Chapter 2: Findings and Analysis- Growth Problem - National Reserve Currency

2.10   Growth Problem

Gold

Fiat supporters have always argued there is not enough Gold in the world to fund the global economy and international transactions.

The total amount of gold that has ever been mined has been estimated at around 165,000 tonnes. Assuming a gold price of $1,500 per ounce, the total value of all the gold ever mined would be around $6.8 trillion. This is less than the value of circulating money in the US alone, where around $1.4 trillion is in circulation and another $11 trillion exists through banking deposits.

The real problem is not that there is too little Gold but the fact there are too many dollars in the world. The US, which has the dollar as its national currency, can continually print money to meet its economic needs because international financial markets and global commodities markets are all priced in dollars.

The money stock in the world far exceeds the value of the global economy. The banking industry creates money through loans and mortgages. It is here the advocates of Fiat argue that the more money existent in an economy the more growth. In reality more money has created more inflation. The need to create perpetual economic growth has driven western economies to print ever more money creating one economic crash after the other. The case in point is not the insufficiency of gold in the world but the instability that unrestricted Fiat brings to national economies.

The proponents of Fiat money argue money plays a crucial role in the economy since sufficient amounts of money need to exist in the economy for transactions to take place. The more transactions that take place the more wealth is created. Monetarists have long argued that giving up such an economic tool handcuffs a government. With the Gold Standard new gold would need to be mined in order to increase money supply and this would impact economic growth.

Capitalist economic growth requires the economy to continually grow, which in turn needs consumers to continually spend, the availability of debt allows this on a massive scale. Pro-Fiat economists believe the ability to print money freely drives economic growth. Whilst a certain amount of money is needed for transactions to take place, in almost all cases of Fiat economies the amount of money always exceeds economic activity that creates inflation and destabilizing the economy.

The last decade saw the financial sector, which was the driving engine of Western economies stimulate economic growth. Through the creation of nearly $1,000 trillion this artificially drove a housing bubble that stimulated the other aspects of the world economy. All of this took place with a real world economy of only $50 trillion or so. The growth in the economy was false, artificial and unsustainable while the recession and its adverse impacts are all too real.

The Gold Standard would have restricted the amount of credit in the global economy and ensured a credit driven bubble never materialized. Since liquidity cannot be accessed either through printing or through interest based credit, the productive activities leading to growth are risk sensitive and sustainable. Unsustainable growth is when the growth is not able to continue without causing socio-economic problems, the potential of which is repeatedly witnessed in the interest based Fiat system.

Economic growth, unemployment and money creation all need to be separated from each other. Economic growth has become synonymous with low unemployment and manageable inflation. Economic growth in any country is more then just these factors. Economic growth can also be driven by competitive labor and consumer markets, it can be driven and supported by innovation and strong public infrastructure. These supply side factors absorb any inflation created from the demand side of the economy. Thus without the supply side of the economy, money creation in the hope of manufacturing demand will just lead to higher prices.

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Chapter 2: Findings and Analysis- Price Instability Problem - National Reserve Currency

2.9     Price Instability Problem

Where open markets operate, the prices of goods and services are determined by changes in their respective demand and supply. Money or currency is used to denominate the prices of goods and services where the value of a currency is determined by the quantity of goods and services that can be bought with a given sum of money.

Increases or decreases in the supply of money itself may cause a general increase or decrease in the prices of goods and services irrespective of supply and demand conditions within individual markets.

Michael David Bordo argued that the adoption of the Gold Standard leads to price instability in the short term and that this inhibits economic activity. At the same time and perhaps paradoxically the Gold Standard is said by others to cause deflation. However, when investigated empirically both assertions are contestable.

Despite the predominance of Fiat currencies in the world today, the first point to make is that over the last 250 years or so, implementation of the Gold Standard has been the norm rather then the exception. Since the beginning of the Industrial Revolution to the start of World War I - in excess of 150 years - the classic Gold Standard was implemented in the major economies of the world.

Looking at the Britain, where the Industrial Revolution began and being the dominant world power in the eighteen and nineteenth centuries, Table 1 above presents inflation in the UK since 1750 as recently published by the Office of National Statistics [3]. In these first 50 years, inflation averaged a steady 2% per annum.

Following a deflationary period between 1801 and 1851 when inflation averaged -1.2% per year, in the next 50 years prices rose by 0.3% per year followed by growth of 0.5% per annum to 1914 when the Gold Standard was abandoned in order to finance the war effort. Average annual price inflation of about 1% over the period 1750- 1914 suggests the classic Gold Standard produced unprecedented long run low price stability.

