Inflation, deflation, gold and currencies

[Higgenbotham]

Are you under the impression that The Great Depression started in 1920? People think of deflation and depression going together, but my point is it was only the first 3 years of the decade, not the whole decade. It ended when they went off the 40% gold standard and could print money freely. I know of no case where a country with a pure fiat currency had a 30% price drop like those first 3 years of the Great Depression. Do you?

I would say the Great Depression started on a rolling basis somewhere in the late 1920s. Some sectors of the economy were suffering before the 1929 crash. If you want to ignore 1920, then why not look at the deflation having started at the second peak in 1926 and lasting 8 years or so. The first 3 or 4 years were mild and the last 3 or 4 years were severe.

Deflation and depression are two different things, although one can affect the other. The original question I thought was how long deflation has typically lasted historically. My best answer would be 20 years plus or minus a few years.

First, a few months back, you asked if there was ever a deflation when a country was not on a gold standard. My answer was yes, that the Bank of England web site showed a severe deflation in the early 1800s when England was not on a gold standard. Other data sources were used to confirm that.

The question you're asking now is whether a severe deflation has occurred where a country had a pure fiat currency. The US doesn't have a pure fiat currency now. A pure fiat currency is where there is no credit market and the only means for payment that exists is a paper currency that has no backing. When a country is not credit worthy, that says something about the condition that country finds itself in, which goes hand in hand with worthless money if the country is not moving in the direction of making itself credit worthy, which is rare.

The amount of paper money in circulation in the US has virtually nothing to do with inflation. An increase in paper money in circulation in the US could even point to deflation, depending on how it comes about. On the other hand, in a pure fiat regime, an increase of paper money in circulation would always be inflationary.

[vincecate]

First, a few months back, you asked if there was ever a deflation when a country was not on a gold standard. My answer was yes, that the Bank of England web site showed a severe deflation in the early 1800s when England was not on a gold standard. Other data sources were used to confirm that.

I missed that answer. Was it on a silver standard? Or returning to either a gold or silver standard?

The question you're asking now is whether a severe deflation has occurred where a country had a pure fiat currency. The US doesn't have a pure fiat currency now. A pure fiat currency is where there is no credit market and the only means for payment that exists is a paper currency that has no backing.

What I mean by "pure fiat currency" is that there is no gold, silver, or other commodity backing the money. I don't care if it is paper or entries in a computer which could be withdrawn as paper later. Who says that there is no credit market in a pure fiat currency?

The amount of paper money in circulation in the US has virtually nothing to do with inflation. An increase in paper money in circulation in the US could even point to deflation, depending on how it comes about. On the other hand, in a pure fiat regime, an increase of paper money in circulation would always be inflationary.

Theoretically, if the banks could do better by loaning out their trillion in "excess reserves" than the 0.25% from the Fed, and theoretically, if when they loaned it out to people those people withdrew paper money, do you think the Fed would not print up paper money to match the entries in the computer?

I think if the Fed refused to print up paper dollars to match the reserves a bank wanted to withdraw that would be the end of the dollar. A delay would be understandable, but refusal would not be. If the banks had to say to their customers, "come back next week we need to get more paper money in", that would be ok. But if they had to tell people "the Fed won't print paper money we can only issue you a check", I think people would stop trusting the dollar.

[Higgenbotham]

The question you're asking now is whether a severe deflation has occurred where a country had a pure fiat currency. The US doesn't have a pure fiat currency now. A pure fiat currency is where there is no credit market and the only means for payment that exists is a paper currency that has no backing.

What I mean by "pure fiat currency" is that there is no gold, silver, or other commodity backing the money. I don't care if it is paper or entries in a computer which could be withdrawn as paper later. Who says that there is no credit market in a pure fiat currency?

The US dollar has indirect backing. Earlier, I mentioned that the two largest hard money asset classes in the world are US real estate and oil. Those both back the dollar indirectly. As long as the US real estate market and economy are solid enough to ensure taxes get paid and as long as oil is traded exclusively in dollars, then the US dollar is more solid than a gold backed currency.

