The value of Money

This article was originally posted on pompeunomics.com

The Value of Money

Once up on a time, there was a society of people creating and exchanging goods. As this society of people increased in number and wealth, it became increasingly difficult to exchange one good for another, the process known as barter. In an effort to facilitate trade we created money.

Money is a commodity which we use to obtain goods and services. This means that money is a measure of value, since we use it to put a price on things. Therefore, getting money “right” is a central issue of economics, since money is the most traded good in the world.

As I said before money is used as a measure of value. This means that money should have certain characteristics to allow it to perform this function properly. For example, money has to be durable, it wouldn’t be very convenient if your savings could disintegrate in a bank vault. Also, money has to be stable in value. If we are using money to value other goods, the good in question should not change value itself, it would be like trying to measure something with a ruler that keeps changing its unit of measure. Overall, money has to be a good store of value.

Historically, money has taken many forms, the Romans used salt, for example, but by far the  most common form of money which arose from the market is gold. Precious metals have been used by societies dispersed across the whole of the globe. Is this a coincidence? You would have to be rather naïve to think so.

The fact is that nothing serves the purpose of money better than gold. Gold, and other precious metals, are durable, easy to smelt into coins, and most importantly they are stable in value.

goldstandard1

There are many reasons why gold is stable in value. The first thing we have to establish, however, is that it has value. Don’t ask me why, but people value gold. Yes it’s true that gold is just a shiny yellow metal, and doesn’t have any “practical” applications, but it does have value. And in fact, we know the value of gold won’t change, precisely because it can’t be used for much and it’s unlikely that new uses will be discovered. Furthermore, evidence of this is the fact that 95% of the gold in the world today is in reserve, simply sitting waiting to be used, so gold is not sensitive to changes in demand or supply, therefore, the price doesn’t change.

So now you know why people choose gold, why it arose from the free-market as the unit of value against which all other things are measured.

 

Now, let’s have a look at a brief history of money in the U.S. to further illustrate this point.

goldstandard

The graph above, shows to value of the U.S. dollar, first known as “thalers” and originating from Spain

As we can see, the value of the dollar remained stable for around 400 years with the exception of war-time periods. This is a direct result of the U.S. using a gold standard system. In 1971, however, the U.S. abandoned the gold standard and through the Bretton Woods pact, which tied all other currencies to the dollar, so did the rest of the world. Since then, we have lived in a world of floating exchange rates where the value of currencies is changing every second in the Forex market. But is this desirable? Didn’t we just say that money should be stable? Indeed we did, and indeed it should be. So what is the best way to guarantee that money has a stable value? Using a gold standard system.

The gold standard.

The gold standard is probably the most misunderstood subject in economics today, yet its understanding is of vital importance.

The first thing to know is that there is not such a thing as the gold standard, but rather, different types of gold standard systems.

The first and most simple form of a gold standard is simply using gold coins. Of course gold coins aren’t always practical. They can be heavy if you carry a lot of them. To make things easier, a new form of gold standard appeared which combined the use of paper notes with the reliability of gold. This kind of system was used in the U.S. from around 1800 during the free-banking era. Basically, each bank could issue their own notes, though they were all called dollars. Why would people accept these pieces of paper? Because they could be cashed in at the bank for gold. People could actually go to the bank, hand in their paper and get gold. In a way, they were still using gold as money.

Later on, the U.S. would adopt a centralized system of currency issuing, much as the one in place in the United Kingdom. This system can work too, as long as the government maintains its link to gold, something which historically has been more of a challenge for some countries.

 

There may be different ways of operating a gold standard, but the fundamental idea is always the same. The value of the currency has to be kept stable with relation to gold, which as we discussed before, is also stable. How does this work? Basically, you just have to adjust the supply of money to keep the value stable. Picture a supply and demand curve intersecting at a given price. If demand changes and the price moves, simply adjust the supply to return to the equilibrium price. It’s not that different from a currency board. A lot of small countries, for example, fix their currencies to the dollar, so that the exchange rate between the dollar and the home currency doesn’t change. Now simply change dollar for gold and you have a gold standard.

