As we saw yesterday, a stable and standard
currency is of the utmost importance to maintain a stable economic and
political situation. The problem we look
at today is how to maintain a stable and standard currency, especially when
there are many different types of money in an economy.
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| The oldest known coin in the west was found in the ruins of the temple of Artemis of the Ephesians |
If the money supply consisted exclusively of
currency issued by the regulatory authority, and if the regulatory authority
maintained the standard without alteration, stability and uniformity of the
currency would not be a problem; the currency would have a stable value in
terms of whatever standard was used, e.g.,
$35.00 per ounce of gold.
There would, however, in a rapidly growing or
industrializing economy be continual problems with inflation and deflation, and
thus periods of “boom” and “bust,” as a result of the money supply not matching
the needs of the economy, but that is a different issue.
Consistent with Say’s Law, however, the money
supply consists not only of currency, but of all contracts that are used in
commerce. Historically, from a transactions
perspective, currency has been the smallest and least important component of
the money supply.
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| Converting money an important business service. |
The problem, then, is how to ensure that all
contracts denominated in terms of the standard have the same value and that there are sufficient media of
exchange to carry out commerce. The
solution is to 1) have the option of converting any and all contracts into the
standard, 2) backed by the word of a trustworthy authority, 3) to deliver
asset-backed reserve currency on demand.
This is the role of the commercial bank. A commercial bank trades contracts issued by
individuals and other institutions (mortgages and bills of exchange) for
contracts issued by the bank (promissory notes). The bank’s promissory notes either circulate
directly as currency (banknotes) or are used to back demand deposits (checking
accounts).
Because not everyone who receives the bank’s
banknotes or accepts checks drawn on the bank is indebted to the bank, holders
of the bank’s obligations (banknotes and checks) must have the right to
exchange or “convert” the bank’s obligations they hold into the official
reserve currency.
Assuming that the reserve currency itself is
sound, this gives the public confidence that the bank’s obligations are worth
in terms of the reserve currency what it states on the face of the
obligation. This is why, whatever backs
all other forms of money in an economy, the reserve currency must be asset-backed.
Inelastic Reserve
Currency
The need for the reserve currency to be
asset-backed is a pillar of the banking principle, and thus of a sound
economy. The problem is that the
traditional assets used as reserve currencies, the precious metals, are
“inelastic,” that is, the amount of reserve currency does not vary directly
with the present value of existing and future marketable goods and services in
the economy. Except by chance, there is
always either too much or too little money in circulation, adversely affecting
the ability of people to engage in commerce.
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| Gold and silver are inadequate for monetary purposes. |
The failure of a specie reserve currency to expand
or contract directly with the needs of the economy causes inflation and
deflation. Backing all or a portion of
the reserve currency with government debt does not solve the problem, and
causes other problems.
One, government debt is not an asset of the issuer,
but a liability of the issuer. This
violates the first principle of reserve currencies that they must be
asset-backed.
Two, if the amount of government debt is fixed,
there is no more practical advantage to backing the reserve currency with government
debt than there is to backing it with gold or silver.
Three, implementing an elastic debt-backed reserve
currency does not solve the problems associated with an inelastic debt-backed
reserve currency. If a debt-backed
reserve currency is well managed, it is still only by chance that the amount of
money in circulation is the amount needed to facilitate commerce and maintain a stable value.
If not well managed, that is, if politicians
succumb to the lure of “free money” and the temptation to finance government
operations or stimulate economic growth without recourse to direct taxation, a
debt-backed reserve currency seriously erodes both economic and political
stability. In extreme cases, this can
lead to loss of national sovereignty as well as hyperinflation.
This is why the rally at the Fed this coming Friday is so important, and you may want to consider attending if you're in DC on April 11, 2014. Go to the Federal Reserve Board of Governors Building from 11:00 am to 1:30 pm, and look for the people demanding a reform of the Fed instead of ending it.