It allows accurate, impartial financial planning and makes the economy more efficient than other arrangements
The recent discussions about the Bitcoin and the gold standard have made it clear that the opposition to the fiat money is rooted in many parts of the TRF readership – I would even say that this question divides our community across the usual ideological lines.
Some Czech crown banknotes
Many of my remarks in these exchanges were enumerating the reasons why the gold or the Bitcoins couldn't be a viable replacement of fiat currencies we are using today. But now I think that it may be much more logical to try to present all my points positively – because the essential message I want to convey is positive, after all.
Net neutrality, off-topic: 60 companies including IBM, Intel, Cisco, D-Link, Qualcomm, and Panasonic NA sent a letter to the FCC opposing net neutrality. With this group, do you still misunderstand why I classify the champions of this ideology as anti-capitalist mujahideens?So why does the society need any money? Why the fiat currencies are better than other setups? What makes a fiat currency system better than others? And why are some of the most widespread criticisms of the whole concept of fiat money unjustified and immaterial?
Tens of thousands of years ago, people would live like animals, eating roots or hunting some other animals and instinctively sharing their food and other vital things in their families and tribes. Certain patterns of behavior were beneficial. The tribes with the beneficial modes of behavior were more likely to survive. And you know all these things: to a certain extent, the people could have been viewed as just another animal species and the natural selection and Darwin's evolution (or its questionable generalization to "memes") applied.
But I don't really want to get too far to the past. We want to talk about economics which only begins when the people's wealth and well-being began to be treated somewhat quantitatively.
At some moment, people began to trade. Barter. One person was growing plants, another person was breeding some animals. They needed to eat regularly but the results of their work was less regular. Harvest only occurs once in a year, and so on.
Instead of constantly fighting and killing others, people learned to "peacefully (and somewhat fairly) collaborate". They could exchange crops for a goat or something else. Perhaps, when they became trustworthy, they could promise to pay the crop next year, and to borrow some capital. Interest has actually been known for 5,000 years (the Islamic view that any interest is "usury" is an isolated downturn) although people wouldn't always appreciate some of its mathematical properties.
These transactions have to be done rather frequently and the people wanted some system and at least some accuracy. They began to accumulate scarce enough things. Almost everyone would talk about gold and silver. Well, I choose to pick another example, marten pelts. They were used to pay in the Middle Ages on the Yugoslav territory – which is why the current Croatian currency is called "kuna", a marten.
You may accumulate X marten skins which allows you to spend them later. It's common sense and I don't want to spend too much time with that: when it came to the simplest applications, marten skins really worked much like the modern-era kunas (or dollars).
Of course, marten skins have some practical disadvantages. They stink and disintegrate, have non-uniform sizes and some other defects. They may occupy too much space. And so on. Precious metals are obviously better than marten skins for those practical reasons.
But both martin pelts and precious metals – and any other commodity money or currency linked to anything specific – have one disadvantage that is more conceptual. Some people own too much of this stuff – or they are able to mine it or produce it – and this fact gives these special people extraordinary power over the whole economy if the economy decides to use this stuff as "reserves" and the tool for all payments.
Critics of fiat money often voice this very criticism against the central banks or governments – they may print as many banknotes as they wish, and that's a big problem, we are told. I will return to this criticism in the case of the fiat money later. But the point I want to stress now is that if we use something more specific, there is someone who has the potential to "change the rules of the game" because he has much more stuff used as the currency than others, or he is able to produce it.
If someone has a farm with martens, he can cripple the whole economy. By expanding his farm by an order of magnitude, he may buy everything in the economy and de facto enslave everyone if the people keep the prices of their product fixed (if expressed in marten skins). Even if they adjust their prices, there are some commitments (debt...) that have already been agreed to involve Y marten skins – and the useful value of 1 marten skin or Y marten skins may be affected by the marten farming corporation.
If crude oil were used as the currency, the people or nations producing oil would have a similar power. But the same comment applies to gold. If you want to spread gold all over the economy, e.g. by minting golden coins, there must be someone who has lots of this gold to start with. But if he has lots of gold, it's either because he's able to produce it; or because he has big reserves, perhaps reserves he hasn't shown to others. In both cases, this allows him to flood the market with the money – in the very same way as the central bank that may print the banknotes. He has completely analogous powers as the central bank or what some people call the government. For practical purposes, he is and always has been the government.
