Counterpoint – Is Fiat Money better than the Gold Standard?

So here’s the rebuttal from the other camp. A comment I received on my previous post Printed Money, Gloom to Doom was from a friend who urged me to look at the opposite view. He said – “Sunil, I’m afraid you’re completely off the mark on money”.

There is no intrinsic virtue to the gold standard. The true basis of any currency is the productive capacity of the economy where it is printed. This has nothing to do with the quantity of gold held by the country. Your credit card issuing bank creates money when it gives you credit. The real issue is when the money supply goes out of kilter with the supply of goods and services in the economy. Right now, inflation is not a problem. Deflation is the threat facing the developed world. The US is tackling that by loosening money supply.

Here, let me help you get on the other side of the debate – “Fiat money is better than the Gold Standard”. The question is why.

1. The inflation vs. deflation issue. This analysis by Mike Moffatt gives some explanations.

Colin Asher, an economist at Nomura Securities, told Radio Free Europe that the problem with deflation is that

“in deflation [there’s] a declining spiral. Businesses make less profits so they cut back [on] employment. People feel less like spending money. Businesses then don’t make any profits and everything works itself into a declining spiral.” Deflation also has a psychological element as it “becomes rooted in peoples’ psychologies and becomes self-perpetuating. Consumers are discouraged from buying expensive items like automobiles or homes because they know those things will be cheaper in the future.”

Mark Gongloff at CNN Money agrees with these opinions. Gongloff explains [the deflation spiral] – 

“when prices fall simply because people have no desire to buy — leading to a vicious cycle of consumers postponing spending because they believe prices will fall further — then businesses can’t make a profit or pay off their debts, leading them to cut production and workers, leading to lower demand for goods, which leads to even lower prices.”

Mike Moffatt goes on to explain inflation thus –

Because inflation is a rise in the general level of prices, it is intrinsically linked to money, as captured by the often heard refrain “Inflation is too many dollars chasing too few goods”. To understand how this works, imagine a world that only has two commodities: Oranges picked from orange trees, and paper money printed by the government. In a year where there is a drought and oranges are scarce, we’d expect to see the price of oranges rise, as there will be quite a few dollars chasing very few oranges. Conversely, if there’s a record crop or oranges, we’d expect to see the price of oranges fall, as orange sellers will need to reduce their prices in order to clear their inventory.

2. The value of money as a function of the productive capacity of the economy.

This issue is the real killer. It takes us back to the era that I call the ages of “Commodity Commerce”. Pre-Internet, Pre-globalisation, Pre-outsourcing … relative to today I might even all it Pre-historic. In the past there was a great divide between the developed world and the developing world. Globalisation, facilitated largely by the information revolution, has been slowly closing the gap and now America (or any other state) cannot afford to continue on an inward focused economic strategy.  

The questions I am asking are those that push mental boundaries.

  • In terms of goods and services, what is the true productive capacity of developed economies and at what costs?
  • Is there a market for the above beyond their own borders?
  • Can the goods and services be produced more cost-efficiently by other economies?
  • What is the total size of a the global economy and what fraction of this size is accounted for by erstwhile markets, viz. US, EU, UK?

Because productive capacity by itself has no meaning unless there is a corresponding demand for the goods and services. This is perhaps the key reason for economic interventions to increase or decrease the value of money through regulatory mechanisms. I am not an economist (thankfully) but I do understand supply and demand. And my naivete tells me that sitting on higher capacities that the market does not need, creates a situation of extra supply and therefore reduces the value of money.

This brings us to the moot question of whether fiat money is beneficial as an instrument of keeping money value at its right levels.

From this article: Debunking The Gold Standard: The Myth of Stability

Critics of the fiat system question what motive such a government has that would compel it not to simply print money as it sees fit, thus inadvertently destroying overnight the value of its own currency. Gold or silver, by comparison, can not be simply produced, and thus acts as a natural check upon this assumed tendency to expand the money supply without consideration for the hyper-inflationary pressures such a move would have.

The problem with this argument is not one of its accuracy, but rather a matter of degree. A fiat system is more prone to governmental expansion of the money supply, but such expansion is neither unique to it nor a probable course of action for its economic governors. A gold based system is less prone to hyper-inflationary tendencies, but by no means immune from them and, as demonstrated under Bretton Woods, is less able to respond to rapid changes in the market. As such, the opposition between Gold Standard and Fiat is neither a binary one nor nearly so clear cut in its costs and benefits as laid out by critics of the existing system.

