One of the more pleasant aspects of all the changes I’ve made here at FTA is to have added the Money & Finance category. I’m a bit excited about getting into it. Of everything I’ve changed, this seems to be the most welcome addition in terms of feedback I’m getting.
I’m no economist, financial analyst, trading guru or theoretician. I have never read Hayek’s The Road to Serfdom, nor Hazlitt’s Economics in One Lesson…nor any of the works of Ludwig von Mises. I did very well in my micro- and macro-economics courses in college, it all made perfect sense to me, and then I just went out and worked with money—eventually founding a firm specializing in debt management for small businesses and individuals. I also traded credit spread-options on the SPX (a derivative of the S&P 500 Index) and a few other derivatives full time for a couple of years.
So my knowledge is more practical experience than armchair theorizing. But ironically, this post is all going to be about the theory; that is, my ideas about what money is, how it works, how it’s created and in later posts, how it’s best managed at the scale of a common medium of exchange for everyone. Whether any of what I have to say conflicts with Nobel Prize winning economists or anyone else, I don’t give a hoot. I’m talking total fundamentals and the reason I’m doing this is to establish a good foundation for reference, such that I can more effectively speak to the practicalities in terms of debt, financial risk, and so on, in the course of time.
I went back and searched for some posts I did back in 2007 that really gives the background of what I’m talking about here. For those really interested in understanding money, you probably want to read each one entirely. For the TL;DR crowd, I’ll excerpt some things from each of the posts.
I’ve always thought (well, since I started thinking) the idea of a “gold standard” — or any commodity-based backing for currency — is wrongheaded; not primitive, per se, but certainly not advanced beyond the industrialization of the 19th century. It’s for concrete-bound, barely conceptual (in a financial sense) people who lack imagination, and, really, a fundamental notion of human potential and that most human of attributes: risk taking.
Gold-backed money is for people who want essentially no risk tied to their currency. OK, and if the State didn’t force a monopoly on it, they could invent a currency backed by whatever, and see if it takes off. But given the reality of the matter, the problem is the State’s monopoly, not the structure or fundamental methodology of the currency itself. And, you have options. You can go buy gold (or whatever). You can do it in the form of stocks, funds, ETFs, or just call up a dealer and buy physical precious metals (the safest way). […]
[Having tangible assets is] not a bad idea. Calculate your net worth, and then purchase 10-15% of that amount in physical gold, secure it, and don’t tell anybody except a sound estate-planning law firm with a reputation going back to the American Revolution (in the event of your death, it can be distributed to heirs). In a financial collapse (accompanied by hyper-inflation), you might expect an 80-90% or more devaluation of the currency, in which case you’d pretty much be 100% hedged. If you have no real net worth, then $5,000 of gold would set you up to profit from such a collapse. You’d eventually convert your gold to [tons of] currency and buy foreclosed properties or other assets selling for pennies on the dollar and the eventual recovery would make you rich. To hedge against a tightening of the money supply (a-la the Great Depression), less dollars chasing more goods and services, the proper hedge is cash itself. Your cash actually becomes more valuable. But debt kills you, as more and more production is required to repay the same debt, so a proper deflationary hedge is some amount of cash and low debt.
This was Real Money in the 1800s—printed by a bank, but was “legal tender.” There were hundreds of such quasi-private currencies in circulation.
I quote from my post, quoting Gordon Haave on Victor Niederhoffer’s blog.
Prior to the Federal Reserve, there were private bank notes. They traded freely, such that if a bank was deemed to have too few reserves, the notes traded at a discount. In the late 1800s there was a big information problem, not only on the quality of the banks, but also authenticity of notes, because of distance. Does someone in St. Louis recognize a bank in New York?
All those problems would be gone today. Citibank and B of A would issue currencies. They would be backed with real assets (like a money market fund, sort of). Everyone would have a real interest in bank solvency, and if banks did silly things, their notes would trade at discounts and their customers would be miffed.
To recap, I’m not a “gold bug,” and never have been. It’s the state monopoly, stupid. Whether the federal government backs its currency with “full faith and credit,” dynamically intervening in the markets with interest rate adjustments, or with gold, seems hardly relevant to me. It’s a monopoly currency, and that’s the problem, assuming there is one. And given what I think I know, credit/debt offers a lot more flexibility than some commodity backing. I recently blogged about all this. Promises to repay, issued by responsible people and institutions, have value to anyone with any sense. In short, I think that a gold standard would be economically stifling. And besides all that, much of the “printing press” money libertarians lament is actually secured by real property and other assets (cars, boats, airplanes, machinery and equipment).
On the other hand, if money were created by separate banks, worldwide, at will with no external restrictions, then they themselves could determine their own proper balance of securitization with warehoused commodities, financial securities, real property, consumer goods, capital equipment, and unsecured promissory notes. Then these currencies all trade on the world market.
