Since Detlev Schlichter is discussed frequently around here, I thought it might be interesting to write a summary of some of the arguments from his book, Paper Money Collapse. Of course I am summarising my understanding of the arguments, so caveats about my fallibility apply; errors and omissions are mine.
He begins with a description of money. It is the medium of exchange. It needs to be something people agree on. Ideally there will be a fixed supply which is infinitely divisible. Precious metals fit the bill. Schlichter distinguishes between exchange value and use value. It is possible to use gold for jewelery and electronic components, so it has use value. But as soon as it is used as the medium of exchange it is the exchange value that dominates. Money has value because it can be exchanged for goods and services.
When people say they want more money, what they usually mean is that they want more goods and services. Nevertheless there is a demand for money as a store of readiness to exchange, in preparation for near-future purchases or unexpected needs. Within the limits of his means, a person can hold exactly the money he wants at any time. If he wants more money, he stops buying stuff and perhaps starts selling it. If he wants less money, he buys goods and services.
If demand for money falls, then more people want to buy goods and services, so prices go up and the purchasing power of a unit of money goes down. This continues until the reduced purchasing power of money causes people to want more money. If the demand for money increases, then more people want to sell goods and services, so prices go down and the purchasing power of a unit of money goes up. This continues until the demand for money is met. In this way, the purchasing power of money changes almost instantly, so the demand for money is met almost instantly. There is no need to create money to meet the demand for money.
Does this cause prices to be volatile? Perhaps, but Schlichter argues that it is impossible for a central authority to control the supply of money quickly enough to counter changes in demand for it. The only way they can measure these changes is by observing prices. By the time the price has changed so that it can be observed, it is too late. He also points to empirical evidence that suggests that prices are more volatile when central banks control the supply of money.
While commodity money has a remarkable record of stability, state fiat monies have, without exception, led to rising inflation and frequently ended in total inflationary meltdown.
In his study Monetary Regimes and Inflation, Peter Bernholz looks at long-run statistics of the cost of living in Britain, Switzerland, France, and the United States. No upward or downward trends are discernible at all from 1750 to 1914. Clear upward trends in the cost of living materialised after 1914, when some governments left the Classical Gold Standard to allow for inflationary war financing. These trends become more marked after 1933 and in particular 1971 , when the United States took the dollar off gold internationally and a complete paper money system was established globally.
And there is the question of what price should be stabilised; what measure of prices should be used? Any average price does not reflect relative prices, so any attempt to stabilize the average price must also change prices relative to one another. So the statistics might look good but an individual will not experience stable prices.
If anything, with commodity money prices will go down as the economy grows because there are more goods and services available and the same amount of money. Isn’t deflation bad? Not this kind of deflation. Nobody complains when high definition TVs or computer hard drives get cheaper. Someone who does not want to take investment risks could simply store money and enjoy getting richer as the economy grows. This is an advantage of commodity money.
Now that we understand money, Schlichter goes on to describe the effects of money injection. How might this be done? Money could be injected evenly, instantly and transparently. Everyone’s bank balance could be increased by 10% overnight. Because everyone holds exactly the amount of money they want at any time, prices have to increase by 10% to make everybody equally content with their money holding. And so they do, and the money injection simply decreases the value of a unit of money by 10%.
Money could be injected evenly and instantly, but without telling anyone. Consumers will spend the extra money on new goods and services thinking themselves to be richer. Producers won’t know whether the new demand is genuine or simply the result of money creation, so they may invest in capital to increase production. All this activity will increase GDP and make the government look good. But as prices start to rise due to the extra money, consumers will stop buying the new goods and services. The new capital is wasted. This is what Schlichter calls a dislocation.
Finally, we can imagine a situation closer to the real one. Money is injected unevenly and without telling anyone. People who get the new money are in luck: they can spend it on shiny things. Shiny thing producers also do very well for a while. Lots of new transactions occur and again there is a temporary spike in GDP. But as the new money disperses, prices will rise, demand for shiny things will decrease, and shiny thing producers will go bust because they have wasted their money on shiny thing making machinery. Some people will see only rising prices and not get any shiny things at all.
To make the model even more realistic, Schlichter introduces savings and interest rates. Left to its own devices, interest rates reflect people’s time preference. If people want goods and services now, they are less inclined to lend out their money so interest rates are high. If their immediate needs are met, they look to the future, lend out their money, and interest rates are low. When interest rates are low, producers are more likely to borrow money to spend on capital creation to increase production capacity. The new production is likely to find demand as people spend their savings.
