August 15, 1971: Unhappy Anniversary (Update)

[Update 8/15/2019: It seems appropriate to republish this post originally published about 40 days after I started blogging. I have made a few small changes and inserted a few comments to reflect my improved understanding of certain concepts like “sterilization” that I was uncritically accepting. I actually have learned a thing or two in the eight plus years that I’ve been blogging. I am grateful to all my readers — both those who agreed and those who disagreed — for challenging me and inspiring me to keep thinking critically. It wasn’t easy, but we did survive August 15, 1971. Let’s hope we survive August 15, 2019.]

August 15, 1971 may not exactly be a day that will live in infamy, but it is hardly a day to celebrate 40 years later.  It was the day on which one of the most cynical Presidents in American history committed one of his most cynical acts:  violating solemn promises undertaken many times previously, both before and after his election as President, Richard Nixon declared a 90-day freeze on wages and prices.  Nixon also announced the closing of the gold window at the US Treasury, severing the last shred of a link between gold and the dollar.  Interestingly, the current (August 13th, 2011) Economist (Buttonwood column) and Forbes  (Charles Kadlec op-ed) and today’s Wall Street Journal (Lewis Lehrman op-ed) mark the anniversary with critical commentaries on Nixon’s action ruefully focusing on the baleful consequences of breaking the link to gold, while barely mentioning the 90-day freeze that became the prelude to  the comprehensive wage and price controls imposed after the freeze expired.

Of the two events, the wage and price freeze and subsequent controls had by far the more adverse consequences, the closing of the gold window merely ratifying the demise of a gold standard that long since had ceased to function as it had for much of the 19th and early 20th centuries.  In contrast to the final break with gold, no economic necessity or even a coherent economic argument on the merits lay behind the decision to impose a wage and price freeze, notwithstanding the ex-post rationalizations offered by Nixon’s economic advisers, including such estimable figures as Herbert Stein, Paul McKracken, and George Schultz, who surely knew better,  but somehow were persuaded to fall into line behind a policy of massive, breathtaking, intervention into private market transactions.

The argument for closing the gold window was that the official gold peg of $35 an ounce was probably at least 10-20% below any realistic estimate of the true market value of gold at the time, making it impossible to reestablish the old parity as an economically meaningful price without imposing an intolerable deflation on the world economy.  An alternative response might have been to officially devalue the dollar to something like the market value of gold $40-42 an ounce.  But to have done so would merely have demonstrated that the official price of gold was a policy instrument subject to the whims of the US monetary authorities, undermining faith in the viability of a gold standard.  In the event, an attempt to patch together the Bretton Woods System (the Smithsonian Agreement of December 1971) based on an official $38 an ounce peg was made, but it quickly became obvious that a new monetary system based on any form of gold convertibility could no longer survive.

How did the $35 an ounce price became unsustainable barely 25 years after the Bretton Woods System was created?  The problem that emerged within a few years of its inception was that the main trading partners of the US systematically kept their own currencies undervalued in terms of the dollar, promoting their exports while sterilizing the consequent dollar inflow, allowing neither sufficient domestic inflation nor sufficient exchange-rate appreciation to eliminate the overvaluation of their currencies against the dollar. [DG 8/15/19: “sterilization” is a misleading term because it implies that persistent gold or dollar inflows just happen randomly; the persistent inflow occur only because they are induced by a persistent increased demand for reserves or insufficient creation of cash.] After a burst of inflation in the Korean War, the Fed’s tight monetary policy and a persistently overvalued exchange rate kept US inflation low at the cost of sluggish growth and three recessions between 1953 and 1960.  It was not until the Kennedy administration came into office on a pledge to get the country moving again that the Fed was pressured to loosen monetary policy, initiating the long boom of the 1960s some three years before the Kennedy tax cuts were posthumously enacted in 1964.

