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November 24, 2008


Michael Blowhard writes:

Dear Blowhards --

Christopher Wood -- aka "the man who saw it coming" -- suspects that the gold standard may soon be making a return. (Link thanks to Charlton Griffin.) Fun facts:

Under Chairman Ben Bernanke, the Federal Reserve balance sheet continues to expand at a frantic rate, as do commercial-bank total reserves in an effort to counter credit contraction. Thus, the Federal Reserve banks' total assets have increased by $1.28 trillion since early September to $2.19 trillion on Nov. 19. Likewise, the aggregate reserves of U.S. depository institutions have surged nearly 14-fold in the past two months to $653 billion in the week ended Nov. 19 from $47 billion at the beginning of September.

A few questions for those smarter than I am?

* How can these actions not result in tremendous inflation?

* Why is deflation bad?

* What's so bad about a gold standard? I have the impression that the Smart Set thinks that only rubes see virtues in a gold standard -- let's all have a laugh at the expense of "gold bugs" who see magical properties in gold, for instance. Yet I never run across explanations of why it's so rube-ish to favor a gold standard.

* I'm under the impression that gold represents what people -- left to their own devices -- settle on as a basis for money. If this is so, why should anyone overrule people's expressed preferences where the question of what should back money is concerned?

* Is it unfair to think of fiat money a representing a usurpation by the elites of control over money?

* If so, what incentive is built into the system for our elites to behave responsibly where protecting the value of money is concerned? Do we really have nothing to depend on but our elites' expertise and goodness of heart? Ahahahahahaha. Sorry, I was just picturing my retirement savings going up in smoke.

* What's the best way for a civilian to buy gold?

Megan McArdle makes the case against a gold standard. A nice line from a Leonard Dickens comment on Megan's posting: "Fiat requires philosopher king-bankers. Commodity money requires mere humans."



posted by Michael at November 24, 2008


I'm just a narrator, so don't take my opinions as being particularly weighty, but here's an analogy that might help people understand the danger of what the Federal Reserve is attempting. Let's say you went on a backpack trip and woke up to find your fire had gone out because of a sudden rain. You frantically try to fan it back to life. Some smoke, but no flame and just a little smoke. You have a finite supply of fuel, which you use to make your food, so you can't use too much of it. You pour it on the smoking wood. No flame. You repeat this exercise and even gather more and more wood. Finally, in desperation you pour your remaining fuel on the wood and get on your knees and start blowing on the area where the smoke is emanating. Suddenly, the whole damn thing explodes into flame, burning you badly in the process. The fire starts roaring.

That's inflation.

So should we risk pouring more fuel on this smoking heap, or suffer the cold and wait for a more propitious moment?

I say put on some clothes and wait for warmer weather.

Posted by: Charlton Griffin on November 24, 2008 11:57 AM

Im an economo-ignoramus. But i have read a little bit on this. If i recall, the very ability to print money (in a recession) is touted as a key advantage of fiat money. Because if you are a keynesian, as we 'all are now' according to nixon, you believe deficit spending by govt during a recession is a net good. i have no opinion personally.

Posted by: Eric j. Johnson on November 24, 2008 11:59 AM

I doubt i the gold standard will ever come back, for one it's too cumbersome to administer, and for another, in the long run people like me would make a killing doing arbitrage between the artificial disconnect between gold standard prices and "outside the gold standard" prices of assets.

but gold may be a good asset to hold during uncertainty.

Posted by: Ramesh on November 24, 2008 12:09 PM

Michael, thanks for the nod.

Probably the best argument for gold I've read is the article Why the Global Financial System is About to Collapse by the pseudonymous "John Law, gonzo economist". I got the linkup from Mencius Moldbug and I'm still not sure they are distinct people. If you like MM, you'll like the piece.

As for how to buy gold: it's quite easy these days. Exchange-traded funds that closely proxy its value are available: GLD is the one I have a lot of. If you can buy normal stocks, you can buy GLD the same way. GLD is a part of the US financial system, though, and it holds its gold in the USA, either of which may be a problem if the shit hits the fan and the government needs to Make Money Fast.

