A Basic Lesson on Money Jude Wanniski January 3, 1997

Supply-Side Economics Lesson No. 5

Memo To: Website students
From: Jude Wanniski
Re: A Basic Lesson on Money

For most of human history, the only "money" used was something of the earth, some thing the price of which was the same as its intrinsic value. The price of a $100 bill is clearly much higher than its intrinsic value. You can "buy" or "exchange" a $100 bill with 100 loaves of bread. Its intrinsic value in paper is not more than a fraction of a cent. The price and value of gold, though, were identical. So too with silver. These two precious metals were the big monies of human commerce. The small monies were those coined of copper, iron, or nickel. These bore some intrinsic value in proportion to gold, which in almost all civilizations was the key money, the proxy for all other monies and the proxy for all goods and services that could be equated, one to the other, through money. Only in those places where gold or silver did not readily present themselves — among islanders, for example — were seashells of a certain type employed for the purposes of money. The indigenous people of North America used wampum, elaborately sewn belts that obviously contained significant labor.

Even before the dawn of civilization, men found great utility in a common currency that would serve as a unit of labor. Gold has held up for several thousand years in that capacity. If you gave a 25-year-old man a shovel 6,000 years ago and asked him to dig a hole of certain dimensions, he would be able to complete the job in roughly the same amount of time that a 25-year-old man would today. The basic unit of labor has not changed. A man who could dig an ounce of gold from the earth 6000 years ago would be able to exchange it for the other things that other men were taking out of the earth at the same time, in the same proportionate amount of labor. These would include the base metals, but primarily it would include anything of caloric value that the earth would yield up to a man's labor. For most of human history, most of the labor of men has gone into hunting or planting for food. A bushel of wheat or a string offish or so many apples would exchange for each other in the same proportions, then as now. In most places on earth, gold evolved as a proxy for these other goods in these same proportions. That is, the same amount of gold could buy so many bushels of wheat or string offish or barrel of apples. The unit of labor thereby also became the unit of account.

Throughout most of recorded history, only a small fraction of any population actually got its hands on big "money." Most exchanges took place via bartering, as producers offish actually swapped so many for bushels of grain. This is because almost all people lived in farm areas and could travel only a few miles to markets. Small money was sufficient where barter was not. For goods traded between more distant points, by caravan or by ship, big money entered the transaction if the values of the traded goods were not in balance. Here we see the utility of "money" as a unit of account, where a caravan might arrive a few thousand years ago with spices and silk valued at 1000 pieces of gold and return with olive oil and wine valued at 980 pieces of gold. Only 20 actual pieces of gold need exist to complete the transaction, but without gold's acceptance as a reliable accounting unit in both places, it would be far more difficult to complete the transaction. We hear from time to time that there is not enough gold in the world to return to a gold standard, because the size of global transactions dwarf the actual amount. That has always been the case, however. It is gold's scarcity, as well as its durability, portability and malleability, that caused it to be selected by mankind as the key money in the first place. There is today in the world roughly 120,000 metric tons of gold, all that has been mined in recorded history. If the Washington Monument were to be replaced with one of solid gold, it couldn't be done. All the gold in the world would only complete the bottom third of the monument. If "money" were only necessary as a medium of exchange or as a storehouse of value, the world might be able to get along satisfactorily with paper money. It is gold's monetary dimension as a unit of account that gives it its extraordinary importance. An accounting unit must be fixed in value, because it incorporates a fixed amount of labor into the needs and wants of all mankind. If it still takes a 25-year-old man with the same shovel the same amount of time to dig a hole of the same dimensions today, as he could 6000 years ago, what benefit is there to pretend otherwise?

It is only in the last several hundred year that gold's monetary function as a unit of account increased, while its function as a medium of exchange and storehouse of value decreased. Rarely is gold used anywhere in the world today as a means of payment for goods received. Nor do investors acquire gold bullion as a store of value in the same proportions as they did hundreds of years ago. It is easier to hold the hard currencies or the stocks and bonds denominated in the hard currencies than to hold gold, which pays no interest or dividends. Still, the world cannot do without gold as a reference point, a unit of account, against which to measure the integrity of the paper currency or bonds issued by governments.

The transformation of gold's utility began when European goldsmiths found they could issue receipts for gold left in their care, and those who had the receipts could trade them for goods in more distant markets. Banking began in this way, as financial intermediaries could finance the exchange of goods valued at 1000 pieces of gold and 980 pieces of gold by supplying the difference for a fee and guaranteeing each side that the exchange would be made. The biggest need for financial intermediation was by governments, which from time to time faced great financial needs. Banks would serve as intermediaries, collecting paper deposits of goods measured in gold units, and lending these to monarchs in a pinch, who would promise to pay the loans back with interest. The banks found they could earn profits in two ways. First, they would earn the fees associated with the transaction. Second, the bank notes they issued to pay back the depositors had such utility as "money," that they need pay no interest. When governments realized their own public debt had monetary value, "seignorage" as it was called, they could negotiate lower fees for the privilege of allowing private banks to issue notes backed by the promise of the government to redeem them.

By now, all countries have socialized this aspect of money. The central banks of the world now operate as agents of government. They "create" money by buying government bonds from private banks. They can also withdraw money from circulation by selling government bonds to private banks. All that is happening is that one form of government debt is replacing another. When money is created, non-interest bearing government debt is injected into the banking system and interest-bearing debt is withdrawn. This is how the Federal Reserve manages the "money supply," buying or selling government bonds.

Supply-side economists for the most part recognize the public role that gold plays in the private market. It is a reliable means of assessing the value of government debt in all the countries of the world that issue debt. When the dollar price of gold rises, it is a signal that the private creditors of the United States are downgrading the value of U.S. debt issues. It is an inflationary signal. When the price of gold falls, it is a deflationary signal. Demand-side economists argued that when the United States suspended the linkage between the paper dollar and gold, in 1971, it "demonetized" gold, as if it would no longer play any monetary role. This turned out not to be the case. After 6000 years as a the world's big money, gold continued to punish governments that allowed its currency to fall relative to it, and reward those that kept its currency from declining relative to it.

This broad overview will raise as many questions as it answers, but money is a large topic. We will return to it again and again in these weekly lessons.