On Gold Standard and Fixed Money Supply Theory

Many Libertarian economist (mostly from Austrian School of thought) believe that government/central bank interference in market is coercive and detrimental. According to them the booms and busts are created by the Central banks which artificially controls money supply by manipulating interest rate and "quantitative easing". Many advocate a gold standard or a "fixed money supply" would bring harmony in markets and protect it from going to extremes (booms and panics). In this post, I want to discuss the consequences of fixed money supply and its impact on market equilibrium.

The consensus among economists is that increase in money supply leads to inflation. In deflationary period, money supply is increased as a remedy to protect economy from going into recessions. Similarly, decrease in money supply leads to deflation and is often used as a tool to control inflation and slow-down the growth of economy. The effective relationship between money supply and commodity prices can be derived by a supply-demand curve. However there is another dimension to it and that is the population growth. This was already discussed in the post (Inflation: A Necessary Evil? ).

The necessary condition for a healthy economy is to have growth for the simple fact that human population grows over time and need to have increase in production to keep up with the demand. In a fixed money supply scenario, increase in production to fulfill growing population-needs causes deflation. There were actually times in late 19th century when deflation was a norm because of constrained money-supply. A fixed money supply would cause prices to fall over time given a positive population growth-rate. The consequence of this deflation will be that people would be more interested in holding cash instead of investing it because the value of currency grows over time (and prices of commodities go down). The result of this decreased investment is high unemployment, falling production in near term. This in turn results in shortage of goods and lead to rising commodity prices. The rising commodity prices will then cause the currency to lose value causing inflation. This inflation in turn will lead to increased investment. This increased investment leads to increase in production and in due course of time causes drop in commodity prices. Thus the economy swings between inflation and deflation cycles (i.e. booms and busts). The duration of these booms and busts is not a week or month but it stretches over a longer duration during which things get over done. The whole cycle gets erratic with prices sharply shooting up and going down as the perception of market participant changes. There will be much more wastage because of abandonment of production-resources during deflationary period. The unemployment rate will fluctuate wildly and will cause a lot of economic instability. That is a fixed money supply would cause more frequent and more extreme economic cycles. This is in complete contradiction to what Libertarian economist portray.

Lastly, if we look back at history, booms and panics in stock market were much more frequent and of much bigger magnitude than in modern times (Pre-Federal Reserve Act period). This is something which all libertarian economists hide in their literature. The fact of the matter is in capitalism where people allocate resources depending on prevailing perception the occurrence of booms and busts is inevitable. Those who blame central banks for this should ponder more over fixed money supply system.

How the Rich Get Richer?

It is a well known fact that in a capitalistic society rich get richer and the gap between the rich and poor keeps growing. While the overall standard of life might improve due to human innovations, the gap between rich and the poor continues to grow with time. The current recession has once again proved this point. “The wealthiest 10 percent of Americans — those making more than $138,000 each year — earned 11.4 times the roughly $12,000 made by those living near or below the poverty line in 2008, according to newly released census figures. That ratio was an increase from 11.2 in 2007 and the previous high of 11.22 in 2003.” (Read more here). Philosopher Adam Smith has summarized the phenomenon as: "The problem with fiat money is that it rewards the minority that can handle money, but fools the generation that has worked and saved money"

In this post, I want to explain this with an analogy. The analogy of capitalism is like a water tank with an outlet near its top (say at 75% of its height). This tank is elastic which means its base area can be expanded or shrunk. For a given volume of water, If we shrink the area of tank the water level rises whereas if we expand its area the water level falls.

The water tank in this analogy is the rich-capitalist class. The common man derives his income from the outlet which is located near the top of the tank. In other words, common man receives the excess-capital which the higher class is willing to invest for Job creation. The amount of capital available for investment is not dependent on the total volume of water available in the elastic-tank but on the water-level of the tank. This means the excess-capital is not dependent on the hard-cash like dollar-bills (or notes) but the market-value of the existing investment. The water that comes in the tank is the revenue from production and services. For a healthy business environment the water inflow has to be greater than the outflow (as most of the businesses are profitable).

