State Currencies and Modern Monetary Economies: Part 2

State Currencies and Modern Monetary Economies: A Primer

Part 2.

Introduction:

Good morning. Yesterday, we had a look at defining monetary instruments and a brief introduction to state currencies. You will recall from our discussion some key points concerning what constitutes a monetary instrument. You need an issuer, a face value, and the issuer must promise to accept it back as payment for something, or you don’t have a monetary instrument. Hence, gold – which is our subject today – is not a monetary instrument. It is a commodity. Monetary instruments are man-made things, yet nobody issues gold. The earth certainly does contain gold, but the earth does not issue it. It cannot increase the supply of gold at will. So, the supply of gold is not elastic. Earth also does not give gold a face value, nor will it accept the gold back as payment for something. The notion of gold itself being a monetary instrument is obviously absurd. So, what then gives the commodity gold value?

Gold is Pretty to Look at, But When It Comes to Economics, It Can be Really Depressing

A little economics joke to start your day. Well, firstly, as the supply of gold is inelastic, meaning that its supply cannot easily increase to meet demand, gold is scarce. So, there’s that. And secondly, utility is another factor in what gives gold value. This means that the value is determined by the use people see in it – what gold means to them. If tomorrow, suddenly nobody liked gold anymore and found no use for it, then the fact that gold is scarce would mean nothing to its value. Its value would drop to zero. So, on this correct view, we understand that gold is a commodity, both useful in the production of certain goods, and as a speculative asset. What gold is not, is a monetary instrument. The government can strike gold coins all day if it likes, but the gold contained within the coin isn’t the ‘money’; it isn’t the monetary instrument. The coin itself is.

Now, you will hear people complain, saying, ‘Ya derned fool! Gold is muneh! By gosh, golly gee, I can buy stuff with it. I’ll betcha there are people out there willing to sell me their stuff for some gold. Don’t tell me that gold isn’t muneh!’

Gold isn’t ‘money’, and no, you cannot ‘buy’ stuff with gold either. You can certainly trade gold for stuff, but that is barter, not ‘buying’. The term for this sort of transaction is ‘payment in kind’. Briefly, payment in kind is when you use a commodity like gold, or some other good like a tin of canned peaches in heavy syrup instead of a monetary instrument to acquire another good or service. That’s really all you need to know there. Now, back to gold coins for a moment.

Why Add Gold to Coins?

As I said, the government can strike a gold coin, but the coin is the monetary instrument, not the gold contained within the coin. This means that the coin contains insurance. It contains a commodity which then acts as collateral, just like if you were to put up your house as collateral for a loan. And historically, one reason that gold was added to coins was because people didn’t trust monarchs all that much.

A monarch is all-powerful, but take Henry VIII for example. Sure, ladies, he said to you, “Nah! No worries then, luv. I’m not gonna cut your head off”, but can you trust him? Not really a good idea. I mean, everything is great at first because you’re the wife of a king, but the moment you give birth to a girl, you wake up the next morning with a splendid view of the inside of a basket, and from that point you have to rely upon someone shaking the basket to change the view. Now, if he were to tell you that he’s going to cut your head off, you could probably take his word for it, but this doesn’t apply vice versa.

And so it was that people didn’t completely trust the word of their king. The king could stamp coins and then break his promise to accept them back as payment for taxes at any time he chose, or just outright refuse to accept them back to begin with. Thus, people wanted some insurance, and monarchs added gold to the coins. This way, if the king wanted to be a dick and tax but not accept his own coins as payment, the people could melt down the coins, obtain the gold and either keep it, or hand it over to the mint and obtain new coins that the king would accept – at least, until he changed his mind again for the hell of it. Piracy and ransoms were another reason for gold coins. “Argh, matey! Argh, and stuff! Black Jacques doesn’t want none of yer promises, Englishman. Now, hand over yer… Damned parrot shat on me shoulder again! Now, hand over yer gold or I’ll skuttle ye with me corsair! Argh! Argh! Me peg leg and all that.” Also, there were members of the nobility held as prisoners of war that needed ransoming.

