Mike Sproul,
Apparently, in a Real Bills economy, banks would issue into circulation the dollar amount of each loan, but where would the dollars come from to pay the interest?
Inflation being the increase of the money supply, the question is to anticipate what kind of money would produce a free banking system. I am not sure that the gold standard would be competitive. With the gold standard, there is certainty that the excess of money will be washed out at some point, i.e there is a mecanism to burn created money, but whatever the reason there has been in history behind bubbles of credit under the gold standard, the burst was always very severe. Austrians say, I believe, that the bubble is the cause of the burst. Thus I anticipate that a free banking system would practise some sort of Central Banking where they would seek to increase or decrease the money supply at a pace that fits the economic needs of their customers so that credit would remain abundant and controlled. Exuberant bubbles as well severe burts must be avoided and for that the financial revolution as well prudent central banking has greatly generated a lower volatility.Which Central Bank has generated the best sustainable pace of economic growth ? seems to me Australia.
Let's say the bank(s) loan a total of exactly $1 million every day into circulation with one-year (365-day) loans at 10% simple annual interest.
Am I correct in the following analysis?On the day at the end of the first year, there would be $365 million minus 1 million capital(paid back to the bank) minus $100,000 (i.e., 10% interest on the first $1 million loan made 365 days previously) which would equal $363.9 million in circulation.$100,000 would be deducted from the dollars in circulation every day in order to pay the interest for the loan made 365 days previously.
The $1 million capital of the first loan would be returned at the end of the year, but that would not diminish the dollars in circulation because another $1 million loan would be made on the same day. The next day $1 million of capital would be repaid and another $1 million loaned thus not affecting the amount of dollars in circulation caused by this movement of loan capital.The $363.9 million in circulation on the day at the end of the first year would diminish by $100,000 each day for (363.9 divided by 0.1 which would equal) 3,639 days or 10 years until the dollars in circulation became completely depleted.
OOPS, THIS IS A REWRITE:
Am I correct in the following analysis?On the day at the end of the first year, there would be $365 million minus $1 million capital paid back to the bank plus $1 million capital loaned by the bank minus $100,000 interest paid to the bank which would equal $364.9 million in circulation.$100,000 would be deducted from the dollars in circulation every day in order to pay the interest for the loan made 365 days previously.
The $1 million capital of the first loan would be returned at the end of the year, but that would not diminish the dollars in circulation because another $1 million loan would be made on the same day. The next day $1 million of capital would be repaid and another $1 million loaned thereby not affecting the amount of dollars in circulation caused by this movement of loan capital.The $364.9 million in circulation on the day at the end of the first year would diminish by $100,000 each day for 364.9 divided by 0.1 which would equal 3,649 days or 10 years when the dollars in circulation would become completely depleted.
Gethky:
If the dollars in circulation do actually become depleted, then interest can be paid in some other form: silver, foreign money, etc. But as long as new dollars are continually issued, the depletion doesn't happen.
Mike Sproul: Gethky: If the dollars in circulation do actually become depleted, then interest can be paid in some other form: silver, foreign money, etc. But as long as new dollars are continually issued, the depletion doesn't happen.
If the only way that dollars get into circulation is through bank loans, then (as I have described in the hypothetical model, above) each interest payment on those loans would deplete the dollars in circulation. As this deflation of the money supply advances, it follows that most prices will become lower and lower. This continued lowering of prices would impose more and more hardship on borrowers trying to scape up enough lower-priced goods to pay off their yearly loans until, finally, people would not be foolhardy enought to take out loans and the dollar economy would then collapse.
Another correction:
Am I correct in the following analysis?On the day at the end of the first year, there would be $365 million minus $1 million capital principal paid back to the bank plus $1 million capital principal loaned by the bank minus $100,000 interest paid to the bank which would equal $364.9 million in circulation.$100,000 would be deducted from the dollars in circulation every day in order to pay the interest for the loan made 365 days previously.
