Thursday, August 20, 2015

Flexible Standards, VI: A Uniform and Stable Currency


The number one rule for a reserve currency — the currency into which other currencies can be converted and in terms of which they are valued — is that it must (and that means must) be asset-backed.  This does not mean that the asset you use to value the reserve currency must back the currency — “gold standard,” for example, does not necessarily mean that the currency is backed by gold, only that the currency is valued in terms of gold.

Cattle: A monetary energy standard with marketable value.
No, as long as the value of the asset that backs the reserve currency can be measured in terms of the standard of value, and the value of the asset is stable, you can back the reserve currency with anything that has real value — but it must be actual, measurable, and (above all) marketable value.

This last requirement confuses many people.  They confuse probability with marketability.  For example, what is the marketable value of a lottery ticket when there are a hundred tickets sold, and the prize is $1,000.00, with the drawing to be in 90 days?  Is it $10?  That’s the answer most people would give — the probability of winning is 1%.

They would be wrong.  The marketable value of a lottery ticket as described above — or anything measured purely in terms of statistical probability — is precisely and exactly zero.  The marketable value of something is what you pay (or receive) for something you actually get (or give).  It is not the chance that you will get it, which is what probability measures.

Bill of Exchange for Fr. 27,000.
Thus, $1 in the above example is the value of the chance that you will get the prize — not the value of the prize itself.  In contrast, take a bill of exchange for $1,000.00 that matures in 90 days discounted at 1%.  What is the present (marketable) value of that bill?  $990.00.

Why is the present value of the lottery ticket zero, while that of the bill of exchange is $990?  Isn’t the rate the same in both cases, 1%?

Yes — but that rate doesn’t mean the same in both cases.  In the first case, that of the lottery ticket, it measures the chance that the holder’s number will be drawn.  It is not certain.  It’s a gamble.  Since you do not have a reasonable expectation that you will receive $1,000 in 90 days when the drawing is made, the market value of that ticket is zip.

A gambler might give you $10 for it, but that’s why it’s called gambling — a 1% chance is not reasonably certain.  The chance is worth $10 to a gambler.  The $1,000 prize — the payoff — is not worth $10.  It’s worth $1,000, which is what the winner of the lottery gets.  At 100 to 1 odds.

That's why they call it a chariot race. . . .
In the second case, receipt of the $1,000 in 90 days is as certain as anything can reasonably be.  If the issuer of the bill doesn’t redeem the bill at the full face value of $1,000 . . . oops.  He or she goes to jail.  Things happen, of course (nothing is absolutely certain), and it’s also worth something to have $990 now instead of $1,000 in 90 days.  That means the marketable value of the bill right now is $990, not $1,000 or zero.  You can use the bill right now to pay a debt of $990, or wait 90 days and get the full $1,000 to use to pay your debts.

Thus, what backs your reserve currency must have real, not speculative or “fictitious” value, as well as being measured in terms of a uniform and stable standard of value.

This, however, is only possible when you don’t change value at random as virtually every government does today by eliminating an objective standard of value that remains stable.

A $1,000 banknote is worth $1,000, today and tomorrow.
As we just said (another however), nothing is absolutely certain.  If you had a stable standard of value, and $1,000 in 90 days were worth $1,000 today (i.e., no time value of money), and you were absolutely certain — and we mean absolutely certain, as in “you’re God and know everything completely, past, present, or future” — that the bill would be redeemed in 90 days, then the present value of the $1,000 bill of exchange would be $1,000 (that’s the old economist’s ceteris paribus assumption, i.e., “everything else being equal”).

On Monday we’ll look at what happens when the price of the standard falls in real terms relative to other commodities and goods.

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