Wednesday, 25 January 2023

Sound or Unsound Money

The is an edited version of one of my businesses' Briefing Notes.  Thoughts?

What is ‘sound money’?  Or, perhaps more importantly, what is ‘unsound money’?

Unsound money can be defined as money which has:-

  • Overwhelming counterparty risk, and
  • Fails to sustain its relative value over time.

To see why this matters we have to understand what money is and what its function is.

Money is any thing which an economy accepts to act a medium of exchange, a store of value and a unit of account (a measure of value).  Commonly this thing that became universally accepted in most exchange economies was, is, gold.

There is also a difference we need to define between money and currency.  These two words are nowadays used interchangeably; as the same thing. But to make sense of ‘sound money’ their meanings need to be differentiated. 

1.    Money, is money.  The fundamental store of value, medium of exchange and unit of account.

2.    Currency is a medium of exchange and unit of account but has to be exchanged for money as a reserve of value.  Witness the statement on a British Ten Pound note – ‘I promise to pay the bearer on demand the sum of Ten Pounds’.  That is such ‘paper money’ is not money but a ‘promissory note’.  A ‘currency’.

Why does the counterparty risk matter? 

Firstly, in effect, no exchange transaction is complete until the receiver of the currency goes to the currency issuer and obtains his money.  Until he makes this exchange what he holds is a promissory note, not money.  Now, this may not matter if he can then, at any time in the future, exchange this promissory note for other real goods and services.  And that the promissory note maintains its relative value.

What do we mean by relative value?  Suppose the currency issuer issues a lot more promissory notes than he has money at hand.  This will increase the supply of currency (and therefore the counterparty risk) relative to other goods and services.  If the number of promissory notes is, say, doubled, then their value must halve.  The currency holder will need twice as many promissory notes to have the same purchasing power.  And hence the prices of goods and services in that reduced value currency must double.  In short, the counterparty has taken half the value of the currency holders’ money for nothing in exchange. This is theft.  Or in money terms, counterfeiting.

It used to be that the free market had evolved over time a sound money system.  Roughly, money was gold.  Gold was held in warehouses, called goldsmiths and latterly banks.  Customers would instruct banks to settle debts using written instructions - ‘please pay A gold to the weight of X on this date signed B depositor’.  As time passed it was realised by banks that they could issue ‘bank notes’ based on the quantity of gold in their vaults which customers could carry and exchange between themselves confident that if at some point they needed to obtain their money they could present the bank note at the bank for settlement in gold.  (I have ignored coin here for simplicity – but similar rules apply).

In due course it dawned on bankers that as long as they did not overdo it they might be able to issue more currency than the value of gold – i.e. money - they held in their vaults.  This practice bestows enormous benefit to currency issuing banks as obviously this new ‘currency’ / aka money, is money for nothing.

Luckily Mr Market was wise to this practice and under laissez-faire banks who pushed this currency expansion too far, were called to account and failed.  There were bank runs.  Some depositors lost money.  But the banks owners, in the age of unlimited liability banking partnerships, lost everything or nearly everything and lost their reputations.  These market disciplines generally kept banks honest and respected.  And excellent example of how this worked is the story of the failure of the Ayr Bank.(1)

Now, moving forward to today.  We live in an age of catastrophically bad money.

In 1944 various of the great and the good (including Mr Keynes) met at a place in the USA named Bretton Woods(2) to sort out a post war international settlement and money order.  Very briefly they agreed that the USD should be linked to gold at the price of $35 per ounce.  And that all other currencies would be linked to the USD.

This was all fine and dandy (actually it was not – it was a huge accident waiting to happen) until the USA got involved in the Cold War/The Korean War/The Vietnam War/and the Great Society Program. They funded all this by simply printing more and more USD.  Until the French got fed up and demanded settlement of their USD balances in gold.  Which of course the USA did not have / would not do.  This led to Nixon closing the gold window on 15th August 1971 and collapsing the Bretton Woods fake gold standard.   We, the West, have been using entirely fiat money (currency) since that date.

The result has been catastrophic.  Sterling and the USD have lost respectively about 99% and 98% of their relative value.  (It is an economic saw that ‘all paper money trends to zero value).  We, the people have been robbed by our governments.  This currency (money) debasement is also a product of the fallacies of Keynesianism. You cannot operate Keynesian with sound money.

The worry for us as individual citizens is how far will this go?  As currencies like the USD, GBP, Euro etc fail (and fail they will) the currency authorities will replace them with programmable CBDC (central bank digital currency), the day by day relative value of which can be manipulated directly by those nationalised currency authorities.  How will be able to grow and preserve our wealth under such an assault?  Let alone our freedom?

