Counting Cats in Zanzibar Rotating Header Image

Medium of exchange

Tell me, a matter to be addressed in a libertarian society -

All fiat currencies inflate, it is in their very nature. It matters not if they are created by men of the utmost strength, probity and integrity, eventually the weak, mendacious and meretricious will gain control, theft will become the order of the day, and the currency will inflate, sure as God made little green apples.

Who cares whether the inflation rate is 2% or 20% per annum, the principle is the same.

Still, simply declaring that more currency exists today than existed yesterday does ensure there’s liquidity in the economy.

On the other hand, take a hard currency backed by, or even composed of, a scarce commodity. Lets take, for instance, just at random you understand, a currency made from, say, minted gold. Is there enough of the stuff to satisfy all transactions? I would suspect not.

Wouldn’t using gold, or any other scarce commodity, as the basis of exchange result in a massive currency shortage? Resulting in both deflation and a chronically, although not perpetually, depressed economy? Every time the economy started to take off it would be brought to a shuddering halt simply by there not being sufficient currency available to support increased expenditure.

Even if other and more common commodities, silver, copper, salt, potato crisps, were used to bulk out the currency, relieving the shortage and used for low value exchanges, we have the same problem. A fixed rate of exchange between commodities would have many of the characteristics of any other fiat currency, but a free rate would be hellish – continually fluctuating prices in multiple commodities.

What is the solution? If any?


  1. BPE says:

    I think it was Murray Rothbard who pointed out that in a market where prices can adjust freely, the supply of money is always sufficient to allow trade – the exchange value of each monetary unit (pound, ounce, whatever) will fluctuate with supply and demand for money sufficient to clear the market of whatever people want to buy and sell.

    If the economy grows against a fixed supply of commodity money the increased demand for money to cover the extra trade will force up its price versus other goods – in other words we would experience price deflation. Yes prices would fluctuate over time, and there would occasionally be hefty corrections, but how is that any different from now?

    As to the larger economic effects of commodity money, well we somehow managed both the agricultural and industrial revolutions on a commodity money system (although there was a bit of fractional reserve banking going on) and the Dutch certainly weren’t complaining in the 17th and 18th centuries when the Bank of Amsterdam was famous for 100% gold backed banking.

    I think it would probably slow growth somewhat as deflationary systems penalise borrowing – on the other hand that would also suppress speculative debt bubbles of the kind we have just experienced. Depends whether you want slow(er), steadier growth versus fast growth and a recession every now and then.

  2. Peter says:

    I recommend reading Selgin’s tract ‘less than zero’. It is great stuff and I believe its free on the IEA website.

    Some answers: while under the gold standard gold constitutes the ‘base currency’, commercial banks in a free banking system (or the central bank under a gold standard) would be free to issue currency only partially backed by gold. While this could cause trouble if everybody wanted their gold from the bank all at once, this is unlikely and normally gold reserves were less than 5% of the redeemable currency. The remaining 95% would be backed by the bank’s loan book. While the loan book is relatively illiquid it still has value in a real sense.

    If we assume that the gold reserve ratio stayed the same, and the velocity of money stayed the same, then indeed, economic growth would have to be facilitated by deflation (by the mv=py identity). As long as the economic growth is due to technological progress this is not a problem however. Also, the relative scarcity of gold would also have an impact (which is one reason why it makes less sense to have a gold standard if you are the only one doing it)

    I recently listened to an econtalk podcast and apparently Hayek explained the great depression as having its root in excessively loose monetary policy (sounds familiar). In the 20s the US saw large price falls due to technological progress. The US central bank was obsessed with stabilising the price level so tried to do this by injecting money into the economy. This lead to a fall in interest rates and a surge in ‘malinvestment’. When the bubble burst and lots of banks started failing the central bank did not try and bail them out, but rather focused their attention on maintaining the link with the gold standard (abandoned a few years later under Roosevelt). This excacerbated the crisis. Imagine the central bank trying to fight the recent financial crisis with the policies of black monday, when we were trying to stay in the European exchange rate mechanism by raising interest rates to god knows what. Anyway, I digress

    Personally I would favour a currency base of a basket of real assets (gold, guns, cans of tuna). While this would tie up useful resources, there is nothing that would prevent the assets being lent out. The bank would instead of holding gold have a claim on gold. Still a real asset; not a pound sign in site, just grams.

    Read Selgin. Illuminating stuff.

  3. Ed says:

    Deflation is a feature, not a bug. It allows more widgets to be bought and sold for the same amount of currency than a year, or 10 years, ago. People who object to deflation should be forced to use 1950′s computers and 1970′s mobile phones :-)

  4. CountingCats says:

    Ed, but deflation also discourages investment and production. Think of the poor schmuck who has an inventory on hand of steadily decreasing value.

    Although, that is a problem already faced by any modern manufacturer or supplier of digital goods.

  5. Plamus says:

    Cats: “… deflation also discourages investment and production.”

