Deflation, borrowing, and economic growth

Economics Economics Questions
21

I’ll go along with that.

True, and this woiuld apply with any commodity money.

Agreed.

Sure, I thiink it actually amounts to the same thing when you think about it.

If you want to look at it that way, that’s fine.

I don’t think that in the whole history of the world there has ever been a mania for the commodity currency. Please correct me if I’m wrong. (i’m not taliking about a gold rush or something like that which is a different phenomenom.) In order for there to be a mania, several things would need to happen. (1) There’d have to be a very high growth situation where the rate of growth in the economy was approaching the pure rate of interest (2) The production of gold from mining would have to be at a virtual standstill—hard to believe when the economy is going like gangbusters, especially in the higher order mining sectors. (3) Investors would have to be convinced that the capital investment markets could never adjust quickly enough to keep the market rate of interest above zero. If all these factors were true, then I suppose there could be a mania.

Yes, but I think the other operating factor (i.e.reduced capital investment), would quickly bring the market rate of interest above zero. So B would be brought back below A in short order, and this would occur even if there were a mania, (although it’s hard to see how a mania could occur in the absence of some new-found commodity use for gold.

Yeah, but that’s a big if…and a whole other question. But let’s say that happened. I’d have to agree with you. The commodity demand for gold could potentially play havoc with the investment markets, but only if it happened very suddenly. If the commodity demand became stable, everything would come back into equilibrium.

I suppose it could, but what kind of currency could be better than gold? Afterall, just about all the other candidates have significant commodity uses. And surely you’re not suggesting a fiat currency are you? Please explain.

22

I disagree that this is the same thing. That’s like saying that buying land to live on is the same as buying it as an investment. There are two separate factors at play here.

I flagged this because a shortened production structure is not necessarily implied by reduced capital investment. Mises has been rightly criticized for suggesting in TMC that it was, though he back-tracked in Human Action.

I’m thinking of the credit crunch that sounds the death-knell of a boom. There is a sudden aversion to debt, and a desperate flight to cash.

The most riveting account I’ve read of this was Jesse Livermore’s “Reminiscences of a Stock Operator” describing the Oct 1907 crash, when JP Morgan himself begged him to cover his shorts because the entire banking system was in danger of collapse.

The most famous example is 1929. There was a frantic scramble OUT OF the assets that rode the crest of the bubble, and INTO cash.

You might say that this is not a mania but the return to sanity, not a new bubble but the lancing of an existing one. That would be a valid point of view. But the way in which you described a flight to gold in your earlier post cast a whole new perspective on the phenomenon. The flight to cash is more violent and more compressed than the monetary expansion that leads up to it. Prices collapse faster than they ever rose. It is a kind of mania in its own right, albeit a corrective one, and also with the potential to overshoot.

No, not fiat. He mentioned silver, I think, and titanium. For the reasons given in my last post, I don’t think the kind of currency “overheating” he contemplated is realistic, but if it did occur then a loan market in an alternative commodity would be preferable to a crippled loan market in gold.

23

On the production structure: Are you saying that reduced capital investment does not imply a shortened production structure and a higher pure rate of interest? Everything I’ve read (Rothbard, deSoto, Garrison) would lead me to believe this is the case. How can a higher pure rate of interest exist without a shortened production structure?

On mania for the currency: Yes sure there’s a mania to sell goods and buy currency at the height of a bubble that’s created by government intervention, but isn’t that a rather different event? What I thought we were talking about in this thread was a situation where there was a stable money supply (no monetary inflation) and rapid growth as a result of a lot of capital investment that occurred in a free market. I thought we were discussing the problems of commodity money in a completely free economy , Of course, in the history of the world, there hasn’t ever really been a free market.

On other currencies: Would silver or titanium be any better? After all, since they’re not inert like gold, they have far more non-monetary uses, and so wouldn’t they be more subject to sudden increased demand from some new industrial process?

In a completely free market, with a non-inflating (more or less) commodity money.like gold, it seems hard to believe that there could be a run on gold given that the pure rate of interest (real rate of return) will always adjust itself to be higher than the expected appreciation on gold. This must be so, unless the credit markets completely collapse, and why would they? It’s hard to see how such a mania could get started, and even if it did, there are many forces driving it back.