Now, the interesting thing to note here is how the whole boom/bust sequence actually make the rich richer whereas common person ends up getting poor (at least after taking into account the inflation).

During the boom period (like late 1990s), the area of the tank shrinks and the water level rises. This higher water level means more water coming out of outlet (i.e. more jobs, more income, more returns on their nominal investment for common man). Note here that the actual volume of water might have increased in the tank (due to actual growth in production and innovation) but the increase in water-level is much more due to shrinking of tank’s area than by increase in water volume. That is to say that the amount of capital available for investment during the boom period is not because of actual increase in book-value but because of anticipation of higher returns and the perception of favorable business-conditions. This can be seen in the high price-to-earnings (PE) ratio of stocks and the low yields-values of bonds.

The increase in water level means more water getting dispensed from the outlet which means more jobs and higher salaries for common people. A common person, for what he is, does not grasp the entire picture and starts to make allowances which he cannot afford during normal times. The real-estate boom of 2004-2005 is a classic example where the crowd got deceived by the low unemployment rate and higher wages and started buying houses on Interest-Only loans or ARMS.

Increased outflow and profitability leads to higher inflow in tank which leads to actual increase of water-VOLUME in the tank. That is to say the appearance of increased prosperity will lead the crowd to spend more which in turn helps capitalist to increase their real wealth due to increase in production and consumption. Thus during the boom-period the rich folks benefit from the increased spending of the whole society. Because of rapid rise in water-level of the tank due to shrinking base-area (i.e. perception) as well as due to real increase in water volume due to increased inflow (i.e. real increase in wealth), the height of outlet increases. For examples if it was at 75% of tank’s height before boom-time, it goes to 80% during boom-time. This rise in outlet level is necessary to increase the amount of profits made by the capitalists. This means the increased company earnings does not linearly translate into increase in salary/compensation of workers. For example Microsoft's net worth has grown from $6/share in 1990 to $59/share in December 1999 (approx. 10 times increase), however this did not lead to a 10 times growth in income of a normal software engineer.

Of course, the boom has to end somewhere and it generally starts with an external event which shakes the belief that prosperity cannot continue forever (i.e. water level in the tank cannot grow forever). The first effect of this change in perception is that the tank starts to expand in area which means the water level which has gone up due to shrinking of tank area (during boom-time) starts to retrace and go lower as the tank-size increases. This means the capitalists who have enormous wealth on paper starts to see it going down as the changed perception causes the stock prices to go down and yields to go higher. This decrease in water level means less water coming out of outlet. This means the common man who was receiving high wages and bonuses starts to realize the sudden decline in his income. He suddenly realizes the allowances that he made for himself during the boom time are no longer affordable. The effect is worse as the level of outlet during the boom-period has increased (as we mentioned earlier from 75% to 80%). This decreased prosperity of common man leads to a "real" decrease in wealth of capitalists due to falling retail sales and profit margins. The level of water begins to fall not only due to increase in tank area (i.e. perception) but also because of decreased inflow (i.e. actual wealth reduction). This can be seen in lower earnings per share (EPS) as well as low PE ratios of stocks during recessions.

The starvation of common man due to decreased capital investment causes the government to come into action. It has to do "something" to assuage the sufferings. The central bank (which is not completely independent of Federal govt., as mentioned in Federal-Reserve act) starts to lower interest rates and adds more liquidity into market. This is like putting more water in the tank by an external source. Fear about the business condition keeps growing. The area of tank continues to expand and Central bank keeps pouring water into it to bring up the water level in order to feed the thirsty crowd. Note how every govt. intervention HAS to go through the water-tank otherwise it will be labeled as communism! (i.e. the system is designed in such a way that the well-being of common man is completely dependent on the prosperity of capitalists).

Ultimately huge monitory easing leads to disappearance of fear and arrival of hope. Confidence develops and begins to increase with government assistance. This means the growth in tank area stops and the water level begins to increase (i.e. the beginning of next boom cycle). In the worst case the water tank keeps expanding and might even develop cracks leading to depression. If the cracks are not mended even by govt. intervention, it might lead to a systemic failure (which was almost the case in October 2009 when Lehman failed and AIG was on the verge of failing).