The $1 million capital principal of the first loan would be returned at the end of the year, but that would not diminish the dollars in circulation because another $1 million loan would be made on the same day. Each following day another $1 million loan principal would be repaid and yet another $1 million loaned thereby not affecting the amount of dollars in circulation.The $364.9 million in circulation on the day at the end of the first year would diminish by $100,000 each day for 364.9 divided by 0.1 which would equal 3,649 days or 10 years when the dollars in circulation would become completely depleted.
We cannot bid up the price for everything at once. Sure, heavy demand for crude drives the price of gasoline higher. Higher costs could be passed on to the consumer to an extent. But that's just the point: if we are paying more for our gas then we have less money for everything else, we have less money to bid up the prices of other things,unless you increase the stock of money in circulation. And that's where the central bank and fractional-reserve banking comes in. I actually read this from an article by Frank Shostak and that article alone explained inflation to me in a way I could easily understand.
Calvin:...unless you increase the stock of money in circulation. And that's where the central bank and fractional-reserve banking comes in.
If banks are basically deflationary, as I show in the above model, then increasing the stock of money in circulation is not caused by banks per se, but by other factors, namely, by increasing the number of loans. E.g., if the number of loans per year in the above model were increased from 365 to 730 per year, then the stock of money in circulation would be $730 million at the end of the first year and then diminish during the next 730 divided by 0.1 = 20 years.
gethky, in your example of the bank loaning money, you act like the interest that the bank earns simply disappears from circulation. It does not. It is used to pay employees, to build new buildings, to purchase advertising, or it is loaned back out. It is still in circulation.
>We cannot bid up the price for everything at once.
For the price of all goods to go up we merely need the subjective value ascribed to money to go down. If some crisis shakes our confidence in the currency then prices for all goods will rise
baxter:gethky, in your example of the bank loaning money, you act like the interest that the bank earns simply disappears from circulation. It does not. It is used to pay employees, to build new buildings, to purchase advertising, or it is loaned back out. It is still in circulation.
I attempted to keep my above model as simple as possible, but why not assume that the bank can meet all its expenses by fractional reserve banking and thereby be able to plow back all interest payments into interest-bearing loans? If that were the case, then the interest payments for those loans would, as in my above model, also have to come from the circulating principal of other borrowers.
So this bank has no debtors in default?
And it's able to charge an inelastic interest rate? Does this bank not face competiton from other lenders?
If the bank really does deplete the money supply, by holding the majority of it in reserves, then it seems that it is not able to be very productive in comparison to its vast resources. Wouldn't the owners liquidate the bank in favor of more productive investments?
Is it just me or is this bank scenario far removed from reality?
BTW, is there something akin to the Austrian Business Cycle theory for a money supply that's being intentionally and continuously deflated?
baxter: So this bank has no debtors in default? And it's able to charge an inelastic interest rate? Does this bank not face competiton from other lenders?
OK, let's subtract $40,000 per day for total expenditures from the previous $100,000 daily payment of interest to the bank(s). According to my above model, on day 365 there would be $365 million in circulation. On day 366 and each day thereafter the bank(s) would receive $1 million as principle and $100,000 as interest. The bank(s) would also loan $1.06 million on day 366 and each day thereafter. $60,000 would then be the net amount of diminuation of the money in circulation every day commencing with day 366. The $364.94 million in circulation would diminish for (364.94 divided by 0.06) 6,082 days or 16 years.
baxter: And it's able to charge an inelastic interest rate? Does this bank not face competiton from other lenders? If the bank really does deplete the money supply, by holding the majority of it in reserves, then it seems that it is not able to be very productive in comparison to its vast resources. Wouldn't the owners liquidate the bank in favor of more productive investments? Is it just me or is this bank scenario far removed from reality? BTW, is there something akin to the Austrian Business Cycle theory for a money supply that's being intentionally and continuously deflated?
