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A short lesson in large scale economics

written by jacob, on Sep 7, 2011 9:17:55 PM.

I apologize for the length of this post, but somebody is wrong on the internet. A while ago, I wrote a blog entry on Bitcoin and Deflation. I got several comments that disagreed with my conclusions including one from William Andressen who pointed me to a book by Murray Rothbard arguing that we should reintroduce the gold standard and a comic book by Irwin Schiff which tries to explain the economic system in simple terms.

They are both quite good reads, as far as they go. Indeed, I would recommend them as rather good starting points for anyone trying to understand where money comes from and how the fiscal system works. However, your model of money after reading these works will be extremely simplistic and totally inaccurate. You need to learn more before you actually have some working understanding.

A fixed size economy versus a growing one

The omission that both books make is that they assume that the economy is of a fixed size. Under those circumstances the model they are advocating actually works. You can have a gold standard, because the availability of gold is not going to change very much. Compared to the amount of gold in circulation, the amount that is lost in industrial products and dropped to the bottom of the sea is small, as is the amount of gold mined each year. If the amount of gold would increase a lot in this economy that has no increase in products or services (like it did when the conquistadors brought the gold of the Aztecs, Mayans and Incas to Europe), you get inflation. If, instead, the gold would be consumed in industrial processes and not be recoverable, you would get deflation. The gold would increase in value as it got more scarce.

In a growing economy, gold becomes more and more scarce because it has to represent the value of more and more goods and services.

There are two things that cause economies to grow - improved efficiency and population increase. The first one once consisted of finding more land to extract resources from and inventions to get more out of existing resources. Except for very brief periods the global population has been growing in historic times. The Black Death was a remarkable exception and it was followed by an economic depression that makes the Depression in the 1930ies look like a walk in the park.

So, when the economy grows, the money supply needs to grow. Otherwise you get deflation. We will soon return to why deflation is such a bad thing.

The character of a good currency

The reasons why gold was such a good currency standard were several. The first one is that gold is extremely stable and durable. It stays the same and does not tarnish. Second, it is rare enough that a reasonable amount of wealth can be carried around (though the limitations were a factor in replacing gold with paper money). Third, the available supply of gold is stable enough that people expect very few surprises. (If we found 100 000 tons of pure gold under the ice in Antarctica, it would have a dramatic effect on the gold price. It would also come as a total surprise.) Fourth, the supply of gold historically grew at about the same rate as the general economy. This was not true in the years from WW2 until the gold standard was abandoned. In the 1980ies and 1990ies, the growth of the gold reserves exceeded the population growth, but in the last 10 years or so, the amount of gold extracted every year has been almost constant.

There are few naturally occurring substances that could compete with gold, and they all have drawbacks. Platinum is probably the best, but it is too rare, it is mined in too few places and it has industrial applications which makes the supply unstable. Plutonium may be rare enough, but handling it is a bitch. Silver was a long time contender, but it tarnishes, it has industrial applications, it is in more abundant supply in the earth, and it requires more volume and weight to represent the same amount of value as gold.

Abandoning the gold standard

With a very slowly growing supply of gold it was extremely hard to manage the supply of paper money in the decades after WW2. The dollar was supposed to have a fixed exchange rate into ounces of gold. However, that would have lead to deflation in the climate of strong economic growth, so the governments and the central banks of the world cheated in various ways. The US printed more bills and the de-facto exchange rate from dollars to gold deteriorated. Richard Nixon put an end to the farce and abandoned the tie between the dollar and the gold. What Rothbard and others fail to understand is that increasing the money supply was necessary in order for there to be enough money to handle the economic growth.

Money as storage

There is another factor we need to take into account when we want to understand money, and that is how well things keep. Milk keeps for a few days, grain stores for a year if kept dry, wood keeps for several years, brick for a hundred years or more. At one end of this scale we find money/gold which keeps forever and at the other we find human labour which is wasted the moment it goes unused. If it is used, it can be converted into something more durable, like getting milk from a cow, sawing planks, or building a house. If we do this for others, we will want to exchange the work for something that is exchangeable with anyone. The best option is money, because it is infinitely durable and therefore infinitely exchangeable.

The evils of deflation

Some people have stores of money which they have acquired by their own labour or by doing trades in which they acquire the results of other people’s labour (this can be through fair trade or through unfair abuse). If the cost of everything halves, the stored money will have doubled in value, without the owner having done anything. In a deflationary economy, you are being paid to be rich. This is very unfair to the poor, because they are the ones who are paying the rich. The poor can’t raise the prices of their labour, because work is not storable. It has to get done/sold or be lost for ever.

