“Inflation is always and everywhere a monetary phenomenon” — Milton Friedman
“He who controls the money supply of a nation controls the nation” — James A. Garfield
Old Definition of Money
Before 1971, when most of the currencies were backed by commodities, such as gold or silver, it was not so easy to substantially increase currency supply. However, since the abandonment of the Bretton Woods Agreement and the Gold Standard, currencies in the world have become “fiat”. Central Banks have increased trillions of currency after the 2008 Global Financial Crisis (GFC) and the COVID-19 pandemic. Figure 1 shows the total assets of the US Federal Reserve. It increased from about US$1T before the GFC to about US$4.5T by means of several rounds of Quantitative Easing (QE). It levelled off since 2015, but then in the wake of the COVID-19 pandemic in early 2020, it sharply increased from US$4T to about US$7.5T (US$7,334,809,000,000 in Jan. 6, 2021)
The asset prices have rebounded strongly and break the records. Figures 2 and 3 show the S&P 500 index (stock market) and the Case & Shiller House Price Index. Both are increasing after the outbreak of the pandemic, and are standing at record high (S&P 500 stood at 3824.68 on Jan 8, 2021 and the Case & Shiller HPI reached 229.932 in Oct 2020).
Unfortunately, the reported inflation rate does not count asset prices. Inflation seems to be mild in the past decade (Figure 4). It has been kept below the 2% target most of the time, and it becomes an excuse for the Fed to keep increasing currency supply. However, it has already resulted in serious wealth inequality and income inequality, especially after the GFC and the pandemic.
New Definition of Money
Thus, people are questioning what is money? Why gold can store value? is crypto-currency money? It has many different answers, but most of them are based on the limited supply hypothesis. Bitcoin, for example, is “stipulated in the protocol that the supply of tokens would be capped at 21 million” and “changing the protocol would require the concurrence of a majority of the computing power engaged in Bitcoin mining, meaning that it is unlikely.” (Investopedia, 2021) In contrast with the unlimited supply of fiat money, the limited supply hypothesis is quite powerful in explaining why certain commodities are money. Indeed the recent 8x upsurge of bitcoin prices (from about US$5,000 to US$40,000) is unprecedented (Figure 5) and is mostly interpreted as an inflation hedge (Urquhart, 2020). Yet, bitcoin was invented after the GFC, we did not have information on its performance in the end of the 2000s. Gold prices, on the other hand, show a very strong increase after the GFC, which is also believed to be a market response to the QEs (Figure 6). It increased from about US$1,000 in 2008 to about US$1,900 in 2011, and then levelled off and fell to about US$1, 300 during the Fed Tapering. With the outbreak of the pandemic, it has increased to a recent peak of US$2,070 in Aug. 2020, which is also interpreted as an inflation-hedging response.
However, such a limited supply hypothesis is based on the fact that many people can agree to use the commodity as a medium of exchange. This necessary condition makes it uncertain whether something can be money or not. For example, whether crypto-currency can be money or not depends very much on whether buyers agree to trade by receiving crypto-currency. This is also the question raised on the future roles of gold and silver. If the reason why gold and silver were used as money in the past is merely because of their limited supply, then once people do not agree to accept them, then they would not have any trading value at all. In other words, the limited supply hypothesis cannot explain why certain commodities would be money or not, as it depends on some mutual agreements among traders. But we do not know why people would agree to exchange bitcoins or gold for other goods?
The question boils down to the fundamentals of survival, I suppose. People value foods and shelters (keeping warm), because they are our basic necessities. Whenever something are or can help produce foods and shelters, then they would be accepted as a medium of exchange. In fact, food was originally one of the most commonly used money, but because of the difficulties in their storage and transportation, they were replaced by gold and silver afterwards.
What exactly are foods and shelters? Scientifically, they are storage of energy that can be used to keep us healthy and warm. For example, vegetables are storage of sun energy. By means of this new definition of money — a store of usable scarce energy, then it explains why petrol and oil are taken as money (petrocurrency) after 1971. According to the Law of Conservation of Energy, energy can neither be created nor destroyed, but only converted from one form to another. However, some forms of energy cannot be stored or not usable, such as heat energy that would be dissipated (Second Law of Thermodynamics). When a commodity that store a large amount of usable energy, then it will be a good candidate of money.
Einstein’s E=mc² tells that all matters are storage of energy, but it depends on how easy they can be extracted. Uranium, for example, is of limited supply, is a store of energy that can be used in nuclear reactors to generate energy, and is therefore a trading commodity in the markets (money) if you can store it safely.
Then why gold is a good candidate of money? Would it be not just because of its limited supply, but also its energy storage? Gold actually comes from outer space, it was created inside massive stars when they exploded into a supernova and arrived the earth via asteroids (Sepanek, 2015). There is a youtube by UC Berkeley (2017) explaining where gold comes from. More recently, scientists are testing to use gold and other precious metals as a catalyst to turn sunlight into liquid fuels (Albrecht, 2015). Yet, very few people would consider money from this energy perspective.
Albrecht, B. (2015) Researchers Using Gold to Harness Solar Fuel, Kitco, Sep 3. https://www.kitco.com/news/2015-09-03/Researchers-Using-Gold-And-Sunlight-To-Make-Hydrogen-Fuel.html
Investopedia (2021) Why Do Bitcoins Have Value? Cryptocurrency, Investopedia. retrieved on Jan 9 at https://www.investopedia.com/ask/answers/100314/why-do-bitcoins-have-value.asp
Sepanek, E. (2015) How is Gold Formed and Where Does it Come From? Scottsdale, May 18. https://www.sbcgold.com/blog/how-is-gold-formed-and-where-does-it-come-from/
UC Berkeley (2017) Origins of universe’s gold discovered in neutron star mergers, Youtube, Oct 17. https://youtu.be/-iaviqwMfJ0
Urquhart, A. (2020) Bitcoin: why the price has exploded — and where it goes from here, The Conversation, Jan 8. https://theconversation.com/bitcoin-why-the-price-has-exploded-and-where-it-goes-from-here-152765