    Cats, the only support for this is the Keynesian derivation of demand for money, which is somewhat complicated, but I can dig up my notes from Macro 101 if you are interested – summarized as, well, people will hold on to money, since it appreciates, and will not spend it. Key word: “spend”, not “invest”.

    Point one: empirical research (example) shows it’s inflation that hurts growth. Economies can grow just fine with deflation, e.g. the US between roughly 1860 and 1900.

    Point two: investment decisions are made based on the real interest rates, not the nominal ones. Assuming for simplicity that real interest (r) is equal to nominal interest (n) minus inflation (i), the relationship is r=n-i (actually it’s r=(n-i)/(1+i), but the approximation is okay as long as inflation is not high). Now, in order for saver Cats to invest in a project by producer Plamus, Plamus must pay to Cats interest – real interest, not nominal. The real interest Cats demands is the same whether i is positive or negative. Only the nominal interest n is affected, and is lower under deflation.

    Now, Keynesians will tell you that Plamus’ potential customers will hold on to their appreciating currency, and spend less, thus Plamus’ project will be less profitable, which is plausible, even if empirical evidence (scarce as it is) does not bear it out – the plural of anecdote is not data. However, those same customers are… other Cats (Catses?), who are on the lookout for investment projects by other Plamuses, if those can return more than the rate of deflation. If anything, investment is likely to be boosted, arguably to the detriment of consumption, and this possibility throws Keynesians into conniptions. But wealth is built by saving and investing, not by consumption, and no magic like the “paradox of thrift” that Keynesians try to pull over you. No investment – no capital accumulation – no wealth.

  6. Plamus says:

    Gah, sorry.. “and no magic like the “paradox of thrift” that Keynesians try to pull over you” – add to this “can change that”.

  7. John B says:

    As Mises pointed out you can only exchange goods and services for goods and services.
    Money is only, ever, a representation of wealth.
    The money is incidental.
    BPE, above, is correct.

  8. El Draque says:

    If fiat currencies always inflate, what happened in Japan the last 20 years? The nominal value of the GDP is exactly the same.

    Rather more interesting is the question what is the right size for a region using the same fiat currency.
    I suspect as follows: the larger the area, the more problems arise. More unequal distribution of wealth, more people struggling to get by, more super-rich. More debts in regions that can’t compete, etc.
    The area using the euro is already too large, I think. They thought they were creating a European dollar, but they are actually getting the European rupee.
    Consider, too, that the euro system of main central bank with smaller subsidiary central banks, is actually based on the system used by the USSR to manage the rouble.
    That worked out well didn’t it?

  9. Current says:

    I agree with Peter, I think Selgin in basically correct. We need to allow free banking to come back into existence. The amount of gold or whatever other currency available isn’t so important.

  10. Andrew Duffin says:

    So how did we manage in Victorian times then? Was the pound not fully backed by gold then, and did prices not gradually fall for several consecutive decades?

    I have not heard that the economy tanked in the 19th century; indeed, looking around at all the wonderful Victorian buildings* in Glasgow, Paisley, and even (yes!) Govan, it seems to have been an era of confidence and progress – as history tells us it was.

    ianae, so perhaps one of you clever devils can square this circle for me.

    * all now, alas, falling into disrepair and ruin, since we choose to spend our much greater wealth on 5-a-day co-ordinators instead of investing it in useful infrastructure…

  11. Paul Marks says:

    First my standard rant – please people do not confuse a gold “standard” (i.e. lots of bits of paper, notes, drafts etc – supposedly “backed” by gold) with gold-as-money or with any commodity as money.

    However, do not fear I am not going to be a Senator Benton over this (look him up – do not fear, he is long dead and will not challenge you to a duel).

    Anyway more economics.

    “It does not matter if the rate of inflation is 2%” – actually, if by “inflation” you mean price rises, it does not matter if there is no “inflation” (in the sense of price rises) at all.

    A credit money bubble is still a credit money bubble – it is still borrowing that is not from real savings (and, contrary to Keynes, monetary expansion is not “saveings”).

    Such a bubble distorts the capital structure of the economy by existing – and it must also burst (sooner or later).

    “Not enough gold” or silver (or whatever people choose to use as money).

    Well it would be unlikely that people would choose to use as money what they can not get their hands on – so why not leave it to voluntary agreement?

    However, say gold was money, with all the Pounds (or Dollars – or whatever) divided by the gold reserves that the government has.

    Well yes a Pound would be worth a tiny speck of gold – but (for example) a twenty Pound note could still be used as long as there really was a speck of gold kept in a vault to represent it (please no “standard” con at this point – i.e. a pretence that gold was money masking credit money expansion, as in the late 1920′s).

    Alternatively (as with the science fiction works of L. Neil Smith) you could actually use the speck of gold in every day exchange.

    Put into a clear plastic coin – marked with how much gold can be seen in the coin.

Leave a Reply

%d bloggers like this: