Quantum Pranx

by Gary North

THIS QUESTION DIVIDES ECONOMISTS even more than it divides voters. Voters do not think much about this question. Economists think about it throughout their careers. They do not agree with each other regarding the answer. The problem is, about half of American economists who specialize in monetary theory and banking policy are either on the payroll of the Federal Reserve System or sell their services to the FED on a piece-rate basis.

Most of the others are trying to get in on the deal. Through the FED, economists set policy for American banking, and, through banking, just about everything else. The economists are not agreed. Federal Reserve policy is therefore not consistent. It is mostly a system of trial and error – these days, very large errors. Through the influence of the FED among foreign central banks, and through the influence of the top dozen American graduate schools, the confusion over what money is has spread to the entire world. In the area of monetary policy more than any other area of modern life, the self-certified, self-policed, and self-confident experts are making it up as they go along. Then the rest of us have to go along. In my forthcoming series of articles (not available here), you will learn the following:

1. The experts do not know horse apples from apple butter about monetary theory.
2. Monetary theory should be an integrated part of a general economic theory of how the world works.
3. Whenever an economic theory of how the world works makes an exception for monetary theory, the proposed monetary theory is incorrect, or the general theory is incorrect, or both are incorrect.
4. Fiat money is always a form of counterfeiting.
5. Counterfeiting produces bad results for almost everyone except the counterfeiters.
6. Fractional reserve banking is legalized counterfeiting.
7. Government fiat money is counterfeit.
8. Those who trust government money will lose wealth more surely than those who do not trust it.
9. There are ways to escape bad monetary policy.
10. The worse the policy, the fewer the avenues of escape.

If you stick with me through this series of articles on monetary theory and policy, you will have a much better idea about where modern society has gone wrong. You will also have a better idea of how to protect yourself against the inevitable consequences, all of which are negative, of the government’s violations of sound money principles.

It boils down to this question: If you don’t know what money is, how will you obtain more of it? This is another way of saying that if you don’t understand the modern violations of monetary theory, you will not understand the extent to which you are vulnerable to bad policies which are going to produce disastrous consequences, just as they have in the past.

THE DEBATE OVER MONEY
What is money? These three words introduce one of the most baffling areas of economic thought. I can think of no other area of economics in which there is greater confusion, leading to greater economic disruptions, than this one.

A characteristic feature of all systems of economic thought except the Austrian School is a failure to integrate monetary theory with general economic theory. With the exception of the Austrian School, all schools of thought create exceptions to the laws of economics that they say apply in all of the other areas of the economy. They insist that the government is necessary to intervene into the free market in order to bring order to monetary affairs.

They argue that money is not part of a system of economic practice and theory. They also imply that monetary theory is not part of an integrated system of economic cause-and-effect. The explanations given for economic causation in every other area of the economy are not accepted as valid in the realm of money. Monetary theory, when coupled with an explanation of how banking works, provides a case study of the unwillingness of economists to pursue the logic of economic causation. This should be a tip-off to the fact that there is something fundamentally wrong with either their theory of money or their general economic theory.

FOUR AREAS OF CONFUSION
The confusion regarding monetary theory and practice has several aspects. First, there is conceptual confusion. There is a lack of understanding of how the free market works. The two fundamental rules governing free-market pricing are these:
1. Supply and demand
2. High bid wins

When you apply these two principles to any area of the economy, you have the conceptual tools necessary to understand the basics of economic causation. All deviations from free-market economic theory invariably involve the abandonment of one or both of these two principles of economic analysis. This certainly applies in the area of monetary theory and monetary policy.

Second, there is the confusion over the origin of money. How did money come into existence? What motivated people to make the decisions that led to the institution of money? What interference with people’s motivation did the state impose in order to gain certain advantages for itself? How do these interventions reduce economic liberty and the smooth functioning of the monetary system?