Lobbying for a return to sound money is one thing we should be doing if we want to preserve the free society.



(2) and


Bayard said...

L, have you read this?

I think you need to make the distinction between money and credit. ISTM that money is merely a unit by which to denominate indebtedness, i.e. credit. By the use of credit, far more wealth existed than there was actual precious metal. If I owe you ten pounds (of silver) because I bought a horse off you, that debt is an asset to you, which could be reassigned, i.e. you could buy something else off a third party and transfer my debt to him. If he then wanted something I owned that was worth ten pounds, then I could give him that and the debt would be cancelled, but at no point did that ten pounds of silver physically exist.

Mark Wadsworth said...

L, it's as simple as B says.

"Money" is just what A owes B. B has money, A has debt (or negative money). In total, there is no 'money' it cancels to zero.

Sound borrower = sound money.
Unsound borrower= unsound money.

Lola said...

B and MW Noted. I will edit. I think the credit argument is implicit in my piece but it's not clear.

Bayard said...

L, apparently, currency was invented so that citizens could pay their taxes more easily. In this it doesn't really matter whether the currency has intrinsic value (silver dollars) or not (1s and 0s in a computer). The currency is simply an IOU from the government (I promise to pay) which is redeemed when your tax is due. The government uses its IOUs to buy real goods and services and then it gets the IOUs back in the form of tax, so currency is just a borrowing against yet-to-be-paid tax.
Because of this, I would disagree with the premise that there needs to be a physical backing for a currency. Whether the currency is precious metal or pieces of paper, it only has the value that it has because of government dictat. After all, gold has no intrinsic value, it's just a shiny and relatively rare metal that doesn't corrode. When an African king turned up in Europe in the C15th with huge amounts of gold, which was relatively abundant in his kingdom, the value of gold plummeted. Currency is worth what it is worth because the government promises to value it's IOUs at the price it sold them to you when it issued them in exchange for goods and services. Of course, in the meantime it could have devalued the currency and swindled you, but then, that's the sort of thing governments do: the big government con trick is inflation. This is presented as something inevitable, but the UK had an industrial revolution and built an empire without inflation.

Lola said...

B. I do not agree with that, exactly.

Currency and money are different, but related things. Money is a market invention, not a state or government one. 'Currency' grew out of banks issuing 'bank notes' to make it easier for bank clients to settle debts as charges against the customers deposit of real money. (We'll ignore pro tem the issuing of bank notes by the bank against its own store of real money and how they have been permitted to leverage that special privilege).

In other words there is no need for any government anywhere to issue or mint its own money. The way it accretes this monopoly is to mandate 'legal tender'. Which again is entirely unnecessary. States and governments deliberately create all these fictions around money and currency to gain power.

And governments have no need of making money/currency to collect taxes. The market has invented good money (one of the functions of which is the unit of account function - i.e. an acre of land has x value in ounces of gold and the rent therefrom is x/y ounces of gold for z term). The government can then mandate that it wants 5% of that rent as tax.

Bayard said...

L, history is against you here, the invention of currency long predates the invention of banks. Banks invented paper currency, it is true, but metal currency, in the form of coinage, is still currency. It took a very short time before governments realised that they could debase the currency and make the face value of the coinage be more than its scrap value, and once they had done that, the coins were no different, really to paper money. Both were no more than a token of government indebtedness. Hence the concept of legal tender, which you don't need if your coinage has the same scrap value as its face value, or your paper money is backed by precious metal. However, both these resorts run up against the problem of the limited supplies of precious metal. This was illustrated in the early days of the tea trade, when the only payment the Chinese would accept for tea was silver, which was fine until there was no more silver in the West to exchange for tea. You can't make silver so the supply just ran out.

Lola said...

B. yes. that's what I said. Markets invented money. As gold (and silver) emerged as money of choice goldsmiths, who had vaults, held money for clients. Goldsmiths morphed into banks.

ALL governments throughout history have all sought to control money (and currency) and ALL have failed as they ALL could never resist debasement.

Banks made coin as well as paper money. There are loads of examples of private mints. Matthew Boulton had one at Soho near Birmingham. One of the main drivers of private mints was government failure to produce enough change of the right quality. There is an excellent book by George Selgin (?) that discusses all this and and how it worked between about 1750 and 1830.

