Understanding Currency

Folks,

Currency is a big topic this year, as I have been suggesting, and this
article may be helpful with its fundamental explanations.

John


http://www.mises.org/fullstory.asp?control=991


The Supply-Side Gold Standard: A Critique



by Frank Shostak


[Posted June 27, 2002]


According to "supply-side" economics, the key to economic growth and

prosperity is low marginal tax rates. However, the supply-side school also

maintains that a low marginal tax rate will not be sufficient, that it must

be accompanied by a monetary policy that aims at achieving price stability.

The pillar of the proposed monetary policy is a gold-price rule, where the

central bank targets the dollar gold price at a specified figure.


Let us say that the Fed has concluded that the "correct" target must be $350

per ounce of gold. If the price of gold falls to below $350 per ounce, this

is indicative of growing demand for money, which the Fed then must

accommodate through open market purchases of government securities, i.e., an

injection of money into the economy. As a result of this injection, the

price of gold will go up.


Conversely, if the price of gold rises above $350 an ounce, it means that

people's demand for money has fallen and that the central bank must take

money out of the system. By selling government securities, money will be

taken out of the system. This, in turn, will exert downward pressure on the

price of gold.


Observe that, for supply-side proponents, gold is not money but rather an

instrument to stabilize the present paper standard. The chief role of money

within this framework of thinking is that money fulfills the role of a unit

of account. Since it is imperative that this unit must remain stable in

order to fulfill this role, supply-siders hold that anchoring the dollar to

gold will do the trick. This, in turn, will make the dollar as good as gold.


But is the definition of money as predominantly a unit of account valid?


Defining money

The purpose of a definition is to present the essence--the distinguishing

characteristic of the subject we are trying to identify. A definition aims

at telling us what the fundamentals of a particular entity are.


To establish a definition of money, we have to ascertain how the money

economy came about. Money emerged because barter could not support the

market economy. A butcher who wanted to exchange his meat for fruit might

not have been able to find a fruit farmer who wanted his meat, while the

fruit farmer who wanted to exchange his fruit for shoes might not have been

able to find a shoemaker who wanted his fruit.


The distinguishing characteristic of money is that it is the general medium

of exchange. It has evolved from the most marketable commodity. On this

Mises wrote,


There would be an inevitable tendency for the less marketable of the

series of goods used as media of exchange to be one by one rejected until at

last only a single commodity remained. Which was universally employed as a

medium of exchange; in a word money.[1]

Since the general medium of exchange emerged from a wide range of

commodities, money must be such a commodity.


Consequently, according to Rothbard,


Money is not an abstract unit of account, divorceable from a concrete

good; it is not a useless token only good for exchanging; it is not a claim

on society; it is not a guarantee of a fixed price level. It is simply a

commodity.[2]

Moreover, "an object cannot be used as money unless, at the moment when its

use as money begins, it already possesses an objective exchange value based

on some other use" ( Mises 1980, p. 131).


Why?


In contrast to directly used consumers or producers goods, money must have

pre-existing prices on which to ground a demand. But the only way this can

happen is by beginning with a useful commodity under barter, and then adding

demand for a medium to the previous demand for direct use (e.g., for

ornaments, in the case of gold). (Rothbard 1981, pp. 3-4).

In short, money is that for which all other goods and services are traded.

This fundamental characteristic of money must be contrasted with those of

other goods. For instance, food supplies the necessary energy to human

beings, while capital goods permit the expansion of infrastructure that in

turn permits the production of a larger quantity of goods and services.


In its capacity, money also fulfills the role of the medium of savings, the

role of a unit of account, and a store of value. The fundamental role--the

essence--of money, however, is that of a general medium of exchange. Because

of this, all other functions of money emerge. In short, the fact that a good

becomes the medium of exchange gives rise to these other functions.


Is there a need to accommodate the demand for money?

When we talk about demand for money, what we really mean is the demand for

money's purchasing power. After all, people don't want a greater amount of

money in their pockets so much as they want greater purchasing power in

their possession.


On this Mises wrote,


The services money renders are conditioned by the height of its purchasing

power. Nobody wants to have in his cash holding a definite number of pieces

of money or a definite weight of money; he wants to keep a cash holding of a

definite amount of purchasing power.[3]

In a free market, in similarity to other goods, the price of money is

determined by supply and demand. Consequently, if there is less money, its

exchange value increases. Conversely, the exchange value falls when there is

more money. In short, within the framework of a free market, there can be no

such thing as "too little" or "too much" money. As long as the market is

allowed to clear, no shortage of money can emerge.


