Tuesday, November 1, 2011

What is sound money?

Sound (or honest) money have 5 characteristics. They are;

  1. Divisibility
  2. Portability
  3. Durability
  4. Recognizability
The first one, divisibility, is important as a unit of account. You need to count things. "It takes 5 of these to get one of that, etc". Portability is for convenience. If it too big or hard to carry, it loses some of it's appeal. Durability is also a necessity. It if wears out or rots, for example, you would have to keep replacing it. Recognizability plays a role in that it is something usable that everybody understands. Let's say someone wants to pay you for your service in a special colored stone from Russia, how much value does it have? Would somebody be willing to trade you his car for it? It needs to be recognizable. The final feature that money needs is scarcity. Why? Quite simply due to supply and demand. The more there is of an item, the less it is worth. As an example, if we as a society decide to use rocks for money, anybody can just pick up a bunch of rocks whenever he wants to buy something from someone else. It does not have value. It is easy to find and use. It would disrupt trade. These are the five characteristics make up sound money.
Why is this important? Because free trade, the division of labor, personal wealth accumulation and higher standards of living count on it.

A little history:

Primitive society started more or less on a barter system. If a hunter landed a buffalo and had more meat than he needed, he could trade a portion of it for some fruit another tribe member collected. Other members may have been better at building housing or clothes, or maybe performed the function of collecting berries. They would trade with each other and with other tribes. This is the beginning of specialization of labor. Some would be better than others at certain tasks. While trade and bartering took place, there were certain items that began to be used as a medium of exchange, thus the first forms of money. The more successful forms of money displayed the 5 traits listed above. An important intrinsic feature of sound money is it's value. It is a way for an individual to save more than he produces for his own use either now or in the future. What was used? Money took many forms. Sea shells, salt, cattle, bear claw are some examples. The most common and enduring forms of money have been gold and silver. These precious metals best displayed the aforementioned five traits of sound money.

And Now?

Now we have what is called a fiat currency. It is paper notes printed by the government and decreed by the government that it is money. At one point, paper money used to represent sound money in that at any time, you can turn in the note to a bank and get the note's  value paid to you in gold or silver. In other words, it was backed by something other than the good word of the issuing government. Is a fiat currency good? No. It has plenty of flaws that lead to big economic problems. That, however, is a blog for another day...