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Fiat money has been a great invention

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.

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snail feedback (30) :

reader Tom Weidig said...

>> 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).

I am very skeptical of this argument. For two reasons, I do not know of historical examples of this happening.

Second, theoretically speaking, many social forces would prevent this from happening. The farm or the gold mine needs to buy other resources, which will cost them a lot if the economy is not functioning well. And look at the curse of resource-rich nations, they are actually not doing that well economically speaking, e.g. Russia or Venezuela.

Moreover, if the farm or gold mines are not state owned, they face serious security issues. If they are, then the state will keep it stable.

reader Tom Weidig said...

reader Vangel said...

Sorry David. Russell is following me around the net and commenting on as many threads on which I comment as he can. He is one of those irrational progressives who believes that consensus matters in science, that the world is in danger from overheating, that studies do not need to look at CO2 when determining if AGW is real, and that a big government that regulates everything is better than free markets. He goes after me because I argue the Libertarian cause and that to be a statist and a progressive one has to abandon reason, somewhat like Pius XI saying that one cannot be a good Catholic and a Marxist at the same time. Our friend does not think much of the scientific method or of liberty. He also may have trouble with Luboš because I have cited him a few times in our AGW debates.

reader Peter F. said...

There is no difference between fiat money and 'metal money' in that its value is what people make it in their minds - do significantly as a result of a few momentous pleiotropic (and 'ambiadvantageously' adaptive) mutations (in a genomic region, FOXP2, that codes for transcription factors) our recent phylogeny.
But, of course, the laboriousness of extracting and printing and distributing "large sums of substantials" can be 'too thick a lubricant' for a growing economy. On the other hand, fiat money can be fabricated and flow so easily that runaway inflation can readily result.

Also, what do we people do when we get very disappointed and frustrated - including for reasons directly flowing from an onset of economic hardship?
Answer: We tend to start FIATING! ;-)

reader Peter F. said...

A pile is vertical and a spread is horizontal. ;-)

reader de^mol said...

I was not saying that there doesn't exist a negative effect on having lots of resources as a country. I just said your examples are no good.

reader davideisenstadt said...

well, now you know how I feel about russell. he's a troll.
I hope you didn't take my response as being directed at you.

reader Heart Moore said...

>> if someone has a village with martens, he can impact the whole economic system. By growing his village by the transaction of scale, he may buy everything in the economic system and de facto enslave everyone if the individuals keep the costs of their item set (if indicated in marten skins).

Spybubble Gratis

reader Rafal Smigrodzki said...

I was under the impression that Friedman saw free choice of monetary standards (and therefore the possibility of using a gold standard) as an ideal, something not likely to happen yet desirable. See this:

especially the quotes at the bottom of the page.

reader Rafal Smigrodzki said...

Not even you can reason your way through the theory of money without knowledge of some history. You need to intimately understand the history of commodity monies and the notion of anomalous demand. Anomalous demand is the sine-qua-non of money, whether fiat or commodity. In the post above you are getting the arrow of causality wrong. It is not the government that imposes the gold standard on the market but it's the market imposing the gold standard on the government (or it used to).

reader Werdna said...

"The gold-to-food price ratio was artificially fixed"

Completely appallingly wrong. A gold standard allows the price of gold in goods to vary freely, it only "fixes" the price of a peice of green paper in gold and vice-versa-because it *defines* the piece of green paper as a claim to a quantity gold. The piece of paper is a *contract*. The prices of all goods in pieces of green paper is allowed to vary freely. But it makes no sense to say that the price of gold in pieces of paper promising to pay an ounce amount of gold, is too high or too low.

One might as well complain of the government fixing the price of a five dollar bill at 500 pennies, or 50 dimes. That's absurd.

Second, again, you write as if the use of gold as a generally accepted medium of exchange had to be imposed by the government. That's wrong. What the governments did was pick up on what units people traded in gold with, and minted coins containing that weight of gold. And then subsequently, having monopolized coinage out of a desire for (A) seigniorage profits and (B) so they could debase the coin to pay their debts. They later defined their pieces of paper as stand ins for these coins. The Gold Standard was just a rule that those pieces of paper must correspond to a particular weight of gold, rather than a particular coin whose gold content may be reduced. It was under the later scenario, that people would melt down coins-among those melters, the government, who could decide what the official gold content of the coins was.

