The Gold Standard is Not Without its Costs

News from the department of “life is bigger than art:” A few days ago I posted a fictitious account of a future Wells Fargo Bank operating on a revived gold standard. Turns out the real Wells Fargo, now a regular large commercial bank with its roots in the California gold rush, has a branch in downtown San Francisco at the site where the bank was first opened in 1852. The branch had an exhibit of historic artifacts, including gold nuggets from the gold rush era. I say had, because last night thieves rammed an SUV into the lobby and made off with the nuggets!

All of which underscores the fact that security is among the real costs associated with a gold standard. There is no law of nature that says free banking has to be based on gold, as I pointed out in my post. The market would, if free to do so, sort out costs and benefits and find the sort of system or systems that best satisfies consumers.

I love Wells Fargo; They Hate Me.

While I have this blog window open I’ll add some unrelated comments about Wells Fargo. I am a happy customer and I credit this to the stiff competition among banks at the retail level. I regularly get solicitations from banks offering $100 bonus to open an account, with strings attached, of course but I stick with Wells Fargo. At the macro level our current banking system is gravely flawed but it works well for us retail customers.

I get free checking, a handy web site, and ATMs all over the place. When my credit card was hacked recently, they replaced it promptly and took my claims about false charges at face value. My average credit card balance last year was nearly $4,000 and I paid zero interest. That’s because I pay it off at the last possible date, which is 25 days after billing. I pay an $18 annual fee but got $300 in cash rebates last year. I never pay late fees or penalties of any kind.

I do not have a savings account with Wells Fargo because those accounts are a joke. Their most popular savings account yields (drum roll) 0.01%. Not one percent, but one hundredth of one percent. For every thousand dollars I might keep in a savings account, I would get ten cents in annual interest, taxable. I do, however, hold shares of Wells Fargo preferred stock which pay 6.8% current yield (for you experts, a somewhat lower yield to call). The shares appreciated about 70% since I bought them at the bottom of the Great Recession.

So I am a money loser for Wells Fargo. They earn merchant fees from my credit card use and that’s about it. They count on their average customer’s ignorance and lack of financial discipline to generate fee income and to carry high-interest balances on their credit cards. Dear reader, if that describes you, don’t despair. You can get out in front of the wave and let the banks work for you, not the other way around. It just takes a little knowledge and some discipline. Most important: if you can’t pay cash for a purchase (or use a credit card paid off before interest kicks in), you can’t afford it! That includes cars. Save up your money and buy a junker. Mortgages are OK for home purchases because of tax breaks, but even there, start with a healthy down payment.

Here endeth today’s sermon. Go in peace and freedom!

A Tale of Free Banking

Herewith we visit an imaginary future where free banking prevails. Government regulation of banks is a thing of the past. Banks have the freedom and the responsibility that they lacked under government regulation. In particular, private banks are free to print money, either literally, in the form of paper banknotes for the shrinking number of customers who want them, but in electronic form for most.

Print money? Horrors, you say! Fraud! Runaway inflation!

Not so fast. Come with me on a fantasy visit to the local branch of my bank, a future incarnation of Wells Fargo to be specific.

The first thing we notice is a display case showing a number of gold coins and a placard that says, “available here for 1,000 Wells Fargo Dollars each, now and forever.” I have in my wallet a number of Wells Fargo banknotes in various denominations. I could walk up to a teller and plunk down 1,000 of them and the smiling young lady would hand over one of these coins. More likely I would whip out my smartphone and hold it up to the near-field reader, validate my thumbprint, and complete the transaction without paper.

I have a few of these beautiful gold coins socked away at home but I don’t want any more today nor do I want to carry them around. Electronic money is ever so much safer and more convenient. Still, I am reassured by the knowledge that I could get the gold any time I wanted it. That is the basis for my confidence in this bank, not the FDIC sticker we used to see in the bank’s window.

Confidence? What about inflation? Wells Fargo can create as many of these dollars as they want, out of thin air. Without government regulation, who will stop them from creating and spending as many dollars as they want?

The market will stop them, that’s who.

In my scenario, Consumer Reports and a number of lesser known organizations track Wells Fargo and other banks. These organizations post daily figures online showing the number of Wells Fargo dollars (WF$) outstanding and the amount of gold holdings that the bank keeps in reserve to back these dollars. Premium subscribers, I imagine, can get an email alert any time a bank’s reserves fall below some specified levels. Large depositors will notify Wells Fargo of their intention to begin withdrawing deposits and/or demanding physical gold. Small depositors piggyback on the vigilance efforts of big depositors. They know it is not necessary for them to pester the bank when the big guys are doing it for everybody.

Wells Fargo practices fractional reserve banking. They cannot redeem all their banknote liabilities and demand deposit liabilities at the stated rate of one ounce of gold per thousand WF$. This situation is clearly outlined in the contract that depositors sign and is printed on their banknotes.

