Wednesday, February 25, 2015

Money and Gold

An article by John Tamny gives me an opportunity to opine on some topics I've been thinking a lot about. Mr. Tamny expresses an opinion common on the libertarian Right, also held by people like Steve Forbes and Rand Paul. These are people I respect because they get the biggest of the big issues right, namely that economic freedom is the most effective way of reducing poverty and improving living standards. So I'm distressed to have to disagree with them.

The problem is that they are looking for utopian simplicity. Thus they take a grain of truth and exaggerate it into absolute certitude. In extreme forms this leads to completely stupid policy suggestions such as going on the gold standard or abolishing the Fed.

For example, Mr. Tamny makes a claim that is simply not true. He argues that money is money is money, and that the euro is just as good (or bad) a currency as the mark or the franc or the drachma. Greece's problems were not caused by the euro, nor would they be solved by leaving the euro. Indeed, Greece leaving the euro is just as unreasonable as Mississippi leaving the dollar, even though it's vastly poorer than New York or California.

He writes:
In truth, money is solely a measure. I have bread, I want your wine, but you don’t want my bread. Money makes a transaction possible between a baker and vintner with differing wants simply because it’s historically been viewed as a stable “ticket” that allows producers of actual wealth to measure what they produce on the way to trade. Money facilitates exchange, and that’s why a common dollar has long made so much sense. That’s why the euro still makes sense.
He uses an analogy from physics. Whether one measures the distance from Chicago to Milwaukee as 90 miles or 150 kilometers, it's still the same distance. The same is true of money: drachmas, dollars, or euros--there is no real difference.

Of course Mr. Tamny is right on some level. Printing up bits of colored paper does not produce wealth. Devaluing a currency changes no comparative advantage between countries. But he's also wrong. While good money creates no wealth, bad money can certainly destroy it. A country that lacks liquidity or secure banks will be neither productive nor wealthy. And that's the difference between Greece and Mississippi. The latter has good money, while the former doesn't.

Let's count the advantages of Mississippi. Many payments are made independently of Mississippi's wealth. Social security recipients receive the same benefits in Ole Miss as they do in the Big Apple. Military pay is the same, as are payments for civil service and postal employees. Thus a significant fraction of Mississippi's income does not depend on current economic circumstances. By using the dollar they are essentially insured against temporary misfortune.

Greece has none of those benefits.

People in Mississippi can move to New York and vice versa. We both speak the same language, share much of the same culture, drive the same cars, and eat the same food. I could move to Mississippi and within a couple months establish residency, obtain a driver's license, register to vote, join a church, and find a job. In a word, in the dollar zone the labor market is very liquid.

Nominally, Greeks have many of the same rights in Germany, but in practice they don't. Very few Greeks speak German, and even fewer Germans speak Greek. Political institutions are completely different in the two countries. Apart from the exceptional few, Greeks working in Germany can't aspire to anything more than the most menial, low-paid job. And Germans have almost no reason ever to move to Greece. By comparison with the dollar zone, labor markets in the EU are massively inefficient.

Even worse, land title, property rights, investment opportunities, taxes, and almost everything about money do not mean the same thing in Greece as they do in Germany. It's likely not possible to accurately translate the word collateral from one language to the other. That means banking customs have to be different between the countries. A German bank working under German rules will not be successful in Greece, and vice versa. They can't do business the same way.

In order to have a functioning banking system there has to be a lender of last resort. Walter Bagehot describes that necessity precisely in his famous 1873 book entitled Lombard Street. Then the (privately owned) banking department of the Bank of England served that role. In New York and Mississippi it is the Federal Reserve Bank system that does the dirty. Without that guarantee of liquidity all banks in any country will inevitably collapse, credit will disappear, and the economy will shrink.

Mississippi has access to liquidity from the Fed. Deposit insurance applies there as much as it does in New York. Greece, on the other hand, has no guarantee of liquidity unless it follows banking rules set by Germany. Accordingly, Greek banks will eventually fail and everybody knows that. You can't have a growing economy without stable credit markets.

