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It is pretty much universally accepted amongst respected economists across the political spectrum, from Milton Friedman to Keynes, that leaving the gold standard helped America's recovery.

They have it exactly backwards. Leaving the gold standard caused the Great Depression, acknowledging the reality that we had left the gold standard and subsequently devaluing the currency forced prices up to fall in line with debt and allowed for rational trading and lending to resume.

The U.S. effectively left the gold standard in 1917 when it began the issuance of over $20B in Liberty Bonds, convertible to gold at maturity, to fund our participation in WWI. These represented 50% of the pre-war GDP and over four times the previous gold obligation of the U.S., an amount that the U.S. could never (and would never) pay off. Those bonds were converted to fixed-rate T-Bills over the course of the next decade in a scheme involving the Fed and Treasury that essentially allowed banks to buy T-Bills on credit at about 2%, sell them immediately to the public at slightly below par, and earn interest on the proceeds at 4-5% until the gov't asked for the money to pay operating costs. The T-Bills rates were fixed at greater than market interest to ensure that all treasuries offered would sell, and the effect was that banks were guaranteed to sell all the T-Bills they purchased to secondary the market. In early 1929, the gov't announced that it would no longer issue T-Bills at fixed rate, but would auction them off, as they still do today. This would cut off a huge source of profit to the banks, and by the time the first auction occurred, in November 1929, the market had already crashed. It was the public's realization that the government had left the gold standard (i.e., could not honor its convertibility obligation), and the banks' unwillingness to play along any longer, that precipitated the crash, and it was the gov't acknowledgment of reality almost five years later that led to a short-lived recovery starting in 1934.

As for the gold standard, there's a lot of misunderstanding going on here. All the gov't needs to do to establish a gold standard is pass a law declaring gold convertibility of U.S. currency at a given rate. That rate would be an exact number = (currency in circulation)/(gold reserves). That number can be as high as it needs to be to provide 100% convertibility. That's the definition of a full reserve gold standard. A fractional reserve gold standard means that the government print more money (or other obligations) than can be redeemed for gold... until the people catch wind.

Fractional reserve banking is a completely different concept. It involves adding other assets as backers of money (M1, M2, M3), so that the monetary base of gold-backed currency can be expanded into monetary aggregates of both currency and asset-backed deposits. A bank that maintains a reserve of currency for day-day transactions and backs its deposits with assets with values considerably larger than the amount of their loans, can operate safely and generate an expanded monetary supply far greater than what could be provided with just gold as a backer of money. This means that the limitations on gold supply act as a regulator but not a hard limit to money supply, even in a full reserve gold standard.

It is when banks fail to maintain adequate reserves that they risk a liquidity run, and it is when they fail to adequately evaluate collateral that they face a solvency crisis. It was the mis-evaluation of house values based on mark-to-market in a bubble that caused banks to back their deposits and MBS's with insufficient salable collateral that caused the mortgage meltdown.

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What I'm really against is the bank printing up currency to more than what they can account for in their reserves.

But it should also be illegal, because I think it would be fraudulent.

This is what fractional reserve banking is defined as. However why is it fraudulent if all parties agree to it? It clearly isn't, especially under a system of competing currencies that you advocate since people would simply switch currencies if they didn't like it.

They have it exactly backwards. Leaving the gold standard caused the Great Depression, acknowledging the reality that we had left the gold standard and subsequently devaluing the currency forced prices up to fall in line with debt and allowed for rational trading and lending to resume.

Here's that chart again:

1000px-Depression_Graph.svg.png

You guys have said you think its weak but I don't see that at all. What I see is that for the US, the UK, and Germany (the worlds 3 biggest economies during the 1930s), when they left the gold standard, a recovery ensued. Being the worlds 3 biggest economies, its also not surprising that a general upturn occurred in other countries even if they were yet to leave the gold standard.

As for the gold standard, there's a lot of misunderstanding going on here. All the gov't needs to do to establish a gold standard is pass a law declaring gold convertibility of U.S. currency at a given rate. That rate would be an exact number = (currency in circulation)/(gold reserves). That number can be as high as it needs to be to provide 100% convertibility. That's the definition of a full reserve gold standard. A fractional reserve gold standard means that the government print more money (or other obligations) than can be redeemed for gold... until the people catch wind.