So, here’s England holding a few French knights prisoner, and France would like them back. English persons don’t really want a bunch of brass coins, and the same holds vice versa, so now what? Well, the French hand the English some coins with gold in them in exchange for the knights, and the English can melt them down and strike more of their own coins. Problem solved. And so, on down through the ages we go with trust issues until we arrive in the 19th century, and we apply the same mistrust that we had for kings 500 years prior this time to our ourselves, embodied in our national government. In a word, it’s a “habit”.

The Gold Standard

Everything that I’m about to say will apply equally to the UK and many other nations. For brevity, I will mostly use the US government as our example.

The US/UK governments issue the US dollar/the British pound. Of that there can be no question. But here we have a situation where paper notes are quite popular, and what is paper anyway? It’s, well, just paper. We have trust issues, so the government is going to have to back up these slips of paper with something, because we need insurance. We need some good convincing, and putting a gun to our heads and threatening us with imprisonment apparently wasn’t convincing enough. So, the US government fixes the value of one dollar to a certain amount of gold. There’s your insurance. But, there’s now a problem for the US government. In order for the insurance policy to work, the government will need to promise to exchange gold for those dollars on demand. Therefore, the government is going to need a supply of gold on hand. So, the major point to take note of here is that the gold standard simply cannot work unless the government agrees to exchange its own currency for gold at the fixed exchange rate which the government declared. And in doing so, the government now faces the problem of running out of gold, when in a purely fiat system, this wouldn’t be a problem. The government cannot run out of dollars, ever. But it sure can run out of gold. Thus, you can now clearly see why understanding what monetary instruments are is a prerequisite to understanding the gold standard.

And it is this deliberate fixing of a man-made monetary instrument, which the government has an infinite supply of called the US dollar, to an inelastic commodity called gold that will create all sorts of unnecessary problems for the government, from addressing domestic unemployment issues to international trade. And when the Great Depression hits, the US government will have little choice but to suspend the conversion of dollars to gold.

Operations Concerning the US Dollar/British Pound During the Gold Standard (Yes, it was very, very different than it is today)

Now, as I’ve just mentioned, the US government had to maintain a supply of gold. Therefore, it had to defend its gold supply at all costs, and the fix is in. The federal government officially fixed one dollar to a certain amount of gold – no turning back. The people get their unnecessary insurance policy; rich people are satisfied. But, how does the federal government defend the gold supply, ensuring that it will not run out of gold since people are able to bring their dollars to the US Treasury and exchange them for gold at any time? Well, clearly, the federal government must take care not to introduce more dollars into circulation than can be exchanged for gold at the fixed exchange rate, else all hell will break loose. Now, the federal government is the sole authority allowed to declare the fixed exchange rate, so if it wished to add more dollars into circulation, it could certainly devalue the dollar. Ah! A popular buzz word finally crops up: Devalue.

Devaluing Currency

The gold standard is what we call a fixed exchange regime. And in a fixed exchange regime, the valuation of currency is an official act of the national government in question and not of the so-called ‘free market’; not the private sector, but the federal government. The government declares a value by saying, “I officially declare that one of my dollars is worth exactly this much gold”. For the sake of brevity, and ease of understanding, we will forego using the historical exchange rates and simply pretend that the federal government fixes one dollar to one pound of gold. We will use this as our example exchange rate from now on.

So, we are at the point where the federal government needs to defend its gold supply, but also needs to add more dollars into circulation to address unemployment issues, and the official exchange rate is one pound of gold for one US dollar. The government decides to officially devalue the currency.

