The Theory of Money, Part 6

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Last week, I wrote about how the gold coin:Labor Unit (LU) ratio adjusts as the market demands depending on how many gold coins are available and how many LUs are needing to be stored.

I’ve been thinking about that topic since I wrote that, and, as is often the case, there’s something that bears clarifying.

This issue of stored LUs is a tricky one. How can you possibly store labor?

I did talk about this way back in part 1, but let me put it in different words this time.

Someone performing labor will typically be paid in accordance to the value they provided. It doesn’t matter so much what the laborer receives in compensation as long as they receive something in return that has a value approximately commensurate with the value they provided. In this way, labor gets turned into an asset. That asset could be gold coins or chickens or partial ownership of a business or anything else.

Historically, most societies have ended up using coins made of precious metals as compensation for labor. This is for many reasons, but the mains ones are that they are intrinsically valuable, they don’t rot or die easily, they’re easy to divide into different valuations, and their value to weight ratio is reasonable.

But what happens if the value of the asset you received in return for your hard-earned LUs suddenly goes down? Say, you got paid in corn, but you stored it in your damp cellar and it got moldy? Tough luck. It’s like you didn’t work as much to store as many LUs. Those LUs you earned are gone. This is why perishable things are not as handy for storing LUs. But non-perishable things are also susceptible to their value changing, so this isn’t a problem exclusive to perishable things. Even precious metals can have big swings in value depending on, of course, supply and demand, such as how fruitful the mines are, or how many other things people want to use them for.

The thing with gold (and other precious metals) is that it has built-in mechanisms to keep its value relatively constant. For example, if a society starts getting really wealthy and is trying to store more and more LUs in the form of gold coins (meaning people are starting to build up piles of gold coins in their houses), the demand for gold coins (and, therefore, its value) has increased. But in response to this, people will start acting differently. Fewer people will buy gold necklaces because they’re too expensive now. And gold miners will find ways to mine more gold, such as by adding a night shift to their mining operation or going after some gold deposits that were previously undesirable due to difficult terrain. The eventual result will be that more gold will be supplied and less gold will be demanded for other purposes, and the price will probably drop back down to close to where it was before.

My point is that market mechanisms will keep gold’s price relatively stable over time, which is very important when it’s being used to store Labor Units. Sure, innovations may end up decreasing the number of LUs it takes to mine new gold, which might make it cheaper over time, but it’s just as probable that over time more uses will be found for this unique metal, so its price may stay constant. Additionally, bigger changes in value are going to be the result of long-term changes in innovation and uses for gold (probably on the order of decades), so gold will be more reliable at storing LUs than other things that have more rapid swings in value.

I was trying to find the price of gold over the ages, but there’s no simple answer available. Even comparing the amount of gold someone would be paid for a day’s worth of unskilled labor in ancient Rome to a day’s worth of unskilled labor today, the number of hours would differ, the working conditions would differ, the quality of the gold may be different, and the quoted ancient prices of gold may have been influenced by government price setting (such as by anchoring a gold piece’s value to a set ratio with the value of a silver piece). So I don’t have any reliable information to show how stable the price of gold has been over the ages.

But I hope my point is clear: No matter what you use as money, it’s always going to be susceptible to shifts in value (meaning the LU:money exchange rate will always change), so the best we can hope for is something that meets the other criteria for an optimal money (i.e., nonperishable, easily carried, easily divided into different amounts, etc.) and that will also shift in value minimally or slowly or predictably.

Now, let’s consider an application of all this to our modern day. For the sake of simplicity, I’ll describe a scenario using our fictitious gold money-based society, and then I’ll talk about its application after.

Let’s say our blacksmith invents a way to counterfeit gold coins. He takes some worthless metal refuse, stamps it into the form of a coin, and paints it gold. The deception will be found out sooner or later (like when someone tries to melt down the coin to make a necklace, or when the paint chips), but until then, think about what would happen.

The total number of Labor Units that people are storing in the form of gold coins hasn’t changed, but suddenly gold coins are much more plentiful. This will make the value of gold coins drop rapidly. In other words, each gold coin will now represent fewer Labor Units. If someone has stored 1,000 LUs in the form of 100 gold coins (because the previous exchange rate was 1 gold coin:10 LUs), maybe now the exchange rate is only 1 gold coin:5 LUs, so their 100 gold coins are only worth 500 LUs now. Their purchasing power has been cut in half.

Things will self-correct once the counterfeits are found out, but what if those counterfeits are never found out? What if the blacksmith keeps counterfeiting more and more gold coins and they all stay in circulation?

The gold coin:LU exchange rate would continue to slowly adjust. What started as 1 gold coin:10 LUs would drop to 1:5 and then 1:1 and keep dropping as long as new counterfeit coins are entering circulation.

Prices would adjust along with the gold coin:LU exchange rate. If the blacksmith’s cook pot used to cost 1 gold coin (because it’s worth 10 LUs), with the new gold coin:LU exchange rate of 1:1, the price would have increased all the way up to 10 gold coins. People would say, “Remember 10 years ago when everything was so cheap? We could get a good quality cook pot for a single gold coin.”

But remember that the true price of things has not actually increased. In fact, I bet innovation in the intervening years would decrease the number of LUs that it takes to make things like cook pots. What’s happened is that the asset people are using to store their LUs in has lost value/purchasing power.

In most countries today, we use paper money, which has negligible intrinsic worth. The government (or, in the U.S., the Federal Reserve) can print as much of it as it likes. Each time they print* more money (like for a COVID-19 stimulus), the US Dollar:Labor Unit ratio has changed. Maybe in 2020 the ratio was something like 1:0.05, but now it’s dropped to 1:0.049. It’s a small change when I write it like that, but let’s think about this for a minute.

First question: Were any new labor units created when the government printed that money? No. So there are the same number of total labor units stored in the form of cash assets. But there are more total dollars now, which means each dollar represents less labor that it did before. The Labor Units stored as cash have all been diluted over a larger total number of dollars.

This is an important point. No new labor units were created! Printing money is not a way to make a society rich. It just dilutes the Labor Units already stored as cash.

So if someone worked hard and earned 1,000 LUs and chose to store them in the form of $20,000 (when the exchange rate was 1:0.05), now how many LUs do they have after the government printed a bunch of new money and changed the exchange rate to 1:0.049? They still have $20,000, but it’s now worth only 980 LUs. This is only a decrease of 2% of their cash-stored wealth, but if government is doing that every year, it will be slowly taking away this person’s savings of LUs without them even realizing how it’s happening!

In this way, the government is acting just like the blacksmith counterfeiting gold coins. They are not generating new Labor Units, they’re just taking them from others through dilution of the money supply.

One last interesting point. The government, when it creates this money, is the first one to spend it. The act of spending this new money is what introduces it into circulation. And prices will only adjust after the new money has entered circulation. So, not only does the government have all this new money that it can spend, but also it gets to spend it at pre-inflation prices!

Ok, this was a longer post than the others in this series, but I wanted to get to this stopping place. I have more to say about the theory of money–we haven’t even invented banks yet!–so this series will be continuing for several more weeks at least, after which I’ll get back to my usual health policy topics.

*I’m speaking metaphorically. Generally these new dollars are not printed, they’re created in a computer at the Federal Reserve by simply changing the listed value of an account. But the effect is the same.

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