Reserve-Based Currency vs. Precious Metals-Based Currency (Part 1)
Part 1 of this series will first examine how the current monetary system and examines the consequences of its abandonment. by Bill Gee
(centrist)
Thursday, February 10, 2011
In two recent columns, "Is Austerity Doomed?" and "Message to Youth: Create Your Own Jobs!" Walt Thiessen, founder and administrator of Nolan Chart, suggested that the problems of government debt, job creation, etc. can be traced to our economy's embrace of what he termed "debt-based currency". Instead, he proposed that we abandon the current system in favor of a precious metal-based currency system similar to the gold standard, which was completely abandoned in the early 1970's.
At first, I thought he was crazy and I said so much in my response to him. He then provided some evidence to support his theory as well as a book he had written on the subject. (The book is a work of fiction, but it was based on extensive research) Therefore, I had to concede that the idea must not be as crazy as I originally assumed. Therefore, for the benefit of the readers of Nolan Chart, we will attempt to settle this debate - or at the very least, present both sides so that you can make an informed decision for yourself.
In this first column, I will present the current thinking on the matter of currency. I will be basing my presentation on conventional Macroeconomic theory, which is presented in most economic textbooks. As you can see, this column is quite lengthy due to the complexities of the issue, and I promise that I am only providing you the minimum highlights.
The following passage comes directly from Chapter 31 of Principles of Economics, 18th Edition, by McConell, Brue and Flynn. The passage is an introduction to the concept of money, specifically how money derives its value in the economy.
Paper currency and checkable deposits have no intrinsic value. A $5 bill is just an inscribed piece of paper. A checkable deposit is merely a bookkeeping entry. And coins, we know, have less intrinsic value than their face value. Nor will government redeem the paper money you hold for anything tangible, such as gold. To many people, the fact that the government does not back the currency with anything tangible seems implausible and insecure. But the decision not to back the currency with anything tangible was made for a very good reason. If the government backed the currency with something tangible like gold, then the supply of money would vary with how much gold was available. By not backing the currency, the government avoids this constraint and indeed receives a key freedom - the ability to provide as much or as little money as needed to maintain the value of money and to best suit the economic needs of the country. In effect, by choosing not to back the currency, the government has chosen to give itself the ability to freely "manage" the nation's money supply. Its monetary authorities attempt to provide the amount of money needed for the particular volume of business activity that will promote full employment, price-level stability, and economic growth.
Nearly all today's economists agree that managing the money supply is more sensible than linking it to gold or to some other commodity whose supply might change arbitrarily and capriciously. For instance, if we used gold to back the money supply so that gold was redeemable for money and vice versa, then a large increase in the nation's gold stock as the result of a new gold discovery might increase the money supply too rapidly and thereby trigger rapid inflation. Or a long-lasting decline in gold production might reduce the money supply to the point where recession and unemployment resulted.
In short, people cannot convert paper money into a fixed amount of gold or any other precious commodity. Money is exchangeable only for paper money. If you ask the government to redeem $5 of your paper money, it will swap one paper $5 bill for another bearing a different serial number. That is all you can get. Similarly, checkable deposits can be redeemed not for gold but only for paper money, which, as we have just seen, the government will not redeem for anything tangible. (McConnell, et al, 2009, p634)
Therefore, the dominant economic culture suggests that money's Acceptability, Legal Tender and Relative Scarcity are all the "backing" it needs. Every major currency in the world has accepted this view, and the modern banking system depends on it.
There are three major flaws to this paradigm of the value of money, all of which can be mitigated by a central bank (i.e. The Federal Reserve) if the entity is nonpartisan, and works diligently towards maintaining a target rate of economic growth so that the economy does not overheat or slow down too much.
Faith
Any given currency has value as a medium of exchange if the government that backs it maintains legitimacy in the eyes of its people and of the rest of the world. There is a good reason why Egypt has not opened its Stock Exchange and currency markets for the last three weeks. While the unrest continues, Egypt's government is facing a legitimacy crisis, which can result in a massive devaluation of its currency. The United States currency is also facing a legitimacy crisis as it becomes more and more unclear as to whether the US Government will be able to pay their obligations in the long run, which will run counter to the Government's ability to guarantee the currency's value.
Inflation Control
The passage assumes that the Federal Reserve has strict controls over the money supply, and therefore can control inflation. Its tools include the control of short-term interest rates, the setting of Reserve Requirements for banks that lend money and they control the actual printing of paper currency. Lately, they have also gotten into the game of buying US Treasury bonds by using cash derived from "whole cloth". Unfortunately, most of the money that is created in the economy these days is created by banks, not the Fed. Here is a quick illustration:
For simplicity, we will assume a Reserve Requirement of 10%.
Jim deposits $100,000 into his local bank.
The bank deposits $10,000 into the Federal Reserve Bank to meet its reserve requirement, and loans $90,000 to Jill, a small business owner.
