A Primer on Money, Banking, and Gold (Peter L. Bernstein's Finance Classics)

Peter L. Bernstein

• Publisher: Wiley
• Year: 2008
• ISBN:
  9780470435205
• Edition: 1
• Topic: Commerce
• Subtopic: Investissements et valeurs mobilières

One of the foremost financial writers of his generation, Peter Bernstein has the unique ability to synthesize intellectual history and economics with the theory and practice of investment management. Now, with classic titles such as Economist on Wall Street, A Primer on Money, Banking, and Gold, and The Price of Prosperity —which have forewords by financial luminaries and new introductions by the author—you can enjoy some of the best of Bernstein in his earlier Wall Street days.

With the proliferation of financial instruments, new areas of instability, and innovative capital market strategies, many economists and investors have lost sight of the fundamentals of the financial system—its strengths as well as its weaknesses. A Primer on Money, Banking, and Gold takes you back to the beginning and sorts out all the pieces.

Peter Bernstein skillfully addresses how and why commercial banks lend and invest, where money comes from, how it moves from hand to hand, and the critical role of interest rates. He explores the Federal Reserve System and the consequences of the Fed's actions on the overall economy. But this book is not just about the past. Bernstein's novel perspective on gold and the dollar is critical for today's decision makers, as he provides extensive views on the future of money, banking, and gold in the world economy.

This illuminating story about the heart of our economic system is essential reading at a time when developments in finance are more important than ever.

PART ONE

THE MONEY PROBLEM

Chapter 1

WHY WORRY ABOUT MONEY AND GOLD?

Everything that King Midas touched turned to gold, until ultimately he was a very poor man, because he had no useful possessions at all. The moral of this story is that money isn’t everything in life. Indeed, money and gold bring wealth and power only in terms of what one can buy with them.

On the other hand, history tells us that money can be crucially important. Revolutions have seldom been caused by an excess of purchasing power, but men have frequently been stirred to violence when they are hungry and factories stand idle simply because no one seems to have enough money to buy what they are able to produce. Poverty in the midst of potential plenty always appears shocking and senseless.

These contrasts are the essence of the subject matter with which this book is concerned. Put in its simplest terms, we want to be sure that we have enough money around so that we can buy everything that has been produced, but never so much that we try to buy more than has been produced. The problem that will concern us most is the difficulty of keeping the number of dollars spent in line with the quantity of goods produced.

Despite the problems money causes, mankind invented it and sticks to it because it relieves us of the almost insurmountable difficulties of doing business through barter. For this reason, even the most primitive societies have tended to use some form of money, whether it be feathers or wampum or giant stones buried under the sea. As societies become more complex and people more specialized in the tasks they perform, money is even more necessary to enable one man to exchange his production for another’s.

With the growing complexities of the marketplace and of the methods of production, we find that the character of money changes. It becomes more and more abstract, until it reaches the highly sophisticated form of our own money, which consists primarily of numbers on the ledgers of the banks that maintain our checking accounts. Although we still use some currency (worth, in reality, no more than the paper it is printed on) and some coins, most of the money we spend moves from buyer to seller through the writing of checks that order the banks to debit one account on their books and to credit another. Thus, most of our money has no real value and no tangible existence: we can’t see it or feel it or smell it. This is one of the reasons why its quantity is so difficult to regulate.

Nevertheless, while we shall be most concerned with this abstract money that exists only on bank ledgers, we shall also see that gold continues to play a crucial role in our financial affairs. Sophisticated as we may be, our links to gold persist. Gold has shown amazing vitality through the ages as the paramount symbol of money and wealth. The Midas legend teaches us that gold may be nothing more than a useless (if beautiful) metal, but it has surely been the cause of an extraordinary amount of rapacious-ness, plunder, and adventure in the history of man.

Why gold is “good as gold” is an intriguing question. Freud suggested that our fascination with gold is related to the erotic fantasies and interests of early childhood. Perhaps its very purity inspires men to violence. Anyone who has ever seen a pile of gold bricks or gold coins will always remember the sense of awe it inspires. In any case, its prosaic physical characteristics—high density and such strong resistance to oxygen that it never tarnishes—have increased its usefulness as money.

Whatever the reasons, men will go to great lengths to find gold and dig it up. After visiting the Klondike and the Yukon, Will Rogers commented: “There is a lot of difference between pioneering for gold and pioneering for spinach.” Although North American gold mines are still producing, most of the free world’s gold comes from South Africa, where the white man owns and profits from the gold but leaves to the black the business of digging it out of the dusty hell two miles below the surface of the earth.

Yet, with all the digging and prospecting and plunder, men have managed to scrape together a surprisingly small amount of this precious stuff. The entire accumulation of monetary gold over the centuries has brought the world’s gold hoard today to just about 40,000 tons; American industry pours 40,000 tons of steel in less than one hour !

While nature essentially controls the quantity of gold in existence, it is men who assign it values in terms of dollars and pounds and rubles; it is also men who decide how much money a given amount of gold may “back.” When we look at the alternations between inflation and deflation in our history, men seem to have done a poor job of regulating the supply of money.

