More on debt

by Russ Roberts on February 29, 2008

in Data

Martin Brock, in response to this post, writes:

Still, the median debt is up 151% since 1989, adjusted for inflation,
and if the "wealth effect" theory of the personal saving rate is
correct, much of this increase is consumer debt (the cars and such). I
don’t see how the clarification makes this increase any less gloomy.
Maybe it’s not very gloomy at all, but if it’s gloomy before the
clarification, it’s still gloomy after.

It’s funny how numbers can be used to scare and mislead. One hundred and fifty one percent seems like a big increase. But the size of that number tells you nothing. It does sound scary. But it tells you nothing. Nothing. All it tells you is that in 1989, the median family with debt had debt of 22,000. In 2004, the median family with debt had debt of 55,000. Good or bad news?  You can’t tell. It tells you nothing by itself. It could mean people are living more and more beyond their means. It could mean that people have more wealth and income and are buying bigger houses and nicer cars. There is nothing inherently gloomy or cheerful until you know more information.

The fact that net worth is up from 68,000 to 93,000 makes it more likely that it’s cheery. But let’s look a little deeper. Here’s another chart from the Federal Reserve Board’s Survey of Consumer Finances, the source of all of these data:

Debtkinds

Look at the line called Goods and Services. Flat. That’s trying to measure people living beyond their means, using debt to buy furniture, food and so on. That’s the line the Washington Post should have used to look at whether debt was being used for what the article called "day-to-day expenses." What this chart shows is that the increase in debt is due to people buying bigger houses and investing in a little more education.

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Steven Horwitz February 29, 2008 at 8:45 am

And NOT cars! Vehicle debt is way down.

Thanks for all this work Russ.

muirgeo February 29, 2008 at 9:25 am

This all started with the Harold Meyerson article suggesting this is a debt driven economy. The federal debt is now $9,000,000,000,000. Also assets values are set to go down dramatically and there is no liquidity left in the market. That's the big picture.

Here's paul craig Roberts:

The US economy has been kept alive by low interest rates, which fueled a real estate boom. Consumers have kept growth alive by refinancing their home mortgages and spending the equity in their houses. Their indebtedness has risen.

Debt-fueled growth is qualitatively different from economic growth that results from an increase in high value-added jobs. Economists who look at the 3+ percent economic growth rate and conclude that things are fine are fooling themselves and the public. When the real estate boom ends, what will be the source of new spending power?

That was December of 2005. He predicted the results of the debt economy. Here were looking at graphs of productivity going up 27% and income rising 4% and claiming everyone and everything is fine as the house of cards collapses around us. I don't get it. We can do much better then this.

Matt C. February 29, 2008 at 9:37 am

I find it interesting that people have more debt in assets that will maintain their value over a longer period of time. Puting money into a car is a losing proposition. As soon as you drive it off the lot you actually have an asset where you have a negative wealth, your debt is higher than the true value of the car. It is not till much later in the note (depending on the vehicle of course) when the vehicle actually becomes a positive wealth asset.

This could mean a couple things, people are either paying more with cash OR they are buying more used cars so the percentage is going doing. The used vehicles are, for the most part, at their true asset value. I don't if used vehicle purchases as actually increased over new vehicle purchases, but it would be interesting to see. It could also be an effect of the specials going on in the domestic market for vehicles with cheap financing. So either way their wealth is going up.

Just like Professor Horowitz, that statistic was the first thing that popped out to me.

Mathieu B├ędard February 29, 2008 at 9:40 am

Is there any way to find out how much of that is due to the Community Reinvestment Act?

Matt C. February 29, 2008 at 9:44 am

Regarding Muirego-
If you have a chart that says where the refi's money went then please show. The graph clearly indicates that home purchases increased as a percentage. The percentage of improvements were down slightly. You provide no proof that the equity taken out of the house went to consumption goods.

Many people who worked with mortgage brokers to pay off a lot of credit card debt using the equity in their home. That doesn't actually change the net wealth though, it just transfers the debt from one category to another. But in the end it actually would save them money on their monthly payments to debt, not to mention they get a tax write off of the interest. Whether it was a wise thing or not is up to that individual.

I personally, don't find the argument you are making convincing.

Steven Horwitz February 29, 2008 at 9:45 am

Matt – I think you might be right about more folks buying slightly used cars. Until my current one, that had been my strategy on the prior 4 or 5. Buy them a year old and save a substantial hunk with little risk.

I also suspect that there's something else at work with cars: they last longer and more folks own cars that don't have payments left. (I also wonder if lease payments are considered "debt" – if not, then the popularity of leasing may make that fall in car debt misleading.) One of the reasons we're seeing longer car loans is that cars last longer – also a sign of increased economic well-being. If you don't get 100K these days, you have a lemon.

Randy February 29, 2008 at 9:46 am

Thanks for the data. That certainly clears things up.

Randy February 29, 2008 at 9:47 am

Muirgeo,

"I don't get it."

Yes, we know.

Dave February 29, 2008 at 10:37 am

Look at the line called Goods and Services. Flat. That's trying to measure people living beyond their means, using debt to buy furniture, food and so on.

Actually, the percent of debt on Goods and Services is flat. If the inflation adjusted amount of debt has increased by 151%, and the percentage of that debt used on Goods and Services is flat, then the inflation adjusted level of debt used toward Goods and Services has risen by about 151%, right?

Randy February 29, 2008 at 10:49 am

No Dave. Take a closer look at the chart. The increase has gone into primary residence, other residential property, and education.

