On Money

...and plenty of money, wrapped up in a five pound note!

I'm not a "gold standard" guy. But sometimes it's useful to think in terms of money-as-gold when thinking about the economy. So let's say the U.S. base money is gold. M0 is gold.

Then M1 money is gold in circulation, and I suppose gold certificates, and checking-account money. And after that, M2, M3, whatever, we have "debt-backed obligations." Okay? So let's start up this economic model and let it run.

Well, we're in trouble already. Because only some of our money is backed by gold. Or more accurately perhaps, there's not enough gold to back every dollar that comes into existence. When the music stops and everybody grabs a chair, only the people in the front row can get gold for their paper.

This isn't a fiat system, this model. It's worse. It's a promise of gold... and an empty promise at that.

Maybe the solution is to make sure the music never stops. That's what a "stimulus bill" is for. Of course, not everybody likes that idea. Austrian economics, for example, seems to see economic growth as some kind of disease. Austrian Robert Murphy has written:

The Fed doesn't "stimulate" the economy by pushing down interest rates, all it does is screw up the market's attempts to rehabilitate itself after a boom....

Regardless, even I can't guarantee there will never be a recession. So, how do we deal with the gold-shortage problem? ...with the problem that there just isn't enough gold to back up all the money? ...the problem that even if we start out with every dollar backed by gold, the money supply grows faster than the gold supply?

Well, FDR handled the problem by devaluing the dollar. Nixon handled it by closing the gold window. Funny thing: Going off the gold standard and onto the fiat standard was a solution to the recurring gold-shortage problem.

I know. People generally look at this from the other side. Most people don't see a gold-shortage problem. They see a printing-money problem. It's the same problem. I'm just looking at it from the other side.

But we're not on the gold standard, so how is all this relevant? It is relevant because we are in a similar fix today. Only instead of gold, our base money is paper. Accounting notations. Whatever. Our M1 money is paper and coin in circulation, and checking-account money. And after that, we have "debt-backed obligations."

We are off gold now, but the recurring problem came back anyway. The problem is not what we use for base money -- it's different this time. The problem is the thing that's the same again: the debt-backed obligations. Debt. Credit in use. Excessive accumulation of debt. Or as I have it, the excessive reliance on credit.

People complain about the government printing money. But most of our money doesn't come into existence by printing. It comes into existence by borrowing. Our recent "credit crisis" came about because there is no longer enough money to keep making timely payments on all the debt we've accumulated. Note that we don't just have an economic crisis, but very specifically a credit crisis.

• In Money Mischief (Chapter 10), Milton Friedman observed base money relative to national income. The ratio "rose sharply, to a peak of about 25 percent in 1946. Since then the ratio of base money to national income has been declining, and in 1990 was about 7 percent."

  Friedman added: "Further financial innovation is likely to reduce still further the ratio of base money to national income..."

• In A Short History of Financial Euphoria, John Kenneth Galbraith wrote, "All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets."

  Galbraith added: "All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment."

• Quoting Martin Wolf in a review of Wolf's Fixing Global Finance, John Mason wrote: "Within the context of the bubble, 'the credit expansion was associated with what was, in retrospect, unsound lending of a particularly innovative kind...'"

Thus we have a relative decline of base money and a dangerous expansion of debt, resulting in a bubble, created by financial innovation. We see that the decline of money and the expansion of debt -- of credit in use -- produces an imbalance in the money. And we know that financial innovation is the process that gets us in trouble.