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About money supply and paper money systems

Monetary expansion: magic or dangerous boondoggle?

The founder of classical economics, Adam Smith, once expressed the following view: "Substitute silver. But this is not the case with today's paper money standard. Defenders of this system argue that paper money is backed by the economic strength of the country in question. But this is true only as long as the amount of paper money does not increase faster than the economic output, otherwise the value of money decreases accordingly. The connection between the money supply and inflation is the subject of particular discussion in the Austrian School.

Milton Friedman is the second figurehead among the economists of the 20th century. his seminal work The Optimal Money Supply was published in 1969. At the center of his monetary theory is the thesis that there is a long-term relationship between the money supply and inflation.[2] In his book Money Rules the World, published almost a quarter of a century later, he states: "Inflations are a monetary phenomenon. They arise because the money supply grows faster than output."[3] The money supply of the 34 OECD countries increased by an average of 10% per year in the period from 1980 to 2011.[4] By comparison, the gold supply increased by 2, and the silver supply by as little as 1.2% per year in the same period.[5] Friedman holds the paper money system responsible for the excessive money creation. In his view, central banks can effectively counter inflation only by limiting the money supply. How money supply and velocity of circulation are related to the price level and the supply of goods is expressed by the Quantity Equation expresses.

It is impossible to estimate in advance what the effect of a change in the money supply will be. This depends, among other things, on future expectations and the preferences of economic agents.[6] Nevertheless, it is attractive for central banks and governments to expand the money supply for the following reasons:[7]

  1. Tax revenue effect: the increase in the money supply appears like additional tax revenue if designed appropriately. In addition, inflation increases the tax progression ("cold progression"), which is only offset with a time lag.
  2. Infrastructure effect: By increasing the money supply, the state can finance economic stimulus programs (as during the financial market crisis of 2008/2009). This enables, for example, infrastructure investments with an impact on the economy to be made (e.g. road construction, refurbishment of public buildings), which would "fall from the sky" through pure money creation.
  3. Growth and income effect: The increase in the quantity of money and the higher velocity of circulation due to the "money illusion", combined with the infrastructure effect and the associated multiplier effects, lead to a growth effect and thus to an increase in nominal income.
  4. Debt reduction effect:
    Inflation - often together with currency devaluation - leads to a partial "redemption" (inflationization) of foreign debt.

The downside, however, is that the supposedly positive short-term effects of money creation turn into the opposite with a time lag. On the one hand, around two years after an increase in the money supply, inflation occurs, which is then difficult to contain, combined with an increasing loss of confidence in the currency. On the other hand, the increase in the money supply distorts the price structure and - as a consequence - the production structure and thus leads to efficiency losses, because the money illusion leads to misdirected incentives at the microeconomic level and, as a consequence, to misdirected investments, which cause inefficient use of resources and thus welfare losses at the macroeconomic level.

John Maynard KeynesAgainst this background, Friedman's proposal to allow central banks to control the money supply was just as fatal as that of John Maynard Keynes, the third figurehead among the economists of the 20th century, to stimulate demand by deficit spending. Money creation and indebtedness are, in fact, the main reasons for the excesses on the financial markets that are becoming increasingly evident today. The results of the implementation of Friedman's economic policy proposals, however, were not very pleasant in another respect:[8] Since he opposed any regulation in the financial sector because, in his view, this would create distortions that triggered the crises in the first place, capital controls were gradually lifted worldwide after the end of the Bretton Woods system. The consequence of this deregulation was that capital increasingly flowed into the financial economy and was consequently withdrawn from the real economy. In the industrialized countries, this led to a dampening of growth rates, increased inflation risks(asset inflation) and pronounced financial market crises.

The three most famous economists of the past century can be sure of the gratitude of the small but increasingly larger group of precious metal investors, because they created the conditions for a continuation of the precious metal price increase in the coming years. To put it bluntly, Friedman is responsible for the drastic expansion of the money supply and the deregulation of the financial markets, Keynes for the exuberant national debt, and Hayek for not having dissuaded his colleagues from their ill-fated proposals.



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Is a new precious metal-backed world reserve currency coming?

