Worried about their currency not being respected as much as
before, some Americans have started to murmur about the value of the dollar and
its role as a reserve currency for the world. Add to this the fact that the Euro
seems to be going downhill nowadays and you can understand why there has been
calls to return to the gold standard, a measure that some people believe will
make of the dollar “sound money” again.
Unfortunately, the fundamental principles involved in this
matter were barely mentioned if at all during those murmurs. But without
developing an understanding of the principles involved, the full discussion of
this subject – if and when it comes -- will be a waste of time. What follows is
an attempt to elucidate the matter to the extent that it can be done, and thus
get to the principles which are involved in giving a currency its value.
Let me start with an example. Twin brothers Peter and John
who think alike marry twin sisters who also think alike. Each of the brothers
inherits the same amount of money, and they launch the same sort of
manufacturing business but do so at opposite ends of the city. Each of the
sisters also starts her own architectural business away from each other. After
a while, both brothers see the need for a bank loan to expand the business, and
so they approach the neighborhood bankers who are not twins and do not think
alike.
Peter's banker says to him draw up an inventory of the
machinery and real estate you have then come back and we'll discuss how much we
can lend to you. I have it right here, says Peter, and he shows the banker a
list where the bottom line says one million dollars ($1,000,000). In this case,
says the banker, we'll extend to you a line of credit in the amount of one million
dollars. Peter goes to his wife and tells her what happened. Too bad, she says,
because I have three talented architects in my own business but very little in
terms of machinery or real estate. We generate of lot of sales, make a good
profit, and I could do better if the bank would lend me enough money to do two
things. I need to print an attractive sales kit showing all that we have
accomplished up to now, and I need to hire and train a sales force that will go
out and seek new customers. But from the looks of it, I have the feeling that
the bank will not lend to me because I have little in terms of capital outlays.
At the other end of town, John's banker says to him draw up
a balance sheet for the last full year of your business, then come back and
we'll discuss how much we can lend to you. I have it right here, says John, and
he shows the balance sheet to the banker where the top line says three million
dollars ($3,000,000) in sales, and the bottom line says thirty thousand dollars
($30,000) in profit. Impressive sales but a small profit, says the banker, and
I suppose you want to borrow money so as to improve on your productivity and
thus generate a better return. Exactly, says John, and the banker says he will
extend to him a line of credit in the amount of one and a half million dollars
($1,500,000). John goes to his wife and tells her what happened. She jumps for
joy because she employs talented architects who generate a lot of sales and
profit; and she knows she can do even better if she advertised. To know that
the bank will lend her as much as half her yearly sales is to know she can
expand the business to its full potential.
We see from these examples that there are at least two ways
to evaluate a business. One way is to base the valuation on the amount of
wealth that the business generates. The other is to valuate the business based
on the amount of capital it has already accumulated. Which way is the better
way? Well, in reality this is not a fair question because other variables come
into play when valuing a business. There is, for example, the question as to
where the economy stands at the time of valuation, what sector of the economy
the business is in, how the sector is expected to perform in the future, what
kind of management the company has and so on. But we assume for the purpose of
this discussion that all of these factors have a negligible effect, and we
ignore them.
We now examine a few other principles before we can resume
the discussion on the currency. To this end, we imagine a spaceship full of
human beings getting stranded on a planet that looks like earth in terms of the
plant and animal life it contains. It is not inhabited by indigenous
intelligent beings which makes it easy for the people from Earth to colonize
it. The earthlings -- now calling themselves people of the planet -- understand
they will be here for several generations without anyone from Earth knowing
where they are or what happened to them. Thus, they decide to make the best of
a bad situation by settling in and putting down the foundation for a whole new
society to emerge and to evolve on this new home planet.
