bradley1719
Full Member
- Oct 26, 2014
- 108
- 41
- Primary Interest:
- All Treasure Hunting
Notes:
Please see my notes in the last post about making comments. Thanks for your understanding.
Intro:
In the last post I talked about the nature of wealth and the gold standard. This discussion assumed that it would sometimes be necessary or helpful to be able to increase the currency supply to match an increase in population or to support an increase in overall net wealth. It may also be desirable to be able to increase the currency supply in order to counteract a period of massive deflation or an economic depression.
I also talked about different types of gold standards. The most common type of gold standard throughout history has been the kind that required the government to hold physical gold in order to back the amount of currency in circulation. In this particular case, increasing the currency supply can also include the requirement to increase the amount of gold being held in reserve. This post talks about the issues of cost and confiscation when trying to acquire gold to back an increase in the currency supply.
Synopsis:
Gold is expensive. Being a physical item, it has non-zero costs. If the government needs to acquire gold in order to expand the currency supply, then the costs can be prohibitively high. One option that is sometimes used to acquire gold without the hassles of having to physically buy it, is confiscation. By wishing for a gold standard, many gold bugs are unwittingly also wishing for the demise of their own gold holdings through potential government confiscation.
The options for acquiring gold:
In the old days, gold was considered “money” by both convention and decree. There were many ways that governments could acquire the gold (and silver) that they needed to back their currency or mint their coins. Some of those methods are no longer considered acceptable. The following is a list of common ways that governments can acquire gold.
1. War/Conquest - It was quite common for countries to acquire gold through the spoils of war. Additionally, countries like Spain would conquer entire continents for the express purpose of acquiring more gold and silver. Today, acquiring gold through conquest is not considered an acceptable practice.
2. Slavery - Many civilizations would rely on slave labor to mine the gold and silver they needed at low cost. Today, slavery is not considered an acceptable practice.
3. Purchase - It is possible to acquire gold by purchasing it on the open market or through a private sale with another country. I will discuss the downsides to this approach later in this post.
4. Confiscation - It is possible to acquire gold by confiscating it from the general public. There are two types of confiscation: compensated, and non-compensated. In compensated confiscation, the public is given something in return for their gold (typically currency). In non-compensated confiscation, the government takes the public’s gold and doesn’t give them anything in return.
By looking at the options listed above, it should be easy to see why ancient civilizations chose gold standards. Many of them weren’t really “paying” for the gold because they would acquire it through conquest and enslavement. If those same civilizations were suddenly forced to actually pay full price for their gold and silver, they likely would have collapsed much quicker than they did. Looking at what happened to Rome, it’s hard not to wonder if this (along with the wealth growth issue discussed in the last post) wasn’t a serious factor in their collapse.
An example of costs:
Let’s give an example to work from. Imagine that an economy is in a depression. The government decides that they would like to increase the currency supply by $2 Million in order to help get the economy back on track. They intend to inject this money into the economy by using it to pay for government infrastructure projects. Let’s also assume that they now need to purchase more gold in order to back the newly created currency. How much gold they have to purchase depends on what gold-to-currency backing ratio they use. This ratio could be anywhere from 1% to 100%.
100% gold-to-currency ratio:
If the gold-to-currency ratio is 100%, this means that for every dollar of currency the government creates, they must also have one dollar worth of gold in their reserves. In our example above, this means they would somehow have to acquire $2 Million worth of gold. But if they had the $2 Million worth of currency they need to actually BUY $2 Million worth of gold, then they wouldn’t need to create the currency in the first place.
This is a contrived example since most countries do not back their currency one-to-one with gold. But it shows that the gold-to-currency ratio can make or break a country’s ability to actually purchase gold for the purposes of backing a currency. The higher the ratio, the more difficult it becomes. A more reasonable example is shown below.
