Best of the Week
Most Popular
1. TESLA! Cathy Wood ARK Funds Bubble BURSTS! - 12th May 21
2.Stock Market Entering Early Summer Correction Trend Forecast - 10th May 21
3.GOLD GDX, HUI Stocks - Will Paradise Turn into a Dystopia? - 11th May 21
4.Crypto Bubble Bursts! Nicehash Suspends Coinbase Withdrawals, Bitcoin, Ethereum Bear Market Begins - 16th May 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.Cathy Wood Ark Invest Funds Bubble BURSTS! ARKK, ARKG, Tesla Entering Severe Bear Market - 13th May 21
7.Stock Market - Should You Be In Cash Right Now? - 17th May 21
8.Gold to Benefit from Mounting US Debt Pile - 14th May 21
9.Coronavius Covid-19 in Italy in August 2019! - 13th May 21
10.How to Invest in HIGH RISK Tech Stocks for 2021 and Beyond - Part 2 of 2 - 18th May 21
Last 7 days
USDT Ponzi Scheme FINAL WARNING To EXIT Before Tether Collapses Crypto Exchange Markets - 22nd Jun 21
Stock Market Correction Starting - 22nd Jun 21
This Green SuperFuel Could Change Everything For the $14 Trillion Shipping Industry - 22nd Jun 21
Virgin Media Fibre Broadband Installation - What to Expect, Quality of Wiring, Service etc. - 21st Jun 21
Feel the Inflationary Heartbeat - 21st Jun 21
The Green Superfuel That Could Disrupt Global Energy Markers - 21st Jun 21
How Binance SCAMs Crypto Traders with UP DOWN Coins, Futures, Options and Leverage - Don't Get Bogdanoffed! - 20th Jun 21
Smart Money Accumulating Physical Silver Ahead Of New Basel III Regulations And Price Explosion To $44 - 20th Jun 21
Rambling Fed Triggers Gold/Silver Correction: Are Investors Being Duped? - 20th Jun 21
Gold: The Fed Wreaked Havoc on the Precious Metals - 20th Jun 21
Investing in the Tulip Crypto Mania 2021 - 19th Jun 21
Here’s Why Historic US Housing Market Boom Can Continue - 19th Jun 21
Cryptos: What the "Bizarre" World of Non-Fungible Tokens May Be Signaling - 19th Jun 21
Hyperinflationary Expectations: Reflections on Cryptocurrency and the Markets - 19th Jun 21
Gold Prices Investors beat Central Banks and Jewelry, as having the most Impact - 18th Jun 21
Has the Dust Settled After Fed Day? Not Just Yet - 18th Jun 21
Gold Asks: Will the Economic Boom Continue? - 18th Jun 21
STABLE COINS PONZI Crypto SCAM WARNING! Iron Titan CRASH to ZERO! Exit USDT While You Can! - 18th Jun 21
FOMC Surprise Takeaways - 18th Jun 21
Youtube Upload Stuck at 0% QUICK FIXES Solutions Tutorial - 18th Jun 21
AI Stock Buying Levels, Ratings, Valuations Video - 18th Jun 21
AI Stock Buying Levels, Ratings, Valuations and Trend Analysis into Market Correction - 17th Jun 21
Stocks, Gold, Silver Markets Inflation Tipping Point - 17th Jun 21
Letting Yourself Relax with Activities That You Might Not Have Considered - 17th Jun 21
RAMPANT MONEY PRINTING INFLATION BIG PICTURE! - 16th Jun 21
The Federal Reserve and Inflation - 16th Jun 21
Inflation Soars 5%! Will Gold Skyrocket? - 16th Jun 21
Stock Market Sentiment Speaks: Inflation Is For Fools - 16th Jun 21
Four News Events That Could Drive Gold Bullion Demand - 16th Jun 21
5 ways that crypto is changing the face of online casinos - 16th Jun 21
Transitory Inflation Debate - 15th Jun 21
USDX: The Cleanest Shirt Among the Dirty Laundry - 15th Jun 21
Inflation and Stock Market SPX Record Highs. PPI, FOMC Meeting in Focus - 15th Jun 21
Stock Market SPX 4310 Right Around the Corner! - 15th Jun 21
AI Stocks Strength vs Weakness - Why Selling Google or Facebook is a Big Mistake! - 14th Jun 21
The Bitcoin Crime Wave Hits - 14th Jun 21
Gold Time for Consolidation and Lower Volatility - 14th Jun 21
More Banks & Investors Are NOT Believing Fed Propaganda - 14th Jun 21
Market Inflation Bets – Squaring or Not - 14th Jun 21
Is Gold Really an Inflation Hedge? - 14th Jun 21
The FED Holds the Market. How Long Will It Last? - 14th Jun 21
Coinbase vs Binance for Bitcoin, Ethereum Crypto Trading & Investing During Bear Market 2021 - 11th Jun 21
Gold Price $4000 – Insurance, A Hedge, An Investment - 11th Jun 21
What Drives Gold Prices? (Don't Say "the Fed!") - 11th Jun 21
Why You Need to Buy and Hold Gold Now - 11th Jun 21
Big Pharma Is Back! Biotech Skyrockets On Biogen’s New Alzheimer Drug Approval - 11th Jun 21
Top 5 AI Tech Stocks Trend Analysis, Buying Levels, Ratings and Valuations - 10th Jun 21
Gold’s Inflation Utility - 10th Jun 21
The Fuel Of The Future That’s 9 Times More Efficient Than Lithium - 10th Jun 21
Challenges facing the law industry in 2021 - 10th Jun 21
SELL USDT Tether Before Ponzi Scheme Implodes Triggering 90% Bitcoin CRASH in Cryptos Lehman Bros - 9th Jun 21
Stock Market Sentiment Speaks: Prepare For Volatility - 9th Jun 21
Gold Mining Stocks: Which Door Will Investors Choose? - 9th Jun 21
Fed ‘Taper’ Talk Is Back: Will a Tantrum Follow? - 9th Jun 21
Scientists Discover New Renewable Fuel 3 Times More Powerful Than Gasoline - 9th Jun 21
How do I Choose an Online Trading Broker? - 9th Jun 21
Fed’s Tools are Broken - 8th Jun 21
Stock Market Approaching an Intermediate peak! - 8th Jun 21
Could This Household Chemical Become The Superfuel Of The Future? - 8th Jun 21
The Return of Inflation. Can Gold Withstand the Dark Side? - 7th Jun 21
Why "Trouble is Brewing" for the U.S. Housing Market - 7th Jun 21
Stock Market Volatility Crash Course (VIX vs VVIX) – Learn How to Profit From Volatility - 7th Jun 21
Computer Vision Is Like Investing in the Internet in the ‘90s - 7th Jun 21
MAPLINS - Sheffield Down Memory Lane, Before the Shop Closed its Doors for the Last Time - 7th Jun 21
Wire Brush vs Block Paving Driveway Weeds - How Much Work, Nest Way to Kill Weeds? - 7th Jun 21
When Markets Get Scared and Reverse - 7th Jun 21
Is A New Superfuel About To Take Over Energy Markets? - 7th Jun 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Can Gold Cause the Boom-Bust Cycle?

