MOST ECONOMISTS are in agreement that the inflation in
the United States during the past three years has been the worst since
the early 1940's, taking account of both severity and duration. But they
cannot agree on the nature of the inflation that is engulfing the
American economy. To some, inflation denotes a spectacular rise in
consumer prices; to others, an excessive aggregate demand; and to at
least one economist, it is the creation of new money by our monetary
authorities.
This disagreement among economists is more than an
academic difference on the meaning of a popular term. It reflects
professional confusion as to the cause of the inflation problem and the
policies that might help to correct it.
A review of some basic principles of economics that are
applicable to money may shed light on the problem.
Two basic questions need to be answered: (1) What are
the factors that originally afforded value to money, and (2) What are
the factors that effect changes in the "objective exchange value of
money" or its purchasing power?
Money is a medium of exchange that facilitates trade in
goods and services. Wherever people progressed beyond simple barter,
they began to use their most marketable goods as media of exchange. In
primitive societies they used cattle, or measures of grain, salt, or
fish. In early civilizations where the division of labor extended to
larger areas, gold or silver emerged as the most marketable good and
finally as the only medium of exchange, called money. It is obvious that
the chieftains, kings, and heads of state did not invent the use of
money. But they frequently usurped control over it whenever they
suffered budget deficits and could gain revenue from currency
debasement.
When an economic good is sought and wanted, not only f
or its use in consumption or production but also for purposes of
exchange, to be held in reserve for later exchanges, the demand for it
obviously increases. We may then speak of two partial demands which
combine to raise its value in exchange - its purchasing power.
The Origin of Money Value
People seek money because it has purchasing power; and
part of this purchasing power is generated by the people's demand for
money. But is this not reasoning in a vicious circle?
It is not! According to Ludwig von Mises' "regression
theory," we must be mindful of the time factor. Our quest for cash
holdings is conditioned by money purchasing power in the immediate past,
which in turn was affected by earlier purchasing power, and so on until
we arrive at the very inception of the monetary demand. At that
particular moment, the purchasing power of a certain quantity of gold or
silver was determined by its non-monetary uses only.
This leads to the interesting conclusion that the
universal use of paper monies today would be inconceivable without their
prior use as "substitutes" for real money, such as gold and silver, for
which there was a non-monetary demand. Only when man grew accustomed to
these substitutes, and governments deprived him of his freedom to employ
gold and silver as media of exchange, did government tender paper emerge
as the legal or "fiat money." It has value and purchasing power,
although it lacks any non-monetary demand, because the people now direct
their monetary demand toward government tender paper. If for any reason
this public demand should cease or be redirected toward real goods as
media of exchange, the fiat money would lose its entire value. The
Continental Dollar and various foreign currencies over the years
illustrate the point.
On Demand and Supply
The purchasing power of money is determined by the
demand for and supply of money, like the prices of all other economic
goods and services. The particular relation between this demand and
supply determines its particular purchasing power. So, let us first look
at those factors that exert an influence on individual demand for money.
As money is a medium of exchange, our demand for it may
be influenced by considerations of facts and circumstances either on the
goods side of the exchange or on the money side. Therefore, we may speak
of goods-induced factors and money-induced factors.
Variation on the Side of Goods
A simple example may illustrate the former. Let us
assume we live in a medieval town that is cut off from all fresh
supplies by an enemy army. There is great want and starvation. Although
the quantity of money did not change - no gold or silver has left our
beleaguered town - its purchasing power must decline. For everyone seeks
to reduce his cash holdings in exchange for some scarce food in order to
assure survival.
The situation is similar in all cases where the supply
of available goods is decreased although the quantity of money in the
people's cash holdings remains unchanged. In a war, when the channels of
supply are cut off by the enemy or economic output is reduced for lack
of labor power, the value of money tends to decline and goods prices
rise even though the quantity of money may remain unchanged. A bad
harvest in an agricultural economy may visibly weaken the currency.
Similarly, a general strike that paralyzes an economy and greatly
reduces the supply of goods and services raises goods prices and
simultaneously lowers the purchasing power of money. In fact, every
strike or sabotage of economic production tends to affect prices and
money value even though this may not be visible to many observers.
Some economists also cite the level of taxation as an
important factor in the determination of the exchange value of money.
According to Colin Clark, whenever governments consume more than 25 per
cent of national product, the reduction in productive capacity as a
result of such an oppressive tax burden causes goods prices to rise and
the purchasing power of money to fall. According to that view, with
which one may disagree, high rates of taxation are the main cause of
"inflation." At any rate, there can be no doubt that the American dollar
has suffered severely from the burdens of Federal, state, and local
government spending and taxing that exceed 35 per cent of American
national product.
Yet, this purchasing power loss of the dollar would
have been greater by far if a remarkable rise in industrial productivity
had not worked in the opposite direction. In spite of the ever-growing
burden of government and despite the phenomenal increase in the supply
of money (to be further discussed below), both of which would reduce the
value of the dollar, American commerce and industry managed to increase
the supply of marketable goods, thus bolstering the dollar's purchasing
power. Under most difficult circumstances, businessmen managed to form
more capital and improve production technology, and thus made available
more and better economic goods which in turn helped to stabilize the
dollar. Without this remarkable achievement by American entrepreneurs
and capitalists, the U.S. dollar surely would have followed the way of
many other national currencies to radical depreciation and devaluation.