Take this scenario: Pure rate: 5%.pa Prices deflating 4% pa in terms of gold. Market rate: 1% pa.

Now let’s say there’s a run on gold (for whatever reason) and let’s say people expect gold’s purchasing power to increase by 10% pa as a result. At the first sign of this, the credit markets will immediately respond by keeping the market rate at 1% pa. (or above 0% anyway). Of course, the pure rate (that capitalists earn from production) has moved to 11%, but it’s not going to stay there for long. Why not? Because all those people who bought gold are going to take it to their savings bank to get 1% on it. Why would they do that? Because in a year’s time 10 oz of gold will be 11 oz of gold, and 11 is always better than 10, no matter what its purchasing power is expected to be. People simply aren’t going to keep gold as cash. Now sure, they might buy more gold, but every time they do, they’re going to take it straight to the bank to get 1%. And that gold’s going right back into the economy. There’s no hoarding-induced price deflation going on. Gold simply isn’t going to appreciate. As soon as people see this, the “mania” (which really could never have started in the first place) ends.

In a truly free economy, there simply cannot be a speculative run on money.

24

I kept on battling the same problem for a while myself. It was the only flaw I found with deflation in unhampered markets, and then it hit me. We’ve got the cart pushing the horse. We’ve confused causality. It is the investment in the first place, that causes the price deflation. Investment through, for example, borrowing (as opposed to retained profits), would lead to improvements in the capital structure (or capital to labour ratio), and cause a lowering of costs, in other words, deflation. When you realise that long-term deflation occurs only as a result of investment and cost-lowering, then you realise that deflation cannot feasibly exceed the interest rate. If I invest in a project by borrowing at 5% per annum (a result of an amalgamation of individual time preferences), I would expect at least more than 5% ROI per annum. Not all investment will go towards lowering costs, and profits will not only result from lower prices, so you could probably say that in general, a project involving 5% ROI (profits) will have an equal to, or less than amount of cost-lowering involved. Thus, deflation cannot exceed interest rates.

Actually, I just sort of made that up on the spot. Any input would help lol.

25

Leonidia:

On the shortened production structure: If you mean that the AVERAGE period of time to payback is shortened, then yes, I agree. If you mean that this shortening will come about because all the most roundabout methods will be jettisonned first, then no, I disagree.

On other currencies: On the implausible assumptions that the rate of interest is the same as the expected appreciation of gold, and that all money is borrowed at that rate of interest, then there would be no loan market in gold. In that case, it would make sense to borrow some other commodity, without sacrificing gold as a medium of exchange. I think that we are all agreed (including Fred now - see his excellent post above) that the flaw in this model lies in the unreality of the assumptions.

“In a truly free economy, there simply cannot be a speculative run on money.”

I disagree. It is precisely speculative runs on cash that keep credit expansion in check, in the freest economies. In the present system the banks enjoy legal privileges to protect them from insolvency, and thus we are saddled with institutionalized credit expansion. Take away those privileges, and the worst excesses disappear with them. But they do not disappear altogether.

Are you familiar with Chancellor’s “Devil Take the Hindmost” or Kindleberger’s “Manias, Panics and Crashes”? Then you would know that credit expansion can take place under any conditions, and will do so as long as anyone is prepared to extend credit to anyone else, i.e. to accept a promise to pay in lieu of payment in cash.

The bubble in 1982 Kuwait which I mentioned above was not funded by the banks, but by the issuing of post-dated checks. The tulipomania of 1636 Amsterdam was funded mostly by “personal credit notes which also fell due in the spring when the bulbs would be dug up and delivered”. Even the South Sea bubble of 1720 London was largely funded by deferred payments of share-purchases.

That is not an argument against a true gold standard, but a vindication of it. For it is precisely the insurmountable limit on the quantity of gold which stops credit getting out of hand. Everyone who has a long position in credit has a short position in cash, and is therefore vulnerable to a short squeeze. Speculators start hoarding gold and the runaway expansion of credit is eventually stopped dead and forced into reverse. Contrast the present system, in which everyone knows that the Fed will step in to relieve any shortage of cash, which fuels the credit boom.