Another thing I should mention is you were musing about silver being up 23 fold over 500 years. In fact, the real price of silver fell from 1477 until 1993. The reason it fell was because as man advanced, precious metals became less and less important and are now the proverbial pimple on the elephant of the world economy. As the world economy fundamentally deteriorates, the real price of silver will rise, unless it deteriorates so severly that storage disappears and there is no economic use for money. In my mind, the intrinsic value of silver has less to do with inflation or deflation and more to do with the complexity and soundness of the world economy.

If the Oracle of Omaha said there is no credit market in a pure fiat currency would you believe him? Do you want me to ask him? Or should I conduct a seance with Nancy Reagan and ask Milton Friedman? Is it pure fiat because some Internet guru who has guru manuals to sell said so?

The amount of paper money in circulation in the US has virtually nothing to do with inflation. An increase in paper money in circulation in the US could even point to deflation, depending on how it comes about. On the other hand, in a pure fiat regime, an increase of paper money in circulation would always be inflationary.

Theoretically, if the banks could do better by loaning out their trillion in "excess reserves" than the 0.25% from the Fed, and theoretically, if when they loaned it out to people those people withdrew paper money, do you think the Fed would not print up paper money to match the entries in the computer?

I think if the Fed refused to print up paper dollars to match the reserves a bank wanted to withdraw that would be the end of the dollar. A delay would be understandable, but refusal would not be. If the banks had to say to their customers, "come back next week we need to get more paper money in", that would be ok. But if they had to tell people "the Fed won't print paper money we can only issue you a check", I think people would stop trusting the dollar.

You keep insisting that all the various forms that the dollar takes are one thing. The dollar exists in dozens of forms, as I've already pointed out. If the above scenario takes hold, which I expect it to in some version or another, the various forms of dollars could stratify and paper dollars could become extremely valuable. That's why everyone should be holding some paper dollars. If a lot of people made the decision today to withdraw electronic money and convert it to paper, that would be deflationary. It would indicate a mistrust of electronic dollars, which Bernanke can theoretically create instantaneously and at will, and a trust of dollars that one can hold in their hand.

So while you may not care about whether it's paper or entries in a bank's computer, you can bet your bottom dollar that I do care.

And the Fed doesn't print paper dollars. The Bureau of Printing and Engraving, Department of the US Treasury prints the Federal Reserve Notes. I suppose it's possible that the Fed could refuse to order and distribute new currency from Treasury, but I don't think they can or would make that decision unilaterally. I think the President would make the decision on the advice of his economic team.

[vincecate]

The question you're asking now is whether a severe deflation has occurred where a country had a pure fiat currency. The US doesn't have a pure fiat currency now. A pure fiat currency is where there is no credit market and the only means for payment that exists is a paper currency that has no backing.

What I mean by "pure fiat currency" is that there is no gold, silver, or other commodity backing the money. I don't care if it is paper or entries in a computer which could be withdrawn as paper later. Who says that there is no credit market in a pure fiat currency?

The US dollar has indirect backing. Earlier, I mentioned that the two largest hard money asset classes in the world are US real estate and oil. Those both back the dollar indirectly. As long as the US real estate market and economy are solid enough to ensure taxes get paid and as long as oil is traded exclusively in dollars, then the US dollar is more solid than a gold backed currency.

Any active fiat money has people who will take it for something, that does not mean it is really "backed" by those things. It is still fiat money. The Arabs could today declare that all future oil purchases had to been in Euros, Yuan, or Gold. Now Sadia Arabia could make a currency that was really backed by 1 liter of oil for each Saudi oil dollar. Then the value of that currency would go up and down with the value of oil. And they could sell oil in that currency. It would be cool.

If the Oracle of Omaha said there is no credit market in a pure fiat currency would you believe him? Do you want me to ask him? Or should I conduct a seance with Nancy Reagan and ask Milton Friedman? Is it pure fiat because some Internet guru who has guru manuals to sell said so?

You said that there was no credit market in a pure fiat currency. On what basis did you say that?

The amount of paper money in circulation in the US has virtually nothing to do with inflation. An increase in paper money in circulation in the US could even point to deflation, depending on how it comes about. On the other hand, in a pure fiat regime, an increase of paper money in circulation would always be inflationary.