Goldsmiths are said to be the first bankers when people started using their receipts as circulating currency, then the goldsmiths/bankers started lending the receipts at interest. Here I'm not considering the interest the bankers pay on deposits and other factors as well so as to allow the example to be as simple as possible and yet include all the important factors of banking that relate to whether or not banking is basically inflationary or deflationary. Instead of using 'receipts' or 'currency' I use '$' which is not to mean any particular country's dollar in the above hypothetical model. Like all models it deviates from reality, but not enough to prevent it from demonstrating that banking is basically deflationary if it keeps any part of the received interest payments out of circulation. Intentionally causing the loan rate to decrease will indeed cause deflation (see Richard Timberlake's "Federal Reserve Follies" at http://blog.mises.org/blog/archives/timberlake.pdf ). The unintentional basic deflation caused by banking is not seen where loans proliferate in expanding economies and/or populations.
http://www.mises.org/story/2331
Hope the link works. Here the author explains that a price cannot be realized simply because the seller asks for it. Assigning a price? In the market, the consumer decides what is the right price.
Calvin:We cannot bid up the price for everything at once.
Wasn't baxter's (Oct 25, 2007 at 5:03 AM) comment, "For the price of all goods to go up we merely need the subjective value ascribed to money to go down. If some crisis shakes our confidence in the currency then prices for all goods will rise" enough?
Increasing the money in circulation is another way to cause most prices to rise.
"In the market, the consumer decides what is the right price." - Calvin
I don't believe you'll find a counter argument to that statement here.
If 100 gold coins represent the total amount of money in circulation, then the most that can be paid for the Mona Lisa is 100 gold coins.
So if I discover that someone just paid 150 gold coins for the painting, I would simply assume that the buyer found more gold coins from somewhere. Whether the buyer discovered a gold mine or shaved off existing coins to create new coins produced the same result. Adding 50 gold coins to the stock of money allowed for the price to go up to 150 from 100 gold coins. Something that wouldn't have happened before.
Calvin: If 100 gold coins represent the total amount of money in circulation, then the most that can be paid for the Mona Lisa is 100 gold coins.
Not true.
The money supply is a limitation on the sum of all the quantities of money simultaneously held by all individuals and other entities. A transaction involving money merely transfers money from one individual or entity to another with no impact on the total quantity of money.
Any final hypothetical achievable distribution of the supply of money can be realized by a series of partial payments without any limitation on the individual net price of any transaction.
Regards, Don
Since part of a bank's job is to serve as a warehouse of money, it seems natural that the existence of a bank would help decrease the money supply. It would encourage the transformation of money from liquid into illiquid forms: from cash into checking and savings acounts. Money warehouses are deflationary. The effect is minor since forms like checking accounts are typically included in most money supply measures - the money is readily available and almost interchangeable with cash.
However, fractional reserve practices also have a big inflationary effect since they appear to create money out of thin air. The total amount of money in existence is the same, but because the banks' insolvency is generally overlooked, the effective money supply is increased. With fractional reserve banking, the money supply is typically increased by several times the amount held in the banks as reserve. Thus, fractional reserve banks are inherently inflationary.
If there were a run on all of the banks, causing them to collapse, many of us would discover that our accounts can't be honored by the banks. We'd be lucky to get any money out at all. The money supply would shrink dramatically. Proving that the banks are inherently inflationary.
You're right, baxter. Therefore, without the interest payment to the bank diminishing the amount of fiat in circulation, my basic banking model would not be deflationary, afterall. Of course there would be a great shortfall if, say, 90% of the loans would suddenly be paid prematurely, but that's extremely unlikely.
As a student of history, I had always been fed the same line about inflation being "natural" or "inevitable" and when it was explained by instructors as a decrease in value the dollar due to an increase in the number of dollars in circulation, I thought that the whole thing sounded ridiculous and that I would never understand economics. The fact is, it is ridiculous. It is not, however, inevitable; it is one of those things that we have simply been taught is inevitable, often by teachers who probably don't understand it themselves.
Incidentally, it was my decision to do some research on Ron Paul after seeing his name chalked on sidewalks all over campus that lead me to realize this. Needless to say, I'm now a huge supporter. I am so thankful that he and others are opening up the discourse on this and allowing people to realize that, quite simply, this is not a free market economy, and that we desperately need to return to one.
