The historical development of currency is characterized by continuous transformations and adaptations to shifting economic requirements across human civilization. Societies have repeatedly attempted to create stability and prosperity through various monetary frameworks, yet significant discrepancies often emerge between theoretical expectations and practical realities. Examining these historical developments reveals that no monetary system is perfect, as each carries its own distinct advantages and disadvantages. The quest for price stability and the function of currency as a standard of value have occupied economic thinkers for countless generations.
Extreme Fluctuations in Purchasing Power
The real interest rate in the United States dropped below a severe negative percentage between March and April of the early twentieth century. Subsequently, prices experienced sudden deflation, causing the real interest rate to jump to a massive positive percentage. These extreme fluctuations demonstrate the inherent instability of monetary systems during times of crisis. Such drastic movements illustrate how rapidly the purchasing power of currency can change and impact the broader economy.
The Illusion of Scarcity Money Stability
Proponents of scarcity money often argue that such a standard leads to price stability because the money supply remains largely fixed. They expect currency appreciation through deflation, assuming a constant money supply faces an ever-growing quantity of goods. These claims can be empirically verified by reconstructing price increase rates for past periods. Observing how prices developed under an actual gold standard provides crucial insights into these theoretical assertions.
Historical Price Volatility in Early America
Analyzing the developments in America and England since the dawn of the modern era offers a relevant perspective on this topic. America historically represented a developing region, while England was the most advanced economy and the birthplace of the industrial revolution. In both cases, prices during a gold peg were not stable but experienced strong fluctuations, even if they declined slightly on average over time. The price development in America before the declaration of independence reveals several interesting aspects that deepen the understanding of monetary systems.
The Chaos of Early Monetary Systems
Before the establishment of the republic, a wild growth of monetary systems existed, including the partial use of commodity money. Foreign coins were utilized alongside local paper currency that usually lost its purchasing power rapidly, as well as the shell money of indigenous populations. Significant price increase rates occurred repeatedly, alternating with periods of deflation. The fluctuations of the price level were substantial, making economic planning exceedingly difficult for the population.
The Failure of Bimetallism and the Deflationary Era
In the final decade of the modern era, the dollar was introduced on a bimetallic standard utilizing multiple precious metals. The hope of controlling price increases through a metal peg failed to materialize because the peg was simply suspended in crucial situations. The consequence was strongly fluctuating price change rates that often alternated between inflation and deflation. The period from roughly the mid-modern era to the early contemporary period most closely resembles the ideal of moderately fluctuating deflation propagated by scarcity money advocates.
Wealth Redistribution Through Monetary Contraction
The national banking act of the mid-modern era ended the era of free banking and introduced federally regulated banks. However, this era was experienced as impoverishing by the affected population, leading to the legislative change being known as a great crime. This legislation stripped silver of its status as official legal tender, causing deflation because the exogenously given money supply was abruptly reduced. The consequence was a massive redistribution of wealth away from independent agricultural workers, who were often debtors, toward creditors who received repayments in more valuable currency.
The Transition to Modern Fiat Frameworks
From roughly the mid-modern era, the Bretton Woods system existed, which created the appearance of a gold peg but factually contained only a very loose coupling. In a specific decade of the modern era, a major shock ended the last semblance of a gold peg for the dollar and the entire system. As a consequence of the oil price shock in a later decade and the debt crisis of developing nations in the subsequent decade, unusually high inflation emerged. This inflation was curbed through consistent central bank policy against the resistance of politicians, initiating the longest calm phase in monetary history.
The Great Moderation and Asset Price Shifts
Even during the crises since the contemporary period, price increase rates have been consistently positive but relatively stable. However, strong shifts between labor and capital income have occurred during this time, often interpreted as asset price inflation replacing consumer price inflation. It is also conceivable that the crises were created by monetary policy in the first place. A nearly analogous picture emerges when examining the British pound, the currency of the most powerful economy of that era.
Volatility During the Industrial Revolution
At the beginning of the industrial revolution, considerable fluctuations of the price level took place despite a metal peg of the British currency. Although the average inflation during the initial portion of the modern era was indeed slightly negative, the annual rate fluctuated considerably. In contrast, the era of fiat money is much calmer, with significantly smaller jumps from year to year. This makes the future much more predictable than the erratic jumps of the preceding metal-backed era.
The Futility of Returning to Old Pegs
After the global conflict, England made the futile attempt to return to the gold standard with the pre-war denomination. Since the currency had been emitted beyond the original peg during the war, the attempt to return to the original value led to a reduction in the money supply and consequently to price deflation. This deflation was extremely negative for most participants involved in the economy. A problem with all self-binding mechanisms is the associated behavior of the participants and the political leadership.