Greece will eventually have to repatriate its banking system. That is, it will have to establish an institution similar to the Fed or the ECB that operates under rules consistent with Greek labor and financial customs. In a word, it needs a drachma. The drachma will not cause economic growth--on this Mr. Tamny is correct--but it is an essential prerequisite before economic growth can occur.

(Mr. Tamny discusses smaller countries that peg their currencies to the dollar or the euro. That works as long as those governments possess sufficient foreign reserves to be a credible lender of last resort. Failing that, the peg will eventually fail. See, e.g., the Argentine peso - dollar peg in effect from 1991 to 2002.)

So it is not true to say that money makes no difference. It makes a huge difference.

Another common simple fix to all our economic woes is to re-institute the gold standard. Mr. Tamny only hints at this in this article, but I'd like to take the topic full on.

Unlike what Mr. Tamny claims, money is not a fixed measure of value in the way a mile is a fixed measure of distance. Money is instead a social convention. You can spend dollars because I'm willing to accept them. That's all there is to it. The value of money is determined by social convention, otherwise known as expectations. I expect a dollar to buy me a donut tomorrow morning. If tomorrow the price of a donut went up to $5, and then the following morning down to thirteen cents, then my faith in the dollar would waver. I'd look for another way to settle my debts.

Inflation is caused when people expect their dollars to buy less tomorrow than they buy today. So they will spend their dollars today. Inflation is not caused by the Fed, or by Congress, or by the price of gold.

Deflation is caused when people expect their dollars to buy more tomorrow than they buy today. So they will stash their dollars and spend them tomorrow. Deflation is not caused by the Fed, or by Congress, or by the price of gold.

Inflation and deflation are caused by changes in expectations. Now in extreme cases--e.g., helicopter drops of massive amounts of currency--the Fed can change expectations. And the Fed certainly tries to change expectations. Mr. Tamny undoubtedly recalls the famous words that Janet Yellen uttered on July 15th of last year. Did she say something about "patience" and "data-driven analysis?" Or was it the other way around? Every speech ever made by Ms. Yellen (or Mr. Bernanke before her) sounds exactly the same. Some days the market moves up. Other days the market moves down.

The Fed is irrelevant. Nothing they do matters at the margin. (Nothing, that is, except their role as the lender of last resort.) All these people who hyperventilate about how the Fed is doing it wrong (or right), or who care about what magic words the Chairman will utter next week or next month, are wasting their time and breath. The Fed has nearly zero control  over inflation, velocity, exchange rates, money supply, interest rates, or anything else.

So now the gold bugs want to have the Fed regulate the price of gold. The largest consumers of gold are jewelry buyers in India. How regulating the jewelry business in India is going to help the US economy is a big mystery to me. But it gets worse. Any regulatory agency is eventually captured by the industry it is trying to regulate. So the Fed (which has no other important function except to serve as the lender of last resort) will eventually kowtow to the needs of Canadian miners and Indian jewelers.

In Mr. Bagehot's day gold was used to reconcile debts between countries. So if an Englishman owed money to a Frenchman, the debt would be settled in the common currency--gold. That led to all sorts of opportunities for arbitrage and fraud, as the book describes.

Today it's much more efficient. We have a foreign exchange market that trades more than $5 trillion dollars every day. It's the biggest, most liquid, most efficient market on earth. But the gold bugs don't like it--they want to force all trades to go through gold first. Why?

Compare that amount with what the people who fret over the feckless Fed are worried about. At the height of quantitative easing, the Fed was pushing less than $3 billion per day into the economy. Our Fed fretters predicted imminent inflation and forecast a rise in the gold price to over $2000/oz. But it's less than 0.1% of the daily currency trade. It's a gnat on the back of an elephant. QE had absolutely zero impact on inflation in the US. It was a complete non-event.

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