For most of my life, I’ve supported a commodity-backed currency, and in particular, gold. The gold standard seems reasonable. Why back money with a commodity? Basically
Gold in particular is a good commodity to base money on. It’s dense, holding a lot of value in a small space. Even though it is dense, it is still light enough to move around. Gold is stable, and not subject to corrosion. Gold is malleable, which makes it easy to work. This means it is easy to divide into smaller pieces, and it is easy to stamp with an image. Gold is hard to counterfeit. And gold is plentiful enough to use as currency, but rare enough to make it valuable.
So why not back a currency with gold? It seems better than a fiat currency, which is backed by nothing more than faith in the government. However, a commodity-based currency has some drawbacks. Trevor Kiviat writes: “The move away from gold was brought on by the realization that commodity money ties a country’s economy to a scarce natural resource, and this can have destabilizing effects. In other words, when Mother Nature controls the supply, shocks can occur that are beyond control.” (Kiviat, 2015, p. 582)
What sort of shocks are these? Well, suppose a large supply of gold is discovered, such that the supply is dramatically increased. This actually happened between the 15th and 17th century, when Spain flooded the market with gold and silver coins created with mineral wealth mined from the new world. The result was inflation, with prices rising 600% over 150 years. While the annual rate of inflation was only 1 – 1.5% per years, this was incredibly high given a commodity-based currency. In the United States, the Panic of 1857 was the result of a cooling international economy and an overheated domestic economy. This exacerbated by the sinking of the SS Central America, carrying 30,000 lbs of gold destined for the banks in New York, and the banks didn’t recover until the end of the Civil War.
The problem with the gold standard is that the supply is limited, making it inherently deflationary. It is better to save money than to spend it, which makes it difficult to invest money in a new business or open a factory. You couldn’t buy a house with the expectation that inflation would make it worth more money in the coming years, or at least enough to pay for the costs of the selling the house. In addition, you could be taxed on your assets, but it’s hard to tax a hoard of coins buried in the ground.
Interestingly, virtual currencies such as Bitcoin have similar problems to commodity-backed currencies, in that the supply is limited, making them inherently deflationary. The fact that early investors are rewarded when they sell currency to late investors makes them appear, in the eyes of some pundits, like Ponzi schemes. The reality is that the people who created these virtual currencies are Crypto Anarchists and technology mavens with little understanding of economics, monetary policy, or even basic accounting (e.g. they call the blockchain a ledger instead of a journal; a ledger is a summary analysis, whereas a journal is a record of individual transactions.)
The very things the gold bugs decry about fiat currency turns out to be the things that make it a more useful type of money. First (and this is huge), it is recognized as legal tender, which means it serves as payment for all debts, public and private. You can’t pay your taxes with gold or Bitcoin. Second, the central bank has control of the money supply, which prevents the economy from heading into a deflationary spiral. Imagine what would happen if the value of money rose and prices dropped over a long term. Wages would drop, which means it would be increasingly difficult to pay mortgages. Third, fiat currencies are backed by indirect collateral, which means a system of interbank loans designed to maintain market liquidity. Fourth, fiat currencies are often insured (for example, U.S. bank accounts are insured by the Federal Deposit Insurance Corporation (FDIC).) The net result is that there are a variety of mechanisms available to control the money supply, which effectively stabilizes prices.
Kiviat, T. I. (2015). Beyond Bitcoin: Issues in Regulating Blockchain Transactions. Duke Law Journal, 65(3/4), 569-608. Retrieved from https://scholarship.law.duke.edu/dlj/vol65/iss3/4