I’ve discussed this before, however, it carries more weight when described by a man of Einstein’s stature.  The one primary flaw in the gold standard was very similar to what we are seeing in Europe today.  Because nations were required to have specific amounts of gold there was generally an imbalance in the global economy due to trade imbalances.  Trade surplus nations were hoarders of gold while trade deficit nations were generally in shortage.  If you were unable to mine or obtain the gold thru other measures your trade deficit put you at a persistent and inherent risk of recession without a reasonable ability to defend your citizenry from depression.  Einstein described the inherent weakness in this monetary system:

“The gold standard has, in my opinion, the serious disadvantage that a shortage in the supply of gold automatically leads to a contraction of credit and also of the amount of currency in circulation, to which contraction prices and wages cannot adjust themselves sufficiently quickly.”

In essence, trade deficit nations (as we see in Europe today) were forced to overcome their trade deficit by counteracting it with high budget deficits.  The sectoral balances must net to zero so a nation which attempts to run high trade deficits cannot also run budget surpluses without experiencing economic contraction.  As we’ve seen in the sectoral balances approach, this is an accounting identity and not opinion.  So, there is an inherent flaw in a monetary system which lacks the flexibility to respond to these imbalances.

This is apparent in Europe today where trade deficit nations have been largely coerced into profligacy with no real ability to defend themselves from the inevitable recession.  Not surprisingly, Germany, the trade surplus nation in the region is booming.  In a floating exchange rate system with monetary sovereignty the periphery nations would simply devalue their currencies and natural market forces would help to remedy the trade imbalances.  Germany’s currency would rise which would make German manufactured goods less attractive, the periphery nations would experience currency devaluation and higher trade.  Over time their economies would stabilize and recover.  This, of course, was not an option under the gold standard and is not an option in modern day Europe.  Hence, the persistent weakness across the region’s periphery nations.

The gold standard is not a viable monetary system.  The reasons why it failed are simple to understand once one sees the natural flaws that the sectoral balances approach exposes.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • Bill

    didn’t the classical economists consider this a feature rather than a bug?

    money leaves, prices fall, trade terms are improved for deficit countries and harmed in the surplus countries. self-correcting market process. in absence of superpower capable of imposing universal fiat reserve currency, you’re stuck with a hard money standard. what other options allow world trade?

    was einstein really a credible authority on economics? this sounds like an appeal to authority argument. but why is einstein an authority on economics?

  • FDO15

    I think Einstein was a socialist.

    But the gold standard didn’t help self correct. That’s why the depression led to many countries abandoning it. The correction was either not taking place or was way to slow to take place.

  • FDO15

    So, Europe needs to go back to their old currencies, right?

  • Bill

    we weren’t on a classical gold standard after 1914. we were on the “gold exchange standard.” check out selgin & white for the difference, if you don’t know. the classical economists of course were only talking about the classical gold standard. i’m not defending the gold standard per se, just pointing out that the einstein crit was considered a positive not a negative by the classical economists.

  • HankB

    The gold exchange standard loosened the restrictions of the gold standard. But it still had the same restraints. All countries were ultimately still pegged to gold prices and so the same imbalances appeared from time to time.

  • FDO15

    What Einstein is referring to is what happened during WWI. Countries could not afford to pay for the wars because they couldn’t expand the amount of currency in their economy. So, they removed it. It makes no sense to be involved in a currency system that restricts a nation from defending itself. In my opinion, it is the duty of the government to protect its people and avoid depression. The gold standard makes both impossible.

  • Newbie

    Bill, pardon my ignorance, but can you explain why prices would fall under your scenario? Thanks.

  • Bill

    modern governments will obviously discard the restraints of a hard money standard when its a question of war. whether this is a positive or a negative, it is a reality that comes with modern governments. you might also notice the inverse fact. before fiat issuing democratic governments, you didn’t have huge catastrophic wars.

    but saying the gold standard caused the great depression is not the same as establishing it to be true.

