"If we want to have money, it must be something that
cannot be
increased with a profit by anybody, whether government or a
citizen.
The worst failures of money, the worst things done to money
were
not done by criminals but by governments, which very often
ought
to be considered, by and large, as ignoramuses but not as
criminals."
-Ludwig Von Mises, speaking at
the Foundation for
Economic
Education, November 8, 1969.
Most people who write about money and banking nowadays
from a free-market perspective criticize the Federal Reserve - and
rightly so - for contributing to uncertainty by alternating between
expansion and contraction. They point to the Fed-induced monetary
manipulations that have led to the boom-bust business cycle. They
criticize especially the Fed's arbitrary contractions of 1929-1933 and
1936-1938, which resulted in economic downturns and were alleviated only
when monetary expansion resumed. They fault the Fed for sitting on its
stockpile of gold and for not using it as a basis for further expansion.
They object to the Fed's inconsistency, alternating between easy credit
one moment and tight credit the next. At the root of their criticism
there appears to be a belief, however, that a continual expansion in the
quantity of money is not only desirable but also necessary for an
economy to prosper.
As an alternative to national control of the monetary
system, these free-market critics of the Fed would prefer private
banking. In their view, private banks would be well able to satisfy the
market's "need" for currency by issuing bank notes to satisfy the
demands of their clientele. Such issues of currency would hold no threat
of inflation, they say, for the issues would necessarily be limited by
the competition of the issues of other private banks as well as by the
obligation of each bank to redeem its notes in real commodity money
according to terms agreed upon.
Private banks with the freedom to issue notes are
certainly consistent with free-market theory. However, by starting from
the premise that the very purpose of free banks is to issue currency, it
would seem that the advocates of private banks ignore basic economics;
they fail to consider, first, what market money is and, second, the
basic role of banks in a free market.
Money is not a piece of paper with a dollar sign
printed on it; money is basically a medium of exchange, something with
market value that market participants are willing to accept in exchange.
Second, banks are institutions dedicated to handling, safeguarding,
lending, and/or managing the funds of depositors, according to
agreed-upon terms. Emphasizing the note-issuing aspect of private
banking assumes (1) that the paper currency itself is money, (2) that
the economy "needs" a certain supply of readily available paper bank
notes, and (3) that a less-than-"adequate" amount of currency
necessarily leads to economic disaster.
Everyone wants more money - you, I, our friends,
families, employers, businessmen. It is not money per se that we want,
but purchasing power; we want what money can buy - food, clothing, and
shelter, of course, and also automobiles, televisions, computers,
medical care, travel, and entertainment. There is practically no end to
the wants we can satisfy if we have more money. Government too wants
more money to buy things - guns, planes, highways, and the ability to
pay its employees; it wants to provide health care, to take care of the
poor and the elderly, to clean up pollution, to insure bank deposits, to
give humanitarian aid to foreigners, to assist some foreign governments
militarily, and so on ad infinitum. There seems to be no limit to the
amount of money people would like to have.
Some people carry over into the field of economics the
idea that each of us would like more money in his own wallet or bank
account. They reason that if everyone would be better off if he had more
money, then it should follow that the more money in the whole economy
the more prosperous the whole economy would be. Some have even carried
this idea to the extreme and have recommended that the government
needn't collect taxes at all but may simply print all the paper money it
wants, and hand it out to people on the theory that their spending will
then bring prosperity. Of course, if this idea were really put into
practice, the printed money would soon be so plentiful that it wouldn't
be worth anything on the market; it would no longer be serviceable as a
medium of exchange, and thus, also, it would no longer be any good as
money. Producers would stop producing and there wouldn't be anything to
buy - at any price.
Continually Increasing Money
Fortunately economists see through such proposals and
do not recommend the unlimited issue of paper money. However, many
persons, unfortunately, believe that for an economy to prosper the total
quantity of money in the economy must be continually
increased.1 They point to occasional monetary contractions
(deflation) in this country and claim that the economy began to pick up
only after the Federal Reserve began again to inflate. Deflation, they
say, must be avoided at all costs. And most people believe it is the
task of government and of the banks to provide the currency, to keep
prices relatively stable, and to prevent deflation.
Private banking, according to its advocates, would
eliminate violent monetary fluctuations. Private banks of course should
be free to issue currency, but their notes would not be legal tender.
