A number of people in the United States with libertarian tendencies follow the example of Ron Paul in proclaiming a gospel of gold. Like the Populists of old with their silver (not ruby) slippers, these folks believe that fundamentally changing U.S. monetary policy is an essential aspect of reversing the problems in this country and in the world, and that departing from the gold standard was one of the worst mistakes in U.S. history. They also argue that the current system of fiat money places way too much power in the hands of the government. For those who do not understand the difference between the gold standard and fiat money, here is a brief explanation:
- Commodity money is a type of currency that has an intrinsic value in and of itself. For instance, in many prisons, cigarettes have become a form of commodity money because they represent a generally accepted medium of economic exchange and denominate the prices of products and services within that microcosm. The value of such money is independent of any central governing authority. While the U.S. dollar was still just a piece of paper under the gold standard, it was backed by a specific amount of gold, so its value was directly tied to the market value of gold.
- Fiat money is a type of currency that is only valuable because people agree that it is valuable. While paper-form commodity money is backed by the value of a certain commodity – such as gold or silver – fiat money is backed by the legitimacy of the institution that issues it – such as the U.S. federal government.
After that explanation, you can see why a gold-based monetary system seems more appealing to many people. Governments can rise and fall, but humanity has almost always placed a high value on gold regardless of whose face or which country’s name is stamped on it. However, the matter is much more complex than just that. Both systems have their advantages and disadvantages, and we need to understand a few more basic economic concepts before we can pass judgment.
Inflation vs. Deflation
In our current society, everyone knows what inflation is: it’s that annoying tendency that money has to gradually lose value over time. The price of a 32-ounce Coca-Cola continues to rise year after year, while the money our employers pay us strangely tends to resist change. To understand inflation, we have to understand exactly what money is in an economy. In any economy, money represents a certain amount of wealth. As a simple example, in an economy of $1,000,000, every dollar represents one-millionth of the total wealth of that economy, with each dollar serving as a tiny slice of the pie.
However, if you print more money – as often happens in a fiat system – that pie is suddenly being sliced into a larger number of pieces. The total amount of wealth that each dollar represents is therefore less. This is inflation.
However, there is something else that happens in economies: deflation. Most people in the United States do not know what deflation is because we have not seen it in some time. Deflation is when the economy grows – thus increasing the total amount of wealth – while the amount of money in the economy stays the same. And what is the result of this? The result is a bigger pie with the same number of slices – which means that each dollar is now worth more than it was worth before.
A common tendency people have is to assume that this is good. Doesn’t it sound good to watch your savings gain in value when you have not done anything at all to risk it? Well, it is actually terrible for economies – worse than inflation. The reason is that, if you know that the economy is probably going to undergo 20% deflation, you are probably not going to bother with starting that company you were thinking of starting or investing money into the stock market. Instead, you are just going to keep all of your money in the bank and watch as you become richer and richer with minimal effort or risk. The result of this scenario is that people stop spending money and all of the wealth in the economy ends up going to the people who can afford to save. Meanwhile, various industries will take a nosedive because, suddenly, no one is spending money unless absolutely necessary. Also, no one is innovating or investing in technology or new companies because, again, if you can gain wealth by risking nothing and doing nothing, why invest?
Why is all of this important when it comes to commodity vs. fiat money? It is important because having a fiat system gives a nation much more ability to control both inflation and deflation. The reason no one knows what deflation is anymore is because, due to our fiat system, we can control inflation and deflation by printing money whenever we need to. As an economy grows, the only way to ensure that price levels – and the value of the currency – stay the same is by printing more money at the same rate at which economic growth occurs. The reason inflation still occurs is because it is impossible to know exactly how much money we should print with absolute certainty. For this reason, we must choose to err either on the side of inflation or deflation. Since deflation tends to be more disruptive to an economy than inflation, we choose to err on the side of inflation, maintaining a constant inflation level of 1-5%.
While a fiat system allows the government to keep price levels relatively constant by giving it the ability to print money (and get it back by selling bonds), a commodity system does not allow the government to do this. For currency growth to occur in a system that abides by a gold standard, the government has to find more gold – on public land. Otherwise, as long as the economy continues to grow, either a trend of deflation will occur forever without limit or the government will have to pay money for the gold that it intends to use as money.
In short, the reason we have a fiat money system is because we have realized that limited inflation is way better than unlimited deflation.
Counterarguments and Misconceptions
Despite all of this, some people – such as Ron Paul – still contend that a commodity money system is better than a fiat money system. Their arguments come in various forms:
“The Federal Reserve is causing hyperinflation!”
In 2008, I was watching Glenn Beck, and I saw him talking about the Federal Reserve’s decision to print a large amount of money. He ranted and raved about how much money the Fed was printing, giving detailed illustrations to show how many crates of hundred-dollar bills it takes to account for that much money, etc. Angry and outraged, he shouted: “Stop printing so much money!” He then talked about how we would soon need a wheelbarrow full of money to buy bread at the 7-Eleven. Well, guess what! That hyperinflation he was warning about? Yeah, it never happened. This is because the Fed was printing so much money expressly because the market was exhibiting a massive trend toward deflation. The end result was a wash and a slight bit of inflation for the year. Remember folks: Glenn Beck attended college for a single semester, and he certainly never studied economics to any depth.
