The gold standard explained Watch

DrunkHamster
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I don't know if anyone cares, but here's essentially my thoughts on why the gold standard would be awesome:

Money

Imagine, first off, that we have a barter market with people trading their goods with each other in kind. Eventually, a form of currency will be introduced, because it would be really inconvenient otherwise (because of the requirement of double coincidence of wants). So let's imagine our barter economy comes up with a currency, call it the quid.

Now our market has two types of things - goods, and quid. I use "goods" in the general sense of not just physical things but rather anything which satisfies people's wants: food, cars, houses, health care, entertainment are all goods. In any decently functioning economy, goods are created all the time: someone grows some vegetables and has hence produced something that wasn't there before and that has value; someone who writes a popular book has done the same. The sum total of the value of these goods is the level of actual wealth in the economy. Of course, actual wealth can be destroyed too, take the recent floods for example.

Quids, on the other hand, are different to goods - they have no intrinsic value. You can't eat a quid if you're hungry, you can't use a quid for shelter, and so on. Money is worth only what you can trade it for. To a man alone on a desert island, it doesn't matter to him one bit if he has 1 quid or 10 million quids, if there is no one to trade with. In the same way, the nominal price level of the economy is set by the number of quids in circulation. It doesn't matter if there are 100 quid, 100 billion quid or even just 1 quid in the economy - no matter how many there are, 1 quid will be worth exactly
(1/ Total number of quid in the economy) X (Total actual wealth in the economy).

And the price level of our economy will reflect this - if a widget (for some reason all the textbooks use widgets as the only example of a good; I don't even know what they are ) costs 2 quid in an economy with a billion quid in it, that same widget would cost 2000 quid in an economy with a trillion quid in it.

Let's assume now that our quid is put onto the gold standard; what does this mean? Essentially, it means the supply is fixed (of course people are mining gold, but the total increase is negligible for our purposes, especially compared to the current system).

So let's say today I can buy a widget for two quid. Technology is always increasing, and people are always striving to come up with better/cheaper/faster ways of producing things. Say our favourite widget maker discovers a 25% better way of manufacturing, and so competes with all the other widget makers by lowering the price to a quid and a half. Later on, his competitor figures out a way to outdo him, and lowers the price again to only a quid! This kind of situation happens all the time - most noticeably and quickly in the computer and car industries, but it does happen. Anyway, what is the result of this better production? My two quid, instead of buying one widget can now buy two. The amount of actual wealth in the economy has doubled!

The quid has gained in value - and as technology continues to increase, the quid will continue to gain in value. It does it directly in proportion to the amount of wealth in the economy. Remember the equation MV=PY? If M (money supply) and V (turnover) are fixed, then a decrease in P (price) must be caused by a proportional increase in Y (output of the economy).

Deflation

The argument that always comes up against the gold standard is that it would cause deflation. Now in a way this is true, but it is also misleading.

It would certainly lead to deflation in the sense a generally falling price level (which is the modern sense of the term) - it would not lead to deflation in the original (and more useful) sense of the term, as a reduction in the money supply. And these are two very different things.

The kind of deflation which would occur under a gold standard is growth deflation, which is an inevitable result of increases in technology. Think of it this way - imagine how much compensation you can trade one hour of labour for now, and compare it with the amount you would get in the middle ages. Hundreds of years ago if someone wanted clothes, he would have had to work hard for days in order to buy some cloth (the raw material) which his wife would then sew into a garment. Now, someone can work for an hour (and work now is a lot less laborious than the middle ages...), walk down to Primark and pretty much buy a full wardrobe! Prices falling because of increases in productivity is a perfectly natural thing, and by no means bad.

The idea that a central bank should be constantly increasing the money supply to keep inflation at exactly the right level to keep consumer goods at the same nominal price is not only unnecessary but impossible too. Why? Because different industries grow at different rates. Bread, for example, has not changed in price considerably in the last 30 years (taking inflation into account of course.) Computers, on the other hand, have - they've gone down in price on a massive scale. So what measure do you use to inflate the currency? Computers or apples? If it's computers, won't everything just cost more? Most importantly, what's the point of inflating in the first place? Adding money doesn't accomplish anything (in fact it does - it redistributes wealth away from people and towards governments and bank, but that's another post).

