The Gold Standard: Part I

“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value” – Alan Greenspan.

In this two part article series, we unpack last week’s featured quote of the weekby ex-chairman of the Federal Open Market Committee (FOMC) of the Federal Reserve Bank of New York, Alan Greenspan.

Part I

Inflation

Inflation has become the norm in our everyday understanding of the modern economy. As a thought experiment, ask your neighbour what inflation is – you would most likely learn that inflation is simply the rise in prices of goods and services; an annoying, but unavoidable fact of life.

The world over, people have come to accept inflation as a natural increase in general prices as a result of a growing economy. But what is inflation really, and how could savings be “confiscated” by a “rise in prices”?

Let’s consider that for over half a century, the world has experienced unprecedented inflation. It is no mere coincidence that, for over half a century, the world has also been on an equally unprecedented fiat paper standard (fiat: a formal authorisation; a decree).

The meaning of a fiat paper standard is that the currency unit—whether the Rand, Dollar, Pound, or whatever – consists of paper (or electronic) tickets manufactured by a central authority. Usually the government (or its central bank and network of fractional reserve banks) enjoys a monopoly over the issuing of these tickets and are able to manufacture these essentially costlessly and ad libitum (as much or as often as necessary or desired). It is especially important to note that there is no intrinsic value to these tickets and that the “value” is derived purely from the decree by the central authority i.e ‘by order of the King’ (read: modern legal tender laws).

With history as our guide, we also know that these central authorities have had an inherent tendency to inflate the supply of a fiat currency – to permanently manufacture ever-increasing amounts of these tickets. Historically, during times of war especially, governments tended to engage in massive expansion of the currency supply to pay for these expensive war efforts, with such expansions always followed by a rise in prices of goods and services.

It is then not too difficult to identify the disincentive and moral hazard implicit in this fiat paper system, and to see inflation for what it truly is…

Inflation is a tax

The central authority uses its monopoly power of expanding the currency supply as a costless (and invisible) financing mechanism to fund wars, social programs, public works etc. By increasing the units of currency in circulation, all existing currency units already in circulation are devalued, with value being transferred to the newly created currency units, which are used for the financing activities.

By this logic, it becomes clear that the rise in general prices of goods and services that we experience as “inflation” is not really the inflation itself, but rather a symptom of the inflation. The real inflation is the expansion of the currency supply – an effective and invisible form of tax (“confiscation”, à la Alan Greenspan) imposed on society by the central authority..

Although seemingly invisible and harmless, the true cost of this “confiscation”, lies exactly in its invisible, but insidious effect on savings.

Savings

Savings form the cornerstone of a productive, growing economy.

When you and I save, we effectively defer consumption of real goods and services, which our hard-earned Rands entitle us to claim in the economy, for the future. We deposit those hard-earned Rands (the claim to those goods and services, or resources) in the bank as savings.

These saved resources then act as the material wherewithal that entrepreneurs and businesses access to invest in productive capacity, whether it be a restaurant or a new processing plant. In turn, these investments produce more real goods and services for you and me to consume and enjoy.

So, in a nutshell: Save > Invest > Produce > Consume. That is how an economy grows.

This growing economy naturally produces jobs and a continually higher standard of living for all of society through its production of more and more real goods and services for society to enjoy.

Summary

So, then let’s wrap it up: Inflation vs Savings..

When the currency supply is inflated, your savings in the bank lose value (read: erode). Your value (read: purchasing power) is transferred to the new units of currency that have been created. Your purchasing power is no longer “stored” as savings in your bank, but rather “confiscated” by the creator of the units of new currency.

Furthermore, as this process erodes savings on a grand scale and societal level, it follows that the structure of a growing and productive economy (as outlined above) is also eroded and weakened at its very foundations.

The culmination of it all is a society that is poorer – in purchasing power; in productive capacity; and in jobs and living standards for all. These pernicious effects of inflation become its true costs that you and I (read: society) bear.

So is there a way to protect yourself from inflation, and preserve your purchasing power?

The Gold Standard

To be continued in next Friday’s Part II of this article series, where we turn our attention to The Gold Standard that Allan Greenspan suggests is the solution to this problem.