The Golden Blind Spot
Off the keyboard of Monsta666
Discuss this article at the Economics Table inside the Diner
It is often said by people who support gold backed currencies that the chief weakness of fiat currencies is it encourages governments and central banks to issue excess amounts of money/credit. While this fact is true it would be a mistake to think this is the main reason why currency devaluation occurs. This is because the issues of overleveraging are primarily problems that stem from the private sector as most money generated in the economy comes from COMMERICAL banking and NOT central banking. In fact depending on sources or the countries in question the amount of money/loans generated as a result of fractional reserve system can be 97% or perhaps even higher if one includes other complex financial instruments such as derivatives in the total money supply.
This excessive money creation can lead to catastrophic results to the national currency if no measures are taken to limit this over expenditure. This over expenditure is present in all monetary systems both fiat and gold based currencies because each system operates with a fractional reserve system. The fiat currency maybe marginally worse because the central banks can encourage even more overleveraging as none of the new money issued by the central bank is bound by gold reserve requirements. This component of money creation only constitutes a small part of total money creation however despite assertions you may hear from Ben Bernanke.
Still, despite this relative small amount of money generated through QE or simple naked money printing this form of money creation can lead to some significant results. As this new money is issued it will enter the commercial banks and due to the process of fractional reserve banking this money can be multiplied creating further inflation in either the real economy or various asset classes such as houses or stocks. In fact this process is called the money multiplier effect in Monetary economics and this is one reason why this practice is promoted by Keynesian economists who wish the governments to issue some money as this printed money will be multiplied by banks by loaning this money out to its customers. Problem is, in this current recession many banks instead of lending have hoarded this money since there are no real returns on investments that can be made from these loans. Instead most of that money is gambled in the biggest casino in the world which is the stock/bond market and since there is quite a lot of excess money floating around this excess cash has the tendency of generating bubbles with overvaluations in stocks such as Facepalm.
But let us go back to the topic at hand which is the issue of currency devaluation. This process has occurred many times in the past even during the eras when countries followed the gold standard which we should note: is a point often forgotten by many people advocating a return to the gold standard. It should be remembered that the US suffered numerous financial crises in the 19th century when it did follow the gold standard, the most notable being the 1873-1879 Long Depression. Indeed this depression was known as the Great Depression until this event was supplanted by the Great Depression of the 1930s. All of which occurred during an era when all the major currencies of the world followed the gold standard.
The causes of this Long Depression are – like the great depression of the 1930s – are still debated among economists but the general problems would appear to share striking similarities. Like the 1930s depression the Long Depression came at a time shortly after a major war, increasing globalisation and most important of all excessive credit creation by the commercial banks. In the case of the Long Depression this was the American Civil War while the Great Depression had World War 1. Such wars meant that the central governments issued an excessive amount of credit to fund the war effort and this excessive spending came despite the fact the gold standard places heavy penalties on countries that do not practice fiscal restraint. This scenario of excessive credit creation coming through war would then spur further credit creation once the main commercial banks got hold off this money. In fact the money created by those banks would be a multiple of the amount of money the government printed. In any case, these wars times should be noted for the fact it is one of the few instances where governments are prepared to risk mortally damaging their currency by money creation. We need to remember they are creating money on two levels: one by direct money printing or QE and then the subsequent process of this money being multiplied by the commercial banks. This behaviour of excessive spending under this circumstance can apply to whatever monetary system is applied be it gold or fiat based currency system. This excess spending and subsequent credit expansion by commercial banks also result in the formation of various bubbles.
To say the Long Depression was caused by excessive war spending would not tell the whole story however. To not mention the next point would be to neglect raising another commonality between the two eras. That is, the immediate period after the civil war was a boom period for the US economy (which again is repeated in the roaring 1920s). This boom in both cases occurred because of an expansion in the money supply. In the case of the 1860s this money expansion came about due to the government and major private companies investing heavily in railroads. Much of those railroads were financed by loans, bonds and subsidies which in many cases were backed by the US government. These cheap loans created overinvestment in the industry and eventually lead to a bubble forming (or overcapacity). As it became clear many of these rail companies could never pay back their loans this caused many banks to fail which eventually culminated with the failure of the major banks of Jay Cooke and Henry Clews which brought the financial sector to its knees. The resulting recession would last six years and growth was below normal until after the 1890s.
