A proposal for natural money, Part 1

Money is one of those things that’s so ubiquitous, it’s rarely analyzed by most people. We consider money as something that just exists, a necessary part of the exchange of goods or simply a convenient shorthand for value. But in reality, the specific properties of money can significantly contribute to the overall health of an economy and, by extension, our personal finances. As with most things, there’s good and bad money, so thankfully economists agree on the properties that make money good. Good money is usually considered to have six properties: portability, durability, fungibility, divisibility, cognizability, and stability of value. It’s the existence of good (or at least acceptable) money that enables economies to prosper.

“Many economists and experts in the field agree that money must be a medium of exchange, a unit of account, and a store of value.” The Money Project

While the two most common varieties of money, precious metal and fiat currencies, both do well in satisfying the first five properties (the first two in the accompanying infographic), they often fail to possess stability of value. It is perhaps not surprising that the property these currencies often fail to exhibit is also the only property not intrinsic to their design. Gold coins and paper dollars were designed to be easy to transport and to withstand at least normal levels of wear; to be capable of being exchanged or changed into smaller or larger units; and to be thought of as money. One may say that these first five properties are natural to precious metal and fiat currencies.

On the other hand, we realize that neither precious metal nor fiat currencies are naturally stable stores of value. This is because the value of a currency is determined by its ability to purchase goods and services (its purchasing power), which is in turn dependent on supply, relative to demand, of the desired goods or services. To see this, consider what occurred during the Spanish Price Revolution. When countless tons of silver were imported to Spain from its new colonies in America, prices exploded as a result of an expanded currency supply that wasn’t accompanied by a substantial increase of the supply of goods that people wanted to buy. For a more modern example, we can look at the the latest Fortune 500 list and ask, “does the value created by most of these companies have any necessary relationship with the number of dollars in existence?”

The preceding depiction is not meant to imply that precious metal or fiat currencies have zero price stability. As the production of other goods increases, either because of an increased population or technological advances, it is likely that more gold will be mined as well. Moreover, the Federal Reserve exists to ensure the price stability of the US dollar and has an array of powerful tools to accomplish this. Rather than claiming there is no stability in precious metal or fiat currencies, I argue that utilizing these currency designs to achieve price stability is akin to attempting to fill a square peg with a round hole. It may work, but not well and only after a great deal of effort. More specifically, this is because precious metals are largely inelastic in their supply and monetary policy is an extremely difficult and inexact practice, involving a quantity of contrasting opinions as to rival the number of actual economists.

Instead of being content with currency designs that do not naturally exhibit all the properties of good money, I repropose a currency paradigm that succeeds in naturally satisfying all six properties of good money and possesses the additional virtue of being automatically countercyclical.

Time to unpack and explain.

  1. The proposal in this post has roots in the work of financial and economic giants such as Friedrich Hayek, who shared the 1974 Nobel Prize in Economics, and Benjamin Graham, the father of value investing and mentor to Warren Buffet.
  2. When claiming that a currency naturally satisfies the properties required of good money, I mean that such properties are necessary features of its design, instead of simply tacked on or achieved by ancillary systems.
  3. The property of being countercyclical refers to the tendency of a currency or monetary policy to exert pressure against the current economic state of affairs. A currency that works countercyclically will work to increase economic growth in times of recession or depression and will slow growth when an economy may be expanding at an unsustainable rate.

Commodity Basket Currency

A properly designed and implemented commodity basket currency (CBC) naturally achieves the six properties of good money, with the added bonus of being automatically countercyclical. Since I have little expectation that anyone will take my word in support of such a claim, let’s look at why this may be true. We assume for now that the first five properties are trivially solved by employing a system of representative units similar to that of currencies already in existence and will focus on how a CBC may serve as a stable store of value. But first, a few quick points about commodities.

  • Commodities are goods such as grains, metals, energy, and industrial precursors that are “interchangeable with other commodities of the same type”. This implies that quality does not vary continuously across different producers, the commodity either meets a threshold standard or it does not. A bushel of corn is a bushel of corn.
  • Commodities are bought and sold around the world at major exchanges such as the Chicago Mercantile Exchange, the Intercontinental Exchange, the Dalian Commodity Exchange, and the London Metal Exchange.
  • In order to facilitate settlement, exchanges store commodities at affiliated warehouses and storage facilities. Depending upon the type of commodity, the amount in storage may range from a few weeks to a year of total production.

With at least that cursory knowledge of commodities, let’s now consider how a CBC system may function and be a stable store of value.

  • Commodity producers deliver goods to be sold at a regional exchange participating in our proposed currency arrangement.
  • Upon delivery, the exchange issues CBC units to the producer. Excepting differences associated with shipping costs and trade barriers, the exchange rate between a commodity and the CBC unit is uniform across all exchanges.
  • Exchanges sell the commodities they hold in exchange for CBC units, in a manner similar to how they sell commodities now for fiat currency.
  • CBC units are destroyed when traded to an exchange for commodities, ensuring that the number CBC units in existences matches the stocks of participating exchanges.
  • Since the average commodity stock held by exchanges is a function of the volume of that commodity passing passing through the exchange, the supply of currency circulating is naturally kept in step with increases or decreases in production.
  • Assuming that the commodity basket employed is sufficiently representative of the entire economy, our CBC units will retain a constant purchasing power and hold their value.

Above I outlined how a CBC currency system may work but neglected to illustrate the countercyclical nature of the system. To understand this property we need to analyze two undesirable economic scenarios.

First, consider a demand-driven recession, like the one begun by the 2008 Financial Crisis. During the 18 months from late 2007 to early 2009, US household wealth declined by nearly 25%, with an estimated $6 trillion lost in housing prices alone. As a result of such a decline in wealth, consumer expenditures drastically decreased causing further economic damage. In demand-driven recessions, demand for goods falls more quickly than their supply.

Via CNN Money, originally from the Federal Reserve

Within our proposed CBC system, this decoupling of the supply and demand of goods will have a favorable impact on the currency supply. In times of a demand-driven economic slowdown, the demand for commodities falls substantially more quickly than production. The result in a CBC system will be an increase in the number of circulating currency units (the supply of capital), which would serve to lower the cost of borrowing. A decrease in the cost of borrowing for consumers and businesses will drive new spending, thus helping to reverse the onset of economic recession or depression. This reduction in borrowing costs is exactly the goal of the Federal Reserve during demand-driven slowdowns. The only difference here is that our CBC system accomplishes the desired outcome naturally, without the need for ad hoc and often flawed policy making.

Now let’s consider the impact of the proposed CBC system in a scenario where an economy is overheating. Economic overheating is often caused by the supply of money growing faster than real economic production. In turn, inflation and asset bubbles will almost inevitably emerge to plague future growth and stability. The benefits a CBC in these situations are simpler to notice than in the case of demand-driven slowdown previously described. Since CBCs are created by production, it is impossible for the currency supply to grow more quickly than the underlying production.

While there are several counterarguments and implementation specific questions that I didn’t address here (stay tuned for more to come!), I hope that this was able to serve as an interesting and informative introduction to commodity money. And with any luck, I’ve managed to convince at least some of you that just maybe, good money is natural money.