How Credit Suppresses the Gold Price (with Alice and Bob)

Alternative title: How Credit Creates Inflation
Alternative title: How Gresham’s Law Destroys the Gold Standard

Our small closed economy has five main protagonists, Alice the Automobile Saleswoman, Bob the Banker, Charlie the Capitalist, Dave the Debtor, and Steve the Saver. This small economy is on a gold coin standard, i.e. gold coins circulate as cash. In order to see how the real price of gold (measured in Ferrari sports cars) depends on the creation of credit, we consider the following scenarios.

• A cash based economy without any lending and without any banks.
• An economy with banks, but without lending.
• An economy with banks and with fractional reserve lending.
• An economy without banks, but with private-to-private lending.
• An economy without banks, but with commercial Real Bills.

The reason for presenting the toy model is our claim in Sections 5 to 7 of The Many Values Of Gold that the fatal flaw that renders the gold standard unsustainable in the long run, is the fact that there exists credit denominated in a weight of gold and that this credit circulates as currency, i.e. that it is accepted as a form of payment for goods and services.

If you are just interested in how credit creates inflation, please ignore all the mentionings of the gold standard, imagine our economy would just use any paper currency such as the US$or the Euro and continue reading. Defenders of the gold standard often claim that the gold standard failed for one of the following reasons and can therefore be made viable if some specific problems are solved: • Mismatch of maturities of bank deposits and loans. If the banking system were organized in such a way that maturities always matched, there would be no problem with the gold standard. • Fractional reserve lending. If the banks were required to be fully reserved, there would be no problem with the gold standard. • The fact that loans are extended for unproductive purposes. If loans were made only for productive enterprises, for example, in the form of Real Bills, there would be no problem with the gold standard. Our toy model allows us to discover which ones of these additional measures succeed in fixing the problems of the gold standard and which ones do not. 1. The Protagonists Our toy model economy is on a Gold Coin Standard. Its currency unit is the dollar ($). One dollar is worth precisely once ounce of fine gold, and for simplicity, all the cash in circulation is in the form of identical gold coins whose fine weight is precisely one ounce. There are no bank notes, and initially there is no credit and no debt either.

• Alice the Automobile Saleswoman plans to sell a Ferrari 458 Italia.

Ferrari 458 Italia

The car is to be auctioned in an open auction. The minimum bid is $10. The bid can be raised in increments of$2. Alice will sell the car to the highest bidder. Initially, she has no cash, but only the Ferrari.
• Bob the Banker runs the bank in our toy model economy if the scenario allows banks. Otherwise he is unemployed. He has $1 in cash which can form the shareholders’ equity of his bank. Bob is a prudent banker and never levers up his bank by more than a factor of three (by this, we mean the inverse of the cash reserve ratio). But he is always available for some good business if a favourable deal presents itself. In the scenarios in which Bob is unemployed, he cannot afford a car. In the scenarios in which he is a banker, he is content with the company car he can use, and so he does not care about the Ferrari that is for sale. • Charlie the Capitalist has long retired from active work. He owns a number of companies and receives plenty of dividends. Right now he has$100 in cash. He, too, is always available for some good business. Since he loves his vintage Aston Martin,

Aston Martin (1937)

he does not care about the Ferrari either.
• Dave the Debtor has a well-paid position at a law firm. Unfortunately, right now, he is out of cash as he just spent everything on new furniture. He has only $1 left. But he would love to buy the Ferrari. • Steve the Saver works as a carpenter. He earns substantially less than Dave, but he has always loved Ferraris, and he has managed to save$10 in cash.

Whenever we say “Back to square one”, this means that these initial conditions are restored: Alice has got the Ferrari, Bob has $1 and a banking licence, Charlie has$100, Dave has $1, and Steve has$10. Let us now study the various scenarios in order to see what happens to the price level in our toy model gold standard economy.

2. The Basic Scenarios

2.1. Cash Based Economy

Back to square one! Alice opens the auction of the Ferrari. In this case, the auction is rather simple and proceeds as follows. The only protagonist who is interested in the Ferrari and who can afford the minimum bid of $10, is Steve. So Steve bids$10 for the Ferrari. As there is no further bid, Alice sells him the Ferrari for $10. Our toy model has discovered the general price level. Well, it has discovered the price for one Ferrari 458 Italia, namely$10. In fact, what the model has discovered is the Free Gold Price in terms of goods and services: one ounce of unencumbered physical gold is worth 1/10 of a Ferrari. For the notion of the Free Gold Price, we refer to Section 7 of The Many Values Of Gold or to FOFOA’s Once Upon A Time.

2.2. Economy with Banks, but without Lending

Back to square one! Whereas in the previous Scenario 2.1, banks were not allowed, this time Bob is in business. But since lending is not allowed, he merely offers depository services. The opening balance sheet of Bob’s Brothers’ bank reads as follows.

Bob’s Brothers – Balance Sheet No. 1
Assets Liabilities and Equity
Cash $1 Shareholders’ Equity$1

Now Bob’s clients walk in and start depositing cash. Dave deposits his $1, Steve his$10, and Alice also opens an account so she can receive the payment for her Ferrari in a direct account-to-account wire transfer.

Bob’s Brothers – Balance Sheet No. 2
Assets Liabilities and Equity
Cash $12 Alice’s Account$0
Dave’s Account $1 Steve’s Account$10
Shareholders’ Equity $1 As soon as everyone is set, Alice opens the auction of the Ferrari. Since lending is still not possible in this scenario, the auction proceeds precisely as in the previous Scenario 2.1. Steve purchases the Ferrari for$10. As we now have a bank and Steve is lazy and does not want to carry around that much cash, he just orders a wire transfer to pay for the Ferrari:

Bob’s Brothers – Balance Sheet No. 3
Assets Liabilities and Equity
Cash $12 Alice’s Account$10
Dave’s Account $1 Steve’s Account$0
Shareholders’ Equity $1 In particular, the price of the Ferrari (our model for the general price level) and thereby also the real price of an ounce of gold are precisely as in Scenario 2.1. 2.3. Economy with Banks and Fractional Reserve Banking Back to square one! Also, please everyone deposit their cash, and so the balance sheet of Bob’s Brothers is precisely as Balance Sheet No. 2 above. Whereas in Scenario 2.2, Bob’s Brothers merely offered depository services, in this scenario Bob is allowed to make use of his banking licence, and he is able to apply fractional reserve banking and to create credit. When Alice opens the auction, Steve immediately bids his$10 for the Ferrari. But Dave is also keen on the Ferrari, and thanks to the additional banking services that have become available, he can also join the bidding. Dave rushes to see Bob and negotiates a line of credit. Bob is a prudent banker, and so he verifies Dave’s employment record at the law firm, and once he is satisfied, he extends Dave the requested loan of $12: Bob’s Brothers – Balance Sheet No. 4 Assets Liabilities and Equity Cash$12 Alice’s Account $0 Loan to Dave$12 Dave’s Account $13 Steve’s Account$10
Shareholders’ Equity $1 Notice that Bob’s Brothers’ balance sheet has expanded to$24 with only $12 of cash in the vault for an overall leverage of 2. This is still within Bob’s Brothers’ regulatory requirement not to lever up beyond a factor of 3. Now Dave rushes back to the auction and bids$12 for the Ferrari. Since Steve has saved only $10 and since he is called Steve the Saver for a good reason, he decides not to bid for the Ferrari on credit, but he rather decides to quit the auction. Dave’s$12 is the highest bid. Therefore, Alice sells the Ferrari to Dave for $12. Again, payment is by wire transfer: Bob’s Brothers – Balance Sheet No. 5 Assets Liabilities and Equity Cash$12 Alice’s Account $12 Loan to Dave$12 Dave’s Account $1 Steve’s Account$10
Shareholders’ Equity $1 Again, our toy model has discovered the general price level, symbolized by the price of the Ferrari 458 Italia. This time, the sports car went for$12. Consumer price inflation!

At the same time, our model has discovered the price of Paper Gold. Whereas in Scenarios 2.1 and 2.2, one ounce of unencumbered physical gold was worth 1/10 of a Ferrari, our model has now discovered a price of gold of only 1/12 of a Ferrari. We use the term paper gold in this case because what determines the price of gold relative to goods and services in this example is no longer unencumbered physical gold, but rather a mixture of physical gold and a loan contract.

Even if Alice had insisted on payment in physical gold rather accepting the wire transfer, the auction price would have been the same. For example, starting from Balance Sheet No. 4 above, Dave could simply withdraw cash from his bank account and pay Alice in cash. Regardless of the precise form of payment, in this Scenario, the price of the Ferrari is $12 rather than$10. What matters is only

1. That somebody (here: Bob the Banker) trusts Dave and extends him a loan denominated in ounces of gold, and
2. That this borrowed gold is accepted as payment for goods and services, i.e. that it circulates as currency. In the example, this became possible because either (Balance Sheet No. 5) Alice accepted credit money as payment (the wire transfer), or alternatively because Bob’s Brothers let Dave take out the cash in order to pay Alice in cash.

This Scenario illustrates the effect described in Sections 5 to 7 of The Many Values Of Gold that what matters for the price of gold relative of goods and services is the currency supply, i.e. the total amount of currency in circulation.

In Scenarios 2.1 and 2.2, the currency supply was $112 ($1 Bob; $100 Charlie;$1 Dave; $10 Steve), but in the present Scenario, the currency supply has been extended to$124 ($1 Bob;$100 Charlie; $13 Dave$12 of which is borrowed; $10 Steve). This was enough to cause consumer price inflation or, conversely, it suppressed the currency price of gold (paper price) below the Free Gold Price. It should come as no surprise that the availability of loans does influence the demand for Ferraris. Without the loan, Dave cannot bid for the Ferrari. With the loan, he can. Conclusion: Extending loans denominated in ounces of gold suppresses the gold price. Remark 1. This toy model is simplified and exaggerated (for example, the increment of the bids in the auction is a full 20%), but it is honest, i.e. the availability of loans does affect demand and thereby the market clearing price. Have you ever wondered what drives real estate prices? Demographics? Wage increases? Scarcity of space? How about the availability of credit? For empirical studies of the effect of currency supply on the price level in the case of Japan, we refer to: Richard A. Werner, New paradigm in macroeconomics: solving the riddle of Japanese macroeconomic performance, Palgrave Macmillan, 2005. Remark 2. In this scenario, Steve the Saver loses the auction to Dave the Debtor. The way in which this happens, contains a bitter irony: The loan to Dave is possible only because Steve deposited his cash in Bob’s Brothers’ bank where it can serve as the reserve that makes the loan to Dave possible. Had Steve kept his savings in a safe place at home or even in a safe deposit box at the bank, the loan to Dave would not have been possible, and Steve would have won the auction for$10. Morale: It is the saver who calls the shots.

Remark 3. One of the key features of the London (OTC) gold market is the availability of bank credit denominated in ounces of gold (Section 8 of The Many Values Of Gold).

Remark 4. What renders the gold standard unsustainable in the long run is the fact that under a gold standard, loans are of course denominated in a fixed weight of gold. This suppresses the currency price of gold as soon as the currency supply (physical gold plus credit created) grows. The sophisticated investors will realize that the market price of one ounce of paper gold of 1/12 of a Ferrari undervalues gold in this scenario. Therefore, by a variant of Gresham’s Law, they will tend to hoard physical gold and spend credit money, draining reserves from the system. In a crisis of confidence, a run on the banking system (in effect a run on the physical gold that forms part of the currency) is the rational response, leaving behind all the collapsing credit. We discuss this in the next Section 3.

Remark 5. Advocates of a gold standard who try to defend the gold standard, often point out that the problem is specific mistakes in the organization of the banking system. We will come back to this in Section 4.1.

