TCS Daily


Understanding the Current Financial Turmoil

By Arnold Kling - August 21, 2007 12:00 AM

"Consider the case of Countrywide, which finances nearly one in every five home mortgages, almost all of them to "prime" borrowers, rather than the riskier "subprime" sort. Despite that commanding position, Countrywide's stock price has been halved since the start of this year. In fact, it's fallen so much that you could buy the entire firm for less than it would cost to buy its assets...the company has already suffered the bond-market equivalent of a bank run....markets are punishing Countrywide irrationally."
--Sebastian Mallaby

When I teach introductory economics, I take pride in using current news stories to demonstrate the relevance of the subject. For example, two years ago, my class at George Mason University began just as Hurricane Katrina struck the Gulf Coast, and the resulting spike in gasoline prices gave the story an economic hook.

This year, those students who are interested in current events (sadly, many of them are not) would be aware of turmoil in financial markets. Financial markets are outside the scope of my usual introductory curriculum, but this year I feel that I owe it to my class to offer an economic perspective.

The Value of Financial Intermediaries

A financial intermediary is a company, such as a bank or a hedge fund, that manages money for investors. For example, think of a bank that uses investors' deposits to fund mortgage loans to individual homebuyers.

Suppose that you want to borrow $400,000 to buy a new home. Your plan is to pay back the loan gradually over a period of many years. I would not lend you that money, for a number of reasons. I do not want my money tied up for such a long time. I have no expertise in appraising your home, so I do not know whether $400,000 exceeds the value of the property. I cannot afford to take the sort of loss that I would incur if it turns out that you cannot repay the loan.

The fact is that I do lend money to people for home mortgages. However, I do so through financial intermediaries. For example, the money I have on deposit at a bank can be used by the bank to fund mortgages. I do not have $400,000 on deposit, but the bank can combine my deposit with other deposits. I am not planning to keep my deposit at the bank for 30 years, but the bank can allow me to access my money whenever I want without having to call in its mortgage loans. The bank has appraisers and mortgage underwriters who are experienced at assessing the loan's viability. Finally, the bank is able to spread the risk of a default across enough borrowers so that even if you fail to repay the loan, the bank itself does not go under.

When financial intermediation is deep and competitive, borrowers pay low rates. In the mortgage market, for example, interest rates have been under 10 percent for many years. On the other hand, pawn brokers tend to charge much higher rates. Even though they are making loans based on collateral, pawn brokers are not as competitive or sophisticated at spreading risk.

The Risk Premium

One economic measure of the value of financial markets is what I might call the "risk premium." The risk premium is the amount by which the interest rate on the loan exceeds what is needed to adjust for the probability of default.

For example, suppose that it is possible to lend money for a year to a borrwer who has no risk whatsoever at an interest rate of 5 percent. On the other hand, suppose that if you borrow $100,000 for one year, the chances are one out of ten that you will default on the principal (but you will pay the interest). That means that on average the bank will lose $10,000 on the loan. If the bank charges an interest rate of 15 percent, then in one year it will get $115,000 if you pay up and $15,000 if you default, so that on average it will get $105,000, which is exactly what it would get lending to the no-risk borrower at 5 percent.

The bank is likely to charge you a higher interest rate than this expected breakeven rate of 15 percent. For example, it might charge 16 percent. The one percent difference between 16 percent and 15 percent is what I call the risk premium.

The entire difference between the 16 percent rate that the bank charges you and the 5 percent rate that it charges a no-risk borrower is a combination of two things: 10 percentage points are what I would call a default premium, and 1 percentage point is what I call the risk premium. Often, financial writers lump the two together under the term "risk premium." Terminology aside, it is important to distinguish between what I am calling the default premium and what I call the risk premium.

When the risk premium is low, financial markets are working very well. When the risk premium is high, then borrowers are unable to obtain credit at a reasonable rate.

Hide and Seek with Risk

In order for financial intermediaries to lower the risk premium, they develop skills at evaluating risk and changing the ways that risk is packaged to investors. This involves an element of hide-and-seek. Investors obtain insulation from risk through various layers of protection, without understanding how those layers of protection work. As an individual, you do not really know what makes your bank deposit secure (government deposit insurance is the ultimate backstop in that case).

