April 14, 2011 Reading Time: 5 minutes

Part III of The Shell Game will be posted next week.

One of the goals of this corner of the Interweb is to help people understand what inflation is and what comes of it.  I would like this week to talk about inflation from a different angle. I have been writing on the premise that sound money is money uncontrolled by a central authority. Although I believe that gold would be (and has been) the best option for a people’s money uses, in reality anything can be money; some things are just better than others.

One of the benefits is that gold has a built in defense against inflation.  But what exactly does that mean? Everyone knows that gold is buried underground, and sometimes even just laying about in streams waiting for bearded men in flannel shirts to pan it out. If this is the case, and gold is money, and inflation is an increase in the money supply, then isn’t gold particularly vulnerable to inflation? After all, it seems like it might be harder for many to fabricate a Federal Reserve Note (FRN) than to start digging or panning.

Why is finding a vein of gold less harmful for an economy than printing a few dozen sheets of hundreds (or, more likely, adding a few zeroes to the accounts of bond traders or Libyan central bankers)? For starters, the obvious: people like gold, but they only like what you can buy with FRN’s. You can wear gold, you can put it in your teeth, you can use it in electronics; you can even shave it down and sprinkle it into liquor to somehow make the drink more appealing (I’m looking at you, Goldschlager), or even wrap your raw fish in it. So when you find gold, society is better off. Even those who don’t want to drink it or cover their wedding cake with it (or, if you’ve ever seen Goldfinger, eliminate Jill Masterson by painting her with it) gain; this is because those who trade their labor for some of the newly discovered gold have decided not to compete for other goods at that time. 

Although they would not be conspicuous in their absence, you were able to purchase those tickets on Ebay a little more cheaply because Jeff preferred a gold necklace (at the cheaper exchange rate relative to his labor thanks to the new discovery of gold) and decided not to bid against you.  Although not as immediate, the price of that DVD player will also drop on the margin.

If you print the sheets of “Benjamins,” on the other hand, those on the receiving end can only derive satisfaction from them by spending them; this means that they are now competing with you for factors for use or purchase. Put simply, when people find gold society has more stuff it wants; whereas when a central bank prints money society doesn’t have any more stuff, but the recipients of the money do get access to the society’s wealth – at the expense of everyone who didn’t receive the funny money. (If this still doesn’t make sense, just imagine that your neighbor printed the money. He is a counterfeiter, and we’ve all been taught that he is bad.).

So what are the natural forces that limit money growth that gold provides and counterfeited money does not? Well, gold is expensive to find or mine. Because at the end of the day the “price level” is essentially the total amount of money in an economy divided by the total amount of goods and services, we can see just by logic that if the amount of money increases without a commensurate increase in a society’s production, the price level must rise to accommodate the new money (e.g. $100/100 = 1; $200/100 = 2. The “price level” will double in the long run, once the money has filtered through the economy).

This means, conversely, that if an economy becomes more productive, the value of their money also increases. If the value of money increases (in this case, gold) then there is an incentive to find more. But if the addition of new gold outpaces the increase in productivity, the opposite will happen. The value of gold will begin to fall relative to other goods, and the incentive to mine more will fall. (This process is reinforced by the fact that the factors necessary to mine the gold in the first place are scarce, and as more people look to mine it the higher the prices for e.g. mining equipment will rise.) This means that at a certain point it will be more expensive to mine the gold than it is worth, and people will stop or go bankrupt.

There is no such mechanism to slow the money printers. For this reason I believe that the best definition for inflation is not merely an increase in the money supply, but an increase in the money supply above the increase in production of the society. In future weeks I will discuss this concept further.

*One important point I neglected to add that was brought to my attention was the difference between, in my article The Shell Game, when the Outsiders bring their unlimited shells, and in the case of a discovery of gold.  The first difference is in the amount and speed of the addition to the money supply.  In the case of The Shell Game the amount of new money being added is for all intents and purposes unlimited, and it is added at a high rate with virtually no transaction costs; the Outsiders must simply go out to their anchored ship and get as many as they want.  It was as if in a world on the gold standard someone discovered a mountain at sea made of pure gold that was 10,000 times the size of all of the gold that had previously been discovered, and anyone with a boat could just cruise out and take as much as they could carry (as opposed to having to search for gold, then bid for mining equipment and labor services to extract what small amounts could be found at any given time).

The second, and extremely important, difference is that the Islanders are forced to accept the shells.  This goes back to my earlier statement that sound money can be anything, as long as people are allowed to choose it freely.  In the case of the stupendous gold find prices denominated in terms of weights of gold would begin to shoot up for reasons already explained; when people realized what was happening they would begin to demand payment in some other form to protect themselves from the plummeting exchange value of the gold.  The process of adjustment would not be instantaneous or perfect, but over time as people adjusted to the fact that gold had become relatively much less scarce they would organically begin substituting some other commodity as the medium of exchange.

This stands in stark contrast to the Islanders and their shells, or Americans and their FRN’s.  When the Federal Reserve prints a mountain of dollars and the world begins search for other media of exchange Americans are forced by law to continue to accept them, exchanging the fruit of their labors for essentially nothing in return.  For the Islanders, at least, it is easy to see who is exploiting them: the Outsiders.  However, in a modern society it is impossible to tell if the dollars you are accepting were earned by their bearer by having produced something, or were printed by one government functionary and handed to another.

Theodore Phalan is an economics student at George Mason University and a previous Sound Money essay contest winner.

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