Consequently, once the market has chosen a particular commodity as money,

the given stock of this commodity will always be sufficient to secure the

services that money provides. Hence, in a free market, the whole idea of

managing the supply of money in line with changes in the demand for money as

suggested by the proponents of supply-side economics is absurd.


According to Mises:


As the operation of the market tends to determine the final state of

money's purchasing power at a height at which the supply of and the demand

for money coincide, there can never be an excess or deficiency of money.

Each individual and all individuals together always enjoy fully the

advantages which they can derive from indirect exchange and the use of

money, no matter whether the total quantity of money is great, or small. . .

. the services which money renders can be neither improved nor repaired by

changing the supply of money. . . . The quantity of money available in the

whole economy is always sufficient to secure for everybody all that money

does and can do.[4]

But how can we be sure that the supply of a selected commodity as money will

not start to rapidly expand on account of unforeseen events? Would that not

undermine people's well-being? If this were to happen, then people would

probably abandon this commodity and settle on some other commodity.

Individuals, who strive to preserve their life and well-being, will not

choose a commodity that is subject to a steady decline in its purchasing

power as money.


This is the essence of the market-selection process and the reason why it

took several thousands years for gold to be selected as the most marketable

commodity. In short, the prolonged market-selection process raises the

likelihood that gold is the most suitable commodity to fulfill the role of

money.


Furthermore, the accommodation of rising demand through the expansion of

money supply will in fact achieve contrary results, because people do not

want more money but more purchasing power. However, raising the supply of

money will dilute its purchasing power and thereby deny people's wishes. It

is like suggesting that because the demand for the Mona Lisa painting has

gone up, we ought to lift the supply by producing counterfeit paintings.


"Dollar" not an independent entity

Since in a true free-market economy, money is gold, there is no such thing

as an independent entity such as a "dollar." Prior to 1933, the name

"dollar" was used to refer to a unit of gold that had a weight of 23.22

grains. Since there are 480 grains in one ounce, this means that the name

dollar also stood for 0.048 ounce of gold. This in turn, means that one

ounce of gold referred to $20.67. Now, $20.67 is not the price of one ounce

of gold in terms of dollars as popular thinking has it, for there is no such

entity as a dollar. Dollar is just a name for 0.048 ounce of gold. On this

Rothbard wrote,


No one prints dollars on the purely free market because there are, in

fact, no dollars; there are only commodities, such as wheat, cars, and

gold.[5]

Likewise, the names of other currencies stood for a fixed amount of gold.

The habit of regarding these names as a separate entity from gold emerged

with the enforcement of the paper standard. Over time, as paper money

assumed a life of its own, it became acceptable to set the price of gold in

terms of dollars, francs, pounds, etc. The absurdity of all this reached new

heights with the introduction of the floating currency system.


In a free market, currencies do not float against each other. They are

exchanged in accordance with a fixed definition. If the British pound stands

for 0.25 of an ounce of gold and the dollar stands for 0.05 ounce of gold,

then one British pound will be exchanged for five dollars. This exchange

stems from the fact that 0.25 of an ounce is five times larger than 0.05 of

an ounce, and this is what the exchange of 5-to-1 means.


The absurdity of a floating currency system is no different from the idea of

having a fluctuating market price for dollars in terms of cents. How many

cents equal one dollar is not something that is subject to fluctuations. It

is fixed forever by definition[6].


In a free market, therefore, the meaning of the gold standard is that gold

is money. Contrast this with the supply-side framework, which views gold as

separate from the dollar. Curiously, supply-siders call the scheme a "gold

standard," which is, of course, erroneous.


Once it is realized that in a free market the name dollar stands for a fixed

weight of gold, it will obviously be preposterous to contemplate the

gold-price rule as suggested by the supply-siders.


Furthermore, once it is realized that money is a commodity, it is obvious

that, in similarity to other goods and services, its exchange value cannot

stay still but will vary in accordance with the supply and demand of gold

and supply and demand of other goods and services. Any attempt to stabilize

prices amounts to stifling the operation of the market economy and results

in the misallocation of resources and economic impoverishment.


Gold-price rule: Recipe for boom-bust cycles

According to supply-siders, the major factor behind boom-bust cycles is not

the Federal Reserve but the high marginal tax rate. For instance, in his

various writings--including the book The Way the World Works--J. Wanniski

regards a high tax rate as the cause of boom-bust cycles. According to

Wanniski, the monetary policy of the Fed has very little to do with

boom-bust cycles. In fact, in a note he wrote, "But first, the Fed (and the

gold standard) needs to be absolved of guilt for the 1930s. The Great

Depression was caused by rising tariffs and taxes worldwide…"


The problem with all this is a failure to define what boom-bust cycles are

all about. The distinguishing characteristic of a successful producer is his

ability to "read the market correctly" and thereby establish a profitable

production structure. It is in the interest of every businessman to secure a

price where the quantity of goods that is produced can be sold at a profit.

