Gold standard and fixed exchange rates – myths that still prevail

There has been a lot of E-mail traffic coming in after my blog on The Greens the other day. At the heart of the matter is the fundamental difficulty people have in appreciating that there has been a fundamental shift since the 1970s in the way our monetary system operates. This shift redefines how we should think about macroeconomics and the role of a national government which issues its own currency. The defenders of The Greens economic policy clearly misunderstand this historical shift. To really get to the heart of how a modern monetary system functions you have to appreciate the difference between a convertible and non-convertible currency and a fixed versus a flexible exchange rate system. The economics that apply to convertible currency-fixed exchange rate systems bears no relation to that which applies to the fiat currency-flexible exchange rate systems that prevail in most economies today. So before you attack my macroeconomics, make sure you understand what a government can do in a modern monetary paradigm. Otherwise, you are a dinosaur and they became extinct.

Gold standard – convertibility and fixed exchange rates

When we talk about the gold standard we are referring to the system which regulated the value of currencies around the world in terms of a certain amount of gold. When the gold standard was in vogue (C19th into the C20th) it was the major way that countries adjusted their money supply.

How does it work?

First, a currency might be valued for its intrinsic value (so gold or silver coins). This is a pure commodity currency system. In the C18th, commodity money systems became problematic because there was a shortage of silver and this system steadily gave way to a system where paper money issued by a central bank was backed by gold. So the idea was that a currency’s value can be expressed in terms of a specified unit of gold. So we might say that a unit of paper currency (a dollar note) might be worth x grains of gold. To make this work there has to be convertibility which means that someone who possesses a paper dollar will be able to swap it (convert it) for the relevant amount of gold.

Britain adopted the gold standard in 1844 and it became the common system regulating domestic economies and trade between them up until World War I. In this period, the leading economies of the world ran a pure gold standard and expressed their exchange rates accordingly. As an example, say the Australian Pound was worth 30 grains of gold and the USD was worth 15 grains, then the 2 USDs would be required for every AUD in trading exchanges.

The monetary authority agreed to maintain the “mint price” of gold fixed by standing ready to buy or sell gold to meet any supply or demand imbalance. Further, the central bank (or equivalent in those days) had to maintain stores of gold sufficient to back the circulating currency (at the agreed convertibility rate).

Gold was also considered to be the principle method of making international payments. Accordingly, as trade unfolded, imbalances in trade (imports and exports) arose and this necessitated that gold be transferred between nations (in boats) to fund these imbalances. Trade deficit countries had to ship gold to trade surplus countries. For example, assume Australia was exporting more than it was importing from New Zealand. In net terms, the demand for AUD (to buy the our exports) would thus be higher relative to supply (to buy NZD to purchase imports from NZ) and this would necessitate New Zealand shipping gold to us to fund the trade imbalance (their deficit with Australia).

This inflow of gold would allow the Australian government to expand the money supply (issue more notes) because they had more gold to back the currency. This expansion was in strict proportion to the set value of the AUD in terms of grains of gold. The rising money supply would push against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external deficit would decline.

From the New Zealand perspective, the loss of gold reserves to Australia forced their Government to withdraw paper currency which was deflationary – rising unemployment and falling output and prices. The latter improved the competitiveness of their economy which also helped resolve the trade imbalance. But it remains that the deficit nations were forced to bear rising unemployment and vice versa as the trade imbalances resolved.

The proponents of the gold standard focus on the way it prevents the government from issuing paper currency as a means of stimulating their economies. Under the gold standard, the government could not expand base money if the economy was in trade deficit. It was considered that the gold standard acted as a means to control the money supply and generate price levels in different trading countries which were consistent with trade balance. The domestic economy however was forced to make the adjustments to the trade imbalances.

Monetary policy became captive to the amount of gold that a country possessed (principally derived from trade). Variations in the gold production levels also influenced the price levels of countries.

In practical terms, the adjustments to trade that were necessary to resolve imbalances were slow. In the meantime, deficit nations had to endure domestic recessions and entrenched unemployment. So a gold standard introduces a recessionary bias to economies with the burden always falling on countries with weaker currencies (typically as a consequence of trade deficits). This inflexibility prevented governments from introducing policies that generated the best outcomes for their domestic economies (high employment).