  • Bill

    a net outflow of gold and a contraction of circulating media naturally leads to falling prices.

    just like prices rose during periods of net influx of gold. e.g., the large inflow of gold to spain from the new world.

  • http://www.pragcap.com Cullen Roche

    That’s theoretical and not necessarily true in reality. In reality, wages really are sticky. So, while prices should theoretically fall the reality is that they are slower to respond than most would assume. The gold standard (or exchange) was not flexible enough to account for this.

  • Bill

    well look cullen, in a world without fiat money, the only available adjustment is prices. that adjustment isn’t necessarily linear or painless, but neither has the fiat rollercoaster been. if you believe long term, responsible fiat money management by sovereign democratic governments is possible (even in a world without a unipolar power like USA 1945-2010), wonderful. i don’t think that is realistic. the actual experience thus far shows that we get piss poor management by a) ignorant governments b) badly incentivized governments (public choice theory). it’s hard to imagine a functioning global economy with no fixed exchange monetary standard in a world not dominated by a single power.

  • http://www.pragcap.com Cullen Roche

    We entirely agree that management of fiat money thus far has been pretty poor. But I don’t think that’s a result of the system itself being corrupt, but rather the men and women who manage it being corrupt. I just don’t see how a gold standard will really make things better. What we need instead is to put people in charge who truly understand how these things work. It’s my opinion that most of the people in charge have practically no clue what is going on so it doesn’t surprise me to see them mismanage the system.

  • breed12

    gold standards are stupid. why constrain monetary units based on what you dig out of the ground. roche is right, bad policy is just bad policy, fiat currency is not at fault for the woes that people are ascribing it, bad government policy is.

  • Bill

    i didn’t say that a gold standard re-inserted into the present system would necessarily improve anything. but i don’t think you responded to my point. could you picture a functioning global economy having developed, or for that matter, continuing, in the absence of a dominant superpower, a unipolar world with a sovereign reserve currency like USD? in absence of a credible fiat currency, backed by a dominant superpower, the only available option is hard money. if i’m wrong on this, you’d think fiat money would have emerged before 1933. before the 20th century, who would have accepted monopoly money? historically, what’s more normal: a unipolar world with a dominant superpower, or a multipolar world engaged in trade with a currency with intrinsic value and private lending?

  • Bill

    you’re imagining that present political conditions are the norm or existed always. this betrays the fact that you were educated in a modern government school. sorry, but people who mock the gold standard betray their myopia and ignorance.

    imagine a world without a unipolar US superpower. the only way trade can take place is with currency which has intrinsic value. hence, that’s what existed for 6 or 7 thousand years of human history.

    my money would be on such conditions existing again in the future. civilization will probably exist for many thousands of years, who knows. but long before then, i’d bet that USG dollars and all existing fiat currencies will be a memory.

    if people intend to have a non barter economy, they will trade with currency which has intrinsic value, or they won’t trade at all.

    i asked cullen above, and i’ll ask anyone else. why didn’t fiat currency emerge before 1971? you don’t think governments were capable of coming up with he brilliant idea of printing money before john law or JM keynes? of course they could. it just wasn’t feasible prior to modern superpowers like USA or USSR.

    i won’t go so far as to call USA ‘totalitarian,’ but a certain assumption of implied unlimited state authority is necessary before citizens will accept fiat money. domestically, that point was reached under FDR. and for fiat money to work internationally, a unipolar world is necessary. this political condition seems to have been reached by 1971.

  • http://www.pragcap.com Cullen Roche

    Fiat money emerged due to the growth of the global economy. This was partially due to convenience (gold is pretty damn inconvenient to lug around), but primarily due to growing global trade. Major trade imbalances did not occur until global entities began trading and generating substantial economic growth via these channels. As the global economy grew the inflexibility of the gold standard became more and more apparent. Until, finally, it burst.

  • troll

    So the way this economical ignoramous understands the “best” monetary policy is this:
    By basing one’s floating exchange rate on nothing concrete (i.e. the good faith and credit…..), we can make it worth anything we want, because it is entirely imaginatory. After all, by basing it on something concrete (i.e. gold….), we must account for it’s worth.
    Did I get that right?

