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A Return to the Gold Standard

This article was written by in Economy, Featured. 78 comments.


Robert Zoellick, president of the World Bank, is concerned about the future of our global monetary system. Once upon a time, every dollar in the United States needed to be backed by gold and silver because these metals were said to have intrinsic value. If the world is losing faith in the U.S. dollar as a reserve currency, would it be a good move to move back to gold, the standard for much of monetary history?

There isn’t enough gold in the world to cover the money supply. After Zoellick’s remarks, the trading price of gold shot past $1,400 per ounce as traders speculated what could happen if the gold standard returns. Demand would skyrocket, supply wouldn’t change, and the price would soar. Anyone owning physical gold, which would suddenly become necessary for governments who need to hold reserves, would be able to sell at an incredibly high price.

I’m not running out to buy gold. A return to the gold standard is highly unlikely. The United Nations and the G20 have been tossing around the idea of using a basket of currencies or a new international currency to stabilize the world’s financial system, and if anything changes, that seems more likely than going back to an abandoned monetary policy.

Are you buying gold with the hope that the value will continue increasing?

Updated November 13, 2010 and originally published November 9, 2010. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @ConsumerismComm on Twitter and visit our Facebook page for more updates.

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About the author

Luke Landes, also known as Flexo, is the founder of Consumerism Commentary. He has been blogging and writing for the internet since 1995 and has been building online communities since 1991. Find out more about him and follow Luke Landes on Twitter. View all articles by .

{ 78 comments… read them below or add one }

avatar Kevin @ Thousandaire.com

Gold only has value because people believe it has value; the same reason the dollar has value. Gold doesn’t really serve a practical purpose, so the intrinsic value just doesn’t exist in my opinion.

So no, I’m not buying gold. I don’t make a habit of purchasing anything when it is at its all time high price. Buy high, sell low isn’t usually a good idea.

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avatar David

“Gold only has value because people believe it has value; the same reason the dollar has value.”

The difference is that the government can print as many dollars as it likes (debasing their value), but it CANNOT print as much gold as it likes.

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avatar Apex

everyone always makes this argument like people sit around with piles of cash. Most people have very little cash or cash equivalent assets. People have houses, cars, stocks, real estate, all of which go up in value if the govt debases the currency, and they have lots of debt which goes way down in cost if the govt debases the currency. So if you have assets purchased with dollars you don’t care what happens to the dollar and if you have lots of debt a dollar debasement is to your benefit. Why gold is the one asset that everyone says is necessary to avoid a dollar debasing inflation can only be explained by the mental defect that has people enamored with gold.

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avatar kyle

What do you buy? nearly everything is at an all time high…if gold doesn’t have any value then why has it remained “money” for thousands of years?

Gold is a place to store wealth. I see no intrinsic value in worthless paper dollars…you can’t eat your house, you can’t eat stock investments, you can’t eat land or bonds but you can trade a 1/4 oz of Gold for food…inflation, which is coming like a freight train, is going to make the dollar just another failed currency, the price of food will be so high people will be rioting in the streets. This has all happened before in Germany in the 1930s and it’s happening again today right before our eyes…so if you want to see where America is headed we have a historical picture before us in pre-Nazi Germany. Just look at the price of gold today Nov. 9 201, $1420…and going straight up…this can tell us only one thing, INFLATION at a rate unseen in America.

Enjoy the ride because it’s going to get scarey.

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avatar Will @ HackingTheBank.com ♦258 (Nickel)

You say that you can’t eat investments, but then point out that you can trade gold for food. I’d also like you point out that you can’t eat gold. You can also trade your investments, real estate and bonds for food.

Telling people to invest in something because it’s going straight up is poor advice. As an investment goes up in price, it’s return is mathematically getting worse. This math is much cloudier when we’re discussing a speculative investment that doesn’t give off any cash flow.

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avatar TakeitEZ ♦549 (Dime)

I agree with Kevin. I would not buy something, gold in this case, at their all-time high. Plus I don’t really know enough about it to make a wise decision :)

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avatar RJ Weiss

Still not buying gold.

I agree with Warren Buffett’s latest remarks on gold… http://money.cnn.com/2010/10/18/pf/investing/buffett_ben_stein.fortune/index.htm

I quote:

“Look,” he says, with his usual confident laugh. “You could take all the gold that’s ever been mined, and it would fill a cube 67 feet in each direction. For what that’s worth at current gold prices, you could buy all — not some — all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”

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avatar eric ♦1,549 (Half-Dollar)

I’m guessing the answer is not the big cube of metal :)

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avatar Apex

The idea of returning to the Gold Standard is an indication of a mental defect. We used to barter with chickens. Maybe we should return to the chicken standard. The gold standard is an old antiquated concept that is not remotely feasible using a limit supply asset in today’s ever expanding economies. Anyone who suggests it can be immediately dismissed as not having a serious understanding of how the monetary system as it is today actually functions.

Likely if you dig deeper you will find that those who suggest it are often times doomsday alarmists who think that Gold is the solution to all of our economic problems. The exact kind of simplistic thinking that appeals to the general population because they like to believe there are silver bullet solutions to complex problems.

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avatar BFskinner

Gold was a “standard” very, very recently….and for thousands of years before. Continuously…with no interruptions. It was the “it” even though other things were bartered, gold was the thing that all agreed upon.
Dollars are printed at the whim of men. That’s a problem. (as is now evident)
National banks are buying gold. Why? Seriously, why would they buy an antiquated relic of a mental defect? The stability of dollars is now being questioned world wide at the highest levels (very, very recent news on just this thing).
What would you suggest? a) it has to be in limited supply, b) it can’t be produced heavily on a political whim, and c) and it should preferably an already “known” thing

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avatar Apex

National Banks are buying gold and that is an argument against mental defect? The same banks that handed money out to people with a pulse who had no ability to pay it back? Yes if national banks are doing it, then it must be smart.

What would I suggest? Dollars! Use dollars to buy things. Don’t hold dollars, hold things. Things will retain their value regardless of what happens to dollars.

Being of limited supply is not only not necessary its the downfall of any hard asset based currency. It worked in antiquity when there were more buffalo than people. It sort of worked in the 20th century but we had to abandon it because we could not longer pretend that we could peg the value of 35 dollars to one ounce of gold. The economy is growing and expanding rapidly. If all money is based on a limited supply asset that cannot expand how is that supposed to work when there are twice as many people and the economy is twice as productive. We would then have need for 4 times as much capital but we would be fixed to a currency that cannot grow with the economy’s demand for it.

Gold itself my or may not be a good investment or store of value at any given time (although silver has been a far better store of value over the last century than gold so why is gold so special). However there can be no doubt, that those who advocate a return to the gold standard where our dollars are actually back by bars of gold sitting in a vault in fort knox and pegged to a price is a serious mental defect. I have never once heard a coherent explanation of how that would work with an ever expanding demand for capital and its demands on the supply of gold. I am always open to being enlightened so perhaps you have the details all worked out that will unify the entire theory and show how we can fix our dollars to a fixed amount of a fixed asset and support an ever expanding and growing population and economy.

Waiting ….

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avatar Aaron

Apex,

To be honest, I have never understood the assertion that an expanding economy needs more currency. If the amount of currency was fixed, prices would decrease as goods and services became more abundant. This is the deflation that Rassah and I are discussing a little bit further down.

So… if a McDouble is $1.00 today, and the amount of currency is fixed as the process of making McDoubles becomes more efficient, a McDouble would cost $0.75 after 10 years. This would not keep anyone from buying or selling McDoubles (or anything else), however. We would need smaller and smaller divisions of currency, rather than larger and larger ones as in our current system.

Finally, it seems like I am not richer if I have $1.25 and that buys one McDouble than I am if I have $1 and that buys one McDouble. Similarly, I am not poorer if I have $0.75 and that buys one McDouble than if I have $1.00 and that buys one McDouble. The only difference is that in the first situation, I am encouraged to buy the McDouble before it goes up in price, and in the second, I am encouraged to save my money, or maybe spend it on something cheaper than the McDouble, because whatever I save will increase in value.

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avatar Apex

Well that’s a new one. Argue against the expanding currency base by arguing for deflation. Haven’t heard that one before but what they heck, anything goes I guess.

Deflation destroys an economy. Every economist, politician, business person, and debt holder is scared to death of it. It encourages people to not spend now but wait until later. It crushes the use of credit and debt for economic expansion and as such suffocates economies. No one wants to take on debt let alone pay interest for it when the cost of that debt gets greater with time not less. Let alone the value of the products you produce with that debt gets smaller through time while the cost of debt gets greater. Only those who have money can afford to do any business ventures because debt is simply a very destructive form of expansion.

I applaud you for acknowledging that the gold standard does not support an expanding currency for the needs of an expanding economy. Unfortunately your solution is worse as a deflating currency is worse than cancer.