50% gold-to-currency ratio:
If the gold-to-currency ratio is 50%, then this means that for every dollar of currency the government creates, they must also have 50 cents worth of gold in their reserves. In our example above, this means they would somehow have to acquire $1 Million worth of gold in order to expand the currency supply by $2 Million.
Acquiring the gold:
There are many ways that the government can try to acquire the $1 Million worth of gold mentioned above. For example, the government could print $2 Million worth of currency and try to use $1 Million worth of it to buy gold on the open market. This would leave them with an extra $1 Million to use for government infrastructure projects. But there are several problems with most of the approaches that could be used.
1. Making a direct purchase of that magnitude will likely increase the price of gold in the open market. This will make it even harder to obtain the amount of gold they want at a price they can afford.
2. The gold may not be available to purchase. If the state of the world is such that a depression is going on in one of the larger economic powers of the world, then it is likely that such conditions may also exist in other countries. It is very hard to convince people and governments to sell you their gold for a currency from a country that is having major economic troubles.
3. Using $1 Million of your currency to purchase gold reduces the effectiveness of your original plan. If you just used $1 Million to buy the gold necessary to expand the currency supply to $2 Million, then you only have $1 Million of wiggle room left to work with. The purchase of the gold itself has diluted the currency that you wanted to inject into the system to help deal with the depression.
Sure, that $1 Million that you used to buy the gold is out there and COULD find its way into your economy. But that currency is likely not going to the places where you need it to go most. In other words, you spent $1 Million buying the gold, so you only have $1 Million worth of currency left to spend on government infrastructure projects.
Purchasing by weight, not by dollar amount:
One thing that might not be clear initially from the discussion above, is that when a government needs to buy $1 Million worth of gold, what they REALLY need to buy is an amount of gold (by weight) that equates to the agreed upon currency-to-gold exchange rate that has been defined by their currency. For example, The United States used to mint a $20 Gold Double Eagle coin. This coin set the standard of 20 US dollars to .9675 ounces of gold (or $20.67 per ounce).
So in our example above, if the United States needed to buy “$1 Million in gold”, what this REALLY means is that the United States needs to buy 48,375 ounces of gold AT THE CURRENT MARKET PRICE which may be different from $20.67/ounce. What happens if the market price of gold goes up to $100 per ounce due to the United States trying to make such a large purchase? Well, then buying 48,375 ounces of gold will end up costing the US government $4.8375 Million. This is clearly an unworkable solution. The government wanted to increase the currency supply by $2 Million, but it is going to cost them $4.8375 Million to buy the gold they need to do so!
Keep in mind, just because the United States says that a US $20 bill is worth 0.9675 ounces of gold, doesn’t mean that the rest of the world agrees! It should now be clear that purchasing gold on the open market for a price that allows you to increase your currency supply at the desired rate is extremely difficult if not impossible.
Confiscation:
So what is a government to do? They need $1 Million worth of gold and just going out and buying it is often not feasible for the reasons listed above. Well…. <drum roll> they can confiscate it from the general populace. Doing so has the following benefits.
1. If the confiscation is a non-compensated confiscation (where the government doesn’t pay the people for their gold; they just take it), then the gold is essentially free of monetary costs (but not of political costs).
2. If the confiscation is compensated, then the government gets to set the price. So the issue of the price of gold going up in the open market due to the government trying to acquire large amounts of it becomes a non-issue. The government is free to set the price to whatever they wish to pay. If the government says that a $20 bill is worth 0.9675 ounces of gold, then that is what they will pay the people (even if the open market says that 0.9675 ounces of gold is really worth $100).
3. The issue of people not wanting to sell you their gold goes away too. The government can make it mandatory which means the people really wouldn’t have a choice.
4. The money is now going directly to the people of your own country instead of to foreign sellers. This is still not the most desirable outcome because your money is not going directly to the specific programs you were wanting to target. But at least the currency is staying in your own country. Additionally, if the people of your country are not allowed to own gold (because you make it illegal as part of the confiscation process), then these people will not be taking that currency and trying to exchange it for gold at a later date. But if you instead buy your gold on the open market (at a potential premium), those people could later try to exchange that currency back for gold again (causing a form of arbitrage).
