Best of the Week
Most Popular
1. Stock Markets and the History Chart of the End of the World (With Presidential Cycles) - 28th Aug 20
2.Google, Apple, Amazon, Facebook... AI Tech Stocks Buying Levels and Valuations Q3 2020 - 31st Aug 20
3.The Inflation Mega-trend is Going Hyper! - 11th Sep 20
4.Is this the End of Capitalism? - 13th Sep 20
5.What's Driving Gold, Silver and What's Next? - 3rd Sep 20
6.QE4EVER! - 9th Sep 20
7.Gold Price Trend Forecast Analysis - Part1 - 7th Sep 20
8.The Fed May “Cause” The Next Stock Market Crash - 3rd Sep 20
9.Bitcoin Price Crash - You Will be Suprised What Happens Next - 7th Sep 20
10.NVIDIA Stock Price Soars on RTX 3000 Cornering the GPU Market for next 2 years! - 3rd Sep 20
Last 7 days
Gold Price Trend Forecast into 2021, Is Intel Dying?, Can Trump Win 2020? - 20th Oct 20
Gold Asks Where Is The Inflation - 20th Oct 20
Last Chance for this FREE Online Trading Course Worth $129 value - 20th Oct 20
More Short-term Stock Market Weakness Ahead - 20th Oct 20
Dell S3220DGF 32 Inch Curved Gaming Monitor Unboxing and Stand Assembly and Range of Movement - 20th Oct 20
Best Retail POS Software In Australia - 20th Oct 20
From Recession to an Ever-Deeper One - 19th Oct 20
Wales Closes Border With England, Stranded Motorists on Severn Bridge? Covid-19 Police Road Blocks - 19th Oct 20
Commodity Bull Market Cycle Starts with Euro and Dollar Trend Changes - 19th Oct 20
Stock Market Melt-Up Triggered a Short Squeeze In The NASDAQ and a Utilities Breakout - 19th Oct 20
Silver is Like Gold on Steroids - 19th Oct 20
Countdown to Election Mediocrity: Why Gold and Silver Can Protect Your Wealth - 19th Oct 20
“Hypergrowth” Is Spilling Into the Stock Market Like Never Before - 19th Oct 20
Is Oculus Quest 2 Good Upgrade for Samsung Gear VR Users? - 19th Oct 20
Low US Dollar Risky for Gold - 17th Oct 20
US 2020 Election: Are American's ready for Trump 2nd Term Twilight Zone Presidency? - 17th Oct 20
Custom Ryzen 5950x, 5900x, 5800x , RTX 3080, 3070 64gb DDR4 Gaming PC System Build Specs - 17th Oct 20
Gold Jumps above $1,900 Again - 16th Oct 20
US Economic Recovery Is in Need of Some Rescue - 16th Oct 20
Why You Should Focus on Growth Stocks Today - 16th Oct 20
Why Now is BEST Time to Upgrade Your PC System for Years - Ryzen 5000 CPUs, Nvidia RTX 3000 GPU's - 16th Oct 20
Beware of Trump’s October (November?) Election Surprise - 15th Oct 20
Stock Market SPY Retesting Critical Resistance From Fibonacci Price Amplitude Arc - 15th Oct 20
Fed Chairman Begs Congress to Stimulate Beleaguered US Economy - 15th Oct 20
Is Gold Market Going Back Into the 1970s? - 15th Oct 20
Things you Should know before Trade Cryptos - 15th Oct 20
Gold and Silver Price Ready For Another Rally Attempt - 14th Oct 20
Do Low Interest Rates Mean Higher Stocks? Not so Fast… - 14th Oct 20
US Debt Is Going Up but Leaving GDP Behind - 14th Oct 20
Dell S3220DGF 31.5 Inch VA Gaming Monitor Amazon Prime Day Bargain Price! But WIll it Get Delivered? - 14th Oct 20
Karcher K7 Pressure Washer Amazon Prime Day Bargain 51% Discount! - 14th Oct 20
Top Strategies Day Traders Adopt - 14th Oct 20
AMD is KILLING Intel as Ryzen Zen 3 Takes Gaming Crown, AMD Set to Achieve CPU Market Dominance - 13th Oct 20
Amazon Prime Day Real or Fake Sales to Get Rid of Dead Stock? - 13th Oct 20
Stock Market Short-term Top Expected - 13th Oct 20
Fun Stuff to Do with a Budgie or Parakeet, a Child's Best Pet Bird Friend - 13th Oct 20
Who Will Win the Race to Open a Casino in Japan? - 13th Oct 20
Fear Grips Stock Market Short-Sellers -- What to Make of It - 12th Oct 20
For Some Remote Workers, It Pays to Stay Home… If Home Stays Local - 12th Oct 20
A Big Move In Silver: Watch The Currency Markets - 12th Oct 20
Precious Metals and Commodities Comprehensive - 11th Oct 20
The Election Does Not Matter, Stick With Stock Winners Like Clean Energy - 11th Oct 20
Gold Stocks Are Cheap, But Not for Long - 11th Oct 20
Gold Miners Ready to Fall Further - 10th Oct 29
What Happens When the Stumble-Through Economy Stalls - 10th Oct 29
This Is What The Stock Market Is Saying About Trump’s Re-Election - 10th Oct 29
Here Is Everything You Must Know About Insolvency - 10th Oct 29
Sheffield Coronavirus Warning - UK Heading for Higher Covid-19 Infections than April Peak! - 10th Oct 29
Q2 Was Disastrous. But What’s Next for the US Economy – and Gold? - 9th Oct 20
Q4 Market Forecast: How to Invest in a World Awash in Debt - 9th Oct 20
A complete paradigm shift will make gold the generational trade - 9th Oct 20
Why You Should Look for Stocks Climbing Out of a “Big Base” - 9th Oct 20
UK Coronavirus Pandemic Wave 2 - Daily Covid-19 Positive Test Cases Forecast - 9th Oct 20
Ryzen ZEN 3: The Final Nail in Intel's Coffin! Cinebench Scores 5300x, 5600x, 5800x, 5900x 5950x - 9th Oct 20