Third, there is the financial issue. That which individuals want for themselves personally, namely, more money, is bad for the economy when either the state or the banking system interferes with private contracts. What we want to achieve for ourselves individually we had better avoid corporately: more money. This is not understood by virtually all schools of economic opinion, with the exception of the Austrian School.

Fourth, there is the political issue. There is great confusion over the proper relationship between civil government and monetary policy. Economists insist that the monetary system should not be autonomous; civil government must interfere in some way to provide stability and predictability to the monetary order. In rare instances, this is limited simply to the enforcement of contracts. In most cases, the principle of necessary government regulation is extended to mandate broad intervention by political authorities.

IDEAS HAVE CONSEQUENCES
There is a familiar phrase in the American conservative movement: ideas have consequences. This phrase comes from the book title of a 1948 book by English professor Richard Weaver. This principle certainly applies to monetary theory. Mistaken ideas have disastrous consequences.

Mistaken ideas in the area of monetary policy have produced more disasters than mistaken ideas in any other area of economic thought. There is a reason for this. Money is at the heart of the modern economy. Mistaken policies in the realm of money and banking spread to the entire economy. There is a kind of multiplication effect. The worse the idea in economic theory, the more widespread and devastating its consequences when the idea is applied to the monetary system.

There are five analytical categories in which mistaken ideas lead to bad economic policy. I summarize them as follows: sovereignty, authority, law, sanctions, and continuity. These five categories are crucial for economic analysis. They are exceptionally crucial in the realm of monetary policy, as I will demonstrate. They are violated constantly in modern society. They have been violated constantly ever since 1914: the outbreak of World War I. National governments and private banking came close to honoring the truth in these five categories for a century: 1815 to 1914. During that century, there was considerable monetary stability for Western Europe, leading to greater economic growth than any other period in the history of man.

Because of the violation of nineteenth-century monetary policy, we have seen the rise of world wars, hyperinflation, and depression. None of these would have been likely apart from fiat money, which is a violation of the law of property. This violation leads to terrible consequences in the real world.

WHAT IS MONEY?
Let us return to the original question: What is money? The best answer to this continual question was provided in 1912 by the Austrian economist, Ludwig von Mises. In his book, “The Theory of Money and Credit” he provided an answer in six words: money is the most marketable commodity. He had in mind gold and silver coins, but his theory encompassed any commodity that can or has served as money in history.

By defining money as the most marketable commodity, Mises integrated monetary theory with general economic theory. His theory of money was an extension of his theory of the free market. He rested his case for the free market on the right of private ownership.
I have said that there are five analytical categories in which mistaken ideas lead to bad economic policy: sovereignty, authority, law, sanctions, and continuity. Now I must explain what I mean.

1. SOVEREIGNTY. Property rights are the foundation of money, Mises argued. Property rights provide the legal setting for voluntary exchange. He argued that the development of money was an unplanned outcome of the decisions of individuals who sought to increase their wealth by increasing their productivity.

Individuals have always sought to specialize in those areas of production in which they have a competitive advantage. This advantage may be due to personal skills. It may be due to geographical location. Whatever the origin of the advantage, the individual seeks to exploit this advantage. He specializes in one area of economic production, so that he will have an increased quantity of goods and services to exchange with other individuals, who specialize in those areas in which they have a competitive advantage. Mises argued that out of the barter system came money. A monetary commodity was originally valued for something other than exchange. It may have been sought because it was beautiful. It may have been sought because it had religious significance. Whatever the reasons that people sought to accumulate a particular commodity, this led to the discovery that this particular commodity could be used to facilitate voluntary exchange.

Instead of having to find a buyer for the particular commodity or service that an individual produced, he could exchange his output for a commodity that was widely desired by other members of society. As these exchanges grew in number, this commodity began to attain value as a result of its ability to serve in the process of exchange. What had originally been a commodity valued for some other characteristic increasingly was valued for the purpose of facilitating exchange. In other words, this commodity became money.