What does that have to do with productivity? Booms often start with shifts in fundamental values caused by productivity breakthroughs. The invention of the internet sparked the Nasdaq boom. The adoption of capitalism by China sparked the Chinese boom, and to some extent the commodities boom. These booms can be turned into bubbles by easy credit, even under a gold standard. And it is the flight to gold that will burst them before they get too big.

26

I don’t know if this point was made already – the thread is getting big – but here banks borrow you money with less interests if you allow the loan to be adjusted to some inflation index. There’s no reason why this wouldn’t apply to deflation.

EDIT: I’m not sure this is longer the case with the Euro…

Anyway, I think a possible serious problem with economic growth and gold money is that gold is only divisible to a point… I personally just advocate a free market on money and then I’d let the market decide. No reason why a responsible autonomous central banker couldn’t be successful.

27

No, but I am familiar with Extraordinary Popular Delusions and the Madness of Crowds, which covers tulipmania, the South Sea bubble and other manias.

Perfectly true.

Wait a minute. These manias occurred in a particular commodity like tulips, or a particular stock. But the price of gold (it’s purchasing power) is represented by all the goods on the market. For there to be a run on gold, there would have to be a speculative bubble in everything. That can’t happen in a free economy. Yes, it can happen in a non-free economy. It’s called a boom, and the flight to gold is called a crash. But in a free economy with 100% reserve gold that can’t happen.

You’re confusing two very different kinds of booms. A productivity boom does NOT lead to a crash in a free economy*.* The boom is not artificial. The supply/demand and time preference of consumers and investors remain in harmony. There is no distortion to the economy. Factors of production are not drawn away from the middle stages of the production structure.

On the other hand, a boom created through fractional reserve banking, or fiat currency, is always unsustainable. It’s a very different kind of boom.

The Nasdaq boom and the subsequent bust were creatures of the Fed’s monetary policy. The Fed also created the boom and bust in real estate a few years later.

No doubt. But the boom is being fueled by China’s lax monetary policy, which will eventually lead to a bust. However, in the long run, unless the Chinese do something very stupid, they’ll get over it, but they might have to endure a 1930s style depression first.

No. Booms affecting the whole economy can only be turned into bubbles when credit is created out of thin air, as in fractional reserve banking for example. Fiduciary media gets out of hand, the bubble bursts, and the credit contraction leads to a bust.

With 100% reserve gold, only genuine booms can occur. In a genuine boom there’s no reason for there to be a credit contraction. It’s possible for there to be bubbles (manias) in particular things like tulips, but not in the economy as a whole.

In a free economy there cannot be a general flight to cash because there are no general busts.

28

I could rest my case there.

Let me repeat a paragraph from my earlier post:

“The bubble in 1982 Kuwait which I mentioned above was not funded by the banks, but by the issuing of post-dated checks. The tulipomania of 1636 Amsterdam was funded mostly by “personal credit notes which also fell due in the spring when the bulbs would be dug up and delivered”. Even the South Sea bubble of 1720 London was largely funded by deferred payments of share-purchases.”

Each of these examples - and I can cite plenty more - were funded by credit “created out of free air”.

If I sell a shop to someone and I agree to be paid in instalments, then between us we are creating credit out of thin air.

Anyone who accepts a credit note in payment, or a post-dated cheque, or any other arrangement for deferring payment in cash, is a party to creating credit out of free air. And the creation of credit out of free air cannot be abolished without abolishing freedom itself.

This reads like a version of the efficient market hypothesis.

Markets are not smooth. They are jerky, human, driven in the short term by investor psychology. And they almost always overshoot. A productivity boom need not develop into a bubble. But if it seduces investors with the allure of riches derived from capital gain, and if they can obtain holdings of rapidly appreciating stock by credit in SOME form, then all the ingredients for a bubble are present.

This is glaringly false, when we consider that events like imminent war might themselves increase the general demand for cash.

