Posts Tagged ‘gold standard’

Why should central banks be independent from the government?

Wednesday, July 16th, 2008

Yesterday, one of our readers asked us this question:

Why is it important to keep central banks independent from the government? Wouldn’t it be better if the board of directors of a central bank are selected by the people, and therefore held accountable to the people for decisions, mistakes, and misjudgements?

At what point did central banks become concerned about targeting inflation? Before they existed, inflation was close to 0%, so surely they wouldn’t have been created with inflation targeting in mind?

The more I read, the more I feel that your ideal of a 100% reserve banking system with no central bank is the best way to control inflation (and to allow the people to understand the true cost of government projects [wars, etc] that is currently paid for through inflation). But why didn’t this work in the first place?

To answer these questions, we will turn back to history. As we explained before in A brief history of money and its breakdown- Part 2,

In the first phase, lasting from 1815 to 1914, the Western world was on a classical gold standard. Each national ?currency? was just a definition of a weight of gold. For example, the ?dollar? was defined as 1/20 of an ounce of gold. Each national currency was redeemable for gold on its pre-defined weight. Thus, if a nation were to recklessly inflate the supply of its money, it would run into danger of having its gold drained from its treasury.

Under an international gold standard, there was an automatic market mechanism to keep government from inflating the money supply and to keep each country’s balance of payment in equilibrium. Hence, the world enjoyed the benefits of only one monetary medium, which facilitated trade, investment and travel. Prices were also kept in check (see What is inflation and deflation?). During that time, there were periods of price rises (e.g. during war) followed by periods of price falls (e.g. when war ends), with relatively stable prices in between.

Why did it not work out in the end? Well, thanks to the First World War. As we all know, modern wars are terribly expensive. Under a gold standard, no country can ‘afford’ to fight any war for an extended period of time. Therefore, the only option was to go off the gold standard and resort to purely fiat paper money as it is today. You can read the rest of the monetary breakdown story at A brief history of money and its breakdown- Part 2.

Now, you know how the US is able to ‘afford’ to fight extended wars in Iraq and Afghanistan with expensive professional armies today.  A gold standard will make this truly unaffordable.

Today, the central banks of the US and Australia follows an inflation targeting policy. That is, monetary policy is set ensure that there is a consistent price rise within a target range. How did inflation targeting develop? Well, it is another long story. You can read about it straight from the RBA at Inflation Targeting: A Decade of Australian Experience.

Next, we come to the most important part: why should central banks be independent from the government?

First, we have to understand the basics. What is the purpose of money? In essence, money functions as (1) a medium of exchange, (2) unit of account and (3) a store of value. To perform these functions, money has to fulfil certain properties as described in Properties of good money and its integrity cannot be tampered with.

Now, consider the situation that we described in Recipe for hyperinflation:

… imagine you are the only person in town who has the authority to create money out of any piece of paper with your own signature. Wouldn?t this make you a pretty powerful person in town? With such power, you can acquire anything you wish at the expense of others.

Under the gold standard, gold is money that is under the control of the free market. No one or institution ‘owns’ or control the money. But today, the central bank is the only institution that has the authority to create money out of thin air. As we said in Recipe for hyperinflation,

Look at any piece of paper money today and you will find the words of a government decree (e.g. ?This Australian note is legal tender throughout Australia and its Territories?) and perhaps a signature or two.

In Australia, the signature belongs to the RBA governor.

What if we give the government (which already has executive power) the power to create money? This will give the government a deeper concentration of power! If you believe the old adage that power corrupts and absolute power absolutely corrupts, then you will not want such a deep concentration of power. As we said before in Have we escaped from the dangers of inflation?,

One final word: fiat money is only as stable as the government that enforce it, and only as safe as the stringency and integrity of the central banks who create it. Gold, on the other hand, yield to neither control nor will of any government.

That is why today, central banks are independent of the government, with complex and elaborate rules of money and credit creation (the exception will be Zimbabwe under Robert Mugabe). Our fear is that with this credit crisis worsening by the day, deflation may prove such a unthinkable threat (e.g. see How do we all pay for the bailout of Fannie Mae and Freddie Mac?) that the government will ‘roll back’ all these rules one by one in order to keep the entire financial system solvent. As the ancient Chinese saying goes, the journey of a thousand mile begins with the first step. Therefore, the journey towards a hyperinflation hell will begin with such measures (see Recipe for hyperinflation). Your belief in whether you will see hyperinflation in your lifetime will depend on your faith on the government to maintain the integrity of money.