(I am absolutely convinced that the actual power of the Bitcoin Foundation – plus a few exchanges and other companies involved in the Bitcoin fad – over a hypothetical Bitcoin-denominated economy would be vastly greater than the actual power of any real-world central bank over a fiat-currency-based economy. What they can do with the value of the Bitcoin if they want is amazing. They would be a government whose control over others would dwarf totalitarian governments. That would be not only "evil"; it would make it impossible to plan anything in your financial future, too. Thankfully, no actual shops have prices denominated in Bitcoins. The prices are being constantly adjusted according to the Bitcoin-USD exchange rate so they only use Bitcoins as a form of dollar-denominated payments.)
The broader point is that whatever "particular thing or commodity" you choose to be your currency, there will be some special people who have a much greater control over this "particular thing or commodity" and they will enjoy a huge advantage and extra power. And that's wrong. For example, it's wrong if the marten farmers control the whole economy. Why exactly the marten farmers? They can't do anything else than encourage martens to... have sex with each other, and feed them. And they stink. The marten-based economy is axiomatically and eternally placing these people at the top which prevents the society from developing because much of the important progress that may be made is related to other things than methods to breed martens.
The situation of gold or silver is completely analogous. Someone who is mining gold or who has accumulated huge reserves shouldn't have this nearly absolute power, either. Such a privileged status of some people distorts the economy because it concentrates much more power and investments into one industry (marten farming, gold mining, minting) relatively to the others. The others suffer from underinvestment and the whole economy suffers as a result.
Moreover, whenever there is a transaction, the transaction is asymmetric. One side is closer to the "people who own the currency" than the other side. So the other side feels oppressed.
A related problem is the volatility. Every particular enough commodity or product – like marten pelts – suffers from price fluctuations. There are too many martens on one year relatively to the previous year. Lots of new gold may be suddenly found somewhere, and so on. Because of these oscillations, people can't really plan too accurately. If I have 7 kilograms of gold, is it enough to feed me and my family for the next 30 years? It looks like it is enough now. But will it be enough in 10 years? The gold price has the potential to double or halve within two years or less. So there are no guarantees.
(This volatility is a huge problem especially if you want to borrow. You borrow 10 Bitcoins for 10 years at some moderate interest rate that I will neglect – will it be about $3,500 like it is today, or will you have to repay $35,000 instead? Clearly, no medium-term and long-term loans are realistically possible with a currency whose value is this volatile.)
This volatility is an extremely serious problem because this largely predictable value is the very point of the money. It's the point why we are saving them. We know that we will approximately need X money during the next month or next year or next 10 years. We can calculate and give a longer perspective to our lives, avoid day-to-day existential problems, and design big projects that require months, years, or decades to be completed.
To a certain extent, this uncertainty is inevitable. The relative price between two objects (the ratio of their prices) is inevitably changing with time. The gold-to-silver or gold-to-oil price ratio is changing because of very good reasons. The supply and demand for different commodities or products aren't evolving in sync. They have almost nothing to do with each other even though there are lots of positive and negative correlations everywhere.
But there is a solution. If you average many things, the relative fluctuations of the average become smaller. And that's the main ingenious realizations behind the fiat money. The fiat money is being exchanged for anything so "one dollar" effectively contains some small amount of gold in it, a fraction of a marten pelt, a tiny amount of Coke, a fraction of a car made by Ford, some droplets of oil from fracking, a broken piece from an iPhone, and many other things. It's a democratic mixture of almost all the things that are being bought and sold in the economy. A multiple of a basket of products that is used to evaluate the inflation.
So no particular sector of the industry has "special powers" over the economy. The total amount of money you have still matters – it's the point of the money – but the money is sector-blind. It is equally hard to produce it by breeding martens or mining gold or inventing iPhones or counterfeiting iPhones or doing other things that people do. This mixture is much more "fair" than any currency closely linked to a particular human activity or occupation. And this neutrality is good because it allows a balanced development of all sectors of the economy.
The stability of the prices always arises when a big enough economy (or a chunk of the economy) is writing lots of price stickers or making commitments denominated in the currency. This gives the system the inertia that leads to stable (or predictably changing) prices of the baskets. I always repeat and the critics of the fiat money never seem to get this essential point: printing of the money doesn't immediately reduce their value. Money only loses value when the supply increases faster than the demand – if you throw them from the helicopters (or donate them to government employees through deficit spending, which is almost the same thing, except that the productive people in the commercial sector are selectively screwed) or offer them through cheap loans (at a lower-than-market interest rate). But trillions of dollars printed and stored in a basement don't change a damn thing about the supply and demand, so they don't change the value of the money. Only if someone starts to offer them at an unnaturally low (below-market) interest rate (something that a commercial, for-profit bank not able to print the money would never do because it would lead to lower profits or losses), one may reduce the value of the currency unit! Printing doesn't change (almost) anything as long as the central bank (approximately) respects the interest rates etc. determined by the free market.