Randy February 29, 2008 at 10:57 am

Then again, you are right that there is probably some increase in the total amount spent on goods and services as well. Since 1989, I've purchased several computers, software, and just recently a couple of flat screen TVs – and I used the credit card every time. If it helps, I consider all of it investment.

Martin Brock February 29, 2008 at 11:40 am

As soon as you drive it off the lot you actually have an asset where you have a negative wealth, your debt is higher than the true value of the car.

A car depreciates, but it is a means of production, because most of us can't effectively work in the modern economy without one. [More people in Europe do though.] You can't just look at the price of the car. You must account for its contribution to productivity. This contribution doesn't fall as soon as you drive it off the lot. The retail price falls, because you've paid marketing and other costs that the dealer must absorb again if he buys it back from you to resell.

That said, cars vary a lot in price, and their contribution to productivity probably varies much less.

It is not till much later in the note (depending on the vehicle of course) when the vehicle actually becomes a positive wealth asset.

If you buy a car for its contribution to productivity rather than as a show piece or a recreational vehicle, it can become a positive asset immediately, even if you leverage it. A used car isn't necessarily a better deal, but Americans pay a lot for the show and recreational value, so used cars probably are more valuable as investments rather than consumption.

I've changed gears here a bit only to debunk the choir boys' assertion that I'm "anti-capitalist" or don't understand leverage. I'll return to a more skeptical posture soon enough. Of course, the utilitarians contributed considerably to the modern understanding of debt and its uses.

Hudson February 29, 2008 at 11:50 am

Both sides are right: debt has grown, assets have grown faster, and thus so has net worth. Some of that is disappearing as we speak because, yes, there has been too much leverage in the economy- as is the case during all booms- but the wealth gains won't completely disappear.

Muirgeo: I believe most of those refi's have gone towards new businesses and paying down higher interest debt rather than consumption; i.e., completely logical endeavors.

However I might agree with you that there are different types of growth, which brings me to my main point: it seems to me that when our monetary system creates money (thus inflation) without creating wealth it is stealing from the wealth creators and giving to the speculators. Basically, the Fed Reserve sysem is not a free market system and when the monetary base is inflated those with first access to the capital (member banks borrowing at the discount rate) benefit at the expense of those with last access (lower wage workers borrowing at high-yield rate).

Such a monetary policy spawns whiners like Miurgeo who advocate for awful socialist policies and government redistribution of wealth when, in fact, we should be trying to defend the wealth creator from the wealth confiscator. I think this site would benefit from a thorough examination of money and monetary policy. I am still learning but highly sceptical of the ciurrent system.

Martin Brock February 29, 2008 at 11:52 am

If the inflation adjusted amount of debt has increased by 151%, and the percentage of that debt used on Goods and Services is flat, then the inflation adjusted level of debt used toward Goods and Services has risen by about 151%, right?

That's a good point, but other percentages are not flat, and these percentages apply to debts (mortgages and student loans) that I expect to be higher than consumer debt in most cases. The rising mortgages tracking rising house prices are the potential problem at this point. They're obviously the problem in the sub-prime mortgage securities market.

The question is: do similar problems exists in other sectors? Does the marginal value of an education really justify the cost for most people these days? That people choose to borrow is no evidence of the answer. People accepted these sub-prime mortgages believing that they'd benefit.

Brad Warbiany February 29, 2008 at 11:58 am

I was going ot make the same point Dave did here, but since it's being questioned, let me expand.

In 1989, the median debt was $22,000, and 6.1% of that was "goods and services". That means that the average indebted household carried debt of about $1340 on goods and services.

In 2004, the median debt was $55,000, and the percentage had dropped slightly to 6.0%. However, that means that the average indebted household was $3300 in the hock for "goods and services".

Of course, you cannot actually do this comparison directly, because the $22K->$55K number is the MEDIAN, whereas the photo that Russ posted was the breakdown for "all families", so it's an aggregate measure. You can't say that the median debt is broken down along these percentages. It could be skewed all sorts of ways (i.e. for a rich family with a $1M mortgage, car debt is a low percentage of total debt, but for a poor family who lives in a rental property, car debt is a high percentage of total debt).

Either way, though, the point is that as American debt goes up, the total amount of debt used to carry "goods and services" goes up as well, as the percentage of debt used in this way has not appreciably changed.

As Russ points out, though, with net worth rising, I'm not necessarily sure this is an entirely gloomy scenario, but if we're going to debate the numbers, we might as well make sure we're using them properly.

Martin Brock February 29, 2008 at 12:00 pm

… but the wealth gains won't completely disappear.

Gains always disappear for some people and sometimes disappear for most people. It hasn't happened in the U.S. in a while. The last time was probably in the seventies. A warfare state is particularly destructive.

Martin Brock February 29, 2008 at 12:00 pm

Brad Warbiany February 29, 2008 at 12:27 pm

Martin,

Note that most of these numbers end in 2004, so while they might take into account some of the mortgage boom due to subprime lending, a lot of the really ridiculous gains came in 2005-2006.

Prices here in California have largely dropped back towards early 2005 or mid-2004 levels. They may still have farther to go, but I wouldn't overstate the subprime portion of this equation as if the home prices you're referring to are the peak levels (late 2006).

Martin Brock February 29, 2008 at 12:34 pm

And NOT cars! Vehicle debt is way down.

It doesn't follow. People take out second mortgages to buy cars for the interest deduction. This debt can't show up in both categories, but it's really vehicle debt. "Vehicle debt" just means debt secured by a vehicle rather than home equity. The debt may purchase a vehicle regardless. This "withdrawal of equity" to consume is the "wealth effect".