3. Gresham’s Law and the End of the Gold Standard

Alice has always been an avid reader of FOFOA’s blog. As soon as she suspects that Dave did not pay her with his savings, but rather with borrowed money, she knows that there is paper gold somewhere in the system, suppressing the price of gold below its Free Gold Price. So Alice knows that by paying only $12 for 12 ounces of gold, she made a good bargain. By thinking through Scenario 2.1, she estimates that 12 ounces of gold should rather be worth 1.2 Ferraris (recall that Scenario 2.1 discovered that the Ferrari is worth only 10 ounces of gold) although she paid only one Ferrari in order to acquire the gold. In currency terms and with the loans present, the Ferrari is worth$12, and so her 12 ounces of gold are truly worth $14.4. Therefore, Alice decides to take the gold out of Bob’s Brothers bank and to hide it at home until the market values this gold at its true value again at some point in the future. Her action is an example of Gresham’s Law. Starting with Balance Sheet No. 5 above, Alice therefore withdraws the proceeds of the Ferrari sale in cash (i.e. gold coins): Bob’s Brothers – Balance Sheet No. 6 Assets Liabilities and Equity Cash$0 Alice’s Account $0 Loan to Dave$12 Dave’s Account $1 Steve’s Account$10
Shareholders’ Equity $1 Grudgingly and with shaky hands, Bob hands her the cash. He knows that Bob’s Brothers has just run out of reserves, but trust is trust, and a business commitment has to be honoured. Before close of business today, he needs to phone the Federal Reserve and ask for an emergency liquidity injection and a courier shipment of additional cash. He will also call Dave and try to pressure him to pay back the loan earlier. Unfortunately, today is not Bob’s day at all. Steve sees Alice walk out of the bank with all the cash and, just for a moment, he is worried that she might have a good reason for taking out the cash. Steve knows from the history books how devastating a run on the banking system can be (1929-1933). Just to be on the safe side, he therefore decides to ask Bob for half of his money in cash ($5), just in order to test whether withdrawals are still possible and in particular in order to see the expression on Bob’s face when he asks.

The story of our gold standard therefore ends here. In tears. It happened because the presence of gold denominated credit suppressed the real price of one ounce of gold from 1/10 of a Ferrari down to 1/12 of a Ferrari. Two rather different components of the currency traded at the same price:

• The physical gold coin, a tangible asset free of counterparty risk and an ideal long term store of value.
• The unit ($1) of credit money in Bob’s Brothers’ bank accounts (and at the same time the unit of all outstanding loans). These are contracts with counterparty risk. The problem of the gold standard is that by construction, these two rather different assets trade at the same price. Theoretical considerations, in our case comparing Scenario 2.3 with Scenario 2.1, show that physical gold is undervalued in this system. It is therefore rational to speculate against the system. Initially, this is done only by sophisticated players (Alice), but in a crisis of confidence, it is obvious to all (Steve) that a run on the bank is the rational response. Remark: If our toy model economy were not on a gold standard, but rather used fiat money such as the actual US$ or the Euro, the consumer price inflation from $10 to$12 for the Ferrari would have occurred in precisely the same fashion. But in this case, when Alice withdraws all her cash and Steve runs on the bank, the Federal Reserve would just buy the loan asset (Loan to Dave) from Bob’s Brothers with newly created base money (Quantitative Easing I) and thereby provide sufficient liquidity to Bob’s Brothers. By exchanging her credit money for cash, Alice would not gain anything.

Let us now see whether the problem of the gold standard can be fixed.

4. Trying to Better Regulate the Banking System

After the disastrous experience in Section 3, Bob’s regulators call in several experts on the gold standard in order to discuss how to fix the banking system. They propose various measures in order to make sure the Federal Reserve does not set the interest rates too low, that the leverage in the banking system is monitored much more carefully, and that mismatch of maturities is avoided.

4.1. Economy without Banks, but with Loans

Let us see whether this helps. Just to make a point, let us abandon the banks altogether. Poor Bob is unemployed again. Dave will not be able to just walk into a bank and get his loan. But what we cannot prevent from happening is that Dave finds somebody else who trusts him and who is willing to extend him a loan – not credit created in the banking system using fractional reserve banking, but rather lending Dave some of his savings. This is where Charlie comes in.

But first, back to square one! Alice opens the auction. Steve bids his $10 for the Ferrari. Dave is also keen on the Ferrari and now that the regulators have closed all banks, he has to consider other options. Fortunately, he remembers his dad’s old friend Charlie. Charlie knows that Dave has the job at the law firm, he knows Dave’s annual salary and estimates that Dave will have no trouble servicing the loan. He trusts Dave, and so he lends Dave$12 from his $100 of cash savings. They both sign a formal contract and determine that the term of this loan is 24 months. Dave rushes back to the auction, bids$12 for the Ferrari and, since this is the highest bid, he manages to purchase the sports car for $12. Where do we stand? Alice has$12. Bob has $1 (and on top of that, he is unemployed). Charlie has$88 in cash and a $12 claim against Dave. Dave has$1 and the Ferrari. Steve as $10. The total currency supply is therefore$124 of which only $112 is physical gold. Precisely as in Scenario 2.3, our model has discovered the price of paper gold which is 1/12 Ferraris per ounce. This happened although there was no fractional reserve banking (Bob is out of business). There was no mismatch of maturities either. Both Charlie and Dave agree about the term of the loan. What matters is only that • There is debt denominated in ounces of gold (the$12 that Charlie has lent to Dave).
• That Dave can use this borrowed money in order to bid for goods and services.

Again, the weakness of this financial system in which lending of gold is possible, is Gresham’s Law. Alice will hoard the cash, Steve will be reluctant to lend his gold to somebody else, and they will wait until there are some loans that go bad. In this case, the Charlies of this world would get fleeced, and once the run on the credit has taken place, the market might one day discover the true value of the gold hoarded by Alice and Steve. (In the real world, the Ferrari would probably be crude oil, Alice be a sheikh, Steve a FOFOA reader, and Charlie a pension fund).

Remark 1: Charlie has a lot of cash at hand, and he is willing to invest some of it in the loan to Dave in order to earn some interest. Notice that, precisely by doing this, he creates consumer price inflation and thus lowers the real value of his savings. Again, it is the saver who calls the shots.

Remark 2: We said above that the currency supply in this example was $124. This is incorrect because Charlie has only$88 in cash plus a $12 claim against Dave. These$12 are not fungible, and Charlie cannot use them to buy groceries. One might therefore object and claim that while the loan enables Dave to consume the $12, it prevents Charlie from consuming the very same$12. The inflationary effect of the loan caused by Dave would therefore be compensated by a deflationary effect caused by Charlie’s lack of consumption.

