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The gold standard begins when people use gold as a medium of exchange and to
store wealth. For example, a peasant might have an extra cow. The peasant
trades the cow to some other peasant for gold, and then buries the gold in
his backyard. The peasant buries a little more gold every year for several
years, and then digs up the gold and trades the gold for more land.
Prices are set by the relationship between the amount of gold and the amount
of everything else. For example, suppose that one year the crops fail,
resulting in a shortage of food. The amount of gold is the same but the
amount of food is less, so the relationship between the amount of food and
the amount of gold has changed, and the price of food increases. Or suppose
that a stranger comes to the village. The stranger has a heavy sack, and is
very protective of the sack, and will not let anyone see what is in the
sack. Then the stranger disappears, and no trace of him can be found, except
for a pool of blood near where he was last seen. Then the suspicious looking
man from the other side of the village whom no one trusts trades gold for
whatever anyone else is willing to trade, and prices rise. Prices rise
because the stranger was murdered and his sack of gold was stolen. Since the
amount of gold in the village has risen, the relationship between the amount
of gold and the amount of everything else has changed, and prices rise.
Inflation is caused by either an increase in the amount of gold or by a
decrease in the amount of everything else. Deflation is caused by either a
decrease in the amount of gold or by an increase in the amount of everything
else.
The government of the village cannot do anything to increase the amount of
anything. But the government can decrease the amount of anything. So the
government could manipulate prices by destroying whatever is in surplus. For
example, if a good harvest leads to a food surplus which leads to low prices
for farmers, the government could gather up the surplus food and bury the
surplus food in hole in the ground, and let the surplus food rot. By
destroying food, the government has reduced the amount of food, which causes
the price of food to increase. But this is obviously a stupid thing to do,
because this reduces the amount of food available to the people of the
village, and makes people hungrier. Or suppose that a poor harvest results
in a food shortage, which causes food prices to rise. The government could
reduce the price of food by destroying gold. The government could destroy
gold by grinding the gold to a powder and then scattering the powder through
the fields. Or the government could hide the gold in a safe place so that no
one could use the gold. Everyone in the village would try to find and
steal the hidden gold, so the government would have to guard the hidden
gold. If the government could successfully hide the gold, then the
government could respond to future deflation by releasing gold. But the real
problem is that there is a food shortage caused by a bad harvest, and no
amount of adjusting the money supply will create more food. No matter what
the government does, the people will still be hungry.
The only way the government can change prices is by creating shortages by
destroying things. Destroying things does not benefit the people of the
village. It is possible for the government to stabilize prices, but it is a
bad policy.
Prices in the village are likely to fluctuate from season to season, and
from year to year. Long term average prices may be stable.
In a complex industrial economy, the government cannot manipulate
prices except by creating shortages by destroying things, and destroying
things makes the society poorer, just like in a preindustrial agricultural
village. The difference is that in a complex industrial economy, it is less
obvious that government price manipulation involves destroying things and
impoverishing the society. For examply, suppose that the government wants to
reduce the price of oil. The government could increase the supply of oil by
destroying oil, but the decrease the price of oil, the government must
destroy everything else. People sell their labor to get the money to buy oil,
so to decrease the price of oil the government must destroy labor.
The gold standard begins to fail when people start borrowing gold. For
example, suppose you want to trade a cow for gold. No one is willing to give
you gold for your cow. Then someone who has no gold offers to take your cow,
and promises to give you gold next year. If you give him the cow, he might
never give you the gold. But if you do not give him the cow, you have to
take the cow home again, and feed the cow, and you do not know how long it
will be before you find someone to trade you gold for the cow. So most
sellers will trade the cow for future gold, but will demand extra gold
(which is the equivalent of interest) to compensate for the risk that he
might never give you the gold. If you were willing to trade the cow for
two ounces of gold today, you would probably demand three ounces if he is
not going to give you the gold until next year.