The ideal situation is a slightly inflating currency. Not a stable one and certainly not a deflating one. If currencies slightly inflate it encourages people to be productive with their capital rather than sit on it but it’s not inflating so much that people have to rush out of cash and into anything they can find. It’s the goldilocks situation. Certainly hyper inflation is a problem that crushes an economy because people the currency can’t hold its value long enough to be useful. A deflating currency is also a cancer because people cannot put the currency to good use as the most productive use for it is often to just sit on it. A stable currency tends to leave an economy in a state of malaise like a hung over pot head because there doesn’t seem to be any advantage or downside to doing anything so everyone just kind of waits to see what will happen (see 2010).

So while I agree with you that what you propose does work mathematically, I think its a complete financial disaster. (Imagine the U.S. Federal debt under a deflating currency, a U.S. default on treasury bonds and bankruptcy would be a mathematical certainty. There would be no way out of it from here). We need some inflation and the sooner the better. And if you want to argue that we can’t stop it once it comes I will refer you to Paul Volker circa 1980. We absolutely can stop it. We have done it before, and we will do it again.

avatar Aaron

Apex, I can’t respond directly to your comment. I think we hit the limit.. So I will respond here.

The assumption that a deflationary economy is bad is a central tenet of Keynesian economics, with which I disagree. All of the scenarios you mentioned seem to derive from Keynes (if I am wrong, let me know).

A deflationary economy would discourage spending and consumption based on debt while encouraging savings. We agree on this. We disagree over whether this would be a bad thing. It would be radically different, and the economy would be savings, rather than debt driven, as you mention.

Productive use of currency is a subjective matter, also. People can’t eat, wear, or live in gold (or any currency), and so spending and consumption, and therefore investment, would still take place. If I could make more money selling McDoubles than I could just sitting on my currency, I would. I would still continue to purchase goods and services from others. I would just be much more careful about my spending if my currency were appreciating.

The federal debt you mentioned doesn’t really apply here. Most of our federal debt is the result of printing more money (we sell debt every time we print). Governments would also have to think hard before they spent any money, and certainly before they spent more than they had collected through taxation.

The net effect of all this is that our economy would drastically reorganize. Saving would be encouraged the way spending is now encouraged. Consumption, spending, and investment would all continue to happen, but bubbles would be much less likely, as they are generally the result of credit being too cheap.

avatar Apex

I don’t disagree that excessive use of credit is bad. A prime example is the housing bubble.

To be clear I am not a Keynesian. I do not agree with throwing money at recessions to try to force the economy to recover prematurely. I think that philosophy is the primary cause of the housing bubble to begin with. it is better that we experience regular recessions to clear out the excess. I am not in favor of the government spending money to stimulate the economy or to create make work jobs to put money in people’s hands.

However I do not see any way the gold standard is remotely workable and I strongly do agree that deflation is both bad and stagnating for an economy. I don’t really care if that is considered a keynesian idea or not (I think most people who are not keynesians currently hold that view as well although that doesn’t prove anything either way).

I agree that if people saved more money that would also be good and had less debt that would be good too. But I make a strong distinction between peoples savings and debt situation and economic credit in the economy. People spending money they don’t have to buy things and creating artificial demand is destructive for them personal and allows an economy to overheat and exacerbates these cycles of excess and makes them more painful when they happen because there are no reserves for people to fall back on. In that sense that availability of easy consumer credit and especially revolving credit card debt has been a destructive cancer for people personally and the economic system as a whole. It also provides no longer term expansion of the economy, it is simply a borrowing from the future. But that is neither an issue of fiat currency (people had debts before paper money) nor of an inflation versus deflation environment.

The credit that is important to the economy is the credit that allows businesses to startup as working capital or to expand and grow the economy making the pie bigger and increasing the wealth of the entire society. That is the credit that deflation is going to make unattractive. You seem to continue to use examples around people spending money on necessities like food. I have no interest in allowing people to use credit to buy McDoubles (or McTriples for that matter :). I don’t want consumer to spend anymore than they have and in fact want them to spend less than they have and save some. I would be in favor of regulations that make consumer credit harder to come by as I think there is very little good reasons for most of the consumer credit we now allow other than to let people spend money they don’t have which I consider destructive.

What I want to encourage is credit for taking business risk. How is that supposed to work in a deflating currency environment? I really don’t think it would work very well at all.

As to the federal debt how can you say that doesn’t apply here. You could argue it shouldn’t apply in a new economy or it should not be a problem for debt going forward but the debt we have exists. It is not going away and it is an ever growing huge percentage of our GDP. If the currency deflates that debt gets larger, much larger. The only way out is to default. Our federal debt is most certainly not remotely related to printing money. Our federal debt is a direct result of the federal government spending more money on government services than it brings in with tax revenues. What does that have to do with printing money. Printing money affects currency valuation. It has nothing to do with the amount of debt you have accumulated. All debt, personal and governmental is simply revenue minus expenses.

I assure you I am not a fan of keynesian economics. I prefer the free market to do it’s job. But I am also not a purist who believes that the free market solves all problems, needs no checks on its susceptibility to greed and corruption, or can have all of its short comings erased by something as simple as a hard asset based currency.

The system is what it is. Fiat currency has its short comings but I far prefer them to the rigid problems that would be caused by being locked into a gold standard straight jacket.

avatar Will @ HackingTheBank.com ♦258 (Nickel)

It always seems that those who are pushing gold have some type of benefit in doing so. Gold, like the paper that money is made of, generally has little value in our daily lives. The value of it certainly isn’t determined by its usefulness. Unfortunately, it seems that media forgets to warn people about how speculative the gold market really is. I’ve had friends ask me if I think they should buy gold right now. I usually tell them no, after which I share with them some great advice from Warren Buffet: “Be fearful when others are greedy, and be greedy only when others are fearful.” It is a great mantra for value investing. Everything becomes a good deal at some price.

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avatar BFskinner

“Be fearful when others are greedy…”. Yes. I get that. It seems true, BUT!!!…
Very, very few people own gold. The bubble may not be anywhere near “here” yet…not even close!
When there was a stock bubble, EVERYONE I knew was a trader!…even the custodian.
When there was a house bubble, EVERYONE was buying…and many were flipping homes!… even the custodian!!!
Gold? I’m not seeing it at all. The price has risen, yes… but the public has not even begun to start buying.
90% of those ads on TV are buying gold (not selling it) at super cheap prices from hapless people in need of cash.

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avatar Rassah

The only decision I ‘ll be making is whether to wait until gold reaches $1,800 or $2,000 before I short it. This bubble will pop. We just don’t know when exactly.

http://www.fool.com/investing/etf/2010/11/02/warning-gold-could-drop-below-500.aspx

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avatar Apex

I am not a supporter of gold as you can tell by my comments above, but if you were fairly confident of your statement above wouldn’t you want to be long gold until it got there?

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avatar Rassah

It will likely go to $600 eventually. If I go long at $1,400 I’ll end up losing long-term. Once it starts crashing, it may be too late to flip positions.

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avatar Aaron

In my mind, the only thing gold has going for it that paper currency does not is that gold is intrinsically limited, and so, over the long term, the average value of gold can be known.

Paper currency has value set by governments. As long as they are careful not to expand the money supply too fast, all is well. But if, in stimulating the economy, they print too much, inflation devalues everyone’s savings. If they expand the money supply way too fast, hyperinflation can set in and cause chaos. So, paper money is only as good as the people in charge. Gold or any other actual asset has value independent from government.

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avatar Dmitry Murashchik

Doesn’t mean rare commodities are immune from manipulation. Diamonds is another rare and very expensive commodity, but De Beers actually buys and stockpiles them to keep the supply on the market low and the price stable. If someone were to do that with gold, they could buy large quantities of some other valuable commodity, promise to pay for it with a set amount of gold, and then dump their reserves into the market, devaluating what they owe us as well.

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avatar Aaron

That is completely true. It is possible that some incredible amount of gold could be discovered and devalue everyone’s gold reserves.

The difference between a freakish gold discovery and government devaluation of currency is that while massive and complete gold devaluation could happen, currency devaluation, over the long term, is pretty much guaranteed to happen. If we are lucky, it doesn’t happen quickly enough to cause major difficulty. This hope involves placing a lot of trust in governments and central banks.

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avatar Rassah

It’s also possible that US convinces China to convert our dollar debt into gold at current market rates, and then dump half of Fort Knox onto the market to make the nominal value of our debt go down. Unlikely, though.
Either way, currency devaluation, even if somewhat moderate, shouldn’t bother anyone. Cash is a terrible way to store wealth, and those that rely on it are only setting themselves up to learn some hard lessons. Personally I don’t hold more than $3,000 in cash, and even that is in high yield savings accounts. Most of my money is in large cap, small cap, and international stocks and mutual funds, which aren’t really affected by inflation.

