Monday, June 18, 2012

Currency Architecture: Gold Standard vs Monopolised Fiat Standard

In my previous post I had mentioned how every 40-50 years we have a change in our currency architecture. This period is quite chaotic not just economically but also politically and has coincided with wars or geopolitical disturbances.

Broadly there are 2 currency systems that we have followed over the last century. 1) Commodity Based and 2) Debt Based. I am of the view that it is impossible to run a communist monetary system that we have today and then poses as if there is any semblance of free markets. Why I call the current monetary setup as such is because the price is set by the government and distribution is controlled through few private institutions "Banks".

In this post I would broadly point out the advantages and disadvantages of the two systems and a possible way forward. Although this topic needs detail explanation but the idea in this blog is to give a glance of things.

Gold Standard: The biggest disadvantage of this system is that the credit supply here is restricted to the amount of gold in the system. It is tantamount to restricting opportunities for young bright kids.

There are two advantages of this system:

- Even though the credit becomes restricted but the system is still somewhat (atleast partially) free market as a government is bound by this system cannot interfere during downturns.

In this system it is the savings that drive credit so the risk reward distribution is more just/correct.

Fiat Monetary System: The biggest advantage of this system is that the supply of credit is pretty much unrestricted and infact the demand for credit drives the supply. It is no question that it is a powerful system that can drive remarkable growth as we have seen since 1960s in many countries (Bretton Woods agreement was not completely fiat based as dollar was still linked to gold but was still more flexible).

During this period many regions of the world saw growth rates at levels never seen in human history. However there are two big problems with this system:

- It is at the end a government monopolised system so the government/Central Banks intervene during every small downturn thus preventing the unwinding of credit due to the misallocation of capital which has led us to the point where now the demand for credit has dried up and any small unwinding/deflation of credit would cause a catastrophe
- The risk rewards are skewed away from labour to equity holders and banks causing the income disparity to grow remarkably (Refer: (Link))

So obviously the current setup is not sustainable and neither is the solution to go back to the gold standard. The system that would work is which takes good features from both these systems i.e. a free market based monetary system.

In this system, money like any other commodity could be produced/printed by anyone, well maybe subject to some basic norms/conditions like we have in many industries. The free market would then decide whose money is worth its salt i.e. people would hold the money that would have stable purchasing power over time or slightly increasing purchasing power.

However more importantly such a type of architecture would not only take into cognizance the good features of both of the standards but also eliminate their negatives. Before I point them out let me clarify one thing: There would always be a phenomena of wealth transfer via one asset class to another. This is the nature of capitalism and its beauty defined mathematically as “stochasticity or randomness”. This very feature enables man to grow and achieve things from nowhere and hence this phenomenon is not what we want to control but instead give people a choice. Please note that the key here is randomness i.e. not because of planned intervention of the government.

So a market based monetary system wherein different currencies are allowed can be accomplished by:

-       Removing the bondage that tax has to be paid in the government printed notes
-       Eliminating any capital gains on various assets (I don’t include real estate in this though which in my opinion should be taxed)
-       Removing a government monopoly on the tax currency would also force the government to reduce its size

This system would combine all the advantages of other two systems:

-       This system would not be a government monopoly so:
o   as mentioned before thus the price of the money would be determined by the market
o   The government would not be able to avoid the downturn caused by the unwinding of the malinvestments

-       The competition would ensure credit supply would not be a constrained (just like in any other product) so it is going to be a demand based credit system

-       The risk/reward would be justifiably distributed as unlike previously now the labour could choose to be paid in a currency where if for some reason the business doesn’t do well the loss would be shared between the creditor and the entrepreneur. This was not possible earlier because there was a government/bank monopoly on the currency and any such setup in this new system would be rejected by the labour. This is because as explained in my post before (Link) the reason why labour settles for less compared to the entrepreneur is because he/she doesn’t take risk of the success of the business.

Next post on this topic would be about the currency myths.

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