The problem with a gold standard today, of course, is that it would need to be artificially introduced rather than evolving naturally through the market process. This point was made in the paper I cited on the last post on the Gold Standard:

Selgin, George. "Law, Legislation, and the Gold Standard." Available at SSRN 2524863 (2014).

And again you should not take for granted that maintenance of well behaved (or actually, neutral) money is best achieved by trying to make a Central Bank follow some "rule." This is at best a second best solution assuming you have a statutory currency monopoly. With free banks allowed to issue their own bank notes redeemable in a reserve commodity, which could be a fixed quantity of base money, or whatever banks and their customers agree to (which could include gold) market forces naturally tend to maintain a stable level of money payments. In other words, market forces with Free Banking would *automatically* "target" the level of nominal income. This is what anyone who believes in limited government should favor. Two good things to read on this subject:

Selgin, George A. The theory of free banking: Money supply under competitive note issue. Cato Institute, 1988.

Selgin, George. "Free banking and monetary control." The Economic Journal (1994): 1449-1459.

Again, I urge you to look at the research in this area, rather than continue to endorse government efforts to centrally plan the supply of money.

reader Karel Strašný said...

I wouldn't be done so quickly with the gold prices...
There is about 1 troy ounce of gold per person on this planet (and this ratio will go down due to populatio growth, not only in poor countries).

Now when you consider a woman with rings, earrings, bracelts etc. she pretty much consumes "her share" just on jewelry ...
Plus the share per person is also affected by other factors:
"I can't melt this rings, it was my grandma's." - so even dead people "own" some gold,

sometimes for several generation - think crown jewels.
Also there is some crazy stuff like 50kg of pure gold used in a bathtub, or a toilet etc.

And then you have a notebook at home, at work, personal phone, work phone, tablet, and "your share" of network switches and servers etc. etc. etc.

My point is that there is not as much gold as it seems. Central banks hold about 17% of gold, other inverstors about 20%.

And also consider the fact that gold production has been rising for some time.

reader lukelea said...

Your point about the volatility of gold is well-taken. Irving Fisher, one of America's greatest economists, wrote about how little price stability there actually was when a country had a gold-backed currency. As I recall, using historical data he showed how prices fluctuated as much as 100% up or down over the course of a decade or two. Will have to look it up.

I agree (with both you and Milton Friedman) that fiat currencies are better in that regard -- or can be, provided that central banks and governments are being run by responsible adults, which they usually are in the West nowadays. But when Kaiser Wilhelm's Reich started WWI under the mistaken impression that it would be over fairly quickly, and that thus there was no need to plan how to finance war production over a periods of years, this set the stage for the hyperinflation that ravaged Germany in the 1920's, which was no small factor in Hitler's rise to power.

Now whether any major country would be so irresponsible today seems doubtful, especially in the West. But I do worry about China, which has wasted something like eight trillions of dollars of its people's hard-earned life-savings on boondoggel infrastructure projects with no hope of returns in order to keep the economic wheels humming and its people employed. When those hundreds of million of people -- and they are not all poor, it includes the urban middle-classes -- who are all counting on these savings to see them through their old age (one child policy, remember) -- when they go to the big state-owned banks where they were forced to put all their savings to withdraw them, there is little doubt that the Party will order these institutions to print up whatever amounts of paper are needed to meet all depositors demands. That could lead to a lot of inflation! Not sure how it will play out, but could lead to social unrest and military aggression as well.

reader johnmerryman said...