But, even if we look only at bubbles, there does not have to be a “general” flight to cash for the value of the monetary unit to rise. There only has to be sufficient additional demand by a subset of debtors. In this case it is the debtors who bought into the bubble and who are now holding near-worthless assets. They have big debts to pay off and no means to do it other than by selling other assets which have not been rendered worthless by the collapse of the bubble. The value of the monetary unit rises as general asset prices fall.

I emphasize that I am not talking about institutionalized boom-bust cycles on the epic scale of today. Today’s epic inflation is the result of currencies which are themselves merely debt instruments. I am talking about relatively muted cycles - thanks to the requirement to pay debts in gold coin. But mini-cycles can never disappear as long as the temptation to substitute credit transactions for cash transactions can be widely indulged.

29

I just realized I accidentally typed the wrong word. I meant to say “Booms affecting the whole economy can only be truned into bubbles when money is created out of thin air.”

Central bank policy and fractiional reserve banking creates money out of thin air, a fraudulent process that creates competing credit claims and an expansion of the money supply. It’s this kind of credit expansion which can lead to a credit contraction when the whole process unwinds.

Extending personal loans from one person to another is a genuine form of loan. It is not fraudulent.The creditor simply defers consumption of present goods in order to receive a greater amount of goods in the future. There are no competing credit claims. There is no expanison of the money supply, and there’s no reason for there to be a general credit contraction. None.

Well yeah, ok, but I’m talking about a general flight to cash as a result of a boom turning to a bust..

No that’s wrong. So long as there are no competing credit claims. Look, where did the people who invested in the bubble get the money from? They borrowed it right? And the people who lent them the money had to get it from somewhere. Where did they get it from? It wasn’t created out of thin air, not in a free economy. So what did they sell? Now the bubble collapses, and the investors are left holding the bag with nothing. They have to sell assets to pay back the loans. Debtors sell assets to give back to creditors. This is simply a transfer of wealth from one class of people to another. There’s no flight to cash here. There’s no overall destruction of wealth either. The “entrepreneurs” who invested in the bubble are put out of business, but the “entrepreneurs” who lent them the money, or those who sold at the top, do very well. It’s simply a big poker bet. The sucker gets taken, and the professional gambler rakes it in. Zero sum game if you like.

30

Suppose that a Nasdaq boom is funded in the way that you imagine. Everyone pays for their shares in cash, i.e. in gold coin, or else by a cheque drawn on an account which is 100% backed by gold coin. Possibly they have obtained a loan to finance their purchase, but all that means is that their deposit account has been funded by means of the time deposits of others.

In that case, it is correct that, no matter how high the Nasdaq shares rise in price, it is at the expense of other goods or services. There is no inflation, and no net rise in prices.

But now suppose that a Nasdaq boom is funded in the way that Tulipomania was funded - out of personal credit notes. Or in the way that the Kuwaiti share bubble was financed - out of post-dated checks. There is no fraud here, since the buyers have an honest belief that they will be able to honor their credit notes or checks. They expect to be able to honor them by selling some of the shares which they are buying with them.

You ask how the seller can afford to accept a mere debt-instrument in payment. That’s easy. If, for example, shares have doubled in price since he bought them, he need merely sell half his shares in return for a credit-note or post-dated check. If the price doubles again, then he can sell half of his remaining shares, and so on.

It is this second method of funding the boom that is inflationary. It is inflationary because it has been financed by credit out of thin air. The prices on the Nasdaq have been lifted, but NOT at the expense of the prices of other goods and services. It is inflationary because there has been an increase in the supply of money, in the broadest sense of something which is accepted as a medium of exchange.

The problem boils down to this. If a promise to pay cash is ever widely accepted in lieu of cash itself, then it is a money substitute, and it has a similar effect on the structure of prices as money proper.

“Central bank policy and fractiional reserve banking creates money out of thin air, a fraudulent process that creates competing credit claims and an expansion of the money supply. It’s this kind of credit expansion which can lead to a credit contraction when the whole process unwinds.”

I’m not disputing that. Present-day banks issue debt-instruments that cannot be redeemed simultaneously in currency, at least not unless the Fed prints reams of new currency. If banks had to redeem in gold coin then they’d never have got away with it for so long.

