Those who are “hard money” advocates like to refer to gold and silver as real money. They see paper currencies as false money, of course, or at least those that are not backed by gold, which includes all the currencies of developed nations now. This is a very limited view, and in the end, money is as valuable as people make it.
It’s true that the dollar was at one time backed by gold. It is also true that if a currency is fully backed by gold a government or central bank cannot manipulate the money supply so easily. Contrary to popular myth, though, this does not guarantee the value of a currency, nor are all the effects of such a system good.
For example, if a currency is based on gold, and there are major gold discoveries, the value of such “real money” would drop because of the new supply. In fact, imagine if science found a way to easily and cheaply extract the gold atoms found in sea water. We could see the supply expand by a factor of ten very quickly, thus destroying most of the value of a currency based on gold.
Furthermore, an expansion of the money supply is difficult when it is limited by the gold a government or central bank holds. This may at first glance appear to be a good thing, but it isn’t necessarily so. Economies expand as more real goods are created, and if the money supply doesn’t also expand, the prices of everything drop over time. Some people might like this, but not owners of real estate and other assets. In fact, prices did drop for decades in the late 1800’s, exactly because the money supply could not be easily expanded when based on metals. As you can imagine, there would be some problems getting loans on homes and land if their values were always falling.
Is Paper Money Just a Confidence Game?
It is commonly said that paper money or “fiat currency” only maintains its value as long as people have faith in it. That sounds very precarious as a system. On the other hand, the same can be said of gold or silver. After all, you cannot eat them, and few people have personal uses for these metals other than as investments. In fact, although both metals have real uses in industry, and so have some real value beyond just monetary, much of the nominal value they have is only because of the faith people have in them. Take away the investor demand for gold and the price would plummet, even though it would still have its industrial uses (silver is actually more useful and so the price doesn’t rely as much on investor demand).
Now, it’s true that as a perceived value, gold has done better historically than most currencies. We have much more confidence that others will want our gold in the future than in others wanting our dollars or pesos or rubles. But this does not mean that paper currencies are destined to fail, even if most do.
Consider our current situation. As the Federal Reserve monetizes the government debt, effectively creating more money than ever in history, we are likely to see inflation eat up the value of the dollar. On the other hand, this is a choice, and is not inevitable. They could choose to be responsible, or future laws could prevent such irresponsibility. And if the supply of money is grown at a reasonable rate (in line with economic expansion), we have no real reason to think that the dollar would become valueless just because it isn’t backed by precious metals or anything else physical.
Part of what keeps the value of a currency intact is the web of contracts denominated in that currency. You can’t pay your mortgage payments in anything but dollars, so you have to get some. The same is true for your other debts, and for the agreements among businesses. The trillions in contracts that are denominated in a currency assure some demand for that currency. Add to this the fact that by law you have to pay taxes in dollars, and you can see that even though you can talk all day about how our money is just worthless paper, you still want some.
Real money is whatever people readily accept in exchange for real goods. And although a currency backed by gold might seem much safer and less prone to the manipulations of an irresponsible government, such irresponsibility makes any money suspect. After all, how would we know if the gold was really there? With or without precious metals or other things backing it, a responsible government could maintain the value of any paper currency if it decided to. That responsibility is what makes a sound currency, not the gold or silver promised for the bills.