The other kind of deflation is monetary contraction - an actual decrease in the amount of money in the economy. This causes prices to decrease too, but only nominally. This is the "bad" kind of deflation which really does ruin economies: and guess what - it cannot happen under a gold standard! It would mean someone would have to actually destroy gold on a massive scale, which just would not happen.

The problem of hoarding

"But surely under a gold standard people would see that prices are always going down and start hoarding their money and then no-one will spend anything and we'll have the Great Depression all over again!"

Fortunately, no.

If you have some gold, it goes up and up in value as the economy grows and grows (proportionally, as I've said). Is this a disincentive to spending, because it will always be worth more in the future and so there's no reason to actually cash it out? No, because there's a natural check on this, called time preference.

People prefer goods sooner rather than later. They are not immortal, they don't want to be the richest corpse in the graveyard. In addition, there is a natural tendency to want things now, and to pay a premium for it. Take, for example, the PS2. In its first week it sold hugely well, even though people realised full well that within a year or so the price would be reduced significantly. This is time preference at work - and it's why hoarding would not be a problem. If you think about it, the argument doesn't make sense anyway - if I put all my money in the bank under the current system, I would be making a percent or so above inflation and so actually making money. Why doesn't everyone do this and put all their money in the bank and never spend anything because they will be worth more next year? It's simple - because spending money now is worth more to people than having an extra percent. And this would be exactly the same under the gold standard.

Any comments/criticisms/agreement from anyone who cares?
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ForeverIsMyName
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Good introduction; very concise.

Will comment more later.
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lordcrusade9
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I think your article is very good. I know very little about how economy operates except for the simple demand and supply, inflation or deflation. (Anyone who play runescape and merchant would realise this. yep I was a loser). That imaginary game world reflect many of the points you made in your article. For example, a full helmet would normally cost less than a chain mail, but a dragon full helmet was recently released and it cost more than twice the price of a dragon chain mail. Reason? people prefer things now and are willing to pay for it. When it is less rare, its price will ultimately go down. Interestingly, the price that only go up is coal because of the inflation (like the bread in your example). However another raw material, flax's price goes down because more and more people realise there is a very cheap way of obtaining them which many merchants used to make millions.

The one question I do have is, in such a model, how does the economy fail without outside factors like war? It is inevitable that economy systems will face crisis, large or minor. How do you think the economy would cope with it? The price of raw product such as Coal, Gas and Oil goes up all the time. If this is incorporated into your system, how would your system change as a consequence?
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Agent Smith
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I'm not an economist, but surely when your widget has halved in cost, that doesn't equate to the amount of actual wealth having doubled at all. You said yourself that quids are not actual wealth; that's defined in terms of product quantity. So for there to be a doubling in the actual wealth of the country/entity, there would have to be double the number of widgets produced. A doubling in purchasing power is not the same thing. In your example, as far as I can see, the only thing that has doubled is the efficiency of WidgetCorp.
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Davetherave
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I don't see how what you're saying is in support of the gold standard...

Improvements in technology and productivity DO have a real effect on how much we can afford, even without a currency fixed to any nominal value. This is why people today can afford many more things than they did 50 years ago. The fact that productivity increases does not mean that the central bank automatically prints extra money to the point where inflation completely erodes any advantages gained by this.

Also gold is in itself a good with little intrinsic worth, and one with a highly volatile price at that. If the price of gold crashes so does the value of the quid in the international marketplace.
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DrunkHamster
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(Original post by Agent Smith)
I'm not an economist, but surely when your widget has halved in cost, that doesn't equate to the amount of actual wealth having doubled at all. You said yourself that quids are not actual wealth; that's defined in terms of product quantity. So for there to be a doubling in the actual wealth of the country/entity, there would have to be double the number of widgets produced. A doubling in purchasing power is not the same thing. In your example, as far as I can see, the only thing that has doubled is the efficiency of WidgetCorp.
Sorry, I meant to explicitly assume also that our economy produces only widgets - if that were the case, and the efficiency of the widget industry doubled, then actual wealth would in fact double too.

Imagine if overnight, somehow, the UK's economy got twice as efficient across the board. If producing x of a good took y resources (i.e. time, labour, raw materials etc) before, it would take y/2 afterwards. Prices would halve (oh noes, deflation!), and everyone would be twice as rich - their actual wealth would have doubled, because they could buy twice as much stuff as they could before.