Ultimately the monetary authority would not be able to resist the demands of the population for higher employment.

The onset of World War I interrupted the operation of the gold standard and currencies were valued by whatever the specific government wanted to set it at. The ensuing 25 odd years saw significant instability with attempts to go back to the standard in some countries proving extremely damaging in terms of gold losses and rising unemployment. The UK abandoned the gold standard in 1931 as it was facing massive losses of gold. It had tried to maintain the value of the Pound in terms the pre-WW1 parity with gold but the war severely weakened its economy and so the pound was massively over-valued in this period and trade competitiveness undermined as a consequence.

After World War 2, the IMF was created to supercede the gold standard and the so-called gold exchange standard emerged. Convertibility to gold was abandoned and replaced by convertibility into the USD, reflecting the dominance of the US in world trade (and the fact that they won the war!). This new system was built on the agreement that the US government would convert a USD into gold at $USD35 per ounce of gold. This provided the nominal anchor for the exchange rate system.

The Bretton Woods System was introduced in 1946 and created the fixed exchange rates system. Governments could now sell gold to the United States treasury at the price of $USD35 per ounce. So now a country would build up USD reserves and if they were running a trade deficit they could swap their own currency for USD (drawing from their reserves) and then for their own currency and stimulate the economy (to increase imports and reduce the trade deficit).

The fixed exchange rate system however rendered fiscal policy relatively restricted because monetary policy had to target the exchange parity. If the exchange rate was under attack (perhaps because of a balance of payments deficit) which would manifest as an excess supply of the currency in the foreign exchange markets, then the central bank had to intervene and buy up the local currency with its reserves of foreign currency (principally $USDs).

This meant that the domestic economy would contract (as the money supply fell) and unemployment would rise. Further, the stock of $USD reserves held by any particular bank was finite and so countries with weak trading positions were always subject to a recessionary bias in order to defend the agreed exchange parities. The system was politically difficult to maintain because of the social instability arising from unemployment.

So if fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction to defend the exchange rate as imports rose in response to the rising national income levels engendered by the fiscal expansion. Ultimately, the primacy of monetary policy ruled because countries were bound by the Bretton Woods agreement to maintain the exchange rate parities. They could revalue or devalue (once off realignments) but this was frowned upon and not common.

Whichever system we want to talk off – pure gold standard or USD-convertible system backed by gold – the constraints on government were obvious.

The gold standard as applied domestically meant that existing gold reserves controlled the domestic money supply. Given gold was in finite supply (and no new discoveries had been made for years), it was considered to provide a stable monetary system. But when the supply of gold changed (a new field discovered) then this would create inflation.

So gold reserves restricted the expansion of bank reserves and the supply of high powered money (Government currency). The central bank thus could not expand their liabilities beyond their gold reserves (although it is a bit more complex than that). In operational terms this means that once the threshold was reached, then the monetary authority could not buy any government debt or provide loans to its member banks.

As a consequence, bank reserves were limited and if the public wanted to hold more currency then the reserves would contract. This state defined the money supply threshold.

Some gymnastics could be done to adjust the quantity of gold that had to be held. But overall the restrictions were solid.

The concept of (and the term) monetisation comes from this period. When the government acquired new gold (say by purchasing some from a gold mining firm) they could create new money. The process was that the government would order some gold and sign a cheque for the delivery. This cheque is deposited by the miner in their bank. The bank then would exchange this cheque with the central bank in return for added reserves. The central bank then accounts for this by reducing the government account at the bank. So the government’s loss is the commercial banks reserve gain.

The other implication of this system is that the national government can only increase the money supply by acquiring more gold. Any other expenditure that the government makes would have to be “financed” by taxation or by debt issuance. The government cannot just credit a commercial bank account under this system to expand its net spending independent of its source of finance.

As a consequence, whenever the government spent it would require offsetting revenue in the form of taxes or borrowed funds.