I'm so pleased that I found this site. Glad to be here in the forums!
In a 100% gold standard system, economic growth would at first decrease the relative supply of currency naturally, simply by an increase in tot\al goods and services. But as this would increase the purchasing power of the individual monetary units, it would become profitable to produce gold -- especially under a system of free coinage -- as the capital and labor that would go into mining and production of gold coins would be lesser than the labor and capital involved in producing the goods and services that those coins could be traded for. As people worked to produce more gold coins and introduced them into the general economy (by spending them on goods and services), the supply of money relative to the supply of goods and services would then increase, and as an equilibrium is again reached, it would no longer ve profitable to produce gold coins, as the labor and capital involved in doing so would be the same or more than the labor and capital needed to produce the gooods and services the coins are traded for. This is the built-in defense against inflation in a 100% gold standard.
In the 21st century we can have no increase in the money supply without having to go back to the gold standard. Banks could provide a market mechanism where money newly created would be destroyed at a later point.
Steve Bachman: I would define inflation as an increase in the money supply relative to the supply of total goods and services in the economy.In a 100% gold standard system, economic growth would at first decrease the relative supply of currency naturally, simply by an increase in tot\al goods and services. But as this would increase the purchasing power of the individual monetary units, it would become profitable to produce gold -- especially under a system of free coinage -- as the capital and labor that would go into mining and production of gold coins would be lesser than the labor and capital involved in producing the goods and services that those coins could be traded for. As people worked to produce more gold coins and introduced them into the general economy (by spending them on goods and services), the supply of money relative to the supply of goods and services would then increase, and as an equilibrium is again reached, it would no longer ve profitable to produce gold coins, as the labor and capital involved in doing so would be the same or more than the labor and capital needed to produce the gooods and services the coins are traded for. This is the built-in defense against inflation in a 100% gold standard.
I would define inflation as an increase in the money supply irrespective of the supply of total goods and services in the economy.
While you are correct in stating that an increase in purchasing power would spur greater production of the monetary unit, I don't think the effect of that extra production is completely neutral or benign. Gold is useful as a monetary unit because it is rare and hard to produce, even when it's purchasing power increases. An increasing money supply can still cause all the distortions in the economy that Austrians talk about, even if the supply of goods and services keeps pace at approximately the same rate.
In the 1920s, improvements in technology and methods of production greatly increased the supply of goods, but the newly created Federal Reserve allowed the money supply to expand at about the same rate. Prices appeared more or less static, but the distortions in the economy caused by the monetary expansion resulted in the Great Depression.
The ideal monetary unit is one where it's supply is non-inflatable. Gold is about as close as you can get to this ideal, which is one reason why throughout the ages it has been used as money. With a completely non-inflating currency, prices will steadily diminish as production of goods and services increases, so people become wealthier, but equally importantly, the structure of production in the economy remains undistorted.
I admit that I have not been studying this quite enough to be absolutely certain of the soundness of my thinking, but I tend to think of the equilibrium of currency (gold) to goods and services as a good thing, price stability being the fundamental point. I agree that the increase of purchasing power of money holders is a good thing, but I see no reason why that purchasing power cannot be represented by an increased quantity of monetary units. Besides, the problem that I envision -- and again, I may well be suffering from unsound thinking due to not being as fully well read on the subject as I intend to become -- is that the increase in the purchasing power of individual monetary units, though on one hand would be beneficial considering the lowering of prices, would also seem to me to be problematic where wages and costs of production are concerned.
Instead of a gradually increasing wage rate sch as most Americans have now, we would have to figure in gradually decreasing wage rates to accomodate sufficiently low costs of production so that sufficent profits could continue to be reinvested, etc., due to the deflationary effects of a static money supply.
