An argument for fiat money

(by guest writer, Glenn McIntosh)

Thanks to Beth for inviting me to post here. I have a lot of respect for what she's trying to do with this blog, and to invite open dialog so that we can all have a better understanding of the issues we're discussing.

In the interests of full disclosure, I'm an information technology professional with a background in Knowledge Management and a particular interest in Corporate Information Compliance, an increasingly important topic for most businesses and governmental organizations in the post-ENRON word. My interests extend to corporate finance, since that subject is at the core of how we design information systems for compliance. I also have a personal interest in Development Economics for emerging economies.

Having said all of that, Beth invited me to post my thoughts on the Gold Standard. I think that I understand a little bit about the audience for Beth's blog and the attendant sensibilities here, so where I can cite and contrast those views, I will (respectfully, of course).

For the scope of this discussion, I won't cover the cases for and against private currencies. From what I've been able to determine, many advocates of the Gold Standard are not necessarily advocates of replacing government agency-issued currency with private currencies, they mainly want to see our federal currency based on a commodity money system.

The original comment I made to Beth that caught her attention (and perhaps her ire) was my comment that all monies are basically belief systems, even commodity money. I don't just mean "belief" in the sense that when you and I make some sort of exchange that we both believe that we are getting something of worth. I also mean to imply that we believe that the managing entity (in this case, a governmental body), has a commitment to an expected system of valuation for the currency. This is true whether or not you have a fiat or a commodity money system. If your government is a credible steward of the money supply, you don't need the Gold Standard; and if it isn't, it won't be able to stay on it long anyway.

I think that readers of this blog would also vigorously support the notion that regardless of what type of currency system we happen to use, vigilance in regards to holding our elected officials accountable for their management of it is an inherent responsibility of citizenship. Again, this is true whether we're talking about fiat money or commodity money.

For backers of the Gold Standard, an important argument is that it is a defense against the government inflating the currency. They view this as a means whereby the government can impose arbitrary valuation on the currency and confiscate wealth, for starters. While this can be a real advantage of commodity money, it is dependent upon the belief that government adheres to the desired valuation policy. See my preceding points about this.

In regards to the basis of our discussion, the advantages of fiat currency that I support would naturally be the ones that readers here would have difficulty with.

For starters, a Gold Standard backed currency cannot do what a well-run fiat currency will do, that is to tailor the country's money supply to the economy's demand for currency. Gold supplies are dependent upon how much of the stuff can actually be dug up out of the ground. If supplies can't be found to keep pace with output and productivity, either the currency supply either has to be inflated, rendering invalid the touted advantage of the Gold Standard, held static or at a lower supply level, which causes a deflationary cycle to occur.

For example, let's say that you have $10,000 today and you intend to buy a car in the next few months. As output and productivity increase over those months, the money supply is held constant or fails to keep pace. This means that the available money must be allocated in increasingly smaller wages and prices to meet the demand of growing output and a growing workforce. The $10,000 purchase you intended to make a few months back is now a $9,000 purchase. If you wait a few months more, it will probably be an $8,000 purchase. You have more incentive to hang onto your currency, because its value will increase over time, not just for this purchase but for others affected by deflation. This is not just because you will be able to buy goods at lower prices, but once your money is spent, any new money you receive will be worth less and you will have incentive to hang onto this too, in the face of further falling prices and wages. In this type of environment, consumption and output decline and become a self-reinforcing loop. The result is the dreaded "liquidity trap".

There will come a point at which equilibrium is attained again, but this may take years and incur great financial hardships on those receiving decreasing wages or holding any debt (because they are having to pay an increasingly greater percentage of their money to service this debt as time goes on). We experienced such cycles in the 1800's and during the early years of the Great Depression.

Deflationary cycles in recent history have tended to be long, painful, and exaggerated in the absence of fiat currency. Some very strong arguments have been made that the countries that largely escaped the Great Depression of the 1930's were those that quickly abandoned the Gold Standard, and moved to a fiat currency in order to escape deflation. For a more detailed reading, Ben Bernanke and Harold James, detailed this in a paper called "The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison" published in 1991, by the National Bureau of Economic Research (NBER).

The 13 nations that abandoned the gold standard in 1931 experienced positive economic growth from 1932 on. The three countries that stuck with the Gold Standard through 1936 (France, Netherlands, and Poland) saw a 6% drop in industrial production in 1935, while the rest of the world was experiencing solid growth.

This is fundamental supply and demand economics, but it serves to depict in a simple sense the danger in unrestrained deflationary cycles. That's why modern industrial nations these days strive to manage their economies to sustain a 1-2% rate of inflation with monetary policy supported by the manipulation of a supply of fiat currency. In cycles of modest inflation, wages are rising (as are prices, but increasing productivity and efficiency, as well as advances in technology, can actually cause prices to fall in relation to wages – think of LCD TV or computer prices, for instance), and consumption rises.

Frankly, inflation can get out of hand with a poorly-managed fiat currency, due to a too rapidly-increased money supply. But a commodity money system is not immune to this either. If the supply of the commodity is sharply increased due to someone discovering a vast, new deposit of it under their land – inflation, due to increased supply of the commodity occurs. Additionally, nations with commodity-back money systems can also find themselves with their currency subject to speculative attacks, causing the price of gold to rise due to increased demand from those wanting to hoard gold during times of economic uncertainty.

There are other reasons that I'm not favorably disposed to the Gold Standard having to do with developing economies and the hardship that it imposes on them in terms of human suffering if they don't happen to have enough of the desired commodity buried underground, or cannot acquire it through trade with nations with commodity money, due to a lack of other natural resources. These countries tend to suffer disproportionately in terms of economic development, because what they really need is vigorous microeconomic activity to develop their educational, manufacturing, healthcare, and governmental infrastructures. They can only do this with the adoption of a currency system that is backed by production and output.

In short, as Beth mentioned, reasonable people with reasoned positions can still have fundamental disagreements about these types of issues. And in a real sense, there is enough history and data available to support a number of arguments of both parties. In each case here, I believe that we can all agree that irresponsible management on the part of a governing entity will render any well thought-out fiscal policy ineffective.


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