Market Oracle FREE Newsletter

How to Get Rich Investing in Stocks by Riding the Electron Wave

The Chimera Of Stable Money

Currencies / Fiat Currency Aug 20, 2016 - 06:11 PM GMT

By: Frank_Hollenbeck

Currencies

Since the early 19th century, economists have consistently preached that the value of money or its purchasing power should be stable or relatively stable. David Ricardo, in 1817, said: “A currency, to be perfect, should be absolutely invariable in value.”

According to this view, money as a unit of account should be equivalent to a yardstick measuring an immutable distance. Over the last century, this view of money has led economists to suggest that prices, reflecting the purchasing power of money, as measured by a price index [1], should also be stable and that central banks should actively interfere with the market economy to bring stability to such an index. The U.S. Central bank has essentially been following such a policy since its inception in 1913. Price stability is inscribed in the Maastricht Treaty, and the goal of hitting a 2% CPI inflation target is a variant of this widely-held view.


Yet, this policy has been mostly responsible for the great depression that started in 1929 and the great recession that began in 2008. It is responsible for the widening growth in income inequalities (here) and the mass economic distortions of the last century. When you do not recognize your errors of the past, you are condemned to repeat them!

The purchasing power of money is determined, like most things in a capitalist system, by supply and demand. [2] Changes in the demand for money (think of shifts in the curve) are caused essentially by two forces:

The first is the subjective valuations by individuals of the value of goods and services which is reflected in the wide array of relative prices in a capitalist economy. Since these subjective valuations are constantly changing, so will relative prices and the purchasing power of money. Some prices will go up, others will fall, and the overall purchasing power of money will vary within a range which can be large or small depending on the changes in these subjective valuations. (see here)

The second is the general expansion or growth of a capitalist economy. A simple example will make this clear. Suppose we have $10 to spend on 10 apples; market forces normally will generate an equilibrium price of $1 per apple. If we double the number of apples, the individual price will fall to 50 cents and the purchasing power of money will have doubled. During the last two centuries, the growth in output of goods and services should have led to a continuous and significant increase in the purchasing power of money. This did not happen.

These changes occurring from the demand side are desirable since they reflect a capitalist system adjustment in relative and absolute prices that attempts to best meet society’s most urgent needs with available resources. Even if the supply of money was perfectly stable, the purchasing power or value of money should be expected to vary and, more importantly, be allowed to vary. Any attempt to counter these desirable changes will cause distortion in absolute and relative prices as well as interest rates. This interference will cause a misallocation of resources creating an ever-growing gap between what society wants and what is being produced. The longer the attempt to counter these forces, the large the gap and the longer the adjustment necessary to realign output with demand. By trying to keep prices stable from 1921 to 1929 and prior to the 2008 crash, the central bank interfered with these two forces: changes in relative prices and the natural tendency for the value of money to increase.