By and large, fiat currencies are backed by public debt, which makes deficit spending necessary for a functioning economy. As such, this makes the money more of a contract, rather than a surrogate commodity. Essentially the Rothschilds happened into this system. As gold traders, they had secure vaults and would issue certificates, rather than trade the stuff around, because it was safer that way. Eventually these certificates became used as a currency and they found they didn't need to have as much gold as they issued currency, just enough to keep people happy. Eventually they took over the English Treasury, as payment for some old war debts and the idea of the private central bank was created, as The Bank of England.
As with the Federal Reserve, the money is created by buying government debt.
An interesting note: Paul Volcker was credited with curing inflation in the early 80's, by raising interest rates. Supposedly he did some of this by selling debt the Fed was holding and taking the money back. Yet he had little luck making it stick, until 1982, when he again tried lowering rates for the second or third time and inflation remained subdued. It should be noted however, that by 1982, Reaganomics had created a 200 billion dollar deficit, which was real money in those days and far more than the Fed was trying to buy back. So what is the difference between the Fed selling debt it is holding and the Treasury issuing fresh debt? Other then the Treasury turns around and spends that money back into the economy, in ways the investors whom it was borrowed from never would have considered. Otherwise known as Keynsian pump priming.
So basically the inflation of the 70's was actually cured with excess Federal spending.
The problem is that as a contract, the one holding the obligations has to profit from them, or eventually the system implodes. Now when banks used to issue their own currency and stand behind its value, they had every right to profit from its popularity and usage. But with the creation of the Federal Reserve system, it is the public which is responsible for maintaining the value of the currency, but the banks which continue to profit from its usage. While this might seem quite clever on the part of the banks for the last 100 years, it actually starts movement toward a fully public banking system.
There was a time when government was a largely private function and worked reasonably well for millennia, yet when it reached the point the entire state revolved around royalty, they became more trouble than they were worth and so government became a public trust, for better or worse. Now the banks are doing the same thing and losing sight of their larger economic function and so we will have to go back to private currencies, or on to public banks. Just as democracy works bottom up, with local, regional and national governments, so to would a public banking system have local, regional and national components, which funneled their profits fairly directly back into the communities generating this wealth.
In fact, if people really began to understand money as a social contract and obligation, then they would likely use less national currencies and start developing local and regional currencies to fill various uses and even more organic stores of value, like healthy and strong communities and healthy environments as legitimate stores of value and not simply resources to be mined for notional wealth.
Now this might well result in a slower economy, but then one of the main reasons this economy keeps having to go faster and faster, is to generate the notional wealth to pay of the debt generated to power it in the first place and there are limits as to what the earth can sustain.
Just some thoughts on money as a dynamic system.

reader Vangel said...

Since all value is subjective your explanation is not very important. What you fail to address is the fact that if I want to increase the money supply under a gold standard of some kind I need to get gold by either producing goods or by mining it. That is not the case under a fiat standard where I can hit a keystroke and increase the quantity by as much as I want.

Monetary commodities are more stable because their quantity does not change much. They protect savers from inflation and generally lead to a mild deflation that increases their purchasing power over time. Try that under a fiat money system where old people have to become speculators to get any return on their savings.

reader Werdna said...

Oh great we've attracted a Chartalist.

reader Werdna said...

" Irving Fisher, one of America's greatest economists, wrote about how
little price stability there actually was when a country had a
gold-backed currency. As I recall, using historical data he showed how
prices fluctuated as much as 100% up or down over the course of a decade
or two here in the US. Will have to look it up."

We could look at some actual data:

From 1879 to 1914 the cumulative percent change in the CPI was about 0.2% The standard deviation of the annual inflation rates from 1880 to 1914 was about 1.97%. The cumulative percent change from 1978 to 2013 was about 257.2%. The standard deviation of the rates from 1979 to 2013 was about 2.74%.

The big episodes of inflation and deflation occurred during period of *suspension of specie payments* by the US government-in other words, going *off* the Gold Standard.

Irving Fisher appears to have either gotten his history wrong, or his data wrong.

reader andy said...

Wow. A lot of nonsense.

reader Luboš Motl said...

No, Werdna, you can't circumvent the laws of mathematics and logic.

The approximate constancy of prices of the "actually useful things" that people need to buy for the money, on an annual basis, has to be fixed for the currency to be useful. This is not a "purely bad" thing: it is absolutely necessary for the currency to be usable.

No farmer would store his financial reserves in gold if he knew it was likely that he would buy 40% fewer things he needs in two years..