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avatar Aaron

You’re right, in stable economic times, investments that keep up with inflation negate the devaluation. Steady inflation isn’t really a problem (for people who understand that it is happening, anyway).

Hyperinflation can cause so much instability as to make markets crash, though. I genuinely hope that the folks in charge of all the quantitative easing (not just in the US, but around the world) are as good at steering the economy as they think they are.

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avatar Rassah

Agreed, and I hope so, too. So far Bernanke hasn’t shown that he’s any worse than Greenspan (who I thought did a great job all things considered, except for the part where he didn’t think something was his job, and thus ignored it). Then again, Benranke hasn’t had much time at the wheel to judge him performance well enough, yet, either.

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avatar Rassah

On the other hand, if hyperinflation hits, all the leveraged companies, which seems to be most of them, will suddenly find their debt worthless and find themselves in a much better position. Then again, hyperinflation is a leading cause of Hitlers >.<

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avatar Aaron

See.. My concern with Bernanke is that he probably sees himself as being in a desperate situation. And desperate situations often shut down one’s cool headed rationalism.

For Keynesian economics to work, one has to have a steady hand at the wheel. One can’t give into the temptation to print too much money even if it seems like a short term solution. I think QE2 is a good indicator that Bernanke is getting less calculated is his approach.

And it isn’t just Bernanke. In our global economy, we need the Bernanke’s of the other major currency systems to also stay cool headed.

I am afraid I have to disagree about hyperinflation being good for leveraged companies. I really imagine that hyperinflation would result in an economic collapse that would pretty much put all companies out of business until a stable currency was established. And the last thing anyone wants is a stable currency being established by someone who “keeps the trains running on time.” :)

avatar KNS Financial ♦404 (Nickel)

Every material thing that is not connected in some major way to our survival has very little intrinsic value. Whether it’s paper or a precious metal, the value is there because we place value in these things. We trust that enough people place value in these things, that we would be able to trade them for what we truly need to survive.

So in that sense, the gold standard isn’t infallible, but it does call for a lot more discipline than fiat money!

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avatar Aaron

Discipline might be the keyword here. It isn’t that the Keynesian economy can’t work, only that it requires discipline on the part of the central banks.

A gold (or other real asset) based economy is intrinsically disciplinary, and simply doesn’t give the central banks as much control as they would otherwise have over the economy.

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avatar Rassah

One MAJOR problem with a gold standard, which no one mentioned yet, is that gold-based currency is intrinsically deflationary. There is no way to expand quantities of gold to keep up with economic and population growth. Larger economy = greater demand. Unchanging supply = rapid growth in price. In the end, everyone will want to just sit on their gold and watch it grow in value instead of going out to spend it. Why spend 9 ounces of gold to buy a car now, when you can wait 3 months and get it for 8 or 7? As a result, the economy will either grind to a halt, or otherwise be severely restrained.
It seems a very common thing in the finance “armchair pundit” world is people choosing to ignore history. A lot of people say we should do so-and-so, and get rid of such-and-such without actually figuring out WHY the so and such are the way they are. This goes for gold, regulation, tax structures, currency, etc.

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avatar Aaron

Rassah,

Gold would be deflationary in the sense that the value of one’s static assets would increase (rather than decrease, as in the current inflationary system). I believe this would encourage savings over spending in some cases.

As many have pointed out, though, one can’t eat gold, live in gold, or wear gold, and so spending and consumption would continue to occur. The economy wouldn’t stop, but it would look radically different, with more saving and less spending.

I believe this would have the side benefit of being good for the environment, as people would have a real incentive to not consume as fast as they could, which is responsible for quite a bit of environmental degradation, but rather to live simpler, more ecologically and economically sustainable lives.

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avatar Rassah

Why would I want to trade my gas guzzler or buy new solar panels or windmills, if gas price is going down compared to my gold, and solar panels are getting much cheaper every month? Why now instead of wait a bit, rather? Or why invest in any technology, if what I’m using now is getting much cheaper, and will be cheaper next year?

avatar Rassah

Important question is what exactly do we want increasing? Would you rather people have an incentive to put their money into increasing gold/cash, which doesn’t add any economic value, or have an incentive to stay away from cash and save by investing in companies (stocks), land, and other beneficial assets? If increasing asset value was the only incentive for increasing saving, S&P500 and bond index funds should be more than enough.

avatar Aaron

Rassah,

For some reason, I can’t reply direct to your comment. Maybe we hit the limit. :)

Actually, I think that in general, keeping a functional machine is better for the environment than destroying it and building a slightly more efficient model.

Taking an extreme example, let’s say I own an SUV that gets 10 mpg and I drive 50 miles a week. If I buy a hybrid that gets 30 mpg, I am saving 2.5 gallons of gas per week, or 130 gallons of gas per year. That isn’t nearly enough to offset the fossil fuel used in making the new car to replace the old, functional car. The only time buying a more efficient version of a machine makes sense, economically or ecologically, is when the old machine is no longer useful and would be replaced anyway.

More generally, fossil fuel prices will continue to rise, under any economic system, as long as fossil fuel supplies continue to dwindle. So even in a gold based economy, it will cost me more gold tomorrow than today to purchase a tank of gas if the supply of gasoline (which is being constantly used up) is low. The incentive to invest in alternative energy would remain.

People would still invest in a gold based economy, but they would do so differently, and probably much more conservatively, as any investment would be competing with the rising intrinsic value of gold. The economy would go more slowly, but almost assuredly more safely than it proceeds now. The cheap credit created by fiat currency wouldn’t exist, and so business ventures would be much more closely scrutinized. Crazy housing and tech bubbles either wouldn’t happen or would be much smaller when they burst.

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avatar Rassah

All valid and very complicated/difficult points. The main point is not so much keeping functional machines, but rather investing in new, better, more efficient machines. That requires investing, borrowing, and most importantly customer demand. All things that deflation works against. Don’t forget that, just as your wage grows in an inflationary system, your paycheck will shrink in a deflationary one. That also would decrease consumer spending, since people would fear not having enough money next year. Worse, your loan and mortgage payments would seem to get bigger and bigger every year.
In macro economics, hyper inflation and deflationary spiral are two opposite financial crises. Economists generally fear deflation WAY more than deflation, since inflation is much easier to fix and control.

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avatar Aaron

See.. I assert that the slowdown in investment in new more efficient technology would be ecologically more than offset by the decrease in consumption. Ecologically, decreasing customer spending and consumption is a very noble goal. Since people would be rewarded for saving rather than spending, I actually think there would be much less worry about the future of the economy.

And yes, paychecks would numerically decrease in a deflationary system, but their value would remain the same. This is pretty much a wash when compared to inflation, where paychecks go up numerically but retain the same value.

Mortgages would be completely different. Home prices would be completely different. Homes appreciate largely because of inflation. In the absence of inflation, homes would be much lower in price. They would likely also be much more modest (another ecological gain). People would save up a much greater proportion of a home’s price before purchasing, rather than getting a mortgage that they hope to be able to afford because of the effects of inflation. This would have saved us from the mortgage bubble.

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avatar Rassah

Damn your rational arguments!
Ok, how about: Hitler and Nazis liked gold :D

Honestly, though, what’s your take on deflationary spirals?

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avatar Aaron

Everyone likes gold! :)

If we switched to a gold standard tomorrow, we would have quite a deflationary spiral on our hands. All of our industry is based on cheap credit right now, and so if credit suddenly got more expensive, it would leave things in a temporary lurch. The move to a gold standard, if it ever takes place, will have to be incremental to avoid chaos. Once the transition is made, though, things will be so much more stable than they were under our current Keynesian system.

Our current bubble was caused by lending people a bunch more money than they could ever pay back to buy way more house than they needed. The people lending that money would have been much more careful in so doing if credit weren’t cheap. When credit is artificially made cheap banks lend at too great a risk – because they need to make money, and lending at low risk yields really low interest in a cheap credit environment. Banks have bills to pay, too, so they have to lend at high risk. When they do, defaults happen.. We know the rest. It just isn’t sustainable in the long term..

avatar Rassah

Admittedly, a large part of this debate comes down to a very subjective question of which is better: fast growing rapidly changing economy, or stable, somewhat predictable, but almost stagnant economy.

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avatar Rassah

Aaron,

FIAT currency credit can be made artificially expensive, too. Fed just raises interest rates. Our current bubble may have been helped by very cheap credit, but that was a response to extremely sluggish economy due to an entirely different and unrelated bubble, remember?
Again, this is a subjective argument on which is better: control, or complete lack of it. Personally, I prefer the Fed having some control over monetary policy than no one having any control at all. I don’t believe that, should we fall into a deflationary spiral, that we would recover until we hit a very very low bottom. There would be nothing to stop the value of the gold from increasing out of control. With FIAT, money supply can be contracted to cut inflation, and expanded to boost a sluggish economy. Subjectively, I like proactive action.