Their paper notes would represent the medium-of-exchange-commodity on
deposit at the bank and would be redeemable by the bank at any time. As
such, their notes could become the community's money. But their status
as money would have to be earned; it would not result from the mere
issue of paper currency labeled "money." A private bank's notes would
have to compete with readily marketable commodities, as well as with
other bank notes, for acceptance as media of exchange. The bank would
have to persuade market participants that its notes had value on the
market, were generally acceptable to traders, and thus were reliable
media of exchange.
The method for introducing the bank's notes into
circulation and the interest rate it asked of borrowers would limit the
effectiveness of supply and demand in checking under - and over - issue.
For instance, a below-market interest rate would invite an increased
demand for loans, which the bank could satisfy only by expanding its
note issue; an above-market interest rate would discourage loan
applications and lead to contraction. However, it is true that the
bank's willingness to redeem on demand all its notes submitted for
redemption would prevent any over-issue.
The monetary problem that the advocates of free banking
are trying to solve, as described by modern monetary economists, is very
complex. But this complexity is not a consequence of the economics of
money. Rather it is caused by governmental, not economic, factors -
especially the designation of government's notes as legal tender for the
payment of debts. The complexity of the monetary situation is the
outcome of many regulations and controls. To analyze the problem and the
views of today's advocates of free banking, one must review some basic
economic principles.
Medium of Exchange
There is really nothing complex about money itself.
Money is simply a medium of exchange. Money came out of barter as a
result of countless purposive actions of individuals. As the development
of specialization and the division of labor expanded to encompass more
and more persons, it became difficult and cumbersome to exchange goods
for goods, that is, to engage in direct exchange, to barter. If Jones
wanted to trade his output for things to consume, he was not always able
to locate a would-be trader willing to take his goods and services in
exchange for the precise items he wanted. As a result, step by step,
Jones and other would-be traders discovered in time that exchanging what
they had for a more widely desired commodity would bring them one step
closer to a successful exchange.
Traders came to recognize, as the outcome of countless
voluntary exchanges, agreements, and contracts, that some particular
commodity could serve as a generally useful medium of exchange in their
community. Such a readily marketable commodity might be held for a while
and then used later when a suitable trading opportunity arose. Thus,
over centuries, perhaps millennia, money evolved. No government
conceived the idea; it came out of the market. The medium of exchange in
any community must be something that has market value, purchasing power.
If a commodity is easily available and free to every one, no one will be
willing to take it in trade for what he is selling. Such a "free good"
will never become a medium of exchange.
The availability of a medium of exchange was a big step
forward toward economic progress. The name given to it is "money." Over
millennia, many commodities have been used as money-gold, silver,
wampum, tobacco, cattle, and more. As a result of voluntary transactions
undertaken by countless traders over years, the various commodities used
as money were finally narrowed down to practically only one-gold.
Although we now talk about our paper US. dollars as if
they were money, we should never forget that whatever we use as money
must be something people will take in trade. Only its tradability, its
acceptability, assures that money is something you and I can exchange
for things we want. It should be "something that cannot be increased
with a profit by anybody, whether government or a citizen , " lest that
government or citizen take advantage of the situation to increase its
quantity until it loses its value as a medium of exchange.
However, we should not dismiss money as unimportant
because it is simply a medium of exchange. In today's world, almost
every interpersonal transaction depends to some extent on a reliable
money. It is essential for a viable economy. It facilitates trade,
calculation, and production. It enables entrepreneurs operating in a
finely specialized division of labor to estimate production costs,
calculate potential income, and anticipate future markets. It makes it
possible for entrepreneurs to carry out far-ranging and complex
financial transactions over long periods of time and across great
distances.
Strictly speaking, the government-is sued currency in
use today, the U.S. dollar, is not money per se. It is a
transmogrification of market money foisted on the people by force
through the legal-tender laws. It is a derivative of the commodity -
gold - that emerged over centuries as the market's medium of exchange.
Similarly, privately issued notes would have to earn their reputation as
reliable media of exchange to become accepted as money.
Banks and Banking
To understand money, it is important also to analyze
banks and their economic beginnings. Banks originated as market
custodians for funds entrusted to them by depositors. They soon began to
serve as middlemen to help arrange financial transactions for customers.