Money is money, so none of these categories is very meaningful. "Goods and services" probably means credit card debt, but people spend home equity credit on goods and services too.

Martin Brock February 29, 2008 at 12:45 pm

Note that most of these numbers end in 2004, so while they might take into account some of the mortgage boom due to subprime lending, a lot of the really ridiculous gains came in 2005-2006.

That's true. I'd like to see the '05 – '07 figures. Economic reports are almost always politically motivated. It's '08. The '05 and '06 figures must be firm by now, so why aren't they reported?

FreedomLover February 29, 2008 at 1:22 pm

Spending equity loans doesn't count as "wealth" to me, but ticking time bomb of bankruptcy. Now being debt-free, except for mortgage and having savings, buying a car for cash, paying college tuition with cash – that is wealth.

Hudson February 29, 2008 at 1:46 pm

FreedomLover: having no debt in an inflationary system (whcih we have) is irrational and stupid unless you think we will eventually enter a deflationary environment. If you have been practicing this all-cash transaction, saving not investing policy you have been getting cleaned out. I still have a lot of college debt locked in at 2% that I can but won't pay off because I'd have to pay it off with money I have in a CD earning a much higher %. Sometimes it makes sense to take on debt, sometimes not, but in our system the debt tends to be inflated away as does savings.

Python February 29, 2008 at 2:03 pm

"The '05 and '06 figures must be firm by now, so why aren't they reported?"

We've already answered that question.

Matt C. February 29, 2008 at 2:06 pm

Martin-
Just responding to your point on what I said about used cars. Your productivity of a vehicle is not used to measure net wealth. I was only speaking of where the market asset value of the vehicle. You may value the car more than you could sell it for. That is quite clearly the case when you buy a new vehicle. In order to calculate the value of an asset in the open market you have to take what you get. That's what prices demonstrate. You buy a new vehicle clearly because you value the vehicle MORE than the amount of money you paid plus interest. Otherwise the trade would never take place. For you then, personally, it would require that someone pay you more than what the vehicle is worth on the open market before you were to sell it. In order to measure Net Wealth though, the general standard is to use what the market would pay for your vehicle.

Market value is the most objective number anyone has to the value of an asset. Your argument doesn't change what I stated. A market value from vehicle to vehicle will vary due to a multitude of reasons, one of which is the productivety that other buyers may or may not get from it. There are some brands of vehicles that will lose value much faster than others. Honda's generally speaking have a market value that will last a lot longer than a Chevy. Why? Well, individual actors within the market have determined that the Honda, generally speaking, is a better value. What encompasses that value is up to the actors, but some include reliability, maintence and performance.

The same point I made to Muirego, do you have any numbers to show where a vast majority of car owners used second mortgages to purchase vehicles? I asked him to show where second mortgages were used to buy consumption goods. I know of a few people who have done that, but I know many, many more people who haven't. Anecdotal evidence really isn't evidence.

Also, let's say for arguments sake, most people in the "blinding world of debt" (I put it in quotes to be tongue-in-cheek) how many people have enough equity to pull money out to pay for all those multitudes of credit card debt AND cars? If I were to venture a guess the amount of people who pulled equity out of their house to purchase a car would be a very, very small percentage.

AGAIN, that only transfer one form of debt to another. Net Wealth is still HIGHER.

FreedomLover February 29, 2008 at 2:11 pm

Matt C – I assume you mean among college graduates holding down 80K jobs?

mith February 29, 2008 at 3:27 pm

Wasn't there an "almost recession" in the beginning of 1990, which would have been reflected by spending levels in 1989? And wasn't 2004 considered something of a booming year?

FreedomLover February 29, 2008 at 3:32 pm

I thought a real recession is decline in GDP for 3 consecutive quarters? Anything less is dumbing down the definition.

Matt C. February 29, 2008 at 5:30 pm

FreedomLover—What?

If you are refering to what I was saying about the debt then no. If you have pulled the equity out of your house, it only is transferred from one form of debt to another form of debt. It doesn't matter whether it's an equity line or a note on a vehicle. Net Worth is still higher. This only accounts for individuals who own their house rather than rent their home.

This still doesn't matter. If you add up all your assets and all of your liabilities and then subtract with that number being positive you have a postive net wealth. You don't have to make 80k a year with a college degree to have a positive net wealth.

I would venture to say, just as individuals begin to earn more money as they get older, their net wealth will increase as well. If you are a high school drop out you will more than likely reach that postive net wealth number later than a college graduate. If that is what you were trying to say. But I am still confused about your statement.

Martin Brock February 29, 2008 at 8:13 pm

Matt C

… do you have any numbers to show where a vast majority of car owners used second mortgages to purchase vehicles?

No. I don't say anything about the vast majority of car owners, but I know I've done it. For my last several cars, I've paid cash, but I've used a home equity line of credit to buy a car. Roberts himself says, "Between 1989 and 2004, Americans accumulated more wealth. They decided to use some of that wealth for increased consumption today." He grants for the sake of this discussion that increased debt is the expenditure of wealth. I don't know why else "auto debt" would have fallen in recent years. If you can deduct the interest, why wouldn't you?

muirgeo February 29, 2008 at 11:40 pm

I personally, don't find the argument you are making convincing.

Posted by: Matt C.

And your argument that people are taking loans to pay off debt so everything must be OK is a bit unconvincing as well.

muirgeo February 29, 2008 at 11:50 pm

Such a monetary policy spawns whiners like Miurgeo who advocate for awful socialist policies and government redistribution of wealth when, in fact, we should be trying to defend the wealth creator from the wealth confiscator. I think this site would benefit from a thorough examination of money and monetary policy. I am still learning but highly sceptical of the ciurrent system.