I see where you're coming from too, in that just because people can by twice as many widgets, doesn't mean they want twice as many widgets - this is obviously artificial because in my example, that's all our economy produces. But if the UK's economy got twice as efficient and all prices halved, it is certainly not true that people would buy twice as much of everything - things like basic foods and clothes would probably be bought in the same quantities as before. The extra money saved would almost certainly go into luxury items instead. But people would still be twice as rich.
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DrunkHamster
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(Original post by Davetherave)
I don't see how what you're saying is in support of the gold standard...
I was trying to pre emptively defend it as a viable system of money (which a lot of people would instinctively disagree with). I'll do another post at some other point and spell out exactly why a central-bank-run fiat system has negative effects on pretty much everyone. Here's an advance preview though - government meddling with the money supply is basically what causes the whole boom/bust business cycle. In addition, by systematically creating inflation, it's essentially a redistributive tax on people who actually have cash, in favour of the government and the banks.

Improvements in technology and productivity DO have a real effect on how much we can afford, even without a currency fixed to any nominal value. This is why people today can afford many more things than they did 50 years ago. The fact that productivity increases does not mean that the central bank automatically prints extra money to the point where inflation completely erodes any advantages gained by this.
Oh, without a doubt there is still an increase in purchasing power, but this is despite the inflationary tendencies of fiat monies, not because of them. And in a way, the central bank does completely erode any advantages gained by the increases in productivity: at least for people who have their assets in cash. A 3% inflation rate doesn't look like much, but if all you keep all your wealth in cash this means that your money will have half the purchasing power after less than 23 years! Those 3 percents add up. What does this mean sensible people with money should do? Put it into non-depreciable assets like houses (property boom anyone?) and gold (ironically which causes the price of gold to increase with inflation).

Also gold is in itself a good with little intrinsic worth, and one with a highly volatile price at that.
And little bits of paper do somehow have massive intrinsic worth? And the price of one of these bits of paper isn't somehow "highly volitile", even though there are people in London who can print them at will?

If the price of gold crashes so does the value of the quid in the international marketplace.
Why would the price of gold crash?
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Gilliwoo
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Good post. Will comment later if I can.
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Davetherave
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^^

Inflation erodes away savings, no doubt, but the fact that people are better off now still attests to the fact that real standards of living have increased despite a non-pegged currency and inflation. Your post assumes that inflation has matched productivity gains 1 for 1, but this clearly has not happened.

Fair enough, gold is not going to crash like dotcom stock, but it still is a raw material like any other whose price is going to reflect the amount of gold available and the amount demanded by industry and consumer tastes. I don't have any price/time graphs handy at the moment, but I'd be suprised if it was a straight line.

Systems fixed currencies have been around before but were abandoned because they effectively led to policy paralysis. An economy that pegs its currency to gold or another currency is effectively depriving its central bank of any policy power.
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DrunkHamster
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(Original post by Davetherave)
^^

Inflation erodes away savings, no doubt, but the fact that people are better off now still attests to the fact that real standards of living have increased despite a non-pegged currency and inflation. Your post assumes that inflation has matched productivity gains 1 for 1, but this clearly has not happened.
Where did I ever say I assumed inflation has matched productivity gains? Of course it hasn't - as you say, real standards of living are always going up. But they're not going up as fast as they could be!

Fair enough, gold is not going to crash like dotcom stock, but it still is a raw material like any other whose price is going to reflect the amount of gold available and the amount demanded by industry and consumer tastes. I don't have any price/time graphs handy at the moment, but I'd be suprised if it was a straight line.
As far as I know, one of the reasons why gold was favoured by the free market as a currency was the fact that it had hardly any industrial uses. Even now, it is used for what, electronics and jewellery? I think I read somewhere that the quantity of gold used in electronics is pretty close to matching the amount mined every year, but I'm not sure. Jewellery, on the other hand, can be explained as a store of value, so it doesn't really pose any problems.

And you're missing probably the main point - if an economy was on the gold standard, the "price" of gold would essentially measure the success of that economy. Excluding a major contraction in the supply of gold (i.e. people purposefully destroying it), it just won't go down in value.

