Sound money and why it matters

We may carry some paper or coins, but most of our transactions are in fact by credit card or online


Friday, 12 January 2018, 16:19


The classic definition of 'money' has three features: (1) a medium of exchange; (2) a store of value; and (3) a unit of account. 'Sound money' is simply a medium of exchange, backed by an asset with an intrinsic value and not liable to sudden appreciation or depreciation.

Money is not a risk asset. It does not, in and of itself, have a yield feature. The yield comes, from placing a EUR in a bank deposit. However, from the moment you make the bank deposit, it is no longer your money; it becomes part of the bank's unsecured liabilities.

The difference between money and bank deposits was learned painfully in Cyprus and Greece, in 2013 and 2015. In Greece, banks and ATMs were closed by the government. In Cyprus, many depositors had cash on deposit forcibly converted to bank stock.

Money has taken many different forms through history; shells, beads, feathers, gold and paper. Gold has been used as money throughout civilisation due to its unique atomic structure, and it is ideally suited to be money. Gold is physical, not digital, money and is subject to less volatility than FIAT currencies. As such, gold provides an insurance against the risks to which digital currencies are exposed. Another form of digital currency is the EUR. We may carry some paper or coins, but most of our transactions are in fact by credit card or online.

The 20 EUR note in your pocket is a FIAT currency as it derives its buying power from FIAT (Latin for 'decree'), a government mandate. No longer backed by the tangible asset of gold, its value rests on confidence in the government bestowing buying power. Confidence is fragile, difficult to earn and easy to lose. In 1971, when President Nixon announced by decree that the US paper currency was no longer redeemable in gold, the US Dollar became FIAT for the first time in its history and the US Government could print as much as it wanted. It printed 84Bn US Dollars a month for six years, following the financial crisis of 2008. It was not necessary to collateralise it with anything, other than confidence in the US government. Historically, however, large scale money printing has led to inflation (too many dollars chasing too few goods and services).

The international monetary system collapsed three times in the 20th century: in 1914, 1939 and 1971. It came close to collapse in 1998 and 2008. Today's international monetary system is largely based on confidence in the US Dollar. The monetary system fails every 30 years or so. The next collapse will be triggered by no confidence in the US Dollar as a store of value.

History teaches us that it's convenient for central banks to persuade people that money is unconnected to gold, so that they can print unlimited paper and devalue their debt. However, there is something to be learned from the fact that today, major developed central banks, together with Russia and China, are net buyers of gold. Gold is still, unquestionably underpinning the international monetary system and is sound money.

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