US dollars are fiat money. They have power because you have to pay taxes with dollars and the government considers them to be legal tender, that is, courts will enforce contracts where payment is required to be in dollars.
There are several problems with non-fiat money as a medium of exchange (I think this is called "commodity money"). It is very difficult to control the value of commodity money. Boom & bust cycles are more pronounced. Inflation is more pronounced, since whoever can figure out a way to produce a greater amount of commodity money will do so to gain a marginal advantage.

Yes, going off the gold standard was explicitly intended to free the government to act as it wanted. It's a sign of our ruling class operating on a higher plane and refusing to be shackled by crude reality. It puts off Thatcher Day (when you run out of OPM).

Interesting to me is that we went off the Gold Standard right at the time when all sorts of other fissures were starting to appear in Industrial Age institutions.

At about the same moment Israel smashed the armies of three more populous nations in a mere six days. And it was mainly done by liberating her officers from top-down centralized management. Israeli doctrine called for units to be given objectives, but to be left to themselves to figure out how to achieve them. With the only requirement being to constantly communicate what they were doing, and where they were.

That's Information Age management in a nutshell.

The reason economists & politicians wanted to go off the gold standard was that it would give them tools to manipulate the money supply -- moderately increase and decrease its availability -- and flatten the boom-bust cycles of the economy. In fact it has done that. It's a matter of historical record that boom-bust cycles have been much more temperate since we abandoned gold.
There is nothing magic about gold. It is a commodity with no intrinsic value.
In fact, throughout history, governments have manipulated the value of gold-backed currencies with taxes on the conversion of bullion to coins and laws against converting coins to bullion.
The gold standard is no ward against the foolishness of politicians and the people who elect them.

Another thing to bear in mind about tying the value of the dollar to gold (or silver or rutabagas) is that a modern economy will often produce goods and services faster than the supply of gold (or whatever the currency is backed with) can increase. Our great-grandparents (well, mine, anyway-- they were all born about the time of the Civil War) saw that in the late 19th Century as the material output of the economy mushroomed while the money-supply didn't change much, and so they had persistent deflation. That's where the controversy about the free coinage of silver came in-- it was a way to get more money into circulation and ease the problem of falling prices.

As for the United States going off the gold standard in about 1970-- keep in mind who the men in charge then were. They were men who had been young men in the 1930s, and knew at first-hand the problem of steep deflation (about 10% in 1932-34) and who remembered the stories they heard from their grandparents about the Depression of the 1870s, how things had hit bottom in 1877, and how (for farmers, especially) times weren't always very good for a long time afterwards, thanks to a dollar being so very valuable and money generally being so very hard to come by.

I'm sure they broke the dollar's tie to gold with the best of intentions (yes, I know-- the road to Hell, and all that), and the better to prevent the disastrous deflation of the early '30s. It's too bad that they and their successors were (and are) caught up in the Taylorist delusion that an economy can be micromanaged into prosperity. I do wish all politicians could be forced to read Hayek and give an oral report on the ideas underpinning his work.

Just running off at the mouth, er, keyboard again.....

Why are falling prices a problem?

Gold is commodity with no intrinsic value.
What is 'intrinsic value' of anything and how it can be found out?

The Miseans had predicted the current crisis well in advance although they could not predict the shape it would take. At that time Cheney was saying tha Deficits don't matter.

Falling prices are a huge problem because if money is increasing in value all on its own, there isn't much reason to invest. Just hold on to your money and it will grow in value.

And those who produce or build new businesses are punished--their products are worth less and less.

"What is 'intrinsic value' of anything and how it can be found out?"

Well, yes, that's the big question. "What is truth?" said Pilate.

And thank you all--you are giving me lots to think about.

Prices have been falling for computer and electronics goods forever and yet there is no dearth of investment in these sectors.

That's a different issue. It's very common for prices of manufactured goods to fall as they are produced and sold in greater quantities. Usually that means greater profits and growing businesses overall.

That's not deflation, although deflation can be part of those falling prices. Deflation is when the same thing costs less and less.

It's easier to see in things that are more slow-moving. Suppose the very same house, in a neighborhood that is not changing, costs less each year. I'll be reluctant to buy, because it will be cheaper later, and because my investment will be worth less and less! Which also means that it's harder to borrow money on the security of my house to do other things.