We find repeated cases in which people seemed to have so little money that they were unable, or certainly reluctant, to buy everything that could be produced. As a result, prices fell, profits vanished, production shrank, and unemployment spread. Only when all prices and all wages had been pushed down so low that the formerly inadequate supply of money seemed sufficient to buy up all the goods and services offered for sale at bargain levels did the wheels finally begin to turn again and men go back to work.

We can also find frequent examples of the opposite situation—the inflationary spiral in which the quantity of money outruns the supply of goods. When people want to buy more than has been produced, prices rise. Then some people lose out through being outbid in the marketplace. Those who suffer most are usually the ones who least deserve to be the losers—the frugal, the conservative, the prudent, together with the poor and unorganized who are unable to battle for the higher incomes they need to stay even with the rising prices.

Thus, regulation of the supply of money is not just a matter that concerns financiers and bankers: it is intimately involved with our prosperity and with our social tranquillity. With all its technicalities, this is a subject with the broadest political and economic implications.

Our analysis of it now begins with the very crux of the process—the links that exist between the quantity of money and the levels of business activity and prices.

Chapter 2

SPENDING AND FINANCING

It is obvious, but nonetheless true, that each of us goes to work to help in turning out goods and services in our economy not for our own use, not out of the kindness of our hearts, but because we expect to sell the fruits of our efforts to other people, and because we expect to be paid for them.⁶ In short, we work for money.

If this is the case, however, businessmen must have the money to pay their workers and suppliers for producing the goods they want to sell, and customers must have the money to pay for the goods they want to buy. Without the wherewithal to pay for them, few goods would be produced and fewer would be sold. This leads, in turn, to the important conclusion that an increase in production or the sale of the same quantity of goods at higher prices simply cannot be sustained unless people are willing and able to lay out the extra money they will need to buy the additional goods or to pay the higher prices for the same quantity of goods.

Take, for example, the case of a family that has been spending $6,000 a year on the basketful of goods and services it requires to maintain its living standards. Now let us assume that we enter into an inflationary phase and, as a result, the price of the same basketful rises from $6,000 to $6,600. To maintain its living standards, this family is now going to have to find an additional $600 every year.Where can they find it?

The breadwinner in the family—most likely, the father—can go to his employer and demand an increase in wages. But then, of course, the employer has to find an additional $600 a year to keep his employee happy. This money must either come out of his own profits from the business (in which case he will have less money to spend) or he must raise his prices and ask his customers to pay it. In that case, the customers must find the additional $600, and we are right back where we started.

If the father of the family is unable to obtain a raise from his employer, he still has several alternatives available to him. He can draw down money that he has accumulated in the past—the cookie jar can be emptied and its contents used to maintain the family’s standard of living. He can go to the savings bank and ask them to give him back the money he previously deposited—but then the savings bank has to be sure it has the money. He can borrow the money from friends or from a finance company, but they, too, must have the money available to lend him.

And what if this family is unable to find the additional $600 it needs to carry on? Clearly, it will have to cut down on the quantity of goods and services it buys. If it can only afford to spend the same $6,000, approximately 10 percent of the things it bought before will now remain unsold. Retailers, finding that sales are falling below expectations and that inventories are piling up on their shelves, will cut down their orders from wholesalers. Wholesalers will tell manufacturers to ship a smaller quantity of goods. Manufacturers will then have to cut back on their production schedules; their employees will probably be laid off or will work fewer hours.

In time, then, the inability to finance the purchase of goods at higher prices results in unemployment and excess productive capacity. The forces of competition at work when businessmen can produce more than they are able to sell will probably lead to the elimination of the price increase. Or, if people are willing to pay for those goods whose prices have been raised, they will have less money to spend on other goods and services, so that unemployment will spread into those industries whose market power is weakest.

Just as an increase in prices must be financed if unemployment is to be avoided, so must an increase in production be financed if it is to take place at all. Here, for example, is a manufacturer of pencils, who is producing and selling 100 million pencils a year for a total of $1,000,000 in sales. He finds that business is excellent and that his dealers are reordering his pencils with increasing frequency. He therefore decides to step up his production schedules and to produce an additional 10 million pencils on which he expects to generate $100,000 in extra sales in the coming year.

But first he is going to have to look around for the money to finance the additional production. He will have to obtain extra amounts of wood, lead, and rubber. He may need new workers or will have to pay his present staff for overtime work. He may even need a new plant or additional machinery. One way or another, he will have to find some way of paying for this expansion, since his customers, whether retailers or wholesalers, will probably pay him only thirty days or so after receiving the merchandise he has shipped to them.

He has a number of alternatives. He may have enough money sitting in his checking account to cover all the extra disbursements he must make. He can ask his suppliers, and possibly even his employees, to wait to be paid until after his customers have paid him. He can draw down his savings account or sell to other investors some financial asset he may possess, such as a short-term Government security or commercial paper. He can borrow the money, or he can take new investors into the business with him.