Yes, finally! Someone here understand's the gold standard. Now I ask why is passing a law to fix gold at a government defined rate, preferable to the current system of letting the dollar float freely against gold?

Here is a good summary of the gold standards effects during the depression (http://www.j-bradfor...ldstandard.html):

The gold standard and the Great Depression. The current judgment of economic historians (see, for example, Barry J. Eichengreen, Golden Fetters) is that attachment to the gold standard played a major part in keeping governments from fighting the Great Depression, and was a major factor turning the recession of 1929-1931 into the Great Depression of 1931-1941.
  • Countries that were not on the gold standard in 1929--or that quickly abandoned the gold standard--by and large escaped the Great Depression
  • Countries that abandoned the gold standard in 1930 and 1931 suffered from the Great Depression, but escaped its worst ravages.
  • Countries that held to the gold standard through 1933 (like the United States) or 1936 (like France) suffered the worst from the Great Depression
    • Commitment to the gold standard prevented Federal Reserve action to expand the money supply in 1930 and 1931--and forced President Hoover into destructive attempts at budget-balancing in order to avoid a gold standard-generated run on the dollar.
    • Commitment to the gold standard left countries vulnerable to "runs" on their currencies--Mexico in January of 1995 writ very, very large. Such a run, and even the fear that there might be a future run, boosted unemployment and amplified business cycles during the gold standard era.
    • The standard interpretation of the Depression, dating back to Milton Friedman and Anna Schwartz's Monetary History of the United States, is that the Federal Reserve could have but for some mysterious reason did not boost the money supply to cure the Depression; but Friedman and Schwartz do not stress the role played by the gold standard in tieing the Federal Reserve's hands--the "golden fetters" of Eichengreen.
    • Friedman was and is aware of the role played by the gold standard--hence his long time advocacy of floating exchange rates, the antithesis of the gold standard.

What surprises me most about this debate is the clear contradictions with Objectivism that the gold standard implies. All I have heard from you guys is "pass a law in order to regulate the amount of reserves banks hold (ie 100% reserves)" or "pass that law to guarantee convertibility to gold at such and such rate". Whatever happened to the non-initiation of force?!

Edited by IceFive
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IceFive, you are misunderstand my position, and I think Agrippa's position. No one here is talking about force. What Agrippa is referring to is taking the gold in the Fort Knox and other government gold reserves, and using that as the gold standard, which it isn't right now. In other words, he is stating that the gold in Fort Knox should be used to back the dollar. I'm looking for a more radical position -- of getting the government out of the currency altogether and selling the gold in Fort Knox back to the people, so we can use it as currency as set up by bankers and merchants. Again, no force is involved on the part of the government. In addition, I say let the banks and the merchants decide what the currency will be by getting the government out of it totally. Agrippa's solution doesn't go far enough, as far as I am concerned.

Recovery from the Great Depression by devaluing the dollar, which is what Agrippa is talking about and what your chart shows, is like putting a band-aid on a large cut. The ensuing inflation that we are still living with caused the dollar to lose a great deal of its value, and basically made a tax on everyone at the rate of inflation. In other words, it was not a solution, but a Ponzie scheme to cook the books to make it look like we had recovered. It might have changed nominal values (in terms of dollars), but it did not fix the underlying cause -- the devaluing of the dollar. It's like diluting a drink and saying you have more of it, when you have just weakened it, and that is what has happened to our money. That's one reason gold is at $2,000 per ounce now, when it was at $300 per ounce a decade or so ago. That is how much the dollar has been weakened over the decades, and it has been far more weakened by devaluing the dollar.

What you don't grasp is the soundness of a gold standard, of having specific commodities as being money. Would this limit the economy? In a way, yes, but it would be a healthy economy based on a sound currency. Inflation (devaluing the dollar),simply cooks the books to make it look like we are accomplishing something when we are not.

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All I have heard from you guys is "pass a law in order to regulate the amount of reserves banks hold (ie 100% reserves)" or "pass that law to guarantee convertibility to gold at such and such rate". Whatever happened to the non-initiation of force?!
That's hyperbole! That is surely not all you've heard.

Firstly, Objectivism definitely does not say the government should disallow fractional-reserve banking where the depositor and the bank are clear about the reality of the contract. The best argument against fractional reserve is that depositors think their deposit is a bailment contract when it is actually a loan. However, assuming that the terms and conditions are fully understood by all, the government should not ban fractional-reserve banking.

