Why Gold Defined Money Is a Necessary Fix

John Tamny Cato Unbound January 13, 2012

by The Editors The ConversationJanuary 4th, 2012

John Tamny is the editor of Forbes Opinions and RealClearMarkets.com, a Senior Development Associate for the Cato Institute, and a senior economic advisor to both H.C. Wainwright Economics and Toreador Research & Trading. He sends us the following letter, which we are pleased to publish in response to our December, 2011 issue.

“The sole use of money is to circulate consumable goods” – Adam Smith, The Wealth of Nations

The debate about monetary policy has taken an improper turn in recent decades, prompted by a very unfortunate misunderstanding about what money is. To some, the creation of money itself is a driver of economic growth, by putting paper in people's pockets. To others, money only works if philosopher kings from the Commanding Heights are allowed to attempt to control its quantity. To still others, the central bank that oversees money’s issuance should ignore its value, instead seeking to manage the cost of accessing it.

Each philosophy misses the point. Money is not a commodity. It is a concept that facilitates the exchange of goods, all the while serving as a measuring rod that enables economic actors to place value on investments.

Money decidedly is not wealth. In truth, money is a method that enables the trading of actual wealth. Reducing to the basics what is already very basic, my employers pay me to write, to edit, to aggregate the work of other writers, and to raise funds. My earnings then allow me to enter into contracts with landlords who put a roof over my head, carmakers who provide me with transportation, and clothiers whose skills with the needle make me appear presentable. I trade the products of my labor for the products of the labor of others.

But when money's value is unstable, the above description of wealth-enhancing trade loses its basic harmony. That's because while I may agree with my landlord to pay $3,000/month in rent, that same landlord will not get $3,000 in value if the measure of wealth—the dollar itself—regularly changes. Simply put, if the dollar declines in value given an absurd belief that the “tickets” used to facilitate exchange should float, the contract agreed to between the landlord and me is broken. The landlord will get 3,000 “dollars,” but they will be greatly reduced in value.

Conversely, if the value of the dollar rises, those 3,000 dollars I hand to the landlord will be worth more than what we agreed to, which means I lose out in the exchange. It should be no wonder that trade among the world's producers became much less harmonious with the emergence of floating currencies in the aftermath of President Nixon's decision to sever the dollar's link to gold. Whereas trade was once the wondrous exchange of wealth between two individuals, in modern times it has become warlike to some degree, since floating money values ensure winners and losers where there used to be only winners.

Looking at investment, the same applies. To state the obvious, there are no companies and there are no jobs without savings and investment first. As Joseph Schumpeter so correctly noted, there are no entrepreneurs without capital, hence entrepreneurs are wholly reliant on the willingness of individuals to forgo consumption in order to put wealth earned to work with an eye on creating something new.

To simplify a bit, investors are buying future income streams; in our case they are measured in dollars. But when money is allowed to float in value, those presumed future returns take on a perilous quality. Assuming my willingness to forgo consumption leads to actual investment returns, if the dollar is in decline I will get returns greatly reduced in real value. That's why inflation—meaning a decline in the value of the unit of account—regularly coincides with subpar economic growth. Inflation, which is once again currency devaluation, is a process whereby currency issuers make the act of investment a very risky proposition. Again, investment is about the purchase of future income streams, and inflation devalues those streams.

In that sense, money must be stable in value. That is so because absent stability, the investment and trade that produces all economic advancement becomes less frequent. Economic thinkers of the classical era seemed to agree.

As John Maynard Keynes wrote in his Tract On Monetary Reform, the “Capitalism of to-day presumes a stable measuring rod of value, and cannot be efficient "“ perhaps cannot survive "“ without one.” Or, to quote David Ricardo, “A currency, to be perfect, should be absolutely invariable in value.”

And while there's no way to ensure complete stability in monetary values, money defined in terms of gold is the best way to achieve a reasonable facsimile. Gold hasn't been used as a measure of exchange for thousands of years by accident; rather gold was used because it's the most stable commodity known to mankind.

As John Stuart Mill put it in his Principles of Political Economy, “In order that the value of the currency may be secure from being altered by design, and may be as little as possible liable to fluctuation from accident, the articles least liable of all known commodities to vary in their value, the precious metals, have been made in all civilized countries the standard of value for the circulating medium; and no paper currency ought to exist of which the value cannot be made to conform to theirs.”

Mill went on to note that gold and silver are the commodities “so little exposed to causes of variation” thanks to the total quantity in existence “so great in proportion to the annual supply.” In short, gold's real value doesn't change very much, thus making it a great money measure.

Sadly, in modern times we have digressed on the monetary front. Our present Fed Chairman, Ben Bernanke, presumes that the mere creation of money stimulates economic growth. This turns monetary history on its head. Not wealth itself, money is a facilitator. So to simply create it when there's no demand for it is to devalue it, and in the process retard the investment and trade that stable money values foster.

Monetarists, though they claim to be for free markets, presume that wise minds know what the proper quantity of money is. Ignored by them is that no central bank and no bureaucrat could ever control the quantity of dollars (presently two thirds of all dollars are overseas), plus implicit in their thinking is that bright minds could possibly know what the proper quantity should be. This is the equivalent of McDonald's promising to limit the creation of Big Macs to a set number per year. The latter would be easy for planning purposes, but assuming demand for Big Macs rises or falls, McDonald's would either have a great deal of unsold inventory (devaluation) on its hands, or a severe shortfall relative to what consumers desire. Instead, McDonald's adjusts quantity to consumer demand.

Those who believe in interest rate targeting presume that those same wise minds know what the proper price of credit should be. Lots of luck there, and as confirmed by the folly of price controls anywhere else, the end result is too little or too much credit. Better it would be to let markets set the price of credit so that the demands of both creditors and debtors are met by those same market forces through an interest rate achieved in the marketplace.

All of which brings us back to gold-defined money. No human could ever have a clue as to the proper supply of money. Gold serves this function and is the only market based money because it's through the market price of gold that the currency issuer knows what economic actors desire.

Assuming a dollar defined as 1/1000th of an ounce of gold, if the price of the yellow metal falls in dollars, that's a market signal that demand for dollars has risen and that the issuer must buy interest-bearing assets in order to increase the dollar supply. Assuming the reverse—if the price of gold rises—that's a market signal telling the issuer that dollars are too plentiful, and that the issuer must sell interest-bearing assets in order to reduce the supply. In short, it's through the gold price set in markets that the proper supply of dollars is arrived at.

After that, the dollar price stability achieved under such a scenario ensures the greatest amount of trade and investment possible. Investors will know that delayed consumption will be rewarded with dollars returned that have held their value. As for those seeking near-term consumption and trade, they'll know that the dollars they receive for the goods offered will not be lower in value after the transaction occurs.

Since 1971 the United States and the rest of the world (no matter what people say, we remain on a dollar standard of sorts) have suffered the constant uncertainty wrought by gyrating currency values that has predictably led to frequent financial crises driven by the malinvestment that always results when money has no definition, as predicted by the Austrian School. To fix this we must return to stable monetary values, and while gold is not perfect as the definer of money, it's the best we have.

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This entry was posted on Wednesday, January 4th, 2012 at 9:44 am and is filed under The Conversation.

Why Gold Defined Money Is a Necessary Fix

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