# Understanding Economics in One Hour, Part Five

## Sound Money

Having seen the nature and causes of unsound money, what can we say about sound money?

It is money that can be trusted, by anyone and everyone who uses it. Trusted to do what? Trusted to retain its purchasing power.

After all, what matters is what money can buy, not the money itself. Sellers of goods and services expect payment for their products in a medium that can be used for making purchases. (Our old friend Say’s Law over again.)

At 3 per cent, the current rate of inflation, the purchasing power of your money will be halved in 23 years. It was not always so. The pound took 164 years, from 1750 to 1914, to halve in value. One dollar today is worth one cent of a century ago!

It could be worse: think of the poor Zimbabwean farmer who wants to export his crop of delicious oranges. Unlike a German exporter, happy to accept payment in his own currency, our farmer will accept payment in just about any currency except Zimbabwean dollars, because they fail the crucial purchasing power test.

### Redeeming those dollars

Throughout the 1950s and early 1960s the USA just kept on printing dollars regardless of whether they could redeem them in gold at $35 to the ounce. They were effectively paying for their imports with fake currency. In 1958 General de Gaulle became President of France and over the next few years he noted with increasing alarm that the French Central Bank was stuffed full of US dollars, and French exports to the USA (wine, cheese, machinery, cars, clothes, etc) were being paid for, not in francs, but in still more dollars. In 1969 De Gaulle started to redeem the dollars France was holding against gold at the official rate of$35 to the ounce.

Other central bankers duly noted this redemption and soon began to follow suit. By 1971 America’s gold reserves had become seriously depleted, and President Nixon took the coward’s way out of the problem by simply declaring that debts denominated in dollars were no longer redeemable in gold – effectively taking America off the gold standard.

[Nixon could, of course, have faced up to the damage inflicted by the Federal Reserve’s systematic dollar destruction over decades. He could have devalued the dollar by restating its revised value in terms of gold, and then desisting from further debasement. It is reliably estimated that the true relationship between dollars and gold in 1971 was around $400 to the ounce. This means the dollar lost almost 90 per cent of its purchasing power over the 27 years from 1944 to 1971. Reinstating the gold standard at that conversion rate could have arrested this slide – subject to acceptance of monetary discipline. Today the “gold conversion price” (the price the Fed would have to set to redeem dollars for gold AND NOT RUN OUT OF GOLD) would be over$14,000 per ounce for base money, or, if savings and short-term bank liabilities are also to be covered, a staggering \$53,000 per ounce!]

Economists who favour state control over the economy claim that the chief drawback of a gold standard is that it restricts government’s ability to control the money supply when, in their view, state intervention is warranted.

However, economists who consider that markets are preferred arbiters of what, if anything is needed, regard this restriction on monetary meddling as the gold standard’s greatest strength!

### “Fiat” Money

In 1971 the gold standard was replaced by a system of “fiat” money under which the currency is not linked to the value of any commodity, but is instead allowed to fluctuate dynamically against other currencies on the foreign-exchange markets.

The term “fiat” is derived from the Latin “fieri” – meaning arbitrary act or decree. In keeping with this etymology, fiat currencies are accepted only because they are defined as legal tender by government decree, not because they retain purchasing power, which they do not!

Finally, you will hear politicians opining on the effect of individual currencies: “If only the Italians ditched the euro and returned to the lira their exports would be more competitive…..” And the same sentiment is voiced over the Greek drachma, Spanish peseta, etc. This is all nonsense. It is not currencies that that need to be made more “competitive”, but production. German cars are not world-beaters because they are cheap, but because their production methods guarantee value for money – any money!

© Emile Woolf May 2018 (website)

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