Now, let us imagine we want to create money by making it available on the loan market. To get people to take out the loans we offer them at low interest rates. This encourages producers to borrow money to spend on capital goods such as new tools and machinery. But the money does not come from people who have decided to save. Those people still want consumer goods today, and are still buying them; the resources used to make them have not been freed up. Some producers of consumer goods switch to making tools and machinery to satisfy the increased demand. Production of consumer goods decreases so prices go up. Now people are paying more for what they do want, consumer goods today, and there is a lot of new machinery making things that people don’t want. The creation of money has not just increased prices but it has changed prices relative to each other. That is a dislocation. In fact, it is a complete mess.
What should happen next is that producers discover that there is no demand for their increased production capacity, and their projects fail. That would be the market correction. But this looks like a recession, so governments encourage even more money creation to postpone the correction. Each time around, larger and larger money injections are needed.
Now all this money creation got started in the first place so that states could spend more, and this reason has not gone away. Much of the newly created money is used to buy government bonds. When the government borrows money, it is not borrowing from future generations as is often said. It is diverting present day resources to be controlled by the government. This weakens the productive capacity of the economy which again is countered with lowered interest rates and GDP-boosting money injections.
None of this is likely to end any time soon, partly because no government wants to be in charge when the almighty correction does happen, and partly because governments need money to be created so that they can borrow increasing amounts of it to make up for their decreasing tax revenues.
I have missed out lots: historical examples; a whole section on fractional reserve banking and the relationship between banks and the state; the role of professional economists; rebuttals to opposing arguments; and so on. But this is a flavour of the gist of it.
Is it just me, or are there several glaring errors in this argument?
– To name the most blatant, precious metals definitely do not “fit the bill” of appearing in a fixed supply – national economies have suffered greatly from inflation under commodity-money systems previously, most famously Spain after the silver mines(and to a lesser extent, gold mines) of the Americas were opened. Something like 3/4 of the gold ever to be mined has been mined in the last century.
– If the exchange value of a commodity used as money dominates, doesn’t that translate to a useful commodity that is largely removed from circulation by the government fiat of choosing it to be money? Depriving industry and jewellers of gold because we would rather keep it all in vaults seems like the sort of interference we ought to be decrying, not encouraging.
– While there is not strictly a need to create money to supply the demand for money(since deflation can perform the same task), it has been found by long history to be desirable to do so. Persistent deflation destroys most ordinary forms of finance – why invest your money when simply holding it returns interest? Also, to pull evidence in from a related field, there’s been a few MMO games who have tried a fixed money supply economy before. All gave up in disgust shortly afterwards, because of serious problems caused by it(most notably hoarding and the resultant inability of new players to actually get any money). The only instances of a fixed money supply producing reasonable results was in the world pre-Industrial Revolution, when the economy was largely fixed and thus the demand for money was. A fixed currency in a growing economy is a recipe for disaster.
– Proclaiming the steady prices in the commodity-money era is a questionable business. I’ve seen people literally brag about how gold was worth the same number of dollars at two points a century apart…in an era when the dollar was literally defined as a fixed weight of gold. That’s not meaningful. Also, simply comparing price indices decades or centuries apart is troublesome, because the economy looks a lot different. How do you compare the prices of plastics or computers today with a century ago? Also, simply because gold is used as money does not mean that the money cannot be inflated – you can simply re-weight the coins, or debase them. Neither of these methods was unknown, or even especially rare, in the premodern world – there’s a lengthy discussion of it in The Wealth of Nations, for example.
– When judging stability of money, it’s important to distinguish between the long term and the short term(or if you like stats-speak, the mean and the standard deviation). Commodity money is very unstable in the short term and very stable in the long term, while fiat money is the opposite. I can predict the value of commodity money a century from now much better than fiat, but I can predict the value of fiat money next year much better than commodity. And for the vast majority of financial decisions, short-term predictability is the most important factor. I don’t much care what my grandfather paid for a car, I care what I’m going to pay for a car next year if I don’t buy this year. In general, but particularly post-1980, fiat money has been vastly more predictable than commodity money.
The concern over governments setting interest rates is valid, but they’re allowed to move more than you’d think, and there’s a lot of concerns going the other way too(like the government setting the price of gold). Overall, the inherent instability of choosing a single commodity to be money is too high for me, and a more general basket of goods is rather impractical, though if you can think of a good way of doing it, I’d be interested in hearing it. Fiat money’s not perfect, but it’s the least bad of the options that I can see.
