out of recession.

The Seventies was the golden age of Keynesian economics.  Freed from the responsible restraints of the gold standard the Keynesians could prove all their theories by creating robust economic activity with their control over the money supply.  But it didn’t work.  Their expansionary policies unleashed near hyperinflation.  Destroying consumers’ purchasing power.  As the greatly devalued dollar raised prices everywhere.  As it took more of them to buy the things they once did before that massive inflation.

The only People Borrowing that QE Money are Very Rich People making Wall Street Investments

The Seventies proved that Keynesian stimulus did not work.  But central bankers throughout the world still embrace it.  For it allows them to spend money they don’t have.  And governments, especially governments with large welfare states, love to spend money.  So they keep playing their monetary policy games.  And when recessions come they expand the money supply.  Making it easy to borrow.  Thus lowering interest rates.  To stimulate those big ticket purchases.  But following the subprime
mortgage crisis those near-zero interest rates did not spur the economic activity the Keynesians thought it would.  People weren’t borrowing that money to buy new houses.  Because of the collapse of the housing market leaving more houses on the market than people wanted to buy.  So there was no need to build new houses.  And, therefore, no need to borrow money.

So this is the problem Ben Bernanke faced.  His expansionary monetary policy (increasing the money supply to lower interest rates) was not stimulating any economic activity.  And with interest rates virtually at 0% there was little liquidity Bernanke could add to the economy.  Resulting in a Keynesian liquidity trap.  Interest rates so close to zero that they could not lower them any more to create economic activity.  So they had to find another way.  Some other way to stimulate economic activity.  And that something else was quantitative easing.  The buying of financial assets in the market place by the Federal Reserve.  Pumping enormous amounts of money into the economy.  In the hopes someone would use that money to buy something.  To create that ever elusive economic activity that their previous monetary efforts failed to produce.

But just like their previous monetary efforts failed so has QE failed.  For the only people borrowing that money were very rich people making Wall Street investments.  Making rich people richer.  While doing nothing (so far) for the working class.  Which is why when Bernanke recently said they may start throttling back on that easy money (i.e., tapering) the stock market fell.  As rich people anticipated a coming rise in interest rates.  A rise in business costs.  A fall in business profits.  And a fall in stock prices.  So they were getting out with their profits while the getting was good.  But it gets worse.

The economy is not improving because of a host of other bad policy decisions.  Higher taxes, more regulations on business, Obamacare, etc.  And a massive devaluation of the dollar (by ‘printing’ all of that new money) just hasn’t overcome the current anti-business climate.  But the potential inflation it may unleash worries some.  A lot.  For having a far greater amount of dollars chasing the same amount of goods can unleash the kind of inflation that we had in the Seventies.  Or worse.  And the way they got rid of the Seventies’ near hyperinflation was with a long, painful recession in the Eighties.  This time, though, things can be worse.  For we still haven’t really pulled out of the Great Recession.  So we’ll be pretty much going from one recession into an even worse recession.  Giving the expression ‘the worst recession since the Great Depression’ new meaning.

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