Why Gold (and Silver) Standards Don't Work: Part III - Human Meddling

A few posts back I noted that, originally, "standards" were just official exchange rates. Here I want to quickly elaborate upon why the real world market gets skewed when humans try to fix these rates.

Let's create a simple example. It's the ancient world and copper is one hundred times more abundant than silver. Making the real world market value of an ounce of copper equal to 1/100th of an ounce of silver.

(I'm just using simple numbers here to make things easier. Also, of course, prices aren't just a reflection of relative scarcity. Usefulness and desirability play a part. If a new invention comes along that requires lots of copper, the market value of copper might go up in relation to silver regardless of abundance.)

Anyway, in this simple example, one ounce of silver is worth about one hundred ounces of copper. Naturally, however, this real world value fluctuates.

So, to simplify the complex world (just as I'm doing here with this simple example), a state - let's say an ancient empire - might set an official rate for the purpose of tax collection or issuing coinage.

They then decree: "One ounce of silver is equal to one hundred ounces of copper."

Now, as long as the real world values don't stray too much from this official statement, things work okay. But once the real world market moves too far things start to break down.

Let's say more copper mines are discovered and more copper floods the market. Lowering the value of copper. Perhaps shifting the real world value from an ounce of silver being equal to approximately one hundred ounces of copper to one ounce of silver equalling approximately one hundred and twenty ounces.

This would then mean that the official decree - the official exchange rate - would need changing to reflect this changing reality. However, doing this is often difficult and unappealing, as it might mean having to change the entire system of coinage.

For example, let's say when the ratio was 1/100, copper coins were minted with this value stated on the actual face of the coins. A one ounce copper coin being labelled as being worth 1/100th an ounce of silver. (Similar to how one hundred pennies are stated to equal a pound, or one hundred cents equal to a dollar).

Originally, when the real world ratio of copper to silver was approximately 1/100, this reflected reality. However, as the value of copper goes down this stops being the case. Now the real world value is 1/120, but the coins are still pegged or labelled as 1/100.

When this happens the copper coins cease to be traded as pieces of actual copper and effectively just become tokens (or IOUs) that happen to be made out of copper. Each coin promising the holder 1/100th an ounce of silver, regardless of the physical value.

So, the state - our ancient empire - is officially stating that one hundred one ounce copper coins can be exchanged for one ounce of silver. Even though, in reality - on the open market - one ounce of silver is actually worth one hundred and twenty ounces of copper. So the state is trying to force a false reality onto the world.

And, as the state has the power to issue currency and force people to pay tax in that currency, people are forced to accept it.

(For the record, this isn't necessarily out of malice, or even greed. It's largely just a consequence of humans trying to impose order on a complicated world. Take the current UK government capping bus fares at £2, for example. Then having to increase this cap to £3. Sooner or later reality catches up, and someone has to pay the real world cost.) 

It's once rates become fixed in this way (i.e. become decoupled from actual reality) that the "standard" becomes a standard as we would think of one today. Where everything is pegged to that one commodity (be it gold or silver), and all coins (or paper notes) made of anything else, just become tokens promising payment in that one commodity.

Meaning you end up with situations where the actual value of the metals in the coins bears little resemblance to the face value. Where everything gets skewed by the "standard." Including the commodity used as the standard itself.

So, money started to break down long before the modern era of fiat currencies and digital/paper dollars. It's been a slow eclipse over centuries. Perhaps millennia.