Money and Meteorites

Like a lot of modern libertarian types, my first in-depth exposure to economics came from the minority ‘Austrian School’ of economics. The Austrian school shares a lot in common with Chicagoan economics, but it parts ways with Chicago — and indeed most other economic schools — on the question of money supply.

Via Thoughts on Freedom comes an op-ed in the Wall Street Journal rehashing the argument, common amongst Austrians, that central banks should be abolished or downsized in favour of a return to the gold standard:

In the aftermath of this financial catastrophe, as we sort out causes and assign blame, with experts offering various solutions — More regulation! Less complex financial instruments! — let’s not lose sight of the most fundamental component of finance. No credit-default swap, no exotic derivative, can be structured without stipulating the monetary unit of account in which its value is calculated. Money is the medium of exchange — the measure, the standard, the store of value — which defines the very substance of the economic contract between buyer and seller. It is the basic element, the atom of financial matter.

It is the money that is broken…

If capitalism depends on designating a person of godlike abilities to manage demand and supply for all forms of money and credit — currency, demand deposits, money-market funds, repurchase agreements, equities, mortgages, corporate debt — we are as doomed as those wretched citizens who relied on central planning for their economic salvation.

Think of it: Nothing is more vital to capitalism than capital, the financial seed corn dedicated to next year’s crop. Yet we, believers in free markets, allow the price of capital, i.e., the interest rate on loanable funds, to be fixed by a central committee in accordance with government objectives. We might as well resurrect Gosplan, the old Soviet State Planning Committee, and ask them to draw up the next five-year plan.

There’s a lot to be said for this analysis. Of the three broad schools of economic thought I know the proverbially dangerous minimum about — Keynsianism, Monetarism and Austrianism — their downfalls have been stories of crisis. Keynsianism was mortally wounded by the stagflation of the 70s because it wasn’t meant to be possible. Monetrism will probably suffer a similar blow to its credibility in this crisis. Austrianism rejects both Keynsian fiscalism and monetarist fiddling with the supply of money; and demands free markets for both. This is a crisis almost custom made for Austrian economists, but there are probably too few for them to storm the gates of the policy-setting citadels around the world.

I have my reservations about a return to the gold standard. The basic argument is that gold has been recognised as universally valuable throughout history and across the world, and remains so today. It is durable, fungible, is scarce, varies in supply slowly, has a high value per unit of volume and mass and is easy to verify. These qualities, goes the Austrian argument, have made it the monetary basis of choice any time in history when there was a free market in money. It is the state’s short-term interest in debasing and inflating the currency, runs the argument, that leads to the cycle of boom and bust.

Counter-arguments tend to focus, witty putdowns by Lord Keynes aside, on the variability in the supply of gold. Pro-gold folk argue that it can only change by a few percent in a year at the most; otherwise put, that the stock of gold already mined and in circulation vastly outstrips the amount of gold that can be mined in a year. Therefore there’s a natural, expensive-to-surmount barrier for inflation to overcome. Furthermore, if currency is pegged to gold, debasement of the currency is immediately visible to citizens, providing a powerful disincentive for politicians or others to try and inflate their way out of trouble.

The counter argument is that we don’t know how much gold is actually in circulation; that a lot of it is tied up in jewelry, tooth fillings and — these days at least — electronics. That gold could flood into the market if gold becomes the backing store for currency, making a nonsense of the stable money claims.

Myself? I’m not too worried about people pulling out their fillings at Harvey Norman to buy a flatscreen TV. I’m more worried about the gold in the asteroid Eros, which contains approximately 705.5 billion ounces of gold. At today’s rates that’s about $605 trillion USD, or, otherwise put, about 9 times the Gross World Product.

Now I have a bad habit of getting things wrong when so many zeros are required to bulk out a number, so I could easily be out by a factor of ten or a hundred. So no worries if someone starts tearing Eros apart: maybe one year of mad inflation and then things return to normal.

Except that Eros is only one near-earth asteroid in our solar system. There are thousands of such objects, and thousands more if you’re prepared to hike out to the asteroid belt, or the trojan asteroids. Not to mention mineral deposits which make be present on the moon or Mars.

