Gold standard = no investment?

[jon_perez]

I was arguing with my roommate and he said that investment requires one to be able to borrow money, and if we had the gold standard we wouldn't be able to borrow money (or something), and so there would be less investment.

You would be able to borrow money (gold, iow), but because the supply tends to be lower (or cannot be increased at will according to 'demand'), interest rates will tend to be quite high.

Remember that even in an era of fiat money, interest rates were able to shoot up to 20% during the Volcker period.

 

[Bradley in DC]

You would be able to borrow money (gold, iow), but because the supply tends to be lower (or cannot be increased at will according to 'demand'), interest rates will tend to be quite high.

Remember that even in an era of fiat money, interest rates were able to shoot up to 20% during the Volcker period.

Jon, Jon, Jon....whatever misguided ideas you have in your head you get the theoretical understanding wrong which leads you to create an historically counter-factual understanding of the real world. Just for kicks, try to illustrate with real world examples to make your case over a longer period of time.

Volker: The experience in the 1970s was a direct result of several factors with Nixon "closing the gold window" in 1971 severing the international tie of the dollar to gold. Because of the irresponsible spending policies of the Vietnam War/Great Society, the monetizing of the government's budget deficits by the Fed created too many dollars (inflation) that forced interest rates to rise accordingly--the opposite of what was happening under the partial gold standard.

Volker, with Reagan's approval, actually contracted the money supply the last year of the Carter Admin after double digit growth previously. That action, more than anything else (along with Reagan's early attempts to cut the deficit, but that's another story where the Fed is the culprit of course) brought down real interest rates. You need to keep in mind real v. nominal interest rates. During the long years with gold and without a central bank monetizing debt, real interest rates were generally relatively lower in the long run than with your fiat sweetheart.

 

[Tom228]

I wonder how many people here are aware that there are many downsides to a gold standard.

 

[jon_perez]

Volker: The experience in the 1970s was a direct result of several factors with Nixon "closing the gold window" in 1971 severing the international tie of the dollar to gold. Because of the irresponsible spending policies of the Vietnam War/Great Society, the monetizing of the government's budget deficits by the Fed created too many dollars (inflation) that forced interest rates to rise accordingly--the opposite of what was happening under the partial gold standard.

Why would too much money cause interest rates to rise? The most basic law there is, is that of supply and demand. And as one can look at interest rates as the "cost of money (or of borrowing it)", the more supply of money there is relative to demand, the cheaper it should get. I don't see how it can be otherwise.

Volker, with Reagan's approval, actually contracted the money supply the last year of the Carter Admin after double digit growth previously.

And how did Volcker contract the money supply? By targeting higher interest rates of course.

You need to keep in mind real v. nominal interest rates. During the long years with gold and without a central bank monetizing debt, real interest rates were generally relatively lower in the long run than with your fiat sweetheart.

Okay, all the explanations aside, this is an interesting assertion and I'm going to keep this in mind.

 

[jon_perez]

You need to keep in mind real v. nominal interest rates.

The distinction between "real" and "nominal" interest rates is contingent upon accepting the definition of inflation as being the rise in nominal prices.

If you claim to stick to the classical/austrian (or whatever) definition of inflation as being [nothing else but] the rise in the money supply (an ideologically driven definition if you ask me), it would be rather disingenuous to try to make a distinction between the two.

 

[therealjjj77]

I was arguing with my roommate and he said that investment requires one to be able to borrow money, and if we had the gold standard we wouldn't be able to borrow money (or something), and so there would be less investment.

Does anyone know much about these types of issues and what I can read to learn more about this?

Thanks.

Over-investing is bad. We saw this happen with the housing market. There is a "right" amount of investing and that should be determined by the market. If there is no manipulation of the money supply(Fed creating money and adjusting rates), you don't have bubbles and busts. The bubbles happen because of too much investing.

It's a bad idea for the market to build too many houses. Then you have a great deal of wasted resources in houses that will not be lived in for many years to come(just one example of this).

There is a right amount of investing and that is not for you or me to determine. The beauty of free market money is the markets will determine this.

What your roommate is referring to is fractional reserve banking. This is something that regular banks engage themselves in. It is a fruadulent practice but is being allowed. Suppose 10% is the amount they need as a "reserve". So if you deposit $1,000 of your money in that bank at 5% return, and that bank had a 10% reserve amount, then they would be able to loan out $10,000(most transactions are checking transactions and electronic transaction that do not use paper cash). Suppose they loan the money out at 9%. Due to the extra money in the market there would be 10 times the buying power. This would cause for a lot of spending which would be interpreted as a booming economy. So what happens to the price of "widget A"? If they max out their loaning ability the price of everything would tend to increase until it reached ten times the amount it was before. And then when the loans were paid back the prices would have to decrease because less money was in the economy and you would have a recession. Ultimately the bank made out big on your meager $1,000 and you lose, the economy loses, and the people they loaned to lose.

At 9% they would have made profit of $2,454.80 if all the loans were 5 year loans. That's like 49% APR. In other words, you really lost 44% since your buying power declined.

 

[jon_perez]

There is a right amount of investing and that is not for you or me to determine.

