The Ideal Money, Part II

Monday, March 21, 2011
Last week, I wrote something here that might seem a little strange for a “sound money” blog. I stated that fiat paper money could be the optimal form of money in an ideal world. Sure, we “sound money” economists see much virtue in a commodity money like gold, because it erects a tall barrier against the potentially severe inflation that tends to arrive, sooner or later, with a fiat money regime. But doesn’t the fact remain that a gold standard involves a large “resource cost” of extracting the shiny metal from the bowels of the earth? As Milton Friedman liked to point out, miners spend much effort digging, blasting, crushing the rock, and smelting the gold, only for the finished product to be sent right back under the ground into the bank vaults. Friedman estimated that all the efforts associated with mining and processing gold would amount to, on average, 2.5% of GDP, which today would be in the hundreds of billions of dollars—not a trifling sum. Sound money economists thus face a challenge: how can we minimize the resource costs of a commodity money, while at the same time minimizing the inflationary potential of fiat money. Sound impossible? Amazingly enough, this is precisely the result that emerges in a fully competitive market economy. In the market economy, merchants and entrepreneurs are free to offer any good as a means of exchange. Competition eventually reveals a small number of dominant monetary goods—e.g. gold—that have superior monetary qualities. Once “the market” selects gold as the money, merchants declare their prices in terms of their local weights: 10 drachmae of gold, 1.1 Troyes ounces, 34 grams, etc. The world now has a universal monetary system. But so far, every exchange requires physical gold to change hands. We haven’t overcome the pesky resource costs problem. Yet in a free economy, any entrepreneur is able to borrow and lend any commodity on mutually agreeable terms. Certain financial specialists will realize a great opportunity to help out other entrepreneurs in the economy and make a tidy profit for themselves. Most merchants have, at times, balances of gold (money) that they are not using at the moment (a.k.a. “savings”). Financiers realize that they can borrow this idle money, and lend it out to merchants who are temporarily in need of cash. But how does this save on the costs of gold mining? Well, astute financiers soon come to realize that they need not lend out the physical gold. It is more economical to issue a promissory note. Legally speaking, such a note is, for the borrower, a claim on a certain amount of money, and for the issuer, an obligation to pay out that money (gold). Naturally, only highly trusted, well-established financiers will be able to circulate such claims (otherwise I would be out shopping right now, issuing “claims” on myself to pay for flat screen TVs and Cadillacs!). But once these notes gain acceptance, fascinating results ensue. Let’s say the borrower is a merchant who spends a batch of these promissory notes at a cloth wholesaler’s shop. The wholesaler may then bring the notes to the financier and claim his gold. But if the financier is highly trusted, the cloth dealer may not feel the need to claim the gold. He may “spend” the notes himself, or hold them as a ready cash equivalent. And because reliable notes are easier to transport and store than physical coins, the latter options become more attractive as the financiers gain the trust of the community. Our financier soon realizes that he can safely issue more talents/ounces/grams’ worth of notes than he has the physical gold in his vaults! You probably recognize this as “fractional reserve banking,” (or simply BANKING, as such borrowing and re-lending via the issuance of promissory notes payable in an underlying monetary medium is the defining feature of all financial banks). There is much more to be said on the economics of this kind of banking system. But let’s take for granted for right now that it can be stable and economically beneficial. The point to see here is that a banking system allows for a dramatic economizing of the monetary commodity, thus sparing the overall economy the heretofore much-vaunted “resource costs.” For if our financier/banker can issue more effective “money” in the form of promissory notes than he has on hand in the form of gold coin, this allows for the supply of “money” available to the economy to be expanded greatly without the need for a parallel increase in gold production. Thus a true free market economy sets the stage for entrepreneurial genius to economize on the resource costs of the gold standard. Bankers can and will extend claims to “idle” money, through a sequence of borrowing and re-lending transactions, creating an effective “money supply” that is a large (but limited) multiple of the stock of actual gold. According to Larry White, a top free banking scholar, a fully competitive banking system can support an effective money supply up to 50 times greater than the physical gold supply. Even in US experience (where the banking system was never fully competitive), banks of issue were able to “stretch” the available monetary gold into a money supply at least 5 times greater than the gold base. As White has pointed out, based on analysis of the most sophisticated historical free banking systems, that the resource costs of a gold standard can thereby be whittled down to a mere .05% of GDP (as opposed to Friedman’s estimate of 2.5%). So, if the free bankers are correct in their assessment, the resource costs of a gold (or similar commodity) standard need not be so drastic. Thus a competitive banking system under a gold standard does indeed offer the “best of both worlds”—a hard constraint against fiat money inflation, along with a significant economization of the actual resource burden of maintaining a “hard money” standard. In light of nearly all historical experience with fiat money, sound money adherents view this as a small price to pay for the ultimate protection against fiat money inflation. Tyler Watts is an assistant professor of economics at Ball State University. Image by Filomena Scalise / FreeDigitalPhotos.net.