World Without Paper Money
June 2, 2008
There is a certain sort of gold-coin fundamentalist, who insists that we must not consider any sort of system that uses any sort of paper money, and only a metal-coin system will do. I’m sure you know the sort I’m talking about.
I often feel like I play economic psychologist, as it is interesting to think about why people are so devoted to these sorts of impractical niche ideas. I figure that one thing that has happened is that the gold standard advocates have become very aware of the general unpopularity of their ideas, and have compensated by offering ideas that are so extreme as to deserve unpopularity. Then, they are not so disappointed when people don’t take them seriously, because they never expected to be taken seriously. It’s the dissonance between a sensible idea and the ridicule it receives that causes psychological stress. If you offer a ridiculous idea, then you are not so surprised if it receives ridicule. Thus, gold standard advocates today tend toward extremist views which have no political chance of success, and, actually, no practical chance of success either, as we will show today.
Another reason for this phenomenon, it seems to me, is that most gold standard advocates today don’t really have a sufficient understanding of monetary economics, in the sense that a mechanical engineer understands the machining of metal. Instead, they have a series of platitudes and vague principles, punctuated by periodic references to the Holy Mises. Platitudes and principles are fine, but they don’t serve in the fundamental engineering-like process that creates a working monetary system. They are aware of their insufficiencies, in the same way that mainstream central banker types are also aware of their insufficiencies, which makes them cling to the existing interest-rate manipulation system rather than proposing sensible alternatives. The mainstream central banker types are equally impotent at creating a working monetary system, because they also lack the fundamental nuts-and-bolts understanding that would allow them to create functioning systems with any sort of features they desire.
The gold standard advocates have thus migrated somewhat toward the “let’s all use gold coins” system, because it seems like there is nothing to manage. You just make coins out of gold –which, you have to admit, is a pretty simple rule, and doesn’t require a paper-currency manager as would be required with a gold-linked paper money system.
The other favorite is the “let the free market figure it out” system, which means “I have no idea but maybe someone else does.” In the 19th century, there was no government monopoly on currency production, and indeed many hundreds of private commercial banks distributed their own paper currencies, which were linked to gold. You can still see this system a little bit in Hong Kong today. However, all of these hundreds of private commercial banks had to have someone, on their staff, who understood the nuts-and-bolts of how to link a paper currency to gold, if they were going to be successful. So, the “let the free market figure it out” solution doesn’t escape the need for a monetary engineer to make the system work.
As I’ve argued, the bullion coin system is not a particularly bad system, when used in a small area. Ecuador could probably adopt a bullion-coin system with no particular ill effects. However, it is not a system that is suitable for the world as a whole. Let’s try to understand why, which is also the reason why paper monies were widely adopted during the industrial 19th century.
The fact of the matter is, there really isn’t that much gold out there. Gold is hardly ever used up or thrown away, and as a result, about 85% of all the gold ever mined in all of history still exists in human possession. Over these many thousands of years of gold mining, humans have been able to extract about four billion ounces of gold. Historically, this amount has risen by about 2% per year due to mining, but recently, world gold production has been falling off rather dramatically despite recent economic incentives to produce more. It looks like we may have hit “Peak Gold,” running into the physical limitations of availability in economic concentrations the Earth’s crust.
So, four billion ounces is about all we’re going to be able to work with. There are almost seven billion people in the world. So, if they all use gold coins, how many gold coins are they going to own?
A traditional problem with gold coins is that they are simply too valuable. A 1/10th oz. coin is about the smallest coin that is practical. There was a 1/20th oz. gold coin in the U.S., but it was really teeny and thus rather impractical and unpopular. A 1/10th oz. gold coin today would be worth about $100. When is the last time you saw a $100 bill? Although they are used commonly outside the U.S., particularly in illegal cash transactions, within the U.S. the $100 bill is very rare. The reason it is rare is not that the government refuses to make them — the government is willing to trade a $100 bill for five $20 bills at any time — but that people don’t like to use them.
Traditionally, smaller transactions were carried out with silver and copper coins. This introduces new problems. The smallest practical silver coin is perhaps 0.05 (one twentieth) oz. The old silver dime of the 1950s had about 0.07 oz. of silver, and was 90% silver by weight. Using the traditional 15:1 silver:gold value ratio, at $1000/oz. gold, the value of the 1950s silver dime would be about $4.60 today. So, even the smallest silver coin is of rather high value, which necessitates the introduction of copper coins. Now, we’ve got a three-metal system, if you’re going to make the coins have a bullion value equivalent to their face value. The actual market values of the metals drift over time, which introduces all kinds of new problems.
The point is, a “gold coin system” is really a silver-and-copper coin system. Today, there is about 1 billion oz. of silver in the world that could conceivably be made into coins. Remember, most small-scale transactions would be done with silver coins. You wouldn’t see gold coins very often, but silver coins would be used every day, at the grocery store for example. How are seven billion people going to make a monetary system with one billion ounces of silver coins? Today, if we use the 15:1 silver ratio, that billion ounces of silver would be worth about $60 billion. There are about $800 billion of U.S. notes and coins in the world, not to mention the notes and coins of other governments. We can see that there isn’t a whiff of a chance of making a silver coin system that would serve the world — although maybe Ecuador could get away with it.
