Gold, silver, paper, crypto
A crash course in crashes, and the money systems that produce them
Ever since people discovered wants that couldn’t be satisfied by barter, they have sought instruments by which to mediate between beer and bread, say, or boots and baskets. An acceptable instrument—money—should fulfill three functions. It should serve as a medium of exchange: you give me a hogshead of tobacco, and I give you ten dollars, which I expect to exchange for something else. Money should provide a unit of account, allowing me to track my trade by a measure that allows comparing apples and oranges. It should be a store of value, so that if I don’t want to use it today, it will still be worth something comparable tomorrow or next month.
Humans have tried all sorts of things as money, but a few stand out historically. Gold has had the longest run, on account of its durability (it is so nonreactive that essentially all the gold ever dug out of the ground still exists as gold, unlike iron, for example, which rusts away), its rarity (a small amount of gold can buy a lot of most other substances), and its irreproducibility (which keeps it rare and thereby valuable). Gold is also visually appealing to a lot of people, although this may be a learned response, given that people have equated gold with wealth for a long time.
The trouble with gold is that its production (by mining and refining) has little connection with broader economic trends, and so prices quoted in gold can fluctuate. Typically, overall economic production has grown faster than the supply of gold, with the result that price levels quoted in gold have fallen (when 100 gold dollars are available to buy 100 bushels of wheat, the average price is 1 dollar per bushel; if the same 100 gold dollars have to be spread over 200 bushels of wheat, the average price is 50 cents per bushel). Deflation, as the phenomenon is called, tends to depress economic activity, for with prices falling, buyers defer purchases, realizing they can pay less in the future.
In many places, including the United States, silver was added to the money supply to make up for the shortfall in gold. Adding silver alleviates the deflation, but it raises new problems. In particular, governments have difficulty maintaining a balance between gold and silver, as more or less silver is discovered and coined, compared with gold. As one or the other becomes more plentiful, it becomes less valuable (by the basic law of supply and demand), causing money users to hoard the other, more valuable one. After the discovery of gold in California in 1848, the supply of gold money grew relative to silver money, causing people to hoard silver, effectively taking it out of circulation.
When supplies of gold and silver have not sufficed to keep up with demand for money, governments have turned to paper: to notes printed by governments or banks, which circulate as money. Sometimes the notes carry the promise that they can been exchanged for gold or silver at the bearer’s request; sometimes they don’t. In the latter case they are called “fiat” money, from the Latin for “let it be done.” They are also called legal tender.
Whether backed by gold or not, paper money, to be successful, requires confidence that it will retains its value, against the failure of governments or banks to redeem their promises, and against the temptation of governments to print more of it. In the United States before the Civil War, paper notes backed by gold were issued by ordinary banks and by the Bank of the United States, a federally chartered bank that held the deposits of the federal government, and by the U.S. Treasury. During the Civil War, these bank notes were supplemented by fiat notes issued by the Treasury and printed in green ink, which gave them, and the U.S. dollar generally, the nickname “greenback.”
The addition of paper to the money mix, along with gold and silver, created a mess of epic proportions during the post-Civil War Gilded Age. Financial panics were a regular feature of American life during the nineteenth century, arriving with almost clockwork regularity in 1819, 1837, 1857, 1873 and 1893. Money troubles triggered some of the crashes. In 1837 the government suddenly demanded gold and silver from purchasers of public land, after years of accepting paper money. In 1857 the sinking of a ship carrying millions of dollars of California gold to New York sent tremors through Wall Street. All of the crashes had monetary effects, with the panic of 1873 completing the disappearance of silver, and the panic of 1893 prompting a run on the gold supply of the U.S. Treasury.
The panics and crashes persisted into the twentieth century. A panic in 1907 led to the creation of the Federal Reserve system, which was charged with doing a better job overseeing the money system than its predecessors. In practice it did a worse job, at least at first, allowing the stock market crash of 1929 to metastasize into the worst economic depression in American history.
One of the effects of the Great Depression was the abandonment of gold by the American government. No longer did gold circulate as money in America; no longer were U.S. bank notes convertible to gold. Silver-backed notes continued to circulate for a few decades, but the result was the triumph of paper money. The United States still honored gold demands internationally, but that link was severed in the early 1970s.
By then paper money was actually, in most cases, electronic. Bank vaults, once stuffed with gold, silver and paper notes, were replaced by computers that recorded balances in digital form. Digital dollars fulfilled the basic functions of money often better than their predecessors. As a means of exchange, they could flash from a buyer’s computer to the seller’s in the blink of an eye, even half way around the world. As a unit of value, they were unsurpassed at comparing apples to oranges, Apples to Samsungs, and anything else to anything else.
As a store of value . . . well, that was another matter, especially when a newer version of digital money—cryptocurrency—came along. Once money was cut loose from gold and silver, maintaining its value was a chronic problem. During the 1970s the United States suffered unprecedented inflation (meaning that the value of the dollar steadily eroded), eventually compelling the Federal Reserve to orchestrate a severe recession (as depressions were called after the Great Depression). The Fed could keep a tight hand on paper currency, but by this time digital bank accounts constituted a much greater portion of the money supply than cash did, and other forms of financial liquidity furnished still more.
Cryptocurrencies—bitcoin and others—compounded the problem. By design, they were beyond the reach of the Fed or any other arm of government. This made them appealing to people who operated outside the law, but also to those who valued privacy for its own sake. In theory cryptocurrencies worked well as mediums of exchange, requiring no involvement of governments or banks, although in practice the blockchain architecture on which they rested bogged down frustratingly. As units of account they largely failed. The key criterion of a unit of account is that most items for sale be purchasable by the money in question, and very few things could actually be bought with cryptocurrencies. Finally, as stores of value, the cryptocurrencies were a disaster. Speculators drove the price of bitcoin up and down, with the result that holders of bitcoin had no idea from one day to the next how much their holdings were worth.
The crypto experience underscored something that had been inherent in money from the start: the fundamental incompatibility of the three functions money was asked to perform. To be an effective medium of exchange, money should be regulated lightly if at all. But without regulation, money misfires as a unit of account and especially as a store of value. Crypto could be the best as a medium of exchange, but gold is a surer store of value, and paper a more comprehensive unit of account.
In practice, designing a money system requires accepting trade-offs. All the systems America has tried have had their ups and downs. Financial crashes have been fewer since gold was retired in favor of paper, but the crash of 2008 was one of the worst in history.
There’s one other thing to keep in mind. Whatever the system, clever and sometimes unscrupulous people will try to game it. They’ll push the boundaries until they break. The crash they cause will chasten them for a time, but they’ll be back. The acquisitive instinct never rests for long.