Deflation is much harder to fight than inflation. It's sort of like psychological depression--if you are depressed, then it's hard to find the energy to fight against depression, so you get stuck.

Gian wrote:
Gold is commodity with no intrinsic value.
What is 'intrinsic value' of anything and how it can be found out?

Food has intrinsic value. It can be eaten. Gold is only valuable because other people think that it is valuable.

Well, gold is used in making electronics. It is a conductor that is never subject to corrosion or oxidation. And it is very useful in making jewelry.

But of course you are right--most of its value is just because we've decide to value it. It would otherwise be fairly cheap stuff.

John, the people who did the best in the inflation of post WWI Germany weren't gold bugs, they were farmers. The substitute for currency, for most people, is not gold, it is barter.

Gian,

The problem with deflation, especially if the deflation rate exceeds 3% per year or so, is that it makes a nonsense out of the banking system.

Let us say that there is price stability (no inflation or deflation), and you have $100 which you put in the bank at 3% interest. The banker takes that money, loans it at 6%, and makes his living off the difference in the two rates.

$106 paid by the borrower to the banker at the end of the year (the principal plus 6% interest), less the $103 the banker pays to you at the end of the year (the $100 deposit that he puts back, after having loaned it out, plus the 3% interest the banker owes you), leaves the banker with $3 profit.

(Yes, this is grossly oversimplified, but bear with me.)

Now, let us say that inflation is running at 10% a year. The banker, to attract deposits, is going to have to offer an interest rate of about 14% (ten percentage points just to offset inflation, plus a slightly higher nominal interest rate-- four percentage points instead of the usual three-- to account for the fact that the dollars at the end of the year are worth less than dollars at the beginning of the year). The banker turns around and loans your $100 at, say 18%.

Yes, 18% sounds like a painfully high interest rate, but when inflation is 10%, the real interest rate is close to 6%, a usual and customary rate.

$118 paid by the borrower to the banker, less the $114 the banker pays you, leaves the banker with $4 at the end of the year.

So far, so good.

Now, imagine that inflation is running at a negative 10% a year, or to put it another way, the deflation rate is 10% a year-- that is, it will take only $90 to buy next year what $100 will buy today.

Again, to attract deposits, the banker has to offer to pay interest. Let us say he offers to pay 1%, giving you $101 at the end of the year. With deflation at 10%, that works out to an 11% real interest rate. Pretty sweet.

Except for one thing: How is the banker going to earn that dollar of interest? He still has to eat, and in order to make his usual $3 from borrowers, he has to lend your deposit money out at 4%.

But a 4% nominal interest rate on a loan, in the face of 10% deflation, is a 14% real interest rate (at the least-- the true rate is closer to 16%!). What borrower in his right mind is going to pay that kind of interest?

That, right there, is (or should be) a big, red, blinking neon sign pointing out just why the banking system in this country ground to a halt in 1932-33. when the general price level fell by about 10% in a year.

Go look at the Consumer Price Index data at the Bureau of Labor.

ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

The 25% drop in the general price level from the summer of 1930 to the summer of 1933 is SCARY.

(The fact that consumer prices started falling off a cliff at about the same time as Congress passed the Smoot-Hawley Tariff Act is NOT a coincidence. But that's a rant for another day.)

Now, some might say that loans could still be made in a deflationary environment using the notion of negative interest rates, but it's a mathematical exercise at best.

Let us say deflation is running at 10% a year. You give the banker $100, and he lends it out at negative 4% interest. At year's end, the borrower pays the banker $96, the banker keeps $3, and you get $93. You're "ahead" on the deal, in the sense that $93 has more buying-power than the $90 you would need to equal the buying-power of the $100 you had at the start of the year. But why would you (or anyone) consent to parting with $7 of hard-earned money just for the privilege of putting it in a bank? Far better to put your money in your mattress.

As I said, Gian, deflation causes economies to grind to a halt, because it makes money-lending darned near impossible.

Here endeth the sermon. :-)

Doesn't an increasing prosperity imply deflation?

Some confusion is because of nominal and real prices. But surely the real prices of most things have fallen in past two centuries.
Surely Americans can afford more meat and butter now than 200 years ago.
Doesn't that mean that meat and butter have fallen in real terms?

Food has intrinsic value. It can be eaten

So man lives by bread alone.