Systems fixed currencies have been around before but were abandoned because they effectively led to policy paralysis. An economy that pegs its currency to gold or another currency is effectively depriving its central bank of any policy power.
I don't think you realise that this is one of the main reasons why people are in favour of the gold standard - precisely to deprive the central banks of "policy power". The exercising of "policy power" is what causes depressions and the business cycle, as well as systematic inflation. Could you explain precisely why the economy needs a central bank with the "policy power" to arbitrarily inflate the money supply at will?
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FadeToBlackout
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What about the Gold Standard's application to international trade? The best thing about it (back in the 1920s) was that it meant that the pound was ALWAYS worth $4.86 and standard number of Marks, Francs etc. that were also fixed to the Gold Standard.
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City bound
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Right, a few points. I should also mention how much I loath these kinds of autopsy inclined.

In the same way, the nominal price level of the economy is set by the number of quids in circulation. It doesn't matter if there are 100 quid, 100 billion quid or even just 1 quid in the economy - no matter how many there are, 1 quid will be worth exactly
(1/ Total number of quid in the economy) X (Total actual wealth in the economy).
Assuming that Velocity is constant, which it isn’t. It’s existence destroys the mechanical relationship.

So let's say today I can buy a widget for two quid. Technology is always increasing, and people are always striving to come up with better/cheaper/faster ways of producing things. Say our favourite widget maker discovers a 25% better way of manufacturing, and so competes with all the other widget makers by lowering the price to a quid and a half. Later on, his competitor figures out a way to outdo him, and lowers the price again to only a quid! This kind of situation happens all the time - most noticeably and quickly in the computer and car industries, but it does happen. Anyway, what is the result of this better production? My two quid, instead of buying one widget can now buy two. The amount of actual wealth in the economy has doubled!

The quid has gained in value - and as technology continues to increase, the quid will continue to gain in value. It does it directly in proportion to the amount of wealth in the economy. Remember the equation MV=PY? If M (money supply) and V (turnover) are fixed, then a decrease in P (price) must be caused by a proportional increase in Y (output of the economy).
Leaving aside the false premise on velocity. The expansion in output isn’t necessarily due to productivity improvements. Rather it could just as easily, indeed more easily and more likely, be due to an expansion of the basic resources used. Population expansion, resource extraction and even land reclamation will add to your deflationary woes.

The kind of deflation which would occur under a gold standard is growth deflation, which is an inevitable result of increases in technology. Think of it this way - imagine how much compensation you can trade one hour of labour for now, and compare it with the amount you would get in the middle ages. Hundreds of years ago if someone wanted clothes, he would have had to work hard for days in order to buy some cloth (the raw material) which his wife would then sew into a garment. Now, someone can work for an hour (and work now is a lot less laborious than the middle ages...), walk down to Primark and pretty much buy a full wardrobe! Prices falling because of increases in productivity is a perfectly natural thing, and by no means bad.
The disparity between the purchasing power is less to do with deflation and more to do with increases in real wages.

So what measure do you use to inflate the currency? Computers or apples?
Firstly, there’s no direct monetary expansion occurring, that’s left to the public, commercial banks and their combined depository activities. Secondly, it’s grossly disingenuous to make such a simplification when inflation indexation is attempting to measure general prices.

The other kind of deflation is monetary contraction - an actual decrease in the amount of money in the economy. This causes prices to decrease too, but only nominally. This is the "bad" kind of deflation which really does ruin economies: and guess what - it cannot happen under a gold standard! It would mean someone would have to actually destroy gold on a massive scale, which just would not happen.
Even if we were to be incredibly generous and suggest that your premise that productivity induced deflation were good, you’ve just contradicted yourself. You suggest that a broad-based reduction in nominal prices (i.e. deflation) caused by monetary contraction is bad but then ignore the fact that the quality you vaunt (the fixed quantity of gold) as the solution causes the problem to become inherent in the supposed replacement system. If the quantity of gold is fixed, any expansion in the basic factors of production induces the same deflationary effect you previously warned against. Unless you propose (necessarily) coercive controls on the world birth rate, the prevention of all further mineral extraction, land reclaimation or re-allocation, you are going to constantly experience such deflation under a gold standard. Given my previous knowledge of your extreme Libertarian viewpoint, I doubt this will be the case.

