Money

A variety of different things have been used for money in the past, are being used now. What are the advantages and disadvantages of the alternatives? What, at present, would be the best form of money?

One obvious desirable feature is portability. Gold is more suitable for coinage than iron because an iron coin of a given value weighs a lot more than the corresponding gold coin. That matters for coinage, does not matter if what circulates are bank notes, claims for gold or iron. A claim for a ton of iron weighs no more than a claim for an ounce of gold.

A second feature is verifiability, being able to distinguish real from fake. Shifting from coins to claims shifts that from depending on how easy it is to distinguish gold from gold plated lead to depending on how easy it is to recognize counterfeit bills and unstable banks.

Mining Money

One disadvantage of gold coins is that someone has to mine the gold. If the circulating medium is not gold coins but claims for gold coins, each for a specific coin sitting in a bank safe, they still have to be mined, although that does cut down on wear and tear. The solution is to replace a 100% reserve system with a fractional reserve system. The note is now a promise to pay a specified amount of gold, not a claim to a particular coin. To make it possible to fulfill the promise the bank holds some of its assets as gold coins but fewer than the notes it has issued. If note holders come for their promised coins the bank pays them with coins from its reserve and replaces them by selling other assets and buying gold.

If the value of gold goes up or the value of the other assets it is holding goes down, the bank might run out. One solution is for the bank to start with assets much larger than its note issue. The banking system of Scotland in the 18^th century, described by Adam Smith, was one of competing fractional reserve banks based on silver. The banks were unlimited liability partnerships with at least one of the partners a wealthy landowner; a modern equivalent might be fractional reserve issue by Apple or Microsoft.

Seen from standpoint of the individual bank, the advantage of a fractional reserve system is that the bank can use some of its money issue to buy silver or gold for its reserve, some to buy interest bearing assets. Seen from the standpoint of the economy, the advantage is that less resources have to be spent mining silver or gold.

Carrying that to its limit …

A Tax Nobody Pays

My friend Kwang Ng, a Vietnamese-Australian economist and one of the smarter people I know, once published an article in the American Economic Review describing a burden-free tax, a tax that not only has no excess burden but no burden at all, a tax the government collects that costs nobody anything.¹

It was a tax on diamonds. Ng’s assumption was that people value diamonds not for their weight but for their value, that what you want on your finger is not a one carat diamond but a two thousand dollar diamond. The government imposes a tax on diamond mining. Fewer diamonds are mined, say half as many, but because fewer are mined the price of diamonds goes up. If, as could happen, the price doubles, the total value of diamonds being produced is still the same, so consumers of diamonds, who value them for their price not their weight, are getting the same value as before. The diamond miners are paying the tax but the diamonds they mine now sell for twice as much so they can mine half as many and get the same income. The tax is being paid out of the savings from mining half as many diamonds.

The numbers don’t have to come out that neatly but there is no reason they couldn’t. It is a tax nobody pays.

It was a very clever idea but I had seen it before. The same idea, in a different and more important context, had been published two hundred years earlier by one of the smartest people I know of.

In Chapter 13 of the Principles of Political Economy, David Ricardo wrote:

If gold were the produce of one country only, and it were used universally for money, a very considerable tax might be imposed on it, which would not fall on any country, except in proportion as they used it in manufactures, and for utensils; upon that portion which was used for money, though a large tax might be received, nobody would pay it. ... The benefit would be this, that if less gold were produced, less capital would be employed in producing it; ... From such a tax, as far as money was concerned, the nations of Europe would suffer no injury whatever; they would have the same quantity of goods, and consequently the same means of enjoyment as before, but these goods would be circulated with a less quantity, because a more valuable money. ...If in consequence of the tax, only one tenth of the present quantity of gold were obtained from the mines, that tenth would be of equal value with the ten tenths now produced.

Ricardo’s version is better than Ng’s for two reasons. First, while diamonds could be valued only by their price, there is no reason why they have to be. In the case of gold used only for money there is a reason, since the usefulness of a coin is the amount it can buy. Second, Ricardo’s example points at the monetary system now in use almost everywhere. Fiat money is the limiting case of what Ricardo describes, money whose production cost is 100% due to the “tax” on its production.

I published a comment on Ng’s piece pointing that out, received a message from Ng that he had used a spirit medium to consult with Ricardo and been told he didn’t mind.

The Problem with Fiat Currency

Seen from the standpoint of production cost, fiat is the ideal form of currency. A fractional reserve system with a 20% reserve ratio eliminates 80% of the cost of producing money. A fiat system eliminates 100%.

The downside is that there is nothing inherent in the fiat system to limit the quantity of money or its price. In a fractional reserve system based on silver, if the banks issue too much money, pushing the value of their notes below the value of the silver they represent, note holders come in to trade notes for silver, the number of notes goes down and their value goes back up; the obligation to redeem controls the quantity of money and the price level. A fiat system has no similar restriction. How much money exists is up to the issuer, normally a government. It could choose to follow a policy of stable prices but it doesn’t have to.

There are a number of reasons why governments often don’t. Issuing more money lets them spend without raising taxes; that tax, unlike Ng’s or Ricardo’s is not burden free, being paid out of the reduction in the value of people’s money holdings. Unexpected inflation benefits debtors at the expense of creditors. The government itself is often a debtor, can inflate away some of the debt. Important voting blocks may be debtors as well, such as the farmers who supported William Jennings Bryan’s campaign to abandon the gold standard. Unexpected inflation also tends to temporarily reduce unemployment, useful around election time.

The Craziest System of All

The Scottish fractional reserve system was based on silver. The US has a fractional reserve system based on fiat money. The advantage of a fractional reserve system is that it economizes on the cost of producing the base commodity, less silver or gold mined to maintain the money supply. Fiat money costs nothing to produce.

The advantage of a commodity based system, coin, 100% reserve, or fractional reserve, is that it produces stable prices by linking the value of the money to the value of the commodity, ultimately to the cost of producing it. That doesn’t work when the “commodity” is fiat money.

The Best System?

My own preferred monetary system consists of competing fractional reserve issuers based on not a single commodity but a commodity bundle. Bring in a million Friedman dollars and you get in exchange ownership of an ounce of gold, forty bushels of grade B wheat, 200 pounds of a specified grade of steel, … a list of goods roughly corresponding to a price index.

One problem with an ordinary commodity system is that changes in the value of the commodity change the value of obligations defined in it, introducing an uncertainty into long run contracts. The combined effect of the discovery of the South African gold fields and the invention of the Cyanide process for extracting gold from low grade ore converted gold from a deflationary to an inflationary currency — and the basis for Bryan’s movement collapsed. I like to say that Bryan was killed, politically speaking, by Cyanide. Since my money is based on a commodity bundle roughly mirroring a price index the change in the value of any single commodity has almost no effect on it.

The same fact plus a (hypothetically) wealthy issuer means that I, and competitors basing their money on a similar bundle, don’t need warehouses full of commodities, just contact information for a large number of brokers. With a reserve ratio at or near zero, my system is as efficient as a fiat system.

And much stabler.

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1. Ng, Yew-Kwang , "Diamonds are a Government's Best Friend: Burden-Free Taxes on Goods Valued for their Values," AER 77 (1987) pp. 186-191.