Posted by: Hudson

No I'm advocating for better regulation not socialism. The current regulation distributes wealth upwards from productive workers to paper pushers and financial wizards who contribute zilch to productivity and actually cost the tax payers billions of dollars.

I'm advocating for an un-redistribution of wealth. And all of fools who think the wealthy don't like regulations are suckers. They love regulation as long as their money sets it up in a way that kills competition and re-distributes it towards them. Sugars subsidies, medicare drug bill, fed policy, deregulation of the financial and banking sectors… it's all wealth stealing noting more.

Heck I'm not the socialist…I sometimes think I'm more Hayekian then the Faux-Liberals who often comment here.

Python March 1, 2008 at 12:58 am

Hey Muirgeo, how's your study on identifying the year in which all of the US is 40 times as dense as modern Manhattan? I'll be waiting for your results.

DS March 1, 2008 at 8:41 am

All of this data is "inflation adjusted" supposedly to make comparisons of one period in time (in this case 1989) with today appear to be relevant.

There is one problem though: In the early 1990's the government changed the way it calculated inflation adding so-called "hedonic" and "substitution" adjustments which were, and still are, highly debatable. Maybe the largest change was switching from arithmetic weighting to geometric weighting which lessened the effects of rising component prices in the index in favor of those that weren't rising or were falling. What isn't debatable is that all of these changes reduced the reported CPI by some amount, between 1% and 5% depending on who you ask.

This had enormous benefits for politicans, bureaucrats and Fed officials, but it makes comparison with previous periods difficult at the least and down right misleading in most cases.

The effects were massive:

Government payments with Cost of living adjustments based on the government-calculated inflation rate were reduced, tax brackets that are indexed for inflation were indexed less resulting in higher taxes, and viola! you get a so-called government surplus.

Workers salaries throughout the economy are generally based on the gvoernment's measures of CPI, which of course means everybody's COLA raises have been less than the rise in prices. If there has been real wage stagnation or decline, this has been the real culprit.

Real GDP which is Nominal GDP reduced by the inflation rate, was artificially inflated which gave incumbent politicans an insurance policy on being thrown out of office. But more importantly it gave an artificial boost to the measured productvity rate (of which Real GDP is the numerator) which "magically" started going up in the mid-1990's, coincidentally about the same time as these inflation statistic adjustments were made.

And most of all, since the Federal reserve implicitly and explicitly uses all of these measures as it's guage of how much money to print they have consistently been on the side of printing too much money and creating too much inflation which we have seen manifest itself in 2 successive asset bubbles and now is manifesting itself in consumer price inflation.

And when even these highly modified statistics still don't justify what the Fed is doing, they start whittling down the statistics, focusing on "core inflation" which is simply a way of cherry-picking the numbers to make them say what they want.

The moral of the story: beware government statistics, since the beginning of time goverments have produced statistics to further their own purposes (staying in power) not to enlighten the citizens and provide better information.

muirgeo March 1, 2008 at 9:58 am

Good point DS.
This video kinda drives it home. But this is the Alice in Wonderland Classic Liberal Economics blog. If you attack the government for policies that may result in upward re-distributions of wealth you will be attacked in defense of the governments actions by these otherwise government hating Classic Liberal Economic Bloggers. Yeah it gets curiouser and curiouser. Didn't they also stop tracking M2 numbers?

Matt C. March 1, 2008 at 10:27 am

Martin-
Just because you can do it doesn't mean that other people will. I can do it too, but I choose not to. Why? Well, most equity lines are variable interest. I'd rather know what my interest rate for a note on my car is going to be.

Most people who need to take a loan for a vehicle will more than likely don't have a home where they can take equity out. My father-in-law pays cash for his cars, not taking a loan. He doesn't make the rule though. Just as though you take a equity line doesn't create the rule.

Muirego-
It is clear from the evidence that people are not taking loans to purchase consumption goods. Home PURCHASE debt is clearly up.

There are individuals who take equity lines out of their homes to PAYOFF credit card debt. IT DOES make their monthly payments lower. They can then use the interest as a deduction. Most of these individuals have high amount of credit card debts. Many of these individuals also have to use sub-prime mortgages. But sub-prime mortgages are a smaller amount of the mortgage business. It would not be a stretch to say that the individuals who do this type of debt rearrangement are a smaller percentage of those who have sub-prime mortgages.

I hope I was more convincing in my argument than your over indulgent statement back to me.

vidyohs March 1, 2008 at 10:33 am

"Sometimes it makes sense to take on debt, sometimes not, but in our system the debt tends to be inflated away as does savings.

Posted by: Hudson | Feb 29, 2008 1:46:09 PM"

Hudson,

I understand your point about your % of gains on investments outweighing your % of loss to debt. But, may I ask a question based upon my quote from your post above?

If one carries more debt than one can pay off quickly with cash in hand or convertible assets, then isn't one exposing one's self to loss of all assets due to repossession or to liens/levies should the economy take a serious sudden downturn that leaves your assets unconvertible(loss of worth plus loss of liquid capital in the market to buy your assets), and also leaves your cash in hand devalued? Would not the debt one carried have to be paid off at higher cost to the individual?

I am not challenging your position I am asking a serious question.

Martin Brock March 1, 2008 at 12:10 pm

Just because you can do it doesn't mean that other people will.