Monetary expansion by the Fed reduced the relative overvaluation of the dollar in terms of other currencies, but the increasing export of dollars left the $35 an ounce peg increasingly dependent on the willingness of foreign government to hold dollars.  However, President Charles de Gaulle of France, having overcome domestic opposition to his rule, felt secure enough to assert [his conception of] French interests against the US, resuming the traditional French policy of accumulating physical gold reserves rather than mere claims on gold physically held elsewhere.  By 1967 the London gold pool, a central bank cartel acting to control the price of gold in the London gold market, was collapsing, as France withdrew from the cartel, demanding that gold be shipped to Paris from New York.  In 1968, unable to hold down the market price of gold any longer, the US and other central banks let the gold price rise above the official price, but agreed to conduct official transactions among themselves at the official price of $35 an ounce.  As market prices for gold, driven by US monetary expansion, inched steadily higher, the incentives for central banks to demand gold from the US at the official price became too strong to contain, so that the system was on the verge of collapse when Nixon acknowledged the inevitable and closed the gold window rather than allow depletion of US gold holdings.

Assertions that the Bretton Woods system could somehow have been saved simply ignore the economic reality that by 1971 the Bretton Woods System was broken beyond repair, or at least beyond any repair that could have been effected at a tolerable cost.

But Nixon clearly had another motivation in his August 15 announcement, less than 15 months before the next Presidential election.  It was in effect the opening shot of his reelection campaign.  Remembering all too well that he lost the 1960 election to John Kennedy because the Fed had not provided enough monetary stimulus to cut short the 1960-61 recession, Nixon had appointed his long-time economic adviser, Arthur Burns to replace William McChesney Martin as chairman of the Fed in 1970.  A mild tightening of monetary policy in 1969 as inflation was rising above a 5% annual rate, had produced a recession in late 1969 and early 1970, without providing much relief from inflation.  Burns eased policy enough to allow a mild recovery, but the economy seemed to be suffering the worst of both worlds — inflation still near 4 percent and unemployment at what then seemed an unacceptably high level of almost 6 percent. [For more on Burns and his deplorable role in all of this see this post.]

With an election looming ever closer on the horizon, Nixon in the summer of 1971 became consumed by the political imperative of speeding up the recovery.  Meanwhile a Democratic Congress, assuming that Nixon really did mean his promises never to impose wage and price controls to stop inflation, began clamoring for controls as the way to stop inflation without the pain of a recession, even authorizing the President to impose controls, a dare they never dreamed he would accept.  Arthur Burns, himself, perhaps unwittingly [I was being too kind], provided support for such a step by voicing frustration that inflation persisted in the face of a recession and high unemployment, suggesting that the old rules of economics were no longer operating as they once had.  He even offered vague support for what was then called an incomes policy, generally understood as an informal attempt to bring down inflation by announcing a target  for wage increases corresponding to productivity gains, thereby eliminating the need for businesses to raise prices to compensate for increased labor costs.  What such proposals usually ignored was the necessity for a monetary policy that would limit the growth of total spending sufficiently to limit the growth of wage incomes to the desired target. [On incomes policies and how they might work if they were properly understood see this post.]

Having been persuaded that there was no acceptable alternative to closing the gold window — from Nixon’s perspective and from that of most conventional politicians, a painfully unpleasant admission of US weakness in the face of its enemies (all this was occurring at the height of the Vietnam War and the antiwar protests) – Nixon decided that he could now combine that decision, sugar-coated with an aggressive attack on international currency speculators and a protectionist 10% duty on imports into the United States, with the even more radical measure of a wage-price freeze to be followed by a longer-lasting program to control price increases, thereby snatching the most powerful and popular economic proposal of the Democrats right from under their noses.  Meanwhile, with the inflation threat neutralized, Arthur Burns could be pressured mercilessly to increase the rate of monetary expansion, ensuring that Nixon could stand for reelection in the middle of an economic boom.

But just as Nixon’s electoral triumph fell apart because of his Watergate fiasco, his economic success fell apart when an inflationary monetary policy combined with wage-and-price controls to produce increasing dislocations, shortages and inefficiencies, gradually sapping the strength of an economic recovery fueled by excess demand rather than increasing productivity.  Because broad based, as opposed to narrowly targeted, price controls tend to be more popular before they are imposed than after (as too many expectations about favorable regulatory treatment are disappointed), the vast majority of controls were allowed to lapse when the original grant of Congressional authority to control prices expired in April 1974.

