Friday, December 30, 2011

The Gold Standard: An Austrian School Contradiction?

One of the chief arguments of the Austrian School of economic thought is that a free market should be allowed to determine prices of its own accord. Fixing of prices leads to adverse effects on other areas of an economy that are not immediately obvious. For a detailed description or if you are not familiar with the argument against price-fixing (a form of economic planning), please read pages 190 to 209 of the following PDF of Economics for Real People by Gene Callahan:

In the pages above, the author describes a scenario in which a person proposes fixing the floor price of a stock at $10 per share. A conversation about this topic ensues, outlining why this would be a bad idea. Accepting the premise that fixing prices is a bad idea, I'd like to explore if it's also a bad idea to fix the rate of change of prices. In the example above, this would be equivalent to limiting daily stock price movement to a range of, for example,  -5% to +5%. Suppose the opening stock price is $100. This would mean that a floor price for the stock during that day would be $95 and a ceiling price for the stock during that day would be $105. In other words, fixing the rate of change of a price is equivalent to fixing simultaneous price floors and ceilings.

In my previous blog post "Inflation and the Optimal Money Supply", I outline the case for attributing inflation to rapid changes in the size of the money supply, and how fixing interest rates (a form of price fixing) is equivalent to tinkering with market supply and demand for cash holdings. Many Austrian School economists advocate the return to a gold standard to resolve this problem. In other words, every dollar should be redeemable for the equivalent amount of gold. Since the amount of gold in the world is fixed and only so much gold can be mined per year, then the money supply won't be able to change size so quickly.

One Warren Buffett quote that got me thinking was the following: "[Gold] gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head."

If we want the same effects of a gold standard without needing to mine the actual gold, we would simply need some sort of law or restriction that the money supply can only grow by a certain amount per year, similar to how only a certain amount of gold is mined every year. In essence, we would want to fix the rate of change of the size of the money supply, which is a form of economic planning. As I've outlined above, fixing a rate of change of a price is essentially fixing the price to a certain range. Upon realizing this, I noticed a contradiction: the Austrian School advocates against price fixing and economic planning, and the Austrian School advocates a gold standard, which can be seen as a way of fixing the rate of change of the size of the money supply through economic planning. This seems to be a contradiction.

I don't know the answer to this conundrum, nor am I entirely certain that I haven't misinterpreted or mis-stated the beliefs of the Austrian School of economic thought. Comments are welcome, as I would love to know more about this particular topic.

Edit: I've thought of some additional insights on this topic; see my other blog post.

Sunday, December 18, 2011

Inflation and the Optimal Money Supply

In recent months, I have learned much about fractional reserve banking, central banks, inflation, interest rates and money supply. In this blog post, I'd like to explain some aspects of inflation, its relation to the money supply, the gold standard, and some considerations on the optimal size of the money supply. In order to accomplish the goal of a discussion on these topics, some background information is necessary.

To begin, I will give a brief overview of fractional reserve banking. To my knowledge, all banks in Canada today are fractional reserve banks. In the early days of banking, customers of a bank could deposit their gold at the bank for safekeeping. To facilitate easy economic exchange between parties, banks began to issue promissory notes representing a certain amount of gold, so that two parties wishing to exchange gold between themselves would not need to withdraw, transport and deposit physical gold. An individual could exchange the note at the bank for the corresponding amount of gold at any time. This is called full-reserve banking with money tied to a gold standard. The promissory notes issued by the banks functioned as currency because their validity was universally recognized within the community, and because the holder of a note equated to the owner of the gold it represented. As people began to use these promissory notes more and more often, the banks noticed that not many people actually came and exchanged their notes for physical gold. As a result, the banks issued more loans to people by distributing more promissory notes for the gold they had just sitting in their vaults. This is called fractional reserve banking, where the bank "loans out" the gold sitting in their vaults. Eventually, banks began to loan out more money than the total gold they had, in effect loaning out more than 100% of their gold deposits. In modern day, money is no longer exchangeable for gold, instead fiat money is used. Fiat money means that the government has declared the bank notes legal tender, and the government's central bank can print more money if they so choose. Most of the money in circulation today comes from loans issued by banks, which is characterized as money creation through lending of credit (since only the central bank can truly "print" money). An astute reader might also notice that this means that interest must be paid on all money created through lending of credit. The total of these two amounts of money issued is called the money supply.