Ultimately, Bretton Woods collapsed in 1971. It was under pressure in the 1960s with a series of “competitive devaluations” by the UK and other countries who were facing chronically high unemployment due to persistent trading problems. Ultimately, the system collapsed because Nixon’s prosecution of the Vietnam war forced him to suspend USD convertibility to allow him to net spend more. Here is an interesting historical video of Nixon abandoning the Bretton Woods system on August 15, 1971. This was the final break in the links between a commodity that had intrinsic value and the nominal currencies. From this point in, governments used fiat currency as the basis of the monetary system.

Fiat currency

The move to fiat currencies fundamentally altered the way the monetary system operated even though the currency was still, say, the $AUD.

This system had two defining characteristics: (a) non-convertibility; and (b) flexible exchange rates. You need to recognise this major shift in history before you can understand why the economic policy ideas that prevailed in the previous monetary systems (based on convertibility) are no longer applicable. You cannot assume that the logic that applied in the fixed exchange rate-convertibility days translates over into the fiat currency era. The fact is that it doesn’t.

What I call neo-liberal macroeconomic reasoning is really the sort of reasoning that prevailed in the days prior to fiat currency. While there were debates about how to conduct macroeconomic policy in those days, there were some obvious key constraints that I have outlined above. This is irrespective of whether you want to call yourself a Keynesian or a Monetarist. The shift in history also renders most of the textbook economics outdated and wrong, in terms of how they depict the operations of the fiat monetary system.

When I talk about modern monetary theory I am referring to the fiat monetary system. I am recognising that a fundamental shift occurred in history when Bretton Woods collapsed and this has dramatically altered the opportunities available to sovereign governments.

First, under a fiat monetary system, “state money” has no intrinsic value. It is non-convertible which means that you can take a $AUD coin to the government and in return you will get a $AUD coin back. There is no responsibility to do more than this. So for this otherwise “worthless” currency to be acceptable in exchange (buying and selling things) some motivation has to be introduced. That motivation emerges because the sovereign government has the capacity to require its use to relinquish private tax obligations to the state. Under the gold standard and its derivatives money was always welcome as a means of exchange because it was convertible to gold which had a known and fixed value by agreement. This is a fundamental change.

Second, given the relationship between the commodity backing (gold) and the ability to spend is abandoned and that the Government is the monopoly issuer of the fiat currency in use (defined by the tax obligation) then the spending by this government is revenue independent. It can spend however much it likes subject to there being real goods and services available for sale. This is a dramatic change.

Irrespective of whether the government has been spending more than revenue (taxation and bond sales) or less, on any particular day the government has the same capacity to spend as it did yesterday. There is no such concept of the government being “out of money” or not being able to afford to fund a program. How much the national government spends is entirely of its own choosing. There are no financial restrictions on this capacity.

This is not to say there are no restrictions on government spending. There clearly are – the quantity of real goods and services available for sale including all the unemployed labour. Further, it is important to understand that while the national government issuing a fiat currency is not financially constrained its spending decisions (and taxation and borrowing decisions) impact on interest rates, economic growth, private investment, and price level movements.

We should never fall prey to the argument that the government has to get revenue from taxation or borrowing to “finance” its spending under a fiat currency system. It had to do this under a gold standard (or derivative system) but not under a fiat currency system. Most commentators fail to understand this difference and still apply the economics they learned at university which is fundamentally based on the gold standard/fixed exchange rate system.

Under a fiat currency system, if the government sets limits on its spending – for example, a rule restricting real growth of spending to be 2 per cent – then this is purely voluntary. It might be a sensible rule given the scale of nominal demand relative to real capacity but it is purely voluntary. These rules, however, usually arise from some mis-perception that the size of the budget deficit is a concern or the growth in public debt is a concern. Neither are particularly relevant to anything germane.

Third, in a fiat currency system the government does not need to finance spending in which case the issuing of debt by the monetary authority or the treasury has to serve other purposes. Accordingly, it serves a interest-maintenance function by providing investors with an interest-bearing asset that drains the excess reserves in the banking system that result from deficit spending. If these reserves were not drained (that is, if the government did not borrow) then the spending would still occur but the overnight interest rate would plunge (due to competition by banks to rid themselves of the non-profitable reserves) and this may not be consistent with the stated intention of the central bank to maintain a particular target interest rate.

