What is “sound money?” The simple answer: a monetary system that best promotes coordination between market agents. Every economist advocates “sound money;” the disagreement is over what exactly constitutes a good monetary system. This is where the issue becomes much more difficult, because we enter the realm of monetary institutions. But, there are some who want you to believe that the problem is much simpler than it actually is. Some of these people are the same who advocate a return to a commodity money (e.g. gold, silver,…).
Will a return to commodity money end the business cycle? Would it end inflation? We can point to the period of U.S. history between, roughly, 1879–1893, and try to answer in the affirmative. After all, that was a period of strong growth and slight deflation (although, there were recurring banking crises). On the other hand, we could just as easily look at just about every other period of history and answer ‘no.’ The European “price revolution” (~1500–1650), for example, is thought to be caused by the large inflow of New World gold and silver. Likewise, it was common for monarchs to debase their currency, whether via clipping, or by replacing valuable content with less valuable metals. So, no, reverting back to commodities will not necessarily make our monetary system any more stable.
What makes, say, gold attractive as money, anyways? It has certain physical characteristics: it is physically scarce (relatively costly to produce), it is durable, and it is divisible, amongst other possible traits. Why do these characteristics matter? Because they help determine the rules that constrain the monetary system.
Suppose we are looking at two isolated societies, each with their own monetary standards. These systems are exactly the same, except for what they are using as money: one uses gold, the other bushels of wheat. We expect the former to outlive the latter. Why? First, wheat is relatively easy to grow, so it does not have that same production constraint as gold — the value of wheat, as money, is easy to drive towards zero. Two, wheat is not as durable. It can be stored, and modern storage methods have allowed us to keep it around for longer, but it doesn’t have the same durability as gold. If the value of wheat is low enough, it would also take a lot of it to buy certain products. These are all factors that determine the rules of the game, or monetary institutions.
What really makes one monetary system better than another, then, are the institutions that constrain it. This should re-frame the terms of the debate, because now we know that what really matters are these rules. And, we can’t just look at some rules over others; we have to consider these institutions in their totality, and how they interact. For example, if the currency is in some way controlled by an extractive government, even if this currency is gold, we can expect a sub-optimal monetary system. Yes, even with commodity money, certain institutions can ruin the game, so to speak.
Another bad rule that could fit with a gold standard — or commodity money, more generally — is full reserve banking. Forcing banks to keep gold in their vaults that they would otherwise somehow get rid of is sub-optimal; that society is forgoing a better use of that gold. Similarly, by constraining a banking system’s ability to expand their liabilities when the demand for money increases, we forgo the opportunity of inter-mediating between a certain group of savers and a certain group of spenders (whether investors or through consumer credit). Finally, a banking system that cannot respond to changes in the demand for money will cause macroeconomic instability.
Despite all the benefits to using certain commodities as money, these benefits alone do not guarantee that they will be “sound money.” You also need good man-made institutions, or additional rules that constrain the monetary system. These rules evolve over time, and in different directions.
One direction is central banking. The Federal Reserve arose to re-write some of the rules that constrain the banking system. Primarily, it serves as the most important clearinghouse, with the ability to expand and contract its liabilities to service its member banks. During times of crisis, a central bank also acts a lender of last resort — a role private clearinghouses also fulfilled. Those who believe that, without a central bank, an economy can be stuck in monetary disequilibrium for long periods of time also advocate for central banking, because it allows for an elastic money supply even in the worst macroeconomic conditions. Of course, central banks — and their rules — evolve over time. One example of this is the general preference for independent central banks, because this weakens the ability of the few to manipulate the money supply at the expense of the many.
Another direction is “free banking,” which refers to financial institutions that arise through a decentralized process of change. This is not all theory; we have seen episodes that come fairly close to completely free banking. This monetary system is still regulated — it is still constrained by rules —, but these rules arise through a decentralized process. Competing systems might have competing rules, and good rules replace bad rules through, for instance, profit and loss. More concretely, if clearinghouses develop sets of rules that they enforce over member banks, separate clearinghouses and their bank networks will compete against each other. Good rules promote a healthier industry, which usually means greater gains, at least over some period of time (a bank that commits fraud might make a high profit at first, but they will certainly lose customers as people catch on). Bad rules promote losses, creating an incentive to replace bad with good.
What’s important here is that what improves the monetary system are rules. Some of these are innate to the type of money being used. But, these institutions might not be strong enough as the market becomes more complex, money is inter-mediated, the pricing process becomes more complicated, et cetera. This is why man-made monetary institutions are ubiquitous: they are experiments to improve monetary systems. In other words, the quest for “sound money” is really a process of developing sound monetary institutions.
Where does this leave commodity money? Many free bankers do advocate commodity money, along with inside money of a form dictated by the market — classically, we usually think of paper money when we think of “inside money,” but it could just as well be “e-money.” But, we should be open to the idea that maybe commodity money is no longer optimal, because of the other institutions that regulate the monetary system. It could very well be that a modern banking system would prefer alternative safe assets as “outside money,” and that gold is antiquated. In any case, when answering “what is sound money,” gold, or silver, or commodity money are not right answers — what matters are institutions, and monetary rules have developed since the 19th century, so returning to a 19th century monetary system is retrogressive.