It is also possible, for the slightly more paranoid, to buy ownership of gold directly. You can do this in a fairly convenient way via and few similar services. They pool ownings and can thereby buy in bulk, even though your fraction really is yours, not theirs. Also, their gold is physically held in Switzerland or London, which being not-the-USA may be advantageous if things go bad. I have not done this route, in part because it is slightly more cumbersome than using my Fidelity accounts which already exist for retirement saving. But also I have the feeling the small delta in legal figleafery you get from titular ownership and from Switzerland won't matter if the USA gets hungry. OTOH, Mencius Moldbug has, I infer, chosen this route. So, that's a strong reason to consider it. I'd love to know his reasoning.

But for true paranoia, you should buy physical gold, in coins (or bars if you're rich), and store it yourself. This can be a safe-deposit box, or buried in the backyard. In the event of a massive and fast economic meltdown (i.e., global economy collapses along with dollar, US Government, Wall Street, etc.), this is what you'd want. Along with guns and ammo and canned food. Or you would want it in a slower meltdown, but you'd better be willing to lie about it when the government comes looking for gold. Me, I don't possess any physical gold. Again, it's not that easy, and the buying/selling fees are very noticeable. On the upside, handling real gold is a neat experience. The stuff is noticeably heavy; it feels real and makes normal USA pocket change feel like the cheap zinc monopoly money it is.

My gut feeling is that our current financial crisis will not be the one which brings down the world financial system and induces the phase change to gold which John Law predicts. But it may well induce a fair amount of money-printing worldwide. GLD is thus a good safe-haven for waiting it out.

Posted by: Leonard on November 24, 2008 1:55 PM

Deflation is bad because it kills business investment -- the money you spend to produce goods today can't be recouped selling cheaper goods tomorrow, or at least it's much harder to recoup it. It helps the consumer dollar stretch further today, but at the price of endangering the consumer's job tomorrow.

But if you're retired on a fixed income, deflation will work for you...for a while. It's tempting to see it as a good thing, lower prices right? Until the resulting economic contraction starts causing the institutions you've stored your assets in to go bankrupt.

That's the argument, anyway...

Posted by: MQ on November 24, 2008 2:01 PM

Deflation is bad because it stops investment. If dollars will be worth more in the future, its best to hang on to them.

Posted by: Dennis Mangan on November 24, 2008 2:24 PM

"How can these actions not result in tremendous inflation?"

Because the central banks are trying to offset apocalyptic deflation. Fractional reserve banking creates money as an exponential function of the leverage fraction. Historically, sane safe banking used a leverage fraction of around 90%, where every $10 of original deposits created $91 of overall money supply.

During the recent credit mania, the leverage fraction was increased to 95% in many large U.S. financial companies, and many of the Euro banks took it to a breathtaking 98+%. For them, $10 of original investment created hundreds or even thousands of dollars of money supply. The implosion of their "investments" is forcibly decreasing their leverage ratio, and thereby the money supply. Left to their own devices, their panic response would make the draw-down even faster and more reckless, producing a global fire sale and a general deflationary collapse. The frantic "loans" from central banks are attempting to prevent a fire sale from taking hold.

"Why is deflation bad?"

Modest, stable deflation is arguably a great good, by making speculation automatically expensive and rewarding savings. It can be argued that inflation is better because it forces money into productive ventures, but I think natural human overoptimism is far stronger and could do with a deflationary brake.

A self-reinforcing deflationary collapse is what's bad.

"What's so bad about a gold standard?"

There have been credit manias under gold currencies that were every bit as bad as our recent one. Humans seem to have a basic ability to leverage debt and treat the resulting paper obligations as money good. The catch is that the government cannot, even in principle, temporarily print up a bunch of gold to unwind a gold-denominated mania.

Also, advances in extraction technology will probably cause a tremendous gold inflation sometime during the nanotech revolution. It could be next year, it could take another 50 years, but it seems likely to me.