Where do we stand? Alice has a credit note for $12. Bob has$1 and is unemployed and without banking licence. Charlie has $100 which he is not allowed to lend. Dave has$1 and the Ferrari. Steve has $10. Again, the total currency supply is$124 of which only $112 is physical gold. Our model has again discovered the price of paper gold which is 1/12 Ferrari per ounce, simply because Alice has extended a loan to Dave that is denominated in ounces of gold. Notice that there is no fractional reserve banking and no mismatch of maturities in this scenario either. 4.3. Real Bills Some defenders of the gold standard propose that the problem is not lending per se, but rather lending for unproductive purposes. The Ferrari might a good case in point. It is quite obvious though that the Scenario 4.2 of vendor financing also applies to the trading of industrial goods and services. So in order to address potential objections that involve real bills, let us adapt our selection of protagonists. • Alice Inc. is a steel mill who sell raw steel. They have already sold almost all of their production. The last remaining ton of raw steel is to be sold in an open auction. The starting bid is$10 with bid increments of $2. • Bob has$1 and is unemployed as there are no banks in this scenario.
• Charlie has $100, but he is not allowed to act in this scenario. • Dave & Co. is a manufacturer of tools. They have only$1 in cash, but they need one ton of raw steel for their ongoing production. They are willing to take on a loan in order to finance this purchase of steel.
• Steve Plc is a car manufacturer. They have $10 in cash and should they be able to acquire a ton of steel for this price, they plan to do so. Should the steel be more expensive though, they will not expand their production any further and not purchase any steel. After going through the Scenarios 2.1 and 4.2, it is clear that in a world without loans, Steve Plc will be able to purchase the ton of raw steel for$10. This is the Free Gold Price: 1/10 ton of steel per ounce.

Let us now assume that we live in a world with real bills. We assume that Alice Inc. have a very efficient cash management due to their high turnover of steel. For the last ton that is on auction, it does not matter to them whether they receive $x in cash or a real bill for$x from which they would receive interest. So they will accept either one of the two forms of payment as long as the $x is the highest bid. In this case, Steve Plc will bid$10 in cash for the ton of steel. But Dave & Co. will offer a real bill for $12 (plus interest) which Alice Inc. promptly accept as the highest bid. So in this case, our model discovers the price of paper gold: 1/12 ton of steel per ounce. Note that when we write that Dave & Co. offer a real bill for$12 (plus interest), we mean that the bill they present has a present discounted value of $12 and will mature at some face value above$12 at some point in the future. The difference is equivalent to the interest on the loan that Alice Inc. provide to Dave & Co.

In a world with real bills, however, this simplified example is no longer honest. Although credit is created and causes price inflation of unfinished goods (the raw steel), the credit allows Dave & Co. to expand their production. This will eventually lead to an increase in the available amount of goods and services which has a deflationary impact on consumer prices. The two effects, inflation in the price level of unfinished goods and an increased amount of finished goods available, counteract each other:

$M\cdot V = P\cdot Q$

Here $M$ is the currency supply, $V$ its velocity, $P$ the price level and $Q$ the real Gross Domestic Product (GDP). Assuming constant velocity, the currency supply is allowed to increase without affecting the price level as long as GDP increases accordingly.

And so, indeed, as long as the total volume of outstanding Real Bills remains at a constant proportion to GDP, the credit created in the form of Real Bills would not cause price inflation in the same fashion as in the previous examples. In order to guarantee this, Real Bills would have to be allowed only in order to finance additional production of existing businesses.

In practice, if one were to suggests to reintroduce a gold standard with Real Bills, it remains to resolve the problems of Scenarios 4.2 and 4.3. In particular, one would have to prevent Charlie in Scenario 4.2 from lending his savings and the vendor, Alice, in Scenario 4.3 from accepting deferred payment from the consumer, Dave.

5. Summary

We have seen that the problem of the gold standard was not fractional reserve banking, nor mismatch of maturities, but rather the presence of credit denominated in a weight of gold. This leads to an undervaluation of physical gold in terms of the currency and renders the speculation against the system trough Gresham’s law profitable. Furthermore, in a crisis of confidence, the run on the bank (better: run on the physical gold) is the optimum strategy.

The solution is therefore to embrace Gresham’s law and to separate the store of value from the currency: Freegold. See, for exmaple, FOFOA’s The Return to Honest Money.

The idea that the flaws of the gold standard cannot be fixed by better regulating the banking system, was also discussed in FOFOA’s Reply To Bron and in the discussion section at FOFOA’s blog starting here.

Aquilus at FOFOA’s blog pointed us to the following comment by FOA on this topic:

Trail Guide (05/11/01; 14:32:34MT – usagold.com msg#: 53425)
[…]
The ongoing over taxation, deficit spending, fiat inflation, deficit trade balances and mismanagement of private economies has always been with us. Yes, under different names and different degrees, that’s true, but no recent period in money history, gold or not, was without an ongoing effort to cheat the system. It was always in a process of decay, no matter what the books tell you. To think otherwise is to disclaim humans as they are.

How often have we heard that some special “hard school of thought” has all this terrible process documented and neatly explains where it all went wrong? Then, goes on to show us how to set it all up again so as to start over on the right foot.

So, trying to present the society as a whole, as “the awful, all controlling big government” on one side and the “good private economy on the other side” argues the lesser side of the larger issue;

—–hard money policy cannot work for long in a credit based system—-!

It makes absolutely no difference if we are even on a 100% gold use money system, if we as a society engage in credit commerce, we will break links with gold.

Consider:

I borrow 100oz of money gold from ten people so as to spend that gold doing commerce business. The hard money theory has us thinking that if I fail and cannot pay back the gold, this little portion of the money supply contracts. Thereby the gold system is perfect, as it slows the economic excess.
This is a minor example of gold banking. On a tiny scale. It works, as long as we don’t act out our motions in a political way.

Conversely, if gold was not part of a banking,,,,, credit,,,,, lending system,,,, rather it is just a tradable, non-lendable non-official money asset,,,,, then those ten people would have given me their gold and became part owners in my (ours now) enterprise. When it fails, our gold money is gone and no credit contract is lost in the process. Society at large will not come to our collective defense, no matter the scale of the loss. You see, we lost our assets, not society’s official money!

The difference:

When gold is lent,,,,, when it’s part of the banking system,,,,, when it becomes the object of a credit contract,,,,,, this whole hard money system falls into political RISK! No matter how perfect the “schools” have show this to work, in real life, political risk degrades our perfect credit money. This is the gray area that’s not ironed out because we cannot iron out society’s emotions. Let’s see:

In the above, the ten people I borrowed gold from would be holding my IOUs for that 100 ounces. Be they private citizens, banks or corporations they have effectively lost their gold money. The very money of the nation state!