Importantly, the source of funds that investors use to buy the bonds is derived from the net government spending anyway (that is, spending above taxation). The private sector cannot buy bonds in the fiat currency unless the government has spent the same previously. This is a fundamental departure from the gold standard mechanisms where borrowing was necessary to fund government spending given the fixed money supply (fixed by gold stocks). Taxation and borrowing were intrinsically tied to the government’s management of its gold reserves.

So in a fiat currency system, government borrowing doesn’t fund its spending. It merely stops interbank competition which allows the central bank to defend its target interest rate.

The flexible exchange rate system means that monetary policy is freed from defending some fixed parity and thus fiscal policy can solely target the spending gap to maintain high levels of employment. The foreign adjustment is then accomplished by the daily variations in the exchange rate.

Conclusion

The two monetary systems are very different. You cannot apply the economics of the gold standard (or USD convertibility) to the modern monetary system. Unfortunately, most commentators and professors and politicians continue to use the old logic when discussing the current policy options. It is a basic fallacy and prevents us from having a sensible discussion about what the government should be doing. All the fear mongering about the size of the deficit and the size of the borrowings (and the logic of borrowing in the first place) are all based on the old paradigm. They are totally inapplicable to the fiat monetary system.

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21 Responses to Gold standard and fixed exchange rates – myths that still prevail

  1. Lefty says:

    Thanks for that summary Bill, that explains a few more things. I had read that Keynes railed against the British governments intention to return to the gold standard after the war.

    Exactly how much of this rare metal I wonder, would we need to adequately back all the worlds currencies today and support a 2% or 3% annual global growth rate? The combined global economy of today must surely dwarf that of 1920. And what sort of resources would we need to expend to get it as opposed to using fiat currency. Fiat seems to make far more sense in the modern age.

    Around the blogs, I do occasionally come across people with some obvious economic tuition calling a for a return to the gold standard. Is it the Austrian school proponents who favour this?

  2. Reformer says:

    Hello Bill,
    >
    > I have learned a lot from your blog in a short space of time. Thank you.
    > I am reforming my world view. The mind only functions when it is
    > open.
    >
    > However there must be some unwritten law or oath of office
    > compelling politicians and officials to keep the “Government
    > spending is not revenue constrained” knowledge from the public.
    > It defies credulity that you can be right on this and be the only
    > person in Australian public life willing to say it. There must be
    > more than just Mitchell, Mosler and Wray on this side of the
    > debate. If true it must be well understood within the upper
    > echelons of power but suppressed. An unmentionable. Secret
    > bankers business.
    >
    > Here is the scary part. Whether you are right may be irrelevant.
    > The whole world from Obama to China are apparently convinced that
    > the opposite erroneous postion is true. And financial market
    > players are similarly convinced. The markets therefore are turbo
    > charged, swirling pits of emotion with herd mentality and now to
    > top it off, incorrect assumptions about the basic mechanics of
    > the economy.
    >
    > Expectations are the key to market action not wisdom. Markets are
    > starting to fear monetary expansion. Markets are fearful of an
    > impending US dollar collapse. It doesn’t matter that they are
    > wrong to be fearful. It should matter but it doesn’t.
    >
    > Hedge funds and OTC derivatives could therefore precipitate an
    > ‘accident’ by shorting the US dollar. Something of a
    > self-fulfilling prophecy of dollar doom. A Weimar style,
    > speculation induced, hyperinflationary dollar collapse.
    >
    > Note that this would be a market based currency phenomenon and has
    > nothing whatever to do with the real economy, real world market
    > mechanics or the size of fiscal stimulus packages.
    >
    > Indeed there may be so many positive benefits to America and the
    > UK from a major hyperinflationary episode that it may be an
    > engineered “accident”. Inflating away losses on toxic assets and
    > inflating away the montrous US forieign debt into insignificance
    > would certainly produce a profound international rebalancing.
    >
    >
    > I am not a commentator with any standing, but when Steve Keen
    > debates you, you may be able to make the point that inflation
    > will not occur as an economic event but may occur as a
    > speculation induced currency event: namely a crisis of confidence
    > in the US dollar, producing hyperinflation.
    >
    > What do you think?