More importantly, managers of large pension funds do not really know what makes some of their investments secure. For example, when they invest with hedge funds, those hedge funds are filled with exotic and complicated securities. It is impossible to know exactly what sorts of risks these hedge funds are taking--they have to keep their investment strategies secret for competitive reasons. The pension funds have to trust that the hedge fund managers know what they are doing.

The Recent Turmoil

What seems to have happened over the past year is that the hide-and-seek process in the financial intermediation process for mortgage loans to risky borrowers got out of hand. Some institutions wound up with more default exposure than they were expecting, based on the information that they could obtain from rating agencies or other parties. With some institutional investors burned in the sub-prime mortgage market, this has caused other institutions to question their own portfolios: which of our investments might have more potential to default than we have been allowing for? What if it turns out that bond ratings are less reliable than we thought?

The net result is that risk premiums, which had been trending down in recent years to historically low levels, have bounced back up in the past several weeks. This adversely affects companies, such as Countrwide Financial, that rely on their strong credit ratings to be able to finance their portfolios using low-cost debt. A small increase in the risk premium faced by Countrywide can cause an enormous drop in its profit margin.

Sebastian Mallaby calls this "irrationality" on the part of investors. Instead, I think of it as a breakdown in trust of the financial intermediation process. This breakdown is occurring not so much at the level of the average consumer, but among large institutional investors. Money managers who a year ago were willing to accept low risk premiums for securities are no longer willing to do so. No one is really sure whose tools for evaluating default probabilities are reliable and whose tools are not. Until financial intermediaries can re-establish the reliability of their estimates of the likely performance of various credit instruments, institutional investors will be skeptical of the hide-and-seek process. This will keep the risk premium high, with adverse effects on housing and business investment.

What Next?

Changes in the risk-premium tend to cascade. When the risk premium falls, financial intermediaries look for more profit opportunities. Their lower cost of funds allows them to compete to lower the risk premium for other borrowers. That is how sub-prime mortgage lending was able to gather momentum from 2003 through 2006.

When the risk premium goes up, financial intermediaries that have been very profitable suddenly find themselves squeezed. As their viability suffers, investors become wary and the risk premium rises further.

The question now is whether the financial markets will establish a new equilibrium soon or whether there will be further shocks leading to further increases in the risk premium, leading to more shocks, etc. If the equilibrium scenario unfolds, then Mallaby is correct and there are many bargains available to investors. But that could turn out to be a "picking up nickels in front of a steamroller" strategy if the adverse scenario were to unfold.

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34 Comments

Fiat currency
Maybe you could address how banks can legally lend more than their deposits creating a fiat currency.

way past that
I think we are way past the point of being able to talk about the financial system in terms of old-fashioned monetary theory. You have to talk about it in terms of the fundamentals of the price of time and the price of risk. See Perry Mehrling's book on Fischer Black and Finance to start to grasp the modern view.

Rationality
“…markets are punishing Countrywide irrationally”

The current stress in the housing and mortgage markets is primarily due to upward pressures on adjustable mortgage rates and the resulting increase in defaults.

Most lenders currently will give a prime borrower a 6.5% 30 year mortgage, but would charge that same borrower 7.5% (or more) for a yearly adjustable note after the first year. A 30 year note is far riskier than a one year adjustable one, and thus should carry a risk premium and a higher rate if the rates are set at the same point in time. A properly designed adjustable note should almost always have a rate that is LESS than the current 30 year rate offered to new borrowers. On an industry wide scale, this is currently not the case. This is because lenders use completely different processes to determine rates for fixed vs. variable instruments. From a risk and logical standpoint, the mortgage industry is broken.

Until the mortgage industry fixes their dysfunctional practices, the lack of confidence in the industry is very RATIONAL.

About time?
Or rather, "What about time?" Wouldn't a 1st-year ARM rate that is greater than the 30-year fixed rate simply be a signal that the financiers think the long-term outlook is for lower rates?

Fiat Currency
Why its the miracle of fractional reserve banking of course, however today, reserve requirements are almost nil, so its more like the miracle of the printing press.

The alternative, a commodity based money would be subject to disruptions from supply shocks, but the time for that has passed, I'm afraid, primarily because the idea of a central bank controlling currency as the best alternative is taught as an article of faith in most econ curricula today.

Rational
“…markets are punishing Countrywide irrationally”


Don't think so. We are at the point know where we know of the EXISTENCE of previously underestimated risks-now time will tell about the NATURE and EXTENT of those risks.

