Several years ago a friend was dating a girl in Canada; at dinner one night he complained that one Canadian Dollar cost ninety seven cents USD and that the exchange rate shouldn’t be that close to one for one. He continued to comment about how he missed the gold standard, we’ll just set aside the fact that he wasn’t even born when the U.S. got off the gold standard, and that made me think about the virtues of asset backed currency and fiat currency. I planned to write this article as the first of my blog but could never seem to find the right time to introduce it but now as the U.S. “debt crisis” looms it seems like a fitting time to speak of the U.S. Dollar.
It is easy to conclude, particularly in these turbulent economic times, that backing currency with something of intrinsic value such as gold is an easy fix to declining currency value which in turn should encourage foreign direct investment and get the economy firing on all twelve cylinders just like the Ferrari in your garage. Sounds good right? Not so fast. First, gold doesn’t exactly serve as a store of value at least not to me. What does gold really do? I can’t eat, breathe, or drink it, nor will it protect me from the elements; so in terms of basic necessities it comes up zero. Well… there are some practical applications in technology and biotechnology and let’s not forget that it can be fashioned into shiny baubles that make women and therefore men happy. Ah gold is highly desired so there is value but if The New England Journal of Medicine published an article tomorrow stating that gold is the most carcinogenic substance on the planet I, for one, would be pulling the emblems off my cars to throw them in the trash along with my cufflinks and watches faster than I pop the clutch when the light goes green. Well fortunately, my cuffs won’t flare open and I won’t be late for meetings because there is some value to gold but N.B. you have to critically think about valuations. Ideas shouldn’t be taken as absolute truth because “it is what it is.”
Let’s stick a pin in gold as a store of value for now given that while there is clearly demand it is also a very much more speculative commodity than anyone will admit. In any event piling up bricks of gold will limit the supply and drive up the price so electronics, medical devices, and the less useful shiny bauble become more scarce and expensive. Storing gold to have a currency pegged to will make a less productive and advanced but more sickly society; sounds pretty bad right? That’s okay we can use silver, much less useful for anything except shiny baubles and more durable flatware, phew. However, there is still the small matter of artificially inflating the price of the commodity. While stockpiling silver won’t make us dumber without our computers or sicker without our tests it will take a lot of silver to back currency but that’s okay right? That all depends on your definition of okay.
Here’s the fundamental thing about money, it doesn’t have to and shouldn’t be anything at all. You’re probably thinking “Are you crazy? Working a 60 hour work week for a difficult boss instead of reading on a beach just to make money, of course it has value.” Thinking like that is why I’m writing and you’re reading so carry on.
Let’s hop in the way back machine. There is a farmer and a blacksmith. The farmer can barely grow enough food to support himself and his family but he has a horse that can help with the work. The horse can’t work without shoes though lest he split a hoof and go the way of the Elmer’s factory. The farmer goes to the blacksmith to get shoes for his horse; which the farmer pays for with bushels of wheat. The horse allows the farmer to work much more of his field and produce more wheat that he can then trade to the blacksmith for better tools to work his field that will yield still more wheat. Everyone is eating, working and happy; but what if the blacksmith still has wheat? Well marginal utility says that the value of the wheat to the blacksmith drops and he’ll require more wheat to compensate him for the same job so inflation becomes a bit of a problem rather quickly. Furthermore what if the blacksmith doesn’t want more wheat at all; what if he’s worried about bugs or it spoiling and he really wants something else? Maybe the blacksmith wants gold, yeah it’s everywhere, to inlay the handle of a sword he is making for the King? The farmer can’t get tools and his fields spoil and he can barely harvest enough for his family. Later the blacksmith is too weak from lack of nourishment to work and can’t make tools for the farmer. The problem is a lack of the coincidence of wants. Money was designed to eliminate the coincidence of wants by exchanging something of no value except for the ability to exchange it for something of value independent of individual preferences.
Pop Quiz: Can you cut a circle in half diagonally? If you answered yes please stop reading and take a nap, if you answered no let’s review. Bartering doesn’t work well as a means of commerce due to coincidence of wants, bartering also causes greater inflation than money, people have an almost omnipresent love for gold (thank god for Tiffany’s and Harry Winston’s, something has to hold the diamonds), pegging currency to gold or other items of intrinsic value waste the commodity and destroy value by condensing two items of value, money and the commodity into one. Now that we’re all caught up, where does the money come from? The most important thing we learned is that if money exists to facilitate trade it should match economic output; as the farmer grew more wheat he made more “money” that could be exchanged with others for goods and services. I had a professor in college that talked about how banks create money by charging interest. The basic idea is that if reserve requirements aren’t 100% a bank can loan out money and charge interest resulting in more money being returned to the bank. That isn’t quite creating money though the underlying economic activity creates money. Money used to be privately created through bank notes and traded at a discount to face value depending on the bank backing the note. Contemporarily sovereign governments create money often leaving the logistics of money supply to the central bank or the Federal Reserve Bank in the case of the U.S.
How do central banks regulate money supply? Using gold or another commodity to back currency is a good method but carries the unintended consequence of creating a global currency, which as the EU might tell you doesn’t always work so well, but at least it has value. Now that we’re off the Bretton Woods system the note in my pocket has “the full faith and credit of the government of the United States of America.” Do you know what that means? In truth it doesn’t mean that much but printed on the face of the note in my pocket is “THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE” and that is the real value of money.