The fact is that the gold standard is not so much a barbarous relic, but a relic of a pre-spaceflight civilisation. It cannot survive what I have previously called ICI — Intrasolar Colonisation and Industrialisation. If, as we surely must, the human race moves into space, the gold standard simply isn’t viable. Asteroidal minerals are available in such vast quantity in such high quality that gold will simply lose its value too completely and too quickly to be a viable store of value.

What replaces gold in an Austrian scheme is anyone’s guess. Free banking, where commercial banks print their own currencies backed by depositor … er … gold, is proposed as one answer. Though again the same problem: there is a presumption that there is some independent, physical measurement of value that can be universally trusted and which has stable value.

Arthur C Clarke once proposed a currency based on the kilowatt hour, but again ICI makes that worthless. It may instead be necessary to develop cryptographically verifiable money and there has been research in that direction by mathematicians. Of course that depends on the quality of the cryptography; currently public cryptosystems rely on the unproven belief that there is no quick way to factor large prime numbers. If someone discovered such a method, they could destroy the currency overnight.

And that’s just one set of problems, never minding economic disruptions like the possibility of mature nanomanufacture. But that’s a post for another day.

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23 Responses to Money and Meteorites

  1. Sinclair Davidson says:

    Jacques, some summer reading. Vienna & Chicago: Friends or Foes?

  2. derrida derider says:

    The really interesting historic example comes from silver. Silver money has been rather more widely used over a longer period than gold (as a BTW, tobacco had a longer run in the US than either). Then the silver mine of San Potosi was discovered in the 17th century.

    The effect was Europe-wide inflation and an eventual distrust of silver as a base. Though some economic historians argue that this mild and sustained inflation in the meanwhile both accommodated and sponsored the early Industrial Revolution (by keeping real interest rates down – presumably our ancestors were subject to money illusion).

    I think gold as a base is far too subject to the vagaries of supply for one thing – exploration and mining techniques have progressed since previous centuries, even without interplanetary travel. Also Goodhart’s law will apply to it as much to it as any other form of controlling money supply. After all it’s not as though economic fluctuations were unknown while everybody was on the gold standard – far from it.

    You need to face facts – free market capitalism provides impressive long-term growth rates, but is not a perfectly self-stable system. Keynes showed one reason why not.

  3. Rafe Champion says:

    DD, one is inclined to argue that free markets do not need to be perfectly free to do better than the kind of political interference that caused Great Depression and the current problems in the US.

  4. Patrick says:

    Is one inclined to so argue or does one so argue?

  5. NPOV says:

    Just out of curiosity, Rafe, which economists outside the Austrian school have argued that political interference “caused” the Great Depression? Because, AIUI, even Friedman argued it was caused as much by central bank inaction as anything.

  6. JC says:

    Jaques:

    The history of gold is actually quite interesting. Governments have always hated gold and unremittingly tried to cheat with the weights and/or find ways to thwart its use. So by that account alone it must be a good thing, right?

    I think the current malaise is almost all to do with monetary disequilibrium; not just in the US but the rest of the world. I really don’t know if we can ever go back on a gold standard as it would be almost impossible now in terms of government sponsorship. I might add that people aren’t prevented from using or storing gold now in most countries so it’s not as though governments are stopping us. We could do a deal now and the contract could based in gold as part of the consideration. My feeling is that we have now past the possibility of ever introducing a gold standard.

    However it doesn’t mean we can’t improve on the current system. Interest rate/inflation targeting is a real problem and very damaging. CPI doesn’t measure value of hard and financial asset prices. We also have the absurd situation where the central bank is forced to raise rates when clear dis-inflationary events occur such as the run up in the price of energy which is clearly not inflation.

    Central banks can only do one of two things. They can either control the price of credit or control the quantity. Interest rate targeting assumes they can do both under the illusion that a central bank armed with countless economic researchers can select the most appropriate interest rate that limits the quantity of money. It can’t as it can set the price of credit too high thereby causing a recession or set it too low creating far more demand for money than is appropriate causing inflationary induced booms.