This is the basis of why governments hate deflation so much. The rich no longer have to take any risks to generate more wealth, while the poorest people will have to leave their homes because they can’t make ends meet.

How this relates to Bitcoin

Bitcoins are mined, like gold. The algorithm ensures a dwindling supply and one day we will reach a point where the Bitcoin supply is capped. The currently available Bitcoin are distributed over a population which is in the tens of thousands. If the population of Bitcoin users grows 10 times while the supply grows by a factor of 2, you will have a huge deflationary factor. The people who already own Bitcoin will have a “risk free” increase in value of a couple of hundred percent. This will draw more capitalists who want the same return. As the supply of Bitcoin gets tied up, deflation will spiral until it reaches an equilibrium. This is when so large a part of the supply is tied up in people’s mattresses that it stops being usable for trade.

The value of Bitcoin comes from its superior trade-ability (and the fact that the supply is capped).

Bitcoin as a threat to the world’s currencies

The accessibilty of Bitcoin makes it easy for anyone to exchange part of his/her savings into Bitcoin and store them on a memory stick at home. It really makes sense for an individual to do so, because many currencies are in a bad shape. The purchasing power of a US Dollar abroad is about 40% of what it was 4 years ago. The money stored that way will not go into consumption and it will not go to investments. It is the power of everyone making a small change in the same direction that cause the cycles in the economy.

Conclusion

This is why the various governments of the world can’t accept competition from a successful Bitcoin. When they wake up, they will use all the legislative power to make Bitcoin unusable.

Comments

  • I don’t agree with your opinion against deflation. If the price of everything halves, including poor peoples’ with no savings work, their economic situation remains the same. More often, growth will be a few percent per year of course.

    You do the same mistake as Rothbard and Shiff and assuming a fixed economy. In a growing economy people can get richer without others getting poorer. And some, probably most, of the extra wealth will get indirectly to benefit or paying the poor.

    More important, deflation will also lead to more saving, which is good for assembling money for sound investments without feeding unnecessary banks. I don’t believe that there won’t be enough people prioritizing the present and both buy stuff they need and stuff they don’t, keeping complanies producing real value alive.

    Comment by Jan-Erik — Sep 7, 2011 10:19:51 PM | # - re

    • I think you have mistaken savings for investments. They are not the same thing. An investment is risking your savings on a venture that may produce more wealth for you. Waiting for deflation to increase the value of your assets is just rent seeking.

      I agree that in a growing economy people can get more wealthy without others getting poorer, but deflation automatically makes people without savings poorer. Deflation triggers recession, because the people with assets put them in safe places, not in investments. Last week, Swiss bonds were sold at negative interest, because they are considered safer assets than for instance German bonds. This is due to people seeking safe harbours and this is what may trigger the next recession.

      Comment by jacob — Sep 7, 2011 10:47:53 PM | # - re

    • I think you are wrong in assuming that poor people’s situation will remain the same if the value of the currency doubles. It means that the rich can buy products for their needs at half the cost and save the rest of their money. They have a motivation not to spend money now, since they will get more for the same amount later. This means that the poor a) will need to spend their money now and won’t get the extra value of spending it later and b) will have less money to compete for with their labour. They lose both ways. If you have no margins in your household economy (which is what it means to be poor), you fall under the threshold of breaking even.

      Comment by jacob — Sep 7, 2011 11:03:12 PM | # - re

    • Can you explain to me exactly how everyone can get richer forever in a world with a limited supply of resources? Can you really cook a dinner that will feed an endless amount of people forever, using only the limited ingredients from your own backyard?

      Comment by Gustav Wetter — Sep 8, 2011 11:30:11 AM | # - re

      • I have no need to explain this. The economics follow fundamental laws of nature. While it is quite obvious that there is a point where the Earth can no longer sustain a larger human population, this does not stop the population from growing and it does not stop people from aspiring for more prosperity. We are heading for catastrophe and there is nothing (that will work) we can do about it.

        Comment by jacob — Sep 10, 2011 10:41:35 AM | # - re

        • So if we can’t do anything about the disaster, why bother to publish a short lesson in large scale economics? I think that you want to help making the world better, you just don’t share my opinion on how to do it.

          I am a realist - I understand that it will be hard to change the way we run the world economy but I’m not going to give up on it. The first step is to acknowledge that we have a problem and that an expanding economy is not the answer.