Economics / Business Cycles Jun 28, 2010 - 08:55 AM GMT

By: Robert_Murphy

Economics

Best Financial Markets Analysis ArticleAt the Mises Academy we are just wrapping up the inaugural class, on the Austrian theory of the business cycle. During the class, one issue that came up repeatedly was whether the Mises/Hayek story of the trade cycle could occur on a completely free market, using gold as money and a banking system that operated on 100 percent reserves.

As any good (and annoying) teacher would, I avoided giving a definitive answer one way or the other. Instead, I tried to give the best possible case for each answer, to prod the students to think it through for themselves. In this article, I summarize how even a Rothbardian could plausibly answer this question either in the affirmative or the negative.


Review: ABCT under Fiat Money and Fractional-Reserve Banking

Before jumping into the hard case, let's do the easy one first. According to Mises, Hayek, and Rothbard, the modern commercial banking system triggers the familiar boom-bust cycle when it floods the credit market with "excess" money.

Suppose we have an economy that is originally in equilibrium, where the interest rate reflects the genuine amount of savings that private individuals are taking out of their incomes. Suddenly, the commercial banks decide to grant $100 million in new loans even though this new credit doesn't correspond to anyone's extra saving. (I describe the process here.)

Because of the greater supply of credit, the market interest rate drops. This "false signal" leads entrepreneurs to borrow more funds and start longer projects than they otherwise would have. A false, unsustainable boom starts, giving most people an illusory sense of prosperity.

Later on, when the banks become worried about rising price inflation, they will slow down or even reverse their injections of unbacked new money. The market interest rate will rise back toward its correct value, and many businesses will be caught with their pants down. They'll need to reduce output, or even shut down altogether. Workers and other resources will be released from those sectors that were stimulated the most during the boom. A general bust or recession sets in.

What If Gold Is Money, and Banks Maintain 100% Reserves?

Now the hard part: Suppose we were in a dream Rothbardian world, where gold itself is money—price tags are quoted in ounces of the yellow metal, people walk around with actual gold coins clinking in their pockets, and so forth. Furthermore, the banks practice 100 percent reserves with their demand deposits (checking accounts).

In this scenario, isn't it theoretically possible that the Misesian boom-bust cycle could still occur? Specifically, suppose that the owner of a gold mine stumbles upon the mother lode. In a very short time, he gains physical possession of several tons of new gold that nobody knew existed the month before.