As a free-market economist, Mises did not attribute the origin of money to the decision of a civil government. It was not that a particular king or group of nobles decided that it would be convenient if a particular commodity were adopted as money. On the contrary, governments began to extend their control over money because they recognized that they could increase their extraction of wealth from private citizens with greater efficiency if they taxed people’s monetary income rather than taxing their individual output. It was easier to collect money and spend it for the purposes of civil government than it was to collect hundreds or even thousands of goods. It was not that the state was the origin of money; it was that money became a tool of the expansion of the state. The state claimed sovereignty over money because it was convenient for the state to gain control over this most central of economic assets.

In short, Mises argued that the free-market social order possesses original sovereignty over money. Any claim by the civil government that it exercises sovereignty over money is not grounded in economic theory or the law of contracts. It is grounded in the desire of civil rulers to extract greater wealth from those under their authority.

2. AUTHORITY. Mises argued that the authority over money originally came from the authority of individuals to exchange their goods and services voluntarily. There is a hierarchy of control that is based on individual ownership. Civil government attempts to gain authority over monetary affairs because it is less expensive for the government to expand its authority over every other area of life when it controls the monetary system. In short, there are both competing sovereignty and competing authority – market vs. state – in the competitive arena of monetary policy.

3. LAW. There is a law of monetary affairs, but this law is not unique to money. The general law of contracts led to the creation of money. A legal order that enabled individuals to exercise control over their labor, their property, and the output of the combination of labor and property led to the establishment of a monetary system.

The law of pricing is no different from the law of any other asset. Again, there are two laws: first, supply and demand; second, high bid wins. As these two laws extend to the general society, the monetary order comes into existence.

Here is Mises’ central point: the monetary system is the product of human action, but not human design. This is what is denied by all schools of economic opinion except the Austrian School. All the schools of opinion believe that, for the proper functioning of money, the civil government, because of its inherent sovereignty, must exercise control over money. So, it must have legal authority over money. This means that the law of money, as an extension of the law civil government, is different from the laws governing voluntary economic exchange.

4. SANCTIONS. Then there are sanctions. Government imposes sanctions for violating civil law. What are the comparable sanctions in the realm of monetary policy? The sanctions are simple: profit and loss. These two sanctions govern the realm of voluntary economic exchange. They therefore govern the realm of monetary policy. The sanctions of profit and loss, which apply to every other area of voluntary exchange, also apply in the realm of monetary policy, and therefore should apply in the realm of monetary theory. But, we find that this is not the case in any school of economic opinion except the Austrian School.

5. CONTINUITY. The fifth category of economic analysis that applies to money is the category of continuity. Continuity is the crucial factor in all ownership. Does an individual have the right to retain possession of his property through time? Do voluntary exchanges transfer ownership of property to other individuals? If the answer is yes, then the same degree of continuity must prevail in the realm of monetary policy. One of the central factors in all forms of money is continuity through time. If an individual does not believe that a particular asset will enable him to purchase scarce goods and services in the future, the value of the monetary unit will fall. It will fall to whatever value that consumers impute to it for their purposes. If gold or silver coins were expected to be abandoned by market participants who are seeking stability of purchasing power over time, the value of the two metals would fall to whatever they are worth in other areas of the economy.

It is more likely that pieces of paper with rulers’ pictures on them will be subjected to doubts concerning their continuity of value than gold or silver coins that are used widely in exchange.

In summary, the original sovereignty over money was established by the free market, which is in turn was an extension of a particular legal order. Second, authority over money inheres in an individual’s right to possess property. Third, the law of money is an extension of the law of private property. It is in no way different from the general legal order that governs ownership and exchange. Fourth, the sanctions of profit and loss apply to money, just as they apply to all the other areas of the free market economy. Finally, there is continuity of money over time because there is continuity of ownership over time.

