There are many different ways to analyze money. The most basic theory is that currency lowers transaction costs for trading. Instead of me looking for a farmer who needs work in investments and trading my work for their food, I work for dollars, and then I can transfer those dollars to someone else for meat haunches. But money exhibits strange features as the scale grows. It breaks classic microeconomic laws. For example, in a microeconomic model printing more money necessarily leads to inflation. This has been shown false with variables such as velocity of money and the ‘propensity to consume’ (amount of money spent on goods and services) altering the affect of printing money on the value of a currency. Economists have made the argument that the danger of printing money is an argument for remaining on a metal standard.
It is actually a serious issue that currency has different properties when viewed on a macroeconomic scale. I will explore the reasons in depth in this piece, as it is a serious philosophical question. The short version is that microeconomics makes assumptions about how individuals act. Since the logical economic laws that follow from these assumptions fail at the macroeconomic level, human behavior and decision making changes. The sum is greater (or at least different) than the parts.
One such challenge to the classical equilibrium occurred under the metal standard, I will assume there is a metal standard in the following examples and then elaborate as to why the global monetary system was (for the most part) changed to fiat currencies. The following examples present situations under metal currency systems that were not easily explained by the classic (microeconomic) equilibrium. A first example is that if the money supply stays constant deflation will occur. This has been observed as true and is consistent with Keynes’ macroeconomic framework. Deflation is the idea that the money you hold will appreciate in value as time moves forward (as opposed to backward). This can cause all types of problems. Increased buying power of cash can decrease investments if hoarding cash is seen as preferable; it harms debtors whose original amount owed remains fixed, so the $100 they owe increases in real terms; and it benefits those who receive fixed incomes (such as retirees) since the value of each predetermined payment either stays the same or increases in value. The problems basically reverse for inflation, which can happen when countries make huge new gold finds while they are on the metal standard. The money supply will increase and inflation will occur; more money in the system means each unit of money is now worth less. Inflation can be damaging since your money depreciates in value over time.
Money and Ricardo’s theory of competitive advantages and marginal costs are often explained using a Robinson Crusoe economy. That is an economy with only a few people. This can help pinpoint the exact moment a microeconomic model fails to explain a macroeconomic phenomenon.
Imagine there is a fishermen, a farmer, and a water-gatherer. They all trade together with 60 shells. One day a new guy finds them and he is skilled at finding coconuts. Now instead of there being 20 shells per person, there are 15. It should be the case that if 4 shells had previously bought a fish, a bucket of water, and a coconut, now 3 shells would buy that basket of goods. The currency would simply adjust in relative value to the goods in the economy. But this doesn’t happen in a macroeconomy. In the macroeconomy deflation would occur since now more goods are being produced and the money supply is fixed at 60 shells. Each shell is now worth more than before, because it must be used to purchase more goods. The value of the currency relative to the basket would not have dropped to 3 shells thus regaining equilibrium. As a result the people in this four person economy would have a recession. Well, they obviously wouldn’t stop working, as they are working to survive and there are only four people in the population. But in a grand huge economy, people do stop working, and unemployment does increase. The formal definition for this phenomenon is sticky prices, o the idea that currency does not automatically adjust to changing conditions in a macroeconomy. While in this small economy they certainly would. With billions of people, millions of contracts, fixed income debt, set wages, and people more inclined to pay attention to nominal rather than real costs, sticky wages do exist.
Keynes argued the reason is that variables are sticky in an economy. This can be explained in two ways. The first fits in with a traditional microeconomic model: lack of good information. People might not realize how much new gold has been entering the market and will therefore fail to adjust their behavior accordingly. That gold might also be spent more in some industries than others leading to disequilibria in the short run. The second reason is behavioral. Often the way debt and wages are structured is that payments aren’t constantly adjusted in real terms even if the money supply has instantly changed. To complicate that issue further, imagine there is a fifty-year-old worker and a twenty year old worker. Now imagine that prices for healthcare suffered a 50% increases that year due to inflation. One employee is getting paid less in real terms since the elderly employee spends more money on healthcare, whereas the younger employee has noticed no difference.
In a sense, money stops being rigid and in a nice equilibrium, and becomes liquid, even in a metallic system. The effect of poor information and behavioral phenomenon prevents money from readjusting to its proper real equilibrium with every gain in money supply or even with a slow increase in population. I have written on banking ratios extensively in past articles (such as Lombard Street) so I will not go into detail now, but consider as well how banks lend out more money than they have in storage based on their perceived risk of meeting daily liabilities. In England when they were on the gold standard massive money market lenders and banks relied on a central bank. At this point defining a money supply is no longer clear. There will be a fixed gold supply but it is important to consider that the ratios banks lend at will change a more observable money supply in the macroeconomy. The velocity of spending will also change an observable supply of money (how fast money is spent). Cycles and events of deflation and inflation can also change the real value of gold towards goods and services in the economy.
This is made far more problematic due to the fact that deflation and inflation can occur asymmetrically across an economy. This will also cause issues in the unemployment number. This was Keynes’ prime argument that he used to begin “The General Equilibrium.” Even if government does not touch the money supply, due to sticky behavioral issues and poor information regarding inflation and deflation, disequilibrium can exist in the unemployment market. An obvious example would be that fast population growth with a fixed money supply could lead to deflation and subsequently to unemployment. Or if lots of gold were found the economy would heat up due to inflation and despite nothing changing, except a large influx of metal, unemployment would drop from its equilibrium. It is also argued that currencies could be created that are based on the value of a basket of goods. But this still is problematic as different baskets have sensitivity to different events such as food shortages and pol supply, and different demographics are more sensitive to price changes of different goods in a basket.