Present-day banking has credit expansion built into it. But even in a free economy, in which banks are subjected to the same insolvency laws as everyone else, they could probably get away with a certain amount of credit expansion. I shall post some thoughts on that separately. At the moment I just want to stress that there will still be malinvestment and bubbles and that men will always find some way to obtain credit out of thin air to engage in speculation, which will in turn lead eventually to a complementary scramble for cash. The gold standard is not a panacea - it will not stop bubbles forming - but it will lance them much sooner when they do.

31

Is credit expansion by the banks possible even in a free economy, in which they keep 100% reserves of gold against demand deposits?

Suppose that a bank issues banknotes and demand deposits against 100% reserves, and that it makes loans entirely out of time-deposits. There are no conflicting claims to currency. Its maturing assets are in sync with its maturing liabilities. Any auditor would give it a big tick. It’s the kind of bank that I would want to put my money in.

Instead of lending out all its funds from time-deposits, the bank might decide to invest some of it elsewhere. And it might even decide to issue interest-bearing banknotes, redeemable at maturity. That might suit people who don’t want to have their money tied up irrevocably in a time-deposit.

These banknotes are less secure than banknotes payable on demand, since the bank might collapse due to bad loans. But the bank might also collapse because it is robbed, and then the holders of demand- banknotes would be out of pocket too. There is never 100% security in notes of any kind.

Now, the present value of an interest-paying banknote would change over time. (For simplicity, suppose that interest is payable only on maturity.) No one is under any obligation to accept them. A merchant who does accept them would probably display a sign, as he does for credit cards. And he would probably need an online device to download the current discount rate and and calculate the discounted value automatically, in the same way that he checks the limit of a debit or credit card online.

Probably third-party organizations would develop who would pay cash for the banknotes, to meet the needs of anyone who needs cash and does not want to wait for the note to mature.

The problem with the notes is that they are fiduciary media. Insofar as they are accepted in exchange, they are a form of money. They usher in many of the problems of credit expansion - inflation, depressed interest rates, business cycles, etc.

Yet they cannot be outlawed as simply as exposing them as duplicate claims to cash. In fact, it is possible that they can all be honored at maturity, until suddenly some of the bank’s investments go bad, or many of its borrowers default when their collateral has plummeted in value.

There is an argument against them, but it is more subtle than a charge of outright fraud. It has to do with their distorting effect on interest rates. But I am not sure that any judge adjudicating in a free society would accept that argument. And if he does not, then here is yet another source of thin-air credit to blow up bubbles.

32

LanceH:

I don’t contend that speculative bubbles can’t occur in a free economy.

But let me make sure I understand your original proposition correctly. Your contention was that in a free economy, a bust that follows a speculative boom in a particular sector of the economy, like tulips, would in turn result in an increase in the purchasing power of gold as people rushed to sell their tulips. As gold’s purchasing power rose, speculators in gold might jump in, raising its purchasing power still further. The “boom” in gold, would give rise to hoarding.

(If I’ve misunderstood your original proposition, please correct me)

I contend that ths can’t happen for the following reasons:

  1. Any boom and bust in a particular sector of the economy, like tulips, must necessarily represent some fraction of the overall economy. This means the increase in the purchasing power of gold that accompanies the bust in tulips, is likely to be muted in comparison.

  2. More importantly, if you argue that gold’s purchasing power will rise following the bust in tulips, then it’s certainly possible that gold’s purchasing power could have fallen in the preceding boom in tulips. In which case, the bust in tulips merely restores gold to it’s original purchasing power.

  3. Further, there’s no reason to believe that the rise in purchasing power in gold could feed on itself, and that this would lead to hoarding. The market rate of interest cannot fall to 0% or below, in which case there’s no reason to keep “surplus” gold as cash. Any gold that was bought as a result of a selling mania in goods, would be immediately invested, even if the interest rate was only slightly above 0%. The gold thus invested would flow right back into the economy. Additionally, any attempt to hoard gold for purely “investment” purposes would lead to a temporary shortage of gold in the credit markets, causing the interest rate to rise and inducing hoarders to reduce their cash balances.