Lets not forget, markets FAIRLY VALUE companies based upon EXISTING INFORMATION. There's always a risk that the scope, breadth or nature of the problem isn't fully understood by management or investors.

The severity of the "punishment" is merely a premium on that uncertainty. If there's irrational punishment, by all means, go long.

Risk premiums come from where?
The article does mention the methods investors use to reduce risk. The best methods are to stick others by FORCE into holding the risk. The means are sinister. First, a nice Fed prints money making what you owe worth less AND if that fails then use Government Sponsored Enterprises like Fannie Mae to buy the loan at too high a price and dump the risk on the tax payers and if that fails then you have deposit insurance....

Of course the product of these helps (thefts from cash holding folks) is to create uncertainty in the value of future money. This leads to a sence that the Government has eaten all the risk and it who cares how much people borrow. Normally this chicanery works fine until the borrowers get over extended and can not pay off loans. Then it begins to unravel.

Of course the current Fed policy is EXACTLY WRONG!!! It should not keep bad investments going but stop these and let better investment get back some of the lost capital and continue to grow the economy.

Misconceptions about commodity based money
"..commodity based money would be subject to disruptions from supply shocks"

Sorry, but that is a mis-conception. Going back to a commodity-based money would not create a situation that would cause 'supply shocks' in and of itself. However, going to a poorly conceived and operated commodity-based monetary system would no doubt.

When the world was last on a de facto gold standard (Bretton Woods), the US dollar was backed by gold reserves of just $12 billion in gold bullion or so, believe it or not. Furthermore, the central banks were not stopped from creating base money to deal with any liquidity problems, like panics.
To be on a gold or any commodity standard, the chosen commodity itself need even be redeemable at all. The central bank can just get away with pegging the price of the currency to gold and maintaining it on the open market. That is why the term "Nixon closed the gold window" came about. This is what Argentina did with its dollar peg prior to abandoning it. And like the Argentina system, the US Bretton Woods system was just fine in and of itself. It was not broken, so to speak. In both the Argentine and US situations, what was broken was the politicians who couldn't live within their means and didn't like the hard peg to a commodity keeping them from raiding the cookie jar, so to speak.

What matters with regards to a currency is its perceived value. And in all fiat systems in operation today, the layers of mumbo-jumbo (fractional reserve banking) or, as Arnold Kling would say, intermediation, make it difficult for the rest of us to figure out what the 'value' of a currency is. Oh, we can determine what the relative exchange value of a currency against another, sure. But I'd press anyone to figure out what the absolute value of a fiat currency is.
And to answer any of you who would counter with belief that "it doesn't matter..what matters is what faith people have in the currency as a store of value and functionality of purchase power exchange", I would counter that that faith is predominantly determined by whatever perceived value people have. Because if I wasn't correct about this, then there would be no need for those FDIC stickers on the bank doors either.

Last observation to get us back on track to the topic at hand: Fiat or commodity currency differences don't have much to do with the financial intermediation issues Kling makes in this article anyway.


"Maybe you could address how banks can legally lend more than their deposits creating a fiat currency."

Banks have the ability to create CREDIT, not BASE MONEY (a.k.a. 'monetary base'). They had that ability under the gold standard just as much as they have it under a free floating fiat currency. Folks like the Rothchilds helped bring that about. People get confused about the two terms and what they mean when trumpeting the "Lets get off this fiat currency fraud where the banks get to create 'money'!"
A fascinating book to read on this subject is GOLD: The Once and Future Money, by Nathan Lewis. ISBN-13: 978-0470047668.

Banks have the ability to create CREDIT, not BASE MONEY
Lending more money than they have on hand is not creating money?

I agree about the value of money. It is what ever people decide it is. In a global economy with multiple currency systems and free trade in currency, the values probably settle out pretty well.

Refinancing a house based upon future worth or on a market that is increasing 10% per year is not creating money? Or at least inflationary?

gold standard
If I understood you right, it's not correct that governments could create fiat money on a gold standard, the way they can now, with money backed by nothing. That's one of the reasons they wanted to have central banks that could print money, so they could manipulate the economy; whearas with the gold standard they couldn't.

comparisons to pawn brokers
I liked the comparison with pawn brokers, who are actually like bankers too in that they lead money to people who don't have much credit rating with normal institutions. That's why you see so many pawn shop type places in crappy thrid world countries like the Philippines etc. Another lever too is that of just plain 'loan sharks' that also exist in underdeveloped countries. They'll often take all your gold jewellry, then spot you half its value, then hope you don't pay back the loan. Another angle for assessing credit rating for mortgages in the US is in the area where Google company is. Apparently in that area if the mortage guys verify that you have actually been hired by Google, them automatically assumed that their own vetting criteria could not be as good, so they just approve the mortagge to anyone who has been hired by Google.