The reason this argument becomes important is that economic philosophies are often tied to certain moral or political movements. There is a lingering belief that a gold standard would promote liberty. Considering the monetary issues on a metal standard in the past paragraph though, I do not understand how this would be the case. Due to continuing issues of inflation, deflation, and unemployment disequilibrium a metal system still has faults that would be endemic to exogenous variables on the money supply. Even a non-fiat system is still subject to shocks from population changes, war, famine, new metal discoveries, policy changes and financial regulation. An argument could be made that the system improves if the government controls mining of precious metals. As a result they could add gold to the system when they need and also take gold out of the system, effectively controlling the money supply. This could help keep control over inflation and deflation. By having control over the money supply they could prevent shocks and potentially long-term inflation by monitoring what is happening and adding more gold if needed. The downside would be that they would be limited to working with a metal and would be tied to a physical component. However, if a government were sufficiently trustworthy and could create a central bank that worked independently of elected officials, a fiat currency could solve the problem of being tied directly to a metal. This would allow for corrections of inflation, deflation, and unemployment disequilibrium. This is what we did and what the Federal Reserve now does. If done correctly it is no more dangerous than a metal system and does not challenge personal liberties. It also allows for stronger and more robust monetary policy. It is easier to induce inflation in this system; however, the U.S. Federal Reserve has done a good job keeping inflation under control since Volcker.
Some groups who are against fiat currencies argue that it allows for exaggerated monetary stimulus (as opposed to careful control to protect from monetary events). Ostensibly while some precautions in a gold standard could be made to protect for shocks and inflation, it hamstrings the central bank from more aggressive monetary stimulus plans. To this I would argue that it is possible to be in favor of properly managed fiat currency whilst still against overly aggressive monetary policy (this was Milton Friedman’s view). The core component being that while a metal system does not allow for aggressive monetary stimulus at all, and thus making it an attractive choice, a libertarian could still argue for a properly managed fiat system that has strict law in place to prevent any type of monetary system. I believe that issue is separate from the debate between metal and paper currency.
The Federal Reserve and macro-economists have many different tools to measure money supply, money demand, and the value of money. These include various different measures of the current money supply in the U.S. economy, known as M1, M2, and M3. They also measure velocity of money, inflation, deflation, value relative to goods, value relative to foreign currencies, and so forth. The measurement of money isn’t simple and discrete. It is a strange and imperfect science. Money does not find a natural equilibrium either, which is why there is monetary policy and why Milton Friedman won a Nobel prize for his work in monetarism.
Most people do not view the money supply this way. When talking about debt, the Federal Reserve, monetary policy, fiscal spending, bailouts and the European debt crisis, most people speak as though there is a zero-sum game being played with a fixed amount of money.
Consider Germany. Now consider their options in bailing out Greece in the short-run. They can either bail Greece out, or not bail Greece out. One does not have a price tag and the other costs billions of dollars. The neo-classical answer would be that Germany should not bail out Greece, as the benefit would be less than the cost. Greece would then attempt to restore its own (non Euro) currency in equilibrium with the rest of the world. They would do this by inducing defaults on their debt (as just recently occurred), switching back to their own currency, and inducing inflation (or devaluing their currency and thereby reducing the value of their own debt). This would also lower the value of their currency relative to others and thereby increase exports, strengthening their economy and supporting growth.
This method would, however, be incorrect due to the nature of interconnected financial institutions and long-term benefits from Greece staying in a common money system. A messy default in Greece would bring down and damage other countries in the EU. If they defaulted (and if they have actually defaulted in the past weeks is still uncertain – ISDA has declared a default but no official repercussions have been experienced yet). people would become scared other countries like Spain and Portugal might default. As a result banks would stop lending to them and the cost for them to issue debt would skyrocket. As banks stop lending and providing liquidity, and as a result the cost for Spain and Portugal to issue debt increases, they enter into a death spiral. Since these countries would be too big to be bailed out, the EU could not stop the spiral. Soon an entire system might collapse. And it could all be prevented by bailing out Greece.
As a result, due to the nature of money, credit, sovereign debt and liquidity, German tax-payers will be better off as a result of paying for Greece’s debt. Based on my explanations the rational move would be to bail Greece out. And this is what they have been doing and what most people agree that they should do. But there is one final factor. This is a moral hazard. This means that Greece might now take advantage of Germany. The Greeks know that in this scenario the rational choice is for the rest of the EU and Germany to bail them out. As a result they might spend more money than they should and start to rely on consistent bail-outs and subsidies. This is why everyone else is upset. They are paying off the debt from Greece’s overly generous social safety net (e.g. Germany has no minimum wage law and Greece is the 6th highest in the EuroZone). However, the cost of a complete financial collapse in the Eurozone would be devastating. So what happens once they are bailed out? Well that’s for them to decide. If they want to risk bailing out Greece again in the future for the benefits of remaining close business partners (and close allies) they should stay together. If they don’t want to put up with Greece anymore, they should let them go (It’s not you—it’s me). But whatever they do, they should not let them default. Monetary policy in the EU is not a zero sum game.