Instead of going to the casino or the yacht dealership, the gold miner goes to his bank and explains, "I am lending you this new money. I recognize that you run a tight 100-percent-reserve ship, but I am adding this to my savings account, not my checking account. I know that I am giving up my money now, in exchange for your promise to pay me back the loan, with interest, down the road."

Now the bank can enter the credit markets with a huge influx of loanable funds. This new supply of savings will clearly push down the market rate of interest, allowing many businesses to expand and start long-term projects that were unprofitable before the gold discovery.

We finally see the conundrum: Is this an example of an unsustainable boom? After all, nobody in the community restricted consumption in order to free up physical resources. So how is this scenario essentially different from the case where the fractional-reserve bankers simply create new loans out of thin air?

As I explained in the introduction, I am not here to say what the definitive answer to this question is. I want to show that one could give a fairly "Rothbardian" answer that goes either way. I think modern Austrians who subscribe to Rothbard's 100-percent-reserves dictum might come down on different sides of this question.

Door #1: The Gold Influx Would Cause an Unsustainable Boom

Both Mises and Rothbard viewed interest as a "real" phenomenon. They both argued that in the undisturbed market economy, the "natural" interest rate reflects the subjective preferences people have for consuming sooner rather than later.

Mises and Rothbard also stressed the point that there was no "optimum" quantity of money. Any amount of money could perform its services as a universally accepted medium of exchange, once prices adjusted. The community would obviously grow wealthier (per capita) if farmers harvested more wheat, or if musicians held more concerts. But if the government printed up more paper money, this didn't make the community richer on average, because the same amount of real goods and services were produced. The new money simply raised prices.

Indeed, even in the case of a commodity money such as gold, new quantities delivered to the market did not make the community richer, except insofar as the new gold was used for industrial or commercial applications. For example, if some of the newly mined gold went towards arthritis treatment, or toward the production of more necklaces, then this increase would be socially beneficial. But the crucial point is that in its monetary capacity, five million tons of gold is just as useful as one million or ten million.

After stressing these standard Misesian and Rothbardian insights on the nature of interest and money, one could very plausibly argue that our mother-lode scenario would trigger an unsustainable boom. After all, suppose the gold miner didn't dump the new tons on the credit market, but instead spent them on consumption goods. Clearly this would just redistribute wealth from the rest of the community into the hands of the miner.

Consider: The total production of cars, food, clothing, and houses wouldn't go up simply because someone stumbled on a bunch of yellow metal. Therefore, the increased consumption of the gold miner could only come at the expense of others in the community, who did not get their hands on the new gold until late in the game.

Note that there is nothing unethical or dubious about a gold miner spending his justly acquired property in order to boost his consumption. We are merely arguing that this extra gold "production" is not socially useful in the same way that extra production by the farmers or dentists would be.

If we can see that spending the new gold on consumption would merely rearrange the same total quantity of real goods and services, then it is clear that the community's real income hasn't risen on account of the discovery of the mother lode.

Finally, if the analysis so far has been correct, then it obviously follows that if the gold miner takes his new money and lends it out at interest, he will distort the production structure away from its proper configuration. At the lower interest rate, businesses will borrow more money (consisting in ounces of gold) for investment spending. Yet nobody in the community will have cut back on consumption just because some guy happened to stumble on a few tons of new gold. If anything, people will consume more once interest rates drop.

Thus we see that a standard Rothbardian analysis could very plausibly conclude that a boom–bust cycle is theoretically possible on a free market.

Door #2: An Unsustainable Credit Expansion Can't Happen on a Free Market

Although the above analysis was purposely constructed along Rothbardian lines, it presents a problem: Murray Rothbard thought that the boom-bust cycle could not possibly happen on a genuinely free market. That's why he placed the analysis of Austrian business cycle theory in the section dealing with government intervention in his treatise Man, Economy, and State.

To my knowledge, Rothbard never specifically addressed the theoretical scenario we are imagining in this article. But if a Rothbardian wanted to deny that a free market could lead to a boom-bust cycle, even under these hypothetical conditions, how might he argue?

First, let's be a bit more concrete in our description of the normal, month-to-month operations of the gold miner. Other businesses collect payment from their customers in physical gold, and they pay their expenses the same way. At the end of each month, the net income of the business is the excess revenues over expenses, measured in gold ounces.

But for the man who owns a gold mine, things are different. He has to pay employees in gold ounces (or grams), and he has to pay for his electricity, gasoline, and other inputs with gold ounces too — just like any other businessman.

The difference is that the revenues of the gold miner come, not from paying customers, but from the new gold that is brought to the surface. In this hypothetical economy, the man is literally finding money buried in the ground. After suitably polishing it up (and perhaps having someone turn it into recognizable coins), these hunks of yellow metal are perfectly interchangeable with the other units of money in people's pockets.