As for gold-standard, a "dollar" should simply be a weight of gold. This is merely a question of setting rates and measures, just as one would define an official, legal gram or ounce. It really is not essential, since one could use physical units too. The government really does not need to decide whether we will use a gold-standard or a silver standard or a multi-commodity standard. Still, setting nomenclature (as in "a dollar is X ounce of gold") is not too objectionable on the face of it... until one sees the havoc it played by allowing Roosevelt to change it.

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Actually, I would be for just using weights for monetary transactions, buying and pricing things in terms of weights of gold -- a car would cost you 10 ounces of gold (instead of $20k). This would end a lot of confusion between the dollar and gold. However, it must be kept in mind now that force is being used against you in the continued devaluation of the dollar. Government is using force against you buy printing up more and more dollars to chase goods and services. It's called inflation, and it is like a percentage tax on everything one purchases. So, what I am proposing is *ending* the force being used against us by the government -- get the government out of currency, and let private bankers and private merchants decide what they will use as a medium of exchange. I think they would switch to gold or silver, as they have in the past,and then we could either define a dollar as a certain amount of gold or silver (ever hear of the gold dollar and the silver dollar?) or get rid of that nomenclature altogether and use weights of gold and silver, but going directly to weights would be the best and less confusing standard. In other words, instead of thinking in terms of dollars, one would think in terms of weights of gold. You would earn weights of gold in your income, and pay out weights of gold when you purchase things. The Federal Reserve "dollar" would be ended, and we would have a gold and silver currency.

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Someone needs to explain how a gold standard can cover all the transactions in the economy since the quantity of gold in the world is finite but money supply has to necessarily increase as the economy grows.
Money supply does not have to necessarily increase as an economy grows.

However, more importantly, a gold-standard is simply one concrete form of value-based money: i.e. a system where some type of value has become acceptable enough as money. It is useful talk about this particular type of money because it has a historical basis. Silver was used too: China and Mexico being the two big examples. There are other values that could work as well.

Many values do not work well as money. E.g. land does not work well because it is not fungible, nor physically divisible into tiny units, nor transportable. However, there are other commodities in the world that have quite a few of the characteristics of money. In our modern electronic/digital world even things like oil can be the basis of "near money" if it is under the protection of a strong and reliable government that guarantees property-rights. [This is where a dissenter brings up John Law as a strawman]. So, in general, there is no shortage of things that people can use as a basis for exchange.

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Firstly, Objectivism definitely does not say the government should disallow fractional-reserve banking where the depositor and the bank are clear about the reality of the contract. The best argument against fractional reserve is that depositors think their deposit is a bailment contract when it is actually a loan. However, assuming that the terms and conditions are fully understood by all, the government should not ban fractional-reserve banking.

Best short summary of the Fractional Reserve issue I've ever seen. Of course we will continue to have people come here and say it's necessarily immoral and/or a violation of rights.

I'd go so far as to say perhaps a FRB banknote is fraudulent if it doesn't state right on it that it is a share of a loan a bank made, rather than actually being a dollar or ounce or whatever, as a paper receipt for a warehouse deposit would be (a case where it actually is a bailment). Both would have some value and both should be allowed to circulate--and people should be allowed to refuse payment in them, as well.

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Someone needs to explain how a gold standard can cover all the transactions in the economy since the quantity of gold in the world is finite but money supply has to necessarily increase as the economy grows.

Deflation would occur. So the money supply would stay fixed but the price level would fall.

Firstly, Objectivism definitely does not say the government should disallow fractional-reserve banking where the depositor and the bank are clear about the reality of the contract. The best argument against fractional reserve is that depositors think their deposit is a bailment contract when it is actually a loan. However, assuming that the terms and conditions are fully understood by all, the government should not ban fractional-reserve banking.

I completely agree with this. Thank you for clarifying Objectivism's position.

As for gold-standard, a "dollar" should simply be a weight of gold. This is merely a question of setting rates and measures, just as one would define an official, legal gram or ounce. It really is not essential, since one could use physical units too. The government really does not need to decide whether we will use a gold-standard or a silver standard or a multi-commodity standard. Still, setting nomenclature (as in "a dollar is X ounce of gold") is not too objectionable on the face of it... until one sees the havoc it played by allowing Roosevelt to change it.

