Money is the modern economy's essential lubricant. But for money, there is only barter trade—and poverty.
Money is anything that is widely accepted as a means of settling a debt or paying for a good or service, simply because it can be similarly passed on. Even unopened packets of cigarettes or bags of sweets have been used as money in extremis.
An unexpected shortage of money can cause recessions or depressions, yet too much money can cause inflationary booms that end painfully. Even modest inflation is a stealth tax on money holdings.
Governments, having monopolised the printing of money, must decide how much to print. That can be a difficult choice, particularly at times of financial stress.
Governments tend to print too much money, unless constrained by non-inflationary arrangements backed by public opinion. Printing more money creates the illusion of greater prosperity. Shrinking the amount of money in circulation is seldom an attractive political option.
Governments found it hard to generate inflation when money had to be backed by gold. Britain adopted the gold standard in 1717 and the US sustained the value of its dollar at US$20.67 per ounce of gold between 1834 and 1934.
But neither country could sustain the gold standard when spending pressures got too great. Britain abandoned it in 1914, the onset of World War I, taking Australia and New Zealand with it. The US devalued its dollar to US$35 per ounce of gold in 1934, amidst the Great Depression, and suspended convertibility entirely in 1970, amidst big fiscal problems.
Two statistics illustrate the inflation that followed these abandonments. First, New Zealand's Consumer Price index (CPI) in March 2014 was 75 times higher than in June 1914. Second, in March 2014, the price of gold averaged US$1,385 per ounce, roughly 67 times its pegged value prior to 1934 and 40 times greater than its pegged value between 1934 and 1970.
New Zealand was slower to curb inflation than the United Kingdom (under Prime Minister Margaret Thatcher) and the United States (under President Reagan). But New Zealand led the world in 1989 in obliging its central bank to focus monetary policy on price stability. The result to date is encouraging. New Zealand's average annual rate of CPI inflation was 11.5 per cent in the 20 years to March 1989 and 2.3 per cent in the 20 years to March 2014.
However, political pressures to print more money in order to create the illusion of greater prosperity endure.
Loosely coinciding with this year’s election campaign, Insights is campaigning for economic literacy from A to Z. Coming up next week: ‘N’ for Nationalisation.