The first known fiat money were used in the 11th century China. The Chinese were trained to treat the paper money as seriously as others were treating gold or silver. In the 13th century, our approximate compatriot Marco Polo was clearly surprised by that observation:
All these pieces of paper are, issued with as much solemnity and authority as if they were of pure gold or silver... and indeed everybody takes them readily, for wheresoever a person may go throughout the Great Kaan's dominions he shall find these pieces of paper current, and shall be able to transact all sales and purchases of goods by means of them just as well as if they were coins of pure gold.It had to be counterintuitive for him. How can it work? The papers don't have any value so how can everyone think that they're as valuable as golden coins? But they clearly are! A nation needs some degree of civilization progress to even start to experiment with abstract policies such as the fiat money. But when they're introduced, they work very well.
People are simply told: "trust the system". When you make a product and want to sell it, don't be afraid to sell it for a banknote because someone else will accept it later. You will be able to spend the banknote, too. And we know that in principle, it works. Most people store their excess wealth in the currency – it's the main thing they possess to buy things in the future. And the money is also the main thing that people accept as compensation for their products and services now – because it's the object that gives them the ability to buy in the future with the most predictable future value. So no one really wants the system to break completely.
The early Chinese system would eventually suffer from inflation, much like many other systems, even in the recent era. But with good enough laws, this trap may be avoided, of course. Inflation targeting, nominal GDP targeting, or policies that may be believed to be sufficiently close to these simple rules really guarantee some value of the currency – relatively to the basket of products (and/or services). These targeting rules have to be imposed and respected and you may have some doubts about this expectation. But you can't really quite believe anybody – and the collective interest of the whole nation has quite some inertia so it may still be more trustworthy than any particular person or a smaller group of people.
The point is that inflation may be tamed and the value of the currency relatively to something that most people or average people care about may be guaranteed for the future, and that's exactly the main virtue that makes one unit of wealth better than other, more volatile units!
Even if a currency suffers from a constant (predictable) inflation rate, like 10% a year – if its value gets divided by 1.1 every year – it doesn't mean that something will be seriously wrong in the economy. It just means that sellers must rewrite price stickers rather often and when they have cash, they need to put it in the bank not to lose the money. But the interest rates (at least the long-term ones) are determined by the supply and demand – the balance between borrowers and lenders – and the real interest rate that you get (nominal interest rates minus the inflation rate) will be the same regardless of the inflation rate.
The free markets are able to adapt to (almost) any conditions, and predictably time-dependent currency units are among the simplest ones that the invisible hand of the free markets may master. There is nothing wrong about the economy with a nonzero inflation rate – it works the same.
An inflation rate, as long as it is constant enough and predictable, only changes the units people use to measure wealth. The change of the unit is time-dependent but that doesn't matter. If you have the price \(P_i(t)\) of anything (\(i\)) at time \(t\) in a non-inflating currency, and if you have a corresponding world with the inflation rate \(I\) (times 100% per year) where the prices are \(P_i^I(t)\), the map between the two situations is simply\[
P^I_i(t) = P_i(t) \exp(It)
\] where \(t\) is in years. It's just a change of variables. The behavior and happiness of all the people in these two worlds will be totally identical. The inflation rate \(I\) may be fluctuating by itself and it can create some extra problems for this isomorphism. For example, if \(I\) is large, then one tends to expect that the fluctuations of \(I\) will be somewhat larger, too. But it is not really guaranteed. If it is so, this problem is related to another problem – that if the fluctuated \(I\) sufficiently drops and the interest rates determined by the market would be negative, people or banks stop lending (at the corresponding time scale).
But if you avoid these traps – if the interest rates are never negative and if \(I\) is small enough, it doesn't really matter at all what \(I\) is. It doesn't matter at all whether the money is losing the value at a 2% or 3% rate in a year because this difference will be compensated by the difference between the interest rates that are ultimately determined by the free markets!