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avatar Aaron

Ehh.. The housing bubble was caused by cheap credit. The fed actually doesn’t raise or lower interest rates directly. Instead, when they want to lower interest rates, they create money until interest rates go down (more money means banks have more to lend, so in their competing with each other, rates get lowered). The fed raises the interest rate by printing less new money, so that the supply of money becomes more limited and banks charge more to lend it. For this reason, the terms “lowering interest rate” and “expanding the money supply” are synonymous. Similarly, “raising the interest rate” is the same as “contracting the money supply.”

The housing bubble (which I think is what caused our current recession) was a result of them printing up too much for too long, cheapening credit to the point that banks lent to people who couldn’t make repayment.

My concern with the QE is that it is basically the same behavior on the part of the fed that got us into this mess. They are trying to dig us out of a hole. Doing so is completely consistent with Keynesian economic theory, with which I disagree.

What I do not disagree with is this rap video put together by a couple of economics professors: http://www.youtube.com/watch?v=d0nERTFo-Sk

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avatar Dmitry Murashchik

Regarding paragraph 1, yeah, we covered that in my undergrad intermediate econ class.
The housing bubble was indeed caused by cheap credit and people believing houses will only go up, but it wasn’t a direct cause of the recession. Derivatives and Mortgage Backed Securities were. Here’s how my now grad teacher explained it.
You know what a derivative is. A Mortgage Backed security is essentially term life insurance for your investment, which pays you out the cash value of your security should it crash. As you know, in our economy people want to get paid extra for taking on risk. Risk-free assets, such as US Treasuries, people are willing to hold at 2%-3%. Corporate bonds, more risky, they want 4%-6%. Large cap stocks, more risky, 8%-10%, and so on. Derivatives, which are mortgage debt, paid whatever he mortgage interest rates were behind them, minus a small maintenance fee, so usually about 4% to 6%. Banks bought up these securities, thinking they are diversified, and then just in case bought insurance on them, or Mortgage Backed Securities (MBS), which they paid a fairly small fee on, maybe of 0.5% to 1%. Two major problems with this. One, they were essentially making a risk-free security that paid as much as 6% minus 1% MBS = 5%. A 5% risk free security in a day when risk free treasuries were about 2% meant that SOMEONE was paying to hold that extra 3% of risk. No one bothered to think about that. Second, people who bought MBS believed they were safely insured, but didn’t stop to think that insurance is only as secure as the insurance company behind it. For some reason no one realized that majority of the MBS insurance was sold by only one company, AIG. IN the end, it turned out that AIG was the one inadvertently “paying” for that 3% of extra risk, and when it went down, a large chunk of the world suddenly found itself with a whole bunch of “risk-free” securities that pay 5%, with no one really willing to take on the “risk-free” part.
Hope I was able to transcribe that more or less ok. Also hope I’m not repeating what you already know. Either way, we do have bubbles come and go all the time, but this was something special…
I’m concerned about QE2 as well, but last time when the economy picked up mostly due to housing and finance, they didn’t bother to raise rates to keep up, worrying about causing another crash. This time I hope they won’t make the same mistake again, and will start raising slowly as soon as there is a hint of inflation or serious bubbles (I don’t think gold will be a serious bubble)

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avatar Rassah

P.S. Rassah and Dmitry are same people on two different computers :D

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avatar Aaron

So.. It seems like you are saying people played too fast and loose with MBS, which caused the recession.. People should have been more cognizant of the risks involved before they invested in MBS.. Is that right?

I am saying that without artificially cheap credit, those risky mortgages would never have been granted, and so MBSes (plurals of words that end in S have always confused me) based on them would ever have existed.

it seems like we are in agreement that central bank mismanagement of the money supply got us into this mess, based on your last paragraph.. Is that right?

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avatar Rassah

Oops! Made a mistake above. Mortgage Backed Securities (MBS) were derivatives. What AIG sold, which I incorrectly called MBS, was called Credit Default Swaps (CDS). That was the insurance that created unrealistic 5%+ risk-free investments.
Not so much fast and loose with MBS and CDS as they didn’t stop to think about fundamentals and why those may not have made sense.

MBSes would have, and have, existed without low interest rates. Banks trade mortgage and credit card loans all the time. Low interest rates only added more risky loans to the mix. This contributed to the bubble, but would not have caused the recession if risk was properly diversified and paid for. If AIG had charged 3% or more for their CDS insurance, bringing MBSes in line with truly rick-free US Treasuries, either people would have been more careful investing in them, or AIG would have had plenty of money to cover foreclosure losses. So, even though Central Bank’s mismanagement was partially responsible, and at least helped to start the bubble, it’s by far not the main cause of our current problem.
(i.e. not %100 guaranteed we would’ve had a crash with low interest rates, but almost 100% guarantee we would have the crash with mispriced CDS’s, even if rates were high). I guess the real bubble wasn’t the houses but the MBSes, which paid more than normal and seemed a sure thing (with CDS’s). Kinda like gold is today.

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avatar Aaron

As an aside, I think gold may well be overpriced today. I am not, but if I were of an apocalyptic mind about the economy, I would probably be stock piling silver, rather than gold. And I would take physical delivery of it. Having an asset on paper that is valued in American dollars is no help if one believes that American dollars will collapse. Again, this isn’t me. Yet, I still remain skeptical of the federal reserve and their ability to fix this for us.

Why do you think AIG acted the way they did? Here are a bunch of people who are supposed to know how this stuff works.. Why would they issue insurance policies they couldn’t cover? These folks go to school to learn to and then get paid obscene amounts to know how percentages and risk work.. Why did they adopt such a caviler attitude?

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avatar Rassah

Why? Shrug. Hindsight 20/20? Maybe their actuaries didn’t see the whole picture and only calculated part of the risk. Maybe people thought “this time is different” and were really convinced real estate only goes up. Don’t know. Likely stupid assumptions that make asses of all of us every time the market takes a downturn. I’m also a bit skeptical of the reserve, but am cautiously optimistic, and still try to convince my friends/relatives not to keep cash in case there is some inflation ahead.

As for gold, I seriously doubt that US, Canada, Europe, China, Russia, Brazil and South America, India, Middle East, and all of Africa will all collapse at the same time. If USA crashes, chances are someone else will make a ton of money off our misery and desperation. Likely it’ll be another country buying up our cheap assets that still have intrinsic value. So keeping your portfolio diversified among US and International stocks should hedge that quite well, especially since stocks can be valued in many different currencies.

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avatar Aaron

See. I think that the psychology that lead to AIG insuring those debts is driven by the fed’s monetary policy. When credit is expensive, as in when there is only as much credit as there is savings, people are much more careful about borrowing or lending money. Lenders particularly can afford to be careful, as their savings are appreciating anyway. Similarly, insurers are much more cautious about insuring, being as a non-inflationary system would not offset their potential losses they way an inflationary system does.

Further, one of the reasons AIG kept insuring risky mortgages has to be that their income from newly insured mortgages appeared to, for a time, offset any early loses. This was only because the bubble was growing, however.

This pathogenic devil-may-care attitude at AIG is a symptom, I think, of an ever expanding money supply. It seems like cheap credit is more intoxicating than any alcohol, and suspends better judgment.

In regard to world economic collapse, my understanding is that China has based their currency on ours.. Roughly translated, my understanding is that the Chinese “fort knox” is full of American dollars (or bonds or what have you).. So if our economy goes, so do theirs.. Is that right?

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avatar Rassah

Cheap debt being the cause is quite possible, and very probable. Other contributors may have also been the general psychological euphoria about how well things were going, everyone wanted to get in on it, worries the other guy (competitor) will get there first, and just generally throwing caution to the wind. USA’s heavy subsidization of housing, with tiny downpayment requirements and tax deductible mortgage interest, no doubt contributed, too.

Yes, USA going down will take down China, but India and Rissia probably won’t be affected much, and Japan and China, countries with fiat currency yet expensive debt, will probably move in and buy us up. Canada, who sits quietly above us and whom no one pays attention to, was not affected by this housing bubble thing almost at all. They just sneakily sit up there, saying “pay no attention to us, our economy, or our vast natural reserves,” and will probably be the first to buy us should we totally crash :D

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avatar Rassah

Yikes! When I said “Japan and China” I meant “Japan and Canada.” Both countries are anti-debt and both tend to save a lot more that average. Germany does, too.

avatar Aaron

So.. The only two solutions are to switch to a gold standard or to start learning to speak, “Canadian”, eh? :)

If those hosers at the reserve don’t stop printing money, I won’t have a looney to my name, eh.. I won’t know how to feel aboot that.

