Mechanical Economists and the Gold Standard

Bill Bonner writes well in the Daily Reckoning Australia about the difference between the humanistic viewpoints of classical economists and the technical viewpoints of modern day economists.

The first economists - the two Adams, Adam Smith and Adam Ferguson - called themselves "moral philosophers." They were studying the human economy as though it were an anthill -- to see how it worked. They figured it must follow rules - just like all other things under Heaven - and tended to see mistakes people made, such as spending too much money, as moral failings.

Modern economists are more like auto mechanics. They think they can control the economy with a screwdriver. And to some extent they're right. Which is why the world economy is in such a mess; they turned the wrong screws. But it's why we moral philosophers are having such a good time; finally, we get to laugh and say "I told you so."

Economic activity is inherently a human process, and economists would need a lot more understanding of psychology (especially mass psychology) and philosophy. Instead, they tend to treat economics like it was a branch of engineering. This is most strongly evident in the modern field of "financial engineering".

But Bill Bonner has a strange fixation on the gold standard, which is actually not so relevant in this issue. He writes:

Since then, the U.S. government could print almost as many dollars as it wanted. Arguably, it printed too many. For something - perhaps it was too much cash and credit in circulation - led American homeowners to think house prices would rise forever.

In this case it is mostly too much credit. Growth of cash has been relatively sluggish (except in the far east and the Euro zone). The reality is that the credit decisions of commercial banks are not tied to the amount of cash anymore. Reserve requirements have been taken to practically zero. And this has happened in a regulatory environment that has the near equivalence of cash and credit as a base assumption.

In earlier times, before the deregulatory wave of the last 30 years, banks were forced to acquire a certain amount of cash for each accepted promissory note. But this is not so anymore. The last major relaxation in the US was in 1995 when retail sweeps were taken into use. There is almost nothing in these regulations to relax anymore. Banks have been able to magic deposits from thin air by accepting huge amounts of promissory notes at a negligible opportunity cost.

This relaxation has been a main cause in the growth of speculative flows as well. When banks can accept a promissory note at zero cost to cash reserves, it is very easy for them to lend huge amounts to speculators that make leveraged short term bets on price fluctuations.

In earlier times banks had to find actual depositors for a fraction of each dollar that they lent out. But now they have almost no opportunity cost at all.

Without cash reserve requirements, the only thing that is left to limit the growth of credit is solvency, either regulatory solvency in the form of capital requirements, or actual solvency. It is only natural that any lower limits of a self-enforcing process will eventually be reached, so here we are, exactly where the deregulators put us, either willfully or unwittingly.

More importantly, the lack of reserve requirements has essentially decoupled the financial economy from any actual monetary policy. When no cash reserves are needed for the growth of credit, a gold standard would not have necessarily saved the banks from this kind of a "race to the bottom".

In a certain sense, a gold standard would have been a fear factor for the bank owners. It would have made many of the ongoing bailout efforts much more difficult, thus raising the impact of the current crisis. This would have encouraged more strident risk controls from bank equity investors, but not in any binding way.

Bill Bonner's orthodox take on the gold standard creates a strange contrast with the philosophical and practical outlook of the classical economists that he so admires. A strict attachment to a crude and inflexible tool like the gold standard is more like a mechanistic view of the economy.

After all, gold has no practical inherent value at all. It is durable and its quantity is hard to manipulate. But it has been responsible for some of the most useless undertakings in human history, like gold rushes, military adventures, occupations and wars.

Money can also retain its value too well in some situations. In a deflationary spiral, money is seen to have a rising value. But cash should only have value as a medium of exchange. It should not be infinitely storeable. Value is only in what goods or services people can provide to each other, not in some heavy and soft (if quite pretty) metal in a safe.

The purpose of monetary policy should be aimed at keeping people from excessive hoarding or excessive consumption, either of actual goods or of the medium of exchange. The only way to create actual savings is to invest in capital goods (no, commodities are not capital goods) that have a value in being able to produce goods and (increasingly) services.