CONCLUSION
Money is an extension of the free-market social order. To the extent that civil government interferes with money, it interferes with the operations of the free-market order. Interference in the area of money beyond the general application of laws governing contracts has more extensive consequences, all negative, than interference in any other area of the economy. This is because money is the universal facilitator of voluntary exchange. An error in policy in the realm of money extends to the entire society.

I have surveyed the Austrian School’s theory of money. This theory began with Ludwig von Mises’ “Theory of Money and Credit” (1912). I presented Mises’ theory of fractional reserve banking and the creation of the business cycle in my mini-book, Mises on Money (2002).

I have done my best to get across a line of reasoning regarding money. This line of reasoning is not shared by other schools of economic thought. To the extent that it is understood by the decision-makers in the governments of the world and central banks, it is resisted. It is regarded as old-fashioned and out of touch with newer, more scientific theories of money and banking.

The crisis of 2008 has led to a revival of interest in the Austrian School’s theory of the business cycle. Why? Because several Austrian School economists and newsletter writers warned of the looming crisis. They did so two years before it hit. These predictions were dismissed as radical and out of touch. The most widely viewed debate over this matter – after the fact – took place on CNBC in 2006. Peter Schiff warned of the recession. Arthur Laffer dismissed it. Finally, the Wall Street Journal ran an article on Mises’ prediction of the Great Depression. The article ran on November 6, 2009. Better late than never.

MY FUNDAMENTAL POINT
Earlier, I made the point that the Austrian School’s theory of money is an extension of its overall theory of economic exchange. This distinguishes the Austrian School’s view from all rival views of money.

The rival views insist that the free market is insufficient to provide a reliable monetary system. Either the national government or the nation’s central bank must intervene in the free market in order to provide stability and reliability to the money system and therefore to the economy.

The logical extension of this outlook is that there is a great need for a world government and a world central bank, which together provide such stability internationally. Most economists and politicians refuse to say this in public, but this is a matter of prudence, not logic.

In contrast, the Austrians say that the free market can provide such a system of world money. We have already seen this system in operation. It was called the gold standard. It operated for most of the nineteenth century. It needed no world government and no world central bank to make it work. It did not need trained economists to make it work. You can imagine how popular Austrian School economics is with economists – about as popular as the gold standard.

The non-Austrians insist that money needs government coercion in order to be money. Money may have started without coercion, but this condition cannot last for long, nor did it. The defenders of this position rarely come out and explain why, in terms of their theory of markets, money is different from other goods and services. If private property and the right of exchange produce efficient markets for other scarce resources, why not for money? They do not say, exactly. They just insist that this is the case.

Then, not surprisingly, we find that in exception after exception, they insist that other aspects of the economy also cannot function without state coercion. In niche after niche, in sector after sector, we are told that market-clearing bids cannot arise. But the biggest sector of all is money.

WHAT IS MONEY?
Mises defined money in 1912. Money is the most marketable commodity. This identifies the central benefit of money: a means of exchange. Contrary to the standard textbook accounts, money is not a measure of value. There is no measure of value. Value is subjective. You could as easily measure your love for your children. Also contrary to these accounts, money is not a store of value, although it is a valuable thing to store. There is no store of value. There is at best continuity of price.

Money is a unit of account. It makes possible modern double-entry bookkeeping. Mises said that this was one of the greatest inventions of the modern world. Mises argued that money arose out of voluntary exchange. A commodity that had been sought and bought for attributes other than its use as a means of exchange became a commonly accepted means of exchange. This created new demand for it. The government did not create money. Individual decision-makers did. Civil government soon insisted on sovereignty over money. It stamped coins. This authenticated the coins. But, when governments found that they could steal from the public by debasing the gold or silver coins with cheaper (base) metals, the newer unauthentic coins de-legitimized the inflating governments. Authenticity became unauthenticity.

