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Studying for a test? Prepare with these 8 lessons on Money, banking and central banks.
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Video transcript
I think now might be a good time to address another question that is probably circulating in your head-- and that is, what happened to the gold? Remember when we started this reserve bank, all of these national banks or whatever we want to call them, they had gold as a reserve. And then at some point, they said, well, why are we each holding gold? Why don't we just all concentrate our gold in one reserve bank? And then that reserve bank can issue-- and it was the only person that could issue-- it could issue bank notes that could be tradeable into gold. And then we said, over time, people just got used to the notion of using the bank notes themselves as reserves. And that's what the reserve ratios were all based on, based on the bank notes themselves. And we talked about that if the Fed or the reserve bank wanted to increase the money supply, it could essentially just print new notes and it would have offsetting notes, outstanding liabilities, and then it could use those to perform open market transactions and it essentially allows it to grow the monetary base with the economy or with the needs of different projects out there so that those projects happen. And in that whole discussion, you might have noticed that this yellow stuff was just sitting here. It had nothing to do with the economy. It was just sitting there and if you really wanted to force me to say what it was doing, well, it was giving a little bit of confidence behind what this thing was, right? It gives you a little bit of confidence. Because at first, at least, when we said that it was backed by the gold-- there was maybe a similar amount of gold as there was there. Maybe a little bit later, we said, this could be exchanged for gold at some rate-- maybe $35 per ounce. I think that's what it was when we were last on the gold standard. But if you think about it, it's a couple of weird things here. First of all, almost from the get-go when we did this, the whole purpose of having this flexible money supply is so you can grow and contract money with the needs of the economy and we would, for the most part, have notes outstanding because this was a fractional reserve system. We would have notes outstanding more than the actual amount of gold. And this has been the case even when we were on the gold standard. You had more dollars than you actually had gold, but you had to keep a little bit of gold there just in case people wanted to call your bluff. In case X percentage of people wanted their gold back. So they would come back to the central bank and say, give us our gold. But the gold fundamentally-- it had no other function. It wasn't in the economy. It wasn't helping transactions happen. It wasn't doing anything. It was just sitting in Fort Knox or wherever it happens to be sitting and to some degree, it's more of a pain than any kind of real value because you have to keep up this notion that these things, these dollar bills, could be translated into gold, it kind of forced a reserve ratio requirement on the central bank itself. And that reserve ratio requirement-- if you think about it, it's kind of arbitrary. It's dependent on how much gold is found in the world, right? In order to increase the money supply with GDP because people are inventing computers and railroads and cars and highways are being built and we're all becoming more efficient-- in order to keep the money supply up with that extra economic activity, if we stay on the gold standard and if we want to keep these ratios between the money and gold, we'd have to grow our gold with the economy. And that's kind of arbitrary. Maybe we'd find a big bunch of gold or maybe we'd find no gold-- and that really should have no bearing on our technological progress and how hard we're working. And it makes a lot of sense. You could imagine in a world where all of a sudden, an asteroid made of gold lands in the middle of the U.S., does that all of a sudden-- because gold is less valuable, should that make the dollar less cheap? Or in another world where for whatever reason we can't find any more gold, should that all of a sudden decrease our ability to circulate money around? And when it becomes-- and I said three videos ago that these dollar bills aren't just the liabilities or the obligations of this central bank. They're actually obligations of the U.S. government. So let me ask you a question. Would you rather have something backed by gold or backed by the U.S. government? And I know many of you, your gut reaction is to say, gold. Gold is real value. The U.S. government-- what are they good for? They're a bunch of crooks. They lie, cheat, and steal. They misallocate wealth all the time. But think about it. Gold really isn't wealth. It can be used to represent wealth only because it's pretty, only because at some period-- and it doesn't corrode. At some period in the past, someone says, I'm willing to plow your field if you give me that cool rock that you found. That's the only value gold has. It can't