“Yes, but….,” you say, “you could make the coins into token coins, and make them redeemable for gold on demand.” This was the case for the silver coins in the U.S. after 1875 or so. Their contained silver value was less than the face value of the coin. The $1 silver coin had about $0.50 of silver in it. However, you could trade twenty $1 silver coins for a $20 gold coin with the government, which is why the coins maintained their value above their commodity value. You could even make a $1 silver coin with $0.001 of silver in it, really just silver plating over aluminum or something like that. This would work just fine as well. It’s how coins work today. However, we can see that a $1 silver coin with $0.50 or $0.001 of silver in it is a token coin, which is functionally equivalent to paper money. A paper $1 bill is like a silver coin with no silver in it at all. So, once again, we have the need for a token coin/paper money manager, who manages the supply of coins/bills to maintain their value at the proper parity.
The bullion-coin advocates like to imagine that bullion coins cannot be devalued. Baloney. Governments were devaluing coins two thousand years before paper money was invented. Just take the $20 gold coin, containing an ounce of gold, and stamp it as a $1000 gold coin, containing an ounce of gold. This is what the Roman goverments did to their silver coins in the fourth century. It’s what the colony of Massachusetts did in the 18th century. It is as common as water. “Yes, but…,” you can hear the gold coin advocates argue already,”at least the coins you own already wouldn’t be devalued.” That’s true. But, the government could just declare holding such pre-devaluation coins to be illegal. The U.S. government did this in 1933, which was the first permanent devaluation in the dollar in U.S. history. Gold coins stayed illegal until 1974.
Actually, you could have a $20 gold coin and a $1000 gold coin, both containing an ounce of gold, trade side-by-side. The $20 coin would have a commodity value of $20, and the $1000 coin would be a token coin with a commodity value of $20. “But, wouldn’t everyone take the $20 coin instead, since they both have the same commodity value?” Well, the five-cent coin in the U.S. now has a commodity value of $0.07 or so. The $20 bill has no commodity value at all. But, they still trade side by side at their face values.
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How much money do you own today? I mean real money — base money — notes, coins, and bank reserves. Probably no bank reserves unless you are both very, very wealthy and also very, very financially creative. So, notes and coins. Look in your wallet. I bet it is less than $500.
Most of what people think of as “money” is really a loan to someone else, like their banker. What happens when you buy something with a debit card, check or credit card? In this case, your banker pays the recipient (actually the recipient’s bank) in real money, in this case a transfer of bank reserves through the bank clearinghouse at the Fed. All monetary transactions take place with base money, which is to say, real money. We must deal with the real world here, not some fantasy world in which people buy houses, or stocks and bonds, with a leather sack of doubloons. We’ve already talked about replacing token notes and coins with bullion. A bullion-based system could replace these bank reserves, which are now electronic, with bullion bars stored in the Fed’s basement. The Fed already does this for central banks around the world. Instead, there would be a cage in the basement with Citibank’s bank reserves in the form of gold, and the bars would shuffle around each day as banks made their payments. You could even make a pooled system, whereby the banks would have an unallocated claim on bullion stored at the Fed, and then you wouldn’t even have to move the bars around.
The amount of bank reserves is really not very much — about $80 billion in the U.S. — and this could conceivably be replaced by bullion. You have to admit, it is a very efficient system, considering the volume of transactions in dollar terms and the very small amount of acutal money (bank reserves) used to make the transactions. Theoretically, if everyone made their transactions in this fashion, using debit cards and such, rather than in bullion coins, then a relatively small amount of bullion could serve. However, this also means that nobody really owns any bullion coins, and that all the bullion is owned by the large banks. In effect, we’ve substituted a paper dollar, linked to gold, with an electronic bank account linked to gold, which is not really any different. In reality, both would be necessary anyway.
What if all transactions were done with “electronic money” (actually bank accounts)? Then nobody would own any bullion coins, although the banks would make payments in bullion to each other. Thus, ironically, you could have an all-bullion system, which is really a no-bullion system. “M2” consists of notes and coins, demand deposits and banks, savings accounts and money market funds, and small time deposits. In May 2008, U.S. M2 was $7.676 trillion. Theoretically, you could go to the bank and ask for your loan to the bank to be repaid in bullion coin. However, if everyone tried to do this, or even a small number of people tried this, the bank would shut its doors and say “sorry, no can do,” for the simple reason that such a quantity of bullion does not exist on this planet.
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I think we can see why an all-bullion system is impractical to the point of impossibility on any kind of large scale. Thus, we would need to have a currency manager, who knows how to manage supply to maintain a currency’s value at its bullion parity. This is not really very hard to do, but you aren’t going to escape that need by making silly claims about bullion coins or the “free market.” The Holy Mises is not going to fly down from heaven and smite your enemies for suggesting that it’s time to move beyond empty platitudes to real solutions.
I am actually a fan of Mises. He was without a doubt one of the 20th century’s greatest economists. If you took all of Mises’ self-proclaimed followers and heaped them in a pile today, it wouldn’t even reach to Mises’ knee. It’s too bad that he’s not around today to say: “You guys are a bunch of goofs.”
Such people account for 99% of gold standard advocates today. The number of people who could set up and maintain a proper, functioning system — the mechanical engineers of money — are extremely rare. Actually, it’s really not all that complicated. We’re going to need some people who know how to play this game, or otherwise, the game will never be played.