Gold Fever

I get asked from time to time what my process is. How do I come up with the topics I discuss here… Okay no one actually asks that, I’m actually just grateful people sometimes take time out of their busy lives to read my thoughts. However I think it is important to routinely explain how these articles come to be. Basically it’s the same every time. I read a few articles, listen to some radio stories, watch some cable news interviews, and suddenly something just clicks. I’m not searching for a topic, in fact a lot of the time the stories, the articles, and the interviews are completely unrelated. Yet there is a narrative that resonates, it’s the same song but played in a different octave. Once I hear the similarities I start digging, I try to find out what are the underlying mechanisms that drive these similarities. In other words if two artist creating in solitude create works that look very similar you need to look into who they’ve been influenced by to figure out what they both saw. In the case of this blog, I try to explain the underlining logic that leads to policy proposals we get fed from both sides, and I try to advocate the ones I think will work the best.
This brings us to today’s topic, GOLD. Actually gold isn’t what we’re talking about. This is important. You’ve been hearing a lot about gold lately. Ron Paul, bless his heart, has spent a lot of time talking about a need to return to the gold standard. Beck is scaring his audience into buying gold coins. Gallons of ink have been spilled talking about gold, but this has nothing to do with gold. What everyone is really talking about is the Federal Reserve. The Fed, is probably one of the least understood institutions in our country. I’m sure my friend the former banker is probably going to have to correct a lot of what I write here today but here was my understanding of the fed up until about a year ago. The Fed is in charge of interest rates, and stores huge bricks of gold, which would have been stolen in Die Hard: with a vengeance, if it wasn’t for John Mcclane! Not that important in my daily life but good to know. Then we started talking about the national Debt, and the Fed popped up in that discussion. Then we started talking about returning to the gold standard, and once more there’s the Fed.
So what does the Fed actually do? It is a quasi-independent central bank that acts to control monetary policy in the US. What, you say. Well basically it tries to make sure the economy grows and people can work. The obvious next question is how it does this. Well the Fed only has one maneuver, it can control the amount of money in circulation. By controlling the amount of money in circulation it can influence interest rate, spur job growth, and manipulate inflation. It’s one move but it’s a really good move. Now at one time the way the Fed did this was buying and selling gold. All the banks in the entire world used to buy and sell gold from one another and it would affect the currencies of nations. Nowadays no nation in the world is on the gold standard, for a very simple reason, there ain’t enough of it. To back a modern economy measured in the trillions by the amount of gold in the world would sky rocket the price of gold. This sounds great if you own gold and, in the first year, it would be great. But modern economies grow by billions of dollars a year. In order to account for this expansion you would need to unearth billions of dollars worth of gold a year every year. This is just not possible. The result would be the value of gold would continue to rise, and eventually you’d wind up with deflation. Deflation would strangle economies because everyone would stop purchasing and wait until economies expanded at the rate equal to the amount of gold uncovered a year. By that point unemployment around the world would be near 20%, If not more.
This is the problem with basing an imaginary currency on a finite resource. That’s right I said imaginary, all money is imaginary. This is not the same as saying fake. A lot of people think if dollars are not based on a hard substance it’s the same as being based on nothing. This is not true, money is a promissory note, in other words it’s a promise. It is a promise of work. When you get money at the end of the week your employer is giving you a representation of the work you performed. You use that money to purchase work from other people. I know this seems very basic but it is the key to understanding that it doesn’t make any more sense to then base the value of that money on some finite resource. By tying the value of money to the amount of gold on the earth it disconnects the value of money from the value of work, this is why money is no longer tied to gold.
If money isn’t tied to some hard resource then how is its value determined? Well this brings us back to the Fed. By controlling the amount of money in circulation the fed controls the value of money, and in essence controls the value of work. There is a presumption made about the amount of work the nation can produce. You take this amount of work and roughly speaking divide that into the amount of money in circulation and you get the value of the dollar. By tweaking the amount of money in circulation they are able to control the cost of work in the country. If the dollar is weak it becomes cheaper to work in this country then abroad, and companies hire more Americans. When too much money is pumped into circulation and it no longer reflects the amount of work capable by the country its value begins to drop rapidly, meaning runaway inflation.
What about interest rates? What the Fed does is buy bonds, specifically US treasuries. When it buys the bond it creates the currency to do so. In doing this it puts more money into circulation. The Fed doesn't buy these bonds from the US government it buys them from banks. The banks were making interest on these bonds, but since they sold them they are now sitting on a pile of cash that isn’t doing anything. They want that pile to make money so they lend it to someone. If all the banks are sitting on piles of money they have to compete to get people to borrow that money. The way they compete is by lowering how much it costs to borrow the money i.e. lower interest rates. If there is too much money in circulation and it starts to cause inflation the Fed starts selling bonds. When the Fed sells the bonds the money they get for the bond is taken out of circulation and increases the value of the remaining money in circulation.
The important thing to realize is, although the Fed has tremendous control over monetary policy, this is still only a reflection of the amount of work a nation can produce. In my last piece I talked briefly about how, even though both Haiti and Japan are suffering at the result of a tremendous tragedy, Japan has a better chance of bouncing back. This was largely due to Japan having the resources to make up for the loss of wealth. People spend a lot of time worrying about the Fed, and what it is doing. This is good, any institution as influential as the Fed should be monitored and held accountable for its decisions. Unfortunately the Fed is given too much credit for its control over the overall economy. It is true that the Fed kept interest rates low, to spur lending. It is not true that the Fed caused the financial meltdown. The banks and the financial sector still bear the lion share of the responsibility since they took extraordinary risk and circumvented their own safety practices. In addition, what was lost in the financial crisis was wealth, not the capacity to do work. Because of this the Fed has taken the limited risk of putting more money in circulation. The fear is runaway inflation. Yet with unemployment still at around 8.9% our country is in no way close to capacity in terms of the amount of work we can produce as a result an uncontrolled inflation is rather unlikely. At the same time this is unlikely to result in sustained job growth either. The Federal Reserve is less the rudder that steers the ship of our economy and more like one of its many oarsmen.