In this whole episode, the volume of the tank has increase enormously which is to say the rich have gotten even richer. The common man ultimately gets his income from the same old outlet at may be a slightly higher rate. The ratio of water available in the tank to what is dispensed rises substantially compared to what it was in the previous boom/bust cycle which means the ratio of wealth held by rich and poor keeps growing!

The Arrogance of Capitalism Vs The Peril of Common Person

As I write this post, the government of USA has pledged about $780 Billion US Dollars (USD) for stimulating the economy. Treasury secretary Timothy Geithner is asking congress to approve about a Trillion USD for bank rescue. Add to this amount 1 trillion that Ben Bernanke (Federal Reserve chairman) is planning to use for TALF and for buying other housing related debts. Government has already approved $700 billion for TARP funds. When you add all this (along with the unemployment benefits for 4 million unemployed), the total comes to a staggering 4 trillion dollar. (The Mere repetition of the word ‘Trillion’ in news might devalue the US dollar!).

If we analyze President Obama’s promising spending plan carefully, it is not as promising as he advocates. There is a lot of criticism from Republican aisle that we all hear in the news. To cut short the rant, I would say the spending plan will not bear any fruit for next 2 years at least. The infrastructure projects do not start overnight. This defeats the very purpose for which the ‘stimulus’ was designed. Apart from this, most of the planned projects are not even critically useful and at least to me it seems like spending for the sake of it.

The bank bailout money is an indirect way of putting toxic assets on Govt.’s balance sheet. I am not advocating that banks should be left alone to deal with this, but there is no use of stuffing money in a feared entity either. With so much money at hand, banks have failed to lend due to their own fears. Stuffing money in bank at this time is like asking a scared child to go in dark. The interest spreads are skyrocketing despite the easy availability of money. In Ludwig Von Mises's words: “As the confidence wanes, the entrepreneurial component of Gross Market Interest spikes to a great height”. It is like a man who escaped from bunch of robbers, he will view every other man with suspicion. The bailout is like asking such a man to be friendly with strangers and lend them money with confidence.

Bernanke’s plan is more sensible than the other two. The problem however is that he realized it a lot later than he should have. He approached the problem with traditional monetary tool like: lowering feds funds rate, putting money in the banking system etc. After seeing them fail (and frankly too late) he realized that the need of the hour is for the Govt. agencies to be more direct in dealing with consumer lending and main-street businesses. Fed will now back securities for consumer and small businesses. It even plans to target securitized loans for larger manufacturing businesses. But all this has come after a year of economic downturn when fear has completely taken over the financial system.

The arrogance of Capitalism lies in failure to acknowledge the fact that sometimes govt. has to take charge of financial sector directly. The current crisis would not have turned out this way if the lawmakers (specially the Conservative Republicans and Libertarians wing) have not considered Capitalism to be a divine system. If the govt. started to directly act as a lender to consumer, things would have been a lot better. This idea may seem eerie (if not ludicrous) to many people in US who are raised with the notion that Capitalism is a sacred system and any govt. interference tantamount to heresy. So much so that any reference to nationalization is viewed as a threat to US itself.

The following things would have happened if Feds started lending directly:

1) It would have eased the credit market.
2) The private sector would have felt challenged in not lending and would have participated alongside the Federal Reserve. The relationship between the two would have been that of comperation (i.e. competition + cooperation).
3) A number of jobs would have been created and many job losses would have stopped. Jobs creation would be due to govt. acquiring people who could interface with the borrowers and participate in consumer lending. Banking sector was the most to suffer during this downturn and many jobs would have been preserved if Feds decided to act boldly. The private sector would not have laid-off so many people due to lack of capital, waning demand (due to economic worries).

I feel that govt. is so altruistic towards Capitalism that they can let the economy collapse and common man suffer. Thosaunds of jobs are being lost everyday, people are losing home but the officials don't want to concede the deficiency in the system.

Let me add, the cost for this logical action would have been far less than 4 trillion USD.

