Monday, September 7, 2009

Advantages and Disadvantages of a Fiat currency

The important distinction between gold and fiat money is that fiat money can and is created in arbitrary amounts, and is made available on a favorable basis to the government and commercial banks. Now I admit there are both advantages and disadvantages to flexible money creation. You can't meaningfully increase the supply of gold over a short period of time. Think about what happened to the Fed balance sheet last fall - in 10 weeks the Fed increased supply by more than 100%! You couldn't do that with gold.

The advantage of being able to do that is that you can manipulate the system to mitigate panics and disasters. Last fall would have definitely been a bigger mess if gold was the monetary numeraire. However, the downside is that the advantages of the credit creation are distributed unfairly - big banks vs little banks, GM and Chrysler vs. other manufacturers, etc - and generally have been rewarding failure. Long-term that isn't good. Plus, it concentrates power in Washington and New York, because that is where the money is coming from - also not good. And finally it is a common and I believe correct argument that it tends to concentrate money in the banks that are closest to the policy decisions (read Goldman and JP Morgan) - really bad! That's what I meant by available to a select few - the big banks, particularly the ones influencing policy decisions, and industries selected by the government. That couldn't happen if gold was the numeraire.

Again, the downside would be that last fall, instead of a scare there would have been a catastrophe.

The upside is that when using gold as money, failure, thievery, oligarchy, corruption, etc. get washed out of the system more regularly.


  1. Thanks for the post and the systematic interaction information. I was looking for this information along with a bit more "proof" that there is unequal distribution and unfair advantages.

  2. Inflation and its consequential boom and bust (business) cycle is exactly the creation of fiat money, not a cause of it. In some economic theories, the fact that we are using fiat money providing easy credit leads us to a "boom" phase characterized by malinvestments to begin with. After this bad planning is realized by the population, then the "bust" cycle begins which means that those malinvestmnets need to be clear out so people can start their economic activities again. Using gold as a currency backup maintains a restriction on both banks and governments from issuing easy credit. People must first save their money so they can make long-term investments while money value by itself must remain stable. Gold, just like silver, copper, iron, rice, pasta or any other material good, has an intrinsic value that paper currency does not have and hence, all these commodities have been used as curency successfully in history. Lastly, who gives the government and private banks the right to create fiat money and even charge interests on it while using taxpayer's real wealth as a collateral? Fiat money is robbery from any legal or moral logic and it can be proven that it only benefits the issuer.

  3. I would disagree that fiat money is the creation of inflation and boom/bust. Clearly boom/bust occurred on the gold standard - the main difference is that it wasn't centrally controlled. Banks still used a fractional reserve system long before 1917, 1933, 1964, or whatever date you want to pick, and so credit still had a boom and bust cycle, but the final arbiter was simpler - namely "who had the gold and who didn't" when things turned sour. Now, the Fed can always choose to move the money supply to wherever it likes, so holding cash does not have the same power that holding gold use to.
    One final note: there is a golden level of capital accumulation (savings) and most developed economies arrived at this level long ago - my main concern is that we have now substituted a lot of foreign savings for domestic, which creates a myriad of problems - primarily substituting current ease for future disease. It think this is becoming consensus view, but we're not there yet.