Already by the summer of 1973, shortages of gasoline and other petroleum products were becoming commonplace, and shortages of heating oil and natural gas had been widely predicted for the winter of 1973-74.  But in October 1973 in the wake of the Yom Kippur War and the imposition of an Arab Oil Embargo against the United States and other Western countries sympathetic to Israel, the shortages turned into the first “Energy Crisis.”  A Democratic Congress and the Nixon Administration sprang into action, enacting special legislation to allow controls to be kept on petroleum products of all sorts together with emergency authority to authorize the government to allocate products in short supply.

It still amazes me that almost all the dislocations manifested after the embargo and the associated energy crisis were attributed to excessive consumption of oil and petroleum products in general or to excessive dependence on imports, as if any of the shortages and dislocations would have occurred in the absence of price controls.  And hardly anyone realizes that price controls tend to drive the prices of whatever portion of the supply is exempt from control even higher than they would have risen in the absence of any controls.

About ten years after the first energy crisis, I published a book in which I tried to explain how all the dislocations that emerged from the Arab oil embargo and the 1978-79 crisis following the Iranian Revolution were attributable to the price controls first imposed by Richard Nixon on August 15, 1971.  But the connection between the energy crisis in all its ramifications and the Nixonian price controls unfortunately remains largely overlooked and ignored to this day.  If there is reason to reflect on what happened forty years ago on this date, it surely is for that reason and not because Nixon pulled the plug on a gold standard that had not been functioning for years.


33 Responses to “August 15, 1971: Unhappy Anniversary (Update)”

  1. 1 JP Koning August 15, 2011 at 8:06 pm

    What a pleasure to read.

    I must confess that I wasn’t aware that during Bretton Woods other countries were undervaluing their currencies so as to promote exports while sterilizing inflows. Sounds like France in the late 20s, and China now. I had always thought that the break down of Bretton Woods was due solely to the US irresponsibility and not that of other nations.

  2. 2 Luis H Arroyo August 16, 2011 at 2:31 am

    Very good post David.
    How much we can learn from a bit of History rather than from a mathematical model.

  3. 3 Benjamin Cole August 16, 2011 at 8:52 am

    Interesting post–people forget that even scholars at the Brookings Institution favored wage-and-price controls. I can remember one session in which a scholar was asked, “Yeah, how about lawyers? Won’t they escape controls?” And the defensive scholar responding, “They always ask us about the lawyers.

    This was a time when Americans had passbook accounts at banks, with regulated interest rates, and S&L’s had “Reg Q” allowing them to pay a quarter-point or half-point more than banks.

    That said, read this:

    Perry Says Fed Spending Before Election Almost ’Treasonous’
    August 16, 2011, 10:49 AM EDT

    By John McCormick

    Aug. 16 (Bloomberg) — Texas Governor Rick Perry, finishing his first full day of campaigning for the U.S. Republican presidential nomination in Iowa, said it would be “almost treacherous — or treasonous” for Federal Reserve Chairman Ben S. Bernanke to increase stimulus spending before the 2012 election.

    “If this guy prints more money between now and the election, I don’t know what you would do with him,” Perry said at a backyard appearance in Cedar Rapids, Iowa. “We would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost treacherous — or treasonous in my opinion.”

    I hope to see a lot of blogging about current history–man, this stuff is going down right in front of our eyes!

  4. 4 David Glasner August 16, 2011 at 9:23 pm

    JP and Luis, Thanks. I am now actually a bit embarrassed because I should have cited Ralph Hawtrey for the assertion that US trading partners were systematically undervaluing their currencies in the post-WWII Bretton Woods period. He made the argument in his last book, Incomes and Money, published in 1967 when he was 88 years old. And it is likely that he also made the argument in some of his other later works. He died in 1975 at the age of 96. The decline in his powers is evident, but it is still an impressive performance for someone that age.

    Benjamin, You are right that there unfortunately was no shortage of economists around at that time who supported wage and price controls. In that respect at least, we have made some progress. It is shocking that anyone would make such a statement let alone a leading candidate for President. We have 15 months of this coming up ahead.