  • http://www.pragcap.com Cullen Roche

    Actually, a fiat currency is based on the goods and services that that economy outputs. It’s when productivity collapses or corruption enters the system that things fall apart. That’s not a failure of the system. It is a failure of its participants.

    A gold standard has equally destructive downsides….

  • Bill

    Fiat money emerged due to the growth of the global economy. This was partially due to convenience (gold is pretty damn inconvenient to lug around)

    lol come on guy. bank notes and short term credit were around for centuries. this has nothing to do with the concept of fiat money.

    fiat money is token money which you have to accept by law. it is used by large governments to mobilize domestic resources, as in time of war. the first world war was the first large scale use of fiat money. no governments prior to this time really had the power to impose a permanent fiat money. certainly the monarchs had a hard time getting away with coin clipping, etc., as power was diffused, limited, and wealth was mobile.

    world wide use of a fiat standard is only imaginable in a unipolar world dominated by a single power. hence it did not emerge until 1971.

    but primarily due to growing global trade. Major trade imbalances did not occur until global entities began trading and generating substantial economic growth via these channels.

    i honestly do not see any logical exposition of an argument in these sentences. between 1 A.D. and 1918 there was a lack of growth in global trade? but from the year 1971 the needs of global trade (rather than the over-issue of US currency due to war) suddenly skyrocketed?

    if we distinguish between the domestic imposition of fiat money from its use internationally things become a little clearer.

    domestically, fiat money has been used by strong central governments to mobilize domestic resources, first in war, then in depression.

    internationally, the use of a fiat currency as the standard emerged only after a single power became dominant, proceeded to abuse its position as issuer of world reserve currency by over-issuing notes, and then, when challenged by a junior province, reneged on its agreements in order to assert its sovereignty (and make clear to countries, like france, that the US would exercise its imperial prerogatives).

    none of this is an argument for or against fiat, or for or against a gold standard. it may be that fiat money is inevitable in a modern industrialized economy with a democratic government. that is, domestic fiat money is probably inevitable in modern, advanced industrial economies with sovereign democratic governments (permanent, totalitarian bureaucracies who’s titular figureheads shift every four years or so). whether or not this improves long term economic performance is very debatable and is being debated. assuming that it can be perfected despite institutional and incentive problems, is not the same as showing that it can be.

    internationally, however, a peacetime fiat standard can probably only exist alongside a dominant superpower. so i think hard money necessarily reemerges in a multipolar world with multiple, equal trading nations. colonies might be expected to accept/hold the fiat paper of a dominant power, but equal powers cannot be assumed to accept each others’ fiat money on faith alone. they will want trade to balance or to settle up with real money with intrinsic value. why hold paper when you can demand real payment if you are equal or greater in power? last i checked, USA still holds the gold…

    i reiterate the point that fiat money, a very simple idea, did not emerge until 1971 internationally and the 1930s domestically. why wouldn’t governments, which had debased coinage as much as they could get away with for centuries, not impose a fiat standard before the 20th century? because they couldn’t.

    As the global economy grew the inflexibility of the gold standard became more and more apparent. Until, finally, it burst.

    cool, but that’s not what happened. internationally a gold standard was maintained until 1971. the US government over-issued its notes, a peripheral nation france demanded payment be balanced by receiving gold, and the US responded by exercising its imperial prerogative of not paying.

    this is the same imperial prerogative the USG exercised upon its own subjects in 1933.

    since fiat money can only be imposed by… err, fiat, its use internationally assumes a dominant power.

    i emphasize this is not a criticism of fiat money per se. it is probably inevitable when running an empire which is not supposed to appear to be an empire, or managing subjects who are supposed to appear as citizens.