    Which means we have to go quantitative management allowing the the market to set interest rates with predetermined and fully transparent money supply growth set as a target. I really don’t think there is any other way under unbacked money. The central bank of Mexico used to operate this way for a good part of the 90’s and it worked reasonably well. They were more or less forced to do so because the market didn’t trust them with interest rate targeting and they also wanted to demonstrate they weren’t inflationists.

  7. MikeM says:

    DD,

    Tobacco is losing its place in the US as a medium of exchange because of the growing prohibition on its use. An article in The Wall Street Journal earlier this month reports that it is being replaced in jails by, of all things, packs of fish:

    There’s been a mackerel economy in federal prisons since about 2004, former inmates and some prison consultants say. That’s when federal prisons prohibited smoking and, by default, the cigarette pack, which was the earlier gold standard….

    Mackerel is hot in prisons in the U.S., but not so much anywhere else, says Mark Muntz, president of Global Source, which imports fillets of the oily, dark-fleshed fish from Asian canneries. Mr. Muntz says he’s tried marketing mackerel to discount retailers. “We’ve even tried 99-cent stores,” he says. “It never has done very well at all, regardless of the retailer, but it’s very popular in the prisons.” …

    Mr. Muntz says he sold more than $1 million of mackerel for federal prison commissaries last year. It accounted for about half his commissary sales, he says, outstripping the canned tuna, crab, chicken and oysters he offers.

    Unlike those more expensive delicacies, former prisoners say, the mack is a good stand-in for the greenback because each can (or pouch) costs about $1 and few — other than weight-lifters craving protein — want to eat it.

    The main disadvantage of mackerel is that you cannot take it with you when your sentence ends.

  8. MikeM says:

    Paul Krugman’s little story from 1998 about the Capitol Hill baby-sitting co-op illustrates why reversion to the gold standard doesn’t help in a recession.

  9. Michael Kalecki says:

    tobacco as a value of exchange went up in smoke.

  10. JC says:

    MikeM
    The example is a falsity of composition as he’s describing one thing to make it appear like something else.

    What he’s describing in his example is hoarding which is a different action to saving.

    Hoarding happens when someone goes to the bank withdraws cash and sticks it under his mattress whereas Saving is something entirely different. Sticking money or gold under the bed is not saving. it’s hoarding.

    Using this example to suggest that saving is somehow bad or would cause a recession is nonsensical. This is basic monetary economics. Perhaps it’s not in every text book, but still surprised he used this as an example.

  11. Ingolf says:

    Quite apart from JC’s comment, MikeM, the Krugman example always struck me as fundamentally flawed.

    I had a look at the Krugman article (when it came up on another site last year as well as in a long discussion on Troppo) and also, out of curiosity, looked for the original article from the Journal of Money, Credit and Banking on which he based his story. (Only the front page out of four is available without shelling out US$44 so I contented myself with that). Interestingly, it seemed to confirm what had seemed to me the most obvious fallacy with Krugman’s analogy. Let me quote the relevant excerpt from that first page:

    Whatever the lessons from the board’s experience [an amusing reference to the Fed], the lessons from the co-op’s are clear. (1) The co-op has been increasing its money supply (scrip) per capita, by running budget deficits, and this has generated inflationary forces. (2) However, the main commodity this scrip buys is baby-sitting time, and the price of baby-sitting is pegged at one unit of scrip for every one-half hour of baby-sitting. Hence, this system of price controls means the inflationary pressure does not drive up the scrip-price of baby-sitting, inflation is suppressed, and shortages are found.

    Exactly. To solve the imbalance, they simply needed to allow the price of the scrip to fluctuate according to the demand for and supply of baby-sitting services. But then it would really just be an ersatz form of money, something which I dont think has ever worked out terribly well. Theres a deeper flaw with using this little scheme as a monetary analogy, though, since the scrip could primarily only be used for one service. To the extent that natural, chronic imbalances whether seasonal or otherwise occur in baby-sitting, they would always have problems using one-purpose scrip. In real life, on the other hand, money can be used for any purpose so come summertime, you’re either willing to pay up to get your sitter or you stay home with the kids. Winter, you could get it for next to nothing.