The Inevitable Suspension of Metal Pegs
A scarcity money detached from the real economy might theoretically lead to household discipline but then causes considerable disruptions in the short term. Even if the theory holds that such money establishes a desirable equilibrium in the medium term, there is an extremely strong incentive to suspend the disciplining effect during the transition phase. This process repeated itself time and again in times of crisis and especially during wartime. Formally, a metal peg existed in the United States during the civil war, but the army was repeatedly paid with pure paper promises that often could not be redeemed.
The Concept of Decaying Currency
Economic thinkers have proposed that currency as a commodity should be no better for anyone than the contents of the markets. The argument suggests that if currency is to have no privileges over goods, it should rot, mold, and decay just like physical commodities. Only then would currency and goods stand on the same hierarchical level and be completely equivalent things. The term inflation is used very differently depending on the context, usually standing for price inflation, which is an upward change in the price level.
Defining Monetary and Real Inflation
Some authors use the term inflation only for a change in the supply of the money supply, which is then the quantity inflation of money. This interpretation dates back to the time of exogenous money, where the quantity theory of money approximately applies, whereas with fiat money, inflation always refers to the price level. Inflation can also relate to different price indices, such as consumer prices, producer prices, or specific groups of goods. A real cause of inflation is a disrupted supply chain system that reduces the real supply of goods and thus causes prices to rise.
The Unreliable Standard of Value
A monetary cause, on the other hand, is a situation that arises from the monetary system itself, such as money supply expansion or overly lax lending. The standard tasks of money consists in being a standard of value with which other goods are evaluated. In contrast to physical units, the exchange value of money is not constant. It acts as if an individual wanted to measure with a centimeter ruler whose length changes constantly, or with a clock that has a high inaccuracy.
The Clock Analogy for Monetary Stability
Imagine having only multiple clocks to choose from for technical reasons. The initial clock fluctuates little in its course but permanently runs several minutes fast per day, changing its drift gradually over multiple days. Technically speaking, there is a low variance and a high serial correlation of the error. The subsequent clock runs on average a minimal amount of time slow per day but fluctuates between a short duration negative and a brief period positive from a single day to the next.
Predictability Versus Erratic Jumps
The course of a single day is completely independent of the previous day and cannot be predicted, representing a high variance and a low serial correlation of the error. It is obvious that the initial clock is more useful for time measurement because its behavior, while annoying, allows an individual to rely on the displayed time to some extent. The subsequent clock, however, makes an unpredictable error that is much more difficult to incorporate into daily planning. Switching from clocks to money, it becomes apparent that our current money exhibits the annoying property of the initial clock.
The Acceptability of Constant Drift
In the times of metal binding, the state of the subsequent clock was much more prevalent. It may be unpleasant to constantly adjust to the changed time display, but if the course of the clock or the purchasing power of money fluctuates little, constant inflation is merely a minor problem. Both personal experience and the legal framework adapt to such a situation so that it hardly represents a problem. It is not a moderate constant inflation that is a problem, but an inflation that fluctuates strongly.
The True Purpose of Liquidity
Furthermore, there is often the idea that money is held long-term to store values, which would be an absurd procedure in a system of constant inflation. The task of money is short-term liquidity, not the long-term preservation of values. For long-term storage, an individual would rather choose a debt instrument that yields interest, where the expected inflation is generally priced in. It is questionable whether an individual can ethically expect a reward for holding money without taking entrepreneurial risks or enabling someone else to advance their consumption.
The Mechanics of Demurrage Money
Hoarding money without enabling productivity increases should not necessarily be rewarded with an increase in exchange value. In connection with inflation, the concept of free money must be mentioned, whose more understandable designation is demurrage money. The idea consists of using a currency that loses purchasing power over time, specifically targeting the disadvantages of scarcity money that tempt people to hoard it. The underlying thought is that there must be an incentive to keep the money in circulation, hence the term circulation money.
Modern Implementations of Demurrage
It was proposed that there should be a fee for storing money, which is equivalent to the purchasing power dwindling during storage. Interestingly, this concept has now been largely implemented unnoticed because the currently common fiat money is subject to constant inflation. To counteract this decay through price inflation, it is not strictly necessary to consume the counter value of the money, but an individual can allocate it to productive investment projects for value preservation. This leads to the insight that money should primarily serve the processing of transactions and only for the short-term storage of values.
