Thursday, December 18, 2008

An argument for a commodity money

In a wonderful and informative email exchange I am having with an avowed Keynesian, we touched on the topic of the gold standard. He began his explanation on why he does not support a commodity money standard with:

I understand the attraction of commodity money in that it does provide a degree of predictability and stability in terms of inflation, and for those who see the current central banking structure as an inherently dangerous entity created on behalf of the federal government to control and confiscate wealth [Beth: That would be me] it offers a means to actually counter those activities. I don’t share those views.

Let’s start with the premise that any money system is a belief system, even one based on a supply of gold. Money only has the value that we assign it, the question is whether or not that value is based on our belief in the perpetual attractiveness and rarity of a precious metal or on the value of productivity and human capital.

The rest of his email follows quite logically from there, expressing concern that a gold standard would leave developing economies at a “decided disadvantage,” because they lack gold. Instead of gold, “these nations need money systems based on productivity and growth (fiat money) not on any particular commodity.”

I heartily agree that we all need money “based on productivity” but I heartily disagree that fiat money fits the bill.

Is money just whatever we choose to give value to? The experience of the past 37 years on a purely fiat money standard would seem to prove that paper is just as capable as gold in serving as a medium of exchange. But serving as a medium of exchange is only one of the essential functions of money, the other two are to serve as a store of value and as a standard of value.

So, what exactly is money? One way to get at the root of the issue is to ask: What are the facts of reality that give rise to the need for money?

When trade occurred on a very small, local level, direct barter was an adequate method of exchange. Increasing specialization and expanding division of labor led to the need for a "middle-man" commodity to serve as a common standard of value. People could then exchange their goods for this "middle commodity" and use it to trade for all other goods. This greatly enhanced the ease and flexibility of exchange. For the greatest utility, this "middle commodity" would have certain specific qualities.

In order to be confident that this "middle commodity" could be relied upon as a medium of exchange, it had to be valued by a sufficient number of other traders. As trade extended over greater distances, the commodity had to be portable and durable, of sufficient value (rarity) to serve for large transactions, and easily divisible to serve for small transactions. In dealing with strangers of unknown integrity, it was important for the exchange commodity to be difficult to counterfeit, of uniform quality and reliably pure.

This "middle commodity" is what we now call money. The commodity that best fit these objective requirements ended up being the precious metal gold. Before 1932, the U.S. primarily functioned on the gold coin standard. Subsequently, monetary policy evolved through various stages of decreasingly-redeemable paper notes until 1971 when Nixon officially defaulted on the gold standard, refusing to honor contractual agreements to pay our debts in gold. Since then, the value of our money has remained disconnected any commodity, and therefore, disconnected from the production of actual wealth. Instead, the volume and value of our currency is completely at the whim of politicians.

Much of the current debate over what government should do in response to recent economic events consists of how to direct those political whims. Money is no longer a measure and standard of wealth to use in trade but a political tool used to achieve political agenda. Should the Fed attempt to stimulate the economy through money creation or “allow” a market correction through money contraction? Should Congress attempt an economic boost with a stimulus package? If so, should the money go to private individuals, private businesses, or government projects? If to government projects, should the money support infrastructure, or prop up whichever struggling businesses politicians choose to support? Or should the government spend more to expand welfare payments? Should government attempt to create more consumer spending? Or, more investment spending? Or, should it create spending barriers so people and business will be more likely to build up reserves through saving and payment of debts?

The range of realistic and acceptable options for government action is partially defined by what is considered appropriate money. If fiat money is inappropriate, then all of the options involving the creation of more fiat money are disqualified. Easy or tight monetary policy, how to define the money supply (M1 or M2 or something else,) creation of money by "monetizing the debt" --all that is irrelevant if the whole idea of fiat money is fundamentally flawed.

Based on the primary functions of money, only a commodity money will maintain a stable and honest system.

Money is a medium of exchange.