Inflation is defined as a rise in prices of consumer goods. There are many aspects to inflation, however the generally accepted cause of inflation is growth of the money supply. When more money is created, each new dollar represents a smaller fraction of the real wealth in the economy, and so more dollars are needed to pay for the same item than before the increase in the money supply. When the initial new money is created, there is an increase in spending as the money changes hands repeatedly. Entrepreneurs see this increase in spending and increase prices accordingly, in order to make a higher profit. According to the previous paragraph, there are two sources of money creation: printing of money by the central bank, and bank-created money by lending of credit. This may seem the case, but the real cause is only one of the above. Firstly, it may seem in the interest of fractional reserve banks to issue as many loans as possible to make more profit. This is not the case for two reasons. Firstly, fractional reserve banks are required to maintain an asset-to-capital multiple. Loans issued by banks are called assets, because they produce interest (income) for the bank. Capital is the amount of cash or easily-convertible-into-cash securities. Banks must maintain a certain amount of cash so that if everyone wants to withdraw their deposits at once, there won't be a run on the bank. (For an amusing example of a bank run, watch this YouTube video). Secondly, the central bank has the power to set the interest rate (called the key interest rate) at which banks lend money to each other. If this interest rate rises, it becomes more costly for banks to borrow money, and so they raise the interest rates on their consumer loans, which in turn discourages further borrowing and encourages paying back loans by consumers. If the key interest rate is lower, it becomes cheaper for banks to borrow money, and so they can issue more loans at lower interest rates, which encourages consumers to borrow and spend money. The central bank uses this key interest rate to control the money supply indirectly and speed up or slow down the creation of credit and the functioning of the economy.

So in essence, the central bank of a country controls the creation of the entire money supply, either directly or indirectly. But, there is a key difference between government-created money and bank-created money. When money is created through credit, the money can be paid back and consequently cease to exist. When money is "printed" by the central bank, it stays in existence. In addition, if the central bank keeps interest rates low, more loans and bank-created money are added to the system. For these reasons, one can blame the central bank for consistently increasing the money supply over the years, and consequently perpetuating inflation.

One might draw the conclusion that the money supply is "too big" and ask the question, what would be an optimal money supply? As it turns out, there is no "optimal" amount of money to have at the scale of today's economy. If central banks were to stop targeting interest rates and printing money when they deem prudent, the free market would determine the amount of money in circulation via supply and demand for money (or cash holdings). Similarly, supply and demand for credit would determine the market interest rates for loans. Inflation is not caused by a single increase in the money supply over the long term, it is caused by the fact that new money is not propagated across the economy instantly. When new money is created, those that hold it benefit by being able to spend the newly created money according to existing prices. Once the money propagates through the economy over time, prices tend to rise to adjust to the new total money supply. At some point, prices will reach a new range and tend to stay in that range according to the business cycle and other factors, provided no new increase in the money supply occurs. Due to central banks, the money supply changes constantly and rapidly, and so the new adjusted price range is never attained before the money supply increases again. The result is a constant increase in prices over the years.

Taken from

Monday, December 12, 2011

Alternatives to Government Bonds

Just recently, I've decided to sell all my government bonds for three reasons. The first reason is that I believe there could be a government bond price crash on the way. Secondly, I've just finished reading an introductory book on the Austrian School of economics. The Austrian School differs in many respect to the mainstream views of Keynesian economics, one of the most significant being the idea of government deficit spending. Keynesian economics recommends a government borrow money (by issuing government bonds) and spend beyond its current means to kick-start a slowed economy. The Austrian School feels that this is unsustainable, and I decidedly agree. For more details, see the link above to my other blog post about government bonds. My last reason is related to the second: I feel a moral opposition to holding my own government in debt to myself. I disagree with deficit spending, and it doesn't feel right to me, similar to how a banker shouldn't feel right lending more money to an already debt-burdened borrower, knowing full well that the borrower can't pay it back.

So, having decided the above, what should I replace my government bond holdings with? Government bonds are the go-to fixed income investment. They're typically safe (just pretend to ignore what's going on in Europe right now), and make a good hedge against stock market price movements and the risks of the equity portion of your portfolio. After some initial research, I've come up with some possible alternatives to holding government bonds. An alternative should fulfill the same requirements that government bonds do: produce income, provide safety, and price movements are independent of the stock market. Not all the suggestions below fill all the requirements perfectly, but they're what I've come up with so far.

  1. Corporate Bonds - Most bond funds have some corporate bonds thrown into their mix. Corporate bonds tend to be riskier than government bonds, but they also tend to have higher yields. Corporate bonds satisfy the income requirement. However, corporate bond prices can take a hit just as hard as the stock market in an economic downturn. At least if a corporation goes bankrupt, the bond-holders are paid off first, then the preferred share holders, then the common share holders, so at least there is some safety.
  2. REITs and Real Estate - Many people are still very wary about real estate exposure since everything that happened in 2008. However, if you're holding quality real estate investments that produce income (such as an REIT), rather than buying for the sake of capital gains, real estate can easily make up a significant chunk of a portfolio. Typical model portfolios I've seen on the web always seem to have "just a smidgen" of real estate exposure. If one does proper research, I don't see why real estate can't compose 10-20% of a portfolio. Real estate prices are supposed to move independently of the stock market, although that hasn't always been true in recent years. If safety is important, consider real estate investments such as companies that rent out to grocery stores and other essentials. Even in 2008, people still had to buy food, which means grocery stores were there paying rent so they could supply food.
  3. GICs and Market-Growth GICs - While GICs typically offer very low yields, they are still a possibility. Another alternative is the market growth GIC. If you buy one of those, you could earn interest anywhere from 0% to some ceiling, depending on how the stock market performs over that period of time. While your principle is always guaranteed, you should be comfortable with the fact that at the end of the term, you may not end up earning any interest at all.
  4. Gold - This last list item doesn't produce income, although I'm starting to give it consideration. Gold prices tend to increase as inflation increases, and governments always seem to be printing more money to pay off their debts and causing inflation. This could make gold a safe investment. There are many ways to get exposure to gold, and I'm researching more on the topic.
My holdings in government bonds currently consist of mutual fund units that can't be sold for 90 days since purchase without incurring an early-sale penalty fee. I intend to stop purchases and wait the 90 days to digest the information I've stated above and to consider alternatives. I might post back again in 2012 about what I decide.