The federal government declares that one US dollar is now worth one-half of a pound of gold. The US dollar is now devalued. Now, when people bring their dollars to the US Treasury, they will only receive in exchange a half pound of gold instead of a pound. What this means is that the US government can now safely increase the number of dollars in circulation without threatening the gold supply. But, the problem with official devaluation is that people would make this poopy-face look and wag their fingers declaring, ‘Yer deeval’ying m’doller’, meaning that the price of a tin of canned peaches in heavy syrup might sort of go up a bit. Whilst we’re on this subject, just remember that when people today say the word ‘devalue’, what they really mean to say is, ‘inflation’. So, devaluation was a no-no, and thus it was poo-pooed. People viewed it as cheating: “Say now, that’s not fair. You’re losing and you are now resorting to cheating to keep playing the game. Well, let me tell you: You need to play the game by the rules! Poo-poo!” So, national governments tried to avoid devaluation wherever possible. The gold supply could only be properly defended in two ways after the government declared a fixed exchange rate:

1.) Taxation

2.) Borrowing

The Function of Taxation and Borrowing During the Gold Standard

As we discussed, the federal government must take care not to introduce more dollars into circulation than can be exchanged for gold at the fixed exchange rate, or else it will be pandemonium and other large words of a threatening nature. Thus, the trick to federal spending was to recycle, or ‘respend’ the dollars that the US government already placed in the economy in years prior. The government achieved this through taxation, and when it deficit spent, it issued treasury bonds and borrowed.

Recall our fixed exchange rate of one dollar to one pound of gold. Now, we will say that the US government has exactly 500 billion pounds of gold on hand. This means that at a fixed exchange rate of $1 for one pound of gold, the US government can safely have 500 billion US dollars in circulation without fear of running out of gold. Taxation allowed the government to defend the supply of gold because it would simply spend the dollars that it collected. So, to demonstrate federal taxation during the gold standard:

We have 500 billion pounds of gold, and $500 billion in circulation. The federal government collects $100 billion in taxes. Afterwards, there are exactly 400 billion dollars left in circulation. The federal government now spends the $100 billion collected back into the economy and the result is the same as before taxation: $500 billion in circulation. The government was able to spend without increasing the number of dollars in circulation, thus defending its gold supply at the fixed exchange rate. Borrowing is the same thing.

Again, we have 500 billion pounds of gold, and $500 billion in circulation. The federal government collects $100 billion in taxes, and wishes to deficit spend $100 billion, so it issues treasury bonds and borrows $100 billion from the private sector on top of what it collected in taxes for a total haul of $200 billion. Afterwards, there are exactly 300 billion dollars left in circulation. Again, the government was able to spend without increasing the number of dollars in circulation, thus defending the supply of gold supply at the fixed exchange rate of one US dollar to one pound of gold.

Thus, we see, back in those days the level of currency in circulation was an important factor that the government had to take into account when it spent, and if the government wished to deficit spend, it had to issue bonds and borrow, but taxing and borrowing was not exactly done to ‘finance’ its deficit per se, but to protect the gold supply. That was the primary reason. So, it was not exactly ‘tax and borrow to spend’, but it was more or less, ‘tax and borrow to defend’. Again, even during the gold standard, the federal government could never run out of US dollars. But, it could run out of gold. It had to refill its coffers with gold, not US dollars. Today, there are no coffers at the US Treasury, or HM Treasury to fill.

Now, we’ve mentioned devaluation, so let’s now mention it again by highlighting yet another way that the federal government could ‘devalue’ the dollar during the gold standard.

Printing Money – A.K.A. “Oh my God, we’re all gonna die from something that no longer exists!”

During the gold standard; meaning, long ago in the days gone by, if the federal government wished to increase the number of dollars in circulation; that is to say, spend more than it could collect in taxes and borrow from the private sector, then it could choose sell bonds to the central bank rather than to the private sector, and the central bank would credit the government’s account. Doing so would increase the number of dollars in circulation because, unlike borrowing from a private sector entity whose supply of dollars is limited because he/she/it is only a user of dollars, the central bank does not have a limited supply of dollars because it is not a user of dollars; it produces dollars. So, by selling bonds to the central bank and then spending the dollars credited to the government by the central bank, the only direction for the number of dollars in circulation to go was up. The technical term for this is ‘debt monetisation’, for which mainstream economists employ the term ‘printing money’ to scare the public. They apply it to today’s monetary system without mercy, though printing money to fund spending does not exist. The humorous thing about all of this, is that the US dollar/British pound itself is a debt instrument; not just the bonds or gilts, but the dollars/pounds themselves. A monetary instrument is a liability of the issuer. So, when an economist mentions printing money, he or she is claiming that the US/UK government is monetising the money. In other words, the government is irresponsibly turning money into money.