Future gold is less valuable than gold now, because you might never get the
future gold. However, future gold has one advantage: future gold cannot be
stolen. No one can steal future gold from you because you do not have future
gold yet. That means you do not need to bury future gold in the backyard,
you do not need to lock future gold in a safe, you do not need to hire armed
guards to protect future gold. The cost of storing future gold is less than
the cost of storing gold now.
If a seller insists on gold today, then the seller cannot sell to anyone
with no gold. A seller who is willing to accept future gold can sell to
anyone with gold, and can sell to anyone without gold. A seller who is
willing to accept future gold has more potential customers. With more
potential customers, the seller can demand higher prices, because if one
customer refuses to pay the higher price, another customer will be willing
to pay the higher price.
The more people borrow gold, the higher prices rise. Borrowing gold has the
same effect as an increase in the supply of gold. Borrowing causes
inflation.
Borrowing is based on trust. The amount of trust in the community varies
more than the amount of gold. If everyone repays their loans, trust
increases, borrowing increases, and prices rise. Then someone fails to repay
a loan, everyone starts wondering who will default next, suddenly no one
trusts anyone else, no one will lend anyone any gold, borrowing decreases,
and prices fall. Probably prices will rise slowly, then fall rapidly, then
rise slowly, then fall rapidly, etc. The economy will have a boom and bust
cycle.
Borrowing changes the gold standard to a gold plus trust standard. The gold
plus trust standard results in greater price variability than a gold
standard.
The gold standard is weakened further when people start using gold
certificates. Some people do not like carrying around gold or protecting
their gold. So banks offer to store gold. You can take your gold to a bank,
and the bank will give you a gold certificate. You can take the gold
certificate back to the bank anytime, and the bank will redeem the gold
certificate for the amount of gold printed on the certificate. Some
certificates are for a specific person, so that if the certificate is lost
or stolen, the bank will replace the certificate. Other certificates are
transferrable, so that you can give the certificate to someone else,
probably in trade for something else.
The banks do not want criminals to create fake gold certificates, so the
banks make the gold certificates difficult to forge. Certificates are made
with unusual ink on unusual paper, lots of strange curly lines, portraits of
famous people like George Washington or the Duke of Wellington, serial
numbers, signatures of the people who issued the certificate, a seal, and
something which you can only see if you look at the certificate from a
specific angle under a specific color light. Look at a paper money and see
how many of these features are used on paper money.
The government might also issue certificates. Certificates issued by
private banks might not be trusted far away from the bank. Certificates issued
by governments might be more trusted than certificates from a private bank
because the government has a bigger (though not always better) reputation.
More people have heard of the government than of the private bank. The
british one pound banknote was originally a certificate for one pound of
silver.
The gold certificates do not change the economy significantly as long as the
banks make sure that the amount of gold in the banks' vaults exactly matches
the amount of gold certificates which the banks have issued. The bank should
know how much gold is in the vault, and how many gold certificates the bank
has issued. But how does everyone else know? The bank says everything is
good, but the bank might be lying. The government could send inspectors to
audit the bank, but a crooked bank could easily fool the inspectors by
filling the vault with yellow bricks and by showing the inspectors fake
account books instead of the real account books.
Sooner or later, the bankers will succumb to temptation and will take some
of the gold from the vault. At first the bankers will rationalize these
thefts, thinking they are only borrowing the gold and will replace it soon.
Next time they take a little more. Then a clever banker will realize that he
can take some of the gold, lend the gold to someone else, and charge
interest on the loan. When the loan is repaid, the banker replaces the gold
but keeps the interest for himself. Or the banker could trade the gold for a
house and rent the house out, keeping the rent for himself. Later the banker
can trade the house for gold and return the gold to the vault. It is almost
impossible to prevent the bankers from stealing the gold from the vault
because it is so profitable and so difficult to detect.
Gradually rumors of what the bankers are doing leak out. Banks which loan
out the gold from the vault will be more profitable than banks which do not,
and so the lending banks gain market share from the nonlending banks. Bank
customers realize that as long as the loans are repaid eventually and the
gold is restored to the bank's vault, then the bank is still solvent and the
gold certificates are still good. Banks stop concealing the fact that banks
are lending the gold to other people. What started as a crime has become
standard operating procedure.
