The scientific method prescribes the use of open debate among both the believers and dissenters of any particular theory in order to fully test its soundness. Even though economics is not one of the “hard” sciences the scientific method retains its use as a measure of soundness. For economics, however, we utilize sound logic as opposed to empirical testing but are still able to derive immutable laws from our inquiries.
Unfortunately, open debate is a rarity. Debate is typically discolored with personal attacks and logical fallacies in an attempt to evade directly answering disliked claims. One such example is the argument over the role of commodity-backed money in the modern economy. Typical opponents of commodity money will include everything from being unable to eat the backing commodity to the inability to expand the quantity in circulation at will in their emotional resistance to a logical theory which runs contrary to their deeply held ideologies. Let us look at the various arguments for and against this type of system in an objective and logical fashion.
THE SYSTEM DEFINED
In order to properly set the stage for discussion, let us define exactly what is meant by “commodity money”. To begin with, commodity money is not synonymous with national currency or government produced money. Many nations throughout history have produced a commodity-backed currency but the differences will be outlined shortly. Commodity money is any medium of exchange which may be redeemed for a fixed amount of a specific physical commodity by the holder at any point in time.
The vast majority of the world today uses a form of currency which is considered valuable primarily because of its status as official currency of a specific nation. For example, the U.S. Dollar is widely accepted within the political boundaries of the United States because businesses and individuals are required by law to accept this method of payment. It is also highly sought in foreign markets because of its petrodollar status, due to the remnants of the Bretton-Woods agreement, and because of the large numbers of businesses and individuals who accept it as payment. Unfortunately, as much of the world is only now coming to realize, there is very little incentive to restrain government spending and/or expansion of the money supply using fiat currency.
Fiat currency is a medium of exchange which obtains its value solely from government decree. In other words, it can only be exchanged for items which another person is willing to trade to you. The “willingness” of individual actors within the economy increases dramatically with legal tender laws which require them to accept fiat currency as payment. Even with legal tender laws in place, the history of fiat currency always ends in hyperinflation and an end to that currency. Therefore, commodity money is simply a representative of a physical asset while fiat currency is a representative of nothing but a government decree.
The expansion of commodity money is limited by the physical supply of backing material. Since there is a finite amount of precious metals (which are most commonly used) there will always be a similar finite amount of commodity money lacking fraud and counterfeiting. No matter how much a government or bank desires to do so, it cannot alter or cease the laws of economics; this is why fiat currency always fails. However, if a government has enough power over the education of its citizens and the flow of information then it is possible to fool a large enough percentage of the population into believing false laws and thus propagating a fiat money system for extended periods.
Unfortunately for us, the laws of economics do not manifest themselves as simply and visually as many of the laws of physics which leaves plenty of room for abuse. As such, the very physical limitation which makes commodity money so much stronger than fiat currency is often claimed to be a detriment. They allege that the sometimes-rapidly-expanding modern economy in which we live would be restricted by a limited money supply. Admittedly, this seems rather plausible based on typical education received regarding the role of money. However, this assertion is as false as the ability of the government to suspend the laws of economics.
The key point to remember is that money is simply a commodity. It is unfortunate that so many governments are clueless regarding market operations and simple economics which has resulted in a massive skewing of currency but it still remains a commodity. For example, without money we could sell some of our labor to the farmer in return for food, some more labor to the tailor for clothes, and more labor to the landlord for housing. Alternatively, we could attempt to exchange goods for goods (i.e. barter) if we happened to possess something which was desired by the other party. Obviously this is highly inefficient and was replaced thousands of years ago with money. Money simply allows us to exchange goods for an intermediary good – money – which we then use in exchange for those goods we highly desire. In other words, money allows us to quantify the goods on the market in direct relation to each other.
So what does this have to do with physical limitations on the quantity of money? The laws of supply and demand tell us that, ceteris paribus (all other things remaining equal), an increase in the supply results in a lower price. This phenomenon applies to money no differently since it is simply another commodity available on the market. As a result, when the quantity of money available increases without an offsetting increase in demand the price of money will decrease. But what is the price of money? A price is simply a quantifiable exchange ratio between two goods. This means that if the price of money is going down its value is going down in relation to other goods which results in more money required to purchase the same amount of goods as could be purchased previously. Or in economic terms, inflation.