  • http://www.pragcap.com Cullen Roche

    Bank money is created through the fractional reserve system. Horizontal money creation is dramatically different from vertical money creation. You’re using the two as if they are the same thing. Some form of fractional reserve banking has existed for a long time, but the development of a truly fiat monetary system did not begin to emerge until global trade became a significant portion of international GDP.

  • Bill

    Bank money is created through the fractional reserve system. Horizontal money creation is dramatically different from vertical money creation. You’re using the two as if they are the same thing. Some form of fractional reserve banking has existed for a long time, but the development of a truly fiat monetary system did not begin to emerge until global trade became a significant portion of international GDP.

    no sir i am not. i wasn’t referring to the concept of vertical vs. horizontal money, which i understand. i was referring to your claim that fiat money emerged in response to the cumbersome nature of transferring gold coins, a problem that was solved centuries earlier by using bank notes, short term credit, etc. it simply did not.

    this is unrelated to the question of vertical vs. horizontal money which has relevant in the modern monetary system. i’m coming to this discussion from a MMT perspective. this has nothing to do with the reasons for the emergence of fiat money as the standard for world trade.

  • Bill

    sorry that i keep forgetting to close italics, that must be annoying.

  • Brian

    Vast improvements in transportation, communication, information and a huge increases in world wide trade are the major reasons we have moved to a fiat currency world. Technology is what made a fiat world possible, not a world superpower.

  • BK

    Didn’t Nixon kill the gold standard?

  • Bill

    the only valid criticism of the gold standard that i’m aware of is that there simply isn’t enough physical gold (vertical money under a classical gold standard, as mosler points out; in MMT, government deficit is equivalent to output of a gold mine under a gold standard) to handle the needs of trade, hence the need for excessive leverage of the horizontal money system (similar to the leveraging up as a result of insufficient deficit during clinton years).

    some of the more simple minded austrians think the price of gold is infinitely elastic, but this cannot be true for any commodity. the market demand for gold, even as money, is only so large and no larger. so it is possible that there is no enough physical gold, placing undue strain on the horizontal money system to facilitate transactions. this probably does not apply to gold as an international standard for settling trade imbalances, which one presumes would be the normal condition of things in absence of a dominant superpower (pre-1945 or 1971, depending on when you fix the date.)

    whether this criticism of gold is accurate depends on whether or not there is enough gold to settle trade between nations, as during bretton woods say. i think the gold supply is most probably adequate to settle trade between nations, but why would the USG want this? the existing system is better for US terms of trade, since the world economy is kind of forced to use the reserve currency under present conditions, if it wants to trade. there’s no other option really. in a multipolar world of multiple equal trading partners, this would not be the case.

    domestically, fiat money is probably inevitable regardless of whether it is necessary or not to handle the volume of trade. i.e., even if it were fully possible for the amount of gold to support the volume of trade without relying on excessive leverage from horizontal money, it probably would not be tolerated by a modern democratic central government. that’s a political question. a small, civilized state could probably do well without fiat money, but not large, hard to manage places like modern USA.

    none of this really touches on the emergence of fiat money as the international standard. or domestically, for that matter. my view is that it is a question of power. once sovereign governments had the power to impose fiat money, they did so domestically. once a dominant power had the ability to impose its fiat money globally, it did so. nothing confusing about that. the question of whether it actually improves trade or economic performance is very debatable. i have not seen persuasive arguments that it does so.

  • http://www.pragcap.com Cullen Roche

    Interesting thoughts Bill. Thanks.

    I personally believe the fiat system is superior due to the reason described in the original post. The removal of this constraint gives a govt dramatic flexibility when defending itself from depression and war. While that might not be in the best interest of the entire world, it is in the best interest of individual nations and ultimately, that’s what govts exist for – to enhance the prosperity of the pvt sector.

    If we were all one big happy global family I think the system would be quite different, however, we’re still a world of individual nations that each act in the best interests of themselves….