You keep insisting that all the various forms that the dollar takes are one thing. The dollar exists in dozens of forms, as I've already pointed out. If the above scenario takes hold, which I expect it to in some version or another, the various forms of dollars could stratify and paper dollars could become extremely valuable. That's why everyone should be holding some paper dollars.

Ok, I see. In some future scenarios the different forms could well be treated differently. For example, in Argentina they froze bank accounts. So money in the bank was not the same as money in the hand, in particular since it was dropping in value fast. Money in hand could buy things today, money in the bank was worth far less by the time you could get it out and spend it.

[ridgel]

John is a great historian but a lousy economist. Gold rising is Economics 101 - more demand, steady supply. Why more demand? Some of it is increased dollars in circulation. John's argument is that the dollars in circulation will fall as debt defaults. That may be true. But there's two other reasons for more demand. One is now pure momentum - bubble thinking. Gold has gone up steadily for a decade now, beating just about any index. Would I invest on that? No, because it can change any time. But the main reason gold is increasing is a decline in attractiveness of treasuries. Interest rates are being artificially suppressed by the Fed. They have been doing this since 2001 by buying treasuries with dollars - first at the short end, now more and more at the long end. So parking money in gold simply doesn't cost as much. If savings account interest rates rose to 5% then a lot of the demand for gold would fall. If they rose to 9% like we had in the 1980s then the gold price would plummet. But the Fed can't raise rates to 5%. It would cause massive defaults, not the least in our Federal Government as 25% of the budget would go to paying interest.

Gold will stop rising when there's a more attractive alternative for saving.

[Higgenbotham]

Any active fiat money has people who will take it for something, that does not mean it is really "backed" by those things. It is still fiat money. The Arabs could today declare that all future oil purchases had to been in Euros, Yuan, or Gold. Now Sadia Arabia could make a currency that was really backed by 1 liter of oil for each Saudi oil dollar. Then the value of that currency would go up and down with the value of oil. And they could sell oil in that currency. It would be cool.

OK, let's say I have some fiat money (yes, I agree it is fiat money but not pure fiat money) in my hand in the form of US dollars (Federal Reserve Notes). My neighbor doesn't pay his real estate taxes. The property will be sold for back taxes if the taxes aren't paid for a certain number of years. I can use my fiat money to buy that property for the back taxes. The state is using its monopoly on violence and power of coercion to indirectly back or give value to the currency.

You said that there was no credit market in a pure fiat currency. On what basis did you say that?

The basis is that by definition only a paper dollar is legal tender for payment of all debts public and private. If a paper dollar were all that existed for payment and other conditions existed that do not exist at present, then it could be a pure fiat currency system. In practice, other debt based forms of dollars that are created outside the scope of the government are accepted as payment (checks drawn on money market accounts, for example). In addition, the dollar is given value indirectly by means of the US worldwide monopoly on violence described above. The private sector's ability to create debt based money which is accepted as a substitute for legal tender, the domestic monopoly the US government has on violence to force and enforce taxation, and the worldwide monopoly the US government has on violence to enforce exclusive dollar transactions in oil and other exchange graded goods are the conditions that preclude the US dollar being considered as a pure fiat currency.

Ok, I see. In some future scenarios the different forms could well be treated differently. For example, in Argentina they froze bank accounts. So money in the bank was not the same as money in the hand, in particular since it was dropping in value fast. Money in hand could buy things today, money in the bank was worth far less by the time you could get it out and spend it.

A more likely future scenario in my opinion would be an EMP event or cyberattack that paralyzes the electronic infrastructure. It would tie the Fed's hands, expose flaws in the system, and would likely be extremely deflationary. I should add that would depend a lot on which parts of the electronic infrastructure are shut down and for how long. One scenario I can envision is it may still be possible to cash checks, but they would be discounted very heavily. Pennies on the electronically deposited dollar in other words.

[vincecate]

First, a few months back, you asked if there was ever a deflation when a country was not on a gold standard. My answer was yes, that the Bank of England web site showed a severe deflation in the early 1800s when England was not on a gold standard. Other data sources were used to confirm that.

