My new book “Bitcoin Nation” was published on the 15th anniversary of the Bitcoin Whitepaper, October 31, 2023. You can read it below, one chapter per week. Or buy it here:
So far, we have used the terms “un-backed” and “backed” money quite loosely in this book. Most often, we spoke of “backed” when the money was deposited one-to-one in gold. However, this term, although frequently used, is misleading and, in my view, incorrect.
We previously clarified how market prices are formed from many individual value judgments, with the “error” of one individual always equally benefiting another person.
To elaborate briefly:
If I pay you 1000 eggs for shoes that have a market price of 750, you gain 250 eggs. If you ask for only 500, I save 250. In both cases, after the transaction, our combined purchasing power remains the same.
But what happens when the money supply expands?
Since it is nearly impossible to study economics empirically due to the many changing parameters that are difficult to measure and control, we must use a thought experiment to answer this question.
Let’s assume that all other individuals in the economy keep their demand and supply constant.
We conduct the shoe transaction with a money supply of 1 million dollars for 1000 dollars. As we shake hands on the deal, the money supply suddenly increases to 2 million dollars. Under the given assumptions, your purchasing power has suddenly been halved. But not only yours, the sum of our combined purchasing powers has also been halved.
Of course, in real life, inflation of the money supply usually does not manifest so directly, as money does not enter the economy evenly. Only in cases of hyperinflation, such as in Venezuela, where the state regularly decides to add or remove zeros from all accounts, can this effect be observed clearly.
In debt-based currencies – like the dollar since the abolition of the gold standard in 1971 – one must look more closely to understand this effect.
As previously discussed, a bank can use a borrower’s collateralized debt to create demand deposits. In a debt-based currency, the central bank does nothing more than grant a loan to commercial banks and, in return, take collateral on their balance sheet. We have already seen the problem with this. Just because collateral covers the debt today does not mean its market value cannot fall, leaving large parts of the debt uncovered.
This is particularly devastating in modern fiat money, as commercial banks create additional demand deposits based on central bank money. If a central bank mistakenly overvalues bank collateral by a factor of 10 and the bank itself leverages its capital by a factor of 10, the coverage shortfall multiplies to 100.
The risk of a deflationary crash is thus significantly higher than in the traditional gold-based fractional reserve system.
To make matters worse, the definition of backing becomes entirely arbitrary. In the gold standard, a fixed exchange rate between gold and certificates is agreed upon. This means the value of money can only fluctuate slightly around that of gold. The fluctuations themselves are primarily due to the difficulty of transporting gold.
The market value of gold in the gold standard arises from the individual value judgments of market participants.
When we trade the shoes in gold, only our subjective evaluations are relevant. To you, an ounce of gold is worth more than the shoes, while to me, the footwear is worth more than the yellow metal.
In an economy where gold is used as the only form of money, this means that the value of all transactions must be represented by the total circulating supply of gold.
Along with the realization that the market price of each individual good is formed solely by the efficiency of its production – when the supply-demand ratio remains constant – it can be concluded that the velocity of circulation is a self-regulating parameter.
In this artificial scenario, it responds to economic growth by increasing and to recession by decreasing. The value of gold is thus a reflection of the individual market values of all other goods. If the price of a good measured in gold decreases, it means that the good is now being produced more efficiently; if the price increases, the good must be more difficult to produce, for example, due to natural disasters.
Although in the real economy, demand for each good is not constant, this statement can be made about all market prices in total. After all, people can only act. Inaction is logically impossible. All market participants continuously express their value judgments, which through gold are transformed into a function of demand, supply, and production efficiency, which is expressed in the price of all goods.
If an economy solely uses gold as money, then the sum value of all ounces of gold must be precisely the sum of all individual goods times their market price.
In this case, gold is not backed by the number of gold atoms in each coin but by the individual decisions of all market participants. The purchase contract gives gold its backing. The physical gold atoms are merely a means to an end, to keep the money supply constant.
This would change abruptly, if someone had Midas’ ability to turn objects into gold by touch.
If all existing gold is in circulation, each market participant can only obtain gold by offering another participant a good or service worth at least as much as the gold. The voluntary purchase contract determines and backs the value of gold.
However, Midas can easily and effortlessly obtain gold. He can outbid any market participant without hesitation. The value of the gold that Midas brings into circulation is determined entirely differently than that of all the gold already in circulation. Its value is formed solely by King Midas’s judgment.
Since Midas can easily obtain abundant gold, he will drive up the price of all the goods he desires by outbidding competing offers. This leads to suppliers of these goods receiving disproportionately large amounts of gold, allowing them to pay more to satisfy their needs in turn.
Thus, the price increase caused by inflation gradually spreads from the source of money into the economy. Those who receive the new gold first gain unearned purchasing power, while those further away from the source of inflation lose purchasing power. The apparent winners are Midas and his court suppliers; the losers are those to whom the money trickles down to last. This is called the Cantillon effect.
Ultimately, however, everyone loses due to this inflation. The distortion of money prevents it from serving as a unit of account. The market price increasingly loses its meaningfulness, making it difficult for companies to calculate their economic performance and thus to allocate their resources efficiently. The economy becomes less and less performant over time.
Thus, while Midas and his courtiers get a larger piece of the pie, the capital stock erodes, and the pie becomes smaller and moldier with every new ounce of gold put into circulation.
A constant money supply is therefore in the interest of all market participants. But how can this be ensured?
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