And indeed, this constancy was approximately the case in the gold era because of the contracts and stickers - people were used to sell something for a certain price, they had obligations to pay a certain number of golden or silver coins to someone else, and that's why these numbers were not changing (as much as they are today). The constancy had nothing to do with the intrinsic value of the gold.

The negative side is that by declaring something a currency, its price is completely distorted - always in the direction up, unless the system totally collapses.

Fiat currencies heavily distort the price of correctly printed pictures of Benjamin Franklin. But it's no big issue because pictures of Benjamin Franklin otherwise pay no role in the society. A gold standard economy totally distorts the price of gold. This is the other, negative interpretation or the flip side of the very same property that was proven to be a vital feature of a working currency - the stability of prices of services, products, and contracts that people actually need and care about.

reader Luboš Motl said...

Dear Karel, you didn't have to make *guesses* about the amount of gold in jewelry. I wrote the *actual* number in the previous blog post. 50% of the gold above the ground i.e. 80,000 tons is used as jewelry. It's 11.4 grams per human being (including very poor countries and babies etc.) - or, indeed, almost an ounce per woman if you only give it women.

How can you use the fact to argue that gold should be this (or more?) insanely expensive? Clearly, you can't. This average woman has an ounce in gold jewelry - $1200. Why so much if the rest of their bijouterie may be bought for a few dollars - and may be done to resemble gold or be prettier? It is clearly due to the group think only. Even in the form of jewelry, gold is mainly an overvalued currency.

reader Luboš Motl said...

The physical gold isn't what gives the people the immense power.

What gives them the immense power is the ability to convince other people - or force them to believe - that gold (or anything else used as the currency) has some special status that allows them to quickly use it to buy anything.

The U.S. government has this ability in the case of the pictures of Benjamin Franklin. In a gold standard, the people benefiting from gold have the same ability in the case of gold.

But you don't seem to understand that the market price of gold in "real objects that matter" is much smaller if gold is demonetized because a really important application of gold is lost. So most of the price of gold in a gold standard system is composed of the hot air and it is exactly the same kind of hot air that assigns values to the pictures of the Benjamin Franklin.

The only differences are disadvantages of the gold system relatively to the fiat currency: the gold unit of payment can't be stabilized too well; and the price of gold itself is completely distorted (inflated) even with the moderate stabilization of prices under the gold standard.

The great realization of the fiat currency is that this exaggeration of the price of the medium generally used for payments and loans is *inevitable* (because something's status of being the currency adds an application, and therefore greatly increases the demand for that) and it's actually much better to pick something that doesn't have any other applications, like pictures of Benjamin Franklin.

reader Karel Strašný said...

Well, of course it is a question of popularity of the comodity.
But market = people, so the behavoir is not always rational... (and that is true about any market, not just gold)

It has been a tradition to make jewels from gold for milenia, I don't think this will change anytime soon.
And now there is also "useful" use for gold in electronics etc.
Another factor is that people usually want what they don't have (yes, irrational, but that's the way people are).

All these are factors that make gold wanted metal. And it's relative scarcity does the rest.

Also it really costs some money to mine gold. I no longer think that you can actually mine an ouce with e.g. 300$ budget (and these costs will go up as well).

So was gold overpriced at 1800$ per ounce? Probably yes.
Is 1000$ per ounce too much? - I no longer think so.

reader cynholt said...

As to what is next in the cards, inflation or deflation, I'll place my bets on deflation, werdan. A deflationary spiral is going to happen and soon, IMO, because of the basic laws of gravity. We've reached peak debt and we can't shove any more debt into the system. It just won't accept anymore, even government debt refinanced at near zero rates. The marginal utility of additional debt issuance has plummeted. There is no more multiplier.

Since it can no longer expand, it must contract. The government can't support moving the entire private debt balance sheet on the public debt balance sheet. Even if they could, it wouldn't do much good. Japan leveraged its government up something crazy over the last two decades and they have nothing to show for it. 20 years of stagnation and they still may end up in the depression they tried to avoid building bridges to nowhere.

reader cynholt said...