I agree that the government need not and should not decide whether people use a gold standard.

Actually, I would be for just using weights for monetary transactions, buying and pricing things in terms of weights of gold -- a car would cost you 10 ounces of gold (instead of $20k). This would end a lot of confusion between the dollar and gold.

Imagine with the general deflation that would occur, the smallest denomination of gold would get increasingly minuscule. To the point that you would be paying things in nanograms and atoms of gold. I guess it could be implemented with a suitable electronic system to account for everyone's holdings of gold and its location. You could even account for fractions of atoms of gold (I'm being serious).

I'm not going to pass judgement on such a system until I've had a think about it a bit more.

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Imagine there is only $1 million worth of gold in a small island community and all transactions are covered with $50,000 left over in the bank. Productivity and consumption goes up 100% across the board due to a baby boom. The total value of all the productivity is now worth more than the $1 million but there is no new gold being added. How can it possibly be true that "Money supply does not have to necessarily increase as an economy grows"?

The Deflation argument assumes that demand for goods/services has dropped, necessitating a reduction in prices. But in the scenario above, demand has actually increased so how does a limited supply of gold lead to deflation and thereby solve the problem I raised?

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Someone needs to explain how a gold standard can cover all the transactions in the economy since the quantity of gold in the world is finite but money supply has to necessarily increase as the economy grows.

I think you are suffering from a modern economics course, because, no the physical amount of gold does not have to increase to have a booming economy -- just the opposite is true.The overall amount of gold in the world will not change all that much. Yes, it is being mined in all sorts of places, but not in very large quantities. That is precisely what makes it valuable and what makes it a great store of value -- the fact that it is rare. What would happen is that prices would tend to fall as production increased, that is things would get lower and lower in prices, just as we see with electronics today, but this would be true of everything. Far from this being a problem, it would show the value of a gold standard. It wouldn't be deflation, which is defined as a decrease in the money supply (under gold it would remain relatively constant), but rather the virtue of production would be readily seen (as it is in electronics today, but across the board).

As far as using micro-ounces for small transactions (i.e. what now cost pennies), we could either use an electronic basis (your debit card), or have bills and notes with that denomination on them. There would be notes and bills for fractions of an ounce on them that would be redeemable for gold at your local bank. Or as an alternative to that, there could be silver and even copper being used as money, which is the way it used to be before the Federal Reserve came and stole all of the gold and silver.

For those who continue to claim it wouldn't work, it did work just a century ago, and it worked well. But that has nearly been forgotten since the Feds stole the gold and gave us paper instead.

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Someone needs to explain how a gold standard can cover all the transactions in the economy since the quantity of gold in the world is finite but money supply has to necessarily increase as the economy grows.

In a gold standard, only the currency in circulation is backed by gold. Demand deposits, savings and time deposits, and money market securities are part of the larger money supply and are tied to currency only by the reserve requirement (whether required by law or by principle) of institutions issuing them. Money supply can expand by decreasing the reserve requirement. Typically the reserve requirement would only lower if interest rates rise enough to offset the increased risk, as judged by institutions and depositors/lenders.

Past the short term, true, there is a finite amount of gold in the world, but the vast majority of it is not economically extractable. Gold is mined only from the relatively small deposits that are profitable. As the economy expands beyond the capability of gold to act as a monetary base, the price of gold (in terms of goods) increases, and the amount of ore deposits that can be economically mined increases quickly. Mines increase production to exploit newly profitable ore deposits, and the money supply increases.

Longer term, as harder-to-get gold becomes profitable the pressure to invest in more efficient gold extraction mounts, and technological innovation makes extraction from all sources cheaper. This expansion of gold extraction technology interacts with broader technology expansion, the main driver of economic growth, so that gold extraction and the economy tend to grow at similar rates. When an economy slows down the profitability of gold extraction drops, mines close, and the money supply falls (if necessary) due to attrition into gold-consuming industries.

Thus gold acts as a short term regulator on economic growth providing monetary base stability to allow natural interest rates to regulate the economy naturally, but long term, gold tends to flex to economic pressures to expand the money supply.

