Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 12th June 2011.
Our 6th June commentary included a short piece titled "What backs today's money?", in which we attempted to explain that money is not "backed" by anything and nor does it need to be. Money is what it is -- the most commonly used medium of exchange within an economy. This piece was subsequently posted as a standalone article at a few web sites and generated an unusually large amount of feedback (questions, comments and objections). Today we'll address the three most common objections.
Based on the emails we received, the most controversial part of our article related to "intrinsic value". Considering that some popular gold market analysts and newsletter writers routinely assert that "intrinsic value" is the most important difference between gold and the dollar, we aren't surprised that many gold bulls reflexively rejected our statement that gold, like the dollar, has no intrinsic value. Our point was simply that all value is subjective. To explain what we meant we said that gold would have no or very little value to someone stranded alone on a desert island, but would likely have a lot of value to someone living in a modern inflation-prone economy.
A common view is that gold has "intrinsic value" because it costs a lot, in terms of materials and labour, to extract gold from the ground and turn it into a readily tradable form, but it is important to understand that something could be costly to produce and yet have little or no value to most people. Again, value is subjective and will often vary depending on personal circumstance.
That the production of gold requires the expenditure of a significant amount of resources is very important, but not because it creates "intrinsic value". It is important because it places a severe physical restriction on the rate of increase in the total supply of gold. In fact, in terms of suitability to perform the role of money, gold's greatest advantage over the US dollar and all the other fiat currencies of the world is the stability of its supply (the total aboveground supply of gold increases at 1.5%-2.0% per year, every year). This relates to the inability of anyone to create gold out of nothing. Looking at it from a different angle, the main problem with today's official money is that banks and governments have the power to create it out of nothing. If you believe that these institutions have not abused this power in the past then there is a large gap in your knowledge of economics history, and if you believe that these institutions will not abuse this power in the future then you are extremely naive.
By the way, the critics of using gold as money often cite the inflexibility of gold supply as a major negative. When they make such a claim they are either being disingenuous or displaying ignorance of the fact that flexibility of supply is most definitely NOT a desirable characteristic of money. Flexibility of money supply benefits the government and the banking industry, but because it distorts price signals it hurts the generators of real wealth.
Moving along to the next objection, some readers argued that the US dollar is backed by the US military. Our response is that if the US military "backs" the US dollar, then what backs all the other fiat currencies? Also, if the US dollar somehow garners support from the US's global military advantage, then why has the Dollar Index lost about 50% of its value over the past 26 years? After all, the US military has never before been as dominant as it is today.
Rather than providing any backing for or adding any value to the dollar, the US military is actually an important fundamental NEGATIVE for the US$. The reason is that the expense of maintaining a massive military leads to greater dollar supply and does nothing for dollar demand (private demand for the dollar is primarily determined by expected real return, and foreign-government demand for the dollar is primarily determined by exchange-rate policy).
Lastly, our view that money is backed by nothing was countered by the claim that a national currency is backed by the associated government's ability to tax. The reality is that the ability to tax is what backs government debt and why buying government debt is ethically unsound. As succinctly put by Murray Rothbard, "the purchase of a government bond is simply making an investment in the future loot from the robbery of taxation." The ability to tax doesn't, however, "back" the money in which a government's debt is denominated. Instead, taxation is part of the demand side of the money supply-demand equation, which means that although it doesn't "back" the money it does have some effect on the purchasing power of the money.
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