This classical line of reasoning has been hard to shake despite the fact that it was never justified in a scientific way. Observations that people think of currency in this way is evidence only of a body of beliefs, not a revelation of universal law. Moreover, currency and the specie that backs it are both currencies of sort. Many thinkers make the (rather sad) error of believing that a block of precious metal has value in and of itself. Precious metals are not used for anything other than as wealth holding assets, and it has always been the common belief in their value - arbitrarily decided by historical events - and nothing more, that creates the value itself.
The false theory of currency value as proportion of backing object value results from two big mistakes in the classical line of reasoning relating to currency value.
1. The classical line of reasoning ignores the possibility of underutilized resources.
2. The classical line of reasoning ignores the fundamental role that uncertainty plays in currency value.
Both of these points are made by Keynes in his General Theory, but I would like to expand on them here in my own direction. Incidentally, both of these are tied to a fundamental problem in economics: the failure of equilibrium models to rigorously represent equilibria as related rates.
First, the case of underutilized resources can be directly highlighted by a few examples:
Suppose that a king wishes to expand his treasury, and devises a brilliant strategy for quickly growing his gold-mining industry. He prints new bills of currency, backed by no matching specie, and enters into contracts with mining firms whereby they will provide him with a portion of the specie that they find, such that it directly matches the quantity needed to back the currency issued. Assuming that the results of the venture meet the king's expected value and that there is a high unemployment rate, how will this affect the value of the currency?
Looking first at time of initial issuance - one can expect demand to rise for machinery and chemicals used in the mining process. This change will then ripple into the spending habits of the producers of these components. The increased revenue of these "component firms" will, due to the assumption of surplus labor, primarily become increased plant capacity and profits for the firm owners. These owners will bid up investments of various types (including real estate), and may spend marginally more on luxury goods.
Having a larger paid labor pool will also have an effect - laborers may increase their food consumption, primarily by demanding greater food variety, but for the most part, increased income will be spent on goods and services. Landlords will see lower vacancy rates as laborers cohabitate less, prompting an increase in rental rates.
Generally, an increase in prices across the board represents a decrease in the value of the currency. However, in the case of currency issue, these increases are the response of suppliers to the increase in quantity demand. In many cases, the supply of a good is sufficiently elastic that only the quantity produced increases. In only a few situations is there a bottleneck such that the supply of a given good cannot increase easily, and it is in this case that a price increase will occur.
To calculate the initial stimulus effect of such an action by a Government, an economist should ask two things: 1)Are the natural resources that will see increased demand readily available for use? 2)Is the economy significantly below full employment? If the answer to both of these questions is "yes", then the vast majority of the quantity demand increase will be expressed in terms of increased output. If the answer to either question is "no", the vast majority of quantity demand increase will be expressed in terms of increased prices.
Next, let us turn to the point when the mining firms begin to transfer precious metals back into the King's treasury. It is hard to see how this could have any effect whatsoever. Other than the labor utilized for the actual movement, inspection, storage, and safeguarding of the specie, no actual changes take place. The King now simply has more of a valuable asset, which is kept out of circulation, and which he will be able to use to meet future obligations if necessary.
Theories that predominated during the time when currency was directly backed by assets most likely had a profound effect on the decisions of the speculative class. When exchange rates were fixed, speculation often surrounded the values of currencies. In any speculative atmosphere, the ideas and decisions of the herd were the primary determinant of changes in prices paid by speculators. Therefore, so long as a sufficient portion of speculators believed in a given economic rule, the market would behave in a way that allowed economists to draw statistical evidence for that rule from the market. The egoes of the wealthy had a further impact on the development of the discipline, in that they believed their own wealth stemmed not from the collective effect of an otherwise arbitrary belief, but from actual knowledge. It is the wealthy that control University endowments, and they want the world to know that they are people of virtue.
Uncertainty also plays a key role in currency value. I invite the reader to imagine an economy in which individuals do not have uncertainty. Note that risk should be treated as a type of uncertainty. The cognition of an individual who does not have uncertainty is really omniscience. Such a person does not respond in a nash equilibrium fashion because he is able to coordinate with others effortlessly. Furthermore, the psychological predisposition of the individual toward equality would be an overriding factor in his economic relationships. Specialized knowledge disappears, and thus workers are no longer differentiable from each other. The only (economically significant) differences between individuals in such a scheme is their preferences and their property.
This thought experiment highlights another aspect of economic life that is seldom mentioned: its ethical connotation as revealed by our impressions. I invite the reader to contemplate the following examples:
- A convicted murderer (about whose guilt there is no doubt) is released from prison due to a legal error by the prosecution. He purchases a lottery ticket and wins the jackpot, becoming a multimillionaire.
- A woman who works hard her entire life, saving a small amount of money from each paycheck, invests her money in a mutual fund that loses more than half of its value in the course of a year.