There is now $190,000 in the money supply because Jim still owns the money in the bank, which he can withdrawal at any time because his deposit is FDIC insured. Jill has $90,000 that the bank gave her, which she spends to expand her business. She will eventually pay that money back with interest, which the bank will then lend to someone else.
This gets a LOT more complex when you add in the games that brought about the Financial Crisis. Aside from adjusting the Reserve Requirement and adjusting interest rates so that Jill would be less inclined to either take out a loan or limit the amount the bank can give out as a loan, the Fed really does not have a lot of control over the creation of money.
Politics
The Federal Reserve is supposed to be non-partisan. The President appoints its Board of Governors for 14-year terms, and every two years, one of the Governors is selected to serve as the Chair by the President. The bullish Alan Greenspan steered the Fed into ever-expansionary monetary policies that were encouraged enthusiastically by both Clinton and Bush. Ben Bernake's tenure has been marked by lowering interest rates to historic levels and pumping money into the money supply, which is more than all of his predecessors combined and all at the urging and support of the White House. Although Republican Presidents first appointed both Greenspan and Bernake, both Democrats and Republicans seem to benefit from an economy that is always expanding rapidly and without constraint.
Abandon at Your Peril
Despite the obvious flaws of the current system, most economists agree that abandoning the system now would be a disaster of global proportions. This includes major disruptions to International Trade, the inability of any nation to pay its debts, a recalibration of equity and bond markets resulting in multi-trillion dollar losses.
Trade Disruptions
International Trade is an intensely complex system that is based primarily on the "Comparative Advantage Theory", but is further complicated by changing exchange rates, Futures Markets, tariffs and trade quotas. To add some consistency to this chaotic market, trade is conducted in dollars (primarily US dollars). With an ever-expanding world market, there is a constant need for additional dollars to be generated into the system that is not constrained to a finite supply of gold or any other precious metal. Should the world suddenly abandon the current monetary system, it is likely that International Trade would grind to a halt, thousands of companies that depend on trade would go out of business overnight, and millions who depend on trade for their very survival would starve.
Government Debts
Governments generally have two primary sources of income: Taxation and Bonds. A true Keynesian economist would argue that in times of recession, governments need to spend more than they collect in taxes and then pay off the debt by raising taxes when times are good. Unfortunately, our government's fiscal policy for the past sixty years has been to lower taxes to stimulate the economy when times are bad, and then leave them alone or lower them further when times are good. In addition, entitlement programs in all industrialized nations have placed enormous spending burdens that are nearly impossible to pay for with tax revenues alone.
Today, investors purchase Treasury Bonds that pay a fixed interest rate in six-month to 30-year durations and those bonds provide a reliable source of investment income for those investors without any risk of default. Therefore, an enormous market for US Treasuries exists that make up the sum total of our National debt. Unconstrained money is the key to both allowing governments to pay their obligations and it is the key to eventually paying down the National Debt. Should the world suddenly abandon the current monetary system, no government would be able to generate enough precious metals to pay their debts, which would lead to massive defaults as investors lose Trillions of dollars in balance sheet values.
Equity and Debt Markets
Global corporations have four primary sources of liquidity: Net Sales, Investment Income, Equity sales, and Debt sales. Net Sales = Total Sales minus Total Costs. Investment Income is the income derived from the purchase and sale of Stocks, Bonds, US Treasury Bonds, Mutual Funds, Derivatives, etc. Equity sales is the income derived by selling a portion of its ownership to investors in the form of company stock. Debt sales is the income derived from the sale of corporate bonds, similar to US Treasury Bonds. The Equity and Bond Markets represent a multi-Trillion dollar industry and is itself a generator of money into the money supply.
Almost every person in the industrialized world directly benefits from this market. These include Insurance Policies, 401K Retirement accounts, 523 College Savings plans, Pensions, Mortgages, Student Loans, etc. Should the world suddenly abandon the current monetary system, the flow of credit, which is essential for this system to work, would stop as the market struggles to take an inventory of currency supply. Payments would stop, the value of current investments would come into question and millions, if not billions of people would lose their jobs. We came dangerously close to this condition in 2008 when the value of the mortgage bond market came under question, so just imagine if the entire equity and bond market were faced with similar uncertainty.
The Devil You Know
If the supporters of a precious metal-based currency can come up with a way to unwind the current economic system without the dire consequences described above, I think we would be willing to listen. We can all agree that the current system has gotten out of control; we need drastic reforms in order to avoid another meltdown. However, unless we are willing to "throw the baby out with the bathwater", the current system is all we have to work with and we cannot and should not be looking back.
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Posted By: Walt
Date: February 10, 2011 03:03:49 PM
Your fellow centrist economists would be proud, Bill! You have cogently and eloquently presented the status-quo, pro-reserve case.
In order to give a full reply to your article, as well as to write a full article of my own, I think I'll reply in two articles. The first will be my point-by-point rebuttal. The second will be the case in favor of competing precious metal currencies. I hope to have them up within 2-3 days. When I do, I'll link to them from an update of this comment, to help readers who want to follow the debate get to the next articles easily.