Let’s assume Wells Fargo backs just 40% of its banknotes and deposits with physical gold. How is this figure arrived at? By trial and error. Managers believe that if they let the reserve ratio slip much below 40% they will start getting flak from the monitoring websites and their big depositors. If they let it rise much above that figure their stockholders will begin complaining about missed profit opportunities.

Under fractional reserve banking, bank runs are possible. A bank run is a situation where a few depositors lose confidence in a bank and demand redemption of their deposits in gold or in notes of another bank. Seeing this, other depositors line up to get their money out, and if left unchecked, the bank is wiped out along with the depositors who were last in line. Bank runs are not a pretty sight.

Wells Fargo has a number of strategies for heading off a bank run. They have an agreement with the private clearing house of which they are a member that allows the bank to draw on a line of credit under certain circumstances. There is a clause, clearly indicated in the agreement with their depositors, allowing them to delay gold redemption for up to 60 days under special circumstances. They can reduce the supply of WF$ by calling in loans as permitted by loan agreements. Most important, though, is Wells Fargo’s reputation. Not once in their long history has Wells Fargo been subject to a bank run. Management is keenly aware of the value of their reputation and will move heaven and earth to preserve it.

To sum up, Wells Fargo’s ability to create unbacked money is limited by the public’s willingness to hold that money. The bank can respond to changes in the demand to hold WF$ whether those changes are seasonal in nature or secular.  They have strategies in place to head off runs should one appear imminent or actually begin.

What about competing banks, you may ask. Does Bank of America issue its own money? If so, there must be chaos with several different brands of money in the market. Are there floating exchange rates? Is a BofA$ worth WF$1.05 one day and WF$0.95 the next? What else but government regulation could put an end to such chaos?

The market, that’s what else.

Competing suppliers of all sorts of products have an incentive to adhere to standards even as they compete vigorously. If we were in a classroom right now I would point to the fluorescent lights overhead. The tubes are all four feet long and 1.5 inches in diameter, with standard connectors. They run on 110 volt 60 Hz AC current. Suppliers all adhere to this standard while competing vigorously with one another. If they don’t adhere to the standards people won’t buy their light bulbs.

So it is that competing banks in my fantasy world have all converged on a gold standard. They all adhere to the standard one ounce of gold per thousand dollars. (I trust it’s obvious that I just made up this number. Any number would do.)

Why gold? Gold has physical properties that have endeared it to people over the ages—durability, divisibility, scarcity to name a few. But other standards might have evolved such as a basket of commodities—gold, silver, copper, whatever.

You may raise another objection. All this gold sitting in vaults detracts from the supply available for jewelry, electronics, etc. That’s a real cost to these industries and their customers.

Yes, it is. It’s called the “resource cost” of commodity-backed money. To get a handle on this cost we must recognize that gold sitting in vaults is not really idle, but is actively providing a service. It is ensuring a stable monetary system immune from political meddling. How valuable is that? The market will balance the benefits of stability against the resource costs of a gold standard.

Furthermore we can expect resource costs to decline slowly as confidence in the banking system increases and people are comfortable with declining reserve ratios. Wells Fargo may find that a 30% reserve ratio rather 40% will be enough to maintain confidence. Other things equal, this development would boost profits temporarily, but those profits would soon be competed away, to the benefit of depositors and the economy as a whole.

Let’s go back to bank runs. Aren’t they something horrible, to be avoided at all costs?

Actually an occasional bank run is something to be celebrated. Not for those involved, of course, but to remind depositors and bank managers alike that they need to be careful. The same is true of the recent Radio Shack bankruptcy. Bad news for stockholders, suppliers and employees but an opportunity for competitors to learn from this bankruptcy.

Under my free banking scenario, depositors must take some responsibility for their actions. That doesn’t mean they have to become professional examiners. They just have to take some care to check with Consumer Reports or other rating organizations before signing on with a bank.

Have I sketched out a perfect situation? There’s no such thing as perfection in human affairs but I submit that this situation would be vastly superior to what we have now, where the Federal Reserve’s policy of printing money to finance government deficits will end badly. Furthermore, relatively free banking has existed in the past and worked well. To learn more, start with Larry White’s “Free Banking in Britain.”

Free Banking Beats Central Banking

In “More Bits on Whether We Need a Fed,” a November 21 MarginalRevolution blogpost, George Mason University economics professor Tyler Cowen questions “why free banking would offer an advantage over post WWII central banking (combined with FDIC and paper money).”  He adds, “That’s long been the weak spot of the anti-Fed case.”

Free banking is better than central banking because only in a free market can the optimal prices and quantities of goods be determined.  Those goods include the money supply, and prices include the rate of interest.

There is no scientific way to know in advance the right price of goods.  With ever-changing population, technology, and preferences, markets are turbulent, and there is no way to accurately predict fluctuating human desires and costs.