Deficit spending is only tolerable if we can reasonably expect to manage the resulting debt load. Right now we do that by keeping interest rates artificially low facilitated by the reserve status of the dollar. Our current debt load is unsustainable at normal interest rates. How long the world will allow us to continue this is uncertain. Further, our current low interest rate policy discourages behaviors we need to encourage (like thrift and saving) and encourages behaviors that are not so healthy (over consumption, gluttony, etc.). We have shot our deficit wad already and need to find another solution.

reader Vangel said...

Actually, Luboš is in a great position to conclude that Friedman was wrong because he is more than qualified to evaluate Friedman’s paper The Methodology of Positive Economics, in which he outlined the method that he believed should be used in economic science.

In this paper, Friedman argues, as Mises does, that economics should be value free. Economists should simply look at the effects of policies or actions without making moral judgments about them.

There is little debate on that point because basing the field on what aught to be requires an abandonment of reason, which is what Marxists and Progressives have done.

Friedman also argues that the effectiveness of economic theory should be built of a foundation of predictive power which is the goal of the experimental methodology that is used in the natural sciences.

But there is one big problem here; the natural sciences study the reactions of inanimate objects to external shocks. Inanimate objects do not think and do not have behavioural responses to changes in external conditions. But human beings do. Positive economics fails because of the absence of controlled variables.

Milton was brilliant but his problem was that he was a better mathematician than an economist and that he specialized in the area in which he was worst. Note that I did not mention that in his models no variables were ever held constant or other problems.

Essentially, Friedman's methodology gave government justification for policies that could not be justified by the use of reason or on moral grounds. But my biggest problem was his admission that often a sound economic hypothesis, "will be found to have ‘assumptions’ that are wildly inaccurate descriptive representations of reality." Essentially, premises and facts do not matter. What matters is the predictive power. But even here there is a big issue. A bad theory could make sound predictions for a while and adherence to it will lead to disaster. That is why Friedman failed to see the damage that Greenspan was causing and could not understand why the price of gold did not fall after the link to the dollar was cut or why a housing crash was inevitable.

reader Vangel said...

I think that you are missing the essential argument my friend. Note that no top down approach was used to 'convince' people that gold was valuable. That was determined by people who wanted to engage in voluntary economic transactions and needed a monetary medium.

All values are subjective, not just that of gold. What gives gold its value is simply its use as hard money. It cannot be created out of thin air. It is durable and fungible. It has a stable supply. It protects savers' purchasing power. All of these have value for individuals.

Note that I am not arguing for gold as money. All I argue is for the elimination of legal tender laws, which force the acceptance and use of fiat money. Get rid of them and you will see how great the Euro, Dollar, Yen, or RMB truly are.

reader davideisenstadt said...

I dont see friedman's work as you do.
suffice it to say that I dont think that friedman's main contribution was his application of math to human was the ability to distiill the fundamentals of human behavior which set friedman apart from other economists.
and, although i studied econ in the early 80's, it has always been the case that economics is, at its core, an amoral discipline...normative values simply have no place in economics...
we will have to disagree then, agreeably.

reader Vangel said...

Friedman was great on many things. But he clearly provided justification for government activities that would have been better handled by the markets. He clearly did that in the monetary sphere as he supported a central banks that kept increasing the money supply and manipulating the rates. He called Greenspan a genius and cheered on the bubble that he had blown without considering how it would end.

Note that he never argued against public schools; he just wanted to make them more efficient. And note the positivism and the methodology, which I have already cited. While he was good on many things and a brilliant man, Friedman was a disaster on where it mattered. Give me Rothbard or Mises over him any day.

reader davideisenstadt said...

Im sorry...friedman opposed the monopoly that public schools enjoy...
also...i will note that he died in 2006.
I think that you distort his thinking, and minimize his achievements.
we note our divergent views on him.

reader Vangel said...

Sorry but I have little time to respond fully. That said, I will give you a few references that support my view.

As for public schools, Friedman just argued for more choice and competition, not for their abolition, which is the moral position. Of course, given the fact that Milton was a moral relativist, what more could we expect.