Topic: Monetary Policy
The Purpose of Money and the Dangers of Fiat Currency Money is a tool: a means of exchange, a standard unity to measure value, and a means to store wealth. There are certain dangers associated with money being limited to a fiat currency. And if the Federal Reserve's inflationary monetary policy was more widely understood, people would demand a return to sound money.by Nick Sheedy
(libertarian)
Tuesday, November 3, 2009
Most people seem to treat money as if it were an object. And for most people, money is an object, or to put it better, acquiring money is an objective. But in reality, money should not be viewed as an object, but rather as a tool. Money serves three main purposes: as a medium of exchange, as a unit by which to measure economic value, and as a means by which to store wealth.
Medium of Exchange One purpose of money is as a medium of exchange. Most people recognize this, and if you asked someone on the street what the purpose of money is, they’d probably say something like, "to buy stuff with." Well, that correct, but it is not the only purpose.
Unit to Measure Economic Value More importantly, money serves as a unit by which to measure the value of all goods and services in an economy. By creating a standard unit of economic measure, we can easily compare the value of different goods and services. Using money as a measurement, we can have a pretty good idea how much our labor or work is worth, and what it will cost us to buy food, clothing, building materials, fuel, and anything else—and it is relatively easy to compare the value of each of these, and manage our budgets accordingly.
Without money, however, we would be stuck with a barter system. For a chicken farmer who wants to build a new barn, he would have to know how many eggs he needs to trade for lumber. And that will be different for different lumbermen according to their need for eggs or who they might know who would want to trade eggs for something else they want. How many eggs is a pound of nails worth? How many pounds of nails would it take to buy a car? How many cars would you need to trade for a house? How many pounds of beef could you buy with your piano? Without money as a standard unit of measurement, the barter system can be rather capricious, and the value of goods and services might vary wildly depending on what each trader needs at that moment, and how perishable the commodities are.
Maybe one board is worth two dozen eggs to the lumber man, and the egg farmer is willing to pay it. But say the farmer needs five-hundred boards; that means he would have to trade a thousand dozen eggs for the lumber to build his barn. Can he get a thousand dozen eggs together all at once? And even if he can, what is a lumber man going to do with a thousand dozen eggs? If he doesn’t need them, he certainly wouldn’t trade for them! And so this touches back on the use of money as a medium of exchange, but it also leads to the third purpose of money:
A Means to Store Wealth All wealth is fleeting to some degree. The value of most goods, and certainly all services, is not permanent. Agricultural products are all perishable. While some grains will store for years, and there are numerous methods to preserve food for a good while, most food will spoil in a relatively short time. The apple farmer might keep his produce for a couple months, and an apple might even become more valuable to a consumer a couple months after the harvest, but in a relatively short period, his apple crop will become worthless as a commodity. And of course, once food is purchased and consumed, it has no more economic value.
The same with energy: what is a gallon of fuel worth? What’s it worth after you burn it? (The only way a consumable good might create economic growth is by adding value to a product that has lasting economic value—but that is a topic for another day!)
Beyond food and other agricultural products, most other goods are also perishable. Even so-called durable goods like refrigerators and television sets will wear out eventually—some sooner than others. Clothing gets worn out, automobiles eventually fall into disrepair, furniture will eventually break or get ruined. Even real estate improvements will eventually lose their value. Land itself may increase in value because supply is static and demand rises, but buildings and other improvements are under constant pressure from the elements: wood will eventually rot, mortar, brick and stone will crack, glass will break, and metal will bend. While a building enjoys more enduring value, it requires continual upkeep and maintenance. The only class of commodities that might be regarded as not being perishable are metals, but even iron will rust, and other metals might not be recycled continually with 100% recovery.
But metals have the distinction of being the least perishable commodities, and so it is no surprise that the acquisition of metals—e.g. gold, silver, copper, etc.—has been a means to store wealth since prehistoric times. In some economies, shells, precious stones, or other items have been used as a type of money.