Thus, money that has to be spent must come from somewhere—either from one’s own cash balance or from somebody else’s money holding. And that somebody else either has to have the money himself or must be able to find still another source to provide it when needed. Unless the pencil manufacturer’s suppliers and employees are to be paid—and, ultimately, unless the manufacturer’s customers are going to be able to find the money to pay him—the extra 10 million pencils will never be produced.

Indeed, money makes the world go round.

The significance of this example is that the supply of money does set limits to how far business expansion can go and how high prices can rise. Both increased production and the same volume of production sold at higher prices involve a higher rate of spending by customers, and, when they have to pay out money, money is the only thing they can pay out. No bill can be paid with Government bonds or shares of stock or jewelry, or even a savings account or life insurance policy. Only a check or currency or coins will be acceptable for this purpose.

Nevertheless, although the supply of money can set the upper limit to a price inflation or to growth in production, we have no ready way of knowing where that limit may be. In fact, the number of dollars in our bank accounts and pockets is only an indirect, and frequently unsatisfactory, guide to the rate at which we are going to spend those dollars. And it is expenditure that counts—it is expenditure that comes into the marketplace to be matched against the supply of goods and services.

The relationship between the quantity of money and the rate of expenditure is so tenuous and variable because of a peculiar characteristic of money—a characteristic that it need not have in theory, but with which we have endowed it. Indeed, without this feature, money would be a much less convenient medium of exchange than it is.

The point is that we need not spend money the instant we receive it. We can take it in payment for something today but wait until the day after tomorrow to spend it. Or, in fact, we can let someone else use our idle dollars for a while, provided they will pay us an adequate rate of interest for the privilege of using our extra cash. But no law tells us that we have to spend every penny we earn, nor that we need spend it today instead of tomorrow, nor that we have to lend it out to someone else if the interest he will pay seems inadequate. In short, some production may go unsold simply because individuals and business firms sit on their money instead of spending it or making it available to others to spend.

Of course, the opposite can also happen. As we saw in the case of the family spending $6,000 or in the case of the pencil manufacturer, we can step up our rate of spending merely by using some of the idle cash that we may have accumulated in the past or by finding others who may now be willing to make their cash available to us to spend. The man who borrows money or draws down his savings account to buy a house or a car, and the respected corporation that borrows money to finance its expansion programs are both spending in excess of their current incomes. When people spend more than they earn producing goods and services, the chances are that they will be trying to buy more than has been produced. This excess demand will then either stimulate an increase in production schedules or an increase in prices.

Thus, the rate of spending can vary widely, even when the supply of money in the economy is relatively stable. Conversely, variations in the supply of money will not necessarily lead to corresponding changes in the sales of business firms. Sometimes people want to accumulate cash rather than spending it or making it available to others to spend; at other times, they are eager to spend their cash hoards or to borrow and spend the cash hoards of others.

To recapitulate, we have seen that our main problem is to keep the rate of spending in line with the production of goods and services—neither so low that prices and demand collapse nor so high that an inflationary spiral begins. But we have also seen that increases in spending must be financed—that the additional dollars must come from the spender’s past accumulations or be made available to him by others. And now we find that the ease or difficulty of financing a higher level of expenditure is only indirectly related to the supply of money: people’s motives for holding, lending, and spending money are seldom constant.

No wonder, then, that we have been so unsuccessful at keeping expenditure in line with production. Controlling the supply of money in the economy is a partial, but by no means certain, technique for achieving our objective. Before analyzing the factors that do determine the number of dollars in existence, then, we must first have a look at the reasons why people want to hold onto more money at some times than at others.

Chapter 3

THE PRICE OF MONEY

The most obvious reason for holding money is that we need it to pay for the things we buy. Most of us spend money at a rate different from the rate at which we earn it. If we should earn $15 a day and spend $15 a day, we would never have to hold money for more than a few hours. But since money comes in to most of us at regular intervals, whereas money is spent in amounts that may vary widely from day to day, we must have some funds available to finance our outlays during those periods when more is going out than is coming in.

Most of the money we hold, then, is for this purpose. And the more we spend, the larger the cash balances we will need to finance these expenditures. This also means that the higher the level of business activity and the more active the volume of production and employment, the more each of us will need the money we have and the smaller the amount we will be able to make available to finance the expenditures of others. For these reasons, we frequently hear that money is “tight” (that is, in tight supply) when business is good and that money is “easy” (that is, easy to obtain) when business is slow.

But most people and most business firms tend to carry a little more money than they absolutely r...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Foreword
• Introduction
• ORIGINAL INTRODUCTION
• PART ONE - THE MONEY PROBLEM
• PART TWO - THE CREATION OF MONEY
• PART THREE - THE CONTROL OF MONEY
• PART FOUR - GOLD
• PART FIVE - THEORY IN PRACTICE
• Conclusion
• Appendix - READING THE WEEKLY FEDERAL RESERVE STATEMENT
• BIBLIOGRAPHY
• Acknowledgements
• INDEX