A policy of continual inflation is encouraged by many economists today partly because they realize the impossibility of accurately matching an increase in the money supply to economic expansion. There is no exact relationship between money supply and economic expansion because the relationship is entirely arbitrary (e.g. an expansion in the economy by $1 million does not necessitate the increase of the money supply by $1 million). Many people reminisce longingly for the days when gasoline was a quarter and hard candy was a penny. What they do not realize is that in real terms, many prices have actually decreased but this decrease is hidden through inflationary symptoms (the opposite is, of course, true as well).
Commodity money, then, restricts the expansion of the money supply by arbitrary and political means. Since each piece of currency in circulation is redeemable for a specific weight of commodity the issuer(s) must limit the production of currency. Whether the specific ratio of outstanding currency to commodity is 1:1 or 10:1 is a matter of business strategy and market cues. In all cases, though, the market can expect a very stable quantity of outstanding money over time.
The typical argument now migrates to a focus on the alleged volatility of precious metals. This accusation rests entirely on measurements in fiat currency and is completely baseless. Commodity money opponents fail to realize that every commodity traded in open markets experience price fluctuations. These variances are even more apparent when dealing with agricultural goods for which price is heavily dependent upon total production as a result of environmental conditions. What is not quite so easy to measure and visualize, however, is the volatility of fiat currency. After all, how are market participants to know whether the price of widgets increased or the price of dollars fell since they both manifest in exactly the same way: a higher price?
Ultimately, commodity money is capped by the laws of physics. Retailers and producers will be able to reliably set prices measured in commodity mass due to the essentially fixed quantity of money available in the market. If the value of money becomes higher than the marginal use of the backing commodity (e.g. gold) then people will begin to sell gold for money thus driving the price of gold down and that of money up. Or, should the market view an excessive supply of money they will begin demanding commodity redemption (e.g. gold) which will have the effect of increasing the price of money and decreasing that of gold. In all cases, the total supply of money will remain in a very limited range barring an invention which turns straw into gold (or other precious metal).
Some will ignorantly claim that gold has little or no intrinsic value; you can’t eat it, you can’t wear it, and you can’t live in it (although the latter two are obviously false assertions). According to Merriam-Webster, intrinsic is defined as, “belonging to the essential nature or constitution of a thing”. In other words, the value of an object is derived from the object itself and has nothing to do with subjective perception. The problem with this viewpoint is that value itself is a purely subjective concept.
How much a particular good is valued is based solely on an individual’s perspective. I might place enormous value on a drawing which my son created while most others would place very little or no value on the drawing as a piece of art. Similarly, I might place very little value on a bottle of water while I am in my home and yet would place much value on the same bottle if stranded in the desert. Value is determined completely and solely due to the perspective and situation of each individual. Prices, subsequently, are derived from the subjective valuations of many individuals considered in the whole.
As mentioned previously, many nations throughout history have produced a commodity-backed currency with abysmal results. This leads many would-be economists to believe that any attempt to create a commodity money will result in failure. These naysayers ignore the intensive meddling in market prices which would be nonexistent in a free-market alternative. Let us consider the U.S. Dollar as an example.
The Coinage Act of 1792 authorized the U.S. Mint to product a wide variety of coins, all of which were denominated in dollar units. The problem was that they not only attempted to establish the official price of certain weights of silver and gold, but that they also created a de facto exchange rate between the metals. For instance, the Dollar itself was defined as 371 4/16 grains of pure silver. So, $1 = 24.06 g silver or $1.38 per ounce. But they also defined the $10 Eagle as 247 4/8 grains of pure gold. So, $10 = 16.04 g gold or $17.68 per ounce. This gives an official exchange rate of silver to gold at 1:12.8. As you can see already, a person would be able to accumulate silver Dollars and exchange them for gold Eagles and profit $2.80 per exchange.
The proper (and free-market) method of commodity money creation would be to specify the value of each bill in mass alone while allowing the market to establish exact prices. In this manner, Acme Bank could produce a wide assortment of Acme Notes which customers could use as the market fluctuations found most efficient. They could perhaps produce 1 ounce gold notes, 1 ounce silver notes, 1 grain gold notes, 1 grain platinum notes, et cetera. However, with exception to the brand (i.e. bank name) imprinted on the note, it would be devoid of any specific price because it is the market which values commodities. In this manner, market prices would be indirectly based off of commodities which are absolutely limited in quantity by the laws of nature, and thus much less volatile and uncertain than fiat currency.
Despite claims of commodity money being an “archaic theory” and “antiquated method”, gold and silver have been the hands-down primary choices in money for thousands of years. The attempts to control the laws of economics by contemporary economists aside, gold and silver will continue to be the primary selection for “honest” money for years to come.