Without a means to store wealth, we would be vastly limited in our economic prosperity. The farmer’s fortunes would be limited to how long his produce keeps for market. The lumberman’s boards will eventually rot. The man with a car lot will eventually have piles of rusty sheet metal. And the laborer would have no way to capture the value of his work. He would be forced to live from hand to mouth, bartering his labor for his daily needs, but never able to save up the fruits of his labor.
And so there you have it. Money provides these tools. Money is the unit by which we measure the value of goods and services in an economy. Money provides a standard medium and facilitates exchange. And it allows us to trade our goods and services for something tangible that will endure. Even if it is just a piece of paper, if its value is agreed upon and is relatively stable, it will serve as a means to store wealth.
A Problem with Fiat Money For most of human history, money has been coined, not printed. And even when currency was printed, it was not actually money. For instance, most printed currency in the United States was merely a note that was redeemable for gold or silver (called "specie"). The gold and silver was legal tender—that is gold and silver was actually money. Currency was merely a note that was intended to represent the specie. From time to time, governments have issued paper currency without backing it with any commodity. The revolutionary colonies printed "Continentals", and during the American War Between the States, the U.S. printed "Greenbacks." But for most of this country’s history (and indeed the long history of civilization), most legal tender has been in the form of gold, silver, copper or other coin, or measured by metal bullion.
With the creation of the Federal Reserve in 1913, we started to see a momentous shift by large banking interests to create a system of fiat money. In 1934, when the federal government confiscated all privately-held gold in the United States, the value of the U.S. dollar was defined in terms of gold, being 0.048379... troy ounces of gold per dollar (or $20.67 per troy ounce of gold). Even after this, and up until 1972, the value of the dollar was defined by law in terms of gold. But after a half-century of money-manipulation, the bankers finally got their way, and the value of the U.S. Dollar was allowed to be determined by other means.
Now, let’s back up about 200 years. The statesmen of the young United States realized the dangers of fiat currency. They saw the value of the "Continentals" printed during the American War for Independence evaporate in short order. For this reason, when they drafted the U.S. Constitution in 1787, they specified that no state shall make anything but gold or silver legal tender. Furthermore, they vested the power to coin money and regulate the value thereof specifically in Congress—and up to 1913, Congress exercised this power without much problem. Then they created the Federal Reserve, and the power to regulate the value of money began to shift from Congress to this banking cartel.
I call the Federal Reserve a banking cartel, because that is what it is. It is a quasi-public entity, chartered by Congress with certain duties and responsibilities, which has been granted a monopoly on managing the money supply in the United States. But it didn’t happen all at once, because at the time it was created, gold and silver were still legal tender, and U.S. treasury notes were still redeemable for specie at a fixed value. It took the crisis of the Great Depression to allow the confiscation of all privately-held gold in the country and replace it with fiat currency, Federal Reserve Notes, which is what we have today. (This is a subject worth a very thick book.)
So we might ask: What is the value of the Federal Reserve Notes in your wallet? Well, the value now fluctuates daily, hourly, by the second. Money traders and banking houses now manipulate the value of currencies all over the world. Since its inception, the monetary policies of the Federal Reserve have created constant fluctuation. But over time, it results in continual inflation: what $1 buys today would have cost less than 5-cents in 1913. But except for a few periods of rampant inflation, this devaluation of the dollar has been relatively gradual, so maybe it isn’t such a big deal.
Who is Favored by Inflation? Now to be sure, some people are favored by an inflationary monetary policy: debtors, for instance. If I owe money to someone, and inflation occurs, when I end up paying that money back, it is worth less than when I first borrowed it, and may be easier to get. But then of course, there is interest, and the lender must be assiduous to make sure the interest is enough to ensure a profit after considering inflation. And if dollars are worth less in the future, that means I’ll have to make sure whatever line of work I am or whatever products I produce, my income at least keeps up with inflation, if I am to pay back that loan, the interest, and come out ahead.