The supply of money comes from three sources. The first is additional mining, if money is a commodity, like gold. The second is the banking sector creating money out of thin air through fractional reserve banking. The third is the government engaging in legal counterfeiting (fiat currencies) or indirectly by influencing the ability of banks to create money out of thin air (or acting as a fractional reserve bank itself).

Now, the economy gains nothing directly from changes in the supply of money. There is no optimum quantity of money since any amount of money will do. Yet, changes in the supply of money alters absolute prices which will change the quantity demanded of money (think of movement along the curve) and since money enters the economy by benefiting the early recipients at the expense of the late recipients, it also alters relative prices and the demand for money (shifts in the curve) indirectly. Therefore, the best money supply is one that does not move.

The advocates for a stable purchasing power usually cite a need to counter either the additional mining of gold (under a gold standard) or changes (increase or decrease) in the money supply resulting from fractional reserve banking. What these advocates seem to miss is that it is impossible to separate or identify changes coming from the supply side and changes coming from the demand side. They occur simultaneously. Any attempt to counter changes in the supply side must interfere with changes that occur continuously on the demand side. Today’s attempts to counter the deflationary force (here and here) that occur naturally in the bust phase of a business cycle are misguided policy because central bankers are simply ignorant of underlying forces determining the value of money.

In the early years of the 20th century, advocates of sound money lost the intellectual battle to those advocating stable money. Only Austrian economists were left to defend sound money.

Sound money is a medium of exchange that enables absolute and relative prices to function the most efficiently in allocating goods and resources that best meet society’s most urgent needs. Its purchasing power is determined by markets, independent of governments and political parties. Sound money does not need, and should not be expected, to be stable. To be perfect, it should be exclusively determined by factors influencing the demand for money.

The gold standard is the closest we have come to sound money. The greatest advantage of a gold standard is to greatly limit the government’s ability to engage in legal counterfeiting. [3] This advantage more than makes up for the few shortcomings of using gold as a medium of exchange. Yet, under a gold standard, the supply of money could still vary considerably. Banks could still create money substitutes that are not 100% backed by gold. The government could also influence the money supply through the creation of unbacked money substitutes and through its influence on the banking sector. When the U.S. central bank was created in 1913, the average reserve requirement went from about 21% to 10% which caused to a surge in the money supply. Yet, during this period, the U.S. was on a gold standard. [4]

In addition, the mining of gold will add to supply. Normally, an increase in supply of any commodity is a benefit to society, since abundance is preferred to scarcity. But in this case, the value of gold is determined primarily by its role as a medium of exchange and not as a commodity.

This should naturally lead Austrian economists to also advocate for the creation of a medium of exchange whose supply is even more stable than gold: a worldwide currency built on block chain technology. If money was this crypto currency (e.g. bitcoin), counterfeiting would be impossible since there is nothing in a crypto currency to counterfeit. Banks would no longer manage deposits since deposits would reside outside these banks in crypto currency wallets. This would essentially end fractional reserve banking (here and here) and the ability of banks to create money out of thin air. What about legal counterfeiting? Normally no, but all currency systems still require governments to play by the rules of the game. The gold standard ended when the government reneged on its social contract to play by those rules.

A monetary reform to sound money would significantly boost growth, as well as significantly alter and diminish the roles of government and banks in our economy. [5]

Stable money was a chimera. It did not bring stability to the world economy. It did not counter the instability emanating from deposit banking. It actually added to the severity of booms and busts. To function efficiently, capitalism needs a foundation of sound money, not stable money.

—–

Footnotes:

1. The CPI is an inaccurate measure of a subset of all prices: everything money can be spent on. (here)

2. Bastiat understood this back in 1849 when he wrote in What Is Money?:

“a measure of length, size, surface is a quantity agreed upon, and unchangeable. It is not so with gold and silver (money). This varies as much as that of corn, wine, cloth or labor, and from the same causes, for it has the same source and obeys the same laws.”

3. Monetary policy is “econspeak” for legal counterfeiting.

4. Rothbard’s, America’s Great Depression, page 26

5. The transition period would require the government to exchange this new crypto currency, before the first transactions (the genesis block), for bank assets in a variant of the Chicago plan. (here)

Frank Hollenbeck teaches finance and economics at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and as an Associate Director of a Swiss private bank. See Frank Hollenbeck's article archives.

You can subscribe to future articles by Frank Hollenbeck via this RSS feed..

© 2016 Copyright Frank Hollenbeck - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules