Wednesday, March 21, 2012

What is Sound Money?

Money has one basic function: to enable trade in a community. Because money allows you to acquire things in a community, money then also gets a second function: it gets hoarded as a store of value. Those are the two common roles of money: to enable trade and to store value for future trade.

What is "Sound Money"

The ideal money would be perfect at both roles. Unfortunately, money that is good at one function is bad at the other. Consider the characteristics of dollars versus gold.

Dollars are excellent at enabling trade. The Fed Reserve releases a bunch of them at the drop of a hat to stimulate the economy or to bail out a member bank. Trade and consumption are constantly stimulated by flooding the economy with dollars.

However, this makes the dollar an extremely poor store of value. Inflation is a regular and desired part of the system, a feature not a bug! Under the Fed Reserve system, value has to be stored elsewhere, usually in stocks or bonds. Storing money in dollars means you are quickly losing purchasing power, because of the inherent inflation built into the system.

The function of banks in this system is to create more money, and distribute it to the consumer economy on easy terms. This is known as fractional reserve banking, as banks create new money through loans, backstopped by the Fed Reserve, which will make sure they never run out of money.

Gold is often called "the only sound money" because it is such an excellent store of value. Gold itself never rusts or corrodes, it can't go bankrupt or be overthrown like companies or governments, it strongly resists counterfeit, and it has a relatively strict limit on supply.

However, it is very poor at facilitating trade. Indeed, precisely because it is such a good store of value, people tend to hoard it. Under the gold regime, anytime people save money, monetary deflation is unleashed on the economy, stifling trade.

Under this system, the function of banks was to get money out of savings and back into circulation. Other people's savings became the basis of new loans, as banks could not, themselves, create new money.

Historically, because of its limitations, gold money was never used as a primary means of exchange, that was left to more common metals like copper or silver, or paper certificates, bills of exchange, and cheques.

The Commodity Problem Facing Money

A fundamental problem facing any money supply is also brought about because money itself quickly takes on the traits of a commodity. Money in too great or too lean a supply can wreak havoc upon the productive economy. There is also the problem that economic activity is wasted when it is concerned with the supply of money itself, since manipulating the money supply itself is not a productive activity.

Thus, the ideal type of money would have three traits: excellent at trade facilitation, excellent at value storage, and not treated as a commodity. A created-on-demand, credit-based, electronic monetary supply appears to be able to meet these conditions, and represents the next major advance in monetary development.

In my next essay, I will detail how this money supply can come into existence and be used to build up the economic health of a community.


Anonymous said...

Why on earth do you think that money should be a store of value?

Money exists to facilitate trade, including investments in productive activities. The deterioration of money over time is a good thing in that it creates an incentive to find productive activities to invest in. That's not a bad thing.

The problem is when debt, rather than equity, becomes the primary means of financing investment.

Justin said...

Well, you think so, I may agree, but many other people disagree. My point is, if we can design money that is good at both functions, it would be better than money that just did one or the other.

Perhaps we can have a system that doesn't rely on deteroriating money value to spur investment. Wouldn't that be a kicker?

Your last sentence is certainly right on the money. Thanks for the comment.