In an attempt to deal with the current cash crisis in Zimbabwe, parents of school children have been encouraged to become creative in their approach to making payments. The Minister of Education has recently suggested goats as one possible payment option. Another ministry official clarified this further, saying “Parents of the concerned children can pay the fees using livestock. That is mostly for rural areas, but parents in towns and cities can pay through other means; for instance, doing certain work for the school.” This is not be the first time that Zimbabwe has reverted to a commodity-based currency. In the 2000s, during hyperinflation, petrol coupons emerged as an alternative free market currency. But livestock is unusual.

Also, the talk of ‘other means’ suggests that Zimbabwe is reverting to a barter-based economy more than anything else.

But I guess it’s important to bear in mind that a commodity-based currency system is really just an advanced version of bartering.

Commodity-Based Currency: Bartering 3.0

So how do we go from bartering to a commodity-based currency?

Well, like this:

  1. At first, everyone is running around, trying to find people to accept their produce in exchange for their produce. So if I gather berries, and I want meat, then I need to shop around until I find someone with meat who wants to trade for berries.
  2. But this is a bit of an annoyance. In this first version of bartering, everyone is constantly striving for the ‘coincidence of wants’. That is: “I want what you have, and I have what you want, and therefore, we can trade.”
  3. And when you multiply that out across a community, that gets cumbersome to manage.
  4. At this point, a solution starts to present itself. What if I can trade what I have for something that you want? Because then I’ve ‘pre-solved’ the coincidence of wants problem. Think of it as double-tiered trading: I might have to trade my berries for eggs, and then trade those eggs with you for meat. There’s an interim step. And this is Bartering 2.o.
  5. But this is still cumbersome.
  6. Idea!
  7. What if the ‘eggs’ part of that trade were something that almost everyone wanted? Because then you don’t necessarily have to ‘want’ the good yourself. As long as everyone wanted it, you’d be able to trade it on later.
  8. And now we’re at triple-tiered trading: I might have to trade my berries for iron, and then trade the iron with you for meat, and then you could use the iron to trade for whatever you wanted.

And ‘iron’ emerges as the freshly-minted commodity-based currency.

In the modern world, these versions of bartering would (I think) roll out incredibly quickly. Large market players (like significant producers) would provide a frame of reference for the commodity that gets selected. And given how large and ubiquitous the requirement for fossil fuels is in a modern economy, it’s not surprising that something like a ‘petrol coupon’ would become a significant currency-alternative.

What makes a good Commodity-Based Currency?

We normally talk about two things: the functions and the characteristics of money.

So first, the functions:

  • It should be a medium of exchange: in that people accept it in exchange for other things when they trade.
  • It should be a unit of account: in that people, while trading, refer to it in their pricing.
  • It should be a store of value: in that people can trade for it, and then use it in a later trade without too much change in relative value.

Well, when it comes to goats:

  • If a school accepts the goat as payment for school fees; and
  • The school can reasonably say that a term’s worth of school will set a parent back 2 goats (or whatever); and
  • The school can keep the goats, and use it to pay teachers later on…
  • Then goats are technically a commodity-based currency.

But then we need to talk about the characteristics of money:

  • Durable (ie. it lasts);
  • Portable (ie. easy to carry around and use);
  • Divisible (ie. you can break it down and use it for smaller payments, and then build it up again to make larger payments without any change in value of the whole);
  • Hard to counterfeit (ie. can’t easily be faked or copied);
  • Valuable (ie. generally holds its value over time); and
  • Generally accepted (ie. most members of a population will use it to trade).

And this is where the goat currency falls apart. Once you’re forced to pay for something with a leg of mutton, your goat just got permanently divided, with questionable durability.

It’s why metals so often end up as the commodity-currency of choice.

However

When it comes to commodity-based currencies, my feeling is that there is another underlying characteristic that doesn’t really get enough attention.

To illustrate this, I want to stick with the goat example. But I want to re-emphasize something about the way that commodity-based currencies emerge. As I said earlier, the commodity that emerges as currency always has its own ‘value in use’. So the commodity has its own market already. To go back to that earlier example, people use iron to make pots and weapons. And the ‘value in exchange’ part only comes about once everyone starts using it to trade. This new value overlays its original usefulness: which is part of what caused it to be universally accepted for trade in the first place.

So bearing that in mind, let’s talk about the goats. If goats were generally accepted as a currency, then goats would have two uses:

  • they’re tasty to eat, as well as giving milk for making cheeses, etc (the primary market); and
  • they’re useful for buying other things (the money market).

And that seems cool, right?

Changes in the Primary Market…

Now let’s say that there is a drought, and goats start to die off (partly because there’s not enough food for them, and mostly because people are eating a lot more roast mutton in the absence of alternatives).

What starts to happen?

Well, goats suddenly become very expensive. Which means that everything else suddenly becomes very cheap.

As an example, let’s say that you could originally exchange a goat for a microwave. After the famine, you might only exchange a goat for two microwaves, because it’s not worth starving for less. But because everything is priced in goats, this should be rephrased as:

“Microwaves available at rockbottom prices! 50% discount – was priced at one goat, now available for only half a goat!”

That is: prices of everything else fall (in goat terms).

That’s deflation, guys

And if the famine extends, you end up being unable to trade the microwave at any price, because goats have become so rare and valuable.

Perhaps that sounds like a good thing – but deflations are depressing. People can’t trade. Jobs are lost. Salaries don’t get paid. The economy freezes until:

  1. either all those prices and salaries adjust; or
  2. the famine ends, and more goats are bred to match the original money supply levels.

So the problematic conclusion: if you have a commodity-based currency whose primary market is vulnerable to demand and supply shocks, then your entire economy is going to be regularly rocked by monetary problems.

And gold (or any other metal) is no different. When there’s a gold rush because new gold reserves are found, gold floods the market and causes inflation. If there’s a sudden market craze for thick gold jewelry, then the primary market bids up the price of gold, causing deflation for the rest of the economy.

The road to fiat money

This problem with commodity-based currencies is part of the reason why we ended up with ‘fiat’ money (or unbacked money) in the first place. Where there is no ‘primary’ market for the currency, then the currency is theoretically not susceptible to these types of demand and supply shocks.

Of course, we’ve done a fairly good job of developing primary markets for fiat money. We currency-trade, where we buy and sell fiat currencies in relation to themselves. And we have debt markets, where we buy and sell fiat currency in relation to future flows of fiat currency. And when those primary markets break down, we get economic crises.

But even though that happens, I think that we must be careful about concluding that the problems with fiat money would disappear if we reverted back to commodity currencies. In some ways, it’s almost as strange an idea as trying to trade today in goats.

Which is a terrible idea, however you spin it.

But perhaps that’s just me.

Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.