  3. jimbo says:

    William Jennings Bryan, 1896:

    “If they dare to come out in the open field and defend the gold standard as a good thing, we shall fight them to the uttermost, having behind us the producing masses of the nation and the world. Having behind us the commercial interests and the laboring interests and all the toiling masses, we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold.\”

    And it was finally abandoned by Nixon (who, as we all know, was the only one who could go to China…) – but they are still nailing us to the phantom cross!

  4. Ramanan says:

    Not just commentators and professors and politicians, even school and college kids use that argument. Some people still think we live in the Gold Standard system, believe me!

  5. Alan Dunn says:

    Dear Reformer,

    Have you heard of Copernicus. Most people were convinced he was wrong as well.

    I think you underestimate the lengths by which the ruling classes will got o to protect their finaical positions.

    As a former economists I can pretty much guarentee that perhaps only 5 in a thousand of my economics students understood that the orthodox explanations were a scam.

    Unfortunately those same 5 would choose to remain ignorant of the truth because they knew they would not get a job otherwise.

    In fact I used to advise my third year Macroeconomics students that if they wanted a job in the public service or in the private sector they would have to live the lie and pretend to believe in the orthodox dogma.

    Finally, you seem to be under the illusion that you understand the dynamics of the inflationary process. The truth is that nobody understands the dynamics of inflation and it is pretty much a waste of time even attempting to.

    P.S I like Steven Keen as a person but as an economist he is completely honking.

    Cheers, Alan

  6. Sean Carmody says:

    This is a useful primer on the difference between fiat currency and the exchangeable currency. There is no doubt that the common analogy between Government and household finances are misleading and much of the reporting of Australia being “mired in debt” is alarmist claptrap. There are, however, two points I would like to make. One a technicality and one a matter of opinion.

    As you describe the operation of fiat currency, it is the Government that prints money. In Australia (and most other countries with fiat countries) this is not in fact how it operates. It is the Reserve Bank of Australia that is responsible for printing money. This can be done either by physically printing notes or minting coins or, more substantially, by means of the Reserve Bank buying Government bonds, increasing the balance of the Government’s bank account. This increased balance, which can then be transferred to the bank account of other banks when the Government purchases goods or services, effectively creates new money and is often referred to metaphorically as printing money. So strictly speaking, the Government can only raise money through taxes and borrowing, but where borrowing is provided by the Reserve Bank rather than the private sector, the effect is to “print money”.

    This point may appear to be an irrelevant technicality but, since the Reserve Bank is independent of the Government with a strong focus on, it is possible (in principle at least) that the Reserve Bank may refuse to purchase Government bonds if they thought that the printing of money was reaching a level that risked significant inflation.

    The second point relates to the view you touch on here an express in other posts that many economists fail to understand that there is no ceiling on the Government’s ability to make payments in their own currency and are stuck in fallacious gold-standard thinking. I am not so sure that this is the case. My impression is that many (perhaps not all) economists who express concerns about significant growth in Government fiscal deficits fully understand that there is technically an endless ability to meet these deficits, assuming an indefinitely cooperative Reserve Bank or, failing that, legislative changes to bypass Reserve Bank control of money printing. My reading is that they believe that there is a practical limit rather than a technical one since unconstrained money printing is ultimately inflationary; witness Zimbabwe. On this basis, they would take the view that fiscal deficits would ultimately be curtailed to avoid runaway inflation and if, once this point is reached, interest payments on debt have become a major proportion of Government spending, other forms of Government spending risk being crowded out.

    While I may be too generous in my interpretation of the thinking of economists, it is at least a possible interpretation.

  7. Alan Dunn says:

    Dear Sean Caromody,

    If the government does not spend the money first, how on earth do the non-government sector come to hold money or bonds?

    Please don’t refer to credit or savings until I get the plastic sheet down first.

    cheers, Alan

  8. bill says:

    Dear Sean

    Thanks for the comment.

    I decided to respond in full because you raise some interesting issues. My response appears in this blog in the second part of that edition.

    best wishes
    bill

  9. Andos says:

    For a humorous treatment of some of these issues, currency and the gold standard, check out the novel ‘Making Money’ by Terry Pratchett.

