Wednesday, March 10, 2010

In which I present a case for commodity money for our friend cvj (and for whomever else that happens by)

This post was borne out of a discussion cvj and I had over at plurk, and although I like plurk, the 140-character limit doesnt allow me to do stuff like this.

The choice is between the status quo, in which the State issues money by fiat out of nothing, and a free monetary system in which the market determines what their medium of exchange is. For centuries, that market seems to have chosen gold as their universal medium of exchange until the State put an end to that and forcibly imposed fiat money, something the market hasnt chosen. But first,

a little history. How did gold get to be the erstwhile medium of exchange?

No one person decided it. Not one all-powerful monarch declared by royal edict that henceforth gold shall be the medium of exchange in all dealings throughout the realm. It was chosen by the market itself. It came about like this:

When people began trading for goods and services, at first they did so by direct exchange. Juan the fisherman wants butter, but all he has is fish. Pedro the dairy farmer has butter, so Juan goes to him and offers his fish in exchange for butter. If Pedro wants to eat fish today, he'll trade his butter for Juan's fish. This is barter or direct exchange. If you have a product A and you want product B, all you had to do was go find someone with product B and see if they want product A. Easy. (Let me digress a bit to disabuse you of the notion that if Juan trades two fish for a pound of butter, that means to Juan, the value of the two fish equals the value of a pound of butter, and since Pedro traded his butter for fish, Pedro also thinks the same. This isnt true. For Juan, the pound of butter is worth more than the fish, and to Pedro, the fish is worth more than the butter. If they were equal in value, why make the exchange at all? In this kind of free trade, both men are trading for things they value more. This is the subjective theory of value.)

Later, Juan wants a chair and so he goes to Jose the carpenter to see if he wants fish in exchange for a chair and so he prepares to negotiate how much fish Jose wants for the chair. But it turns out Jose doesnt want fish at all. What he wants is butter in exchange for the chair. What does Juan do? Does he go home chairless? No. He knows Pedro has butter and Pedro likes fish so Juan asks Jose how much butter he wants for the chair. He then goes to Pedro, trades his fish for butter, takes the butter to Jose, and goes home with the chair. This is indirect exchange.

After numerous transactions of this sort, everyone finds out that a lot of people like butter and almost everyone would accept butter as payment for whatever goods or services theyre offering. Butter then becomes a medium of exchange. Soon people begin storing butter in their larders not to eat it, but to use it for trade. It has turned into money. Butter is a convenient medium since 1) people accept it, and 2) it is easily divisible so one can easily cut it into the proper weight that another wants in exchange. But they have this nasty habit of melting or turning rancid in the summer, and no one wants rancid butter. Butter therefore isnt a good store of value. (Let me remind you that Im only using butter as an example. It could very well have been any other commodity like bat guano.)

Eventually, after numerous trials wherein different media of exchange were tried in the marketplace (salt, cowrie shells, copper, silver, etc.), the market settled on gold. Gold, according to the market, is perfect since 1) People accepted it for some reason, (maybe because it's so pretty -- who knows?); 2) It's divisible and malleable and can be formed into convenient shapes; 3) It's durable -- they dont corrode for instance; 4) It's relatively rare, that is, you can't just pick them off of the street or manufacture it, and the rarer something is, all things being equal, the more valuable it is in the market.

So for centuries gold was the medium of exchange and all was well until some royal frassum-wassum decided that it would be a good idea for him to have a monopoly on coining such that only 'government-issued' coins were accepted. And as is their wont, kings waged war on their neighbors mostly because of some property dispute* and gold being rare, they had this good idea to mix it with some other metal like copper, while stamping it with a number that fixes its value. So this coin is Five Florins or whatever no matter what its weight is or its gold content. And it all went downhill from there. Even if governments turned 'democratic' after the WWI, the government monopoly continued. First they gave us the gold standard wherein they issued paper redeemable in gold. Then they gave us the gold exchange standard wherein only governments were permitted to redeem their paper in gold, then finally to the full fiat currency, where the government forces you to accept their paper currency with nothing to back it up. Thus freed from their commodity tether, governments can print money at will, and with the electronic age, they didnt even have to do that; they can create new money with a few keystrokes thereby dooming us all to an endless cycle of booms and busts until, inevitably, the currency collapses. When private individuals do this, it's called fraud. When governments do this, it's called monetary policy.

Why a commodity-backed currency is better than fiat currency

We'll get to that in a bit, but first I'd like to acknowledge that cvj is making a good point when he says there really is no difference between commodity money and fiat money if both are issued by the State. I agree. Whether or not the State-issued money is backed by a commodity or not is irrelevant if the State continues to have a monopoly on its issuance. States, for whatever reason, but war being its most egregious reason, routinely inflated its currency even when they were nominally backed by gold. So having the State have a monopoly on the issuance of money, whether backed by a commodity or not, is practically the same thing. The solution therefore is to institute free banking. But even with commodity money being a monopoly of the state, it's still better than fiat money. Ive written on the effect inflationary government policies cause the business cycle here.

cvj in one of his plurk comments said "and if a person accepted fiat money, then same principle applies" meaning a commodity-backed currency is no different from fiat currency since people accept fiat currency. This is wrong. Let us ignore the fact that people are forced to accept fiat currency. (In fact rejecting government-issued fiat currency is a crime.)

