The Theory of Money, Part 42

Last week, I described what I believe to be an optimal monetary system, which is based on commodity money and 100% backed receipt money. It was simple and did not allow for manipulations of the money supply with all their associated costs.

At the end of last week’s post, I said my ideal money system is totally not realistic in the near future in the U.S. But that doesn’t stop us from imagining, just for fun, how we could get there anyway!

There are two different methods: the catastrophic method and the gradual method. I’ll describe the former this week.

The catastrophic method is pretty straightforward. For whatever reason, the government loses all restraint with how much new money it’s creating and kills the goose that’s laying the golden eggs (which is its 0% backed fiat monetary system). By creating too much new money, they induce hyperinflation.

People, seeing the rapid rate of inflation, realize that if they don’t spend their money this week, it could be worth half as much next week, so they start spending like crazy. Short-term demand skyrockets, which increases prices.

Businesses are also realizing that they need to price things to take into account how much less the money they’re getting will be worth next week, so they are pricing with an anticipation of further rapid inflation.

All these factors combine to cause prices to launch up so fast that people are soon paying with wheelbarrows of money. We’ve seen this many different times in history.

When the value of money drops so rapidly like this, it soon becomes completely worthless, which means people lose all their cash assets. Luckily, most people probably have more assets stored in non-cash assets, so many people do okay in this situation. But not everyone. Many people who had long-term contracts with money owed to them suddenly have no claim anymore because their debtor just paid off their entire loan with worthless money. And others who didn’t have much in the way of food storage or other non-cash assets go hungry.

And then there’s the effect on the economy as a whole. When an economy loses its monetary system, which acts as the grease that helps the gears of the economy continue turning, economic activity grinds almost to a halt. Very quickly you discover the incredible utility of having a common medium of exchange when you see an economy without one.

This catastrophic method of eliminating a monetary system can have an upside though. When there’s no official money anymore, what do people do when they want to make trades? They barter. And, soon enough, generally accepted commodities to facilitate exchange start to naturally arise, which is called commodity money. Basically, a society in this situation starts over with the progression of money that we just went through in the first 40 posts of this series.

And that is the prime opportunity to lay the foundation for a new, permanent, sound monetary system by enacting some constitutional amendments to prevent money from ever again going down the same road again, which is the road that always terminates in 0% backed fiat money.

I don’t know of a country that has capitalized on that situation to achieve this, but maybe one day it will happen. It would be an interesting case study to see how such a system fares in the modern world.

As I learn more about different issues related to government, I have been realizing lately that my learnings always seem to consolidate into clauses that I would put into a constitution. A well-crafted constitution is the holy grail of setting up an optimal government, and I think getting to be involved in writing one would be a pretty incredible opportunity. Maybe one day I will put the thought and research into writing an optimal constitution. But, in the meantime, I will accumulate my recommended clauses, which already include insights from studying money, lots of things about how government should and should not get involved in markets (including healthcare), how to structure checks and balances in a way that prevents would-be dictators from killing the democracy (I learned about this in How Democracies Die by Levitsky and Ziblatt), and structuring the voting system to allow for greater cooperation and freedom of ideas than our American system allows (I learned about this in The Politics Industry by Gehl and Porter).

Anyway, I’ll describe my suggested gradual (and more realistic) process to getting back to a sound monetary policy next week.

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