Wednesday, January 14, 2009

Why metals make lousy currency

As the government throws more and more money at the financial crisis, the cries of the gold standard folks seem to be getting louder. On the surface, the idea of a currency based on gold or some other precious metal seems sound. The notion of a paper currency that can be printed at will seems dubious at best. I don't read much about why metals aren't used to back currency, but maybe it should be more broadly discussed. I've actually arrived at my conclusion as to why metals aren't used as currency independently, though it's so obvious I'm sure professional economists are well aware of it. They just need to tell the public.

As best I can tell, the idea of a currency that is fixed in quantity is incompatible with an expanding economy. Throughout most of human history, economies really didn't grow...or at least they grew so slowly as to be imperceptible in a human lifetime. In such a steady-state economic environment, the idea of a currency of fixed, finite quantity makes perfect sense. However, the Industrial Revolution has changed all that. For the last two centuries, the global economy has experienced remarkable growth due to both increased productivity and surging populations. Nearly every year, the global economy and nearly all individual national economies produce measurably more goods and services than they did the year before (2009 may prove to be an exception...we'll see). If we were stuck using a fixed currency such as gold, this would require that products and services get cheaper and cheaper every year as a result. This should be obvious: If a fixed amount of money has to be used to purchase an increasing amount of goods, the only way this can happen is for the goods to get cheaper. So as a result, if somebody chooses to simply put gold under the proverbial mattress, the savings of this person would increase in value over time.

Now so far this probably sounds great to savers, especially savers who believe in bringing back the gold standard. But think about what would happen in such an economic environment where simply hoarding money is the most economically sensible thing to do. Investment in productive activity would severely diminish, of course! Why should an investor risk losing money by lending it to a business when they can simply stash their money away safely and watch it rise in value? Further consider that any enterprise they invest in is going to perpetually receive diminishing returns. While ACME Widget company might be able to return 10% of an investment the first year, the diminishing value of their product will reduce returns year after year. (Of course the company's costs would also decline, but if the profit margin remains the same, then return on investment will diminish.) Investing in productive economic activity becomes foolish in such an environment. Of course, this problem would quickly find a "solution". Once investment activity stops, or drops off dramatically, overall productivity of the economy will cease to improve. At this point, the value of goods would stop deflating...and hoarders of gold might be tempted to invest in productive activity again. Of course, the moment the economy starts increasing productivity, deflation would again set in and the best investment strategy would once again be to simply hoard gold.

For this reason, using a currency based on gold, metals, or any material found in finite quantities will doom an economy to zero growth in the long run. It seems counter-intuitive that the quality of gold that makes it so desirable to some as a currency--the fact that it cannot be created and it's quantity cannot be increased by any significant amount--is actually the quality that makes it terrible as a currency.

Ironically enough, the non-sensical central banking games we play now where money is created almost from thin air is actually the only effective currency for an economy capable of experiencing long-term growth.



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