3.4 Commodity and Credit Monies

Truth be told, the people who used lion teeth or rocks with holes in them as money might find moderns a bit off their rockers for using money created by the government. The reason is simple: commodity monies are self-equilibrating, but government fiat monies are not because they are sometimes subject more to the whims of politicians and bureaucrats than to the forces of supply and demand, as we will see in Chapter 13 "Central Bank Form and Function". Commodity money systems can self-equilibrate, or essentially run themselves, because commodities are scarce (but as noted above, not necessarily rare). In other words, the opportunity costs of their acquisition and production are greater than zero. That means that at some point people will find it just as profitable to produce nonmonetary goods as to produce money directly. At that point, money creation naturally ceases until more is needed.

Suppose, for example, that clams are money and that ten can be found in one hour, on average. Suppose too that people on average can also produce a bow in two hours, an arrow in one hour, and a dead rabbit in three hours. In that situation, an arrow would cost ten clams, a bow twenty clams, and a rabbit thirty clams because at those prices people would be indifferent whether they spent, say, six hours collecting clams (6 × 10 = 60), making arrows (6 × 10 = 60), making bows ([6/2 hours per bow] = 3 bows produced in 6 hours; 3 × 20 = 60), or hunting rabbits ([6/3] = 2; 2 × 30 = 60). If a big clambake takes clams out of (monetary) circulation by putting them in (bloodstream via the digestive tract) circulation, it will be more remunerative to harvest clams than to make bows or arrows or to fricassee rabbits until the supply of clams is restored, which should not be long. (In fact, if people expected the clambake, the adjustment might well be instantaneous. We’ll discuss the importance of expectations in Chapter 7 "Rational Expectations, Efficient Markets, and the Valuation of Corporate Equities" and Chapter 26 "Rational Expectations Redux: Monetary Policy Implications".)

Commodity money systems also automatically adjust to structural changes in the economy. If it suddenly became easier to find clams, say, twenty in an hour, everybody would harvest clams until the clam prices of arrows, bows, and rabbits doubled, restoring equilibrium. If clam production dropped to five an hour, prices would also drop by half because no one would harvest clams when they could earn twice as many clams in an hour producing arrows, bows, or rabbits. If clam production remained steady but it became easier to produce bows, the only thing that would change would be the price of bows relative to the prices of arrows and rabbits, and not the price level, or all prices. For example, if it was possible to produce bows in 1.5 hours instead of 2, the price of bows would drop to 15 clams (when 10 clams can be harvested in an hour).

As noted above, gold is a very good commodity money in most respects. It fell from grace early in the twentieth century, however, primarily because of competition from superior types of exchange medium and the inelasticity of its supply. When gold became more abundant and output remained constant, the price level increased because there was more money chasing the same amount of goods and services. When the quantity of gold remained constant and output increased, the price level declined because there was no longer enough gold around to maintain the former prices, as in Figure 3.5 "A higher price for gold means a lower price for everything else". By making each ounce of gold more valuable, thus increasing one’s ability to purchase more goods and services than formerly, the decline in prices should have triggered an immediate increase in gold production, thereby rendering the deflation, or reduction of the price level, mild and transitory, as in our hypothetical clam case above. Due to the difficulty of finding new veins of gold, however, changes in the price level were often prolonged.This chart depicts changes in the price level in the United States between 1865 and 1900, when the country’s unit of account was defined in gold. Note that prices fell in most years. That deflation led to a series of political upheavals that resulted in the formation of the Populist Party and a prolonged struggle among Silverites, who desired to raise prices by monetizing silver; Greenbackers, who sought to raise prices through the issuance of fiat money; and Gold Bugs, who insisted on maintenance of the status quo. The Wonderful Wizard of Oz, a children’s book by Frank Baum made legendary by a movie version starring Judy Garland as protagonist Dorothy, is an allegory depicting the major political divisions of the era. Oz is of course the abbreviation for ounce; the yellow brick road refers to the gold standard; the Emerald City symbolizes Greenbacks; and in the book, Dorothy’s slippers were silver, not ruby, as they were depicted in the movie.

During the deep economic troubles of the 1930s, many countries experiencing prolonged deflations, including the United States, decided it was better to abandon gold in favor of much more elastic credit and fiat monies.