They never ever run up against the scarcity of precious metal. Ever. Under the gold standard there was always 'enough' gold to act as sound money. Twice during the 19th century there was 'inflation' - the Klondyke and the South African gold fields. From about 1750 to about 1914 money had a very stable relative value. Prices of goods and services fell by about a fcator of four and wages rose by about the same fact. And goods and services got better and better - i.e. huge qualitative gains even though real prices were falling. The scarcity of gold argument is an absolute fallacy.

That's a problem for the Chinese. Not the buyer. The buyer will go and buy their tea from India or Ceylon say.

Bayard said...

"Markets invented money. As gold (and silver) emerged as money of choice goldsmiths, who had vaults, held money for clients. Goldsmiths morphed into banks."

Nope, money predated banks and goldsmiths by hundreds of years, at least in Britain. Governments issued coins and people used scrap precious metals in addition as currency, but most money had no physical existence at all, it was a nominal value of debts and credits. Take the example I give above, where I sell you a horse for ten pounds (of silver). You don't actually have ten pounds weight of silver, but that transaction has generated ten pounds value of money
for so long as the debt remains unpaid. How is this any difference to banks "splitting the zero" and "creating money out of nothing"?

"Banks made coin as well as paper money. There are loads of examples of private mints."

Which just goes to show you can have metal bank IOUs as well as paper ones. They are still only as good as your ability to persuade someone else to accept them as payment for goods and services. Ever tried to buy a bag of potatoes in Dorset with a Scottish bank note? I have, and I didn't end up with any potatoes.

The problem about using gold to back a currency, is that gold is only a proxy. What would happen if everyone decided they didn't want gold, as in Sir Thomas Moore's Utopia? How sound is your money then? The point remains that sound money is money that you can be sure that will buy you what you thought it would in the way of goods and services and unsound money is money that you can have no confidence in. Once you leave barter, trust and confidence is all you have to go on. The problem comes when people abuse that trust to enrichen themselves. Gold makes that harder, but it's not a panacea. As to gold running out, economically, there should be no limit to the amount of money in an economy, whereas the amount of gold on this planet is fixed. The fact that it has been sufficient up to now does not mean that it will always be sufficient. The West really dis start to run out of silver, because China had a closely-guarded monopoly on the production of tea. You couldn't get it from Ceylon or India, because at that time there was none grown there.

Lola said...

B I know! That was what I was trying to say in my post!

Last para. Over time gold emerged as the most reliable universally accepted money. So what if something else discovered and developed by the market takes it place?

And your assertion that there should be no limit to the amount of money in an economy is unsound. Money needs to be scarce, That's a crucial quality.

Bayard said...

"Money needs to be scarce, That's a crucial quality."

However, as you have just pointed out, if there is not enough money around, people simply make their own. Anything will serve as money , so long as you can have confidence that it will retain its value vis a vis the goods and services you wish to buy with it. In prison camps, cigarettes became money. Another example of this is that in Poland you used to see big stacks of bricks outside many rural houses. This didn't mean that the owner was about to embark on a building project, those bricks were money. Rather than put their money into a bank where it might disappear, the rural Poles would buy bricks on the basis that everyone needs bricks sooner or later and so their value would not depreciate. Not only that, but you can store bricks outside and you didn't need any great security.

Bayard said...

Gold also has the problem that, you need your money based on gold because you can't trust the politicians and the bankers not to swindle you by devaluing it if it isn't. However, since you can't have your gold on public view all the time, which you obviously can't, for security reasons, how can anyone have the confidence that the same politicians and bankers aren't going to pretend that there is a lot more gold in their vaults than their actually is, precisely as the US did towards the end of the Gold Standard? If you need confidence in the politicians and bankers for the gold standard to work, then it's not much better than a fiat currency. Gold is a confidence prop, but it's no panacea. For sound money, a sound system is not enough, you need sound people in charge of it and that is a problem in a totally different league.

Lola said...

Bayard That point suffers from the 'so what' test. In fact that is pretty well what happened in England between about 1750 and 1820 and 'the market' resolved it with private mints which 'the market' very effectively policed as to the soundness of the private coinage.

Lola said...

Bayard (2) Well, you could store your gold yourself. But history shows that most people had it stored by third parties that eventually morphed into banks. And the problem with that is not an issue with gold backed money but the banking settlement. Which we've previously had a go at. So, banking reform is probably necessary if we want sound money, maybe based on a gold metallic standard, to work.

There were two phases in the US abandoning the gold standard. All IMHO inevitable after the creation of the Federal Reserve. Stage one was Roosevelts stupid meddling as he failed with the Great Depression - making things worse - and sought to blame the private holding of gold and legislated to steal it from US citizens. Second stage was the inevitable collapse of the Bretton Woods fake gold standard in 1971. That was triggered by 'the market' in the shape of De Gaulle demanding settlement in gold (wanting French gold back) as he thought that they were running out of the stuff - which they were.