  • Bill

    can you refer to the evidence? i’m aware of criticisms of the inter-war gold exchange standard, that there are some who say the great depression was caused by he gold standard, which aren’t very persuasive. i’ve also seen lots of persuasive explanations of the depression from other perspectives.

    i’m actually not aware of any real sincere arguments that closing the gold window in ’71 had anything to do with the complexity of trade. we closed it cuz we didn’t want to lose our gold. and we had the power to do so, so we did. but since you don’t want to make the argument yourself, after all you have a blog to run, maybe you can refer me to some articles or authors. thanks.

  • Bill

    true enough.

  • Bill


    that’s most probably partly true. fiat was not feasible before modern all-powerful governments. (and let’s face it, modern USG is all powerful, despite appearances. the ability to impose fiat in the first place shows its power. new deal introduced modern, powerful central gov’t). despite the two party kabuki theatre, we have a very firmly entrenched permanent bureaucracy, large military, large federal police force, which isn’t going any where voluntarily. tea partiers might not like that fact, but it’s so.

    whether this is a good thing or not, for economic performance, is the question. i think the evidence has been mounting that it’s piss poor for economic performance, especially when the powers-that-be don’t even realize they’re running an MMT system. it’s like, hey sauron, ya got the ring of power dude. use it.

    whether economic conditions would be worse or better if the government was run by people who understood MMT is also an open question. to assume that our democratic government would exercise MMT power responsibly is almost a funny question. is their inept f-ing up worse than their adept f-ing up would be? i.e., would they f up even worse if they understood MMT principles? would that not just enhance their ability to squander resources and transfer wealth to chosen constituencies?

    these of course are all questions of political economy which are not answered by an MMT understanding. they must be answered by other areas of economic and political theory. or better yet, in practice, we’ll learn what’s what.

  • Tom Hickey

    Why Socialism? by Albert Einstein

    Short and very worthwhile. It’s more a critique of capitalism and very apt today.

  • LZ

    How many bubbles around world since Nixon severed link to gold? Japanese stocks bubble, nasdaq bubble, Chinese stocks bubble, Real estate bubble, Chinese real estate bubble, emerging market bubble, oil bubble, gold bubble, copper bubble, uranium bubble, food bubble, bond bubble, My goodness, a lot more to come, to keep your paper money house of cards from collapsing.

  • Bill

    that’s probably the most salient point the libertarians/austrians fail to understand. that’s why i say fiat is most likely inevitable domestically, when you have strong & mutually competing central governments.

    but internationally, as i have said, it depends on whether there’s a dominant power within a large enough power bloc to impose use of its reserve currency. in absence of such a power, hard money seems the inevitable default. just as, if the central government is not sufficiently powerful, hard money is the default of the private sector.

    the question of economic performance, good governance, effective regulation of private sector, is entirely separate. certainly fiat money has not been managed wisely by its practitioners, which we agree on. and there is the possibility that it cannot be managed efficiently in a dysfunctional political setting.

    thanks for taking the time to reply.

  • LZ

    “The removal of this constraint gives a govt dramatic flexibility when defending itself from depression and war.”

    Lol today we have to face depression every a few years and in irrelevant wars forever. That is the cruelest irony.

  • Anonymous

    Today’s finacial transaction(virtual economy) vs. trade transaction(real economy) is roughly about 100:1.7
    I guess that is becuae of fiat currency system.

  • Bill


  • Bill

    i was wondering if you read the selgin, white, lastrapes paper “has the fed been a failure?” from a few months ago.

  • Bill

    thanks for the reference.

    Here’s something from Selgin on the topic,

    George Selgin (University of Georgia), Review of:
    The Great Depression: An International Disaster of Perverse Economic Policies
    by Thomas Hall and David Ferguson (University of Michigan Press, 1998)
    Southern Economic Journal
    Jan. 1999. Vol. 65, No. 3. pp 653-656


    Hall and Ferguson trace the roots of the depression to World War I, when the belligerent nations of Europe abandoned the gold standard. Gold payments were resumed during the 1920s but at parities that were generally inconsistent with international equilibrium: The pound was overvalued while the dollar and franc were undervalued, causing a gold outflow from Britain that was worsened by American and French attempts to sterilize gold inflows. Although the Fed did switch to an expansionary policy, for Britain’s sake during 1927, it reversed policy a year later in response to gold outflows and advancing stock prices. This reversal is supposed to have initiated the depression by triggering the U.S. stock market crash. The depression then continued to deepen because of falling stock prices and in response to a continuing decline in the quantity of money, which the Fed (influenced by the real-bills doctrine) failed to prevent. In the meantime, Congresspassed the Smoot-Hawley tariff, dealing a serious blow to international trade. Overseas, Austrian and German bank failures added to deflationary pressures.