Posted by: Daniel Newby on November 24, 2008 3:32 PM

Q: How can these actions not result in tremendous inflation?
A: They can't not result in tremendous inflation.
BTW, here's a question a lot of people will be asking themselves five or ten years from now: "What on Earth was I thinking, not buying gold in 2008 when I could see trillions of dollars in government expenditures being made with no mention of where the money was coming from? Damn my 'Certified Financial Planner' to hell!"

Q: Why is deflation bad?
A: It's good, since its free-market cause (slowly-growing stock of gold vs faster-increasing production) is the opposite of price inflation (caused by rapid expansion of fiat currency).

Q: What's so bad about a gold standard?
A: Its advocates look so silly in their tinfoil hats.

Q: I'm under the impression that gold represents what people -- left to their own devices -- settle on as a basis for money. If this is so, why should anyone overrule people's expressed preferences where the question of what should back money is concerned?
A: Yes, it *appears* to defy elementary logic, but there are very complicated reasons (as expressed in books full of equations written by academic economists) that us rubes could never understand.

Q: What's the best way for a civilian to buy gold?
A: Bullion in one's personal possession eliminates counterparty risk, but that gets replaced by the risk of good old-fashioned thievery. Paper bullion abounds, such as Perth Mint Certificates, Central Fund of Canada, GLD, and SLV. These are very convenient, but they're taxed like bullion (around 25%, regardless of length of time held...even generic bullion in bar form is taxed as a "collectible"), and in a hyperinflationary environment that tax rate is likely to be raised to the moon. Piles of bullion in various safe deposit boxes around the world would seem to be the most conservative approach, but even if you have that kind of money, few overseas banks will open accounts for Americans nowadays (due to US government harassment).

Mining equities are an interesting way to play the coming precious metals rise, since they are valued not so much on present profits but on how much metal the miner has in-ground. They are of course riskier than straight paper gold, and are heart-stoppingly volatile. But if one diversifies among them, they're likely to do very well as a group when inflation gets roaring. I'm betting mining (and energy) stocks will be the Next Big Thing, because sooner or later Wall Street will have to stop spurning them and climb on the bandwagon. When seafloor mining ends up being the epicenter of the mania, well, you heard it from me first.

Posted by: Poseidon on November 24, 2008 3:58 PM

Just to make my stake in the debate clear, I do not advocate a gold standard. Having said that, I will comment on Megan's Atlantic article. Her first argument against a gold standard is valid. She should have elaborated on it further, because her second and third arguments are nothing but bravo Sierra (to put it politely).

Her third argument, however, does present a clue as to why she does not like deflation. Deflation rewards people who are fiscally conservative and who take on little or no debt. Conversely, deflation punished people who take on lots of debt. Since the Smart Set like to live well and be so pretentious in life, they and the institutions they manage have taken on quite a lot of debt over the past 15 years. A protracted period of deflation (say 1-2% per year) for 5-7 years will be very hard on these people. I think Megan is one of these people, which is why she fears and dislikes the prospect of deflation.

I, on the other hand, have never used much debt and have definitely lived within my limits, even when it was not fashionable to do so. Thus, I should be OK with a protracted period of deflation, providing I can keep my head above water (I am self-employed) with my business activities.

The problem is that people like Megan and Krugman is that they want people like me to pay the price for bailing out the Smart Set people like them. Of course this is not acceptable to me.

So, what recourse do people like me have if we end up having inflation to pay for the screw up of the Smart Set? Simple, do business in a different currency. Most of my business involves buying or selling between the U.S. and various Asian countries. I will simple switch the currency that I do business in so that I am not adversely affected by inflation. Also, is it not likely that the banks and investment houses (ones that were not stupid enough to play the sub-prime bond speculation game) will offer their customers investments in various currencies (yen, Swiss Franc, Singaporean dollar, etc.)?

Posted by: kurt9 on November 24, 2008 4:00 PM

The problem with a gold standard is that it does not allow the money supply to be increased in proportion to the economic growth rate. Also, the supply of gold is subject to unexpected changes whenever an existing mine runs out of gold or a new supply is discovered. Having the money based on a basket of commodities (gold, silver, platinum, rhenium, etc.) can make it a little more stable, but not much. Also, speculation on gold itself can create problems. This was the root of the collapse in Silver prices in the 1870's and the so-called "free Silver" movement out West.