BTW, I agree that the Federal government should not mandate use of a federal currency. The adoption of a currency standard (i.e., definition of a dollar) voluntarily by private banks would allow those banks to compete with the government in the issuance of notes. If the gov't (or any bank) started to overprint money and move towards a fractional gold standard, the conversion of suspect gov't dollars to gold and then to competing dollars would put a quick stop to it. As to objections to the use of multiple currencies, with the modern trend away from cash and the technology available, vendors could easily convert prices from a benchmark currency (their choice, but probably standardized over time) to any currency being issued, and make a similar conversion when depositing collected revenues into their accounts. The Free Market, not gov't, should provide the solution to these imagined "problems."

Government force, in the form of mandating that only gov't-issued dollars be used for all private transactions, is a fatal weakness in any gold standard because it leads to abuse by the gov't. It's no coincidence that the gov't starting issuing "gold-convertible" Liberty Bonds just four years after establishing the Fed, and that the collapse of the gold standard quickly followed.

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Thomas, I do not disagree with a gold standard. I am just seeking clarification on the "finite quantity problem". Your assumption that prices fall with more production is only true if demand does not increase correspondingly. Which is why I introduced the thought experiment above to take things to the extreme and see how well the gold standard holds up. So far, your explanation does not address my island situation in which demand and supply have increased almost equally, thereby increasing demand for money to transact (unless I am missing something).

agrippa1, your explanation sort of makes sense but even if I accept that the purchasing power of gold increases over time in my island scenario above, what about the fact that the paper currency backed by gold has a fixed quantity? ie there is only $1 million of paper currency at a fixed rate to the gold and since the gold quantity cannot increase, there will be a severe shortage of money supply, making new transactions impossible. Would this therefore not mean that the ratio between gold and currency would need to be changing every day, thereby going back to an earlier point I made?

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Also, in the very long term, there are considerable amounts of gold (and other rarer elements) present on both other planets in the solar system, as well as asteroids. I think the price of gold is already high enough (at 1700/oz it's about $54 500/kg or 54.5 million per metric ton) that it could be profitable to launch a spacecraft and get the stuff somewhere else. If not profitable today, that would certainly become profitable very soon if either the price of gold continues to rise, or it gets cheaper to launch stuff into space. There are basically limitless quantities of gold in the Universe (practically speaking, it's of course not really limitless, but for all intents and purposes it is), just waiting for someone to retrieve them.

The same holds true for many other expensive elements. Yeah, someone has to take a risk and start a venture, and figure out how to mine in space, but I wouldn't put it past an enterprising businessman to come up with a solution like that.

*I am not an expert on current launch costs, but I'd be very surprised if 54.5 million per ton is not above what it costs to launch something into space. I think it is considerably less than that with a good, cheap heavy lift vehicle.

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Thomas, I do not disagree with a gold standard. I am just seeking clarification on the "finite quantity problem". Your assumption that prices fall with more production is only true if demand does not increase correspondingly. Which is why I introduced the thought experiment above to take things to the extreme and see how well the gold standard holds up. So far, your explanation does not address my island situation in which demand and supply have increased almost equally, thereby increasing demand for money to transact (unless I am missing something).

agrippa1, your explanation sort of makes sense but even if I accept that the purchasing power of gold increases over time in my island scenario above, what about the fact that the paper currency backed by gold has a fixed quantity? ie there is only $1 million of paper currency at a fixed rate to the gold and since the gold quantity cannot increase, there will be a severe shortage of money supply, making new transactions impossible. Would this therefore not mean that the ratio between gold and currency would need to be changing every day, thereby going back to an earlier point I made?

How is an island with only enough resources to have 1 million worth of paper/gold equivalents going to have an economy that booms so much that they're having currency shortages? That seems a tad counter-intuitive?

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Thomas, I do not disagree with a gold standard. I am just seeking clarification on the "finite quantity problem". Your assumption that prices fall with more production is only true if demand does not increase correspondingly. Which is why I introduced the thought experiment above to take things to the extreme and see how well the gold standard holds up. So far, your explanation does not address my island situation in which demand and supply have increased almost equally, thereby increasing demand for money to transact (unless I am missing something).

agrippa1, your explanation sort of makes sense but even if I accept that the purchasing power of gold increases over time in my island scenario above, what about the fact that the paper currency backed by gold has a fixed quantity? ie there is only $1 million of paper currency at a fixed rate to the gold and since the gold quantity cannot increase, there will be a severe shortage of money supply, making new transactions impossible. Would this therefore not mean that the ratio between gold and currency would need to be changing every day, thereby going back to an earlier point I made?