Another benefactor of inflation is the government’s collection of taxes. When you buy or sell anything, the IRS makes you determine your capital gains by subtracting the base value from the gross sale price (and perhaps subtracting other associated costs). Let’s use an example: say Mr. and Mrs. Peterson bought a house in 1970 for $35,000 and they sold it in 2000 for $155,000. Their profit, for tax purposes, was $120,000. At a 15% tax rate, they owe $18,000 in capital gains taxes. But what did the value of the dollar do in those 30 years? Well, there are a number of things you might compare: the consumer price index, average annual wages, the value of a commodity like silver or gold, etc. Let’s just use the U.S. Bureau of Labor Statistics’ Consumer Price Index. It says that $35,000 in 1970 dollars would be equivalent to about $155,000 in 2000 Dollars. So, if the dollar lost so much value that it takes $155,000 in 2000 to buy the same amount of goods and services as $35,000 in 1970, what was Mr. and Mrs. Peterson’s actual profit? What they had to sell and work for the buy the house in 1970 is actually equal to what they would have to sell and work for to by the same house in 2000! Realizing the inflation of the Dollar, there was no actual profit! But to the IRS, Mr. and Mrs. Peterson owe $18,000 in taxes (in 2000 Dollars). And so there’s one example of how inflationary policy favors government tax collection at the expense of tax payers.
But other people benefit from an inflationary monetary policy: the people who get to spend the new money first. When the money supply grows faster than the aggregate of all the goods and services in an economy, the result is inflation. But when new money is printed, the person who spends the money first gets to enjoy the value of that cash before the general value of the currency decreases. And so who is it that usually spends that money first? Banks. Those who borrow new money from banks. Government. Contractors who are paid by the government. These are the folks who realize an advantage by spending the new money before inflation occurs from the increased money supply.
And there is a third class of people who benefit from a monetary policy that allows the value of money to fluctuate: banks and money-traders. As I will explain with an allegory, while over the long-term tendency is for inflation to devalue fiat currency, in the short-term the value of a given currency might go up and down. This allows for clever traders to capitalize on these exchange differences, acquire when the exchange is down, and trade when it goes up, and pocket the difference. Such trading activity does nothing to add value to the money, nor does it create any wealth or contribute in any positive way to economic prosperity. But it is a simple way to make a profit, and a small percentage of this exchanged money is continually skimmed by the banks and other money-changers.
Alrighty. Now we get down to the nitty-gritty. Why should we care that the Federal Reserve and a bunch of money-changes are determining the value of our dollar based on their control over money supply and the way they exchange our money with each other and for other currencies?
Well, for one, the U.S. Constitution stipulates that power to regulate the value of money is vested in Congress. In defense of the Federal Reserve, someone might say that this power has been delegated to the Federal Reserve, and they might even emphasize the importance of having an independent central bank determine monetary policy rather than a political body like Congress. But wait a minute! What about the Constitution? Can Congress just decide to divest itself a Constitutional authority? What other constitutional powers are vested in Congress? Here’s three examples: The power to declare war. The power to impeach the President. The power to levy taxes.
What would you say if Congress decided to delegate the power to declare war? They might set up a War Declaration Tribunal which would be appointed by the President and confirmed by Congress, with some oversight every so often—or perhaps some of the members of the tribunal would be selected by some other means to make it even less influenced by politics. Anyway, going to war is such a big decision, we wouldn’t want it to be politicized, or influenced by the whims of fleeting irrational sentiments. Of course, we wouldn’t want decisions to be made based on weather or not the Congressman or Senator might be elected next term. A decision as important as going to war needs to be objective, and so it might make perfect sense to delegate this authority to some independent tribunal, composed of really smart people who we could trust to act in our best interest. How about impeaching the President? We all saw what a politicized fiasco it was when the U.S. House of Representatives impeached President Clinton, and that circus of a trial in the U.S. Senate. Of course, we would want to avoid such partisan politics from playing out again, so it might make sense for Congress to create an independent non-partisan committee and delegate this power to impeach the President. And then there are taxes. Do you think it would be proper for our Representatives in Congress to delegate the power to levy taxes to some independent non-elected taxing authority? (Since the IRS is already collecting the taxes, maybe we could just give them the power to levy new taxes in the first place, and that would make it a whole lot simpler to have the same people deciding what you have to pay.) Somehow, I doubt that most people would go along with that. In fact, I seem to remember reading somewhere that we fought a war over taxation without representation. I seriously doubt that any thinking person would believe that Congress has the authority to divest itself of a Constitutional power. Otherwise, what good is the Constitution? And so we’re back to this power to regulate the value of money. How can Congress divest itself of this Constitutional authority? Who will stand up and argue that the power to regulate money should not be in the hands of Congress? Well, unfortunately, many economists and banking interests would argue just that. They want you to believe that it’s necessary for monetary policy to be independent of Congress. But that’s just not what our Constitution says, and there’s no getting around that.
