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Many types of currencies have been used throughout history. Sometimes commodities defined them. Other times, private bank notes circulated as mediums of exchange. Today, fiat currencies reign supreme while some eye cryptocurrencies as the future. Like so many aspects of money, currencies are hotly debated. This results from money’s many and conflicting definitions. Properly defining it, though, sheds light on why commodities work well as currencies, fiats fail, and cryptocurrencies are a distant hope.
While many conflate the two, currency is a distinct concept from money. Money is properly defined as a common measure of value (only). Currencies mediate exchange utilizing the money concept. They are always assets, ranging from “hard” assets—like metals—to softer ones such debt. Their reliabilities depend upon the difference between the worthiness of their asset values and their monetary denominations.
Commodity and credit theories of money seem incompatible
There are two dominant views of money today: credit theories of money and commodity money. Commodity theories posit that money must be some commodity, such as gold, and hence is an asset. Credit theories view money as debt and a liability. Thus, these views are seemingly at odds with each other. Which is it: asset or liability?
Commodity money is a straight forward concept. These theories define money as concrete, physical objects. Many different types of commodities defined money throughout history including gold, silver, copper, salt, pepper, shells, feathers, tobacco, barley, tea, sugar, cod, animal skins, iron, cattle, amber, cacao nuts, and cloth, to name a few. Metal coins are perhaps the most well-known commodity monies. As early as 600 B.C., humans minted monetary metals into coins of standard denominations which were then used in commerce. To commodity money theorists, money is an asset. It’s a valuable object that’s sufficiently marketable such that buyers and sellers willingly accept it in trade.
Credit theories of money supporters posit that money, credit, and debt are the same, just viewed from different perspectives. Alfred Mitchell Innes, an early proponent of the Credit Theory of Money, saw money as a creditor’s right to acquire a payment from a debtor. The value in question is money. According to Mitchell Innes, money is strictly a promise to pay someone, something, not a commodity. It’s an IOU. Money represents liabilities.
Many societies employed credit-based systems of money. The Sumerians in Mesopotamia created one with clay tablets. Wooden tally sticks in medieval England, notched strips of bamboo in China, and knotted cords in South America recorded debts too. They all accounted for and settled financial transactions. In fact, even metallic coins act mostly as value-tracking tokens rather than monetary standards. Mitchell Innes documented the large degree by which coins of equal denominations in ancient Greece and France between 457 and 751 A.D. varied in their metal content and purity. The variances were too large for the metals to act as monetary standards themselves. Instead, Mitchell Innes concluded, coins represented value rather than contained value.
As currency theories, both commodity and credit theories seem valid
Credit and commodity theories of money conflict. Yet each rest upon valid observations. While both define money as a common measure of value and medium of exchange, commodity theorists consider money an asset while credit proponents see it as a liability: exact opposites! Interestingly, their commonalities and differences greatly helped me understand money; but not until I viewed these as currency theories, not money theories (more on this later).
Credit theorists correctly observe that transactions occur based on promises. Hyman Minsky famously noted that “in principle [anyone] can ‘create’ money—the only problem for the creator being to get it ‘accepted’.” An IOU written on a bar napkin can suffice in some instances. Even coins comprised of precious metals had a credit component to their values as they traded in denominations well above —and apart from—their intrinsic values (i.e. the value of their metal content), as Mitchel Innes illustrated. Thus, currency need not be a commodity.
Yet, commodities played important monetary roles throughout history. Whenever removed from currencies serious inflations emerged. The inflation following the debasement of the Roman denarius played a central role in Rome’s demise. The heavily indebted and economically hobbled Germany tried to print its way out of its debilitating World War I reparation payments by purchasing foreign currency with newly-produced fiat bank notes. The strategy backfired and resulted in its infamous hyperinflation. China too, between 1905 and 1950, experienced greater than 300% inflation rates when it transitioned to fiat currency from a silver-anchored one. The fact that over 150 fiat currencies have failed due to hyperinflation reveals that commodities play an important role too.
By mediating trade, currencies carry risk
Once I reframed money as a common measure of value only, the differences between commodity and credit theories disappeared. I now see how both describe characteristics of currencies, not money, but from different perspectives. Currencies do track credits and debts; they are assets; commodities do make great currencies; fiat currencies can work, but are fragile; the best currencies are objective (objective means observable by all; not that all agree that the value observed is “right”).
Money is the concept that quantifies the economic value of things. Currencies and credit are applications of money. They utilize its language. Credit and debt describe the relationship of an asset (i.e a thing) to a person. The owner of that asset can account for it as a credit, denominated in money; someone who owes payment to another has a debt. Note that one person’s debt (a liability) is another’s credit (an asset). Mitchell Innes was correct.