  5. 5 John Hawkins August 16, 2011 at 9:27 pm

    Nassim Taleb wrote an article for foreign affairs where he compared democracy’s ability to constantly communicate with leadership through voting and protests to the price system of the market. Dictatorships that squelch dissent miss the signals of unrest (who saw Egypt coming?) leading to massive and immediate political disruptions that cause deep rifts in society for long periods. The idea that the economic analog of price controls caused deep rooted discoordinations and dislocations that lasted nearly a decade later (especially as we were performing political “price controls” in the arab countries from which most of the problems were coming) sounds very plausible, no matter how much the “Chicagoan” in me disagrees, and the book looks like an interesting read.

    Here’s a link to the Taleb article if you’re interested.

  6. 6 Cantillon Blog August 17, 2011 at 5:17 pm

    Outstanding post, David. Reminds me of just how unreflective and lacking in coherence much economic commentary one finds elsewhere has become.

  7. 7 Mike Sproul August 17, 2011 at 5:33 pm


    If the Fed’s assets are sufficient to buy back all its dollars at $35/oz, then the Fed will have no trouble maintaining convertibility at $35/oz. But if the Fed’s assets are only enough to buy back its dollars at $42/oz, then the Fed’s attempt to maintain convertibility at $35/oz will result in a run on the Fed (gold outflows), which is exactly what was happening in 1971. At that point, a sensible response is either to devalue to the affordable rate of $42/oz., or to suspend convertibility, and let the market settle the value of the dollar (which, of course, will be at $42/oz).

  8. 8 Peter Laan August 18, 2011 at 9:43 am

    I don’t understand the ‘keep the currency undervalued to boost exports’ argument. Why don’t the prices adjust to compensate for this? And if they don’t adjust, why should we be upset if some other country want to give us favourable trade deals?

  9. 9 David Glasner August 18, 2011 at 7:36 pm

    John, Thanks for the link to Taleb. He is an interesting guy and I have enjoyed reading some of his articles, though I have not read his Black Swan book. And he seems a bit too aggressively full of himself. Couldn’t quite figure out what you were getting at with this sentence.

    “The idea that the economic analog of price controls caused deep rooted discoordinations and dislocations that lasted nearly a decade later (especially as we were performing political “price controls” in the arab countries from which most of the problems were coming) sounds very plausible, no matter how much the “Chicagoan” in me disagrees, and the book looks like an interesting read.”

    Cantillon, Thanks. Just wondering, are you still an optimist?

    Mike, The Fed and the Treasury were being called upon to sell gold at $35 an ounce not buy, so I am not sure what your point is. Help me out.

    Peter, You raise a well-known, but difficult, point. Max Corden has a classic paper on “Exchange Rate Protectionism” in which he works out the theory. Clearly part of what is going on is that the monetary authority has to be able to sterilize inflows of cash so that it can keep the prices of its non-tradable goods from rising, causing resources to be “overallocated” to the tradable goods sector. What is the harm to other countries from exchange rate proftectionism? Because their tradables are at a competitive disadvantage relative to the protectionist country’s tradables, their non-tradable sector expands compared to the tradable sector. And if wages are rigid in the tradable sector there may be chronic unemployment.

  10. 10 Mike Sproul August 18, 2011 at 10:30 pm


    I’m confused about why you’re confused. I didn’t say they were buying gold. They were selling gold at $35/oz., which is to say, they were buying dollars for 1/35 oz. If the Fed’s assets are only enough to buy back dollars at 1/42 oz/$, then when the Fed pays 1/35 oz./$, dollars will flow into the Fed and gold will flow out. It’s an ordinary bank run, caused by trying to maintain convertibility at a rate the bank can’t afford.