It's a theory of the decline in "auto debt". I have no evidence supporting the theory, but I don't know why else auto debt would would decline while other categories rise. Have auto sales declined?

FreedomLover March 1, 2008 at 3:09 pm

Posted by: Matt C. | Feb 29, 2008 5:30:22 PM

If you have $150K in house-debt and no other debts, take a $50K equity line to buy a car and other things, you've just increased your debt to $200K. That seems simple enough to me. Bottom line is that Americans are up to debt in their eyeballs. Heck, I can't imagine if had any debts other then my mortgage.

Martin Brock March 1, 2008 at 5:23 pm

I recently heard another housing bubble theory that I hadn't considered but that seems reasonable to me. I was listening to a talk from 2006, so I'm not discussing the situation now. The events I'm discussing are mostly behind us in this bubble.

In the early stages of the bubble, all house prices rise, because interest rates are low and the cost of ownership is low, so people can bid up all prices. In the middle stage, prices have been rising for a while, so a speculative inertia sets in, and prices rise above an affordable level. In the late stage, especially after an interest rate rise, prices are prohibitive. People simply stop buying because they can't buy. In this bubble, we had an even later stage in which credit terms became ridiculously loose, but that's not the interesting part.

All income groups don't stop buying simultaneously. Lower income people stop buying first. This fact had occurred to me, but a not so obvious consequence hadn't. Lower income people stop buying first, so houses at the low end of the market stop selling first. Low end prices don't fall suddenly, because people avoid selling at a loss if they can, especially if they're in negative equity, and most people can stay in their houses if they must. In a way, prices do fall, but the fall is not measured.

Houses at the upper end of the market keep selling, but the prices stop rising. Low priced houses stop selling. High priced houses keep selling. All house prices stop rising. Makes sense. Right?

Here's the interesting part. In this scenario, even though all house prices stop rising, an "average house price" keeps rising, because this measure is the average price of a house sold. The average rises not because any house price sells for a higher price but because fewer lower priced houses contribute to the average. Incredibly, this measure can rise even when all house prices are falling, because lower priced houses stop selling before higher priced houses all the way up the chain. The measure falls only when the rate at which higher prices fall somehow exceeds a rate at which lower priced houses stop selling. By the time we measure a falling "average house price", prices can have been falling for some time.

Counterintuitive results like this one are the most interesting part of any science.

Sam Grove March 2, 2008 at 12:18 pm

No I'm advocating for better regulation not socialism.

Except in the case of medicine and, no doubt, entitlement programs.

If you attack the government for policies that may result in upward re-distributions of wealth you will be attacked in defense of the governments actions by these otherwise government hating Classic Liberal Economic Bloggers.

Another classic straw man from muirgeo.

Most libertarians think we should close the FED (the main engine of the upward redistribution), end corporate subsidies, etc, whereas you think they should be better managed though better government.

Martin Brock March 2, 2008 at 7:59 pm

The Fed is a state agency regulating the extension of credit. If we eliminate it, we'll only replace it with something else eventually. If the price of gold were fixed now, other prices would be falling, and falling prices can wreak havoc on established contracts. To this day, the leaseholders on the Empire State Building effectively own the building, because the lease presumes a century of deflation that didn't happen. Today's contracts are biased in the opposite direction. They presume some degree of inflation.

Sam Grove March 2, 2008 at 8:36 pm

If we eliminate it, we'll only replace it with something else eventually.

Do you think this function must be a monopoly?

Sam Grove March 3, 2008 at 12:02 am

What did they do prior to 1913?

Martin Brock March 3, 2008 at 5:38 pm

Do you think this function must be a monopoly?

For a single currency, the regulatory function must be a monopoly. U.S. dollars are not Canadian dollars. Could we have many different "dollars" in the U.S.? I suppose so, but we've been down that road before, and it led here.

In the nineteenth century, we actually had many different varieties of bank note with "dollar" denominations, and they didn't trade one for one. Gold buffs think this fact reflects fractional reserve banking, because different banks lent different multiples of their gold reserve, but this theory is laughable. Then as now, a bank's gold reserve was not its principal asset. Its loans (and the assets securing them) were its assets.

If I owned a bank with a million dollars in gold in my vault, I might extend two million dollars in credit. This extension didn't mean that my dollar banknotes were worth fifty cents, because I lent the notes against the value of houses and other assets. If gold in my vault ran low as people demanded an exchange of notes for gold, I only had to take the records of my assets (the loans) to another bank with excess reserves and exchange them for gold.

The exchange rate of my notes for other notes depended on the security of my assets, the loans, not on the value of gold in my vault. It's not like gold is the only asset with any value. Under a gold standard, gold is the standard of value, i.e. it trades at a fixed price, so the value of everything else effectively is measured relative to the value of gold.

The problem with all of the different dollar denominated bank notes was a practical one. Different "dollars" had different values. It was an accounting nightmare. We didn't really have a single currency at all, and without a single currency, a single monetized market is problematic.

Martin Brock March 4, 2008 at 9:43 am

We're experiencing a run on gold right now, evidenced by the rapidly rising price. If the price of gold were fixed, this run would set in motion events driving the price of everything else down. You demand gold from the bank, so the bank must liquidate other assets to obtain more gold. These other assets are its loans secured against houses for example. The bank must have gold to sell to fix its price despite the growing demand, so it demands that borrowers sell their houses (calls their loans) to obtain all the gold that depositors are demanding at the fixed price.

DS March 9, 2008 at 12:27 pm

"The problem with all of the different dollar denominated bank notes was a practical one. Different "dollars" had different values. It was an accounting nightmare. We didn't really have a single currency at all, and without a single currency, a single monetized market is problematic."