Again this period of recession and sluggish growth shares a similar similarity to the Great Depression. So why bring up the point of the Long Depression and Great Depression? I think the point to take from all these events is that despite being on the gold standard (in the case of the 1870s the gold and silver standard) banks and corporations found ways of overleveraging the monetary system and the main method was by employing the system of fractional reserve banking. When those loans could not be paid back it resulted in large scale defaults which almost caused the destruction of the financial system. Now it can be argued that since a fiat currency encourages more spending (as currency is no longer bound by reserves of gold) then the magnitude of the problem will be that much greater so the level of defaults required to bring the system into balance would be greater but then the argument becomes one of a matter of degree.
The main issue I see with the gold standard – despite assertions to the contrary – is it is not immune to reckless spending. Reckless spending can come through poor lending practices and these practices have a particular tendency of loosening during WAR TIMES and BOOM TIMES. In the case of war the risk of financial collapse is acceptable to fight the war while in the case of boom times the perception of risk becomes distorted so market participants take out excessive loans thinking the risk of failure is lower than reality. This human behaviour must be accounted for when suggestions of moving to a gold standard system are ushered.
If one wants to assure there is no risk of financial mismanagement then one needs to get at the root of the problem and that is one of leverage. Every major currency in existence today follows a debt based fiat currency system with many of the commercial banks operating with a fractional reserve system. This system of fractional reserve banking is not well understood by most members of the public but most of the loans/money generated through the system comes about through here. This point is important as it is the leveraging that ultimately causes the instability in the monetary system NOT whether the currency is backed by gold or promises (as is the case in fiat).
To gain a good idea how a fractional reserve works it is best to find out how the system started in the first place. That way we can learn it simply and not be baffled and confused with all the mumbo jumbo that some smarty pants will put in front of us to confuse us. All these terms and convoluted descriptions are just smoke and mirrors to make the public feel intimidated and not ask further questions about the fraud being committed right in front of their eyes. Notice how no one actually teaches how monetary systems actually operate in school? Anyways, I digress and let us focus on the topic at hand.
The fractional reserve system originally came about when early bankers would help store pieces of gold bullion for various customers. To make transfers more convenient the early banks would issue notes which allowed the customer to redeem their gold. This meant people did not have to travel back and forth with gold bars which was a major drag (literally) not to mention quite dangerous. After sometime however the banks realised that customers would only trade these notes instead of exchanging gold directly. In fact those notes became a form of ad-hoc currency and it became apparent that the more notes that were issued the more money would be generated which meant more profit to the banks. So the banks began the path to the dark side by issuing more notes than they held in gold reserves. Thus it was the beginning of the fractional reserve banking and as the name implies, the banks only hold a fraction of the total deposits in reserves.
Once the banks had found that most people did not take out money or gold from their deposits creating excessive notes posed no real risk of them being found out or going bankrupt. However this practice did lead to the issuing of more money which while fraudulent benefited the upper class massively as it allowed them greater means to spend, invest – and most important – lend money to various major public projects. It should be remembered that most major public projects cannot pay for themselves and such projects can only be financed through debt. To see more information on this matter please refer to the three part Large Public Work series.
These extra loans also had the effect of extracting more wealth from its subjects via interest payments from the extra loans generated from this operation. As a result even though this form of fraud became known to the government it was not outlawed. Instead laws were made to limit the amount of risk such practices posed to the overall financial system. From this point onward the financial system developed extra complexity but on a fundamental level they all operate on the same premise. To many this is really a legalised system of fraud and one wonders how the general population would behave if it learnt the truth of the matter and how money really works. It is this fact why all banks are vulnerable to a bank runs because if people run to the banks in mass to collect their deposits the bank would soon become bankrupt due to lack of reserves.