    Faced with massive declines in aggregate demand, depressed nations could hope to recover either by reviving spending through aggressive monetary or fiscal actions or by allowing prices and wages to decline to levels consistent with fallen demand. Germany, one of the two hardest hit nations, expanded both its money stock and government spending (in the unfortunate form of Nazi-sponsored militarization programs). The United States, also hard-hit, took some steps (including the bank holiday and later devaluation of the dollar) to restore its money stock and aggregate spending, but simultaneously instituted the National Recovery Act (NRA), which tended to raise prices and wages, undermining the output and employment gains that demand expansion might otherwise have achieved.

  • http://www.pragcap.com Cullen Roche

    I do recall reading it. But it’s based on a very neoclassical belief in economic theory so, naturally, my conclusions are all different.

    I don’t think the Fed has necessarily been a failure. I think they have simply bitten off (or been force fed) more than they can chew. It should not be their responsibility to stabilize prices or target full employment. They don’t have the tools to do either so it’s kind of like asking your blind friend to help your children cross the street.

    Personally, I think the Fed should be merged with tsy and that the shenanigans with the markets, int rates and whatnot should be ended. The Fed is far less important than most people think, however, their constant tinkering has been destructive from a psychological level. But who cares what I think?

  • http://www.pragcap.com Cullen Roche

    Here’s the link to that paper. If nothing else it’s a good historical overview of the currency evolution.


  • Bill

    cool thanks.

  • Bill

    your readers of course… the academics and scholars are great, but they all are in love with their own theories, disagree with each other, overemphasize the value and importance of their own data and biases. writers and bloggers, who show good judgment, take in, cull, measure, weigh and synthesize all that info, and help to put it into its proper place and assign it its proper weight. you seem to have a pretty coherent and effective understanding of our economy and its markets. when i have an economic thought or question i bring it here, rarely elsewhere. bloggers are our unsung modern intellectual heroes, lol. shit, MMT probably owes as much to its bloggers as to its intellectuals. i was shocked to learn that they had been around publishing papers for like 2 or 3 decades. they must be terrible at PR or penetrating the journals. if it wasn’t for winterspeak, steve keen, prag cap, etc., i would never have heard of it. for someone to be able to read and take in all the perspectives on the spectrum and put out a coherent synthesis, like your do on your blog, shows a sharp, confident and independent mind at work.

  • http://www.pragcap.com Cullen Roche

    Thanks Bill. It’s really great to have readers like yourself who are responsive, intelligent and often carry alternative perspectives. We’re all trying to find answers to these important questions and discussions like these are a step in the right direction. I’m off for a few hours of sleep. Have a good one.

  • goddfriend

    simple & crystal clear description of this issue

  • goddfriend

    i would prefer Sauron, if he has the ring of power, unable to understand has to use it. Politicians, if they were to understand MMT would probably enter into massive Ponzy scheme before each election.

  • goddfriend

    “Prices and wages decline in line without lower demand”. i.e. real wages adjustment ? lowering them would have provoked an even lower demand. Guess only solution was then govt spending…

  • Jim Schroeder

    This has been a very interesting group of comments on a very important and volatile subject. A fiat system may, on its own not be corrupt, but there are inadequate safeguards to protect the public from abuse of the system by those entrusted to administer it. The inflexibility of the gold standard is the blunt enforcer of accountability. From bitter experience we have learned that those seeking public office frequently have a higher interest in their fortunes rather than those that they serve.