No, all bank notes were denomenated in dollars which was simply a measure of how much gold a one dollar banknote would have to be exchanged for if the holder requested it. Bank notes would trade at a discount based on the reputation of the note issuing bank – in other words if you were absolutely certain that you would be able to exchange that bank note, without cost, for 1 dollar of gold the bank note would trade at par value. If there was some risk it could not easily be exchanged or if there was a transaction cost associated, then it would tarde at some fraction of par.

Having a dollar that consistently loses 4% of it's value each year causes accounting problems too (and many others that are much worse). Accountants deal with this sort of thing all the time.

The single currency was gold. Anybody could demand gold at any time in exchange for their bank notes. The more likely the holder believed that they would be able to make this exchange the less likely they were to actually demand gold.

"Gold buffs think this fact reflects fractional reserve banking, because different banks lent different multiples of their gold reserve, but this theory is laughable. Then as now, a bank's gold reserve was not its principal asset. Its loans (and the assets securing them) were its assets."

It is hardly laughable, you have certainly presented no evidence of "laughability". Whatever collateral the bank held was of no consequence to those who deposited their savings. They would not be compensated in a fraction of a house or recievable for raw materials inventory or any other hard asset.

The discount from par was ultimately a function of the likelihood of receiving gold in exchange for the bank note. The lower the reserve ratio the lower the par value – and the more likely that somebody would demand payment in gold of all deposits. Fractional reserve banking is an inherently unstable arrangement.

"We're experiencing a run on gold right now, evidenced by the rapidly rising price. If the price of gold were fixed, this run would set in motion events driving the price of everything else down."

The price of gold in the value of real assets is pretty much fixed, it's the fiat dollar price of everything, including gold that is increasing because the value of the dollar, and every other currency on the planet, is decreasing because none of those currencies are convertable. The price of bread in gold terms is pretty much the same as it was in Roman times.

You are confusing the cause and effect.

Martin Brock March 9, 2008 at 1:47 pm

No, all bank notes were denomenated in dollars which was simply a measure of how much gold a one dollar banknote would have to be exchanged for if the holder requested it.

All bank notes were denominated in dollars, but notes with identical denominations from different banks did not trade one for one.

Bank notes would trade at a discount based on the reputation of the note issuing bank – in other words if you were absolutely certain that you would be able to exchange that bank note, without cost, for 1 dollar of gold the bank note would trade at par value.

Right. This reputation reflected the value of the bank's assets. See above.

If there was some risk it could not easily be exchanged or if there was a transaction cost associated, then it would tarde at some fraction of par.

The risk that a note could not be exchanged was the risk that a bank could not obtain gold for its assets. See above.

Having a dollar that consistently loses 4% of it's value each year causes accounting problems too (and many others that are much worse). Accountants deal with this sort of thing all the time.

Don't keep dollars in your pocket for a year at a time. Keep them invested in real assets. When you need liquidity, sell an asset.

Four percent per year seems excessive. What matters is real economic growth. I don't much trust any of these statistics, but a fixed gold price is no panacea.

The single currency was gold. Anybody could demand gold at any time in exchange for their bank notes. The more likely the holder believed that they would be able to make this exchange the less likely they were to actually demand gold.

Gold was a commodity with a price fixed by statute. When the denomination a bank's circulating notes ceased to reflect the value of its assets (primarily its loans rather than its gold), the value of these notes fell, but the statute still required the bank to sell gold at the fixed price in its notes. A run on the bank's gold reserve ensued.

It is hardly laughable, you have certainly presented no evidence of "laughability".

The fact that bank notes did not trade dollar for dollar is this evidence. Banks redeemed notes at the fixed price as long as they could, but the value of the notes didn't reach zero when the bank's vault was empty, because the notes were still claims on the bank's assets.

Whatever collateral the bank held was of no consequence to those who deposited their savings.

It was consequential, because the collateral secured the bank's ability to collect as much gold as depositors demanded. This gold was not simply in the bank's vault. It couldn't have been.

They would not be compensated in a fraction of a house or recievable for raw materials inventory or any other hard asset.

They would be compensated in a fraction of a house in fact. A bank would sell its assets to another bank for gold. If the house was not worth enough gold to pay depositors, depositors received less.

The discount from par was ultimately a function of the likelihood of receiving gold in exchange for the bank note.

This truism is true, but it doesn't contradict any assertion of mine. The likelihood of receiving gold in exchange for the bank note reflected the value of the bank's assets, so you simply stop describing the process one step before I do.

The lower the reserve ratio the lower the par value – and the more likely that somebody would demand payment in gold of all deposits. Fractional reserve banking is an inherently unstable arrangement.

No. It wasn't the ratio of gold in reserve to notes in circulation. It was the ratio of notes in circulation to the value of the bank's assets. Banks routinely replenished gold reserves by selling assets. The system could not have worked otherwise.

The price of gold in the value of real assets is pretty much fixed, it's the fiat dollar price of everything, including gold that is increasing because the value of the dollar, and every other currency on the planet, is decreasing because none of those currencies are convertable. The price of bread in gold terms is pretty much the same as it was in Roman times.

Who told you that dollars aren't convertible? You may exchange dollars for gold any time you like. The price isn't fixed. That's all. The prices of silver and platinum and corn and wheat and pork bellies aren't fixed either.

You are confusing the cause and effect.