In light of these facts if one wishes for stability then one needs to confront the fractional reserve system. If a person does wishes for total stability then the reserves must equal 100% of the currency available. Any leverage will create some instability and the more leveraged it becomes the greater the resulting instability. It should be noted however that the fractional reserve system – despite its obvious flaws and shortcomings – has one big advantage. This method of generating excess cash has a great effect in delivering growth for the general economy which was a great BOON to an ever expanding industrial economy. In fact if one looks at the term capitalism the main objective of this system is to acquire capital. This can be through actual assets or cash and since fractional reserve banking delivers on this objective one can see why it is so prevalent in modern economic systems. However as noted by many others this growth cannot go on indefinitely and in a contracting economy excessive credit creation can quickly become a bane to society. In fact one can easily say a fractional reserve system would not be fit for purpose for an economy that is continually contracting. In fact it would be catastrophic.
Still, one should not forget that this system must be removed if one wishes for future stability. What needs to be understood however is if one does wish for complete stability with full fractional reserve banking then one must confront several problems most of which are considerable; by moving from a fractional based reserve system to a fully backed reserved system it would mean a large percentage of the total money supply be removed or large amounts of new capital must be acquired. To take the former option of money/credit destruction would mean a massive almost total deflationary event. In other words, all current assets would lose nearly all their value. In addition since all existing loans will still remain the same in nominal terms then a massive deflationary event will mean the value of those outstanding loans would rise massively in real terms leading to large scale defaults which would create further havoc on an already overstrained system. These defaults, which are likely to be considerable, if not total, would reduce the money supply further still. In short this solution could not provide an acceptable method of returning to a fully backed reserve system.
The other option highlighted in the paragraph above is to increase the amount of capital or reserves in the system. The easiest way of achieving this feat would be through some means of issuing non-debt based money which would basically amount to a form of debt jubilee. This process of money generation would however, if left unrestrained, lead to massive inflation as a large amount of money would be spent on non-essential purchases. Even if laws were put in place to force consumers to pay back all existing debts before the money could be used for other activities it would result in a large scale deflation event as a lot of the existing debt based money is wiped from the system. This solution however would not result in larger scale defaults mentioned earlier as those debts would be expunged from the system. It should be noted that such a move would directly harm the banks as they would lose nearly all their assets and as such they could be forced into bankruptcy. Furthermore the other biggest losers would be the financial elite who hold most of the world assets. Since these people and organisations have the most influence in this current system it seems fanciful they would implement a plan that damages their interests the most. This solution has numerous proponents most notably economist Steve Keen (see 19:00 of the video).
For this solution to have a lasting effect however it would need to put a full reserve banking system in place after the debt jubilee is issued otherwise the system will fall into the same problems of excessive debt.
If such a system of full reserve banking were developed it would then lead to another problem which is a lack of growth of debt that is required for modern banking to operate. Without debt accumulation it is hard to see how banks could generate sufficient profits to remain viable. If banks do not possess the ability to create money through loans then the only income they could derive would be from service charges from holding deposits. The other possibility would be to use those existing deposits for lending to businesses and corporations who would then pay the banks with interest through means of expansion. However such a system could not operate unless there is an expansion of the money supply by a central bank or by the banking sectors growing at the expense of other industries. In any case such a system would sacrifice much growth and could still face some potential dangers in currency devaluation.
It would seem that while a transition to a more sound system is favourable it cannot realistically occur until there is a large-scale reduction in the existing money supply, loss of capital by some other means or large scale debt jubilees of which the outcome is unlikely to come and even if implemented will lead to large scale bankruptcies and possible supply-chain contagion as result of this.
One also needs to consider the possibility of a society that can be happy with a non-growth economy which would be basically be enforced by applying a full reserve banking system. This question needs to be considered under the light of growing populations and the three desires of greed, power and competitive nature of man. What are the chances some expansionary monetary system will be devised to cater to such basic desires and realities facing man in the future?