The Hindu Business Line : Why money must be gold-plated

The greatest danger in not adopting a gold standard would be that when the paper currency system collapses, critics of liberalisation would claim that capitalism has failed

`...Whenever destroyers appear among men, they start by destroying money, for money is men's protection and the base of a moral existence. Destroyers seize gold and leave to its owners a counterfeit pile of paper. This kills all objective standards and delivers men into the arbitrary power of an arbitrary setter of values. Gold was an objective value, an equivalent of wealth produced. Paper is a mortgage on wealth that does not exist, backed by a gun aimed at those who are expected to produce it. Paper is a check drawn by legal looters upon an account which is not theirs: upon the virtue of the victims. Watch for the day when it becomes, marked: `Account overdrawn.'

Francisco d'Anconia, in Ayn Rand's Atlas Shrugged

So what is this money that Francisco is so passionately arguing about? While it is not easy to define, most of us would agree that money is the single most important good that we need and that without it we would not be able to survive.

Yet, Robinson Crusoe or the more recent Chuck Noland (Tom Hanks in the film Castaway) would have found money completely useless.

Even when Crusoe makes economic transactions with his Man Friday, money would hardly be deemed useful. Money clearly becomes important only because it serves as a medium of exchange in a large society.

Exchange happens due to the diversity in nature of skills, natural resources and needs of humans. Exchange of goods is what allows each of us to specialise in what we do best thereby maximising the output of society. Man initially started this exchange with the process of barter but soon transitioned into an indirect system of exchange through a "good" that has come to be known as "money". Money is the abstraction that allowed definition of value of goods and indeed permitted civilisations to develop.

So what should be the good that can be the medium for this indirect exchange? Historically, cattle, sugar, tobacco, salt, copper, zinc, etc., were tried and ultimately, gold and silver emerged as the most acceptable form of "money" in the free market.

All of the leading currencies originally represented units of gold or silver. The British pound denoted a pound of silver and the US dollar represented an ounce of the metal. The important point is that currencies were defined in terms of gold and silver and not the other way around as we do today.

Another Commodity

Therefore, it is to be understood that money is simply another commodity. The only difference is that the demand for money comes because it is useful as a medium of exchange and not because of its consumption value. Many textbooks say that money has several other functions such as measures of value, unit of account, or store of value. But these are all proxies for the one great function, that is, medium of exchange. The above difference leads to one fundamental property of money that is often not understood. While increased production of all other commodities confers a societal benefit, excess production of money offers no such benefit. For example, if the quantity of money suddenly doubles, then all it would mean is that the price of all other goods would also double (a more accurate statement would be that the price of money has fallen by half).

This process of producing more money than available goods leading to a reduction in the value of money is known as debasement. It is worthwhile illustrating how the early kings achieved debasement. The first step was to create a state monopoly of the minting business.

Then, all the existing coins were recalled to the mint and melted. The citizens were then returned the same number of coins but of a lighter weight. The excess gold or silver was then used by the king and the profits of this debasement were termed as "Seniorage". Of course, Seniorage is just a more sophisticated term for what is actually producing money from thin air.

This debasement of the currency is what causes the prices of goods to go up, that is, "inflation". As long as the supply of money was decided by market forces, the production was controlled to meet the demand in much the same way it is done for other goods such as cars, chocolates and shirts today. Even when the state monopolised the production of money, the ill-effects of Seinorage was limited as citizens could physically see the mechanism of debasement and protest against it. Thus, till we transitioned to the current "unbacked" paper system, the inflationary actions of governments were controlled by their inability to create too much money out of thin air.

The Situation Today

Under the current paper money system, governments can practically realise unlimited gains, and that too even without the citizens realising the process of debasement. These days many central bankers talk tough on inflation, but as explained, central banks are the primary reason for inflation in the first place.

Even more ironical is that when prices go up, the usual suspects are bad monsoons, hurricanes, corporate profiteering or even "growth". While inflation is and will always remain a monetary phenomenon, there has never been an instance of a central bank stepping forward to say, "Sorry, we printed too much money."

The founding fathers of the US Federal Reserve realised the disastrous consequences of placing such enormous power in the hands of the government and hence the US Fed was created as an independent institution.

However, for all practical purposes it has behaved no differently from other central banks, printing as fast as the Presidents are willing to spend. The realisation is that as long as the incentive of Seniorage is there, it will be exploited and the only way to prevent debasement is to remove this arbitrage opportunity.

Make the transition

The Swiss Government was the last to shift away from the gold standard, in 2000. However, that is no reason why the Reserve Bank of India should continue the practice of debasing the currency (see "Is Our Monetary Policy Sound?" January 11). With the technology available today, it would be easy to transition to a 100 per cent gold standard. Indeed, we believe that markets would ultimately move towards one irrespective of the decision of central banks. In the long-term, a rupee backed 100 per cent by gold would be the ideal solution.

However, in an environment where we cannot even agree that it is not the job of the government to be running hotels, airlines and entertainment channels that is an indeed great expectation.

The least the RBI can do is to re-examine the assumptions on inflation and money supply (M3 at 20 per cent will result in only 5 per cent inflation).

The greatest danger in not doing so would be that when the paper currency system collapses like a pack of cards, and it has to sooner or later simply because of its fiat nature, then critics of liberalisation would claim that capitalism has failed.

Nothing however would be further from the truth. We would have failed not because of the market, but because of ignoring for decades the signals it had sent.

(The author is a Director at Benchmark Advisory Services and can be contacted at shan.sundaram@benchmarkconsulting.in. His previous publications can be accessed at http://financial-musings.blogspot.com/">//financial-musings.blogspot.com/)