Rather than see their losses made final, and cause harm, they partition the government to intervene by recognizing those money (gold) loans as good on the books. Further, the government is asked to lend some of it’s gold (collected through taxes) to me to extend my business life. I continue to function in a small way as I pay on those gold (money) loans. Further, those loans (held by ten lenders) become marketable as they become seasoned. Then, at a discount to their face value, they can be sold or kept as collateral assets. Over time, this is the political risk that seeps into any hard money system. Over time, even a gold credit system is expanded,,,,,, inflated,,,,,, until outright fiat must come into play.

It never starts out as “big corrupt government and their awful bankers” controlling the “good honest people”,,,,,, rather,,,,, it’s when a large enough segment of the “good honest people” are threatened with losing enough (gold) money that it could take down the economy,,,,,, they demand (elect into office) that their government and therefore bankers, expand the (gold) credit enough so as to slow the fall.

Acknowledgements

Many thanks to Aristotle at FOFOA’s blog for suggesting improvements to this article and to Motley Fool and costata for pushing me to give Real Bills a fair treatment.

If you have comments, suggestions or corrections concerning this article, please comment here (comments are moderated, and it may take a while until I have time to check for new comments). For the general discussion on the role of gold in the monetary system, please go to the comments section at FOFOA’s and so we do not fragment the discussion.

33 Responses to How Credit Suppresses the Gold Price (with Alice and Bob)

1. Motley Fool says:

Excepting my (little) disagreement on 4.3 this is a excellent post. I like the crystal clarity you bring to the subject. :)

• MF,

there is something else that I need to correct regarding Real Bills – may take a day or two.

Regards,

Victor

• LQ says:

I disagree with 4.1. Charlie’s money already exists when lent. What the loan did do though is temporarily dishoard Charlie’s savings so, in effect, the loan increased the velocity of his money but not the money stock itself.

Increases in velocity lead to transitory increases in the GPL, not permanent ones.

• Wasn’t it the point that Charlie never intended to spend his savings for at least some 30+ years? He has two options: (1) hoard the money and do nothing; (2) lend it to Dave. Choice no. (2) raises consumer prices for a period as long as the loan to Dave. Option no. (1) doesn’t. Everything else is semantics and nit-picking about the definitions.

2. Matt says:

Hi Victor, Matt from FOFOA’s blog here. I just want to mention something quickly (and you probably can imagine what it is already!)

“Charlie has $88 in cash and a$12 claim against Dave….Again, the total currency supply is $124 ” Once you cross this bridge then you have instigated fractional reserve banking. The loan is an asset rather than money, and it may be that its a near money asset but it is not actually money in the normal sense of being universally accepted as common means of payment (floating against/pricing the assets of the world) UNLESS we have a FRB banking system in place where it is. If we don’t have FRB in place then if Charlie’s claim is money, Dave’s liability is negative money. So, having said all that I appreciate that the whole subject is open to many many alternate interpretations depending on your point of view and the influences picked up along the way, the above is just mine and I don’t mean to enforce my view, It’s just different is all! • Matt, you are right that – as I have formulated 4.1 above – Charlie can immediately spend only$88 while the $12 claim has been made illiquid for the duration of the loan to Dave. I have two comments. 1) How could these$12 be made liquid again? This could be done by securitizing the loan. For example, Dave could have left Charlie a credit note, stating that Dave will pay the holder of the note $12 plus interest at some specified future date. Then Charlie could again use this credit note in trade and use it in order to bid for goods and services. As far as currency supply is concerned, this is equivalent to fractional reserve banking, but there is no bank and there is no reserve. It is achieved just by private contracts. So if someone proposed to outlaw fractional reserve lending, they would have to interfere with every single private contract. 2) Let us assume Charlie does not intend to spend his$100 any time soon. Say, he wants to save the sum for at least 30 further years and perhaps pass it on to his kids without ever using it himself. In this case, the question of whether Charlie has liquid funds of only $88 or of the full$100 is irrelevant to the fate of the rest of the economy. Nevertheless, the consumer price inflation that can be seen in the auction price of the Ferrari is real and leads to Alice’s speculation against the present financial system.

Regards,

Victor

• LQ says:

Victor, what you’re really grasping here is an intertemporal relationship. Charlie’s loan to Dave has brought forward consumption but, at the expense of consumption tomorrow in my view. Whatever Dave consumes today, Charlie cannot tomorrow. The interest payments are compensation to Charlie for that incurred opportunity cost.

Matt’s correct to the extent that should the claim on Dave become fungible, this example reverts to a model of fractionally-reserved lending of sorts.

Great post overall.

3. kid dynamite says:

pretty interesting post, Victor

4. Anon731 says:

This is an excellent article because it shows why a fixed-rate gold standard is doomed to fail in a world where there indeed are good reasons and strong incentives for having both a fractional reserve banking system and the ability to extend credit. It also provides an easy-to-understand way to explain how freegold can provide an important check on a banking system and government without introducing this fatal flaw from traditional gold standards.

Many people hear and believe that return to “the gold standard” is not a good idea, but they don’t understand why. In the confusion, many become convinced that gold is inherently flawed and should not be part of a monetary system. They simply don’t understand that freegold is not a return to the kind of gold standard we’ve had before. It separates the role of currency from store-of-value and basis store-of-value on something real and limited (rather than on somebody else’s promise to pay or collect future taxes). Even advocates for returning to gold (e.g., Ron Paul) speak as though they don’t know about the “freegold alternative”.

I’d like to suggest that you incorporate your article into the wikipedia entry for freegold: http://en.wikipedia.org/wiki/Freegold Your examples can illustrate for anybody why the traditional gold standard is fundamentally flawed. And you can point out how freegold is different. You also could expand your article to show how freegold functions when there is a tendency toward excessive credit creation and government borrowing.

5. confederate miner says:

In the case of 100 percent there was no price inflating on any other goods.Dave might have paid to much for the car but that is on him. The capitalist deferred his consumption in order to lend. Now Dave will have to consume less in the future. Just because Dave overpayed doesn’t. Prove anything.