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avatar Rassah

Or just buy stocks and learn to speak Canadian :) I only have $30k invested, but if hyperinflation hits, that should still be $30k Canadian. and I’ll be able to pay off my 15 year mortgage and student loans in a month or two. I.e., I’m not worried, eh?

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avatar Aaron

I see.. So, you are invested in stocks that are in a currency where credit is expensive as insurance against US hyperinflation.

That makes sense, except if hyperinflation is bad enough to allow you to pay off all your debts with the proceeds from the Canadian stocks in a period of months rather than years, it is also probably bad enough to shut down industry (grocery stores, gas stations) for a while. Do you have pop tarts stock piled someplace? :)

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avatar Rassah

Technically, my stocks are in International stock mutual funds. As real assets they don’t really depend on a specific currency. As for pop tarts? Nope. Just a US passport, employable skills, enough gas to drive north, some Canadian friends, and willingness to say “eh” and “aboot” once in a while :D I tend to visited Canadia almost once a year, and like their country, too, although US still has more money making opportunities.

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avatar Aaron

Man… I gotta tell ya.. That you have even a tentative “bug out plan” (this is a survivalist term I have encountered on the internet, I am not sure of its derivation) is sobering. I assume (and you can correct me if I am wrong) that you are a Keynesian..

For a Keynesian to have gas and a passport and generally be in a state of readiness to leave means things are maybe worse than I thought.

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avatar Rassah

I’m actually a mix of Keynesian and free market. Fan of Ayn Rand’s Objectivism, and believe in free market, but understand that we need a social system to establish a base on which that economy will be able to work. Stuff like protection, legal structure, instrastructure, some regulation of natural monopolies, etc.
I’m an immigrant from USSR (was 10 when I came here), from an aristocrat family, and love to travel to other countries, thus the passport.
As for gas, Canada is about 5 hours north of me, and I have a tendency to procrastinate on going to gas stations, so after running out of gas multiple times now keep a spare container in the trunk :)

So, it’s not as much a “bug out” plan as a “meh, whatever, I’ll probably be ok” plan.

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avatar Aaron

So.. You were right when you said it comes down to subjective philosophy.. I distrust government regulators more than I distrust the market, and you have the opposite configuration of distrust. :)

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avatar Rassah

Don’t get me wrong, I distrust government regulators more than I distrust the market, too. But I believe that in certain situations they are a necessary evil. As for mistrust of regulators, I just assume them to be more inept, rather than having some nefarious reasons.
But yes, it’s all very subjective :) There’s just not enough freely available and reliable information for everyone to know all this for certain.

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avatar Aaron

There isn’t enough information. That is for sure.. Also, I would be perfectly willing to accept ineptitude, rather than nefariousness as an explanation of our monetary policy. :)

How do you feel about a fed audit to make this information more available? Whether they are evil or just inept, they would probably improve if someone was keeping a better eye on them. They are supposed to work in our best interest, after all. Why can’t we be allowed to see what they are doing with our money?

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avatar Rassah

I’m all for a Fed audit, but only rarely. Part of the reason our economy can operate smoothly is because no one knows what they’re doing, and makes similar cautious assumptions. If everyone knew everything about the Fed every time they had a problem, we would have panics all the time. It’s like the reason we’re ok with keeping money in banks is cause we trust they’re doing ok, and that Fed will bail us out if they crash. Helps avoid runs on the bank. How do you prevent a run on the Fed, after all.
As for deflationary and Keynesian, Keynesian is demand side, so I’m assuming you mean that you don’t have a problem with consumers not buying, and saving their money instead. But what about businesses and suppliers? If I’m an entrepreneur with a great business idea, chances are I won’t be able to get a loan or find investors to help me fund my business. They’d rather sit on their secure appreciating gold investment. Likewise for businesses that deal with inventory. Every one of them holds inventory with borrowed money, expecting to sell it at a profit and pay off the interest. If my inventory debt keeps growing by itself, it would be tough to make enough sales to cover both my expenses and my debt. As a business or supplier, I wouldn’t be able to supply much, and customers wouldn’t be buying, anyway. Only way to fund business would be by accumulating cash/gold, and when there’s constantly less and less of it, it’ll only get harder and harder, until very few people have it to buy inventory, and fewer have it to buy as consumers.

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avatar Aaron

Okay.. We can audit the fed rarely. We can agree that it is time, yes?

Consumers would still need food, clothing and shelter, and they would still want iphones, HD TVs and PS3s. They would still spend a deflationary currency to get these things, just maybe not with the same manic gusto they do now.

People would still invest in businesses so that those businesses could purchase inventory or develop new products. They would just be much more careful about their investments. The investments would just have to have the potential to beat deflation, the same way they have to have the potential to beat inflation, now. There would still be high risk and low risk investments, with the higher risk paying off better. The low risk investments would be slightly over currency appreciation, just not by much. On a side note, any purchased inventory would also be gaining value (generally) in a deflationary system, so purchasing inventory or keeping your gold is kind of a wash for a business.

If my $1.00 buys one McDouble today, and I suspect it will buy 2 in ten years (so we are assuming a 10% deflation per year, roughly), I will still buy the McDouble if I am hungry. I will still buy an iphone if I want one. I will just have to weigh every purchase against a built in savings instrument.

avatar Rassah

Btw, just realized that one of the major pivot points in this debate is savings. What does “saving” mean to you, and how do you suppose it will work or benefit us in a deflation? Now when I save, I put my money in the bank, which looks for productive people with great ideas, and lets then use that money. Key is it’s used for productive activity…

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avatar Aaron

Now we are having two conversations at once! I already replied to your previous comment. :)

Savings in a deflationary economy would be similar. People would still put their money in banks. The banks would still lend it out at interest (higher interest, because it would have to be currency appreciation + profit for the bank).

People would be more likely to bank their money, because they would get currency appreciation plus whatever percentage of the interest their bank paid them.

avatar Rassah

Sorry, some of this is getting too complicated and above my education level. Specifically we’re getting into economic modeling and constructing present value calculations using negative growth and negative demand. I don’t have much experience or understanding of those from that perspective, and although all I can counter with is “something doesn’t feel right here,” I’m going to have to say I’m sticking with opinions of my econ teachers, agree to disagree, and bail.
Thank you for a very stimulating debate, though :)

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avatar Aaron

I am sorry to see you go.. Please come back.

We are NOT talk about negative growth or demand.. Economic growth is more goods and services being produced. It is not, directly speaking, stock prices increasing. Printing more money will cause stock prices to increase, but it doesn’t necessary cause economic growth.

Not printing money will usually cause stock prices to decrease, but that is not synonymous with economic decline. Again, growth has to be defined as more goods and services, decline by fewer. Stock prices are an indicator that can be artificially manipulated.

Also.. And I don’t want to put too fine a point on this, just because an idea is espoused by the majority of academia doesn’t make it right, nor does it raise the issue in question beyond the purview of the general public. I imagine a quick youtube search could turn up dozens of members of the intelligentsia asserting that nothing was wrong with the economy days before the crash.

Please come back and ponder these issues for yourself. Or get those econ professors to come talk with us. :)

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avatar Aaron

Apex, I am replying here. I can’t reply directly to your comment.

I really think that in a deflationary system, people would still spend to consume and spend to invest. As I said in another area, consumers would still need food, clothing and shelter, and they would still want iphones, HD TVs and PS3s. They would still spend a deflationary currency to get these things, just maybe not with the same manic gusto they do now.

Investments would go forward as they do now. Investments would only have to do better than the built in savings instrument of currency itself to attract investors. People would still want to invest, with some preferring higher risk / higher reward scenarios and others preferring to either invest at very low risk, which would probably only barely beat currency appreciation, or not invest at all. These are the same three choices people make today.

As I said elsewhere, our current bubble was caused by lending people a bunch more money than they could ever pay back to buy way more house than they needed. The people lending that money would have been much more careful in so doing if credit weren’t cheap. When credit is artificially made cheap banks lend at too great a risk – because they need to make money, and lending at low risk yields really low interest in a cheap credit environment. Banks have bills to pay, too, so they have to lend at high risk. When they do, defaults happen.. We know the rest. It just isn’t sustainable in the long term.. With a deflationary system, total credit and total savings would be the same number. It would be very hard to have credit cheap enough to fund such a bubble.

Our federal debt is caused by the yearly federal deficit. Every year when the federal government spends more money than they gather through taxation, they borrow the rest, print it up to pay their deficit, and thus pump more money into the economy. With these recent stimulus packages, they just borrowed more than they usually do.

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avatar Apex

It’s clear we will have to agree to disagree as nothing new is being added to the conversation.

I take solace in my complete confidence that something like the gold standard has zero chance of being implemented in my lifetime.