Compensating the people:
But there is still a problem when it comes to compensated confiscation. Where do you get the currency necessary to compensate the people? Well, one option is to print it just as if you were buying the gold on the open market. In fact, compensated confiscation where the people are paid a fair price for their gold doesn’t really differ TOO much from the case where you just buy it outright. You still have the issue that you have diluted the original amount of currency you wanted to create to help get your country out of the depression. But you will have been able to take advantage of all the other benefits listed above.
So in the end, even compensated confiscation is often more desirable than buying it outright on the open market. And if the open market is unwilling to sell you the gold you need at a price that is fair, then confiscation may be the only answer if you want to stay on the gold standard.
Reducing the gold-to-currency backing ratio:
Another option that is often used is just reducing the gold-to-currency backing ratio that you use to determine how much currency is allowed to be in the system. In this case, you may not have to even buy any additional gold to back the currency you want to create (or at least, not as much). And this approach was used quite often. If you are currently backing your currency by 50%, then you can reduce that percentage to 25% and increase the amount of currency in the economy proportionately. However, this only works for so long. Eventually, you reach a point where your gold-to-currency backing ratio is so low that people panic and a bank run can occur. This has happened many times throughout history. Most countries who tried to use gold standards eventually had to suspend the ability to exchange gold for currency because they simply didn’t have enough gold in the face of a massive bank run by the public.
Summary:
The physical nature of gold means that there is a cost associated with acquiring it. Long gone are the days where gold could be acquired virtually for free through conquest and enslavement. Today, a government that needs to acquire more gold in order to expand the currency supply must either buy it on the open market, or confiscate it from the public. Confiscation can have some benefits over attempting to buy it which is why gold bugs wishing for the return of a gold-backed currency standard may actually be advocating a system that will be more likely to result in confiscation of gold from the public.
If you made it this far, thanks for listening!
Please see my notes in the last post about making comments. Thanks for your understanding.
Intro:
In the last post I talked about the nature of wealth and the gold standard. This discussion assumed that it would sometimes be necessary or helpful to be able to increase the currency supply to match an increase in population or to support an increase in overall net wealth. It may also be desirable to be able to increase the currency supply in order to counteract a period of massive deflation or an economic depression.
I also talked about different types of gold standards. The most common type of gold standard throughout history has been the kind that required the government to hold physical gold in order to back the amount of currency in circulation. In this particular case, increasing the currency supply can also include the requirement to increase the amount of gold being held in reserve. This post talks about the issues of cost and confiscation when trying to acquire gold to back an increase in the currency supply.
Synopsis:
Gold is expensive. Being a physical item, it has non-zero costs. If the government needs to acquire gold in order to expand the currency supply, then the costs can be prohibitively high. One option that is sometimes used to acquire gold without the hassles of having to physically buy it, is confiscation. By wishing for a gold standard, many gold bugs are unwittingly also wishing for the demise of their own gold holdings through potential government confiscation.
The options for acquiring gold:
In the old days, gold was considered “money” by both convention and decree. There were many ways that governments could acquire the gold (and silver) that they needed to back their currency or mint their coins. Some of those methods are no longer considered acceptable. The following is a list of common ways that governments can acquire gold.
1. War/Conquest - It was quite common for countries to acquire gold through the spoils of war. Additionally, countries like Spain would conquer entire continents for the express purpose of acquiring more gold and silver. Today, acquiring gold through conquest is not considered an acceptable practice.
2. Slavery - Many civilizations would rely on slave labor to mine the gold and silver they needed at low cost. Today, slavery is not considered an acceptable practice.
3. Purchase - It is possible to acquire gold by purchasing it on the open market or through a private sale with another country. I will discuss the downsides to this approach later in this post.