• Dear confederate miner,

I suppose you are referring to Section 4.1 in which Charlie lends Dave $12 from his savings. It is true that by borrowing money, Dave has shifted future consumption to the present (where it causes price inflation). So if at some point in the future, Dave consumes less, this would cause deflation in the future, perhaps (?) precisely compensating the present inflationary effect. I think this objection is valid, but let us see what the options are. 1) Dave might consume more today, but less in the future. In this case, you are right, and there would be a future deflationary impact. But when? When the total volume of loans (of all the Daves of this world) eventually contracts, i.e. say in 1929 (after a decade long credit binge). Sure, but in the meantime it was nevertheless a rational strategy for Alice to speculate on a collapse of the system. Finally, 1929-1933 demonstrated that your idea was right, but I think we have to agree that Alice was the “winner” of this game. The point is that Alice acts rationally when she helps cause the collapse of the system, even if Dave faces some lean years – rightly so. 2) Dave might default so that Charlie faces a loss. If Charlie intended to save his$100 for 30 years or more and perhaps leave it to his kids (see my response to Matt above), this writedown would not have any deflationary effect any time soon. Again, Alice’s speculation against the system is rational.

3) When the government sees all the Daves in trouble in the future, they might just abandon the gold standard (1933!) or at least devalue the $with respect to gold. Or, all the Daves who are suddenly in trouble simply elect a new government that does this for them. In this case, Alice was right, too. Regards, Victor 6. confederate miner says: In the example you included the claim on gold as money increasing the supply to 124. I do not count that as money just a claim on money also the 12 dollars hopefully was honestly earned through the productive efforts of the saver. He should be able to do what he wants with it. How did Alice collapse the system or make the correct bet? I don’t. See the system collapsing from. This example. 7. Lawrence Crissman says: Victor: I tried to post this on FOFOA, as you suggest, but my Google ID failed to work. Anyway, this might be a more appropriate venue. Or not. Anyway, it is a means of contacting you directly so you can contact me directly if you wish.. I wrote something that is too long to actually post here, as a result of your posting (somewhere that I have forgotten) that the LMBA was 10 times the size of the COMEX. A correspondent to whom I had sent your post referred it to Ted Butler, who in a private reply, took exception to it. So, I decided to investigate the matter. You win! Going by available figures, I reckon that the LMBA OTC markets trade around 9 time the physical gold that changes hands on the COMEX, and around 12 times the silver. There are further issues with regard to what a ‘spot price’ is how HFT affects markets that are in my piece. Since I have no website to post my findings on, please respond to me at the email I have entered on your form if you wish me to send you a copy. You can then post it somewhere if you think it would be worthwhile, which i would like in order to get some comments. Or, if you do not post it, but have some feedback for me, that would be greatly appreciated. Larry Crissman 8. Robert LeRoy Parker says: You may want to examine these documents from lbma: alchemist pdf lbma power point via google docs 9. Alex P. III says: Victor, I had an email conversation with a buddy of mine who studies at Mises’ Institute. He pointed out following (see below). Since it went a bit over my head, I’d like to ask you for comment… Quote: With all due respect, I think Victor needs to read the Theory of Money and Credit quite urgently. He treats credit instruments in all scenarios as part of the money supply. They are that exactly under fractional, fiat systems. They are not under fully reserved systems. In the case 4.1 Charlie lends Dave$12=12 gold ounces. This does indeed increase the price of the ferrari, but the credit contract does not increase the money supply. The extra bid for the car depresses bidding for all other goods by the same amount. The loaned gold reduces charlies other bidding by the same amount. There is no effect on the general price level.

True, Charlie can sell the credit instrument and resume spending, but then the person that buys it must reduce spending. Because there is a risk in the instrument, charlie could only sell at a discount to face value.

If the loaned gold comes out of a hoard, there is indeed an actual increase in the money supply in circulation, but so what? This would tend to a limit rapidly and is part of the normal fluctuation of the price of money, up and down.

I do not know what Victor refers to as the “failure” of the gold standard? He appears to mean bank runs. These were caused by legally privileged banks taking risks which they would not be able to do under a pure gold system, not the gold standard itself. Such legal privileges are in fact suspension of the standard.
End quote.

• Dear Alex,

this is a very good question, and there are a lot of details that you need to think about before you can see where the true issue is.

In the case 4.1 Charlie lends Dave $12=12 gold ounces. This does indeed increase the price of the ferrari, but the credit contract does not increase the money supply. The extra bid for the car depresses bidding for all other goods by the same amount. Firstly, we agree that the price of the Ferrari goes up. Secondly, I am not claiming that it would increase the money supply using his definition. I guess he defines money supply to be the usual M2 or M3. No, they do not increase, and I know that indeed. The question is what can you learn from using the common M2 or M3. The answer is close to nothing. If you want to understand how money supply affects consumer prices, they are unfortunately not very useful. The problem is that just by looking at M2 or M3, you cannot see whether the ‘money’ is used to bid for goods and services (leads to consumer price inflation immediately), whether it is used to bid for other assets, for example mortgages are used to bid for real estate (leads to rising real estate prices, but not to consumer price inflation as a first order effect), or whether it is used to bid for financial assets (in this case, it creates asset price inflation there, but again not immediately consumer price inflation). A further problem is that all these different ‘types of money’ in practice have drastically different velocities. So if you average over them, you don’t get anything useful. In order to cut through this noise, you need to disentangle what the various kinds of credit are used for. This leads to the Credit Theory of Money and the disaggregation of credit. When you do this, you can see that the total amount of mortgages outstanding today correlates with real estate prices about 6-9 months in the future. This has been demonstrated empirically for the boom and bust in Japan (see R. Werner’s work). This is the reason why I don’t care about what happens to M2 or M3, simply because their relevance cannot be demonstrated empirically, but different (and better!) measures of credit indeed have empirical relevance. But the entire point “Secondly,…” was about the word money supply rather than about the reality of the toy model. The relevant question is rather the following: Thirdly, does the fact that Charlie lends$12 to Dave reduce consumption elsewhere and thereby counteracts the inflationary effect that it had on the Ferrari. Now this depends on Charlie, doesn’t it?

a) If Charlie always spends all the money he has, then, yes, if he lends some of his money to Dave, he cannot consume as much as otherwise, and this will have a deflationary effect at the same time on some other products. Later, when Dave pays back the loan, there will be a deflationary effect on Dave’s consumption which is compensated by an inflationary effect on Charlie’s consumption who now gets the money back. If (a) is the case, then, yes, the inflation of the Ferrari price is compensated by deflation elsewhere, and when the loan matures, then things are reversed.

b) If Charlie intends to save his surplus for the long run, say, for retirement (more than 20 years) or even intends to pass it on to his children (more than 40 years), then he can lend some of these funds in the meantime without affecting the amount of consumption that happens elsewhere in the economy. In this case, as long as the loan to Dave is open, the price level will be elevated. In aggregate over the entire economy, the price level will depend on the total volume of outstanding consumer loans of this sort. An increase in the volume means inflation and a decrease means deflation (of consumer prices).