The people obsessed with the gold or Bitcoin standards find it very important that the total amount of gold or the number of Bitcoins in circulation is fixed or at least predictable – that the total number can't really be manipulated by someone. So they are imagining that their "1 kilogram of gold" or "50 Bitcoins" are "completely constant". But this feeling of "constancy" only shows that these people haven't understood economics at all. What matters in economics is the value – relatively to the products and services that people ultimately want to buy for their money and savings. And the value of 1 kilogram of gold has dropped by nearly 40% since 2011 (much like it quadrupled in a previous decade). From the economic viewpoint, there is nothing constant about "1 kilogram of gold" or "50 Bitcoins" at all!
In a gold standard economy, the government can arguably not "print" a doubled amount of gold – the amount of gold is pretty much constant – but it may manipulate the actual price of gold (relatively to everything else that people care about, like food or real estate), and it's the thing that matters! It can manipulate the gold price simply because it has huge gold reserves by itself and by hording them or spreading them, it may affect the inflation rate just like the central bank. And if the gold standard economy's government has no significant gold reserves, it's also a bad thing because the "bad interventions" described in the previous sentence are often totally needed to save the whole system.
If a person understanding the basics of modern economics deals with a capital in the money, he knows that the numerical value of the money will change in time. It should better beat the inflation, or at least most of it. But if you have $1 million today, you know that in 2040 if you are around, you should be talking about $1.5 million from this amount. The numbers should be different. The dollar in 2014 and the dollar in 2040 are different objects. But there are good reasons to expect that what you will be able to afford in 2040 for the money that will arise from the $1 million investment will be "similar" to what you can afford for $1 million today – plus minus some gains or losses that are largely predictable.
If you have 1 kilogram of gold, it may look as the "same" 1 kilogram of gold that will be left in 2040. It's some bunch atoms that don't oxidize. But if the gold is used as your wealth, you want to know whether it will be enough for that year (or 10 years) that it seems to cover today. And you just can't know that because there are no mechanisms today that would link the price of gold with the price of a basket of products. The inflation rate expressed in gold price isn't being targeted so gold is unusable for planning to the future, and that's why a troy ounce of gold isn't a good unit for planning of savings or loans (the latter is even worse). You have simply no clue what interest rate you should demand if you lend gold to someone.
In the previous centuries, the inflation expressed in gold was nearly predictable because gold has been used as the currency. But this stability resulted from the constancy of the "price stickers" and commitments which were expressed in gold, not from the existence of an actual underlying material. The material – the gold – didn't matter for the constancy at all; the material was only useful to guarantee that no one can counterfeit the money and the transfers are complete. These "price stickers" for selling real products and commitments (e.g. promises to pay pension etc.) were more important than the gold itself which is why they were kept constant, or were slowly and predictably evolving. However, the inevitable consequence of this system that fixes the gold price was that the price of gold at the end didn't have anything to do with the market price of gold. The gold-to-food price ratio was artificially fixed. While the bread-to-butter ratio could evolve according to the market conditions, the gold-to-food couldn't. And one may also adopt the perspective (units) that it's the gold price that ended up being completely wrong, totally distorted by the special role that the precious metal played in the monetary system.
My point is that it is completely irrational to say that the gold guaranteed some "intrinsic value" when it was used as the currency because the price of gold itself was completely distorted, manipulated (by requiring the price stability expressed in gold, something that simply cannot occur naturally because the gold-to-food price ratio is a frantically evolving random function of time), and had nothing to do with any underlying reality. So the golden coins may be nicely shining but this shine is only good enough to encourage many people to lose all of their rationality.
If the market gold-to-food price were ever higher than the artificially imposed ratio of these two prices, people would start to melt the coins and use it for jewelry or electric contacts in the radars or whatever is the actual "non-currency" application of the gold. This has never happened, of course. In reality, the market gold-to-food price (which would exist if gold were demonetized) was of course smaller (much smaller) than the artificially imposed one, so if people were inclined to move gold from one type to another, they were always motivated to melt their jewelry and counterfeit the golden coins! The monetization of gold artificially distorted the gold price in the positive direction. If people were obliged – or trained – to accept feces as payments, feces would probably also end up being overvalued, right? You wouldn't just throw them away, and even using them as fertilizers would look like a waste of resources. The gold has been in the same situation for centuries.
And we're still in a post-gold-standard era in which the price of gold is artificially inflated by the idea that gold may one day be reintroduced and the value of the world's gold will approximately match the value of everything else once again. Today, it's just about 1% of the value of "everything else" (or 1-2 months of the global GDP/income), well, depending on what kind of money supply or GDP you count. But the actual gold price would be (even) much smaller if there weren't this many people believing in some miraculous return of gold as the ultimate currency imposed on everyone, the chance that the total value of the world's gold will be comparable to the value of everything else combined again.
The more rational people will become and the more they realize that gold has lost the special status and it's just one among millions of things that you can buy for your money (and the number of alternatives to buy is increasing, much like the number of copies of each alternative – as the population is increasing etc.), the smaller the gold-to-food or gold-to-copper price ratio will be.
One more comment, about a rhetorical trick. People criticizing the concept of fiat currencies – which "primarily" means the U.S. dollar – like to mention Zimbabwe and its hyperinflation because it's the "same thing". Well, sorry if this comment seems racist to someone, but the currency of Zimbabwe is not the same thing as the currency of the United States of America. Whether a nation does it in the right way (and whether it has the capacity to do it correctly at all) matters.
And it's far from the truth that currencies of countries different from the U.S. are short-lived and quickly end in hyperinflation or something like that.
Czech lands in the Austrian Empire: a bonus historical story
The Czech currency is an excellent example of the historical continuity. I don't have to tell you that the number of dramatic political changes that have taken place in the Czech lands since the 16th century has been astronomical. The Czech kingdom would be redistributed in the dynamical Holy Roman Empire and the Austrian Monarchy and Austria-Hungary and Czechoslovakia was created before it was broken to pieces by Hitler and absorbed by the Third Reich 6 months later. Communism, socialism with human face, occupation by the Warsaw Pact, Velvet Revolution, Velvet Divorce, membership in the EU, and so on.
But despite this lively history, we actually use the same currency as we did in the 16th century – to say the least, we may directly translate our current Czech crowns and convert them to the 16th century coins through a totally calculable conversion factor which is a very simple rational number! I could probably go deeper than to the 16th century but I am no historian and the 16th century looks impressive enough to me.
In the 16th century, Maxmillian II would introduce Kreuzer (Czech: krejcar) in the Czech lands. This small-value, cent-like South Tirol [town: Meran] silver coin (with a cross, therefore the name) had actually been minted since 1271 and since 1559, it was equal to 1/60 of a gulden (Czech: zlaťák). One Groschel (Czech: grešle, i.e. grošíček, small groš), another silver coin, was equal to 3/4 of Kreuzer, a truly small penny that was later switched from silver to copper.
I don't want to describe all the other coins, especially Groschen, especially because the Hungarians would sometimes use "1 forint = 1 gulden" and sometimes a different ratio. At any rate, the Guldens and Kreuzers lasted up to 1892 when the new gold standard was introduced (before that moment, the "gulden" is ironically enough made of silver although it had been golden centuries earlier). The conversion was: 1 gulden (Czech: zlatý) became 2 crowns (Czech: koruna).
Amusingly enough, this 1-to-2 conversion made in 1892 is still reflected in the Czech language. Czechs use the word "pětka" (number five) for the 10-crown coins (and previously banknotes). Why would ten units of a currency be colloquially known as "five"? Well, because 10 crowns is equal to 5 guldens by the 1892 conversion factor. ;-) The same money used to have "5" on them.
At any rate, since 1892, we had the crown. When Austria-Hungary dissolved in 1918, Czechoslovakia was actually the only state on its territory that kept the old currency! ;-) So we still had a Czechoslovak crown that was made out of the Czechoslovakia-stationed Austrian-Hungarian crowns at parity. The crown was treated continuously (but also gradually evolved) during the Munich Betrayal, occupation by the Nazis, liberation, communist coup, Prague Spring, Velvet Revolution, Velvet Divorce (involving currency split at parity again), and of course our entry to the NATO and the EU (so far not the eurozone).
So one Czech crown is still "what has evolved" out of 1/2 of the gulden that has been minted for nearly 1,000 years. It's funny to compare their values. The golden/zlatý, also known as one florin, was minted from 11.7 grams of silver since 1754. This amount of silver contained in the "2 crown" gulden coin costs 140 Czech crowns according to the current silver price, unless I made a mistake, so since 1754, the value was reduced by a factor of 70.
It looks like a lot but during most of the time, you could get nontrivial interest rates for the crowns in the bank. And 70 is equal to exp(4.25) – it's the multiplicative increase by 425% in total, if you understand what I mean, which has occurred in 250 years. So if the interest rate was at least 1.7%, and it's likely that it was much higher (the very low interest rates only belong to the present), you earned some real money from the 1750s. ;-)
It's funny to see the prices of things in the Medieval Czech lands.