If you have some gold, it goes up and up in value as the economy grows and grows (proportionally, as I've said). Is this a disincentive to spending, because it will always be worth more in the future and so there's no reason to actually cash it out? No, because there's a natural check on this, called time preference.
The main issue with hoarding isn’t generally at the individual level, it’s at the national, the institutional and even at the HNWI (High Net Worth Individual) level; though less so with the latter. A level where time preference is greatly diminished.

Time preference diminishes exponentially with the agent’s wealth; indicated by the variations in the allocations to cash within the investment portfolio of HNWI. It’s this that induces the reduced investment of a deflationary environment. However, this negative effect is minor in comparison to the issue of the extensive power granted to governments and large institutions. These have little in the way of time preference as they almost entirely transcend the major factor in it’s creation, mortality. There’s a very good reason for the use of the term ‘war chest’ in this context. Any sufficiently determined government can restrict the monetary supply of other’s economies. In fact it was a major cause of conflict in the ancient world. Frankly, I’m willing to accept an environment of persistent inflation to mitigate this point alone.
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Davetherave
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(Original post by DrunkHamster)
Where did I ever say I assumed inflation has matched productivity gains? Of course it hasn't - as you say, real standards of living are always going up. But they're not going up as fast as they could be!
You said the ratio of the cash in the economy to the price of widgets is constant. This is effectively saying that inflation erodes productivity gains, no?



(Original post by DrunkHamster)

As far as I know, one of the reasons why gold was favoured by the free market as a currency was the fact that it had hardly any industrial uses. Even now, it is used for what, electronics and jewellery? I think I read somewhere that the quantity of gold used in electronics is pretty close to matching the amount mined every year, but I'm not sure. Jewellery, on the other hand, can be explained as a store of value, so it doesn't really pose any problems.
Why do you think gold is so different from any other natural resource? Gold is used in all sorts of high-tech appliances. A major new gold ore discovery is likely to do similar things to the price of oil as a major oil field discovery. Here's that graph of the price of oil over time since the 1960s... hardly horizontal line: http://www.amark.com/graphs/Ggraph.gif

(Original post by DrunkHamster)
you're missing probably the main point - if an economy was on the gold standard, the "price" of gold would essentially measure the success of that economy. Excluding a major contraction in the supply of gold (i.e. people purposefully destroying it), it just won't go down in value.
Don't quite understand...the domestic exchange rate between gold and quid is fixed, the international price of gold is not.



(Original post by DrunkHamster)
I don't think you realise that this is one of the main reasons why people are in favour of the gold standard - precisely to deprive the central banks of "policy power". The exercising of "policy power" is what causes depressions and the business cycle, as well as systematic inflation. Could you explain precisely why the economy needs a central bank with the "policy power" to arbitrarily inflate the money supply at will?
If that's what you think I suppose we just have very different views on what a central bank actually does. A central bank responds to demand-induced recessions or overheating by injecting or withdrawing money from the economy. Most competent central banks to not "arbitrarily" inflate the money supply, the do so to nurse an ill economy. One of the main reasons for the Great Depression was the Fed's inertia. One of the main reasons the stock market crash of 87 didn't become another depression was the Fed's swift response. If all that CBs did was make the economy go haywire why would anybody have them?
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Duran Duran
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What if there was a new, major source of gold found in abundance in the world ?
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Davetherave
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(Original post by The_Adarshster)
What if there was a new, major source of gold found in abundance in the world ?
The price would most likely dip, at least in the absence of artificial shortages created by supply cartels.
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Duran Duran
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What effect would that have on the global economy ?
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Davetherave
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(Original post by The_Adarshster)
What effect would that have on the global economy ?
Are you asking because you don't know or are you trying to lead me somewhere?
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DrunkHamster
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(Original post by City bound)


Assuming that Velocity is constant, which it isn’t. It’s existence destroys the mechanical relationship.
Fair point, it's not true that (1/ Total number of quid in the economy) X (Total actual wealth in the economy) holds exactly at every point in time when the money supply is changing, but it is true that the economy will tend towards this equation being true. Disparities in the value of money and actual wealth will inevitably be corrected by the market. Incidentally, this is exactly why the creation of new money (via a printing press) and fractional reserve banking are good for the people doing them but bad for everyone else - they get to use the new money at the old price, before the economy adjusts.