[Sidebar: I’ve recently read an article about the prevalence of credit and the decline of hard currency to the extent that some establishments only accept credit cards. That same professor when discussing the value of money always used an example of a store only accepting blood and not money; but I always asserted that as the aforementioned quote tells us in the U.S. I can use those notes for all debts so they can’t be refused. I know someone, let’s call this person Puddles. Two important things to know about Puddles is that while you are walking to the parking garage in a hand tailored suit Puddles will remorselessly drive through a puddle splashing you, fair warning. The other thing to know is that Puddles likes to say “You can’t prove it, it’s your word against mine, I’m gonna’ sue you for defamation.” Be forewarned if you’re in the U.S. and don’t accept my notes I’m listening to Puddles and suing the $hit out of you.]
I don’t care what is behind money or if it is “the man behind the curtain” what I care about is that when I go to buy gas, food, or even gold that the person on the other end of the transaction will accept it. Our monetary system is basically predicated upon; I’ll do work in exchange for notes that I believe I’ll be give to others in exchange for goods and services. As long as I’m able to exchange my notes for goods and services I’m happy.
Now we’re getting to the topical nature of this rant; fiat money is good because it doesn’t hoard precious resources and artificially inflate their prices. Fiat money is also more flexible than asset backed money; by having asset backed currency there needs by definition to be the asset to back it which limits the supply of currency to the asset reserve this is bad because if the fundamental driver of the economy is production and currency only exists to facilitate trade then currency must be able to match economic output. Fiat money must be perfect then since it doesn’t have exorbitant production costs that mining resources does and it has the flexibility to match economic output so we’re all set right?
Governments are pretty good about printing or minting money but what about contracting the supply? The Fed conducts open market operations to control the supply of money by buying bonds to increase the supply and selling bonds to decrease the supply but eventually the bonds mature and more money is released into the economy with interest. I guess the treasury could sent out muggers to recover notes but while I’m not an attorney I’m pretty sure that’s illegal. You could hope that a fire engulfs a storage facility or that a ship caring vast sums sinks but the best possible outcome is that people sit on money and hoard it under their mattresses. This is the real problem with fiat money, particularly in a digital and credit driven society, is that we can’t even rely on a dollar falling down the sewer grate when buying a pretzel now so there is less accidental destruction resulting in a larger real supply. The best way to contract the money supply is probably to use fiscal or taxation policy to take in and remove the excess from circulation. I don’t believe in levying extra taxes so let’s find another way.
At the end of the day a lot of people think we could have avoided this recession by remaining on the gold standard but we couldn’t. Anyone who thinks asset backed currency is a good strategy is silly and doesn’t truly understand money’s function in society. While there are still supply issues to workout with fiat money it is the best system.
Here endeth my blathering, for now.
{ 3 comments… read them below or add one }
you hit the most important point that the real value of money comes from the government’s requirement that people accept it. that requirement gives it a solid foundation such that unless you believe the country will be no more or the currency insanely debased, you have no real reason not to use it.
that being said, i disagree with some other points.
“creating a global currency, which as the EU might tell you doesn’t always work so well, but at least it has value.”
this is true, however the difference is that they are all using the same currency. therefore what one does, affects all of them. i.e. a greek default. this weakens the euro because they all share that currency. one might argue that if they all used gold they are using the same currency but the difference is that gold is an asset and has some level of value, intrinsic or otherwise. if the countries comprising the EU were all using gold/silver/whatever as their asset backed base for their communal currency, a greek default doesn’t mean possible disaster for the entire EU. it’s communal, yet separate at the same time. and that is because it’s not some fictional paper that they create and assign value to.
i don’t dislike the idea of asset backed currencies. however, i agree there are some real issues that arise, which you have mentioned – supply and demand, inflated prices, cornering the market, etc.
the major problem i have with fiat, besides the fact that the federal reserve essentially creates money and NOT our own government (which is a whole other issue), is that it allows for total and complete abuse. this is exactly what we have seen with the massive expansion of credit and the money supply over the past 10+ years.
i would instead prefer a fiat system with TIGHT controls over the money supply. and our government should be in control of it, not a private entity comprised of banks. but the controls would have to be tight since people by nature are self serving and thus cannot be trusted with something like this. the government should not just be able to magically print a trillion dollars because they decided to underfund a program like social security or medicare. that’s an indirect tax on everyone because it now lowers the value of my money.
perhaps a system where the monetary base is fiat in nature and is structured so that the government maintains a money supply in accordance with the population. for example, $1,000,000 per US citizen. as long as we are still growing as a society, expansion of the money supply would occur. it would also occur in a predictable fashion and it would also solve the problem you mentioned of money needing to have the ability to match production of the economy. money, people, inflation, production – they would all go hand.
this would, in theory, also have an economy that experiences little to no inflation since there is always that $1,000,000 target per person. wages would essentially never increase because the same amount of money per person is constant. and you can’t have REAL, lasting inflation without wage increases. everything else would be a bump in the road and nothing permanent.
Turc,
You make some valid points and I generally agree with you. However, I must take issue with your idea of pegging money supply to population as this will artificially set supply and worker productivity levels. I agree that the current system is flawed but I think you are missing the point that money supply should be tied to real economic output not currency manipulation, inflation concerns, fixed assets, or population. If you think about the barter system most of the goods and services are non-durable; that is to say that they lose all or most of their value quickly after consumption. This serves as a reset to the “money supply” and that is what is needed in a properly administered fiat system; money supply can’t grow indefinitely without debasing the currency.
Thank you for your comment; it is discussions like this that are what the site is designed for; please continue.
Fiat currency is bullshit for several reasons: 1) Governments control the value of the currency instead of the people. It allows governments to indirectly tax citizens without their consent by way of printing money. 2) It allows governments to fund things like wars that may not otherwise be popular or affordable. 3) Interest rates should be determined by market factors NOT set by central in order to reduce unemployment or spur investment.
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