Exchange of what? Goods and services. The results of the productive labor of one person for the results of the productive labor of another. Honest trade consists of the voluntary exchange of value for value. A commodity money keeps us bound to the fact that in order to obtain a value, you must offer an acceptable value in exchange. This is the essence of trade. Where do values come from? Productive labor. To exist, values must first be produced. It is possible to obtain values without offering an acceptable value in exchange. If done voluntarily, it is called charity. If done by force or fraud, it is called theft. Fiat money gives the appearance of exchanging value for value (production for production) but indistinguishably includes exchanges of nothing for something

Money is a store of value.

A commodity money is valued as a commodity itself. It both represents wealth and is wealth. A commodity money is wealth that is convenient and durable enough to last without a deterioration of quality or quantity and can therefore be stored for future use. Fiat money can be "stored for future use," but has no causal relationship to any real wealth. Fiat money only has value through government decree and enforcement. Commodity money is a store of value because it is a store of wealth - goods produced. Fiat money is not wealth, and therefore can not be a store of value. It does not represent any good produced, just laws passed.

Money is a standard of value.

Against this standard, we measure and express the value of all other goods and services. This comparison is truthful and useful only to the extent the standard is held constant. (Imagine the confusion and chaos if the length of the meter was subject to arbitrary change.) A commodity money is held constant through its relationship to an actual physical substance. Historically, the amount of new gold added each year has been dwarfed by the amount already in existence, and thus new gold has had minimal inflationary effect. There is no evidence that this ratio between new and existing gold stocks will change in the future. Additionally, once created, gold money essentially never goes out of existence, so a deflationary "contraction" can not occur.* In contrast, the value of fiat money is subject to arbitrary, political manipulation. The ability of governments to create and destroy money is essentially infinite. The value of money, as in all things, is subject to the law of supply and demand. As government creates (or withdraws) currency or reserves, the value of each unit will fall (or rise) thus destroying the "standard of value" function of money.

By allowing the government to create money without the prerequisite production of wealth that gives money its real value, fiat money enables one-sided transactions (theft, fraud, charity) to look like a fair exchange of values. The government attempts to create something from nothing, and then use its legal power to force us to accept that nothing in exchange for our productive efforts. Increasing the stock of fiat money does not create wealth. Instead, it expropriates the wealth created by others.

Historically, gold has been the most universal commodity money. In addition to meeting the requirements for a useful money (see above), gold is valued in and of itself. In a system of free money (as opposed to a system of legal tender) should gold no longer meet the requirements to serve as money (it becomes insufficiently rare or valuable as a commodity itself) a new commodity would gradually emerge as the preferred medium of exchange and measure of value. This evolution depends on traders being free to choose which commodity they prefer to accept in their exchanges, a freedom which is denied by legal tender laws.

As a culture and nation, we have come to understand the importance of freedom of choice in religious values, and our laws rigorously work to maintain the separation of Church and State. Production and trade are also expressions of value choices, and as such, deserve similar protections. One of the most fundamental of those protections is the legal support for an honest, stable money free of political manipulation. A money based on an objective standard with a physical existence independent of the desires of men: a commodity money, not a political money. A money based on voluntary exchange, not government fiat.
*This is true for a system of free banking and free currency which would result in 100% reserve banking--but that elaboration must wait for another day.
Image: 1957 Silver Certificate "one dollar in silver payable to the bearer on demand" - retrieved from my grandfather's piggy bank, along with silver coins.


Michael Neibel said...

Well done Beth. Your position makes sense.

Anonymous said...

Ayn Rand's "Egalitarianism and Inflation" really made this subject make sense to me.

Anonymous said...

Arguments for fiat or commodity money seem to both have merit. I fall in with Glenn, though. The point about money being what we all agree it is is important to me. The benefit of commodity money is the inhibition to printing money that doesn't exist (I think). I have a couple of questions at the moment.