The way write of it makes sound as if money, once "used" to purchase something, somehow gets tied up and can't be used again for "new" transactions. The example you give is extremely hypothetical - an island on which all other resources are expanding dramatically, except for the resource being used as money. Maybe they should choose one of the other resources for their money?

Seriously, though, the supply of money only limits transactions if prices stay the same, but they don't, they fall. As prices drop, the amount of money, measured in goods, stays pretty stable. Mathematically, where M is money, G is amount of goods produced (say, widgets), and P is the price of a widget, the following holds generally M = G * P. As G goes up , P goes down with constant M. (to simplify I've left out the time base, which would require another variable, V, the velocity of money). In a case where production goes up but the supply of gold stays the same, the main issue short term is that the cost of borrowing dollars gets very expensive, in goods terms. But in that case, lenders can charge a negative interest and still make goods-measured profit (and write off their dollar-valued losses!) It's only that we have a mindset that measures gain in dollar terms (even though we tend to ignore actual losses resulting from dollar devaluation) that blocks us from thinking rationally when it comes to a hypothetical deflation scenario. If you look at the greatest episode of so-called destructive deflation, from 1929 to 1933, you'll see that prices fell in terms of the CPI, from 17.3 to 12.6. That sounds real scary until you look back and see that 12.6 was the CPI level in 1917, before the government started issuing gold-convertible Liberty Bonds (do I sound like a broken record yet?). The deflation after the crash was simply a winding down of inflation caused by the gov't with its reckless issuance of worthless "gold-backed" debt to fund WWI.

The only real issue with falling prices is that eventually prices drop to such a low level that fine tuning them with one-cent resolution becomes less and less efficient.

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Thomas, I do not disagree with a gold standard. I am just seeking clarification on the "finite quantity problem". Your assumption that prices fall with more production is only true if demand does not increase correspondingly. Which is why I introduced the thought experiment above to take things to the extreme and see how well the gold standard holds up. So far, your explanation does not address my island situation in which demand and supply have increased almost equally, thereby increasing demand for money to transact (unless I am missing something).
You speak of both demand and supply increasing and that is fine. Demand is based on supply. If I have a good harvest, end up producing lots of more wheat, my supply has increased; but, so has my demand. My demand has increased because my supply has increased. (ref. Keynes's formulation of Say's law).

So, far so good. However, why do you think this would be inconsistent with falling prices under a fixed amount of gold-money? That is the part that is not clear to me.

For instance, what do you speculate would happen if production doubled and gold stayed constant? Imagine, for instance, that one guy produced twice as many CDs and another produced twice as many cars and a third produced twice as much food. Would they each only sell half of their stuff and keep the rest? Or would they solve their dilemma some other way? In terms of gold they would all charge less for their product; but, qua buyers, they would therefore also pay less (in terms of gold). Finally, the underlying goods-to-goods barter that is going on, will go on just as well.

It is true that if a radical change were to play out in a short-duration, there could be some disruption. Anything unexpected will create disruption to the plans of mice and men. However, assuming that the productivity grows over time, and assuming gold is not growing as fast, prices will tend to fall (non-linearly) in terms of gold.

It is important not to overdo the distinction between gold/silver etc. on the one hand and regular goods on the other. They are not so different. If gold is money, all it means is that people decided that they will always keep a certain type of good on hand, because it is readily accepted by others (and has the other "characteristics of money"). These qualities give that good an "exchange value" even to people who see no "use value" in it. In a prison, people will often use cigarettes as money, to improve the efficiency of what otherwise has to be a barter system. Perhaps they could use chewing gum (I'm out of ideas here... porn, maybe?), but that is not as widely acceptable. If cigarettes are confiscated, they might resort to chewing gum after all. Also, if their demand for money increases, while the supply of cigarettes stays constant, they might start storing some value in chewing-gum, as a second choice of money.

Like any other good, if the supply of gold stays scarce while the supply of something else increases, then the exchange-value (aka price) of that other good will typically fall relative to gold. This perspective (i.e. that "gold is just another good, like any other") is not precise; yet, is a good way of "testing" prototypical examples. [Aside: Of all the things the monetarists did, one of the worst was to introduce a type of dualism into economics, where money is on one side of their favorite "Quantity Theory" equation, and all other values are on the other side. It is a source of too much confusion.]