Factors on the Side of Money
There also are a number of factors that affect the
demand for money on the money side of an exchange. A growing population,
for instance, with millions of maturing individuals eager to establish
cash holdings, generates new demand, which in turn tends to raise the
purchasing power of money and to reduce goods prices.
On the other hand, a declining population would
generate the opposite effect.
Changes in the division of labor bring about changes in
the exchange value of money. Increased specialization and trade raises
the demand and exchange value of money. The nineteenth century frontier
farmer who tamed the West with plow and gun was largely self-sufficient.
His demand for money was small when compared with that of his great
grandson who raises only corn and buys all his foodstuff in the
supermarket. Under a modern and a highly advanced division of labor, one
needs money for the satisfaction of all his wants through exchange. It
is obvious that such demand tends to raise the exchange value of money.
On the other hand, deterioration of this division of labor and return to
self-sufficient production, which we can observe in many parts of Asia,
Africa, and South America, generates the opposite effect.
Development and improvement of a monetary clearing
system also exert an influence toward lower money value. Clearing means
offsetting payments by banks or brokers. It reduces the demand for
money, as only net balances are settled by cash payments.
The American clearing system which gradually developed
over more than 130 years from local to regional and national clearing,
slowly reduced the need and demand f or cash and thus its purchasing
power. Of course, this reduction of the dollar's exchange value was
negligible when compared with that caused by other factors, especially
the huge increase in money supply.
Business practices, too, may influence the demand for
money and therefore its value. It is customary f or business to settle
its obligations on the first of the month. Tax payments are due on
certain dates. The growing popularity of credit cards reduces the need
for money holdings throughout the month, but concentrates it at the
beginning of the month when payments fall due. All such variations in
demand affect the objective exchange value of money.
The Desires of individuals for Larger or Smaller Holdings
The most important determinant of purchasing power of
money under this heading of "money-induced factors" is the very attitude
of the people toward money and their possession of certain cash
holdings. They may decide for one reason or another to increase or
reduce their holdings. An increase of cash holdings by many individuals
tends to raise the exchange value of money, reduction of cash holdings
tends to lower it.
This is so well understood that even the mathematical
economists emphasize the money "velocity" in their equations and
calculations of money value. Velocity of circulation is defined as the
average number of times in a year which a dollar serves as income (the
income velocity) or as an expenditure (the transaction's velocity) . Of
course, this economic use of a term borrowed from physics ignores acting
man who increases or reduces his cash holdings. Even when it is in
transport, money is under the control of its owners who choose to spend
it or hold it, make or delay payment, lend or borrow. The mathematical
economist who weighs and measures, and thereby ignores the choices and
preferences of acting individuals, is tempted to control and manipulate
this "velocity" in order to influence the value of money. He may even
blame individuals (who refuse to act in accordance with his model) for
monetary depreciation or appreciation. And governments are only too
eager to echo this blame; while they are creating ever new quantities of
printing press money, they will restrain individuals in order to control
money velocity.
It is true, the propensity to increase or reduce cash
holdings by many people exerts an important influence on the purchasing
power of money. But in order to radically change their holdings,
individuals must have cogent reasons. They endeavor to raise their
holdings whenever they foresee depressions ahead. And they usually lower
their holdings whenever they anticipate more inflation and declining
money value. In short, they tend to react rationally and naturally to
certain trends and policies. Government cannot change or prevent this
reaction; it can merely change its own policies that brought forth the
reaction.
The Supply of Money
No determinant of demand, whether it affects the goods
side of an exchange or the money side, is subject to such wide
variations as is the supply of money. During the age of the gold coin
standard when gold coins were circulating freely, the supply of money
was narrowly circumscribed by the supply of gold. But today when
governments have complete control over money and banking, when central
banks can create or withdraw money at will, the quantity of money
changes significantly from year to year, even from week to week. The
student of money and banking now must carefully watch the official
statistics of money supply in order to under stand current economic
trends.
Of course, the ever-changing supply of money must not
be viewed as a factor that evenly and uniformly changes the level of
goods prices. The total supply of money in a given economy does not
confront the total supply of goods. Changes in money supply always act
through the cash holdings of individuals, who react to changes in their
personal incomes and to changing interest rates in the loan market. It
is through acting individuals that supply changes exert their influences
on various goods prices.
In the United States, we have two monetary authorities
that continually change the money supply: the U.S. Treasury and the
Federal Reserve System. As of February 28, 1969, the U.S. Treasury had
issued some $6.7 billion of money, of which $5.1 billion were fractional
coins. The Federal Reserve System had issued $46.3 billion in notes and,
in addition, was holding some $22 billion of bank reserves. Commercial
banks were holding approximately $150 billion in demand deposits and
some $201 billion in time deposits, all of which are payable on demand
in "legal money," which is Federal Reserve and Treasury money.