The problem for the gold standard is that if the loan volume is elevated for a longer period, say, 1921 to 1929, in the meantime, Alice’s speculation against the system is rational and profitable, and there is nothing you can do about it. It is just Gresham’s law.

If the loaned gold comes out of a hoard, there is indeed an actual increase in the money supply in circulation, but so what?

Am I correct that you agree with my point (b)? Then as long as the volume of outstanding loans is elevated, the price level will be elevated and thereby gold undervalued, rendering Alice’s speculation against the system rational. Alice will be able to cash in on her speculation if the bank run happens before the credit volume decreases naturally for some other reasons.

c) There is even a way in which you can replicate fractional reserve lending entirely with private contracts and without banks. Imagine that Dave writes Charlie an official IOU when he borrows, stating that “Dave pays the holder of this note $12 plus interest on March 23, 2014.”. Now it does not matter whether the borrowed money comes out of a hoard (b) or not (a). There is now a duplicate of the borrowed$12 – on the one hand there is the cash and on the other hand the IOU which is a securitized loan – and both can circulate. If people trust Dave’s IOU (perhaps he is General Electric?), you have doubled the currency in circulation although no bank has been involved.

So even if you dream of fixing the gold standard by heavily regulating the banks, you would need to regulate all private contracts as well.

I do not know what Victor refers to as the “failure” of the gold standard? He appears to mean bank runs. These were caused by legally privileged banks taking risks which they would not be able to do under a pure gold system, not the gold standard itself.

The failure of the gold standard is that it invites Alice to speculate against the system as explained above. The issue with the legally privileged banks and some reckless speculation certainly describes the reality of the 1920s, but it is nevertheless a straw man argument because it is not the reason for the failure of the gold standard. The gold standard fails because Alice’s behaviour is optimal, i.e it fails because of Gresham’s law.

There is a second, entirely pragmatic, objection. If you get a total system failure (1929-1933) just because a couple of greedy bankers manage to bribe the politicians and behave recklessly for a couple of years, then your system was not robust enough. You want to design a monetary system for the real world with real (fallible) humans in the executive positions, not some theoretical system that works only if everyone is both infinitely competent and infinitely honest and law-abiding.

Please, forward this response to your friend at the Mises Institute. I do think they still have something to learn about the monetary system.

Kind regards,

Victor

• Alex P. III says:

Victor,

Here’s the response from my friend:

1.I am not talking at all about M2 or M3. M3 is a very misleading measure, btw, for reasons I cant go into here. There is an austrian measure, the true money supply-TMS, but I am not talking about that either. You can check that out on the mises site.

Rather I am saying that money is the generally accepted medium of exchange and that the loan instrument is not. No-one bids for goods and services with LT loans, not even AAA government bonds. If they did it would be barter and the loan instrument would be discounted in all circumstances and heavily discounted in the ferrari case, because the loan is secured on a rapidly depreciating asset or else the income stream of a clearly feckless individual. The individuals who would accept such “payment” for any goods are extremely limited-I cannot go into a shop and buy milk with such an instrument, nor with government bonds. If I use these to collateralise further loans, then that money is removed from the owners capacity for spending with no effect on overall prices.

2. Victor talks about the price level being elevated by “open” consumer loans. The price level is not elevated if the loans are extended from real savings.

The issue of velocity is neutral. That is, it does not depend on credit. What Victor seems to be arguing is that the credit transaction augments the volume of spending in the economy and therefore under PV=MT the price level rises. But anything that increases the volume of spending would have this effect considered in isolation-economic growth for example creates new opportunities to spend money and amore advanced clearing can increase the number of transactions possible in a given period, with no reference to credit. The only driver of greatly increased velocity is economic growth, which offsets the velocity effect and overall causes a reduction in prices.

Ex hypothesi there is no reason to assume an increase in V anyway.

3.Now-

“Thirdly, does the fact that Charlie lends \$12 to Dave reduce consumption elsewhere and thereby counteracts the inflationary effect that it had on the Ferrari. Now this depends on Charlie, doesnt it?”

No.

None of Victors remarks affect this point-Charlies spending is curtailed by the amount of the loan. The loan asset does not restore this.

It is possible to bid up the price of the ferrari, but this implies a fall in the price of other consumer goods, under the assumption that the money supply is fixed as in a pure gold standard. There is no fall in the price of money, i.e. no increase in the aggregate price level. So,

“If Charlie intends to save his surplus for the long run, say, for retirement (more than 20 years) or even intends to pass it on to his children (more than 40 years), then he can lend some of these funds in the meantime without affecting the amount of consumption that happens elsewhere in the economy”

misses the point that Charlies spending is curtailed by the exact amount of the loan, so that overall demand is unaffected.

Again, if charlie has hoarded the money, then money coming out of hoards, from charlie and others like him, will increase the price level but only to a limit rapidly reached-it will not cause an ongoing trend in inflation. And this assumes a change in human nature such that no-one else will start hoarding. If Victor wishes to push this point, again it is neutral with respect to credit-it doesnt matter how money would come out of the hoard, credit or immediate spending, the effect on prices is the same.

4.I dont consider points on Alices speculation and Greshams law because they do not apply if my points are accepted

5.”The problem for the gold standard is that if the loan volume is elevated for a longer period, say, 1921 to 1929, in the meantime, Alices speculation against the system is rational and profitable, and there is nothing you can do about it. It is just Greshams law.”

There was no gold standard in the 1920s. Rather the statist mess of the Gold Exchange Standard. Under a fuller standard in C19, though without full reserves, none of the phenomena Victor mentions materialised.

