Sunday, May 10, 2009

Introduction to Economic Reasoning - Chapter 10: The Gold Standard

As demonstrated in previous chapters, money must originate as a commodity. One cannot use praxeology to determine which commodity will do so. Still, praxeology tells us that the commodity must have a wide acceptance among people, and that they must see that it will be accepted as a means of exchange for other goods.

The recognition that a good is widely accepted and will serve as a medium of exchange need not occur slowly. It can happen quite quickly. Cigarettes in prison camps for example arose quite quickly as media of exchange without any formal decision.

Historically gold and silver have arisen as near universal money because of their qualities (divisibility, durability, wide acceptance).

If there are two monies, like gold and silver, how can both be used? The market solves this problem. Gold and silver will simply trade at a ratio to one another as other goods do with them. This ratio, like other ratios can not be expected to remain constant.

Furthermore, goods priced in silver will tend to be priced the same in gold as it relates to silver. Should a good cost more in gold than in silver, its price in gold will fall This will happen for one of two reasons, or a combination of both.

For one, suppliers of that particular good will bid for less and less gold until the amount of gold suppliers want for the good matches its ratio to silver. For another, holders of gold will want more of a good for the amount of gold they are offering until the amount reaches the same they could get if they had silver. At some point the amount of a good the demander could obtain with his gold will match what he could get with silver at the ratio gold and silver are trading.

Economic reformers posit that the fluctuation of the ratio between gold and silver is a problem. They contend the fluctuation can occur to quickly for some market participants to respond, and that it opportunity for arbitrage continually presents itself. To address these problems reformers advocate fixing the ratio between gold and silver to make it easier for market participants to calculate prices and eliminate the opportunity for arbitrage.

The reformers, however, are obligated to demonstrate why price fluctuation and arbitrage are ethically wrong. They cannot trot in a value judgment such as they have without making the case for why it must be recognized.

Specifically, why is it that the rate at which the ratio between gold and silver fluctuates be instantaneous? The reformer is right to say that a change takes time, but when he suggests it takes too much time he is making an ethical judgment that requires an argument to support.

The other assumption the reformer must explain is why arbitrage opportunities must be eliminated or reduced. He must explain why arbitrage is wrong.

These ethical cases may be valid, but one is not obligated to recognize them without an argument for their support.

Leaving aside the ethical questions, fixing the ratio introduces the problem of Gresham’s Law.

Say a gold mine is discovered which increases the supply of gold. The market ratio of silver to gold falls from 16 to 1 to 15 to 1. Meanwhile the ‘official’ ratio between them remains at 16 to 1. What will happen?

Holders of gold will happily trade their once of gold for 16 oz. of silver when the market values gold at only 15 oz. Those who hold silver, however, will be reluctant to trade silver at that price. Moreover, they will be unwilling to spend it into circulation to pay for other goods as these goods will be more expensive in terms of silver than gold.

As gold and silver are not only money, but also commodities, a fixed price between them will cause shortages and surpluses of them. As silver is undervalued by the fixed price it will not be offered for sale and experience a shortage. Gold, on the other hand, being overvalued by the fixed price will enjoy a surplus. In short, silver will be driven from the market in preference for gold. Gresham’s law states bad money will drive out good money. It is more accurate to say that overvalued money will drive out undervalued money.

As shown above, two commodities can coexist as money without issue on the market. Still, one commodity may eventually dominate, eventually causing the other to lose value until it is valued strictly for utility and not exchange. Though not a praxeological law, one can expect a single metal currency standard to arise on the free market and replace the tow metal currency standard. Between gold and silver the one to do so would probably be gold.

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