33

Rothbard did an excellent analysis of what constitutes the money supply in “Austrian Definitions of the Money Supply”. In it he discusses how some CDs are redeemable on demand at a discounted rate and should therefore can be considered part of the money supply. Your hypothetical interest bearing note sounds very much like a fully negotiable version of that. The critical point is that sellers of goods would have to believe that they wrere redeemable at some value. If this happened then they would function as genuine money substitutes. if widely accepted as money substitutes they would be inflationary. Since such notes would represent competing claims on credit, I have to think they would be outllawed in a free economy.

34

I am familiar with that paper and I think it is very helpful, though controversial amongst Austrians.

Rothbard ruled out the possibility that a debt instrument of varying value could be money, on the grounds that it could not be redeemed either at par or at a pre-determined discount to par value.

However, he he did not consider the possibility that it might itself be accepted as a means of payment directly. It then becomes money by definition.

It is not a “competing claim on credit”. It is just like taking your title to a time deposit, and exchanging it with the merchant in return for goods. You get the goods, and he gets a time deposit payable to bearer.

It is no different from my paying for the good with a personal credit note, e.g. an IOU to pay him in 7 days, plus interest.

There is nothing wrong with the claim. It is the merchant’s acceptance of that claim as payment that is inflationary. But, in a free society, who can stop him?

35

Not quite. The bubble is financed by debt. The price of the bubble-assets rise, as does the size of the debt.

Speculators start hoarding cash as soon as they see a credit bubble forming. They anticipate the bursting of the bubble.

After the bubble has burst, many holders are left with big debts and little to show for it. Debts can be paid only in cash. There is a mad scramble for cash. They sell some of their OTHER, hitherto unaffected, assets at firesale prices to raise cash. (Some are forced sales of collateral by banks to recover loan-defaults.)

It is now that the speculators, like vultures, move in. They pick up the sound assets at firesale prices. Their buying helps restore prices to their original level.

This process is not normally described from a cash point of view, but it is illuminating to do so. We see three moves - a speculative hoarding of cash, a short-lived bubble in cash (i.e. assets at firesale prices), and finally the drop back to normality.

If you look at a price chart of the Dow you can see where the manias for cash have reached their apogee.

This is all somewhat tangential to the thread. But the perspective from the point of view of gold can also help throw light on the OP’s original question…

36

Gold has an extraordinary characteristic. The rate of mine-supply over the past 100 years or so (as far back as I’ve checked) roughly matches world population growth over that period, at 1-2%.

This implies that, if the average demand per head for holding gold remains roughly unchanged, then the rate of growth in the demand for gold is very close to the increase in supply. In a world of shifting supply & demand for all goods and servcies, gold stands relatively aloof.

This in turn implies that gold is a suitable yardstick by which to compare the price of anything over time. And that is true whether gold is the medium of exchange or not. Instead of saying that gold has become more and more valuable over time, it would be better to say that most things have become cheaper and cheaper. And the reason for those price-drops, of course, is improvements in productivity under capitalism over time.

Another way of to put it is that the rate of appreciation of the purchasing power of gold is generally a good measure of the increase in real GDP.

What, then, does it mean if a project is unprofitable when costed in terms of gold? It means that the project is not expected even to match the AVERAGE improvement in productivity. For example, if the price of pencils in terms of gold is expected to drop by 3% over the next year, then it is no good building a plant with a 2% return. That would be producing at a loss.

Because interest rates (expressed in gold) cannot be negative, the only projects which can never be funded on the gold loan market are those which would be loss-making, i.e. their productivity is worse than average.

In no sense, then, does this act as a constraint on economic growth. To definitively exclude loss-making projects is a plus, not a minus.

Might the balance of supply and demand be upset by the hoarding of gold? In general, no. In a free economy in which gold is the medium of exchange, hoarding gold would not be profitable, unless perhaps a credit bubble were brewing. It would generally be more profitable to hoard land, or Picasso paintings, neither of which have supply-increases to dilute their value. The hoarding of gold, beyond what is needed to meet short term cash requirements, may therefore be disregarded.

