I have a question about backed currencies

[TexasAggie09]

I have gotten into discussions with people about fiat currency and inflation. I am able to hold my own on most issues except when questioned on the flexibility and room for growth when using a currency backed by a standard. How does a backed currency allow for flexibility and growth?

 

[AceNZ]

How does a backed currency allow for flexibility and growth?

It depends on what you mean by "flexibility and growth"....

The short answer is that the value of money can change. With fiat money, one of the core goals is to increase the money supply so that prices stay "relatively" constant as the economy grows. With a backed currency (a gold standard is the only form of backing that makes any sense to me), the amount of money stays the same, and prices fluctuate based on free market forces. For example, if the economy is growing, then everything else being equal, prices would go down as the demand for money increases.

 

[DrCap]

It depends on what you mean by "flexibility and growth"....

The short answer is that the value of money can change. With fiat money, one of the core goals is to increase the money supply so that prices stay "relatively" constant as the economy grows. With a backed currency (a gold standard is the only form of backing that makes any sense to me), the amount of money stays the same, and prices fluctuate based on free market forces. For example, if the economy is growing, then everything else being equal, prices would go down as the demand for money increases.

Also prices would go down for most things regardless due to increased technology. With new tech items we always have deflation- computers, dvd players, flat screens etc- The rate at which technolgy leads to manufacturers making products cheaper outpaces the inflation which we see occurring. Generally, in a stable currency situation, most items would fall in price as people come up with more effecient methods of producing the same (or better) items for less money. In real terms most items would cost a lot less to make now than 50 years ago as people are always finding new ways to make these items cheaper (due to competition). This effect goes for mining as well, farming as well, etc. as people get better at finding minerals, better at extracting oil, better at farming. (obviously if demand was increasing faster than technology increases production the prices could increase - though this is a statistical question and is not a common scenario).

One could try to make an argument that only perhaps land would remain constant in price and not deflate. Deflation is the natural course in an economy which allows technology to function. Inflation has been a desired method of increasing government revenue for at least 2000 years, because people don't really see it easily. That's why inflation looks natural and normal. When we were on a strict gold standard, we generally had deflation with the cost of most items

 

[Zippyjuan]

When we were on a strict gold standard, we generally had deflation with the cost of most items

When was this?
We had deflation during the banking crises of the 1920s and also during the Great Depression.
http://en.wikipedia.org/wiki/Image:US_Historical_Inflation.svg and high inflation both before and after.

 

[Chester Copperpot]

When was this?

we've had a lot of periods being on a gold standard.. we go back and forth between gold backed and non-gold backed.

 

[DrCap]

When was this?
We had deflation during the banking crises of the 1920s and also during the Great Depression.
http://en.wikipedia.org/wiki/Image:US_Historical_Inflation.svg and high inflation both before and after.

Look at the big picture, and see the red-
http://en.wikipedia.org/wiki/Image:US_Historical_Inflation_Ancient.svg

Though I still would like to see exactly where the data is from, and what they are comprising, remember whenever you look at inflation, it means it means, comparing two things relative values to each other - i.e. has milk inflated or deflated compared to land- how much milk did it cost to buy an acre of land 100 years ago and how much does it cost now- that then tells you these two relative values to each other but nothing else. Generally when we think of inflation, we think of the cost of stuff we want to buy, I don't care about the infation or deflation of the price of land in tibet, measured in gold, cause I've got no current plans to buy there- and if I was allergic to nuts I couldn't care less about the inflation of nuts...

Don't get confused by the dollar a constant measure- it's not the same as an inch or ounce or gram or whatever, which hasn't changed in a 100 years in measurement.

 

[Zippyjuan]

I see the red. It does not stay red. It goes red and quickly back to incredibly high inflation within just a year or two. That is not a sign of a stable economy. They are comparing changes in prices of particular items from one year to the next- not relative prices and not the value of the dollar. The gold standard did not produce stable prices nor consistant deflation. Numbers before 1913 are difficult to judge since there were not consistant ways of measuring and very limited information to base it on.


http://www.econlib.org/library/Enc/GoldStandard.html

Performance of the Gold Standard

As mentioned, the great virtue of the gold standard was that it assured long-term price stability. Compare the aforementioned average annual inflation rate of 0.1 percent between 1880 and 1914 with the average of 4.2 percent between 1946 and 1990. (The reason for excluding the period from 1914 to 1946 is that it was neither a period of the classical gold standard nor a period during which governments understood how to manage monetary policy.)

