The Gold Standard
Tying our currency to a commodity has some benefits, but the disadvantages make it not worthwhile.
When people talk about sound money or currency, they are normally thinking of a commodity-based currency system such as a gold or silver standard. As long as prices are only dependent on the forces of supply and demand, and as long as there is no shortage or glut in the supply of the metal, the amount of gold or silver that buys any given good or service remains approximately the same over an extended period of time. Thus gold and silver can serve as sound money when you have a free market. However as the economy grows, it is unlikely that the amount of gold or silver will grow continuously with it, as there is only a fixed supply of these metals. Thus over a long period of time, you would expect any currency tied to gold or silver to experience deflation.
Arguments for the Gold Standard
The argument in favour of precious metals as standards for currency can be made based on two grounds. The first is the evolution argument, which is that over thousands of years, gold and silver have emerged as the preferred currencies of many people. While it is true that gold and silver have served people well as currencies, this is only true when the use of these metals has been organic and spontaneous among the people. When a government takes over and makes gold or silver a national currency, they tend to debase the currency, as happened in ancient Rome for example, and people eventually lose faith in the currency. In more recent times, under the gold standard, banks debased the currency by issuing much more gold certificates than the actual gold they had, until people lost faith in the currency and there were bank runs. In the final phase of the last gold standard, the United States cut the link to gold completely, resulting in the currency system we have today. While many countries still have faith in their modern currencies, some have already seen people lose faith, as happened with the Weimar Republic and more recently in Zimbabwe.
The second argument for precious metals as currency is that they have “intrinsic” or use-value which means that they can always be redeemed for goods or services, since other people will find value in them. This argument also holds as long as people are using the currency by their own choice, and it is not made a national currency through legal tender laws. Once it is made a national currency and it is no longer a person’s choice to accept the coins or certificates, the use-value becomes meaningless. You have to accept it no matter the amount of gold or silver in the coin, or the actual amount of gold or silver in the bank’s vault, because the law requires you to do so. The government is therefore free to debase the coin as they wish, and history has shown that they always do so. It is therefore very important to understand that there is a difference between currencies arising naturally from the exchange process between people in a society, and currencies instituted by government, even if the government currency is based on one that evolved organically. The key factor is choice; in currencies that evolve naturally, people have a choice of whether to use them or not, while there is no choice in fiat currencies.
The gold standard has its disadvantages, such as being prone to bank runs. However it also has its advantages, one of them being the absence of inflation under normal circumstances. However, in a growing economy, a gold standard would eventually result in deflation, which has its own problems. One also has to wonder whether tying the currency to one particular good or service is worthwhile. Fluctuations in the supply of that good could lead to big swings in the value of the currency. Furthermore, with the gold standard, each unit of currency is redeemable for some amount of gold, which means that tonnes of gold would have to be kept in storage so people could redeem their gold certificates for their share of this gold. I think that this doesn’t really make sense in a true free market. Finding the best use for resources is one of the features of the free market. Yet here we have tonnes of a valuable resource such as gold simply sitting in vaults so that gold certificates can be used as currency. This makes me suspect that we have got our notion of currency quite wrong. Even though we have moved away from the gold standard, our current unbacked fiat currency system is an extension of that standard. It evolved from the gold standard, and in truth is really the natural conclusion of the evolution of a gold standard currency. Just as the ancient Romans debased silver coins by reducing the amount of silver in the coins until it was insignificant, government and banks of more recent times debased the gold standard currency by creating more gold certificates than they had gold for, i.e., by altering the reserve ratio. With a fixed amount of gold and a growing economy, this outcome is to be expected, especially since the gold certificates were not infinitely divisible. This led to the natural conclusion where the link to gold was eventually removed. Instead of currency being created based on gold, currency is now created out of thin air by banks.
Some people may be tempted to go back to the gold standard, but I believe that a gold standard will always degenerate into an unbacked fiat system similar to what we have now. Gold is supposed to keep government spending in check, but that is not the only way to achieve that. The gold standard is also not a true free market currency system since it requires legal tender laws. i.e. force, to make make people use it. A true free market has competing currencies, arising out of exchanges between people in the market. The national currency similarly arises from the exchanges between the public and public service providers.
