The Ideal Money

Wednesday, March 16, 2011
The emergence (note I don’t say “invention”) of money stands out as one of the great boons to human economic development. Life before money was frustrating. For a mutually beneficial trade to take place, there must be a “double coincidence of wants”: Ug has to have exactly what Zog wants and want exactly what Zog has, and vice-versa. Money allows for “indirect” exchange. Ug and Zog can simply sell their wares for cash, and use the money to buy whatever they need in the market. This “monetization” of the economy sets the stage for an awesome increase in trade, specialization, and the division of labor—the main ingredients of economic growth and wealth creation.  But as economists say, “that which has benefits, also has costs.” Money is no exception; the costs of using a monetary system are not zero. In early monetary systems, these “resource costs” of money were obvious: commodities that were dedicated to monetary uses, such as gold and silver, could not be applied to other uses like tools or jewelry. But oh, that money were free! Economic life could be greatly enhanced: all the benefits of a monetary system with none of the sacrifice of other uses of the monetary commodities. We could have our monetary cake and eat it, too. It is possible, at least in theory. The trick would be to somehow get everyone to use something really cheap—say, paper—as money. If this new monetary standard could get off the ground, and come into widespread use, then all the gold and silver tied up in monetary uses could now be liberated for more direct uses like gold chains and silverware, instead of collecting dust in a bank vault. Thus in an ideal world, strangely enough, paper money might be the optimal form of money.  Enter Fiat MoneyBut switching from gold and silver to a cheap substitute like paper is not simple. Whereas “any old gold” will work for a gold standard, not just “any old paper” will work for fiat money. After all, if anyone could print his own money, the system would obviously break down into inflationary chaos rather soon. For fiat money to work, there can be only one issuer, with a distinctive logo, and sole legal authority to issue money. In other words, fiat money requires a government monopoly on money.    Once it is established, though, the low “production cost” of fiat money gives it the potential to spare the resource costs of commodity money. But herein lies the great, often tragic, irony of fiat money: precisely because it is so cheap, the temptation is immense for the monetary authority to just keep on printing it. After all, if you have a monopoly on money creation, and the cost of producing new money only amounts to a tiny scrap of paper and blot of ink, what would you do? Answer: you would print money to satisfy your ever expanding “needs.” And indeed, a strikingly regular pattern crops up in the history of fiat monies: once established, the inflation process begins as governments increasingly rely on their monetary monopoly to finance ever-expanding programs, like wars and handouts to powerful interest groups. And in most cases, the inflation quickly gets out of hand, destroying that particular brand of money as a stable form of purchasing power and bringing economic pain and chaos.  The Point of the Gold Standard In light of the unbridled inflationary potential that fiat money uniquely possesses, the resource costs of commodity money might not seem so bad. Indeed, it is the relatively high cost of producing new gold and silver that makes them stable stores of purchasing power for the long run. Gold and silver cannot be printed out of thin air; even in the midst of historical gold and silver bonanzas, the flow of new money relative to the stock of existing money has been relatively small, providing a natural check against high rates of inflation. The worst inflation under commodity monies—the so-called “price revolution” of the 1500s-1600s which resulted from the massive gold and silver bonanzas in Latin America—brought an average inflation rate in the neighborhood of 4-6% per year, and peak rates approaching just 20%. For comparison, the first two fiat money episodes in the United States featured average inflation rates well above 10%, and peak rates north of 25%. And we haven’t even begun to discuss the more notorious examples of hyperinflation! Fiat money could be an ideal money in a world where we could trust government authorities to exercise self-restraint. In the real world, a commodity money like the gold standard, with its real resource burden, prevents knavish politicians from abusing the money system for their own personal gain. In the words of Ludwig von Mises, “[T]he gold standard…limits the government’s power to resort to inflation. The gold standard makes the determination of money’s purchasing power independent of the changing ambitions and doctrines of political parties and pressure groups. This is not a defect of the gold standard; it is its main excellence.”  Tyler Watts is an assistant professor of economics at Ball State University. Image by Filomena Scalise /