Thursday, March 6, 2014

The Nature Of Money And Currency Part 2: Bimetallism And Gresham's Law

The previous essay merely set forth the properties that distinguish a money commodity from a currency. I trust it was clear that I greatly prefer moneys founded on a precious metal -- once was once known as a specie standard -- to currencies that cannot be redeemed in a similarly valuable and durable commodity.

Yet today there are no precious-metal moneys in the world. The question one must naturally ask is why. Part of the answer lies in the economic mechanism described by Gresham's Law.

The policy called bimetallism was commonplace in the nations of the West before the fiat-currency era. In a nation under a bimetallic monetary standard, there are two "official" moneys, usually gold and silver, and a legislatively fixed rate of exchange between them. For example, the original legal ratio between gold and silver in the United States was 15:1, meaning that one ounce of gold was legally held to be equal in value to fifteen ounces of silver. Any debt that could be satisfied by one ounce of gold could also be satisfied by fifteen ounces of silver, and vice versa.

The problem here is three-fold:

  1. There's far more silver in the Earth's crust than gold;
  2. The silver is easier to mine and extract from its ores;
  3. Even in the absence of points 1 and 2, common persons value gold over silver at a greater ratio than 15:1.

The result, of course, was that Americans preferred to pay for their purchases in silver and to retain their gold. This common-sense response to an exchange-rate fixed by law is known as Gresham's Law:

When a government sets a legal exchange ratio between two money metals, such that one is undervalued relative to the other, the undervalued money will leave the country or disappear from circulation into hoards, leaving only the overvalued money in circulation. (Colloquially, "Bad money drives out good.")

As with all other "laws" about economics, this one has a domain of applicability, outside which it ceases to function. The years of the French assignat and mandat inflation provide an example. Because the French revolutionary government printed so many assignats and mandats, the general public came to regard them as worthless. Legal commerce virtually ceased, while "underground" commerce was conducted solely (and illegally) in gold. Thus, when the "bad money" attained wastepaper status, the "good money" retook the field.

Similarly, a restricted bimetallic standard, in which a second precious metal is used for small change and nothing else, is relatively safe from Gresham's Law: The volume of small change is seldom large enough to persuade common persons to transact in it exclusively. Thus, if the monetary standard defines its unit (e.g., the dollar) as a weight of gold, but allows the limited coinage of small change in silver, gold and gold-backed notes will remain in circulation.

The key to a stable bimetallic standard appears to be exactly such a restriction.

The history of bimetallism in the United States is a checkered one, principally because our original definition for the dollar was as a weight of silver, whereas our major trading partners' moneys were founded on a weight of gold. Because silver is plentiful in North America, it was deemed expedient to keep a silver definition for the dollar while specifying an exchange rate against gold at which we would deal externally.

America's problems with bimetallism arose as the quantity of silver mined and sold to federal mints began to rise. If silver was to be the money of the American domestic economy, but gold the preferred medium of the international economy, impediments to Americans' trade with other nations would be inevitable. However, there was a powerful group of U.S. Senators, collectively termed the "silver senators," that agitated ceaselessly for "free coinage of silver," and, as is often the case with a special-interest group with a short, passionately advanced agenda, frequently got its way.

The defection of the Cleveland Democrats to the Republican Party, in the wake of populist-inflationist William Jennings Bryan's capture of the Democrat presidential nomination in 1896, brought an effective end to the bimetallic dollar and the problems it entailed. From 1896 through 1971, the official definition of the dollar was as a weight of gold, though that weight was changed several times over that period.

The transition from a bimetallic standard afflicted by Gresham's Law to a monometallic (or restricted bimetallic) standard requires three things:

  1. Official coinage minted prior to the transition, if it remains in circulation, must be honored at its face value;
  2. The coinage being abandoned -- in nearly all cases, this will be the overvalued money -- must be gradually withdrawn from circulation as it's used to pay tax debts and other federal charges;
  3. Policies 1 and 2 must remain in effect until the abandoned coinage has been reduced to token levels, and the general public must be convinced that this will occur.

Under such a regime, coins minted from the previously overvalued money acquire a new status: tokens whose face value entitles the holder to that amount of the new, monometallic money. If their quantity is expeditiously reduced, they will pose no problem to future commerce, whether domestic or international. Some will become collector's items; others will be melted down, that their metal might be used for something else. Stability in the market will be largely assured, though transient local fluctuations will occur.

However, the transition imposes a requirement on governments to which they seldom adhere: the de-facto reduction of tax revenue paid in the overvalued money. There's no escaping this; at least some of those coins must be destroyed for the transition to proceed. If they're returned to circulation, the problems of bimetallism will persist.

France destroyed its assignat and mandat presses; Weimar Germany ceased to issue the worthless Mark, allowed it to depart from circulation, and replaced it with a new unit, the Rentenmark. But I know of no nation which has transitioned from an unrestricted (a.k.a., "free coinage") bimetallic standard to a monometallic or restricted bimetallic system while complying fully, and with full public confidence, with the three rules above.

The subject of monetary standards is vast. There are aspects to it that are bitterly argued by monetarist economists even today. For example, I have yet to discuss panics and runs under a specie standard. So I must say once again:

More anon.

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