Thursday, May 5, 2011

Gold as money? Are you mad?

In the USA and many other countries, we have to go several generations back to find people that actually used both gold and silver coins as money instead of government printed money. This is an important fact to mention as this implies the great majority of today's population look at gold as money from a perspective where they know only about paper money. Several misconception or lack of understanding about money comes from this narrow perspective. In this article, I want to address the most prevalent ones and allow the audience the opportunity to see it from another perspective.
As I stated in another post before, one of the best way to fight the great divide between the rich and the poor is using sound money (concentration of wealth is more acute today than in the past). Government paper money has come in 2 forms in history, either directly printed by the government such as Lincoln's greenback during the American civil war, or via a central bank. By extension, we can include ancient civilizations where their governments (or kings) were debasing their coins with cheaper metals, hence similar to a government directly printing its money (or debasing). Central banking came up for the first time with the Bank of England in the 17th century where a central bank with the monopoly on money prints the money out of thin air and lends it to the government who in turns spends it. This requires the government to pay back the interest on that money, but usually some of that interest is returned to the government. Still, part of that interest flows to the banking corporations owning part of the central bank. Central banking is more subtle and complex but quite more interesting for the bank as we will illustrate in a future post. But in both cases, the poor are the one who will suffer the most as they are the least able to protect themselves from this printing. Essentially, all those government programs to help the poor and some of the middle class are actually paid by the poor and the middle class. When considering the drawback of a monopoly when the government is the sole provider of the service, the overall deal is more a loss than a gain for the poor and nearly all of the middle class.

But let's come back to gold.

If we use gold and silver as money, prices will decline as there is not enough gold. That's bad isn't it!?
It's bad if we are in debt, but good otherwise, as any computer buyers would tell you. Prior to the creation of the Federal Reserve, people were buying houses and cars full cash. It was mainly companies and industries that were getting loans for improving their facilities and increase their productions. Savings was not a losing gain but rather a real pay off since all the technological improvements made everything cheaper - in gold. Any workers would save up 10% or more of their paycheck and then spent it on the car or the house. If they decided to deposit it at a bank and collect interest, the gain was even more - as long as they chose a bank that was making loans to sound companies. Houses build would get even better with even better material with the same price or perhaps even lower price, but since the builders would too enjoy price deflation, they would be able to still make a profit.

If we used gold, it would limit growth in the economy isn't it?
The capacity of the economy is limited by the resources available (human labor and material) to it as well as the new machinery's and tools that can be developed to increase its performance. It would be time consuming initially for Robinson Crusoe, stuck on the island, who needs to knock down coconuts by climbing on each tree until he takes the time to develop some long perch that will help him knock them down from the ground. This applies to an economy as well with new industrial tool and system. That we print more paper money will not change such capacity. If many savers decide to save their gold coins under the bed rather depositing it at the bank to make new loans, such high saving rate hidden from the system would lower the price of everything, making the little amount of gold coins left more valuable for the borrowers (companies) who get them. In essence, the scale is adjusted with the available gold coins in circulation. When the companies increases its output from the new tool/system, more products can come up and those savers might become spenders - buying these new products made in much larger quantities. You suddenly have more products and more gold coins, but it will keep adjusting. The key is the resources available can only vary so much, and a fixed amount of gold, or somewhat increasing via gold mining, will reflect it.

How will governments be able to spend without higher taxes?
I admit, the question is silly, but I've added it to show that it governments would not be able to lie anymore about where the money comes from. Politicians are humans and they love power and it is the very reason they are attracted to politics. To get elected to power or to stay in power requires making and giving promises, spending in favor of a given electoral group. But taxing is not seen favorably by the electors and the amount of taxes required are likely not enough to match the spending. Borrowing is the way they use, but this increases interest rate in an environment with gold as money. The government has to compete with corporations that borrow to improve their manufacturing. More demand, higher interest rate and hence, the government is locked up in higher payments.

One of my favorite: Gold could not be used as money, there is not enough gold
At this current price, that's true. If tomorrow gold was the standard world money (along with any other metal the market would choose), its value would increase to match the true amount of wealth it can be used for exchanges. Note also that its current price is undervalued because of government suppression (see for more info). Instead of the typical standard family homes selling for about 120 ounces of gold, it would sell for 1 ounce of gold. Likely, we might be talking about grams of gold which is a smaller unit. Basically, the market will naturally adjust its value to match the need of the market, with supply and demand.

Why is paper money more bad for the poor and the middle class?
I don't want to mean all of the middle class, but a large majority of them. In essence, the middle class would be in a better position if not for paper money, even though most would disagree with this statement. To illustrate the reason, we have to understand how the money flow. When money is printed, it will lose value but this devaluing is not shown equally across the board. The monetary system we have today creates paper money out of thin air via 2 ways:
  1. Commercial banks when they print money via fractional reserve banking on a new loan for either a business or an individual.
  2. The central bank when it buys treasury bonds from the federal government.
Fractional Reserve banking is like an inverse pyramid. A few dollars at the bottom creates 10 times more dollars at the top and commercial loans are on the top of the money printed by the central bank when it buys treasury bonds.
This means the very first class of goods and services that this new money from commercial bank affect are the asset class: stocks, bonds and real estate. If the interest rate is lowered too much, it allows easy lending and hence, a runaway bubble leading to a market crash (think late 1920s after the low interest rate allowed for investors to borrom money to buy stocks - or early 2000s for real estate).
Wouldbe homeowners bid up prices as the interest rates are artificially lowered down. Too many are required to take ever increasing loans to afford a house,... until the bubble burst.

The same as when the soviet unions had politburos figuring out how much of toothpaste or carrots had to be produced rather than letting the free market decide, the same applies to interest rate which is the rent on money. It inevitably leads to misallocation.

I will add more points if I read comments with other questions that require so.
Other interesting articles:

Thanks for reading.
Take care

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