April 21, 2011

Is our current monetary system sustainable?

This is a very complicated topic. I've been thinking about it (and things related to it) for a long time, and I still don't know what to think. I'd be delighted to talk about it for quite a long time - it's important and interesting. Here's some of my thinking - let me know what you think!

Here are my thoughts at this moment:

I think that the last 60 years have been quite exceptional - a real golden age. Can it be sustained? I tend to think so, but there are certainly a lot of risks.

I think the great majority of economists think that "fiat" money is a much better way to manage an economy. If you look at the years 1800-1940, you see a lot of deep recessions, like the one from about 1870-1890, which appear to have been at least partly caused by the gold standard. I think that the "establishment" (central banks, governments, big private banks, most economists, etc) isn't even considering going back to it, and would fight it tooth and nail. I suspect they'll succeed at that fight.

The fact that gold is in limited supply guarantees that under a gold standard periodic deflations will happen, most of them very painful and recessionary. A "fiat" currency can be expanded along with the economy, and a small amount of inflation (maybe 2%) can be maintained to encourage people to keep their money out of mattresses.

Hyper inflations of fiat currencies certainly have happened in the past. The biggest example I know of, Weimar Germany, was caused not by government incompetence or avarice, but more or less by fundamentals: France was taking revenge for the reparations that followed the 1870 war by demanding huge reparations from Germany after WWI, and Germany blew up their currency rather than comply and be impoverished.

The conventional explanation for the large increase in M1 is that the velocity of money dropped dramatically, so that the overall money supply (which more or less depends on "velocity x bank deposits") didn't really expand. That seems to make sense to me. Ufortunately, velocity is very hard to measure, so I'd say that the Fed is navigating by the seat of their pants. I'd say some inflation in the next few years (roughly 3-4%) is a good possibility. On the other hand, wage earners have no leverage at all, so a wage-price inflationary spiral seems very unlikely.

The level of US debt depends on what happens to oil prices and imports. Will we be smart, and move ASAP to hybrids, extended range electric vehicles like the Volt, EVs like the Leaf? Will shale-oil (like the Bakken, not Green River) production expand? We can only hope. Oil imports have dropped by 25% in the last 3 years - if we can keep that up, the US will be much stronger economically.

Regulation of the financial markets is lax, and this laxness caused the Great Recession. I'm afraid we're likely to see future bubbles and blow ups, though I'm not sure where or when. If we could figure that out, we could be rich! On the other hand, we've survived an awful lot of bubbles in the past - see "This time is different - eight centuries of fiscal folly" for proof.


Paul N said...

We should just go back to a gold standard - that will eliminate a bunch of the game playing that goes on.

The recessions of 1870 etc were not "caused" by the gold standard, they are caused by the behaviour of people. Gold is the most stable thing there is - it just sits there and stays shiny.

Unlike fiat money which devalues daily, if not faster. i don't think the mattress argument is relevant anymore - not many ordinary people have much money in cash, or ordinary bank deposits - it is mostly debt(!) or in other monetary instruments like bonds, mutual funds etc.

besides, without a gold standard, what then is the meaning of a "golden age"?

A "fiat age" just doesn;t have the same ring to it - except maybe to the Italians who drive them...

Anonymous said...

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