          Comment by Gustav Wetter — Sep 12, 2011 12:48:28 PM | # - re

          • There is no point in changing anything unless you understand the consequences of what you change. Currently, I think that continued economic growth is the best way to postpone the catastrophe, since declining wealth is bound to cause social unrest and probably devastating wars. Getting developing countries to a standard of living where family sizes a small enough to allow a shrinking population could be a way out of the dilemma, but it is only a faint hope. We are more likely to exhaust Earths resources before we reach the equilibrium point.

            You are assuming that something can be done, therefore we must do something. I believe that given human nature, nothing can be done to avert the catastrophe. I try to improve my understanding and the understanding of others in order to try and falsify my hypothesis.

            Comment by jacob — Sep 18, 2011 8:56:01 PM | # - re

  • What it all boils down to in the end is the amount of areable land, fresh water and minerals on the planet in relation to the size of the human population. We can’t have an infinitely growing economy in a finate world - this simple truth is something that you must be either a modern day economist or politician not to acknowledge.

    We can’t continue to base the world economy on the assumption that creating new credit (money), which in turn leads to further exploitation of our common resources on the planet (the so-called “growth” of the economy) will work forever. Sure, in a short term perspective the poor have raised their standards thanks to this system, but at the expense of our limited common resources (oil, anyone?). We do not want a growing economy since it will ruin us all in the end, we need a SUSTAINABLE economy.

    The problem with money (credit) today is that the right to create it have been given away to private banks. They create a vast supply of credit for which there exists no real value. They then loan this money to people and governments charging interest - all in the name of non-sustainable, short term economic growth. This leads to a finacial bubble that bursts when the “market” starts to doubt that it will be able to transform all the paper/electronic money into somthing tangible (real value). Therefore, the first step towards a sustainable economy is taking back the right to create new money from the banks and put it under democratic (state) control.

    Since the banks do not carry their own losses (the taxpayers bail them out time and time again, as we have seen both in the US and here in Sweden) one can really question why we shouldn’t socialize the banks alltogether. Now only the banks LOSSES are socialized, not their profits…

    Comment by Gustav Wetter — Sep 8, 2011 11:23:26 AM | # - re

    • I think we are already beyond the point at which the planet can sustain the population. There are many signs that show that natural resources, like fish, rain forests and arable soil are getting depleted at a higher rate than the population growth plus economic growth.

      I think this is unstoppable due to much more fundamental factors than the banks creating more money. Nobody is ready to cut their standard of living so that there will be something left for future generations or to improve the standard of living for people in less fortunate parts of the world. In the same way, people adjust their family sizes to what makes sense in their circumstances, not what the global sustainability needs.

      I agree that the politicians make matters worse. They fear shrinking population numbers, because there will not be enough people to take care of the elderly. Personally, I think this is bullshit. There are many ways to deal with that problem.

      As for the bankers, they are just following the rules set by our politicians. A bank that is conservative in a frenzy of lending makes less money in the short term. Since the politicians have to bail out banks when they over-stretch, the only sane course of action for a banker is to grab as much as they can, while they can. The politicians have wizened up a little bit and are putting better limits on how solid the balance sheet of a bank has to be.

      Socializing all the banks would be a stupid move. History shows that there is no way to run a socialized bank efficiently. However, it makes sense for the government to seize a bank that has broken the rules once in a while. This was done to Carnegie in Sweden, and it sent a very strong message to all the other banks.

      Comment by jacob — Sep 10, 2011 11:13:19 AM | # - re

      • We already HAVE socialized the banks, but only their losses. Why should we (the state) not socialize the profits aswell? Suddenly the bankers could be held accountable by the people who elected them, wouldn’t that be great? How well are private banks running the show currently, would you say? Which history are you referring to when you say that no socialized banks have been run efficiently? https://secure.wikimedia.org/wikipedia/en/wiki/Mutual_savings_bank

        Comment by Gustav Wetter — Sep 12, 2011 1:12:58 PM | # - re

        • Mutual savings banks are not socialized. They are not run by the government. In general, they are a very useful form of banks, providing individuals and small businesses with low risk banking services. I’m all for them and I’m sorry that they are mostly a thing of the past.

          However, there are other types of banks needed in the economy, to take on larger risk. Without them, the international trade would not work and it would be impossible to build things like state of the art electronic chip manufacturing plants.

          Now, these banks have been able to take on risks which turned out to be both dangerous and detrimental to the economy. The solution to the problem is not to socialize the banks, but to regulate them better.

          For instance, I can’t see why a bank should be allowed to trade in the stock of other companies, using its own capital (trading for customers is a natural service of the bank). This sort of trade increases the risk that the bank goes bust, while not providing any useful services to the public.

          Comment by jacob — Sep 18, 2011 9:12:33 PM | # - re

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