by Steve Forbes
Foreign exchange markets were ready to attack their currencies because they had little faith that the governments of these countries would do what was necessary to maintain currency stability. This could have easily been accomplished had these nations used the dollars held in reserve by their central banks to buy their own currencies and shore up their value. But such relatively simple steps are rarely taken or executed correctly because most nations today don’t understand the importance of having stable money.
A similar loss of trust brought on the devastating Asian currency crisis in 1997. That disaster was precipitated by Thailand’s easy domestic money policy as well as by the U.S. dollar, which had been strengthening as a result of growth-inducing tax cuts and the inadvertent tight money of the Federal Reserve. A strong U.S. economy was causing investors to dump the baht and other currencies in favor of the dollar. Observers felt too many bahts were being created to keep it pegged to the greenback at a fixed exchange rate. Like most other monetary bureaucrats, Thailand’s central bankers didn’t know how to defend the baht, which would have meant temporarily reducing its supply. In its advice to other nations, the International Monetary Fund (IMF) was just as ignorant. In fact, it recommended devaluations.
Foreign exchange traders soon realized policy makers in Thailand didn’t perceive the importance of maintaining a stable currency. Their loss of faith in the integrity of the baht led to a collapse.
Trustworthy Money: The Bedrock of Prosperity
When a country has stable, trustworthy money, the opposite scenario unfolds: people want to hold their currencies. Capital and investment flow into countries with stable money. That’s why stable money is the bedrock of prosperity.
The classic example is Great Britain. The British pound was tied to gold at a fixed rate for over 200 years and holds the record for stability. After Great Britain formally established the ratio for the pound to gold in 1717, lenders could rest assured they would be paid back in money that wouldn’t lose its value. Capital creation and investment in the country exploded. The strength of Great Britain’s currency helped create capital markets that turned that island from a second-tier nation to the mightiest industrial power in the world.
Propelled by its stable money and capital markets, Great Britain gave us the steam engine, railroads, and countless other advances that marked the beginning of the modern era. Its spectacular success led the United States and other countries to follow its example. The late nineteenth century saw the era of the classical gold standard. The United States, most of Europe, and eventually Japan pegged their currencies to gold. More wealth was created by far in the 1800s than all the previous centuries put together.
In the twenty-first century, there is no such thing as stable money. But countries that manage to keep their currencies relatively sound tend to be better economic performers; examples are Switzerland, Singapore, and China. It’s easier for them to have a vibrant economy because transactions are made easier.
In this era of unstable money, nations that have relatively sound currencies can occasionally suffer from too much of a good thing. During the sovereign debt crisis of 2011, which imperiled the euro, many sought refuge in Swiss francs. The value of the Swiss franc shot up so high relative to the euro that it hurt Swiss exporters. The Swiss government eventually had to place a cap on the franc’s value vis-à-vis the euro.
The Importance of Monetary Demand
When you have desirable money you have global demand. The importance of demand in determining the value and supply of money is widely unappreciated.
Demand for money is created by a strong and growing economy. Proportionately there is a greater supply of U.S. than Canadian or Australian dollars because there are more uses for the U.S. dollar globally. The U.S. dollar is more desired around the world than those other currencies because our economy is bigger and our capital markets are deeper.
How can a government increase demand for its money? To quote Austin Powers: behave. Signal to markets that a future devaluation is unlikely by implementing economy-boosting, pro-market initiatives and by showing fiscal restraint.
After the United States cut tax rates and did not pass costly national healthcare reform in the late 1990s, money flowed into the States, strengthening the greenback. People wanted to invest in America, and they wanted more dollars.
Keynesians and monetarists focus too much on supply of money rather than demand. If demand is not there, an attempt to create money sets up what in the 1930s was called “pushing on a string.” The economy doesn’t move.
Economic Torpor and a Crisis of Faith in the Dollar
Stagnation has essentially been the story since the financial crisis of 2008–2009. The last several years have seen an explosion of the Fed’s balance sheet, enormous stimulus spending, the historic expansion of government—most notably the thousands of pages of regulations coming from Dodd-Frank financial reform and the Affordable Care Act—along with record levels of government debt. These misguided policies have suppressed both the economy and monetary demand, undermining long-term faith in U.S. currency.
The price of gold, you may remember, shot up to a breathtaking high of $1,900 an ounce in 2011. And as we noted, the rating agency Standard & Poor’s downgraded U.S. credit in 2011. China, our largest foreign creditor, and many others have worried that a U.S. default on bond payments could set off a worldwide financial meltdown many times worse than the 2008 financial crisis; that would cause the dollar to collapse. Even absent such a dire scenario, they worry that the dollar faces a long-term decline.
