Infernal Ramblings
A Malaysian Perspective on Politics, Society and Economics

Fiat Money Over A Gold Standard

Written by johnleemk on 1:47:19 pm Jun 21, 2007.

One constant debate in economics is whether it is preferable to tie a currency to some metal (i.e. gold) or to allow the government, typically via the central bank, to issue fiat money without needing the value of money to be commensurate to any measure.

The gold standard has garnered a lot of support from many, especially those in favour of less government economic intervention and those who just don't like to see the hyperinflation which is guaranteed to arise under an irresponsible government.

The only good reason I can see for insisting on a gold standard is that fiat money provides a risk of hyperinflation if the central bank prints it irresponsibly.

However, this is a bit like saying we should allow the free market to take care of everything, even if it means people dying, since the government could act irresponsibly in taxing people and running its social programmes.

(Of course, there are a few nutcases out there who remain convinced that the market is always right and the government is always wrong. As a general rule, these people are a lost cause, considering they are going against even some of the most extreme libertarian economists like Friedrich Hayek and Milton Friedman.)

One valid criticism of fiat money is that it constitutes government intervention in the economy for no apparent reason. Why not let the market set the value of the currency by tying the currency's value to the value of some real object, such as gold?

The problem with this line of thinking is that this ignores the reason there is a currency in the first place. The government has to standardise on a form of currency — in other words, actively intervene in monetary issues — in order to avoid a barter economy, where people trade goods for other goods. Without the government enforcing something as legal tender, things get pretty iffy since some people will demand payment in certain forms and others will prefer a different method of payment.

Moreover, why should the government intervene and declare that the value of the currency be tied to the value of gold? Why not tie it to the value of silver, or platinum, or diamonds? Gold standard advocates are themselves demanding some form of government intervention — they implicitly acknowledge that total anarchy in deciding what constitutes good currency means that we cannot standardise on any one currency.

The inherent problem with the gold standard, in any event, is that its value fluctuates far too much with not much correlation to the value of other goods and services. Princeton economist Paul Krugman has pointed out that if you calculate the real value of stocks and equity by calculating it through the price of gold, you find that the rich are actually poorer than they were a few decades ago (an argument actually seriously made by one prominent gold standard supporter).

In reality, as Krugman notes, the rich are richer now because they can afford to buy more of anything, except for gold, because the price of gold did not rise commensurately with the general price level.

So, why should we opt for the risk of fiat money? Simple — because it allows the market to function. For instance, we are not inclined to accept nominal wage cuts, even if our real wage remains the same because the general price level has fallen thanks to deflation.

This is a real problem whenever recessions arise, since that is when deflation occurs (and that, friends, is also why deflation is generally a bad idea). However, if the central bank is allowed to fight the deflation and inflate the currency's value, then your boss can give you a nominal raise — even if the real value of your wage remains the same or actually falls.

In other words, mild inflation can be good for the economy because it avoids the sticky problem of human nature and restores the market mechanism in the labour market. Obviously this is a bit of an oversimplified explanation, but it nevertheless is the main reason for why most economists are firm believers in many aspects of monetarism (a school of thought founded by Friedman which argues that the central bank should control the currency).

Fiat money has its risks. But managed properly, it yields substantial benefits. The gold standard is a good idea in theory, but in practice, it's just not workable.

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Infernal Ramblings is a Malaysian website focusing on current events and sociopolitical issues. Its articles run the gamut from economics to society to education.

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