Lending gold is profitable for banks, so banks try to lend as much gold as
possible, and leave as little gold as possible in the vault. Banks try to
guess how much gold they will need to redeem gold certificates in the near
future, and keep that much gold in the vault, and lend out all the rest of
the gold. So the amount of gold in the vault is only a fraction, probably
5-20 percent, of the amount of gold certificates which the bank has issued.
This is fractional reserve banking.
Fractional reserve banking has two effects on the economy.
First, fractional reserve banking is inflationary. If you deposit gold in a
bank in exchange for a gold certificate, you can go to the market and spend
that gold certificate. Meanwhile, the bank lends your gold to someone else,
who can also go to the market and spend the gold. With more people spending
more money, sellers will raise prices. You may find yourself bidding against
someone who is bidding with your gold!
Second, fractional reserve banking means that gold certificates are no
longer backed by gold in the bank's vault, but by trust that the bank can
acquire the gold when you redeem the certificate. The total number of gold
certificates issued by all banks may exceed the total amount of gold in the
economy. Money is no longer backed by gold, but by trust. The natural
actions of the free market has transformed the gold standard into a trust
standard.
Fractional reserve banking makes gold less important and trust more
important in the economy. But as I stated before, the amount of trust is more
variable than the amount of gold. So fractional reserver banking will
intensify the boom and bust cycle.
However, there is a limit to the boom and bust cycle. Intelligent people
understand the boom and bust cycle, and will realize that if
you trade everything for gold during the boom, and then trade the gold for
everything else during the bust, you can make a vast fortune. Once a few
people succeed at this, other people will imitate them. The actions of these
people will lessen the intensity of the boom and bust cycle. Over time the
costs of information and trading will fall. Lower information and trading
costs make it easier for people to trade against the boom and bust cycle.
The boom and bust cycle will become less intense over time and will
eventually disappear.
The boom and bust cycle will become more intense as an agricultural economy
develops into an industrial economy, and then become less intense as the
industrial economy develops into an information economy.
home
home
The gold standard begins when people use gold as a medium of exchange and to
store wealth. For example, a peasant might have an extra cow. The peasant
trades the cow to some other peasant for gold, and then buries the gold in
his backyard. The peasant buries a little more gold every year for several
years, and then digs up the gold and trades the gold for more land.
Prices are set by the relationship between the amount of gold and the amount
of everything else. For example, suppose that one year the crops fail,
resulting in a shortage of food. The amount of gold is the same but the
amount of food is less, so the relationship between the amount of food and
the amount of gold has changed, and the price of food increases. Or suppose
that a stranger comes to the village. The stranger has a heavy sack, and is
very protective of the sack, and will not let anyone see what is in the
sack. Then the stranger disappears, and no trace of him can be found, except
for a pool of blood near where he was last seen. Then the suspicious looking
man from the other side of the village whom no one trusts trades gold for
whatever anyone else is willing to trade, and prices rise. Prices rise
because the stranger was murdered and his sack of gold was stolen. Since the
amount of gold in the village has risen, the relationship between the amount
of gold and the amount of everything else has changed, and prices rise.
Inflation is caused by either an increase in the amount of gold or by a
decrease in the amount of everything else. Deflation is caused by either a
decrease in the amount of gold or by an increase in the amount of everything
else.
The government of the village cannot do anything to increase the amount of
anything. But the government can decrease the amount of anything. So the
government could manipulate prices by destroying whatever is in surplus. For
example, if a good harvest leads to a food surplus which leads to low prices
for farmers, the government could gather up the surplus food and bury the
surplus food in hole in the ground, and let the surplus food rot. By
destroying food, the government has reduced the amount of food, which causes
the price of food to increase. But this is obviously a stupid thing to do,
because this reduces the amount of food available to the people of the
village, and makes people hungrier. Or suppose that a poor harvest results
in a food shortage, which causes food prices to rise. The government could
reduce the price of food by destroying gold. The government could destroy
gold by grinding the gold to a powder and then scattering the powder through
the fields. Or the government could hide the gold in a safe place so that no
one could use the gold. Everyone in the village would try to find and
steal the hidden gold, so the government would have to guard the hidden
gold. If the government could successfully hide the gold, then the
government could respond to future deflation by releasing gold. But the real
problem is that there is a food shortage caused by a bad harvest, and no
amount of adjusting the money supply will create more food. No matter what
the government does, the people will still be hungry.