Currencies mediate the movement of money between people. They are assets that facilitate the acquisition of goods and services by people. Currencies can be physical, like cash and coins, or accounted for as credits, such as in credit card transactions and checks. We always trade our goods and services for the goods and services that currencies can buy, not for the currencies themselves. Thus, currencies have no use and no value on their own apart from mediating exchange.
All currencies bear acceptance risk—the risk that someone else will not accept it in a transaction thus leaving the holder with a worthless token. Trade exchanges value for value on agreed terms. One party receives currency in return for a tangible asset. In doing so, he/she assumes a risk of the currency retaining its value and use in trade at a later date. If currencies don’t, they simply can’t play their part in transactions and currency holders lose out. For this reason, the best currency is one that maintains a stable value. Buyers and sellers must trust that they can use it again and in their denominated amounts.
The less acceptance risk the better
Acceptance risk explains why commodity currencies fare better than fiat currencies or pure credit systems. Commodities must be physically produced and have graspable (if not directly observable) market values. They provide perceptual reminders of a commodity currency’s value. Furthermore, these values cannot be easily manipulated or faked. Debasements are measurable and observable.
Note that commodities can’t eliminate acceptance risk. They can, however, mitigate it. The commodity content can be extracted and sold from an unwanted commodity currency providing a partial recovery to the holder. Thus, the closer a currency’s commodity value is to its denomination, the lower its acceptance risk.
Hence, fiat currencies are riskiest. Fiat currencies cost little to make and have de minimis intrinsic values. For example, it costs less than 8 cents to produce a physical $1 bill and 17 cents for a $100 note. An unwanted bill has no virtually no marketable use or value. Thus, the acceptance risk of a $100 fiat bill is much greater than a similarly denominated gold coin. While fiat currencies can clearly be used successfully, holders assume significant downside risk. They can also easily and cheaply be created making debasements imperceivable. Thus, political stability factors large into fiat currency values. It’s no accident that U.S. dollars are more readily accepted than the official currency in Zimbabwe. The U.S.’s relatively free political environment lowers the risk that it will be overproduced, lose value, and shunned in transactions. However, absent government mandates I doubt fiat currencies would exist.
Cryptocurrencies have too much acceptance risk to function as currencies
While many eye cryptocurrencies as the mediums of exchange of the future, I remain skeptical. Without an economic use-case, cryptocurrencies suffer from the same shortfalls as fiat currencies. Currently, they have large gaps between their intrinsic values and denominations, and can easily be created and destroyed. Their only chance to be used as currency is to acquire commercial uses. Only then can a cryptocurrency lower its acceptance risk enough for people to trust it in trade.
To be fair, some cryptocurrencies are being developed with this in mind. Bitcoin’s decentralized blockchain ecosystem was designed to send and receive electronic payments. Ethereum’s smart contracts were created with commercial applications in mind. However, none have enough utility today to reliably function as currency (not to mention that they suffer from flaws such as Bitcoin’s fixed and inelastic supply which prevents it from scaling with and representing progressive amounts of value creation). Thus, I see cryptocurrencies as fintech and currency longshots.
Commodity currencies’ low acceptance risk makes them good currencies
Money remains topically for good reason. It plays a central role in our economic lives, from banking, to monetary policy, to cryptocurrencies. Currencies are just one aspect that impacts investing.
Competing theories characterize currencies as assets or liabilities. This creates factions favoring gold, or fiat currencies, or Bitcoin. Yet, valid observations underpin each. Only by separating currencies (medium of exchanges) from money (a common measure of value) could I make their connections.
Currencies are assets, but tokens that trade above their intrinsic values. The best ones minimize acceptance risk. Thus, their most desirable qualities are commercial utility, stability, and transparency. This explains why commodity currencies functioned best, fiats have been failure-prone, and cryptocurrencies have a long road to adoption. As I learned, formulating reliable currencies is crucially dependent upon formulating reliable concepts of money.
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9 comments on "Why Commodity Currencies Are Better Than Fiat and Crypto"
I have no problem holding fiat in a stable monitary system. The US is towards the end of a credit cycle and depends on forever expanding credit to function. This system will be stable until it’s not. Every country with a central bank has a soveign debt issue. the way out will be to print money and further debase fiat currencies until we enter a new system. My guess is that this system will be global and a CBDC will be its currency. Whatever happens, if you own a store of value (metals/Bitcoin, land, etc.) you will then be able to covert into whatever new currency that arises. I will not speculate to know the future exactly, but to diversify some coins in different stores of value seems wise to me. DON,T PRESUME THE FUTURE. PREPARE FOR IT!
While I agree that CBDC’s are coming, and that is not a positive in my mind, I disagree that there will be a global system. the benefits of minting your own money/currency are far too great for countries to cede them to any outside body unless under duress. so there will be digital dollars, pounds euros and yen amongst others in my view.
