Money has three roles; a medium of exchange, store of value, and unit of account. A unit of account is the most important role of money and the least understood. A unit of account is a monetary standard of reference. It is a measuring stick in the monetary realm for the efficient, frictionless exchange of the galaxy of goods and services that require an unchanging, defined standard of reference. This is no different in theory than the scientific world’s Systeme International (SI) seven base units of measure, defined by the speed of light. No one would conceive of the absence of a standard of reference for measurement in the scientific and mathematical world, nor should they in the economic world.
Commodities can be used as money and have been throughout history. Commodities may act as a medium of exchange and store of value. However, with the exception of gold, commodities do not fulfill the role of unit of account. Over time and a trial and error process, gold evolved as the most monetary of all commodities. (Silver acted as a parallel unit of account with gold for most of history, but proved inadequate for this role in the late 1800s when its value began to decline relative to gold.) Gold’s properties are uniquely monetary. International gold standards evolved in the late 17th century from this trial and error process. Paper currency linked to gold acted as a unit of account, medium of exchange, and store of value under gold standards. Three hundred years of successful monetary stability and vibrant economic growth is the documented result of eras when national governments properly understood and maintained gold standards. Great Britain and the U.S. built global empires on the foundation of monetary stability based upon properly implemented gold standards.
Commodities have intrinsic value. Currency (I use the term currency interchangeably with the term money) has no intrinsic value beyond the paper on which it is printed. Weimar Germany and Zimbabwe tragically proved this point. Venezuela seems intent on repeating it. However, currency supply can be regulated to maintain a fixed value with a defined weight of gold. The U.S. dollar was defined at $20.67/oz from 1792 to 1933 and $35.00/oz from 1933 to 1971 by regulating its supply to maintain the fixed parity with the defined weight of gold. Maintained at a fixed parity, currency becomes as “good as gold”, its value exactly equal to gold, the monetary standard of reference. The supply of currency (base money) can be expanded or contracted as necessary to meet the demands of the economy without its value ever changing. Inflation and deflation are eliminated. The monetary exchange of goods and services works at its most efficient. Currency linked to gold acts as a unit of account, medium of exchange, and store of value. The same cannot be said for commodities. Defined by the three roles of money, a commodity—with the exception of gold—is not money.
Is money a commodity? Depending on how you define “commodity” and “money” this becomes more an exercise of inconsequential semantics or academic noodling. Since only money linked to gold acts as a unit of account and non-gold commodities do not, we can state that money is not a commodity. What is important to understand are the three roles of money and the unique properties that establish gold as a monetary standard of reference.
Thus enters the blockchain and the pioneer cryptocurrency bitcoin into the monetary world. Is bitcoin money, a commodity, tulip mania, or perhaps a concept as ethereal as the nothingness which hashes it into existence? Bitcoin has potential to meet the three requirements of money but as designed will never realize its promise as a decentralized currency of the future.
It is the blockchain’s immutable ledger and mining characteristics that gives bitcoin monetary value. Bitcoin promises transactional disruption with digital exchange and infinite divisibility advantages. But to realize this potential, bitcoin must evolve into money as defined by the three roles of money.
By limiting bitcoin’s supply to a fixed 21 million units over 123 years and then into perpetuity—80 percent of bitcoins are already mined—Satoshi guaranteed that bitcoin will never achieve the role of money. Instead it will quickly evolve from the characteristics of a commodity, to a digital tulip mania, and unless its supply issue is corrected, eventually back into the ether from which it is hashed.
Whether bitcoin changes its mining algorithm and gets its role as money right is consequential only to the current volatile speculation in its price. Satoshi, despite not understanding money, created the blockchain foundation that will eventually propel forward the promise that cryptocurrency offers.
Very interesting set of articles, thanks for writing them. Also as an aside, I am an aeronautical engineer by training and the love of flying machines probably unites us.
But back to the point … I am not sure I agree with your comment that under a gold standard inflation and deflation are eliminated. The statement contradicts historical evidence: in both the UK and Germany at the end of the 19th century, periods of high deflation and inflation (respectively) took place as reserves of gold dwindled in the case of the former and increased in the case of the latter.
Also, the period 1780’s to 1914, which you refer as a period during which a gold standard was present in most advanced economies of the Western World was also a period full of various wars. During those periods of conflicts, warring governments would intermittently ditch their gold standard in order to finance their military operations. So by no means was that period a continuous uninterrupted period of sound money.
Thanks for your comment.
A gold standard only insures a foundation for the most efficient monetary exchange of production. When combined with fiscal policy of low taxes and free trade, which necessarily results in limited government and reduced regulation, it results in periods of great economic growth and progress. A gold standard alone is not a panacea for growth. The Great Depression occurred while the U.S. adhered to a gold standard. Horrible fiscal policy starting with the global tariff wall from Smoot Hawley legislation and continuing with Hoover’s tax increase and FDR’s socialist fiscal policies caused the Great Depression.
I noted in my 1/3/2019 piece, Market Indices and Gold, that Roy Jastram in his book, The Golden Constant, showed through meticulous data that the price level remained stable—the absence of inflation or deflation—when Great Britain and the U.S. adhered to their gold standards. (Great Britain left their gold standard during the Napoleonic Wars and the U.S. during the Civil War. They each returned to a gold standard and these were brief interludes over their 300 year history.)
Nathan Lewis looked at the statistical data for the international gold standard period from 1870-1914. It was a period of uninterrupted growth and great progress. He notes:
“During the 20th century, and now into the 21st, no central bank in the world has been able to match this performance. They are not even in the same galaxy. No world monetary arrangement has provided even a pale shadow of that era’s incredible successes.”
Noted Michael and thanks for the prompt response. Let me look at Jastram’s and Lewis’ data, but my hunch is that the story is not that simple … in that the health of the economy is a multi-factored optimisation problem (as you pointed out by stating that fiscal policy is an important factor) and historical context is equally important (peace, war, conflict, etc.).
I will get back to you once I have reviewed those 2 sources.
Another question that bothers me: your claim that base money is unrelated to the amount of gold held. Clearly under a gold standard that can’t be true. Just to be clear about definitions, base money (which is what the central bank controls) is currency in circulation + bank deposits at the central bank; gold held is gold held at central bank; and convertibility is the statutory % requirement of gold reserve holdings over base money (100% denotes full convertibility, 0% denotes no possible convertibility)
Base money is cash and reserves, liabilities on the Fed’s balance sheet, that you correctly state is 100% controlled by the Fed.
I address the fallacy of gold reserves in Gold Standard Fallacies.
You have to go outside of academia to find reliable information on how gold standards work. Academia long ago ceded any interest in understanding gold standards. Despite a 300-year history of success that was the monetary foundation of two empires, Great Britain and the U.S., gold standards remain a microscopic footnote in academic economics.
While academia has ceded knowledge of gold’s monetary properties, there remains among the general population an inherent natural understanding of gold’s stability of value.