Modern Fiscal Setup Versus Zakat-Based Islamic System

The credit crisis which started in 2007 has brought into light many defects in the current economic system. One of them, which I will discuss in this post, is the intricate relationship between economic condition and fiscal spending power (of Government).

The major source of revenue for government’s fiscal spending comes from taxes on:
1) Revenue generated (by individuals and corporations).
2) Taxes on real-estate property and other fixed-assets.

In an economic downturn, the decline in economic activity leads to a decrease in:
(1) Individual incomes as well as a decrease in corporate revenue.
(2) Devaluation of fixed assets.

All this factors lead to decrease in government’s tax revenue.

However, this is the very time when people lose jobs and start to depend on government’s public welfare schemes. Government’s expenditure shoots up and is in dire need of money. The tax-revenue (as we discussed above) falls sharply and government goes into huge deficit. In short, the current fiscal structure is designed in such a way that an economic downturn becomes a double whammy for the country and sharply raises the fiscal deficit and decreases the standard of living.

Let us compare this with the Islamic system. In an Islamic system, apart from the regular taxes, a major source of revenue for the Government’s public welfare fund (baithul-maal) comes from Zakat. Zakat is an Islamic principle of contributing a percentage of a person’s wealth (not income) towards public welfare. It is mandatory upon eligible Muslims to give out this charity and in an Islamic system this becomes a law.

Apart from the generous charitable aspect of Zakat, there is another beautiful aspect that I want to bring out. And that is, the fact that this charity is independent of the economic cycle. In fact, in some cases the charity goes up during bad economic times. The reason is that Zakat is based on an individual’s total liquid assets and not the yearly income. Liquid asset is anything which is available or can be readily converted to cash. One of the features of economic downturn is that people flock to cash and pull out money from the economic system. This increases the liquid asset of an individual which should lead to an increase in the amount of money that gets collected as Zakat.

In other words, while the modern fiscal policies lead to a dearth in fiscal revenue during an economic downturn, the Zakat-based Islamic system generates consistent (if not excess) charity for the welfare of poor and needy in the most needed time. This in turn protects the economic system from catastrophic collapse.

Indeed, this type of policy (Zakat) is something which modern nations of the world have to learn from Islam.

Functioning of Fractional Reserve System

Ever wondered how our fractional reserve system works. How $100 printed by Federal Reserve (Fed) can generate a $1000 worth of economic activity (assume a 10% reserve requirement). Fractional reserve requirement is the percentage of money that a commercial bank has to keep with Central Bank as reserve (Currently it is 10% in United States). In this post, I will try to briefly explain how this "borrow from Peter to pay Paul" type system works.

Lets say the Feds decide to float $100,000 in the market. They do this by writing a blank check against themselves and buying Treasuries in open market worth $100,000. This buying releases $100,000 in the banking system.

Lets say Bank-B1 decides to sell $100,000 worth of Treasury bill to Feds.

* The result would be B1 will have $100,000 to loan.

* B1 lends $90,000 to Paul who wants to buy land from John. ($90,000 because $10,000 has to be kept in reserves due to reserve requirement).

* John deposits the amount $90,000 that he received in bank-B2.

* B2 lends $81,000 (keeping $9,000 in reserves) to Peter who uses it to buy a fleet of cars from Mary

* Mary deposits $81,000 in bank-B3. B3 in turn lends $72,900 (Keeping $8,100 in reserves) to Jim who wants to upgrade his kitchen by contracting the work to Home Depot.

* Home Depot then deposits $72,900 in bank-B4 and the chain continues.

The total worth of economic activity generated (in dollar terms) can be computed by summing up all the activities described above. All these activities can be expressed as a geometric sequence whose sum can be computed by using standard geometric progression formula:

100,000*(1 + 0.9 + (0.9)^2 + (0.9)^3 + .....infinite series) = 100,000/(1-0.9) = 1000,000

The overnight lending between the banks and Central Bank keeps the capital fully tied up (in terms of loan) and keeps the economy flowing. Any stagnation in lending between the banks will cut that geometric series (described above) short and hampers the capitalist economy.

Inflation: A Necessary Evil?