4. Confiscation - It is possible to acquire gold by confiscating it from the general public. There are two types of confiscation: compensated, and non-compensated. In compensated confiscation, the public is given something in return for their gold (typically currency). In non-compensated confiscation, the government takes the public’s gold and doesn’t give them anything in return.
By looking at the options listed above, it should be easy to see why ancient civilizations chose gold standards. Many of them weren’t really “paying” for the gold because they would acquire it through conquest and enslavement. If those same civilizations were suddenly forced to actually pay full price for their gold and silver, they likely would have collapsed much quicker than they did. Looking at what happened to Rome, it’s hard not to wonder if this (along with the wealth growth issue discussed in the last post) wasn’t a serious factor in their collapse.
An example of costs:
Let’s give an example to work from. Imagine that an economy is in a depression. The government decides that they would like to increase the currency supply by $2 Million in order to help get the economy back on track. They intend to inject this money into the economy by using it to pay for government infrastructure projects. Let’s also assume that they now need to purchase more gold in order to back the newly created currency. How much gold they have to purchase depends on what gold-to-currency backing ratio they use. This ratio could be anywhere from 1% to 100%.
100% gold-to-currency ratio:
If the gold-to-currency ratio is 100%, this means that for every dollar of currency the government creates, they must also have one dollar worth of gold in their reserves. In our example above, this means they would somehow have to acquire $2 Million worth of gold. But if they had the $2 Million worth of currency they need to actually BUY $2 Million worth of gold, then they wouldn’t need to create the currency in the first place.
This is a contrived example since most countries do not back their currency one-to-one with gold. But it shows that the gold-to-currency ratio can make or break a country’s ability to actually purchase gold for the purposes of backing a currency. The higher the ratio, the more difficult it becomes. A more reasonable example is shown below.
50% gold-to-currency ratio:
If the gold-to-currency ratio is 50%, then this means that for every dollar of currency the government creates, they must also have 50 cents worth of gold in their reserves. In our example above, this means they would somehow have to acquire $1 Million worth of gold in order to expand the currency supply by $2 Million.
Acquiring the gold:
There are many ways that the government can try to acquire the $1 Million worth of gold mentioned above. For example, the government could print $2 Million worth of currency and try to use $1 Million worth of it to buy gold on the open market. This would leave them with an extra $1 Million to use for government infrastructure projects. But there are several problems with most of the approaches that could be used.
1. Making a direct purchase of that magnitude will likely increase the price of gold in the open market. This will make it even harder to obtain the amount of gold they want at a price they can afford.
2. The gold may not be available to purchase. If the state of the world is such that a depression is going on in one of the larger economic powers of the world, then it is likely that such conditions may also exist in other countries. It is very hard to convince people and governments to sell you their gold for a currency from a country that is having major economic troubles.
3. Using $1 Million of your currency to purchase gold reduces the effectiveness of your original plan. If you just used $1 Million to buy the gold necessary to expand the currency supply to $2 Million, then you only have $1 Million of wiggle room left to work with. The purchase of the gold itself has diluted the currency that you wanted to inject into the system to help deal with the depression.
Sure, that $1 Million that you used to buy the gold is out there and COULD find its way into your economy. But that currency is likely not going to the places where you need it to go most. In other words, you spent $1 Million buying the gold, so you only have $1 Million worth of currency left to spend on government infrastructure projects.
Purchasing by weight, not by dollar amount:
One thing that might not be clear initially from the discussion above, is that when a government needs to buy $1 Million worth of gold, what they REALLY need to buy is an amount of gold (by weight) that equates to the agreed upon currency-to-gold exchange rate that has been defined by their currency. For example, The United States used to mint a $20 Gold Double Eagle coin. This coin set the standard of 20 US dollars to .9675 ounces of gold (or $20.67 per ounce).