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avatar Rassah

As I mentioned, our current bubble had more to do with mis-pricing risk. Even with very cheap credit or low inflation, had banks been more aware of this risk, they would have made credit a bit more expensive or would have been more cautious. It really didn’t depend on whether we had inflation or deflation.
Regarding cash/dollars, please think of them as nothing but a commodity, like sugar or oil, which only have value in relation to other items, and don’t actually affect the intrinsic value of those other things. That said, regarding stocks, they, or the company they represent, increase in value, not nominal dollar price. If there is inflation of 3% and the stock value grows by 2%, your stock price will go up by 5%. Stocks don’t really care what the dollar does most of the time, since dollars and cash is just a separate commodity. It’s also pretty impossible to manipulate stocks (although I’d like to hear how you think stock price indicator can be manipulated). If, however, there is deflation of -3% and the stock value goes up by 2%, the stock price will go up by -1% in cash value. And this is where it gets really weird.
I ran some calculations in excel to try to understand what’s going on a bit better. Pretend I’m a business in a current inflationary economy. Inflation is 3% a year. I need to borrow money to fund my business idea (or get credit to maintain inventory). I also want people to invest in my business.
With inflation being 3%, my business has to create value at a rate of at least 3% to keep up with inflation. If I do that, people would rather invest in me and get 0% value increase (-3% inflation + 3% return = 0%) than sit on their cash and lose 3% every year. If I borrow money at 5% to fund my business, every year the value amount of cash I need to come up with will decline by 3%. So, a $10,000 loan at 5% for 10 years will cost me $1,295.05 the first year, and only $955.00 on the last year. I can easily start a business and keep more of my money as I go forward, but have a huge incentive to make the business do something and create lots of value (in this case at least 3%).
Now, let’s flip things around and put me in a 3% deflation economy. In order for people to invest in me, my business has to create a value of 0%. Not 3%, but 0%, because if all I do is sit on their money, I am making them 3% on deflation alone. In contract to inflation, where people look for a better return, they would have absolutely no preference whether to sit on their own money, or give it to me, since they’ll make the same amount. From the loan side, though, every year the value of my loan payment will increase by the 3% deflation amount, so that exact same loan above will now cost me $1,295.05 in year 1 and $1,740.43 in year ten. This means that I have to figure out how to grow my business at 3% a year just to stay even with the loan payments. So, in the end, I have absolutely no incentive to create a business that creates value, and no incentive in expanding my business with a loan, since it will only cost me more and more and take away more and more of my profits every year. In the end, I’d rather just sit on my hands and do nothing. This also means that I won’t bother hiring anyone to do this nothing for me, and as more and more people agree with me, more and more will lay people off. Especially since it’s also easier to lay someone off than to cut their paycheck every year.

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avatar Apex

@Rassah,

This is exactly the point I have been making above in my discussions with Aaron (which aren’t nearly as long as yours). The only response I can seem to get is people will still want McDoubles so everything will be fine. Obviously people will still eat, but the business has no incentive, indeed a disincentive to attempt to go out and invent the iPhone. The fact that consumers would like an iPhone and would pay for one is irrelevant because the business doesn’t have the incentive to go create it. Too many financial factors make the risk too high. Obviously if there was no risk and you could guarantee that the iPhone would be created, be successful, and be purchased wildly then it would make sense to move forward inspite of the financial hurdles, but business doesn’t work that way. Most business risks don’t work out so well and so if you can sit on your money and get 3% return and borrowing money means ever increasing debt costs, what business wants to take that risk? Very few. Only the ones that know they will be successful, like selling McDoubles cause we know those work and people will buy them. So progress is stiffled and economic growth is smoothered.

So that’s why I have left it at agree to disagree with him because it just keeps coming back to the circular argument that people want McDoubles.

My experience with gold bugs is that it is nearly impossible to get passed the mental defect. Its nearly a religious belief system and logic is not very helpful. People still want McDoubles you know, so gold is good.

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avatar Aaron

Apex,

I use McDoubles because they are a convenient and universally understood value index for a dollar.

And asserting that you are going to agree to disagree is inconsistent with then posting a comment about how I am wrong. :)

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avatar Apex

I wasn’t talking to you, just about you spurred by a comment from someone else. I didn’t say I wasn’t going to talk about it anymore, just that I was not interested in debating you anymore because you don’t understand the concept of business credit. And that is still true as evidenced by my lack of response to your comment below which is just more of the same.

avatar Rassah

Oh, also forgot, with inflation of 3%, I’d be ok to take out a high interest loan (as long as the rate is not too high), since my inflation-adjusted payments will decrease every year. With deflation, I wouldn’t even want a 0% interest loan, since even then my inflation-adjusted payments will grow by 3% every year. A 0% interest loan with inflation is only as attractive as the bank actually paying ME to loan money from them in deflation. No banks would do that. So, no banks, no financial services, no finance systems to move liquidity. We’d be worse than in stagnation, we’d be in a depression. And, actually, deflation, aka credit crunch aka high demand for currency, is what causes bank runs and depressions, including the Great one.

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avatar Aaron

Rassah,

You’re right.. Borrowers do have a greater incentive to borrow in an inflationary economy, and lenders have greater incentive to lend. My central assertion is that they both have too much incentive, and that this creates the boom and bust cycle we experience.

You’re also right that In a deflationary economy, a business would have to produce a value greater than the rate of deflation for its investors. This is just the way investors hope business works today, though. Investors hope that a business will create more value than inflation.

So.. In your example of a 3% loan in a deflationary economy, a business would only have to produce 4% value the first year to be attractive to investors. Also, in a deflationary system, I doubt loan terms would be as long as ten years. My understanding is that the “commercial paper” loans that business currently run on is about 3 months, and that is in our inflationary economy.

So.. Truly profitable companies would still be started and continue. In our current system, companies that only produce enough value to keep up with inflation aren’t really producing any value at all. Their funding is an artifact of our inflationary system. They wouldn’t exist in a deflationary system. No one would mourn them. :)

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avatar Rassah

I think you’re thinking of this backwards. Think “value-added” and modifying widgets. In a deflationary economy, if I do something to my widget to make it worth 1% more, I can sell it at 4% price increase at the end of the year (3% deflation + 1% value-added = 4%). In an inflationary economy, if I don’t do anything to the widget, at the end of the year I can sell it for 3% less than what I bought it for. Inflationary economy is where I would have to add 4% value to it to make it be worth it (-3% inflation + 4% value-added = 1%).
Regarding incentive, I think that is directly tied to risk. Less risk = more incentive, and vice-versa. Risk can be mitigated by deflation, but it can also be mitigated by charging more for it. I.e. higher interest rates on loans or higher required rates of return on investments. These rates are currently set by the market, and personally I would rather continue to have the market establish how much risk should cost, instead of trying the cost of risk to an inflexible currency no one can control. And true, sometimes things can get convoluted and the economy can break, but that’s true for anything we pay for, be it risk, gold, oil, or tech stocks, and the market will always eventually find equilibrium. (this is my Adam Smith side talking :)
There are lots of companies that rely on long-term debt, mainly because that debt is tied in assets that are not liquid. If I borrow $50,000,000 to build a factory, I won’t be able to come up with $50mil in three months. I can keep extending my debt, but that’s the same as getting a single 30-year loan, just with a lot more paperwork. Main reason for long-term loans is to be able to afford larger items with smaller monthly payments. Again, nothing to do directly with inflation/deflation. Deflation only makes paying them much more difficult in the long-term.
And the point is really just incentives. Sure, there were lots of truly profitable companies back when we had deflation, but they were very rare. Not because it was difficult to come up with a profitable company, but because not many wanted to, or had the enormous sums of cash saved up to do it.
Last, and probably most important point, is definition of “saving.” I don’t think you ever explained what you mean exactly by it, or what you would expect people do to. Saving, by itself, as in stuffing your money under a mattress, does absolutely no good to anyone. All you are doing is taking capital out of the economy and having it sit there, not increasing in real value and not helping the economy grow. Now, when we save, we usually mean put the money into a bank, which in turn invests it in other companies, government bonds that pay for infrastructure, or helps people buy cars and houses. Although to us it’s “saving,” the money is still doing something. With deflation, people would much rather just sit on their money. And even if they give it to the banks, not many people would want to borrow or risk building businesses, so banks will likely just sit on it, too. Economy would stagnate. And in the end, it’s a question of personal liked: Would you like our economy to grow at an average GDP of 3% per year, or would you like it to grow at a GDP of 0.5%? I suspect with the later we’d still be where we were in 1940′s technologically speaking.