A growing number of economists - though not yet the representatives of the mainstream entrenched in the existing system - are advocating the abolition of national monetary monopolies and a strengthening of currency competition, something John Maynard Keynes already proposed at the end of World War II in the course of the reorganization of the world financial system; in effect, this would mean a return to the gold standard or a similar currency system.[9] The Bank of China recently recalled the proposal put forward by Keynes at the Bretton Woods conference in 1944 - supported by Hayek - which envisaged the introduction of a world reserve currency called the bancor as an international unit of account, a basket of gold and silver plus some other metals or commodities.[10] This was intended to dampen both money creation and economic fluctuations.

Alongside Keynes and Hayek, however, Friedman was by no means averse to a precious metal-backed reserve currency. In his view, expressed in the early 1990s, "the almost universal introduction of irredeemable paper currencies in the world has made the discussion of precious metal currencies, whether gold or silver, bimetallic or symmetallic, a matter of purely historical interest at the present time. This situation may well change again. ... Bimetallism is not at all a thoroughly disproved fallacy, but, on the contrary, for theoretical, practical, and historical reasons, offers many advantages by virtue of which it is ... superior to a monometallic system."[11] The conclusion that he was open to a precious metal peg is also suggested by his reference to Irving Fisher - whom Friedman considered the best economist the U.S. ever produced - who considered a move away from a precious metal peg to be a "curse on the country concerned."[12]

Of all people, the legendary ex-Fed chief Alan Greenspan - derided as the king of paper money systems and conductor of the greatest bubble orchestra in history[13] - is in some ways one of the star witnesses for the merits of a precious metals standard. Indeed, Greenspan was not always a proponent of unbridled flooding of the world with unbacked paper money, but was once an ardent advocate of the gold standard. in 1966, he published an essay describing the functions of money and the purpose of a gold standard in this context. The following is a short passage from this essay, written almost half a century ago, which clarifies the background of the rejection of the gold standard as well as the sovereign debt crisis of 2011/2012:[14]

"Under a gold standard, the amount of credit an economy can bear is limited by the real tangible assets of the economy, because every credit relationship is ultimately a claim on a real tangible asset. But government bonds are not backed by real tangible assets, but only by the government's promise to pay for them out of future tax revenues. They cannot therefore be readily absorbed by the financial markets. A large amount of new government bonds can only be sold to the public at constantly rising interest rates. Therefore, government debt financing under a gold standard is tightly constrained. The abolition of the gold standard allowed the advocates of the welfare state to abuse the banking system for unlimited credit expansion. ... Without a gold standard, there is no way to protect savings from expropriation by inflation. There is then no longer a safe store of value. If there were, the government would have to declare its possession illegal, as has been done in the case of gold. The financial policies of the welfare state make it necessary that there be no way for asset owners to protect themselves. This is the sordid secret behind the demonization of gold by the representatives of the welfare state. Government debt is simply a mechanism for the 'hidden' expropriation of wealth. Gold prevents this insidious process.

Another proposal for reorganizing the monetary system was made by the Chinese central bank in 2009. According to this proposal, the Special Drawing Rights (SDRs) at the International Monetary Fund (IMF) are to be expanded as a new supranational world reserve currency and admitted as a means of payment for the settlement of world trade.[15] An SDR is a means of payment allocated to members by the IMF for the first time in 1970 for circulation between central banks for the purpose of procuring foreign currency to supplement existing currency reserves.[16] Initially, one SDR was equivalent to one U.S. dollar or just under 0.9 grams of gold. After the abolition of the gold redemption requirement for the US-$ and the transition to flexible exchange rates, this was replaced by a basket of currencies, which today includes the US-$, the €, the Japanese yen and the British £. China would like to see the yuan added to the SDRs as well. The value of the SDR is determined daily based on current exchange rates. Every five years, the composition of the currency basket is reviewed, with the benchmark being the currencies' share of world trade. In the 1970s, nine-tenths of world trade was invoiced in U.S. dollars, but this figure has since fallen to just over half.[17] The expansion of the SDR in line with China's ideas would contribute to replacing the U.S. dollar as the leading world reserve currency with a more broadly based currency unit, whereby it would also make sense to include precious metals.