Next, what if we let the people vote for the board of directors who control the central banks? If shareholders have trouble keeping the directors of their company honest and accountable, then it will be the same for the central bank.

A brief history of money and its breakdown- Part 2

Wednesday, January 10th, 2007

In today?s topic, we will continue from the previous topic, A brief history of money and its breakdown- Part 1 by touching on the gradual breakdown of the monetary system from two centuries ago till now. Today, the world?s money is totally fiat (money that enjoys legal tender status through the authority of the government instead of through the choice of the free market). Again, the recommended reading for today is Murray Rothbard?s What Has Government Done to Our Money? As Rothbard said in that book:

To understand the current monetary chaos, it is necessary to trace briefly the international monetary developments of the twentieth century, and to see how each set of unsound inflationist interventions has collapsed of its own inherent problems, only to set the stage for another round of interventions. The twentieth century history of the world monetary order can be divided into nine phases.

In the first phase, lasting from 1815 to 1914, the Western world was on a classical gold standard. Each national ?currency? was just a definition of a weight of gold. For example, the ?dollar? was defined as 1/20 of an ounce of gold. Each national currency was redeemable for gold on its pre-defined weight. Thus, if a nation were to recklessly inflate the supply of its money, it would run into danger of having its gold drained from its treasury. At this point, we must stress that gold was not any arbitrary choice by the government. Rather, it was the choice of the free market over the course of centuries as the best money. Thus, at that time, the world had a uniform money medium, which as Rothbard said, ?facilitated freedom of trade, investment, and travel throughout that trading and monetary area, with the consequent growth of specialization and the international division of labour.? Furthermore, such an international gold standard put a rein on government inflating the money supply as well as helped kept the balance of payment of each nation in equilibrium. Though it was not perfect, it ?provided us with by far the best monetary order the world has ever known, an order which worked, which kept business cycles from getting out of hand, and which enabled the development of free international trade, exchange, and investment.?

Next, the First World War arrived. Under the confusion of a wide-scale war, each warring government (except the United States) came off the gold standard and printed money to fund the prohibitive cost of waging war, which would not be possible under the gold standard. Thus, national currencies were devalued and fell in relative value to gold and the US dollar.

After the First World War, the most logical step would be to return to the gold standard at a redefined weight of gold for each national currency. However, British insistence at maintaining the unrealistic pre-war definition (due to national pride) led to their economic malaise. Instead of rectifying the folly of their ways, they induced and coerced foreign governments into the same mistakes at the Genoa Conference of 1922. This resulted in a gold exchange standard whereby (1) the US remained in the gold standard, (2) the British remained in a pseudo-gold standard and ?US-dollar standard,? and (3) the rest on the ?pound standard.? The outcome was a ridiculous pyramid of US dollars on gold, pounds on dollars and the other European currencies on pound. By 1931, as expected, the absurd gold exchange standard collapsed.

At this point in time, it was back to the post-war chaos of fiat currencies again. The US went off the gold standard partially?US dollars were only redeemable to foreign governments and central banks at a re-defined rate of 1/35 of an ounce. International trade and investment were at a standstill and ensuing economic conflict was said to be one of the leading causes of World War Two.

After World War Two, the United States led the way to a new monetary system?the Bretton Woods system. In this system, the US remained in a partial gold standard?US dollars were redeemable for gold by foreign governments. Other countries pyramid their currencies on top of the US dollars. Initially, the US dollar was undervalued and European currencies were overvalued. However, as time went by, with the US inflating their supply of dollars, their gold was increasingly being redeemed by European governments. Soon, it became harder and harder for the US to maintain the free market value of gold at $35.

By 1968, there was a crisis in confidence in the US dollars. The US then decided to abandon maintaining the US dollar at $35 in the free market. From then on, the US decided to ignore the gold free market and maintain the inter-government gold peg at $35. As expected, the free market value of gold soared above $35.

In August 15 1971, the US severed the last link between gold and the dollar. As a result, from then on, the world?s monetary system became totally fiat.

In December 1971, the Smithsonian Agreement was introduced to create some order by maintaining fixed exchange rates among currencies and without any gold backing. With the US continuing to inflate their dollars, fixed exchange rates were untenable. Finally, the agreement collapsed in February 1973.

Finally, that is what we have today?freely fluctuating fiat currencies. As Rothbard said,

Since the U.S. went completely off gold in August 1971 and established the Friedmanite fluctuating fiat system in March 1973, the United States and the world have suffered the most intense and most sustained bout of peacetime inflation in the history of the world. It should be clear by now that this is scarcely a coincidence.