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February 28, 2007

It’s All About The Money

by Brad Warbiany

The other day, in the comments on Doug’s post about Ron Paul, Kevin and tarran got into it a bit over money. Specifically, they got into the nature of a gold standard, as to why a gold standard makes sense (or doesn’t).

tarran gave a pretty good synopsis of money, and got this response from Kevin:

Gold, like Federal Reserve Notes, or hell anything else for that matter, only has value in the eye of the beholder. We use paper money because we believe it is valueable because it is backed up the force of government. If you and I got together and started using printing our own currency or agreed on another medium of trade for doing business with each other, we would consider it valuable to us; however, if we went to the neighbor’s house to buy his car with our currency or a bunch of gold coins, he would laugh at us because gold or the homemade money is not as valuable to him as the Federal Reserve Notes.

One statement here is true. Gold is valuable because we give it value. After that, things get murky pretty quickly, so I felt it might take a full post to explain this. And to do so, we need to start at the beginning.

At the beginning, anything can be money. Money is an abstract term used to describe a fungible asset that is used between people to ease the process of exchanging goods or services. All that is required for something to be money is that it is used by people to settle their debts.

So what could be money? Well, it could be gold. Or it could be specially-printed paper. Or it could be rubber chickens. Or it could be cow feces. It really doesn’t matter what it is, for it to have value. The key to value is that it is agreed by both parties to a transaction that whatever is being used to barter has value.

Likewise, that value can come from many places. You can rely on a scarce quantity of a “precious” metal to as denoting a value. You can rely on the promises and force of government to give it its value. But where Kevin says that I couldn’t go to my neighbor and offer him gold coins or our currency in exchange for his vehicle, he is wrong. After all, it is nearly universally accepted that gold, as a metal, has a value on the market: i.e. it can be exchanged for other goods. If we could convince him of the value of our currency– for example, by certifying that it can be exchanged for US dollars, or for a fixed quantity of rubber chickens– he would accept it as currency.

So anything can be money. Everything can be money. But that doesn’t make all money equal. Some money is better than others.

For example, let’s say we decided to back our currency with diamonds. Diamonds are expensive and relatively scarce, right? So why wouldn’t they make just as good of a backing for currency as gold, or other metals? Well, it’s simple. Diamonds— unlike gold— are not uniformly valued by weight, they’re valued based upon the quality of each particular stone. This if I say that my 5,000 dollar note can be redeemed for a 1 carat diamond, that doesn’t mean anything to a holder of that note, because a 1 carat diamond can have a widely variable worth.

What lesson, then, can we draw from this? Money, to be a good type of money, must have relatively predictable value. Note that I didn’t say “fixed” value, by the way. Even gold doesn’t have a fixed value, because they’re still mining for it all over the world, and producing more of it as we speak.

No, for a money to be good, we need for it to have predictable value. Gold works well for this, of course, because it’s relatively scarce and difficult to pull out of the ground, so the quantity of it doesn’t change regularly. When refined, it’s of consistent quality, and thus if I back a note by 1/20 ounce of pure gold, it’s value is predictable for anyone who takes that note. Of course, if we, as a world, suddenly decided that gold was worthless (or, as tarran points out, find the secret of alchemy), it would cease to be a good money. But unless we have a better alternative, that’s incredibly unlikely to happen. So backing our currency with gold helps us to retain the predictability of its value.

But currency doesn’t have to be backed to be stable and predictable. For example, if you have a country with very low (1-2%) inflation of their fiat paper currency, it’s value is predictable and there is really no danger in the currency not being backed. Heck, as long as the currency value tracks that of the size of the economy, purchasing power will hold firm. But there’s an implicit assumption here: the government must be trustworthy to retain the value of the currency. When have you ever known government to be trustworthy?

America’s currency has lost 96% of it’s purchasing power since 1913, when the Federal Reserve was created. It’s largely thought that the government’s decision last year to stop reporting the M3 was a sign that they intend to open the floodgates and start printing money like we’ve never seen in this country. And I don’t really need to explain why that’s a bad thing, but I’ll give it a shot.