Or rather, if we left it up to you or me or even someone with access to gargantuan amounts of economic data such as the Fed, none of these parties would still be able to come close to doing a proper job of determining the proper interest rates compared to the market as a whole.

This, at least, is the serious (as opposed to fanciful conspiracy theories) premise behind wanting to abolish the Fed.

 

[jon_perez]

Volker: The experience in the 1970s was a direct result of several factors with Nixon "closing the gold window" in 1971 severing the international tie of the dollar to gold. Because of the irresponsible spending policies of the Vietnam War/Great Society, the monetizing of the government's budget deficits by the Fed created too many dollars (inflation) that forced interest rates to rise accordingly--the opposite of what was happening under the partial gold standard.

By the way, can you give the source where you got the above?

 

[Bradley in DC]

By the way, can you give the source where you got the above?

HA!

Like all of my other posts, it was my writing. In deference to your criticisms, I didn't hyperlink my comments with references. (not really, I was just a bit lazy, but you are certainly welcome to research it yourself if you're still in your mindless habit of just trying to refute what I say. )

 

[Bradley in DC]

The distinction between "real" and "nominal" interest rates is contingent upon accepting the definition of inflation as being the rise in nominal prices.

If you claim to stick to the classical/austrian (or whatever) definition of inflation as being [nothing else but] the rise in the money supply (an ideologically driven definition if you ask me), it would be rather disingenuous to try to make a distinction between the two.

No, if you could understand how economists think and talk rather than popular misperceptions, these discussions would be easier.

Inflation (the loss of purchasing power of the monetary unit) is the cause of the symptom of a rise in nominal prices. Just for the sake of argument here, let this one go for now. The questions on interest rates will be more productive for us and the thread, me thinks.

 

[Bradley in DC]

Why would too much money cause interest rates to rise? The most basic law there is, is that of supply and demand. And as one can look at interest rates as the "cost of money (or of borrowing it)", the more supply of money there is relative to demand, the cheaper it should get. I don't see how it can be otherwise.

Excellent question, my boy! Now we're getting somewhere. You're on the right track but not following it all the way through. Good to ask questions rather than just "dastardly" attacks. S & D, yes. Interest rates are the P in the S & D graph yes (and don't worry, we Austrians aren't that big on the crazy false empiricist equations so this won't get too complicated). So...

Holding the supply of money constant for this part of the theory, would you also agree that interest rates (the price of money/cost of money) are an expression of a ratio of savers' willingness to lend relative to borrowers' willingness to borrow? This would be the natural price level of money (interest rates) in a market economy. (your "time preference" for money, but we'll work on these terms later--and the importance of the inter-temporal aspects of money prices)

Now introduce the villain in this story, the Fed. Suppose for the sake of argument (and really stretching your limits of imagination here ), the Fed increases the supply of money artificially (definition of inflation, but we're having that discussion on another post). By "artificially" I mean that the Fed is increasing the supply of money beyond what savers are willing to lend freely. Put yourself now in the mind of that saver who has money to lend and consider S & D & P. In order to get the same REAL return on your investment under the new villainous scenario, you'd have to add an inflation premium to offset the loss of value of the purchasing power of your lending dollars. Thus, one always, by economic law, finds NOMINAL interest rates much higher in an inflationary environment. It's worse actually, especially for longer-term investments, because of the introduction of the added uncertainty there is a marginal increase in that nominal money price to compensate for that uncertainty. (Yes, this is a very simplified explanation.)

And how did Volcker contract the money supply? By targeting higher interest rates of course.

Okay, all the explanations aside, this is an interesting assertion and I'm going to keep this in mind.

The relative importance of the tools of the Fed has evolved over the years. I suspect your insights are a bit dated. For example, no one talks about reserve requirement ratios anymore because of the "sweeps" software (banks, justifiably, "sweep" the affected accounts offshore to the Cayman Islands overnight for a higher rate of return and to avoid the cost of the regulation and then "sweep" it back again the next morning), currency controls (anti-money laundering regulations aside, the breakdown of the Smithsonian Agreement put an end to this as an effective tool of monetary policy here--not in China, North Korea and other places though--I hope you're not arguing for their policies!); etc.

Because of a variety of reasons, the interest rate setting tools are similarly less relevant than Keynes envisioned. Market forces always seem to find a way of working around stupid regulations and other governmental interventions. The same is true here. The relaxation of capital controls, sweeps software, increases in communications technology, increased globalization of finance ("money goes where it's welcome and stays where it's well treated," as the saying goes), and a variety of other factors continue to change the debate.

In short, yes, the Fed has some direct control over (an increasingly irrelevant) set of interest rates. The marginal effect of that control has been severely limited for about half a century. In practice, the Fed affects interest rates by the FOMC's interventions in the supply of money. That is how Volker did it even back then: he CONTRACTED the money supply to combat inflationary price rises--the effect of which was a rise in interest rates. Yes, though, you're right, the real increase in market interest rates would, for the reasons I've outlined, be a natural and rational RESULT of those Fed interventions.