Smashing Capitalism
"Global capitalism will survive the current credit crisis; already, the government has rushed in to soothe the feverish markets. But in the long term, a system that depends on extracting every last cent from the poor cannot hope for a healthy prognosis. Who would have thought that foreclosures in Stockton and Cleveland would roil the markets of London and Shanghai? The poor have risen up and spoken; only it sounds less like a shout of protest than a low, strangled, cry of pain."

http://www.thenation.com/doc/20070827/ehrenreich

To all who believe the government should control and regulate corporations, customers will perform that function more ruthlessly and efficiently than any government agency.

Supply Shocks
Sorry, but that is a mis-conception. Going back to a commodity-based money would not create a situation that would cause 'supply shocks' in and of itself.

Uh, sorry but yes it would-especially when money has been based on metal-everytime there was a big find,there was a supply shock. Even with satellite imagery and all the other tools of the moden extractive industries-there will be unexpected finds of precious commodities here and there, just as a few years ago, a guy with an interest in geology became convinced that there were emeralds?/sapphires? in North Carolina-although professional geologists disagreed. Weeks from ruin, he was proven right.

Beyond certain numismatic or industrial purposes, gold has little intrinsic use. It is valuable to me only because I expect it to be accepted in trade. A huge find would flood the market.

Looking at history, this was the rule, not the exception. While this had little to do with being "poorly designed", show us a durable effectively designed monetary system OF ANY KIND. Expecting governments to suddenly be effective architects of economic systems is a dream of the utopian left.

Wow
Marjon, thanks for your work in extracting that turd from the house organ of political coprophiliacs, its good to be reminded how odiferous their product really is.

the exception and the rule (as it really was).
"Uh, sorry but yes it would-especially when money has been based on metal-everytime there was a big find,there was a supply shock. A huge find would flood the market...Looking at history, this was the rule, not the exception."

Sorry, not true (about the rule/exception part). For the last thousand years or so, the average annual increase in total gold has been less than 2%. The exceptions were when New World gold plundered from Mesoamerica flooded Europe and the California/Yukon gold rush periods of the second half of the 19th century.

Again, misperceptions on this thread abound
"Lending more money than they have on hand is not creating money?"

Nope. Because they don't create MONEY. They create CREDIT.
CREDIT is not MONEY. Credit is a type of contract denominated in money. A bank deposit it not money either, but a debt instrument like a bond and thus another contract denominated in money.

The IOUs your grandma had you write out when you borrowed $5 from her is also a debt instrument denominated in money (unless she was smart enough to denominate it in labor like mowing her lawn).

But, all monetary transactions take place with BASE MONEY. Now if two banks cancel out checks (IOUs denominated in money) drawn against each other instead of going the extra mile and converting the drafts into actual money, that's a financial transaction. Thus, as far as this little topic goes, the term 'monetary' thus refers primarily to changes in the value of currency and the term 'financial' refers primarily to changes in credit relationships.

It may seem that you buy stuff with money in your bank account or from your credit card, but that's because the bank automatically takes care of the technical details involved in repayment of your bank credits in base money -- specifically, from banking reserves held at the Fed.

Likewise, the expansion of credit is not a monetary expansion and not inflationary because it does not alter the value of the currency. When the Fed creates more base money (like it is doing now to smooth over our little Sub-Prime Liquidity Crisis), THAT is what is inflationary.

Asset value pricing bubbles such as overpriced housing markets are not monetary inflation, although they can be exacerbated by them. When they pop, the liquidity crises that ensue can bleed over to deflationary effects on the currency, depending upon how the central bank handles it. This is regardless as to whether we have fiat or gold or 8-track tape - based currencies.

All of these are important distinctions in understanding how money, credit, fractional reserve banking and such really work. It is a real brain-twister, I admit.

Some 'conceptual disinentangling' needs to occur here.
You are confusing the monetary system with the banking system in place. Whether a currency is fiat or based on cowrie shells or whatever doesn't mean financing is or is not handled by the banks via fractional reserve banking. They can -- and have in the past just as now -- coexist with each other.