Finally, let’s try to figure out what it means to have fiat currency, and how the Federal Reserve and its inflationary policy really affects you.
A Fun Allegory As I mentioned way back at the beginning, the primary purpose of money is to establish a unit by which to measure the value of the goods and services in our economy. Just as Congress is vested with the authority to regulate the value of money, the U.S. Constitution also vested in Concress the authority to establish standards of weights and measures. In the United States, we use a pound, made up of 16-ounces (twelve troy ounces), and the mile, equal to 5,280 feet, as standard units of measurement.
What if Congress were to say that the mile was no longer to be defined as a fixed measurement of 5,280-feet, and instead they were going to allow the value of a mile to fluctuate on the open market to determine its current length? You’d laugh yourself silly, and say it would never happen! Well, it wouldn’t happen quite that way. It would more likely happen something like this:
The government decides that, for convenience sake, they are going to create paper mile-notes so that anyone wanting to travel just need to exchange these notes for the required distance. One mile-note would be worth traveling the distance of 5,280 feet. Simple enough? Now, what if the government decides they want to delegate the job of printing and exchanging these mile-notes to some quasi-public or private entity? Don’t know for sure how you’d feel about that? Well, it wouldn’t be an entirely new institution. You see, there are already some companies that have established themselves in the business of trading other forms of mile-credits, and who would be more qualified to take on this new job than these experienced outfits? Still don’t know for sure if this is a good idea? Well, never mind about that, the government has now created a quasi-public entity and granted it the exclusive authority to provide and exchange the mile-notes this country needs to keep moving! This new institution essentially has a monopoly on this authority (after all, we don’t want any counterfeiters or anyone else meddling with our ability to travel!) Because of this exclusive authority, you could say this quasi-public entity is a cartel. Does it matter if their chairman is appointed by the President and approved by Congress, but the board of directors is not? Does it matter that most of their other decision-makers are appointed or elected by members of those other already-existing entities who have now become members and stock-holders in this new quasi-public cartel? Don’t think for a moment that they’ll have a free-hand to do whatever they want with our country’s mile-notes! They will have some strict requirements prescribed by law, and their returns on the stock they’re required to buy will be set at 6%--so no one better argue that they’re in this to make a profit, because if a return of 6% is mandated by law, there can be no accusation of mile-note-grubbing there! And what about the fact that their decision-making processes occur behind closed-doors, and they keep many of their transactions secret—even from Congress? What’s the harm in that? After all, the value of the mile-note is the same: 5,280 feet, and it doesn’t really affect you who’s printing the paper, nor controlling its exchange, does it?
But now, there’s a bit of an issue. Since this new cartel is charged with facilitating the exchange of the mile-notes, they’ve decided that it would be best if they were able to trade them with you and other entities in the most convenient manner they can think of, and so a business is created by which clearinghouses are allowed to trade mile-notes among each other and with the distance-notes of other countries. This network is a real boon to facilitate the easy exchange of mile-notes! But this is where we start getting into trouble, because these clearinghouses don’t want to do this for nothing. They need to profit somehow. One way they can profit is by loaning someone a mile-note when they can’t buy it outright, or selling it to them on terms and charge interest. That doesn’t seem too terrible—if you or I had some extra mile-notes we weren’t using, we might do the same thing! Yet, another way to profit is by exchanging mile-notes in such a way that the value is not fixed; instead, the value might be allowed to be discounted somehow or determined by supply and demand. Better yet, someone might create yet different notes, contracts or instruments, like bonds, insurance policies for deposits of mile-notes, or mile-note default swaps to hedge against an unexpected drop in their value—and keep in mind that one tricky aspect of all this is that each of these might in some way influence the value of the mile-notes, so it creates lots of variables. This could be a good thing, because allowing lots of different variables to influence the value of mile-notes might help keep the value relatively stable. But back to the all-important scheme: a variable exchange rate would allow the value of the mile-note to fluctuate; and by capitalizing on this, clever traders could acquire mile-notes at a slightly lower exchange and trade them at slightly higher rates. Even if the differences were ever so small, they could make it up by volume, and over time these clearinghouses could skim quite a tidy profit!