 

[Bradley in DC]

Or rather, if we left it up to you or me or even someone with access to gargantuan amounts of economic data such as the Fed, none of these parties would still be able to come close to doing a proper job of determining the proper interest rates compared to the market as a whole.

This, at least, is the serious (as opposed to fanciful conspiracy theories) premise behind wanting to abolish the Fed.

I'm not sure what you're saying here. The importance of letting the market set prices rather than artificial governmental/Fed interventions is paramount, yes. Prices tell information, or send "price signals" for savers and borrowers and investors. It is when the Fed falsifies those price signals that we get the cause of the artificial booms and busts in the economy.

 

[jon_perez]

Now introduce the villain in this story, the Fed. Suppose for the sake of argument (and really stretching your limits of imagination here ), the Fed increases the supply of money artificially (definition of inflation, but we're having that discussion on another post). By "artificially" I mean that the Fed is increasing the supply of money beyond what savers are willing to lend freely. Put yourself now in the mind of that saver who has money to lend and consider S & D & P. In order to get the same REAL return on your investment under the new villainous scenario, you'd have to add an inflation premium to offset the loss of value of the purchasing power of your lending dollars. Thus, one always, by economic law, finds NOMINAL interest rates much higher in an inflationary environment.

But who would borrow from you at the higher nominal interest rate you desire when they can get it from the Fed (and their minions) at their lower targeted rate?

 

[Bradley in DC]

But who would borrow from you at the higher nominal interest rate you desire when they can get it from the Fed (and their minions) at their lower targeted rate?

Good observation. For those few special interests, you're right (the purple pocketed). But I thought we were talking about the real world where people mattered too! The Fed is much less relevant than you realize...and less so each day.

As I said, it was a very simplified explanation. There are, of course, myriad interest rates for different time periods (general yield curve would look like a flattened "U" since there are higher relative fixed costs for short-term loans and greater uncertainty--especially with the Fed's uncertainty premium factored in--for long term loans). There are different loan types with different qualities of assets with or without collateral, etc.

Do you get the reasoning and theory behind my explanation generally first? (after that we can differentiate the real world examples--but first we have to see if we understand each other and agree on the fundamentals. It has been clear you've not understood mine)

 

[jon_perez]

Good observation. For those few special interests, you're right (the purple pocketed). But I thought we were talking about the real world where people mattered too! The Fed is much less relevant than you realize...and less so each day.

As I said, it was a very simplified explanation. There are, of course, myriad interest rates for different time periods (general yield curve would look like a flattened "U" since there are higher relative fixed costs for short-term loans and greater uncertainty--especially with the Fed's uncertainty premium factored in--for long term loans). There are different loan types with different qualities of assets with or without collateral, etc.

Do you get the reasoning and theory behind my explanation generally first?

Inflation means people will only be willing to lend their money out at a higher interest rate, but the Fed tries to combat this by creating more money in an attempt to drive the rates down to their target level. But given that they can create as much money as they can, how can they not win everytime?

 

[Bradley in DC]

Over-investing is bad. We saw this happen with the housing market. There is a "right" amount of investing and that should be determined by the market. If there is no manipulation of the money supply(Fed creating money and adjusting rates), you don't have bubbles and busts. The bubbles happen because of too much investing.

In Austrian-speak, it wasn't a problem of "over-investing" but "malinvestment"--resources being shifted from their highest use value based on time preferences because of the corrupting of the market price signals by the Fed.

 

[Bradley in DC]

Inflation means people will only be willing to lend their money out at a higher interest rate, but the Fed tries to combat this by creating more money in an attempt to drive the rates down to their target level. But given that they can create as much money as they can, how can they not win everytime?

Too many pronouns, sorry. What?

 

[jon_perez]

Inflation means people will only be willing to lend their money out at a higher interest rate, but the Fed tries to combat this by creating more money in an attempt to drive the rates down to their target level. But given that the Fed can create as much money as they need to, how can the Fed targeted interest rate not ultimately prevail?

 

[Bradley in DC]

Inflation means people will only be willing to lend their money out at a higher interest rate, but the Fed tries to combat this by creating more money in an attempt to drive the rates down to their target level. But given that the Fed can create as much money as they need to, how can the Fed targeted interest rate not ultimately prevail?

I'm not totally sure I understand you point, so here goes (if it seems I'm off, sorry): interest rates are set by the market (ok, not the ones the Fed directly controls); Fed interventions, yes, do affect the factors determining interest rates, as we've discussed. The Fed under Nixon/Carter had a "loose" monetary policy and interest rates were sky high (20% mortgages, if I remember that right). Beyond this, I'm not sure what you're trying to say.

 

[jon_perez]

I'm not totally sure I understand you point, so here goes (if it seems I'm off, sorry): interest rates are set by the market (ok, not the ones the Fed directly controls); Fed interventions, yes, do affect the factors determining interest rates, as we've discussed. The Fed under Nixon/Carter had a "loose" monetary policy and interest rates were sky high (20% mortgages, if I remember that right). Beyond this, I'm not sure what you're trying to say.

I would've thought a "loose/easy" monetary policy is heavily associated with lower interest rates and not the opposite. Greenspan after all gets blamed for creating the mortgage crisis by keeping rates at 1% for along time.