China's Role in the World Monetary System

Since the turn of the millennium, China has kept the yuan in an almost stable relationship to the U.S. dollar through ongoing dollar purchases. In effect, China introduced a fixed exchange rate to the U.S. dollar, as other Asian countries had done before when they were still emerging markets (Japan, South Korea, Thailand). In this way, China wants to secure its competitive advantages in exports to the USA. In return, China - together with other Asian countries - finances large parts of the U.S. current account deficit through capital exports to the U.S. The U.S., in turn, can import low-priced goods from Asia. Then, interestingly enough, the upswing in precious metal prices began in 2001 of all years, which is probably no coincidence, because the pegging of the yuan to the U.S. dollar effectively increased the dollar by the amount of the yuan.

The catch is that the strategy, which on the surface appears mutually beneficial, resulted in depressed long-term U.S. interest rates. This massively limited the U.S. Federal Reserve's steering options, as the increase in the short-term key interest rate was unable to dampen either the economy or the rise in asset prices - such as in the real estate sector - to the desired extent. Capital inflows from Asia thus contributed to the creation of the real estate bubble and, after it burst, to the financial market crisis of 2008/2009.

China has now accumulated currency reserves of more than three trillion U.S. dollars.[18] Of this, around one-third is probably invested in U.S. bonds. Meanwhile, China is stepping up efforts to gradually diversify its reserves - including through purchases of precious metals and commodities - in order to reduce upward pressure on the yuan and thereby maintain its competitiveness.[19] This policy orientation by China - as well as other emerging markets - has a price-increasing effect on precious metals in three ways:

(1) The pegging of the yuan to the U.S. dollar increases uncertainties for the global monetary system and negative systemic effects on the financial system. The devaluation race between the U.S. and China increases the money supply and fuels inflation fears or dangers. In the medium term, there is much to suggest that there will be a fundamental reorganization of the world monetary system. In such a new world monetary order, precious metals will play a key role. Even before this new order comes into effect, this is likely to be reflected in precious metal prices.

(2) The demand potential resulting from the necessary diversification of the currency reserves of the emerging countries is also significant, because China and other emerging countries will (have to) shift their considerable reserves into precious metals to a considerable extent in the coming years. It should be mentioned here that the government of China had already banned the private ownership of gold in its own country in 1949. This makes it the only country authorized to buy gold. What potential this holds for China alone, if it shifts its reserves into precious metals, can be illustrated by a simple calculation example: If China wanted to raise the share of gold in its foreign reserves overnight to the global average of 10% (for comparison, the share of U.S. foreign reserves in March 2012 was 77%, that of Germany 74%), it would either have to buy up two world productions of gold in 2011 or the price of gold, which averaged US$1,750 in October 2012, would have to rise to US$7,500.

(3) Another emerging market-specific aspect should also not be underestimated: The growth of a high-income middle class in China, India and other Asian, Latin American and Eastern European emerging markets, as well as in the Middle East, will result in a sharp increase in jewelry and investment demand in the coming years. Precious metals will then no longer be just crisis metals, as was often the case in the past, but also wealth metals at the same time.[20]

Rising Lending Rates: Harbingers of the declining paper money system

The significance of precious metal lending rates can be characterized as follows:[21] Lending rates of close to zero signal a stable paper money system in which market participants have confidence. Precious metal demand as a hedge against paper money losses is then low and central banks' gold holdings are considered largely useless in monetary terms. Rising lease rates, on the other hand, signal a rising monetary character of precious metals. If lending rates eventually exceed the interest rate on paper money, and if this condition persists over a period of time, there is no longer an interest rate advantage that justifies the risk of preferring unbacked paper money to precious metals of value. For fear of not being able to get them back, precious metals are no longer lent out despite the rise in yields. The prices of precious metals then rise sharply, but even at these prices one will then no longer receive precious metals for paper money. Only precious metals will then be accepted as money, and the paper money system will collapse. We are already in the twilight of the gods of our paper money system and before the re-monetization of precious metals.

