Monday, April 16, 2012

Sound Money is Unsound

Wouldn't it be great if a dollar was a dollar and you never had to worry about the Fed inflating you into poverty?  Well then I have a great plan for you!  What if we backed the dollar with a fixed amount of gold, or the reverse (it's a matter of phrasing, but the same thing in practice)?  Now your dollar isn't just a piece of paper, it's based on something solid, something real.

Hop in a time machine and see if your dollar is worth something a thousand years ago.  I bet not!  But your gold will be.  So keep that in mind.  It might work in the future too.

A gold bar is a gold bar is a gold bar.  Perfect, right?  Well, a dollar is a dollar is a dollar.

Gold is not magical.  It's a commodity.  It's just another thing subject to supply and demand.  Just like a dollar.  Increase the supply and the price goes down, increase demand and price goes up.  Aha, prices!  There's the key, we want price stability, right?  Price stability makes it easier to predict costs and that encourages investment and gives us that much more information when deciding whether to borrow or lend.  Price stability.

Enter inflation.  But first, let's break that apart and make sure we're all on the same page.  Money inflation will refer to the number of dollars, or gold.  Price inflation will refer to the price of what you tend to buy, so a 'basket', as the economists call it, of food, gasoline, cars (economists have a strange way of counting a typical shopping trip).  Over the long term, these follow each other.

If you wake up and everyone has twice as much gold and twice as much gold in their contracts (wages, salaries, bond payments, etc.) then after a brief bit of thinking they're rich, everyone will settle into a new habit of everything being exactly the same as it was before, just with all the numbers doubled, along with the population claiming that candy bars were a nickle back in their day.  Hint: Back when they'd have cost a nickle (by backtracking inflation), candy bars wouldn't have had so much inexpensive refined sugar and wouldn't be worth a nickle anyway.

Okay, so now here we are with price inflation and money inflation seemingly interchangeable because money sets the price.  It looks as if price stability is based on money stability.  But that would be wrong.

If the supply of wheat doubles, what happens to the price of wheat?  It falls.  What if the supply of everything except gold doubles?  The price of everything except gold falls, meaning that the price of gold has risen.  Even without any change in the money supply (gold), the price level has fallen.  Price inflation is not the same as money inflation.  Pour money in and sure, you'll get price inflation, so it's a bad idea to just dump money in willy-nilly (which the Fed knows and if you look at the amount of money actually flowing, it hasn't tripled as Ron Paul supporters would claim).  But even without changing the money supply, you're going to get price instability because money is relative to the economy.


Takeaway: A gold standard does not guaranteed price stability and therefore is not a guaranteed store of wealth or an economic panacea.

We can, of course, mine more gold.  Or less.  As the economy grows and technology advances, or as a recession comes and we produce less, we can change the gold supply.  Really?  No!  Gold is subject to the market like anything else.  It will be mined more when its value goes up (meaning a shortage of gold) and less when the prices go down (the inverse), but there are problems.  One is lag, that the gold supply will not react instantly.  Mining and purifying take time.  There would obviously be people keeping gold in reserve, partially out of the supply, who would then see the benefit of buying low and selling high.  This will help to stabilize the supply shocks, but cannot give price stability because the money supply (gold) will still be variable, managed (regulated?) by people around the world with gold reserves.  But we're not even in the long-term yet.  That's when it gets really bad.  In the long term, we don't know if the gold supply will increase in proportion with the economy.  That means that in the long term, there could be a significant amount of money deflation, relative to the economy, which as we saw before, is what really matters (money/economy moving in sync).  A stable money supply, with a growing economy, will trigger price deflation.

Imagine an economy which produces ten bushels of wheat a year and has ten bars of gold (it's a pretty bad economy).  We can't quite say what a bushel will cost, but I think we can recognize that if it produces twenty bushels, the cost of wheat, relative to gold, will drop.  That is price deflation and relative to the economy, money deflation.

Deflation kills economies.  Hyper[money]inflation will too, but it takes a lot of sustained inflation to do that, whereas just a bit of deflation can do the trick.  And it's a bubble.  Money inflation has a limit in the sense that only a money-printer can cause it (or loose loaning standards, but we're working with gold), and if there is no money-printer (central bank), then there cannot be money supply inflation except to the extent that gold gets dug up and that will be based on the value of that money, so in theory it is self-correcting.  Deflation does not have the same limit.  If gold rises in value, what will I do?  Sell?  Oh no, not if I see a trend, then I buy!  And so do others.  If not buy, then they hold.  After all, if a gold bar guys a ton of wheat today and two tons tomorrow, wouldn't you wait a day?  Of course.  So now we see hoarding and a slowdown in buying.  Which lowers the gold in circulation, raising the value, triggering more hoarding and buying up, and so on.  Eventually the 'flowing' gold is at a trickle and the economy has frozen up.

 So fine, fine, let's do this: let's print money but link it to gold.  Then if the economy grows faster than the gold, we print more money.  But now you're doing something wrong.  You're either assigning more dollars to each unit of gold, inflating the money relative to the gold, and therefore devaluing the very money you were supposed to be protecting with the gold link, or you're just lying and saying that money has gold linked to it, when it doesn't.  That's going to not only cause inflation of the money supply, but it's also going to create a false impression of the supply of gold and therefore the relative value of the dollar, effectively devaluing without telling anyone, which might work just fine... as long as not too many people ask for their gold.

Gold does have some things going for it.  As a physical substance it is rare, but not too rare.  It is stable: not reactive and not radioactive.  It's shiny, which is not a trivial matter and certainly played a role in its historical use as a standard of value.  It's traditional.  We think it is valuable because we've always thought it was valuable.  Just like a dollar for billions of people who grew up in a world where a dollar was money because that dollar, rather than being shiny or stable or old, was used to buy things in the biggest economy in world.

Money is what we use to buy things and that is entirely a social/economic construct.  Gold is only valuable as long as we thing it is.  In terms of practical value, it has some use in the jewelry industry (where much of the time we think it looks nice because it's expensive) as well as more practical purposes in industrial and electronic use, but "industrial and electronic use" are not strong foundations on which to stand.

If we really do what price stability then what we really need is a money supply that can grow with the economy.  That means some amount of money inflation.  Does that mean that the dollars i your pocket will be worth less?  Sure.  But your paycheck will go up in price, and the next, and so on, so that the supposed loss from inflation is just a small loss on a small amount of money, but in return you get predictable prices and a stronger economy.  Those are going to give you far more wealth than a pocket of gold coins.

This does not mean that a fiat currency is perfect.  It can be over-printed (or over-electroniced), or under-printed.  In part the Great Depression was worsened by a tightening of the money supply through bank behavior, something which could have been compensated for with, yes, some more printing of money to keep the overall flow constant and the economy moving.  It can be managed poorly.  But it can be managed and it can be tuned to work with the economy.

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