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Edited on Thu Sep-25-03 04:38 PM by Nederland
The key to understanding all money and fiat money in particular is to understand that a nation's currency is ultimately nothing more than a commodity. Like any commodity, its value fluctuates depending upon supply and demand. If the supply of a currency exceeds the demand, the value of that currency will fall. If the supply of a currency falls short of demand, the value of that currency will rise. This is true of any currency, whether it be paper, gold, silver, or sea shells. Money is a commodity, and its value shifts like one.
The argument that money should be backed by something physical like gold or silver relies upon the attraction of those metal's scarcity. When a government has a currency backed by gold, you can't simply print more money. There is only so much gold in the world, therefore there is a limit to how much money you can print. However, this is precisely the problem with having a currency back by metals: you cannot expand or contract the money supply as needed.
Now why would you want to be able to expand or contract the money supply? The answer is best given with an example. Let's say you have a town with 1000 people in it that has a fixed money supply consisting of 100,000 dollars. There is no way of expanding or contracting this number--its 100,000 regardless of what happens to the town. Now let's suppose that over time this town grows to a population of 2000. Nothing unusual there, right? Populations grow all the time, especially when times are good. But consider what happens to this town with its fixed money supply. Since the money supply is limited to 100,000 dollars, the number of dollars per person has gone from 100 per person to 50 per person, making money much more scarce than it was. What happens when a commodity is scarce? Its value goes up. An apple that used to cost $2, now costs $1 because dollars are so scarce you now need fewer of them to buy something. As we all know, when the prices of goods are falling, we have deflation.
So having a fixed money supply isn't all its cracked up to be. If an economy grows and the quantity of money available doesn't keep pace, you'll get deflation. This is precisely what happened in the US in the late 1900's. The population was growing, the economy was producing more and more goods, but the gold backed money supply was relatively fixed in size. The natural result: massive deflation. Now who benefits most from deflation? Answer: the rich. Poor people tend to have there wealth tied up in the things they need, their house, farm equipment, animals, etc. Rich people (at the time) tended to hold lots of cash. When the value of goods is dropping and the value of money is increasing, its easy to see that the people who have little cash are going to get screwed.
So the deflationary periods of the late 1900's led to the push for a fiat currency. Economists of the day realized that the only way to create a stable money supply with consistent currency values was to create a system the allowed you to expand and contract the money supply as economic conditions warranted. The risk was huge. You were basically trusting government to correctly look at the economy and determine if the money supply needed to be expanded or contracted, and more importantly trusting government to resist the temptation of printing more money whenever it needed it. The solution was to create the Federal Reserve, a quasi-public entity entrusted with monitoring economic conditions and adjusting the size of the money supply as economic conditions warranted.
How successful has the Federal Reserve been? Its record is mixed. Like any institution that is run by people, it is subject to the flaws of people. During the Great Depression, the people that ran the Federal Reserve royally screwed up in thinking that a contraction in the money supply was what the economy needed. In retrospect, the notion is almost laughable. Everybody today knows that if you are in a depression you should loosen the money supply in an effort to spur economic growth, but back then people weren't so sure. Many argued that the last thing you want to do with all those banks failing was to make it easier for them to loan out more money and potentially create more failures. They were wrong, and the people of the US paid the price. More recently, the Federal Reserve has done an excellent job. The value of the US dollar has stayed remarkable consistent the last 15 years, with inflation staying in a tight range of 1% - 6%. From a historical perspective, this is an amazing feat and a testimony to increased understanding of how economies work and the accuracy of economic data we now collect on a routine basis.
To return to the actual subject of this thread, a return to the gold standard would be a disaster. In the last 100 years, growth in the money supply has outstripped growth in the gold supply by several orders of magnitude. It is naive to think that a world which has seen growth rates of 5% to 7% could be well served by a gold supply who size grows at a mere 1%. If the US and the rest of the world had remained on the gold standard, we would have never seen the rise of the middle class and the rise in home ownership that we saw following WW2. Money would simply have been too scarce, and its holders a select few. I think that is something most Democrats can hardily agree is a bad idea.
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