December 10, 2014
Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 7th December 2014. Also, excerpts from our newsletters and other comments on the markets can be read at our blog: http://tsi-blog.com/
Some comments by John Mauldin towards the bottom of a recent article reflect popular opinions about money that can be summarised as: “a growing economy needs a growing money supply” and “there isn’t enough gold in the world for gold to be used as money today”. These opinions reflect a basic misunderstanding about money.
Here are the Mauldin comments to which we are referring. We’ve put notes below each excerpted comment, but the main part of our response is further down the page.
“The current structure of Bitcoin carries the same inherent flaw that gold does (and to some extent the euro, too): in a world of ever-increasing abundance, gold is massively deflationary and provides unreasonable “rents” to those who hold it. Even given that inherent flaw, it has been the most stable store of value for millennia.”
[Our note: The last sentence in the above excerpt contradicts the first sentence, in that gold cannot be “massively deflationary” and at the same time be a “stable store of value”.]
“…if we were to decide to use gold as the sole basis for our currency, we would have to value it at some order of magnitude higher than it is today in order not to create massive deflationary instability. I’m not sure that $10,000 or even $20,000 per ounce of gold would be nearly high enough, given the massive amount of sovereign debt in the world.”
[Our note: There will only be a realistic chance of gold again becoming money after the market has re-valued gold to the point where the price of gold is consistent with the quantity of fiat currency. In other words, once things get bad enough to create sufficient popular support for a return to gold money, no re-valuation will be necessary.]
“But even supposing that we (as a global system) could somehow manage to deal with the logistical nightmare of moving to a single, physical, commodity-backed currency, future growth in the world would soon overwhelm the limited supply of gold, and the prices of goods and services would deflate over time, creating their own backlash. History buffs will recall William Jennings Bryan and his famous cry, “We [mostly referring to farmers] will not be crucified on a cross of gold!”
[Our notes: 1) The prices of goods and services are supposed to deflate over time. That’s a natural effect of economic growth. The computing and mobile-communications industries are classic examples. Where’s the backlash against plummeting prices for high-tech equipment and software? Not from consumers, that’s for sure. And not from producers such as Apple and Google, which are generating huge profits. 2) The election slogan of an economically-illiterate politician cannot rationally be used to support a monetary or economic theory!]
“Now some might see ever-falling prices as a good thing, but they would induce a different type of instability in the system. Given the overwhelming extent of global debt, I think the chances of moving to a physical currency based on gold are slim to none, and Slim left on the morning train. Go back and read the economic history of the latter half of the 1800s in the US. From one point of view it was a golden era of growth and prosperity driven by huge leaps in technology. But it created serious problems for many of those on the lower economic rungs. If you think income inequality is a problem today, then you won’t like what happened in the late 1800s.”
[Our notes: 1) Refer to our recent blog post for an outline of what actually happened during the late-1800s. It definitely was a “golden era of growth and prosperity”, but it would have been better if not for three financial crises. These crises were primarily due to fractional reserve banking and secondarily due to the government’s misdirection of investment (subsidising the building of uneconomic railroads, for example); they were not due to having gold as the basis of the monetary system. 2) Income inequality, per se, is never a problem. Without income inequality there would be no incentive to work harder and smarter or to engage in entrepreneurial activities. The problem is the income inequality that stems from monetary inflation and special (government-granted) privileges.]
“The leaders of that era came together to try to create a new system that could prevent the frequent panics and crashes that were inherent in the financial system of the day, and eventually we got the Federal Reserve and other ostensible improvements.”
[Our note: No, bankers and politicians of that era came together to create a new system that would enable greater balance-sheet expansion by the banks and greater deficit-spending by the government.]
“But that does not mean the current system of central banks and fiat currencies does not have its own flaws. We should not limit our thinking to the economic systems of the past or present as we think about a future economic system. How do we create a truly stable, equitable, and efficient basis for exchange?”
[Our note: There is no “we” that has to sit down and plan-out a new monetary system. The best system will be the one chosen by the free market if the government gets out of the way and banks lose their special privileges.]
The main point to understand is that once something becomes the general medium of exchange (money), any amount of it is as good as any other amount of it. The reason is that the service provided by money, that is, the ability of money to facilitate indirect exchange, isn’t altered by a greater or a lesser supply. To further explain, what the holders of money want is a certain amount of purchasing power, not a certain quantity of monetary units. In terms of the ability of money to fulfill its primary purpose, X units of money with a purchasing power of Y per unit are no better or worse than 2X units of money with a purchasing power of 0.5Y per unit.
By the way, we aren’t saying that an increase or a decrease in money supply doesn’t matter, as major economic problems clearly result from rapid increases or decreases in the money supply. What we are saying is that once something has become the most commonly used medium of exchange, increasing its supply provides no benefit to the economy and is most definitely not required to enable real economic growth.
For a fuller explanation of why any economy-wide quantity of money is no better or worse than any other economy-wide quantity of money, refer to Frank Shostak’s article at http://mises.org/library/how-much-money-should-there-be.
In conclusion, we are inclined to say that money-supply stability is the ideal, but that wouldn’t be completely correct. Although it could reasonably be argued that a stable money supply would be a vast improvement on what we have today, it would not be the optimum situation. For example, the current monetary system is so unstable that maintaining a constant money supply while keeping everything else in place would quickly lead to monetary and financial-system collapse. Instead, the optimum situation would be for the free market to determine what is money and the supply of money. Currently, the government determines what is money, and the supply of money is mostly determined by the ability and the desire of the banking establishment (the central bank and the commercial banks) to create money out of nothing.
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