Economics encompasses two realities, the explicit and the implicit. The explicit is visible, obvious, recorded, and quoted. Explicit expenses are paid to others and recorded by accountants. The explicit is also called “nominal,” since that is what is named. For example, nominal interest is what a bank says it is paying, and the money it pays to depositors.
But there is also an implicit realm that is also real. Indeed, the implicit is more real than the explicit. What is explicit is often merely the superficial appearance. But things are often not what they appear to be. The reality beneath is implicit, not visible, not quoted, and not recorded, yet it is the true reality. Economists often use the adjective “economic” to designate the real thing in contrast to the explicit number or the accounting data.
An enterprise has explicit and implicit expenses. The explicit expenses are recorded by bookkeepers and accountants. The implicit expenses are non-recorded opportunity costs, such as what the owner of a business would have earned elsewhere, or what the assets of the firm would yield if sold and converted to bonds. The real cost of oil is not what the buyer pays but also includes the implicit costs of pollution damage not paid for by the customer.
Real interest is the nominal interest minus the inflation rate. Economic profit is accounting profit minus implicit expenses. Real GDP is nominal GDP (in current dollars) adjusted for inflation. Economists deflate prices and include implicit costs to get at the implicit reality.
Land rent is another implicit reality. The economic rent of land is the difference in the value of the output of a plot relative to the output at the least productive land in use. This rent is also the payment for the use of land at which the quantity of land available equals the quantity demanded by users. This implicit rent can be different from the explicit rental payment a tenant pays to a landlord. If the explicit rent payment is less than the economic rent, then the tenant is receiving the rest as implicit rent.
We can apply the explicit and the implicit to money also. Explicit money is the currency and bank deposits we use for transactions. Prior to World War I, in much of the world, explicit money was gold. Paper currency was a money substitute convertible into the real money, gold. Money substitutes such as traveler’s checks are explicit.
Today, governments and their central banks issue paper currency not convertible into gold, thus fiat money, based only on law and custom. Yet many governments also keep substantial amounts of gold. Why?
Because the cost of production of fiat money is basically zero, and so the value of fiat currency can ultimately fall to zero. Witness the currency of Zimbabwe, which has experienced hyperinflation. Governments and their central banks hold gold because it is implicit money.
Even though gold now is not used explicitly to exchange for goods, gold could be so used. Gold is a quite liquid asset, readily converted into currencies or readily exchanged for goods. Gold is a better store of value than fiat currencies such as the US. dollar, which have been subject to continuous inflation. Gold does not default, and gold does not go broke. Gold does not rust or deteriorate with age. Gold holds much value in a small volume.
In a financial crises or economic collapse, gold will still have value. If you want an asset that will have value one thousand years from now, you could not do better than gold. A plot of land may have value today, but not tomorrow if that location has gone bad.
A good currency is one that you can carry in your pocket. Some reformers have proposed commodities such as bricks or electricity or land as money. Good luck carrying bricks to the store! A good currency is one that one cannot cheaply make more of, as is the case with bricks or electricity. Land is fixed in supply, but you can’t put it in your pocket to carry to the store. You could say to the store owner, “I have a quarter acre of land in Vermont that I want to pay with.” Good luck with that.
You could try to base money on an hour of electricity, but if the government issues huge amounts of currency convertible into electricity, there would be so many notes that it could never all really be converted, so both the notes and electricity would trade at a discount relative to other goods. If you can’t carry it in your pocket, it is not good money, and the market will come up with an implicit currency that can be carried, such as gold.
Gold has natural properties that make it suitable to use as money, which is why the world moved to a gold standard prior to World War I. Governments prefer fiat money, because they can expand it at will, yet they hold gold because it retains value, and they can exchange it for goods when squeezed by circumstances. Its potential and eternal exchange value makes gold eternally and universally the premier form of implicit money.
[Editor’s note: this essay first appeared on Dr. Foldvary’s blog, the Foldvarium, on June 20 2010]