Debt, Finance & Money (9/26/07)
Yesterday, the dollar traded at an “all time low.” Everyone drops context when they claim, as you can find in all sorts of places, that since the creation of the Fed in 1913, the dollar has “lost 90% of its purchasing power.“
Now, the only thing that can possibly mean in practical relevant terms is that average people in 1913 had the power to purchase goods and services to sustain and improve their lives in magnitudes 10 times greater than we do today. Is that the case? Or is it rather the case, perhaps, that the dollar was inflated 1000% since 1913 and the credit from that inflation has purchased industrialization, technology, and economies of scale that give you 10,000% the purchasing power of a 1913 individual? My percentages are for illustration. Hopefully you get the point. Think about it. When you secure credit, such as to buy a house, you’re inflating your own net worth. But you’re also leveraging it, and when you do it with some thought and cleverness, the bounty from the leverage far outweighs the inflation. It works the same way on a macro scale.
I’m no particular fan of the Fed, for reasons I’ve explained. But let’s keep a bit of perspective, shall we? The simple fact of the matter is that you can participate in the financial economy, such as it is, and you can become very wealthy. Having tokens (a gold standard) in place of “money out of thin air” credit is not going to help you to become wealthy, if such is in any way one of your objectives. It will help you to retain the relative value of your money if you choose to stuff it in a mattress for a rainy day and sit on your ass for the rest of your life. That’s about it.
The “gold standard” is for chipmunks.
Alright, just a final thing I don’t think I’ve blogged about: Fractional Reserve Banking—virtually what all modern banks operate with worldwide, the currency being backed by tangibles (like gold) or intangibles (like debt) is largely irrelevant. Well, if I had a nickel for every time I’ve seen a libertarian bemoan fractional reserve going back 20 years I’d be plenty rich. I don’t think I was ever mistaken into believing that any of them truly understood what FRB was, most fundamentally.
First ask, how do you create new money, new currency? Let’s think out loud in a few different scenarios.
- You live in a trinket economy, like gold (but could be anything relatively scarce). Whatever the trinket, it has to either be mined or produced in some way to create new money. Not enough trinkets because nobody can find anymore or nobody wants to produce them or can’t for some reason? Deflation: fewer trinkets chasing more goods & services. Someone hits the mother load to outside proportions? Inflation: more trinkets chasing less goods & services. Same sorts of problems we face today.
- You live in a totalitarian regime where the government is the central bank and all banks. All banking is a function of government. Private lending and interest collection is outlawed. The government doesn’t loan money either. New money is simply printed up and injected into the economy via the various social programs as needed for the sake of equality of results. There’s not really any inflation or deflation unless by explicit government policy to change the prices of something. All production and value is labor based (see Marx’s Labor Theory of Value). So, there’s no interest, no investments, no capital gains, no development of land or resources for individual gain. It’s labor & wages and handouts, the only way to get money.
- You live in a mixed economy like all the world’s socialist democracies (including the US). You have a monopoly fiat currency, a central bank, and a network of federal and state chartered banks all tied to the central bank. The money supply (new money creation) can be done in a number of ways but let’s keep it simple. First and foremost, via Fractional Reserve Banking. When a bank lends you money, they’re not lending you someone else’s money (entirely) from the vault or balance sheet, they are creating new money (partially) to loan to you (The horror, right? We’ll see.). Secondly, the state can simply print it without any reason to, except perhaps to make interest payments on its own debts (Treasury Bonds). Both could potentially be inflationary (creating too much money chasing fewer goods and services), but in the first case of FRB, this is more self regulating if…IF…interest rates were always determined by market dynamics and not Fed edict to lower interest rates (the rates at which banks borrow) to “stimulate the economy,” or whatever other manipulation they have in mind.
Of all of the above, it’s fractional reserve banking that’s the bee’s knees and cat’s meow all in one. It’s ingenious from a “lifting society up” standpoint—when done conservatively…in the blue-pin-striped, traditional, humorless, hard-nosed way of a banker whose reputation and trustworthiness are his prime business assets. Pure financial genius. And why? It’s because of the multiplier effect, the societal leverage. Guess what else? It’s been around for centuries and was not invented by government, but by banking and lending entrepreneurs.
Here’s where society in general is ignorant, but libertarians being not ignorant, go off the rails. Suppose you ask Joe Average how much a bank can lend out if it gets a $100 deposit and is subject to a 10% reserve requirement. Simple math, right? They’ll tell you the bank can lend $90, assuming they understand the question which is a leap, I admit. …The bank pays the depositor some amount of interest on $100 and/or provides services like checking, ATM, etc., and it charges the borrower of the $90 far more interest and the spread is the bank’s gross margin.
Now ask Joe Libertarian the same question and he won’t get it wrong…while he spins in circles of outrage. Theoretically, if every bank is subject to the same 10% reserve requirement, that $100 deposit can multiply to $1,000, $900 of it being “money created out of thin air.” Of course, that theory leaves supply and demand out of the equation. I’d guess very rarely do deposits reach theoretical multiplier levels.
And now I shall leave you in suspense until the next post in this category, within a few days to a week. I’ll explain to you how that $900, when created properly, is the most powerful, abundant money humans ever created and is backed by the very basis of our survival as a species.
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