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To: Tolerance Sucks Rocks
I appreciate the sentiment, but it wouldn't be such a good idea with the current financial set-up. Fiat currency is inherently inflationary, but fractional-reserve banking is inherently deflationary in times of financial stress.

If it were possible for the typical bank to get through an all-out bank run unscathed, then the gold standard would be a good idea. But, unfortunately, deleveraging of the fractional-reserve system combined with a gold standard would lead to an all-out deflation. There's only one way to adjust debt levels to a lower price level: default. The 1930s stand out as an example of what happens when fractional-reserve deleveraging meets the gold standard.

Nowadays, I think it would be worse because the debt levels are a lot higher now than they were in 1929.

On the other hand...bankruptcy ain't what it used to be. Instead of the all-or-nothing option, it's not uncommon to reschedule. If the bankruptcy laws were amended to allow for an automatic rescheduling in the case of deflation, by the amount of the CPI droppage, it would contain a deflationary implosion because debt levels could be lowered along with the price level.

Example: if prices drop by 5%, the borrower has the option of imposing a 5% haircut on the principal and/or the interest payments required. It's not exactly the flipside of an adjustable-rate loan, but it's close.

Granted that such an amendment partakes of pick-on-the-creditor, and it would lead to higher rates to compensate for deflation risk, but it would well prevent massive defaults in an environment where the borrower is obliged to pay back in dearer dollars - and the consequent push to all-out defaults.

"Deflation rescheduling" would take much of the risk out of going back to a gold standard in a fractional-reserve environment by acting as a somewhat-painful vaccination against an outright credit implosion.

19 posted on 12/10/2010 7:21:44 PM PST by danielmryan
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To: danielmryan

“But, unfortunately, deleveraging of the fractional-reserve system combined with a gold standard would lead to an all-out deflation. “

That’s not quite accurate. Milton Friedman writes in ‘A Monetary History’ that it was the absence of deposit insurance that resulted in the collapse of the American money supply in the 1930s.

When banks failed in the 30s depositors were ruined along with the bank’s investors. One third of America’s banks failed between 1930-33 and an equal quantity of the money supply disappeared.

This hasn’t been the case since the invention of FDIC, which Friedman believed to be the most important innovation rising out of the Depression. The deflation of the 30s wasn’t something peculiar or inherent to the gold standard.


27 posted on 12/10/2010 7:32:58 PM PST by Pelham (Islam, the mortal enemy of the free world)
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