The first thing they do is establish a system of valuation
for the goods they produce and the services they perform. They know they will
soon be able to print money which they will use as a medium of exchange but
until they do, they institute a system of barter that is based on the relative
value of the goods and services they exchange with each other. Because the
population is small, they do not rely on the marketplace to determine the value
of each item. Instead, they consider the egg to be the unit value of the barter
currency, and they price everything else accordingly. For example, when it
comes to the proteins, a chicken is worth ten eggs; a lamb is worth ten chickens
and a cow is worth ten lambs. As to the grains, legumes, fruits and vegetables,
the people of the planet fabricate a basket, the content of which is given a
value depending on what that content is. For example, a basket of apples is worth
five eggs; a basket of wheat is worth seven eggs; a basket of mangoes is worth
a chicken plus two eggs and so on. In the services, a haircut is worth half a
dozen eggs and everything else is bargained for. The arrangement is not
tailored to function like a commune or a system of free enterprise; it is
something in-between.
Years later, the population has grown large enough for the
people of the planet to move to the next stage. They print money, call it the
Mighty Egg (ME) and use it as a medium of exchange. They also introduce
elements of the free market economy where the forces of supply and demand are
allowed to determine the relative price of each item. They elect a woman to
operate the printing press, and call her the banker. But the economy is not yet
a fully fledged one, and so the banker estimates how much goods and services
will be produced each day, also estimates what the price of each item will be
on that day, and does the math. She comes up with a figure and prints money in
that amount.
The people of the planet muddle through for a time but after
a while things start to go wrong, and everybody feels it. However, because the
people are still nice to each other -- being in it together on this isolated
planet -- they do not complain right away. With time, however, enough cracks
accumulate in the system to create one big problem that has several sides to
it. This is when the people decide to face up to the reality that they have a
serious situation and that they must do something about it. They elect a number
of individuals from among their ranks and delegate to them the power to go sit
with the banker and discuss the situation on their behalf. The delegation meets
with the banker who says she does the best she can to assess how much of each
item the people of the planet will be producing during the day, and she prints
the corresponding amount of money. But the members of the delegation reassure
her that the mismatch between her assessment and the reality is so minor, it is
not the problem they came to discuss. So then, what is the problem? she asks.
They say it is the way she distributes the money. To respond
to them, she picks yesterday's example and explains what she did. She says she
estimated that the planet will produce two hundred thousand (200,000) Mighty
Eggs (MEs) worth of goods and services, and she printed this much to serve as
money supply for that day. She divided 200,000 by the 20,000 inhabitants of the
planet and got the number 10 which represented the number of MEs there was per
capita. She distributed the money to each family according to its size. For
example, a family of 4 received 40 MEs; a family of 7 received 70 MEs and so
on. But this is precisely what is wrong, they say to her, because while the
move may be laudable as an egalitarian gesture, it sets up a flawed situation
whereby people are paid not for what they accomplish but for being there. They
ask that the system be amended whereby each person will be paid according to
merit based on what they have accomplished say, the day before.
We'll try that, says the banker, and she tells the people of
the planet to get ready for a whole new social experiment, one that is based on
meritocracy and not on egalitarian principles. To this end, she asks everyone
who is of working age to pick ten people at random at the end of each day, and
evaluate the work they did on that day. The people are to vote at the computer
terminal she programed for the purpose when they come to pick up their salary
at the end of the day. The thing everyone knows is that the computer is the one
they had on the spaceship; it is so advanced it recognizes each person and will
disallow anyone from voting for themselves.
Things went well on the first day of the experiment in that
people got paid almost as much as before plus an allowance for the dependents
they have. As a result, the price of goods and services remained more or less
stable. But by the next day, and for every day after that, the pace of things
picked up. What happened was that some people started to get paid evermore with
each passing day. This meant that more money had to be printed, a move that
resulted in prices inflating evermore with each passing day. It took little
time for inflation to turn into hyperinflation, and the people whose salary did
not keep up with the rising prices revolted. They asked that things be returned
to what they were under the old regime; the banker agreed and so ordered. And
she followed by appointing a commission to find out what went wrong.
