Friday, February 3, 2012

Money, Banks, and National Debt Unmasked - II

In a previous blog, realization that our money is both IOUs of the Fed and backed by computer spreadsheet entries might have raised some curiosity or incredulity. It might even make the arguments of certain US Congressmen and OWS protesters for a gold standard sound pretty good. That is, until we look into it a little further.
Gold Standard is Gone - Fortunately
The US was on a gold standard for a long time until President Nixon “closed the gold widow” in 1971. Since then, the US and most other countries have used a so called fiat currency, without gold backing (convertibility to gold).
A gold standard is based on a fixed price of gold by weight. The idea is that each dollar, would be backed by a fleck of gold. This puts a limit on the dollars the Fed can issue unless more gold is obtained to fill the needs of a growing economy. To obtain more gold, we must mine it, get it by exporting goods to other countries, or borrow it at some rate of interest. 
Because we engage in international trade, our trading partners would have to agree on some sort of foreign exchange formula or be on a gold standard also. Such an arrangement existed under the Bretton Woods system after World War II. Because the US had most of the gold, it had a gold standard, and other currencies were pegged to the dollar and were convertible to gold.
US currency was then constrained by the amount of gold reserves that could support it, and it had a fixed foreign exchange rate. Viet Nam war deficits led to several years of international turmoil and discontent over the operation of the existing monetary system. Then, President Nixon pulled the plug. He states his case in the following video.

Because a gold-standard currency is constrained in quantity of IOUs that can be issued and has a fixed exchange rate, it is inflexible to changes in either economic growth or international trade conditions. Consequently, a gold standard almost always collapses chaotically in a panic to cash paper money for gold after some unexpected economic event.
Fiat Currency Has Value
Unlike the gold standard, our fiat currency is unconstrained and has a floating exchange rate. There is no functional constraint on the quantity of IOUs, and international exchange rates can accommodate changes in international economic conditions. The system can flex rather than break.
Oddly, we still have laws that require the US to act as if we are still on a gold standard. So, we have goofy rules about debt ceilings and selling bonds that appear to fund government spending. We’ll get to those later in the series.
Whether gold or fiat, the value of money lies in its convertibility into hours of labor or the product thereof. We look at the following three factors that support our fiat currency.
National Productivity:
Increased productivity allows more output for the same effort or the same output with fewer workers. Thus, we either increase productivity or unemployment, and the former increases the dollar’s value. Whether the outcome is productivity or unemployment depends on the fiscal and monetary policies of government. It really is controllable even though recent experience suggests otherwise.  
Currency Stewardship
Federal stewardship of the currency is demanded by the Constitution, and Congress has charged the Fed with with containing inflation and maximizing employment. In the past 60 years inflation as measured by the Consumer Price Index has averaged less that 3.5% with some wide variations. Unemployment has been a persistent problem, that has been “solved” by accepting a 4 - 5% unemployment rate as a natural hedge against inflation. Modern Money Theorists reject this acceptable level and advocate a federal jobs program to maintain full employment and productivity.
Government must enforce taxes and require payment in US dollars to maintain demand for the currency.
Productivity, stewardship, and taxes together determine what we can buy with the dollar that forms the basis for market activity.
We should also take note that the US government is the only entity that can create the US dollar. Thus, our currency is sovereign. And as we have seen, our’s is a fiat currency that is unconstrained and has a floating exchange rate. The lack of constraint allows flexibility and policy options, and stewardship prevents reckless spending.
Other advanced countries have the same currency system. Unfortunately, countries in the Euro Zone do not have sovereign currencies. They all use the euro that can be issued only by the European Central Bank. Consequently, the EZ countries operate under a system of constraints that is a de facto gold standard. And, that is the fundamental fault underlying current EZ debt problems. 
The value of an unconstrained fiat currency with floating exchange rate outweighs that of a constrained gold standard with its fixed exchange rate. There is more to the story that will be addressed in subsequent blogs. 
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