Patterico's Pontifications


You Really Want Government in Control of the Money? Do You Want to Change That Answer?

Filed under: General — Patterico @ 7:52 pm

In my posts about the gold standard, fractional reserve banking, and money, one theme comes up again and again in comments: money is built on trust, and must have value backing it.

My question is: why in the world would you want the government involved in money?

People seem to take it as a given that governments have to be the ones who make money. But that’s not so, at all.

The other day I told the long and interesting story of how money came to be. In short, the original barter system cried out for a common medium of exchange to lubricate the workings of commerce — because, say, a lawyer who wanted to buy eggs from a farmer could not count on the farmer wanting his legal services at the same moment. So people sought to exchange their goods and services for commodities that others would readily accept. Naturally, people sought the most desirable commodities that would be widely accepted, durable, divisible, scarce, and otherwise suitable as a medium of exchange. Most societies settled on gold and silver as the medium of exchange containing the best mix of characteristics required for a medium of exchange. The longer version is here.

There are two things about gold and silver at this point. First: their value was measured in weight. Most commonly used currencies were originally defined by the weight of gold they represented. A dollar represented a bit less than 1/20 of an ounce of gold. A British pound was roughly 1/4 of an ounce of gold. And so forth. Critics call this valuation of the dollar “arbitrary” — but once you knew the weight of the gold a particular unit would buy, you knew what it was worth.

Second: nothing about any of this required government. Entrepreneurs could coin money, and provide a service by standardizing the weights of coins upon which people could rely. Indeed, there are many examples in history, including in the United States, of private coinage.

But then, government took over. Tom Woods explains the process by which this happens:

First, society adopts a commodity money, as described above. (As I noted above, for ease of exposition we’ll choose gold, but it could be whatever commodity the market selects.) Government then monopolizes the production and certification of the gold. Paper notes issued by banks or by governments that can be redeemed in a given weight of gold begin to circulate as a convenient substitute for carrying gold coins. These money certificates are given different names in different countries: dollars, pounds, francs, marks, etc. These national names condition the public to think of the dollar (or the pound or whatever) rather than the gold itself as the money. Thus it is less disorienting when the final step is taken and the government confiscates the gold to which the paper certificates entitle their holders, leaving the people with an unbacked paper money.

This is how unbacked paper money comes into existence. It begins as a convertible substitute for a commodity like gold, and then the government takes the gold away. It continues to circulate even without the gold backing because people can recall the exchange ratios that existed between the paper money and other goods in the past, so the paper money is not being imposed on them out of nowhere.

My, that is a dramatic flourish, that reference to government confiscating gold. That could never actually happen in America, though. Right?

Wrong. It already happened. A mass confiscation of gold by government took place in this country in 1933. Did you know that? It happened when FDR issued Executive Order 6102. (And you thought Obama’s executive orders were bad!)

FDR’s gold confiscation meant private owners were obliged to take their coins, bars or gold certificates to a bank, and exchange them for dollars at the prevailing rate of $20.67 per ounce. Over the next year, the president then raised his official gold price to $35 per ounce, effectively cutting 40% off the dollar in a bid to stoke inflation and spur the economy.

It continued to be illegal to own gold in the U.S. (without a special license) from 1933 to 1974, at which point we were safely off the gold standard. Which is not to say you can’t own gold nowadays. You can get it for the reasonable price of under $1300 an ounce!

Nowadays, currencies are not tied to gold in any manner. That is due to government’s taking over control of the money supply.

And guess what? Oddly enough, governments all over the world have run up unsustainable debt. Go figure.

Also, inflation has taken place on an unprecedented scale. Coke was 5 cents in 1886. And it was 5 cents in 1959 — and all 70+ years in between. There’s even a Planet Money episode about it. The reasons for the stability of the price are varied, including a quirky and unwise contract, and the size of coin slots in vending machines. But, ultimately, the thing that pushed Coke off its 5-cent price was abandoning the gold standard, and the resulting inflation. It took a few years, but the prices of the inputs eventually rose to such a degree that Coke had to raise its price.

If unsustainable debt and runaway inflation don’t sell you on fiat money, how about the bank bailouts? Those were pretty awesome, right? And impossible without fractional reserve banking and the abandonment of the gold standard.

BONUS ANTI-FED RANT: I still haven’t gotten to the natural brake that the gold standard places on runaway inflation — for that, stay tuned! — but the point of this post is to show that government control of the money supply is neither necessary nor desirable. If you still think the steady hand of the Fed is the best thing since sliced bread, let me offer this: Ben Bernanke making a fool of himself. The audio peters out after a few minutes, but give it a couple three minutes and get your guffaw muscles ready.

As Tom Woods notes in Rollback: Repealing Big Government Before the Coming Fiscal Collapse, Bernanke told a gathering of academics in January 2007:

Together with the knowledge obtained through its monetary-policy and payments activities, information gained through its supervisory activities gives the Fed an exceptionally broad and deep understanding of developments in financial markets and financial institutions. . . .

In my view, however, the greatest external benefits of the Fed’s supervisory activities are those related to the institution’s role in preventing and managing financial crises.