    Don’t think there’s any insoluble problem there.

  12. derrida derider says:

    Oh MikeM, I wasn’t referring to informal use – I was referring to tobacco (and banknotes backed by it) as the only legal tender. The trouble was that debasement of the monetary base was too easy – Gresham’s Law took over. By the end of it anything that could be vaguely passed off as tobacoo was.

    JC, of course, is missing Krugman’s (and Keynes’) point. Hoarding is one particular form of saving. The choice between it and other less liquid forms of saving depends upon what you think it will buy later. Neither Keynes nor Krugman argued that saving is necessarily or even usually a Bad Thing – quite the contrary.

    Also, isn’t your comment about “allowing the the market to set interest rates with predetermined and fully transparent money supply growth set as a target” very precisely what Uncle Milton used to say? Even he backed away from after it failed it’s empiric test because of Goodhart’s Law (which was actually invented by a central banker to explain this failure). To say the only way to maintain stability is through M1 targets is tantamount to saying there is no way to maintain stability. And as I said, other forms of money don’t have that flash a record for that either.

    But let’s not get too far into a thread about money creation – we’ve been there, done that, and are still recovering.

  13. JC says:

    Hi DD:

    JC, of course, is missing Krugmans (and Keynes) point. Hoarding is one particular form of saving. The choice between it and other less liquid forms of saving depends upon what you think it will buy later. Neither Keynes nor Krugman argued that saving is necessarily or even usually a Bad Thing – quite the contrary.

    I think we really need to be very careful with definitions/terms and analogies in economics, DD. Hoarding is not a form of saving in the way we understand saving in a normal functioning economy. In of itself hoarding could be viewed as a good thing as it’s fulfilling the needs of an individual however in the wider context it’s also symptomatic of economic conditions….. that are not so good.

    Krugman was using hoarding to imply there is a demand management problem when it’s the economic conditions causing such behavior so well described by Ingolf?

    ———————-
    Look DD, I really think there is a fundamental weakness in the worlds monetary system that causes these slides into darkness. There’s no doubt in my mind that the current problems can lay at the foot of the Fed’s door and if not directly responsible certainly indirectly so.

    Conversely look at the bloody mindedness of the ECB that sits on the opposite side of the fence… they’re too tight and dogmatically so.

    I think there is a difference between Milt’s monetarism and quantitative theory

  14. rog says:

    I think we really need to be very careful with definitions/terms and analogies in economics

    Especially when no one has a clue, que?

  15. rog says:

    Looking at the flight to the $US, people are panicking (ie people in the collective sense) and the $US is the only stable currency around – compared to the rest.

    And all the rest is just chat….

  16. JC says:

    Did I see the word panic, Rog? The Aussie is now at 64.50 cents. That’s a panic :-)

    Never seen anything like this move. 35% move in 3 1/2 months and 20 move in a week.

  17. rog says:

    Yep, buy your telly now as they arent going to be cheaper ( I think).

  18. Tel_ says:

    Arthur C Clarke once proposed a currency based on the kilowatt hour, but again ICI makes that worthless.

    I doubt I’ll live to see the kWh become worthless, so far it just keeps getting more and more expensive. With a hefty supply of cheap kWh you can create most other commodities that you need (not land, but you can create heat, food, water, gold, etc).

    Which means we have to go quantitative management allowing the the market to set interest rates with predetermined and fully transparent money supply growth set as a target. I really dont think there is any other way under unbacked money. The central bank of Mexico used to operate this way for a good part of the 90s and it worked reasonably well. They were more or less forced to do so because the market didnt trust them with interest rate targeting and they also wanted to demonstrate they werent inflationists.

    We can go back to every bank issuing its own paper currency which puts an exchange-rate calculating burden onto ordinary money users (i.e. everyone) but also makes them think carefully about who they trust (people who think? danger, danger!) and very rapidly isolates any bank caught trying to print more paper than they can back. Given that pocket electronic calculators cost approximately nothing these days and given that small units of data transfer also cost approximately nothing, the exchange-rate calculation is easier now than ever before in history… maybe time to wake up an old idea. Indeed, in a market of bank-issued currencies, someone is sure to use all manner of metal and commodity standards.