The quantity of money in the economy is no different from other goods.  The optimal amount can only be discovered by the dynamics of supply and demand in a market.  The impact of money on prices depends not just on the amount of money, but also on its velocity, that is, how fast the money turns over. The Fed cannot control the velocity since it cannot control the demand for money, that is, the amount people want to hold. Also, even if the Fed could determine the best amount of money for today, the impact on the economy takes several months to take effect, and so the central bankers would need to be able to accurately predict the state of the economy months into the future. Continue reading

Gold as Implicit Money

Economics encompasses two realities, the explicit and the implicit. The explicit is visible, obvious, recorded, and quoted. Explicit expenses are paid to others and recorded by accountants. The explicit is also called “nominal,” since that is what is named. For example, nominal interest is what a bank says it is paying, and the money it pays to depositors.

But there is also an implicit realm that is also real. Indeed, the implicit is more real than the explicit. What is explicit is often merely the superficial appearance. But things are often not what they appear to be. The reality beneath is implicit, not visible, not quoted, and not recorded, yet it is the true reality. Economists often use the adjective “economic” to designate the real thing in contrast to the explicit number or the accounting data.

An enterprise has explicit and implicit expenses. The explicit expenses are recorded by bookkeepers and accountants. The implicit expenses are non-recorded opportunity costs, such as what the owner of a business would have earned elsewhere, or what the assets of the firm would yield if sold and converted to bonds. The real cost of oil is not what the buyer pays but also includes the implicit costs of pollution damage not paid for by the customer.

Real interest is the nominal interest minus the inflation rate. Economic profit is accounting profit minus implicit expenses. Real GDP is nominal GDP (in current dollars) adjusted for inflation. Economists deflate prices and include implicit costs to get at the implicit reality. Continue reading

Gold and Money, II

Last [blog post], we examined some propositions about gold as money, drawing from theory and history. [In] this [blog post] we ask whether and how gold might once again serve a monetary function.

Money of any sort, commodity-based or not, derives its value in large part from what economists call a “network effect.” Like a fax machine, whose value depends largely on how many other people have fax machines, we value money because other people value it. We feel confident our money will buy us what we need tomorrow. A strong network effect means that something drastic has to happen before people will give up their familiar form of money.

Something drastic was happening when U.S. Rep. Ron Paul’s Gold Commission was set up in 1979. By the time the commission’s report was issued in 1980, inflation had reached alarming levels: The consumer price index was at 14 percent and rising. The prime rate was over 20 percent, and in 1980 silver exploded to $50 an ounce and gold surpassed $800 (about $2,300 in today’s dollars). Bestselling books urged people to buy gold, silver, diamonds, firearms, and rural hideouts.

We now know that inflation was peaking and that the silver price spike was a fluke caused by a failed attempt to corner the silver market. But none of this was apparent at the time, so it was reasonable to wonder whether our monetary system would survive. What did happen, of course, was that the new Fed chairman, Paul Volcker, stepped on the monetary brakes hard enough to break the back of inflation. Two back-to-back recessions resulted but were followed by a long period of recovery in which both inflation and interest rates dropped steadily. The Gold Commission was largely forgotten, though the U.S. Mint did get into the business of producing gold coins in a big way. Continue reading

Gold and Money

Nothing seems to arouse passions—pro and con—quite like suggestions that gold should once again play a role in our money. “Only gold is money,” says one side. “It’s a barbarous relic,” says the other. Let’s turn down the heat a bit and look into some propositions about gold. That should lead us to some reasonable ideas about whether or how gold might return.

Propositions About Gold

Gold has intrinsic value. Actually, nothing has intrinsic value. The value of any good or service resides in the minds of individuals contemplating the benefits they might derive from it. What gold does have is some rather remarkable physical properties that make it very likely that people will continue to value it highly: luster, corrosion resistance, divisibility, malleability, high thermal and electrical conductivity, and a high degree of scarcity. All the gold ever mined would only fill one large swimming pool, and most of that gold is still recoverable.

Only gold is money. Although gold was once used as money, that is no longer the case. Money is whatever is generally accepted as a medium of exchange in a particular historical setting. Right now, government-issued fiat money, unbacked by any commodity, is the only kind of money we find anywhere in the world, with some possible obscure exceptions.

Perhaps people who say this mean that gold is the only form of money that can ensure stability. That’s what future Federal Reserve Chairman Alan Greenspan thought in 1967, when he wrote “Gold and Economic Freedom” for Ayn Rand’s newsletter. “In the absence of the gold standard, there is no way to protect savings from confiscation through inflation,” he said. When later asked by U.S. Rep. Ron Paul whether he stood by that article, Greenspan said he did. But he weaseled out by saying a return to gold was unnecessary because central banks had learned to produce the same results gold would produce. Continue reading