Now I am against fractional reserve banking as a matter of principle, but not because of anything to do with whether or not we have a fiat currency. I personally prefer a debt-free fiat demurrage currency. But that won't ever happen. http://en.wikipedia.org/wiki/Demurrage_(currency).

What does matter is how they relate to each other. If a central bank has a peg on gold or silver or another currency (the dollar or euro), it must keep the declared value of their currency in relation to that commodity in sync no matter what. It does so by either creating base money or destroying it. Another way is to directly purchase or sell quantities of the pegged commodity. And since the amount of credit banks can cook up is dependent upon the base money they have on reserve at the central bank, then the total aggregate limit of credit creation is thus tied to the total aggregate amount of base money in reserve.
Since presumably the central bank can't create gold or silver or other commodity they peg the currency to, then they can't create base money willy nilly like as happened to EVERY fiat currency in the history of mankind. It is not so much as a limit as it is a breaking mechanism, for all real-world practical discussions.

In fact, a central bank can peg its currency to a commodity it doesn't even have any reserves of! It just has to peg the VALUE of the chosen commodity in terms of the currency being pegged. To maintain the peg, scroll back up and read about the mechanics of doing so in the previous paragraph.

So, no. Going back to a gold standard does not mean the end of fractional reserve banking. It does not even mean that dollars have to be redeemable in gold. It just means that the peg determining the currency's value in that commodity on a transparent and open market has to be maintained.

What is money?
Whatever you say it is?

Seriously, ultimately, money represents energy.

Money is..
A claim on wealth so powerful that it is confused with wealth.

Anything that represents a standard of value, a store of value and is accepted as a medium of exchange. In various times and places, beads, tobacco, pepper, gold, silver and enormous practicably immovable stones (island of yap) have been used as money. We currently use metal coins, specially inscribed paper and specially coded ones and zeros on computers as money.

I know the Gold Standard is Utopia but...
Averages can conceal wild swings and any measure of central tendency is useless without a measure of variability.

In any case, those shocks were highly disruptive.

The gold standard had positive attributes, but it isn't perfect and it certainly isn't magic, as some orophiliacs would have us believe.

pegging currencies
If you peg a currencie to something that you don't have any of, then it's still a phoney, fiat currency. But in a true gold standard say, the currency must be backed by real gold, which cannot be made, but only gained by trading. That's why politicians hate it, because they can't control it. There is a vast literature out there on partial gold standards etc. as you talked about. The british tried a partial one and it didn't work. But since governments are not as interested in proper economics as they are in control of people, I also don't hold my breath about it. We all just have to try to do our best under coercive, repressive, predatory parasitical regimes.

What is base money?
It could be a number written on a piece of paper or stored on a computer disk.

But that number has to have some basis referenced to the value of something.

not perfect, but best so far invented,eom
,

Base money on energy
Gold and silver were used as money for their unique characteristics, rare, pretty, easy to work, and resistant to corrosion.

It led to the mad rushes to find the metal and to government controls of the metals.

If money were denominated in units of energy, everyone could easily participate in finding money and the incentives for using less energy and finding more energy and more efficient energy sources would be enhanced.

In many ways, modern money is tied to implicitly tied to energy, but explicitly defining money as energy would certainly change a global paradigm.

Putting it Simply
"When you or I write a check there must be sufficient funds in out account to cover the check, but when the Federal Reserve writes a check there is no bank deposit on which that check is drawn. When the Federal Reserve writes a check, it is creating money." ~ 'Putting it Simply', Boston Federal Reserve Bank

"Banks lend by creating credit. They create the means of payment out of nothing" ~ Ralph M. Hawtrey, Secretary of the British Treasury

"Most Americans have no real understanding of the operation of the international money lenders. The accounts of the Federal Reserve System have never been audited. It operates outside the control of Congress and manipulates the credit of the United States" ~ Sen. Barry Goldwater (Rep. AR)

"Give me control of a nation's money and I care not who makes it's laws" ~ M.A.B. Rothschild

"Every Congressman, every Senator knows precisely what causes inflation...but can't, [won't] support the drastic reforms to stop it [repeal of the Federal Reserve Act] because it could cost him his job." ~ Robert A. Heinlein, _Expanded Universe_



The Federal Reserve
is not federal, and it has no reserves.

If you believe anything else, then you're simply under a magic spell.