An obvious advantage of fiat money is the speed at which economic corrections can be made. For one, you don’t have to wait to mine more gold if you need to ‘stabililse’ the value of money. You do not have to transport material in exchange for what you want to buy. It is a convenient exchanging mechanism for expediting trade and commerce within an economy and across the world. But since history has shown us several repercussions of misuse of the ‘conveniences’ the system provides, it needs to be checked and controlled. One of the ways to check and balance could be a simplistic combination with the Gold Standard. Some way to make the monetary systems less binary.

Glad that a live debate has started. And it’s global. Because it affects all of us and not just America.


Summary:

This post is a counterpoint to evangelising the Gold Standard and looking for a new monetary system that’s less binary. Fiat money tied to something tangible as a check and balance is a possible way to innovate the new global monetary order.

Reblog this post [with Zemanta]
Advertisements

3 Replies to “Counterpoint – Is Fiat Money better than the Gold Standard?”

  1. You can either click on the link above Misconceptions about Gold – Part 2 or go to Why Does Fiat Money seemingly work?.

    I’m getting more and more convinced that this either/or way of thinking is not going to work. This is what got us into the current predicament in the first place, don’t you think? I am reminded of a quote attributed to Einstein –
    “We can’t solve problems by using the same kind of thinking we used when we created them.”

    Like

  2. Hi, I’m trawling blogs to see what people have to say about Fiat Monetary regimes. I’d like to contribute my opinion to your debate.

    I am not overly concerned to find out whether a metallic regime or a fiat is better. Both serve a purpose and both are subject to debasing and gaming.

    What is different is that a fiat monetary system allows much greater flexibility in the form of leverage. This greater flexibility translates into a capacity to postpone the business cycle at the cost of a much more severe bust later.

    In a metallic monetary regime money supply can only be expanded by employing more human and productive capital. That is, you have to locate the metal, then you have to extract it, then transport it and refine it and then distribute it. Therefore, a metallic monetary system, by necessity, can only be expanded if the rest of the economy is expanding.

    Conversely, in a fiat monetary system, politicians and bankers can expand the monetary system and credit at will and at very little cost. Inevitably, this means that any crisis will be met with deliberate inflation of the money supply and credit thus temporarily altering the business cycle.

    Thus, in a metallic monetary system the expansion of the economy is constrained by the supply of metal. A fiat monetary system on the other hand, allows for far greater rates of expansion.

    But…. there is a but and it is a fairly large BUT.

    Artificially and aggressively inducing inflation in an economy without pause, does have limits.

    The limit is reached once the underlying economy is unable to generate sufficient income to service the debt.

    At that point, deflation must and will set in.

    During the inflationary cycle, corporations and individuals take on ever greater debt which in turn sustains the nominal values of assets.

    At some point, revenue streams may no longer enable corporations and individuals to service debt. At this point, some assets have to be sold to diminish the debt burden or extinguish it.

    However, in an economy that is 80% “services”, the question of how much tangible wealth is in that 80% is vital because only wealth that can be sold onwards can be used to diminish the debt burden. In other words, holidays, restaurant meals, vehicles, consulting services, or massage therapy may not be sold onwards once purchased and used the first time.

    Therefore, at the point at which revenue is no longer sufficient to cover debt service, corporations and individuals must dispose of whatever tangible assets they may own.

    When debt burdens are in the six figures, there are few assets other than real estate that can help diminish or extinguish debt.

    As the quantity of assets sold increases, underlying values initially hold up but eventually as more entities hit the debt service limit, demand wanes and asset values follow.

    Deflation is not so much a psychological event whereby people “don’t spend” because they don’t feel like it or because they think they can get lower prices. Deflation sets in once total wealth is no longer sufficient to cover the outstanding debt. As corporations and individuals start selling assets in an attempt to diminish the debt burden, they incur losses. These are real losses not perceived losses. So their unwillingness to spend isn’t psychological at all, as much as it is material.

    Like

    1. Your views are very insightful. Thanks for your detailed analysis. As you rightly point out,

      “Deflation sets in once total wealth is no longer sufficient to cover the outstanding debt. As corporations and individuals start selling assets in an attempt to diminish the debt burden, they incur losses. These are real losses not perceived losses. So their unwillingness to spend isn’t psychological at all, as much as it is material.”

      This defines the current state of the US economy which has been accelerated by uncontrolled hyperinflationary measures, without understanding the on-ground damage that successive “fiat” corrections have caused.

      Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s