In setting this price, a producer/entrepreneur will have to consider how

much money consumers are likely to spend on the product. He will have to

consider the prices of various competitive products. He will also have to

consider his production costs.


A producer must also pay attention to likely movements in interest rates. By

complying with market prices and interest rates, the producer is said to be

"in tune" with reality. Whenever he misjudges future prices and interest

rates, he is said to be "out of sync" with market conditions, and he suffers

losses.


A major factor that distorts producers’ judgments regarding the true

conditions of the market is the central bank’s easy monetary policy. This

policy leads to an artificial lowering of interest rates and thereby

falsifies an important market signpost that producers pay attention to.

Consequently, this triggers activities that are out of touch with reality;

an economic "boom" is set in motion.


The central bank’s easy monetary policy causes producers to make business

errors. Once the central bank tightens its monetary stance, however, the

facts of reality are revealed, various activities that sprang up on the back

of previous loose monetary policies are abandoned, and an economic bust

emerges. From this we can infer that a recession is: a process whereby

business errors brought about by past easy monetary policies are revealed

and liquidated once the central bank tightens its monetary stance.


This definition of a recession--a business-error liquidation

process--informs us that the driving force behind boom-bust cycles is

central bank monetary policies.


This definition of a recession embraces not only "ordinary" recessions but

also depressions. The only difference between a recession and a depression

is the extent of business errors. In other words, the longer the boom, all

else equal, the more severe the bust is going to be. Furthermore, the

severity of the slump is affected by the state of the real pool of funding.

A growing pool of funding--savings and capital stored up to make future

production possible--will make the business error adjustment process easy to

handle. Conversely, a stagnant or a declining pool will make the adjustment

process more painful.


While a growing government and hence higher taxes will weaken the real pool

of funding, which in turn will prolong the recession, they don’t of

themselves set in motion boom-bust cycles as such. In order to provide an

explanation of a bust, one must present a theory of a boom. But how can

rises in taxes by themselves explain the phenomenon of a boom, which is

accompanied by a general rise in prices? Without the increase in money

supply, no boom and general rise in prices can emerge. Moreover, if,

according to Wanniski, the Great Depression continued for a decade solely

because of high taxes, then why didn’t we have a permanent depression from

World War Two, since tax rates have been much higher since then?[7]


Obviously, then, if the Fed were to follow the supply-siders’ dollar-gold

rule, it would not eliminate boom-bust cycles. Thus, whenever the price of

gold fell below the nominated $350-an-ounce level, the Fed would pump money

thereby setting in motion an economic boom. Once the price of the yellow

metal rose above the $350 an ounce, the Fed would tighten its stance thereby

setting in motion an economic bust.


Observe that the boom and the bust are set in motion regardless of the

demand for money. Thus when the Fed pumps more money in response to the

lower gold price, the rise in the demand for money cannot neutralize the

effect of the expansion in the money stock. In short, the newly injected

money will always cause damage to the real economy by setting an exchange of

nothing for something, or consumption not supported by production.


Those of the supply-side movement like to project themselves in the image of

free-marketers and in opposition to government interference. Yet their

entire approach runs contrary to the spirit of a free market. In fact, they

are very much like the rest of mainstream economics. While mainstream

economists advocate the management of demand, supply-siders advocate the

management of supply. It is even argued that, in order to promote greater

production, there must be a preference for taxing consumption rather than

production. According to Raymond J Keating, "In addition, supply-side

recognition that supply comes before demand in the economic order leads to a

preference for taxing consumption rather than production."[8]


In the free-market economy, neither demand nor supply is managed. Both

consumption and production are equally important in the fulfillment of

people’s ultimate goal, which is the maintenance of life and well-being. In

short, consumption is dependent on production, while production is dependent

on consumption. The loose monetary policy of the central bank breaks this

unity by creating an environment where it appears that it is possible to

consume without production. This unity can be restored by bringing back the

market-selected money: gold.


Conclusion

The belief that the present unstable financial system can be cured by means

of a monetary policy that targets the price of gold is erroneous. This

framework, which is offered by the supply-side-economics movement, is likely

to further destabilize the economy. What supply-siders are advocating is the

replacement of one form of government monetary control with another form of

control--erroneously believing that their form of money manipulation will

achieve economic prosperity. What is needed, then, is not a reversion to the

bankrupt Bretton Woods system, as is suggested by supply-siders, but a

genuine gold standard where gold is money.

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