No. That's you. The declining value of a bank's assets (its loans) caused the value of its notes to decline, and this decline caused a run on the bank's gold reserves that the bank ultimately couldn't satisfy. If the bank's assets were valuable enough, it could satisfy the demand by selling the assets to other banks for gold.

DS March 9, 2008 at 11:39 pm

"Don't keep dollars in your pocket for a year at a time. Keep them invested in real assets. When you need liquidity, sell an asset."

That's simply a strategy for partially mitigating the ill effects of inflation. It does not illiminate the ill effects. Only being able to demand a fixed amount of gold or other commodity eliminates the ill effects of inflation. By this strategy I have to put my money at risk with the hope that the asset I buy will inflate by more than my money has lost value. I have lost something (or more accurately have had something stolen from me) in that transaction even if the asset appreciates equally in value, which is never guaranteed.

"Four percent per year seems excessive. What matters is real economic growth. I don't much trust any of these statistics, but a fixed gold price is no panacea."

First of all, nothing is a panacea, gold is simply the most effective vehicle for maintaining value. Fiat currency, backed only by assets denomenated in the same fiat currency, is not an effective way to insure that money maintains a constant value.

4.3% a year, the current government reported CPI for 2007, is the lowest possible estimate, the real number is definitely higher. But since the government has changed the way the statistics are calculated about 6 times since 1980, it's hard to make real comparisons. The statistics are largely useless, but there is no motivation whatsoever for the government to over-report inflation. So it's safe to say that the dollar lost at very least 4.3% of it's purchasing power and most likely a lot more.

"When the denomination a bank's circulating notes ceased to reflect the value of its assets (primarily its loans rather than its gold), the value of these notes fell, but the statute still required the bank to sell gold at the fixed price in its notes. A run on the bank's gold reserve ensued."

The statute required that the bank pay the depositor the same value that they had deposited in the bank, on demand, which is what a demand deposit is. The fact that the bank couldn't come up with that value on demand was the bank's problem. Fractional reserve banking is a house of cards after all.

"It was consequential, because the collateral secured the bank's ability to collect as much gold as depositors demanded. This gold was not simply in the bank's vault. It couldn't have been."

Then the banks shouldn't have agreed to pay back depositors gold on demand. Of course then the bank would have to pay higher interest to depositors in order to compensate them for limited availability of their own funds, which would make banking less profitable.

And by they way, the obligation to pay depositors on demand has nothing to do with the gold standard, it is a basic legal obligation.

"If the house was not worth enough gold to pay depositors, depositors received less."

And that was the case the bank should have been forced to declare bankrupcy and close it's doors, forever. Like any other business that defrauds it's customers or can't pay it's legal obligations.

What actually happened most of the time was the government would allow banks to suspend payments of specie, robbing depositors of their money.

"No. It wasn't the ratio of gold in reserve to notes in circulation. It was the ratio of notes in circulation to the value of the bank's assets. Banks routinely replenished gold reserves by selling assets. The system could not have worked otherwise."

As with any currency the value is inversely proportional to the amount of currency in circulation. If the amount of notes increased but the amount of gold in the vault stayed the same (i.e., the reserve ratio went down) then the value of the notes decreased. Supply and demand – increase supply and the value goes down.

"Who told you that dollars aren't convertible? You may exchange dollars for gold any time you like. The price isn't fixed. That's all. The prices of silver and platinum and corn and wheat and pork bellies aren't fixed either."

No, no, no.

Just because you may exchange paper dollars for goods, services, commodities or assets denomenated in paper dollars of any value at all doesn't make them convertible. Convertiblity means that the entity that issues a piece of paper as proxy for an agreed upon amount of gold agrees to pay that amount of gold on demand. What you are proposing is that depreciated paper dollars can be exchanged for a declining amount of a commodity, good or service. That's just not the same thing.

Convertibility is a means of insuring the value of bank note. When the bank (or the Fed) issued the note it had a certain value. If the value of that piece of paper is not maintained – depreciated due to the value of that bank note declining – then the note is not convertible. If that note depreciates in value and I can still exchange for a fixed amount of gold then the loss due to that depreciation is borne entirely by the bank – where it should be.

You appear to be using the world "convertible" in an entirely different context, implying that if I can exchange it for any value at all, even cents on the dollar, that the condition of convertibility has been satisfied. It has not.

Martin Brock March 10, 2008 at 1:07 pm

That's simply a strategy for partially mitigating the ill effects of inflation. It does not illiminate the ill effects.

A small amount of inflation is probably a good thing. Currency is a unit of current account, not an asset to be held.

Only being able to demand a fixed amount of gold or other commodity eliminates the ill effects of inflation.

Fixing the price of gold or another commodity or an index of commodities is a monetary policy, and regulating the price of a commodity index is a policy I sometimes advocate for the sake of discussion, but it's no panacea for economic health.

By this strategy I have to put my money at risk with the hope that the asset I buy will inflate by more than my money has lost value.

You think that holding gold is any different than holding currency when the price of gold is fixed? People who held currency under a gold standard weren't immune to the risk of loss.

I have lost something (or more accurately have had something stolen from me) in that transaction even if the asset appreciates equally in value, which is never guaranteed.

Nothing is stolen from you when prices change. You aren't entitled to the same prices tomorrow that you see today, and you shouldn't be. If you really believe that gold is a good inflation hedge, hold gold. There's no law against it, and I oppose any law against it.

Fiat currency, backed only by assets denomenated in the same fiat currency, is not an effective way to insure that money maintains a constant value.

Constant prices are not the only possible goal of monetary policy. A gold standard itself involves a currency backed by assets (gold) denominated in the same currency, and holding the banknotes rather than the gold itself always entails risk.