“The federal government should not have so much power.”
Those who advocate a return to the gold standard do so largely because they think that the Federal Reserve is an evil institution bent on the destruction of the United States as we know it. They talk about how the Federal Reserve, in one fell swoop, could suddenly print so much money that whatever money we hold will suddenly become virtually worthless, and this move will somehow pave the way for a New World Order takeover. However, let me point out that the federal government is and always will be in charge of the U.S. Armed Forces. In a totalitarian takeover scenario, compared to the power held by our military, the power of the Federal Reserve is trivial. Many would argue that “Commanding the military is something natural for the federal government to do.” Well, maintaining price stability is also something that naturally falls within the realm of government. It is intrinsically impossible for the private sector to do so – especially when operating on the gold standard.
“The Federal Reserve is as ‘federal’ as Federal Express!”
This is actually the strongest argument that these folks have: that the Federal Reserve is an institution with huge power that is not led by elected officials. The logic behind the fact that Federal Reserve officers are appointed rather than elected is the same as the logic behind why Supreme Court justices are appointed rather than elected. I would be open to the idea of requiring the Chairman of the Federal Reserve to be elected. However, we need to realize that this would make monetary policy as susceptible to political vacillations as our fiscal policy is. Also remember that we could have elected leaders in charge of the Fed without going to the gold standard. These are two separate issues.
“Our currency is backed by the federal government. If the federal government collapses, my money will be worth nothing.”
Those who make this argument do not realize the potential gravity of a total collapse of the U.S. federal government. If the federal government collapses, your car, computer, iPhone, stocks, and bonds will all equally become virtually worthless, regardless of monetary policy. Such a collapse would lead to a worldwide economic catastrophe second only to what a nuclear holocaust would cause. Pretty much your only possessions that would be of any value at that point would be your house and any food or weapons you own. Remember: gold is even less edible than paper. And even if it were edible, the gold standard would not put gold in your pocket anyway. Rather, it would put paper in your pocket and back that paper with gold somewhere far away – guarded by federal employees. With no more federal government, would those federal employees continue protecting your wealth? Um…no.
“It is ridiculous to assume that people will stop investing and starting companies just because their money is appreciating in value. The natural thing for people to do is build, create, and take risks.”
It’s very ironic that libertarians and conservatives use this argument to try to show that deflation is actually good for an economy – because Marxists make the same argument to promote Marxism. The whole problem with Marxism is that it removes the reward someone can collect from taking a risk or bringing about an innovation, thus causing people to not take risks or make innovations. Libertarians and conservatives know this and make it a point to remind Marxists of it whenever they can. However, as soon as we’re talking about monetary policy, these guys suddenly want to make economic decisions based on a general assumption of human altruism, which is fundamentally opposed to free market theory. One may say that altruism is not the assumption, as one can conceivably profit much more from starting a business than from leaving his money in the bank to appreciate in value due to deflation. However, potential return is not the only factor here: there is also the matter of risk. Faced with a choice of a 10% profit that is a sure thing or an 80% profit that comes only after much toil, headache, and risk, what would you do? Many people would take the 10%. Thus, we can see the intrinsic problem of a protracted state of deflation. The libertarian/conservative assumption that everyone will opt for the risky 80% over the safe 10% is as baseless as the Marxist assumption that we will all work as hard as we can and do as much as we can regardless of the payoff.
“The officers of the Fed use their position to influence the money market and profit from the fluctuations that they know are about to occur.”
I cannot be 100% sure that this is not happening. In fact, it may be happening. However, it cannot be happening to any high degree because, if their goal were to simply increase their personal wealth by tampering with the market, what we would be seeing would be massive fluctuations in the value of currency. That’s because the way you make money in speculation is by buying when prices are at rock-bottom and selling just before the bubble bursts. For this reason, speculators love volatility. On the contrary, the Federal Reserve does its job more effectively than virtually any other part of the federal government: it constantly keeps inflation rates at low levels and does not allow deflation to occur at all. The fluctuations in currency value that we see now are actually much less volatile than what occurred under the gold standard.
“The Founding Fathers saw fit to enact a commodity-based monetary policy, so that is what we should have.”
George Washington, James Madison, and Thomas Jefferson knew virtually nothing about fiat money as we have it today. They did not weigh two options and pick the one that God told them to pick: they simply continued with a monetary policy similar to what they had experienced under the British Empire.
Science and Religion
Do not let yourself get manipulated or misled. While our fiat monetary system has its disadvantages, it is a much better system than Ron Paul and Glenn Beck would lead you to believe. Unless we can somehow find gold at a rate that exactly matches economic growth and then make gold disappear when there is an economic contraction, our fiat system is much better than the gold standard. We simply have to make sure that we elect wise politicians who would never appoint crazies to take the reins of the Federal Reserve. In discussing this issue with people who have actually studied economics, I have found that those who say we should return to the gold standard reject all economic data and base their arguments on pure ideology rather than fact because the verifiable facts undermine their position. Like Marxists, they turn economic theory into an unyielding religion rather than a continually developing science.
*Final Note: I just realized that the pie charts do not view correctly in some browsers.