    Having said all that, I think it is fair to point out that if a decently broad range of shares and commodities are easily available for regular citizens to purchase (with online trading and similar) and if people make a habit of not holding too much fiat cash at any one time, then to all intents and purposes inflation does not matter much. If you think gold is the best asset to weather a tough market then buy it…

    You need to face facts – free market capitalism provides impressive long-term growth rates, but is not a perfectly self-stable system. Keynes showed one reason why not.

    As I’ve mentioned before, capitalism is an integral controller, they are never stable. Check a basic textbook on linear feedback systems. The real world is not linear of course, and at the extreme of the swing is where the most notable nonlinear effects start to kick in (government steps in to arbitrarily twiddle the dials for example, voters demand a quick fix, etc).

  19. Jacques Chester says:

    I doubt Ill live to see the kWh become worthless, so far it just keeps getting more and more expensive. With a hefty supply of cheap kWh you can create most other commodities that you need (not land, but you can create heat, food, water, gold, etc).

    My point is that compared to human enterprise, the output of the sun is limitless. In space if you want to create some more kwh you just push out some solar panels or set up a concentrator dish.

    Post-ICI is the key, though. With a mature industrial base in space, producing panels is trivial. Neatly enough this makes a lot of energy intensive industries attractive. Without gravity and with ample room there’s probably no engineering reason why you couldn’t build 100GW smelter complexes or the like.

  20. rog says:

    A few weeks ago Westpac were forecasting parity with $US 0- just goes to show about forecasts

  21. Tel_ says:

    Quite apart from JCs comment, MikeM, the Krugman example always struck me as fundamentally flawed.

    Interesting article, thanks for the pointer. I can see it flawed in a number of other ways. Krugman suggests that the winter/summer fluctuation is solved by inflation because inflation means that easy savings collected over winter are devalued for spending in summer. He conveniently ignores the converse where hard-earned savings made during summer are also devalued in winter time. It would require backwards inflation to fairly reward the people who sacrifice their summer evenings and want additional compensation in winter time… but backwards inflation requires a recession and we can’t have a recession because more scrip gets printed, so summer babysitters are guaranteed to get burnt. Since everyone knows this will happen, you STILL can’t get a babysitter in summer.

    It get’s worse if you consider the midwinter’s night when a famous opera singer comes to town “for one night only” and all the couples want to go out for just that night and no other. You can have any reserve of scrip you like and you still won’t buy a babysitter that night, but the night before and after are no problem. Does Krugman suggest massive inflation one night then some insane backwinding on the very next night?

    I agree with Ingolf that you need some cross-dimensional connection to break the problem (i.e. something else to buy than just babysitting). For the “one night only opera” someone still finally has to babysit (kids hate opera, as do I) so something has to compensate this particular couple enough to make it worth missing out.

  22. Tel_ says:

    My point is that compared to human enterprise, the output of the sun is limitless. In space if you want to create some more kwh you just push out some solar panels or set up a concentrator dish.

    Until enough other people are doing it and everyone is living in someone else’s shadow. Then the sun in blacked out by a haze of collectors, each one picking up what their closer competitors have let slip past and once again kWh are in short supply.

    Someone may have already done this before us, which might explain all the dark matter in the universe :-) (no, I’m serious, it almost makes sense). :-) :-)

  23. Jacques Chester says:

    Until enough other people are doing it and everyone is living in someone elses shadow. Then the sun in blacked out by a haze of collectors, each one picking up what their closer competitors have let slip past and once again kWh are in short supply.

    You’ve described a Type I Dyson Sphere.

    Someone may have already done this before us, which might explain all the dark matter in the universe (no, Im serious, it almost makes sense). :-)

    Dyson proposed that we should look for anomalous infrared sources, as these are likely to be Dyson sphere civilisations radiating waste heat.

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