The expansion in output isn’t necessarily due to productivity improvements. Rather it could just as easily, indeed more easily and more likely, be due to an expansion of the basic resources used. Population expansion, resource extraction and even land reclamation will add to your deflationary woes.
It's certainly true that most of these things will also cause deflation, but so what? In every case, the reason why prices have gone down is because purchasing power has gone up. (Population expansion is debatable though) Either way, you haven't made any argument to suggest that such deflation (growth deflation) is bad, all you've done is assert that. Why, exactly, is it bad to have long term deflation provided it is caused by underlying growth in the economy?

The disparity between the purchasing power is less to do with deflation and more to do with increases in real wages.
You're confusing issues here - the disparity between purchasing power now and 800 years ago is solely because of increases in productivity (which inevitably lead to an increase in real wages). Deflation is in no way a cause of this, but an effect (provided, of course the money supply is constant which it hasn't been).


Firstly, there’s no direct monetary expansion occurring, that’s left to the public, commercial banks and their combined depository activities.
What do you mean it's left to the public? The public clearly can't just print money at will. It's the banks working in conjunction with the central bank (which you admit) and the government who are the ones that really expand the money supply (through government bonds, T-bills in the US).

Secondly, it’s grossly disingenuous to make such a simplification when inflation indexation is attempting to measure general prices.
I don't see how it's disingenuousfor me to make this point. Of course its an oversimplification - the economy doesn't produce solely apples and computers. But the point remains the same - industries grow at different rates, and therefore the idea of an average price level which is growing at a uniform rate is just ridiculous. Which is why "attempting" is the operative word in your sentence.


Even if we were to be incredibly generous and suggest that your premise that productivity induced deflation were good,
Note that you still haven't given a single reason why growth deflation is bad. Anyway:

you’ve just contradicted yourself. You suggest that a broad-based reduction in nominal prices (i.e. deflation) caused by monetary contraction is bad but then ignore the fact that the quality you vaunt (the fixed quantity of gold) as the solution causes the problem to become inherent in the supposed replacement system. If the quantity of gold is fixed, any expansion in the basic factors of production induces the same deflationary effect you previously warned against.
I really don't have a clue what you're arguing. I said that growth deflation is good (or at least not bad). I said deflation in the sense of a contraction in the money supply is bad, but that this simply cannot happen under the gold standard. You seem to be arguing that an expansion in the the basic factors of production is deflationary - it is. But you also seem to be saying that this is contractionary deflation rather than growth deflation, which it clearly isn't.


The main issue with hoarding isn’t generally at the individual level, it’s at the national, the institutional and even at the HNWI (High Net Worth Individual) level; though less so with the latter. A level where time preference is greatly diminished.
The "problem" of hoarding is nothing but a fallacy. How much money does someone need to have before they are "hoarding"? If you want a full demolition of the fallacies, look here

Time preference diminishes exponentially with the agent’s wealth; indicated by the variations in the allocations to cash within the investment portfolio of HNWI.
Not necessarily true - link

It’s this that induces the reduced investment of a deflationary environment. However, this negative effect is minor in comparison to the issue of the extensive power granted to governments and large institutions. These have little in the way of time preference as they almost entirely transcend the major factor in it’s creation, mortality. There’s a very good reason for the use of the term ‘war chest’ in this context. Any sufficiently determined government can restrict the monetary supply of other’s economies. In fact it was a major cause of conflict in the ancient world. Frankly, I’m willing to accept an environment of persistent inflation to mitigate this point alone.
Ah, here we come to it. I'm advocating getting the government out of money in the first place and letting the market take care of it by returning to a gold standard. You think this is a bad idea because governments will abuse it. What you forget to mention is the way that governments abuse the fiat system so much more.
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Agent Smith
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I said deflation in the sense of a contraction in the money supply is bad, but that this simply cannot happen under the gold standard.
Why not?
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DrunkHamster
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Well, it's not metaphysically or logically impossible for there to be a contraction in the money supply, but it still won't happen.

How could there be a large scale (i.e. at all significant) reduction in the amount of gold in human hands? People would have to actually consciously destroy it (and the kind of people crazy enough to do this most likely won't have much money to begin with) or there would have to be a natural disaster which somehow manages to lose more physical cash than is being mined. Either way, the level of improbability is sufficiently high for me to say it just won't happen.
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