Reisman sort of discusses this in this article:
The rising productivity of labor and correspondingly falling product prices that the businessmen and capitalists achieve take place in this context of wage rates that are determined by the independent supply of and demand for labor. Thus, as product prices fall, wage rates do not fall, and, therefore, real wages rise. (If, the quantity of money and volume of spending in the economic system remaining the same, there is a growing supply of labor while the productivity of labor rises, money wage rates fall, but prices fall by more.) Of course, to the extent that the quantity of money increases while the productivity of labor rises, the demand for labor and products both increase. As a result, the rise in real wages may be accompanied by rising money wage rates and by constant or even rising product prices. But the relationship between wages and prices will reflect the change in the productivity of labor, for that reduces product prices relative to wages, while the increase in the quantity of money operates to affect both of them more or less equally. (Under a gold standard, there would be a modest rate of increase in the quantity of money, which would probably be accompanied by falling prices and rising money wages.)
Steve Bachman:I admit that I have not been studying this quite enough to be absolutely certain of the soundness of my thinking, but I tend to think of the equilibrium of currency (gold) to goods and services as a good thing, price stability being the fundamental point.
Sounds nice when you say it (maybe) but remember that the increase in the money supply needed to do this will cause a business cycle. Why is this goal of "stable prices" worth causing all that misallocation of resources and the resulting recession?
Steve Bachman:but I see no reason why that purchasing power cannot be represented by an increased quantity of monetary units.
Because this penalizes savings, and emphasizes wages. You're saying, I think, that the worker's standard of living goes up because prices remain stable, but his wages increase. But this means that only current income increases in purchasing power, not previous income.
Steve Bachman:Instead of a gradually increasing wage rate sch as most Americans have now, we would have to figure in gradually decreasing wage rates to accomodate sufficiently low costs of production so that sufficent profits could continue to be reinvested, etc., due to the deflationary effects of a static money supply.
Except that none of this is how wages are determined. Employers cannot decrease wages in order to increase reinvestment - if they could, they would have done it already. Wages are determined by the interplay of various subjective valuations - i.e. "supply and demand." Also, why do we need to "accomodate" low costs of production?
Steve Bachman:I tend to think of the equilibrium of currency (gold) to goods and services as a good thing, price stability being the fundamental point.
Why is price stability good? Falling prices are good in the context of increased produtivity and monetary stability.
Steve Bachman:I see no reason why that purchasing power cannot be represented by an increased quantity of monetary units
Because an incease in the quantity of monetary units leads to misallocations of capital and distortions in the structure of production irrespective of price stability.
Steve Bachman:the increase in the purchasing power of individual monetary units, though on one hand would be beneficial considering the lowering of prices, would also seem to me to be problematic where wages and costs of production are concerned.
No, because while the other factors of production are becoming cheaper and more plentiful due to increased productivity, the supply of labor does not, so in relative terms the price of labor (wages) becomes higher.
The cost of any factor of production is determined by its discounted marginal value product (DMVP), which in turn is determined by the price of the finished good in the market. In an economy with static money supply where prices of goods are falling, the DMVPs of all factors of production fall in nominal terms, but the price of labor falls less than the price of other factors. Thus, relative to the price of goods, wages rise (i.e. they rise in real terms), and the cost of other factors fall.
Thanks for the replies, all.
Steve Bachman:I admit that I have not been studying this quite enough to be absolutely certain of the soundness of my thinking, but I tend to think of the equilibrium of currency (gold) to goods and services as a good thing, price stability being the fundamental point. I agree that the increase of purchasing power of money holders is a good thing, but I see no reason why that purchasing power cannot be represented by an increased quantity of monetary units.
I admit that I have not been studying this quite enough to be absolutely certain of the soundness of my thinking, but I tend to think of the equilibrium of currency (gold) to goods and services as a good thing, price stability being the fundamental point. I agree that the increase of purchasing power of money holders is a good thing, but I see no reason why that purchasing power cannot be represented by an increased quantity of monetary units.