In summary, gold is far better than any form of money which maintains its purchasing power (relative to some arbitrary index) over time, since that would not us whether we were any better off from year to year. But gold tells us exactly that, and by how much.

37

Whether this comes to pass or not depends on one crucial factor - whether the central bank decides to try to inject new cash into the system during the “cash bubble” (with the view that the whole problem was caused by some lack of paper money)… Looking at what’s going on from a cash point of view is only really useful in retrospect. For folks like you and I, when the whole mess is going on, we have no way of knowing whether hording cash is a good idea or not. If the central bank decides to try to inflate then people hording cash could loose the greater portion of the value associated with those cash savings (in which case gold would be a better bet). If the central bank does not inflate and during the market turmoil there is deflation (which is what you described as a “cash bubble”) then holding on to cash is a good idea. It’s pretty much a 50/50 split whether cash with increase in value (as in the Great Depression) or whether it will loose most of it’s value (as in the 1970s).

Under a gold system, as in a fiat system, massive deflation could only occur as a result of a massive change in the ratio of the quantity of gold, (in circulation being used as money) and the quantity of goods/services on offer… which implies either massive economic expansion or what some people refer to as “hording” en masse. However, can you think of an example of such “hoarding” which was not performed/caused by a banking cartel or central bank? There doesn’t appear to be any motivation for the individual actors in an economy to hoard money since, for individuals, this merely equates to deferred consumption - but deferred means exactly that - deferred and anyone deferring consumption only does so because they expect to be able to consume more in the future as a result of doing so. There’s no point in my hoarding gold until I’m 85 and I die of a stroke… the whole point of hoarding that gold was to get the big yatch I’ve been dreaming of or whatever… at which point I’m doing the opposite of hoarding - I’m spending (which will drive prices up). And, like anything in a market, the price (interest) that is paid to persuade me to defer consumption will adjust until it’s at a point that the demand from those who want to borrow is met by the supply from those willing to loan (i.e those willing to defer consumption).

The only way we could see a breakdown in this price mechanism (with the “price” of money being reflected in the interest rates being agreed upon in the market) would be for exactly the same reason(s) we see price failures elsewhere in the economy, related to other goods. This is a long list and it includes price ceilings, price floors, price targets, subsidies, tariffs and any number of other forms of regulatory interference… most of which you’ll find in one place or another in the world of modern banking. Almost invariably these price distortions are, and always have been, caused by central banks… with the only exception being when they’re caused by unsanctioned banking cartels (with no official governing body or central bank coordinating them).

38

OK. Well this sounds plausable, but I have to think that in a free economy it would not represent a significant problem, and is certainly not an indictment of gold. Those who invested in the bubble would lose their shirts, but so long as there’s no fraud, it simply amounts to an entrepreneurial error.

39

Well, this is a very grey area. and an example of why defining the money supply is so difficult. I think what it boils down to is whether or not people actually believe the instrument in question is as good as cash, and functions like cash i.e. a genuine money substitute. If they do, then it’s part of the money supply. If they don’t, then it’s not. But how do you assess what people believe? And what if it’s acceptable to some people, and not acceptable to others? I mean, not many stores are going to take a bond, for example, even if it’s AAA rated or even if it’s severely discounted, but I guess some might. Are your hypothetical bank notes much different?

40

True, they are not a lot different from bonds. They have just been tarted up with a fancy name “interest bearing banknotes”.

Just because it isn’t acceptable to everyone doesn’t rule it out as money. Many people won’t accept checks. I’ve even had small stores refuse a $100 note. Credit cards are normally accepted only by merchants. But it does have to be widely accepted - not just by a handful. At least as widely accepted as credit cards, I would say.

I can’t see interest-bearing banknotes gaining much acceptance today. But that is because banks can create credit on demand. Under a gold standard with 100% reserves, a craving for credit would not be so easily satisfied. It is then that people might turn to new instruments. In fact, if history is a guide, that is exactly what they will do. Personal credit notes, post-dated checks, deferred payment arrangements, bills of exchange, promissory notes … you name it - all have been widely accepted as money at some point.