The statistics are largely useless, but there is no motivation whatsoever for the government to over-report inflation.

Like I said, I don't much trust these statistics.

The fact that the bank couldn't come up with that value on demand was the bank's problem.

It was also the depositor's problem. Your distinction between "depositor" and "bank" is a common misconception. Depositors are the bank. They are investors in the bank. At my credit union, we're called "share holders".

Fractional reserve banking is a house of cards after all.

Fractional reserve banking decentralizes the authority to issue currency. Currency is a unit of account, accounting for the value of everything not only the value of gold.

Then the banks shouldn't have agreed to pay back depositors gold on demand.

You're right. Thus banks abandoned the gold standard.

And by they way, the obligation to pay depositors on demand has nothing to do with the gold standard, it is a basic legal obligation.

Under a gold standard, the fixed price of gold is the legal definition of "dollar". Banks often didn't promise redemption of a gold deposit on demand, and even if they did, "on demand" often meant waiting a while. If you demand a gold deposit and don't receive it immediately, telling your neighbors to line up at the bank with similar demands is foolish.

Of course then the bank would have to pay higher interest to depositors in order to compensate them for limited availability of their own funds, which would make banking less profitable.

If you expect interest on your deposit, you necessarily expect the gold to be lent, and any lending involves a risk of loss. A fractional reserve requirement enables a higher yield for gold depositors, but it need not involve more risk. It can involve less risk, because more houses and other assets secure the loans.

Suppose you give me ten pounds of gold and expect three percent interest. Now, I must lend your gold to earn the interest. The value of ten pounds of gold is comparable to the value of a house, so I lend your gold at five percent to someone purchasing a house.

I don't write any bank notes. I just hand out the gold. Clearly, you risk loss of the gold. Even if I hand out a bank note instead of the gold, the seller of the house gets the bank notes and must be entitled to exchange them for your gold, so you still risk loss of the gold.

Suppose I lend bank notes denominated at twice the value of your gold. These notes secure two different houses. Both houses are equivalent in value to ten pounds of gold. I have your gold and loans secured by assets equal in value to twice the value of your gold. If the new homeowners meet their obligations, you earn a higher interest rate. What's the problem?

Suppose I may not lend bank notes denominated at twice the value of your gold. A home builder has two houses to sell and no other bankers exist. We just don't finance the second house? Someone must pay cash for a house or it doesn't sell?

In reality, no one pays cash for the second house in this scenario. Instead, the home builder extends credit himself without involving the services of our bank, and we simply lose the business opportunity.

And that was the case the bank should have been forced to declare bankrupcy and close it's doors, forever. Like any other business that defrauds it's customers or can't pay it's legal obligations.

Bankruptcy didn't necessarily close businesses then any more than it does now. Competing interests divided the value as they do now.

If the amount of notes increased but the amount of gold in the vault stayed the same (i.e., the reserve ratio went down) then the value of the notes decreased.

No. Currency denominates the value of everything, not only the value of gold.

Just because you may exchange paper dollars for goods, services, commodities or assets denomenated in paper dollars of any value at all doesn't make them convertible. Convertiblity means that the entity that issues a piece of paper as proxy for an agreed upon amount of gold agrees to pay that amount of gold on demand.

This convertibility involves a fixed price of gold.

What you are proposing is that depreciated paper dollars can be exchanged for a declining amount of a commodity, good or service. That's just not the same thing.

No. Even if we agree that gold trades at a fixed price, the volume of currency has nothing fundamentally to do with the volume of gold, because currency denominates the value of everything, not only the value of gold. Expecting the money supply to equal the gold supply while the gold price is stable is like expecting the money supply to equal the milk supply when the milk price is stable. This expectation makes no economic sense.

Convertibility is a means of insuring the value of bank note.

That's true, but it doesn't require a money supply strictly reflecting the supply of banked gold. The gold standard never worked this way. A "dollar" bank note was supposed to be worth as much as a dollar's worth of gold, where the price of gold was fixed by law.

When the bank (or the Fed) issued the note it had a certain value. If the value of that piece of paper is not maintained – depreciated due to the value of that bank note declining – then the note is not convertible.

In a decentralized monetary system in which banks issue currency (bank notes), the value of the notes depends on the value of the assets securing the loans, not on the value of gold in bank vaults. The trade in banked gold at the fixed price limits the issuance of currency, but it doesn't limit the money supply to the supply of banked gold. It couldn't possibly.

If that note depreciates in value and I can still exchange for a fixed amount of gold then the loss due to that depreciation is borne entirely by the bank – where it should be.

No. Depositors bear this risk. "The bank" is not some rich guy who takes your money and gives it back to you on demand. If you're a depositor, you are among the company of rich guys comprising the bank.

You appear to be using the world "convertible" in an entirely different context, implying that if I can exchange it for any value at all, even cents on the dollar, that the condition of convertibility has been satisfied. It has not.

I use "convertible" in its ordinary, common sense. If you want to hold gold risklessly, find a remote place to bury it and don't tell anyone where it's buried. If you want an interest in the business of extending credit, you must accept some risk. No state on Earth can absolutely guarantee the convertibility of bank notes, used to extend credit, for gold at a fixed price, and I don't want any state offering this guarantee.

DS March 11, 2008 at 1:29 pm

"A small amount of inflation is probably a good thing."

I wish you would have made that statement at the beginning so I didn't waste my time debating with you.

Your arguments make much more sense if your goal is to purposely create inflation. We're obviously not talking about the same thing.

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