PS: I plan to split these gold/money posts into some existing topic, instead of having them in this "Occupy Wall St." topic.

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I think part of the problem with the Island Scenario (limited amount of dollars on an island) as presented is that it is discussing the situation in terms of dollars ($1 million dollars) instead of in terms of quantity of gold. Let's say we start off with 10,000 ounces of gold on our island, and that is all the gold that exists on the island and they can't find any more, so the quantity of gold is relatively fixed (some can be made into statues and whatnot, so not all of it will be money, but let's assume it will all be used for money). The great thing about gold is that it is divisible. Take a bar of gold or a coin of gold and cut it in half, and then again, and then again, and you still have something of value. You can't do this with a dollar bill, which is why I think a false premises is being snuck in for the original scenario of $1 million dollars.

So, they have this 10,000 ounces of gold, and let's say they make coins of 1 ounce to use as transactions. So, there would be 10,000 coins on the island. As demand for the gold goes up (there is a population boom, and they all want the gold), the value of the gold increases. Eventually it increases so much that they can now purchase goods and services with a fraction of an ounce. But they have no denomination for that, so they have to melt down some of the coins and mint new ones. As a hypothetical, let's say that demand for gold doubles. What can they do? Well, they would mint 1/2 ounce coins instead of 1 ounce coins. And that half-ounce has become so valuable (everything else being equal) that the 1/2 ounce gold coins buy as much as the 1 ounce previous gold coins. So, now they have more than 10,000 coins. If they split them all, they now have 20,000 gold coins to use in transactions, so there is plenty to go around. This is similar to what has been mentioned before, I'm just playing with the figures. Eventually, the demand for gold goes even higher, and they decide to make 1/4 ounce coins. If they convert them all, then now they have 40,000 gold coins for circulation. And so on and so forth.

Of course, in reality, production will drive down prices so that 1 ounce gold coins is too much for general transactions, so they split the coins similarly to what I have covered. But in the long run, in a booming economy, the amount of gold does not have to increase because gold is divisible. Instead of getting more gold, they simply makes smaller denominations. Problem solved.

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Don't forget too that an economy can expand simply by having the money spent more often... the same 10000 ounces (or whatever you want to name the unit) could simply be spent twice as often as people buy twice as much stuff. This would be true even if no individual is spending twice as often and the growth is simply a doubling of the population; the money would be spent twice as often.

I believe you'd see a combination of the two effects (this one and the subdividing of coin) on your hypothetical island.

Edited by Steve D'Ippolito
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Thomas, thanks for that explanation although I still have a problem. In my scenario, people are not using much of the gold itself for transactions in form of coins. Rather, they are using paper currency equal to the amount of gold (or electronic debit cards if you wish). If for example they fixed the currency as $100 per ounce, the total amount of the currency is only $1 million, equivalent to the 10,000 ounces of gold which is locked in a mini Fort Knox. So when demand for money increases beyond the $1 million cash in circulation, what happens to the currency?

softwareNerd, increasing supply does not necessarily translate into increased demand. For example, when people began abandoning the typewriter, no amount of increased production would have driven up demand. Prices can fall when supply increases, demand drops, there is a price war, more efficient methods of production come in, etc. It is possible for demand to increase over time and for supply to match it. Prices will not drop in such a case. But even assuming prices are dropping over time, it does not follow that there will be enough gold to cover all transactions on the island. The economy may overall grow much faster than the decline in prices. Besides, if your argument is correct, then for money purposes, we do not need to ever mine more gold.

Steve, you make a valid point though in the long run, there comes a point when the amount of transactions in a single day becomes greater than the total money available.

My question remains. What do we do about the currency with respect to gold since a gold standard demands a fixed ratio of currency to gold?

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softwareNerd, increasing supply does not necessarily translate into increased demand. For example, when people began abandoning the typewriter,... ...
To answer this, we'd need to agree on what we mean by "supply" and "demand". However, I think this is really a distraction to the issue, so I'll leave it be unless you choose to define the terms more specifically.

... ..., if your argument is correct, then for money purposes, we do not need to ever mine more gold.
We really do not need to mine more gold. Even if all the gold on earth disappeared, there are other goods that have fairly decent money-qualities, and there are many more that are near enough though far from ideal.