A bank's assets consisted of the funds left with it for safekeeping and
money entrusted to it for managing and/or lending. If banks lent funds
left with them for safekeeping they did so only at the risk that their
depositors, who expected their money to be kept safe and available on
demand, might ask for it and find it gone. However, experience taught
bankers that all depositors would not ask for all their money at the
same time; so a bank could lend a portion of these funds - if it was
careful. The bank knew that the rate of interest it asked could
influence a person to borrow more or less. If the bank lowered its
interest rate, it could expand its currency issue and lend more for its
own profit. But lending more increased the bank's risk. It always
realized that such over-lending might be discovered and it would then
have to make up the shortfall from elsewhere or face bankruptcy.
It is argued that expanding credit to lend more money
promotes prosperity because it puts money in the hands of businessmen
who can use it to good advantage. This argument depends on considering
the "seen" and ignoring the "unseen." It ignores the fact that new
credit over and above the available supply of savings can be granted
only by issuing loans at below-market interest rates. This means
expanding credit artificially. Those who benefit from the additional new
credit, created for the profit of the issuing bank, are helped; they
appear on the market ahead of others, bid up prices, and walk off with
their credit-financed purchases. Those who do not benefit from the new
credit, the savers on whose funds the expansion was based, are hurt. But
they are not seen. Not having received any of the new credit, they do
not become visible spenders; they are prevented by the beneficiaries of
the new credit from using their own money as they wish.
Banks are expected, of course, to lend the money that
savers leave with them for that purpose, sharing part of the interest
earned with those who furnished the funds. But even in such cases, banks
must be cautious. They soon learned from experience that the periods for
which loans are made must be coordinated with the dates when the money
lent has to be repaid to depositors. In other words, deposits that its
customers could claim on demand at any time must always be redeemable
from funds on hand. Funds to repay short-term loans must be financed by
credits that will be repaid by the end of the short terms specified. And
long-term loans may be financed by funds repayable to the bank over
longer periods. But those funds too must be back in the bank by the date
when they must be repaid to the depositors. For instance, if a bank's
short-term loans are backed by long-term mortgages, the bank would be in
trouble.
The Role of Government
Much has changed over the centuries since money first
evolved on the market and since entrepreneurs first opened banks to
serve the needs of persons who engage in money transactions. But the
basic economic principles remain the same. To serve as money, a
commodity must still possess widespread marketability as a medium of
exchange. And to remain in business private banks must still fulfill
their obligations.
Governments have become more and more involved with
monetary matters. It started when they were called on to settle disputes
that arose over contracts. Courts and judges were frequently asked to
decide whether the two parties to an agreement had actually complied
with the terms agreed upon. Suppose one person agreed to exchange
bushels of wheat for money of the realm, and the other agreed to pay a
certain amount of money for wheat. When the time came for the farmer to
deliver wheat and the buyer to deliver money, one or both parties might
object that the other had not complied with the agreement. It was then
up to the courts to decide. Was the wheat delivered actually the
quantity and quality specified in the contract? Was the money paid -
whether gold, silver, wampum, tobacco, dollars, or pesos - actually
"money" as called for in the contract? Only that, and nothing more than
that, the courts and judges had to decide.
Government's role in the field of money was soon
broadened. From the idea that courts must settle disputes over what was
meant by "money" in specific cases, there developed the doctrine that
money was whatever the government said it was. Governments took
advantage of this situation. They not only decreed what money was but
they expanded for their own profit the quantity of whatever they decreed
to be money. Then they compelled people to accept that money in trade by
declaring it to be legal tender for the payment of debts.
Counterfeiters try to piggyback for their own profit on
a community's money. A government does essentially the same thing. In
ancient times, governments clipped or adulterated their coins and then
compelled the people to accept them at their previous nominal value.
Later, with the invention of the printing press, it became easier to
debase the currency. The government could simply declare anything to be
money, even a piece of paper. Then government privileged certain banks
and protected them from bankruptcy if they printed bank notes for the
profit of the government over and beyond the gold or silver deposits in
their vaults. And the government gave these bank notes legal-tender
status. With the establishment of the Federal Reserve system in this
country in 1913, the monetary system of legal-tender paper bank notes
based on reduced gold and silver backing was formalized. In time the
U.S. government itself, through the Federal Reserve, assumed the
responsibility for issuing this country's currency. And these paper
notes enjoy legal-tender status today.