do work. It can't be eaten. It doesn't make us more motivated. It doesn't make us happier. It's not real wealth. Now what about the U.S. government? Well, it has the right, the authority, to tax. I know taxes are bad words and I don't like them myself, but it essentially-- can extract these rents from the U.S. economy, right? Tax the U.S. economy. And U.S. economy-- that's real wealth. That's labor, ideas, land, resources. Everything that makes us tick. Our labor, our goods and services, our ability to educate ourselves, and innovate, and come up with technology, and become more productive. That's real wealth. So if you really think about it-- I know I'm getting a little abstract here, but I really want to hit this point home because a lot of people, I think, are still under the notion that somehow something is somehow tradeable for gold, that it is of a sounder currency, while if it's an obligation of a government with a very dynamic economy, but not gold, it's somehow backed by less wealth, but I'd argue that this is actually a more profound amount of wealth. I mean, we've had currencies in ancient history that were backed by gold, but in a lot of cases, you still had inflation. When the Spanish currency in the 15th century was backed by gold, but all of a sudden they discover that Central America had a lot of gold and you had a ton of inflation and that gold really didn't give any real wealth to the Spaniards of the time. It just made everything more expensive for them. It did allow them to buy a little bit more from other countries, but it really didn't create any innovation. It didn't really make their pie that bigger, except they did steal some pie pieces from other parts of the world-- but we'll leave that aside for now. But this is real wealth-- a currency backed by a whole nation's ability to generate wealth, in some ways, is a lot more valuable. But gold was a stepping stone and it was necessary because in order to get this whole thing started and in order for people to really have trust in this currency, just the way people are trained to think, you had to originally sell them on gold, right? So if you think about it, gold didn't play any role. So in 1971, when Richard Nixon decides to go off of the gold standard, if-- and this is a big if-- if you trust the government's ability to manage the money supply effectively, that they're not going to print so much money that we have hyperinflation or they're not going to print so little money that we end up with a deflationary spiral. If you trust the government's ability to do that, it really doesn't matter that we went off of the gold standard. And it really just kind of gets rid of a little nuisance. And if you actually look at the Federal Reserve's balance sheet today, there still is some gold sitting on their balance sheet because it is really not obvious what they needed to do with it so they just kept it. Anyway, we'll we'll talk a lot about this-- what is wealth and what isn't wealth in the future. One example I often tell people is-- let's say your plane is going down-- you're the pilot of a plane and it's it's going down. It's burning and you see two islands in the horizon and you have to ditch your plane on one of those islands. So one of those islands it just has a big pile of gold on it. And then another island-- you can see with your telescope from the plane, it has cows on it, it has-- I don't know-- all these random fruit trees on it with these luscious fruits. You see-- I don't know-- it has a big random pool of-- I can't draw oil because oil is black on a blackboard. It has a pool of oil. It has another big nice lake of fresh water that's away from the oil so it doesn't get contaminated. And you can see from your telescope that it has a bunch of hard working, innovative, smart people on it who can-- I don't know-- do all sorts of interesting things. They have roads and they have horses. They have all sorts of stuff. Which island would you ditch your plane on, assuming that you'll never be able to get back to civilization? Well, the obvious answer is you'd rather ditch your plane on that island because that island has more wealth. And so when we went off of the gold standard-- I know it seems like this big horrible thing in the whole scheme of the world-- and gold has become a lot more expensive. It's no longer $35 an ounce. It's whatever-- $700 or $800 an ounce now. So you might think, there's been all this inflation. It would've been great if we were on the gold standard. But think about what's happened since 1971. Other than some of this excess credit that was given out maybe over the last 10 or 15 years-- other than these bubbles, we've seen a tremendous amount of innovation and we haven't seen hyperinflation and that's all in the world of-- you can call it a fiat currency, a currency that's not backed by any kind of hard asset. It's backed by people's trust in the ability of the U.S. economy to support debt to pay off the value of this currency. We'll talk more about that in the future. I don't want to get too circular in my conversations. But I'll see you in the next video. I just wanted to touch on that point that we are now off the gold standard.