[1] Vgl. Smith, A. (1776), Der Wohlstand der Nationen. London.

[2] Vgl. Wikipedia, Milton Friedman (Internet:, Abruf vom 01.10.2012).

[3] Vgl. Friedman, M. (1992), Geld regiert die Welt. Neue Provokationen vom Vordenker der modernen Wirtschaftspolitik. ECON Verlag, Düsseldorf: S. 237.

[4] Eigene Berechnung in Anlehnung an: Schulte, T. (2012), Vermögen retten. In Silber investieren. Jochen Kopp Verlag, Rottenburg: S. 20f.

[5] Anmerkung: Der Anstieg des überirdischen Goldbestands lag im Jahr 2011 unter der Annahme, dass 90 % des geförderten Golds erhalten blieben, bei 1,7 %. Die Minenförderung betrug bei Silber 2011 bezogen auf die überirdischen Silberbestände einem Bruttoanstieg von 3,5 %; geht man davon aus, dass 90 % des von der Industrie und 25 % des von der Fotografie verbrauchten Silbers unwiederbringlich verlorengeht, lag der Nettoanstieg der überirdischen Silbermenge im Jahr 2011 daher nur bei 1,4 %.

[6] Eine Geldmengenerhöhung führt beispielsweise nicht zwingend zu einer Erhöhung der Nachfrage: Pferde, die nicht saufen wollen, lassen sich nicht alleine dadurch zum Trinken bringen, dass man ihnen mehr Wasser gibt.

[7] In Anlehnung an Friedman, M. (1992), Geld regiert die Welt: S. 195ff.

[8] Vgl. Bozsoki, J (2003), Die politische Ökonomie des Geldes bei Milton Friedman. Eine kritische Analyse des Monetarismus und mögliche Alternativen. Wien (Internet: onlinetexte/hausarbeit_friedman_bozsoki.pdf, Abruf vom 01.10.2012): S. 17f.

[9] Vgl. Plickert, P. (2009), Rückkehr zum Goldstandard? F.A.Z vom 24. März 2009 (Internet:, Abruf vom 01.10.2012).

[10] Vgl. Plickert, P. (2009), Rückkehr zum Goldstandard? (Internet-Abruf vom 01.10.2012).

[11] Vgl. Friedman, M. (1992), Geld regiert die Welt: S. 161.

[12] Vgl. Friedman, M. (1992), Geld regiert die Welt: S. 53.

[13] Vgl. Bocker, H.J. (2009), Freiheit durch Edelmetalle als Investment. Argumente und Hintergründe. Stuttgart).

[14] Vgl. Greenspan, A. (1966), Gold und wirtschaftliche Freiheit (ungekürzt im Internet: 20Freiheit.pdf, Abruf vom 01.10.2012).

[15] Vgl. Geinitz, C. (2009), China schlägt eine neue Leitwährung vor? F.A.Z vom 24. März 2009 (Internet: D76C741C59D2F4F9B3D3A97A8~ATpl~Ecommon~Scontent.html, Abruf vom 01.10.2012).

[16] Vgl., Sonderziehungsrecht (SZR) (Internet: wirtschaftslexikon24. net/d/sonderziehungsrechte-szr/sonderziehungsrechte-szr.htm, Abruf vom 01.10.2012).

[17] Vgl. Stöferle, R.-P. (2009), In Gold we trust. Spezial Report Gold. Erste Bank. Wien (Internet:, Abruf vom 01.10.2012): S. 39.

[18] Vgl. (2011), Devisenreserven – Warnung aus China lässt Dollar-Kurs einbrechen (Internet:,1518,767075,00.html, Abruf vom 01.10.2012).

[19] Vgl. Stöferle, R.-P. (2009), In Gold we trust (Internet-Abruf vom 01.10.2012): S. 41.

[20] Vgl. Schürmann, C. (2011), Gold und Silber – Die Goldhausse beschleunigt sich (Internet:, Abruf vom 01.10.2012).

[21] Vgl. (2010), Denken Sie langfristig immer in wahren Werten (Internet:, Abruf vom 01.10.2012).


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