But because economies under the gold standard were so vulnerable to real and monetary shocks, prices were highly unstable in the short run. A measure of short-term price instability is the coefficient of variation, which is the ratio of the standard deviation of annual percentage changes in the price level to the average annual percentage change. The higher the coefficient of variation, the greater the short-term instability. For the United States between 1879 and 1913, the coefficient was 17.0, which is quite high. Between 1946 and 1990 it was only 0.8.

Moreover, because the gold standard gives government very little discretion to use monetary policy, economies on the gold standard are less able to avoid or offset either monetary or real shocks. Real output, therefore, is more variable under the gold standard. The coefficient of variation for real output was 3.5 between 1879 and 1913, and only 1.5 between 1946 and 1990. Not coincidentally, since the government could not have discretion over monetary policy, unemployment was higher during the gold standard. It averaged 6.8 percent in the United States between 1879 and 1913 versus 5.6 percent between 1946 and 1990.

Finally, any consideration of the pros and cons of the gold standard must include a very large negative: the resource cost of producing gold. Milton Friedman estimated the cost of maintaining a full gold coin standard for the United States in 1960 to be more than 2.5 percent of GNP. In 1990 this cost would have been $137 billion.

Conclusion

Although the last vestiges of the gold standard disappeared in 1971, its appeal is still strong. Those who oppose giving discretionary powers to the central bank are attracted by the simplicity of its basic rule. Others view it as an effective anchor for the world price level. Still others look back longingly to the fixity of exchange rates. However, despite its appeal, many of the conditions which made the gold standard so successful vanished in 1914. In particular, the importance that governments attach to full employment means that they are unlikely to make maintaining the gold standard link and its corollary, long-run price stability, the primary goal of economic policy.

 

[theseus51]

Prices would go down, and if gold is in high demand, interest rates would be high.

But you don't need a large money supply to expand the economy. Granted the economy will expand slowly, but it won't contract either. When you have money that's too cheap to borrow, then you have rapid growth. But you also have massive recessions too.

 

[DrCap]

Regarding the questions of deflation
Joseph Salerno wrote in 2002:
"The price deflation that was observed in the past three decades in selected highgrowth
industries, however, was not an unprecedented or even unusual occurrence. In
fact, historically, the natural tendency in the industrial market economy under a
commodity money such as gold has been for general prices to persistently decline as
ongoing capital accumulation and advances in industrial techniques led to a continual
expansion in the supplies of goods. Thus throughout the nineteenth century and up until
the First World War, a mild deflationary trend prevailed in the industrialized nations as
rapid growth in the supplies of goods outpaced the gradual growth in the money supply
that occurred under the classical gold standard. For example, in the U.S. from 1880 to
1896, the wholesale price level fell by about 30 percent, or by 1.75 percent per year,
while real income rose by about 85 percent, or around 5 percent per year.8 This
deflationary trend was only interrupted during periods of major wars, such as the
9
Napoleonic Wars in Europe and the American Civil War, which the belligerent
governments invariably financed by printing paper fiat money.
Also, it is noteworthy that the fall in the sale prices and average production costs
of consumer goods occurring during the growth process does not necessarily entail a
decline in the selling price of labor. If the supply of labor is fixed, money or “nominal”
wage rates will remain constant while “real” wage rates rise to reflect the increase in the
marginal productivity of and employers’ demand for labor as the purchasing power of
every dollar earned rises with the decline of consumer prices.

taken from this link:
http://www.mises.org/journals/scholar/salerno.pdf

And a few other deflation articles:
http://www.mises.org/story/1254
http://www.mises.org/story/2373
http://www.mises.org/story/1583

I admit all of this does require even those with substantial general economics background to do some thinking, the reality is that the monetary supply is not privatized because governments wouldn't be able to tax/steal from people in a free market of currency. That is the only reason the world has fiat currency, even if most politicians don't realize it.
RP is suggesting the idea of legalizing currency production- if the federal government could do it better than the private market, that would be fine, but it would loose. Really no different than the fact that it is illegal to start a company competing with the post office for 1st class mail- the government doesn't want to do that because, again, it would eventually loose- competition would be bad for our government but good for our country.