Now we have to ask: is there anything odd or illegitimate about this constant stream of income for the gold miner, month after month? After all, he is able to use his gold production each month to pay his business expenses and to enjoy a nice lifestyle himself.

When push comes to shove, it is hard to see how a Rothbardian could, in any way, object to the miner's real income (assuming he had acquired ownership to the mine in a legal and proper fashion). In the first place, the new gold lowers the purchasing power of an ounce of gold, allowing everyone to benefit more readily from gold's nonmonetary uses (dental work, jewelry, etc.).

If we try to argue that the portion of gold that goes into cash balances (as opposed to necklaces and tooth fillings) is somehow socially useless, we run into the problem that these transactions occur on a voluntary basis, and the people trading for the gold would definitely report that they gained from the exchange.

"It's not our job as economists to say whether the customers' preferences are 'legitimate' or 'socially useful' from some objective standpoint."

Generally speaking, Rothbardians don't think economic science can deny the social utility of an exchange, so long as it is truly voluntary and no one else's property rights are violated. If a producer wants to burn half his coffee crop in order to extract more revenues from his customers, Rothbard has no problem with that outcome — again, so long as the government plays no part in the restrictive policy.

In this light, then, it's hard to see how a Rothbardian could claim that the gold miner's net income is somehow less deserved or "real" than anyone else's. After all, a Rothbardian would say that a fortune teller's monthly income is due to her "marginal productivity," as measured by her customers' willingness to pay. It's not our job as economists to say whether the customers' preferences are "legitimate" or "socially useful" from some objective standpoint.

If we've come this far, it's a short step to say that a massive gold discovery doesn't change the essence of the argument. If it's perfectly legitimate and "efficient" for the gold miner to bring, say, 1,000 new ounces of gold to market every month, there's no reason our opinion should change if he suddenly brings 10 tons of gold to market. That is still his income, and the community is that much richer, in nominal terms.

It's true, we might quibble and say in real terms — adjusted for price inflation — the community isn't richer. That is fine. We can look at the increase in the gold prices of milk, eggs, gasoline, and so forth, to account for the fact that a new influx of 10 tons of gold will cause (gold) price inflation. That still doesn't change the fact that the gold miner's nominal income was what it was, and is just as legitimate as it would have been had he only brought 1,000 ounces of gold to market, as usual.

We've finally reached our destination: If we accept that the gold miner's nominal income — measured in gold — is every bit as "legitimate" as anybody else's, then if he decides to save 9.5 tons of his new gold holdings by lending them out, it is perfectly accurate to say that the amount of savings in the community has increased.

Again, if we wish we can bring up the distinction between nominal and real (price-inflation adjusted) savings, but as good Misesians we must not lose sight of the "driving force of money." We can't fall into the mainstream trap of thinking about the economy as a set of "real" exchanges, and then throwing money on as an afterthought. Yes, the new influx of gold will drive up the gold-prices of goods and services in the community, and this rise in prices will cause lenders to insist on a higher nominal interest rate than they would otherwise. This inclusion of a "price premium" in the gross-market interest rate will work in the opposition direction of the increased savings, keeping the interest rate from falling as much as it otherwise would have.

In any event, it is difficult to see how a Rothbardian could claim that the gold miner's actions — bringing new gold to market, which everyone is eager to acquire, and then deciding to save a large portion of his windfall income, rather than blowing it on Caribbean cruises — are somehow detrimental to the rest of the community.

Rothbard argued against the very concept of a negative externality, so long as everyone's property rights were respected. The "correct" market interest rate in our hypothetical scenario would be just as we have described — it is the interest rate that would spontaneously emerge from the voluntary trades of everyone in the community, including the gold miner.

Conclusion

In this essay I have deliberately ignored certain tensions between the two sides, lest I come down one way or another on the issue. We know that it can't be the case that the two trains of thought above are both correct, because they lead to opposite conclusions. And yet, the reader must agree that each is a plausible application of Rothbardian thought.

In the real world, of course, the real danger of credit expansion and the boom-bust cycle comes from fiat money and fractional-reserve banking. Yet it is still important for economists in the Austrian tradition to think through hypothetical scenarios in order to refine our thinking and weed out any inconsistencies in our principles.

Robert Murphy, an adjunct scholar of the Mises Institute and a faculty member of the Mises University, runs the blog Free Advice and is the author of The Politically Incorrect Guide to Capitalism, the Study Guide to Man, Economy, and State with Power and Market, the Human Action Study Guide, and The Politically Incorrect Guide to the Great Depression and the New Deal. Send him mail. See Robert P. Murphy's article archives. Comment on the blog.

© 2010 Copyright Ludwig von Mises - 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