The redemption in gold or silver of legal tender was at
first discouraged and then halted completely. In 1933 it became
impossible for citizens to obtain gold for their paper money, and they
were eventually prohibited from owning any monetary gold at all. The
U.S. government even reneged on its own promises to redeem its bonds and
debts in gold. In January 1975, U.S. citizens regained the right to own
gold, but they are still compelled to accept the government-issued
legal-tender notes.
Throughout all the years since the Federal Reserve
Banks opened, the quantity of legal-tender money has continually
increased. And the market value, the purchasing power, per unit of this
money has continually declined, reflecting the subjective value that
individual market participants place on the dollar relative to other
goods and services.
Inflation: More Money or Higher Prices?
One reason for confusion over money results from the
changed definition of the word "inflation." Originally and traditionally
it meant an increase in the quantity of money and/or credit, and it is
so defined in Merriam Webster 's Second International Dictionary
(1954).2 Only in recent decades has the word been widely used
to refer to one consequence of a monetary increase: an increase in
prices. Granted, this new definition is now widely accepted, but that
does not make it correct or expedient. Not only does it leave the
language without a term for a monetary increase, but it shifts the blame
away from the real culprits to the victims. While the U.S. government
and the government-established Federal Reserve are responsible for
increasing the quantity of money for their own profit and hence for
causing prices to rise, it is the victims-businessmen, savers, workers,
investors, consumers, and so on - who are blamed for asking or paying
higher prices.
Now let us consider the Federal Reserve as "an engine
of inflation." Granted, it is difficult to compare the number of dollars
in circulation over the years. Statisticians frequently revise their
"money stock" estimates, even changing what they include. However, there
can be no doubt that there has been a tremendous increase in the number
of dollars since 1913 when the Fed was established. There was a
Fed-inspired monetary expansion from 1921 to 1929. In 1913, the
country's "money stock" (gold, coins, and notes) was estimated at $3.798
billion.3 On June 30, 1929, at the peak of the stock market
boom, this figure had more than doubled to $8.538 billion, representing
a substantial inflation. If market prices did not climb to the same
extent during those years, as most economists agree they didn't, it is
because the effect of the monetary increase on prices was hidden by
increased production, due to the initiative, innovation, and
productivity of entrepreneurs, creating a downward pressure on prices.
To return to the statistics, the money stock reported
on June 30, 1930, dropped slightly from 1929 to $8.306 billion, but by
June 1932 it had climbed to $9.004 billion. The Fed's figures show that
the country's money has been increased more or less steadily ever since,
bounding up especially during war years.4 By the end of 1998,
M2 figures came to $4,288.3 billion. And they continue to climb. If U.S.
prices have not risen proportionately, it is due not only to the
tremendous initiative, ingenuity, adaptability, and productivity of
entrepreneurs but also to the mushrooming demand by foreigners to hold
dollars - as their preferred medium of exchange - for their own security
and as a hedge against the potential loss in value from inflation of
their own country's currencies.
Being unable to trade in gold, and having long since
been compelled to accept the U.S. legal-tender dollars in payment of
debts, market participants have come to accept them by default as the
best available medium of exchange. Having no other realistic
alternative, entrepreneurs do their best to calculate their costs and
potential markets in terms of dollars. In making business plans, they
try to anticipate future fluctuations in the value of the dollar. And as
long as the Federal Reserve practices relative restraint, market
participants worldwide adjust and adapt fairly successfully. But in the
last analysis, the market value of the US. paper/credit dollar depends
on the judgment of fallible human beings who take into consideration,
among other factors the political climate, the interests and profit of
the US. government.
The Effects of Inflation
Supply, demand, and competition for the
medium-of-exchange commodity are determined by the subjective values of
market participants. This is true whether the medium is gold, a paper
substitute for gold, a paper note decreed by government to be legal
tender, or a private bank's paper note. Every dollar added to the
existing supply of money to which the market has adjusted has at least
three inevitable consequences: (1) it confiscates some wealth from
anyone who owns dollars; (2) it upsets the calculations of
entrepreneurs; and (3) it reduces purchasing power.
New issues of money and/or credit withdraw or extract
some value, some purchasing power, from every existing dollar asset,
whether in a wallet, savings account, bond, insurance policy, or debt
payable in dollars. The value of every person's dollar holdings shrinks
even as he sleeps. New issues of money and/or credit upset the
calculations entrepreneurs made in dollar terms, distorting production,
causing mal-investment, and setting the stage for a boom/bust business
cycle. Of course, holders of privately issued currency that does not
enjoy legal-tender status are not helpless; they may refuse to accept it
if it loses value and turn to some other medium of exchange.