So in our example above, if the United States needed to buy “$1 Million in gold”, what this REALLY means is that the United States needs to buy 48,375 ounces of gold AT THE CURRENT MARKET PRICE which may be different from $20.67/ounce. What happens if the market price of gold goes up to $100 per ounce due to the United States trying to make such a large purchase? Well, then buying 48,375 ounces of gold will end up costing the US government $4.8375 Million. This is clearly an unworkable solution. The government wanted to increase the currency supply by $2 Million, but it is going to cost them $4.8375 Million to buy the gold they need to do so!
Keep in mind, just because the United States says that a US $20 bill is worth 0.9675 ounces of gold, doesn’t mean that the rest of the world agrees! It should now be clear that purchasing gold on the open market for a price that allows you to increase your currency supply at the desired rate is extremely difficult if not impossible.
Confiscation:
So what is a government to do? They need $1 Million worth of gold and just going out and buying it is often not feasible for the reasons listed above. Well…. <drum roll> they can confiscate it from the general populace. Doing so has the following benefits.
1. If the confiscation is a non-compensated confiscation (where the government doesn’t pay the people for their gold; they just take it), then the gold is essentially free of monetary costs (but not of political costs).
2. If the confiscation is compensated, then the government gets to set the price. So the issue of the price of gold going up in the open market due to the government trying to acquire large amounts of it becomes a non-issue. The government is free to set the price to whatever they wish to pay. If the government says that a $20 bill is worth 0.9675 ounces of gold, then that is what they will pay the people (even if the open market says that 0.9675 ounces of gold is really worth $100).
3. The issue of people not wanting to sell you their gold goes away too. The government can make it mandatory which means the people really wouldn’t have a choice.
4. The money is now going directly to the people of your own country instead of to foreign sellers. This is still not the most desirable outcome because your money is not going directly to the specific programs you were wanting to target. But at least the currency is staying in your own country. Additionally, if the people of your country are not allowed to own gold (because you make it illegal as part of the confiscation process), then these people will not be taking that currency and trying to exchange it for gold at a later date. But if you instead buy your gold on the open market (at a potential premium), those people could later try to exchange that currency back for gold again (causing a form of arbitrage).
Compensating the people:
But there is still a problem when it comes to compensated confiscation. Where do you get the currency necessary to compensate the people? Well, one option is to print it just as if you were buying the gold on the open market. In fact, compensated confiscation where the people are paid a fair price for their gold doesn’t really differ TOO much from the case where you just buy it outright. You still have the issue that you have diluted the original amount of currency you wanted to create to help get your country out of the depression. But you will have been able to take advantage of all the other benefits listed above.
So in the end, even compensated confiscation is often more desirable than buying it outright on the open market. And if the open market is unwilling to sell you the gold you need at a price that is fair, then confiscation may be the only answer if you want to stay on the gold standard.
Reducing the gold-to-currency backing ratio:
Another option that is often used is just reducing the gold-to-currency backing ratio that you use to determine how much currency is allowed to be in the system. In this case, you may not have to even buy any additional gold to back the currency you want to create (or at least, not as much). And this approach was used quite often. If you are currently backing your currency by 50%, then you can reduce that percentage to 25% and increase the amount of currency in the economy proportionately. However, this only works for so long. Eventually, you reach a point where your gold-to-currency backing ratio is so low that people panic and a bank run can occur. This has happened many times throughout history. Most countries who tried to use gold standards eventually had to suspend the ability to exchange gold for currency because they simply didn’t have enough gold in the face of a massive bank run by the public.
Summary:
The physical nature of gold means that there is a cost associated with acquiring it. Long gone are the days where gold could be acquired virtually for free through conquest and enslavement. Today, a government that needs to acquire more gold in order to expand the currency supply must either buy it on the open market, or confiscate it from the public. Confiscation can have some benefits over attempting to buy it which is why gold bugs wishing for the return of a gold-backed currency standard may actually be advocating a system that will be more likely to result in confiscation of gold from the public.
If you made it this far, thanks for listening!
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