    Example: The Fed’s total assets are worth 1000 oz, and they have issued a total of $35000, so each dollar is worth 1/35 oz. Then the Fed issues another $7000 while getting no assets in return. There are $42000 laying claim to assets worth 1000 oz., so each dollar is worth 1/42 oz. If the Fed maintains convertibility at $35, then dollars rush to the fed to get gold. The first 35000 dollars to get to the fed will get 1/35 oz each, and the last $7000 get nothing. This is a bank run. It would be better to devalue to $42/oz, or the same thing would be accomplished by suspending convertibility and letting the market set the value of the dollar at $42/oz. Either way there os no bank run

  11. 11 David Glasner August 22, 2011 at 5:17 pm

    Mike, Are you saying that there could be no run on the Fed at $35 an ounce as long as the Fed had enough assets to buy back all the dollars it issued at $35 per ounce of gold? Which assets are you referring to — assets on the Fed balance sheet or all the property owned by the Federal Government? Which dollars are you referring to? The monetary base, M1, M2 or M3? Somehow my intuition is not working and I can’t exactly see how these different magnitudes are logically connected. How do changes in the real value of gold caused by changes in the demand and supply for gold affect your analysis?

  12. 12 Mike Sproul August 22, 2011 at 9:32 pm


    The easiest question to answer is which dollars I am referring to: I refer only to the dollars that are issued by the fed and show up as a liability on the Fed’s balance sheet—the monetary base.

    As long as the Fed has enough assets to buy back all of its dollars at $35/oz, note holders would have no reason to run on the bank, since they know that if they did run, they would all get assets of equal value to the dollars they brought in. But if the fed’s assets are inadequate, then people will run, since nobody wants to be last in line.

    As to which assets I refer to, that’s not as clear. If the fed were completely independent, with no chance of ever being bailed out by the government, then only the fed’s assets would be relevant. But if the fed is just a branch of the government, and people expected the government to bail out the fed in the event of a crisis, then I’d say that I’m referring to the government’s assets.

    If the supply or demand for gold changes, so that 1 oz buys half the groceries that it used to, then in the simple case, the dollar will also buy half as much. But remember that the fed’s assets might consist of a diverse bundle of assets, including gold. In that case a fall in the relative value of gold will have less effect on the value of the dollar, since the rest of the assets backing the dollar would have presumably held their value.

    If gold rose in value, then in the simple case the dollar will rise too. But if the fed’s assets are diversified, then the dollar would not rise as much. In this case any attempt to maintain convertibility at the old value (e.g., $35/oz) would result in a run, so it would be best to suspend and let the dollar float.

  13. 13 David Glasner August 25, 2011 at 2:22 pm

    Mike, If a lot of banks are creating liabilities (deposits) that are convertible into currency (issued by the Fed) which is convertible into gold, do the assets of the Fed have to be sufficient to buy back all the currency and all the deposits of the banks? How does that work?

  14. 14 Mike Sproul August 25, 2011 at 3:05 pm


    The Fed only needs to be able to buy back the paper dollars that it issued, while the private banks only need to be able to buy back the checking account dollars that they issued. This shows on T accounts, since paper dollars show as the Fed’s liability while checking account dollars show as the liability of the private bank that issued them.

    A stock market analogy helps: GM issues 1000 shares at $60 each and uses the $60,000 to buy plant and equipment worth $60,000. Then Merrill Lynch issues 2000 call options on GM stock with a strike of zero and no expiration. Merrill sells the calls for $60 each and gets $120,000, which it invests in bonds or something. GM is responsible only for the genuine GM shares that it issued, while Merrill is responsible only for the calls that it issued. If every holder of a call wants to redeem it, then Merrill has enough bonds to buy them all back at $60 each. Similarly, if GM is liquidated, the plant and equipment is sold for $60,000 and GM buys back all 1000 of the shares it issued at $60 each. (Obviously, this assumes no change in the value of plant and equipment.)

    GM stock is the base security and calls on GM are the derivative security. Green paper dollars are base money, and checking account dollars are derivative money.

  15. 15 David Glasner August 25, 2011 at 5:42 pm

    Mike, OK I get that, but suppose that the Fed doesn’t want private banks to fail if it will lead to a run on other banks or that the Fed directly or indirectly insures the deposits of the banking system. Then what?

  16. 16 Mike Sproul August 25, 2011 at 7:29 pm

    Then the Fed loses assets. Assuming it doesn’t get a bailout from some other source, the paper dollars would lose value in proportion to the Fed’s loss of assets. Checking account dollars, being claims to paper dollars, would lose value in step. (Exception: if checking account dollars are not pegged to paper dollars, then the private bank’s gain of assets can cause checking account dollars to rise relative to paper dollars.)