The truth is that a gold standard is simple to understand and simple to run. I find it surprising that mainstream economics is plagued with fallacies such as:

Gold standard is deflationary/inflationary: Quite the opposite. Inflation occurs because of a change in the value of the currency. If the currency is worth half of what it was before prices will have to double. A gold standard system prevents changes in the value of money and therefore prevents both deflation and inflation.

There’s not enough gold in the world to run a gold standard:  This is simply wrong. First of all, the United Kingdom ran the world reserve currency during the 20th century with gold reserves equal to 1.2% of the aboveground gold in the world. Secondly, you don’t even need any gold to have a gold standard! I personally would prefer a system where you could go and get your gold at the bank, but the truth is that this isn’t even necessary to have a stable currency. Like I said before, the important thing is that the supply of the currency be adjusted to maintain a given price in relation to gold, no gold is actually necessary. An example of this is Germany in 1927. Their episode of hyperinflation was ended by eliminating the old currency and issuing a new one, the Rentenmark. To the surprise of many Germans, the currency held its value and did not suffer from inflation. Why? Because the Rentenmark followed the rules of the gold standard to maintain its value stable, but Germany didn’t in fact have any gold.

Supply of money will grow at the rate of gold mining(around 2% annually): This fallacy is used both by critiques and advocates of the gold standard. Sadly, neither is right. Gold mining has nothing to do with the amount of money issued by the currency managers. The supply of money is adjusted to match the price of gold. If the currency is falling in value, the supply is reduced, if the currency is above its gold price, you increase the supply of money. The amount of money, therefore, is a residual operation, and the amount is unknown. In the U.S. for example from 1850 to 1950 the supply of money increased by 44x. This is much more than the amount of gold mined in that time and is a result of the great levels of growth that the country experienced.

 

The gold standard is a barbarous relic: I believe it was Keynes who coined this phrase. But he couldn’t have been more wrong. The gold standard is the best monetary system man has ever devised. The problem Keynes had with the Gold standard is that it prevented governments from applying his Keynesian quick fix remedies, such as interest rate manipulations. Many people forget, also, that a gold standard system was used as recently as 1971, and talk as if returning to a gold standard, would be like returning to the dark ages.

 

In conclusion, a gold standard system ensures that currencies have the properties to act well as money, because gold is a good form of money. On the other hand, bits of paper issued by your government are not going to be as good as gold. The main problem we face today, is that the supply of money has been politicized. Central Banks nowadays control the supply of money to steer interest rates and try to “boost” the economy (political reasons). This is wrong on many levels.

First of all, the efforts of Central Banks have little if no effect on the real economy. Interest rate manipulation like any form of price fixing will inevitably misallocate resources and is described by some economic commentators as “pushing on a string”.

Secondly, the pursuit of these ideas, to try and boost the economy by jiggling the currency, are preventing the currency from doing what it really needs, to provide a stable measure of value. It might strike you as a surprise, but the dollar has depreciated over 400% since 1971. In other words, in 1971 an ounce of gold was worth 35$. Now an ounce of gold sells for around 1300$. In effect, the poor users of the dollar have been robbed by the currency issuers. This wealth is inconspicuously stolen from us and given to the political elite and financial institutions. For every time that a new dollar is created to lower interest rates, facilitating the business of banks, the dollars you have lose part of their value.

This perversion of our monetary system is by far the biggest obstacle that our economy faces today. To return to a world of sound money, is just about the best thing we could do to boost growth around the globe.

As in many other areas, we must eliminate political influence from our monetary system and return to the system that originated from the market. This won’t be easy, and the first step is to expand the knowledge on the subject and dispel the myths surrounding the gold standard. I hope that today I have achieved that, at least to some degree.

 

James Foord, editor at Pompeunomics and author of 21stcenturyeconomics.wordpress.com

 

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