An untethered fiat currency allows the government to increase the money supply at will. What's wrong with that? In fact, cvj, in one of his comments makes the surprising assertion: "An economy can grow only if the money supply expands." Gold is too rare, he implies, to allow for an expansion of the money supply. What is wrong with that is an increase of a supply of something lowers its value. I think cvj is coming from a Keynesian-Friedmanite mindset which seeks to steer the economy by monkeying around with the money supply. This view puts a premium on nominal value and ignores real value. (Mandated minimum wage, for example, does this. It increases nominal wages while reducing real wages due to the inevitable higher prices, as well as tending to increase the ranks of the unemployed.) Increasing the money supply means that the 100 pesos I have could buy less stuff today than it did before the government increased the supply of money. The money I have in the bank is now worth less than when I deposited it, and the money I put away for my retirement would be worth less when I finally decide to retire. With untethered fiat money, value is destroyed. It punishes savers and rewards borrowers thereby discouraging savings and enticing people to get things on credit. (On the other hand, if I put away one ounce of gold 10 years ago, it's still one ounce of gold now.)

Granted, even with a commodity-backed money, governments, evil as they are, can still inflate. In fact governments routinely did this especially when they waged their wars, but the commodity provided a check on the extent governments inflate. For example, in the government of Engkantasia, one ounce of gold is worth one Engkantasian dollar (ED), but it was at war with its neighbor Kosmekistan and so to finance the war it inflated its currency such that there were now twice the amount of EDs for every ounce of gold they had. They used the EDs to buy weapons and other war materiel. The holders of the EDs, many of them foreign governments, when they try to redeem the EDs for gold, will find out that there is not enough gold to cover their EDs and so will try to redeem their gold while it's still available; a sort of bank run. When news of Engkantasia's financial situation gets around, no one would be willing to trade with Engkantasia using EDs. Perhaps theyll demand to be paid in some other sound currency depleting Engkantasia's foreign reserves, or they could demand to be paid in gold bouillon. Either way, Engkantasia and the ED will be screwed. Knowing that, they will limit the extent to which they inflate if they want to continue to trade with other countries. (It must be noted that in the real world, most if not all countries have the US dollar as their reserve currency and the US dollar is backed by nothing tangible except the hard work of the Americans whose government routinely confiscates their earnings in the form of taxes and inflationary monetary policies and uses these confiscated earnings to bail out financial institutions that couldnt survive in the free market and to invade other countries.)

Freed from central banking or State monopoly, commodity money is even more powerful as a regulator. Free banking is when private banks can issue tradeable paper by themselves. (I believe Hong Kong did this once.) If for example Bank A has assets worth 1000 ounces of gold they can lend out, they can issue paper representing that 1000 ounces and anybody holding this paper can redeem it for gold. Dispersed in this way, if in case some rogue bank were to issue paper in excess of how much assets they have, the resulting malinvestments (boom-bust cycle) are local and will not cover the whole country or indeed the whole world. And other banks can check the extent to which Bank A has over-issued paper when they redeem Bank A paper deposited with them by their clients.

Financing with fiat money

cvj also has put forth an interesting premise: "Without finance, there won't be capitalism. Finance preceded capitalism." And by finance Im assuming he meant people willing to lend money to other people at interest. Let's not quibble over the details of whether or not capitalism would have happened if it werent for finance and assume it is true for the purposes of this blog post.

I have already discussed the dangers of fiat currency on the economy in the post linked above but to reiterate, government increasing the money supply lowers the interest rates artificially making people invest in things they wouldnt normally invest in if the interest rate were allowed to go to their true levels. And with inflation destroying the value of stored or saved money, people are less inclined to save. This is tragic because savings is the only legitimate source of investment.

A fundamental difference

The fundamental difference between my position and his I suspect is this: I tend to trust people's decisions on what they think is good for them, while cvj thinks that government (or any enlightened authority figure -- scientists, academics, whoever) knows better or at least is necessary in the cycle of people's decision-making. Whether Im right and he's wrong or vice versa is beside the point. Maybe people are idiots who'd sooner poke themselves in the eye if you hand them a butter knife so they need the government to hold their hand and tell them what to do. Or that the primary motivation of Homo economicus is to screw his neighbor out of all his wealth and so government is needed to protect man from his fellow man. But the fact is, government cannot be trusted to make economic decisions, not because theyre evil or because theyre stupid, but because they can't know everything. Information is dispersed throughout society. Millions of brains making individual decisions and value judgements, and the only thing coordinating these individual decisions is the market. And the market is all of us.

*Kings waged wars for real estate mostly, and they were limited wars. Wars waged by democratic societies tend to be bloodier and waged for such reasons as 'spreading democracy'.


R.O. said...

Argh. I'm afraid I have to read this in three installments, just so I could digest it better. Btw, where is CVJ? Why is he no longer blogging? Is Plurking more enjoyable? Isn't that just like Twittering?

Jego said...

He's still in Singapore with a new job, I think.

Plurk is just like Twitter except that plurk has a commenting option. That is, if you comment on a plurk, everybody on the other fella's plurk list can can see it. So plurk is more 'discussion friendly'.

網智 said...

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