    Fiat systems and the Federal Reserve system together are hand maidens to the political system providing “flexibility” for those in power to pursue their nefarious goals. Any system that systematically robs savers of their assets is not in the best interest of the citizens. The inability to have a stable store of value in the national unit of account is, in my opinion, criminal. The good Dr. Bernanke would like us to gracefully accept 2% inflation, why?

    We need a new system and if it is the inflexible one based on Au then so be it.


  • goodfriend

    and great dialogue with Bill ! now i’ve got to read the D’Arista paper

  • boatman

    the problem here is there will never be anyone independant or/and prescient enough to correctly implement fiat money/Keynesism…..tighten when things are getting better to keep from overheating?…..not happening.

    we are flawed creatures…..its what makes us human…it is a fact.

    we will stumble around, blow bubbles……retired people will be screwed w/inflation, working stiffs who blindly trust money managers will lose money, bankers will be bailed out,….etc.

    cause of death from mistakes in hospitals is between 5th to 9th on the list(human errors) and were supposed to come up with people that can effectivly run monetary systems with all the power n corruption that follows money and politics.

    but this is all interesting reading, and i do appreciate the education, Cullen

  • Obsvr-1

    fiat money did exist before 1971, greenbacks for the civil war (once non-convertibility was mandated), Continentals for the revolutionary war. And many historical references when notes were deemed non-convertible by the power elite.

    I agree with Bill on the return to the gold standard to constrain the flawed-man from corrupting any monetary system. It was amazing to see Greenspan come out an say “gold standard” and that the economy worked before 1913 e.g. End the FED.

    Eliminating FRB would stop the other flawed-men (banksters) from counterfeiting currency.

  • http://asianom.com Rob Parenteau

    Cullen: I am glad to see you are using the financial balance approach in your note. However, please be careful with the conclusions you draw from this approach, which in its simplest form, only says that the financial balances of all the sectors in the economy must net to zero.

    We know this to be true from many centuries of double entry book keeping. Total income earned on final goods and services must equal total expenditures on the same for any accounting period, so the deficit spending by some sectors must be accompanied by an equal and offsetting net saving position (saving out of income flows in excess of investment in tangible capital goods or structures)for the remaining sectors.

    You take an additional step and link sector financial balances to income growth. While it is true both a fiscal surplus and a current account deficit will drain cash flow from the domestic private sector, we also must allow for times and conditions when the domestic private sector wishes to deficit spend. During asset price booms, for example, we often find domestic households and firms are willing and able to spend more money than they earn. If the desire to deficit spend by the domestic private sector is large enough, you can still get income growth in the economy despite a rising fiscal balance and a falling current account balance.

    Take a look at the late ’90s during the New Economy Boom in the US, and this is precisely the configuration you will observe. The problem is unless the asset price boom can be perpetuated, the private sector deficit spending will tend to show up on balance sheets as an unsustainable accumulation of debt, which makes the economy more financial fragile and prone to outright financial crisis.

    So it is possible to have growth even with high and rising fiscal balances, and low and falling current account balances, but it tends to be a growth path that eventually produces a financial crisis. It is not a very stable growth path, but it is a possible growth path nonetheless.

    Regarding the gold standard, what history tends to reveal is that if there is not a market or policy mechanism that encourages the chronic current account surplus nations to reinvest their proceeds from trade in the productive capacity of the chronic current account deficit nations, then eventually the current account deficit nations tend to default on (or restructure)the external liabilities they issue. Germany can either buy the paper issued by the peripheral European nations, or buy the tradable products they produce – it has no other choice if it wishes to run a trade surplus within the eurozone. If there is not a strong reinvestment rate in the production capacity for tradable products in trade deficit nations, eventually restructuring or default will be required on the claims Germany is accumulating on the periphery. This is why it may be useful to view the various policy mechanisms being devised (like EFSF) as thinly veiled tools for bailing out the banks in the current account surplus nations of the eurozone.


    Rob Parenteau