    The stock market analogy still works. If GM doesn’t want Merrill to fail and transfers some of its own assets to Merrill, then GM stock falls. Merrill’s call options, being claims to GM shares, will lose value too. (Same exception as above.)

    Of course this makes things hard to quantify. The Fed might intend to bail out insolvent banks, but this mere intention doesn’t show up on any balance sheet. Furthermore, Congress might intend to bail out the Fed, and this too is something that doesn’t show on a balance sheet. If we wanted to test the backing theory, we’d probably be limited to looking at extreme cases where both the central bank and its government were broke. I understand from Finance professors that they have a hard time empirically verifying that the value of corporate stock depends on the value of the firm’s assets (assets being broadly defined). I expect it would be much harder to verify that the value of the Fed’s dollars depends on the Fed’s assets.

  17. 17 David Glasner September 1, 2011 at 7:53 am

    Mike, Sorry for not replying sooner, but I’ve been busy on the blog and other stuff. So, let’s say that the Fed has assets way in excess of its liabilities and the we observe that the value of dollars is fluctuating, how would you account for those fluctuations. Or, put another way, if an issuer with a lot of capital on its balance sheet is pegging its money to another asset, it’s the peg that determines the value of the money, not the net worth as long as the net worth is sufficiently great that no one thinks that there’s any chance of default. Does that sound right to you?

  18. 18 Mike Sproul September 1, 2011 at 9:35 am


    If the Fed’s assets are enough that it could maintain convertibility at 1 oz/$ then of course it could, if it wanted, maintain convertibility at 0.5 oz./$. If we think of actual metallic convertibility, we could explain fluctuating dollar values as a result of the Fed changing the peg. Even if metallic convertibility is suspended, there are other kinds of convertibility, and if the Fed changes the rate at which those other kinds of convertibility occur, then the value of the dollar will change. For example, the Fed might hold assets worth 1 oz./$ now, and it might promise that 100 years from now it will be liquidated and its dollars will then be redeemed for whatever assets the Fed has. If the interest rate is R, and the costs of printing and handling dollars is C, then this promise makes each dollar worth 1/(1+R-C)^100 ounces today. No other kind of convertibility is offered, and no other kind is necessary. (Note that if R=C, the value of the dollar will be constant over time.) A simple change in peoples’ expectation of the 100-year payoff could be enough to make the dollar fluctuate now, even though the Fed’s assets are (for now) constant.

    As you said: As long as net worth is large enough, the issuer can set the value of money just by setting the peg. Naturally, the issuer can’t set the peg so high that his net worth becomes negative, as that would start a bank run.

  19. 19 David Glasner September 6, 2011 at 9:39 am

    Mike, So what is your understanding of the implicit convertibility promise now in operation for US currency? And with a given demand to hold US currency today, how would an increase in the currency stock, say 10%, affect the price level?

  20. 20 Mike Sproul September 6, 2011 at 10:12 am


    Think of two kinds of convertibility: physical (the Fed buys back its dollars with gold) and financial (The Fed buys back its dollars with a dollar’s worth of something—usually bonds). Physical convertibility is obvious: The Fed stands ready to buy back its dollars with 1/35 oz of gold.

    Financial convertibility is less obvious, so let’s say that the Fed is currently maintaining physical convertibility at 1/35 oz. Now suppose some people find they have too many paper dollars in their wallets (after Christmas, for example). They start returning their dollars to the Fed, demanding gold. But the Fed could head off this demand for redemption by selling bonds and soaking up the unwanted dollars. Financial convertibility has just replaced physical convertibility. In principle, the Fed could always stand ready to pay out gold, but it might never have to pay out any actual gold as long as it conducted open market operations with bonds so as to maintain the value of the dollar at 1/35 oz.

    Of course there are many kinds of convertibility: instant, delayed, certain, uncertain, physical, financial, at the customer’s option or at the Fed’s option, tax convertibility, etc. So the above doesn’t fully explain my view of the implicit convertibility of US currency, but it gives a good start.