This dialogue highlights the utility of separating the concepts of money and currency. Currencies can be legislated but money cannot. Remember, money is production. Thus, while governments can (and have historically) manipulate the former, we can measure and store wealth in anyway we see fit. Just look at the what Chinese citizens have been doing with theirs. To be sure, it’s sad that they have to go to such great extents, but life finds a way.
I agree with a lot of what you say here, but I conclude that fiat is better than commodity. Here’s why.
Acceptance risk: Yes, gold has intrinsic value. But the amount of gold held by investors is much, much greater than the amount that could be used in the foreseeable future by the industries that use it (jewelers, electronics manufacturers, dentists etc.) so if everyone in the world tried to exchange their gold holdings at once, there would be a limit to what the market could take. On the other hand, a government that issues a fiat currency will always accept it, and so will most major businesses under its jurisdiction.
Value instability: With a commodity such as gold, there’s no mechanism to link the price of the commodity with the prices of things that people care about in everyday life (food, housing, transportation, health care, etc.) and indeed, if one looks at a chart of the consumer price index versus gold, one finds a lot of volatility. But with fiat, the central bank has tools to respond to market conditions to stabilize the currency. Yes, there are lots of cases of fiat currencies where that failed, but it’s generally due to poor choices by the central banks. Then I’d conclude it’s important to have good quality institutions when operating a fiat currency. Whereas with a commodity currency, there’s no recourse and you just have to accept whatever depression or inflation occurs due to fluctuating commodity values.
I believe what I argue above is conventional wisdom and is the reason that most economies today prefer fiat over commodity.
Thanks for your comment. I’ve never been satisfied with “better bureaucrats” solutions. I prefer the wisdom of crowds which have overwhelmingly chosen commodity-defined money throughout history the reasons for which I discuss herein.
Good institutions are precisely those that don’t depend on “better bureaucrats” but rather have built-in mechanisms to keep bureaucrats in check. The US doesn’t necessarily have better bureaucrats than some random country with a failing currency. What it does have is stronger ways to hold them accountable.
As for the crowds overwhelmingly choosing commodity-defined money, I’m not sure what precisely you mean by that. Most people for most of history have not been in a position to make a choice between holding a commodity or a fiat currency. But if you would offer to make a payment to someone today, I’m sure most people would probably prefer to receive their local fiat currency rather than a commodity. You disagree? Must we turn to facts and figures on amounts invested in gold versus held in cash today?
All institutions rely upon the enforcement of their rules (even the built in ones) by the people who run them, aka bureaucrats. The US has both better institutional rules and better bureaucrats. We have a better defined and respected legal system of individual rights than other countries (the Constitution) and a culture that respects it more. However, a look throughout our history shows that some bureaucrats respected those built in rules more than others at various points in time. To be sure, this is cultural.
Commodities are not the same as commodity-defined money. The former is just a thing. The latter is measurement standard for value and incompatible with fiat currency, by definition. Few would choose a commodity over fiat currency since a commodity is not fungible with other goods like fiat is currently. I suspect the answer might change when faced between commodity-defined money and fiat currency. These two have never coexisted. Why is it that people have routinely turned to commodity monetary standards in the wake of fiat collapses throughout history? Why has fiat currency only been implemented coercively? These are clues. I’m simply exploring the topic (among others) and writing up what I find.
The thing about a good institution is, there won’t be a single point of failure where one entity alone (a bad bureaucrat or a bad branch of the bureaucracy) can overturn it. But if an entire society becomes filled with corruption, I doubt having a commodity currency alone would be enough to save its economy, nor has that been true historically.
Commodity-backed currency and fiat currency have co-existed in a number of times and places in history and people have exchanged freely between the two. Example: Bank of Amsterdam florin (a fiat currency since late 17th century) was widely accepted all over Europe at the same time as the gold-based currencies of other European countries, held its value well, and it wasn’t only people under Dutch rule who accepted it. The Swiss Franc has been tied to gold until very recently, becoming fully fiat only as late as 2000. That certainly didn’t kill the dollar, yen, and other popular world currencies. Other examples could be multiplied, if needed.
Agreed. A commodity currency is no savior as some in the crypto-sphere believe. Good institutions are political issues requiring political solutions (as discussed here). My coexistence comment with respect to fiat and commodity currency related to within the same country. Governments give fiat currencies utility value by decree. So long as people deem those governments trustworthy and stable they can (and have) been used successfully, as noted in the article. Fiat currencies are simply more prone to catastrophic failure due to the acceptance risk I note in the article. Note that representative currency (i.e. convertible into gold, for example) is more risky than commodity currency for this reason too.