The essential point to understand is that money is goods. Money is not something apart from goods.

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My question remains. What do we do about the currency with respect to gold since a gold standard demands a fixed ratio of currency to gold?

I think you first have to get rid of your notion that gold would be fixed at $100 to the ounce, since that is not the way a gold standard works.The way true gold money in bills or notes currency works is that the bills or notes designates a certain amount of gold. The dollar would say (if done today) redeemable for 1/2000 ounce of gold. So that fact that you are using bills instead of coins doesn't really change anything regarding the sub-divisibility of gold. New notes would simply be printed representing the greater value of gold. Instead of just having dollars, you would have half dollars (1/4000 ounce of gold) and quarter dollars (1/8000 ounce of gold). This is originally how our monetary system worked. There were gold dollars and gold half dollars and gold quarter dollars. So, having bills currency doesn't change anything except for the ease of carrying around your money (you wouldn't have to carry small vials of gold dust for smaller transactions, you would carry notes redeemable for small fractions of an ounce (one ounce, one tenth of an ounce, one one hundredth of an ounce and so forth). In other words, the same principle outlined in my previous post would apply, the gold would be sub-divided as it became more an more valuable as demand for gold increased.

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Don't forget too that an economy can expand simply by having the money spent more often... the same 10000 ounces (or whatever you want to name the unit) could simply be spent twice as often as people buy twice as much stuff. This would be true even if no individual is spending twice as often and the growth is simply a doubling of the population; the money would be spent twice as often.

I believe you'd see a combination of the two effects (this one and the subdividing of coin) on your hypothetical island.

Unless the price of the goods fell in such a scenario, the circulation only exemplifies how many trades transpired, not necessarily economic expansion. The division of the coins to support a growing population and/or growing economy demonstrates an increase of value of the monetary instrument, and/or the increase of efficiency or additional products from which to choose.

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Here's that chart again:

You guys have said you think its weak but I don't see that at all. What I see is that for the US, the UK, and Germany (the worlds 3 biggest economies during the 1930s), when they left the gold standard, a recovery ensued. Being the worlds 3 biggest economies, its also not surprising that a general upturn occurred in other countries even if they were yet to leave the gold standard.

We're in agreement that when the govt's abandoned the pretense of convertibility they were able to devalue their currency to bring the price of assets up in line with their loan values, and that the economy was able to start once this happened. (The same is true today: until the price of homes rises to the level of the mortgages they back, those mortgages will be a continuing drain on bank resources as they default.) But the impressive increase in personal income is not so impressive when you put it into the context of what was happening in the late 30's and on past the right side of your graph. U.S., Britain, and especially Germany embarked on huge debt binge, printing and borrowing money to build up for war. I'm pretty sure if you extend the graph just a few years to the right, you'll see personal income in Germany, Britain, and most of the world drop just a tad as the results of all that borrowing and malinvestment paid their dividends. The debts they ran up to finance the expansion of the economy and personal income, debts that were never paid off, were made possible by the abandonment (whatever your definition) of the gold standard.

Where we disagree is whether the point at which they "left the gold standard," was when they abandoned the pretense of convertibility or when they adopted the pretense by issuing more debt (currency and bonds) than they knew how to pay off.

I contend that the gold standard was abandoned in the U.S. when the govt went from about $3B in currency and less than $1B in debt in 1916, to $4B in currency and over $23B in debt by 1919. The massive debt incurred globally in WWI set in motion everything that has happened since, including the inevitable and imminent collapse of fiat currency.

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Thomas, what you are saying therefore means that when we want to "divide" the currency, larger notes have to be widthrawn from circulation and replaced with smaller note denominations. For example, a thousand Dollar note can represent an ounce and when it needs to be divided, it can be burned and a thousand one Dollar notes printed. All this sounds alright so far but then why for example was there a shortage of Silver coinage in the 1790s in England, since they could have easily just melted the available coins and minted smaller ones? Indeed many times in history, gold was abandoned as soon as the govt went broke during a war. So I guess a gold standard in itself severely limits the ability of govt to wage unnecessary wars. Is it possible to maintain a gold standard while other countries do not have it? How would this work in practice?

softwareNerd, you are the one who said "Demand is based on supply... My demand has increased because my supply has increased". So maybe you need to clarify what you meant.

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