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avatar Matthew Walton

Rassah, your remark that “stocks don’t really care what the dollar does most of the time, since dollars and cash is just a separate commodity” is basically true. And yet you speak of inflation as something that your business “has to keep up with”, as if the value of your stock is in some way tied up with the value of cash and that as the value of cash drops, you have to make a conscious decision to increase the value of your business in response. But like you say, your business’s stock does “not really care”. Setting aside the complexity of the actual mechanisms of inflation and how they don’t impact the entire economy equally and simultaneously, assume that they DO impact the entire economy equally and simultaneously and recognize that a 3% increase in the money supply will generally result in a 3% increase in the price of everything. The value of everything did not change. In fact the value of nothing but the dollars changed. We just have more dollars chasing the same stock of goods and services. So it costs 3% more to buy anything. Your business finds that it has to pay 3% more for its supplies. It also has to pay 3% more to retain labor. And then in finds itself charging 3% more for its final product in order to keep up with increasing costs. On paper revenue and net income are both up 3%. The number that is the company’s net worth is also 3% higher. But the true value of the company didn’t change. It made no conscious effort to produce more product for less money. Nor did it improve the quality of the product. It just became “worth more” in terms of dollars, not because the company is truly more valuable, but because the dollars are worth less. In short, the company did nothing to “keep up with inflation” and yet the “worth” of the company, in terms of dollars (not in any real terms), went up naturally. It did nothing other pay more for its supplies and labor, and then turned around and pass this increasing expense on to its clients. In other words, while creating 0% additional actual value, the price of the company’s stock went up roughly 3% to reflect the 3% increase in revenue. The company did not “keep up with inflation” as much as inflation forcefully pushed the price of the company up. I see no reason to believe that inflation somehow provides incentive to the business to expand or improve its operations or create any additional real value.

And if inflation does not incentivize the creation of real value, neither does deflation disincentive the creation of real value. Given a state of 3% deflation you say that “in order for people to invest in me, my business has to create a value of 0%. Not 3%, but 0%, because if all I do is sit on their money, I am making them 3% on deflation alone. In contrast to inflation, where people look for a better return, they would have absolutely no preference whether to sit on their own money, or give it to me, since they’ll make the same amount.” I’m a little confused as to what you are saying here, but I think you are suggesting that since my company will automatically and passively increase in value due to deflation, without my asserting any conscious effort, that I will be content to allow my business’s value to naturally increase at 3%—people might opt to invest in me, or they might just keep the cash. Two things. First, people will most certainly NOT invest any money in my company under these conditions because I pose to them a risk. If their options are A: a guaranteed rate of return of 3%, or B: a possibility of complete loss (if I do something foolish with their investment) OR a potential rate of return of 3%, they will choose A every time. So if I wish to attract investors I have to demonstrate the potential for a return that exceeds that which can be had simply by hanging on to cash. So I have all kinds of incentive to increase the value the value of my company.

In addition, if I simply continue to maintain the statusquo, as a business manager, I leave myself vulnerable to competitors discovering how to provide a better product than mine for the same price, or providing the same product at a discount. And so my very survival depends on my providing a return that exceeds the return on passive cash savings, as well as ensuring that I stay ahead of the curve in terms of technological progress, otherwise the competition will take my customers and I will be unable to continue providing that premium on passive cash savings.

It is true that inflation favors debtors because as the loan’s life progresses repayment takes place with dollars that are worth less, and this does incentivize borrowing—without question. It is also true that as the value of the dollar increases, that it buys more with less, and that my business could find itself in a situation where its real revenue is constant, but in terms of dollars, its cash revenue drops. My supplies cost less. I can hire labor for less. And I have to pay less and pass this drop in price on to my customers. My competition forces this. Nobody is actually harmed because if I experience a 25% drop in expenses and also a 25% drop in revenue, it is all a wash, because everyone is able to purchase 25% more with these more valuable dollars. But my loan is contracted for a repayment of X dollars, not X-deflation dollars.

Still, if we assume that I didn’t impose a foolish burden upon myself by borrowing inordinately more and spending more than was necessary to actually get the business off the ground, and if that initial investment was simply what it took for anyone to get started in my particular field, then my competition will have to carry a similar burden and that loan repayment is simply going to figure into the price of my product. And if the loan amount is significantly large, then the price of my particular product might simply not drop immediately to the level deflation is pushing it. Deflation won’t impact the price of everything instantaneously. There might be a lag until loans are repaid.

And it is true that under these conditions, loans will be made more cautiously and carefully than they were made in the past. The ability to handle the burden of the loan over time will, without question, be taken into serious consideration in determining whether or not the loan will be made. And I think we should agree that this is good. The thing is that people who argue for an elastic currency find themselves speaking out of both sides of their mouths on this issue. They’re afraid that tight money will stifle business, so they want currency elasticity, but when the money supply expands and foolish, wasteful, harmful loans are made they cry for greater regulation of the banking industry. But the market is already completely capable of imposing this regulation naturally. We all know that it is because the elastic currency supply advocates, for some strange reason, are really afraid of this naturally occurring regulation. They actually want to defeat that natural regulatory mechanism, and then when it becomes clear that we need SOME regulatory mechanism, they call for artificial government regulation. This is artificial regulation that never would have seemed necessary had we simply maintained a consistent playing field of currency supply stability—when you do this, the regulation is automatic.

Another consideration is that if we find that the fear of loan repayment is so drastic that loans that SHOULD be taking place are in fact not, the banks have every incentive to deal with this problem. After all, they want to make loans. If the debtor has so many fewer dollars, but those dollars are worth so much more, there is no reason the bank wouldn’t be willing to accept fewer dollars in repayment if this increases the chances of convincing people to take the loans in the first place. The situation in which we will most certainly NOT find ourselves is one where there is money to loan, people who want to borrow and will reliably repay, in terms of real value, and banks not figuring out a way to make this happen. If deflation proves to be a significant burden, the loans will be structured to accommodate deflation. Simple as that.

You say, “Regarding incentive, I think that is directly tied to risk. Less risk=more incentive…I would rather continue to have the market establish how much risk should cost..” YES!! “…instead of tying the cost of risk to an inflexible currency no one can control” NO!!! This is a remarkable statement! You want the market to determine how much risk should cost, but then you say we need a flexible currency so that risk can be “controlled”! It’s the inflation of currency that essentially “socializes” risk. We all pay for this cheap credit via the devaluation of our dollars. And we have a master puppeteer pulling the levers on the money supply and, thereby, interest rates. You want the “market” to establish this, but then you want “controls” that someone can tweak. The seems like a pretty serious contradiction, unless I’m missing something.

You say “there were lots of truly profitable companies back when we had deflation, but they were rare.” I don’t understand this Under fixed currency supply deflation would only happen BECAUSE companies are profitable. The drive to survive the competition and continue to create profits is what drives the innovation, technology, and process-improvement that creates deflation in the first place. In a fixed currency supply scenario, deflation means that we have MORE stuff—MORE goods and MORE services, with the same number of dollars chasing that increased supply. In terms of real wealth, everyone, individuals and corporate entities are increasing in real profit. They’re not making more dollars because the supply of those dollars is fixed, but those dollars are now purchasing more and more stuff every year. In other words, in terms of REAL profit, you can’t have deflation and FAIL to produce significant profits. Profits are so closely correlated that you almost can’t have one without the other, unless you are artificially manipulating the money supply.

If someone wants to hoard their money and stuff it in their mattress this causes absolutely zero damage to the economy. By keeping the money in their mattress, they have essentially removed that money from circulation. In the sense of real circulating money, this money doesn’t exist. It is a decision on the part of the money holder to NOT invoke his claim on the goods and services offered by the economy. Imagine that half the money supply is stuffed in mattresses. That simply means that we have half the supply of money chasing the stock of goods and services. And so roughly, prices will be half what they would otherwise be if the mattress-savers either spent their dollars or loaned them out. So while there is half the money available for loans, the need for loans in the first place is exactly half what it would be if people pushed that money into circulation. If all the capital for a business costs half as much, you only need to borrow half as much. So this money hoarding is not a problem at all.

What IS a problem is bad investment. When someone is incapable of making good investment decisions (a lack of skill, knowledge, time to do the necessary research, etc.) we really do not WANT them investing their money. Every time a business fails, it hurts more than the investors who lose their investment. All of that capital and labor was tied up in a non-productive enterprise. People developed skills that were perhaps irrelevant. This means that while malinvestment occurred, resources were diverted away from the improvement of quality and efficiency in other areas. This idea that we need to spur people into the stock market, whether they are ready to do it or not, is bad.

This idea that the money in the mattress is somehow “taking capital out of the economy” is wrong. Keeping the money in the mattress does nothing to change the availability of labor, natural resources, and human ingenuity. It just means that person is opting not to “vote” on how those real capital resources will be utilized. And if they’re going to vote poorly, we would all be better off with that person simply staying home.

