Thursday, December 18, 2008

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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11 comments:

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Darin said...

I would like to comment on this debate against commodity money. First off, I must (without intending to offend the author) say that I am surprised I survived the preface to the point of the article. Is this you, anonymous?

Aside from that, I have three or so main points to contest here.

"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."

There were several other important factors that have been left out of this equation. To speak of the U.S., we must include the problems that Smoot-Hawley created - that is retaliation from foreign markets which crippled our ability to sell products. The other is the high taxes that were imposed on the American people (especially those who were the producers).

"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."

This effect (price drops as productivity increases) is the result of what Schumpeter labeled "creative destruction" in a capitalist economy, not necessarily because "healthy inflation" numbers. Inflation at any level decrease buying power, thus real prices actually rise as a result of too much (in overall quantity) money.

"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."

What about the very necessary increase in labor to extract this new gold find ( needed energy, as well). It would seem to me that this increase in demand for factors of production would equal most of the demand for increasing commodity money. Both demand and supply increase, simultaneously, on average.

"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."

This is a fair point, however, accurately debated I'm not sure. It seems that this point doesn't differ any from what "Director's Law" states about taxes actually steering money and opportunities away from the poor to the rich. Additionally, only governments deter trade so, if government created currency dictates government control and interference in the economy than how can we make the case that the opposite would be also be true?

I see the (in the preface) mention of Keynesian views, however, it appears to me that many of the author's ideas are monetarist in their development. I must admit, that I am not completely off of monetarist notions; however, empirical evidence leads me to believe (again given the fact that it requires government control of the economy) that it, too, results in failure.

economicsfreedommatters.blogspot.com

Beth said...

Darin: Glenn is not anonymous. anonymous is still anonymous.

Darin said...

One more point that I meant to include in my first post - -

When Nixon stated that “We are all Keynesians, now”, we should look at the implications and effects this had on us. The sole purpose of un-tying our currency to the gold standard at the Bretton Woods conference was to allow for, in part a floating currency base; however, the idea was the we could deficit spend without regard and or constraint.

Beth, I believe explained pretty well the value that must first exist for currency to serve as a unit of exchange. In fact, the primary purpose of currency is that is serves as a unit of exchange. Society is made better off having one, trustable unit of exchange - as this allows specialization and division of labor to expand thus allowing for standard of living to vastly increase. I believe that we can all agree on this.

However, as Mises pointed out, it (currency) must first be derived from something that is deemed valuable. Gold and silver, throughout the ages has been the most popular commodity money basically because of the inherent value and pureness that gold and silver contain. Aside from ancient rulers altering the consistency of their coins in order to create the first forms of inflation, gold and silver cannot be destroyed like fiat dollars can. Gold and silver can last forever; fiat dollars can be destroyed, animals die (when used in trade, for work and or feed) and have unpredictable life spans, salt dissipates.

Beth said...

Glenn,

Thanks so much for taking the time to compose your thoughts and the willingness to post them here knowing that the bulk of readers would not agree with your point of view.

To all:

I have spent sometime now thinking over Glenn's post. The next topic I think I need to explore and integrate further is that of "deflationary cycles." Periods of deflation are economically painful and disruptive to individual lives and to the progress of prosperity. The question remains, however, as to whether inflation is the solution or the cause and how to assess that relationship. This gets us into the matter of explaining the occurrence of the business or trade cycle--and here there is little agreement, even amongst free trade advocates. To help discussion, I have started a glossary (see side bar) so we can be sure we are using key terms in similar ways. In the next few days I plan to post definitions for inflation and deflation. Respectful comments, as always, are welcome.

z said...

One thing that does not make sense to me about deflationary cycles is the idea that only gold can be money under a gold standard. Glenn says that the economy grows but gold mining is not able to keep up with the expansion of the money supply which is needed. Why would the money supply be wedded to changes in rates of production in gold under a non-fiat system? I would think with modern advanced mining methods would make this less of a problem than it was 130 years ago or so. Since then we had the invention of crude oil and nuclear power and railroads, air-travel etc. I don't see any logistical or practical problems which could hamper the money supply these days.

Also, the word inflation suggests a bubble to me. Wouldn't there need to be a deflation at some point? Shouldn't the money supply keep pace with the growth of the economy, rather than growing faster than the economy, even at a steady 1% pace. Small inflation, then small deflation, like that? Why would it be good for the money supply ever to get bigger faster than the economy, even if at a slow pace?

Darin said...

Z, I believe you have made the inflationary point very well.

Since inflation occurs, and inflation is a hidden tax we must all bear, corrections in the money supply are surely to follow. Booms most often occur as a result of easy credit (an inflationary measure), therefore, as we experience today, we must in turn go through a necessary correction. Productivity and investment must catch up to monetary exuberance, and during this time corrections, including deflation, are necessary.

As many of the Austrians have made the case that the business cycle is the result of central banking, would we experience the money cycle (inflation and deflation) without monetary policy? Once banks begin to again adhere to fractional reserve banking, Fed rates of near 0% are going to be very destructive. The “fatal conceit” is that no one person will know exactly when to move the rates up before the damage is already been done.

Anyone care to guess which sector will experience the next boom as a result of the current Fed policy? I wish I knew! ($$$$)

economicsfreedommatters.blogspot.com

z said...

The money supply is just like the supply of anything else in an economy. Just like the food supply and the medicine supply and the energy supply. There is supposed to be a supply of it, which keeps pace with the demand for it. Am I wrong that inflation is the continuous over-supply of money?

Anonymous said...

No, Darin, ‘twas not I, Anonymous, who posted the post to which you refer. Your approach, however, makes pursuit of economic understanding secondary. If we understand economics perfectly, it will be to no avail if we continue to provoke one another with inept socialization or outright abrasiveness.

“I would like to comment on this debate against commodity money. First off, I must (without intending to offend the author) say that I am surprised I survived the preface to the point of the article. Is this you, anonymous?

Aside from that, I have three or so main points to contest here.”

You could have accomplished your purpose by saying:

“I would like to comment on this debate against commodity money. I have three or so main points to contest here.”

Inclusion of “First off, I must (without intending to offend the author) say that I am surprised I survived the preface to the point of the article. Is this you, anonymous,” is extraneous to your purpose. Further, it distracts from the argument you make by exposing your intent to insult the author, and in the end, you are out of line.

Have I ever posted anything similar in style or content to what was posted here? A modicum of astute analysis would lead you to the conclusion that I have not.

Try tightening up your prose and refraining from passive aggressive attacks on others, the identity of whom you know not.

-Anonymous

Darin said...

Anonymous, my point was not to insult the author but rather to opine that the preface to their blog was exhaustively long, and, to me, a bit distracting for their argument (it seemed to take a long time to get to the “meat and potatoes”, if you will). Anyway, I apologize to have made light of our previous encounters. However, please feel free to elaborate on the topic as opposed to bloviate about my character flaws. I will refrain from future, unnecessary opinions.

economicsfreedommatters.blogspot.com

z said...

I don't think the question should be "fiat vs. commodity". I think they are fundamentally different because one uses force and another doesn't. The problems that arise under commodity money are logistical problems, which are more easily solved as technlogy has increased. The problems under fiat are another kind altogether. This whole idea that some small group of people could be the "steward" of anything for the vast majority of us is insulting. Supply problems of a gold standard such as people finding vast reserves suddenly or simply running out, to the extent that they are problems, are combatted by diversification in metals and plain old reason. Inflation and deflation are natural parts of the economy, just like gravity and air-pressure are part of flying. They are best combatted by the profit-motive in reaction to surpluses and scarcity.