Fiat money is a form of counterfeiting. In a world of fiat national moneys that are in competition with each other, national governments have become members in a kind of competitive cartel of counterfeiters. “My counterfeit money is better than yours!” they insist. Gresham’s law states that bad money drives out good money. This law holds true only when governments set price controls – fixed rates of exchange – between different forms of money. The artificially overvalued money drives the artificially undervalued money out of circulation. We do not see gold and silver coins in use as money today because governments have artificially overvalued their own national currencies.

FIVE DECIDING ISSUES
There are five fundamental issues in every social order and every institution: (1) sovereignty, (2) authority, (3) law, (4) sanctions, and (5) continuity. Put in easily memorized form, they are:

1. Who’s in charge here?
2. To whom do I report?
3. What are the rules?
4. What do I get if I obey? (disobey?)
5. Does this outfit have a future?

With respect to money, the Austrian theory of money answers these questions as follows:
1. The free market
2. The individual who has money
3. The right of exchange/contract
4. Profit and loss
5. Long use encourages future use

With respect to money, the other schools of opinion differ from each other, but not on these issues:

1. The state
2. The fractional reserve banking system
3. Never allow price deflation
4. Big bank bailouts
5. People will adjust to price inflation

The universal outlook of the non-Austrian schools of thought is that a steady price deflation is always bad, but a little price inflation is not so bad, and it is surely better than price deflation, recession, or depression. In all theories of money except Austrianism, the state is seen as the necessary agent of planning. Even in schools of thought that proclaim the inefficiency of central planning, the members hold to the necessity of scientific central planning of money. All of them call for the economists employed by the state-created central bank to adjust the money supply in order to achieve specific outcomes. Deep within every non-Austrian free market economist, there is a central planner screaming to get out.

FRACTIONAL RESERVE BANKING
Under fractional reserve banking, banks are allowed to lend out money that has been promised to depositors. The depositors think of their deposits as money. So do borrowers. Borrowers spend this money. Then, one dark day, depositors also try to spend this money. A bank run begins.

Let us review how the system works. A bank accepts a deposit of $100. It sends $10 to the regional Federal Reserve Bank as its mandated legal reserve. It lends out $90. The borrower spends this money. His bank takes $9 and sends it to the FED. Then it lends out $81. On and on it goes, until the original $100 deposit turns into $900. Inflationary? You bet!

The fractional reserve process allows the banking system to expand the money supply. This creates an economic boom by lowering commercial interest rates. To lend this new money, banks must find borrowers. To lure them in, the banks have to offer lower interest rates than what prevailed before the fiat money was created.

Entrepreneurs who borrow the money begin new projects. But then they find that they are running short of capital. The increase in fiat money did not represent an increase in thrift: future-orientation of consumers, i.e., a willingness to defer consumption. Businessmen must now compete for more money to finish projects. Interest rates rise. More companies then shut down incomplete projects. The recession begins.

Fractional reserve banking rests on an impossibility: that all depositors can withdraw currency at the same time, even though the money has been loaned out. The bank’s contract allows depositors to withdraw currency on demand. This contract is inherently fraudulent. It cannot be fulfilled in a banking crisis. There are two legal claims on the same money: depositor and borrower.

If the bank’s contract with depositors had specified that the money would not available until the subsequent loan was repaid by the borrower, there would be no problem. The problem arises from the simultaneity of economic value across time. Future value is always discounted by time. This is the phenomenon known as the time value of money. Mises called it time preference.

The heart of the contract’s problem is that current money is always worth more than future money. The value of future money is discounted by three factors:

1. The discount of all future value
2. The risk of non-payment
3. The inflation premium (depreciated money)

Fractional reserve banking rests on an impossibility: “The discount applied to future money will not change.” When a banking crisis occurs because of this, the size of the discrepancy between the present value of money and its future value, there are bank runs. The discount applied to future money increases due to a rising risk of default. “A bird in hand is worth two under the bush.” Depositors want their now even more valuable present money rather than a legal claim on now less valuable future money. The banks do not have the currency to pay off the depositors.