Saving dollars in the mattress deprives the greater economy of absolutely nothing at all. In the short term it means the prices of everything are less than if the mattress-savers spent their money. If these people aren’t qualified to make good investments, and they are content with the simple passive appreciation of their money, we are better off. We are far better off without their destructive malinvestment and the resulting unproductive diversion of resources and labor.

avatar Rassah

Matthew Walton:

Judging from your website, you seem to be making and proclaiming the same somewhat mistaken idea, that money/dollars is something that measures wealth. It’s not. All dollars are are a commodity used for exchange of wealth. No different from sugar, oil, or gold. We use dollars because they are convenient and we trust that the supply of this commodity isn’t going to suddenly skyrocket, but we can use other commodities to trade. If dollars are too risky for you, you can use euros, yen, stock certificates, or even videogame currency (I bought my $750 phone using currency I made in a business in SecondLife game). It’s also strange that you tie the Fed to the government, as if the government has any control over what the Fed does and controls it with sneaky and malicious intent. Also slamming on “the rich” because they steal value from the poor’s dollars, when “the rich” generally don’t hold dollars but assets, seems kind of hard-left. But anyway, regarding your reply:
Paragraph 1 – Excellent point! In a perfectly and instantly adjusted economy with no depreciating assets, the company would not be affected by inflation at all. But that’s not our economy. In inflation the things it has to worry about is the drop in value of items in inventory (just due to age) and the drop in value of the cash it holds. If the company holds $100 in cash and does nothing, that money will buy less next year. If it just buys inventory and lets it sit, depending on what it was, it’ll probably be worth less by end of the year, too. So the company has an incentive to take that money and use it to buy something else, such as inventory, and ways to add value to that inventory. If inventory grows in value by itself, that’s an investment business, not a production one. A company can already buy gold and just sit on it, letting it “deflate,” and make money without producing, or even buy gold ETFs (gold-tied “currency), making money on it’s own mini deflation. In a hyperinflation situation, though, the inventory and assets of the company continue to decline at the real value rate that they did at before, and that is why stocks don’t really care about inflation. Not because the company owns cash, but because it owns real hard assets (I fully expect cash-heavy stocks like banks and some current tech firms will be hurt severely).
Paragraph 2 – I guess I should have been more specific. Inflation incentivizes creating value through production, while deflation allows value be created through cash appreciation. You need work to make money under inflation much more than you need it under deflation. And in your option, people choosing A is what leads to stagnation.
Paragraph 4 – As you said, it’s a wash. But how does it affect your cash and inventory? If you have $100, you’re better off just holding on to it unless your business can make at least 3%. If your inventory declines a bit at the end of the year, you can resell it for.. ??? I guess more or less depending on how much deflation there was? Your employees cost you more at the end of the year, and you have to cut their salaries annually (will they take your explanation for having their paychecks cut, or argue that they are adding more and more value to your company?). And in a hyperdeflation, you’re better off just buying more and more cash, since it’ll keep going up in value more than what you can get by producing. Also buying more or it will decrease its supply, making it go even higher, in a self-perpetuating cycle.
Paragraph 5 – One quirk with borrowing. Most of the time it’s done against collateral. If you have a business idea and nothing to actually back it up yet, chances are your house is the collateral (I work at a bank where we give out business loans, and if your business fails, we go after other assets). Under inflation, bank gives you $100k, your collateral is worth $100. Next year you owe $97, your collateral is worth $97 (stuff gets older and worn out). Under deflation, next year you owe $103, and your collateral is worth $97 or (deflation-adjusted $100). Ten years later, you owe $130, your collateral is worth $100. The only way for a loan to work in this deflationary situation is for a bank to front-load most of the loan. So, you want $100k? You owe us $130k in collateral to start with. We’ll tack on interest from there. It just makes things way more complicated and unpleasant. With inflation the idea is that both stuff and money wears out.
Paragraph 6 – As I mentioned previously, how easily loans are acquired depends on how much the bank things it should charge for the risk of giving the money in interest rates. Even in hyperinflation, banks can hedge themselves by making loans with enormous interest, thus continuing to disintenvizing people from taking out loans. The banking regulation that people have been talking about recently is not for forcing an arbitrary price on risk, but to make sure banks report the details of their assets correctly, so that others can know what risk is involved and price it correctly as well. The multitude of bad loans was a problem, but the number one problem was that the banks who resold them didn’t explain fully what it was that they were selling. If other entities who bought those bad loans knew more about them, they would either pay less for them, or not buy them at all, and in the end only the banks selling them would have went under. This has nothing to do with inflation vs deflation, since under deflation some bank could just as easily sell a whole bunch of bad loans, claim they’re risk free, sell them to a bunch of suckers without disclosing their details, and crash the system when people who got those loans couldn’t pay them. The natural regulation is paying correctly for risk. The needed regulation is making sure it’s disclosed properly. The reason it is needed is because without it we all would waste an enormous amount of time researching every single bank in detail before making any decision, or all the competitors would race towards the lowest common denominator, and we’ll be going with whoever claims they’ll give us the best returns, risk be damned.
Paragraph 7 – Why would banks want to make loans? Now they want to make loans because cash isn’t giving them anything, and they would rather put it to good use. If there is a deflation, why wouldn’t they just want to sit on it, or better yet try to accumulate as much of it as possible to artificially decrease the supply and make their own holdings be worth even more?
Paragraph 8 – Good point. You’re right, that was a weird statement. I think by “control” I meant more as “under control versus going wildly in all directions” and not “is under direct manipulation” I prefer an economy where we know money will devalue and have a fairly reasonable expectation of what future inflation will be (since we have someone controlling the amount of that commodity in circulation with an incentive to keep it inflating at a low rate), rather than having no idea if the currency will continue to slowly deflate, contract/deflate very suddenly because everyone started hoarding it, or suddenly inflate because some foreign country decides to dump all their reserves on the market to buy up military hardware to use to invade our now economically broken country (extreme example, I know). Businesses, and I, like predictability. Currency that has too many players, such as gold, is unpredictable.
Paragraph 9 – You said “Under fixed currency supply deflation would only happen BECAUSE companies are profitable.” Not true. Deflation happens because companies become profitable by making more valuable things, but also because they accumulate the money, decreasing it’s supply in the market, because individuals hoard money, decreasing it’s supply, because population grows due to birth and immigration, spreading limited supply among more people, and due to imbalances in international currencies and currency reserves. With all these factors playing in the economy, with a fixed currency a company can be profitable from making great products, or it can be profitable from just holding currency. Again, think of money as just a commodity. Companies that now collect and invest in diamonds or precious metals are still making profits, despite not doing anything other than betting on increases in prices. Same deal in a gold-tied economy, except everyone will be doing it.
Paragraph 10 – If you say that printing money, or adding a supply of a commodity to an economy, causes problems, you can’t turn around and say that reducing that supply doesn’t cause problems. People hoarding money under mattresses means that where there used to be a certain supply of money, now that supply has decreased. If everyone stuffed half of the world’s gold into mattress, now everyone who has a loan now has to pay twice what they owed previously. If I buy $10k cars that I wanted to sell at my dealership and paid $10k for each, I’m now only able to sell them for $5k each. Problem is, the person I bought them from still wants $10k per car. We’re talking about hyper inflation and hyper-deflation here, but point is still that if you believe small inflation will cause problems, so will small deflation.
Paragraph 11 – If you don’t want people investing, how do you propose we stop them? Regulation? They would recklessly invest in a deflationary economy, too. And with inflation, companies that aren’t performing will become quickly obvious when they fail to keep up with inflation, while companies that are under-performing may be able to hide their lack of performance by relying on appreciating assets like cash. Granted in both situations companies can just rely on appreciating assets, so this whole point is kind of moot. The idea is that we want companies, not just people, to do something with their cash, lest they lose it. Their option is do nothing and fail, or do something and be ok. With deflation, their option is do nothing, and still make money on rising value of cash. And it’s businesses that largely drive economies, not individual people.
Paragraph 12 and 13 – You are correct, hoarding gold-based dollars doesn’t decrease the world’s capital outside of the value of those dollars. But it does make everyone’s dollars go up in value for no reason other than that some people are hoarding gold. It makes the people hoarding gold lazy, in that they don’t have to work, research, or think where they should invest and which companies they should reward in other to become richer. It also deprives the economy of a means of exchanging goods.
Last, and biggest point, is that there is a reason for things being they way they are. Gold standard isn’t some new radical idea that will help us fix stuff, it’s an idea that we tried previously which failed horribly, and thus was replaced. Again, money, dollars, and gold is nothing but a commodity. If you don’t like dollars, just go ahead and buy gold. Why do you need the government middle-man to switch to your own private gold standard? And if we did go back to the gold standard, once a deflationary spiral hits, or the same problems that made us switch last time creep up, people will just switch to other means of exchange for goods, like any number of foreign currencies, commodities, or private corporate paper.

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avatar xavier

7 months later and gold is still going strong. Fiat Currencies have the inherent flaw, gold is real money.

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