The only way the government can change prices is by creating shortages by
destroying things. Destroying things does not benefit the people of the
village. It is possible for the government to stabilize prices, but it is a
bad policy.
Prices in the village are likely to fluctuate from season to season, and
from year to year. Long term average prices may be stable.
In a complex industrial economy, the government cannot manipulate
prices except by creating shortages by destroying things, and destroying
things makes the society poorer, just like in a preindustrial agricultural
village. The difference is that in a complex industrial economy, it is less
obvious that government price manipulation involves destroying things and
impoverishing the society. For examply, suppose that the government wants to
reduce the price of oil. The government could increase the supply of oil by
destroying oil, but the decrease the price of oil, the government must
destroy everything else. People sell their labor to get the money to buy oil,
so to decrease the price of oil the government must destroy labor.
The gold standard begins to fail when people start borrowing gold. For
example, suppose you want to trade a cow for gold. No one is willing to give
you gold for your cow. Then someone who has no gold offers to take your cow,
and promises to give you gold next year. If you give him the cow, he might
never give you the gold. But if you do not give him the cow, you have to
take the cow home again, and feed the cow, and you do not know how long it
will be before you find someone to trade you gold for the cow. So most
sellers will trade the cow for future gold, but will demand extra gold
(which is the equivalent of interest) to compensate for the risk that he
might never give you the gold. If you were willing to trade the cow for
two ounces of gold today, you would probably demand three ounces if he is
not going to give you the gold until next year.
Future gold is less valuable than gold now, because you might never get the
future gold. However, future gold has one advantage: future gold cannot be
stolen. No one can steal future gold from you because you do not have future
gold yet. That means you do not need to bury future gold in the backyard,
you do not need to lock future gold in a safe, you do not need to hire armed
guards to protect future gold. The cost of storing future gold is less than
the cost of storing gold now.
If a seller insists on gold today, then the seller cannot sell to anyone
with no gold. A seller who is willing to accept future gold can sell to
anyone with gold, and can sell to anyone without gold. A seller who is
willing to accept future gold has more potential customers. With more
potential customers, the seller can demand higher prices, because if one
customer refuses to pay the higher price, another customer will be willing
to pay the higher price.
The more people borrow gold, the higher prices rise. Borrowing gold has the
same effect as an increase in the supply of gold. Borrowing causes
inflation.
Borrowing is based on trust. The amount of trust in the community varies
more than the amount of gold. If everyone repays their loans, trust
increases, borrowing increases, and prices rise. Then someone fails to repay
a loan, everyone starts wondering who will default next, suddenly no one
trusts anyone else, no one will lend anyone any gold, borrowing decreases,
and prices fall. Probably prices will rise slowly, then fall rapidly, then
rise slowly, then fall rapidly, etc. The economy will have a boom and bust
cycle.
Borrowing changes the gold standard to a gold plus trust standard. The gold
plus trust standard results in greater price variability than a gold
standard.
The gold standard is weakened further when people start using gold
certificates. Some people do not like carrying around gold or protecting
their gold. So banks offer to store gold. You can take your gold to a bank,
and the bank will give you a gold certificate. You can take the gold
certificate back to the bank anytime, and the bank will redeem the gold
certificate for the amount of gold printed on the certificate. Some
certificates are for a specific person, so that if the certificate is lost
or stolen, the bank will replace the certificate. Other certificates are
transferrable, so that you can give the certificate to someone else,
probably in trade for something else.
The banks do not want criminals to create fake gold certificates, so the
banks make the gold certificates difficult to forge. Certificates are made
with unusual ink on unusual paper, lots of strange curly lines, portraits of
famous people like George Washington or the Duke of Wellington, serial
numbers, signatures of the people who issued the certificate, a seal, and
something which you can only see if you look at the certificate from a
specific angle under a specific color light. Look at a paper money and see
how many of these features are used on paper money.
The government might also issue certificates. Certificates issued by
private banks might not be trusted far away from the bank. Certificates issued
by governments might be more trusted than certificates from a private bank
because the government has a bigger (though not always better) reputation.
More people have heard of the government than of the private bank. The
british one pound banknote was originally a certificate for one pound of
silver.
The gold certificates do not change the economy significantly as long as the
banks make sure that the amount of gold in the banks' vaults exactly matches
the amount of gold certificates which the banks have issued. The bank should
know how much gold is in the vault, and how many gold certificates the bank
has issued. But how does everyone else know? The bank says everything is
good, but the bank might be lying. The government could send inspectors to
audit the bank, but a crooked bank could easily fool the inspectors by
filling the vault with yellow bricks and by showing the inspectors fake
account books instead of the real account books.
Sooner or later, the bankers will succumb to temptation and will take some
of the gold from the vault. At first the bankers will rationalize these
thefts, thinking they are only borrowing the gold and will replace it soon.
Next time they take a little more. Then a clever banker will realize that he
can take some of the gold, lend the gold to someone else, and charge
interest on the loan. When the loan is repaid, the banker replaces the gold
but keeps the interest for himself. Or the banker could trade the gold for a
house and rent the house out, keeping the rent for himself. Later the banker
can trade the house for gold and return the gold to the vault. It is almost
impossible to prevent the bankers from stealing the gold from the vault
because it is so profitable and so difficult to detect.
Gradually rumors of what the bankers are doing leak out. Banks which loan
out the gold from the vault will be more profitable than banks which do not,
and so the lending banks gain market share from the nonlending banks. Bank
customers realize that as long as the loans are repaid eventually and the
gold is restored to the bank's vault, then the bank is still solvent and the
gold certificates are still good. Banks stop concealing the fact that banks
are lending the gold to other people. What started as a crime has become
standard operating procedure.
Lending gold is profitable for banks, so banks try to lend as much gold as
possible, and leave as little gold as possible in the vault. Banks try to
guess how much gold they will need to redeem gold certificates in the near
future, and keep that much gold in the vault, and lend out all the rest of
the gold. So the amount of gold in the vault is only a fraction, probably
5-20 percent, of the amount of gold certificates which the bank has issued.
This is fractional reserve banking.
Fractional reserve banking has two effects on the economy.
First, fractional reserve banking is inflationary. If you deposit gold in a
bank in exchange for a gold certificate, you can go to the market and spend
that gold certificate. Meanwhile, the bank lends your gold to someone else,
who can also go to the market and spend the gold. With more people spending
more money, sellers will raise prices. You may find yourself bidding against
someone who is bidding with your gold!
Second, fractional reserve banking means that gold certificates are no
longer backed by gold in the bank's vault, but by trust that the bank can
acquire the gold when you redeem the certificate. The total number of gold
certificates issued by all banks may exceed the total amount of gold in the
economy. Money is no longer backed by gold, but by trust. The natural
actions of the free market has transformed the gold standard into a trust
standard.
Fractional reserve banking makes gold less important and trust more
important in the economy. But as I stated before, the amount of trust is more
variable than the amount of gold. So fractional reserver banking will
intensify the boom and bust cycle.
However, there is a limit to the boom and bust cycle. Intelligent people
understand the boom and bust cycle, and will realize that if
you trade everything for gold during the boom, and then trade the gold for
everything else during the bust, you can make a vast fortune. Once a few
people succeed at this, other people will imitate them. The actions of these
people will lessen the intensity of the boom and bust cycle. Over time the
costs of information and trading will fall. Lower information and trading
costs make it easier for people to trade against the boom and bust cycle.
The boom and bust cycle will become less intense over time and will
eventually disappear.
The boom and bust cycle will become more intense as an agricultural economy
develops into an industrial economy, and then become less intense as the
industrial economy develops into an information economy.
home