Members of the general public who believe that the federal government monetises the money, love to talk about the dangers of printing money and scream “Weimar!”, because they tend to think that the rules of the gold standard still apply today, and they tend to regard the economy as a cash-based system, though most of them have debit cards. Go figure. Thus, they view the term ‘printing money’ to mean the government turns on the printing press at the Bureau of Engraving and Printing, cranks the handle, and churns out loads of fake, ‘Monopoly Money’ toy dollars.

The upside to printing money during the gold standard was that the government increased the number of dollars in circulation so that it could address a major issue like domestic unemployment, but the downside was that the government put its gold supply at risk. All that being said, let’s briefly look at another false assumptions that people have about printing money, and why people mistakenly apply this to today’s US dollar/British pound.

People have the mistaken impression, based on gold standard operations and their errant view that gold is ‘muneh’, that there are two kinds of US dollars/British pounds:

1.) Real, all-natural, wholesome US dollars/British pounds which are scarce, precious commodities, and,

2.) These fake, counterfeit paper thingies which the US/UK government prints up and they just fling to the wind, spending like there’s no tomorrow, and devaluing our real dollars/pounds. But people can’t tell the difference between a real dollar/pound and these fake dollars/pounds, because they look identical. You’d need an expert engraver from the government to tell the difference and believe me, he ain’t talkin’, buddeh! You’d swear they were the same thing. And, before you know it, hyperinflation sets in. A powerful, forceful wind that no man can withstand begins buffeting the economy to and fro; paper flying everywhere like confetti; houses, cars, cats, twigs, termites, and tins of canned peaches in heavy syrup just a whippin’ around like a load of knickers enduring the spin cycle of a washer. One, giant finger of God, F-9,000 big ole tornado, just a whistlin’, and a whirlin’, and a swallerin’ up everything. In the end, all that’s left is a scene from “Life After People” and a hissing sound.

As we can clearly understand through our examination of the gold standard thus far, this absurd, ridiculous belief of real dollars/pounds vs fake dollars/pounds stems from the nonsensical idea that the dollars/pounds that were in circulation during the gold standard era prior to the government fixing an exchange rate were actually commodities – private sector ‘money things’ that had always been there since the beginning of time. Or, at least since who knows when, and that it certainly wasn’t the government that put them there. No sir. That’s not possible. Maybe it was God that put the dollars/pounds there, or the founding fathers, or the arch-angel Gabriel, or Johnny Appleseed, or the universe itself – even John Jacob Jingleheimer Schmidt is a potential suspect. But, it certainly was not the US/UK government because, in their minds, that’s not possible.

What really occurred which people cannot see, was that the US/UK government first spent the dollars/pounds into existence and then after they were already circulating, the US/UK governments voluntarily constrained themselves, promising the private sector that they would never add more dollars/pounds to the economy if it could be helped, and they proved to everyone who had trust issues that they were serious by fixing dollars/pounds to gold. All dollars/pounds back then were real dollars/pounds, and all dollars/pounds today are real dollars/pounds.
And as it should be quite clear now, this nonsense is the exact reason why I oppose using the term ‘printing money’ to explain high powered money creation to the public. If you are going to use the term, you really need to know beforehand who you are dealing with.

That is all I have for today. I thank you for listening.

This concludes part two of the series. In part 3, we will further examine the gold standard with a look at the effect of gold on international trade, as well as discuss some aspects of the Great Depression.