Interest Rates and Hard Currency

 Posted by on 2 May 2013 at 10:00 am  Economics, Free Society
May 022013

Just before my March radio discussion of how government control encourages short-range thinking, Tim Lee sent me the following example, which I blog with his permission:

The Federal Reserve has taken control of the future by dictating interest rates. The capital budgeting decision essentially depends on an interest rate tied to reality, an interest rate that connects actual savings to loanable funds. The now vs. later decision involves a discounting of future cash flows using an interest rate that functions as a reference. Whether it makes sense to build a factory or not depends ultimately on the specific interest rate at which capital can be borrowed. But since the Fed arbitrarily sets interest rates, that means business owners have been denied the basis on which to plan. Moreover, since the practice of driving interest rates below the natural rate has the consequence of generating the boom/bust cycle, an added level of uncertainty is added that not even the Fed can predict.

A restoration of the gold standard and naturally determined interest rates is required to make long range planning possible.

This article discusses the economic crisis and how interest rate manipulation caused it: Interest-Rate Targeting During the Great Moderation by Roger W. Garrison

That’s an excellent example, unfortunately. (FYI: I’ve not read the article in question, and I don’t have the technical background in economics to judge it.)

On a related topic: Objectivists and other free-market advocates often talk of the need to return to a gold standard. That seems wrong to me. Yes, our current system of fiat currency should be replaced by hard currency. (By “hard currency,” I mean commodity-backed currency, not merely stable currency.) However, that need not entail the gold standard.

In a truly free market, the government might choose to accept only gold-backed currency, but that choice shouldn’t be imposed on anyone else. Banks might choose to issue silver-backed or platinum-backed currency. Heck, a bank in a free market could issue currency backed by any fungible good, from crude oil to large eggs. The best option, it seems to me, would be money issued by banks backed by a “basket of commodities.” That would help stabilize prices in cases of major changes in the supply or demand of a single commodity.

So, for those of you who advocate for the gold standard: What do you mean by that? Do you mean that the government would issue legal tender backed only by gold? If so, how is that consistent with free market banking? If not, then why advocate for a “gold standard” rather than hard currency?

I’m not being snotty here. I’m not any kind of expert in economics, and I want to know if I’m missing something!

  • Kyle Haight

    I think we’re on essentially the same page — the phrase I’ve heard for it is ‘the denationalization of money’. Calling what I advocate a ‘gold standard’ is really a misnomer. I advocate a free choice of currency, and history leads me to believe that given that freedom gold will be the currency chosen.

    There is a real economic cost to having too many currencies active in a market at the same time. Taken to the extreme such a system is indistinguishable from a barter system. When the values of commodities are freely floating, as they would be in a ‘hard currency’ system, the transaction costs on converting between different currencies would be significant. Merchants would have to split up their ‘cash on hand’ across multiple commodities to allow them to give customers change in their preferred form of money. Etc. Some of these problems could be mitigated with modern technology, and perhaps they would be. If so, fine.

    So really calling what I advocate a ‘gold standard’ is conceptually muddled. It mixes together a government policy (freedom to choose the currency one uses) with the projected result of that policy (people choose to use gold).

  • Jennifer Snow

    Pretty much what Kyle said, although I suspect a system with 3 or more types of currency would function without too many problems. Why? Because I play Dungeons and Dragons Online, an MMO with, yes, an economy. Or, I should say, several of them. There are two major “supported” currencies that you can use via the in-game auction houses: platinum and astral shards. And then there are the fungible items that players use as currency: dragon scales, shroud ingredients, and high-level items.

    The “supported” currencies would equate to whatever commodity the government was prepared to accept–because you can pay the government (or, in this case, Turbine and in-game vendors) with that currency, it will always have value and be accepted almost everywhere except among the elite of the elite who have bags of it and cannot buy the rare and difficult-to-obtain items they really want from other elites except with other rare items.

    I suspect it will generally be the case that in a free economy things may trend toward a “standard currency” and an “elite currency” simply because when you’re talking about enormous transactions, using the standard currency is even more cumbersome and problematic than the difficulties involved in not having a standardized currency–it’s much more difficult to secure a truckload of gold than, say, a high-value but tiny artwork, and even if the actual trade is only taking place in the form of bank notes, that truckload of gold still needs to be under lock and key somewhere.

    This might actually be an economic opportunity for artists to produce this elite currency. If you watch any television at all, you’ve probably run across shows where people buy and sell rare items for often quite substantial sums. The only thing lacking from this market is fungibility, so it might be in the best interests of certain artists to make small numbers of items with exquisite craftsmanship which were nevertheless similar enough to be traded in this manner.

    A possibility, anyway.

  • JebusKhrist

    I don’t even see the problem with a fiat currency as long as it’s not forced on anyone. Bitcoins are an interesting example that will probably fail (very soon) for a variety of reasons but theoretically I don’t see why a currency must necessarily be hard to have value and function as money.

    • Kyle Haight

      When I hear “fiat currency” part of my brain wants to interpret it as money backed by Italian automobiles.

    • sajid24

      “I don’t even see the problem with a fiat currency as long as it’s not forced on anyone”

      I think only a government can print fiat currency. If a bank said “Hey, why don’t you buy our currency–everyone else does and it’s legally tradable”, no one would ever buy it.