 

[Acala]

banking

When looking at historical patterns of price inflation and deflation, you need to keep in mind that even with a full-gold currency it is possible to have inflation and deflation as a result of fractional reserve banking - especially when a central bank is backing up the fractional reserve practices of the banks.

To have a truly stable currency, you need to have commodity money - most likely gold and/or silver - and full-reserve banking. Then you will have a slow, stable decline in prices over time as a result of gains in productivity due to accumulation of capital and also due to economic growth increasing demand for a relatively stable money supply. No inflationary booms causing malinvestment of capital and looting some parts of the economy for the benefit of other parts, and no busts where malinvested resources and jobs are lost. You will also have a built-in restraint on one kind of government fiscal irresponsibility.

 

[Paulitician]

I have gotten into discussions with people about fiat currency and inflation. I am able to hold my own on most issues except when questioned on the flexibility and room for growth when using a currency backed by a standard. How does a backed currency allow for flexibility and growth?

As long as you have a steady increase in the amount of money (with gold it's roughly around 3% annually) and no deflation (deflation meaning the contraction of the supply of money/credit), than there is more than enough room for growth in the long run. I will submit that in the short run you can have some problems if economic growth is very rapid. However, that's true even wtih fiat money because central banks aren't smart/quick enough to know the growth (because they first have to collect data, and when they do start pumping money, things could have changed and it takes time for money to make it's way through the market anyway). It's best if central banks try not to issue money based on their predictions for growth as they will surely screw everything up. I don't know what you mean when you say flexibility. There is a problem with gold, however (and this actually a plus as well), as productivity rises or even becomes stable, the natural order of things is for prices to decline as others have mentioned. Since the real value of goods comes down, it is natural for a business to lower its workers' wages (in order to maximize profits), and this has a negative effect psychologically. After all, no one wants to see their paychecks go down, and at the same time if person has debt, it's harder to pay that debt because a person's debt level doesn't go down like prices do, it stays the same. Nonetheless, their "real" wages will stay relatively the same too.

On the other hand, with fiat money, it's the opposite even though people think they're getting "wealthier" when in fact in real terms peoples wages are going down (this is because of increased government spending ergo taxes, and the fact that governments tend to overinflate). There is also increased moral hazard, malinvestments etc.

So, if you ask me, I rather live in a world where prices went down, the real value of money were stable in the long run, and government couldn't tax and become big like it is today. But, I know that an ideal asset-backed currency, and even an ideal fiat currency, is utopian. It have never existed, nor will it ever exist IMO.

EDIT: I'd also like to mention that the whole notion that a currency can increase or "stimulate" growth has been thoroughly discredited. Because eventually you'll have setbacks anyway. You can not fool the markets always and entirely! It's productivity that creates growth, not currency.

 

[scooter]

Under a gold standard the money will fluctuate also. It just depends on how much metal the government holds.

It has pretty much been shown in history that movements in the quantity of money either direction do not hurt prices significantly as long as those movements are slow and at least somewhat expected. When economies have had problems in the past is during periods of high rates of deflation or inflation.

The metal-backed currencies showed to be stable in the past because they did cause deflation of prices, but at a slow enough pace to where it did not create disruptions in pricing. There were a few periods of bad deflation, though, so it wasn't a perfect system. But what we have now is pretty far from that anyway... in the opposite direction.

The only positive to slight inflation over slight deflation is a mental one. People feel better having their wages rise slightly over time even though they aren't getting more wealthy. With slow deflation, prices decline and are stable, but mentally people feel like they are getting poorer because their wages and the items they sell will go down.

 

[jon_perez]

Economic issues aside, what opinon do the people here have about the assertion that not having a fiat money standard makes it nearly impossible for governments to finance wars?

Seems like a great argument for getting off fiat.

 

[constituent]

I have gotten into discussions with people about fiat currency and inflation. I am able to hold my own on most issues except when questioned on the flexibility and room for growth when using a currency backed by a standard. How does a backed currency allow for flexibility and growth?

once gold became too expensive, people would increasingly use other metals or goods (perhaps represented by paper notes) as a medium of trade.