Central Bankers Don't Know What They're Doing: They're Faking It


April 28, 2012

(This item originally appeared in Forbes.com on April 22, 2012.)

http://www.forbes.com/sites/nathanlewis/2012/04/22/central-bankers-dont-know-what-theyre-doing-theyre-faking-it/



One of the hardest things for many people to comprehend is that the people in charge of currency management around the world – central bankers, the IMF and so forth – don’t actually know what they are doing. They’re faking it.

How do we know this? Because as soon as they are called upon to do something specific, they fail miserably.

A gold standard is a type of value peg. It is not really any different than pegging one currency to another, or to a currency basket. It’s just a different target.

Obviously, if you are going to have a policy of maintaining a currency at a specific value – whether it be 35 units per ounce of gold, or ten units per U.S. dollar, or anything else – then you need some technique to make this happen.

One of the reasons that central bankers are loathe to adopt any kind of value-peg type policy is that as soon as they are called upon to do so, they fail miserably. The peg blows up in their face. This is embarrassing. Someone might figure out that they’re faking it.

Of course they immediately blame “the market” or “speculators” or some other external factor, not their own incompetence. It’s nice to be a central banker. You get to make speeches at Davos. Otherwise, they might have to get a degree in accounting.

This has happened so many times now, particularly since the advent of floating currencies in 1971, that central bankers avoid even the slightest suggestion that they be asked to actually perform such an act. Ben Bernanke mentioned this a number of times in his recent speeches.

Thus, anyone who endeavors to have any sort of value target policy, whether a gold standard or a dollar peg or what have you, must master the techniques by which you can make it happen.

I have given some examples of the simplest possible sort of gold standard system. You can call it the “making change” system.  One problem with gold coins is that their value is much too large for daily commerce. Thus, we need some kind of small-denomination item. You could divide an ounce of gold into 1000 units, called goldenbucks, each worth 1/1000th of an ounce of gold, or about $1.65 today. You could even subdivide these still further into cents. We do this all the time.

We never have any problem maintaining the “peg” between a dollar bill and a ten-dollar bill. The Fed never has to intervene in the domestic exchange market. This “peg” is, in a sense, totally arbitrary. There is nothing about a ten-dollar bill that naturally makes it worth more than a one-dollar bill. It is the same sort of piece of paper, with a slightly different arrangement of ink. Why is one worth ten times more than the other? Why don’t these “pegs” ever blow up in central bankers’ faces?

Could you make a banknote with “ten dollars” on it trade for twenty dollars, and a banknote with “twenty dollars on it” trade for ten dollars? Sure. Just agree to give a “twenty dollar” banknote for ten one-dollar bills, and a “ten dollar” banknote for twenty one-dollar bills. It would be a little silly, but you could do it.

The “making change” type gold standard is quite similar.  You offer to give G$1000, in small bills – which you created with a printing press — for every ounce of gold you receive. You’re making change. No different than if someone gives you a $10 bill and you give them a thousand pennies. You keep this gold bullion in a vault, so that there is one ounce of gold in the vault for every G$1000 in circulation. The amount of currency in circulation increases by G$1000 and the amount of gold in your vault increases by one ounce.

Note that there is no discretionary element to this process. It is driven entirely by some private market participant, who comes to you to “make change.”

If someone decides that they would rather have an ounce of gold than small bills, then they bring G$1000 of small bills to you, and get an ounce of gold in return. The paper currency in circulation shrinks by G$1000, and the amount of gold in the vault shrinks by one ounce.

You can see that, as long as nobody is able to counterfeit the goldenbucks paper currency, this system is foolproof. Even if the currency became very unpopular, and every person who had some came to the currency manager to get gold in return, the last G$1000 would come in when the last ounce of gold went out, and the system would quietly go dormant with no currency in circulation and no gold reserves.

Someone will no doubt argue that there are “other kinds of money” that people could sell, like bank deposits. As I explained earlier, bank deposits are not money. They are loans to a bank, callable on demand. When you pay for something with your “money in the bank,” what really happens is that you request the bank to pay back your loan to them. The bank then pays the payee with this money. The bank has to make this payment with real money – either paper banknotes, or the electronic equivalent of bank reserve deposits recorded at the central bank. Both are considered “base money,” or real money.

Thus, in that case, the bank would have to come up with G$1000 in paper bills, or its equivalent in bank reserves. It is important to understand this point, or you won’t understand how the “making change” system works. You would blow things up like every other bonehead central banker today.

There are many, many other variations on gold standard systems, but they are all really just versions of this basic “making change” process. So, you have to get that clear in your mind.

Central bankers really are numbskulls. They get away with it because nobody understands this stuff. You can understand it. It’s easy. Then, you will know more than most central bankers. Certainly more than Ben Bernanke. You will understand what I mean when I say that these people are imbeciles.

Ben Bernanke would pick up on this. They are basically courtiers, and their primary purpose in life is to avoid embarrassment. To avoid embarrassment, they would have to figure out what you now know.

At that point, the road to a new worldwide monetary system based on gold would open up, because we would finally understand how to actually implement such a thing. It is actually no harder than “making change.” If you can trade ten one-dollar bills for a ten-dollar bill, you already know how to do it.