The end of gold’s reign was, in a sense, overdue. Gold’s monetary life had been extended by the invention and widespread use of fiduciary, or credit, money, including banknotes and deposits, because such money essentially rendered the gold supply more elastic. By the late seventeenth century, goldsmiths, skilled artisans who made gold watches and other auric goods, began to safeguard gold for their customers and to issue a form of representative money by issuing receipts to depositors. Like tobacco receipts, the gold receipts could be returned to the issuing goldsmith for gold. People often preferred to hold the receipts rather than the gold itself because they were even more portable and easily authenticated than the metal. So the receipts began to circulate as a medium of exchange. Credit money was born when the goldsmiths, now proto-bankers, discovered that due to the public’s strong preference for the receipts, they could issue notes to a greater value than the gold they had on physical deposit.

By the eighteenth century, banks in Great Britain, the United States, and a few other places increased the elasticity of the supply of gold by engaging in just such fractional reserve banking. Consider the following bank balance sheetA financial statement showing the sum or stock of an economic entity’s assets (things owned) and liabilities (things owed). Assets should equal liabilities, including equity (aka capital or net worth).:

Because most people preferred to hold notes and deposits instead of gold, the bank could hold only a small reserve of gold to pay to holders of its demand liabilities (notes and deposits) and earn seigniorage, or the profit from the issuance of money, on the rest.Seigniorage can be earned in several ways. One way is to earn interest on assets acquired with liabilities that pay no interest or, more generally, on the positive spread between return on assets and the cost of monetary liabilities. The Federal Reserve, for example, pays no interest on its notes or deposits but earns interest on the Treasury securities and other assets that it buys with its notes and deposits. Another way to earn seigniorage is to mint coins that have a higher face or nominal value than production cost. Debasing the coinage, or extracting seigniorage by increasing the nominal value of a given sum of gold or silver, was highly profitable and therefore a favorite sport of kings. Here only 200 (dollars or pounds or whatever) of gold did the work of 900 (the sum of notes and deposits). Bankers essentially made gold less rare and also gained some control over its elasticity via the reserve ratio (reserves/monetary liabilities or 200/900), which was relatively unregulated by government at that time. Bankers could change the ratio as they saw fit, sometimes decreasing and sometimes increasing it, thereby changing the money supply, or the total quantity of money in the economy.

Since its invention, credit money has been extremely successful because it is an almost perfect medium of exchange. Take, for example, bank deposits. Essentially just an accounting entry crediting so much money (unit of account) to a person or organization, deposits are easily authenticated, perfectly uniform, divisible to fractions of a penny, highly portable via written or electronic orders, and extremely durable. Moreover, their supply is highly elastic because they can be created and destroyed at will. The usefulness of deposits is further extended by varying their characteristics to meet different risk, return, liquidity, and maturity preferences. The most common and familiar type of deposit, called a checking, transaction, or demand deposit account, pays no or relatively low interest, but funds can be withdrawn at any time via teller during banking hours, via ATM 24/7, or with a debit card or check. Other deposits, called time or savings deposits or certificates of deposit, pay relatively high interest but either cannot be withdrawn at all before a prespecified date or can be withdrawn only if the depositor suffers a penalty that wipes out much of the interest earned. Between those two extremes have emerged a variety of hybrids, like automatic transfer from savings (ATS)An account that automatically moves funds from your savings account if your checking account is depleted. (Of course, such an account doesn’t help if you don’t have any money in your savings account either.), and sweep accountsAn account that automatically moves funds from your savings account if your checking account is depleted. (Of course, such an account doesn’t help if you don’t have any money in your savings account either.), and money market mutual fundsMMMFs are mutual funds that invest in short-term, or money market, instruments. Fund owners earn the going market interest rates, minus management fees, and can draw upon their shares by check but at a cost higher than that of most bank checking accounts.. Most forms of electronic or e-money, like sQuidcards,http://www.squidcard.com/corporate/emoney.html are just new forms of credit money.

The biggest problem with credit money is that the issuer may default. Many banking regulations, as we will see in Chapter 11 "The Economics of Financial Regulation", attempt to minimize that risk. Other issuers of credit money are not so closely regulated, however, and hence constitute serious credit risksThe probability of not being paid a sum due. for holders of their liabilities.