It was due to these problems that fiat currencies were created in the first place. Fiat currency is generally superior to commodity based currencies, but only when you have responsible people in charge of the money issuance (meaning people who do not inflate the money supply for political expediency).

I believe that globalization and the easy access to foreign exchange provides a partial solution to the manipulation of currency by the political elites. Another is the issuance of private currencies. However, that is a discussion for another day.

Posted by: kurt9 on November 24, 2008 4:25 PM

Great comments in this thread, and I'm no economics major, but I want to add one note from experience.

Hong Kong (where I've lived for a long time) suffered from about four years of non-stop deflation in the early 2000s. I can assure you that to the casual observer, at least, it's no fun at all. Businesses dry up, everybody hunkers down, and although prices drop, so do salaries. It's a big mistake to think that you'll just keep on making what you're making and pay less for what you need to buy. Unless you're retired and on a fixed annuity or pension, you'll eventually have to take a pay cut, too.

People working in the private sector here routinely took 20-30% salary cuts, or even more, and even civil servants eventually absorbed 10-15% cuts. Plus the values of your other assets (especially your real estate) are likely tanking as well.

So no, not recommended.

Posted by: mr tall on November 24, 2008 8:23 PM


The problem with a gold standard is that it does not allow the money supply to be increased in proportion to the economic growth rate.

What do you mean by this sentence? You are using the passive voice. Who is printing the new money? Who gets it? And why on earth is counterfeiting required for economic growth?

If you simply meant a "redenomination" ( analogous to a stock split), I can see how this would make transactions easier over time, but that's very different from what the federal reserve actually does.

Posted by: Devin Finbarr on November 24, 2008 9:33 PM

The advocates of a gold standard simply want a currency whose value cannot be manipulated for political expediency. The advocates of fiat currency need to come up with a credible method for ensuring this. For some reason I don't understand, they always seem to fail to do this.

Posted by: kurt9 on November 24, 2008 10:52 PM

There's a lot of myths about deflation. For example, that deflation stops investment, presumably because money worth more next year won't ever be spent. As I noted in McArdle's gumdrop of ignorance: does the possibility of earning interest on money prevent you from spending? Logically, 2% deflation is the same as earning 2% in a savings account.

People then turn to the "savings doing work" meme, another bit of inflationist apologia with no basis in reality. No, money does no work. Money is a store of value; that's its only purpose. There is a price to the government's scheme of artificial creation of lendable money: it falsifies the interest rate, "telling" entrepreneurs to borrow and buy capital, for future goods which are not demanded. It also lowers real interest rates, in addition to degrading the value of money. This double-whammy makes saving not pay what it otherwise would, depressing the savings rate. It also weakens the very point of money: to store value.

What one can say against deflation, is that within the context of the current money system (fiat money + fractional reserve), deflation only happens when the central bankers have truly and deeply fucked up. As they did when they triggered the Depression. Thus, deflation is highly correlated with all kinds of bad stuff. But it's not causing that stuff; that stuff is happening because credit bubbles cannot pop without economic pain.

Posted by: Leonard on November 24, 2008 11:06 PM

Great thread. Daniel Newby's comment above is particularly good. The injections of money are not necessarily inflationary because they are replacing money that vanished as various financial assets got revealed as worthless and banks had to deleverage (thus reducing the effective money supply). Also, as he points out, one could imagine a situation where modest and steady deflation could work as a sort of consistent monetary bias against the short-sighted optimistic psychological bias that produces bubbles and manias. But just like there is the threat of inflationary spirals, there is the threat of deflationary spirals as well, which may be more dangerous. Contra Mr. Newby, one could argue that we need a bit of inflation to counter the tendency of technologically advanced societies to steadily grow more productive, which by itself lowers real price levels.

Posted by: MQ on November 24, 2008 11:53 PM

As I said before, the debate is really about creating a currency the value of which cannot be manipulated for political expediency. Some people seem to thing a gold standard is the way to go. However, a gold standard has its own problems. If not gold, the question remains of how to create a currency which the value of cannot be manipulated by political expediency.