To be sure, the fluctuation in value will probably be very slight—likely not more than one-tenth of one percent either way in a day, and probably even less. In this way, one day, a mile-note might allow you to travel 5,278-feet; the next day, perhaps it’s worth 5,282. To be sure, the daily differences probably wouldn’t be reflected on a daily basis in common transactions, so any fluctuation would only be felt very gradually. And so what if, over the course of a few months, the distance of a mile fluctuated a few feet? Would this really make a huge difference in your life?
Now, to allow the clearinghouses to be more flexible in meeting the demands of a traveling public, they must be allowed to increase the supply of the mile-notes by extending credit for mile-notes, or perhaps they can just print more of them. Of course, when the Government wants to move their army or any public works need done, they’ll need to acquire some mile-notes (and of course, to be charitable, the government needs to share some mile-notes with people who otherwise can’t afford them). To be sure, this quasi-public mile-note cartel will be quite happy to supply the government with all the mile-notes it needs—at interest, of course. You might even be able to buy into these deals by trading some of your present mile-notes for a bond that will pays you more mile-notes in the future—what a great deal (providing, of course, that the interest is greater than inflation)!
And so, over time, the supply of mile-notes will increase, and the value of each mile-note will inevitably decrease, but it will be so slight that you won’t notice from day-to-day, nor probably even month-to-month—but it would be a bit of an inconvenience to re-place all those mile-markers along the highway and re-calibrate our vehicle odometers all the time. However, over the course of several decades, the results could be more dramatic. Instead of the length of a mile being 5,280-feet, it could be reduced to 242-feet. The distance you used to be able to travel with one mile-note would now require you to use 21.83 mile notes! Well, that would be a bit of a shocker!
Do you think that would be crazy? Do you wonder how in the world our economy might function over the long term if the unit of measurement we use to gage distance is allowed to fluctuate according to market demands—market demands that are manipulated by a quasi-public cartel and clearinghouses that manipulate the supply and value? And what about the profits the clearinghouses and the cartel members pocket by charging interest as well and trading according to the fluctuating exchange—a fluctuation that they cause by increasing and decreasing the supply? Do you think that this scenario is absurd? Well, you’re right, it is utterly preposterous!
And that’s exactly what we have allowed Congress and the Federal Reserve and the money-changers to do to our Dollar!
(Also, I didn’t pick those inflationary mile-note numbers randomly. They reflect the inflation of the U.S. Dollar since the Federal Reserve was created in 1913: According to the U.S. Bureau of Labor’s Consumer Price Index, the goods and services that would have cost $1 in 1913 now costs $21.83.)
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Posted By: Jahfre Fire Eater
Date: 2009-11-03 20:53:08
Hi Nick,
Good article! The unit to measure economic value paragraph should also mention the distortion in that unit when govenment subsidies and price fixing (wage controls, minimum wage, etc.) are used to turn the market into a political tool.
Since nothing has intrinsic value, only relative value, the value I place on a particular good may be drastically different than the value you place on it. Any manipulations of the relative values of goods through government policies makes the unit of measure less reliable. In today's economy there is so much manipulation and resulting malinvestment that perhaps all fiat currencies will become suspect so that they all have to be revalued and pegged to earthly realities.
Nice presentation. But also, money is what people accept and they accept fiat currency, i think that pretty much ends the discussion of its "soundness."