In this classic period of deflation (Dec 2008), one must be wondering why I am writing about inflation. But the fact is, as soon as the economy bottoms out, inflation will strike back again. Once again, the purchasing power of the dollar will go down, and people will recall those good old days when gas used to be $1.50.

One wonders how the money is actually getting devalued. Money is supposed to be a store of value—an asset that a human preserves by refraining from immediate consumption. Yet it defies the very definition and loses its value gradually.

The major reason, as any economist in the world would suggest, is an increase in the money supply. The simple logic they refer to is the supply/demand equation. The number of dollars (or any other currency) has increased at a rapid rate compared to other assets whose value is being analyzed. The number of dollars has particularly gone up when we consider the money in the sense of M3 (Physical currency + Checking Accounts + Time deposits + Money Market funds). (For more discussion on money supply, click here.)

But this explanation, to me, is an oversimplification of a complex issue. The fact of the matter is no wealth is created unless we have inflation. Wealth is defined as "anything that has utility and is capable of being appropriated or exchanged." Increase in wealth includes:

1. Any new thing that is useful for humanity

2. Increase in production of existing things to satisfy the needs of a growing population.

Hence, the growth of wealth is necessary for the survival of a growing population as well as to make human life more comfortable.

Let us analyze the role of Central Banks in this increase of wealth. For a moment, let’s assume that Central Banks stop minting (or printing) more money and assume human beings will continue on their mission to increase wealth and population. In such a case, money (dollars) will become scarce compared to total human wealth. The purchasing power of money (dollars) will increase over time, and big investors and the general public alike would want to store their wealth in dollars. Ideal scenario, isn’t it? No! Because this would lead to a lack of investment, resulting in an actual decrease in wealth and disruption of the production cycle. Unemployment would rise, and the standard of living for many people would fall apart.

This is where the Central Bank comes into the picture. They dilute the demand for money (dollars) by printing more of it, leading to a re-establishment of balance between wealth and the number of dollars. This dilution of dollar demand leads investment bankers and the general public to think about preserving their purchasing power by investing their surplus capital into the production system.

Thus, dilution of dollar demand is key to the creation of new wealth. One might wonder: if the job of Central Banks is to establish equilibrium between the number of floating dollars and wealth, then why is the value of individual items (like gasoline) rising? Why is gasoline more expensive now than in 1972 (if the Central Bank is doing what it is supposed to do)?

The answer is:

The number of goods available in 1972 was far fewer than what we have now. Think about all the iPhones/GPhones/Hi-tech computers/Fax machines/Advanced weapons, etc.—we did not have them in 1972. The equilibrium is being established between aggregate wealth and the number of dollars (not between an individual item and the number of dollars). The reason for inflation in individual commodities (like gasoline) is that their rate of growth has been lower compared to the rate of growth of dollars. The reason, as stated above, is the creation of new goods. Had we had the same number of items and the same technology that we had in 1972, then the Central Bank would have increased the money supply in such a way that the cost of each item would have been almost the same.

However, one needs to remember that economics is an inexact field. The Central Bank doesn't have an exact measure of what the wealth of each year is (especially when you include the service sector in wealth computation). So the effect of their dollar-printing activity will have an uneven effect on different commodities/goods.

So, it is unjust for people to blame the Central Bank for inflation, because the creation of new wealth, sustenance of a growing population, and the desire for increased human convenience require the Central Bank to do what it is doing (i.e., printing more dollars and diluting dollar demand). However, this does not mean that Central Banks (Federal Reserves) are perfect organizations; they have many drawbacks, which will be discussed in a separate post.

Some people (especially from the Austrian School of economics) argue that markets take care of themselves. They will themselves establish the equilibrium between the number of dollars and wealth. But the fact of the matter is, it would be very chaotic if the markets were left to bring this equilibrium. The Great Depression of 1928 and the frequent booms/busts before it (in the late 19th and early 20th centuries) clearly show that markets do figure out this equilibrium, but in a very painful way.

Of course, there is one (impractical) way of stopping inflation, and that is:

1. Human beings should stop improving their standard of life.

2. Human beings should stop increasing their population.

Any comments/criticism are welcome.