What happens when gold productivity suddenly increases, such that the per capita gold supply increases? Don't we have inflation? Alternatively, what happens if the population increase outstrips gold production such that the per capita gold supply decreases. Don't we have deflation? Finally, does it really matter after we translate it into real wages, which if productivity goes up, buys more whether the money wage has gone up or down?

More important than what may be "right" or "wrong" regarding either monetary system, what would be the effect of a change. As we are now using fiat money, what would be the effect if we went to a gold (or something) standard, and the rest of the world stays on the free floating fiat money standard?

Anonymous said...

What did "Egalitarianism and Inflation" say?

Would I be correct in guessing that the idea is that the more we try to ensure that everyone has the same amount of money (or wealth) the more we will stoke inflation?

For those of us who are not familiar with the content of the texts that are central to your views a short statement would be helpful.

HaynesBE said...

URL for essay "Egalitarianism and Inflation" (Haven't read it yet.)

The questions about inflation, deflation and the stock of gold are good ones and I plan to address them as soon as I can get to it.

Anonymous said...

"Egalitarianism..." is much longer, but the gist of it is as I guessed.

Regarding a change back to the gold standard, Bernstein in "The Capitalist Manifesto" suggests that a unilateral imposition of a gold standard would not survive until capitalism is established by mankind (p 377). Maybe the gold standard is the right way to go; the obstacle of production certainly would at least hamper attempts to rapidly expand the money supply and would deter inflation. But if it is done unilaterally, I think it wouldn't effect any changes because the price of gold would still fluctuate due to foreign exchange. What was the motivation for going off the gold standard in the first place?

Anonymous said...

Re: "Money is a medium of exchange.

Exchange of what? Goods and services. The results of the productive labor of one person for the results of the productive labor of another. Honest trade consists of the voluntary exchange of value for value."

At my workplace, two dozen employees earn $15K each, while our employer made $3M last year,

What kind of exchange is that?

HaynesBE said...

RE: What was the motivation for going off the gold standard in the first place?

I am still working on a better understanding of this very issue. From what I can gather so far, it seems that the it has to do with the fact that you can not have your cake and eat it too.

By that I mean: you cannot stay on a gold standard and have an inflationary monetary policy without loosing all of your gold stock. This is true for private banks and bank notes as well as government-issued paper money. The gold stocks were progressively drained by those cashing in their paper claims to gold. In order to avoid bankruptcy, the US government had to decide between either abandoning the inflationary debasement of our money or abandoning the gold standard. It chose to jettison the latter.

If someone else has a different take on this, I’d love to hear it.

Anonymous said...

Anonymous, I'm still attempting to rationalize your situation. The main thought on this site (which I'm not totally convinced of) is that (1) you presumably work voluntarily, therefore (2) you accept the $15,000 and if you don't you can (3) find employment elsewhere, (4) improve your skills and go out on your own and compete with your current employer, or (5) improve your skills and move up in the company, or (6) improve your skills and take them to another employer. I have no problem with any of this, except that employers have an unfair advantage over unorganized labor and if it is used to abuse labor by demanding excessively long hours or unsafe conditions then there is a moral problem in my view. Many on this blog would simply refer you back to #3. I'm still thinking about this.

Beth, regarding choice of gold. Sounds good to me. Essentially, gold or fiat are equivalent if the fiat is not manipulated. This is interesting to me, because much of what I have seen on this blog assumes actions consistent with rational self-interest. Yet, we acknowledge here that even those among us who should have the utmost in discipline, as well as understanding of their actions, can't be relied upon to restrain themselves. that sort of suggests that the average person in the street may veer significantly from the rational to the irrational at any given time. And when he or she does, it may be in the context of a mass movement (e.g. stock market). This all adds up to a lack of long term vision in laissez-faire capitalism that would obviate the space program, long term defense projects, and long term climate monitoring or planning (we probably wouldn't have an IPCC whose findings we could bicker over), as none of these endeavors, or those like them, has near or long term profit potential. So, under laissez-faire, is it OK to tax for these projects, or does it say we should just forgo them until a private entity decides to take an interest?