Monday, May 30, 2011

A Primer on Money, Banking, and Gold

My Car was broken into, and all of my economics books and related journals were stolen. (Maybe that's why I bought Atlas Shrugged?) I started over with new journals, and purchased this classic book from the 1960's on Banking to give me some new materials to read. The book, written by Peter L. Bernstein, is called A Primer on Money, Banking and Gold. It covers: (1) the structure, history, tools, and purpose of the federal reserve; (2) the creation and destruction of the money supply in its many forms; (3) the role of Gold in the United States under the Bretton Woods system, and the relationship between Gold and currency in general. Some of the most potent lessons and observations are, in my opinion, the following:

(1) As long as monetary policy does not
actively finance an inflationary spiral when
full employment has already been achieved,
the productivity of an economy is the ultimate barrier to runaway inflation.

(2) The physical supply of currency sets a theoretical limit to the supply of money in the economy, but determining that limit is difficult, and the intermediate supply schedule shifts due to changes in liquidity preference, expectations, monetary policy etc.

(3) The largest portion of our money supply is locked up merely in numbers on balance sheets, and doesn't even merit the tangible existence of a federal reserve note.

(4) Aside from tangible currency and notes, most of our money is created by banks lending short-term deposits to long-term borrowers (and betting on reserves to cover the occasional withdrawal of those deposits). Some or all of the loaned money becomes a deposit at another bank, which allows that bank to lend more (but not as much as the first bank). The result is a potential multiplicative increase in the money supply by lending (but not without limit). The government and federal reserve can also influence the money supply with monetary and fiscal policy.

(5). The major tools of the federal reserve are: open market operations (buying/purchasing treasuries to increase/decrease the money supply), the discount rate (raising/lowering the rate on borrowing from the fed to decrease/increase the money supply), and the reserve requirements ratio (raising/lowering reserve requirements to decrease/increase the money supply).

(6) The government can effect the money supply by raising/lowering taxes and/or increasing or decreasing spending. Lowering taxes increases the money supply, while raising them decreases it. Increasing spending (by borrowing) increases aggregate expenditure, and the converse is also true.

(7) Gold is not as dissimilar from fiat currency as is imagined by some. It has some value in use, but it has little or no bearing on its value as currency. Its historical value as currency came primarily from its resistance to tarnishing, relative ease of transport, difficulty to counterfeit, and its undeniable beauty. In short, the demand for gold as a currency as opposed to fiat notes is mostly a subjective fascination shaped by historical experience.

(8) The major advantage of gold as opposed to fiat currency is the difficulty in increasing its supply. It's very difficult (although the Spanish Empire shows it is possible), to have problematic inflation with gold. Yet the difficulty in increasing the supply can also be a barrier to economic expansion (a bigger economy needs a bigger money supply). It is the opinion of the author (and I agree) that for these reasons the benefits of a fiat currency generally outweigh the costs (for a large and developed economy).

Discussion

All in all, I thought that this book was very well written. Although it has nothing to say about the large and complex world of derivatives and integrated financial structure that exists today, you might be able to guess from my past posts that I'm more of a (back to the basics) kind of person. The author also completely underestimated the potential for rampant inflation in the American economy (which actually occurred in the 1970s). However, he is quick to acknowledge the fact and explain himself in the introduction, and it really has no bearing on his analysis of how the banking world functions. Furthermore, given the zealous criticism of the Fed in recent history, I thought it was refreshing to get a description of the day to day workings of the Fed, and its imagined purpose, from the writings of someone removed from today's debate by decades of history. I could be imparting a degree of romanticism to the experience, but I feel that his book captures the American Financial System in a time that was much more hands on and realistic. It makes me resent the sometimes cold numerical detachment that I feel has sometimes made it all too easy to reach easy short-term conclusions that have hard and unexpected long-term consequences.

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