The Chinese see the U.S. economy as stalled and U.S. leadership as floundering. They see a government paralyzed by political disarray, seemingly unable to govern itself. During the 2013 partial government shutdown, an angry commentary by the Chinese government’s Xinhua News Agency slammed “the cyclical stagnation in Washington for a viable bipartisan solution over a federal budget and an approval for raising debt ceiling [that] has again left many nations’ tremendous dollar assets in jeopardy and the international community highly agonized.” The editorial renewed calls for a “de-Americanized world” with a new reserve currency “to replace the dominant U.S. dollar, so that the international community could permanently stay away from the spillover of the intensifying domestic political turmoil in the United States.”
Default was averted when Congress and the president eventually agreed to end the government shutdown. But this has not stemmed concerns about the dollar. To the contrary: Republicans agreed to let the Obama administration raise the debt ceiling and borrow even more. The move had some observers wondering whether the dollar’s collapse was not a matter of if, but when.
The Bitcoin and Other Alternative Currencies
When people lose trust in a currency, alternatives start springing up. That is happening today as the result of faltering confidence in the dollar. In 2012 thirteen states were considering laws that would allow people to use gold and silver currency in place of the dollar. Other recent alternatives include the now-banned Liberty Dollar and the more recent and highly controversial digital currency known as the bitcoin.
These initiatives are not as radical as they sound. People today forget that for a good part of U.S. history, Americans used more than one currency. From the mid-1830s to the mid-1850s, it was legal in the United States to use gold and silver coins from different countries along with the U.S. dollar, as well as coins from U.S. mints. The Spanish silver dollar was used heavily in colonial America and as late as the mid-1800s.
Utah governor Gary Herbert may have had this history in mind when he signed a bill into law that allowed gold and silver coins from the U.S. Mint—American Gold and Silver Eagles—to be used in that state as money.
Then there’s the bitcoin. The digital currency was designed as a stateless alternative to traditional money. A fixed number were created that could be purchased and used in online transactions beyond the reach of government or banks, in addition to being traded. Offering the advanta
ge of freedom from government fiat and surveillance, the bitcoin initially created excitement and attracted a passionate following.
The euphoria came to an end when the digital money drew legal scrutiny. Its promise of anonymity made it a perfect cover for illegal transactions, including drug dealing. In 2013 the FBI arrested the drug kingpin known as Dread Pirate Roberts, a.k.a. Ross William Ulbricht, who used bitcoins for drug deals in the online black market known as Silk Road, which he allegedly created. The 29-year-old former grad student was collared inside a San Francisco public library, and his site was shut down by the Feds.
In 2014, Tokyo-based Mt. Gox, the world’s largest bitcoin trading exchange, shut down abruptly when it was revealed that hundreds of thousands of bitcoins had been stolen. The massive sell-off that followed caused the currency to virtually collapse.
Critics attributed the failure of the bitcoin to the fact that it is unregulated and anonymous. The real reason was that it isn’t really money. The high-tech bitcoin may have captured the imaginations of those seeking alternatives to the dollar, but with its wild fluctuations it is not a stable measure of value. For that reason, it can’t function as an instrument of trust.
Forbes.com writer Kashmir Hill set out to live on bitcoins for a week. She invested $600 in bitcoins at $126.69 each. When she finally received the digital money, online trading had sent the value of her bitcoins up to $142 each.
Unfortunately, their value could also plummet just as fast—as much as 61% in a single day. To put that in perspective, the Dow crashed about 13% on Black Monday of 1929 and about 23% on Black Monday of 1987.
Little wonder that long before the crash of the bitcoin, Hill found few places willing to accept them.
The story of the bitcoin shows how money attempts to rise up when there is a need. But even if people were able to develop a viable alternative money, it would probably not last long in today’s unstable environment because of a principle known as Gresham’s law: bad money drives out good. History has shown that when money is debased, people tend to hoard the “good,” accurately valued money while dumping the “bad,” overvalued money in the marketplace. Gresham’s law was why the printing of paper money by the colonial governments of New England drove out the silver coins that were also in circulation, pushing monetary values down further.
There’s no refuge from the destruction caused by the debasement of money.
Money Communicates
Trust is not the only reason that we need currency stability. Stability is essential if money is to fulfill its role as an instrument of communication in the marketplace. The economist Friedrich Hayek explained that money facilitates communication in the market, and in society, through the mechanism of prices.
The price system is why products and services in a free economy seem to spring from out of nowhere without a bureaucrat ordering them to appear. Hayek observed: “The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action.”
Prices don’t simply inform buyers and sellers in a particular transaction; they also provide information that producers and consumers throughout an economy use to make decisions. Rising prices, for instance, indicate increasing demand for a product or service. Conversely, when the price of a product drops, rendering it less profitable, that’s a signal people no longer want what is being offered.
One example is portable cassette players. Thirty years ago Sony created a sensation when it came out with the Walkman. You could listen to music with great fidelity on a pair of light headphones from a small device that you could keep in your pocket. The price of the very first Walkman sold in Japan was $1,000. It debuted in the United States at around $200 in 1979 dollars. Sales and profits went through the roof—overnight, everyone was making them.