In other words, the Fed can prevent most crises and manage the ones that do occur.

Finally, the wide scope of the Fed’s activities in financial markets — including not only bank supervision and its roles in the payments system but also the interaction with primary dealers and the monitoring of capital markets associated with the making of monetary policy — has given the Fed a uniquely broad expertise in evaluating and responding to emerging financial strains.

The bubble burst later that year. Heckuva job, Benny.

The Fed did a lot to create the housing bubble. And this is the fool who you want to put in charge of your money? Rather than trusting the distributed intelligence of the market to set interest rates, you want them to be determined by a clown like this?

End the Fed. End government control over our money. Let’s return to a true free market where individual decisionmakers determine prices, interest rates, and other important factors of the economy.

Stop the rule of the know-it-alls who end up knowing nothing.

It can be done. But first you have to understand why. That’s why I took the time to write this. And if you made it this far, great. I hope this post and other recent posts are causing some of you to look a little differently at government and its relationship to our money. Please let me know if that applies to you.

Big Money, Big Hypocrisy

Filed under: General — Dana @ 7:14 pm

[guest post by Dana]


On a three day swing through California, President Obama spent last evening at a Democratic party fundraiser held in Bel-Air. Unfortunately, it is no longer surprising to see the hypocrisy of this president, and once again it was on display last night. It *should* be a surprise, but that it isn’t only evidences that we’ve seen it so often it’s become an expected behavior.

In a sober political assessment, President Barack Obama told donors Wednesday that disquiet and a sense of frustration in the country is fueling cynicism about government that could hurt Democratic turnout in the November congressional elections.

Obama told high-dollar contributors that he feels a sense of urgency about the election and needs the Senate to remain Democratic. Republicans have a chance to win control of the Senate this year.

Obama spoke at the home of Disney Studios Chairman Alan Horn before about 90 contributors who paid from $10,000 to $32,400 to attend. Among those attending were Hollywood luminaries Barbra Streisand, James Brolin and Jeffrey Katzenberg

Obama said the political system faces challenges from legislative procedures, a partisan media and too much money in politics. But he said the main cause for gridlock was fundamental differences between what Democrats believe and “what this particular brand of Republicans in Congress believes.”

Apparently the president is unaware of the closely guarded group Democracy Alliance, which I wrote about here. One of their primary goals: pump Big Money into the Democratic party. And perhaps he is unaware of Democratic billionaire Tom Steyer, who puts his money where his mouth is – straight into the Democratic party. And so it goes…


How Commercial Banks Create Money

Filed under: General — Patterico @ 7:35 am

In the comments to one of the gold standard threads, a controversy is brewing that I think it might be helpful to bring to the fore in a post. Namely, I think I am blowing some commenters’ minds by noting that commercial banks create money when they make loans. Indeed, it’s the main way that money is created!

The Bank of England put out a couple of papers that describes the mechanism involved. Here is one (.pdf), and here are a couple of key passages supporting my contention that commercial banks create money when they lend money and create deposits:

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

. . . .

The vast majority of money held by the public takes the form of bank deposits. But where the stock of bank deposits comes from is often misunderstood. One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.

Watch these videos for some elaboration. First a short video from two bankers telling you, very clearly, that bankers do not simply lend out the deposits they have. They create money when they make the loan and create the deposit:

Here is a slightly longer, but still short, video featuring one of the authors of the Bank of England paper. One of his main points is that, while people think deposits enable loans, the truth is actually the reverse: loans enable (create) deposits.

When banks lend money, they create deposits, which are IOUs. Typically, no currency changes hands; a credit is simply posted to a bank account. As long as the bank stays within regulatory requirements, it need not have 100% of the cash on hand to fund these IOUs. It just creates the deposit.

The difference between these IOUs and IOUs from any other institution is that bank IOUs function as a medium of exchange and can be easily converted into currency.

Now, when banks lend this money, they have the loan, which is an asset, and they create a deposit, which is a liability. This balances out — but there is still new money in the system . . . until the loan is repaid, at which point the money is destroyed.

But the key point to recognize is that the bank does not need to have the cash on hand to make the loan. They simply create a deposit, by pushing a button on a computer keyboard, and voila! new money is created.

Commenters in the other thread note that banks cannot simply create this money “willy-nilly.” Well, of course. Banks are constrained by the need to have the loan repaid, and that means they need a supply of creditworthy borrowers. The bank’s ability to make a profit is affected by the interest rates set by the central bank.

So, if bankers can affect the money supply, thank God for the Fed, right? After all, bankers don’t have society’s interests in mind., so we need to rely on the steady hand and immense wisdom of our central bankers to prevent runaway inflation . . . right?

Yeah, not so much. Under the gold standard, there was a natural brake on bankers’ natural tendency to overinflate the supply of money . . .

. . . but that’s another post.

CAVEAT: As always, this comes with the caveat that I am not an economics expert, and I assure you that several commenters here could talk rings around me when it comes to balance sheets and the like. However, I have done enough reading on the topic to feel comfortable with my position, and am happy to have it challenged with facts, logical arguments, and links. As always, please keep dismissiveness and ad hominems out of the discussion. We’re all learning here.

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