  10. Sean Carmody says:

    Alan: I think that you missed my point. I certainly do not disagree with Bill’s core point that in a fiat monetary system, money effectively comes into existence by means of Government spending first. My point was about the detail of the mechanism. The Government doesn’t do the money creation directly, that is done by the Reserve Bank. Imagine, for simplicity, that there was no money and we were to kick of the fiat money system. To make it easier, let’s imagine that all money was to be printed as notes rather than using bank accounts. To start with, the Government would issue, say, $1 billion in Government bonds (i.e. borrow money) to the Reserve Bank, who would print $1 billion in notes and give these to the Government. The Government would then spend the money and it would spread through the economy. Among other things, money would be spent on taxes, so some of it would come back to the Government. Also, once the notes were in the system, the Reserve Bank could also sell Government bonds who had accumulated money by providing goods or services either to the Government in the first instance or, later, to others who had accumulated money. If necessary to kick along economic activity, the Government could issue more bonds to the Reserve Bank to allow the printing of more money, but the only really difference between this and the picture that Bill painted, is that since the Reserve Bank is doing the printing not the Government, at some point the Reserve Bank may stop facilitating the printing. To get closer to a real picture of the Australian monetary system, you need to add in Reserve Bank bank accounts as well as physical notes and coins, but that doesn’t change the mechanics at all.

    Bill: I am about to start reading your follow-up post. Thanks for responding to my comment!

  11. Alan Dunn says:

    Dear Sean,

    Thanks for the reply.

    Cheers, Alan

  12. Vinodh says:

    Bill and everybody! Thanks for directing me to this blog. I am starting to understand. Still have a lot of questions. But arent you oversimplifying the situation saying that there is no convertibility. IN reality there is some sort of convertibility right since individual sovereign economies trade among themselves. Consider a situation, Country X a developing country wants to resort to deficit spending upto 10-15% of its GDP to fund immense infrastructure projects like power, road, railways, without issuing bonds, which means it just spends by printing money. Also country X does not have its own energy reserves, so needs to buy oil and coal for which it needs to hold USD. Now the currency markets see that Country X’s sovereign money is being printed and there is going to be a supply increase sending the local currency’s value tumbling down. Isnt this inflation or will this not cause hyper inflation? In other words my question “this fiat currency model of unlimited spending capacity for the governments does it work for developed economies with a lot of resources “apart from labor” available. IN case of a developing country its just predominantly labor.

    Or am I confusing two different things? Thanks for your patience everybody

  13. Sean Carmody says:

    Here “convertibility” means convertible at a fixed exchange rate (or perhaps within a range). So, while the Australian dollar can clearly be exchanged for other currencies, the exchange rate is free-floating, determined by supply and demand in the market. By contrast, many other currencies are “pegged” to another currency, usually the US$ these days. In the past, currencies were convertible to gold at a fixed exchange rate.

    You are certainly correct that if markets took a dim view of high levels of deficit spending, then the exchange rate on a free-floating (non convertible) currency could suffer. While this would make imports more expensive, it would also make exports more competitive, so the net effect on the economy would depend on the balance between imports and exports as well as the extent of the fall in value of the currency.

    Finally, Bill regularly makes the point that while sovereign spending in a non-convertible currency has no absolute upper limit, it should in practice be constrained because if deficit spending exceeds the excess capacity of the economy then it would certainly be inflationary. While determining that point is not tricky, it is fairly safe to say we are a fair way away from it right now.

  14. bill says:

    Dear Vinodh

    Convertibility is about the currency unit being backed by something of “intrinsic value” which gives it a reason for people to “demand it”. The value of the currency unit is then mediated via the fixed exchange rate and reflects some conception that the “backing commodity” has invariant value. So as Sean notes, the currency was backed by gold which before widespread new discoveries were made was thought to be an invariant value commodity. So the currency unit was fixed against some weight in gold (which had a stable market value). Then all the parities between currency units (AUD, USD, Yen etc) were fully determined.

    So the AUD is a non-convertible currency – strictly – because it is issued by the Australian Government (as a monopoly supplier) and they do not guarantee to convert it into anything of intrinsic value.

    Saying it might have an exchange parity with other currency units does not relate to convertibility.

