There's a tendency to throw around the term Sound Money without really knowing what it means, so here's a primer on what it is, where it comes from, and why it matters.
What is Sound Money?
Sound money is a money that has an iron-clad monetary policy that cannot be changed by governments, central-banks, or other entities.
In other words, the supply is fixed, meaning nobody can produce more of it -- or much more of it in a way that is unpredictable -- even if the demand for it increases.
Sound money gains in value over time, meaning that holding onto it is likely to offer an increase in purchasing power.
Sound money is what the market freely chooses to be money, and what remains under the control of its owner, safe from government intervention.
One example of Sound Money is Gold. Another one, naturally, is Bitcoin. We’ll come back to this.
Unsound money, on the other hand, refers to money whose quantity is easy to increase.
Let’s take copper for example. If people move toward copper as money, copper miners may be incentivized to increase supply and bring price back down, which would unfairly hurt the people who are holding onto copper as a store of value.
Gold, on the other hand, is sound money because even if the price of gold increases drastically, it is very hard for gold miners to increase the supply of gold in the world. Gold only increases at ~1.5% of existing stock per year, and the highest rate of new supply in past century was ~3%. Therefore, gold serves as a good store of value in the long run.
The US Dollar is not only unsound because it can print more whenever it wants (although that alone makes it quite unsound), but also because, due to fractional reserve banking, for-profit banks are able to lend out 10x their reserves and effectively print non-existent money out of thin air.
Why is Sound Money important?
Sound Money has very positive second order effects.The better the money is at holding its value, the more it incentivizes people to save money. While this is bad news for Keynesians (more on this in a future post), it enables people to dedicate resources for future production, which leads to more capital accumulation and an improvement of living standards.
A counterexample to Sound Money is the Venezuelan Bolivar. Venezuelans do not believe the currency will hold its value over time so it doesn’t make sense for them to hold savings in bolivares. So, as a result, they spend more, save less, and thus accumulate less capital in the future.
Here’s a quote from Saifedean Ammous' The Bitcoin Standard which sums it up nicely:
“Sound Money allows people to make rational calculations about their future wants and need. Unsound Money warps and distorts this calculation. Imagine trying to measure and build a table from scratch, but every time you tried to measure a piece, the definition of "1 inch" changed.”
Indeed, Sound Money is important because of what it is not — Unsound Money.
Unsound money is a money whose supply and monetary policy can be changed by centralized actors — typically governments.
Unsound money is a compounding problem: Having the ability to print money increases the power of any government, and, while some people believe that governments can self-regulate, governments typically look for anything that give them more power, not less.
The resulting inflation that comes from printing more money, in effect, takes wealth away from people who produce it and gives it to people who control of money without actually producing things valued by society, and, most insidiously, it does so without citizens knowing they are doing it!
In other words, governments can do whatever they want: confiscate, inflate, reward nepotism, and finance trillion dollar wars — all while hiding the costs via printing money. At first the citizens enjoy the newfound services -- but they suffer the consequences later as they witness their wealth and purchasing power evaporate.
Sound Money, however, keeps governments in check: With sound money, they can no longer borrow from tomorrow to finance wars or fund short term political objectives at the expense of long term wealth.
Indeed: In order for government to finance its objectives, they have to tax their citizens, which means they rely much stronger on the consent of its population, whereas with unsound money they could just hide the costs.
The costs of unsound money in politics are particularly harmful: It creates an arms race where politicians are promising more and more services and no one is incentivized to promote restraint, lest they not get elected in the first place.
But perhaps most dramatically, Unsound Money has consistently led to war.
How? Unsound Money distorts the value between countries and makes trade flow a political issues, worsening relations between countries. Sound Money means that governments have to tax their citizens in order to go to war, which means citizens will a lot more thoughtful of the costs. With Unsound Money, war is much easier to justify.
Had European nations remained on the gold standard, history might have been different. Perhaps WWI could have been settled militarily within a few months of conflict.
We’ve been covering Sound Money, but notice we haven’t been spoken at all about payments, or microtransactions. Sound Money is about much more than the ability to buy coffee at Starbucks. It’s about the ability to save and invest with confidence, instead of feeling pressure to borrow and consume. It’s about the ability to check one’s government from financing wars by printing money. It’s about the ability to hold billions of dollars of wealth and sleep soundly knowing it won’t be inflated or confiscated. Ultimately, that's what it means for a money to be sound.