Do you remember how you found that on their site? I am not sure where to look.

http://search.bankofengland.co.uk

Or another source?

[Higgenbotham]

First, a few months back, you asked if there was ever a deflation when a country was not on a gold standard. My answer was yes, that the Bank of England web site showed a severe deflation in the early 1800s when England was not on a gold standard. Other data sources were used to confirm that.

Do you remember how you found that on their site? I am not sure where to look.

http://search.bankofengland.co.uk

Or another source?

http://www.bankofengland.co.uk/educatio ... /chart.htm

Down at the bottom it notes the gold standard was suspended from 1797 until 1821 and that area can be highlighted on the chart. Over on the left hand side there is an inflation calculator that goes back to 1750.

The max I could find was using 1813 to 1821. There was 37% total deflation and prices fell 5.5% per year on average.

[vincecate]

http://www.bankofengland.co.uk/educatio ... /chart.htm

Down at the bottom it notes the gold standard was suspended from 1797 until 1821 and that area can be highlighted on the chart. Over on the left hand side there is an inflation calculator that goes back to 1750.

The max I could find was using 1813 to 1821. There was 37% total deflation and prices fell 5.5% per year on average.

Thanks. They suspended gold payment from 1797 to 1821 but then returned to gold backing. When a fiat currency is returning to gold backing they often have deflation. That is really what was going on in the early 30s, people were turning in paper money for gold and so reducing the total money (since the Fed could have 2.5 paper dollars for ever dollars worth of gold they held). I am looking for an example of double digit deflation with a fiat currency that has no formal backing and is not moving to formal backing by metals. Do you know any like that?

What I am looking for is a historical example that is really similar to the US fiat money situation that had double digit deflation. The US has no formal backing. It is not temporarily suspending backing with the intent to return to gold backing.

[Higgenbotham]

Thanks. They suspended gold payment from 1797 to 1821 but then returned to gold backing. When a fiat currency is returning to gold backing they often have deflation. That is really what was going on in the early 30s, people were turning in paper money for gold and so reducing the total money (since the Fed could have 2.5 paper dollars for ever dollars worth of gold they held). I am looking for an example of double digit deflation with a fiat currency that has no formal backing and is not moving to formal backing by metals. Do you know any like that?

If I was prone to getting headaches, I'd be getting one about now. The earlier period from 1813 to 1821 didn't have a gold standard. The later period from 1926 to 1933 had a gold standard. Both 7-8 year periods had huge deflations in excess of 30%. It's true that it was known around 1819 that convertibility was probably going to be reintroduced but nobody rang a bell in 1813, when the deflation started. It was also suspected around 1931 that convertibility would be suspended, but that didn't stop the deflation. As I've said, in my opinion, a deflation doesn't have as much to do with a gold standard or lack of a gold standard as people think. The Internet hard money community is mesmerized by their own delusions.

What I am looking for is a historical example that is really similar to the US fiat money situation that had double digit deflation. The US has no formal backing. It is not temporarily suspending backing with the intent to return to gold backing.

You're never going to find that. All anyone can do is go through the spirals of history and try to draw the correct conclusions as time moves forward. Studying history is very tricky and hard work because every cycle has a different fundamental world view that is almost impossible for those in another cycle to understand. Therefore, direct comparisons across cycles don't necessarily work because you have to find the aspects of human nature and conditions that are unchanged. That's what Generational Dynamics tries to do in my opinion and that's why it's limited in what it can do (the random events John talks about). There are many reasons why our monetary system must be different from anything that's ever existed before and why it almost certainly can't ever be what it was. It's my guess that gold backing can only work when an economy is primarily agrarian. A currency in an industrial economy can't be formally backed with real estate or oil, etc., as it can be with gold, but that's where the core hard asset value of the economy is. It's not practical to drive over to the Federal Reserve Bank and get a fixed weight of real estate or oil for a Federal Reserve Note. 150 years ago people were living in cabins with no plumbing or electricity and burning wood that they chopped by hand. Today people sit in front of their computers in their fancy houses, drive to the supermarket, and dream of a gold standard, but it's only a dream.