So, yes, you cannot trust governments and banks with your money. But, reform of the banking settlement (to make them custodians of your demand deposits and that demand deposits cannot be used for credit expansion) would sort part of it and the fact that GBP was priced in gold would stop government inflationism.

Bayard said...

"In due course it dawned on bankers that as long as they did not overdo it they might be able to issue more currency than the value of gold – i.e. money - they held in their vaults."

I don't think things happened that way at all. All credit is effectively lending money, there isn't credit that is issuing currency and credit that isn't issuing currency. When a bank lends money, it's exactly the same as when I do work for someone. Until I am paid, I am extending them credit, in exactly the same way as the bank is extending credit. Debt=credit=money. One way that commerce got around the restrictions imposed by the gold standard when it was in operation was to use private debts as currency. If A owed you money, and gave you a piece of paper stating that, you could sell that piece of paper to B and A would now owe B the money. That piece of paper was effectively currency, but you would have no gold in your vaults to back it. I believe such currency was called "paper" and the more trustworthy your "paper" was, the closer to its face value you could sell it for.

Lola said...

Bayard. Yours at 290123 20.17 That seems t me to be a banking argument not a money argument?

Bayard said...

L, well yes, I feel that you are over-emphasising the banks' role in creating reserveless currency. I think they simply horned in on a process that was already in operation.

Bayard said...

"Lobbying for a return to sound money is one thing we should be doing if we want to preserve the free society."

Thinking about it, it seems to me that the unsoundness of money is just a symptom of a larger malaise, which is the displacement of industrial capitalism, which is based on adding value and increasing wealth, with financial capitalism, which is based on moving wealth about and skimming some of it off the top. The latter has all of the disadvantages to society of the former and none of the advantages. Under financial capitalism, the rich only get richer to the extent they rob the poor. It is in the industrial capitalists' interest to have sound money, because it makes their business easier, but, unfortunately the same thing can be said about financial capitalists and unsound money. To get back to sound money, we need to cure the disease which is financial capitalism.

Lola said...

Agreed - and as a de facto 'off the top skimmer my self' - I can assert that this is the case.
However it's chicken and egg. I think think the money destruction precipitated the financialisation. And I am not alone in that. All Austrian Econ scholars have that view - that unsound money is the root of all evil. Notably Rothbard.

Bayard said...

L, I think we shall have to disagree on this point. AFAICS, as soon as society started to produce a surplus, there arose rent seekers who captured that surplus without generating it. Even in hunter-gatherer societies there was probably a chief who did no gathering and only hunted when he wanted to. Financial capitalism is just very advanced rent-seeking, so I think it was the financial capitalists who destroyed the money, not the other way around. After all, with sound money, there is far less ability for speculators to make themselves wealth at others' expense, so they have a strong incentive to get rid of it.

Lola said...

B. I don't we are disagreeing. The sons a of successful industrial revolution industrialists were largely encouraged to enter the 'professions' - i.e. off the top skimmers - of a kind

And 'of course' re rent seeking. Isn't that rather why we are here? LVT and all that?

Bayard said...

"It is the ambition of every wealthy Englishman who has made his money through his and others' industry to join the landed gentry and live off rents in idleness."

I don't know if anyone famous actually said that, but they should have.

Lola said...

Bayard. Got it in one. That is exactly what's been going on. From The Right or The Left. Both malign philosophies - in their own individual ways - are based entirely on 'rent seeking'.

Bayard said...

Considering currency, It seems to me that a coin must always have been minted with a face value greater than its intrinsic (scrap) value, or why else would a government go to the effort and expense of minting coins, which can then be devalued by clipping, filing or "sweating", when they could just accept the equivalent value of precious metal? I don't know about the value of other currencies, but the pound sterling was originally defined as a pound weight, not of silver, but of silver coins called "sterlings" because they had a small star on them.

Also the three different uses of money that you give are separate. Money only needs either a physical existence or a reliable promise of existence to be a store of value. It can be a medium of exchange and a unit of account simply by people agreeing to its value, like with a LETS currency. Nobody actually minted any "Stroud pounds". You can have a store of value that is not money (your bag of scrap gold at the goldsmiths) and you can have money that is not a store of value (the Stroud pound). The issues with "soundness" and counterparty risk apply only to money-as-a-store-of-value. You want to be certain that, in the future, those marks in the ledger or 1s and 0s in the computer are going to translate to physical goods or services.