The bank then calls in whatever loans that it can. The debtors cannot repay. They go bankrupt. Then banks that lent them the money go bankrupt. A depression takes place because pricing of capital goods was made on a false assumption: the depositors would never all demand their money at the same time. The assumption is false because the initial premise was false: “The present value of future money will not depreciate so much as to cause a run on the banks.”

But couldn’t bans raise the interest paid to depositors? Of course. They could get out their iPhones and speed dial 1-800-FREE-LUNCH!

Maybe depositors get fired because their employers could not meet the demand for repayment to the banks. The depositors then demand immediate money. Banks cannot deliver. The collapse of overextended banks exacerbates the depression. The inverted pyramid of debt collapses. What goes up (boom) must come down (bust). But not for long. The central bank then steps in and creates new money to forestall this collapse. Another round of counterfeiting begins.

BOOM-BUST, BUST-BOOM
The reason why economies suffer from booms and busts is because the fractional reserve banking process continues. It continues because there is an enforcer who calls the bust to a stop before prices have adjusted to the new conditions of supply and demand. The enforcer is the central bank.

A central bank’s primary function in every nation is to keep large banks in the banking cartel from going bankrupt. The big banks are never allowed to go belly-up. The central bank always intervenes and creates new fiat money to bail out the big banks. If it doesn’t, the government does. The cure for the bad outcome of fiat money inflation – depression – is always another round of monetary inflation. This sets off the boom-bust cycle once again.

Once started, the process continues, generation after generation. The groups that prospered from the fiat money–induced boom demand bailouts. Some of them do get bailed out by the government. These bailouts are paid for by new government debt (no change in the money supply) and also by fiat money issued by the central bank. There is never a day of final reckoning. Everyone plays kick the can. This is point five: continuity. It is the continuity of deferred judgment (point four). The profit and loss system is not allowed to work. Monetary reform never takes place because everyone wants to defer final judgment. Everyone wants to go to heaven, but nobody wants to die. Everyone wants a stable economy with growth. No one wants recession and increased bankruptcies to re-price capital goods. So, kick the can always results in another round of monetary inflation. The boom-bust cycles repeat.

This is continuity in the modern fiat money economy. The voters want it. The debtors want it. The banks want it. Businessmen want it. The result: American prices as measured by the consumer price index have risen by a factor of 20 since the Federal Reserve System began operating in 1914. The dollar has depreciated by about 95%. There is never a monetary reform that in fact reforms the system. All monetary reforms are applications of kick the can.

WHERE DOES IT ALL END?
If kick the can continues, fiat money will depreciate. People will take on new debt on the assumption that inflation will let them repay their debts with money of reduced purchasing power. When recession hits, they demand government action. This means more inflation.

Mises argued that when people catch on to the game, they will take evasive action. They will make plans in terms of rising prices. Other economists have agreed. But this led Mises to argue that the economic contraction would come if the supply of money were not increased at an ever-higher rate and unexpected rate. Inflation would become hyperinflation. He saw this take place in Austria a decade after The Theory of Money and Credit was published.

He was once asked if he had a hedge against inflation. He replied: “Age.”

There must be a default at some point. The question is: “Which kind?” If the central bank ceases to inflate, a recession begins. If the government or the central bank refuses to intervene, many banks go under. This shrinks the money supply. The recession becomes a depression. Bankruptcies and unemployment increase.

Tax revenues fall. The government cannot pay its debt and also meet all of its promises. It must choose:
1. Default on all of the debt
2. Default on part of the debt
3. Tell the central bank to inflate
4. Raise taxes and cut expenditures
Choice #3 starts the process over. The ultimate result: the destruction of the currency. This is default through inflation. It is nonetheless a default.

CONCLUSION
Decide which way of default is most likely. Then decide when. Then plan accordingly.
Or you can do what the policy-makers do. Kick the can. Most people do.
But then, one day, there is a day of reckoning. However, until then. . . .
“We’ll have fun, fun, fun till the market takes our T-bills away.”