The evidence on inflation for the UK at least is clearly at odds with the argument that the Gold Standard causes deflation. Between 1800 -1914, UK prices were almost as likely to fall as to rise, when average annual inflation was close to zero. Since this was often caused by an increased supply of goods and services and not by a shortfall of demand, the resulting deflation was benign. Prices tended to rise when many countries abandoned the Gold Standard, during the First World War. As countries aimed to restore the Gold Standard at the pre-war parity in 1925, prices were required to fall back - resulting in policy induced deflation. This expectation of prices to fall helped contribute to an environment with relatively flexible prices and nominal wages.

From 1925-1929, the falling prices and increasing output make this deflation to be the likely consequence of beneficial developments reflecting the increased ability of the economies to provide goods and services. Since WWII, there have been few episodes of deflation worldwide, with UK experiencing an average inflation of 7% since then.

Between 1999 -2005 an unwinding of inflated asset prices associated with a crisis in the Japanese banking system prompted deflation in Japan, where consumer prices fell by an average of 0.5% per year. The argument of short-term price instability solely hinges on relatively high coefficient of variation ratios over the period of the Gold Standard (as cited by Bordo). However the coefficient of variation is a highly unstable statistic when the average (mean) of a dataset is close to zero as was the case with relatively low and stable long term inflation over the period of the Gold Standard. Thus the high coefficient of variation shows spurious short-term variability over the period of the Gold standard and is an unsuitable and improper measure of statistical variation.

Far from destabilizing markets, short-term price variability around a low average in actual fact suggests markets were providing effective signals for producers and consumers to actively engage in economic activity during the period of the Gold Standard. Indeed the unprecedented increase in industrial and agricultural output and international trade during the Industrial Revolution suggests the implementation of the Gold Standard had no apparent adverse or lasting impact on the economy. This is shown by the 0.5% per annum growth in the UK’s GDP per capital between 1750 and 1850 [4] - during implementation of the Gold Standard - allowing for the increase in population and inflation. Steady though unspectacular growth implies the Gold Standard had no underlying adverse impact on economic activity. Economic activity rose ahead with inflation and population increasing ‘average’ livelihoods, in spite of the inherent disparities in income and wealth created by capitalism.

Looking at the experience of Britain, this period between 1750 and 1914 of the implementation of the Gold Standard can be contrasted with the following decades when the Gold Standard was intermittently or partially implemented.

The Gold Standard was abandoned between 1915-1925 and 1932-1945 with inflation in Britain rising by 5.4% and 3.8% respectively. 1946 to 1971 saw the partial implementation of the Gold Standard through the Bretton Woods system and inflation rose slightly above 4% per year. Since the demise of Bretton Woods the UK’s inflation has been very variable exceeding 8% per annum between 1972 and 1993 with Fiat currencies in operation.

The Gold Standard anchors a currency to a relatively fixed monetary base guaranteeing low inflation, with possible periods of low deflation. In contrast Fiat currencies have a tendency to generate inflation – often at high growth rates - even allowing for the mitigating effects of restrictive monetary and fiscal policy.

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Chapter 2: Findings and Analysis- Supply of Gold Problem - Fear of Deflation - National Reserve Currency

2.8     Supply of Gold Problem - Fear of Deflation

Gold

It is often stated that there is insufficient gold in circulation to account for all the trade around the world. Estimates of the value of gold are in the region of 6.5 trillion dollars and the world’s GDP, as far as the real economy is concerned, is around 50-70 trillion dollars. How then could Gold currency be used in place of the Fiat currency that has replaced it?

In light of the above, it is argued that countries which transition to a Gold Standard would clearly not be able to maintain current prices and the realignment of prices would occur leading to significant levels of price deflation across all sectors of the economy. After this initial drop, then relative stabilization would occur.

At the heart of this criticism of the Gold Standard is the aversion and irrational fear of deflation. To refute this dogma, an analysis of the supposed harms of deflation will be discussed along with an alternative view of how deflation can be a positive force in the economy, not being a trigger for recession and also a positive force behind the distribution of wealth in an economy. Deflation is argued as a bigger evil than inflation for numerous reasons including the following:

• It increases the burden of debt as debts increase in real terms as money is worth more when prices are falling.
• It is suggested that people will delay purchasing goods and services in anticipation of prices falling further with an attendant fall in demand thereby leading to a vicious spiral towards recession and ultimately depression.
• It renders monetary policy ineffective as there is no incentive to borrow and therefore no way that central banks can instigate a self-sustaining recovery. Some theorists such as John Maynard Keynes called this phenomenon a liquidity trap.

In response to this charge it is clear that many products have experienced rapid sales growth during prolonged phases of deflating prices due both to technological advancements such as the growth of ecommerce, or periods where growth in output has outstripped the supply of currency. The former would cause prices to deflate in specific sectors of the economy whereas the latter would cause a general decrease in the prices of all commodities as the ratio of money to goods and services would fall and a smaller quantity of money would need to cater for a larger volume of trade and hence each unit of money would be worth more in real terms (manifested in a drop in prices).