The vast power of money creation held by the Federal
Reserve System, which is our central bank and monetary arm of the U.S.
Government, becomes visible only when we compare today's supply of money
with that in the past. Let us, therefore, look at the volume of Federal
Reserve Bank credit on various dates since 1929:
| Date |
Total in Billions |
| 1929 June |
$ 1.3 |
| 1939 Dec. |
2.6 |
| 1949 Dec. |
22.5 |
| 1959 Dec. |
29.4 |
| 1969 Aug. 20 |
58.2 |
|
Source: Federal Reserve Bulletins.
These figures clearly reveal the nature and extent of
the inflation that has engulfed us since the early 1930's. The 1940's
and again the 1960's stand out as the periods of most rapid inflation
and credit expansion.
How Government Creates Money
Why and how do our "monetary authorities" create such
massive quantities of money that inevitably lead to lower money value?
During the 1940's, the emergency argument was cited to justify the
printing of any quantity the government wanted for the war effort.
During the 1960's, the Federal government through its Federal Reserve
System was printing feverishly in order to achieve full employment and a
more desirable rate of economic growth. Furthermore, the ever-growing
public demand for economic redistribution inflicted budgetary deficits,
the financing of which was facilitated by money creation.
How was it done? The Federal Reserve has at its
disposal three different instruments of control which can be used singly
or jointly to change the money supply. It may conduct "open-market
purchases," i.e., it buys U.S. Treasury obligations in the capital
market and pays for them with newly-created cash or credit. Nearly all
the money issued since 1929 was created by this method. Or, the Federal
Reserve may lower its discount rate, which is the rate it charges
commercial banks for accommodation. If it lowers its rate below that of
the market, demand will exceed supply, which the Federal Reserve then
stands ready to provide. Or finally, the Federal Reserve may reduce the
reserve requirements of commercial banks. Such a reduction will set
Federal Reserve money free for loans or investments by commercial banks.
It does not matter how the new money supply is created.
The essential fact is the creation by the monetary authorities. You and
I cannot print money, for this would be counterfeiting and punishable by
law. But our monetary authorities are creating new quantities every day
of the week at the discretion of our government leaders.
This fact alone explains why ours is an age of
inflation and monetary destruction.
Variable Responses
The Quantity Theory, which offers one of the oldest
explanations in economic literature, demonstrates the connection between
variations in the value of money and the supply of money. Of course, it
is erroneous to assume, as some earlier economists have done, that
changes in the value of money must be proportionate to changes in the
quantity of money, so that doubling the money supply would double goods
prices and reduce by one-half the value of money.
As was pointed out above, changes in supply always work
through the cash holdings of the people. When the government resorts to
a policy of inflation, some people may react by delaying their purchases
of certain goods and services in the hope that prices will soon decline
again. In other words, they may increase their cash holdings and thereby
counteract the price-raising effect of the government policy. From the
inflators' point of view, this reaction is ideal, for they may continue
to inflate while these people through their reaction may prevent the
worst effects of inflation. This is probably the reason why the U.S.
Government, through post office posters, billboards, and other
propaganda, endeavors to persuade the American people to save more money
whenever the government itself resorts to inflation.
When more and more individuals begin to realize that
the inflation is a willful policy and that it will not end very soon,
they may react by reducing their cash holdings. Why should they hold
cash that depreciates, and why should they not purchase more goods and
services right now before prices rise again? This reaction intensifies
the price-raising effects of the inflation. While government inflates
and people reduce their money demand, goods prices will rise rapidly and
the purchasing power of money decline accordingly.
Passing the Buck
It may happen that the government may temporarily halt
its inflation, and yet the people continue to reduce their cash demand.
The central bank inflators may then point to the stability of the money
supply, and blame the people for "irrational" behavior and reaction. The
government thus exculpates itself and condemns the spending habits of
the people for the inflation. But in reality, the people merely react to
past experiences and therefore anticipate an early return of
inflationary policies. The monetary development during most of 1969
reflected this situation.
Finally, the people may totally and irrevocably
distrust the official fiat money. When in desperation they finally
conclude that the inflation will not end before their money is
essentially destroyed, they may rush to liquidate their remaining cash
holdings. When any purchase of goods and services is more advantageous
than holding rapidly depreciating cash, the value of money approaches
zero. The money then ceases to be money, the sole medium of exchange.
When government takes control over money, it not only
takes possession of an important command post over the economic lives of
the people but also acquires a lucrative source of revenue. Under the
ever-growing pressures for government services and functions, this
source of revenue - which can be made to flow quietly without much
notice by the public - constitutes a great temptation for weak
administrators who like to spend money without raising it through
unpopular taxation. The supply of money not only is the best indicator
as to the value of money, but reflects the state of the nation and the
thinking of the people.
At the time of the original publication, Dr. Sennholz
headed the Department of Economics at Grove City College in
Pennsylvania.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
November 1969, Vol. 19, No. 11.
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