    I think Sean has answered your question concern about inflation. Governments which net spend up to the real capacity of the economy to absorb nominal demand are fairly safe. There might be some specific asset bubbles (real estate, for example) but in general the economy quantity-adjusts (that is, increases production and employment) up to full capacity.

    The same principle applies in a developing country even though there might be different resource constraints present. But typically labour is always in surplus in developing countries and a sovereign government can always purchase that labour (at a fixed price) and put it to work to expand public purpose.

    best wishes
    bill

  15. Vinodh says:

    Bill!

    There are blogs like this, that argue as though the fiat monetary system is bad.
    http://dailyreckoning.com/fiat-currency/. How do you answer to each of these cases mentioned in this blog? I am still learning and cannot completely come up with arguments in this case.
    But the essential assumption you make is that the government is sovereign and contrinues to enjoy sovereignity during the deficit spending period right?

    Thanks
    Vinodh

  16. bill says:

    Dear Vinodh

    The reference you supply makes no basic case against the fiat monetary system although it thinks it does. It conflates two issues, which are always conflated by the neo-liberals – the currency unit and the opportunities it provides, on the one hand; and the mistakes that governments have made on the other. The two do not necessarily go together especially in the modern age of computers and more accurate information about the state of the economy. Note the reference to Marco Polo – everything was fine until they extended the economy too far. A government running a fiat monetary system just has to push up to the full employment (inflation) barrier and not beyond.

    What is the best way to know you are there? Offer a job at a fixed wage to anyone who wants one. The last person employed will tell you that you have spent the minimum necessary to utilise real capacity. If this situation is not fully utilising the capacity in the private firms then they will hire the workers out of the buffer. The last one hired is an indication of full capacity. Then you need to work out how to expand productive capacity further by skills development and investment.

    Even under a pure gold standard you can get “uncoordinated spending impulses” which would be inflationary. Same cure as a fiat monetary system – cut back aggregate demand.

    So I would disregard the arguments you have been reading about. Standard inflation scare-mongering.

    Under a fiat monetary system, the government is certainly not revenue-constrained and can enjoy that status to push the economy towards its real capacity which means using all the human capacities available. That is the best way in which we provide for a better future for all.

    best wishes
    bill

  17. Sean Carmody says:

    I think of fiat money as a form of powerful technology which, like many technologies, can be abused but that is no reason in and of itself to reject its use. While the Daily Reckoning post goes back a long way through history, the early examples really only show fledgling attempts at fiat money. It was really only developed to its modern form in the last quarter of the 20th century. Of course, like most technologies, few people understand how it works. In other cases, like computers and video recorders, this isn’t a problem but since issues of money end up being a key factor in the practice of Government, it is somewhat problematic that the understanding of money is so poor.

    Back to the question of abuse. In the Daily Reckoning, things went wrong either because those in control didn’t understand how to use money responsibly or, more simply, those in power took advantage of that power to enhance their own wealth and this pattern escalated out of control. A similar argument could be made for the current circumstances in Zimbabwe. However, I would argue that the appropriate defence is not to abandon fiat money but to establish robust democratic institutions to control its use appropriately. In regimes such as Zimbabwe there are other abuses. For example, armies and police forces are used to oppress the broader population and yet very few people argue that we should get rid of our police force because of the way police can be abused in dysfunctional regimes!

  18. Sergei says:

    Whoever reads this post and wonders about the issue raised by Reformer should go to this comment. It answers this concern pretty well

    http://bilbo.economicoutlook.net/blog/?p=7409&cpage=1#comment-2938

    I just happened to read both posts on the same day

  19. Isobel says:

    Thanks so much for this blog & all the replies: illuminating, thought-provoking. I especially appreciate the Q&A discussions which are in marked contrast to the illogic and/or ranting in the comments on so many major news sites.

    So glad I stumbled across this site, & have bookmarked it to return to. Best wishes to all.

  20. Apt says:

    Great article
    Thanks for explaining this is such a clear concise way.

  21. Pricesoptions says:

    Hello,
    Question about government borrowing, which you say stops interbank competition to allow the central bank to defend its base rate. Can you explain this a little more? Indeed i have often wondered why it is necessary to have such advertised, formal and final “base rate”.
    Rgds

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