Second, "sound" money- ? of the past ? where ? when ? what sound economics did the gold standard or ANY other previous money offer ? any economy, anywhere - could you tell me ? And, you are saying, in using "sound" money there is NO inflation ?? Not true. Sound money, anytime, anywhere, any how in the past did not resolve major economic depressions, crisis, lack of confidence, etc. since ancient Egypt and Rome. So, I don't know from what history - where and when- is the "greatness" of sound money referred from ?? I would like to know.
You're correct, many people accept fiat money as their currency, and this is about the only thing that allows it to continue to function. But a great many people are concerned about the way the Dollar's value has weakened--and this is primarily a result of its fiat nature. You are correct: "sound money" (specie, or money backed by a commodity) will not completely prevent inflation or deflation, as all values are relative in an economy. However, if money is backed by a tangible and relatively finite commodity, then the overall quantity of money is physically limited--unless the specified quantity of specie backing currency is altered by law (Congress did this a number of times, changing the gold-content of the dollar, etc.) The use of Sound Money makes it far more difficult for the money manipulators to increase the money supply at their will, and play with the exchange to skim profits. And I think that is probably the most important part of this article: that by allowing the relative values of currency to fluctuate on an “open market”, the banks and money-traders are allowed to play with the value of our money, capitalize on the fluctuations that they bring about, and skim cash with every exchange. This sort of activity serves no positive purpose in our economy; in fact, it simply allows the money-changers to acquire cash at everyone else's expense! If we had sound money, this would be far more difficult to do, the value of people's savings would be better preserved, and the money-changers would not be able to play with the value of currency and skim the way they do now. This has been a major issue with many currencies throughout history: the money changers manipulating exchange rates in order to skim profits for themselves. This allows the money changers to transfer wealth into their own pockets for no reason other than they have created this opportunity for themselves. --Nick
By allowing money-changers to manilulate exchange rates and play with the value of our money, skimming a cut with each exchange, they treat currency as a sort of commodity. This fundamentally changes the nature fo currency: instead of merely being a tool to measure value, facilitate exchage and store wealth, currency becomes a comodity with a fluctuating value. This endangers the three primary purposes of money, and turns our currency into a sort of commodity with a fluctuation value. Money is not supposed to be a commodity in and of itself. This is one of the the great dangers that is created by allowing a banking cartel, banks and money-changers to play with the value of our Dollar they way they do.
James Wrote: "money is what people accept and they accept fiat currency, i think that pretty much ends the discussion of its "soundness."
You don't seem to grasp what "Sound Money" means. The only reason most people accept fiat currency (e.g. Federal Reserve Notes) is because federal statutes require them to do so, and if they didn't accept it, or tried to use any other thing of value as money, they'd be prosecuted, their wealth would be confiscated, and they would go to prison. The fact that people are forced by statute and coercion to accept fiat money in no way ends the discussion of its "soundness."
I don't deny what you're presenting, I agree, the exception is that you are making the case of the "advantages" of sound money, hard money, backed-money, etc. and there are certainly some advantages. The problem is, there are giant disadvantages- when you have other economic problems- if you "can't" manipulate your currency- there is not much you can do to help your economy- and thus, you have prolonged depressions, frequent economic collapses. To me, that trumps the advantages of sound money. In addition, the fact that "some" profit from our current system of money is " a cost of doing business" for the people to have a relatively stable economy, as opposed to economic chaos of the past. I don't believe that the "manipulation" of our currency is driven by the secret cabals for them to profit, but rather, they profit when the currency " is " manipulated as part of our overall economic policies- driven by the state of the economy and our set of targets- i.e.. lowering inflation, stimulating employment, recovery from recession, etc. which are all things pretty much impossible to do with sound currency. So, in my opinion, the profiteering from currency manipulation is a "by-product" of our fiscal and monetary policies. I mean currency "manipulation" is NOT a secret, the word manipulation translates as fiscal and monetary policy. There is no secret or hidden agenda that we manipulate or currency to suit economic conditions and to foster a stable low inflation economy.
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