Money only has value because other people think it has value. Other people can think money has value because it can be exchanged for something generally recognized to be valuable (gold) or because they believe that other people believe that it has value (dollars and almost all other currencies are like this). The problem with the later “monopoly” money system is that governments can print out more money whenever they get into debt. Think of it like an “IOU from the government” that everyone accepts. When this happens there is more money floating around able to buy stuff so people are willing to pay more for stuff so prices go up.
So is the government being able to print out money backed by nothing but a promise ever a good idea? Most non Austrian school economists (those that follow the Mundell-Fleming model etc) think that it can be. Occasionally people may switch from the normal state of save a little, spend most, borrow a little to one of two other states. The inflationary state of spend a lot, save a little, borrow loads. The deflationary state of spend a little, save a lot, borrow very little. It might be irrational for people to live in these two states but one individual will find it difficult to swim against the tide. In fact when other individuals move the economy to one of these states it is in the individuals interests to act this way too. The advantage of being able to print or burn money when you want to is that this change in the money supply can move the economy from one of these strangely attractive undesirable states.
There are problems with backing a currency by Gold.
1. Gold was very useful when you wanted something small you could hide from rampaging Vikings. In a world where Vikings have quit their rampaging and now sell us flat pack furniture some unit of wealth that fits more the needs of today’s society might be useful
2. Everyone hording their gold seems strangely reminiscent of Scrooge MacDuck swimming in gold coins crossed with Humphrey Bogart in Terror in the Sierra Madre.
3. Gold is useful for making overpriced audio leads and Jesus pieces. It does have an intrinsic value for making things and this leads to the employment of jewelers and such. If we lock away all our gold it cannot be used to clad rappers out in bling.
4. When a currency becomes backed by gold, gold will rise in price. So a load of people will go out and start digging up gold. These people could better use there time creating something that had an intrinsic value that was not altered by it being used to back the currency.
I hope we have moved away from an economy of fear (of Vikings) and hoarding to one where we can value things based on what they cost to produce. I will discuss backing a currency by the unit of production (the kilowatt) in the next article.