- A man witnesses a stranger help a blind person across a busy intersection and buys him a drink.
- A student who earns straight A's has her allowance increased.
- The city council passes a tax increase that affects only a single business owner.
- The city council passes a tax increase that includes an exemption that only a single business owner can take advantage of.
Considering our ethical impluses and our way of evaluating our own economic position, a society of omnipotent individuals will have a certain political equilibrium. Currency will not be necessary because the actions of each individual will be known to all. Each person will understand the full configuration space of individual action combinations and their consequences. Labor would be divided between individuals only on the basis of their preferences. Nobody would want to see the basic needs of others go unmet, and will balance this desire against selfish interests. Labor could not be divided between workers and management because management is completely unnecessary - the only possibility is the existence of a capitalist class who own the means of production, but even this is unlikely given that these capitalists would face perfectly coordinated resistance by the rest of the society and collective bargaining by their workers.
Individuals also have foreknowledge of all their future consumption needs. Therefore, individuals would be able to enter into contracts with each other for the direct exchange of goods between current and future dates. For example, I may work in a machine shop for an hour, with the understanding that this earns me a loaf of bread from the baker. The baker would understand how this settles some contract he is involved in, or establishes a future compensation for him.
Currency is really an effort at approximation of this system of contracts. Approximation is necessary because of the incompleteness of individual knowledge. This incompleteness is synonymous with uncertainty. Uncertainty has three principal effects:
1) The use of risks and estimates
2) Creation of search costs that establish a value for information.
3) Existence of liquidity
Returning now to an example of a theoretical "normal human" economy, if the total quantity of currency in circulation is X, during any given time period somewhat less than every unit in X (X-a) will change hands at least once. Of the exchanges that take place, some will be at a price that has not been actively reevaluated. When reevaluations do take place, the price-setter must generally plan for a price that will not need to be raised (or lowered) again for some time, meaning the change will be in greater proportion than what is initially required, and often will occur later than expected. In other words, price changes and rebalances do not freely propagate across economies, but actually move at a certain estimable rate. Furthermore, price changes may not be made at all if the cost threshold for change and accompanying discounting rate of the costs are not met. Therefore, even if the economy is at capacity when the currency supply is changed, the question is not merely by how much but for whom the change is taking place.
A tax can be seen as a transfer of currency from one group to another. It is paired with government services that are funded by the tax, and these services are, in turn, expressible as monetary savings for the individuals who benefit from these services. Often, the Government can provide services more optimally than the private sector. We may, in accordance with our ethical prerogatives, denote certain services as providing a greater contribution to quality of life than others. So long as tax policy shifts the balance of goods and services provided toward those that provide a greater benefit to quality of life, it is justified.
Returning to the concept of the money supply in contrast to the effective money supply, suppose that the money supply is expanded or contracted in some fashion. The economic effect of this change is wholly dependent on who receives the currency. Let us rank the individuals within a society based on (1) their propensity to spend an additional dollar received and (2) their propensity to take each dollar reduction in income from spending rather than savings. These two variables are bound to have some degree of covariance, but that is beside the point. Imagine a scale going from zero (will not spend) to one (will spend) for these measures. Then each individual will occupy a point on this scale. Savings are only reintegrated into the economy as loans. Thus, private debt is a function of the total level of savings. Payments on debt lead to income concentrations in the hands of debt holders. Thus, either price levels must fall, income levels must increase, or debt levels must increase for individuals to maintain their consumption levels over time. When left alone, the trend seems to be toward a glut of savings in the hands of the ultra rich, a lack of viable investments, and a inevitable drop in the price and employment level.
An injection of additional currency targeted to the least likely to consume will lead only to an increase in loan issuance. If the loans market is saturated, it will lead to a direct increase in savings and no overall change in the economy (X and a increase in parity).
An injection of additional currency targeted to the most likely to consume will lead to an increase in consumption levels. This will mean that the effective quantity of money has directly increased. Prices may rise, but they will not rise in a greater portion than income, as this additional currency is first expressed through income. However, the added currency will eventually reach the hands of those least likely to consume and it will "fall out" of the market in this fashion (X increases but a stays constant).
A tax placed on those least likely to consume will lead to a decrease in loan issuance, or to no change if the loans market is saturated. The direct decrease in savings will precipitate no change to the actual economy because the effective supply of money has not been changed (X and a decrease in parity)
A tax placed on those most likely to consume will lead to a direct contraction in the economy. It will precipitate a reduction in the effective money supply and would be very harmful to the economy (X decreases but a stays constant).
For the reasons just outlined, the policy of the US government of backing its deficit spending with bond issues is silly (actually I think of it as grand theft of taxpayer dollars). The government can simply issue additional quantities of currency and should not be concerned with balancing its books. Rather, it should pay attention to the macroeconomic effect of its actions and work to bring unemployment down.