Saturday, December 10, 2011

The Coming Government Bond Price Crash

Today, I finished an introductory book on the Austrian School of economic thought. The differences in economic beliefs of the Austrian School compared to the mainstream Keynesian school of thought are quite stark. According to Keynesian economics, when the economy is slowing or has slowed down (recession), the government should use deficit spending and set low interest rates to kick-start the economy again. Ever since 2008, the U.S. federal funds rate has been quite low, and the federal debt has increased significantly. Canada has managed to grow federal debt at a much slower rate, however interest rates in Canada are also quite low.

Because both countries are in relatively large amounts of debt (although to different degrees), both countries have a significant portion of the federal budget devoted to interest payment on that debt. There are three ways a government can obtain income for the purpose of spending: taxes, borrowing, and printing money. Tax increases are quite difficult to implement due to typically fierce opposition. This leaves borrowing, and printing money. Since governments are aware of what can happen if too much money is printed (hyperinflation), printing money may still be used to service debt, but not likely in excess. All that is left is to borrow more money to pay the interest on currently borrowed money. The U.S. debt scare during the summer of 2011 is proof that borrowing will simply continue because it's the only way not to default on interest payments (never mind paying down the principle amount!).

The method through which the government borrows money is to issue government bonds. Individuals and institutions buy these bonds, and receive their principle back plus interest at a later date. As with many other securities, bonds can be bought and sold on the market. Bond prices tend to move opposite of current interest rates at the time. To see why, consider the following. A bond yielding 2% interest is offered on the bond market for a certain price. Interest rates go up, and new bonds being sold yield 3%. Why would anyone buy the 2% bond when they could buy the higher-yielding 3% bond? To attract buyers, the price of the 2% bond must go down. If interest rates were to go down to 1%, the bond yielding 2% is now actually more valuable because it yields more interest. If this is the case, the price for the bond goes up.

As with any market good, bonds are subject to the laws of supply and demand. If there are few bonds being sold (small supply) and lots of people wanting to buy bonds (large demand), prices will tend to go up, and the highest bidders will get to buy the bonds. Conversely, if there are lots of bonds (large supply), and not many people wanting to buy bonds (small demand), prices will tend to go down to try and attract buyers.

At the current moment in time, it is difficult to tell what the demand for bonds is. Some consider bonds a pretty safe investment, and so may want to buy bonds. Others may not want to invest in bonds because they want access to their money right away, or they may not want to do any investing whatsoever due to all the horror stories about the economy not doing well. However, due to the government needing to borrow to service debt, it is safe to assume that the supply of bonds will in the best case stay constant and in the worst case increase.

Given the above statements, it is easy to summarize what will likely happen to bond prices in a chart:

Since it is more likely that the supply of bonds is going to increase, the price of bonds will either stay where it is if there is enough demand for bonds, or the price will fall (either somewhat or significantly). But remember the effect interest rates have on bonds! (Not represented in this chart). If interest rates go up, bond prices tend to go down. Interest rates are already low, and so have nowhere to go but up. So if we factor in that at some point in the future, interest rates will eventually go up, we can conclude that bond prices are in for a plummet at a certain point in time. This point in time will be when there is increased government borrowing and increased interest rates, both of which are almost certain to happen.

Success #3: Back To Business

Well, this blog of mine seems to have been feeling kind of neglected lately. It's because of many reasons, some of which are that I started blogging about finance on my work's internal blog not viewable by the public, I've been very busy with university, and I haven't had many funds available for investing.

Since I only started learning about personal finance about a year and a half ago, my views on how to invest have been constantly changing. In addition, I've been reading some books on value investing, as well as economics. Since it was my birthday in August and I changed from age 22 to age 23, I figured it was time to update my blog title. Not only that, I felt that a theme change would be fitting for my renewal in this blog's interest.

So what can you expect in the future on this blog? I'll be blogging about economics, as well as personal finance and investing. I'm decidedly a big believer in income investing and value investing, and I've learned much about how money is created, what central banks are, and some views on how those should play a role in the economy as a whole. I'll add a new "economics" label for posts so that there is a new category, as well as an "opinion" label. I hope you enjoy Starting Started at 22's revival!