The Real Versus the Monetary Sphere
Consider an example where multiple goods are to be exchanged in a circle, using coins or surrogates as an intermediate step to simplify the process. The goods represent the real level, while the money elements represent the monetary level. The prosperity of the participants comes exclusively from the real level, and the monetary level initially does not influence the utility of the participants. It is as if an individual measures a house in different units of length; regardless of whether the size is stated in inches or centimeters, the house and its associated utility remain the same.
The Illusion of Nominal Security
An individual occasionally finds the argument that the presence of money provides a sense of security, and thus a subjective utility emanates from the monetary level. However, this sense of security is not triggered by the nominal numerical value of the money, but by the certainty of being able to acquire real goods with it. If a financial intermediary turns out to be a fraudster who provided fake portfolio statements, the nominal account balances remain unchanged, but the comforting feeling of security vanishes completely. It is undeniable that it ultimately does not depend on the unit of account, but on the potential real goods that can be procured with it.
The Non-Neutrality of Money in Dynamics
Viewed statically, the monetary level is completely neutral, and only the real level matters. However, this perspective is static and assumes no future exists, whereas in the real world, there are numerous feedback effects of the monetary on the real level. The monetary system determines which types of real transactions are possible at all. A cumbersome system where physical goods must be transported makes trade much more expensive than a system where money can be transferred at the push of a button.
Distributional Effects and Contractual Manipulation
Money is an essential lubricant of the economy and therefore anything but neutral, as changes in the monetary system can lead to considerable changes in the distribution of wealth. Deflation makes creditors richer and debtors poorer, while inflation does the opposite, and the effects of an exogenous money supply inflation spread slowly, causing significant distribution effects. Considerable fluctuations in inflation rates make economic activity riskier because an individual never knows exactly which real prices have been agreed upon in a contract. Money always has a social component, and a legal system also adjusts to a monetary system and no longer fits when it changes.
The Unique Properties of Physical Cash
An individual can retroactively change existing contracts and social agreements by manipulating the monetary system, similar to retroactively claiming that cadastral plans referred to feet instead of meters. Physical cash is the only form of central bank money that citizens directly come into contact with, entering circulation through commercial banks just like all other fiat money. This leads to the possibility of a bank run, where customers withdraw money from their accounts en masse and have it paid out in cash. Such a process can drive a completely healthy bank to ruin, but on the other hand, it can have a disciplining effect in advance because every bank wants to avoid such a state.
Cash as a Shield Against Financial Repression
Cash often gives users the impression that it is safer than book money at commercial banks, as it is not subject to the insolvency risk of an individual bank. It acts as an external constraint on commercial banks because they cannot produce it themselves, unlike book money, thus exerting a disciplining effect. Cash has another function in the monetary system that is not immediately obvious: it prevents financial repression through negative interest rates. In a world without cash, where individuals are obliged to hold their money in an account, they can always be charged fees that exceed inflation.
The Defense of Anonymity and Privacy
This is not easily possible with cash because an individual can simply withdraw the money and keep it at home in the event of fees or negative interest rates, guaranteeing a lower limit of zero for interest rates. Many efforts to abolish cash or restrict its use actually aim to enable this form of financial repression. Another important property of cash is its anonymity, which secures freedom and privacy, making it an almost completely anonymous form of payment. However, there are more and more initiatives against this anonymity, including reporting obligations, cash upper limits, or even a complete cash ban.
The Rise of Informal Transfer Systems
To settle international cash payments, an underground payment system has emerged, known as the alternative informal financial transfer system. It is an informal money transfer system that operates outside regular banking, used primarily in South and Central Asia, the Middle East, and North Africa. No money is physically or digitally moved across borders; instead, the transfer takes place through the contact of intermediaries who sometimes operate on the basis of a parallel underground legal system. It is questionable whether it is really sensible to make anonymous payments inaccessible to the normal citizen and only available to an underground organization.
The Erosion of Civil Liberties
It took centuries in which citizens laboriously fought for civil liberties against princes and the state, including the right to freedom of expression and the inviolability of the home. It is alarming at what speed these protective functions are being given up against an intrusive state just because new technologies have emerged. The best protection always consists in the fact that certain possibilities do not even exist technically. Cash offers this protection and undoubtedly justifies the costs of such a system.
The Imperative of Systemic Resilience
The main costs arise from the infrastructure for the secure transport and storage of cash, but this system must absolutely be maintained for another reason: resilience. Resilience is the technical term for the willingness to defend against unforeseen events, such as a widespread power outage or a persistent disruption of the internet due to a cyber attack. In such a situation, it must continue to be possible to make purchases and maintain the division of labor, which only succeeds with cash. Preparation for such a case must take place permanently, making it indispensable to continue using cash regularly to keep the system in operation.
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