Thoughts about commodity money.

Here is an argument against the goodness of a commodity money: that it will lead to deflation, which is a fall in consumer prices. The basic premise of this argument is that the supply of the commodity money will be outpaced by the supply of all other goods in the economy. So, there will be relatively less "money" being exchanged for a greater quantity of goods, and so prices of goods will generally fall.

Now, this argument against the goodness of a commodity money is not due to its causing price deflation. Rather, the argument is that price deflation will discourage borrowing in terms of the commodity money. Here's how: suppose that one day A lends B 5 pounds of gold (which at the time would by 5 widgets). Later on, when the loan is to be repaid, the principal amount of 5 pounds would have more buying power, let's say 10 widgets. That must be paid with interest. Thus price deflation means that the borrower is actually paying the loan back more dearly than if prices were inflating. If prices were inflating, then the borrower would be paying back a principle amount that actually has less buying power than when it was borrowed, and so it seems the borrower is paying back the loan less dearly.

Now, why is that bad? The argument goes that no one would want to borrow in terms of the commodity money, and so commodity money is bad. I suppose then that the desire is to have a make-believe money, one whose amount can be adjusted at will. I believe this is one of the aims of the federal reserve bank: to increase the money supply to outpace the overall supply of goods in the economy. This would cause some degree of price inflation rather than deflation, and would be impossible to accomplish with a commodity money.

The truth is that I don't understand why this argument is conclusive with respect to borrowing ceasing in terms of commodity money. It seems to me that if borrowing is desired, then a commodity money would not prevent an agreement being reached between the borrower and lender. It seems that some agreement could be reached so that the lender and borrower each benefited. Since prices are deflating, it may be that each party could still benefit if the loan were paid back without interest, or paid back at slightly less than principal.

In any case, I guess the real question is whether people are generally wealthier in an economy based on a money supply that is outpaced by the supply of other goods. This is an economy with price deflation. Now, this question is not going to be answered on a blog post by someone who has no education in economics, and the question may not even be properly stated in the first place.

In any case, this post of mine was all caused by a (one star) review on Amazon.com of Ron Paul's book End the Fed. I copy the review here and add some of my own remarks.

"But, for an easy to understand response on why Paul's tract is a load of baloney, here's a good way to think about it: gold is, in itself, a commodity. That means it's worth as much as laws of supply and demand say it's worth. It's subject to bubbles (some would say we're in one now, though I haven't spent enough time analyzing the gold market to have an opinion one way or the other) driven by what people are willing to pay for it. But it's a HORRIBLE currency because, simply, it's completely detached from output. Here's a simple model for understanding why. Imagine a closed economy with 100 people and a fixed supply of gold. Say output over 25 years doubles (a perfectly reasonable assumption if that economy grows 3% annually), but the supply of gold stays fixed. Now you've got twice as much output chasing the same amount of gold, so prices deflate (by half). Wages do the same thing. Now imagine for a second that you took out a loan in year 1 for 5 pounds of gold. Now, in year 25, the nominal value of your principal is the same, but the real value of the loan is double, PLUS interest. Given that kind of deflation, no one's going to be too willing to borrow in gold. Instead, they'll spend as little of their gold as possible and sit on it, waiting for it to appreciate. [Okay, one sentence ago, it seemed the claim was no one will want to borrow in gold, due to price deflation. Then, the next sentence seems to claim that no one will want to lend in gold, which doesn't seem to follow from price deflation.] But if everyone's doing that, then where does the demand for goods and services come from? The simple answer is: from nowhere. [Okay, so people would hang on to their appreciating gold, even if it means forgoing food, shelter, etc.?] Instead the gold standard discourages credit, depresses demand, and makes the money supply contingent on something as random and unpredictable as the amount of gold that is mined in a given year."