Thursday, May 7, 2015

Gold standard or fiat: Why it matters

Most people especially pundits and politicians do not understand our fiat monetary system. Their understanding is based on a gold-standard system, which we gave up completely in the mid 1970s. Here we look at simple, basic differences between these two monetary systems. 

For simplicity, we will imagine colonizing two islands with primitive but productive populations. Both islands have a culture, but have not established monetary systems. They barter goods and services as best they can, and they are poor by our standards but content.

We arrive at each island intent upon establishing production of goods and and services within a capitalist economy based on a monetary system. 

Gold Island

To get the gold we need for our monetary system, we offer paper money to the people to mine gold. They are not at all interested until we demand that they pay taxes with the money we pay them for the gold. Of course, there will be some unpleasant consequences should they not pay their taxes. Taxes are always imposed through coercion.

Gold Island: Spending limited by amount of money. 

This is similar to the actual experience of the British when they colonized part of East Africa late in the 18th century. They imposed hut taxes enforced by the threat to burn down the huts of delinquent tax payers.

By imposing taxes we have made the population unemployed. And, they will have to work to earn the money needed to pay their taxes. 

This may be a strange notion to some. Introduction of a monetary system causes unemployment through taxation.

At last, the miners take the money in proportion to the amount of gold they deliver. In terms we understand the miners and those who feed and house them are the private sector. Our government now has the gold, which it buries in a safe place. And, the private sector has the money with which to trade among themselves.

The private sector can set up banking to facilitate loans between those who wish to save and those who wish to invest in business development. Historically banks have extended the money supply by issuing their own bank notes. That’s a practice leading to bank panics.

As the island prospers we want the government to provide armed forces for our defense. Also, we want it to establish a legal system that protects ownership of our property and punish those who steal. Other services might include health for the poor and walking canes for the elderly the better for them to go dumpster diving.

Because the private sector has the money, the government must borrow from or tax the private sector to get back the money it needs to provide services. This puts government and the private sector in competition for the limited amount of money available. The more government spends the less money remains in control of the private sector. As a consequence, there is pressure from the private sector to keep government and its spending small.

The advantage of a gold standard is that the value of money and prices are stable. But, there are disadvantages. Banks might lend too much and be unable to cover depositor withdrawals leading to panics. There may be too little money available to provide for the poor, sick, and disabled. Also, competition between the private sector and government for money causes interest on loans to rise. Most important, with a fixed amount of money the economy can not expand to accommodate a growing population. This leads to constant unemployment.

Fiat Island

As we need no gold, we offer our fiat money to the people for work we want them to do. When they demur, we impose taxes or else. This coercion, as on the gold island, causes unemployment so that people work for the money that will be accepted for taxes.

Fiat Island: Spending limited by available workers.

Unlike Gold Island, the quantity of Fiat Island money is not limited. Government can provide services without interfering with the private sector. There is no need for government to tax or borrow to spend. Where Gold Island is limited by the amount of money available, Fiat Island is limited by the number of willing workers.

When government does tax or borrow it is retrieving money that it has already spent. This is also true on Gold Island. The difference lies in what is bought. On Gold Island it is gold; on Fiat Island it can be whatever can be done with the available workers.

Banking can be set up as either private or public functions. In either case government must allow banks to create money for private investment. And, government controls the interest rate at which banks obtain money.

With both the government and private business able to spend at will, there might be too much money in circulation. When people have too much money to spend, demand for products exceeds our productive capability, and inflation occurs. Inflation manifests as increased prices for goods and labor. 

Taxes are a ready remedy for inflation. Government and private spending put money into circulation. Taxes take money out of circulation. This allows control of the economy through appropriate spending and taxation (fiscal) policies. Another tool against inflation is interest rate (monetary) policies. The cost of borrowing is set by Government and can influence how much the private sector borrows to spend.

Or, the economy can deflate, the opposite of inflation. If the private sector borrows too much, debt service may become a problem, and people will reduce consumption. 

Why it matters

Anything that causes reduced consumption results in unemployment. Such causes are taxes, consumer decisions to save rather than make purchases, increased interest rates, or decisions to import from abroad. Under a fiat monetary system, government can offset reduced consumer demand by hiring the unemployed at a fair minimum wage.

A fiat system allows government more options than the gold standard. There is no reason that anyone should go without a job or suffer substandard wages.

Government budget decisions will always involve political interactions. And, there will be clashes among different points of view. Under a gold standard private business is at the center of discussions and the push is toward a smaller government role. A fiat system puts government at the center of regulating the economy, and it can make fiscal and monetary decisions looking at how they effect the whole economy.

Around the world, nations with fiat systems are running their economies as if they were on a gold standard. Politicians spread fear of running out of money to convince their electorates to make decisions against their best interests. Running out of money is not a problem with a fiat system. One might wonder if this fear mongering is because of ignorance or undue influence by big business.

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