When the quantity of money is increased, the new money
is passed from one person to another throughout the economy. But this
takes time. Every additional monetary unit created - whether by gold
miner, the printing press, credit expansion, or deficit financing
(monetization of debt) - goes to some individuals first. It necessarily
affects their value judgments, reducing in their minds the marginal
utility of each unit of money. Those who receive the new money or new
credit first benefit, feel more affluent, spend more freely, and are
willing to offer higher prices for goods and services. Their demand for
goods and services creates pressures on the market pushing prices
upward. The delayed and uneven effect on the market of an inflation
helps the early recipients of the new money at the expense of others.
Those who do not receive any of the new money until later are hurt; they
must pay the higher prices resulting from the pressure of the increased
demands of the early beneficiaries before they get any of the new money
themselves.
There have been many times in history when the value of
money has dropped drastically because governments have increased the
quantity for their own profit. One of the most dramatic cases is that of
the German mark after World War I. By 1923, the number of German marks
was increased by billions, the market value of a single mark fell
practically to zero. The marks still enjoyed legal-tender status.
However, they were no longer reliable and ceased to serve as money.
Creditors engaged in all kinds of subterfuges to avoid being repaid in
marks, and debtors tried various tactics to trick their creditors into
accepting payment in the depreciated marks.
Many other national currencies have suffered similar
fates in recent years - the Bolivian and Argentine pesos, the Russian
ruble, the Italian lire, the Thai baht, the Indonesian rupiah, the
Hungarian forint, to name a few. Such examples show clearly that there
can be too much money.
How Much is Enough?
Any quantity of money is adequate because prices will
adjust. Individual market participants, bidding and competing with one
another, will bring the purchasing power parity principle into effect.
They will bid more or less for units of money, and more or less for
goods and services, depending on their subjective values. The purchasing
power per monetary unit will tend to decline as the number of monetary
units increases. It will tend to rise as the number of monetary units
drops. In the end, the purchasing power per monetary unit will shrink or
stretch so that the total available quantity of money, large or small,
will suffice to purchase the available goods and services. Thus, any
amount of money is enough money, if it is not changed abruptly or
arbitrarily and if it is not made legal tender.
At the time of the original publication, Bettina
Greaves was resident scholar at FEE
1. This article was sparked by Professor Richard H.
Timberlake's three articles in The Freeman (April, May, and June 1999)
2. It defines inflation basically as a
"Disproportionate and relatively sharp and sudden increase in the
quantity of money and credit, or both, relative to the amount of
exchange business."
3. Statistics approximate, taken from the monthly
Federal Reserve Bulletins.
4. The Fed's monetary statisticians apparently took a
holiday in 1933 along with the banks. But they returned to the task
after the gold stock was revalued from $20.67 to $35.00 per ounce by
FDR's diktat. The value of the money stock as of December 3. 1933
($17.470 billion) reflected the increased value of the government's gold
holdings. By December 1941, when World War II started, the money stock
had increased to $90.435 billion. By the end of the war, it had been
expanded to $113.597 billion. In the 1950s, the U.S. gold holdings began
to go down as other countries started to withdraw their gold from the
United States. However, money stock statistics continued to climb. At
the end of the Korean War (1955) it was approximately $133.3 billion. In
1971, Federal Reserve statisticians revised their money stock figures
(M2 consisted of currency outside of banks, demand deposits, plus time
deposits at commercial banks) and backtracked, calculating M2 in 1964 to
have been $273.8 billion. In 1971, Nixon stopped the sale of gold to
foreign governments and foreign central banks. He devalued the U.S.
dollar in December 1971, to $38 an ounce, and then again in February
1973 to $42.22. In January 1975, the U.S. government resumed selling
gold and U.S. citizens regained the right to own gold coins and gold
bullion. The price of an ounce of gold zoomed of the charts, indicating
the extent to which the effects of inflation, defined as monetary
increases, had been suppressed. After the end of the Vietnam War, M2
figures came to $576.5 billion.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
October 1999, Vol. 49, No. 10.
Yourname@libertyhaven.com