Alsadius, almost everything you said is wrong. This really isn’t the place for an extended discussion of Schlichter’s argument (he wrote an entire book about it, after all, and I would encourage you to explore some of the articles on his blog and/or listen to his excellent talk at the Adam Smith Institute a few weeks ago), but I’ll attempt a brief rebuttal of some of your points.
> Inflation in commodity-based money systems is extremely rare, and the example of Spain you cited is just about the only one in history. The growth of the supply of gold is generally very stable, and that’s even more true today than it was 400 years ago because it’s highly unlikely that any huge new strikes will be found. (There are no new continents to discover!) Conversely, fiat money always results in inflation (which is fundamentally theft of value by the government); you can’t cite a contrary example. Oh, and debasing coins is simple theft, as is printing fiat currency. Just because it is possible for someone to cheat you isn’t a valid argument against commodity money, especially when (a) there are simple ways to protect against it, and (b) it is precisely what fiat currencies do consistently anyway.
> The use of gold as jewelry is essentially immaterial, and moreover it can always be re-purposed in either direction.
> Deflation is not the bug-a-bear you (and most mainstream economists) claim it is. Price deflation is a good thing (we all like it when the cost of computers or whatever goes down, or we get more value for the same price). Price deflation also increases purchasing power (your money buys more in the future), which encourages saving and thus holds down interest rates. The only ones hurt by it are debtors, which means that people will be more careful with their borrowing and only do so for projects which are truly economically viable. Schlichter covers this at length; listen to what he says.
> Commodity-based prices are remarkably stable, when you are comparing the same type and quality of good over time. (No sensible person compares the dollar value of gold over different time periods; that’s a complete red herring.)
> I don’t know where you get that odd idea about short-term and long-term price “stability” (as if that’s inherently a good thing), but have you noticed what’s happening to the prices of oil, grains, and other things lately? Massive price fluctuations are a daily occurrence. What exactly does “stability” mean to you?
> With a true commodity-based currency government’s couldn’t “set the price of gold”; the concept is nonsensical. They could peg the currency unit to a given quantity of gold, but unless the purchasing power of that unit fluctuated with the market people would simply exchange it for the gold. That’s Gresham’s Law in operation.
Lots of commodities have served as “money” in the long history of mankind, but gold (and, to a lesser extent, silver) is the far and away the most popular choice, and for very good reasons. No fiat currency was ever created because the market demanded it; in every instance it was created by governments purely to serve their own ends. And in every case it has eventually come to ruin. Study monetary history and you’ll see this.
Schlichter is the most intelligent and knowledgable writer on monetary history and theory in the world today. Rob Fisher has done us a service by summarizing some of the major points here, but as he himself says he has necessarily omitted much important detail. In his writings Schlichter refutes all of your arguments (and many more besides). He deserves your attention.
More gold does get found, but it’s predictable. Schlichter never claims that commodity money is perfect, but he does explain why attempts to fix the imperfections by the state are much much worse.
It’s like you read my mind. The other day I was googling “Detlev Schlichter summary” in search of… well, this. I had meant to have read the book by now but it hasn’t happened.
A little suggestion: could you, somewhere, include the word “summary” in your summary? You have “summarise” and “summarising” but not “summary”, so far as I can see. Then your article will show up the next time someone does the same Google search as I did.
But how are you at summarising Proust?
I’ve been smited. It was a fairly trivial comment but when you have a moment, please unsmite me.
You do not need government for there to exist a form of money.
The inflation from finding new sources of silver (if silver is being used as money) is tiny compared to the inflation that can be caused either by the printing press – or by the creative accounting of modern banking (backed by the government Central Bank, if the banks are not so backed then their credit bubbles do NOT create long term inflation as the “boom”, “busts”).
By the way Spain was not destroyed by large amounts of silver and gold comming in from the New World.
Spain was destroyed by vast taxes that were slapped on Castile (due, I would argue, to the wrong side winning the Civil War of the late 15th century) and by the endless regulations (what came to be called “Spanish Practices”) that were imposed on various aspects of the economy.
The gold and silver was not bad for Spain (any more than it was bad for the Soviet Union) – on the contray the influx of gold and silver allowed the farce to go on much longer than would otherwise have been the case.
As for Schlechter’s arguments – most of them are straight forward and can be best followed by reading his latest book (which is not long and is written in perfectly clear English).
I suppose I could do a comment.
Starting from the origin of money, and going on from there to the crises we are now in – and likely future events.
But Schlichter has already done that.
Natalie: done.