The Inconveniences of a Debased Currency

February 22nd, 2011
in Op Ed

cigarettes.jpg by Dirk Ehnts

Lately, there has been a lot of talk about the debasement of ‘our’ currency, which in this case refers to the US-dollar. I believe that the people who use the term ‘debasement’ or ‘debased’ (dollar) have little knowledge about monetary economics. Here is an extract of a text called The Economic Organisation of a P.O.W. Camp by R. A. Radford, Economica, vol. 12, 1945:

Follow up:

The cigarette currency

Although cigarettes as currency exhibited certain peculiarities, they performed all the functions of a metallic currency as a unit of account, as a measure of value and as a store of value, and shared most of its characteristics. They were homogeneous, reasonably durable, and of convenient size for the smallest or, in packets, for the largest transactions. Incidentally, they could be clipped or sweated by rolling them between the fingers so that tobacco fell out.

Cigarettes were also subject to the working of Gresham’s Law. Certain brands were more popular than others as smokes, but for currency purposes a cigarette was a cigarette. Consequently buyers used the poorer qualities and the Shop rarely saw the more popular brands: cigarettes such as Churchman’s No. 1 were rarely used for trading. At one time cigarettes hand-rolled from pipe tobacco began to circulate. Pipe tobacco was issued in lieu of cigarettes by the Red Cross at a rate of 25 cigarettes to the ounce and this rate was standard in exchanges, but an ounce would produce 30 home-made cigarettes. Naturally, people with machine-made cigarettes broke them down and rerolled the tobacco, and the real cigarette virtually disappeared from the market. Hand-rolled cigarettes were not homogeneous and prices could no longer be quoted in them with safety: each cigarette was examined before it was accepted and thin ones were rejected, or extra demanded as a make-weight. For a time we suffered all the inconveniences of a debased currency.

The problem here is that money is not homogeneous any more. One cigarette can differ from the other in weight, and it is not easy to spot the difference between the two. Therefore, transaction costs rise since you have to examine the money more closely before you accept it.

In today’s world, the amount of dollars is inflated not by changing the size of the dollar bills (or coins), but by creating more and more ‘real’ dollar bills. This money is put into the financial system when the Fed uses it to buy bonds or other assets from the financial sector.

The main difference here is control: while in debasing a currency you have mostly criminal behavior which causes huge transaction costs to business, inflating a currency is perfectly legal and creates no such transaction costs to business. Whether a central bank should engage in such activities is, of course, a different question, which I will not tackle at this point.

To conclude, let me point out that inflating or deflating a currency leads to shifts in the distribution of wealth. In the short run, inflation is good for debtors, who can pay back more easily when prices (and wages) have risen. Deflation is good for creditors. The use of a monetary policy that shifts wealth from one group to another is an important issue. The reason it is used is that apparently some wealth has eroded, and those groups that the burden would have fallen upon have dodged this.

It is the misallocation of capital in the last years up to the crisis that is ultimately responsible for the financial crisis. Some assets that were considered as wealth turned out to be no good. Now the loss has to be distributed among the groups of society. This is done via monetary policy, since US politics does not allow for higher taxes or lower government spending, which would ultimately allocate the burden.

Those complaining now about the opaque monetary policy seem at times to be identical to those that think that neither higher taxes nor lower government spending are possible. It is the same in Europe, where the losses are also not allocated. The political side of this is quite clear: lots of wealth has turned out to be an illusion – so the messenger will be ‘killed’ by the angry electorate. That is why the messenger is still looking for a sneaky route, even if it takes much longer.

Dirk Ehnts small Dr. Dirk Ehnts is a research assistant at the Carl-von-Ossietzky University of Oldenburg (Germany). His focus is on economic integration and economic geography, covering trade, macro and development. He is working at the chair for international economics since 2006 and has recently co-authored a book on Innovation and International Economic Relations (in German). Ehnts has written at his own blog since 2007: Econblog 101Curriculum Vitae.

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