April 27, 2015

One of the criticisms of the current monetary system is that the money isn’t backed by anything. However, while there are some big problems with the current system, this criticism isn’t valid. The reason is that money is never backed by anything.

Taking the specific case of the US dollar, the view that the US$ should be backed by something and the related view that the absence of backing implies a major flaw is a hangover from the Gold Standard. Under the Gold Standard that existed in the US prior to the early-1930s, a US dollar represented and was exchangeable into a fixed amount of gold.

The critical point is that under the Gold Standard the US$ wasn’t money; gold was money. The US dollars in circulation were receipts or IOUs that entitled the bearer to a certain amount of gold (money). The dollar itself wasn’t money. At most, it was a “money substitute”.

Today’s paper dollars are not IOUs or receipts. They are not “money substitutes”, they are money proper. Consequently, they do not need to be backed by anything. In fact, if they were backed by something then whatever was doing the backing would be money and the dollar itself would be a money substitute rather than actual money.

The situation isn’t as clear with regard to dollars in bank deposits as it is with regard to paper dollars, as the dollars in bank deposits are backed by the promise of the banking system to convert from electronic to paper on demand. It could therefore be argued that electronic dollars in bank deposits are money substitutes rather than money, although it is reasonable to count them in the money supply because the central bank has the ability to meet any demand for the conversion of electronic dollars into paper dollars.

The fact that today’s money isn’t backed by anything is therefore not the problem. If gold were money then the money also wouldn’t be backed by anything. That’s the nature of money. The problem, instead, is that for something to be GOOD money its supply should be fairly stable and it should be widely perceived to have value outside its role as a medium of exchange. The US dollar and all of today’s official monies fail to meet either of these requirements, whereas cryptocurrencies such as Bitcoin fail to meet the second requirement.

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