That's a clever magical incantation you've intoned more than once: "base money". Heh.

Money itself is the instrument by which I might exchange some of my wealth in return for a product or a service that I don't have the time, ability, or resources to produce or perform myself.

You don't seem to realize that you are, albeit unintentionally (I think), equating credit with wealth. But credit is not wealth. In the realm of finances, credit is faith--and faith is "the substance of things hoped for, the evidence of things not seen." Credit is the measure of some other person's or group's belief that you either elsewhere possess or very quickly could gather a certain amount of wealth if called upon to do so.

People with poor credit ratings have not demonstrated the best ability to gather wealth and they have not demonstrated that they have much wealth.

This principle shows forth why people correctly note that the people who need a loan the most are the ones who are least likely to be able to qualify for one.

The words "wealth" and "health" have the same root, which means "wholeness". However, "credit" comes from Latin roots meaning "loan" or "entrust".

Fractional reserve banking turns entirely on the idea that many will deposit, but few will withdraw, at any given time.

So. All credit must be based squarely on wealth. Wealth must be based squarely on something real, actual, tangible.

The concerns being expressed here are that banks are very often plagiarists; crediting themselves wealth that they do not possess.

base money
Gold isn't just resistant to corrosion, it's pretty much indestructable. And i'ts very limited supply meant that it retains value. I know they say that energy cannot be created or destroyed, but still there is so much of it in various forms, that it couldn't be used as a base for currencies. In the same manner, you couldn't base it on other things either like water, or oxygen, etc. Gold is the best one so far, and that's why it was valued over all history, by most cultures of the world.

Silver can be destroyed
Set some by a fast neutron source for a while and you won't have much left after a while.

Maybe gold can be transmuted.

Why not platinum or some other rare metal for money.

Gold only has real value in its inherent properties, high conductivity, low corrosion and high reflectivity.

All other value is based upon what society adds by valuing it for money.

Energy has real value because it makes things happen.

Gold only has the value you and others give it to put in your safe.

I remember reading a science fiction book about a post nuclear society. Gold had become radioactive. Some value.



silver and gold and platinum
I said gold, not silver re destruction. To say that 'maybe' gold can be transmuted is some kinda mystical notion, or like alchemists trying to change lead to gold. Also, re gold becoming radioactive; I don't believe that can happen, or at least it HAS never happened. Platinum also not as good as gold. Even tho its price is usually higher than gold, its not as usuful as a base for a currency. Unlike gold, platinum can be corroded by cyanides, halogens, sulfur, and caustic alkalis. This metal does dissolve in the mixture known as aqua regia (forming chloroplatinic acid). So its not as stable as gold. I think it can also have medical side affects when exposed to humans, in some of its forms. Also it has been around for hundreds of years, and women would still rather have a gold necklace than one of platinum because gold has a good feel and look to it, whearas platinum is more like a gray hunk of steal. I've heald gold bricks in my hands, and anyone who has done that knows why it has been valued by most societies over humankind. It should be the base for money so that governments cannot manipulate it as they do now. But that's why politicians hate gold, they prefer control over economic soundness.

Base Money
Base Money (as I and others of the classical economist leaning) is simply cash (coins and notes) plus bank reserves at the Fed.
Only the Fed can create base money. Banks create credit, constrained only by how much base money they have on reserve at the Fed.
When the Fed 'creates' money, it buys bonds for money it creates in thin air. When it wants to 'destroy' money, it sells those bonds and then deletes the moneys from that sale forever.
Cash involves more steps, as cash is physical and needs to be transported, stored, etc.
To peg a currency to something (euro, dollar, gold, etc.), it is commonly believed that the bank or currency-board needs to have actual reserves of the commodity in question. But that isn't so. All the bank needs to do is increase/decrease the base money supply to keep it roughly at par with the commodity. So, if gold is trading on the open markets at $520 = 1 oz and the Fed wants to keep parity at $500/oz., the Fed just has to decrease the base money supply appropriately until the par value is achieved. If gold is prices at $480, they would increase the base money supply the same way. That's it. No messing around with interest rates or all that drek is needed. The central bank doesn't even need any pre-established reserves of the commodity in question, either.

Estonia operates its hard link to the Euro exactly that way.

What matters isn't the amount of gold/commodity available. Nor even the amount of dollars, per se. What matters is the price information. What is the value of the dollar in relation to gold/commodity.