Trade and investment is not inhibited by prices that fall as a result of increasing efficiency. The growth as a result of the industrial revolution is ample evidence of the case where entrepreneurs can effectively anticipate and predict price and cost trends and make informed decisions in the present time to ensure maximum benefit. Had this not been true, then the declining cost of communications technology would have seen many technology companies go out of business instead of an increase in growth and market presence as new market participants can now afford such products thereby increasing sales even further.

One of the reasons cited by the Keynesian school for deflation being a precursor to a recession is that while the selling price of goods and services are falling, cost prices, especially wage costs, are resistant to a corresponding fall and as such business start to increase redundancies which has an effect of lowering the overall level of demand in the economy which further exacerbates the fall in prices into a perpetual downward spiral until the government steps in to break the process and starts to exert its own demand through starting projects to compensate for the private sectors shortfall in demand.

The challenge here is to demonstrate how the costs of production can fall to enable businesses to remain competitive in such a deflationary climate and thus not suffer the ill effects described above. If businesses were able to drop their input costs and by so doing preserve their profitability, they would be relatively immune from the effects of declining prices.

Price inflexibility especially downward cost price movement can occur in areas such as labor costs where it is referred to as ‘wage stickiness’, or in other factors of production such as rent on land, due to long term leasing contracts which are hard to renegotiate. Wage stickiness can occur due to psychological factors as individuals look to the nominal rather than the real value of money. This concept is known as ‘money illusion’ as the phenomena where workers will be less inclined to accept lower pay despite the fall in prices than they will argue for their wages to rise when prices rise. If workers realized the contradiction they would be less likely to resist wage cuts especially if they saw the wider implications on their job prospects and on the wider economy.

Flexible labor markets are therefore a necessary condition to counter the negative effects of falling prices in product markets. In Islam there are various concepts such as the notion that Allah provides the sustenance and also a clearer concept towards value, in this case the value of money as defined by its purchasing power, to ensure the market does not suffer from such inflexibilities.

In contrast to this notion of measuring utility as a standalone feature of a commodity, the early Capitalist theorists (the Marginal School) adopted a concept of value called the theory of diminishing marginal utility which defined the value of a commodity as its utility at the point of consumption when satisfying the weakest point of need; this level of utility enabled the comparison of commodities for the purposes of exchange.

Money naturally became the universal good which acted as this scale for the measurement of the value of all things. The problem however was that with this ratio (called ‘price’) people started to measure the value of objects through the prism of price instead of the inherent utility of the object. Hence if the price or absolute amount of their pay is reduced, the implication being that this must be a bad thing.

The implication of this confusion of looking at value through price is clearly demonstrated in the example of the phenomena of money illusion were workers cannot see the real value of their wages. Instead workers think about their wages in nominal terms measuring their pay through a nominal construct in the form of an absolute monetary amount devoid of real value, in this case real value would be through the purchasing power of money.

Had market participants been operating in an Islamic economic environment with clarity over these concepts (in the case of value became confused by early classical economic theorists) and thus been able to see value in real terms, then the correct view of the worth of ones wage in a deflationary phase would have resulted in workers more likely to accept lower wages knowing that the purchasing power and hence value of their pay would not be affected as a result. Furthermore the constant fear of inflation associated with the Fiat system exacerbates this fear and further discourages workers to accept pay cuts.

Furthermore, a 1999 study in North America entitled “Why Wages don’t Fall During a Recession” by Truman Bewley [published by Harvard University Press], which was based on interviews with over 300 businessmen union-leaders and recruiters, found a huge disparity between the theoretical modeling of wage stickiness and actual causes.

The study cited reasons such as employers fear or lowering worker morale out of fear that lower nominal wages would lead to a lower standard of living. The study found that employers would fear an increase in staff turnover and this is very costly. The implication being that employers would rather lay off a percentage of workers as a means of reducing labor costs to counteract this effect instead of dropping wages. Clearly if the reality of money illusion was clarified, and the view towards value was understood, then the reluctance to lower wages would be minimized and so would the negative effect on morale which acts as an impediment to lowering wages.

In conclusion to this point, it can be said that wages and other input prices would need to fall to help the market readjust to new equilibriums necessary to avoid the downward spiral towards contraction of the market towards recession, high unemployment and ultimately depression. However if the underlying investment were not robust enough to withstand such shocks then it would be better for the business entity to fail instead of being bailed out by the taxpayer.

Finally as far as people delaying making purchases, this is an argument which is blown out of proportion to justify the Quantitative Easing (QE) programs that target the creation of inflation to counteract the deflation described above. If wages are more flexible as shown in the preceding analysis, then the incentive to delay a purchase when wages will fall, potentially before the drop in the price of the good or service in question negates this false dogma.

It must be noted that advocating a bimetallic standard that’s gold and silver providing the monetary based. The bimetallic standard will augment the money supply, as it would not rely upon gold alone.

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