Opinion | The monetary system, explained

Pegging the U.S dollar to any commodity is a bad idea.

Opinion+%7C+The+monetary+system%2C+explained

Shahab Khan, Opinions Columnist


The quiet resurgence of the goldbugs, those who want to peg the value of the U.S. dollar to the price of gold, is emblematic of the fact that some lawmakers do not understand how the monetary system works.

During the post-2008 recession recovery, former Rep. Ron Paul routinely sparred with former Federal Reserve Chairman Ben Bernanke about this very topic. Paul, the moron-in-chief of the goldbugs, rambled on about how money derives its natural value from gold.

Bernanke would then explain to him that gold is a precious metal, not the basis of money. Rather, money derives its value from the government that provides it backing.

Throughout history, money has served three important functions. First, it is a medium of exchange, as we can use it to buy things. Second, money serves as a store of value. We can save money in order to make future purchases down the line.

The third property of money is that it serves as a unit of account, communicating to consumers the value of goods or services they own or want to buy.

Essentially, if you were to time travel to ancient Mesopotamia, society there would be using money the same way we do in 2021. That being said, the forms that money comes in have changed in the two thousand years since money’s invention.

In today’s monetary system, there are two types of money: base money and bank money. Base money is the cash that individuals, firms, and commercial banks have on hand, plus the balances that commercial banks hold at the Federal Reserve.

Bank money on the other hand is the base money that commercial banks loan out to firms and households creating a liability for the bank. When firms and households have to pay those loans back, they pay with interest, thus allowing the commercial bank to make a profit and create money.

Finally, the government allows for the value of money to be free floating, or fiat, meaning that it isn’t fixed to the price of other commodities. This is the feature that most goldbugs rail against because they argue that, if currency is free-floating, then the government will print more money to fund its programs leading to inflation that destroys the economy.

To ensure responsible spending, they say, the government must return to the gold standard, an economic system in which the value of a currency is based on a fixed amount of gold. This is not the case.

What separates the 2008 recession from the Great Depression in the 1930s is the role the gold standard played in exacerbating the latter crisis.

The two crises started out very similarly in that they were caused by banks making risky loans and investments to increase their profits, then the firms and individuals who received the bank loans defaulted. As a result, the banks did not have enough base money to the point they became insolvent, thus shrinking the base money, and the real economy.

This is where things start to diverge. In 2008, the Federal Reserve was able to save the economy by using electronic cash that did not exist before to buy securities from banks, thus allowing them to remain solvent.

Unfortunately, because the U.S. was on the gold standard in the Great Depression, the Federal Reserve could not print the necessary amount of money to help banks remain solvent, turning a recession into a depression.

In 1933, when it was too late, President Franklin Delano Roosevelt took the U.S. off of the gold standard, before it was put back in place by the post-World War II Bretton Woods system. The Bretton Woods System was maintained until another financial crisis in the 1970s forced President Richard Nixon to permanently take the U.S. off the gold standard.

The lessons of the past provide a valuable insight about our monetary system. It works and we should not upend it for something worse.


Columns reflect the opinions of the authors and are not necessarily those of the Editorial Board, The Daily Iowan, or other organizations in which the author may be involved.


 

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