Again I ask, "Why do the defenders of fiat currency seem to refuse to even discuss this issue?".

Posted by: kurt9 on November 25, 2008 11:44 AM

With safe-haven securities paying next-to-nothing combined with severe economic uncertainty, people are hoarding money. That is the main reason I believe we do not have runaway inflation. You can't demand higher prices from buyers when there are no buyers.

Posted by: Bill on November 25, 2008 1:29 PM

kurt9, I think their silence is eloquent testimony, don't you? You can as effectively enslave a man with debt as you can with chains. Come to think of it, probably more effectively, because with debt a slave-to-be will willingly snap the shackles into place of his own free will.

Posted by: Charlton Griffin on November 25, 2008 2:50 PM

Kurt, the reason is clear enough: because to them, manipulability of the money supply is a vital criterion for what makes good money. Right up there with "store of value". Because, recall, they are experts, and they are chartered by us little people to do good things for us. How can they do good things, like stop the next depression, prevent nasty deflation, or pop a bubble before it grows large, if they can't do anything?

Posted by: Leonard on November 25, 2008 3:34 PM

"Why is deflation bad?"

Deflation means money is worth more. That sounds great, until you realize that it is slowly becoming more expensive for your employer to pay you your (fixed) wage, while the price he can charge for your output is steadily falling. That leads to one of two events - layoffs or wage cuts. Neither are exactly great for morale, but layoffs has the advantage of getting rid of the ones most disadvantaged, so their morale doesn't matter anymore. Now your employer can hire new guys at lower wages. Lather, rinse, repeat until all of the old guys are gone and have been replaced at lower and lower wages, and then start over.

On a macro scale, this translates into an increase in frictional unemployment.

Posted by: rvman on November 26, 2008 4:16 PM

MQ wrote: The injections of money are not necessarily inflationary because they are replacing money that vanished as various financial assets got revealed as worthless and banks had to deleverage (thus reducing the effective money supply).

I don't think this is quite right. Money is not vanishing. When I borrow money from a bank to buy a house for $500,000, that money goes to the seller. Then when the value of the house drops to $250,000, no actual money has disappeared. The $500,000 I spent is still out there; it's just not in my hands anymore.

What is happening is that the speculative value of paper promises (loans, investment accounts, etc) and assets (houses) is being revalued lower. But the same amount of money exists as existed before. It seems to me that these speculative manias have the effect of inducing money to move from the pockets of a whole bunch of people into the pockets of a relatively few successful speculators - the people who got in at the ground floor of the pyramid scheme and got out near the top. So then a whole bunch of people who traded their actual money for paper promises or speculative assets like condos, in the hope that those promises and assets would become valued more highly in the future, are finding that the promises and assets are duds. And those people are unhappy. So the Fed and Treasury are effectively coming in and saying "here's actual new money to replace the value you thought you had with those speculative assets and promises." This drastically increases the money supply. Remember, no actual money has disappeared because of the house price declines and credit crunch - only the market value of paper promises, which the Fed and Treasury are now acting to redeem for new, real money.

(I understand that much of what the Fed and Treasury have done so far is not to actually give out money, but to make guarantees or buy crappy assets - but at some point these guarantees will be redeemed for actual money so the result will be the same.)

So after a little time for the panic to pass, all that brand new money will start being leveraged up into fantastic speculative excess like the lesser amount of money was before. And the Fed and Treasury will be loathe to rein that in because everyone loves a speculative bubble - everyone feels like they have a chance to get rich quick.

But at some point, the interest owed on the national debt will exceed the entire amount collected in tax revenue, and the only way for the government to pay the interest will be to borrow more even more money. That will drive up interest rates sky-high, and then the Fed will print money to reduce the rates, destroying the value of the money. And my guess is that the government will engage in every "easy", destructive trick in their bag - printing money, confiscating gold (either outright or through massive "windfall profits" taxes), confiscating IRAs and 401ks (again, through new taxes on them), currency controls, wage and price controls, tariffs, the whole shebang - anything but get on a commodity money standard and suffer through a short harsh depression to burn out the imbalances.

Posted by: Mark on November 28, 2008 12:03 PM

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