Redeemability (i.e., I take $500 to a US mint and expect 1 oz of gold for it), need not be required either, as modern communications and banking systems make it possible for those who want gold for their dollars to just buy it on the open market (minus transaction, security and transport fees, of course). In fact, it is those buyers/sellers whom the central bank depends upon to send the price signals they need to monitor in order to know what to do with the base money supply.

Now, as to the 'why', well fortune smiles on me. A new TCS Daily article on this very subject was release a day or so ago: http://www.tcsdaily.com/Article.aspx?id=082407B

Simplistic Syllogisms Don't Cut It
Banks can create credit, but not base money. Only the Fed can create base money. Banks create credit. Credit is not the same as base money.

When the Fed 'creates' base money, it does so by buying bonds and other assets of such value. So, when the Fed wants to increase the base money supply by $10 billion, it creates the money, buys the bonds valued at $10 billion total. The bonds become collateral or asset reserves for the base money created.
When the Fed 'destroys' base money, it does so by selling such assets and removing the money gained from those sales from circulation.
Either way, there's a 1:1 ratio of assets to currency out there. The Fed can buy back all the base money it has ever created should it feel like doing so.

Banks do create credit. But in order for you (the borrower) to use it for something, like buying a car or house, the bank still has to use base money from its reserves to do so. But, most banks have a flow of base money coming in as well as going out. So, they can cover the transaction. To you, me and Robert A Heinlein, the distinctions I just made are all invisible. If the banks can't cover it, they have to borrow from the money markets or (last resort) from the Fed. The Fed thus functions as a lender of last resort to deal with short-term liquidity problems of exactly that nature. But either way, the bank has to cough up the real base money, when the time comes for you to use it after getting that loan or line of credit. If they didn't, you could sue them for breach of contract at the very least. The banking regulators would come down on them hard, too.

Thus, the primary reason why I take on these notions that are the core concepts behind all those quotes is simply that people don't understand what is credit and what is 'real' money and how they interact in our financial and monetary systems. It's a real mind-bender and I only know what I know from repeatedly coming across these concepts in my various on-going education on the subject. In fact, most people who work at banks don't know any of this either.

Gold was chosen because of its stability in value/quantity
Gold is stable. I know that doesn't look like it when you see the history of the price of gold over the past 25+ years. But remember, those are prices in DOLLARS, the supply of which has been anything but what could ever be called stable during that time period. The quantity of gold and increases of it have been dependable to an almost exacting degree.

The supply of gold for centuries has increase a little less than 2% per annum. There have been hiccups like when the Spanish raped the Aztecs and Incas or when the California & Yukon gold rushes occurred. But by and large, the supply of gold has remained quite ultra-stable.

The only thing I can think of that would interrupt that would be if somebody was finally able to find a gold rich asteroid and was able to economically mine it. Then, gold's value would take a sharp hit.

Anyway, prosperity requires stable currency. History has proven this overwhelmingly for sure. And by definition, 'stable currency' is not one that is tweaked by policy makers (which has been the case since even before the end of the Bretton Woods system), either. There have been other periods of time when floated currencies were issues. But they always ended with return to a gold standard. Silver lost its value big time when most nations gave up maintaining bi-metallic standards. Pegging a currency to a basket is not stable for the same reasons the bi-metallic standards weren't.

Gold will disolve in mercury.
That's how they painted the domes in Russia.

As to the main point, gold has little RATIONAL value except for those industrial properties of high conductivity and reflectivity.

Because is was pretty, rare, and easy to work it lent itself to becoming an easy money.

But it is only money if someone is willing to take it as money.

Gold can be just as easily controlled as any other money by governments. The USA fixed the price to limit further exploration.

Diamonds could be a valid money. It is rare and pretty and difficult to create.

If money were based upon fixed quantities of certain commodities, I could see that as having functional value.

I don't disagree that politicians don't want to fix money to something they can't control, but I don't believe gold is a rational commodity to be used for money.

I would rather be able to trade a Euro or dollar for a gallon of oil or a bushel of corn or a gallon of ethanol or a quantity of Pt. Even gold cold be part of the commodity basket, but its value would be based upon its demand for industry or for jewelry.

Gold was chosen also for control
The state controlled gold just as it controls any other money.
The USA hastened NV entry into the USA so it could use its silver.
No mater what you decide is money, the state must control its value.
Unless you advocate no state control of any money?

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