After a thorough investigation it was revealed that a system
of “you scratch my back and I scratch yours” got into the works and permeated
the system. While it was true that people could not vote for themselves, they
could form cabals and protection rackets whereby the members could vote for
each other. This is what happened, in fact, as the people voted the highest
grade for one another, a fraud that the computer did not detect. Those who got
ahead as a result left behind those who were not adept at playing this sort of
social games. In the end, it became clear that the system of meritocracy got
corrupted by the fact that instead of true merit being attributed based on the
work done by each individual, a false merit was attributed based on the
political abilities of some individuals, on their ruthlessness and such other
considerations as may go under the rubric of “beauty contest.” Moral
degradation set in and played a big role in the collapse of the whole
arrangement.
What to do now? asked the people of the planet. They
discussed the matter and came up with the idea of having a full fledged free
enterprise arrangement coupled with a monetary system that was based on the
gold standard. From then on, the people who had a business would hire workers
and pay them wages and salaries. To get going, the business owners were allowed
to borrow from the banker an amount commensurate with the capital they had
accumulated so far or the amount of sales they were doing on a daily basis.
An ounce of gold was fixed at the price of 35 Mighty Eggs,
and every financial institution was required to keep in its vaults an amount of
gold valued at no less than 10% what the institution normally loans to its
clients. Things worked nicely for a while in that consumer prices were held
steady. But what was not immediately apparent to most people was that pressure
was beginning to build. The few wizards who knew what was going on, realized
that an explosion was inevitable and that it would come sooner or later. The
trouble they saw coming was two-pronged. The first prong was that wages had
risen so much, it was costing almost 35 MEs to produce an ounce of gold; and
this was forcing the gold mining companies to shut down. This in turn put an
upward pressure on the price of gold that nevertheless was not allowed to rise in
price by law. And this is why the gold miners were asking that the price of
gold be liberated and allowed to move according to market forces.
The second prong of the problem was that the planet had gone
from being a handful of hamlets to being a sizable city state. It now contained
buildings, infrastructures and machines worth billions of MEs. These could be
used as collateral by the businesses that wanted to borrow except that the
lending institutions could not lend this much money because they did not have
the gold reserves that the law required them to have. And this is why the
business people and the financial institutions were asking that this provision
of the law be dropped or that the price of gold be liberated and allowed to
move according to market forces.
And this brings us back to the question: Which way is the
better way to evaluate a business? Is it to base the valuation on the amount of
wealth that the business generates? Or is it to valuate the business based on
the amount of capital it has already accumulated? The answer is that it does
not matter which way you do it because these are the two faces of the same
coin. In fact, what we have here is not even a coin-like flat object; it is a
multi-dimensional object with several faces, three of which are important to
this discussion.
And this is how all this relates together. The level to
which an economy has evolved is expressed by the permanent infrastructures
underlying it. And these infrastructures could not exist were it not for the
wealth that the economy generates on a daily basis. And so, these two aspects
of the economy are so closely and naturally related, they must be thought of as
one and the same phenomenon. For a bank manager to pick one or the other, and
use that to assess the value of a business is purely a matter of personal
preference. But whether it is one or the other, the cumulative effect of these
choices by the lending institutions is what determines the size of the money
supply in an economy. This, in turn determines the value of the currency.
What is not naturally related to that phenomenon is the
value of gold. Given that the supply of the precious metal is finite, what
comes into play here is the law of supply and demand. Whereas the daily output
of an economy and the size of its infrastructures are determined by human
activity, the supply of gold is largely determined by its availability in
nature. Thus, to use gold as the only factor by which to give value to a
currency is to take the wrong approach. What is needed, instead, is a system
that will take into account other commodities as well. Added to the mix should
be the level of development in the world as it is measured by the output of all
the goods and services produced by the entire planet.
A currency that is real such as the dollar or the Yuan, or a
currency that is virtual such as the Special Drawing Rights, can then be
created based on that mix. It should also be made to vary and remain in step
with the evolution of the planetary economy.