Then a new technology appeared: the portable compact disc player. Demand for cassette players dropped—and so did prices and profits. Producers turned their attention to CD players. Then came the iPod and downloadable digital audio content. Portable disk players too became history. There are still portable cassette and CD players, but there’s far less demand for them; you can now get one of those devices for as little as $20.
Prices also convey advances in productivity. Thirty years ago, a cell phone that was as big as a shoebox cost $3,995. Cell phones are now many times smaller and more powerful and they cost a fraction of that—and they’re free with some calling plans.
Another example, out of many: flat-screen TVs. Prices are less than a tenth of what they were a decade ago, and they incorporate far more sophisticated technology.
That’s why advocates of the need for price stability are often off base. They can mistake price changes resulting from shifts in productivity and supply for inflation or deflation. In a vibrant, innovative, and productive economy, prices as a whole should decline as producers find ways to make products more cheaply. A dozen years ago the memory device in the iPad would have cost $10,000. Today, it costs a mere $50.
The prices and profits facilitated by money are what allow a market economy to provide for the needs of society. When money is made artificially unstable by government, the information it provides ends up being corrupted. Both producers and consumers respond to distorted market signals. The end results are gluts, shortages, or market bubbles.
Money Is Not Wealth
As a standard of measurement, an instrument of communication, and a promoter of trust, money facilitates the creation of wealth in a society. But money itself is not wealth. Money is simply a tool.
Adam Smith was among the first to recognize this truth. Smith defined money as “an instrument of commerce and a measure of value.” Artificially increasing the amount of money in the economy, he wrote, was as futile as increasing the number of cooking pots when there was no demand for them. In his influential masterwork The Wealth of Nations, he offered the brilliant observation that money, like other tools, appeared spontaneously when there was a need:
If the quantity of victuals were to increase, the number of pots and pans would readily increase along with it, a part of the increased quantity of victuals being employed in purchasing them, or in maintaining an additional number of workmen whose business it was to make them.
Just as buying too many unneeded cooking utensils would impoverish a family, Smith wrote, government attempts to acquire vast amounts of gold or silver “necessarily diminish[es] the wealth which feeds, clothes, and lodges, which maintains and employs the people.”
Unlike others of his time—and, indeed, these days—Smith recognized how money advanced society by facilitating profit-making. Giving the example of the manufacturing of pins, he explained how the increase in productivity brought about by the division of labor means that “every workman has a great quantity of his own work to dispose of beyond what he himself has occasion for.” The surplus goods and services, he explained, are then used as capital to create more wealth and “a general plenty diffuses itself through all the different ranks of the society.”
The Wealth of Nations was published in 1776, the year the Declaration of Independence was signed. Smith’s ideas about free trade and sound money—and his rejection of mercantilism, with its state controls—enormously influenced the Founding Fathers, including, most notably, Alexander Hamilton.
Hamilton faced the challenge of restoring the economy of the young republic that had been devastated by the Revolutionary War and the relentless money printing of “Continentals.” Like Smith, he knew history. The key to recovery, he wrote, was “introducing order into our finances.” In order to remain independent and not fall back into the clutches of Great Britain, the new nation needed a banking system with expertise in the uses of credit:
Banks were the happiest engines that ever were invented for advancing trade. Venice, Genoa, Hamburg, Holland, and England are examples of their utility. They owe their riches, commerce, and the figure they have made . .
. to this source. Great Britain is indebted for the immense efforts she has been able to make in so many illustrious and successful wars essentially to that vast fabric of credit raised on this foundation. ’Tis by this alone she now menaces our independence.
Following the example of Great Britain, Alexander Hamilton established the First Bank of the United States, as well as a mint with a dollar fixed by law to a specific weight in gold. Hamilton’s system of banking and stable money quickly attracted and generated capital. It turned the American economy into the leading industrial power in the world.
THE NUGGET
Money measures wealth, but it does not create it.
CHAPTER 3
Money and Trade
A Deficit in Understanding
International transactions are always in balance, by definition . . . for every buyer there is a seller. But different items in the great circle carry different labels. . . . The mystery is why we even collect these figures; if we kept similar statistics for Manhattan Island, Park Avenue would lie awake at night worrying about its trade deficit.
—ROBERT BARTLEY, The Seven Fat Years
THE BUREAUCRATS WHO SET OUR MODERN MONETARY policies are in many ways a throwback to the mercantile era of the sixteenth to the eighteenth centuries. Back then, currency consisted of precious metal—gold and silver bullion, or “specie.” Money was synonymous with wealth. Because nations were frequently at war, wealth was often acquired through conquest.
Jean-Baptiste Colbert, Louis XIV’s Machiavellian finance minister and über-mercantilist, wrote in his Mémoire: “Commerce causes a perpetual combat in peace and war.” To Colbert and mercantilists throughout Europe, trade between nations was a battle for supremacy, with money its foremost weapon. Like many of his peers, Colbert looked with envy at Spain, whose New World mines flooded its coffers with gold and silver.