Also, I do not suggest heavily regulating banks. I am not getting into the free banking/full reserve debate but merely wish to point out that removing the legal privileges not extended to any other type of company of being allowed to continue to trade while insolvent is a necessary condition of a proper monetary system. It does not “fix” the gold standard, it fixes the legal status of banks-the presence of such privileges are a coercive restriction of the standard.

6. Conclusion

Consumer loans do not become money. Producer loans, e.g. to GEC as indicated, can become sought after investment instruments, but are not money either. Money is used to acquire these and to that extent, reduces demand elsewhere. The money in each case is only in one place, available to one person, at one time-the new good that has been created i.e. the income stream from the loan, itself competes in the array of choices of goods and services the money holder can consider. Charlies has in effect chosen to buy a consumer loan rather than save, or buy the ferrari himself.

I certainly have a lot to learn about the monetary system and so does everyone else, but alas, I fear, not from Victor.

• I had already replied to these points above, and so just very briefly:

2. Victor talks about the price level being elevated by “open” consumer loans. The price level is not elevated if the loans are extended from real savings.
[…]
misses the point that Charlies spending is curtailed by the exact amount of the loan, so that overall demand is unaffected.

If Charlie never intended to spend the amount that he is now lending to Dave, this is clearly not true. This was already covered in my first reply btw. And you are admitting it a few lines later when you say

And this assumes a change in human nature such that no-one else will start hoarding.

It need not be a change of human nature. It is perfectly enough if a certain behaviour is fashionable for a longer period, say, perhaps a decade, before the behaviour returns to the long term average. During this decade, the system is unstable because of the incentive it provides to Alice.

Finally,

Consumer loans do not become money. Producer loans, e.g. to GEC as indicated, can become sought after investment instruments, but are not money either.

We have one example in which the ‘consumer loan’ becomes (partly) fungible and is accepted as payment for goods and services: the scenario of vendor financing. We also have an example in which a ‘producer loan’ becomes (partly) fungible and is accepted as payment for supplies: real bills.

You are right, if you could force people to first trade in the securitized loan for cash and then use the cash to bid for goods and services, there would be no such problem. But we already know these two cases in which the loan becomes (partly) fungible. I am making this point because it shows that it is not enough to carefully regulate the banking system. There can be private contracts outside the banking system that have precisely the same effect as using a fractional reserve.

Victor

• Alex P. III says:

Victor,

Thank you very much for your time. I’ll pass this on and leave it at that.

(plus I will re-read your post and this exchange a few times… to get it)

Thanks!

Alex

• DP says:

Alex,

All you really have to understand from Victor’s rebuttal of your friend’s position, is that savers choosing to lend out money they were not otherwise going to spend today, allows more money to be spent today on the same amount of available goods and services in the wider economy, by the borrower. They would not borrow money to not spend it.

MV=PQ

To quote a wise man: The saver calls the shots. (Whether he understands the wider implications of his choices or not is another matter. Being a saver doesn’t automatically make you smart.)

Your buddy can dress up what he’s trying to say with a bunch of fancy Latin if he likes, but that doesn’t change the fact it’s half-baked. Plain English is plenty good enough if you understand what you’re trying to say and you want everyone else to understand it too.

I hope this cleared things up for you a little.

Sincerely,

DP :-)

• DP,

thanks for you support ;)

There is actually an issue here when you try to describe all the Charlies of the world in aggregate. In the present paper money system, as far as I understand (and this is somewhat supported by R. Werner’s empirical work), if the Charlies lend some of their savings, then in aggregate they consume less. And so Alex’ friend has a good reason to challenge my claim.

But note that in my example, Charlie actually hoards cash for the long run. In the present paper money system, there is no point in doing so, and in the real world, people bring the surplus cash to the bank, the surplus that they neither spend nor invest directly. As I understand things, this is the reason for the observed effect: if the Charlies lend directly, in aggregate they consume less.

But in the example in the article, cash consists of gold coins, Charlie hoards these coins, and hoarding makes a lot of sense. So you have the effect that the saved surplus consists of hoards of actual cash. Now lending or not lending does make a difference.

Victor

• Alex P. III says:

DP, thank you. Yes, that helps. Although I have the feeling I understand this intuitively… I still have a big problem arguing on the topic. ;)

• DP says:

As Victor says above, there’s little point hoarding cash outside the system while we’re on a paper fiat system. The system administrators just QE more base money to maintain system integrity whenever there is a shortage. In so doing they dilute the value of every unit of currency in existence.

But they can’t QE physical gold. So it is rational to hoard that if you intend to save for the long term.

• DP says:

In my earlier comment I should have emphasised the ‘V’ (and the ‘P’) to better make the point.

MV = PQ

• DP says:

In the case of QE, the ‘M’ (and the ‘P’) should be emphasised.

MV = PQ

Same effect, different cause.

10. Alex P. III says:

Victor,

Thanks for explanation, I’ve passed it on.

Either I’ll get back to you when I have a reply or he [my friend] will post it himself.

In any case, thanks for your time… and for helping me (and others) better understand FG. ;)

Best regards,
Alex

• Is it fair to say Alice’s optimization does not result in a failure of Gresham but rather a reversal due to frictionless nature of the transaction. Furthermore does the bank license include the ability to securitize in-ground gold reserves? If so, who’s playing the role of the military in your scenario?

11. Grinners says:

Victor, thanks for the article. I have read it a number of times and think it is a great summary.

In relation to FreeGold and the concepts within this article I have a question:

One of the basic premises of the article, I take it, is that by loaning in the same medium that you save in, you are in fact diminishing the value of your savings. Hence, FreeGold would suggest to store value in one medium and spend (which eventually becomes ‘lend’) in another.

My question is, if one was (instead of combining the SOV and MOE) to save in gold and transact/lend in cash, would this actually have any difference on the value of the lenders savings as compared to the examples in your article?

We can see clearly from your example that by lending the gold out, the saver’s gold value is diminished. If, however, the saver had gold saved, then wanted to loan someone cash for a car they would either need to sell some of their gold and provide the borrower the cash, or provide the gold to the borrower, who would sell the gold for the cash for the vehicle.

In either scenario, the amount of gold circulating is increased by the lender selling (directly or indirectly) part of his gold reserves. Does this not reduce the value of his savings in the same way that it would by simply loaning the gold?