      If money was ever deregulated, there probably would be a period in which all sorts of currencies backed by all sorts of tangible and intangible goods were freely traded. After a few years, for the sake of convenience, the currencies would be consolidated into three or four major ones, all of which would be backed by a “basked of goods and services”. However, in this situation, if one currency decided to inflate its money supply, economists would surely develop some metrics to know instantly that the currency was overvalued and then the market would adjust.

      Also, if there are three or four major currencies serving one market then competition would ensure that no money providing agency had too much power or had overextended itself by printing too much currency.

      Of course, there are probably reasons the above does not occur. Early on, the reason was that people needed one store of value in which they could all have faith. Thus, they either chose gold or a currency backed by the government (and thus law). However, with the advent of electronic communication, every single economic transaction can be recorded down to its smallest detail. Thus, even if there were a thousand different countries, theoretically all you would need is a mobile phone and an app and boom–not only is your transaction done–your phone would also convert it to your currency of choice so you know exactly how much you spent.

      Now all I have to do is wait for a real economist to tell me some reasons why private currencies could be incredibly unstable or something. I do hope that someone investigates the idea in detail.

      • JebusKhrist

        “If a bank said “Hey, why don’t you buy our currency–everyone else does and it’s legally tradable”, no one would ever buy it.”

        Actually that’s pretty much what Bitcoins did and millions of dollars have been traded for the digital currency.

  • Kyle Haight

    More seriously, I’m not sure that bitcoins are a fiat currency, strictly speaking. They’re in a somewhat bizarre grey zone. The big problem with standard fiat currency is that it can be created without a corresponding increase in real production. Ben Bernanke hits a few keys in his office at the Federal Reserve and hey presto the money supply expands by a trillion dollars. The great advantage of ‘hard’ currency is that the money supply only expands when real commodities are produced, so there is always and by definition a corresponding increase in production.

    Bitcoins can’t be created out of thin air for trivial effort the way Bernanke-bucks can, so they’re different from standard fiat currency. But at the same time the effort required for their creation is in some sense arbitrary — it isn’t genuinely productive the way digging metal out of the ground, refining and minting it is. Rather, it’s an artificial product of a computationally-intensive encryption algorithm. It feels a bit like a currency backed by carrying rocks from one place to another. Sure, you expended effort, but not all effort is productive effort.

    Bitcoins look desirable compared to Bernanke-bucks because their supply seems inherently more restricted, but the decoupling of effort-to-create from real production rubs me the wrong way.

  • JebusKhrist

    There are problems with “hard” currency too. Take a gold backed currency for example.

    For a currency to be backed by gold means that some institution somewhere has to warehouse the gold, right? Besides the political danger (the gold backing your cash is only as safe as the country it resides in). It also means that all that gold would be removed from global supply making it unavailable for manufacturing and other uses raising the price of a useful commodity.

    Something like bitcoins on the other had are not reliant on any institution, enterprise or country. There is no building to raid or server to shut down. And they are not taking any commodity out of global production supply and raising manufacturing costs.

    • Kyle Haight

      I view some of those as strengths of physical commodity-backed money, not weaknesses. You’re right that physical commodities have to be stored and can be physically taken. Bitcoins, however, have implicit dependencies on the reliability of the encryption on which they’re based. Somebody invents a quantum computer and your entire currency vanishes in an almost-literal puff of logic.

      The integration of a commodity-backed money into a productive economy is the thing that determines the rate at which the currency expands. More money is created when it is profitable to do so, and that profitability is directly connected to the combination of monetary and non-monetary uses of the commodity in question. The rate at which Bitcoins are created depends on the availability of computrons.

      • JebusKhrist

        You dont sound like you know that much about bitcoins which is ok, most don’t. Understand that they do not rely on some encryption. The code is openly published for all to see so no person or super computer can hack bitcoins like that. And the rate at which bitcoins are created is also very much predictable. They can however be taken or stolen like cash if someone were to take your digital file.

        Also a digital currency like bitcoins would expand in the same way you suggest because I’m sure a free market would produce fractional reserve banking.

        • Kyle Haight

          Fair enough; I have had neither the time nor interest to investigate bitcoins in depth. My sense of them at present is basically “interesting idea, let’s see how it plays out”. I think we both agree that in a free economy people should be free to choose what they are willing to accept or reject in trade, and that would include bitcoins or other similar informational constructs.

  • DougFromOz

    Something I’ve always wondered about a gold backed currency (and I suppose using a basket of commodities instead would help with this) is what happens when we get into space properly and start asteroid mining? Gold, platinum ect are valuable because of their rarity, which would change rapidly.

    • Kyle Haight

      There are a number of criteria that a commodity has to meet to function well as money. It has to be durable, fungible, malleable, rare, etc. If a commodity ceases to have some of these attributes, or comes to have them in lesser degree, then it functions less well as money. So if a commodity money becomes substantially less rare (due to asteroid mining or cheap elemental transmutation or some other such breakthrough) it opens the possibility that some other commodity might take over the top spot as ‘most suitable for use as money’. If that happens, people will switch.

      • JebusKhrist

        You’re forgetting portable, another reason gold and other metals aren’t good as money.

  • JebusKhrist

    Here’s a good article on Bitcoins for anyone interested.

Suffusion theme by Sayontan Sinha