Steve Bachman:Instead of a gradually increasing wage rate sch as most Americans have now, we would have to figure in gradually decreasing wage rates
Time will tell
Paper money is not created out of thin air. Nobody is stealing anything, and there is no comparison of paper money issue to counterfeiting. Every time any bank (the Fed included) issues a dollar, it gets a dollar's worth of assets in return, and it stands ready to use those assets to buy back the dollars it has issued. As long as the bank's assets rise in step with the money it issues, the value of each dollar is unaffected. The same is true of any financial security. If General motors issues new shares of stock and sells them for the market price (say $60 each), then GM's assets rise in step with the number of shares issued, and the value of each share is unaffected.
If there is no steal, I guess that it is a profitable game. Why not then buy all the bonds detained by the financial institutions, all the bonds newly issued by the Government and perhaps all well rated corporate and municipal bonds ? You'd have under the premise of profitability a more ample money supply, bond issuers would just have to get a good rating.
Well it does not work this well. Rather, it is a loosing game.When the Fed creates money, generally rates go down : the Fed buys Bonds from commercial banks and every financial institutions buy Treasuries from others. When the Fed sells Bonds, less money circulates and every financial institutions sell Treasuries too. But the money supply is still higher than it was at the onset of the creation of money by the Fed as unfavorable Bond prices can not pump enough money out.
At the end of the cycle, The Fed has lost money, it has given out more money than it has received. A central bank would not exist this way without the power of the government. Everyone seems to like the idea of having a central bank. The price to pay is inflation, destruction of profitabilty (the CPI can not go down) and worse, financial crises every 5 years.
Mike Sproul: Paper money is not created out of thin air. Nobody is stealing anything, and there is no comparison of paper money issue to counterfeiting. Every time any bank (the Fed included) issues a dollar, it gets a dollar's worth of assets in return, and it stands ready to use those assets to buy back the dollars it has issued. As long as the bank's assets rise in step with the money it issues, the value of each dollar is unaffected. The same is true of any financial security. If General motors issues new shares of stock and sells them for the market price (say $60 each), then GM's assets rise in step with the number of shares issued, and the value of each share is unaffected.
Why is it that any time there is a chance Wall Street can get hit hard in the financial sector, the fed (entity of congress) goes on a charitable crusade in the form of lower FFR (federal funds rate) and a rather large cash infusion??? If this fiat money wasnt effected by lack of confidence, the fed would let WS correct itself. Instead, poor banking practices and weak investment gets bailed out...
What happens when the assets the bank requires for collateral decrease in value relative to the initial amount of money loaned??? Its times like this when foreclosure is the most apparent. What happens to that floated money after only a % of it was collected after a default???
Seriously, there has become a lack of responsibility. Some would call this a "moral hazard".
The argument i receive at a constant rate from left wing America is, "the feds ability to help cushion the fall on businesses and banks allows for recessions to be less severe and people dont have to suffer as much. During the "gold era", recessions were much more turbulent and our current system makes life easier for us all."
I dont know whether to throw up when hearing that, or say to myself, "Darwin was right". As said very effectively by George Carlin, "the kid who swallows to many marbles shouldnt grow up to have kids of his own." If a company was/is unable to make it through a recession without going completely under, it didnt deserve to be in business in the first place...
The reason that people ignore the Austrian (Correct) view and subscribe to some other view is that people hope that their suppliers of life, governments, are telling them the truth. It is just that simple. People have become so dependent on government that they believe it to be their savior.
We got there through the ultimate government program: WAR!!!! People had a stupendous amount of faith in government at after WWII that they kept the stupid ideas of Keynes and Rosevelt. People thought what could be a more powerful agent of peace and prosperity other than the government that won WWII?
First, let me say I am a neophyte to this subject so please excuse my ignorance as I work my way through the subject of inflation. Earlier someone mentioned the price decrease in computers, so using that item for my question; if the supply of money is the cause of inflation, and computers have bucked this trend trough productivity, technological advances… Using lets say $1,000 as the starting price and then a few years later the price is now $800 is it safe to assume that the new $800 price was still affected by the inflationary factors of the money supply? In other words without the inflation the computer my have only cost (for agreements sake) $600 now?