Gold standard and the fiat money system (was: Information requested: US.

John O'Donnell wrote:

> First is the oft made confusion between "backing" and "standard." The 
>"gold
> bugs" stance always argues for a standard but simultaneously demands
backing.

There may be some confusion here.  Just a few comments in an effort to 
clarify

the picture.

Gold standards have been run with relatively stable value of gold in terms 
of
paper currencies. For instance, in the US dollar - gold exchange standard
lasting
for almost 20 years, gold was priced at $35. Prior to WWI the gold standard
run
by the British had a gold value fixed at $21 (and an equivalent fixed value 
in

sterling) for decades. The central banks  had little problem in achieving a
stable price of gold, which represented a backing for the paper notes 
issued.
What was a problem, however, was the amount of money in the system, when a
physical resource (gold) determined its supply.  Triffin's "Dollar Crisis" 
was

about the US printing more money notes than it had gold reserves to back. 
When

the "allies" lost confidence in the dollar and demanded gold for their 
dollar
holdings, the system broke down and dollars flooded the market.  The 
inflation

that followed prooved too much liquidity had been injected into the system.

The essential problem of a gold standard was its focus on the stable "value"
of
money, with liquidity becoming the stochastic residual of the system. The 
fiat

money system, which measures value in reference to an evolving CPI basket, 
has

solved the problem of adequate liquidity. However, this has been achieved 
with

"value" in some sense having become the stochastic residual of the system.
Hence
inflation may be the new "threat", not inadequate liquidity (expressed as
deflation and falling activity).

Specifically, the fiat money system may have a more unpredictable 
transmission

mechanism than is currently envisioned -- borrowing Marxist terms -- such 
that

central bank's focus on the "productive circuit" is misplaced, because the
"money-circuit" (which captures the money used for exchange AND finance) is
absorbing a growing amount of the supply, resulting in stable value of the
former. However, this may depend on the money circuit remaining in a 
positive
cycle (rising asset values). However, a shock to stock markets -- with 
prices
falling sharply -- could result in money returning to the productive 
circuit,
resulting in a rise of goods inflation.  However, as the central bank 
controls

this process, the system may continue ad infinidum.  That said, the question
arises if the US has again issued too much money for inflation to remain
stable,
especially if the system is at some point subject to a truly exogenous 
shock.


> A better choice of standard, even with its difficulty of frequent
measurement,
> is an index based on a meaningful basket of goods and services such as 
>that
> used for the CPI.

In short, the problem of a monetary system (stable value and ample 
liquidity)
may
not have been solved as decisively by the fiat money system as its 
proponents
think.  It is always a matter of a trade-off.

Best regards,

Thor Thorgeirsson