When we look, as libertarians, at the tax structure, we talk about how the incredible complexity and high tax rates for companies to waste money worrying about how to manage their taxes, rather than how to grow their business. When we look, as libertarians, at the size of government, we talk about how government directing huge federal contracts and creating onerous regulations cause companies to spend time and money trying to meet the requirements of those federal contracts or lobbying to have regulations that favor their own business written into the CFR, at the expense of their own growth.

So what happens when our government inflates our currency at unpredictable and high levels? Well, it forces companies, investors, and individuals to focus on how to beat inflation rather than how to produce more goods and services. They start investing in gold rather than in biomed and nanotechnology. They start putting their money into foreign-denominated markets and assets as a hedge against the falling dollar. And if inflation gets bad enough, we’ll see a point at which other governments no longer use the dollar as their reserve currency, and we’ll finally have to start paying for the cost of our own government. None of us want to do that. Look around at the countries facing high inflation. They’re consistently the worst economic performers. This isn’t an accident, and we need to control inflation to keep it from happening here.

So what does that mean for the gold standard? Nothing really— we don’t necessarily need to be on a gold standard. But being on some sort of standard would force our government to stop inflating the currency and causing problems for us down the road. Of course, if we could trust our government to retain the value of our fiat currency, we wouldn’t have a problem either, but that’s highly unlikely these days, and the government here is getting more and more untrustworthy as it grows.


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5 Comments

  1. Way to go Brad, Amen.

    Comment by T F Stern — February 28, 2007 @ 11:15 pm
  2. good read. While gold backing isn’t perfect it does restrain the government. There is also a reason the Swiss franc has historically been the most stable currency, it was backed 40% by gold until recently.

    Comment by Michael — March 1, 2007 @ 8:54 am
  3. Well written!

    All this is what makes inflation the worst form of legal plunder by government. Taxation, at least, is abrupt and it’s generally noticable when they take money from you.

    Inflation, on the other hand, is slow and insidious as the government knowingly and willfully decreases the value of what you’ve earned.

    Comment by trav.is — March 1, 2007 @ 6:26 pm
  4. Well said, Brad!

    I have a few points I’d like to contribute to the discussion.

    One advantage of hard money is that the commodity underlying it has value as a consumption good. This acts as a buffer. When thee is a lot of demand for gold, gold consumption is reduced, and “consumed” gold gets converted to a form used for money (people selling old jewelry to be melted down into bullion). Conversely, if some guy finds a gold mountain, and the price of gold in terms of other goods falls, consumption will naturally rise, again mitigating the price fall.

    My next point is about fiat currencies. I disagree with Ron Paul that should the Federal Govt establish a gold standard again, that we would have moved away from a fiat money; a fiat money is one that is imposed, and whether or not we are on a gold or a paper standard is irrelevant, some one, somewhere is commanding that people use the standard, and backing it by some degree of force.

    The problem I have with fiat currencies are that they are not being established on a free market. A free market money is one that is selected, over time, by market participants as the primary medium of indirect exchange. Because the process is voluntary, and arises out of the decisions of numerous actors, it results in a money that is widely popular and thus more likely to be in demand in the future.

    If I were named supreme dictator for life of the Earth, and decreed that we would hence-forth be on a moon-rock standard, odds are that if I should die, or be deposed, or just change my mind, people’s reserves of moon rocks could suddenly become worthless. This is far less likely with a free-market money. So to me, the U.S> returning to the gold standard, while a step in the right direction is not sufficient. We must end this notion of governments dictating what is money and what isn’t.

    OK with that out of the way, I have a devil’s advocate type contrarian postulate (meaning I don’t agree with this, but am throwing it out there for people to jaw over).

    There is one advantage to financing a government through inflation rather than taxation; rather than having an expensive and intrusive enforcement apparatus to collect the taxes, you have a relatively inexpensive printing press. If the government can resist the temptation to try to fight inflation with price controls and the like (Ha! Ha!), then people will be allowed to structure their affairs however they want. Of course, this is more or less what happened to the Continental and it got us the U.S. Constitution, which I believe was the first step in a long road headed in the wrong direction. :)

    Comment by tarran — March 1, 2007 @ 9:15 pm
  5. There you go with your doctrinaire an-cap positions again… ;-)

    But we’re in agreement. A gold standard is quite preferable to what we have now. And free-market created money, in my opinion, is preferable even to a gold standard.

    Comment by Brad Warbiany — March 2, 2007 @ 11:07 am

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