    The best way I can answer your question about a 10% increase in currency is to suppose that all currency is full-bodied silver coins. What if 10% more silver coins were minted? The right answer is that the Law of Reflux would come into play. Someone would find it profitable to melt the extra coins back to bullion. Either that or if there were some substitute moneys circulating in addition to the silver, then those other moneys would reflux to their issuers. So my answer about a 10% increase in the quantity of paper currency (adequately backed by new assets, I presume) is that the new currency, or some substitute currency, would reflux to its issuer and prices would not change. Of course, if the new currency was not matched by new assets, then 10% inflation would result.

  21. 21 David Glasner September 10, 2011 at 7:54 pm

    Mike, So am I correct that you do agree that there are conditions under which a monopoly issuer of a fiat (but backed) currency could print more money and cause inflation despite the law of reflux? I am not trying to understand how to apply your model.

  22. 22 Mike Sproul September 11, 2011 at 10:54 am


    I hope that “not” in your last sentence was a typo.

    One obvious way that printing more money could cause inflation is if the new money were not adequately backed by new assets. If a bank printed 10% more money, while increasing its assets only 4%, then the backing theory implies roughly 6% inflation.

    I think you were thinking of a tougher question: Can we get inflation when the bank issues 10% more money while getting 10% more assets? If that money was silver coins, then silver coins could lose value, but only enough value to pay the costs of melting the coins back to bullion. That might be 2%, so in that case I’d say that a monopoly issuer of silver coins could, at most, cause their value to fall by 2%. Any more than that and silver will reflux faster than it can be minted.

    The case is the same with paper or credit currency. This kind of money also refluxes to its issuer, though the channels of reflux are not as obvious as for silver. Reflux can occur when the government collects taxes, sells off buildings or furniture, etc. If this reflux involves a 2% handling cost, then I’d say that a monopoly issuer of paper can also cause a 2% inflation before people start finding it profitable to let their excess paper money reflux to its issuer.

  23. 23 David Glasner September 22, 2011 at 9:31 am

    Mike, You are a careful reader, it was a typo.

    So let’s assume that the Fed has way more assets than liabilities and it just decides to create some new liabilities with no assets backing them. What happens to the value of the liabilities? Are you saying that the new liabilities must flow back (reflux) to the Fed? If so, what assumptions are you making about the shape of the demand curve for Fed liabilities?

  24. 24 Mike Sproul September 22, 2011 at 11:02 am


    Suppose the Fed initially gets deposits of 100 oz. of silver, and for each oz. received, the Fed issues a paper dollar redeemable for 1 oz. Then the Fed issues another $200, in exchange for 200 oz. worth of government bonds. (Could have said $200, but this simplifies the arithmetic.) The $300 is adequately backed by 300 oz of assets, so each dollar remains worth 1 oz. in in spite of the tripling of the money supply.

    Now throw in your assumption that assets are way more than liabilities. This could happen if the Fed gets a gift of another 300 oz. of silver out of the blue. There are now $300 backed by 600 oz. of assets, so I’d normally say that each dollar will rise to 2 oz./$. But lets allow your logic to work and suppose the dollar remains at 1 oz./$. This might happen if the Fed announces that it will never pay out that extra 300 oz., but just keep it for decoration.

    Now suppose, as you say, that the Fed issues another $100 with no new assets. I think the fairest way to work through your thought experiment is to suppose that the Fed now changes its mind and decides that it will set aside 100 oz. of that 300 oz., as backing for the extra $100. So now, even though the Fed’s assets technically total to 600 oz., only 400 of those oz. are really backing the $400 of cash that the Fed issued. Thus the value of the dollar is unchanged at 1 oz.

    I suppose that the community originally found that a real money supply of 300 oz. was enough to conduct their business. They now have 400 oz. worth. Thus 100 oz. worth will reflux to the Fed. I think this means that I’m assuming that the demand for Fed liabilities ($ on horizontal axis, oz./$ on the vertical) is a rectangular hyperbola. I might be misunderstanding you. I don’t normally think in terms of a demand curve for Fed liabilities.

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.


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