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Money: The Second Essential Fact

Why It Is Important to Remember That Money Is Trash

Lots of folks are beset by a profound feeling that money, as important as it is, should not be trash. It should be gold or silver or something else intrinsically valuable. Not (gasp!) mere paper. As understandable as this feeling is, it is wrong. We need to explain why.

Types of Money. When something intrinsically valuable is used as money, it is called commodity money; paper money that is not linked to a commodity—that has value as money only because the government says it does—is fiat money. Although all sorts of things have been used as commodity money, it almost always takes the form of scarce metal: gold, silver, or copper.

There are a number of problems presented by metal as money. Like all other commodities, its value will fluctuate. It can, and almost invariably will, be adulterated. If, as is usually the case, different metals are used in the same monetary system (i.e., gold for high denominations, copper for low, and silver for intermediate values), fluctuations in the supply of one metal relative to another will make one type of coin more valuable than another. For example, in a system in which ten silver coins are nominally worth one gold coin, and a new, large supply of silver is discovered, the silver coins will become “inflated” with respect to gold. Gresham's famous law, that bad money drives out good, will take over. Gold will be hoarded and disappear from the market. Historically, this has happened many times. Sometimes it was silver that was overvalued, and sometimes it was gold.

Money Must Be Flexible. Metals are also heavy and bulky, a nuisance to carry around. But the most important disadvantage of commodity money is its lack of flexibility. To serve its purpose in an economy, the amount of money in circulation should match the goods and services being produced and offered for sale. Too much money and you have inflation; too little and you are cursed with deflation. Either one can be bad, but deflation is by far the worse. If an economy is growing faster than the supply of the gold or silver of the money supply, as is likely, you will have deflation. Which will stop the growth of the economy.

So in spite of the prejudice in favor of gold and silver, as our economy has grown more and more complex, governments have had to move to fiat money. It has been a gradual process. Even the minting of coins is a step from pure commodity money to fiat currency. Why? Because the intrinsic value of the metal in the coin is always significantly less than the face value of the coin. As noted, the value of precious metals, like that of all commodities, fluctuates. If government tried to make the face value exactly equal the actual value, there would be times when the actual value would be greater. And the coins would be melted down.

Issuing paper money based on metal (gold or silver “standard”) was the next step. It is important to remember that although such money claims to be redeemable in gold or silver, there is actually never enough gold or silver on hand to meet all the claims were they to be made at the same time. In the same fashion banks never have enough money to make good the claims of all of their depositors. If every dollar or euro had to be separately backed by an equal and exact amount of gold, the economy would come to a grinding, screeching halt.

Taxes. And finally, fiat money does not have value only because the government tells us that we must accept it. It has value because the government will accept it: as taxes. Taxes are, in fact, the foundation of the value of all government certified currency, from the Roman denarius with Caesar's portrait stamped on it to the modern dollar bill.

[Next: Summing Up, So Far.]